Monthly Archives: February 2019

RIA PRO: The Trade War Is Over, Long Live The Trade War


  • New Newsletter Format
  • Market & Portfolio Positioning Review 
  • The “Art Of The Deal” & How To Lose A Trade War
  • New: Financial Planning Corner
  • Sector & Market Analysis
  • 401k Plan Manager

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New Newsletter Format

We have recently been running lots of surveys on our newsletter, particularly with those who “unsubscribed” to our email list. Over the years, the newsletter has transformed several times due to your inputs.

We are always trying to improve the quality of our content to keep you informed on what is happening with your money, our portfolios, and the world between us.

It is with this understanding we are implementing a few new “tweaks” to our newsletter.

  1. A couple of weeks ago we introduced a new Financial Planning Corner to assist with some of the questions faced by individuals approaching, or in, retirement. 
  2. The “market review” at the beginning of the newsletter will remain but will be expanded to include what we are doing, if anything, with our client portfolios. 
  3. The “macro view” is now being written as a separate piece and will be a prominent link in the newsletter. This will shorten the length of the newsletter but still provide access to our macro-viewpoints on the economy and markets. 
  4. Lastly, the 401k Plan Manager has been condensed to make it more useable in a “quick format” structure. We have also launched a full “live” version which compares your portfolio to our recommended model at RIAPRO.NET.

We hope you will find these changes useful and we continue to look forward to your recommendations, criticisms, and comments so we can continue to improve our newsletter for your benefit.

After all, it is YOUR money we want to make sure you keep it.

Merry Christmas.

Lance Roberts, RIA Advisors



Catch Up On What You Missed Last Week


Market & Portfolio Positioning Review

“The ‘Trade War” Is Dead…
Long Live The ‘Trade War.'”

On Friday, “Phase One” of the “Trade Deal” was agreed to, with the Trump Administration originally stating that “Phase Two” would not begin until after the 2020 election.

Then reality set in. 

Since 2018, President Trump has come to understand that if the market declines, a “tweet” about a “trade deal coming” would spark a market rally. Without a “trade deal” to negotiate, there is no catalyst to support asset prices heading into the election. This is why on Friday, Trump immediately declared that “Phase Two” of the trade deal would begin immediately. 

Long live the “trade war.” 

In our “Macro View” piece below we go into much more detail about the “trade deal” and what to expect next. However, from an investment view, the agreement is clearly about two things:

  1. Boosting exports of Agricultural Products; and,
  2. Devaluing the Dollar. 

With the Fed giving up on their mandate to maintain price stability, (they recently stated they will let inflation “run hot,”), the path was cleared for the Trump Administration to devalue the U.S. dollar (which is inflationary) without worries the Fed will start hiking rates. 

This is one of the reasons we have started laying commodity exposure into our portfolios with the recent positions in precious metals and energy. We recently published a thesis “Collecting Tolls On The Energy Express” for our RIAPRO subscribers. (You can download the full report with a FREE 30-Day Trial.) 

“This model forecasts the price of MLPI based on changes to the price of XLE and the yield of U.S. Ten-year Treasury Notes. The model below has an R-squared of .76, meaning 76% of the price change of MLPI is attributable to the price changes of energy stocks and Treasury yields. Currently the model shows that MLPI is 20% undervalued (gray bars).  The last two times MLPI was undervalued by over 20%, its price rose 49% (2016) and 15% (2018) in the following three months.”

The Demise Of The Dollar

As shown in the chart below, the dollar has broken below both its rising trendline from its previous lows and the 200-dma. 

(We cover the dollar and positioning each week for our RIAPRO subscribers because the dollar impacts exports which makes up about 40% of corporate profits.)

Currently, the breakdown is very early in it potential progress. As we saw in June, that breakdown was short-lived before it reversed as foreign dollars continue to poor into USD denominated assets for both safety and higher returns than elsewhere in the world. 

We previously discussed this important point in “The Great Cash Hoard Of 2019.”

“As it relates to foreign positioning, it is worth noting that EURODOLLAR positioning has been surging over the last 2-years. This surge corresponds with the surge in dollar-denominated money market assets.

What are Euro-dollars? The term Eurodollar refers to U.S. dollar-denominated deposits at foreign banks, or at the overseas branches, of American banks. Net-long Eurodollar positioning is at an all-time record as foreign banks are cramming money into dollar-denominated assets to get away from negative interest rates abroad.”

Importantly, when positioning in the Eurodollar becomes extremely NET-LONG, as it is currently, the reversal of that positioning has been associated with short- to intermediate corrections in the markets, including outright bear markets. 

What could cause such a reversal? A pick up of economic growth, a reversal of negative rates, a realization of over-valuation in domestic markets which starts the decline in asset prices, or the devaluation of the US Dollar.

A reversal of positioning would spark a virtual spiral, with assets flowing out, which lowers asset prices, leading to more asset outflows. While the bulls are certainly hoping the “cash hoard” will flow into U.S. equities, the reality may be quite different.

Watch the dollar closely.

Santa To Visit Broad & Wall

As we head into the last two weeks of the year, and the decade, it is time for Santa to visit “Broad & Wall.” While I expect the markets to try to rally into year end there are a couple of caveats which could derail that optimism. 

Currently, “bullish sentiment” and “optimism” is once again extremely lopsided. Currently, investor cash is at extremely low levels, with investors fully allocated to equity risk. This is a sharp reversal from this summer when “everyone” thought a “recession” was near. 

Lastly, the markets are back to extremely extended and overbought conditions in the short-term which suggests the majority of the current advance has been made and a correction is needed before a further advance can be made.

With the market currently overbought and more than 7% above the 200-dma, corrections usually come before the next advance ensues.. Such suggests being a little prudent in adding exposure too aggressively and look for weakness to opportunistically position portfolios. 

On a monthly basis we see much the same deviation from long-term (3-year) moving averages. Historically, when extensions from the long-term moving average are this extreme, corrections have tended to occur. In most instances that reversion entailed a correction back to the long-term mean. 

Rules For A Santa Rally

Currently, our portfolio allocations remain primarily long-biased although we are carrying a slight overweight position in cash, we have also recently added positions to take advantage of a potentially weaker dollar, and a steeper yield curve. We also recently took profits in our Healthcare sector which has gotten grossly extended. 

These processes follow our basic rules of portfolio management which you can apply to your portfolio as well to reduce overall volatility risk.

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

Notice, nothing in there says “sell everything and go to cash.”

Remember, our job as investors is actually pretty simple – protect our investment capital from short-term destruction so we can play the long-term investment game. Here are our thoughts on this.

  • Capital preservation
  • A rate of return sufficient to keep pace with the rate of inflation.
  • Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)
  • Higher rates of return require an exponential increase in the underlying risk profile.  This tends to not work out well.
  • You can replace lost capital – but you can’t replace lost time.  Time is a precious commodity that you cannot afford to waste.
  • Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

With forward returns likely to be lower and more volatile than what was witnessed over the last decade, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the coming decade.


The Macro View

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

See you next week.


“NEW” – Financial Planning Corner

by Danny Ratliff, CFP®, ChFC®


Diversification

How well do you know diversification? Not your typical asset class diversification that every advisor talks about. BUT, beyond the typical industry norm of having Large cap, Mid cap, Small cap, international stocks and bonds as diversification.  The type that many advisors don’t speak of, but I feel there is a growing army of advisors ready to conquer. These advisors are ready and willing to equip you with more information, better information to help you make the best decisions beyond just diversification of your investments, but to giving your investments freedom.

Freedom! We all like freedom, well most of us do. It’s kind of a funny thing to think about freeing your money; but let me explain. Assets are only worth what they are on paper until they are taxed.

If you could have funds in 3 different accounts: a partially taxable account, a tax free account and a fully taxable account where would you want these funds?

Allow me to put these in order:

  1. Tax Free
  2. Partially Taxable
  3. Fully Taxable

WHAAAA???? You guys ever seen the minions? I’d put a picture here, but you know that little copyright thing. Look it up and you’ll understand, but this is how I imagine many reactions.

CPA’s as well. (Unfortunately, most people judge them on how much they can save us today versus a forward looking or advisory view.)

Understandably so, you’ve been taught, we’ve all been taught that we need to sock away every dollar we can into a pretax account because inevitably we will all be in a lower tax bracket when we retire.

What if we aren’t?

What if the government spends to much money? What if they just want to redistribute? What if we see higher taxes?

What if after your work benefits, retirement contributions and health care premiums you’re in the same tax bracket in retirement as you were in your working years.

How far will your money go?

Scared yet? Yeah, #metoo. Let’s start a movement. #makethesefundsmineagain catchy if I don’t say so myself.

In the new year we’ll be discussing how to keep more money from the dreaded tax collector and more in your pocket. We’ll also discuss what types of accounts fall into the categories of tax free, partially taxable and fully taxable. Today I hope I caught enough of your attention to start at the very least thinking about not only diversification of assets, but of accounts.

You’ll be hearing more about more specific strategies to diversify soon, but don’t hesitate to give me any suggestions or questions.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Improving – Energy (XLE)

The improvement in Energy has stalled for now as as the rotation to “value” gave way back to momentum for the “QE Chase.” Energy needs to break above the downtrend to become an attractive candidate for portfolios. We recently added 1/2 position in AMLP to portfolios and are looking to add XLE on a break above the 200-dma. 

Current Positions: 1/2 AMLP

Outperforming – Technology (XLK), Healthcare (XLV), Industrials (XLI), Financials (XLF)

Financials have been running hard on Fed rate cuts and more QE. The sector is extremely overbought and extended and due for a correction. Take profits and be patient to add exposure.

Industrials, which perform better when the Fed is active with QE, broke out to new highs recently, but has since stalled and started to consolidate at a high level. Given the sector is extremely overbought, we will look to add but will wait for this correction to play out first.

Technology and Healthcare have been the leaders as of late. Healthcare made a sharp recovery from weakening to leading relative to the overall market, and the sector is now grossly overbought and extended. As recommended we took profits in XLV reducing it from overweight to portfolio weight. Like everything else, XLK is extremely overbought so wait for a correction to add exposure.

Current Positions:  1/2 weight XLI, Full weight XLK, XLV

Weakening –

No sectors in the weakening category.

Current Position: N/A

Lagging – Real Estate (XLRE), Staples (XLP), Discretionary (XLY), Communications (XLC), Materials (XLB), and Utilities (XLU)

Despite Staples remaining in the “lagging” category this past week, the sector continues to ratchet new highs. Momentum reamins strong, but the sector is GROSSLY extended and overbought. Take profits.

Discretionary remains a real laggard and has been unable to break out to new highs. As noted last week, the weakness suggest that retail sales would likely not be as strong as expected which was indeed the case in the latest retail sales report. Watch XLY, a failure at support will likely suggest a larger corrective process.

Communications broke out to new highs, but is still lagging the overall market. Given the sector is very overbought, be patient for a better entry point.

XLRE and XLU came under pressure last week on the jump in interest rates. However, with both these sectiors now oversold, look for an entry point to add to portfolios. 

Current Position: Target weight XLC, XLY, XLP, XLRE, 1/2 weight XLB

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Small- and Mid-caps broke out of the previous ranges as the rotation to risk continues. This past week, we added small-cap fund to our portfolios and we will look to pair that fund with a small-cap ETF. We will update you accordingly.

Current Position: KGGIX, Looking To Add SLYV, MDYV

Emerging, International (EEM) & Total International Markets (EFA)

Emerging and International Markets, rallied recently on news of a “trade deal” and finally clearly broke above important resistance. 

We are going to add positions in both emerging market and international value  positions in the next few days provided the breakouts can hold. Watch our portfolio and position update reports at RIA PRO.

Current Position: Looking To Add EFV and DYVE

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

Be aware that all of our core positions are EXTREMELY overbought. A short-term correction or consolidation is likely before a further advance can be made.

Current Position: RSP, VYM, IVV

Gold (GLD) – Gold is holding support at the $140 level and about to register a buy signal. GDX has also held support and turned higher with a triggered buy signal.  We have taken our holdings back to full-weights after taking profits earlier this year. 

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

Bonds (TLT) – 

Bonds rallied back to the 50-dma but failed on Friday as the realization that the “trade deal” is likely not as much of a trade deal as hoped. Stay long current positions for now, and look for an opportunity to add to holdings.

Current Positions: DBLTX, SHY, IEF

Sector / Market Recommendations

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

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

Portfolio/Client Update:

This past week, the market into the “trade deal,” which was not really a “deal at all,” but pushed asset prices above breakout or resistance levels in several key areas. 

One of the aspects, noted in the main body above, is the weakening of the dollar relative to other currencies. This is good for gold and commodities and supports our portfolio changes this week. 

Over the last couple of weeks , we have discussed looking for the opportunity to add exposure to small and mid-caps, international and emerging markets, as well as industrials, materials, and energy. 

As noted previously, we have been “picking through the ruble” of the energy sector looking for a couple of tradeable ideas in the sector as well. We have identified an interesting yield play that we are looking for the right entry point for. You can read the research note here.

This past week we added the first half of our position in AMLP. We will look to add XLE if it can foster a breakout above the 200-dma. 

We also added back into our Gold Miners and Gold positions taking them back to full weight, along with the first step in our addition of a small-cap value fund.

The addition of the small-cap value fund is a long-term structure we will build into over the next several quarters. The rotation to value has not truly started yet, but when it does, it will be a big winner for the portfolio. In the short-term it will likely drag on performance, so please be aware this is a long-term macro theme we are building into. 

  • New clients: We are holding off onboarding new client assets until we see some corrective action or consolidation in the market.
  • Equity Model: We bought 1/2 position of AMLP, added to GDX and IAU.
  • ETF Model: Reduced XLV to target weight, Bought 2% KGGIX

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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.)

If you need help after reading the alert; do not hesitate to contact me.

Click Here For The “LIVE” Version Of The 401k Plan Manager

See below for an example of a comparative model.


Model performance is based on a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. This is strictly for informational and educational purposes only and should not be relied upon for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril. 

401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k p

 The code will give you access to the entire site during the 401k-BETA testing process, so not only will you get to help us work out the bugs on the 401k plan manager, you can submit your comments about the rest of the site as well.

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

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

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

“The Art Of The Deal” & How To Lose A “Trade War.”

This past Monday, on the #RealInvestmentShow, I discussed that it was exceedingly likely that Trump would delay, or remove, the tariffs which were slated to go into effect this Sunday, On Thursday, that is exactly what happened.

Not only did the tariffs get delayed, but on Friday, it was reported that China and the U.S. reached “Phase One” of the trade deal, which included “some” tariff relief and agricultural purchases. To wit:

“The U.S. plans to scrap tariffs on Chinese goods in phases, a priority for Beijing, Vice Commerce Minister Wang Shouwen said. However, Wang did not detail when exactly the U.S. would roll back duties.

President Donald Trump later said his administration would cancel its next round of tariffs on Chinese goods set to take effect Sunday. In tweets, he added that the White House would leave 25% tariffs on $250 billion in imports in place, while cutting existing duties on another $120 billion in products to 7.5%.

China will also consider canceling retaliatory tariffs set for Dec. 15, according to Vice Finance Minister Liao Min. 

Beijing will increase agricultural purchases significantly, Vice Minister of Agriculture and Rural Affairs Han Jun said, though he did not specify by how much. Trump has insisted that China buy more American crops as part of a deal, and cheered the commitment in his tweets.”

Then from the USTR:

The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”

Not surprisingly, the market initially rallied on the news, but then reality begin to set in.

Art Of The Deal Versus The Art Of War

Over the past 18-months we have written numerous articles about the ongoing “trade war,” which was started by Trump against China. As I wrote previously:

“This is all assuming Trump can actually succeed in a trade war with China. Let’s step back to the G-20 meeting between President Trump and President Xi Jinping. As I wrote then:

‘There is a tremendous amount of ‘hope’ currently built into the market for a ‘trade war truce’ this weekend. However, as we suggested previously, the most likely outcome was a truce…but no deal.  That is exactly what happened.

While the markets will likely react positively next week to the news that ‘talks will continue,’ the impact of existing tariffs from both the U.S. and China continue to weigh on domestic firms and consumers.

More importantly, while the continued ‘jawboning’ may keep ‘hope alive’ for investors temporarily, these two countries have been ‘talking’ for over a year with little real progress to show for it outside of superficial agreements.

Importantly, we have noted that Trump would eventually ‘cave’ into the pressure from the impact of the ‘trade war’ he started.

The reasons, which have been entirely overlooked by the media, is that China’s goals are very different from the U.S. To wit:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk-off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 4-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

As noted in the second point above, on Friday, Trump caved to get the “Trade Deal” off the table before the election. As noted in September, China had already maneuvered Trump into a losing position.

“China knows that Trump needs a way out of the “trade war” he started, but that he needs something he can “boast” as a victory to a largely economically ignorant voter base. Here is how a “trade deal” could get done.

Understanding that China has already agreed to 80% of demands for a trade deal, such as buying U.S. goods, opening markets to U.S. investors, and making policy improvements in certain areas, Trump could conclude that ‘deal’ at the October meeting.”

Read the highlighted text above and compare it to the statement from  the WSJ: on Thursday:

“The U.S. side has demanded Beijing make firm commitments to purchase large quantities of U.S. agricultural and other products, better protect U.S. intellectual-property rights and widen access to China’s financial-services sector.”

What is missing from the agreement was the most critical 20%:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

These are the “big ticket” items that were the bulk of the reason Trump launched the “trade war” to begin with. Unfortunately, for China, these items are seen as an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program.

The USTR did note that the Phase One deal:

“Requires structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.”

However, since there is no actual enforcement mechanism besides merely pushing tariffs back to where they were, none of this will be implemented.

All of this aligns with our previous suggestion the only viable pathway to a “trade deal” would be a full surrender.

“However, Trump can set aside the last 20%, drop tariffs, and keep market access open, in exchange for China signing off on the 80% of the deal they already agreed to.”

Which is precisely what Trump agreed to.

This Is The Only Deal

This is NOT a “Phase One” trade-deal.

This is a “Let’s get a deal on the easy stuff, call it a win, and go home,” deal.

It is the strategy we suggested was most likely:

“For Trump, he can spin a limited deal as a ‘win’ saying ‘China is caving to his tariffs’ and that he ‘will continue working to get the rest of the deal done.’ He will then quietly move on to another fight, which is the upcoming election, and never mention China again. His base will quickly forget the ‘trade war’ ever existed.

Kind of like that ‘Denuclearization deal’ with North Korea.”

Speaking of the “fantastic deal with N. Korea,” here is the latest on that failed negotiation:

“Reuters reported Thursday via Korean Central News Agency (KCNA) that, even if denuclearization talks resumed between both countries, the Trump administration has nothing to offer.

North Korea’s foreign ministry criticized the Trump administration for meeting with officials at the UN Security Council and suggested that it would be ready to respond to any corresponding measures that Washington imposes. ‘The United States said about corresponding measure at the meeting, as we have said we have nothing to lose and we are ready to respond to any corresponding measure that the US chooses,’ said KCNA citing a North Korean Foreign Ministry spokesperson.”

While Trump has announced he will begin to “immediately” work on “Phase Two,” any real agreement is highly unlikely. However, what Trump understands, is that he gets another several months of “tweeting” a “trade deal is coming” to keep asset markets buoyed to support his re-election campaign.

Not Really All That Amazing

While Trump claimed this was an “amazing deal” with China, and that America’s farmers need to get ready for a $50 billion surge in agricultural exports, neither is actually the case.

China did not agree to buy any specific amount of goods from the U.S. What they said was, according to Bloomberg, was:

  • CHINA PLANS TO IMPORT U.S. WHEAT, RICE, CORN WITHIN QUOTAS

Furthermore, there is speculation the agreement is primarily verbal in terms of purchases, and the actual agreement of the entire trade deal will never be made public.

But let’s put some hard numbers to this.

Currently, China is buying about $10 billion of farm produce in 2018. That is down from a peak of $25 billion in 2012, which was long before the trade war broke out.

Since the trade war was started, China has sourced deals from Brazil and Argentina for pork and soybeans to offset the shortfall in imports from the U.S. These agreements, and subsequent imports, won’t be cancelled to shift to the U.S. since at any moment Trump could reinstate tariffs.

More importantly, as noted by Zerohedge on Friday, if this “deal” was as amazing as claimed, the agricultural commodity index should be screaming higher.

Importantly, even if China agrees to double their exports in the coming year, which would be a realistic goal, it would only reset the trade table to where it was before the tariffs started.

While China may have “agreed” to buy more, it is extremely unlikely China will meet such levels. Given they have already sourced products from other countries, they will import what they require.

Since most don’t pay attention to the long-game, while there will be excitement over a short-term uptick in agricultural purchases, those purchases will fade. However, with time having passed, and the focus of the media now elsewhere, Trump will NOT go back to the table and restart the “trade war” again. As I wrote on May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations. What the current administration fails to realize is that China is not operating from short-term political-cycle driven game plan.

As we stated in Art Of The Deal vs. The Art Of War:”

“While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

Trump lost the “trade war,” he just doesn’t realize it, yet.

No More “Trade Tweets?”

Since early 2018, and more importantly since the December lows of last year, the market has risen on the back of continued “hopes” of Federal Reserve easing, and the conclusion of a “trade deal.”

With the Fed now signaling that they are effectively done lowering rates through next year, and President Trump concluding a “trade deal,” what will be the next driver of the markets. While will the “algo’s” do without daily “trade tweets” to push stock markets higher?

While I am a bit sarcastic, there is also a lot of truth to the statement.

However, what is important is that while the Trump administration are rolling back 50% of the tariffs, they are not “removing” all of them. This means there is still some drag being imposed by tariffs, just at a reduced level.

More importantly, the rollback of tariffs do not immediately undo the damage which has already occurred.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • The “repo” market is suggesting that something is “broken.”
  • All of which is leading to rising recession risk.

In other words, while investors have hung their portfolios hopes of a “trade deal,” it may well be too little, too late.

Over the next couple of months, we will be able to refine our views further as we head into 2020. However, the important point is that since roughly 40% of corporate profits are a function of exports, the damage caused already won’t easily be reversed.

