Monthly Archives: April 2020

TPA Analytics: Comparing To The Last Time The S&P 500 Was Here.

Comparing things to the last time the S&P 500 was here.

With the S&P 500 futures up 0.62% preopen, and the S&P 500 at 3080, up 37% from the 3/23/20 low, which was just 50 trading days ago, it is a time to take stock.

The last 10 days have seen widespread protests in major cities across the U.S. in response to the death of George Floyd. People have been hurt and killed, many have been arrested, and there has been a lot of destruction coincident with the protests. The rally in stocks seem incongruent when looking at the economic and emotional pain of the country. In the end, however, the stock market is an objective discounting system. TPA prints Benjamin Graham’s words on each report, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” 

TPA wanted to see what has changed since the last time the market was at this level. So much has occurred in a relatively brief span of time that it is difficult to know where to start and how to make comparisons, but TPA decided to use the S&P 500 close of 3078 on 11/4/19 as a marker to see what has changed since stocks were last at this level (see the chart below). 

The table that follows compares 11/4/19 to 6/3/20 using the following:

  1. Covid-19 statistics
  2. U.S. Economic data
  3. The Federal stimulus
  4. Major U.S. market indexes
  5. Major U.S. market sectors
  6. Non-equity benchmarks
  7. Major World markets

What Has Gone Wrong

Stocks were consistently marching higher when the Coronavirus made itself known. As of last night, the total cases worldwide and in the U.S. stood at 6,474,559 and 1,881,256, respectively. The number that have died from Covid-19 worldwide and in the U.S are 382,921 and 108,062, respectively.

Much of the U.S economy was shut down for 2 months and is only now tentatively reopening. Retail Sales are down an astounding 23% or $121 billion. Unemployment stands at 14.70%; a 320% increase from the 3.50% number on 11/4/19. The 10-week cumulative number for new unemployment claims is over 40 million; a historic record.

Crude has rallied from a never-before-seen negative levels the 3rd week in April to 37.47, but it is still down 33% from the 56.54 close on 11/4/19.

The Federal Solution

The U.S. government’s answer to the crisis has been also been historic. The FED’s balance sheet has increased to a record $7 trillion, which is a 75% increase from the $4 trillion that existed on 11/4/19.  PPP has loaned over $500 billion to businesses to keep people employed. The IRS has sent out over $200 billion in stimulus checks to American taxpayers.

Money is cheap now as rates have fallen to their extremes. The Fed Funds is basically 0.00; the effective rate is 0.05. The U.S. 10-year yield has fallen to 0.69% from 1.77% on 11/4/19.

S&P 500 Overview

Broadly

After rallying steadily for the early months of 2020, the S&P 500 dove 34% bottoming on 3/23/20.  The S&P 500 has now rallied and stands approximately where it was on 11/4/19. The Russell 3000, which includes Small Cap stocks, which have fared worse in the downdraft, is a bit lower. The Nasdaq, with its heavy TECH weighting is by far the best major index; closing Tuesday 17% higher than the close on 11/4/19.

Sectors

The winners since the S&P 500 was last at this level are mostly those areas least affected by the shutdown; TECH +15%, Healthcare +9%, Communications (which includes stocks like FB, GOOGL, DIS, and NFLX) and Consumer Discretionary (which includes companies that could function during the shutdown like AMZN and WMT). The loser, unsurprisingly, were those areas that were hurt by the shutdown; Energy -33%, Financials -19%, Transportation -15%, Industrials -15%, and REITs (especially hurt by Commercial and Office REITs) -14%.

What’s Next For The S&P 500

As discussed in previous World Snapshots, investment managers are paid by their clients to stay invested.  So, managers will do their job and own stocks. The only way the indexes can keep going down is if there are liquidations; investors take assets away from investment managers. So far, this has not happened. Managers who sold in March anticipating liquidations, had to buy back stocks when they realized that they had too much cash in their portfolios.

As also discussed above, stocks discount a future world. Right now, investors see the parabolic increase in Covid-19 cases stalling, an economy opening up, and a federal government with infinite resources willing to do whatever it takes to return to normalcy.

The situation may not be great for the average guy stuck at home, with or without a job, and watching violent riots in the street, but as long as there are not mass liquidations, the FEDs keep up their support, and Covid-19 cases trends lower, the market will be stable or go higher. Of course, there really is a limit to how much the FED can do if the economy cannot open up, even if Covid-19 cases come under control, the response by consumers is uncertain. TPA clients should play along with the market, but watch for cracks in the present bullish argument.

  • Covid-19 cases rising
  • Liquidations from asset managers
  • A cautious and tepid return to life for the majority of Americans
  • The Federal government beginning to waver in its support


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

Why The Recovery Will Fall Short of Forecasts

Why The Recovery Will Fall Short of Forecasts

Market pundits seem to have strong opinions about how fast or slow the economic recovery will be once it starts. Such clairvoyance is stunning given the uncertainty of the current GDP forecast, which is already two-thirds in the books.

If the world’s leading economists cannot come to any consensus about today, why should we assume anyone has clarity for tomorrow?

We do not have great clarity either, but we can provide guidance using what we know about the past and present. Our logic presented here is grounded in optimistic assumptions and historical data. The result is an outcome that is well below the hope-based forecasts of most economists. 

Quite frankly, what we present today may be the best possible scenario. It strays far from the popular narrative but deserves serious consideration.

Alphabet Economy

Will the economy recover in “V”, “U” or “L” – shaped fashion?

We hope for a speedy “V”-shaped recovery, but we are realists and understand that the odds of quickly rekindling the economic growth rates from the prior decade are poor. Our stark assessment is due to numerous factors that existed well before the virus and the extreme fiscal and monetary policy responses to the virus.

The last sentence is loaded. We will follow it up in future articles explaining why a full recovery is so difficult. In the meantime, we present a simple economic model, using very optimistic assumptions showing why this recovery is likely to be measured in years, not months.

It is important to stress; the assumptions in our model are the best case. It is easy to come up with more severe scenarios.

GDP

Gross domestic product (GDP) is how economic activity and growth are quantified. GDP is the sum of personal consumption expenditures (PCE), gross business investment, net government spending, and the amount of exports less imports.

The most substantial weighting in GDP is personal consumption expenditures (PCE). Over the prior economic expansion, lasting a decade, PCE constituted 74% of GDP. Since 1948, it has averaged 65%.

The outsized significance of consumption and the secondary effect it has on the other contributors to GDP, allows economists to use PCE as a proxy to forecast economic growth. Statistically, using three-year moving averages, PCE and Real GDP have a correlation of .7789.

Jobs > PCE > GDP

As PCE drives GDP, labor drives PCE. The vast majority of families in the U.S. work to consume. Some wealthy households can rely on investments and savings, and some poor citizens depend on the government. However, the large majority of citizens must consume its wages. Accordingly, PCE is mostly a function of employment and the size of our paychecks.

The graph below shows the year over year change in the number of employed versus the year over year change in PCE. When averaged over two years, as the darker lines show, the correlation is clear.

Forecasting Employment

Given the strong relationship between the labor market and consumption, we can use labor forecasts to arrive at PCE estimates. This is a two-step process.

First, current data and near-term expectations afford a forecast for when and at what level the labor market may trough. Second, we use prior recession data to calculate the rate at which the labor market may recover from the trough.

Step 1– As of the April 2020 BLS jobs report, the number of people counted as employed fell 13.5% to 131 million. Economists expect it to fall another 6% to 123 million when the May report is released this Friday. We aggressively presume that the May report will mark the low point in jobs and that the number of employed will increase going forward.

Step 2– The graph below helps illustrate the rate in which job growth might return to its prior peak. The orange bars show the depth of employment losses in terms of number and time. We invert the second y-axis for comparative purposes.

The most recent, 2008/09 recession, took 76 months for the number of jobs to go from peak to trough and back to the prior peak.

2008

When considering the last three recessions, the recession of 2008/09 is the best proxy to model future expectations. Not only was it the most recent recession, but it best captures our current mindset and economic standing.

  • The recession was broader based, and affected more industries, citizens, and nations, than the prior recessions of 1990 and 2001.
  • The 2008/09 recession and recovery also required significantly more fiscal and monetary policy to boost economic activity.
  • The amount of federal, corporate, and individual debt was significantly lower in 1990 and 2001 then 2008/09.
  • The natural economic growth rate for 1990 and 2001 was higher than the rate going into the 2008/09 recession.

Our current economy is saddled with more debt than the last recession, and the natural rate of growth has diminished over the previous ten years. As we will share in a future article, the economic growth rate going forward may be half of the already weak pace heading into the current recession.

As has progressively been the case, new debt issuance to fight the current recession will cost us in the future.  Accordingly, we think the 2008 experience is an optimistic proxy to analyze the time and rate at which the labor market might recover. In fact, The 2008/09 scenario may likely be the absolute best-case scenario. The number of job losses is already much more severe than that seen in the financial crisis, and the duration of the recovery seems certain to be longer than that episode.

In the 2008/09 recession, the payrolls number troughed two years after the recession started, falling 6.3% from the prior peak. From that low point, it took over four years for the labor market to fully regain the losses. In total, the labor market required six years to recover the pre-recession peak.  

2020

The number of people the BLS considers employed peaked in February 2020 at 156.463 million. It dipped by a little less than one million in March and then plummeted in April by over 25.4 million to 131.045 million.

Today, the range of estimates for the number of current employees is wide. For our analysis, we assume that the May jobs report will mark the trough. The current estimate for the number of employed is 123 million.  

Putting 2 and 2 Together

To review, our forecast assumes that jobs will trough in May. From June going forward, jobs will recover at the same rate and duration as in the aftermath of 2008. Using this assumption we create the PCE forecast shown below.  

If the historical relationship between labor and PCE holds up, and consumption continues to be the predominant contributor to GDP, we should not expect GDP to regain prior highs until 2025.

Summary

The recovery we laid out above is not a “V” or “U” shape. It resembles the Nike swoosh logo with a sharp decline and a long period of recovery. 

Interestingly, the Congressional Budget Office (CBO) agrees with us in that recovery will be much longer than most economists forecast. The CBO’s Nike swoosh forecast below shows the economy will not fully recover for at least a decade.

As mentioned, this analysis assumes a recovery akin to what the economy experienced in 2008. While 2008 was tough, the natural rate of economic growth at the time was more robust and the amount of debt was less.

Since 2008, the ratio of Federal debt to GDP has almost doubled. It now sits close to 120%, well beyond the rate that many economists consider sustainable. Corporate debt to GDP and profits are also growing at unsustainable rates, as shown below.

The simple takeaway is that debt will weigh even more heavily on the current path of growth as the economy recovers.

Economists, when forecasting economic activity, often fail to account for the existing headwinds fully and rarely the new ones. Are they willfully ignorant, or might their employers have a vested interest in portraying a favorable outcome?

Sector Buy/Sell Review: 06-02-20

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

HOW TO READ THE SECTOR BUY/SELL REVIEW CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • 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 have a tendency of working better than when below the zero line.

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

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

Basic Materials

  • As noted last week, XLB reclaimed the 61.8% retracement, but remains overbought, and was underperforming the market. However, over the last week, the performance improved markedly. 
  • The trade got away from us, so we will need to wait for a pullback to support to add materials to the portfolio.
  • If you are long Materials, the fundamentals remain poor so maintain a tight stop.
  • We raising our trading alert to $53.
  • Short-Term Positioning: Bullish
    • Last Week: No Positions
    • This Week: No Positions
  • Long-Term Positioning: Bearish

Communications

  • XLC continues to perform better than the overall market. 
  • We added to this sector previously as the 200-dma retracement level was taken out. However, it is extremely overbought and we took some profits previously. 
  • We continue to like the more defensive quality of the sector, so we continue to look for a pullback to add back to our holdings.
  • Our have set an alert at $51 to revisit adding to our holdings.
    • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Hold positions
  • Long-Term Positioning: Neutral

Energy

  • Energy stocks are getting very overbought short-term and a pullback is likely over the next month or so. 
  • We added to our holdings previously by increasing exposure in XOM and CVX in the equity model and adding those two positions to the ETF model. 
  • We have a stop-loss alert set at $32.50, with a high-alert set at $42.5. The sector is about at the same level as last week, so no action taken. 
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Hold positions
    • Stop loss adjusted to $32.50.
  • Long-Term Positioning: Bearish

Financials

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

Industrials

  • XLI had a good rally last week and finally broke out of its consolidation. XLI is lagging the market overall, and still trades well below other sectors of the market.
  • We sold all of our holdings previously and will opt to wait for a better market structure to move back into the sector. 
  • We have moved our alert to $62 to evaluate positions
  • Short-Term Positioning: Bearish
    • Last week: No position.
    • This week: No position.
  • Long-Term Positioning: Bearish

Technology

  • Technology continues push higher and we continue to hold our exposure to the sector.
  • The rally is starting to fade here a bit as the sector runs into the bottom of the uptrend line from the July 2017 lows. 
  • If we get a pullback that holds support at the 200-dma, we will look add more weight to the sector.
  • We have moved our alert to $87.5.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions.
    • Long-Term Positioning: Bullish

Staples

  • After adding to XLP recently, it started a move higher towards the 200-dma.
  • XLP is not overbought after working off the previous extension, so there is “fuel” for a further rally if it can break above resistance.
  • We are moving our stop-loss alert to $55 as our stop-level.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions
    • Long-Term Positioning: Bullish

Real Estate

  • XLRE held support at the 38.2% retracement and rallied. We also added some exposure to our holdings previously.
  • The sector is just starting to move back into overbought territory and remains oversold relative to the overall market. 
  • We have a low limit alert at $31 as our stop-loss level.
  • Short-Term Positioning: Neutral
    • Last week: Hold positions
    • This week: Hold positions.
    • Long-Term Positioning: Bullish

Utilities

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

Health Care

  • XLV finally ran into resistance near all-time highs and has been consolidating. Late last week, it broke out of that consolidation near all-time highs.
  • The 200-dma is now important support and needs to hold, along with the previous tops going back to 2018. 
  • The sector is very overbought short-term.
  • We have an alert set at $95 to add more to our holdings.
  • Short-Term Positioning: Bullish
    • Last week: Hold positions
    • This week: Hold positions.
  • Long-Term Positioning: Bullish

Discretionary

  • Discretionary performance has improved much over the past couple of weeks. The sector is still at a lot of risk from earnings, but momentum is carrying the sector higher for now. 
  • Last week, XLY rallied to the 200-dma and finally broke above it, and is now struggling with the uptrend from 2018.
  • The sector is VERY overbought, so a pullback is likely. So, use pullbacks to add exposure between 117.50 and 120.00.
  • Short-Term Positioning: Bullish
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Neutral

Transportation

  • The sector finally mustered a breakout rally from the 38.2% retracement level it struggled with over the last couple of months. 
  • The sector performance has improved but still lags the broader market. 
  • There is a trading opportunity for transports, but the sector is very overbought and extended. Look for a pullback to $49-50 for a trading entry. 
  • We are moving our trading alert level to $49, but we aren’t excited about it.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: Too Fast, Too Furious As Fed Liquidity Slows

Too fast, too furious. That describes the April/May advance following the fastest 30% decline in history. The reason was not an improvement in fundamentals, but a generation of investors front running Fed liquidity flows.

