Monthly Archives: November 2019

Major Market Buy/Sell Review: 05-25-20

HOW TO READ THE MAJOR MARKET BUY/SELL CHARTS FOR THE WEEK OF 05-25-20.

There are three primary components to each Major Market Buy/Sell chart in this RIAPro review:

  • 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.

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

NOTE: I have added relative performance information to each Major Market buy/sell review graph. Most every Major Market buy/sell review graph also shows relative performance to the S&P 500 index except for the S&P 500 itself, which compares value to growth, and oil to the energy sector. 

S&P 500 Index

  • This past week, the market rallied and flirted with the 200-dma. However, it was unable to close above that resistance and remained stuck between the 61.8% retracement and the 200-dma.
  • The market remains overbought, so the risk is still high, but taking a trading position on a break above the 200-dma is logical.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No core position
    • This Week: Trading positions only. 
    • Stop-loss moved up to $280 for any positions.
    • Long-Term Positioning: Bearish

Dow Jones Industrial Average

  • DIA is a little different story as it continues to struggle with its recent highs. This week it rallied to it again, but is underperforming other markets.
  • If DIA fails this week, we will likely see a retest of previous support at the 38% retracement level.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions
    • Stop-loss moved up to $235
  • Long-Term Positioning: Bearish

Nasdaq Composite

  • QQQ is outperforming SPY by a wide margin, but it is not surprising that the top-5 stocks in the SPY are also the top-5 in the QQQ and are mostly technology-related shares. 
  • Last week QQQ continued to push toward all-time highs and will likely accomplish that task in the next week or so. 
  • The market is extremely overbought short-term so a correction is likely. Take trading positions on pullbacks that hold support above $210.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions
    • Stop-loss remains at $200
  • Long-Term Positioning: Bearish due to valuations

S&P 600 Index (Small-Cap)

  • Small caps rallied again this week on a potential catch up rotation, but it remains unimpressive.
  • No change to our positioning on Small-caps, which are still “no place to be as both small and mid-cap companies are going to be hardest hit by the virus.”
  • Avoid small-caps. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions.
    • Stop-loss adjusted to $52 on trading positions.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • As with Small-caps, we have no holdings. 
  • The relative performance remains poor. MDY pushed above the 50% retracement level but is struggling with resistance at recent highs. 
  • As with SLY, we need to see some follow-through. 
  • Mid-caps are working off their extreme overbought condition, so we will see if a tradeable opportunity occurs. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No holding
    • This Week: No holding
    • Stop Loss moved up to $290 for trading positions. 
  • Long-Term Positioning: Bearish

Emerging Markets

  • As with small and mid-cap stocks, emerging, and international markets are underperforming the S&P 500 and Nasdaq. Maintain domestic exposure for now. 
  • We previously stated that investors should use counter-trend rallies to liquidate. EEM turned lower last week and is testing support at the 38.2% retracement level. It must hold. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position
    • This Week: No position.
    • Stop-loss moved up to $35 for trading positions.
  • Long-Term Positioning: Bearish

International Markets

  • EFA is performing a little better than EEM but not by much. 
  • The rally cleared the 38.2% retracement level but failed at recent highs. There is still nothing to get excited about currently, and the overbought condition is concerning.
  • Remain out of these markets for the time being.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position.
    • This Week: No position.
    • Stop-loss moved up to $54 for trading positions.
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Oil prices continued their torrid rally this past week and broke above the 38.2% retracement level.
  • Prices are very extended and grossly overbought. Look for a correction as we head into June.
  • We are continuing to hold our positions in XLE, but it is very overbought currently. We are going to wait for a correction this summer to add to our holdings at better prices.
  • We continue to carry very tight stops. 
  • Short-Term Positioning: Bearish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Gold

  • We remain long our current position in IAU and GDX. 
  • This past week Gold broke out to new highs, and we did increase our weighting in IAU.
  • We took profits and rebalanced back to our original weighting in GDX previously, and need a small pullback to increase out weightings. 
  • The sectors are VERY overbought short-term, so a pullback is likely. Use pullbacks to add to current holdings. 
  • Short-Term Positioning: Bullish
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss moved up to $150
    • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

  • Bonds have now corrected and got back to oversold while holding support. Such sets us up for two events – a rally in bonds, as the stock market corrects.
  • We added again to both TLT and IEF in our portfolios to hedge against our modest increases in equity risk. 
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is $150.00
    • Long-Term Positioning: Bullish

U.S. Dollar

  • We previously added a position to the Dollar to hedge against the global dollar shortage issue. 
  • Our reasoning was explained in detail in “Our 5-Favorite Positions Right Now.”
  • Stop-loss remains at $98

The Arrival Of The “Unavoidable Pension Crisis”

In 2017, I wrote an article discussing the “Unavoidable Pension Crisis.”  At that time, most did not understand the risk. However, two years later, the “Unavoidable Pension Crisis” has arrived.

To understand we are today, we need a quick review.

“Currently, many pension funds, like the one in Houston, are scrambling to marginally lower return rates, issue debt, raise taxes, or increase contribution limits. The hope is to fill the gaping holes of underfunded liabilities in existing plans. Such measures, combined with an ongoing bull market, and increased participant contributions, will hopefully begin a healing process.

Such is not likely to be the case.

This problems are not something born of the last ‘financial crisis,’ but rather the culmination of 20-plus years of financial mismanagement.

An April 2016, Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by fund assets, future contributions, and investment returns ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields an average 2.6%.

With employee contribution requirements extremely low, the need to stretch for higher rates of return have put pensions in a precarious position. The underfunded status of pensions continues to increase.”

The Crisis Is Here

Since then, the situation has continued to worsen as noted by Aaron Brown in 2018:

“Today the hard stop is five to 10 years away, within the career plans of current officials. In the next decade, and probably within five years, some large will face insolvency,

We are already there. Here was the key sentence in Brown’s commentary:

The next phase of public pension reform will likely be touched off by a stock market decline. Such creates the real possibility of at least one state fund running out of cash within a couple of years. The math says that tax increases and spending cuts cannot do much.”

Brown was right, and the COVID-19 pandemic has likely triggered a rolling pension collapse over the next couple of years. Via the NYT:

Now the coronavirus pandemic have it ticking faster.

Already chronically underfunded, pension programs have taken huge hits to their investment portfolios over the past month as the markets collapsed. The outbreak has also triggered widespread job losses and business closures that threaten to wipe out state and local tax revenues.

That one-two punch has staggered these funds, most of which are required by law to keep sending checks every month to about 11 million Americans.”

Over Promise Under Deliver

Here is the real problem:

“Moody’s investor’s service estimated that state and local pension funds had lost $1 trillion in the market sell-off that began in February. The exact damage is hard to determine, though, because pension funds do not issue quarterly reports.”

At the end of the year, we will find out the true extent of the damage. However, this is not, and has not been, a real plan to fix the underfunded problem. “Hope” for higher rates of sustained returns continues to be the only palatable option. However, targeted returns have continuously fallen short of the projected goals.

To wit:

“Over the past decade, public pensions had ramped up stockholdings and other risky investments to meet aggressive return targets that average around 7%.

For the 20 years ended March 31, public pension-plan returns have fallen short of that target, however, returning a median 5.2% according to Wilshire TUCS.”

While State and Local governments all want to ignore the problem, it is isn’t going away. There is a simple reason why pensions are in such rough shape: The amount owed to retirees is accelerating faster than assets on hand to pay those future obligations. Liabilities of major U.S. public pensions are up 64% since 2007, while assets are up 30%, according to the most recent data from Boston College’s Center for Retirement Research.

More importantly, there is nothing that can, or will, change the two pre-existing problems which have plagued the economic shutdown is exacerbating pensions.

Problem #1: Demographics

With pension funds already wrestling with largely underfunded liabilities, demographics are another problem as baby boomers age. The number of pensioners has jumped due to longer lifespans and a wave of retirees over the past decade, while the number of active workers remained relatively stable.

The problem compounds as the labor-force participation for the prime-age working group of 25-54 years of age declines due to the economic shutdown.

At the same time, companies are forcing the over-65 participants into retirement. These individuals are immediately able to start taking pension distributions.

A Fertility Problem

One of the primary problems continues to be the decline in the ratio of workers per retiree as retirees are living longer (increasing the relative number of retirees), and lower birth rates (corresponding number of workers.) Such is due to two demographic factors:

  1. An increased life expectancy coupled with a fixed retirement age; and,
  2. A decrease in the fertility rate.

In 1950, there were 16-workers per social security retiree. By 2015, the support ratio dropped to 3:1, and by 2035 it is projected to just 2:1.

As discussed previously, the problem is that while the “baby boom” generation may be heading towards retirement years, there was little indication they were financially prepared to retire. To wit:

“As part of its 2019 Savings Survey, First National Bank of Omaha examined Americans’ habits, behaviors, and priorities when it comes to saving, monthly spending, and retirement planning. The findings showed that nearly 80% of Americans live paycheck to paycheck.

Many have now been “asked to retire,” which means they cannot collect unemployment benefits. They are also permanently removed from the labor force.

Such is particularly problematic for pension funds because this will lead to an immediate demand for payouts at a time when pension fund assets decline. Unfortunately, the ultimate burden will fall on those next in line.

Problem #2: Markets Don’t Compound

The biggest problem is the computations performed by actuaries. The assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables, consistently turn out wrong.

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values. However, high expected returns are required to reduce the required contributions to the pension plans.

There is a significant difference between actual and compounded (7% average annual rate) returns. The market does NOT return an AVERAGE rate each year, and one negative return compounds the future shortfall. (Forward projections are a function of expected return values due to rising deficits, valuations, and demographics.)

With pensions still having annual investment return assumptions ranging between 6–7%, 2020 will likely be another year of underperformance.

As noted, pensions do not have much choice but to hope for high returns. If expected returns decline by 1–2 percentage points, the required contributions increase dramatically. For each point of reduction in the assumed return rate, pensions require a roughly 10% increase in contributions.

For many plan participants, particularly unionized workers, increases in contributions are difficult to obtain. Pension managers must maintain better-than-market return assumptions that requires them to take on more risk.

Guiding Down

But therein lies the problem.

The chart below is the S&P 500 TOTAL return from 1995 to present. Projected returns use variable rates of market returns with cycling bull and bear markets, out to 2060. I have also added projections of 8%, 7%, 6%, 5%, and 4% average rates of return from 1995 out to 2060. (I have made some estimates for slightly lower forward returns due to demographic issues.)

Given real-world return assumptions, pension funds SHOULD lower their return estimates to roughly 3-4% to potentially meet future obligations and maintain some solvency.

Again, pension funds won’t, and really can’t, make such reforms because “plan participants” won’t let them. Why? Because:

  1. It would require a 30-40% increase in contributions by plan participants they simply can not afford.
  2. Given many plan participants will retire LONG before 2060 there simply isn’t enough time to solve the issues, and;
  3. The bear market is already further crippling plan’s abilities to meet future obligations without massive reforms immediately. 

Government Bailouts

Such is why municipalities across the country have been lobbying the Democratically controlled Congress to pass another funding bill to provide financial relief. The bill, passed by House Democrats,  specifically included the following:

“The cornerstone of the 1,800-page bill is $875 billion for state and local governments. “

Unfortunately, $875 billion is a drop in the bucket.

The real crisis comes when there is a ‘run on pensions.’ With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the ‘fear’ that benefits will be lost entirely. 

The combined run on the system, which is grossly underfunded, at a time when asset prices are declining will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.”

This is why the Fed is terrified of a market downturn. The pension crisis IS the “weapon of mass destruction” to the financial system, and it has started ticking.

Pension plans in the United States have a guarantee by a quasi-government agency called the Pension Benefit Guarantee Corporation (PBGC), the reality is the PBGC is nearly bust from taking over plans following the financial crisis. The PBGC will run out of money in 2025. Moreover, its balance sheet is trivial compared to the multi-trillion dollar pension problem.

We Are Out Of Time

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. Many of them are public-sector employees. In a 2015 study of public-sector organizations, nearly 50% of the responding organizations stated they could lose 20% or more of their employees to retirement within the next five years.

Local governments are particularly vulnerable: a full 37% of local-government employees are at least 50-years of age in 2015.

It is now 5-years later, and the problems are worse than before.

It is no surprise that public pension funds are completely overwhelmed, but they still do not realize that markets do not compound at an annual return of 7% annually. Such has led to the continued degradation of funding levels as liabilities continue to pile up

If the numbers above are right, the unfunded obligations of approximately $5-$6 trillion, depending on the estimates, would have to be set aside today such that the principal and interest would cover the program’s shortfall between tax revenues and payouts over the next 75 years.

That isn’t going to happen.

The “unavoidable pension crisis” has arrived, and the consequences will devastate many Americans, depending on their retirement pensions.

“Demography, however, is destiny for entitlements, so arithmetic will do the meddling.” – George Will

Whatever amount you are saving for retirement is probably not enough.

Bear Market? Or Just A Big Correction?


In this issue of “Was This A Bear Market? Or Just A Big Correction?”

  • Still Stuck In The Middle
  • What Defines A “Real” Bear Market?
  • A Growing List Of Concerns
  • Portfolio Positioning
  • MacroView: Why Jeremy Siegel Is Wrong About Bonds
  • Sector & Market Analysis
  • 401k Plan Manager

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


Catch Up On What You Missed Last Week


Still Stuck In The Middle

As noted last week, the markets remain stuck between the 50- and 200-dma. That remained the case this week once again, keeping any expansion of equity positioning on hold.

The shaded blue area shows the containment of the market between the two moving averages. With the market very overbought short-term (orange indicator in the background), there is downside pressure on prices short-term.

This past week, the current risk/reward ranges remain unfavorable. I have updated the levels from last week:

  • -7.6% to the 50-dma vs. +5% to the March peak.
  • -11.5% to -17.1% to the late March peak or early April low vs. +13.6% to all-time highs.
  • -24.7% to March 23rd lows vs. 13.6% to all-time highs.

For now, we remain “stuck in the middle.”

However, if the markets can\ break above the 200-dma, and maintain that level, it would suggest the bull market is back in play. Such would change the focus from a retest of previous support to a push back to all-time highs.

While such would be hard to believe, given the economic devastation currently at hand, technically, it would suggest the decline in March was only a “correction” and not the beginning of a “bear market.”

Was This A Correction Or A Bear Market?

Price is nothing more than a reflection of the “psychology” of market participants. A potential mistake in evaluating “bull” or “bear” markets is using a “20% advance or decline” to distinguish between them.

Such brings up an interesting question. After a decade-long bull market, which stretched prices to extremes above long-term trends, is the 20% measure still valid?

To answer that question, let’s clarify the premise.

  • A bull market is when the price of the market is trending higher over a long-term period.
  • A bear market is when the previous advance breaks, and prices begin to trend lower.

The chart below provides a visual of the distinction. When you look at price “trends,” the difference becomes both apparent and useful.

This distinction is important.

  • “Corrections” generally occur over very short time frames, do not break the prevailing trend in prices, and are quickly resolved by markets reversing to new highs.
  • “Bear Markets” tend to be long-term affairs where prices grind sideways or lower over several months as valuations are reverted.

Using monthly closing data, the “correction” in March was unusually swift but did not break the long-term bullish trend. Such suggests the bull market that began in 2009 is still intact as long as the monthly trend line holds.

However, I have noted the market may be in the process of a topping pattern. The 2018 and 2020 peaks are currently forming the “left shoulder” and “head” of the topping process. Such would also suggest the “neckline” is the running bull trend from the 2009 lows. A market peak without setting a new high that violates the bull trend line would define a “bear market.”

Valuations

Valuations also suggest the decline in March was just a correction and not a bear market.

The chart below shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. The defining difference between bull and bear markets is valuations. Bull markets are defined by expanding valuations, while bear markets contract valuations. Market “corrections” tend to have minimal impacts on valuations.

During trending bull markets, valuations remain elevated even during corrective processes. However, during bear markets, valuations tend to compress as prices adjust to weaker earnings growth.

The surge in valuations in recent weeks suggests the markets remain in a “corrective” process rather than a “bear market.”

While monetary policy has kept the valuation reversion process from completing, it likely hasn’t eliminated the risk.

If March was indeed just a “correction,” then earnings will need to quickly recover back to previous levels to support current valuation levels. However, given the economic devastation, I suspect the “correction” was likely the beginning of a more protracted valuation reversion process and “bear market.” 

Monthly Moving Average Crossover

Lastly, from a purely technical perspective, we have not confirmed a “traditional” bear market. One of the key identifiers of a “bear market” versus a “correction” is the “bearish crossover” of the short and long-term moving averages.

In both 2001 and 2008, the moving average crossover delineated the start of a more protected “bear market” process. Despite the one month correction in March, the rebound in April and May have kept the moving average crossover from triggering.

Without a monthly moving average crossover, there is little historical precedent to suggest the decline in March was anything other than a deep corrective process.

However, if we are in the beginning stages of a longer-term valuation reversion process, then the crossover will occur in the months ahead.

Bear Markets Begin With Corrections

There is one crucial point that needs addressing.

Was the decline in March just a “correction” or the start of a “bear market?”

Only time will tell with certainty, but all “bear markets” begin with a “correction.” 

Every bear market in history has an initial decline, a reflexive rally, then a protracted decline which reverts market excesses. Investors never know where they are in the process until the rally’s completion from the initial fall.

Given the deviation of the market, due to Fed stimulus, was so extremely deviated above long-term trends, the depth of the “correction” was not surprising. However, if this is the start of a “bear market,” confirmed by a change in trend, the depth of the decline will eventually be equally as great.

A Growing List Of Concerns

What we do know is there is a litany of warning signs which suggest risk greatly outweighs the reward of being aggressively invested in the markets. Here is a shortlist:

  • Frantic positioning and extreme readings in market internals.
  • Speculative positioning in options markets.
  • Small investors are incredibly bullish.
  • Put/Call ratios are massively elevated.
  • A lack of risk hedging.
  • Buying interest has hit extremes.
  • Forward P/E ratios are historically rich.
  • Value to Growth ratios are at some of the lowest levels in history.
  • The hope for a “V-shaped” recovery is likely to be disappointed.
  • Expectations for an earnings recovery remain overly exuberant.
  • Unemployment is likely to remain elevated longer than most expect.
  • Consumer confidence will likely not bounce back as fast as hoped.
  • Rising delinquencies, defaults, and bankruptcies will be problematic.
  • A resurgence of COVID-19 later this summer will set back recovery expectations.
  • Fed liquidity is likely much more limited than markets expect.
  • A resurgence of a “trade war” with China could not be more ill-timed.
  • Risk of acceleration of geopolitical tensions with China
  • Corporate profitability will plunge

I could go on, but you get the idea.

Don’t Fight The Fed

With the amount of economic devastation that is in process, and will likely continue for quite some time, it is hard to suggest the decline in March was only a “correction.”  There are numerous headwinds that could derail markets in the months ahead despite the Fed’s liquidity.

Speaking of liquidity, the basis of the “Don’t Fight The Fed” mantra, has now shrunk from $75 billion/day in March to just $5 billion/day. 

The most logical view is that we  are in the midst of a torrid reflexive rally that seems to be losing steam. Such would be typical of a reflexive “bear market rally.,” Over the next couple of months the markets will have to come to grips with economic and fundamental realities.

The next leg lower will likely surprise most investors.

Positioning Update

This analysis is part of our thought process as we continue to weigh “equity risk” within our portfolios.

We remain focused on our positioning, and we again modestly increased our equity exposure during this past week. However, we also balanced that increase with matched weights in Treasury bonds to hedge our risk.

Taking profits in our trading positions also continues to be a “staple” in our management process. This past week we took profits in the Communications space that has gotten extremely extended. We also continue to rebalance portfolios regularly.

We don’t like the risk/reward of the market currently, and suspect we will have a better opportunity to increase equity risk later this summer. But, if things change, we will also.

What is essential is remembering one investing truth. Investing isn’t a competition of who gets to say “I bought the bottom.” Investing is about putting capital to work when reward outweighs the risk. 

That is not today.

Bear markets have a way of “suckering” investors back into the market to inflict the most pain possible.

Such is why “bear markets” never end with optimism but in despair.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

Note: The technical gauge bounced from the lowest level since both the “Dot.com” and “Financial Crisis.” However, note the gauge bottoms BEFORE the market bottoms. In 2002, the market retested lows. In 2008, there was an additional 22% decline in early 2009.


Sector Model Analysis & Risk Ranges

How To Read.

  • Each sector and market  is compared to the S&P 500 index in terms of relative performance.
  • The “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • The price deviation above and below the moving averages is also shown.


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 – Materials (XLB)

This past week, the market continued to struggle between the 61.8% retracement levels and the 200-dma. Materials continue to underperform due to a very weak economy, and there is no reason to maintain exposure to the sector currently.

Current Positions: No Positions

Outperforming – Discretionary (XLY), Technology (XLK), Communications (XLC), Staples (XLP), and Healthcare (XLV), 

Previously, we added to our core defensive positions Healthcare, Staples, and Utilities. We continue to hold our exposures in Technology. This past week we did trim our Communications exposure slightly due to the extreme overbought condition. These sectors are continuing to outperforming the S&P 500 on a relative basis and have less “virus” related exposure. We trimmed our Communications exposure due to the recent run up.

Current Positions: XLK, XLC, XLP, and XLV

Weakening – Utilities (XLU)

After adding a small weighting in Utilities, we continue to look for an opportunity to increase our exposure. We continue to watch again this week.

Current Position: 1/3rd Position XLU

Lagging – Industrials (XLI), Financials (XLF), Real Estate (XLRE), and Energy (XLE)

Financials continue to underperform the market. As we have said previously, Financials and Industrials are the most sensitive to Fed actions (XLF) and the shutdown of the economy (XLI).

We continue to hold our Energy sector (XLE) exposure, and we did add slightly to those holdings last week. We also are doing the same with our recent Real Estate exposures, which remain oversold on a relative basis.

Current Position: 1/3rd Position XLE, 1/2 XLRE

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) We continue to avoid these sectors for now aggressively, and there is no rush to add them anytime soon. Be patient, small, and mid-caps are lagging badly. You can not have a “bull market” without “small and mid-cap” stocks participating.

Current Position: None

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

Same as Small-cap and Mid-cap. Given the spread of the virus and the impact on the global supply chain.

