Tag Archives: 720 Global

Bonds Burning, Equities Fiddling

It is said that while a massive fire consumed Rome in 64 A.D., Rome’s ruler, Nero, played his violin night and day. Since then the quote, “Rome burned while Nero fiddled,” has become a phrasing used when a palpable problem is ignored.

Currently, the bond market and the Federal Reserve are on fire, screaming at the top of their lungs that something is wrong. All the while, the stock market fiddles as if everything is normal. In this article, we explore the steep decline in bond yields to understand what is frightening bond traders.

The Fire

The following graphs and tables will help you appreciate the message emanating from the bond markets.


The first graph below charts Eurodollar contract spreads which provide us with market expectations changes for the Fed Funds rate in the future.

Each Eurodollar contract represents a forward three month LIBOR rate for a specific three month period in the future. LIBOR, or the London Interbank Offer Rate, is the base rate that foreign banks lend to each other, corporations and other entities. For example, the current third Eurodollar contract represents the three -month LIBOR rate from mid-December of 2019 to mid-March of 2020. When various calendar Eurodollar rates are compared to each other the differences in yields provides us implied expectations for changes in the Fed Funds rate.

Data Courtesy Bloomberg

Currently, as shown with the blue line above, the difference between the third contract starting in mid-December is 18 basis points (0.18%) less than the first contract starting in mid-June. The difference tells us that the Eurodollar market currently expects three month LIBOR to decline 18 bps (0.18%) between June and December of 2019.

Since October of 2018, the three curves, spanning three different time frames (6, 9 and 21 months), have gone from a consensus expectation of approximately 0.50% of rate increases over the next two years to 0.18-0.56% of rate decreases over the same period. The 0.75% to 1.00% shift is remarkable over such a short period. Global traders, banks, and corporations that account for much of Eurodollar/LIBOR activity, influenced by fluid Fed outlook changes, have made sharp adjustments to their economic forecasts.

Yields and Yield Curves

The next chart shows the shift of the U.S. Treasury yield curve since January of 2018. The table below it provides further perspective for yield changes and curve gyrations.  RIA Pro subscribers can better appreciate the shifting yield curve by reviewing the Latest Commentary from March 26, 2019. In that update, we provided an animated yield curve showing monthly yield curve movements since January 2018.

Data Courtesy Bloomberg

The graph below is based on an assessment of ten yield curves of varying time frames. As shown and labeled by the orange bar on the right side, half of them are currently inverted. Note that every time since the 1970’s that at least 50% of the curves were inverted a recession was soon to follow.

Data Courtesy Bloomberg

Negative Yielding Bonds

It is not just the Eurodollar and U.S. Treasury markets that think something is amiss.  The final graph provides a global perspective on rates. Specifically, it plots the amount of negative yielding bonds worldwide. Again, the changes to economic outlooks and central bank policy that have occurred since last fall are not just related to the U.S. but are global.

Graph Courtesy Bloomberg

There is nothing normal with a negative yield, and we take notice when such a large number of bonds are trading below zero.


Bond markets around the world are worried that economic growth and inflation are slowing drastically. In the U.S., expectations have shifted from a Fed that would gradually raise rates through 2019 and 2020 and continue to reduce their balance sheet, to a Fed that is likely to cut rates over the next six to nine months and has announced the end of balance sheet reductions.

As illustrated in the table below, changes in Fed policy are a durable recession signal as the end of rate hike cycles are frequently followed by a downturn in the economy. If the Fed follows the market’s lead and puts an end to the hiking cycle that began in 2015, then we might very well be looking at a recession shortly.

Table Courtesy David Rosenberg at Gluskin Sheff

Fueling the bond markets are statements from past and present Fed Governors that are not only dovish but discuss a resumption of QE and negative interest rates. Former Fed Chairman, Janet Yellen, recently said the Fed needs more tools to battle a financial crisis. This is the same Janet Yellen that, in June of 2017, stated that she did not believe we would have a financial crisis in our lifetimes.

The Fed is sounding the alarms.

The bond market is burning.

The equity market is fiddling.