Furthermore, the Fed’s massive infusions of liquidity into the overnight lending market signal that something has “broken,” but few are paying attention.

Our suspicion is that the conclusion of the “trade deal” could well be a “buy the rumor, sell the news” type event as details are likely to be disappointing. Such would shift our focus from “risk taking” to “risk control.” Also, remember “cash” is a valuable asset for managing uncertainty.

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. 

I am not suggesting you do anything, but just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

#WhatYouMissed On RIA: Week Of 12-09-19

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

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

  • What do Decennial Cycles, Presidential Cycles have to do with markets?
  • What happens when inexperienced advisers offer counsel to inexperienced investors?
  • The ugly sausage-making of employment numbers: BLS vs ADP
  • The Great Cash Hoard: What happens when money flows reverse?

Our Best Tweets Of The Week

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Robertson: Ain’t Nobody Home

One of the great challenges of financial markets is that certain important events only happen infrequently – which makes it all the easier to overlook them during intervening periods. One of those important situations is when it becomes extremely difficult, if not impossible, to sell an investment because too few people are both willing and able to buy it.

Through the course of a cycle the phenomenon of illiquidity occurs periodically but is normally contained to very specific situations and does not affect broader markets. Increasingly, however, there are signs that liquidity could be a problem in the foreseeable future, so it is a good time to review the risks.

To start with, there is nothing inherently wrong with illiquid investments. In fact, illiquid investments can produce higher returns for investors who don’t need immediate liquidity. As a result, they can make great sense for long term investors like pension funds and endowments. Indeed, David Swensen has made famously good use of this characteristic with the endowment at Yale.

Of course, many other investors who might need the liquidity are also attracted to those incremental returns, and especially so in an environment of exceptionally low yields. As a result, many investors have succumbed to the temptation by plowing into private equity, venture capital, real estate, structured credit, fixed income ETFs and all kinds of other investments for which liquidity can be a problem.

As investors pursue this course of action, however, a couple of things happen along the way. One is that the prices of illiquid investments get bid up and therefore the prospective returns come down. Another is that as progressively more money flows into investment vehicles that can be difficult to exit, systemic risk increases. I described these phenomena in “A formula for losing money“.

As the risk of systemic illiquidity increases it can challenge, and overtake, the risk of slowing economic growth as a key risk factor. This change manifests itself in a subtle way. Unlike in 2017 when markets rose in a climate remarkably devoid of volatility, this year there are a number of rumblings underneath the calm veneer of market index performance. The Financial Times reports:

“Yet, through all of this, the sanctity around the market price has remained. Most don’t question whether basic formation of market prices is faulty. What if market gyrations are less to do with shifts in expectations on the economy or company performance, and more to do with participants coming to terms with a less well-functioning market?”

It is now time to add another worry to the list: the unravelling of the market liquidity illusion.

The “unraveling of the market liquidity illusion” is both a worthy consideration, and increasingly, a timely one. Further, there is a growing body of evidence to support the hypothesis. As the FT spells out, increasing bond market volatility is a signal:

“’It’s impossible to know the catalyst, and this market is good at shrugging off bad news. [But] bond market volatility is a good sign of the fragility,’ Mr Croce said. ‘We’ve seen steadily rising bond volatility this autumn, and that will eventually have an impact on asset prices’.

Auctions in fixed income markets have also been highlighted by Zerohedge:

“The number of high yield credits trading at spreads over a thousand basis points over treasuries has been rising all year long. Also, you’re seeing a lot more volatility in the leveraged lending space. Credit Investors increasingly are firing first, and ask questions later.”

Russell Clarke provided similar foreshadowing in a Realvision interview dated September 18, 2019:

“Like I said, the weird classic macro indicators are diverging radically from what equities are doing. That does happen sometimes. Usually, the macro indicators are right.” 

In addition, another signal can come from broader market factors. Since the relationship of supply to demand for securities is relative, whenever sellers overwhelm prospective buyers, deficiencies in liquidity can arise. This phenomenon often occurs when investors chase a common theme, as the FT describes:

But Marko Kolanovic, head of quantitative strategy at JPMorgan, says there is still ‘extreme crowding’ in the more defensive, bond-like parts of the stock market, as well as in stocks enjoying positive momentum. He said this was evidence of the ‘prevalence of groupthink … across investment strategies’.”

With several signs all pointing in the same direction, the chances of some kind of liquidity event appear to be increasing. Importantly, many of the warning signs are virtually invisible to investors and advisors who rely primarily on market indexes for information content.

Lest investors forget what happens when liquidity dries up, Russell Clarke provides a useful refresher:

Speaking of the Lehman bankruptcy in 2008, Clarke described: “Then suddenly, and it was very weird, didn’t make a lot of sense. Then suddenly, it broke in way. That’s typically how markets work. They force everyone into an asset at exactly the wrong time and then liquidity just disappears, and you are stuck in it.

The notion of suddenly being “stuck in it” was also crystallized by the FT in a recent report. The UK Mexican restaurant chain Chilango issued mini-bonds and intentionally lured investors with an attractive yield: “Free food for four years! Plus 8 per cent APR!”

The only problem was, just months after its last mini-bond offering, the company’s solvency came into question and it was forced to hire restructuring advisers. While Chilango is reminiscent of WeWork’s bond offering to sophisticated investors, there was one major difference:

“While red-faced hedge fund managers can sell their WeWork bonds at a loss and move on, Chilango’s bonds are explicitly non-transferable. The doors are locked.”

Unfortunately, retail investors are learning another lesson from institutional debt markets the hard way: liquidity matters.

In simple terms, there is no way for investors to get their money out of Chilango’s mini-bonds. They are stuck. This is exactly what can happen when liquidity vanishes for whatever reason. Although there may be some recovery down the road, there will be no access to those funds for the indefinite future.

This leads to a few important lessons regarding liquidity risk. One is that it is an insidious risk. It gathers gradually, over time, without revealing at what point it might strike. Indeed, markets can be most alluring at the most dangerous times. As Clarke notes, “They [markets] force everyone into an asset at exactly the wrong time.”

Liquidity is also nonlinear – and this is very hard for many investors to fully appreciate. It is easily available for long periods of time and then suddenly vanishes. When investors start running for the proverbial exits, many end up getting trapped inside. While it is true that this happens only infrequently, it is also true that there are no do-overs – the damage can be permanent.

Finally, when liquidity shuts down, it can be contagious. When it becomes impossible to exit illiquid investments, investors have only one choice if they need cash – and that is to sell what they can – and that is usually more liquid assets. As a result, problems in a relatively small niche of illiquid investments can easily infect a much broader realm of assets. This was an important dynamic in the financial crisis of 2008 when problems with subprime mortgages started surfacing. It is a lesson that still applies today.

An important takeaway is that investors should not be unduly focused on a market crash as the worst possible outcome. Crashes happen but can be recovered from. However, if investors urgently need liquidity and cannot access it, they can suffer permanent harm. Indeed, insufficient access to cash, not a market crash itself, many be the greater risk for many investors.

The risk of losing liquidity is a real one for investors, but it is often underappreciated. B.B. King illustrates the same basic point in his classic song, “Ain’t nobody home”, in a way that is both personal and memorable.

He describes how he once fawned over a girl and followed her “wherever you’d [she’d] lead me” and in the process, endured some “pain and misery”. After he finally decides he’s had enough, she begs him to come back. By then, he is no longer in a forgiving mood and lets her know, “Ain’t nobody home.”

In a similar way, liquidity can seem so ample and forthcoming at times that it is easy to take for granted. When the tables turn, however, investors had better beware. Just when they need it most, there might not be anyone home.

Why Every Investor Should Go On An Information Diet

I spend a lot of time thinking about the information that I consume. Do you?

We all consume exabytes of information. Have you ever noticed that people spend way more time thinking about the food they consume than the information they consume?

I have family members who are health nuts—watching every bite they eat and augmenting it with supplements—but think nothing of spending 10 minutes cruising around The Drudge Report, which will make you feel like the world is coming to an end pretty much any time you load the page.  Some people have read Drudge for twenty years. Imagine how that would make you feel.

I gave up Drudge about six or seven years ago. I keep track of politics on Twitter—but I don’t follow people who are toxic waste. I don’t watch cable news. Before I started the radio show, I watched NBC Nightly News, but I’m glad to be rid of that. I’ve Marie Kondo-ed my information intake, getting rid of anything that doesn’t bring me joy.

Monitoring your information intake is crucial to your mental health. It is also crucial to your investment decision-making.

The Bulls and the Bears

If you want to read bearish information, there are places to do that. If you want to read bullish information, there are places to do that.

Funny—most people spend all their time either reading just the bearish or bullish information. They don’t get both sides of the story.

People like to point out that if you consumed nothing but bearish information since 2009, you would have missed out on a historic stock market rally and you would have drastically underperformed. This is true.

But if you’re consuming nothing but bullish information, about how index funds are king and stocks for the long run and dollar cost averaging, you’ll probably get fricasseed when the bear market begins. We will get one eventually.

Polarization

Political polarization has happened for a lot of reasons, but chief among them is the advent of social media. Go look at charts of polarization—it didn’t really start happening until Facebook and Twitter came on the scene.

It is not particularly difficult to see why. Ever spend 5-10 minutes on Facebook and feel… unsettled?

People spend a lot of time on Facebook. I spend some time on Facebook. It’s pretty rare that Facebook makes me feel good.

There is a lot of crap, memes and such. But there are also people’s terrible political opinions. Funny thing about political opinions on Facebook. I don’t really care to read any of them, even the ones that I agree with. Facebook is full of user-generated content, and the problem with the user-generated content is that it is uninformed, hysterical garbage.

I hide opinionated people on Facebook, but not because the opinions bother me. It is really for my emotional health. I don’t want to log on and feel worse. I have been curating my feed for years, and I finally have it where I want it. As for me, I basically post pictures of my cats, which always make people feel good.

You may find this hard to believe, but there are lots of people out there whose purpose in life seems to be arguing on the internet. I blundered into communist Twitter the other day—not fun.

There are armies of trolls out there. The internet facilitates polarization because we are not dealing with each other face to face. It’s easy to dehumanize “the other side” online. If we were all sitting in the same room, we’d probably just have a normal conversation.

I hope that someday we get bored of arguing on the internet. But it seems to be getting worse, not better.

Politics < Ethics < Philosophy

It is easy to drown in the noise. Politics is noise. Above politics is ethics, and above ethics is philosophy.

If you’ve been following all the tit-for-tat and the drama of the impeachment hearings, if the names McGahn and Strzok mean anything to you, if you can actually recite the timeline of all the China trade negotiations, then you are spending time in politics, in the noise.

Imagine what you could have done with your time instead of learning about this nonsense. If you think this helps you have an opinion on the direction of the stock market, all I have to say to that is LMAO.

If you eat Big Macs and fries and fast food and other junk, you will get fat and feel terrible. I know this from experience. If you read toxic, opinionated trash, you will go crazy, and feel terrible.

And you will think all kinds of things, like, the stock market will crash, or the stock market will go up forever.

As it is with everything in life, the truth is somewhere in between.

Active Vs. Passive & The Simple Reasons You Can’t Beat An Index

Just recently, I was reading an article from Larry Swedroe which “discussed” the “Surprising Results From S&P’s Latest SPIVA Analysis.” To wit:

“Over the 15-year period, on an equal-weighted (asset-weighted) basis, the average actively managed U.S. equity fund underperformed by 1.4% (0.74%)per annum. The worst performances were small caps, with active small-cap growth managers underperforming on an equal-weighted (asset-weighted) basis by 1.99% (0.90%) per annum, active small-cap core managers underperforming by 2.43% (1.82%) per annum, and active small–value managers underperforming by 2.00% (1.71%) per annum. So much for the idea that the small-cap asset class is inefficient and active management is the winning strategy.”

As Larry concludes from that analysis:

“S&P’s SPIVA scorecard provides persuasive evidence of the futility of active management.”

See, according to Larry, it is clear you should just passively index in funds and everything will be just fine. 

If it were only that simple.

We Are Supposed To Be Long-Term Investors

In any given short-term period, a manager of an active portfolio may make bets which either outperform or underperform their relative benchmark. However, we are supposed to be long-term investors, which suggests that we should focus on the long-term results, and not short-term deviations. 

The following chart of Fidelity Contra Fund versus the Vanguard S&P 500 Index proves this point. Which fund would you have rather owned?

(Source: Morningstar)

Finding funds with very long-term track records is difficult because the majority of mutual funds didn’t launch until the late “go-go 90’s” and early 2000’s. However, I did a quick look up and added 4-more active mutual funds with long-term track records for comparison. The chart below compares Fidelity Contrafund, Pioneer Fund, Sequoia Fund, Dodge & Cox Stock Fund, and Growth Fund of America to the Vanguard S&P 500 Index.

(Source: Morningstar)

I don’t know about you, but an investment into any of the actively managed funds over the long-term horizon certainly seems to have been a better bet. 

Even Index Funds Can’t Beat The Index

Do you want to know what fund did NOT beat the index according to Morningstar? The Vanguard S&P 500 Index fund. 

How is it that a fund that is supposed to purely replicate an index, failed to exactly match the performance of the index. 

Simple.

Fees, taxes, and expenses.

Unfortunately, in the “real world” where people actually invest their “hard earned savings,” their overall returns are constantly under siege from taxes, previously commissions, fees, and most importantly – taxes. 

An “index,” which is simply a mathematical calculation of priced securities, has no such detriments. 

The chart below is the S&P 500 Total Return Index before, and after the same expense ratio charged by the Vanguard S&P 500 Index Fund. Since most advisers don’t manage client money for free, I have also included an “adviser fee” of 0.5% annually. 

Of course, if your adviser is simply indexing for you, then maybe the real question is exactly what are you paying for? 

The Differences Between You And An Index

Which brings us to why you, nor any investment product that exactly mimics the S&P 500 index, can actually match it, must less beat it.

While Wall Street wants you to compare your portfolio to the ‘index’ so that you will continue to keep chasing an index, which keeps money in motion and creates fees for Wall Street, the reality is that you and an index are very different things. This is due to the following reasons:

1) The index contains no cash, 

If you maintain cash for expected expenses, taxes, or any other reason, your performance will lag the benchmark index. 

2) The index has no life expectancy requirements – but you do.

While it may sound great that if you just hold an index long-term you will generate 8-10% annual returns, the reality is that your investment horizon between accumulation and distribution fall within one “full-market” cycle. Start on the wrong end of a cycle (high starting valuations) and the end result will be far less than advertised.

3) The Index does not have to compensate for distributions to meet living requirements.

At the point in life when you begin withdrawing money to live on, performance is affected by the withdrawals against the value of the portfolio.  (Read more here)

4) The index requires you to take on excess risk.

Cullen Roche once penned a salient point:

“Benchmarking is a pernicious thing in financial circles. Not only because it disconnects the way the client and a fund manager understand the concept of ‘risk’, but also because the concept of benchmarking seems to be misunderstood.”

Risk is rarely understood by investors until it is generally too late.

Chasing the S&P 500 index requires you to have your portfolio fully allocated to equity risk, at all times. This vastly increases the “risk profile” of the portfolio which may not be optimal for investors approaching, or in, retirement. (Read more here)

5) It has no taxes, costs or other expenses associated with it.

As noted above, an index does not have to pay taxes on realized gains and dividends, does not have management fees, or other expenses which must be covered. All of these items will lead to underperformance from one year, to the next, versus an index.

6) It has the ability to substitute at no penalty.

In an index, if a company goes bankrupt, the index simply takes it out and substitutes another stock in its position. The index value is then adjusted for the “market capitalization” of the new entrant and the index resumes. However, in your portfolio, given you only have a “finite” amount of capital, when a company goes bankrupt, or losses the majority of its value, you have to sell that stock at a loss and buy the replacement with whatever is left or add more capital. 

It’s Your Brain, Man

Unfortunately, investors rarely do what is “logical,” but react “emotionally” to market swings.  When stock prices are rising, instead of questioning when to “sell,” they are instead lured into market peaks. The reverse happens as prices fall. First, comes “paralysis,” then “hope” that losses may be recovered, but eventually “capitulation” sets in as the emotional strain becomes too great and investors “dump” shares at any price to preserve what capital they have left. They then remain out of the market as prices rise only to “jump back in” about mid-way to the next market peak.

Wash. Rinse. Repeat.

Despite the media’s commentary that “if an investor had ‘bought’ the bottom of the market,” the reality is that few, if any, actually ever do. The biggest drag on investor performance over time is allowing “emotions” to dictate investment decisions. This is shown in the Dalbar Investor Study which showed “psychological factors” accounted for between 45-55% of underperformance. From the study:

“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”

In other words, investors consistently bought the “tops” and sold the “bottoms.”  You will notice the other two primary reasons for underperformance was related to a lack of capital to invest.  This is also not surprising given the current economic environment.

The Only Question That Matters

There are many reasons why you shouldn’t chase an index over time, and why you see statistics such as “80% of all fund underperform the S&P 500.” The impact of share buybacks, substitutions, lack of taxes and trading expenses all contribute to the outperformance of the index over those actually investing real dollars who do not receive the same advantages. 

More importantly, any portfolio that is allocated differently than the benchmark to provide for lower volatility, create income, or provide for long-term financial planning and capital preservation will underperform the index as well. Therefore, comparing your portfolio to the S&P 500 is inherently “apples to oranges” and will always lead to disappointing outcomes.

“But it gets worse.  Often times, these comparisons are made without even considering the right way to quantify ‘risk’. That is, we don’t even see measurements of risk-adjusted returns in these ‘performance’ reviews. Of course, that misses the whole point of implementing a strategy that is different than a long only index.

It’s fine to compare things to a benchmark. In fact, it’s helpful in a lot of cases. But we need to careful about how we go about doing it.” – Cullen Roche

For all of these reasons, and more, the act of comparing your portfolio to that of a “benchmark index” will ultimately lead you to taking on too much risk and into making emotionally based investment decisions.

But here is the only question that really matters in the active/passive debate:

“What’s more important – matching an index during a bull cycle, or protecting capital during a bear cycle?”  

You can’t have both.

If you benchmark an index during the bull cycle, you will lose equally during the bear cycle. However, while an active manager that focuses on “risk” may underperform during a bull market, the preservation of capital during a bear cycle will salvage your investment goals.

Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. So, do yourself a favor and forget about what the benchmark index does from one day to the next. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index, but you are likely to achieve your own personal investment goals which is why you invested in the first place.

When It Becomes Serious You Have To Lie: Update On The Repo Fiasco

Occasionally, problems reveal themselves gradually. A water stain on the ceiling is potentially evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has appeared to vanish. Yet, every day the stain reappears and the Fed’s work begins anew. One is left to wonder why the leak hasn’t been fixed. 

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.  

At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that they lacked a reasonable explanation for the disruption. Since then, our surprise has turned to concern and suspicion.

We harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing. 

As we were putting the finishing touches on this article, the Bank of International Settlements (BIS) reported that the overnight repo problems might stem from the reluctance of the four largest U.S. banks to lend to some of the largest hedge funds. The four banks are being forced to fund a massive surge in U.S. Treasury issuance and therefore reallocated funding from the hedge funds to the U.S. Treasury.  Per the Financial Times in Hedge Funds key in exacerbating repo market turmoil, says BIS: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” – was a key factor behind the chaos, said Claudio Borio, Head of the monetary and economic department at the BIS.

In the article, the BIS implies that the Fed is providing liquidity to banks so that banks, in turn, can provide the hedge funds funding to maintain their leverage. The Fed is worried that hedge funds will sell assets if liquidity is not available. Instead of forcing hedge funds to deal with a funding risk that they know about, they are effectively bailing them out from having to liquidate their holdings. If that is the case, and as the central bank to central bankers the BIS should be well informed on such matters, why should the Fed be involved in micro-managing leverage to hedge funds? It would certainly represent another extreme example of mission creep.

Excuse #1

In the article linked above, we discussed the initial excuse for the funding issues bandied about by Wall Street, the banks, and the media as follows:

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons.”

While the excuse seemed legitimate, it made little sense as we surmised in the next sentence:

“We are not convinced by either excuse as they were easily forecastable weeks in advance.”

If the dearth of liquidity in the overnight funding markets was due to predictable, one-time cash demands, the problem should have been fixed easily. Simply replenish the cash with open market operations as the Fed routinely did prior to the Financial Crisis.

Since mid-September, the Fed has elected instead to increase their balance sheet by over $320 billion.  In addition to conducting daily overnight repo auctions, they introduced term repo that extends for weeks and then abruptly restarted quantitative easing (QE).

Imagine your plumber coming into your house with five other plumbers and a bull dozer to fix what you assumed was a leaky pipe.

The graph below, courtesy Bianco Research, shows the dramatic rise in the Fed’s balance sheet since September.

Based on the purported cash shortfall excuse, one would expect that the increase in the Fed’s balance sheet would have easily met demands for cash and the markets would have stabilized. Liquidity hole filled, problem solved.

However, as witnessed by the continuing growth of the Fed’s balance sheet and ever-increasing size of Fed operations, the hole seems to be growing. It is worth noting that the Fed has committed to add $60 billion a month to their balance sheet through March of 2020 via QE. In other words, the stain keeps reappearing and getting bigger despite increasing amounts of paint. 

Excuse #2

The latest rationale used to explain the funding problems revolves around banking regulations. Many Fed members and banking professionals have recently stated that banking regulations, enacted after the Financial Crisis, are constraining banks’ ability to lend to other banks and therefore worsening the funding situation. In the words of Randy Quarles, Federal Reserve Vice Chair for Banking Supervision, in his testimony to the House Financial Services Committee:

We have identified some areas where our existing supervision of the regulatory framework…may have created some incentives that were contributors

Jamie Dimon, CEO of JP Morgan, is quoted in MarketWatch as saying the following:

“The turmoil may be a precursor of a bigger crisis if the Fed doesn’t adjust its regulations. He said the liquidity requirements tie up what was seen as excess reserves.”

Essentially, Quarles and Dimon argue that excess reserves are not really excess. When new post Financial Crisis regulatory requirements are factored in, banks only hold the appropriate amount of reserves and are not exceeding requirements.