Current Position: None

S&P 500 Index (Core Holding) – Given the overall uncertainty of the broad market, we previously closed out our long-term core holdings. We are using SPY and QQQ index ETF’s for trading positions only for now.

Current Position: None

Gold (GLD) – Previously, we added additional exposure to IAU this past week and currently remain comfortable with our exposure. We rebalanced our GDX position back to target weight previously.
We are also maintaining our Dollar (UUP) position as the U.S. dollar shortage continues to rage and is larger than the Fed can offset.

Current Position: 1/2 weight GDX, 2/3rd weight IAU, 1/2 weight UUP

Bonds (TLT) –

As we have been increasing our “equity” exposure in portfolios over the last few weeks, we added more to our holding in TLT to improve our “risk” hedge in portfolios. We did so again last week by adding to IEF, and TLT, and reducing SHY slightly.

Current Positions: SHY, IEF, BIL, TLT

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. Such is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio / Client Update

This past week, the market remained range-bound between the 61.8% retracement level and the 200-dma. As discussed previously, there is some short-term upside, but as we head into the summer months, the relative risk/reward ratio is not in our favor. (Please see the analysis in the main body of this week’s missive.)

While it certainly seems that no matter how dire the data is, the market only wants to go higher, such is also the trap. We are mindful of how markets work over longer periods, but also realize performance is important to you. Therefore we continue to add exposure and balance risk as we can.

Changes

Our process this week remains the same. We continue to work around the edges to add exposure while managing risk. In models, we added to our position in Clorox (CLX), after taking profits previously and added Phillips (PHG), the maker of UV lighting.

We also brought our exposures in positions that were underweight to target weight, including increasing our exposure to energy slightly.

We offset those increases in equity risk with additions to our bond and gold holdings. Our process is still to participate in markets while preserving capital through risk management strategies.

For now, there is much more “trading” activity than usual as we work out way through whatever market is going to come. Is the bull market back? Maybe. Maybe Not. Once the bottom is clearly in, we will settle back down to a longer-term, trend-following, structure. Now is not the time for that.

We continue to remain defensive and in an excellent position with plenty of cash, reduced bond holdings, and minimal equity exposure in companies we want to own for the next 10-years. Just remain patient with us as we await the right opportunity to build holdings with both stable values, and higher yields.

Please don’t hesitate to contact us if you have any questions or concerns.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k plan manager.

Compare your current 401k allocation, to our recommendation for your company-specific plan as well as our on 401k model allocation.

You can also track performance, estimate future values based on your savings and expected returns, and dig down into your sector and market allocations.

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

Shedlock: The Economy Won’t Soon Return To Normal

The economy won’t soon return to normal. Here’s why.

Numerous chain reaction ripple impacts will delay the economic recovery. Let’s start with a look at car rental companies.

No Magic Answers

Bankruptcies happen when there is too much debt leverage accompanied by some sort of economic shock. 

For example, Hertz filed for bankruptcy on Friday. Now, the entire rental industry is Scrambling for Answers, but there really aren’t any.

Covid-19 caused air traffic to plunge 90%. But blame debt for the Hertz bankruptcy, not Covid.

Layoff Impact

CNN comments on the Hertz Bankruptcy.

Hertz has notified 12,000 employees in North America that that they were losing their jobs, and another 4,000 are on furloughs. Its US workforce stood at 38,000 employees at the start of the year, with about a quarter of them represented by unions.

Auto Manufacturing Impact

Ford (NYSE:F), GM (NYSE: GM) and Fiat Chrysler (NYSE: FCAU) all face a steep drop in rental fleet purchases. 

Last year, Hertz alone bought 1.7 million US automobiles, about 10% of the US auto industry production according to Cox automotive.

CNN commented “Avis Budget said it expects its fleet in the Americas will be reduced by 20% by the end of June, compared to a year earlier.”

Used Car Price Impact

If Avis, Hertz, Budget, etc., have too many cars, then a flood of cars will hit the used car market. It’s already happening.

Hertz had already announced it would not purchase any new cars for the rest of this year, and that it is starting to sell its vehicles as used cars. As of early March, it had sold 41,000 cars out of its US fleet and another 13,000 out of its European fleet. 

Regional Impact

On Friday, the FAA granted airlines the right to halt service to regional cities. 

As many as 60 cities face flight shutdowns.

For details, please see Airlines to Abandon Dozens of Regional Cities

Corporate Travel Impact

  1. Companies forced to allow more work-at-home have noticed no loss in productivity. 
  2. The same applies to use teleconferencing instead of air travel.

Both cut down on eating out and driving (think local restaurants and gas stations). 

Point number two is an additional hit to car rental companies and hotels. 

This means more layoffs or fewer people recalled from furloughs. 

Attitude Change

It’s important to factor in the change in consumer attitudes.

Some retail is going away, never to come back. It will take a while for people feeling comfortable having to sit in a full capacity theater, stadium, or airplane.

  • Some people forced to cut their own hair will continue doing so.
  • Some people who seldom cooked, learned how. They will be slow to return to eating out for many reasons.
  • In general, any persons who suffered a huge income reduction will be very slow to resume eating out, traveling, or buying a car.

To entice people to buy cars, the automakers will have to cut prices, and perhaps dramatically given a new model year is coming up.

Existing Home Sales Plunge 17.8% Much Worse is on the Way

Note that Existing Home Sales Plunge 17.8%

April will not mark the bottom in sales. Here’s why.

  • Existing sales are recorded at closing whereas new sales are counted at signing.
  • April sales represent transactions that occurred in February and March.

May sales (transactions in March and April) are sure to be worse. Even June sales could be worse.

Real Estate Agent Impact

Price is sure to follow traffic lower, and real estate agents will get hit twice. First on the amount of traffic, and second as prices decline. 

April sales price rose, bit that was heavily skewed by the reduction in sales. 

Grim Economic Data

  1. 5/8: Over 20 Million Jobs Lost As Unemployment Rises Most In History
  2. 5/15: Retail Sales Plunge Way More Than Expected
  3. 5/15: Industrial Production Declines Most in 101 Years
  4. Also on 5/15: GDPNow Forecasts the Economy Shrank by a Record 42%. It’s 41.9% as of May 19.

Ripple Impacts May Last Years

The economic data has been grim and the ripple impacts may last for years.

Powell Warns Recovery May Stretch to the End of 2021

Fed Chair Jerome Powell Warns Recovery May Stretch to the End of 2021.

Powell is likely to be optimistic. 

Fed in Panic Mode

Seldom does the Fed openly ask Congress to spend more money or to engage in fiscal stimulus. 

But that happened on May 14 when both Powell and Minneapolis Fed president Neel Kashkari.

For details, please see Fed Promotes More Free Money.

This is a sure sign the Fed is in a state of panic about the economy.

Global COVID-19 Risk Ranges Up to $82 Trillion

To understand the total global risk, please see Global COVID-19 Risk Ranges Up to $82 Trillion

Anyone who expects the economy to make a fast recovery out of this mess is delusional.

Seth Levine: Collateral, Leverage, Volatility & How To Invest

There’s nothing like a crisis to bring foundational investing principles to the fore. They lay all my triumphs and tribulations bear for me to see. Evasion is no longer possible. Assumptions, rationalizations, and truths are crystallized as profits and losses. This turbulence, though, is a crucible for learning. For me, the past few months illustrated how collateral, leverage, and volatility interplay to drive investment performance. I see them as the “what”, “how”, and “when” to invest, respectively.

So much of investing is focused on what to buy. Valuation, factors, price, and trend get all the attention. Naturally, the investments selected and the idiosyncrasies of the economic landscape drive performance. But as Daniel Want, the Chief Investment Officer of Prerequisite Capital Management, puts it:

“Throughout different times in history, what is considered a ‘collateral’ asset can change, in some circumstances collateral could mean cash, or certain currencies, or treasury bonds, or gold, or commodities, or real estate, or even certain types of equities at times. You just have to simply ask yourself… in light of how the system currently is structured and working within view of the predominant issues, (1) what things would rise with conditions of ‘growing confidence’, and (2) what things would likely rise in conditions of ‘growing demand for collateral’ (& collapsing confidence)? At different points in history you will answer very differently to these questions.”

Daniel Want, Prerequisite Capital Management’s July 14th 2019 Quarterly Client BRIEFING

As Want points out, there are factors other than “what” to consider when investing. How to own your exposure and when its best to do so are just as impactful. Want sees these as matters of collateral and confidence. For me, viewing investments through the lens of collateral, leverage, and volatility provides this perspective.

Collateral

I see collateral as the foundation of investing. Collateral are things directly exchangeable for currency with a direct use value. The value can be for consumption—like wheat; for accumulation—like a bond (i.e. a contractual stream of cash flows); or have intangible value, like a trademark. Even cash is collateral since its utility is to mediate exchange.

Collateral are assets in the most basic form. It’s the “what” in investing. iPhones, sneakers, advertising slots, computer code, electricity, transportation, cloud storage, and even people’s attentions are all types of collateral. They are the goods and services that we trade for every day in society. As investors, it’s collateral’s value that we ultimately seek exposure to and on which we speculate.

Leverage

However, most collateral sits outside the realm of financial markets. It’s simply inefficient to buy a bunch of smartphones and sell them overseas to a clamoring population. Thus, we rarely cross paths with collateral in a pure form in the investment markets. More commonly, we find it in the presence of leverage.

Commodities provide one clear illustration of this. Each one would constitute collateral on its own—oil, gold, corn, soybeans, pork bellies, etc. However, in financial markets commodities take the form of futures and forward contracts. While we call these commodities, they are actually rights (or obligations) to specified quantities of the underlying asset. In reality, commodity contracts are leveraged exposures to the referenced commodities, and specifically financial leverage.

However, there’s an even more common form of leveraged collateral: stocks! Companies are organizations that profit from creating goods and services. They employ specialized infrastructures calibrated to maximizing productivity. Why purchase a bushel of corn to resell when you can buy a stake in a farm’s entire harvest, presently and in the future? By applying operating leverage—the fancy name for this infrastructure investment—corporations supercharge the value reaped by producing various types of collateral. They can also employ financial leverage (i.e. debt) to compound the effects of their operating leverage.

In our modern society tuned for efficiency, leverage is inescapable. Hence, it’s ubiquitous in financial markets. Financial and operating leverage come in many different forms and in countless combinations from which the investor can choose. In all instances, leverage is the “how” collateral is owned.

Volatility

In the financial world, volatility describes the price fluctuations of investment values. The more a price gyrates, the greater the asset’s volatility. Thus, volatility is often conflated with risk, as it conveys a range of price movements that an investment experienced or is anticipated to have in the future (depending on the metric used).

While true, volatility in its more conceptual form describes uncertainty. Investment prices are forward looking. They change only when the present view of the future proves to be inaccurate and requires adjustment. Thus, volatility describes the magnitude of error of past expectations. It’s a scorecard of forecast accuracy. The greater the price volatility, the less accurate the market was at predicting an asset’s future price.

In this mental model for investing, volatility is the “when” for investing. Since it relates to price movements, we can use it to determine when to apply leverage and, by extension, in what forms and amounts.

Investing is What, How, & When

It’s easy to see how different collateral types can generate different investment returns. Hence, it tends to garner the most attention. Should I invest in Stock A or Stock B; in retail or technology; in bonds or gold; etc.?

However, how one owns collateral can be just as big a return factor, if not more. The greater an investment’s volatility the more leverage impacts returns, positive and negative. The profit from the same $100 rise in the price of gold will be different for a $1,000 investment in gold coins, gold futures contracts, and a gold mine (with unhedged production), all due to leverage. Thus, one’s expectation for gold’s volatility, in this example, should dictate his/her preferred investment vehicle for the desired collateral.

Investing is an act of selection. Buying and selling specific assets is just one piece of the pie. Sizing those exposures according to our convictions in their potential range of future prices is the other. In other words, investing is the combined expression of collateral, leverage, and volatility!

What, How, & When in Practice

It’s one thing to mentally model investing as collateral, leverage, and volatility. It’s another to put it to practice. While sounding abstract, this seemingly has been done for ages, purposely or not.

Scaling investment exposures by volatility is hardly a new idea. Value at risk models are cornerstones in risk management. Strategies like risk parity and vol targeting have been around for decades. In fact, even the “classic” 60-40 portfolio balances collateral, a bond position, with leverage, i.e. equities.

While these techniques all use volatility in a particular way, we need not follow suit. To me, a more logical goal is to coordinate one’s use of leverage with expected changes in volatility regimes. For example, if your maximum leverage coincides with a fall in volatility, you should profit from the narrowing of possible price ranges (if you’re right). Conversely, carrying less leverage when price uncertainty explodes minimizes the cost of error and best positions you to act in the more uncertain environment.

A Mental Model For Investing

What to own, how to do so, and when are some of the most important determinants of an investor’s success. Ultimately, we all rely on some kind of model to invest, whether we know it or not. Perhaps viewing these fundamental questions as matters of collateral, leverage, and volatility can provide a useful framework, and even help us adopt some commonplace techniques to better achieve our individualized investment goals.

Relative Value Sector Report 5/22/2020

The Sector Relative Value Report provides guidance on which industries or sectors are likely to outperform or underperform the S&P 500.

Click on the Users Guide for details on the model’s relative value calculations as well as guidance on how to read the model’s graphs. 

This report is just one of many tools that we use to assess our holdings and decide on potential trades. Just because this report may send a strong buy or sell signal, we may not take any action if it is not affirmed in the other research and models we use.

Commentary

  • The most telling story about this week’s graphs is that we enlarged the y-axis to 4 standard deviations from 3. We did this to accommodate the Communications and Energy sectors, which rose above 3 during the week but backed off with Thursday’s market sell-off.  
  • A 3 standard deviation event is rare, and it signals future relative value performance for those sectors will be weak. We are also keeping a close eye on other market internals as this may be a sign the market as a whole is getting ready to reverse.  
  • Staples, Utilities, and Health, all considered safety sectors, became more oversold this past week, while the two noteworthy momentum sectors, Energy and Communications, became more overbought. The momentum trade is in full swing as investors are chasing recent winners at the expense of those recently lagging.
  • Because of the sharp divergence in relative value between Utilities and Communications, we are considering adjusting our allocations toward Utilities from Communications.
  • In addition to this report, we are working on another relative value analysis that is not quite ready for prime time. However, early results show us that the Dow Jones Industrial Average (DIA) and 20 Year UST ETF (TLT) are oversold versus the S&P 500, while the Nasdaq (QQQ) is over overbought. These readings are also evidence of the momentum trade.
  • The R-squared on the sigma/20 day excess return scatter plot is strong at .9124.

Graphs

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY

#MacroView: Is The Fed Walking Into A Trap?

Currently, the Fed is injecting liquidity into the markets and economy at a record pace. While liquidity does have positive short-term benefits, is the Fed walking into a trap?

The Unseen

Over the last decade, the Federal Reserve, and Central Banks globally, have engaged in never-ending “emergency measures” to support asset markets. While the stated goal was that such actions were to foster full employment and price stability, there has been little evidence of success.

The chart below shows the expansion of the Fed’s balance sheet and its effective “return on investment” on various aspects of the economy. No matter how you analyze it, the “effective ROI” has been lousy.

These are the unseen consequences of the Fed’s monetary policies.

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

The Seen

The only reason Central Bank liquidity “seems” to be a success is when viewed through the lens of the stock market. Through the end of the Q1-2020, using quarterly data, the stock market has returned almost 127.79% from the 2007 peak. Such is more than 3x the growth in GDP and 6.5x the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

Unfortunately, the “wealth effect” impact has only benefited a relatively small percentage of the overall economy.

While in the short-term ongoing monetary interventions may appear to be “risk-free,” in the longer-term, the Fed may be getting trapped.

The Fed Liquidity Trap

One of those traps is a “liquidity trap,” which we have discussed previously. Here is the definition:

“When injections of cash into the private banking system by a central bank fail to lower interest rates and fail to stimulate economic growth. A liquidity trap occurs when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.

Signature characteristics of a liquidity trap are short-term interest rates remain near zero. Furthermore, fluctuations in the monetary base fail to translate into fluctuations in general price levels.

Pay particular attention to the last sentence.

Even though the Fed tried to increase rates in 2017-2018, the tightening of monetary policy led to negative economic consequences. In response, the Fed lowered rates back to the zero bound. (Recently, Fed Fund futures have been teasing “negative” rates.)

Inflation Conundrum

What monetary policy did not do was lead to “general fluctuations in price levels.” Despite the annual call by the Fed of higher rates of inflation and economic growth, the realization of those goals remains elusive.

It is difficult to attribute the decline in interest rates and inflation to monetary policies when the long-term trend has been negative for decades. As I discussed in last week’s MacroView:

“The high correlation between the three major components of our economic composite (inflation, economic and wage growth) and the level of interest rates is not surprising. Interest rates are not just a function of the investment market, but rather the level of ‘demand’ for capital in the economy.

When the economy is expanding organically, the demand for capital rises as businesses increase production to meet rising demand. Increased production leads to higher wages, which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. 

(Currently, we do not have the type of inflation that leads to more robust economic growth, just increases in the costs of living that saps consumer spending – Rent, Insurance, Health Care)”

bond bull market, #MacroView: Why Siegel Is Wrong About End Of Bond Bull Market

As stated, it is not just monetary policy that is responsible for the long-term degradation in economic growth. It is also the ongoing increase in debts and deficits which are supported by the Fed’s actions.

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

Monetary Velocity Trap

“The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Velocity is useful in gauging the health and vitality of the economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.” – Investopedia

There is no evidence the Fed’s “zero interest rate policy” led to robust economic growth via the transactions of goods and services. Monetary velocity has been clear on this point.

A “liquidity trap” states that people begin hoarding cash in expectation of deflation, lack of aggregate demand, or war.  

Well, as discussed in “The Savings Mirage,” we are now officially there.

"savings mirage" save economy, #MacroView: “Savings Mirage” Won’t Save The Economy

The issue of monetary velocity and saving rates are critical to the definition of a “liquidity trap.”

As noted by Treasury&Risk:

“It is hard to overstate the degree to which psychology drives an economy’s shift to deflation. When the prevailing economic mood in a nation changes from optimism to pessimism, participants change. Creditors, debtors, investors, producers, and consumers all change their primary orientation from expansion to conservation. Creditors become more conservative, and slow their lending. Potential debtors become more conservative, and borrow less or not at all.

As investors become more conservative, they commit less money to debt investments. Producers become more conservative and reduce expansion plans. Likewise, consumers become more conservative, and save more and spend less.

These behaviors reduce the velocity of money, which puts downward pressure on prices. Money velocity has already been slowing for years, a classic warning sign that deflation is impending. Now, thanks to the virus-related lockdowns, money velocity has begun to collapse. As widespread pessimism takes hold, expect it to fall even further.”

Deflationary Spiral

Such is the biggest problem for the Fed and one that monetary policy cannot fix. Deflationary “psychology” is a very hard cycle to break, and one the Fed has been clearly fearful of over the last decade.

“In addition to the psychological drivers, there are structural underpinnings of deflation as well. A financial system’s ability to sustain increasing levels of credit rests upon a vibrant economy. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest owed.

As the slowing economy reduces borrowers’ ability to pay what they owe. In turn, creditors may refuse to underwrite interest payments on the existing debt by extending even more credit. When the burden becomes too great for the economy to support, defaults rise. Moreover, fear of defaults prompts creditors to reduce lending even further.”

For the last four decades is every time monetary policy tightens, it has led to an economic slowdown, or worse. The reason is that a heavily debt-burdened economy can’t support higher rates.

The relevance of debt growth versus economic growth is all too evident. Over the last decade, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

In other words, without debt, there has been no organic economic growth.

Running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

While it may appear such accommodative policies aid in economic stabilization, yet it was lower interest rates increasing the use of leverage. The consequence was the erosion of economic growth and deflation as dollars were diverted from productive investment into debt service.

Unfortunately, the Fed has no other options.

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

The Fed Inflation Trap

While “deflation” is the overarching threat longer-term, the Fed is also potentially confronted by a shorter-term “inflationary” threat.

The financial markets have currently priced in perfection. A “V-shaped” recovery back to pre-recessionary norms, no secondary outbreak of the virus, and a vaccine. If such does turn out to be the case, the Federal Reserve will potentially have a huge problem. 

The “unlimited QE” bazooka is dependent on the Fed needing to monetize the deficit to support economic growth. However, if the goals of full employment and economic growth quickly come to fruition, the Fed will face an “inflationary surge.”

The “reopening” risk compounds further with the massive surge in the money supply due to the various programs which have sent money directly to businesses and households. Historically speaking, surges in the money supply lead inflationary pressures by about 9-months.

Should such an outcome occur, it will push the Fed into a very tight corner. The surge in inflation will limit the ability to continue “unlimited QE” without further exacerbating inflation. Unfortunately, if they don’t “monetize” the deficit through the “QE” program, interest rates  will surge as the Treasury issues more debt.

It’s a no-win situation for the Fed.

The End Game Cometh

Over the last 40-years, the U.S. economy has engaged in increasing levels of deficit spending without the results promised by MMT.

There is also a cost to MMT we have yet to hear about from its proponents.

The value of the dollar, like any commodity, rises and falls as the supply of dollars change. If the government suddenly doubled the money supply, one dollar would still be worth one dollar, but it would only buy half of what it would have purchased before their action.

Such is the flaw MMT supporters do not address.

Modern Monetary Theory (MMT) is not a free lunch.

MMT is paid for by reducing the value of the dollar and ergo your purchasing power. It is a hidden tax paid by everyone holding dollars. The problem, as Michael Lebowitz outlined in Two Percent for the One Percent, inflation tends to harm the poor and middle class while benefiting the wealthy.

Such is why the wealth gap is more pervasive than ever. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.

As I stated above, the U.S. has been running MMT for the last three decades and the only result is social inequality, disappointment, frustration, and increasing demands for socialistic policies.

It is all just as you would expect from such a theory put into practice, and history is replete with countries that have attempted the same. Currently, the limits of profligate spending in Washington has not been reached, and the end of this particular debt story is yet to be written.

But, it eventually will be.

TPA Analytics: It’s Time To Sell Oil & Gas E&P Stocks

On Wednesday, TPA told clients that it was time to sell a basket of Oil & Gas E&P stocks and we are reiterating that stance today.

