Monthly Archives: June 2019

  • John Kelly – White House Chief of Staff
  • James Mattis – Secretary of Defense
  • Jeff Sessions – Attorney General
  • Rex Tillerson – Secretary of State
  • Gary Cohn – Chief Economic Advisor
  • Steve Bannon – White House Chief Strategist
  • Anthony Scaramucci – White House Communications Director
  • Reince Priebus – White House Chief of Staff
  • Sean Spicer – White House Press Secretary
  • James Comey – FBI Director

Every week is shark week in the Trump White House,” wrote The Hill contributing author Brad Bannon in August of 2018.  A recent Brookings Institution study shows that the turnover in the Trump administration is significantly higher than during any of the previous five presidential administrations. The concern is that for a president without government experience, a rotating cast of top administration officials and advisors presents a unique challenge for the effective advancement of U.S. policies and global leadership. Bannon (no relation to former White House Chief Strategist Steve) adds, “Inexperience breeds incompetence.”

Although the sitting president has broken just about every rule of traditional politics, it is irresponsible and speculative to assume either ineffectiveness or failure by this one argument. One area of politics that falls within our realm of expertise is a “rule” that Donald Trump has not yet broken; firing the Chairman of the Federal Reserve.

Following the December Federal Open Market Committee (FOMC) meeting in which the Fed raised rates and the stock market fell appreciably, Bloomberg News reported that President Trump was again considering relieving the Fed Chairman of his responsibilities. This has been a continuing theme for Trump as his dissatisfaction with the Fed intensifies.

Not that Trump appears concerned about it, but firing a Fed Chairman is unprecedented in the 106-year history of the central bank. Having tethered all perception of success to the movements of the stock market, it is quite apparent why the president is unhappy with Jerome Powell’s leadership. Trump’s posture raises questions about whether he is more worried about his barometer of success (stock prices) or the long-term well-being of the economy. Acquiescing to either Trump or a genuine concern for the economic outlook, Chairman Powell relented in his stance on rate hikes and continuing balance sheet reduction.

Clamoring for Favor

Notwithstanding the abrupt reversal of policy stance at the Fed, President Trump continues to snipe at Powell and express dissatisfaction with what he considers to have been policy mistakes. Before backing out of consideration, Steven Moore’s nomination to the Fed board fits neatly with the points made above reflecting the President’s irritation with the Powell Fed. Moore was harshly critical of Powell and the Fed’s rate hikes despite a multitude of inconsistent remarks. Shortly after his nomination, Moore and the President’s Director at the National Economic Council, Larry Kudlow, stated that the Fed should immediately cut interest rates by 50 basis point (1/2 of 1%). Those comments came despite rhetoric from various fronts in the administration that the economy “has never been stronger.”

Now the Kudlow and Moore tactics are coming from within the Fed. St. Louis Fed President James Bullard dissented at the June 19th Federal Open Market Committee meeting in favor a rate cut. Then non-voting member and Minneapolis Fed President Neel Kashkari publicly stated that he was an advocate for a 50-basis point rate cut at the same meeting.

All this with unemployment at 3.6% and GDP tracking better than the 10-year average of 2.1%. Given Trump’s stated grievance with Powell, Bullard and Kashkari could easily be viewed as trying to curry favor with the administration. Even if that is not the case, to appear to be so politically inclined is very troubling for an institution and board members that must optically maintain an independent posture. It is unlikely that anyone has influence over Trump in his decision to replace or demote Powell. He will arrive at his conclusion and take action or not. If the first two years of his administration tells us anything, it is that public complaints about his appointed cabinet members precede their ultimate departure. Setting aside his legal authority to remove Powell, which would likely not stand in his way, the implications are what matter and they are serious.

For more on our thoughts on the ability of Trump to fire the Fed Chairman, please read our article Chairman Powell You’re Fired.

Prepare For This Tweet

Given Trump’s track record and his displeasure with Powell, we should prepare in advance for what could come as a surprise Tweet with little warning.

Ignoring legalities, if Trump were to demote or fire Powell, it is safe to assume he has someone in mind as a replacement. That person would certainly be more dovish and less prudent than Powell.

Under circumstances of a voluntary departure, a replacement with a more dovish disposition might be bullish for the stock market. However, the global economy is a complex system and there are many other factors to consider.

The first and largest problem is such a move would immediately erode the perception of Fed independence. Direct action taken to alter that independence would cast doubts on Fed credibility. Other sitting members of the Federal Reserve, appointed board members, and regional bank presidents, would likely take steps to defend the Fed’s independence and credibility which could create a functional disruption in the decision-making apparatus within the FOMC. Further, there might also be an active move by Congress to challenge the President’s decision to remove Powell. Although the language granting Trump the latitude to fire Powell is obtuse (he can be removed for “cause”), it is unclear that Presidential unhappiness affords him supportable justification. That would be an argument for the courts. Financial markets are not going to patiently await that decision.

With that in mind, what follows is an enumeration of possible implications for various key asset classes.

FX Markets

The most serious of market implications begin with the U.S. dollar (USD), the world’s reserve currency through which over 60% of all global trade transactions are invoiced.  The firing of Powell and the likely appointment of a Trump-friendly Chairman would drop the value of the USD on the expectations of a dovish reversal of monetary policy. The question of Fed independence, along with the revival of an easy money policy, would likely cause the dollar to fall dramatically relative to other key currencies. An abrupt move in the dollar would be highly disruptive on a global scale, as other countries would take action to stem the relative strength of their currencies versus the dollar and prevent weaker economic growth effects. The term “currency war” has been overused in the media, but in this case, it is the proper term for what would likely transpire.

Additionally, the weaker dollar and new policy outlook would heighten concerns about inflation. With the economy at or near full employment and most regions of the country already exhibiting signs of wage pressures, inflation expectations could spike higher.

Fixed Income

The bond market would be directly impacted by Fed turbulence. A new policy outlook and inflation concerns would probably cause the U.S. Treasury yield curve to steepen with 2-year Treasuries rallying on FOMC policy change expectations and 10-year and 30-year Treasury bond yields rising in response to inflation concerns. It is impossible to guess the magnitude of such a move, but it would probably be sudden and dramatic.

Indecision and volatility in the Treasury markets are likely to be accompanied by widening spreads in other fixed income asset classes.

Commodities

In the commodities complex, gold and silver should be expected to rally sharply.  While not as definitive, other commodities would probably also do well in response to easier Fed policy. A lack of confidence in the Fed and the President’s actions could easily result in economic weakness, which would lessen demand for many industrial commodities and offset the benefits of Fed policy changes.

Stock Market

The stock market response is best broken down into two phases. The initial reaction might be an extreme move higher, possibly a move of 8-10% or more in just a few days or possibly hours. However, the ensuing turmoil from around the globe and the potential for dysfunction within the Fed and Congress could cause doubt to quickly seep into the equity markets. Two things we know about equity markets is that they do not like changes in inflation expectations and they do not like uncertainty.

Economy

Another aspect regarding such an unprecedented action would be the economic effects of the firing of Jerome Powell. Economic conditions are a reflection of millions of households and businesses that make saving, investing, and consumption decisions on a day-to-day basis. Those decisions are dependent on having some certitude about the future.

If the disruptions were to play out as described, consumers and businesses would have reduced visibility into the future path for the economy. Questions about the global response, inflation, interest rates, stock, and commodity prices would dominate the landscape and hamstring decision-making. As a result, the volatility of everything would rise and probably in ways not observed since the financial crisis. Ultimately, we would expect economic growth to falter in that environment and for a recession to ensue.

Summary

Although economic growth has been sound and stocks are once again making record highs, the market and economic disruptions we have recently seen have been a long time coming. Market valuations across most asset classes have been engineered by excessive and imprudent monetary policy. The recent growth impulse is artificially high due to unprecedented expansion of government debt in a time of sound economic growth and low unemployment. In concert, excessive fiscal and monetary policy leave the markets and the economy vulnerable.

The evidence this year has been clear. Notwithstanding the Federal Reserve’s role in constructing this false reality, President Trump has not served the national interest well by his public criticism of the Fed. If Trump were to remove Powell as Fed chair, the prior sentence would be an understatement of epic proportions.

Hello, my name is Seth and I’m a recovering perma-bear. (Hi Seth.) It’s true that I used to think that doom was inevitably just another quarter or two away. I was hyper-aware of the business cycle and the encroachment of government into the free markets. Thus, I concluded that growth would end soon. From an investment perspective I was simply wrong. It’s only now that I know that I lacked a robust process—a way of making sense of the investment landscape so that I could act profitably; that investing is mostly about managing losses; and that human ingenuity can overcome lots of adversity.

I’m better now, truly. Yet, I find myself terrorized by the current economic landscape in the U.S. It appears to be weakening. Due to my affliction predisposition, I am mindful of confirmation bias. Herein lies my conundrum. What’s a recovering bear to do at such a crossroad?

There’s only rightful action to take; look at the objective facts, stripped of opinion.

Below is a shortlist of interesting charts that, in my opinion, characterize the economic landscape. To be sure, there is an endless, complex list that one can examine. However, my purpose here is not to make a call on the economy, per se. Rather, it’s to fortify my process; to look for confirming and refuting evidence. This blog, after all, is like my therapy. Thus, I will keep things simple and look at five sets of data for both the bullish and bearish cases.

Some Bearish Facts

To me, there is no better economic signal than the yield curve. While there are plenty of pundits with plenty of reasons for why one should discount its bearish message, explaining away the data is precisely what I’m trying to avoid. The simple fact is that inversions (and subsequent steepenings) have strong correlations with forthcoming recessions (importantly, not causation). They don’t, however, time them well. The yield curve first inverted in March. This is nothing to ignore.

The economy is often touted as strong. However, the trend in corporate profits reveals otherwise. They actually peaked in the third quarter of 2014 and have been declining ever since. Note that last year’s tax cuts did in fact reverse the trend on an after tax basis (red line), but no benefit to pretax earnings (blue line) are evident. Since economic activity is strictly a function of production, corporate profits are the best measure, in my view, of the economy’s health. Note that this is different and more robust than the oft-cited S&P 500 earnings per share metrics

The trend in ISM’s manufacturing Purchasing Managers’ Index (PMI) is another negative item. It has a long history as a leading indicator of business cycles. We can see below that manufacturing PMIs have trended sharply lower for both the U.S. and elsewhere. This likely portends weakening conditions ahead.

Employment trends are also cited as a strength of the economy. However, it is a lagging indicator. Initial jobless claims provide a more real-time snapshot. Here, we can observe two facts. The first is that initial claims are at extremely low levels. While this appears bullish, they might have recently bottomed. A reversal in trend—which is too early to call just yet—would be troublesome.

Purchases of big ticket items, such as cars, can also provide some economic insight. Declining auto sales are more data that paint a gloomy economic picture. Of note, they have plateaued for both new (the first chart below) and used cars (the second chart below). True, they are coming off high levels, and used car sales rebounded as of late (not shown); but declines are declines nonetheless.

Some Bullish Facts

To be sure, not every data set is negative. Perhaps the most obvious, positive signal is the U.S. stock market. Equities are discounting mechanisms. If investors were truly worried that a change in corporate fortunes were upon us then this sentiment should be reflected in equity prices. Sitting near the at-time-highs suggests that investors are not concerned.

Retails sales are also strong. While no economy, including the U.S., is “consumer led” (I’m sorry, consumer spending makes up 70% of GDP which is only a proxy for economic output, not an actual measure of it), a drop in spending would logically follow a drop in economic production. Here too, we see continued year-over-year expansion of demand.

While manufacturing PMIs are trending lower and flirting with contractionary levels, ISM’s U.S. service sector PMI points to continued growth. This tempers the former’s negative read since the service sector is the larger of the two.

ISM’s Non Manufacturing PMI indicates future growth is likely.

source: tradingeconomics.com

As noted above, employment trends are still positive. Unemployment remains low and has yet to bottom. Furthermore, worker compensation is on the rise. These also suggest that economic conditions remain favorable.

However, the most bullish signal to me is that being bearish is commonplace. Growth scares tend to catch people by surprise. Thus, today’s setup does not seem conducive to producing the kind of negative shock that leads to market selloffs. As shown below, most investors are already defensively positioned.

Looking Both Ways

So there you have it, a bunch of facts about the economy and markets. While I come out bearish, the purpose of this is article is not to convince you of my position. Rather it’s to present some commonplace data in order to overwhelm my own inherent biases.

Does a weakening economy mean recession? Hardly so. However, if one mentally models economies and markets as carry trades (as I explain here and more thoroughly in this report beginning on page 7) it becomes evident why even slowing of growth matters. But even if a recession were obvious and evident, we investors care about asset prices, not recessions as such. Thus, profitable trading might entail positioning in counterintuitive ways.

The first step to recovery is admitting that you have a problem. I suffered from a major case of perma-bear-itis. Building a process is just the second rehabilitating step. Progress comes piecemeal. Thus, this recovering perma-bear intends to thoroughly look both ways before venturing out across the investment crossroads.

The labor market is tight. However, summer jobs for teens, especially in leisure and hospitality are in demand.

While just 35% of teens aged 16-19 participated in the labor market last year, global outplacement and business and executive coaching firm Challenger, Gray & Christmas, Inc. predicts job opportunities could increase around 5% this year and the teen participation rate could rise as well, according to its 2019 annual outlook.

How can you as a parent make the most out of your teen’s first summer job? Here are 3 money tips. Don’t let an opportunity to make the most of the experience fade away before the new school year starts.

Celebrate the ‘rite of passage’ from payout to paycheck.

Most likely, there’s been a long-standing allowance agreement at home. Sure, you taught the basics of save, share and spend early on, helping your child formulate a simple yet impressionable strategy of monetary discipline. It’s time to re-visit the discussion. The addition of sweat equity adds another dimension to save, share and spend. Have a “big picture” talk and explore how take-home pay was allocated.

Celebrate the wrap-up of such an accomplishment at a special yet informal setting – Allow your child to share deeper thoughts around save, share and spend. Initiate the “Level 2, Triple S” protocol. 

No, it’s not the title of a new Mission Impossible movie. It’s how Save, Share and Spend takes on renewed relevance in proportion to the past. It’s the “Triple S, Level 2” rite of passage. As a child, allocating an allowance or cash for chores, was important. With a summer job, parents and kids make allocation decisions with greater impact.

Oh, there’s another interested party looking to share in your child’s success: It’s the IRS. Taxes are now a consideration. As an employee, your child was to complete a W4 form to indicate the correct amount of tax to be withheld from each paycheck. For 2019, a dependent youth doesn’t require a tax return filed if earnings do not exceed $12,200.



Fund a Custodial Roth IRA.

Working leads to new investment vehicle opportunities. Fund a Custodial Roth IRA with a savings allocation of at least 30% of summer earnings directed into a Roth as a contribution. For 2019, the maximum that can be placed in a Roth IRA is $6,000. Even invested conservatively, a $1,500 deposit, earning annually at 4% has the potential to be worth over $11,000 tax-free by the time your teen reaches 67 years old.

Time is your child’s greatest ally; part-time employment provides the opportunity to jumpstart full-time retirement.

Start a cash-flow discovery exercise.

Emphasize budgeting in your discussions. It’s crucial children maximize what’s left of a paycheck after taxes and savings. Teach kids to make saving a priority and to pay themselves first. It’s one of the best financial habits you can instill as parents. Set aside 20 minutes, initiate a “cash flow discovery” exercise to review expenditures and the overall work experience. A paycheck is exciting. Some kids get carried away and go through what I call an “independence splurge” where spending increases along with the first paychecks.

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AAPL – Apple, Inc.

  • We previously took 20% of our position off the table at the beginning of May. Since then, AAPL has mustered a meager rally and is holding above its short-term moving average.
  • With AAPL not overbought yet, and still on a buy signal currently, we are maintaining our reduced position.
  • We currently don’t see a need to increase our weight at this time.
  • Stop moved up to $180.

AGNC – AGNC Investment Corp.

  • We added two positions to our portfolio as of late to take advantage of a “steeper” yield curve which we should see prior to the onset of a recession. (The steeper curve is from short-term yields falling faster than long-term yields)
  • We bought 1/2 position initially as AGNC is still on a sell signal but is deeply oversold and holding a long-term base of support.
  • With a yield of nearly 13% we don’t might holding the position while waiting on capital appreciation down the road.
  • Stop-loss is set at $15.50

NLY – Annaly Capital Management

  • The second of our “steepner” plays in Annaly Mortgage. Like AGNC, both of these companies hold government guaranteed mortgages which benefit from a steeper yield curve.
  • NLY pays nearly a 10% dividend yield, so like AGNC we can get paid to wait for capital appreciation to come.
  • We bought 1/2 position currently as NLY remains on a sell signal currently but is deeply oversold.
  • Stop-loss is set at $8.50 currently.

GDX – Gold Miners

  • GDX was added to our portfolios to hedge against potential volatility and rate risk in portfolios.
  • The hedge worked well in the recent sell-off and broke out of resistance on news of the ECB becoming more dovish along with the Federal Reserve.
  • We continue to hold our position for now and with the break above $23 we can actively start looking for an opportunity to increase our holdings further.
  • A pullback to $23-24 would provide a decent entry point.
  • Our stop is set at $20

DUK – Duke Energy

  • As noted last week:
    • “Of our defensive Utility exposure DUK has weakened in terms of performance lately and is sitting on important support. The lack of performance has to do with the current “Sell” signal which we are watching closely.”
  • This past week DUK broke out of its consolidation pattern and surged to close at all-time highs. This push higher has also started to reverse the short-term sell signal.
  • With the break above resistance we can look to add to our position opportunistically if the overbought condition is reduced somewhat.
  • Stop-loss remains at $86 for profits and an absolute stop at $83.

HCA – HCA Healthcare

  • HCA broke above resistance this past week and looks set to also reverse the sell signal that has plagued the stock for this entire year.
  • We like our healthcare exposure and this uptick provides support for our defensive positioning case.
  • HCA is not overbought and if the sell signal is reversed we will look to add to our position.
  • We remain long our position currently and our stop-loss remains at $120

IAU – Ishares Gold Trust

  • Like GDX, we added IAU previously as a hedge against volatility risk. The recent spike in Gold confirms our position as well as the reconstituted buy signal.
  • We will look to add to our position on a pullback that doesn’t violate support or reverse the current buy signal.
  • Stop-loss is set at $12

JNJ – Johnson & Johnson

  • Like HCA, JNJ has also gotten a nice boost higher as “defensive” position continues to attract money floes as yields fall.
  • Yield stocks perform better in slow growth economic environments and the break out of the consolidation we have see as late provides support to hold our position along with the reaffirmed buy signal.
  • With JNJ back to very overbought conditions we will look for an opportunity to add to our position as needed.
  • Stop-loss is moved up to $130

UNH – UnitedHealth Group

  • Our worst healthcare performance comes from UNH. We like the company and where it is positioned currently so we remain long our holding.
  • UNH is coming off a deep oversold condition and is VERY close to registering a confirmed buy signal.
  • We will add to the position on a confirmed break above the current downtrend which could come from better than expected earnings.
  • Stop loss is currently set at $230

UTX – United Technolgies

  • UTX has been a bit of a laggard after a stellar run from the December lows.
  • Currently, UTX is holding support and is close to registering a short-term sell signal.
  • A break above $135 will make UTX much more interesting.
  • The technical set-up is not great, so we are not rushing to add more to our holdings and we are looking to tighten up our stops.
  • Stop-loss is moved up to $122.50

For the fourth time, since the end of 2017. the market has set an all-time high. Each previous all-time high has led an almost immediate sell-off. 

