Monthly Archives: August 2020

Bulls Continue To Push Stocks Higher As Risk Rises


In this issue of “Bulls Continue To Push Stocks Higher As Risk Rises.”

  • Bulls Push Stocks To New Highs
  • Market Queuing Up For A Correction
  • The Fed Broke It
  • Portfolio Positioning
  • The Illusion Of Soaring Savings Amid Rising Economic Uncertainty
  • Sector & Market Analysis
  • 401k Plan Manager

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors can now manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes, we can get you in the “right lane” for retirement.

This Week 1-15-21, #WhatYouMissed On RIA This Week: 1-15-21

Catch Up On What You Missed Last Week


Bulls Push Stocks To New Highs

What better way to celebrate a new President than to push stocks to new all-time highs? On Wednesday, the market surged as Joe Biden got sworn in as the 46th President of the United States. Interestingly, it was a rotation from the reflation trade back into the “Old Gaurd” of the FANG stocks that led the way.

In fact, despite hopes that the reflation trade would be the thing, it has been just the opposite. The chart below is the differential in performance over the last week between market-cap and equal-weighted markets. (FANG dominates market cap whereas equal-weight has a much larger weighting in industrials)

Notably, that rotation is a function of money managers repositioning portfolios to reduce risk. The risk gets reduced by moving from significantly extended and deviated areas of the market back to less extended or oversold segments. As noted last week, there is nothing screaming risk more at the moment than the small-cap sector.

Markets Queuing Up For A Correction

Currently, managers can’t afford to be out of the market and potentially suffer a performance drag. So, the rotation in the market reduces risk while still maintaining exposure to equities. However, as discussed last week, there is ample evidence that “everyone is currently in the pool.”  Such leaves the market vulnerable to three risks:

  1. More stimulus and direct checks into the economy lead to an inflationary spike that causes the Fed to discuss hiking rates and tapering QE.
  2. The current rise in interest rates continues over higher inflation concerns until it impacts a debt-laden economy causing the Fed to implement “yield curve control.” 
  3. The dollar, which has an enormous net-short position against it, reverses moves higher, pulling in foreign reserves, causing a short-squeeze on the dollar. 

The reality is that both a rise in the dollar, with higher yields, is likely to start attracting reserves from countries faced with economic weakness and negative-yielding debt. Such would quickly reverse the tailwinds that have supported the equity rally since March.

In the following video, we discuss why the markets are setting up for a correction over the next month of 3-5%. (We publish a daily 3-minute video click here to subscribe)

Important Note: A correction can take on one of two forms. The market either declines in price to alleviate the overbought condition, or it can consolidate sideways. 

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

The Fed Broke It

In his latest letter to investors, The Financial Times reported that Seth Klarman of Baupost Capital blamed the world’s central banks for flooding the financial system with liquidity masking the US economy’s real health. To wit:

“With so much stimulus being deployed, trying to figure out if the economy is in recession is like trying to assess if you had a fever after you just took a large dose of aspirin. But as with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognise the danger.

While the entire article is worth a read, his point is what we addressed previously in “Moral Hazard.”  What exactly is the definition of “moral hazard.”

Noun – ECONOMICS
“The lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.”

Take a look at the following chart, which is a clear example of investors adopting the idea of “insurance” against loss. (Charts courtesy of ZeroHedge)

Of course, given the price-to-sales ratio is at a record high, such also suggests that investors are vastly overpaying for future outcomes. When there is a lack of perceived risk, the outcome has always ended poorly without exception.

More Of The Same

As Seth Klarman notes, it is the unprecedented flood of global liquidity that is driving the mayhem.

“The Fed’s policies and programs have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated.”

While The Fed’s drastic measures have arguably helped to boost economic activity and rescue ailing businesses (or more correctly, raise stock prices enabling issuance and collapse yields and spreads enabling issuance), Klarman warns:

“They have also kindled two dangerous ideas: that fiscal deficits don’t matter, and that no matter how much debt is outstanding, we can effortlessly, safely, and reliably pile on more.”

Unfortunately, 40-years of history have already shown us the problem with debts and deficits in economic prosperity for the masses.

Another decade of the same should about finish the job.

Signs Of Enthusiasm

Sentiment Trader had a great piece out on Thursday discussing sentiment and enthusiasm.

“The biggest challenge with this market, one we haven’t really ever had to deal with before, is the conflict between an impressive recovery from a historic selloff, superimposed against a backdrop of record levels of speculative activity.

Recoveries from a bear market typically take much longer. By the time they’ve recovered and been at new highs for a while, speculation comes in, markets plateau, divergences form, and sentiment cycles back down during a correction.

If we look at a typical Sentiment Cycle, then we basically went from enthusiasm to panic and right back to enthusiasm, all in record time.”

There is little arguing that we’re in this part of the cycle. As the Knowledge Base article, “How do I use sentiment?” points out, this part of the cycle is identified by:

  • High optimism – CHECK
  • Easy credit (too easy, with loose terms) – CHECK
  • A rush of initial and secondary offerings –CHECK
  • Risky stocks outperforming – CHECK
  • Stretched valuations – CHECK

All boxes are checked there. More objectively, when we look at the correlation between the S&P 500’s price path lately versus the Enthusiasm phase of past cycles, there is a high positive correlation.”

Investors Are There

While none of this suggests the markets are about to crash, it does indicate that short-term risk/reward is not favorable currently. As SentimenTrader summed up:

“Sentiment is horrifically extreme and almost all signs are present, screaming at us that we’re seeing the kinds of behavior that are almost solely and universally seen at medium-term peaks in stocks.”

As noted above, a short- to intermediate-term correction to reduce current levels of exuberance would be a healthy thing. Longer-term, the dynamics to support a continuation of the bull market will become more challenging, particularly if inflation and interest rates start to push higher.

Portfolio Positioning – A Correction Is Coming

As noted, a correction is coming.

Let me clarify. I am NOT saying the markets are about to crash. 

However, after the recent runup from November, all of our indicators are beginning to align. Such suggests a 3-7% correction over the next month. Could it be 10% or more? Absolutely. Once the correction begins, we can garner a better understanding of the downside risk.

Over the past year, we have remained primarily allocated toward equity exposure but have also worked around the edges hedging risk, raising stop levels, and staying mostly domestic-focused. Given our outlook for a steeper yield curve earlier this year, we also shortened the duration of our bond allocations and increased credit quality.

On Friday, we did increase our cash levels and reduce our equity-index longs for the time being. We may be a bit early, but we feel the risk currently outweighs the reward. These portfolio adjustments to allocations follow our time-tested portfolio management rules.

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

Notice, nothing in there says, “sell everything and go to cash.”

Our Job As Investors

Remember, our job as investors is pretty simple – protect our investment capital from short-term destruction so that we can play the long-term investment game.

  • Capital preservation
  • A rate of return sufficient to keep pace with the rate of inflation.
  • Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)
  • Higher rates of return require an exponential increase in the underlying risk profile.  This tends to not work out well.
  • You can replace lost capital – but you can’t replace lost time.  Time is a precious commodity that you cannot afford to waste.
  • Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

With forward returns likely to be lower and more volatile than witnessed over the last decade, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes, and limiting investment capital’s destruction will likely be the real formula for investment success in the coming decade.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

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


Portfolio Positioning “Fear / Greed” Gauge

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

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 97.0 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read.

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


Weekly Stock Screens

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

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

S&P 500 Growth Screen

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

NEW!  Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

With the inauguration now behind us, the focus turns to corporate earnings. So far, with the first week of earnings behind us, everything is pretty much as expected. The question will be if the rest of the year can stand up to too optimistic forecasts.

As noted above, many of our indicators are starting to send off warning signs we could be close to a short-term correction. When those signals begin to trigger will sell our index position holdings of SPY and RSP, which will immediately increase cash by 15%.

We also started adding duration back into our bond portfolio this past week, which should also act as a hedge against any corrective event. As noted below, we adjusted our holdings to align with our benchmark more closely. Such should help increase performance this year while allowing our risk management strategies to curtail downside risk. 

As always, if you have any questions, please don’t hesitate to reach out to your advisor.

Portfolio Changes

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

We are slowly making changes to the portfolio allocation model to move it closer to the benchmark weightings. Given we were underweight technology and discretionary, and overweight communications, we are modifying holdings to correct those imbalances.” – 01/19/21

  • Sell 100% of CMCSA (Comcast) – Communications
  • Buy 2% of portfolio value in LOW (Lowe’s) – Discretionary / Stop-loss is $160
  • Add 1% of portfolio value to AAPL (Apple) increasing weight to 3% / Stop-loss is $120
  • Also add 1% of portfolio value to MSFT (Microsoft) increasing weight to 3% / Stop-loss is $210
  • And add 1.5% of portfolio value to AMZN (Amazon) increasing weight to 3% / Stop-loss is $3000

“We sold the entirety of our position in UNH this morning. While we like the company very much it really came down to the fact that we were overweight healthcare, relative to the equal weight S&P 500 benchmark, and needed to reduce our weighting slightly.”  – 01/21/21

  • Sell 100% of UNH (United Healthcare)

This morning’s sell-off has now triggered our money flow indicator requiring us to take our two index trading positions off of the table. We are also selling CVX in response to Biden’s executive order to ban drilling on Federal lands and in offshore waters. We are holding our other drillers which should benefit from the eventually reduced supply caused by this order resulting in higher oil prices.” – 01/22/21

  • Sell 100% RSP, SPY
  • Sell 100% CVX

We are aware of the risks and are carrying tight stops on all positions.

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

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

As anRIA PRO subscriber (You get your first 30-days free), you can access our live 401k plan manager.

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

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

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

Technical Value Scorecard Report For The Week of 1-22-21

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

Commentary 1-22-21

  • In last weeks relative value graphs many of the sectors were widely dispersed, with more than half of the sectors either considerably overbought or oversold. Today, they are much more aligned around fair value versus the S&P 500. Staples, however, remain deeply oversold. We have seen a few hints that the reflation trade is slowing. A change back to a more deflationary environment would likely prove beneficial to many companies in the staples sector.
  • After showing weakness over the last few weeks, technology has moved back to fair value, along with communications. These were the drivers of the market through the initial recovery rally in the summer and fall and may be taking the lead once again.
  • Emerging Markets remain grossly overbought versus the S&P, while some of the other hot indexes, like small/mid-cap, and the equal-weighted S&P (RSP) have moved back toward fair value. Last week was clearly a rotation back to the large-cap growth momentum trade. Might this signal the reflation trade is coming to an end?
  • The excess return chart at the bottom shows that XLE, XLB, XLI, and XLF, the hot reflation sectors performed poorly last week versus the S&P. For XLF, XLB, and XLI the weaker trend is going on two weeks.
  • On the absolute graphs, Staples are the weakest sector, while discretionary and healthcare the strongest. Utilities and real estate, after having been oversold for a few weeks, are now back to fair value.
  • The absolute factor/index graph shows all major markets are decently overbought. The score on the S&P 500, shown in the bottom right of the second graph, is also back to recent highs. Not surprisingly, it is now above its 50 day ma Bollinger band and very close to breaching the 20 day and 200 day Bollinger bands.
  • In general, the overbought broad market absolute scores and recent retreat from the reflationary trade offer caution for the weeks ahead.

Graphs (Click on the graphs to expand)


Users Guide

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

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

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

The ETFs used in the model are as follows:

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

The Illusion Of Soaring Savings Amid Rising Economic Uncertainty

The following chart, making the rounds lately, suggests an unprecedented level of savings among Americans. The problem is that it is an illusion amid the reality of rising economic uncertainty.

The Savings Mirage

To understand why the “savings rate” is not what it appears to be, you must understand its underlying construction. The website HowMuch.com recently provided that calculation of us.

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

While the table is dated, the point is that for most, there is often little left for “savings.”

Lies, Damn Lies, and Statistics

There are also multiple problems with the calculation.

  1. It assumes that everyone in the U.S. lives on the budget outlined above.
  2. It also assumes the cost of housing, healthcare, food, utilities, etc., are standardized across the country. 
  3. That everyone spends the same percentages and buys the same items as everyone else. 

The cost of living between California and Texas is quite substantial. While the inflation-adjusted median household income of $68,703 may raise a family of four in Houston, it will be problematic in San Francisco.

While those flaws are apparent, the top 10% of income earners skew the rate sharply upwards. The same problem also plagues disposable personal income and debt ratios, as previously discussed  in “America’s Debt Burden Will Fuel The Next Crisis.” To wit:

More importantly, the top 20%, and specifically the top 5%, of income earners skew the measure. 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.)”

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

Since the top income earners have more than enough income to maintain their living standards, the balance falls into savings. This disparity in incomes also generates a “skew” to the savings rate.

Yes, there is a significant amount of cash and deposits relative to the economy, which is also skewed higher by falling GDP, but the wealthy have it.

If savings were indeed soaring, then the average American wouldn’t be so concerned about their financial security. Such got documented in a recent survey by SimplyWise.

Financial Insecurity

Despite buoyant markets, millions of Americans faced unprecedented financial hardship caused by COVID-19. It has upended what work, income, and employment opportunities look like, as well as retirement. It has eaten into savings, forced people into debt, and created unprecedented levels of housing instability. And while the rollout of vaccinations gives some hope, continued lockdowns coupled with the change of power in Washington and current political unrest are causing many to continue feeling uncertain about the future. Yet certain populations, including seniors, people of color, and lower income Americans, have been disproportionately impacted both by the virus itself and the instability in its wake.” – SimplyWise

Here are some of the key findings:

  • 55% of people are more concerned about retirement today than this time last year.
  • 44% of Americans worry they’ll never be able to retire—an all-time high.
  • 23% of Americans don’t have any retirement plan.
  • 51% of Americans will need a 3rd stimulus check within the next 3-months.
  • 48% of White Americans could not last more than 3-months off of their savings.
  • 25% of Americans in their 60s could not last more than 3-months off their savings—an all-time high.
  • 75% of people laid off due to COVID-19 couldn’t come up with $500 cash.
  • 45% of Black Americans now fear falling behind on their rent or mortgage compared to 44% of Hispanic Americans and 28% of White Americans.

These critical issues encapsulate the ongoing financial distress that not only existed before the pandemic but have since worsened. Despite a surging stock market that has increased the wealth disparity in the economy, most Americans remain financially insecure.

Rising Concerns Across The Spectrum

While economic statistics such as debt-to-income, savings, and net worth seem to have improved in aggregate, such has not been the case. In every case, the top-10% of income earners who carry little debt, have substantial free cash flow and invest heavily skew the data upward. A previous Wall Street Journal analysis revealed the same.

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.

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

Given this disparity in incomes and net worth, it is not surprising the SimplyWise survey found that more than half of Americans (55%) are concerned about their retirement.

Again, this is a vastly different response to what current “savings rates” would suggest.

The D.A.D. Plan

The problem isn’t getting better despite repeated stimulus checks, monetary interventions, and fiscal policy hopes. Currently, 44% of Americans fear they will never be able to retire.

The lack of financial security, and concerns over the solvency and stability of social welfare, has led to an increasing number of Americans adopting the D.A.D. retirement plan. (Die. At. Desk.)

The survey also found a record number of Americans planning to work into retirement.

“Yet for a majority of Americans today, ‘retiring’ no longer means the end of. The January Index found that 71% of workers plan to continue working in retirement.” – SimplyWise

Most importantly, individuals in their 50’s and 60’s are planning to postpone retirement due to financial insecurity.

“An Index-high of 32% of people in their 50s are now planning to postpone retirement from work. And a record 21% of people in their 60s are now planning to postpone retirement from work.” – SimplyWise

These statistics are not new. However, there are far-reaching consequences on the fiscal solvency and social welfare of a large portion of the population.

The Savings Dilemma

Yes, these are pretty depressing statistics and certainly don’t support the mainstream bullish narrative. However, for the bottom-80% of income earners whose income growth has been stagnant over the last two decades, the roadblocks to being “financially secure” for retirement shouldn’t be surprising. A recent study from Brookings shows the problem.

“Adjusted for inflation, hourly wages of workers in the very middle (the 50th percentile, or the worker who makes more than half of all workers but less than the other half) grew 12% between 1979 and 2018. In contrast, wages toward the top (the 90th percentile, the worker who makes more than 90% of all workers) rose 34 percent. Toward the bottom (the 10th percentile), wages have grown only 4%.”

Again, back to our surging savings chart, if savings were equally distributed, then we wouldn’t see more than 50% of those surveyed unable to come with $500 in cash to meet an emergency.

We also wouldn’t be talking about a vast majority of Americans unable to save for their retirement substantially.

As noted in a previous survey from Kiplinger and Personal Capital, Americans’ inability to save for retirement comes from their living and debt costs.

  • The high cost of health insurance. “From 1999 to 2017, the cost of family health insurance coverage has more than doubled the amount of take-home pay it consumes.”
  • Disappointing investment performance.Just under 30% of all respondents (29.4%) said that disappointing investment performance had stopped them from saving as much as they would have liked to for retirement.” 
  • The amount of consumer debt they carried. “21.3% of Americans said that debt, not including student loans, kept them from saving for retirement combined with the increased costs of living.”

Real Debt-To-Income Ratios

There is a vast difference between the level of indebtedness (per household)  for those in the bottom 80%. 

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

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

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

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.

Such is also why interest rates CAN NOT rise by very much without triggering a debt-related crisis. The chart below is the interest service ratio on total consumer debt. (The graph is exceptionally optimistic as it assumes all consumer debt benchmarks to the 10-year treasury rate.)  It only takes small increases in rates to trigger a “recession” or “crisis” event.

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

An Illusion Of Prosperity

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

They aren’t.

The majority of 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 a widening of 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 will remain the case as exceedingly large debt and deficits used for non-productive purposes further inhibit economic prosperity. 

Those hoping that “savings” will rescue the economy will likely be disappointed when the mirage fades into dust.

#WhatYouMissed On RIA This Week: 1-22-21

What You Missed On RIA This Week Ending 1-22-21

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

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

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



What You Missed In Our Newsletter

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



What You Missed: RIA Pro On Investing

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



The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 1-22-21


What You Missed: Video Of The Week

Michael Lebowitz and I dig into why the Fed may not get inflation despite a sharp increase in the money supply as monetary velocity will likely remain elusive.



Our Best Tweets For The Week: 1-22-21

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

See you next week!

David Robertson: The Inherent Trouble With Bubbles

The trouble with bubbles

During the fourth quarter, the economy continued to recover but remained well below pre-pandemic activity levels. Simultaneously, the political environment became even more fraught as challenges to the presidential election confirmed the worst fears of political divisiveness.

Despite these challenges, the fourth quarter continued with a strong performance as the Russell 1000 index was up 11.78% in November alone. The Market Ear captured the frothy sentiment: “Upside remains the panic trade.” The open question for investors is to make of the increasing dissonance between the market and underlying conditions?

A Bubble By Any Other Name

Indeed, trying to make sense of that dissonance was an ongoing challenge throughout the last three quarters of 2020 and into the new year. The coverage of the phenomenon by earlier market reviews entitled “Calibrating the craziness” and “Should I stay or should I go?” and also traced out by the weekly “Observations” newsletter.

More recently, Jeremy Grantham came out with a note, Waiting for the Last Dance, that expresses his assessment of the dissonance between markets and fundamentals:

Make no mistake – for the majority of investors today, this could very well be the most important event of your investing lives. Speaking as an old student and historian of marketsit is intellectually exciting and terrifying at the same time … “

The critical point here is that the current market environment is like to have an enormous impact on investors. Although it doesn’t matter what you call it, Grantham does refer to it as a bubble.

Criteria 

Fortunately, there are ways to identify and manage through bubbles, albeit on a more qualitative basis than some investors might prefer. Grantham describes:

The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behavior, especially on the part of individuals.

Not surprisingly, there is plenty of evidence of crazy investor behavior. There has been a strong foundation of just “regular crazy” investor behavior. The phenomenon of the massive capital raises at a record pace despite economic travails, and widespread insider selling is the highlight of a previous blog post. New equity issues garnered special attention as the IPO market re-ignited and special purpose acquisition companies (SPACs) became all the rage.

Incidents of “really crazy” behavior were initially sporadic but became increasingly prominent as the year wore on. Many involved the actions of individual investors. A slew of technological developments combined with the discovery of options vastly reduced friction and increased leverage for individuals eager to capitalize on rising stocks.

First, Nasdaq and bitcoin outperformed other indexes, and then in the fourth quarter, bitcoin launched into an even higher trajectory. Story stocks, most-shorted stocks, and stocks preferred by individual investors outperformed. Inflows into stock funds were strong. John Authers reported, “that behavior is indeed moving to the ‘barking mad’ end of the dial.”