The main points from the 5/20 reports are:

1. CRUDE OIL @ RESISTANCE– Crude has rallied from negative to 34-35 and that is important technical resistance from the March break down (charts 1 and 2 below)

2. E&P @ RESISTANCE – The 7 O&G E&P stocks (CVX, HES, CXO, VLO, COP, EOG, and PSX) in the basket have all rallied back to resistance from their March breakdowns. Charts 3 and 4 below show the technical issue with the index of the 7 stocks. They are right at stiff resistance after huge rallies.

3. VERY OVERBOUGHT – The table below shows that the average rally of the 7 stocks from their lows on 3/18/20 is over 69%. Individually the stocks have rallied between 43% and 92%. In the same period the S&P 500 is up juts 21%.

The final table shows the entry point for the E&P sales that were done VWAP on 5/20.

These stocks should still be sold at current levels.

The entire 5/20/22 recommendation to sell Oil & Gas E&P stocks is at the bottom of this report.

TIME TO SELL A BASKET OF Oil & Gas STOCKS (5/20/20 Report)

As TPA explained in the 5/19 World Snapshot, both Crude (WTI) and XOP, the Oil & Gas Exploration & Production ETF have had huge rallies from the March lows, but are now at or near technical resistance from their early March break downs through important support levels. XOP was down almost 3% yesterday – after TPA’s research note, but there is most likely more downside for the ETF and the subsector. TPA recommends selling a basket of O&G E&P stocks with a target P&L of +20% and a stop of -6%.

A table of E&P stocks is below. The basket is comprised of 7 E&P stocks: CVX, HES, CXO, VLO, COP, EOG, and PSX, and the table of all the XOP holdings can be found at the bottom of this report. The basket stocks are the larger stocks in the XOP, with market caps of $10 billion or greater.

As shown in the table below the time period since 3/18/20, the S&P500 and XOP were up 21.89% and 65.28%, respectively. The average price change for the 7 stocks in the S&P basket has been +70.09%.

“Crude”ly Speaking

The first 2 charts below examine Crude (WTI), which fell below important 2 ½ year support in early March and then plummeted to trade at a negative price during expiration. Crude has now rallied, but is facing stiff resistance from the early March break.

Charts 3 and 4 show the O&G E&P short basket. The basket broke 2 major support lines before plummeting to its low on 3/18/20. Consequently, the basket rallied as much as 72% from the 3/18 low before pulling back slightly. The basket is still very vulnerable given its huge rally and proximity to technical resistance.

Charts 5 through 11 show the individual stock charts for CVX, HES, CXO, VLO, COP, EOG, and PSX. Each stock has rallied between 52% and 88% and is not facing technical resistance. These stocks are very vulnerable to a pullback at these levels.

TPA will use today’s VWAP was cost for this trade.


#WhatYouMissed On RIA This Week: 05-22-20

What You Missed On RIA This Week.

We know you get busy. So, with so much investing content pushed out each week from the RIA Team, here is a synopsis of what you missed. A collection of our best thoughts on investing, retirement, markets, and your money.

Webinar: The Great Reset REPLAY

If you missed our recent webinar, you can watch it now.

The Week In Blogs

Each week, the entire team at RIA publishes the research and thoughts which drive the portfolio management strategy for our clients. The important focus are the risks which may negatively impact our client’s capital. If you missed our blogs last week, these are the risks we are focusing on now.

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Our Latest Newsletter

Each week, our newsletter covers important topics, events, and how the market finished up the week. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how to trade it.

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What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free) If you are a DIY investor, this is the site for you. RIAPRO has all the tools, data, and analysis you need to build and manage your own money.

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The Best Of “The Real Investment Show”

What? You didn’t tune in last week. That’s okay. Here are the best moments from the “Real Investment Show.” Every week, we cover the topics that mean the most to you from investing, to markets, and your money.

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What You Missed: Video Of The Week

Are You Living In Communist America?

Last week, I went off on a bit of rant about Government over-reach, debts, deficits, and the perils of a centrally planned government.

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What You Missed: Our Best Tweets

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. Here are a few from this past week that we thought you would enjoy. Follow us on twitter @lanceroberts and @michaellebowitz.

See you next week!

Our 5-Favorite Positions Right Now

As we get ready to wind up the week, we wanted to share with you a few thoughts about our outlook going forward along with our favorite 5-positions that align with these ideas.

There is a lot of “hope” currently the Fed’s monetary policies will completely offset the ramifications of an economic shutdown and a reversion of earnings. However, we are not so sure as:

  • A major support of asset prices over the last decade, stock buybacks, are gone.
  • Jobless claims hitting levels never seen in history
  • Unemployment at 15% or more, and will be a long-time in recovering.
  • Dramatic declines in both consumer and investor confidence.
  • A loss of many small businesses which make up 45% of GDP and 70% of employment.
  • A draining of corporate coffers.
  • Lack of access to capital or credit markets outside those loans guaranteed by the Fed.
  • Surging mortgage forbearance.
  • Rising consumer credit card and auto-defaults
  • A dollar funding shortage
  • A sharp decline in retail sales and personal consumption expenditures.

I could go on, but you get the idea.

It ain’t good.

Importantly, this will all translate into the most important thing for the markets – earnings.

As I noted last Tuesday in “Chase Momentum Until Fundamentals Matter”

The other problem is investors remain overly optimistic about the recovery prospects for earnings going into 2021. As shown, in April 2019, estimates for the S&P 500 was $174/share (reported earnings) at the end of 2020. Today, estimates for Q4-2021 now reside at $147/share. Such is a 15% contraction in estimates when we are discussing a 30-40% decline in GDP.”

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

“With expectations for the S&P 500 to return to all-time highs in 2021, such would mean that valuations currently paid by investors remain at historically high levels.”

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

With that analysis, and a bit of an understanding of our expectations of the economy, and markets, going forward, here are the 5-stocks we like the best in our portfolios currently. 

PHG

   

With the economy opening back up, we previously discussed our position in CLX as the need for disinfectant will continue. This is also why we like PHG which manufactures ultraviolet (UV) lights for disinfectant purposes.

Phillips also has a heavy concentration of their business in the health services field which will continue to benefit from the COVID-19 pandemic for quite some time.

With the stock breaking back above the 200-dma, we could see prices move higher. We will look to add to our exposure on pullbacks. 

  • Target Price: $50
  • Stop Loss: $40

ABBV

There is a common theme between our Equity and ETF portfolio: “Long Staples, Healthcare & Technology, and out of most everything else.”  The reason is that these sectors continue to outperform the S&P overall, and have a bit of “virus” protection to them. 

On the healthcare front, we continue to like our holdings in ABBV which we have owned since September 2019. We have previously taken profits and reduced holdings and then rebuilt the position since the lows. 

Currently, ABBV is very overbought, but we will look for any weakness that holds the breakout level to increase our position size. (We also like our holdings in JNJ, ABT, and UNH for many of the same reasons.)

  • Target Price: $110
  • Stop: $80 

V

Back to our “reopening” story, we recently repurchased V. We owned it previously since early 2019, took profits a couple of times and sold it entirely in early March. We have added the position back to the portfolio as a beneficiary of the reopening process given they profit as shoppers return to the previous activities. 

While they will have credit loses to contend with due to unemployment, much of that is relegated to the issuers which are the banks. (A reason we don’t own banks.)

After clearing the 200-dma, V has continued to climb back towards old highs. The position is overbought so we do expect a pullback to the 200-dma at which time we can increase our exposures. 

  • Target Price: $215
  • Stop: $170

IAU

Our last two positions are the repeated from our previous report, as we seriously love these two holdings for the long-term. 

The first is GOLD. There are three reasons we own gold. 

  1. The Fed
  2. The Fed
  3. The Fed

While monetary stimulus has not been proven to be inflationary in the past, as it is an asset swap, this time may be different because of the economic shut down. 

With massive amounts of liquidity sloshing around the market, when the economy re-opens, eventually, there could well be an inflationary impulse that gets ahead of the Fed. If inflation heats up this will be good for gold. In such a case, the Fed would need to reverse the monetary jets to avoid inflation. Given it took 7 years after the financial crisis to even begin QT, we find it probable the Fed will be even slower this time.

Also, as noted below, we own gold to offset the risk of a global dollar shortage which is becoming a serious problem currently in the global markets. 

Lastly, gold tends to act as a “hedge” against market volatility which reduces our overall portfolio risk if something happens to break.

  • Target Price: $20.00
  • Stop: $15.00

UUP

The second is the DOLLAR.

Our long dollar position is very important to us. 

“The Federal Reserve has identified the Achilles heel of the world economy: the enormous global shortage of dollars. The global dollar shortage is estimated to be $13 trillion now, if we deduct dollar-based liabilities from money supply including reserves.

How did we reach such a dollar shortage? The reason is simple, domestic and international investors do not accept local currency risk in large quantities knowing that, in an event like what we are currently experiencing, many countries will decide to make huge devaluations and destroy their bondholders.

According to the Bank of International Settlements, the outstanding amount of dollar-denominated bonds issued by emerging and European countries in addition to China has doubled from $30 to $60 trillion between 2008 and 2019. Those countries now face more than $2 trillion of dollar-denominated maturities in the next two years and, in addition, the fall in exports, GDP and the price of commodities has generated a massive hole in dollar revenues for most economies.

If we take the US dollar reserves of the most indebted countries and deduct the outstanding liabilities with the estimated foreign exchange revenues in this crisis … The global dollar shortage may rise from 13 trillions of dollars in March 2020 to $ 20 trillion in December … And that is if we do not estimate a lasting global recession.” – Mises Institute.

This is why we are long the dollar now, and will likely increase it to as much as 10% of our portfolio in the future. 

The Federal Reserve can not “fix” this problem. It is too big and it is growing. The rest of the world needs at least $20 trillion by the end of the year. Even if the Fed increases their balance sheet to $10 trillion, the US dollar shortage would remain.

“In the current circumstances, and with a global crisis on the horizon, global demand for bonds from emerging countries in local currency will likely collapse, far below their financing needs. Dependence on the US dollar will then increase. Why? When hundreds of countries try to copy the Federal Reserve printing and cutting rates without having the legal, investment and financial security of the United States, they fall into a trap of ignoring the demand of their own currency.” – Mises

Two things:

  1. The dollar is going to rise and likely by a lot as the global recession intensifies.
  2. A strong dollar is not good for the stock market.

Have a great weekend.

Eric Hickman: COVID-19 Defies Hyperbole

Eric Hickman discusses how COVID-19 has defied hyperbole.

The economic effects from COVID-19 will be devastating. Stock and asset prices will fall dramatically and will take years to recover. U.S. Treasury yields will turn negative. Sell “risk-on” assets, increase cash, and buy Treasury bonds.

The U.S., if not the world’s economy was primed for a serious recession coming into 2020. I argued in an article published on January 13 that, based on economic indicators, a U.S. recession would begin sometime before the end of 2020 and likely by March. In this context, COVID-19 was just the catalyst (albeit, a transcendent one) that tipped the world into it. Pandemic or not, the world was oversupplied and due to flush-out bad debt, weak companies and inequality. It only needed a push. China hadn’t had a recession in 42 years (since modern records have been kept in 1978), Australia in 28 years, and the U.S. in 10 years. Creative destruction had been waiting a long time.

And what a push it was. Just 10 days later (on January 23), I wrote an e-mail to my clients with an article from The Washington Post about emerging issues in Wuhan saying, “I get the sense that this is a bigger story than we are aware of.” In the ensuing months, COVID-19 has become everything.

The health side of the story is bad enough, but the economic one is worse. The combined economic effects of the global simultaneous lock-down, nine or more months of social distancing/rolling lock-down until a potential vaccine/treatment is available (the “90% Economy” as The Economist has termed it), as well as the normal deleveraging side of the business cycle (the “knock-on” effects or mentality change that usually is the recession) make for an economic contraction that will be deep (severe), wide (pervasive), and long (time).

And yet, stock markets are pricing a quick return to normal. It won’t happen. We are still in the first (dare I say, “denial”) stage; something akin to the spring of 1930 when the stock market had rallied back to be down just 19% from the 09/03/1929 peak. I suspect there are many years and chapters of COVID-19 yet to come.

At the same time, it isn’t the end of the world. If one can appreciate how it works, there are investments that will do well; but just a few.

COVID-19 Will Be Here For A While

Many prominent people and publications are saying serious things about this virus’ severity and duration:

  • Bill Gates, “It is impossible to overstate the pain that people are feeling now and will continue to feel for years to come.” 4/23/2020
  • German Chancellor Angela Merkel, “We are not living in the final phase of the pandemic, but still at the beginning.” 4/23/2020
  • CDC Director Robert Redfield, “There’s a possibility that the assault of the virus on our nation next winter will actually be even more difficult than the one we just went through.” 4/21/2020
  • WHO Special Envoy David Nabarro, “We think it’s going to be a virus that stalks the human race for quite a long time to come until we can all have a vaccine to protect us…” 4/12/2020
  • Former CDC Director, Tom Frieden, “As bad as this has been so far, we’re just at the beginning.” 5/7/2020
  • New York Magazine, “The FDA has never approved a vaccine for humans that is effective against any member of the coronavirus family, which includes SARS, MERS, and several that cause the common cold.” 4/20/2020

A vaccine requires several steps past finding the right formula. Once a promising discovery is made, there is animal testing, human testing, dose finding, regulatory approval, large-scale production, distribution and the issue of who pays for it. You cannot inject all humans with something until there is relative certainty it is not going to have adverse effects. Experts seem to agree that this cannot be done faster than nine months. Under the best case scenario, the world will be forced into the “90% economy” until sometime in 2021.

COVID-19 Is Still Mysterious To Scientists.

It has several phenomena that make it problematic:

  • Contagious without symptoms;
  • A relatively long incubation period;
  • Symptoms throughout the body (i.e., blood clotting, COVID toe, organ failure);
  • Unknown immunity duration after recovery; and
  • Uneven virulence across strains, the population, and within an infection.

COVID-19 hit the developed world first; presumably in places where there is greater international travel. And because of that, most developed nations are now seeing a plateau or decrease in new infections (in the first wave at least). But seemingly, many developing economies are just starting their first wave. Developing economies generate the lion’s share of global GDP (estimated to be 60-70%) and thus have a large impact on the developed world.

The Economic Picture Is Serious

The economic damage already done from the lock-down as well as the idea that the world was near to a recession will result in a secular change in spending mentality that favors saving over spending.

Beyond lock-downs, the social distancing required until a potential vaccine is available has direct ramifications to economic activity. Gatherings with less density imply less demand for goods and services. Common examples are flights with empty middle seats or stadiums half-filled. Social distancing policies will enforce less economic output until a vaccine can be found and distributed broadly.

Economic data releases have been “off the charts” bad but dismissed by investors as aberrations. And as yet economists are increasingly clear that even if the economy has already bottomed (I doubt it), it will be a years-long recovery back. But the stock market is priced for a V-shaped recovery (more on this below). Investors are imagining that the new infections curve (of a given country) to be inversely correlated to its economic curve. As the new infections rate falls, the economy will come back in the same proportion. But the economic indicators are “off the charts” in the same proportion to how severe this incident is. In other words, they are real numbers and they are commensurately scary.

In any past recession, there were geographical areas or industries that were somewhat unaffected and could mitigate the heavily affected areas. In this case, whole aspects of the global economy were turned off simultaneously in a very specialized and optimized (“just-in-time”) global economy. Also, unlike older historical pandemics when it took days or weeks for news to travel, humanity knew about it at the same time, changing our economic behavior (a little or a lot) all at once. This is unprecedented in human history.

With reduced tax revenue, U.S. state, local, and municipal governments are struggling and will likely need a stimulus package of their own. If this is happening in the United States, imagine the fiscal crises that will strike less wealthy economies.

Countries that have not locked down (Sweden) or countries well on the other side of the infections curve (South Korea, China) are showing depressed economies even without the lock-down.

With the U.S. unemployment rate at 14.7%, the Taylor Rule implies the Fed funds rate should be less than minus -6% to be stimulating the economy. If the unemployment rate were to rise to 25% in May (per Treasury Secretary Steven Mnuchin on 05/10/2020), the Taylor Rule would suggest the Fed funds rate should be below minus -16% to be stimulative. I’m not suggesting the Fed will get to these levels, but it illustrates the scale of the crisis.

Several others have stern warnings about the economic severity of COVID-19:

  • Chairman and CEO of BlackRock Larry Fink, surreptitiously, “Mass bankruptcies, empty planes, cautious consumers and an increase in the corporate tax rate to as high as 29% were part of a vision Fink sketched out on a call this week.” 05/06/2020
  • Minneapolis Federal Reserve Bank President Neel Kashkari, “Large banks are eager to be part of the solution to the coronavirus crisis. The most patriotic thing they could do today would be to stop paying dividends and raise equity capital, to ensure they can endure a deep economic downturn.” 4/16/2020
  • Sam Zell, “Sam Zell, the billionaire known for buying up troubled real estate, said the coronavirus pandemic will leave the same kind of impact on the economy and society as the Great Depression 80 years ago, with long-lasting changes in human behavior that imperil many business models.” 05/05/2020
  • Nouriel Roubini, “The Coming Greater Depression of the 2020s,” 04/28/2020
  • Warren Buffett “I don’t know that three, four years from now people will fly as many passenger miles as they did last year.” 05/02/2020
  • Scott Minerd, CIO of Guggenheim Investments, “To think that the economy is going to reaccelerate in the third quarter in a V-shaped recovery to the level where gross domestic product (GDP) was prior to the pandemic is unrealistic. Four years from now the economy will most likely recover to the same level of activity that it was in January.” 4/26/2020
  • Historian Niall Ferguson, “It will take much longer than people assume for the economy to recover.” 05/06/2020

Global Stock Markets Will Fall To New Lows

Prominent publications have come out with specific warnings about the stock market:

  • The Economist, “A one-month bear market scarcely seems enough time to absorb all the possible bad news from the pandemic and the huge uncertainty it has created. This stock market drama has a few more acts yet.”
  • Financial Times, “Equities generally are still priced for a near-perfect bounce-back from the coronavirus crisis. Lockdowns may last longer than planned. Exits may prove bumpier. Hopes that the virus can be eradicated quickly, and a second wave of infections avoided, may be proven wrong. A quick rebound to the status quo ante looks increasingly implausible. Amid so many unknowns, a further market correction looks more than likely.”

Despite it seeming as though the Federal Reserve and Treasury have spent infinite amounts of money to prop things up, it is still less than the money lost. In a general sense, if the stimulus funds were as big as the problem, economic indicators wouldn’t be weakening. Politicians never accidentally make people more than whole (in the aggregate). No matter how much liquidity there is, stocks are still ultimately beholden to corporate earnings.

The stock market is fundamentally expensive. The price earnings ratio (trailing) of the S&P 500 is near 20. Prices will need to come down a great deal before stocks look secularly attractive. They will have to come down even further if earnings weaken materially. Multi-decade secular bull markets have begun when these ratios are below 10 (see chart below).

This is a big enough demand shock (an economic “earthquake”) that virtually any company (U.S. or international) will struggle for years. Even after the virus and economy improve, paying the huge public debt bills that economies have amassed will become the focus. Higher taxes will ultimately weigh on profitability for decades. There will be exceptions (say Clorox or Netflix, so far), but the majority will struggle.

Because COVID-19 has only been known for four months (really just three, as the markets are concerned), investors can still imagine a V-shaped recovery.

The chart below puts the U.S. stock market’s (S&P 500) performance from its recent peak in the context of past major bear markets.In this view, things have only begun. For instance, in the Great Depression, it took nearly three years from the peak to the trough. We are just four months into this.

The stock markets went down through alternating waves of hopes (prices higher) and fears (prices lower). There will be many chapters to COVID-19. We are in the first one.

The table below shows all of the bear-market rallies greater than 10% in the cycles identified above. There were several strong rallies. The average length of those rallies was about two months (1.8). The current rally has lasted a very similar 1.2 months (assuming 04/29/2020 was the peak).

What To Invest In?

There is nothing wrong with cash.

Today, we call money not being invested “cash,” but at one time, it was just called “savings.” The importance of savings is that the money is there more than it is growing. Japan has rediscovered this dynamic in the last 30 years. Despite cash earning nothing (and it won’t again for years), if you are in cash and the stock market falls, you get to buy it back cheaper. Having cash gives an investor the freedom to invest in opportunities as they arise and be the “buyer” in a buyer’s market. Don’t think you have to invest all your money to be productive.

U.S. Treasury bonds will appreciate. They appreciate in price when yields fall and depreciate when yields rise. The more that yields move lower, the more that prices move higher. As an example, if the current 30-year Treasury’s yield were to drop from where it currently yields 1.33% (5/15/2020), to 0.75%, this bond would appreciate by 15%. If it dropped to a zero yield, it would appreciate 40%. These aren’t small returns. But bond prices decrease in the same proportion if rates were to rise.

As has already happened in Japan and Germany, U.S. Treasury interest rates will fall well below zero as this crisis intensifies. This is why:

Deflation will be the theme of the “90% economy” because it implies a 90% price. Meaning that if the economy is expected to operate 10% lower than before, supply and demand would suggest that prices (inflation) would be 10% lower too. I am not suggesting a one-time drop of 10%, but rather that there will be tremendous pressure towards lower prices (in aggregate that-is; individual sectors may have higher prices). But, it isn’t just the initial shock, there will continue to be deflationary pressure as long as the output gap is negative. That is going to take years and years to close. Deflation implies lower Treasury yields, because if prices are deflating at say 5% per year, a minus 4% yield on a Treasury would be valuable (as saving 1% over the alternative). Because of this, there is no limit to how negative Treasury rates can go, they are a function of inflation/deflation.