Will this time be different?

Such is the belief currently which is being driven primarily by the “Pavlovian” response of a more “accommodative” Federal Reserve which is expected to cut rates sharply by the end of this year. It is also the “hope” there will be a resolution to the ongoing “trade war” with China at the G-20 Summit next week. 

Nowhere was this “Pavlovian” response more evident than in Jeffry Bartash’s latest post for MarketWatch:

A stream of negative news pointing to a slower economy has not only failed to halt the latest bull run on Wall Street, it’s actually encouraged investors to snap up more stocks.

In the sometimes wacky world of Wall Street, the reason is understandable enough. Investors expect weaker U.S. growth to force the Federal Reserve to cut interest rates and supply more stimulus to the economy. Lower rates also make stocks more attractive investments.”

After a decade of near zero interest rates, $33 Trillion in liquidity, and a seemingly unstoppable “bull market run,” which was caused by zero-rates and an endless stream of liquidity, it is not surprising investors expect the same outcome – forever.

However, assumptions are always a dangerous thing. Markets have a nasty habit of doing exactly the opposite of what the masses expect. 

As I noted this past weekend:

“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. Today, it is entirely reversed.

The extremely negative environment that existed in 2009, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more different.

Lowering interest rates and quantitative easing are ‘incentives.’ Incentives work when there is pent-up demand for a product, but are much less effective when everyone always has what you’re offering.  

There is little “pent-up” demand for assets currently, which increases the risk of disappointment. 

Nonetheless, the “hope” of lower interest rates, and more liquidity, certainly provided the support needed in June for the “sellable rally” we discussed at the end of May.

“In the very short-term the markets are oversold on many different measures. This is an ideal setup for a reflexive rally back to overhead resistance.” 

The chart below shows that previous test of multiple support levels and the rally back to overhead resistance. 

While there is nothing wrong with “hoping” for rate cuts and a positive outcome from “trade talks,”  the rush to “buy”equities has effectively “priced in” the best of all possible outcomes. This leaves investors vulnerable a whole host of possible disappointments:

  1. Trade deal isn’t reached as China refuses to give in to demands for economic reform. 
  2. Trade deal is made but the magnitude of concessions is disappointing.
  3. Trade deal gets extended, again, with no real progress towards a “deal.”
  4. Trade deal made and tariffs are ended, but such is likely already priced into current asset prices. 
  5. Trade negotiations collapse. (Worst possible outcome.)
  6. Fed doesn’t cut rates as soon, or a much, as the market is hoping for.
  7. The Fed cuts rates but signals that further rate cuts may not come.
  8. The Fed stops QT but provides no guidance towards restarting QE.

The point is that there are more than a few outcomes which could disappoint the financial markets. One of the most likely outcomes is a “buy the rumor, sell the news” type event, and if the news is bad, the resulting sell-off could be larger than currently anticipated.

Market Has Gotten Way Ahead Of Itself

While I am not suggesting the markets are about to suffer a massive correction, I am suggesting the markets have gotten a bit ahead of themselves. Short-term technical indicators also show the violent reversion from extreme oversold conditions back to extreme overbought, and prices are more than 6% above their 200-dma. Rapid deviations from the mean tend not to last long and tend to revert with some consistency. The last three all-time highs met a similar fate.

More importantly, the breadth of the breakout in the S&P 500 has been fairly narrow as shown in the chart below. When the S&P 500 market cap weighted index performs much better than the equal-weighted index, it is a sign money is crowding into the largest-capitalization weighted stocks. A reversion was generally quick to follow.

Interest Rate Cuts May Not Be Enough

While it is currently hoped that interest rate cuts will be enough to sustain the bull market rally indefinitely into the future, there is a potential argument which suggests this may not be the case. 

Share buybacks.

Here is the most important point:

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

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

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

As shown in the chart below since 2014, almost 100% of net purchases belong to corporations.

But that may well now be coming to an end. As the benefit of the recent tax cut legislation fades, the amount of capital for share repurchases is declining. 

It is likely that 2018/2019 will be the potential peak of corporate share buybacks, thereby reducing the demand for equities in the market. 

This “artificial buyer” explains the high degree of complacency in the markets despite recent volatility. It also suggests that the “bullish outlook” from a majority of mainstream analysts could also be a mistake. 

If the economy is weakening, as it appears to be, it won’t be long until corporations redirect the cash from “share repurchases” to shoring up operations and protecting cash flows. 

It may seem the markets are currently ignoring the poor economic data and weakening earnings, but such may only be a temporary issue.

The important point here is that from a contrarian standpoint, markets have gotten way ahead of the underlying fundamentals. While the market may indeed end the year on a higher note, it will most likely not do that without lower prices first. 

This was supported by data recently from Ned Davis research:

“It is easy to imagine bullish paths for a second-half recovery. The self-sustaining route would be the natural rebound in the earnings cycle aided by an end to the trade war with China and a bottom in the global economy. The less graceful path would involve the Fed moving to an easing policy after economic data and/or equity markets clearly deteriorate.”

Steve Deppe also made an important observation Twitter that when the S&P 500 has gained at least 2% in a week and finished at a new weekly high — the case on Friday — the S&P was lower six weeks later 70% of the time.

 

This data supports much of our own analysis which suggests that investors will be better off waiting for a corrective process, at least back to the 200-dma, before taking on additional equity exposure. 

The current “all-time” high appears to be a classic “bull trap” in the making. Erring to the side of caution, for now,, will likely be the right choice.

Conclusion & Suggestions

While remain primarily allocated toward equity risk, we have, as noted at the beginning of May, taken profits and shifted our bias towards more “defensive” holdings. We still carry a higher than normal slug of cash, and both lengthened duration of our bond portfolios and added gold as a hedge. 

We are expecting a further correction over the next couple of months which we will use to adjust our exposures accordingly depending on how markets are developing as summer comes to its conclusion. In the meantime, we continue to suggest following a regular regime of risk management in portfolios. 

Step 1) Clean Up Your Portfolio

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

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

Step 3) Have positions ready to execute accordingly given the proper market set up.

As noted previously in 10-Investment Wisdoms:

“The absolute best buying opportunities come when asset holders are forced to sell.” – Howard Marks

We haven’t gotten to that point just yet.

Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

In Part I, we discussed the problems with the “savings” side of the equation as it relates to building wealth.

It is always interesting reading article comments as they are generally full of excuses why saving money and building wealth can’t be done. The general thesis is that as long as you have social security (which is threatening payout cuts over the next decade) and/or a pension (which only applies to 15% of the country currently,) then you don’t need to save as much. 

Personally,  I don’t want my retirement based on things which are a) underfunded 2) subject to government-mandated changes, and 3) out of my control. In other words, when planning for an uncertain future, it is always optimal to hope for the best but plan for the worst.

However, the premise of the article was to clear up the disconnect between the cost of living today and 30-years into the future, as well as the amount of money needed to be financially independent for the entire lifespan after retirement.

Yes, we can all get by on less, in theory. But an examination of retirement savings statistics and the cost of healthcare in retirement (primarily due to poor healthcare habits earlier in life) doesn’t necessarily support those comments that saving less and being primarily dependent on Social Security is optimal. 

The Investing Problem

While “Part One”  focused on the amount savings required to sustain whatever level of lifestyle you choose in the future, we also need to discuss the issue of the investing side of the equation. 

Let’s start with a comment made on Part-One of this series:

“If you want to play it safe just buy a no-load, low fee, index fund and index into it regularly. Pay yourself first. Let the power of compounding do its magic.”

See, it’s so easy. Just buy and index fund, dollar cost average into it, and “bingo,” you have got it made. 

Okay, I’ll bite. 

If that is the case, then why this?

“More than half of Americans who were adults amid the Great Recession said they endured some type of negative financial impact, Bankrate found. And half of those people say they’re doing worse now than before the crisis.”

Or this:

“According to a brand new survey from Bankrate.com, just 37% of Americans have enough savings to pay for a $500 or $1,000 emergency. The other 63% would have to resort to measures like cutting back spending in other areas (23%), charging to a credit card (15%) or borrowing funds from friends and family (15%) in order to meet the cost of the unexpected event.”

As I stated in the previous article, I am all for any program and process which encourages people to save and invest for their retirement. My hope is that we can clear up some of the “misconceptions” to improve the chances that retirement years are not spent collecting food stamps and shopping at the local “Goodwill” store, 

Let’s start by clearing up the numerous erroneous comments on the previous article with respect to returns and investing. 

Compound & Average Are Not The Same Thing

” Markets have returned roughly 10% per year of compounded growth, INCLUDING the down years.”

What the commenter is confused about is, as stated previously, is that markets have variable rates of returns. Historically, over the last 120 years, the market has AVERAGED roughly 10% annually. (6% from capital appreciation which is equivalent to the long-term economic growth rate, and 4% from dividends. Today, economic growth is averaging 2%ish since 2000 and dividends are 2% so do the math for future return expectations. 2+2=4%. (Since 2000, average growth has been just a bit more than 5% and the next bear market will roll that average back to 4%)

The chart below shows the difference in nominal values of $1000 invested on an actual basis versus a compounded rate of return of 6% (For the example we are using capital appreciation only.)

Mathematically, both of those lines equate to a 6% return.

The top line is what investors THINK they will get (compound returns.) The bottom line is what they ACTUALLY get 

The difference is when losses applied to invested dollars. The periods of time spent making up previous losses is not the same as growing money. (Bonds, which mature at face value and have a fixed coupon, have had the same return as stocks since the turn of the century.)

This “math problem” is the reason there is a pension fund crisis in the U.S. The massively underfunded pension system was caused by depending on 7%-annual returns in order to reduce saving rates. 

Variable Rates Of Return Change The Game

In Part 1, we laid out a simple example of various current incomes adjusted for inflation 30-years into the future. I am presenting the chart again so the subsequent charts have context.

Now, let’s look at the impact of variable rates of returns on outcomes.

Let’s assume someone starts a super aggressive program of saving 50% of their income annually in 1988. (This was at the beginning of one of the greatest bull market booms in history giving them every advantage of front loaded returns and they get the benefit of the last 10-year long bull market.)  Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

Wow, they certainly saved a lot of money, and they met the amount need to completely replace their inflation-adjusted living standards for the rest of their lives.

Unfortunately, our young saver didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

Given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is likely unrealistic. If it wasn’t then we would not have statistics like this:

Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually. (Which is theMagic Number” for success)

Okay, it’s not so “Magic.” 

There are two important things to note in the charts above. 

The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 13-year period from 2000 to 2013 which left individuals far short of their retirement goals. 

What the majority of investors misunderstand when throwing around numbers like 6% average returns, 10% compound returns, etc., is that losses matter, and they matter a lot.

Here are the TWO most important lessons:

  1. Getting back to even is not the same as making money.
  2. The time lost in reaching your financial goals can not be recovered.

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is during these long periods where valuation indicators “appear” to be “wrong” that investors dismiss them and chase market returns instead.

Such has always, without exception, had an unhappy ending. 

Things You Can Do To Succeed

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting”events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. As an example, the chart below shows how using a simple 12-month moving average to avoid major drawdowns can impact long-term returns. We used the same 10% savings rate as above, dollar cost averaged into an S&P 500 index on a monthly basis, and moved to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually. It doesn’t matter what methodology you use to minimize risk, the end result will be same if you can successfully navigate the full-cycles of the market.  

You Can Do This

Last week, we laid out some suggestions on what you can do to build savings. This week will add the suggestions for the investing side of the equation.

  • It’s all about “cash flow.” – you can’t save if you don’t have positive cash flow.
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over spending is “social media” and “keeping up with the Jones’.” If advertisers were getting your money from social media they wouldn’t advertise there.
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Expectations for future returns should be downwardly adjusted. (You aren’t going to make 6% annually)
  • The potential for front-loaded returns going forward is unlikely.
  • Control investment behaviors and emotions that detract from portfolio returns is critical.
  • Future inflation expectations must be carefully considered.
  • Account for “variable rates of returns” in your plan rather than “average” or “compound.” 
  • Understand risk and control drawdowns in portfolios during market declines.
  • Save money regularly, invest when reward outweighs the risk. Cash is always an alternative.

Lastly, remember that “time” is your most valuable commodity and is the only thing we can’t get more of. 

As the probability of a U.S. recession in the next year grows rapidly (it may be as high as 64%), many bullish economists and financial commentators are unsurprisingly downplaying this risk. One of their main arguments is that interest rates have not been hiked aggressively enough to tip the economy over into a recession. While it is true that U.S. interest rates are still very low by historic standards, the reality is that rates do not have to rise anywhere near as high as they did in the past to cause recessions due to America’s debt load that has grown dramatically over the past several decades.

Since the early-1980s, total U.S. debt – both public and private – has been growing at a faster rate than the underlying economy, as measured by the nominal GDP:

As a result of debt growing faster than our underlying economy, America’s debt as a percent of GDP soared from just over 150% in the early-1980s to approximately 350% in recent years. This higher debt burden is the reason why our economy simply cannot handle interest rates as high as they were before 2008.

Particularly worrisome is the fact that U.S. federal debt is at a record of over 100% of the GDP (vs. 62% before the Great Recession), which will make it a much greater challenge to keep the economy afloat in the coming recession:

Market strategist Sven Henrich described our conundrum quite well:

As the Fed Funds rate chart below shows, the interest rate threshold necessary to trigger recessions (recessions are designated by the gray bars) keeps falling as our debt burden increases:

Though many optimists are quick to point out that the benchmark Fed Funds rate was only increased from 0% to 2.5% during the current tightening cycle, the reality is that the current tightening cycle is even more aggressive than the past several cycles when the Fed Funds rate is adjusted for quantitative easing (this is known as the shadow Fed Funds rate – learn more). According to this methodology, interest rates have increased by the equivalent of 5.41% in the current cycle versus just 3.62% before the 2001 recession and 4.26% before the Great Recession of 2007 to 2009:

The 10-year U.S. Treasury note yield also confirms the message given by the Fed Funds rate: the U.S. economy has become increasingly sensitive to higher interest rates:

Dangerous economic bubbles form during periods of low interest rates and burst when rates are increased – that’s what typically causes recessions. During the low interest rate period of the past decade (not just in the U.S., but globally), bubbles have formed in global debtChinaHong KongSingaporeemerging marketsCanadaAustraliaNew ZealandEuropean real estatethe art marketU.S. stocksU.S. household wealthcorporate debtleveraged loansU.S. student loansU.S. auto loanstech startupsshale energyglobal skyscraper constructionU.S. commercial real estatethe U.S. restaurant industryU.S. healthcare, and U.S. housing once again. Those bubbles are going to burst in the coming recession, which is extremely worrisome.

As I explained last week, the probability of a U.S. recession in the next twelve months may be as high as 64%:

The rapidly-approaching recession poses a serious risk to the extremely inflated U.S. stock market, which is up 300% since its 2009 low. The U.S. stock market is experiencing an unsustainable bubble due to the aggressive actions of the Fed (see my detailed explanation).

To summarize, interest rates do not need to rise much to throw the heavily-indebted U.S. economy into a recession now; furthermore, interest rates have likely already risen to the levels that are necessary to tip our feeble economy over into a recession, as evidenced by rapidly weakening economic data. At this stage of the game, everyone needs to be realistic – we can’t expect to have a full decade of unprecedented central bank stimulus without a tremendous bust. Central banks can only create temporary economic booms by borrowing from the future rather than sustainable, organic economic booms. Anyone who does not believe in that truth right now, or is not aware of it, will inevitably become a firm believer in the coming bust.

