Monthly Archives: March 2019


  • Market Review & Update
  • Bulls Are Betting On A “Long Shot”
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Review & Update

Over the last several weeks, we have been discussing the potential for a market correction simply due to divergences in the technical indicators which suggested near-term market risk outweighed the reward. Then, the White House reignited the “trade war” with China. To wit:

“The “Trade War” is not a good thing for markets or the economy as recently suggested by the President. David Rosenberg had an interesting point on this as well on Friday:

‘Tracing through the GDP hit from a tariff war on EPS growth and P/E multiple compressions from heightened uncertainty, the downside impact on the S&P 500 would come to 10%. I chuckle when I hear economists say that the impact is small- meanwhile, global trade volumes have contracted 1.1% over the year to February…how is that bullish news exactly?’

Remember, at the beginning of 2018, with ‘tax cuts’ just passed, and earnings growing, the market was set back by 5% as an initial tariff of 10% was put into place. Fast forward to today, you have tariffs going to 25%, with no supportive legislation in place, earnings growth and revenue weakening along with slower economic growth. 

In the meantime, the bond market is screaming ‘deflation,’ and yields have clearly not been buying the 3-point multiple expansion from the December 24th lows.” 



It was due to that analysis, and the trade war, that we made the following recommendations last week to our clients and RIA PRO subscribers. (Try NOW and get 30-days FREE)

Continuing from yesterday’s discussion on the impact of ‘trade wars’ on various sectors has us beginning to reposition out of some the areas most susceptible to tariffs. Yesterday, we closed out our position in Emerging Markets, and sold 1/2 of our position in Basic Materials.

Today, on the bounce as laid out yesterday, we sold half of our position in XLI (industrials) and XLY (consumer discretionary) and added one-half position in XLRE (real estate) which should be defensive with lower interest rates.

We still maintain a long-bias towards equity risk. But, that exposure is hedged with cash and bonds which remain at elevated levels. (If you haven’t taken any actions at all recently, read my previous newsletter for Portfolio Management Guidelines)

While the market got very oversold previously, we noted last weekend a bounce was likely. 

Unfortunately, that bounce was unable to hold above the 50-dma on Friday which negates the break above it earlier in the week. Importantly, the deeply oversold condition was somewhat reversed which now sets the market up for a potential retest of the 200-dma average over the next couple of weeks. A failure at that level and we have to start having a different conversation about portfolio allocation models. 

For now, the market is working a corrective process which is likely not complete as of yet. As we head into the summer months, it is likely the markets will experience a retracement of the rally during the first quarter of this year. As shown in a chart we use for position management (sizing, profit taking, sells) the market has just issued a signal suggesting risk reduction is prudent. (This doesn’t mean sell everything and go to cash.)

There is no “law” that says you have to be “all in” the market “all the time.” 

Every good gambler knows how to “size their bets” relative to the “hand they hold.” This is particularly the case when it certainly appears the “bulls are betting on a long shot.” 



Betting On A Long-Shot

Last week, we discussed in a lot of detail the re-escalation of the “trade war” and the potential impact to earnings in the quarters ahead. To wit:

“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.

Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.”

“The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.”

“Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has ‘broken,’ but few are paying attention.”

For the bullish narrative, the earnings growth story is going to become increasingly difficult to ignore. This is particularly the case given that just this past week economic data continues to show weakness. As shown in the following chart, global economic trade has collapsed to levels not seen since prior to the financial crisis. 

Of course, since almost 50% of corporate revenue and profits are generated from international activity, it is not surprising to see a problem emerging. 

As J. Brett Freeze, CFA discussed on Friday, dissected the key drivers of economic growth: Capital Expenditures.

The graph shows that when the economy is coming out of recession and optimism is budding, capital expenditures as a percentage of the economy are high. Conversely, as optimism wanes, and the economic cycle is long in the tooth capital expenditures peak, trend sideways and then drop sharply. (The data in the graph is normalized using six quarter moving averages and standard deviations as reflected on the Y-axis.)

The 1960s and the current period are unique in that those periods saw a sharp decline in capital expenditures that did not lead to a recession. We know the current episode is a result of a resurgence of corporate optimism due to the election of Donald Trump and importantly, the corporate tax cut that incentivized corporate spending. With much of the tax cut stimulus behind us, the temporary fiscal boost appears to be fading.    

Unsurprisingly, all of this data aligns with rising recession risks. 

(Important Note: The graph above is based on lagging economic indicators which are subject to huge negative revisions in the future. Therefore, high current risk levels should not be readily dismissed as the recession will have started before the data is revised to reveal the actual start date.)



Here is my point.

If you had been living on Mars for the last 24-months and just reviewed the data above, you would, most logically, assume the market would be down, and probably significantly so.

That certainly isn’t the case, as noted above, with the markets just a couple of percentage points away from their all-time highs. So, despite the data, the resurgence of a “trade war” with China, rising delinquency rates and falling demand for loans, and weak outlooks by businesses, the bulls are certainly “betting on a long-shot” of an outcome that is currently well outside the current data. 

In that is the case, then what are the “bulls” betting on? My friend Patrick Hill sent me a good note on this issue.

“In watching Bloomberg, it seems the market is betting on:

1 – The Fed will lower interest rates.  The Fed Funds rate forecast shows at least once this year. Interestingly, historically, when the Fed begins lowering interest rates it has been in response to a recession, not a slowdown.

2 – The trade war will not be as bad as thought as Trump and Xi will meet at G20 and resolve everything. But that may not be the case given China’s positioning on Friday:

“The US has completely abandoned commercial principles and disregarded law. Its barbaric behavior against Huawei by resorting to administrative power can be viewed as a declaration of war on China in the economic and technological fields. It is time that the Chinese people throw away their illusions. Compromise will not lead to US goodwill.”

3 – Corporations can continue to churn out revenue growth as China stimulus will help out EM countries and US companies can sell to them

4 – Corporate debt at levels at record highs, and leveraged loans at twice the level of subprime debt in 2008, is of no real concern. 

5 – Corporate stock buybacks will continue to provide a bid to the market. (Of course, what happens when sales continue to fall.) Ned Davis research noted their research shows the S & P is up 19 % over what it would not be without buybacks. Buybacks have also made up about 80% of the “bid” to the market. 

6 – There is no concern that tariffs will push price inflation higher despite the fact that tariffs will lift costs on both consumers and businesses. 

7 – The Fed will respond to any weakness providing a permanent bid the market.

In other words, at the moment, data doesn’t matter to the markets – it is simply “hope” based momentum magnified with a “crap ton” of liquidity (Yes, that is a technical term.)

Doug Kass recently discussed the issue of the current disconnect.

“‘(Very) leveraged strategies involving yield enhancement, allocations based on risk assessment (risk parity) and other volatility targeting funds are contributing factors to a new and heightened regime of volatility that has recently intensified. And so does the popularity and proliferation of passive ETFs and the proliferation of CTA (extreme momentum-based) strategies, exaggerate short term price moves. (Even BlackRock’s Larry Fink has missed this important reason for the market’s sharp advance this year).

There is such a limited discussion of the enormous sums of money that are now being managed by Quants and Pseudo Quant hedge funds, algorithmic trading with MASSIVE leverage, all of which dominates the investing landscape.

The aforementioned strategies (based on momentum and the assessment of asset class risk), embraced by many, work until they don’t and when a trend changes (from up to down) massively levered products (like risk parity) are forced to delever and buy back volatility (to offset their short vol positions) – further exacerbating the move lower.

The problem, of course, is ‘uncovered’ when too many are on the same side of the boat.

A state of stability should not be as trusted as much today as in the past it will likely morph into more frequent episodes of instability – a series of ‘Minsky Moments.'” 

This is an important point, stability eventually breeds instability due to the buildup of “complacency.” The entire bullish “bet” currently is that despite a growing laundry list to the contrary, the markets will continue their advance simply waiting for the data to improve. 

Primarily, this belief is hinged on the idea the Fed will come to the rescue. The problem, as  noted previously:

“The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. In 2008, when the Fed launched into their ‘accommodative policy’ emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%.”

If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.”

“The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the “norm” are negatively extended, confidence is hugely negative. In other words, there is nowhere to go but up.”

That is hardly the case currently as prices have become detached from both the economic and fundamental cycles of the market. The bulls are clinging to narratives to justify excessive valuations and deviations from the norm.

“We live in an investment world in which much of the silly, fairy tale narratives have little to do with the real world – a lot is basically “made up.”  It is that simple.” – Doug Kass, Real Money Pro

So, what are we doing now?

We realize that out clients have to make money when markets are rising, but that we also have to manage the risk of loss. 

It’s an incredibly tough job and doesn’t always work out the way we plan. But that is the essence of investing to begin with. 

With the recent market weakness, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

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

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector-by-Sector

Over the last two weeks, I have noted the concern about the internal deterioration of the market.

“Notice in the Sector Rotation Graph above that leadership is becoming much more narrow in the market (Technology, Discretionary, and Communications) all of which are being driven by just 5-stocks currently – MSFT, AAPL, GOOG, AMZN and FB.

The crowding of the majority of sectors into the LAGGING quadrant suggests we are likely close to experiencing a fairly significant rotation among sectors. Such would suggest a ‘risk off’ rotation over the next couple of months which would likely coincide with a bid to more defensive sectors of the market. (Healthcare, Utilities, Real Estate, Bonds, Value vs. Growth)”

I had an interesting criticism last week on my comment above:

“Five technology stocks can’t be driving three sectors of the market. So, clearly you are wrong.”

A year or so ago, that statement but have been correct. However, S&P has recalibrated their index constituency which puts the previous technology behemoths into three categories. Of course, so same five stocks are also roughly 40% of the total capitalization weighting of both the S&P 500 and then Nasdaq.

The point is that the leadership of the market is not as strong as it seems. 

Improving – Energy

While Energy remains in the improving category, it only does so barely. Oil prices did tick up last week and bounced off its respective 200-dma. However, energy has failed to pick up performance to a great degree. Any weakness next week, and the sector will slip back into the “lagging camp.” with the vast majority of other sectors. We recommended taking profits and rebalancing risk over the last two weeks. That recommendation remains as the sector broke back below its 50-dma and 200-dma. 

Current Positions: 1/2 Position in XLE

Outperforming – Technology, Discretionary, Communications

As noted above, these three sectors are driving the bulk of the market movement now. Last week, I suggested that with all three sectors GROSSLY overbought it was a good idea to take profits and rebalance portfolio risks accordingly. That remains the same recommendation this week. 

Current Positions: Sold 1/2 XLY, XLK – Stops moved from 200 to 50-dma’s.

Weakening – Real Estate and Industrials

Despite the “bullish” bias to the markets, the more defensive sectors of the markets like Real Estate has continued to attract buyers. That remained the same this week, particularly as bond yields declined following the resurgence of the trade war with China. As noted last week, there was a decent entry opportunity for positioning as a defensive play against a likely rotation out of Technology and Discretionary holdings. We added 1/2 position.

With the “trade war” back on we reduced exposure to sectors most affected by tariffs. We reduced our Industrial exposure in our portfolios. 

Current Position: Sold 1/2 XLI, added 1/2 XLRE last week.

Lagging – Healthcare, Staples, Financials, Materials and Utilties

As noted two weeks ago, “Materials is also on the verge of slipping back into underperforming the S&P 500 and also suggests, as recommended last week, to take some profits.” With XLB exposed to the “trade war” we cut our position in half to protect gains.

Staples, while lagging the S&P 500, remain a sector where money is hiding. Staples remain on a buy signal but are extremely overbought and extended. Take profits and rebalance in portfolios.  The same goes for Utilities as well. 

We noted previously that Financials were underperforming but we would give the sector some room, Currently, financials are holding important support, but performance is weakening again as the yield curve inverts. If you haven’t done so, take profits and rebalance risk. 

We are overweight healthcare currently where relative performance is improving as a “risk off” rotation occurs. We remain slightly overweight in Healthcare again this week. 

Current Positions: Sold 1/2 XLB, XLF, XLV, XLP, XLU

Market By Market

Small-Cap and Mid Cap – Small-cap failed to hold above it’s 50- and 200-dma which keeps us from adding a position in portfolios. Mid-cap is holding support at the 50-dma but failed the 200-dma. We were looking to add a position last week, but the failure of support kept us on the sidelines. 

Current Position: No position

Emerging, International & Total International Markets 

As noted last week,

The reinstitution of the “Trade War” kept us from adding weight to international holdings. We are keeping a tight stop on our 1/2 position of emerging markets but “tariffs” are not friendly to the international countries. 

Last week, we were stopped out of our emerging market position. 

Current Position: Sold 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. 

As we stated last week:

“Core holdings remain currently at target portfolio weights but all three of our core positions are grossly overbought. A correction is coming, it is now just a function of time.” 

That correction has begun. We will wait to see what happens next before making any recommendations.

Current Position: RSP, VYM, IVV

Gold – Continues to struggle despite the risk of international escalation due to trade, Iran, etc. The reality is that currently there is “no fear” in the market to drive prices higher…for now. We are holding our current positions as a hedge against a pickup in volatility which we expect as this summer unfolds.

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

Bonds 

As noted three weeks ago, we said bonds were setting up for a nice entry point to add additional bond exposure. Bonds bounced off the 50-dma holding important support last week. Bonds are now back to overbought, take some profits and rebalance weightings but remain long for now.

Current Positions: DBLTX, SHY, TFLO, GSY

High Yield Bonds, representative of the “risk on” chase for the markets, continued to correct again last week but worked off most of the overbought condition. As noted previously:

“If the S&P 500 corrects over the next couple of months, it will pull high-yield (junk) bonds back towards initial support at the 50-dma.”

That initial target was hit last week, however, it appears junk may push lower over the summer months. Last week, we recommended taking profits and rebalancing risk accordingly. International bonds, which are also high credit risk, have had been consolidating over the last couple of weeks but pushed higher last week. The sector remains very overbought currently which doesn’t offer a decent reward/risk entry point. 

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 noted in the main body of this missive, with the recent market weakness, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

There are indeed some short-term risks in the market as we head into summer, so any positions added to portfolios in the near future will carry both tight stop-loss levels and will be trading positions initially until our thesis is proved out. 

  • New clients: We will use the recent correction to onboard clients and move into specified models accordingly. 
  • Equity Model: After taking profits recently, we will look to opportunistically add to our stronger positions with this recent pullback and are looking at adding both core equity holdings as well as some additional trading positions.
  • ETF Model: We sold EEM and 1/2 of XLI, XLY, and XLB to reduce exposure to “trade war” risk.
  • In both the Equity and ETF Models: We are looking to increase the duration of bond portfolio by adding in 7-10 year duration holdings and hedge our risk with an increased weighting in 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

Being Patient

As noted above, the market tried to rally last week but failed to hold above the 50-dma which negated our plans to increase equity exposure. 

Next week, it is critical for the markets to muster a rally or we are going to wind up retesting the 200-dma. 

I encourage you to read the missive above. It is important. 

In the meantime, we will be patient this next week and see how things unfold. 

  • 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 – remain where you are until the market gives us a better opportunity to increase exposure to target levels.

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

Exciting News – the 401k Plan Manager is “Going Live”

We are making a “LIVE” version of the 401-k allocation model which will soon be available to RIA PRO subscribers. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more. 

This service will also be made available to companies for employees. If would like to offer our service to your employees at a deeply discounted corporate rate please contact me.

Stay tuned for more details over the next couple of weeks.

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

 

Art and collectibles prices have exploded in the past decade as a result of the extremely frothy conditions created by central banks. Hardly a week goes by without news headlines being made about ugly, tacky, or just plain bizarre works of art fetching tens of millions, if not hundreds of millions, of dollars at auction houses like Sotheby’s and Christie’s (often sold to rich buyers in China or Hong Kong). Make no mistake: we’re currently experiencing a massive art bubble of the likes not seen since the Japan-driven art bubble of the late-1980s that ended disastrously. Two art market records were made in the past week: the $91.1 million “Rabbit” sculpture by Jeff Koons, which set the record for the highest amount paid for a piece of art by a living artist, and the sale of Monet’s ‘Meules’ painting for $110.7 million, which set a record for an Impressionist work.

