Monthly Archives: March 2020

Shedlock: The Great Inflation Debate. When & How Big?

Jim Bianco at Bianco Research shares his views on the great inflation debate. When it will come, how big it will be, and when the Fed will hike.

When and Why Will the Fed Hike?

This is a guest post by Jim Bianco who explains his views on When Will the Fed Hike and Why.

Summary

The market is starting to see a Fed hike on the distant horizon. This is how a shift in thinking begins. The driving reason for this change seems to be a resurgence of inflation over booming real growth.

Over the summer, the Fed started suggesting they would hold off on any rate hikes for years. In late July (brown line), the market was flirting with the idea of negative rates, as shown by the fed funds futures curve.

By late October (blue line), the forward curve was back to positive, but still not pricing in a rate hike for years. A rate hike is expected when the implied yield is above 0.125%.

The combination of the election and Pfizer’s vaccine news resulted in the fed funds curve jumping higher (cyan and red lines). This morning (orange line), the market is getting closer to pricing in a 2023 rate hike. 

This is how a shift in thinking begins. The market prices in a distant hike and then start to move it closer and closer to the present as data warrants.

Why Is This Happening?

The next chart shows the jobs lost from the pandemic (cyan) and the projection of non-farm payroll growth from a survey of about 70 economists conducted by Bloomberg (shaded area). To date, over 10 million jobs lost to the pandemic have yet to be recovered (green line). This shortfall is expected to be cut to 4.7 million jobs by the end of 2021 (cyan line). Given the Fed’s preference for jobs over inflation, this means there should be no talk of the Fed hiking rates. Yet, the market is inching toward that reality.

Restoration of Jobs

Tracking the restoration of jobs

This same survey of economists expects economic growth to slow to pedestrian levels between now and the end of next year. No estimate, even after factoring in the election and vaccine news, expects real GDP growth to top 4% through the end of 2021. It is too early to consider 2022 forecasts.

With these levels of expected growth, real GDP is not expected to recover its previous peak (Q4 2019) until Q4 2021 (black line).

Measuring the Expected GDP Contraction

Measuring the Expected GDP Contraction

All of this is to say there is no reason for the market to start thinking about rate hikes or even higher long rates. But that is what is happening. Why?

We believe the market is pricing in a higher likelihood of inflation. 

The next chart shows the 10-year inflation breakeven rate continues to move higher, suggesting more future inflation is being priced in.

US TIPS 10-year Inflation Breakeven Rate

US TIPS 10-year Inflation Breakeven

But it is important to define “high inflation.”

According to the Fed’s preferred measure of core PCE, a move above 2.5% on a year-over-year basis would essentially be a 27-year high in inflation. We would define this level as high.

Core PCE

Core PCE Bianco

The next chart shows core PCE on a rolling 5-month annualized basis. In the five months ending in April 2020, when the pandemic really began taking hold, prices declined the most in a generation. During the re-opening (five months ending in September 2020), prices rebounded at their fastest rate since the earlier 1990s.

5-Month Annualized Core PCE

5-Month Annualized Core PCE

We do not expect prices to continue to accelerate at this level, but we do expect prices to continue to advance enough to challenge 2.5% on a year-over-year basis next year.

Dow New Low, Markowski: Could The Dow See A New Low Before Recession Ends?

Why Will Inflation Advance?

Above we showed that the economy is below potential and will not recover the lost GDP for years. This means less supply that should help reduce excess capacity in the economy, especially given population growth is not reversing, so the demand for goods and services will not wane as much. 

In addition to reduced supply, the stimulation of demand has been unprecedented. As the next chart shows, the government’s total outlay (spending) was over 33% of 2020’s GDP. In the 200+ years show, the government only had a bigger footprint on the economy in the war years of 1943 to 1945 (note the government’s fiscal year ends September 30, so 2020 is the full year).

Total Government Outlays as a Percentage of GDP

Total Government Outlays as a percentage of GDP

This spending has led to massive government borrowing. This has blown out the deficit to $3.13 trillion (top panel), or more than 16% of GDP (bottom panel).

The U.S. Federal Deficit

The U.S. Federal Deficit

16% of GDP is rarefied air for the deficit. Only the year after WW1 (1919) and the WW2 years of 1943 to 1945 were larger.

Surplus or Deficit as a Percentage of GDP

Surplus Deficit as a Percentage of GDP

The chart above shows huge deficits relative to GDP in 1864, 1919, 1943 to 1945, and now. As the chart below shows, all these periods aligned with bouts of high inflation.

Huge deficits mean huge spending. Huge spending bids prices higher, otherwise known as inflation.

Year-Over-Year CPI Back to 1800

Year-Over-Year CPI Back to 1800

Why Does Inflation Matter?

Think of the Fed as a post and the bond market as a horse tied to that post. The horse will remain in place, tied to that post, unless spooked by inflation. The horse has the ability to rip that post from the ground and run wild. The post cannot stop a scared horse. 

We have argued the 0.33% low in 10-year yields on March 9 marked the end of the 39-year bull market. Rates should be moving higher, but they are being suppressed via massive QE. At some point, we expect the “horse” to tear the post from the ground and start running with higher yields.

End Bianco Guest Post

According to Bianco, the Horse has not yet left the barn, but the Fed cannot keep the horse penned in forever.

That’s quite the presentation and a very good case. 

If we factor in housing prices, inflation is already roaring. 

Case Shiller Composite Indexes

Case Shiller Composite Indexes 2020-11

I would be more convinced of an inflation surge had Democrats won the Senate and Progressives got the agenda they wanted. 

A longs as Republicans control the Senate the agenda will not go totally bonkers. 

Yet, it is hard to say what bonkers even means. No one even bats an eye at talk of $3.13 trillion deficits.

The Wall Street Journal notes Investors Bet Economic Recovery Won’t Spark Jump in Inflation

“The big picture view is that the disinflationary effects of the pandemic are outweighing the inflationary effects,” said Gero Jung, chief economist at Mirabaud Asset Management. “We think inflation will come down even further” in the short term.

Longer-term, expectations haven’t changed significantly. The U.S. 10-year inflation break-even rate, a measure of how much inflation investors expect annually over the next decade, was largely flat at 1.72% on Wednesday, compared with 1.77% at the end of last year. At this year’s highest, it was about 1.8% in August.

We’ve been long inflation, with a positive view on the recovery story, particularly because of very loose monetary and fiscal stimulus working in tandem. Now we’re starting to question that,” says Adam Skerry, rates, and inflation fund manager at Aberdeen Standard Investments.

Two Inflationary Tail Risks For US Investors

Lacy Hunt at Hoisington Management is still a bond bull, but he has concerns about what the Fed might do.

Hunt sees Two Inflationary Tail Risks For US Investors

We identify two-tail risks for long term Treasury investors: (1) a huge new debt-financed fiscal package and (2) a major change in the Fed’s modus operandi. The first risk would change the short-run trajectory of the economy. This better growth, although short-lived, could place transitory upward pressure on interest rates in a fashion that has been experienced many times. Over the longer run, disinflation would prevail, and the downward trend in Treasury yields would resume.

The second risk would bring a rising inflationary dynamic into the picture, potentially becoming much more consequential. As this dissatisfaction intensifies, either de jure or de facto, the Federal Reserve’s liabilities could be made legal tender or a medium of exchange. The Fed has already taken actions that appear to exceed the limits of the Federal Reserve Act under the exigent circumstances clause. However, so far, they are still lending and not directly funding the government’s expenditures in any meaningful way. But some advocate making the Fed’s liabilities spendable, and a few central banks have already moved in this direction. If the Fed’s liabilities were made a medium of exchange, the inflation rate would rise, and inflationary expectations would move ahead of actual inflation. In due course, Gresham’s law could be triggered as individuals move to hold commodities that can be consumed or traded for consumable items. This would result in a massive decline in productivity. Thus real growth and the standard of living would fall as inflation escalates.

Questions

What will Congress do for those who don’t have job? 

Those who kept their job and are working at home got a huge income boost. 

What about asset prices? The Fed targeted the stock market and that boosted home prices as well. 

A sustained plunge could be quite deflationary, but I have given up attempting to figure out when bubbles will pop. I sit in gold instead.

Open Mind

My readers know that I have dissed most inflation claims for years, decades actually, (at least as the Fed and BLS calculate inflation).   

Now I have an open mind as the bond market is flashing some warning signs, and so is the Fed, as observed by Lacy Hunt.

Lend vs Spend

It’s important not to confuse the Fed’s ability to lend with ability to spend.

Here is Lacy Hunt in a Bloomberg Interview in August 2020

Bloomberg: Lastly, I want to ask you about the rise of Modern Monetary Theory within economics and some proposals to have the Fed give money directly to individuals.

LH: The great risk is that we become dissatisfied with the way things are, and either de jure or de facto, the Federal Reserve’s liabilities are made legal tender. The Federal Reserve as it’s constituted today can lend, but it cannot spend. Now, they’ve done some things that are different from what the Federal Reserve Act said under the exigent circumstances clauses, but so far, they’re lending. 

LH: Some folks want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off. However, everyone would be totally miserable in concise order because no one would want to hold money. You would trigger Gresham’s Law — people would only want to hold commodities they can consume and commodities that can be traded for others. 

LH: But there is that risk that you could use the Fed’s liabilities to pay directly. The Bank of England has made a small move in that direction — they say it’s temporary. Others want to try that because they’re frustrated that issuing the debt is not getting the job done. So we could significantly alter the whole structure of the U.S. economy. But if you use the Fed’s liabilities for directly funding goods and services, the consequences could be very extreme and very quick.

For the full interview and a followup discussion, please see Bond Bull Lacy Hunt Warns of a Huge Monetary Risk

Is the Bond Bull Over?

Keep your eye on the treasury barn door. I would not at all be surprised if the 0.33% low in 10-year yields on March 9 marked the end of the 39-year bull market. 

What Value Remains? 

If you believe, as I do, that the Fed will not take interest rates negative, what value in the 10-year treasury remained at 0.33%? 

Now at 0.85% perhaps one can find 50 basis points of “value” with a risk of 200 to 300 basis points of losses.

There is more value but also more risk in the 30-year long bond yielding 1.56%.

Why Not Negative?

The Fed can easily see negative rates hurt Japan and the ECB. Whereas the ECB punished banks by charging them interest on excess reserves, the Fed slowly recapitalized US banks over time by flooding the banks with excess reserves then paying them free money all the while.

The Fed might try other tactics such as making the Fed’s liabilities legal tender, but that would have Hunt headed for the door in a flash.

Hello Fed, Low Interest Rates Do Not Promote Growth

To further discuss these ideas, including negative rates and a recap of Lacy Hunt’s position, please see Hello Fed, Low Interest Rates Do Not Promote Growth.

All bull markets come to an end. This end will have fireworks if the Fed does the wrong thing.

What Is The Great Medicare Mistake?

What is the Great Medicare Mistake? Let’s explore what it is and how to avoid it.

We are in the throes of Medicare open enrollment season. The political ads are gone (thankfully). However, Medicare Advantage commercials continue to inundate the airwaves and interrupt my Westerns. 

As much as I love Joe Namath, he shouldn’t win out over Matt Dillon!

For all the television spots and direct mailers, most older Americans are resistant to review or compare coverage options because, frankly, the process is overwhelming and confusing.

Let’s face it; the exercise is as fulfilling as doing your own taxes. However, seniors must examine their Medicare Advantage (Part C) and Prescription Drug D coverages annually – even if they’re satisfied with their choices because one of the greatest Medicare mistakes is to be complacent about saving money!

The Senior Citizens League weighs in.

For example, an analysis by The Senior Citizens League, www. seniorsleague.org, of the twelve most frequently prescribed drugs discovered that Medicare recipients frequently overpay. 

From the 2019 study: 

Although Medicare has an annual Open Enrollment period, when beneficiaries can compare drug plans and switch to lower costing drug plans, few retirees actually do so. 

“In most areas of the country, the Medicare beneficiaries have more than two dozen Part D plans to sort through, and the average person just don’t know where to begin, or that free, unbiased help is available,” Johnson says.  “Consequently, Medicare beneficiaries winds up overpaying for prescriptions that could be obtained for a lower cost from a different drug plan.”

The difference in drug prices among the lowest and highest costing plans can range from hundreds to thousands of dollars. Drug plans with the highest premiums do not necessarily provide better coverage. Compare multiple plans which carry your prescriptions in their formulary.

Don’t Take Prescription Drugs? You Still Require Part D Coverage!

If you’re eligible for Part D but do not take prescription drugs, it’s still important to shop for a Part D plan.  If not, you may owe a late enrollment penalty if, at any time after your Initial Enrollment Period, there’s a period of 63 or more days in a row when you don’t have Medicare drug or other creditable drug coverage. You’ll pay the penalty for as long as you have Medicare drug coverage (as long as you live?)

If you’re fortunate enough not to require prescription drugs, initially consider an inexpensive plan to avoid the penalty. From there, look to change coverage during the annual enrollment period if your drug status changes.

Yes, the message for Medicare recipients is to set aside time to investigate. Recipients who spend about an hour every enrollment period find they save money, discover additional benefits, and overall are more sensitive to adverse changes to current plan benefits.

Do you participate in Original Medicare, Medicare Advantage, or a prescription drug Part D plan? Then mark your calendar every year to review or change coverage.

Insight from Medicare.com’s Christian Worstell. 

As we enter the final weeks of 2020 enrollment, I want to share some interesting and salient information from several sources, including Christian Worstell – a licensed insurance agent and writer for www.medicare.com, a non-government insurance website powered by eHealth, the health insurance agency.

The survey of 891 Medicare beneficiaries is enlightening but not surprising. Older Americans prefer to comparison shop automobile coverage over Medicare insurance even though healthcare expenses remain a primary concern for people over 65. Roughly one out of three Medicare beneficiaries do not review their coverage every year.

Per Medicare.com, seniors have withdrawn an estimated $22 billion from investments to pay for healthcare. One can only imagine the future of medical costs as the lingering effects of Covid affect older Americans long term.

Medicare recipients would almost prefer to clip grocery coupons and peruse supermarket ads than shop Medicare plans!

The Likelihood to Comparison Shop. 

Graphic showing percentage of Medicare beneficiaries who comparison shop for various services

Medicare insurance shopping ranks high in unpleasantness. Recall how I referenced ‘doing taxes.’

Graphic showing how unpleasant Medicare beneficiaries find various processes

Who Do Seniors Consult For Medicare Insurance Advice?

Unfortunately, financial advisors don’t make the cut. However, we pride ourselves at RIA how clients, blog readers, and radio listeners indeed reach out to us for Medicare guidance.

Older Americans initially seek out the advice of friends and then medical professionals. They also largely trust the government for Medicare information. Four out of five seniors have utilized the Medicare Plan Finder tool on Medicare.gov. 

A Few Things To Remember When Shopping for Medicare Plans.

Don’t be seduced by ads or direct mailers. I admit the advertisements are very tempting. They make every plan appear perfect, most inexpensive, and for some, cool gifts are part of the pitch. Medicare Advantage plans are lucrative ventures for most insurance companies and an area of explosive growth. On the surface, they appear less expensive and offer more than Medigap supplemental coverage.

The Meteoric Rise of Medicare Advantage.

With retiree cash flows under duress due to the lingering effects of COVID on future healthcare costs, Medicare Part B inflation, and consistently poor COLA adjustments for Social Security, I expect Medicare Advantage plans to continue their meteoric pace of growth.

Enrollment in Medicare Advantage programs has doubled over the last decade, which will spur increased competition, which is great, but it’s also going to make your review process increasingly arduous. 

Let the advertisements signal you to do homework. Consider all the direct mailers an ‘Annual Medicare Enrollment Awakening.‘ The alert to set a couple of hours aside for review each year.

Zero premium plans are popular but dig deeper. Per KFF.org, nearly two-thirds of Medicare Advantage enrollees pay no premiums except, of course, their Part B premiums.

Remember, zero-premium is a single factor. Medicare Advantage plans have deductibles and co-pays that must be assessed holistically depending on your overall state of health and the estimated frequency of doctor visits and diagnostics. 

Out Of Network Costs

Be prepared to pay more out-of-pocket if out of network. Generally, Medicare Advantage plans prefer you stick with their respective HMO or PPO networks. If your current doctor, hospital, physician specialist is out of network, understand the ramifications, especially if you travel out of state often and find yourself in need of health coverage.

Is there a chance you may be in the hospital for longer than five days? Interesting analysis by KFF:

In 2020, virtually all Medicare Advantage enrollees would pay less than the Part A hospital deductible for an inpatient stay of 3 days. For stays of 5 days, among the half of Medicare Advantage enrollees required to pay more than the beneficiaries in traditional Medicare, those enrollees would pay $1,644 on average. Nearly two-thirds (64%) of Medicare Advantage enrollees are in a plan that requires higher cost sharing than the Part A hospital deductible in traditional Medicare for a 7-day inpatient stay. More than 7 in 10 (72%) are in a plan that requires higher cost sharing for a 10-day inpatient stay.

At RIA, we believe Medicare Advantage plans are best for the healthiest households who aren’t in the hospital often or visit the doctor frequently. As a reminder, I’ve listed the differences between Advantage and Medigap below.

Medicare Advantage vs. Medigap.

Medicare Advantage Plans are inclusive, which means they cover all services of Original Medicare, including prescription drugs. Most offer extra coverage like vision, hearing, dental, and/or wellness plans. Two-thirds of the plans offered are through closed-physician network HMOs.

Advantage Plans usually have lower premiums than Medigap (also known as Medicare Supplemental Insurance) and are offered without insurability evidence.

Per KFF.org: While average Medicare Advantage premiums paid by MA-PD enrollees have been relatively stable for the past several years ($36 per month in 2017), enrollees may be liable for more of Medicare’s costs, with average out-of-pocket limits increasing 21 percent and average Part D drug deductibles increasing more than 9-fold since 2011; however, there was little change in out-of-pocket limits and Part D drug deductibles from 2016 to 2017.

At RIA, we suggest older Americans select a Medigap policy over Medicare Advantage, but our views may change in the future. Monthly premiums for Medigap policies will absolutely be higher. However, the Medigap insured can benefit from more choice among providers and ultimately lower total out-of-pocket costs.

Healthcare insurance homework is an ongoing process.

Healthcare insurance and coverage require ongoing due diligence by older Americans. The great Medicare mistake is to let annual enrollment go ignored.

Please let us know if our team can help you make sense of what’s available. 

Technically Speaking: Investors Go “All-In” Without A Net

We have recently written a couple of posts about the “exuberance” that has invaded the market since the election. Such is often seen near short- to intermediate-term peaks in markets as investors go “all-in” without a net.

It was on December 5th, 1996, during a televised speech, that Fed Chairman Alan Greenspan stated:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

It is an interesting point that the U.S. has sustained low rates of inflation combined with monetary and fiscal stimulus, which have lowered risk premiums, leading to an inflation of asset prices.

Unfortunately, the knock-off effects has been lower rates of profitability and economic growth. As shown, the market has completely detached from both economic growth and corporate profitability. The last two times such occurred, the outcome was not terrific.

Exuberance Abounds

Over the last two weeks, we have noted the more “exuberant levels” of sentiment from investors since the election. As stated in “Bulls Go Ballistic:”

“Our composite ‘fear/greed’ indicator, which primarily comprises investor positioning, shows much of the same as ‘bullish sentiment’ pushes back to extremes.”

Chart updated through last Friday.

Importantly, investors are once again positioning themselves into equity “risk” at a rather alarming rate, with confidence surging higher. The 4-panel chart below shows investors have piled into equity funds, have a high level of confidence about the future, and complete evaporation of “short-interest” in the market. (Charts courtesy of The DailyShot)

Previously, we saw this type of surge in December of 2017, followed by a near 20% decline just two months later. We saw it again in February of this year.

Importantly, this is just the “fuel” necessary for a more critical correction in the market. As long as “no one strikes a match,” investors have little to be concerned about.

The Spark That Lights The Fuse

However, there are plenty of catalysts currently, which could “light the fuse.” My colleague Doug Kass laid out a list of potential candidates:

  1. The virus mutates, rendering “vaccines” ineffective. 
  2. There are unexpected manufacturing, distribution, and storage problems with delivering a Covid-19 virus.
  3. With a delay and without a timely vaccine, the spread of Covid-19 intensifies.
  4. As Covid spreads over the next month, there is an increase of state lockdowns, business, school closings, “stay at home orders,” and curfews enacted around the country.
  5. The debated election results linger into 2021 as lawsuits multiply.
  6. Global economic growth fails to reaccelerate in the second quarter of 2021.
  7. Housing falls under the weight of higher home prices – affordability suffers. Housing’s economic multiplier effect moves into reverse.
  8. Consumer and business confidence takes a downturn.
  9. Bond spreads widen.
  10. A divided and partisan House fails to deliver a sizeable and credible stimulus bill.
  11. Investors realize that monetary policy can no longer foster or catalyze economic growth.
  12. Deflationary conditions accelerate based on unexpected economic weakness.
  13. A sizeable corporate fraud gets discovered – further deflating investor confidence.

