Monthly Archives: October 2019

RIA PRO: Trade Deal Done? Is 3300 The Next Stop For The Market?


  • Trade Deal Done
  • QE, Not QE, But It’s QE
  • Sector & Market Analysis
  • 401k Plan Manager

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Trade Deal Done

On Thursday and Friday, the market surged on hopes that a “trade deal” was coming to fruition. This was not a surprise to us, as we detailed this outcome two weeks ago:

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

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

As we discussed in that missive, a limited “trade deal” would potentially set the markets up for a run to 3300. To wit:

Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.” 

This is not the first time we presented our analysis for a “bull run” to 3300.

Every week, we review the major markets, sectors, portfolio positions specifically for our RIA PRO subscribers (You can check it out FREE for 30-days)Here was our note for the S&P 500 previously.

  • We are still maintaining our core S&P 500 position as the market has not technically violated any support levels as of yet. However, it hasn’t been able to advance to new highs either.
  • There is likely a tradeable opportunity approaching for a reflexive bounce given the depth of selling over the last couple of weeks.

This is the outcome we expected.

  • There is no “actual” deal.
  • The “excuse” will be this deal lays the groundwork for a future deal.
  • No one will discuss a trade deal ever again.

It is almost as if Bloomberg read our work:

“The U.S. and China reached a partial agreement Friday that would broker a truce in the trade war and lay the groundwork for a broader deal that Presidents Donald Trump and Xi Jinping could sign later this year.

As part of the deal, China would agree to some agricultural concessions and the U.S. would provide some tariff relief. The deal under discussion, which is subject to Trump’s approval, would suspend a planned tariff increase for Oct. 15. It also may delay — or call off — levies scheduled to take effect in mid-December.”

So, who won?

China.

  • China gets to buy agricultural and pork products they badly need.
  • The U.S. gets to suspend tariffs.

Who will like the deal?

  • The markets:  the deal removes a potential escalation in tariffs.
  • Trump supporters: Fox News will “spin” the “no deal” into a Trump “win” for the 2020 election. 
  • The Fed: It removes one of their concerns potentially impacting the economy.

By getting the “trade deal” out of the headlines, this clears the way for the market to rally potentially into the end of the year. Importantly, it isn’t just the trade deal providing support for higher asset prices short term:

  • There now seems to be a pathway forward for “Brexit”
  • The Fed is injecting $60 billion a month in liquidity into 2020 (More on this below)
  • The Fed has cut rates and is expected to cut again by year end.
  • ECB back into easing mode and running negative rates
  • Fed and ECB loosening capital requirements for banks (Because they are so healthy after all.)

This is also a MAJOR point of concern.

Despite all of this liquidity and support, the market remains currently confined to a downtrend from the September highs. The good news is there is a series of rising lows from June. With a “risk-on” signal approaching and the market not back to egregiously overbought, there is room for the market to rally from here. 

Let me repeat what we wrote back in July:

“As we face down the last half of 2019, we can once again run some projections on the bull and bear case going into 2021, as shown in the chart below:”

The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal

However, while the case for a push higher is likely, the risk/reward still isn’t great for investors over the intermediate term. A failure of the market to make new highs, given the amount of monetary support, will be a very bearish signal. 

The Fed’s “Not QE”, “QE”

Sure thing, Brian.

As I noted previously:

“Then there are the tail-risks of a credit-related event caused by a dollar funding shortage, a banking crisis (Deutsche Bank), or a geopolitical event, or a surge in defaults on “leveraged loans” which are twice the size of the “sub-prime” bonds linked to the “financial crisis.”  (Read more here)

Just remember, bull-runs are a one-way trip. 

Most likely, this is the final run-up before the next bear market sets in. However, where the “top” is eventually found is the big unknown question. We can only make calculated guesses.”

Think about this logically for a moment.

  1. The yield curve inverts which puts pressure on bank loans and funding.
  2. The Fed cuts rates, which puts pressure on banks net interest margins.
  3. The banks are chock full of leverage loans, risky energy-related debt, subprime auto loans, etc. 
  4. The Fed begins reducing excess reserves.
  5. All of a sudden, banks have a problem with overnight funding.
  6. Fed reduces liquidity regulations (put in place after Lehman to protect the financial system)
  7. Fed now has to commit to $60 billion in funding through January 2020 to increase reserves.

The last point was detailed in a recent FOMC release:

“In light of recent and expected increases in the Federal Reserve’s non-reserve liabilities, the Federal Open Market Committee (FOMC) directed the Desk, effective October 15, 2019, to purchase Treasury bills at least into the second quarter of next year to maintain over time ample reserve balances at or above the level that prevailed in early September 2019. The Committee also directed the Desk to conduct term and overnight repurchase agreement operations (repos) at least through January of next year to ensure that the supply of reserves remains ample even during periods of sharp increases in non-reserve liabilities, and to mitigate the risk of money market pressures that could adversely affect policy implementation.

In accordance with this directive, the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.”


NOTE: If you don’t understand what has been happening with overnight lending between banksREAD THIS.


The Fed is in QE mode because there is a problem with liquidity in the system. Given the Fed was caught “flat-footed” with the Lehman bankruptcy in 2008, they are trying to make sure they are in front of the next crisis.

The reality is the financial system is NOT healthy. 

If it was, then we would:

  1. Not still be using “emergency measures” to support banks for the last decade. (QE, LTRO, Etc.)
  2. Not be pushing $17 trillion in negative interest rates on a global basis.
  3. Have reinstated FASB Rule 157 in 2012-2013 requiring banks to mark-to-market the assets on their books. (A defaulted asset can be marked at 100% of value which makes the bank look healthy.)
  4. Not be needing to reduce liquidity requirements.
  5. Not be needing $60 billion a month in QE.

Oh, but that’s right, Jerome Powell denies this is “QE.”

“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis. Neither the recent technical issues nor the purchases of Treasury bills we are contemplating to resolve them should materially affect the stance of monetary policy. In no sense, is this QE,” – Jerome Powell

It’s QE. 

Just so you can understand the magnitude of the balance sheet increase over the last couple of weeks, the largest single week increase from 2009 to September 20th, 2019 was $39.97 billion.

The last two weeks were $58.2 and $83.87 billion respectively. 

But, it’s not Q.E.

So, what was it then?

This was not about covering unexpected cash draws to pay quarterly taxes, which was one of the initial excuses for the funding shortfalls. 

Nope.

This was bailing out a bank that is in serious financial trouble. It started with the ECB a month ago loosening requirements on banks, then proceeded to the Fed reducing capital reserve requirements and flooding the system with reserves. 

Who was the biggest beneficiary of all of these actions? Deutsche Bank.

Which is about 4x as large as Lehman was in 2008 and is currently following the same price path as well. Let me repeat, the Fed is terrified of another “Lehman Crisis” as they do not have the tools to deal with it this time.

(Courtesy of ZeroHedge)

The problem for the Fed, is that while they insist recent rate cuts are “mid-cycle” adjustments, as was seen in 1995 to counter the risk of the Orange County bankruptcy, the reality is the “mid-cycle” has long been past us.

With the Fed cutting rates, injecting weekly records of liquidity into the system, at a time where economic data has clearly taken a turn for the worse, the situation may “not be in as good of a place” as we have been told. 

Being a little more cautious, taking in some profits, and rebalancing risks continues to be our recipe for navigating the markets currently. 

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), Industrials (XLI)

The relative performance improvement of HealthCare relative to the S&P 500 regained some footing this past week as money still sought safety. Industrials, have also been performing much better on hopes for a trade deal, and picked up steam on Friday with the announcement. We remain underweight until a breakout occurs. 

Current Positions: Target weight XLV, 1/2 weight XLI

Outperforming – Staples (XLP), Utilities (XLU), Real Estate (XLRE)

As noted, our more defensive positioning continues to outperform relative to the broader market. After taking some profits, we trimmed profits out of XLP previously and re-positioned the portfolio. We are remaining patient to see how the market responds to the trade announcement next week.

Real Estate, Staples, and Utilities all continue to flirt with highs but remain GROSSLY extended. Trend overall remains positive so we are holding the position for now.

Current Positions: Target weight XLP, XLU, XLRE

Weakening – Technology (XLK), Discretionary (XLY), Communications (XLC)

As noted last week, Technology, and Discretionary turned higher and are looking to test highs and performed well on Friday as the removal of tariffs directly benefit this sector. Relative performance has improved, and we will likely see these sectors breakout to new highs if the market continues to rally.

Current Position: Target weight XLY, XLK, XLC

Lagging – Energy (XLE), Basic Materials (XLB), and Financials (XLF)

We were stopped out of XLE previously. XLE failed to clear above important downtrend resistance and turned lower as oil prices have dropped. Basic materials picked up performance with the trade deal announcement but has some work to do before providing the right opportunity to increase our weightings. We previously got stopped out of XLF, but will likely look to re-enter the position shortly with the Fed now engaged in increasing bank reserves. 

Current Position: 1/2 weight XLB

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – Small- and Mid-caps popped sharply on the announcement of the trade deal but have not dramatically improved their overall technical damage. We have seen these pops before which have quickly failed so we will need to give these markets some room to consolidate and prove up performance. 

Current Position: No position

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

The same advice goes for Emerging and International Markets which we have been out of for several weeks due to lack of performance. These markets rallied recently on news of a “trade resolution,” and the Fed jumping back into QE. However, the overall technical trend is not great so we need to see if this is sustainable or just another “head fake.” 

Current Position: No Position

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

Current Position: RSP, VYM, IVV

Gold (GLD) – The previous correction in Gold continued this week. We may look to take profits here soon, as we digest what the “trade deal” and “more QE” means for “risk adversity.” Gold is testing critical support and is working off its overbought condition. We will be patient but with a tighter stop.

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

Bonds (TLT) – 

Bonds also took a hit on “trade deal” news as the “risk off” rotation turned back to “risk on.” We are holding our positions for now, but are tightening up our stops and are looking at potential trades to participate with a move higher in yields if they occur. 

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

Current Positions: DBLTX, SHY, IEF

Sector / Market Recommendations

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

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

Portfolio/Client Update:

Over the last 16-months we have been wrestling with the on again, off again, on again “trade deal.” As discussed in detail above, Trump finally caved into China and game them a “deal” to get it out of the way before the election. 

At the same time, the Federal Reserve has started to once again aggressively increase their balance sheet, while cutting rates to stimulate economic growth. 

Despite the fact none of this really changes much on the economic front, we suspect it will get the bulls excited in the short-term and put pressure on stocks to move higher. 

For newer clients, we have begun the onboarding process bringing portfolios up to 1/2 weights in our positions. This is always the riskiest part of the portfolio management process as we are stepping into positions in a very volatile market. However, by maintaining smaller exposures, we can use pullbacks to add to holdings as needed. We also are carrying stop-losses to protect against a more severe decline. 

As we move into next week, depending on how markets are acting, we may look to increase our equity exposure modestly to “rent whatever rally” we may get from the “trade deal.” 

  • New clients: Please contact your adviser with any questions. 
  • Equity Model: No change this week. 
  • ETF Model: No change this 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

Trade Deal Done?

As we stated last week:

“The market rallied on at the end of last week on “bad news” which gave the market “hope” the Fed would more aggressively cut rates. This is a short-term boost with a long-term negative outcome. Low rates are not conducive to economic growth, and the Fed cutting rates aggressively cuts financial incentive in the economy and leads to recessions in the economy.

We advise caution, but suggest remaining weighted toward equity exposure for now. Despite the rally this week, there is some risk heading into the ‘trade deal’ next week. As noted, we expect a deal to be completed which will provide a lift to equities but we recommend weighting for the news before adding to risk.”

Once we get a handle on how the markets are going to react to all of the news, please read the main body of the missive above, we will look to increase overall equity exposure accordingly. In the meantime, you can prepare for the next moves by taking some actions if you haven’t already.

  • 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

Become a RIA PRO subscriber and be part of our “Break It Early Testing Associate” group by using CODE: 401 (You get your first 30-days free)

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

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

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

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 10-07-19

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

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

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!

Non-QE QE and How to Trade It

“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.” He then stated: “In no sense is this QE.” –Federal Reserve Chairman Jerome Powell 10/8/2019

Jerome Powell can call balance sheet growth whatever he wants, but operationally and in its effect on the bond markets, it is QE. For more on the Fed’s latest iteration of QE, what we dub the non-QE QE, please read our article QE By Any Other Name.

Non-QE = QE4

It is increasingly likely the Fed will announce an asset purchase operation at the FOMC meeting on October 30, 2019. Given Powell’s comments, the asset purchases will differ somewhat from QE 1, 2, and 3 in that the Fed will add needed reserves to the banking system to help alleviate recent bouts of stress in overnight funding markets. Prior versions of QE added excess reserves to the system as a byproduct. The true benefit of prior rounds of QE was the reduction of Treasury and mortgage-backed securities in the marketplace, which pushed investors into riskier stocks and bonds.  

Since the Feds motivation seems to be stress in the short term funding markets, we believe the Fed will purchase short-term notes and Treasury bills instead of longer-term bonds. QE1 also involved the purchase the short term securities, but these securities were later sold and the proceeds used to purchase longer term bonds, in what was called Operation Twist.

Trading Non QE QE4

In Profiting From a Steepening Yield Curve and in a subsequent update to the article, we presented two high dividend stocks (AGNC and NLY) that should benefit from a steeper yield curve. When we wrote the articles, we did not anticipate another round of QE, at least not this soon. Our premise behind these investments was weakening economic growth, the likelihood the Fed would cut rates aggressively, and thus a steepening yield curve as a result.

The Fed has since cut rates twice, and Wall Street expects them to cut another 25bps at the October 30th meeting and more in future meetings. This new round of proposed QE further bolsters our confidence in this trade.

If the Fed purchases shorter-term securities, the removal of at least $200 to $300 billion, as is being touted in the media, should push the front end of the curve lower in yield. Short end-based QE in conjunction with the Fed cutting rates will most certainly reduce front-end yields. The rate cuts combined with QE will likely prevent long term yields from falling as much as they would have otherwise. On balance, we expect the combination of QE and further rate cuts to result in a steeper yield curve.

The following graph shows how the 10yr/2yr Treasury yield curve steepened sharply after all three rounds of QE were initiated. In prior QE episodes, the yield curve steepened by 112 basis points on average to its peak steepness in each episode.  

Data Courtesy: Federal Reserve

New Trade Idea

In addition to our current holdings (AGNC/NLY), we have a new recommendation involving a long/short bond ETF strategy. The correlation of performance and shape of the yield curve of this trade will likely be similar to the AGNC/NLY trade, but it should exhibit less volatility.

Equity long/short trades typically involve equal dollar purchases and sales of the respective securities, although sometimes they are also weighted by beta or volatility. Yield curve trades are similar in that they should be dollar-weighted, but they must also be weighted for the bond’s respective durations to account for volatility. This is because the price change of a two-year note is different than that of a 5 or 10-year note for the same change in yield, a concept called duration. Failing to properly duration weight a yield curve trade will not provide the expected gains and losses for given changes in the shape of the yield curve. 

Before presenting the trade, it is important to note that the purest way to trade the yield curve is with Treasury bonds or Treasury bond futures. Once derivative instruments, like the ETFs we discuss, are introduced, other factors such as fees, dividends, and ETF rebalancing will affect performance.  

The duration for SHY and IEF is 2.17 and 7.63, respectively. The ratio of the price of SHY to IEF is .74. The trade ratio of SHY shares to IEF shares is accordingly 4.75 as follows: [(1/.74)*(7.63/2.17)]. As such one who wishes to follow our guidance should buy 5 shares for every 1 share of IEF that they short.

Because we cannot buy fractions of shares, we rounded up the ratio to 5:1. This slight overweighting of SHY reflects our confidence that the short end of the yield curve will fall as the Fed operates as we expect.

Summary

In Investors Are Grossly Underestimating the Fed, we highlighted that every time the Fed has raised and lowered rates, the market has underestimated their actions. To wit:

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

Despite the Fed’s guidance earlier this year of one or two cuts and their characterization of it as a “mid-cycle adjustment”, the Fed has already lowered rates twice and appears ready to cut rates a third time later this month. If, in fact, the market is once again underestimating the Fed, the Fed Funds rate and short term Treasury yields will ultimately fall to 1% or lower.

In an environment of QE and the Fed actively lowering rates, we suspect the yield curve will steepen. That is in no small part their objective, as a steeper yield curve also provides much needed aid to their constituents, the banks. If we are correct that the curve steepens, the long-short trade discussed above along with AGNC and NLY should perform admirably.  AGNC and NLY are much more volatile than IEF and SHY; as such, this new recommendation is for more risk-averse traders.  

Mauldin: Social Security Is Screwing Millennials

Social Security is a textbook illustration of how government programs go off the rails.

It had a noble goal: to help elderly and disabled Americans, who can’t work, maintain a minimal, dignified living standard.

Back then, most people either died before reaching that point or didn’t live long after it. Social Security was never intended to do what we now expect, i.e., be the primary income source for most Americans during a decade or more of retirement.

Life expectancy when Social Security began was around 56. The designers made 65 the full retirement age because it was well past normal life expectancy.

No one foresaw the various medical and technological advances that let more people reach that age and a great deal more, or the giant baby boom that would occur after World War II, or the sharp drop in birth rates in the 1960s, thanks to artificial birth control.

Those factors produced a system that simply doesn’t work.

A few modest changes back then might have avoided today’s challenge. But now, we are left with a crazy system that rewards earlier generations at the expense of later ones.

Screwing Millennials

I am a perfect example.

I’ve long said I never intend to retire, if retirement means not working at all. I enjoy my work and (knock on wood) I’m physically able to do it.

Social Security let me delay collecting benefits until now, for which I will get a higher benefit—$3,588 monthly, in my case.

Now, that $3,588 I will be getting each month isn’t random. It comes from rules that consider my lifetime income and the amount of Social Security taxes I and my employers paid.

That amount comes to $402,000 of actual dollars, not inflation-adjusted dollars. (I also paid $572,000 in Medicare taxes. Again, actual dollars, not inflation-adjusted dollars.)

What did those taxes really buy me? In other words, what if I had been allowed to invest that same money in an annuity that yielded the same benefit? Did I make a good “investment” or not?

That is actually a very complicated question, one that necessarily involves a lot of assumptions and will vary a lot among individuals.

In my case, if I live to age 90 and benefits stay unchanged, the internal real rate of return on my Social Security “investment” will be 3.84%. If I only make it to 80, that real IRR drops to 0.75%.

While this may not sound like much, it actually is. Even 1% real return (i.e., above inflation) with no credit risk is pretty good and 3.84% is fantastic. If I live past 90 it will be even better.

But this is not due to my investment genius. Four things explain my high returns.

  • Double indexing of benefits in the early 1970s (thank you, Richard Nixon).
  • I delayed claiming benefits until age 70, which I could afford to do but isn’t an option for many people.
  • I will probably live longer than average, due to both genetic factors and maintaining good health (thank you, Shane!).

But maybe most of all because

  • The system is massively screwing the next generation. From a Social Security benefit standpoint, being an early Boomer is a pretty good deal.

Social Security structurally favors its earliest users. The big winners are not the Baby Boomers like me, but our parents.

They paid less and received more. But we Boomers are still getting a whale of a deal compared to our grandchildren.

Now, consider a male who is presently age 25, and who earns $50,000 every year from now until age 67, his full retirement age.

Such a person is not going to get anything like the benefits I do, especially with benefit cuts, which my friend Larry estimates will be as high as 24.5%.

So, if this person lives an average lifespan and gets only those reduced benefits, his real internal rate of return will be -0.23%.

I suspect very few in the Millennial generation know this and they’re going to be mad when they find out. I don’t blame them, either.

The Next Quadrillion

The reason Millennials won’t see anything like the benefits today’s retirees get is simple math. The money simply isn’t there.

The so-called trust fund (which is really an accounting fiction, but go with me here) exists because the payroll taxes coming into the system long exceeded the benefits going to retirees.

That is no longer the case.

Social Security is now “draining” the trust fund to pay benefits. This can only continue for so long. Projections show the surplus will disappear in 2034. A few tweaks might buy another year or two. Then what?

Well, the answer is pretty simple. If Congress stays paralyzed and does nothing, then under current law Social Security can only pay out the cash it receives via payroll taxes. That will be only 77% of present benefits—a 23% pay cut for millions of retirees.