This may be the case, and if so, the amount of true excess reserves was dwindling several months prior to the repo debacle in September.  Any potential or forecasted shortfalls due to the constraints should have been easily identifiable weeks and months in advance of any problem.

The banks and the Fed speak to each other quite often about financial conditions and potential problems that might arise. Most of the systemically important financial institutions (SIFI banks) have government regulators on-site every day. In addition, the Fed audits the banks on a regular basis. We find it hard to believe that new regulatory restraints and the effect they have on true excess reserves were not discussed. This is even harder to believe when one considers that the Fed was actively reducing the amount of reserves in the system via Quantitative Tightening (QT) through 2018 and early 2019. The banks and the regulators should have been alerting everyone they were getting dangerously close to exhausting their true excess reserves. That did not occur, at least not publicly.

Theories and Speculation

A golden rule we follow is that when we think we are being misled, especially by market participants, the Fed, or the government, it pays to try to understand the motive.  “Why would they do this?” Although not conclusive, we have a few theories about the faulty explanations for the funding shortage. They are as follows:

  • The banks and the Fed would like to reduce the regulatory constraints imposed on them in recent years. Disruptions demonstrating that the regulations not only inhibit lending but can cause a funding crisis allow them to leverage lobbying efforts to reduce regulations.
  • There may be a bank or large financial institution that is in distress. In an effort to keep it out of the headlines, the Fed is indirectly supplying liquidity to the institution. This would help explain why the September Repo event was so sudden and unexpected. Rumors about troubles at certain European banks have been circulating for months.
  • The Fed and the banks grossly underestimated how much of the increased U.S. Treasury debt issuance they would have to buy. In just the last quarter, the Treasury issued nearly $1 trillion dollars of debt. At the same time, foreign sponsorship of U.S. Treasuries has been declining. While predictable, the large amount of cash required to buy Treasury notes and bonds may have created a cash shortfall. For more on why this problem is even more pronounced today, read our article Who Is Funding Uncle Sam. If this is the case, the Fed is funding the Treasury under the table via QE. This is better known as “debt monetization”.
  • Between July and November the Fed reduced the Fed Funds rate by 0.75% without any economic justification for doing so. The Fed claims that the cuts are an “insurance” policy to ensure that slowing global growth and trade turmoil do not halt the already record long economic expansion. Might they now be afraid that further cuts would raise suspicion that the Fed has recessionary concerns? QE, which was supposedly enacted to combat the overnight funding issues, has generously supported financial markets in the past. Maybe a funding crisis provides the Fed cover for QE despite rates not being at the zero bound. Since 2008, the Fed has been vocal about the ways in which market confidence supports consumer confidence. 

The analysis of what is true and what is rhetoric spins wildly out of control when we allow our imaginations to run. This is what happens when pieces do not fit neatly into the puzzle and when sound policy decisions are subordinated to public relations sound bites. One thing seems certain, despite what we are being told, there likely something else is going on.

Of greater concern in this matter of overnight funding, is the potential the Fed and banks were truly blindsided. If that is the case, we should harbor even deeper concern as there is likely a much bigger issue being painted over with temporary liquidity injections.

Summary

In the movie The Outlaw Josey Wales, one of the more famous quotes is, “Don’t piss down my back and tell me it’s raining.”

We do not accept the rationale the Fed is using to justify the reintroduction of QE and the latest surge in their balance sheet. Although we do not know why the Fed has been so incoherent in their application of monetary policy, our theories offer other ideas for thinking through the monetary policy maze. They also have various implications for the markets, none of which should be taken lightly.

We are just as certain that we are not entirely correct as we are certain that we aren’t entirely wrong. Like the water spot on the ceiling, financial market issues normally reveal themselves gradually. Prudent risk management suggests finding and addressing the source of the problem rather than cosmetics. We want to reiterate that, if the Fed is papering over problems in the overnight funding market, we are left to question the Fed’s understanding of global funding markets and the global banking system’s ability to weather a more significant disruption than the preview we observed in September.

It’s a Wonderful Time of Year to Face Financial Ghosts.

What are your ghosts?

Ghosts of the past are notorious for creeping into the present, especially when holidays roll around.

If you’ve unpacked an ornament from 30 years ago or got lost in a memory while watching A Charlie Brown Christmas, then you understand.

The ghosts of Financial Mistakes Past are sometimes not so kind. In other words, they’re not mindful of seasons; they aren’t warm and fuzzy either. Rattling chains of the ghosts of financial mistakes can be uninvited guests for years to come.

December is the month to objectively review your financial history – expose the good and bad – then, outline tactics to sever ominous chains and sprout wings to the beneficial for 2020. Oh, watch for financial disciplines or lack of them that may conjure the ghosts of financial future.

Just because I partner with others on personal finance challenges doesn’t mean I don’t own my share of mistakes. Thankfully, my Ghosts of Financial Mistakes Past lose their power to frighten me, especially as I too assess my consistent progress to slay them. As a financial professional, let’s just say I remain ‘fiscally aware’ throughout the year. Hey, it’s my job.

This month, as you prepare your favorite meals from recipes that have been in the family for decades, watch a timeless film, (White Christmas is my favorite), and go through old photographs, take some time to unwrap financial gifts and pack away the mistakes.

Here are three ideas to get your started.

  1. Calculate your household debt-to-income ratios.

I know. Math. I promise this isn’t a difficult task. As a society, we tend to base our lifestyle on the ability to meet monthly payments but rarely consider the damage to net worth by spending too much or taking on excessive debt.

I complete a couple of calculations for my household. I’ll also share with you, RIA’s financial guardrails. I won’t lie: Our tenets are tough; I promise your net worth will thank me 10 Decembers from now.

First, I isolate my mortgage, HOA, and homeowner’s insurance payments and divide the sum by my NET or ‘take-home’ monthly income.  Currently, my ratio is 7.6%. The standard rule in finance is a house payment shouldn’t exceed 28% of pre-tax income. It’s a horrible rule. It’s designed to push the boundaries on cash flow and sell you more house than is necessary. Throw it out if you desire financial flexibility, cash to cover emergencies and save for a prosperous financial future. Dave Ramsey suggests 25% of after-tax income. Not bad. However, you need to do better.

Our rule at RIA is a total mortgage payment should not exceed 15% of after-tax income. I didn’t extract this percentage out of thin air. I’ve watched how households over the last two decades who utilized this rule continue to increase their wealth by thinking of a primary residence as a place to live, not an investment. In other words, an intimidating mortgage obligation was just too painful for couples who employed  long-term consideration of other important goals they sought to fund.

I then consider my household’s variable and specific fixed expenses – entertainment, groceries, clothing. I also examine costs for utilities, car insurance (not cheap with a college-bound daughter driving). The general rule is 30% of after-tax income for ‘wants.’ Obviously, auto insurance is a need, not a want. However, with the ability to shop around for better rates or utilize insurance company ‘drive-pay’ programs which reward responsible drivers, I place auto insurance into the variable category.

Currently, my variable expenses are 10% of monthly after-tax household income. I understand I no longer have a household with young children where variable expenses are greater. However, that doesn’t mean as a growing family, you shouldn’t create your own rules which still allow for a robust savings rate.  At RIA, we believe variable monthly expenses shouldn’t exceed 20% of after-tax income.

If you’re disappointed by your ratio results, be grateful for new awareness and schedule a meeting with your financial professional in January to create an action plan for improvement so when ratios are calculated next year, they’re much healthier.

 2. Openly communicate about money, especially mistakes, with loved ones. It’s a good time to have conversations!

Holidays, when there is downtime from work and family gathers, seem to allow for communication flow about money within families.

Children: You children are monitoring your relationship with money. What is your outward expression towards debt, savings and general household financial management, especially when communicating with immediate family?

If your relationship with money is positive or one of control and discipline, your children will learn from the example. If your relationship with money is negative, stressful, extravagant or reckless, the kids will pick up on that, too. Smart money beliefs and actions can lead to smart money imprints by the younger generations around you.

Generally, if you’re a saver your children will be too. According to a www.moneyconfidentkids.com survey from 2017, parents who have three or more types of savings are more likely to have kids who discuss money with them and less likely to have kids who spend money as soon as they get it or lie about their spending.

I have found that parents who openly communicate their financial failures along with how they worked through them, raise fiscally intuitive children. Kids want to know you’re human. You mess up! Most important is how you acknowledged and changed erroneous behavior. Give the gift of wisdom this season!

Parents: Older parents are challenged to communicate final intentions with their children; or they decide to let estate planning documents speak for them. Big mistake. If you seek to create a Ghost of Future Turmoil for heirs, go ahead and remain tight-lipped about how you wish assets dispersed including family heirlooms and whom you selected as the executor of your will and why. Perhaps John doesn’t want great-grandmother’s fine China, but Erica does.

 Or Alan is bitter and wondering why your younger son, his brother, Edward is executor of the estate instead of him. These are not small things. I’ve witnessed them generate irreparable family rifts. Make December the month where you communicate with the children and ask questions about the items they’d wish to inherit upon your passing. Take a moment to explain to siblings why one is selected executor and the logic that drove the decision.

3. Trim the expense tree.

The evergreen fir has been a part of winter festivals for roughly 1,000 years. Per www.whychristmas.com:

The first documented use of a tree at Christmas and New Year celebrations is argued between the cities of Tallinn in Estonia and Riga in Latvia. Both claim that they had the first trees; Tallinn in 1441 and Riga in 1510. Both trees were put up by the ‘Brotherhood of Blackheads’ which was an association of local unmarried merchants, ship owners, and foreigners in Livonia (what is now Estonia and Latvia).

Year-end credit card and checking account statements should be available from your financial institutions the first week of January. Today’s statements do an excellent job categorizing expenses. Access, print and review all statements. Scrutinize your spending for 2019. Many statements will also outline prior years’ spending by category and how it compares to the current. From there, begin to outline a spending budget for 2020 with a focus on expense reduction and debt-to-income ratio improvement.

Let’s all try to make our financial ghosts the ones we don’t mind inviting into our homes at any time of year.

Selected Portfolio Position Review: 12-11-19

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, we will now review some of positions in our Equity Portfolio which are either a concern, an opportunity, or are doing something interesting.

AMLP – Alerian MLP (New Buy)

  • Over the past couple of weeks, we have been discussing our potential buy in the Energy space. Read our latest report: Collecting Tolls On The Energy Express
  • On Monday we made our initial 1/2 position purchase of AMLP.
  • The ETF is very oversold and on a really deep sell-signal. We are looking for the position to firm up and hold recent support before adding the second 1/2 position. With a near 10% yield, we can get paid while we wait.
  • There is a lot of value in the energy space and we are looking at additional opportunities to add to the portfolio.
  • Stop is set at $7.00

XOM – Exxon Mobil

  • We bought XOM at the beginning of the year and sold half of the position near the April highs.
  • We recently bought back the 1/2 we sold near the recent lows and are back to a full-weight in the position.
  • Currently, XOM is about to trigger a short-term buy signal, but remains trapped within the long-term consolidation range.
  • A break above $72 creates a very bullish outlook for XOM, but oil prices need to come up and stay at $60 or above. This may be challenge heading into 2020.
  • Stop set at $66 currently.

AAPL – Apple, Inc.

  • We also bought AAPL at the beginning of the year and sold 20% of the position near the May highs and more just recently taking us to 1/2 weight in the position.
  • AAPL is EXTREMELY overbought and extended. Historically, such periods of overbought conditions have lead to decent corrections which have corresponded to broader sell-offs in the market.
  • Pay attention to AAPL – as AAPL goes, so goes the market.
  • We are moving our stop up to the 200-dma for now.
  • Stop loss is set at $210

ABT – Abbott Laboratories

  • We have owned ABT since the beginning of the year, and have previously taken profits in the position.
  • Despite ABT being on a very DEEP oversold “sell signal,” the position continues to hold it bullish uptrend along the 200-dma.
  • We continue to like our position and have been hoping for a better opportunity to add to our current holding.
  • For now, we will be patient and keep our stop trailing along the 200-dma.
  • Stop loss is set at $80

AGNC – AGNC Investment Corp.

  • We bought two positions about mid-year to accommodate for a potentially steeper yield curve – Annaly (NLY) and AGNC (AGNC)
  • Both have performed well as the yield curve uninverted and steepened accordingly.
  • However, the positions are now EXTREMELY overbought, so wait for corrections to add to current holdings.
  • For now we are holding our current position and moving the stop up.
  • Stop has been moved up to $16.25

DUK – Duke Energy

  • We have been concerned about our position in DUK as performance was lacking as of late and it had broken support at the 200-dma.
  • However, DUK has managed to recover and hold support for now while working into a fairly deep SELL signal. If DUK can hold support here and begin to reverse the sell signal we will have a good opportunity to add back to our position after taking profits previously.
  • Stop is currently set at $86

UTX – United Technology

  • BA and UTX are our two defense sector plays in the portfolio.
  • While BA continues to wrestle with the 737MAX issues, UTX has advanced nicely since our acquisition.
  • We have taken profits previously, but the position is extremely extended and overbought.
  • Look for a correction back to the 200-dma to add to holdings.
  • We are moving our stop up on the position as a whole.
  • Stop loss has been adjusted to $130.00

MU – Micron Technology

  • MU had a nice rally following our initial purchase and got extremely overbought very quickly.
  • We are now consolidating that advance and potentially setting up support at the 200-dma which could provide an additional entry point to increase holdings.
  • MU is very subject to the “trade deal,” so we are keeping our stops tight on the position for now.
  • Stop loss set at $40

PG – Procter & Gamble

  • PG had gotten EXTREMELY overbought with the advance from the May lows in 2018.
  • However, that overbought condition has been reversed and even with a “sell signal” in place, PG has held its bullish trend.
  • We will look to add to our holdings if PG continues to hold up and triggers a “buy signal.”
  • We are moving our stop up on the whole position.
  • Stop-loss moved up to $110

V – Visa, Inc.

  • Consumers keep “swiping the plastic” and with Christmas here the “sales are ringing.”
  • V continues in a solidly bullish uptrend despite being on a fairly deep sell signal.
  • If the sell-signal reverses back to a buy, we can add to our position. We would relish a bit of a pullback to add to holdings at a better price level.
  • Be patient for now,.
  • Stop loss moved up to $165

Sector Buy/Sell Review: 12-10-19

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.

NOTE – We have been talking about the market needing a correction for the last couple of weeks. As we approach mutual fund distributions, this week, and with the “trade war” likely to reignite, risk is to the downside currently. Most of the analysis reflects both of these points.

Basic Materials

  • As noted previously, XLB is trying to reverse the overbought condition, and has successfully tested support twice.
  • While XLB is overbought short-term, XLB can be added for a trading position currently with a stop-loss at recent support levels.
  • We currently hold 1/2 position and are looking to add the second 1/2. However, with the trade war front and center this coming weekend, with tariffs set to increase, we are just going to wait and see what the outcome is. If tariffs are delayed we will add the second 1/2 to our current holdings.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with a tighter stop-loss.
    • Stop-loss adjusted to $59
  • Long-Term Positioning: Neutral

Communications

  • XLC finally broke out to new highs and joined its brethren technology sector.
  • With a “buy signal” in place, there is little for us to do currently but wait.
  • If you need to add a position, wait for a pull back to test the recent breakout support level and add there.
  • XLC is currently a full-weight in portfolios but should perform better if a year-end advance ensues.
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions
    • This Week: Hold trading positions.
    • Stop adjusted to $48.50
  • Long-Term Positioning: Neutral

Energy

  • XLE has been stuck in a downtrend since the end of 2018.
  • With relative performance improving, we have added 1/2 position of AMLP to our portfolios. Please read the related PORTFOLIO TRADE UPDATE on the Dashboard.
  • We are holding a slightly expanded stop on AMLP at $7 to allow for potential tax-loss selling over the next couple of weeks, and will add to our position at lower levels.
  • Short-Term Positioning: Bearish
    • Last week: No Position – looking to add
    • This week: Added 1/2 AMLP To Portfolios
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • XLF finally broke out to new highs which makes it much more interesting to add to the portfolio. The recent bounce off of the uptrend line is also bullish.
  • However, the sector remains extremely overbought, and the buy signal is extremely extended as well. A pull back or consolidation is required to add holdings into the portfolio.
  • We need a decent correction to work off the extreme overbought.
  • Short-Term Positioning: Neutral
    • Last week: Hold Positions
    • This week: Hold Positions
    • Stop-loss adjusted to $28
  • Long-Term Positioning: Bearish

Industrials

  • Like XLB, XLI broke out to new highs, but the trade war now threatens the sector.
  • The current correction is working off the extreme overbought condition, but support needs to hold at the breakout level.
  • We are looking for a bit of consolidation and/or pullback to work off some of the extreme overbought condition before increasing our weighting. And, as with XLB, we are waiting to see what happens to tariffs this weekend.
  • We have adjusted our stop-loss for the remaining position. We are looking to add back to our holdings on a reversal to a buy signal.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $78
  • Long-Term Positioning: Neutral

Technology

  • XLK is extremely overbought on both a price and momentum basis.
  • We are currently target weight on Technology, but may increase exposure on a pullback to support within the overall uptrend. (A retest of the breakout that holds) The upper rising trendline is also providing resistance so look to add on a pullback that holds the lower trendline support.
  • Short-Term Positioning: Bullish
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $77.50
    • Long-Term Positioning: Neutral

Staples

  • Defensive sectors have started to perform better as money is just chasing markets now.
  • XLP continues to hold its very strong uptrend as has now broken out to new highs. However, XLP is back to more extreme overbought.
  • If the short-term “sell signal” is reversed, it could provide additional lift to the sector.
  • We previously took profits in XLP and reduced our weighting from overweight.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $60
    • Long-Term Positioning: Bullish

Real Estate

  • As noted last week, XLRE was consolidating its advance within a very tight pattern but broke to the downside. The subsequent rally failed to move back above previous support so the risk is to the downside currently.
  • We had previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected which has now been completed.
  • XLRE is now on a VERY deep “sell signal” and is very oversold. With support holding, trading positions can be added to portfolios. We are fully weighted the sector currently so there isn’t any change required in our portfolios at this time.
  • You can add to positions if you are underweight but maintain a stop at recent lows for new purchases.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.00 for profits.
  • Long-Term Positioning: Bullish

Utilities

  • XLRE and XLU are virtually the same commentary with XLU rallying to test previous resistance but holding a very tightening support line.
  • After taking profits, we have time to be patient and wait for the right setup. We may be getting an opportunity here soon if support can hold as the overbought condition is reversed.
  • Long-term trend line remains intact but XLU and the sell signal is now fairly deep which suggests we may see a rotation back into defensives soon.
  • We are currently at full weight, so no change is required currently. However, trading positions can be added with a very tight stop.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to support at $59.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has remained intact and broke out to new highs and has accelerated that advance.
  • However, the rapid acceleration of the sector has taken XLV to extreme overbought conditions which will give way sooner than later. Take profits and rebalance holdings.
  • We noted previously, healthcare would begin to perform better soon as money looked for “value” in the market. That has been the case as of late, but has gone too far, too quickly.
  • With XLV now at the top of its range, take profits and wait for another opportunity to add exposure.
  • Short-Term Positioning: Neutral
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to $94
  • Long-Term Positioning: Bullish

Discretionary

  • The rally in XLY has not participated as much as other sectors like Financials, Healthcare, and Technology, and has failed to break above resistance.
  • We added to our holdings previously to participate with the current rally, but are carrying a tight stop on the whole position.
  • XLY is struggling to reverse back to a buy signal, and overhead resistance is going to problematic short-term.
  • Hold current positions for now, as the Christmas Shopping Season is in full swing, but the market doesn’t seem to be “buying” the strong “retial numbers” we have been told are happening. Either the sector is wrong and will catch up, or the sector is telling us the economy is weaker than it looks.
  • The dismal performance relative to other sectors of the markets suggests not adding new/additional exposure currently.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $115.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has broken out of consolidation but quickly ran into resistance and failed back below support.
  • Like XLY, XTN is closely tied to economic activity. So, if XTN breaks down from current levels, there may be other issues we need to deal with.
  • With a “buy” signal in place, and very extended, a better setup is forming to add holdings.
  • Be patient, XTN has a good bit of work to do to prove its position in portfolios.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: Monthly “Buy Signal” Say Bull Is Back? But For How Long?

Just recently, there have been numerous “bullishly biased” analysts and bloggers discussing the turn up in the monthly MACD indicators as a “sure sign” the bull market rally is set to continue.

While “bullish buy signals” on any long-term indicator is indeed a positive sign, there are a few “warning labels” which must also be considered. For example:

  1. Since these are monthly indicators, the signal is only valid at the end of the month. Mid-month signals can be reversed by sharp price movements.
  2. No one signal provides any “certainty” about future market outcomes.
  3. Time frames of signals matter. Given monthly signals are long-term in nature, the signal time frames are important in providing actionable information.

So, is the bull market back?

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. You can view an unlocked version here. (We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and commodities. You can try RIA PRO FREE for 30-days)

But as longer-term investors and portfolio managers, we are more interested in the overall trend of the market. While it is fundamental analysis derives “what” we buy, it is the long-term “price” analysis which determines the “when” of the buying and selling aspects of portfolio management over the long-term.

For us, the best measures of the TREND of the market is through longer-term weekly and monthly data. Importantly, as noted above, these longer-term data signals are only valid at the end of the period. It is not uncommon for signals to be triggered and reversed during the middle of the period, which creates “false” signals, and poor outcomes. Since we are more interested in discerning changes to the overall “trend” of the market, we find monthly indicators, which are slow-moving, tend to reveal this more clearly.

In April of 2018, I penned an article entitled 10-Reasons The Bull Market Ended,” in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. Of course, 2018 turned out to be a tough year culminating in a 20% slide into the end of the year. Since then, we have daily reminders we are “close to a trade deal,” and the Fed has completely reversed course on hiking rates and extracting liquidity. In July, we published S&P 3300, The Bull Vs. Bear Case.

While volatility and sentiment have reverted back to levels of more extreme complacency, the fundamental and economic backdrop has deteriorated further.

