Monthly Archives: August 2019

RIA PRO: Powell Fails, Trump Rails & The Failure Of Negative Rates


  • Trump & Powell Square Off
  • Negative Yields Everywhere
  • Why The Fed Won’t Go Negative
  • Sector & Market Analysis
  • 401k Plan Manager

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Trump & Powell Square Off

Let’s start with a simple chart:

This has been an impossible market to effectively trade as rhetoric between the White House, the Fed, and China, has reached a fevered pitch. 

On Friday, several things happened which have at least temporarily significantly heightened market risk.

Jerome Powell disappointed the markets, and the White House, by sticking with their previous guidance concerning monetary policy actions. To wit:

  • We Will Act As Appropriate To Sustain The Expansion (Will cut rates if needed)
  • Says Events Since The July Fomc Have Been `Eventful’  (Trade War/Tariffs)
  • Carefully Watching Development For Impact On U.S. (China/US Trade)
  • Monetary Policy Has No Rulebook For International Trade 
  • We’ve Seen Further Evidence Of A Global Slowdown (Germany in recession)
  • Fitting Trade Policy Into Risk-Management Framework Is a New Challenge
  • Fed Faces Heightened Risk of Difficult-to-Escape Periods of Near-Zero Rates (Neg. rates)
  • U.S. Economy Has Continued to Perform Well Overall  (No rush to cut rates)
  • Sees Financial Stability Risks as Moderate, but Will Remain Vigilant

However, this commentary was not a surprise to us. We have suggested for several months the Fed should be slow to use what little ammo they currently have. 

“With the markets pushing record highs, recent employment and regional manufacturing surveys showing improvement, and retail sales rebounding, it certainly suggests the Fed should remain patient on cutting rates for now at least until more data becomes available. Patience would also seem logical given the limited room to lower rates before returning to the ‘zero bound.’”

Not surprisingly, Chairman Powell’s comments did not sit well with President Trump who has frequently pressed the Fed to cut rates aggressively. Mr. Powell stopped short of promising any specific monetary-policy easing, saying instead the central bank would “act as appropriate.”

After Powell’s closely watched speech in Jackson Hole, Trump tweeted, ‘As usual, the Fed did NOTHING!’ 

After China announced more import tariffs on U.S. goods early Friday, Trump said he would respond Friday afternoon. The president also asked ‘who is our bigger enemy,’ Powell or Chinese President Xi Jinping.” – MarketWatch

By the end of the day on Friday both the U.S. and China had hiked tariffs on one another.

“China said it would increase existing tariffs by 5% to 10% on more than 5,000 U.S. products, including soybeans, oil, and aircraft. A 25% duty on American-made cars would also be reinstituted. The value of these products is estimated by the Chinese Commerce Ministry to total around $75 billion.

Trump responded after financial markets closed by saying he would raise current U.S. tariffs. A 10% duty on $300 billion in Chinese goods will be raised to 15% in September while a 25% tariff on $250 billion in imports would be increased to 30% in October.” – MarketWatch

The Investing Conundrum

The problem with managing money is that markets are now trading on “tweets,” and “headlines,” more than fundamentals. This makes being either long, or short, particularly difficult. 

This was a point made earlier this week to our RIAPRO subscribers:

With the volatility seen in just the past two weeks, it is too difficult to trade short positions without being ‘whipsawed’ out of the holdings.

Trading Rule:

When you are ‘unsure’ about the best course of action, the best course of action is to ‘do nothing.’”

This is where we are currently. 

Over the past few months we have reiterated the importance of holding higher levels of cash, being long fixed income, and shifting risk exposures to more defensive positions. That strategy has continued to work well. 

  • We have remained devoid of small-cap, mid-cap, international and emerging market equities since early 2018 due to the impact of tariffs on these areas.
  • For the same reasons we have also reduced or eliminated exposures to industrials, materials, and energy
  • With the trade war ramping up, there is little reason to take on additional risk at the current time as our holdings in bonds, precious metals, utilities, staples, and real estate continue to do the heavy lifting. 

If you are being advised to hold all these asset classes for “diversification” reasons, you should be asking yourself, “why?”

Trade wars, and tariffs, are not friendly to these markets. With those “taxes” being ramped up by both parties, things will get worse, before they get better. 

Risk management is critically important to long-term returns, and risk is becoming more elevated daily. So, if you are paying for a “buy and hold” portfolio, you may want to reconsider what you are paying for?

From a technical perspective, the market is back to oversold, so a bounce next week is possible, but as noted last week, this is “still a sellable rally.” However, if the market breaks the current consolidation to the downside, a test of the 200-dma will be critically important. Any failure at that support will bring the December lows back into focus.

As we have continued to note over the last few weeks, the ongoing deterioration of small and mid-capitalization companies continues to suggest the overall backdrop of the markets is not healthy.

We continue to remain cautious for the time being. 



Negative Yields Everywhere

As I noted last week in “Pavlov’s Dogs & The Ringing Of The Bell:”

“The ‘ringing of the bell’ over the last decade has trained investors to rush into equity-related risk.”

With Powell disappointing traders, and Trump retaliating with additional tariffs, the initial response was to flee to “safety,” or rather should I say ” bonds.”

While retail investors continue to cling onto stocks hoping for a resurgence of the “bull market,” institutions are piling into bonds as the tidal wave of data continues to warn something is “broken.”

(You don’t have $17 Trillion in negative-yielding sovereign debt if there is economic and fiscal stability.)

Doug Kass reminded me on Thursday of a memorable lesson from “Wall Street.” 

“Quick buck artists come and go with every bull market, but the steady players make it through the Bear Markets. Enjoy it while it lasts – ’cause it never does.'” – Lou Mannheim

The message that negative yields are sending coincides with weaker growth rates in:

  • Corporate profits
  • Employment
  • CapEx
  • Personal Consumption Expenditures
  • Real Retail Sales
  • GDP

You can see this visually in the 6-panel chart from last week’s missive

Yes, the data is not negative which is why we aren’t in a recession…yet, (However, the data is subject to substantial negative revisions, and as we showed last week, the month before the last recession started all the data was positive as well.)

This is also the reason the Fed stopped hiking rates.

Last September, the Fed believed they needed to hike rates more aggressively as they believed the “neutral rate,” (code for economic growth) was considerably higher. We warned then several natural disasters were skewing the economic data, and that hiking rates was a mistake. By December, as rates reached 2%, and with the markets down 20%, the “neutral rate” had been achieved.

Don’t mistake the following comment from Fed member Patrick Harker earlier this week:

“This was a situation where we were getting back to what I would see as a neutral rate. In December 2018, we raised rates by 25 basis points. At that time, I was not supportive of that move because I thought that we didn’t need to do that. So, we’re just recalibrating back to where I thought we should have been, with a 25-basis-point cut.”

Since that is a lot of “Fed speak,” let me translate:

“Listen, as a member of the Fed, I can’t tell you the economy has weakened significantly, and the threat of a recession has risen markedly.  If I did say that, the market would crash, consumer confidence would crash, and we would immediately be in a recession. 

The reality is that we needed to get rates off of zero percent, and we were hoping to get rates closer to 4%, to give us some room to support the economy during the next recession. Unfortunately, we actually ‘over tightened’ which led to the market disruption last year. The rate cut in July was to be supportive of the economy short-term, but we need to hold as much ‘ammo’ as possible in reserve for when the recession hits.”

Here is a chart of the Effective Fed Funds Rate versus the Neutral Rate (Real GDP):

You should note a couple of things.

  1. It wasn’t until the 1990’s that the “neutral rate” became a thing. However, one of the best indicators of an impending recession is when the 10-year rate is inverted to the Fed Funds rate, as it is now.
  2. The indicator is even more timely when the curve is inverted combined with the Fed cutting rates, as they are now.

Could this time be different? Absolutely, there is always the possibility this time could be different. However, betting on possibilities versus probabilities tends not to work out well. 



Why The Fed Won’t Go Negative

Since the Fed meeting in July when they cut rates by 0.25%, the Fed has been working diligently to lower expectations of further rates cuts. As noted, this is because the Fed understands the trap they have gotten themselves into. 

  1. With just a bit more than 2% between the current Fed funds rate and ZERO, the Fed understands what little bit of precious ammo they have to fend off the next recession. 
  2. They won’t go “negative” on rates.

Concerning the second point, my colleague Daniel LaCalle summed it up well:

“The paper ignores the collapse in net income margin and ROE and even dismisses ROTE (return on tangible equity) to try to defend the idea that banks earnings have not suffered from negative rates.

The worrying part is that these statements ignore the fact that one of the main reasons why banks’ bottom line has not fallen more is they have almost stopped making provisions on bad loans.

His point is critically important.

Negative rates have irreparably damaged European banks, which only can be resolved through a massive debt revulsion.

The Fed is at least smart enough to understand this dynamic, which is why they are defending what room they have with the one rate they can directly control. 

Wolf Richter also had some excellent points in this regard:

“Negative interest rates drive banks to chase yield to make some kind of profit. So they do things that are way too risky and come with inadequate returns. For example, to get some return, banks buy Collateralized Loan Obligations backed by corporate junk-rated leveraged loans. In other words, they load up on speculative financial risks. And as this drags on, banks get more precarious and unstable.

This is not a secret. The ECB and the Bank of Japan and even the Swiss National Bank have admitted that negative interest rates weaken banks. The ECB has even been talking about a strategy to ‘mitigate’ the destructive effects its policies have on the banks.

So that’s the issue with negative interest rates and banks. They crush banks.”

Don’t forget. 

Why did the Fed launch Q.E., and cut rates to zero, to begin with? 

To bail out the member banks of the Federal Reserve, or should I just say, “Wall Street.”

Interest rates are a function of economic growth. Globally, despite massive levels of QE, and low interest rates, economic growth is faltering, not strengthening.

The Fed does understand this.

Unfortunately, the Fed is still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S., just as it failed in Japan. The reason is simple. You can’t cure a debt problem with more debt. Therefore, monetary interventions, and government spending, does not create organic, sustainable, economic growth. 

Simply pulling forward future consumption through monetary policy continues to leave an ever growing void in the future that must be filled. Eventually, the void will be too great to fill.

If rates ever do rise, it’s game over as borrowing costs surge, deficits balloon, housing falls, revenues weaken, and consumer demand wanes. It is the worst thing that can happen to an slow growing economy that is dependent of further debt expansion just to sustain current growth.

As Wolf noted, lower rates are not the solution, they are the problem. 

So far, the outcomes are already bad, and now, because the outcomes are already bad, they’re wanting to drive interest rates even lower to deal with the bad outcomes that these low interest rates have already caused.”

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 (XLV)

While we are maintaining exposure to Health Care for now, as defense continues to shield against volatility risk, the performance improvement has begun to wane this past week. However, healthcare is currently oversold and is testing critical support. After taking profits previously, we are holding tighter stops for now. 

Current Positions: Target weight XLV

Outperforming – Staples (XLP), Utilities (XLU), Materials (XLB), Communications (XLC)

Trade war rhetoric hit Materials hard on Friday, but is currently holding support. We have moved stops up on our holdings a break of support will likely reduce our allocation further. Utilities and Real Estate have continued their performance, and after taking profits, we are maintaining our holdings in these sectors.

Current Positions: Overweight XLP, Target weight XLU, 1/2 XLB and XLC

Weakening – Technology (XLK), Discretionary (XLY), Real Estate (XLRE)

While Technology, and Discretionary did turn higher, the performance was relatively weak. The rise of trade war tensions hit these two sectors hard on Friday but support is currently holdings. Raise stops and manage risk accordingly. Real Estate continues to hold up from defensive positioning.

Current Position: 1/2 weight XLY, Target weight XLK, XLRE

Lagging – Energy (XLE), Industrials (XLI), Financials (XLF)

Energy is in a lot of trouble as oil prices remain weak due to a global slow down. Industrials broke support last week, and failed at resistance. We were stopped out of XLE previously, but are maintaining our “underweight” holdings in XLI for now. We are close to getting stopped out on this position as well. We also reduced our holdings in the Financial sector as both the Fed lowering rates, and an inverted yield curve, are not beneficial their profits.

Current Position: 1/2 weight XLF & XLI

Market By Market

Small-Cap and Mid Cap – Small- and Mid-caps collapsed on Friday as more tariffs have a larger impact on their profit margins. Small- and Mid-caps have both violated their 200-dma. Mid-caps are only marginally in a better technical condition than small-caps but there is no reason to have weightings in either index currently. 

We noted a month ago that with small and mid-caps extremely overbought, it was “a great opportunity to rebalance portfolio risk and reducing weighting to an underperforming asset class for now until things improve.”  That turned out to be good advice.

Current Position: No position

Emerging, International & Total International Markets

We have been out of Emerging and International Markets for several weeks due to lack of performance. However, the addition of tariffs are not good for these markets and prices have collapsed over the last few weeks. As we noted previously, “patience will be rewarded either by avoiding portfolio drag or gaining a more advantageous entry point.”  Not having exposure to these areas continues to pay off for now.

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 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.

Current Position: RSP, VYM, IVV

Gold – Gold continued to push higher due to the deteriorating economic backdrop. This continues to be bullish set up for “gold bulls.” We are holding out positions for now, and continue to look for a better entry point on a pullback to add to holdings. We haven’t gotten one yet.

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

Bonds 

Like Gold, bonds continued to attract money flows as investors search for “safety.” There has also been a massive short-covering rally with all those “bond bears” being forced to cover. However, as noted previously, bonds are EXTREMELY overbought. We are looking to increase our duration and credit quality on a pullback in price. We aren’t expecting much of a correction, so we will likely scale into additional holdings during a correction process. 

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

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

High Yield Bonds, representative of the “risk-on” chase for the markets had been consolidating and got oversold. Last week, junk bonds surged back to highs as traders chased “risk on.”  With yield spreads very compressed this is a good opportunity to take profits and reduce risk. If this market does begin a bigger correction, there will be a lot of investors left “holding the bag.” 

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 above, the volatility in the market currently has made “trading” portfolios extremely complicated. Whatever you do, looks good one day, and terrible the next.

However, this is the market we are in currently and the feud between the White House, the Fed, and China is likely not going to end well. The correction continued again this past week, which has now gotten the market fairly oversold. The big news, of course, was the inversion of the yield curve, which has dominated headlines as of late. However, as I noted last week, it is when the yield curve un-inverts, as the Fed is aggressively cutting rates, that the recession is likely in process. 

We are watching this very closely.

With the volatility in the markets, and the fact the markets have not  done anything technically “wrong” as of yet, we have taken no actions this past week. 

However, there is a rising probability that we are about to start getting stopped out of positions that are directly tied to the “trade war” such as Materials, Industrials, and Discretionary holdings.

For newer clients, we are keeping accounts primarily in cash as our onboarding model is currently on a “sell signal” suggesting that risk outweighs reward currently. 

In the meantime, we continue to carry tight stop-loss levels, and any new positions will be “trading positions” initially until our thesis is proved out.

  • New clients: We are holding cash until our onboarding model turns back onto a “buy signal.” At that time we will begin buying 1/2 of our target positions and step into the model allocation to minimize entry risk. 
  • Equity Model: No trades this past week. 
  • ETF Model:  No trades this past week. 

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

Trump Pushes The Trade War 

Interestingly, what I wrote previously is worth reusing today:

“A less than anticipated rate cut, and outlook, by the Fed tripped up participants. Then Trump deciding to add additional tariffs on China, in order to force the Fed to cut rates, roiled stocks even more. Stocks sold off for the entirety of last week, so expect a rally early next week to sell into. Take some actions if you have not already as the next two months could bumpy. The correction is likely not complete yet.

More tweets and volatility this week, inverted yield curves, etc.

With Powell disappointing the markets and President Trump on Friday, Trump took to his Twitter account to chastise the Fed and increase tariffs on China. Notably, China also increased tariffs on the U.S. – we are now in the midst of a “real trade war.”

Don’t dismiss the risk of a trade war. As Otto T. Mallery wrote in “Economic Union and Durable Peace:”

“When goods don’t cross borders, soldiers will.” 

Trade wars are not economically healthy and, historically, pose a national threat. However, for the moment, the biggest risk is to the markets if investors begin to reprice risks. 

While volatility has risen markedly, the markets really haven’t done anything “wrong” as of yet. This is one of those times we have to sit on our hands and wait. With markets moving from one tweet to the next, it is impossible to successfully trade these swings. 

However, note in the chart above, that both weekly “buy/sell” signals are close to triggering a “sell.” Also, not that each penetration above the long-term upper trend line has repeatedly failed. A confirmed “sell” signal at this juncture will require a further reduction in equity risk.

Downside risk is elevated, so we are maintaining underweight holdings for now. However, if we begin to break supports, we will recommend reducing risks further. 

If you haven’t taken any actions as of late, it is not a bad time to do so. 

  • If you are overweight equities – Hold current positions but remain aware of the risk. Take some profits, and rebalance risk to some degree if you have not done so already. 
  • If you are underweight equities or at target – rebalance risks and hold positioning for now.

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

401k Plan Manager Beta Is Live

We have rolled out a very early beta launch to our RIA PRO subscribers

Be part of our Break It Early Testing Associate” group by using CODE: 401

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

We have several things currently in development we will be adding to the manager, but we need to start finding the “bugs” in the plan so far.

We are currently covering more than 10,000 mutual funds and have now added all of our Equity and ETF coverage as well. 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 the 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 you 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.)


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

Comparing Yield Curves

Since August of 1978, there have been seven instances where the yields on ten-year Treasury Notes were lower than those on two-year Treasury Notes, commonly referred to as “yield curve inversion.” That count includes the current episode which only just occurred. In all six prior instances a recession followed, although in some cases with a lag of up to two years.

Given the yield curve’s impeccable 30+ year track record of signaling recessions, we think it is appropriate to compare the current inversion to those of the past. In doing so, we can further refine our economic and market expectations.

Bull or Bear Flattening

In this section, we graph the seven yield curve inversions since 1978, showing how ten-year U.S. Treasuries (UST), two-year UST and the 10-year/2 year curve performed in the year before the inversion.

Before progressing, it is worth defining some bond trading lingo:

  • Steepener- Describes a situation in which the difference between the yield on the 10-year UST and the yield on the 2y-year UST is increasing. Steepeners can occur when both securities are trending up or down in yield or when the 2-year yield declines while the 10-year yield increases.
  • Flattener- A flattener is the opposite of a steepener, and the difference between yields is declining.  As shown in the graph above, the slope of the curve has been in a flattening trend for the last five years.
  • Bullish/Bearish- The terms steepener and flattener are typically preceded with the descriptor bullish or bearish. Bullish means yields are declining (bond prices are rising) while bearish means yields are rising (bond prices are falling). For instance, a bullish flattener means that both 2s and 10s are declining in yield but 10s are declining at a quicker pace. A bearish flattener implies that yields for 2s and 10s are rising with 2s increasing at a faster pace.  Currently, we are witnessing a bullish flattener. All inversions, by definition, are preceded by a flattening trend.

As shown in the seven graphs below, there are two distinct patterns, bullish flatteners and bearish flatteners, which emerged before each of the last seven inversions. The red arrows highlight the general trend of yields during the year leading up to the curve inversion.  

Data for all graphs courtesy St. Louis Federal Reserve

Five of the seven instances exhibited a bearish flattening before inversion. In other words, yields rose for both two and ten year Treasuries and two year yields were rising more than tens. The exceptions are 1998 and the current period. These two instances were/are bullish flatteners.

Bearish Flattener

As the amount of debt outstanding outpaces growth in the economy, the reliance on debt and the level of interest rates becomes a larger factor driving economic activity and monetary and fiscal policy decisions. In five of the seven instances graphed, interest rates rose as economic growth accelerated and consumer prices perked up. While the seven periods are different in many ways, higher interest rates were a key factor leading to recession. Higher interest rates reduce the incentive to borrow, ultimately slowing growth and in these cases resulted in a recession.