Such should not be surprising as this is what was intended by the Federal Reserve from the outset. The Fed delved into “classical conditioning” to specifically obtain the outcome they wanted.

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

As noted in yesterday’s post, in 2010, then-Fed Chairman Ben Bernanke introduced the “neutral stimulus.” By adding a “third mandate” to the Fed’s responsibilities, the creation of the “wealth effect,” the neutral stimulus was achieved.

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate this additional action.” 

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

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

Fed Liquidity Didn’t Work As Intended

Given the massive interventions into markets by the Federal Reserve, as Bernanke noted, “investors anticipated the additional action” and jumped back into the stock market.

Ring the bell. Investors salivate with anticipation.

The Fed was successful in fostering a massive lift to equity prices and a corresponding lift in consumers’ confidence. Unfortunately, there was relatively little translation into wages, full-time employment, or corporate profits after tax, which ultimately triggered very little economic growth.

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

It also suggests monetary policy may be much less effective in stimulating economic growth going forward. If such is the case, investors may be betting on a future outcome that fails to materialize.

For now, however, we are still in a bull market.

Still A Bull Market

Let’s review “Was March A Bear Market?”

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

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

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

Bear Market, Bear Market? Or Just A Big Correction? 05-22-20

“This distinction is important.

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

However, this was the most important point.

I have noted the market may be in the process of a topping pattern. The 2018 and 2020 peaks are currently forming the “left shoulder” and “head” of the topping process. Such would also suggest the “neckline” is the running bull trend from the 2009 lows. 

A market peak without setting a new high that violates the bull trend line would define a “bear market.”

Fed Liquidity Is Slowing

On a technical basis, the market remains in a bull market. However, the supports of the bull market over the last decade, and the last 2-months, continue to erode.

While the Fed’s liquidity interventions did lure investors back into the market, those flows are quietly fading. As noted recently by Zerohedge:

“From an initial $75 billion per day when the Fed announced the launch of Unlimited QE in mid-March, the US central bank first reduced its daily buying to $60 billion per day, then announced a series of consecutive ‘tapers.’

After again shrinking the average daily POMO to $5 billion last week, in its latest just published schedule, the Fed unveiled that in the coming week it would purchase ‘only’ $4.5BN per day, or a total of $22.5BN for the week.”

Retail investors may not have caught onto this fact just yet.

However, given the depth of the current economic crisis, reversions in earnings, and the reality there will not be a “V-shaped” recovery, the risk of a market failure has risen.

Market Support Deterioration

Such is particularly the case as the market rally to date has been defined by the five largest stocks in the index. Via Goldman Sachs:

“Broader participation in the rally will be needed for the aggregate S&P 500 index to climb meaningfully higher. The modest upside for the largest stocks means the remaining 495 constituents will need to rally to lift the aggregate index.”

Such also becomes problematic when corporations are issuing debt at a record pace to supplant liquidity needs to offset the economic crisis rather than repurchasing shares. It’s worth remembering that over the last decade, buybacks have accounted for almost 100% of net stock buying.

Overbought & Extended

Besides the supportive underpinnings, the technical backdrop is also conducive for corrective action in the short-term. As discussed this past weekend:

“The number of stocks above the 50-dma is pushing record levels. Historically, whenever all of the overbought/sold indicators have aligned, along with the vast majority of stocks being above the 50-dma, corrections were close.”

Market, Market Breaks Above 200-DMA. Is The Bull Back? 05-30-20

Such doesn’t mean a “bear market” is about to start. It does suggest, at a minimum, a correction back to support is likely.

Overly Optimistic

Lastly, investors remain overly optimistic that corporate earnings and profits, will catch up with elevated asset prices. Historically, such has never been the case, and prices have ultimately “caught down” to fundamental realities.

There is more than a casual relationship between the cumulative growth of the financial market to corporate profits. While deviations can last for a while, eventually, those gaps are filled.

As my colleague Victor Adair at Polar Trading:

The growing divergence between the ‘stock market’ and the economy the past couple of months might be a warning flag that Mr. Market is too exuberant. The Presidential election is just over 5-months away with polls showing that Biden may be the next President. The U.S./China tensions have been escalating, and the virus’s first wave continues to spread around the globe. However, the ‘stock market’ continues to be pulled higher by a handful of ‘Megacaps.’ The late Friday rally after Trump’s ‘punish China’ speech shows ‘animal spirits’ are alive and well!”

I agree, and while such may be the case for the moment, markets like this have a nasty habit of delivering unpleasant surprises.

Why We Hedge

This is why we hedge.

Currently, our portfolios are long-biased, meaning we have more equity-risk in our allocation than fixed income and cash.

Given the market’s advance, and the data points set out above, we only have three choices in how we manage our client portfolios currently:

  1. Do Nothing – if the markets correct, we lose some of our gains and have to wait for the portfolio to recover.
  2. Take Profits – as we have done with extremely overvalued assets in the past. We can take profits, raise cash, and reduce our equity exposure in advance of a correction. Such actions mitigate the damage of the decline. We will have to repurchase positions, or add new ones, to resize the portfolio in the future.
  3. Hedge – adding a position to the portfolio that is the “inverse” of the market. (the position goes up in value as the market declines.) This action allows us to keep our existing positions intact, and by “shorting against the portfolio,” allows us to effectively reduce our equity risk (and related capital destruction) during a market correction.

Which Do We Choose

Option 1 – is never really a good option. Riding the market up and down, and spending time “getting back to even,” doesn’t make much sense.

Option 2 – is something that we took advantage of twice this year already. We took profits at the peak of the market in January and February before both the decline. We also added new exposures in April as the market recovered. So, taking profits again in some positions would lead to a gross underweighting in certain portfolio allocation areas.

Option 3 is the most optimal at this stage of the rally.

With the Fed engaged in pumping liquidity into the markets, the most opportunistic method to hedge risk is “short the market” against our long positions. As noted this weekend, the risk/reward ranges are apparent at this point.

Market, Market Breaks Above 200-DMA. Is The Bull Back? 05-30-20

  • -2.8% to the 200-dma vs. +1.7% to the March peak. Negative
  • -9.2% to the 50-dma vs. 5.6% to February gap down. Negative
  • -10.5% to the consolidation support vs. +10.1% to all-time highs. Neutral
  • -19.7% to April 1st lows vs. +10.1% to all-time highs. Negative
  • -27% to March 23rd lows vs. +10.1% to all-time highs. Negative

When we discuss hedging against risk, invariably readers mistakenly think we have sold the entirety of our portfolio and are betting on a “market crash.” 

Never is this the case.

By taking prudent actions in the portfolio management process, we can reduce capital risk, and potentially add some incremental “alpha” to portfolios if a correction occurs.

That is how we manage risk.

You have a choice to either manage risk or ignore it.

The only problem is that ignoring risk has a long history of not working out very well.

Cartography Corner – June 2020

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

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

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

GTA Users Guide


May 2020 Review

E-Mini S&P 500 Futures

We begin with a review of E-Mini S&P 500 Futures (ESM0) during May 2020. In our May 2020 edition of The Cartography Corner, we wrote the following:

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

  • M4                 3756.00
  • M3                 3235.25
  • PMH              2965.00
  • Close             2902.50
  • MTrend        2819.42      
  • M1                 2793.00
  • M2                 2675.50    
  • PML               2424.75     
  • M5                1712.50

Active traders can use PMH: 2965.00 as the pivot, maintaining a long position above that level and a flat or short position below it.

“The purpose of each trading month is to take out the high or the low of the previous month…”

Figure 1 below displays the daily price action for May 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The month of May began with the first two trading sessions seeing the market price descend to our isolated clustered-support levels at MTrend: 2819.42 / M1: 2793.00.  That support held on its first test.

The next five trading sessions saw the market price make its first assault upon our isolated pivot level at PMH: 2965.00.  That assault fell short on May 11th at 2947.00.  The market price settled that session in the middle of the trading range at essentially the level where it opened.  In candlestick terminology, that is called a “Doji” and is often a reversal signal.  And reverse it did.  Over the following two trading sessions, the market price declined 109.75 points (closing basis) right into our isolated clustered-support levels.  That support held on its second test.

The following seven trading sessions saw the market price make its second assault upon our isolated pivot level at PMH: 2965.00.  The market price first reached that level on May 18th (essentially) and spent the next four trading sessions building energy to decisively “take it out”.

On May 26th, the market price settled at 2994.50.  The final three trading sessions achieved and maintained marginally higher prices.

Under the cover of darkness on a holiday weekend, the “Pajama Brigade” succeeded in its purpose.

Figure 1:

 U.S. Dollar Index Futures

We continue with a review of U.S. Dollar Index Futures (DXM0) during May 2020.  In our May 2020 edition of The Cartography Corner, we wrote the following:

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

  • M4         107.530
  • M2         103.100
  • PMH       101.03
  • MTrend  99.051
  • Close        99.028
  • M3            98.964
  • PML        98.815             
  • M1         98.100                         
  • M5           93.670

Active traders can use 99.051 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 98.100 as the downside pivot, whereby they maintain a flat or short position below it.

Figure 2 below displays the daily price action for May 2020 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  The first trading session of May saw the market price test our clustered-support levels at MTrend: 99.051 / M3: 98.964 / PML: 98.815.  That support held on its first test, with the market price settling above our isolated upside pivot level at MTrend: 99.051.

The following nine trading sessions saw the market price ascend towards our next isolated resistance level at PMH: 101.030.  The rally fell short of April’s high by 0.425, peaking on May 14th at 100.605Please, take a moment now and locate in Figure 1 the day that the E-Mini S&P 500 future achieved its low during May.  A coincidence perhaps, but, we think not.  Central Banks have a long history of foreign exchange intervention…

The following nine trading sessions saw the market price make its second assault upon our clustered-support levels at MTrend: 99.051 / M3: 98.964 / PML: 98.815.  The market price first reached those levels on May 20th and moved decisively on May 28th to take out April’s low price.  Please, take a moment now and locate in Figure 1 the day that the E-Mini S&P 500 future decisively took out April’s high.  A two-session discrepancy but, again, we think not a coincidence.

The final trading session tested, yet settled above, our isolated downside pivot at M1: 98.100.

The “Pajama Brigade” succeeded again.

Figure 2:

June 2020 Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESM0).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Current Settle         3042.00       
  • Daily Trend             3028.06
  • Weekly Trend         2932.00       
  • Quarterly Trend      2918.33       
  • Monthly Trend        2782.31

In the quarterly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”, after having been “Trend Up” for four quarters.  Stepping down one time-period, the monthly chart shows that E-Mini S&P 500 Futures are in “Consolidation”, after having been “Trend Down” for three months.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P 500 Futures are in “Consolidation”, with the week of May 11th causing that condition despite having been “Trend Up” for seven of the past eight weeks.  The relative positioning of the Trend Levels is bullish.

One rule we have is to anticipate a two-period high (low), within the following four to six periods, after a Downside (Upside) Exhaustion level has been reached.  We now anticipate a two-period high in the quarterly time- period over the next four to six quarters and in the monthly time-period over the next one to three months.  Any tick higher than May’s high at PMH: 3065.50 will satisfy that requirement.

We believe that the market price is nearing a crucial inflection point, equivalent to the “Return to Normal” point on the classic bubble-and-burst graph that has been making the rounds on Twitter.   Our rationale is as follows:

  1. Our anticipated two-period high in the monthly time-period will be satisfied with any tick above 3065.50.
  2. A market can retrace 80% of its prior move and still be corrective. Calculated using settlement prices, that level equates to 3142.00. (It can be calculated using intra-day highs and lows as well.)
  3. The March candle is the control candle. April and May’s trading activity are classified as inside-month ranges.  It will take a break of the March range to initiate the next substantial directional trend.  The high of the March candle is 3137.00.
  4. Resistance in June exists at M2: 3095.75 and M1: 3166.00 / M3: 3181.50.

OUR ANALYSIS SUGGESTS THAT THE BEST OPPORTUNITY FOR THE MARKET TO TURN LOWER IS BETWEEN 3065.75 AND 3181.50.

Support/Resistance:

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

  • M4                 3706.25
  • M3                 3181.50
  • M1                 3166.0
  • M2                 3095.75
  • PMH             3065.50      
  • Close             3042.00
  • MTrend        2782.31
  • PML              2760.25      
  • M5               2555.50

If active traders do not agree with our rationale detailed above, they can use PMH: 3065.50 as the pivot, maintaining a long position above that level and a flat or short position below it.  If active traders do agree with our rationale detailed above, they can sell against each resistance level between 3065.50 and 3181.50 with tight stops until the market sustains a turn lower.   We provide the map; you drive the car.