The first chart shows the monthly buy/sell signals stretched back to 1995 (25 Years). As shown, these monthly “buy” and “sell” indications are fairly rare over that stretch. What is interesting, is that since 2015 there have been two-major sell signals, both of which were arrested by Central Bank interventions.

Importantly, while Central Bank interventions have been able to halt declines, the trade-off has been a negative divergence in overall momentum. This negative divergence in momentum suggests that the current monthly “buy signal,” if it is able to hold through the end of December, could quickly reverse if the Fed ceases, or reduces, its current monetary interventions.

With global economic growth continuing to drag, an unresolved “trade war,””Brexit,” and weaker earnings growth, the question is whether Central Banks can accommodate the markets long-enough for all of these more negative issues to be resolved?

Given that we are 10-years into a “cyclical” bull market, and have yet to complete the second half of the “full-market” cycle, there is risk to the bullish view.

I know…I know…

“But this time is different because of ‘_(fill in the blank__'”

Maybe, I certainly won’t argue the point of Central Bankers manipulating markets currently.

However, we can take those same monthly momentum indicator above back to 1950, and add two confirming monthly indicators as well. The vertical “red dashed lines” are when all three indicators have aligned which reduces false signals.

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

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destruction of capital, the reversal of those signals were signs to “get back in.”

Investing, long-term, is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “buy signal,” which since 1950 has been a good indication of rising markets. Yes, the bull market is back! However, when these signals have existed in a “negative tren,d,” and are diverging from the market, corrections have often followed. While the most current buy signal could indeed last for 6-months to one-year, which would conform to our cyclical indications, there are several things to consider:

  1. As was seen in the 1960s and 70s, “buy signals” in the negative trend led to repeated rallies and corrections until the cycle was completed at the bottom of the 1974 bear market.
  2. A rising trend in the “buy signals” was more aligned with a longer-term “secular” bull market cycle which consisted of very short-term sell signals.
  3. With markets very overbought on a longer-term basis, price advances could be somewhat limited.

Yes, the recent “buy” signal could turn out to be a “1995” scenario where the market rallied almost non-stop into the “Dot.com” crash, but the fundamental and technical backdrop doesn’t really support that thesis.

Furthermore, the QUARTERLY chart remain concerning given the massive extension above the long-term trend and continued overbought conditions. Historically, reversions from such extensions above the long-term trend line have not been kind to investors.

Let me be VERY clear. Both the MONTHLY and QUARTERLY signals confirm the “bull market” that began in 2009 remains intact currently.  This is why we are maintaining our long-biased exposure in portfolios. However, the current market cycle is extremely extended and is approaching a reversion within the next 12-24 months. That reversion will likely extract most of the gains of the previous bull market. As noted this past weekend, such an occurrence would be part of a normal full-market cycle.

One of the biggest reasons not to equate the current monthly “buy” signal to a “1995” type period is valuations. In 1987, valuations were low and rising at a time where interest rates and inflation were high and falling. Today, that economic and valuation backdrop are entirely reversed.

Currently, a correction from current price levels of the market to PE20 (20x current earnings) would be a 13.8% decline. However, a drop back to the long-term average of PE15 would entail a 34.8% fall, with a full-reversion to PE10, which would be required to “reset” the market, would wipe our 56.2% of the total market value.

Emotionally, the hardest thing for investors to do is to sit on their hands and avoid “risk” when the markets are rising. But this is the psychological issue which plagues all investors over time which is to “buy high” and “sell low.”

It happens to everyone.

David Rosenberg previously summed up investor sentiment very well.

“Well, the bulls certainly are emboldened, there isn’t any doubt about that. And this confidence, bordering on hubris, is proving very difficult to break. We are back to good news being good news, and bad news is also treated as good news.”

That is indeed the situation currently. “Bad news” means more Central Bank intervention, and “good news” is, well, just good news and is taken at face value with few questions. Don’t forget that “all good things do eventually end,” and being able to identify, and act, when the change comes is what separates winners from losers.

What This Means And Doesn’t Mean

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

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

  • Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
  • Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.
  • Move Trailing Stop Losses Up to new levels.
  • Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Here is the question you need to answer for yourself. What’s worse:

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

Currently, the monthly and quarterly indicators are indeed bullish. However, it is important to remember that it takes some time for these indicators to reverse, and issue clear signals to extract cash from the market. Currently, the risk of disappointment greatly outweighs the potential for upside surprises at this juncture.

What happens next may just surprise everyone.

Major Market Buy/Sell Review: 12-09-19

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

  • With a “buy signal” triggered, there is a positive bias, however with both the price and “buy signal” very extended we expect a short-term correction for a better entry point to add exposure.
  • The correction on Monday and Tuesday was not enough to trigger an index “buy,” but was enough to require us to close out our “short S&P 500” index hedge for now in both the Equity and ETF portfolios. We took a small loss in the position but the rest of the portfolio continues to perform well. We will look to add the position back at a later date.
  • Given the deviation from the mean, and the more extreme overbought condition, it is advisable to wait for some consolidation/correction before increasing equity allocations.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position with a bias to add to holdings.
    • Stop-loss moved up to $290
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • DIA broke out to new highs with the reversal of the “buy” signal to the positive. However, that buy signal is pushing some of the higher levels seen historically so a correction is likely.
  • Despite the rally at the end of the week, DIA remains below its recent highs.
  • Hold current positions, but as with SPY, wait for a correction before adding further exposure.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $265.00
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • Like DIA, the technology heavy Nasdaq has broken out has did not get back above its recent at the end of the week. QQQ is pushing very extended levels.
  • The Nasdaq “buy signal” is also back to extremely overbought levels so look for a consolidation or correction to add exposure.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $185
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted previously, small-caps broke out above previous resistance but have been struggling.
  • Last week, small-caps successfully tested the breakout level, there is now a bias to add exposure.
  • However, as suggested, be patient as these historical deviations tend not to last long. SLY is extremely overbought and deviated from its longer-term signals.
  • We are actively looking for a trading opportunity that sets up.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss previously violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY is holding up better than SLY and has not broken back down into its previous consolidation range.
  • MDY has now registered a short-term “buy” signal, but needs a slight correction/consolidation to reduce the extreme overbought and extended condition. The buy signal is very extended as well.
  • Look to add exposure to the market on a pullback that doesn’t violate support.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM continues to underperform and failed to hold its breakout.
  • With the “buy signal” extremely extended, the set up to add exposure here is not warranted. Watch the US Dollar for clues to EEM’s direction.
  • As we noted last week, PAY ATTENTION to the Dollar (Last chart). If the dollar is beginning a new leg higher, EEM and EFA will fail.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position
    • Stop-loss violated at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like MDY, EFA rallied out of its consolidation channel and is holding that level but is struggling with previous resistance.
  • Like EEM, it and the market are both EXTREMELY overbought.
  • Be patient for now and wait for a confirmed breakout before adding exposure, and again, watch the U.S. Dollar for important clues.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss was violated at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • While commodities tend to perform well under liquidity programs due to their inherent leverage. Oil has continued to languish under the problems of over-supply and weak sector dynamics.
  • There is a short-term buy signal for oil, and oil prices finally rallied this week to the top of the downtrend channel. It is important for oil to break above $60 to set up a trade in the energy space.
  • We are starting to dig around the sector for some trading opportunities. Read our report on the site:
  • Collecting Tolls On The Energy Express
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position
    • Stop-loss for any existing positions is $54.
  • Long-Term Positioning: Bearish

Gold

  • Gold got back to oversold and broke support at the 200-dma previously.
  • We are sitting on our stop-loss for the position currently, and had previously sold half our position.
  • With the “QE4” back in play, the “safety trade” may be off the table for a while. So, if we get stopped out of our holdings, we will look to buy them back at lower levels.
  • Short-Term Positioning: Neutral
    • Last week: Hold remaining position.
    • This week: Hold remaining position.
    • Stop-loss for whole position adjusted to $132.50
    • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Like GLD, Bond prices also broke support and triggered a sell-signal.
  • However, this past week, as “trade deal turbulence” returned, bonds rallied back to the top of its current downtrend channel and are still holding support.
  • Watch your exposure and either take profits or shorten your duration in your portfolio for now.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is moved up to $132.50
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Despite much of the rhetoric to the contrary, the dollar remains in a strongly rising uptrend. Given a “strong dollar” erodes corporate profits on exports (which makes up 40% of corporate profits overall) a strong dollar combined with tariffs isn’t great for corporate bottom lines. Watch earnings carefully during this quarter.
  • The dollar continues to hold support at the 200-dma and the bottom of the uptrend. If the dollar rallies back to the top of its trend, which is likely, this will take the wind out of the emerging market, international, and oil plays.
  • The “sell” signal is also turning up. If it triggers a “buy” the dollar will likely accelerate pretty quickly.

The Myth Of The “Great Cash Hoard” Of 2019

Tell me if you heard this one lately:

“There’s a trillion dollars in cash sitting on the sidelines just waiting to come into the market.” 

No.

Well, here it is directly from the Wall Street Journal:

“Assets in money-market funds have grown by $1 trillion over the last three years to their highest level in around a decade, according to Lipper data. A variety of factors are fueling the flows, from higher money-market rates to concerns over the health of the 10-year economic expansion and an aging bull market.

Yet some analysts say the heap of cash shows that investors haven’t grown excessively exuberant despite markets’ double-digit gains this year, and have plenty of money available to buy when lower prices prevail.”

See…there is just tons of “cash on the sidelines” waiting to flow into the market.

Except there isn’t.

The Myth Of Cash On The Sidelines

Despite 10-years of a bull market advance, one of the prevailing myths that seeming will not die is that of “cash on the sidelines.” To wit:

“’Cash always makes me feel good, both having it and seeing it on the sidelines,’ said Michael Farr, president of the money-management firm Farr, Miller & Washington.

Stop it.

This is the age-old excuse why the current “bull market” rally is set to continue into the indefinite future. The ongoing belief is that at any moment investors are suddenly going to empty bank accounts and pour it into the markets. However, the reality is if they haven’t done it by now, following 4-consecutive rounds of Q.E. in the U.S., a 330% advance in the markets, and ongoing global Q.E., exactly what is it going to take?

But here is the other problem.

For every buyer there MUST be someone willing to sell. As noted by Clifford Asness:

“There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Every transaction in the market requires both a buyer and a seller with the only differentiating factor being at what PRICE the transaction occurs. Since this is required for there to be equilibrium in the markets, there can be no “sidelines.” 

Think of this dynamic like a football game. Each team must field 11 players despite having over 50 players on the team. If a player comes off the sidelines to replace a player on the field, the player being replaced will join the ranks of the 40 or so other players on the sidelines. At all times there will only be 11 players per team on the field. This holds equally true if teams expand to 100 or even 1000 players.

Furthermore, despite this very salient point, a look at the stock-to-cash ratios (cash as a percentage of investment portfolios) also suggest there is very little available buying power for investors currently. As we noted just recently with charts from Sentiment Trader:

As asset prices have escalated, so have individual’s appetite to chase risk. The herding into equities suggests that investors have thrown caution to the wind.

With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it suggests investors are now functionally “all in.” 

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and;
  2. The stock/cash ratio, shown below, is at levels normally coincident with more important market peaks.

But it isn’t just individual investors that are “all in,” but professionals as well.

Importantly, while investors are holding very little ‘cash,’ they have taken on a tremendous amount of ‘risk’ to chase the market. It is worth noting the current levels versus previous market peaks.”

Even Ned Davis noted that investors remain more invested in riskier assets than has historically been the case.

“Cash is low, meaning households are fairly fully invested.” 

So, Where Is All This Cash Then?

The Wall Street Journal was correct in their statement that money market cash levels have indeed been climbing. The chart from the Office Of Financial Research shows this:

There are a few things we need to consider about money market funds.

  1. Just because I have money in a money market account, doesn’t mean I am saving it for investing purposes. It could be an emergency savings account, a down payment for a house, or a vacation fund on which I want to earn a higher rate of interest. 
  2. Also, money markets are used by corporations to store cash for payroll, capital expenditures, operations, and a variety of other uses not related to investing in the stock market. 
  3. Foreign entities also store cash in the U.S. for transactions processed in the United States which they may not want to immediately repatriate back into their country of origin.

The list goes on, but you get the idea.

If you take a look at the chart above, you will notice that the bulk of the money is in Government Money Market funds. These particular types of money market funds generally have much higher account minimums (from $100,000 to $1 million) which suggests that these funds are predominately not retail investors. (Those would be the smaller balances of prime retail funds.)

So, where is all that cash likely coming from?

Hoarding Cash

You are already most likely aware that Warren Buffett is hoarding $128 billion in cash, and that Apple is sitting on a cash trove of $100 billion, with Microsoft holding $136.6 billion, and Alphabet amassing $121 billion.

Yes, some of that cash has been used for share buybacks, but much of it is sitting there waiting for acquisitions, R&D, capital expenditures, etc. However, that cash is primarily sitting in short-term and longer-term dated treasuries, AND, you guessed it, money market funds.

However, as noted above, there is also a flood of money coming into U.S. Dollar denominated assets for better yield and safety than what is available elsewhere in the world.  

At RIAPRO.NET we regularly track the U.S. Dollar for our subscribers. (You can access these reports with a FREE 30-day Trial.)

  • Despite much of the rhetoric to the contrary, the dollar remains in a strongly rising uptrend. Given a “strong dollar” erodes corporate profits on exports (which makes up 40% of corporate profits overall) a strong dollar combined with tariffs isn’t great for corporate bottom lines. Watch earnings carefully during this quarter.
  • Furthermore, the dollar bounced off support of the 200-dma and the bottom of the uptrend. If the dollar rallies back to the top of its trend, which is likely, this will take the wind out of the emerging market, international, and oil plays.
  • The “sell” signal is also turning up. If it triggers a “buy” the dollar will likely accelerate pretty quickly.

Much of the bulls rallying cry has been based on the dollar weakening with the onset of QE, but as shown above, that has yet to be the case. However, US Dollar positioning has been surging as of late as money has been flowing into US Dollar denominated assets. Importantly, it is worth watching positioning in the dollar as a reversal of dollar-longs are usually reflective of short- to intermediate-term market peaks.

As shown above, and below, such net-long positions have generally marked both a short to intermediate-term peak in the dollar. The bad news is that a stronger dollar will trip up the bulls, and commodities, sooner rather than later.

However, as it relates to foreign positioning, it is worth noting that EURO-DOLLAR positioning has been surging over the last 2-years. This surge corresponds with the surge in dollar-denominated money market assets.

What are Euro-dollars? The term Eurodollar refers to U.S. dollar-denominated deposits at foreign banks, or at the overseas branches, of American banks. Net-long Eurodollar positioning is at an all-time record as foreign banks are cramming money into dollar-denominated assets to get away from negative interest rates abroad.

Importantly, when positioning in the Eurodollar becomes NET-LONG, as it is currently, such has been associated with short- to intermediate corrections in the markets, including outright bear markets. 

What could cause such a reversal? A pick up of economic growth, a reversal of negative rates, a realization of over-valuation in domestic markets, which starts the decline in asset prices. Then, the virtual spiral begins of assets flowing out, lowers asset prices, leading to more asset outflows.

While the bulls are certainly hoping the “cash hoard” will flow into U.S. equities, the reality may be quite different.

That’s how the bear markets begin.

Slowly at first. Then all of a sudden.

RIA PRO: 2020 – The Year Decennial & Presidential Cycles Collide


  • Here Comes The Santa Claus Rally
  • When Presidential & Decennial Cycles Collide
  • New: Financial Planning Corner
  • Sector & Market Analysis
  • 401k Plan Manager

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Here Comes Santa Claus (Rally)

On Friday, the market rallied sharply on the back of a much better than expected employment report and comments from Larry Kudlow that a “trade deal” is near. Given we are now at the last stages of the year where mutual, pension, and hedge funds need to “window dress” for year-end reporting, we removed our small equity hedge from the portfolio for the time being.

A quick word about that employment report.

While the headline number was good, it remained primarily a story of auto workers returning to work and continued increases in lower wage-paying jobs and multiple jobholders. Such has been the story of the bulk of this recovery. However, more importantly, the bump did not change the overall dynamics of the job market cycle, which is clearly deteriorating as shown in the chart below.

The key to trend change is CEO confidence which is extremely negative and coincident with employment cycle turns. Note that the end of employment cycles, when compared to CEO confidence, looks very similar at the end of each decade.

Nonetheless, in the short-term, the market dynamics are positive suggesting the market can indeed rally into the end of the year. As noted above, we have removed our equity hedge for now to allow our long-positions to fully benefit from the expected “Santa Claus” rally.  (Or if you prefer the more PC version then it would be the expected “Jovial Full-Figured Holiday Person” rally.)

With the market back to short-term overbought, and the short-term “sell signal” still in place, it is possible we could see a bit of a correction next week. However, as we head into the last week of the year, a retest of highs is quite likely. 

In the longer-term, as we will discuss more in a moment, the risk remains to the downside. It is highly unlikely there will be a “trade deal” anytime soon, and with the upcoming election, there will likely be increased volatility going into 2020.

From a purely technical perspective, on a monthly basis, the market is exceedingly overbought and at the top of the long-term trend channel. When these two conditions have been filled previously, we have seen fairly sharp corrections within the confines of the bullish trend.

With QE-4 in play, the bias remains to the upside keeping our target of 3300 on the S&P 500 in place. This is particularly the case as we head further into the seasonally strong period combined with an election year cycle.

Currently, we are exploring the energy space in particular where there is value being generated after the long drought of interest in energy-related stocks.

We have just released a research report for our RIAPro Subscribers (30-Day Free Trial)  on where we are looking for opportunity. Here is a snippet:

A decline in the dividend yield to the norm, assuming the dividend payout is unchanged, would result in a price increase of 13.17% for AMLP. Alternatively, if oil declined about 20% in value, the current AMLP dividend yield would then be fairly priced. We consider this a significant margin of safety should the price of oil fall, as it likely would if the U.S. enters a recession in the near future.”

When Presidential & Decennial Cycle Collide

There have been quite a few articles out lately suggesting that in 2020 the 10-year bull market is set to continue because it is a presidential election year. This sounds great in theory, but Wall Street and the financial media always suggest that next year is going to be another bullish year.

However, there are a lot of things that will need to go “right” next year from:

  1. Avoidance of a recession
  2. A rebound in global economic growth
  3. The consumer will need to expand their current debt-driven consumption
  4. A marked improvement in both corporate earnings and corporate profitability
  5. A reduction or removal in current tariffs, and;
  6. The Fed continues to remain ultra-accommodative to the markets.

These are all certainly possible, but given we are currently into both the longest, and weakest, economic expansion in history, and the longest bull market in history, the risks of something going wrong have certainly risen.

(While most financial media types present bull and bear markets in percentages, which is deceiving because a 100% gain and a 50% loss are the same thing, it worth noting what happens to investors by viewing cumulative point gains and losses. In every case the majority of the previous point gain is lost.)

However, what about the election coming up in less than a year?

Presidential Cycle

With “hope” running high that things can continue going into 2020, the question becomes whether or not the Presidential election cycle can hold its performance precedent.  Since 1871, markets have gained in 35 of those years, with losses in only 11.

Since 1948, there have only been two losses during presidential election years which were 2000 and 2008. In fact, stocks have, on average, put in their second-best performance in the fourth year of a president’s term. (The third year has been best as we are seeing currently.) 

With a “win ratio” of 76%, the media has been quick to assume the bull market will continue unabated. However, there is a 24% chance a bear market will occur which is not entirely insignificant. Furthermore, given the duration, magnitude, and valuation issues associated with the market currently, a “Vegas handicapper” might increase those odds just a bit.

One thing to remember about all of this is that while the odds are weighted in favor of a positive 2020 from an election cycle standpoint – there have been NO cycles in history when the majority of the industrialized world was on the brink of a debt crisis all at the same time.

While the election of the next President will impact the market’s view towards policy stability; it is the world stage that will drive investor sentiment over the coming months and years. The biggest of those drivers is employment which has been weakening as of late. Importantly, there is an important correlation between consumer/investor sentiment, CEO confidence, and employment as noted above.

“Take a closer look at the chart above.

Notice that CEO confidence leads consumer confidence by a wide margin. This lures bullish investors, and the media, into believing that CEO’s really don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

‘I’m sorry, we think you are really great, but I have to let you go.’” 

“It is hard for consumers to remain ‘confident,’ and continue spending, when they have lost their source of income. This is why consumer confidence doesn’t ‘go gently into night,’ but rather ‘screaming into the abyss.’”

But there is another cycle that we need to consider which is colliding with the Presdential election cycle, and that is the 10-year or decennial cycle.

Decennial Cycle

Using the same data set going back to 1833 we find a little different outlook. While the 10th year of the decade (2020) is on average slightly positive, it’s win/loss ratio is only 56%, or not much better than a coin toss.

Furthermore, while presidential election years have a near 10% average annual return profile, the 10th-year of the decennial cycle is markedly weaker at just 1.91% on average.

The best year of the decade is the 5th which has been positive 79% of the time with an average return of 22%. The worst year is the 7th with only a 53% win rate but a negative average annual return. As noted, 2020 comes in as the second place for the worst of the annual returns.

With a win/loss record of 11-7 an investor betting heavily on a positive outcome for 2020 may be left short changed given the current political, economic, fundamental, and financial environment.

I have also overlaid the 1st-year of the new presidential cycle with the “orange boxes” above. You will notice that again, return parameters and win/loss percentages are low. This should suggest some caution for investors over the next 24-months given the length of the current bull market advance.

A Lot Of If’s

All of this analysis is fine but whether the market is positive or negative in 2020 comes down to a laundry list of assumptions:

  • If we can avoid a recession in the U.S. 
  • If we can avoid a recession in Europe. 
  • If corporate earnings can strengthen.
  • If the consumer can remain strong.
  • Etc.

Those are some pretty broad “if’s” and given the weakness is imports, which suggests a weakening domestic consumer, and struggling manufacturing, the risk of something going wrong is elevated.

As far as corporate earnings go – they peaked this year as the tax cut stimulus ran its course, and forward expectations are being sharply ratcheted lower. As we discussed on Tuesday:

“Since April, forward expectations have fallen by more than $11/share as economic realities continue to impale overly optimistic projections.”