And please understand, there is no trust fund. Congress already spent that money and must borrow more to make up the difference.

This IS going to happen. Math guarantees it.

Missing Opportunities

These problems would be less serious if more people saved for their own retirements and viewed Social Security as the supplement.

There are good reasons many haven’t done so. Worker incomes have stagnated while living costs keep rising.

But more important, telling people to invest their own money presumes they have investment opportunities and the ability to seize them. That may not be the case.

The prior generations to whom Social Security was so generous also had the advantage of 5% or better bond yields or bank certificates of deposits at very low risk.

That is unattainable now. And let’s not even talk about mass numbers of uninformed people buying stocks at today’s historically high valuations. That won’t end well.

So, if your solution is to put people in private accounts and have them invest their own retirement money, I’m sorry but it just won’t work.

It will have the same result as those benefit cuts we find so dreadful: millions of frustrated and angry retirees.

So, what is the answer if you are in retirement or approaching it? The easiest answer is to raise the retirement age. Yes, that’s really just a disguised way to cut benefits, but making it 70 or 75 would get the program a lot closer to its original intent.

Today’s 65-year-olds are in much better shape than people that age were in 1936 or even 1970.

(Note, I would still leave the option for people who are truly disabled to retire younger. I get that not everybody is a writer and/or an investment adviser who makes their living in front of the computer or on the phone. Some people wear out their bodies and really deserve to retire earlier.)


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.

Will Monetary or Fiscal Stimulus Turnaround the Next Recession?

A recession is emerging with interest rate curves inverted, the end of the business cycle at hand, world trade falling, and consumers and businesses beginning to pull back on spending.  The question is: will monetary or fiscal stimulus turn around a recession? 

In this post, we find both stimulus alternatives likely to be too weak to have the necessary economic impact to lift the economy out of a recession. Finally, we will identify the key characteristics of a coming recession and the implications for investors.

Our economy is at the nexus of several major economic trends formed over decades that are limiting monetary and fiscal options. The monetary policy of central banks has caused world economies to be abundant in liquidity, yet producing limited growth. Central bankers in Japan and Europe have been trying to revive growth with $17 trillion injections using negative interest rates.  Japan can barely keep its economy growing with an estimate of GDP at .5 % through 2019. The Japanese central bank holds 200 % of GDP in government debt.  The European Central Bank holds 85 % of GDP in debt and uses negative interest rates as well. Germany is in a manufacturing recession with the most recent PMI in manufacturing activity at 47.3 and other European economies contracting toward near-zero GDP growth.  

Lance Roberts notes that the world economy is not running on a solid economic foundation if there is $17 trillion in negative-yielding debt in his blog, Powell Fails, Trump Rails, The Failure of Negative Rates. He questions the ability of negative interest policies to stabilize world economies,

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

Negative interest rates and extreme monetary stimulus policies have distorted financial relationships between debt and risk assets. This financial distortion has created a significantly wider gap between the 90 % and the top 1 % in wealth.

Roberts outlines in the six panel chart below how personal income, employment, industrial production, real consumer spending, real wages, and real GDP are all weakening in the U.S.:

Source: RIA – 8/23/19

Trillions of dollars of monetary stimulus have not created prosperity for all. The chart below shows how liquidity fueled a dramatic increase in asset prices while the amount of world GDP per money supply declined by about 25 %:

Sources: The Wall Street Journal, The Daily Shot – 9/23/19

Low interest rates have not driven real growth in wages, productivity, innovation, and services development that create real wealth for the working class. Instead, wealth and income are concentrated in the top 1 %. The concentration of wealth in the top one percent is at the highest level since 1929. The World Inequality Report notes inequality has squeezed the middle class between emerging countries and the U.S. and Europe. The top 1 % has received twice the financial growth benefits as the bottom 50 % since 1980:

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

There are several reasons monetary stimulus by itself has not lifted the incomes of the middle class. One of the big causes is that stimulus money has not translated into wage increases for most workers.  U.S. real earnings for men have essentially been flat since 1975, while earnings for women have increased though basically flat since 2000:

Source: U.S. Census Bureau – 9/10/19

If monetary policy is not working, then fiscal investment from private and public sectors is necessary to drive an economic reversal.  But, will the private and public sector sectors have the necessary tools to bring new life to an economy in decline?

Wealth Creation Has Gone to the Private Sector

The last 40 years have seen the rise of private capital worldwide while public capital has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

Essentially, world banks and governments have built monetary and fiscal economic systems that increased private wealth at the expense of public wealthThe lack of public capital makes the creation of public goods and services nearly impossible. The development of public goods and services like basic research and development, education and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  

Why is building high levels of private capital a problem?  Because, as we have discussed, private wealth is now concentrated in the top 1 %, while 70 % of U.S GDP is dependent on consumer spending.  The 90 % have been working for stagnant wages for decades, right along with diminishing GDP growth.  There is a direct correlation between wealth creation for all the people and GDP growth.

Corporations Are Not In A Position to Invest

Some corporations certainly have invested in their businesses, people, and technology.  The issue is the majority of corporations are now financially strapped.  Many corporate executives have made profit allocation decisions to pay themselves and their stockholders well at the expense of workers, their communities and the economy. 

S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Source: Real Investment Advice

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

In 2018 stock buybacks at $1.01 trillion were at the highest level they have ever been since buybacks were allowed under the 1982 SEC safe harbor provision decision. It is interesting to consider where our economy would be today if corporations spent the money they were wasting on boosting stock prices and instead invested in long term value creation.  One trillion dollars invested in raising wages, research, and development, cutting prices, employee education, and reducing health care premiums would have made a significant impact lifting the financial position of millions. This year stock buybacks have fallen back slightly as debt loads increase and sales fall:

Source: Dow Jones – 7/2019

Many corporations with tight cash flows have borrowed to purchase shares, pay dividends and keep their stock price elevated causing corporate debt to hit new highs as a percentage of GDP (note recessions followed three peaks):

Source: Federal Reserve Bank of Dallas – 3/6/2019

Corporate debt has ballooned to 46 % of GDP totaling $5.7 trillion in 2018 versus $2.2 trillion in 2008.  While the bulk of these nonfinancial corporate bonds have been investment grade, many bond covenants have become weaker as corporations seek more funding. Some bondholders may find their investment not as secure as they thought resulting in significantly less than 100 % return of principal at maturity.

In a recession, corporate sales fall, cash flow goes negative, high debt payments become hard to make, employees are laid off and management tries to hold on.  Only a select set of major corporations have cash hoards to ride out a recession, and others may be able obtain loans at steep interest rates, if at all.  Other companies may try going to the stock market which will be problematic with low valuations.  Plus, investors will be reluctant to buy stock in negative cash flow companies.

Thus, most corporations will be hard pressed to invest the billions of dollars necessary to turnaround a recession. Instead, they will be just trying to keep the doors open, the lights on, and maintain staffing levels to hold on until the day sales stop falling and finally turn up.

Public Sector is Also Tapped Out

In past recessions, federal policy makers have turned to fiscal policy – public spending on infrastructure projects, research development, training, corporate partnerships, and public services to revive the economy.  When the 2008 financial crisis was at its peak the Bush administration, followed by the Obama government pumped fiscal stimulus of $983 billion in spending over four years on roads, bridges, airports, and other projects. The Fed funds interest rate before the recession was at 5.25 % at the peak allowing lower rates to have plenty of impact. Today, with rates at 1.75-2.00 %, the impact will be negligible. In 2008, it was the combined massive injection of monetary and fiscal stimulus that created a V-shaped recession with the economy back on a path to recovery in 18 months. It was not monetary policy alone that moved the economy forward.  However, the recession caused lasting financial damage to wealth of millions. Many retirement portfolios lost 40 – 60 % of their value, millions of homeowners lost their homes, thousands of workers were laid off late in their careers and unable to find comparable jobs.  The Great Recession changed many people’s lives permanently, yet it was relatively short-lived compared to the Great Depression.

As noted in the chart above, public sector wealth has actually moved to negative levels in the U.S. at – 17 % of national income.  Our federal government is running a $1 trillion deficit per year.  In 2007, the federal government debt level was at 39 % of GDP. The Congressional Budget Office projects that by 2028 the Federal deficit will be at 100 % of GDP

Source: CBO – 4/9/19

We are at a different time economically than 2008. Today with Federal debt is over 100% of GDP and expected to grow rapidly. The Feds balance sheet is still excessive and they formally stopped reducing the size (QT).  In a recession federal policymakers will likely make spending cuts to keep the deficit from going exponential. Policy makers will be limited by the twin deficits of $22.0 trillion national debt and ongoing deficits of $1+ trillion a year, eroding investor confidence in U.S. bonds. The problem is the political consensus for fiscal stimulus in 2008 – 2009 does not exist today, and it will probably be even worse after the 2020 election. Our cultural, social and political fabric is so frayed as a result of decades of divisive politics it is likely to take years to sort out during a recession. Our political leaders will be fixing the politics of our country while searching for intelligent stimulus solutions to be developed, agreed upon and implemented.

What Will the Next Recession Look Like?

We don’t know when the next recession will come. Yet, present trends do tell us what the structure of a recession might look like, as a deep U- shaped, slow recovery measured in years not months:

  • Corporations Short of Cash – Corporations already strapped are short on cash, will lay off workers, pull back spending, and are stuck paying off huge debts instead of investing.
  • Federal Government Spending Cuts – The federal government caught with falling revenues from corporations and individuals, is forced to make deep cuts first in discretionary spending and then social services and transfer funding programs. The reduction of transfer programs will drive slower consumer spending.
  • Consumers Pull Back Spending – Consumers will be forced to tighten budgets, pay off expensive car loans and student debt, and for those laid off seeking work anywhere they can find a job.
  • World Trade Declines – World trade will not be a source of rebuilding sales growth as a result of the China – US trade war, and tariffs with Europe and Japan.  We expect no trade deal or a small deal with the majority of tariffs to stay in place. In other words, just reversing some tariffs will not be enough to restart sales. New buyer – seller relationships are already set, closing sales channels to US companies. New country alliances are already in place, leaving the US closed out of emerging high growth markets.  A successor Trans Pacific Partnership (TPP) agreement with Japan and eleven other countries was signed in March, 2018 without the US. China is negotiating a new agreement with the EU. EU and China trade totals 365 billion euros per year. China is working with a federation of African countries to gain favorable trade access to their markets.
  • ­Pension Payments in Jeopardy – Workers dependent on corporate and public pensions may see their benefits cut from pensions, which are poorly funded today with markets at all-time highs. GE just announced freezing pensions for 20,000 employees, the harbinger of a possible trend that will  reduce consumer spending
  • Investment Environment Uncertain – Uncertainty in investments will be extremely high, ‘get rich quick’ schemes will flourish as they did in 2008 – 2009 and 2000.
  • Fed Implements Low Rates & QE – The Fed is likely to implement very low interest rates (though not negative rates), and QE with liquidity in abundance but the economy will have low inflation, and declining GDP feeling like the Japanese economic stasis – ‘locked in irons’.

Implications for Investors

The following recommendations are intended for consideration just prior or during a recession with a sharp decline in the markets, not necessarily for today’s markets.

Cash – It is crucial to maintain a significant cash hoard so you can purchase corporate stocks when they cheapen. The SPX could decline by 40 – 50 % or more when the economy is in recession.  Yet, good values in some stocks will be available.  At the 1500 level, there is an excellent opportunity to make good long term growth and value investments based on sound research.

CDs – as Will Rogers noted during the Depression, “I’m more interested in Return of my Capital than Return on my Capital”, a prudent investor should be too.  CDs are FDIC insured while offering lower interest rates than other investments. Importantly, they provide return of capital and allow you to sleep at night.

Bonds – U.S. Treasuries certainly provide safety, return of principal, and during a recession will provide better overall returns than high-risk equity investments. Corporate bonds may come under greater scrutiny by investors even for so-called ‘blue chips’ like General Electric. The firm is falling on hard times with $156 billion in debt. GE is seeking business direction and selling off assets. The major conglomerate’s bonds have declined in value by 2.5 % last year with their rating dropped to BBB. Now with new management the price of GE bonds is climbing up slightly.

Utilities – are regulated to have a profit.  While they may see declining revenues due to less energy use by corporations and individuals, they still will pay dividends to shareholders as they did in 2008.  Consumer staple companies are likely to be cash flow strained; most did not pay dividends to investors during the 2008 – 2009 recession. REITs need to be evaluated on a company by company basis to determine how secure their cash streams are from leases. During the 2008 – 2009 downturn, some REITs stopped paying dividends due to declining revenues from lease defaults.

Growth & Value Equities– invest in new sectors that have government support or emerging demand based on social trends like climate change: renewables, water, carbon emission recovery, environmental cleanup. From our Navigating A Two Block Trade World – US and China post, we noted possible investments in bridge companies between the two trade blocks; services, and countries that act as bridges like Australia. Look for firms with good cash positions to ride out the recession, companies in new markets with sales generated by innovations, or problem solving products that require spending by customers.  For example, seniors will have to spend money on health services. Companies serving an increasingly aging population with innovative low cost health solutions are likely to see good demand and sales growth.

The intelligent investor will do well to ‘hope for the best, but plan for the worst’ in terms of portfolio management in a coming recession.  Asking hard questions of financial product executives and doing your own research will likely be keys to survival.

In the end, Americans have always pulled together, solved problems, and moved ahead toward an even better future. After a reversion to the mean in the capital markets and an economic recession things will improve.  A reversion in social and culture values is likely to happen in parallel to the financial reversion. The complacency, greed, and selfishness that drove the present economic extremes will give way to a new appreciation of values like self-sacrifice, service, fairness, fair wages and benefits for workers, and creation of a renewed economy that creates financial opportunities for all, not just the few.

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

Three Of Our Favorite Dividend Kings For Rising Income

This is a guest contribution by Bob Ciura with Sure Dividend.  Sure Dividend helps individual investors build and maintain their high quality dividend growth portfolios rising passive income over the long run.

Dividend growth stocks can offer strong shareholder returns over the long term. One place to look for high-quality dividend growth stocks is the list of Dividend Kings, which have increased their dividends for at least 50 consecutive years.

In order for a company to raise its dividend for over five decades, it must have durable competitive advantages and consistent growth. It must also have a shareholder-friendly management team dedicated to raising its dividend.

The Dividend Kings have raised their dividends each year, no matter the condition of the broader economy. They have outlasted recessions, wars, and a variety of other challenges, while continuing to increase their dividends every year.

With this in mind, these three Dividend Kings are attractive for rising dividend income over the long term.

Dividend King #1: Genuine Parts Company (GPC)

Genuine Parts Company is a diversified distributor of auto and industrial parts, as well as office products. Its biggest business is its auto parts group, which includes the NAPA brand. Genuine Parts has the world’s largest global auto parts network, with over 6,700 NAPA stores in North America and over 2,000 stores in Europe. Genuine Parts generated over $18 billion of revenue in 2018.

Genuine Parts is benefiting from changing consumer trends, which is that consumers are holding onto their cars longer. Rather than buy new cars frequently, consumers are increasingly choosing to make minor repairs. At the same time, repair costs increase as a car ages, which directly benefits Genuine Parts. For example, Genuine Parts stats that average annual spend for a vehicle aged six to 12 years is $855, compared with $555 for a vehicle aged one to five years.

Vehicles aged six years or older now represent over 70% of cars on the road, and Genuine Parts has fully capitalized on the market opportunity. The company has reported record sales and earnings per share in seven of the past 10 years. As the total U.S. vehicle fleet is growing, and the average age of the fleet is increasing, Genuine Parts has a positive growth outlook.

Acquisitions will also help pave the way for Genuine Parts’ future growth, particularly in the international markets. In 2017, it acquired Alliance Automotive Group, a European distributor of vehicle parts, tools, and workshop equipment. The $2 billion acquisition gave Genuine Parts an instant foothold in Europe, as Alliance Automotive holds a top 3 market share position in Europe’s largest automotive aftermarkets.

The company has reported steady growth for decades. In fact, profits have increased in 75 years out of its 91-year history. This has allowed the company to raise its dividend every year since it went public in 1948, and for the past 63 consecutive years. The stock has a current dividend yield of 3.3%.

Dividend King #2: Altria Group (MO)

Altria is a tobacco giant with a wide variety of products including cigarettes, chewing tobacco, cigars, e-cigarettes and wine. The company also has a 10% equity stake in Anheuser Busch Inbev (BUD).

Altria is challenged by the continued decline in U.S. smoking rates. However, last quarter Altria still managed 5% revenue growth from the same quarter last year. Its core smokeable product segment reported 7.4% sales growth, as price increases more than offset volume declines. Adjusted earnings-per-share increased 9% for the quarter, and Altria expects 4%-7% growth in adjusted EPS for 2019.

This growth allowed Altria to raise its dividend by 5% in late August, marking its 50th consecutive year of dividend increases.

Altria has tremendous competitive advantages. It has the most valuable cigarette brand in the U.S., Marlboro, which commands greater than a 40% domestic retail share. This gives Altria the ability to raise prices to drive revenue growth, as it has done for many years.

Going forward, Altria is preparing for a continued decline in the U.S. smoking rate, primarily by investing in new product categories. In addition to its sizable investment stake in ABInbev, Altria invested nearly $13 billion in e-cigarette manufacturer Juul, as well as a nearly $2 billion investment in Canadian marijuana producer Cronos Group (CRON).

Altria also recently invested $372 million to acquire an 80% ownership stake in Swiss tobacco company, Burger Söhne Group, to commercialize its on! oral nicotine pouches. Lastly, Altria is preparing its own e-cigarette product IQOS, which is being readied for an imminent nationwide launch.

Like Coca-Cola, Altria is taking the necessary steps to respond to changing consumer preferences. This is how companies adapt, which is necessary to maintain such a long streak of annual dividend growth.

Dividend King #3: Dover Corporation (DOV)

Dover Corporation is a diversified global industrial manufacturer with annual revenues of ~$7 billion and a market capitalization of $14 billion. Dover has benefited from the steady growth of the global economy in the years following the Great Recession of 2008-2009. In the most recent quarter, Dover grew earnings-per-share by 20% excluding the spinoff of Dover’s energy business Apergy. Revenue from continuing operations increased 1%.

It may be a surprise to see an industrial manufacturer on the list of Dividend Kings. Indeed, companies in the industrial sector are highly sensitive to the global economy. Industrial manufacturers tend to struggle more than many other sectors when the economy enters recession. But Dover has maintained an impressive streak of 64 years of annual dividend increases, one of the longest streaks of any U.S. company. One reason it has done this despite the inherent cyclicality of its business model is because of the company’s diversified portfolio.

Dover spun off its energy unit, which is especially vulnerable to recessions. Of its remaining segments, many service industries that see resilient demand, even during recessions, such as refrigeration and food equipment.

Dover expects to generate adjusted earnings-per-share in a range of $5.75 to $5.85. At the midpoint, Dover would earn $5.80 per share for 2019. With a current annual dividend payout of $1.96 per share, Dover is projected to have a 34% dividend payout ratio for 2019. This is a modest payout ratio which leaves more than enough room for continued dividend increases next year and beyond.

Dover has a current dividend yield of 2.1%, which is near the average yield of the broader S&P 500 Index. While the stock does not have an extremely high yield, it makes up for this with consistent dividend increases each year.

Final Thoughts

It is not easy to become a Dividend King, which is why there are only 27 of them. Of the ~5000 stocks that comprise the Wilshire 5000, the most widely-used index of the total stock market, only 27 have increased their dividends for at least 50 consecutive years.

Because of this, the Dividend Kings are a suitable group of stocks for income investors looking for high-quality dividend growth stocks. In particular, the three stocks on this list have competitive advantages, future growth potential, and high dividend yields that make them highly attractive for income investors.

Long-Short Idea List: 10-10-19

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

LONG CANDIDATES

AMZN – Amazon.com

  • Last week, we noted that “if the market is going to move higher into year-end, then AMZN should lead the way particularly as we head into holiday shopping season.”
  • The trade setup didn’t change much this past week, and with AMZN’s sell signal pretty deeply oversold there is a decent entry point.
  • Buy at current levels.
  • Stop is adjusted to $1700 hard stop.

ABBV – AbbiVie Inc.

