Monthly Archives: May 2020

Technical Value Scorecard Report For The Week of 9-24-21

Relative Value Graphs

  • The third graph below highlights the recent strength of inflationary sectors versus weakness in defensive sectors against the S&P 500. This is not surprising given the emergence of risk-on sentiment after the FOMC meeting Wednesday.
  • The first graph shows that most inflationary sectors strengthened versus the market, except for materials which remains very oversold on a relative basis.
  • The factor/index chart similarly reflects the risk-on sentiment, with small-caps, mid-caps, momentum, and international all gaining ground versus the S&P 500. Emerging markets were left out of the rally due to the situation in China. Meanwhile, the FAANG heavy NASDAQ 100 weakened versus the S&P 500.
  • The over-arching theme this week was a return to risk-on sentiment as markets digested the Evergrande situation and the Fed announced its decision to not yet taper asset purchases.

Absolute Value Graphs

  • On an absolute basis, most sector scores fell this week except for some of the inflationary sectors, which got a boost from the Fed’s decision Wednesday.
  • Most of the inflationary sectors remain in overbought territory, except for industrials and materials which are slightly oversold.
  • Momentum and the NASDAQ 100 saw the biggest drawdowns in their absolute scores but remain the most overbought factors.
  • Interestingly, this week the S&P 500 dipped to its most oversold level this year before rebounding back into slightly overbought territory.
  • The fourth table shows that of the sectors, factors, and indexes, only energy is significantly above its 20-day moving average, by just over two standard deviations. A close second is transportation, at 1.72 standard deviations above its 20-dma. On the flipside, utilities are approaching two standard deviations below their 20-dma after a sharp selloff this week. There are no sectors more than two standard deviations from their 50 or 200 dma.  

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

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

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Bulls Remain in Charge As Rebound Continues

Futures are slightly lower this morning after two strong days of gains as bulls remain in charge but the rebound continues. Treasury bonds and the dollar sold off as the risk-on sentiment took hold. The S&P 500 gained 1.2% to close above its 50-day moving average for the first time since last Friday. The 10-Year Treasury yield rose by roughly 7 bps to 1.41%, and the dollar lost 0.46%. Based solely on the sharp rise in bond yields, it appears the initial reaction to the FOMC meeting is signaling that the Fed may be too late to curb inflationary pressures.

Index futures are pointing slightly down this morning, while the longer end of the yield curve is flat to slightly higher. Cryptocurrencies and crypto-related stocks are struggling in response to a new policy out of the Peoples Bank of China that makes all crypto-related transactions illegal, according to Bloomberg.

Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: New home sales, month-over-month, August (1.0% expected, 1.0% in July)

Earnings

  • No notable reports scheduled for release

Politics

  • The Federal Reserve will host a virtual Fed Listens event at 10:00 a.m. ET, called “Perspectives on the Pandemic Recovery.” Chair Jerome Powell will provide opening remarks and other Fed governors will moderate the conversation among leaders in the private sector.

Market Trading For Friday, Sept. 24th.

Heading into September, we spilled a lot of ink about us raising cash, increasing bond duration, and rebalancing equity risk. With our previous “sell signal” beginning to reverse, we have spent the last couple of days putting that excess cash back to work.

With the market reclaiming the 50-dma and buy signals close to triggering, the bulls are back in charge. It will be important for the market to hold the 50-dma by the close of trading today. There is still some downside risk short-term with the “debt-ceiling” debate, China, and markets still processing the Fed’s announcement.

Maintaining some risk hedges, for now, is logical until the market clears the 50- and 20-dma moving averages successfully.

Buybacks Are Surging And That’s Good For Stocks

Buybacks have been a major contributor to stock market returns over the last 5-years. With corporations flush with cash after pandemic-related bailouts, they are putting that cash to work. However, they are doing that in the one area that benefits insiders the most.

As opposed to the mainstream narrative, stock buybacks are NOT a return of capital to shareholders. We dig into the reasons why in this article.

PMI

The PMI composite index fell slightly as growth is “hampered by severe supply chain hold-ups and capacity shortages.” Both manufacturing and services sectors continue to signal solid economic expansion. Inflation however remains a concern. The following paragraph from the report leads to concern the recent stabilization in headline inflation data may not be lasting: “

On the price front, input costs rose at a sharper pace during September. The rate of cost inflation was the quickest for four months, and the second-highest on record, as supply chain disruptions and material shortages pushed prices and transportation costs up. Meanwhile, output charges continued to increase markedly, continuing to rise at a pace far outstripping anything seen in the survey’s history prior to May, as firms sought to pass on higher costs to clients where possible.

The Evergrande Saga

Evergrande is required to pay $83 million of interest on a dollar-denominated bond today. Per Newsquawk, they have a 30-day grace period as part of an existing agreement before the debt is classified as a default. It appears as if Evergrande may give a preference to paying off Yuan-denominated debt and obligations over foreign-held dollar-denominated debt. They have another $47.5 million dollar-denominated interest payment due next week.

Is Now the Time to Buy Stocks?

Fed Rate Projections

The two graphs below are the “dot plots” from the Federal Reserve showing Fed member expectations for where the Fed Funds rate will be in the coming years. The graph on top is the set of projections from June. At the time only 5 members thought they would raise rates four times or more by the end of 2023. As shown on the bottom graph, with yesterday’s projections, that number stands at 9.  There are also 2 more Fed members that think the Fed will hike rates in 2022 compared to three months ago.

June

September

All Ears on the Fed

With the Fed meeting behind us, Fed members can now speak publicly. We expect a deluge of speeches and interviews over the coming days as members try to clarify the Fed’s views as well as their personal opinions. We are on the lookout for dissension in the ranks by the members that are overly concerned with higher inflation. While Powell clearly set out a time frame for taper, the Fed might get cold feet if the equity markets turn lower. If that were to happen some of the hawks may become even more vocal about the need to taper and ultimately raise rates. In The Fed Speaks Loudly and Carries a Feather, we decompose the Fed members by their voting status and degree of influence. The chart below and the article provides some context for their latest thoughts on the economy and policy.

The Coming “Reversion To The Mean” Of Economic Growth

From stimulus boom to income thud, the coming “reversion to the mean” of economic growth is happening faster than economists expected.

We previously noted that while many mainstream economists believed the current economic “boom” would persist, several factors suggested it wouldn’t.

The first problem is the math. As I previously discussed in “As Good As It Gets, the “second-derivative” of growth is now problematic. To wit:

“There is much at risk in the market as we head into the third quarter of 2021. For clarity, we need to review the “second-derivative” effect.

‘In calculus, the second derivative, or the second-order derivative, of a function f is the derivative of the derivative of f.” – Wikipedia’

In English, the ‘second derivative’ measures how the rate of change of a quantity is itself changing.

I know, still confusing.

Here is a simplistic example.

Assume the economy is $1000 in value in Year 1. Then, in Year 2, there is a 50% recession. However, in Year 3, the economy grows back to $1000. And, in Year 4, the economy remains at $1000.”

Q2 Peak Reporting 07-02-21, As Good As It Gets. Will Q2 Mark Peak Reporting? 07-02-21

“The ‘second derivative’ effect is evident in years 3 and 4. In year 3, the economy recovers by $500, a 100% increase from Year 2’s level of $500. However, in Year 4, the growth rate falls to ‘ZERO’ as the economy remains at $1000.”

Why am I telling you this? Because we are at that point in the recovery cycle. Over the next few quarters, the year-over-year comparisons will become much more challenging. Q2-2021 will likely mark the peak of the economic recovery.

Confidence, Consumption & Economic Growth

In “Did The Fed’s Monetary Experiment Fail,” I discussed the importance of consumer confidence as it relates to the economy.

“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.” – Bernanke

We must not overlook the importance of consumer confidence, given the significant contribution of personal consumption expenditures to economic growth.

At nearly 70% of the GDP calculation, it is not surprising there is an exceedingly high correlation. The vertical spike at the end of the chart is most important. That spike was from the Government injecting 20% of GDP (roughly $5 Trillion) directly into the economy during the pandemic-driven shutdown. As we will discuss momentarily, the coming reversion will be problematic.

However, before we discuss the future, it is essential to note that since 1960, the expansion of consumption (PCE), and subsequently GDP, has come from a massive increase in household debt.

Given that wages haven’t risen fast enough over the last 20-years to compensate for increased living costs, the rise in household debt is not surprising. But, as noted, the increase in debt is not for the consumption of “more stuff,” instead, debt gets used to fill the gap between wages and living standards.

As noted, the linkage between confidence, consumption, and economic growth is critical. Thus, the recent plunge in consumer confidence as financial supports run out should not get dismissed lightly. Moreover, that breakdown of consumer confidence will likely show up in consumption in the future quarters and, ultimately, economic growth.

Fed's Monetary Policy Experiment, Did The Fed’s Monetary Policy Experiment Just Fail?

The Coming Reversion

Over the next several quarters, the real risk is a slowdown in consumption due to the lack of financial supports, stagnant wage growth, and high levels of underemployment.

However, it is also just a “math problem.” As noted above, the second-derivative of economic growth will have a more considerable impact in the future. Such is the problem of a larger economy due to the monetary injections. The chart below projects the annualized rate of economic growth through 2022. The polynomial trend line gets calculated using only current economic data. As you note, and not surprisingly, the two will intersect during the mean reversion.

While the “speed” of the reversion can get debated, the eventuality is just a function of math. As the economy grows, the annual growth rate will decline. The intersection of the economy to the polynomial trend will occur, aligning with the Fed’s own long-term economic growth projections.

As you will note, economic growth rates peaked in 1980 and continued a steady trend lower. Again, such is a function of stagnant wage growth and rising debt levels. Importantly, given the importance of PCE on growth, the rate of consumption continues to set lower trend growth levels after each major recession. As shown, PCE slowed after the “Dot.com” crash, the “Financial Crisis,” and likely will set a new lower trend level next year.

The “New New Normal”

After the “Financial Crisis,” the media buzzword became the “New Normal” for what the post-crisis economy would like. It was a period of slower economic growth, weaker wages, and a decade of monetary interventions to keep the economy from slipping back into a recession.

Post the “Covid Crisis,” we will begin to discuss the “New New Normal” of continued stagnant wage growth, a weaker economy, and an ever-widening wealth gap. Social unrest is a direct byproduct of this “New New Normal,” as injustices between the rich and poor become ever more evident.

If we are correct in assuming that PCE will revert to the mean as stimulus fades from the economy, then the “New New Normal” of economic growth will be a new lower trend that fails to create widespread prosperity.

Of course, none of this is a surprise.

It has been in process for the last 30-years. Yet, mainstream economists still fail to recognize the consequences of rising debt levels and the failure of socialistic policies.

For them, the answer to slower growth has been more debt. When more debt failed to spur growth, the answer was we didn’t go into debt far enough.

Well, in 2020, the country expanded its debt massively. The Fed and Government flooded the economy with liquidity to prevent the recession from doing its much-needed job of cleansing excesses from the system.

If more debt doesn’t create growth this time, we have only ourselves and the economists to blame.

Stocks Rally As Fed Teases Taper

Stocks rally nearly 1% higher yesterday despite a surprisingly hawkish tone from Fed Chair Jerome Powell teasing taper. Next on the horizon for the bulls is the 50-day moving average at 4435. With taper looming on the horizon will the moving average act as resistance?

If overnight trading is any indication we may answer that question this morning. The NASDAQ is leading the way, up .75% this morning with the S&P and Dow closely behind. S&P 500 futures are less than ten points below the key moving average. The dollar is weaker this morning as the currency markets appear to be taking Powell’s word that the Fed remains on course to start tapering in November and finish in mid-2022.

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Chicago Fed National Activity Index, August (0.50 expected, 0.53 in July)
  • 8:30 a.m. ET: Initial jobless claimsweek ended September 18 (320,000 expected, 332,000 during prior week)
  • 8:30 a.m. ET: Continuing claimsweek ended September 11 (2.600 million during prior week)
  • 9:45 a.m. ET: Markit Manufacturing PMI, September preliminary (61 expected, 61.1 in August)
  • 9:45 a.m. ET: Markit Services PMI, September preliminary (54.9 expected, 55.1 in August)
  • 10:00 a.m. ET: Leading Index, August (0.7% expected, 0.9% in July)

Earnings

Pre-market

  • 7:00 a.m. ET: Darden Restaurants (DRI) is expected to report adjusted earnings of $1.65 per share on revenue of $2.24 billion

Post-market

  • 4:05 p.m. ET: Vail Resorts (MTNis expected to report adjusted losses of $3.50 per share on revenue of $169.36 million
  • 4:15 p.m. ET: Costco (COSTis expected to report adjusted earnings of $3.55 per share on revenue of $61.57 billion
  • 4:15 p.m. ET: Nike (NKEis expected to report adjusted earnings of $1.12 per share on revenue of $12.47 billion

Courtesy Of Yahoo!

Buy Stocks As The Fed Put Is Alive And Well

The Federal Reserve did exactly as expected yesterday and threaded the needle well on putting “taper on the table” and assuring markets the “punch bowl” wasn’t being taken away just yet.

“There has been a great deal of handwringing by some market participants over the potential market implications of the Fed’s eventual tapering of asset purchases, and a great deal of ink spilled on the topic too. But at the risk of merely contributing to the latter, we hope to assuage those who worry about the former.

In sum, we think that the tapering of Fed asset purchases (likely a $10 billion reduction in U.S. Treasury purchases and a $5 billion reduction in agency mortgages per month) is likely to have minimal market impact at this stage. This is partly because the Fed has done a decent job of telegraphing when tapering is likely to begin (most market participants believe the announcement will come this year), but more importantly it’s because the asset purchase reductions are likely to be trivial when seen in the context of how large the fixed income markets are today, and how overwhelming the demand for income has become.” – Rick Rieder, BlackRock’s CIO of Global Fixed Income

With stocks deeply oversold on a short-term basis, as noted yesterday, and the threat of “taper” largely baked into the recent decline, there is a decent entry point for traders to add exposure near term. As noted, the 50-dma is the only really challenge ahead but will likely be resolved today.

Powell Q&A Session: A More Hawkish Picture

Following a vague reference to taper in the FOMC statement, Jerome Powell made some hawkish comments during his press conference:

  • With respect to progress towards taper, Powell commented, “In my own thinking, the test is all but met”.
  • “I think if the economy continues to progress broadly in line with expectations and the overall situation is appropriate for this, we could easily move ahead [with taper] by next meeting, or not…”
  • Again, with respect to a decision for November taper, “I don’t need to see a good employment report next month; I just need to see a decent employment report”. Powell is clearly signaling that Fed is likely to announce taper in November barring an unexpected deterioration in economic conditions.
  • Powell commented that it may be appropriate for taper to conclude by mid-2022.
  • As expected, Powell is leaving a back door open in case taper doesn’t go over well. “If necessary, we can accelerate or decelerate the taper”.

Taper Talk Continues

Changes to the FOMC statement are highlighted below. Of note, the Fed signaled taper could be around the corner, but did not drop any hints in the statement with respect to timing. “Since then, the economy has made progress towards these goals, and if progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”. However, in the FOMC press conference Q&A session, Powell noted that taper could come “as soon as the next meeting”.

The Fed reduced their projection for 2021 real GDP growth to 5.9% from 7%. Further, the Fed raised their core PCE inflation forecast for 2021 to 3.7% from 3.0%. The “dot plot” graph below shows the level of Fed Funds that each Fed member expects by year. There are now 9 FOMC members that think the Fed will hike rates as soon as next year, compared to only 7 in June. This represents an even split between members that see liftoff in 2022 and those who don’t, and could have implications for the pace of taper once initiated.

FOMC Pre-Taper Market Review

Adobe Q3 Earnings

ADBE reported earnings for the 3rd quarter yesterday after the close. GAAP EPS of $2.52 easily beat the consensus estimate of $2.29. Similarly, revenue of $3.94B (+22% YoY) beat expectations of $3.54B, driven by a 24% increase in subscription revenue. Management guided to Q4 revenue of $4.07B- slightly above the consensus of $4.05B. Guidance for non-GAAP EPS is also above consensus, at $3.18 vs. an expected $3.09. ADBE is down ~4% in pre-market trading despite beating expectations across the board and guiding above consensus for Q4. We hold a 1.5% position in the Equity Model.

FedEx is Raising Prices

Federal Express announced that effective January 2022, FedEx Express, FedEx Ground, and FedEx Home Delivery shipping rates will increase by an average of 5.9%. FedEx Freight rates will increase by an average of 5.9% to 7.9%. We suspect UPS and other carriers will take similar action.  Given a large number of goods are now ordered online, the increase in shipping costs will inevitably work its way into higher prices next year.

Cash on the Sidelines

The graph below from Sentimentrader compares the amount of cash in money market funds to corporate equity issuance. Per Sentimentrader:

“During the pandemic panic, the ratio neared 30 and was the highest in 30 years. In other words, there was 28 times more cash available than shares offered in supply. There are ways to quibble with the technicals, but it’s simply meant as a reflection of sentiment.

Over the past year, the ratio has declined steadily as supply ramped up. Corporations are “feeding the ducks,” as the saying goes. Even though money market assets haven’t been drained much, the skyrocketing supply has caused the ratio to drop below 10 for the first time since the year 2000.”

Record buybacks have been a major support of asset prices this year.

Declining Earnings Confidence

The graph below, courtesy of the Market Ear, shows declining sentiment towards earnings expectations. Each line representing the four major global equity markets shows the number of earnings upgrades less the number of downgrades, divided by the total number of estimates. Each line is approaching zero but still above it, denoting net confidence remains positive but if falling.

The Market is Deeply Oversold And Looking For A “Dovish” Fed

As we will discuss, the market is deeply oversold and looking for a “dovish” Fed to spark buying. Traders and investors will be laser-focused on the Fed meeting adjourning at 2 pm ET. Of importance, the decision on taper and their characterization of the economic recovery and inflation. If they do elect to announce a taper schedule, the pace of tapering and any caveats that may delay tapering will be of utmost importance.

Like yesterday markets are opening up a half to one percent higher. Will they hold onto the gains, unlike yesterday? The answer likely lies with the Fed at 2 pm.

Daily Market Commnetary

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended September 17 (0.3% during prior week)
  • 10:00 a.m. ET: Existing home sales, month-over-month, August (-1.7% expected, 2.0% in July)
  • 2:00 p.m. ET: FOMC policy decision

Earnings

Pre-market

  • 7:00 a.m. ET: General Mills (GIS) is expected to report adjusted earnings of 89 cents per share on revenue of $4.30 billion

Post-market

  •  4:10 p.m. ET: KB Home (KBH) is expected to report adjusted earnings of $1.62 per share on revenue of $1.57 billion
  • 5:05 p.m. ET: BlackBerry (BB) is expected to report adjusted losses of 7 cents per share on revenue of $166.80 million

Politics

Market Deeply Oversold – Looking For Some “Dovish” Tones

The rolling correction over the last 3-weeks has pushed the market into deeply oversold conditions on a short-term basis. Such provides plenty of “fuel” for a decent rally over the next month or two given some news to spark buying. Today, the Fed could do the trick with Jerome Powell delivering his post-FOMC press conference with a “dovish” tone. With Congress battling over the debt ceiling, the Treasury running out of money, and the risk of a Government “Shutdown” looming, the Fed has all it needs to provide plenty of “caveats” to its “taper” plans.

Fear Greed Index Near Lows

Another reason for near-term bullish optimism, is that both the AAII bullish allocation and the “Fear/Greed” index are near their respective lows. Combined with the oversold market conditions, such typically provides a buying catalyst as traders reposition themselves in equity risk.

Trading Game Plan for the S&P 500

The markets are trading well in overnight trading following yesterday’s flat-trading day. The bounce provides us with another set of levels, in addition to the 50, 100, and 200-dmas, to guide our trading. The graph below shows the Fibonacci retracements from the recent high to low. If this rally proves to be a bull trap, it is likely to give up between the 38% retracement (4395) and the 62% retracement (4451). There is also a gap between 4400 and 4430.

It is common for such gaps to fill and then reverse direction. If the market surges higher through the gap and retracement levels, the outlook becomes more bullish. A rally above the 4451 retracement level and well through the 50dma (4436) will likely lead to new highs. Conversely, the 50 dma (4436) may prove to be resistance. The first line of support is yesterday’s lows and the 100dma (4328). A break of the recent low leaves a target of 4106, the 200dma.

Follow Up to Monday Market Mayhem

Easy Lending Standards

Employment and inflation tend to get the headlines as far as rationales for the Fed to take action. As we consider what the Fed may do tomorrow, we should also consider lending standards. The graph below shows the lending standards for large banks’ credit card customers are as easy as they have been in 20 years. On its own, very easy lending standards, as we have, push the Fed toward a more hawkish stance. Easy borrowing conditions incentivize personal consumption. More consumer activity, especially given current supply line problems, is likely to further agitate inflationary conditions.

Chinas & Evergrande. Will They or Won’t They?

In addition to concerns with China, Evergrande, and possible contagion, the markets are also grappling with Wednesday’s Fed meeting. In what was likely a purposeful leak last week, the WSJ laid the groundwork for a taper announcement Wednesday and the reduction in asset purchases in November. With the U.S. and foreign markets skidding yesterday some are asking how the Fed might react. In a Bloomberg interview, ex-New York Fed President, Bill Dudley, warns “They’re not going to react to small market moves and defer the tapering on that basis. They have to change their economic forecast,” he said Monday during an interview on Bloomberg Television with Lisa Abramowicz, Tom Keene and Jonathan Ferro. “At this point, it’s really premature to reach that conclusion.”

When Will “Transitory Inflation” Overstay Its Welcome?

There has been much talk of “transitory inflation”, but the evidence is starting to suggest the term may overstay its welcome.

The Fed chose the word “transitory” to describe this instance of rising prices because of its imprecision. Transitory can denote hours, months, or decades. Using transitory versus a specific period provides the Fed freedom to be wrong but be grammatically correct.

While the Fed uses ambiguous words, Mr. Market may have more defined expectations. If investors grow impatient with the Fed’s transitory, bond markets may react. In such a case, how will the Fed respond to “enduring” or “lasting” inflation coupled with higher yields? If they are already tapering, will such conditions push them to speed up their pace?

Conversely, recent data shows inflation may be stabilizing. Maybe the Fed is correct, and inflation rates will normalize in the coming months. If so, will they hold off on tapering or reduce the rate of tapering?