In reality, we have no idea what the catalyst will be. No one expected a “pandemic” in March, but here we are. The point is that with markets extremely overbought, extended, and deviated from long-term means, with overly confident investors, the risk of a reversion has grown.

7-Impossible Trading Rules

In the “heat of the moment,” it is easy to get swept up into narratives as the “Fear Of Missing Out” overtakes our logical thought processes. As such, here are the 7-impossible trading rules to follow:

1) Sell Losers ShortLet Winners Run:

It seems like a simple thing to do, but the average investor sells their winners and keeps their losers, hoping they will eventually return to even.

2) Buy Cheap And Sell Expensive: 

If an investment isn’t “cheap, – it isn’t. Don’t make excuses to justify overpaying for an investment. In the long run, overpaying always reduces returns.

3) This Time Is Never Different:

As much as our emotions and psychology always want to hope for the best – this time is never different. History may not repeat exactly, but it generally rhymes.

4) Be Patient:

There is never a rush to invest. There is also NOTHING WRONG with sitting on cash until a real opportunity comes along. Being patient is an excellent way to keep yourself out of trouble.

5) Turn Off The Television: 

The only thing you achieve by watching the television from one minute to the next is increasing your blood pressure.

6) Risk Is Not Equal To Your Return: 

Risk only relates to the loss of capital incurred when an investment goes wrong. Invest conservatively and grow your money over time with the least amount of risk possible.

7) Go Against The Herd: 

When everyone agrees on the market’s direction due to any given set of reasons – generally, something else happens. Such also cedes to points 2) and 4). To buy something cheap or to sell expensive, you are buying when everyone is selling and selling when everyone is buying.

Conclusion

These are the rules. They are simple but impossible to follow for most. However, if you can incorporate them, you will succeed in your investment goals in the long run. In the end, it is crucially important to understand that markets run in full cycles (up and down).

While the bullish cycle lasts twice as long as the bearish cycle, investors’ damage comes not from lagging markets as they rise but in capturing the decline.

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

The markets are indeed currently exceedingly exuberant on many fronts. With margin debt back near peaks, stock prices at all-time highs, and “junk bond yields” near record lows, the bullish media continues to suggest there is no reason for concern.

Of course, such should not be a surprise. At market peaks – “everyone’s in the pool.”

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

Viking Analytics: Weekly Gamma Band Update 11/23/2020

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update 11/23/20

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model has similar returns to a long-only position in SPX, albeit with much lower risk exposure.   The Gamma Band model has resulted in a 74% improvement in risk-adjusted return since 2007 measured by the Sharpe Ratio. 
  • The Gamma Band model has maintained a 100% exposure to the S&P 500 for nearly two weeks, as the market has rallied since the U.S. Presidential election.  The value of SPX has been trading near or above the upper Gamma Band for over a week, and this does not reduce exposure in our model.  
  • The model will adjust to a partial SPX allocation when the value of the SPX closes on a daily basis below Gamma Neutral, which is currently at 3,479.
  • Our binary Smart Money Indicator continues to have a full allocation; however, this index could be turning cautionary.
  • SPX skew, which measures the relative cost of puts to calls, shows that risk appetite is in a middle range (neither bullish nor bearish).
  • We publish several signals each day, ranging from a fast signal in ThorShield to a less active signal (as represented by the Gamma Bands and published in the daily SPX report).  Samples of our SPX and ThorShield daily reports can be downloaded from our website.

Smart Money Residual Index

This indicator compares “smart money” options buying to “hot money” options buying.  Generally, smart money will purchase options to insure stable returns over a longer term.  Smart money has in-depth knowledge and data in support of their options activity. In contrast, “Hot money” acts based on speculation, seeking a large payoff.

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position during this time.  When the smart money turns more cautious than hot money, the Residual Sentiment Index in the second graph turns to red, then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

In evaluating equity market risk, we also consider the cost of buying puts versus the cost of buying calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this might be a signal to reduce equity exposure. 

Heading into the U.S. election, investors were paying a meaningful insurance premium, and that risk premium has been meaningfully reduced.

Gamma Band Background

Market participants are increasingly aware of how the options markets can affect the equity markets in a way that can be viewed as the “tail wagging the dog.” 

We created a Gamma Band indicator to demonstrate the effectiveness of the Gamma Neutral level in reducing equity tail risk.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 74% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal if one’s goal is to increase risk-adjusted returns.  We also publish a faster, daily signal in a portfolio model which we call Thor’s Shield.  Thor Shield has a 20-year Sharpe of 1.5 and a rolling 1-year Sharpe of over 3.4.  Free samples of our daily SPX report and Thor’s Shield model can be downloaded from our website.

Authors

Viking Analytics is a quantitative research firm that creates tools to navigate complex markets.  If you would like to learn more, please visit our website, or download a complimentary report.

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


MoneyShow: Investing When Markets Detach From The Economy

“The stock market is not the economy.” Such remains the “Siren’s Song” of investors as valuation expansion is the sole driver of the market’s performance. Given that corporations derive their revenue from economic activity, how do you invest when the economy is detached from the economy?

I explored this issue in my presentation at the MoneyShow Virtual Expo last week. In the presentation I cover:

  • Why we are still in a “bull market.” 
  • The stock market is not the economy.
  • The linkage between the economy and the stock market
  • Where to invest in 2021 
  • The trading rules to follow.

The following articles I recently wrote provide more clarity on the issues I discuss in the following presentation.

#MacroView: The Rescues Are Ruining Capitalism

Investors Ignore Evidence At Their Financial Peril

Buffett Indicator: Why Investors Are Walking Into A Trap

With the Federal Reserve creating “moral hazard” in financial markets, it certainly seems as if stocks can never go down. The problem, of course, is that is exactly what sentiment was like prior to the last two major bear markets.

Currently, just about every measure of valuation is predicting low to negative returns over the next decade.

one, You’ve Got To Ask Yourself One Question. Do You Feel Lucky?

While such does not mean that every year will be negative, it suggests we will likely witness increased volatility and more frequent declines. As Michael Lebowitz, CFA recently noted:

“Regardless of the economic environment, taking significant risks, and accepting pitiful expected returns is a bad idea. However, there is one more factor we must consider. The Federal Reserve supplies a massive amount of liquidity, much of which is finding its way into the asset markets.

The Fed will likely continue as long as inflation is held at bay. The result may be that stock prices continue to rise, and valuations eclipse all prior norms. However, the music will stop someday, and the facts presented here will be apparent.”

2021 May Be A Challenge

The trend is your friend, currently. The Fed will continue to supply liquidity, which will help the market ignore the reality of valuations, technical deviations, and excessive bullishness for now.

However, as we saw in March, such does not preclude hair-raising volatility and large declines, but it does support prices on the margin regardless of the environment. The problem comes when the Fed backs off, whether by its design, inflation, or an inability to absorb larger levels of debt issuance from the Government. At that point, slower economic growth, massive debt overhead, and rich valuations will matter.

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

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 a straightforward 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.”

Enjoy the presentation.

The MoneyShow: Investing In 2021

I hope you enjoyed it.

Vaccine Rally Fizzle, Markowski: Premature Vaccine Rally To Soon Fizzle!

MoneyShow Presentation Deck

The PDF of the slide deck is provided below for your convenience.

Feel free to email me any questions you have.

Risk Exceeds Reward – Why We Took Profits


In this issue of “Risk Exceeds Reward – Why We Took Profits.”

  • Market Struggles With All-Time Highs
  • Sentiment Is Getting Overly Bullish
  • Valuations Vs. Momentum
  • Portfolio Positioning Update
  • MacroView: The Fed Will Monetize All Debt Issuance
  • Sector & Market Analysis
  • 401k Plan Manager

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Catch Up On What You Missed Last Week


Market Struggles With All-Time Highs

Last week, I started “Market Breaks Out” with the following paragraph.

“If you like volatility, then this past week was for you. On Monday, the announcement by Pfizer sent markets screaming higher. Subsequently, the market faded into the end of the day. Since the highs of September, the market is now just 0.50% higher today. Like I said, if you like volatility, you have gotten a good dose of it.

Fast-forward to this past Monday, and I can repeat the same opening.

“If you like volatility, then this past week was for you. On Monday, the announcement by Moderna sent markets screaming higher. Subsequently, the market faded into the end of the day. Since the highs of September, the market is -.65% lower today. Like I said, if you like volatility, you have gotten a good dose of it.

Importantly, just because the market is overbought, extended, and deviated from long-term averages does not necessarily mean an immediate correction. Such requires a catalyst. The overbought conditions provide the fuel for the correction. (We discuss the potential catalyst in “Portfolio Positioning” below.)

However, with the market slowly “leaking” over the past week, a “sell” signal is approaching. Over the last few months, it has paid to be a bit more cautious at this point.

Furthermore, with the number of stocks now trading above their 200-dma at the highest level we have seen over the last 5-years, short-term corrections have often followed.

As we wrote in “Bulls Go Ballistic,” bullish sentiment has surged post-election despite rising virus cases, returning shutdowns, and lack of stimulus. 

Bulls Go Ballistic Reduce Risk, Technically Speaking: Bulls Go Ballistic – Time To Reduce Risk

At the same time, investors are rushing in; insiders are “selling out.” 

Bulls Go Ballistic Reduce Risk, Technically Speaking: Bulls Go Ballistic – Time To Reduce Risk

For these reasons, we continue to suggest some caution through active portfolio risk management until some of the excesses get reversed.

Sentiment Is Getting Very High

As noted, it just isn’t domestic “sentiment” becoming extended. SentimenTrader shows that sentiment has shot up to extremes on a global basis as well. To wit:

“The stock market has mostly only gone in 1 direction since March: up. Since the various pullbacks along the way were very shallow, extremely optimistic sentiment never had a chance to properly wash out. As a result, sentiment across the world is now at sky-high levels. For example, our Smart Money/dumb Money Confidence Spread is at -0.69, one of the lowest readings ever.”

And optimism on an intermediate-term basis is at one of its highest readings of 83.

Importantly, and as we discussed on Tuesday, there is a plurality of indicators showing simultaneous outbreaks of optimism.

Buy The Rumor. Sell The News.

Jeffrey Marcus summed up our thoughts well in his Monday morning post to RIA Pro Subscribers (30-Day Risk-Free Trial)

“The recent rally has been driven by the former losers and much of this performance happened after the PFEs 11/9 announcement of very positive vaccine data. The moves since 11/9 are so dramatic that they have destroyed many statistical models.

Jon Quigley who manages $3.8 billion wrote to clients, that events that happened statistically should never happen. The occurrence statistically only happens roughly once every:

‘5,944,505,312,905,660,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 days in a normally-distributed return series, (Bloomberg 11/13/20).’

How long exactly is that? It equates to roughly

  • 1 in every 1.629 x 10^76 years, OR
  • 1.2 x 10^66 age of the universe.

Bulls Go Ballistic Reduce Risk, Technically Speaking: Bulls Go Ballistic – Time To Reduce Risk

“In a market run in part by models, machines, and day-traders, this probably should not have been a surprise. Its not a coincidence were seeing more 6 sig+ moves relative to history, Cem Karsan, founder of Aegea Capital Management LLC, tweeted, using the symbol denoting standard deviation.

These arent your fathers equity markets.

Jeff concludes with two questions.

  1. Is the current relative performance pattern sustainable?
  2. Should we now expect more fat-tail events?

His answers were simplistic:

  1. Maybe not; and,
  2. Definitely.

So You Are Saying A “Crash” Is Coming?

No, that’s not what I am saying, implying, or even remotely suggesting.

For some reason, the markets have become more bipartisan than politics – with ‘bulls’ and ‘bears’ both ‘social distancing’ as much as possible.” – Real Investment Show

When it comes to investing, being either “bullish” or “bearish” is detrimental to your long-term returns. Confining yourself into one “camp” or the other stops you from evaluating data that may run contrary to your view. In behavioral finance, such is called “confirmation bias.”

To be a successful investor long-term, you must evaluate data for what it is and make decisions even if it runs contrary to mainstream views.

The data tells us the current market advance is well ahead of itself in the short-term. Historically, when “optimism” levels get to more extreme levels, the markets have experienced short- to intermediate-term corrections at the least, and sometimes more.

It is worth repeating my concluding point from last week:

“When people take ‘a little risk’ and get rewarded for it, they are then encouraged to take ‘a little more risk.’  As my colleague Victor Adair notes, ‘People in the ‘crowd’ don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.'”

Such is currently the case. Everyone is now thoroughly convinced that markets can not go down due to the Federal Reserve interventions.

Maybe they are right? Perhaps this time is different?

Unfortunately, it usually just about the time “the crowd” becomes overly optimistic that an unexpected outcome occurs.

As Bob Farrell once quipped:

“When all experts agree, something else usually happens.” 

Valuations Vs. Momentum

My partner, Michael Lebowitz, penned an excellent piece this week on valuations and long-term returns. I highly suggest reading the entirety of the article, but here is the crucial point.

“Regardless of the economic environment, taking significant risks, and accepting pitiful expected returns is a bad idea. The average of the 10-year expected returns from the four gauges is -0.75%. When the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.”

one, You’ve Got To Ask Yourself One Question. Do You Feel Lucky?

The NYSE is the only place in the world that when the sign says ‘Everyday high prices’, everyone gets excited. If Walmart had the same sign, instead of ‘Everyday low prices’, no one would show up.” – Peter Boockvar 

Running With The Herd

As we have stated, “valuations” are a terrible “market timing” indicator. However, valuations tell you everything you need to know about future returns. It is about “sentiment” and “herd psychology” more than anything else in the very short-term.

As my colleague, Doug Kass observed on Thursday in his “Real Money Diary.”

‘Time and time again traders and investors robotically and often emotionally follow price and ignore the simple notion that higher stock prices are the enemy of the rational buyer and lower prices are the ally of the rational buyer.

Too often as stock prices rise, investors cheer and commonly ignore the consequences of buying at a high and elevated entry price. 

And, too often as stock prices drop, investors panic and commonly ignore the consequences of selling at a low and depressed exit price. 

Thanks to a changing market structure, where active investing is overwhelmed by passive investing, mentalities have changed. Such also helps explain the popularity and proliferation of exchange-traded funds, quant strategies, and products that worship at the altar of price momentum. In its essence, ‘buyers live higher and sellers live lower.’

This evolution in market structure has arguably resulted in the least informed investor base in history as machines and exchange-traded funds know nothing about price and everything about value.”

The problem is volatility has become a “wicked master.” As we saw in March, the “elevator down” can come swiftly. With investors piling into ETFs, and algorithmic quant strategies chasing momentum, markets will be more susceptible to wild future swings. When investors and robots try to “exit the theater” simultaneously, the drops will be swift with little notice.

Portfolio Positioning Update

Last Monday, just after Moderna made their vaccine announcement, I tweeted:

Our job is to adjust our allocations to capture profits and protect capital when the “risk/reward” profile becomes unbalanced. On Monday, we reduced our exposure by increasing our bond holdings last Wednesday and raising cash levels Monday. Such was the point I made Tuesday in our “3-Minutes” video.

A Catalyst For A Decline

When markets are incredibly exuberant and extended, all that is needed to spark a short-term corrective process is a “catalyst.”

Following Thanksgiving and into the first two weeks of December, mutual funds must distribute their capital gains and interest for the year. As shown below, fund managers are carrying some of the lowest cash balances on record; we could see selling pressure to make distributions. 

We Play The Probabilities

While many will read this article as being “bearish,” it isn’t. 

As portfolio managers, we manage the risk of capital loss against the potential for reward. In other words, we “we prepare for the probabilities, but leave room to adjust for the possibilities.”

No one knows with certainty what the future holds, which is why we must manage portfolio risk accordingly and be prepared to react when conditions change.

I am neither bullish nor bearish. I follow a straightforward set of rules that are the core of our portfolio management philosophy. We focus on capital preservation and long-term “risk-adjusted” returns. Importantly, no discipline is perfect. Nothing works “all the time.”

However, any discipline or strategy works better than “no strategy at all.”

Bulls Go Ballistic Reduce Risk, Technically Speaking: Bulls Go Ballistic – Time To Reduce Risk

Everyone approaches money management differently.

Such is just the way we do it.


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

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. 


Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.


Sector Model Analysis & Risk Ranges

How To Read.

  • The table compares each sector and market to the S&P 500 index on 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 table shows the price deviation above and below the weekly moving averages.


Weekly Stock Screens

Currently, there are 3-different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Aggressive Growth Strategy


Portfolio / Client Update

The past week was crazy. On Monday, Moderna announced they might have a vaccine that could be 94.5% effective, trumping Pfizer’s 90% effectiveness. That market rallied on Monday but gave it all back on Tuesday and Wednesday.

As noted last week, we finally got some “love” in our “value” stocks like CLX, CVS, CVX, and RTX. And this past week, due to more extreme extensions in these stocks, we took profits and raised cash levels by 5%. (See below)

With next week being a holiday-shortened week, the “inmates tend to run the asylum.” If we continue to see a relative increase in these value names, we will add some more incrementally. Having extra cash will give us a bit of protection against volatility. Also, as noted in the newsletter’s main body, we are about to enter the mutual fund distribution season, which could apply more pressure to stocks. We may raise more cash and hedge if our indicators turn lower.

Portfolio Changes

This past week we made the following changes to portfolios, as we noted in real-time on RIAPRO.NET.

“As noted in this past weekend’s Real Investment Report the market has gotten back to more extreme overbought, extended, and bullish levels. Historically, such a setup has led to short-term corrections, or worse.

While the vaccine news on this morning is certainly welcome, the markets have already priced much of that into stocks currently. Considering a vaccine won’t be widely available to mid- to late-next year, the economic weakness will continue to weigh on profitability for now.

As such, we are taking profits in some of our more egregiously extended positions and will use a post-Thanksgiving correction to add back to holdings at a cheaper level.”

Equity Portfolio – Taking Profits 

  • CVX from 2.5% to 1.5%
  • CMCSA from 3% to 2.5%
  • GOOG from 2.5% to 2%
  • AAPL from 3% to 2.5%
  • VZ from 3% to 2.5%
  • UNH from 2.5% to 2%
  • CVS from 2% to 1.5%
  • TLT from 15% to 12.5%

ETF Portfolio – Taking Profits

  • CVX from 2.5% to 1.5%
  • XLV from 9% to 8%
  • XLP from 6.5% to 5.5%
  • XLB from 3% to 2%
  • TLT from 15% to 12.5%

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

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 one should not rely on it 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 anRIA PRO subscriber (You get your first 30-days free), you can access our live 401k plan manager.

Compare your current 401k allocation to our recommendation for your company-specific plan and 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.

Nick Lane: The Value Seeker Report- Raytheon Technologies Corporation (NYSE: RTX)

This article is an RIA PRO exclusive for subscribers. If you are reading this article, this is a good example of the insights our subscribers read every day. Try it RISK-FREE for 30-days.

In this edition of the Value Seeker Report, we analyze an investment opportunity in Raytheon Technologies Corporation (NYSE: RTX) using fundamental and technical analysis. We currently own a 0.5% position of RTX in our Equity Model.

Overview

  • Raytheon Technologies Corporation (RTX) is an aerospace and defense company that serves customers across the world. RTX belongs to the Industrials sector and has a market cap of $108B.
  • In April 2020, the legacy companies of United Technologies and Raytheon Corporation completed a “merger of equals” to become one of the largest aerospace and defense companies in the world. Pro-forma results for the combined entity yield total revenue of $74B in 2019.
  • RTX reports revenue in four segments: Collins Aerospace (33%), Pratt & Whitney (27%), Raytheon Missiles & Defense (21%), and Raytheon Intelligence & Space (19%). Within these segments, RTX serves customers in three distinct areas of the market – Commercial, Military, and Government.
  • RTX’s stock is currently trading at $71.14 per share. Using our forecasts, we arrive at an intrinsic value of $68.34 per share. This implies a downside of 3.9% on the investment.