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

  • XLB back to extreme overbought and challenging resistance. A failure of a trade-deal from the G-20 meeting will likely pressure the sector lower if more tariffs ensue.
  • XLB failed at initial resistance on Monday.
  • Short-Term Positioning: Neutral
    • Last Week: Sell down positions to 1/2 weight and hold
    • This Week: Hold current positions with tighter stop-loss
    • Stop-loss moved up to $56
  • Long-Term Positioning: Bearish

Communications

  • XLC has mustered a moderate rally which has been less than inspiring.
  • While on a buy signal, XLC is back to very overbought. If you are still long positions, take profits and reduce exposure.
  • Short-Term Positioning: Neutral
    • Last Week: Maintain trading positions.
    • This Week: Hold trading positions, but take profits.
    • Hard Stop set at $47.50
  • Long-Term Positioning: Bearish

Energy

  • XLE has mustered a strong rally over the last few trading sessions as the sector rallied over Iran worries.
  • Currently, XLE is running into the 200-dma, take profits and rebalance risk accordingly. If this level proves to be resistance a retest of recent lows is probable.
  • The “sell-signal” remains intact for now but is trying to reverse. A break above the 200-dma would clear the way for a move higher, but wait for the break first.
  • Short-Term Positioning: Neutral
    • Last week: Reduce exposure
    • This week: Hold current position, add to holding on a break above the 200-dma.
    • Stop-loss adjusted to $62
  • Long-Term Positioning: Bearish

Financials

  • XLF has rallied and is now testing, and struggling with. previous resistance.
  • XLF remains on a “buy” signal currently but the oversold condition has almost been fully reversed.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $25.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI has failed to rally to a new high, and the previous triple top remains formidable resistance.
  • Our stop level has held for now and XLI is rallying back to overhead resistance.
  • Much hangs in the balance for a trade-deal from the G-20. Failure of progress may result in a reversal of the recent gains. Take profits if needed.
  • Short-Term Positioning: Neutral
    • Last week: Sell 1/2 position at current levels.
    • This week: Hold remaining 1/2 position.
    • Stop-loss moved up to $72
  • Long-Term Positioning: Neutral

Technology

  • XLK has reversed back to an overbought condition and is challenging the previous highs.
  • XLK has been driven by the largest cap-weighted companies so it may pay to remain cautious for now.
  • The buy signal remains intact, which is bullish, so remain long positions for now.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss moved up to $72.5
  • Long-Term Positioning: Neutral

Staples

  • Defensive positions continue to lead the charge in the most recent advance.
  • XLP has registered new highs and is grossly extended.
  • Take profits and rebalance risks but maintain holdings.
  • The “buy” signal (lower panel) is still in place and is back to very extended. We continue to recommend taking some profits if you have not done so.
  • XLP was oversold and we stated additional gains were likely. $56.50 was initial resistance which was taken out with new all-time highs.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Profit stop-loss moved up to $57.50
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE, like XLP, has broken out to all-time highs as “defense” continues to catch the majority of the rally.
  • We previously recommended taking profits and rebalancing risk. That is still advisable.
  • Buy signal is being reduced along but XLRE is back to overbought.
  • We recently added to our XLRE position and are now carrying a full weight.
  • Short-Term Positioning: Bullish
    • Last week: Holding full position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.50
  • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE and XLP above, continue to advance from the “defensive” shift in allocations.
  • Long-term trend line remains intact and the recent test of that trend line with a break to new highs confirms the continuation of the bullish trend.
  • Buy signal worked off some of the excess. (bottom panel) but the sector is back to overbought once again.
  • Short-Term Positioning: Bullish
    • Last week: Hold overweight position
    • This week: Hold overweight position
    • Stop-loss moved up to $57.50.
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel) remains intact currently but previous support is holding and the sell signal is about to reverse to a buy signal.
  • XLV performance improved markedly last week as another defensive position moves to the fore.
  • XLV is back to overbought so $90 is now important support.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position (overweight)
    • This week: Hold current position (overweight)
    • Stop-loss set $86
  • Long-Term Positioning: Neutral

Discretionary

  • With AMZN and AAPL now considered discretionary stocks, it is not surprising to see XLY rise and fall with XLK and XLC as those two major stocks rallied last week and on Monday.
  • The “buy” signal has been reduced and is holding up and XLY did break above previous resistance and is now challenging all-time highs.
  • XLY was oversold and is now back to extreme overbought.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 of position.
    • This week: Hold 1/2 position with stops in place.
    • Stop-loss adjusted to $107.50 after sell of 1/2 position.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has continued to lag the overall market and continues to suggest there is “something wrong” economically.
  • XTN has reversed its buy signal (bottom panel) and while the sector is bouncing off of an oversold condition, there is a lot going wrong.
  • We noted last week to “look for a failed rally to $60 to sell into if you are still long positioning.”
  • That failed rally occurred yesterday, sell and raise cash accordingly. .
  • 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: No position
  • 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

  • We previously noted the correction had set up a tradeable opportunity into June and that we were approaching our initial target of $290. That target was hit and we took 1/2 of our trading positions back in.
  • We noted last week, the current setup “suggests a bit more rally could occur next week given comments from both the Fed and the G-20 summit are on deck.
  • On Friday, SPY broke out to new highs but is back to a more extreme overbought condition while remaining on a buy signal. These keeps us long our remaining 1/2 position for now and we will look for a bit of consolidation at these new highs to go back to a full weighting. July and August tend to be weaker months which could provide the entry we are looking for.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss adjust to $275
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • DIA has not had as a compelling of setup as SPY. But on Friday did break out to new highs and triggered a short-term buy signal.
  • DIA is very overbought short-term, so like SPY above, we will look for a better entry point to suggest adding weighting to portfolios.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $252.50
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is now back to very overbought.
  • We noted last week that the market could rally further into previous resistance from the August/September highs of 2018. The rally has been fairly weak, but it did get above last years resistance levels. New highs are the next challenge.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 1/2 position with a target of $185
    • This Week: The $185 target was reached but hold position currently.
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted several weeks ago, SLY has fallen apart as market participation has weakened. SLY, and MDY are particularly susceptible to “trade wars” and slowing economic growth.
  • The modest “buy” signal has reversed and is now on a sell signal.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape.
  • MDY did regain its 200-dma but the rally has been weak.
  • Mid-caps did rally this past week but is not overbought yet. This suggests we could see a a bit more of a rally this coming week given some positive news from the G-20 meeting.
  • Short-Term Positioning: Neutral
    • Last Week: Use any further rally this week to sell into.
    • This Week: Use any further rally this week to sell into.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM rallied back to the top of its downtrend channel on news that the ECB will potentially cut rates and increase QE programs.
  • We are looking to add a small trading position this coming week and the “sell signal” is close to being reversed.
  • Short-Term Positioning: Bearish
    • Last Week: No position recommended at this time.
    • This Week: Buy 1/2 position for a trade at $43
    • Stop-loss set at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA rallied on news the ECB will leap back into action to support markets.
  • Last week, EFA broke above its downtrend line while maintaining a “buy signal.”
  • We can add a trading position back into portfolios.
  • EFA is maintaining its 200-dma which is positive but the overall trend is concerning.
  • Short-Term Positioning: Neutral
    • Last Week: Positions sold on stop-loss violation.
    • This Week: Add 1/2 trading position.
    • Stop-loss is set at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • Oil rallied last week on both a slight crude draw, tensions over Iran, but primarily from a weaker USD.
  • The market remains in a major downtrend and the current bounce in oil prices is likely just that with $59 providing the most likely top.
  • Oil is not overbought yet, and is close to registering a buy signal.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position, but look for pullback to $54 to add a trading position.
    • Stop-loss for new positions is $50.
  • Long-Term Positioning: Bearish

Gold

  • Gold has quickly reversed its oversold condition to extreme overbought and has also broken above important overhead resistance.
  • We also noted, that the mild sell-signal has been reversed back to a “buy.”
  • Gold is too extended to add to positions here. Look for a pullback to $127-128 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole set at $126
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Bonds prices on bonds have gone parabolic and are now at extremes. Even the “buy” signal on the bottom panel has reached previous extremes which suggests a reversal in rates short-term is likely.
  • Comments from the Fed last week suggesting they will cut rates soon sent bond prices soaring.
  • Currently on a buy-signal (bottom panel), bonds are now back to extremely overbought and need to pullback, which should be coincident with a further rally in equities in the next couple of weeks.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $119.
  • Short-Term Positioning: Bullish
    • Last Week: Take profits and rebalance risks. A correction IS coming which will coincide with a bounce in the equity markets into the end of the month.
    • This Week: Same as last week.
    • Stop-loss is moved up to $126
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Comments from the Fed about more accommodative policies tripped up the dollar.
  • Over the last couple of weeks, the dollar has pulled back and has gotten extremely oversold.
  • However, the dollar broke support at the trend line, the 200-dma, and has registered a short-term sell signal.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Stop loss violated, close position.
    • Stop-loss at $96 was violated.


  • Review & Update
  • What The Fed Said & Didn’t Say
  • What Happens Next?
  • Sector & Market Analysis
  • 401k Plan Manager

Follow Us On: Twitter, Facebook, Linked-In, Sound Cloud, Seeking Alpha


Wednesday, June 26th from 12:30-1:30 pm.


Review & Update

Every week, we are fortunate enough to gain numerous subscribers to our weekly newsletter. So, first, I certainly want to welcome you to our missive, but I also need to brief our newest readers where we have been positioned over the last couple of months. 

On May 4th, we penned: “It Never Hurts To Ring The Cash Register:” we suggested taking profits and reducing risk in portfolios after a stellar run from the beginning of the year. We made specific recommendations to our RIA PRO Subscribers (Try Free For 30-Days) at the time:

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.”



We also said:

“From a portfolio management standpoint, the reality is that markets are very extended currently and a decline over the next couple of months is highly likely. While it is quite likely the year will end on a positive, particularly after last year’s loss, taking some profits now, rebalancing risks, and using the coming correction to add exposure as needed will yield a better result than chasing markets now. Given that every given year has some corrective action in it, betting this year will be different is a low probability event.

What we didn’t know at the time is that the May sell off would start the next week. 

Then, June 1st, we wrote “Selloff Overdone, Looking For A Sellable Rally:” To wit:

“In the very short-term the markets are oversold on many different measures. This is an ideal setup for a reflexive rally back to overhead resistance.”

Again, for our RIA PRO subcribers, we recommended taking on index positions to participate.

(Click here for the unlocked report.)

  • The “buy” signal in the lower panel was massively extended, as noted several weeks ago, which as we stated, suggested the reversal we have seen was coming.
  • The correction last week has set up a tradeable opportunity into June.
  • Short-Term Positioning: Bullish
    • Last Week: Add 1/2 position with a target of $290.
    • This Week: Hold position (full weighting)
    • Stop-loss remains at $275

The rally we have been discussing since the beginning of June has been a good trade and increased the value of our portfolios. 

However, for most investors, it has simply been a recovery back to the same level almost 2- months ago. 

This is why managing risk is important. 

Okay, now that you are up to date, let’s talk about what the Fed said, didn’t say, and what it means from here. 



What The Fed Said, & Didn’t Say

On Wednesday, the Federal Reserve completed their two-day FOMC meeting (Federal Open Market Committee) and provided their prepared statement afterward. 

It is worth noting it is the SAME statement following each meeting with only slight wording changes each time. The text below shows those red lined changes in the release from the last two meetings. I am only excerpting the more important points for today’s discussion.

“Information received since the Federal Open Market Committee met in Marchyindicates that the labor market remains strong and that economic activity rose at a solid is rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained lowGAlthough growth of household spending and business fixed investment slowed in the first quarter appears to have picked up from earlier in the year, indicators of business fixed investment have been soft.

The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes,but uncertainties about this outlook have increased. In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.

Wall Street voraciously searches for these changes to try a derive the Fed’s intention about future policy actions. It is akin to reading the “tea leave” in the bottom of a cup.

It was the last sentence above which got the bulls excited as it was interpreted to mean rate cuts.

However, what the “bulls” missed is the Fed DID NOT say the “would” cut rates, only that they would monitor incoming data and act appropriately. 

“The Federal Reserve on Wednesday said it does not expect any rate cuts this year, but did forecast one for 2020.” – CNBC

This is a far cry short of reducing rates 3-times this year, and more next year, pushing rates back towards the zero bound.

This leaves a lot of room for the markets to be disappointed. 

However, there is sufficient reason to expect the Fed will indeed cut rates, it is only a question of timing and by how much. 

As David Rosenberg penned last week:

“What does it mean when the real yield on the 5-year T-note is down to around 30-basis points and for the 10-year maturity, a mere 40-basis points? It’s the bond market’s way of foreshadowing the weak economy that lies ahead.

There can be little doubt that Powell took his cue from [the ECB’s Mario} Draghi and the ECB’s concern over the weakening growth backdrop and even deeper inflation undershoot in the Euro-area. I am talking about the recession. You know – the one that nobody ‘sees.'”

Given that the Fed has a very limited “toolbox” currently, I would expect them to use rate cuts VERY sparingly. Considering rates fall on average between 3-4% during a recession, the Fed is starting at just 2.4%. From a historical perspective, when the Fed does engage in rate reduction programs, it has not been an ideal point to be heavily invested in the financial markets.

As noted by PNC this week:

“That would absolutely be a policy misstep. With industrial production data coming in ahead of expectations, retail sales ex-autos and gas beating up expectations, earnings season for Q1 beating and Q2 revisions moving in a positive direction, it just seems to me as if the backdrop doesn’t warrant that swift of a policy reversal and that cuts really shouldn’t be on the table.” – Amanda Agati

Also, the 10-year yield is hovering at just 2% and seems the equity market is under appreciating the probability of a bad scenario which is being embedded into bond prices. Given the bond market is a reflection of the “flight to safety” by investors, it suggests the “bulls” could be wading into a trap. 

(Note: it is NOT the inversion of yield curves which signal a recession, it is when those inversions reverse.)

Lastly, the markets are already pricing in two events which haven’t even occurred yet:

  1. Rate cuts
  2. Trade deal with China

There is a decent probability that neither happens soon, and could be a “sell the news” event when they do.

Let me reiterate something I wrote previously which I believe to be most important at this juncture:

“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.

“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. Today, it is entirely reversed.

The extremely negative environment that existed in 2009, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, as shown in the table above, the economic and fundamental backdrop could not be more different.”

Lowering interest rates and quantitative easing are “incentives.” Incentives work when there is pent-up demand for a product, but are much less effective when everyone always has what you’re offering.  

Bill Bonner had the best explanation:

“Investors’ animal spirits were titillated brought last week by the Fed, which — in the wake of a deteriorating economy — seems ready to shift to Mistake No. 3 even before it has completed Mistake No. 2. 

You’ll recall that Mistake No. 2 is raising interest rates to try to mitigate the damage done by Mistake No. 1 (leaving rates too low for too long). Mistake No. 3 is dropping them too sharply to try to undo the damage caused by Mistake No. 2.”



What Happens Next

We recently suggested this “sellable rally” had room to go into the end of this month. That still seems to be the most likely case. However, July through September are going to become much more difficult from both an earnings and economic perspective. 

The red shaded bars denote the last two times that markets hit “all-time” highs coincident with an ongoing “sell signal” as denoted by the yellow circles. In both previous cases, the subsequent rally, while failing to hit new highs, almost reversed the sell signal before the markets turned lower again. While I am not suggesting that current market action will play out in the same fashion, it is worth considering before getting aggressively long-biased at this juncture.

More importantly, just about every other major index is NOT CONFIRMING the S&P 500’s new highs. Small, Mid, International, and Emerging Markets are all suggesting that something isn’t quite right, and even the “tech heavy” Nasdaq has failed to set new highs so far.

So, what is pushing the S&P 500 index to new heights. It has primarily been the rotation into “defensive positioning,” which also suggests a “risk off” mood by investors. (This rotation is something we recommended to our clients in Mid-may.)

The risk is that the current breakout is another failed attempt in this 18-month long consolidation process. The chart below shows a more concerning backdrop. As noted above, it is when the 10-year less the 2-year yield spread starts to increase, combined with a monthly “sell signal,” which as denoted major turning points in the market. 

Therefore, we don’t recommend buying the breakout just yet.

Why aren’t we getting more bearish in our positioning? 

Simply because the market has done nothing wrong as of yet.

If the market can breakout, and confirm new highs, then a push towards 3100 is likely.

However, such a move would only likely be temporary and would only serve to further inflate current overvaluation and extensions of the market. Such will exacerbate the expected decline in late summer and early fall.

We suggest maintaining a long-equity base in portfolios, but continue to carry both higher levels of cash and hedges against a pickup in volatility. (We added Gold and Goldminers a couple of months ago for this very reason.)

Stay long for now, but I would not get too comfortable.

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

Improving – Healthcare

After having lagged for the last couple of months, our overweight bet on “healthcare” has begun to pay off as the anticipated rotation OUT of the previous leaders of Technology and Discretionary led to buying of underperforming assets like Healthcare. Stay long for now. 

Current Positions: Overweight XLV

Outperforming – Staples, Communications, Financials, & Utilities

As noted last week,

“Technology, Discretionary and Communications are on the verge of turning from outperformance to underperformance of the S&P 500 on a relative basis. While the rally in the market, as we discussed last week, continued for a second week in a row, it has been defensive positioning continuing the outperformance.” 

That rotation occurred this past week as our overweighted positions in Staples and Utilities continued to lead as money chased defensive sectors. We are maintaining our target portfolio weight in Financials for now. Take profits and rebalance across sectors accordingly. 

Current Positions: Overweight XLP, XLU, Target weight XLF

Weakening – Technology, Discretionary, Real Estate, Industrials

Real Estate has continued to attract buyers particularly as interest continue to weaken. Performance improved again this past and Real Estate will likely move back into outperformance next week. We continue to carry our current weight in Real Estate, we also added to agency REIT’s to out equity portfolio last week. We continue to looking for opportunities to overweight the sector. Industrials bounced this past week, but their relative performance continues to drag. We remain underweight industrials currently. 

As noted above the previous “leaders” are now lagging in terms of relative performance. Pay attention as this does not suggest the current breakout to new highs in the S&P 500 is sustainable. 

Current Position: 1/2 weight XLY, Reduced from overweight XLK, Target weight XLRE, 1/2 weight XLI

Lagging – Energy, Materials

This economically sensitive sectors have held up okay this past week but continue to lag on a relative performance basis. For now, we are maintaining our “underweight” holdings in both energy and materials until the “trade war” with China passes.

Current Position: 1/2 weight XLE, XLB

IMPORTANT: The oversold condition that existed at the beginning of June has been fully reversed back to an extreme “overbought.” Take some action to rebalance portfolio risk if you have not done so previously.

We may have some follow through rally this week, but use any further rise to take action accordingly. 

Market By Market

Small-Cap and Mid Cap – While Mid-cap did break above it’s 50-dma this past week, it is still confined to an overall downtrend and not confirming the recent highs in the S&P 500. Small-cap continues to perform even worse, which is logical, given its sensitivity to weaker economic environments. We will need to patient to see if there is any follow through. As noted, these sectors are mostly tied to the domestic economy and their lack of performance is concerning relative to the economic backdrop. 

Current Position: No position

Emerging, International & Total International Markets

Both emerging and industrialized markets popped last week on rumors of more QE and lower interest-rates from the ECB. We were previously stopped out of our positions but will look to add some weight back to portfolios if the recent move back above the 50- and 200-dma can hold. 

Current Position: No Position

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.

The rally over the last three weeks has fully reversed the previous oversold condition. Make sure and rebalance weightings in portfolios if you have not done so already.

Current Position: RSP, VYM, IVV

Gold – With rates dropping sharply and deflationary pressures on the rise, Gold finally got a bid over the last couple of weeks. Last week, the Fed’s comments on potentially cutting rates sent both Bonds and Gold soaring higher. Gold has provided a good hedge in our portfolios against the recent decline and a breakout above current levels would suggest substantially higher prices. 

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

Bonds 

As noted above, Bonds soared higher last week on comments from the Fed which suggest the economic backdrop is much weaker than many believe. Bonds are EXTREMELY overbought, take some profits and rebalance weightings but remain long for now.

Current Positions: DBLTX, SHY, TFLO, GSY, IEF

High Yield Bonds, representative of the “risk on” chase for the markets rallied sharply with the market this week as “shorts” were forced out of their holdings. Not surprisingly, the “junk” rally has taken the market from oversold back to extremely overbought. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk rated” risk and improve credit quality in portfolios. 

IMPORTANT: The oversold condition has been fully reversed. Take action if you have not done so.

Sector / Market Recommendations

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

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

 

Portfolio/Client Update:

No change this past week. Despite the market testing highs, as noted in the main body of this missive, it is NOT confirmed by other major markets. Also, with the yield spread widening in conjunction with a monthly “sell” signal, historical outcomes for excessive risk exposure have not been kind. 

HOWEVER, with that said, we do realize markets are rising and that we need to take in participation when we can. Therefore, we will opportunistically look for areas we can add money too to participate without taking on excessive risk. As noted at the beginning of May. we have shifted 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. Such remains the case again this week. 