Natural Gas Futures

For June, we focus on Natural Gas Futures.  We provide a monthly time-period analysis of NGN0.  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Quarterly Trend    2.199             
  • Weekly Trend       1.873
  • Daily Trend           1.860             
  • Current Settle       1.849             
  • Monthly Trend      1.842

As can be seen in the quarterly chart below, Natural Gas has been “Trend Down” for five quarters.  Stepping down one time-period, the monthly chart shows that Natural Gas is in “Consolidation”, after having been “Trend Down” for five months.  Stepping down to the weekly time-period, the chart shows that Natural Gas has been “Trend Down” for four weeks.

When deciding what market analysis to include in The Cartography Corner each month, one factor that we consider is the extent of the opportunity presented by our analysis.  In June, the potential downside of (21%), as measured from our pivot, in Natural Gas caught our attention.

Support/Resistance:

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

  • M4         2.803
  • M1         2.224
  • PMH       2.162
  • M2         1.961
  • Close        1.849
  • MTrend   1.842
  • M3         1.749  
  • PML        1.741              
  • M5           1.382

Active traders can use 1.741 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

Summary

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

Major Market Buy/Sell Review: 06-01-20

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

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

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

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

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

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

S&P 500 Index

  • This past week, the market broke above the 200-dma. 
  • With that breakout we added a 5% “trading position” to portfolios. We will increase that weighting to 10% on a successful test of support at the 200-dma. This follows what we said last week:
    • The market remains overbought, so the risk is still high, but taking a trading position on a break above the 200-dma is logical.”
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No core position
    • This Week: Added 5% Trading Position
    • Stop-loss moved up to $285 for any positions.
    • Long-Term Positioning: Bearish

Dow Jones Industrial Average

  • DIA is a little different story as it continues to struggle with overhead resistance. This week it rallied above the 61.8% retracement level but remains below the 200-dma.
  • DIA continue to lag both the S&P and the Nasdaq.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions
    • Stop-loss moved up to $235
  • Long-Term Positioning: Bearish

Nasdaq Composite

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

S&P 600 Index (Small-Cap)

  • Small caps rallied again this week on a potential catch up rotation, but it remains unimpressive. On Thursday and Friday that rally failed to hold above the 50% retracement.
  • No change to our positioning on Small-caps, which are still “no place to be as both small and mid-cap companies are going to be hardest hit by the virus.”
  • Avoid small-caps. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No positions
    • This Week: No positions.
    • Stop-loss adjusted to $52 on trading positions.
  • Long-Term Positioning: Bearish

S&P 400 Index (Mid-Cap)

  • As with Small-caps, we have no holdings. 
  • The relative performance remains poor. MDY pushed above the 61.8% retracement level but is struggling with resistance at the 200-dma. This rally will likely fail in the next week or so. 
  • Mid-caps are back to very overbought. Keep stops tight.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No holding
    • This Week: No holding
    • Stop Loss moved up to $290 for trading positions. 
  • Long-Term Positioning: Bearish

Emerging Markets

  • As with small and mid-cap stocks, emerging, and international markets are underperforming the S&P 500 and Nasdaq. Maintain domestic exposure for now. 
  • We previously stated that investors should use counter-trend rallies to liquidate. EEM is testing previous highs but is struggling to gain traction. 
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position
    • This Week: No position.
    • Stop-loss moved up to $35 for trading positions.
  • Long-Term Positioning: Bearish

International Markets

  • EFA is performing a little better than EEM but not by much. 
  • The rally cleared the 50% retracement level but is now testing the 61.8% resistance. There is still nothing to get excited about currently, and the overbought condition is concerning. 
  • Relative performance is extremely poor.
  • Remain out of these markets for the time being.
  • Short-Term Positioning: Bearish – Market Risk Is High
    • Last Week: No position.
    • This Week: No position.
    • Stop-loss moved up to $54 for trading positions.
  • Long-Term Positioning: Bearish

West Texas Intermediate Crude (Oil)

  • Oil prices continued their torrid rally this past week and are now pushing up to the 50% retracement level.
  • Prices are very extended and grossly overbought. Look for a correction as we head into June.
  • We are continuing to hold our positions in XLE, but it is very overbought currently. We are going to wait for a correction this summer to add to our holdings at better prices.
  • We continue to carry very tight stops. 
  • Short-Term Positioning: Bearish
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stops Triggered for any direct crude oil positions.
  • Long-Term Positioning: Bearish

Gold

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

Bonds (Inverse Of Interest Rates)

  • Bonds have now corrected and got back to oversold while holding support. Such sets us up for two events – a rally in bonds, as the stock market corrects.
  • While we haven’t had a correction in stocks yet, bonds suggest it is coming soon. 
  • We added again to both TLT and IEF in our portfolios to hedge against our modest increases in equity risk. 
  • Short-Term Positioning: Neutral
    • Last Week: Hold positions
    • This Week: Hold positions
    • Stop-loss is $150.00
    • Long-Term Positioning: Bullish

U.S. Dollar

  • We previously added a position to the Dollar to hedge against the global dollar shortage issue. 
  • USD is testing important support at the 200-dma and must hold. We expect with the dollar oversold a rally is coming soon. 
  • Our reasoning was explained in detail in “Our 5-Favorite Positions Right Now.”
  • Stop-loss remains at $98

Riots Across America Are About More Than George Floyd

The death of George Floyd was both unjust and tragic. However, his death was the catalyst that lit a powder keg of dissension, which has simmered beneath the headlines for over a decade. 

While we focus on events that fill our media streams, it is worth remembering Oscar Grant, Trayvon Martin, Manuel Diez, Kimini Gray, and Michael Brown. These events, and many others throughout history, show civil unrest has deeper roots. Pew Research made a note of this in 2017:

“The U.S. economy is in much better shape now than it was in the aftermath of the Great Recession. It cost millions of Americans, their homes, and jobs. It led him to push through a roughly $800 billion stimulus package as one of his first business orders. Since then, unemployment has plummeted from 10% in late 2009 to below 5% today, and the Dow Jones Industrial Average has more than doubled.

But by some measures, the country faces serious economic challenges: A steady hollowing of the middle class and income inequality reached its highest point since 1928.”

Look at the faces of those rioting. They are of every race, religion, and creed. What they all have in common is they are of the demographic most impacted by the current economic recession. Job losses, income destruction, financial pressures, and debt create tension in the system until it explodes. 

It has been the same in every economy throughout history. While the rich eat cake, the rest beg on street corners for scraps. Eventually, those most disenfranchised and oppressed storm the castle walls with “pitchforks and torches.” 

The Root Of The Problem

A recent article by MagnifyMoney hit on this issue.

“As the coronavirus pandemic continues to pummel the economy, many Americans are decreasing their retirement contributions, but some are raiding their retirement accounts to pay for essentials. A new survey found 3-in-10 Americans dipped into the funds meant for their golden years — and the majority of those who have done so spent their nest egg on groceries.”

America was not prepared financially for the downturn caused by the pandemic. They are angry, financially stressed, and the visible face of their ire has become Wall Street and the Fed. 

Since the “Financial Crisis,” the role of the Federal Reserve shifted from its dual mandate of “full employment” and “price stability” to a seeming inclusion of a “third mandate” supporting consumer confidence via the inflation of asset prices. As Ben Bernanke stated in 2010: 

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose, and long-term interest rates fell when investors began to anticipate the most recent action.

Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

Unfortunately, it didn’t work out that way.

Federal Reserve, The Federal Reserve & It’s Ongoing Destruction Of The Bottom 90%

Unintended Consequences

As with all things, there are always the unintended consequences which follow. For the vast majority of  Americans:

  • Housing did not become more affordable.
  • Wall Street bought massive numbers of homes at distressed prices and went into the landlord business, which led to a rise in home prices. 
  • Many Americans, still recovering from the “Financial Crisis” were unable to obtain financing.
  • For many others, affordability due to suppressed wage growth was the issue.
  • Lower corporate bond rates didn’t lead to more investment, but rather increased share repurchases which benefited “C-Suite” executives at the expense of the working class.

Instead, as discussed previously, the Fed’s policies led to a growing divergence between the stock market and the economy. To wit:

“The one lesson that we have clearly learned since the 2008 “Great Financial Crisis,” is that monetary and fiscal policy interventions do not lead to increased levels of economic wealth or prosperity. What these programs have done, is act as a wealth transfer system from the bottom 90% to the top 10%.

Since 2008 there have been rising calls for socialistic policies such as universal basic incomes, increased social welfare, and even a two-time candidate for President who was a self-admitted socialist.

Such things would not occur if “prosperity” was flourishing within the economy. “

This is simply because the stock market is not the economy.

Stocks Are Not The Economy

The Fed’s interventions and suppressed interest rates have continued to have the opposite effect of which was intended. I have shown the following chart below previously to illustrate this point.

From Jan 1st, 2009 through the end of March, the stock market rose by an astounding 159%, or roughly 14% annualized. With such a large gain in the financial markets, one would expect a commensurate growth rate in the economy. 

After 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which totaled more than $33 Trillion, cumulative real economic growth was just 5.48%.

While monetary interventions are supposed to be supporting economic growth through increases in consumer confidence, the outcome has been quite different.

Low, to zero, interest rates have incentivized non-productive debt, and exacerbated the wealth gap. The massive increases in debt has actually harmed growth by diverting consumptive spending to debt service.

“The rise in debt, which in the last decade was used primarily to fill the gap between incomes and the cost of living, has contributed to the retardation of economic growth.”

Federal Reserve, The Federal Reserve & It’s Ongoing Destruction Of The Bottom 90%

Financial Shortcomings

The recent economic downtown caused by the pandemic has once again exposed the financial weakness that plagues the broader economy. The  report by MagnifyMoney shows nearly 50% of Americans made changes to their plans within the first month of the pandemic for basic necessities.

What this tells you is that individuals could not survive more than ONE MONTH before tapping retirement savings. But what about the 50-60% of individuals that didn’t have a plan to start with?

“A 2018 report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.”

, Boomers Are Facing A Financial Crisis

Here are some findings from that report:

  • Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
  • The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
  • Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.

Read those finding again.

If we use a more optimistic number of 50%, then 50% of American workers did not have the ability to tap additional “savings” to offset financial hardships during the pandemic.

It’s no wonder they are in the streets rioting.

Federal Reserve, The Federal Reserve & It’s Ongoing Destruction Of The Bottom 90%

Only The Few

While the “savings rate” suggests that individuals are “hoarding money” due to the downturn, the reality is quite different. If American’s had savings they would not be tapping into 401k plans and begging for checks. However, Deutsche Bank recently showed the savings rate for 90% of Americans is negative. 

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

This is far different than the Governmental statistics suggesting the average American is saving 33% of their income.

In actuality, if you aren’t in the “Top 20%” of income earners, you probably aren’t saving much, if any, money.

The problem for the Fed is their own policies are what created the “wealth gap” to begin with. As noted by the WSJ.

“As of December 2019—before the shutdownshouseholds in the bottom 20% of incomes had seen their financial assets, such as money in the bank, stock and bond investments or retirement funds, fall by 34% since the end of the 2007-09 recession, according to Fed data adjusted for inflation. Those in the middle of the income distribution have seen just 4% growth.” – WSJ

Federal Reserve, The Federal Reserve & It’s Ongoing Destruction Of The Bottom 90%

This isn’t surprising. A recent research report by BCA confirms one of the causes of the rising wealth gap in the U.S. The top-10% of income earners owns 88% of the stock market, while the bottom-90% owns just 12%.

Federal Reserve, The Federal Reserve & It’s Ongoing Destruction Of The Bottom 90%

The Fed Did It

The lack of economic improvement is clearly evident across all demographic classes. However, it has been the very policies of the Federal Reserve which created a wealth transfer mechanism from the poor to the rich. The ongoing interventions by the Federal Reserve propelled asset prices higher, but left the majority of American families behind.

The problem is the Fed has become trapped by its policies, and consequently, started taking direction from Wall Street. Such has led the Federal Reserve to become a “hostage” of its own making.

If the Fed removes any monetary accommodation, the market declines. The Fed is forced to subsequently increase support for the financial markets, which exacerbates the wealth gap.

It’s a virtual spiral from which the Fed can not extricate itself. It’s a great system if you are rich and have money invested. Not so much if you are any one else.

As we are witnessing, the United States is not immune to social disruptions. The source of these problems is compounding due to the public’s failure to appreciate “why” it is happening.

Eventually, as has repeatedly occurred throughout history, the riots will turn their focus toward those in power.

That, as they say, is when “s*** gets real.” 

Breakout! Market Breaks Above 200-DMA. Is The Bull Back?


In this issue of “Market Breaks Above 200-DMA, Are All-Time Highs Next?”

  • Market Breaks Above 200-DMA
  • Are Bulls TOO Optimistic
  • Technical Review
  • Portfolio Positioning
  • MacroView: CFNAI Crashes Most On Record, 
  • Sector & Market Analysis
  • 401k Plan Manager

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


Upcoming Event  – CANDID COFFEE

Sign up now for this virtual “Financial Q&A” GoTo Meeting

June 13th from 8-9 am

Send in your questions and Rich and Danny will answer them live.


Catch Up On What You Missed Last Week


Market Breaks Above The 200-DMA

In last week’s missive, we discussed how the market remained stuck between the 50- and 200-dma. At that time, we noted the risk/reward ranges, which encompassed a breakout or retracement within that range. (The chart is updated through Friday’s close.)

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

While the market did break above the 200-dma, such does not change the negative risk/reward characteristics of the market.

  • -2.8% to the 200-dma vs. +1.7% to the March peak. Negative
  • -9.2% to the 50-dma vs. 5.6% to February gap down. Negative
  • -10.5% to the consolidation support vs. +10.1% to all-time highs. Neutral
  • -19.7% to April 1st lows vs. +10.1% to all-time highs. Negative
  • -27% to March 23rd lows vs. +10.1% to all-time highs. Negative

However, as stated last week, the break above the 200-dma is currently changing the complexion of the market.

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

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

While the negative risk/reward dynamics are evident, the more negative outcomes are becoming less probabilistic. However, on a longer-term basis, a deeper correction becomes more possible, given the deviation in prices from the underlying fundamentals. 