Given the scale of COVID-19, the Fed (and other developed economy central banks) will need to cut short-term rates deeply negative. This will pull all Treasury yields lower. I can already hear the chorus of arguments (“it hasn’t worked!”, “it creates a liquidity trap!”, “it creates hyperinflation!”) Yes, there will be tremendous resistance, but a threshold exists where the importance of protecting an industry (money market managers, banking) will pale in comparison to the economic needs of the whole country. In other words, there is a point where the Fed will alienate creditors at-large for the bigger picture. There are two prominent voices calling for negative rates so far (below), but I suspect these voices will grow in number:

  • Professor of Economics and Public Policy at Harvard University Ken Rogoff, “…the Fed could push most short-term interest rates across the economy to near or below zero. Europe and Japan already have tiptoed into negative rate territory. Suppose central banks pushed back against today’s flight into government debt by going further, cutting short-term policy rates to, say, -3% or lower.” 5/4/2020
  • Former President of the Minneapolis Federal Reserve Bank, Naranya Kocherlakota, “Unprecedented situations require unprecedented actions. That’s why the U.S. Federal Reserve should fight a rapidly deepening recession by taking interest rates below zero for the first time ever.” 4/24/2020

But “yield curve control” is the Fed’s next-biggest tool and I suspect it will be used before negative rates because it is more palatable to the banking and money-market industries. “Yield curve control” is a fancy way of saying that the Fed could control longer-term interest rates like they do with short-term rates. Japan is currently doing it and the U.S. did it in the 1950s. The idea is to force term rates down to, or below, a certain threshold to encourage lending. For instance, the Fed could target the 10-year Treasury yield to be 0.25% and ensure it by committing to buy enough 10-year Treasury bonds to take it there. “Committing” is the key word because if the central bank is credible enough, it doesn’t always have prove it with real capital; the threat is enough for the market to take it there. Assuming the mortgage market was functioning normally, it could help get mortgage rates down to 1%. Anyone with a mortgage can imagine how helpful that would be.

Some worry that the amount of stimulus the U.S. is spending will lead to hyper-inflation or equivalently, a weakened currency. The fiscal/monetary picture of the U.S. isn’t as extreme as it is made to be. Japan’s finances are a useful example of how far a super-power’s credit stretches. On almost any dimension, Japan’s finances are in worse shape than in the US, and yet their 10-year yield is 0.00% (see table below). Credit risk should show up first in Japan before we would see it in the U.S. They are the canary in the coal mine on this issue.

All of these things combined portend a continuing U.S. Treasury bull market (lower yields) for a few more years. Then, once everyone has given up on the stock market and P/E ratios are in the single digits, it will be time to buy stocks.

COVID-19 is the equivalent of a 300-year flood. It will be the theme of financial markets for an enduring horizon.


Eric Hickman is president of Kessler Investment Advisors, Inc., an advisory firm located in Denver, Colorado specializing in U.S. Treasury bonds.

COVID-19 Triggers Transformation into a New Economy – Part 1

The COVID-19 pandemic has triggered a transformation into a “new economy.”

The economy was a very nice photo, than the pandemic turned it into a jigsaws puzzle that’s all messed up, now we’re trying to put it together and figure out if all the pieces are still here or not.

Mohammed A. El-Arian, Chief Economist, Allianz

The novel COVID-19 virus has driven the world economy into the deepest recession since the Great Depression and shattered the linkages that held it together. Economists are still trying to make sense of what has happened to the supply chain and demand channels. As El-Arian, notes key economic components may be missing. As such, some new components will need to be created. All these components will then need to realign into a “New Economy.”

The challenge of rebuilding the economy will be influencing consumer behavior. Consumer spending is 70% of GDP.  Thus, growing employment is crucial toward increasing consumer confidence and recovery.  The central question is: how will the economy shift to a growth track? We’ll look at crucial signposts along the way in building a new growth track by presenting the following topics: (Note: This article, Part 1, includes sections 1, 2, 3 below. Sections 4 and 5, which look at the “new economy” will be forthcoming in Part 2.)  

  1. COVID-19 – Unique Event – Examines the unique characteristics of the pandemic and how they set up specific economic trends.  Part 1
  2. Virus Drives the Economy – Looks at how the virus is driving the economy, how it is out of control and what strategies are working toward containment – Part 1
  3. Outlook For The U.S. Economy – Takes a new perspective by overlaying the virus cycle with a deep “U shaped” economic cycle and how economic activity changes during each stage of the cycle.  – Part 1
  4. New Economy – Describes the transformation of our society, how these changes will create winning and losing businesses, and how consumers will likely have more conservative spending and saving habits – Part 2
  5. What We Need To Do To Create a New Economy – Recommends a federal team of scientific experts be authorized to lead virus containment, investment in self-renewing innovation centers in hard hit pandemic areas, and focus employment development on climate change solutions – Part 2

COVID-19 Unique Event

The COVID-19 crisis is causing deep psychological shock combining panic, depression, and recession. It is a new type of crisis or ‘panipression’.  We combined three-word stems: pan for all and Greek word for their god of terror in the word panic, press a state of pressing down and sion for state or quality of something.

People are emotionally stressed, not sleeping well, and worried about their families as in other recessions. Unlike other economic speed bumps, health is added to their worries.  It is a sense of falling, that doesn’t seem to stopThis worldwide virus contagion is incredibly pervasive, going right to the heart, soul, and experience of every American.  The social fabric of our society is being shredded. 

Now we must stitch our social fabric back together.  Every day our way of living is turned upside down.  The previous ways of doing things have disappeared; social interaction has shifted to digital networks. It has been a fast two-month social upheaval, and we are in just in the early stages of the transformation.

Business leaders are grappling with this tsunami of change and what it will mean to their businesses. Executives used the word ‘unprecedented’ 50% more in their recent first-quarter earnings conference calls than in the descriptions of business conditions during the Great Recession.

Virus Drives the Economy

Since March 11th when a national emergency was declared, the COVID-19 virus swept swiftly through the country to cause 84,100 deaths and 1.3M infections at an average rate of 22,000 per day. 

Source: New York Times – 5/14/20

The economic impact has devastated U. S. economy, with 36.5 million people receiving unemployment assistance, an unemployment rate of 14.7% in April, and 30% of Americans reporting a drop in income. 

When the virus infection and death rates drop steeply for an extended period, then the economy will begin to recover.  So, how are policymakers succeeding in controlling the virus? Dr. Anthony Fauci, White House Infectious Disease Advisor, testified to the Senate on May 12th  that the virus is still out of control. He expected by now to see a steep drop in the new infection rate but instead sees a slow decline with peaks.  The performance of states in mitigating the pandemic impact is due to several factors such as how early lockdowns were instituted, population density, and hospital infrastructure. Performance rates vary widely from California’s death rate at 7.5 per 100k, to 140 for New York.

What techniques are working to rein in the virus?  The New York Federal Reserve examined the 1918 Spanish Flu pandemic and found that early lockdowns and social distancing had a positive impact on mortality rates and medium-term employment growth.

Sources: The New York Federal Reserve, New York Times – 5/5/20

Researchers noted that very different results occur in the same geographic area, such as the twin cities of Minneapolis and St. Paul.  Minneapolis had a longer lockdown period and a 30% increase in medium-term employment versus St. Paul that had a shorter lockdown period and only a 15% employment increase.

States like California instituted early lockdowns and are very slowly phasing in the economic opening.  Other states like North Dakota did not implement lockdowns, while others varied significantly in how quickly they instituted lockdowns. States were left on their own with only vague national guidelines on what levels of virus control they needed to achieve to reopen their economies.

The following two charts show the status of lockdowns organized by state and infection rates in nine key states. Of significant concern are states that are opening up which have increasing infection rates: Mississippi, Tennessee, Georgia, North Dakota, Utah, Alabama, Missouri, Texas, and South Carolina:

Sources: Bloomberg, COVID Tracking Project – 5/6/20 & 5/7/20

A Yale School of Public Health analysis showed that travelers from New York in March and April seeded an average of 82% of the infections in the Mountain West, Midwest, South, and East and 43% on the West Coast.  Thus, cross-infection from virus hotspots spread and continue to spread throughout the U.S. to areas where the virus was thought to be controlled.

Dr. Fauci warned in his Senate testimony, that opening states too early without widespread testing, tracing, and treatment infrastructure in place increases the probability of a second wave of infections and threatens economic recovery. Most states only test people if they are symptomatic, so we don’t know how widespread the virus is in our communities. Some states are just beginning to gear up comprehensive tracing programs. Treatment drugs like remdesivir show promising results in speeding the recovery of infected patients, but has limited distribution. The point is the virus is ahead of U.S. containment efforts, Dr. Tom Frieden, former director of the Centers for Diseases Control and Prevention observed:

We’re not reopening based on science, we’re reopening based on politics, ideology and public pressure. And I think it’s going to end badly.”

Outlook For The U.S. Economy

The virus is driving the economy right now, so overlaying the phases of virus infection and containment with a U shaped economic cycle is helpful to understand the direction of the economy.  The Federal Reserve and federal government have focused on providing ample liquidity to the economy and temporary relief to consumers.  But, the path to build consumer spending is unclear.  We have decided to focus on consumers by reviewing how during each phase of the economic cycle key factors change, such as unemployment, small business, job loss expectations, and consumer confidence.  World trade was added to understand how American companies may benefit from increasing trade to boost the economy and employment. Shifts in these indicators act as signposts along the path toward recovery.

Source: Patrick Hill – 5/12/20

Contraction Phase –The economy seems to be in the early stages of a contraction based on the huge jump in the unemployment index for April of 14.7% reported by the Bureau of Labor Statistics.  Neil Kashkari, Federal Reserve Governor for Minneapolis, noted that if those misclassified unemployed are added the unemployment rate, it is closer to 20% or 1930s levels. Plus, if a person stops looking for work they are then viewed as out of the labor force and not counted.  Due to ‘panipression’ many workers will be stunned and have a difficult time even start a job search. The economy will not come out of the contraction phase until the virus is contained, or at least it becomes evident to consumers that it is safe to go out into the community to shop, travel, or work.

Large corporations accessed their credit lines by $200 billion in April.  Plus, large businesses have had good access to bond markets and private equity that small companies don’t enjoy. The Small Business Administration estimates that there are 31 million small businesses in the U.S., with fewer than 500 employees. Small businesses are the hiring engine of the economy with 64% of all U.S. new hires in 2019, creating 1.5 million new jobs. The majority of small businesses have only twenty-seven days of cash, and then they must have to borrow heavily or close their business.  Only 30% of small businesses are making a profit, with another 30% breaking even and 40% losing money. Thus, 70 % of small businesses were already on a financial cliff as lockdowns began in mid-March.  Forty percent of all small companies missed their May rent payments.

Sources: The Wall Street Journal, The Daily Shot – 5/4/20

Congress quickly funded the first phase of the Paycheck Protection Program (PPP) in early April with most of the funds going to existing large bank customers and many major corporations, leaving millions of small businesses off the list.  A significant benefit of the PPP program was the conversion of the loan to a grant if funds were used primarily for keeping employees on payroll until July 30th.  Subsequently, Congress passed a second law providing an additional $484 billion for PPP funding. Banks began taking applications on April 30th.  Audits show that of those small businesses applying for funds, 70% were approved, and 60% had received checks by May 11th.  So, many small businesses now have funding. However, the funding law was general in establishing the use of funds requirements and left the final spending rules to the Treasury department.

The Treasury department set rules placing a 25% of total loan value limit on rent, mortgage, and utility payments. Even with the PPP assistance, many small businesses in major cities with high rents like New York, San Francisco, Los Angeles, and Chicago will be hard-pressed to pay fixed costs like rent and utilities.

A survey by the Society for Human Resource Management (SHRM) of small businesses reported that 52% of owners expected to close within 6 months, or about 15 million firms. The SHRM survey was conducted before the second wave of small business PPP loans. It is possible that many businesses that were denied the first phase of PPP funding will receive funding during the second wave. Another program of loans by the Federal Reserve for small businesses will likely not help many small businesses as the Fed tightened eligibility requirements.  

All these relief programs need to be inclusive, flexible, and fast, or there will be a small business solvency crisis this summer. We are concerned about all the chaos and confusion, so we forecast a reduction in the number of small businesses to 22 million by the end of the contraction.

A Bankrate job security survey showed that 25% of workers said they expected to lose their job within 12 months. Their insecure job expectations fit with the loss of consumer confidence for April, the steepest drop in five years. The direct payments of $1200 to individuals will help to provide temporary relief through July, but after that month, it is not clear what many workers will do if their temporary furloughs turn into permanent job layoffs.

Economists forecast a conversion of temporary to permanent layoffs to range from 10% to 45%. For example, airlines have been hit hard with planes only 10% full for April. If passenger traffic does not bounce back quickly in the summer, permanent layoffs are likely to rise in the fall. High tech companies that depend on advertising like Google and Facebook will not be immune to the decline in consumer spending. A 33% drop in ad spending is forecast for this fall.  Thus, there may be layoffs in the high technology sector as well. As layoffs continue, the number of workers expecting to lose their job in 12 months may increase to 35%. 

World trade will not lift the U.S. economy out of a recession. The World Trade Organization forecasts a reduction of year over year of world trade by 10% with a decline to – 25% by year end.  S & P 100 corporations receive 60% of their revenue and 70% of their profits from overseas customers. A decline in foreign business will squeeze profit margins as well. The U.S. and China are exacerbating the trade tension with threats related to the pandemic and the Phase One trade deal. U.S. businesses will come under increasing federal government pressure to move manufacturing back home for strategic reasons causing an increase in payroll and overhead costs. Reducing costs and market access are vital reasons why firms moved offshore to begin with, and now those advantages may be lost.  

Trough Phase – As the virus comes under control, we expect the economic damage will last longer than the health impact on people. During this phase, the next level of economic activity will begin as the economy stabilizes at a much lower level of activity.  Optimistic forecasts call for consumers to jump right back into their pre-pandemic buying habits, yet surveys of consumer buying interests show their reluctance to leave home. The New York Times reported in a survey that showed even in states that opened quickly, consumers still did not want to leave home for shopping, sporting events, or travel. A survey of 6,730 adults from lockdown and opening states confirmed consumer hesitation:

Sources: The Democracy Fund, UCLA Nationscape Project, New York Times – 5/8/20

Unemployment will stabilize at 24 %, as federal government programs to jump start public works projects assist but are not likely to stem the tide as the government does not have the funding or political will for major projects.

The number of small businesses will slip to 18 million in the early stage of the trough.  Small businesses will have a tough time surviving the control of major companies moving into their market segments and buying up failing businesses to gain market share.

We expect consumer confidence to drop to a twelve-year low at 25, as job prospects dim.  Companies will be in survival mode and reluctant to hire. Management will be looking for signs of steadily increasing sales and a stabilizing economy. We forecast that as the economy stabilizes, consumer confidence will rise to 55.

Workers that have jobs in information technology and software services will likely be the first group to increase consumer purchasing and resume major purchases for cars and trips.

Millennials and those low on cash will further shift to using car-sharing services. Automotive companies will likely see declining sales overall. 

Corporations will find that they need workers in customer-facing positions or want to differentiate their services with personal assistance.  

Manufacturers will install automation systems next to workers to drive production output up while meeting social distancing requirements. Automation systems will stay in place. 

During this trough phase, it is likely that those left out of the previous expansion will be frustrated and look for more government programs and support that will put even more pressure on the federal deficit and the Federal Reserve to monetize the debt. The federal government will be hard-pressed to provide fiscal stimulus to the economy, leaving the private sector to lead investment in growth sectors. The economy will show peaks and valleys in different industries, but overall the combined growth will likely be flat and cap business revenue growth year over year.

Trade will stay depressed as the U.S – China trade war splits world trade into two blocks with bridge-building countries like Australia and Singapore providing conduits of international commerce. World trade hits a low of -32%. Please see our post Navigating A Two Block  Trade World for further analysis of the shift in world trade patterns.  Finally, the entrepreneurship engine that typifies the U.S. self-renewing economy will begin to show ‘green shoots’ from startups giving hope for recovery just around the corner.

Recovery Phase – Consumers will feel comfortable freely moving about and quit thinking about the possibility of becoming infected.

Unemployment will fall to 12.7% as creative small businesses during the contraction, and trough phases begin to gain traction deploying their business models. Private equity firms and banks will be more willing to finance expansion as they see business revenues increase and profits start to emerge.  New high tech and software services startups incubated during the trough phase will start growing quickly and hire new workers at an accelerated rate.

New small businesses will develop in various business segments, including online services, personal assistance, home-based applications, and health advice.  Artificial intelligence is no longer isolated as a field but is integrated into autonomous cars and trucks, healthcare, and personal services. More details on the winning and losing businesses and new sectors of the New Economy please read Part 2 of this article.

The number of small businesses will increase to 22M and begin to lift the economy and communities.  Worker job expectations that they will lose their job in 12 months falls to 14% and a more moderate 9% by the peak in the recovery period.

Consumer confidence will solidly increase, causing spending to grow and drive business revenues and earnings into the black as economic momentum takes hold.

Trade will finally increase by plus 5% as countries tired of combating each other find they need to collaborate to rebuild the global economy.  

Final Comment

We expect corporate leaders to take the lead in employment development for a long term economic transformation as political divisions will continue.  We noted in our post: A Pandemic Iceberg Hits the ‘Unsinkable’ US Economy’ that the fabric of a solid labor safety net needs to be built to mitigate the impact of an economic crisis like COVID-19 on labor in the future.  It is in the interest of executives to build businesses where workers are thriving, not just surviving. The focus must be on building an innovative economy that is creating new jobs through entrepreneurship. Otherwise, we are faced with a stagnating economy dependent on government transfer payments. We conclude with the following declaration from that post:

Americans built the most innovative, self-renewing, wealth building economy in the world.  It is the American spirit of entrepreneurship combined with invention, self-sacrifice, equal opportunity, and creativity that will build the businesses of the future. These new businesses will adjust to new social realities and pave the way for workers to gain job security and become confident enough to spend at robust levels.”

Patrick Hill is the Editor of The Progressive Ensignhttps://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: @PatrickHill167

Sector Buy/Sell Review: 05-20-20

Each week we produce a Sector Buy Sell 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 SECTOR BUY/SELL REVIEW 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.

NEW PORTFOLIO TOOL:  Under the PORTFOLIO tab you will see a new tool called ALERTS. When you click on the link, any position that you in a WATCHLIST or PORTFOLIO will show up in the ALERTS window.  You can add SELL TARGETS, STOP LOSS, and Daily % Changes. When those levels are triggered, you will be sent an email and the alerts will show on your dashboard. 

We are using this system for all our current positions and will be reporting our targets in these daily updates.

Basic Materials

  • XLB reclaimed the 61.8% retracement with Monday’s rally, but remains overbought, and is underperforming the market. 
  • We are out of the sector for now due to the underperformance. However, if we do enter a trade, parameters will be very tight as the outlook for earnings remains dismal 
  • We raising our trading alert to $46 which may set up a tradeable opportunity.
  • Short-Term Positioning: Bearish
    • Last Week: No Positions
    • This Week: No Positions
  • Long-Term Positioning: Bearish

Communications

  • XLC continues to perform better than the overall market. 
  • We added to this sector on Monday as the 200-dma retracement level was taken out. 
  • We continue to like the more defensive quality of the sector, BUT on a short-term basis it is very overbought. We are looking for a pullback to add further to our holdings.
  • Our have set an alert at $49 to revisit adding to our holdings.
    • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Added slighly.
  • Long-Term Positioning: Neutral

Energy

  • Energy stocks have been trading much better than the commodity as relative strength has improved for the sector. 
  • We added to our holdings on Monday by increasing exposure in XOM and CVX in the equity model and adding those two positions to the ETF model. 
  • We have a stop-loss alert set at $30, with a high-alert set at $40. The sector is about at the same level as last week, so no action taken. 
  • Short-Term Positioning: Bearish
    • Last week: Hold positions
    • This week: Added slightly
    • Stop loss is $30.
  • Long-Term Positioning: Bearish

Financials

  • Financials have lagged the bear market rally badly, and continue to underperform. 
  • We sold out of financials previously and will re-evaluate once the market calms down and finds a bottom. 
  • We continue to suggest selling rallies in financials.
  • We have an alert set at $21 to start evaluating holdings.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Industrials

  • As with XLB, so goes XLI.
  • XLI had a good rally on Monday but failed to break out of its consolidation. 
  • We sold all of our holdings previously and will opt to wait for a better market structure to move back into the sector. 
  • We have an alert set at $58 to evaluate positions
  • Short-Term Positioning: Bearish
    • Last week: No position.
    • This week: No position.
  • Long-Term Positioning: Bearish

Technology

  • Technology continues to be our strong suit and we added more exposure to the sector on Monday. 
  • The rally on Monday continues the push toward all-time highs and is back into positive territory for year. However, it is a narrow advance driven by the 5-major constituents. So goes AAPL, so goes the market. 
  • If we get a pullback that holds support at the 200-dma and the 50% retracement level, we will look add more weight to the sector. We have an alert set at $86.
  • Short-Term Positioning: Bullish
    • Last week: Holding positions.
    • This week: Added slightly
    • Long-Term Positioning: Bullish

Staples

  • We also added to XLP this week a smidge. 
  • XLP is working off the overbought condition somewhat, but still has more to go. Importantly, XLP continues to hold support at the 50% retracement.
  • We have an alert set at $55 as our stop-level.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Added slightly
    • Long-Term Positioning: Bullish

Real Estate

  • XLRE held support at the 38.2% retracement and rallied. We added some exposure to our holding on Monday. 
  • The sector is not overbought and is oversold relative to the market. 
  • We have a low limit alert at $30 if lower support is getting threatened.
  • Short-Term Positioning: Bullish
    • Last week: No position
    • This week: Added slightly
    • Long-Term Positioning: Bullish

Utilities

  • XLU, like XLRE, held support at the 38.2% retracement level and turned up. We added some exposure to the sector as we look for a rotation into more defensive names. 
  • We should see a relative “risk off” safety trade with XLU if we see a pullback in the broader market.
  • We have an alert set at $54.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Added slightly
  • Long-Term Positioning: Bullish

Health Care

  • XLV finally ran into resistance near all-time highs and has been consolidating.
  • The 200-dma is now important support and needs to hold. 
  • The sector is very overbought short-term.
  • We have an alert set at $95 to add more to our holdings.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Added slightly
  • Long-Term Positioning: Bullish

Discretionary

  • Discretionary is performing better now. 
  • XLY rallied to the 200-dma and finally broke above it. 
  • AMZN makes up about 70% of the entire ETF, so this is really an AMZN story more than discretionary retail overall. 
  • The sector is VERY overbought, so a pullback is likely, but there is a trading opportunity if XLY can hold this break above the 200-dma.
  • We are focusing on Staples for the time being but have an alert set to add Discretionary as a trading position at $110.00 on a pullback or $118 on a breakout.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Transportation

   

  • We have remained out of the economically sensitive sector as the impact of the “coronavirus” continues to rip through earnings in this sector. 
  • The sector mustered a weak rally from lows back to the 38.2% retracement level, got very overbought, and has now failed at resistance. 
  • We have an alert set for a trading opportunity set at $44, but we aren’t excited about it.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

The Fed Enters Monetary Light Speed

The Fed Enters Monetary Light Speed

Ben Kenobi: How long before you make the jump to lightspeed?