  • ABBV recently bounced off of critical support and has triggered a buy signal.
  • We are looking to add a position to both the Equity and Long-Short portfolios as we like the almost 6% yield in this environment.
  • With the buy signal in place, we are looking for a pullback to $70 that holds to add 1/2 of our position. We will add the second 1/2 position on a break above resistance.
  • Stop after initial entry is $64

CAT – Caterpillar, Inc.

  • I am not crazy about this trade but CAT has been consistently holding support and is deeply oversold at this juncture.
  • Buy at current levels with a very tight stop at $115
  • Take profits at $130.

CRM – Salesforce.com

  • CRM has gotten pretty oversold and the sell-signal is very deep. Importantly, CRM has held a rising trendline support which is bullish.
  • CRM has a tendency to beat earnings and do well, so there is a decent trade setup here.
  • Buy CRM at current levels.
  • Stop loss is set at $142.50

DE – Deere & Co.

  • Both DE and CAT should do well if there is some sort of trade deal.
  • However, DE has been in a long-term consolidation and is close to breaking out to the upside.
  • Buy a position in DE only IF it breaks above current resistance at $170.
  • Stop loss is set at $150.

SHORT CANDIDATES

AVY – Avery Dennison Corp.

  • Last week, we suggested AVY for a long-trade on a breakout above $117.50. That didn’t happen and the “sell signal” has now been triggered.
  • We had originally suggested a short of AVY on a break below the previous stop of $112.50
  • That level has been triggered.
  • Target for trade is initially $100
  • Stop-loss is $115

AMD – Advanced Micro Devices

  • We recently suggested a short-position on AMD if it broke below its consolidation pattern and triggered a sell signal. Both have occurred.
  • Sell short at current levels.
  • Target for trade is $22
  • Stop-loss is $30

FB – Facebook, Inc.

  • Last week, we discussed shorting FB which had been consolidating in a tightening pattern over the last couple of months.
  • With a “sell signal” now triggered at a fairly high level, downside risk remains decent.
  • Sell short FB at current levels.
  • Target for trade is $160
  • Stop-loss is set to $185

BUD – Anheuser-Busch InBev

  • BUD had a very good run this year but that now appears to be over.
  • With the break of the bullish uptrend line, the risk is currently to the downside.
  • Short BUD on any failed rally to $95
  • Stop loss is $97.50 after entry.
  • Target for trade is $80

STZ – Constellation Brands, Inc.

  • STZ has been in a choppy uptrend from the December 24th lows. We actually like the company and will probably add it back to the portfolio at lower levels.
  • However, for now, it has broken important support and looks to go lower.
  • Sell Short at current levels.
  • Target for trade is $170
  • Stop-loss after shorting the position is set at $195

The Myths Of “Broken Capitalism” – Part 2

Read Part 1 – The Distortion Of Capitalism By Wall Street

Read Part 3 – Capitalism Is The Worst, Except For The Rest


In the introduction to this series, we discussed the bit of the history leading us to the outcry against capitalism. As I concluded:

“The important point is that ‘capitalism’ isn’t broken, but there is one aspect of the system which has morphed into something no one intended. As you hear candidates promising to ‘eat the rich,’ remember ‘political narratives’ designed to win votes is not always representative of what is best for you in the long run.”

In every economy, throughout history, there have always been those individuals who aspire to wealth and privilege and those that beg on street corners for scraps. The battle between “haves” and “have nots” has been going on since men lived in caves.

“Did you see Ugg’s new cave? He’s got a T-Rex floor covering by the fire pit.”

Likewise, throughout history, there have also been the subsequent revolts where the oppressed have stormed the castle walls with “pitchforks and torches” to change the balance of inequity. Unfortunately, those changes only lasted for a little while. Eventually, the system imbalances always return due to our basic human nature:

  • Aspiration (the will to take risks, determination, and drive),
  • Education, and socio-economic factors (access to capital, connections, etc.), and;
  • Greed

However, it is our human nature of greed and competition, which lifts individuals out of poverty. Inequality should not be viewed as a negative, but rather as a driver of prosperity and innovation. As Daniel LaCalle recently wrote in his new book “Freedom, Equality, & Prosperity Through Capitalism:”

“By contrast, the U.S. has historically been a clear example of positive inequality. ‘Mimic inequality’—where you want to do your best and make it seem to others that ‘you’ve made it’–is a positive force. That’s what we all call The American Dream. The reason why millions emigrate to the U.S. is the promise of equal opportunity, not equality. Very few ever emigrate to socialist countries. In fact, governments in those regimes spend large sums of money trying to prevent their citizens from escaping”

This is a vastly important statement. We should be seeking to foster is equal opportunity, not wealth equality.

Fortunately, the United States is rich with opportunity. All you have to do is take advantage of it.

Myth: The System Is Unfair, You Have To Be Rich To Start With

Jeff Bezos, the creator of the world’s largest online retailer and one of the richest men in the world, took advantage of capitalism. Now he has become villainized for it.

What did he have that allowed him to generate billions in personal wealth that others didn’t?

Nothing.

  1. He had an idea. (We all have ideas.)
  2. He took on the “risk of failure.” (Would you quit your job to start a business that could fail?)
  3. He had an educational background. (Princeton University. But education isn’t everything. Bill Gates dropped out of college. Education can provide access to potential contacts and resources.)
  4. He had access to capital. (His dad loaned him $250,000 to seed the company. However, this is why private equity and venture capital firms exist which can fund startup projects.)
  5. He dedicated himself to the project to see it to completion. (Determination and drive in the face of potential failure.)

There is nothing extraordinary about Jeff Bezos. Any person in the U.S. could achieve the same outcome. We see it occur every day with products and services that we use from Grubhub to Uber. FedEx is another great example of capitalism at work.

“Fred Smith developed the idea of a global logistics company when he was a student at Yale University with other notable students such as future President George W. Bush and Democratic presidential candidate John Kerry.” – Education and Contacts

“Smith submitted a paper that proposed a new concept where one logistics company is responsible for a piece of cargo from local pickup to ultimate delivery, while operating its own aircraft, depots, posting stations, and ubiquitous delivery vans.” – Innovative Idea

“Smith began Federal Express in 1971 with a $4 million inheritance from his father and $91 million of venture capital.” – Access to capital

“The first three years of operation saw the company lose money despite being the most highly financed new company in U.S. history in terms of venture capital. It was not until 1976 that the company saw its first profit of $3.6 million based on handling 19,000 packages a day.” – Dedicated to an idea in the face of adversity, risk of loss of his inheritance.

Here are a few others who started with nothing, took risks, and built substantial wealth:

  • Jan Koum, CEO and Founder Of WhatsApp, who once lived on food stamps.
  • Kenny Troutt, founder of Excel Communications, paid his way through college selling life insurance.
  • Howard Schultz grew up in a housing complex for the poor.
  • Investor Ken Langone’s parents worked as a plumber and cafeteria worker.
  • Oprah Winfrey was born into poverty.
  • Billionaire Shahid Kahn washed dishes for $1.20 an hour.
  • Kirk Kerkorian dropped out of school in the 8th grade to be a boxer.
  • John Paul DeJoria, founder of Paul Mitchell, once lived in a foster home and out of his car.
  • Do Won Chang, founder of Forever 21, worked as a janitor and a gas station attendant when he first moved to America.
  • Ralph Lauren was a clerk at Brooks Brothers.
  • Francois Pinault quit high school in 1974 after being bullied because he was so poor. 

So, what exactly is your excuse? It is easy to make excuses for “why you CAN’T do something.”

The only difference between you, and Jeff Bezos, is that Jeff didn’t make excuses.

Myth: The Rich Don’t Pay Their “Fair Share”

Bernie Sanders suggests “billionaires” shouldn’t exist; such implies we should confiscate all their wealth to support the public good. This seems fair, considering the ongoing “claims” the rich don’t pay their “fair share of taxes.” The data below clearly shows the issue.

“By contrast, the lower 60% of households, who have income up to about $86,000, receive about 27% of income. As a group, this tier will pay NO net federal income tax in 2018 vs. 2% of it last year. Roughly one million households in the top 1% will pay for 43% of income tax,up from 38% in 2017. These filers earn above about $730,000.”

Since we are currently running a trillion-dollar annual deficit, we should probably think twice about keeping the rich in a position to continue feeding the public coffers.

As Daniel Lacalle noted:

“In effect, the message of taxing the rich to solve multibillion-dollar spending problems is simply a way of advancing total control, creating clients in low-income voters and creating a group of industries that benefit from being close to the government—in other words, cronyism. This is why governments always use the fallacy of taxing the rich to obtain total control and destroy freedom.

This doesn’t mean that high earners shouldn’t pay their fair share. It means that the magic trick played on us all is to make us look at one hand (the rich) when the trick is in the other (excess spending and increased intervention and government control)

If taxing the rich were the solution to high debt, inequality, and excess spending, the world would have no such problems by now.”

Myth: The Rich Don’t Share

According to Giving USA, in 2017, total donations to charity clocked in at $410 billion, a figure (in current dollars) that has increased almost every year for four decades. The 50 largest families gave $7.8 billion in disclosed donations in 2018 alone, and $14.7 billion to nonprofits the year prior. (2017 was skewed due to Gates donation of $4.8 billion to their charity.) 

Those donations support everything from United Way to the St. Jude’s Hospital, which provides free healthcare to children and housing for their parents. Without those billions in donations, charities which support everything from art, to music, education, research, healthcare, etc. would all cease to exist.

Unintended consequences are very important to consider.

Myth: More Government Is The Answer

“Who cares? No one deserves to have that much wealth. The Government would do a better job.”

The following are the two most high profile proposals of Democratic candidates.

So, we need $4.5 trillion to pay for those two proposals in Year 1, and $3 trillion more annually to pay for “Medicare-For-All” going forward – forever. (This doesn’t include the current $70 trillion unfunded liability of the social welfare system currently.)

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar currently goes to non-productive spending. 

In 2018, the Federal Government spent $4.48 trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of the total spending, ONLY $3.5 trillion was financed by Federal revenues. The shortfall of $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of the total revenue coming in. 

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

In 2018, Forbes identified the 585 U.S. billionaires which had $3.1 trillion in net worth combined.

So, if we confiscated 100% of the wealth from those 585 billionaires we could:

  1. We pay off all the student debt, and;
  2. We can pay for 1/2 of “Medicare-For-All” in year one

This leaves a shortfall of $1.5 trillion in the first year, plus the existing $1 trillion deficit, or $2.5 trillion further in debt in year one. In year 2, and beyond, assuming no increase in the current deficit, the shortfall would grow to $4 trillion annually.

But therein lies the problem.

Who pays the most in taxes?

Since we confiscated all the wealth of the billionaires, tax revenue is going to fall markedly, further increasing the annual deficit.

Moreover, since those billionaires made their wealth by building Fortune 500 companies, they will reconsider exactly what they are doing operating within the confines of a country that has now taken all their wealth.

So, which companies created the most jobs in the U.S.?

Importantly, each of those companies have:

  1. Created thousands of other companies,
  2. Which employee millions of people,
  3. Who sell to, support, or sell the products and services of those companies.

The economy is a living organism that creates hosts and parasites, which feed upon each other for survival.

“The inequality debate is often an excuse to intervene. Politicians don’t want the poor to be less poor, so long as the middle and upper classes are less wealthy. That’s because interventionism assumes that inequality is a perverse effect that can be solved by state intervention.

But the truth is interventionism perpetuates bad inequality–inequality in opportunity, in job availability and in access to a better life. In fact, it deepens it. What matters to us is equality of opportunity, and that is what the state has to focus on, not on penalizing success.” – Daniel LaCalle

So, you may want to consider the consequences of “killing the ‘Golden Goose.'”


Part 3, How To Take Advantage Of “Capitalism” To Realize The American Dream

Selected Portfolio Position Review: 10-09-19

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

AEP – American Electric Power

  • After taking profits out of the position previously, we are likely going to do it again soon. Utilities have been a clear winner this year, but that run will end at some point.
  • AEP is currently on a “sell signal” but remains overbought.
  • There is risk to the position, so we are looking to sell 10% of the holding when we rebalance the portfolio.
  • Stop is set at $87.50.

CHCT – Community HealthCare Trust

  • Real estate has been one of the leading sectors this year, and in particular over the last several months.
  • CHCT is extremely overbought and extended, so we will likely take some profits very soon.
  • Stop is at $40.

MSFT – Microsoft

  • MSFT has been consolidating its large gain this year.
  • Currently on a “sell signal” but still overbought, there is risk of a larger correction in the market begins to markedly weaken MSFT.
  • We are looking to take profits, but continue to watch the consolidation closely.
  • Stop loss is moved up to $130

MDLZ – Mondelez International

  • I hate writing about this position because it makes me crave “Oreo’s.”
  • However, after taking profits previously, we have been watching the position consolidate its breakout gains from early this year.
  • Currently on a “sell signal” and overbought, support needs to hold. There are two levels very close to each other; the uptrend line from the January lows, and support along recent bottoms.
  • We are likely take profits again soon as we rebalance.
  • Stop loss is moved up to support at $52

PEP – Pepsico, Inc.

  • PEP recently consolidated its gains, held support and then broke out to new highs. This is very bullish for the company.
  • However, PEP is overbought and the “buy signal” is at risk of turning.
  • We will take profits on a rebalance, and look for our next entry point.
  • Stop-loss moved up to $132.50

PG – Proctor & Gamble

  • PG has been on a seemingly unstoppable advance. With a consumer staple conglomerate trading at 88x earnings, we have to take profits and reduce our valuation risk.
  • The stock is grossly overbought and extended.
  • We will likely sell up to 20% of the position to reduce risk.
  • Stop loss is moved up to $117.50

V – Visa Inc.

  • V has been consolidating its previous advance and has been holding important support at the 32.8% Fibonacci retracement level.
  • The sell signal has been triggered and the overbought condition is being worked off.
  • We like the company longer-term, as consumers are going to keep going into debt, but we need a bigger correction to add to our position.
  • We will likely take profits when we rebalance.
  • Stop-loss is set at $160

WELL – Welltower Inc.

  • Same as with CHCT, real estate holdings have continued to perform well. WELL in particular has traded in a fairly tight channel.
  • Not surprisingly, we are looking to take profits, and rebalance risk accordingly.
  • The buy signal is extremely extended and CHCT is grossly overbought.
  • Stop-loss is moved up to $82.50

XOM – Exxon Mobil Corp.

  • Back in April of this year we sold 50% of our holdings in XOM and have been waiting for the right opportunity to add back to our position. We are getting there.
  • Energy shares actually have some value in them, and XOM is trading at a very long-term set of bottoms.
  • With the stock deeply oversold and on a very deep “sell signal,” there is a greatly reduced risk of adding back to our position opportunistically.
  • With a 5% yield, we can afford to hold the position with a wider stop-loss.
  • We will update our holdings when we add to the position.
  • Stop loss is at $63

YUM – Yum Brands, Inc.

  • YUM moved from an uptrend in 2018 to an accelerated uptrend in 2019.
  • YUM is grossly overbought and has recently triggered a sell signal.
  • We are looking to take profits and reduce the position by 10% when we rebalance the portfolio.
  • Stop loss is moved up to $107.50

The Voice of the Market- The Millennial Perspective

Those who cannot remember the past are condemned to repeat it.” – George Santayana

Current investors must be at least 60 years old to have been of working age during a sustained bond bear market. The vast majority of investment professionals have only worked in an environment where yields generally decline and bond prices increase. For those with this perspective, the bond market has been very rewarding and seemingly risk-free and easy to trade.

Investors in Europe are buying bonds with negative yields, guaranteeing some loss of principal unless bond yields become even more negative. The U.S. Treasury 30-year bond carries a current yield to maturity of 2.00%, which implies negative real returns when adjusted for expected inflation unless yields continue to fall. From the perspective of most bond investors, yields only fall, so there’s not much of a reason for concern with the current dynamics.

We wonder how much of this complacent behavior is due to the positive experience of those investors and traders driving the bond markets. It is worth exploring how the viewpoint of a leading investor archetype(s) can influence the mindset of financial markets at large.

Millennials

The millennial generation was born between the years 1981 and 1996, putting them currently between the ages of 23 and 38. Like all generations, millennials have unique outlooks and opinions based on their life experiences.

Millennials represent less than 25% of the total U.S. population, but they are over 40% of the working-age population defined as ages 25 to 65. Millennials are quickly becoming the generation that drives consumer, economic, market, and political decision making. Older millennials are in their prime spending years and quickly moving up corporate ladders, and they are taking leading roles in government. In many cases, millennials are the dominant leaders in emerging technologies such as artificial intelligence, social media, and alternative energy.

Their rise is exaggerated due to the disproportionately large baby boomer generation that is reaching retirement age and witnessing their consumer, economic, and political impact diminishing. An additional boost to millennials’ influence is their comfort with social media and technology. They are digital natives. They created Facebook, Twitter, Snapchat, Instagram, and are the most active voices on these platforms. Their opinions are amplified like no other generation and will only get louder in the years to come.

Given millennial’s rising influence over national opinion, we examine their experiences so we can better appreciate their economic and market perspectives.

Millennial Economics

In this section, we focus on the millennial experience with recessions. It is usually these trying economic experiences that stand foremost in our memories and play an important role in forming our economic behaviors. As an extreme example, anyone alive during the Great Depression is generally fiscally conservative and not willing to take outsized risks in the markets, despite the fact that they were likely children when the Depression struck.

The table below shows the number of recessions experienced by population groupings and the number of recessions experienced by those groupings when they were working adults, defined as 25 or older.

Data Courtesy US Census Bureau – Millennial Generation 1981-1996

About two-thirds of the Millennials, highlighted in beige, have only experienced one recession as an adult, the financial crisis of 2008. The recession of 1990/91 occurred when the oldest millennial was nine years old. More Millennials are likely to remember the recession of 2001, but they were only between the ages of 5 and 20.

Unlike most prior recessions, the recession of 2008 was borne out of a banking and real-estate crisis. Typically, recessions occur due to an excessive buildup in inventories that cause a slowing of new orders and layoffs. While the market volatility of the Financial Crisis was disturbing, the economic decline was not as severe when viewed through the lens of peak to trough GDP decline. As shown in the table below, the difference between the cycle peak GDP growth and the cycle trough GDP growth during the most recent recession was only the eighth largest difference of the last ten recessions.

Data Courtesy St. Louis Federal Reserve

One of the reasons the 2008 experience was not more economically challenging was the massive fiscal and monetary stimulus provided by the federal government and Federal Reserve, respectively. In many ways, these actions were unprecedented. When the troubles in the banking sector were arrested, consumer and business confidence rose quickly, helping the economy and the financial markets. Although it took time for the fear to subside, it set the path for a smooth decade of uninterrupted economic growth. A decade later, with the expansion now the longest since at least the Civil War, the financial crisis is a fleeting memory for many.

The market crisis of 2008 was harsh, but it did not last long. It is largely blamed on poor banking practices and real-estate speculation issues that have been supposedly fixed. Most Millennials likely believe the experience was a black swan event not likely to be repeated. One could argue there’s a large contingent of non-millennials who feel likewise.  Given the effectiveness of fiscal and monetary policy to reverse the effects of the crisis,  Millennials might also believe that recessions can be avoided, or greatly curtailed. 

Half of the millennial generation were teenagers during the financial crisis and have few if any, memories of the economic hardships of the era. The oldest of the Millennials were only in their early to mid-20s at the time and are not likely to be as financially scarred as older generations. In the words of Nassim Taleb, they had little skin in the game.

No one in the millennial generation has experienced a classical recession, which the Federal Reserve is not as effective at stopping. With only one recession under their belt, and minimal harm occurring as a result of their relatively young age, recession naivete is to be expected from the millennial generation.

Millennial Financial Markets

As stated earlier, the dot com bust, steep equity market decline, and the ensuing recession of 2001 occurred when the millennial generation was very young.

The financial crisis of 2008-2009 occurred when millennials were between the ages of 12 and 27. More than half of them were teenagers with little to no investing experience during the crisis. Some older Millennials may have been trading and investing, but at the time they were not very experienced, and the large majority had little money to lose. 

What is likely more memorable for the vast majority of the generation is the sharp rebound in markets following the crisis and the ease in executing a passive buy and hold strategy that has worked ever since.  

Millennial investors are not unlike bond traders under the age of 60 – they only know one direction, and that is up. They have been rewarded for following the herd, ignoring the warnings raised by excessive valuations, and dismissing the concerns of those that have experienced recessions and lasting market downturns.

Are they ready for 2001?