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: Our onboarding indicators have reversed back to “risk on” so new accounts will be onboarded selectively into their models where risk can be controlled. Positions that were transferred in are on our global review list and being monitored. We will use this rally to liquidate those positions to raise cash to transition into the specific portfolio models.
  • Equity Model: No changes this past week. 
  • ETF Model: We overweighted our exposure to defensive areas by adding Real Estate and overweighting Staples and Utilities. We are looking at adding an agency REIT ETF (REM) to our portfolios in the coming week as we did with the equity portfolio. 

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

Will New Highs Stick

I encourage you to read the main body of this week’s missive. 

However, in a nutshell, while the S&P 500 hit new highs this past week, all of the other major markets didn’t, including the technology heavy Nasdaq which has led the market all year. Leadership is important. 

While the breakout to new highs on Thursday was positive, we will need to see them hold through next week before considering taking on additional risk exposure. 

July and August tend to be challenging months for the market, so we want to be careful, particularly with the economic backdrop weakening and bond yields dropping so sharply. 

Take the following actions on Monday.

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. Raise some cash and reduce equities to target weights. Have a plan in place in case new highs fail to hold.
  • If you are underweight equities or at target – rebalance risks, look to increase cash rather than buying bonds at the moment, and use the current rally to rotate out of small, mid-cap, emerging, international markets. 

Lastly, the markets are back to extremely overbought conditions, this is a good time to take some action and clean up areas of your portfolio which have not been performing well. 

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

401k Plan Manager Beta Launch Coming

Thank you for all the emails of plans. We have been imputing them into the 401k plan manager (we are going to roll out the beta shortly with a few samples for testing purposes.)  We are currently covering more than 10,000 mutual funds initially, and are adding ETFs and Stocks hopefully in time for the beta test.

Our “live” 401k plan manager which will soon be available to RIA PRO subscribers for the beta test.

Once we have the bugs located, we will roll it out to new users. If you want to be part of the beta, you can subscribe to RIA PRO and get your first 30-days free. You will be able to compare your portfolio to our live model, see changes live, receive live alerts to model changes, and much more. 

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

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

I have gotten quite a few plans, so keep sending them and I will include as many as we can. 

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

Current 401-k Allocation Model

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

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

The Best Of “The Lance Roberts Show”

Podcast Interview Of The Week

Our Best Tweets Of The Week

Our Latest Newsletter

What You Missed At RIA Pro

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

See you next week!

Last week the Business Roundtable, an organization of large company leaders, released its quarterly CEO Economic Outlook Index.

The index tracks what executives expect for sales, capital spending, and hiring over the next six months.

The good news is the index has been above its historic average for 10 consecutive quarters. The bad news is, it fell the last five of those quarters.

CEO optimism peaked in Q1 2018, following a climb that began in Q4 2016. Now in Q2 2019, much of the confidence is gone.

Tax Cuts Didn’t Help

While correlation isn’t causation, those dates coincide with some turning points.

  • Q4 2016: Donald Trump wins the US presidential election with a Republican-controlled House and Senate. This sparked hopes for tax cuts and deregulation, which CEOs tend to like.
  • Q1 2018: The expected corporate tax cut took effect, giving companies a windfall many used to buy back shares and elevate their stock prices. CEOs liked that too.

Under other conditions, confidence should have continued to grow as the tax cuts stimulated the economy. It didn’t. The tax bill’s passage marked peak confidence.

One reason: the tax changes really didn’t do much for the economy. A new Congressional Research Service study estimates they added only 0.3 percentage points to 2018 GDP growth. It’s nowhere near enough to offset the government’s revenue loss.

Meanwhile, Q1 2018 also marked the launch of President Trump’s trade war, which is now negating the already-small fiscal stimulus. CEOs are noticing it as well.

Costly Risks

Globalization obviously hasn’t worked as well as hoped. Too many people haven’t shared its benefits while still feeling its costs.

Nonetheless, decades of (relatively) free trade gave CEOs enough stability to make long-term business plans.

That stability is now disappearing. Trump isn’t the only reason, but he’s making it worse.

The president’s assorted tariff threats are often just threats—but sometimes they turn into reality, and it happens often enough to keep everyone guessing. CEOs can’t ignore him when he talks about things that affect their operations.

This is a problem, as Gavekal Research described in a recent note:

Corporations have been organized to maximize global resources. They must now reorganize to mitigate policy risks, which should come at a cost.

On the margin, this means less goods will be delivered at a higher cost. Some of this cost will be absorbed by reduced margins and some by higher consumer prices.

In its totality, the additional risk in the global trading system points to lower growth and a tougher profits outlook. This calls for reducing risk exposure, including in the US.

As Gavekal says, businesses can usually adapt to the trade war. They find alternate sources, reorganize their supply chains, or make other adjustments. But it takes time and money.

Coerced Cooperation

The time and money CEOs spend reorganizing is time and money they aren’t spending on other things.

Worse, Trump can change his mind faster than businesses can adapt. So at some point, their best alternative is to simply do nothing. Stop expanding, stop hiring, and just wait for normality to return.

The problem there: it could take some time.

Trump is in office until January 2020, at least. The legal power he is using to impose tariffs and other trade barriers will stay in his hands that whole time, unless Congress takes it back.

Which is unlikely because opponents would need a two-thirds majority in both House and Senate to override his veto of any changes.

Hence, we see Trump now using presidential trade powers to coerce cooperation on non-trade issues, like immigration with Mexico. He thinks it worked, so he will probably do it again.

Where will that end? “Hey, Europe. Spend more on defense or I put 50% tariffs on your auto imports to the US.”

In that scenario, Europe would retaliate against US exporters while European automakers might close their US plants, laying off American workers. It would escalate from there.

Would Trump back down? Maybe, maybe not. No one knows.

Again: Trump has this authority right now, and Congress doesn’t have the votes to take it back. There’s every reason to think he will keep using it.

The trade chaos is slowly but surely paralyzing business, both within and outside the US. Business paralysis will eventually induce recession.

The open question is when. Your guess is as good as mine, but the time is coming.

The House overwhelmingly passed a new bipartisan bill 417-3 called the SECURE ACT or Setting Every Community Up for Retirement Enhancement Act focusing on making big changes to the U.S. Retirement System.

Here’s what you need to know about the bills proposals:

One of the major talking points is raising the age RMD’s aka Required Minimum Distributions must be taken from Retirement accounts from 70 ½ to 72. This is a move in the right direction, but why stop at age 72 when the fastest growing demographic of workers is those over the age of 65? Why punish those still working or people who would still like to contribute to IRA’s by stopping at 72. Certainly a move in the right direction, but still falls short of meaningful reform. Thank goodness the House’s bill does away with the downright confusing age of 70 ½ for those pesky RMD’s.

Ok, this one I know many of you are rolling your eyes at, but being able to have annuities inside 401k’s is a BIG deal.

You’re probably asking why?

Well quite frankly because the vast majority of Americans are underfunded in the retirement savings department. In a recent study by Fidelity Investments they found that the average retirement savings account balance for individuals between 60-69 is $195,500.

Using the old school and stodgy 4% rule individuals can expect to collect $7,820 annually or $651.67 each month. Combine that with the estimated average monthly Social Security benefit payment in January 2019 of $1,461 for a total of $2,112.67 average monthly income for retirees. This means many are going to have to continue working, find a part time job or live on much less in retirement than they anticipated.  This part of the bill will help retirees and employers. It will help retiree’s by being able to choose to utilize an annuity inside of their 401k. An annuity for these intentions is generally defined as a guaranteed stream of income that an annuitant (you the owner) can’t outlive. Key word’s- stream of income that you can’t outlive. Believe it or not having this option is a good thing for Americans.

Here’s where the small business owners or employers win on the 401k front which is flying under the radar is actually providing some safety to employers when using state licensed insurance companies in which the company is domiciled for annuity products if an insurance company went out of business. This is good because it will protect employers from liability assuming proper due diligence and requirements are followed.

The Secure Act will also allow employers with affiliations to ban together to reduce administrative and fiduciary costs. If this bill ultimately passes all hurdles I expect you will begin to hear more about MEPs or Multiple Employer Plans. This is another win for small business owners.

Another win for the consumer – albeit a small win, because I do believe most 401k plans already provide this service – is making it a requirement for 401k providers to show the estimated income you can expect based off of current or future balances in a 401k. This is a win for the consumer.  However, investors need to be cautious and understand what types of returns these simulations use. Too many times to count we see software and media financial pundits alike lull investors into a false sense of security by projecting unrealistic and much higher than average returns. Understanding how the markets work and the math of loss will give you a leg up in planning for your retirement. The market is not always bull and neither is your financial plan.

The Kiddie Tax change is a win for all parents out there who are putting funds aside in their children’s names! The Kiddie Tax most are familiar with was changed with the tax code in 2017. The Kiddie Tax after 2017 was boosting tax rates on unearned income received by children to their parents tax rates. It will now be repealed.  This is especially important for families in lower to middle income as it more often than not catches them by surprise. That really hurts when you’re trying to make ends meet and also put funds aside only to be penalized in the long run. This has two thumbs up from RIA.

Want to know the one thing about this bill I hate the most?

Have you ever heard of a stretch IRA?

A stretch IRA has been a well utilized strategy enabling families to stretch out IRA distributions to future generations after death.

Guess what, potentially gone.

Currently when a non-spouse beneficiary inherits an IRA as of right now they have several options to distribute funds.

  1. Take the funds within 5 years
  2. Stretch out over your lifetime using your IRS life expectancy numbers
  3. Take the money and run

Guess what, the government giveth and they taketh.

The new bill states that all distributions (with the exception of spouses and minor children) all funds must be taken out within a 10 year time frame. This provision in the bill is estimated to generate 16 billion over the next 10 years. This is a shame and brings to light what we all know about the government, they need our tax dollars and now more than ever.

This should have you thinking about what you can do to protect your assets and beneficiaries.

Now could be a good time to utilize surgical Roth Conversions. This could prove to be an extremely beneficial tool especially while most are enjoying lower tax brackets.

Run a distribution analysis to determine if you are taking distributions to keep you in a lower tax bracket over the life of your plan.

If you have questions, your advisor hasn’t simulated for Roth conversions or how to pinpoint how much and where to take your distributions from call or email us, we’d love to help.

Bottom Line:

With this bill lawmakers fail to address some of the bigger issues.

  • Where does this plan actually help Americans? 
  • What about the 1/3rd of Americans who can’t afford a $400 emergency?
  • The average Joe’s are being overlooked yet again.

There is a lot of good in this bill, but I think it’s a half-assed attempt for Uncle Sam and the broader government to say, “look what I did for you today! Elect me tomorrow”!

Keep in Mind:

This bill still has to go before the Senate which already has a similar bill on the docket so I would expect changes or slight modifications. If this is moved on by the Senate, the bill will then head to the President’s desk. I think it’s very unlikely that anyone regardless of party will not vote for this bill.

My bet is there will be some modifications. As they come, your financial plan will be updated accordingly.

This article was originally published Friday, June 14th, but with Thursday’s big rally and gold hitting a 5 ½-year high, many people believe that this was a major upside breakout. I’ll start with the updated chart, which does not convince me – yet – that a breakout is in place. Of course, new information can change that view but we cannot trade based on what has not happened yet.

The daily chart is even more stretched. So, given this new information, the case for a major breakout is now in play but I need to see how the market reacts to its short-term condition. I’m not a buyer today, barring fresh geopolitical news, but a modest pullback to test the breakout would be a better way to play.

And just for further mud, the U.S. dollar index may be on the verge of a short-term breakdown, which will support gold. This is far from confirmed.

Here is the original piece, written a week before the attempted breakout.

A name-brand fund manager now calls for a recession soon and is buying gold. A name-brand invstment bank thinks that economic conditions today are worse than they were during the financial crisis.

Naturally, we would expect the metals markets, with their safe-haven statuses, to be rip roaring higher. But they really are not.

True, gold has looked pretty strong over the past few weeks thanks to tariffs and trade wars. And it even got the benefit of a short-term trendline breakdown in the U.S. dollar late last month for a little extra juice.

But in the bigger picture, it has not yet really broken out.

This weekly chart shows the market at resistance in the 1350-1385 area. Basically, no breakout – yet.

Now, I can see that a move above resistance will break a six-year basing pattern to the upside and that would have some bullish long-term implications. I could see that targeting as high as 1700, albeit over many months.

So why, then, does silver look so, ahem, tarnished? This market, as well as platinum, has been bumping along the bottom for literally years and that has pushed the gold/silver ratio to a 26-year high.

What does that mean? Honestly, other than silver being cheap relative to gold, I don’t know. More of an interest in hedging with gold vs. the combination hedging/industrial use for silver?

To me, it suggests that with silver weak and gold at resistance, the yellow metal is not about to break out. The ratio could revert somewhat back to the mean with falling gold, staying within the base.

That makes sense when we see the greenback jump up sharply today (June 14). Of course, that move is a single event, not yet a trend although it does look like a continuation higher of the 2019 trend, if not the 2018-2019 trend.

Therefore, I’m still not backing up the truck for gold but then again, if the market changes – a base breakout – then I will change my mind.

….and that, my friends, is the whole point of this update.

“The greatest trick the Devil ever pulled was convincing the world he didn’t exist.” The Usual Suspects (1995)

Just recently, Politico ran a story by Brain Faler entitled: “Big Businesses Paying Even Less Than Expected Under GOP Law.” To wit:

“The U.S. Treasury saw a 31 percent drop in corporate tax revenues last year, almost twice the decline official budget forecasters had predicted. Receipts were projected to rebound sharply this year, but so far they’ve only continued to fall, down by almost 9 percent or $11 billion.

Though business profits remain healthy and the economy is strong, total corporate taxes are at the lowest levels seen in more than 50 years. Analysts agree they can’t yet explain the decline in corporate tax payments.

Uhm, excuse me?

This is where I get to say, “I Told You So!”

The Big Lie #1

While the Devil may have convinced the world he doesn’t exist, it was that “corporate cronyism” devoured Washington politics.

“Our companies won’t be leaving our country any longer because our tax burden is so high.” – Donald Trump 

That was an outright lie.

First of all, there is a massive difference between “statutory,” the stated tax rate, and the “effective” tax rate, or what companies actually pay. The chart below shows corporate profits before and after-tax with a measure of what the effective tax rate was.

Just prior to the passage of the tax cut bill, the effective tax rate for U.S. companies was about 16%, or less than half of the statutory rate of 35%. After the passage of the legislation, the effective tax rate fell to 11%, again less than half of the statutory rate of 21%.

There is also the matter that every other country in the world has a “value added tax,” or VAT, added to their corporate tax rate. Dr. John Hussman did a good piece of analysis on this.

“I’ll add that another feature of Wall Street’s blissful delusion is the notion that ‘U.S. corporate taxes are the highest in the world.’ It’s striking how disingenuous this claim is. The fact is that among all OECD countries, the U.S. is also the only country that does not levy any tax at all on corporate value-added in the production of goods and services.”

“The main point is this. The argument that U.S. taxes on corporate profits are somehow oppressive relative to other countries is an apples-to-oranges comparison. It wholly ignores that the U.S. levies no value-added tax on corporations at all, whereas the value-added tax is the principal revenue source for most other countries. The rhetoric on corporate taxes here is unfiltered effluvium.

It is a myth that the U.S. has the highest corporate tax rate in the world. We simply didn’t, and don’t.

The Big Lie #2:

The second big lie was:

““It’ll be fantastic for the middle-income people and for jobs, most of all … I think we could go to 4%, 5% or even 6% [GDP growth], ultimately. We are back. We are really going to start to rock.” – Donald Trump

So, what happened?

Nearly seven months PRIOR to the passage of the legislation, I discussed that engaging in tax cuts at the end of an economic cycle would nullify the majority of the expected effect.

“Tax rates CAN make a difference in the short run, particularly when coming out of recession as it frees up capital for productive investment at a time when recovering economic growth and pent-up demand require it.”

The reason that tax receipts have fallen since the passage of tax reform is that top-line revenue growth has slowed along with both domestic and global economies. However, we already knew this was going to be an issue as we discussed in that 2017 article noted above. To wit:

Importantly, as has been stated, the proposed tax cut by President-elect Trump will be the largest since Ronald Reagan. However, in order to make valid assumptions on the potential impact of the tax cut on the economy, earnings and the markets, we need to review the differences between the Reagan and Trump eras. My colleague, Michael Lebowitz, recently penned the following on this exact issue.

‘Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:’”

The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging, declining interest rates, and inflation provided huge tailwinds for corporate profitability growth.

Just for clarity, tax rates CAN make a difference coming out of recession. However, given the economy was already growing near maximum capacity in 2018, the boost from tax cuts was mostly mitigated.

Secondly, corporations, which is where the tax cuts were primarily focused, used the tax cuts not to increase productivity, make investments, or grow revenues. Such investment most likely would have resulted in greater economic growth and higher tax revenue, however, the windfall was mainly used to manipulate stock prices through massive share buybacks.

“A recent report from Axios noted that for 2019, IT companies are again on pace to spend the most on stock buybacks this year, as the total looks set to pass 2018’s $1.085 trillion record total.”

“The reality is that stock buybacks create an illusion of profitability. Such activities do not spur economic growth or generate real wealth for shareholders, but it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.”

The Big Lie #3:

The third big lie was that tax cuts would pay for themselves.

“Not only will this tax plan pay for itself, but it will pay down debt.” – Treasury Secretary Steven Mnuchin

That didn’t happen.

In fact, the debt and deficit got materially worse as I predicted they would in “3 Myths About Tax Cuts:”

“During the previous Administration, the GOP wielded ‘fiscal conservatism’ as a badge of honor. Since the election, they have completely abandoned those principals in a full-blown effort to achieve tax reform.

We are told, by these same Republican Congressman and Senators who passed a fiscally irresponsible 2018 budget of more than $4.1 trillion, that tax cuts will ‘pay for themselves’ over the next decade as higher rates of economic growth will lead to more tax collections.

Again, we see that over the “long-term” this is simply not the case. The deficit has continued to grow during every administration since Ronald Reagan. Furthermore, the widening deficit has led to a massive surge in Federal debt which is currently in excess of $22 trillion, and growing much faster than economic activity, or the nations ability to pay if off.

This was the exact point made in “Tax Cuts & The Failure To Change The Economic Balance:”

As noted in a 2014 study by William Gale and Andrew Samwick:

The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Since the tax cut plan was poorly designed, to begin with, it did not flow into productive investments to boost economic growth. As we now know, it flowed almost entirely into share buybacks to boost executive compensation. This has had very little impact on domestic growth. The ‘sugar high’ of economic growth seen in the first two quarters of 2018 has been from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. These activities simply pull forward “future”consumption and have a very limited impact but leaves a void which must be filled in the future.

Nearly a full year after the passage of tax cuts, we face a nearly $1 Trillion deficit, a near-record trade deficit, and empty promises of surging economic activity.

It is all just as we predicted.