Han Solo: It’ll take a few moments to get the coordinates from the navicomputer.

Luke Skywalker: Are you kidding??! At the rate they’re gaining—

Han Solo: Traveling through hyperspace ain’t like dusting crops, boy! – Star Wars, Episode IV

Light Speed

In the early Star Wars movies, Han Solo was the captain of the rusting Millennium Falcon spaceship. When making a daring escape, Solo would command the ship to jump to light speed. The surrounding stars would blur in streaks as they left their pursuers in stardust and suddenly ended up somewhere across the galaxy far, far away.

On April 9, 2020, the Fed made the jump to light speed with their announcements of even more remarkable stimulus packages. The new operations were in addition to the myriad of operations in March and prior months.

To define monetary light speed, the Fed’s balance sheet rose from $3.76 trillion at the end of August 2019 to $4.16 trillion at the end of February 2020 – a change of $400 billion. As of May 13, 2020 it was at $6.93 trillion. A shocking increase of $2.77 trillion in ten weeks, dwarfing anything seen during the financial crisis.

Having  promised to purchase Treasuries, mortgages, and municipal bonds, in whatever amount necessary, they set off on a new path. Now they can buy investment grade corporate securities, high yield bonds (junk), and even certain Collateralized Loan Obligations (CLOs – the securitized form of high-risk leveraged loans). These operations will take place through the newly formed Secondary Market Corporate Credit Facility (SMCCF).

Per the Federal Reserve Act, the Fed can only purchase or lend against securities that have a government guarantee. So how can they purchase non-government guaranteed securities?

SPV Back Door

The simple answer is the Treasury is enabling the Fed to side-step the law, or to be more accurate, break the law.

As the Fed’s accomplice, the Treasury Department provides $75 billion of initial funding from the Exchange Stabilization Fund. The funds are deposited into a special purpose vehicle (SPV), and specifically aimed to purchase secondary market corporate bonds. Technically, the Treasury, not the Fed, is buying those securities on behalf of taxpayers.

Enter the co-conspirator. The Fed, acting as an intermediary and employing asset manager BlackRock, intends to leverage that amount ten times. This allows the Fed to buy an additional $675 billion in securities and select Exchange Traded Funds (ETFs).

Calling Out the Fed

As John Hussman described on April 20, 2020, Congress never granted that authority (the leverage) to the Fed, making such a maneuver illegal.

“… additional purchases to “leverage” that funding are neither secured by non-financial collateral, nor have security sufficient to protect taxpayers from losses. They are illegal, both under Section 13(3) of the Federal Reserve Act, and under Section 4003(c)(3)(B) of the CARES act, which “for the avoidance of doubt” specifically invokes 13(3) “requirements relating to loan collateralization, taxpayer protection, and borrower solvency.”

Given the leverage and speculative nature of the securities the Fed is acquiring in the SMCCF (SPV) scheme, a 10% drop or more in the value of the SPV assets would result in immediate insolvency and losses to taxpayers.

In simple terms:

  • The Treasury Department funds the SMCCF SPV with $75 billion (a legal action)
  • The Fed acting as the intermediary of the SPV, stated they may leverage those funds 10 times (an illegal action)
  • If at any point up to the $750 billion of investments made through the SPV, the value of held assets drops by more than the initial $75 billion funded by the Treasury, the loss is in breach of what Congress authorized.
  • The assets the Fed will buy do not meet the stated requirement of sufficient security intended “for the avoidance of doubt” about the potential for loss (to the taxpayer). It is an illegal structure.

If the economy and markets regroup, borrowing and consumption patterns return to pre-virus outbreak levels, and investors shed all fears of another leg down in markets, then maybe we can sound the all-clear.

Economic Reality

However, even Pollyanna would not subscribe to such an optimistic path. Unemployment in April was 14.8%, consumer spending, industrial production, and confidence are plummeting. Every industry and many individuals have their hands out for taxpayer-sponsored relief (bailout).

GDP is expected to drop by 12-15% in the second quarter and that may be optimistic. In a May 17th 60 Minutes interview, Fed Chairman Jerome Powell said it could be down as much as 30%.

Making matters worse, the economic carnage affects all industries and is global in nature. As if depression-like economic data were not enough, there is not yet a therapy or vaccine for the Coronavirus. Although there is little doubt one will be forthcoming, the timing is uncertain and appears to be, at best, months out in the future.

The probability of corporate losses on the Treasury’s balance sheet amounting to over $75 billion is not at all unrealistic. Plus, there is the continuing uncertainty in the economic outlook despite hopes for the economy to reopen gradually. Current valuations of the bonds in the Fed’s SPV do not adjust for the risk of a global economic outlook that is more constrained and restricted than at any time since the great depression.

Again, from John Hussman:

“As a result, the newly created SMCCF is either a Ponzi scheme at public expense (if the Fed plans to allow portfolio losses to exceed 10%) or a 1987-style portfolio insurance scheme (if the Fed plans to liquidate securities into a falling market in order to cap its losses at 10%).”

Pick your poison.

Fed Independence

The SPV scheme applies to several non-traditional lending facilities also used in the 2008 financial crisis and many new facilities. The collaboration merges the Fed and the Treasury into one organization. This plan follows a recommended script published as an Op-Ed by former Fed Governor Kevin Warsh in the Wall Street Journal on March 15, 2020.

Winners and Losers

The SPV scheme was used on a limited basis with much higher quality assets during the financial crisis but was quickly unwound as the economy recovered. Given the expansion of powers this time, we should assume these actions could reduce Jay Powell’s authority over monetary policy. Essentially he is indirectly ceding control of our “independent” central bank to the Treasury Department. The risk is that the executive branch may end up with dominant influence over certain important operations at the Fed. What this means is that the line between monetary and fiscal policy is even further blurred given the exposure taxpayers unknowingly assume for losses on risky SPV holdings.

Corporate executives reaped unwarranted multi-million-dollar rewards for short-term-oriented, profit-maximizing behavior over the past ten years. However, once again, the taxpayers, most of whom did not benefit from irresponsible corporate and fiscal actions are on the hook.

The SPV structure allows the Fed and Treasury to nationalize major segments of the financial markets. With that, the credibility of pricing signals is lost. The capital markets are not only crucial for raising capital but equally important in the way they offer traffic signals to businesses and individuals concerning true economic conditions. Without these signals, capital allocation becomes distorted, and productivity growth flounders. Based on observations over the past ten years, it is safe to say we are well past that point.

If Jay Powell and Steve Mnuchin were legislated to assume personal risk in their scheme, would they be willing to accept it?

No. Certainly, they would not accept it.

Summary

It is shameful to watch the blatant abuse of power where Constitutional order requires the Fed and other government officials to abide by proper laws intended to restrict such behavior.

As recently as January’s impeachment hearings, both sides of Congress were well-versed in quoting from the Constitution. Today, however, the laws of those guiding documents are largely ignored.

By most accounts, it seems very likely that the Fed will, sooner or later, buy equities in the ultimate act of expediency. Buying high yield bonds is but one very short step away from the next level down in the risk continuum – stocks.

With the Fed now engaged in light speed monetary policies, our future is likely to include:

  • Zero bound and potentially negative interest rates
  • A lower natural economic growth rate
  • An even larger wealth inequality gap
  • Loss of Fed independence from the Executive branch of government
  • Price instability (deflation then inflation)
  • Significant and damaging volatility
  • Nationalized financial markets
  • Irrelevant market signals

The Fed does not have the benefit of Star Wars technology or Hollywood special effects to avoid fostering ever new mutant forms of moral hazard. Quite the opposite, in fact. Their monetary “navicomputer” does not protect against the economic equivalent of slamming into a stray asteroid or planet.

Indeed, it seems more likely to steer the country into such a disaster.

Every crisis provides the latitude for an ever-greater power grab without regard for constitutional authority. The virus is inconvenient, but the policy actions taken with no regard of forethought are quite another matter.

No, the Fed is not “dusting crops” at this stage.

Shedlock: If The Fed Follows The Market, Rates Go Negative

If the Fed really does follow the market, then negative rates are almost assured. However, even though the market pared back bets on negative interest rates, questions still persist.

A chicken and egg scenario involving the Fed has emerged. Who is following whom?

Traders Trim Bets

Does the Fed Follow the Markets?

It appears that way, but if all the Fed does is follow the markets, why do we need the Fed at all? 

Fed Uncertainty Theory

I discussed the above question in detail, on April 3, 2008, before the collapse of Lehman in the Fed Uncertainty Principle.

It is still one of my favorite posts. Here are the key ideas.

The Observer Affects The Observed

Most think the Fed follows market expectations.

However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?This is a very interesting theoretical question. 

While it’s true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

I liken this to Heisenberg’s Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

Fed Uncertainty Basic Principle:

The fed, by its very existence, has completely distorted the market via self-reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed’s actions. There would not be a Fed in a free market, and by implication, there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn’t know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Negative Rates?

No, the Fed may not know much but it has observed that negative rates did not help either Europe of Japan.

It’s easier to see someone else’s mistakes than your own. 

Fed Beholden to Banks

And whereas the ECB punished European banks by charging interest on excess reserves, the Fed paid the banks money effectively bailing them out over time. 

Given the Fed is beholden to the banks,the Fed will not set rates in negative territory although it may be possible for rates to go a few basis points negative for technical reasons. 

Why Are We In This Mess?

In regards to corollary number 1, we are in this mess because once again the Fed held rates too low, too long blowing another huge asset bubble in the wake. 

There Are No Temporary Measures, Just Permanent Lies

In regards to corollary 4, the Fed announced that it will buy junk bonds. This exceeds its legal authority, adding to illegal actions it took fighting the Great Recession.

Supposedly, junk bond buying is temporary.

But as I pointed out, There Are No Temporary Measures, Just Permanent Lies

Gold vs Faith in Central Banks

Gold vs Faith in Central Banks4

Buy Gold

Stephanie Pomboy, President-Meridian Macro Research, summed things up nicely in two short sentences.

The Fed is clueless. Not like a little clueless…like A LOT clueless

Buy Gold

TPA Analytics: Trade Setup – Long XLP & Short XLY

TPA sees an opportunity to go long XLP (Consumer Staples) and short XLY (Consumer Discretionary).

  • PAIR: XLP/XLY
  • Buy: XLP (Consumer Staples)
  • Sell: XLY (Consumer Discretionary) TARGET +20% STOP -6%

The Top 10 sectors and holding of each ETF is shown in the tables below. TPA has two active BUY recommendations on AMZN, which is 25% of the XLY. It is also most of the reason for it outperforming XLP recently.

Still, given the incredible and historic weakness in Retail sales and Employment, there is a technical vulnerability of many of the top holdings in XLY. TPA sees the positive action of AMZN eventually being overwhelmed by XLY’s other constituents.

With 70% of the U.S. economy directly driven by the consumer, and another 20% is indirectly affected, the end-user eventually drives business to business decisions.

TPA’s explains its reasoning in the charts that follow. The focus is on the ratio of XLP/XLY or the relative performance of XLP versus XLY.


Technically Speaking: Chase Momentum Until Fundamentals Matter

On Monday, the markets surged on hopes for a “virus vaccine” and encouraging words for the Federal Reserve that liquidity isn’t going away. Such puts us in the awkward position of having to chase market momentum, knowing fundamentals will eventually matter.

As portfolio managers, we are in the unfortunate position of having to deliver performance for our clients. Such means that while “fundamentals” paint a very an inferior risk/reward environment for investors, momentum continues to trump reason.

As I noted in “The Great Divide:”

“The juxtaposition between economic data and the ‘bull market’ in stocks is quite astonishing.”

“In other words, to no one’s real surprise, the driver of the market is simply ‘The Fed.’ As the Fed engages in ‘QE,’ it increases the “excess reserves” of banks. Since banks are NOT lending to consumers or businesses, that excess liquidity flows into the stock market.”

Bull Market, Depressionary Economy Vs. A Bull Market. Both Can’t Be Right.

Jerome Powell’s promise of “unlimited liquidity” on Sunday’s 60-minutes interview was all the markets needed on Monday to take out the trading range.

Fundamentals Will Matter

I certainly understand it seems like “fundamentals don’t matter.” However, eventually, they will.

For now, the excuse is that markets are looking “past” 2020 and into 2021. While such may indeed be the case, there are two problems with that assessment.

  1. The current advance is pricing in the best possible outcomes in the future, i.e., a “v-shaped” economic recovery, a successful vaccine, and no secondary viral outbreak. A failure on any, or all, of those outcomes, will leave a void beneath stocks.
  2. With earnings estimates already dropping for 2020 and 2021, investors who are looking past 2020 are banking on a “hockey stick” recovery in earnings. However, there is more than a substantial risk earnings fall a lot more before they start to recover.

We addressed the second point in “Stuck In The Middle:”

“The other problem is investors remain overly optimistic about the recovery prospects for earnings going into 2021. As shown, in April 2019, estimates for the S&P 500 was $174/share (reported earnings) at the end of 2020. Today, estimates for Q4-2021 now reside at $147/share. Such is a 15% contraction in estimates when we are discussing a 30-40% decline in GDP.”

Seasonal Sell, Stuck In The Middle As Seasonal Sell Signals Trigger 05-16-20

“With expectations for the S&P 500 to return to all-time highs in 2021, such would mean that valuations currently paid by investors remain at historically high levels.”

Seasonal Sell, Stuck In The Middle As Seasonal Sell Signals Trigger 05-16-20

But it isn’t just me, Goldman Sachs is showing the same thing. (Chart courtesy of ZeroHedge)

“Goldman is lowering its EPS growth estimates for 3Q to -30% (from -21%) and no longer sees a full recovery in the fourth quarter, instead of expecting Q4 EPS to be down -17%Y/Y (from +27%) “to reflect a more gradual recovery with quarterly EPS remaining below 2019 levels for the full year.”

All That Matters Is Momentum

Despite the fundamental problems, all that matters currently is the Fed. With momentum pushing stocks higher, as noted above, we have to allow for participation in portfolios while managing inherent risk.

The breakout of the month-long consolidation range to the upside, and above the 61.8% retracement level is indeed bullish.

The “gap up” opening on Monday also flipped the short-term “sell signals” back to “buy,” which suggests we could potentially see some follow-through over the next couple of days.

The “bad news,” if you want to call it that, is the market is now wrestling with both the 200-dma, and the previously broken uptrend line. This level of resistance will be important for the “bulls” to conquer if the markets are going to push higher in the near term.

If the “momentum” trade can indeed break above the 200-dma there is little to stop the market from rallying back to 3100. However, the more extreme overbought conditions will also potentially limit the upside in the short-term.

Re-Evaluating Risk & Reward

The last time the market was at 2900, we laid out the risk/reward suggesting there was downside risk to the 50-dma. The sell-off last week approached that level of support. With the rally and breakout, yesterday, we can re-evaluate those risk/reward brackets.

  • -5.5% to last week’s lows vs. 1.4% to the 200-dma. Risk/reward negative.
  • -7.6% to the 50% retracement/50-dma vs. 5.6% to the March peak. Risk/reward negative.
  • -16.9% to the April 1st lows vs. 9.1% to January’s bottom. Risk/reward negative.
  • -24.1% to the March 23rd low vs. 14.5% to all-time highs: Risk/reward negative.

While it may not seem like it at the moment, the risk of a downside retracement, as we head into summer months, outweighs the current upside. Importantly, this does NOT mean the markets can’t rally to all-time highs. It is possible. It is also just as likely that things do go as smoothly as planned, and we wind up retesting March lows.

Such is why we have to weigh the risk and reward of chasing markets.

Positioning Changes

With seasonal sell signals in place, we are very focused on our positioning. Over the last couple of weeks, we have continued to increase our equity exposure. However, as noted previously, we continue to do so in areas that remain defensive, currently out of favor, or opportunistic.

We also balanced our increases in “risk” exposure with matched weights in shorter-duration Treasury bonds, gold, or dollar hedges to reduce our risk.

Yes, we are clearly chasing momentum at the moment. However, we do so with a clear understanding of our risk, reward, and overall net positioning. We continue also to hold a larger than normal level of cash to mitigate volatility risk.

As portfolio managers, we have an obligation to our clients to “make money” when we can. We have a “fiduciary duty” to protect them from significant declines that would destroy their financial plans.

The Pin That Pricks The Bubble

The problem for the market going forward, as noted, is that markets have priced in a speedy recovery back to pre-recession norms, no secondary outbreak of the virus, and a vaccine. If such does turn out to be the case, the Federal Reserve will have a very big problem. 

The “unlimited QE” bazooka is dependent on the Fed needing to monetize the deficit and support economic growth. However, if the goals of full employment and economic growth are quickly reached, the Fed will face a potential “inflation surge.”

Such will put the Fed into a very tight box. The surge in inflation will limit their ability to continue “unlimited QE” without further exacerbating the inflation problem. However, if they don’t “monetize” the deficit through their “QE” program, interest rates  will surge, leading to an economic recession.

It’s a no-win situation for the Fed.

It’s worse for consumers as the Fed’s actions have historically operated as a “wealth transfer” system from the middle-class to the rich.

The only outcome that allows the Fed to monetize the deficit without an inflationary surge is for fundamentals to matter ultimately. A reversion in asset prices will provide the cover needed to continue monetary interventions, but it also means “bullish case” didn’t work out as expected.

Of course, this has always been the case historically. Just as the “Coyote” always wound up going over the cliff when chasing the “Roadrunner,” excessive bullish optimism is always met with disappointment.

Major Market Buy/Sell Review: 05-18-20

HOW TO READ THE MAJOR MARKET CHARTS

There are three primary components to each Major Market Buy/Sell chart in this RIAPro review:

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

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

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

NOTE: I have added relative performance information to each Major Market buy/sell review graph. Most every Major Market buy/sell review graph also shows relative performance to the S&P 500 index except for the S&P 500 itself which compares value to growth, and oil to the energy sector. 

S&P 500 Index

  • As I stated last week:
    • “Week before last, SPY failed at the 61.8% retracement level. This past week, the market rallied to test it a second time. Given the short-term extreme overbought condition the rally is very extended so a failure could well occur.”
  • The market did indeed selloff last week back to the 50% retracement which held. The market remains overbought, so risk is still high, but a trading position can be added for a trade back to the 61.8% retracement level. 
  • We are looking for a confirmed breakout above resistance, and the 200-dma, to signal a substantial increase in equity risk is warranted. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No core position
    • This Week: Trading positions only. 
    • Stop-loss moved up to $280 for any positions.
    • Long-Term Positioning: Bearish

Dow Jones Industrial Average

  • DIA is a little different story as it failed at the 50% retracement and closed below it. This week it rallied to it again, but is underperforming other markets.
  • If DIA fails this next week, we will likely see a retest of previous support at the 38% retracement level.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions
    • Stop-loss moved up to $235
  • Long-Term Positioning: Bearish

Nasdaq Composite

  • QQQ is outperforming SPY by a wide margin, but not surprising given the top-5 stocks in the SPY are also the top-5 in the QQQ and are mostly technology related shares. 
  • Last week QQQ pulled back a small bit, but not significantly enough to provide a tradeable entry. 
  • The market is extremely overbought short-term so a correction is likely. Trading positions can be set on pullbacks that hold support at $210.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions
    • Stop-loss remains at $200
  • Long-Term Positioning: Bearish due to valuations

S&P 600 Index (Small-Cap)

  • Small caps failed again as the economic realities remain weak. 
  • No change to our positioning on Small-caps which are still “no place to be as both small and mid-cap companies are going to be hardest hit by the virus.”
  • Avoid small-caps. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions.
    • Stop loss adjusted to $52 on trading positions.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • As with Small-caps, we have no holdings. 
  • Relative performance continues to remain exceedingly poor. MDY failed at the 50% retracement level  previously but IS trying to hold support at the 38.2% retracement level. 
  • As with SLY we need to see some follow through. 
  • Mid-caps are working off their extreme overbought condition, so we will see if a tradeable opportunity occurs. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No holding
    • This Week: No holding
    • Stop Loss moved up to $290 for trading positions. 
  • Long-Term Positioning: Bearish

Emerging Markets

  • As with small and mid-cap stocks, emerging and international markets are under-performing the S&P 500 and Nasdaq. Maintain domestic exposure for now. 
  • We previously stated that investors should use counter-trend rallies to sell into. If you haven’t done so, do so on MONDAY.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position
    • This Week: No position.
    • Stop-loss moved up to $35 for trading positions.
  • Long-Term Positioning: Bearish

International Markets

  • Same with EFA as with EEM. 
  • The rally failed to hold the 38.2% retracement level as support. 
  • Remain out of these markets for the time being.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position.
    • This Week: No position.
    • Stop-loss moved up to $54 for trading positions.
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Oil prices continued their torrid rally this past week and are approaching their 38.2% retracement level. I suspect prices will fail there. 
  • We are continuing to hold our positions in XLE but it is very overbought currently. We are going to wait for a correction this summer to add to our holdings at better prices.
  • We are still carrying very tight stops though. 
  • Short-Term Positioning: Bearish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Gold

  • We remain long our current position in IAU and GDX. 
  • This past week Gold broke out to new highs and we will look to increase our weighting in IAU this week if the breakout holds. 
  • We took profits and rebalanced back to our original weighting in GDX previously, and need a small pullback to increase out weightings. 
  • The sectors are VERY overbought short-term so a pullback is likely which can be used to add to current holdings. 
  • Short-Term Positioning: Bullish
    • Last week: Hold positions.
    • This week: Hold positions
    • Stop-loss moved up to $150
    • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

  • As noted previously: “Bonds are back to ‘crazy’ overbought with the Fed buying everything from the banks who are happy to mark-up prices and sell it to them.”
  • We finally got a bit of a pullback this week. We have now added to both TLT and IEF in our portfolios to hedge against our modest increases in equity risk. 
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is $150.00
    • Long-Term Positioning: Bullish

U.S. Dollar

  • We previously added a position to the Dollar to hedge against the global dollar shortage issue. 
  • Our reasoning was explained in detail in “Our 5-Favorite Positions Right Now”
  • Stop loss remains at $98

Did The Fed Over-React To A “Natural Disaster?”

Is it possible the Fed over-reacted to a natural disaster?