Bullish Insurance Flattener

As noted, the current period and 1998 are different from the other periods shown. Today, as in 1998, yields are falling as the 10-year Treasury yield drops faster than the 2-year Treasury yield. The curve thus flattens and ultimately inverts.

Seven years into the economic expansion, during the fall of 1998, the Fed cut rates in three 25 basis point increments. Deemed “insurance cuts,” the purpose was to counteract concerns about sluggish growth overseas and financial market concerns stemming from the Asian crisis, Russian default, and the failure of hedge fund giant Long Term Capital. The yield curve inversion was another factor driving the Fed. The domestic economy during the period was strong, with real GDP staying above 4%, well above the natural growth rate.  

The current period is somewhat similar. The U.S. economy, while not nearly as strong as the ’98 experience, has registered above-trend economic growth for the last two years. Also similar to 1998, there are exogenous factors that are concerning for the Fed. At the top of the list are the trade war and sharply slowing economic activity in Europe and China. Like in 1998, we can add the newly inverted yield curve to the list.

The Fed reduced rates by 25 basis points on July 31, 2019. Chairman Powell characterized the cut as a “mid-cycle adjustment” designed to ensure solid economic growth and support the record-long expansion. Some Fed members are describing the cuts as an insurance measure, similar to the language employed in 1998.

If 1998-like “insurance” measures are the Fed’s game plan to counteract recessionary pressures, we must ask if the periods are similar enough to ascertain what may happen this time.

A key differentiating factor between today and the late 1990s is not only the amount of debt but the dependence on it.   Over the last 20 years, the amount of total debt as a ratio to GDP increased from 2.5x to over 3.5x.

Data Courtesy St. Louis Federal Reserve

In 1998, believe it or not, the U.S. government ran a fiscal surplus and Treasury debt issuance was declining. Today, the reliance on debt for new economic activity and the burden of servicing old debt has never been greater in the United States. Because rates are already at or near 300-year lows, unlike 1998, the marginal benefits from borrowing and spending as a result of lower rates are much less economically significant currently.

In 1998, the internet was in its infancy and its productive benefits were just being discovered. Productivity, an essential element for economic growth, was booming. By comparison, current productivity growth has been lifeless for well over the last decade.

Demographics, the other key factor driving economic activity, was also a significant component of economic growth. Twenty years ago, the baby boomers were in their spending and investing prime. Today they are retiring at a rate of 10,000 per day, reducing their consumption and drawing down their investment accounts.

The key point is that lower rates are far less likely to spur economic activity today than in 1998. Additionally, the natural rate of economic growth is lower today, so the economy is more susceptible to recession given a smaller decline in economic activity than it was in 1998.

The 1998 rate cuts led to an explosion of speculative behavior primarily in the tech sectors. From October of 1998 when the Fed first cut rates, to the market peak in March of 2000, the NASDAQ index rose over 300%. Many equity valuation ratios from the period set records.

We have witnessed a similar but broader-based speculative fervor over the last five years. Valuations in some cases have exceeded those of the late 1990s and in other cases stand right below them. While the economic, productivity, and demographic backdrops are not the same, we cannot rule out that Fed cuts might fuel another explosive rally. If this were to occur, it will further reduce expected returns and could lead to a crushing decline in the years following as occurred in the early 2000s.  

Summary

A yield curve inversion is the bond market’s way of telegraphing concern that economic growth will slow in the coming months. Markets do not offer guarantees, but the 2s-10s yield curve has been right every time in the last 30 years it voiced this concern. As the book of Ecclesiastes reminds us, “the race does not always go to the swift nor the battle to the strong…”, but that’s the way to bet.

Insurance rate cuts may buy the record-long economic expansion another year or two as they did 20 years ago, but the marginal benefit of lower rates is not nearly as powerful today as it was in 1998.

Whether the Fed combats a recession in the months ahead as the bond market warns or in a couple of years, they are very limited in their abilities. In 2000 and 2001, the Fed cut rates by a total of 575 basis points, leaving the Fed Funds rate at 1.00%. This time around, the Fed can only cut rates by 225 basis points until it reaches zero percent. When we reach that point, and historical precedence argues it will be quicker than many assume, we must then ask how negative rates, QE, or both will affect the economy and markets. For this there is no prescriptive answer.

#WhatYouMissed On RIA: Week Of 08-19-19

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


The Best Of “The Lance Roberts Show”

Video Of The Week

Message From The Yield Curve

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!

Stock Buybacks Imperil Corporate Viability

Goldman Sachs just completed an analysis of corporate balance sheets and found that dividend and stock buybacks accounted for 103.8% of their free cash flow. Meaning that they were paying more out in cash than they had on hand!  Over the last year, free cash flow has dropped 15 %, while debt is up 8 %.

This corporate balance sheet squeeze is unprecedented; it is the worst cash flow crisis since 1980 and is unsustainable.  Corporate executives have turned to excessive borrowing levels to keep this financial merry-go-round going. A good amount of this debt is used for stock buybacks to hype share prices and keep earnings per share higher than they would be without buybacks.  

If sales and profits drop due to the trade war and/or consumer spending declines as it has in the last four months, some corporations will default on their debt. A downward economic spiral can be triggered. 

Maybe this is another reason the Fed announced a cut in interest rates and a shift to an ‘inflation averaging framework.’  JPMorgan recently commented in Marketwatch that they believe Fed economists are shifting to a position of not worrying about inflation but instead on keeping money flowing to corporations at low interest rates possibly as low as zero in the future. 

By keeping rates extraordinarily low, the Fed enables executives to waste profits on stock buybacks to increase their stock-based compensation and further increase stock prices. If we want strong, durable, and sustainable economic growth, then we need strong companies making investments in research, development, innovation, productivity improvements, employee training, and raising wages. When the economy works for all democracy is strengthened.

The financial music will stop when sales and profits decline and an already desperate cash flow position becomes untenable, putting many companies viability in doubt.  Looking out a year or two, we expect the Fed to come to the rescue after possible zero interest rates have panned out. Last March, former Fed Chair, Janet Yellen recommended that the Fed be authorized to purchase corporate stock and bonds to keep the economy going if a recession hits.

Mauldin – MMT Could Destroy This Nation

I am back from my 14th annual Maine fishing camp.

The private event at Leen’s Lodge is generally called Camp Kotok in honor of David Kotok of Cumberland Advisors who started these outings many years ago.

CNBC and others began calling it the “Shadow Fed,” but it is really just a meeting of wickedly smart people focused on economics and markets. (I am allowed to attend for comic relief.)

We discussed the world’s problems and the general mood was that many of those problems are beginning to catch up.

Among other topics, there was an open “debate” about Modern Monetary Theory (MMT) and US fiscal strategy.

There was the usual pushback, but I have to admit that I was struck by the private conversations after the debate.

Many smart, well-informed thinkers agreed MMT may be actually attempted in the next decade.

If we attempt MMT, it will end the US dollar’s reserve currency status and produce out-of-control inflation. That will essentially destroy the Boomer generation’s ability to retire with anything like most envision today.

I can’t say it any stronger. If I really see MMT coming, I will reposition my portfolio to heavily weight gold, real estate, and a few biotech companies. I simply can’t imagine a more dire economic scenario.

Unprecedented Stimulus

Many participants had read my analysis of the potential for $45 trillion worth of US debt by the end of the 2020s.

When I started talking about the potential for $20 trillion of additional quantitative easing, it was clear the question made some uncomfortable.

There was general agreement that neither political party can balance the budget. The latest “deal” between Trump and Congress raised spending $320 billion over the next two years.

The previous “sequester” deal that at least tried to limit spending is out the window. With it will go any control on the spending process. Current deficit projections will seem mild compared to what we actually get.

As I said a few weeks ago, using CBO projections from earlier this year and assuming one recession, the national debt would rise to almost $45 trillion by the end of the 2020s.

This new deal will add at least another $1.5 to $2 trillion to that amount. If there is a second recession, we would be looking at north of $50 trillion.

We don’t have $40 trillion, let alone $50 trillion, to put into federal debt. It would crowd out all funding for productive private enterprises and sharply reduce GDP growth. Which is why I expect to see massive, currently inconceivable amounts of quantitative easing.

Thinking the Unthinkable

The 2020s will force us to continually think the unthinkable. No, that is probably too mild. We are going to find ourselves having to continually DO the unthinkable.

Doom and gloom? Not really. The math is from the Congressional Budget Office.

It is politically impossible for them to project a recession, so they don’t. I would also admit that it is also statistically impossible to predict a recession, so they don’t. I don’t have such a restriction.

Below are the charts that I’ve printed in part four of the discussion with Ray Dalio a few weeks back, assuming recession in either 2020 or 2022. You can see what happens to the deficits and revenues.

This first graph assumes a recession in 2020. Note that revenues fall below mandatory spending by the middle of the decade, then never get back above mandatory spending plus defense spending.

Then by the end of the 2020s, mandatory spending will again rise to consume all tax revenue. And again, these don’t include significant off-budget spending.

This next graph assumes recession in 2022 instead of 2020. The pattern is basically the same, except that the $2-trillion deficits don’t begin until 2023. Again, this uses actual CBO projections and adjusts revenues by the same percentage they fell in 2008–2009, and recovered thereafter.

The Future Looks Grim

I asked one person after another what they thought would happen. How can we avoid this? I got no good answers. Others were clearly just as frustrated as I am. Let me tell you, I am way past frustration. I am seriously worried for the future of the Republic and our children and retirees.

I asked at least a dozen attendees (and maybe more) this question: If we introduce MMT and the result is what we all think it will be, I think there is a 50–50 chance some states will want to secede from the union. Do you agree or disagree?

I got literally no pushback on that admittedly outrageous idea. When you undertake policies that will destroy the very fabric of society in the name of “justice and equality for all,” those damaged in the process will push back.


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.

Corporate Debt Is At Risk Of A Flash Crash

The world is awash in debt.

While some countries are more indebted than others, very few are in good shape.

The entire world is roughly 225% leveraged to its economic output. Emerging markets are a bit less and advanced economies a little more.

But regardless, everyone’s “real” debt is likely much bigger, since the official totals miss a lot of unfunded liabilities and other obligations.

Debt is an asset owned by the lender. It has a price, which—like anything else—can go up or down. The main variable is the lender’s confidence in repayment, which is always uncertain.

But there are degrees of uncertainty. That’s why (perceived) riskier debt has higher interest rates than (perceived) safer debt. The way to win is to have better insight into the borrower’s ability to repay those loans.

If a lender owns debt in which his confidence is low, but you believe has value, you can probably buy it cheaply. If you’re right, you’ll make a profit—possibly a big one.

That is exactly what happens in a recession.

Investment-Grade Zombies

While it’s easy to point fingers at profligate consumers, households largely spent the last decade reducing their debt.

The bigger expansion has been in government and business. Let’s zoom in on corporate debt.

The US investment-grade bond universe is considerably more leveraged than it was ahead of the last recession:


Source: Gluskin Sheff

Compared to earnings, US bond issuers are about 50% more leveraged now than in 2007. In other words, they’ve grown debt faster than profits.

Many borrowed cash not to grow the business, but to buy back shares. It’s been, as my friend David Rosenberg calls it, a giant debt-for-equity swap.

There’s another factor, though. Today’s “investment-grade” universe contains a higher proportion of riskier companies. The lowest investment grade tier, BBB, now constitutes half of all issuers:


Source: Gluskin Sheff

All these are just one downgrade away from being high-yield “junk bonds.”

The best data I can find shows that there are roughly $3 trillion worth of BBB bonds and another roughly $1 trillion worth of lower-rated bonds that would still be called “high-yield.”

If it happens like last time, the ratings agencies will wait until their fate is already sealed before they cut ratings on these zombies. But that’s only part of the problem.

Selling Under Pressure

I expect liquidity in these below-investment-grade bonds to disappear quickly in the next financial crisis.

We got a small hint of how this will look in the December 2015 meltdown of Third Avenue Focused Credit Fund (TFCVX), which had to suspend redemptions and then spend two years liquidating its assets.

The fund managers made the right call to liquidate their holdings slowly, getting the best values they could. But that won’t work if the entire fund industry is strained at the same time.

This is a structural problem with mutual funds and ETFs. They must redeem their shares on demand, usually in cash (though some reserve the right to do it in-kind).

If enough shareholders want out at the same time, this can force them to sell fund assets on short notice.

Falling Apart Quickly

When the recession hits, we will see junk bonds—and the riskier end of corporate debt generally—go into surplus.

There will be more available for sale than investors want to buy. The solution will be prices dropping to a point that attracts buyers. I don’t know where that point is, but it’s a lot lower than now.

But there’s a problem. We talked about that $3 trillion worth of BBB bonds. Any that are downgraded by merely one grade will no longer qualify as “investment grade.”

That means that many pension funds, insurance funds, and other regulated entities by law won’t be able to hold them. They have a very short time to sell them back into the market.

Let’s say company X issues $100 million of a bond rated BBB by Moody’s or Standard & Poor’s. There is a high likelihood that some will be in regulated pension or insurance funds, and there will be forced selling at lower prices.

This will set a new price for that bond issue. Every mutual fund and ETF that holds those bonds will have to use the lower price when they mark-to-market at the end of the day.

I have seen this happen three times in my career. Yields go from fairly low to 20% or more at what seems like warp speed. If you are in one of those funds, you’re going to see your value drop precipitously.

Unless you are a professional and/or have some systematic trading signal that tells you when to trade, it’s probably best to avoid anything that looks like a high-yield mutual fund or ETF.

More money is going to be lost by more people reaching for yield in this next high-yield debacle than all the theft and fraud combined in the last 50 years.

A Once-in-a-Lifetime Opportunity

I can understand the plight of retirees who are struggling to live on today’s meager yields. Those high-yield funds have been so good for so long, it’s easy to forget how disastrous a bear market can be. But it gets worse.

Quick personal story, and I have to be vague about names here.

Some bond issues have been bought in their entirety by a small handful of high-yield bond funds. The problem is that the company that issued these bonds has defaulted on them. Not just missed a payment or two, but full default.

Their true value, if the funds tried to sell them, might be 25–30% of face if they actually traded, according to the people who told me this. But the funds still value them at the purchase price of $0.95 on the dollar.

How is it they’re still valued much higher? Because the funds haven’t tried to sell them. No transactions mean they can still be “priced” at the last trade, and since there have been no subsequent trades, there is no “mark-to-market” price.

If any of those few funds sold any of these bonds, it would set a “market price” and all would have to mark down the entire holding. So naturally, they aren’t even trying to avoid taking the hit to their NAV.

So here’s my question: How many other junk bond issues are in similar positions?

Note this isn’t just high-yield funds. Lots more “conservative” bond funds try to juice their returns by holding a small slice in high-yield. Regulations let them do this, within limits, but these funds are so huge the assets add up.

This game could fall apart very quickly. Any event that triggers redemptions could set off an avalanche.

I don’t know what that event would be, but I’m pretty sure one will happen. My own goal is to be a buyer, not a seller, whenever it occurs. For now, that means holding cash and exercising a lot of patience.

If I’m right, the payoff will be a once-in-a-generation chance to buy quality assets at pennies or dimes or quarters on the dollar. I think the next selloff in high-yield bonds is going to offer one of the great opportunities of my lifetime.

In a distressed debt market, when the tide is going out, everything goes down. Some very creditworthy bonds will sell at a fraction of the eventual return. This is what makes for such great opportunities. They only come a few times in your life.

There will be one in your near future.

Investors Dilemma: Pavlov’s Dogs & The Ringing Of The Bell

Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.

What does this have to do with investing. Let’s start with a tweet I got recently in response to the article “Fed Trapped In A Rate Cutting Box.”

This is a great example of “classical conditioning” with respect to investing.

In 2010, then Fed Chairman Ben Bernanke introduced the “neutral stimulus” to the financial markets by adding a “third mandate” to the Fed’s responsibilities – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

Importantly, for conditioning to work, the “neutral stimulus,” when introduced, must be followed by the “potent stimulus,” for the “pairing” to be completed. For investors, as each round of “Quantitative Easing” was introduced, the “neutral stimulus,” the stock market rose, the “potent stimulus.” 

More than 10-years, and 300% gains later, the “pairing” has been completed.

The brutal lessons taught to investors in 2008, the last time the Fed cut rates, has been replaced by the “salivary response” to the “Fed ringing the bell.”  

“Markets, as would be expected, tend to rally after rate cuts, because those policy actions translate into lower borrowing costs for individuals and corporations and tend to support higher moves for stocks.” – MarketWatch

Not surprisingly, the markets jumped on Monday and Wednesday as Trump, and the Fed, once again rang “Pavlov’s bell.”

Ring the bell. Investors salivate with anticipation.

However, let’s review why the Fed is implementing “emergency measures.”

In 2010, when Bernanke made his now famous statement, the economy was on the brink of potentially slipping back into recession. The Fed’s goal was simple, ignite investors “animal spirits.”

“Animal spirits” came from the Latin term “spiritus animalis” which means the breath that awakens the human mind. Its use can be traced back as far as 300BC where the term was used in human anatomy and physiology in medicine. It referred to the fluid, or spirit, that was responsible for sensory activities and nerves in the brain. Besides the technical meaning in medicine, animal spirits were also used in literary culture and referred to states of physical courage, gaiety, and exuberance.

It’s modern usage came about in John Maynard Keynes’ 1936 publication, “The General Theory of Employment, Interest, and Money,” wherein he used the term to describe the human emotions driving consumer confidence. Ultimately, the “breath that awakens the human mind,” was adopted by the financial markets to describe the psychological factors which drive investors to take action in the financial markets.

The 2008 financial crisis revived the interest in the role that “animal spirits” could play in both the economy, and the financial markets. The Federal Reserve, then under the direction of Ben Bernanke, believed it to be necessary to inject liquidity into the financial system to lift asset prices to “revive” the confidence of consumers. The result of which would evolve into a self-sustaining environment of economic growth.

“Bernanke & Co.” were indeed successful in fostering a massive lift to equity prices which, in turn, did correspond to a lift in the confidence of consumers. (The chart below shows the composite index of both the University of Michigan and Conference Board surveys. Shaded areas are when the index is above 100)

Unfortunately, despite the massive expansion of the Fed’s balance sheet and the surge in asset prices, there was relatively little translation into wages, full-time employment, or corporate profits after tax, which ultimately triggered very little economic growth.

The problem is the “transmission system” of monetary policy collapsed following the financial crisis.

Instead of the liquidity flowing through the system, it remained bottled up within institutions, and the ultra-wealthy, who had “investible wealth.” However, those programs failed to deliver a boost to the bottom 90% of American’s who continue to live paycheck-to-paycheck.

The failure of the flush of liquidity to translate into economic growth can be seen in the chart below. While the stock market returned in excess of 100% since the 2007 peak, that increase in asset prices was nearly 5x the growth in real GDP, and roughly 3x the growth in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not as subject to manipulation.) 

Given that asset prices should be a reflection of economic and revenue growth, the deviation is evidence of a more systemic problem.

The Ringing Of The Bell

In reality, “Animal Spirits” is simply another name for “Irrational Exuberance.” The chart below shows the stages of the previous bull markets and the inflection points of the appearance of “Animal Spirits.” 

Not surprisingly, the appearance of “animal spirits” has always coincided with the latter stages of a bull market advance and is always coupled with overvaluation, high levels of complacency, and high levels of equity ownership.

There is a difference this time.

There is an old Wall Street adage:

“No one rings the bell at the top.” 

Consider this. What if the “bell” that is ringing isn’t the Fed’s “Q.E. bell?”

As I noted last week, the Fed is cutting interest rates as concerns over economic growth are rising. The push to cut rates is also occurring at a time when the yield curve is “inverted.” Historically speaking, this is the “bell ringing at the top.”

Interestingly, instead of investors being concerned about the level of “equity risk” they are currently exposed to, they are instead “salivating” at the possibility of more “neutral stimulus” (QE and lower rates.) 