The next recession and market decline are more likely to be traditional in character, i.e. based on economic factors and not a crisis in the financial sector. Current equity valuations argue that a recession could result in a 50% or greater decline, similar to what occurred in  2008 and 2001. The difference, however, may be that the amount of time required to recover losses will be vastly different from 2008-2009. The two most comparable instances were 1929 and 2001 when valuations were as stretched as they are today. It took the S&P 500 over 20 years to recover from 1929. Likewise, the tech-laden NASDAQ needed 15 years to set new record highs after the early 2000’s dot com bust.

Those that were prepared, and had experienced numerous recessions were able to protect their wealth during the last two downturns. Some investors even prospered. Those that believed the popular narrative that prices would move onward and upward forever paid dearly.

Today, the narrative is increasingly driven by those that have never really experienced a recession or sharp market decline. Is this the perspective you should follow?

Summary

 “Those who cannot remember the past are condemned to repeat it.

We would add, “those who remember the past are more likely to avoid it.”

The millennial generation has a lot going for it, but in the case of markets and economics, it has lived in an environment coddled by monetary policy. Massive amounts of monetary stimulus have warped markets and created a dangerous mindset for those with a short time perspective.

If you fall into this camp, you may want to befriend a 60-year old bond trader, and let them explain what a bear market is.

Sector Buy/Sell Review: 10-08-19

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

  • As noted last week:
    • “There are multiple tops that are providing tough resistance for the sector to get through, so while the buy signal has turned back up, which is bullish, XLB has to get above resistance before considering adding to our position.”
  • XLB failed at support and working towards a retest of the 200-dma. Unfortunately, it appears a “trade deal” may be at risk, and the recent “buy signal” is threatening to turn lower.
  • We are remaining underweight the sector for now, unless trade deal negotiations appear to be improving.
  • 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

  • The good news is that XLC is working off its overbought condition, and the correction is holding above short-term support at $48.50
  • There are two support levels between $47.50 and $48.50. A violation of the lower support level will take us out of our position for now.
  • XLC has a touch of defensive positioning from “trade wars” and given the recent pullback to oversold, a trading position was placed in portfolios.
  • One concern of the overall market is that the former “generals” of the market, namely AMZN, NFLX, and GOOG, have been not be performing well.
  • Short-Term Positioning: Neutral
    • Last Week: Hold trading positions
    • This Week: Hold trading positions.
    • Stop adjusted to $47.50
  • Long-Term Positioning: Bearish

Energy

  • There isn’t much to say about XLE following the complete breakdown of the recent rally.
  • As we noted last week, the failed test of the 200-dma put $58 as the next target of support, which has now also failed.
  • The “sell signal” was in the process of being reversed, but that has failed also as stated last week.
  • While there is “value” in the sector, there is no need to rush into a position just yet. The right opportunity and timing will come, it just isn’t right now.
  • We were stopped out of our position previously.
  • Short-Term Positioning: Bearish
    • Last week: Stopped out.
    • This week: Stopped out.
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • XLF is another sector trapped below multiple highs.
  • XLF has reversed its “sell” signal” on a short-term basis, but is threatening to turn lower.
  • We previously closed out of positioning as inverted yield curves and Fed rate cuts are not good for bank profitability. The “trading opportunity” we discussed last week, has not yet coalesced either.
  • Short-Term Positioning: Neutral
    • Last week: Closed Out/No Position.
    • This week: Closed Out/No Position.
    • Stop-loss adjusted to $26.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI also, after failing a breakout, remains trapped below multiple highs.
  • The breakout failed, as we suggested might be the case, and now the retracement back to initial support is also threatening to fail.
  • XLI is working off the overbought condition but is close to triggering a “sell signal.” If a “trade deal” doesn’t manifest soon, we will likely be stopped out of our reduced position.
  • We have also adjusted 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 is beginning to reverse its short-term overbought condition, but has now broken previous support at two different levels, most importantly, the bullish trend line from the December lows.
  • The buy signal is close to reversing to a “sell,” which if it does, will suggest lower prices.
  • A retest of $75 is likely the market doesn’t improve very quickly.
  • Short-Term Positioning: Bullish
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $75.00
  • Long-Term Positioning: Neutral

Staples

  • Defensive sectors continue to rally and, as noted last week, “Is now an EXTREMELY crowded trade, and we suggest taking profits.”
  • We also suggested that if there is a trade deal, these defensive sectors could get hard very quickly as money rotates back to non-defensive trades.
  • The “buy” signal (lower panel) is still in place but has been worked off to a good degree. Risk is clearly elevated.
  • The recent correction held important support and XLP is retesting all-time highs.
  • We previously took profits in XLP and reduced our weighting from overweight. We will likely look to reduce further when opportunity presents itself.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $58
    • Long-Term Positioning: Bullish

Real Estate

  • As with XLP above, XLRE was consolidating its advance, then pushed to new highs and is back to extremely extended.
  • XLRE is also a VERY CROWDED defensive trade like XLP and XLU.
  • Be careful adding new positions and keep a tight stop for now. A pullback to $37-38 would be a better entry.
  • We previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected. That advice remains.
  • Buy signal has been reduced which is bullish 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

  • XLRE and XLU are virtually the same commentary.
  • After taking profits, we have time to be patient and wait for the right setup. We haven’t gotten one as XLU continues to rally and last weeks surge is making owning this sector seriously more dangerous.
  • Long-term trend line remains intact but XLU is grossly deviated from longer-term means. A reversion will likely be swift and somewhat brutal.
  • Buy signal reversed, held, and is now back to extremely overbought. Take profits and reduce risks accordingly.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to support at $58.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has triggered a sell signal but has remained intact and is trying to recover with the market. If a buy signal is issued that may well support a higher move for the sector.
  • XLV continues to hold support levels but is lagging the overall market.
  • Healthcare will likely begin to perform better soon if money begins to look for “value” in the market. We are looking for entry points to add to current holdings and potentially some new holdings as well in the Equity portfolio.
  • We continue to maintain a fairly tight stop for now.
  • Short-Term Positioning: Neutral
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to $88
  • Long-Term Positioning: Neutral

Discretionary

  • The rally in XLY failed at previous highs where resistance sits currently.
  • We added to our holdings previously to participate with the current rally, but are carrying a tight stop on the whole position.
  • XLY has reversed its “sell signal” to a “buy” which could support a move to new highs if it holds. Currently that is questionable.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $115.
  • Long-Term Positioning: Neutral

Transportation

  • XTN spiked higher over the last couple of trading sessions on an “oversold” bounce and is now extremely overbought once again.
  • XTN remains is a very broad trading range, and as we noted last week:
    • “This rally is most likely going to fail at the previous highs for the range. It is now make or break for the sector.”
  • The rally failed and a retest of support is likely.
  • XTN has reversed its “sell” signal and is trying to work off the overbought condition.
  • We remain out of the position currently.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: This Is Nuts & The Reason To Focus On Risk

Since the lows of last December, the markets have climbed ignoring weakening economic growth, deteriorating earnings, weak revenue growth, and historically high valuations on “hopes” that more “Fed rate cuts” and “QE” will keep this current bull market, and economy, alive…indefinitely.

This is at least what much of the media suggests as noted recently by Rex Nutting via MarketWatch:

“‘Recessions are always hard to predict,’ says Lou Crandall, chief economist for Wrightson ICAP, who’s been watching the Fed and the economy for three decades. But after looking deeply into the economic data, he concludes that ‘there’s no reason’ for the economy to topple into recession. The usual suspects are missing. For instance, there’s no inventory overhang, nor is monetary policy too tight.”

Since the financial markets tend to lead the economy, he certainly seems to be correct. 

However, a look at the economic data indeed suggests that something has gone wrong in the economy in recent months. The latest Leading Economic Index (LEI) report showed continued weakness along with a myriad of economic data points. The chart below is the RIA Economic Composite Index (a comprehensive composite of service and manufacturing data) as compared to the LEI.

The downturn in the economy shouldn’t be surprising given the current length of the overall expansion. However, the decline in the LEI also is coincident with weaker rates of profit growth.

This also should be no surprise given the companies that make up the stock market are dependent on consumers to spend money from which they derive their revenue. If the economy is slowing down, revenue and corporate profit growth will decline also. 

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

This is nuts!

Lastly, given the economic weakness, as noted above, is going to continue to depress forward reported earnings estimates. As I noted back in May, estimates going into 2020 have already started to markedly decline (primarily so companies can play “beat the estimate game,”) 

For Q4-2020, estimates have already fallen by almost $10 per share since April, yet the S&P 500 is still near record highs. 

As we discussed in this past weekend’s newsletter, it all comes down to “hope.” 

“Investors are hoping a string of disappointing economic data, including manufacturing woes and a slowdown in job creation in the private sector, could spur a rate cut. Federal funds futures show traders are betting on the central bank lowering its benchmark short-term interest rate two more times by year-end, according to the CME Group — a welcome antidote to broad economic uncertainty.” – WSJ

Hope for:

  • A trade deal…please
  • More Fed rate cuts
  • More QE

The reality, of course, is that as investors chase asset prices higher, the need to “rationalize,” a byproduct of the “Fear Of Missing Out,” overtakes “logic.” 

As we also discussed this past weekend, the backdrop required for the Fed to successfully deploy “Quantitative Easing” doesn’t exist currently. 

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, and confidence is extremely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, the backdrop could not be more diametrically opposed.”

If we are correct, investors who are dependent on QE and rate cuts to continue to support markets could be at risk of a sudden downturn. This is because the entire premise is based on the assumption that everyone continues to act in the same manner.  This was a point we discussed in the Stability/Instability Paradox:

With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the ‘instability of stability’ is now the most significant risk.

The ‘stability/instability paradox’ assumes that all players are rational and such rationality implies an avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

Simply, the Fed is dependent on “everyone acting rationally.”

Unfortunately, that has never been the case.

The behavioral biases of individuals is one of the most serious risks facing the Fed. Throughout history, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.

This time is unlikely to be different.

Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term means even further. Such is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.

The correction over the last couple of months has done little to correct these extensions, and valuations have become more expensive as earnings have declined. 

Yes,. the bullish trend remains clearly intact for now, but all “bull markets” end….always.

Given that “prices are bound by the laws of physics,” the chart below lays out the potential of the next reversion.

This chart is NOT meant to “scare you.”

It is meant to make you think.

While prices can certainly seem to defy the law of gravity in the short-term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

There are substantial reasons to be pessimistic about the markets longer-term. Economic growth, excessive monetary interventions, earnings, valuations, etc. all suggest that future returns will be substantially lower than those seen over the last eight years. Bullish exuberance has erased the memories of the last two major bear markets and replaced it with “hope” that somehow, “this time will be different.”

Maybe it will be.

Probably, it won’t be.

The Reason To Focus On Risk

Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. Higherer returns are generated from the management of “risks” rather than the attempt to create returns by chasing markets. That philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;

“As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty, we must decide and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.

“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”

We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Just something to consider.

Portfolio Model Review: 10-07-19

On Friday, I went through the sector analysis of the market and our portfolio positioning. If you missed it, I am providing that analysis today. The regular market and sector reports will return starting tomorrow.

Feel free to email with any questions or comments.

Let’s start with the UGLY

The ugliest of sectors remains Energy (XLE). The trend remains sorely negative and even the recent spike due to the Saudi oil refinery explosions failed at the downtrend resistance line. With the economy slowing, particularly in the manufacturing sector, the pressure on oil prices, and the energy sector, remains to the downside for now. 

Current Positioning In Portfolios: No Sector Holdings, 1/4th weight XOM


Small stocks remain in a declining trend overall, however, volatility in this market has provided some decent trading opportunities for nimble investors. Small Cap stocks are the most sensitive to changes in the economic environment and don’t benefit from share repurchase activity to the degree major large cap companies do. With the small-caps trading below both their 50- and 200-dma, there is more risk to the downside currently.

There is no reason to be invested in small-caps currently as they have increased portfolio volatility and provided additional drag on performance. Buy and hold asset allocation models are not a suitable fit for late-stage bull market cycles. 

Current Positioning In Portfolios: No Holdings


Emerging markets, like small-caps, are very subject to changes in global-trade, and in this case, “trade wars” and “tariffs.” 

Also, like small-caps, emerging markets have been in a long-term downtrend and have added additional drag, and increased volatility, to traditional asset-allocation models. With the 50-dma crossed below the 200-dma, the risk to emerging markets remains to the downside currently. 

Current Positioning In Portfolios: No Holdings


 Transportation is literally the “heartbeat” of the American economy. If you eat it, consume it, wear it, watch it, or listen to it, it was transported to you by truck, train, plane or ship at some point on its way to you. The importance of this statement is that transportation tells you a lot about the economy, and currently it is suggesting things aren’t all that great. 

With transportation trading below the 50- and 200-dma, the risk is to the downside. Importantly, the 50-dma is close to crossing below the 200-dma as well. A break of lows is an important signal for the sector and the economy, so pay attention. 

Current Positioning In Portfolios: No Sector Holdings, 1/2 weight NSC


Not Really BAD, More OKAY-ish

Financial’s have been trading sideways since May and have continued to consolidate. While the chart pattern doesn’t look so bad, the risk to the sector is rising as credit risk in the sector is high. There is a tremendous amount of debt sitting on the borderline between investment grade (BBB) and junk. There is also a good amount of junk debt related to the energy sector as well, and declining oil prices is accelerating that risk. If you are long the sector, that has been “okay” for now, but watch lower support. A break of that level will signal a substantial risk increase to the overall market given the weighting of the sector to the overall market. 

Current Positioning In Portfolios: No Sector Holdings. underweight V


Like financials, the healthcare sector hasn’t really provided much lift to portfolios this year, but has added a good amount of volatility. Support continues to hold, but the sector continues to trade below the 50-dma. Healthcare tends to be a “risk off” sector, so we are maintaining some weighting as a defensive position, but are maintaining a tight stop at recent lows.

Current Positioning In Portfolios: Target Weight XLV, JNJ, HCA, UNH, ABT, CVS


Basic Materials and Industrials have been in a long sideways consolidation waiting for a resolution to the ongoing “trade war” which has plagued the sectors for the last 18 months. The good news is that both sectors continue to defend support at the 200-dma, However, there is now significant overhead resistance at recent highs which also trace back to early 2018.

As we noted in last weekend’s newsletter, we expect a trade deal to be announced, or at least the beginning process of a deal, next week. This should theoretically lift the sectors out of their slump. The risk, of course, is a disappointment which sends the sectors lower quickly, particularly if tariffs are increased further. 

Current Positioning In Portfolios: 1/2 Weight XLB & XLI, Underweight VMC, DOV, UTX, BA


Mid-Cap stocks look a whole like Industrial and Basic Materials. Like Small-caps, mid-capitalization stocks do not benefit as much from share buybacks, and are more economic sensitive. If a “trade deal” is completed, I would expect to the see the sector move higher, however, a failure, or more tariffs, will likely see a break of important support. 

Mid-cap stocks have provided no appreciable benefit to traditional asset-allocation models and have increased overall volatility. While mid-caps are holding support at the 200-dma, they are underperforming their large-cap brethren and remain below the 50-dma which has now turned lower. Some caution is advised. 

Current Positioning In Portfolios: No Holdings


The Good

Market participants have continued to chase momentum in the market. This chase continues to confine money flows into a few sectors which show relative strength and have high liquidity. Discretionary continues to be one of those sectors which remains in a very defined uptrend. The recent double top is a concern and we are watching that closely, particularly since we are seeing early warning signs coming out in falling retail sector employment and weaker core durable goods. 

It is important the sector holds its current uptrend line and climbs above the 50-dma next week. The consolidation between the lower uptrend line and the declining tops is critically important. A failure to break out of the upside of this consolidation will likely coincide with a weaker overall market.

Current Positioning In Portfolios: XLY, AAPL, MDLZ, YUM, COST


Real estate has continued to be a strong performer and remains in a strong uptrend particularly as interest rates continue to fall. The sector is very overbought, and a traditional “defensive” sector has become a “momentum” trade and is now very crowded. 

However, for now, the trend is positive and pullbacks to the 50-dma continue to provide “buyable” entry points. However, that moving average, and subsequent trendline, are now an important “sell signal” if violated. Continue to take profits on rallies to the top of the trend channel.

Current Positioning In Portfolios: XLRE, CHCT, WELL 


Staples and Utilities, like Real Estate, and Utilities, have continued to be the “safe haven” trade amidst the “sea of volatility” in other sectors of the market. However, all three of these sectors share the same traits of a very defined uptrend, extreme overbought long-term conditions, are historically extremely over-valued, and have become a very “crowded” momentum trade. 

As with Real Estate above, a violation of the lower bullish trendline, which coincides with the 50-dma is now a “hard stop” for the sector which will suggest that something in the markets have changed, and likely for the worse.

Current Positioning In Portfolios: XLP, XLU, PG, PEP, AEP, DUK


While the Technology and Communications sectors remain in positive uptrends, the performance to the S&P 500 has started to deteriorate. Both sectors are testing the lower bounds of their current uptrend, with communications remaining below the 50-dma. Technology is in a better position above the 50-dma but remains in a downtrend from the July highs. 

Given that technology is a major weight of the S&P 500, if the leadership continues to falter here, this is going to have a more important impact to the overall trend of the S&P 500. Stops for both sectors remain at their current uptrend lines.

Current Positioning In Portfolios: XLC, XLK, CMCSA, VZ, MSFT


Overall portfolio positioning remains slightly overweight cash, underweight equities with a bias to defensive positioning, and fixed income, where we have shortened duration a bit and improved credit quality.

Once we see the outcome of the “trade negotiations” next week, we will look to make other portfolio allocation adjustments accordingly. 

How Wall Street Destroyed Capitalism – Part 1

Read Part 2: Exploring The “Myths Of Broken Capitalism”

Read Part 3: Capitalism Is The Worst, Except For The Rest


Over the last decade, wealth inequality in America has become a political battleground. It started with #OccupyWallStreet early in President Obama’s term and has morphed into direct calls for socialistic reforms.

Is there a problem with capitalism? Does it need reform? Or, is Bernie Sanders correct when he says:

In this three-part series, we will explore:

  1. How Capitalism Got Distorted By Wall Street
  2. The Myths Of Capitalism.
  3. Why Government Isn’t The Answer.
  4. The Cost Of Socialism
  5. Why Inequality Is A Good Thing.

Introduction

Is “capitalism,” as an economic system, wrong? Ray Dalio, the head of the largest hedge fund in the world, thinks so. He recently stated that wealth and income disparity was a failure of capitalism. He argues that capitalism is not achieving its goal of more equitably distributing the fruits of capitalism.

Ray is wrong.

Capitalism is an economic system based on the premise of property rights, the rule of law, and free markets, which allows ANY individual the opportunity to create wealth. In other words, as John Mauldin, once penned:

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

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

So when you say that capitalists are not very good at sharing profits, I would say that capitalism is not designed to do so.”

So, what type of economic system do you have when profits, goods, and services are shared on an equal basis? “Socialism.”

Importantly, what Ray Dalio is referring to is not a problem of “capitalism,” it is a problem of Wall Street.

How Capitalism Got Distorted By Wall Street

Despite all of the angst surrounding the idea of capitalism, it has benefited all Americans very well. Currently, the median income for the U.S. is $59,039. If you are trying to raise a family of four on that income, it certainly doesn’t make you feel very rich.

However, when compared to the rest of the world, the byproduct of capitalism is a wealth standard far above that of any other country.

According to the Global Rich List, a $32,400 annual income will easily place American school teachers, registered nurses, and other modestly-salaried individuals, among the global top 1% of earners.

Nonetheless, there is little arguing that when 1% of the country controls more wealth than the bottom 80%, something certainly doesn’t seem right.

“Wealth is distributed in a highly unequal fashion, with the wealthiest 1 percent of families in the United States holding about 40 percent of all wealth and the bottom 90 percent of families holding less than one-quarter of all wealth.”  – Washington Center For Equitable Growth

This division between the “rich” and “poor” has become a “political football” perfectly suited for the 2019 primaries as the “wealth gap” in America has become a visible chasm.

Here is what you need to be aware of. The debates over capitalism aren’t about Mike Jones, who started an auto mechanic repair shop. Nor, are they about Annie Smith, who opened a personal training studio down the street from her home. Mike and Annie are participating, and taking advantage of, a capitalist economy where the freedom to compete allows them to earn more wealth than simply “working for the man.” 