There are two different types of “recessionary” events that occur throughout history. The first is a “business cycle” recession, which happens with some regularity as excesses build up in the economy. These cycles generally take 12-18 months to complete as those excesses are reversed.

Then there are “event-driven” recessions that can occur from “natural disasters.” These are generally much shorter in duration and can be sector specific. One such event was the Japanese earthquake/tsunami in 2011, which led to a temporary manufacturing recession.

Understanding the type of recessionary cycle you are fighting is essential in ensuring the Government applies the correct monetary and fiscal response. As with any illness, the application of the wrong medication can lead to unintended consequences.

There are growing expectations of the COVID-19 economic shutdown, and the subsequent recessionary backlash will be very short-lived. The assumption is that if the economy reopens, the activity will resume, and the economy will quickly regain its footing.

If such an outcome is indeed the case, has the Fed applied the wrong “medication” to cure the economic patient?

Monetary Medicine

As I addressed in “Is The Debt Chasm, Too Big For The Fed To Fill.”

“Over the last month, the Federal Reserve, and the Government, have unleashed a torrent of liquidity into the U.S. markets to offset a credit crisis of historic proportions. A list of programs already implemented has already surpassed all programs during the ‘Financial Crisis.'”

  • 03/06 – $8.3 billion “emergency spending” package.
  • 03/12 – Federal Reserve supplies $1.5 trillion in liquidity.
  • 03/13 – President Trump pledges to reprieve student loan interest payments
  • 03/13 – President Trump declares a “National Emergency” freeing up $50 billion in funds.
  • 03/15 – Federal Reserve cuts rates to zero and launches $700 billion in “Q.E.”
  • 03/17 – Fed launches the Primary Dealer Credit Facility to buy corporate bonds.
  • 03/18 – Fed creates the Money Market Mutual Fund Liquidity Facility
  • 03/18 – President Trump signs “coronavirus” relief plan to expand paid leave ($100 billion)
  • 03/20 – President Trump invokes the Defense Production Act.
  • 03/23 – Fed pledges “Unlimited QE” of Treasury, Mortgage, and Corporate Bonds.
  • 03/23 – Fed launches two Corporate Credit Facilities:
    • A Primary Market Facility (Issuance of new 4-year bonds for businesses.)
    • A Secondary Market Facility (Purchase of corporate bonds and corporate bond ETFs)
  • 03/23 – Fed starts the Term Asset-Backed Security Loan Facility (Small Business Loans)
  • 04/09 – Fed begins several new programs:
    • The Paycheck Protection Program Loan Facility (Purchase of $350 billion in SBA Loans)
    • Main Street Business Lending Program ($600 billion in additional Small Business Loans)
    • The Municipal Liquidity Facility (Purchase of $500 billion in Municipal Bonds.)
    • Expands funding for PMCCF, SMCCF and TALF up to $850 billion.

Racking Up The Debt

Here is the Fed’s balance sheet through this past Wednesday (estimated at time of writing)

As investor Paul Tudor Jones stated:

“Investors can take heart that we’ve counteracted this existential shock with the greatest fiscal, monetary bazooka. It’s not even a bazooka. It’s more like a nuclear bomb.”

Was It Too Much?

Jones’s comment was correct. However, was applying a “nuclear bomb” of monetary policy the proper response to a virus? Such is the question for consideration. 

Historically, the world has been through several viruses, world wars, financial panics, major natural disasters, inflationary spikes, terrorist events, corporate defaults, attacks, and more. In every case, the economy, markets, and population survived and eventually flourished.

Was COVID-19 going to change history? I doubt it.

In hindsight, it is becoming easier to comprehend that shutting down the entire economy was probably not the right choice. Infection rates and death tolls are far lower than initially estimated, and the economic fallout was a steep price to pay. However, going in to the crisis such a modest outcome was not known and politicians had touch decisions to make.

The magnitude of the Fed’s response was also a function of “panic” based more on “recency bias” than facts. The Fed quickly returned to the “Financial Crisis” playbook to anticipate events that may occur in the credit markets rather than responding to outcomes.

There is a difference.

The Financial Crisis was a problem with the banking system. The COVID-19 pandemic is a health crisis. 

Notice the difference between the 2008 crisis and today concerning yield spreads, financial conditions, and the Fed’s balance sheet.

The Yield Tale

The singular purpose of the Fed’s actions was to ensure the proper functioning of the credit markets. While yields did initially spike, that ignition was quickly quenched by the “fire hose” of liquidity from the Fed. 

However, the Fed has not ceased their actions. Last week, the Fed began its process of buying corporate and high-yield bond ETF’s. These purchases are being done under the SMCCF program (Secondary Market Corporate Credit Facility) with the sole purpose of ensuring corporate credit markets function smoothly. 

“Purchases are focused on reducing the broad-based deterioration of liquidity seen in March 2020 to levels that correspond more closely to prevailing economic conditions,” the document said. It listed an array of metrics that would guide investments, including transaction costs, bid-ask spreads, credit spreads, volatility, and “qualitative market color.”

Once market functioning measures return to levels that are more closely, but not fully, aligned with levels that correspond to prevailing economic conditions, broad-based purchases will continue at a reduced, steady pace to maintain these conditions.”

Such is interesting as credit condition never blew out and have already returned to levels more closely aligned with previous economic conditions. In fact, in the one area where there is the densest concentration of bonds “at risk,” effective yields haven’t risen much at all. 

More Debt

Corporate issuers also have had NO trouble issuing debt as of late. In fact, over the past couple of months, there has been a record amount of debt issuance in investment-grade bonds, with high yield issuance close to previous levels.

If yields are within more normal ranges, and bond issuance isn’t a problem, then why is the Federal Reserve continuing to act as if a credit crisis is in process?

Do they see issues in the credit markets the data doesn’t show? Or, are they trying to “front-run” any potential credit disruptions which may occur as the economy reopens? 

There Will Be Consequences

If the Fed is correct, and a credit crisis is in process, then the current levels of stimulus may fall short. As noted on April 10th:

We are now looking at a potential decline of 20% in GDP, which will equate to roughly a $10 Trillion reduction in debt as defaults, bankruptcies, and restructurings rise. 

There is a real possibility the Fed is ‘filling in a hole’ that is growing faster than they can fill it. (The Fed is injecting $6 Trillion via the balance sheet expansion versus a potential $10 Trillion shortfall.)”

, #MacroView: Is The “Debt Chasm” Too Big For The Fed To Fill?

Unfortunately, that estimate of the decline in GDP was a bit optimistic. Last week, the Atlanta Fed’s real-time economic indicator was predicting a -42.8% decline, or nearly twice the current levels of most estimates.

However, if this turns out to be a short-lived crisis and economic activity comes surging back, then the Fed’s stimulus may be too much, leading to a surge in inflation and downward pressure on the middle class. 

Regardless of the eventual outcome, there is one consequence of massive debt and deficit expansions that will not change – slower economic growth. 

No Other Choice

With the economy facing an “economic depression,” and in the middle of an election year, the Federal Reserve had a choice to make.

  1. Allow capitalism to take root by allowing corporations to fail and restructure after spending a decade leveraging themselves to the hilt, buying back shares, and massively increasing their executives’ wealth while compressing the wages of workers. Or, 
  2. Bailout the “bad actors” once again to forestall the “clearing process” that would rebalance the economy, and allow for higher levels of future organic economic growth.

As the Fed’s balance sheet heads toward $10 Trillion, the Fed opted to impede the “clearing process.” By not allowing for debt to fail, corporations to be restructured, and “socializing the losses.” They have removed the risk of speculative practices and ensured a continuation of “bad behaviors.” 

Unfortunately, given we now have a decade of experience of watching the “wealth gap” grow under the Federal Reserve’s policies, the next decade will only see the “gap” worsen.

Furthermore, given that we now know surging debt and deficits inhibit organic growth, the massive debt levels added to the backs of taxpayers will only ensure lower long-term rates of economic growth. The chart below shows the 10-year annualized run rates of economic growth throughout history with projected debt and growth levels over the next decade.

, The Fed’s Only Choice – Exacerbate The Wealth Gap, Or Else.

The End Game

History is pretty clear about future outcomes from the Fed’s current actions. More importantly, these actions are coming at a time where there were already tremendous headwinds plaguing future economic growth.

  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

Yes, another $4-6 Trillion in QE will likely be successful in inflating a third “bubble” to counteract the last deflation.

The problem is that after a decade of pulling forward future consumption to stimulate economic activity, a further expansion of the wealth gap, increased indebtedness; low rates of economic growth will weigh on future economic opportunity for the masses.

Supporting economic growth through increasing levels of debt only makes sense if “growth at all cost” uniformly benefits all citizens. Unfortunately, we are finding out there is a big difference between growth and prosperity.

The United States is not immune to social disruptions. The source of these problems is compounding due to the public’s failure to appreciate it. Until the Fed’s policies are discussed publicly and reconsidered, the policies will remain, and the problems will grow.

Was the “medicine” applied by the Fed to counteract a “virus” the correct prescription? If the patient ultimately dies, we will have our answer.

Stuck In The Middle As Seasonal Sell Signals Trigger


In this issue of “Stuck In The Middle As Seasonal Sell Signals Trigger:”

  • View Of The Markets & Portfolio Positioning
  • MacroView: Why Jeremy Siegel Is Wrong About Bonds
  • Sector & Market Analysis
  • 401k Plan Manager

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


Catch Up On What You Missed Last Week


Stuck In The Middle

Currently, we seem to be stuck in the middle even as seasonal sell signals trigger. It reminds me of the lyrics of one of the classics.

“Trying to make some sense of it all,
But I can see that it makes no sense at all,
Is it cool to go to sleep on the floor,
‘Cause I don’t think that I can take any more
Clowns to the left of me, jokers to the right,
Here I am, stuck in the middle with you” – Stealers Wheel

It’s a fascinating dichotomy in the markets currently. As noted last week:

“There is currently a “Great Divide” happening between the near “depressionary” economy versus a surging bull market in equities. Given the relationship between the two, they both can’t be right.”

This week, the continuation of depressionary economic data continued:

  • NFIB Survey fell to 90.9
  • CPI fell 0.8% in one month
  • PPI fell by 1.3% last month.
  • Jobless Claims rose by 2,981,000 
  • Continuing Claims exceeding 22 million
  • Retail Sales (40% of PCE) plunged by 17.2% last month 
  • Industrial Production declined by 11.2%

These are numbers not seen since the Great Depression, with expectations for economic growth in the second quarter at a -31.5% growth rate (shown below). The Atlanta Fed GDP Now is even worse with a -42.8% decline in GDP growth in the second quarter.

These numbers are mentally hard to grasp. Yet, the markets remain range-bound between the 50% and 61.8% retracement levels, consolidating the advance from the March 23rd lows.

The reason for the dichotomy is simple.

The bullish argument for stocks remains simple. As long as the Federal Reserve is pumping in liquidity, buy stocks.

Earnings Continue To Decline

As investors, however, we need to be paying attention to earnings. There is a simplistic correlation between the economy and the markets. As I questioned in “The Stock Market Is Not The Economy?”

“The relationship becomes more evident when looking at the annual change in stock prices relative to the yearly change in GDP.”

stock market economy, Economically Speaking: The Stock Market Is Not The Economy?

“Again, since stock prices are driven in part by the ‘psychology’ of market participants, there can be periods where markets become detached from fundamentals. However, there is no point in previous history, where the fundamentals catch up with stock prices.”

stock market economy, Economically Speaking: The Stock Market Is Not The Economy?

As stated, the equation is simplistic:

“Slower economic growth = less consumption (due to unemployment) = lower profit and revenue growth.”

Based on the current economic devastation, earnings estimates for the next couple of quarters have fallen sharply. Unfortunately, they still have not compensated for the coming drop in revenues.

It’s The Economy Stupid

How do I know that?

“PCE depends on jobs and wages as well as an intact supply chain, neither of which are in good condition. Regarding unemployment, the U6 rate, which is a more reliable indicator of job market health, is at 22.8% currently and rising while the labor market participation rate has dropped to about 60%.  These factors do not bode well for growth and earnings for most companies.” – A Brinkley, Jr.

His statement is correct. There is a precise correlation between PCE and GDP. Not surprisingly, if consumption contracts due to high levels of unemployment, then economic growth declines. (PCE is 70% of GDP)

stock market economy, Economically Speaking: The Stock Market Is Not The Economy?

The other problem is investors remain overly optimistic about the recovery prospects for earnings going into 2021. As shown, in April 2019, it was estimated the S&P 500 would earn $174/share (reported earnings) at the end of 2020. Today, estimates for Q4-2021 now reside at just $147/share. This is a 15% contraction in estimates when we are discussing a 30-40% decline in GDP.

Valuations Matter

With expectations for the S&P 500 to return to all-time highs in 2021, such would mean that valuations currently paid by investors remain at historically high levels.

As Warren Buffett states: “Price is what you  pay, value is what you get.”

While it seems these concerns are irrelevant due to the Federal Reserve’s ongoing liquidity injections, fundamentals and valuations always matter over time.

3-Different Bulls

We have talked before about the “narrowness” of the market. Since the March 23rd lows, the “bull market” advance was three different “bull markets.” The three charts below break out the sectors of the market down into “bull market” groupings. I have recalibrated each sector to a $50 starting price in January of this year.

The “Struggling Bull” market has been in sectors that we currently maintain no exposure to in portfolios. These are the sectors most exposed to either the “Coronavirus” impact, or the Fed’s monetary liquidity and zero interest rates.

Industrial and Transportation stocks are most affected by the economic shutdown, while Financials are impacted by reductions of net interest income from zero interest rates, and rising delinquency rates. All three sectors remain below $40, and only marginally above the March 23rd lows.

The next group we classify as a “Stuttering Bull” as the recovery has been better, but the sectors continue to underperform overall. These sectors have been primarily range-bound between $40 and $45/share since coming off their $30 lows.

These sectors are still susceptible to the impacts of the “economic shutdown” from reduced revenues, bankruptcies, unemployment risks, etc.

The last grouping are the sectors we remain most heavily weighted in. These are the companies that are “deemed” to be the most protected from the impacts of the “economic shutdown.” These sectors did not decline as much as the others during the selloff, and now all trade above $45/share.

The sectors are in a “Raging Bull” market and are within striking distance of all-time highs.

This data tells us two important things.

  1. If you wanted to beat the S&P 500 this year, you needed only to own 4-market sectors, and;
  2. While earnings may not seem to matter at the moment, they eventually will. Staples, Technology, Communications, and Healthcare are all trading at very elevated valuations. 

Most importantly, while the advance has been notable, participation has not only remained weak but continues to weaken during this consolidation.

With the MACD “seasonal sell” triggered, it may be time to turn a bit more cautious for the summer.

Seasonal Sell Signals Trigger

As I discussed with our RIA PRO subscribers (30-day RISK FREE Trial) the “Sell In May” strategy might be worth paying attention to this year. To wit:

“While not every ‘summer period’ is negative, the long-term history of investing during the summer months is not stellar.”

"Sell In May", “Sell In May” Might Be A Good Risk Strategy This Year.

“However, the adage ‘Sell in May’ may be more appropriate this year given the state of the actual economy, earnings risk, and a potential revaluation of markets. The odds of a weak summer period have risen markedly.”

With the “seasonal sell” signal now firmly entrenched, the markets overbought on many levels, and participation remaining weak, the “risk” of having aggressive equity exposures has risen.

While the market can undoubtedly resolve stretched conditions by grinding sideways, such won’t fix the issues of participation and momentum.

Positioning Update

In our portfolios, we are very focused on our positioning. While we did modestly increase our equity exposure during last week’s pullback, we did so in areas which remain defensive. We also balanced that increase in exposure with matched weights in shorter-duration Treasury bonds to hedge our risk.

Taking profits in our trading positions continues to be a “staple” in our management process. Such is particularly the case in positions like Clorox (CLX), which have become grossly extended. Importantly, as noted in the sector performance analysis above, we also continue to rebalance portfolios into outperforming areas of the market.

The process is simple. As we continue to adjust our equity exposures to participate with the markets, we are balancing those increases with offsetting hedges, and a larger than average level of cash, to protect against sudden declines.

As I concluded last week:

“There is only one thing I am sure of, a raging bull market in stocks can NOT co-exist with a depressionary economy for long. The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices – corporate profits.”

We don’t like the risk/reward of the market currently, and suspect we will have a better opportunity to increase equity risk later this summer.

But, if things change, we will also.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

Note: The technical gauge bounced from the lowest level since both the “Dot.com” and “Financial Crisis.” However, note the gauge bottoms BEFORE the market bottoms. In 2002, the market retested lows. In 2008, there was an additional 22% decline in early 2009.


Sector Model Analysis & Risk Ranges

How To Read.

  • Each sector and market  is compared to the S&P 500 index in terms of relative performance.
  • The “MA XVER” is determined by whether the short-term weekly moving average crosses positively or negatively with the long-term weekly moving average.
  • The risk range is a function of the month-end closing price and the “beta” of the sector or market.
  • The price deviation above and below the moving averages is also shown.


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 – Discretionary (XLY), and Materials (XLB)

This past week, the market sold off as trading remains confined to a range between the 50% and 61.8% retracement levels. As noted above, there is no rush to get into either Discretionary or Materials stocks until AFTER we get through earnings season. With the economy very weak, and retail sales plunging, the discretionary sector remains at risk. We continue to focus on Staples for the time being.

Current Positions: No Positions

Outperforming – Technology (XLK), Communications (XLC), Staples (XLP), and Healthcare (XLV), 

Previously, we added to our core defensive positions Healthcare, Staples, and Utilities. We continue to hold our exposures in Technology and Communications, which remain at full weight. These sectors are continuing to outperforming the S&P 500 on a relative basis and have less “virus” related exposure. Small additions to Staples, Healthcare, and Communications were previously made.

Current Positions: XLK, XLC, XLP, and XLV

Weakening – Utilities (XLU)

After adding a small weighting in Utilities, we continue to look for an opportunity to increase our exposure. We continue to watch again this week.

Current Position: 1/3rd Position XLU

Lagging – Industrials (XLI), Financials (XLF), Real Estate (XLRE), and Energy (XLE)

Financials continue to underperform the market. As we have said previously, Financials and Industrials are the most sensitive to Fed actions (XLF) and the shutdown of the economy (XLI).

We continue to hold our Energy sector (XLE) exposure and are looking to add to those holdings opportunistically. We also are doing the same with our recent Real Estate exposures, which are oversold on a relative basis.

Current Position: 1/3rd Position XLE, 1/2 XLRE

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) – We continue to aggressively avoid these sectors for now, and there is no rush to add them anytime soon. Be patient, small, and mid-caps are lagging badly. You can not have a “bull market” without “small and mid-cap” stocks participating.

Current Position: None

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

Same as Small-cap and Mid-cap. Given the spread of the virus and the impact on the global supply chain.

Current Position: None

S&P 500 Index (Core Holding) – Given the overall uncertainty of the broad market, we previously closed out our long-term core holdings. We are using SPY and QQQ index ETF’s for trading positions only for now.

Current Position: None

Gold (GLD) – Previously, we added additional exposure to both our GDX  and IAU positions and are comfortable with our exposure currently. We rebalanced our GDX position back to target weight last week.

We also added a position in the Dollar previously (UUP) as the U.S. dollar shortage continues to rage and is larger than the Fed can offset.

Current Position: 1/2 weight GDX, 2/3rd weight IAU, 1/2 weight UUP

Bonds (TLT) –

Bonds have rallied as the Fed has become THE “buyer” of bonds on both a “first” and “last” resort. Simply, “bonds will not be allowed to default,” as the Fed will guarantee payments to creditors. As we have been increasing our “equity” exposure in portfolios over the last few weeks, we added more to our holding in TLT to improve our “risk” hedge in portfolios.

Current Positions: SHY, IEF, BIL, TLT

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. Such is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio / Client Update

This past week, the market sold off back to the 50% retracement level after having rallied to the 61.2% retracement last week. As discussed previously, there is some short-term upside, but as we head into the summer months, the relative risk/reward ratio is not in our favor.

Let me restate from last week:

“The earnings and economic data have been horrific. While the markets do not seem to care at the moment, in hopes that there will be a rapid ‘V-shaped’ recovery in the market, the data will eventually matter. It is not a question of ‘if’ just a matter of ‘when.'”

While it certainly appears not to be the case at the moment, due to the Federal Reserve, reversions can happen very quickly. We remain suspicious but continue to invest where we can.

Changes

We continue to work around the edges to add exposure while managing risk. In models, we continue to rebalance our exposures. We trimmed our position in Clorox (CLX) after a significant gain and added to our holding of Community Healthcare Trust (CHCT) to balance our previous purchase of MPW.

We also added a position in Visa (V) that should benefit from increased transactions as the economy reopens.

In both models, we add to our holdings of Treasury Bonds using IEF to hedge our additional equity risk. Our process is still to participate in markets while preserving capital through risk management strategies.

For now, there is much more “trading” activity than normal as we work out way through whatever market is going to come. Is the bull market back? Maybe. Maybe Not. Once the bottom is clearly in, we will settle back down to a longer-term, trend-following, structure. Now is not the time for that.

We continue to remain defensive and in an excellent position with plenty of cash, reduced bond holdings, and minimal equity exposure in companies we want to own for the next 10-years. Just remain patient with us as we await the right opportunity to build holdings with both stable values, and higher yields.

Please don’t hesitate to contact us if you have any questions or concerns.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k plan manager.

Compare your current 401k allocation, to our recommendation for your company-specific plan as well as our on 401k model allocation.

You can also track performance, estimate future values based on your savings and expected returns, and dig down into your sector and market allocations.

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

Relative Value Sector Report 5/15/2020

The Sector Relative Value Report provides guidance on which industries or sectors are likely to outperform or underperform the S&P 500.

Click on the Users Guide for details on the model’s relative value calculations as well as guidance on how to read the model’s graphs.

This report is just one of many tools that we use to assess our holdings and decide on potential trades. Just because this report may send a strong buy or sell signal, we may not take any action if it is not affirmed in the other research and models we use.

Commentary

  • Despite the modest sell-off, the relative value of most sectors was little changed on the week.
  • On the Relative Value vs. 35 days ago graph, you will notice that the orange diamonds move from overbought to oversold, left to right. When we designed the graph, we sorted the sector ordering on the graph from more conservative to more aggressive. Currently, you can see the more conservative sectors tend to be oversold, and the more aggressive ones overbought.
  • Technology (XLK) and Communications (XLC) remained relatively strong and became slightly more overbought last week.
  • On the week, Energy (XLE) fell by almost 1 standard deviation but remains overbought.
  • Banks (XLF) remain a concern and continue to underperform. As we discussed and graphed on today’s market commentary, the four largest banks (BAC, C, JPM, and WFC) are all trading near their March lows.
  • The R-squared on the sigma/20 day excess return scatter plot improved to .8811.