This earnings boom cycle was skewed heavily by accounting rule changes, loan loss provisioning, tax breaks, massive layoffs, extreme cost cutting, suppression of wages and benefits, longer work hours, and massive share buybacks along with extraordinary government stimulus.

But when it comes to actual reported “profits,” which is what companies actually earned, reported, and paid taxes on, it is a vastly different story.

“Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

The chart below shows the real, inflation-adjusted, profits after-tax versus the cumulative change to the S&P 500. Here is the important point – when markets grow faster than profitability, which it can do for a while; eventually a reversion occurs. This is simply the case that all excesses must eventually be cleared before the next growth cycle can occur. Currently, we are once again trading a fairly substantial premium to corporate profit growth.

So, if, somehow, maybe, possibly, all these things can be sustained we should be just fine.

The problem is, however, all of the pillars that supported the earnings boom are now going away beginning next year, each of them to some degree, which throws into question the sustainability going into 2020-2021.

While doing statistical analysis on the Presidential and Decennial cycles certainly make for interesting articles, it is crucially important to remember what drives the financial markets the short-term which is psychology and sentiment.

In the next 12-18 months, there will be more than enough event risks to skew the potential outcomes of the markets. This doesn’t mean that you should go and hide all in cash or gold. It does suggest you need to actively pay attention to your money.

This idea plays into our allocation theme of higher quality income, hedged investments and precious metals as an alternative to direct market risk. With expectations of lower economic growth in the coming quarters, reduced earnings, and pressure on the consumer, the markets are likely to remain highly volatile with little overall progress.

While we are in the midst of prognostications, it has also been predicted the world will end in 2020, so anything other than that will be a “win.”

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

See you next week.


“NEW” – Financial Planning Corner

by Danny Ratliff, CFP®, ChFC®

10-Don’t Miss Year-End Financial Planning Tips

Let’s give thanks that Thanksgiving week and the numerous “big” shopping days have officially come to a close.  Christmas is fast approaching and now would be an easy time to push these year-end tips to 2020. Don’t. Spend 15 minutes and make sure you’re doing all you can to take advantage of 2019 and setting yourself up for a successful 2020.

  1. Evaluate this year’s financial plan progress: If you created a plan for 2019 how are you doing? What have you accomplished for the year and what do you still have time to complete? Many people just look at the investment returns and while that’s important don’t forget to look at your behaviors. How much have you spent and saved?
  2. Take another look at your 401(k): Does your employer match your 401(k) contributions? Now would be a good time to make sure you aren’t leaving any money on the table in the form of matching contributions. For 2019 you can contribute up to 19,000 to your 401(k) and an additional catch up of 6,000 if you turned 50 this year. Once the calendar turns to 2020 you won’t be able to go back and make up those missed contributions.
  3. Have access to a Health Savings Account (HSA,) max it out: HSA accounts are like the fountain of youth for the financial planning world. They’re almost too good to be true. This is the only account in the world that will give you a triple tax benefit. Money goes in tax free, grows tax free and if used for medical expenses comes out tax free. Think your medical expenses in retirement won’t be that bad? Thank again, Fidelity just did a study that shows the average 65-year-old couple will spend $280,000 in medical expenses.   In 2019 individuals can contribute $3,500 and a family can contribute $7,000. Here’s the kicker, if you really want to maximize these plans you need to try to pay for current medical expenses out of pocket and let these funds grow.
  4. Use the balance of your Flexible Spending Account (FSA): If you have an FSA, now is the time to spend that unspent balance. Some plans will allow you to carry over a small amount of the funds to next year, but many won’t. So, use it or lose it.
  5. Review your Insurance Coverage: If you have life, health, disability, homeowners or long- term care insurance make some time to review your policies. Has anything changed with your policies, have premiums gone up? In regard to your life insurance have you had any life events that would warrant a change in your coverage?
  6. Review or Create Estate Planning Documents: If you and I have had a face to face meeting this is something I’ve probably asked you. This is so important, but often overlooked or pushed to the back burner. Stop denying the inevitable, you’re going to die, make sure your loved ones are taken care of the way you wish.
  7. Review Expenses: Many people have no idea how much they spend each month or where they are spending their money. This goes back to #1 evaluating your progress in your plan.
  8. Have a Conversation with your Tax Advisor: Between now and Christmas is a great time to have a chat with your tax advisor to ensure you aren’t leaving any deductions on the table before we get into 2020 and it’s to late. Everyone likes to reduce their tax bill.
  9. Roth Conversions: While you’re talking with your CPA and Advisor find out if you have any room for a Roth conversion. We talk about these often and run many analyses, they’re not for everyone, but these can be a great tool to give you more flexibility in retirement.
  10. Sell Losers to offset Gains: Tax loss harvesting is an easy way to lower your taxes on a year to year basis. Do you have any gains for the year and hold positions with losses? Realize your losses to offset those gains. The losses will offset your gains dollar for dollar. You can also use an additional $3,000 to offset other income and if you have more than $3,000 in excess losses you can carry that over indefinitely until those losses are exhausted.

Achieving your financial goals is a never-ending process and staying on top of financial planning is imperative to your success. December is an ideal time to assess your current situation and ensure you’re taking advantage of all you can for 2019.

Need a financial partner to help keep you on track or looking for ways to fine tune your financial plan? Contact us to see how we can help create a financial plan that uses realistic data that will provide your family peace of mind and security.

Don’t hesitate to send me an email if you have any questions or if you, or someone you know, needs help. We encourage your feedback and look forward to hearing from you.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Improving – Energy (XLE)

The improvement in Energy has stalled for now as as the rotation to “value” gave way back to momentum for the “QE Chase.” Energy needs to break above the downtrend to become an attractive candidate for portfolios. We are digging around this space currently, but haven’t executed a position just yet.

Current Positions: No holdings

Outperforming – Technology (XLK), Healthcare (XLV), Industrials (XLI), Financials (XLF)

Financials have been running hard on Fed rate cuts and more QE. The sector is extremely overbought and extended and due for a correction. Take profits and be patient to add exposure.

Industrials, which perform better when the Fed is active with QE, also broke out to new highs recently but has been consolidating at a very high level. Given they are still extremely overbought, we will look to add but will wait for this correction to play out first.

Technology and Healthcare have been the leaders as of late. Healthcare made a sharp recovery from weakening to leading relative to the overall market, and the sector is now grossly overbought and extended. Take profits and look for a better entry point later. Like everything else, XLK is extremely overbought so wait for a correction to add exposure.

Current Positions:  1/2 weight XLI, Full weight XLK, XLV

Weakening – Utilities (XLU)

Utilities have not made a lot of ground, but haven’t lost much either but has corrected a big chunk of their previous overbought condition. Positions can be added on a break above the 50-dma.

Current Position: Target weight XLU

Lagging – Real Estate (XLRE), Staples (XLP), Discretionary (XLY), Communications (XLC), Materials (XLB

Staples have been a surprising winner over the last couple of weeks as money is still seeking a bit of defensive positioning. However, Discretionary other the other hand, has been a real laggard as of late which I suspect has more to deal with the “real economy,” rather than just a sector lagging the market currently. Watch XLY, a failure at support will likely suggest a larger corrective process. Communications broke out to new highs, but is still lagging the overall market. Given the sector is very overbought, be patient for a better entry point.

Current Position: Target weight XLC, XLY, XLP, XLRE, 1/2 weight XLB

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – While Small- and Mid-caps broke out of the previous ranges the rotation to risk finally regained some strength over the last week. Both sectors are very overbought so look for any weakness that holds support to add positions to portfolios.

Current Position: No position

Emerging, International (EEM) & Total International Markets (EFA)

Emerging and International Markets, rallied recently on news of “more QE,” and finally broke above important resistance. However, these markets are sensitive to the US Dollar which is showing some strength. With both markets EXTREMELY overbought currently, be patient for the right entry point.

Current Position: No Position

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

Be aware that all of our core positions are EXTREMELY overbought. A short-term correction or consolidation is likely before a further advance can be made.

Current Position: RSP, VYM, IVV

Gold (GLD) – Gold broke support at the $140 level but held support at $136. Stops should be placed on all positions at $132. Gold is very oversold and a break above the 50-dma will be a tradeable opportunity.

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

Bonds (TLT) – 

Bonds rallied back to the 50-dma but failed on Friday as the chase for stocks resumed. Support continues to hold so look for this correction to provide an oversold reading to buy bonds into.

Stay long current positions for now, and look for an opportunity to add to holdings.

Current Positions: DBLTX, SHY, IEF

Sector / Market Recommendations

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

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

Portfolio/Client Update:

As we discussed previously, we hedged our portfolios against a short-term market correction due to the extreme overbought condition which existed at the time. This past week, the market mildly corrected on Monday and Tuesday, but then a strong employment report and a litany of “trade deal” headlines quickly reversed the entire correction before it was complete. Regardless, given the minor correction that occurred, it cleared the market for a year-end rally. Therefore, we have temporarily removed the hedge until after the year-end performance chase is complete.

We will likely need to re-add the short position back to portfolios in January as the markets remain grossly overbought and, after the rise in the markets this past year, we will likely see a bout of selling to take in gains and defer the taxes until 2021.  We will wait, watch, and act accordingly.

As noted in the main body of this missive, the market remains extremely overbought which limits our ability to add “broad market” exposures. However, we are looking to selectively add exposure to ETF Models in small and mid-capitalization markets, basic materials, industrials, financials and energy.

As noted previously, we have been “picking through the ruble” of the energy sector looking for a couple of tradeable ideas in the sector as well. We have identified an interesting yield play that we are looking for the right entry point for. You can read the research note here.

However, whatever actions we wind up taking in the short-term remains a “rent the rally” for now.

  • New clients: We are holding off onboarding new client assets until we see some corrective action or consolidation in the market.
  • Equity Model: We sold SDS. Looking add to some core equity positions opportunistically. 
  • ETF Model: Same as Equity Model.

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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.)

If you need help after reading the alert; do not hesitate to contact me.

Click Here For The “LIVE” Version Of The 401k Plan Manager

See below for an example of a comparative model.


Model performance is based on a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. This is strictly for informational and educational purposes only and should not be relied upon for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril. 

401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k p

 The code will give you access to the entire site during the 401k-BETA testing process, so not only will you get to help us work out the bugs on the 401k plan manager, you can submit your comments about the rest of the site as well.

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

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

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

Collecting Tolls On The Energy Express

The recent surge in passive investment strategies, and corresponding decline in active investment strategies, is causing strong price correlations amongst a broad swath of equities. This dynamic has caused a large majority of stocks to rise lockstep with the market, while a few unpopular stocks have been left behind. It is these lagging assets that provide an opportunity. Overlooked and underappreciated stocks potentially offer outsized returns and low correlation to the market. Finding these “misfits” is one way we are taking advantage of a glaring market inefficiency.

In July 2019, we recommended that investors consider a specific and underfollowed sector of REITs that pay double-digit dividends and could see reasonable price appreciation. In this article, we shed light on another underfollowed gem that also offers a high dividend yield, albeit with a vastly different fundamental profile.

The Case for MLP’s

Master Limited Partnerships (MLPs) are similar in legal structure to REITs in that they pass through a large majority of income to investors. As such, many MLP’s tend to pay higher than average dividends. That is where the similarities between REITs and MLPs end. 

The particular class of MLPs that interest us are called mid-stream MLPs. We like to think of these MLPs as the toll booth on the energy express. These MLPs own the pipelines that deliver energy products from the exploration fields (upstream) to the refiners and distributors (downstream). Like a toll road, these MLPs’ profitability is based on the volume of cars on the road, not the value of the cars on it. In other words, mid-stream MLPs care about the volume of energy they carry, not the price of that energy. That said, low oil prices can reduce the volume flowing through the pipelines and, provide energy producers, refiners, and distributors leverage to renegotiate pipeline fees.

Because the income of MLPs is the result of the volume of products flowing through their pipelines and not the cost of the products, their sales revenue, income, and dividend payouts are not well correlated to the price of oil or other energy products. Despite a different earnings profile than most energy companies, MLP stock prices have been strongly correlated to the energy sector. This correlation has always been positive, but the correlation is even greater today, largely due to the surge of passive investment strategies.

Passive investors tend to buy indexes and sectors containing stocks with similar traits. As passive investors become a larger part of the market, the prices of the underlying constituents’ trade more in line with each other despite variances in their businesses, valuations, outlooks, and risks. As this occurs, those marginal active investors that differentiate between stocks and their associated fundamentals play a lesser role in setting prices. With this pricing dynamic, inefficiencies flourish.

The graph below compares the tight correlation of the Alerian MLP Infrastructure Index (MLPI) and the State Street Energy Sector ETF (XLE).

Data Courtesy Bloomberg

Before further discussing MLP’s, it is worth pointing out the value proposition that the entire energy sector affords investors. While MLP cash flows and dividends are not necessarily similar to those companies in the broad energy sector, given the strong correlation, we must factor in the fundamental prospects of the entire energy sector.

The following table compares valuation fundamentals, returns, volatility, and dividends for XLE and the S&P 500. As shown, XLE has traded poorly versus the S&P 500 despite a better value proposition. XLE also pays more than twice the dividend of the S&P 500. However, it trades with about 50% more volatility than the index.  

The following table compares two valuation metrics and the dividend yield of the top 6 holdings of Alerian MLP ETF (AMLP) and the S&P 500. A similar value story emerges.

As XLE has grossly underperformed the market, so have MLPs. It is important for value investors to understand the decline in MLP’s is largely in sympathy with the gross underperformance of the energy sector and not the fundamentals of the MLP sector itself. The graph below shows the steadily rising earnings per share of the MLP sector versus the entire energy sector.

Data Courtesy Bloomberg

Illustrating the Value Proposition

The following graphs help better define the value of owning MLPs at current valuations.

The scatter graph below compares 60-day changes to the price of oil with 60-day changes in AMLP’s dividend yield. At current levels (the orange dot) either oil should be $10.30 lower given AMLP’s current dividend yield, or the dividend yield should be 1.14% lower based on current oil prices. A decline in the dividend yield to the norm, assuming the dividend payout is unchanged, would result in a price increase of 13.17% for AMLP. Alternatively if oil declined about 20% in value, the current AMLP dividend yield would then be fairly priced. We consider this a significant margin of safety should the price of oil fall, as it likely would if the U.S. enters a recession in the near future.   

Data Courtesy Alerian and Bloomberg

The graph below highlights that AMLP’s dividend yield is historically high, albeit below three short term spikes occurring over the last 25 years. In all three cases oil fell precipitously due to a recession or a sharp slowdown of global growth.

Data Courtesy Alerian and Bloomberg

Due to their high dividend yields and volatility, MLP’s are frequently compared to higher-yielding, lower-rated corporate debt securities. The graph below shows that the spread of AMLP’s dividend yield to the yield on junk-rated BB corporate bonds is the largest in at least 25 years. The current spread is 5.66%, which is 5.18% above the average since 1995.

Data Courtesy Alerian and St. Louis Federal Reserve

To help us better quantify the pricing of MLPs, we created a two-factor model. This model forecasts the price of MLPI based on changes to the price of XLE and the yield of U.S. Ten-year Treasury Notes. The model below has an R-squared of .76, meaning 76% of the price change of MLPI is attributable to the price changes of energy stocks and Treasury yields. Currently the model shows that MLPI is 20% undervalued (gray bars).  The last two times MLPI was undervalued by over 20%, its price rose 49% (2016) and 15% (2018) in the following three months.

The following summarizes some of the more important pros and cons of investing in MLPs.

Pros

  • Dividend yields are very high on an absolute basis and versus other higher-yielding securities
  • Valuations are cheap
  • Earnings are growing in a dependable trend
  • Balance sheets are in good shape
  • Potential for stock buybacks as balance sheets improve and stock prices offer value

Cons

  • Strong correlation to oil prices and energy stocks
  • “Peak oil demand” – electric cars/solar
  • Sensitivity to global trade, economy, and broad asset prices
  • Political uncertainty/green movement
  • High volatility

Summary

The stronger the market influence that passive investors have, the greater the potential for market dislocations. Simply, as individual stock prices become more correlated with markets and each other, specific out of favor companies are punished. We believe this explains why MLP’s have traded so poorly and why they are so cheap today.

We urge caution as buying MLPs in today’s environment is a “catching the falling knife” trade. AMLP has fallen nearly 25% over the last few months and may continue to fall further, especially as tax selling occurs over the coming weeks. It has also been in a longer-term downtrend since 2017.  We are unlikely to call the market bottom in MLPs and therefore intend to scale into a larger position over time. We will likely buy our first set of shares opportunistically over the next few weeks or possibly in early 2020. Readers will be alerted at the time. We may possibly use leveraged MLP funds in addition to AMLP.

It is worth noting this position is a small part of our portfolio and fits within the construct of the entire portfolio. While the value proposition is great, we must remain cognizant of the current price trend, the risks of owning MLPs, and how this investment changes our exposure to equities and interest rates.

This article focuses predominately on the current pricing and value proposition. We suggest that if you are interested in MLPs, read more on MLP legal structures, their tax treatment, and specific risks they entail.

AMLP does not require investors to file a K-1 tax form. Many ETFs and all individual MLPs have this requirement.

*MLPI and AMLP were used in this article as a proxy for MLPs. They are both extremely correlated to each other. Usage was based on the data needed.

#WhatYouMissed On RIA: Week Of 12-02-19

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

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

Hedge Fund Telemetry founder Thomas Thornton reveals his secret sauce for tracking the markets, indicators he likes best, and what the charts are saying about the 2020 elections.

Our Best Tweets Of The Week

Our Latest Newsletter


What You Missed At RIA Pro

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

The QE-4 Report below was released to our subscribers 3-weeks ago. Subscribe today for a FREE trial and get the UPDATED version of this report.

See you next week!

Is Inflation Really Under Control

Recently, analysts have been discussing the pros and cons of using negative interest rates to keep the U.S. economy growing.  Despite this, Fed Chairman Jerome Powell has said that he does not anticipate the Federal Reserve will implement a policy of negative interest rates as it may be detrimental to the economy.  One argument against negative interest rates is that they would squeeze bank margins and create more financial uncertainty. However, upon examining the actual rate of inflation we are likely already in a ‘de facto’ negative ­­interest rate environment. Multiple inflation data sources show that actual inflation maybe 5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data points to understand why there is such a divergence between the Fed assumptions that inflation is under control versus the much higher rate of price hikes consumers experience.

In October, the Bureau of Labor Statistics (BLS) reported that the core consumer price index (CPI) grew by 2.2% year over year.  The core CPI rate is the change in the price of goods and services minus energy and food.  Energy and food are not included because they are commodities and trade with a high level of volatility.  However, the Median CPI shows a ten year high at 2.96% and upward trend as we would expect, though it starts at a lower level than other inflation indicators. The Median CPI excludes items with small and large price changes.

Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19

Excluding key items that have small and large price changes is not what a consumer buying experience is like. Consumers buy based on immediate needs. When a consumer drives up to a gas pump, they buy at the price listed on the pump that day.  Consumers buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the food. Recent consumer purchase research shows that prices of many goods and services continue to increase at a rate much higher than 2.2%.

Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers buy at Walmart and Target.  The study showed that from June 2018 to June 2019, prices increased about 5%. 

Sources: Gordon Haskett Research Advisors, Bloomberg – 8/10/19

Walmart and Target are good proxies for consumer buying experiences. Walmart is the largest retailer in the U.S. with over 3,000 locations marketing to price-conscious consumers. Target has 1,800 locations in the U.S. and is focused on a similar consumer buyer profile, though a bit less price sensitive. Importantly, both Walmart and Target have discount food sections in their stories.

Housing has been rapidly increasing in cost as well.  Rental costs have soared in 2019 as the following chart shows a month over month shift to .45%, which is an annualized rate of 5.4%.

Sources: Bureau of Labor Statistics, Nomura – 5/13/19


The costs of other services like health care and education have increased dramatically as well. Service sectors, which make up 70% of the U.S. economy, are where wages are generally higher than in manufacturing sectors. Techniques to increase service productivity have been slow to implement due to service complexity. Without productivity gains, prices have continued to rise in most services sectors.

Sources: Deutsche Bank – 11/14/19

Medical care costs have increased by 5.2% per year, and education costs have risen 6.8 % per year. Wages of non-supervisory and production workers have fallen behind at 3.15 % increase per year. Note that the overall CPI rate significantly underestimates the rate of costs in these basic consumer services, likely due to underweighting of services in the cost of living calculation.

For many consumers, housing, utilities, health care, debt payments, clothing, and transportation comprise their major expenses. Utility and clothing costs have generally declined. While transportation, housing, and health care costs have increased.  The rate of new car annual inflation was as low as 1 percent in 2018.  Yet, according to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019. The soaring price of vehicles has caused auto loans to be extended out to 7 or 8 years, in some cases beyond the useful life of the car. 

Dealers are financing 25% of new car purchases with ‘negative equity deals’ where the debt from a previous vehicle purchase is rolled into the new loan.  The October consumer spending report shows consumer spending up by .3% yet durable goods purchases falling by .7% primarily due to a decline in vehicle purchases.  A 4.2% increase in vehicle prices year over year is unsustainable for most buyers and indicates likely buyer price resistance resulting in falling sales. The October durables sales decline could have been anticipated if inflation reporting was based on actual consumer purchasing experiences.

The trade wars with China, Europe, and other countries are contributing to significant price increases for consumer goods.  Tariffs have driven consumer prices higher for a variety of product groups, including: appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports vehicles, housekeeping supplies, and sewing equipment.

Sources: Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot – 5/13/19

In the chart above, prices increased by about 3.5% over 16 months before mid-May 2019. As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices will likely continue to rise. The President has announced new tariffs of 15% on $160 billion of Chinese consumer goods for December 15th if a Phase One deal is not signed. On December 2nd, he announced resuming tariffs on steel and aluminum imports from Argentina and Brazil and 100 % tariffs on $2.4 billion of French goods. The implementation of all these tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying inflationary trend that is being under-reported by government agencies.