Implications

One of the critical implications is that market drivers are primarily behavioral ones, not objective, fact-based ones. The line between behavioral motivations and objectively based views are never obvious, but at times of excess, a subjective narrative applies to every detail.

For example, the purpose of investing in stocks with low valuations is to provide a margin of safety against the downside. As John Authers relates in a recent commentary, however, the effort to protect against downside risk has been completely abandoned in the Russell 2000 index:

“The P/E of the Russell 2000 topped at above 10,000 last month. For the last three weeks, the index hasn’t had a P/E because on aggregate it has had no E; the losses of its constituent companies have more than counterbalanced the profits.”

Even crazier situations have occurred in individual stocks. Tesla was the poster child of bubble behavior in 2020, but several instances of bankrupt stocks were panic bid. Axios reported the stock Signal Advance continued its surge on Monday “as the stock rose by 438%, after previously gaining 1800% during one 24-hour period.” The catalyst was a tweet by Elon Musk regarding the messaging app Signal, not the company Signal Advance. On Tuesday, it was down 74%.

A Really Crazy Run

Suffice it to say, the condition of “really crazy” investor behavior got met in spades. Once this happens, the proposition of being exposed to stocks changes in subtle but important ways.

One marker of the change is when investment commentary shifts from the realm of the “probable” or “expected” to the realm of the “possible.” The question, “What is to stop stock prices worldwide going on a really crazy run?” by the Economist is a great example.

When the standard transforms from the probable to the possible, the risk profile also transforms. While there may be opportunities for trading, the opportunities for long-term investors saving for retirement diminish.

Herein lies the rub of bubbles. Rapidly expanding markets and individual instances of explosive gains can prove alluring to all kinds of investors. Such becomes a very slippery slope for long-term investors. It is all too easy to fall for the prospect of impressive short-term gains without accounting for the implication of considerably lower long-term expected returns.

It is easy for short-term traders to get caught up in bubble excitement as well. When stocks make big moves more often than not, it is tempting to try to get a piece of the action. Such is especially true when other options to increase wealth are hard and fraught with their challenges.

Also, this exposes a common misunderstanding about trading. So much of the thrill is in making short-term gains. Many novice traders don’t realize that making money is the easy part; keeping the money is the hard part. Doing that over an extended period requires diligence, discipline, and risk management. Without those, all of the actions that produced gains in a bull market will also produce losses when things change.

Lessons

But this is the problem with bubbles; it is tough to tell when things change. There are no objective criteria. There usually aren’t warning signs. Everything is situation-specific, so few rules exist to provide guidance. As Grantham explains,

The great bull markets typically turn down when the market conditions are very favorable, just subtly less favorable than they were yesterday. And that is why they get missed.

Further, it is not like the big investment houses will be helpful either. They will be more likely to be egging investors on well after the bubble pops than to provide a suitable warning in advance. Grantham describes:

“So, don’t wait for the Goldmans and Morgan Stanleys to become bearish: it can never happen. For them it is a horribly non-commercial bet. Perhaps it is for anyone. Profitable and risk-reducing for the clients, yes, but commercially impractical for advisors. Their best policy is clear and simple: always be extremely bullish. It is good for business and intellectually undemanding.”

With so many people on one side of the market, there are opportunities for investors and advisors who can afford to take, and stick to, a contrarian position:

“Fortunes are made and lost in a hurry and investment advisors have a rare chance to really justify their existence. But, as usual, there is no free lunch. These opportunities to be useful come loaded with career risk.”

Finally, investors must contend with their own worst tendencies of being too smart by half. Almost everyone who trades in bubble conditions believes they can exit just before others do. Such cannot be the case in aggregate. Worse, because the appropriate time to leave only gets known in hindsight, most traders remain engaged long after the bubble pops.

A Real Humdinger

While bubbles are extreme events that can radically reorder investment outcomes, there are good reasons to believe this time around will be even more disruptive than usual.

For one, technology has significantly enabled bubble-like behavior. Commission-free trading eliminates the cost of trading. Smartphone trading apps and gamification make trading both fun and convenient. Fractional share trading further reduces obstacles. Today there is exceptionally little friction to inhibit reckless trading.

Besides, the social mores around gambling have softened considerably. Whereas gambling used to be taboo and kept out of the limelight, it is now openly embraced and promoted. It is hard to watch a sporting event without seeing ads for DraftKings or some other gambling service. People who strike it rich get lauded more than people who work to earn their money.

Finally, the structure of the market has changed in ways that amplify bubbles. Mike Green of Logica funds recently discussed this issue on a podcast hosted by Grant Williams and Bill Fleckenstein. He argued that because passive funds do not care about stock prices, as long as net money flows remain positive, there is nothing to “stand in the way of insanity.”

What is worse is there is nothing to stand in the way of insanity during the decline. As Green described, “When the scale [of selling] that hits the market is incapable of being absorbed by the market … that’s where chaos occurs”. In other words, there are likely to be instances of massive price disruptions once the selling gets started.

 Conclusion

Bubbles can be hard to navigate because of their insidious ability to prey on human weaknesses. Long-term investors get lured into making short-term wagers. Risk management discipline gets discarded for a shot at spectacular gains. It is all so tempting and looks so easy. Grantham captured this point perfectly:

“And when price rises are very rapid, typically toward the end of a bull market, impatience is followed by anxiety and envy. As I like to say, there is nothing more supremely irritating than watching your neighbors get rich.”

So, the trouble with bubbles is they prove very tempting opportunities to do the wrong thing. Many investors will take their chances and disregard the warning. They will follow overly optimistic projections to the top and will also follow them back down to the bottom. Some will try but fail to resist the temptation. Grantham explains the challenge:

“For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in.”

However, some others will be able to draw on their grit, adhere to their long-term plan, and avoid the worst of the pain. As a result, another aspect of bubbles is they represent significant transformations. Namely, “These great bubbles are where fortunes get made and lost.”

Richard Rosso’s 2021 Recommended Reading List

I’m not sure what I would do without books; thus, my RIA recommended reading list for 2021.

When I think of all the books still left for me to read, I am certain of further happiness.

Jules Renard

Through countless weekends, I’m nose-deep in dusty volumes that rot on used bookstore shelves. Or rummaging through boxes in poorly-lit corners of small-town Texas antique stores in search of books written in many instances, over 100 years ago from authors most of us never knew existed.

These books don’t cost much, but the words are priceless.

I enjoy fiction and self-improvement, as well as financial or economic titles. My reading interests are purposely varied to exercise both sides of my brain and minimize confirmation bias. 

Candidly, as much as investors believe money is about numbers, it’s equally about emotions and intuition. After all, what are investments but stories? What are your actions with money but scripts created by others and mentally imbed consciously or unconsciously? Money matters are much grayer than we’re lead to believe.

For example, many of the twenty-something self-proclaimed ‘market mavens’ who trade on Robinhood are lemmings seduced solely by stories; eventually, I expect most of them to be ‘Friar Tucked.’ You can guess what that means!

As an interesting sidenote, Robinhood is taking heat for ‘gamification’ strategies designed to suck in young investors. They employ gaming elements as a marketing technique, such as displaying ‘confetti raining down’ after a trade. I mean, what could go wrong?

Avoid the Business Insider reading list!

Business Insider is prolific with the number of reading lists they produce. They fail when it comes to the topic of investing. Blind buy-and-hold is the overarching theme, so I decide to ignore their choices. It’s not that I haven’t read them. I have. I find little relevance to these books.

With over 30 years of financial services industry experience and employed 14 of them by a large organization that minimized the financial crisis’s impact on client portfolios, I cannot in good faith endorse their most popular investing and finance selections.

I had witnessed the anguish firsthand of those who needed to postpone retirement indefinitely, failed to meet goals, died before they broke even. I’ve studied their investing book choices that ignore the devastating impact of loss as it collides with the time it takes to break even or get ahead financially.

So, no thanks.

My top five selections reflect where my current focus lies. The books of 2021 accentuate my learning objectives. If you enjoy them too, let me know.

Lives Of The Stoics: The Art of Living from Zeno to Marcus Aurelius by Ryan Holiday & Stephen Hanselman.

Seemingly, Ryan’s lifetime mission is to bring the lessons of ancient Stoics, their sage advice, and habits into the current century. Over the years, through numerous books, daily writings, and journals, he has succeeded. In the latest book, Ryan resurrects the greatest thinkers in history along with salient lessons for today.

Although slaves and emperors, rich and poor, Stoics possessed a shared passion for being, above all else, teachers for humankind. They didn’t escape persecution. Some were killed or encouraged to commit suicide.

This book represents personal highs and lows, the genesis of these all-too-human-souls who inwardly-examined and documented the demons and gods that motivate us. Their writings teach how to foster virtue from mistakes. Their words inspire with numerous examples of resiliency. Overall, these philosophers’ message is to let go of what we cannot control and even look forward to events you cannot change.

Epictetus: The Free Man.

Candidly, I have a favorite Stoic. Epictetus, the ‘free man’ ironically, was born the son of a slave woman and thus a slave himself. One of the Roman Empire laws, Lex Aelia Sentia, made it impossible for slaves freed before their thirtieth birthday. However, inside his mind, Epictetus was a freer man in spirit than most.

In 1965, Colonel James Stockdale shot down over Vietnam, contemplated a dark fate. Capture as a prisoner of war was inevitable, so he fortified himself internally with the teachings of Epictetus. As he parachuted down, a thought filled his mind – “I am leaving the world of technology and entering the world of Epictetus,” per the book.

This Stoic believed that how you perceive your surroundings determines your state of mind and dictates success or failure. He would say – “It’s not things that upset us; it’s our judgment about things.” Epictetus didn’t believe it was possible to be offended or frustrated by external forces. “If someone succeeds in provoking you, realize that your mind is complicit in the provocation.”

I strongly suggest this book for blog readers frustrated by the pandemic’s effects, the elections, or anything else outside of their control.

The Myth of Capitalism: Monopolies and the Death of Competition by Jonathan Tepper (an important REREAD in light of the times).

In his eye-opening book, Jonathan references Google and other tech companies’ potential dangers to obliterate the competition. Today, we witness the realization of such hazards; thus, this tome is a vital re-read. For those who haven’t picked up this choice yet, now is the time.

Not popular with the hedge fund and C-Suite crowd, Jonathan Tepper outlines how capitalism as we know it is in danger and, in many cases – dead. The U.S. economy has morphed from an open, competitive market place to an economy dominated by a few mighty companies. He analyzes the impact of this seminal change on business and consumer rights as we advance.

Monopolies have accelerated wealth inequality, suppressed wage growth, and dramatically reduced the number of business startups. Jonathan’s book is impressively thorough, and researched.  He outlines the structural disrepair in the American economy and how to rectify it.

The truths shared will sit uncomfortably with you. However, after reading, you’ll understand how a cancerous thread has corralled the once noble and enlightened vision of American capitalism.

Abe: Abraham Lincoln in His Times by David S. Reynolds.

Ok, so this is more beast than a book: 1,066 pages (not a typo). Perfect for pandemic entertainment.

Distinguished Professor David S. Reynolds is my favorite historian as he employs a unique lens to the lives of historical figures and thankfully shares his vision with all of us.

There are hundreds of books covering Abe Lincoln (who disdained being called Abe but realized it was essential to capture the hearts of the ‘everyman’); however, this book is a unique view. It thoroughly outlines the ‘why’ behind Mr. Lincoln’s actions and motives.

What was behind Lincoln’s axiomatic nature of cerebral calm and thought through such a period of the bloodiest turmoils? I always wondered how a man with such a humble background became so disciplined. In other words, what made Lincoln tick? David examines the man from such a unique perspective.  If you love history as I do, this book must be on your list.

Falling Upward: A Spirituality for the Two Halves of Life by Richard Rohr.

The author, a Franciscan priest, explores what it means to return to our ‘absolute’ selves, which is a path that’s forged mostly in the second halves of our lives.

From Father Rohr:

The phrase “two halves of life” was first popularized by Carl Jung, the Swiss psychologist. He says that there are two major tasks. In the first half [of life] you’ve got to find your identity, your significance; you create your ego boundaries, your ego structure, what I call “the creating of the container.” But that’s just to get you started.

In the second half of life, once you’ve created your ego structure, you finally have the courage to ask: What is this all for? What am I supposed to do with this? Is it just to protect it, to promote it, to defend it, or is there some deeper purpose? The search for meaning is the task of the second half of life. (This is not always a chronological matter – I’ve met 11 year-old children in cancer wards who are in the second half of life, and I have met 68 year-old men like me who are still in the first half of life.)

Father Rohr’s pages are a highlighted but delightful mess. His words resonate with me. Do you know of someone trapped inside their ego? Perhaps this book could help —one of my influential reads and worth a place on my re-read shelves.

Essentialism: The Disciplined Pursuit of Less by Greg McKeown.

This book, released in 2014, has since gained a massive following with a million editions sold. 

The Art of less means more.

The art of less resonates now.  It’s a hunger. Perhaps finally, Americans are getting the hint and focusing on what’s essential for their households to sustain. Stripping down everything once believed about being financially healthy ties into a mental and physical fortification. I think this book fits well with RIA’s Financial Guardrails and how our RIA teams work together for a common clear goal: The financial well-being of the client.

For example, the principle of “less but better” builds clear, useful teams as well it helps individuals live lives that truly matter. 

Are you a non-essentialist or essentialist? Essentialists envision trade-offs as a positive. They focus on what to release and enhance the guide on where to go big. Essentialists focus on priorities, build on their strengths, and learn to say no with surprising alacrity!

We require space to escape to clear the fog, discern the ‘essential few from the trivial many.’ Non-Essentialists are too busy doing rather than thinking about life and most likely working on unproductive, less life-fulfilling activities. A beneficial exercise is to break down and rebuild focus, especially during a pandemic. Think of it as a reset for the brain.

Sharing books? Not a fan.

Someone asked me if I share my books – only with two people close to my heart. Frankly, I’m selfish and don’t care to risk never seeing them again, especially my highlights and notes. I just happily purchase copies for friends who ask and gift them on birthdays and holidays!

Before summer, I’ll share another reading list for the hectic days ahead.

The Fed’s Inconvenient Truth: Inflation Is “M.I.A.”

The Fed’s Inconvenient Truth: Inflation Is “M.I.A.”

The amount of money in the US economy is 25% higher than it was at the start of 2020, eclipsing any pace of money growth seen since the Federal Reserve was established (1913)” RB Advisors Deputy CIO Dan Suzuki.

In recent weeks we have seen a non-stop flow of ominous statements like the one above.

The author is 100% factual and it should be a cause for deep concern. Historically, such surges in the money supply were often met with significant inflation.

While the sharp increase in the money supply provides context to the depth of our economic problems, our inflation warning bells are not ringing, at least not yet. Here is why.

What is Inflation?

Inflation, or aggregate price increases, results from economic activity, along with the amount of money and its velocity.

A famous economic formula called the Monetary Exchange Equation uses those factors to create a mathematical identity that precisely determines the inflation rate.

We co-authored an article with Brett Freeze entitled Stoking The Embers of Inflation. The article went into great detail about the monetary exchange equation.  We summarize a few key points here:

Per the inflation identity, the rate of inflation or deflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), less the rate of output growth (%Q). 

%M – As noted earlier, the change in the monetary base is a direct function of the Fed’s monetary policy actions. To increase or decrease the monetary base, the Fed buys and sells securities, typically U.S. Treasuries and more recently Mortgage-Backed Securities (MBS).

%V – Velocity is nominal GDP divided by the monetary base (Q/M). Velocity measures people’s willingness to hold cash or how often cash turns over. Lower velocity means that people are hoarding cash, which usually happens during periods of economic weakness, credit stress, and fear for banking institutions’ going-concern.

So if we exclude GDP, inflation is dependent on money supply and velocity changes. Money supply data is published weekly and easily forecastable with the Fed’s QE schedule. Velocity, on the other hand, is posted once a quarter and much more challenging to forecast. As such, let’s dive into velocity.

Understanding Monetary Velocity

Velocity is a measure of how fast cash circulates in an economy.

We consider two extreme examples of money printing and monetary velocity to appreciate the interaction of money supply and velocity.

  1. The Fed prints $10 trillion and buries it in a hole.
  2. The Fed prints $10 trillion, sends each American a $30,000 check, and tells them they have five days to spend it or lose it.

The two examples have polar opposite effects on prices, despite the same massive increase in the money supply.

In example 1, the Fed does not affect inflation. The $10 trillion is not fungible as long as it stays buried.

In example 2, hyperinflation would result as the new money rapidly circulates through the economy and dwarfs the economic system’s production capacity. Essentially, the demand for goods and services outstrips the supply.

The amount of money greatly matters, but equally important is how it moves through the economy. The graph below compares the money supply chart above with the velocity of money and inflation.

When you view money supply and velocity together, one notices they tend to offset each other. However, we highlight the late 1970s, the last highly inflationary period, to show a period they did not counteract each other.

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

Velocity Trends

Currently, monetary velocity is plummeting. Despite the surge in money supply, the money is not circulating as fast, as a percentage of the economy, as it was before COVID. To help us understand why we first focus on the consumer. Consider the recent trends in revolving credit debt outstanding and savings rates shown below.

The next chart shows the sharp rise in the Fed’s balance sheet and the commensurate increase in the Federal deficit.

The deficit data (red) is not current on the graph, but if it were, you would see that the Fed’s balance has risen perfectly in line with the deficit. Said differently, the surge in the money supply is indirectly funding the government.

If the government spent all the money it borrowed and the recipients of the money spent it, velocity and GDP growth would be much higher. As a result, prices would likely be higher.

The problem is not only frugal consumers but, believe it or not, the U.S. Treasury. The graph below shows Treasury’s cash balance, held at the Fed, is over $1.5 trillion more than average. The treasury essentially funded over $1 trillion, backed by a higher money supply, which it has yet to spend.

Remember our non-inflationary example where the Fed prints money and buries it in a hole?  About a third of the $3 trillion the Fed added to the money supply is in a hole. Like consumer savings and debt repayments, the Treasury’s activities are weighing on velocity.

An Inconvenient Truth For The Fed

Per the inflation identity, the rate of inflation or deflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), less the rate of output growth (%Q).

Velocity, therefore, equals GDP divided by the money supply.

The rate of velocity at the end of the third quarter of 2020 is 3.92. Assuming a 5% GDP growth in the fourth quarter, we should see velocity fall to 3.28. Note, we know the money supply rose by $1.1 trillion in the fourth quarter. The annual percentage changes in M1 and velocity will approximate a 65% advance and decline, respectively.

Herein lies an inconvenient truth for the Fed. They are boosting the money supply, and it’s having an equally negative effect on velocity. As such, it’s hard to forecast much inflation given current Fed policies.

To quote John Hussman- “Once short-term interest rates drop to zero, further expansions in monetary base simply induce a proportional collapse in velocity.”

Monetary Equation versus Reality

We think it’s helpful to briefly segue and show how well the monetary equation holds up in the real world. The graph below is from our article mentioned above. As shown below, solving for inflation using the equation ties out nearly perfectly with the GDP price deflator and is well correlated to CPI.

CPI is a flawed construct as it is impossible to get accurate prices on all transactions. Further its equally impossible to properly weight them based on consumption trends. As such, CPI rises and falls more than the deflator or the output of the equation. Since 1948 CPI has averaged .4% higher than the deflator/equation with a correlation of 95%.

Summary

The Fed pushed the money supply higher by nearly $3 trillion or 70% throughout 2020. At the same time, GDP is $600 billion less than it was at the beginning of 2020. As a result, velocity has sharply declined.

GDP is recovering nicely but remains below levels of a year ago. The Fed expects to push the money supply higher at a 15% rate this year. All else equal, velocity will likely further decline and offset the money supply growth.

While we are not concerned about inflation today, we offer caution for tomorrow. The Fed and Treasury are playing a dangerous game. The numbers we discuss above are massive and dwarf anything seen in American history. If consumers start spending their savings, and the government keeps borrowing and spending unprecedented amounts, velocity can pick up rapidly. We leave you with a vital question to better understand the prospects for inflation.

Will the Fed have the wherewithal to reduce money supply growth if velocity increases?

Eric Lytikainen: The Gold Bull Market Is Just Getting Started

The Gold Bull Market Is Just Getting Started

2021 marks the 50th anniversary of President Nixon’s decision to suspend the convertibility of U.S. dollars into gold. At that time gold was just $35 per ounce. As we approach the August 13th “golden anniversary” date, a review of the past 50-years is worthwhile.