Graphs

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY

#MacroView: Why Siegel Is Wrong About End Of Bond Bull Market

Wharton’s Jeremy Siegel recently declared the end to the 40-year bond bull market.

“History has shown that somewhere this liquidity has to come out, and we’re not going to get a free lunch out of this. I think ultimately, it’s going to be the bond holder that’s going to suffer. That’s certainly not the popular notion right now.” – J. Siegel via CNBC

Such has been the same message from bond bears since the “Financial Crisis.” Yet, during the entirety of the past decade, rates have consistently headed lower.

The reasons have been clear, and since June of 2013, I have been pushing back against calls for higher rates from the likes of Bill Gross and Jeffrey Gundlach. While there have certainly been upticks in rates, as nothing travels in a straight line, the long-term trend remains lower.

Economic Growth Drives Rates

As noted by Jeremy Siegel, the primary argument for why rates must go up, is because rates are low.

“Forty years of a bull market in bonds. It’s really hard to turn your head around, and say could this be a turning point? But I think history will say yes. I see rates rising continuously over the next several years.”

The problem, however, is that interest rates are vastly different than equities. When people go to make a purchase on credit, borrow money for a house, or get a loan for a new car, they “buy payments.” What ultimately drives the purchase decision is “how much will this cost me?”

The determining factor in the purchase decision is the interest rate effect on the loan payment. If interest rates rise too much, consumption stalls. As consumption makes up 70% of GDP, one should not ignore the relationship between rates and consumption. As noted previously:

“There is a precise correlation between PCE and GDP. Not surprisingly, if consumption contracts due to high levels of unemployment, then economic growth declines.”

The trend and level of interests are the single best indicator of economic activity. As shown below, the rise and fall of rates correlates to the ebb and flow of the economy. When rising interest rates become constrictive on consumption, economic activity falls, pulling rates lower with it.

Such is why yield spreads are vital in determining the recessionary risks in the economy. As the yield spread flattens, it is reflective of economic weakness and diminishing demand for credit. As noted last year, it isn’t the “inversion” of the yield curve, which signals recession, it is the subsequent steepening.

In other words, “It’s the economy, stupid.”

Long-Term History

The chart below is a history of long-term interest rates going back to 1857. The dashed black line is the median interest rate during the entire period. I have compared interest rates to the 5-year nominal GDP growth rate over the same period.

(Note: As shown, interest rates can remain low for a VERY long time.)

Interest rates are a function of healthy, organic, economic growth that leads to rising demand for capital over time. There have been two previous periods in history which have been supportive of rising interest rates.

The first was during the turn of the previous century as the country became more accessible via railroads and automobiles.Manufacturing increased as World War I began, and America began shifting from an agricultural to an industrial one.

The second period followed World War II as America became the “last man standing.” After the war, France, England, Russia, Germany, Poland, Japan, and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding a war-ravaged Europe.

But that was just the start of it.

In the late ’50s, America embarked upon its greatest quest in human history as humankind took its first steps into space. The space race, which lasted nearly two decades, led to leaps in innovation and technology that paved the wave for the future of America.

These advances, combined with the industrial and manufacturing backdrop, fostered high levels of economic growth, increased savings rates, and capital investment, which provided support for higher interest rates.

The Structural Shift

Currently, the U.S. is no longer the manufacturing powerhouse it once was, and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor, which suppresses wages as productivity increases.

The number of workers between the ages of 16 and 54 is at the lowest level relative to that age group since the late ’70s. That is a structural and demographic problem that continues to drag on economic growth. Such won’t change soon, with nearly 1/4th of the American population now permanently dependent on some form of governmental assistance.

This structural employment problem remains the primary driver as to why “everybody” is still wrong in expecting rates to rise.

The high correlation between the three major components of our economic composite (inflation, economic and wage growth) and the level of interest rates is not surprising. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy.

When the economy is expanding organically, the demand for capital rises as businesses increase production to meet rising demand. Increased production leads to higher wages, which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. 

(Currently, we do not have the type of inflation that leads to more robust economic growth, just increases in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

Low Demand For Capital

In the current economic environment, the need for capital remains low, outside of what is needed to absorb incremental demand. The impact on the economy from record levels of unemployment will have a wide range of impacts, which will forestall an economic recovery.

The profound suppression of wage growth from job losses will greatly reduce the demand for credit. Consumers’ focus will turn from a “want” to finance autos, durable goods, and houses, to the “need” to survive.

"savings mirage" save economy, #MacroView: “Savings Mirage” Won’t Save The Economy

Simultaneously, the demand for credit is colliding with a lack of desire to “issue” credit. With reduced incomes, it is not only harder to make ends meet, but also harder to obtain additional credit. Given consumers are dependent upon credit to “fill the gap,” and with banks tightening lending standards, access to credit becomes more difficult.

"savings mirage" save economy, #MacroView: “Savings Mirage” Won’t Save The Economy

Importantly, the majority of the job losses came from the very same areas that produced the most job “gains” in recent years. Those were the lower wage paying and temporary jobs in healthcare, leisure, and retail, which do not foster higher levels of consumption.

Currently, there are few economic tailwinds prevalent that could sustain a move higher in interest rates. The reason is simple. Higher interest rates reduce the flow of capital within the economy.

The Implications Of A Bond Bear

If there is indeed a bond bubble, a burst would mean bonds decline rapidly in price, pushing interest rates markedly higher. Such is the worst thing that could happen. 

1) The Federal Reserve has been buying bonds for the last decade and has now moved into permanent “QE.” The recovery in economic growth remains dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.

2) The Fed currently runs the world’s largest hedge fund with over $6 Trillion in assets. Long Term Capital Mgmt., which managed only $100 billion, nearly crashed the economy when rising rates caused it to collapse. The Fed is 60x that size.

3) Rising rates will immediately kill the housing market. People buy payments, not houses, and rising rates mean higher payments.

4) An increase in rates means higher borrowing costs that leads to lower profit margins for corporations. Such will negatively impact the stock market as capital investment, buybacks, and debt issuance for M&A declines.

5) One of the main arguments of stock bulls over the last 10-years has been the stocks are cheap based on low-interest rates. When rates increase, the market becomes quickly overvalued.

6) The massive derivatives market will trigger another credit crisis as rate spread derivatives go bust.

7) As rates increase, so does the variable rate interest payments on credit cards. 

8) Rising defaults on debt service will negatively impact banks, which are still not adequately capitalized and burdened by large levels of bad debts.

9) Commodities, which are sensitive to the global economy’s direction and strength, will plunge in price as the current recession extends.

10) The deficit/GDP ratio, which is already surging, will escalate as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new estimates propel higher.

I could go on, but you get the idea.

The Japan Syndrome

The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.

I won’t argue there is not much room for interest rates to fall in the current environment; there is also not much tolerance for increases. Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment. This idea suggests is that there is one other possibility that the majority of analysts and economists ignore, which I call the “Japan Syndrome.”

Like Japan, the U.S. is caught in an ongoing ‘liquidity trap’ where maintaining ultra-low interest rates is the key to sustaining an economic pulse. As we are witnessing in the U.S., the unintended consequence of such actions is the battle with deflationary pressures. The lower interest rates go – the less return the economy can generate. An ultra-low interest rate environment, contrary to mainstream thought, has negative impacts on productive investments, and risk begins to outweigh the potential return.

As shown in the chart below, interest rates are relative globally. Rates can’t increase in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.”

Should We Worry About Government Debt? Probably., Should Worry About Government Debt? Probably.

Conclusion

Japan is has been fighting many of the same issues for the past two decades. The “Japan Syndrome” suggests that while interest rates are near lows, it is more likely to reflect the real levels of economic growth, inflation, and wages.

If that is true, then rates are most likely “fairly valued,” which implies that the U.S. could remain trapped within the current trading range for years as the economy continues to “muddle” along.

Jeremy Siegel, in time, will likely be proved wrong about the end of the “40-year bond bull” market. History suggests that not only is the “bond bull” alive and well, it likely has quite a long way as the U.S. will become more like Japan over time.

#WhatYouMissed On RIA This Week: 05-15-20

What You Missed On RIA This Week.

We know you get busy. So, with so much investing content pushed out each week from the RIA Team, here is a synopsis of what you missed. A collection of our best thoughts on investing, retirement, markets, and your money.

Webinar: The Great Reset IS TOMORROW

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The Week In Blogs

Each week, the entire team at RIA publishes the research and thoughts which drive the portfolio management strategy for our clients. The important focus are the risks which may negatively impact our client’s capital. If you missed our blogs last week, these are the risks we are focusing on now.

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Our Latest Newsletter

Each week, our newsletter covers important topics, events, and how the market finished up the week. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how to trade it.

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What You Missed: RIA Pro On Investing

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free) If you are a DIY investor, this is the site for you. RIAPRO has all the tools, data, and analysis you need to build and manage your own money.

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The Best Of “The Real Investment Show”

What? You didn’t tune in last week. That’s okay. Here are the best moments from the “Real Investment Show.” Every week, we cover the topics that mean the most to you from investing, to markets, and your money.

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What You Missed: Video Of The Week

The Fed Is Bailing Out The Bond Market

This week, Michael Lebowitz and Lance Roberts discuss the Fed bailing out the bond market. Are they going to far at a time when the bond market is functioning properly? Are they making a mistake?

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What You Missed: Our Best Tweets

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. Here are a few from this past week that we thought you would enjoy. Follow us on twitter @lanceroberts and @michaellebowitz.

See you next week!

TPA Analytics: Should You Bet Against Druckenmiller & Tepper?

Should You Bet Against Druckenmiller & Tepper?

Yesterday two of the greatest investors in history slammed equities and investors should listen. Both Stanley Druckenmiller, former chief strategist for George Soros and David Tepper of Appaloosa Management declared the stock market was not a place to be right now.

Druckenmiller said,

“The risk-reward for equity is maybe as bad as I’ve seen it in my career.”

He does not believe the FED’s actions will help the economy.

“It was basically a combination of transfer payments to individuals, basically paying them more not to work than to work. And in addition to that, it was a bunch of payments to zombie companies to keep them alive.”

Tepper said the stock market is “maybe the second most overvalued.” The most overvalued market, according to him, was the Dot-com bubble of 1999. He also said,

“The market’s pretty high and the Fed’s put a lot of money in here. The market is by anybody’s standard pretty full. There’s a lot of liquidity there and the Fed’s still there. It’s too hard to say the market can’t go up or something like that, but it’s not a very good risk-reward market.”

Risk-reward is what stands out to TPA, since that is a calculation we do every day. Both Druckenmiller and Tepper are saying the possible return from here does not outweigh the risk from here. TPA believes that clients should listen.

TPA’s current buy to sell recommendation ratio is 37% to 63%.

Looking at the benchmark S&P 500, TPA sees 4 critical levels to watch.

S&P 500 Levels:

  • 2950 – Is where the S&P 500 fell below 2020’s uptrend line mid-March (Chart 1). Chart 2 shows that the market rallied just shy of 35% from the intraday low on 3/23, but cannot seem to move above the 2950 level. This is the “proving level.” The point that needs to be surpassed to show that the huge oversold rally since the third week in March has staying power.
  • 2800 – Chart 3 shows that, if the market fails at 2950, the next level down for support is around 2800.
  • 2720 – After 2800, the next level of support is 2720, which matches up well with the lows of March and June 2019.
  • 2500 – The next test will be S&P500 2500. TPA spoke about the 2500 level intraday on 3/12 and in the World Snapshot on 3/13. Chart 4 shows that 2500 was the level of support for the long term, 11-year uptrend from the financial recession lows on 3/9/09. A break of 2500 in March initiated a cascade that brought the market down briefly below 2200. 2500 could hold, but the fact that it has been breached once, means that it is now a less trusted long term support level.

S&P 500 Index

Zoom

S&P 500 Index  – 2019-2020

S&P 500 Index – 2008-2020

Markowski: Secular Nature Of The Stock Market & Fed’s Uphill Battle

The secular nature of the stock market is well documented.

The S&P 500’s rally from its March 2020 low to within 13.2% of its 2020 high has been primarily fueled by the US Federal Reserve’s monetary stimulus. The Fed has and continues to spend trillions to provide the economy with liquidity and to artificially prop up the markets. The rally will prove to be futile and based on my calculations below the S&P 500 will have declined by 85.3% when it reaches its final bottom in Q4 2022. There is no amount of monetary or fiscal stimulus that will enable investors to escape the secular bear which replaced the 2009-2020 secular bull market on February 20, 2020.

The stock market has been secular since its origin in 1802. Every secular bull has been followed by a secular bear and vice versa. The minimum declines from all of the secular bull peaks to the secular bear troughs have been 60%.  Secular bulls and bears are the nature of the stock market. You can’t have one without the other.

Secular Bulls & Bears

Secular bulls and bears are defined by “public” or consumer sentiment. Investor sentiment is completely irrelevant to a secular bull or bear. Neither government fiscal or central bank monetary stimulus change the mood of the public from negative to positive.

The blue line in the chart below depicts the growth trend for the Dow Jones index over the last 101 years. The 7.5% growth trend is the equivalent to sum of the percentage changes for population growth and inflation. For those periods in which the public is optimistic, such as the roaring twenties, the index for an extended number of years above the trend line. When public becomes pessimistic, as was the case after the 1929 crash, Dow trades for extended number of years below its 7.5% trend line.

The 1949 to 1966 bull in the above chart was due to the public becoming optimistic after the end of World War II.  The 1966 to 1982 secular bear included the Vietnam war, interest rates of 20%, the highest inflation rate since the civil war and the first and only resignation of a US President.

The circumstances around the crashes of the markets from their 2020 all time or multi-year highs and the ensuing collapses for the economies of the US and 12 other countries are eerily similar to the US’ 1929 crash.  The crash of 1929 resulted in the US unemployment rate surging by 400% from September 1929 to March 1930 and doubling to 800% in September 1930.  Similar to 2020, the President and US government in 1929 were proactive to mitigate damage to the economy.   Despite the enactment of fiscal stimulus consumers still cut back their spending.   See 1929 and 1930 excerpts from Herbert Hoover Presidential library archives:

1929

After the stock market crash, President Hoover sought to prevent panic from spreading throughout the economy.  In November, he summoned business leaders to the White House and secured promises from them to maintain wages.  According to Hoover’s economic theory, financial losses should affect profits, not employment, thus maintaining consumer spending and shortening the downturn.  Hoover received commitments from private industry to spend $1.8 billion for new construction and repairs to be started in 1930, to stimulate employment.

The President ordered federal departments to speed up their construction projects and asked all governors to expand public works projects in their states. He asked Congress for a $160 million tax cut while doubling spending for public buildings, dams, highways, and harbors.

1930

Praise for the President’s intervention was widespread; the New York Times commented, “No one in his place could have done more. Very few of his predecessors could have done as much.”  Together, government and business spent more in the first half of 1930 than in the entire previous year. Still consumers cut back their spending, which forced many businesses and manufacturers to reduce their output and lay off their workers.

Common Denominators

The common denominator for 1929 and 2020 crashes and collapsing economies for the US and a dozen other countries is what separates them from all of the other notable market crashes. That pivotal piece is the extreme and immediate polar opposite change in sentiment for an entire population within days of a crash commencing.

Consumer sentiment went from extremely positive with unemployment at an all-time low in 1929 to extremely negative by the beginning of 1930.   The University of Michigan’s recent US consumer confidence survey results is a great example.   The chart below depicts the sudden and significant decline in consumer confidence in April 2020 as compared to February 2020’s reading which was the highest since 2002.

Consumers worldwide are becoming increasingly pessimistic and are retrenching due to their concerns about being infected with the Covid-19 Coronavirus and also about losing their jobs.  The chart below depicts the 500% increase in US unemployment from February 2020 to April 2020.

The recovery from the fears of pandemics job losses will likely take years for consumers to overcome.  Thus, the probability is extremely low that consumer sentiment will reverse from extremely negative to even somewhat positive in the current decade.

What To Anticipate

Investors should anticipate that the PE multiples for all shares will contract to near historical lows by 2022. The chart below depicts the contractions and expansions of the PE multiples of the S&P 500 for the 1966-1982 secular bear and the 1982 to 2000 secular bull markets respectively. For seven of the 16 years for the 1966 to 1982 secular bear PE multiples were below 10 and the PE bottomed at 6.79 in 1980. For the 1982 to 2000 secular bull the PE reached a high of 34 in April 1999. The fall of the Berlin Wall and China opening its economy in 1990 resulted in the 1982-2000 secular bull being the longest ever since 1802.

As shown below, the S&P 500’s earnings and PE ratios from December 31, 1927 through December 31, 1932. The index’s earnings reached a 12 year high of $24.16 on December 31, 1929, and then declined by 66% to $8.08 on December 31, 1932. The high for the S&P 500’s PE multiple was 20.2 in September 1929 and low was 9.3 in June 1932.

Assuming the S&P 500’s 2019 peak to 2022 trough earnings mimic the 66% decline from 1929 to 1932 its earnings will fall from $162.93 at 12/31/2019 to $53.77 in late 2022. Assuming a low PE equivalent to 1932’s low of 9.3 the index based on its earnings will reach a low of 500.06. From the S&P 500’s 2020 high of 3393.52, the index will have declined by 85.3% when it reaches its final bottom.


Michael Markowski has been involved in the Capital Markets since 1977. He spent the first 15 years of his career in the Financial Services Industry as a Stockbroker, Portfolio Manager, Venture Capitalist, Investment Banker and Analyst. Since 1996 Markowski has been involved in the Financial Information Industry and has produced research, information and products that have been used by investors to increase their performance and reduce their risk. Read more at BullsNBears.com

Negative Rates Are Not An Option

Negative rates are not an option. That was Fed Chair Jerome Powell’s point as he reiterated the Fed’s position on negative rates. He gave his economic assessment as well.

Economic Outlook “Highly Uncertain”

In a live economic interview with PIIE, Jerome Powell discussed the Fed’s outlook for the economy and the advisability of negative interest rates.

The video interview is above and here is Here is Powell’s Prepared Transcript.

Key Transcript Snips

The scope and speed of this downturn are without modern precedent, significantly worse than any recession since World War II. We are seeing a severe decline in economic activity and in employment, and already the job gains of the past decade have been erased. Since the pandemic arrived in force just two months ago, more than 20 million people have lost their jobs. A Fed survey being released tomorrow reflects findings similar to many others: Among people who were working in February, almost 40 percent of those in households making less than $40,000 a year had lost a job in March.

While the economic response has been both timely and appropriately large, it may not be the final chapter, given that the path ahead is both highly uncertain and subject to significant downside risks. Economic forecasts are uncertain in the best of times, and today the virus raises a new set of questions: How quickly and sustainably will it be brought under control? Can new outbreaks be avoided as social-distancing measures lapse? How long will it take for confidence to return and normal spending to resume? And what will be the scope and timing of new therapies, testing, or a vaccine? The answers to these questions will go a long way toward setting the timing and pace of the economic recovery. Since the answers are currently unknowable, policies will need to be ready to address a range of possible outcomes.

Job Losses & Economic Impact

The loss of thousands of small- and medium-sized businesses across the country would destroy the life’s work and family legacy of many business and community leaders and limit the strength of the recovery when it comes. These businesses are a principal source of job creation—something we will sorely need as people seek to return to work. A prolonged recession and weak recovery could also discourage business investment and expansion, further limiting the resurgence of jobs as well as the growth of capital stock and the pace of technological advancement. The result could be an extended period of low productivity growth and stagnant incomes.

The current downturn is unique in that it is attributable to the virus and the steps taken to limit its fallout. This time, high inflation was not a problem. There was no economy-threatening bubble to pop and no unsustainable boom to bust. The virus is the cause, not the usual suspects—something worth keeping in mind as we respond.

At the Fed, we will continue to use our tools to their fullest until the crisis has passed and the economic recovery is well under way. Recall that the Fed has lending powers, not spending powers. A loan from a Fed facility can provide a bridge across temporary interruptions to liquidity, and those loans will help many borrowers get through the current crisis. But the recovery may take some time to gather momentum, and the passage of time can turn liquidity problems into solvency problems. Additional fiscal support could be costly, but worth it if it helps avoid long-term economic damage and leaves us with a stronger recovery. This tradeoff is one for our elected representatives, who wield powers of taxation and spending.

Negative Interest Rates

The above transcript takes up the first 9 minutes of the video. The rest is a Q&A discussion between PIIE president Adam S. Posen and Powell .

Posen asked Powell about negative interest rates. 

“The committee’s view on negative rates has not changed. This is not something that we are looking at. … We revisited this question last October and the minutes said all FOMC presidents – and that’s not a sentence you get to say very often – that participants did not see negative rates as an attractive policy.”

This subject comes up time and time again. Even before the Fed openly discussed negative rates I was of the view the Fed would never do so.

That Tweet was in response to articles like these.

In Search of the Effective Lower Bound

Last September I penned Negative Interest Rates Are Social Political Poison.

Also last September I discussed the lower bound in In Search of the Effective Lower Bound

The Fed pays interest on excess reserves but the ECB charges them. Whereas the Fed gave free money to banks, the ECB charged the banks for excess reserves it forced into the system.

Whereas the Fed slowly recapitalized banks over time by paying interest on excess reserves, the ECB further punished the banks, perhaps purposely.

What better way to get Eurobonds or debt commingling that to purposely kill the banks?

No Economy-Threatening Bubble 

I strongly disagree with the Fed’s self-serving statement “There was no economy-threatening bubble to pop and no unsustainable boom to bust.

The Fed blew the third major economic bubble in 20 years. 

  1. Dotcom Bubble
  2. Housing Bubble
  3. Everything Bubble

What many label as the “Everything Bubble” is really a junk bond and asset bubble. 

What one label’s it isn’t important, how it came about is. 

The Fed embarked on a nonsensical battle against routine CPI deflation spawning the third major asset bubble.

Plenty of Inflation

There was plenty of inflation, in housing, in junk bonds, in Airbnb leverage, in borrowing everywhere and in the search for yield. 