In July, we wrote Just How Transitory is Inflation?  The article is a deep dive analysis of CPI. At the time, we sought a better understanding of what was causing inflation to rise. With two more months of inflationary data, an update is essential.  

Understanding inflation beyond the headlines helps us answer the all-important question: Just how transitory is transitory? From there, we can begin to assess potential Fed and market reactions.

Headline CPI Summary

In the latest CPI report, covering August, the monthly CPI figure rose by 0.3% or 3.6% annualized. The year-over-year rate is +5.30%. In comparison, June’s monthly CPI rose by 0.90% or nearly 11% annualized. Despite the big difference in monthly rates, June’s year-over-year change of +5.40% is only 0.10% higher than August.

As shown, the monthly CPI and core (excluding food and energy) are turning lower. While not as pronounced, the annual data is following suit. Two months does not make a trend, but it appears to be fulfilling the transitory definition. Core CPI, at +0.10% last month, is 0.10% below the average for 2017-2019. Headline CPI is only 0.10% above the average.

The headline data is supportive of the transitory narrative; however, it does not tell the whole story.

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The Breadth of CPI

Digging deeper into CPI and looking beyond the headline averages may not support the word transitory. The graph below shows the CPI Index based on the median price of the goods and services in the index. Unlike the headline CPI Index, median CPI is still rising and at the highest level since 2008.

The distribution graph below compares June to August regarding how the prices of all the underlying goods and services within CPI are changing on an annual basis. We separate the data into 2% price buckets.

The blue (August) and orange (June) bars comparing the two months may look somewhat similar, but there are differences worth discussing.

In June, 75% of the CPI components were rising at a rate slower than the 5.4% inflation rate. In August, 71% were rising at a slower rate than the 5.3% rate of inflation.

The number of goods whose prices rose between 2% and 10% increased from 66 to 77. The number of goods whose prices rose by 2% or less fell from 72 to 55. While subtle in the graph, the number of goods shifting to the right (more inflation) is noteworthy.

52 of the goods and services have price declines from June to August. Six were unchanged, and 95 had price increases. Again, more goods are rising in price than falling.

The breadth of the market is not supportive of the transitory theme. A wide swath of prices are broadly rising, albeit not at an alarming pace.

Outliers

In the original article, four goods had year-over-year price changes of greater than 20%, as shown below.

  • Used Cars 45.2%
  • Gasoline 45.1%
  • Fuel Oil 44.5%
  • Other Motor Fuels 32.1%

In the August report, six goods had greater than 20% increases. The four goods from June maintain annual 20% rates of inflation. Added to the list are propane and utility services.

The inflationary outliers continue to be energy and auto-based. Both are rising in large part due to the reopening of the economy and supply disruptions. We expect both will moderate in the coming months. As this occurs, they will put less upward pressure on the CPI Index.

Employee and school cafeteria food prices are down well below 20%. Over time these should moderate as schools and offices come online. Such will result in inflationary pressures.   

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Big Contributors

In June, 92% of CPI was due to the price changes of the ten largest index weightings, as shown below. Those ten goods played slightly less of a role in August, contributing 82% to the change in the index. Below is a comparison of the same ten contributors for June versus August.

The prices of Used Cars and Transportations rose at a lesser rate than June, but every other category was little changed.

In the original article, we warn Shelter prices are the most considerable risk to more inflation. Driving our concern is Shelter’s 30%+ contribution to CPI and rapidly rising home and rent prices.  As we show above, higher home and rental prices are barely making their way into CPI.  

What gives?

In our article BLS’ Housing Inflation Measure is Hypothetical Bull****, we stated: It appears impossible to calculate the BLS version of OER or rent.”

We remain concerned that a double-digit increase in rent and home prices (OER) will push Shelter prices higher in the months ahead. However, history proves reality, and the BLS Shelter measure has a near-zero correlation.

Flexible Prices

As we wrote in June, CPI tends to be heavily correlated with goods and services that have flexible prices. These are goods like gasoline, whose prices tend to fluctuate both up and down. The Atlanta Fed publishes data on flexible and sticky prices, as shown below.

The graph shows sharp increases in both flexible and sticky-price goods are leveling off over the last two months. Given the Atlanta Fed measure of flexible prices has a 96% correlation with CPI, we are hopeful the upsurge is halting.

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Expectations

The graph below shows a glaring divergence between Wall Street inflation expectations and those of Mom and Pop. Five and ten-year market-implied inflation expectations have been stable since January. All the while, the University of Michigan survey of consumers sees steadily rising inflation expectations.

While Wall Street buys into the transitory theme, consumers are not. This divergence matters as personal consumption drives about two-thirds of economic activity.

The New York Fed, via their latest Consumer Expectations Survey, highlights why confidence is weak. Per their survey, expected inflation is now over 5% and rising. At the same time, expected wage growth is 2.5% and stable/falling. As a result, consumers expect to lose 2.64% (red line) in purchasing power over the next year. Would you be confident taking a 2.64% pay cut?  

Summary

We are witnessing unprecedented pressures on the supply and demand side of pricing equations. Forecasting, with such uncertainty, is challenging. As such, we maintain a humble approach to inflation forecasting.

The latest round of data provides some evidence inflationary pressures are abating. However, the breadth of the data tells us there are still many goods and services still rising in price. This difference may help explain why consumer inflation expectations are higher than the market’s and confidence is falling.

Just How Transitory is Transitory? We suspect the market will have its answer in the next few months. Prolonged rising or high inflation beyond December will likely get many to question if inflation is truly transitory. Until then, pay attention to headline inflation, the breadth of the data, and especially any effects from rising Shelter prices on CPI.

Stocks Bounce Off Hard Off The Lows Reclaiming Losses.

Yesterday, stocks bounced hard off the lows reclaiming a chunk of earlier losses. But, as we will discuss, the 100-dma held firm as the stocks look to be trying to replay the March sell-off. This morning, futures are pointing sharply higher, suggesting the bulls are still roaming.

The benefit of the doubt remains with the bulls, which have repeatedly saved the market after minor losses. Will they come to the rescue again, or do we have to sweat out the 200dma (4105)? Unfortunately, answering the question is a little more complicated than it has been.

The Fed meets on Wednesday and will likely announce their plans to taper QE in November. Given the Evergrande situation and its effect on domestic and global markets, they may delay announcing “taper” or make it contingent on various factors. Also for consideration, they may well proceed with taper, despite risks to equity prices. Regardless, the Fed will play a big role in swaying investors’ moods.

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Housing starts, month-over-month, August (1.0% expected, -7.0% in July)
  • 8:30 a.m. ET: Building permits, month-over-month, August (-1.8% expected, 2.3% in July)
  • 8:30 a.m. ET: Current Account Balance, Q2 (-$190.8 billion expected, -$195.7 billion in Q1)

Earnings

Pre-market

  • 6:55 a.m. ET: AutoZone (AZO) is expected to report adjusted earnings of $29.81 per share on revenue of $4.57 billion

Post-market

  • 4:00 p.m. ET: FedEx (FDX) is expected to report adjusted earnings of $4.92 per share on revenue of $21.88 billion
  • 4:05 p.m. ET: StitchFix (SFIXis expected to report adjusted losses of 14 cents per share on revenue. of $548.07 million
  • 4:05 p.m. ET: Adobe (ADBE) is expected to report adjusted earnings of $3.01 per share on revenue of $3.89 billion

Will The Bulls Rush Back In?

As noted, the market solidly cracked below the 50-dma as the bulls failed to show. Such was a warning we discussed in “Investors Fail To Buy The Dip” this past weekend. To wit:

“We can attribute the weakness on Friday to ‘quadruple witching,’ where every type of option (stock index futures, stock index options, stock options, and single stock futures) all expired simultaneously.

However, history is also not on the market’s side, with the S&P 500 averaging a 0.4% decline for September, the worst of any month, according to the Stock Trader’s Almanac. Friday, in particular, began a historically weak period for stocks as those September losses typically come in the back half of the month.

Also, the markets are a bit nervous about the Fed’s meeting next week with an announcement of “tapering” asset purchases expected.

With the market very oversold, a counter-trend bounce next week will not be a surprise. However, if the market fails to hold the 50-dma, the risk of a more substantial correction is likely.

I have updated the chart below for Monday’s close. Note the similarity to the March period where the market closed well off its lows for the day. That bounce off the lows came with similar oversold conditions, and a follow-through rally reclaimed the 50-dma.

In today’s Technically Speaking, we discuss the two possible paths of the market now and the guidelines to follow over the next few days to rebalance portfolio risks accordingly.


There is Much More To The Evergrande Story

There is a lot more to the failure of China’s Evergrande company than meets the eye. At $16 billion, (China’s GDP) is no longer that far from that of the U.S. ($22 billion) and nearly three times Japan, the world’s third-largest economy. So, what China does and how they do it matters a lot. Not just to China but for the global economy. To help keep you better informed, we share a must-read commentary of the situation from @INArteCarloDoss.


60 Minutes Warned Us

In a memorable show, eight years ago, 60 Minutes reported on China’s property bubble and ghost cities. The Evergrande Company, on the verge of default and mentioned in the clip, is just the tip of the iceberg. If you want to understand better the imploding bubble China faces, watch the dated but poignant short episode.


What To Do With Markets In Turmoil


The Week Ahead – It’s All Fed

The Fed’s FOMC meets on Tuesday and Wednesday. Investors will focus on the policy statement and press conference. There is a large expectation that some taper announcement is likely to begin in November. The market will need to digest the pace at which they plan on tapering and what events or economic data may cause them to speed it up or slow it down. If they do not announce tapering, there is another factor that few investors are considering. As we wrote in The Fed Speaks Loudly and Carries a Big Feather, there is the possibility of dissension from some voting members. Per the article: Will they dissent? One or two dissents, while not frequent, are not uncommon either. The market reaction might get muted to a bit of friction. Where we offer caution is if the number of dissenting voters totals four or five or even more.”

The economic calendar is light this week with a slew of housing data. Of interest will be the Thursday PMI survey. Such will be the first national survey of manufacturing conditions for September. Recent regional manufacturing surveys have been better than expected over the last week, leading us to believe PMI may as well.

Technically Speaking: Stocks Bounce Off The Lows. Time To Buy?

On Monday, stocks solidly cracked below the 50-dma, but the bounce off the lows has investors asking if it’s “time to buy?”

The sell-off was not unexpected. As I discussed in “Investors Fail To Buy The Dip:”

“We can attribute the weakness on Friday to ‘quadruple witching,’ where every type of option (stock index futures, stock index options, stock options, and single stock futures) all expired simultaneously.

However, history is also not on the market’s side, with the S&P 500 averaging a 0.4% decline for September, the worst of any month, according to the Stock Trader’s Almanac. Friday, in particular, began a historically weak period for stocks as those September losses typically come in the back half of the month.

Also, the markets are a bit nervous about the Fed’s meeting next week with an announcement of “tapering” asset purchases expected.

With the market very oversold, a counter-trend bounce next week will not be a surprise. However, if the market fails to hold the 50-dma, the risk of a more substantial correction is likely.

I have updated the chart below for Monday’s close. Note the similarity to the March period where the market closed well off its lows for the day. That bounce off the lows came with similar oversold conditions.

The decline on Monday was not a surprise as we have discussed the need to “carry an umbrella.”

Why We Carry An Umbrella

We slowly decreased “risk” and adjusted holdings for the last several weeks to prepare for an eventual downturn.

“As we discussed with our RIAPRO subscribers, our goal is to reduce the “volatility” of the portfolio, thereby reducing risk without significantly sacrificing performance.

We still hold a slightly higher cash balance in the equity sleeve (~10%) and the fixed income sleeve (~10%). We use the cash as a risk hedge against an equity draw and “shorten duration” in the bond allocation. While we were previously increasing the duration of our bond portfolio to capture the decline in rates, we are holding cash to add longer-duration bonds on upticks in rates.”

Fed No Taper Now, Fed Says Taper Is Coming. Bulls Hear “No Taper Now.” 08-27-21

While those actions did not entirely shield our portfolios for such a steep and swift correction, those actions did limit the damage considerably. In addition, such allows us to use the correction to “buy assets” that are now oversold and have an improved “risk vs. reward” profile. 

Such is the advantage of “risk management” versus a “buy and hold” strategy. You can’t “buy cheap” if you don’t have any cash to “buy” with. 

Stocks Bounce, Is It Time To Buy?

The question on everyone’s mind is simplistic.

“Since stocks bounced, is it time to buy?”

As shown in the chart above, it is a difficult question to answer.

  • On one hand, the market has reached more extreme oversold conditions, sentiment is increasingly bearish, and the longer-term bullish trends remain intact. Such bodes well for a bounce.
  • Conversely, the market did break a key support level, is still well above the longer-term moving average, and internal indicators remain exceptionally weak. Such suggests any rally could fail short-term.

That statement may seem “wishy-washy,” however, the simple truth is I don’t know with certainty.

My best guess is the market likely gives us a one to two-day rally back to the 50-dma, which should get used to rebalance portfolio risk. However, if the market fails at that level, I suspect the market will continue the corrective action, and a test of the 200-dma is likely (red dashed line.)

On the other hand, if the market can muster a rally above the 50-dma, then an attempt at all-time highs is possible (purple dashed line).

As I said, it’s the best guess at two potential outcomes.

Patience Likely Needed

No. This is LIKELY NOT a buying opportunity for longer-term investors, people near retirement, or individuals who pay little attention to their investments.

For short-term traders, speculators, and opportunistic positioning, I suspect we are close to a bottom.

Regardless, the next buying opportunity will come. However, multiple issues are weighing on the market currently, to which investors need some clarity.

  1. China’s “Lehman Moment” with Evergrande
  2. The Fed meeting on Wednesday and risk of “taper.”
  3. Declining consumer sentiment
  4. Weakening economic growth
  5. A sharp reduction in global liquidity. 
  6. Increasing warnings on corporate earnings
  7. Debt ceiling debate
  8. Treasury funding and potential default worries.

Some of these issues will get solved in short order. Others won’t. I suspect the Federal Reserve will likely provide “dovish” guidance on Wednesday, which will give some relief to the market.

Therefore, we continue to suggest using rallies to rebalance risk accordingly.

Navigating Whatever Comes Next

The purpose of the analysis above is to provide you with information to make educated guesses about the “probabilities” and “possibilities” over the following days and weeks.

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

However, the analysis currently suggests the risks now outweigh the potential reward, and a deeper correction remains a distinct possibility. Such is particularly the case if the Fed takes a more “hawkish” stance.

While we remain optimistic about the markets currently, we are also taking precautionary steps to tighten up stops, add non-correlated assets, hold extra cash, and hedge risk opportunistically on any rally.

There is never any harm in reducing risk opportunistically and being pragmatic about your portfolio and your money. 

Portfolio Actions To Take Now

Here are the rules that we will continue to follow over the next few days and weeks.

  1. Move slowly. There is no rush in making dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.
  2. If you are over-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. Again, after big declines, individuals feel like they “must” do something. Think logically above where you want to be and use the rally to adjust to that level.
  3. Begin by selling laggards and losers. These positions were dragging on performance as the market rose and they led on the way down.
  4. Add to sectors, or positions, that are performing with, or outperforming the broader market if you need risk exposure.
  5. Move “stop-loss” levels up to recent lows for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  6. Be prepared to sell into the rally and reduce overall portfolio risk. There are a lot of positions you are going to sell at a loss simply because you overpaid for them to begin with. Selling at a loss DOES NOT make you a loser. It just means you made a mistake. Sell it, and move on with managing your portfolio. Not every trade will always be a winner. But keeping a loser will make you a loser of both capital and opportunity. 
  7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

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

We hope you find something useful in it.

Viking Analytics: Weekly Gamma Band Update 9/20/2021

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

Gamma Band Update

The S&P 500 (SPX) closed last week below the gamma flip level and with a negative slope, which resulted in a daily model allocation to 30% SPX (along with 70% cash).  Following the key quarterly option expiration week, there is less of a re-hedging upward current, so this morning’s weakness is not surprising. The chart below shows a dashed line for each of the last five monthly option expiration dates; this shows the tendency for weakness, before, on and/or after these dates.  In this “negative gamma” regime, the options market makers will tend to buy the rallies and sell the dips.  This results in an amplification of price direction, which feeds up and down volatility.

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. When the daily price closes below Gamma Flip level (currently near 4,465), the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,275), the model will reduce the SPX allocation to zero.  

 

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  Our “Smart Money” Indicator signal remains long but may be turning cautionary as we head deeper into the fall months.

With stocks climbing to historically high valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

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

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


Evergrande- Why Most Analysis Is Dead In The Water

Evergrande- Why Most Analysis Is Dead In The Water

There is a lot more to the failure of China’s Evergrande company than meets the eye. For the last year, China has been taking steps to curb speculation and promote economic productivity.

At $16 billion, (China’s GDP) is no longer that far from that of the U.S. ($22 billion) and nearly three times Japan, the world’s third-largest economy. What China does and how they do it matters a lot, not just to China but for the global economy. To help keep you better informed, we share a must-read commentary of the situation from @INArteCarloDoss. Please give him a follow on Twitter for powerful analysis on China and macroeconomic/market topics worldwide.

The following is from a series of Twitter postings, so please ignore the post’s casualness and any spelling/grammatical errors.  All highlights are ours.

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Evergrande: why most analysis is dead in water and how best to understand and navigate what’s happening? Both denialists and alarmists are getting it wrong. Let’s start by understanding this: what is happening is the result of a CCP-initiated policy change to curb leverage.  (CCP- China’s Communist Party)

It started a while back and has seen other defaults, including SOEs. What are the specific policy changes? Most important is the introduction of the 3 red lines a year ago: – L/A < 70%,  net leverage < 100%,  cash to ST debt > 1   (SOE= State-owned enterprises)

What’s the point of the 3 red lines? First and foremost, to forestall a systemic crisis that could have brought down the whole financial sector if left unchecked. Real estate amounts to a significant chunk of China GDP with strong linkages upstream and downstream.

And believe it or not, the sector was levered to the gills. The 3 red lines are hardly draconian, yet all the CCC, a large chunk of the B, and a good 1/3 of the BB did not pass them a year ago. Needless to say, it was really not too early. But there is more to it than leverage

One common practice of these construction companies, a game Evergrande excelled at, was to bid land at prices significantly higher than the market. It didn’t matter to them, coz the risk got transferred to flat buyers and banks that financed the purchase.

That model worked well for local governments, banks, and households because house prices were going up. So much so over the last 15 years, that a serious affordability crisis emerged in major cities AND HH debt soared way above disposable income – below HH debt as % GDP  (HH= Household)

So, it wasn’t hard to figure out the economic disaster in the making: exponential price rises with explosive HH and Construction leverage. But that’s not all. There is another problem that escapes most China analysts.

As a result of years of seeking easy growth through construction and leverage, the misallocation of capital was : 1- capital starving more innovative and high tech sectors (see chart) and 2- creating a headwind for a re-balancing towards a more consumption-driven growth.

At some point, reigning in lending to the RE sector became vital in order to address the structural issue of capital misallocation. That also explains the curbs on VC investments in RE and most importantly, a curb on all the irregularities that characterized RE.  (RE=real estate)

The issue of irregularities is at the core of what is happening with Evergrande. More on that later. It’s a long introduction, but it seemed important to explain these issues to understand the long-term nature of this problem and why its resolution will be tedious.

So, there is a new paradigm dictated by a set of economic realities that CCP could no longer ignore, and most importantly, they can relax the rules a bit, but can’t reverse course. They can’t allow consumers to be bust nor a rogue unproductive sector to balloon further.

The tail risk emanating from the implementation of this new paradigm is being priced in. It’s not only Evergrande’s credit that is collapsing but the whole HY market. Contagion is AT work. China HY is some 10% away from its March 2020 low….that’s not benign  (HY= High yield aka Junk Bonds)

Within construction, many weak operators are seeing their credit collapse: Fantasia, R&F, Suna, China Aoyuan. But that’s not all. The stress is spreading to the banks and financials. Here is Minsheng and Ping An – next level up would be IG starting to show stress

So, we established that we are in the phase of pricing the tail risk. All in all, it’s pretty China-centric for now. How could it create contagion beyond? There are significant losses already for the international holders of China credit and equities. That’s one channel.

Any broader contagion on towards the financial sector in China will prompt temporary policy responses like liquidity injection (done this week). But don’t expect a turnaround. They can’t. How will it resolve itself? Well, it started with leverage as the big issue.

So it will get resolved through asset sales. Idiosyncratic stories will dominate. Stronger balance sheet players will snap land and construction sites. SOEs will snap some assets. State will unwind bad players to help make whole employees and home buyers.

There is a shady side to many of these construction sites, none more so than Evergrande and their Wealth management products sold mostly to employees. They can’t discharge the guarantees on many of these products and there are rumors of insider selling.

Expect more rot to be exposed, trials, accountability, compensation, etc…Stabilizing the onshore property market will be long, arduous, and risky. Evergrande alone has an order book of 1,7 m residential units. Those are down-paid for, yet unfinished.

Uncertainty and volatility will remain elevated. None of the ill-informed « they will bail them out » scenario is possible. One thing is certain, there will be a protracted construction slump in activity and price increases. CCP might not allow for house and land prices to fall.

There’s obviously a read-cross for all commodities, but mostly steel. Dalian Iron Ore started collapsing in July and never looked back. Unsurprisingly, August showed the biggest drop in steel output on record…

And guess who is taking note? The miners are. That’s how contagion works. Aussie miners are the obvious play here: you can see that RIO has established a downtrend and is looking primed for a large move down. $BHP and $FMG looking equally awful.

It’s not only a commercial issue. China’s consumers are very levered and while output has been restored to pre-COVID levels, consumers can’t keep up. Retail sales plunged recently to 11% below trend and all high-frequency measures are showing sluggish spending.

And China is looking at a winter of power shortages that is going to challenge its output further. It’s looking pretty dire, and a last level of pernicious contagion will come from the losses all unsuspecting US moms and pops will incur following years of reckless inflows.

While some signs of funding stress are emerging like the Onshore USD/CNY 1y swap rates ticking up, it’s still largely benign. China is a financial system where state and banks are one and liabilities locally dominated and held.

If funding stress signs don’t emerge, don’t conclude that there is no contagion. Contagion is playing out already if you know where to look.