Pros

  • RTX expects to capitalize on substantial cost synergies from the recent merger. The company is working on almost 550 synergy projects, and management forecasts that RTX will unlock over $1B in gross run-rate cost savings.
  • In an effort to weather the pandemic and come out leading its peer group, RTX is taking actions to further cut costs and preserve cash while ensuring the health and safety of its employees. The company has announced $2B of cost initiatives and $4B of cash initiatives year-to-date.
  • Both legacy firms paid investors a healthy dividend prior to the merger. After the deal closed in April 2020, Management elected to set RTX’s dividend below that of either legacy company. However, the current dividend still provides investors with a solid yield of 2.7%.
  • A lower dividend payout lends RTX flexibility in investing for the future while navigating a global pandemic. As shown below, our forecasts indicate that RTX will produce enough free cash flow to safely cover its projected dividend and debt payments throughout the forecast period.

Cons

  • RTX has significant exposure to the commercial aerospace market through its Collins Aerospace and Pratt & Whitney segments. Even with the recent vaccine news, it will likely be a slow grind until commercial air traffic reaches pre-pandemic levels.
  • Further, COVID relief efforts have widened the fiscal deficits of several leading nations. Measures taken by governments to help shore up budgets in a post-Covid economy may result in cuts to defense spending. Thus, as commercial aerospace revenue recovers, RTX could see weakened demand from its Military and Government customers. There are also factors at play that could support defense spending despite large deficits. An important one stems from US’ rocky relationships with China and Russia.
  • On a trailing-twelve-months (TTM) basis, RTX is trading at a Price to Earnings (P/E) ratio of 14.8. This is within fairly close proximity to its 20-year historical average of 16.3, which signals the stock may be trading near fair value.  
  • Finally, in late October, RTX disclosed that it received a subpoena from the Department of Justice for information related to an investigation into the historical accounting and control procedures in its Raytheon Missiles & Defense business. Whether this will have material consequences for RTX is yet to be seen, but investors should be aware of the risk.

Key Assumptions

  • Revenue growth for 2020 is based on three quarters of results and Management’s comments in RTX’s third-quarter earnings call. Considering Management’s tone and recent developments on the vaccine front among other things, we forecast gradual recovery in revenue spanning through 2023. Revenue growth will then trend down to a modest long-term forecast by 2026. The chart below illustrates our forecasts in relation to historical revenue.
  • We forecast 2020 margins to remain flat year-over-year despite headwinds caused by the pandemic, due to aforementioned cost reduction efforts. We then forecast margins to gradually improve as RTX experiences a recovery in demand through 2023. Thereafter, margins are expected to remain steady for sometime, then shrink marginally toward the long-term level. The chart below shows how our forecasts of EBITDA evolve in comparison to historical figures.

Sensitivity Analysis

  • A brief note on why we present sensitivity analysis can be found here.
  • Our sensitivity analysis reminds us of an important consideration. The stock appears near fair value using our base assumptions, however, RTX exhibits some upside potential when using more optimistic growth and margin forecasts. If changing circumstances result in a faster than expected recovery in commercial air traffic, which is a very real possibility, the intrinsic value of RTX could be substantially higher.

Technical Snapshot

  • RTX has been in a sharp trend higher since the arrival of encouraging news surrounding two potential Covid vaccines. In fact, four of the previous five trading days have been positive for RTX. The stock is now sitting above both its 50-day and 200-day moving averages, after trading below them prior to the vaccine news.
  • At the same time, RTX is in the process of testing a substantial level of resistance near $71 per share. With the combination of these factors, RTX may be primed for a pullback in the near future.

Value Seeker Report Conclusion On RTX

  • RTX has been on a wonderful run since the encouraging news broke on the vaccine front. After a 22% gain since the beginning of November, we believe the stock is slightly overvalued. Based on our forecasts, RTX has roughly 4% of downside remaining before reaching its intrinsic value.
  • The company is certainly poised to benefit from its recent merger and cost cutting initiatives, however we believe those aspects are fully priced in to the stock.
  • While market conditions could improve for RTX, we believe there may be better places for investors to put their money to work for the time being.
Latest Report DateTickerLast Close PriceIntrinsic ValueForecast Upside Remaining*Original Conviction Rating*Current Conviction RatingCurrently Held in RIA Pro Portfolio?Notes
8/6/2020T$ 28.28$ 38.0934.7%3-Star2-StarNo 
8/13/2020XOM$ 37.40$ 55.4248.2%3-Star2-StarNo 
8/28/2020VIAC$ 33.43$ 36.709.8%4-Star2-StarNo 
9/3/2020DOX$ 64.25$ 76.7619.5%3-Star3-StarNo 
9/11/2020CVS$ 66.06$ 85.3529.2%3-Star3-StarYes 
9/18/2020PETS$ 29.47$ 41.1439.6%3-Star3-StarNo 
9/24/2020SPB$ 65.77$ 61.18-7.0%4-Star4-StarNoPrice Target Achieved
10/2/2020DKS$ 55.97$ 68.7622.9%4-Star4-StarNo 
10/9/2020WCC$ 62.82$ 61.42-2.2%4-Star4-StarNoPrice Target Achieved
10/30/2020KMI$ 14.40$ 13.98-2.9%3-Star3-StarNoPrice Target Achieved
11/6/2020FANG$ 39.44$ 36.32-7.9%3-Star3-StarNoPrice Target Achieved
11/20/2020RTX$ 71.11$ 68.34-3.9%4-Star4-StarYes 

*Our conviction rating aims to express the intensity of our feelings toward the stance taken in each report. Reports are assigned a rating from 1 to 5 stars. 

For the Value Seeker Report, we utilize RIA Advisors’ Discounted Cash Flow (DCF) valuation model to evaluate the investment merits of selected stocks. Our model is based on our forecasts of free cash flow over the next ten years.

Technical Value Scorecard Report For The Week of 11-20-20

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You can find more detail on the model and the specific tickers below the charts.

Commentary 11-20-20

  • We start with an analysis of the Absolute charts below. Despite most markets consolidating over the past week, most sectors and markets remain well overbought. The S&P 500, for instance in the lower right graph (absolute charts), is still at overbought levels last seen in late August before a nearly 10% decline.
  • Foreign Developed Markets and Value are the most extreme overbought indexes with both their scores and normalized scores (sigma) at or above 80%. Technology and Momentum are overbought but to a lesser extreme than the rest of the major indexes.
  • At a sector level, Utilities are the least overbought, while Banking is the most.
  • On a relative basis versus the S&P 500, the reflation sectors (Materials, Industrials, Banks, Energy, and Transportation) remain the most overbought. Tech and traditional lower beta conservative sectors (Staples, Utilities, Healthcare, and Realestate) are slightly oversold versus the S&P. If you are looking to fade the reflation trade, Tech and Momentum are the most oversold indexes versus the S&P.
  • Utilities were the most overbought sector a few weeks ago. At the time we reduced our exposure to the sector and recommended doing the same. It has underperformed the S&P 500 by 5.35% over the last 20 days. XLU is not grossly oversold but bears closely watching to potentially add back positions. It is the only sector or index below its 20 day moving average.
  • The scatter plot in the relative set of charts has a poor correlation (R2) for the week meaning that returns and scores are not in line. This is largely due to the energy sector which handily outperformed (>10%) what one would expect given its scores.

Graphs (Click on the graphs to expand)


Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

The first set of four graphs below are relative value-based, meaning the technical analysis score and sigma is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. Lastly, we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is just one of many tools that we use to assess our holdings and decide on potential trades. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

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
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP

#MacroView: A Vaccine And The “New New Normal”

Moderna and Pfizer recently announced they had potential vaccines for COVID-19 that are more than 90% effective. With that, the market surged, and a rotation into “economically sensitive” sectors occurred. While a “vaccine” will eventually come to the market, it will only ensure a return to the “New New Normal.”

The Old “New Normal”

Following the “Financial Crisis,” there was much discussion in the media about the “New Normal.”

The term originated cautioning economists and policy-makers’ belief industrial economies would revert to levels seen before the financial crisis. In other words, the “new normal” economy would look a lot different, and worse, after the financial crisis was over. 

Such did turn out to be the case. Economic growth struggled to maintain a 2.2% annualized growth rate, interest rates remained abnormally low, and inflation was nascent. Despite the Fed’s best efforts, productive investments or increases in the labor force participation rate failed to appear.

The chart below shows productivity increases through automation, and technology did not lead to higher employment levels relative to the population.

In the “Old-New Normal,” the shift in employment, combined with increased productivity, led to weaker income growth for the bottom 80% of the population. Such was a point we discussed recently concerning the Federal Reserve’s latest study on consumer finances. To wit:

“The real story becomes much more apparent when breaking incomes into deciles.”

Fed Top 10% Richer, Fed Study: How We Made The Top 10% Richer Than Ever.

“Interestingly, the ONLY TWO age-groups where incomes have improved since 2007 are those in the top 20% of income earners. Again, this suggests the plunge in the LFPR is not a function of “retirement.” Individuals are working well into their retirement years, not because of a desire to, but due to necessity.”

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

The Vaccine Doesn’t Solve The Problem.

Please understand me. “Vaccine news” is certainly good and very welcome. However, don’t get too excited just yet. Even if Pfizer and Moderna get through Phase-IV trials and produce a drug, most of the population will not see it for many months. As noted by the Wall Street Journal:

“However, it could be many months before any vaccine is administered to enough people to ease the need for lockdown measures that have been recently reimposed across the West. Duke Global Health Innovation Center estimates that there won’t be enough vaccines to cover the world’s population until 2024.

Of course, such also assumes you can get people to get vaccinated.

“While previous vaccination programs have spread over years and focused on specific demographics such as children or the elderly, governments are hoping to do something they never have done before and inoculate a majority of the population in a matter of months.

Even for rich nations with developed vaccination programs, that presents a host of problems including building new databases to track who is getting the shot, working out ways to encourage mass uptake among younger people, ensuring adequate supply and running large-scale inoculation centers where the shots can be safely and quickly administered.

Those challenges mean that even if a vaccine is soon approved, it could be many months before it is administered to enough people to ease the need for lockdown measures that have been recently reimposed across the West.” – WSJ

However, even if we assume we get an effective vaccine produced starting in January, AND we get everyone in the country vaccinated, it won’t change the math.

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

The New “New Normal”

Here is the problem. There is currently much hope that following the “pandemic,” the world will experience an explosion of growth. The issue is the “Old Normal,” as shown above, wasn’t all that great for the bottom 80% of the population.

The lockdowns accelerated the “work-from-home” mentality for many companies and employees. That trend will not reverse quickly, if ever.

Corporations are now seeing the benefit of reduced labor forces, less office space, and increased productivity through technology. All of these are significant “cost-savings” to the corporation’s bottom lines.

The consumer also will likely continue to do more things online. While travel will likely increase, it may be quite some time to see airlines, hotels, and rental car companies back to previous capacities. As Bloomberg noted in “Get Ready For The New Normal 2.0:”

“The U.S. economy post-Covid-19 will look a lot like the one that struggled to recover from the 2008-09 financial crisis –- only in some ways worse.

Growth will be disappointingly tepid after an initial rebound and, for a time at least, inflation dangerously lower and unemployment heartbreakingly higher than they were back then. Government debt -– and the Federal Reserve’s balance sheet -– will be much bigger, while interest rates stay low.”

The Fed’s New Mandate

The last paragraph is the most important. As we discussed previously in “The Fed Will Monetize All The Debt:”

“in 1998, the Federal Reserve “crossed the ‘Rubicon,’ whereby lowering interest rates failed to stimulate economic growth or inflation as the ‘debt burden’ detracted from it. When compared to the total debt of the economy, monetary velocity shows the problem facing the Fed.”

Fed Monetize Debt Issuance, #MacroView: The Fed Will Monetize All Of The Debt Issuance

Following the “Financial Crisis,” the massive expansion of debt, deficits, and continues Federal Reserve interventions led to collapsing monetary velocity rates and retardation of economic growth. Before 2008, the long-term growth trend of the real economy was 3.2%. That collapsed to 2.2% as debt exploded.

Bloomberg noted that the “New-New Normal” would consist of even more massive debts, deficits, and Federal Reserve monetizations, with sustained interest rates near zero. Such will see the trend of economic growth step down again to below 2%.

Even with a “vaccine,” an even slower economic growth rate has substantial consequences on employment and the wealth gap.

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

Employment Will Recover Only On Paper

Companies’ fast adoption of technology, along with increased productivity and change in demand, will further retard employment in the “New-New Normal.”

To generate economic growth and prosperity, “full-time” employment is critical. After the “Financial Crisis,” the number of “full-time” jobs relative to the population collapsed and only recovered about half of what was lost. We witnessed the same following the “dot.com” crash. It is highly likely that “full-time” employment will take another stop down as weaker demand requires fewer full-time staff.

Furthermore, participation in the labor force has dropped to levels not seen since 1973 and is a crucial measure to watch. Since the “Financial Crisis,” the participation in the “Labor Force” never significantly rose despite “record low unemployment rates.”  Such is because the labor force was shrinking sharply over the last decade as more and more participants were “no longer counted.” 

Those “Not In Labor Force” are individuals that are considered out of the labor force and no longer seeking employment. Do you believe that nearly 50% of the working-age population are no longer looking for work?

Such is the “New New Normal.” 

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

The New-New Normal

The structural transformation over this past year and the last decade has permanently changed the economy’s financial underpinnings as a whole. Such would suggest the current state of slow economic growth is the new normal. As such, interest rates will remain stuck near the zero-bound as we continue to struggle with the myriad of problems plaguing growth.

  • A low savings rate for 80% of Americans
  • 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

The lynchpin remains demographics and interest rates. As the aging population grows, they will become a net drag on “savings.” Such increases the dependency on the “social welfare net,” which will continue to expand over time.

Fed Top 10% Richer, Fed Study: How We Made The Top 10% Richer Than Ever.

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

The end game of three decades of excess is upon us, and we can’t deny the weight of the debt imbalances currently in play. The medicine the Federal Reserve is prescribing is a treatment for the common cold; in this case, a typical business cycle recession.

The outcome of those policies, while unintended, is destroying the bottom 90% of the population who suffer from “debt cancer.” Trying to solve a debt problem with more debt is akin to giving a patient “aspirin” for the pain. While such a prescription may temporarily mask the “pain,” it is not a “cure.”

If it were, then a rising percentage of Americans would not be supporting the idea of “socialism?”

But that is what we face in the “New New Normal.”

#WhatYouMissed On RIA This Week: 11-20-20

What You Missed On RIA This Week Ending 11-20-20

It’s been a long week. You probably didn’t have time to read all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. If you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed.


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What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.



What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.



What You Missed: RIA Pro On Investing

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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.” Each week, we cover the topics that mean the most to you from investing to markets to your money.

Best Clips Of The Week Ending 11-20-20


What You Missed: Video Of The Week

An encore presentation of my MoneyShow discussion on Thursday morning about “How to invest in a market that is detached from the economy.”



Our Best Tweets For The Week: 11-20-20

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

Follow us on twitter @lanceroberts and @michaellebowitz.

See you next week!

Markowski: Premature Vaccine Rally To Soon Fizzle!

The Premature Vaccine Rally To Soon Fizzle

The stock market rally after Pfizer announced that its Coronavirus vaccine was 90% effective was premature since the vaccine:

  • Now in stage 3, clinical trials have been fast-tracked by the FDA for emergency use ONLY
  • Must finish Stage 3 and also stage 4 clinical trials before being approved for masses
  • Not scalable since it requires storage at -70 degrees Celsius (-97 F)

Probability is high for the vaccine driven rally to fizzle with Dow Jones 30 Industrials & S&P 500 composites reverting to their October 30th lows and declines of approximately 10% by the end of 2020 for three reasons:

1 – Surges of the following to new highs for the week ended November 15, 2020:

  • S&P 500 to a recent6 all-time closing high.
  • AAII (American Association of Individual Investors) Investor Bull Ratio Sentiment Survey from prior week’s 37.96% bullish to 55.84%, a three-year high. The chart below depicts that from January of 2018 through November 13, 2020, four spikes in investor sentiment were above 45% bullish, and two of the four were above 55%.  

The chart below overlays the S&P 500’s all-time highs since January 2018, which occurred either slightly before or after the four bullish sentiment spikes. The occurrences of both sentiment spikes and all-time highs for the S&P 500 resulted in sharp corrections ranging from 11% to 35%.

2. Smart Money Is Selling Stocks.

Excerpt and chart below from “The Smart Money Is Leaving Town” by CFA Mike Lebowitz, published by RIA Pro on 11/12/20.  

“Bloomberg’s Smart Money Flow Index is a measure of how ‘smart money’ is positioning itself in the S&P 500. The logic behind the index is that smart investors tend to trade near the end of the day, while more emotional-based traders dominate activity in the first 30 minutes of the trading day. The index is calculated as follows: yesterday index level – the opening gain or loss + change in the last hour.  As shown below, the Smart Index and the S&P were well correlated until late August. Since then, as highlighted by the red arrow, they have diverged sharply. Over the last ten years, the S&P 500 and the Smart Index have a strong correlation of .65. As such, we expect they will converge in time. The light blue circle shows they also diverged, albeit to a much lesser extent, in January and February as the smart money correctly sensed problems.”

3. Sharp decline in University of Michigan’s November 2020 readings for two Consumer confidence surveys.

After reaching its highest level since March of 2018, in February 2020, the reading declined to its lowest level since 2011.  Since July of 2020, the reading had climbed for four consecutive months.

Sentiment Readings

The chart below depicts the sentiment readings for a University of Michigan niche survey of participants from the Republican and Democratic parties.  The decline in the sentiment of Republicans from over 120 to 70 provides further rationale for a market correction to be swift and severe.  The plummeting consumer confidence readings for the members of the Republican Party, long known as the party for the wealthy, spells disaster for the stock market and the US economy.   The sharp decline in Republican sentiment increases the probability that they will become sellers of stocks. According to the Bureau of Labor Statistics, the wealthiest 20% of Americans are responsible for approximately 40% of consumer spending.

The two surveys are critically crucial since there is a correlation of Consumer confidence to consumer spending, which accounts for 70% of US GDP.   The chart below depicts the tight correlation between the University of Michigan’s consumer confidence and consumer spending from 2003 to 2019.

History Of Secular Markets

After the correction occurs, the Dow Jones 30 index will likely stage a secular bear market rally before it heads to new lows in 2021.  The fourth secular since 1929 began after the aggregate valuation of the Dow Jones 30 Industrials composite members reached a ratio of 132% to US GDP in February 2020.  The two prior secular bears began after the Dow’s ratio peaked at 116% and 123% of US GDP.

The chart below depicts the Dow to GDP ratios at the secular bear market bottoms.

The chart below depicts the durations and percentage declines for the past three secular bears.


Michael Markowski has worked 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, he has worked 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.

Seth Levine: How I Process Ideas Into Investments

How I Process Ideas Into Investments

Investing is incredibly hard. Mapping observations to security price movements are complex. Often, the relationships governing these moves are unknown. Yet, this is the investor’s task. I’ve used this blog as a tool for exploring some of these connections. It’s been incredibly rewarding. Not only has writing brought many of my wrong ideas to light, but it refined my process for constructing an investment portfolio. I now have an improved method for mapping themes to actual concrete positions, which I’ll illustrate here.

I’ve explored a broad spectrum of investment ideas over the years. I’ll admit, the applications aren’t always apparent. Take postmodernism’s influence in the markets. For example, what’s the trade there? How does discussing that central banks don’t create money or that inflation is misplaced in a fiat currency regime improve my returns? Oddly enough, they have. Working through these kinds of topics helped me build an investment framework and a process for incorporating them into my portfolio.

Disclaimer

Of course, I must start with a disclaimer. The following is not investment advice. It’s merely an illustration of how I might utilize various investment themes in my investment process. These are just my personal opinions and should not be construed as investment advice or recommendations to purchase or sell any investment, product, or service; nor should this content be relied upon for making investment decisions. You all know the drill.

The Process

I take our core tenets seriously. Reason, Reality, and Investing. I firmly believe that what is should dictate how I ought to invest. Such sounds simple, but I find it anything but simple. First, it’s nearly impossible to determine what something in its entirety. Investment markets are complex systems with many degrees of freedom. Realistically, I can only place things on a spectrum of certainty. But that’s OK. I can account for this.

Secondly, it’s hard to identify potential investment themes, let alone express them in market terms. Yet, this is the essence of investing. Real-world events almost always impact capital flows, and when they are, there’s money to be made (and lost).