Recessionary Warning

While well-designed tax reforms can certainly provide for better economic growth, those tax cuts must also be combined with responsible spending in Washington. That has yet to be the case as policy-makers continue to opt for “continuing resolutions” that grow expenditures by 8% per year rather than doing the hard work of passing a budget.

Given that tax receipts fall as the economy slows, tax receipts as a percentage of GDP is a pretty good indicator of recessionary onset.

The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As debt levels, and subsequently deficits, increase, economic growth is burdened by the diversion of revenue from productive investments into debt service. 

As expected, lowering corporate tax rates certainly helped businesses increase their bottom line earnings, however, it did not “trickle down” to middle-class America. As noted by Jesse Colombo:

“‘In 1929 — before Wall Street’s crash unleashed the Great Depression — the top 0.1% richest adults’ share of total household wealth was close to 25%, today, the that same group controls more wealth than the bottom 50% of the economy combined.”

Not surprisingly, focusing tax cuts on corporations, rather than individuals, only exacerbated the divide between the top 1% and the rest of the country as the reforms did not focus on the economic challenges facing us.

  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These challenges will continue to weigh on economic growth, wages and standards of living into the foreseeable future.  As a result, incremental tax and policy changes will have a more muted effect on the economy as well.

As investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals.

The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t. 

Deutsche Bank strategists Jim Reid and Craig Nicol wrote a report this week that echos what I and other Austrian School economists have been saying for many years: actions taken by governments and central banks to extend business cycles and prevent recessions lead to even more severe recessions in the end. MarketWatch reports

The 10-year old economic expansion will set a record next month by becoming the longest ever. Great news, right? Maybe not, say strategists at Deutsche Bank.

Prolonged expansions have become the norm since the early 1970s, when the tight link between the dollar and gold was broken. The last four expansions are among the six longest in U.S. history .

Why so? Freed from the constraints of gold-backed currency, governments and central banks have grown far more aggressive in combating downturns. They’ve boosted spending, slashed interest rates or taken other unorthodox steps to stimulate the economy.

“However, there has been a cost,” contended Jim Reid and Craig Nicol at the global investment bank Deutsche Bank.

“This policy flexibility and longer business cycle era has led to higher structural budget deficits, higher private sector and government debt, lower and lower interest rates, negative real yields, inflated financial asset valuations, much lower defaults (ultra cheap funding), less creative destruction, and a financial system that is prone to crises,’ they wrote in a lengthy report.

“In fact we’ve created an environment where recessions are a global systemic risk. As such, the authorities have become even more encouraged to prevent them, which could lead to skewed preferences in policymaking,” they said. “So we think cycles continue to be extended at a cost of increasing debt, more money printing, and increasing financial market instability.”

As I have explained in the past, when central banks like the U.S. Federal Reserve cut interest rates to low levels, they manage to create economic booms by encouraging borrowing and higher asset prices. These economic booms are often based on dangerous economic bubbles that burst and lead to recessions when interest rates are normalized again. As the chart below shows, financial crises and recessions (see the gray vertical bars) occur after rate hike cycles, including the dot-com and U.S. housing market crashes.

After the Great Recession, the Fed and other central banks held interest rates at record low levels for a record length of time in order to encourage another economic boom. The central banks got their economic boom alright, but it’s based on the inflation of these extremely dangerous bubbles: global debtChinaHong KongSingaporeemerging marketsCanadaAustraliaNew ZealandEuropean real estatethe art marketU.S. stocksU.S. household wealthcorporate debtleveraged loansU.S. student loansU.S. auto loanstech startupsshale energyglobal skyscraper constructionU.S. commercial real estatethe U.S. restaurant industryU.S. healthcare, and U.S. housing once again. I believe that the coming recession is likely to be caused by the bursting of those bubbles (read my detailed explanation).

The false economic booms that occur when central banks interfere with the business cycle trick investors and entrepreneurs into thinking that they are organic and sustainable booms. When the booms inevitably turn to busts, the bad investments that result are known as malinvestments

Malinvestment is a mistaken investment in wrong lines of production, which inevitably lead to wasted capital and economic losses, subsequently requiring the reallocation of resources to more productive uses. “Wrong” in this sense means incorrect or mistaken from the point of view of the real long-term needs and demands of the economy, if those needs and demands were expressed with the correct price signals in the free market.

Random, isolated entrepreneurial miscalculations and mistaken investments occur in any market (resulting in standard bankruptcies and business failures) but systematic, simultaneous and widespread investment mistakes can only occur through systematically distorted price signals, and these result in depressions or recessions. Austrians believe systemic malinvestments occur because of unnecessary and counterproductive intervention in the free market, distorting price signals and misleading investors and entrepreneurs.

For Austrians, prices are an essential information channel through which market participants communicate their demands and cause resources to be allocated to satisfy those demands appropriately. If the government or banks distort, confuse or mislead investors and market participants by not permitting the price mechanism to work appropriately, unsustainable malinvestment will be the inevitable result.

Because the current economic cycle has lasted for an unusually long time due to the actions of central banks, an unprecedented amount of malinvestment has built up globally that needs to be cleansed in the coming recession. It’s similar to a night of drinking: the more you drink and the later you stay out, the worse your hangover is going to be. Globally speaking, the last decade has been the bender to end all benders and the coming hangover is going to be proportionally severe.

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

BMY – Bristol Meyers

  • As stated last week, “This is not a great long-term set up but for a short-term trade there is an opportunity.”
  • BMY has registered a short-term buy signal.
  • We recommended buying BMY at current levels last week.
  • Target is $52
  • Hold current positions
  • Stop-loss is at recent lows of $45.

ADBE – Adobe Systems, Inc.

  • ADBE broke out to all-time highs this week while maintaining its current buy signal.
  • While ADBE is overbought on a short-term basis, breakouts are usually bullish for continuing advances.
  • Buy 1/2 position at current levels and look for a retest of support to add the second half.
  • Stop-loss is set at $270

CMI – Cummins, Inc.

  • Despite a slowdown in trucking and hauling, CMI continues to do well.
  • CMI maintained its “buy” signal last week and held support.
  • Buy 1/2 position on a breakout above $170 and add the second half on a retest of support following the breakout.
  • Stop-loss is $160

REG – Regency Realty Corp.

  • REG has a lot of catching up to do in the REIT space and the breakout above previous tops may be a sign of a pending advance.
  • The “buy signal” remains intact but REG is overbought.
  • Buy 1/2 position at current levels and add the second half on a retest of support.
  • Stop-loss is set at $66

INCY – Incyte Corp.

  • INCY broke out of a short-term consolidation pattern which is promising.
  • The “buy” signal remains intact and a break above $80 could see a stronger rise.
  • Buy 1/2 position now with a target of $80. Add the second half position on a break above $80.
  • Stop loss is $75

SHORT CANDIDATES

AMTD – TD Ameritrade Holding Corp.

  • As we noted last week, “AMTD is not looking good. With a sell signal being triggered and the downtrend holding firm, it looks like AMTD is going to break to the downside of this consolidation pattern.”
  • That happened this past week and a “sell signal” was triggered.
  • Short AMTD on at current levels.
  • Stop-loss is set at $54
  • Target for trade is $40.

CRM – Salesforce.com

  • CRM is hanging on to critical support.
  • A break below $150 could see CRM test $125-130 in fairly short-order.
  • Short CRM on a break below $150
  • Stop-loss is $155
  • Target is $120

EA – Electronic Arts

  • EA is in a very serious downtrend and there are lot’s of fundamental problems with the company.
  • EA is close to triggering a sell signal which will put $70 into focus.
  • Short EA at current levels with a stop-loss at $85
  • Downside target is $70

GWW – WW Granger, Inc.

  • GWW remains on a sell-signal and a major downtrend. The recent rally looks to fail at overhead resistance which provides a decent short-entry.
  • Short 1/2 position in GWW at $280
  • Stop-loss is $290
  • Add second half of the position on a break below $260
  • Target for trade is $160-170

EMN – Eastman Chemical Co.

  • Last week, we laid out the premise for shorting EMN stating: “On a newly issued sell signal following a brief bounce, more downside is currently likely.”
  • The parameters were to “short on a break of previous support at $67.50 with a stop-loss at $75”
  • EMN did not hit our target last week, but is now running into resistance but there is upside to $80.
  • We will revisit this position again next week.
  • No action this week.
  • Target for trade is $60

I recently wrote a piece that was widely read called “Why You Should Not Underestimate The Severity Of The Coming Recession.” In that piece, I argued that the odds of a recession in the not-too-distant future were increasing rapidly and that mainstream economists are incorrect for assuming that it will be a mere ebb of the business cycle rather than a more powerful economic crisis like we experienced in 2008 or even worse. The reason why I am worried about a much more powerful than usual recession is because of the tremendous risks – namely bubbles and debt – that have built up globally in the past decade due to ultra-stimulative central bank policies. In the current piece, I will argue that the probability of a recession in the next year is likely even higher than indicated by the popular New York Fed recession probability model that many economists follow.

According to the New York Fed’s recession probability model, there is a 30% probability of a U.S. recession in the next 12 months. The last time that recession odds were the same as they are now was in July 2007, which was just five months before the Great Recession officially started in December 2007. July 2007 was also notable because that is when Bear Stearns’ two subprime hedge funds lost nearly all of their value, which ultimately contributed to the investment bank’s demise and the sharp escalation of the U.S. financial crisis.

Many bullishly-biased commentators are trying to downplay the warning currently being given by the New York Fed’s recession probability model, essentially saying “So? There is only a 30% chance of a recession in the next year, which means that there is a 70% chance that there won’t be a recession in the next year!” The reality is that, as valuable as this model is, it has greatly underestimated the probability of recessions since the mid-1980s. For example, this model only gave a 33% probability of a recession in July 1990, which is when the early 1990s recession started. It only gave a 21% probability of a recession in March 2001, which is when the early-2000s recession started. It also only gave a 39% probability of a recession in December 2007, which is when the Great Recession started.

The New York Fed’s recession probability model has underestimated the probability of recessions in the past three decades because it is skewed by the anomalous recessions of the early-1980s. The New York Fed’s model is based on the Treasury yield curve, which is based on U.S. interest rates. The early-1980s recessions were anomalous because they occurred as a result of Fed Chair Paul Volcker’s unusually aggressive interest rate hikes that were meant to “break the back of inflation.” I have found that only considering New York Fed recession probability model data after 1985, and normalizing that data so that the highest reading during that time period is set to 100%, gives more accurate estimates of recession probabilities in the past three decades. For example, this methodology warned that there was an 85% chance of a recession in December 2007, when the Great Recession officially started (the standard model only gave a 39% probability). This methodology is warning that there is a 64% chance of a recession in the next 12 months, which is quite alarming.

The reason why a two-thirds chance of a recession in the next year is so alarming is because the next recession is not likely to be a garden-variety recession or a mere ebb of the business cycle, as I explained two weeks ago. Not only has global debt increased by $70 trillion since 2008, but scores of dangerous new bubbles have inflated in the past decade thanks to ultra-low interest rates and quantitative easing programs. These bubbles are forming in global debtChinaHong KongSingapore, emerging markets, CanadaAustraliaNew ZealandEuropean real estatethe art marketU.S. stocksU.S. household wealthcorporate debtleveraged loansU.S. student loansU.S. auto loanstech startupsshale energyglobal skyscraper constructionU.S. commercial real estatethe U.S. restaurant industryU.S. healthcare, and U.S. housing once again. I believe that the coming recession is likely to be caused by (and will contribute to) the bursting of those bubbles.

For example, one of the most obvious bubbles is forming in the U.S. stock market. The U.S. stock market (as measured by the S&P 500) surged 300% higher in the past decade:

The Fed’s aggressive inflation of the U.S. stock market caused stocks to rise at a faster rate than their underlying earnings, which means that the market is extremely overvalued right now. Whenever the market becomes extremely overvalued, it’s just a matter of time before the market falls to a more reasonable valuation again. As the chart below shows, the U.S. stock market is nearly as overvalued as it was in 1929, right before the stock market crash that led to the Great Depression.

The Fed’s aggressive inflation of U.S. stocks, bonds, and housing prices has created a massive bubble in household wealth. U.S. household wealth is extremely inflated relative to the GDP: since 1952, household wealth has averaged 384% of the GDP, so the current bubble’s 535% figure is in rarefied territory. The dot-com bubble peaked with household wealth hitting 450% of GDP, while household wealth reached 486% of GDP during the housing bubble. Unfortunately, the coming household wealth crash will be proportional to the run-up, which is why everyone should be terrified of the coming recession. 

In addition, Goldman Sachs’ Bear Market Risk Indicator has been at its highest level since the early-1970s:

Another indicator that supports the “higher volatility ahead” thesis is the 10-year/2-year Treasury spread. When this spread is inverted (in this case, flipped on the chart), it leads the Volatility Index by approximately three years. If this historic relationship is still valid, we should prepare for much higher volatility over the next few years. A volatility surge of the magnitude suggested by the 10-year/2-year Treasury spread would likely be the result of a recession and a bursting of the massive asset bubble created by the Fed in the past decade.

The moral of the story is that nobody should be complacent in these times when recession risk is so high, especially because the coming recession is likely to set off a global cluster bomb of dangerous bubbles and debt. The current probability of a recession is the same as it was during the Big Short heyday of 2007 when subprime was blowing up – just let that sink in for a minute. Do you think “this time will be different“? How can it be different when we didn’t learn from our mistakes and have continued binging on debt and inflating new bubbles?! Anyone who believes that “this time will be different” is seriously delusional and will be taught a very tough lesson in the not-too-distant future.

Income investing is hard.

Let’s say you buy 20 bonds. Each of them yields 5%. Nineteen out of 20 mature at par and you get your money back, with interest.

One of them defaults. You are back where you started!

It is said that income investing is a negative art. Your goal isn’t to pick the winners—it’s to avoid the losers. You want to pick winners, invest in stocks. Have you seen a chart of Beyond Meat? Bonds generally don’t do that.

It is also said that income investing is like picking up nickels in front of a steamroller. You’re earning a 4–5% coupon, and you could get whacked pretty much any day, just like what happened at Toys “R” Us. It is a bit like selling puts.

As a negative art, bond investing has become more and more difficult. Yields are slim, and they are not what I would call “safe.”

The default rate is virtually zero, which means we are at the peak of the cycle. And getting 3% on XYZ high-grade corporate bond fund does not sound like a great idea.

This is one reason why there has been such a historic rally in municipal bonds, pension nonsense notwithstanding.

Bond investors now allegedly think about what could go wrong.

What Could Go Wrong

I am far from the first person to worry about the corporate credit cycle.

Nine months ago, people were flipping their lids about the rise in BBB credits and the potential enormous migration to junk.

Never happened.

I know a few smart hedge funds who bet against all the paranoia. They did quite well.

The credit cycle will turn eventually.

Corporate debt issuance has been historic. Up until this point, there has been near-limitless demand for it.

It will take a skilled portfolio manager to avoid the turds.

I think last Friday was the first day I seriously considered the possibility that we were headed towards a recession—with two-, three-, and five-year note yields plunging below two percent.

The Key to Investing

I suspect most income investors reading this are dividend investors. Dividend investing is similar to bond investing.

High dividends are good, but they can also be bad if they are signaling a future dividend cut. Anything much over a 5–6% dividend in a stock should be viewed with some suspicion.

With regard to dividend investing, the key is not necessarily to buy big, fat dividends, but to buy growing dividends. Most people have it all wrong—they go yield hogging and end up paying the price.

Believe it or not, Apple is one of my favorite stocks. Not because it is a growth stock, but because it is a dividend stock.

It has a decent yield, but one that is likely to grow. One day it will have to figure out how to more aggressively return cash to shareholders.

I am going to tell you the secret to investing. Are you ready?

Invest in companies with dividend growth, and reinvest the dividends on a regular basis.

That’s it.

Say you had a million dollars. Buy 20 stocks with dividend growth. Set up the dividends to reinvest. Look at the P&L once a year. Make some adjustments. Repeat.

The 35/55/3/3/4 Portfolio

My guess is that this growth phase we’ve had in the stock market for so long is getting down to tag ends.

Recent history has demonstrated that it has paid to buy stocks without dividends. I have never understood why you would buy a stock without a dividend. Making enough extra cash to give some to you is how a company demonstrates that it’s profitable.

I have written before about the 35/55/3/3/4 portfolio. But I have never spent much time talking about the composition of the component parts.

The 35% in equities should all be invested in stocks with growing dividends, across all sectors.

The 55% in fixed income should be split between Treasuries (including TIPS), corporates, mortgages, municipal bonds, and a handful of international bonds.

Then you have the 3% commodities, the 3% gold, and the 4% REITs.

The blended yield of this portfolio is probably around 3 to 3.5%. You could retire on that!

Yield hogging is a pejorative term, and it should be. The whole financial crisis started because people decided to reach for another 30 basis points. Rule number 42: don’t be dumb.

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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.

BA – Boeing Co.

  • As a recap, we took on 1/2 position in BA following the collapse in the stock price due to the 737 MAX crash.
  • We stated we would be patient and wait for improvement, and a buy signal, to add the second half.
  • BA broke above initial resistance last week and the “sell” signal is pretty deep suggesting a substantial rally once a “buy” signal is triggered.
  • It is not time to add the second position just yet, but we may be getting close.
  • Stop remains at $300

DOV – Dover Corp.

  • We originally took on DOV as a play for a “trade war” resolution.
  • Despite the fact we have no trade war resolution as of yet, DOV has performed nicely and we previously took profits in the position.
  • The current buy signal is very extended and close to sell signal.
  • Look for an opportunity to add to positions that hold support at $87.50
  • Stop-loss is moved up to $85

COST – Costco Wholesale

  • We previously took profits in COST and after a breakout to all-time highs, and confirmed, we can look for an opportunity to increase our holdings.
  • COST is currently overbought but on a buy signal. We will be patient for now and wait for the right opportunity to add to our current position.
  • Look to add around $240-250 on a pullback and support holds.
  • Stop-loss remains at $230 for now.

GDX – Gold Miners

  • GDX was added to our portfolios to hedge against potential volatility and rate risk in portfolios.
  • The hedge worked well in the recent sell-off and broke out of resistance on news of the ECB becoming more dovish along with the Federal Reserve.
  • We continue to hold our position for now and with the break above $23 we can actively start looking for an opportunity to increase our holdings further.
  • Our stop is set at $20

DUK – Duke Energy

  • Of our defensive Utility exposure DUK has weakened in terms of performance lately and is sitting on important support.
  • The lack of performance has to do with the current “Sell” signal which we are watching closely.
  • DUK continues to consolidate in a wedge pattern so a break out above or below resistance/support will dictate our next move./
  • We remain long DUK for now and will only look to add to the position on a breakout above $89
  • Stop-loss remains at $86 for profits and an absolute stop at $83.