The New York Post reports on the Koons sale

A sculpture of a silver rabbit by artist Jeff Koons sold at Christie’s auction house in Manhattan Wednesday for $91.1 million, setting the record for the highest amount fetched for a piece of art by a living artist.

Koons’ “Rabbit” surpassed the previous record, which was set just last November when British painter David Hockney’s “Portrait of an Artist (Pool with Two Figures)” sold for $90.3 million. Both totals include the auction house fees.

Art dealer Bob Mnuchin, the father of Treasury Secretary Steven Mnuchin, made the winning bid for the Koons work, Bloomberg reported. Mnuchin made the purchase for a client, according to the report.

The sculpture, which stands just over 3 feet high, is made of stainless steel and based on an inflatable children’s toy, according to the auction house.


“Rabbit” by Jeff Koons is displayed at Christie’s in New York on May 3, 2019. Photo credit: AP

Reuters reports on the Monet sale

One of the few paintings in Claude Monet’s celebrated “Haystacks” series that still remains in private hands sold at auction on Tuesday for $110.7 million, setting a record for an Impressionist work.

The oil on canvas, titled “Meules” and completed in 1890, is the first piece of Impressionist art to command more than $100 million at auction, said Sotheby’s, which handled the sale.

That also represents the highest sum ever paid at auction for a painting by Monet, the founder of French Impressionism and a master of “plein air” landscapes who died in 1926, aged 86.

“Meules” was one of 25 paintings in a series depicting stacks of harvested wheat belonging to Monet’s neighbor in Giverny, France.

The works are widely acclaimed for capturing the play of light on his subject and for their influence on the Impressionist movement.

“Meules” by Claude Monet is displayed at Sotheby’s New York on May 3, 2019. Photo credit: Reuters

Last month, I wrote about “bubble drunk” millennials in Hong Kong who paid $28 million for Simpsons art:

The Kaws Album’, KAWS. Courtesy Sotheby’s.

Today’s art bubble (like many other bubbles that are currently inflating) formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:

In addition to holding interest rates at record low levels for a record length of time, central banks pumped trillions of dollars worth of liquidity into the global financial system in the past decade:

Assets around the world – from art to stocks to property – have been levitating on the massive ocean of liquidity that has been created by central banks. For example, the S&P 500 has soared 300% since its low in early-2009:

In order to understand today’s art bubble, it is helpful to learn about the art bubble of the late-1980s that ultimately crashed and burned. Throughout the 1980s, Japan had a bubble economy that was driven by debt and bubbles in property and stocks. Japan’s economy was seemingly unstoppable – almost everyone in the West was terrified that Japan’s economy and corporations would trounce ours while destroying our standard of living in the process. Of course, few people knew how unsustainable Japan’s economy was at that time.

As a result of hubris and the enormous amount of liquidity that was flowing throughout Japan’s economy in the late-1980s, Japanese businesspeople and corporations started to speculate in art, often bidding previously unheard of sums that Western art collectors would never have dreamed of paying. For example, Yasuda Fire and Marine Insurance paid a record $39.9 million for Vincent van Gogh’s “Sunflowers” at a London auction in 1987. Ryoei “wild fellow” Saito, Chairman of the Daishowa Paper Manufacturing empire, paid $160 million for the world’s two most expensive paintings – a Van Gogh and a Renoir. At the peak of the art market in 1990, Japan imported more than $4 billion worth of art, including nearly half of all Impressionist art that was on the market. Of course, the art market plunged along with Japan’s bubble economy in the early-1990s.

Vincent van Gogh “Sunflowers” 1888.

Unfortunately, today’s art bubble will burst just like the art bubble of the late-1980s. China, with its massive debt bubble, is currently playing the role that Japan played in the Eighties. While most people are probably not worried about the coming art market bust and won’t be directly affected by it, the point of this piece is to show how the art market acts like a barometer for the amount of froth there is in the global economy and financial markets. When the art market goes ballistic, that is typically a sign that the economic cycle is in its latter stages. We are fast approaching a time when art speculators will deeply regret paying $91.1 million for a steel rabbit sculpture and tens of millions of dollars for Simpsons art.

The recent running of the Kentucky Derby marks the time of year of horse racing’s prestigious Triple Crown and everything that goes along with it. Temperate spring weather, increasingly beautiful spring foliage, ostentatious hats, parties, and of course, the impressive physical prowess of the horses and the jockeys are all part of the season.

It is also a reminder of another race that has been going on, albeit with considerably less pageantry: The race to fund pension plans. This is a different kind of race because it is ongoing and because there aren’t distinct winners. There definitely are losers, however. It is also a race that has driven considerable interest in risky assets such as stocks and private equity.

In a sense, investors are accustomed to racing because it is something of a race to fund a retirement before it happens. The reality that many people wait too long to even start the race, and often don’t contribute enough money once they do start, only highlights the inherent challenges of the exercise.

There is yet another factor in the retirement equation that many investors have not bargained for though: The race has gotten harder over time due to low interest rates. This makes it even harder for investors to reach their retirement objectives and has created incentives for investors to increase risk. The Financial Times reported on how the process started over ten years ago in Japan, where the demographic challenges are even more urgent:

“Banks today offer only token interest rates of 0.1–0.45 per cent and ‘it is necessary to make money work harder’, says Tomoo Sumida, senior economist at Nomura Asset Management. ‘The baby-boomers will live for 20 years after they retire and there is no way they can support themselves without investing,’ says Mr Hirakawa at UBS’.”

The report confirmed that “the search for higher returns has begun” with cash and bank deposits declining as a share of overall household financial assets and stocks and other investments increasing share.

While the search for higher returns is understandable, it often belies the important consideration of risk. Financial assets, after all, are not utilities that consistently provide certain returns. While it is generally true that riskier assets produce higher returns than less risky assets over very long periods of time, they can also underperform for periods easily stretching to ten to twenty or more years. For many investors with comparable investment horizons, such as retirees and those nearing retirement, the historical average long-term returns of financial assets obscure the risk of falling short of their goals.

A better gauge for determining expected returns for stocks over a ten- to twenty-year investment horizon is to infer the returns implied by current prices and expected cash flows. John Hussman regularly performs this exercise and recently concluded that stock valuations “offer investors among the most offensive investment prospects in financial history.”

In his analysis, he also highlights an important difference between now and the tech boom in 2000 when valuations were also exceptionally high:

“An important aspect of current valuation extremes is that they are far broader than what was observed even at the 2000 market peak … Strikingly, the current multiple [median price/revenue ratio of S&P 500 component stocks) is far beyond what was observed at the 2000 peak.

With the exception of stocks in the very highest valuation decile, every other decile is more overvalued today than it was at the 2000 market peak.”

In other words, not only does investing in stocks provide the bleak prospect of low to negative returns over the next several years, but unlike in 2000 when only a few stocks were significantly overvalued, now almost everything is overvalued so there is nowhere to hide. The bottom line is that the chances of hitting retirement goals by searching for higher returns in stocks is extremely low.

The conditions of having under-saved for impending expenses while also confronting an interest rate environment that is adverse to accumulating wealth is one that is also starting to hit pension funds in the US hard. Even though such funds are typically managed by professional investors who can carefully evaluate risk, the reflex reaction of these institutional investors to search for higher returns has been extremely similar.

The only real difference is that the search for higher returns by institutional investors is even more vigorous, which is evidenced by many of them going even further out on the risk curve by increasing allocations to private equity. Grants Interest Rate Observer reports on one of the biggest players in the space in its April 5, 2019 edition:

“‘So, if I could give you a one-line exact summary of this entire presentation, it would be: We need private equity, we need more of it and we need it now,’ Ben Meng, GIG of the California Public Employees’ Retirement System, said at the pension plans’ Feb. 19 investment committee. ‘So, let’s talk about the first question. Why do we need private equity? And the answer is very simple, to increase our chance of achieving the seven-percent rate of return‘.”

Grants describes the decision-making logic:

“What’s a fiduciary to do? You can hardly meet a 7% investment hurdle with a 10- year Treasury yielding 2.5%, much less with a 10-year bund yielding negative 0.05%. The same low rates, of course, have decreased the cost of leverage and flattered the size of projected future cash flows—well and good for private equity’s cosmetic appeal.”

The case for private equity has more than just cosmetic appeal. The environment in which institutional funds make allocation decisions is culturally amenable to the strategy as Rusty Guinn reveals in a piece entitled, “Deals are my art form“:

“But if you want to understand, by and large, how big pools of capital make big decisions about how much of their plan will be allocated to private equity, venture capital, private real estate, hedge funds, alternative premia (and everything else), you must focus on the interactions that take place between the CIO office, the consultants and the board.

Asset owner boards are dominated by politicians, lawyers and businesspeople. Deal people. People for whom – like the Donald – The Deal is their art. Understanding the decision-making process of large pools of capital means understanding the deals! meme.”

In the challenging context of relatively high required returns, Guinn illustrates how the proclivity towards deal-making at the highest levels of institutional decision-making manifests itself:

“Consultants and some CIO offices that are targeting higher necessary returns are increasingly anchored to the asset classes that these assumption-driven models like. Why? Because every strategic asset allocation meeting for the last 5 years began, and every strategic asset allocation meeting for the next 10 years will begin with something akin to the following: Well, to meet our real return targets with these assumptions, we’d have to allocate 100% to either private equity or emerging markets! Ha ha ha! Of course, doing that would be imprudent, but…

Yeah, ‘but.’ Because by this time, the conversation has been framed. And in hundreds of rooms filled with truly smart, truly ethical, truly honest and well-meaning people infected with the deals! meme, private assets will not just feel like the understandable and straightforward strategy, they will look like the right and sensible and prudent thing to do as fiduciaries.”

While the high level of interest in private equity can be explained by the deal! meme and its cultural amenability, something else is going on to compel institutional investors to overcome its obvious shortcomings. And the critiques of private equity are widespread, harsh, and compelling.

For example, Grants quotes Daniel Rasmussen, who has written extensively on the subject. He asks, “Why would you, in aggregate, buy disproportionately levered companies at disproportionately high prices in a very late stage of a bull market?” He answers, “That doesn’t seem like a very good idea. But when you call it private equity and take away the mark to market, suddenly it is a thing that everybody wants.”

James S. Chanos, founder and managing partner of Kynikos Associates, L.P., also speaks out against private equity in Grants. He thinks the value proposition of private equity will start undergoing the same kind of scrutiny that has been applied to hedge funds the last five to ten years. Specifically, Chanos thinks asset allocators will start to question why they are increasing allocations to an asset class “that over the long run seems to be matching at best public-market indexes with reduced liquidity, higher fees after a monstrous rise in corporate valuations and a once-in-a-generation drop in interest rates.”

AQR Capital Management also recently published its own evaluation of private equity and also found the approach lacking in merit. The AQR report assesses, “Our estimates [of returns on private equity] display a decreasing trend over time, which does not seem to have slowed the institutional demand for private equity.” They too suspect that the “return-smoothing properties of illiquid assets in general” may be part of the appeal to certain investors.

John Dizard summarizes the value proposition of private equity in the Financial Times:

If stock volatility is scary, lever up the portfolio with borrowed money, stop marking to market, and call it ‘private equity’. Problem solved.

Whether it is individual investors increasing exposure to stocks or institutional investors increasing exposure to private equity, it is clear that the search for higher returns has evolved into a heated competition. The competition though, is based on a fallacy. When Guinn describes the pension conversation as being “framed”, he means that it is unduly and artificially constrained in its consideration of possible solutions.

Ben Inker from GMO elaborates on exactly this scenario by noting, “Risk is not merely a function of the volatility of the investment portfolio but also of the relationships between the investment portfolio, the liability, and the nonportfolio assets.” While changes can be made to the liability variable by renegotiating retirement benefits, Inker focuses on the importance of considering contributions:

“But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem – the potential of the fund sponsor to make additional contributions to the pension portfolio when needed.”

The appropriate allocation of financial assets to a retirement plan depends partly on the expected returns of those assets, but only partly. It also depends on the level of retirement benefits desired and on contributions (and asset volatility and investment horizon). As a result, undue focus on returns is a false choice. The bad news is that many institutional pension plans have little or no ability to reduce benefits or increase contributions. The good news is that individuals normally have a great deal more flexibility to manage through a low return environment.

Just how little flexibility many institutions have in regard to pension funding is illuminating. Grants captures this with the testimony by James P. McNaughton, assistant professor of management at the Kellogg School of Management, to a House of Representatives subcommittee dealing with the pensions crisis:

“While approximately 60% of multiemployer plans are currently certified in the green zone in recent PBGC reports, that number would drop to around 7% if discount rates were based on current corporate bond yields. In other words, on an annuity purchase basis, only 7% of plans have 80% of assets needed to purchase annuities for their participants.” 

This describes fairly clearly the predicament that pension fund managers are in. Only 7% of multiemployer plans are funded well enough to honor their promises with a very high likelihood of success. All the others are stuck between a rock and hard place: They can either try to renegotiate the promises by reducing pension benefits (which is difficult politically) or they can increase allocations to riskier assets and significantly increase the risk of losses.

Such incredibly poor funding levels reveal a number of important things about the investment landscape. For one, the response by many institutions to chase returns, increase leverage, and obscure volatility has all the makings of desperation. As Grants points out, “If you expect big, perhaps unreasonable, things from your p.e. allocation, it’s because you need them. You want to believe.” It sounds more like someone down on their luck going to a loan shark than it does a high-quality decision-making process.

As it happens, some private equity funds even seem to be playing the role of loan shark. The Financial Times reports that despite the increasingly problematic value proposition of private equity and the pressure on fees almost everywhere, some funds are actually raising their performance fees in what appears to be a form of surge pricing:

“Investors seem to have a weak hand when it comes to negotiating terms. Large institutions — under pressure to seek yield in a low interest rate environment — do not complain about terms because they fear being cut back or being excluded from a popular fund.”

This raises an interesting possibility that also reflects on today’s investment environment. Typically, large institutional investors have been considered “smart money”. As a result, other investors look to them for information content, clamoring to benefit from whatever they are doing. When institutional investors go progressively further out on the risk spectrum, it sends a signal that that might be a “smart” thing to do.

But what if the “smart money” isn’t so smart anymore? It’s not to suggest that the people running institutional funds are any less intelligent but rather that they are more desperate. They aren’t chasing returns so much because they think it is a great investment decision but because they believe they have to do something, and they don’t have a choice. Insofar as this is the case, their search for higher returns signals an increasingly desperate race that is likely to end badly. It is one that should be avoided, not emulated.

John Dizard sums it up well, barely containing his revulsion:

“Prof Siegel and his followers have been telling people what they want to hear, though he no doubt believes it himself. I believe the collective opinions, policies and investment decisions based on the high equity return cult will lead to social, economic and political disaster.

This suggests another important thing about the investment landscape. The pension funding crisis is a very big and interconnected issue that will affect everyone. There is already talk of legislation to rescue multiemployer pension plans that fail. Any effort to do so will set a dangerous precedent of redistributing tax income to bail out mismanaged plans. John Mauldin expects there to be pain and describes how it will likely affect incomes: “As with the federal debt, some portion of this unfunded pension debt is going to get liquidated in some manner. Any way we do it will hurt either the pensioners or taxpayers.”

In a similar sense, Grants describes (in its August 10, 2018 letter) how the pension funding crisis will likely affect risk assets:

“The fancy prices that the p.e. firms pay for listed companies (or the neglected and undermanaged subsidiaries thereof) contribute to the lift in public-market equity averages. The returns that p.e. has earned, and—it is hoped—will earn again, support an immense structure of debt. Unwarranted expectations concerning p.e. returns raise false hopes for deeply underfunded pension funds. In short, private equity is everybody’s business.”

