Monthly Archives: March 2019


  • Market Review & Recap
  • What The Fed Really Said
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Review & Recap

The volatility in the markets continued this week with another big whipsaw for investors following the Fed meeting. On Thursday, the S&P soared after the Fed announced they would not be hiking rates this year and ending their balance sheet reduction by September. On Friday, the rally was reversed as the realization of what the Fed actually said sank into the markets.

In just the course of 4-weeks, the market has swung from overbought, to oversold, back to overbought and then begin correcting back to oversold on Friday. I am exhausted just writing about it. 

These swings make portfolio management very difficult. While the markets have been fairly well contained, allowing us to “hold” our long-equity exposure currently, the market continues to show signs of exhaustion” in the recent price action. As I wrote at the beginning of the month:

“The markets are not immune to the ‘laws of physics.’ While the price action is indeed bullish in the short-term, the shorter-term moving averages act like ‘gravity’ on prices. Given the current extension and deviation above the 50-dma the odds of a pullback, before a continued advance, is a high probability.

As shown in the table below, it is very likely that if you sold everything today, and went to cash, that you would miss little over the balance of the year. In other words, the bulk of the gains have likely been made for the year.”

For the month of March, the S&P 500 is up 0.61%.

Bonds, as measured by the Core U.S. Aggregate Bond index is up 1.72%

Oh, and the by the way, since 2000, bonds have outperformed stocks particularly when measured on a risk-adjusted basis. 

Let me say something here that you should at LEAST consider.

“Given current valuations on stocks, it is highly probable that over the next decade bonds will continue to substantially outperform stocks to a large degree.” 

Now, I am not saying that you should “sell everything” and hide in cash.

What I am saying is that managing your equity portion of your portfolio to adjust for relative risk, and reduce volatility, will allow you to adhere to your investment discipline over the long-term. 

While our portfolios remain long-equity, we have substantially hedged our risk with a slightly overweight cash position and fixed income. 

One of the issues which keeps our portfolios hedged currently is that despite the rally from the December lows, the market both remains in a potential topping process and technical measures of price momentum continue to negatively diverge. 

On a very short-term basis, the market has broken back below the October-November highs. Given the market is not oversold on a short-term basis, and has triggered a short-term sell signal as shown below, it is likely we will see a continued correction into next week. 

I also want to remind you of the divergence between stocks and bonds as shown below.

This divergence between stocks and bonds still signals that “smart money” continues to seek “safety” over “risk.” Historically, the bond market generally has it right.



The rally from the December lows, so far, remains a reflexive rally within a correction process as new highs have yet to be reached. Very long-term consolidation correction processes can be very bullish for investors provided the market eventually breaks out to new highs. However, until that happens, the correction that began in 2018 remains intact. 

The rally from the December lows is at risk currently. The chart below shows the rally from the December lows which is currently testing the bottom of a rising wedge pattern. The difference this time is that the market is testing the bottom of the rising trend line from the lows and is not oversold (gold boxes in the top panel) as it was previously. 

The good news is that if the market does break to the downside, there are numerous levels of logical support for the market between the current level and the December lows. 

“The market will never go that low, This going to be another ‘buy the dip’ opportunity.”

Before you jump into that particular pond consider the following:

In March and April of last year, I laid out reasons why the “bull market” had ended for the time being. While such a statement is always misconstrued as “Lance just said the markets are going to zero,” all it means is that the market is unlikely to advance for some time. 

Of course, the markets hit new highs in June of last year bringing out all manner of trolls to point to how my analysis was wrong and the “bull market lives.” At that juncture, if we ran the same analysis on a retracement as in the chart above, the “buy the dip opportunities” were just as prevalent and a retest of February lows seemed just a laughable. 

By December, there were few that were laughing. 

Which brings us to why the markets are likely to retest lows, or worse, during the remainder of 2019.

What Did The Fed Really Say?

In a widely expected outcome, the Federal Reserve announced no change to the Fed funds rate but did leave open the possibility of a rate hike next year. Also, they committed to stopping “Quantitative Tightening (or Q.T.)” by the end of September. 

As we noted in our missive following the announcement:

“What is interesting is that despite the language that ‘all is okay with the economy,’ the Fed has completely reversed course on monetary tightening by reducing the rate of balance sheet reductions in coming months and ending them entirely by September. At the same time, all but one future rate hike has disappeared, and the Fed discussed the economy might need easing soon. To wit, my colleague Michael Lebowitz posted the following Tweet after the Fed meeting:”

Naturally, all the market “heard” was the Fed is “returning the punch bowl” which sent stocks soaring on Thursday.  Via the WSJ:

“On Wednesday, the Fed had given the market what it wanted in December. On rates, the Fed signaled it is indefinitely on hold due to heightened risks to the global economy and because strong U.S. growth and falling unemployment last year didn’t deliver an expected upturn in inflation.

On the portfolio, most Fed officials still don’t believe the runoff of their mortgage and Treasury holdings played a major role in the market’s swoon late last year.

The last sentence made me chuckle, because if they TRULY believed the extraction of liquidity from the markets didn’t have an impact on the markets, then why the quick decision to stop reducing it. Maybe because of this:

But let’s talk about what the Fed REALLY said. 

Over the past several months we have noted that weaker rates of economic growth was going to severely limit the Fed’s ability to hike rates. Even though the Fed made a point to note the U.S. economy remains solid, they rather dramatically lowered their outlook for the U.S. economy not only in the short-term but over the long-term as well. 

As Barbara Kollmeyer noted asked on Friday:

“Does the Fed know something investors don’t?”

Given the rapid reversal on policy given just one little hiccup in the economy and the markets, one should wonder. 

To answer Barbara’s question, “yes.”

The Fed’s comments are NOT supportive of higher asset prices driven by stronger profit growth. What investors picked up on Friday was this:

“A weaker outlook for the economy means weaker profit growth. As such, this puts a market currently valued at 30x earnings at risk of a repricing to equate it with reduced expectations for future cash flows.” 


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As my friend and colleague Doug Kass noted on Friday there are substantial impediments to the economy and markets in the near-term which support the Fed’s reversal. 

  • “Negative or near zero interest rates represent conditions that understandably exist immediately following a deep recession, not 10-years after. 
  • Fewer Tools Left in the Policy Shed as the Fed ends the tightening cycle with the absolute and real Federal Funds rate several hundred basis points lower than any economic cycle in history. 
  • Debt Is a Governor to Growth and debt that is not self-funding is future consumption brought forward. 
  • Deficit and Demographic Threats combined with a Fed balance sheet, which is four times normal, and slowing population growth, diminish intermediate to longer-term economic and profit growth prospects. Such is not supportive of higher valuations or asset prices. 
  • No Country Is an Economic Island and the lack of coordination between the super economic powers in the world will likely exacerbate worldwide economic risks.
  • The Misallocation of Resources Causes Bubbles and low interest rates which we have experienced for years have always – in every cycle – been a source of “mischief” and a misallocation of resources. The only question is “when” something breaks it will ripple through the financial markets like a tidal wave. (Think about the proliferation of ‘covenant-lite’ loans.)”

As stated, these risks, which we have chronicled many times in the past, are not lost on the Fed. They realize that by continuing to hike interest rates, and tighten monetary policy, they are exacerbating the risk of something “breaking.” 

However, they may already be too late, as the bond market is already sniffing out the problems. Currently, 5 out of 10 yield curves we track (50%) are now inverted. Such is the highest risk of a recessionary onset as we have seen since 2007.

WARNING: An inversion of the yield curve in and of itself DOES NOT mean the market will immediately crash and a recession will start. As you will notice in the chart above, once the inversions begin, the recession doesn’t start, historically speaking, until the inversion is reversed. 

Why is that?

Because, when the recession starts, money is coming out of “risk” and moving into instruments affected by the shortest-end of the yield curve. (Money markets, CD’s, etc.) This causes yields to plummet faster on the short–end than on the long-end which reverses the inversion. However, overall yields are still falling. 

You don’t want to wait for that to happen as the damage to your equity portfolio will be substantially larger than you can you fathom currently. Furthermore, as noted last weekend, the yield curve is simply acknowledging the rising risks of a recessionary onset.

Despite numerous articles at end of last week continuing to encourage retail investors to ignore the warnings and stay invested in the stock market (without a safety net), you might want to pay attention to what institutional investors are doing with their money. You will notice that “defensive” positioning is in demand currently.

Clearly, professional investors have continued to pile into fixed income and safer equity income assets over the last several months despite the sharp ramp up in asset prices. This demand for “yield” and “safety” has been one of the reasons we have remained staunchly bullish on bonds in our portfolios as of late despite continued calls for the “Death of the Bond Bull Market.” 

Charlie McElligott noted on Friday the three most important points about low interest rates (h/t Zerohedge)

  1. Low interest rates are (ultimately) deflationary, sustaining zombie-firms in a “liquidity-trap,” which weigh on overall economic performance while also weakening investment.  
  1. Low interest rates and QE are deflationary as you incentivize mal-investment and blow perpetual speculative-asset bubbles, which (ultimately) correct and drive deleveraging—thus the ‘balance sheet recession.’ 
  1. As there is still a lot of debt-related “scar tissue,” you can’t push credit on a string. This then leads to quick “muscle memory” returns to a defensive posture: “If there is no return on capital, capital should not be deployed.” 

Here are the most important takeaways from all of this:

  1. Despite an expected uptick in economic growth in Q2, look for weaker economic growth through the end of this year and into 2020.
  2. Employment is set to weaken markedly over the next 12-24 months. 
  3. Wage growth gains will also reverse as tightness in the labor force eases.
  4. Inflationary pressures will remain non-existent as debt, disruption, and demographic forces continue to suppress economic growth. 
  5. Go back to #1.

This is the cycle we are likely locked into currently and will continue to play out over the next several quarters. 

Let me add to our list of actions from last week:

Simple Actions To Take Now, You Will Appreciate Later

  1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
  2. Sell underperforming positions. If a position hasn’t performed during the rally over the last three months, it is weak for a reason and will likely lead the decline on the way down. 
  3. Positions that performed with the market should also be reduced back to original portfolio weights. Hang with the leaders.
  4. Move trailing stop losses up to new levels.
  5. 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.
  6. Look to reposition portfolio composition from “risk” toward “safety.” Look to reduce assets specifically tied to economic growth and increase holdings in assets which tend to be more defensive in nature. 
  7. If you just don’t know what to do – cash is the best alternative. With cash now yielding more than the S&P 500, holding cash IS an option until you figure out what to do. Remember, investing is about making a bet where the potential for reward outweighs the risk of loss. If you can’t find that opportunity right now, cash is the best alternative until you do.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

But if you need help click here.

See you next week. 


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Last week, I noted the overbought condition across sectors had not been fully reversed which suggests more downward pressure on asset prices over the next week. I also noted that defensive sectors were outperforming offensive sectors of the market as well. That weakness re-emerged last week. 

Technology, Staples, Utilities, Real Estate – defensive positioning remained the strongest sectors of the market last week. While all sectors of the market are overbought, the rally in the overall market continues to narrow which is a cautionary sign in and of itself. 

Current Positions: XLP, XLU, XLV, XLK – Stops moved from 50- to 200-dma’s.

Discretionary is close to triggering a “buy” signal as the 50-dma crosses above the 200-dma. This doesn’t mean the sector can’t have a rather substantial correction back to support; it just means that price action is biased to the upside for now. Stops need to be set at the 50/200 dma. 

Current Position: XLY

Financials – broke down last week as the Fed reversed their monetary policy stance which collapsed the yield curve. Since banks borrow short and lend long it is not profitable for banks in the near term. While financials did break their 50-dma, they are oversold and sitting on important support. If financials rally next week, consider reducing exposure. 

Current Position: XLF

Industrials, Materials, Energy, Healthcare, and Communications – all pulled back with the market last week, but are all sitting on supports currently. Basic Materials and Industrials, after big runs, are consolidating and are oversold. Keep stops at the 50/200 dmas for now. 

Current Positions: XLB, XLI, XLV, XLE (1/2) – Stops remain at 50-dmas.

Importantly, all sectors of the market are still operating within a bearish crossover of the 50- and 200-dma’s. It all appears very “toppy” at the moment, so the right course of action is to take profits, rebalance risk, and wait for whatever happens next to determine the next course of action. 

As I wrote last week:

“The recent rally in the market is likely complete for now and more corrective/consolidation action is needed to reverse the previous overbought conditions.”

Market By Market

Small-Cap and Mid Cap – both of these markets are currently on macro-sell signals and have failed to hold above both the 50- and 200-dma and stops have now been triggered. As we have noted over the last several weeks, these two sectors are more exposed to global economic weakness than their large-cap brethren so caution is advised. Take profits and reduce weightings on any rally next week until the backdrop begins to improve. 

Current Position: None

Emerging, International & Total International Markets 

As noted last week, Emerging Markets pulled back to its 200-dma after breaking above that resistance. We did add 1/2 position in EEM to portfolios three weeks ago understanding that in the short-term emerging markets were extremely overbought and likely to correct a bit. That corrective action is occurring with some of the overbought condition being reduced. The sell-off on Friday took the market back to support at the 50-dma. Stops are set at the 200-dma.

Major International & Total International shares DID finally break above their respective 200-dma’s on hope the worst of the global economic slowdown is now behind them. The pullback last week has brought the market back to test its 200-dma. It is critical support holds next week. Keep stops tight on existing positions, but no rush here to add new exposure. 

Stops should remain tight at the running 50-dma which is also previous support. 

Current Position: 1/2 position in EEM

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with respect to 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.

Core holdings are currently at target portfolio weights.

Current Position: RSP, VYM, IVV

Gold – Despite the reversal of the Fed, the collapse of the yield curve, and concerns about global economic growth, Gold did not really get much of a bump last week. While the metal is holding above the rising trend of the 50-dma, and is reversing its oversold condition, there isn’t a compelling reason to add more at this juncture. A move above $124.50 will make things more interesting. 

Current Position: GDX (Gold Miners), 1/2 position IAU (Gold)

Bonds 

The big move last week was in Bonds. If you have been following our recommendations of adding bonds to portfolios over the last 13-months, this portion of the portfolio offset most of the weakness in portfolios on Friday.  Intermediate duration bonds remain on a buy signal after we increased exposure last month and just broke out above the trading range triggering another major buy signal. With bonds extremely overbought currently, look for a pullback that holds 2.50% on the 10-year Treasury to increase exposure.