JPM – JP Morgan Chase

  • JPM continues to hold its own, and we are collecting a dividend, but overall performance has been “Meh.”
  • The good news is JPM broke out of its consolidation, retested that breakout and moved higher which is very bullish.
  • With JPM on a “buy” signal currently, we will continue to hold our position for now and will add to it on a break out to new highs.
  • We remain long our position currently and are moving our stop-loss up to $105

NSC – Norfolk Southern Corp.

  • NSC has been consolidating its strong run from previous lows and is close to registering a short-term sell signal.
  • We are okay with that after taking profits in the position.
  • We are looking to add back to our holding between $180-190 with a tight stop-loss just below $180
  • Stop-loss is set at $179

XOM – Exxon Mobil Corp.

  • After selling 1/2 of our position back in May as oil prices hit their peak, the slide in oil prices, and share price, have likely hit a short-term nadir.
  • It is too soon to buy back the previous 1/2 of our position as there is currently risk to the downside in oil prices.
  • However, we are looking for an optimal point to rebuild our position in XOM.
  • Given we sold 1/2 of the position, we have lowered our stop-loss to $65.

PPL – PPL Corp.

  • PPL, another defensive utility play, and fundamentally very cheap, continues to grind along its upward path.
  • With PPL just about to trigger a “buy” signal we will be looking for some positive action to add to the position. In the meantime, we are collecting in excess of a 5% dividend, so we are patient.
  • Stop loss is currently set at $29.50

PEP – Pepsico, Inc.

  • PEP continues to power higher after breaking out to all-time highs.
  • The chase for defensive income stocks continues and has accelerated after talks by the Fed of lowering interest rates.
  • PEP is grossly overbought so a pullback to old highs and a bit of consolidation is needed to add to our holdings.
  • Target to add to holding is $127.50
  • Stop-loss is moved up to $117.50
Since President Trump first discussed firing Jerome Powell, out of a sense of frustration that his Fed Chair pick was not dovish enough, he has regularly expressed his displeasure at Powell’s lack of willingness to do whatever it takes to keep the economy booming beyond its potential. Strong economic growth serves Trump well as it boosts the odds of winning a second term.

This thought of firing the Fed Chair took an interesting turn yesterday when Mario Draghi, Jerome Powell’s counter-part in the ECB, commented that he was open to lowering interest rates and expanding quantitative easing measures if economic growth in the E.U. didn’t start to pick up soon.

This led to the following Trump tweet:

The bottom line is that the ECB will push Trump harder to lean on the Fed to be more aggressive with lower rates and QE. Trump’s urgency for Fed action also increases the odds that Powell could be replaced or demoted, as such a discussion was rumored to have been discussed. Look for fireworks on Trumps Twitter page today if the Fed does not take a dovish tact. We remind you:

“[Powell]’s my pick — and I disagree with him entirely,” Trump said last week in an interview with ABC News.

“Frankly, if we had a different person in the Federal Reserve that wouldn’t have raised interest rates so much we would have been at least a point and a half higher.”

The following article was published last October and is even more relevant today. If Powell becomes an impediment to aggressive Federal Reserve policy and therefore hurts Trump’s chances of winning in 2020, we might just see Chairman Powell get fired or demoted. Is that possible?


On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

Financial wellness is difficult to achieve without steeled resolve for fiscal self-preservation and an endlessly skeptical nature about the information provided by mainstream financial media.

You as saver, investor and commander of assets and liabilities that steer the household balance sheet toward achievement of financial milestones such as retirement planning, must carefully navigate popular financial advice which has progressively morphed into statistical click-bait.

The stock market is sliced and diced to present its prettiest façade. Investing time frames that I argue best fit the lifespan of vampires not humans indeed connect to consistent double-digit returns.

Statistical foreplay makes it easy to promote risk assets like stocks as the solution to every financial ailment. I posit this sentiment is fueled hot by overconfidence, a backstop provided by a Federal Reserve that listens to and fears market downturns and recency bias as professionals have forgotten the damage created by bear market cycles.

New advisors and brokers are convinced that bear markets are occurrences of the past and trained by their big box brokerage allegiances to perceive them as great opportunities. For young investors market derails may be opportunities; especially for those who are in accumulation mode and seek to purchase stock shares at lower prices. For people near or in retirement who require investment account distributions, a bear market can be devastating to longevity of portfolio assets.

When (if) bear markets occur, every investor trades time for dollars. So, what is your time worth? How much of your overall portfolio should be allocated to stocks if you consider how long it may take to make up for losses? If you consider risk first, reward second, especially at a time when market valuations portend to lower future returns, outside of the media telling you to “eat your stocks!”, what do you believe is right?

Search for the truth. It’ll crystallize sane thoughts. Understand how long it can take to break even from market disconnects and decide accordingly.

I’ve been studying individual stocks since I was 16. When I was 12 years old, I called the Dreyfus mutual fund company to receive information on a money market named Dreyfus Liquid Assets (ironically, I worked for Dreyfus from 1990-1998).

At that time, I recall the fund had a hefty front-end load to invest. Yes, a money market fund with a front-end charge! We’ve come a long way. I realized I was way over my head as I labored through voluminous square-stapled pages comprised of paragraphs in very small type. Each word came across as important. Although I comprehended a mere 2% of what I read, the exercise along with studying stocks helped me to realize that money is deadly serious and downturns in markets and flowery fabrication of long-term market returns should be taken seriously too – which is one reason I teamed up with Lance Roberts who I believe communicates money truth for today’s market and macro-economic conditions.

Please don’t misunderstand me – Stocks are indeed part of an overall lifetime financial strategy – they’re just not the solution to every financial shortfall. Even if they are the best answer, valuations and time frames as head or tailwinds to success of the asset class, must be considered as a practical measure when helping investors meet long-term financial milestones.

I recall a period in my career when a blended portfolio of 60% stocks, 40% bonds provided solid double-digit returns. Over the last 20 years, the same asset mix, similar risk provided returns in low-to-mid single digits. I deem it a stealth financial repression.

Let’s imagine I’m 25 and save consistently for 40 years in an S&P 500 Index Fund; using past performance through December 2018 as a guide, I may achieve an annualized return greater than 11%. Not shabby. My beef with mainstream financial media is not their certainty of future rosy returns more than it is the financial reality today which prevents people from investing consistently for 40 years.

For example, many households have still not recovered financially from the Great Recession. A recent nationwide Bankrate survey discovered that 48% of Americans who were adults when the recession began in 2007, have seen no improvement in their financial situation. How does one save for the long-term to take advantage of market returns for 40 or 50 years if this is their present state?

Vanguard’s 2019 edition of their How America Saves analysis breaks down the behavior of 5 million participants in 1,900 defined contribution plans (most of them 401ks), they administer.

My beef on occasion with Bankrate is their sample size is too small – roughly 1,000. Although I do admire their initiatives to measure the pulse of the financial distress still prevalent in America that most outlets are reluctant to discuss. Vanguard casts a wide net as a lead provider of defined contribution plans.

In 2018, the average account balance for Vanguard participants was $92,148. The median balance was a paltry $22,147. For those 65 and older, Vanguard found these average balances at $192,877 with the median being a woefully deficient $58,035.

Something is broken. Now you know why I focus much in my writing about the importance of making smart, unemotional decisions about Social Security which is now America’s primary pension.

Today, I meet with individuals and couples – Millennials, Generation X’ers – I teach 20-something Gen Z young adults about financial basics; I wonder how in reality they’re going to be able to invest interrupted for 40 years, especially when more of the risk of saving for retirement and healthcare cost burdens are incurred by the employee, not employer.

Although wage growth has improved over the last 12 months, in real (inflation-adjusted) terms, median annual income is only $674 higher than it was in the beginning of 2008, according to Sentier Research.

I am encouraged by the fiscal habits of Generation Z, those born after 1995. They are aggressively price conscious with purchase decisions, seem to master the temptation of immediate gratification, save money at a higher rate than previous generations and are even willing to discuss formal financial planning.

I pray I’m dead wrong. However, based on how I assist young generations prioritize (juggle) their saving, debt and investment goals, without consistent, inflation-adjusted wage growth and strong resolve to live below their means, I am having a challenge envisioning how this group saves interrupted for two decades, let alone four.

If I’m correct, stock returns just due to lack of time invested in markets may be closer to 6.5%; if current valuations are considered then maybe returns are closer to 3%. Unless wages consistently increase which could allow for heftier savings and investing rates, Gen X and Gen Z populations are going to require information that’s based more on their reality than the ancient history of euphoric fiscal tailwinds that Baby Boomers faced in the 80s and 1990s.

I don’t believe the financial industry is up for the educational task nor the noble responsibility to align with the financial reality that younger generations are going to encounter. The focus would be less of an emphasis on stocks as a wealth-building tool or full-on retirement savior. Imagine?

Portfolios will need to include longevity insurance or annuities to replace lost pensions. These structures should only be offered if holistic, lifetime financial planning suggests they’re warranted.

I’m afraid it’ll be best for the industry to stick with lush memories of big returns derived within the expanse of semi-centennial stock investing.

Limited information which details the impact of bear markets may scare young generations away from stocks forever once 30%+ losses become part of their reality. I observe how risk-averse Generation X and Z tend to be; perhaps an imprint of their not so prosperous recollections of what their families went through during the financial crisis and the hardships they’re still experiencing. After all, breaking even is a b*tch as I meet with investors today who haven’t recovered from losses incurred during the Great Recession. Not just stock losses. There remains a drag on wages, which is worse.

It’s time for financial professionals to align with the mindset of these generations – help them focus on the basic skills required to create robust financial balance sheets. Help them to combat financial fragility by focusing on the benefits of building and maintaining emergency cash reserves as a priority over retirement accounts, debt control, small mortgages and the benefits of health savings accounts. It’ll be a refreshing change from the myopia over the so-called magical financial elixir that only seems to be manufactured on Wall Street in the form of stock investing.

As fiduciaries we can’t afford to be so narrow minded.

What is the yield curve and what does it mean for the economy and the markets?

Over the last few months, the financial media has obsessed on those questions. Given the yield curve’s importance, especially considering the large amount of debt being carried by individuals, corporations, and the government, we do not blame them. In fact, we have given our two cents quite a few times on what a flattening and inversion of various yield curves may be signaling. Taking our analysis a step further, we now look at investment ideas designed to take advantage of expected changes in the yield curve.

An inversion of the 2yr/10yr Treasury yield curve, where yields on 10-year Treasury notes are lower than those of 2-year Notes, has accurately predicted the last five recessions. This makes yield curve signaling significant, especially now. It is important to note that in the five prior instances of yield curve inversions, the recession actually started when, or shortly after, the yield curve started to steepen to a more normal positive slope following the inversion. In our opinion, the steepening, and not the flattening or inversion of the curve, is the recession indicator.  

As discussed in Yesterday’s Perfect Recession Warning May Be Failing You, we believe the 2yr/10yr curve may not invert before the next recession. It may have already troughed at a mere 0.11 basis points on December 19, 2018. If we are correct, the only recession warning investors will get could be the aforementioned curve steepening. Another widely followed curve spread, the yield difference between 3-month Treasury bills and 10-year Treasury notes, recently inverted and troughed at -25 basis points, which makes the likelihood of a near-term recession significant.

The remainder of this article focuses on REITs (real-estate investment trusts). Within this sector lies an opportunity that should benefit if the yield curve steepens, which we noted has occurred after an initial curve inversion and just before the onset of the last five recessions.  

What is an Agency Mortgage REIT?

REITs are companies that own income-producing real estate and/or the debt backing real estate. REITs tend to pay higher than normal dividends as they are legally required to pay out at least 90% of their taxable profits to shareholders annually. Therefore, ownership of REIT common equity requires that investors analyze the underlying assets and liabilities of the REIT to assess the potential flow of income, and thus dividends, in the future.  

The most popular types of REITs are called equity REITs. These REITs own equity in apartments and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREITs), which own the debt (mortgages) on real-estate properties. Within this sector is a subset known as Agency mREITs (AmREITs) that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

From an investor’s point of view, a key distinguishing characteristic between equity REITs and mREITs is their risk profiles.  The shareholders of equity REITs are chiefly concerned with vacancy rates, rental rates, and property values.  Most mREIT shareholders, on the other hand, worry about credit risk and interest rate risk. Interest risk is the yield spread between borrowing rates and the return on assets. AmREITS that solely own agency guaranteed mortgages assume no credit risk as timely payment of principal and interest is advanced by the security issuer (again either Fannie Mae, Freddie Mac, or Ginnie Mae, all of whom are essentially government guaranteed). Therefore, returns on AmREITs are heavily influenced by interest rate risk. Almost all REITs employ leverage, which enhances returns but adds another layer of risk.

Agency mREITs

Earnings for AmREITs are primarily the product of two sources; the amount of net income (yield on mortgages they hold less the cost of debt and hedging) and the amount of leverage.

A typical AmREIT is funded with equity financing and debt. The capital is used to purchase government-guaranteed mortgages. Debt funding allows them to leverage equity. For example, if a REIT bought $5 of assets with $1 of equity capital and $4 of debt, they would be considered 5x leveraged (5/1). Leverage is one way REITs enhance returns.

The second common way they enhance returns is to run a duration gap. A duration gap means the REIT is borrowing in shorter maturities and investing in long maturities. A 2-year duration gap implies the REIT has an average duration of their liabilities that is two years less than the duration of their assets. To better manage the duration gap and the associated risks, REIT portfolio managers hedge their portfolios. 

The Fed’s Next Move and AmREITs

With that bit of knowledge, now consider the Fed’s quickly changing policy stance, how the yield curve might perform going forward, and the potential impact on REITs.

Recent speeches from various Fed members including Chairman Powell and Vice Chairman Clarida are leading us and most market participants to believe the Fed could lower rates as early as the July 31st FOMC meeting. Most often, yield curves steepen when, or shortly before, the Fed starts lowering rates. While still too early to declare that the yield curve has troughed, it has risen meaningfully from recent lows and is now the steepest it has been since November of 2018.  

If we are correct that the Fed reduces the Fed Funds rate and the yield curve steepens, then AmREITs should benefit as their borrowing costs fall more than the yields of their assets. Further, if convinced of a steepening event, portfolio managers might reduce their hedging activity to further boost income. The book value of AmREITs have a strong positive correlation with the yield curve, and as a result, the book value per share of AmREITs should increase as the curve steepens.

The following two graphs compare the shape of the 2yr/10yr yield curve versus the book value per share for the two largest AmREITs, Annaly Capital Management (NLY) and AGNC Investment Corporation (AGNC). The third and fourth graphs below show the same data in scatter plots to appreciate the correlation better. The current level of book value per share and yield curve is represented by the orange blocks in each scatter plot. Statistically speaking, a one percent steepening of the yield curve should increase the book value per share by approximately $2 for both stocks. Given both stocks have dividend yields in the low double-digits, any book value appreciation that results in price appreciation would make a good return, great.

Data Courtesy Bloomberg

While a steepening yield curve will likely create more spread income and thus a higher book value for these REITs, we must also consider the role of leverage and the premium or discount to book value that investors are currently paying.  

  • NLY is employing 8.2x leverage, which is slightly higher than their average of 7.6x since 2010, but less than their 20+ year average of 9.94.
  • AGNC uses more leverage at 10.2x, which is higher than their average of 8.8x since 2010. The REIT was formed in late 2008, therefore we do not have as much data as NLY. 
  • NLY trades at a discounted price to book value of .94, slightly below their historical average
  • AGNC also trades at a discounted level of .92 and below their historical average.

The risks of buying AGNC or NLY are numerous.

  • We may be wrong about the timing of rate cuts and the curve may continue to invert, which would decrease book value. In such a case, we may see the book value decline, and potentially even more damaging, the discount to book value decreases further, harming shareholders.
  • Even if we are right and the yield curve steepens and the REITs asset/liability spreads widen, we run the risk that investors are nervous about real-estate going into recession and REITs trade to deeper discounts to book value and effectively offset any price appreciation due to the increase in book value.
  • Leverage is easy to maintain when markets are liquid; however, as we saw a decade ago, REITs were forced to sell assets and reduce leverage which can also negatively affect earnings and dividends. It is worth noting that NLY had an average of 12.90x leverage in 2007, which is significantly larger than their current 8.20x.

Summary

Despite double-digit dividend yields and the cushion such high dividends provide, buying NLY or AGNC is not a guaranteed home run. The two REITs introduce numerous risks as mentioned.  That said, these firms and other smaller AmREITs, offer investors a way to take advantage of a steepening yield curve while avoiding an earnings slowdown that may hamper many stocks in an economic downturn.

While NLY and AGNC are in the same industry, they use different portfolio tactics to express their views. As such, if you are interested in the sector, we recommend diversifying among these two companies and others to help reduce idiosyncratic portfolio risks. We also recommend investors assess the IShares Mortgage Real ETF (REM). Its two largest holdings, accounting for over 25% of the ETF, are NLY and AGNC.  It is worth noting however, this ETF introduces risks not found in the AmREITs. The ETF holds the shares of mortgage REITs that contain non-guaranteed mortgages as well as mortgages on commercial properties.