Finally, we must actively monitor each position once initiated. Such is arguably the most challenging part of investing. Sizing and managing positions may be the most significant return determinants.

Ultimately, there are countless ways to invest. The trick is finding something that works for you. Here’s how I’m starting to implement a process I developed through writing this blog. Please note that what you read is a work in progress. Strong views held loosely.

The steps of my process are:

  • Identifying themes
  • Understanding the effects
  • Identifying expressions
  • Identifying trade types
  • Determining conviction and sizing
  • Determining timeframes

Identifying Themes

I write a lot about potential investment themes. These are the significant, real-world events that (may) underpin market moves. Investment themes are distinct from trades. For one thing, they are not investible by themselves. Instead, we must break down themes into specific investments. They are merely starting points. However, a single theme may spawn many trades and persist for long periods. Themes may even overlap with other themes.

For example, one theme that fascinates me is the growth in passive investing. There are lots of potential market implications. Inflows into passive investing strategies have been growing for decades. While first an equity phenomenon, passive is now taking share from active managers in fixed income, commodities, derivatives, and even for retirement planning, to name a few. The impacts are potentially enormous, affecting the supply and demand for individual securities, relative style performance, and even the investment management business itself! As exciting as this be, you can’t trade “growth in passive investing” directly.

Identifying Effects

Once I identify a theme, I try to tease out its effects in investment markets—if any. Like themes, effects are also not directly actionable. There’s still more work to be done, but I’m getting closer to the prize.

My passive investing theme above likely has many effects. First, the proliferation of passive investing also diminishes market diversity. Such is especially true if assets under management (AUM) concentrate on a few massive players. As market diversity decreases, I’d expect fragility to increase. Such should manifest as infrequent but severe bouts of volatility amid an otherwise overly-tranquil environment.

Another effect may be that momentum strategies outperform value. The latter tends to play more prominently in active managers’ portfolios. As investors shift their assets to passive strategies, redemptions force active managers to sell. Such might cause their preferred strategies (i.e., value) to underperform since popular market capitalization-weighted passive strategies have implicit momentums components.

Like “growth in passive,” these effects need to be broken down into actual investments.

Identifying Expressions

After identifying the effect of a theme, I need to figure out how to express it in investment terms. Such sounds easier than it always is. It is also where the artistry of the investment masters is in full display.

Sometimes I can’t express my views as trades. When I can, I try to find assets that most capture the upside and limit the potential downside. In other words, I need to determine what to own, how to do, and when. I think of these in terms of collateral, leverage, and volatility. See here for an explanation of how I use these concepts.

There can be many ways to express an investment theme. Not all, though, may make great investments. Take a desired long position in gold, for example. I can buy jewelry, physical coins, bars, an ETF, futures contracts, options, gold miners, etc. My choice (and return) depends on my desired exposures to collateral, leverage, and volatility.

Identifying Trade Types

The way I see things, there are only two types of possible trades: speculating that a trend will persist or that a trend will reverse. It matters not how one makes this determination: valuation, technical analysis, or quantitative signals. Ultimately, I only care about an asset’s price, and its price can only move in two directions—up or down—or not at all.

Rightly or wrongly so, I transpose these into the investment factor nomenclature of momentum and value. I think of momentum trades as those that will continue with their current trends and value trades as those that will begin to work. In my view, both have roles to play in a portfolio. Empirical research supports this thesis.

I categorize each portfolio position as either momentum or value trade. Such provides a clearer understanding of how I’d expect them to behave. It also facilitates me having both types of investments in my portfolio. They need not all be value plays, for example.

I can express my passive investment theme in terms of both momentum and value. A momentum trade could be to buy an S&P 500 index ETF (S&P 500 ETF). Persistent inflows into S&P 500 ETF could create more buying demand such that its price continues to rise irrespective of the fundamental performance of the underlying companies. One potential value-trade is a long volatility exposure. If severe bouts of volatility sporadically interrupt an overly tranquil investment landscape, volatility will periodically spike (i.e., break the low volatility trend). Being long volatility at such times would likely be profitable (and infrequent). Perhaps I could buy a well-designed volatility EFT or (more likely) invest in a fund that specializes in long volatility strategies.

Conviction, Sizing, and Timeframes: A.K.A. Position Size

Last, in my process, come the most important elements; those that relate to trade management. Though, these all boil down to position size. In the past, a conviction was a real hurdle for me. I wouldn’t invest unless I was fully convinced. I also sized every position equally and never changed them. These were mistakes that cost me plenty over the years.

I now see all investments as matters of position size. The greater my conviction, the bigger I size my trades. I also manage this size according to how events unfold. I’ll add to winning trades and reduce my losers to manage the risk of being wrong. I’m also assigning timeframes to each position to help eliminate thesis creep. If a transaction hasn’t played out over my expected time horizon, I try to reevaluate it.

Putting it All Together

Below are a couple of examples of how I might put this process to work. I start with my theme—in this case, the growth of passive investing. Then, I continue to break down its effects until I can express it in terms of individual securities. Last, I gauge my conviction, size my position, and assign an approximate timeframe. Not only do I find this a useful exercise for idea generation, but it also gives me documentation to review later in the trade.

This illustration contains the two investment ideas previously discussed. One was purchasing the S&P 500 ETF on the premise of momentum. Such is a high conviction trade and thus should be sized accordingly (not shown in the example). The value play—investing in a long volatility fund—has not yet been initiated due to unfavorable market conditions. Note that the logical chain from theme to timeframe is all here, allowing for later analysis.

A Process for My Framework

Abstract investment themes are much more than entertainment. They’re serious business and have roles to play in portfolios. After all, what “is” occurring in the world “ought” to influence how we invest our capital. However, this process is not always exact.

I’ve walked the reader through my method for transposing my views of the world into investment terms. To be sure, “there’s more than one way to skin a cat.” My process remains a work in progress. However, rudimentary it currently stands, I find it useful for applying reason to my best understanding of reality when it comes to investing.

You’ve Got To Ask Yourself One Question. Do You Feel Lucky?

You’ve got to ask yourself one question. Do you feel lucky?

On November 9, 2020, Pfizer announced encouraging test results pointing to an effective COVID vaccine. In response, investors aggressively bought the stocks most negatively affected by COVID and sold those stocks that had benefited. For example, Netflix was down 8.6% while Disney was up 12%. Banking, industrials, materials, transportation, and energy stocks did well while technology and communications fell sharply. The divergence of winners and losers was one for the ages.

To wit, in our latest Technically Speaking we shared the following:

“The recent rally has been driven by the former losers and much of this performance happened after the PFEs 11/9 announcement of very positive vaccine data. The moves since 11/9 are so dramatic that they have destroyed many statistical models.

Jon Quigley who manages $3.8 billion wrote to clients, that events that happened statistically should never happen. The occurrence statistically only happens roughly once every:

‘5,944,505,312,905,660,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 days in a normally-distributed return series, (Bloomberg 11/13/20).”

The prospects of a vaccine and return to normalcy are exciting, but we do not share investor enthusiasm for stock prices. For starters, already tepid economic growth rates pre COVID will be weaker during the next expansion. Within that context, equity valuations do not reflect weak economic and earnings growth rates and appear far too high.

This article will address both issues and provide a clear road map free of unwarranted enthusiasm.

Future Growth

We start by looking backward so we can look forwards. The Decade Long Path Ahead To Recovery Part 1 shows how the growth rate in each of the last three economic expansions was lower than the one before it.

As we wrote: “The new paradigm of weak recoveries is due to the Fed’s policy prescription for recessions; debt-fueled consumption. Through lower interest rates they incentivize people, corporations, and the government to borrow. The benefits are here and now as economic recovery ensues. The cost is paid tomorrow.”

In simpler terms, during each recession, we pull consumption forward from the future and accumulate debt in its place. Accordingly, future economic growth is weaker.

In the same article, we show what that looks like over the last 40 years.

Had we grown our economy at the rate of the 1980s, GDP would be over 50% higher than it is today.

There is no doubt that massive amounts of new federal, municipal, and corporate debt used to weather the COVID storm will have the same economic dampening effect as it has had. Based solely on the strong relationship between the ratio of government debt to GDP, we estimate that the coming expansion’s real growth rate could be as low as 1.07%.

Corporate Earnings

Stock valuations are generally based on a multiple of expected future earnings. Expected future earnings are determined by future economic activity. If economic growth is slower in the future, then logically, corporate profits will follow. As shown below, corporate profits and economic growth are well correlated.

Thus far, we have established that economic growth is likely to be lower than it was in the past decade. Therefore we can also assume that corporate profit growth will also be weaker than in the past decade.

Current Valuations

The economic prognosis and earnings outlook may appear to be bad for stocks. While useful data, what matters most is price. At the right price, everything has value regardless of its outlook. Accordingly, an assessment of valuations offers essential insight about whether or not share prices compensate investors for a weaker economic environment.

The scatter charts below illustrate various valuation techniques. Within the graphs, each dot represents quarterly comparisons of the valuation metric and the subsequent ten year annualized total return of the S&P 500. The trend line slicing through the data helps us approximate how returns stack up against the various valuation levels. We use standard deviations of each valuation versus actual readings to graph them together and individually. The vertical line shows the current standard deviation. The intersection of the trend and standard deviation line, as circled, highlights the expected annual return.

In all of the graphs except price to sales, the data covers the period from 1954 to the present. Price to sales data starts in 1965.

Market Cap to GDP

Market Cap to GDP, supposedly one of Warren Buffett’s favorites, compares the stock market’s size relative to the economy. Given the strong correlation of corporate earnings to GDP, this ratio has a lot of validity.

Currently, the ratio is near 1.50, or more than twice the historical average. The only other time it was this high was in the first quarter of 2000, as the tech bubble was bursting. As shown, the expected annualized return for the next ten years is 0%. 

Tobin’s Q Ratio

Tobin’s Q ratio measures the relationship between the total equity market cap and its aggregate intrinsic value. Intrinsic value is simply the replacement cost of a company or market’s assets. The ratio quantifies if a market or a stock is over or undervalued.

Currently, the ratio is near 1.80, or more than two and a half times the historical average. Similar to the ratio of market cap to GDP, the only other period Tobin’s Q ratio was this high was during the 2000 tech bubble.  The expected annualized return for the next ten years is 1%. 

Cyclically Adjusted Price-to-Earnings Ratio (CAPE 10)

CAPE 10 uses Nobel Laureate economist Robert Shiller’s methodology to generate secular price to earnings ratios. The model averages ten years’ of historical earnings versus more commonly used one year periods. This tweak provides a more stable measure that is not as subject to temporary economic and earnings gyrations.

Currently, the ratio is 33, or about 75% higher than the historical average. Like the prior two indicators, the only other period it was higher was in the late 1990s.  The expected annualized return for the next ten years is +2.5%. 

Price to Sales

The price to sales ratio is the multiple investors are willing to pay for revenues. CAPE 10 and traditional one-year price-to-earnings ratios use earnings per share in the denominator. Share buybacks and accounting gimmickry artificially boost earnings per share. Revenues, on the other hand, are much harder to manipulate.

Currently, the ratio is 2.59, or about 300% more than the historical average. Unlike the prior periods, the market has never seen anything close to current levels. The expected annualized return for the next ten years is -6.5%. 

Summary of Four Factors

The Fed

Regardless of the economic environment, taking significant risks and accepting pitiful expected returns is a bad idea. However, there is one more factor we must consider. The Federal Reserve supplies a massive amount of liquidity, much of which is finding its way into the asset markets.

The Fed will likely continue as long as inflation is held at bay. The result may be that stock prices continue to rise, and valuations eclipse all prior norms. However, the music will stop someday, and the facts presented here will be apparent.

Summary

In the movie Dirty Harry, Clint Eastwood famously said, You’ve got to ask yourself one question. Do I feel lucky?” 

If so, the trend is your friend. The Fed will continue to supply liquidity, which will help the market ignore the reality of the barometers shown above. As we saw in March, that does not preclude hair-raising volatility and large declines, but it does support prices on the margin regardless of the environment.

The average of the 10-year expected returns from the four gauges is -0.75%. When the Fed backs off, whether by its design or due to inflation, slower economic growth, or massive debt overhead, rich valuations will matter.

At that point, investors who feel lucky are likely to find themselves staring down Mr. Market’s version of a .44 Magnum.

fundamentals, The Death Of Fundamentals & The Future Of Low Returns

Viking Analytics: Weekly Gamma Band Update 11/17/2020

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update 11/17/20

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model has similar returns to a long-only position in SPX, albeit with much lower risk exposure.   The Gamma Band model has resulted in a 74% improvement in risk-adjusted return since 2007 measured by the Sharpe Ratio. 
  • The Gamma Band model has maintained a 100% exposure to the S&P 500 since the last update. The value of SPX has been trading near or above the upper Gamma Band for over a week, and this does not reduce exposure in our model.  
  • Our binary Smart Money Indicator continues to have a full allocation, and this is discussed in greater detail below.
  • SPX skew, which measures the relative cost of puts to calls, shows that risk appetite is increasing. Put buyers are no longer paying a large premium compared to call buyers.
  • We publish several signals each day, ranging from a fast signal in ThorShield to a less active signal (as represented by the Gamma Bands and published in the daily SPX report).  Samples of our SPX and ThorShield daily reports can be downloaded from our website.

Smart Money Residual Index

This indicator compares “smart money” options buying to “hot money” options buying.  Generally, smart money will purchase options to insure stable returns over a longer term.  Smart money has in-depth knowledge and data in support of their options activity. In contrast, “Hot money” acts based on speculation, seeking a large payoff.

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position during this time.  When the smart money turns more cautious than hot money, the Residual Sentiment Index in the second graph turns to red, then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

In evaluating equity market risk, we also consider the cost of buying puts versus the cost of buying calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this might be a signal to reduce equity exposure. 

Ahead of an important U.S. presidential election, the put buyers are paying a meaningful premium for the protection. 

Gamma Band Background

Market participants are increasingly aware of how the options markets can affect the equity markets in a way that can be viewed as the “tail wagging the dog.” 

We created a Gamma Band indicator to demonstrate the effectiveness of the Gamma Neutral level in reducing equity tail risk.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 74% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal if one’s goal is to increase risk-adjusted returns.  We also publish a faster, daily signal in a portfolio model which we call Thor’s Shield.  Thor Shield has a 20-year Sharpe of 1.5 and a rolling 1-year Sharpe of over 3.4.  Free samples of our daily SPX report and Thor’s Shield model can be downloaded from our website.

Authors

Viking Analytics is a quantitative research firm that creates tools to navigate complex markets.  If you would like to learn more, please visit our website, or download a complimentary report.

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


Sector Buy/Sell Review: 11-17-20

HOW TO READ THE SECTOR BUY/SELL REVIEW: 11-17-20

Each week we produce a “Sector Buy/Sell Review” chartbook of the S&P 500 sectors to review where the money is flowing within the market as a whole. Such helps refine decision-making about what to own and when. It also guides what sectors to overweight or underweight to achieve better performance.

You can also view sector momentum and relative strength daily here.

There are three primary components to each chart below:

  • The price chart is in orange.
  • Over Bought/Over Sold indicator is in gray in the background.
  • 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 tend to work better than when below the zero lines.

SECTOR BUY/SELL REVIEW: 11-17-20

NOTE: Last Monday, I wrote: “Yesterday’s surge in the market from the announcement of a “vaccine’ led to a very bifurcated advance. As shown in the sector charts below, some sectors are egregiously overbought.” Interestingly, it was the same again yesterday with another “vaccine” announcement.

The rotation to “value” is way ahead of itself. We began taking profits yesterday to reduce risk in areas that are now pushing 4-standard deviations above their 50-dma.

Basic Materials

  • XLB blew through the double-top resistance and is now 4-standard deviations above the moving average. 
  • Such will lead to a correction short-term, so take profits and rebalance. 
  • Keep stops on trading positions at the 50-dma, which is now critical support. 
  • Short-Term Positioning: Bullish
    • Last Week: Hold Positions
    • This Week: Take Profits. We reduced XLB by 1%.
    • Stop-Loss moved up to $62
  • Long-Term Positioning: Bullish

Communications

  • Communications rallied into 3-standard deviation territory and are now very overbought.
  • XLC underperformed the market yesterday, and since it is a large sector in portfolios, it led to a performance drag.
  • Take profits as needed.
  • Stops remain at $58.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
  • Long-Term Positioning: Bullish

Energy

  • Energy rallied sharply on Monday as a “vaccine” would allow people to return to work and consume more energy. 
  • XLE finally broke above the 50-dma and is testing major resistance at the 200-dma. 
  • XLE is also now pushing well into 3-standard deviations from the 50-dma. Take profits accordingly. 
  • The previous suggestion for Traders to add positions with a stop at $27.50 and a target of $34 has been fulfilled. Take profits and wait for a correction. 
  • Short-Term Positioning: Bearish
    • Last week: Hold positions
    • This week: Took profits in CVX and reduced weight.
  • Stop-loss set at $27.50
  • Long-Term Positioning: Bearish

Financials

  • Financials found some life as yields soared on expectations that inflation would return with a “vaccine.” I wouldn’t count on it since we haven’t had inflation in a decade.
  • XLF is 4-standard deviations above its mean. Take profits and rebalance risks. 
  • The last time XLF was this extended; there was a sizable correction.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Industrials

  • Like XLB, XLI is also 4-standard deviations above the mean.
  • Take profits and rebalance risks.
  • Short-Term Positioning: Bullish
    • Last week: No change.
    • This week: No change.
  • Long-Term Positioning: Bullish

Technology

  • Technology stocks and the Nasdaq underperformed on Monday but did much better than last Monday’s “vaccine” announcement.
  • The sector is not extremely overbought and will likely catch a rotation trade here soon. 
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions
  • Stop-loss moved up to $110
  • Long-Term Positioning: Bullish

Staples

  • XLP is well into a 3-standard deviation extension. 
  • Take profits and rebalance risks and look for a correction to add back to holdings.
  • The sector remains in a bullish trend, and the declines in some of the major staples are likely an entry opportunity.
  • Longer-term investors should continue to use any rally to rebalance holdings and tighten up stop-losses.
  • We are moving our stop-loss alert to $62 as our stop-level.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Reduced XLP by 1%.
  • Long-Term Positioning: Bullish

Real Estate

  • On Monday, Real Estate rallied sharply. Again as money was chasing yields.
  • XLRE held a double bottom and broke above the 50-dma. Now, the sector is once again pushing into 3-standard deviation territory and is overbought.
  • Use pullbacks that hold the 50-dma to add exposure. 
  • Keep stop-losses the series of bottoms at $34.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions.
  • Long-Term Positioning: Bullish

Utilities

  • XLU remains well extended in the overbought territory after breaking above the 200-dma.
  • The rally on Monday also doesn’t make much sense as Utilities are sensitive to higher rates. However, with the yield chase in play, such suggests a bid is still there. 
  • Take profits and rebalance risk. 
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold reduced positions
  • Long-Term Positioning: Bullish

Health Care

  • Despite the news from MNRA, Healthcare stocks lagged on Monday. With XLV now 3-standard deviations above the mean, we took profits. 
  • The sector is short-term overbought, so rebalance risks accordingly. 
  • The 200-dma is now essential price support for XLV.
  • We are moving our absolute stop to $100
  • Short-Term Positioning: Bullish
    • Last week: Hold positions.
    • This week: Reduced XLV by 1%.
  • Long-Term Positioning: Bullish

Discretionary

  • On Monday, discretionary stocks staged a nice advance as we head into the retail shopping season. 
  • We previously suggested traders add to holdings in AMZN. That remains this week. 
  • Stop-loss remains at $140
  • Short-Term Positioning: Bullish
    • Last week: No changes.
    • This week: No changes.
  • Long-Term Positioning: Bullish

Transportation

  • The rally on Monday pushed XTN into a 4-standard deviation territory. 
  • The “buy signal” remains extended and the overbought condition back to extremes.  
  • Take profits in the sector and rebalance risks accordingly. 
  • Maintain an absolutely stop-loss at $56
  • Short-Term Positioning: Neutral
    • Last week: No change
    • This week: No change
  • Long-Term Positioning: Neutral

Technically Speaking: Bulls Go Ballistic – Time To Reduce Risk

In this past weekend’s newsletter, we discussed the exceedingly deviated price and overbought conditions. When we combine the technical backdrop with the “bulls going ballistic,” it once again makes sense to reduce risk in our portfolios.

“The rally from the October lows was a ‘sellable rally.’ The current rally is as well. Given the more overbought condition, we expect a one to two-week correction at the beginning of December as mutual funds make their annual distributions.