Evidently, the prices for goods and services that consumers experience are vastly different from what the federal government reports and uses to establish cost of living increases for programs like Social Security. So, why is there a disconnect between the government CPI rate of 2.2% and consumer reality of inflation at approximately 5%?  The raw data that the Bureau of Labor Statistics (BLS) uses to calculate the CPI rate is not available to the public.  When a Forbes reporter asked the BLS why the data was not available to the public the BLS response was companies could ‘compare prices’. This assumption does not make sense as companies can compare prices on the Internet, in stores, or find out from suppliers. The ‘basket of consumer items’ approach was discontinued in the 1980s for a ‘cost of living’ index based on consumer buying behaviors. There was political pressure to keep the inflation rate low. If real inflation figures were reported the government would have to increase payments to Social Security beneficiaries, food stamp recipients, military and Federal Civil Service retirees and survivors, and children on school lunch programs.  Over the past 30 years the BLS has changed the calculation at least 20 times, but due to data secrecy there is no way to audit the results. The BLS tracks prices on 80,000 goods and services based on consumer spending patterns, not price changes on goods and services per se.  For example, if consumers substitute another item for a higher-priced one it is discontinued in the calculation. 

Economist John Williams has calculated inflation rates based upon the pre-1980s basket approach versus the cost of living formula used by BLS today.  His findings show a dramatically higher rate of inflation using the 1980s formula.

Source: Shadow Government – 10/2019

His calculation using the earlier basket formula sets the present inflation rate at nearly 10%.  Based on our research on various price reporting services, we think the real consumer inflation rate is probably about 5 to 6%.

The implications of this gap between real inflation and reported inflation rates are profound and far-reaching.  Federal Reserve complacency about a low inflation rate to justify a low Fed Funds rates is called into question. In fact the economic reality of today is we are living in a 3.25%  ‘de facto’ negative interest rate environment where the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity pumping into the economy, based in part on low inflation, is overheating risk assets while providing support for corporate executives to take on debt at decade record levels.

Building the economic framework on erroneous inflation data versus the reality for consumers and businesses lead to massive financial dislocations. This economic bubble is unsustainable and will require a brutal recession to rebalance the economy.  As part of a possible soft ‘landing’ policy, the BLS could make price data available to all economists. Full data access will provide an opportunity for objective comments and feedback based on other consumer price research.

The Fed actually focuses on the even lower Personal Consumption Expenditure rate of 1.6% reported by the Bureau of Economic Analysis for October. The Fed prefers the PCE rate because a consumer survey technique is used, while economists prefer the CPI, which is more granular so it is easier to identify goods and services categories that are driving inflation. Using unrealistically low inflation assumptions leads to misguided policy decisions and perpetuation of the myth that inflation is under control. Yet, in fact inflation it is out of control due to extremely low Fed interest rates, liquidity injections, and trade war tariffs.

Patrick Hill is the Editor of The Progressive Ensignhttps://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Mauldin: The Dirty Secret Behind America’s “Full Employment”

Should just being “employed” make people/workers happy?

On one level, any job is better than no job. But we also derive much of our identities and self-esteem from our work.

If you aren’t happy with it, you’re probably not happy generally.

Unhappy people can still vote and are often easy marks for shameless politicians to manipulate. Their spending patterns change, too.

So it ends up affecting everyone and everything.

Unhappy Employment

There’s this plight of people who, while not necessarily poor, aren’t where they think they should be—and perhaps once were.

This disappointment isn’t just in their minds; the economy really has changed. Yes, you can probably get a job if you are physically able, but the odds it will support you and a family, if you have one, are lower than they once were.

The US Private Sector Job Quality Index aims to give data on this… distinguishing between low-wage, often part-time service jobs and higher-wage career positions.

What they have found so far isn’t encouraging.

Looking at “Production & Non-Supervisory” positions (essentially middle-class jobs), the inflation-adjusted wage gap between low-wage/low-hours jobs and high-wage/high-hours jobs widened almost fourfold between 1990 and 2018.

Worse, the good jobs are shrinking in number. In 1990, almost half (47%) were in the “high-wage” category. In 2018, it was only 37%.

Work More, Earn Less

Much of the wage gap came not from the hourly rates, but from the number of hours worked.

The labor market has basically split in two categories with little in between.

There are low-wage service jobs in which you get paid only when the employer really needs you, and higher-wage jobs that pay steady wages.

The number of young people working in the so-called gig economy, working multiple part-time jobs, is growing. And part-time jobs generally are not high-paying jobs.

This also helps explain why so many relatively well-off people feel like they are always working and ahave no free time. They aren’t imagining it. Their employers really do keep them busy.

So we really have two generally unhappy groups: people who want to work more and raise their income, and people who want to work less but keep their income.

What’s the answer? We need to find one, and to do so we must talk about it. And that is possibly an even bigger problem.

Broken Politics

The national anxiety level got where it is for many different reasons. Some are largely outside our control, like the technological advances that have replaced some human jobs.

Hence political decisions need to be made.

The problem is that the ideological gap between the median Democrat and the median Republican has widened into a huge chasm in this century.

What as recently as 2004 was a mountain-shaped distribution with a small dip in between now looks more like a volcanic crater.

The simple fact is that the “center” is shrinking. It is hard to consider compromises when positions are so hardened that no compromise is allowable.

Whatever the reason for this (which is another debate), it prevents our political system from addressing important issues. This leaves an anxious population to feel either completely abandoned, or thinking it must align with one side or the other just to survive.


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

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

Why Every Investor Should Be Politically Flexible

Things used to be so simple.

You buy a stock, the government cuts taxes, the stock goes up.

Actually, things still are that simple.

And yet vastly more complex. We cut taxes in 2017, but future tax increases—large ones—are likely.

The Federal Reserve is lowering interest rates because it is told to by the president.

There are tariffs, things we haven’t seen in a while. Deficits are rising with zero collective will to contain them.

And we’ve seen a sharp rise in authoritarian behavior from elected leaders of all stripes, globally, which is a source of consternation.

There have been many articles written about how you should not mix your politics with your investing. Many. Except… occasionally, you should.

From 2009 to 2011, it paid to be a far-right gold bug. The liberals were left in the dust.

Since 2011, it has paid to be a liberal growth stock indexer.

Maybe going forward, it will pay to be an MMT-er. Who knows.

My point here is that the stock market goes through political regimes, much like it goes through volatility regimes.

It took me years to understand this. My early investing years were spent thinking that center-right policies were good for the stock market. In general, that is true.

And it is always and everywhere true that cutting taxes, especially corporate taxes and investment taxes, results in higher stock prices.

Aside from that, things get a little hazy. Tariffs are supposed to be bad for stocks, but on a long-term basis, they haven’t been.

As for deficits, the record is a bit mixed. Stocks have gone up when debt is both rising and falling.

Now that the debt issue is becoming a bit hard to handle, you might think that stocks would begin to care. Clearly, they don’t.

Crazy Town

You can’t say anything for certain anymore.

There are some folks out there—like Leon Cooperman—who say the stock market might not even open if Elizabeth Warren is elected president.

I tend to agree. But maybe not!

Maybe Elizabeth Warren gets elected—and stocks go up!

Sometimes stock markets go up when bad things are happening. This was true in Weimar Germany, Zimbabwe, and Venezuela.

There isn’t a person alive who can say with 100% certainty what stocks are going to do. After all, the conventional wisdom was wrong about Trump. The only thing you can say with 100% certainty is that it is going to be a surprise.

I try not to make normative statements about the stock market anymore.

I try not to say what the stock market should do.

I try to predict what the stock market will do.

One of the things I have been writing about is that supply and demand ultimately drives stock prices, and right now stock supply is down because of all the buybacks.

I’m not saying the market can’t go down, I’m saying it’s hard for it to go down.

Basically, nothing would surprise me about 2020. Nothing at all.

Political Investing

One of the hardest things about investing is to be intellectually malleable. To think one thing one day, and then think another thing the next.

Even harder is to be politically malleable. To have one political belief one day, and the opposite belief the next. Impossible.

I do not know one person who got it right from 2009 to 2011 and also got it right from 2011 to today. People take sides, they put on a jersey, and they play for that team. Which means you get to be right every so often, but not all the time.

I can sort of switch sides, but not really.

If it isn’t obvious by now, I am a libertarian-slash-classical liberal. Which means I have missed out on the stock market rally from about 2015 onwards.

I have run into a few people in my career who have actually told me that they would rather lose money than buy a stock like Alphabet. Or whatever. That gets into a central thesis of mine—the vast majority of people would rather be right than make money.

Ideally, you get to do both. But that is pretty rare. I remember buying fluffy tech stocks in 2013. It felt terrible, but I did it because it was the right trade. The trade worked. I was never comfortable with it. It was an unnatural act.

If you want to be right, put it on your tombstone. In this life, we make money.

Market Internals Review 12-05-19

A review of important measures of market breadth and participation.

Advance-Decline Line

  • Currently, the cumulative advance-decline line confirms the bull market recent new highs.
  • With no sign of weakness at the moment, the indicator suggests the bullish trend will likely continue for now. (That doesn’t mean we won’t have short-term corrections.)
  • One note is the A-D line does not distinguish between a 20% decline and a full-blown mean reverting event.
  • Also, the MACD of the indicator is close to triggering a SELL SIGNAL. The 4-previous events have led to decent corrections, so this is worth paying attention to.
  • The A-D Line is also a very COINCIDENT indicator. It is pretty useless other than letting you know the overall participation in the market.
  • Reading: Bullish

Bullish Percent

  • The S&P Bullish Percent index shows the percentage of stocks on bullish “buy” signals.
  • Despite the markets reaching all-time highs, the number of stocks on bullish “buy” signals remains in a negative trend.
  • This negative divergence tends to suggest latter stages of bull market advances as money flows into fewer stocks.
  • The current buy signal of the indicator suggests market support, but these signals have been fleeting in the past.
  • Reading: Neutral / Cautious

Percent Of Stocks Above Moving Averages

  • The number of stocks in the S&P 500 which are currently trading above their respective 50, 150, and 200 day moving averages remains weak despite new highs.
  • Again, this is consistent with latter stage markets as money flows into few stocks as momentum overtakes the investing mentality.
  • The negative divergence is a warning, but is not always an immediate indicator. So this is worth watching but NOT making immediate portfolio changes.
  • Reading: Neutral / Cautious

McClellan Oscillator

  • You are probably noticing a lot of similarities in these indicators.
  • As markets are hitting all-time highs, there are negative divergences across a multitude of indicators.
  • As noted, these negative trends occur leading into bear markets, and can persist for a very long time before the bear market sets in.
  • However, the important takeaway is that the bull market is still largely intact but there is some deterioration around the edges. This suggests that investors should remain invested for now, but maintain risk controls accordingly.
  • All good things do eventually come to an end.
  • Reading: Neutral

NYSE New Highs – New Lows

  • Again, we see another negative divergence of the new high-low index not reaching new highs even as the overall market does.
  • If the high-low index can reverse and make new highs, then that will confirm the new highs of the market and be supportive of further gains.
  • Keep a watch on this index and look for confirmation before becoming overly aggressive on risk exposure.
  • Reading: Cautious

Overbought / Oversold Conditions

  • On a technical basis the market are correcting an extremely overbought condition. This suggests the current correction may have a bit more to go over the next week or so.
  • The other measures also confirm the same, and when all of them are aligned, they have a decent record of predicting the markets next move.
  • The one important note is the market is trading below its previous broken bullish trend which makes the most recent lows critical support for this advance.
  • Given the short-term overbought condition of the market, use pull backs in the market to add exposure accordingly.
  • Reading: Bullish

Dimon’s View Of Economic Reality Is Still Delusional

“This is the most prosperous economy the world has ever seen and it’s going to be a very prosperous economy for the next 100 years.” – Jamie Dimon

That’s what the head of JP Morgan Chase told viewers in a recent “60-Minutes” interview.

“The consumer, which is 70% of the U.S. economy, is quite strong. Confidence is very high. Their balance sheets are in great shape. And you see that the strength of the American consumer is driving the American economy and the global economy. And while business slowed down, my current view is that, no, it just was a slowdown, not a petering out.” – Jamie Dimon

If you’re in the top 1-2% of income earners, like Jamie, I am sure it feels that way.

For everyone else, not so much.

This isn’t the first time that I have discussed Dimon’s distorted views, and just as we discussed then, even just marginally scratching the surface on the economy and the “household balance sheet,” reveals an uglier truth.

The Most Prosperous Economy

Let’s start with the “most prosperous economy in the world” claim.

As we recently discussed in “Socialism Rises,” 

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

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

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

With the slowest average annual growth rate in history, it is hard to suggest the economy has been the best it has ever been.

However, if an economy is truly prosperous it should benefit the majority of economic participants, which brings us to claim about “household balance sheet” health.

For Billionaires, The Grass Is Always Green

If you are in the upper 20% of income earners, not to mention the top .01% like Mr. Dimon, I am quite sure the “economic grass is very green.”  If you are in the bottom 80%, the “view” is more akin to a “dirt lot.” Since 1980, as noted by a recent study from Chicago Booth Review, the wealth gap has progressively gotten worse.

“The data set reveals since 1980 a ‘sharp divergence in the growth experienced by the bottom 50 percent versus the rest of the economy,’ the researchers write. The average pretax income of the bottom 50 percent of US adults has stagnated since 1980, while the share of income of US adults in the bottom half of the distribution collapsed from 20 percent in 1980 to 12 percent in 2014. In a mirror-image move, the top 1 percent commanded 12 percent of income in 1980 but 20 percent in 2014. The top 1 percent of US adults now earns on average 81 times more than the bottom 50 percent of adults; in 1981, they earned 27 times what the lower half earned.

The issue is the other 80% are just struggling to get by as recently discussed in the Wall Street Journal:

The American middle class is falling deeper into debt to maintain a middle-class lifestyle.

Cars, college, houses and medical care have become steadily more costly, but incomes have been largely stagnant for two decades, despite a recent uptick. Filling the gap between earning and spending is an explosion of finance into nearly every corner of the consumer economy.

Consumer debt, not counting mortgages, has climbed to $4 trillion—higher than it has ever been even after adjusting for inflation. Mortgage debt slid after the financial crisis a decade ago but is rebounding.”WSJ

The ability to simply “maintain a certain standard of living” has become problematic for many, which forces them further into debt.

“The debt surge is partly by design, a byproduct of low borrowing costs the Federal Reserve engineered after the financial crisis to get the economy moving. It has reshaped both borrowers and lenders. Consumers increasingly need it, companies increasingly can’t sell their goods without it, and the economy, which counts on consumer spending for more than two-thirds of GDP, would struggle without a plentiful supply of credit.” – WSJ

I show the “gap” between the “standard of living” and real disposable incomes below. Beginning in 1990, incomes alone were no longer able to meet the standard of living, so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2600 annual deficit that cannot be filled. (Note: this deficit accrues every year which is why consumer credit keeps hitting new records.)

But this is where it gets interesting.

Mr. Dimon claims the “household balance sheet” is in great shape. However, this suggestion, which has been repeated by much of the mainstream media, is based on the following chart.

The problem with the chart is that it is an illusion created by the skew in disposable incomes by the top 20% of income earners, needless to say, the top 5%. The Wall Street Journal exposed this issue in their recent analysis.

“Median household income in the U.S. was $61,372 at the end of 2017, according to the Census Bureau. When inflation is taken into account, that is just above the 1999 level. Without adjusting for inflation, over the three decades through 2017, incomes are up 135%.” – WSJ

“The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A third of the gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

‘On the surface things look pretty good, but if you dig a little deeper you see different subpopulations are not performing as well,’ said Cris deRitis, deputy chief economist at Moody’s Analytics.” – WSJ


With this understanding, we need to recalibrate the “debt to income” chart above to adjust for the bottom 80% of income earnings versus those in the top 20%. Clearly, the “household balance sheet” is not nearly as healthy as Mr. Dimon suggests.

Of course, the only saving grace for many American households is that artificially low interest rates have reduced the average debt service levels. Unfortunately, those in the bottom 80% are still having a large chunk of their median disposable income eaten up by debt payments. This reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged, and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

With respect to those who say “the debt doesn’t matter,” I respectfully argue that you looking at a very skewed view of the world driven by those at the top.

Mr. Dimon’s Last Call

What Mr. Dimon tends to forget is that it was the U.S. taxpayer who bailed out the financial system, him included, following the financial crisis. Despite massive fraud in the major banks related to the mortgage crisis, only small penalties were paid for their criminal acts, and no one went to jail. The top 5-banks which were 40% of the banking system prior to the financial crisis, became 60% afterwards. Through it all, Mr. Dimon became substantially wealthier, while the American population suffered the consequences.

Yes, “this is the greatest economy ever” if you are at the top of heap.

With household debt, corporate debt, and government debt now at records, the next crisis will once again require taxpayers to bail it out. Since it was Mr. Dimon’s bank that lent the money to zombie companies, households again which can’t afford it, and took on excessive risks in financial assets, he will gladly accept the next bailout while taxpayers suffer the fallout. 

For the top 20% of the population that have money actually invested, or directly benefit from surging asset prices, like Mr. Dimon, life is great. However, for the vast majority of American’s, the job competition is high, wages growth is stagnant, and making “ends meet” is a daily challenge.

While Mr. Dimon’s view of America is certainly uplifting, it is delusional. But of course, give any person a billion dollars and they will likely become just as detached from economic realities.

Does America have “greatest hand ever dealt.”

The data certainly doesn’t suggest such. However, that can change.

We just have to stop hoping that we can magically cure a debt problem by adding more debt, and then shuffling it between Central Banks. 

But then again, such a statement is also delusional.

Selected Portfolio Position Review: 12-04-19

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, we will now review some of positions in our Equity Portfolio which are either a concern, an opportunity, or are doing something interesting.

This week we are reviewing positions which may require some additional attention soon, either trimming, adding, or removing, plus recent additions.

SDS – Proshares Ultra-Short S&P 500

  • In recent postings, we discussed all the various measures of “overbought and extended” conditions which currently exist in the market.
  • Finally, the markets cracked as the “trade deal” rhetoric fell apart.
  • As noted previously, we have taken profits and rebalanced risks in portfolios over the course of the last several months, we have a lot of equity exposure vulnerable to a short-term correction.
  • We previously added 5% of a 2x leveraged S&P 500 index which gives us an effective 10% equity hedge in portfolios against a short-term decline.
  • While we are currently down about 0.5% in the position, that is okay because our defensive and bond positioning have been offsetting the drag. As an example: yesterday the equity portfolio was off by .24% while the S&P 500 was down -.66%
  • Given the market has worked off a good bit of the previous short-term overbought condition we will be looking to exit the position over the next couple of days.
  • Stop is set at $26ish

BA – Boeing Co.

  • We bought BA following the 737MAX crash and have been patiently holding the position and collecting the dividend. The basing and consolidation has continued for months with brief spurts of activity,.
  • Currently, BA is about to trigger a short-term buy signal, but remains trapped within the long-term consolidation range.
  • Which ever way the stock eventually breaks out will be a big move. So we are maintaining our stop at the bottom of the range.
  • Stop set at $320

CHCT – Community Healthcare

  • CHCT has been one our better performers this year as interest rates have declined.
  • Currently, CHCT continues to try and work off some of the more extreme overbought conditions while continuing to hold its bullish trend.
  • We are moving our stop up to the 200-dma for now.
  • Stop loss is set at $40

ABBV – AbbVie, Inc.

  • We had been watching ABBV for a while before adding it to the portfolio. We love the healthcare space because of the aging demographic.
  • Since adding it to the portfolio, it has surged sharply and ran into resistance.
  • We need a pullback to add to our holdings and while ABBV is on a buy signal it is extremely overbought.
  • We are looking for a pullback to the 50-dma which has now crossed above the 200-dma.
  • Stop loss is set at $72.50

NSC – Norfolk Southern

  • We have previously taken profits in NSC but have been looking for an entry point to add back to the position. We may be getting close to that point.
  • NSC held important support at $170 and turned up with the onset of QE-4.
  • With a buy signal now triggered, we are watching to see if NSC can hold support at the 200-dma. If it does we will add to our position.
  • With the market overbought in total, if the market pulls back, so to will NSC. We would like to use a temporary respite to add to our holdings.
  • For now we are holding our current position and moving the stop up.
  • Stop has been moved up to $180

DOV – Dover Corp.

  • We bought DOV earlier this year and it turned into one of best performers. Despite trade rhetoric, the company continues to make gains.
  • DOV is EXTREMELY overbought so a correction is needed to consider adding to the position. We took profits previously.
  • With the buy signal extremely extended some consolidation or correction is highly likely.
  • Stop is currently set at $95

GDX – VanEck Vectors Gold Miners

  • GDX broke out strongly earlier this year and after a strong run we sold 1/2 of our position to take profits.
  • Currently, GDX is on a “sell signal” and is oversold. Importantly, it has continued to hold support at $26 and looks to be turning up.
  • It is too soon to add to our position, but if volatility begins to increase and “trade issues” return, Gold will likely start making gains again.
  • For now we will move our stop up on the position as a whole.
  • Stop loss has been adjusted to $25

MU – Micron Technology

  • MU had a nice rally following our initial purchase and got extremely overbought very quickly.
  • We are not consolidating that advance and potentially setting up support at the 200-dma which could provide an additional entry point to increase holdings.
  • MU is very subject to the “trade deal,” so we are keeping our stops tight on the position for now.
  • Stop loss set at $40

PG – Procter & Gamble

  • PG had gotten EXTREMELY overbought with the advance from the May lows in 2018.
  • However, that overbought condition has been reversed and even with a “sell signal” in place, PG has held its bullish trend.
  • We will look to add to our holdings if PG continues to hold up and triggers a “buy signal.”
  • We are moving our stop up on the whole position.
  • Stop-loss moved up to $110

WELL – WellTower, Inc.