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

  • The bounce we discussed previously has occurred and XLB has gone from extreme oversold back to extreme overbought.
  • As noted previously, XLB is back to very overbought conditions and is testing both previous resistance and the downtrend line. Use this opportunity to trim back holdings is still at target weight or more.
  • XLB failed at initial resistance on Monday.
  • Short-Term Positioning: Neutral
    • Last Week: Hold balance for rally to $55 to $55 1/2
    • This Week: Sell down positions to 1/2 weight and hold for now.
    • Stop-loss moved up to $55.50
  • Long-Term Positioning: Bearish

Communications

  • As noted previously, XLC broke support and failed at a rally turning support into resistance. Support is holding at current levels but just barely and XLC is now testing important overhead resistance.
  • We stated last week, that the “stop-loss” was violated, look for a bounce to $47 to $47 1/2 to sell position. We are there now.
  • Short-Term Positioning: Neutral
    • Last Week: Sell remaining position
    • This Week: Look for either a failure or breakout to add a trading position.
    • Hard Stop set at $47.50
  • Long-Term Positioning: Bearish

Energy

  • A month ago, I stated that XLE was currently at a critical juncture. A failure below the 200-dma was going to bring the low-$60’s into focus. That break happened and XLE tested the $59 level.
  • The previous “buy signal” has reversed putting more pressure on the sector currently. Use any rally to reduce exposure to the sector for now.
  • Short-Term Positioning: Neutral
    • Last week: Reduce exposure on this rally, initial target of $61 hit, $63 is likely max.
    • This week: Reduce exposure
    • Stop-loss adjusted to $59
  • Long-Term Positioning: Bearish

Financials

  • XLF has rallied and is now testing, and struggling with. previous resistance.
  • XLF remains on a “buy” signal currently and the overbought condition was reversed to provide for the bounce. XLF is not back to overbought levels as of yet.
  • Short-Term Positioning: Neutral
    • Last week: Recommended “hold” 1/2 position
    • This week: Hold 1/2 position, add on a pullback to $26.50 that holds.
    • Stop-loss moved up to $25.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI has put in a “triple top” at recent highs which makes that resistance level critically important.
  • As stated three weeks ago:
    • For now, the buy signal in lower panel is reversing and industrials are now oversold. With “trade war” rhetoric ramping up, watch for a break below support. XLI must hold $72.
  • Our stop level has held for now and XLI is rallying back to overhead resistance. There is a potential “had and shoulder” pattern being formed short-term so remain cautious.
  • Short-Term Positioning: Neutral
    • Last week: Look to sell on failed rally to $75-76
    • This week: Sell 1/2 position at current levels.
    • Stop-loss moved up to $72
  • Long-Term Positioning: Neutral

Technology

  • XLK reversed nicely off of the short-term oversold condition as expected.
  • The break above resistance, which has been driven by just AMZN, MSFT, AAPL, and GOOG, is set to test old highs at best.
  • Since we previously took profits, continue to hold the remaining positions for now.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss remains at $70
  • Long-Term Positioning: Neutral

Staples

  • XLP rallied sharply as money sought “safety” and “defense” once again this past week. New highs above trend are being made.
  • XLP’s “buy” signal (lower panel) is still in place and extended. We continue to recommend taking some profits if you have not done so.
  • XLP was oversold and we stated additional gains were likely. $56.50 was initial resistance which was taken out with new all-time highs.
  • Short-Term Positioning: Bullish
    • Last week: Add to current holdings if needed. We are currently carrying an overweight position.
    • This week: Hold positions, take profits if needed.
    • Profit stop-loss moved up to $57.50
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE, like XLP, has broken out to all-time highs as “defense” continues to catch the majority of the rally.
  • We previously recommended taking profits and rebalancing risk. That is still advisable.
  • Buy signal is being reduced along but XLRE is back to overbought.
  • We recently added to our XLRE position and are now carrying a full weight.
  • Short-Term Positioning: Bullish
    • Last week: Holding full position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.50
  • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE and XLP above, continue to advance from the “defensive” shift in allocations.
  • Long-term trend line remains intact and the recent test of that trend line with a break to new highs confirms the continuation of the bullish trend.
  • Buy signal worked off some of the excess. (bottom panel) but the sector is back to overbought once again.
  • Short-Term Positioning: Bullish
    • Last week: Hold overweight position
    • This week: Hold overweight position
    • Stop-loss moved up to $57.50.
  • Long-Term Positioning: Bullish

Health Care

  • Sell-signal (bottom panel) remains intact currently but previous support is holding and the sell signal is reversing upward.
  • While Healthcare is holding up for now, there is a downtrend forming in the sector. Keeps stops in place.
  • XLV has been in a consolidation for the last 18-months. So whichever direction healthcare breaks out to will be a big move.
  • XLV is back to overbought so $92 is important resistance.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position (overweight)
    • This week: Hold current position (overweight)
    • Stop-loss set $86
  • Long-Term Positioning: Neutral

Discretionary

  • With AMZN and AAPL now considered discretionary stocks, it is not surprising to see XLY rise and fall with XLK and XLC as those two major stocks rallied last week and on Monday.
  • The “buy” signal has been reduced and is holding up and XLY did break above previous resistance bring all-time highs into focus.
  • XLY was oversold and is now approaching overbought as the previously expected rally has occurred.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 of position.
    • This week: Hold 1/2 position with stops in place.
    • Stop-loss adjusted to $107.50 after sell of 1/2 position.
  • Long-Term Positioning: Neutral

Transportation

  • XTN has continued to lag the overall market and continues to suggest there is “something wrong” economically.
  • XTN has reversed its buy signal (bottom panel) and while the sector is bouncing off of an oversold condition, there is a lot going wrong. Look for a failed rally to $60 to sell into if you are still long positioning..
  • 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: No position
  • Long-Term Positioning: Bearish

Over the last three weeks, we have discussed the “sellable rally” in the markets. However, one of the more stunning movements in the market was in interest rates which have fallen sharply in recent months as “deflation” and “economic weakness” have become points of concern for the Federal Reserve.

Just last year, the Federal Reserve was hiking rates with the expectations of stronger economic growth and rising inflationary pressures from a tight labor market. Almost a year later, the markets, and the White House, are begging for the Fed to cut rates, and stop reducing their balance sheet, as the economic data has weakened substantially.

Despite these concerns, the markets remain within reach of all-time highs as the market continues to ignore the risks under the assumption “this time is different” and the Fed will indeed “come to the rescue.”

Will that be the case? No one knows for sure. 

What we do know is that markets move based on sentiment and positioning. This makes sense considering that prices are affected by the actions of both buyers and sellers at any given time. Most importantly, when prices, or positioning, becomes too “one-sided,” a reversion always occurs. As Bob Farrell’s Rule #9 states:

“When all experts agree, something else is bound to happen.” 

So, how are traders positioning themselves currently? 

Positioning Review

The COT (Commitment Of Traders) data, which is exceptionally important, is the sole source of the actual holdings of the three key commodity-trading groups, namely:

  • Commercial Traders: this group consists of traders that use futures contracts for hedging purposes and whose positions exceed the reporting levels of the CFTC. These traders are usually involved with the production and/or processing of the underlying commodity.
  • Non-Commercial Traders: this group consists of traders that don’t use futures contracts for hedging and whose positions exceed the CFTC reporting levels. They are typically large traders such as clearinghouses, futures commission merchants, foreign brokers, etc.
  • Small Traders: the positions of these traders do not exceed the CFTC reporting levels, and as the name implies, these are usually small traders.

The data we are interested in is the second group of Non-Commercial Traders.

This is the group that speculates on where they believe the market is headed. While you would expect these individuals to be “smarter” than retail investors, we find they are just as subject to “human fallacy” and “herd mentality” as everyone else.

Therefore, as shown in the series of charts below, we can take a look at their current net positioning (long contracts minus short contracts) to gauge excessive bullishness or bearishness. With the exception of the 10-Year Treasury which I have compared to interest rates, the others have been compared to the S&P 500.

Volatility Not Marking A Bottom

The extreme net-short positioning on the volatility index in early May suggested a peak to the advance from the December lows was likely. However, while the short-positioning has been reduced over the last several weeks as the market has corrected, there is still a sizable short-position which exists.

Given that most “bottoms” occur when short-VIX positioning has been fully reversed, the complacency of the recent decline suggests that a disappointment by the Federal Reserve, a failure of any progress on trade, or some other economy shock, could lead to a deeper decline. 

 

While the market did bounce following the sell-off in May, as we have been discussing in our series on a “Sellable Rally,” that rally is occurring within the confines of a longer-term “sell signal,” (upper panel) and falling volume. Historically, when both the “sell signal” turns lower, and the “volume signal” turns higher, such has marked important tops for the market.

It is likely the continuation of the correction will occur as we head into July and August.

Crude Oil Extreme

The recent attempt by crude oil to get back above $60/bbl coincided with a “mad rush” by traders to be long the commodity. However, they failed to take into account the building supply of crude oil in the face of a drop in demand amidst a slowing economic backdrop. Crude traders currently remain very “long the commodity, despite the recent drop back to $50/bbl, as we warned our RIA PRO subscribers (Try 30-Days FREE)

  • A month ago, we noted the rally in oil had gotten way ahead of itself in the face of building supplies and that the risk was clearly to the downside. We also noted that if support at $60 failed, along with the 200-dma, the risk was to the mid- to low-$50’s.
  • Despite the Iran issue last week, supply builds continue to weigh on oil prices. Support is at $50/bbl. A break below that is a whole other issue and will likely indicate the onset of recession.
  • Oil remains deeply oversold, so a counter-trend bounce in oil prices will not be surprising. Such would be in conjunction with a market rally on positive news from the Fed and the G-20 meeting.

It is worth noting that crude oil positioning is also highly correlated to overall movements of the S&P 500 index. Therefore, a deeper reversal in oil prices will likely coincide with a further correction in the S&P 500.

While oil prices could certainly fall below $40/bbl for a variety of reasons, the recent bottoming of oil prices around  $45/bbl should provide some reasonable support (barring an economic recession.)

US Dollar Extreme

Recent weakness in the dollar has been used as a rallying call for the bulls. However, a reversal of US Dollar positioning has not been extremely sharp and there remains a fairly large long-bias to dollar positioning. Importantly, as shown in the chart below, the reversal of dollar-long positioning is usually reflective of short- to intermediate-term market peaks.

As shown above, and below, such net-long positions have generally marked both a short to intermediate-term weakness in the dollar. The good news is that a weak dollar should bode well for both oil and gold prices which trade globally in U.S. dollars. 

It is also worth watching the net-short positioning the Euro-dollar as well. Historically, when positioning in the Eurodollar becomes NET-LONG, as it is currently, such has been associated with short- to intermediate corrections in the markets, including outright bear markets. The reversal is still early but worth watching closely.

Interest Rate Extreme

One of the biggest conundrums for the financial market “experts” is why interest rates fail to rise. Earlier this year, I wrote “The Bond Bull Market” which was a follow up to our earlier call for a sharp drop in rates as the economy slowed. That call was based on the extreme “net-short positioning” in bonds which suggested a counter-trend rally was likely.

The last time I wrote this report I stated:

“The reversal of the net-long positioning in Treasury bonds will likely push bond yields lower over the next few months. This will accelerate if there is a“risk-off” rotation in the financial markets in the weeks ahead.”

Both things occurred.

However, as shown in the updated chart below, despite the sharp drop in rates, traders are still betting on a surge in rates and the net-short positioning on the 10-year Treasury is at the second highest level on record. Combined with the recent spike in Eurodollar positioning, as noted above, it suggests that there is a high probability that rates will fall further in the months ahead; most likely in concert with the onset of a recession. 

The chart below looks at net-short positioning ONLY when net-short contracts exceed 100,000. Since peaks in net-short contracts generally coincide with peaks in interest rates, it suggests there is more room for rates to fall currently. 

Amazingly, investors seem to be residing in a world without any perceived risks and a strong belief that the financial markets are NOT at risk. The arguments supporting those beliefs are based on comparisons to previous peak market cycles and current positioning suggests traders believe the “bulls” will prevail. 

Unfortunately, they tend to be wrong at the extremes.

The inherent problem with much of the mainstream analysis is that it assumes everything remains status quo. But data, markets, economies, and liquidity are never the same. The question is simply what can go wrong for the market?

In a word, “much.”

With retail positioning very long-biased, as shown in the chart below, the recent correction has not imposed a level of “fear” that would denote a more lasting market bottom has been put into place.

The other famous Bob Farrell Rule to remember: 

“#5 – The public buys the most at the top and the least at the bottom.”

Just because a warning doesn’t immediately translate into a negative consequence, doesn’t mean you should not pat attention to it. It is akin to constantly running red lights and never getting into an accident. We begin to think we are skilled at running red lights, rather than just being lucky. Eventually, your luck will run out.

Pay attention, have a plan, and act accordingly.

Let me start out by saying that I am all for any piece of advice which suggest individuals should save more. Saving money is a huge problem for the bulk of American’s as noted by numerous statistics. To wit:

“American have an average of $6,506 in credit card debt, according to a new Experian report out this week. But which expenses are adding to that balance the most? A full 23% of Americans say that paying for basic necessities such as rent, utilities and food contributes the most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.”

That $6500 credit card balance is something we have addressed previously as it relates to the ability of an average family of four in the U.S. to just cover basic living expenses.

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

Flawed Advice

The media loves to put out “feel good” information like the following:

“If you start at age 23, for instance, you only have to save about $14 a day to be a millionaire by age 67. That’s assuming a 6% average annual investment return.”

Or this one from IBD:

“If you’re earning $75,000, by age 40 you need 2.4 times your income, or $180,000, in retirement savings. Simple as that.” (Assumes 10% annual savings rate and a 6% annual rate of return)

See, it’s easy.

Unfortunately, it doesn’t work that way.

Let’s start with return assumptions.

Markets Don’t Compound

I have written numerous times about this in the past.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up.

$1 Million Sounds Like A Lot – It’s Not

I get it.

$1 million sounds like a whole lot of money. It’s a nice, big, round number with lot’s of zeros.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year.

Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal.

If you are part of the F.I.R.E. movement and want to live in a tiny house, sacrifice luxuries, and eat lots of rice and beans, like this couple, that is certainly an option.

For most there is a desire to live a similar, or better, lifestyle in retirement. However, over time our standard of living will increase with respect to our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are in the latter camp, like me, a “million dollars ain’t gonna cut it.”

Don’t Forget The Inflation

The problem with all of these “It’s so simple a cave man could do it” articles about “save and invest your way to wealth” is not only the variable rates of returns discussed above, but impact of inflation on future living standards.

Let’s set up an example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he actually gets that 6% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That pretty straightforward math.

IT’S ENTIRELY WRONG.

The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the current living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.

If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.

Things You Can Do To Succeed

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

  • Pay yourself first, aggressively. Saving money is how you pay yourself for working. 30% is the real magic number. 
  • It’s all about “cash flow.” – you can’t save if you spend more than you make and rack up debt. #Logic
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over-spending is “social media” and “keeping up with the friends.” If advertisers were not getting your money from social media ads they wouldn’t advertise there. (Side benefit is that you will be mentally healthier and more productive by doing so.)
  • Pick up a side hustle, or two, or threeOnce you drop social media it will free up 4-6 hours a week, or more, with which you can increase your income. There are tons of apps today to let you earn extra money and “No” it’s not beneath you to do so. 
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Future inflation expectations must be carefully considered.
  • Expectations for compounded annual rates of returns should be dismissed 

Don’t misunderstand me….I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

There is one sure-fire way to go from “being broke” to being “rich” – write a book on how to do it and sell it to broke people. (See “Broke Millennial” and “Millennial Money.”– but hey that’s capitalism and you can do it too.)

But, if investing were as easy as just sticking your money in the market, wouldn’t “everyone” be rich?


Click here for PART 2

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

  • Over the last couple of weeks, we noted the SPY “buy” signal in the lower panel was massively extended, which as we stated, suggested the reversal we have seen was coming.
  • We also noted: “The correction last week has set up a tradeable opportunity into June and that we were approaching our initial target of $290”
  • That target was hit and we took 1/2 of our trading positions back in.
  • SPY is not back to more extreme overbought conditions just yet, and remains on a buy signal, which suggests a bit more rally could occur next week given comments from both the Fed and the G-20 summit are on deck.
  • Short-Term Positioning: Bullish
    • Last Week: Sell 1/2 of position on any rally next week that hits our target.
    • This Week: Hold remaining position.
    • Stop-loss reamins at $280
    • Long-Term Positioning: Neutral

Dow Jones Industrial Average

  • DIA has not had as a compelling of setup as SPY.
  • Nonetheless, DIA did rally and reversed a bulk of the oversold condition but is challenging overhead resistance.
  • More importantly, DIA has registered a “sell signal.”
  • Short-Term Positioning: Neutral
    • Last Week: Hold previous position given rally reversed “sell” level.
    • This Week: Hold current positions.
    • Stop-loss moved up to $252.50
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied from the oversold condition and is not overbought yet.
  • Such gives the market a chance to rally further next week into previous resistance from the August/September highs of 2018. The rally has been fairly weak.
  • QQQ is no longer oversold and the “buy signal” has been reversed. However, the “buy” signal is close to reversal suggesting the current rally may be limited to previous resistance levels.
  • Short-Term Positioning: Bullish
    • Last Week: Hold 1/2 position with a target of $185
    • This Week: Hold 1/2 position with a target of $185
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • As noted several weeks ago, SLY has fallen apart as market participation has weakened. SLY, and MDY are particularly susceptible to “trade wars” and slowing economic growth.
  • The modest “buy” signal has reversed and is now on a sell signal.
  • There are a lot of things going wrong with small-caps currently so the risk outweighs the reward of a trade at this juncture.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position.
    • Stop loss violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape.
  • MDY did regain its 200-dma but the rally has been weak.
  • Mid-caps did rally this past week back above the 200-dma but is not overbought yet. This suggests we could see a a bit more of a rally this coming week given some positive news from the Fed or the G-20 meeting.
  • Short-Term Positioning: Neutral
    • Last Week: Look to sell any further rally this week if not already done so.
    • This Week: Use any further rally this week to sell into.
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM has failed support, broke below the 200-dma, and has continued within its longer-term downtrend.
  • Last week, a “sell signal” was triggered.
  • Short-Term Positioning: Bearish
    • Last Week: No position recommended at this time.
    • This Week: No position recommended at this time.
    • Stop-loss violated.
  • Long-Term Positioning: Neutral

International Markets

  • EFA rallied over the last couple of weeks, but remains confined to a longer-term downtrend.
  • EFA is maintaining its 200-dma which is positive but the overall trend is concerning.
  • International markets have reversed its oversold condition but is not overbought yet.
  • Short-Term Positioning: Neutral
    • Last Week: Positions sold on stop-loss violation.
    • This Week: No position.
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • A month ago, we noted the rally in oil had gotten way ahead of itself in the face of building supplies and that the risk was clearly to the downside. We also noted that if support at $60 failed, along with the 200-dma, the risk was to the mid- to low-$50’s.
  • Despite the Iran issue last week, supply builds continue to weigh on oil prices. Support is at $50/bbl. A break below that is a whole other issue and will likely indicate the onset of recession.
  • Oil remains deeply oversold, so a counter-trend bounce in oil prices will not be surprising. Such would be in conjunction with a market rally on positive news from the Fed and the G-20 meeting.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss violated at $60.
  • Long-Term Positioning: Bearish

Gold

  • Gold has quickly reversed its oversold condition to overbought and did break above its downtrend.
  • We also noted, that the mild sell-signal would reverse back onto a “buy” which has occurred.
  • We are maintaining our position as a hedge against a potential pick up in volatility over the summer.
  • Gold is too extended to add to positions here.. Look for a pullback to $122-123 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole set at $120
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Bonds prices on bonds have gone parabolic and are now at extremes. Even the “buy” signal on the bottom panel has reached previous extremes which suggests a reversal in rates short-term is likely.
  • With the Fed and G-20 meeting on deck for this week, look for a reversal in rates for a better trading opportunity.
  • Currently on a buy-signal (bottom panel), bonds are now back to very overbought conditions and are testing the previous highs from 2016.
  • Support held at $122 which now become extremely important support.
  • Strong support at the 720-dma (2-years) (green dashed line) which is currently $118.
  • Short-Term Positioning: Bullish
    • Last Week: Take profits and rebalance risks. A correction IS coming which will coincide with a bounce in the equity markets into the end of the month.
    • This Week: Same as last week.
    • Stop-loss is moved up to $122
    • Long-Term Positioning: Bullish

U.S. Dollar

  • Over the last couple of weeks, the dollar has pulled and has now gotten oversold and is testing the bottom of its previous uptrend.
  • USD has triggered a short-term sell signal.
  • Hold current positions but maintain stop levels.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop loss is set at $96


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Wednesday, June 26th from 12:30-1:30 pm.