Strategic View: Gold Could see $25,000 in 10 years

The two big rallies in gold occurred over roughly 10-year periods. Both saw dramatic increases in the value of gold.  From August 1971 to 1980, gold rallied from $35 per ounce to over $700 per ounce, a twenty-fold increase.  Please note a significant pullback from $200 to $100 per ounce during this time, a 50% drawdown.  Even in a bull market, prices often have to correct before finding new footing.

Great Reset

One might say that there was a “great reset” of the financial system in 1971, which moved the world past the Bretton Woods agreement.

Tech Bubble Bursting

In 2001, following the bursting of the tech bubble, the gold price again rallied over 10-years. This instance resulted in a maximum gain of seven to eight times the rally’s beginning point ($250).  The tech bubble, followed by the housing bubble of 2007-2008, provided policy support for gold inflation through quantitative easing and other measures.

In 2021, amid a worldwide pandemic and political and societal upheaval, the World Economic Forum and other prominent world organizations call for and/or promote a “Great Reset.”  Whether this Great Reset results in a new worldwide monetary paradigm is unclear.  However, with government world debt increasing, concurrent with declining economic growth, the timing appears to be good for world leaders to have those discussions.

Regardless of whether we are on the cusp of a new monetary paradigm, the case for increased allocations to gold is compelling.  As governments continue to add to their deficit spending, the expectations for inflation are rising.  Gold tends to perform well in these inflationary environments.

It is our view that the next big bull market in gold is just getting started.  In 2020, gold broke to new highs before recently pulling back to the $1,800 per ounce level. If we look back at the last two big runs higher in gold, it is reasonable to expect that gold could achieve ten-fold or twenty-fold increases over the next 10-years. Such is especially true if the world financial system experiences a “great reset.”

Technical and Tactical View

At the beginning of a bull market, one option for investors would be to increase gold allocations and hang on for the next decade or so.  Such investors should prepare to endure meaningful drawdowns along the way.

We are long-only in our gold and precious metals holdings.  Since gold follows seasonal and other patterns, we look for areas to accumulate more and take profits.  We believe that we are near a decent point to accumulate more gold, miners, and other precious metals.

The $1,800 per ounce area was a significant resistance level in 2012 and 2013, and the breaching of this level in 2020 was a significant event.  This resistance level has become a support level, and the $1,800 level was already successfully back-tested in November 2020.  Another pull-back to the $1,800 per ounce level could be a good point for accumulation.

Zooming in to a weekly view, we see gold is trading near the 50-week moving average in a triangle formation and/or bull flag above $1,800.  Such is undoubtedly a critical technical level, and we could see volatility, both up and/or down, over the next few weeks as gold seeks to find direction for its next move.   If it falls below the 50-week moving average, then the next accumulation zone might be along the lower trend support line near $1,650.

Gold Options Sentiment

Each day, we publish signals related to more than twenty different options markets.  Our proprietary Options Sentiment index for gold is suggesting that this could be a good accumulation zone. Recently, when Options Sentiment was less than 20% (such as now), it has been an excellent time to accumulate.

Investors will recall the events of March 2020, which saw meaningful draw-downs in stocks, gold, and many other asset classes. If there is another flight to liquidity soon, we could see significant drawdowns in the gold price, as investors seek safe-haven cash to avoid all kinds of volatility.

Final Thoughts

We are very bullish for gold over the next ten years, and we will be looking for good entry points for gold, silver, and gold miners here in 2021. We will not be surprised to see $25,000 per ounce of gold by the year 2030.  It will likely be a volatile ride higher, with large drawdowns along the way.

Technical analysis suggests that the $1,800/oz and $1,650/oz levels are good entry points for gold at this time.  Options Sentiment also indicates that now is a decent time to accumulate more gold and/or precious metal mining stocks.

Disclaimer

The report is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer at www.viking-analytics.com.

Deconstructing Bitcoin’s Zeal Into An Investible Thesis

Deconstructing Bitcoin’s Zeal Into An Investible Thesis

It’s all Bitcoin all day in my Twitter feed these days. Quiet are the Tesla bears, the Fed-obsessed, and even the gold bugs. The HODLers are out in full force celebrating Bitcoin’s parabolic, seven-fold resurgence from the ashes of $5,000 (as of the morning of this writing). Frankly, I’m skeptical of Bitcoin. I see it as a speculative tech stock, not digital money. However, I’m not avoiding cryptocurrency. Instead, I’m trying to determine an appropriate position size and strategy consistent with my investment framework.

I’ve been around the Bitcoin hoop for a while now. I traded a minimal amount in the early days and made no significant gains (in absolute terms). At first, I got drawn into the prospect of decentralized money and banking—the theoretical and practical benefits that cryptocurrencies potentially possess. However, I expected more development 12 years into Bitcoin’s existence. To me, it still more resembles a tech stock in 1999 than a burgeoning currency—all potential; no (meaningful) practicality (yet).

While I’m certainly not the most plugged into the cryptocurrency scene, I do understand it. Given Bitcoin’s high market capitalization ($666 billion as of this writing)—eclipsing that of Walmart, Johnson & Johnson, and all but a handful of blue-chip companies—I’m surprised that Bitcoin still has so little utility in comparison with these household names. Indeed some people are using Bitcoin, but the overwhelming majority appears to be hoarding it in the hope of higher prices.

Value Requires Utility, Even for Money

Value, in my view, requires utility. Thus, “intrinsic value” is illogical. I don’t see how something can have value in and of itself; just because it exists. For an asset to have value, it must have value to someone else, a.k.a. a value-er.

Material objects as such have neither value nor disvalue; they acquire value-significance only in regard to a living being—particularly, in regard to serving or hindering man’s goals.

Ayn Rand, “From the Horse’s Mouth,” Philosophy: Who Needs It

Food, housing, entertainment, art, etc., all serve purposes for the purchasers of such items. Their market prices reflect this value. Remember, oil was a property-devaluing nuisance before 1859. Today, however, the opposite is true. What changed? The invention of oil refining birthed utility to the previously useless sludge transforming it into the black gold we know today.

Money is no different. It serves a human purpose from which it derives its value. Money is a measurement concept for the economic worth. It quantifies value, making it relatable among people and hence facilitates trade. Just like there could be no houses, cars, or smartphones without standards of length (feet, inches, meters) or time (seconds, hours, days), modern economies necessitate monetary standards.

Bitcoin is Not Money (and Probably Never Will Be)

Bulls commonly consider Bitcoin to be the future of money. I don’t see it. Money is simply a unit of account, which is a type of specific measurement used to tally economic value. Money is not synonymous with a medium of exchange or store value. While these functions get denominated in money-terms, they are distinct concepts, in my view. This conflation only breeds confusion.

My delimited—if not uncommon—definition of money highlights Bitcoin’s challenge here. Until you get paid by your employer or buy groceries, in Bitcoin, it won’t serve as a commonplace measurement of economic value. People will mentally convert any Bitcoin transactions into the local monetary standard (dollars, euros, yen, etc.), no matter how splashy the headline.

Panthers’ Russell Okung made Bitcoin headlines by allegedly becoming the first NFL player to be paid in Bitcoin …

However, an actual read of the details reveals that the team is paying him in dollars (i.e., fiat). Half of his salary will be automatically get converted to Bitcoin at the spot rate. Using similar logic, Okung is also getting paid in food, clothing, and cars.

That said, just because Bitcoin is not money doesn’t make it valueless. Its supporters make other reasonable claims which can systematically be analyzed once unpacking Bitcoin from its many slogans. These other use cases are more plausible, in my view, and potentially give Bitcoin its value.

Bitcoin’s Value is All in the Future

When you boil it all down, Bitcoin is fundamentally a database. Its innovation is in how it’s maintained. Bitcoin requires no central authority (i.e., an owner, like a company) to operate like all others. Preferably, the database’s maintenance is a function of the decentralized Bitcoin network (i.e., participants’ ecosystem).

Decentralization carries both benefits and drawbacks, with Bitcoin’s main virtue being its immutability. However, this robust integrity comes with a cost. Updating the Bitcoin database is very slow.

Bitcoin’s database fidelity is as innovative as it is potentially valuable. Satoshi Nakamoto’s vision—Bitcoin’s mythical creator—was for it to serve as a trustless system for electronic transactions, “a purely peer-to-peer version of electronic cash.” In other words, the initial vision of Bitcoin was as a payment platform for transmitting value efficiently and cheaply—i.e., electronic currency. Such differs from today’s systems, which are slow, expensive, cumbersome, and the result of byzantine regulations.

Technology

While I find Bitcoin’s technology promising, it’s nonetheless more potential than reality. There’s little evidence that Bitcoin is being used much for anything other than financial speculation. The is a large disconnect between Bitcoin’s price and its use in transactions—its utility. The former has exponentially soared while the latter has stagnated.

Transaction volumes do not seem to impact Bitcoin’s price.

To be sure, the world is digitizing. However, there’s little evidence that Bitcoin—or any other existing cryptocurrency—is required to effectuate this future. Despite (alleged) hordes of smart people working on cryptocurrency-related projects, there’s presently little use for Bitcoin. Its prospects lie firmly in the future and are far from certain. Thus, while I’m hopeful for Bitcoin’s success and mass adoption, I see it as another “trading sardine” for the time being.

There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”

Seth Klarman, Margin of Safety via ValueWalk

My Bitcoin Framework

Calling Bitcoin a trading sardine is no knock. There’s good money to made in its speculation. For me, until I was able to size it up in my framework, I’ve been gun-shy to commit meaningful amounts of capital to it. After all, everyone needs an investment philosophy, whether we know it or not. While I see Bitcoin’s promise, I also see zealots giving me pause.

For me, Bitcoin fits into two distinct strategies. The first is purely a momentum trade. I want to trade its trend. Such could be very significant since most investors appear to be accumulating positions with no intention to sell. Thus, the emergence of more and larger players, like institutions, could have outsized price implications on the limited supply of Bitcoin circulating. (The opposite is also true!)

My second strategy is value-oriented. I, too, am enamored by Bitcoin’s potential to transform financial services. If Bitcoin gets adopted en masse, its price would surely rise as use case demand met the fixed supply. However, I have a shallow conviction in this. First, I am skeptical that it will occur given the vast amount of regulation in the space. Furthermore, I’m not convinced that Bitcoin would necessarily emerge as the winner should my capitalist utopia materialize.

The above is an illustration of how I transform my views on Bitcoin into a concrete investment.

Thus, I have a hard time committing significant amounts of capital to either trade. However, I am still able to participate by managing my position size. I’m keeping them small, given my skepticism. Of course, these are my opinions. Others will have different views and different exposures.

Deconstructing Bitcoin into Specific Trades Helps

Bitcoin may be the most emotionally charged investment asset of my career. Its supporters make the proponents of gold, Tesla, or even homeownership look skeptical. While their zeal raises a giant red flag for me, I don’t want to write Bitcoin off either reflexively. Instead, I’m trying to dissect the theses, analyze its prospects, and devise a potential plan for trading it.

I see two potentially different ways in which to profit from Bitcoin. The first is a momentum strategy. I want to follow its trend. The second is a value-based, fundamental view. If Bitcoin can serve as a backbone to a next-generation financial services sector, then demand is sure to rise.

To be sure, I have low conviction in both strategies. However, by isolating these views within my framework, I can now systematically allocate capital towards each with more confidence by scaling my position size to my conviction.

The future is always unknowable. Sizing up financial risks is what investors do best. While emotions provide valuable signals, further analysis can often improve their utility.

Viking Analytics: Weekly Gamma Band Update 1/18/2021

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 01/18/21

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model has similar returns to a long-only position, although with much lower risk exposure.   The Gamma Band model has resulted in a 74% improvement in risk-adjusted return since 2007 (measured by the Sharpe Ratio).  A quick video introduction of the Gamma Band model and other indicators can be seen by following this link.
  • The Gamma Band model has maintained a high exposure to the S&P 500 since the U.S. election. The model will generally maintain a 100% allocation as long as price closes above Gamma Neutral, currently at 3,753.
  • The model will cut S&P 500 exposure to 0% if price closes below the lower gamma bound, currently near 3,520.
  • Our binary Smart Money Indicator continues to have a full allocation but could turn cautionary if smart money becomes more protective. The Smart Money had been trending towards the safe zone, but recently stopped its decline, perhaps signaling more bullishness.
  • SPX skew is approaching a cautious range, which may seem odd with stocks close to all-time-highs.
  • We publish many different signals each day in four different pdf reports. A sample copy of all of our reports can be downloaded by visiting our website

Smart Money Residual Index

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

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position.  When the Sentiment goes below zero (and the line moves from green to red), then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

Another tool we use to evaluate market risk is called “skew,” which is the relative cost of buying puts versus calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this can often be a signal to reduce equity exposure. 

As the market continues to settle near all-time highs, one might expect a more bullish skew result.  There is perhaps some risk priced in ahead of the January 20th inauguration.

Gamma Band Background

Market participants are increasingly aware of how the options markets be the “tail that wags the dog” of the equity market. 

The Gamma Band indicator adjusts equity exposure dynamically in relation to the Gamma Neutral and other related levels.  This has shown to reduce equity tail risk and improve risk-adjusted returns.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 74% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal.  Free samples of all of our daily reports can be downloaded from our website.

Authors

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

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

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


Technically Speaking: Signs Of Exuberance Warn Of Correction

During the past couple of weeks, I have discussed the rising levels of exuberance in the markets. Importantly, that exuberance combined with surging margin debt levels warns of an impending correction.

I recently discussed why this is not a “new bull market,” which changes the dynamic of the understanding of “risk” in markets.

Following actual “bear markets,” investor sentiment is crushed, valuations revert toward their long-term means, and price trends are negative. Notably, few investors are willing to “buy” assets in the market. However, “corrections” do not accomplish any of those outcomes.

While the mainstream definition of a “bear market” is a 20% decline, such has little relevance to what constitutes a “bear market.” As noted in “March Was Only A Correction,” there is a significant difference.

“The distinction is essential.

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

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

Tale Of Two Bull Markets, #MacroView: A Tale Of Two Bull Markets

Several other factors confirm March was just a correction.

Investors Are All In

As noted, following an actual “bear market,” investors are very slow to return to the market. Following the “Dot.com” crash, it took several years before investors returned their allocation levels to “fully allocated” levels. The same occurred following the “Financial Crisis.” 

However, following the March decline, investors quickly allocated back into equities, which coincides with corrections rather than bear markets.

Further, as we discussed in “Sign, Sign, Everywhere A Sign,” investors are now “all in” in terms of portfolio risk. As noted by SentimenTrader on Saturday:

“We didn’t think traders could get any more speculative than they were at the end of August. We were wrong. For the first time, small trader call buying (adjusted for equivalent shares) exceeded 9% of total NYSE volume last week.”

As we saw at the peak in 1999, investors are again piling into companies reporting “negative” earnings. Following bear markets, speculative behavior such as this takes years to return.

Most importantly, “bubbles” are not formed immediately following a bear market. Instead, bubbles are a function of “bull markets” where investors rationalize why “this time is different.” As Jeremy Grantham noted recently:

“The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior. I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.

The Issue Of Margin Debt

Another indication we are not in a “new bull market,” but rather an extension of the bull market that began in 2000, is occurring in margin debt. As I explained previously:

“Margin debt is not a technical indicator for trading markets. What margin debt represents is the amount of speculation that is occurring in the market. In other words, margin debt is the ‘gasoline,’ which drives markets higher as the leverage provides for the additional purchasing power of assets. However, ‘leverage’ also works in reverse as it supplies the accelerant for more significant declines as lenders ‘force’ the sale of assets to cover credit lines without regard to the borrower’s position.”

The last sentence is the most important. The issue with margin debt, in particular, is that the unwinding of leverage is NOT at the investor’s discretion. It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once, as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Margin Debt Confirms March Correction

Another indication that March was only a correction and not a bear market is that free-cash balances remain negative. During bear markets, banks force borrowers to cover margin loans as prices drop. Such causes further declines in asset prices, causing more margin calls, causing further price declines. The process continues until liquidation of margined investors is complete, and free-cash balances return to positive territory.  That did not occur following the March correction.

In fact, despite a short-term correction in margin debt, the “speculative frenzy” following the correction pushed margin debt back to record highs.

As noted, when markets are rising, and investors are taking on additional leverage to increase buying power, margin debt supports the advance. However, the magnitude of the recent surge in margin debt also confirms the current levels of investor exuberance.

The chart shows the relationship between cash balances and the market. I have inverted free cash balances, so the relationship between increases in margin debt and the market is better represented.

Note that during the 1987 correction, the 2015-2016 “Brexit/Taper Tantrum,” the 2018 “Rate Hike Mistake,” the “COVID Dip,” the market never broke its uptrend, AND cash balances never turned positive.

Both a break of the rising bullish trend and positive free cash balances were the 2000 and 2008 bear markets’ hallmarks. Such is another reason why March was just a “correction.”

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Margin Debt Suggests Risk Is Elevated

Margin data goes back to 1959 to get a long-look at margin debt and its relationship to the market. The chart below is a “stochastic indicator” of margin debt overlaid against the S&P 500.

The stochastic indicator is a momentum indicator developed by George C. Lane in the 1950s. The chart shows the position of the most recent margin debt level relative to its previous high-low range. The indicator measures the momentum of margin debt by comparing the closing level with the range over the past 21-months.

The stochastic indicator represents the speed and momentum of margin debt level changes. Such means the stochastic indicator changes direction before the market. As such, it can be considered a leading indicator.

When margin debt is increasing rapidly, such has usually been coincident with short to intermediate-term peaks in markets. Given that investors tend to “buy the most at the top,” rapidly increasing levels of margin debt tend to confirm exuberance.  

The two charts below confirm the acceleration of speculative risk increases in the market. The chart below is the rate-of-change of margin debt from the preceding 12-month low.

The chart confirms the same by measuring the raw rate-of-change in margin debt over the preceding 8-months.

By all measures, margin debt acceleration is a sign of caution for investors in the short-term. Such is particularly the case, as noted yesterday, there are “alarm bells” in the most speculative areas of the market.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

It’s All Coincident

Margin debt, much like valuations, are “terrible market timing” indicators and should not be used as such. Rising levels of margin debt, and high valuations, are a reflection of investor psychology and overconfidence.

I agree and disagree that margin debt levels are simply a function of market activity and have no bearing on the market’s outcome. As we saw in March, the double-whammy of collapsing oil prices and economic shutdown in response to the coronavirus triggered a sharp sell-off fueled by margin liquidation.

Currently, the majority of investors have forgotten about March. Or worse, assume it can’t happen again for a variety of short-sighted reasons. However, investors are more exuberant now than at the peak of the market in 2000 or 2008.

Excuses Won’t Work

Sure, this time could indeed be different. That has remained the “sirens song” of investors since March. However, as Sentiment Trader summed up the last time we wrote on this topic, such is usually not the case.

Whenever some of this data fails to lead to the expected outcome for a few weeks or more, we hear the usual chorus of opinions about why it doesn’t work anymore. This has been consistent for 20 years, like…

  • Decimalization will destroy all breadth figures (2000)
  • The terror attacks will permanently alter investors’ time preferences (2001)
  • The pricking of the internet bubble will forever change option skews (2002)
  • Easy money will render sentiment indicators useless (2007)
  • The financial crisis means relying on any historical precedents are invalid (2008)
  • The Fed’s interventions mean any indicators are no longer useful (2010 – present)

All of these sound good, and for a time it seemed like they were accurate. Then markets would revert and the arguments would get swept into the dustbins of history.”

It’s not too late to take action to preserve capital now, so you have the money to invest with later.

NFIB Survey: Sends A Strong Warning About Small-Cap Stocks

In September 2019, I wrote “NFIB Survey Trips Economic Alarms,”  Of course, it was just a few short months later the U.S. economy fell into the deepest recession since the “Great Depression.” The latest NFIB survey is sending a strong warning to investors piling into small-cap stocks.

While the mainstream media overlooks the NFIB data, they really shouldn’t. There are currently 30.7 million small businesses in the United States. Small businesses (defined as fewer than 500 employees) account for 99% of all enterprises, employ 60 million people, and account for nearly 70% of employment. The chart below shows the breakdown of firms and jobs from the 2019 Census Bureau Data.

Despite all the headlines about Microsoft, Apple, Tesla, and others, small businesses drive the economy, employment, and wages. Therefore, what the NFIB says is relevant to what happens in the economy.