While it is feasible, the markets will end the year positively; we will likely see a better entry point first. 

These more extreme overbought, extended conditions rarely last long. We reduced our risk exposure in our portfolios yesterday morning via RIAPro.net:

“The market has gotten back to more extreme overbought, extended and bullish levels. Historically, such a setup has led to short-term corrections, or worse.

While the vaccine news this morning is certainly welcome, the markets have already priced much of that into stocks currently. Considering a vaccine won’t be widely available to mid-to late-next year, the economic weakness will continue to weigh on profitability for now.

As such, we are taking profits in some of our more egregiously extended positions and will use a post-Thanksgiving correction to add back to holdings at a cheaper level.”

Risk Begets Risk

Not surprisingly, I received more than a few emails chastising me for “bailing on the bull market, which is going higher.” 

Such is hardly the case. We reduced our weighting in some of the companies which have had substantial gains over the last year. We remain primarily long-biased in our portfolios, but given the extreme technical overbought and deviated conditions; it was prudent to raise some cash and protect our gains.

Interestingly, such was also a point made in this past weekend’s newsletter:

When people believe that they need to take ‘a little more risk’ to generate greater returns, they may be making a very BIG mistake if they underestimate what ‘risk’ really means to them.”

As we noted in Moral Hazard,” the Federal Reserve believes that insuring people against investment losses is a dangerous one. While investors are encouraged to take more risk currently, as prices rise, they begin to disregard risk for what it is.

When people take “a little risk” and get rewarded for it, they are then encouraged to take “a little more risk.”

People in the ‘crowd’ don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.”

Bullish Outbreaks

However, it wasn’t just the conditions we discussed, which have us concerned about the markets in the short term. Investor positioning has also reached rather extreme levels. As Bob Farrell once wrote:

“Investors buy the most at the top, and the least at the bottom.”

Following the election, investors aggressively added to their equities. The last time we saw this type of surge was in December of 2017, followed by a near 20% decline just two months later.

Our composite “fear/greed” indicator, which primarily comprises investor positioning, shows much of the same as “bullish sentiment” pushes back to extremes.

Most notably was the AAII bullish sentiment, which has remained suppressed since March. All of a sudden, they decided it was time to get bullish again. As noted:

The percentage of bulls in the American Association of Individual Investors (AAII) survey rose to 55.8% while bears dropped to 24.9%, pushing the Bull Ratio, a more accurate measure of optimism, above 69%. The last 2 times it got this high, stocks ended up running into trouble eventually.” – SentimenTrader

Market Vaccine Cases, Market Breaks Out On Vaccine Hopes As Cases Surge 11-13-20

Technical Extremes

Every week, we provide RIAPRO subscribers (Try Free for 30-Days) with the latest updated technical composite score. This hybrid gauge combines extension, deviation, and momentum into a single weekly measure. Readings above 85 (Currently 87.39) are always associated with short-term corrective actions in the market.

Our risk/reward range table is also sending an important warning. With deviations from the long-term weekly moving averages at extremes and prices well outside of regular monthly price changes, short-term corrections have been nearby.

With all of these conditions aligned, the “probability” of a short-term correction has increased. Given that risk outweighs reward in the short-term, we decided it was prudent to reduce that equation’s numerator.

It May Be Time To Be Contrarian

While reducing risk currently may seem a bit premature, some other signs suggest that markets are well ahead of themselves. “Insider selling” has reached more important extremes and typically coincides with short-term market corrections.

Also, as Michael Lebowitz pointed out in the newsletter:

Bloomberg’s Smart Money Flow Index is a measure of how ‘smart money’ is positioning itself in the S&P 500. The logic behind the index is that smart investors tend to trade near the end of the day, while more emotional-based traders dominate activity in the first 30 minutes of the trading day. The index is calculated as follows: yesterday index level – the opening gain or loss + change in the last hour.

As shown below, the Smart Index and the S&P were well correlated until late August. Since then, as highlighted by the red arrow, they have diverged sharply. Over the last ten years, the S&P 500 and the Smart Index have a strong correlation of .65. As such, we expect they will converge in time. The light blue circle shows they also diverged, albeit to a much lesser extent, in January and February as the smart money correctly sensed problems.”

Market Vaccine Cases, Market Breaks Out On Vaccine Hopes As Cases Surge 11-13-20

By reducing risk now, it provides us three benefits for the future.

  1. Less equity risk, and higher cash levels, lower the portfolio’s volatility, which will allow us to navigate a correction process and protect our investment capital.
  2. It gives us capital to reinvest back into positions we currently own at better prices; or,
  3. Buy new positions which have corrected in price.

While it is entirely true that “you can not time the market,” you can manage the risk of capital loss.

Buy The Rumor. Sell The News.

Jeffrey Marcus summed up our thoughts well in his Monday morning post to TPA Subscribers.

“The recent rally has been driven by the former losers and much of this performance happened after the PFEs 11/9 announcement of very positive vaccine data. The moves since 11/9 are so dramatic that they have destroyed many statistical models.

Jon Quigley who manages $3.8 billion wrote to clients, that events that happened statistically should never happen. The occurrence statistically only happens roughly once every:

‘5,944,505,312,905,660,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 days in a normally-distributed return series, (Bloomberg 11/13/20).’

How long exactly is that? It equates to roughly

  • 1 in every 1.629 x 10^76 years, OR
  • 1.2 x 10^66 age of the universe.

“In a market run in part by models, machines, and day-traders, this probably should not have been a surprise. Its not a coincidence were seeing more 6 sig+ moves relative to history, Cem Karsan, founder of Aegea Capital Management LLC, tweeted, using the symbol denoting standard deviation.

These arent your fathers equity markets.

Jeff concludes with two questions.

  1. Is the current relative performance pattern sustainable?
  2. Should we now expect more fat-tail events?

His answers were simplistic:

  1. Maybe not; and,
  2. Definitely.

We Play The Probabilities

The probability is that we will see another 5-10% correction in the not too distant future. Such was the same call we made in February, August, and early October.

While many will read this article as being “bearish,” it isn’t. 

As portfolio managers, we manage the risk of capital loss against the potential for reward. In other words, we “we prepare for the probabilities, but leave room to adjust for the possibilities.”

No one knows with certainty what the future holds, which is why we must manage portfolio risk accordingly and be prepared to react when conditions change.

While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am neither bullish nor bearish. I follow a straightforward set of rules that are the core of my portfolio management philosophy, focusing on capital preservation and long-term “risk-adjusted” returns.

The current market advance has pushed back to more extreme bullish positioning. How long it can last is anyone’s guess. However, remember that markets ebb and flow around long-term moving averages. When markets rise too far above them, “gravity” tends to take over.

Everyone approaches money management differently.

Such is just the way we do it.

Buffett Indicator: Why Investors Are Walking Into A Trap

“The stock market is not the economy.” Such has been the “Siren’s Song” of investors over the last couple of years as valuation expansion has been the sole driver of the market’s performance. However, given that corporations derive their revenue from economic activity, the “Buffett Indicator” suggests investors may be walking into a trap.

Read Part 1 For More On This Chart

Understanding The Buffett Indicator

Many investors are quick to dismiss any measure of “valuation.” The reasoning is if there is not an immediate correlation, the indicator is wrong. As I discussed previously in “Shiller’s CAPE – Is It Just B.S.”

The problem is that valuation models are not, and were never meant to be, ‘market timing indicators.’  The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level it means that:

  1. The market is about to crash, and;
  2. Investors should be in 100% cash.

Such is incorrect. Valuation measures are simply just that – a measure of current valuation. More, importantly, when valuations are excessive, it is a better measure of ‘investor psychology’ and a manifestation of the ‘greater fool theory.'”

What valuations do provide is a reasonable estimate of long-term investment returns. It is logical that if you overpay for a stream of future cash flows today, your future return will be low.

“Price is what you pay. Value is what you get.” – Warren Buffett

Such is what the Buffett Indicator tells us as it measures “Market Capitalization” to “GDP.” To understand the relative importance of the measure, we must understand the economic cycle.

The premise is that in an economy driven roughly 70% by consumption, individuals must produce to have a paycheck to consume. That consumption is where corporations derive their revenues and ultimately profits from. If something occurs, which leads to less production, the entire cycle reverses leading to an economic contraction.

The Historical Relationship

The example is simplistic, as many factors impact both the economy and markets short-term. However, there is a strong historical correlation between the market and the economy.

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. Such is particularly the case given the significant role spending has in the GDP equation. The chart shows the correlation between the two.

Given the historical data, the current “negative correlation” is quite an anomaly. 

The Fed Impact

The break in the historical correlation has nothing to do with a change to market fundamentals. Instead, it is the Federal Reserve’s massive monetary interventions.

As Societe Generale recently noted, the distortion of market pricing from the economy is quite astronomical.

“Using the bank’s equity risk premium framework on the impact of QE…understand how the different US equity indices have been impacted since 2009. There is a huge dispersion among the equity indices under review. The Nasdaq 100 has been the most impacted, even more so this year. The S&P. 600 Small Caps, which has been the least impacted. As of Oct-2020, the Nasdaq 100 price level was 57% explained by QE.

Without QE the Nasdaq 100 should be closer to 5,000 than 11,000, while the S&P 500 should be closer to 1,800 rather than 3,300.”

The distortion of the financial markets by the Federal Reserve has created an illusion that the economy is doing exceedingly well when it reality it isn’t.

The Buffett Indicator

With this background, we now have a better understanding of what the “Buffett Indicator” represents as it measures Market Capitalization” to “Gross Domestic Product.” 

The indicator shows us that when “disconnects” between market participants and the underlying economy occur, a reversion ensues.

The correlation is more evident when looking at the market versus the ratio of corporate profits to GDP. With a 90% correlation, investors should not dismiss these deviations.

There is additional confirmation with an 84% correlation between the S&P 500 and corporate profits growth.

Since corporate profits are a function of economic growth, the correlation is not unexpected. Hence, neither should the impending reversion in both series.

The current detachment would not exist without the Fed’s largesse.

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. 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

Valuations & Forward Returns

I previously quoted Cliff Asness on this issue in particular:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”

We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Asness continues:

“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”

And since we are discussing Mr. Buffett, let me remind you one of Warren’s more insightful quotes:

“Price is what you pay, value is what you get.” 

The “Buffett Indicator” confirms Mr. Asness’ point.

Not surprisingly, like every other measure of valuation, forward return expectations are substantially lower over the next 10-years as opposed to the past 10-years.

, Profits & Earnings Suggest The Bear Market Isn’t Over.

Fundamentals Don’t Matter

I will agree with many that fundamentals don’t matter in the “heat of the moment.” As stated, they are poor timing indicators. 

In a market where momentum is driving participants due to the “Fear Of Missing Out (FOMO),” fundamentals are displaced by emotional biases. Such is the nature of market cycles and one of the primary ingredients necessary to create the proper environment for an eventual reversion.

Notice, I said eventually.

As David Einhorn once stated:

The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

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

Probably not.

James Montier summed it up perfectly in “Six Impossible Things Before Breakfast,” 

Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance workhorses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

Our Take

Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, as depicted in the scatter graph below, return expectations for the next ten years are as likely to be negative as they were for the ten years following the late ’90s.

Read more on this graph from RIA PRO (30-Day Free Trial)

While investors insist the markets are currently NOT in a bubble, it would be wise to remember investors believed the same in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point, it was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

Conclusion

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

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 a straightforward 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.”

Major Market Buy-Sell Review: 11-16-20

HOW TO READ THE MAJOR MARKET BUY-SELL REVIEW 11-16-20

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 tend to work better.

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

Major Market Buy/Sell Review 11-16-20

S&P 500 Index

  • The sharp rally this past week took the markets back to all-time highs, which is certainly bullish heading into the end of the year.
  • However, the markets are now back to more extreme short-term overbought conditions, which have repeatedly been an excellent opportunity to lift profits and rebalance risks.
  • Such is likely good advice as we head into early December where Mutual Funds will have to make redemptions to meet annual distribution requirements. 
  • Maintain current exposures for now, but manage risk as needed.
  • Short-Term Positioning: Bullish
    • Last Week: Maintaining holdings.
    • This Week: Maintaining holdings.
    • Stop-loss set at $310 for trading positions.
    • Long-Term Positioning: Bullish

Dow Jones Industrial Average

  • As with SPY, the Dow has also completely reversed its oversold condition and is pushing back into resistance. 
  • Wait for weakness now to buy.
  • Take profits and rebalance risks accordingly.
  • Short-Term Positioning: Bullish
    • Last Week: No position.
    • This Week: No position.
    • Stop-loss moved up to $260
  • Long-Term Positioning: Bullish

Nasdaq Composite

  • The Nasdaq is not completely overbought yet, and Technology has been underperforming over the last week. We suspect that will change as the virus continues to weigh on economic growth. 
  • As noted last week: “The underperformance relative to the S&P 500 is likely going to provide another good trading opportunity soon.”
  • Markets are back to short-term overbought, so use corrections to add to holdings.
  • Hold current positions and honor stop losses.
  • Short-Term Positioning: Bullish
    • Last Week: No changes this week.
    • This Week: No changes this week.
    • Stop-loss moved up to $240
  • Long-Term Positioning: Bullish

S&P 600 Index (Small-Cap)

  • SLY is back to extreme overbought. 
  • Take profits and reduce risk next week. 
  • Short-Term Positioning: Bullish
    • Last Week: No positions
    • This Week: No positions.
    • Stop-loss set at $60
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • Like SLY, MDY is back to extreme overbought levels. 
  • Take profits and reduce risk accordingly. Look for pullbacks to the 50-dma that holds to add exposure. 
  • The $330 stop-loss remains intact, but just barely. 
  • Short-Term Positioning: Bullish
    • Last Week: No holding
    • This Week: No holding
    • Stop Loss is set at $330
  • Long-Term Positioning: Bullish

Emerging Markets

  • EEM is grossly extended and overbought. Take profits and reduce the risk for now and look for a pullback to the 50-dma for a trading opportunity. 
  • Short-Term Positioning: Bullish
    • Last Week: No position
    • This Week: No position.
    • Stop-loss moved to $44 for trading positions.
  • Long-Term Positioning: Bullish

International Markets

  • International markets are egregiously overbought and extended. 
  • Take profits and rebalance risk as needed.
  • Use pullbacks that hold support at the 50-dma to add exposure.
  • Maintain stops.
  • Short-Term Positioning: Bullish
    • Last Week: No position.
    • This Week: No position.
    • Reset stop-loss at $62
  • Long-Term Positioning: Bullish

West Texas Intermediate Crude (Oil)

  • The rally in oil finally came. Oil is not overbought yet, and energy stocks have finally started to outperform short-term. 
  • It is too early to jump in, but a bottom may be forming for a reasonable opportunity. We are still holding our small energy exposure, but we are building a shopping list if this rally can build support and hold. 
  • Short-Term Positioning: Bearish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop for trading positions at $32.50
  • Long-Term Positioning: Bearish

Gold

  • After previously adding to our positions in GDX and IAU, we continue to hold our positions. 
  • Last week, gold and gold miners pulled back with the short-term rotation to value. Such is very likely a very limited trade and we will see a reversal back to concerns about the economy next week. 
  • We are going to look to add to our positions on this weakness that holds support.
  • We believe downside risk is relatively limited, but as always, maintain stops.
  • Short-Term Positioning: Bullish
    • Last week: No changes this week.
    • This week: No changes this week.
    • Stop-loss adjusted to $165
    • Long-Term Positioning: Bullish

Bonds (Inverse Of Interest Rates)

  • Bonds remain at historically very extreme oversold conditions. They bounced nicely last week but are not trading correctly just yet. 
  • The upside potential in bonds from the current oversold condition is good and will coincide with a larger stock correction. 
  • The “sell signal” is now at levels that have typically preceded more massive rallies in bonds, so continue to maintain exposure.
  • Investors can add to Treasuries at current levels. Post-election, we will take our duration much further out. 
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions.
    • This Week: We increased TLT by 5% on Wednesday.
    • Stop-loss moved up to $157.50
    • Long-Term Positioning: Bullish

U.S. Dollar

  • The dollar rally stumbled last week and retested previous lows.
  • However, the bottoming process continued, and the dollar rallied back into the uptrend channel is has been building.
  • A breakout above that trend and the dollar rally will be on. Such will be bad for international stocks and commodities, so watch the dollar closely.
  • Traders can continue to build a position here with a stop loss at recent lows. 
  • Stop-loss adjusted to $92.

Market Breaks Out On Vaccine Hopes As Cases Surge


In this issue of “Market Breaks Out On Vaccine Hopes As Cases Surge.”

  • Market Breaks Out Barely
  • Vaccine Will Arrive Too Late
  • The “Smart Money” Is Leaving Town
  • Portfolio Positioning Update
  • MacroView: The Fed Will Monetize All Debt Issuance
  • Sector & Market Analysis
  • 401k Plan Manager

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Catch Up On What You Missed Last Week


Market Breaks Out – Barely

If you like volatility, then this past week was for you. On Monday, the announcement by Pfizer sent markets screaming higher. However, it wasn’t like rallies we had seen previously. Instead, it was a fierce rotation from the previous leaders to laggards.

Nonetheless, the market initially surged to all-time highs immediately following the news. But as we will discuss in a moment, the news wasn’t really what it seemed. Subsequently, the market faded into the end of the day. The rotation to value turned out to be very short-lived as markets returned to the reality of rising Coronavirus cases and no “stimulus” on the horizon.

Since the highs of September, the market is now just 0.50% higher today. Like I said, if you like volatility, you have gotten a good dose of it.

Yes, It’s Still A Sellable Rally

Importantly, we had stated last week, the stock market rally had already gotten ahead of itself. To wit:

“However, before you get all excited and go throwing your money into the market, you may want to step back and re-evaluate your risk. If you haven’t liked the ups and downs in the market over the last couple of months, you have too much ‘risk’ in your portfolio. 

Furthermore, while we did expect this rally and added exposure in our portfolios, the previous ‘oversold’ condition has now been largely reversed. As shown below, the market is now back to more ‘overbought’ conditions, which suggests limited upside from current levels. Also, the deviation from the 200-dma is now back to levels that have previously led to mild, short-term corrections.”

Chart updated through Friday:

The rally from the October lows was a “sellable rally.” The current rally is as well. Given the more overbought condition, we expect a one to two-week correction at the beginning of December as mutual funds make their annual distributions.

While it is feasible, the markets will end the year positively; we will likely see a better entry point first. 

However, there is the problem of the surge in virus cases as we head into year-end.

Vaccine Will Arrive Too Late

“Vaccine news” is certainly good and very welcome. However, do not get overly excited. Since the coronavirus emerged in January, almost 200 vaccine candidates have gone into development. Only 15 got to human trials, and there are no approvals for use. The odds of creating a successful vaccine are very low, and most vaccines fail before production.

While Pfizer’s vaccine, so far, seems to be moving along the path, there are several things to consider. Foremost is that while Pfizer did announce the potential effectiveness of their vaccine, it is yet to be peer-reviewed or approved for use by the FDA. While the drug is on a “fast-track” for use by year-end for emergency use, it will not be available for widespread use anytime soon. To wit:

“But the vaccine’s complex and super-cold storage requirements are an obstacle for even the most sophisticated hospitals in the United States and may impact when and where it is available in rural areas or poor countries where resources are tight.

The main issue is that the vaccine, which is based on a novel technology that uses synthetic mRNA to activate the immune system against the virus, needs to be kept at minus 70 degrees Celsius (-94 F) or below.”

Furthermore, they are only in Phase-3 of their drug trials. As noted, a very high percentage of drugs fail in Stages 3 and 4. Pfizer will have to start Phase IV once the FDA approves the drug. That phase will incorporate testing the drug in limited use on several hundred or thousands of patients. This phase will take quite some time to accomplish, and if unknown side-effects appear, it could stop the production of the vaccine altogether.

Not As Easy As It Sounds

Lastly, even if Pfizer gets through Phase-IV and begins to produce the drug, and solves the “freezer” problem, it is unlikely to be seen by most of the population for many months. As noted by the Wall Street Journal:

“However, it could be many months before any vaccine is administered to enough people to ease the need for lockdown measures that have been recently reimposed across the West. Duke Global Health Innovation Center estimates that there won’t be enough vaccines to cover the world’s population until 2024.

Of course, such also assumes you can get people to get vaccinated.

“While previous vaccination programs have spread over years and focused on specific demographics such as children or the elderly, governments are hoping to do something they never have done before and inoculate a majority of the population in a matter of months.