Review & Update

This week I want to step back and talk about some misconceptions with concerning markets, cycles, and investing. However, before we get to that, let me give you a quick review and update on where we are following the “sellable rally,” we have discussed over the last couple of weeks.

In review, we said last week: 

“We remain primarily long-biased in our portfolios, but are also slightly overweight in cash, and portfolio weight in fixed income. We are also carrying some hedge by having overweighted “defensive” stocks a couple of months ago which have continued to provide outperformance. 

There is a very good possibility this rally will continue next week as momentum and short-covering levels have been breached. However, if the market fails to set a new high and turns lower, the risk of a downside break will grow as we progress into summer.”

The rally did continue on Monday and hit our initial targets. We alerted our RIA PRO subscribers (FREE 30-day trial) to this on Monday. To wit:

  • As stated last time:
    • “The correction last week has set up a tradeable opportunity into June.”
  • That tradeable rally is in process and we are approaching our initial target of $290
  • Short-Term Positioning: Bullish
    • Last Week: Hold full position with a target of $290.
    • This Week: Sell 1/2 of position on any rally next week that hits our target.
    • Stop-loss moved up to $280
    • Long-Term Positioning: Neutral

That target was hit on Monday, and we sold 1/2 of our trading positions accordingly. 



Since then, the market has languished around the 50-day moving average seemingly awaiting some catalyst to move it in one direction of the other. Fortunately, there are plenty of those on deck as next week the Fed will give us their latest musings on whether they are inclined to cut rates or not and Trump will be confronting China in the upcoming G-20 meeting. 

Pass the popcorn, please. 

As shown in the chart below, the short-term oversold condition has been reversed which limits upside, but the 50-day moving average has acted as support all week. 

The concern this coming week will continue to be adverse news from the Fed, the White House, or the economic data which has continued to take a turn for the worse. Global economic growth has plunged as well as Q2 and Q3 economic growth estimates. 

This also puts forward earnings at risk of recession, which will not play well with a market trading at rather extreme historical valuations. 

“Oh my gosh, you are so bearish. You must just be all in cash and hiding in a bunker.” 

Well, for those that are reading impaired, it must certainly sound that way.

However, in reality, we have consistently maintained long exposure to the markets, but continue to control our risks to protect against sudden losses of capital.

That brings us to today’s missive.



Understand Bear Markets, Don’t Fear Them

I am a value-oriented investor and prefer to buy assets when they are fundamentally cheap based on several factors including price to sales, free cash flow yield, and high return on equity. However, being a strict value investor can also lead to a variety of investment mistakes, primarily emotional, when markets become both highly correlated and driven by speculative excess.

Currently, there is little value available to investors in the market today as prices have been driven higher by repeated Central Bank interventions and artificially suppressed interest rates. 

What we do know is that despite these interventions, the markets will eventually mean revert to the point that “value” is once again present. 

The problem for investors is two-fold:

  1. Knowing when to sell excessively valued markets which seemingly will not stop rising, and;
  2. Knowing when to buy back into markets which seeming will not stop falling.

This is why a good portion of our investment management philosophy is focused on the control of “risk” in portfolio allocation models through the lens of relative strength and momentum analysis. 

The effect of momentum is arguably one of the most pervasive forces in the financial markets. Throughout history, there are episodes where markets rise, or fall, further and faster than logic would dictate. However, this is the effect of the psychological, or behavioral, forces at work as “greed” and “fear” overtake logical analysis.

I have discussed previously the effect of full market cycles” as shown in the chart below.

What is also important to note is that these full market cycles are ultimately driven by the economic cycle. As shown in the next chart, the sector rotation appears to lead the economic cycle.

Importantly, it should be noted that investment styles also shift during the broader cycle.

  • During recessionary bottoms, when assets are truly selling at “bargain basement” prices, deep discount value strategies tend to perform the best as investors are panic selling to find safety over risk.
  • As markets begin to recover, investor’s begin to cautiously re-enter the markets and begin to seek some risk with a degree of safety. Value oriented investment strategies will still work during while these early recovery cycles and growth strategies began to gain momentum.
  • During the latter stages of the economic cycle, growth and value give way to pure momentum as investor “greed” and “exuberance” began to view “value” as “out of favor.” 

It is during this last stage of the cycle that “fundamentals appear not matter” as the fundamentally worst stocks lead the markets higher.

In other words, we begin hearing discussions of why “This Time Is Different (TTID),“The Fear Of Missing Out FOMO),” and “There Is No Alternative (TINA).” 



Complacency Lives

For now, complacency lives. Despite geopolitical turmoil, slowing economic data, weak corporate profitability, tariffs, and “trade wars,” the markets remain astonishingly close to their all-time highs. Furthermore, volatility, remains amazingly close to its historical lows despite a market that has gone nowhere for eighteen months.

Moreover, complacency also in how much investors are willing to pay for each dollar of profits from owning stocks relative to overall economic growth. As shown below, investors are paying much more for every dollar’s worth of profits than what the economy should actually generate. (Profits are a reflection of economic activity, not the other way around.)

Clearly, paying excess valuations is not uncommon throughout history. However, so are the eventual reversions are investors reprice values during economic slowdowns and recessions.

But the driving force behind today’s multiple expansion has been the relentless expansion of global central bank balance sheets since the outbreak of the financial crisis nearly a decade ago. Overall, global central bank balance sheets have expanded from just over $5 trillion prior to the crisis in 2007 to nearly $22 trillion today.

There is little doubt we are currently in a bull market. But as with all things, despite hopes from the mainstream media to the contrary, they do come to an end. This should be of no real surprise to anyone that has managed money for any length of time.

But here is the most important point for investors.

The speculative asset chase over the last decade, which is a direct result of Central Bank activity, has locked investors into a period of near zero prospective total returns in virtually in every asset class for the coming decade.

Read that again.

  • The 1999-2000 Dot.com bubble was about technology stocks. (7-Years to breakeven)
  • The 2007-2008 debacle was centered around real estate and subprime debt. (7-years to breakeven)
  • The 2020, or whenever it occurs, scenario will involve multiple bubbles in stocks, corporate debt, and real estate.

There is little doubt that we are in both the late stages of an economic cycle and a momentum driven market. Therefore, investment focus must be adjusted to current market dynamics that requires a focus on relative strength and momentum as opposed to valuation-based strategies.

There have been many studies published that have shown that relative strength momentum strategies, in which as assets’ performance relative to its peers predicts its future relative performance, work well on both an absolute or time series basis. Historically, past returns (over the previous 12 months) have been a good predictor of future results. This is the basic application of Newton’s Law Of Inertia, that states “an object in motion tends to remain in motion unless acted upon by an unbalanced force.”

The chart below shows a simple example of a strategy using the 12-month moving average. The theory is you are long equities when the S&P 500 is above the 12-month moving average, and in cash when below it.

Momentum strategies, which are trend following strategies by nature, have been proven to work well across extreme market environments, multiple asset classes and over historical time frames.

Unfortunately, few investors can actually use such a system for the following reasons:

  • Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late cycle stages.
  • Investors are ultimately driven by the “herding” effect. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
  • Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

The end effect is not a pretty one.

By applying momentum strategies to fundamentally derived investment portfolios it allows the portfolio to remain allocated during rising markets while managing the inherent risk of behavioral dynamics.

It is just really hard to do because of the “psychological pull” from the markets and the media.

However, this is why, despite the fact that I write like a “bear,” the portfolio model has remained allocated like a “bull” during the market’s advance. Our job is simple, make money for our clients when markets are rising and avoid potentially catastrophic losses when trends change.

Maintaining your portfolio through a disciplined investment process will reduce risk and increase long-term profitability. With markets currently hovering near all-time highs, despite a continuing erosion of underlying fundamental and technical strength, the risk/reward ratio remains out of favor.

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

Eventually, this cycle does end, and the reversion process back to value has historically been a painful one. 

But the important point is that you shouldn’t “fear” bear markets. 

They are just part of the investment cycle and are required for the next “great bull market” to begin. 

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

Improving – None

We have recently discussed that relative performance of Staples and Financials were improving as the outperformance lead of Technology, Discretionary and  Communications were weakening. That performance rotation continues this week with Financials and Staples rotating into the outperformance quadrant.

Current Positions:

Outperforming – Technology, Discretionary, Communications, Financials, Staples

As noted above Technology, Discretionary and Communications are on the verge of turning from outperformance to underperformance of the S&P 500 on a relative basis. While the rally in the market, as we discussed last week, continued for a second week in a row, it has been defensive positioning continuing the outperformance. 

Take profits and rebalance across sectors accordingly. 

Current Positions: 1/2 weight XLY, Reduced from overweight XLK, Overweight XLP, Target weight XLF.

Weakening – Real Estate and Industrials

Real Estate has continued to attract buyers particularly as interest continue to weaken. Performance improved again this past and Real Estate will likely move back into outperformance next week. We continue to carry our current weight in Real Estate, we also added to agency REIT’s to out equity portfolio last week. We continue to looking for opportunities to overweight the sector. Industrials bounced this past week, but their relative performance continues to drag. We remain underweight industrials currently. 

Current Position: XLRE, 1/2 XLI

Lagging – Healthcare, Materials, Energy, and Utilities

While these sectors are currently lagging the performance of the S&P 500, on a short-term basis, that performance continues to improve, with the strong exception of energy, as defensive continues to attract capital flows. 

As noted, we have slightly overweighted healthcare and utilities to go along with our overweight positioning in staples and financials. While we are maintaining a 1/2 position in XLE, it is not performing well and we may be required to “cut it loose” if performance doesn’t improve soon. 

IMPORTANT: Two weeks ago we noted that:

“All sectors are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.”

That oversold condition has been almost fully reversed. Take action if you have not done so.

We may have some follow through rally this week, but use any further rise to take action accordingly. 

Current Positions: 1/2 XLB, 1/2 XLE, Overweight XLV, Overweight XLU

Market By Market

The rally this past week was very concentrated and has all the earmarks of a short-term “short-covering” rally. 

Small-Cap and Mid Cap – Small-cap and Mid-cap previously both failed to hold above their respective 50- and 200-dma which keeps us from adding a position in portfolios. Last week, Midcap rallied back to its 200-dma but ran into a lot of resistance. We will need to patient to see if there is any follow through. As noted, these sectors are mostly tied to the domestic economy and their lack of performance is concerning relative to the economic backdrop. 

Current Position: No position

Emerging, International & Total International Markets 

As noted two weeks ago:

The re-institution 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. We have no long exposure to international markets currently. However, industrialized international is challenging its 50-dma once again. It is too soon to take on exposure as the current trend remains concerning. However, we are watching for an opportunity to add exposure if the technicals warrant the risk.

Current Position: No Position

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.

The rally over the last two weeks has almost fully reversed the previous oversold condition. Make sure and rebalance weightings in portfolios if you have not done so already.

Current Position: RSP, VYM, IVV

Gold – As noted last week, with rates dropping sharply and deflationary pressures on the rise, Gold finally got a bid over the last couple of week. Gold is now challenging its highs from February of this year and failed to breakout to highs. Gold has provided a good hedge in our portfolios against the recent decline and a breakout above current levels would suggest substantially higher prices. 

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

Bonds 

Bonds tested cycle highs and pulled back slightly before attempting a retest of highs this week. Bonds are extremely overbought, take some profits and rebalance weightings but remain long for now.

Current Positions: DBLTX, SHY, TFLO, GSY, IEF

High Yield Bonds, representative of the “risk on” chase for the markets rallied sharply with the market this week as “shorts” were forced out of their holdings. Not surprisingly, the “junk” rally has taken the market from oversold back to fairly overbought. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk rated” risk and improve credit quality in portfolios. 

IMPORTANT: Two weeks ago we noted that:

“All sectors are VERY OVERSOLD currently. Look for a rally in the next week to begin rebalancing risks and weightings accordingly. This could be your best, last chance, for the rest of the summer.”

That oversold condition has been almost fully reversed. Take action if you have not done so.

Sector / Market Recommendations

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

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

 

Portfolio/Client Update:

As noted at the beginning of May. we have shifted 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: Our onboarding indicators are “risk off” currently, so new accounts will remain in cash for the time being. Positions that were transferred in are on our global review list and will be monitored for an opportunity to liquidate to raise cash to transition into the specific portfolio models.
  • Equity Model: We sold MU last week as the position was simply not performing despite the fact the company is extremely cheap at 3x earnings. We will buy this position back in the future when technicals improve. We are also publishing a report this week on a “bullish steepener” in rates as short-term rates fall faster than long term (think recession). Therefore we starting buying two agency REIT’s, NLY and AGNC, to benefit from the uninversion of the yield curve. In the meantime we will collect at near 13% yield on both. 
  • ETF Model: We overweighted our exposure to defensive areas by adding Real Estate and overweighting Staples and Utilities. We are looking at adding an agency REIT ETF (REM) to our portfolios in the coming week as we did with the equity portfolio. 

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

Week Two Of The Bounce 

As noted last week:

“As reiterated in the main missive above this week, the “risks” still outweigh the “rewards” as we head deeper into the summer months. Importantly, don’t mistake an oversold, short-covering, rally as a bullish sign. More often than not, it is a trap.

We have remained patient over the last several weeks which has helped minimize some of the volatility.”

While the rally over the last couple of weeks was certainly welcomed, it was not impressive in terms of breadth or strength. Our suspicion is it will fail sooner than later UNLESS the Federal Reserve cuts rates and Trump inks a deal with China.

Given the unknowns, and the potential volatility of a “surprise” coming to fruition, continue following the same rules and guidelines from the last couple of weeks. 

  • If you are overweight equities – take some profits and reduce portfolio risk on the equity side of the allocation. Raise some cash and reduce equities to target weights. 
  • If you are underweight equities or at target – rebalance risks, look to increase cash rather than buying bonds at the moment, and rotate out of small, mid-cap, emerging, international markets. 

As noted last week, with week two of the rally now in the books and the markets back to very oversold, it is time take some action this coming week.

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

401k Plan Manager Coming Soon

Thank you for all the emails of plans. We have been imputing them into the 401k plan manager (we are going to roll out the beta shortly with a few samples for testing purposes.)  We are currently covering more than 10,000 mutual funds initially, and will add ETFs and Stocks in the coming updates.

We are also adding some retirement planning and savings tools to keep you on track.

Our “live” 401k plan manager 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. 

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

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

I have gotten quite a few plans, so keep sending them and I will include as many as we can. 

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

Current 401-k Allocation Model

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

Ray Dalio is the thoughtful, somewhat controversial founder of the world’s largest hedge fund, Bridgewater Associates, which he started in 1975.

While much of his writing is private, I (and many others) peruse every word we can of his and the Bridgewater team’s thinking. I find it to be some of the most interesting market commentary I read.

Lately, Ray has been far more open with his thinking, posting books and essays. He posted on LinkedIn rather controversial stories: Why and How Capitalism Needs to Be Reformed, Parts 1 and 2 and a follow-up piece titled It’s Time to Look More Carefully at ‘Monetary Policy 3 (MP3)’ and “Modern Monetary Theory.

On first reading those, I will admit to thinking, “Ray Dalio is kinda, sorta wrong.” I agreed with much of Part 1, with a few quibbles. Ditto for Part 2. But when I read the third piece I found myself thinking, “Ray Dalio is really, really wrong.”

In that essay he basically endorses Modern Monetary Theory (MMT).

Socialism Is Back

Coming from someone of Ray’s stature, and knowing that others like Bill Gross are beginning to endorse MMT either obliquely or directly, I found myself wanting to shout, “Stop! This is dangerous!”

He is clearly a generous man. And watching him in interviews and on stage, he is both disarming and comes across rather warmly. Definitely not dangerous. But ideas have consequences…

Ray has done us all a service by pointing out the elephants in the room (some tinged with pink), which are rarely mentioned in public discourse. We discuss various parts of the elephant, but seldom the entire creature.

By that, I mean the rapidly growing potential for left-of-center “progressive” control of both Congress and the White House. Part of that growth stems from an increasing frustration over the perceived differences between haves and have nots.

As The Economist reported recently, 51% of those polled between ages 18–29 have a positive view of socialism. That should scare you.

A growing number of that generation are taking that view into the voting booth. Democratic presidential candidates are all burnishing their “progressive” credentials.

I have zero insight into who might win that nomination fight, but there is a more than reasonable chance it will be the most left-leaning presidential nominee in a very long time, since at least George McGovern (for whom I voted).

And given the potential for recession between now and the election, they have a reasonable chance of winning.

Tough Choices

Just as Trump figured out how to energize the frustration of enough voters to win the presidency, it is likely we will see a populist nominated on the Democratic side.

A Democratic president and Congress will give us higher spending and taxes, and if that election happens amid recession, there will be an increasing drumbeat to “do something” radical.

The already-huge $2-trillion deficit we will have by then could easily swell even more.

Dalio, to his credit, recognizes that would be a negative outcome. He proposes dealing with the increasing deficit and debt via Modern Monetary Theory (MMT) or directly printing money. He also hopes it would help equalize the increasing income and wealth disparities.

I agree that we have a problem. The current situation could easily become a series of crises that would in fact be “existential,” as seen from today’s relatively benign world.

We are being forced into difficult choices, both political and economic, and the longer we kick the proverbial can down the road, not dealing with the real fundamental issues, the more difficult and starker those choices will be.

We are rapidly approaching a time in which there will be no good choices, only extremely difficult, controversial and/or bad choices, none of which resolve the fundamental problems.

That said, we need to make sure our choices don’t exacerbate the problems.

Is Capitalism the Problem?

Dalio talks about wealth and income disparity as a failure of capitalism. He argues that capitalism is not achieving its goal of more equitably distributing the fruits [read: profits] of capitalism.

To his point, my good friend Ben Hunt of Epsilon Theory notes that the S&P 500 companies have the highest earnings relative to sales in history.

Let me push back with what is admittedly a small quibble in the grand scheme of things. I think of capitalism more in the context of property rights, rule of law, and free markets.

Properly understood, it provides a level playing field for entrepreneurs to offer goods and services that produce incomes and profits. I don’t think equitably distributing those profits is capitalism’s role.

Ensuring that all participants are treated fairly and, to some extent, regulating these personal and corporate endeavors is the role of society in general and government in particular.

So when you say that capitalists are not very good at sharing profits, I would say that capitalism is not designed to do so. That is the role of society and government.

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

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