NFIB Shows Confidence Drop

In December, the survey declined to 95.9 from a peak of 108.8. Notably, many suggest the drop was “politically driven” by conservative owned businesses. While there was indeed a drop following the election, the decline continues what started in 2018.

As I discussed when the index hit its record high previously:

Record levels of anything are records for a reason. It is the point where the sustainability of activity can not be increased further. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY, of a cycle.” 

That point of “exuberance” was the peak of the economy.

Before we dig into the details, let me remind you this is a “sentiment” based survey. Such is a crucial concept to understand as “Planning” to do something is a far different factor than actually “doing” it.

An Economic Boom Will Require Participation

Currently, many analysts expect a massive economic boom in 2021. The basis of those expectations is massive “pent-up” demand when the economy reopens.

I would agree with that expectation had there been no stimulus programs or expanded unemployment benefits. Those inflows allowed individuals to spend during a recession where such would not usually be the case. Those artificial inputs dragged forward future or “pent-up” consumption into the present.

However, the NFIB survey also suggests much the same.

Small businesses are susceptible to economic downturns and don’t have access to public markets for debt or secondary offerings. As such, they tend to focus heavily on operating efficiencies and profitability.

If businesses were expecting a massive surge in “pent up” demand, they would be doing several things to prepare for it. Such includes planning to increase capital expenditures to meet expected demand. Unfortunately, those expectations peaked in 2018 and are lower again.

There are important implications to the economy since “business investment” is a GDP calculation component. Small business capital expenditure “plans” have a high correlation with real gross private investment. The plunge in “CapEx” expectations suggests business investment will drop sharply next month.

As stated, “expectations” are very fragile, and reality is often quite different.

Employment To Remain Weak

If small businesses think the economy is “actually” improving over the longer term, they would also be increasing employment. Given business owners are always optimistic, over-estimating hiring plans is not surprising. However, reality occurs when actual “demand” meets its operating cash flows.

To increase employment, which is the single most considerable cost to any business, you need two things:

  1. Confidence the economy is going to continue to grow in the future, which leads to;
  2. Increased production of goods or services to meet growing demand.

Currently, there is little expectation for a strongly recovering economy. Such is the requirement for increasing employment and expanding capital expenditures.

Now you can understand the biggest problem with artificial stimulus.

Yes, injecting stimulus into the economy will provide a short-term increase in demand for goods and services. When the funds are exhausted, the demand fades. However, small business owners understand the limited impact of artificial inputs. As such, they will not make long-term hiring decisions, an ongoing cost, against a short-term artificial increase in demand. 

Also, given President Biden is focused on more government regulation and higher taxes (which falls squarely on the creators of employment), increased costs will further deter long-term hiring plans.

The Big Hit Is Coming

Retail sales make up about 40% of personal consumption expenditures (PCE), which comprises roughly 70% of the GDP calculation. Each month the NFIB tracks both actual sales over the last quarter and expected sales over the next quarter. There is always a significant divergence between expectations and reality.

While stimulus may lead to a short-term boost in consumption, the impact of higher taxes, more regulations, and weak employment growth will suppress consumption longer-term.

The weakness in actual sales explains why employers are slow to hire and commit capital for expansions. As noted, employees are among the highest costs associated with any enterprise, and “capital expenditures” must pay for themselves over time. The actual underlying strength of the economy, despite cheap capital, does not foster the confidence to make long-term financial commitments to anything other than automation.

Despite mainstream hopes, business owners must deal with actual sales at levels more commonly associated with ongoing recessions rather than recoveries. 

Of course, this remains an argument of ours over the last couple of years. While the media keeps touting the strength of the U.S. consumer, the reality is quite different. If such were indeed the case, there would be no requirement to inject billions of dollars in stimulus to keep individuals afloat.

So what does all this have to do with small-caps?

Small Caps May Disappoint

With this background, it is easier to understand why the recent exuberance in chasing small-cap stocks may be premature. While small-cap companies do historically perform well coming out of recession, the basis was an organic recovery cycle of increasing productivity.

Currently, the run-up remains the assumption that the stimulus-fueled recovery is sustainable. Such is only the case if the stimulus becomes a regular benefit and increases in size annually. However, since deficit-based spending is deflationarythe outcome will fall well short of expectations.

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

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

Such is a critical point as it relates to small-cap companies given their high correlation to small-business confidence. There has only been one other period in history that small-caps detached from underlying confidence, and the outcome for investors was not good.

Given that investors continue to push the small-cap index to historical deviations from long-term means, the risk of disappointment is extremely high. The data above suggests the economic recovery won’t be strong enough to justify current prices for small-cap companies.

Furthermore, small-cap companies’ valuations on a 2-year forward estimate all but guarantee a poor outcome for investors in the future.

Conclusion

Given that debt-driven government spending programs have a dismal history of providing the economic growth promised, disappointment over the next year is almost a guarantee.

However, suppose additional amounts of short-term stimulus deliver higher rates of inflation and higher interest rates. In that case, the Federal Reserve may become contained in its ability to continue to provide an “insurance policy” to investors.

There are risks to assuming a strong economic and employment recovery over the next couple of quarters. The damage from the shut-down on the economy, and most importantly, small business, suggests recovery may remain elusive.

While there is nothing wrong with being optimistic, when it comes to your investment portfolio, keeping a realistic perspective on the data will be essential to navigating the risks to come. For small-cap investors, the time to take profits and move to “safer pastures” has likely arrived.

Everyone Is In The Pool. More Buyers Needed.


In this issue of “Everyone Is In The Pool. More Buyers Needed.”

  • Everyone Is In The Pool
  • Sentiment & Technicals Pushing Extremes
  • A Heat Map Of Valuations
  • Investor Resolutions
  • MacroView: Yellen’s Arranged Marriage To The Fed
  • Sector & Market Analysis
  • 401k Plan Manager

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors can now manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes, we can get you in the “right lane” for retirement.

This Week 1-15-21, #WhatYouMissed On RIA This Week: 1-15-21

Catch Up On What You Missed Last Week


Everyone Is In The Pool

At the halfway point of January, the market has struggled to hold onto its gains. Such is surprising given the recent passage of a $900 billion stimulus bill and Biden’s proposal for another $1.9 trillion on Thursday. With another $2.8 trillion in stimulus hitting the economy, inducing the Fed to do more QE, markets were seemingly unimpressed.

For the first two weeks of January, the market is up by 0.32% YTD.

As we discussed recently in “There Is No Cash On The Sidelines,”  the markets are driven by buyers’ and sellers’ supply and demand.

In the current bull market advance, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case, and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.”

Such is also the definition of the “Greater Fool Theory:”

“The greater fool theory states that it is possible to make money by buying securities, whether or not they are overvalued, by selling them for a profit at a later date. This is because there will always be someone (i.e. a bigger or greater fool) who is willing to pay a higher price.”

The problem comes when buyers are no longer willing to pay a higher price. When sellers realize the change, there will be a rush to sell to a diminishing pool of buyers. Eventually, sellers begin to “panic sell” as buyers evaporate and prices plunge.

3-Risks In 2021

As we will discuss in a moment, there is ample evidence that “everyone is currently in the pool.”  Such leaves the market vulnerable to three risks we debated over the past week:

  1. More stimulus and direct checks into the economy lead to an inflationary spike that causes the Fed to discuss hiking rates and tapering QE.
  2. The current rise in interest rates continues over higher inflation concerns until it impacts a debt-laden economy causing the Fed to implement “yield curve control.” 
  3. The dollar, which has an enormous net-short position against it, reverses moves higher, pulling in foreign reserves, causing a short-squeeze on the dollar. 

The reality is that both a rise in the dollar, with higher yields, is likely to start attracting reserves from countries faced with economic weakness and negative-yielding debt. Such would quickly reverse the tailwinds that have supported the equity rally since March.

The following video covers the current market exuberance and the importance of the dollar.

The Problem With Monetary Policy

There is also the problem of monetary policy. As discussed in “Moral Hazard,” investors are chasing risk assets higher because they believe they have an insurance policy against losses, a.k.a. the Fed.

However, this brings us to the one question everyone should be asking:

“If the markets are rising because of expectations of improving economic conditions and earnings, then why are Central Banks pumping liquidity like crazy?”

Despite the best of intentions, Central Bank interventions, while boosting asset prices may seem like a good idea in the short-term, in the long-term has harmed economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves an enormous void that must get continually refilled in the future.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever-larger amounts of monetary policy to maintain the same activity level.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and, ultimately, a recession as economic activity recedes.
  4. Job losses rise, the wealth effect diminishes, and real wealth gets destroyed. 
  5. The middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 164% since the 2007 peak, which is more than 3.8x the growth in corporate sales, and 7.5x more than GDP.

But, for the 10% of the population that owns 90% of the stock market, the sentiment is now getting extreme.

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

Sentiment Is Getting A Bit Extreme

While the video discusses some of the extremes currently developing in the market, none better shows this than our investor sentiment gauge. As explained previously, this gauge compiles several measures of investor “positioning” in the markets in terms of actual equity exposure. As shown, we are at levels that have historically had poor outcomes.

Of course, seeing that, you shouldn’t be surprised to see that retail investor confidence (dumb money) is near its highest levels on record.

The interesting thing about the market is that investors are rushing into equities in anticipation of an economic recovery. However, while there will indeed be a recovery, it is likely to fall far short of investor expectations. Such is generally the case. However, with “euphoria” now at mania levels, the only question is just how disappointed they will be?

As noted above, it is quite clear everyone is “now in the pool.” Such raises the question of:

“Who is left to buy?”

Technical Warning Signs

While sentiment measures are certainly worth considering, as the old axiom goes, “markets can remain irrational longer than you can remain solvent.” Therefore, from a portfolio management point of view, we want to focus on the technical signs, suggesting that starting to hedge against “risk” is likely prudent.

When markets are exuberantly bullish, along with investors believing there is “no risk” to investing, you see virtually every stock moving higher. We can view this specifically in looking at the number of stocks trading above their 200-dma. As noted by Sentimentrader:

Of course, to no surprise, the put/call ratio is back to a record that usually has preceded short-term corrections.

Such does not mean the market is about to crash, although such would not be unprecedented. The combination of these indicators does suggest that a correction between 5-10% is likely within the next couple of weeks.

What will cause that correction? Who knows. But such is why we have slowly started adding some “risk hedges” back into our portfolios this week. Profit-taking will come next.

A Heat Map Of Valuations

By Michael Lebowitz, CFA

We talk a lot about valuations and their importance, but such discussions can be hard to put into context. Therefore, I have produced a series of charts that visualize various valuations of the S&P 500 companies. Not surprisingly, such also corresponds to the current behavior of Wall Street analysts and investors. Instead of cluttering up the commentary space on RIAPro.Net (30-day Risk-Free Trial), we thought you would better appreciate the charts and can share them more easily in an article format.

The charts below are called heat maps. What we like about heat maps is their ability to show two data points in one easy to read format. The following maps show the S&P 500 components market cap and along with a second factor. The larger the company’s market cap is in relation to other companies in the sector, the larger the square. Each graph has a scale on the bottom right relating to the second factor. In the first graph (Price to Earnings), the brighter the red, the more overvalued a company is. Conversely, green is relatively cheaper. Companies are sorted by their sectors and sub-sectors.

The first three graphs are popular measures of valuation. The fourth graph shows that analyst recommendations, despite valuations, are pretty bullish. As shown in the fifth graph, investors are also overly bullish as there is a very low percentage of short positions in general. Lastly, the sixth graph shows this is not just domestic, but high valuations are occurring in many other countries.

1. Price to Earnings:

You have to look pretty hard to find stocks that are not wildly overvalued.

heat, Real-Time Commentary Heat Maps

2. Price to Sales:

A ratio between 2-3 is considered somewhat normal, especially for well established mature companies.

heat, Real-Time Commentary Heat Maps

3. Price to Book:

P/B is also typically in the lower single digits for mature companies.

heat, Real-Time Commentary Heat Maps

4. Analyst Recommendations

You have to look pretty closely to find stocks that do not have buy recommendations.

heat, Real-Time Commentary Heat Maps

5. Short Interest as a % of total float:

The continual grind higher has scared away almost all short sellers.

heat, Real-Time Commentary Heat Maps

6. World Price to Earnings:

These are not as extreme as the U.S., but P/E ratios around the world are very high. Keep in mind that historical P/E ratios in most countries are lower than in the U.S. for several reasons. But importantly, P/E ratios are relative to the country that domiciles the company. Therefore, just because it may appear cheap relative to the U.S. does not necessarily mean it is a value.

heat, Real-Time Commentary Heat Maps

No matter how you look at the markets, either from a technical or fundamental point of view, the long-term risk/reward is not favorable.

What eventually derails the bullish bias is unknown. However, what is certain is that when it occurs, given the more extreme levels of leverage combined with a lack of liquidity, the reversion will be swift.

During a bull market advance, investors always take on substantially more risk than they realize. Unfortunately, it is a painful lesson taught quickly and repeatedly throughout history.

Investor Resolutions

Here are my annual resolutions for the coming year to be a better investor and portfolio manager:

I will:

  • Do more of what is working and less of what isn’t. 
  • Remember that the “Trend Is My Friend.”
  • Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
  • Remember it is “Okay” to pay taxes.
  • Maximize profits by staging my buys, working my orders, and getting the best price.
  • Look to buy damaged opportunities, not damaged investments.
  • Diversify to control my risk.
  • Control my risk by always having pre-determined sell levels and stop-losses.
  • Do my homework. I will do my homework. I will do my homework.
  • Not allow panic to influence my buy/sell decisions.
  • Remember that “cash” is for winners.
  • Expect, but not fear, corrections.
  • Expect to be wrong, and I will correct errors quickly. 
  • Check “hope” at the door.
  • Be flexible.
  • Have the patience to allow my discipline and strategy to work.
  • Turn off the television, put down the newspaper, and focus on my analysis.

These are the same resolutions I attempt to follow every year. There is no shortcut to being a successful investor. There are only the basic rules, discipline, and focus that is required to succeed long-term.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

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


Portfolio Positioning “Fear / Greed” Gauge

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

NOTE: The Fear/Greed Index measures risk from 0-100. It is a rarity that it reaches levels above 90.  The current reading is 95.50 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read.

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


Weekly Stock Screens

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

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

S&P 500 Growth Screen

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

NEW!  Fundamental Growth Screen

Aggressive Growth Strategy


Portfolio / Client Update

With the first two weeks of the year behind us, exuberance remains a clear partner with the market. As we have discussed this past week in several of our videos, we haven’t seen a period where investors were this leveraged and confident since 1999.

However, these periods can last longer than logic would predict, which is why we continue to rebalance portfolios, reduce laggards, trim winners, and add hedges as necessary. While there are undoubtedly many indicators that suggest the “bull market” is very much intact, which is why we currently carry full weightings to equities in portfolios, there are just as many suggesting risk is more than present.

Such is why we started adding duration back into our bond portfolio this past week, as noted below.

Portfolio Changes

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

“The market is getting egregiously overbought, and exuberant, which suggests that we will likely move into a corrective mode sooner than later. We are currently VERY underhedged at the moment and carrying greater than 60% equity exposure. With bonds extremely oversold we are adding a 5% position of TLT to portfolios for a short-term hedge. This move has less risk than trying to short the market directly at this point.”

  • Initiate a 5% position of TLT at the open / Stop-loss is $150

“We are adding a 2% position of ZM (Zoom Video) to the portfolio. We will add to our position if the longer-term MACD also turns positive. This is a purely technical based trade so we are carrying a fairly tight stop for now, but if the position migrates into a stronger technical position by breaking above the recent downtrend at $400, then we will consider it a longer-term hold.”

  • Buy 3% of the portfolio in ZM / Stop-loss is $330
  • Rebalanced FANG (Diamond Back Energy) back to original position weight 1%.

 While we like the Utilities sector defensively, we were stopped out of both of our positions this week:

  • Sell 100% of D (Dominion Energy)
  • Sell 100% of WEC (WEC Energy)

We are aware of the risks and are carrying tight stops on all positions.

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

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors


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


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


401k Plan Manager Live Model

As anRIA PRO subscriber (You get your first 30-days free), you can access our live 401k plan manager.

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

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

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

Technical Value Scorecard Report For The Week of 1-15-21

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

Commentary 1-15-21

  • The banking sector (XLF) remains the most overbought sector on a relative basis, closely followed by energy and materials. Again, more inflation and a resulting steeper yield curve will boost earnings for most companies in those sectors. The risk is that the deflationary trend of the last decade rears its head. On the flip side of the reflation trade are staples, real estate, and utilities.
  • The communications sector traded about 3% weaker than the S&P 500 last week. Google and Facebook represent 40% of the sector. Recent censorship actions they have taken and the potential repercussions weighed on those stocks and given their huge weighting, the entire sector.
  • This analysis provides what appears to be a clear road map for the weeks and months ahead. Tracking TIP breakevens, Treasury yields, the U.S. dollar, and the inflation/deflation mindset over the coming months should help dictate if current trends continue or not.
  • Small-cap and mid-cap, along with emerging markets are the most overbought indexes. Emerging markets benefit from a weaker dollar and inflation as many emerging economies are commodity producers. RSP, the equal-weighted S&P 500, is now well overbought versus the S&P 500. This is in large part due to the outperformance of smaller companies and the relatively weak performance of the FANG stocks.
  • The correlation graph in the lower right of the sector graph remains very high. As such, if you think the inflation trade stays in vogue, those sectors and indexes with high scores and sigmas should continue to do well on a relative basis, and vice versa.
  • The broad themes are very similar in the absolute graphs. Energy, transports, banks, materials, health care, small/mid caps, and emerging/ developed foreign markets are extremely overbought. The NASDAQ remains the weakest index for a second week. If we think the reflation trade reverses and the markets fall, it is not implausible to think of the tech sector as a safety trade, similar to the way utilities and staples traditional act in down markets.
  • The S&P, like the NASDAQ, is near fair value on an absolute basis.
  • Energy, small cap, and emerging markets are above two standard deviations over their 50 dma and 200 dma respectively. Communications and staples are close to two standard deviations below their 20 dma.
  • The “spaghetti” chart shows how XLF (brown) and XLE (blue) are pushing into the extreme upper right of the graph. They can keep going up, but we frequently see a rotation at such levels to fairer valued sectors.

Graphs (Click on the graphs to expand)


Users Guide

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

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

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

The ETFs used in the model are as follows:

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

#MacroView: The Problem With Analysts Forecasts

We can’t predict the future. If we could, fortune tellers would all win the lottery.  They don’t, we can’t, and we aren’t going to try. However, this doesn’t stop the annual parade of Wall Street analysts from putting out forecasts on the S&P 500.

The Problem With Forecasts

In reality, all we can do is analyze what has happened in the past, weed through the noise of the present and try to discern the possible outcomes of the future.

The biggest single problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.

Ed Yardeni annually publishes the two following charts which also show analysts are always overly optimistic in their estimates.

This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.

Furthermore, the reason that earnings only grew at 6% over the last 70-years is that the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term. 

“Since 1947, earnings per share have grown at 6.21% annually, while the economy expanded by 6.47% annually. That close relationship in growth rates should be logical, particularly given the significant role that consumer spending has in the GDP equation.”

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

We can see this correlation even better when looking at the corporate profits versus stocks.

Roaring 20's Fundamental Bullish, The “Roaring 20’s” – The Fundamental Problem Of The Bullish View

Conflicted Forecasters

The McKenzie study noted that on average “analysts’ forecasts have been almost 100% too high” and this leads investors into making much more aggressive bets in the financial markets. Wall Street is a group of highly conflicted marketing and PR firms. Companies hire Wall Street to “market” for them so that their stock prices will rise and with executive pay tied to stock-based compensation you can understand their desire.

However, if analysts are bearish on the companies they cover – their access to information to the company they cover is cut off. This reduces fees from the company to the Wall Street firm hurting their revenue. Furthermore, Wall Street has to have a customer to sell their products to – that would be you.

Talk about conflicted. Just ask yourself why Wall Street spends billions of dollars each year in marketing and advertising just to keep you invested at all times.

Since optimism is what sells products, it is not surprising, as we head into 2021, to see Wall Street’s average expectation ratcheted up another 6.5% this year. Of course, comparing your portfolio to the market is often a mistake anyway.

Comparison Is The Root Of Disappointment

“Comparison” is the root of unhappiness. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. The social comparisons come in many different guises. “Keeping up with the Joneses,” is one well-known way.

But let me give you an example of why you should stop comparing yourself to everything, or everyone, else.

Let’s assume your boss gave you a Mercedes as a yearly bonus. You would be thrilled—right up until you found out everyone else in the office got two cars. Now, you are upset. But really, are you deprived of getting a Mercedes? Isn’t that enough?