Are Market Bulls Too Optimistic

Currently, the markets are rallying in hopes of a “V-Shaped” economic recovery, which will be supported by a COVID-19 vaccine and no second wave of the virus. If such is the case, then it is expected the depression level readings of unemployment and GDP will quickly reverse, supporting the stock market’s current valuations.

There are several underlying problems with this narrative:

  1. There is a very high probability that as states reopen their economies, there will be a “second-wave” of COVID-19.
  2. Out of the dozens of companies that are in the process of developing both therapeutics and a potential vaccine, the odds are incredibly high the vast majority, if not all, will fail.
  3. Corporate profits and earnings were already struggling, heading into the recession. While they will rebound as the recession passes, they are unlikely to return to levels to support current valuations.
  4. Unemployment will likely remain higher for longer than expected. Up to 50% of small businesses, which account for about 25% of all employment, are expected to shutdown. Consumption, which is where earnings and profits come from, will be cut accordingly. 

Currently, investors have gotten back to more extreme stages of bullishness as the market has relentlessly rallied from the lows. 

Valuations Matter Long-Term

However, the complete detachment from the underlying fundamentals is likely to weigh on the markets soon than later. Irrespective of Fed stimulus, valuations do matter over the longer-term time and will drive forward returns.

The problem is the valuation levels are worse than shown as earnings are still being revised lower, and will get worse. We know this because corporate profits were released this past week for Q1 and showed a record drop. That drop was for a quarter where the shutdown accounted for only 2-weeks of the reporting period. The decline in the second quarter will be materially worse as the entire month was lost to the pandemic.

Castle Of Sand

We can see the deviation between GAAP earnings and corporate profits if we use the data for first-quarter.

The shaded areas show the lag between the decline in profits and the decline in GAAP earnings. Over the next couple of quarters, profits are forecasting a much deeper decline for S&P 500 earnings. With estimates still in the $95/share range, we could see a rather substantial decline.

As stated, investors have priced in a “perfect” economic recovery story. Such leaves much room for disappointment as the deviation between what investors “expect,” and “reality” is at the highest level on record.

Historically, sharp declines in corporate profits are met by equally sharp declines in GAAP earnings.

While investors are “hopeful” this time will be different, the reality of 40-million unemployed, mass failures of small businesses, and a contraction in consumption, argues differently.

“It’s too ‘happy days are here again. It’s just not going to work like that. Not with 38 million unemployed. You can’t keep building on a castle of sand. I see a lot of quicksand underneath some moves. I wish we would just calm down and digest some of these things.” – Jim Cramer, Mad Money

Technical Review Of The Market

No matter how you want to slice the data, the markets are back to more egregious overbought conditions on a short-term basis. With the markets very overbought, and in a very tight ascending wedge, watch for a break to the downside to signal the start of a correction.

Also, with roughly 95% of stocks now trading above the 50-dma, such has historically signaled short-term corrections to resolve the overbought condition.

While much of the media has been talking about positive returns from stocks over the next 12-24 months, we could also have a 2015-2016 type scenario.

At that time, the markets climbed above the 200-dma, combined with a “Golden Cross” as the 50-dma also “crossed the Rubicon.”  While the media bristled with bullish excitement, it was quickly extinguished as the markets set new lows as “Brexit” engulfed the headlines.

Importantly, while concerns about a “Brexit” on the global economy were valid, “Brexit” never materialized. Conversely, the economic devastation in the U.S., and globally, is occurring in real-time. The risk of a market failure as “reality” collides with “fantasy” should not be dismissed. It CAN happen.

Lastly, speaking of the number of stocks above the 50-dma, that indicator is laid behind the S&P 500 in the chart below. Historically, whenever all of the overbought/sold indicators have aligned, along with the vast majority of stocks being above the 50-dma, corrections were close.

Such doesn’t mean the next great “bear market” is about to start. It does mean that a correction back to support that reverts those overbought conditions is likely. Therefore, some prudent risk management may be in order.

Portfolio Positioning For An Overbought Market

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

Positioning, and the related risk, remains our primary focus. This past week made changes that reduced risk in our overall portfolio by taking profits out of the largest gainers and adjusting weightings in defensive holdings. The following is trade commentary provided to our RIAPRO subscribers (30-day Risk-Free Trial)

Rebalancing The Equity Portfolio

In the equity portfolio we have rebalanced our exposures to align with our Relative Value Sector Report:

We are taking profits in:

  • AAPL – 1.5% to 1% portfolio weight
  • MSFT – 1.5% to 1%
  • CHCT – 1.5% to 1%
  • MPW – 1.5% to 1%
  • RTX – 1.5% to 1.25%
  • ABBV – 1.5% to 1.25%

We added exposure to:

  • UNH – 1.5% to 2% portfolio weight
  • DUK – 1.5% to 2%
  • AEP – 1.5% to 2%
  • NFLX – 1% (Trade only – see Jeffrey Marcus commentary)

Taking profits in our portfolio positions remains a “staple” in our risk management process. We have also increased our treasury bond and precious metals to hedge our increased risk over the last two months.

We don’t like the risk/reward of the market currently, and continue to suspect a better opportunity to increase equity risk will come later this summer. If the market violates the 200-dma or the ascending wedge, as noted above, is breached to the downside, we will reduce equity risk and hedge further.

I will conclude this week with a quote from my colleague Victor Adair at Polar Trading:

The growing divergence between the ‘stock market’ and the economy the past couple of months might be a warning flag that Mr. Market is too exuberant. The Presidential election is just over 5-months away with polls showing that Biden may be the next President. The U.S./China tensions have been escalating, and the virus’s first wave continues to spread around the globe. However, the ‘stock market’ continues to be pulled higher by a handful of ‘Megacaps.’ The late Friday rally after Trump’s ‘punish China’ speech shows ‘animal spirits’ are alive and well!”

I agree, and while such may be the case for the moment, markets like this have a nasty habit of delivering unpleasant surprises.

Pay attention to how much risk you are taking.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet

Will return next week.


Performance Analysis

Will return next week.


Technical Composite

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


Sector Model Analysis & Risk Ranges

How To Read.

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


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels.

Sector-by-Sector

Improving – Materials (XLB), and Energy (XLE)

This past week, the market finally broke out above the 200-dma. Materials continue to underperform due to a fragile economy, and there is no reason to maintain exposure to the sector currently.

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

Current Positions: 1/3 position XLE

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

Previously, we added to our core defensive positions Healthcare, Staples, and Utilities. We continue to hold our exposures in Technology. This week we adjusted weightings in our portfolios to these areas specifically to alter our risk profile. These sectors are continuing to outperforming the S&P 500 on a relative basis and have less “virus” related exposure.

Current Positions: XLK, XLC, and XLV

Weakening – Utilities (XLU), and Staples (XLP),

After adding a small weighting in Utilities previously, we added to our positions in the equity portfolio this week. XLP is underperforming at the moment, but we continue to like the defensive qualities of the holdings, especially when a second wave of the COVID-19 virus occurs

Current Position: XLP, 1/3rd Position XLU

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

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

Real Estate is lagging currently but remains a “risk-off” rotation trade, but is starting to show some relative improvement. If it turns up meaningfully, we will add to our current holdings.

Current Position: 1/2 position XLRE

Market By Market

Small-Cap (SLY) and Mid Cap (MDY) We continue to avoid these sectors for now aggressively, and there is no rush to add them anytime soon. With roughly 50% of small businesses expected to fail, there is significant risk in these two markets. Be patient as small and mid-caps are lagging badly.

The rally last week failed over the previous two trading sessions as expected. We expect to see further underperformance next week.

Current Position: None

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

Same as Small-cap and Mid-cap. Given the spread of the virus and the impact on the global supply chain, we continue to expect underperformance. There was a brief rotation rally last week like we have seen previously, that will likely fail next week. Continue to avoid these markets for now.

Current Position: None

S&P 500 Index (Core Holding) – Given the overall uncertainty of the broad market, we previously closed out our long-term core holdings. We are currently using SPY as a “Rental Trade” with the break above the 200-dma. We have stop set slightly below that support level.

Current Position: None

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

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

Bonds (TLT) –

As we have been increasing our “equity” exposure in portfolios, we have added more to our holding in TLT to improve our “risk” hedge in portfolios. With the bond market oversold currently, we are looking at potentially adding more exposure next week.

Current Positions: SHY, IEF, BIL, TLT

Sector / Market Recommendations

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

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

Portfolio / Client Update

This past week, the market broke above the 200-dma, but it was overly convincing. We added a 5% “rental” trade to portfolios using SPY, which will increase to 10% if the market holds the 200-dma next week.

As discussed above, the market is extremely overbought. Still, there is some short-term upside as momentum continues to push stocks. The markets can “taste” all-time highs in the Nasdaq, which will pull the S&P 500 due to the largest cap-weighted names in both indices. As we head further into the summer months, the relative risk/reward ratio is not in our favor. (Please see the analysis in the main body of this week’s message.)

The economic data is getting substantially worse in “real” terms. Such is going to drag on earnings and profits, which the market will pay attention to eventually. While it certainly seems that no matter how dire the data is, the market only wants to go higher, such is also the trap. We are mindful of how markets work over more extended periods, but also realize performance is crucial to you. Therefore we continue to add exposure and balance risk as we can.

Changes

Our process this week remains the same. We continue to work around the edges to add exposure while managing risk. In the equity portfolios, we adjusted holdings, as noted in the main missive above, by taking profits and adding to defensive areas. Our additions of NFLX, and INTC, and increases in DUK and AEP, continue to balance risk appropriately.

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

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

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

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

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

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

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

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

#MacroView: CFNAI Economic Indicator Crashes Most On Record

In 2013, I wrote an article discussing comments made by Russ Koesterich, CFA, regarding the Chicago Fed National Activity Index (CFNAI). Given this economic indicator just crashed by the most on record, it is worth reviewing his comments. To wit:

“While economic numbers like GDP or payroll reports garner the headlines, the most useful statistic often goes ignored by investors and the press.”

On Thursday, the Bureau of economic analysis released revisions to the GDP report for the first quarter of 2020. It fell from a 2.3% annual real growth rate in the 4th quarter of 2019 to a -5% rate in the first.

Importantly, the decline in the first quarter only encompassed 2-weeks of the economic shutdown. Considering the entire month of April was a “bust,” we already have a good idea Q2-2020 GDP will be substantially worse.

To gauge just how bad it will be, we could look at the New York or Atlanta Federal Reserve’s real-time GDP trackers. We are currently tracking more than a 30% decline in the second quarter, which is where we derived the estimate in the chart above.

Regardless, we are discussing unprecedented numbers going back to 1947 when the tracking of the data began.

A Better Measure

As noted, the Chicago Fed National Activity Index (CFNAI) often goes ignored by investors and the press. Importantly, the CFNAI is a composite index made up of 85 sub-components, which gives a broad overview of overall economic activity in the U.S.

The markets have run up sharply over the last couple of months because the Federal Reserve intervened again in the markets. The hopes are the record plunge in GDP in Q2 will be reversed with a record surge in Q3. However, a 30% decline in GDP, followed by a 30% advance, does not get you out of a recession. (A 30% recovery number is wildly optimistic, most likely we will see a 15-20% increase) 

If recent CFNAI readings are any indication, investors may want to alter their growth assumptions for next year. Most economic data points are backward-looking statistics, like GDP itself. However, the CFNAI is a forward-looking metric providing some indication of how the economy will look in the coming months.

If the CFNAI is currently even close to historical accuracy, current expectations are likely overly optimistic.

Breaking CFNAI Down

To garner a better understanding of the index, let’s dig into its construction. From the Chicago Fed website:

“The CFNAI is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates the national economy is expanding at its historical trend rate of growth. A negative value indicate below-average growth, and positive values indicate above-average growth.

The overall index is broken down into four major sub-categories which cover:

  • Production & Income
  • Employment, Unemployment & Hours
  • Personal Consumption & Housing
  • Sales, Orders & Inventories

To better grasp these four major sub-components and the predictive capability, I have constructed a 4-panel chart. The chart compares each sub-component to the most common matching economic reports on an annualized basis.

  • Industrial Production
  • Employment
  • Housing Starts
  • Personal Consumption Expenditures. (70% of GDP)

Analyzing the data in this manner provides a comparative base to the construction of the CFNAI.

The correlation between the CFNAI sub-components and the underlying major economic reports do show some very high correlations. Even though this indicator gets very little attention, it is very representative of the broader economy. Currently, the CFNAI is suggesting the mainstream view of a deep but short recession, is likely wrong.

A Composite Match

The CFNAI is also a component of our RIA Economic Output Composite Index (EOCI). The EOCI is a broader composition of data points, including Federal Reserve regional activity indices, the Chicago PMI, ISM, National Federation of Independent Business Surveys, PMI composites, and the Leading Economic Index. Currently, the EOCI further confirms that “hopes” of an immediate rebound in economic activity is unlikely. To wit:

“There is much hope that as soon as the ‘virus quarantine’ is lifted, everyone will return to work. The reality is that many businesses will cease to exist. Many more will be very slow to return to normal, and all businesses will be slow to rehire. Such will be the case until there is sufficient demand to support expanded payrolls.”

“Currently, the EOCI index suggests there is more contraction to come in the coming months. Such will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading further into 2020.”

The last sentence is the most important. Currently, the stock market is running at some of the highest valuations on record relative to both reported earnings and corporate profits. Given the economic debasement that is coming, the risk earnings estimates are still overly optimistic is a significant risk.

The correlation between the EOCI index and the market, as shown above, provides a clear warning. Currently, equity markets are priced as if the recession and economic compression have already passed. It hasn’t.

Forecasting The Market

The warning of lower asset prices from the EOCI is also confirmed by the CFNAI index.

The Chicago Fed also provides a breakdown of the change in the underlying 85-components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components provide us a better understanding of the broader changes inside the index itself.