Should Mike and Annie, who have taken risks as entrepreneurs, be forced to share the fruits of their 50-70 work weeks, with everyone else who did not take those risks? It’s pretty obvious the answer is “no.” 

So, if “capitalism” at its most basic core is NOT broken, then what are we discussing?

The debate should be focused on the “distortion of capitalism” by Wall Street, and the ongoing share repurchases, which invoke images of corporate greed, inequality, and populism.

However, we should “hate the game,” not the “player.”

The buyback boom began with Bill Clinton’s 1993 attempt to reign in CEO pay. Clinton thought, incorrectly, that by restricting corporations to expensing only the first $1 million in CEO compensation for corporate tax purposes, corporate boards would limit the amount of money they doled out to CEO’s.

To Bill’s chagrin, corporations quickly shifted compensation schemes for their executives to stock-based compensation. Subsequently, CEO pay rose even higher, and the gap between profits and wages has become vastly distorted. Rising profitability, fewer employees, and increased productivity per employee has all contributed to the surging “wealth gap” between the rich and the poor.

In 1982, according to the Economic Policy Institute, the average CEO earned 50 times the average production worker. Today, the CEO Pay Ratio is 144 times the average worker with most of the gains a result of stock options and awards.

You can understand why it is a political “hot topic” for 2020.

The debate over share repurchases came to the fore following the tax cuts in December of 2017. The bill was targeted at corporations and lowered the tax rate from 35% to 21%. The tax cut plan was “sold” the the American public as a “trickle down” plan, and by giving money back to corporations; they would hire more workers, increase wages, and invest in America.

Unsurprisingly, it didn’t happen as the money primarily went to share repurchases.

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

A recent study by the Securities & Exchange Commission supports this claim.

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

Jesse Fried also wrote for the WSJ:

“The real problem is that buybacks, unlike dividends, can be used to systematically transfer value from shareholders to executives. Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.

Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.”

What is clear is that the misuse and abuse of share buybacks to manipulate earnings, and reward insiders has become problematic.

However, rather than hating capitalism, fix the legislation.

Most people have forgotten that share repurchases used to be illegal. Via Vox:

“Buybacks were illegal throughout most of the 20th century because they were considered a form of stock market manipulation. But in 1982, the Securities and Exchange Commission passed rule 10b-18, which created a legal process for buybacks and opened the floodgates for companies to start repurchasing their stock en masse.”

As William Lazonick via The Harvard Business Review noted, the problem is easily fixed:

If Americans want an economy in which corporate profits result in a shared prosperity, the buyback and executive compensation binges will have to end. As with any addiction, there will be withdrawal pains.” 

Unfortunately, given the incestuous relationship between Washington and Wall Street, there are no easy fixes, and banning share repurchases is probably a “horse that has left the barn.”

As Michael Lebowitz wrote in Short Term Pain, Long Term Gain.

Executives should be incentivized to promote the long-term health of their company, the prosperity of the employees who work for it, and the communities in which the employees live and work. These objectives contrast sharply with current decision-making behavior and demands balanced investment decisions, discipline, and quite often a measure of sacrifice in the short-run.”

The important point is that “capitalism” isn’t broken, but there is one aspect of the system which has morphed into something no one intended. 

As you hear candidates promising to “eat the rich,” remember “political narratives” designed to win votes is not always representative of what is best for you in the long run.

RIA PRO: Market Review: The Good, The Bad & The Ugly

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  • The Good, The Bad & The Ugly
    • The Ugly
    • Not Really Bad, More Okay-ish
    • The Good
  • Hope For More Q.E.
  • Will It Work Next Time
  • The Fly In The Ointment
  • Sector & Market Analysis
  • 401k Plan Manager

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



The Good, The Bad & The Ugly

For quite some time, we have been talking about weakening macroeconomic and earnings trends, which, combined with more aggressive Fed rate cuts, have historically denoted the beginnings of “bear markets.” 

None of this has seemed to matter up to this point as market participants have continued focus on the “hope” of trade deals, and more importantly, further monetary stimulus from Central Banks. To wit:

“Investors are hoping a string of disappointing economic data, including manufacturing woes and a slowdown in job creation in the private sector, could spur a rate cut. Federal funds futures show traders are betting on the central bank lowering its benchmark short-term interest rate two more times by year-end, according to the CME Group — a welcome antidote to broad economic uncertainty.” – WSJ

This week, we are going to deviate from our normally more macro-market/economic view to specifically delve into the S&P 500 index and the underlying sectors. We will wrap it up with a review of our reasoning why Fed actions may not have the result investors are banking on. 

When looking at financial markets, price patterns can give us clues as to what the market participants are thinking as a whole. This year, has been more notable than most, as investors have continued to “crowd” into a decreasing number of sectors in the ongoing chase for returns, liquidity, and potentially some “safety” from a weakening economic backdrop. As shown below, we can define these three “price patterns” as the good, the bad, and the ugly. 

Every week, we review the major markets, sectors, portfolio positions specifically for our RIA PRO subscribers (You can check it out FREE for 30-days)Here was our note for the S&P 500 on Thursday:

  • We are still maintaining our core S&P 500 position as the market has not technically violated any support levels as of yet. However, it hasn’t been able to advance to new highs either.
  • Yesterday’s sell-off did NOT violate support, but is also NOT oversold as of yet, which suggests further downside is possible.
  • There is likely a tradeable opportunity approaching for a reflexive bounce given the depth of selling over the last couple of days.
  • Short-Term Positioning: Bullish
  • Stop-loss moved up to $282.50
  • Long-Term Positioning: Neutral due to valuations

This week, we are going to review each of the major sectors as compared to the chart patterns above to determine where money is likely going to, where it is coming from, and what we need to be on the watch out for. 

Let’s start with the UGLY

The ugliest of sectors remains Energy (XLE). The trend remains sorely negative, and even the recent spike due to the Saudi oil refinery explosions failed at the downtrend resistance line. With the economy slowing, particularly in the manufacturing sector, the pressure on oil prices, and the energy sector, remains to the downside for now. 

Current Positioning In Portfolios: No Sector Holdings, 1/4th weight XOM


Small stocks remain in a declining trend overall. However, volatility in this market has provided some decent trading opportunities for nimble investors. However, Small Cap stocks are the most sensitive to changes in the economic environment and don’t benefit from share repurchase activity to the degree major large-cap companies do. With the small-caps trading below both their 50- and 200-dma, there is more risk to the downside currently. 

There is no reason to be invested in small-caps currently as they have increased portfolio volatility and provided an additional drag on performance. Buy and hold asset allocation models are not a suitable fit for late-stage bull market cycles. 

Current Positioning In Portfolios: No Holdings


Emerging markets, like small-caps, are very subject to changes in global trade, and in this case, “trade wars” and “tariffs.” 

Also, like small-caps, emerging markets have been in a long-term downtrend and have added additional drag, and increased volatility, to traditional asset-allocation models. With the 50-dma crossed below the 200-dma, the risk to emerging markets remains to the downside currently. 

Current Positioning In Portfolios: No Holdings


 Transportation is literally the “heartbeat” of the American economy. If you eat it, consume it, wear it, watch it, or listen to it, it was transported to you by truck, train, plane, or ship at some point on its way to you. The importance of this statement is that transportation tells you a lot about the the real-time activity in the economy. Currently, it is suggesting things aren’t all that great. 

With transportation trading below the 50- and 200-dma, the risk is to the downside. Importantly, the 50-dma is close to crossing below the 200-dma as well. A break of lows is an important signal for the sector and the economy, so pay attention. 

Current Positioning In Portfolios: No Sector Holdings, 1/2 weight NSC


Not BAD, More OKAY-ish

Financial’s have been trading sideways since May and have continued to consolidate. While the chart pattern doesn’t look so bad, the risk to the sector is rising as credit risk in the sector is high. There is a tremendous amount of debt sitting on the borderline between investment grade (BBB) and junk. There is also a good amount of junk debt related to the energy sector as well, and declining oil prices is accelerating that risk. If you are long the sector, that has been “okay” so far but watch lower support. A break of that level will signal a substantial increase in risk given the weighting of the sector to the overall market. 

Current Positioning In Portfolios: No Sector Holdings. V


Like financials, the healthcare sector has not provided much lift to portfolios this year but has added a large amount of volatility. Support continues to hold, but the sector continues to trade below the 50-dma. Healthcare tends to be a “risk-off” sector, so we are maintaining some weighting as a defensive position, but also have a tight stop at recent lows.

Current Positioning In Portfolios: Target Weight XLV, JNJ, HCA, UNH, ABT, CVS


Basic Materials and Industrials have been in a long sideways consolidation waiting for a resolution to the ongoing “trade war.” The good news is that both sectors continue to defend support at the 200-dma, There is now significant overhead resistance at recent highs, which also traces back to early 2018. 

As we noted in last weekend’s newsletter, we expect a trade deal to be announced, or at least the beginnings of a deal, next week. This should theoretically lift the sectors out of their slump. The risk, of course, is a disappointment which sends the sectors lower quickly, particularly if tariffs are increased further. 

Current Positioning In Portfolios: 1/2 Weight XLB & XLI, Underweight VMC, DOV, UTX, BA


Mid-Cap stocks look much like Industrial and Basic Materials. Like Small-caps, Mid-capitalization stocks do not benefit as much from share buybacks, and are economically sensitive. If a “trade deal” is completed, I would expect to the see the sector move higher, however, a failure, or more tariffs, will likely see a break of important support. 

Mid-cap stocks have provided no appreciable benefit to traditional asset-allocation models and have increased overall volatility. While mid-caps are holding support at the 200-dma, they are underperforming their large-cap brethren, and remain below the 50-dma, which has now turned lower. Some caution is advised. 

Current Positioning In Portfolios: No Holdings


The Good

Market participants have continued to chase momentum in the market. That chase continues to confine money flows into fewer sectors which have relative strength and have high liquidity. Discretionary continues to be one of those sectors which remains in a very defined uptrend. The recent double top is a concern, and we are watching that closely as we are seeing early warning signs coming out of falling retail sector employment, and weaker core durable goods. 

It is important the sector holds its current uptrend line, and climbs above the 50-dma next week. The consolidation between the lower uptrend line and the declining tops is critically important. A failure to break out of the upside of this consolidation will likely coincide with a weaker overall market.

Current Positioning In Portfolios: XLY, AAPL, MDLZ, YUM, COST


Real estate has continued to be a strong performer, and remains in a bullish uptrend as interest rates continue to fall. The sector is very overbought, and a traditional “defensive” sector has become a “momentum” trade, which is now very crowded. 

For now, the trend is positive, and pullbacks to the 50-dma continue to provide “buyable” entry points. The moving average, and subsequent trendline support, are now an important “sell signal” if violated. Continue to take profits on rallies to the top of the trend channel. 

Current Positioning In Portfolios: XLRE, CHCT, WELL 


Staples and Utilities, like Real Estate, and Utilities, have also continued to be the “safe haven” trade amidst the “sea of volatility” in other sectors of the market. They are also “the momentum trade.” However, all three of these sectors share the same traits of a very defined uptrend, extreme overbought long-term conditions, are historically extremely over-valued, and have become a very “crowded” momentum trade. 

As with Real Estate, a violation of the lower bullish trendline, and the 50-dma, is now a “hard stop” for the sector. A violation of both will suggest that something in the markets has changed, and likely for the worse.

Current Positioning In Portfolios: XLP, XLU, PG, PEP, AEP, DUK


While the Technology and Communications sectors remain in positive uptrends, the performance relative to the S&P 500 has deteriorated. Both sectors are testing the lower bounds of the current uptrend, with Communications remaining below the 50-dma. Technology is in a better technical position above the 50-dma, but remains in a downtrend from the July highs. 

Given that technology is a major weight of the S&P 500, a failure of its leadership is going to have a significant impact to the overall trend of the S&P 500. Stops for both sectors remain at their current uptrend lines.

Current Positioning In Portfolios: XLC, XLK, CMCSA, VZ, MSFT


Overall portfolio positioning remains slightly overweight cash, underweight equities with a bias to defensive positioning, and fixed income where we have shorted-duration a bit and improved credit quality. 

Once we see the outcome of the “trade negotiations” next week, we will look to make other portfolio allocation adjustments accordingly. 

The Hope Of Q.E. 

The worse the economic data gets, the more the “bulls” believe the Fed will cut rates and restart QE. While the narrative is likely correct, the outcome may be not as expected.

Over the last couple of months, the Fed has not only stopped Q.T., but started to increase the balance sheet to battle the recent Repo crisis. Fed “hawks” have also turned more “dovish” with the Dallas Fed President, Robert Kaplan, seemingly open to further cuts by saying he would rather “lower rates when it matters, which I think is doing it sooner, rather than later.”

As noted, this “hope” has kept the bull market narrative alive despite weakening earnings growth and estimates. In fact, for 2019, the entirety of the increase this year has been valuation expansion, or rather, investors betting on “hope” versus the fundamentals.

The recent “Repo crisis,” a byproduct of the Fed’s “quantitative tightening,” has led to calls for a new round of QE as Michael Lebowitz recently noted:

“Brian Sack, a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management, was formerly head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, both argued in their paper the Fed should first promptly establish a standing fixed-rate repo facility and, second, ‘aim for a higher level of reserves.’”

That is code for Quantitative Easing to be introduced. Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

Will Q.E. Work Next Time?

The current belief is that QE4 will be implemented sooner rather than later. 

We disagree.

We think that QE will likely only be employed when rate reductions aren’t enough. In other words, the Fed will first cut the Fed Funds rate to zero before instituting further measures. This was also the assessment of David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., in 2016 when he released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

The Federal Reserve is caught in a liquidity trap which has kept them from being able to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications, as discussed previously, the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

The Fly In The Ointment

The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures. This was something I pointed out previously:

“In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was only about $915 Billion. The Fed Funds rate was at 4.2%. If the market fell into a recession tomorrow, the Fed would be starting with roughly a $4 Trillion balance sheet with interest rates 2% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

The table below compares a variety of financial and economic factors from 2009 to present.

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been “blown out,” deviations from the “norm” are negatively extended, confidence is hugely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, the backdrop could not be more diametrically opposed.

This suggests that the Fed’s ability to stem the decline of the next recession may be much more limited than the Fed, and investors, currently believe.

If more “QE” works, great. However, as investors, with our retirement savings at risk, what if it doesn’t?

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:

See main body of report.

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:

Last week, the market rallied sharply on Thursday and Friday, not because of “good news” but rather “bad news” which increases “hope” the Fed will cut rates. 

This is not a strong fundamental reason to own stocks.

However, we do expect there to be a “trade deal” of some sort next week, which should boost stocks in the short-term (through the end of the year). If such a deal is announced we will add to our sector and market index holdings accordingly. 

We continue to maintain a defensive bias to portfolios. Please read the main body of this missive to see our allocations and reasonings, and why we continue to “rent” this rally, for now.

For newer clients, we have begun the onboarding process bringing portfolios up to 1/2 weights in our positions. This is always the riskiest part of the portfolio management process as we are stepping into positions in a very volatile market. However, by maintaining smaller exposures, we can use pullbacks to add to holdings as needed. We also are carrying stop-losses to protect against a more severe decline. 

  • New clients: Please contact your advisor with any questions. 
  • Equity Model: No change this week. 
  • ETF Model: No change this 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

Trade Deal Next Week?

The market rallied on at the end of last week on “bad news” which gave the market “hope” the Fed would more aggressively cut rates. This is a short-term boost with a long-term negative outcome. 

Low rates are not conducive to economic growth, and the Fed cutting rates aggressively cuts financial incentive in the economy and leads to recessions in the economy. 

We advise caution, but suggest remaining weighted toward equity exposure for now. Despite the rally this week, there is some risk heading into the “trade deal” next week. As noted, we expect a deal to be completed which will provide a lift to equities but we recommend weighting for the news before adding to risk. 

  • 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

Become a RIA PRO subscriber and be part of our Break It Early Testing Associate” group by using CODE: 401 (You get your first 30-days free)

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

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

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

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. 

 

Confidence Drives The Economy & Trump’s Trade War Is Killing It

Economic growth isn’t random.

It comes from individual decisions to buy, sell, or do nothing. We all make dozens every day.

Corporate CEOs and CFOs make bigger decisions, like whether thousands of people get hired or a factory gets built.

That means, the economy generally does better when business leaders see growth opportunities, and worse when they don’t.

Right now, the latter is happening. We know why, too: President Trump’s erratic trade policies make long-term planning difficult, to say the least.

If you spent decades building a transoceanic supply chain and are now unsure the US government will let you use it, then your best bet is to postpone investment decisions until you have clarity.

Allowing “clarity” isn’t in the Trump playbook. But without it, every path leads downhill.

Falling Confidence

Back in June, I reported the Business Roundtable’s CEO Economic Outlook Index had fallen for five consecutive quarters. Now it’s six.

The index, which combines hiring plans, capital spending plans, and sales expectations, declined enough to fall below its long-term average.

Two of the three components are below average, too. Hiring plans are still historically high, but capital investment and sales expectations are lagging.

(Curious disconnect here. Why are these CEOs hiring if they don’t expect higher sales and aren’t willing to make growth investments? I don’t know. One explanation is they are trading expensive workers for lower-paid ones, but that’s just a guess).

Still, for now, the survey doesn’t point to recession. It’s consistent with other surveys like the NFIB Small Business Optimism Index, which shows weakening but not collapse.

On the other hand… confidence can drop fast. CEOs were still relatively optimistic well into 2008—about like they are now. Then they suddenly weren’t.

A new Duke University survey of chief financial officers isn’t comforting, either.

Some 55% of finance chiefs became more pessimistic last quarter. They predict less than 1% capital spending growth over the next year. The CFOs say “economic uncertainty” is now their biggest concern.

From where does this uncertainty emanate? We don’t have to look far.

Stifled Demand         

One of Trump’s first trade moves was to “help” American steel producers with import tariffs.

That was last year. How are they doing now? Here’s a Sept. 18 Bloomberg headline:

“Trump Trade-War Boomerang Hits Steelmakers as Prices, Profit Sag”

That doesn’t sound like a win for the US. It’s certainly not a win for the steel industry. From the Bloomberg story:

Since the Trump administration announced tariffs last year, domestic steelmakers’ shares have slumped, partly on concern that trade tensions with China threatened global economic growth and demand for the commodity. Now, there’s evidence that those fears are being borne out, with U.S. Steel Corp., Nucor Corp. and Steel Dynamics Inc. all warning this week on third-quarter profit outlooks.

So look what happened. Tariffs “protected” American steel producers from foreign imports. But the tariffs also threatened global growth and steel demand. The tariffs hurt US companies more than they helped.

But it doesn’t stop with the steel industry. Bloomberg interviewed a trader who described the problem well.

“All of these trade battles that are going on are creating uncertainty for everyone at every level, all the way from the manufacturer down to the end consumer,” Randy Frederick, a vice president of trading and derivatives who helps oversee $3.7 trillion in assets at Charles Schwab in Austin, Texas, said in a telephone interview. “And uncertainty always breeds complacency, which ultimately is going to stifle demand for things like steel.”

This is what I keep saying. Tariffs aren’t the main problem. They’re not great, but businesses could adapt.

The real problem is no one knows what to expect next. This makes business planning impossible and, as that trader says, stifles demand.

Wide Latitude

In a rational world, the powers-that-be would see their strategy isn’t achieving the desired results and try something different. Unfortunately, it isn’t happening that way. More like the opposite.

The conservative billionaire Koch brothers—who support Trump on many other issues—have been using their political network to argue against the trade war. Last week, they admitted it isn’t working.

“The argument that, you know, the tariffs are adding a couple thousand dollars to the pickup truck that you’re buying is not persuasive,” a senior Koch official, who declined to be named, said during a briefing in New York. “It doesn’t penetrate with the people that are willing to go along with the argument that you have to punish China.” (CNBC)

That’s another way of saying the Trump base is all aboard. Other surveys show even suffering Midwest farmers often still support agricultural tariffs.

As I’ve said before, shared adversity tends to unify people, especially when they have a charismatic leader like Trump. So the base is rock-solid.

But you know who else will be rock-solid behind Trump’s 2020 campaign? The same Koch brothers who hate his tariffs.

Think about it. Are the Kochs or other conservative activists going to support a Democrat against Trump? No way.