Current Positions: DBLTX, SHY, TFLO, GSY

High Yield Bonds, representative of the “risk on” chase for the markets, declined with the market last week. However, with the announcement from the ECB last week, of no rate hikes and more stimulus, and the Fed this past week, international bonds soared last week. If you are long international bonds take profits now and rebalance risk back to normal portfolio weights. The current levels are not sustainable and there will be a price decline which will offer a better entry opportunity soon. 

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:

There were no changes to portfolios last week:

Last week, we noted the markets had continued to ignore the economic data. This week, after the Fed reversed course and lowered their outlook, economic data suddenly matters. 

With the markets early in a potential correction process we are made no changes to portfolios last week. However, next week we will be watching the Financial sector most importantly as they are the most impacted by the yield curve reversion. 

  • New clients: No changes
  • Equity Model: Last week we sold FDX and bought MU both prior to earnings. Both were correct calls. We will likely take some profits in Basic Materials, Industrials, Real Estate and Utilities, this next week depending on market action.
  • ETF Model: No changes.

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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

401k-PlanManager-AllocationShift

Patience Pays Off

Last week, we stated to remain patient despite the market rally:

“The sharp rally in stocks has gone too far, too quickly, so just be patient here and wait for a correction/consolidation to increase exposure. The rally this past week was positive but remains very narrow in terms of participation.”

As noted all throughout this week’s missive, the reversal of the Fed has led the markets to reconsider their position of ignoring rising economic risk. 

Of course, over the last several weeks we have repeatedly warned this was THE risk.

“Take a look at the chart above. Beginning in 2016, I drew a bull trend channel for the market in the chart above (the dashed 45-degree black lines) which have contained the bull market rally since the 2009 lows.

In January 2018, the market made, as we stated then, and unsustainable break above that upper trend line. I add the horizontal black dashed line at that point and said that ultimately we would see a correction back the long-term bull trend line. 

Since then, exactly that has happened and rather than the market retesting the lower bullish trend line and then beginning a more normal advance, the market rocketed higher in 2-months to hit AND FAIL at the upper bullish trend line. 

If the last decade provides any clues, it is likely the market is going to remain range bound within this rising trend for now, which suggests that waiting for a better entry point to increase exposure will be rewarded.” 

As we noted last week, continue to remain patient. The underweight equity exposure continues to provide risk-adjusted performance. 

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. However, hold the bulk of your positions for now and let them run with the market.
  • If you are underweight equities or at target – just sit tight for now and let’s see what happens next. 

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


Current 401-k Allocation Model

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

401k Choice Matching List

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

401k-Selection-List

 

So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself” – Franklin Roosevelt March 4, 1933

Those infamous words were spoken by President Franklin D. Roosevelt at a time when the nation was mired in the great depression, and the stock market had collapsed 80% from the highs of 1929.

We argue in this article that today, fear is exactly what we should fear as a wave of complacency rules the markets.

Investors fear volatility. Low levels of implied volatility are the result of investors that are complacent and not protecting against risks. Conversely, when volatility is higher, investors tend to be anxious, concerned about the future and as such take prudent actions to hedge and protect their assets.

Based solely on today’s levels of implied volatility, the media, central bankers and uninformed cocktail chatter would have us conclude that there is little to worry about. We see things quite differently and believe current indicators offer far more reason for fear than when implied volatility is high and fear is more acute.

No Fear to be Found

The graph below is constructed by normalizing VIX (equity volatility), MOVE (bond volatility) and CVIX (US dollar volatility) and then aggregating the results into an equal-weighted index. The y-axis denotes the percentage of time that the same or lower levels of aggregated volatility occurred since 2010. For instance, the current level is 1.91%, meaning that only 1.91% of readings registered at a lower level.

Data Courtesy Bloomberg

Beyond the very low level of volatility across the three major asset classes, there are two other takeaways worth pondering.

First, the violent nature in which volatility has surged and collapsed twice since 2018. The slope of the recent advances and declines are much steeper than those that occurred before 2018. The peak -to- trough -to- peak cycle over the last year was measured in months not years as was the case before 2018.

Second, when the index reached current low levels in the past, a surge in volatility occurred soon after that. This does not mean the index will bounce higher immediately, but it does mean we should expect a much higher level of volatility over the next few months.

Investment Takeaway

Given that volatility is cheap, wise investors should take advantage of this opportunity to buy options to hedge stock, bond and dollar positions. Traders might want to consider taking our advice a step further by getting long volatility with various options strategies or by buying call options on volatility. Volatility is just another asset class into which we might allocate when it becomes cheap and sell when it becomes rich. As Chris Cole at Artemis Capital says, “it is THE asset class since it is embedded in all others.”

Reasons for Fear

The following considerations fly in the face of the high level of complacency ruling the financial markets:

  • The global economy is slowing
  • Growth in European economies is slowing dramatically, including Germany where 10-year bond yields dropped below zero for the first time since 2016.
  • China, representing 30% of global GDP growth, is weakening rapidly.
  • Domestic GDP is expected to rise by only .50% in the first quarter according to the Atlanta Fed.
  • The trade war with China, and to a lesser degree Europe, could flare up on a single tweet or statement and cause market and economic disruptions.
  • Despite being ten years into an expansion and unemployment near 50-year lows, the Fed decided that Fed Funds above the historically low rate of 2.75 over the next two years is harmful to the economy. What does the Fed know that we do not?
  • The potential for a hard BREXIT is growing by the day.
  • Political drama is heating up with an election and possible Mueller findings.

These and other factors should raise concern.  

Summary

As highlighted by the volatility graph, the three major domestic financial markets are extremely complacent. If history proves reliable, a violent reversal is a clear and present danger. Our greatest fear today is easily the apparent lack of it.

This situation reminds us of a rip-tide on a sunny, beautiful day at the ocean. The water looks relatively calm for all to enjoy without taking precautions. However, within a few steps lies a vicious underwater current capable of imposing swift and unsuspecting demise. The difference between a great day at the beach and a disaster are closer than you think.

Now is a good time to heed the warning of the lifeguard.

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

This complete set of articles discusses the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given markets cycle over time, it is important to understand how markets and investing actually work, the impact on your wealth, and what you can do about it.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.











On Wednesday, the Fed announced that it does not expect to raise interest rates for the rest of this year, which further confirms the complete dovish reversal of the Fed’s position from the fall of last year. The 20% stock market rout and pressure from President Donald Trump are the reason for the Fed’s flip-flop. Many market commentators – including CNBC’s Jim Cramer – cheered the Fed’s dovish shift:

“I thought that Jay was great [Wednesday],” Cramer told “Squawk Box, ” referring to Powell’s news conference at the conclusion of the central bank’s two-day policy meeting. “It’s not easy to start. You make your rookie mistakes, you come back. He’s a great guy. Anyone who knows him knows that he course corrected.”

Throughout the fall of 2018, Cramer was criticizing Fed chairman Jerome Powell’s desire to normalize the Fed’s monetary policy after a decade of ultra-low interest rates and trillions of dollars worth of asset purchases to boost the economy and financial markets (ie., quantitative easing):

“Memo to Powell: keep listening. Be patient. Enjoy the employment gains. Let’s keep the strength going by waiting a little and not being too judgmental about rate hikes like some of your colleagues,” Cramer said.

The “Mad Money ” host reiterated his distaste in some Fed officials’ tendency to stick to traditional metrics when gauging how the economy is doing.

“How can you claim to be data-dependent if you’ve made up your mind before you see the data that you need one or two more rate hikes to get back to normal?” he asked. “Normal is where the data says you should go. Normal is the natural progression of jobs being created without a lot of inflation. Normal is not a percent.”

As I’ve said about President Trump, Jim Cramer is completely naive and misguided about the Fed and interest rates. The Fed’s ultra-loose monetary policies of the past decade have created an artificial economic boom including a dangerous bubble in stocks and other assets (read my explanation in Forbes). Our economy is completely addicted to monetary stimulus and Trump and Cramer are advocating for the Fed to keep pumping more and more to keep the fake boom alive. They do not realize that the more we try to put off the day of reckoning, the harder the economy is going to fall in the end.

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

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

As I wrote earlier this week, the Fed keeps stepping in to support the financial markets every time they stumble:

While constantly supporting the stock market may seem like a good thing at first blush, it’s creating a massive stock market bubble that is becoming riskier with each intervention. The Fed has convinced investors and speculators that they can take virtually unlimited risk because the Fed will always have their backs. This moral hazard or Fed put is enabling risk to build up to such a high level that will eventually overwhelm the Fed’s ability to control it, which is when the ultimate crash will occur.

The Fed will throw everything (including the kitchen sink) at trying to prop up the wildly inflated stock market and economy to no avail. This desperate attempt to prop up the market and economy will entail printing ever-increasing amounts of dollars, which is what will lead to the currency crisis that economist Ludwig von Mises warned about in the quote above. By demanding that the Fed keeps interest rates low forever and never normalizing its monetary policy, Jim Cramer and President Trump are inadvertently asking for a currency and economic crisis that will be orders of magnitude worse than the one they are trying to push off now. It’s mind-boggling how people can rise to such high positions in government and the financial world and not understand basic economics – that’s why a crisis is guaranteed.

So, What Can You Do About It?

These are the things that we worry about for our clients, and we take into account when managing portfolios. Here are the guidelines that we discuss with our clients that may help you navigate a more volatile market in the future.

  • Understand that Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.
  • Check emotions at the door. You are generally better off doing the opposite of what you “feel” you should be doing.
  • Realize the ONLY investments you can “buy and hold” are those that provide an income stream with a return of principal function.
  • Know that market valuations (except at extremes) are very poor market timing devices.
  • Understand fundamentals and economics drive long term investment decisions – “Greed and Fear” drive short term trading.  Knowing what type of investor you are determines the basis of your strategy.
  • Know the difference: “Market timing” is impossible – managing exposure to risk is both logical and possible.
  • Investing is about discipline and patience. Lacking either one can be destructive to your investment goals.
  • Realize there is no value in daily media commentary – turn off the television and save yourself the mental capital.
  • Investing is no different than gambling – both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in”.
  • Most importantly, realize that NO investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.

These are the core principles we discuss each and every week in our newsletter. You can click here to sign up for free and have it delivered right to your inbox.

In a widely expected outcome, the Federal Reserve announced no change to the Fed funds rate but did leave open the possibility of a rate hike next year. Also, they committed to stopping “Quantitative Tightening (or Q.T.)” by the end of September. 

The key language from yesterday’s announcement was:

Information received since the Federal Open Market Committee met in January indicates that the labor market remains strong but that growth of economic activity has slowed from its solid rate in the fourth quarter. Payroll employment was little changed in February, but job gains have been solid, on average, in recent months, and the unemployment rate has remained low.

Recent indicators point to slower growth of household spending and business fixed investment in the first quarter. On a 12-month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy remains near 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed.”

What is interesting is that despite the language that “all is okay with the economy,” the Fed has completely reversed course on monetary tightening by reducing the rate of balance sheet reductions in coming months and ending them entirely by September. At the same time, all but one future rate hike has disappeared, and the Fed discussed the economy might need easing in the near future. To wit, my colleague Michael Lebowitz posted the following Tweet after the Fed meeting:

This assessment of a weak economy is not good for corporate profitability or the stock market. However, it seems as if investors have already gotten the “message” despite consistent headline droning about the benefits of chasing equities. Over the last several years investors have continued to chase “safety” and “yield.” The chart below shows the cumulative flows of both ETF’s and Mutual Funds in equities and fixed income. 

This chase for “yield” over “return” is also seen in the global investor positing report for March.

Clearly, investors have continued to pile into fixed income and safer equity income assets over the last few years despite the sharp ramp up in asset prices. This demand for “yield” and “safety” has been one of the reasons we have remained staunchly bullish on bonds in recent years despite continued calls for the “Death of the Bond Bull Market.” 

The Reason The Bond Bull Lives

Importantly, one of the key reasons we have remained bullish on bonds is that, as shown below, it is when the Fed is out of the “Q.E” game that rates fall. This, of course, was the complete opposite effect of what was supposed to happen.

Of course, the reasoning is simple enough and should be concerning to investors longer-term. Without “Q.E” support, economic growth stumbles which negatively impacts asset prices pushing investors into the “safety” of bonds. 

As the Fed now readily admits, their pivot to a more “dovish” stance is due to the global downturn in economic growth, and the bond market has been screaming that message in recent months. As Doug Kass noted on Tuesday:

“Which brings me to today’s fundamental message of the fixed income markets – which are likely being ignored and could be presaging weakening economic and profit growth relative to consensus expectations and, even (now here is a novel notion) that could lead to lower stock prices. That message is undeniable – economic and profit growth is slowing relative to expectations as financial asset prices move uninterruptedly higher.

  • The yield on the 10 year U.S. note has dropped below 2.60% this morning. (I have long had a low 2.25% forecast for 2019)
  • The (yield curve and) difference between 2s and 10s is down to only 14 basis points.
  • High-frequency economic statistics (e.g. Cass Freight Index) continue to point to slowing domestic growth.
  • Auto sales and U.S. residential activity are clearly rolling over.
  • PMIs and other data are disappointing.
  • Fixed business investment is weakening.
  • No country is an economic island – not even the U.S.
  • Europe is approaching recession and China is overstating its economic activity (despite an injection of massive amounts of liquidity).”

He is correct, yields continue to tell us an important story. 

First, three important facts are affecting yields now and in the foreseeable future:

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largess in the future, the budget deficit will eclipse $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo. As such they will have to be even more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion and might push the 10-year yield towards zero.

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.

Okay…maybe not so clearly. 

Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. This should not be surprising given that consumption is roughly 70% of economic growth.

As Doug notes, the credit markets have been right all along the way. At important points in time, when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. A perfect example is the initial rate hike path set out in December 2015 by then Fed Chairman Janet Yellen. This was completely wrong at the time and the credit markets told us so from the beginning. 

The credit markets have kept us on the right side of the interest rate argument in repeated posts since 2013. Why, because the credit market continues to tell us an important story if you are only willing to listen. 

The bond market is screaming “secular stagnation.” 

Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.

As I wrote in mid-2017:

“The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain near zero and fluctuations in the monetary base fail to translate into higher inflation. 

Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets.”

It didn’t take long for that prediction to come to fruition and change the Fed’s thinking.

On December 24th, 2018, while the S&P 500 was plumbing it’s depths of the 2018 correction, I penned “Why Gundlach Is Still Wrong About Higher Rates:”

“At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.

When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.”

What I didn’t know then was that literally the next day the Fed would reverse course. 

The chart below shows the rolling 4-week change in the Fed’s balance sheet versus the S&P 500. 