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Our Summary

China is trying to pop a massive speculative bubble in real estate. To avoid an uprising or revolution, they must do it to avoid significant losses to the people. Given sizeable real estate holdings by their people, threading this needle will not be easy.

At a minimum, China’s actions will curb their insatiable demand for building commodities. Countries and companies that serve China in this regard are most at risk.

The author alludes that the same reckless speculation plaguing China will eventually occur here. We can debate all day whether China should or shouldn’t pop the real estate bubble. What is not debatable is that China is taking actions that will likely strengthen its economy via more productive investments in the long run.

If you want more background on China’s property bubble, please watch this dated but poignant short 60 Minutes episode- LINK.

Expecting “Stimulus?” Household Credit Explodes Higher.

In the second quarter, household credit exploded higher as stimulus payments ran dry. Was the surge a function of excess spending, inflation, or an expectation of more “stimmies” coming?

The chart below shows the total amount of household credit currently.

Consumer Credit Balances and Composition

If you stare very hard, you can make out the slight dip in credit usage during the “pandemic-driven shutdown.” However, such is not the case despite the narrative households paid down a bulk of their debt.

However, that narrative is a function of the following chart.

Consumer debt payments credit

While the chart suggests Americans are more solvent, as explained previously, it is an “illusion.”

An Explosion In Credit Usage

Not surprisingly, as three rounds of “stimulus payments” got spent, households returned to spending on credit. Here are some stats from Mish Shedlock:

  • In June, non-revolving credit rose by $19.83 billion. Revolving credit rose by $17.86 billion, and total consumer credit rose by $37.69 billion.
  • Total consumer credit is new record $4,318.65 billion.
  • In May, non-revolving credit rose by $27.60 billion. Revolving credit rose by $9.09 billion, and total consumer credit rose by $36.69 billion.
  • Despite a two-month surge in revolving credit of $26.95 billion, revolving credit at $992.25 billion is still down $105.28 billion from the pre-pandemic high of $1,097.53 billion.
Consumer Credit in Billions

However, the annual rate of change shows the surge in revolving credit as stimulus payments ran dry.

Consumer Credit Annual Change

While mainstream media was quick to tout the surge in credit, suggesting consumers are confident, the reality is quite different. Two factors are driving the surge in credit, and neither of them is good:

  1. Cost of living (inflation)
  2. Lack of wage growth.

Debt Required To Sustain, Not Increase, Standard Of Living

Every year, most Americans go further into debt to “sustain” their standard of living. To wit:

“In 1998, monetary velocity peaked and began to turn lower. Such coincides with the point that consumers were forced into debt to sustain their standard of living. For decades, WallStreet, advertisers, and corporate powerhouses flooded consumers with advertising to induce them into buying bigger houses, televisions, and cars. The age of ‘consumerism’ took hold.“

Consumer use debt (credit) to maintain standard of living.

Average Americans have a general lifestyle within which they survive. Such includes living necessities such as food, running water, electricity, mobile phone, computer, and high-speed internet connection. So, while the monthly cost of the mortgage and health insurance may not change, the rest of the necessities do.

Such becomes problematic when “inflation” rises faster than income. Such requires the addition of “debt” to make ends meet. Here is the critical point, individuals are NOT buying “MORE” stuff. They are just “PAYING” more for the same amount.

Annual change in wages not adjusting for inflation.

With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels. Such is because the debt service continues to divert savings from productive investment.

Reviewing Market Signals 06-11-21, Reviewing Market Signals As Warnings Increase 06-11-21

A Temporary Boost To Incomes Fills The Gap

As discussed in our previous article on the illusion of debt-to-income ratios, this snippet from the WSJ is worth repeating.

The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.”

Debt-To-Income, Why Debt-To-Income Ratios Are Worse Than They Appear

“Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A full 33% of that gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.”

Debt-To-Income, Why Debt-To-Income Ratios Are Worse Than They Appear

Such is essential in understanding the “illusion” of declining debt-to-income ratios, which is skewed by those in the top-10% of income earners.

More importantly, the sharp decline in debt-to-income ratios was a function of surging government transfers. At the peak of the pandemic stimulus, government transfers comprised over 40% of disposable personal incomes. With that ratio falling sharply as stimulus payments and benefits cease, it is not surprising to see the surge in credit usage.

Social Benefits as a percent of disposable incomes.

The Illusion Of Solvency

Much of the mainstream economic analysis utilizes either “averages” or “median” measures of a particular set of data. While there is nothing inherently wrong with reporting such data, the message can get distorted when there is a skew in the underlying data set.

Such is particularly the case when it comes to disposable incomes. The calculation of disposable personal income (income minus taxes) is primarily a guess due to the variability of households’ income and individual tax rates.

More importantly, as noted, the measure becomes skewed by the top 20% of income earners, needless to say, the top 5%. The chart below shows that those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)

median real incomes and the illusion of solvency

Disposable And Discretionary Are Not The Same

Furthermore, disposable and discretionary incomes are two very different animals.

Discretionary income is the remainder of disposable income after paying for all mandatory spending like rent, food, utilities, health care premiums, insurance, etc. For the bottom 80% of income earners, the cost of living outstrips a vast majority of those individuals (shaded area).

In other words, given the bulk of the wage gains are in the upper 20%, any data that reports a “median” or “average” of the information is inherently skewed to the upside. Such is why a vast difference between the debt service levels (per household) exists between the bottom 80% and top 20%.

debt service rations and the illusion of solvency for the bottom 80%,

Of course, the only saving grace for many American households is that artificially low-interest rates have reduced the average debt service levels. But, unfortunately, those in the bottom 80% still have a large chunk of their median disposable income eaten up by debt payments. Such reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged, and wage growth stagnant, the capability to increase consumption to foster higher economic growth rates is limited.

Expecting Another Bailout

The illusion of the decline in the debt-to-income ratios obfuscates real economic problems and fosters the belief that policies are working.

They aren’t.

Most Americans cannot increase consumption, the driver of economic growth, without further increasing debt burdens. For those in the top-10% of the wealth holders, higher asset prices, tax cuts, etc., do not lead to increases in consumption as they are already at capacity. 

While the Federal Reserve’s ongoing interventions, stimulus programs, etc., have certainly boosted asset prices higher, the only real accomplishment has been widening the wealth gap. What monetary interventions have failed to accomplish is an increase in production to foster higher economic activity levels.

With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels. Such is because the debt service continues to divert savings from productive investment. 

You can also understand why there is a demand for additional “stimulus payments,” bailouts, and other socialistic policies. Furthermore, since the Government has “shown their hand,” individuals now “expect:” that every time the economy stumbles, they will get bailed out again. So, why act responsibly.

Of course, they don’t realize those policies are what is exacerbating their “wealth inequality.”

Unfortunately, until the deleveraging cycle is allowed to occur, the attainment of more robust and autonomous economic growth will remain elusive.

In the meantime, those in the top 10% of income brackets will continue to enjoy an increase in overall prosperity. But, for everyone else, it is improbable that debt-to-income ratios have improved much.

Markets Set To Drop As Fed “Taper” Approaches

Markets are set to drop this morning as the Fed “taper” announcement approaches. Market bulls spent the better part of Friday trying to hold 50-dma but failed. At the time of this writing, futures are down sharply point to steep losses at the open.

The sell off isn’t a surprise, as we have noted previously, given the more extreme length of time without a correction of 5% of more. September is historically a weak month, and there has been a steady drumbeat of corporate earnings warnings. While the retail sales numbers were strong, they were primarily a function of “back to school” shopping. Consumer sentiment remains soft, and market internals have been very weak.

The one thing that has remained incredibly strong has been the flow of money into equities this year which has been a literal “off the chart” record. Despite the weak opening this morning, unless something changes that flow of capital into equities, the current correction will likely not be very deep.

Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: NAHB Housing Market Index, September (74 expected, 75 in August)

Earnings

  • No notable reports scheduled for release

Politics

  • President Biden will make his way to New York City for three days of meetings at the United Nations General Assembly. The president kicks things off with a bilateral meeting with UN Secretary-General António Guterres this evening. Biden will then speak to the assembly Tuesday and host a virtual COVID-19 Summit on Wednesday.
  • Both the U.S. House of Representatives and the Senate return to Washington this afternoon with deadlines looming. The lawmakers want to avoid a government shutdown and pass the infrastructure deal by the end of the month. They also hope to avoid a government debt default and pass Biden’s package of social spending soon afterwards.

Will Market Bulls Buy The Dip?

As noted, the market is set to slide sharply at the open, but cracks of the 50-dma are not unprecedented. In March we saw a similar break that quickly recovered. As shown below, the market is oversold on a short-term basis with the TRIX indicator (lower-panel) approaching levels where decent entry points previously existed. Such does not mean the market can not go lower over the next few days, but the recent decline reduced much of the short-term risk. If the Fed disappoints this week with a more “hawkish” statement than anticipated we could well see a move lower. A more “dovish” statement, which we expect, will likely see a quick recovery.

With September wrapping up the “seasonally weak” period of the year, we are looking to start increasing our equity exposure opportunistically over the next couple of weeks. While 2021 will almost undoubtedly end on a positive note, the risks into 2022 continue to build.

Yields Are So Low, And That “Ain’t” Necessarily A Good Thing

“Charlie Bilello noted that the dividend yield of the S&P500 was at its lowest point since the stock market bubble of 2000.  With the treasury bond market offering so little in interest rates, it begs the question: Is there anywhere to find yield today?

In his 2020 letter to shareholders, Buffett stated “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”  We quote him extensively in our piece examining the inflation of the 1970s and believe the charts below tell the story with brutal clarity.” – Kailash Concepts

The S&P500’s dividend yield is approaching the lowest level in over 40 years. Unfortunately, yield-starved investors seeking income have few alternatives.

In the dot.com bubble, you could buy risk-free 10 year Treasury Bonds with ~7% interest payments. Today, those same bonds offer virtually no return for record duration risk.

“These dismal bond yields have investors chasing returns in the most expensive equity market in history. One that also offers all-time low dividend yields.

The timing could not be worse. With over 10,000 Americans turning 65 every day, we are reminded of legendary value Investor Jean-Marie Eveillard. He once quipped, “Life’s bills do not come at market tops.” We believe these are times for avoiding the behavioral errors that have plagued investor returns where people crowd in at the highs and panic out at the lows.”

University of Michigan Sentiment Survey

After last month’s plunge, the University of Michigan Consumer Sentiment Survey was stable at 71.0, up slightly from last month. The index is well off the 110-120 rate it was running at for most of 2018 and 2019. Of focus, one year expected inflation seems to be stabilizing albeit at a high 4.7% rate. Longer-term 5-10 year expectations are 2.9%.  Per the survey, inflation concerns are spreading to a broader chunk of the population. Consider the following quote: “over the past few months, complaints about rising prices have increased among younger, richer, and more educated households

Excess Cash No More

On many occasions this year we noted how the Treasury is carrying excessive levels of cash. The graph below shows the spike in cash due to the massive pandemic-related debt issuance and slow-to-follow spending. Federal spending has caught up, and cash balances are back to normal. The result will be an increase in the supply of Treasury debt. This dynamic is occurring at the same time the Fed is contemplating buying fewer bonds. Over the last six months, Treasury supply has not been a concern for the market due to large Fed purchases and reduced issuance. The supply/demand equation will change in the months ahead possibly pressuring yields higher.

Shipping Costs Soar

Is It Time To Buy The Dow?

The ratio of the Dow Jones Industrial Average to the NASDAQ is approaching levels last seen at the peak of the Tech Bubble. Favoring the Dow over the NASDAQ paid handsome dividends from 2000 to 2003. Are we nearing a similar opportunity? The composition of the Dow has changed over the last 20 years.

Unlike, the late 90s the Dow now has more tech exposure, like Microsoft at 5.7% of the index and SalesForce at 4.8%. It also holds Apple, albeit at a lesser weight. The Dow’s three top holdings, accounting for a fifth of the index. Those are UNH, GS, and HD. That compares to the NASDAQ’s top three holdings AAPL, MSFT, and  AMZN account for nearly a third of the index. While the Dow has MSFT and other tech companies, a bet on the Dow is a bet against the world’s largest technology companies. Currently, the FAANG stocks driving the NASDAQ’s outperformance are considered both high growth and safety stocks. That narrative must change before the Dow has a fighting chance.

Investors Fail To “BTFD” As They Await Fed “Taper.”

In this 09-17-21 issue of “‘Investors Fail To BTFD As They Await Fed Taper.

  • Investors Fail To BTFD
  • The Slope Of Hope
  • A Reason The Fed Can’t Taper…Yet
  • Portfolio Positioning
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Starts A Correction Right On Cue

As noted last week:

That correction started on Monday with the week ending in 5-straight down days which is the worse slide since February.

However, while that sounds terrible, the total decline for the week was just -1.69%. Yes, that’s it, less than 2%. While CNBC probably ran their “Markets In Turmoil” segment, traders huddled over candles and incense chanting incantations at the Fed for more accommodation.

The hope, of course, was that retail investors would step in to “Buy The Dip,” as they have done repeatedly this year, at the 50-dma. But, interestingly, such was not the case with the market finishing the week down, as shown below.

If you back the time frame up a bit, you kind of need to squint to see the correction.

Perspective is always important.

Waiting On The Fed

We can attribute the weakness on Friday to “quadruple witching,” where every type of option (stock index futures, stock index options, stock options, and single stock futures) all expired simultaneously.

However, history is also not on the market’s side, with the S&P 500 averaging a 0.4% decline for September, the worst of any month, according to the Stock Trader’s Almanac. Friday, in particular, began a historically weak period for stocks as those September losses typically come in the back half of the month.

Also, the markets are a bit nervous about the Fed’s meeting next week with an announcement of “tapering” asset purchases expected.

While all that sounds terrible, the total decline for the last two weeks is just -2.4%. Yes, that’s it, just 2.4%. As noted, it looks much worse on a short-term chart due to the low volatility advance this year.

As noted last week, the sell-off to the 50-dma was not a surprise.

With sell signals in place, volume rising, and breadth weak, a retest of the 50-dma early next week will not be a surprise. The question will be whether traders show up again, as they have done every other time over the last 6-months to ‘buy the dip.’

As shown, the market remains well confined to its rising trend with support sitting at the 50-dma. Volatility did pick up late last week as volume spiked suggesting more selling pressure on Monday.

With the market very oversold, a counter-trend bounce next week will not be a surprise. However, if the market fails to hold the 50-dma, the risk of a more substantial correction is likely.

Longer-term market risk remains exceptionally high.



It’s Always Time To Buy Stocks

When looking at long periods of market history, the current market stands out as an apparent anomaly. Many younger investors in the markets today are unaware of the “melt-up” in prices and the Fed’s naivety of the laws of physics. After more than a decade of rising prices, accelerating markets seem entirely normal, detached from underlying fundamentals. During these periods, investors create new acronyms like “TINA” and “BTFD” to rationalize accelerating prices.

However, a more extended look at price history suggests the current market environment is anything but ordinary. More importantly, the moral hazard” created by the Federal Reserve’s continuous bailouts have put individual investors at significant risk.

In the short term, like the chart above, prices don’t seem that extraordinarily stretched. However, this is because the chart lacks context from a historical perspective. Once we look at the market from 1900 to the present, a different picture emerges compared to its exponential long-term growth trend.

Usually, I would present a long-term chart like this using a log-scale which reduces the impact of large numbers on the whole. However, in this instance, such is not appropriate as we examine the historical deviations from the underlying growth trend.

What you should take away from the chart above is apparent. Investing capital when prices are exceedingly above the underlying growth trend repeatedly had poor outcomes. Investing capital at peak deviations led to very long periods of ZERO returns on capital. (Interestingly, as the Fed became active in the markets, the periods of zero returns got cut in half.)


Daily Market Commnetary

The Slope Of Hope

Sir Issac Newton discovered the relationship between the motion of the moon and the motion of a body falling freely on Earth. His dynamical and gravitational theories established the modern quantitative science of gravitation. Moreover, Newton realized that this force could be, at long range, the same as the force with which Earth pulls objects on its surface downward.

Notably, there is a clear “gravitational pull” of prices to the exponential growth trend line. Thus, without fail, when prices have deviated well above the trend line, there was an eventual reversion below the trend.

Even on a short-term basis, 1990-present, the current advance also stands out. The chart below shows the slope of the linear regression of the market. Historically, markets trade above and below that linear trend. However, currently, the slope is surging higher.

It is important to note that these are all monthly data points. As such, change will come slowly. The problem for investors is that when a “warning” doesn’t immediately devolve into a correction, it gets assumed the warning is wrong.

Therefore, it is essential to be aware of the excesses that currently exist in the financial markets. At some point, something will happen, and a change in “psychology” will occur. When the algorithms eventually switch from “BTFD” to “STFR” (Sell The ****ing Rally), it will be too late for most to avoid capital destruction.

For now, BTFD remains alive and well, as long as the Fed “put” remains.

But is that about to change? Maybe not.


In Case You Missed It


A Reason The Fed Can’t Taper…Yet

While the market expects the Fed to announce “taper” plans next week, there is one reason they might stall.

“As repo expert Scott Skyrm said, ‘for the past several years, Congress always reached a compromise before the possibility of a ‘technical default’ creeped into the markets. This year, as we get closer to the ‘drop dead date’ (which hasn’t yet been determined) the markets will start pricing in distortions.

Mitch McConnell, Senate Minority Leader, repeated to Secretary Yellen what he has said publicly since July: ‘This is a unified Democrat government, engaging in a partisan reckless tax and spending spree. They will have to raise the debt ceiling on their own and they have the tools to do it.” – Zerohedge

As we discussed previously, the current mandatory spending of the Government consumes more than 100% of existing tax revenues. Therefore, all discretionary spending plus additional programs such as “infrastructure” and “human infrastructure” comes from debt issuance.

Bulls September Weakness 09-03-21, Can The Bulls Defy The Odds Of September Weakness? 09-03-21

As shown, the 2021 budget will push the current deficit towards $4-Trillion requiring the Federal Reserve to monetize at least $1 Trillion of that issuance per our previous analysis. We discussed this previously, but there is a critical point.

The scale and scope of government spending expansion in the last year are unprecedented. Because Uncle Sam doesn’t have the money, lots of it went on the government’s credit card. The deficit and debt skyrocketed. But this is only the beginning. The Biden administration recently proposed a $6 trillion budget for fiscal 2022, two-thirds of which would be borrowed.” – Reason

The CBO (Congressional Budget Office) recently produced its long-term debt projection through 2050, ensuring poor economic returns. I reconstructed a chart from Deutsche Bank showing the US Federal Debt and Federal Reserve balance sheet. The chart uses the CBO projections through 2050.

Bulls September Weakness 09-03-21, Can The Bulls Defy The Odds Of September Weakness? 09-03-21

For The Democrats It’s “Reconciliation Or Bust!”

The problem for the Democratically controlled Congress is they can not issue a “Continuing Resolution” solely to lift the debt ceiling. Such would entail passing a resolution that takes last year’s base budget spending and adding 8% to it.

While doing so would immediately solve the funding problem for the Government, it would force Congress to abandon the “reconciliation process” for passing their massive socialistic, debt-driven agenda. For the Democrats, who only hold slim majority control, their spending plans depend on the reconciliation process. The process is a budgetary procedure to align the House and Senate on spending bills and only requires a majority vote. (51%).

Such was a point made by Bloomberg:

The expansive $3.5 trillion package entails much of Biden’s first-year agenda and includes a mix of tax increases on the wealthy and corporations, as well as greater spending in areas including child care, health care, and climate change. 

With Republicans unified in opposition, Democrats are pushing it through the Senate using a process called reconciliation that lets them skirt a GOP filibuster. But with the slimmest of majorities in both chambers, Democrats will have to be unified in support.

The differences among Democrats manifested themselves as the House panels finished their work. The Ways and Means Committee deferred action on raising the limit on the state and local tax deductions, or SALT, and a sweeping proposal to regulate drug prices failed to win approval in the Energy and Commerce Committee. It will be up to party leaders to decide whether those provisions can be inserted later in the process and still muster the votes needed to pass the final bill.

Caught In Their Own Trap

If the Democrats pass a continuing resolution to raise the debt ceiling and fund the Government without including the $3.5 trillion “human infrastructure” bill, then the spending bill would require a 60-vote margin to pass. Given that no Republicans will support the spending bill, a failure to include it in the budget process is a “death knell.”

“In reconciliation, we’re going to all come together to get something big done and it will be our intention to have every part of the Biden plan in a big and robust way. We’re going to work very hard to have unity, because without unity we’re not going to get anything.” – Senator Chuck Schumer, Senate Majority Leader

In other words, the Democrat’s own “greed” to shove their agenda down the throats of the American people, rather than working on a bipartisan solution (the way Congress is supposed to work), now has them trapped into a “do or die” situation.

Given the Democrats recognize this problem, they are unlikely to pass a “C.R.” anytime soon. Such will force the Treasury to use “emergency measures” to fund mandatory spending. If that is indeed the case, the Fed will not be able to “taper” their balance sheet purchases unless they are willing to risk a surge in interest rates, a collapse in economic growth, and a deflationary spiral.

Things are likely to start getting interesting.



Portfolio Update

The expected correction back to the 50-dma occurred right on schedule. As noted in our daily market commentary:

The graph below shows the incredible regularity of the market over the last four months. As shown, every 20 days the S&P 500 tends to decline for a few days, bottom, and then rally back to prior highs.

Buy The Dip, Time To “Buy The Dip” & Bitcoin’s “Golden Cross”

So the only question is whether this time will be different?

We have no idea what will happen next week, given the Fed’s announcement. Therefore, we are maintaining our current allocations. As noted last week, equity allocations remain underweight, bond duration remains close to our benchmark, and cash remains roughly 10% of our equity allocations.

While there currently seems to be “no risk” to taking on excessive “risk,” this overconfidence in our abilities always leads investors to make overwhelming bad decisions in their portfolio.

Let me close this week with a quote from Howard Marks of Oaktree Capital Management:

Information and knowledge are two different things. We can have a lot of information without much knowledge, and we can have a lot of knowledge without much wisdom. In fact, sometimes too much data keeps us from seeing the big picture; we can “miss the forest for the trees.”

It’s extremely important to know history, but the trouble is that the big events in financial history occur only once every few generations. In the investment environment, memory and the resultant prudence regularly do battle with greed, and greed tends to win out.