There two important points of consideration:

  1. When the diffusion index dips below zero, such has coincided with weak economic growth and outright recessions. 
  2. The S&P 500 has a history of corrections, and outright bear markets, which correspond with negative reading in the diffusion index.

The second point should not be surprising as the stock market ultimately reflects economic growth. Both the EOCI index and the CFNAI maintain a correlation to the annual rate of change in the S&P 500. Again, the correlation should not be surprising. (The monthly CFNAI data is very volatile, so we use a 6-month average to smooth the data.)

How good of a correlation is it? The r-squared is 50% between the annual rate of change for the S&P 500 and the 6-month average of the CFNAI index. More importantly, the CFNAI suggests the S&P 500 should be trading 64.7% lower to correspond with the economic damage. Throughout its history, the CFNAI tends to be right more often than market players.

Investors should also be concerned about the high level of consumer confidence readings. While they have fallen from recent peaks, as we warned in 2019, they have yet to fall enough to correspond with the economic damage still forthcoming.

Overly Confident In Confidence

Here is a snippet from the article linked above:

“The RIA Composite Confidence Index, combines both the University of Michigan and Conference Board measures. The chart compares the composite index to the S&P 500 index. The shaded areas represent when the composite index was above a reading of 100.

On the surface, this is bullish for investors. High levels of consumer confidence (above 100) have correlated with positive returns from the S&P 500.”

The issue is the divergence between “consumer” confidence and that of “CEO’s.” 

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company that has the best view of the economic landscape. Sales, prices, managing inventory, dealing with collections, paying bills, tells them what they need to know about the actual economy?”

Notice that CEO confidence leads consumer confidence by a wide margin. Such lures bullish investors, and the media, into believing that CEO’s don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

“I’m sorry, we think you are great, but I have to let you go.” 

Despite hopes of a quick rebound in the economy and employment, the decline in CEO confidence suggests employment may be slow to return.

More Confirmation From CFNAI

The CFNAI also tells the same story as significant divergences in consumer confidence eventually “catch down” to the underlying index.

As I noted in October 2019:

“This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead, if history is any guide to the future.”

While no one believe that statement then, the data was already telling us an important story.

CFNAI Includes The Fed

Importantly, the historical data of the CFNAI and its relationship to the stock market have included all Federal Reserve activity.

The CFNAI, and EOCI, incorporate the impact of monetary policy on the economy in both past and leading indicators. Such is why investors should hedge risk to some degree in portfolios as the data still suggests weaker than anticipated economic growth. The current trend of the various economic data points on a broad scale is not showing indications of a recovery, but of a longer than expected recession and recovery. 

Economically speaking, such weak levels of economic growth do not support more robust employment, higher wages, or justify the markets rapidly rising valuations. Weaker economic growth will continue to weigh on corporate earnings and profits as troughs in the data have not yet been reached.

Portfolio Positioning

From a portfolio positioning perspective, if both the CFNAI and EOCI are correct in their outlooks, the rotation into cyclical, small-, and mid-capitalization stocks is likely wrong. As the economic impact weighs on earnings growth, defensive positioning will continue to pay dividends (literally.) At the same time, bonds will gain in price as yields fall towards zero. 

The current rotation from the March lows was based on the premise of a sharp economic rebound. However, the data hasn’t confirmed it as of yet. Such also sets the market up for disappointment when the expected recovery in earnings growth fails to appear.

Reviewing the data from both the CFNAI and EOCI suggests the last point is most likely, as the driver for the former is lacking.

Maybe the real question is, why aren’t we paying closer attention to what these indicators are telling us?

Shedlock: New Jobless Claims Top 2-Million For 10-Straight Weeks

Initial jobless claims for the week ending May 23 were 2,123,000. That’s the 10th-week claims topped 2-million.

Ten-Week Total Jobless Claims

The ten-week running total of initial claims is 40.732 million.

However, some of those workers have been called back as states have opened. Also some people submitted claims and were not really eligible.

Continuing claims paint a better picture at this point as to what is happening.

Continued Unemployment Claims

Continued Unemployment Claims 2020-05-28

First Dip Continuing Claims in 9 Weeks

Continued claims lag new claims by one week. They took their first dip in 9 weeks.

For the week ending May 16, continued claims were 21,052,000 down from 24,912,000 for the week ending May 9.

BLS Reference Week

The reference week for the BLS Household Survey unemployment report is the week that contains the 12th of the month. It is that week’s survey that determines the unemployment rate.

For the May Jobs Report coming out Friday, June 5, the reference week was May 10 through May 16.

Household Data from April Jobs Report

Household Survey April 2020

As noted on May 9, there was a 6.4 Million Discrepancy Between Employment and Unemployment.

The BLS is very aware they published a bogus unemployment number for April and issued this notice.

If the workers who were recorded as employed but absent from work due to “other reasons” (over and above the number absent for other reasons in a typical April) had been classified as unemployed on temporary layoff, the overall unemployment rate would have been almost 5 percentage points higher than reported (on a not seasonally adjusted basis). However, according to usual practice, the data from the household survey are accepted as recorded. To maintain data integrity, no ad hoc actions are taken to reclassify survey responses.

Data Integrity

To maintain “data integrity” the BLS reported a number known to be bogus.

There is still more to this BLS fiddling saga.

Click on the preceding link for details about Seasonal Adjustments and  an unusual statement regarding their Birth-Death model adjustments.

Unemployment Rate Calculation

For a change, we have a solid reference point on which to make an advance estimate of the unemployment rate.

If we assume the number of unemployed is roughly equal to the number of continued claims (likely +- a few million) and we also assume the BLS will do a better job this month of elicting the correct answers (questionable), we can calculate the unemployment rate as follows:

Unemployment Rate = (Unemployed / Labor Force) * 100

UR = (21.052 million / 156.481 million) * 100 = 13.5%

If so, that would be down from 14.7% in April.

The equation makes an additional assumption that the Labor Force will not change much and the BLS does not further mess with their Birth-Death model.

Given the assumptions, a range of 12%-17% seems about right.

Regardless, there will be a long road to job recovery as noted by recent reports.

Boeing is the Tip of the Layoff Iceberg

Please consider Boeing is the Tip of the Layoff Iceberg

Yesterday, Boeing announced over 12,000 Layoffs in the wake of plane cancellations and dearth of new orders.

Also note 114,327 Retail Job Cuts, Most on Record, as More Stores File Bankruptcy.

Retailers Pier 1 Imports, JC Penney, J. Crew, and Neiman Marcus have all filed for bankruptcy.

Malls in general are dying. 9,300 stores closed in 2019, breaking the record of 8,000 store closures in 2018. According to Coresight Research, another 15,000 stores could close in 2020.

The energy and service sectors are also hard hit.

How many people will soon go back to their old ways of dining out as much, going to the movies, getting their nails done, singing karaoke?

Fed Can Print Money But It Cannot Print Jobs

That’s a nice saying but I did not come up with it. I can find at least three instances dating back to 2010.

Belts and Suspenders

However, I can claim a sarcastic Don’t Worry, the Fed has Belts and Suspenders

Unfortunately, all the Fed is doing is creating zombie corporations unable to survive expect with permanently low interest rates.

Grim Economic Data

  1. 5/8: Over 20 Million Jobs Lost As Unemployment Rises Most In History
  2. 5/15: Retail Sales Plunge Way More Than Expected
  3. Also 5/15: Industrial Production Declines Most in 101 Years
  4. Also 5/15: GDPNow Forecasts the Economy Shrank by a Record 42%. It’s 51.2% as of May 29th.

Ripple Impacts May Last Years

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

Global COVID-19 Risk Ranges Up to $82 Trillion

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

Ripple Impacts

For a detailed synopsis of the state of the economy and the ripple impacts, please see The Economy Will Not Soon Return to Normal: Here’s Why.

S&P 500 Monthly Valuation & Analysis Review – 6-01-2020

S&P 500 Monthly Valuation & Analysis Review



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

Arete’s Observations 5/29/2020

David Robertson, CFA serves as the CEO and lead Portfolio Manager for Arete Asset Management, LLC. Dave has analyzed stocks for thirty years across a wide variety of sizes and styles. Early in his career, he worked intimately with a sophisticated discounted cash flow valuation model which shaped his skill set and investment philosophy. He has worked at Allied Investment Advisers and Blackrock among other money management firms. He majored in math with extensive studies in economics and philosophy at Grinnell. At Kellogg, Dave majored in finance, marketing, and international business while completing the CFA program concurrently.

Market observations

The market got off to a strong start this week and again with little incremental news or information to provide a clear rationale. Nice weather (in the northeast) over the holiday weekend probably helped as did reopenings in many locations.

In addition, there is certainly a widespread belief that the additional liquidity major central banks have provided in the last couple of months is bound to support stock prices. Technical indicators may also be playing a part as major indicators are approaching important thresholds. I also wouldn’t neglect any of the reasons I have suggested in prior notes either.

All of that said, there is yet another factor that strikes me as especially interesting. For the past sixteen days (by this chart) the S&P 500 is virtually unchanged during the day session; all the action has happened overnight.

As it turns out, this pattern goes back a long time. It is easy to hypothesize that some actors are buying futures in low volume at night and selling them when new flows come in the next day.  

The more important takeaway, however, is this activity does not represent how most investors visualize the market nor is it an indicator of overwhelming market health. Sure, prices move, but not in a way that reflects ongoing processing of economic and business information.

Economy

Bankruptcy Tsunami Begins: Thousands Of Default Notices Are “Flying Out The Door

“’The default letters from landlords are flying out the door,’ said Andy Graiser, co-president of commercial real estate company, A&G Real Estate Partners. ‘It’s creating a real fear in the marketplace’.”

I have highlighted this before and I am highlighting it again because I think the issue of impending bankruptcies is not getting enough attention. One reason is that as the quote highlights, tensions flare and behaviors change long before a bankruptcy ever happens. Another is that even when bankruptcy does occur, it is a process that takes time. Fortunately, that process is reasonably efficient in the US, but it certainly doesn’t happen overnight.

Finally, and importantly, when a company goes bankrupt, it’s capital gets restructured which typically means the equity is destroyed and debt is written down to a sustainable level. In that process, money gets destroyed. This is key. While the Fed has provided a great deal of liquidity thus far, that will be offset by liquidity that evaporates through the process of bankruptcies. In one door, out the other.

Another factor to keep in mind is that the efficiency of that bankruptcy process will depend on having adequate capacity. Gillian Tett reports in the Financial Times how strains are already appearing.

Swamped bankruptcy courts threaten US recovery

“What is even more alarming is that America’s legal and financial infrastructure seems ill-prepared.” 

“The fifth — and biggest — problem is a shortage of judges.”

“The alternative is a plague of zombies, sitting in legal limbo, that saps economic growth, erodes enterprise values and creates more investor uncertainty.”

Housing

Ivy Zelman and Barry Habib presented at the Mauldin Strategic Investment conference and provided some interesting insights into the US housing market. By way of background, Zelman is one of the pre-eminent analysts on housing and homebuilders and Habib has done excellent work exposing the intricacies of the mortgage market.

Both were more optimistic about the housing market than I would have guessed. An important reason is demographics. The prime age to buy a house is 33 years old and that segment of the population will be growing for the next several years. So, the demand side looks solid.

Another reason is the way homebuilders have adapted since the last crisis. During the last housing boom, buyers wanted bigger and bigger houses and builders competed to acquire property in attractive areas with good schools.

Now, builders are focusing much more on entry level homes where the incremental demand is. Accordingly, “now 70% of new builds are FHA approved”. Indeed, Zelman pointed out that for most markets, excluding the coasts, owning is cheaper than renting.

It will be interesting to see how this affects demand for housing in cities outside of the top tier. While some first-time home buyers are clearly looking to get out of the city altogether, I suspect quite a few will still be attracted to what cities have to offer. It will be interesting to see if cities that are less dense and more affordable than New York City gain some population.

Tidbits

$650 Billion Facebook To Cut Pay Of Remote Workers Moving To Lower Cost-Of-Living Areas

“The company could be cutting pay – or ‘adjusting compensations’ as CNBC so lovingly put it – based on the cost of living of where people will be working from.” 

“We’ll adjust salary to your location at that point. There’ll be severe ramifications for people who are not honest about this”

Facebook was a good early indicator of the work from home trend when it implemented the policy early in March. We’ll see if it will also be a good leading indicator for compensation adjustments. Regardless, this will be an interesting additional element for workers to incorporate into calculations about moving out of major cities. If it becomes more widespread, it could also have very interesting effects on inflation.

Canada

Almost Daily Grants email, 5/20/20   “The Canada Mortgage and Housing Corp. (a government sponsored mortgage insurer similar to Fannie Mae in the U.S.) sounded the alarm yesterday evening, as CEO Evan Siddall testified to the House of Commons that pandemic-related problems in the housing market are ‘cause for concern for Canada’s long-term financial stability’.”

“Signs of housing-related distress have appeared in greater frequency on the northern side of the border.  Canadian mortgage payment deferments account for roughly 12% of all mortgages according to the CMHC, up from 0.3% at year-end (by comparison, 8.2% of U.S. mortgages are in forbearance as of May 10).”

Canada never suffered a housing crisis the way the US did in the mid – late 2000s and as a result, never experienced a recalibration. That appears to be happening now. As house prices continued to climb, so did household/GDP. By a recent survey, Toronto and Vancouver rank as two of the very least affordable housing markets in the world.

This would be problem enough as is, but the Canadian economy is also heavily dependent on natural resources. As a leading exporter of oil and natural gas, the price declines of those commodities this year will severely affect the economy through lower income and lost jobs. This isn’t going to be fun.

China

“Points of return” email from John Authers, 5/26/20

It is probably fair to say that one of the more important flashpoints across the globe right now is Hong Kong. Belligerent rhetoric between the US and China has been escalating, most recently in the form of a clampdown on Hong Kong security by China.

There is a key point worth keeping in mind here. Hong Kong is a critical entrée to doing business in China because it represents the best of both worlds: stable rule of law on one side and access to China on the other. That appears to be changing. The implication is that there will be a different way of doing business with China for many companies going forward.