The issue for the Fed is that they have become “market dependent” by allowing asset prices to dictate policy. What they are missing is that if share prices actually did indicate higher rates of economic growth, not just higher profits due to stock buybacks and accounting gimmickry, then US government bond yields would be rising due to future rate hike expectations as nominal GDP would be boosted by full employment and increased inflation. But that’s not what’s happening at all.

Instead, the US 10-year bond is pretty close to 2.5% and the yield curve is heading into inversion.

Since inversions are symptomatic of weaker economic growth, such would predict future rate hikes by the Fed will be limited. Not surprisingly, that is exactly what is happening now as shown by yesterday’s rapid decline in the Fed’s outlook.

Why?

Let’s go back to that 2017 article:

“However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect ‘payments,’ increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.”

All it took was for interest rates to crest 3% and home, auto, and retail sales all hit the skids. Given the current demographic, debt, pension, and valuation headwinds, the future rates of growth are going to be low over the next couple of decades – approaching ZERO.

While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

Whether, or not, you agree there is a high degree of complacency in the financial markets is largely irrelevant. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital.

Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

“I don’t know what the seven wonders of the world are, but the eighth is compound interest.” – Baron Rothschild 


The new SCAN TOOL also has several new screening parameters to include both fundamental factors (Piotroski Score) and momentum factors (Mohanram Score) along with Zack’s rankings.

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

DAN – Dana Inc.

  • DAN recently broke above resistance on a buy signal but was unable to hold that breakout.
  • With a bullish crossover of moving averages, and the buy signal still in place, there is a potential for a move higher.
  • Add 1/2 position on a close above $19
  • Add a second 1/2 position on a move above $21
  • Stop loss is at support at $16.50

COG – Cabot Oil & Gas

  • With oil prices moving up in the short-term, COG has risen as well breaking above resistance.
  • Currently, COG is pushing 2-standard deviations above its intermediate term trend so scaling into the position makes some sense.
  • Buy 1/2 position now and 1/2 position on a pullback to $25.50 that holds.
  • Stop-loss is currently $24.50

AMZN – Amazon.com, Inc.

  • AMZN is close to triggering a “buy” signal and broke above its longer-term moving average last week.
  • Buy 1/2 position at current levels.
  • Buy 1/2 position on a pullback towards $1700 that holds.
  • Stop-loss is $1600

PM – Phillip Morris Int’l Inc.

  • PM recently broke out of a 2-year broad downtrend channel.
  • On a buy signal currently, but very overbought, look for a pullback to the top of the downtrend channel that holds to add a trading position.
  • Buy 1/2 position at $87.5 and add second 1/2 position on breakout above $92.50
  • Stop Loss is set at $82.50

PNR – Pentair, Inc.

  • PNR also just broke out of a downtrend and triggered a buy signal.
  • After a successful retest of the breakout, it is looking move higher above resistance at $43.50.
  • Buy on breakout above $43.50
  • Stop is set at $41

SHORT CANDIDATES

CAT – Caterpillar, Inc.

  • As the global economy weakens, it is a threat to international companies like CAT.
  • In a very tight wedge consolidation, a break to the downside could derive a much bigger decline for the stock.
  • Close to triggering a “sell” signal, look to short CAT on a break below $130
  • Target for trade is $115
  • Stop-loss is at $$140

CHRW – C. H. Robinson Worldwide, Inc.

  • A very similar setup and story as CAT above.
  • Short at current levels with a stop at $90
  • Target is $80

IP – International Paper Co.

  • IP has remained confined to a long-term downtrend currently.
  • Also, like CAT and CHRW, it is affected by the global slowdown as well.
  • The recent rally to the downtrend has failed.
  • Short at current levels with a stop set at $48
  • Target is $40

PVH Corp.

  • PVH has been struggling with a slowing consumer in the U.S.
  • The recent failure at the downtrend line sets up a decent short opportunity on a break below current support.
  • Short 1/2 position at current levels and add to short on a break below $103.50
  • Stop is set at $117
  • Target for the trade is $90

RF – Regions Financial Corp.

  • RF recently broke down out of the pennant pattern it was building and is close to triggering another sell signal.
  • Short 1/2 at current levels and add second 1/2 position on a break below $14.50
  • Set stops at $16
  • Target for trade is $12.50

The bull market of the past decade since the Great Recession has been an unusual one: despite all of the economic damage that occurred during the global financial crisis and rising risks (including global debt rising by $75 trillion), it has been the longest bull market in history. The explanation for this paradox is simple: it’s not an organic bull market because the Fed and other central banks keep stepping in to prop up the market every time it stumbles. Though the Fed has two official mandates (maintaining stable consumer prices and maximizing employment), it has taken on the unofficial third mandate of supporting and boosting the stock market since the Great Recession.

The chart below, which was inspired by market strategist Sven Henrich, shows how the Fed or other central banks have stepped in with more monetary stimulus (quantitative easing, promises to keep interest rates low, etc.) every time the S&P 500 has stumbled over the past decade:

As we noted in this past weekend’s newsletter (subscribe for free e-delivery):

“An economy that is growing at 2%, inflation near zero, and Central banks globally required to continue dumping trillions of dollars into the financial system just to keep it afloat is not an economy we should be aspiring to. But despite commentary the financial system has been ‘put back together again,’ then why are Central Banks acting? Via Bloomberg:

‘Led by the Fed, many central banks have either held back on tightening monetary policy or introduced fresh stimulus, soothing investor fears of a slowdown. Fed Chairman Jerome Powell says he and colleagues will be patient on raising interest rates again, while European Central Bank President Mario Draghi has ruled out doing so this year and unveiled a new batch of cheap loans for banks.

Elsewhere, authorities in Australia, Canada and the U.K. are among those to have adopted a wait-and-see approach. China, at its National People’s Congress this month, signaled a willingness to ease monetary and fiscal policies to support expansion.’”

(Click here for an unlocked version of our Premium Newsletter to see how we are positioning our clients in today’s market.)

This is an important consideration because stocks are one of the major components of U.S. household wealth, when the stock market rises, household wealth does as well (and vice versa):

In turn, household wealth is a major variable that affects U.S. consumer spending. When household wealth is growing, consumers feel more confident and have more buying power, which means that they are more willing to spend money – a phenomenon known as a wealth effect. Wealth effects can also run in reverse, as it did in the early-2000s and during the Great Recession. Because the U.S. economy has been in such a precarious situation in the last ten years and the federal government has little ammunition left to fight a recession, the Fed has been doing everything it can to prop up stocks and household wealth in order to prevent a reverse wealth effect from occurring. Though household wealth plunged at the end of 2018 (which is why the blue line in the chart below fell so sharply), the Fed panicked and began to boost the market again starting in late-December. By the time the next quarterly household wealth statistic is reported, it will be much higher due to the Fed’s re-inflation of the stock market (the S&P 500 is up 20% from its December low).

Thanks to the Fed’s constant inflation of the market in the past decade, the S&P 500 rose much faster than earnings and is now at 1929-like valuations, which means that a painful correction is inevitable one way or another:

The Fed’s constant intervention in the market has created a moral hazard on a scale that has never been experienced before by humanity. A generation of traders and speculators now believe that the market never goes down and that the Fed will always have their backs, so they can take virtually unlimited risk. By backstopping the market, the Fed is inadvertently enabling and encouraging an unprecedented buildup of risk that will eventually overwhelm its ability to step in and rescue the market, which is when the ultimate crash will occur.

To learn how to position your portfolio in this unusual environment, please click here to sign up for our free weekly newsletter.

We asked a few friends what the picture below looks like, and most told us they saw a badly drawn bird with a wide open beak. Based on the photograph below our colorful bird, they might be on to something. 

As you might suspect, this article is not about our ability to graph a bird using Excel. The graph represents the current bull market and economic cycle as told by the yield curve and investor sentiment.

As the picture is almost complete, the bird provides a clue to where we are in the current cycle and when the next cycle may begin. For investors, one of the most important pieces of information is understanding where we are in the economic cycle as it offers a critical gauge in risk-taking.

Cycles

Economic Cycles- Economic cycles are frequently depicted with a sine wave gyrating above and below a longer-term trend line. Throughout history, economic cycles include periods where economic growth exceeds its potential as well as the inevitable busts when slower than potential growth occurs.  Most often cycles track a trend line, oscillating above and below it, but spend little time at the trend other than passing through it.

Boom and bust periods occur because economic activity is governed by human behavior. In other words, our spending habits are erratic because we are subject to bouts of optimism and pessimism about the economy, our financial prospects and a host of other non-financial issues.

The graph below shows the sine wave-like quality of U.S. GDP growth, which has wavered above and below trend growth for decades. 

Data Courtesy: St. Louis Federal Reserve (FRED)

Stock Market Cycles- Stock markets also follow a pattern that is well correlated to economic cycles. Strong economic activity results in investor optimism. During these periods, investors tend to believe that rising economic growth and strong corporate profits are long-lasting. As such they are prone to extrapolate these shorter-term trends over longer periods. Investors temporarily forget that periods of above-average growth will inevitably be met with periods of below-average growth. During bust periods, these mistakes are corrected and often over-corrected.

Implied volatility is a great measure of aggregate investor sentiment. It measures the expected market movement as determined by the supply and demand for options. When investors are optimistic about future returns, they tend to neglect to hedge in the options market. The sustained and methodical reduction in options pricing causes implied volatility to decline. In recent years, ETF’s and professional strategies whose objectives were to be short volatility steadily gained in popularity and helped push implied volatility down. Conversely, when investors grow concerned over higher valuations, they hedge more frequently using options and drive implied volatility higher.

Yield Curve Cycles- The yield curve also takes on a similar path that tends to mirror economic cycles. When the economic cycle portends strong growth, the yield curve steepens. That is to say, the difference between longer and shorter maturity yields rises. This occurs as investors in longer maturity bonds become increasingly concerned with the potential for rising inflation resulting from stronger economic growth.

When strong growth spurs inflation expectations or actual inflation rises, the Fed begins to take action. To combat rising price expectations, they tighten policy with a higher Fed Funds rate. Shorter-term bond yields follow the Fed Funds rate closely, and as the Fed tries to dampen growth, the yield curve flattens. In that instance, longer-term investors are comforted by the Fed actions. This causes longer maturity yields to rise by less than those of shorter maturity yields, or it can help push longer maturity yields lower on an outright basis.

A steeper yield curve increases the incentive to lend and generates more economic growth while a flatter curve reduces the incentive and slows economic growth. The graph below shows how an inverted yield curve, where the yield on a  2-year U.S Treasury note is higher than that of a 10-year U.S. Treasury note, has paved the way for every recession since at least 1980.

Data Courtesy: St. Louis Federal Reserve (FRED)

The Bird is the Word

The graph below shows a scatter plot of the relationship between implied volatility as represented by spot VIX and the 3-month to 10-year yield curve spread. With proper context, you can see the bird is a graph depicting the most recent cycle of stock market optimism (VIX) and the economic growth cycle (yield curve). The graph uses monthly periods encompassing two -year averages to smooth the data and make the longer-term trends more apparent.

Data Courtesy: St. Louis Federal Reserve (FRED)

When we started on this project, we expected to see an oval shaped figure, slanting upward and to the right. Despite the irregularities of the “beak” and “front legs,” that is essentially what we got.

The blue triangle on the bottom-left is the first data point, representing the average VIX and yield curve spread from January 2006 through December of 2007. The years 2006 and 2007 were the economic peak of the prior market cycle. As shown, the two-year average progresses forward month-by-month and moves upward and to the right, meaning that VIX was increasing while the yield curve was steepening. In this period, the yield curve steepened as the Fed began rapidly reducing the fed funds rate in mid-2007. Likewise, VIX started spiking thereafter as the recession and financial crisis began to play out.

The gray and yellow segments on the graph reflect the decline in volatility as the financial crisis abated. Since 2010, the yield curve steadily flattened, and volatility fell to record lows. The one real break to the cycle trend was the “bird leg,” or the periods including 2013 when the yield curve steepened amid the taper tantrum. After that period, the oval-cycle pattern resumed. The red circle marks the most recent monthly data points and shows us where the trend is headed.

Interestingly, note that the number of dots forming the belly of the bird is much greater than those forming the back. This is typical as the expansionary portion of economic and market cycles tend to last five to ten years while market declines and recessions are usually limited to two or three years.

Summary

Think of the economy and stock market as a long-distance runner. At times they may pick up the pace for an extended period, but in doing so, they will inevitably overexert themselves and then must spend a period of time running at a below average pace. 

The stock market has been outrunning economic growth for a long time. This is witnessed by valuations that have surged to record highs. The yield curve is quite flat and volatility, despite spiking twice over the last year, currently resides well below the long-term average and not far from record lows. The current trajectory, as shown with the dotted red arrow in the chart above, is on a path towards the peak of the prior cycle.

The Fed has recently made a dovish (no pun intended) policy U-turn and appears to be on the path to lower rates. This likely means that the curve flattening is nearing an end and steepening is in the cards. At the same time, the market is showing signs of topping as witnessed by two large drawdowns and spikes in implied volatility over the last 15 months.

Based on the analysis above, it appears that the current cycle is close to completion. It is, however, but one piece of information. To borrow from Howard Marks, author of the book Mastering Market Cycles, he states the following:

While they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle….there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent.  All we can do is assemble anecdotal evidence and try to draw the correct inferences from it.

We concur and will use the “bird” as evidence that the cycle is mature.

So, have you scheduled your colonoscopy?

How’s the diet going?

How much weight have you lost?

How many hours of sleep do you get a night?

Welcome to client/advisor conversations of the future.

And the future is now.

It’s easy to comprehend how unhealthy people accumulate less wealth, may be forced to retire sooner and suffer shorter life expectancies. If anything, being unhealthy in retirement even if one has the finances, makes for an emotionally challenging existence.

According to De Nardi, Pashchenko and Porapakkarm authors of NBER Working Paper 23963 The Lifetime Costs of Bad Health, unhealthy people accumulate substantially less wealth than healthy people. Among 65-year-old males with a high-school degree, the median wealth of healthy individuals is almost twice that of those who are unhealthy – $230,000 vs. $120,000 in 2015 dollars.

According to Fidelity Investments, the average couple will spend a total $280,000 in today’s dollars for medical expenses throughout retirement not including long-term care. In retirement, I’ve witnessed unhealthy couples spend close to half of their annual income on healthcare costs which includes Medicare premiums plus out-of-pocket costs. I’ve seen their annual inflation rates hit close to 6% and the quality of their retirements deteriorate.