So, this season for horse racing serves as a useful reminder that the race to fund pension plans is on but promises to be a much uglier affair. As such, it also serves as a reminder for investors to carefully align the risks of their assets with their investment horizons. Otherwise, they may end up chasing returns in a thankless race.

Just a week ago, I was still fairly comfortable with the bullish argument. Note that I did not say that I was a bull, or a bear, or any other market animal. What I saw on the charts, and yes, from the fundamental side, was still supportive of higher prices in the near-term.

My argument to readers/listeners was that the S&P 500 hit a very likely, and yes, logical, place where those looking to cash out might do so.

That’s a fancy way to say the index hit resistance. And naturally, the next step was to look for a likely place for this pullback to find support.

Could it be the 38.2% Fibonacci from the December low? That would be roughly an 8% decline from peak prices in May. Hmmm… that seems a bit hefty for a garden variety pullback. That’s more like a correction if we are to believe the concocted cutoffs pushed by the media (10% is a correction, 20% is a bear market). I prefer to call then farkakteh cutoffs. (I like that this word was in MS-Word’s spell check).

So what’s next? Well, Monday morning as the Dow is down 500 or so on the latest on-again, off-again trade talks with China, the S&P is down about 4% from its peak. That seems reasonable for a pullback. No, I am not calling a bottom here, just looking for likely places that might occur.

Lo and behold, there is support there from October, November and December interim highs. But when emotions rule – more than usual – these are but mere suggestions of support. I certainly would not buy based solely on that.

One thing that caught my eye over the past week was that these opening morning dumps have mostly been reversed as the days wore on. Again, no forecast of that but if it happens yet again then we have to admit that there is still a good desire to buy stocks, despite the news.

Market breadth really did not deteriorate much. Not too much money flowed out of the major ETFs. And gold is not moving higher. All things that right now are not so bad for stocks.

But keeping with money flows, each peak over the past year has been trending lower, even though prices made similar or higher highs.  That’s not great.

My conclusion? It is close to decision time. The pullback is still in line with a rising trend from December and is still above the 200-day average. But I need some sort of signal that the upside reversal is at hand because I also see a downside bowtie crossover perhaps a few days away. If that happens, then I will have to re-evaluate my stance.

Myopia

As a long-time glasses and contact lens wearer, I am quite qualified to define this word. It means being able to see what’s right in front of me but not what’s out there farther away.  You may call it “nearsighted.” As a side note, I’ve had cataract surgery on both eyes and no longer need any corrections. I won’t say it has helped my market forecasting but I am quite happy with the results, otherwise.

Anyway, we often zero in on the S&P 500 as the go-to index we use in prognosticating. As some now look for a potential triple top here (I disagree with that characterization, but that is for another time), the same pattern is not evident in other major indices. The Dow is close to having three similar peaks. NYSE composite? No. Russell 2000? No. Transports? No. And even my “four horsemen” sectors (tech, housing, retail and financial) are not even close to this formation.

Therefore, it is hard for me to say that “the market” hit resistance and fell away. Yes, the S&P 500 is the big daddy of market cap but it is also rather at the mercy of international trade. And right now, everyone seems to have their panties in a bunch over China. Without getting sucked into the politics, the Chinese stock market looks a lot weaker than the domestic market and that tells me they have a weaker hand to play.

The numbers here still look pretty good (yeah, fundamental dabbling). And as long as Congress is in full gridlock mode, that is usually pretty good for stocks, too.

Therefore, I am hopeful but waiting for a sign that the buyers are back for real. If not, this is not a falling knife I’m willing to catch.

When we embarked on our Value Your Wealth series, we decided to present it using a top-down approach. In Parts One and Two, we started with basic definitions and broad analysis to help readers better define growth and value investment styles from a fundamental and performance perspective. With this basic but essential knowledge, we now drill down and present investment opportunities based on the two styles of investing.

This article focuses on where the eleven S&P sectors sit on the growth-value spectrum. For those that invest at a sector level, this article provides insight that allows you to gauge your exposure to growth and value better. For those that look at more specialized funds or individual stocks, this research provides a foundation to take that analysis to the next level.

Parts One and Two of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Sector Analysis

The 505 companies in the S&P 500 are classified into eleven sectors or industry types. While very broad, they help categorize the S&P companies by their main source of revenue. Because there are only eleven sectors used to define thousands of business lines, we must be acutely aware that many S&P 500 companies can easily be classified into several different sectors.

Costco (COST), for instance, is defined by S&P as a consumer staple. While they sell necessities like typical consumer staples companies, they also sell pharmaceuticals (health care), clothes, TVs and cars (discretionary), gasoline (energy), computers (information technology), and they own much of the property (real-estate) upon which their stores sit.

Additionally, there is no such thing as a pure growth or value sector. The sectors are comprised of many individual companies, some of which tend to be more representative of value and others growth.

As we discussed in Part Two, we created a composite growth/value score for each S&P 500 company based on their respective z-scores for six fundamental factors (Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend Yield, and Earnings Per Share). We then ranked the composite scores to allow for comparison among companies and to identify each company’s position on the S&P 500 growth-value spectrum. The higher the composite score, the more a company is growth oriented and the more negative the score, the more value-oriented they are.  

The table below summarizes the composite z-scores by sector.  To calculate this, we grouped each company based on its sector classification and weighted each company’s z-score by its market cap. Given that most indexes and ETFs/Mutual funds are market cap weighted, we believe this is the best way to arrange the sector index scores on the growth-value spectrum. 

Data courtesy Bloomberg

As shown, the Financial, Energy, and Utility sectors are the three most heavily weighted towards value.  Real-estate, Information Technology, and Consumer Discretionary represent the highest weighted growth sectors.

While it might be tempting to select sectors based on your growth-value preferences solely using the data in the table, there lies a risk. Some sectors have a large cross-section of both growth and value companies.  Therefore they may not provide you the growth or value that you think you are buying. As an example, we explore the communications sector.

The communications sector (represented by the ETF XLC) is a stark combination of old and new economy stocks. The old economy stocks are traditional media companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend on newer, cutting edge technologies include companies like Google, Facebook, Twitter, and Trip Advisor. 

As one might expect, the older media companies with more reliable earnings and cash flows are priced at lower valuations and tend to be defined as value stocks by our analysis. Conversely, the new economy companies have much higher valuations, are short on earnings, but come with the prospect of much higher growth potential.

The scatter plot below offers an illustration of the differences between growth, value and market capitalization within the communications sector. Each dot represents the intersection of market capitalization and the composite z-score for each company. The table below the scatter plot provides fundamental and performance data on the top three value and growth companies.

Data courtesy Bloomberg

As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.

The following table compares the weighted average z-score for each S&P sector along with the variance of the underlying companies within the sector and the percentage of companies that are considered value and growth. We use standard deviation on the associated composite z-scores to determine whether companies are close together or far apart on the growth/value spectrum.  The lower the standard deviation, the more similar the companies are in terms of growth or value

Data courtesy Bloomberg

Again here, weightings, market capitalization, and the influence of individual stocks within a sector are important to understand The industrial sector, as shown above, has a score of +0.232, which puts it firmly in growth territory. However, Boeing (BA), due to its large market cap and significant individual growth score skews this sector immensely. Excluding BA, the weighted average composite score of the industrial sector registers as a value sector at -0.07. Again this highlights the importance of understanding where the growth and or value in any particular sector comes from.

Takeaways

The graph below shows the clear outperformance of the three most heavily growth-oriented sectors versus the three most heavily value-oriented. Since the beginning of the post-financial crisis, the three growth companies grew by an average of 480%, almost three times the 166% average of the three value companies.

This analysis provides you a basis to consider your portfolio in a new light. If you think the market has a few more innings left in the current expansion cycle, odds continue to favor a growth-oriented strategy. If you think the economy is late-cycle and the market is topping, shifting towards value may provide much-needed protection.  

While we believe the economic and market cycles are late stage, they have not ended. We have yet to receive a clear signal that value will outperform growth going forward. At RIA Advisors, growth versus value is a daily conversation, whether applied to sector ETF’s, mutual funds or individual stocks.  While we know it’s early, we also know that history has been generous to holders of value, especially after the rare instances when growth outperformed it over a ten-year period as it has recently.

At the beginning of this year, I was at dinner with my wife. Sitting at the table next to us, was a young financial advisor, who was probably in his mid-30’s, meeting with his client who appeared to be in his 60’s. Of course, the market had just experienced a 20% correction from the previous peak and the client was obviously concerned about his portfolio.

“Don’t worry, there is always volatility in the market, but as you can see, even bear markets are mild and on average the market returns 8% a year over the long-term.” 

Here is the chart which shows the PERCENTAGE return of each bull and bear market going back to 1900. (The chart is the S&P 500 Total Return Inflation-Adjusted index.)

Here is the narrative used with this chart.

“The average bear market lasts 1.4 years on average and falls 41% on average.-The average bull market (when the market is rising) lasts 9.1 years on average and rises 476% on average.”

While the statement is not false, it is a false narrative.

“Lies, Damned Lies, and Statistics.”– Mark Twain

Here are the basics of math.

  • If the index goes from 100 to 200 it is indeed a 100% gain.
  • If the index goes from 200 back to 100, it is only a 50% loss.
  • Mathematically it would seem as if an investor is still 50% ahead, however, the net return is actually ZERO.

This is the error of measuring returns in terms of percentages as it masks the real damage done to portfolios during a decline. To understand the real impact of bull and bear markets on a portfolio, it must be measured in POINTS rather than percentages.

The chart above exposes the basic realities of math, loss, and time. What becomes much more apparent is that bear markets tend to destroy most or all of the previous advance and has done so repeatedly throughout history.

Importantly, what was not being discussed between the advisor and his 60-something client was simply the risk of “time.”

There are many financial advisors, commentators, experts, and social media gurus who have never actually “been invested” during a real “bear market.” While the “theory of ‘buy and hold'” sounds good, kind of like MMT, in practice it is an entirely different issue. The emotional stress of loss leads to selling even by the most “die hard” of individuals. The combined destruction of capital and the loss of time is the biggest issue when it comes to individuals meeting their retirement goals.

The following chart the real, inflation-adjusted, total return of the S&P 500 index.

Note: The green lines denote the number of years required to get back to even following a bear market. It is worth noting the entirety of the markets return over the last 118-years occurred in only 4-periods: 1925-1929, 1959-1968, 1990-2000, and 2016-present)

That comment corresponds to the next chart. As noted, there have currently been four, going on five, periods of low returns over a 20-year period.

As discussed last week:

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”

In other words, the most important component of your investment success depends more on WHEN you start rather than IF you start.

That brings me to my second point of that nagging problem of “time.” 

Time Is An Unkind Companion

While it is nostalgic to use 100+ years of market data to try and prove a point about the benefits of “buy and hold” investing, the reality is that we “mere mortals” do not have the life-span required to achieve those returns.

“Despite the best of intentions, a vast majority of the ‘bullish’ crowd today have never lived through a real bear market.”

I have been managing money for people for a very long time. The one simple truth is that once an individual has lost a large chunk of their savings, they are very reluctant to go through such an experience a second time. This is particularly the case as individuals get ever closer to their retirement age.

Let’s remember that our purpose of investing is to:

 “Grow savings at a rate which maintains the same purchasing power parity in the future and provides a stream of living income.” 

Nowhere in that statement is a requirement to “beat a benchmark index.” 

For most people, a $1 million account sounds like a lot of money. It’s a big, fat round number. The problem is that the end number is much less important than what it can generate. The table below shows $1,000,000 and what it can generate at varying interest rate levels.

30-years ago, when prevailing rates were substantially higher, and living standards were considerably cheaper, a $1,000,000 nest egg was substantial enough to support retirement when combined with social security, pensions, etc.

Today,  that is no longer the case.

Since most investors only have 20 to 30-years to reach their goals, if that period begins when valuations are elevated, the odds of success falls dramatically.

This is why “time” becomes such an important determinate of success.

In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing. Therefore, in order to estimate future inflation-adjusted total returns, we must adjust the formula to include “life expectancy.” 

RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)

Where:

  • Ca = Capital Appreciation
  • D = Dividends
  • I = Inflation
  • Si = Starting Investment Age
  • Lfe = Life Expectancy

For consistency, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.

Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual. 

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.

In every single case, at the point of death, the invested capital is short of the promised goal.

The difference between “close” to goal, and not, was the starting valuation level when investments were made.

This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals. 

The Next Bear Market Will Be The Last

After two major bear markets since the turn of the century, a vast majority of “baby boomers” are woefully unprepared for retirement. Dependency on social welfare is at record highs, individuals are working far longer into retirement than at any other point in history, and after a decade long bull market many investors have only just recently gotten back to where they were 10-years ago.

It is from this point, given valuations are once again pushing 30x earnings, that we review the expectations that individuals facing retirement should consider.

  • Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
  • The potential for front-loaded returns going forward is unlikely.
  • Your personal life expectancy plays a huge role in future outcomes. 
  • The impact of taxation must be considered.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 10-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.

Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize.

For the majority of individuals today facing, or in, retirement the two previous bear markets have left many further away from retirement than they ever imagined.

The next one will destroy those goals entirely.

Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation, not the market, over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.

You can do better.

We are adding a new monthly review of important commodities which may provide clues as to both the strength and direction of the markets and the economy.

CRB Index

  • If the economy was as strong as headlines suggest, the commodity index should be rising as demand for commodities grows. This was clearly apparent in mid-2017 as 3-major hurricanes and 2-massive wildfires devastated the U.S. requiring demand for raw materials.
  • This same story will be evidence in the following economically sensitive commodities as well.
  • A break below $178 will likely signal a test of fairly long-term lows below $170
  • No trade yet for $CRB

Copper

  • Copper, often called “Dr. Copper” because of its sensitivity to economic demand has remained weak as the rolloff of demand from natural disasters continues.
  • Still correcting its recent overbought condition and close to a sell signal suggests copper may well continue to weaken.
  • No position currently.
  • A break below $2.50 will likely suggest a test of $2.00 amidst a pickup in economic weakness.

Lumber

  • Lumber is looking to retest lows of the last 3-yeas, and like the CRB, it is clear the demand spike, and subsequent economic input from natural disasters, is over.
  • Lumber is close to triggering a “sell signal.”
  • A break below $300 will suggest both accelerating economic weakness and substantially lower lows.
  • No position currently.

Soybeans

  • One look at this chart and you can understand why American farmers are filing for bankruptcy.
  • With global demand slowing, the acceleration of the decline is becoming apparent. It is unlikely even a trade agreement with China at this point will repair the damage.
  • Soybeans are oversold BUT on an important sell signal.
  • There is a trade to $875 only. But the downside risk outweighs the reward.
  • Stops must be set at $800

Live Cattle

  • Demand for beef is on the decline and I am pretty sure “Beyond Meat” is NOT the culprit.
  • Given the cost of meat, cattle is a decent indicator of economic strength.
  • Cattle are oversold here BUT on an important “sell” signal.
  • No trade currently, but watch the message live cattle are sending.

Lean Hogs

  • Hogs are current performing better than live cattle and support is holding at $6.00
  • However, Hogs are overbought on the short-term and are carrying a very elevated “buy” signal.
  • If economic weakness is increasing, then look for a break back down to previous lows.
  • No position currently, but watch the $6.00 level for the next signal.

US Dollar Index

  • With roughly 40-50% of corporate profits coming from exports, all commodities globally traded in dollars, and the dollar impact on the bond market, this is a key measure to watch. Trade war will have an impact across many sectors of the market and the dollar will likely tell the story.
  • Currently, the dollar is breaking out of previous resistance and has now registered a buy signal. The combination of these two catalysts suggests the dollar could rise toward $100 on the index.
  • With the dollar flirting with a “buy signal,” a stronger dollar looks to be the play as the “trade war” attracts foreign dollars into U.S. Treasuries.
  • Be long the dollar with an initial target of $100.