  • WELL has pulled back to the 200-dma and is deeply oversold.
  • We are looking to add to our position but would like to see some stabilization and see the “sell signal” turn up first.
  • Be patient for now, but an entry point is approaching.
  • Stop loss remains at $80

Beware Of Those Selling “Technology”

“3. And they said to one another, ‘Come, let us make bricks, and burn them thoroughly.’ And they had brick for stone, and bitumen for mortar. 4. Then they said, ‘Come, let us build ourselves a city, and a tower with its top in the heavens, and let us make a name for ourselves; otherwise we shall be scattered abroad upon the face of the whole earth.’” Genesis 11:3-4 (NRSV)

Technology

Technology can be thought of as the development of new tools. New tools enhance productivity and profits, and productivity improvements afford a rising standard of living for the people of a nation. Put to proper uses, technological advancement is a good thing; indeed, it is a necessary thing. Like the invention of bricks and mortar as documented in the book of Genesis, the term technology has historically been applied to advancements in tangible instruments and machinery like those used in manufacturing. Additional examples include the printing press, the cotton gin, and the internal combustion engine. These were truly remarkable technological achievements that changed the world.

Although the identity of a technology company began to emerge in the late 1930s as IBM developed tabulation equipment capable of processing large amounts of data, the modern-day distinction did not take shape until 1956 when IBM developed the first example of artificial intelligence and machine learning. At that time, a computer was programmed to play checkers and learn from its experience. About one year later, IBM developed the FORTRAN computer programming language. Until the early 1980s, IBM was the dominant tech company in the world and largely stood as the singular representative of the burgeoning technology investment sector.

The springboard for the modern tech era came in 1980 when the U.S. Congress expanded the definition list of copyright law to include the term “computer program.” With that change, software developers and companies like IBM involved in programming computers (mostly mainframes at that time) had a legal means of preventing unauthorized copying of their software. This development led to the proliferation of software licensing.

As further described by Ben Thompson of stratechery.com –

This highlighted another critical factor that makes tech companies unique: the zero marginal cost nature of software. To be sure, this wasn’t a new concept: Silicon Valley received its name because silicon-based chips have similar characteristics; there are massive up-front costs to develop and build a working chip, but once built additional chips can be manufactured for basically nothing. It was this economic reality that gave rise to venture capital, which is about providing money ahead of a viable product for the chance at effectively infinite returns should the product and associated company be successful.

To summarize: venture capitalists fund tech companies, which are characterized by a zero marginal cost component that allows for uncapped returns on investment.

Everybody is a Tech Company

Today, every company employs some form of software to run their organization, but that does not make every company a tech company. As such, it is important to differentiate real tech companies from those that wish to pose as one. If a publicly traded company can convince the investing public that they are a legitimate tech company with scalability at zero marginal cost, it could be worth a large increase in their price-to-earnings multiple. Investors should be discerning in evaluating this claim. Getting caught with a pretender almost certainly means you will have bought high and will be forced to sell low.

Pretenders in Detail

Ride share company Uber (Tkr: UBER) went public in May 2019 at a market capitalization of over $75 billion. Their formal name is Uber Technologies, but in reality, they are a cab company with a useful app and a business producing negative income.

Arlo Technologies (Tkr: ARLO) develops high-tech home security cameras and uses a cloud-based platform to “provide software solutions.” ARLO IPO’ed at $16 per share in August 2018. After trading as high as $23 per share within a couple of weeks of the initial offering, they currently trade at less than $4. Although the Arlo app is available to anyone, use of it requires an investment in the Arlo security equipment. Unlike a pure tech company, that is not a zero marginal cost platform.

Peloton (Tkr: PTON) makes exercise bikes with an interactive computer screen affording the rider the ability to tap in to live sessions with professional exercise instructors and exercise groups from around the world. Like Arlo, the Peloton app is available to anyone, but the experience requires an investment of over $2,000 for the stationary bike. PTON went public in September 2019 at the IPO price of $29 per share. It currently trades at roughly $23.

Recent Universe

From 2010 to the end of the third quarter of 2019, there have been 1,192 initial public offerings or IPOs. Of those, 19% or 226 have been labeled technology companies. Over the past two years, many of the companies brought to the IPO market have, for reasons discussed above, desperately tried to label themselves as a tech company. Using analysis from Michael Cembalest, Chief Strategist for JP Morgan Asset Management, we considered 32 “tech” stocks that have gone public over the past two years under that guise. We decided to look at how they have performed.

In an effort to capture the reality that most investors are not able to get in on an IPO before they are priced, the assumption for return calculations is that a normal investor may buy on the day after the IPO. We acknowledge that the one-day change radically alters the total return data, but we stand by it as an accurate reflection of reality for most non-institutional investors.

As shown in the table below, 23 of the 32 IPOs we analyzed, or 72%, have produced a negative total return through October 31, 2019. Additionally, those stocks as a group underperformed the S&P 500 from the day after their IPO date through October 31, 2019 by an average of over 35%.

Data Courtesy Bloomberg

Summary

Over the past several years, we have seen an unprecedented move among companies to characterize themselves as technology companies. The reason is that the “tech” label carries with it a hefty premium in valuation on a presumption of a steeper growth trajectory and the zero marginal cost benefit. A standard consumer lending company may employ technology to convince investors they are actually a new-age lender on a sophisticated and proprietary technology platform. If done convincingly, this serves to garner a large price-to-earnings multiple boost thereby significantly (and artificially) increasing the value of the company.

A new automaker that can convince investors they are more of a technology company than other automobile companies’ trades at many multiples above that of the traditional yet profitable car companies. Still, the core of the business is making cars and trying to sell them to a populace that already has three in the driveway.

Using the technology label falsely is a deceptive scheme. Those who fall for the artificial marketing jargon are doomed to sacrifice hard-earned wealth as has been the case with Lyft and Fiverr among many others. For those who are not discerning, the lessons learned will ultimately be harsh as were those described in the story of the tower of Babel.

It is not in the long-term best interest of the economic system or its stewards to chase high-flying pseudo-technology stocks. Frequently they are old school companies using software like every other company. Enron and Theranos offer stark lessons. Those were total loss outcomes, yet the allure of jumping aboard a speculative circus is as irresistible as ever, especially with interest rates at near-record lows. The investing herd continues to follow the celebrity of popular “momentum” investing, thereby they ignore the analytical rigor aimed at discovering what is reasonable and what allows one to, as Warren Buffett says, “avoid big mistakes.”

Never Forget These 10 Investment Rules.

“Psychology is probably the most important factor in the markets, and one that is least understood.”

– David Dreman

A motive of the financial industry  is to blur the lines between investor and trader. I’m convinced it’s to make investors feel guilty for taking control of their portfolios. After all, Wall Street firms ares the experts with YOUR money.

How dare you question them?

Sell to take profits, sell to minimize losses, purchase an investment that fits into your risk parameters and asset allocations; it’s all enough to brand one as ‘trader’ in the buy & forget circles  that are paid to push the narrative that markets are on a permanent trek higher and bears are mere speed bumps. Wall Street has forgotten the financial crisis. You can’t afford such a luxury.

And, if you’re a reader of RIA, you’re astute enough to know better.

“You’re a trader now?”

Broker at a  big box financial shop.

A planning client called his financial partner to complete two trades. Mind you, the only trades he’s made this year. His request was to sell an investment that hit his loss rule and purchase a stock (after homework completed on riapro.net). His broker was dismayed and asked the question outlined above. 

Investors are advised – Be like Warren Buffett and his crew: You know, he’s buy and hold, he never sells! Oh, please. 

From The Motley Fool:

Here’s what Berkshire sold in the third quarter:

During the third quarter, Berkshire sold some or all of five stock positions in its portfolio:

  • 750,650 shares of Apple. 
  • 31,434,755 shares of Wells Fargo. 
  • 1,640,000 shares of Sirius XM. 
  • 370,078 shares of Phillips 66. 
  • 5,171,890 shares of Red Hat.

What Do Paul Tudor Jones, Ray Dalio, Ben Graham, and even Warren Buffett have in common?

  • A strict investment discipline.
  • Despite mainstream media to the contrary, all great investors have a process to “buy” and “sell” investments.

Investment rules keep “emotions” from ruling investment decisions:

Rule #1:

Cut Losers Short & Let Winners Run.

While this seems logical,  it is one of the toughest tenets to follow.

“I’ll wait until it comes back, then I’ll sell.”

“If you liked it at price X, you have to love it at Y.”

It takes tremendous humility to successfully navigate markets. There can be no such thing as hubris when investments go the way you want them; there’s absolutely no room in your brain or portfolio for denial when they don’t. Investors who are plagued with big egos cannot admit mistakes; or they believe they’re the greatest stock pickers who ever lived. To survive markets, one must avoid overconfidence.

 Many investors tend to sell their winners too soon and let losers hemorrhage. Selling is a dilemma. First, because as humans we despise losses twice as much as we relish gains. Second, years of financial dogma have taken a toll on consumer psyche where those who sell are made to feel guilty for doing so. 

It’s acceptable to limit losses. Just because you sell an investment that isn’t working doesn’t mean you can’t purchase it again. That’s the danger and beauty of markets. In other words, a stock sold today may be a jewel years from now.  I find that once an investor sells an investment, it’s rarely considered again.  Remember, it’s not an item sold on eBay. The beauty of market cycles is the multiple chances investors receive to examine prior holdings with fresh perspective.

Rule #2:

Investing Without Specific End Goals Is A Big Mistake.

I understand the Wall Street mantra is “never sell,” and as an individual investor  you’re a pariah if you do. However, investments are supposed to  be harvested to fund specific goals. Perhaps it’s a college goal, or retirement. To purchase a stock because a friend shares a tip on a ‘sure winner,’ (right), or on a belief that an investment is going to make you wealthy  in a short period of time, will only set you up for disappointment. 

Also,  before investing, you should already know the answer to the following two questions:

 At what price will I sell or take profits if I’m correct?

Where will I sell it if I am wrong?

 Hope and greed are not  investment processes.

Rule #3:

Emotional & Cognitive Biases Are Not Part Of The Process.

If your investment  (and financial) decisions start with:

–I feel that…

–I was told…

–I heard…

–My buddy says…

You are setting yourself up for a bad experience.

In his latest tome, Narrative Economics,  Yale Professor Robert J. Shiller makes a formidable case for how specific points of view which go viral have the power to affect or create economic conditions as well as generate tailwinds or headwinds to the values of risk assets like stocks and speculative ventures such as Bitcoin.  Simply put: We are suckers for narratives.  They possess the power to fuel fear, greed and our overall emotional state.  Unfortunately, stories or the seductive elements of them that spread throughout society can lead to disastrous conclusions. 

Rule #4:

Follow The Trend.

80% of portfolio performance is determined by the underlying trend

Astute investors peruse the 52-week high list for ideas. Novices tend to consider stocks that make 52-week highs the ones that need to be avoided or sold. Per a white paper by Justin Birru at The Ohio State University titled “Psychological Barriers, Expectational Errors and Underreaction to News,” he posits how investors are overly pessimistic for stocks near 52-week highs although stocks which hit 52-week highs tend to go higher.

Thomas J. George and Chuan-Yang Hwang penned “The 52-Week High and Momentum Investing,” for  The Journal of Finance. The authors discovered  purchasing stocks near 52-week highs coupled with a short position in stocks far from a 52-week high, generated abnormal future returns. Now, I don’t expect anyone to invest solely based on studies such as these. However, investors should understand how important an underlying trend is to the generation of returns.

Rule #5:

Don’t Turn A Profit Into A Loss.

I don’t want to pay taxes is the worst excuse ever to not fully liquidate or trim an investment.

If you don’t sell at a gain – you don’t make any money. Simpler said than done. Investors usually suffer from an ailment hardcore traders usually don’t – “Can’t-sell-taxes-due” itis

An investor which allows a gain to deteriorate to loss has now begun a long-term financial rinse cycle.  In other words, the emotional whipsaw that comes from watching a profit turn to loss and then hoping for profit again, isn’t for the weak of mind.  I’ve witnessed investors who suffer with this affliction for years, sometimes decades. 

Rule #6:

Odds Of Success Improve Greatly When Fundamental Analysis is Supported By Technical Analysis. 

Fundamentals can be ignored by the market for a long-time.  

After all,  the markets can remain irrational longer than you can remain solvent. 

The RIA Investment Team monitors investments for future portfolio inclusion. The ones that meet our fundamental criteria – cash flows, growth of organic earnings (excluding buybacks), and other metrics, are sometimes not ready to be free of “incubation,” which I call it; where from a technical perspective, these  prospective holdings are not in a favorable trend for purchase. 

It’s a challenge for investors to wait. It’s a discipline that comes with experience and a commitment to be patient or allocate capital over time. 

Rule #7:

Try To Avoid Adding To Losing Positions.

Paul Tudor Jones once said “only losers add to losers.”

The dilemma with ‘averaging down’ is that it reduces the return on invested capital trying to recover a loss than redeploying capital to more profitable investments.

Cutting losers short, like pruning a tree, allows for greater growth and production over time. 

Years ago, close to 30, when I was starting out at a brokerage firm, we were instructed to use ‘averaging down’ as a sales tactic. First it was an emotional salve for investors who felt regret over a loss. It inspired false confidence backed up by additional dollars as it manipulated or lowered the cost basis; adding to a loser made the financial injury appear healthier than it actually was. Second, it was an easy way for novice investors to generate more commissions for the broker and feel better at the same time.

My rule was to have clients average in to investments that were going up, reaching new highs. Needless to say, I wasn’t very popular with the bosses. It’s a trait, good or bad, I carry today. Not being popular with the cool admin kids by doing what’s right for clients has always been my path.

Rule #8:

In Bull Markets You Should be “Long.” In Bear Markets – “Neutral” or “Short.”

Whew. A lot there to ponder.

To invest against the major “trend” of the market is generally a fruitless and frustrating effort. 

I know ‘going the grain’ sounds like a great contrarian move. However, retail investors do not have unlimited capital to invest in counter-trends. For example, there are institutional short investors who will  continue to commit jaw-dropping capital to fund their beliefs and not blink an eye. We unfortunately, cannot afford such a luxury.

So, during secular bull markets – remain invested in risk assets like stocks, or initiate an ongoing process of trimming winners.

During strong-trending bears – investors can look to reduce risk asset holdings overall back to their target asset allocations and build cash. An attempt to buy dips believing you’ve discovered the bottom or “stocks can’t go any lower,” is overconfidence bias and potentially dangerous to long-term financial goals.

I’ve learned that when it comes to markets, fighting the overall tide is a fruitless endeavor. It smacks of overconfidence. And overconfidence and finances are a lethal mix.

We can agree on extended valuations; or how future returns on risk assets may be lower because of them. However, valuation metrics alone are not catalysts for turning points in markets. With global central banks including the Federal Reserve  hesitant to increase rates and clear about their intentions not to do so anytime in the near future, expect further ‘head scratching’ and  astonishment by how long the current bullish trend may continue. 

Rule #9:

Invest First with Risk in Mind, Not Returns.

Investors who focus on risk first are less likely to fall prey to greed. We tend to focus on the potential return of an investment and treat the risk taken to achieve it as an afterthought.

Years ago, an investor friend was excited to share with me how he made over 100% return on his portfolio and asked me to examine his investments. I indeed validated his assessment. When I went on to explain how he should be disappointed, my friend was clearly puzzled.

I went on to explain how based on the risk, his returns should have been closer to 200%! In other words,  my friend was so taken with the achievement of big returns that he went on to take dangerous speculation with his money and frankly, just got lucky. It was a good lesson about the danger of hubris. He now has an established rule which specifies how much speculation he’s willing to accept within the context of his overall portfolio. 

The objective of  responsible portfolio management is to grow money over the long-term to reach specific financial milestones and to consider the risk taken to achieve those goals. Managing to prevent major draw downs in portfolios means giving up SOME upside to prevent capture of MOST of the downside. As many readers of RIA know  from their own experiences, while portfolios may return to even after a catastrophic loss, the precious TIME lost while “getting back to even” can never be regained.

To understand how much risk to consider to achieve returns, it’s best to begin your investor journey with a holistic financial plan.  A plan should help formulate a specific risk-adjusted rate of return or hurdle rate required to reach the needs, wants and wishes that are important to you. and your family. 

Rule #10:

The Goal Of Portfolio Management Is A 70% Success Rate.

Think about it – Major League batters go to the “Hall Of Fame” with a 40% success rate at the plate.

Portfolio management is not about ALWAYS being right. It is about consistently getting “on base” that wins the long game. There isn’t a strategy, discipline or style that will work 100% of the time. 

As an example, the value style of investing has been out of favor for a decade. Value investors have found themselves frustrated. That doesn’t mean they should  have decided to alter their philosophy, methods of analysis or throw in the towel about what they believe. It does showcase however, that even the most thorough of research isn’t always going to be successful.

Those investors who strayed from the momentum stocks such as Facebook, Amazon, Netflix and Google have  paid the price. Although there’s been a resurgence in value investing since October, it’s too early to determine whether the trend is sustainable. Early signs are encouraging. 

Chart: BofA Merrill Lynch US Equity & Quant Strategy, FactSet.

A trusted financial professional doesn’t push a “one-size-fits-all,” product, but offers a process and philosophy. An ongoing method to manage risk, monitor trends and discover opportunities.

Even then, even with the best of intentions, a financial expert isn’t going to get it right every time as I outlined previously. The key is the consistency  to meet or exceed your personalized rate of return.

And that return is only discovered through holistic financial planning.

Fundamentally Speaking: Earning Season’s Good, Bad & Ugly

With the third quarter of 2019 reporting season mostly behind us, we can take a look at what happened with earnings to see what’s real, what’s not, and what it will mean for the markets going forward.

The Good

As always is the case, the majority of companies beat their quarterly estimates, as noted by Bespoke Investment Group.

With 73% of companies beating estimates, it certainly suggests that companies in the S&P 500 are firing on all cylinders, which should support higher asset prices.

However, as they say, the “Devil is in the details.” 

The Bad

As I noted previously:

One of the reasons given for the push to new highs was the ‘better than expected’ earnings reports coming in. As noted by FactSet: 

73% have reported actual EPS above the mean EPS estimate…The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (76%) average and above the 5-year (72%) average.”

The problem is the ‘beat rate’ was simply due to the consistent ‘lowering of the bar’ as shown in the chart below:

Beginning in mid-October last year, estimates for both 2019 and 2020 crashed. 

This is why I call it ‘Millennial Soccer.’ 

Earnings season is now a ‘game’ where scores aren’t kept, the media cheers, and everyone gets a ‘participation trophy’ just for showing up.

Let’s take a look at what really happened with earnings.

During Q3-2019, quarterly operating earnings declined from $40.14 to $40.05 or -0.25%. While operating earnings are completely useless for analysis, as they exclude all the “bad stuff” and mostly fudge the rest, reported earnings declined by from $34.93 to $34.33 or -1.75%.

While those seem like very small declines in actual numbers, context becomes very important. In Q3-2018, quarterly operating earnings were $41.38 and reported earnings were $36.36. In other words, over the last year operating earnings have declined by -3.21% and reported earnings fell by -5.58%. At the same time the S&P 500 index has advanced by 7.08%.

It’s actually worse.

Despite the rise in the S&P 500 index, both Operating and Reported earnings have fallen despite the effect of substantially lower tax rates and massive corporate share repurchases, which reduce the denominator of the EPS calculation.

Steve Goldstein recently penned for MarketWatch

“Research published by the French bank Societe Generale shows that S&P 500 companies have bought back the equivalent of 22% of the index’s market capitalization since 2010, with more than 80% of the companies having a program in place.

The low cost of debt is one reason for the surge, with interest rates not that far above zero, and President Trump’s package of tax cuts in 2017 further triggered a big repatriation of cash held abroad. Since the passage of the Tax Cuts and Jobs Act, non-financial U.S. companies have reduced their foreign earnings held abroad by $601 billion.

This repatriation may have run its course, and stock buybacks should decline from here, but they will still be substantial.

This is no small thing.

As noted in “4-Risks To The Bullish View,”  previously, share repurchases have made up roughly 100% of the net purchases of stocks over the last year.

We have discussed the issue of “share buybacks” numerous times and the distortion caused by the use of corporate cash to lower shares outstanding to increase earnings per share.

“The reason companies spend billions on buybacks is to increase bottom-line earnings per share, which provides the ‘illusion’ of increasing profitability to support higher share prices. Since revenue growth has remained extremely weak since the financial crisis, companies have become dependent on inflating earnings on a ‘per share’ basis by reducing the denominator. As the chart below shows, while earnings per share have risen by over 360% since the beginning of 2009; revenue growth has barely eclipsed 50%.”

Chart updated through Q3-2019

The problem with this, of course, is that stock buybacks create an illusion of profitability. However, for investors, the real issue is that almost 100% of the net purchases of equities has come from corporations.

The issue is two-fold:

  1. That corporate spending binge is slowing down, as noted by Mr. Goldstein; and,
  2. If a recession sets in, share repurchases could easily cease altogether. 

If you don’t think that’s important, the charts above and below should at least make you reconsider.

Of course, such should not be a surprise.

Since the recessionary lows, much of the rise in “profitability” have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, which is directly connected to a consumption-based economy, has remained muted.

Since 2009, the operating earnings per share of corporations has risen 296%. However, the increase in earnings did not come from a commensurate increase in actual revenue which has only grown by a marginal 62% during the same period. At the same time, investors have bid up the market more than 300% from the financial crisis lows of 666.

Needless to say, investors are once again extremely optimistic they haven’t overpaid for assets once again.

Always Optimistic

But optimism is certainly one commodity that Wall Street always has in abundance. When it comes to earnings expectations, estimates are always higher regardless of the trends of economic data. As shown, Wall Street is optimistic the current earnings decline is just a blip on the way to higher-highs.

As of April 2019, when Wall Street first published their estimates for 2020, the expectations were that earnings would grow to $174.29 by the end of next year.

The difference between Wall Street’s expectations and reality tends to be quite dramatic.

You can see the over-optimism collided with reality in just a few short months. Since April, forward expectations have fallen by more than $11/share as economic realities continue to impale overly optimistic projections.

Unfortunately, estimates are still too high and have further to fall. It is very likely, particularly if “tariffs” remain in place into 2020, that the majority of expected earnings growth will be reversed.