This is an interesting conundrum for investors.

The “ringing of the bell” over the last decade has trained investors to rush into equity-related risk. However, as I noted previously, the economic and fundamental backdrop is vastly different today than what it was then.

Again, what if the “the bell” investors are hearing isn’t the one they think it is?

As David Einhorn once stated:

There was no catalyst that we knew of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

This is a crucially important point.

Currently, investors are as hopeful about the future of the equity market as they have ever been.

Why shouldn’t they be with the S&P 500 within a few percentage points of all-time highs?

However, once you start looking beyond the “mega-cap driven” S&P 500 index, a more worrisome picture emerges. Small and Mid-Capitalization stocks are significantly off their peak. Since small and mid-cap companies are more affected by changes in the domestic economy (and aren’t big stock repurchasers) such suggests there is cause for concern.

The same holds for rest of world as well.

Besides the stock market, economically sensitive commodities also have a tendency to signal changes to the overall trend of the economy given their direct input into both the production and demand sides of the economic equation.

Oil is a highly sensitive indicator relative to the expansion or contraction of the economy. Given that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness. The chart below shows oil prices relative to economic growth, inflation, and interest rates (combined into a composite index.)

One important note is that oil tends to trade along a well defined trend, until it doesn’t. Given that the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which have a negative impact on the manufacturing and CapEx spending inputs into the GDP calculation.

As such, it is not surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates. The drop in oil prices is also confirming the message being sent by the broader market as well.

The rise in the dollar over the last several weeks already suggests that foreign capital is flowing into the U.S. dollar for safety as the rest of the globe slows. This will accelerate as global markets decline, and foreign capital seeks “safety” in U.S. Treasuries (the global storehouse for reserve currencies). 

The surge in “negative rates” globally is another warning sign that something has broken economically. As the economy slips into the next recession, domestic interest rates will continue to fall as “safety” becomes the priority over returns.

From the equity perspective, this is a time to consider reducing risk.

The evidence continues to mount the “bell has been rung.”

It just isn’t the “bell” that most investors are salivating for.

Inverted Yield Curve Is Actually Bullish

My favorite meme following last week’s yield curve inversion was captioned, “I survived the yield curve inversion.”

My favorite tweet (from @jfahmy) was, “The next Jobs Report should be very strong with the 50,000 “Yield Curve Experts” that were added this week.”

Last Wednesday, the day the Dow dropped 800 points, the yield curve inverted for a few hours. There is a lot to unpack in that sentence, so let’s get to it.

First, I have to briefly define what the heck a yield curve is so if you already know, skip the next three paragraphs.

The Explanation

The curve is a representation, or plot, of the yield on bonds from the same issuer across all maturities for which it is issued. Typically, we talk only about the yield curve of U.S. Treasuries, although they do exist for many sovereign debt markets. Analysts looking at the U.S. version have the luxury of a robust curve with maturities running from three and six months, to one, two, five, seven, 10, 20 and 30 years.

The normal yield curve is upward-sloping, meaning that yields on shorter maturities are lower than yields on longer maturities. Investors are paid more to take the risk of loaning their money for longer periods of time.

When the curve is flat or downward-sloping, that’s when we think the economy is running into trouble. The downward-sloping curve is called the inverted curve. This frequently appears a year or longer before recession begins, but as they say, the inverted yield curve has predicted 15 of the last 10 recessions. In other words, it does not always work.

Inversion Therapy

OK, now that our more sophisticated readers are back with us, the curve got somewhat funky in April when the five-year yield dipped below the 3-month yield. Then in May, the three-month yield was above the seven year and then above the 10-year.

Some pundits called the three-month to 10-year condition the inverted yield curve. My opinion is that was questionable, at best. Why? See next paragraph.

For most of June, only the three-month was out of whack, which we can partially blame on the Federal Reserve’s rate policy. Everything else looked to be a regular, upward-sloping yield curve.

Then one grey day it happened (Jackie Paper came no more.) On August 14, the two-year ticked above the 10-year to create the dreaded inversion. The financial media went nuts. Recession is coming! Recession is coming!

However, within hours, the curve un-inverted. Was recession averted? Did that temporary inversion mean anything at all? And the real question, does a positive 10 basis point spread (0.10 percentage points) mean something all that different from a negative 10 basis-point spread? And if the economy is going to go into the pooper, shouldn’t the inversion last for weeks and months, not just hours?

How it Got There Matters

Just like knowing how a stock got to its current price, we should know how the yield curve got to its inverted state, albeit a temporary one.

I’m not a bond maven but I did notice that the 10-year yield dropped like a stone recently and that is what seemed to have driven the inversion. We’ll get to the why that happened later.

After posing the question to a group of pros, I got the answer from a real bond maven, Michael Krauss, the former Managing Director and Head of Global Fixed Income Technical Analysis and U.S. Equity Technical Analysis at JP Morgan Securities.

It turns out that my observation was right (blind squirrel, I know). It does matter how the yield curve got flat or inverted. What Krauss said was that the steep drop in the 10-year yield and a slower drop in the two-year yield was called a “bull flattener.”

When they talk about an inverted yield curve, most people think of the “bear flattener” variety, where short rates rise quickly and long rates do not. This is where the Fed sees something overheating in the economy or the ugly head of inflation rearing so it clamps down on easy money. This tends to lead to a slowing of the economy and weakness in the stock market.

However, the bull flattener means something entirely more positive. It could mean sentiment for a stronger economy is strong. Or that investors are piling into longer-term bonds. The latter seems to be the case as money from around the world is pouring into U.S. bonds.

Why? Because trillions of dollars’ worth of global government bonds have negative yields. Negative!

Of course, money will flow to the best return and that is in good ol’ America. We also can see that in the strong U.S. dollar, which everyone needs to buy U.S. bonds.

Don’t believe me. Former Fed Chief said the same thing.

Mutual funds specializing in bonds are also seeing record inflows of money.

Making Sense Of 100-Year Bonds At 0% & 30-Year Bonds At Negative Yields

Over 50% of European gov’t bonds have a negative yield. Globally there’s $15 trillion in negative-yield debt.

$15 Trillion in Negative-Yield Debt

Excluding the US 44% of Bonds Have a Negative Yield

European Negative Yield Government Bonds

As of mid-June, over 50% of European government bonds have a negative yield. The total is higher now.

Negative-Yield 30-Year Bond

Yesterday, Germany issued a 30-year bond yielding less than 0%. Held to maturity you will not even get your money back.

Logically this is impossible. But it’s happening. And Trump likes it.

What Happens on Hundred-Year Bonds?

Austria has a 100-year bond that was trading at 116% of par on December 31 and 198% of par yesterday.

Note that if held to maturity, the bond would get about half your money back.

I asked Jim Bianco at Bianco Research a pair of questions.

  1. What happens if the yield very quickly rises to 0.25%, 0.5%, 1.0%, 2.0%?
  2. Same thing in reverse. What happens if the yield very quickly falls to -0.25%, -0.5%, -1.0%, -2.0%?

Jim responded that movement is not linear because of duration and convexity.

Convexity measures the degree of the non-linear relationship between the price and the yield of the bond.

Austria 100-Year Bond Example

​Bianco Comments

  • If the Modified Duration (green line) goes up and the Yield-to-Maturity (blue line) drops, the bond has “positive convexity”. Callable bonds like mortgages, because we can “pre-pay them when we re-finance, have “negative convexity”.
  • The 100-year Austria bond is the longest ever recorded in history. The Modified Duration is now effectively 56.64.
  • The orange line represents the price. On December 31, the price was 116.5. It’s now 198.1. That’s a year-to-date gain of 70%. Add is 8/12s of a 2.1% coupon and its total return is over 71%. This might be the best total return for an investment-grade bond in human history.
  • You would lose over half your money if the Austrian 100-year yield “skyrockets” to the nose-bleed interest rate of 1.7%. What would cause that to happen? An economic recovery.
  • So, yes the bond market is at risk of blowing up should Europe’s economy recover. That said, Germany all but admitted they are in recession which is why they are considering pump priming fiscal stimulus.

Bond Market Blow-Up

Clearly, no one intends to hold a 30-year negative-yield bond to maturity. Losses will be both steep and sudden should yields rise.

At some point the bond market is guaranteed to blow up. Timing the point is difficult.

Traders have been betting against Japan for two decades, incorrectly.

Negative Yield Madness

The 10-year Swiss bond yield of negative 1% implies it is better to have 90 cents ten years from now than a dollar today.

That is logically impossible. It would never happen in the real world without central bank intervention.

Yield vs Storage Costs

It’s important to distinguish between yield and storage costs.

One would expect to pay a small nominal storage costs for gold.

But if one lent gold, as opposed to placing it in a bank for safekeeping, the yield would never be negative or zero.

Lending Gold

Historically, banks collapsed when they lent more gold than they had rights to do so.

Lending gold that is supposedly available on demand is fraud. Gold cannot be available on demand if it is lent. The same applies to checking accounts whose money is also supposedly available on demand.

The bottom line is fractional reserve lending is a fraud. This is why I support a 100% gold-backed dollar.

Making Sense of the Madness

  • Those buying 100-year bonds are betting there will not be an economic recovery.
  • Those buying negative-yield bonds are speculating that yields will go even further negative.

Even though we can rationalize purchasing negative-yield bonds, the fact remains that negative yields are logically impossible and can only occur with central bank intervention and outright monetary fraud.

Gold vs Faith in Central Banks

What Gold is and Isn’t

In addition to being money, gold is primarily a hedge against central bank sponsored monetary madness.

If you believe central banks have everything under control, don’t buy gold.

However, negative yield bonds are proof of monetary madness.

Everything Under Control?

  1. “Zero Has No Meaning” Says Greenspan: I Disagree, So Does Gold
  2. 30-Year Long Bond Yield Crashes Through 2% Mark to Record Low 1.98%
  3. More Currency Wars: Swiss Central Bank Poised to Cut Interest Rate to -1.0%
  4. Inverted Negative Yields in Germany and Negative Rate Mortgages.
  5. Fed Trapped in a Rate-Cutting Box: It’s the Debt Stupid

If you believe monetary madness, negative interest rates, and negative rate mortgages prove central banks do not have things under control, then you know what to do.

Buy gold, but please understand what gold is and isn’t.

Gold is Not an Inflation Hedge

In contrast to popular belief, Gold is Not a Function of the US Dollar Nor is Gold an Inflation Hedge in any meaningful sense with one exception (sustained high inflation including hyperinflation).

Gold has historically been money for thousands of years. Governments and central banks have not changed that fact.

Selected Portfolio Position Review: 08-21-19

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AAPL – Apple, Inc.

  • AAPL has been in a long consolidation process since October of last year. We took profits at the last peak in May, but the breakout above the downtrend is indeed bullish.
  • We are continuing to hold our position, but are looking for a retest of support at the breakout to add to our current holdings.
  • The position is overbought abut on a rising “buy” signal.”
  • Stop loss moved up to $185.

NSC – Norfolk Southern

  • We have taken profits on NSC a couple of times and are now underweight our position in the portfolio.
  • The correction to support was anticipated and with the buy signal getting oversold, we are looking for an opportunity to increase our exposure.
  • So far, important support is holding at the $170
  • Stop-loss is set at $160

AGNC – AGNC Investment Corp.

  • AGNC is one of two of our “bullish steepner” trades which due to the makeup of their assets should perform better as the yield curve steepens. We added to our position this week on this pullback and are leaving NLY waiting to see if we get a better opportunity.
  • With an 11% yield we can afford to give this position some time to work out. It is oversold on multiple levels and within a broad trading range.
  • Stop-loss is set at $15 currently.

PPL – PPL Corp.

  • We have discussed over the last couple of months that we were planning on selling PPL as it was just not performing as we hoped. We still like the company from a valuation perspective and we may return to the position in the future.
  • We closed out the position on Monday

DUK – Duke Energy Corp.

  • DUK has been one of our better defensive plays as of late. As yields fall, defense Utilities and Real Estate continue to perform well.
  • We recently took profits in DUK, but are maintaining our holdings for now.
  • The breakout above multiple tops gives us an opportunity to add to the position on a pullback.
  • Stop-loss moved up to 84

JNJ – Johnson & Johnson

  • With the sale of PPL we took part of the proceeds and added to our position in AGNC. We also added to our JNJ holdings with the pullback to support.
  • We are likely closer to the end of the negative news impact from the “Talc” suit, so the fundamentals of JNJ will likely come back into focus.
  • With JNJ very oversold, downside risk is somewhat limited.
  • Stop loss is set at $125

MDLZ – Modelez International

  • MDLZ is close to triggering a “sell signal” from a very elevated level. However, it is currently holding onto the uptrend support.
  • MDLZ is very overbought, and after taking profits, we are in serious need of some corrective action before we can consider adding to our holdings.
  • That correction is in process but will take longer to complete. Look for support to hold at $51 for now.
  • Stop-loss is set at $50

NLY – Annaly Capital Management

  • NLY is the second “bullish steepener” play discussed above with AGNC.
  • As stated, we are looking to build out the rest of our position in NLY but are waiting to see if we can get a bit better price to to do so.
  • Both NLY and AGNC make up a thesis trade on an un-inversion of the yield curve. So we are scaling into the positions accordingly.
  • Stop-loss is set at $8

ABT – Abbott Laboratories

  • ABT continues to provide great performance even after we previously took profits.
  • ABT recently flipped back onto a “buy signal” but is overbought short-term. The position needs to correct before we can consider adding to the holdings.
  • Hold positions for now, after taking profits, and watch the uptrend line from the 2017 lows.
  • Stop loss is moved up to $77.50

CMCSA – Comcast Corp.

  • CMCSA has been consolidating its previous advance for the last few months and finally broke out to the upside.
  • The recent test of support confirms the breakout and is a positive for the position in the short-term.
  • CMCSA is very overbought and has triggered a short-term sell signal. A pullback to $40 could give us an opportunity to add to our holdings longer-term.
  • We are moving our stop-loss up to $38.50

The Dog Whistle Heard Around The World

On August 15, 2019 the Washington Post led with a story entitled Markets sink on recession signal. The recession signal the Post refers to is the U.S. Treasury yield curve which had just inverted for the first time in over ten years.

We have been highlighting the flattening yield curve for the past six months. As we have discussed, every time the ten-year Treasury yield has fallen below the two-year Treasury yield, thus inverting the yield curve, a recession has eventually developed.

Blaming the yield curve for market losses because it inverted by a couple of basis points is a nonsensical narrative for talking heads on business television. This article is about a different concern, a second-order effect caused by headlines like the one shown below. The story in the Post and similar ones in many major publications have awoken the public to the real possibility that a recession may be coming. It is a dog whistle that may cause the public to alter their behavior, and even slight changes in consumption habits can produce outsized effects on economic activity.

Reality

The 2s/10s yield curve stood at 265 basis points on January 1, 2014, meaning the ten-year yield was 2.65% higher than the two-year yield. From that date forward, as shown below, it has steadily declined. Like the changing of the seasons, as the days passed, that spread steadily fell. Unlike the seasons, investors are somehow now suddenly shocked to learn that economic winter follows fall.  Since the beginning of 2019, the curve has been as steep as 25 basis points but has flirted with inversion on numerous occasions.

Given that the shape of the yield curve has been steadily flattening for five years, its current inversion ought not to be news. From an economic perspective, who cares, nothing has changed. The difference in a few basis points on the yield curve is truly meaningless. What has changed is investors’ behavioral instincts.

Explanation Bias

Blaming the yield curve for a market downturn is a narrative designed to fill the public need for an explanation on equity market losses. We talked to Peter Atwater, a behavioral specialist and guest on the Lance Roberts Show, to help us understand human behavior.

Per Peter: Confidence requires perceptions of certainty and control. Easily grasped narratives – even when they are woefully incorrect – fulfill both needs. Not sure that there is a formal name to the bias, but I would call it “Explanation Bias” – we need an easy story to fight against the anxiety that would arise from what would otherwise be randomness. And randomness is untenable.

We highly recommend following Peter on Twitter at @peter_atwater

In our need to explain and attempt to understand randomness, the public is now aware of a real and growing threat that was ignored just days prior. The sudden drop in the stock market and a potential catalyst for a much steeper decline is not necessarily about finance and economics; behavioral instincts are now in play.  

Over the past several months we have said the window for a potential recession is open. By this, we meant that economic stimulus was waning, global growth was slowing, and the potential for a recession has increased as a result. The hard part of our forecast was to name the catalyst that could tip the economy into recession.

We postulated that it might be the brewing trade war, Iran, slowing global growth, or any number of other topics in the media at the time. The problem, as we pointed out in naming a single catalyst or narrative, was that it really could be something inconsequential or something we have not pondered.

This concept is akin to avalanches. The structure of the hill, weather, and the way the snow is perched determine whether an avalanche will occur. The catalyst, however, is but one snowflake that causes a chain reaction.

It is possible the snowflake in our case is the media and the public’s awareness of the relationship between yield curve inversions and recessions.

If the headlines do spark new concern and even slightly modifies consumption patterns, a recession may come sooner than we think. If you harbor concerns that a recession is coming, aren’t you more likely to eat in or put off buying a new TV? These little and seemingly inconsequential decisions made by a minority of consumers can tip the scale and create negative economic growth.

Here is another way to think about it. Picture your favorite restaurant, one that is always packed and has a waiting list. One day you arrive on a Saturday night expecting to wait an hour for a table, but to your delight, the hostess says you can sit immediately. You look around and the restaurant is crowded, but uncharacteristically there are a few empty tables. Those empty tables, while seemingly insignificant, may mean the restaurant’s sales are down a few percent from the norm.

A few percent may not seem like a big deal, but consider that the average annual recessionary growth low point was only -1.88% for the last five recessions. If economic growth is weak, then small negative changes in output can take an economy from expansion to contraction quicker than if growth rates were stronger. This seems to exemplify the current situation as growth has been fairly tepid post-financial crisis.

Summary

We can follow all the economic data and trends diligently, but consumption accounts for over 70% of U.S. economic growth. Therefore, recessions ultimately tend to be the effect of changes in consumer behavior. If the narrative de jour is enough to trouble even a small percentage of consumers, the likelihood of a recession increases. The evidence of such a change will eventually turn up in sentiment surveys, and when it does, the problem has already taken root. This is not a dire warning of recession but rather offers consideration of a legitimate second-order effect that potentially threatens this record-long economic expansion. 

While the media focuses on the inversion narrative, alerting the public to recession warnings and driving consumers to re-think their planned purchases, we care more about when the yield curve will steepen. The steepening curve caused by aggressive Fed action after a curve inversion is the tried and true recession warning. For more, please read Yesterday’s Perfect Recession Warning May Be Failing You.

No Recession In Sight? But Cutting Rates To Avoid One

President Trump and his economic advisor Larry Kudlow have important announcements. I can help with translations.

Please consider Trump ‘Not Ready’ for China Trade Deal, Dismisses Recession Fears.

Consumers Doing Well

  • Trump: “We’re doing tremendously well, our consumers are rich, I gave a tremendous tax cut, and they’re loaded up with money.”
  • Trump Translated: The “tremendous tax” cut primarily benefited the wealthy. Consumers are tapped out. That’s why housing and autos are on the ropes.

Deal With China

  • Trump: “I’m not ready to make a deal yet [with China].”
  • Trump Translated: China is damn sick and tired of my tactics. They prefer to wait hoping for a Democrat president.
  • Trump: “I would like to see Hong Kong worked out in a very humanitarian fashion,” Trump said. “I think it would be very good for the trade deal.”
  • Trump Translated: I have completely abandoned the idea there will soon be a trade deal unless I further capitulate to the demands of China. I was forced to give Huawei Another 90-Day Reprieve and sadly, I Chickened Out by Delaying my Trade War Tariffs to Save the Holiday Season.

Recession

However, if there is “no recession” in sight, then by is Barron’s writer Matthew Klein proposing to stop the recession by cutting interest rates like it’s 1995.