Comparison-created unhappiness and insecurity are pervasive if only judging from the amount of spam mail touting everything from weight-loss to plastic surgery. The basic principle seems to be that whatever we have is enough until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.

It is this ongoing “measurement complex” that remains the key reason why investors have trouble being patient and allowing the investment process to work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you have made them upset. The whole financial services industry is constructed to make people upset. When they are upset they will move their money to chase the next promise of riches. Money in motion creates fees and commissions. The constant push of comparison to benchmarks is nothing more than to keep individuals in a perpetual state of outrage.

A Note On Risk Management

What is important is to focus on what is important to you. Your specific goals, risk tolerance, time frames, and conservatively growing your savings to outpace inflation.

Such is why we always focus on the management of risks. Greater returns are generated from the management of “risks” rather than the attempt to create returns. Although it may seem contradictory, embracing uncertainty reduces risk while denial increases it.

Another benefit of acknowledged uncertainty is it keeps you honest.

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

The reality is that we can’t control outcomes; the most we can do is influence the probability of certain outcomes. Such is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Shades Of 1999

“Maybe this time is different. Those words, supposedly the most dangerous to utter in the investing realm, came to mind amid the frenzied pops in the highly anticipated initial public offerings recently.”

That quote was from Randall Forsyth discussing why the current market mania reminds him of the “Shades of 1999.”

There are certainly many similarities between today and 1999. From exceedingly high valuations to a rush by private equity investors to IPO overly priced companies as quickly as possible. As discussed previously, “valuations” are a representation of market excesses. However, it requires a supportive underlying narrative, a “siren’s song” to lure “sailors onto the rocks.” 

“I discovered what I believe to be the strongest bull case in an article by Rothko Research:

  • In the past cycle, the Fed has become very sensitive to a sudden tightening in financial conditions, especially when equities start to fall aggressively
  • Another $5 trillion USD is expected to resume in the coming months.
  • Such would send US equities to new all-time highs
  • Any bear retracement in the near term is a good opportunity to “buy the dip.”
  • It is not a good time to try to short equities

One crucial thing that we have learned over the past 12-years is that the Fed has become very sensitive to a sudden tightening in financial conditions, especially when equities start to fall aggressively.” – Greg Frierman

If price acceleration in the market is a sign of investor optimism, then this chart should raise some alarms.

The only other time in history where the Dow advanced this rapidly was during the 1995-1999 period of “irrational exuberance.” 

Maybe it’s just coincidence.

Maybe “this time is different.”

Or it could just be the inevitable beginning of the ending of the current bull market cycle.

Risk Is Building

While analysts rushing to “out-predict” the other guys, it is worth noting:

In other words, after 11-straight years of a bull market advance, what is the “risk” you are taking to garner additional returns?

While the odds of a positive year in 2021 are more, or less, evenly balanced, one should not dismiss the potential for a decline. With the current market already well advanced, pushing more extreme overvaluations, and significant deviations from long-term means, the risk of a decline is not minuscule.

Conclusion

I read most of the mainstream analyst’s predictions to get a gauge on the “consensus.”  This year, more so than most, the outlook for 2021 is universally, and to some degree exuberantly, bullish.

What comes to mind is Bob Farrell’s Rule #9 which states:

“When everyone agrees…something else is bound to happen.”

The real economy is not supportive of asset prices at current levels. The more extended prices become, the greater the potential for a future market dislocation. For investors that are close to, or in retirement, some consideration should be given to capital preservation over chasing potential market returns.

Will 2021 turn in another positive performance? Maybe. But, honestly, I don’t really know.

#PortfolioHedgesMatter

#WhatYouMissed On RIA This Week: 1-15-21

What You Missed On RIA This Week Ending 1-15-21

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

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

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



What You Missed In Our Newsletter

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



What You Missed: RIA Pro On Investing

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



The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 1-15-21


What You Missed: Video Of The Week

Michael Lebowitz and I dig into why more stimulus will likely not create either economic growth or the inflationary pressures many expect. In fact, more stimulus may actually be deflationary.



Our Best Tweets For The Week: 1-15-21

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

See you next week!

Real-Time Commentary Heat Maps

We talk a lot about valuations and their importance, but such discussions can be hard to put into context. Therefore, I have produced a series of charts that visualize various valuations of the S&P 500 companies. Not surprisingly, such also corresponds to the current behavior of Wall Street analysts and investors. Instead of cluttering up the commentary space on RIAPro.Net, we thought you would better appreciate the charts and share them more easily in an article format.

The charts below are called heat maps. What we like about heat maps is their ability to show two data points in one easy to read format. The following maps show the S&P 500 components market cap and along with a second factor. The larger the company’s market cap is in relation to other companies in the sector, the larger the square. Each graph has a scale on the bottom right relating to the second factor. In the first graph (Price to Earnings), the brighter the red, the more overvalued a company is. Conversely, green is relatively cheaper. The companies are sorted by their respective sector and sub-sectors.

The first three graphs are popular measures of valuation. The fourth graph shows that analyst recommendations, despite what valuations tell us, are pretty bullish. As shown in the fifth graph, investors are also overly bullish as there is a very low percentage of short positions in general. Lastly, the sixth graph shows this is not just domestic, but high valuations are occurring in many other countries.

1. Price to Earnings:

You have to look pretty hard to find stocks that are not very overvalued.

heat, Real-Time Commentary Heat Maps

2. Price to Sales:

A ratio between 2-3 is considered somewhat normal, especially for well established mature companies.

heat, Real-Time Commentary Heat Maps

3. Price to Book:

P/B is also typically in the lower single digits for mature companies.

heat, Real-Time Commentary Heat Maps

4. Analyst Recommendations

You have to look pretty closely to find stocks that do not have buy recommendations.

heat, Real-Time Commentary Heat Maps

5. Short Interest as a % of total float:

The continual grind higher has scared away almost all short sellers.

heat, Real-Time Commentary Heat Maps

6. World Price to Earnings:

These are not as extreme as the U.S., but P/E ratios around the world are very high. Keep in mind that historical P/E ratios in most countries are lower than in the U.S. for many reasons. But importantly, P/E ratios are relative to the country in which the company is domiciled. Therefore, just because it may appear cheap relative to the U.S. does not necessarily mean it is a value.

heat, Real-Time Commentary Heat Maps

No matter how you look at the markets, either from a technical or fundamental point of view, the risk/reward long-term is clearly not favorable.

What eventually derails the bullish bias is unknown. However, what is certain is that when it occurs, given the more extreme levels of leverage combined with a lack of liquidity, the reversion will be swift.

During a bull market advance, investors always take on substantially more risk than they realize. Unfortunately, it is a painful lesson taught quickly and repeatedly throughout history.

Shedlock: Reader Asks Why The Is Euro So Strong?

A reader from Brussels asks they the Euro is so strong.


Reader Question

Why is the Euro currency so strong? It is not that everything is hunky-dory here because it definitely isn’t. But this counterfeit currency was created with the one and only purpose: to benefit export-driven Germany.

The euro is flawed. It’s a currency too weak for Germany and too strong for the other countries allowing them to ‘happily’ buy German products.

Fatally Flawed

The Euro is indeed fatally flawed.  But what about the US dollar?

I am asked far more frequently “What’s holding the US dollar up?

Hated Dollar

The “dollar is so extremely oversold, over-hated, and over-shorted that it all but has to rally for a while at some point soon.”

Dollar Weakness is Structural 

Regarding the dollar, the Fed is set to print, and print, and print. If you prefer, it’s QE until the cows come home. 

Right now those cows are somewhere over the moon. 

The US dollar index surged above 100 in belief the Fed was on a tightening cycle. 

Then it wasn’t and now short-term treasury yields are back close to zero.

But at least they are above zero. 

Note that the yield on the 10-year treasury is +1.1%.

The yield on the 10-year German bond is -0.53%. Yes, that is a negative sign. 

And note there are no Euro bonds to speak of. It’s every county for itself. that’s part of the fatal flaws of the Euro.

Target2 Imbalances

Target2 Imbalances 20210-01

Chart from the ECB Statistical Warehouse.

What is Target2?

Target2 represents creditors and debtors in the EMU Eurozone Monetary Union.

It represents goods purchased by debtors in Spain, Italy, Portugal, and Greece owed to creditors in Germany, Luxembourg, etc. 

It is also a measure of capital flight. 

Some, me included, believe the -330.7 ECB number hides loans to Italy and Spain. 

Regardless of what the ECB is doing, it’s an imbalance of some sort.

Do you really believe these debts will be paid back? I don’t. 

And if Italy left the Eurozone as it once threatened, the whole mess cascades. Spain and even Greece would be responsible to make good on the default.

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

Mutualized Debt

Target2 is one of the biggest fundamental flaws in the Eurozone. The Euro founders were well aware of it. But it was the only way to get Germany to go along. 

The Maastricht Treaty that created the Euro excluded mutualized debt at Germany’s instance. There are no Eurobonds. 

The debt of each county is supposed to be equally good. But the Euro crisis proved the debt of EMU countries is not equally solvent. If it were, German bonds, Greek bonds, and Portuguese bonds would all trade at the same interest rate.

Don’t Be So Centric

Whenever I get asked “What’s holding the dollar up?” I tend to reply don’t be so US centric.

My response to “What’s holding the Euro up?” is don’t be so Euro centric.

ECB and Fed Balance Sheets 

ECB and Fed Balaqnce Sheets

The above Balance Sheet Chart is from Brookings.

The ECB is papering over Target2 imbalances, interest rate imbalances, etc., and is killing banks with negative interest rates, perhaps on purpose.

The Fed is more open in its mischief.

Structural Weakness vs Fatal Flaws

The dollar weakness is “structural” but the euro was “fatally flawed by design” as an appeasement to Germany.

Those are the competing forces. 

Meanwhile, we have an ECB out of control with negative interest rates and QE vs a Fed out of control with QE while pledging to ignore inflation and stock market bubbles.

Sentiment

Whether the dollar or euro is rising or falling is determined by sentiment at the moment.

Right now, the market is focused on US structural weaknesses including trillion dollar deficits and a Biden election.

At times, the market is more worried about Target2 imbalances, fatal flaws of the Euro, negative interest rates, or a eurozone breakup.

Take your pick. 

Tell me what the more important concern will be a year from now and I will tell you which one will be sinking faster. 

Currencies Don’t Float

Meanwhile, please note that fiat currencies don’t float. They sink at varying rates. Right now the dollar is sinking faster. 

Got Gold?

Is Inflation In Your Best Interest, Or The Feds?

Is Inflation In Your Best Interest Or The Feds?

“We want to see American citizens pay higher prices for milk, butter, eggs, bread, and toilet paper. To reach our goal, we will adjust monetary policy to make these goods and other goods and services more expensive in the future.”

How long before mobs storm the Mariner Eccles building (Fed headquarters) if Jerome Powell were to make such a statement?

Is our mock proclamation that different from Powell’s comment on 12/16/2020:

“With inflation running persistently below 2%, we will aim to achieve inflation moderately above 2% for some time so that inflation average is 2% over time and longer-term inflation expectations remain well-anchored at 2%.

During Powell’s most recent press conference, not one reporter asked how the public benefits from paying more for goods and services. Not one reporter has ever asked if inflation benefits all citizens or just a few. On rare occasions do reporters assess the efficacy of the Fed’s inflation target or its monetary operations?

Today we share with you what the Fed, media, and Wall Street will not. By doing so, we help you decide if inflation is for the greater good.

What is Price Stability?

Congress delegates responsibility for monetary policy to the Fed but maintains oversight. They are supposed to ensure the Fed adheres to its statutory mandate of “maximum employment, stable prices, and moderate long-term interest rates.”

What are stable prices? Merriam Webster defines the word stable when used as an adjective, as follows:

  • firmly established: fixed, steadfast stable opinions
  • not changing or fluctuating: unvarying in stable condition

If the price of a dozen eggs rises from $4.00 today to $5.12 in a decade, would you say the price did not change or fluctuate?

Does firmly established characterize a 28% increase in the price of eggs over ten years (2.5% inflation rate).

In July 1996, Fed Chairman Greenspan opined on the definition of price stability. He stated- “I would say the number is zero if inflation is properly measured.

In a paper from 2006, Fed economists Robert Rasche and Daniel Thornton lend credence to his opinion: “In so doing, he (Greenspan) confirmed that the rate of inflation that results in the maximum sustainable growth rate of output is zero.”

So if stable prices mean no inflation, why does the Fed crave more inflation?

Why Inflation?

  • “In a move that Chairman Jerome Powell called a “robust updating” of Fed policy, the central bank formally agreed to a policy of “average inflation targeting.” That means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time” following periods when it has run below that objective.”-CNBC 8/27/2020
  • If we generated some modest inflation, I think we would consider that a success,” –Neel Kashkari 12/2020
  • If we got 3 percent inflation that would not be so bad.” Charles Evans 1/2021
  • “By committing to achieve inflation outcomes that average 2 percent over time, the Committee would make clear in advance that it would accommodate rather than offset modest upward pressures to inflation in what could be described as a process of opportunistic reflation. This approach will help move inflation expectations back to our 2 percent objective, which is critical to preserve conventional policy space.” – Lael Brainard 2/2020

Debt is the principal reason Fed members are increasingly troubled with low inflation. Debt has increasingly become an economic engine. Some of it went toward productive purposes. Most of this debt results in growth and pays for itself. Slowing productivity, GDP, corporate earnings, and wage growth argue a large percentage was put to non-productive use.

Non-productive debt boosts economic activity for a short period. That is what makes it attractive to the Fed in times of sub-optimal economic growth. The flaw of this logic is that it does not produce enough income to pay off future debt. Accordingly, it weighs on future economic growth and requires ever more debt to keep the economy rolling.

Currently, there is $83 trillion of total debt outstanding, powering a $21 trillion economy. Include future liabilities such as social security, and the amount of debt nearly doubles.

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

Solving a Debt Problem

With the debt growing substantially faster than the ability to pay for it, there are three options to deal with the problem.

  • Austerity
  • Default
  • Inflation

The Fed shuns options one and two above. Austerity would squash economic growth, which the Fed and lawmakers will not tolerate. Defaulting on a moderate share of debt will devastate the financial markets and hurt the economy. While both options require severe short-term pain, they promote more robust growth in the future.

That leaves inflation. Inflation deflates the real value of debt. Higher wages, profits, and taxes resulting from inflation make debt payments less onerous.

The Fed is trapped. They want robust economic activity and soaring asset prices. In the current environment, this can only occur with more debt and leverage. To make existing and additional debt manageable and appealing, they must reduce interest rates.

With interest rates near zero, inflation becomes a more critical tool. QE and recent programs with the Treasury are how they hope to generate inflation. The graph below comparing QE to GDP shows the effect of the Fed’s herculean efforts to keep the debt scheme going.

Inflation Benefits Few At the Expense of Many

Not only is the Fed perpetuating and making the debt problem larger, but importantly the benefits and costs of such policy are not equally distributed.

In Two Percent For The One Percent, we explain how inflation benefits the wealthy and crushes the low and middle class. To wit:

Summary- Is Inflation in the Greater Good?

Now you know why the Fed desperately wants you to pay more for milk, butter, eggs, bread, and toilet paper. They are deep in a trap of their own making. They can keep digging deeper into the trap, or they can change their ways.

Despite rhetoric to the contrary, change is not politically palatable to the political ruling class on both sides of the aisle. As such, years of fiscal and monetary negligence leave the Fed with one option- inflation. If the Fed does not make us pay more for goods and services, the scheme comes to an end.

The growing economic and societal rifts of the last few years are only just beginning. Each dollar of QE and basis point reduction in interest rates enforce the inequalities of monetary policy. When QE fails to serve its purpose, the Fed will find a new trick. We fear it will be literal money printing.

Technically Speaking: 2021 Investor Resolutions & January Stats

With 2021 already off to a good start, with the market up almost 2% in January, such is an excellent time to review our “investor resolutions.”

So Goes January

There is an abundance of “Wall Street Axioms” surrounding the first month of the New Year as investors anxiously try and predict what is in store for the next twelve months. You are likely familiar with the “Superbowl Indicator” to “So Goes The First 5-days. So Goes The Month.”

Considering that trying to predict the markets more than just a few days in advance is mostly an exercise in “folly,” it is nonetheless a traditional ritual as the old year passes into the new. While Wall Street espouses their always overly optimistic projections of year-end returns, reality has often tended to be somewhat different.

However, from an investment management perspective, we can look at some of the statistical evidence for January to gain insight into performance tendencies looking ahead. From this analysis, we can potentially gain some respect for the risks that might lay ahead.

According to StockTrader’s Almanac, the direction of January’s trading (gain/loss for the month) has predicted the course of the rest of the year 75% of the time. Starting from a broad historical perspective, the chart below shows the January performance going back to 1900.

Furthermore, twelve of the last sixteen presidential election years followed January’s direction. Speaking of Presidential election years, the first year of a new President statistically has the lowest average return rate with roughly a coin toss of being a positive year.

Digging In

The table and chart below show the statistics by month for the S&P 500. As you will notice, there are some significant outliers like August with a 50% one-month return. These anomalies occurred during the 1930s following the crash of 1929.

The critical point is that January tends to be one of the best return months of the year. Interestingly, the first week of January has already surpassed the historical average and median monthly returns.

January also holds the title for the most favorable return months, followed only by December and April.

But January is not always a winner. While the statistical odds are high, particularly after a strong start, it does not always end that way. It is worth noting that while January’s maximum positive return 9.2%, the maximum drawdown for the month was the lowest for all months at -6.79%.

An Overly Excited Beginning

While I don’t directly make asset allocation decisions based on monthly returns from a portfolio management perspective, the statistical weight of evidence suggests a couple of things worth considering.

The odds of January being a positive month greatly outweigh those of it being negative.

With the market already extremely extended, overbought, and euphoric, a mid-month reversal would not be surprising. The panic/euphoria index is at an all-time high.

February is potentially a different animal with only 50/50 odds of being positive. So, with investors overly allocated to equities, leveraged, and unhedged, the potential for a negative catalyst to spark a reversion is high.

Speaking of leverage, whenever margin debt has spiked sharply from its 12-month low, such has usually been associated with short- to intermediate-term market peaks.

Importantly, given the length of the uninterrupted bull market run from 2009 to the present, the risks are mounting the current bull market cycle has entered into the “mania” phase. Such fundamental realities suggest a more conservative approach to investment allocations.

The Battle Of Wits

“Wait, so you are saying January tends to be a good month, but it could correct.”

Yes.

The dichotomy reminds me of the scene from “The Princess Bride” where the “Sicilian” is in a “Battle Of Wits” with “The Dread Pirate Roberts.” 

While it may seem confusing for investors, it comes down to time frames.

For short-term traders, the odds are high that January will post a positive trading month, therefore, allocations should remain tilted towards equity related exposure. If you are a nimble trader and can adjust for the swings in the market, the “odds are in your favor.” 

For longer-term investors, particularly those that are nearing retirement, risks are mounting for at least a short-term correction. Such potential outcomes suggest a more cautious approach to equity allocations in portfolios.

No one knows about “mania driven markets” is how long the mania will last. It is often the case that they tend to last longer than you would logically expect.

Such is why it is vital to have a set of guides to follow. As we kick off the New Year, it is an excellent time to set out our “investing resolutions” for the year.

Investor Resolutions For 2021

Here are my annual resolutions for the coming year to be a better investor and portfolio manager:

I will:

  • Do more of what is working and less of what isn’t. 
  • Remember that the “Trend Is My Friend.”
  • Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
  • Remember it is “Okay” to pay taxes.
  • Maximize profits by staging my buys, working my orders, and getting the best price.
  • Look to buy damaged opportunities, not damaged investments.
  • Diversify to control my risk.
  • Control my risk by always having pre-determined sell levels and stop-losses.
  • Do my homework. I will do my homework. I will do my homework.
  • Not allow panic to influence my buy/sell decisions.
  • Remember that “cash” is for winners.
  • Expect, but not fear, corrections.
  • Expect to be wrong, and I will correct errors quickly. 
  • Check “hope” at the door.
  • Be flexible.
  • Have the patience to allow my discipline and strategy to work.
  • Turn off the television, put down the newspaper, and focus on my analysis.

These are the same resolutions I attempt to follow every year. There is no shortcut to being a successful investor. There are only the basic rules, discipline, and focus that is required to succeed long-term.