10-Year Interest Rates

  • As noted above, the stronger dollar and the “trade war” are driving foreign investors into the “safety” of the U.S. Dollar.
  • Rates just broke below the previous lows of 2.4% and suggests a potential test of 2.1% may be in the works.
  • Add to long-bond positions and increase duration slightly in portfolios. (7-10 years).
  • Rates are oversold so a buy towards 2.5% would likely be an ideal entry point to add exposure.

Gold

  • Gold held important support at $1270 and is wrestling to climb above its 50-dma.
  • Gold is threatening to trigger a short-term sell signal so support at $1270 needs to hold for the time being.
  • Hold positions but be patient in adding exposure until the 50-dma is broken above.
  • Maintain at stop-loss at $1250

Oil – Black Gold

  • The rally in oil from the 2018 lows appears to be complete.
  • The good news is that oil is holding support at the 50-dma which has finally crossed back above the 200-dma.
  • Stay long oil and energy-related investment for now BUT be critically mindful that oil is ultimately negatively impacted by both a weaker economy and strong dollar.
  • Stops must be set at $58.
  • That signal has been triggered and VTR is not yet oversold.
  • We blew through our initial $60 target so cover 1/2 of the position immediately.
  • Stop is now moved to $62
  • Position can be re-shorted on a failed rally to $61.50

For the last several years, there has been a tremendous amount of activity and hype in the tech startup arena. In addition to the tens of thousands of startups that been founded in recent years, there are over three-hundred new “unicorn” startups that have valuations of $1 billion or more. Most of these unicorns came of out virtually nowhere and amassed tremendous valuations despite hemorrhaging cash, which is a tell-tale sign of a bubble. The recent announcement of a new Silicon Valley stock exchange for “hot startups, particularly those that are money-losing” is an indication of the amount of hubris and hype there is in the startup arena right now –

Long-Term Stock Exchange CEO Eric Ries

The U.S. Securities and Exchange Commission approved the creation of the Long-Term Stock Exchange, or LTSE, a Silicon Valley-based national securities exchange promoting what it says is a unique approach to governance and voting rights, while reducing short-term pressures on public companies.

The LTSE is a bid to build a stock exchange in the country’s tech capital that appeals to hot startups, particularly those that are money-losing and want the luxury of focusing on long-term innovation even while trading in the glare of the public markets.

The stock exchange was proposed to the SEC in November by technology entrepreneur, author and startup adviser Eric Ries, who has been working on the idea for years. He raised $19 million from venture capitalists to get his project off the ground, but approval from U.S. regulators was necessary to launch the exchange.

The tech startup bubble formed as a result of the Fed and other central banks’ extremely loose monetary policies after the Great Recession. In a desperate attempt to jump-start the global economy again, central banks cut and held interest rates at virtually zero percent for much of the past decade and pumped trillions of dollars worth of liquidity into the global financial system. The chart of the Fed Funds rate below shows how bubbles form when interest rates are at low levels:

Loose global monetary policy led to an explosion of venture capital activity over the past several years:

Trillions of dollars worth of central bank-created liquidity has been sloshing around the globe looking for a home and a portion of it found its way into unicorn companies that are worth billions of dollars each:

Today’s unicorns are equivalent to dot-com companies in 1999 and will have the same fate, unfortunately. Though some of the unicorns will survive and become successful in the longer-run like Amazon and eBay, there is going to be a tremendous shakeout that is going to slash valuations and weed out the Pets.coms and Webvans. Thousands, if not tens of thousands, of tech startups are going to fold when this bubble bursts. The abysmal performance of two recent high-profile unicorn IPOs, Lyft (down nearly 50% since its IPO) and Uber, may be a sign that air is starting to come out of the unicorn bubble. It will be interesting to see if the Long-Term Stock Exchange will be able to go live before the unicorn bubble bursts.

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.  

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

Whether its yen, euros, wampum, bitcoin, dollars or any other currency, as long as society is accepting of such a unit of exchange, trade will occur. When TRUST in the value of a currency wanes, commerce becomes difficult, and the monetary and social prosperity of a nation falters. The history books overflow with such examples.

Maslow and Currency

Before diving into the value of a currency, it is worth considering the role it plays in society and how essential it is to our physical and mental well-being. This point is rarely appreciated, especially by those that push policies that debase the currency.

Maslow created his famous pyramid to depict what he deemed the hierarchy of human needs. The levels of his pyramid, shown below, represent the ordering of physiological and psychological needs that help describe human motivations. When these needs are met, humans thrive.

Humans move up the pyramid by addressing their basic, lowest level needs. The core needs, representing the base, are physiological needs including food, water, warmth and rest. Once these basic needs are met, one then seeks to attain security and safety. Without meeting these basic physiological and safety needs, our psychological and self-fulfillment needs, which are higher up the pyramid, are difficult to come by. Further, as we see in some third-world countries, the social fabric of the nation is torn to shreds when a large part of the population cannot satisfy their basic needs.

In modern society, except for a few who live “off-the-grid,” fiat currency is the only means of attaining these necessities. Possession of currency is a must if we are to survive and thrive. Take a look back to the opening paragraphs and let’s rephrase that last sentence: possession and TRUST of currency is a must if we are to survive and thrive.

It is this most foundational understanding of currency that keeps our economy humming, our physical prosperity growing and our society stable. The TRUST backing the dollar, euro, yen, etc. is essential to our financial, physical and psychological welfare.

Let’s explore why we should not assume that TRUST is a permanent condition.

Deficits Don’t Matter…. or Do They?

Having made the imperative connection between currency and TRUST and its linkage to trade and commerce along with our physical and mental well-being, we need to explore the current state of the United States government debt burden, monetary policy, and the growing belief that deficits don’t matter.

Treasury debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond is paid in full at maturity, however, to secure the funds to pay that holder, the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand, swelling the amount of debt outstanding. Think of this arrangement as taking out a new credit card every month to pay off the old card.

The chart below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.

Data Courtesy: St. Louis Federal Reserve

Continually adding debt at a faster rate than economic growth (as shown above) is limited. To extend the ability to do this requires declining interest rates, inflation and a little bit of financial wizardry to make debt disappear. Fortunately, the U.S. government has a partner in crime, the Federal Reserve.

As you read about the Fed’s methods to help fund deficits, it is important to consider the actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST in the currency and allows it to retain its functional purposes.

The Fed helps the government consistently run deficits and increase their debt load in three ways.

  1. The Fed stokes moderate inflation.
  2. The Fed manages interest rates lower than they should be.
  3. The Fed buys Treasury and mortgage securities (open market operations/QE) and, as we are now witnessing, monetizes the debt.

Inflation

Within the Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has averaged 3.11% annually. That rate may seem inconsequential, but it adds up. The chart below illustrates how the low but consistent rate of inflation has debased the purchasing power of the dollar.

Data Courtesy: St. Louis Federal Reserve

$1 borrowed in 1913 can essentially be paid off with .03 cents today. Inflation has certainly benefited debtors.

Interest Rate Management

For the better part of the last decade, the Fed has imposed price controls that kept interest rates below what should be considered normal. Normal, in a free market economy, is an interest rate that compensates a lender for credit risk and inflation. Since Treasury debt is considered “risk-free,” the predominant risk to Treasury investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The Mind Blowing Concept of Risk-Free’ier.

If the yield on the bond is less than inflation, as has recently been the case, the purchasing power and wealth of the investor declines in the future.

The table below highlights how U.S. Treasury real rates (yields less CPI) have trended lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are not properly compensated by the U.S. Treasury, the onus of government debt is partially being put upon investors. We have the Fed to thank for their Fed Funds (FF) policy of negative real rates.

Data Courtesy: St. Louis Federal Reserve

Fed Balance Sheet

The Fed uses its balance sheet to buy and sell U.S. Treasury securities to manage the money supply and thus enforce their interest rate stance. In 2008, their use of the balance sheet changed. From 2008 through 2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed securities in what is called Quantitative Easing (QE). By reducing the supply of these securities, they freed up liquidity to move to other assets within the capital markets. The action propped up asset prices and helped keep interest rates lower than they otherwise would have been.

Since 2018, they have reversed these actions by reducing the size of their balance sheet in what is called Quantitative Tightening (QT). This reversal of prior action essentially makes the benefits of QE temporary. However, if they fail to reduce it back to levels that existed before QE was initiated, then the Fed permanently monetized government debt. In plain English, they printed money to extinguish debt.

As we write this article, the Fed is in the process of ending QT. Based on the Fed schedule as announced on March 20, 2019, the balance sheet will permanently end up $2.28 trillion larger than from when QE was initiated. To put that in context, the balance will have grown 269% since 2008, as compared to 48% economic growth.

Data Courtesy St. Louis Fed

The methods the Fed employs to manage policy as described above, all involve using their balance sheet to alter the money supply and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics law; when there is more of something, it is worth less. When something of value is created out of thin air, its value declines.

At what point is debt too onerous, deficits too large and the Fed too aggressive such that TRUST is harmed? No one knows the answer to that question, but given the importance of TRUST in a fiat currency regime, it would be wise to avoid actions that could raise doubt. Contrary to that guidance, current fiscal and monetary policy throws all TRUST to the wind.

Prelude to Part 2

As deficits grow and government debt becomes more onerous, the amount of Fed intervention must become greater.  To combat this growing problem, both political parties are downplaying deficits and pushing the Fed to do more. In part 2 we will explore emerging fiscal mindsets and what they might portend. We will then define money, and with this definition, show why the difference between currency and money is so important. 

The global economy is apparently facing a significant problem. Inflation’s gone missing! Central bankers can’t seem to stoke it no matter how deftly they act. Neither lowering interest rates to zero (and less) nor endless amounts of Quantitative Easing (QE) appear to make any difference. This, we’re told, is a problem that is equally as serious as it is perplexing. However, this position puzzles me. What if it’s not inflation that’s lacking, but rather our understanding of it? More importantly, might this disconnect have significant ramifications for investment portfolios?

In my opinion, there are two ways in which inflation is misunderstood. The first stems from misapplying a commodity-based monetary standard practice to a fiat convention. The second potential error is placing too much importance on unit prices as an economic signal. It’s possible, I think, that both had a hand in producing the 40-year secular decline in interest rates.

Inflation Is A Currency Phenomenon

Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Merriam-Webster dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” Here, we can see that inflation is a relative term. It compares the value of goods and services to money.

While these definitions are commonplace today, they are in fact modern redefinitions. Inflation was first used to describe the value of (paper) currency compared to a monetary standard, not to goods and services. Emperors clipping coins didn’t devalue money per se. The standard, which was typically defined as some unit weight of commodity metal, remained constant. Rather, they merely lessened the monetary value of each coin in circulation. Hence, it took more currency to purchase the same goods and services. The same held true for paper currencies convertible into gold. Lowering exchange rates reduced their purchasing power. This was inflation. To clarify Dr. Friedman’s definition, inflation is not a monetary phenomenon, it’s a currency phenomenon!

Inflation Was Lost In Translation

Today, however, we operate under a fiat monetary standard. There is no physical definition of a dollar apart from the currency itself. A dollar is simply what someone else is willing to accept for it in trade. Given that governments create the fiat currencies used in commerce (currencies, not money!), it follows that monetary authorities would require some metric to assess if the quantity produced is optimal.

Enter the modern—and in my view, flawed—concept of inflation. It’s determined by tracking the change of the average price of a basket of goods. There are many different indices with many different mixes of goods and services, with many different kinds of adjustments made. Inflation’s use in monetary policy is to provide policymakers with an objective signal with respect to the amount of currency in circulation.

“In the earlier definition, inflation is something that happens to the circulating media at a given price level; in the later definition, an inflating currency is defined to exist when it produces a rise in the general price level, as suggested by the quantity theory. What originally described a monetary cause came to describe a price effect.” [Emphasis is mine.]

Michael F. Bryan, On the Origin and Evolution of the Word Inflation

The attempt to bring objectivity to an arbitrary, fiat system is valiant. It is, however, flawed. Put aside the issues of measurement and representation of the popular indices (hedonic adjustments anyone?). Defining monetary value in terms of tangible goods and services ignores the most fundamental fact about human wealth and prosperity creation; and it’s hiding in plain sight.

Deflation Is The Hallmark Of Prosperity And Progress

There’s no surer way to scare a macroeconomist than to utter the word “deflation.” This euphemism for falling prices conjures up thoughts of economic depression, breadlines, unemployment, and poverty. Thus, deflation must be avoided at all cost it is thought. This fear has apparently short-circuited the critical thinking mechanism of some very bright people. None seem to realize that, by our modern definition, deflation is the hallmark of prosperity and progress.

Just think for a moment. The dramatic fall in general prices is a corollary to wealth. Affordability yields abundance, comfort, and joy. Who doesn’t want more and better goods and services at an exponentially cheaper cost? (Well, macroeconomists I suppose, but I bet most are compartmentalized on this subject.)

One study demonstrates this very fact by scaling food costs to the value of unskilled labor. It found that prices exponentially fell for basic needs.

  1. The time price (i.e. nominal price divided by nominal hourly wage) of our basket of commodities fell from 47 hours of work to ten … .
  2. The unweighted average time price fell by 79 percent … .
  3. Put differently, for the same amount of work that allowed an unskilled laborer to purchase one basket of the 42 commodities in 1919, he or she could buy 7.6 baskets in 2019 … .
  4. The compounded rate of ‘affordability’ of our basket of commodities rose at 2.05 percent per year … .
  5. Put differently, an unskilled laborer saw his or her purchasing power double every 34 years … .”

Marian L. Tupy, Unskilled Workers and Food Prices in America (1919-2019)

This becomes more starkly apparent if you remove money from the equation altogether. Consider this: Go back far enough and everyone was a subsistence farmer (or hunter/gatherer). In other words, virtually 100% of an entire population’s time and effort was spent on producing the basic necessities for survival. Today, less than 5% of those in developed countries work in agriculture. The other 95% produce everything else that improves our lives.

Source: Our World in Data

Now that’s some massive deflation, at least according to our modern definition! Were these horrible times? Hardly so! Deflation, it turns out, is present throughout all prosperous periods of human history. Of course no one called this deflation because, quite frankly, it’s not. True inflation is a currency phenomena. It has nothing to do with the value of goods and services.

Using the modern inflation concept in monetary policy simply makes no sense. Deflation is desirable. It’s inflation we should fear. A rise in general prices can only result from wealth destroying shortages or the imposition of unnatural competitive barriers (i.e. regulation and tariffs). The invisible hand ensures just this.

Inflation’s Usage Is Misplaced

Putting this aside for a moment, macroeconomists apply inflation inconsistently. It can connotes both economic growth (good) and monetary debasement (bad). What I find most bizarre though, is for exactly 2.0% inflation to be monetary panacea despite its arbitrary origin.

“’It was almost a chance remark,’ [former Reserve Bank of New Zealand Governor] Mr. Brash said in a recent interview. ‘The [2% inflation target] figure was plucked out of the air to influence the public’s expectations.’”

Neil Irwin, Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel

Furthermore, the importance that macroeconomists place on unit prices is misplaced in my view; that is if one is interested in monitoring economic conditions.

Inflation in macro is assumed to be information-laden. To practitioners, it signals tightening economic conditions such that prices rise. Falling prices, on the contrary, indicate excess “slack”; that resources are under-utilized and a cause for alarm. Perhaps most silly is the belief that price declines prevent consumers from spending. If this were truly the case few would own TVs and other consumer electronics; the Industrial Revolution would have stopped dead in its tracks.

Lost on these economists is that prices are just one tiny piece of the economic machinery. Companies change them for a whole slew of reasons. In fact, not only should prices fluctuate, they do because they are effects.

Getting Micro With The Macro

While on the surface this inflation perspective appears logical, it lacks a basis in reality. For inflation to carry significance, prices should be of paramount concern to businesses. After all, macroeconomics is merely the aggregation of the micro. Analyzing commercial activities reveals that this is simply not the case.