Credit

Almost Daily Grants, 5/22/20

“Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, noted that between January 20 and May 15, option-adjusted spreads across the bond market widened in relative lockstep, with triple-As jumping to 107 basis points from 54bps (or 1.98 times wider) and single-Bs to 805bps from 335bps, a 2.4 times ratio.  The one outlier was from the double-B contingent, which more than tripled to 560bps from 186bps. Fridson concludes: ‘Imperfect absorption of newly created fallen angels is a bona fide effect’.” 

Fridson is one of the foremost experts when it comes to high yield and the point he makes here is absolutely worth watching. With the investment grade (IG) bond market much larger than that of high yield, and with a huge portion of IG bonds rated right at the threshold of high yield, there is all kinds of potential for indigestion when IG bonds get downgraded. Fridson’s data show this is already happening.

Topics – inflation vs deflation

“Tree rings” letter by Luke Gromen from 5/22/20.

Gromen raised an interesting point that I have heard few others talking about. In no time flat, The Treasury General Account (TGA) has exploded from about $400B to over $1T. And this happened after several years when it never breached $200B.

According to Investopedia, the TGA is the Treasury’s “general checking account” and “The U.S. government makes all official payments from this account”. All of this begs the question, “what are the monster bills that are coming due?”

“… if the US government begins to spend the record $1.1 trillion it currently has sitting in the Treasury General Account (TGA) into the economy over the next 4-5 months in an attempt to juice the economy (and markets) ahead of the election.”

Gromen’s hypothesis is that this a war chest for the upcoming election. While this theory certainly has some conspiratorial notes to it, they happen to also be corroborated by Janan Ganesh, who has done an excellent job covering US politics for the FT

Donald Trump has a way to win the US presidency again: spend massively

“As his standing deteriorates, then, Mr Trump has one hope. He must ‘own’ the fiscal effort to save the economy. This means demanding another bill to that end — Congress passed the first in April — and skewing it to households over business. It means rivalling Joe Biden’s Democrats for federal largesse and not fretting about moral hazard. The president must spend his way to re-election.”

Who knows, maybe we’ll see some significant increases in inflation at the end of the summer in important swing states?

Implications for investment strategy

The Three Sides of Risk

Risk and risk management are subjects that typically cause eyes to glaze over so its unusual to find a discussion of the subject as captivating as Morgan Housel’s. In a beautifully written piece, Housel highlights one of the most important lessons investors could ever learn:

“In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on.”

What does this mean for investors? For one, it means that the vast majority of daily news and research will not have any material effect on long-term outcomes like retirement. As a result, they are not things investors should focus on. This is a point I made in a recent blog: https://www.areteam.com/blog/investing-for-the-end-game.

What types of things should be focused on? For one, valuations are excellent indicators of future returns over long periods of time. If you buy at excessive valuations, like they are right now, the chances of realizing attractive future returns is exceptionally low.

Another issue to focus on is investment strategy. Over the last 35 years or so, both stocks and bonds have performed remarkably well. That means the mix hasn’t really mattered much, so long as you didn’t have too much cash.

The record of financial assets over the last 35 years stands out as an anomaly across a broader history and broader geographic scope, however. In other words, one of the most damaging things that can happen to many investors is that neither bonds nor stocks perform very well through one’s investment horizon. If both perform poorly, with insufficient cash reserves, retirement income could be substantially impaired.

Yet another tail-end consequence is inflation – which is why I have been doing so much research on the subject. I don’t think inflation is an imminent threat, in fact, I believe deflation is the more imminent prospect. However, I also believe that the landscape is setting up such that the emergence of inflation is a distinct possibility well within the investment horizons for a lot of people. If it does emerge, it will wreak havoc with a lot of investment portfolios.

At this point, I would like to add a few comments about value and valuation. The reason why the value investment style has worked over time is because it based on a discipline of not overpaying for securities. The key is to buy something cheap enough so as to ensure a margin of safety in the investment.

Unfortunately, this approach has performed dismally for over ten years now:

Source: John Authers “Points of Return” email, 5/28/20

This raises an extremely important conundrum for investors: Why has value underperformed so substantially and when can it be expected to regain its longer-term advantage?

There are two parts to the answer and they are related. One is that economic growth has just not been especially strong and corporate debt has continued to rise. As a result, stocks that are cyclical or confronted by idiosyncratic challenges do not have the tailwinds to help them through to the other side like they have had in the past.

Another part is that monetary policy exacerbates these conditions. Low rates encourage higher debt levels which in turn constrains economic growth. Also, measures to “ensure liquidity” are also measures that prevent or abbreviate significant selloffs. As a result, the opportunities for value investors to buy cheap are significantly limited.

The result is captured perfectly by Demonetized in a post at https://www.epsilontheory.com/the-end-of-the-beginning/: “Economic policy will hamper mean reversion.” In other words, monetary policy has substantially undermined the mechanisms which tend to generate excess returns for the value approach.

Unfortunately, these policies put investors in a terrible position. You can invest in value stocks even though policies continue to constrain their performance. Not fun and not profitable, at least for the time being. Or, you can chase growth stocks regardless of valuation which almost ensures terrible returns over the long-term. Fun for a while, but ultimately not profitable.

At some point these things will change and we can pick up where we left off. For now, however, it is incredibly important to be paying attention to “the tail-end consequences of risk”.

Feedback

This publication is an experiment intended to share some of the ideas I come across regularly that I think might be useful. As a result, I would really appreciate any comments about what works for you, what doesn’t work, and what you might like to see in the future. Please email comments to me at drobertson@areteam.com. Thanks!        – Dave

Re-imagining Investment Services

While I have always believed that the investment management industry is well placed to provide helpful services for investors, I also believe that the industry has not stood out as an exemplar of aggressively improving outcomes for investors. My white paper, “Re-imagining Investment Services”, lays out how the investment landscape has changed and suggests some ways in which service providers might adapt to meet new challenges and opportunities.

If you would like to get a copy of the white paper please email me at drobertson@areteam.com.

Principles for Areté’s Observations

  1. All of the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.
  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.
  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.
  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.
  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization’s particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.

Relative Value Sector Report 5/29/2020

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

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

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

Commentary

  • The most notable trade over the last week was a rotation from Technology and Communications into some of the more beaten-down sectors. As a result, XLK is now a slight bit oversold, and XLC is not nearly as overbought versus the S&P 500.
  • Of the “beaten down” sectors, banks, materials, industrials, and transportation stocks are all in overbought territory. Transportation (XTN) and materials (XLB) are worth watching for underperformance versus the market.
  • While not displayed below, both small-caps and mid-caps made strong relative moves versus the S&P 500 over the past two weeks. This plays on a similar theme where investors are rotating in cheaper sectors.
  • The healthcare sector is currently the most oversold with the potential to outperform.
  • This past week we added to our Utility stock holdings as we also believe they will outperform.
  • The R-squared on the sigma/20 day excess return scatter plot declined to .65 as there is a growing divergence between technical scores and expected performance.

Graphs

The ETFs used in the model are as follows:

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

#WhatYouMissed On RIA This Week: 05-29-20

What You Missed On RIA This Week.

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

Webinar: The Great Reset REPLAY

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

The Week In Blogs

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

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Our Latest Newsletter

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

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What You Missed: RIA Pro On Investing

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

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The Best Of “The Real Investment Show”

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

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What You Missed: Video Of The Week

The Pedro DeCosta Interview

Pedro DeCosta and I dig into the Federal Reserve, implications of debts and deficts, and what the Federal Reserve rally should do to fix the economic problems.

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What You Missed: Our Best Tweets

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

See you next week!

TPA Analytics: NFLX – Almost At High Conviction Buy Level

Netflix (NFLX) is down 11% in 7 days and is almost at support from the important, high conviction breakout in April @390.

Chart 1 shows Netflix repeatedly stalled at the 390 level from October 2019 to April 2020. The eventual breakout was very constructive; leading to a huge 3-day rally (see zoom chart).

Now Netflix is close to 390 support, which should be a good entry point. Comparing Netflix to the S&P500 (SPY – chart 3) and the Communications sector (XLC – chart 4), it has also fallen back to breakout levels versus these benchmarks. Such should signal support.

On a comeback rally, Netflix should see new highs.

Netflix

Netflix – Zoom

Ratio of NFLX/SPY

Ratio of NFLX/XLC

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

Why We Increased Our Equity Exposure

Yesterday afternoon we added a 5% position of the S&P 500 (SPY) to both our sector and equity models. The trade follows our strategy of increasing equity exposure as the S&P 500 surpasses critical technical levels.

On Tuesday, the S&P 500 broke above its 200-day moving average. After falling back and testing the average Wednesday morning, it bounced and surged higher.  The positive technical signal of breaking the 200-day moving average and then holding the average, convinced us to increase our equity exposure. We have a tight stop loss on this position at 2965 in case this proves to be a false breakout.

We are very suspicious of recent market gains given the economic devastation and many unknowns related to the virus. We are treating this as a rental position. If the market continues to rally, we may add to our equity exposure and possibly replace the rental with stock and sector positions. If the market falters, we will adhere to our risk limits and reduce our exposure.   

Robertson: Investing For The End Game

Most people are familiar with Thomas Edison’s quote that “genius is one percent inspiration and ninety-nine percent perspiration.” In making this statement he was trying to disabuse people of the notion that innovation “just happens.” Rather, it requires a lot of hard work.

Another notion that often needs to be disabused is that the key to successful investing is primarily intellect. This misplaced focus underestimates the role emotions can have in overwhelming reason and also underemphasizes the role many of our behavioral tendencies can have in undermining broader goals. It also makes the examination of these tendencies an especially fruitful exercise for long term investors.

As it turns out, Charlie Munger, a long-term investor extraordinaire, made a special point of highlighting the importance of behavior for investment success:

“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains …”

This point was also singled out by behavioral economist, Dan Ariely, by way of a memorable demonstration at the CFA Annual Conference ten years ago. The exercise involved bidding for a twenty-dollar bill. The only rule was that when the bidding stopped, the payer for the bill would not be the highest bidder, but the second highest bidder.

Immediately several hands went up. Five dollars. Six. Seven. Eight. Then several people stopped bidding. Two remained. Seventeen. Eighteen. Nineteen. Twenty. Twenty-one.

Of course, at this point, it became abundantly clear that whoever stopped bidding would also be the loser and have to pay. As a result, there was an incentive to keep bidding despite the obviously absurd consequences. And so the bidding went on. Thirty. Thirty-one. Thirty-two.

When the bidding finally stopped, it was significantly over twenty dollars. Someone won $20 and someone else not only had to pay for it but paid a hefty premium too. As such, the exercise left everyone in the room with a memorable impression.

It also provided a memorable lesson: It is incredibly hard for us to think long term and therefore it is often hard to see the “end game”. Not surprisingly, this quirk can end up being costly.

This phenomenon arises in many aspects of our lives and in many walks of life. We compete for small, incremental advantages on a routine basis and do so without considering big picture ramifications. The same things also happen in more public spheres where the impact can be much greater.

One of the more visible areas is stock trading. The dramatic rebound in stocks since late March can be attributed in part to expansive fiscal and monetary stimulus and to an abiding belief that you can’t “fight the Fed”.

A closer look at policy measures reveals much greater focus on short-term goals than long-term ones. While fiscal stimulus did cushion the blow of lost incomes and monetary stimulus eased constraints on liquidity, neither program provided meaningful support for future growth. Further, forbearance of rents and mortgages and the deferral of ratings downgrades change the timing of recognition of problems but do nothing to fix problems. Finally, when these problems eventually become manifested in bankruptcies, they will destroy liquidity. We just don’t know by how much yet.

As a result, bets on a quick and fairly complete recovery of stocks have all the markings of gambles instead of investments. Indeed, increasing evidence reveals this is exactly what is happening. As lockdowns have severely limited opportunities for sports betting, a number of gamblers are turning to stocks. The Financial Times describes:

“Gamblers who cannot bet on professional sport because fixtures have been scrapped are flocking instead to the US stock market, creating a new class of customer for online brokerages and adding fuel to the market rally.”

One of the new stock market participants captured the sentiment:

“I’m not here for the long run — I just want to throw a thousand bucks at something to see if I can make a few hundred”.

The point here is not to condemn people who are drawn to speculation. It is not something I endorse, but as long as it doesn’t hurt anyone else, I don’t have a big problem with it.

Rather, the point is to highlight the degree to which speculative and short-term oriented behavior has permeated society. When long-term investors see stock prices rising against a backdrop of terrible economic news, it can be helpful to understand that these bizarre circumstances are more a function of speculative tendencies than of sound fundamental reasoning.

Unfortunately, focus on the short-term at the expense of more important longer-term goals has also permeated public policy circles (where it can hurt lots of people).

For instance, we have plenty of evidence now that monetary policy has been conducted with an insufficient appreciation of the end game. During the financial crisis of 2008 (GFC), many unconventional policies were designed with one overarching goal: to stop the unraveling of markets in housing and stocks and bonds.

What resulted was a potpourri of unconventional policies including exceptionally low rates and quantitative easing. Given the urgency of improving market functioning, longer term concerns about moral hazard, perverse incentives, and counterproductive behavior were sidelined.

Now, twelve years later, we can see that low rates led (predictably) to more borrowing. Quantitative easing reduced volatility to such a degree that complacency increased. In addition, persistent fiscal deficits have caused government debt to increase. And higher

levels of debt have constrained growth. In short, many of the short-term challenges from the GFC have morphed into even bigger problems today.

The public policy response to the coronavirus has also revealed an insufficient appreciation of the end game in many respects. For starters, the virus is extremely contagious which means its spread is an exponential function. This alone is all that needs to be understood to appreciate the absolute urgency of addressing the problem early and comprehensively. And yet, the initial reaction from policy makers in both China and the US was to ignore the threat and hope it would go away. In both cases, short-term expediency proved costly and quickly eliminated several useful response options.