For me personally, it was a wake-up call to make dramatic improvements to my health habits over three years ago. I don’t want a retirement saddled by poor health. Nor do I want to witness clients go through a lifetime of hard work just to face a poor-quality retirement. Ostensibly, it will require that financial advisors step up and begin to incorporate health tips and monitoring to the financial planning equation.

Health checklist – Work personally on tackling the top 3 common health issues that plague the U.S.

There are dramatic improvements you can make to battle the top 3 most common health issues we face in America: Lack of physical activity, being overweight or obese and tobacco usage. Improvements in these areas are squarely in your control. Just like a financial discipline to pay yourself first, small, steady improvements over the years can lead to big results.

When people come to me to help analyze their spending habits and create a budget, I make sure to discuss the importance of additional spending on high-quality, unprocessed foods. Many seek to cut the gym expense. Not only do I outline the importance of continuing the membership, I look for ways for people to invest in a personal trainer and possibly a nutritionist to hold them accountable.

Start small and form one positive health habit. Right. Now.

Studies show it takes about three weeks for a habit to stick.

In his latest book, “Own The Day, Own Your Life,” Aubrey Marcus founder and CEO of Onnit one of the fastest growing companies in the country, has a chapter on water, light and movement that describes his morning ritual. I’ve taken up this regimen after I read that 78% of Americans are chronically dehydrated. He outlines that how you handle your first 20 minutes out of bed sets your day.

So, every morning on an empty stomach and before caffeine, I down 14 ounces of room temperature filtered water with a squeeze of lemon and a dash of dissolved pink sea salt. I then complete deep breathing exercises for 5 minutes and bask in 10 minutes of blue-light exposure using a Philips GoLite Energy Light Therapy Lamp as the natural light of the sun is still three and a half hours away from gracing my front yard.

Whatever ritual you choose, exclude checking e-mail or a smartphone at first open eye and think to prioritize hydration and motivation. Some successful people I know also journal in the morning to start the day on a positive note.

Tie physical health into your financial health.

I created a mental trick that helps to keep both my long-term financial and physical health on the right track and in the forefront of my thoughts. Before I indulge in an activity, I mentally increase or reduce my retirement savings by $100. For example, if I trade out a burger and fries for a salad, I add $100. If I’m about ready to indulge in something unhealthy or miss a workout, I subtract $100. All this mental ruse is designed to do is compel me to halt, consider what I’m about to do and operate less on impulse.

At the end of a week, I review my additions and subtractions. The goal is to finish net positive. Some weeks, I’m 100% positive and reward myself with a treat. It’s at the point where this mental accounting exercise is on auto-pilot and has been highly effective to keep me on a healthy path.

Postpone retirement.

In the National Bureau of Economic Research working paper 24127, The Mortality Effects of Retirement: Evidence from Social Security Eligibility at Age 62, penned by Fitzpatrick & Moore, even Social Security can be a health hazard if taken early. In their analysis the authors studied mortality data from the National Center for Health Statistics’ Multiple Cause of Death files for the years 1979-2012 and discovered a significant increase in deaths among Social Security recipients especially men, who took retirement income benefits at age 62.

Floss after every meal and once before bed.

According to a Henry J. Kaiser Family Foundation report, most Medicare beneficiaries lack dental coverage and go without needed care. Shockingly, per KFF.org, almost half of all Medicare beneficiaries did not have a dental visit within the past year. Over 65% of the Medicare population does not carry private dental insurance.

It’s incredibly shortsighted how Medicare doesn’t include dental benefits even though oral health and overall physical health are interlinked. Ultimately, poor oral hygiene leads to greater healthcare expenses for seniors which in turn places more pressure on Medicare when it’s probably less expensive just to add dental coverage. A dental health regimen that includes flossing can reduce periodontal disease which shares common risk factors with cancer and heart disease.

If your job jeopardizes your health, try to make a change.

 Listen, I know. I was there.

Although I love serving clients’ financial needs, my past experience in the brokerage industry was nothing short of deadly. Unreasonable quotas, long hours, lack of job security and deterioration of a once-honorable corporate culture took their toll. I found out firsthand that prolonged stress is a silent killer. I developed high blood pressure, Type 2 diabetes and a consistent and embarrassing twitch in my left eyelid. Today, my health is better than ever. Perhaps you need to assess how your current employment situation is affecting your health and ultimately your wealth. It could be a matter of life or death.

A recommended reading list on health – My top 3 go-to books.

  1. “Own The Day, Own Your Life: Optimized Practices for Waking, Working, Learning, Eating, Training, Playing, Sleeping and Sex,” by Aubrey Marcus.
  2. “The Bulletproof Diet: Lose Up to a Pound a Day, Reclaim Energy and Focus, Upgrade Your Life,” by Dave Asprey.
  3. “The Healing Power of Essential Oils: Soothe inflammation, Boost Mood, Prevent Autoimmunity, and Feel Great in Every Way,” by Eric Zielinski D.C.

It’s time to consider the overall impact of health on the quality of retirement and life overall. Certainly, DNA plays a part. However, a proactive attitude coupled with actions may decrease the odds of spending more on out-of-pocket healthcare expenses throughout retirement. 

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AAPL – Apple, Inc.

  • As we stated previoulsy, following the brutal sell off last year, Wall Street got very negative on the companies prospects. This sets up a reasonable opportunity for an upside surprise during earnings season.
  • We added 1/2 of a position last week, and the stock has run up to resistance at the 200-dma.
  • We are looking for a pullback to flesh out the position, so either a pullback that holds support at $170 or a break above the 200-dma that triggers a buy-signal.
  • Stop-loss set at $160

BA – Boeing Co.

  • As noted, we bought 1/2 position in Boeing (BA) following the initial announcement of the 737 MAX crash in Ethiopia.
  • The sell-off held support at previous highs and the 200-dma and is starting the process of building a potential base. This process will take some time as the “news” filters out.
  • Fundamentals remain strong and this event will pass.
  • We are going to give BA some initial leeway and then will tighten up stops as the stock finds its footing.
  • Stop remains at $340
    • Holding 1/2 position currently
    • Looking for opportunity to increase exposure opportunistically.

CMCSA – Comcast Corp.

  • CMCSA finally broke above important resistance and is very overbought currently.
  • We noted previously we were looking for a pullback which works off some of the overbought condition. That has not occurred as of yet, so we will remain patient.
  • We are looking to add to the position at $39 and would like to see some consolidation first.
  • Stop is at $37

FDX – Federal Express

  • We are going to sell Federal Express (FDX) in the morning, as the company has now missed earnings twice in the last two quarters. While the company fundamentals remain sold, the global weakness continues to weigh on performance.
  • We will look for a replacement for FDX after we close out the position tomorrow morning.
  • Stop was at $170

MSFT – Microsoft

  • Since adding MSFT to the portfolio, it has broken out to all-time highs.
  • While close to triggering a “buy” signal, MSFT is extremely overbought short-term.
  • We are looking for a pullback to the recent highs, or some consolidation of the recent advance, to add to our position.
  • Stop-loss is moved up to $110

MMM – 3M Company

  • We initially bought MMM on the idea of a trade war resolution.
  • The recent rally has triggered a “buy” signal, but MMM is extremely overbought.
  • We initially bought 1/2 postion in MMM and are looking for an opportunity to increase exposure. A break above $210 will likely be that entry point.
  • After the initial failure at resistance, MMM is trying again to break above multiple tops.
  • However, we are tightening up stops to protect our profits.
  • Stop is at $200

HCA – HCA Healthcare

  • HCA, along with UNH, had sold off previously on concerns of “Medicare For All.”
  • We used that sell off as an opportunity to add to both positions.
  • Both positions have rallied off the recent lows reinforcing support levels.
  • Stop-loss moved up to $125

IAU – IShares Gold Trust

  • We recently added a position in gold to our portfolio after having been out of the metal since 2013.
  • The recent pullback to support gave us the right opportunity to add the second position bringing IAU to target portfolio weight.
  • Stop-loss is tight at $12.20 currently.

JPM – JP Morgan Chase

  • JPM has rallied recently above its 50-dma finally broke out of its price wedge it had been building to the upside.
  • With JPM very close to a buy signal, we added 1/2 position to the portfolio last week.
  • If JPM can break out above its 200-dma we will add the second 1/.2 of the position.
  • However,we will carry a fairly tight stop for now at $100.

UTX – United Technologies

  • We previously added 1/2 position in UTX to our portfolios and since then have had a stellar advance.
  • With the recent break above the 200-dma, and a triggering of a “buy” signal, we are looking for a bit more consolidation to add to our current holdings.
  • If UTX can hold $125 during the this consolidation, we will add the second 1/2 to our holdings.
  • Stop-loss is currently $117.50
On the heels of the February employment report, we wrote an RIA Pro article entitled Quick Take: Unemployment Anomaly, which highlighted inconsistencies in BLS employment data. In particular, our focus was on the fact that despite jobless claims and the unemployment level reaching nearly 50-year lows, the time it takes for unemployed workers to find a new job is currently 10-15 weeks longer than has been typical at prior levels of unemployment. This study was constructed with over 70 years of monthly data. Based solely on the historically strong statistical correlation of the unemployment rate to the duration of unemployment, the current duration of unemployment lines up with what one would expect for an unemployment rate close to 8%, and not the current 3.8%. Not surprisingly the BLS U6 unemployment rate, a more encompassing measure of inflation, currently sits at 7.3%.

In this article, we present additional data that further questions the health of the labor market. Specifically, we focus on the relationship of the Federal Government’s tax revenue and employment. Once again, something doesn’t add up.

Taxes and GDP

From 1948 until 2010, the annual change in federal tax receipts was 74% correlated with GDP, meaning that 74% of the changes in tax receipts is attributable to the change in economic growth. This makes perfect sense given that during stronger economic periods, wages rise as the supply of labor falls and vice versa. The graph below highlights the relationship.

Of particular interest to us is the shaded area representing the last four years. The graph below magnifies a divergence starting in 2016.

As shown, the deviation from a historical perspective is quite odd. Since 2016, the correlation between the unemployment rate and federal tax receipts has been -58%, meaning that economic growth has a statistically moderate measure of negative correlation. Based on the relationship we should expect tax receipts to decline .58% for every 1% increase in economic growth.

The scatter plot below, dating back to 1990, is another way to highlight how the current relationship compares to recent history. Worth considering is the opposite directions of the slopes of the dotted trend lines of the two periods.

Our Take

The recent change in Federal tax law is certainly responsible for some of this irregular behavior over the last year. However, it is important to note that despite relatively strong economic growth and record low unemployment in recent quarters, weaker tax receipt growth has persisted since the financial crisis.

The graph below shows the steady decline of personal tax receipt growth, despite the significant decline in the unemployment rate. Personal tax receipts were not largely affected by the tax legislation and provide firmer evidence that something is amiss in the data.

The graphs shown in this article, along with the preceding Quick Take on the duration of unemployment, suggest the labor market is not as vibrant as we are led to believe. We also know this from numerous indicators of tepid wage growth despite jobless claims sitting at record low levels.

Our recommendation is to continue to follow the economic data as it can have a large effect on the short-term direction of stock prices. Importantly, however, it may be wise to ignore the narratives surrounding such data. Investors would be well-served to consider the entire scope of incoming data to assess its validity.

Although temporarily suspended by the influences of fiscal and monetary policy, the health of the economy over the long-term drives corporate sales and earnings and ultimately stock prices.

Personal Request:

I need your assistance with a new project.

We have recently launched a beta version of our new Financial Health App backed by the power and security of Yodlee, AWS, ForgeRock, and Intrinio. Our goal is to develop the next generation financial application to help you get control of, and grow, your wealth. Once you try it out, give us feedback as we continue to develop many new features over the next few months. 


A Different Way To Look At Market Cycles

In this past weekend’s newsletter we noted the issues of similarities between the current market environment and previous market peaks in the past. To wit:

“It isn’t just the economy that is reminiscent of the 2007 landscape. As noted above, the markets also reflect the same. Here are a couple of charts worth reminding you of. 

Notice that at the peaks of both previous bull markets, the market corrected, broke important support levels and then rallied to new highs leading investors to believe the bull market was intact. However, the weekly ‘sell signal’ never confirmed that rally as the ‘unseen bear market’ had already started.”

“Currently, relative strength as measured by RSI on a weekly basis has continued to deteriorate. Not only was such deterioration a hallmark of the market topping process in 2007, but also in 2000.”

“The problem of suggesting that we have once again evolved into a “Goldilocks economy” is that such an environment of slower growth is not conducive to supporting corporate profit growth at a level to justify high valuations.”



My friend and colleague Doug Kass penned an important note about the current market backdrop on Monday:

“‘Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits-a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.’ – John Maynard Keynes

The markets, confounding many, have vaulted higher from the Christmas Eve lows with nary a selloff.

This morning, let’s briefly explore the catalysts to the advance and consider what might follow:

  1. Liquidity (and financial conditions) have improved, as Central Bankers, to some degree, have reversed their tightening policies. Interest rates and inflationary expectations have moved lower than expected, providing hope for an elongated economic cycle that has already been a decade in duration and appeared to be “long in the tooth.”
  2. Market structure (and the dominance of price following products and strategies like ETFs, CTAs and Risk Parity and Volatility Trending/Targeting) exacerbated the trend lower into late-December. The breadth thrust and reversal in price momentum contributed to the post-Christmas rally. As I have previously noted, in an investment world dominated by the aforementioned products that worship at the altar of price momentum – ‘buyers live higher and sellers live lower.’ This phenomenon has exaggerated market moves and has created an air of artificiality and absence of price discovery (on both the upside and the downside).
  3. Corporate buybacks – abetted by tax reform introduced 15 months ago – provided another reason for a strong backdrop for higher stock prices.
  4. As a result of the above factors (and others) animal spirits rose and valuations expanded.

These four conditions have offset the deceleration in the rate of global economic growth and U.S. corporate profit growth.”

He is correct, the “animal spirits,” which were awakened by consecutive rounds of financial stimulus on a global scale, has enticed investors into the belief that all risks of a market cycle completion have been removed. The problem, as I have discussed previously, is this optimism comes at a point in history diametrically opposed to when President Reagan instituted many of the same conservative policies.

It is this exuberance that reminded me of the following “investor psychology” chart.

This chart is not new, and there are many variations similar to it, but the importance should not be lost on individuals as it is repeated throughout history. At each delusional peak, it was always uttered, in some shape, form or variation, “this time is different.” 