Consider this: Businesses seek to maximize profit (or cash flow). Profits are a function of both revenues and expenses. While important, prices are just one component of the profit algorithm.

Profit ($) = price ($ per unit) x volume (units) – costs ($)

From this equation it should be abundantly clear that a company’s fortune rests upon more than unit prices. In fact, profits might rise despite prices falling. This routinely happens when companies expand capacity or increase productivity (i.e. lower unit costs). Lower prices facilitate higher volumes which can increase efficiency. This combination often leads to greater profits, which is the ultimate goal .

True, falling prices might indicate a lack of demand. But often times they times don’t. The same applies for the economy writ large.

Profound Investment Implications

In summary, I find the treatment of inflation to be flawed in two ways. First, defining monetary stability in terms of goods and services is inconsistent with its original conception. Inflation simply has no relevance in a fiat currency regime due to the lack of an objective standard. Secondly, the fixation on unit prices for assessing macroeconomic health seems disconnected from microeconomic realities.

Today’s lack of inflation is not a problem; it’s prosperity. So long as markets and people are left free to create and work, deflation will likely persist. We should expect (and welcome) inflation target undershoots in spite of policymakers concocting all sorts of crazy theories and policies in order to stoke it. (Thank goodness!)

The investment implications are potentially profound. What if these misunderstandings underpin the secular decline in interest rates? If so, it seems likely that markets will continue to incorrectly process the incoming inflation data given how institutionalized inflation is in investment frameworks. This should present profitable opportunities for the rest of us. Perhaps the undershooting of inflation targets—and other related trends—will persist as the growth we’re enjoying continues. In that case, I, for one, look forward to disappointing inflation readings for years to come … for both my wallet’s and investment portfolio’s sake.

In 2009, I shared 2 words on Facebook that I felt would shape the future of our social and economic discussions:

Socialism & Nationalism.

Not trying to be a smarta**, however, I told you so.

A shallow economic recovery (one of the weakest post-WW2), since the Great Recession, intervention by the Fed and persistent greed from U.S. corporations that place shareholders and senior executives above all else, have blossomed dissatisfaction with the very heart of our system.

In 2012, I outlined in my book Random Thoughts of a Money Muse, how I believed the financial crisis would permanently alter the focus of C-Suite executives and corporate boards. My thought was publicly traded companies would operate in a state of permanent recession regardless of business cycle, and lastingly consider employees as ‘excess baggage,’ thus seek to reduce headcount whenever possible. I also wrote that wage growth would remain stagnant and employees would bear a greater burden of healthcare costs through high-deductible insurance plans.

No, I’m no psychic. My personal corporate employment experience post-financial crisis forced me on a path of painful self-discovery. Creative pay cuts, cancerous morale where motivational speak sounded more like threat of unemployment (BE THANKFUL you have a job), crushing sales targets, outright lies to the frontlines meant to keep clients in an imploding proprietary product, compelled me to re-shape my views about the company and jumpstart additional research into corporate behavior. At a contentious arbitration, I vocalized how I went from the custodian of the clients’ dreams to custodian of shareholder dreams. That’s not what I signed up for. I am and always will be a fiduciary and advocate for clients first.

Jonathan Tepper wrote in his eye-opening tome “The Myth of Capitalism:” Today, votes for Sanders, Trump and Brexit are the expression of discontent by the “Newly Poor.” They feel the system is rigged against them and future is not as bright as the past.

Historian Will Durant warned that societies fall apart when inequality is too severe.”

The market now pays attention to extreme views which reinforces my belief that socialism has crept into conventional thought. There was a time when markets would ignore outlier political sentiments. The recent example of healthcare stocks trashed in fear of Medicare for all initiatives tells me the market, as a leading indicator, believes our capitalist structure is being questioned. The cracks are beginning to spring leaks.

Here are 4 charts that outline how the private sector has helped to nurture the seed of socialism in our American soil.

Surprisingly, Warren Buffett believes that stock buybacks represent an excellent use of capital. A passionate believer in value has now been converted into a momentum-growth market participant. There was a time in our history that stock buybacks were illegal. Considered stock price manipulation (which it is). So, what’s changed? Today, it’s a prevalent form of financial engineering. Corporations purchase shares in the open market, artificially boost EPS, decrease float and ultimately drive stock prices higher. Not coincidentally, CEO compensation lives and dies by stock share price.

If you’re investing periodically in index or other mutual funds in a 401(k) or another type of company defined-contribution plan, stock buybacks have indeed been a tailwind to your net worth.

Unfortunately, while we enjoy a light breeze at our financial backs as retail investors, the richest 10% of households control 84% of the total value in stocks as outlined in a 2017 NBER Working Paper penned by NYU professor Edward N. Wolff – “Household Wealth Trends In The United States, 1962-2016: Has Middle Class Wealth Recovered?

The richest households have experienced a full gale force of appreciation in risk assets thanks primarily to record stock buybacks and unorthodox central bank policies such as quantitative easing and persistently low short-term interest rates. In addition, less than 42% of small businesses – those with two to 99 employees – offer any kind of retirement benefits which means their employees may not participate in market returns at all.

Keep in the mind, the wealth of the bottom 90% of the population is in primary residences. Houses with mortgages which require income to make payments. In other words, to many Americans, rising household incomes and the appreciation of home prices, not the possibility of future gains in the stock market, fuel the faith in prosperity envisioned by the American dreamers. House prices rose post-Great Recession. However, wealth grew more vigorously at the top of wealth distribution than in the middle, due to the increase in stock prices.

Which leads me to chart #2.

Abigail Disney, the grandniece of Walt Disney was on CNBC in April lamenting over Disney CEO Bob Iger’s $65.6 million 2018 paycheck, calling it “insane.” Her tweet from April 21st has been retweeted 12,958 times and liked by over 42,000.

According to the Economic Policy Institute which examines trends in CEO compensation, in 2017, the average CEO of the 350 largest U.S. firms received $18.9 million in total compensation – a 17.6% increase over 2016. Worker compensation remained flat.

From the EPI:

“The 2017 CEO-to-worker compensation ratio of 312-to-1 was far greater than the 20-to-1 ratio in 1965 and more than five times greater than the 58-to-1 ratio in 1989 (although it was lower than the peak ratio of 344-to-1, reached in 2000). The gap between the compensation of CEOs and other very-high-wage earners is also substantial, with the CEOs in large firms earning 5.5 times as much as the average earner in the top 0.1 percent.”

Listen, CEOs, senior managements, deserve big pay and incentives. I get it.  However, one needs to ponder whether they’re worth 312 to 1. I don’t think so. What do you think? Is Abigail Disney correct to rail about Iger’s pay package?

Ironically, in March, Disney World increased ticket prices by 23%. A one-day ticket will now set us back a lofty $159. What is a middle-class family going to do? Will they pay up? Probably. Despite consistent price hikes every year, park attendance continues to hit new records. As customers we just deal with the financial hit, shift items around in the budget, use credit, to make memories with our children.

Profligate compensation and price disparities not only raise the ire of those with socialist interest. Believers in the capitalist system consider them questionable, too.

What about the current state of household income? Sentier Research known for its thorough analysis of trends in household income, reported in March that median household income is now 3.5% higher than back in January 2000. Stagnation in household incomes finally broke after 18 years, which is good news.

However, the long-term financial distress to middle class wage earners may take decades to recover. The lingering financial vulnerability has done tremendous damage to the confidence in the American system, especially among post-Baby Boomer generations who feel their lives may never be as prosperous as their parents.

Chart #3 is an eye-opener, courtesy of Lance Roberts.

There is a marked deterioration in the willingness of corporations to share their prosperity with employees. The gaps of profits to employees and corporate unwillingness to share the wealth have never been so wide.

Lance’s analysis helped me to personally understand what I experienced at my former employer post-Great Recession. I lived these charts. I’m certain many readers have experienced the same. In my opinion, the interminable focus on shareholders over employees is one of the reasons extreme or outlier political views have become more widely accepted.

Last, The New School’s Schwartz Center for Economic Policy Analysis has undertaken eye-opening research which dives deep into the reality of U.S. retirement readiness. Teresa Ghilarducci, the Director of SCEPA along with her team, has been banging the drum hard over retirement inequality among lifetime earnings quintiles.

Low and moderate wage earners have experienced a dramatic deterioration in retirement wealth due to the death of pensions. However, there’s damage in every quintile which proves to me how defined contribution plans such as 401ks have failed a majority of Americans as primary retirement savings vehicles regardless of the impressive bull run in markets over the last 10 years.

Two major stock market derails along with a decade to break even after the financial crisis, lack of financial literacy, poor savings skills, oh, and the ability to tap plan account balances for loans and down payments for primary residences (which I believe is fiscally irresponsible), have proven that defined contribution plans should have remained a compliment to pensions as originally envisioned, not a replacement.

Per SCEPA’s analysis, among workers in the bottom fifth of the earnings distribution, the share of those with no retirement wealth increased from 45% to 51% between 1992 and 2010.

Workers are grouped below into five tiers of lifetime earnings. The share of total retirement wealth held by the top fifth of earners held steady from 1992 to 2010 at around half of all retirement assets. The lowest-earning quintile, meanwhile, held only 1 percent of retirement wealth in 2010, down from 3%.

Even WITHIN quintiles, the top 10% of savers held 10-20 times the retirement wealth of the bottom 10%.

Retirement inequality can compel workers to vote their dissatisfaction for mainstream political candidates within their respective parties.

Read The New School Policy Note here.

Corporate America has prospered enough to benefit both shareholders and employees. They have failed to do so. Shortsightedness and outright greed have allowed outlier political views to prosper enough for markets to pay attention.

Capitalism will always prevail over socialism. The proof is in the prosperity and growth we enjoy in America when compared to all other nations.

However, the C Suite’s bastardized definition of capitalism isn’t the answer. Nor is cloying regulation and massive Federal Reserve intervention appropriate responses.

If these conditions persist, be prepared for continued unwelcomed surprises to emanate from voting booths across America.

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 Computer

  • Two weeks ago, we took 20% of our position off the table to lock in some profit and protect capital.
  • Currently AAPL has retraced back to the 50% Fibonacci level and is holding support.
  • We would like to see a consolidation around support to add back into our holding.
  • Stop is set at $170

CHCT – Community Healthcare

  • Defensive Utility and Real Estate stocks continue to get a bid during turmoil.
  • CHCT continues to sit near highs and is overbought currently.
  • Look for a pullback to support at $33-34 to add to the position.
  • Stop-loss is moved up to $32

CMCSA – Comcast Corp.

  • CMCSA, despite the recent rout in the market, continues to hold up well.
  • The position is overbought and deviated from support.
  • Take profits and hold position long for now. Look for a pullback to support to add to the position.
  • Stop-loss remains at $39

COST – CostCo Wholesale

  • After almost giving up on COST last year, the company has performed well as defensive position continues to outperform during market volatility.
  • With the position overbought, but on a buy signal, we are looking for a pullback to support to add to our holdings.
  • Our stop is set at $220

DUK – Duke Energy

  • DUK has pulled back to support with the recent selloff in the market and needs to hold currently.
  • With the position not oversold and triggering a sell-signal we are monitoring the holding closely.
  • While we like Utilities here with respect to defensive positioning, DUK is performing less well than its cohorts in the portfolio.
  • Stop-loss is set at $86 for now.

JPM – JP Morgan Chase

  • After a sharp spurt higher last month, JPM is pulling back to support.
  • With JPM still on a buy signal, we can look to add to the position if support holds at $107.50
  • Our stop-loss is moved to $105

MDLZ – Mondelez International

  • After MDLZ broke out of its long consolidation, the price has remained elevated and extremely overbought.
  • After taking profits we are looking for an entry point to add back to the position. There simply isn’t one right now so we will be patient and watch.
  • We are moving our stop-loss up to $46

PEP – Pepsico, Inc.

  • Like MDLZ – consumer staples continue to attract money flows from their more defensive positioning.
  • Nonetheless, PEP is extremely overbought and needs to have a correction to add to the position.
  • Our stop-loss is moved to $118

PPL – PPL Corp.

  • PPL is another defensive Utility position to offset market risk in the short-term.
  • PPL is also one of the few utility companies which trades at a discount to fair value.
  • Stop loss is currently set at $30

XOM – Exxon Mobil

  • Give me credit! Or rather, Americans keep taking on more of it. V has held up well with the recent market swoon.
  • However, V remains extremely overbought and extended. We are looking for a better opportunity to add to the holding in the future.
  • Stop-loss is set at $145.
In June of 2018, as the initial rounds of the “Trade War” were heating up, I wrote:

“Next week, the Trump Administration will announce $50 billion in ‘tariffs’ on Chinese products. The trade war remains a risk to the markets in the short-term.

Of course, 2018 turned out to be a volatile year for investors which ended in the sell-off into Christmas Eve.

As we have been writing for the last couple of weeks, the risks to the market have risen markedly as we head into the summer months.

“It is a rare occasion when the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occur early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

“With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.”

Well, that certainly didn’t take long. As of Monday’s close, the entirety of the potential 5-6% decline has already been tagged.

The concern currently, is that while the 200-dma is critical to warding off a deeper decline, the escalation of the “trade war” is going to advance the timing of a recession and bear market. 

Let me explain why.

The Drums Of “Trade War”

On Monday, we woke to the “sound of distant drums” beating out the warning of escalation as China retaliated to Trump’s tariffs last week. To wit:

“After vowing over the weekend to “never surrender to external pressure,” Beijing has defied President Trump’s demands that it not resort to retaliatory tariffs and announced plans to slap new levies on $60 billion in US goods.

  • CHINA SAYS TO RAISE TARIFFS ON SOME U.S. GOODS FROM JUNE 1
  • CHINA SAYS TO RAISE TARIFFS ON $60B OF U.S. GOODS
  • CHINA SAYS TO RAISE TARIFFS ON 2493 U.S. GOODS TO 25%
  • CHINA MAY STOP PURCHASING US AGRICULTURAL PRODUCTS:GLOBAL TIMES
  • CHINA MAY REDUCE BOEING ORDERS: GLOBAL TIMES
  • CHINA ADDITIONAL TARIFFS DO NOT INCLUDE U.S. CRUDE OIL
  • CHINA RAISES TARIFF ON U.S. LNG TO 25% EFFECTIVE JUNE 1

China’s announcement comes after the White House raised tariffs on some $200 billion in Chinese goods to 25% from 10% on Friday (however, the new rates will only apply to goods leaving Chinese ports on or after the date where the new tariffs took effect).

Here’s a breakdown of how China will impose tariffs on 2,493 US goods. The new rates will take effect at the beginning of next month.

  • 2,493 items to be subjected to 25% tariffs.
  • 1,078 items to be subject to 20% of tariffs
  • 974 items subject to 10% of tariffs
  • 595 items continue to be levied at 5% tariffs

In further bad news for American farmers, China might stop purchasing agricultural products from the US, reduce its orders for Boeing planes and restrict service trade. There has also been talk that the PBOC could start dumping Treasuries (which would, in addition to pushing US rates higher, also have the effect of strengthening the yuan).”

The last point is the most important, particularly for domestic investors, as it is a change in their stance from last year. As we noted when the “trade war” first started:

The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”

Clearly, China has now put those options on the table, at least verbally.

It is essential to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. As you can see, there is a high correlation between fluctuations in the Yuan and treasury activity.

One way for China to both penalize the U.S. for tariffs, and by “the U.S.” I mean the consumer, is to devalue the Yuan relative to the dollar. This can be done by either stopping the process of sanitizing transactions with the U.S. or by accelerating the issue through the selling of U.S. Treasury holdings.

The other potential ramification is the impact on interest rates in the U.S. which is a substantial secondary risk.

China understands that the U.S. consumer is heavily indebted and small changes to interest rates have an exponential impact on consumption in the U.S.. For example, in 2018 interest rates rose to 3.3% and mortgages and auto loans came to screeching halt. More importantly, debt delinquency rates showed a sharp uptick.