Kleion says How to Avoid a Recession? Cut Interest Rates Like It’s 1995.

One of the most reliable harbingers of U.S. recession—short-term interest rates on U.S. Treasury debt higher than longer-term yields—has been flashing warning signs for months. That doesn’t mean the economy is doomed to a downturn.

So-called yield-curve inversions have preceded every U.S. downturn since the 1950s, with only one false positive in 1966. This past week, the yield on two-year Treasuries briefly surpassed the yield on 10-year notes for this first time since 2007. The most straightforward explanation is that traders…

Absurd Notion

The rest of the article is behind a paywall, but I can tell you with 100% certainty Klein’s notion is absurd.

Inverted yield curves do not cause recessions. They are symptoms of a buildup of excess debt, or other fundamental problems.

Those problems will not not go away if the Fed “cuts rates like 1995” or even like 2008.

If a zero percent interest rate stopped recessions, Japan would not have had a half-dozen recessions in the past decades that it did have, many without inversions.

Not even negative rates can stop recessions.

The Eurozone, especially Germany, has negative rates. Yet, it’s highly likely the Eurozone is in recession now and even more likely Germany is (with the rest of the Eurozone to follow).

Monetary Madness

As a prime example of global monetary madness, witness Inverted Negative Yields in Germany and Negative Rate Mortgages.

Even if the Fed made a 100 basis point cut (four quarter point cuts at once), what the heck would that do?

Stop recession for how long? Zero months? Six months? And at what expense?

What Then?

Yes, what then? Negative mortgages? A 10-year yield of -1.0% like Switzerland.

And if that doesn’t work?

Hello @M_C_Klein What then?

Central banks are the source of problems, not the cure. If central banks could stop recessions, there never would be any!

5-Things Your Broker Wont Tell You – Part 2

Valuations Matter.

As I mentioned briefly in Part 1 of the series,  investors about to the enter the retirement distribution phase of their lives or seeking to extract money from a basket of variable assets like stocks and bonds to re-create a retirement paycheck, must be keenly aware of portfolio risk and prepare for a cycle of muted portfolio returns.

Newbies to the retirement experience and those who aspire to retire within the next 3-5 years must seriously consider comprehensive financial and distribution planning to ensure the retirement income paychecks they require are realistic, tax-effective and sustainable over a lifetime.

I passionately believe that people who retired last year and those looking to retire within the next 5 years will need to deal with a tremendous headwind to returns on variable assets. In other words, a traditional portfolio of bonds and stocks will fail to generate the returns and income required to maintain the annual 4% standard withdrawal rate touted by the masses of financial experts.

In addition, financial planning is going to become downright perilous for consumers. Planners and consultants employed by big-box financial retailers are not motivated to adjust downward their projected global stock and bond market returns. After all, it’s not in the best interest of their employers to downplay future returns to sell managed money products. There’s too much career risk for those who want to do the right thing; the responsibility for truth discovery is going to fall on the shoulders of clients of these firms.

Going forward, second opinions must be the standard for consumers of financial planning and asset management, especially those going through retirement preparation. Investors will need to employ a “two-plan strategy,” if their broker (most likely), has not prepared for lower future asset-class returns. Unfortunately, lives will change, but it’s not too late.

On a regular basis our planners at RIA must re-adjust consumer expectations especially when they come to us for second opinions on retirement plans completed by their brokers. As fiduciaries, our goal is to be objective and help people plan for reality. Market fantasy is dangerous for those looking to re-create a paycheck in retirement.

For example, one of the financial planning programs we utilize has a projected asset class return of 5.03% for a balanced portfolio of stocks, bonds and cash. Based on our analysis of valuations, we believe future returns for a similar portfolio will average closer to 2.5%. John Hussman, Ph. D one of the finest analysts of complete market cycles is less hopeful. In his market commentary from July 14, “They’re Running Toward the Fire,” he outlines:

“As of Friday July 12, our estimate of likely 12-year total returns for a conventional portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills, has dropped to just 0.5%. A passive investment strategy is now closer to “all risk and no reward” than at any moment in history outside of the three weeks surrounding the 1929 market peak.”

Will there be years when 5.03% is attainable or exceeded? Sure. However, on a consistent basis we don’t believe it’s going to happen until the current ultra-rich level of stock valuations have been worked off. Thus, a consistent ‘surprise gap’ in expected returns will require investors especially pre-retirees, to consider specific actions:

1). Work longer. Retirement at 65 is an outdated aspiration. Today, people are either working longer or returning to the workforce.

Notice the dramatic 74% increase in the Labor Force Participation Rate for 75 & older since the year 2000. For some older Americans, working longer allows them to remain social and engaged which crucial to health. However, like younger cohorts, seniors have utilized debt to maintain standards of living. They have taken on increased credit card debt and co-signed loans for children and grandchildren. In the latest U.S. Census Report, 44.4% of households led by people older than 65 are wallowing in debts.

Per NBER Working Paper No. 24226 titled “The Power of Working Longer,” by Bronshtein, Scott, Shoven & Slavov, the delay of retirement by 3-6 months has the same impact on the retirement standard of living as saving an additional 1% of labor earnings for 30 years. Yea, you read that correctly. We witness the results daily. Those who decide to work longer, even another year (which goes by quick), witness a marked increase in the probability of financial plan success even with our lower projected portfolio returns!

2). Remain unemotional when it comes to planning for potential guaranteed streams of income. Through a period of increased sequence of returns risk whereby withdrawals can have a deleterious impact on overall portfolio returns, a future retiree should maximize Social Security benefits (waiting until age 70 to file), re-consider an employer’s pension options over lump-sum rollovers to IRAs and investigate annuity options such as single premium immediate or fixed-indexed annuities with income riders. Guaranteed income alleviates the burden of a portfolio to bear the full burden of lifetime withdrawal requirements.

3). Rethink expectations. The results of a comprehensive plan can help people gain tremendous perspective of the financial viability of future goals in a world of lower returns; with compromise and a bit of soul-searching, retirement during a period of greater sequence of returns risk can still be rewarding. A reduction of spending on wants like big vacations, a revised definition of expectations and new methods that ensure a quality retirement on a budget should be topics on the table. A fiduciary planner who studies market cycles should be hired to communicate objectively and help you prepare for probable future reality, as unpleasant as it may be, not projected hopes of lofty investment returns.

4). Live smaller starting ten years before retirement. I have helped clients accomplish this task – it works. I have witnessed dramatic downsizing efforts as couples shed large two-story homes and settle into quaint one-story 1500 square feet abodes. I have watched pre-retirees purge most possessions, clean things out, donate aggressively, gift heirlooms to kids who want them, all to live simpler. Lower overhead, adherence to a micro or strict household budget, aggressive savings rates north of 30%, along with a redefinition of retirement enrichment can reap formidable results. In other words, without the tailwind of robust investment returns, people are going to need to close the ‘surprise gap’ with their own sweat equity and ingenuity.

Whew. Now, for the valuation metrics that investors especially pre-retirees, should consider.

With the current Shiller P/E at 29x and other market valuation metrics at stretching points, those who are 5 years or less from retirement should act today to reduce portfolio risk.

RIA’s CAPE-5, a more-sensitive adjunct compared to the Shiller P/E, correlates highly with movements in the S&P 500.

There is a positive correlation between the CAPE-5 and the real (inflation-adjusted) price of the S&P 500. Before 1950, the CAPE and the index closely tracked each other. Eventually, the CAPE began to lead price. The current deviation of 68.28% above the long-term five-year CAPE ratio has occurred only three times in recent history.

What if you retired last year and began a distribution plan?

I’m surprised to find that many investors still do not realize that markets had a poor showing in 2018. You may be shocked to find out that although S&P 500 returns are higher by 15.23% YTD through August 16th, over the last 12 months the major index has done nothing but tread water.

I have been a proponent of Ed Easterling’s market valuation work since 2010. At Crestmont Research they have created their equivalent to the P/E-10 (or Shiller P/E) ratio.

The Crestmont P/E is now at 33.1 which is 130% above its average.

 To maintain perspective, the 33.1x P/E exceeds the Tech Bubble, August and September of 1929.

Irrational exuberance, anyone?

There are financial advisors and pundits who scoff at valuation metrics. They are afflicted with terminal recency bias with little hope of recovery. I peruse their comments on social media; I listen to their words. The tone smacks of defiant “this time it’s different.” I remain eternally humble when it comes to markets. They are designed to obfuscate the masses. Markets are great levelers.

In all fairness to the doubters, unorthodox monetary stimulus from global central banks along with short-term interest rates being lower for longer, indeed push money into risk assets and manipulate markets. Finally, in a period of sustained negative interest rates overseas and accelerated lower rates domestically, the effectiveness of central bank intervention to move markets I believe, is finally starting to crack which could be the catalyst required to jump-start lower future investment returns. In other words, central banks are employing every tool in the magic box and yet economic growth is faltering and global markets are not as enamored with monetary efforts. It’s ‘pushing on a string’ at its shining hour.

Ruchir Sharma, author of the book “The Rise and Fall of Nations: Forces of Change in the Post-Crisis World,” recently penned an eye-opening opinion piece in The New York Times titled “What’s Wrong With the Global Economy? ” If you have the time, it’s worth a thorough read. Overall, he makes the case that demographics are the main driver of economic growth; let’s just say  we should calculate a  global “baby dearth rate.”

He writes:

“The benchmark for rapid growth should come down to 5 percent for emerging countries, to between and 3 and 4 percent for middle-income countries like China, and to between 1 and 2 percent for developed economies like the United States, Germany and Japan. And that should just be the start to how economists and investors redefine economic success.”

If the global central bank drug has lost efficacy – If younger generations begin to redefine their own economic success by living smaller and not looking to have children (I witness this in my own Gen Z daughter and friends), if earnings growth remains muted during a period of massive overvaluation as we’re in now, then the probabilities of lower investment returns are going to be a reality investors need to face.

So, what if I’m wrong?

I hope I am.

I hope consumers and clients who come to RIA for planning and investment guidance consistently beat the heck out of their personal investment return hurdle rates and easily meet financial milestones. I hope their biggest dilemma is how to spend more or leave a greater legacy to loved ones and charities.

At the least, even if you scoff at what I’ve written, it may compel you to monitor your annual portfolio distribution rates, be flexible to change them through periods of poor sustained returns, ask more questions of your brokers about how to maximize guaranteed income options including Social Security. Perhaps I’ve helped you get your financial head out of the dirt and propel you to prepare just in case. Maybe I’ve spurred motivation to create a contingency plan that places your household on solid financial footing regardless of how cycles play out.

What if I’m correct?

Time will tell. If correct, I’ve properly tempered expectations. We will not be surprised or need to scramble to have very difficult conversations with clients about uprooting their lives mid-retirement.

Either way – I win. You win, too.

And at night regardless, I can sleep like a baby.

Sector Buy/Sell Review: 08-20-19

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • XLB remains confined to a very broad topping pattern currently. With the buy signal fading the risk remains to the downside for now particularly as trade wars continue to linger on.
  • XLB is not extremely oversold short-term which could keep XLB in a trading range for a while with risk down to support at $55
  • We are remaining underweight the sector for now.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with tighter stop-loss
    • Stop-loss adjusted to $55
  • Long-Term Positioning: Bearish

Communications

  • XLC had gotten very extended and the “buy signal” was also pushing very high levels all of which are now being reversed.
  • XLC failed at resistance and has now established a double top. The good news is support is holding so far at $48
  • XLC has a touch of defensive positioning from “trade wars” and given the recent pullback to oversold a trading position was placed in portfolios.
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions
    • This Week: Hold trading positions.
    • Hard Stop moved up to $48
  • Long-Term Positioning: Bearish

Energy

  • XLE failed at its 200-dma and remains extremely weak.
  • XLE broke support and is now rallying to test the previous support as resistance.
  • We were stopped out of our position recently.
  • Short-Term Positioning: Bearish
    • Last week: Hold current position
    • This week: Stopped out.
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • XLF has been in a long consolidation rage since the beginning of 2018.
  • XLF remains on a “buy” signal currently and is back to oversold. Look for a bounce back to the top of the trend line. Support must hold at $26.50.
  • Fed rate cuts are not “bank friendly” so we will likely reduce exposure to the sector in the ETF model soon.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss adjusted to $26.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI failed at a “quadruple top” which puts a tremendous amount of overhead resistance on the sector.
  • XLI is back to oversold and the buy signal has reversed to a sell signal.
  • We reduced our risk to the sector after reaching our investment target. We are now adjusting our stop-loss for the remaining position.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $72
  • Long-Term Positioning: Neutral

Technology

  • XLK remains one of the “safety” trades against the “trade war.”
  • While XLK is not overbought,it is still fairly extended and a crowded trade.
  • XLK failed at the uptrend line so it must hold support at $75.
  • The buy signal remains intact but is weakening.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss adjusted to $70.00
  • Long-Term Positioning: Neutral

Staples

  • We noted last week that after taking profits in the sector, we were finally getting a much needed correction to work off the excess. That is over as “defensive holdings” charged higher on Friday and Monday.
  • The “buy” signal (lower panel) is still in place and is very extended. We continue to recommend taking some profits if you have not done so.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $56
  • Long-Term Positioning: Bullish

Real Estate

  • As with XLP above, XLRE was consolidating its advance and has now pushed to new highs.
  • XLRE is back to very overbought so be careful adding new positions and keep a tight stop for now.
  • We previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected. That occurred.
  • Buy signal is being reduced along, but is holding for now.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.00 for profits.
    • Long-Term Positioning: Bullish

Utilities

  • Again, defensive positioning continues to win in the market. XLU likewise is back to overbought but the previously extended buy signal has worked off most of that condition.
  • After taking profits, we have time to be patient and wait for the right setup.
  • 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.
  • Short-Term Positioning: Bullish
    • Last week: Take profits and rebalance holdings.
    • This week: Hold position
    • Stop-loss adjusted to support at $55.50.
  • Long-Term Positioning: Bullish

Health Care

  • XLV remains on a buy signal but failed at important resistance.
  • While the current correction was expected, support is holding which is bullish.
  • Short-Term Positioning: Neutral
    • Last week: Reduce to portfolio weight
    • This week: Hold position
    • Stop-loss adjusted to $88
  • Long-Term Positioning: Neutral

Discretionary

  • With the latest round of “tariffs” directly targeting consumer goods, XLY is now under attack.
  • Interestingly, despite the “delay” in those tariffs, the sector is still weak and threatening to trigger a sell signal.
  • We recommended taking profits previously.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position.
    • This week: Hold 1/2 position
    • 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 triggered a “buy” signal but remains confined to a consolidation which has lasted all year. The continued topping process continues to apply downward pressure on the sector.
  • There is still no compelling reason at this juncture to add XTN to portfolios. We will watch and see what happens.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: This Is Still A “Sellable Rally”

In last Tuesday’s “Technical Update,” I wrote that on a very short-term basis the market had reversed the previously overbought condition, to oversold.

This could very well provide a short-term ‘sellable bounce’ in the market back to the 50-dma. As shown in the chart below, any rally should be used to reduce portfolio risk in the short-term as the test of the 200-dma is highly probable. (We are not ruling out the possibility the market could decline directly to the 200-dma. However, the spike in volatility and surge in negative sentiment suggests a bounce is likely first.)”

Chart updated through Monday’s close

This oversold condition is why we took on a leveraged long position on the S&P 500, which we discussed with our RIAPRO subscribers last Thursday morning (30-Day Free Trial).:

“I added a 2x S&P 500 position to the Long-Short portfolio for an ‘oversold trade’ and a bounce into the end of the week.”

I followed that statement up, saying we would hold the position over the weekend as:

“Given the President is fearful of a market decline, we expect there will be some announcement over the weekend on ‘trade relief’ to support the markets.”

That indeed came to pass as the President announced he extended the ability of U.S. companies to sell product to Huawei for another 90-days. (China gave up nothing in return.) Furthermore, the President re-engaged against the Fed on Twitter:

Neither point is positive over the longer-term. As noted on Monday, investors are continuing to pay near-record prices for deteriorating corporate profits.

“Despite a near 300% increase in the financial markets over the last decade, corporate profits haven’t grown since 2011.”

This Is Still A “Sellable Rally.” 

On Monday, we closed out 25% of our long trading position. We will also continue to sell into any further rally as the market challenges overhead resistance. The rest of our portfolios remain defensive, hedged, and are carrying an overweight position in cash.

The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a “topping process.” 

My colleague Charles Hugh Smith summed this up nicely on Monday:

“As the saying goes, a market-topping is not an event, it’s a process. There are a handful of historically useful characteristics of topping markets:

  1. Declining volume / liquidity
  2. Increasing volatility–major swings up and down that increase in amplitude and frequency
  3. Inability to break decisively above previous resistance (i.e. make sustainable new highs in a stairstep that moves higher).

We see all these elements in the S&P 500 over the past few years. A healthy, stable advance in 2017, led to a manic blow-off top that crashed in February of 2018, setting off a period of high volatility.

This set up another stable advance that was shorter than the previous advance, and also steeper. This led to the multi-month period of instability that concluded in a panic crash in December 2018.

Since then, advances have been shorter and steeper, suggesting a more volatile era. Three advances to new highs have all dropped back to (or below) the highs of January 2018. In effect, the market has wobbled around for 18 months, becoming more volatile after every rally.”

Adding to his comments, you can also see that bullishness by investors still remains aggressive even as the market trades below its accelerated trendline.

Here is a closer look.

There repeated failures along the previous uptrend line suggests a change of trend is potentially underway. As Charles notes, “topping processes” are a function of time, and previous violations of the bullish trend were clear warnings for investors to become more cautious.

1998

2006

You will notice that in each previous case, the “bullish story” was the same.

However, the primary warning signs to investors were also the same:

  • A break of the longer-term bullish trend line
  • A marked rise in volatility
  • A yield curve declining, and ultimately, inverting as the Fed cuts rates.

The last point we discussed in more detail in this past weekend’s missive:

“While everybody is “freaking out” over the “inversion,” it is when the yield-curve “un-inverts” that is the most important.

The chart below, shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving “risk” to seek the absolute “safety” of money markets, i.e. “market crash.”)”

In other words, while a bulk of the mainstream media keeps pointing to 1995 as “the” example of when the Fed cut rates and the market kept rising afterward, it is important to note the yield curve was NOT inverted then. However, when the Fed did begin to aggressively cut rates, which collided with the inverted yield curve, the “bear market” was not too far behind.

Lastly, Helene Meisler wrote yesterday: 

“Over the course of the last week, we saw the TRIN reach 2.10 a week ago on Aug. 12, followed by an extraordinary reading of 3.72 a few days later on last Wednesday. At the time, I explained that we don’t often get over 2.0, so a reading at almost 4.0 was literally “off the charts.”

This brings us back to the 10-day moving average, which as you can see, has skyrocketed to over 1.50. The first thing to note is that this is higher than it got even in the fourth-quarter decline. It’s more than the January and February 2018 decline as well. In fact, we have to go all the way back to 2015 and 2016 to see the kind of selling we saw last week, using this indicator. I have boxed those off in red on the left side of the chart.

Notice that these types or readings don’t occur often and they tend to occur in violent markets. All the way on the left, in July 2015, you can see this indicator reached over 1.50. The S&P 500 enjoyed a rally– a small one, but still a rally. But then you can see we came back down.

The second spike up that took the indicator to just over 1.70 arrived in August of 2015, which was accompanied by the plunge you see in the S&P of nearly 10%. Now squint even further, and you can see the rally in September – off that August low — and how we came back down in late September and early October to form a “W” in the S&P.

All of those instances are examples of a rally and back down again. I’m sure if I went back in time I could find a few examples when this indicator got this high and did not rally and come back down, but this is more typical as you can see.

All of this data supports the idea of a “sellable” rally for now.

Could that change? 