Of course, to the detriment of those who fell prey to that belief, it was not.

As I was studying the chart, something struck me.

During my history of blogging and writing newsletters, I have often discussed the importance of full-market cycles.

“Long-term investment success depends more on the WHEN you start investing. This is clearly shown in the chart below of long-term secular full-market cycles.”

“Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8 major market cycles since 1871. Every other period yielded a return that actually lost out to inflation during that time frame.”

By looking at each full-cycle period as two parts, bull and bear, I missed the importance of the “psychology” driven by the entirety of the cycle. In other words, what if instead of there being 8-cycles, we look at them as only three? 

This would, of course, suggest that based on the “psychological” cycle of the market, the bull market that began in 1980 is not yet complete. 

Notice in the chart above the CAPE (cyclically adjusted P/E ratio) reverted well below the long-term in both prior full-market cycles. While valuations did, very briefly, dip below the long-term trend in 2008-2009, they have not reverted to levels either low or long enough to form the fundamental and psychological underpinnings seen at the beginning of the last two full-market cycles.   

Long-Run Psychological Cycles

It is from that basis, and historical time frames, that I have created the following thought experiment of examining the psychological cycle overlaid on each of the three full-cycle periods in the market.

The first full-market cycle lasted 63-years from 1871 through 1934. This period ended with the crash of 1929 and the beginning of the “Great Depression.” 

The second full-market cycle lasted 45-years from 1935-1980. This cycle ended with the demise of the “Nifty-Fifty” stocks and the “Black Bear Market” of 1974. While not as economically devastating to the overall economy as the 1929-crash, it did greatly impair the investment psychology of those in the market.

The third (current) full-market cycle is only 39-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not?

The idea the “bull market” which begin in 1980 is still intact is not a new one. As shown below, a chart of the market from 1980 to the present, suggests the same.

  1. The long-term bullish trend line remains
  2. The cycle-oscillator is only half-way through a long-term cycle.
  3. On a Fibonacci-retracement basis, a 61.8% retracement would almost intersect with the long-term bullish trend-line around 1200 suggesting the next downturn could indeed be a nasty one.

Again, I am NOT suggesting this is the case. This is just a thought-experiment about the potential outcome from the collision of weak economics, high levels of debt, and valuations and “irrational exuberance.”

It’s All Asymmetric

A second supporting theory of full market cycles was George Soros’ take on bubbles.

“First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said:

‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’

Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.”

The chart below is an example of asymmetric bubbles.

Asymmetric-bubbles

Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view.  Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.  As Soros stated:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis.  I then took a look at the markets prior to each major market correction and overlaid the asymmetrical bubble shape as discussed by George Soros.

There is currently much debate about the health of financial markets. Have we indeed found the “Goldilocks economy?” Can prices can remain detached from the fundamental underpinnings long enough for an economy/earnings slowdown to catch back up with investor expectations?

The speculative appetite for “yield,” which has been fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction currently is simply a catalyst to put “fear” into an overly complacent marketplace.  

In the long term, it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the current levels of asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to, once again, lose a large chunk of their net worth.  

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run is telling much the same story.  History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

It is critically important to remain as theoretically sound as possible as a large majority of investors have built their portfolios on a foundation of false ideologies.

The problem is when reality collides with widespread fantasy.

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • Previous support from February lows has been broken and remains resistance.
  • XLB has triggered a “buy” signal but is wrestling with resistance at the 200-dma.
  • XLB is still very overbought (top panel) and the failure at resistance is troubling given materials and industrials both stand to benefit from a “trade deal.”
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 position.
    • This Week: Hold
    • Stop-loss remains at $53
  • Long-Term Positioning: Bearish

Communications

  • XLC broke above previous resistance and held that support. But now is testing another level of overhead resistance.
  • Currently on a “buy” signal.
  • Sector back to extreme overbought.
  • Short-Term Positioning: Neutral
    • Last Week: Recommended to “hold” 1/2 position
    • This Week: Hold 1/2 position
    • Stop-loss moved up to $45
  • Long-Term Positioning: Bearish

Energy

  • XLE broke above the 200-dma and has retested that support and held.
  • Sell-signal (bottom panel) has reversed to a “buy signal”
  • Currently, XLE has reversed back up to extreme overbought short-term.
  • Short-Term Positioning: Neutral
    • Last week: We added 1/2 position.
    • This week: Hold and wait for a pullback to support, or a break out, to add.
    • Stop-loss moved up to $64
  • Long-Term Positioning: Bearish

Financials

  • XLF finally broke above downtrend resistance but lots of resistance from 2018 remains.
  • A “buy” signal has been triggered (bottom panel)
  • XLF has reversed back to overbought limiting the ability to add exposure currently.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position and look for a breakout above resistance to add.
    • Stop-loss moved up to $25.50
  • Long-Term Positioning: Bearish

Industrials

  • We noted previously that XLI had rallied sharply on hopes of a resolution on trade. However, whatever deal is struck, it has likely already been priced in.
  • Buy signal in lower panel is very extended.
  • The extreme overbought condition is being corrected short-term, after taking profits in current holdings continue to be patient for a pullback to support to add exposure.
  • Previous all-time highs remain a likely target.
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Rebalance holdings. Hold 1/2 position, add on pullback to $72
    • Stop-loss moved up to $70
  • Long-Term Positioning: Neutral

Technology

  • Currently XLK is on a “Buy” signal (bottom panel)
  • Given the current extreme overbought conditions short-term, look for a pullback to add exposure to portfolios.
  • We noted previously the push above the downtrend resistance set up a test of old highs.
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, Add on pullback to $68-70
    • Stop-loss moved up to $66.00
  • Long-Term Positioning: Neutral

Staples

  • After breaking above the 400-dma, XLP broke above resistance and is approaching previous highs.
  • XLP has triggered a “buy” signal (lower panel)
  • Currently still overbought, however the pullback to $53.50 hit our target to add exposure.
  • Short-Term Positioning: Bullish
    • Last week: Added 1/2 position with pullback to $53.50
    • This week: Add 1/2 position on pullback to $54.50 which turns previous resistance into support.
    • Stop-loss moved up to $53
  • Long-Term Positioning: Bullish

Real Estate

  • “This is just nuts.” Real estate is now incredibly extended to the upside, along with utilities (XLU), as the “defensive” play in markets continues. Take profits and be careful.
  • Long-term trend line is currently holding.
  • After breaking out to all-time highs, it has just kept going. There has not been a decent risk/reward opportunity to increase exposure.
  • Buy signal reaching more extreme levels (bottom panel)
  • Remains at more extreme overbought condition short-term. (top panel)
  • Short-Term Positioning: Bullish
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Add on any weakness that works off over-bought condition or holds support at $34
    • Stop-loss adjusted to $33
  • Long-Term Positioning: Bullish

Utilities

  • As noted above – “This is crazy.”
  • Long-term trend line remains intact.
  • Previous support continues to hold.
  • Buy signal has been registered.. (bottom panel)
  • Back to extreme overbought conditions.
  • Broke above resistance and moved to all-time highs.
  • Short-Term Positioning: Bullish
    • Last week: Rebalance holdings and continue to hold.
    • This week: If you didn’t take profits last week, do so now and hold target weight.
    • Stop-loss moved up to $54 with a target of $60
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel) is being reversed.
  • The current overbought condition was being worked off, but reversed back up after the recent dip.
  • XLV is holding support currently at the long-term uptrend line.
  • Short-Term Positioning: Neutral
    • Last week: Add a full position to portfolios last week.
    • This week: Hold current positions.
    • Stop-loss remains at $89
  • Long-Term Positioning: Neutral

Discretionary

  • Long-term trend line remains broken.
  • Previous support was successfully tested in recent sell off.
  • A “buy” signal has been registered (lower panel)
  • Extreme overbought conditions currently limit upside.
  • The recent correction to $108 hit our target to add exposure.
  • Short-Term Positioning: Neutral
    • Last week: Added 1/2 position.
    • This week: Hold current position, add on breakout or retest of support.
    • Stop-loss moved up to $107
  • Long-Term Positioning: Neutral

Transportation

  • Previous support failed in recent sell-off. Rally on Monday also failed to solidly reclaim that level.
  • Buy signal. (bottom panel) has been triggered..
  • Overbought condition is being relieved on a short-term basis.
  • The recommendation to add exposure at $60 with a tight stop at $58 remains.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 of position or add exposure at $60 for a “catch-up trade”
    • Stop-loss adjusted to $58
  • Long-Term Positioning: Bearish
Last week, Jeff Desjardins of Visual Capitalist wrote in a post:

“While it’s true that putting your money on the line is never easy the historical record of the stock market is virtually irrefutable: U.S. markets have consistently performed over long holding periods, even going back to the 19th century.”

This goes back to Wall Street’s suggestion of “buy and holding” investments because over 10- and 20-year holding periods, investors always win.

There are two major problems with this myth.

First, on an inflation-adjusted, total return basis, long-term holding periods regularly produce near zero or negative return periods.

Secondly, given that most individuals don’t start seriously saving for retirement until later on in life (as our earlier years are consumed with getting married, buying a house, raising kids, etc.,) a 10- or 20-year period of near zero or negative returns can devastate retirement planning goals.

It should be obvious, when looking at the two charts above, that WHEN you start in investment journey, relative to current valuation levels, is the most critical determinant of your outcome.

(We have written a complete series on the Myths Of Investing For Long-Run. Chapters 1, 2 & 3 cover the concepts above in much more detail)

Baby Boom Generation Should Be Rich

Let’s look at this differently for a moment.

The financial media and blogosphere is littered with advice on how easy it is to invest. As noted above, over long-periods of time there is absolutely nothing to worry about, right?

Okay, let’s assume that is true.

The “Baby Boom” generation are those individuals born between the years of 1946 and 1964.  This means that this group of individuals entered the work force between 1966 and 1984. If we assume a bit of time from obtaining employment and starting the saving and investing process, most should have entered the markets starting roughly in 1980.

So, despite the little “flatish” period of the markets between 2000 and 2013, the markets have been in a extremely long rising trend. (One could argue the bull market which began in 1980 is still going.)

And, if we look at it the way the financial media and most financial advisors show it, the bull markets have exploded personal wealth historically. (The chart below is the cumulative percentage gain (real total return) of the S&P 500 index.)

Despite those two little minor percentage drawdowns, baby boomers have been fortunate to participate in two massive bull markets over the last 38-years.

So, given this steadily rising trend of the market, most individuals should be well prepared for retirement, right?

The why isn’t that case. Let’s take a look at some of the myths and facts.

Myth: Everyone contributes to a retirement plan.

Fact: Not so much. 

According to a recent NIRS study only 51% of Americans have access to a 401k plan.

More importantly, only 40% of individuals actually contribute to one.

Here is another way to look at it. Almost 60% of ALL WORKING AGE individuals DO NOT own assets in a retirement account. 

And of those that do own retirement accounts the majority are of the wealth, unsurprisingly is owned by those with the highest incomes.

It’s actually worse than that.

The typical working-age household has only ZERO DOLLARS in retirement account assets. Importantly, “baby boomers” who are nearing retirement had an average of just $40,000 saved for their “golden years.”

Lastly, only 4-0ut-of-5 working-age households have retirement savings of less than one times their annual income. This does not bode well for the sustainability of living standards in the “golden years.”

Myth: Individuals save money in lot’s of other ways.

Fact: Not so much.

According to the study by MagnifyMoney:

“Although the average American household has saved roughly $175,000 in various types of savings accounts, only the top 10 percent to 20 percent of earners will likely have savings levels approaching or exceeding that amount. 29 percent of households have less than $1,000 in savings.”

So, What Happened?

If investing is as easy as the financial media and advisors portray it to be, then why is the vast majority of American literally broke?

Go back up to that S&P 500 cumulative percentage gain and loss chart above.

That is the most deceiving chart ever made to convince individuals to plunk their money down in the market and leave it.

As Mark Twain once quipped:

“There are three kinds of lies. Lies, damned lies, and statistics.” 

Using percentages to dispel the impact of losses during bear market declines false into the “statistics” category.

If the market rises from 1000 to 2000, it is up 100%. However, if it then falls by 50%, you don’t lose just 50% of what you gained. You lose 50% of everything.

If we revise the chart of the real, total-return, S&P 500 chart above to display the cumulative gains and losses in points, rather than percentages, the reality of damages from bear markets is revealed.

You will notice that in every case, the entirety of the previous bull market advance was almost entirely wiped out by the subsequent decline.

So, what happened to all those baby boomers? Well, let’s walk through the sequence:

  1. Age 30’s: In 1980 the “baby boomer” generation is working, saving, and participating during one the 80-90’s bull market.
  2. Age 50’s: From 2000 to 2002, the “Dot.Com” crash cuts their savings by 50%.
  3. Age 53-57: From 2003-2007 the full market grows savings back to their previous level in 2000.
  4. Age 57-58:  The 2008 “Financial Crisis” wipes out 100% of the gains of the previous bull market and resets savings values back to 1995 levels.
  5. Age 58-63: From 2009-2013 financial markets rise growing savings back to the same levels in 2000.

At the age of 63, “baby boomers” are staring retirement in the face. Yet, because of the devastation of two major bear markets they are no closer to their retirement goals than they were 13-years earlier.

This problem is clearly shown in the retirement statistics above.

But it is actually worse than that.

From 2008 to present, the S&P 500 has more than tripled in value. Yet, as shown by the table from Fidelity investments below which is a great sample size for most Americans, 401k accounts and IRA’s barely even doubled.

The reason, of course, is psychology. Despite the best of intentions, psychology makes up fully 50% of the reason investors underperform over time. But notice, the other 50% relates to lack of capital to invest. (See this)

These biases come in all shapes, forms, and varieties from herding, to loss aversion, to recency bias and are the biggest contributors to investing mistakes over time.

These biases are specifically why the greatest investors in history have all had a very specific set of rules they followed to invest capital and, most importantly, manage the risk of loss.  (Here’s a list)

The problem that is unfolding for investors going forward is that while the mainstream financial press continues to extol the virtues of investing in the financial markets for the “long-term”, the assumptions are based on historical data which is not likely to repeat itself in the future. 

Jeff Saut, Liz Ann Sonders, and others have continued to prognosticate the financial markets have entered into the next great “secular” bull market. As explained previously, this is not likely to the be case based upon valuations, debt, and demographic headwinds which currently face the economy.