A Year Of Challenges

At the moment, every analyst is wildly optimistic about the new year. Expectations are high for explosive economic growth, more stimulus, debt-driven infrastructure spending, and 4100-4500 on the S&P by year-end.

Maybe that will be the case. However, investors have priced the market for perfection with high valuations, low interest-rates, and low inflation. Any shortfall in earnings growth, economic recovery, or a rise in interest rates or inflation could have an immediate and negative impact on investors.

The biggest problem for investors is the bull market itself.

When the “bull is running,” we believe we are smarter and better than we actually are. We take on substantially more risk than we realize as we continue to chase market returns and allow “greed” to displace our rational logic. Just as with gambling, success breeds overconfidence as the rising tide disguises our investment mistakes. 

Unfortunately, during the subsequent completion of the full-market cycle, our errors return to haunt us. Always too painfully and tragically as the loss of capital exceeds our capability to “hold on for the long-term.” 

Conclusion

While most of the financial media and blogosphere suggest that investors should only “buy and hold” for the long-term, the reality of capital destruction during major market declines is a far more pernicious issue.

With market valuations elevated, leverage high, economic weakness pervasive and profit margins deteriorating, investors should be watching the month of January carefully for clues. The weight of evidence suggests that despite ongoing “bullish calls” for the markets in the year ahead, this could be a year of disappointment.

Pay attention. Things may start to get interesting.

Viking Analytics: Weekly Gamma Band Update 1/11/2021

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 01/11/21

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model has similar returns to a long-only position, although with much lower risk exposure.   The Gamma Band model has resulted in a 75% improvement in risk-adjusted return since 2007 (measured by the Sharpe Ratio). 
  • The Gamma Band model has maintained a high exposure to the S&P 500 since the U.S. election. The model will generally maintain a 100% allocation as long as price closes above Gamma Neutral, currently at 3,732.
  • The model will cut S&P 500 exposure to 0% if price closes below the lower gamma bound, currently near 3,500.
  • Our binary Smart Money Indicator continues to have a full allocation but could turn cautionary if smart money begins to buy more long-dated puts. The Smart Money had been trending towards the safe zone, but recently stopped its decline, perhaps signaling more bullishness.
  • SPX skew is in a normal range. The market continues to show signs of caution with stocks achieving all-time highs on a weekly basis.
  • We publish many different signals each day in four different pdf reports. A sample copy of all of our reports can be downloaded by visiting our website.

Smart Money Residual Index

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

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position.  When the Sentiment goes below zero (and the line moves from green to red), then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

Another tool we use to evaluate market risk is called “skew,” which is the relative cost of buying puts versus calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this can often be a signal to reduce equity exposure. 

As the market continues to push to all-time highs, one might expect skew to be more bullish; some analysts see market risk ahead of the January 6th approval of the U.S. electoral ballots.

Gamma Band Background

Market participants are increasingly aware of how the options markets can be the “tail that wags the dog” of the equity market. 

The Gamma Band indicator adjusts equity exposure dynamically in relation to the Gamma Neutral and other related levels.  This has shown to reduce equity tail risk and improve risk-adjusted returns.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 75% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal.  Free samples of all of our daily reports can be downloaded from our website.

Authors

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

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

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


Yes, Virginia. There Is A Stock Market Bubble.

“Yes, Virginia. There is a stock market bubble. “

In 1897, an 8-year girl named Virginia O’Hanlon sent a letter to the New York Sun questioning Santa Claus’s existence. Why? Because her friends had all told her that Santa Claus didn’t exist.

As we enter 2021, there are two myths told to investors to support the bull market narrative. The first, as we debunked recently, is that low-interest rates justify high valuations. The second is that since valuations are not as high as the “dot.com” crisis, there is no “stock market bubble.”

Both of these views are rationalizations by investors to continue overpaying for assets during a liquidity-fueled bull market. Unfortunately, as investors pile further into risk assets, driven by herd mentality and confirmation bias, the eventual outcomes have been less than kind.

“My confidence is rising quite rapidly that this is, in fact, becoming the fourth ‘real McCoy’ bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.”Jeremy Grantham

That was a comment he made during a CNBC interview when discussing the market’s rapid rise following the March correction. 

What Is A Bubble?

What is the definition of a bubble?  According to Investopedia:

“A bubble is a market cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Typically, what creates a bubble is a surge in asset prices driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset’s intrinsic value (the price does not align with the fundamentals of the asset).

While this definition is suitable for our discussion, there are three components of a “bubble.” The first two, price and valuation, are often discussed and readily dismissed during the inflation phase.

Jeremy Grantham recently produced the following chart of 40-years of price bubbles in the markets. During the inflation phase, each was readily dismissed under the guise “this time is different.” 

Valuations are also quickly dismissed with “new metrics,” like Shiller’s recent endeavor into “earnings yield.” 

But what we do know is that valuations have a massive impact on expected returns.

Here is “the thing.”

“Market bubbles have NOTHING to do with price or valuations.”

The Rudimentary Theory Of Bubbles

Let me explain.

If market bubbles are about “psychology,” as represented by investors’ herding behavior, then price and valuations are reflections of that psychology.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.

Notice that except for only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently.  As shown in the table below from Tavi Costa at Crescat Capital, markets are currently trading in the top decile of valuations on many levels.

Secondly, all market crashes, which resulted from the preceding bubble,  have been the result of things unrelated to valuation levels. Those catalysts have ranged from liquidity issues to government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.

Bubbles Are About Psychology

We previously touched on George Soros’ theory on bubbles.

Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s relatively insignificant. At other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.

Every bubble has two components:

  1. An underlying trend that prevails in reality, and; 
  2. A misconception relating to that trend.

When positive feedback develops between the trend and the misconception, such sets a boom-bust process into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, will reinforce both the trend and the misconception. Eventually, market expectations become so far removed from reality that it forces people to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the inertia sustains the prevailing trend.

As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, we reach a tipping point as the trend reverses; it then becomes self-reinforcing in the opposite direction.”

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually, then flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

Asymmetry

The chart below is an example of asymmetric bubbles.

The bubble pattern is interesting because it changes the argument from a fundamental view to a technical viewpoint. Prices reflect the market’s psychology, which can create a feedback loop between the markets and fundamentals.

We see the asymmetric bubble pattern at every bull market peak in history.

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.

As Soro’s went on to state:

Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions.

  • In the passive or cognitive function, the fundamentals are supposed to determine market prices. 
  • In the active or manipulative function market, prices find ways of influencing the fundamentals. 

When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the other’s dependent variable, so neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

There is a strong belief that the financial markets are not in a bubble. However, those beliefs use flawed comparisons to past market bubbles.

It is likely in a world where there is “no fear” of a market correction, an overwhelming sense of “urgency” to be invested, and a continual drone of “bullish chatter,” the markets are primed for the unexpected, unanticipated, and inevitable event.

In other words, the markets are in a bubble.

Evidence Of A Bubble

One does not have to dig too deeply to find evidence of the “psychology” driving the current stock market bubble.

Speak with almost any retail investor, and you will hear a common refrain from “the Fed won’t like markets decline” to common justification catch-phrases like the “Fear Of Missing Out (F.O.M.O)” or “There Is No Alternative (T.I.N.A.)”

There is also plenty of anecdotal evidence of a market bubble in investor’s actions. Investors are currently exhibiting all of the behaviors associated with previous stock market bubbles, from aggressive equity allocations to risk leverage.

Currently, investors are holding nearly the highest levels of equities on record.

At the same time, they are leveraging their investment risk by carrying the highest levels of “call options” in history.

Of course, they are doing this because they are too “confident” the market will not be allowed to correct.

Yes, Virginia. We are in a stock market bubble.

Reflections

When thinking about excess, it is easy to see the reflections of excess in various places. Not just in asset prices but also in “stuff.” All financial assets are just claims on real wealth, not actual wealth itself. A pile of money has use and utility because you can buy stuff with it. But real wealth is the “stuff” — food, clothes, land, oil, and so forth.  If you couldn’t buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they’re printed on (if you’re lucky enough to hold an actual certificate). 

But trouble begins when the system gets seriously out of whack.

“GDP” is a measure of the number of goods and services available, and financial asset prices represent the claims (it’s not a very accurate measure of real wealth, but it’s the best one we’ve got.) Notice the divergence of asset prices from GDP as excesses develop.

Buffett Indicator Investors, Buffett Indicator: Why Investors Are Walking Into A Trap

We see that the claims on the economy should, quite intuitively, track the economy itself. Excesses occur whenever the economy’s claims, the so-called financial assets (stocks, bonds, and derivatives), get too far ahead of the economy itself.

This Time Is Different

Such is an essential point. 

“The claims on the economy are just that: claims. They are not the economy itself!”

Take a step back from the media and Wall Street commentary for a moment and make an honest assessment of the financial markets today.

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable future correction. The only missing ingredient for such a reversion is the catalyst to bring “fear” into an overly complacent marketplace.  

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now-famous words: “Stocks have now reached a permanently high plateau.” 

This “time IS different.” 

However, “this time” is only different from the standpoint the variables are not the same as they have been previously.

The variables never are. But the outcome is always the same.

But maybe it is the very “denial” of the bubble that suggests we are indeed in one.

Five Forces Driving The 2021 Economy

Five Forces Driving the 2021 Economy

Social, cultural, and behavioral patterns create economic forces evident in the buying and selling of goods and services. The pandemic shocked demand and supply channels of the real economy causing social, relationship, geographic and financial dislocations.  These dislocations have changed social behavior, desires, relationships, and expectations temporarily and, in other cases, permanently.  The crisis created profitable opportunities for some businesses and jobs for workers. Yet, other companies experienced losses, debt, and threats to survival.  The pandemic is a once in one hundred year event. As such, there is limited experience and knowledge about the economic consequences of shelter in place lockdowns and health policy. However, we can see critical social, cultural, and behavioral forces begin to emerge.

Looking Back At 2020 To Look Ahead at 2021

To understand how the 2021 economy may unfold, we have identified five fundamental driving forces that shaped the real economy in 2020. Some of these forces are driving the economy while others are weak retarding growth. The key forces are the virus, jobs engine, work-from-home migration, housing debt bubble, and trade. The status of each force is examined with suggested indicators to monitor.

  1. Virus

The virus continues to be the controlling factor in the economy as it penetrates every aspect of social life. The virus fractures the U.S. economy as it suffocates social activity. Health care providers are in crisis mode as I.C.U. capacity is at near-zero levels across hotspot states like California and New York. As such, Health officials implemented more restrictive lockdowns of non-essential businesses, indoor gathering places like restaurants and bars, and entertainment venues.  The rate of infections is at the highest level recorded since the March emergency declaration. Dr. Jeff Smith, medical officer for Santa Clara County, California, summarized the staggering number of deaths in this way: “It’s as if we have the loss of life that we had for 9/11 each day.”

Source: The New York Times – 12/31/20

Vaccinations Fail To Hit Inoculation Targets

COVID-19 vaccines from Pfizer and Moderns were produced in record time and approved for distribution in early December.  Federal officials set a goal of vaccinating 20M health workers and the elderly by December 31st.  Yet, the distribution and injection program has been a failure by achieving only 15% of that goal or 2.8M doses by year-end.

The Biden administration has set a goal of 100M doses in the first 100 days after the presidential inaugural on January 20th.  If state and federal government vaccination programs come close to 90% of the 100M goal in inoculating people, it may reach the tipping point of control.  Thus, the impact of the virus may decline by late spring or summer. We can recognize the tipping point when people stop worrying about catching the virus and venture out of their homes. The boost in consumer confidence will trigger new economic activity.

Indicators To Monitor:  Look for a steady decline in virus cases and deaths over weeks and months, increased capacity of I.C.U.s, rapid rise in vaccinations, the achievement of 70 – 80% of the population vaccinated for herd immunity, and a steady rise in consumer mobility as people begin to venture out into the community.

2. Jobs Engine

The executives’ expectations that business revenues, profits, and markets will show consistent long term growth fuels the jobs engine. Job losses have surged to extent that 19M workers are on continuing unemployment rolls. Yet, most professional employees can work from home and maintain employment.  The number of jobs increased for warehouse workers, transport workers, and couriers supporting e-commerce.  Yet, steep job declines of 70 – 80% occurred in the hospitality industry, including restaurants, bars, gift shops, and rental car firms. Small businesses in core cities like New York and San Francisco experienced 70 – 80% declines in sales.  And, as the pandemic wore on, workers furloughed began to see their jobs permanently terminated.  Accordingly, the shift to permanent layoffs is evident in the increasing number of workers on extended unemployment benefits programs.

Sources: Oxford Economics, Haver Analytics, The Daily Shot – 12/18/20

10.7M Jobs Gap

The economy has lost 22M jobs since February.  The CARES Act and Federal Reserve injections of liquidity have spurred job growth to regain about 12M jobs.  Therefore, there still is a 10.7M job growth gap since the pandemic hit the U.S. This gap in job growth will continue to put a drag on the recovery.

Source: Bureau of Labor Statistics – 11/15/20

Congress moved to close the job loss gap by passing the $900B Bipartisan COVID Relief Act in December.  The law includes a one-time $600 payment to most Americans, an extension of unemployment benefits for 11 weeks, an additional $300 weekly unemployment benefit,  and $319B in Payroll Protection Loans and small business funding.

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

Will The $900B Stimulus Bill Increase Hiring?

The question remains, will the $900B stimulus bill be enough to increase hiring?  Consumers did increase spending with CARES Act $1, 200 checks buying cars, appliances, and internet services. But, executives lack confidence in consistent business growth, which would trigger hiring. A recent survey of 238 CEOs showed that 64% planned labor force reductions in the next year.  The survey responses were collected before the relief bill passed.  But, experts at the Philadelphia Federal Reserve analyzed hiring in past recessions and found that recessions accelerated automation and slowed hiring. The report noted:

Since the 1980s, almost all employment losses in routine occupations, which are relatively easier to be automated, occurred during recessions.  Automatable jobs held by minority workers were hit particularly hard by the pandemic, putting these workers who were already vulnerable in the job market at a greater risk of permanent job loss.

Executives will remain hesitant to resume hiring until substantial domestic spending growth is evident for 3 – 6 months.  Also, management at S&P 100 companies dependent on international sales for 60 – 70% of their growth will be looking for global markets to open, travel to resume, and orders to increase consistently. We are skeptical that executives will quickly ‘bounce back’ into firm hiring action even after vaccinations reach herd immunity levels.  The herd immunity level is a necessary first step in recovery. But it is not sufficient to shift a manager’s perspective that sales are on a strong growth track.

There Are Growth Opportunities 

However, there are growth opportunities amid the crisis and its aftermath. The economy’s growth is likely to be highly unevenly, skewed to upper-income consumer spending and work from home digitally based markets.  New small business applications are up 20 – 25% as entrepreneurs identify new business opportunities for services businesses, and pandemic triggered demand.  Plus, the Biden campaign has proposed a $2.4T clean energy infrastructure investment in bridges, roads, renewable energy systems, and grid improvements. If enacted, Moody’s Analytics estimates that it will create 18.6M jobs to focus on small business development while holding major corporations accountable for clean energy standard compliance. A slim Democrat majority in the House of 5 votes and a divided Senate make the passage of a significant bill unlikely.

Indicators To Monitor: C.E.O. Confidence in sales growth, and hiring, Department of Labor State Unemployment reports for decreases in initial and continuing unemployment in parallel to increases in job openings, small business hiring reporting from Homebase, surveys of worker expectations for having a job in the next 6 – 12 months. The Census Household Pulse Survey, Opportunity Insights Track the Recovery.

3. Work-From-Home Migration

Sixty-seven million workers are estimated to be working from home today, or about 44% of the workforce. Over 240k workers have moved out of the top five metro urban cities since the pandemic started.  Professionals who had saved up to buy a home saw an opportunity to move to a less expensive area and spend more time with their families.  New and existing home sales have surged through the spring and summer and are now declining as this buyer segment has made the moves they plan to make.

The latest report from Kastle Systems, a key fob security firm, shows 2,600 buildings in the top ten metro areas at an average occupancy rate of 22.9% for the week of December 21st.  Occupancy rates range from 37% in the Dallas metro to 12% for New York City.

Source: Kastle Systems – 12/21/20

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

Small Businesses Struggle, CRE Valuations Drop

The work-from-home (WFH) migration has impacted small businesses in core cities like New York and San Francisco, where sales dropped 60 -70%.  We noted in our post on commercial real estate valuations, that there is a real probability that property valuations will drop due to high vacancy rates.  A recent survey by the Society for Human Resource Management (SHRM) of 238 corporations showed that executives expect 20% of their employees to permanently work from home. The lack of office space demand is a massive headwind for the commercial real estate market and a drag on the recovery.  In our post, we noted:

Thus, if 20% of employees WFH will mean a 20% reduction in office space requirements nationwide. In the same survey, employers expected to bring back only 16% of permanently laid-off workers. Managers will look for ways to reduce office space costs by increasing the number of employees who WFH. Executives will find WFH an excellent way to increase profit margins.  Therefore, corporations are interested in leveraging WFH culture and are doing it with fewer employees overall.”

The Long Term Impact of WFH Is Unknown

The economic impact of millions of employees working from home has yet to be determined. However, trends are emerging, showing permanently working from home professionals, accelerated software automation, and small business sales losses.  Offsetting these trends are entrepreneurs working on attractions to bring people back into core cities and managers requiring workers to return to the office. The recently passed stimulus bill will provide relief to workers and help to stabilize the economy. But, the funding will not change the migration out of core cities. Conversely, the relief money may trigger a second wave of moves from additional employees looking to lower living costs.

Indicators to Monitor:  Kastle Systems Occupancy Barometer, surveys of employee interest in working from home, social mobility tracking data gathered from smartphones as people travel to inner cities, commercial real estate company delinquency rates, rate of defaults on office space loans, bond values for office space companies.

4. Housing Debt Bubble

A $90 – 100B debt bubble has grown since March for renters and low-income homeowners out of work. This debt bubble is above the ongoing payments that renters and homeowners need to pay monthly.  About 12M renters faced eviction for January 2021.  The December relief bill extended an eviction moratorium signed by President Trump in August based on C.D.C. virus containment to January 31st. Also, the bill provides $25B in funding for a renter assistance fund.  The move does not offer much time for renters to pay back debt and bring monthly payments current.  The total amount of aid is inadequate for the massive size of the debt bubble.  Unemployed renter households have an average of $5,379 of debt accrued since March.

Sources: Federal Reserve Bank of Philadelphia, The Washington Post – 12/7/20

Sixty-five percent of renters behind on payments have resorted to credit cards to pay their rent bill.  Credit card debt is surging for renters. The predicament creates the possibility that renters will be evicted and become delinquent on their credit cards. Delinquency on their credit cards will trigger a reduction in their credit rating.  With a low credit rating, renters will have difficulty renting again once the economy begins growing.

Small Business Landlords Are Financially Stressed

Landlords receive no funding from the December relief act.  Small business landlords who own 22M of the 44M multi-unit buildings gaining new funding or loans are crucial.  A November UC Berkeley study reported that 40% of small business landlords were not confident they could make mortgage payments in the next few months.   We noted in our post about the Housing Debt Bubble that a solution must be found fast:

“…, small business landlords may evict tenants to find a paying renter… finding another paying tenant could be problematic.  Small business landlords facing declining income and poor prospects for new paying tenants will likely default on their mortgage. There is likely to be a surge in multi-unit buildings for sale, causing a decline in multi-unit building construction.”

The $25B in aid to renters and $600 stimulus checks may mitigate a wave of evictions over the next few months. However, the huge debt remains.

Homeowner Delinquencies Are Increasing

Low-income homeowners continue to have difficulty making payments as mortgage delinquencies jumped to 8.2% last August from 6.1% in July. Delinquencies have stabilized with more forbearance lender agreements.

Black Knight reports that 3M mortgages were in forbearance as of last November.  Eighty percent of those homeowners have requested a six-month extension providing more time to find funding until March 2021.  Without further assistance, they will likely default on their mortgage and causing a forced sale or foreclosure.

Indicators to Monitor:  renter surveys of percentage missing next month’s payments, Mortgage Banker Association reports on total mortgage debt, forbearance totals, and delinquencies and defaults, landlord multi-unit outstanding debt, landlord defaults, number of evictions.

5. Trade

Broad-based tariffs on China have resulted in the highest trade deficit in U.S. – China trade history.  The trade imbalance with China was supposed to grow smaller due to broad tariffs on Chinese goods. Instead, the trade imbalance surged as U.S. consumers continued to buy Chinese goods. While U.S. companies faced declining market share and sales as a result of retaliatory tariffs.