Prudence is particularly dismissed when risky investments have paid off for a span of years. John Kenneth Galbraith wrote that the outstanding characteristics of financial markets are shortness of memory and ignorance of history.

Have a great weekend.

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 71.08 out of a possible 100.


Portfolio Positioning “Fear / Greed” Gauge

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

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 74.8 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “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. (Ranges reset on the 1st of each month)
  • Table shows the price deviation above and below the weekly moving averages.

Weekly Stock Screens

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

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

S&P 500 Growth Screen

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

Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

After a near 2% market crash, the “BTFD” crowd failed to appear. The good news is that the portfolio models withstood the massive selloff with minor damage. (I know, I am a little sarcastic, but if you have been watching CNBC, you would think someone lit the world ablaze.)

There were no changes to our current model allocations last week. As discussed previously, we continue to manage risk exposures to reduce volatility while still participating with the market’s advance. The stock selection remains key to carrying an overweight cash position and still outperforming our benchmark index.

To repeat from last week:

The continuing deterioration of market internals continues to suggest a rising risk profile to the markets. Such is why we continue to remain cautious in our allocation models.”

That did not change from the previous week.

It is hard to write informative updates in low volatility and complacent markets. It has been much like “watching paint dry.” However, such does NOT mean that we are not paying close attention to your money and investment goals. On the contrary, we take that job very seriously.

For now, there seems to be minimal risk in a market that continues to creep higher. Unfortunately, however, we will not always get to enjoy such low volatility markets, so enjoy them while you can.

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

No Trades Last Week

As always, our short-term concern remains the protection of your portfolio. Accordingly, we remain focused on the differentials between underlying fundamentals and market over-valuations.

Lance Roberts, CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors



Attention: In the next couple of weeks, the 401k plan manager will no longer appear in the newsletter. However, the link to the website will remain for your convenience. Be sure to bookmark it in your browser.

Commentary

Last week was more of the same. While the market action was a bit sloppier, the market decline barely encompassed 2%. Such is not a correction we can consider “buying into.”

As noted last week:

“The one thing to watch for is a violation of the 50-dma, which will most likely indicate we are starting a bit larger correction between 5-10%. Given the Fed looks to be aggressively moving towards tapering their balance sheet purchases, we may have seen the peak in the market for now. However, the bullish bias remains very strong, so it is still too early to get overly defensive.”

That remains the case this week. Continue to take some actions to reduce portfolio risk accordingly. Continue moving all new contributions to either money market or stable value funds for now. Rebalance your equities and bonds back to weightings as equities are now out of tolerance. Remain clear of international and small-cap stocks that continue to underperform,

There is no need to be aggressive here. We will have the opportunity eventually to do so, but it remains a seller’s market for now.

Model Descriptions

Choose The Model That FIts Your Goals

Model Allocations

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

Or, let us manage it for you automatically.


401k Model Performance Analysis

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

Have a great week!

A Financial Crisis Is Brewing in China. Will It Spread?

Evergrande, a Chinese company with over $300 billion in debt, is failing. Will it get bailed out, and if so how? While investors focus on the nuts and bolts of Evergrande, we sense a financial crisis of sorts is brewing in China. Given China is the world’s second-largest economy and driver of global growth, our focus turns to the possibility their financial crisis spreads beyond the Great Wall.

Trading might be volatile today due to quadruple witching in the options and futures markets. That said equities, bonds, and the U.S. dollar are trading relatively flat in pre-market trading this morning. The primary focus today and early next week will be on the Fed’s FOMC policy meeting on Tuesday and Wednesday. It is widely expected they will announce a taper timeline starting at the early November FOMC meeting. Investors will take their cue from the pace of QE as well as any stipulations that might derail, slow, or speed up the process.

Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: University of Michigan Sentiment, September preliminary (72.0 expected, 70.3 in August)

Earnings

  • No notable reports scheduled for release

Market Update

While investors did show up to BTFD yesterday, the “buying” was less than impressive. In recent months, when the market has touched the 50-dma, there were impressive rallies that pushed the markets back to all-time highs over the next couple of days. That aggressive buying has not been evident as of yet. With options expiration completing today, maybe we will see some buying again later this afternoon.

However, at the open this morning we are not seeing any follow-through as of yet with futures pointing lower.

Junk Bonds in China

The graph below continues our discussion of Evergrande. Yields in China’s junk bond market have doubled since late May. The problems facing its property markets and economy, in general, are widespread. China’s junk bond yields are back to levels when COVID first roiled markets. As a comparison, BofA’s B-rated U.S. junk index is 4.41%, well below 12.50% from March 2020.

Retail Sales on Fire (Sort Of)

U.S. Retail Sales unexpectedly rose 0.7% in August versus an expected .8% decline. However, last month’s data was revised from -1.1% to -1.8%.  Excluding gas and autos, sales rose 2.0%. While the data is economically positive, the markets may not like it as it bolsters the rationale for tapering.

The media exuberance was on bull parade yesterday as noted by Yahoo:

“U.S. consumers are riding to the rescue — yet again — by spending with reckless abandon in the face of potentially stagnating growth. August’s retail sales surprised to the upside, and although July’s data saw a sharp downward revision, National Retail Federation (NRF) calculations showed that sales have spiked by 12% year-over-year.

It gets better: Through August, the NRF estimates that sales are 15% higher than the comparable year-ago quarter, putting 2021’s retail sales on track to grow by double-digits from 2020, to at least $4.4 trillion. That’s unequivocal good news for an economy that’s ⅔ powered by consumer spending.”

However, there were two big factors feeding into the retail sales number yesterday – seasonal adjustments and “back to school” shopping which was not the case last year at this time. Such is what contributed to the 15% gain over last year’s sales. When we view retail sales in total we see that sales growth is rapidly dropping and returning back to previous trends.

These numbers were also influenced by the last remnants of stimulus. Such is why we are now seeing a massive surge in the use of credit to make ends meet.

While the NRF is optimistic, and they always are, the data is likely to disappoint in the months ahead as consumers are faced with higher costs and stagnant incomes.

Three Hot Stocks We Are Watching

Evergrande is Sinking

China’s largest real estate developer, Evergrande, is suspending trading in its bonds today but intends to resume trading tomorrow. The rumor is they will not pay interest or repay principal on any of its debt this week. Evergrande, with over $300 billion in debt, poses risks to the Chinese banking system and many foreign creditors. It is unclear whether the Chinese government will bail out its shareholders. With its stocks and bonds trading down significantly, investors are betting against it.

Michael Pettis (China Property Slowdown Deepens as Evergrande Hurts Outlook) provides great coverage on the problems in China’s property markets driving Evergrande’s potential default.

Rising Labor Costs

The table below, courtesy of Goldman Sachs, shows the sensitivity of each sector to rising labor costs. Industrials, which are typically labor-intensive businesses are not surprisingly, the most affected sector. It’s also worth noting, as shown at the bottom of the table, smaller companies have twice the EPS sensitivity to labor costs as larger companies.

Ferrari’s Are Cheap

We finally found a valuation technique that claims stocks are cheap. The graph below compares the earnings yield of the S&P 500 to junk bond yields. To put this technique into context, it is like saying a Ferrari is cheap when compared to a Lamborghini. Junk bonds have never been more expensive. Currently, the B-rated, Bank Americal junk bond index yield is 4.44%, about 2% below its average from 2016-2019. It’s also worth noting this measure deems stocks as expensive at the market lows of 2001, 2009, and recently in March of 2020.

Technical Value Scorecard Report For The Week of 9-17-21

Relative Value Graphs

  • This week’s results are interesting as the divergences between growth/low beta and value/cyclical sectors are not as evident as over the last few months.
  • Transports are the most overbought sector, albeit not at a very high score. Energy has moved up as well. That said, materials and industrials, two other sectors affiliated with cyclical sectors, are the most oversold sectors.   
  • Energy stocks had a great week, beating the S&P by over 3.5%. Over the last four weeks, it has been the best performing sector with an excess return of 7.42%.
  • Most factors/indexes remain oversold, with small and mid-cap stocks the most oversold. Inflation, worker shortages, and higher wages have a more significant adverse effect on these companies than many larger S&P 500 companies.

Absolute Value Graphs

  • Materials and Industrials are the only sectors oversold on the absolute graphs. Like small and mid-caps, higher wages and input costs are weighing on those sectors. Discretionary is the most overbought sector, but with a score just north of 50%, it has room to strengthen before we offer caution. Energy, trading better due to higher crude and natural gas prices, had the largest increase in its absolute score. It is overbought but not terribly so.
  • The S&P 500, bottom-right in the second set of graphs, is overbought as well, but within the year’s range. Its low scores earlier in the week almost brought it to fair value. For now, fair value seems to mark the lows for any local sell-off.  
  • There are no sectors more than two standard deviations from its 50 or 200 dma. The only close one is Technology at 1.75 standard deviations above its 200 dma.
  • Broadly speaking, there is little in this report to offer a warning that the recent sell-off could worsen. The new trend worth consideration is the bifurcation of the cyclical sectors due to inflationary concerns on profit margins.

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

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

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

#MacroView: Deficit Deniers & 40-Years Of Economic Erosion

After 40-years of economic erosion, there are still deficit deniers.

The belief that debt and deficits “don’t matter” primarily stems from the basis the economy hasn’t collapsed and become a historical equivalent of Weimer, Germany. However, the rather elementary view fails to distinguish that dropping a frog into boiling water or slowly bringing the water to a boil equates to the same outcome. That latter just takes longer to get there.

A recent article by Barry Ritholtz entitled “Time To Stop Believing The Deficit Bullshit” is an interesting read. It makes a logical argument as to why running massive deficits doesn’t seem to matter. (Such is the basis for Modern Monetary Theory)

We are told (over and over, again and again) that if we allow the federal government to deficit spend, a parade of horrors awaits us, including:

  • Excess Federal spending will crowd out Private Capital, choking innovation and new company formation;
  • The costs of US borrowing will skyrocket, making the debt impossible to manage;
  • The US Dollar will be devastated, and it will be radically devalued against all other currencies;
  • All of this will cause rampant inflation, spiking prices to levels not seen before;
  • Deficits will act as a drag on the overall economy;

It has been 50 years of hearing this — and NONE OF IT HAS PROVEN TRUE. So I am calling bullshit on this — and you should, too.”

On the surface, everything he states is correct. We haven’t seen the destruction of the underlying economy over the last couple of years from running a massive deficit.

In other words, deficits didn’t seem to drop the economy into a vat of boiling water.

But just because the evidence isn’t obvious, does that mean it doesn’t exist? For that answer, we must take a longer-term view.

Not All Deficit Spending Is Bad

In “Learn To Love Deficits,” I quoted Dr. Woody Brock, author of “American Gridlock,” on the critical distinctions between good and bad deficit spending. To wit:

The problem is that these progressive programs lack an essential component of what is required for ‘deficit’ spending to be beneficial – a ‘return on investment.’ 

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that in order for government ‘deficit’ spending to be effective, the ‘payback’ from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is ‘Country A.”

As Barry aptly notes, using deficit spending for projects that have a “return on investment” such as power production (geothermal, nuclear, tidal) or broadband, all of which users pay a fee to consume, is valid. Such is because the long-term revenue generated by these projects repays the debt over time.

Using deficit spending to fund social welfare programs has a long-term negative multiplier to economic growth.

Boiled Alive By Deficits

Barry is also correct that surging deficits have not led to a noticeable collapse in the dollar, private capital, rampant inflation, slower economic growth, and surging borrowing costs. However, like bringing the water to a slow boil, the frog doesn’t realize it is trouble until it’s too late.

The government’s serious endeavors into deficit spending began with Ronald Reagan in 1980. Since then, politicians concluded that a lot should be better if a little deficit spending is good. But, importantly, there only seems to be the positive benefits of a boost in activity and getting re-elected to office.

In the longer term, however, the water temperature is clearly on the rise.

While the dollar hasn’t collapsed under the weight of deficit spending, the negative strength trend relative to other currencies is clear.

Of course, as the dollar weakens and deficits grew, Inflation, for both producers and consumers, rose.

While it may not appear that deficits are crowding out private investment, the rise of behemoth companies like Apple, Google, and others, do crowd out innovation and new company formations. Such activities require capital, and there is a reasonable correlation between the ebbs and flows of deficits and capital acquisition.

Not surprisingly, as the dollar weakens, the movement of capital slows, and inflation rises, the rate of economic growth slows. Such should not be surprising as debt used for non-productive purposes diverts money away from productivity to interest service.

The one thing that deficits have not led to is surging interest rates and massive increases in borrowing costs.

However, that suppression of interest rates has come from two primary sources.

  1. Slower rates of economic growth
  2. Massive interventions by the Federal Government to suppress rates.
Krugman's delusion, Krugman’s Delusion: The Difference Of Theory Versus Reality.

But what about Japan?

The Japan Syndrome

As Barry notes:

“Not that we want to be like Japan, but their Public Debt to GDP ratio is 275%; in the U.S., it is 102%. None of the bad things about the Yen or private capital or borrowing costs have occurred. Japan can still borrow all it wants, and at very low rates, too.”

While he is correct the U.S. isn’t Japan, yet, I am not sure such is a template we want to follow.

Since the financial crisis, Japan has been running a massive “quantitative easing” program, which, on a relative basis, is more than 3-times the size of that in the U.S. Despite that massive surge in Central Bank interventions, it, like the U.S., has had little effect on economic prosperity.”

Japanization Nikkei, Japanization: The S&P 500 Is Tracking The Nikkei Of 1980

“Japan remains plagued by rolling recessions and low inflation, and low-interest rates. (Japan’s 10-year Treasury rate fell into negative territory for the second time in recent years.)”

Japanization Nikkei, Japanization: The S&P 500 Is Tracking The Nikkei Of 1980

Why is this important? Because Japan is a microcosm of what is happening in the U.S. As I noted previously:

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

Japanization Nikkei, Japanization: The S&P 500 Is Tracking The Nikkei Of 1980

Japan is a template of the fragility of global economic growth. 

Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible.

The Deficit Middle-Ground

Barry is correct that there is a middle ground on deficit spending.

Should governments use deficit spending for “productive investments” during periods of economic downturns? That answer is clearly in the affirmative category.

However, once the economy returns to growth, the deficits should get reversed into surpluses to prepare for the next inevitable downturn. Such is the entire underlying premise of Keynesian economic theory. But, unfortunately, politicians, in their ongoing endeavor to get reelected, just ignored the part of repaying debts.

While short-term deficits may have no consequences, the rising levels of corporatism, wage disparities, and wealth inequality provide ample evidence that something has gone wrong.

Are all the problems in the U.S. solely the result of unbridled deficit spending? Of course, not. The U.S. has spent four decades making poor political and economic choices as well.

  1. Massive increases in consumer and corporate debt.
  2. A shift from productive to non-productive labor.
  3. Poor immigration policies.
  4. The slow erosion of the rule-of-law; and,
  5. An undermining of capitalism and move to socialistic policies.

If you ignore all of the anecdotal evidence, an argument can get made for running continual economic deficits. However, suggesting “deficit hawks” are wrong is incorrect.

We can continue the path we are on for quite some time, and probably longer than most imagine.

But, just because we haven’t realized it yet, doesn’t mean we aren’t slowly being “boiled by deficits.”

Investors Show Up To “BTFD.” Will It Stick?

As we suspected investors showed up to BTFD but will it stick?

At a mere 10 points above the 50 dma animal spirits were ignited yesterday. Does yesterday’s bounce signal record highs are straight ahead or is it fools gold? At yesterday’s close, the S&P was only 70 points below the recent all-time high of 4550. The 50 dma sits below at 4430.

Unlike prior BTFD’s in the last few months, equity markets are opening slightly lower, and foreign markets are not jumping on the BTFD bandwagon. Further pressuring confidence, China’s largest real estate developer, Evergrande, is suspending trading in its bonds today. They have over $300 billion in debt outstanding. It is unclear whether the Chinese government will bail out shareholders.

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Retail Sales Advance, month-over-month, August (-0.7% expected, -1.1% in July)
  • 8:30 a.m. ET: Retail Sales excluding autos and gas, August (unchanged expected, -0.7% in July)
  • 8:30 a.m. ET: Initial jobless claimsweek ended Sept. 11 (323,000 expected, 310,000 during prior week)
  • 8:30 a.m. ET: Continuing Claims, week ended Sept. 4 (2.740 million expected, 2.783 million during prior week)
  • 8:30 a.m. ET: Philadelphia Fed Business Outlook Index, September (19.0 expected, 19.4 in August)
  • 10:00 a.m. ET: Business inventories, July (0.5% expected, 0.8% in June)
  • 4:00 p.m. ET: Total Net TIC Flows, July ($31.5 billion in June)
  • 4:00 p.m. ET: Net long-term TIC Flows, July ($110.9 billion in June)

Earnings

  • No notable reports scheduled for release

Courtesy of Yahoo!

Investors BTFD

As has been the pattern as of late, investors showed up yesterday to once again “BTFD.” As we have noted over the past few reports this activity has become almost clock work with declines bottoming during options expiration week.

During the recent “market crash” of nearly 2%, the slow decline, and heavy sector rotation, worked off the previously overbought condition (top panel.) That oversold condition has consistently provided the fuel necessary for a short-term bounce. With strong support at the 50-dma, the bounce was not unexpected as we discussed in this past weekend’s newsletter:

With sell signals in place, volume rising, and breadth weak, a retest of the 50-dma early next week will not be a surprise. The question will be whether traders show up again, as they have done every other time over the last 6-months to “buy the dip.”

The question, as noted above, is the bounce yesterday a signal to jump in with markets running back to all-time highs? Or, will the internal deterioration of the markets finally play catchup?

Buyback Support

One of the biggest supports for asset prices this year remains corporate share repurchases. As companies are sitting on a mountain of cash, with few options to deploy it, the most beneficial use of corporate coffers for insiders are share buybacks.

If you think the share buybacks are a “return of cash to shareholders” you need to read this:

Trouble in China?

Stringent lockdowns and political pressures are showing up in China’s economic data. For example, YoY growth in retail sales fell to 2.5% in August versus the estimate of 7% from a Bloomberg survey of economists. Furthermore, construction investment is down 3.2% YTD following China’s new property restrictions, which is impacting global demand for commodities. For example, Chinese steel output is at a 17-month low in August according to Bloomberg. China’s government avoided broad stimulus to support economic recovery, but some economists believe conditions will ease on margin moving forward due to slowing growth.

Can “Buy The Dippers” Drive Markets Higher?

Apple Has No Inflation

A great quote from Yahoo this morning following yesterday’s “Apple Product Release” day.

“CNBC’s Jon Fortt astutely observed that the House that Steve Jobs built opted to keep prices at iPhone 12 levels — effectively making the iPhone “inflation-proof.

Back in 2011, then-New York Federal Reserve President William Dudley attempted to reassure Queens consumers about spiking food prices. The central banker cited the latest iPad that cost the same as the prior version as a reason why “you have to look at the prices of all things.”

As one can imagine, the analogy went down badly with Dudley’s working-class audience. One attendee tossed out a memorably biting quip: “I can’t eat an iPad.”

A decade later, it suffices to say that iPads — or iPhones — still aren’t edible. Policymakers would do well to remember that.

Praseodymium and Neodymium Prices are Soaring

Why should I care about the prices of materials I have never heard of, you might be asking. These largely unknown metals and other are worsening supply delays and causing inflation in many popular technology goods. “Tech industry braces for skyrocketing rare earth prices” by NikkeiAsia, discusses why the prices of many rare earth materials are surging and the effect it’s having on tech manufacturers.

Per the article:“Praseodymium and neodymium belong to a category of metals known as rare-earth elements and are used to make neodymium-iron-boron (NdFeB) magnets. These permanent magnets, as they are known, are essential to a swath of tech gear — everything from speakers and electric vehicle motors to medical devices and precision munitions.”

Peaking Natural Gas Prices?

On Monday we pointed out natural gas prices are broaching the upper band of its ten-year range. Forex Live has interesting commentary arguing there may be more gains to come. For support, they cite the TD Securities graph below showing gas storage versus demand is at record lows (outside of the green band). It is also well below the recent five-year average. They think many analysts focus too much on the supply of gas and not enough on demand. Per the article, demand is picking up for the following reasons:  “What that ignores is that demand for natural gas has grown considerably in the past five years. The construction of many LNG facilities, the conversion of coal-fired power plants to natural gas and pipelines to Mexico all mean that larger inventories are needed.”  Further: “What’s especially worrisome is that there are no signs of increased drilling.

Peaking Delta?

Quite a few Fed members mention the Delta variant as a reason they should delay tapering. John Hussman’s model below expects fatalities from Delta to peak in the coming weeks. Assuming his model holds up, as it has, the number of fatalities should hopefully drop significantly into November and December. Accordingly, it should alleviate concerns from some Fed members.

5 Ways To Increase Spending in Retirement

Here are five ways to increase spending in retirement. Throughout their lifetimes, many retirees experience ‘portfolio withdrawal anxiety.’ It makes sense. After an eternity of being an accumulator or saving for retirement, psychologically, it’s a massive hurdle to begin and continue a withdrawal strategy, especially from portfolios comprised of variable investments like stocks. For those experiencing the anxiety of withdrawals and the ambiguity of retirement spending calculators, read on.

But first:

It’s normal to experience spending hesitation.

Keep in mind, you’re not alone if increasing spending in retirement scares you a bit, far from it. It’s rational and normal to feel this way. Why? The spending in retirement math is fraught with unknowns.

I call it the Uncertainty MEETS Uncertainty equation.

Investors are told by financial media and their brokers how they’re able to withdraw a FIXED 4% annually from a VARIABLE portfolio comprised of stocks, bonds, and cash. It’s like somebody telling you – sure, oil and water DO MIX (occasionally, that is).

JUST BELIEVE US!

Meanwhile, academics were explaining how 2.4% was the new 4% withdrawal rate during the pandemic. What gives? I’ll tell you what gives. It’s all a big guessing game with you and your wealth holding the short end of the stick. Surprise!

Let me be clear, repeat after me:

YOU CANNOT WITHDRAW AN INDEFINITE, SAME FIXED PERCENTAGE from your portfolio throughout retirement. Therefore, I cannot tell advise with complete confidence that a VARIABLE PORTFOLIO CAN PROVIDE THE SAME FIXED WITHDRAWAL RATE over a lifetime. If I did, I’d be lying. Or, at the least, I’d be depending blindly on a stale academic study older than most of our adult children.