Nor will most business leaders. They may dislike some Trump policies, but they have even more issues with any Democrat. As sometimes happens (tragically) with abused spouses, they will stay with Trump no matter how badly he hurts them.

This gives Trump wide latitude to do whatever he wants, and a trade war is clearly high on his list.

Eventually, this will push the US economy into recession, which probably won’t help Trump. But he’s ready for that, too. He will blame recession on Jerome Powell and the Federal Reserve.

Very little can stop this trade war, and it will probably get worse. That means business confidence will keep falling. Recession will follow.

Some folks know this and think they can handle it. We will know soon if they’re right.

#WhatYouMissed On RIA: Week Of 09-30-19

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

The Week In Blogs


The Best Of “The Lance Roberts Show”

Video Of The Week

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!

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

ESG Investing & The Quest For Sustainability

Almost anywhere you look there is commentary on sustainability. What used to be known fairly narrowly as “socially responsible investing” has now grown into a broad effort captured by the acronym “ESG” (environmental, social, governance). These issues range from climate change to sustainable food production to better versions of capitalism.

It is easy to infer from all this coverage that sustainability is something we should be talking about. It is far less clear, however, what we should actually be doing about it. The bad news is that some sustainable efforts are ineffective and even harmful. The good news is that the dialogue on sustainability is maturing in meaningful ways.

In August the Business Roundtable made waves when it released a statement indicating that the purpose of a corporation is to benefit all stakeholders, including customers, employees, suppliers, communities and shareholders. Signed by 181 CEOs, this statement marked a break from the past and made a lot of headlines.

Interestingly, several other organizations have also recently upped the ante on highlighting various sustainability issues. The Economist recently published its “Climate” issue under the pretense that “Climate change touches everything this newspaper reports on.” The Financial Times recently heralded a “New Agenda” which explicitly responds to the fact that the “liberal capitalist model” has “come under strain.” Advisor Perspectives recently sent out its “most read commentaries on ESG, SRI and impact investing.”

As if there weren’t already enough dots to connect, Ben Hunt and Rusty Guinn from Epsilon Theory recently identified the top six articles from the past 24 hours [as of September 23, 2019] that were the “most on-narrative (i.e. interconnected and central) stories in financial media. Those articles were: 

  • “Danish pensions to put $50 billion into green investments” [Reuters] 
  • “Gender diversity pays off: A new Stanford study finds equitable hiring boosts companies’ stock prices” [Business Insider] 
  • “Aluminium industry must commit to carbon reductions” [Business Insider] 
  • “Daughter of Ebony founder resigns from spot on magazine’s board” [Chicago Tribune] 
  • “At Amazon, workers push climate policy; Bezos sets net-zero carbon emission goals, but employees want more urgent action.” [Vox]
  • “General Motors Shares Extend Declines As Nationwide UAW Strike Hits Day Five” [The Street]

The narrative is clear: Sustainability issues are front-and-center. Guinn offers a couple of hypotheses as to why this is happening now: 

“We have commented before that ESG specifically tends to follow the fortunes of the market. It usually becomes a cohesive, high attention narrative when times are good and investors feel confident. When markets decline and perceived risk rises, ESG issues tend to fade from investors’ attention.

Independent of ESG investing as a topic in itself, however, the politics of climate, inequality and identity that we have shown to be dominant in electoral coverage are becoming similarly prominent in financial markets coverage.”

Another hypothesis seems to suggest, shall we say, a more sustainable explanation. An FT report on “The limits of the pursuit of profit” notes:

“Prof Ioannou’s latest research, with George Serafeim of Harvard Business School, shows the adoption of common sustainability practices is increasingly a survival issue. ‘The ones that fall behind in adopting best practices are the ones whose performance gets hit in the long run,’ he says.” The article continues, “Chief executives face the threat that if they fail — or if they only apply a veneer of stakeholder concern — they will be accused of ‘purpose-washing’, leading to further cynicism about their motives.”

While this research is encouraging, the reality on the ground is often less straightforward. The very same FT article, which highlighted Danone as a positive example of sustainable approaches, admitted,

It is shareholders, not other stakeholders, who are most in need of convincing with regard to Danone’s good intentions.

The FT also noted the challenge of “persuading asset owners to approach investment differently” when it reported, What is blindingly obvious is that it is very hard for company bosses to take such steps if investors are pulling very strongly in the opposite direction.

What is also blindingly obvious is that many efforts to address sustainability simply do not work. The FT identified Vanguard funds that were designed to “invest in companies with strong environmental, social and governance records” but which also happened to own “A private prison operator, a gun manufacturer and Rupert Murdoch’s media groups.” Vanguard claimed, “the companies were included ‘erroneously’ in an ESG index designed by FTSE Russell”, but regardless of the cause, the funds failed to do the one thing they were designed to do.

Nor have quantitative efforts produced much headway. The FT reports on efforts to “find a so-called ESG ‘factor’ — a systematic, repeatable way of identifying such stocks which rivals would find hard to copy.” Despite the potential that “The rewards for the fund managers could be huge”, the truth is that “It’s extremely hard to find that factor”.

The silver lining in such failures is that they are leading to more robust and constructive discussions around the relevant issues. “The limits of the pursuit of profit” story in the FT, for example, highlights the fundamental definitional issues of sustainable investing. While a wealthy individual may care relatively more about the “impact” of an investment than the ultimate financial returns, a pension fund has an obligation to produce adequate returns for their beneficiaries. Paul Singer, founder of activist hedge fund Elliott Management, said that earning a rate of return for pension funds and charities “is itself a social good — a very high one”. He’s right.

Not only can the “investment” aspect be understated in ESG efforts, but the “sustainable” element can be overstated. The story also reveals the potentially negative consequences of simple ESG ratings which can be “based on incomplete information, public shaming and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion”. The worst part is that the consequences of such misguided efforts “ultimately fall on real people”.

Bill Gates also recently chimed in on the debate by challenging a common practice among sustainability practitioners. He criticized efforts at divestment saying they “won’t change anything“. Gates explained, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline.” As a result, Gates concluded, “Climate activists are wasting their time lobbying investors to ditch fossil fuel stocks.”

Helpfully, he offers an alternative approach that he thinks has greater potential to make a difference:

“Those who want to change the world would do better to put their money and energy behind the disruptive technologies that slow carbon emissions and help people adapt to a warming world”.

Indeed, Gates is among a cadre of wealthy businesspeople who are thoughtfully considering what types of actions can really promote sustainability and really make money. The Economist’s “Climate” issue describes them as people who are “putting serious money into climate-friendly investments – and expect serious returns”. According to the piece, “All want to do good by the planet. Most expect to do well for themselves.”

In addition, Sarah Kaplan of Toronto’s Rotman School of Management describes a model by which business leaders can succeed with sustainable investment.

“One way to survive,” she says, “is for companies that have already pursued the business case for responsible action, to ‘innovate around trade-offs’.”

“One example is how Nike, attacked over its suppliers’ working conditions in the 1990s, not only improved standards but developed an entirely new manufacturing process to take pressure off the old supply chain. The US sportswear company’s Flyknit ‘woven’ shoe was one result.”

This course is a noticeable break from the modus operandi of many global companies. When confronted with such challenges it is frequently the case that the problem is solved by some combination of moving to a jurisdiction with less scrutiny, leveraging the company’s power and authority, and simply paying penalties if they are not excessive. In other words, a lot of people get paid good money to dodge the spirit, if not the letter, of the law.

Looking across the realm of sustainable investing today reveals some striking features. One is that a lot of shortcomings regarding sustainability are related to deficiencies in enforcement. Why would a company spend a lot of money upfront to avoid penalties if the penalties are so small as to be trivial and the chances of being penalized are slim? It is a real business tradeoff.

Further, it is often the case that rules don’t even need to be broken if regulations can be cleverly arbitraged. Too often, regulators and enforcement authorities are no match for their corporate counterparts. Sustainability could be greatly improved simply by leveling this playing field. Penalties and enforcement reflect society’s values. If they are substantive enough, they will incentivize compliance.

Another striking aspect of the sustainability movement is just how noncommittal many consumers are. Many people express opinions, and many people take some action, but actual consumer behavior is not matching the sustainability preferences being expressed.

A recent article in The Economist provides a possible explanation, “Many consumers neither read nor understand the contracts they sign”, even when it is clearly in their interest to do so. While the research was conducted primarily in regard to the “terms and conditions” of apps and online services, the behavioral phenomenon is broadly applicable. Many consumers simply don’t want to exert the effort to ensure better outcomes.

Researchers “concluded that savers doubted the benefits of shopping around and were put off by the perceived inconvenience.” The Economist suggested, “‘Caveat emptor’, it seems, may apply in principle but not in practice.”

This results in any number of interesting paradoxes. For example, if a big beverage company packages soda in a can with a liner containing BPA, that company is often targeted for its unfriendly business practices. If, however, a local craft brewer packages its products in the same can, is lauded for its “sustainable” practices and the BPA is conveniently overlooked. Nobody even asks the question even though it is exactly the same practice.

In addition to paradoxes, the incomplete engagement by consumers creates a real hurdle for well-intentioned sustainability efforts to overcome. You may have great ideas and you may be right it the long run, but if consumers don’t vote for you by way of their purchase decisions, none of it really matters. 

This is a shame because the threats of unsustainable practices are becoming very real. Gillian Tett reports in the FT that an information asymmetry regarding climate change appears to be widening. 

Jupiter, a climate advisory group that provides modelling for banks and insurance companies, “forecasts a tripling of losses from flood damage in the next couple of decades.” The company arrives at its conclusion by evaluating the type of residential mortgage exposure of a real bank. This is consistent with work done by McKinsey:

“Coastal regions such as Florida … could deliver asset price shocks for lenders, insurers and homeowners. So, too, in places such as Spain, southern France, Greece and Italy which are projected to see eye-popping increases in drought.”

Further, when the information asymmetry narrows, it could be punishing for many homeowners: “while American households typically use 30-year mortgages to buy properties, the price of insurance is reset annually.”

The same information asymmetries exist in the markets for financial assets as well. According to the entity Principles for Responsible Investment (which is supported by the UN), “financial markets today have not adequately priced-in the likely near-term policy response to climate change”. Tett voices her concern about the likely consequences:

“History shows that extreme information asymmetries produce market shocks. That’s what happened in the subprime mortgage saga. It is hard to believe it will be any different with climate change.”

Given such risks, what can investors, leaders, and consumers do to overcome inertia and narrow the information asymmetries? Dave Stangis, ESG expert and former CSO of Campbell Soup, provides a useful perspective:

“I always sense the macro challenge is trying to find the right language to describe what so many people are talking/writing about.  I do believe the expectations of good business have shifted and we see many examples of business done right (not just activities or initiatives) can deliver measurable benefit to shareowners, execs, other employees and customers/consumers.  The debate seems centered around what is that called when it works and how do we describe when it misses the mark – or when it is something else (negative screening).”

In other words, don’t get hung up on the language and miss the forest for the trees. Sure, there are frivolous and virtue signaling sustainability efforts, and sure, there are business practices that extract disproportionate benefits from society. But those can all be identified as such and avoided.

On the other hand, there are real efforts to innovate around tradeoffs. Properly considered, these can be characterized as something like continuous improvement in capitalism. It takes ongoing effort, thought, and research to differentiate between “business done right” and business “missing the mark”, but expectations are shifting and the benefits can be substantial. Conversely, the costs of failing to do so are rising every day.

Mauldin: Economics Is Like Quantum Physics

I often say a writer is nothing without readers. I am blessed to have some of the world’s greatest. Your feedback never fails to inspire and enlighten me.

My last week’s That Time Keynes Had a Point letter brought many more comments than usual. Apparently Keynes is still provocative 73 years after his death, no matter what you say about him.

But my real point was about the twisted economic thought that is having dangerous effects on us all. And we can’t blame it just on Keynes.

Today I want to share some of the feedback I received, add a few thoughts, and then show you some real-world consequences that are only getting worse. But first, let me wax philosophic for a minute.

Economic Dispute

This economic dispute is, at its core, a very old argument about how we understand reality. The ancient Greek philosopher Aristotle might agree with some of today’s economists. He taught deductive reasoning with the classic syllogism:

  • All men are mortal
  • Socrates is a man
  • Therefore, Socrates is mortal

In other words, Aristotle said to move from general principles to specific conclusions. That’s what the bulk of modern macroeconomics does, using their (much more elaborate) models to deduce the “best” policy choices.

Centuries later, Sir Francis Bacon turned Aristotle upside down when he advocated inductive reasoning.

Rather than start with broad principles and apply them everywhere, he said to presuppose nothing, observe events and move from specific to general as you gather more observations… what we now call the “scientific method.”

Today’s economists may think that’s what they are doing, but they often aren’t. They begin with models that purport to include all the important variables, then fit facts into the model. When the facts don’t fit, they look for new ones, never considering that the model itself may be flawed.

Furthermore, as I have shown time and time again, they assume away reality in order to construct models that are in “equilibrium” with themselves. This is supposed to give us insight into the reality that has been assumed away.

That process isn’t necessarily wrong, but it’s not science. It is the opposite of science. Bacon would be horrified to see this. He tried to show the world a better way and now, centuries later, some of our most learned professors still don’t get it.

This is sadly not just a philosophical argument. It has real consequences for real people, including you and me.

Uncertainty Principle

Speaking of science, I received this note from an actual scientist (i.e., not an economist).

“Dear John, having been an avid reader of your articles for many years now I wanted to write to say how much I tend to agree with your commentary, and in particular how much I enjoyed this week’s article. I’d like to make a couple of comments about this week’s material.

Firstly, reference was made to comparing economics with physics, and how economists suffer from “physics envy” (I should say that I have a PhD in physics from Oxford and subsequently worked as a physicist at the European Center for Nuclear Physics Research (CERN) in Geneva, Switzerland, although I left behind my career as a physicist a long time ago.)

Economies and financial markets are much more like the world of quantum mechanics than the world of classical physics. In classical physics there is complete independence between the observer and the system under observation. However, in the realms of quantum mechanics, the systems under observation are so small that the act of observation disturbs the system itself, described by Heisenberg’s Uncertainty Principle.

This situation is similar to that of financial markets, where the actions of market players is not separate from market outcomes; rather the actions of market players PRODUCE the market outcomes.

Betting on financial markets is different from betting on the outcome of an independent event, such as the outcome of a horse race or a football match. The latter are akin to classical physics where there is independence between observer and observed. Whilst actions in the betting market change the odds on which horse/team is favored to win, they don’t impact the outcome of the event, which is rather determined by the best horse/team on the day.” —Paul Shotton

Thank you, Paul, for pointing out this important distinction. I can’t pretend to understand quantum mechanics but your point about independent observation is profound.

Economists don’t just build models; they (and all of us) are parts of the model. We are the economy and the economy is us. While discussing it, we also affect it.

George Soros calls this the principle of reflexivity, the idea that a two-way feedback loop exists in which investors’ perceptions affect that environment, which in turn changes investor perceptions. (Here’s his essay explaining more.)

That means these macroeconomic models, which with their Greek letters and complex equations look very scientific to a layperson, are often at odds with the scientific method.

You can’t conduct independent observations and experiments on an entire economy. That doesn’t render the models completely useless, but greatly limits them.

Borrowing from Clint Eastwood, this might be fine if those who use these models would respect the limitations. All too often, they don’t. And this is where it gets a little complicated.

I confess that I use models. I build them and work with others who build even better ones. Models can help inform us of potential outcomes and better understand risk and reward.

But there are clearly inherent limitations on using historical or theoretical observations to predict future results.

(Dis) Equilibrium

Here are a couple more letters, taking issue with my comments on equilibrium.

“Just to clarify… Even if the economy can be modeled in some sense by a sand pile that will ultimately collapse, that does not mean that the economy is, at any point in time, not in equilibrium. In fact, it must be in equilibrium in order to form the sand pile! You could argue that the equilibrium is “unstable,” perhaps, but it is certainly a (possibly unstable) equilibrium.” —John Bruch

***

“John, I’ve been a reader for years and love your letter. But your comment today is over the top;

The entire premise of equilibrium economics is false. Efficient market hypothesis is over the top but the premise of equilibrium is perfectly modeled in your sand pile letter. Cycles have always existed and always will exist.

Natural market forces will always move markets towards equilibrium but government interference slows the process making the sand pile grow in size and magnitude. To say that the principle of equilibrium is false is just ignoring reality.

The economy is like our forests. When a fire starts in the forest you let it burn so that nature’s cycle can run its course. If you keep putting out the fire you build excess fuel and then at some point you have a catastrophic fire that no humans can control. Mother Nature eventually steps in and puts out the fire and puts life back into equilibrium.

I agree that we need to rethink economics. But the principle of equilibrium, however short lived that moment in time is, is a sure reality.” —Dennis Carver

John and Dennis raise an interesting question. The mere fact that the “sand pile” exists intact for some period of time means that equilibrium exists for that interval. Fair enough. The grains of sand do, in fact, line up so that they don’t collapse.

But we are constantly adding more sand and each additional grain changes the equilibrium. The previous equilibrium ends at that point, having been so brief as to be meaningless.

Eventually a grain of sand will create an unstable equilibrium, causing the pile to partially or completely collapse (and then be in equilibrium once again). So if no single state of equilibrium can exist for more than an instant, I would argue it’s not really “equilibrium” for any practical purpose. We can’t rely on it to continue. Every moment brings a new, unknown situation.

Let’s look at it another way. The sandpile model assumes there will be moments of instability. In economic terms, we are experiencing transitory equilibrium. The sandpile model is inherently unstable, a perfect example of Minsky’s Financial Instability Hypothesis: Stability leads to instability and the longer the period of stability, the greater the instability will be at the end.

(Nassim Taleb’s Antifragility Principle is important to understand when we think about equilibrium, or rather the lack of it. His book Antifragile is important and you should at least read the first half.)

My old friend and early economics mentor Dr. Gary North sees this idea of “equilibrium” as not just wrong, but downright evil.

In his 1963 textbook for upper division economics students, [Israel] Kirzner wrote about the assumptions of economists regarding the use of equilibrium as an explanatory model. They use it to describe the system of feedback that the price system provides the market place. “The state of equilibrium should be looked upon as an imaginary situation where there is a complete dovetailing of the decisions made by all the participating individuals.”

This means not only perfect knowledge of available economic opportunities, but also men’s universal willingness to cooperate with each other. In short, it conceives of men as angels in heaven, with fallen angels having conveniently departed for hell and its constant disequilibrium, where totalitarian central power is needed to co-ordinate their efforts. “A market that is not in equilibrium should be looked upon as reflecting a discordancy between the various decisions being made.”

The heart of free market economic analysis is the concept of monetary profits and losses as feedback devices that persuade people to cooperate with each other in order to increase their wealth. “But the theorist knows that the very fact of disequilibrium itself sets into motion forces that tend to bring about equilibrium (with respect to current market attitudes)” (Market Theory and the Price System, p. 23). Presumably, even devils cooperate on this basis. They, too, prefer profits to losses.

Biblically speaking, this theory of equilibrium is wrong. It is not just wrong; it is evil. It adopts the idea of man as God as its foremost conceptual tool to explain people’s economic behavior. It explains the market process as man’s move in the direction of divinity. Economists are not content to explain the price system as a useful arrangement that rewards people with accurate knowledge who voluntary cooperate with each other. They explain the economic progress of man and the improvement of man’s knowledge as a pathway to divinity, however hypothetical. The science of economics in its humanist framework rests on the divinization of man as a conceptual ideal.

Setting aside the theology, the point here is that economists assume human beings are perfectly rational and consistent, or at least wish to be. That’s what makes equilibrium possible.

But we know humans aren’t perfect or consistent. So how can we have equilibrium? We can’t, unless we assume markets are in equilibrium because they act in a manner we deem appropriate or ideal.

Insane Ideas

Again, this isn’t an academic argument. People who believe these ideas either hold seats of power or have influence on those who do. They truly think they can twist some knobs on their models and make everything better.

If we just had better monetary or fiscal policy, if the government could tax the right people and distribute the money correctly, everyone would be so much better off. And of course, their highly complex models and theories will conveniently lead to their desired political conclusions.

It is increasingly obvious that conventional monetary policy is useless now that rates have been so low for so long, and everyone believes they will remain low.

Nothing the central banks do incentivizes anyone to make immediate growth-generating decisions. If you need to borrow money, you likely did it long ago.