Later, policies of sheltering in place were rolled out, but again, with little apparent consideration of the consequences. While the lockdowns did serve the immediate purpose of staunching the spread of the disease, they came at the expense of dealing a powerful economic blow to many businesses. It is hard to find any evidence of careful consideration of tradeoffs or longer-term consequences of these policies.

In aggregate, these examples are interesting because they demonstrate just how pervasively decisions get made without proper consideration of the end game.

Part of the reason for this is a widely accepted belief system that emergencies demand a singular focus and a separate set of rules. Accordingly, time is of the essence and all efforts should be made to expedite resolution. You simply don’t have the luxury of entertaining secondary considerations.

Of course, there is truth to this right-sounding mandate. From another perspective, however, it simply enables the all-too-human tendency to overlook long-term consequences. Interestingly, there is no dearth of critical situations and emergencies encountered by military special forces, but they embrace a different approach: Slow is smooth. Smooth is fast.

This implies that it is not just speed that is crucial, but also correct action. It also implies that speed without smoothness is often counterproductive. It is important to be deliberate. Get it right the first time, and you won’t have to waste time or miss an opportunity.

All of this really comes back to risk. It is a lot easier to get by without considering long-term implications if the consequences are trivial. It is a lot harder if the consequences are severe. For example, what if you lost an enormous share of your retirement assets?

To this point, Morgan Housel recently provided a vivid illustration of risk. Suffice it to say, when you have experienced meaningful risk firsthand, you don’t mess around with it. In his words, “tail-end consequences – the low-probability, high-impact events – are all that matter.”

This turns the tables on how many investors think about risk. Many investors think of risk in relation to benchmark performance. Others think of risk in terms of long-term averages for major indexes. Some completely disregard low probability events. All of these overlook the bigger point: it is the relatively rare, high-impact events that are all that matter for the end game.

By contrast, veteran investor, Felix Zulauf, showed what such an approach to risk looks like in practice. Presenting recently at John Mauldin’s Strategic Investment Conference. Zulauf explained that he is not finding attractive investment opportunities in the presence of so many constraints on global growth and excessively high debt levels. As a result, he “has been out of the market since 2015.” 

At a time when many investors are feverishly trying to expand their retirement pots, it can be tempting to chase short-term opportunities to gain marginal advantages. In doing so, however, it is absolutely essential to keep the end game in mind and to avoid high-impact events. Munger may have summed it up best,

“The big money is not in the buying and selling. But in the waiting.”

Shedlock: Don’t Worry. The Fed Has Belts & Suspenders

Don’t worry. The Fed has belts and suspenders.

The Fed’s balance sheet is approaching $7 trillion dollars. This is what Bernanke meant by suspenders.

On February 27, 2013, Ben Bernanke spoke to US Congress about how the Fed would unwind its balance sheet.

Bernanke said, We Have “Belts, Suspenders” to Unwind Balance Sheet .

Bernanke’s vague answer to Sen. Richard Shelby, R-AL, when asked how the Fed will deleverage the balance sheet, was this: “In terms of exiting from our balance sheet… a couple of years ago we put out a plan; we have a set of tools. I think we have belts, suspenders – two pairs of suspenders. I think we have the technical means to unwind at the appropriate time; of course picking the exact moment to do, of course, is always difficult.

Belts and Suspenders Detail

Belts and Suspenders Detail

Belts and Suspenders Synopsis

  • Belt tightening took the Fed’s balance sheet from $4.46 trillion to $3.77 trillion. 
  • Suspenders took the Fed’s balance sheet from $3.77 trillion to $6.90 Trillion in just 9 months.

Tapering, That’s All You Get

Debate Over Balance Sheet Reduction 2109-09-18

Please recall the September 18, 2019 QE Debate: What Did Powell Mean by “Need to Resume Balance Sheet Growth”?

Powell’s Prophecy

And we are going to be  assessing the question when it will be appropriate to resume the organic growth of our balance sheet.”

More prophetic words have seldom been heard.

Some objected to my post because of the word “organic”. I commented.

The Fed may do a brief period of “organic” expansion (which by the way can mean anything the Fed wants), but I propose more QE is coming whether the Fed “intends” to do so or not.

Fed’s 2019 Interest Rate Expectations vs Market’s Expectations

Here’s a look at the Fed’s 2019 Interest Rate Expectations vs Market’s Expectations

I propose the Fed is wrong, again, as usual.

For discussion of today’s FOMC decision, please see Fed Cuts Rates 1/4 Percent, Three Dissents: Dot Plot Suggests No More 2019 Cuts

Dot Plot September 26, 2018

Dot Plot 2018-09-26 Bullard

That’s quite a hoot isn’t it?

Even without Covid-19, the Fed was not remotely close to its expectations.

My Dot Plot comment at the time: “I side with those who expect more rate cuts.”

Clueless Wizards 

Some people have immense faith in proven clueless wizards. Others think the Fed does nothing but follow market expectations.

However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? 

More pointedly, why isn’t the market to blame if the Fed is simply following market expectations?This is a very interesting theoretical question. 

Fed Uncertainty Principle

I discuss the above paradox in If the Fed Follows the Market, Why Won’t Rates Go Negative?

Corollary number one stands for the for plot example above.

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

In case you missed the post, please give it a look. There’s lots more in play regarding what the Fed knows and doesn’t.

Message From Gold

Another pair of suspenders is on deck. 

Gold has that message. Do you?

The Crosscurrents of In/De-Flation – Part 2 Equity Analysis

The Crosscurrents of In/De-flation Part 2

  • Extraordinary times call for extraordinary measures.
  • Extraordinary times and extraordinary measures do not usually lead to ordinary outcomes.

In the first part of this article, The Crosscurrents of In/De-Flation, we raise the specter that inflation may result from the synchronized combination of a variety of factors, including surging money supply, fractured supply chains, and in time, economic resurgence.

The current environment is deflationary, but what matters for investors is what will happen to prices tomorrow. Because monetary stimulus and economic activity are dynamic, answering the question is akin to solving an enormous jigsaw puzzle. Adding to the complexity and frustration, the image of this puzzle is changing as we work through it.

Regardless of what our half-finished puzzle looks like today, we must plan and strategize for contingencies that are out of the realm of recent experiences.  Many investors view inflation as a low-probability event because of the dramatic decline in global economic activity.

Further influencing the consensus outlook is the economic experience coming out of the financial crisis. At that time, many thought that the radical policy steps taken in 2008-2009 would generate price inflation.  It did not, at least not in traditional form.

Lastly, very few economists and investors have worked in a true inflationary era.

Analysis On In/De-flation

As we are fond of saying, you cannot predict, but you can prepare. Although inflation appears to be dead, those events that seem most unlikely would also be the most devastating due to a lack of preparedness.

To prepare for the possibility of an inflationary outcome, we analyzed equity data going back to 1938. The data allows us to assess how the stocks of 49 specific industries performed during the seven inflationary periods noted in the first article and shown below.  We also broke out the two inflationary periods of the 1970s as they most resemble today’s environment.

Cumulative Industry Returns

The chart below shows cumulative returns for the 49 industries through the seven inflationary periods. The gains and losses over each period compound upon each other. We break out the two periods in the 1970s in the second graph.

The dissimilarity between the returns of the 1970s and the other five periods is imposing. As shown, only four industries had positive real (after inflation) returns in the 1970s. Thirty-one industries had positive real returns through all seven periods, including the 1970s.

Excess Returns

The bar chart below shows the excess returns versus the S&P 500 by each inflation era for the top eight industries. Below the chart is the excess return data for the top eight and bottom four sectors for all periods, as well as just the two episodes in the 1970s.

Best performing industries.

Worst performing industries.

Equity Valuations and Inflation

Now we take a step back and consider overall market valuations and how they react to bouts of inflation.

Equity valuations are a function of confidence. The price to earnings ratio (PE), for instance, measures the multiple the market is willing to pay for the future cash flows of a company or index. PE’s should be highest when the economic environment is not only favorable but predictable. Conversely, PE’s tend to be lowest during recessions and unstable financial periods.

Valuations from the months and years before Covid19 were historically high. Today, despite the economic devastation, they are even higher.  As shown below, the price to forward earnings for the S&P 500 is accelerating and sits at levels last seen in the dotcom bubble. 

The scatter plot and bullet points below show that PE’s tend to be highest during periods with stable prices and lower during periods of inflation and deflation.

  • Shiller’s CAPE ratio (CAPE) averaged 15.80 when inflation was less than 1%.
  • CAPE averaged 13.29 when inflation was higher than 4%.
  • CAPE averaged 20.43 when inflation was between 1% and 4%

Analysis from Ed Easterling at Crestmont Research in the table and chart below confirm our findings.

Copyright 2004-2020, Crestmont Research (www.CrestmontResearch.com)

Margins and Valuations

Inflation tends to shrink profit margins and is, therefore, a key factor in valuations. Below we present a proxy for profit margins using total corporate profits as a percent of GDP. The data in the graph is closely aligned with data from S&P but covers a more extended span allowing us to cover all seven inflationary periods.

In five of the seven inflation periods, including both episodes in the 1970s, corporations experienced margin compression. The late 1980s/early 1990s was rather flat. The last era of inflation, post the 2008/09 recession, was the only one that saw margin improvement.

Currently, margins are off recent highs but still historically unparalleled. Odds are they revert to the norm if there is a whiff of inflation.

If inflation occurs, and history repeats, reduced margins, and lower valuations will cause many stocks to underperform grossly. Picking the right stocks and sectors will prove invaluable.  

Summary Of In/De-Flation

What is sure about our current set of circumstances is that there are no experts on whom to rely. More than ever, we should consider the most unlikely outcomes as possibilities. Investors’ ability to protect wealth will depend on not being caught surprised.

The puzzle image will continue to change, with existing pieces going away and new pieces showing up. Inflation, if it does make an appearance, would be a significant wild card forcing investors to make very difficult, puzzle-altering, decisions.

Inflation will also force investors to throw away their processes and logic that has guided them well for the last thirty years.

TPA Analytics: The 2-Month Small-Cap Rally Is Deceiving

Be careful. The 2-month small-cap rally is deceiving as it is tied to healthcare and COVID-19.

Is the rally broadening out? Are Small Cap stock stocks finally going to get their due after being thrown aside for so long for a narrow group of large cap growth stocks? If the answer to this question is “yes”, it would be easier to feel more comfortable with the recent huge rally, since a broad based rally is always a healthier rally than a narrow rally based on a small subset of stocks. Technical analysis likes to see “participation” or a lot of stocks getting involved to believe that a rally is sustainable.

The pattern has improved for small cap stocks. The first relative performance chart below shows that on a 2020 YTD (year to date) basis, the Russell 2000 trails to S&P500 by a wide margin; Russell 2000 down 18.76% and the S&P500 down 8.53%. Since the 3/23/20 low, however, the relative performance of the Russell 2000 has been much improved. The Russell 2000 Index is up 35.22% since the March low, while the market benchmark S&P500 is up 32.09%. It would seem that small cap stocks are finally being recognized and that investors can feel comfortable that the rally has broadened out to include more stocks.

Digging Into Small-Cap Rally

If one digs deeper, however, there is also a narrow rally in small cap stocks driven by the specifics of the Pandemic.

Chart 2 shows that small cap growth is the best performer since 3/23; up 41.60%, while small cap value is the worst performer of all the broad market categories; up only 27.47%.

If clients look at the period performance table below, they will see each broad market category ranked by performance for 2019, 1 year, 2020 YTD, and since the 3/23 low. The chart that follows shows the rank change over these periods. One can see the Russell 2000 growth index moving up 2 rankings, while both the large and small cap value indexes are unchanged and in last place. What happened since 3/23 as small cap growth did so well, while small cap value underperformed? TPA would point to the group weightings for the answer.

The table below shows the top industry groups in the Russell 2000 Growth Index. The second table highlights the Healthcare related weightings in the index. The groups Biotech, Pharma, and Healthcare make up a third (32.79%) of the small cap growth index. Healthcare has been the main focus because of Covid-19.

Small Cap Rally Breakdown

32% of the Russell 2000 Growth index is biotech, pharma, and healthcare.

Finally, the table below looks at the performance of the constituents of the Russell 2000 since 3/23. The Healthcare related parts of the small cap index were up 49.23%, on average. This far outperforms the Russell 2000 (+35.23%0 and the S&P500 (+32.09%) and even crushes the performance of the small cap growth index, which was up 41.60% in the same timeframe.

After diving deep into the reasons for the Russell 2000 outperformance, it is plain that small cap outperformance was due to the return of small cap growth and certainly not small cap value, which was a huge underperformer. Also, the outperformance of small cap growth was actually due to one group; Healthcare. The next table shows that the top 2 groups in small cap value are Banks and REITs, which badly underperformed, up only 20.64% and 7.62%, respectively, off of the March low.

Small cap’s rally may broaden out, but the outperformance of small cap since the 3/23 was due to small cap growth and, more particularly, small cap Healthcare and Covid-19. If clients are going to look for small cap stocks to own, they will still need to focus their attention on certain well-performing groups.


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

Sector Buy/Sell Review: 05-26-20

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

HOW TO READ THE SECTOR BUY/SELL REVIEW CHARTS

There are three primary components to each chart:

  • The price chart is in orange
  • 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 have a tendency of working better than when below the zero line.