So, give yourself a break. The uncertainties of future common stock returns over the long term (from this point where the Shiller P/E stands at close to 40x, I wouldn’t expect greater than 3% for market performance over the next decade or so), along with not owning the Magic 8 Ball of life expectancy, warrants increased awareness of spending in retirement. It doesn’t mean you shouldn’t spend; it means you tend to be conservative in the face of variability. It’s a completely rational response.

A recent analysis.

In a June 2021 NBER study, David Blanchett and Michael Finke tackle spending behavior (or lack thereof) in their academic paper Guaranteed Income: A License to Spend. More on the topic of guaranteed income and their analysis later. The authors also source multiple studies on spending trepidation.

The 2020 EBRI Retirement Confidence survey.

For example, the 2020 EBRI Retirement Confidence Survey found that 1 in 20 retirees don’t have a strategy to spend down their assets, and 2 out of 3 are looking to preserve assets for future generations. Survey participants were found to be living exclusively off the income their portfolios produce, which must be an extremely austere existence in this low-interest-rate environment.

One could say this is an extreme response to longevity risk. But, candidly, I understand how investors may be hesitant to tap deeper into their nest egg in a turbulent macro-economic environment where the only thing that seems to be working IS the stock market. Only because it’s a matter of time before the market pays attention and the Federal Reserve snaps it into reality by cutting off the QE drug.

You may be asking – How much can I spend in retirement?

This isn’t an easy question to answer. There’s no hard, fast rule of thumb. That’s why comprehensive financial planning is so important to create spending confidence and awareness. I’ll share with you what retirement nirvana is, however.

Mentor and retired Professor Emeritus of finance at Boston University Zvi Bodie told me retirement paradise was when a household’s retirement spending on mandatory expenses was covered 100% by guaranteed income options. Not stocks. Guarantees. An income a household could never outlive comes assuredly from products that provide income for life. In the old days, for the most part, these vehicles were called pensions.

So, here are 5 ways to increase spending in retirement.

ONE: Turn the unknowables to as knowable as you can get.

It is possible to envision, crystallize and plan a lifetime retirement spending strategy. Several factors are in your control. Obviously, we don’t know how long we’ll live, but thankfully based on a realistic assessment of lifestyle habits and an understanding of our families’ health histories, a life expectancy calculator such as www.livingto100.com can provide some clarity. If you go through the exercise, you’ll notice most of the questions are based on health-related habits.

Then, document the fixed expenses or necessities—mortgage, rent, all that’s required to keep a roof over your head. By the way, I have witnessed many people get really creative with lowering fixed expenses in preparation for retirement.

For example, a new retiree I assist slashed his fixed expenses by 30% by relocating to a manufactured home community in the Florida Keys. Communal breakfasts, neighborhood gardens, shared dinner gatherings, robust social activities. He purchased a modest home for $90,000. I know there’s an overall negative image of trailer parks; however, you sometimes need to think outside the box and keep an open mind.

This savvy retiree doesn’t regret the decision. On the contrary, I think the community and his home are simplistically beautiful because actions that guard against financial vulnerability make me feel all warm inside. Like cinnamon-roll-just-out-of-the-oven-warm! Living modestly is proving to be healthy for this investor’s overall fiscal and mental health.

Don’t squash your second childhood.

Next, envision the variable expenses and the fun stuff to spend money on in retirement. Of course, these expenses are the ones retirees are always told they should easily cut. But if retirement is indeed a second childhood, wouldn’t one look to bolster these expenditures or not stress so much over them?

Now, that may not mean trips to the French Riviera every year, but it could mean an additional road trip or an occasional excursion to Disney with the grandkids. In addition, I worked with a pre-retirement couple that maintained a generous health-wellness expense category which included spending on massages, vitamins, gym memberships, and annual mental health retreats!

A comprehensive financial plan that outlines specific goals and the probabilities of meeting them makes the unknowable knowable. Not completely, but enough to foster spending confidence. Investors who complete plans feel comfortable increasing spending in retirement because they possess a working knowledge of their tangible needs, wants, wishes, and overall income needed to cover or adjust them accordingly.

Keep in mind that a realistic plan matches the correct inflation rate to each goal and adjusts future investment returns based on current market valuations.

To sum it up, planning generates awareness. It’s a complete household financial health diagnostic. Awareness bolsters confidence, especially if a retiree micro-budgets for a year or two before the official launch. A micro-budgeting exercise where every household expense is accounted for allows retirees to dig deep into where their money goes and where changes need to be made. Zero-based budgeting allows for every dollar to be accounted for. Every dollar has a job. Miscellaneous is not a spending category.

Budgeting templates.

I prefer old-fashioned pencil and paper budget templates like Dome’s Simplified Home Budget Book. However, for those who prefer an online worksheet, look at the Weekly Budget Worksheet Budget Template from Google.

Keep in mind that your spending categories will change when retired, so be receptive to reducing them. Broad spending categories such as clothing and commuting will most likely be reduced. In addition, remember that saving for retirement is no longer an expense you need to worry about in retirement. For some, that was a significant expense category that will no longer exist. Retirees still need to manage their money wisely, especially the risk of investment loss. However, saving for retirement is an expense to wave to through life’s rearview.

Happiness is an ethereal concept, although economists and behavioral psychologists have spent entire careers attempting to define what it means to be happy. As a result, there are hundreds of studies about the topic. That’s fine, I guess. They are interesting to read.

To define retirement happiness on your terms, it’ll require a strong sense of self and an objective deep dive into how you define satisfaction. The idea is to untether money from the definition. The exercise will result in a stronger reconnect of dollars to expenditures. In other words, the unit of happiness per dollar spent can be enhanced, which means I won’t need as much money as I think to feel secure and fulfilled.

I love books. This is not a surprise for most RIA readers. The smell of pages, the inspiration of words. Since I was a boy, I loved musty used book stores in New York’s Greenwich Village, where the walls were so full of paperbacks I thought they sprouted from the cracked plaster.

Today, I still roam aged book and antique outlets to spend pennies on the dollar compared to new. I also have a library card (they still exist). In other words, I can achieve happiness from books at a much lower cost per dollar and revel in the excitement of experiencing unique book store locales. Some retirees use this thinking to boost happiness and reduce spending too.

A popular study on happiness.

One of the landmark studies on money and happiness from famed psychologist Daniel Kahnemann and co-author Angus Deaton links the subjective state of well-being with annual income levels. Per their research, a household income of roughly $75,000 “buys” happiness. Again, this is a captivating analysis. However, I can show you retirees with incomes significantly less than $75,000 who live enriching lives. So, again, happiness is subjective and is certainly an inside job.

Interestingly, spending on experiences, not material goods, was found to be more conducive to happiness. I find retirees especially tenured ones, love to spend on experiences. The simpler, the better. Modest lunches with friends, ice cream dates with grandkids, and even magazine subscriptions. For instance, a senior retiree I know subscribes to adult activity books to keep her mind sharp.

Redefining happiness may help retirees increase spending on categories that provide the maximum inner reward per dollar. Kahnemann’s study also found that spending on small indulges rather than big splurges fosters happiness.

I witness a similar conclusion with many of the retirees we serve.

THREE: Guaranteed income and increased spending in retirement.

A recent study outlines how consumers are fine with the words guaranteed income but not the word annuity, but for the most part, they are the same. Unfortunately, it seems that the creative word salad mollifies the populace.

Either way, a guaranteed lifetime income option, whether through the maximization of Social Security benefits, a product offered through an insurance carrier, or both, will be an important part of a retiree’s income strategy.

At RIA, we are preparing for a decade-long cycle of below-average returns for equities. Valuations inevitably will be a factor when the demand for stocks wanes. Keep in mind, lofty valuations don’t mean stocks need to crash. They can sit sluggishly for years working off the weight of the math. Think of it like sitting around in a daze after a third helping of pumpkin pie at Thanksgiving.

Ostensibly, for investors saving for retirement, low future returns are frustrating. However, during these periods, an investor’s strong fiscal habits, like saving more, reducing debt, and taking on personal improvements that increase wages, can make up for deficiencies in portfolio performance.

Distribution portfolios must be treated differently.

For retirees, investment return tailwinds are a unique, ongoing challenge. Anemic returns without a plan to monitor or adjust annual portfolio distribution can drain a nest egg quicker than anticipated. This is where guaranteed income products can shine, and I believe it’s a perfect time to consider them.

For example, a long-term headwind for market returns can exhaust it prematurely when a variable asset portfolio shoulders most of the retirement income burden. Think about what it must be like to run with a hundred-pound weight on your back. How far are you going to get?

Now, what if you could cut that weight by at least 50%? That’s what guaranteed income vehicles do. They lift weights. They shoulder some of the burdens of lower portfolio returns. That’s why the most successful retirees, even those with more than sufficient investment assets to afford a comfortable retirement, have greater breathing room to spend when they incorporate guaranteed income strategies.

A new study reveals guaranteed income sources help retirees overcome a psychological barrier to spend.

Per a June 28, 2021 paper for NBER by David Blanchett and Michael Finke entitled Guaranteed Income: A License to Spend, retirees who are behaviorally resistant to spending down savings may better achieve their lifestyle goals by increasing the share of their wealth allocated to annuitized income.

In other words, a guaranteed income gives retirees psychological breathing room to spend! The delay of claiming Social Security until age 70, an employer pension, an income annuity from a private insurer are examples of guaranteed income.

Annuities add clarity to the spending decision. Intuitively, it makes sense. After all, if I don’t need to worry about income running out, bear markets, and fluctuating portfolio withdrawal rates, I feel more comfortable increasing my spending psychologically.

From the study:

Annuities can both reduce the risk of an unknown lifespan as well as allow retirees to spend their savings without the discomfort generated by seeing one’s nest egg get smaller.

Annuities must be planned, not sold.

Generally, annuities get a bad rap because they’re sold to consumers who rarely understand them. Imagine purchasing an airplane and never being taught how to operate the cockpit. Instead, you sit and stare at the dials and switches, regretting the decision and wondering why you own this plane in the first place.

Not everyone needs an annuity. Most people have Social Security. That’s their annuity. However, a comprehensive plan can flush out a need for additional guaranteed income vehicles. Frankly, I don’t understand how annuities are sold like used cars. I mean, how can I even offer you an income annuity if I don’t know your needs, wants, wishes, household cash flow, income sources, and health status?

Regardless, the study makes sense. A guaranteed income vehicle makes the unknowable knowable. I don’t know how long I’m going to live. I don’t know if a bear market is going to wipe me out. Thus, the comfort of knowing about that check coming in no matter what is a great relief. Thus, I feel free to spend knowing I can never run out of money!

FOUR: Work longer to increase spending in retirement.

Ok, nobody wants to hear it, but working longer can add life to your portfolio, and possibly you too! Working longer for older cohorts has been on a dramatic rise since 2000. In addition, the pandemic has forced older Americans to consider retirement. However, the reality is that most retirees will need to work at least part-time to supplement retirement cash flow and postpone filing for Social Security to receive maximum benefits.

Today, one in three people aged 65-69 is working, and one in five age 70-74 is working, most of them are women.

Hey, it’s not all bad.

Bet you didn’t know that something as easy as working three to six months longer boosts retirement income by as much as increasing retirement contribution percentages by one percentage point over 30 years of employment. Yes, you read that correctly. The analysis is from another NBER Working Paper titled Working Longer Can Sharply Raise Retirement Income. The authors discover that primary earners of ages 62-69 can substantially increase their retirement living standards by working longer.

Conclusion: there are several obvious reasons why working longer helps increase income, which can bolster spending in retirement. Older workers still contribute to savings, postpone withdrawals, can purchase income annuities, and, cheaper and most importantly, wait to take Social Security.

As the analysis outlines:

The largest factor is the increase in Social Security benefits from claiming later. For example, if an average 66-year-old works one year longer and claims Social Security one year later, that person sees a 7.75 percent rise in retirement income, the researchers calculate. Some 83 percent of the gain comes from the rise in Social Security benefits. The federal program offers a higher benefit to a given individual if that person claims benefits at age 67 rather than at age 66.

Working longer is good for your health. No, really it is. And for spending too!

There exists a strong positive correlation between employment, longevity, and social engagement. For example, a Pension Research Council Working Paper by Tim Driver and Amanda Henson from The Wharton School links working longer to health and longevity.

After retirement, there’s a great chance of cognitive decline in older adults. Work staves off the adverse effects of social isolation. Interestingly, most older workers polled for a survey referenced in the paper would rather work a job completely different from what they’ve done in the past. For example, a new retiree I partner with recently applied for a job at Cabela’s because of his expertise with firearms.

Vibrancy in retirement comes from feeling important to ourselves and the community. Of course, a part-time job provides many internal rewards outside of the money but, the extra cash to increase spending in retirement doesn’t hurt!

FIVE: Think outside (or inside) the box when looking to increase retirement spending.

The majority of the wealth of middle-class households sits on a foundation. According to Visual Capitalist, a principal residence for over 61% of households with a net worth of $0 and $471K represents the cornerstone of wealth. So, why not consider the equity in a house an untapped source of retirement cash flow? Why not use your home to help increase spending in retirement?

Reverse mortgages or home equity conversion mortgages have a bad reputation even though they have changed dramatically over the years. No longer predatory, HECMS can be a powerful income tool in a fiscally responsible retiree’s arsenal.

Facts about reverse mortgages.

Reverse mortgages have several layers of costs (nothing like they were in the past), and it pays for consumers to shop around for the best deals. Understand to qualify for a reverse mortgage, the homeowner must be 62, the home must be a primary residence, and the debt limited to mortgage debt.

One of the smartest strategies is to establish a reverse mortgage line of credit at age 62, leave it untapped, and allow it to grow along with the home’s value. The line may be tapped for long-term care expenses or to generate a monthly distribution for increased spending in retirement. Also, consumers can use the reverse mortgage line for income in years where portfolios are down, thus buying time for the portfolio to recover. Once assets do recover, rebalancing proceeds or gains may be used to pay back the reverse mortgage loan, consequently restoring the line of credit.

Here’s an example of how a reverse mortgage can work. Keep in mind, if you plan to remain in your residence through retirement or age in place, a reverse mortgage doesn’t require repayment.

Using rough numbers and the calculator at reversemortgage.org, I came up with the following to help increase spending in retirement:

House value in zip code 77008: $700,000.

Existing mortgage: $200,000.

If I were age 66 (I used a Social Security Full Retirement Age), I would be able to collect $301 a month generally for as long as I’m in the home.

Keep in mind the fees came in at roughly $26,000. I wouldn’t come out of pocket for those, by the way.

Finally, consumers can use a reverse mortgage to pay off their existing mortgages, thus increasing retirement cash flow by eliminating payments.

To learn more about reverse mortgages, click here.

A note about retirement spending calculators

There are more retirement spending calculators on the internet than photos of Kim Kardashian in a bikini. Ok, I have no idea but, I believe it’s a reasonable assumption. I would say, for the most part, be skeptical of these quick and dirty tools. Why? Just like that cellophane-wrapped sandwich sitting in a warm fridge at the local gas station, you don’t really know what’s in them. What rates of returns do they use for investments? How do they calculate inflation?

Retirement spending calculators from reputable financial firms such as Vanguard and Fidelity may be used as a starting point but keep in mind, they’ll use HISTORICAL asset class return numbers, and the classic “past performance is not indicative of future results” applies more than ever based on current lofty market valuations.

Ways to increase spending in retirement: a final word

The best path to understanding how much you need to save for and spend in retirement is completing a comprehensive financial plan with a trusted fiduciary like RIA, who estimates future asset class returns and monitors trends in healthcare costs and inflation overall.

Overall, increasing spending in retirement is achievable, but it requires multiple steps and ongoing monitoring of budgets and withdrawal rates. As a child, you received an allowance. In retirement, you also pay yourself an allowance. You’re the parent, the mindful steward, AND the child now.

Use the money to capture memories, do what you love, and stay healthy enough to enjoy every dollar spent.

David Robertson: The Inelastic Market Hypothesis.

What is the “Inelastic Market Hypothesis?”

If you take a quick look at returns for the S&P 500 over the last few years, it is easy to be impressed with how lucrative stocks can be. Total returns above 31% in 2019, 18% in 2020, and 21% year-to-date (as of 8/31) can make a difference. Unfortunately, the levitation at the end of this summer hardly stands out in this context. Instead, it is just more of the same.

When stocks are rolling along this well, it’s easy just to let it happen. So why ask too many questions? While nobody wants to “jinx” the run, it behooves long-term investors to be at least aware of the risks. After all, a big run-up followed by a big run down on a roller coaster may be exciting, but retirement funds can be painful. A new theory about market behavior identifies some of those risks, challenges some old assumptions, and has profound implications for investors.

While it is easy to bask in the strong stock returns of the last few years, it is healthy to maintain some perspective. Trey Reik does this in spades in the September 3, 2021, edition of Grant’s Interest Rate Observer:

“After achieving 2019 total return of 31.48% on the back of meager 5% earnings growth, the S&P 500 proceeded to alchemize its 33% earnings collapse in 2020 into additional gains of 18.39%. Now, with Q2 2021 warnings largely in the bag, S&P trailing 12-month reported earnings ($150.20E) are finally poised to exceed the low $130s level they first reached back in calendar 2018 ($132.39), a feat so far rewarded in 2021 with additional gains of 20.01% (8/13).”

In other words, all of that impressive performance has come on the back of earnings that have done absolutely nothing.

The Inelastic Markets Hypothesis

It doesn’t take a rocket scientist to sense something might be wrong with this picture. A recent paper by Xavier Gabaix and Ralph S.J. Koijen, entitled “In Search of the Origins of Financial Fluctuations:

The Inelastic Markets Hypothesis” provides a very plausible explanation. The Economist provides a good summary of it:

“Using statistical wizardry, the authors isolate flows into stocks that appear unexplained (by, for example, GDP growth) over the period from 1993 to 2019. They find that markets respond in a manner contrary to that set out in the textbooks: they magnify, rather than dampen, the impact of flows. A dollar of inflows into equities increases the aggregate value of the market by $3-8. Thus, markets are not ‘elastic,’ as textbooks say they should be. Messrs Gabaix and Koijen, therefore, call their idea the ‘inelastic markets hypothesis.’”

How It Works

The logic behind the hypothesis is straightforward and focuses on the dynamics of supply and demand for stocks. According to Gabaix and Koijen, “Households allocate capital to institutions,” and those institutions “are fairly constrained” in what they can do. More specifically, most investment institutions have “moderate scope for variation in response to changing market conditions.”

As a result, “the price elasticity of demand of the aggregate stock market is small, and flows in and out of the stock market have large impacts on prices.” For example, if a fund “wants to buy $1 worth of equities”, the reality is, “many funds actually cannot supply that [incremental $1 worth of stock]”. Stock index funds cannot suddenly sell stocks and replace them with bonds.

There are other reasons for inelasticity. Gabaix and Koijen also show “that equity shares are quite stable over time for broad classes of investors.” The empirical evidence confirms that most institutions maintain relatively stable equity shares due to having rigid mandates. The authors attribute this phenomenon at least in part to the introduction of target-date funds.

In addition, the transfer of equity risk isn’t any more likely to happen across investor sectors than within them. The authors explain this “implies that the demand elasticity of most investors is quite small or that investors experience nearly identical demand shocks.”

Markets could be inelastic if there is a shortage of organizations that can arbitrage away mispricings caused by inelastic demand. Unfortunately, while the authors make this case, they do not provide especially compelling evidence. That said, given the number of the valuation-based funds that have either closed down or reoriented strategy, it is very plausible that little capital is left to absorb shocks in demand for equities.

What It Means

In simple terms, the consequence of demand inelasticity is that imbalances in supply and demand get resolved by way of price. In other words, when excess money flows to funds with rigid mandates, something has to give. For example, when funds flow to stock funds, one of the primary sources of supply must be balanced funds. The only way for a balanced fund to remain in balance is if it sells stock. Or if the stock gets sold at a price high enough to maintain the relative position of remaining holdings. Voila, higher prices.

With this market structure, stock prices do not necessarily reflect discounted cash flows, i.e., underlying economic value. Instead, prices represent the supply and demand for stocks at a point in time. Indeed, this explains observed market behavior quite well. Stocks don’t need earnings or assets to go up; they need a regular source of inflows.

As shocking as this may seem, it is not hard to reconcile the inelastic market hypothesis with more conventional beliefs about elasticity. The critical issue is the market has lost diversity. For a market to function well, it needs a relatively large number of participants, who are diverse, and who act independently. That has changed over the last couple of decades with the proliferation of passive funds and target-date funds.

There are commentators who claim passive funds do not yet dominate market share and therefore have little effect on markets. But this semantic stubbornness misses the more significant point: It is not about what the funds get called, but what they do. For example, what happens when there is a demand shock? Increasingly, funds do the same thing, and there is too little capital on the other side to offset the incremental flows.

Market Efficiency

This leads to another interesting and hugely important phenomenon: The market is reasonably efficient in the short term but has become inefficient in the long term. As Gabaix and Koijen point out:

But again, it [the stock market] is “short-term predictability efficient” (it smooths announcements) and “micro efficient” (it processes well the relative valuations of stocks). Still, it is not “macro efficient” (as Samuelson (1998) put it) or “long-term predictability efficient” – it does not absorb well very persistent shocks.

The authors conclude, “The contrast between the market’s ‘short-run efficiency’ and ‘macro efficiency is sharp.”

To restate in plainer terms, inelastic markets, combined with regular inflows to stocks, have enabled stock prices to levitate far beyond what is justified in any economic sense. The pricing algorithm has become quite simple: if net flows are positive, prices go up. That’s it. There is nothing more to it. As the authors assess, “the stock market in this simple model is a very reactive economic machine.”

Implications For Investors

One implication is there is very little information content in stock prices other than a reflection of flows. As a result, investors should quell tendencies to associate rising stocks with improving economic performance, individual company performance, or any other metric of economic value creation. Stock prices are not a good representation of underlying value in this environment.

Such isn’t to say there aren’t still a lot of voices promulgating such notions. Plenty of academics still adhere to the efficient markets hypothesis. Plenty of tech advocates claim cheap and accessible information is massively increasing the efficiency of markets. These ideas are nice-sounding but increasingly wrong.