Source: Bloomberg, The Daily Shot – 12/5/20

‘America First’ Has Become ‘America Isolated’

The program to put ‘America First’ has become ‘America Isolated’ while other countries set up new trade ties. On December 30th, the European Union and China announced a trade investment agreement negotiated over the past decade.  The agreement paves the way for German car manufacturers to lower costs while making it easier to access Chinese buyers.  China is now the European Unions’ number one trade partner with $590B in total trade in 2020. The U.S. fell out of first place as an EU trade partner.

Four years ago, when the U.S. left the Transpacific Partnership Pact, the Chinese took America’s place with 12 South East Asian countries.  As a result, China has expanded the agreement to include three more countries in a new pact. The pact is called the Regional Comprehensive Economic Partnership or RCEP.  The agreement calls for lowering trade tariffs, easing customs entry, and standardizing trade protocols. The deal includes all the ASEAN trade countries, Australia and New Zealand, along with China. The RCEP is the world’s largest trade bloc of 2.2 billion people and G.D.P. of 26.2T.

To improve trade, the Trump administration successfully renegotiated the NAFTA agreement with Canada and Mexico. Accordingly, the new agreement provides more access for U.S. farmers to North American markets, ensures job protections domestically, and increases U.S. content of manufactured goods.

World trade will fall by 13 to 32 %, depending on whether the optimistic or pessimistic forecasts prove true for 2020. The World Trade Organization (W.T.O.) forecast 2021 calls for a year to year increase of 5%.

Source: W.T.O. – 6/12/20

However, the W.T.O. sees virus containment, increased trade restrictions, and general deterioration of trade relations as significant headwinds for trade growth.

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

World Trade Growth Is Critical To Global U.S. Corporations

World trade growth has been a critical growth engine for U.S. multi-national corporations.  S & P 100 companies realize 60 % of their sales and 70 – 80% of total profits from overseas operations.  With world trade uncertain, U.S. corporations will seek to replace weak international sales with domestic customers.  But, the U.S. economy is in a deep recession now and will likely take at least a year or two to recover fully.  It is likely to be 4 or 5 years to return to pre-pandemic employment levels based on previous deep recession history.  The U.S. consumer provides 30% of world consumer spending. Thus, executives looking for growth overseas to jump-start U.S. sales may be disappointed.

Biden Administration Will Focus on Rebuilding Global Partnerships

The Biden campaign proposes to bring the U.S. back into the international world order. The first step is rejoining the Paris Climate Agreement.  Plus, the Biden government will fulfill obligations to fund the World Health Organization and the World Trade Organization. Yet, the new Democratic administration has signaled that it will not reverse all the present trade barriers with China.  So, U.S. companies will have difficulty navigating an uncertain trade relationship in a 1 billion consumer market. It will be a slow grind to retool trade relations with China. Trade relationships take years to build and sustain, so we do not expect international trade to provide economic tailwinds anytime soon.

Indicators to Watch: W.T.O. trade volume, Canada and Mexico to U.S. trade volume and sales, U.S. company international sales, multi-national trade agreements, trade deficit – export and imports, global sales and profits for companies like Apple, Microsoft, Applied Materials, Intel, and other high technology firms.

Major Obstacles Remain To Achieve a Solid 2021 Recovery

The $900B stimulus bill is a band-aid for the 2021 economy.  The liquidity injection is not a cure for the pandemic induced recession.  Intelligently structured, innovative initiatives are required.  Plus, to shift the economy onto a recovery track, trillions of dollars need to be invested.

Mohamed El-Erian, Chief Economist at Allianz, notes the need for policymakers to do the economic structural work necessary for a healthy recovery:

The immediate injection of fiscal relief should help moderate what recent data suggest is an accelerating loss of momentum for the economic recovery. But it will not alter significantly the general direction of the bumpy road in the short term. Nor will it do much to offset the longer-term risks to economic, social, and institutional well-being.”

 Significant headwinds are picking up strength:

  • Too Slow A Vaccination Program To Achieve Herd Immunity by Summer
  • The Jobs Engine Is Stalled or Shut down For Many Sectors
  • WFH Migration Hollows Out Core Cities:

              – Creating Huge Vacant CRE and Driving Small Business Closings

  • Housing Debt Bubble Ready to Burst
  • Trade Sales & Profits Will Be Slow to Return

The bottom line is the virus still is in control of the economy.  Until the virus is under control, the recovery will continue to sputter.  Plus, permanent changes to social, geographic, and spending patterns will dislocate existing companies if they don’t change their business models quickly.  The Federal Reserve will continue to provide liquidity.  However, the Federal Reserve is propping up zombie companies, speculative hedge funds, junk bonds, and high risk real estate loans.   Will the Fed have enough monetary firepower to support real investment initiatives if they pass in the next Congress?

Will the Biden Administration Be Successful in Passing Stimulus Bills?

If the Biden Administration can pass major fiscal legislation, then the economy will likely recover quickly. The first six months of the new administration’s work to control the virus, pass fiscal initiatives, and apply innovative policymaking will set the stage for a recovery. Or, a lack of federal leadership will lead to a stalling economy that continues to lose jobs, cut profits, and undermine asset valuations.

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

Bulls Loving The “Heads I Win, Tails I Win” Market


In this issue of “Bulls Are Loving The ‘Heads I Win, Tails I Win’ Market

  • Bulls Loving The “Heads I Win, Tails I Win” Market
  • The Risk To The Bullish View
  • Is The Reflation Trade Over?
  • Portfolio Positioning Update
  • MacroView: The Two Primary Risks In 2021
  • Sector & Market Analysis
  • 401k Plan Manager

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors can now manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes, we can get you in the “right lane” for retirement.


Catch Up On What You Missed Last Week


Bulls Loving The Heads I Win, Tails I Win Market

It was a close call, but Santa finally delivered with a strong rally this past week, pushing the markets to all-time highs. Interestingly, despite the “Blue Sweep” of the Georgia elections, the markets quickly turned from worrying that such would be harmful to the markets. Markets quickly dismissed concerns of higher taxes by justifying it with more stimulus and more significant deficits. In other words, “buy everything in sight.”

As I tweeted out on Tuesday:

While I do jest a bit, market participants quickly justify paying continually higher prices for investments.

Why not? Mainly when it’s a “Heads I win, Tails I win” market.

As I noted last week, it certainly seems as if there is no “risk” in investing. As markets continue to rise, investors are becoming increasingly confident. But therein lies the risk as confidence breeds complacency. 

In the short-term, the bullish trends remain intact. After a month-long choppy process, the S&P 500 finally set a new all-time high. The good news is that short-term MACD signals and money flows are favorable, suggesting prices could rise higher in the short-term.

However, notice that while the MACD, and money flow, are positive, the market remains significantly overbought short-term. Such suggests that while markets could rise, it could be somewhat limited return relative to the risk.

On a longer-term basis, the markets remain grossly extended from long-term means. The only other times we have seen these extensions in recent years often resulted in the loss of short-term gains rather quickly.

A correction within the next 2-months would not be surprising given the deviations from long-term means. However, such does not preclude more upside first.

Santa Claus Broad Wall, Technically Speaking: Will “Santa Claus” Visit “Broad & Wall”

The Risk Of The Bullish View

As we noted last week:

“Currently, every single analyst has the same story going into 2021.

  • Prepare for an economic boom.
  • Interest rates will rise.
  • Inflation is coming back.
  • The stock market is going to 4100-4500
  • Small-caps are the new ‘new trade.'”

You get the idea. Everyone is incredibly “bullish” about the coming year with hopes of more stimulus, infrastructure spending, and a vaccine.

Somehow, despite millions of people still unemployed, the economy has just shifted into a “Golden Age” not seen since the 1950s.

However, therein lies the problem.

We Can’t Go Back

There have been two previous periods in history that have had the necessary ingredients to support a rising trend of interest rates, inflation, and economic growth over an extended period.

The first was during the previous century’s turn as the country became more accessible via railroads and automobiles. Production ramped up for World War I, and America began shifting from an agricultural to an industrial economy. (Read more on why this isn’t the “Roaring 20s.”

The second period was post-World War II. The war left America the “last man standing” after France, England, Russia, Germany, Poland, Japan, and others were devastated. It was here that America found its most substantial run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed.

The U.S. is no longer the manufacturing powerhouse it once was, and globalization has sent jobs to the cheapest labor sources. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 participating in the labor force is near the lowest level relative to that age group since the late 70s.

There is also a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance. These issues are only going to worsen due to long-term demographic trends, not only domestically but globally.

In other words, the ingredients required for sustained levels of more robust economic growth and prosperity are not available.

Trending In The Wrong Direction

As shown below, there is a correlation between the three major components of economic growth: inflation, interest rates, and wage growth.

Interest rates are not only a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as a business increases production to meet rising demand. Increased production leads to higher wages, which in turn fosters more aggregate demand. As consumption increases, so does producers’ ability to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to more robust economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

Note that “production” is the key to economic growth. Consumption that is dependent solely on increases in debt, or stimulus, has a negative impact on growth.

The chart above is a bit busy. If we combine the individual subcomponents into a composite index, the correlation with interest rates becomes clearer.

Blue Plans Won’t Lead To Growth.

Currently, investors hope that with a “Blue Wave,” more stimulus, increased deficits, and infrastructure spending is soon on their way. Goldman Sachs just upgraded their estimate of GDP growth based on the expectation of another $750 billion stimulus bill.

The surge in deficit spending, combined with the pick up in short-term demand for construction and manufacturing processes, will give the appearance of economic growth. Such will likely get both the Federal Reserve and the “bond bears” on the wrong side of the trade.

The impacts of these “one-off” inputs into the economy will fade rather quickly after implementation as organic productivity fails to increase. While many always hope these programs will lead to an ongoing economic expansion, a look at the last 40 years of fiscal and monetary policy suggests it won’t.

Why?

Because you can’t create economic growth when financed by deficit spending, credit, and a reduction in savings.

You can create the “illusion” of growth in the short-term, but the surge in debt reduces both productive investments and the output from the economy. As the economy slows, wages fall, forcing consumers to take on more leverage and decrease their savings rate. As a result, of the increased leverage, more of their income is needed to service the debt, which requires them to take on more debt.

While more stimulus and infrastructure spending may spur the economy and markets initially, the payback tends to be severe. Such is why we keep ending up at this point, demanding more spending to fix the last drawdown. 

Wash. Rinse. Repeat.

Is The Reflation Trade Over?

The trade du jour has been to buy stocks that benefit the most from inflation. Energy and materials have been the hottest sectors over the last few weeks, and bitcoin is on fire. Conversely, utilities and REITs have suffered as higher interest rates tend to accompany inflationary expectations.

As such, the graph below is essential for stock investors to follow. Yes, we know it is TIP bonds, but it accurately quantifies the inflationary sentiment driving stocks.

The graph compares 2-year, and 10-year implied inflation levels. By comparing TIP yields to nominal Treasury yields, we extract the breakeven, or implied, inflation rate that makes investors indifferent between the two securities. As shown, short term expectations have risen from nearly -1% in April to 2.25% today. Short term expectations are at the highest level since 2013. 10-year inflation expectations are less volatile but have risen sharply.

The genius of the graph is the interaction of inflation expectations to the spread between the two. Short term inflation expectations tend to be lower than long term expectations. However, when they reach or exceed long-term expectations, they tend to peak and reverse sharply. The dotted lines highlight the seven times in the last 12 years this has occurred.

The bulls argue this time is different and inflation is a real threat, unlike the past. The bears rely on the past relationship and forecast a rapid decline in inflation expectations.

The eagles, ourselves included, have the luxury of watching the data and adjusting our stance as we see how the two rates react to the curve inversion.

Portfolio Positioning Update

With January kicking off with a bang, we are maintaining our long bias with reduced hedges at the moment. 

We made some changes to align our portfolio more with our equal-weighted benchmark index during the past week by reducing some of our overweight in technology, healthcare, and communications. While many other sectors of the market are grossly overbought short-term, we added a 5% weighting of RSP (S&P Equal Weight ETF) and SPY (S&P Market Weight) to our portfolios for the time being as placeholders.

We are currently slightly overweight equities and underweight our hedges in fixed income as interest rates press higher.

As noted last week, the rally this week was not unexpected:

“With the stimulus bill passed, and checks going out, we won’t be surprised to see a short-term pop in economic activity. However, given the checks are 50% smaller than the first round, along with extended unemployment benefits, the economic bump will be short-lived. The real question going into 2021 is whether President Biden can spend further into debt to do more stimulus. Or, will a shift toward fiscal responsibility begin to take hold? Much will depend on the Senate run-off outcome in Georgia.

Regardless, the evidence is mounting that economic and earnings data will likely disappoint overly optimistic projections currently. Furthermore, investors are way too confident. Historically, such has always turned out to be a poor mix for a continued bull market advance in the short-term. 

Even with the Senate now a 50/50 split, more moderate Democrats may start to balk at massive increases in debt. There may also be some pushback against some of the more far-left socialistic policies as well.

We will have to wait and see.

For now, we will continue to trade accordingly.


The MacroView

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

See You Next Week

By Lance Roberts, CIO


Market & Sector Analysis

Analysis & Stock Screens Exclusively For RIAPro Members


S&P 500 Tear Sheet


Performance Analysis


Technical Composite

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


Portfolio Positioning “Fear / Greed” Gauge

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

NOTE: This week, I published the 4-Week Average of the Fear/Greed Index. It is a rarity that it reaches levels above 90.  The current reading is 96.07 out of a possible 100.


Sector Model Analysis & Risk Ranges

How To Read.

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


Weekly Stock Screens

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

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

S&P 500 Growth Screen

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

Aggressive Growth Strategy


Portfolio / Client Update

It’s a new trading year, and we are entering into it with a fully weighted portfolio with reduced hedges. Such makes us uncomfortable, but the “market exuberance” has gone “off the chart.” 

While market momentum can last a lot longer than logic would predict, it doesn’t necessarily mean a smooth ride higher. For now, we are maintaining our exposures and will look for short-term corrections to rebalance risk and adjust our allocation models for the new administration and the economic outlook.

For now, the general bias is that no matter what, markets can only go higher. While that certainly does seem to be the case, the thesis is on a fairly unstable foundation. Rising interest rates and inflation on a debt-laden economy will likely not have the outcome most expect.

The significant risk to the markets currently, besides more extreme overvaluation, is the disappointment in both earnings and economic growth. Given the more extreme expectations now, the risk of that occurring is elevated.

I have traded through many markets over the last 30-years, and I have only seen this type of market exuberance once previously. Yes, it was in 1999.

Portfolio Changes

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

We are rebalancing the equity model. We reduced the following stocks below (tech, communication, and healthcare) and added 5% of RSP as a placeholder for now.

While this is a net reduction of equity exposure, it is only temporary as we look for short-term corrections to add to current holdings or add new holdings.

Currently, the equity model has 64% equity, and the sector model has 66%. Both figures include gold and gold miners.

In Both Models

  • CLX – Selling 100% of the position
  • GDX – Selling 100% of the position
  • IAU – Selling 100% of the position
  • SPY – Added 5% to current holdings.

In the Equity Model

  • AMZN – Reduce to 1.5%
  • AAPL – Reduce to 2%
  • NFLX – Reduce to 2%
  • ADBE – Reduce to 1.5%
  • CRM – Reduce to 1.5%
  • MSFT – Reduce to 2%
  • JNJ – Reduce to 2%
  • ABT – Reduce to 2%
  • UNH – Reduce to 1%
  • CMCSA – Reduce to 1%
  • VZ – Reduce to 1.5%

As always, we are aware of the risks and are carrying tight stops on this position.

Our short-term concern remains the protection of your portfolio. We have now shifted our focus to 2021 and where markets go in the New Year.

Lance Roberts

CIO


THE REAL 401k PLAN MANAGER

A Conservative Strategy For Long-Term Investors



RIA Advisors can now manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes, we can get you in the “right lane” for your retirement.


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


401k Plan Manager Live Model

As anRIA PRO subscriber (You get your first 30-days free), you can access our live 401k plan manager.

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

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

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

Technical Value Scorecard Report For The Week of 1-08-21

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

Commentary 1-08-21

  • The relative value graphs show the amazing divergence in fortunes that occurred over the past few weeks. Banks (XLF) are about as extreme overbought versus the S&P 500 as we witnessed this past year, while Staples (XLP) the most extreme oversold. In theory, banks benefit from the relation trade as the yield curve steepens and boosts profit margins. Conversely, many staples have to pay higher input costs to produce their goods and may find it difficult to fully pass the costs on to consumers, thus weaker profit margins.
  • Materials are decently overbought, and Realestate is strongly oversold. Both sectors are also heavily affected by a perceived ramp-up in inflation. Most other sectors are close to their fair value versus the S&P.
  • Not surprisingly, small-caps and mid-caps are deeply overbought versus the S&P. Emerging markets and Developed foreign markets are also overbought as the dollar continues to languish.
  • We haven’t discussed bonds in a while but it’s worth noting that TLT (20yr UST) is about as deeply oversold versus IEI (5-7yr UST) as is possible. Again, as long as inflation remains a concern we can expect such underperformance. The same is true on the absolute level analysis in the second set of graphs.
  • The sector score scatter plot has a very high R-squared of .814 denoting that most sector returns are in line with their respective relative performance versus the S&P.
  • On an absolute basis, most sectors are decently overbought with healthcare and banks leading the way. Staples, despite being grossly oversold versus the S&P, is fairly valued on an absolute basis. Utilities and Realestate are slightly oversold.
  • On a factor/index level almost everything is nearing extreme overbought levels (>80%). The S&P 500, shown in the bottom right of the second set of graphs is also nearing the most extreme levels of the last year.
  • The third graph below shows that many sectors, and all but one factor/index, are trading above 2 Bollinger bands versus their 20 day ma. There are also a handful trading 2 bands above their respective 50 and 200 day ma’s.
  • It may be a little early to bottom fish in the staples sector, but if you are interested in keeping an eye on a few companies, the fourth table below shows the relative score of XLP’s leading companies against each other as well as against the sector ETF (XLP). Using this analysis, Colgate Palmolive (CL) appears to be the most oversold versus XLP and every other company. That said, its relative underperformance versus XLP over the last 20 days of -2.29% is not as bad as we would have guessed based on its score. The underlying companies are by and large trading in line with each other.

Graphs (Click on the graphs to expand)


Users Guide

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

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

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

The ETFs used in the model are as follows:

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

#MacroView: El-Erian & The Two Primary Risks In 2021

In 2019, I discussed the disconnect between the markets and the economy. After years of Central Bank interventions, stock markets have soared to record highs, while economic growth has remained weak. Mohamed El-Erian recently discussed the two primary risks heading into 2021.

El-Erian began his article by asking the most relevant question.

“What, if anything, will happen to the great disconnect between Wall Street and Main Street?”

The Great Disconnect

Currently, Wall Street analysts are projecting record stock markets in 2021, with stock prices rising another 10% and earnings surging toward record levels.

Main Street, however, believes the economy is heading in the wrong direction.

Such is the question we have discussed previously, given that the “stock market is ultimately a reflection of the economy.”

The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to ‘remain irrational longer than logic would predict.’

However, such detachments never last indefinitely.

The stock market is NOT the economy. But the economy is a reflection of the very thing that supports higher asset prices – corporate profits.”

Importantly, this detachment is now a key consideration for policy-makers and investors as we head into 2021.

A Remarkable Gap

“Throughout this pandemic year, we have experienced a further sharp widening of an already remarkable gap between financial markets and the economy. A rapid recovery in asset prices from the March 23 lows took major US indices to record levels, even before the recent good news on Covid-19 vaccines. Combined with even more accommodative central bank policies, this enabled record debt issuance at historically low levels of compensation for creditors.” – El-Erian

There is no doubt that corporations did indeed take the Federal Reserve up on both near-zero interest rates and a guaranteed buyer of bond issuance. In 2020, investment-grade bond issuance hit a record with total non-financial debt soaring to all-time highs. Such was occurring at a time when revenues and profits were plunging.

That data includes the record levels of “junk bond” issuance in the market.

“Issuance in 2020 through August was $291.9 billion, up 71% year over year. Credit strategists at BofA Global Research now project a full-year primary volume of $375 billion. Such would shatter the current record total of $344.8 billion in 2012, according to LCD.”

moral hazard, Neel Kashkari Is The Definition Of “Moral Hazard”

Of course, the issue is that over the next few years, there is a tremendous amount of debt coming due. If rates risk markedly, or if the market demands payment for the relative risk, refinancing could become problematic.