None of that shows up in the CPI. Home prices are nor in the CPI, just rent. 

Very Deflationary Outcome Has Begun: Blame the Fed

On March 5, well before the Covid-19 bust, I cautioned Very Deflationary Outcome Has Begun: Blame the Fed

To be fair, that was not timely because something like this would trigger a deflationary bust, all in the name of “preventing deflation”

Economic Challenge to Keynesians

Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.

My Challenge to Keynesians “Prove Rising Prices Provide an Overall Economic Benefit” has gone unanswered.

BIS Deflation Study

The BIS did a historical study and found routine deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the BIS study.

The existing bubbles ensure another deflationary outcome.

So prepare for another round of debt deflation, possibly accompanied by a lower CPI especially if one accurately includes home prices instead of rents in the CPI calculation.

Historical Perspective on Deflation

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations: How Damaging are They?

Fed Lie of the Day: “Low Inflation is One of the Major Challenges of Our Time”

Please recall my May 18, 2019 post Fed Lie of the Day: “Low Inflation is One of the Major Challenges of Our Time”.

In reality, Fed-sponsored bubbles were the major challenge. Then when bubbles pop, what the Fed claimed to be preventing happens.

Supply Shock and a Demand Shock Coming Up

A Supply Shock and a Demand Shock are Coming Up.

So prepare for another round of debt deflation, possibly accompanied by a lower CPI especially if one accurately includes home prices instead of rents in the CPI calculation.

Central banks’ seriously misguided attempts to defeat routine consumer price deflation is what fuels the destructive asset bubbles that eventually collapse.

And here we are, with the Fed’s Balance Sheet Ballooning Out of Control hoping to prevent the asset bubble deflation that the Fed itself caused.

Putting A Price on the S&P 500

Putting a Price on the S&P 500

Honey, I bought a new set of golf clubs for 40% off. What a deal!

Dearest, I also found a bargain. I bought XYZ stock at $30, and it was trading at $50 two weeks ago.

Our happy couple seems to have found some great bargains. Their purchases may be cheap in their minds, but are they? To answer the question, we need an understanding of what the right price is, not what the price was yesterday.

Why Do We Invest Our Hard-Earned Money?

There is no way to value a set golf clubs conclusively. Those that play three times a week value the latest and greatest set of clubs much higher than hacks like ourselves.

Stocks and other financial assets, on the other hand, are a little easier. Various forms of quantitative valuation methods allow a calculation of “fair value.” Such can be applied to every financial asset from the safest U.S. Treasury bills to the riskiest penny stock. The fair value for golf clubs, on the other hand, is primarily based on enjoyment, a qualitative factor.

As we will discuss and show, “fair value” allows us to objectively assess whether or not those who are buying the S&P 500 are getting a good deal.

Calculating the Fair Value of a Stock 

One popular method to calculate the present value of a stock is to take its prior earnings, formulate a reasonable set of future earnings based on an assumed growth rate, establish an acceptable return, and calculate a fair value from those inputs.

Since no one can precisely know where fair value is, it is common to have a range of fair values based on various cash flow projections. Those ranges typically run from high, to low, and a base case, for example.

“Better than Best” Fair Value Estimate for the S&P 500

Just as we can forecast earnings for a stock, we can also use aggregated earnings to price the S&P 500. From those earnings we can determine if the current price is rich or cheap to what a model suggests is a fair price.

So with corporate earnings falling ill to COVID 19, we calculate a range of fair values for the S&P 500.

To run this analysis, we made the following assumptions:

  • Future earnings growth – we base this on the 4.85% growth rate of earnings from 2012 to the end of 2019. The forecast makes the bold, and dare we say impossible, assumption that growth in the second quarter and beyond are unaffected by the Corona Virus.
  • Acceptable return premium – we assume a 7% discounting factor based on historical equity returns
  • Years of cash flows to value – we project and discount earnings for the next 25 years.

Currently, with most earnings reported, we have a reasonable estimate of first-quarter earnings for 2020. Our “better than best” case scenario uses that first-quarter data point and grows it at the prior earnings growth (4.85%) rate going forward.

This forecast is very aggressive as we know that second-quarter earnings and those further out will fall well short of these projections. While optimistic, it at least allows us to form a baseline using reliable historical data.

The current fair value of the S&P 500 based on the assumptions listed above is an S&P 500 price of 2510. The current price of the S&P 500 as of 5/11/2020 is 2911. Therefore the S&P is overvalued by about 15%, as shown below.

Even if we can magically erase the bad earnings already seen in April and have an instant “V” shaped recovery, the market is still 15% overvalued.

The graph below provides some history on the price and fair value using the same assumptions and actual prior earnings.

The yellow area plots the percentage difference between the price and the fair value calculation. As shown, markets often go through prolonged periods of over and undervaluation. The biggest takeaway, however, is that prices always regress to at least fair value after these episodes. A more extended history argues that when prices do revert toward the mean, they usually go below fair value.

Given that we know our assumptions used above are too optimistic consider more realistic inputs of earnings projections to calculate a range of possible fair values.

Analysis Based on 2000 and 2008

As mentioned, the above example was our “better than best” case scenario. A logical next step is to take actual earnings declines from the prior two recessions as a forecast for the next few years.

In the Dot Com Bust recession of 2001, earnings per share for the S&P 500 were cut in half and did not fully recover for four years.

During the Financial Crisis and recession of 2008/09, earnings per share fell to near zero and also took four years to recover fully.

We use the percentage earnings declines and duration of shortfalls to forecast earnings for the second quarter of 2020 and outwards, as shown below.

Based on the prior two recessions:

  • The fair value for the S&P 500 using the earnings experience of the 2001 recession is 1980.
  • The fair value for the S&P 500 using the earnings experience of the 2008/09 recession is 1926.

Both experiences imply an approximate 30%+ decline from current levels to reach fair value.

The “What if” Worst Case Scenario

What if the recession starting in 2020 is worse than those scenarios modeled above?

Given the already recognized economic impact from COVID19 and the lack of a vaccine or treatment, it is hard for us to forecast a “V” shaped recovery in the coming months. The unemployment rate is at levels last seen in the Great Depression, and GDP will join it when reported in July. Simply, the depth and breadth of this episode dwarf the prior two recessions.

We also know the diffusion, or the number of industries and other countries affected is casting a much wider net than the prior two recessions.

At this point, the only unknown is the duration.

Given those metrics and even not knowing the duration of the recession, a worst-case scenario, fair value calculation based on a longer duration is well below the 2000 and 2008 based forecasts listed above.

Disclaimer

Greed, fear, optimism, and pessimism about the stock market and/or economy can result in significant premiums or discounts.

However, over time, reality has a way of catching up with greed and fear and brings prices back to fair value, if only for a short time. Valuations most commonly pass through fair value on their way to being overvalued or undervalued.

In today’s environment, we must also factor in a central bank that indirectly supports stock prices.

Summary

The impressive stock rebound may continue. The markets may reach or exceed the record highs of February. Prices have well deviated from fair value, and the divergence may get worse as valuations are sustained or even rise despite the collapse of earnings.

Make no mistake; however, buying the S&P 500 15% below where it was a few months ago is not the rational investors’ idea of a bargain. Far from it, in fact.

Selected Portfolio Positions Review: 05-13-20

Each week we produce a chart book of 10-selected portfolio positions to review in our equity model. Specifically, we are looking at positions which warrant attention, or are providing an opportunity to buy or sell.

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 three primary components to each chart:

  • The ORANGE price chart is overlaid on the short-term “Over Bought / Over Sold” indicator which is in GREY. 
  • 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 (Lower Panel) when the BLUE histogram is above (BUY) or below (SELL) the zero line.

When the price of a position is 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 add to a winning position, or look for an opportunity to add to holdings which have not violated trailing stops.

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


WMT – WalMart (Add)

  • We added WMT on Monday to the portfolio taking advantage of the recent pullback to previous support. 
  • Channel checks look good as people are shopping WMT and COST consistently so earnings should be stable going forward. 
  • Stop loss is set at $117.50

COST – CostCo Wholesale (Added)

  • As we added WMT to our portfolio, we added to our current position of COST for the same reasons.
  • Earnings should be stable as shopping continues (with or without restrictions)
  • Trend is very positive and is not overbought. Sideways consolidation since the beginning the year has removed much of the risk of ownership.
  • Stop has been raised to $290

INTC – Intel (Looking To Add)

  • We are looking to add INTC to the portfolio and just waiting for the right setup as we are underweight technology in the Equity portfolio.
  • We would like to see a pullback to the 200-dma that holds, or a consolidation that works off the overbought condition.
  • Be patient and wait for the right entry point. 
  • Stop will be set at $55

CAG – Conagra Foods (Sold)

  • We previously added to CAG  and it broke above the 200-dma and gained some traction. 
  • We sold CAG to take profits in the position and make room in the portfolio for increasing some of our other holdings. (We explained this in the portfolio commentary previously.)
  • There is nothing wrong with CAG technically or fundamentally. This was an allocation decision for our portfolio structure.
  • Stop is moved up to $30 if you are still long.

MPW – Medical Properties REIT (Add)

  • REITs have gotten oversold and out of favor relative to the Technology heavy sector. There will be a rotation to REITs eventually, so we are placing some early, small, bets.
  • We added MPW which, like our other REIT holding CHCT, is in the Healthcare space (which we like due to demographics) and provides us a decent yield.
  • MPW is not overbought and we will look to add to our holdings on a pullback to support that holds.
  • Stop loss is set at $14

GDX – Gold Miners (Reduced)

  • We took profits out of GDX and reduce our holding back to 1.5% of the portfolio.
  • GDX is grossly extended so we are looking for a pullback to support about $32 to add to our postiion.
  • We have traded gold miners a couple of times, and we have been building a position since March in the miners due to valuations relative to the price of gold. 
  • Stop is moved up to $29.00

CLX – Clorox Co. (Looking To Take Profits)

  • CLX has been a bit of a runaway train since adding the holding. 
  • We are going to take profits and reduce our position size temporarily to await a pullback to support and reduce some of the extreme overbought condition.
  • Stop is moved up to $180

NSC – Norfolk Southern (Looking For Entry)

  • We have owned NSC previously and took profits several times before closing out the position due to the shutdown of the economy.
  • With the economy starting to reopen we are seeing rail traffic starting to recover.
  • NSC is extremely overbought so we are looking for a bit of a correction to add a position back to our portfolios. 
  • As with INTC, we are not in a rush and will just wait for the right opportunity.
  • Stop loss will be set at $150

CMCSA – Comcast Corp. (Watch)

  • CMCSA is underperforming the market as a whole and performance has been disappointing as of late.
  • After taking profits previously, we are at a reduced weighting in the portfolio.
  • We are watching the position for now and evaluating it, however, if it doesn’t start to pick up performance soon, we will likely remove it and replace it with another candidate.
  • Current stop remains at $34

CHCT – CHCT Healthcare REIT (Looking To Buy)

  • CHCT was beat up badly during the liquidation in the credit markets. We still maintain a position in CHCT and are now looking to add to the holding. 
  • It got hit on Tuesday as Los Angeles announced they will remain closed for the rest of the summer. This will impact the rents of commercial REITs, but so goes the sector, so goes the holdings of all REITs.
  • We will use this opportunity to add to our holdings, but we will look for a bottom.
  • Buy at $31-32
  • Stop loss adjusted to $28

Sector Buy/Sell Review: 05-12-20

Each week we produce a Sector Buy Sell 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 SECTOR BUY/SELL REVIEW 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.

NEW PORTFOLIO TOOL:  Under the PORTFOLIO tab you will see a new tool called ALERTS. When you click on the link, any position that you in a WATCHLIST or PORTFOLIO will show up in the ALERTS window.  You can add SELL TARGETS, STOP LOSS, and Daily % Changes. When those levels are triggered, you will be sent an email and the alerts will show on your dashboard. 

We are using this system for all our current positions and will be reporting our targets in these daily updates.

Basic Materials

  •  XLB failed at the 61.8% retracement rally last week, is overbought, and is underperforming the market. It failed again at the 61.8% retracement level on Monday.
  • We are out of the sector for now due to the underperformance. However, if we do enter a trade, parameters will be very tight as the outlook for earnings remains dismal 
  • We have lowered our trading alert to $46 which may set up a tradeable opportunity.
  • Short-Term Positioning: Bearish
    • Last Week: No Positions
    • This Week: No Positions
  • Long-Term Positioning: Bearish

Communications

  • XLC continues to perform better than the overall market. 
  • We added to this sector previously, and the 200-dma retracement level has been reached. With the break above the 61.8% retracement level we added again to the sector on Monday.
  • We continue to like the more defensive quality of the sector, BUT on a short-term basis it is very overbought. We are looking for a pullback to add further to our holdings.
  • Our have set an alert at $49 to revisit adding to our holdings.
    • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
  • Long-Term Positioning: Neutral

Energy

  • Energy stocks have been trading much better than the commodity as relative strength has improved for the sector. 
  • We added a holding of XLE to our sector model (XOM, CVX to the equity model) to trade this current rally. We are looking for an opportunity to add to our holdings. 
  • We have a stop-loss alert set at $30, with a high-alert set at $40. The sector is about at the same level as last week, so no action taken. 
  • Short-Term Positioning: Bearish
    • Last week: Hold positions
    • This week: Hold positions
    • Stop loss is $30.
  • Long-Term Positioning: Bearish

Financials

  • Financials have lagged the bear market rally badly, and continue to underperform. 
  • We sold out of financials previously and will re-evaluate once the market calms down and finds a bottom. 
  • We continue to suggest selling rallies in financials.
  • We have an alert set at $21 to start evaluating holdings.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Industrials

  • As with XLB, so goes XLI.
  • XLI had a good rally and is again retesting the 38.2% retracement level.
  • We sold all of our holdings previously and will opt to wait for a better market structure to move back into the sector. 
  • We have an alert set at $58 to evaluate positions
  • Short-Term Positioning: Bearish
    • Last week: No position.
    • This week: No position.
  • Long-Term Positioning: Bearish

Technology

  • Technology continues to be the best looking sector chart available. We are at full weight in the sector now but will look to overweight on a pullback to support.
  • The rally on Monday continues push toward all-time highs and is back into positive territory for year. However, it is a narrow advance driven by the 5-major constituents. So goes AAPL, so goes the market. 
  • If we get a pullback that holds support at the 200-dma and the 50% retracement level, we will look add more weight to the sector. We have an alert set at $86.
  • Short-Term Positioning: Bullish
    • Last week: Holding positions.
    • This week: Holding positions.
    • Long-Term Positioning: Bullish

Staples

  • XLP recently pulled back and held support at the 50% retracement level. We increased our exposure slightly to the sector on this test. 
  • XLP is working off the overbought condition somewhat, but still has more to go.
  • We have an alert set at $55 as our stop-level.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Holding positions
    • Long-Term Positioning: Bullish

Real Estate

  • XLRE has recently rallied back to the 61.8% retracement level, and failed support at the 50% retracement last week. 
  • The sector is not overbought and is oversold relative to the market. If XLRE holds the $32 level, we should see some better performance here soon on a “safety rotation” trade with “bonds.” 
  • We have a low limit alert at $32 if lower support is getting threatened.
  • Short-Term Positioning: Bullish
    • Last week: No position
    • This week: Be patient.
  • Long-Term Positioning: Bullish

Utilities

  • XLU ran into the 61.8% retracement level, failed, and has now broken the 50% retracement support level. 
  • If XLU is working to hold support at the 32.8% retracement. If it can hold that support and work off the overbought condition, we will likely add to our holdings. 
  • We should see a relative “risk off” safety trade with XLRE if we see a pullback in the broader market.
  • We have an alert set at $54.
  • Short-Term Positioning: Bullish
    • Last week: Hold position.
    • This week: Hold position
  • Long-Term Positioning: Bullish

Health Care

  • XLV finally ran into resistance near all-time highs. The 200-dma is now important support and needs to hold. 
  • Look for a short-term pullback that holds the 62.8% retracement level and the 200-dma and consolidates a bit here before adding weight. The sector is very overbought short-term.
  • We have an alert set at $95 to add to our holdings.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Look to add
  • Long-Term Positioning: Bullish

Discretionary

  • Discretionary is performing better now. 
  • XLY rallied to the 200-dma and failed, but is again retesting that level of resistance on Monday. 
  • The sector is VERY overbought, so a pullback is likely, but there is a trading opportunity to if XLY can break above the 200-dma.
  • We are focusing on Staples for the time being but have an alert set to add Discretionary as a trading position at $110.00 on a pullback or $118 on a breakout.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Transportation

  • We have remained out of the economically sensitive sector as the impact of the “coronavirus” continues to rip through earnings in this sector. 
  • The sector mustered a weak rally from lows back to the 38.2% retracement level, got very overbought, and has now failed at resistance. 
  • We have an alert set for a trading opportunity set at $44, but we aren’t excited about it.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Economically Speaking: The Stock Market Is Not The Economy?

“The stock market is not the economy.”

Such is the latest rationalization to support the “bull market” narrative. The question, however, is the validity of the statement. As I noted in this past weekend’s newsletter:

“There is currently a ‘Great Divide’ happening between the near ‘depressionary’ economy versus a surging bull market in equities. Given the relationship between the two, they both can’t be right.”

There is a close relationship between the economy, earnings, and asset prices over time. The chart below compares the three going back to 1947 with an estimate for 2020 using the latest data points.

Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.

The Consumption Function

While stock prices can deviate from immediate activity, ultimately, reversions to actual economic growth eventually occur. Such is because corporate earnings are a function of consumptive spending, corporate investments, imports, and exports. 

I subsequently received an email discussing the point.

“PCE depends on jobs and wages as well as intact supply chains, neither of which are in good condition. Regarding unemployment, the U6 rate, which is a more reliable indicator of job market health, is at 22.8% currently and rising while the labor market participation rate has dropped to about 60%.  These factors do not bode well for growth and earnings for most companies.” – A Brinkley, Jr.

His statement is correct. There is a precise correlation between PCE and GDP. Not surprisingly, if consumption contracts due to high levels of unemployment, then economic growth declines. 

 

Furthermore, given that consumption drives imports, the correlation also stands.

Exports, which comprise roughly 40% of corporate profits, also have a high correlation to consumption and related economic activity. 

It should be evident that corporate earnings and profits are highly correlated to economic activity. While Business Investment and Government Spending do have an input into the economy, it is consumption which ultimately drives profits.

Stock Prices & The Economy

As stated, over short-term periods, the stock market often detaches from underlying economic activity as investor psychology latches onto the belief “this time is different.” 

Unfortunately, it never is. 

While not as precise, a correlation between economic activity and the rise and fall of equity prices does remain. In 2000, and again in 2008, as economic growth declined, corporate earnings contracted by 54% and 88%, respectively. Such was despite calls of never-ending earnings growth before both previous contractions. 

As earnings disappointed, stock prices adjusted by nearly 50% to realign valuations with both weaker than expected current earnings and slower future earnings growth. While the stock market is once again detached from reality, looking at past earnings contractions, suggests it won’t be the case for long.

The relationship becomes more evident when looking at the annual change in stock prices relative to the yearly change in GDP.

Again, since stock prices are driven in part by the “psychology” of market participants, there can be periods where markets become detached from fundamentals. However, there is no point in the previous history, where the fundamentals catch up with stock prices.

The Stock Market Isn’t The Economy

When it comes to the state of the market, corporate profits are the best indicator of economic strength.

The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to “remain irrational longer than logic would predict.”

However, such detachments never last indefinitely.

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham

As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP, we see a process of mean-reverting activity over time. Of course, those mean reverting events always coincide with recessions, crises, or bear markets.

As shown below, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe corrections in the stock market over time. Such should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability.

More importantly, corporate profit margins have physical constraints. Out of each dollar of revenue created, there are costs such as infrastructure, R&D, wages, etc. Currently, one of the biggest beneficiaries to expanding profit margins has been the suppression of employment, wage growth, and artificially low borrowing costs. The recession will cause a rather marked collapse in corporate profitability as consumption declines.

, Profits & Earnings Suggest The Bear Market Isn’t Over.

Recessions Reverse Excesses

The chart below measures the cumulative change in the S&P 500 index as compared to corporate profits. Again, we find when investors pay more than $1 for a $1 worth of profits, there is a reversal of those excesses.

The correlation is more evident when looking at the market versus the ratio of corporate profits to GDP. Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.  Hence, neither should the impending reversion in both series.

To this point, it has seemed to be a simple formula that as long as the Fed remains active in supporting asset prices, the deviation between fundamentals and fantasy doesn’t matter. It has been a hard point to argue.

However, what has started, and has yet to complete, is the historical “mean reversion” process which has always followed bull markets. This should not be a surprise to anyone, as asset prices eventually reflect the underlying reality of corporate profitability.

Recessions reverse excesses.

Rallying Into Uncertainty

While it may seem for the moment that stock prices can remain detached from the economic devastation, it is likely not the case indefinitely. Such is especially the case given stocks are rising into a increasing list of uncertainties. (Adapted from Doug Kass.)

  • The “value proposition” no longer exists.
  • A summer swoon? Seasonality is coming into play. 
  • Corporate profits have been flat since 2014 and are likely to deteriorate markedly.
  • My S&P EPS estimates are well below consensus at $80-90/share.
  • Economic challenges going forward will absorb a vast majority of the Fed’s liquidity. 
  • The Federal Reserve is already rapidly slowing the rate of QE
  • 5-stocks dominate the market and are responsible for the rally.
  • Small- and Mid-caps stocks are sorely lagging.
  • Market participants have rapidly returned to exuberance during the rally.
  • No one wants to buy a “bear market” bottom.
  • Surging debts and deficits are economic retardants, which will eventually reflect in earnings, profits, and weaker economic growth.
  • A Democratic Presidential Win Could Be “Market Unfriendly”
  • Buyback activity, which has comprised almost the entirety of the markets advance over the last several years, is slowing markedly. 
  • Pension plans problems are likely to become even larger problems, as discussed previously.
  • Bonds do not agree with the stock market. Bonds, more often than not, are right.
  • Trump is on the verge of restarting the “Trade War” with China.

Conclusion

There are a tremendous number of things that can go wrong in the months ahead. Such is particularly the case of a surging stock market against weakening fundamentals. 

While investors cling to the “hope” that the Fed has everything under control, there is more than a reasonable chance they don’t. 

Regardless, there is one simplistic truth. 

“The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices – corporate profits.”