Such raises another interesting point: the narrative regarding how the market works is changing. Mike Green from Simplify Asset Management and a couple of other prominent commentators have emphasized the importance of market structure for some time. Mostly these discussions have appeared in venues such as Real Vision, various podcasts, and other distinctly non-traditional outlets for financial information.

Now the ideas are coming through the Economist and Financial Times (here and here), which are decidedly more mainstream. As the narrative becomes more broadly recognized and accepted, it is reasonable to expect more investors to act according to that knowledge. Specifically, this is likely to increase awareness of the heightened level of risk associated with overvalued stocks and the heightened importance of flows in affecting stock price movements.

Stock Buybacks

Indeed, in the framework of the inelastic market, flows become a critical market indicator. What might affect flows? Certainly, stock buybacks have been a significant factor and have the potential to continue exerting influence. In addition, a decline in the labor force would reduce the number of automatic contributions to retirement funds.

A little further out, the combined forces of Baby Boomers taking mandatory withdrawals from retirement funds and reducing risk as they age could significantly turn the tide of stock flows. If commensurate demand volumes do not balance those selling volumes, the marginal buyer is unlikely to be insensitive to the price. When that happens, valuation will matter a lot.

Of course, if a significant threat to market values presents itself, the Fed may also consider the potential for buying stocks as a matter of public policy. Equity markets are inelastic, so the Fed would not need to buy a lot to maintain prices at elevated levels. Thus, it could get a lot of bang for the policy buck. Such creates the potential for a relatively binary set of potential outcomes.

Finally, markets have become increasingly inelastic as money management has transitioned from individuals to institutions and money under management has transitioned from active to passive. As many things have changed in the investment environment, the stock market has become progressively less capable of dynamically adapting to those changes. Somewhat ironically, this creates a significant opportunity for active management.

Conclusion

The inelastic markets hypothesis provides some very interesting intellectual fodder for investors. At the very least, it gives a plausible explanation for why markets have been so robust despite weak financial performance. The hypothesis also provides a serious challenge to the mental model of efficient markets. As such, stock prices don’t provide investors with very much information content. Finally, the hypothesis highlights flow as a critical variable for setting prices. If and when flows to stocks become persistently negative, stock prices are likely to adjust based on an entirely different paradigm.

Should Investors “BTFD” The Crucial 50-DMA?

Should investors “BTFD” with the market near the 50-day moving average (DMA)? As we wrote yesterday, the 50-dma has been a great level to buy the dip. Odds favor that to be the case this time, but will it? The S&P 500 50-DMA is currently at 4429 about 14 points below where it closed yesterday.

Chinese economic data continues to weaken. Last night Retail Sales, Industrial Production, and Property Investment all fell short of expectations and prior month readings. Once again, markets are brushing off more signs troubling signs from the world’s second largest economy. To wit, crude oil continues higher, up another $1 this morning and almost $10 from recent lows in mid-August.

Daily Market Commnetary

What To Watch Today

Economy

  • 7:00 a.m. ET MBA Mortgage Applications, week ended September 10 (-1.9% during prior week)
  • 8:30 a.m. ET: Empire Manufacturing, September (17.9 expected, 18.3 during prior month)
  • 8:30 a.m. ET: Import Price Index, month-over-month, August (0.2% expected, 0.3% in July)
  • 9:15 a.m. ET: Industrial Production, month-over-month, August (0.5% expected, 0.9% in July)
  • 9:15 a.m. ET: Capacity Utilization, August (76.4% in August, 76.1% in July)
  • 9:15 a.m. ET: Manufacturing Production, August (0.4% expected, 1.4% in July)

Earnings

  • Before market open: Weber (WEBR) is expected to report adjusted earnings of 35 cents per share on revenue of $669.40 million

Politics

  • President Biden will be meeting with business leaders and CEOs at the White House to discuss COVID-19 vaccine mandates and the business community. Ahead of the 1:30 p.m. ET meeting, Biden says he believes there is “positive support for mandates.”
  • Over on Capitol Hill, today is the deadline set by U.S. House Speaker Pelosi for the House Budget Committee to receive all the elements of the Democrats’ massive reconciliation bill and begin to shape it into a final package. The Ways and Means Committee is one of the committees set to finish their work today.

Courtesy of Yahoo

A Rolling Correction

Over the last week and a half, the market has declined roughly 2% as the rotation among stocks has been extremely rapid. Such is particularly seen in the divergence of the Advance-Decline line from the index itself.

However, while the internal breadth remains extremely week, that rapid rotation is sectors has given the market enough support to not decline markedly. Now, after a rough start to September, the market is now sitting back on support at the 50-dma and is oversold on a short-term basis as shown.

9 out of 10 Bears Say Market Correction Coming

More importantly, given the large number of Wall Street firms predicting a market decline of 10%, it would not be surprising to see the “BTFDipers” show back up in force to run stocks back towards all-time highs.

We discussed this in more detail here.

Is the Sell-off Over?

Yesterday we shared a recent dependable market pattern. The S&P declines for a few days mid-month with upward-sloping movement before and after the decline. Similarly, the graph below also shows a reliable pattern for the VIX. The VIX spikes with each mid-month market decline. Each of the recent spikes has been above its Bollinger band. The current upper Bollinger band is 21.46 and VIX is at 19.37, after coming close to touching the band. A similar spike, as we have seen, implies a run to the 24-25 area.

Market Drawdowns

The table below from The Market Ear shows the lack of any substantial drawdown this year. Through three quarters of the year, the largest drawdown is only 4.2%. Of the 94 instances in the table, only three years (2017, 1995, and 1964) have seen smaller intra-year drawdowns.

However, in every instance, the years following a year of a minimum drawdown experienced significantly larger drawdowns.

Median CPI

While the CPI data was lower than expected, the breadth of the data was not as friendly. As shown below, the median CPI rose .33% month over month and, unlike CPI, is up for three months in a row.

“Now the bad news: It’s becoming increasingly apparent that those “transitory” costs won’t be enough to normalize prices to pre-pandemic levels, and will likely continue what one economist recently called a half-century trend of soaring prices.

There are at least a few reasons behind this, but two in particular stick out: Businesses and service providers have grown more comfortable charging customers (a function of still elevated demand), and housing prices are still climbing in the face of COVID-era challenges.” – Yahoo

CPI Review

CPI came in weaker than expected across the board. Of most importance to the Fed, the core CPI (excluding food and energy) only rose 0.1% for the month. As a result, the annual core rate fell from 4.3% to 4.0%. Accounting for about 30% of CPI, Shelter costs continue to rise. Owners Equivalent Rent (OER) is up .25% on the month, while rent rose .31%. Given their large contribution and sharply rising rental prices as of late, it’s way too early to claim inflation has been tamed.

Value In Washed-out Japan?

David Robertson, an author for Real Investment Advice, shares interesting thoughts on potential value in Japanese stocks. He cites a Bloomberg article in which John Authers reviews how beaten up Japanese stocks are versus those in the U.S.

“John Authers provides some good background on Japan and its struggles over the years. After so many people have been burned so many times, it’s hard to seriously entertain the idea of investing in Japan. Perhaps that is exactly the type of washed-out situation that presents a value opportunity, however. Further, Japan’s epic underperformance started from the top of an epic bubble. What if the tables are turning? In a world of precious few cheap stocks or sectors, Japan is interesting.”

The Fed Speaks Loudly And Carries a Feather

The Fed Speaks Loudly And Carries a Feather

 “Speak softly and carry a big stick” President Theodore Roosevelt on foreign policy.

In other words, let your actions, not your words set the tone.

It appears the Fed may be taking the opposite tack. Many Fed members are vocal about tapering soon, but there is reason to believe the Fed will not back their words with action.

Might the Fed be speaking loudly and carrying a feather?  

Expectations for the Fed to turn “hawkish” and announce a tapering schedule at the next meeting or two are high. A recent Wall Street Journal article hints at an announcement at the September 2021 meeting and tapering in November. The solid economic recovery, coupled with gains in employment and a higher than the target inflation rate, supports such an action.

We think the Wall Street Journal timetable is correct. However, an analysis of the composition of the Fed by voting status and their degree of influence leads us to keep an open mind.

Hawkish Winds Are Blowing

The quotes below from various Fed members speak to a sense of urgency to begin tapering QE.

  • “It would be my view that if the economy unfolds between now and our September meeting … if it unfolds the way I expect, I would be in favor of announcing a plan at the September meeting and beginning tapering in October,” Robert Kaplan Dallas Fed August 2021
  • My preference would be to get to a decision in September and start sometime after that,” Bullard told reporters on Friday after giving a virtual speech. “My main goal would be to get done by the end of the first quarter.”– James Bullard St. Louis Fed per Bloomberg July 2021
  • We should go early and go fast, in order to make sure we’re in position to raise rates in 2022, if we have to,” Fed governor Christopher Waller August 2021
  • Philadelphia Federal Reserve Bank President Patrick Harker said on Friday that he still supports tapering the central bank’s asset purchases sooner rather than later.” Reuters- August 2021
  • Fed’s Bostic Urges Faster Bond Taper as Economy Strengthens” Bloomberg August 2021
  • “I’m less precise about amounts and dates, and really more focused on saying: Sooner rather than later,” Esther George Kansas City Fed August 2021
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Why So Hawkish?

The most recent Fed’s Beige Book, describing economic conditions in each of the 12 Federal Reserve Districts, explains why many members are concerned with inflation and eager to taper.

The document starts with a one-paragraph highlight from each district. As shown below, all the summaries include a statement on labor shortages and or wage pressures. The topic is top of mind at the Fed, as it should be. If there are widespread job shortages and intense hiring pressures, as seen in the record number of job openings, wages may continue to rise and foster more inflation.

Boston: “inability to get supplies and to hire workers.”

New York: “businesses reporting widespread labor shortages.”

Philadelphia: “while labor shortages and supply chain disruptions continued apace.”

Cleveland: “Staff levels increased modestly amid intense labor shortages.”

Richmond: “many firms faced shortages and higher costs for both labor and non-labor inputs.”

Atlanta: “wage pressures became more widespread.”

Chicago: “Wages and prices increased strongly while financial conditions slightly improved”

St. Louis: “Contacts continued to report that labor and material shortages.”

Minneapolis: “hiring demand continued to outstrip labor response by a wide margin.”

Kansas City: “Wages grew at a robust pace, but labor shortages persist.”

Dallas: “Wage and price growth remained elevated amid widespread labor and supply chain shortages.”

San Francisco: “Hiring activity intensified further, as did upward pressures on wages and inflation.”

Fed Composition

Recent market gyrations highlight investors are paying close attention to the quotes above and many others like it.

The cries for taper are easy to justify. Justification is one thing, but monetary policy decisions are based on the decisions of the Federal Open Market Committee (FOMC).

The FOMC currently has 18 members, but only 11 are eligible to vote on monetary policy. The other members can only influence the committee.

The chart below, from InTouch Capital Markets, provides the names and positions of the 18 members.  Importantly it shows their voting eligibility and sorts them by their policy stance.

Fed FOMC Hawk Dove Analysis

There are six members Intouch deems dovish or more willing to continue an excessive monetary policy. They seek more affirmation of economic recovery before changing policy.

There are two members deemed neutral, leaving the FOMC with ten hawkish members. Many of the hawks are outspoken about the need to taper QE sooner rather than later. At first glance, it appears the hawks can steer policy.

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Hawks vs. Doves

The hawk/dove breakdown favors the hawks and their calls to taper. Nevertheless, we must also consider voting eligibility and influence.

When only contemplating the 11 voting members, the doves have the majority. Five of the six doves can vote this year, while only four of the ten hawks can vote in 2021.  The two other voters are neutral.

More important than the number of hawkish or dovish votes is the level of influence each member has on policy decisions. Chairman Powell, a dove, is the lead decision-maker at the Fed. While he may aim for a strong consensus, he ultimately makes the decisions.

Next in line behind Powell is the neutral Vice Chair, Richard Clarida. Behind him, the New York Fed President John Williams is dovish and wields clout. The New York Fed manages the trading operations supporting Fed policy and influences the largest banks and brokers. Lastly is another dove in board member Lael Brainard. She is a candidate to replace Powell when his term ends next year. Beyond the Chair, Vice-Chair, and President of the New York Fed, Brainard probably has the most influence on the committee.

Of the four most influential voters, one is neutral, and three are dovish.

Dissension in the Ranks

The analysis thus far argues the loud tone from the hawkish Fed members is secondary to Chair Powell and the other Fed influencers. The markets acknowledged this with a strong rally following Chair Powell’s dovish address at the Jackson Hole Symposium. While some thought he might take a step toward announcing a taper time frame, he was non-committal, preferring to wait for more economic data.

The Fed meets on September 22nd.  They may acknowledge some concern about inflation. They will also discuss the continuing recovery of the labor market. Despite grossly exceeding their inflation goal and making significant progress toward their employment goal, they may hold off announcing a tapering schedule.

If this proves to be the case, the number of dissenting voters is meaningful. Voters would dissent because they want to taper immediately. Many hawks are satisfied that the job market is on the road to recovery and are concerned about inflationary pressures.

Will they dissent? One or two dissents, while not frequent, are not uncommon either. The market reaction might be muted to a bit of friction. Where we offer caution is if the number of dissenting voters totals four or five or even more.

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Summary

It’s apparent by market behaviors investors care much more about the amount of Fed liquidity than economic data, valuations, and fundamentals. The graph below from Bridgewater shows Fed liquidity trumps fundamentals at a level not seen in at least the last 50 years.

Stocks are now more sensitive to Fed liquidity than economic growth.

As we wrote in AMC Foolishness Comes At A Dear Cost:

Bad economic news is good news for share prices because it ensures the Fed will provide stimulus for longer.”

Most investors agree delaying tapering is good for the market. Conversely, removing liquidity via tapering, given such high valuations, portends risks. While Powell and his dovish clan may put off tapering, investors will not take multiple dissensions lightly.

Powell, in the last few months of his term, must thread the needle. He likely wants to avoid a market meltdown so he can be reappointed. At the same time, he needs to show he has complete control of the Fed.

If he can corral the hawks and get them to agree on a later time frame for taper, he might accomplish his personal goal of another term while keeping markets afloat a while longer. If investors believe he is losing control of the Fed, he not only faces market volatility but the potential to lose his job.

Time To “Buy The Dip” & Bitcoin’s “Golden Cross”

Is it time to “Buy The Dip?” The S&P 500 broke its five-day losing streak, as it rose .25% on Monday to 4470, 1.00% above its 50-day moving average. As we graph in the commentary below, the 50-day moving average has supported the S&P 500 on nine separate occasions in the last year. We have no reason to doubt the power of the trading algorithms this time around, but we must consider a meaningful break of the moving average could put the 200-day moving average in play at 4086.

Markets are opening slightly higher this morning while bonds are giving up some of yesterday’s gains. At 8:30 am ET, CPI provides an update on inflation. Expectations are for the headline monthly number to decline 0.1% from last month’s 0.5%.

Daily Market Commnetary

What To Watch Today

Economy

  • 6:00 a.m. ET: NFIB Small Business Optimism, August (99.0 expected, 99.7 during prior month)
  • 8:30 a.m. ET: Real Average Weekly Earnings, year-over-year, August (-0.9% during prior month)
  • 8:30 a.m. ET: Consumer Price Index, month-over-month, August (0.4% expected, 0.5% in July)
  • 8:30 a.m. ET: Consumer Price Index excluding food and energy, month-over-month, August (0.3% expected, 0.3% in July)
  • 8:30 a.m. ET: Consumer Price Index, year-over-year, August (5.3% expected, 5.4% in July)
  • 8:30 a.m. ET: Consumer Price Index excluding food and energy, year-over-year (August (4.2% expected, 4.3% in August)

Earnings

  • 7:30 a.m. ET: FuelCell Energy (FCEL) is expected to report adjusted losses of 6 cents per share on revenue of $20.63 million

Politics

  • U.S. Securities and Exchange Commission Chair Gary Gensler is before the Senate at 10 a.m. ET for an oversight hearing. His plans for cryptocurrency are expected to be a key topic with Gensler set to argue for more power in order to add new consumer protections for crypto markets.
  • Today is the final day in California’s recall election. The voting — conducted over the mail — ends at 8:00 p.m. PT with polls showing California Gov. Gavin Newsom in a strong position to survive the recall attempt.
  • The U.S. House Ways and Means Committee will formally debate the Democratic plan for tax increases at 9:00 a.m. ET. Meanwhile, U.S. Secretary of State Antony Blinken will face a second day of questioning on Capitol Hill at 10:00 a.m. ET after a contentious first round yesterday.

Will The 50-Day Moving Average Save the Day?

Nat Gas is on Fire!

As we show below, the price of Natural Gas is up sharply over the last few months sitting at the upper bound of its 10-year range. Will it break higher or fall back as it did in 2014 and late 2018 when it was at similar levels?

Inflation and Confidence

The New York Fed, via their latest Consumer Expectations Survey, shows the role that rising inflation expectations are having in declining confidence. The graph below shows expected inflation is now over 5% and rising. At the same time expected wage growth is 2.5% stable/falling. As a result, consumers expect to lose 2.64% (red line) in purchasing power over the next year.

Will the Market Bottom on September 21st?

The graph below shows the incredible regularity of the market over the last four months. As shown, every 20 days the S&P 500 tends to decline for a few days, bottom, and then rally back to prior highs. If the cycle plays out again this month we should expect a market bottom on 9/21. Monthly options expirations, which fall around the market troughs, are largely responsible. Liquidity is lacking, so options-related trades are driving direction on the days surrounding expirations.

Bitcoin’s Golden Cross

After a drubbing earlier this year, the August surge has led to a “Golden Cross” of the 50-dma and 200-dma moving averages. Bitcoin needs to hold support at these levels and turn higher to confirm the “bullish signal.” If it does, such would suggest a run back towards $60,000 is likely.

In a recent CNBC interview, Cathy Wood, CEO of ARK Investments stated that she expects Bitcoin’s price to top $500,000 in the next five years.

“If we’re right, and companies continue to diversify their cash into something like crypto, and institutional investors start allocating 5% of their funds toward crypto…We believe that [bitcoin’s] price will be tenfold of where it is today.”

Wood also said her confidence in Ether “has gone up dramatically,” as the blockchain starts its transition from proof-of-work to proof-of-stake.

When asked by CNBC what her picks are, if only investing in one cryptocurrency, Wood said she would allocate 60% to bitcoin and 40% to ether. 

Valuations Are “Crazy”

Markets In Turmoil

Bracing for CPI

CPI on Tuesday is the big market event of the week. Given the Fed is making substantial progress toward its employment goal, inflation concerns are moving front and center. While the Fed laid out a timeframe for taper in the WSJ last week, high CPI could speed that schedule up. Expectations for the monthly rate are 0.4%, slightly less than last month’s 0.5%.  Also of importance this week is Thursday’s Retail Sales report. Will the recent plunge in confidence be felt by retailers? Speaking of confidence, the University of Michigan Consumer Survey will come out on Friday.

Next Tuesday and Wednesday is the next Fed meeting. Later this week most Fed members will enter the media blackout period.

Rental Inflation

30% of the CPI index is based on “Shelter” cost, i.e. real and imputed rental prices. The graph below should provide a warning that tomorrow’s CPI report can run hotter than expected. Luckily, the BLS uses questionable means to calculate rent. In BLS’ Housing Inflation Measure is Hypothetical Bull*** we analyze “Shelter” costs. Our conclusion: If either OER or Rental prices show some correlation to reality, CPI could not only continue to run hot but could rise from elevated levels. That said, looking at historical BLS data, it appears Shelter prices will not change markedly from current levels.”

Technically Speaking: Too Many Bears Looking For A Correction?

Are there too many “bears” looking for a correction?

When it comes to financial markets, there is one truism as noted in Bob Farrell’s famous investment rules:

“When all experts agree, something else tends to happen.”

Such makes perfect sense given that the “market” is a reflection of the psychology of “buyers” and “sellers.” Such is why sentiment plays such an important role in market expectations.

As an example, a recent Deutsche Bank survey found that 58% of the 550 global market professionals surveyed expect a 5-10% correction by year-end.

Of those managers, only 14% saw the index higher than it is currently, in the next 3-months.

There are many good reasons for concern beyond just a very extended period without a meaningful correction. Currently, the market has gone 319-days without a correction to the 200-dma.

A Wall Of Worry

As the Deutsche Bank strategists also noted:

“Are too many expecting it [a correction] will happen?”

Historically speaking, markets tend to climb a “wall of worry.” But, as noted above, when many Wall Street analysts expect something to happen, it is often profitable to bet in the opposite direction.

Over the last year, in particular, the market ignored concerns over valuations, the impact of the “Delta” variant, inflationary pressures, slowing economic growth, and numerous geopolitical events. Instead, as noted in “Investors Hold Record Allocations,” individuals have ramped up exposure to risk betting on the continuation of the Fed’s ongoing monetary interventions.

It is not surprising that equity ownership is at record highs and highly correlated to valuations. Such is the representation of rising prices on investor psychology. As a result, investors continue to chase overvalued equities until the eventual mean-reverting event occurs.

Such is also the very essence of the meaning of “climbing a wall of worry.” Despite the fact investors “know” they are overpaying for stocks, the “Fear Of Missing Out” leads to the dismal of concerns as “greed’ overtakes “logic.”

Currently, this is the phase of the cycle we are in now, and the desire to “buy the dip” outweighs concerns of a more significant correction.

As noted this past weekend, it is certainly possible the market can continue its low volatility advance for a while longer. However, historically speaking, low volatility has always led to higher volatility. The table below (courtesy of TheMarketEar,) shows the maximum drawdown in any given year. Note that years of minimal drawdowns always get followed by years of larger ones.

In other words, while there may be “too many bears” currently, it doesn’t mean they will be wrong.

The question is, when will the markets start paying attention to the risk?

Heed Thy Warnings

As noted this past weekend, there are numerous warnings from weakening breadth, lower participation, and negative divergences. Sentiment Trader provided additional commentary.

“To differentiate temporary slowdowns from real problems, we look for significant macro deterioration. The Macro Index Model combines 11-diverse indicators to determine the state of the U.S. economy. Investors should be bullish when the index is above 0.7 and bearish when below.

Once the final reports were in for August, the model plunged below 46%, the 2nd-lowest reading of the past decade.