More importantly, as John Mauldin recently noted:

“When that next recession and bear market hit, it will take even longer to bounce back. The recovery will be even slower than this last one. As the research I’ve shared in previous letters shows, large amounts of debt slows recoveries. Very large amounts create flat economies. We are approaching large amounts in the US…but I think the recovery will be much slower, at a minimum. A double dip recession is clearly possible, making those stock market index fund losses even worse.”

John goes on to restate what I have detailed many times previously,

You must have some kind of strategy for dealing with market volatility. 

Invest in programs that give you at least a chance to dodge bear markets. Buy and hold works in theory, but not for most people because we are humans with emotions. We should recognize that and take steps to control it. “

Bingo.

He’s right. Combine high levels of debt, with high valuations, and psychological impediments and the outlook for investors isn’t great.

Does this mean you should NOT invest at all when valuations are high?

No. What it means is that you have to CHANGE the way you invest.

  • When valuations are low and rising, you absolutely should be a “buy and hold, dollar cost averaging, investor.”
  • Conversely, when valuations are high, you have to shift your thinking more to capital preservation and being more opportunistic on how you invest.

Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.

With this in mind, individuals need to carefully consider the factors that will affect their future outcomes.

  • Expectations for future returns and withdrawal rates should be downwardly adjusted.
  • The potential for front-loaded returns going forward is unlikely.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerate the principal bleed. Plans should be made during rising market years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you likely want. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to reach their retirement goals.

Yes, you can do better. 

You just have to turn off the media to do so.

There should be no one more concerned about YOUR money than you, and if you aren’t taking an active interest in your money – why should anyone else?

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

  • The rally off of the 200-dma, as we previously discussed, was expected and the break above 2800 resistance sets up a test of all-time highs.
  • Longer-term “buy signal” is in place which is bullish
  • The break above resistance sets up a tradeable entry but keep stops very tight due to the overbought condition of the market.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 1/2 position
    • This Week: Add 1/2 position, bring to full weight.
    • Stop-loss moved up to $275
  • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • Recent rally failed at the January highs and remains very overbought.
  • DIA remains well above its 200-dma but that will be critical support.
  • A “buy signal” is in place
  • Market is back to extreme overbought, so break above resistance is key before taking on additional exposure. Most of the underperformance can be attributed to BA last week, and due to its impact on the index, focus on SPY and QQQ for now until there is so resolution with BA.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss remains at $250
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • The rally last week, took QQQ above resistance and set up a test of all-time highs. With technology leading the charge currently, the probability of a test of all-time highs is very possible.
  • A buy signal was triggered last week.
  • Market remains very overbought but support held at the 200-dma.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 1/2 of position
    • This Week: Add 1/2 of position going back to full weight.
    • Stop-loss moved up to $170
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • Recent rally failed at the 200-dma and is now testing important support at the Oct-Nov lows.
  • A “buy” signal was triggered last week.
  • Small-caps have reversed about half of its overbought condition so there is still downside risk currently.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss remains at $66 – could break next week.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • Like it’s small-cap brethren, the recent rally failed to hold the 200-dma.
  • Currently, Mid-caps are testing support at the Oct-Nov highs
  • Mid-caps have recently flipped back onto a buy signal. However, the recent correction has not reduced the overbought condition we noted last week.
  • Short-Term Positioning: Neutral
    • Last Week: After taking profits previously, hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss is adjusted to $337.50
  • Long-Term Positioning: Neutral

Emerging Markets

  • EEM is currently testing its 200-dma which is still declining currently.
  • The extreme overbought condition is being worked off, so it will be important for EEM to maintain support over the next week. So far that has been the case with a second successful test of the 200-dma last week.
  • After adding a 1/2 position to portfolios we suggested a short-term corrective action was likely. If the position holds support and turns up and breaks recent highs, we will add to our holdings.
  • Short-Term Positioning: Bullish
    • Last Week: Hold current position.
    • This Week: Hold current position.
    • Stop-loss moved to $41
  • Long-Term Positioning: Bearish

International Markets

  • Recent rally finally pushed above the 200-dma.
  • The downtrend from all-time highs and remains and international markets are extremely overbought.
  • While a “buy signal” has been triggered, EFA reamins very overbought in the short-term.
  • Short-Term Positioning: Neutral
    • Last Week: After taking profits, hold 1/2 of position
    • This Week: Hold 1/2 of position, looking to add second 1/2 on pullback to support.
    • Stop-loss moved up to $63
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Oil showed some muscle by breaking above the 3-year trend channel and above the 38.2% Fibonacci retracement.
  • $60 is the next major resistance level at the 50% retracement which will coincide with the downward trending 200-dma.
  • Oil is very close to triggering a “buy” signal which will allow us to add exposure if some of the short-term overbought condition can be worked off.
  • Short-Term Positioning: Neutral
    • Last Week: After taking profits, hold 1/2 position
    • This Week: Hold 1/2 position, look for a break above the 50% retracement.
    • Stop-loss adjusted to $55
  • Long-Term Positioning: Bearish

Gold

  • As we noted last week, the sell-off tested support at the 61.8% retracement of the decline and is now back to oversold.
  • Gold turned up last week and remains on a “buy” signal.
  • Currently on “buy” signal (bottom panel) so positions can be added.
  • Short-Term Positioning: Bullish
    • Last week: Added 1/2 position and carrying a full weight.
    • This week: Hold positions
    • Stop-loss for whole position set at $120
  • Long-Term Positioning: Improving From Bearish To Bullish

Bonds (Inverse Of Interest Rates)

  • Support continues to build along the 720-dma. The rally following the recent sell-off is testing resistance within this current consolidation.
  • Currently on a buy-signal (bottom panel), bonds have once again swung from oversold to overbought.
  • Entry point was triggered at $120 with reversal of overbought condition.
  • Resistance remains from $122 to $124
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
  • Short-Term Positioning: Bullish
    • Last Week: Recommended adding to holdings.
    • This Week: Hold positions.
    • Stop-loss adjusted to $119
  • Long-Term Positioning: Bullish


  • Market Review & Recap
  • The Goldilocks Warning
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Review & Recap

Over the last couple of weeks we discussed the “wild swings” in the market in terms of price movements from overbought, to oversold, and now back again. The quote below is from two week’s ago but is apropos again this week.

“Despite the underlying economic and fundamental data, the markets have surged back to extremely overbought, extended, and deviated levels. The chart table below is published weekly for our RIA PRO subscribers (use code PRO30 for a 30-day free trial)

On virtually every measure, markets are suggesting the fuel for an additional leg higher in assets prices is extremely limited.”

Just for visual sake, the chart below compares the last three weeks of wild gyrations. (Click To Enlarge)

The chart below also shows the short-term reversal of the market as well. Note how in just a few days the market went from overbought, to oversold, back to overbought. 

Importantly, as I specifically noted last week:

“This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term, remains the resistance level building at 2800.”

On that analysis, we did increase equity exposure early last week in both our ETF and Equity Portfolios. In the RIA PRO version of this letter we gave specific recommendations to add exposure particularly to Healthcare due to the recent sell-off over concerns of “Medicare for all.”

Despite the rally, the bounce is still largely at risk for the three following reasons:

  1. As noted previously, the market has not reversed to levels which normally signals short-term bottoms. The red lines in the bottom four panels denote periods where taking profits, and reducing risk, has been ideal. The green lines have been prime opportunities to increase exposure. As you will note, these indicators tend to swing from extremes and once a correction process has started it is usually not completed until the lower bound is reached. 

Important Note: This does not mean the market will decline sharply in price. The current overbought conditions can also be resolved by continued consolidation within a range as we have seen over the last two weeks. 

2) The divergence between stocks and bonds still signals that “smart money” continues to seek “safety” over “risk.” Historically, these bond market generally has it right.

3) As discussed in “Will The Next Decade Be As Good As The Last,” the weekly chart below shows the S&P 500 hitting an all-time high last September before falling nearly 20% into the end of 2018. While the first two months of 2019 has seen an impressive surge back to its November highs, the market is starting to build a pattern of lower highs, and lower bottoms. More importantly, both relative strength and the MACD indicators are trending lower and negatively diverging from the markets price action.

As John Murphy noted last week for StockCharts:

  • The bull market that ended in March 2000 preceded an economic downturn by a year.
  • The October 2007 stock market peak preceded the December economic peak by two months.
  • The March 2009 stock upturn led the June economic upturn by three months.
  • Historically, stocks usually peak from six to nine months ahead of the economy. Which is why we look for possible stock market peaks to alert us to potential peaks in the economy that usually follow. And we may be looking at one.

If you are a longer-term investor, these issues should be weighted into your investment strategy. While we did add exposure to our portfolios early last week, we are still overweight cash and fixed income.

  • In the RIA PRO Equity Model – we bought Boeing (BA) on the initial plunge, and added positions in JPM, AAPL and PPL. 
  • In the RIA PRO ETF Model – we added Healthcare (XLV), Energy (XLE) and Gold (IAU). 


As always, we start with trading positions which have very tight stop-loss parameters. If our thesis on the position is proved correct, the position size is increased and is moved into a longer-term holding status with widened safety protocols. 

This is how we approach linking longer-term views to short-term opportunities. Managing a portfolio of investments is simply measuring risk and reward and placing bets when reward outweighs the potential risk. Tweaking exposure to “risk” over time improves performance tremendously over the long-term. 

The Goldilocks Warning

Lately, there has been an awful lot of talk about a “Goldilocks economy” here in the U.S. Despite a rather severe slow down globally, it is believed currently the domestic economy is going to continue to chug along with not enough inflation to push the Fed into hiking rates, but also won’t fall into recession. It is a “just right” economy which will allow corporate profits to grow at a strong enough rate for stocks to continue to rise at 8-10% per year. Every year…into eternity.

Does that really make any sense? 

Particularly as we are looking at the longest expansion cycle in the history of the U.S. The problem is in the rush to come up with a “bullish thesis” as to why stocks should continue to elevate in the future, they have forgotten the last time the U.S. entered into such a state of “economic bliss.” 

You might remember this:

“The Fed’s official forecast, an average of forecasts by Fed governors and the Fed’s district banks, essentially portrays a ‘Goldilocks’ economy that is neither too hot, with inflation, nor too cold, with rising unemployment.” – WSJ Feb 15, 2007

Of course, it was just 10-months later that the U.S. entered into a recession followed by the worst financial crisis since the “Great Depression.”

The problem with this “oft-repeated monument to trite” is that it’s absolute nonsense. As John Tamny once penned:

A “Goldilocks Economy,” one that is “not too hot and not too cold,” is very much the fashionable explanation at the moment for all that’s allegedly good. “Goldilocks” presumes economic uniformity where there is none, as though there’s no difference between Sausalito and Stockton, New York City and Newark. But there is, and that’s what’s so silly about commentary that lionizes the Fed for allegedly engineering “Goldilocks,” “soft landings,” and other laughable concepts that could only be dreamed up by the economics profession and the witless pundits who promote the profession’s mysticism.

What this tells us is that the Fed can’t engineer the falsehood that is Goldilocks, rather the Fed’s meddling is what some call Goldilocks, and sometimes worse. Not too hot and not too cold isn’t something sane minds aspire to, rather it’s the mediocrity we can expect so long as we presume that central bankers allocating the credit of others is the source of our prosperity.”

John is correct. An economy that is growing at 2%, inflation near zero, and Central banks globally required to continue dumping trillions of dollars into the financial system just to keep it afloat is not an economy we should be aspiring to. But despite commentary the financial system has been “put back together again,” then why are Central Banks acting? Via Bloomberg:

“Led by the Fed, many central banks have either held back on tightening monetary policy or introduced fresh stimulus, soothing investor fears of a slowdown. Fed Chairman Jerome Powell says he and colleagues will be patient on raising interest rates again, while European Central Bank President Mario Draghi has ruled out doing so this year and unveiled a new batch of cheap loans for banks.

Elsewhere, authorities in Australia, Canada and the U.K. are among those to have adopted a wait-and-see approach. China, at its National People’s Congress this month, signaled a willingness to ease monetary and fiscal policies to support expansion.”

Unfortunately, today’s “Goldilocks” economy is more akin to what we saw in 2007 than most would like to admit.

Job growth is slowing down.

Along with economic growth.

And recession risks are rising sharply.

However, it isn’t just the economy that is reminiscent of the 2007 landscape.  The markets also reflect the same. Here are a couple of charts worth reminding you of. 

Notice that at the peaks of both previous bull markets, the market corrected, broke important support levels and then rallied to new highs leading investors to believe the bull market was intact. However, the weekly “sell signal” never confirmed that rally as the “unseen bear market” had already started.


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Currently, relative strength as measured by RSI on a weekly basis has continued to deteriorate. Not only was such deterioration a hallmark of the market topping process in 2007, but also in 2000.

The problem of suggesting that we have once again evolved into a “Goldilocks economy” is that such an environment of slower growth is not conducive to supporting corporate profit growth at a level to justify high valuations.

It is true that the bears didn’t eat Goldilocks at the end of the story…but then again, there never was a sequel.

Simple Actions To Take Now, You Will Appreciate Later

  1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
  2. Sell underperforming positions. If a position hasn’t performed during the rally over the last three months, it is weak for a reason and will likely lead the decline on the way down. 
  3. Positions that performed with the market should also be reduced back to original portfolio weights. Hang with the leaders.
  4. Move trailing stop losses up to new levels.
  5. 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.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

See you next week. 


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Last week, I noted the overbought condition across sectors had not been fully reversed which suggests more downward pressure on asset prices over the next week. I also noted that defensive sectors were outperforming offensive sectors of the market as well.

This past weeks rally, as I suggested would be the case, returned most sectors back to overbought conditions. However, it was still defensives leading the charge. 

Technology, Staples, Utilities, Real Estate, Healthcare – all rallied hard last week with Technology, Utilities, and Real Estate leading the charge. These sectors are GROSSLY overbought and extended. Take profits and wait for a pullback to add exposure. As noted last week, we added healthcare to portfolios. 

Current Positions: XLP, XLU, XLV, XLK – Stops moved from 50- to 200-dmas.

Discretionary, Industrials, Materials, Energy, Financials, and Communications – While other sectors of the market have performed much better, these sectors have rallied “failed to impress.” Discretionary stocks regained their 200-dma along with Materials and Communications. Watch these weaker sectors as they are very economically sensitive. 

Current Positions: XLB, XLY, XLF – Stops remain at 50-dmas.

Importantly, all sectors of the market are still operating within a bearish crossover of the 50- and 200-dma’s. It all appears very “toppy” at the moment, so the right course of action is to take profits, rebalance risk, and wait for whatever happens next to determine the next course of action. 