Certainly, and if it does, and our “onboarding” model turns back onto a “buy signal,” we will act accordingly and increase equity risk in portfolios. However, for now, the risk still appears to be to the downside for now.

“But the Central Banks won’t let the markets fall.” 

Maybe.

But that is an awful lot of faith to put into a few human beings who spent the majority of their lives within the hallowed halls of academia. 

There is a rising probability that Central Banks are no longer as effective is supporting asset markets as they once were. As noted by Zerohedge yesterday:

“The Fed meeting on July 31st was a sell the news event because it had been so telegraphed, and priced. The fact that the Fed arguably disappointed with only a 25bps cut means they are now behind the curve; until they get in front of it, multiples are unlikely to expand again. The Fed put expired on July 31st.”

If you disagree, that is okay.

However, given we are now more than 10-years into the current bull market cycle, here are three questions you should ask yourself:

  1. What is my expected return from current valuation levels?  (___%)
  2. If I am wrong, given my current risk exposure, what is my potential downside?  (___%)
  3. If #2 is greater than #1, then what actions should I be taking now?  (#2 – #1 = ___%)

How you answer those questions is entirely up to you.

What you do with the answers is also up to you.

Ignoring the result, and “hoping this time will be different,” has never been a profitable portfolio strategy. This is particularly the case when you are 10-years into a bull market cycle.

The “Trade War” Is Over, Trump Just Doesn’t Realize It Yet.

On Tuesday, the markets bid higher following a statement from the U.S. Trade Representative’s office that tariffs will commence on September 1st, but that some products will be delayed until December 15th. To wit:

“…some tariffs will take effect on Sept. 1 as planned, ‘certain products are being removed from the tariff list based on health, safety, national security and other factors and will not face additional tariffs of 10 percent. Further, as part of USTR’s public comment and hearing process, it was determined that the tariff should be delayed to December 15 for certain articles.”

The only part the algos heard was “tariffs delayed,” which sent them into stock panic buying mode.

However, stocks crashed again on Wednesday as the yield curve inverted, sending “recession fears” through the markets.

Of course, since President Trump has pegged the success of his Presidency on the rise and fall of the markets, on Wednesday, as “tweets” about a “trade talks continuing” failed to lift the markets, he resorted to more direct measures to manipulate the markets: Via CNBC:

“Trump held the call with J.P. Morgan Chase CEO Jamie Dimon, Bank of America’s Brian Moynihan and Citigroup’s Michael Corbat, according to people with knowledge of the situation.”

This, of course, was reminiscent of the call made by Steve Mnuchin, U.S. Treasury Secretary, during the market rout last December. But most importantly, this is about the upcoming election:

“Trump has been reaching out to corporate leaders this week amid his concerns that a slowing U.S. economy could impact his reelection chances, according to a Thursday piece from the Washington Post.”

Hopefully, he will listen to them.

But even if the trade dispute was ended today, the damage is likely already done.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • Interest rates are signaling there is something “broken”
  • Yield curves are negative as “deflationary” pressures are rising
  • All of which is leading to rising recession risk.

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



Art Of The Deal Versus The Art Of War

This is all assuming Trump can actually succeed in a trade war with China.

Let’s step back to the G-20 meeting between President Trump and President Xi Jinping. As I wrote then:

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

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

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

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

Of course, Trump caving to China was evident in the agreement made during the G-20 summit.

By agreeing to continue talks without imposing more tariffs on China, China gained ample running room to continue to adjust for current tariffs to lessen their impact. More importantly, Trump gave up a major bargaining chip – Huawei.

“One of the things I will allow, however, is — a lot of people are surprised we send and we sell to Huawei a tremendous amount of product that goes into a lot of the various things that they make — and I said that that’s OK, that we will keep selling that product.” – President Trump

Oh…so all the spying, technology stealing, etc. doesn’t matter now?

As I stated then, it was only Trump who was surprised. Not by the amount of product sold to Huawei, but rather by the pressure applied by U.S. technology firms to lift the ban. While Trump appeased his corporate campaign donors, he Trump gave up an important “pain point” on China’s economy.

Yes, China agreed to buy more agricultural products from U.S. farmers, which was crucially important as the “rust belt” were big supporters of Trump during the 2016 campaign, but China had no intention of following through. As I wrote on May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the ‘deficit’ in exchange for ‘no tariffs,’ China removed the most important threat to their economy as it will take 18-24 months before the current administration realizes the problem.”

What the current administration fails to realize is that China is not operating from short-term political-cycle driven game plan. Their goal is very different. To wit:

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

A War Trump Can’t Win

While President Trump thought “trade wars would be easy to win,” they aren’t, and the domestic economic pain will likely be more than he bargained for. Such is already evident as corporate profits continue to come under pressure.

“Despite a near 300% increase in the financial markets over the last decade, corporate profits haven’t grown since 2011.”

But, if you think China is going to acquiesce any time soon to Trump’s demands, you haven’t been paying attention. China previously launched a national call in their press to unify support behind China’s refusal to give into Trump’s demands. To wit:

“Lying behind the trade feud is America’s intention to stifle China’s development. The U.S. wants to be a permanent leader in the world, and there is no way for China to avoid the ‘storm’ through compromise.

History proves that compromise only leads to further dilemmas. During previous trade tensions between the U.S. and Japan, Japan made concessions. As a result, its political stability and economic development were adversely affected, with structural reform being suspended and hi-tech companies being severely damaged.

The only way for a country to win a war is through development, not compromise. To achieve development, China will open its door wider to the world and fight to the end.”

These were Xi Jinping’s mandates.

While China agreed to purchase more agricultural products from the U.S., there was nothing committing China to do anything. Since buying agricultural products would have boosted support for Trump, it should be of no surprise that China failed to follow through.

June 19, 2018:

“The U.S.- China confrontation will be a war of attrition: while China has shown a willingness to make a deal on shrinking its trade surplus with the U.S., it has made clear it won’t bow to demands to abandon its industrial policy aimed at dominating the technology of the future.”

China has no intention of giving in.

They are not going to compromise as they know time is growing extremely short for President Trump as the election cycle heats up.

The problem for Trump will be the mounting economic, and corporate, pressure the Administration will face. That pressure is what led to the latest mistake.



Trump’s Latest Mistake

Trump’s latest move to delay tariffs is another critical error with respect to dealing with China. As I wrote last time, Trump may well be following his “Art Of The Deal” tactics, but Xi is clearly operating on the foundation of Sun Tzu’s “The Art Of War.”

“If your enemy is secure at all points, be prepared for him. If he is in superior strength, evade him. If your opponent is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant. If he is taking his ease, give him no rest. If his forces are united, separate them. If sovereign and subject are in accord, put division between them. Attack him where he is unprepared, appear where you are not expected.

As noted above, China has been attacking the “rust-belt” states, which are crucial to Trump’s 2020 reelection. As noted  by MarketWatch:

“China has lashed back with tariffs on $110 billion in American goods, focusing on agricultural products in a direct and painful shot at Trump supporters in the U.S. farm belt.”

Trump caved to corporate pressures over Huawei at the G-20 summit, and has now caved to pressures from retailers heading into the critical shopping season(The tariffs on electronics, apparel, shoes, and other items are specific goods which will impact consumers the most during the critical holiday shopping season. 

“We’re doing this for the Christmas season. Just in case some of the tariffs would have an impact on U.S. customers.” – President Trump

Not “just in case.” 

As noted above, this was directly is response to his calls with corporate leaders early last week. Those tariffs would have further crushed sentiment and the profits of companies who are dependent on the holiday shopping season for a bulk of their annual revenue. 

From China’s perspective, this is another “nail in the coffin” of Trump’s negotiating strength.

While the U.S. will now expect China to reciprocate by buying U.S. agricultural products in the coming weeks, China has no incentive to do so.

Why does China have to agree to anything, given that Trump is now negotiating with himself to keep his corporate donors happy?

For China, this is a big “win.”

Chinese experts said the sudden postponing of impending tariffs showed that the maximum pressure tactics of the US are losing their bite when it comes to China. These measures are set to greatly reduce the weight of US tariffs, as electronics goods alone account for about $130 billion.

The US has realized that its maximum pressure strategy to force China back to the negotiating table has not worked as expected. Washington knows that only through talks can the two sides reach a deal,’ Wang Jun, chief economist at Zhongyuan Bank, told the Global Times on Tuesday.”

With Trump’s own economy working against him, China doesn’t have to do much, but wait.

Yes, China will gladly have meetings to talk about “trade” as they now know that following each meeting they will walk away with more time.

Time is all they need.

When Trump is out of office, the next administration will abandon the “trade war” as the first order of business.

However, with the “yield curve” plummeting, there is a rising possibility, China may not have to wait that long.

As I wrote last time:

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

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

Major Market Buy/Sell Review: 08-19-19

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

S&P 500 Index

  • As noted in our daily portfolio commentary we added a 2x long back into the Long-Short portfolio Thursday pre-market.
  • We are holding the position over the weekend as the market is not overbought yet.
  • With the market close to registering a “Sell” signal, it is unlikely the current correction is over, but given the reversal in the overbought/sold indicator there is potential for a bit more rally next week. It will be one to sell further into.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position.
    • Stop-loss moved up to $285
    • Long-Term Positioning: Neutral due to valuations

Dow Jones Industrial Average

  • DIA bounced off its 50-dma this past week which is positive.
  • However, like SPY, it is very close to registering a “Sell” signal. Look for this rally to fail likely next week.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions
    • This Week: Hold current positions.
    • Stop-loss moved up to $255.00
  • Long-Term Positioning: Neutral

Nasdaq Composite

  • QQQ rallied modestly last week, but was uninspiring.
  • The buy signal is deteriorating, like DIA and SPY, and a reversal to a sell will likely see a correction to more major support. Remain cautious and keep stops in place.
  • Short-Term Positioning: Bullish
    • Last Week: Hold position
    • This Week: Hold position
    • Stop-loss moved up to $175
  • Long-Term Positioning: Neutral

S&P 600 Index (Small-Cap)

  • SLY continues to disappoint.
  • The buy signal is about to reverse to a sell, and performance is very disappointing.
  • As we have repeatedly stated, 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)

  • Same as above. MDY, like SLY, is technically not in great shape, and is breaking down suggesting the economic backdrop is weaker than headlines suggest.
  • We have recommended over the last several weeks to take profits and reduce holdings.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM continued to breakdown this past week on trade war concerns.
  • A sell signal has been triggered as well.
  • This past week, EEM broke further support. Next support is $38.
  • As noted previously we closed out of out trading position to the long-short portfolio due to lack of performance.
  • Short-Term Positioning: Bearish
    • Last Week: No position
    • This Week: No position
    • Stop-loss violated at $41
  • Long-Term Positioning: Neutral

International Markets

  • Like EEM, EFA continues to drag.
  • EFA broke its downtrend line while maintaining a “buy signal” and is now broke support at the 200-dma.
  • EFA has also triggered a sell signal
  • As with EEM, we did add a trading position to our long-short portfolio model but it, like EEM, was not performing so we closed it.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position.
    • Stop-loss was violated at $64
  • Long-Term Positioning: Neutral

West Texas Intermediate Crude (Oil)

  • If there was ever an economic indicator to pay attention to – it’s oil.
  • Oil continues to languish and remains on a sell signal currently. This doesn’t really bode well for either economic growth, or energy stocks near-term.
  • Oil is not over sold and is in a downtrend. There is no reason to be long oil currently.
  • Short-Term Positioning: Neutral
    • Last Week: No position
    • This Week: No position
    • Stop-loss for any existing positions is $54.
  • Long-Term Positioning: Bearish

Gold

  • Gold remains extremely overbought including its longer-term “buy signal.”
  • As noted three weeks ago, we said that if support holds we will be able to move our stop-loss levels higher. That was indeed the case and we moved stops higher.
  • Gold is too extended to add to positions here. Look for a pullback to $134-136 to add.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss for whole position move up to $130
  • Long-Term Positioning: Neutral

Bonds (Inverse Of Interest Rates)

  • Like GLD, Bond prices have gone parabolic over the last week.
  • The overbought condition is rather extreme, so be patient and wait for a correction back to the breakout level to add holdings.
  • Prices could pullback to the $134 range which would be a better entry point.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions after taking profits.
    • This Week: Hold positions
    • Stop-loss is moved up to $130
    • Long-Term Positioning: Bullish

U.S. Dollar

  • The dollar had rallied above, and is holding support, at its 200-dma. This is bullish and suggests a stronger dollar as foreign dollars flow into U.S. Treasuries for yield and safety.
  • We noted previously the dollar broke above key overhead resistance and suggests a move back towards $98-99 is likely. We are still in the process of that move.
  • USD is holding support at the previous resistance line. Look for a rally next week that flips the dollar back onto a “buy” signal.

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Quick Review

Do you love volatility yet? 

Last week the market swung wildly back on forth on “trade talks,” “tariff relief,” inverted yield curves, and recession fears to finish the week on “hopes” banks will rescue the markets once again.

The bounce on Friday, was not unexpected as the market had gotten very oversold on a short-term basis. As shown in the chart below, the bounce off support gives the market a little room to the upside before several levels of resistance kick in. 

This oversold condition is why we took on a leveraged long position on the S&P 500 which we discussed with our RIAPRO subscribers on Thursday morning:

“I added a 2x S&P 500 position to the Long-Short portfolio for an ‘oversold trade’ and a bounce into the end of the week. We will re-evaluate the holding tomorrow.”

We are holding the position over the weekend, as there is still room in the current advance for further gains. Also, given the President is fearful of a market decline, we expect there will be some announcement over the weekend on “trade relief” to support the markets.

However, this does NOT negate our commentary from last week suggesting this remains a “sellable rally.” To wit:

“The market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics. As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.”

With sell signals in place, maintaining higher levels of cash, hedging, and holding fixed income continues to provide benefits. 

This is particularly the case given the narrowing participation in the broader market. While the S&P 500 is still holding up, that is due to crowding into the largest of market-capitalization-weighted stocks. If you look at the Valueline Geometric Index, there is substantially more damage being done beneath the surface which is supportive of falling yields as money seeks safety. The negative divergences continue to suggest a higher level of caution.

While the market did “bounce” on Friday, the media was quick to suggest it was something more than just a “bounce.” Here is the WSJ:

“The move came on top of gains on Thursday and seemed to reflect a belief that, just maybe, the U.S. economy isn’t in as much trouble as some investors had feared.”

Be careful falling into that trap.

Let’s get into our analysis for this week.



Listen To The Yield Curve Message

On Wednesday, CNBC ran the following headline:

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

On Thursday, CNBC runs the following headline:

“Economists ratchet up their GDP forecasts for the third quarter to a median 2.1% after a batch of better-than-expected data, according to to the CNBC/Moody’s Analytics Rapid Update. The data paints a picture of an economy that looks nowhere near as bad as recent action in the bond market would suggest, and economists say it’s the strength of the U.S. consumer driving the economy. The manufacturing sector does show signs of strain, but the consumer is two-thirds of the economy and it is pulling its weight.”

So, which message is correct? 

Let’s start with the economic data, which is showing a stronger than expected economy. The 6-charts below are the major measures of the economy most viewed by economists.

Clearly, there are NO signs of recession currently:

  • 5% annualized real personal income growth
  • 2.6% annualized employment growth
  • 4.8% annualized industrial production growth
  • 11.5% annualized real personal consumption expenditure growth
  • 13.4% annualized growth in real wages
  • 4.8% annualized real GDP.

Yet, the yield curve is close to inverting.

So, which indicator is right?

As an investor, should you be betting on the economic data, or the “yield curve?” 

My apologies, I forgot to add the X-Axis to the charts above. (Not really, it was intentional)

That time frame is 1991 though 1999.

I don’t need to remind you what happened next.

Now, which indicator would you follow?  The yield curve?

How about the stats in December 2007?

  • 1.4% annualized real personal income growth
  • 0.8% annualized employment growth
  • 2.2% annualized industrial production growth
  • 4.6% annualized real personal consumption expenditure growth
  • 5.7% annualized growth in real wages
  • 2.0% annualized real GDP.

Again, there is clearly no recession in sight, right?

Here is the yield curve from 2003-2008

So, how about today.

CNBC says the consumer is strong, and the yield curve is wrong. 

Here is the 6-panel chart of the current economic cycle to compare to the chart above.

(It is worth comparing the markedly weaker economic growth statistics between today and the late 90’s. This goes a long way in explaining the disparity of wealth in the country today and surging debt levels.)

Here are the final stats as of the latest reports:

  • 3.4% annualized real personal income growth
  • 1.5% annualized employment growth
  • 0.5% annualized industrial production growth
  • 3.8% annualized real personal consumption expenditure growth
  • 5.4% annualized growth in real wages
  • 2.3% annualized real GDP.

To CNBC’s point, based on this lagging, and currently unrevised, economic data, there is “NO recession in sight,” so you should be long equities, right?

Here is that pesky yield curve again. (2009-Present)

Which indicator should you follow?

The yield curve is an easy answer.

While everybody is “freaking out” over the “inversion,” it is when the yield-curve “un-inverts” that is the most important.

The chart below, shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving “risk” to seek the absolute “safety” of money markets, i.e. “market crash.”)

As noted above, the current economic data is only a “guess” about the current economy. In the next 12-months, we will see the “revised” data, but the yield curve is already telling you it will be weaker.

Just as in December 2007, there was “no recession.” It wasn’t until December 2008 that the data was revised, and the National Bureau of Economic Research (NBER) announced the recession had begun a full year earlier in December 2007. 

By the time the announcement was made, it did little to help investors avoid the damage. The chart below is the historical track record of recession dating and market turns. 

Despite commentary to the contrary, the yield curve is a “leading indicator” of what is happening in the economy currently, as opposed to economic data which is “lagging” and subject to massive revisions.

More importantly, while the consumer may be continuing to support growth currently, such can, and will, change dramatically when job losses begin to occur. Consumers are fickle beasts, and when a change in psychology occurs, it will happen very rapidly.



No One Ever Says Sell

Mark Kolanovic of J.P. Morgan penned:

“Historically, equity markets tended to produce some of the strongest returns in the months and quarters following an inversion. Only after [around] 30 months does the S&P 500  return drop below average,”

While the statement is not incorrect, it is advice that will ultimately lead to disappointment. 

As discussed, in 1998 there was “no recession in sight,” and investors were repeatedly advised to ignore the yield curve because “this time was different.” Over the next two years, that advice held true as bullish optimism seemed well-founded. It was in early 2000 that Jim Cramer issued his Top 10-Stock Picks for the next decade. 

The problem was that no one ever said “sell.” 

While gains were made during the period between the initial yield curve inversion and the peak of the market, all of those gains, plus much more, were wiped out in the ensuing decline. By the time the selling was done, portfolio values had reverted to where they were roughly a decade earlier.

Since the majority of mainstream financial advice never suggest selling, investors had no clue that if they had gone to cash in 1998, they saved themselves both much grief, and years of losses to recover.

Following the “Dot.com” crash, the entire tragic event was considered an anomaly; a once-in-a-100-year event which would not be replicated anytime again soon. 

Unfortunately, just 4-years later, in 2006, investors were once again told to ignore the yield curve inversion as it was a “Goldilocks economy” and “sub-prime mortgages were contained.” While many of the individuals who had told you to stay invested leading up to 2000 peak were mostly gone from the industry, a whole new crop of media gurus, and advisors, once again told investors to “ignore the yield curve.”

For a second time, had investors just sold when the yield curve inverted, the amount of damage that would have avoided more than paid off for the small amount of gains missed as the market cycle peaked.

This quad-panel chart below shows the 4-previous periods where 50% of 10-different yield curves were inverted. I have drawn a horizontal red dashed line from the first point where 50% of the 10-yield curves we track inverted. I have also denoted the point where you should have sold and the subsequent low.

As you can see, in every case, the market did rally a bit after the initial reversion. However, had you reduced your equity-related risk, not only did you bypass a lot of market volatility (which would have led to investor mistakes) but ended up better off than those trying to “ride it out.”