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

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

Basic Materials

  • XLB reclaimed the 61.8% retracement last week, but remains overbought, and is underperforming the market. 
  • If we do enter a trade, parameters will be very tight as the outlook for earnings remains poor.
  • We raising our trading alert to $49 which may set up a tradeable opportunity.
  • Short-Term Positioning: Bearish
    • Last Week: No Positions
    • This Week: No Positions
  • Long-Term Positioning: Bearish

Communications

  • XLC continues to perform better than the overall market. 
  • We added to this sector previously as the 200-dma retracement level was taken out. However, it is extremely overbought and we took some profits on Friday. 
  • We continue to like the more defensive quality of the sector, so we are looking for a pullback to add back to our holdings.
  • Our have set an alert at $51 to revisit adding to our holdings.
    • Short-Term Positioning: Bullish
    • Last Week: Hold positions
    • This Week: Took profits, hold balance.
  • Long-Term Positioning: Neutral

Energy

  • Energy stocks have been trading much better than the commodity as relative strength has improved for the sector. 
  • We added to our holdings previously by increasing exposure in XOM and CVX in the equity model and adding those two positions to the ETF model. 
  • We have a stop-loss alert set at $32.50, with a high-alert set at $40. The sector is about at the same level as last week, so no action taken. 
  • Short-Term Positioning: Bearish
    • Last week: Added to holdings
    • This week: Hold positions
    • Stop loss adjusted to $32.50.
  • Long-Term Positioning: Bearish

Financials

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

Industrials

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

Technology

  • Technology continues to be our strong suit and we added more exposure to the sector last week.
  • The rally continued the push toward all-time highs and is back into positive territory for year. However, it remains a narrow advance. 
  • If we get a pullback that holds support at the 61.8% retracement, or the 200-dma, we will look add more weight to the sector. We moved our alert to $87.5.
  • Short-Term Positioning: Bullish
    • Last week: Added slightly
    • This week: Hold positions.
    • Long-Term Positioning: Bullish

Staples

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

Real Estate

  • XLRE held support at the 38.2% retracement and rallied. We also added some exposure to our holdings.
  • The sector is not overbought and is oversold relative to the market. 
  • We have a low limit alert at $30 if lower support is getting threatened.
  • Short-Term Positioning: Bullish
    • Last week: Added slightly
    • This week: Hold positions.
    • Long-Term Positioning: Bullish

Utilities

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

Health Care

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

Discretionary

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

Transportation

  • We have remained out of the economically sensitive sector as the impact of the “coronavirus” continues to rip through earnings in this sector. 
  • The sector mustered a weak rally from lows back to the 38.2% retracement level and continues to consolidate below that level last week. We will see if it can get above it this week.
  • We have an alert set for a trading opportunity set at $44, but we aren’t excited about it.
  • Short-Term Positioning: Neutral
    • Last week: No position
    • This week: No position
  • Long-Term Positioning: Bearish

Technically Speaking: Defining The Market Using Long-Term Analysis

This past weekend, I asked if the decline in March was a bear market or just a big correction. The debate that ensued was polarizing, to say the least. However, defining the market using long-term analysis is essential in determining the current trend, potential outcomes, and portfolio assumptions.

The Recap

Let’s start with the analysis from “Was March A Bear Market?”

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

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

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

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

Bear Market, Bear Market? Or Just A Big Correction? 05-22-20

“This distinction is important.

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

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

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

Defining Long-Term Market Cycles

That analysis brings up an interesting question.

What if the secular bull market that began in 1980 is still in process?

Before you adamantly deny this possibility, we need to consider the context of both long-term investor psychology cycles and valuations.

Let’s start with the following chart of investor psychology.

Investing Psychology Cycle

This chart is not new, and there are many variations similar to it, but do not dismiss the importance. Throughout history, individuals have repeatedly responded to market dynamics in the same fashion. At each delusional peak, it was always uttered, in some form or variation, “this time is different.” 

Valuations Matter

I have often discussed the importance of full-market cycles.

“Long-term investment success depends more on the WHEN you start investing. Such is shown in the chart of valuation cycles.”

Real S&P 500 Index With Recessions and Valuation Cycles

“Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8-major market cycles since 1871. Every other period yielded a return that lost out to inflation during that time frame.”

However, by looking at each full-cycle period as two parts, bull and bear, it obscures the importance of the “full cycle.” What if instead of there being 8-cycles, we look at them as only three? 

Full Market Valuation Cycles

Note in the chart above that CAPE (cyclically adjusted P/E ratio) reverted well below the long-term trend in both prior full-market cycles. When viewed in this manner, we see the full-market cycle encompasses many bull and bear market cycles, but only completes when valuations are reset.

While valuations briefly dipped below the long-term trend in 2008-2009, they did not revert to previously low levels. Given valuations have remained elevated since 1982; it suggests the full-market cycle has yet to complete. Such a reversion would align the fundamental and psychological underpinnings seen at the beginning of the last two full-market cycles.  

Long-Term Analysis – Is The 80’s Bull Still Running?

We can further examine the idea of long-term market cycles if we overly the psychological and time-frame analysis. The first full-market cycle lasted 63-years from 1871 through 1934. This period ended with the crash of 1929 and the beginning of the “Great Depression.” 

, 3 Things: What If The 1980-Secular Bull Is Still Running?

The second full-market cycle lasted 45-years from 1935-1980. This cycle ended with the demise of the “Nifty-Fifty” stocks and the “Black Bear Market” of 1974. While not as economically devastating as the 1929-crash, it did greatly impair the investment psychology of those in the market.

, 3 Things: What If The 1980-Secular Bull Is Still Running?

The Running Bull Market

The current full-market cycle is only 38-years in the making. Here is a short-list of what prices are pushing up against:

  • Elevated valuations
  • Collapsing economic data
  • Declining earnings and corporate profitability
  • Weak economic growth
  • Surging debt levels
  • Deflationary economic pressures
  • Suppressed wage growth
  • Weakening demand from consumption

Even this short-list of headwinds makes it worth questioning whether the current full-market cycle has completed. Such is particularly the case when Central Banks are required to maintain ever-increasing levels of monetary interventions to keep financial markets functioning.

Full Market Cycle 1980-Present

The idea of the “bull market,” which begin in 1980, is still intact is not a new one. As shown below, a chart of the market from 1980 to the present suggests the same.

1980-Present SP500 Index Cycle

The long-term bullish trend line remains, and the cycle-oscillator is only half-way through a long-term cycle. Furthermore, by the time the market resolves itself, a 61.8% retracement would reset markets back to the 1999 levels. Such is based only on the assumption that the long-term full market cycle has not yet completed.

I am NOT suggesting this is the case. 

Instead, this is a thought-experiment about the potential outcome from the collision of weak economics, high levels of debt, valuations, and investor’s “irrational exuberance.”

Yes, this time could entirely be different.

It just never has been before.

Using Long-Term Analysis To Measure Potential Outcomes

Regardless of whether you agree with the premise, do not completely dismiss the importance of long-term price cycles. Currently, it is “in vogue” to believe it is only monetary policy driving markets now. Over the long-term, there have been many excuses for rising prices, which eventually gave way to “fundamental gravity.”

One of the most interesting emails I received in response to my monthly analysis above was from Jim Colquitt, President of Armor Index, Inc. To wit:

“If we draw the ‘Head & Shoulders’ pattern you described above, we find an interesting symmetry. The distance from the beginning of the left shoulder (September 2017) to the end of the left shoulder (December 2018), is the same distance (15 months) from the end of the left shoulder to the end of the head (March 2020).

If we assume this symmetry remains intact, it will allow us to complete the right shoulder of the head and shoulder pattern 15 months later in June 2021. Such would be somewhere in the price range of ~2,030 or roughly ~31% lower than current levels.”

Head Shoulders Technical Patter

Where Do We Go From Here

What does this analysis suggest if the market breaks below the neckline? Or, what if markets bounce off of the neckline as support?. 

‘Head & Shoulder’ pattern theory suggests a move to the downside would put the target price at the equivalent of the distance from the head to the neckline as measured from the neckline. A break would equate to roughly ~840 on the index, or ~72% lower than current levels (see “Chart 2”). 

Conversely, if the neckline is rejected, pattern theory suggests the distance above is used but is added to the top of the right shoulder. Such would equate to an index level of roughly ~4,160 or ~41% higher than current levels (see “Chart 2”). However, such a rise would likely come after testing the neckline (~2,030) and would equate to more than a 100% return from that point.

March Correction and Market Projections

It is also interesting that current market levels are almost perfectly in line with the left shoulder peak in September 2018, the resistance/support levels from April through July 2019, and February through April 2020. Such could be the top for the right shoulder.

Should we test the lows of the worst case scenario, pattern theory puts the target range at levels, which are almost perfectly in line with the lows of the 2002 and 2008 recessions (see “Chart 3”).

Upside Downside Long-Term Forecasts SP500

Jim is correct in the analysis. We certainly hope markets don’t revisit the lows of the previous two bear-markets. For investors that is the worse possible outcome. However, such an outcome does have historical precedents within the context of completing a full-market cycle.

Conclusion

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, fueled by Central Bank liquidity, it is understandable why mainstream analysis believe markets can only go higher.

Bear market cycles rarely end in a single month. There is much “hope” the Fed’s flood of liquidity can arrest the market decline. However, there is still a tremendous amount of economic damage to contend with over the months to come.

When analyzing the markets using monthly data, it certainly appears as if the long-term bull market that began in 1980 remains intact currently. However, we have roughly a decade of potentially hard times ahead of us if we are early in the process of completing the second half of the full-market cycle.

If you are a short-term market trader, this analysis likely has little importance to you. It also doesn’t mean market returns over the next decade are negative every single year. What it does suggest is that investors will face increased volatility and low average rates of return.

For most investors, a “buy and hold” investment strategy will likely leave you far short of your goals.

That is just what this particular set of analysis suggests. There is an unlimited number of potential outcomes that can occur over the next decade. Some of them good, some of them bad. Such is why it is important to measure the amount of risk being taken to achieve financial goals and manage that risk accordingly.

Or, you can disregard the analysis entirely and continue hoping for the best.

However, if investing worked as the media tells you, then why, after three major bull markets in the last 30-years, are 80% of Americans still broke?

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

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

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

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

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

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

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

S&P 500 Index

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

Dow Jones Industrial Average

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

Nasdaq Composite

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

S&P 600 Index (Small-Cap)

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

S&P 400 Index (Mid-Cap)

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

Emerging Markets

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

International Markets

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

West Texas Intermediate Crude (Oil)

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

Gold

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

Bonds (Inverse Of Interest Rates)

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

U.S. Dollar

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

The Arrival Of The “Unavoidable Pension Crisis”

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

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

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

Such is not likely to be the case.

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

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

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

The Crisis Is Here

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

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

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

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

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

Now the coronavirus pandemic have it ticking faster.

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

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

Over Promise Under Deliver

Here is the real problem:

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

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

To wit:

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

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

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

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

Problem #1: Demographics

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

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

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

A Fertility Problem

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

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

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

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

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

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

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

Problem #2: Markets Don’t Compound

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

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

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

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

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

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

Guiding Down

But therein lies the problem.

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

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

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

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

Government Bailouts

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

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

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

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

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

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

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

We Are Out Of Time

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

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

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

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

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

That isn’t going to happen.

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

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

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

Bear Market? Or Just A Big Correction?


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

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

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


Catch Up On What You Missed Last Week


Still Stuck In The Middle

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

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

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

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

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

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

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

Was This A Correction Or A Bear Market?

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

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

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

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

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

This distinction is important.

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

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

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

Valuations

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

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

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

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

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

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

Monthly Moving Average Crossover

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

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

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

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

Bear Markets Begin With Corrections

There is one crucial point that needs addressing.

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

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

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

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

A Growing List Of Concerns

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

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

I could go on, but you get the idea.

Don’t Fight The Fed

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

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

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

The next leg lower will likely surprise most investors.

Positioning Update

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

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

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

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

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

That is not today.

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

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


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

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


Sector Model Analysis & Risk Ranges

How To Read.

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


Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels.

Sector-by-Sector

Improving – Materials (XLB)

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

Current Positions: No Positions

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

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

Current Positions: XLK, XLC, XLP, and XLV

Weakening – Utilities (XLU)

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

Current Position: 1/3rd Position XLU

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

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

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

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

Market By Market

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

Current Position: None

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

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

Current Position: None

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

Current Position: None

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

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

Bonds (TLT) –

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

Current Positions: SHY, IEF, BIL, TLT

Sector / Market Recommendations

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

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

Portfolio / Client Update

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

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

Changes

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

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

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

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

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

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

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

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

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

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

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

Shedlock: The Economy Won’t Soon Return To Normal

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

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

No Magic Answers

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

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

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

Layoff Impact

CNN comments on the Hertz Bankruptcy.

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

Auto Manufacturing Impact

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

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

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

Used Car Price Impact

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

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

Regional Impact

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

As many as 60 cities face flight shutdowns.

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

Corporate Travel Impact

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

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

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

This means more layoffs or fewer people recalled from furloughs. 

Attitude Change

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

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

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

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

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

Note that Existing Home Sales Plunge 17.8%

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

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

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

Real Estate Agent Impact

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

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

Grim Economic Data

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

Ripple Impacts May Last Years

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

Powell Warns Recovery May Stretch to the End of 2021

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

Powell is likely to be optimistic. 

Fed in Panic Mode

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

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

For details, please see Fed Promotes More Free Money.

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

Global COVID-19 Risk Ranges Up to $82 Trillion

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

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

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

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

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

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

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

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

Collateral

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

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

Leverage

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

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

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

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

Volatility

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

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

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

Investing is What, How, & When

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

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

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

What, How, & When in Practice

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

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

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

A Mental Model For Investing

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

Relative Value Sector Report 5/22/2020

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

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

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

Commentary

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

Graphs

The ETFs used in the model are as follows:

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

#MacroView: Is The Fed Walking Into A Trap?

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

The Unseen

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

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

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

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

The Seen

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

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

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

The Fed Liquidity Trap

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

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

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

Pay particular attention to the last sentence.

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

Inflation Conundrum

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

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

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

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

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

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

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

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

Monetary Velocity Trap

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

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

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

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

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

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

As noted by Treasury&Risk:

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

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

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

Deflationary Spiral

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

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

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

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

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

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

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

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

Unfortunately, the Fed has no other options.

Momentum Fundamentals, Technically Speaking: Chase Momentum Until Fundamentals Matter

The Fed Inflation Trap

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

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

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

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

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

It’s a no-win situation for the Fed.

The End Game Cometh

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

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

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

Such is the flaw MMT supporters do not address.

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

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

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

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

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

But, it eventually will be.

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

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

The main points from the 5/20 reports are:

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

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

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

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

These stocks should still be sold at current levels.

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

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

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

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

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

“Crude”ly Speaking

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

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

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

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