The recent rally in the market is likely complete for now and more corrective/consolidation action is needed to reverse the previous overbought conditions.

Market By Market

Small-Cap and Mid Cap – both of these markets are currently on macro-sell signals but have rallied along with the entire market complex. Both Mid and Small-caps, failed to hold above the 200-dma and are looking to retest support at the 50-dma. These two sectors are more exposed to global economic weakness than their large-cap brethren so caution is advised. Take profits and reduce weightings on any rally next week until the backdrop begins to improve. 

Current Position: None

Emerging, International & Total International Markets 

As noted last week, Emerging Markets pulled back to its 200-dma after breaking above that resistance. We did add 1/2 position in EEM to portfolios three weeks ago understanding that in the short-term emerging markets were extremely overbought and likely to correct a bit. That corrective action is occurring with some of the overbought condition being reduced. With the 50-dma rapidly approaching a cross above the 200-dma, we will add to our position on a breakout of this consolidation process we have been in as of later. 

Major International & Total International shares are extremely overbought but DID finally break above their respective 200-dma’s on hope the worst of the global economic slowdown is now behind them. Keep stops tight on existing positions, but no rush here to add new exposure. However, a pullback to support, and/or a bullish crossover of the 50-dma, and we will add exposure to our portfolios. 

Stops should remain tight at the running 50-dmas. 

Current Position: 1/2 position in EEM

Dividends, Market, and Equal Weight – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with respect to 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.

Core holdings are currently at target portfolio weights.

Current Position: RSP, VYM, IVV

Gold – We have been discussing a pullback in Gold to add exposure to portfolios. The overbought condition in gold was reversed over the last week as gold broke its 50-dma. The bullish backdrop remains currently, and gold needs to rally next week back above the 50-dma. 

Current Position: GDX (Gold Miners), 1/2 position IAU (Gold)

Bonds 

Intermediate duration bonds remain on a buy signal after we increased exposure last month. We are holding our current bond allocation for the time being. However, as we noted last week:

“The bond rout last week, which was greatly needed to reduce the overbought condition, has pushed bonds back to an extreme oversold condition. With strong support sitting at $118, we will look to take on a tactical trading position over the next couple of weeks.”

Unfortunately, the reversal in bonds was so rapid last week we did not get to increase our exposure as we wanted. However, the recent action is bullish and a test of the 50-dma that holds will likely be a good opportunity to take on trading positions. We remain fully allocated to bonds so the performance pick up was welcome. 

Current Positions: DBLTX, SHY, TFLO, GSY

High Yield Bonds, representative of the “risk on” chase for the markets, declined with the market last week. However, with the announcement from the ECB of no rate hikes and more stimulus, international bonds soared higher last week. If you are long international bonds take profits now and rebalance risk back to normal portfolio weights. The current levels are not sustainable and there will be a price decline which will offer a better entry opportunity soon. 

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 noted last week:

“Last week, the market failed at the 2800-resistance level and failed to hold the 200-dma. However, the market did hold support at the longer-term 300-dma and is short-term oversold. It will be important for the market to get back above the 200-dma next week and continue the ongoing consolidation of the previous 2-month rally.”

The rally we expected occurred and not only did the market break back above the 200-dma it also hurdled over 2800 as well. This puts all-time highs in focus for the markets currently as long as they continue to ignore the economic data. 

As we said last week, the pullback to short-term oversold conditions allowed us to take some actions in portfolios. 

  • New clients: We added core positions AND our fixed income holdings to new portfolios. Since our “core” positions are our long-term holds for inflation adjustments to income production we can add without too much concern. 
  • Equity Model: The recent rout in Healthcare, Materials, and Discretionary give us an opportunity to increase holdings in some of our longer-term holdings. We also added holdings in BA, JPM, AAPL and PPL. 
  • ETF Model: Adding XLV, 1/2 position in XLE, and filled out our holdings of IAU. 

Note for new clients:

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


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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

401k-PlanManager-AllocationShift

Market Rallies, Be Patient

As we have been discussing over the last several weeks, the sharp rally in stocks has gone too far, too quickly, so just be patient here and wait for a correction/consolidation to increase exposure. The rally this past week was positive but remains very narrow in terms of participation.

The break out of the recent consolidation range is bullish so you CAN increase exposure in portfolios modestly. However, the backdrop is not strong enough on a risk/reward basis to take the portfolio allocation model back to 100% just yet. 

Also, this rally remains concerning, as I stated last week:

“Take a look at the chart above. Beginning in 2016, I drew a bull trend channel for the market in the chart above (the dashed 45-degree black lines) which have contained the bull market rally since the 2009 lows.

In January 2018, the market made, as we stated then, and unsustainable break above that upper trend line. I add the horizontal black dashed line at that point and said that ultimately we would see a correction back the long-term bull trend line. 

Since then, exactly that has happened and rather than the market retesting the lower bullish trend line and then beginning a more normal advance, the market rocketed higher in 2-months to hit AND FAIL at the upper bullish trend line. 

If the last decade provides any clues, it is likely the market is going to remain range bound within this rising trend for now, which suggests that waiting for a better entry point to increase exposure will be rewarded.” 

As we noted last week, wanted to be patient and wait for a rally. That rally ran faster than expected but broke above recent resistance. 

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. However, hold the bulk of your positions for now and let them run with the market.
  • If you are underweight equities or at target – rebalance portfolios to model weights currently. Hold positions for now and increase allocations in modestly as needed to get towards target weights. 

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


Current 401-k Allocation Model

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

401k Choice Matching List

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

401k-Selection-List

 

Believe it or not, any domestic bond trader under the age of 55 has never traded in a bond bear market. Unlike the stock market, which tends to cycle between bull and bear markets every five to ten years, bond markets can go decades trending in one direction. These long periods of predictable rate movements may seem easy to trade, especially in hindsight, but when the trend changes, muscle memory can trump logic leaving many traders and investors offside.

If you believe higher yields are upon us in the near future, there are many ways to protect your bond portfolio. In this article, we present one idea applicable to municipal bonds. The added benefit of this idea is it does not detract from performance if rates remain stubbornly low or fall even lower.  Who says there is no such thing as a free lunch?

Munis

Municipal bonds, aka Munis, are debt obligations issued by state and local government entities. Investors who seek capital preservation and a dependable income stream are the primary holders of munis. In bear markets, munis can offer additional yield over Treasury bonds, still maintain a high credit quality, and avoid the greater volatility present in the corporate bond or equity markets.

Munis are unique in a number of ways but most notably because of their tax status. Please note, munis come in taxable and tax-exempt formats but any reference to munis in this article refers to tax-exempt bonds.

Because of their tax status, evaluating munis involves an extra step to make them comparable to other fixed income assets which are not tax-exempt. When comparing a muni to a Treasury, corporate, mortgage backed security, or any asset for that matter, muni investors must adjust the yield to a taxable equivalent yield. As a simple example, if you are in a 40% tax bracket and evaluating a muni bond yielding 2%, the taxable equivalent yield would be 3.33% (2.00% / (1-40%). It is this yield that should be used to equate it to other fixed income securities.

Negative “Tax” Convexity Matters

Thus far, everything we have mentioned is relatively straight-forward. Less well-understood is the effect of the tax rate on muni bonds with different prices and coupons. Before diving into tax rates, let’s first consider duration. Duration is a measure that provides the price change that would occur for a given change in yield. For instance, a bond with a duration of 3.0 should move approximately 3% in price for every 1% change in yield.

While a very useful measure to help quantify risk and compare bonds with different characteristics, duration changes as yields change. Convexity measures the non-linear change in price for changes in yield. Convexity helps us estimate duration for a given change in yield.

For most fixed rate bonds without options attached, convexity is a minor concern. Convexity in the traditional sense is a complex topic and not of primary importance for this article. If you would like to learn more about traditional convexity, please contact us.

Munis, like most bonds, have a small amount of negative convexity. However, because of their tax status, some muni bonds have, what we call, an additional layer of negative tax convexity. To understand this concept, we must first consider the complete tax implications of owning munis.

The holder of the muni bond receives a stream of coupons and ultimately his or her invested principal back at par ($100). The coupons are tax free, however, if the bond is sold prior to maturity, a taxable capital gain may occur.

The table below illustrates three hypothetical muni bonds identical in structure and credit quality. We use a term of 1 year to make the math as simple as possible.

In the three sample bonds, note how prices vary based on the range of coupons. Bond A has the lowest coupon but compensates investors with $2.41 ($100-$97.59) of price appreciation at maturity (the bond pays $100 at maturity but is currently priced at $97.59). Conversely, Bond C has a higher coupon, but docks the holder $2.41 in principal at maturity.

For an uninformed investor, choosing between the three bonds is not as easy as it may appear. Because of the discounted price on bond A, the expected price appreciation ($2.41) of Bond A is taxable and subject to the holder’s ordinary income tax rate. The appropriate tax rate is based on a De minimis threshold test discussed in the addendum. Top earners in this tax bracket pay approximately 40%.

Given the tax implication, we recalculate the yield to maturity for Bond A and arrive at a net yield-to-maturity after taxes of 4% (2.50% + (2.50 *(1-.40). Obviously, 4% is well below the 5% yield to maturity offered by bonds B and C, which do not require a tax that Bond A does as they are priced at or above par. Working backwards, an investor choosing between the three bonds should require a price of 95.88 which leaves bond A with an after tax yield to maturity of 5% and on equal footing with bonds B and C.

Implications in a rising yield environment and the role of “tax” convexity

Assume you bought Bond B at par and yields surged 2.50% higher the next day. Using the bond’s stated duration of .988, one would expect Bond B’s price to decline approximately $2.47 (.988 * 2.5%) to $97.53. Based on the prior section, however, we know that is not correct due to the tax implications associated with purchasing a muni at a price below par. Since you purchased the bonds at par, the tax implication doesn’t apply to you, but it will if anyone buys the bond from you after the 2.5% rise in yields. Therefore, the price of a muni bond in the secondary market will be affected not just by the change in rates, but also the associated tax implications. Assuming the ordinary income tax rate, the price of Bond B should fall an additional $1.65 to $95.88.  This $1.65 of additional decline in Bond B’s price is the penalty we call negative tax convexity.

The graph below shows how +/- 2.50% shifts in interest rates affect the prices of bonds A, B, and C. The table below the graph quantifies the change in prices per the shocks. For simplicity’s sake, we assume a constant bond duration in this example.

It is negative tax convexity that should cause investors, all else being equal, to prefer bonds trading at a premium (such as bond C) over those trading at par or a discount. It is also worth noting that the tax convexity plays an additional role in the secondary market for munis. Bonds with prices at or near par will be in less demand than bonds trading well above par if traders anticipate a near term rise in yields that will shift the par bond to a discounted price.

Summary

Yields have fallen for the better part of the last thirty years, so muni investors have not had to deal with discounted bonds and their tax implications often. Because of this, many muni investors are likely unaware of negative tax convexity risk. As we highlighted in the table, the gains in price when yields fall are relatively equal for the three bonds but the negative deviation in price in a rising yield environment is meaningful. Given this negative divergence, we recommend that you favor higher coupon/ higher priced munis. If you currently own lower priced munis, it may be worth swapping them for higher priced (higher coupon) bonds.


Addendum: De minimis

The tax code contains a provision for munis called the de minimis rule. This rule establishes the proper tax rate to apply to capital appreciation. The following clip from Charles Schwab’s Bond Insights provides a good understanding of the rule.

The de minimis rule

The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.

Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).

For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).

It is important to note that some bonds are issued at prices below par. Such bonds, called original issue discount (OID), use the original offering price and not par as the basis to determine capital gains. If you buy a bond with an OID of $98 at a price of $97.50, you will only be subject to $0.50 (the difference between the OID price and the market price) of capital gains or ordinary income tax.

It’s hard to go anywhere these days without coming across some mention of artificial intelligence (AI). You hear about it, you read about it and it’s hard to find a presentation deck (on any subject) that doesn’t mention it. There is no doubt there is a lot of hype around the subject.

While the hype does increase awareness of AI, it also facilitates some pretty silly activities and can distract people from much of the real progress being made. Disentangling the reality from the more dramatic headlines promises to provide significant advantages for investors, business people and consumers alike.

Artificial intelligence has gained its recent notoriety in large part due to high profile successes such as IBM’s Watson winning at Jeopardy and Google’s AlphaGo beating the world champion at the game “Go”. Waymo, Tesla and others have also made great strides with self-driving vehicles. The expansiveness of AI applications was captured by Richard Waters in the Financial Times [here}: “If there was a unifying message underpinning the consumer technology on display [at the Consumer Electronics Show] … it was: ‘AI in everything’.”

High profile AI successes have also captured people’s imaginations to such a degree that they have prompted other far reaching efforts. One instructive example was documented by Thomas H. Davenport and Rajeev Ronanki in the Harvard Business Review [here]. They describe, “In 2013, the MD Anderson Cancer Center launched a ‘moon shot’ project: diagnose and recommend treatment plans for certain forms of cancer using IBM’s Watson cognitive system.” Unfortunately, the system didn’t work and by 2017, “the project was put on hold after costs topped $62 million—and the system had yet to be used on patients.”

Waters also picked up on a different message – that of tempered expectations. In regard to “voice-powered personal assistants”, he notes, “it isn’t clear the technology is capable yet of becoming truly useful as a replacement for the smart phone in navigating the digital world” other than to “play music or check the news and weather”.

Other examples of tempered expectations abound. Generva Allen of Baylor College of Medicine and Rice University warned [here], “I would not trust a very large fraction of the discoveries that are currently being made using machine learning techniques applied to large sets of data.” The problem is that many of the techniques are designed to deliver specific answers and research involves uncertainty. She elaborated, “Sometimes it would be far more useful if they said, ‘I think some of these are really grouped together, but I’m uncertain about these others’.”

Worse yet, in extreme cases AI not only underperforms; it hasn’t even been implemented yet. The FT reports [here], “Four in 10 of Europe’s ‘artificial intelligence’ startups use no artificial intelligence programs in their products, according to a report that highlights the hype around the technology.”

Cycles of inflated expectations followed by waves of disappointment come as no surprise to those who have been around artificial intelligence for a while: They know all-too-well this is not the first rodeo for AI. Indeed, much of the conceptual work dates to the 1950s. In reviewing some of my notes recently I came across a representative piece that explored neural networks for the purpose of stock picking – dated from 1993 [here].

The best way to get perspective on AI is to go straight to the source and Martin Ford gives us that opportunity through his book, Architects of Intelligence. Organized as a succession of interviews with the industry’s leading researchers, scholars and entrepreneurs, the book provides a useful history of AI and highlights the key strands of thinking.