That’s just history

Oh, as we noted last week, we just hit the 80% mark of inversions on the 10-spreads we track. (Historically, there has never been a point where 80% of yield curves were inverted that a recession wasn’t pending.)

This time is unlikely to be different.

More importantly, with economic growth running at less than 1/2 the rate of the previous two periods, it will take less than half the amount of time for the economy to slip into recession. 

The yield curve is sending a message which shouldn’t be ignored, and it is a good bet that “risk-based” investors will act sooner rather than later. Of course, it is simply the contraction in liquidity which causes the decline that will eventually exacerbate the economic contraction.

While it is unwise to use the “yield curve” as a “market timing” tool, it is just as unwise to completely dismiss the message it is currently sending.

Moreover, I am certainly NOT suggesting you sell everything and go to cash today. However, history is pretty clear that you will likely not miss much if you did.

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

Defensive positioning has returned to the fore in terms of relative performance as volatility returned to the markets over the last week. We are continuing to maintain our exposure to Health Care for now as defense continues to shield against volatility risk.

Current Positions: Target weight XLV

Outperforming – Staples, Utilities, Materials

Interestingly, despite the “trade war” rhetoric, Materials turned higher, however, it was still defensive sectors ruling the advance. After taking profits, we are maintaining our holdings in these sectors.

Current Positions: Overweight XLP, Target weight XLU, 1/2 XLB

Weakening – Technology, Discretionary, Communications, Real Estate

While Technology, Discretionary and Communication did turn higher, the performance was relatively weak. We did add slightly to our Technology position and added 1/2 weight to XLC. Real Estate continues to hold up from defensive positioning.

Current Position: 1/2 weight XLY and XLC, Target weight XLK, XLRE

Lagging – Energy, Industrials, Financials

Energy is in a lot of trouble as oil prices remain weak due to a global slow down. Industrials broke support last week, and failed at resistance. We were stopped out of XLE last week, but are maintaining our “underweight” holdings in XLI for now. We also reduced our holdings in the Financial sector as both the Fed lowering rates, and an inverted yield curve, are not beneficial their profits.

Current Position: 1/2 weight XLF & XLI

Market By Market

Small-Cap and Mid Cap – Small- and Mid-caps did pop with a short-covering rally on Friday, but remain very negative. Small-caps have violated their 200-dma with the 50-dma crossing back below the 200-dma. Mid-caps only marginally held onto its 200-dma after violating it but the trend is negative so I suspect it will fail soon. Both of these markets are oversold, so a bounce is likely. That bounce should be sold into.

We noted a month ago that with small and mid-caps extremely overbought, it was “a great opportunity to rebalance portfolio risk and reducing weighting to an underperforming asset class for now until things improve.”  That turned out to be good advice.

Current Position: No position

Emerging, International & Total International Markets

We have been out of Emerging and International Markets for several weeks due to lack of performance. However, the addition of tariffs are not good for these markets and prices have collapsed over the last few weeks. As we noted previously, “patience will be rewarded either by avoiding portfolio drag or gaining a more advantageous entry point.”  Not having exposure to these areas continues to pay off for now.

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 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.

Current Position: RSP, VYM, IVV

Gold – Gold continued to push higher due to the deteriorating economic backdrop. This continues to be bullish set up for “gold bulls.” We are holding out positions for now, and continue to look for a better entry point on a pullback to add to holdings. We haven’t gotten one yet.

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

Bonds 

Like Gold, bonds continued to attract money flows as investors search for “safety.” There has also been a massive short-covering rally with all those “bond bears” being forced to cover. However, as noted previously, bonds are EXTREMELY overbought. We are looking to increase our duration and credit quality on a pullback in price. We aren’t expecting much of a correction, so we will likely scale into additional holdings during a correction process. 

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

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

High Yield Bonds, representative of the “risk-on” chase for the markets have been consolidating and last week broke through the 50-dma. High yield bonds are setting up for either a bigger correction, or a decent trading opportunity. We will wait and see how it plays out.

High yield bonds are NOT a long-term play. Junk bonds are almost pure risk due to the inherent bankruptcy risk. It is still a good time to like take profits and reduce risk short-term. Given the deteriorating economic conditions, this would be a good opportunity to reduce “junk-rated” risk and improve credit quality in portfolios. 

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:

Two weeks ago, I wrote:

“As we have been discussing over the past couple of weeks, we needed to take profits and rebalance risks somewhat in portfolios. Despite the recent rally, there are plenty of warning signs which suggests a near-term correction is coming.”

The correction continued last week, which has now gotten the market fairly oversold. The big news, of course, was the inversion of the yield curve. While it was blasted all over media headlines, the inversion of the yield curve itself is not a sign of immediate recession. It is when the yield curve un-inverts, as the Fed is aggressively cutting rates, that the recession is likely in process. 

We are watching this very closely. We did add positions to both the Equity and ETF portfolios to participate when the yield curve does reverse its inversion (REM, AGNC, NLY).

For newer clients, we are keeping accounts primarily in cash as our onboarding model is currently on a “sell signal” suggesting that risk outweighs reward currently. 

In the meantime, we continue to carry tight stop-loss levels, and any new positions will be “trading positions” initially until our thesis is proved out.

  • New clients: We are holding cash until our onboarding model turns back onto a “buy signal.” At that time we will begin buying 1/2 of our target positions and step into the model allocation to minimize entry risk. 
  • Equity Model: No trades this past week. We are still looking to add to our holdings of JNJ, NLY, AGNC, and WELL. However, the setup is not quite correct so we are being patient at the moment.
  • ETF Model: We were stopped out of XLE last week, however, we added to our holdings in XLK, and a new position in XLC to keep our equity weighting flat. Also, these two positions are short-term oversold and are somewhat less affected by the trade war. 

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

Trump Is Making This Really Tough – Part 2

As I wrote two weeks ago:

“A less than anticipated rate cut, and outlook, by the Fed tripped up participants. Then Trump deciding to add additional tariffs on China, in order to force the Fed to cut rates, roiled stocks even more. Stocks sold off for the entirety of last week, so expect a rally early next week to sell into. Take some actions if you have not already as the next two months could bumpy. The correction is likely not complete yet.

More tweets and volatility this week, inverted yield curves, etc.

While volatility has risen markedly, the markets really haven’t done anything “wrong” as of yet. This is one of those times we have to sit on our hands and wait. With markets moving from one tweet to the next, it is impossible to successfully trade these swings. 

Downside risk is elevated, so we are maintaining underweight holdings for now. However, if we begin to break supports, we will recommend reducing risks further. 

If you haven’t taken any actions as of late, it is not a bad time to do so. 

  • If you are overweight equities – Hold current positions but remain aware of the risk. Take some profits, and rebalance risk to some degree if you have not done so already. 
  • If you are underweight equities or at target – rebalance risks and hold positioning for now.

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

401k Plan Manager Beta Is Live

We have rolled out a very early beta launch to our RIA PRO subscribers

Be part of our Break It Early Testing Associate” group by using CODE: 401

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

We have several things currently in development we will be adding to the manager, but we need to start finding the “bugs” in the plan so far.

We are currently covering more than 10,000 mutual funds and have now added all of our Equity and ETF coverage as well. 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 the 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 you 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.)


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

#WhatYouMissed On RIA: Week Of 08-12-19

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


The Best Of “The Lance Roberts Show”

Video Of The Week (The Yield Curve Inverts)

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!

Superforecasting A Bear Market

There’s an ongoing debate about whether or not the U.S. is approaching a recession. As an investor, this question is of utmost importance. It is precisely at these times when fortunes can be made and lost. There’s no shortage of pundits with strong opinions in both the affirmative and negative camps armed with plausible narratives and supporting data sets. How to decide which side to take? Applying some proven forecasting methods to historical data can help bring clarity to this question.

Forecasting is tricky business. It’s really hard to do well consistently, especially in investing.

Fortunately for us, Philip Tetlock has made a study of forecasting. In the book Superforecasting: The Art and Science of Prediction (aka Superforecasting) he and coauthor Dan Gardner share their findings of a multi-year study aimed to discover the best forecasters, uncover their methods, and to determine if forecasting skills could improve. There are many great lessons conveyed in the book. We can thus apply them to our problem at hand: the question of whether or not the U.S. will enter a recession.

The Lessons

By running a series of geopolitical forecasting tournaments, Tetlock and Gardner discovered a group of elite forecasters and uncovered their best practices. Ironically, specialized knowledge played little role in their success. Rather, it was their approach.

Superforecasting had a profound impact on me. I took away a more concretized framework for dealing with predictions. Rather than feeling my way through a situation, Superforecasting gave me a method I could apply. Well-devised forecasts share four characteristics:

  1. They’re probabilistic
  2. They start with a base rate formed by an “outside view”
  3. They’re adjusted using the specifics of the “inside view”
  4. They’re updated as frequently as required by incoming facts, no matter how small the increments

Think Probabilistically

The best forecasters (aka Superforecasters) made predictions in a probabilistic manner. In other words, outcomes weren’t binary—i.e. something would or would not occur. Rather, the Superforecasters ascribed a probability to a forecast. For example, they would assign a 30% chance to the U.S. entering a recession rather than saying it was unlikely. This precision is important.

Establish a Base Rate Formed by an “Outside View”

Before making a prediction, the Superforecasters first established a base rate informed by an “outside view.” A base rate is merely a starting probability. It will later be adjusted. An outside view, as introduced in his book Thinking, Fast and Slow by Daniel Kahneman, is a perspective that looks for historically analogous situations for guidance.

To establish a base rate using an outside view, we should first look at previous recessions and periods where economic conditions were similar. How often did conditions deteriorate into recessions? What events tended to precede them? This should give us starting point.

Adjust Using the “Inside View”

After establishing a base rate using an outside view, the Superforecasters adjusted it by taking an inside view—another Kahneman concept. An inside view is a perspective that only considers the situation at hand. It ignores historical precedents and seeks to induce an outcome using only the current facts. In a sense, every situation is treated as unique.

Thus, the Superforecasters considered both the historical context and idiosyncratic characteristics to inform their predictions. In a lot of ways this resembles using deductive and inductive reasoning in concert with each other; a practice I condone. To follow with our example, a Superforecaster would adjust their 30% recession base rate up or down based on current economic and market conditions. It might be increased due to the prospect of a trade war; it might be reduced based on strong jobs data.

Frequently Updated

Lastly, the Superforecasters frequently adjusted their forecasts. They constantly updated their probabilities, even in increments that seemed insignificant if warranted by new information. While this might sound trite, Tetlock and Gardner found it to be a key component of accuracy. Thus, forecasts might be changed with each presidential tweet in our ongoing example.

Establishing a Recession Base Case

Armed with an improved forecasting method, I applied it to the recession question. I ditched my bullish or bearish perspective and established an outside view base rate. Here, I illustrate my process using two of the most hotly debated metrics: the Institute for Supply Management’s Purchasing Manager’s Index (PMI) and the U.S. Treasury yield curve (YC), defined by the 10 year U.S. Treasury bond minus the Federal Funds Rate.

I compiled monthly data through July 2019. I then looked at the frequency of negative monthly returns for the S&P 500 index (SPX) after a specific threshold was breached. For the PMI I used its latest reading of 51.2. For the YC I looked at periods of inversion (i.e. when the spread was zero and below). Once these months were identified, I calculated the SPX’s return over the following 1 month, 3 months, 6 months, 12 months, and 24 months.

Note that I analyzed SPX returns and not whether or not a recession occurred. As an investor, my only concern is if asset prices will rise or fall, not recessions as such. It just so happens that recessions and falling stock prices coincide; but it’s the values that we ultimately care about, not recessions.

Findings From PMI Data

Below is my analysis of SPX returns for when the PMI historically reached these levels (51.2). Note that my data covered 858 months for my 1 month sample period and 835 months when looking at 24 month returns (i.e. 23 less data points). The PMI was 51.2 or below in 322 of those months, or ~38% of the time across sample periods. During these instances, successive SPX returns were negative for 14% of the months using a 24-month time horizon and 35% of the months using a 1-month one. Thus, 29% is a reasonable base rate for taking a bearish stance on the SPX over a 6 month time horizon using an outside view of PMI data.

Also, note that the longer the negative return environment persisted the larger the average losses.

Here is a similar table examining YC inversions. Both the instances and magnitudes of negative SPX returns appear to be higher for this data set. A base rate of 52% seems reasonable for taking a bearish stance on the SPX over a 6 month time horizon for this data set.

Findings From Combined PMI & YC Data

It’s an even rarer occurrence for the YC to invert when the PMI is 51.2 or below. This happened in just 65 months out of the past 780, or 8% of the time. SPX returns were negative 28% to 55% of the time depending on one’s timeframe, with 3 month displaying the highest frequency. We could use a 46% base rate for a 6 month time horizon. While losses were less frequent using this dual-signal than the YC alone, they were also more severe. Average drawdowns ranged from 4.3% to 31.4%.

Calibrating Your Grizzly

This analysis affords us two advantages. First, it removes the binary guesswork in trying to predict a recession. We no longer need to make a definite call on whether returns are likely to be higher or lower under the current conditions; we can take a more nuanced, probabilistic approach. Secondly, we can establish a starting base rate that is grounded in historical data.

According to the best practices discussed in Superforecasting this is just the first two steps in creating a robust forecast. The base rate requires adjusting by considering an inside view of today’s economic and market landscapes. It must also be updated as new information materializes.

The conditions examined (a PMI lower or equal to 51.2 and an inverted YC) were recently triggered. History suggests that we’re in a serious position. In the past, SPX returns were negative nearly half the time over the succeeding 3 to 12 months. To be sure, using just two signals is not an exhaustive process. However, it was a good first step in helping me calibrate my bearish instincts.

I’ll leave it to you, the reader, to apply your own inside view of the markets to this base rate. Ultimately, we must determine the extent to which “it’s different this time.” While forecasting is guesswork by definition, Superforecasting provided me with a useful framework to apply to all investing situations. Hopefully I’ll do so profitably.

Financial Success Formula Failure

The US economy grew at a 2.1% annualized pace in the second quarter, according to data released last week. That was better than economists expected but hardly impressive.

Even President Trump recognized this, tweeting the growth rate was “not bad considering we have the very heavy weight of the Federal Reserve anchor wrapped around our neck.”

That’s the same Federal Reserve of which Trump himself appointed the chair and a majority of board members. But I guess he has to blame somebody.

Sadly, though, quite a few Americans really do have financial anchors wrapped around their necks. I recently reported on Federal Reserve survey data showing 39% of American adults can’t cover a $400 emergency expense without borrowing money or selling something.

That story drew a lot of positive response, but distressingly, I also heard from people who would rather blame the victims.

It’s their own fault, you see. They don’t know “The Secret.”

Missing Factors

My Left-Behind Economy article provoked some disagreement. Several comments went like this (paraphrasing):

“These people who don’t have $400 for emergencies should have done like me: work hard, save money, live frugally. It’s their own fault. They get what they deserve.”

Let’s unpack this.

First, congratulations to these financially stable readers who made good choices. However, it’s worth asking: What enabled those choices?

Success comes from good decisions but not everyone has the same menu. The choices in front of you are different if, for instance…

  • Your parents were a hedge fund manager and a corporate lawyer, or
  • You got a college athletic scholarship that let you earn a degree without accruing student debt, or
  • You’re the child of a single mom who had to work instead of help you study your math and science.

Are these choices? Not really. Even hard-training athletes benefit from their genetic attributes and coaching.

That doesn’t relieve us of responsibility, of course. We can all make the best of what we have. But the data doesn’t support this idea that everyone “gets what they deserve.”

That’s obvious when you think about it. If the formula is…

Hard work x frugal living x smart decisions = financial success

… then everybody who does those three things should get the same results. But clearly they don’t.

  • We all know smart people who work hard and live simple lives, yet accrue very little money.
  • We also know less-than-intelligent folks who waste their time and cash, yet stay wealthy.

These exceptions tell us the equation must have other factors. Yet people still believe it.

Law of Attraction

American culture is deeply invested in the “self-made man” idea, that anyone can do anything if they just put their mind to it.

That stems partly from our Puritan religious heritage. Calvinist theology said God favored the chosen “Elect.” If that’s your belief, you are highly incentivized to prove you are in that group. Those who appeared unfavored were sometimes shunned.

Versions of that attitude survive today—sometimes overtly in “Name It and Claim It” fundamentalist sects, but more often in tacit form. Otherwise non-religious people fervently believe their own talents and hard work led to a kind of financial redemption. They insist others must follow this same plan of salvation.

This idea exists in New Age movements, too.

Remember The Secret book and film? It was wildly popular in the early 2000s, describing a “Law of Attraction” that made success inevitable if you wanted it badly enough.

(Saturday Night Live did a hilarious satire you can watch here.)

The implicit flip side Oprah didn’t mention: Anyone who isn’t successful must be somehow deficient. You should avoid them so it doesn’t rub off.

From there, it’s a quick jump to “They got what they deserve.”

No One Wins Alone

We all need a little motivation to work hard and do our best. Slothful behavior doesn’t have the immediate life-or-death consequences it once did.

But more often, we take it too far. Very few people achieve financial and career success on their own. They had help—from family, friends, strangers, and yes, the government. There shouldn’t be any shame in that.

In economic reality, no one fails or succeeds alone. So the question is: Who helps whom, and how? It can happen many different ways, some of which work better than others.

But we don’t have that discussion if we’re busy lauding ourselves for “success” that isn’t fully ours and denigrating others who haven’t achieved the same.

These attitudes are far less common in some parts of the world. Those regions are growing faster. Maybe there’s a connection.

Unmasking The Voodoo Yield Curve

To normal people, the typical response might be, “What in the name of the almighty are you talking about?

To market geeks likes us, it means the yield curve is as flat as its been since just before the financial crisis and recession.

Still not getting it? Not to worry, you are still normal. The panic in pundit hearts is that a flat yield curve suggests a recession is near. No, not tomorrow, but sometime in the next year or so.

Lazy are we are, we use the spread between the 10-year U.S. Treasury note and the 2-year note as the proxy for the whole curve. The whole curve is actually all the key Treasury rates from three and six months all the way out to 30-years.

Basic Curvology

Normally, these VooDoo articles are mostly time agnostic. However, the current state of the yield curve allows us to cover all sorts of things so I am going to go with it. It will keep, however, once the curve gets more benign again.

Here’s a picture of what everyone calls a normal yield curve (source: StockCharts.com). It is upward sloping as we go from short-term rates to long-term rates. The idea is that investors get paid more to take more risk. And since these are supposedly default-risk free U.S. Treasuries, that risk is interest rate risk. Having your money exposed, i.e. locked up, in longer maturities puts you at risk for rates going higher and your principle going lower.

You know, bond prices and yields move inversely to one another. If you want more, you’ll have to use the google because that will take me too far off track here.

Anyway, that’s the way the world works when things are, ahem, normal. But since the financial crisis and the artificial lowering of short-term rates by they who shall remain nameless (the Fed), this is what the yield curve looked like for the past few years.

Note it still has that nice upward slope. The difference is that the left side (the short end of the curve) starts near zero.  Don’t forget, this was smack in the middle of a rip-roaring bull market is stocks so the economy was humming along, albeit at rather low growth.

Next, look at it today.

Most of it is still upward sloping but something is still pretty different in the short-end. The three-month rate is above the 10-year rate. And the two-year is closing in on the 10-year.

I still call this “somewhat” inverted. You still get paid more to take time risk but you get even more to hold cash (T-bills are pretty much cash equivalents). That’s not good.

Now check out what it looked like when it was really inverted just before the stock market peaked and the first major market shock hit is mid-2007. Now that’s inverted.

Where do we go now?

If I knew that, I’d be writing my novel, not a post here. However, there are a few things we can discuss.