The other problem is if the economy fails to have a robust economic recovery as Wall Street currently expects.

Expectations For Recovery May Fall Short

There is a significant problem currently which we discussed in “Recessions Are A Good Thing:”

“‘Zombies’ are firms whose debt servicing costs are higher than their profits but are kept alive by relentless borrowing. 

Such is a macroeconomic problem. Zombie firms are less productive, and their existence lowers investment in, and employment at, more productive firms. In short, a side effect of central banks keeping rates low for a long time is it keeps unproductive firms alive. Ultimately, that lowers the long-run growth rate of the economy.” – Axios

moral hazard, Neel Kashkari Is The Definition Of “Moral Hazard”

The number of “Zombie” companies in the market has hit decade highs in 2020. The massive Federal Reserve interventions, bailouts, and zero rates provided the life support failing companies needed. From a market perspective, the Federal Reserve’s liquidity flows increased speculative appetites, and investors piled into “zombies” with reckless abandon.

These companies’ survivability is based upon a continued low rate environment, a robust debt market, and economic recovery to ensure the ability to repay debt holders.

However, the “recovery” may not be nearly as strong as Wall Street currently expects.

An uncertain economic outlook with notable dispersion among systemically important countries is but one of the Covid-19 legacies that markets have set aside due to sky-high faith in central banks’ ability to shield asset prices from unfavorable influences.” – Mohamed El-Erian

Even with a “Second Stimulus,” the underlying erosion of economic growth from rapidly rising debts and deficits leaves little margin for error.

“[The economy] requires increasing levels of debt to generate lower rates of economic growth. The chart shows both CARES Acts and the impact on GDP growth.”

stimulus economic impact, Why The Second Stimulus Won’t Have Much Economic Impact

Such is why the Federal Reserve has found itself in aliquidity trap.”

Rates MUST remain low, and debt MUST grow faster than GDP, to keep the economy from stalling out.

Moral Hazard

In the short-term, however, market participants have been lulled into a false sense of security. Currently, investors are paying astronomical prices for “risk” assets. At the same time, they accept low rates on “high yield” debt (aka junk bonds) relative to the risk of default.

The detachment of investor attitudes from the underlying risk is precisely the definition of “Moral Hazard:”

“Noun – ECONOMICS

The lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.”

As Mohammed El-Erian specifically noted:

Markets being markets, investors have readily extended the protective nature of the umbrella to asset classes that, at best, are only indirectly supported by central bank funding (such as emerging markets).

It is an extremely powerful dynamic, and one that inevitably overshoots.

In other words, investors “believe” they have an insurance policy against “risk.

Nothing is more reassuring to an investor than the knowledge that central banks, with much deeper pockets, will buy the securities they ownparticularly when these buyers are willing to do so at any price and have unlimited patient capital.

The rational investor response is not just to front-load their buying but also to look for related opportunities where return-seeking funds will be pushed to. The result is not just seemingly endless liquidity-driven rallies regardless of fundamentals.

Such does seem to be the case until an unexpected exogenous event occurs, or if the Fed tries to normalize monetary policy. In either event, the underlying “risk” becomes quickly realized as a “financial crisis.”

moral hazard, Neel Kashkari Is The Definition Of “Moral Hazard”

The resulting destruction of household net worth requires an immediate response by the Fed of zero interest rates and liquidity. Subsequently, they are forced to create the next “bubble” to offset the deflation of the last.

Irrational Exuberance

Importantly, what the Federal Reserve did accomplish was creating a demand for “risk” assets by distorting market functions and price discovery. As El-Erian noted:

“While investors will continue to surf a highly profitable liquidity wave for now, things are likely to get trickier as we get further into 2021. Central banks’ deepening distortion of markets will be harder to defend in a recovering economy amid rising inflationary expectations.

Nowhere is this more evident than in recent surveys that show an extremely high level of investor exuberance despite the underlying detachment from fundamentals.

“The chart below shows the combined average of institutional and individual investor valuation confidence subtracted from future returns confidence. When the reading is positive, the confidence the market will be higher one year from now is more elevated than the confidence in the market’s valuation.  The opposite is the case when the reading is in negative territory.

The key takeaway is that investors think simultaneously, the market is over-valued but likely to keep climbing.” – Charting 2020’s Speculative Mania

2020 Speculative Mania, Technically Speaking: Charting 2020 – A Year Of Speculative Mania

Such is the same phenomenon famously described by former Fed Chair Alan Greenspan in a December 1996 speech on “Irrational Exuberance.” 

Whenever such detachments between the real economy and markets have previously occurred, investor outcomes have not been kind. It is unlikely this time will be different.

Investors might rue the day they ventured into asset classes far from their natural habitat that lack sufficient liquidity in a correction. Navigating such a landscape will require analytical tools that would, ironically, have detracted from returns during the bulk of the liquidity-driven rally.” – El-Erian

stocks economy, #MacroView: The Great Divide Between Stocks & The Economy

The Wealth Gap Explodes

The problem of the disconnect between the economy and the markets is that it is unsustainable long-term. According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928.

There are various social, political, and economic factors driving this growing discrepancy, but one critical factor is ignored – The Federal Reserve. When the Fed inserted itself into the economic equation, their contribution led to rising imbalances between economic classes.

Over the last decade, as stock markets surged, household net worth reached historic levels. If one just looked at the data, it was clear the economy was booming. However, for the vast majority of Americans, it wasn’t. The WSJ showed this previously:

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.”

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

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.

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

No Longer Sustainable

What policy-makers, and the Federal Reserve missed, is the “stock market” is NOT the “economy.” 

This “wealth gap” can be directly traced back to a decade of monetary policy that almost solely benefited those who either had money to invest in the financial markets or were compensated through increases in corporate asset prices. However, those policies failed to produce substantial rates of either wage growth or full-time employment.

The reality is that we have likely reached the efficacy of monetary interventions. As such, El-Erian’s concluding comment is most important.

“Already, the great disconnect has continued much longer than most expected. This illustrates, yet again, the unintended consequences of a policy approach that places an excessive burden on central banks.

There are two risks, and not just for markets.

First, what is desirable may not be politically feasible, and second, what has proven feasible is no longer sustainable.”


#WhatYouMissed On RIA This Week: 1-8-21

What You Missed On RIA This Week Ending 1-8-21

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

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


RIA Advisors Can Now Manage Your 401k Plan

Too many choices? Unsure of what funds to select? Need a strategy to protect your retirement plan from a market downturn? 

RIA Advisors now has the capability to manage your 401k plan for you. It’s quick, simple, and transparent. In just a few minutes we can get you in the “right lane” for retirement.


What You Missed This Week In Blogs

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



What You Missed In Our Newsletter

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



What You Missed: RIA Pro On Investing

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



The Best Of “The Real Investment Show”

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

Best Clips Of The Week Ending 1-8-21


What You Missed: Video Of The Week

Jeremy Grantham is right. We are in a stock market bubble, but its NOT about valuations.



Our Best Tweets For The Week: 1-8-21

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

See you next week!

The Fed is Juicing Stocks

The Fed Is Juicing Stocks

We came across the following bullet points from a Seeking Alpha article titled- The Fed is not Juicing the Stock Market.

  • It makes for a great headline, but the Fed is not the cause of this rally.
  • Every dollar the Fed has pumped into the economy is spoken for, and it is not in equities.
  • The truth is a lot more boring and scary than the conspiracy theory.

After explaining how the Fed is not culpable for rising stock prices, the author ends the article with the following challenge: “So please, I invite anyone to explain to me, like I was a 5-year-old, what exactly is the mechanism that explains “the Fed is juicing the market,” when we know exactly where all the Fed’s money is, and we know that it isn’t in the market.”

We are always up for a challenge.

The following article describes four ways in which the Fed juices the stock market.

Draining the Asset Pool

The Fed conducts monetary policy by governing the Fed Funds Rate. To do this, they buy and sell Treasury securities via open market operations. When the Fed wants to lower rates, they buy Treasury debt. In doing so, they reduce the supply of investible debt, making remaining debt more expensive (lower yield). They most often buy or sell short term Treasury Bills to affect the short term Fed Funds rate. Open market operations also add or drain the banking system’s liquidity to help further hit their target.

More recently, with Fed Funds at zero percent, they have conducted QE or large-scale asset purchases. These operations help manipulate rates across the maturity curve and not just Fed Funds. QE, as with traditional open market operations, reduces supply, boosts prices, and lowers yields.

With knowledge of the Fed’s modus operandi, let’s go swimming.

Think of the asset markets as a big swimming pool. The kiddie pool is for risk-averse investors, and the deep end is home for the riskiest of investors. While the depth of the water varies extensively, the water level is the same throughout the pool.

Imagine the Fed comes to our pool with a giant bucket and removes gallons of water from the shallow end. What happens to the water level for the entire pool? It falls, and consequently, there is less water to swim in. The effect is more obvious in the shallow end as the depth was lower to begin with. Regardless of appearances, the water level in the deep end falls by the same amount.

Some of our risk-averse shallow end swimmers will now take a step or two towards the deep end.  They may move from Treasury Bills to short term corporate bonds or mortgages. As investors take on more risk, they start crowding out other investors and pushing everyone toward the deep end.

Less water means less supply of investible assets. The basic laws of supply and demand clearly state that less supply and the same demand result in higher prices.

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

Leverage

One of the Fed’s recent accomplishments during this economic crisis is fostering easy financial conditions. Such an environment allows companies to borrow and reduce the possibility of default. Another benefit is it encourages investors to use more leverage as borrowing is easier to attain and cheaper.

The two graphs below show borrowing conditions have rarely been easier. Typically a recession has the exact opposite effect on lending conditions.

U.S. financial conditions are the easiest they’ve been in more than a quarter century as stock markets scale new heights on hopes of an end to the Covid-19 pandemic, according to an index compiled by Goldman Sachs Group Inc.” – Bloomberg 12/14/2020

More leverage allows speculators and traders to amass larger holdings than would otherwise be possible. Much of this leverage comes from the repo markets. Repurchase transactions, or repo, is a loan collateralized with an asset. For example, an investor buys a security, pledges it as collateral, and uses the borrowed funds to buy more assets. The investor holds more assets with the same original investment.

The Fed has been actively providing funds to the repo markets resulting in more liquidity and lower borrowing rates since the fall of 2019. At its peak in March, the Fed supplied over $400 billion in repo funding to the market. This source of funds allowed for the increased demand for assets, and as you would expect, this includes stocks.

Fed Put

Investors are like Pavlov’s dogs. Increasingly they associate Fed actions with more stimulus, easier financial conditions, and higher asset prices. The Fed has responded by becoming more verbally accommodative via talking up policy options when markets hit rough patches.

Fed actions or even words of encouragement become buying opportunities. As such, prices do not decline as much as they might have, and volatility is muted as a result. Muted volatility encourages more investment and speculation as risks, measured using common financial math, such as standard deviation, are perceived to be lower.

More return with less perceived risk encourages more risk-taking, ergo more interest in stocks.

Fed Supports Passive Investing

Reduced volatility and eye-popping returns are increasingly leading investors to focus on momentum and passive strategies. Active investors, forecasting economic and earnings trends, and assessing valuations get left behind in momentum-driven markets. As these investors lose assets or switch to more passive strategies, passive strategies by default play a more prominent role in asset pricing. For more, please read our article: The Market’s Invisible Guardrails Are Missing.

Active investors tend to hold cash to take advantage of opportunities that may occur in the future. Further, at times like today, when valuations are historically extreme, active investors take profits and may not find suitable replacements, also increasing their cash balances.

Passive investors are typically fully invested. Cash, after all, is a performance drag in upward trending markets. They do not sell because of high valuations but switch from one index to another based on momentum.

Due to the steady gravitation from active to passive strategies over the last decade, system-wide cash balances are reduced, and there is more demand to buy assets. As shown below, courtesy SentimentTrader, equity mutual fund cash balances are 70-year lows.

Summary

Our summary is short and sweet, so even a five-year-old can understand.

The Fed juices stocks!

Technically Speaking: S&P 500 – Trading At Historical Extremes

Welcome to 2021. As we kick off a new year, we begin with the S&P 500 trading at historical extremes. It is essential to have some perspective to set reasonable expectations for future returns and quantify the “risk” of something going wrong.

As we discussed with our RIAPRO.NET subscribers yesterday, the real risk to the market in 2021 is over-confidence.

“Currently, Wall Street analysts are wildly exuberant on expectations of explosive economic growth, rising interest rates, and inflation. The problem with those expectations is that in an economy that is $85 Trillion in debt, higher rates and inflation are a ‘death knell’ to economic growth.

Yes, while the Fed may come to the rescue with more QE, with markets already trading at 36x times earnings it is becoming increasingly difficult to justify overpaying for earnings. Eventually, corporate earnings are going to have to markedly improve, or prices will revert.”

There is a high long-term correlation between the index and earnings of 88%. As shown, extreme deviations from the long-term correlation have always preceded short- to intermediate-term corrections.

Short-Term It’s A Coin Toss

In the short-term, which equates from a few days to a few weeks, markets are sentiment-driven. As we showed in “2020-A Year Of Speculative Mania,” investor sentiment is just about as “bullish” as it can get.

“The chart below shows the combined average of institutional and individual investor valuation confidence subtracted from future returns confidence. When the reading is positive, the confidence the market will be higher one year from now is more elevated than the confidence in the market’s valuation.  The opposite is the case when the reading is in negative territory.

The key takeaway is that investors think simultaneously, the market is over-valued but likely to keep climbing.” 

2020 Speculative Mania, Technically Speaking: Charting 2020 – A Year Of Speculative Mania

“Such is the same phenomenon famously described by former Fed Chair Alan Greenspan in a December 1996 speech on ‘Irrational Exuberance.'”

However, it is that “sentiment,” or more commonly known as the “Fear of Missing Out,” that can continue to drive prices higher in the short-term.

As shown, the S&P index is currently overbought and trading significantly above its 200-dma. However, with the Bollinger Bands narrowing, the market could trade higher over the next month.

Such a move higher would align with our expectations of the current bullish trade to continue into January.

However, with the more extreme deviation from the 225-day moving average, somewhere between February and March, we could see a correction take hold. Such would be akin to what we saw during the first half of the last 3-years.

Intermediate-Term Is Worrisome

For investors, the outlook becomes much more troubling as we look further out.

The market is trading 3-standard deviations above its long-term mean and is incredibly overbought on a weekly basis. At the same time, there is a negative divergence in relative strength (RSI), which is also a cause of concern.

Since weekly charts are slower moving, such does not mean the markets will crash immediately. Long-term charts indicate that price volatility will likely be higher in the months ahead, and investors should monitor their risk accordingly. While momentum-driven markets can remain irrational much longer than logic would predict, eventually, a reversion has always occurred.

The chart below shows the price deviation from the one-year weekly moving average. Given the deviation is above 15%, price corrections have always been nearby. (Such does not mean a market crash. A correction of 10-20% is well within norms.)

Long-Term View Is Bearish

The monthly chart of the S&P 500 is likewise just as problematic. Again, long-term charts predict long-term outcomes and are NOT SUITABLE for trading portfolios short-term. As shown, the deviation from long-term monthly means and negative divergences in relative strength has previously been warning signs for more significant corrections.

We see the same problematic setup when viewing the market’s current deviation from its 2-year monthly moving average. The current deviation has only occurred 5-times since 1960 and has always led to a correction over the next several months. (Some worse than others.)

However, since 1900, using QUARTERLY analysis, the picture is bearish for returns over the next decade. The research below aligns valuation, relative strength, and deviations into one chart.

There is little to suggest investors who are currently extremely “long equity risk” in portfolios now won’t eventually suffer a more severe “mean-reverting event.” 

While valuations and long-term deviations suggest problems for the markets ahead, such can remain the case for quite some time. It is this long lead time that always leads investors to believe “this time is different.” 

Because of the time required for long-term data to revert, monthly and quarterly data is more useful as a guide to managing expectations, allocations, and long-term exposures. In other words, this data is not as valuable as a short-term market-timing tool.

What Could Cause A Correction In 2021? 

Lots of things.

The market is currently priced for perfection betting on explosive economic growth, a falling dollar, interest rates remaining low, consumer spending surging sharply, and inflation remaining muted. The reality is that none of those things will likely turn out to be the case.

The one thing that always trips of the market is the one thing that no one is paying attention to. For me, that risk lies with the US Dollar. As noted previously, everyone expects the dollar to continue to decline, and the falling dollar has been the tailwind for the emerging market, commodity, and equity-risk trade. Whatever causes the dollar to reverse will likely bring the equity market down with it.

That is the risk we are paying attention to right now.

What This Means And Doesn’t Mean

Let me repeat the following just so there is no confusion.

“What this analysis DOES NOT mean is that you should ‘sell everything’ and ‘hide in cash.’”

As always, long-term portfolio management is about managing “risk” by “tweaking” things over time.

If you have a “so so” hand at a poker table, you bet less or fold.

It doesn’t mean you get up and leave the table altogether.

What this analysis does suppest is that we should use rallies to rebalance portfolios. 

  1. Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
  2. Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they will decline more when the market sells off again.
  3. Move Trailing Stop Losses Up to new levels.
  4. Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you have an aggressive allocation to equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Could I be wrong? Absolutely. But what if the indicators are warning us of something more significant?

What’s worse:

  1. Missing out temporarily on the initial stages of a longer-term advance, or;
  2. Spending time getting back to even, which is not the same as making money.

Conclusion

For most investors, the recent rally has been a recovery of what was lost last year. In other words, while investors have made no return over the previous eighteen months, they have lost 18-months of their retirement saving time horizon.

Yes, if the market corrects and reduces some of its current overbought condition without violating supports and maintaining the current bullish trend, we will miss some of the initial upside. However, we can quickly realign portfolios to participate from that point with a much higher reward to risk ratio than what currently exists.

However, if I am right, the preservation of capital during an ensuing market decline will provide a permanent portfolio advantage in the future. The real power of compounding is not in “the winning” but in the “not losing.”

As I noted recently in our blog on trading rules: 

Opportunities are made up far easier than lost capital.” – Todd Harrison

Viking Analytics: Weekly Gamma Band Update 1/04/2021

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 01/04/21

  • The SPX Gamma Band model can be viewed as a long-only trend-following model that reduces exposure when options markets show elevated risk. Since 2007, following this model has similar returns to a long-only position, although with much lower risk exposure.   The Gamma Band model has resulted in a 74% improvement in risk-adjusted return since 2007 (measured by the Sharpe Ratio). 
  • The Gamma Band model has maintained a high exposure to the S&P 500 since the U.S. election. The model will generally maintain a 100% allocation as long as price closes above Gamma Neutral, currently at 3,676.
  • The model will cut S&P 500 exposure to 0% if price closes below the lower gamma bound, currently near 3,465.
  • Our binary Smart Money Indicator continues to have a full allocation but could turn cautionary if smart money begins to buy more long-dated puts. The Smart Money had been trending towards the safe zone, but recently stopped its decline, perhaps signaling more bullishness.
  • SPX skew is in a normal range. One might expect skew to be more bullish with stocks near all-time highs; there is apparently some caution ahead of the January 6th electoral ballot count in Washington, DC.
  • We publish many different signals each day in four different pdf reports. A sample copy of all of our reports can be downloaded by visiting our website.

Smart Money Residual Index

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

At the moment, hot money is more cautious than smart money, and the back-test for this model supports a long position.  When the Sentiment goes below zero (and the line moves from green to red), then this model will cut all equity exposure to zero.  When the market is in the red regime below, the market has an overall negative return.

SPX Skew – the Price of Protection

Another tool we use to evaluate market risk is called “skew,” which is the relative cost of buying puts versus calls.  When puts command a larger-than-usual premium to calls, then the market will have higher volatility (in the red zone below), and this can often be a signal to reduce equity exposure. 

As the market continues to push to all-time highs, one might expect skew to be more bullish; some analysts see market risk ahead of the January 6th approval of the U.S. electoral ballots.

Gamma Band Background

Market participants are increasingly aware of how the options markets be the “tail that wags the dog” of the equity market. 

The Gamma Band indicator adjusts equity exposure dynamically in relation to the Gamma Neutral and other related levels.  This has shown to reduce equity tail risk and improve risk-adjusted returns.  In our model, we compare the daily close of the SPX to the Gamma Neutral and Lower band levels to adjust our equity exposure allocation from 0% to 100%.  

We back-tested this strategy from 2007 to the present and discovered a 74% increase in risk-adjusted returns (shown below).  The Gamma Band model is a relatively slow but reliable signal.  Free samples of all of our daily reports can be downloaded from our website.

Authors

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

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

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