Two high level insights emerge from the book. One is that despite the disparate backgrounds and personalities of the interviewees, there is a great deal of consensus on important subjects. The other is that many of the priorities and concerns of the top AI researches are quite noticeably different from those expressed in mainstream media.

Take for example, the concept of artificial general intelligence (AGI). This is closely related to the notion of the “Singularity” which is the point at which artificial intelligence matches that of humans – on its path to massively exceeding human intelligence. The idea has captured people’s concerns about AI that include massive job losses, killer drones, and a host of other dramatic manifestations.

AI’s leading researchers have very different views; as a group they are completely unperturbed by AGI. Geoffrey Hinton, Professor of computer science at the University of Toronto and Vice president and engineering fellow at Google said, “If your question is, ‘When are we going to get a Commander Data [from the Star Trek TV series]’, then I don’t think that’s how things are going to develop. I don’t think we’re going to get single, general-purpose things like that.”

Yoshua Bengio, Professor of computer science and operations research at the University of Montreal, tells us that, “There are some really hard problems in front of us and that we are far from human-level AI.” He adds, “we are all excited because we have made a lot of progress on climbing the hill, but as we approach the top of the hill, we can start to see a series of other hills rising in front of us.”

Barbara Grosz, Professor of natural sciences at Harvard University, expressed her opinion, “I don’t think AGI is the right direction to go”. She argues that because the pursuit of AGI (and dealing with its consequences) are so far out into the future that they serve as “a distraction”.

Another common thread among the AI researches is the belief that AI should be used to augment human labor rather than replace it. Cynthia Breazeal, Director of the personal robots group for MIT media laboratory, frames the issue: “The question is what’s the synergy, what’s the complementarity, what’s the augmentation that allows us to extend our human capabilities in terms of what we do that allows us to really have greater impact in the world.” Fei-Fei Li, Professor of computer science at Stanford and Chief Scientist for Google Cloud, described, “AI as a technology has so much potential to enhance and augment labor, in addition to just replace it.”

James Manyika, Chairman and director of McKinsey Global Institute noted since 60% of occupations have about a third of their constituent activities automatable and only about 10% of occupations have more than 90% automatable, “many more occupations will be complemented or augmented by technologies than will be replaced.”

Further, AI can only augment human labor insofar as it can effectively work with human labor. Barbara Grosz pointed out, “I said at one point that ‘AI systems are best if they’re designed with people in mind’.” She continued, “I recommend that we aim to build a system that is a good team partner and works so well with us that we don’t recognize that it isn’t human.”

David Ferrucci, Founder of Elemental Cognition and Director of applied AI at Bridgewater Associates, said, “The future we envision at Elemental Cognition has human and machine intelligence tightly and fluently collaborating.” He elaborated, “We think of it as thought-partnership.” Yoshua Bengio reminds us, however, of the challenges in forming such a partnership: “It’s not just about precision [with AI], it’s about understanding the human context, and computers have absolutely zero clues about that.”

It is interesting that there is a fair amount of consensus regarding key ideas such as AGI is not an especially useful goal right now, AI should be applied to augment labor and not replace it, and AI should work in partnership with people. It’s also interesting that these same lessons are borne out by corporate experiences.

Richard Waters describes how AI implementations are still at a fairly rudimentary stage in the FT [here]: “Strip away the gee-whizz research that hogs many of the headlines (a computer that can beat humans at Go!) and the technology is at a rudimentary stage.” He also notes, “But beyond this ‘consumerisation’ of IT, which has put easy-to-use tools into more hands, overhauling a company’s internal systems and processes takes a lot of heavy lifting.”

That heavy lifting takes time and exceptionally few companies are there. Ginni Rometty, head of IBM, characterizes her clients’ applications as “Random acts of digital” and describes many of the projects as “hit and miss”. Andrew Moore, the head of AI for Google’s cloud business, describes it as “Artisanal AI”. Rometty elaborates, “They tend to start with an isolated data set or use case – like streamlining interactions with a particular group of customers. They are not tied into a company’s deeper systems, data or workflow, limiting their impact.”

While the HBR case of the MD Anderson Cancer Center provides a good example of a moonshot AI project that probably overreached, it also provides an excellent indication of the types of work that AI can materially improve. At the same time the center was trying to apply AI to cancer treatment, its “IT group was experimenting with using cognitive technologies to do much less ambitious jobs, such as making hotel and restaurant recommendations for patients’ families, determining which patients needed help paying bills, and addressing staff IT problems.”

In this endeavor, the center had much better experiences: “The new systems have contributed to increased patient satisfaction, improved financial performance, and a decline in time spent on tedious data entry by the hospital’s care managers.” Such mundane functions may not exactly be Terminator stuff but are still important.

Leveraging AI for the purposes of augmenting human labor collaborating with humans was also the focus of an HBR piece by H. James Wilson and Paul R. Daugherty [here]. They point out, “Certainly, many companies have used AI to automate processes, but those that deploy it mainly to displace employees will see only short-term productivity gains. In our research involving 1,500 companies, we found that firms achieve the most significant performance improvements when humans and machines work together … Through such collaborative intelligence, humans and AI actively enhance each other’s complementary strengths: the leadership, teamwork, creativity, and social skills of the former, and the speed, scalability, and quantitative capabilities of the latter.”

Wilson and Daugherty elaborate, “To take full advantage of this collaboration, companies must understand how humans can most effectively augment machines, how machines can enhance what humans do best, and how to redesign business processes to support the partnership.” This takes a lot of work that is well beyond just dumping an AI system into a pre-existing work environment.

The insights from leading AI researchers combined with the realities of real-world applications provide some useful implications. One is that AI is a double-edged sword: The hype can cause distraction and misallocation, but the capabilities are too important to ignore.

Ben Hunt discusses the roles of intellectual property (IP) and AI in regard to the investment business [here], but his comments are widely relevant to other businesses. He notes, “The usefulness of IP in preserving pricing power is much less a function of the better mousetrap that the IP helps you build, and much more a function of how neatly the IP fits within the dominant zeitgeist in your industry.

He goes on to explain that the “WHY” of your IP must “fit the expectations that your customers have for how IP works” in order to protect your product. He continues, “If you don’t fit the zeitgeist, no one will believe that your castle walls exist. Even if they do.” In the investment business (and plenty of others), “NO ONE thinks of human brains as defensible IP any longer. No one.” In other words, if you aren’t employing AI, you won’t get pricing power, regardless of the actual results.

This hints at an even bigger problem with AI: Too many people are simply not ready for it. Daniela Rus, Director of the Computer science and artificial intelligence laboratory (CSAIL) at MIT, said, “I want to be a technology optimist. I want to say that I see technology as something that has the huge potential to unite people rather than divide people, and to empower people rather than estrange people. In order to get there, though, we have to advance science and engineering to make technology more capable and more deployable.” She added, “We need to revisit how we educate people to ensure that everyone has the tools and the skills to take advantage of technology.”

Yann Lecun added, “We’re not going to have widely disseminated AI technology unless a significant proportion of the population is trained to actually take advantage of it”. Cynthia Breazeal echoed, “In an increasingly AI-powered society, we need an AI-literate society.” These are not hollow statements either; there is a vast array of free learning materials for AI available online to encourage participation in the field.

If society does not catch up to the AI reality, there will be consequences. Brezeal notes, “People’s fears about AI can be manipulated because they don’t understand it.” Lecun points out, “There is a concentration of power. Currently, AI research is very public and open, but it’s widely deployed by a relatively small number of companies at the moment. It’s going to take a while before it’s used by a wider swath of the economy and that’s a redistribution of the cards of power.” Hinton highlights another consequence, “The problem is in the social systems, and whether we’re going to have a social system that shares fairly … That’s nothing to do with technology.”

In many ways, then, AI provides a wakeup call. Because of AI’s unique interrelationship with humankind, AI tends to bring out its best and the worst elements. Certainly, terrific progress is being made on the technology side which promises to provide ever-more powerful tools to solve difficult problems. However, those promises are also constrained by the capacity of people, and society as a whole, to embrace AI tools and deploy them in effective ways.

Recent evidence suggests we have our work cut out for us in preparing for an AI-enhanced society. In one case reported by the FT [here], UBS created “recommendation algorithms” (such as those used by Netflix for movies) in order to suggest trades for its clients. While the technology certainly exists, it strains credibility to understand how this application is even remotely useful for society.

In another case, Richard Waters reminds us, “It Is almost a decade, for instance, since Google rocked the auto world with its first prototype of a self-driving car.” He continues [here]: “The first wave of driverless car technology is nearly ready to hit the mainstream — but some carmakers and tech companies no longer seem so eager to make the leap.” In short, they are getting pushback because current technology is at “a level of autonomy that scares the carmakers — but it also scares lawmakers and regulators.”

In sum, whether you are an investor, business person, employee, or consumer, AI has the potential to make things a lot better – and a lot worse. In order to make the most of the opportunity, an active effort focusing on education is a great place to start. If AI’s promises are to be realized it will also take a lot of effort to establish system infrastructures and to map complementary strengths. In other words, it’s best to think of AI as a long journey rather than a short-term destination.

The new SCAN TOOL also has several new screening parameters to include both fundamental factors (Piotroski Score) and momentum factors (Mohanram Score) along with Zack’s rankings.

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

CRM – Salesforce

  • Two weeks ago we recommended CRM as a potential long.
  • With the 50-dma crossing above the 200-dma, a breakout to new highs, and a triggered “buy” signal, the bullish trend for CRM remains.
  • We said that with CRM being very overbought to look for a pullback to support to add exposure.
  • We recommended buying 1/2 position and add on a on pullback to $150-155.
  • That target was reached this week, and the rally this week keeps it on our long-list.
  • Stop moved up to $150

ALE – Alete, Inc.

  • ALE recently broke above its previous highs.
  • Currently, ALE is pushing 2-standard deviations above its intermediate term trend so scaling into the position makes some sense.
  • Buy 1/2 position now and 1/2 position on a pullback to $80 that holds.
  • Stop-loss is currently $78

AMT – American Tower Corp.

  • AMT was a buy recommendation several weeks ago, since then it has just gone parabolic and is grossly extended.
  • It’s time to take profits for now.
  • Sell 1/2 of the position and look for a pullback to $170 to add back holdings.
  • Stop-loss is $160

BLL – Ball Corp.

  • BLL was another long-recommendation we made previously which likewise has just gone vertical.
  • It is time to take profits out of the position.
  • Sell 1/2 of the position and look to add back to BLL on a pullback to support at $51 currently.
  • Stop Loss on balance moved up to $50

VZ – Verizon Communications

  • Note: We are long VZ in the Equity Portfolio
  • After several months of consolidation, VZ finally broke out to the upside.
  • A position can be added at current levels.
  • Stop is currently $55

SHORT CANDIDATES

AMD – Advanced Micro Devices

  • After a rally with the rest of the market, it looks like the trade is done for AMD.
  • Global economic weakness is likely to continue weighing on the semi-conductor space for now.
  • Parameters are very tight for this trade.
  • Short on break, and close, below the 50-dma ($21.50 currently)
  • Stop-loss is at $25

APA – Apache Corp.

  • The oil and gas drillers continue to struggle under weaker energy prices and the slowing economy doesn’t bode well for them in the near term.
  • The recent rally in APA is likely done and there is a reasonable short set-up on the position.
  • Short at current levels with a stop $35
  • Target is $26

BMY – Bristol Meyers Squibb

  • BMY continues to struggle currently.
  • The recent rally failed at the 200-dma and has now broken back below the 50-dma.
  • Short at current levels with a stop set at $54
  • Target is $46.

Anheuser-Busch InBev


  • BUD recently failed on a rally to its 200-dma which has defined its downtrend over the last 18-months.
  • Short at current levels with a stop at $82.50
  • Target for the trade is $65-67.50

COTY – Coty Inc.

  • COTY remains in a long-term downtrend and the recent earnings related rally did nothing to change that.
  • Short at current levels with a stop at $11.50
  • Target for trade is $6-7

There has been a lot of commentary as of late regarding the issue of corporate share repurchases. Even Washington D.C. has chimed into the rhetoric as of late discussing potential bills to limit or eliminate these repurchases. It is an interesting discussion because most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982. 

Even after the ban was lifted, share repurchases were few and far between as during the “roaring bull market of the 90’s” it was more about increasing outstanding shares through stock splits. Investors went crazy over stock splits as they got more shares of the company they loved at half the price. Most didn’t realize, or understand the effective dilution; but for them it was more of a Yogi Berra analogy:

“Can you cut my pizza into four pieces because I can’t eat eight.” 

However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:

  • Company A earns $1 / share and there are 10 / shares outstanding. 
  • Earnings Per Share (EPS) = $0.10/share.
  • Company A uses all of its cash to buy back 5 shares of stock.
  • Next year, Company A earns $0.20/share ($1 / 5 shares)
  • Stock price rises because EPS jumped by 100%.
  • However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
  • The next year Company A still earns $1/share and EPS remains at $0.20/share.
  • Stock price falls because of 0% growth over the year. 

This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts ever-increasing amounts of cash from productive investments and takes away from longer term profit and growth.

As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.

(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)

The Abuse & Misuse 

As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

cooking-the-books-2

The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.

As shown in the table above, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

The use of stock buybacks has continued to rise in recent years and went off the charts following the passage of tax cuts in 2017. As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we expected it would. To wit:

“Not surprisingly, our guess that corporations would utilize the benefits of “tax cuts” to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad'” 

Share buybacks are expected to hit a new record by the end of 2019.

“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”

There is a problem with that statement.

Share buybacks only return money to those individuals who sell their stock. This is an open market transaction so if Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.

So, who are the ones mostly selling their shares?

As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

A recent report on a study by the Securities & Exchange Commission found the same:

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

As Jesse Felder wrote:

“Without that $4 trillion in stock buybacks and in a market where trading volume has been falling for decades they never would have been able to soar as high as they have. The chart below plots ‘The Buffett Yardstick’ (total equity market capitalization relative to gross national product) against total net equity issuance (inverted). Since the late-1990’s both valuations and buybacks have been near record highs. Is this just a coincidence? I think it’s safe to say it’s not.”

The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance. 

The explosion of corporate debt in recent years will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

This was recently noted by the Bank of International Settlements. 

“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic. 

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.

This article may be best summed up with just one word:

Fraud – frôd/ noun:

Wrongful or criminal deception intended to result in financial or personal gain.