Consumers have very little “wiggle room” to adjust for higher borrowing costs, higher product costs, or a slowing economy that accelerates job losses.

However, it isn’t just the consumer that will take the hit. It is the stock market due to lower earnings.

Playing The Trade

Let me review what we said previously about the impact of a trade war on the markets.

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

While the markets have indeed been more bullishly biased since the beginning of the year, which was mostly based on “hopes” of a “trade resolution,” we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the acceleration a “trade war.” 

In June of 2018, I did the following analysis:

“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

The red dashed line denoted the expected 11% reduction to those estimates due to a “trade war.”

“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.

The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.

Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has “broken,” but few are paying attention.

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that you will outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs, the decline will destroy most, if not all, of the returns accumulated over the last decade.

China understands that Trump’s biggest weakness is the economy and the stock market. So, by strategically taking actions which impact the consumer, and ultimately the stock market, it erodes the base of support that Trump has for the “trade war.”

This is particularly the case with the Presidential election just 18-months away.

Don’t mistake how committed China can be.

This fight will be to the last man standing, and while Trump may win the battle, it is quite likely that “investors will lose the war.” 

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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

  • As noted last week, XLB met its initial “match” at the downtrend resistance line from the 2018 peak. With the “buy” signal extremely extended as noted by the horizontal dashed red line, a correction was inevitable.
  • That correction begin in earnest last week and continued Monday with the resurgence of the trade war with China.
  • Short-Term Positioning: Neutral
    • Last Week: Hold position.
    • This Week: Sold 1/2 position on Monday with violation of Stop-loss.
    • Stop-loss moved up to $52, sell remaining half on rally..
  • Long-Term Positioning: Bearish

Communications

  • We noted that over the last few of weeks, XLC has gone parabolic as only a few number of stocks are driving the market now. As noted, it wasn’t a normal advance. We also stated that with the current “buy” signal very extended, and the sector very overbought, be patient for a better entry point.
  • The trade war hit the sector hard on Monday, violating support. XLC is not oversold yet so remain patient.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 position
    • This Week: Hold 1/2 position
    • Stop-loss moved up to $47
  • Long-Term Positioning: Bearish

Energy

  • As noted last week, the rally in oil prices pushed XLE into further resistance back at the November highs. The move failed at that level for now. With XLE impacted by trade disputes, the sector broke important support and the 200-dma on Monday.
  • The current “buy signal” remains intact and the sector is oversold short-term. Use any rally to reduce exposure to the sector for now.
  • Short-Term Positioning: Neutral
    • Last week: Hold and wait for a pullback to support to add.
    • This week: Stop violated, sell on rally that fails to get above $64 this week.
    • Stop-loss moved up to $64
  • Long-Term Positioning: Bearish

Financials

  • We noted last week that XLF broke out above initial resistance but was running into a cluster of previous tops from last year. That rally failed on Monday with the decline in the broad market.
  • While a “buy” signal has been triggered (bottom panel) the recent rally has pushed sector back to overbought.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, add on a pullback to $25 that holds.
    • Stop-loss moved up to $25.00
  • Long-Term Positioning: Bearish

Industrials

  • We noted previously that XLI had rallied sharply on hopes of a resolution on trade. However, with the failure of trade deal over the weekend, the risk is to the downside currently.
  • Buy signal in lower panel is very extended and at the highest levels we have seen in recent history. While XLI is not completely oversold yet, use a rally to reduce positioning in the sector for now.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “rebalance” and “hold” 1/2 position
    • This week: Sell 1/2 position on rally.
    • Stop-loss moved up to $72
  • Long-Term Positioning: Neutral

Technology

  • As noted last week, XLK is on a “Buy” signal (bottom panel) but that signal is “crazy” extended like many other sectors of the market. The market is becoming very confined to a smaller number of stocks leading the charge higher. Technology has become the poster child for momentum.
  • That all came undone on Monday with the rise of the trade war and XLK broke support at the previous highs from 2018.
  • The correction back to $75 in the near-term failed to hold which puts the sector as risk of a deeper decline.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Look to reduce holdings further on a failed rally back to $75
    • Stop-loss moved up to $70
  • Long-Term Positioning: Neutral

Staples

  • XLP held up much better than the broad market yesterday and money sought out safety in defensive sectors and fixed income.
  • XLP’s “buy” signal (lower panel) is back to extreme levels. So, taking profits remains advised.
  • Currently still overbought, however the pullback to $54-$54.50 can be used to add exposure.
  • Short-Term Positioning: Bullish
    • Last week: Holding full position, take profits and rebalance.
    • This week: Take profits if you haven’t done so.
    • Stop-loss moved up to $53.50
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE, along with XLU, found support on Monday and caught money looking for defense against the “trade war.”
  • We previously recommended taking profits and rebalancing risk. That is still advisable.
  • Buy signal is being reduced along with the overbought condition. This will set up an opportunity to add XLRE to portfolios here soon.
  • Short-Term Positioning: Bullish
    • Last week: “Hold” 1/2 position
    • This week: Looking to add 1/.2 position this week.
    • Add on any weakness that works off over-bought condition or holds support at $34.50
    • Stop-loss adjusted to $33.50
  • Long-Term Positioning: Bullish

Utilities

  • Like Real Estate above, XLU has finally taken a breather from its recent advance but not much of one.
  • Long-term trend line remains intact, and money is chasing XLU in defense from the trade war.
  • Previous support continues to hold.
  • Buy signal is beginning to work off some of the excess. (bottom panel) and the sector is once again oversold.
  • Short-Term Positioning: Bullish
    • Last week: Rebalance holdings and continue to hold.
    • This week: Hold position, look to add 1/2 position to portfolios.
    • Stop-loss moved up to $54.
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel) remains intact currently but previous support is holding.
  • While Healthcare is holding up better for now, there is a downtrend forming in the sector. Keeps stops in place.
  • XLV is reversing the oversold condition.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position.
    • This week: Hold current position.
    • Stop-loss set $86
  • Long-Term Positioning: Neutral

Discretionary

  • XLY was running well ahead of where it should be given the sensitivity to the U.S. consumer. The trade war put a little reality back in the sector on Monday.
  • The “buy” signal has been registered (lower panel) and is at extreme levels and was pushing Extreme overbought conditions.
  • The decline broke support at the 2018 highs which puts the January 2018 highs into focus.
  • Short-Term Positioning: Neutral
    • Last week: Rebalance, Take profits, Hold current position..
    • This week: Look to sell 1/2 position on a rally that fails at overhead resistance.
    • Stop-loss moved up to $112.50
  • Long-Term Positioning: Neutral

Transportation

  • While Transportation was finally trying to play catch up with the rest of the market, that came to a halt at the downtrend resistance line on starting last week.
  • Buy signal. (bottom panel) is maintaining itself and the short-term overbought condition is being reversed.
  • As we have been saying for several weeks, our “sell stop” was triggered previously. No real need to rush back into adding a new position. We will watch and see what happens.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: Looking to add a position that holds support at $56-57
  • Long-Term Positioning: Bearish

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

  • As noted last week, the SPY was testing the bottom of the uptrend line from both the 2017 post-election bounce and the 2016 lows. It failed.
  • Currently, SPY is correcting the overbought condition but is not oversold as of yet.
  • Also, as we noted last week, the “buy” signal in the lower panel is at a level which has always denoted at least short-term market tops.
  • Despite the correction last week, the risk still outweighs further reward. As discussed in this past weekend’s newsletter, there is a high probability of a correction during this summer to allow for better entry points.
  • Short-Term Positioning: Bullish
    • Last Week: Recommended taking profits
    • This Week: If you haven’t taken profits and rebalanced previously, now is the time.
    • Stop-loss remains at $280
  • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • From last week: “DIA is currently in the process of potentially setting up a double top. With earnings season drawing to a close focus will return back to fundamentals and economics which, beyond headlines, are showing significant weakness.” That double top process is sitting on important support currently.
  • Also from last week: “The test of highs in next few days will not be surprising. However, a failure at those levels, as stated will also not be a surprise.” Remain cautious again this week.
  • Market is working off the overbought but the current buy signal is extremely extended.
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 of position
    • This Week: Hold 1/2 of position
    • Stop-loss moved up to $255
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • While QQQ broke out to all time highs, it has been a narrow push with MAGA stocks driving index higher (MSFT, AAPL, GOOG, AMZN)
  • From last week; “With the market and the underlying “buy signal” extremely stretched to the highest levels we have seen in several years, an initial failure at these levels would not be surprising. The breakout to highs was not on inspiring volume.”
  • Support at $185 is important this coming week.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position, take profits, and rebalance holdings.
    • This Week: Same advice this week.
    • Stop-loss moved up to $180
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • Last week, we noted that Small Caps broke above resistance at the 200-dma. It didn’t last long and the SLY broke support last week.
  • Currently on a modest “buy” signal but now back to overbought, for now small-caps continue to lag the overall market.
  • Short-Term Positioning: Bearish
    • Last Week: Add initial 1/2 position.
    • This Week: Hold
    • Stop is at $67
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY failed at its support last week with the rise of the trade war.
  • Mid-caps are on a buy signal, however, that signal is at more extended levels with extreme overbought levels. The short-term overbought condition is being worked off.
  • Support needs to hold this week.
  • Short-Term Positioning: Neutral
    • Last Week: Add 1/2 position on any weakness that holds support.
    • This Week: Add 1/2 position on any weakness that holds support at $350
  • Long-Term Positioning: Bearish

Emerging Markets

  • Last week, EEM failed support with the initiation of tariffs which will have an adverse effect on those economies.
  • Last week we noted with the current “buy” signal, and the market itself extremely overbought, look for a pullback to support at the tops of the previous consolidation which works off some of the overbought condition to add to holdings.
  • The failure at support negates that recommendation.
  • Short-Term Positioning: Bullish
    • Last Week: Hold current position.
    • This Week: Hold current position but stops are adjusted to $41
    • Stop-loss moved up to $41
  • Long-Term Positioning: Neutral

International Markets

  • EFA also broke below important support last week, which also negates previous recommendations.
  • The downtrend from all-time highs remains and EFA is heading back to oversold levels.
  • The “buy signal” also remains extremely overbought in the short-term
  • Short-Term Positioning: Neutral
    • Last Week: Hold 1/2 position
    • This Week: Hold 1/2 position.
    • Stop-loss moved up to $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • As noted, the rally in oil had gotten way ahead of itself in the face of building supplies. The correction continues again this week.
  • There is support at $60 which needs to hold, otherwise we are looking at mid-$50’s in pretty short order if it doesn’t.
  • As noted three weeks there was a “decent risk of a short-term reversion to work off some of the extreme overbought condition.” That process continued this week.
  • Advice remains, this is a good opportunity to scalp some profits and reduce risk currently.
  • Short-Term Positioning: Neutral
    • Last Week: After taking profits, hold 1/2 position
    • This Week: Hold 1/2 position
    • Stop-loss adjusted to $58
  • Long-Term Positioning: Bearish

Gold

  • Two weeks, Gold broke critical support at the 61.8% retracement level of the previous decline. GLD is back to oversold but the “buy” signal is about to trigger a “sell.” It is critical the 50% retracement level holds which it did last week.
  • As noted last week: “Gold broke support at $121 which was our stop. However, with the more extreme oversold condition, and support at the 50% retracement level, look for a bounce to sell into unless the $121 level can be regained.” Gold closed the week above that level…so we are back on hold for now.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole position adjusted to $120
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Bonds rallied again this week as “trade war” rattled the equity markets sending money searching for “safety.”
  • Currently on a buy-signal (bottom panel), bonds are working their way back to short-term overbought currently.
  • Support continues to hold at $122, but there is risk to the trade still back into our range of $118 and $122.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
  • Short-Term Positioning: Bullish
    • Last Week: Trimmed 1/4th of holdings to take profits.
    • This Week: Hold current positions and look to add exposure if support holds.
    • Stop-loss adjusted to $120
    • Long-Term Positioning: Bullish

U.S. Dollar

  • With roughly 40-50% of corporate profits coming from exports, all commodities globally traded in dollars, and the dollar impact on the bond market, this is a key measure to watch. Trade war will have an impact across many sectors of the market and the dollar will likely tell the story.
  • Currently, the dollar is breaking out of previous resistance and has now registered a buy signal. The combination of these two catalysts suggests the dollar could rise toward $100 on the index.
  • Short-Term Positioning: Bullish
    • Buy a full position at current levels
    • Target for trade is $101-102
    • Stop loss is set at $96
Since the beginning of 2019, the market has risen sharply. That increase was not due to rising earnings and revenues, which have weakened, but rather from multiple expansion. In other words, investors are willing to pay higher prices for weaker earnings.

The issue, of course, is that while it may not seem to matter in the short-term, valuations matter a lot in the long-run.

I know what you are thinking.

“There is NO WAY cash will outperform stocks over the next decade.” 

I understand. After a decade-long market advance, it’s hard to fathom a period where stocks fail to perform. However, despite what you have been told, this time is not different, valuations do matter, and “no,” Central Banks do not have it all under control. (In reality, the Federal Reserve are the “Firemen” in Fahrenheit 451.)

While the media is rife with historical references about why you should only “buy and hold” investments over a 100-years, they tend to ignore the measures which dictate 5, 10, and 20-year investing cycles which have the greatest impact on most Americans.

Let me explain that.

Unless you have contracted “vampirism,” then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Despite commentary to the contrary, the evidence is quite unarguable. As shown in the chart below, the cyclical nature of valuations and asset prices is clear.

Not surprisingly, valuations are linked to future returns. This is as it should be, and why Warren Buffett once quipped:

“Price is what you pay. Value is what you get.” 

This is why over rolling 10- and 20-year periods you have stretches where investors make little or no money.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals. One great thing+ about valuations, such as CAPE, is that we can use them to form expectations around risk and return. The graph below shows the actual 20-year annualized returns that accompanied given levels of CAPE.

20-years is a long time for most investors. So, here is what happens to returns over a 10-year period from 30x valuations as we have currently.

Again, as valuations rise, future rates of annualized returns fall. This is math, and logic states that if you overpay today for an asset today future returns must, and will, be lower.

I know. Ten years is still long. How about 5-years?

We can reverse the analysis and look at the “cause” of excess valuations which is investor “greed.” As investors chase assets, prices rise. Of course, as prices continue to rise, investors continue to crowd into assets finding reasons to justify overpaying for assets. However, there is a point where individuals have reached their investing limit which leaves little buying power left to support prices. Eventually, prices MUST mean revert to attract buyers again.

The chart below shows household ownership of equities as a percent of household ownership of cash and bonds. (The scale is inverted and compared to the 5-year return of the S&P 500.)

Just like valuation measures, ownership of equities is also at historically high levels and suggests that future returns for equities over the next 5, 10, and 20-years will approach ZERO.

No matter how you analyze the data, the expected rates of return over the next decade will be far lower than the 8-10% annual return rates currently promised by Wall Street.

Every Year Won’t Be Zero

This is where things get confusing.

When you discuss a decade, or more, of near-zero returns it does NOT mean that every year will be ZERO.

During that period there is going to strong up years, an extremely bad year or two, then some more good years. In the end you average annual return for the past decade will be close to zero. (Here is an example of how that plays out.)

Or here is how it played out the last time we ran a large national debt, had high starting valuations, and had just finished a period of excessive investment accumulation. (1929-1948)

This is because there are only two ways in which valuations can revert to levels where future returns on investments rise.

  1. Prices can rapidly decline, or;
  2. Earnings can rise while prices remain flat.

Historically, option #2 has never been an outcome.

Michael Lebowitz explained why this is the case for our RIA PRO members (Try FREE For 30-days)

“The all-important link between stock prices, economic and productivity growth, and true corporate earnings potential are being ignored. Stock prices and many other investment asset prices are indirectly supported by the actions and opinions of the central banks. Investors have become dangerously comfortable with this dubious arrangement despite the enormous market disequilibrium it is causing. History reminds us time and again that a state of disequilibrium is highly unstable and will ultimately revert to equilibrium – often violently so.”