The Fed is in a bind. Although the economy is still is pretty good shape, the yield curve DEMANDS they lower their rates. If they do, the curve normalizes a bit and buys us time. Here, if the long-end of the curve falls, too, then we are in deep Chobani. That would mean businesses do not want to borrow for major projects. And home buyers would not be buying, pressuring mortgage rates lower and the rest of long rates lower by extension (tail wags dog but you get the idea).

What if we make long bonds less attractive to foreign buyers with a plunging U.S. Dollar? It’s a bit of chicken or egg but that would lower demand and lower bond prices means higher yields.  Too bad the global economy is stinko and the best place for growth is right here.

Higher commodities prices via the lower dollar and, unfortunately for reality, improved global growth. A little inflation would push long rates higher.

And finally, since all of that, except for the Fed, is pie in the sky, what if we got a good deal with China, signed the USMCA (new-NAFTA) and decided to put country above party?

Hmmm…….

We could get the first two, although the second would need a little element of the third.

What’s the real deal with the curve?

The upward sloping yield curve means banks can borrow at low, short-term rates and lend at higher long-term rates. The bigger the spread, the more money they make and the more they want to lend.

Banks, then, should do well with a steep curve. If they don’t, then we got problems.

Inflation keeps the long-end higher because borrowers want to be paid for the risk they take that the money they lend will be worth less when they get it back in 10-, 20- or 30-years. If there is inflation and the long-end stays low, then we got problems.

What if the curve stays flat and there is inflation? Then we got problems. Anyone here old enough to remember the term “stagflation?” A stagnant economy and higher prices.

And now for another bit of current events. A good chunk of the world now has negative interest rates on their debt. You give them money and they give you less back. I suppose that would be great in a deflationary environment, and yes, then we got problems. But right now, I think this is a policy tool, put in place by economic tools, yes, I said it, to ty to stimulate global economies.

Here’s a thought, make them more business friendly and let them be free.

The good news is that if the curve really inverts, the problems don’t really start for a while, and probably not until the curve un-inverts again. You can use the google to read more from real experts on the topic.

And if the U.S. goes negative, there goes the entire saving class.

But for now, the yield curve is simply the plot on a yield vs. maturity chart that shows us where rates are.

Special Report: S&P 500 Plunges On Yield Curve Inversion

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical green lines are buy periods, red lines are sell periods.)

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the months ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

UNLOCKED RIA PRO: S&P 500 Plunges On Yield Curve Inversion

We have unlocked yesterday’s report that went out to our RIA PRO subscribers following the crash. You can subscribe at RIAPRO.NET and get 30-DAYS FREE to gain access to our portfolio models, analysis, and research.

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into their allocation models. (Vertical green lines are buy periods, red lines are sell periods.)

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the months ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

Selected Portfolio Position Review: 08-14-19

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

WELL – Welltower, Inc.

  • WELL fits within our dual theme of an aging demographic and a shift to “safety” over “risk” within allocations. With a 4% yield, the total return continues to be attractive.
  • The drop in interest rates has fed into interest rate sensitive sectors and pushed WELL to all-time highs.
  • The position is overbought and on an elevated “buy” signal so we are keeping a close stop on the position currently.
  • Stop loss moved up to $80.

DOV -Dover Corp.

  • We originally took profits in DOV back in May, then again in July. Since then it has finally corrected a bit and triggered a short-term sell signal.
  • So far, important support is holding at the $87.50 level and after taking profits we can give DOV a bit of room to find a re-entry point to add back into holdings.
  • Stop-loss is set at $87.50

AEP – American Electric Power

  • Utilities have been consolidating a bit after an exceptionally strong run. As noted above, with interest rate declines feeding into interest rate sensitive sector, Utilities have continued to get a bid.
  • AEP is one our stronger defensive plays, but is both extremely overbought and extended.
  • AEP has triggered a short-term sell signal, so we are watching the sector closely. We have taken profits but will likely do so again soon.
  • Stop-loss is set at $84 currently.

GDX – Gold Miners

  • GDX was added to our portfolios to hedge against potential volatility and rate risk in portfolios.
  • We continue to hold our position for now but the position has gone parabolic for now. We have not had a good entry point as of yet to add to our position further.
  • GDX is on a “buy signal” so we continue to be bullish on the position. The overbought condition suggests a short-term pullback is in order.
  • Our stop is moved up to $25

BA – Boeing Co.

  • We are still maintaining our 1/2 position in BA as it continues to struggle with 737 MAX issues.
  • However, BA is extremely oversold on its trading signal and a reversal of the signal would likely equate to a strong breakout above this base BA has been building since 2018.
  • Stop-loss remains at $300.

JPM – JP Morgan Chase

  • Financials continue to struggle with the inversion of the yield curve and with the Fed cutting rates.
  • JPM recently sold off and tested support at the 200-dma.
  • JPM is close to triggering a short-term sell signal so support needs to hold.
  • Stop loss is set at $105

PEP – Pepsico, Inc.

  • PEP has performed well since we added it to portfolios but has needed a correction for quite some time.
  • That correction is in process and support is holding.
  • PEP has triggered a short-term sell signal so we are watching the position closely for now.
  • Profit stop-loss is set at $127.50
  • Stop-loss is set at $122.50

V – Visa

  • If you can’t pay cash for it, charge it. People are doing just that and credit card debt keeps climbing along with our holdings in V.
  • Like most of our positions, V is grossly overbought and extended on multiple levels.
  • We are moving up our stop-loss levels to protect our gains.
  • Stop-loss is moved up to $165

ABT – Abbott Laboratories

  • ABT continues to provide great performance even after we previously took profits.
  • ABT recently flipped back onto a “buy signal” but is overbought short-term
  • Hold positions for now, after taking profits, and watch the uptrend line from the 2017 lows.
  • Stop loss is moved up to $77.50

CMCSA – Comcast Corp.

  • CMCSA has been consolidating its previous advance for the last few months.
  • The position is very overbought and has triggered a short-term sell signal. A pullback to $40 could give us an opportunity to add to our holdings longer-term.
  • We are moving our stop-loss up to $38.50

Negative Is The New Subprime

What is nothing? What comes to mind when you imagine nothing? The moment we try to imagine what nothing is, we fail, because nothing cannot be envisioned. There is nothing to envision or ponder or even think about. Nothing is no thing.

Yes, the point above is tedious, but the value of nothing in the financial theater is the latest magic trick of the central bankers and the most vital factor governing all investments.

If I invest my hard-earned capital in an asset the guarantees a return of nothing, what should I expect as a return? Nothing is a good answer, and somewhat absurdly, there is the possibility that nothing is the best-case scenario. Let’s take it one step further to beyond nothing. In the current age of financial alchemy, there is nearly $15.5 trillion in sovereign and corporate bonds available that promise a return of not only nothing but actually less than nothing.

If I am hired to steward capital and I invest in something that returns less than nothing, I have knowingly given away some portion of the capital I invested, and I should find another profession. And yet, on this very day, there are trillions of dollars’ worth of bonds that promise a return of less than nothing. Furthermore, there are many professional investors who knowingly and willingly are buying those bonds! The table below shows the many instances of negative-yielding sovereign bonds, with U.S. yields as a comparison.

Data Courtesy Bloomberg

Warped Logic

The discussion and table above highlight just how far astray the financial system has gone in Europe and Japan. What we are witnessing is not just coloring outside the lines; it is upside down and inside out. Central bankers are frantically turning cartwheels to convince us that current circumstances, though deranged and highly abnormal, are perfectly sane and normal. More often than not, politicians, the media, and Wall Street fail to challenge these experiments and worse generally echo the central bankers’ siren song.

How do investors conclude that there will be only good outcomes as a result of what are imprudent and illogical decisions and actions? Is it prudent to expect a bright future when the financial system punishes prudent savers who are most able to invest in our future and rewards ill-advised borrowing beyond one’s means?  

The current market and economic environment beg for lucid evaluation of circumstances and intelligent, honest discourse on the potential implications. Unfortunately, most market participants would prefer to keep their head in the sand. Chasing the stock and bond markets for the past decade has produced handsome returns and, for most investment advisors, delivered praise and a generous wage. As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Compounding wealth is the most important and most difficult financial concept for investors to grasp. Over the last ten years, many investors spent significant time recouping losses from the financial crisis, and they assumed great risk in doing so. Having recovered some or all of those losses, many are back in a position of compounding wealth. At this point, they can continue to look backward and believe that irrational policies will ensure that the past is prologue, or they can exercise some independent thought and recognize that the risk of another serious drawdown is not negligible. Prudent risk management is very generous to those who elect patience over expedience. Most financial advisors will not volunteer a fee-reducing, conservative approach even though it would be in their own best interest to do so at critical times.

Entities empowered with the responsibility of directing traffic and ensuring against bad behavior that wish to “manage” markets are increasingly weighed and found wanting. They have become a part of the bad behavior they were entrusted to prevent, yet again. Actions, or the lack thereof, that resulted in the destruction of wealth in recent history have been on full display for over the past decade. However, with stock markets near record highs today, these actions (or inactions) are cloaked in an artificial façade of success.

Retrospect

It has become cliché to point back to October 1929, the dot.com bubble, and the housing bubble as a reminder of what may transpire. Bulls confidently look at the bears citing those periods, just as Monty Python’s King Arthur looks at the Black Knight after dismembering his arms and legs and says, “What are you going to do, bleed on me?”

Yet, historical episodes are the correct frame of reference. Just as in those prior bubbles, the problem today is right in front of our face. The evidence is clear and the lunacy unmistakable. The poster child in 2000 was Pets.com and the sock puppet; in 2006 it was skyrocketing home prices and negatively amortizing subprime “liar” loans. Today, it is negative interest rates.

It is not hyperbole to say that today’s instance of finance gone wild is more insane than Pets.com, neg-am liar loans and any other absurd Ponzi scheme that has ever been perpetrated, ALL PUT TOGETHER.

The dot.com market collapse cost the economy roughly $8 trillion. The estimate of the cost of the 2008-09 financial crisis is $22 trillion. The market value of debt outstanding with negative interest rates is over $15 trillion.

Data Courtesy Bloomberg

Although $15 trillion is less than the financial crisis losses, what must be considered is the multiplier effect. The losses in prior recessions were in part caused by the factors listed above but magnified by their ripple effect on other aspects of the economy and financial markets. This is the multiplier of the cause or the epicenter. Consider the following:

  • The S&P 500 Information Technology sector market cap was roughly $4 trillion in March 2000. The total market losses from the tech bubble amounted to about $8 trillion; therefore, the damage in that episode was about $2 for every $1 of exposure ($8T losses vs. $4T exposure) to the epicenter of the problem, so the multiplier was 2:1.
  • The toxic sub-prime part of the mortgage market was about $2 trillion. So, the impact of losses was $11 for every $1 of exposure ($22T loss vs. $2T exposure) to the epicenter, or a multiplier of 11:1.
  • If a problem emerged today and we are correct that the epicenter of this problem, negative-yielding debt, is further reaching than those prior mentioned episodes, then using a simple 11-to-1 ratio on $15 trillion is $165 trillion in losses, may be understating the potential problems. Even being very conservative with a 2:1 multiple yields mind-boggling losses.

This is unscientific scenario analysis, but it does provide a logical and reasonable array of possible outcomes. If one had postulated that the sub-prime mortgage market would spark even $2 trillion in losses back in 2007, they would have been laughed out of the room. Some people did anticipate the problem, made their concerns public, and were ridiculed. Even after the problem started, the common response was that sub-prime is too small to have an impact on the economy. In fact, the Fed and other central banks stood united in minimizing the imminent risks even as they were wreaking havoc on the financial system. Likewise, the “scientific” analysis currently being done by Ph.D. economists will probably miss today’s problem altogether.

European Banks

The concept of negative-yielding debt is totally irrational and incoherent. It contradicts every fundamental rule we learn and attempt to apply in business, finance, and economics.  It implies that the future is more certain than the present – that the unknown is more certain than the known!

When the investment/lending hurdle rate is not only removed but broadly disfigured in how we think about allocating resources, precious resources will be misallocated. The magnitude of that misallocation depends on the time and extent to which the policy persists.

As brought to our attention by Raoul Pal of Global Macro Investor and Real Vision, the first evidence of problems is emerging where the negative interest rate phenomenon has been most acute – Europe. European financial institutions are growing increasingly unhealthy due to the damage of negative rate policies. Currently, the Euro STOXX Bank index, as shown below, trades at levels below those of the trough of 2009 and its lowest levels since 1987. More importantly, the index is on the verge of breaking through a vital technical level to the downside. The shares of Germany’s two largest banks, Deutsche Bank and Commerzbank, are at historical lows.  Just as subprime was not isolated to the U.S., this problem is not isolated to Europe. These banks have contagion risk that, if unleashed, will spread throughout the global financial system. 

Data Courtesy Bloomberg

Summary

The market is reflecting a growing lack of confidence in the European banking and financial system as telegraphed through stock market pricing shown above.

The risk facing the global financial system is that, as problems emerge, the second and third-order effects of those issues will be both impossible to anticipate and increasingly difficult to control. Trust and confidence in the world’s central bankers can fade quickly as we saw only ten years ago.

Compounding wealth depends upon minimizing the risk of a large, permanent loss. If markets falter and the cause is monetary policy that advocated for negative interest rates, investors will have to accept accountability for the fact that it was staring us in the face all along.

It’s Not Gold That’s Getting Me Nervous

The recent breakout in gold got a lot of people excited. How many mummified gold bugs were reanimated, saying, “See, I told you all of that money printing was going to push prices higher!”

Thanks, 49er, that’s not why gold is rising.

Rather than obsess over the why’s and whatnot, let’s take a slightly deeper dive into what is happening. From there, we can draw some conclusions and from what I see, the rest of the year may not be so kind for the economy and for stocks.

I’ve posted charts of gold already so let’s just stipulate that the yellow metal broke out from six-year base in June. It immediately fell into a new trading range before breaking out again this past week.

Was it China’s move to devalue? Probably. But again, the why is not my thing. All I know is that gold moved into a bullish trend until it tells us otherwise.

If gold is rallying, it makes sense that the other precious metals are rallying. And they are. Silver moved nicely since a June breakout of its own, albeit that breakout was not from any major base.

Curious. Now let’s look at a chart comparing gold and silver.

(Click on image to enlarge)

As you can see, the two tracked fairly well until 2016. I don’t know what happened then and I really don’t care. All I see is that the two-headed in different directions.

And yes, both have short-term breakouts. However, only gold as a long-term breakout.

I’m not much of a gold/silver ratio guy although it seems on the surface that silver is the better bet right now. But then again, silver is less precious that gold and by that I mean it is far more sensitive to the economy. It has far more uses in industry.

Does that mean we have an economic red flag? Maybe.

Now let’s look at platinum. Remember the good old days when platinum was hundreds of dollars more per out than gold? With gold now in the $1500 area, it is 70% or so higher than platinum.

(Click on image to enlarge)

The overlay chart shows the same story as with silver. Gold it up, platinum is down, only with no short-term breakout at all.

Again, platinum has far more uses in industry than gold. Another red flag? Or at least the same one?

If we are talking economics, we have to look at copper. Blah, blah, PhD. in economics. We all know.

(Click on image to enlarge)

This chart is copper on its own. The ratio of copper to gold is just pure downhill and has been for two years. Actually, take away the post-election bounce and it’s been down since 2006.

As we can see in the chart, copper formed a nice support over the past year and change and seems to be bouncing off it this week. But even so, this is not a bullish chart.

This one is a red flag, too, although it’s been a red flag for quite some time. A breakdown would not be a good omen for the economy.

And finally, let’s look at industrial metals stocks.

(Click on image to enlarge)

Just lousy. You don’t need any fancier analysis from me.  But what I should say is that this group is at the base of the economy. If it stumbles, the rest of the economy built on top of it can fall.

Is there good news?

It’s never quite this simple. Right now, there is good news as market breadth is still fairly positive. And even though there have been a few brushes with Hindenburg-like divergences, the advance-decline is still right up there. Tech is still in a leadership role.

Let’s also not forget the market is still only a few percent off all-time highs and above its December 2018 trendline. It’s also above its 2009 trendline, albeit with room to fall.

True, small caps are lagging. But they’ve been lagging most of the year.

And the yield curve does not look so healthy. The 2-10 is not inverted but the 3mo-10yr is getting a lot of panties in a bunch. The problem, however, seems to get started after the curve inverts and then goes back to normal so that pushes problems out into the future.

The wild card is a deal with China. If that happens, chances are the stock market zooms higher, at least for a while. The real question is whether this is actually priced into the market already, save for the initial euphoria rally. After that cools, we’ll have to see if metals change.

But for the evidence on the table now, I would not push my luck in stocks. I’m not completely heading for the hills, either, but preparing for a rough market is a good idea.

5-Things Your Broker Will Ignore – Part 1

Investors mistakenly believe their financial partners are students of holistic financial planning. Outside of sell-side biased market information pumped out daily by an employer’s research department, there are several areas of study that many brokers would prefer to avoid.

Worse are the practitioners who confidently communicate erroneous Medicare and Social Security advice which results in consumers leaving thousands of lifetime income dollars on the table. Then, there are the brokers who utilize comprehensive financial planning as a tool to sell products with little focus on sequence of returns risk or lower future asset class returns that may drain a retiree’s investment nest egg faster than anticipated.

There are 5 areas of concern investors must consider (even though brokers will discount their importance). I decided to break the actions into 5 separate blog posts so readers are not overwhelmed.

1). Inflation must be adjusted and matched to specific goals.

Inflation is personal to and differs for every household.

My household’s inflation rate will differ from yours.

Thanks to an inflation project undertaken by the Federal Reserve Bank of Atlanta, there’s now a method to calculate a personal inflation rate. A smart idea is to compare the results of their analysis to the inflation factor your financial professional employs in retirement and financial planning. Instruct your adviser to complete an additional planning scenario which incorporates your personalized consumer price index and see how it affects your end results or outcomes.

The bank has undertaken a massive project to break down and study the elements of inflation along with the creation of a myCPI tool which captures the uniqueness of goods that individuals purchase.

Researchers estimate average expenditures using a calculation which incorporates various cross-demographic information including sex, age, income, education and housing status. The result is 144 different market baskets that may reflect a closer approximation to household’s personal cost of living vs. the average consumer. It’s easy to use and sign up for updates.

My personal CPI peaked in July 2008 at an annualized rate of 5.2%. Currently, it’s closer to 1.7%. For living expense planning purposes, I use the average over the last decade which comes in at 2.1%.

The tool can help users become less emotional and gain rational perspective about inflation. Inflation tends to be a touchy subject as prices for everything must always go higher (which isn’t the case). I’ve witnessed how as a collective, we experience brain drain when we rationalize how inflation impacts our financial well-being. It’s a challenge to think in real (adjusted for inflation) vs. nominal terms.

I hear investors lament about the “good old days,” often where rates on certificates of deposit paid handsomely. For example, in 1989, the year I started in financial services, a one-year CD yield averaged 7.95%. Inflation at the time was 5.39%. After taxes, investors barely earned anything, but boy, those good old days were really somethin’ weren’t they?

We’re all inflation experts because we live with it daily. It’s an insidious financial shadow. It follows us everywhere. We just lose perspective at times as the shadow ebbs and flows, shrinks and expands depending on our spending behavior. Interestingly, as humans, we tend to anchor to times when inflation hit us the hardest.

I’m not saying inflation isn’t important. The dilemma is that a majority of brokers will blindly adhere to default inflation rates provided in their respective financial planning software. If inaccurate inflation rates are employed, or not personalized for a household’s goals, they have the potential to under or overestimate spending needs, especially throughout retirement.

As an investor, I want you to be prepared to consider inflation in a logical manner (perhaps teach your financial partner a thing or two).

Here are 3 concepts to remember.

2). Specific financial goals may require varied rates of inflation.