Investors Allocation Warnings 09-10-21, Investors Hold Record Allocations Despite Rising Warnings 09-10-21

At the same time, Sentiment Trader noted their Bear Market Probability Indicator also jumped. This model has 5-inputs, namely the unemployment rate, ISM Manufacturing index, yield curve, inflation, and valuations.

“The higher the score, the higher the probability of a bear market in the months ahead. Last May, the model was in the bottom 10% of all months since 1950. This month, it jumped into the top 10% of all months.

Investors Allocation Warnings 09-10-21, Investors Hold Record Allocations Despite Rising Warnings 09-10-21

The combination of these two measures should not be overlooked. To wit:

“The chart below shows the spread between the Bear Market Probability and Macro Index models. The higher the spread, the higher the probability of a bear market. The chart shows that the S&P 500’s annualized return is a horrid -17.6% when the spread is above 20% like it is now.”

Investors Allocation Warnings 09-10-21, Investors Hold Record Allocations Despite Rising Warnings 09-10-21

Morgan Stanley Wealth Management’s Lisa Shalett is also predicting a 15% pullback for a market she sees as “priced for perfection.”

She, like us, has suggested raising cash levels, adding non-correlated assets, and reducing overall risk, stating:

“The strength of major U.S. equity indexes during August and the first few days of September, pushing to yet more daily and consecutive new highs in the face of concerning developments, is no longer constructive in the spirit of ‘climbing a wall of worry.’”

Being A Contrarian

There is a not so insignificant risk this market will shake off short-term concerns for the time being. Thus, a “buy the dip” opportunity could well be in the offing in the next few days. Such has repeatedly been the case since last November.

However, at some point, the markets will violate this upward trend and complete a retest of the 200-dma.

It is one of the few things of market dynamics that is virtually a guarantee. What will cause it, or when it will happen, is always unknown.

It is times like these I find it helpful to remind myself of something Howard Marks once wrote:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.

Moving against the “herd” is where investors generate the most profits in the long term. But, unfortunately, the difficulty for most individuals is knowing when to “bet” against those who are being “stupid.”

Portfolio Actions To Take Just In Case

As noted above, there is a reasonable possibility the market could bounce as “Pavlovian investors” once again “buy the dip.” However, there is also a possible risk of a correction between 5% and 10%.

Unfortunately, I don’t know which it will be until we start seeing definite signs of the market breaking down. At that point, it will be too late to make adjustments. Such is why, as we have stated previously, this is an opportune time to get in front of risk by taking some simplistic actions.

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Hedge portfolios against major market declines. (Cash, Non-correlated Assets, Direct Hedges)
  3. Take profits in positions that have been big winners
  4. Sell laggards and losers
  5. Raise cash and rebalance portfolios to target weightings.

These actions will not protect you entirely from a decline. They will, however, lessen the blow and allow you to rebalance risk accordingly where the time comes.

Or, you can do nothing and hope for the best.

Viking Analytics: Weekly Gamma Band Update 9/13/2021

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

Gamma Band Update

The S&P 500 (SPX) closed the week with a close below the gamma flip level, which resulted in a model allocation to 50% SPX (along with 50% cash).  As we enter option expiration week, it is relevant to note that the last four monthly option expiration weeks have seen pullbacks and volatility, followed by buying pressure the following week.  The large open interest on this week’s quarterly expiration could act as volatility fuel, especially with price below the gamma flip level.  In this “negative gamma” regime, the options market makers will tend to buy the rallies and sell the dips.  This results in an amplification of price direction, which feeds up and down volatility.

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. When the daily price closes below Gamma Flip level (currently near 4,500), the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,300), the model will reduce the SPX allocation to zero.  

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  Our “Smart Money” Indicator signal remains long, but may be turning cautionary as we head into the fall months.

With stocks climbing to historically high valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

 

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

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

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


November Taper – Trial Balloon or Reality?

Equities are clawing back Friday’s losses despite weekend rumors that corporate and capital gains taxes may rise under a new Biden proposal. Further, the market appears to be brushing off concerns that a taper timeline aiming for November seems more like reality than a trial balloon. Comments from various Fed speakers early this week will shed more light on any potential change to policy. Crude oil is trading back over $70 a barrel as tropical storm Nicholas threatens already battered gulf coast oil/gas production facilities.

Daily Market Commnetary

What To Watch Today

Economy

  • 2:00 p.m. ET: Monthly budget statement, August (-$175.0 billion expected, -$200.00 billion during prior month)

Earnings

Post-market

  • Oracle (ORCL) is expected to report adjusted earnings of 97 cents a share on revenue of $9.77 billion.

Politics

  • Congressional Democrats will formally unveil their tax plan as soon as today and a draft has already leaked. The proposal is estimated to raise $2.9 trillion in new taxes from wealthy Americans and corporations and will be discussed in committee hearings today.
  • President Biden is headed West today for a two-day trip that will take him to Idaho, California, and Colorado. He’ll be focused on wildfires with a stop at the National Interagency Fire Center as well as politics with a campaign stop for California Gov. Gavin Newsom ahead of the recall election tomorrow.
  • U.S. Secretary of State Antony Blinken will be in the hot seat with his first appearance before Congress since the United States’ withdrawal from Afghanistan. Blinken is expected to face some of the most aggressive questioning of his career during a hearing scheduled for 2:00 p.m. ET.

Courtesy of Yahoo

Dead Cat Bounce

Market set to bounce at the open this morning. As we noted in this past weekend’s newsletter:

That correction started on Monday with the week ending in 5-straight down days which is the worse slide since February.

However, while that sounds terrible, the total decline for the week was just -1.69%. Yes, that’s it, less than 2%. While CNBC probably ran their “Markets In Turmoil” segment, traders huddled over candles and incense chanting incantations at the Fed for more accommodation.

Investors Allocation Warnings 09-10-21, Investors Hold Record Allocations Despite Rising Warnings 09-10-21

On a very short-term basis, the market is oversold enough for a tradeable bounce. However, as we concluded:

“With sell signals in place, volume rising, and breadth weak, a retest of the 50-dma early next week will not be a surprise. The question will be whether traders show up again, as they have done every other time over the last 6-months to ‘buy the dip?’”

Trend Channel

Since the lows of the “Financial Crisis,” the market has remained confined to a well-defined “trend channel.” As BofA noted on Friday stocks have now retraced from the break of the lower bound to the top of the channel.

At some point, the market will violate this trend channel in one direction or the other. Given the length of the bull market advance from the “GFC” lows, current valuations, and slowing economic growth, logic would suggest it will be to the downside. However, the markets have a very interesting way of surprising everyone.

A 10% Correction Call Is Broadening

“You should always be expecting a 10% correction. If you’re investing in equities, you should be prepared for that at any time,” Morgan Stanley’s Chief Investment Officer Mike Wilson told Yahoo Finance Live. “The bottom line for us… is the risk reward is not particularly great at the index level from here, no matter what the outcome is. That’s why we don’t have any upside to the S&P for the rest of the year.” – Yahoo

There is clear evidence of deterioration in the markets as of late. With markets extended and market breadth weakening the risk of a 10% correction has clearly risen.

But the biggest risk is in the contraction of liquidity which stocks have been more sensitive to over the last decade rather than economic and earnings growth.

That liquidity flow is now at risk.

The Fed Has Spoken

Often the Fed leaks policy changes or sends trial balloons via the media. They tend to have their favorite media outlets and authors in which to do it. Nick Timiraos from the Wall Street Journal is a current favorite. His latest article, Fed Officials Prepare For November Reduction in Bond Buying,  lays out a timeline for the Fed to taper QE. While the article is not an official declaration, it will become the market assumption until we learn more at the September 22nd Fed meeting.

Per the article:

While they are unlikely to do so at their meeting on Sept. 21-22, Fed Chairman Jerome Powell could use that gathering to signal they are likely to start the process at their following session, on Nov. 2-3.

Under the plans taking shape, officials could reduce those purchases at a pace that allows them to conclude asset buying by the middle of next year.

PPI

The producer price index (PPI) is slightly higher than expectations. PPI, while not as well followed as PCE or CPI provides unique insights. First, PPI tends to lead CPI. Higher or lower input prices often eventually make their way to changes in the prices of goods companies sell, i.e. CPI. Second, other than labor, input costs are often the second largest expense for companies. Given rising wages and PPI, producers and other companies dependent on labor and commodities are likely to feel margin pressure.

Inflation is becoming problematic for the Fed mainly if these pressures are not as “transient” as hoped. Higher wages are corrosive to both earnings and margins. As shown below, strongly rising producer prices are initially good for profit margins until inflation can not get passed along to consumers. Such is the case currently, with the most significant historical spread between PPI and CPI.

Investors Allocation Warnings 09-10-21, Investors Hold Record Allocations Despite Rising Warnings 09-10-21

With supply chain disruptions looking to last longer than expected, the Fed is trapped between supporting a slowing economy and fighting inflation.

Dow Theory

Dow Theory, a once-popular way of evaluating the market, is well over 100 years. The theory follows that transportation stocks lead the broader markets. Per Business Insider: “The general idea is that both averages, over time, should move in tandem, given that the transportation average represents companies responsible for the movement of goods across the country. For that reason, it should serve as a leading indicator.Many question the value of the theory today due to the tremendous technological progress. However,  the fact of the matter is we still consume goods that must be shipped.

The graph below shows the Dow Transportation Index is down nearly 10% since May. At the same time, the broad market S&P 500 has steadily risen by 10%. For those following Dow Theory, this is a warning.

Will They Taper?

The chart below, courtesy of InTouch Capital Markets, breaks down the Federal Reserve Board by the degree to which they are policy hawks or doves. The graph also shows their respective voting eligibility by year. There are about twice as many hawks as doves, but three of the four most influential voters are dovish (Powell, Williams, and Brainard). The other, Vice-Chair, Richard Clarida, is neutral. Five of the six doves vote in 2021, while only four of the ten hawks vote in 2021. Despite the hawkish overtone from many Fed speakers, this chart points to a more dovish policy stance going forward. We will have much more on this graph and its implications in our next article this coming Wednesday.

What’s Wrong With Gold? Absolutely, Nothing.

Gold. What’s wrong with it? From spiking inflation, falling real interest rates, and massive money printing, it seems logical that gold, a touted inflation hedge, should be rising. Yet, so far this year, gold has done little.

So, what’s wrong with this precious metal? Absolutely, nothing.

Is Gold Really An Inflation Hedge

One of the primary arguments for owning precious metals, particularly physical gold, is its effective hedge for inflation. However, is that still the case today?

The chart below shows the non-inflation-adjusted price and key events throughout history.

The U.S. being on a “gold standard” is a crucial consideration of the argument of gold being an effective hedge against inflation.

“The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.”Investopedia

As you can see in the chart above, prices remained stable until the point that President Nixon ended the gold standard in the U.S. However, for this analysis, the question is whether the golden metal is, or was, a good hedge against inflation?

Timing Is Everything

The answer is both “yes” and “no.”

As with all things investing-related, it is always a function of when you start. For investors in the stock market, those who started when valuations were in low double to single digits did much better than those with high valuations. (That is a lesson many of the Millennial and Gen Z investing group will come to learn.)

The chart below shows $1 invested in gold (non-inflation adjusted) and “inflation” as measured by the Consumer Price Index.

At first glance, like with the stock market, it is easy to see the precious metal outperformed inflation over time. However, that is only true if you bought gold before 1980, between 2002 and 2013, or in 2017. If you purchased gold outside those periods, you lost money relative to inflation.

The following chart makes this concept easier to grasp by showing the difference in the annual rate of change and inflation.

For every investment, there is always an “opportunity cost.” There is nothing wrong with owning gold in your portfolio, except when other assets, in this case, we will use the S&P 500 index, provides a higher rate of return.

Currently, given the influx of $120 billion a month from the Federal Reserve, the stock market provides a higher rate of return on investment than owning gold. Therefore, market participants choose to own ethereal assets due to the belief in “insurance against loss” rather than hard assets.

Will this “psychology” eventually change? Absolutely.

However, the question is, how much “lost opportunity” was there in the process? That is an evaluation that each investor will have to make for themselves to determine if such aligns with their investment goals and objectives.

Daily Market Commnetary

Gold’s Correlation to the Fed’s Footprint

As noted, there are certainly valid concerns of the Fed’s ongoing monetary interventions. As Michael Lebowitz previously reported:

Linking real rates to the degree of central bank action form the basis on which we can look at the dollar’s value through the prism of gold. The first graph below shows gold has trended similarly to the monetary base.”

Fed's Golden Footprint, Lebowitz: The Fed’s Ever-Growing Golden Footprint

The next set of scatter plots are more compelling. They tell the story of how the price of the preciious metal became increasingly correlated to real yields as they decline. Said differently, gold is growing more positively correlated to the size of the Fed’s footprint.

The three scatter plots break down the relationship into three-time horizons as shown below.

Fed's Golden Footprint, Lebowitz: The Fed’s Ever-Growing Golden Footprint
  • The Pre QE period, covers 1982-2007. During this period, real yields averaged +3.73%. The R-squared of .0093 shows no correlation.
Fed's Golden Footprint, Lebowitz: The Fed’s Ever-Growing Golden Footprint
  • The second graph covers Financial Crisis-related QE, 2008-2017. During this period, real yields averaged +0.77%. The R-squared of .3174 shows a moderate correlation.
Fed's Golden Footprint, Lebowitz: The Fed’s Ever-Growing Golden Footprint
  • The last graph, the QE2 Era, covers the period after the Fed started reducing their balance sheet and then sharply increasing it in late 2019. During this period, real yields averaged +0.00%, with plenty of instances of negative real yields. The R-squared of .7865 shows a significant correlation.
Fed's Golden Footprint, Lebowitz: The Fed’s Ever-Growing Golden Footprint

As he concludes:

The message is not in the price of gold per se but its strong correlation to destructive fiscal and monetary policies.

The Gold “Fear Trade”

There is one key “takeaway” from this article.

“Fear.”

Investors tend to buy “hard assets” when there is “fear” of increasing debt, inflation, a dollar decline, recession, a market crash.

So, let’s revisit the “original” question: “What is wrong with gold?”

Absolutely nothing. Except there is presently no “fear” present to drive investors into the psychological “safe haven” of gold. That lack of fear is evident in everything from:

  • Record issuance of money losing IPO’s.
  • Mass issuance of SPAC’s
  • Record margin debt levels.
  • Near record stock valuations.
  • Retail investors taking on personal debt to invest.
  • Bitcoin.
  • Belief by investors of the “Fed Put”

You get the idea.

Two Primary Problems

When it comes to investing, individuals need to determine “why” they own gold? Is it a short-term bet on prices rising or a “psychological” trade based on “fear” and “emotion?”

If it is the former, there is nothing wrong with owning gold. It is a commodity that will rise and fall in price. Given that gold has no fundamentals (earnings or dividends), the “price” of gold is all you need to know to trade the metal successfully.

The latter is more problematic. Given that gold is no longer exchangeable for currency, and vice versa, the broken link as an inflation hedge remains. In today’s “fiat” currency economy, the ability to use gold as a method for transactions on a global scale remains destroyed. Therefore, gold has become a “fear trade” over concerns of the dollar’s demise, inflation, and an economic reset.

While there are valid reasons to be concerned with such disastrous outcomes, those events can take decades to play out. For example, Japan is the poster child of a demographic timebomb combined with the world’s highest debt-to-GDP ratio. Such remains the case since the turn of the century, but the “bug has yet to hit the windshield.” Yes, it eventually will, but how much longer it will take is unknown.

Final “Precious” Thoughts

Therefore, from an investor’s standpoint, the question is not whether you should own gold, but “when?” Too much of your asset allocation in a “fear trade” when there is literally “no fear” in the financial markets could lead to a more significant loss of future purchasing power than inflation. In other words, “opportunity cost” can have as large an outcome on your financial future as inflation or the dollar’s demise.

As is always the case, timing is everything.

Is there anything wrong with Gold? No.

However, as long as the Federal Reserve is engaged in inflating asset prices and forcing investors to take on excess risk, gold will likely continue to underperform.

Will that eventually change? Absolutely.

When? As soon as the market participants realize the error of their ways.

Investors Hold Record Allocations Despite Rising Warnings

In this 09-10-21 issue of “‘Investors Hold Record Allocations Despite Rising Warnings.

  • Market Starts Correction Right On Cue.
  • Investors Record Allocations & Rising Warnings
  • Beige Book Highlights Fed’s Biggest Problem
  • Portfolio Positioning
  • Sector & Market Analysis
  • 401k Plan Manager

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Market Starts A Correction Right On Cue

As noted last week:

“However, in the meantime, the “stairstep” advance continues with fundamentally weak companies making substantial gains as speculation displaces investment in the market. Thus, while prices remain elevated, money flows weaken, suggesting the next downturn is roughly one to two weeks away. So far, those corrections remain limited to the 50-dma, which is approximately 3% lower than Friday’s close, but a 10% correction to the 200-dma remains a possibility.”

That correction started on Monday with the week ending in 5-straight down days which is the worse slide since February.

However, while that sounds terrible, the total decline for the week was just -1.69%. Yes, that’s it, less than 2%. While CNBC probably ran their “Markets In Turmoil” segment, traders were huddled over candles and incense chanting incantations at the Fed for more accommodation.

With sell signals in place, volume rising, and breadth weak, a retest of the 50-dma early next week will not be a surprise. The question will be whether traders show up again, as they have done every other time over the last 6-months to “buy the dip.”

As shown, the market remains well confined to its rising trend with support sitting at the 50-dma. Volatility did pick up late last week as volume spiked suggesting more selling pressure on Monday.

The question is “this time different.” Will the market hold the 50-dma again, or has the risk of a more substantial correction finally caught up with investors.

As noted previously, 5-10% corrections are absolutely normal in any given market year. However, if you didn’t like the 1.69% correction this week, a 10% correction will feel like an all-out “crash.”

Such is why we have repeatedly suggested taking some actions in advance.

Macro Conditions Continue To Deteriorate

Over the last couple of weeks, I noted the deterioration of underlying market conditions. Weakening breadth, lower participation, and negative divergences all suggest risks of a correction. On Thursday, Sentiment Trader provided some additional commentary supporting our concern.

“To differentiate temporary slowdowns from real problems, we look for significant macro deterioration. The Macro Index Model combines 11-diverse indicators to determine the state of the U.S. economy. Stock market investors should be bullish when the Macro Index is above 0.7 and bearish when below or equal to 0.7.

Once the final reports were in for August, the model plunged below 46%, the 2nd-lowest reading of the past decade.

At the same time, Sentiment Trader noted their Bear Market Probability Indicator also jumped. This model has 5-inputs, namely the unemployment rate, ISM Manufacturing index, yield curve, inflation, and valuations.

“The higher the score, the higher the probability of a bear market in the months ahead. Last May, the model was in the bottom 10% of all months since 1950. This month, it jumped into the top 10% of all months.

So, what does all of this mean? According to Sentiment Trader, the combination of these two measures should not be overlooked. To wit:

“The chart below shows the spread between the Bear Market Probability and Macro Index models. The higher the spread, the higher the probability of a bear market. The chart shows that the S&P 500’s annualized return is a horrid -17.6% when the spread is above 20% like it is now.”

The point here is that while the market remains exceedingly bullish, there are signs of trouble brewing beneath the surface. Such is why we suggested raising cash levels, adding non-correlated assets, and reducing overall risk.

But as Paul Harvey used to say: “There is more to this story.”



Investor Record Allocations

As noted, there is certainly cause for concern. However, investors aren’t.

Such should be of no surprise after an extended bull market advance with very low volatility. Without any concern for corrections, individuals have increased equity risk levels relative to their overall net worth.

Or, we see the same when we analyze their equity allocations as a percentage of their overall financial assets.

Regardless of the calculations, the message is the same. As we noted in Thursday’s Daily Market Commentary:

Bob Farrell’s rule #5 states: “The public buys the most at the top and least at the bottom.”

The two charts above speak volumes as to the wisdom of Bob Farrell’s rules. Previous peaks in equity ownership have corresponded with peaks in financial markets.

As the old Wall Street axiom states: “If everyone has already bought, who is left to buy?”

At the moment, however, investors are incredibly confident that markets can only go higher as long as the “Fed” remains accommodative. While there is undoubtedly a substantial argument as to the ability of the Fed to keep markets inflated, there are other “risks” present that could lead to a short-term correction.


Daily Market Commnetary

An Increasing Number Of Correction Warnings

While investors are carrying record allocations, some of the largest Wall Street banks are worrying. A recent article on Zero Hedge compiled their outlooks. To wit:

“Andrew Sheets warns that equity market internals has continued to follow a “midcycle transition.” That process usually ends with quality stocks, like the FAAMGs, getting hit and poses an outsized risk to the S&P 500 through October.” – Morgan Stanley

“Suvita Subramanian, warned that ‘downside risks remain’ and asking ‘what good news is left?’ Sentiment is all but euphoric with our Sell Side Indicator (see SSI) closer to a sell signal than at any point since 2007.” – Bank of America

Deutsche Bank’s strategists ‘expect an imminent correction even though they see the S&P 500 rising back around current levels by year-end. Some more details on the coming pullback in markets which DB believes will see the S&P drop 6%-10%:

Christian Mueller-Glissmann stated that high valuations have increased market fragility. If there is a new negative development, it could generate growth shocks that lead to rapid de-risking. As such, there is very little buffer left if you get large negative surprises.” – Goldman Sachs

You get the idea. Between the leverage in the market, economic growth slowing, and rising inflationary pressures, numerous issues could disrupt the high levels of market complacency.

The bullish argument is that such a correction will force the Fed’s hand. As Zerohedge aptly concluded:

“Even the smallest market hiccup will prompt a furious response at the Marriner Eccles building, because we are now well beyond the point of no return and Jerome Powell and company simply can not afford even the smallest drop in stocks without risking a full-blown market meltdown, much to the chagrin of the banks above who are predicting just that.”


In Case You Missed It


Beige Book Reveals The Fed’s Biggest Problem

The most significant risk for the market is a change in investor psychology. As long as nothing disrupts that bullish bias, investors will continue to aggressively “buy dips.” However, that psychology is directly linked to the Fed’s ongoing balance sheet expansion. Thus, the potential problem for investors is inflation.

The Fed’s Beige Book is a summary of economic conditions in the 12 Federal Reserve Districts.