A new Deutsche Bank analysis says the major world economies now have government debt, on average, exceeding 70% of GDP, the highest peacetime level of the past 150 years.


Source: Financial Times

This is obviously unsustainable but the economics profession (and the bankers) desperately want to sustain it. With monetary tools no longer useful, they are turning to fiscal policy. Serious people are mapping strategies like helicopter money, debt monetization, MMT, and worse.

These all, in various ways, essentially say that government debt doesn’t matter, and in some cases we actually need more of it. Historically, the only way that can be right is if we are on the cusp of another WW2-like crisis.

This horrifying but well-researched Bloomberg article is chock full of links to insane ideas. Some look superficially attractive, especially to those unfamiliar with even basic economics. Many have familiar, heavyweight names attached to them. All have, to me at least, a whiff of desperation. They are frantic attempts to make the world stop spinning.

I don’t think these ideas will work. I think we are beyond the black hole’s event horizon. Bad things are going to happen, culminating in some kind of globally coordinated debt liquidation I have dubbed the Great Reset. I really see no other way out.

Every day brings more signs of the impending crisis. Duke University’s latest quarterly CFO survey found more than half of finance chiefs foresee a US recession before the 2020 election. Possibly worse, they project only a 1% increase in capital spending over the next 12 months.

An economy in which near-zero interest rates can’t spur more investment than that is an economy with serious problems. And I expect them to get worse, not better.

Furthermore, an increasing body of evidence says that increasing sovereign debt is a slow but inexorable drag on GDP. It is like the frog being boiled in water, but so slowly that we as citizens don’t really understand what is happening to us. We do sense something is wrong, though. Hence today’s worldwide populist movements.

The driver for 1930s populism was the Great Depression and unemployment. Now the impetus is rising debt and underemployment, with people unable to improve their lives as past generations did. Millions no longer expect to be better off economically than their parents. That frustration is sparking unproductive political partisanship and has the potential to bring political chaos as governments try to protect their own technology and businesses.

The world in general has clearly benefited from globalization and automation, but that is a hard argument to make as jobs disappear. And more jobs will disappear as technology increasingly lets businesses replace expensive humans with cheap robotics and algorithms. Sigh… I wish I had answers. Well, I do, but I don’t think they’ll going to get a great deal of traction.

This won’t be the end of the world. I really do think there are ways that you can properly position your portfolio and your personal life to not just survive but to thrive. We will get through it and be better on the other side. But it’s going to be a bumpy ride.


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.

Special Report: Market Review & Update 10-03-19

With the sell off this week, I have been getting a lot of emails asking if anything has changed technically. Normally, on Thursday, we produce a Long-Short Idea List. However, I wanted to use the opportunity today to update a few of the major markets and five sectors that warrant some attention.

Feel free to email me with any questions.

S&P 500 Index

  • We are still maintaining our core S&P 500 position as the market has not technically violated any support levels as of yet. However, it hasn’t been able to advance to new highs either.
  • Yesterday’s sell-off did NOT violate support, but is also NOT oversold as of yet, which suggests further downside is possible.
  • There is likely a tradeable opportunity approaching for a reflexive bounce given the depth of selling over the last couple of days. We will look to add a 2x long-S&P 500 to the long-short portfolio if the market looks like it is going to try and firm up.
  • Short-Term Positioning: Bullish
    • Last Week: Hold current core positions
    • This Week: Hold current core positions.
    • Stop-loss moved up to $282.50
    • Long-Term Positioning: Neutral due to valuations

S&P 600 Index (Small-Cap)

  • The sell-off was more brutal in small and mid-cap stocks as economic weakness hits smaller capitalization companies harder.
  • SLY had gotten overbought, and the sell-off has not retraced back to oversold as of yet.
  • The “buy signal” is still intact at the moment but the technical trend is terrible. If support is broken at $85, a retest of $82 is likely. Below that it gets ugly quickly.
  • 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 previously violated.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • MDY, like SLY, is technically not in great shape. Importantly, MDY has now failed at the top of the downtrend line.
  • While MDY registered a short-term “buy” signal, the inability to follow through is disappointing and a failure at the 200-dma will lead to a retest of previous lows.
  • We have no exposure to Mid-caps currently and the risk/reward of a trade setup really isn’t there.
  • Short-Term Positioning: Neutral
    • Last Week: No holding
    • This Week: No holding
  • Long-Term Positioning: Bearish

Emerging Markets

  • EEM continues to underperform. The sector did rally previously on hopes of a trade resolution, and the ECB cutting rates, but that rally is simply another rally in a long-term downtrend.
  • A sell signal has been triggered as well, but is trying to reverse.
  • Unfortunately, EEM failed at resistance, and has violated the 200-dma and support.
  • 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 remains in a downtrend, and failed at the downtrend resistance line.
  • While EFA has triggered a buy signal, the failure to advance keeps the market unattractive as a trading opportunity currently.
  • If the 200-dma is violated we will see a retest of previous lows.
  • 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

Basic Materials

  • “XLB remains confined to a very broad topping pattern currently BUT it continues to hold onto support at the 200-dma.
  • The sharp sell-off yesterday comes as data has begun to really address the economic weakness we have been forecasting for a while.
  • XLB is set to retest recent lows and the 200-dma. However, with multiple failures at recent highs, the risk/reward for a trade isn’t that appealing. This is particularly the case if economic data continues to weaken.
  • We are remaining underweight the sector for now, unless trade deal negotiations appear to be improving.
  • 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

Energy

  • Previoulsy, we discussed the surge in XLE due to the bombing in Saudi Arabia. That surge is over as oil prices have fully retraced the spike.
  • XLE broke below the test of the 200-dma and has now violated the support level we noted on Tuesday at $58. Next support is previous lows.
  • The “sell signal” was in the process of being reversed, but that failed as prices didn’t pick up.
  • While there is “value” in the sector, there is no need to rush into a position just yet. The right opportunity and timing will come, it just isn’t right now.
  • We were stopped out of our position previously.
  • Short-Term Positioning: Bearish
    • Last week: Stopped out.
    • This week: Stopped out.
    • No position currently
  • Long-Term Positioning: Bearish

Industrials

  • XLI failed at previous tops and has turned lower and broken through initial support.
  • XLI is not oversold which puts $72 as the next support level that must hold.
  • The recent buy signal is also at risk of reversing.
  • We reduced our risk to the sector after reaching our investment target. We have also adjusted 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” but that sector was unable to avoid the selloff yesterday.
  • XLK is reversing it’s short-term overbought condition but is getting close to reversing its current buy signal and uptrend line from the 2018 lows.
  • XLK held support at $75 previously, and needs to do so again or things could get dicey for the sector.
  • Short-Term Positioning: Bullish
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $75.00
  • Long-Term Positioning: Neutral

Staples

  • Defensive sectors took a hit yesterday along with everything else.
  • As noted previously, defensive sectors are an EXTREMELY crowded trade, and we suggested taking profits.
  • The “buy” signal (lower panel) is still in place but has been worked off to a good degree. Risk is clearly elevated.
  • We previously took profits in XLP last week and reduced our weighting from overweight. We will likely look to reduce further when opportunity presents itself.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $58
    • Long-Term Positioning: Bullish

Health Care

  • XLV remains on a sell signal but failed to hold support at previous lows.
  • XLV has been underperforming as of late and after reducing our position previously, we will look to reduce further if the next support levels are violated.
  • We continue to maintain a fairly tight stop for now.
  • Short-Term Positioning: Neutral
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss is at $86
    • Long-Term Positioning: Neutral

QE By Any Other Name

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

  1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
  2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

Selected Portfolio Position Review: 10-02-19

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

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

HOW TO READ THE CHARTS

There are four primary components to each chart:

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

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

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

I have been asked many questions lately about how to add positions that we currently own into the Equity Portfolio. The following 10-stocks are exhibiting traits which will allow additions to portfolios provided the specified criteria are met.

ABT – Abbott Laboratories

  • After taking profits out of the position twice previously, ABT has finally begun to correct back to trendline and important support.
  • ABT is currently on a “sell signal” and is working off the overbought condition.
  • Buy 1/2 position at a target buy price of $80.
  • Place a stop on the initial position at $77.50
  • Buy the second 1/2 position at $85.
  • Place a stop on the whole position at $80.

BA – Boeing Corp.

  • As noted last week,
    • “We bought 1/2 position in BA right after the 737MAX crash occurred. Since then BA has continued to consolidate and build a strong base of support. The recent breakout of the consolidation is very encouraging and with a triggering of the buy signal we are going to look to add to our position.”
  • We did add to the position last week.
  • Positions can be added at current levels down to $350
  • Stop is at $330.

DUK – Duke Energy Corp.

  • We took profits in DUK previously, but just recently, after a fairly long consolidation, DUK broke out and has been on a tear.
  • DUK is overbought, but the buy signal has only recently turned back up.
  • Buy any correction that reduces the price back into the low 90’s but maintains above the previous breakout level at $90
  • Stop loss is moved up to $88

DOV – Dover Corp.

  • DOV has been consolidating its previous advance over the course of this year.
  • If a “trade deal” gets done we could well see this position move higher.
  • Wait for the “buy signal” to be registered before adding a position.
  • Buy level is $95-97.50
  • Stop loss is moved up to support at $87.50

NSC – Norfolk Southern Corp.

  • NSC has been a great performer and after taking profits, we have been looking for an entry opportunity. We are now getting there.
  • NSC is oversold and the “sell signal” is deeply oversold with NSC holding support following the recent sell-off.
  • This is an ideal setup to add to our holdings and we would like to see the “sell signal” begin to close the gap to confirm our entry point. A little more patience here.
  • Stop-loss moved up to $170

JNJ – Johnson and Johnson

  • We previously added to our position in JNJ at these lower levels and over the last couple of weeks the stock has begun to turn up.
  • The stock is on a deeply oversold sell signal, so it will likely take little to get the stock moving higher soon. Fundamentals remain very solid and the position held the longer-term uptrend line.
  • Buy at current levels.
  • Stop loss is moved up to $125

NLY – Annaly Capital Management

This image has an empty alt attribute; its file name is NLY.png
  • As noted previously, we added to “yield curve steepener” positions to our portfolios. NLY and AGNC are constructed in a manner that benefit from a steeper yield curve.
  • The recent flattening in the yield curve and inversion, pulled the positions lower but held our stop-loss levels and are now deeply oversold.
  • We are looking for the right setup to continue building out these positions which also carry a hefty yield of 10%+.
  • We will add to our holdings as soon as we see a triggering of the “buy signal.”
  • Stop-loss is set at $7.40

AGNC – AGNC Investment Corp.

  • Same as above, AGNC is the second position in our “steepener” duo.
  • We are looking to add to these positions opportunistically as the yield curve steepens.
  • Due to the rather large yields we are using wider stop-losses on both positions. We are looking for the “buy signal” to turn positive.
  • Stop-loss is set at $13.00

HCA – HCA HealthCare

  • HCA has been under pressure due to concerns of Democratic candidates proposals for “Medicare for all.” Despite their promises, this is a “pipe dream” at best.
  • The correction remains in process and a sell signal has been triggered but that signal is deeply oversold.
  • Buy 1/2 position at current levels.
  • Look for a reversal to a “buy signal” to add the second 1/2 of your position. This is not unusual for the stock so we are now looking for V to hold support to add back into our position.
  • Stop loss is at $115

VZ – Verizon Communications

  • VZ has been in a long-term consolidation and just recently broke out and triggered a deeply oversold buy signal.
  • Buy a position between $59-60
  • Stop loss remains at $57

GDP Estimates Collapse After Dismal ISM Report

GDPNow and other GDP estimates took a dive today on weaker than expected manufacturing reports.

The GDPNow forecast for third-quarter GDP fell to 1.8% today on weak economic reports.

Gold and Treasuries Rally

GDP Estimates

Oxford Estimate

Real Final Sales

The important number is “Real Final Sales“.

That’s the bottom line estimate for the economy. The rest is inventory adjustment which nets to zero over time.

The GDPNow estimate of Real Final Sales fell to 1.6% today, a new low for the series. It’s near, and possibly below the economic stall point.

Also, please see my report today: Manufacturing ISM Worst Since 2009 on Severe Contraction of Export Orders.

A Somewhat Bullish Market Commentary

Let’s just put the lead where it should be. Stocks are resilient and short-term dip notwithstanding; they are likely to be higher before the end of the year.

Here’s the evidence in bullet form.

  • The NYSE advance/decline is hovering at all-time highs.
  • Three-month bill yields are dropping hard. The Fed will cut rates one more time this year.
  • Financials are holding tight near resistance thanks to the “uninverting” of the yield curve. You can argue with me on that point later.
  • Trade deals are getting done (Japan) so China will feel the heat. I do not buy the argument that the Chinese are waiting out the current administration (i.e. impeachment or failed reelection). They know better than that.
  • Sector rotation is a healthy sign. Chart below of value and growth.
  • Retail is not dead. Chart below.

Of course, it’s not all great. I’d like to see more stocks hitting new highs and small caps, which started to perk up nicely, have eased back.

Now let’s talk about those headlines.

  • Impeachment inquiry. This may or may not hurt the orange fella but it is likely to seal the deal for Elizabeth Warren on the blue side. Wall Street has already vocalized that it will crumble for President Warren.
  • Softening economic numbers. Nothing stays that good forever. The U.S. is still the best game in town. Why else is the U.S. dollar at a 2 ½ -year high? Yeah, we’ve got positive bond yields but we’ve also got a growing economy. By the way, the UUP bullish dollar ETF is at an 11-year high.
  • What the heck happened to gold? After a major, long-term upside breakout in June and a nice rally to resistance in August, it is now overstaying its welcome as a correcting market. That pesky dollar, right? Well, gold priced in euros has been flat for more than a month, too.
  • And while I’m using such foul language, what the heck happened to bitcoin? It was supposed to get a boost from all this economic turmoil. And when I say foul language, I mean bitcoin.

So, unless something big and bad happens, I’m still a stock market fan.

In the spirit of Warner Wolf, CMT, let’s go to the charts.

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Important support for big cap indices.

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Important support for the Transports (yes, this is a chart of DJTA, not what eSignal labeled it).

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Rotation value from growth.

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Retail ice age seems to be enjoying a little market climate change.

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There you go. A new low.

Your move Chairman Powell.

Portfolio Returns Are The Least Of Your Worries

At RIA – through the blog and in meetings with clients and readers who require objective investment and planning guidance, our team has been clear about our view along with the analysis to back it up: Investors are going to experience future real portfolio returns which will rival the lowest experienced since 1966-1982. 

It’s not that the market as represented by the S&P performed badly through through that cycle; inflation was the household wealth nemesis which dramatically eroded real or inflation-adjusted returns. Back then, households in general were in healthy fiscal shape I believe, due to several reasons – Personal savings rates – think a consistent 10-14% of household incomes saved every year, strong wage growth which I surmise was due primarily to the proliferation of unions, including public sector unions. Heck, I lived through the experience in the 1970s as I watched my grandparents – both janitors for Brooklyn, New York public schools, own a home, new car every few years, and save for retirement – all at the same time!

In addition, the wide-scale shift to globalization didn’t accelerate until the 1980s which meant private-sector workers were able to command attractive wages. Last, personal fiscal responsibility was prevalent as the depression-era mindset impacted permanently a generation to save, abhor big debt and live below or  well within their means.

It was indeed a frustrating time to be invested in variable assets – crippling inflation, bonds performing poorly and real returns on stocks at or close to zero. The cycle went on for so long that in August 1979, BusinessWeek Magazine declared the ‘death of equities.’  At the beginning of 1982, the price/earnings of the S&P 500 was 7.73. The lowest since 1918.

Over the last decade, it’s been a fun ride for stock and bond investors. Complacency has ruled. Markets have moved higher with infrequent periods of correction.

Change is coming.

I believe we’re due for another cycle of stock market stagnation due to a Great Financial Suppression which began after the financial crisis and continues today. Since the Great Recession, global GDP has remained below 3% a year for most of the period. 

The Great Financial Suppression comes in the form of: 1. lower household incomes due to returning wage stagnation and eventually, higher taxes, 2. suppression of risk asset returns due to overwhelming government debt coupled with irresponsible central bank monetary policy manipulation, 3. stretched market valuations, 4. younger generations such as Gen X and Z who favor smaller households (less or no children), small homes and less material wealth. In other words, it’ll be a global economy – just not so grand.

Wait, Rich – Hasn’t wage growth improved? In the short term, yes. However, unless global economies structurally reform, don’t expect the party to last. Negative and sustained low interest rates are a sign of structural problems that cannot be rectified through monetary policy; global central banks for some reason, have been given the responsibility to employ blunt instruments as the sole method to fix broken economic engines. 

Per a recent analysis by Daniel Aaronson, vice president and director of microeconomic research, Luojia Hu, senior economist and research advisor, and Aastha Rajan, research assistant at the Federal Reserve Bank of Chicago:

“Real wage growth has come in low during this expansion, relative to historic relationships between labor market conditions and real wage growth. That pattern holds for women in nearly every age-education group, with particularly large gaps among college-educated women. For men, there is a striking dichotomy by education. Like college-educated women, college-educated men have experienced wage growth well below what we would have expected given pre-2008 relationships; this is especially true for college-educated men aged 45–69. “

If  you’re retired or looking to be within 3-5 years, there are going to be equally bigger concerns to face in addition to anemic portfolio returns.

Continued erosion of cost-of-living adjustments for America’s pension – Social Security.

Based on CPI-W so far, (September’s inflation numbers obviously still pending), the Social Security cost-of-living adjustment for next year will likely be half or less than it is today. We may be talking a paltry 1.6% in 2020. To put it in perspective, Social Security retirement benefits average roughly $1,400 a month; the estimated COLA would add $22.40 a month. The monthly Medicare Part B base premium is estimated to increase by $8.80 to $144.30 next year. Social Security recipients who have Medicare Part B premiums subtracted from their payments would net a whopping $13.60 a month.

Medigap and health-care cost inflation twice the national average or greater.

HealthView Services is a company that provides healthcare projection analysis and tools to the financial services industry. The organization draws upon a database of 530 million medical cases, longevity and government statistics to create their projections. They estimate that the total lifetime healthcare costs (which include premiums for Medicare, supplemental insurance, prescription drug coverage,) for a healthy 65-year-old couple retiring this year are projected to be $387,644 in today’s dollars assuming the Mr. lives 22 years and Mrs. – 24. Health-care inflation is averaging roughly 4.4% a year; we use a 4.5% inflation rate in our planning at RIA. Medigap or supplemental insurance coverage which is offered by private insurance companies has increased consistently by more than 6% a year, according to The Senior Citizens League.

Where do you believe tax rates are headed in the future? 

Income taxes will place growing pressure on portfolio depletion – unless you believe income tax rates are headed lower. Please let me know if you believe tax rates are going to be lower in the future. I’d love to hear the rationale. The financial services industry has done an outstanding job brainwashing a nation of investors to direct every long-term investment dollar into pre-tax accounts. Tax-deferred compounding and the search for methods to cut taxes today may have serious repercussions on the quality of life tomorrow when you’re retired and no longer at career earnings machine.

Oh, I know. You’ve been told that your tax rate will drop in retirement. Another blanket myth the industry irresponsibly spouts; who is going to pay the price for it?

You are.

Granted, for some retirees, taxes will fall. However, our planners witness firsthand, the long-term financial damage of sheltering every retirement dollar in pre-tax accounts and the negative impact of ordinary income taxes on distributions.

Nobody knows for certain where tax rates are going; although I’ll make a solid guess (again), that future rates must move higher due to fixes required to entitlements such as Medicare along with other rising costs of an aging population. When the taxation of Social Security retirement benefits is considered, there’s a high probability that the ordinary income tax distributions from pre-tax accounts are going to generate an additional tax burden that rarely gets considered.

A married couple filing jointly with provisional income (a convoluted mix of ordinary income, tax-exempt income & ½ Social Security benefits), within the threshold amounts $32,000-$44,000, must add to gross income the lesser of 50% of Social Security benefits or the amount by which provisional income exceeds the threshold amount. Provisional income over $44,000 raises the percentage to 85%. Retirees must pay attention to the marginal tax rate danger zone where Social Security benefits are not fully taxed at 85% yet provisional income is high enough to trigger additional tax.