(This shouldn’t surprise you. We previously warned that by the end of 2018, the entirely of the “Trump Tax Cut” benefit would be erased.)

The Ugly

This divergence in stock prices not only shows up in operating earnings but also in reported corporate profits. As noted previously, the deviation between prices and profits is at historically high levels which cannot be sustained indefinitely.

“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

While the market has rallied sharply in 2019 on continued “hopes” for a “trade deal,” and more accommodative actions from the Federal Reserve, the deviations from fundamentals have reached extremes only seen at peaks of previous market cycles.

The chart below shows the real, inflation-adjusted, profits after-tax versus the cumulative change to the S&P 500. Here is the important point – when markets grow faster than profitability, which it can do for a while; eventually a reversion occurs. This is simply the case that all excesses must eventually be cleared before the next growth cycle can occur. Currently, we are once again trading a fairly substantial premium to corporate profit growth.

Since corporate profit growth is a function of economic growth longer term, we can also see how “expensive” the market is relative to corporate profit growth as a percentage of economic growth. Once again, we find that when the price to profits ratio is trading ABOVE the long-term linear trend, markets have struggled, and ultimately experienced a more severe mean-reverting event. With the price to profits ratio once again elevated above the long-term trend, there is little to suggest that markets haven’t already priced in a good bit of future economic and profits growth.

While none of this suggests the market will “crash” tomorrow, it is supportive of the idea that future returns will be substantially weaker in the future.

Currently, there are few, if any, Wall Street analysts expecting a recession currently, and many are certain of a forthcoming economic growth cycle. Yet, at this time, there are few catalysts supportive of such a resurgence.

  • Economic growth outside of China remains weak
  • Employment growth is going to slow.
  • There is no massive disaster currently to spur a surge in government spending and reconstruction.
  • There isn’t another stimulus package like tax cuts to fuel a boost in corporate earnings
  • With the deficit already pushing $1 Trillion, there will only be an incremental boost from additional deficit spending this year. 
  • Unfortunately, it is also just a function of time until a recession occurs.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

While no one on Wall Street told you to be wary of the markets in 2018, we did, but it largely fell on deaf ears as “F.O.M.O.” clouded basic investment logic.

The next time won’t be any different.

Sector Buy/Sell Review: 12-03-19

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.

NOTE – We have been talking about the market needing a correction for the last couple of weeks. As we approach mutual fund distributions, this week and next, and with the “trade war” likely to reignite, risk is to the downside currently. Most of the analysis reflects both of these points.

Basic Materials

  • XLB has started to reverse the overbought condition, and is set to test support at the recent breakout level. It needs to hold.
  • With the trade war likely to reignite in response to Trump signing the Pro-HongKong support bill and implementing tariffs on Brazil and Agentina, there is risk to the downside currently.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with a tighter stop-loss.
    • Stop-loss adjusted to $57
  • Long-Term Positioning: Bearish

Communications

  • XLC finally broke out to new highs and joined its brethren technology sector as $AMZN finally mustered a rally.
  • With the reversal of the “sell signal” it should lift the sector higher, but in the short-term XLC is extremely overbought.
  • XLC is currently a full-weight in portfolios but should perform better if a year-end advance ensues.
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions
    • This Week: Hold trading positions.
    • Stop adjusted to $47.50
  • Long-Term Positioning: Bearish

Energy

  • XLE failed at downtrend resistance which is disappointing. As noted in the market report yesterday, oil prices also broke support to the downside.
  • With relative performance weakening again, we will remain out of the position for now.
  • While there is “value” in the sector, there is no need to rush into a position just yet. The right opportunity and timing will come, it just isn’t right now.
  • Short-Term Positioning: Bearish
    • Last week: No Position – looking to add
    • This week: No Position – looking to add
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • XLF finally broke out to new highs which makes it much more interesting to add to the portfolio. The recent bounce off of the uptrend line is also bullish.
  • However, the sector is extremely overbought, and the buy signal is extremely extended as well. A pull back or consolidation is required to add holdings into the portfolio.
  • We will see if a break above resistance can hold before adding exposure back into portfolios for a “trading basis” only. We need a decent correction to work off the extreme overbought.
  • Short-Term Positioning: Neutral
    • Last week: Hold Positions
    • This week: Hold Positions
    • Stop-loss adjusted to $28
  • Long-Term Positioning: Bearish

Industrials

  • Like XLB, XLI broke out to new highs, but the trade war now threatens the sector.
  • A correction is needed to correct the extreme overbought condition, but support needs to hold at the breakout level.
  • We are looking for a bit of consolidation and/or pullback to work off some of the extreme overbought condition before increasing our weighting.
  • We have adjusted our stop-loss for the remaining position. We are looking to add back to our holdings on a reversal to a buy signal.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $78
  • Long-Term Positioning: Neutral

Technology

  • XLK is extremely overbought on both a price and momentum basis.
  • We are currently target weight on Technology, but may increase exposure on a pullback to support within the overall uptrend. (A retest of the breakout that holds) The upper rising trendline is also providing resistance so look to add on a pullback that holds the lower trendline support.
  • Short-Term Positioning: Bullish
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $77.50
    • Long-Term Positioning: Neutral

Staples

  • Defensive sectors have started to perform better as money is just chasing markets now.
  • XLP continues to hold its very strong uptrend as has now broken out to new highs. However, XLP is back to more extreme overbought.
  • If the short-term “sell signal” is reversed, it could provide additional lift to the sector.
  • We previously took profits in XLP and reduced our weighting from overweight.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $58
    • Long-Term Positioning: Bullish

Real Estate

  • As noted last week, XLRE was consolidating its advance within a very tight pattern but broke to the downside. The subsequent rally failed to move back above previous support so the risk is to the downside currently. The rally in XLRE failed on Monday.
  • We had previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected which has now been completed.
  • XLRE Registered a deep “sell signal” and is oversold. A trading opportunity is approaching but be cautious currently.
  • You can add to positions if you are underweight but maintain a stop at recent lows for new purchases.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.00 for profits.
  • Long-Term Positioning: Bullish

Utilities

  • XLRE and XLU are virtually the same commentary with XLU rallying to test previous support. Unfortunately, the test of support failed which now turns it into future resistance.
  • After taking profits, we have time to be patient and wait for the right setup. We may be getting an opportunity here soon if support can hold as the overbought condition is reversed.
  • Long-term trend line remains intact but XLU and the sell signal is now triggered. A reversal of the sell signal will provide more lift.
  • Hold off adding new positions currently.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to support at $58.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has remained intact and broke out to new highs and has accelerated that advance.
  • However, the rapid acceleration of the sector has taken XLV to extreme overbought conditions which will give way sooner than later. Take profits and rebalance holdings.
  • We noted previously, healthcare would begin to perform better soon as money looked for “value” in the market. That has been the case as of late, but has gone too far, too quickly.
  • We are looking for entry points to add to current holdings, but it is too overbought currently.
  • We are moving our stop up for now, but look for a reduction of the overbought condition to add weight to the sector.
  • Short-Term Positioning: Neutral
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to $90
  • Long-Term Positioning: Neutral

Discretionary

  • The rally in XLY has not participated as much as other sectors like Financials, Industrials and Materials, and has failed to break above resistance.
  • We added to our holdings previously to participate with the current rally, but are carrying a tight stop on the whole position.
  • XLY is struggling to reverse back to a buy signal, and overhead resistance is going to problematic short-term.
  • Hold current positions for now, as the Christmas Shopping Season is approaching, which should help push the sector higher. However, the dismal performance relative to other sectors of the markets suggests not adding new/additional exposure currently.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $115.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has broken out of consolidation but quickly ran into resistance.
  • XTN is now testing breakout support and needs to hold. But the trade war may well put a damper on the sector. A break below $63 won’t be a good sign.
  • With a “buy” signal in place, combined with the fact XTN is not overbought, a better setup is forming to add holdings. Take profits if long, and wait for a pullback to add to holdings.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Cartography Corner – December 2019

J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


A Review of November

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESZ9) during November 2019. In our November 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for November are:

  • M4                 3221.00
  • M3                 3093.00
  • M1                 3084.25
  • PMH              3055.00
  • Close             3035.75     
  • MTrend         2950.42
  • PML               2855.00     
  • M2                 2821.00    
  • M5                2684.25

Active traders can use 3055.00 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2950.42 as the downside pivot, whereby they maintain a flat or short position below that level.

Figure 1 below displays the daily price action for November 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first trading session of November saw the market price settle above our isolated upside pivot level at PMH: 3055.00.  The market price never looked back. 

Over the following eight trading sessions, the market price ascended, and settled, above our next isolated resistance levels at M1: 3084.25 and M3: 3093.00.  It is worth noting the long lower shadows on the six candlesticks of November 8th through November 14th (highlighted in the chart).  These lower shadows demonstrate the battle between longs and shorts, through increased intra-session volatility, as these isolated resistance levels were reached.  Once the market price settled above these levels, despite the volatility, it never rotated back below them on a settlement basisThese candlesticks provide a good example of why we choose to emphasize settlements in our decision-making framework.

The remainder of November was spent with the market price continuing its ascent towards our isolated Monthly Upside Exhaustion level at M4: 3221.00, stopping short by 2.05%.

Active traders following our analysis had the opportunity to capture a 2.63% profit.   

Figure 1:

New Zealand Dollar Futures

We continue with a review of New Zealand Dollar Futures (“Kiwi”, 6NZ9) during November 2019.  In our November 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for November are:

  • M4         0.6627
  • M3         0.6558
  • PMH       0.6444
  • M1         0.6426
  • Close       0.6416
  • MTrend   0.6361
  • PML        0.6215             
  • M2         0.6169                         
  • M5           0.5968

Active traders can use 0.6361 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for November 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first eight trading sessions were primarily spent with the market price descending to, and settling below, our isolated pivot level at MTrend: 0.6361.  The low settlement price for the month of November was realized on November 8th at 0.6330, 0.48% below the Monthly Trend.  Three trading sessions later, on November 13th, Kiwi traded a big-figure higher, testing our isolated resistance level at M1: 0.6426.  In the November 14th session, Kiwi reversed course again, testing Monthly Trend at MTrend: 0.6361.  Volatility anyone?

The remainder of November was spent with Kiwi ascending back to, and essentially straddling, our isolated resistance level at M1: 0.6426.  After much volatility, Kiwi settled the month of November at 0.6423, basically unchanged from October.  We retain a positive intermediate outlook, for a sustained Trend Reversal, since November’s settlement price remained above Monthly Trend.

Active traders following our work most likely were victims of the intra-month volatility, in the worst-case capturing an approximate 2.00% loss.

Figure 2:

December 2019 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESZ9).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Daily Trend             3145.06       
  • Current Settle         3143.75
  • Weekly Trend         3118.03       
  • Monthly Trend        3018.97       
  • Quarterly Trend      2840.92

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for six months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for eight weeks.  The relative positioning of the Trend Levels is bullishly aligned.  The market price is above all of them (with exception of Daily Trend) which is bullish as well.

Support/Resistance:

In isolation, monthly support and resistance levels for December are:

  • M4                 3455.00
  • M1                 3255.00
  • M3                 3251.75
  • M2                 3211.00
  • PMH              3155.00     
  • Close              3143.75
  • PML               3033.00     
  • MTrend         3018.97     
  • M5                3011.00

Active traders can use 3155.00 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

U.S. Ten-Year Note Futures

For the month of December, we focus on U.S. Ten-Year Note Futures (“Tens”).  We provide a monthly time-period analysis of TYH0.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Monthly Trend      130-02           
  • Daily Trend           129-17
  • Current Settle       129-12           
  • Weekly Trend       129-10           
  • Quarterly Trend    126-16

As can be seen in the quarterly chart below, Tens have been “Trend Up” for four quarters.  Stepping down one time-period, the monthly chart shows that Tens are in “Consolidation”, after having been “Trend Up” for twelve months.  Stepping down to the weekly time-period, the chart shows that Tens are in “Consolidation”, after having been “Trend Down” for six weeks.  The Trend Levels are beginning to rotate above the market price.

In the monthly time-period, the “signal” was given in August 2019 to anticipate a two-month low within the following four to six months.  That two-month low was realized in November 2019 with the trade below 128-16.

As we stated in our November edition, “Our first priority in performing technical analysis is to identify the beginning of a new trend, the reversal of an existing trend, or a consolidation area.”  The twelve-month uptrend that began in November 2018 has ended.  Only time will tell if this weakness is consolidation or if a new downtrend develops.  

 

Support/Resistance:

In isolation, monthly support and resistance levels for December are:

  • M4         131-30
  • PMH       130-16
  • MTrend  130-02
  • Close      129-12
  • M1           128-30
  • M3           128-14
  • PML        128-00             
  • M2         126-30                         
  • M5           123-30

Active traders can use 130-16 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

Major Market Buy/Sell Review: 12-02-19

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

  • With a “buy signal” triggered, there is a positive bias, however with both the price and “buy signal” very extended we expect a short-term correction for a better entry point to add exposure.
  • As noted previously, we did add a “short S&P 500” index hedge to both the Equity and ETF portfolios. We are okay with the little bit of performance drag it provides relative to the risk reduction we get in the portfolio.
  • Given the deviation from the mean, and the more extreme overbought condition, it is advisable to wait for some consolidation/correction before increasing equity allocations.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position with a bias to add to holdings.
    • Stop-loss moved up to $290
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • DIA broke out to new highs with the reversal of the “buy” signal to the positive. However, that buy signal is pushing some of the higher levels seen historically so a correction is likely.
  • Hold current positions, but as with SPY, wait for a correction before adding further exposure.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $265.00
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • Like SPY and DIA, the technology heavy Nasdaq has broken out to new highs but is pushing very extended levels.
  • The Nasdaq “buy signal” is also back to extremely overbought levels so look for a consolidation or correction to add exposure.
  • However, as with SPY, QQQ is EXTREMELY overbought short-term, so remain cautious adding exposure. A slight correction that alleviates some of the extension will provide a much better entry point.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $185
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted previously, small-caps broke out above previous resistance but have been struggling.
  • Last week, small-caps successfully tested the breakout level, there is now a bias to add exposure.
  • However, as suggested, be patient as these historical deviations tend not to last long. SLY is extremely overbought and deviated from its longer-term signals.
  • We will wait to see where the next oversold trading opportunity sets up.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss previously violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY is holding up better than SLY and has not broken back down into its previous consolidation range.
  • MDY has now registered a short-term “buy” signal, but needs a slight correction/consolidation to reduce the extreme overbought and extended condition. The buy signal is very extended as well.
  • Look to add exposure to the market on a pullback that doesn’t violate support.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM continues to underperform and failed to hold its breakout.
  • With the “buy signal” extremely extended, the set up to add exposure here is not warranted. Watch the US Dollar for clues to EEM’s direction.
  • As we noted last week, PAY ATTENTION to the Dollar (Last chart). If the dollar is beginning a new leg higher, EEM and EFA will fail.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position
    • Stop-loss violated at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like MDY, EFA rallied out of its consolidation channel and is holding that level but is struggling with previous resistance.
  • Like EEM, it and the market are both EXTREMELY overbought.
  • Be patient for now and wait for a confirmed breakout before adding exposure, and again, watch the U.S. Dollar for important clues.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss was violated at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • While commodities tend to perform well under liquidity programs due to their inherent leverage. Oil has continued to languish under the problems of over-supply and weak sector dynamics.
  • There is a short-term buy signal for oil, but the price failed at the downtrend and has now broken back down below the 200-dma.
  • We are starting to dig around the sector for some trading opportunities, but setups look terrible. We will keep you appraised in our weekly position report.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position
    • Stop-loss for any existing positions is $54.
  • Long-Term Positioning: Bearish

Gold

  • Gold got back to oversold and broke support at the 200-dma previously.
  • We are sitting on our stop-loss for the position currently, and had previously sold half our position.
  • With the “QE4” back in play, the “safety trade” may be off the table for a while. So, if we get stopped out of our holdings, we will look to buy them back at lower levels.
  • Short-Term Positioning: Neutral
    • Last week: Hold remaining position.
    • This week: Hold remaining position.
    • Stop-loss for whole position adjusted to $132.50
    • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Like GLD, Bond prices also broke support and triggered a sell-signal.
  • However, this past week, as “trade deal turbulence” returned, bonds rallied back to the top of its current downtrend channel.
  • Watch your exposure and either take profits or shorten your duration in your portfolio for now.
  • As noted last week, with the oversold condition in place, the bounce we were looking for arrived. Given bonds are still oversold, an equity correction will like move bond prices higher short-term. Use any bounce to rebalance holdings.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is moved up to $132.50
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Despite much of the rhetoric to the contrary, the dollar remains in a strongly rising uptrend. Given a “strong dollar” erodes corporate profits on exports (which makes up 40% of corporate profits overall) a strong dollar combined with tariffs isn’t great for corporate bottom lines. Watch earnings carefully during this quarter.
  • Furthermore, the dollar bounced off support of the 200-dma and the bottom of the uptrend. If the dollar rallies back to the top of its trend, which is likely, this will take the wind out of the emerging market, international, and oil plays.
  • The “sell” signal is also turning up. If it triggers a “buy” the dollar will likely accelerate pretty quickly.

The Most Important & Overlooked Economic Number

Every month, and quarter, economists, analysts, the media, and investors pour over a variety of mainstream economic indicators from GDP, to employment, to inflation to determine what the markets are likely to do next.

While economic numbers like GDP, or the monthly non-farm payroll report, typically garner the headlines, the most useful statistic, in my opinion, is the Chicago Fed National Activity Index (CFNAI). It often goes ignored by investors and the press, but the CFNAI is a composite index made up of 85 sub-components, which gives a broad overview of overall economic activity in the U.S.

The markets have run up sharply over the last couple of months due to the Federal Reserve once again intervening into the markets. However, the hopes are that U.S. economic growth is going to accelerate going into 2020, which should translate into a resurgence of corporate earnings. However,  if recent CFNAI readings are any indication, investors may want to alter their growth assumptions heading into next year.

While most economic data points are backward-looking statistics, like GDP, the CFNAI is a forward-looking metric that gives some indication of how the economy is likely to look in the coming months.

Importantly, understanding the message that the index is designed to deliver is critical. From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.

The overall index is broken down into four major sub-categories which cover:

  • Production & Income
  • Employment, Unemployment & Hours
  • Personal Consumption & Housing
  • Sales, Orders & Inventories

To get a better grasp of these four major sub-components, and their predictive capability, I have constructed a 4-panel chart showing each of the four CFNAI sub-components compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI, I have used an annual percentage change for these four components.

The correlation between the CFNAI sub-components and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy. Currently, the CFNAI is not confirming the mainstream view of an “economic soft patch” that will give way to a stronger recovery by next year.

The CFNAI is also a component of our RIA Economic Output Composite Index (EOCI). The EOCI is even a broader composition of data points including Federal Reserve regional activity indices, the Chicago PMI, ISM, National Federation of Independent Business Surveys, and the Leading Economic Index. Currently, the EOCI further confirms that “hopes” of an immediate rebound in economic activity is unlikely. To wit:

“The problem is there is not a ‘major shift’ coming for the economy, at least not yet, as shown by the readings from our Economic Output Composite Index (EOCI).”

“There are a couple of important points to note in this very long-term chart.

  1. Economic contractions tend to reverse fairly frequently from high peaks and those contractions tend to revert towards the 30-reading on the chart. Recessions are always present with sustained readings below the 30-level.
  2. The financial markets generally correct in price as weaker economic data weighs on market outlooks. 

Currently, the EOCI index suggests there is more contraction to come in the coming months, which will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading into 2020.”

It’s In The Diffusion

The Chicago Fed also provides a breakdown of the change in the underlying 85-components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components give us a better understanding of the broader changes inside the index itself.

There two important points of consideration:

  1. When the diffusion index dips below zero have coincided with weak economic growth and outright recessions. 
  2. The S&P 500 has a history of corrections, and outright bear markets, which correspond with negative reading in the diffusion index.

The second point should not be surprising since the stock market is ultimately a reflection of economic growth. The chart below simply compares the annual rate of change in the S&P 500 and the CFNAI index. Again, the correlation should not be surprising.

Investors should also be concerned about the high level of consumer confidence readings. There have been numerous headlines touting the “strength of consumer” as support for the ongoing “bull market.”

Overly Confident In Confidence

As we discussed just recently. 

“The chart below shows our composite confidence index, which combines both the University of Michigan and Conference Board measures. The chart compares the composite index to the S&P 500 index with the shaded areas representing when the composite index was above a reading of 100.

On the surface, this is bullish for investors. High levels of consumer confidence (above 100) have correlated with positive returns from the S&P 500.”

The issue is the divergence between “consumer” confidence and that of “CEO’s.” 

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis?”

Notice that CEO confidence leads consumer confidence by a wide margin. This lures bullish investors, and the media, into believing that CEO’s really don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

“I’m sorry, we think you are really great, but I have to let you go.” 

The CFNAI also tells the same story with large divergences in consumer confidence eventually “catching down” to the underlying index.

This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead, if history is any guide to the future.

This last statement is key to our ongoing premise of weaker than anticipated economic growth despite the Federal Reserve’s ongoing liquidity operations. The current trend of the various economic data points on a broad scale are not showing indications of stronger economic growth but rather a continuation of a sub-par “muddle through” scenario of the last decade.

While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages, or justify the markets rapidly rising valuations. The weaker level of economic growth will continue to weigh on corporate earnings, which like the economic data, appears to have reached their peak for this current cycle.

The CFNAI, if it is indeed predicting weaker economic growth over the next couple of quarters, also doesn’t support the recent rotation out of defensive positions into cyclical stocks that are more closely tied to the economic cycle. The current rotation is based on the premise that economic recovery is here, however, the data hasn’t confirmed it as of yet.

Either the economic data is about to take a sharp turn higher, or the market is set up for a rather large disappointment when the expected earnings growth in the coming quarters doesn’t appear. From all of the research we have done lately, the latter point seems most likely as a driver for the former seems lacking.

Maybe the real question is why we aren’t paying closer attention to what this indicator has to tell us?

S&P 500 Monthly Valuation & Analysis Review – 12-1-19

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.