A financial plan is a voluminous snapshot of wealth building in process. A plan (hopefully, along with a knowledgeable financial partner), helps forecast how specific actions can lead to success (or failure) to meet future goals. However, the effectiveness of a plan is only as good as the inputs employed to create it.

The adage of “garbage in, garbage out,” not only goes for the accuracy of personal financial information shared to prepare the plan, it also applies to the asset-class returns and inflation estimates employed. Financial planning software is user-ready with built-in assumptions about returns and inflation estimates; it’s the responsibility of your advisor or brokerage firm to review defaults and decide if or when they require change. For example, one of several programs we utilize at RIA defaults to the Consumer Price Index (CPI) for its base inflation rate. A series of default projected asset class returns are also provided.

As a group, we annually review these inputs and update if warranted. Early in 2018, we decided to reduce forecasted returns on every asset class due to stretched fundamentals, excluding international and emerging markets. Although our investment committee finds international stocks attractive from a valuation perspective, we maintain zero broad exposure to them. I’m getting ahead of myself as I expand on valuations in the second blog post of the series.

As a reminder, the Consumer Price Index is the average change over time in prices paid for a market basket of consumer goods and services. There are two target populations or groups the Bureau of Labor Statistics calculates for its main series: All Urban Consumers (the “CPI-U” population), and Urban Wage Earners and Clerical Workers (the “CPI-W” population).

From the BLS:

The CPI-U population covers about 88 percent of the U.S. population or households in all areas of the United States except people living in rural nonmetropolitan areas, in farm households, on military installations, in religious communities, and in institutions such as prisons and mental hospitals.

The CPI-W is a subset of CPI-U and covers the CPI-U population households for whom 50 percent or more of household income comes from wages and clerical workers’ earnings. The CPI-W’s share of the total U.S. population has diminished over the years; the CPI-W population is now about 28 percent of the total U.S. population. The CPI-W population excludes households of professional and salaried workers, part-time workers, the self-employed, and the unemployed, along with households with no one in the labor force, such as those of retirees.

Listen, it’s the best we have when it comes to broad measures of inflation. Thus, the historical inflation rate used in most financial planning programs are not incorrect per say, it’s just designed to capture spending of the mass population, not your household where spending may differ. It’s acceptable to be utilized in plans but when it comes to specific future spending goals especially in retirement, perhaps we can do better.

3). Gain a grip on your household’s PIR or Personal Inflation Rates.

So, how do you create PIR or Personal Inflation Rates? Initially, seek to partner with a fiduciary or Certified Financial Planner® to create and prioritize financial goals segmented into needs and wants. Needs are the financial milestones which are most important and may include college funding requirements, retirement income needs and healthcare and long-term care insurance costs. Wants and wishes as secondary, tertiary desires such as overseas trips or the convertible foreign sportscar you always wanted should also be in a plan!

For each goal, it should be determined whether current CPI (or CPI-U) over the last 12 months should be employed or a rate which differs higher or lower than CPI. I would also spend a few minutes and discover your household’s rate of inflation through the Federal Reserve Bank of Atlanta’s myCPI tool. Complete the brief questionnaire and collect data for 12 months (you’ll receive regular e-mail updates from the Reserve Bank), before consideration as replacement for the broad-based CPI in your plan. I recommend waiting a year as I’ve witnessed the rate change dramatically, so it’s best to gain an understanding of the trend in your personal rate.

Specific goals such as college funding, long-term care coverage, and additional healthcare-related expenditures above what Medicare-related insurance will cover, consistently trend at twice or greater the broad-based CPI. Planning software must be adjusted accordingly.

For example, at RIA we monitor trends in healthcare and long-term care inflation through the Kaiser Family Foundation research at www.kff.org, www.medicarerights.org, and www.genworth.com, respectively. We monitor overall trends including inflation that is “sticky,” or consistently rising, through the Federal Reserve Bank Of Atlanta’s ongoing inflation project at www.frbatlanta.org.

4). Keep an open mind: Inflation can change throughout retirement.

I love westerns, especially “The Big Valley.” Rich story lines and robust acting by Barbara Stanwyck as the matriarch of the Barkleys, along with Lee Majors and Richard Long as members of a California ranching family, have captivated me for years.

Your spending in retirement is mostly a big valley. I’ll explain:

Several of the Certified Financial Planners at RIA partner with clients who have been in retirement-income distribution mode for over a decade.  In other words, these clients are re-creating paychecks through systematic portfolio withdrawals and Social Security/pension retirement benefits. Although we formally plan for an annual cost-of-living increase in withdrawals, rarely if at all does this group contact us every year to increase their distributions!

There’s a time series in retirement where active-year activities, big adventures conclude, and retirees enter the big valley of level consumption. I call it the “been there done that,” stage where a retiree has moved on; the overseas trips have been fulfilled and enrichment thrives a bit closer to home.

Retirees move from grandiose bucket list spending to a long period or valley of even-toned, creative, mindful endeavors. It’s a sweet spot, an extended time of good health; so, healthcare is not so much an inflationary or heavy spending concern. The big valley stage is just a deeper, relaxed groove of a retirement lifetime.

A thorough analysis I refer to often because it reflects the reality I witness through clients, was conducted by David Blanchett, CFA, CFP® and Head of Retirement Research for Morningstar. The research paper, “Estimating the True Cost of Retirement,” is 25 pages and should be mandatory reading for pre-retirees and those already in retirement (along with financial professionals).

David concludes:

“While research on retirement spending commonly assumes consumption increases annually by inflation (implying a real change of 0%), we do not witness this relationship within our dataset. We note that there appears to be a “retirement spending smile” whereby the expenditures actually decrease in real terms for retirees throughout retirement and then increase toward the end. Overall, however, the real change in annual spending through retirement is clearly negative.”

David eloquently defines spending as the “retirement spending smile.” As a fan of westerns, I envision the period as a valley bracketed by the spending peaks of great adventures on one side, healthcare expenditures on the other. Hey, I live in Texas. This analogy works better for me.

In comprehensive financial planning, it’s prudent to be conservative and incorporate an inflation rate to annual spending needs.

Medical costs affect retirees differently. Unfortunately, it’s tough as we age to avoid healthcare costs and the onerous inflation attached to them. Thankfully, proper Medicare planning is a measurable financial plan expense as a majority of a retiree’s healthcare costs will be covered by Medicare along with Medigap or supplemental coverage.

Unfortunately, many retirees are ill-prepared for long-term care expenditures which are erroneously believed to be covered by Medicare. Generally, long-term care is assistance with activities of daily living like eating and bathing. At RIA, we use an annual inflation factor of 4.5% for additional medical expenses (depending on current health of the client), and the cost of long-term care.

David suggests an alternative inflation proxy for older workers. The Experimental Consumer Price Index for Americans 62 Years of Age and Older or the CPI-E, reflects contrast of category weightings when compared to CPI-U or CPI-W, the CPI for urban consumers and urban wage earners, respectively.

Unfortunately, don’t expect CPI-E to gain traction as it would result in robust COLA or cost-of-living adjustments to Social Security benefits. Intuitively, it makes sense that greater relative importance is placed on medical care for seniors. However, based on the burden of social programs on the federal budget, don’t expect CPI-E to be employed anytime in the foreseeable future.

Table 2. Comparative analysis of CPI relative importance data of selected expenditure groups, December 1995.

Expenditure Group                  CPI-U   CPI-W   CPI-E

All items                                        100.00  100.00  100.00

  Food and beverages                    17.33   19.26   15.00 

    Food at home                                9.88   11.21     9.66 

    Food away from home                5.89    6.37      4.23

    Alcoholic beverages                     1.57    1.68      1.10

  Housing                                          41.35   38.89   46.89 

    Shelter                                          28.29   25.98   33.88

  Apparel and upkeep                       5.52    5.53    3.93 

  Transportation                             16.95   19.02   13.82 

  Medical care                                     7.36    6.26   12.14

    Medical care commodities           1.28    1.06    2.57

    Medical care services                    6.08    5.21    9.57

        Health Insurance                           .36     .25    1.09

  Entertainment                                   4.37    4.03    3.35 

  Other goods and services                7.12    7.01    4.87

  College tuition                                   1.61    1.19    0.59

Inflation is indeed the omnipotent boogeyman in the room and must be addressed.

Due to globalization, technological advancement, increased competition and decreased domestic energy dependence, inflation overall has progressively trended lower for decades (thankfully).

Chart courtesy of www.inflationdata.com.

A responsibility of your advisor (among many), is to study current macro/micro trends in inflation and update your plan accordingly to determine how these trends may impair or complement future financial aspirations.

Next up in the blog series:

2). The “Valuations Matter,” pre-retirement portfolio adjustment.

Sector Buy/Sell Review: 08-13-19

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

HOW TO READ THE CHARTS

There are three primary components to each chart:

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

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

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

Basic Materials

  • I previously noted XLB was back to extreme overbought and failed at resistance again. The important May support level also failed to hold as trade wars ramped up again.
  • XLB is not extremely oversold short-term and the buy signal, which is very elevated, has begun to correct. This could well keep XLB in a trading range for a while with risk down to support at $55
  • We are remaining underweight the sector for now.
  • Short-Term Positioning: Neutral
    • Last Week: Hold current positions with a tighter stop-loss.
    • This Week: Hold current positions with tighter stop-loss
    • Stop-loss adjusted to $55
  • Long-Term Positioning: Bearish

Communications

  • XLC had gotten very extended and the “buy signal” was also pushing very high levels all of which are now being reversed.
  • XLC failed at resistance and has now established a double top. The good news is support is holding so far at $48
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions, but take profits.
    • This Week: Hold trading positions.
    • Hard Stop moved up to $48
  • Long-Term Positioning: Bearish

Energy

  • XLE failed at its 200-dma and remains extremely weak.
  • XLE is now oversold and sitting on critical support, but just triggered a “sell” signal once again.
  • We are long 1/2 position in our longer-term ETF portfolio, but we will sell if the current stop-loss is violated.
  • Short-Term Positioning: Neutral
    • Last week: Hold current position
    • This week: Hold current position
    • Stop-loss adjusted to $58
  • Long-Term Positioning: Bearish

Financials

  • XLF has been in a long consolidation rage since the beginning of 2018.
  • XLF remains on a “buy” signal currently and is back to oversold. Look for a bounce back to the top of the trend line. Support must hold at $26.50.
  • Fed rate cuts are not “bank friendly” so we will likely reduce exposure to the sector in the ETF model soon.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss adjusted to $26.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI failed at a “quadruple top” which puts a tremendous amount of overhead resistance on the sector.
  • XLI is back to oversold and the buy signal is close to reversing to a sell signal.
  • We reduced our risk to the sector after reaching our investment target. We are now adjusting our stop-loss for the remaining position.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position.
    • Stop-loss adjusted to $72
  • Long-Term Positioning: Neutral

Technology

  • XLK remains one of the “safety” trades against the “trade war.”
  • While XLK is not overbought,it is still fairly extended and a crowded trade.
  • XLK failed at the uptrend line so it must hold support at $75.
  • The buy signal remains intact but is weakening.
  • Short-Term Positioning: Bullish
    • Last week: Hold 1/2 position
    • This week: Hold 1/2 position
    • Stop-loss adjusted to $70.00
  • Long-Term Positioning: Neutral

Staples

  • After taking profits in the sector, we are finally getting a much needed correction to work off the excess.
  • The “buy” signal (lower panel) is still in place and is very extended. We continue to recommend taking some profits if you have not done so.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $56
  • Long-Term Positioning: Bullish

Real Estate

  • XLRE had been consolidating its advance and the drop in rates over economic concerns has pushed the sector to new highs.
  • XLRE is back to very overbought so be careful adding new positions and keep a tight stop for now.
  • We previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected. That occurred.
  • Buy signal is being reduced along, but pay attention if it reverts to a “sell” as that has accompanied very sharp short-term drops.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position.
    • Stop-loss adjusted to $36.00 for profits.
    • Long-Term Positioning: Bullish

Utilities

  • XLU likewise is back to overbought but the previously extended buy signal is very close to triggering a sell signal.
  • Like XLRE above, those “sell signals” have tended to be short-lived but produced rather brutal sell-offs short term.
  • After taking profits, we have time to be patient and wait for the right setup.
  • 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.
  • Short-Term Positioning: Bullish
    • Last week: Take profits and rebalance holdings.
    • This week: Hold position
    • Stop-loss adjusted to support at $55.50.
  • Long-Term Positioning: Bullish

Health Care

  • XLV remains on a buy signal but failed at important resistance.
  • While the current correction was expected, the big issue is the if support will hold. That support is threatening to be violated, but continued to hold so far this week.
  • Short-Term Positioning: Neutral
    • Last week: Reduce to portfolio weight
    • This week: Hold position
    • Stop-loss adjusted to $88
  • Long-Term Positioning: Neutral

Discretionary

  • With the latest round of “tariffs” directly targeting consumer goods, XLY is now under attack.
  • Like XLK, it also failed at resistance from the uptrend line, but is holding support for now.
  • The “buy” signal is reversing and is threatening to revert to a sell signal.
  • We recommended taking profits previously.
  • Short-Term Positioning: Neutral
    • Last week: Hold 1/2 position.
    • This week: Hold 1/2 position
    • 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 triggered a “buy” signal but remains confined to a consolidation which has lasted all year. The continued topping process continues to apply downward pressure on the sector.
  • There is still no compelling reason at this juncture to add XTN to portfolios. We will watch and see what happens.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: 5 Reasons To Be Bullish (or Not) On Stocks

Just recently, Tom Lee, head of Fundstrat Global Advisors, published a list of 5-bullish signs for the stock investors which he says you should “ignore at your own peril.” As he notes:

“In short, these signals are saying the S&P 500 is set up for a monster 2H rally. We are not ignoring the negative signal of a plunge in interest rates, nor saying that a full-blown trade war is negative for the World. But, we believe the trifecta of strong US corporates, positive White House (towards biz) and dovish Fed, are major supports for the US equity market.”

His view is that the short-term disruption of the market over “trade” issues is an opportunity for investors to increase equity exposure.

Over the last few weeks, we had discussed the excessive deviation to the market above the 200-dma, which suggested that a reversal of that extension was probable. The question now is whether Tom’s view is correct?

Are the markets set up for “monster second-half rally,” or is this just the continuation of the topping process that began last year.

While these are certainly reasons to be “hopeful” that stocks will continue to rise into the future, “hope”has rarely been a fruitful investment strategy longer term. Therefore, let’s analyze each of the arguments from both perspectives to eliminate “confirmation bias.” 

Economic Growth To Improve

No matter where you look as of late, economic growth has been pretty dismal. However, there is always hope for improvement that could support a recovery in asset prices.

“Still, many analysts remain optimistic that the U.S. economy can continue expanding even if growth slows down. The Citigroup Economic Surprise Index for the U.S., which measures broadly whether data points are meeting expectations, has risen sharply in recent weeks.” – WSJ

After a recent slate of feeble economic data points, the improvement should come as no real surprise. The quarterly, or annual comparisons, can certainly show some improvement. However, it should be noted the improvement is still within the context of a very negative environment, or rather, the data is just “less negative,” rather than “positive.” 

This can be seen more clearly in our economic composite index, which is a broad measure of the U.S. economy including both the service and manufacturing sectors.

The problem for the bullish case is that 10-years into the current advance, there is little lifting power for monetary policy at this juncture. Yes, lower rates from the Fed could indeed provide a short-term bump to markets based solely on momentum. However, the ability to pull-forward accelerated rates of consumption to increase economic growth is much less likely. Most likely, the short-term increase in “less negative” data will turn lower as we move further into the year.

Volatility Signals A Bottom?

Volatility, as measured by the volatility index, spiked up recently. For the bulls, the spike in volatility has been a “siren’s song,” to “buy the f***ing dip.” This has been a winning strategy for investors over the last 10-years.

Is this time different? Take a look at the chart below. The volatility index is inverted for clarity purposes. The red vertical dashed line is when the monthly sell signal was issued, suggesting a reduction in equity risk in portfolios. The blue vertical dashed line is when the volatility index bottomed with extreme complacency and volatility begin a regime of trending higher.

The change in the trend of the volatility, trending lower to trending higher, is a hallmark of previous bull market peaks. 

While the market is short-term oversold, combined with a surge in the VIX, the market will likely bounce short-term.  However, with volatility now trending higher, that rally could be short-lived if a larger corrective cycle is beginning to take hold.

Earnings Not That Bad

“For Q2 2019 (with 77% of the companies in the S&P 500 reporting actual results), 76% of S&P 500 companies have reported a positive EPS surprise and 59% of companies have reported a positive revenue surprise.” – FactSet

On an operating basis, corporate earnings are providing the bulls boost of optimism, as hopefully, the “trade war” impact is limited. Earnings are strong, so prices should be higher.

Here’s the problem with that analysis.

As shown, for 76% of companies to beat estimates, those estimates had to be dramatically lowered. More importantly, as shown in the chart below, if we look at corporate profits for all companies, a more dire picture emerges. (The chart below strips out the profits from the Federal Reserves balance sheet.)

Despite a near 300% increase in the financial markets over the last decade, corporate profits haven’t grown since 2011. Importantly, corporate profits, have turned lower in the first quarter and that slide is continuing into the second. I have compared corporate profits, less Federal Reserve, to the Wilshire 5000 for a more comparative index.

The slide in corporate profits suggests weaker asset prices in the future as the economy, and ultimately corporate profits, continue to slow.

Sentiment Is Bearish

As Tom Lee noted in his “plea” for investors to “buy equities,” investor sentiment, very short-term is indeed negative. As shown in the chart below, the spread between bullish and bearish investors (according to AAII) is currently at -26. This is indeed a pretty bearish tilt and does suggest a short-term bottom is likely.

While that statement is true, it is a VERY short-term indicator more useful for trading rather than investing.

However, on a longer-term basis, we see that investor confidence is just about as bullish as it can get with investors outlook for stock price increases over the next 12-months near the highest levels on record.

The same is true when we look at the Commitment of Traders (COT) report which shows that speculators are just about as long as they can be in the markets.

While short-term the market could indeed rally over the next couple of weeks, investor sentiment suggests that the topping process for the markets is set to continue for a while longer.

The Fed Is Cutting Rates

Another one of Tom Lee’s points is that when the Fed cuts rates, it has previously led to a positive return over the next 6-months.

That is a true statement.

The problem is that Tom Lee isn’t going to tell you to “sell” in 6-months. There will find another reason to tell you to be bullish. This is the problem with the mainstream media, the market is “always a buy” in order to keep you buying the “products” Wall Street is selling.

For investors, the outcome of the Fed cutting rates is not a function of stronger economic growth, but a response to weaker growth, declining profitability, and lower asset prices. As I wrote last week:

“This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

The Fed has a long history of making policy mistakes which has led to negative outcomes, crisis, bear markets, and recessions.”

It is becomingly increasingly clear from a variety of inputs that deflationary pressures are mounting in the economy. Recent declines in manufacturing, and production reports, along with the collapse in commodity prices, all suggest that something is amiss in the production side of the economy.

The Fed is going to cut rates further. Unfortunately, those rate cuts are not going to lead to higher asset prices.

What Should You Do Next

With the current bull market already up more than 300% of the 2009 lows, valuations elevated, and signs of economic weakness on the rise, investors should be questioning the potential “reward” for accelerating “risk” exposure currently. \

Ultimately, stocks are not magical pieces of paper that provide double-digit returns, every single year, over long-term time frames. Just five periods in history account for almost all the returns of the markets over the last 120 years. The other periods wiped out a bulk of the previous advance.

Too often it is forgotten during that “thrill of the chase” that stocks are ownership units of businesses. While that seems banal, future equity returns are simply a function of the value you pay today for a share of future profits.

The chart below shows that rolling 20-year real total returns from current valuation levels have been substantially less optimistic. 

What is important for investors is to understand each argument and its relation to longer-term investment periods. In the short-term, Tom’s view may well be validated as current momentum and bullish “biases” persist in the markets.

However, for longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.

As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”