Even for rich nations with developed vaccination programs, that presents a host of problems including building new databases to track who is getting the shot, working out ways to encourage mass uptake among younger people, ensuring adequate supply and running large-scale inoculation centers where the shots can be safely and quickly administered.

Those challenges mean that even if a vaccine is soon approved, it could be many months before it is administered to enough people to ease the need for lockdown measures that have been recently reimposed across the West.” – WSJ

Shutdowns Aren’t The Solution.

For the markets, the race against time is likely already lost. There is currently “no stimulus” bills in progress in Congress. The “virus” is surging across the country, with cities once again calling for lockdowns and reversals of opening progress. Such is very bad economically and will further delay openings.

As discussed yesterday in our “3-Minutes.” another shutdown would be economically damaging and would not solve the pandemic.

As noted, the pandemic’s surge, shutdowns, and lack of stimulus are terrible for corporate earnings and, ultimately, the market. With markets extraordinarily overbought and deviated from long-term means, the risk of a correction is more than elevated.

Notably, the rotation to “value” is likely premature as these companies specifically require a more robust economy to generate revenue and earnings growth. The current environment is not conducive to that. Expect a reversal of the trade soon, and money rotates back towards “pandemic” related companies.

Such is also why the “Smart Money” has already been exiting the market.

The Smart Money Is Leaving Town

If you haven’t checked out RIAPro (30-day Risk-Free Trial), we provide a daily market commentary on what is happening. On Thursday, Mike Lebowitz posted an essential piece.

“Bloomberg’s Smart Money Flow Index is a measure of how ‘smart money’ is positioning itself in the S&P 500. The logic behind the index is that smart investors tend to trade near the end of the day, while more emotional-based traders dominate activity in the first 30 minutes of the trading day. The index is calculated as follows: yesterday index level – the opening gain or loss + change in the last hour.

As shown below, the Smart Index and the S&P were well correlated until late August. Since then, as highlighted by the red arrow, they have diverged sharply. Over the last ten years, the S&P 500 and the Smart Index have a strong correlation of .65. As such, we expect they will converge in time. The light blue circle shows they also diverged, albeit to a much lesser extent, in January and February as the smart money correctly sensed problems.”

Yields Have It

“The graph below compares 10 year UST yields versus 10 implied breakeven inflation rates. The current gap between the two is relatively wide but even wider, considering that UST yields are usually higher than the inflation rate, not lower. In other words, real rates are negative. 

If the economy is going to fully recover, we should expect the UST yield to gravitate to and above the inflation rate. If that were to happen, it would imply 10-year yields of approximately 1.50-2.00%. We do not think the odds of that occurring are high because such “high” rates would heavily weigh on the economy. It is more than likely the Fed continues to aggressively buy bonds to keep yields much lower than where they should be.

The other way the gap potentially closes is if the market has inflation expectations wrong and the implied inflation rate falls. Such a scenario suggests the recovery falters.”

“Finally, the graph above shows the two components used to calculate real yields. As shown above, the blue line (UST yield) has made recent progress toward closing the gap with inflation expectations, ie real rates are now less negative.

The next graph shows the strong negative correlation between the level of real rates (blue line) and the price of gold. If real rates continue to rise and become less negative or even positive, we should expect the price of gold to suffer, and vice versa if real rates reverse the recent trend.”

Mom & Pop Finally Turn Optimistic

As noted, while “Smart Money” is leaving town, the bullishness of retail investors has finally spiked to the highest level in years. Such is months after the recovery from the lows. Historically, such has also been an excellent short-term contrarian indicator.

“The percentage of bulls in the American Association of Individual Investors (AAII) survey rose to 55.8% while bears dropped to 24.9%, pushing the Bull Ratio, a more accurate measure of optimism, above 69%. The last 2 times it got this high, stocks ended up running into trouble eventually.” – SentimenTrader

As Bob Farrell once quipped:

“Investors buy the most at the top, and the least at the bottom.” 

Portfolio Positioning Update

When the market does things that are entirely unexpected, irrational, or just plain illogical, such is any living organism’s behavior. The stock market is just that.

The wild rotation from growth to value and back again was undoubtedly one of the unexpected events. Our job is to adjust our allocations to capture these rotations when trends are changing as portfolio managers. However, the difficult part is knowing the difference between a “kneejerk reaction” and a “trend change.” 

On Monday, we decided to remain with our allocations, which already has some “value” to allow the market time to play out. That decision proved correct as our portfolio’s growth portion quickly came back into play after a rough couple of days.

More importantly, we took the opportunity to buy Treasury bonds, which got deeply oversold and 3-standard deviations below their moving average, as shown in the chart below. Such deep oversold conditions rarely last for long and generally lead to decent trading opportunities. That additional bond exposure played out well for the remainder of the week.

What’s The Biggest Mistake Investors Make?

My friend and trading colleague Victor Adair penned a great note last week:

“Interest rates are currently the lowest they’ve been in hundreds of years. In the early 1980s, people could get 13% interest on a bank account, but now ‘high interest’ accounts pay less than half a percent.

You might say that it’s wrong for savers to suffer because the Central Bank has cut interest rates to zero to support the economy. I’d agree, but the fact is that ultra-low interest rates have forced many otherwise cautious people into taking “a little more risk” to earn a decent return on their investments.

When people believe that they need to take ‘a little more risk’ to generate greater returns, they may be making a very BIG mistake if they underestimate what ‘risk’ really means to them.”

His point is incredibly important. As we noted in Moral Hazard,” the Federal Reserve believes that insuring people against investment losses is a dangerous one. While investors are encouraged to take more risk currently, as prices rise, they begin to disregard risk for what it is.

When people take “a little risk” and get rewarded for it, they are then encouraged to take “a little more risk.”  As Victor notes, People in the ‘crowd’ don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.”

What Is The “Risk?”

“One way to measure ‘risk’ in today’s markets is to think of it as the difference between current market prices and the price where ‘value investors’ like Howard would start buying. Believe me; the difference is HUGE.” – Victor Adair.

The incredible stock market rally of the last 40 years has occurred while falling interest rates have forced more and more people to shift from being savers to being “investors.”  

It’s not just the stock market. Virtually all asset prices have gone up as interest rates have tumbled. When there is no “hurdle rate” to the cost of money, then a lot of money gets “invested” poorly. There are very few bargain-priced assets these days.

As Victor notes, if we are indeed in another stock market bubble, then “valuations” don’t matter much. The only thing that matters is “confidence,” and if people are confident that the market will keep going higher, it will until something triggers a “loss of confidence.”

Biggest Mistake Investors Make, What’s The Biggest Mistake Investors Make?

“In a bull market, the Fear Of Missing Out (FOMO) is so strong that people see marketing schemes such as “passive investing” as brilliant ideas. They willingly sign up to have money clipped off their paycheck and invested in the stock market every month, regardless of price. They do this because they have chosen to believe (or have been sold on the idea) that stock prices will only go higher.” – Victor Adair

Manage The Risk

Victor is correct when he states there has been much irrational exuberance in the past few years. Along with that exuberance, asset prices got bid aggressively higher. There is nothing wrong with that except that the “risk of loss’ from these levels is much greater now.

It is essential to have a strategy and discipline that can minimize downside volatility. If you don’t have one, then work with your investment advisor to assess your portfolio, risk, and risk tolerance. Decide if it is time to make portfolio changes. If not, then make plans to reduce risk systematically if the market starts to fall. That way, you won’t panic and make ‘spur of the moment” decisions if the market takes a tumble.

If you don’t have a disciplined investment strategy and are just part of the crowd, here are 10-rules of risk management to get you thinking.

How you chose to manage your portfolio is up to you. However, over the long-term, being aggressive without acknowledging the risks has tended not to work out well over time.


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

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data.  Readings above “80” are considered overbought, and below “20” is oversold. 


Portfolio Positioning “Fear / Greed” Gauge

The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, to more likely the market is closer to a correction than not. The gauge uses weekly closing data.


Sector Model Analysis & Risk Ranges

How To Read.

  • The table compares each sector and market to the S&P 500 index on 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 table shows the price deviation above and below the weekly moving averages.


Weekly Stock Screens

Currently, there are 3-different stock screens for you to review. The first is S&P 500 based companies with a “Growth” focus, the second is a “Value” screen on the entire universe of stocks, and the last are stocks that are “Technically” strong and breaking above their respective 50-dma.

We have provided the yield of each security and a Piotroski Score ranking to help you find fundamentally strong companies on each screen. (For more on the Piotroski Score – read this report.)

S&P 500 Growth Screen

Low P/B, High-Value Score, High Dividend Screen

Aggressive Growth Strategy


Portfolio / Client Update

The past week was crazy. On Monday, Pfizer announced they might have a vaccine that could be 90% effective. Unfortunately, if you read this week’s newsletter, that vaccine is still a very long way off. Nonetheless, the announcement led to a massive rotation into the market’s most beaten-up sectors with “momentum names” selling off. Then, on Wednesday, the entire trade reversed, and the market spent the week only making a small overall gain and is only 0.50% than it was back at the September highs.

We finally got some “love” in our “value” stocks like CLX, CVS, CVX, and RTX. If we continue to see a relative increase in these value names, we will add some more incrementally.

Bonds were also extremely oversold, so our addition to TLT also helped performance this week. Once TLT gets back to overbought, we will reduce the duration and size of our bond holdings and rebalance portfolios to position for 2021.

Portfolio Changes

This past week we made the following changes to portfolios, as we noted in real-time on RIAPRO.NET.

EQUITY & ETF Models:

“While the Pfizer news caused a couple of days of sector rotation, the reality is that a vaccine is not coming soon. As such, the markets are going to start gravitating back to companies that can grow earnings regardless of the economic environment as people remain working from home and the virus remains a threat.

As such we used the pullback in CLX to add to our position.  Also, bonds got extremely oversold (3-standard deviations below the 50-dma) which is an ideal setup for a trade.”

In Both Portfolios:

  • Add 1% to CLX, bringing the total weight up to 3% of the portfolio. 
  • Add 5% to TLT, bringing the total weight up to 15% of the portfolio. 

We have brought equity weights up and reduced our hedges temporarily to participate with the market’s advance. Once markets return to more extreme overbought conditions, we will take profits and rebalance risks accordingly.

As always, our short-term concern remains the protection of your portfolio. We have now shifted our focus from the election back to the economic recovery and where we go from here.

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 one should not rely on it 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 can access our live 401k plan manager.

Compare your current 401k allocation to our recommendation for your company-specific plan and 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.

Trading Desk Notes 11-13-20

Victor Adair’s Trading Desk Notes For The Week Of 11-13-20

The Vaccine “Silver Bullet”

The Pfizer vaccine news was released Monday just before 7 am New York time. The overnight Dow futures surged ~1,400 points within the next 2 hours to an All-Time High of “30,000” for a gain of ~4,000 points (15%) in only 7 trading days.

As the psychological impact of a “silver bullet” vaccine spread throughout the market, gold tumbled over $100, bond yields climbed to an 8-month high, and the US Dollar soared against the Yen and the Swiss Franc. (Gold, bonds, the Japanese Yen, and the Swiss Francs are all viewed as “haven” assets. The vaccine news apparently obliterated the need for havens.) 

My Short Term Trading

I started this week with no positions. Stock indices had rallied hard the previous week, and I expected them to open higher Monday morning since “political uncertainty” had settled down a bit over the weekend.

I thought the stock market rally from the October 31st low (~2,500 Dow points in 5 trading days) looked “stretched,” and there might be an opportunity to re-short the market sometime this week. (I had been short the last 2 weeks of October and thought the market was still overlooking a lot of negative factors.)

The major indices hit their highs on the vaccine news early Monday morning and started to fall back before the cash market opened. Around mid-day, the market bounced but failed to get back to the opening range, and I saw that pattern as a good opportunity to short the S+P. My thinking was that bullish psychology was “as good as it gets” following the vaccine announcement and the highs of the mid-day bounce gave me a natural stop out level. I covered the trade the next day to gain ~70 S+P points (about 700 Dow points.)

The Euro

The Euro initially rallied to a 2-month high following the vaccine news but then reversed lower. I sold it short as it broke below its overnight low. For the past few weeks, my thinking has been that Euro sentiment was “too bullish,” so I’ve been trading it from the short side when I saw a good setup. I covered the position 2 days later to gain ~50 ticks when the Euro staged a late-day rally.

The Canadian Dollar looked like a short on Monday as it reversed from a 2 year high above 77, but I already had “the trade” on with short positions in the S+P and Euro, so I didn’t sell CAD. A big part of my risk management process is watching out for “concentration” risks, given the correlations between markets. CAD has been highly correlated with the S+P (and to a lesser degree) with the Euro this year.

Stocks & Bonds

I shorted the S&P twice more as the week progressed, thinking that it might have a serious breakdown if it broke below Tuesday’s lows. I was stopped for minimal losses on both of those trades and was glad to be out as the market rallied into the Friday close.

On this 240 minute chart, you can see that the S+P gapped higher Sunday afternoon from Friday’s close, spiked higher on the vaccine news, and then (pretty much) held above last week’s highs all of this week and closed strong Friday – a bullish sign.

Long Treasury yields rose to an 8-month high on Wednesday – their highest yield since February. I thought that might have been a “blow-off ” top in yields following the vaccine enthusiasm, so I bought TNotes on Thursday with a tight stop. That’s the only position I’m holding into the weekend. (Bond prices up = yields down.)

Keeping The Time Frames of My Trading And Analysis In Sync

Keeping the time frames of my trading in sync with my analysis’s time frames is one of the most important parts of my risk management process. For instance, on Monday, I shorted the S+P just a couple of hours after it had traded at All-Time Highs. Talk about picking a top! But on an hourly timeframe, I was shorting the market after it had made a double top with the 2nd top lower than the primary top – one of my favorite shorting setups.

The Vaccine Announcement May Have Been A Major Turning Point

My friend Kevin Muir published a piece Friday with the essential message:

The virus is done. The scientists won. They nailed it…markets will look through any (short term) negatives and realize the end is in sight.”

I highly recommend Kevin’s piece because he really makes a case for “why” the Pfizer vaccine (and the other vaccines that will follow) may be the “silver bullet” that the market has been waiting for. Kevin’s view is that the market is a discounting mechanism, and the Big Money will look past the coming dark days of winter and position for the bright days of next summer.

Kevin thinks that in the future, we will look back at the Pfizer vaccine announcement and see that it marked a major turning point in the Value Vs. Large-cap tech spread. If he’s right, the unwind could have a long way to go!

Buying Value/selling Growth has been a widow-maker trade for the past 20 years. Kevin thinks the vaccine may have changed that.

Managing Risk Is More Important Than Having A Good Crystal Ball

In my recent Trading Principles post, I talked about how successful traders find a way to participate in the market that suits them. I seem to be a naturally skeptical guy. I’m more inclined to call bullshit than to go along with the herd. So as a trader, I look for opportunities (good setups) to fade popular narratives.

I think changes in market psychology drive the market, and right now, bullish sentiment is very high. Probably close to, “As good as it gets.” That doesn’t mean I get short and hang on because I know I’m right. It means I wait and watch for a confirmation that “the time has arrived” to take a trade.

Risk management (where/why I get into a trade and where/why I get out) is the key to my survival. Risk management also means sizing, waiting for the right setup, using stops, and not using long term predictions to justify staying with a short-term trade that has gone sour.


Victor Adair is a veteran trader with 50-years of experience trading all types of markets. After retiring from “the business,” he set up a personal website to share his notes, ideas, and “the trading life.”  You can subscribe to his website to receive his weekly newsletter. You can get his past notes on his website, “The Trading Desk.”

#MacroView: Is The Fed Stuck With “Forever Stimulus?”

I recently have discussed both the “Importance of Recessions” and how the ongoing Rescues Ruining Capitalism.” However, while the data is clear that ongoing stimulus programs lead to weaker economic growth and a rising wealth gap, is the Fed stuck with “forever stimulus?”

Such was a point that Mohammed El-Erian recently made, stating:

“They are increasingly on what I call a no-exit paradigm.” 

To understand the problem, we have to go back to the beginning. As we noted in our article on financial rescues, the bailouts and stimulus programs started in 2008 when the Federal Reserve intervened with the insolvency of Bear Stearns. They haven’t stopped since.

To date, the Federal Reserve, and the Government,  have pumped more than $36 Trillion into the economy. As shown below, the amount of economic growth achieved has been minimal during that same time frame. (The chart is the cumulative growth of interventions compared to the incremental increase in GDP.)

What this equates to is more than $12 of liquidity for each $1 of economic growth.

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

Trapped

The trap the Federal Reserve has stumbled into is that it continues to require more interventions to sustain lower rates of economic growth. Whenever the Fed withdraws interventions, economic growth collapses.

As shown, since the turn of the century, each economic cycle has failed to attain a higher rate of growth than previously. The Federal Reserve lowered interest rates to stimulate growth. However, after reaching the “zero bound,” the Fed engaged in expansionary monetary policy.

Such is why Fed Chairman Jerome Powell has repeatedly pressed for more “fiscal” support from Congress. Without more debt issuance, the Federal Reserve’s ability to “monetize” bonds to provide “monetary stimulus” to the markets is limited. In theory, boosting asset markets should increase consumer confidence and create a “trickle-down” effect on the economy.

Unfortunately, as shown below, this has yet to be the case. Since 2009, the raw increase in just the Fed’s balance sheet, excluding all the other interventions in the table above, was 438%. During that same time frame, the S&P 500 increased by 199.94% and GDP just 21.24%.

Again, while Jerome Powell continues to suggest “the recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side,” there is little evidence to support that statement.

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

Debts Are The Problem

The question that plagues Central Bankers globally is why higher economic growth rates, and ultimately inflation, fail to appear.

“Instead, faced with slowing global growth and resurgent infections, the focus of policy makers at last week’s all-virtual International Monetary Fund and World Bank meetings was on more support for the world economy, not less. Central banks are pulling out the stops to do all they can, boosting financial markets with massive asset purchases and pushing government borrowing costs to record lows.” – Bloomberg

As previously discussed, there is a long historical correlation between increasing debts and lower economic growth rates.

“Unfortunately, higher levels of debt continue to retard economic growth keeping the Fed trapped in a debt cycle as hopes of “growth” remain elusive. The current 5-year average inflation-adjusted growth rate is just 1.64%, a far cry from the 4.79% real growth rate in the ’80s.”

Fed Monetize Debt Issuance, #MacroView: The Fed Will Monetize All Of The Debt Issuance

“In 1998, the Federal Reserve “crossed the ‘Rubicon,’ whereby lowering interest rates failed to stimulate economic growth or inflation as the “debt burden” detracted from it. When compared to the total debt of the economy, monetary velocity shows the problem facing the Fed.”

Fed Monetize Debt Issuance, #MacroView: The Fed Will Monetize All Of The Debt Issuance

As stated, this isn’t just a “Fed” problem. It’s a “global” problem.

No Exit

As stated, the Federal Reserve is in a trap from which there is no exit. As Former Fed Governor Randall Kroszner recently said:

“The big debts that governments are racking up are going to make it difficult for central banks to raise rates when they feel the need to do so because that will increase borrowing costs.”

In an economy laden by $75 Trillion in debt, a record number of “Zombie” companies kept alive only by low borrowing costs, and a near-record number of companies with negative equity, higher rates are a “death knell.”

Furthermore, despite Wall Street’s demands to keep asset prices elevated, the Federal Reserve has allowed itself to become politicized by Congress, who allocated money to the Treasury to set up emergency lending facilities.

The Federal Reserve can’t withdraw the “life support” even though the support may be doing more harm than good in the long run.

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

Markets Are Now Dependent On The Fed

“The Central Bank has conditioned the market to such an extent that every time the Fed tries to step back, the market forces them back in by selling off and tightening financial conditions.” – Mohammed El-Erian

Such explains the trap the Federal Reserve has gotten themselves. Even Former Bank of England policymaker Paul Tucker agreed that the financial markets have come to expect periodic support from central banks. Such is not surprising after years in which policymakers delivered just that.

“I wait, longing for a central banker to do for financial stability what Paul Volcker did for inflation, which is to break that psychology that you, the capitalist markets, are actually utterly dependent on the Federal Reserve and other central banks, propping up prices come what may,” – Paul Tucker

Such is the problem facing the Fed.

The debt deluge, and co-dependent financial markets, is leading to other potential consequences. The Treasury market is now so large that it may not function smoothly on its own during times of stress. Such was a point made by Fed Vice Chair for Supervision Randal Quarles.