The Real Value Of Cash

For most of the last decade, the mantra was “T.I.N.A. – There Is No Alternative” because cash in the bank yielded ZERO.

Today that is no longer the case with money market yields now pushing 2%, or more, in many cases. Nonetheless, the belief was ingrained into the current investing generation that “cash” is a “bad” investment.

I do agree that if inflation is running higher than the return on cash, then you do lose purchasing parity power in the short-term. However, there is a huge difference between the loss of future purchasing power and the destruction of investment capital.

The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 (using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves to cash at a ratio of 23x.

(I would never recommend actually managing your portfolio this way, but this is for illustrative purposes.)

I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970’s there is a downward slope in the value of cash. While the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset concerning reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.

While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at low valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.

We can debate over methodologies, allocations, etc., the point here is that “time frames” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of loss of purchasing power is appropriate. Alternatively, if the holding of cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.

8-Reasons To Hold Cash

Over the last 30-years, I have that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong I make the proper adjustments to increase risk in portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.

Here are my reasons having cash is important.

1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash. 

2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are somewhat related. 

4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong because we have seen two declines of over -50%…just in the past two decades! Keep in mind, it takes a +100% gain to recover a -50% decline.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also simply transfers the “risk of being wrong” from one side of the ledge to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.” 

8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms. 

Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.

With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important. 

Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.

Besides, what’s the worse that could happen?

Last week, President Donald Trump reiterated his call for the Fed to cut interest rates:

President Trump is technically correct in saying that the economy (or, more accurately, the stock market) would “go up like a rocket” if the Fed cut rates by 1%, but only because doing that would supercharge the dangerous bubbles that are driving our growth. If Trump theoretically got his way and the Fed cut rates by 1% (assuming it was a preemptive move rather than a reaction to a sharp economic slowdown), the stock market would most likely launch a powerful 1999-style melt-up, which would ultimately culminate in an equally devastating bust like we experienced in the early-2000s.

Here’s what led to the 1999 market melt-up: the Asian financial crisis, the Russian debt default, and the resulting failure of U.S. hedge fund Long Term Capital Management roiled the financial markets in 1997 and 1998 and led to concerns about a more extensive contagion. Even though U.S. economic data was still very strong, Fed Chair Alan Greenspan cut the Fed Funds rate three times in rapid succession in late-1998 (25 basis points each time for a total cut of .75%) in an effort to shore up confidence and help cushion the U.S. economy.

Prudential Securities analyst Michelle Laughlin captured the thinking behind the rate hikes at the time:

This tells me the Fed is correctly looking forward, looking at the risk of consumers pulling back in spending because stocks have fallen. They’re working in anticipation of that to make sure the U.S. economy does not slip into recession. I’m very encouraged by the Fed’s action.

The Fed’s aggressive preemptive interest rate cuts in 1998 were like pouring gasoline onto a fire: the Nasdaq Composite Index exploded 280% in the next year-and-half as the dot-com bubble went into overdrive. Of course, the dot-com bubble peaked in March 2000 and the Nasdaq proceeded to crash 80% over the next three years. The Nasdaq’s bear market erased the entire post-1998 gain and then some.

There are enough parallels between today’s market and the late-1990s market that if Trump got his way and the Fed slashed rates aggressively, the U.S. stock market could pull another ’99. Though the S&P 500 is up 300% from its 2009 lows, it has basically stalled since the start of 2018. The market pulled back approximately 20% in late-2018 (in a move similar to 1998’s pullback), before the Fed panicked and backpedaled on its previously hawkish outlook for rate hikes and quantitative tightening.

In 1998, the U.S. stock market was already quite overvalued just like it is now (in both 1998 and now, the cyclically-adjusted P/E ratio was in the low-30s). After the Fed slashed rates in 1998, the stock market surged and the cyclically-adjusted P/E ratio went into the low-40s – an all-time high. If Trump gets his way, the market would likely surge and valuations would approach their old highs.

Considering how stretched today’s market already is, Trump’s demand for a 1% rate cut is nonsensical and downright dangerous. As a result of the current stock and bond market bubbles, U.S. household net worth has hit record levels relative to the GDP in recent years, which is a sign that household wealth is overly inflated. The last two times household wealth became so stretched relative to the GDP were during the dot-com bubble and housing bubble, both of which ended in disaster. If Trump got his way, the current household wealth bubble would inflate even further, which would result in an even more powerful crash in the end.

It is extremely irresponsible for President Trump to demand a strong interest rate cut and more quantitative easing at a time when asset prices are already so inflated. It appears that he cares more about having the Fed juice the financial markets to help ensure his 2020 election win rather than the long-term economic health of the country. Although the Fed is supposed to be independent to avoid influence from political leaders, reality is quite different: heavy pressure from Trump during the late-2018 market rout likely contributed to the Fed’s about-face on rate hikes. If there is another market rout or even the slightest sign of economic weakness, President Trump will undoubtedly step up the pressure on the Fed to cut rates. If Trump gets his way, the market may take off like a rocket, but will ultimately experience the mother of all crashes.


  • Market Review & Update
  • Game Of Thrones
  • Sector & Market Analysis
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Market Review & Update

As we discussed last Saturday it was important for the markets to hold within to consolidation band, or break out to the upside, if the bulls were going to maintain control of prices in the short-term. The return of “Tariff Man” put the markets back on edge. 

As I noted then:

“The market’s stellar run is set for a breather over the next couple of months. Specifically, as we approach the end of the seasonally strong period, the odds of a ‘reset’ rise markedly.”



I also discussed our portfolio actions with respect to our clients:

“This brings me to what we did with our equity portfolios last Tuesday and subsequently reported to our RIA PRO subscribers on Wednesday morning. (Try NOW and get 30-days FREE)

“A common theme through today’s report is ‘Profit Taking.’ Over the last couple of weeks, we have continued to discuss taking profits and rebalancing risks. Yesterday we sold 10% of our many of holdings prior to earnings to capture some profits. We also added to some of our Healthcare holdings which have been under undue pressure and represent value in a market that has little value currently.”

Yes, markets are hovering near all-time highs, and everything certainly seems to be firing on all cylinders. However, such is ALWAYS the case before a correction begins. Such is the nature of markets.”

Currently, the bulls do remain in charge, and as investors, we must “pay homage at the alter of momentum” for now. This aligns with a note my Canadian research department sent me from Tom McClellan last week:

“We are now 4-months into the rebound off of the Dec. 24, 2018 low, so it is a natural question to wonder if the uptrend is going to continue, or whether, instead the major averages are going to stop here at the level of the prior highs.  This week’s chart offers us some useful clues about which answer applies this time.

Here is the shortcut version: Gobs of breadth is a good thing.” – Tom McClellan, April 25th.

We agree, which is why we still maintain a long-bias towards equity risk. But, that exposure is hedged with cash and bonds which remain at elevated levels. As shown below, The summation index has turned lower which typically precedes correction periods in the market. This doesn’t mean the markets will “crash,” but does suggest downward pressure on asset prices in the near term. (It also doesn’t mean stocks won’t bounce while working their way lower either.)

“Momentum” driven markets are “fickle beasts” and will turn on you when you least expect it. 

In Tuesday’s technical update, I noted the fundamental underpinnings continue to erode which is consistently reducing the support for asset prices at current levels. To wit:

“Not only are earnings on the decline, but so is forward guidance by corporations.”

As we will discuss momentarily in more depth, the “Trade War” is not a good thing for markets or the economy as recently suggested by the President. David Rosenberg had an interesting point on this as well on Friday:

“Tracing through the GDP hit from a tariff war on EPS growth and P/E multiple compressions from heightened uncertainty, the downside impact on the S&P 500 would come to 10%. I chuckle when I hear economists say that the impact is small- meanwhile, global trade volumes have contracted 1.1% over the year to February…how is that bullish news exactly?” 

Remember, at the beginning of 2018, with “tax cuts” just passed, and earnings growing, the market was set back by 5% as an initial tariff of 10% was put into place. Fast forward to today, you have tariffs going to 25%, with no supportive legislation in place, earnings growth and revenue weakening along with slower economic growth. 

In the meantime, the bond market is screaming “deflation,” and yields have clearly not been buying the 3-point multiple expansion from the December 24th lows. 

Lastly, stock market positioning was excessively bullish with record long stock exposure combined with record shorts on the volatility index and our technical composite index back near record levels (shown below). 

The table was set for a decent correction; all that was needed was the right catalyst.

Since it is ALWAYS and unexpected event which causes sharp declines in asset prices, this is why advisors typically tell their clients “since you can’t predict it, all you can do is just ride it out.” 

This is not only lazy, but ultimately leads to the unnecessary destruction of capital and the investors time horizon.”

(If you missed that article, it contained our Portfolio Management Guidelines)

On a short-term basis, as shown below, the market is very oversold, so the bounce on Friday was expected (which is why we took on a trading position in 2x S&P 500 in our equity trading account.) However, we plan to use any rally next week to rebalance risk into as we head into summer. 

Most importantly, the failure of the market to confirm new highs now puts adds additional resistance and confirms the current topping process continues. 

The “megaphone” pattern which has continued to build over the last 18-months suggests a deeper correction is likely during the coming months. As I addressed on Tuesday:

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.

I am not suggesting you do anything, it is just something to consider when the media tells you to ignore history and suggests ‘this time may be different.’

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



Game Of Thrones

Just as Jon Snow faced the “White Walkers'” in the battle to save civilization, Trump has squared off with China again over trade. 

Most of the comments I have read about the ongoing “trade deal” negotiations are, in my opinion, wrong. The general belief is that China “wants” a deal with the U.S. and Trump has the upper hand in this matter. To wit a recent comment by Kevin Giddis via Raymond James:

“It doesn’t help when the Chinese reportedly backed away from issues important to the U.S. just days before they are set to meet to negotiate a deal. Could this be as simple as a ‘clash of culture,’ or the way each side has postured themselves to get a deal done?”

I believe this to be incorrect and I laid out my reasoning Tuesday in “Trade War In May, Go Away:”

“The problem, is that China knows time is short for the President and subsequently there is ‘no rush’ to conclude a ‘trade deal’ for several reasons:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. As I have stated before, China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 5-years at most. It is unlikely, the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that is unlikely to be supported in the future is unlikely. It is also why many parts of the trade deal already negotiated don’t take effect until after Trump is out of office when those agreements are unlikely to be enforced. 

Even with that said, the markets rallied from the opening lows on Monday in ‘hopes’ that this is just part of Trump’s ‘Art of the Deal’ and China will quickly acquiesce to demands. I wouldn’t be so sure that is case.”

Doug Kass agreed with my views yesterday:

“It was never likely that tariff pressures were ever going to force China to succumb and altar deep rooted policy and the country’s ‘evolution’ and planned economic growth strategies.

Trump’s approach failed to comprehend the magnitude of the tough structural issues (that were never going to be resolved with China) and, instead, leaned on a focus of the bilateral trade deficit. Technology transfer, state-sponsored industrial policy, cyber issues and intellectual property theft were likely never on the table of serious negotiation from China’s standpoint and despite Trump’s protestations that discussions were going well.

As I have suggested for months, the unilateral imposition of tariffs will cause more economic disruption than the Administration recognizes (in our flat and interconnected economic world):

  • China’s role in world trade is important – the country is the third largest exporter in the world.
  • Specifically, China is a prime source of cheap, imported goods for American consumers.
  • China is the largest owner of U.S. debt.

Last night at a political rally in the Panhandle of Florida the president said that “we don’t have to do business” with China. That statement is short-sighted.

I agree particularly with the last point. There is little evidence that U.S. consumers have the “willpower” to either forgo purchases or be willing to pay substantially higher prices. 

Trump was also misguided on Friday when he tweeted:

The economy is not built on “goodwill.”  Let’s examine his comment.

  • We tax China more, which means their consumption of U.S. products will decline as they seek cheaper sources elsewhere and in turn U.S. exports fall which comprises more than 40% of U.S. profits.
  • U.S. buys products from farmers and gives it poor countries. While a great idea from a humanitarian standpoint, and does stabilize farmers short-term, it again has a negative impact on exports and corporate profits from other sectors of the economy.
  • Trade is a zero-sum game. There is only a finite amount of supply of products and services in the world. If the cost of U.S. products and services is too high, China sources demand out to other countries which drain the supply available for U.S. consumers. As imbalances shift, prices rise, increasing costs to U.S. consumers. 

As noted, tariffs impact domestic consumers more than then impact to China. If tariffs impact China they stimulate their economy with massive credit injections just as we have seen them do recently. The U.S. doesn’t have that luxury currently which is why both President Trump and Vice-President Mike Pence have discussed the need to drop rates by 1% now while the economy is still expanding. To wit:

This is also extremely short-sighted and dangerous. 

Yes, it would have the effect of lifting markets higher temporarily, but would only ensure that the next recession and coinciding market crash would be larger with no “policy tools” available to offset the slide. 

Secondly, Trump attacking China on the trade deficit is equally short-sighted. 

We have run a trade deficit since Reagan came into office as American’s went on a “credit-driven” consumption spending spree. That deficit has continued to grow over the years as credit-based consumption in the U.S. has outstripped the rest of the world’s ability to keep pace. As a function, we import more than we export. 

Again, exports account for roughly 40-50% of corporate profitability and we are a very “flat and interconnected world.” 

The attack on the trade is having a knock-off effect of pushing the dollar higher which is a direct negative to exporting companies. Furthermore, global economic weakness is gaining steam and the demand for exports is declining. Note in the chart below, that it is not “negative” net exports that signal recessions, but it is when net exports peak and decline toward zero. (While 2012 was not an official recession, it was for all intents and purposes a manufacturing recession.)

The chart below deconstructs net exports (exports less imports, a direct input into the GDP calculation) where you can see that both the demand for exports and imports is declining. This is indicative of a weakening economic environment which will translate into weaker earnings for U.S. multi-national corporations. 

Trump is picking the wrong time in the cycle to add additional costs to both consumers and exporters. While imposing “tariffs” may sound like a good idea in theory, the reality is that it is the consumer that pays the price, literally.

For Trump…time is short.  A recession is coming and the Federal Reserve is already preparing for it. Via Mish Shedlock on Friday:

“Two Fed governors now propose targeting the long end of the yield curve if there is another recession.

Targeting yields on longer-term rates gets renewed attention from a second Fed governor. The proposed QE Replacement Mechanism was Last Used in WWII.

“Federal Reserve Governor Lael Brainard on Wednesday became the second U.S. central banker to talk about the possibility of targeting longer-term interest rates as a ‘new’ tool to combat the next recession.

Fed Vice Chairman Richard Clarida floated the idea in a speech earlier this year,and has done research on its use in Japan.

‘Once the short-term interest rates we traditionally target have hit zero, we might turn to targeting slightly longer-term interest rates—initially one-year interest rates, for example, and if more stimulus is needed, perhaps moving out the curve to two-year rates,’ Brainard said.

‘Under this policy, the Fed would stand ready to use its balance sheet to hit the targeted interest rate, but unlike the asset purchases that were undertaken in the recent recession, there would be no specific commitments with regard to purchases of Treasury securities,’ she added.”

Think Japan.

Brainard and Clarida are worried about the short end of the curve. Negative interest rates did not help the ECB nor Japan. Then again, pinning the 10-year yield at 0% did not help Japan either.

The result is easy to spot: bubbles and busts of increasing amplitude over time.

By the way, this talk is indicative of a Fed that is far more concerned about a recession than they want you to believe.

In 2007, the banks were preparing for a credit crisis. No one paid attention until it was too late. 

For the last 6-months, the Fed has consistently been leaking messages about rising risk in the credit markets and has been quietly prepping for a recession.

Once again, no one is paying attention

The problem for Trump has always been “time.” He entered office at the tail-end of an economic cycle, and while his policy prescriptions have certainly helped extend the current cycle, they haven’t, and won’t, repeal it. 