  • Boston: “Inability to get supplies and to hire workers.”
  • New York: “Businesses reporting widespread labor shortages.”
  • Philadelphia: “Labor shortages and supply chain disruptions continued apace.”
  • Cleveland: “Staff levels increased modestly amid intense labor shortages.”
  • Richmond: “Many firms faced shortages and higher costs for labor and non-labor inputs.”
  • Atlanta: “Wage pressures more widespread.”
  • Chicago: “Wages and prices increased strongly”
  • St. Louis: “Contacts continued to report labor and material shortages.”
  • Minneapolis: “Hiring demand outstriped labor response by a wide margin.”
  • Kansas City: “Wages grew at a robust pace.”
  • Dallas: “Wage and price growth remained elevated amid widespread labor and supply chain shortages.”
  • San Francisco: “Hiring activity intensified further, as did upward pressures on wages and inflation.”

Inflation is becoming problematic for the Fed mainly if these pressures are not as “transient” as hoped. Higher wages are corrosive to both earnings and margins. As shown below, strongly rising producer prices are initially good for profit margins until inflation can not get passed along to consumers. Such is the case currently, with the most significant historical spread between PPI and CPI.

With supply chain disruptions looking to last longer than expected, the Fed is trapped between supporting a slowing economy and fighting inflation.

It’s a battle they are likely going to lose, no matter what they choose.



Portfolio Update

As noted above, market action became sloppier this week.

Over the last few weeks, we discussed that stock selection was essential to portfolio performance as breadth continues to narrow in the market. This past week was not much different. The question is now whether the previous leaders will become laggards? Such could suggest more trouble overall for markets.

In the meantime, equity allocations remain underweight. We have increased the bond portfolio duration closer in alignment with our benchmark as we continue to look for lower rates as economic growth slows. Cash remains roughly 10% of our equity allocations as a risk hedge for now.

As noted above, there is a reasonable possibility the market stalls at current levels and works off some of the overbought conditions. There is also a more than a possible risk of a correction between 5% and 10%.

However, I don’t know which it will be until we start seeing definite signs of the market breaking down. At that point, it will be too late to make adjustments. Such is why, as we have stated previously, this is an opportune time to get in front of risk by taking some simplistic actions.

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Hedge portfolios against major market declines. (Cash, Non-correlated Assets, Direct Hedges)
  3. Take profits in positions that have been big winners
  4. Sell laggards and losers
  5. Raise cash and rebalance portfolios to target weightings.

These actions will not protect you from a decline. They will, however, lessen the blow and allow you to rebalance risk accordingly where they become present.

Or, you can do nothing and hope for the best.

It’s your choice.

Have a great weekend.

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

The technical overbought/sold gauge comprises several price indicators (RSI, Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. The current reading is 76.91 out of a possible 100.


Portfolio Positioning “Fear / Greed” Gauge

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

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 80.93 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read This Table

  • The table compares each sector and market to the S&P 500 index on relative performance.
  • “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. (Ranges reset on the 1st of each month)
  • Table shows the price deviation above and below the weekly moving averages.

Weekly Stock Screens

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

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

S&P 500 Growth Screen

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

Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

I know, another boring week. But in a way, that is a good thing. When higher volatility comes, and it will, we will all be wishing for the “good ole’ days.”

In the meantime, our current model allocation remains primarily unchanged. We did increase our longer-duration bond holdings previously, which has served us well. As discussed earlier, we manage risk exposures to reduce volatility while still participating with the market’s advance. Stock selection has been key to carrying an overweight cash position and still outperforming our benchmark index.

The continuing deterioration of market internals continues to suggest a rising risk profile to the markets. Such is why we continue to remain cautious in our allocation models. That has not changed from last week.

“We still hold a slightly higher cash balance in the equity sleeve (~10%) and the fixed income sleeve (~10%). We use the cash as a risk hedge against an equity draw and “shorten duration” in the bond allocation. While we were previously increasing the duration of our bond portfolio to capture the decline in rates, we are holding cash to add longer-duration bonds on upticks in rates.

If there is a risk-off event in the market, yields will drop to 1% or less providing a nice bump in appreciation in our bond portfolio. In the meantime, we are collecting a bit of income while holding the hedge.

For now, there seems to be minimal risk in a market that continues to creep higher. Unfortunately, however, we will not always get to enjoy such low volatility markets, so enjoy them while you can.

Portfolio Changes

During the past week, we made minor changes to portfolios. In addition, we post all trades in real-time at RIAPRO.NET.

*** Trading Update – Equity and Sector Models ***

No Trades Last Week

As always, our short-term concern remains the protection of your portfolio. Accordingly, we remain focused on the differentials between underlying fundamentals and market over-valuations.

Lance Roberts, CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors



Attention: In the next couple of weeks, the 401k plan manager will no longer appear in the newsletter. However, the link to the website will remain for your convenience. Be sure to bookmark it in your browser.

Commentary

This past week was a bit rougher for markets than usual. However, while the market did violate its 20-dma, it remains well-entrenched above the 50-dma. Moreover, with the market having sold off every day last week, a rally next week will not be surprising heading into options expiration.

The one thing to watch for is a violation of the 50-dma, which will most likely indicate we are starting a bit larger correction between 5-10%. Given the Fed looks to be aggressively moving towards tapering their balance sheet purchases, we may have seen the peak in the market for now. However, the bullish bias remains very strong, so it is still too early to get overly defensive.

In the meantime, we can take some actions to reduce portfolio risk accordingly. First, continue to move all new contributions to either money market or stable value funds for now. Also, rebalance your equities and bonds back to weightings as equities are likely now out of tolerance.

International and small-cap stocks continue to underperform as of late as the momentum chase has turned back to the growth trade. Remain underweight these sectors.

There is no need to be aggressive here.

Model Descriptions

Choose The Model That FIts Your Goals

Model Allocations

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

Or, let us manage it for you automatically.


401k Model Performance Analysis

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

Have a great week!

Technical Value Scorecard Report For The Week of 9-10-21

Relative Value Graphs

  • The third graph below shows the general weakness of all sectors versus the S&P 500. Given the market has been led by only a few stocks (FAANG stocks), the result is not surprising.
  • The first graph shows that almost all sectors weakened on the week versus the market. The scatter plot confirms the broad-based relative weakness across sectors. Only two sectors (technology and real estate) are overbought and not meaningfully so. At the same time, a third of the sectors have given up 4% or more over the last 20 days to the S&P 500.
  • The factor/index chart shows a similar pattern with everything but the FAANG heavy NASDAQ beating the S&P 500.
  • The loud message being sent frm this analysis is the breadth of the market is very weak. This tool provides further rationale for our decision to reduce equity exposure, increase our bond holdings, and be mindful of risks to the markets as we advance.

Absolute Value Graphs

  • On an absolute basis, all sector scores fell last week except the FAANG heavy NASDAQ, which was flat, and the discretionary sector.
  • Except for the industrial sector, the Dow Jones, and Emerging Markets, all sectors, factors, and indexes are slightly overbought.
  • Real estate, which was grossly overbought last week, saw its absolute score fall sharply. It was down nearly 3% last week. Utilities were also well overbought but saw its score fall sharply despite being flat on the week. This analysis uses multiple time frames and different types of technical analysis. In most cases, the past week’s price action can be offset by price action from past periods that falls out of the analysis period.
  • The fourth table shows that no sectors, factors, or indexes are two standard deviations or greater from their important moving averages. That said, technology and utilities are just shy of two standard deviations from their respective 200 dmas.

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take any action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60 the signals are more reliable.

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

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Are Labor Shortages Stoking Inflation Fears At The Fed?

The Fed’s Beige Book, on the heels of a new record number of job openings, seems to be stoking inflation concerns at the Fed. Interestingly, the warnings we quote below from every Fed district are being ignored by the bond markets, as yields decline in recent days.

Pre-market trading is reversing yesterday’s price action. Bonds are opening weaker while most stock indexes have recouped yesterday’s declines. PPI will be released at 8:30 this morning. Investors will keep a close eye on the data as it can serve as a proxy for future profit margins. Higher than expected producer prices along with rising wages will prove troublesome, especially for the manufacturing sector.

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Producer Price Index, month-over-month, August (0.6% expected, 1.0% in July)
  • 8:30 a.m. ET: Producer Price Index excluding food and energy, month-over-month, August (0.6% expected, 1.0% in July)
  • 8:30 a.m. ET: Producer Price Index, year-over-year, August (8.2% expected. 7.8% in July)
  • 8:30 a.m. ET: Producer Price Index excluding food and energy prices, year-over-year, August (6.6% expected, 6.2% in July)
  • 10 a.m. ET: Wholesale Inventories, month-over-month, July final (0.6% expected, 0.6% in prior print)

Earnings

Pre-market

  • Kroger (KR) is expected to report adjusted earnings of 66 cents a share on revenue of $30.753 billion

Did They Leak Their Own Story To Not Spook Markets?

It is no big secret that members of Congress, major Wall Street firms, and the Federal Reserve have an uncanny ability to manage their investments, capitalize on opportunities (before they happen) and avoid major drawdowns.

Early this week, Richard Kaplan, President of the Dallas Federal Reserve, got much (likely unwanted) attention from the media over his disclosures of purchases or sales in excess of $1 million in 22 different companies.

In a surprise twist, Kaplan and Eric Rosengren (Boston Fed President) liquidated all of their positions yesterday as noted in a Zerohedge article.

“Well, less than two days after the widespread public fury at this grotesque discovery, the presidents of the Federal Reserve banks of Boston and Dallas said Thursday they would sell their individual stock holdings by Sept. 30 amid “ethics concerns”, and invest the proceeds in diversified index funds or hold them in cash.”

Besides that obvious individuals with access to “inside information” should be disallowed from trading individual securities (i.e. Nancy Pelosi) there is a strange timing to all of this. Take a look at the chart below.

Given the Fed is now talking of “taper,” the question is what do Kaplan and Rosengren “know” that you don’t?

Did they really decide to sell “now” for ethical reasons? If “ethics” were a concern, they should have sold when they took office, not when they got caught.

Or, did they intentionally leak the story to give them an excuse to sell without spooking markets prematurely?

Inquiring minds want to know.

Regardless, it certainly appears to be very auspicious timing for those on the “inside.” Yes, the same insiders who also happen to control the monetary levers supporting asset prices.

Warning Signal Or Excessive Caution?

SocGen’s proprietary Multi-Asset Risk Indicator (SG MARI) is based on investor positioning in futures and options markets. That indicator is currently hovering just above deep risk-off territory despite incessantly rising markets.

The indicator has seldom been at such a low level. As noted by Soc Gen:

“It has indicated ugly and even terrible things in the past (tech bubble, credit crisis, taper tantrum) when declining further. Conversely, whenever the indicator has bounced back from current levels, it has typically heralded the start of a more positive tone, which is good for equity and commodities but not for rates.”

Given that retail investors are exceeding long equity allocations (below) and that options positioning is primarily driven by institutions, the question is really who knows what? This risk-off positioning is coming at a time when equity markets are up 20% for the year, economic growth is strong (on a relative basis), and interest rates are low. The only dynamic that would change the bullish backdrop for equities, given excessive valuations, is the Fed “taking away the punchbowl.”

Maybe Rosengren and Kaplan know more than we think?

A Bear Market Signal?

Of course, the market and macro-economic data are confirming the need to be more cautious with equity risk.

“The chart below shows the spread between the Bear Market Probability and Macro Index models. The higher the spread, the higher the probability of a bear market. The chart shows that the S&P 500’s annualized return is a horrid -17.6% when the spread is above 20% like it is now.” Sentiment Trader

Another Strong Auction

On the heels of yesterdays’ strong 10-yr auction, 30yr bonds were very well bid. (Another risk-off warning sign?) The 1.91% yield on the bonds is nearly 2bps below where it was trading before the auction and the lowest auction yield in nine months. 30-year bond yields are down 10bps since peaking at 2% on Tuesday. Per Zero Hedge: “Dealers were left holding on to 13.1% of the auction, the lowest Dealer takedown on record!” Given there is little need for dealers to distribute what they own, selling pressure may be minimal in the days ahead. The bond is trading about 3bps lower in yield post-auction.

Fed’s Beige Book- Labor Shortages

The Fed’s Beige Book is a summary of economic conditions in the 12 Federal Reserve Districts. Before delving into each district’s report, the document starts with a one-paragraph highlight from each district. As shown below, all of the summaries include a statement on labor shortages and or wage pressures. The topic is clearly top of mind at the Fed, as it should be. If there are widespread job shortages and strong pressure to hire, as seen in the record number of job openings, wages may continue to rise and foster more inflation. Is it any wonder many Fed members are increasingly growing concerned with inflation?

Boston: “inability to get supplies and to hire workers.”

New York: “businesses reporting widespread labor shortages.”

Philadelphia: “while labor shortages and supply chain disruptions continued apace.”

Cleveland: “Staff levels increased modestly amid intense labor shortages.”

Richmond: “many firms faced shortages and higher costs for both labor and non-labor inputs.”

Atlanta: “wage pressures became more widespread.”

Chicago: “Wages and prices increased strongly while financial conditions slightly improved”

St. Louis: “Contacts continued to report that labor and material shortages.”

Minneapolis: “hiring demand continued to outstrip labor response by a wide margin.”

Kansas City: “Wages grew at a robust pace, but labor shortages persist.”

Dallas: “Wage and price growth remained elevated amid widespread labor and supply chain shortages.”

San Francisco: “Hiring activity intensified further, as did upward pressures on wages and inflation.”

How To Prepare For A Market Correction

Jobless Claims Continue to Fall

Initial jobless claims fell to 310,000, a decline of 35,000 from last week. This is the lowest level for initial claims since March 14, 2020, when it was 256,000. In 2018 and 2019 jobless claims were steady in the low 200,000’s.

Inflation Expectations

The graph below shows inflation expectations have stabilized after rising sharply in 2020. Expectations are probably more important than actual inflation figures like PCE, CPI, and PPI as the Fed tends to believe inflation follows expectations. Given the unprecedented supply line pressures along with pent-up demand, and massive fiscal stimulus, the Fed’s reliance on the markets might be a trap this time.

The equity markets are affirming stable inflation expectations. Cyclical sectors, that traditionally benefit from higher prices and strong economic growth, are lagging while more conservative, less economically sensitive sectors are leading the way. The sector performance map below points shows where money is flowing to and from. It appears investors are seeking shelter in more conservative, lower beta sectors like utilities, healthcare, and REITs. Large-cap technology and communication, like Apple, Microsoft, Facebook, and Google, have also done well as their earnings are thought to be minimally affected by slowing economic growth. The cyclical sectors like energy, materials and industrials are lagging as growth prospects decline.

#MacroView: The Insecurity Of Social Security

The latest annual report from the Social Security Trustees showed the insecurity of social security.

According to the July 2021 snapshot from the Social Security Administration, nearly 70-million people receive a monthly benefit check, of which 51.3 million are over the age of 65.

Social Security provides the majority of income to most elderly Americans. The system provides at least 50 percent of incomes for about half of seniors. For roughly 1 in 4 seniors, it provides at least 90 percent of total incomes. But, that dependency ratio is directly tied to the financial insolvency of the vast majority of Americans. According to a CNBC report:

“Morning Consult found that nearly 18% of adults with an annual income of $50,000 or less have no savings, while some 34% have enough to cover just three months of expenses. Another 11% would deplete savings within six months. Only 10% of that income group has more than a year’s worth of cash.

Higher-income households are only somewhat better prepared, the survey found. Among those with annual incomes of $50,000 to $100,000, about 18% said they have between three months and six months of savings. About 25% said their cash would last less than three months, and 6% had set aside nothing at all. None of those questioned in that income group had more than a year’s worth of savings.”

Such is a huge problem that will impact boomers in retirement.

The Insecurity Of Social Security

Given the financial insecurity of the bottom 90% of Americans, the dependency on social security is problematic. Here are some facts from the latest SSI report from CRFB:

  • Social Security is Only 13 Years from Insolvency. Social Security cannot guarantee full benefits to current retirees under current law. The Trustees project the Social Security Old-Age and Survivors Insurance (OASI) trust fund will deplete its reserves by 2033. The Social Security Disability Insurance (SSDI) trust fund will be insolvent by 2057. The theoretical combined trust funds will exhaust their reserves by 2034. Upon insolvency, all beneficiaries will face a 22% benefit cut.
Source: CRFB
  • Social Security will run cash deficits of $2.4 trillion over the next decade. Such is the equivalent of 2.3% of taxable payroll or 0.8% of (GDP). Social Security’s 75-year actuarial imbalance totals 3.54% of taxable payroll. That is 1.2% of GDP or nearly $21 trillion in present value terms.
  • Finances Are Deteriorating. Social Security’s finances worsened over the last year. Current projections show Insolvency occuring a year earlier, and the 75-year actuarial deficit is over 10 percent larger. The 75-year shortfall is nearly 85% larger than orginally estimated in 2010.

The problem is evident. Given the large and growing dependency on social security, benefits will get cut for recipients if Congress fails to act. As noted by the Center Of Budget & Policy, social security for many retirees is the difference between living in poverty or not.

Demographics Are Destiny

One of the primary contributors to the insecurity of social security is demographics.

In 1940, the life expectancy of a 65-year-old was just 14 years. Today it is over 20 years. By 2035, the number of Americans 65 and older will increase from approximately 56 million today to over 78 million.

The problem for social security is that in 1940, nearly 16-workers paid into the program for each person receiving benefits. Currently, that ratio is just 2.8 workers for each Social Security beneficiary. By 2035, that ratio will decrease to 2.3 covered workers for each beneficiary.

“Social Security will see negative cash flow of $147 billion this year. The deficits will keep adding up as the population ages as fewer workers pay into the system relative to the number of retirees collecting benefits.” – Reason

Such increases in the number of retirees and lower birth rates decrease the relative number of workers. However, this decline in the “support ratio” is not just domestic, but global.

“Recently released official U.S. birth data for 2020 showed births fell continuously for more than a decade. The ‘total fertility rate,’ is a measure constructed from the data to estimate the average total number of children born. That rate fell from 2.12 in 2007 to 1.64 in 2020. It is now well below 2.1, the value considered to be ‘replacement fertility,’ which is the rate needed for the population to replace itself without immigration.

However, the problem isn’t just the “replacement rate” of workers paying into the system. But also the structural change to the workforce itself.

Daily Market Commnetary

A Structural Employment Problem

The structural shift in employment is due to technology and automation. Yet, it is an overarching problem most give little attention to.

While the mainstream media focuses their attention on the daily distribution of economic data points, there is a hidden depression running along the country’s underbelly. While reported unemployment is heading back to historically lower levels, there is a swelling mass of uncounted individuals. These are individuals assumed to have either given up looking for work or are working multiple part-time jobs. 

The chart strips out the argument of retiring baby boomers, who ironically, aren’t retiring. Such is not because they don’t want to retire, but because they can’t afford to.

These higher levels of under and unemployment apply downward pressure on wages even as work hours increase. Real wage declines are evident as companies opt for increasing productivity, continued outsourcing, and streamlining employment to protect corporate profit margins. However, as the cost of living is affected by the rising food, energy, and health care prices without a compensatory increase in incomes, more families are forced to turn to assistance to survive.

Without government largesse, many individuals would live on the street. The chart above shows all the government “welfare” programs and current levels to date. The black line represents the sum of the underlying sub-components. Thus, while unemployment insurance did taper off after its sharp rise post-pandemic, social security, Medicaid, Veterans’ benefits, and other social benefits continue to rise.

Importantly, these social benefits are critical to the average person’s survival as they make up more than 25% of real disposable personal incomes.

With 1/4 of incomes dependent on government transfers, it is not surprising the economy continues to struggle. Recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

The Social Security Insecurity Endgame

As stated above, the biggest problem for Social Security, and the U.S. in general, comes when Social Security begins paying out more in benefits than it receives in taxes. Then, as the cash surplus gets depleted, Social Security can not pay full benefits from its tax revenues alone.

Already, welfare programs in the U.S. are consuming ever-growing amounts of general revenue dollars to meet obligations. As noted recently, mandatory spending already consumes more than 100% of Federal tax revenues.

“In the fiscal year 2019, the Federal Government spent $4.4 trillion, amounting to 21 percent of the nation’s gross domestic product (GDP). Of that $4.4 trillion, federal revenues financed only $3.5 trillion. The remaining $984 billion came from debt issuance. As the chart below shows, three major areas of spending make up most of the budget.”

corporate taxes, Hiking Corporate Taxes Won’t Improve Economic Outcomes

Think about that for a minute. In 2019, 75% of all expenditures went to social welfare and interest on the debt. Those payments required $3.3 Trillion of the $3.5 Trillion (or 95%) of the total revenue collected. Given the decline in economic activity during 2020, those numbers become markedly worse. For the first time in U.S. history, the Federal Government will have to issue debt to cover the mandatory spending.

Eventually, either the benefits will get slashed, or the rest of the government will have to shrink to accommodate the “welfare state.” It is improbable the latter will happen.

Conclusion

Demographic trends are reasonably easy to forecast and predict. Each year from now until 2035, we will see successive rounds of boomers reach the 62-year-old threshold. Two problems are resulting from these consecutive crops of boomers heading into retirement.

The first is that each boomer has not produced enough children to replace themselves, which leads to a decline in the number of taxpaying workers. It takes about 25 years to grow a new taxpayer. We can estimate, with surprising accuracy, how many people born in a particular year will retire. The retirees of 2070 were born in 2003, and we can see and count them today.

The second problem is the employment problem. The decline in economic prosperity is the result of four decades of misguided policy:

  • Increases in non-productive debt and deficits,
  • Reduction in savings,
  • Declining income growth due to productivity increases; and,
  • The shift from a manufacturing to service based society that generates lower levels of taxable incomes in the future.

“The more time that passes, the heavier the lift will be. According to an analysis from the Committee for a Responsible Federal Budget, which advocates for low deficits and sustainable entitlement programs, delaying action until insolvency hits in 2034 will make the needed tax increases or benefit reductions about 25 percent larger than if Congress acted today. In either case, the changes will be seriously disruptive to Americans’ retirement plans and financial security.” – Reason

The entire social support framework faces an inevitable conclusion where no wishful thinking will change that outcome. The question is whether our elected leaders will start making the changes necessary sooner, while they can get done by choice or later when forced upon us.