“It is an open question of whether the Fed would have to keep buying Treasuries to aid the working of the market.”

We know that the Fed is dependent on the financial markets, believing the “Fed” will provide support as needed. With the entirety of the financial ecosystem now more heavily levered than ever, the “instability of stability” is now the most significant risk.

The Paradox

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

The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.

The Fed is dependent on “everyone acting rationally.”

Unfortunately, that has never been the case.

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

  • In the early 70’s it was the “Nifty Fifty” stocks,
  • Then Mexican and Argentine bonds a few years after that.
  • “Portfolio Insurance” was the “thing” in the mid -80’s
  • Dot.com anything was an excellent investment in 1999
  • Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy.
  • Today, well, it’s pretty much everything tied to “debt.” 

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. That is, until suddenly, and often without warning, it all goes “pear-shaped.”

Market Surges Vaccine Hopes, Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

The Single Biggest Risk To Your Money

“If the Fed and other central banks are constrained from scaling back emergency stimulus, the continued flood of liquidity could spur asset bubbles and even too-rapid inflation.” – Bloomberg

Such is already likely the case and underscores the single most significant risk to your investments.

In extremely long bull market cycles, investors become “willfully blind” to the underlying inherent risks. Or rather, it is the “hubris” of investors as they believe they are now “smarter than the market.”

Yet, the list of concerns remains despite being completely ignored by investors and the mainstream media.

  • Growing economic ambiguities in the U.S. and abroad: surging autos and housing against a backdrop of high unemployment.
  • Political instability.
  • The failure of fiscal policy to ‘trickle down.’
  • An important pivot towards easing in global monetary policy.
  • Geopolitical risks.
  • Deteriorating earnings and corporate profit margins.
  • Record levels of private and public debt.

For now, none of that matters as the Federal Reserve continues providing stimulus to the market. The problem comes when they can’t do more, or the markets demand more than the Fed can give.

That is the point where “instability” will exceed the grasp of Central Bankers.

Technical Value Scorecard Report For The Week of 11-13-20

The Technical Value Scorecard Report uses 6-technical readings to score and gauge which sectors, factors, indexes, and bond classes are overbought or oversold. We present the data on a relative basis (versus the assets benchmark) and on an absolute stand-alone basis. You can find more detail on the model and the specific tickers below the charts.

Commentary 11-13-20

  • The past week was characterized by Monday’s massive sector rotation and its echo throughout the week. The clear winners were the most beaten-down stocks and sectors. To wit, XLE was the best relative performer beating the S&P 500 by over 11% last week. The Transportation and Financial sectors were next in line with a relative outperformance of about 8%. Of the major indexes, the Dow led the way, beating the S&P by 5.30%. As we noted last week, Emerging markets were ripe for profit-taking and it gave up 1.5% versus the S&P.
  • On a relative basis, Transportation is grossly overbought and ripe for underperformance versus the S&P. Discretionary and Technology are grossly oversold versus the S&P on a normalized basis but that is largely due to their outperformance over the last few months. Their scores only point to a slight level of oversold.
  • Likewise, QQQ is oversold on a normalized basis but not as much on a scoring basis. Most of the other sectors are close to fair value versus the S&P.
  • On an absolute basis, almost every sector remains overbought, but the degree of which lessened since last week. Thursday’s sharp decline is largely to blame. Discretionary is closest to fair value while the Financials are the most overbought. Similar story on the factor/index front as most are overbought but not aggressively so.
  • Using the “spaghetti charts” one can see that XLF, XLE, and XLI are the strongest sectors as they appear headed for the upper right-hand corner of their respective graphs. While positive, there is not much more room for relative and absolute expansion. A correction in these sectors would be healthy if the trends are to continue.

Graphs (Click on the graphs to expand)


Users Guide

The score is a percentage of the maximum/minimum score, as well as on a normalized basis (sigma) for the last 200 trading days. Assets with scores over or under +/-60% and sigmas over or under +/-2 are likely to either consolidate or change trend. When both the score and sigma are above or below those key levels simultaneously, the signal is stronger.

The first set of four graphs below are relative value-based, meaning the technical analysis score and sigma is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. Lastly, we present “Sector spaghetti graphs” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner the most bearish.

The technical value scorecard report is just one of many tools that we use to assess our holdings and decide on potential trades. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

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
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP

#WhatYouMissed On RIA This Week: 11-13-20

What You Missed On RIA This Week Ending 11-13-20

It’s been a long week. You probably didn’t have time to read all the headlines that scrolled past you on RIA. Don’t worry, we’ve got you covered. If you haven’t already, opt-in to get our newsletter and technical updates.

Here is this week’s rundown of what you missed.


Join Me Virtually For The MoneyShow

Please join me for a presentation on “How To Invest When Markets Are Detached From The Economy” at the MoneyShow.

When: November 19th @ 10 am EST / 9 am CST 

Register Now to reserve your spot.


What You Missed This Week In Blogs

Each week, RIA publishes the research and thoughts behind the portfolio management strategy for our clients. The important focus is the risks that may negatively impact our client’s capital. These are the risks we are focusing on now.



What You Missed In Our Newsletter

Every week, our newsletter delves into the topics, events, and strategies we are using. Our technical review provides the basis of how we are positioning our client portfolios, what we expect to happen, and how we plan to trade it.



What You Missed: RIA Pro On Investing

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



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.” Each week, we cover the topics that mean the most to you from investing to markets to your money.

Best Clips Of The Week Ending 11-13-20


What You Missed: Video Of The Week

I discuss why “shutting down” the economy is neither a “cure” for the virus or an economic savior.



Our Best Tweets For The Week: 11-13-20

If you don’t follow us on Twitter, that is where we drop some quick market, investing, and financial thoughts. However, just in case you missed it, here are a few from this past week you may enjoy. You may also enjoy the occasional snarky humor.

Follow us on twitter @lanceroberts and @michaellebowitz.

See you next week!

The Housing Debt Bubble Is Going To Burst

The $100B+ Housing Debt Bubble Is Going To Burst

“Being self-employed, I don’t like to add extra bills or burdens, and with a moratorium, there’s no guarantee that later I won’t be further into debt.” 

                                                Lucy, freelance photographer, Colorado – July 2020

Lucy’s concern about accumulating debt echoes across America. Millions of renters and homeowners are anxious about paying both their monthly housing bill and a ballooning debt balance.

Based on present missed payment rates, consumers will accumulate at least $100B in housing debt by January 2021. The following model describes a set of linked health, social and economic events. These events are likely to unfold in next 6 months.  An uncontrolled wave of virus infections drives the cascading economic impact:

    Virus growth uncontrolled > economic activity contracts > unemployment rises

  > personal income falls > consumers miss rent and mortgage payments

 > rent and mortgage payment moratoriums fail > consumers use credit cards to make payments

> small business apartment landlords & homeowners default on mortgages (debt bubble bursts)

> consumer spending dives

Our analysis starts by examining the virus 3rd wave and a likely increase in lockdowns.

Virus Growth Uncontrolled

On November 2st the U.S. had a 44% increase in daily COVID-19 to 93,581. The chart below indicates the second wave of infections did not decline to the first wave low. Thus, experts forecast a third winter wave peak of cases will be higher than the second spring wave peak.

Source: New York Times – 11/3/20

Hospitalizations are rising in 42 states. Nineteen states report their highest hospitalization rate since the pandemic began in March.  Uncontrolled virus infections will result in more partial or full lockdowns of intense social activity businesses including, hotels, restaurants, bars, theaters, sports stadiums, indoor arenas, offices, transit, airlines, hair salons, and personal services.  An indication of what the U.S. may face soon is unfolding now in the United Kingdom, Germany, and France. These EU countries are tightening pandemic restrictions at levels not seen since last June.  Meantime, U.S. businesses, such as internet entertainment, technology services, eCommerce and, socially distanced grocery stores, will continue to grow.

Economic Activity Contracts

The U.S. Economy is contracting according to the latest Sales Manager Index. The next chart shows a U.S. Sales Manager survey of national economic activity jumping in the 3rd quarter and then rolling over into contraction.

Source: World Economics, The Daily Shot – 10/22/20

Components of the Sales Manager Index that are falling or flat include business confidence contracting, market growth flat, sales growth flat, profit margins weakening, and staffing levels falling. Accordingly, staffing levels are critical to watch as more layoffs mean an increase in unemployment.

Covid-19, COVID-19 Triggers Transformation into a New Economy – Part 2

Unemployment Rises

The latest report from the Department of Labor for state unemployment claims and continuing benefits shows a high level of unemployment continuing. The trend chart below shows that while regular state benefits are declining, extended emergency benefits increase for long-term jobless workers.

Sources: Department of Labor, J.P. Morgan, The Daily Shot – 10/23/20

There are 22.6M workers on continuing unemployment assistance. This level of continuing unemployment is 22 times the level of 1M a year ago. Considering 2 -3M workers who have not qualified for extended benefits or have used up their extended benefits the number of eligible workers for unemployment is closer to 25 – 26M. Twenty-six million workers unemployed is about 17.3% of the labor force.  Labor experts set the unemployment rate at 20% if other workers who did not apply for benefits are added. High unemployment rates are driving personal income down.

Personal Income Falls

Consumer personal income received a boost from several sources.  The CARES Act provided $1,200 stimulus checks, enacted the Payroll Protection Program targeting small businesses, a $600 weekly increase in unemployment insurance, and other emergency loans.  The following Oxford Economics analysis indicates that a budget squeeze began in October.

Sources: Oxford Economics, The Daily Shot – 10/8/20

Oxford forecasts that household income will fall by 3% below pre-COVID levels beginning in November.  The model shows how tight household budgets will become by January 2021.  

Consumers Miss Rent and Home Mortgage Payments

The Mortgage Bankers Association reports for the 2nd quarter of 2020 rental income losses of $9.1B and mortgage payments missed of $16.3B.   For the 3rd quarter, rental losses were $9.1B and $19.4B in missed mortgage payments.  For the 4th quarter, we forecast a continuing $35B total for both missed rental income and mortgage payments. The total forecast for both rental income losses and missed mortgage payments by 2021 is $90B.

However, Moody’s Analytics forecasts $70B in missed rental payments alone by 12.8M renters by January 2021.  Confirming the 12.8M figure, a study by Joint Center For Housing Studies at Harvard reports that 12.1M renter households have at least one at-risk-industry worker. Due to the wide variance in estimates, we forecast at least $100B in rental and mortgage debt due in January 2021.

Our forecast of $100B in looming housing debt builds on our earlier analysis in a recent Executive – Employee Catch 22 post. In that post we identified two consumer segments, workers and professionals. We noted all homeowners reported no-confidence in making next month’s payment.  The analysis indicates that 16% of professional homeowners reported little or no-confidence in making mortgage payments for September. Yet, workers reported twice the no-confidence rate of professionals at 34%. 

Covid-19, COVID-19 Triggers Transformation into a New Economy – Part 2
http://www.riapro.net

 Rent and Mortgage Moratoriums Fail

The CARES Act mortgage and rent moratorium covered homes and apartment buildings secured with federal loans through July 31st.  Renters obtained payment relief, while landlords continued to pay mortgage loans from their funds or relief act assistance.   In mid-August, President Trump signed an executive order instructing the Centers for Disease Control and Prevention to identify households where infections may increase and mandate that household members be protected from eviction to ensure public safety.  Since the federal moratorium ended and the CDC policy has been put into effect, thousands of landlords have filed suits challenging the CDC authority to protect renters from eviction. 

Courts in some states are finding in favor of landlords causing evictions to rise. Moody’s Analytics forecasts that 16% of all renters will face eviction by January 2021.  States like California and Washington passed blanket rent moratoriums in effect until January 1st,  2021.  Rent debt is not erased in any case. The California moratorium calls for landlords to receive 25 % of the debt balance in January and 50% in February, followed by 25% increments to zero. With no stimulus assistance to renters and distressed homeowners, housing debt will likely continue to soar.

Consumers Use Credit Cards To Make Payments

Credit card usage by renters increased by 70% last spring. As renters received stimulus payments, the rate dipped to 50%. However, the credit card payment rate has risen to 65% due to the end of stimulus assistance.

Sources: The Philadelphia Federal Reserve, Census Bureau, The Wall Street Journal – 10/27/20

Consumers building credit card debt while unemployed or on reduced income assistance is unsustainable.  Many consumers will be unable to make their credit card payments. Defaulting on their credit cards will hurt their credit score and make it more difficult to obtain other housing because they have an eviction record.  A surge in credit card defaults will increase losses for credit card issuing banks as well. Today, missed rent payments force millions of small business landlords to fall behind in their mortgage payments.

Small Business Landlords Default on Mortgages

When renters miss payments, their landlords must continue to pay the mortgage on their building.  Property corporations with access to low-interest bank loans or bond markets will have a cushion during this rent loss period.  However, many small business landlords are financially stressed. Small business landlords own 22M properties, which are usually 1- 4 unit buildings Local small unit landlords finance their purchases with savings, other business profits, or family and friends. Only 12% of small unit buildings were covered by the CARES Act rent moratorium, which ended on July 31st.  So, some small business landlords have taken action to evict tenants.

Facing a cash flow crunch, anxious small business landlords applied for CARES Act business emergency loans to mitigate income loss.  The Terner Center for Housing Innovation at UC Berkeley survey of small business landlords found 40 % of owners are not confident they can pay operating costs over the next few months. So, small business landlords may evict tenants to find a paying renter.  However, by 1st quarter of 2021, there are likely to be millions of people evicted or with poor credit so, finding another paying tenant could be problematic.  Small business landlords facing declining income and poor prospects for new paying tenants will likely default on their mortgage. There is likely to be a surge in multi-unit buildings for sale, causing a decline in multi-unit building construction.

Covid-19, COVID-19 Triggers Transformation into a New Economy – Part 2

Home Owners Default on Mortgages

Homeowners enter into forbearance plans with their lenders to avoid penalties and fees when they are likely to be delinquent on their payments. Black Knight reports there are 3M mortgages in forbearance as of October 31st. This forbearance rate is ten times the 300k mortgages in forbearance in February of 2020.  Most of these mortgages are approaching their six-month renewal date from last March and April.  Homeowners can apply for a six-month renewal under the CARES Act.  However, after March 2021, the forbearance period ends, and homeowners must begin paying their balance owned while continuing monthly payments.

Eighty percent of present forbearance payers have applied for a six-month extension. With unemployment increasing and lockdowns forecast, there may be an increase in the number of forbearance plans.  Other homeowners who don’t qualify for forbearance are delinquent in making payments. Mortgage delinquencies outside of forbearance are up by 107% YTD as of October. By the end of 1st quarter, 2021 defaults are likely to rise significantly.

Consumer Spending Dives

A perfect economic storm is gathering strength from the health, social and financial forces we have identified in this post.  The corona virus continues to penetrate all facets of American life, driving uncertainty in the economy.  Until we have a national virus containment program implemented, the pandemic will force economic activity down.  Without a stimulus package from Congress, millions of unemployed workers, renters, and small businesses will struggle. With the bottom 80% of consumers facing severe economic headwinds, consumer spending will likely dive in the first half of next year.

For investors, this is the time to prepare for a possible severe economic storm coming this winter. Scott Minerd, Global CIO at Guggenheim, observes that we have a pause now giving us time to prepare for an economic whirlwind:

the relative calm  we feel in the markets right now isn’t the end of the storm, it is just the eye, it may seem like there is no storm at all…yet the worst is yet to come.

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: @PatrickHill1677, email: patrickhill@theprogressiveensign.com

Cobras, Windows, and Executive Compensation Part II

Cobras, Windows, and Executive Compensation Part II

In Part One of this series (Tales of Cobras, Windows, and Economic Promise), we discuss the “cobra effect.” It is a term that derives from a venomous cobra outbreak in India. We chose this tale to exemplify how solutions to problems, on occasion, have the opposite of the intended effect.

In this article, we present a two-headed cobra effect. First, government legislation designed to limit executive compensation and second, the influence of economists and academia to base executive compensation on “performance.”

Bush vs. Clinton

In the early 1990s, like today, there was a disproportionate gap between corporate executive compensation and employees. There was also discontent from academia that the level of executive compensation was not justifiable based on performance.  Many leaders thought that closing the compensation gap would benefit employees and the economy.

At the time in 1992, there was a presidential election between George Bush, the sitting President, and the two-term governor from Arkansas, Bill Clinton. Part of Clinton’s campaign pledge was to tame what he deemed “excessive executive pay.”

Specifically, Clinton intended to reverse a recent veto by President George Bush, limiting corporate tax deductions for executive compensation.

Elected in November of 1992, Clinton soon after signed into law section 162(m) of the IRS code. The code limits corporate deductibility of executive pay to $1 million for “named executives” at publically traded companies.

Financially penalizing companies with high wage-earning executives may seem like a smart way to limit compensation. Then again, putting a bounty on cobra heads also seems like a reasonable way to get rid of cobras.

30 years later

Now, 30 years later, we can clinically evaluate the effectiveness of that legislation. The graph below illustrates one measure comparing executive pay to worker compensation.

Data Courtesy: The Economic Policy Institute

Executives tend to have excellent legal counsel and they employ the best accountants money can buy. That being the case, they quickly found ways to avoid the penalties imposed by Clinton’s legislation. Essentially they would limit their traditional take-home pay and increase other forms of compensation. Most notably, stock and stock option awards.

The graph below shows a distinct change in the makeup of compensation packages starting in 1992.  While the graph is only through 2008, the trends continue to this day.

Executives not only helped their company’s tax planning but increased their pay immensely. Changes in pay structure were pleasing to economists and academia who were of the belief that economic progress excels with performance-based compensation.

However, the definition of performance has different meanings to different people.

Incentives

Stock-based compensation as a percentage of total executive compensation has proliferated since 1992. Laws written and passed based on “sound academic analysis” radically modified incentives.

A person paid in stock will be motivated to get the stock to trade for as high a price as possible. Logically, the next issue to analyze is the correlation between stock performance, long-term corporate profitability, and employee welfare.

According to research from the Harvard Law School Forum on Corporate Governance, since 1990, CEO median pay at large U.S. corporations has grown 514% adjusted for inflation. Over the same period and on an after-inflation basis, median household income has increased by 21%, GDP slightly less than 100%, and S&P 500 earnings by 129%.

Such massive outperformance of executive compensation over corporate and economic performance is telling. As CEO pay becomes more closely aligned with the stock price, CEOs and executive leadership, in general, target corporate decisions which drive share prices higher. These include cutting expenses, leverage up the company, neglect investments into the future, and of course, manipulate the stock price via share buybacks.

With a focus on share prices, not only do corporate profits suffer but so do economic and productivity growth.  Executives grew more prosperous at the expense of the economy and a large segment of the population.

Sowing the Seeds

It is easy to blame political leadership and their legislation, but they had a lot of support. As noted, at the time, academia lobbied for performance-based executive compensation in the name of enhancing “shareholder value.” They theorized that basing pay on performance would solve the compensation problem. This line of thought was not new. They were parroting what economists were saying over the prior 20 years. In Short Term Gain – Long Term Pain, we wrote the following:

“In the early 1970’s, economists began to argue that the motives of agents (executives) were different from those of the principals (shareholders), thus in their opinion, a principal-agent problem existed. To align the interests of executives and shareholders, economists promoted a theory that executives should be given financial incentives derived from corporate stock performance.”

With the “do-gooder” economists, think tanks, and large universities behind him, Clinton enacted legislation that laid the groundwork for economic failure. They put a bounty on cobras without considering that executives would begin breeding them for income.

Simple Fix

One would think that shareholders would be aghast at what has occurred. They are not, and for a good reason. The average holding period of stocks has shrunk from eight years in the 1960s to less than one year today. While the graph below is dated, we venture the current holding period indeed has not lengthened. Most investors are no longer “investing” as part owners in a company. They have become stock renters, flipping electronic pieces of paper with a click or two of a mouse.

Short-term shareholders do not care about long-term corporate performance. Buybacks are cheered and will always trump investments into a company’s future.

The fix is easy. Pay executives on metrics related to corporate profitability in the future. Force their attention to that which is best in the long run for shareholders, employees, and the communities they operate in. Not only will shareholders prosper, but workers and the economy will as well. It may be wishful thinking given the power structure. Still, corporate, economic, and monetary policies must be re-aligned away from short-termism and expediency to those which will deliver organic growth and long-term prosperity.

fundamentals, The Death Of Fundamentals & The Future Of Low Returns

Summary

What started in 1992 as a seemingly noble idea to shrink the wealth gap and income disparity now quite clearly has only made the problem worse. Poorly thought-out legislation hurt productivity growth, economic trends, and the prosperity of almost every citizen.