“Winter IS Coming.” 

The only question is whether investors are prepared for it?

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

See you next week.


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


NEW: Technical Composite


ETF Model Relative Performance Analysis


Sector & Market Analysis:

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

Sector Rotation Graph

Sector-by-Sector

Last week, I stated:

“Notice in the Sector Rotation Graph above that leadership is becoming much more narrow in the market (Technology, Discretionary, and Communications) all of which are being driven by just 5-stocks currently – MSFT, AAPL, GOOG, AMZN and FB.

The crowding of the majority of sectors into the LAGGING quadrant suggests we are likely close to experiencing a fairly significant rotation among sectors. Such would suggest a “risk off” rotation over the next couple of months which would likely coincide with a bid to more defensive sectors of the market. (Healthcare, Utilities, Real Estate, Bonds, Value vs. Growth)”

The number of sectors crowding into the lagging quadrant suggests a correction process is underway, and current leadership will turn lower. 

Improving – Energy

While Energy remains in the improving category, it only does so barely. If oil prices don’t pick up next week, it will join the majority of other sectors in the lagging camp. We recommended taking profits and rebalancing risk last week. That recommendation remains as the sector broke back below its 50-dma. 

Current Positions: 1/2 Position in XLE

Outperforming – Technology, Discretionary, Communications

Communications joined the “outperforming group” last week, however, with the exception of Technology, the outperformance of these sectors is marginal. As noted above, the outperformance of ALL THREE sectors is being driven by just 5-stocks. This isn’t really a sign of a strong market. Therefore, with all THREE of these sectors GROSSLY overbought so it is a good idea to take profits and rebalance portfolio risks accordingly.

Two weeks ago, we trimmed Technology and increased our weight in Healthcare.

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

Weakening – Real Estate and Industrials

Despite the “bullish” bias to the markets, the more defensive sectors of the markets, Real Estate has continued to attract buyers. That remained the same this week, particularly as bond yields declined following the resurgence of the trade war with China. However, Real Estate is still somewhat overbought but is correcting that condition and will provide a decent entry opportunity for positioning as a defensive play against a likely rotation out of Technology and Discretionary holdings. 

Industrials performance lead over the S&P 500 is weakening but the sector is still performing well with Materials on the hopes of a trade resolution. Take some profits, rebalance portfolios, raise stops but remain long for now

Current Position: XLI, will add XLRE opportunistically

Lagging – Healthcare, Staples, Financials, Materials and Utilties

As noted last week, “Materials is also on the verge of slipping back into underperforming the S&P 500 and also suggests, as recommended last week, to take some profits.”  That performance lag continued this week and Materials did indeed slip back into underperformance. 

Staples, while lagging the S&P 500, remain a sector where money is hiding. Staples remain on a buy signal but are extremely overbought and extended. Take profits and rebalance in portfolios.  The same goes for Utilities as well. 

Financials as noted last week are performing okay, so we are giving the sector some room and will re-evaluate holdings again next week.

As noted last week, we are still looking for a defensive rotation over the next couple of months. We remain overweight in Healthcare again this week. 

Current Positions: XLF, XLV, XLP, XLU

Market By Market

Small-Cap and Mid Cap – Small-cap failed to hold above it’s 200-dma last week which keeps us from adding a position in the position. However, Mid-cap did hold support and is performing better currently. We will add 1/2 position to Mid-Cap on Monday with a stop at the 200-dma. 

Current Position: Adding 1/2 Position SLY, MDY

Emerging, International & Total International Markets 

As noted last week,

“EEM did pull back to the 50-dma last week, and held support, so positions can be added with a very tight stop at the 50-dma currently. The rising dollar is a risk to emerging markets, so a break below the 50-dma will suggest a reduction in weightings.” 

The reinstitution of the “Trade War” kept us from adding weight to international holdings. We are keeping a tight stop on our 1/2 position of emerging markets but “tariffs” are not friendly to the international countries. 

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 remain currently at target portfolio weights but all three of our core positions are grossly overbought. A correction is coming, it is now just a function of time. 

Current Position: RSP, VYM, IVV

Gold – Last week gold held support and picked up performance as international tensions are rising. It isn’t just trade bringing some fear back into the markets, but rising tensions with Iran, North Korea, and China. Gold miners aren’t performing as well as Gold currently, but we will give GDX a little breathing room here. 

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

Bonds 

As noted three weeks ago, we said bonds were setting up for a nice entry point to add additional bond exposure. Bonds bounced off the 50-dma holding important support last week. Bonds are not overbought yet, so keep a close watch on holdings. 

Current Positions: DBLTX, SHY, TFLO, GSY

High Yield Bonds, representative of the “risk on” chase for the markets, continued to correct again last week but still remain overbought. As noted last week, “If the S&P 500 corrects over the next couple of months, it will pull high-yield (junk) bonds back towards initial support at the 50-dma.” That initial target was hit last week, however, it appears junk may push lower over the summer months. Last week, we recommended taking profits and rebalancing risk accordingly. International bonds, which are also high credit risk, have been consolidating over the last couple of weeks, but remains very overbought currently which doesn’t offer a decent reward/risk entry point. 

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:

Last week, the market began the long-awaited correction due to another round of “trade war ‘chicken’ with China.” With our near term buy signals in place, we didn’t need to take a lot of action after recent profit taking, but are now looking forward to opportunistically adding positions as the overbought conditions of the market are worked off. 

There are indeed some short-term risks in the market as we head into summer, so any positions added to portfolios in the near future will carry both tight stop-loss levels and will be trading positions initially until our thesis is proved out. 

  • New clients: We will use the recent correction to onboard clients and move into specified models accordingly. 
  • Equity Model: After taking profits recently, we will look to opportunistically add to our stronger positions with this recent pullback and are looking at adding both core equity holdings as well as some additional trading positions.
  • ETF Model: We will look to increase our equity exposure to target levels after the recent correction.

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

Trade War Returns

The market sold off last week as the “trade war” returned. 

As we have discussed over the last several weeks, the market was very overbought and in need of a rest. 

“As stated above, given the run higher this year, a retracement this summer is highly likely which will provide the best opportunity to tactically take portfolios to 100% of target. 

As is always the case, by the time these more ‘bullish” actions occur, the risk/reward opportunity in the short-term is not generally favorable. In this case, in particular, the angle of ascent of the markets from the December lows has been more abnormal than not.

That opportunity is coming soon, and is why ‘patience’ is required when investing.”

With that opportunity to add exposure to portfolios forming, we are now on alert next week for some resolution to “trade negotiations” that pulls the pressure off the market. With the markets holding support on Friday, this is good news and once we see how Monday opens we may be able to increase exposures to equities next week. 

Again, as noted last week,

“With both ‘buy’ signals now in place, we WILL move target allocations to 100% equity exposure on any corrective actions which reduces the extreme overbought short-term condition without violating important support.” 

In the meantime, we can prepare for this opportunity by continuing our actions we have recommended over the last several weeks. 

  • 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 – remain where you are until the market gives us a better opportunity to increase exposure to target levels.

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

Exciting News – the 401k Plan Manager is “Going Live”

We are making a “LIVE” version of the 401-k allocation model which will soon be available to RIA PRO subscribers. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more. 

This service will also be made available to companies for employees. If would like to offer our service to your employees at a deeply discounted corporate rate please contact me.

Stay tuned for more details over the next couple of weeks.

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

Pinterest, Zoom, Lyft and a host of other companies led a surge in Initial Public Offerings (IPOs) over the first four months of 2019. Totaling nearly $1 trillion in new offerings, 2019 is already closing in on the annual record set in 2000.  

The gray line in the chart above, courtesy Sentiment Trader, compares the S&P 500 to the annual amount of IPOs. The easy takeaway, given that two of the three prior high water marks in IPO issuance were 2000 and 2007, is that the current surge in IPOs bodes poorly for the stock market. Such logic follows that IPO’s, especially for companies with little to no earnings yet high growth expectations, are easiest to bring to market when investor complacency is high.

Comparing today’s IPO issuance to prior examples may prove wrong as it did in 2014. Investors must consider the overall supply of shares outstanding in the entire market before jumping to conclusions. The graph below, courtesy Ed Yardeni, shows net stock issuance, IPOs and share repurchases included, have been in decline over the past decade. It is possible that IPO issuance is just a small offset to the massive number of shares that corporations have bought back over the last few years and therefore it is not the warning sign some market prognosticators make it out to be.

“So, if the housing market isn’t going to affect the economy, and low interest rates are now a permanent fixture in our society, and there is NO risk in doing anything because we can financially engineer our way out it – then why are all these companies building up departments betting on what could be the biggest crash the world has ever seen?

What is more evident is what isn’t being said. Banks aren’t saying “we are gearing up just in case something bad happens.” Quite the contrary – they are gearing up for WHEN it happens.

When the turn does come, it will be unlike anything we have ever seen before. The scale of it could be considerable because of the size of some of these leveraged deals.”Lance Roberts, June 2007

It is often said that no one saw the crash coming. Many did, but since it was “bearish” to discuss such things, the warnings were readily dismissed.

Of course, what came next was the worst financial crisis since the “Great Depression.”

But that was a decade ago, the pain is a relic of history, and the surging asset prices due to monetary policies has once again lured both Wall Street and Main Street into the warm bath of complacency.

It should not be surprising warnings are once again falling on “deaf ears.”

The latest warning came from the Federal Reserve who identified rising sales of risky corporate debt as a top vulnerability facing the U.S. financial system in their latest financial stability report. Via WSJ:

Officials, for the second time in six months, cited potential risks tied to nonfinancial corporate borrowing, particularly leveraged loans—a $1.1 trillion market that the Fed said grew by 20% last year amid declining credit standards. They also flagged possible concerns in elevated asset prices and historically high debt owned by U.S. businesses.

Monday’s report also identified potential economic shocks that could test the stability of the U.S. financial system, including trade tensions, potential spillover effects to the U.S. from a messy exit of Britain from the European Union and slowing economic growth globally.

Specifically, the Fed warned a downturn could expose vulnerabilities in U.S. corporate debt markets, ‘including the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans.’”

It has become quite commonplace to dismiss the current environment under the thesis of “this time is different.” This was also the case in 2007 where the general beliefs were exactly the same:

  1. Low interest rates are expected to persist indefinitely into the future, 
  2. A pervasive belief that Central Banks have everything under control, and;
  3. The economy is strong and there is “no recession” in sight.

Remember, even though no one knew it at the time, the recessions officially started just 5-months later.

The issue of “zombie corporations,” or companies that would be bankrupt already if not for ongoing low interest rates and loose lending standards, is not a recent issue. Via Zerohedge:

“As Bloomberg reports, in a particularly striking sign, the Fed said the businesses with the biggest existing debt loads are also the ones taking on the riskiest loans. And protections that lenders include in loan documents in case borrowers default are eroding, the U.S. central bank said in its twice-a-year financial stability report. The Fed board voted unanimously to approve the document.

‘Credit standards for new leveraged loans appear to have deteriorated further over the past six months,’ the Fed said, adding that the loans to firms with especially high debt now exceed earlier peaks in 2007 and 2014.

‘The historically high level of business debt and the recent concentration of debt growth among the riskiest firms could pose a risk to those firms and, potentially, their creditors.’

Leveraged loans are routinely packaged into collateralized loan obligations, or CLOs. Investors in those securities — including insurance companies and banks — face a risk that strains in the underlying loans will deliver ‘unexpected losses,’ the Fed said Monday, adding that the secondary market isn’t very liquid, “even in normal times.”

‘It is hard to know with certainty how today’s CLO structures and investors would fare in a prolonged period of stress,’ the Fed added.”

Yes. CLO’s are back.

And it was the Central Bank’s largesse that led to the latest bubble. As noted by WSJ:

“Financial stability has remained a central focus at the Fed because of the easy-money policies employed to nurse the economy back to health in the years following the financial crisis. Critics have warned that the Fed’s large bond-buying campaigns and years of near-zero interest rates risked new bubbles.”

One of the common misconceptions in the market currently, is that the “subprime mortgage” issue was vastly larger than what we are talking about currently.

Not by a long shot. 

Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors.

Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.

Of course, that didn’t end so well.

Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well.

As noted by John Mauldin:

“In just the last 10 years, the triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high.

To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.

And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.”

As the Fed noted a downturn in the economy, signs of which we are already seeing, a significant correction in the stock market, or a rise in interest rates could quickly cause problems in the corporate bond market. The biggest risk currently is refinancing the debt. As Frank Holmes noted in a recent Forbes article, the outlook is rather grim.

“Through 2023, as much as $4.88 trillion of this debt is scheduled to mature. And because of higher rates, many companies are increasingly having difficulty making interest payments on their debt, which is growing faster than the U.S. economy, according to the Institute of International Finance (IIF).

“On top of that, the very fastest-growing type of debt is riskier BBB-rated bonds — just one step up from ‘junk.’  This is literally the junkiest corporate bond environment we’ve ever seen.  Combine this with tighter monetary policy, and it could be a recipe for trouble in the coming months.”

Let that sink in for a minute.

Over the next 5-years, more than 50% of the debt is maturing.

As noted, a weaker economy, recession risk, falling asset prices, or rising rates could well lock many corporations out of refinancing their share of this $4.88 trillion debt. Defaults will move significantly higher, and much of this debt will be downgraded to junk.

As noted by James Grant in a recent interview:

“Many companies will get into trouble if the real interest rate on ten-year treasuries rises over 1%. These businesses are so leveraged that they can’t cover their debt payments at levels even as humble and as low as a 1% real interest rate on ten-year treasuries as it translates into corporate borrowing. Just look at the growth in the herd of listed zombies; companies whose average operating income has fallen short of covering the average interest rate expense over three consecutive years. As it turns out, the corporate living dead, as a share of the broad S&P 1500 index, are close to 14%. Former Fed-Chairman Ben Bernanke once tried to reassure everyone that the Fed could raise rates in 15 minutes if it wanted to. Well, it turns out the Fed cannot do that. So, it’s a brave new world we’re living in.”

Not Just Corporate Debt

While subprime and CDO’s blew up the markets in 2008. It isn’t just corporate debt that has ballooned to problematic levels in recent years.

There is another financial risk of epic proportions brewing currently. If you are not familiar with “shadow banking,” you should learn about it quick.

Nonbank lending, an industry that played a central role in the financial crisis, has been expanding rapidly and is still posing risks should credit conditions deteriorate.

Often called ‘shadow banking’ — a term the industry does not embrace — these institutions helped fuel the crisis by providing lending to underqualified borrowers and by financing some of the exotic investment instruments that collapsed when subprime mortgages fell apart.

This kind of lending has absolutely exploded all over the globe since the last recession, and it has now become a $52 trillion dollar bubble.

In the years since the crisis, global shadow banks have seen their assets grow to $52 trillion, a 75% jump from the level in 2010, the year after the crisis ended. The asset level is through 2017, according to bond ratings agency DBRS, citing data from the Financial Stability Board.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, and a $5 trillion dollar funding gap, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. 

The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping, credit is collapsing, and shadow-banking freezes, the ensuing debacle will make 2008 look like mild recession. 

It is unlikely Central Banks are prepared for, or have the monetary capacity, to substantially deal with the fallout.

As David Rosenberg noted:

“There is no way you ever emerge from eight years of free money without a debt bubble. If it’s not a LatAm cycle, then it’s energy the next, commercial real estate after that, a tech mania years after, and then the mother of all of them, housing over a decade ago. This time there is a huge bubble on corporate balance sheets and a price will be paid. It’s just a matter of when, not if.”

Never before in human history have we seen so much debt.  Government debt, corporate debt, shadow-banking debt, and consumer debt are all at record levels. Not just in the U.S., but all over the world.

If you are thinking this is a “Goldilocks economy,” “there is no recession in sight,” “Central Banks have this under control,” and that “I am just being bearish,” you would be right.

But that is also what everyone thought in 2007.