A marginal tax rate danger zone is the point where each additional income dollar has the potential to be taxed at $1.50 or $1.85. For example, if married filing jointly, the 12% marginal tax bracket threshold is $78,950. However, depending on Social Security income received, (the average benefit is $33,456), a retiree can experience a tax rate as high as 22% on each additional dollar above Social Security provisional thresholds.

Per CFP Elaine Floyd’s tremendous work examining this insidious bracket creep, $30,000 in annual social security income along with $17,000-$59,000 in modified adjusted gross income (not counting Social Security), can cause your marginal income tax rate to increase to as much as 22%. Roth accounts being 100% tax free on withdrawals, do not get added to the provisional income equation (even though tax-exempt or municipal bond income does!).

A retiree may delay the receipt of Social Security benefits until age 70. This decision will lead to greater lifetime income due to the delayed 8% annual retirement credits which accrue every month from FRA or full retirement age until age 70. Concurrently, a recipient can reduce a future tax burden on benefits by drawing down an IRA or 401(k) account to fund retirement living expenses.

Currently, we plan for most clients to initiate annual surgical Roth conversions along with coordination of distributions for living expenses to accelerate the reduction of IRA or 401(k) balances prior to mandatory distributions at age 70 ½. It’s important that your financial partner and tax advisor work together to ensure that the upper limits of your personal tax rate aren’t exceeded. 

For example, if you and your spouse require $4,000 a month to meet living expenses, even with taxes withheld there’s still ‘bandwidth’ in the 12% bracket to complete a surgical Roth conversion. You want to make sure you have enough cash outside your IRA to pay taxes on conversion dollars. 

If you follow a ‘Pay Yourself First,’ strategy, in almost every case a Roth is a better choice. I’m not concerned about your current tax bracket; I’m worried about your possible tax implications in retirement.

I care about how you’re going to gain more consumption dollars in retirement and the impact of taxation on Social Security benefits. John Beshears a behavioral economist and assistant professor of business administration at Harvard Business School in a study – “Does Front-Loading Taxation Increase Savings?: Evidence from Roth 401k Introductions,” along with co-authors, outlines that plan participants who place their retirement savings on auto-pilot and direct a percentage of gross income, say 10%, into a Roth vs. a traditional pre-tax 401k, will wind up with more dollars to spend in retirement.

 It’s rare when a financial rule-of-thumb like ‘pay yourself first,’ is a truly a benefit. And you don’t need to do much to receive it! The reason the strategy works is front loading of taxes. In other words, sacrificing tax savings today (when working and paying the taxes isn’t as much of a burden as it would be in retirement when earning power drops dramatically), and failing to adjust the percentage of auto-pilot savings to compensate for the current tax impact of switching from pre-tax to Roth, allows for greater future consumption dollars. 

From Lauren Lyons Cole Business Insider article on the study:

“If a worker saves $5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $120,000 in spending power, which a life annuity will translate into about $700 a month in extra spending.” John Beshears.

Taxes are an important component of net investment return – Taxes, fees, along with disappointing future portfolio returns are going to force retirees to closely re-examine their lifestyles and initiate big changes whether they want to or not.

Pre-retirees must prepare to work longer, save more and consider a dramatic reinvention of their retirement lifestyles.

Start now to prepare for reality.

If you need a roadmap, we’re here to assist.

S&P 500 Monthly Valuation & Analysis Review – 10-1-19

J. Brett Freeze, CFA, founder of Global Technical Analysis. Each month Brett will provide you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. If you are interested in learning more about their services, please connect with them.


Cartography Corner – October 2019

J. Brett Freeze and his firm Global Technical Analysis (GTA) provides RIA Pro subscribers Cartography Corner on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework. We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

GTA presents their monthly analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


A Review of September

U.S. Treasury Bond Futures

We begin with a review of U.S. Treasury Bond Futures (USZ9) during September 2019. In our September 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for September are:

  • M4         181-00
  • M1         176-26
  • M3         174-29
  • PMH       166-30
  • Close        165-08
  • MTrend    157-17
  • M2         157-02             
  • PML        154-31                          
  • M5            152-28

Active traders can use 166-30 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

In our September edition, we anticipated weakness and cautioned, “Short-time-period-focused market participants. . . Caveat Emptor.”  Figure 1 below displays the daily price action for September 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first nine trading sessions were spent with bonds descending in price by seven points and twenty-two thirty seconds.  Ours was a most timely warning. 

Astute readers will notice that the low price of the month was realized at the price of 157 18/32.  That price was one tick above September’s Monthly Trend level of 157 17/32.  Monthly Trend was also the first monthly support level offered by our analysis.   Another prime example of the importance of Monthly Trend as a significant pivot level.

The final eleven trading sessions were spent with bonds retracing as much as 75% of the initial decline.

Active traders following our analysis had the opportunity to capture the entire trade down, which equated to a $7,687.50 profit per contract.  Once Monthly Trend held, drawing from their understanding of our analysis, they also would have known it was worth using the Monthly Trend to acquire a long position with a well-defined stop in place (clustered support at Monthly Trend / M2) to limit risk.

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures during September 2019.  In our September 2019 edition of The Cartography Corner, we wrote the following:

In isolation, monthly support and resistance levels for September are:

  • M4                 3073.00
  • PMH              3014.25
  • M1                 2999.00
  • MTrend        2924.92
  • Close            2924.75      
  • M3                 2867.25
  • PML               2775.75     
  • M2                 2596.00    
  • M5                2522.00

Active traders can use 2924.92 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Figure 2 below displays the daily price action for September 2019 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first nine trading sessions of September saw the market price ascend 101.00 points from August’s settlement price.  The gains accelerated once it settled above our isolated pivot level at MTrend: 2924.92.  The high price for the month was realized on September 13th, the exact same day that the low price in bonds was achieved.       

The purpose of every trading month is to surpass the high or low of the previous trading month.  As can be seen in Figure 2, the high price for August 2019 was at PMH: 3014.25.  The price action exceeded PMH: 3014.25, running the “obvious brothers’” buy-stops in the process.  However, the market did not settle above that level which signaled that it was time for active traders following our analysis to take profits on their purchases.

On September 20th, the market price rotated and settled back below M1: 2999.00, now acting as support.  If active traders following our work had not previously sold their long positions, they should have on that day. The final six sessions of September were spent with the market price declining back towards Monthly Trend.

Active traders following our analysis had the opportunity to capture the initial trade up, which equated to a $4,412.50 profit per contract.

Figure 2:

October 2019 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESZ9).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Weekly Trend         2989.90       
  • Current Settle         2978.50
  • Daily Trend             2974.61       
  • Monthly Trend        2952.81       
  • Quarterly Trend      2840.92

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for four months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”.

Like we commented in August, the slope of the Weekly Trend could be in the initial stage of forming a rounded top.  Also, the market price has settled below Weekly Trend for two consecutive weeks.  Weekly Trend for this week is at 2989.90.  This deserves focus from short time-period-focused market participants.  A trend change in the short time-period is often a precursor to a trend change in the longer time-period(s).  We will watch closely to see if this occurs, bolstering the case for a topping pattern.

Support/Resistance:

In isolation, monthly support and resistance levels for October are:

  • M4                 3275.75
  • M1                 3037.25
  • M3                 3032.25
  • PMH              3025.75
  • M2               3002.25      
  • Close             2978.50
  • MTrend         2952.81     
  • PML               2889.00     
  • M5                2763.75

Active traders can use 3037.25 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2952.81 as the downside pivot, whereby they maintain a flat or short position below that level.

Random Length Lumber Futures

For the month of October, we focus on Random Length Lumber Futures.  Lumber prices are often seen as an indicator of economic activity due to its widespread use in real estate.  Regardless of whether you may trade lumber, the analysis and price action of lumber may provide some clues as to the future direction of the economy.  We provide a monthly time-period analysis of LBX9.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Weekly Trend        376.33          
  • Daily Trend            370.83
  • Current Settle        367.10          
  • Quarterly Trend     366.80          
  • Monthly Trend       364.03

As can be seen in the quarterly chart below, lumber is in “Consolidation”.  Stepping down one time-period, the monthly chart shows that lumber has been “Trend Up” for four months.  Stepping down to the weekly time-period, the chart shows that lumber has been “Trend Up” for three weeks.

In the quarterly time-period, the lumber market realized its last “substantial” price move (lower) in 3Q2018.  It has been consolidating since.  In the monthly time-period, the lumber market realized its last “substantial” price move from February 2019 to May 2019.  It has been consolidating since.  Astute readers will also notice that the current market price is resting just above BOTH Quarterly Trend and Monthly Trend.  The lumber market has been building energy for the next substantial move for four quarters and four months, respectively.  Relative to our technical methodology, it is a 50-50 proposition as to which direction.  As noted earlier, once this direction reveals itself, we may be simultaneously gifted with an indication of the state of the economy.

Support/Resistance:

In isolation, monthly support and resistance levels for October are:

  • M4         447.90
  • M1         407.70
  • PMH       393.50
  • Close      367.10
  • MTrend   364.03
  • M3           363.20
  • M2         357.10             
  • PML        348.10                         
  • M5           316.90

Active traders can use 363.20 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight into many different markets.  If you are a professional market participant and are open to discovering more, please connect with us.  We are not asking for a subscription; we are asking you to listen.

Sector Buy/Sell Review: 10-01-19

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

  • As noted last week:
    • “XLB remains confined to a very broad topping pattern currently BUT it continues to hold onto support at the 200-dma as rumors of a “trade deal” seem to always come just in the “nick of time.”
  • XLB rallied from lows on comments from Trump that a trade deal was near, and is now back to overbought without getting above important resistance.
  • There are multiple tops that are providing tough resistance for the sector to get through, so while the buy signal has turned back up, which is bullish, XLB has to get above resistance before considering adding to our position.
  • We are remaining underweight the sector for now, unless trade deal negotiations appear to be improving.
  • 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

  • There is a common thread to the market – multiple tops that can’t seem to be broken. XLC falls into this camp and has failed at all-time highs once again.
  • XLC is starting to work off its overbought condition, so this correction needs to hold above support at $48.50
  • There are two support levels between $47.50 and $48.50. A violation of the lower support level will take us out of our position for now.
  • 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.
    • Stop adjusted to $47.50
  • Long-Term Positioning: Bearish

Energy

  • Two weeks ago we discussed the surge in XLE due to the bombing in Saudi Arabia. That surge is over as oil prices have fully retraced the spike.
  • XLE broke below the test of the 200-dma which puts $58 as the next target of support.
  • The “sell signal” was in the process of being reversed, but that will fail also if prices don’t pick up this week.
  • While there is “value” in the sector, there is no need to rush into a position just yet. The right opportunity and timing will come, it just isn’t right now.
  • We were stopped out of our position previously.
  • Short-Term Positioning: Bearish
    • Last week: Stopped out.
    • This week: Stopped out.
    • No position currently
  • Long-Term Positioning: Bearish

Financials

  • XLF is another sector trapped below multiple highs.
  • XLF has reversed its “sell” signal but is back to very overbought. Look for a pullback that retests the breakout of the downtrend to add exposure to the sector.
  • We previously closed out of positioning as inverted yield curves and Fed rate cuts are not good for bank profitability. However, there is a trading opportunity present with the right setup.
  • Short-Term Positioning: Neutral
    • Last week: Closed Out/No Position.
    • This week: Closed Out/No Position.
    • Stop-loss adjusted to $26.00
  • Long-Term Positioning: Bearish

Industrials

  • XLI also, after failing a breakout, remains trapped below multiple highs. Hopes of a trade war “resolution” has kept the sector elevated, but not enough to sustain higher levels.
  • The breakout failed, as we suggested might be the case, and we will now look for a retracement back to initial support.
  • XLI is back to overbought but the sell signal has reversed to a buy.
  • We reduced our risk to the sector after reaching our investment target. We have also adjusted 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.”
  • XLK has moved back to short-term overbought, and remains a fairly extended and crowded trade.
  • XLK held support at $75 and broke above its short-term consolidation. This breakout needs to hold if old highs are going to be tested. The support line is being tested this week.
  • The buy signal is close to reversing to a “sell,” which if it does, will suggest lower prices.
  • Short-Term Positioning: Bullish
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $75.00
  • Long-Term Positioning: Neutral

Staples

  • Defensive sectors continue to rally. It is now an EXTREMELY crowded trade, and we suggest taking profits. IF there is a trade deal, these defensive sectors will likely get hard very quickly as money rotates back to non-defensive trades.
  • The “buy” signal (lower panel) is still in place but has been worked off to a good degree. Risk is clearly elevated.
  • Last week, we took profits in XLP and reduced our weighting from overweight. We will likely look to reduce further when opportunity presents itself.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions, take profits if needed.
    • This week: Hold positions, take profits if needed.
    • Stop-loss adjusted to $58
    • Long-Term Positioning: Bullish

Real Estate

  • As with XLP above, XLRE was consolidating its advance, then pushed to new highs and is back to extremely extended.
  • XLRE is also a VERY CROWDED defensive trade like XLP and XLU.
  • Be careful adding new positions and keep a tight stop for now. A pullback to $37-38 would be a better entry.
  • We previously recommended taking profits and rebalancing risk as the overbought condition needed to be corrected. That advice remains.
  • Buy signal has been reduced which is bullish 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

  • XLRE and XLU are virtually the same commentary.
  • After taking profits, we have time to be patient and wait for the right setup. We haven’t gotten one as XLU continues to rally and last weeks surge is making owning this sector seriously more dangerous.
  • Long-term trend line remains intact but XLU is grossly deviated from longer-term means. A reversion will likely be swift and somewhat brutal.
  • Buy signal reversed and held and has now turned higher. Take profits and reduce risks accordingly.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to support at $58.00
  • Long-Term Positioning: Bullish

Health Care

  • XLV has triggered a sell signal but has remained intact and is trying to recover with the market. If a buy signal is issued that may well support a higher move for the sector.
  • XLV continues to hold support levels and has turned higher.
  • We continue to maintain a fairly tight stop for now.
  • Short-Term Positioning: Neutral
    • Last week: Hold position.
    • This week: Hold position
    • Stop-loss adjusted to $88
  • Long-Term Positioning: Neutral

Discretionary

  • The rally in XLY failed at previous highs where resistance sits currently.
  • We added to our holdings previously to participate with the current rally, but are carrying a tight stop on the whole position.
  • XLY has reversed its “sell signal” to a “buy” which could support a move to new highs if it holds. Currently that is questionable.
  • Short-Term Positioning: Neutral
    • Last week: Hold position
    • This week: Hold position
    • Stop-loss adjusted to $115.
  • Long-Term Positioning: Neutral

Transportation

  • XTN spiked higher over the last couple of trading sessions on an “oversold” bounce and is now extremely overbought once again.
  • XTN remains is a very broad trading range, and as we noted last week:
    • “This rally is most likely going to fail at the previous highs for the range. It is now make or break for the sector.”
  • The rally failed and a retest of support is likely.
  • XTN has reversed its “sell” signal but is extremely overbought.
  • We remain out of the position currently.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: The Risk To The Bullish View Of Trade Deal

In this past weekend’s newsletter, I discussed the bullish view of a trade deal with China. 

“Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.” 

This is not the first time we presented our analysis for a “bull run” to 3300. To wit:

“The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal”

While I did follow those statements up with why a “bear market” is inevitable, I didn’t discuss the issue of what happens is Trump decides to play hardball and the “trade negotiations” fall apart. 

Given Trump’s volatile temperament, this is not an unlikely “probability.” Also, there is more than just a little pressure from his base of voters to press for a bigger deal.

As I noted, China cannot agree to the biggest issues which have stalled negotiations so far:

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

For China, these items are an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program. This is something that President Xi is extremely unlikely to do, particularly for a U.S. President who is in office for a maximum of 4-more years. 

Of course, if talks break down, there are two potential outcomes investors need to consider for the portfolio:

  1. Everything remains status quo for now and more talks are scheduled for a future date, or;
  2. Talks breakdown and both countries substantially increase tariffs on their counterparts. 

Given that current tariffs are weighing on Trump’s supporters in the Midwest, and both Silicon Valley and retail’s corporate giants have pressured Trump not to increase tariffs further, the most probable outcome is the first. 

No Trade Deal,  No New Tariffs

Unfortunately, that outcome does little for the market in the short-term as existing tariffs continue to weigh on corporate profitability, as well as consumption. Given that earnings are already on the decline, the benefits of tax cut legislation have been absorbed, and economic growth is weakening, there is little to boost asset prices higher. 

Therefore, under this scenario, current tariffs will continue to weigh on corporate profitability, but “hopes” for future talks will likely continue to keep markets intact for a while longer. However, as we head into 2020, a potential retracement will likely occur as markets reprice for slower earnings and economic growth.

In this environment, we would continue to expect some underperformance by those sectors most directly related to the current tariffs which would be Basic Materials, Industrials, and Emerging Markets. 

Since the beginning of the “trade war,” these sectors have lagged overall market performance and have been under-weighted in portfolios. We alerted our RIA PRO subscribers to this change in March, 2018:

“We closed out our Materials trade on potential “tariff” risk. Industrials are now added to the list of those on the “watch, wait and see” list with the break below its 50-dma. Tariff risk continues to rise and Larry Kudlow as National Economic Advisor is not likely to help the situation as his ‘strong dollar’ views will NOT be beneficial to these three sectors. Also, we reduced weights in international exposure due to the likely impact to economic growth from ‘tariffs’ on those markets which have continued to weaken again this week.”

That advice turned out well as those sectors have continued to languish in terms of relative performance since then.

Furthermore, a “no trade deal, no tariff change” outcome does little to change to the current deterioration of economic data. As we showed just recently, our Economic Output Composite Index has registered levels that historically denote a contractionary economy. 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)”

No Trade Deal Plus New Tariffs

The second outcome is more problematic.

In this scenario, Trump allows emotion to get the better of him, and he blows up at the meeting. In a swift retaliation, he reinstates the “tariffs” on discretionary goods, and increases tariffs across the board as a punitive measure. The Chinese, in an immediate retaliation levy additional tariffs as well. 

With both sides now fully entrenched in the trade war, the market will lose faith in the ability to get a “deal” done. The increased tariffs will immediately be factored into earnings forecast, and the market will begin to reprice for a more negative outcome. 

In this scenario, Basic Materials, Industrials, Emerging, and International Markets will continue to be the most impacted and should be avoided. Because of the new tariffs which will directly impact discretionary purchases, Technology and Discretionary sectors should also likely be under-weighted. 

The increase in tariffs is also going to erode both consumer and economic confidence which have remained surprisingly strong so far. However, once the consumer is more directly affected by tariffs, that confidence, along with related consumption, will fade. 

 

What About Bond Yields And Gold

In both scenarios above, a “No Trade Deal” outcome will be beneficial for defensive positioning in portfolios. Gold and bond yields have already performed well this year, but if trade talks fall through, there will be a rotation back to the “safe haven” trade as equity prices potentially weaken. This is specifically the case in the event our second outcome comes to fruition. 

While bond yields are overbought currently, it is quite likely we could see yields fall below 1%. Also, given the large outstanding short-position in bonds, as discussed recently, there is plenty of “fuel” to push rates lower.

“Combined with the recent spike in Eurodollar positioning, as noted above, it suggests that there is a high probability that rates will fall further in the months ahead; most likely in concert with the onset of a recession.”

As I noted, there is no outcome that ultimately avoids the next bear market. The only question is whether moves by the Administration on trade, combined with the Fed cutting rates, retards or advances the timing. 

“Furthermore, given the markets never reverted to any meaningful degree, higher prices combined with weaker earnings growth, has left the markets very overvalued, extended, and overbought from a historical perspective.”

Our long-term quarterly indicator chart has aligned to levels that have previously denoted more important market tops. (Chart is quarterly data showing 2-standard deviations from long-term moving averages, valuations, RSI indications above 80, and deviations above the 3-year moving average)

While we laid out the “bullish case” of 3300 over the weekend, it would not be wise to dismiss the downside risk given how much exposure to the “trade meeting” is currently built into market prices. 

We are assuming that Trump wants a “deal done” before the upcoming election, which should also help temporarily boost economic growth, but there remains much that could go wrong. An errant “tweet,” a “hot head,” or merely a breakdown in communications, could well send markets careening lower.

Given that downside risk outweighs upside reward at this juncture by almost 3 to 1, in remains our recommendation to rebalance risk, raise some cash, and hedge long-equity exposure in portfolios for now. 

This remains a market that continues to under-price risk.

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