The solutions for solving some of our economic woes are neither complex nor difficult. They will, however, require sacrifice to establish proper incentives. Much of that sacrifice falls on the top 1% who benefit the most from an artificially inflated stock market.

As we hope you will notice with this series of articles, the rationale and justification for addressing a problem are often well-founded. Still, the resulting incentives borne out of the “solution” can lead to viperous unintended consequences.

Technically Speaking: S&P 3750 – Market Surges On Vaccine Hopes

In Mid-August, I posited a potential bullish run on the S&P index to 3750. For that to occur from the levels we discussed then, several things would have to happen. One of those was a “vaccine.” Yesterday, the market surged higher on news the Pfizer was close to delivering a COVID-19 vaccine. Such sent investors scrambling on hopes that a vaccine will set the course for continued economic recovery.

In yesterday’s post, “Investors Ignore Evidence,” we discussed the problems with the “fundamental backdrop.” Most notably was the more extreme valuation of the market currently. To wit:

“There are two crucial points to take away from the data.

  1. There are several periods throughout history, where market returns were not only low but negative. (Given that most people only have 20-30 functional years to save for retirement, 20 years of low returns can devastate plans.)
  2. Periods of low returns follow periods of excessive market valuations and encompass the majority of negative return years.”

Importantly, as I also noted,  valuations are often dismissed in the short-term because there is no immediate impact on price returns. By their very nature, valuations are HORRIBLE predictors of 12-month returns.

Such is why I want to focus solely on the current technical backdrop of the market.

Don’t Get Too Excited.

Before we get into the market’s short-term technical conditions, watch this short “3-minutes Video” from yesterday morning.

While the “vaccine” is certainly good news and gets people back to work, it inhibits the potential for more stimulus, and specifically QE. With employment rapidly heading back to “full employment,” and a vaccine potentially leading to an inflationary surge, the Fed may quickly become trapped in providing more support.

In the very short-term, the other problem is that markets are now back to extreme overbought levels following the gains last week.

Bulls Target 3750

Let me go back to the analysis from August.

“Technical analysis works well when there are defined “knowns” such as a previous top (resistance) or bottom (support) from which to build analysis. However, when markets break out to new highs, it becomes much more of a ‘wild @$$ guess’ or ‘WAG.’

I previously denoted several “risk/reward ranges.”

“With the markets closing just at all-time highs, we can only guess where the next market peak will be. Therefore, to gauge risk and reward ranges, we have set targets at 3500, 3750, and 4000.”

I have updated the chart below. The “black arrow” was where I initially did the analysis.

Since that point, the market has spent the last couple of months making very little headway. However, as noted in the past weekend in “Market Surges As Election Turns Into Optimal Outcome:”

“It was quite the reversal. The rally pushed the market back above the 50-dma and the downtrend of lower highs. Such sets the market up for a retest of all-time highs next week.”

On Monday, the market hit new all-time highs, keeping our target of 3750 intact for now.

Not Out Of The Woods

However, before you get all excited and go throwing your money into the market, you may want to step back and re-evaluate your risk. If you haven’t liked the ups and downs in the market over the last couple of months, you have too much “risk” in your portfolio. 

The volatility most likely isn’t over. Particularly as we head into 2021.

Furthermore, while we did expect this rally and added exposure in our portfolios, the previous “oversold” condition has now been completely reversed. As shown below, the market is now back to more extreme “overbought” conditions, which suggests limited upside from current levels. Also, the deviation from the 200-dma is now back to levels that have previously led to mild, short-term corrections.

While it is undoubtedly feasible the markets will end the year closer to 3750 than not, it is likely we will see better entry opportunities along with way.

More importantly, much of the rally yesterday was in the most heavily shorted and beaten-up sectors. Such tends to occur at the latter end of a rally rather than the beginning.

Bulls Chant Into A Megaphone

While the bulls are currently cheering “all-time highs,” it falls within the context of an ongoing topping process referred to as a “megaphone” pattern. Here is the definition:

“A broadening formation is a price chart pattern characterized by increasing price volatility and diagrammed as two diverging trend lines, one rising and one falling. 

These formations are relatively rare during normal market conditions over the long-term since most markets tend to trend in one direction or another over time. The formations are more common when market participants have begun to process a series of unsettling news topics. Topics such as geopolitical conflict, a change in Fed policy, or a combination of the two, are likely to coincide with such formations.

Broadening formations are generally bearish for most long-term investors since they are characterized by rising volatility without a clear move in a single direction.” 

It’s Just A Chart

This broadening, or megaphone, the market pattern is seen below on the monthly chart. Notably, despite the “correction” in March, the “bull market” that began in 2009 remains intact as the low monthly close did not break the 4-year moving average.

Furthermore, this is a “monthly” chart, so it takes a long period to form. As such, it is critical to consider this analysis in context. The chart does not mean the markets are about to crash, nor is it a useful tool to try and “time” the market.

As I noted back in August when I first published this chart:

“The market will hit new highs as it reaches the top of the upper trendline, meeting more formidable resistance. With the market back to a more extreme overbought condition, the ‘low hanging fruit’ has been picked.”

It is worth noting the market rallied to the upper trend line on Monday and held there. The long-term negative divergence in relative strength, and the extreme overbought condition, are certainly concerning.

While the impetus of a “vaccine” is certainly welcome, it is not as if the market is starting to rally from deeply oversold conditions that would align valuations with a recessionary economy.

Instead, we are launching from an overvalued, extended, and deviated market from long-term means. 

Warning Signs

In the short-term, the market seems headed higher. However, it is worth remembering that every previous peak of the market since 2016 has been from “all-time” highs.  

With the market again back to all-time highs, there are numerous warning signs of excess built up, which could trigger a short-term correction.

Currently, our Technical Gauge is back to more extreme levels (RIAPro technical gauge below)

Almost every sector is above its monthly risk-ranges, suggesting a short-term correction is likely.

Lastly, the S&P 500 is pushing 3-standard deviations above the 4-year moving average. Such usually has been a point where a correction ensued.

Monthly, we also see a market that is signaling several cautionary signs.

  1. Despite the rally since 2018, the market has continued to exhibit a negative divergence in relative strength. 
  2. The market is once again pushing 3-standard deviations above the 4-year moving average.
  3. The market is now 22.47% above the 4-year moving average, which matches previous highs.

Currently, the evidence is mounting that markets are reaching the limits of the current move. By itself, these signs reflect the prevailing extremely bullish attitude of market participants.

However, the more extreme extensions provide the “fuel” for a sell-off given an unexpected catalyst. The ensuing “reversion” tends to catch overly confident “bulls” off guard. 

Conclusion

As we noted in the weekend’s newsletter:

“After the election passed, and we could see where the markets were positioning themselves, we reallocated that cash and took our equity exposure back to target weightings.

There were two primary reasons for the reversal. The first was that the sell-off had removed short-term risk over the last few weeks. The second was the outcome of the election perceived as favorable to the markets, as discussed above. There are still risks to that view until the election is officially over. Therefore, we will keep a close watch on holdings and tighten up our stops.

Unfortunately, whatever short-term “entry point” existed to add equities to portfolios, the torrid rally extinguished it.

While the next two months tend to be positively biased, there is still a considerable risk to the markets, as shown in the charts above. Significantly, the more extreme deviations from long-term means do limit further upside.

It is important not to chase markets. Remain patient and wait for opportunities to add exposure and rebalance risks accordingly.

Yes, the markets are indeed bullishly biased, and while it may seem markets can only go higher, they generally don’t.

That tends to happen just when you least expect it.

Sector Buy/Sell Review: 11-10-20

HOW TO READ THE SECTOR BUY/SELL REVIEW: 11-10-20

Each week we produce a “Sector Buy/Sell Review” chartbook of the S&P 500 sectors to review where the money is flowing within the market as a whole. Such helps refine decision-making about what to own and when. It also guides what sectors to overweight or underweight to achieve better performance.

You can also view sector momentum and relative strength daily here.

There are three primary components to each chart below:

  • The price chart is in orange.
  • Over Bought/Over Sold indicator is in gray in the background.
  • 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 tend to work better than when below the zero lines.

SECTOR BUY/SELL REVIEW: 11-10-20

NOTE: Yesterday’s surge in the market from the announcement of a “vaccine” led to a very bifurcated advance. As shown in the sector charts below, some sectors are egregiously overbought. The ones that sold off have decent entry points. This suggests a sector rotation will occur sooner than later.

Basic Materials

  • XLB blew through the double-top resistance and is now 4-standard deviations above the moving average. 
  • Such will lead to a correction short-term, so take profits and rebalance. 
  • Keep stops on trading positions at the 50-dma, which is now critical support. 
  • Short-Term Positioning: Bullish
    • Last Week: Hold Positions
    • This Week: Take Profits.
    • Stop-Loss moved up to $62
  • Long-Term Positioning: Bullish

Communications

  • Communications struggled on Monday as NFLX sold off, and Comcast advanced sharply. Such makes little sense since they are in the same market. 
  • XLC underperformed the market yesterday substantially, and since it is a large sector in portfolios, led to a performance drag.
  • Stops remain at $58.
  • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
  • Long-Term Positioning: Bullish

Energy

  • Energy rallied sharply on Monday as a “vaccine” would allow people to return to work and consume more energy. 
  • XLE finally broke above the 50-dma, but there is major resistance ahead.
  • If you have been trapped in energy stocks needing a point to sell, this is likely a good opportunity. 
  • We suggested Traders could add positions last week with a stop at $27.50 and a target of $34. That remains this week. 
  • The overall trend is fragile, remain clear for now from an investment perspective.
  • Short-Term Positioning: Bearish
    • Last week: Hold positions
    • This week: Hold positions.
  • Stop-loss set at $27.50
  • Long-Term Positioning: Bearish

Financials

  • Financials found some life as yields soared on expectations that inflation would return with a “vaccine.” I wouldn’t count on it since we haven’t had inflation in a decade.
  • XLF is 4-standard deviations above its mean. Take profits and rebalance risks. 
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Industrials

  • Like XLB, XLI is also 4-standard deviations above the mean.
  • Take profits and rebalance risks.
  • Short-Term Positioning: Bullish
    • Last week: No change.
    • This week: No change.
  • Long-Term Positioning: Bullish

Technology

  • Technology stocks and the Nasdaq failed to perform on Monday as the FANGS were drug down on the rotation into the most beaten up and shorted sectors. 
  • The sector is working off the very overbought and setting up for a good entry opportunity soon. 
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions
  • Stop-loss moved up to $110
  • Long-Term Positioning: Bullish

Staples

  • XLP is also correcting the extreme overbought underperformed the market yesterday. 
  • The sector remains in a bullish trend, and the declines in some of the major staples are likely an entry opportunity.
  • Longer-term investors should continue to use any rally to rebalance holdings and tighten up stop-losses.
  • We are moving our stop-loss alert to $62 as our stop-level.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions.
  • Long-Term Positioning: Bullish

Real Estate

  • On Monday, Real Estate rallied sharply. As higher rates are not good for Real Estate, money was chasing yield nonetheless.
  • XLRE held a double bottom and broke above the 50-dma. Using pullbacks that hold the 50-dma to add exposure. 
  • Keep stop-losses the series of bottoms at $34.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold positions.
  • Long-Term Positioning: Bullish

Utilities

  • XLU remains well extended in the overbought territory after breaking above the 200-dma.
  • The rally on Monday also doesn’t make much sense as Utilities are sensitive to higher rates. However, with the yield chase in play, such suggests a bid is still there. 
  • Take profits and rebalance risk. 
  • Short-Term Positioning: Neutral
    • Last week: Hold positions.
    • This week: Hold reduced positions
  • Long-Term Positioning: Bullish

Health Care

  • The news from PFE led to a sharp rally in Healthcare stocks, with XLV now 3-standard deviations above the mean. 
  • The sector is short-term overbought, so rebalance risks accordingly. 
  • The 200-dma is now essential price support for XLV.
  • We are moving our absolute stop to $100
  • Short-Term Positioning: Bullish
    • Last week: Hold positions.
    • This week: Hold positions.
  • Long-Term Positioning: Bullish

Discretionary

  • On Monday, discretionary dragged as AMZN was sold off on a rotation to the “beaten-up economically sensitive” sector.
  • This is likely a good opportunity to add to holdings in AMZN.
  • We said last week: “We will look for an opportunity to add to our “holiday shopping” stocks on this weakness – after the election is over, of course.” That opportunity is likely here. 
  • Stop-loss remains at $140
  • Short-Term Positioning: Bullish
    • Last week: No changes.
    • This week: No changes.
  • Long-Term Positioning: Bullish

Transportation

  • The rally on Monday was pushed XTN back into a 4-standard deviation territory. 
  • The “buy signal” remains extended, and the overbought condition back to extremes.  
  • Take profits in the sector and rebalance risks accordingly. 
  • Maintain an absolutely stop-loss at $56
  • Short-Term Positioning: Neutral
    • Last week: No change
    • This week: No change
  • Long-Term Positioning: Neutral

TPA Analytics: Top 10 Buys & Sells As Of 11-10-20

Top 10 Buys & Sells As Of 11-10-20

These are high conviction stocks that TPA has recommended recently. They are technically positive for “buys,” or negative for “sells.” They are also trading at, or near, the recommended action price levels.


Note from the RIAPro Team:

We are proud to offer TPA Analytics to you at a deeply discounted price. TPA has been serving institutional clients with their trading ideas and strategies. Now you can add the same long-short strategies and ideas to your portfolio as well.

Click on RIAPro+ today to add TPA Research to your subscription for just $20/month. 

As a subscriber, you will receive real-time alerts of trading activity by TPA and a minimum of 2-reports each week.

Turning Point Analytics utilizes a time-tested, real-world strategy that optimizes the clients entry and exit points and adds alpha. TPA defines each stock as Trend or Range to identify actionable inflection points.

What’s The Biggest Mistake Investors Make?

What’s the biggest mistake investors are making in today’s markets?

Interest rates are currently the lowest they’ve been in hundreds of years. In the early 1980s, people could get 13% interest on a bank account, but now “high interest” accounts pay less than half a percent.

You might say that it’s wrong for savers to suffer because the Central Bank has cut interest rates to zero to support the economy. I’d agree, but the fact is that ultra-low interest rates have forced many otherwise cautious people into taking “a little more risk” to earn a decent return on their investments.

When people believe that they need to take “a little more risk” to generate greater returns, they may be making a very BIG mistake if they underestimate what “risk” really means to them.

I’ve been trading financial markets for 50 years. I recently retired from the commodity and stock brokerage business after 44 years, and these days I actively trade my own money in the futures markets. The most important thing I do every day is to identify and manage risk. To me, that’s far more important than picking what to buy or sell.

Bullish investor psychology has driven markets higher.

During my brokerage career, I learned a lot about investor psychology. I learned that when people take “a little risk” and get rewarded, then the next thing they do is take “a little more risk.”  First thing you know, they have become part of the “crowd” that has pushed the prices of many stocks and other assets far beyond any reasonable valuation.

People in the “crowd” don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.

So, what is the “risk” in markets these days?

I’m a futures market speculator, but I read all kinds of books about all kinds of markets. One of my all-time favorite books is The Most Important Thing by Howard Marks. Howard is a veteran market operator, he manages a $100 billion fund, and he also writes very thoughtful memos from time to time that you can read on his website at www.OaktreeCapital.com. I highly recommend Howard to you because he is a classic “Value” investor, and he clearly explains why he sees very little value in today’s overpriced markets.

One way to measure “risk” in today’s markets is to think of it as the difference between current market prices and the price where “value investors” like Howard would start buying. Believe me; the difference is HUGE.

Take A Look

Take a long hard look at what has happened to the S+P 500 market index over the past 40 years. It has had a spectacular rally. If you really want to get nervous, then study the Apple chart.

The amazing stock market rally of the last 40 years has occurred while falling interest rates have forced more and more people to shift from being savers to being “investors.”  

The fact that many stocks have gone parabolic is a testament to how aggressively buyers have embraced risk. I think it would be fair to say that many of their market decisions have been more emotional than tactical.

My point is not that I expect the stock market to fall in half (which would take AAPL all the way back to where it was 6 months ago!) My point is that many people are underestimating their risk of loss in the stock market these days.

It’s not just the stock market. Virtually all asset prices have gone up as interest rates have tumbled. When there is no “hurdle rate” to the cost of money, then a lot of money gets “invested” poorly. There are very few bargain-priced assets these days.

Could the stock market keep going up?

Yes. The stock market could double from here. I think we’re in a bubble, and if we are, then “valuations” don’t much matter. The only thing that matters is “confidence,” and if people are confident that the market will keep going higher, it will probably. If people lose confidence for any reason, then the market will tumble.

When a market keeps trending higher, and higher bullish psychology becomes so deeply ingrained (Buy Any Dip), it creates the trend. The popular belief at market tops is that the trend is your friend.

In a bull market, the Fear Of Missing Out (FOMO) is so strong that people see marketing schemes such as “passive investing” as brilliant ideas. They willingly sign up to have money clipped off their paycheck and invested in the stock market every month, regardless of price. They do this because they have chosen to believe (or have been sold on the idea) that stock prices will only go higher.

Maybe they will. Maybe they won’t. I’m not saying bailout while there’s still time. I’m not saying put everything you have in gold or bonds or whatever. I’m just saying there’s been a lot of irrational exuberance the past few years, and asset prices have been bid aggressively higher. That means there is a greater risk of loss from these levels.

What should you do?

Work with your investment advisor to assess your portfolio risks and your risk tolerance. Decide if now is the time to make some portfolio changes. If not, then make plans to reduce risk systematically if the market starts to fall. That way, you won’t panic and make ‘spur of the moment” decisions if the market takes a tumble.

Like Sgt. Esterhaus from Hill Street Blues, back in the day when bank savings accounts paid a decent return, I’m just saying, “Be careful out there.”


Victor Adair is a veteran trader with 50-years of experience trading all types of markets. After retiring from “the business,” he set up a personal website to share his notes, ideas, and “the trading life.”  You can subscribe to his website to receive his weekly newsletter. You can get his past notes on his website, “The Trading Desk.”

Viking Analytics: Weekly Gamma Band Update 11/09/2020

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update 11/09/20

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model would have resulted in similar returns with lower risk exposure.   The model has resulted in a 74% improvement in risk-adjusted return since 2007 measured by the Sharpe Ratio. 
  • The Gamma Band model increased S&P 500 exposure to 100% last Thursday and entered this week with a full allocation.  At the time of writing, the S&P 500 was trading over 3,600, meaningfully higher than the upper band.  
  • Our binary Smart Money Indicator continues to have a full allocation, and this is discussed in greater detail below.
  • SPX skew, which measures the relative cost of puts to calls, shows that risk appetite is no longer fearful following the U.S. presidential election. Put buyers are no longer paying a large premium compared to call buyers.
  • We publish several signals each day, ranging from a fast signal in ThorShield to a less active signal (as represented by the Gamma Bands and published in the daily SPX report).  Samples of our SPX and ThorShield daily reports can be downloaded from our website.

Smart Money Residual Index

This indicator compares “smart money” options buying to “hot money” options buying.  Generally, smart money will purchase options to insure stable returns over a longer term.  Smart money has in-depth knowledge and data in support of their options activity. In contrast, “Hot money” acts based on speculation, seeking a large payoff.

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position during this time.  When the Residual Sentiment Index in the second graph turns to red, then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

In evaluating equity market risk, we also consider the cost of buying puts versus the cost of buying calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this might be a signal reduce equity exposure. 

Ahead of an important U.S. presidential election, the put buyers are paying a meaningful premium for the protection. 

Gamma Band Background

Market participants are increasingly aware of how the options markets can affect the equity markets in a way that can be viewed as the “tail wagging the dog.” 

We created a Gamma Band indicator to demonstrate the effectiveness of the Gamma Neutral level in reducing equity tail risk.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 74% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal if one’s goal is to increase risk-adjusted returns.  We also publish a faster, daily signal in a portfolio model which we call Thor’s Shield.  Thor Shield has a 20-year Sharpe of 1.5 and a rolling 1-year Sharpe of over 3.4.  Free samples of our daily SPX report and Thor’s Shield model can be downloaded from our website.

Authors

Viking Analytics is a quantitative research firm that creates tools to navigate complex markets.  If you would like to learn more, please visit our website, or download a complimentary report.

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a B.S. in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Furthermore, he has deep experience with market data, software, and model building in financial markets. Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.