It is highly unlikely they are both right.

Videocast- Has The Cycle Reached Its Tail?

On March 20th we published Has This Cycle Reached Its Tail? With the help of a badly drawn bird, the article described the economic and market cycle of the last ten years. Through an understanding of cycles and importantly, where we are in within a cycle, investors are provided clues on how to position our portfolios for what the cycle has in store.

We believe the current economic cycle is close to a turning point. This is incredibly important to managing wealth, as such we produced the following video that dives further into cycles.

View Part 1

View Part 2

The “Only Way To Win”

“Here’s the argument,” Thaler said. “The Raiders are down, and they will be getting these [four] picks to help them rebuild their team. I believe the only way to win in football is to have players who play better than their salaries. Let’s stipulate that [Kahil] Mack is getting top-of-market value for his services, so it will be hard for him to play better than his salary. Let’s also stipulate Mack is worth the money. But is Mack worth all that money plus four good draft choices?”

The following quote is from Richard Thaler, a Nobel Prize winner in Economic Sciences. His quote about the Oakland Raiders trading all-pro Khalil Mack to the Chicago Bears sheds knowledge well beyond the football field. Essentially Thaler argues that teams should seek undervalued players and trade (sell) players that are fully priced or overvalued. In investment terms, his quote can be translated into: buy stocks with upside and limited downside and avoid stocks with limited upside and significant downside.

To help make better sense of Thaler’s wisdom, we bring equity valuations to the forefront once again with a look at the ratio of price -to- sales (P/S). As we will show you the market has plenty of Khalil Macks.

Valuing Corporate Revenue 

Before presenting a current P/S ratio for a variety of indexes and S&P sectors, it is important first to consider two related concepts that frame the message the market is sending us.

Concept #1 – Investors should accept higher than normal valuation premiums when potential revenue growth is higher than normal and require lower than average premiums when potential revenue growth is lower than normal.

Consider someone who is evaluating the purchase of one of two ice cream shops (A and B). The two businesses are alike with similar sales, pricing, and locations. However, based on the buyers’ analysis, store A’s future revenue is limited to its historical 2% growth rate. Conversely, the potential buyer believes that store B, despite 2% growth in the past, has a few advantages that are underutilized and might produce a revenue growth rate of 10%. If stores A and B are offered at the same price, the buyer should choose to purchase store B. It is also likely that the buyer would be willing to pay a higher price for store B versus store A. Therefore highlighting that revenue growth potential is a key factor when deciding how much to pay for a business.

Purchasing a mutual fund, ETF or equity security is essentially buying a claim on a potential future stream of earnings cash flows, just like the ice cream business. The odds, therefore, of a rewarding investment are increased substantially when a company, or index for that matter, offering substantial market growth potential is bought at a lower than average P/S ratio. Value investors actively seek such situations.

Concept #2 – Corporate Earnings Growth = Economic Growth

Corporate earnings growth rates and economic growth rates are nearly identical over long periods. While many investors may argue that corporate earnings growth varies from the level of domestic economic activity due to the globalization of the economy, productivity enhancements that lower expenses for corporations, interest rates and a host of other factors, history proves otherwise.

Since 1947, real GDP has grown at an annualized rate of 6.43%. Over the same period, corporate earnings grew at a nearly identical annualized rate of 6.46%. Thus, expectations for future corporate earnings over the longer -term should be on par with expected economic growth, although short term differences can arise.

The graph below shows the running three-year annualized growth rate of U.S. real GDP since 1960.  While there have been significant ebbs and flows in the rate of growth over time, the trend as shown by the black dotted regression line is lower.

Data Courtesy: St. Louis Federal Reserve

As we have shared before, the combination of negligible productivity growth, heavy debt loads, and negative demographic factors will continue to produce headwinds that extract a heavy price on economic growth in the years ahead.  Barring major changes in the way the economy is managed or a globally transformative breakthrough, there is little reason to expect a more optimistic outcome. Given this expectation, the outlook for corporate earnings is equally dismal and likely to produce similar growth rates.


The following graphs are constructed using data from 1995 to the present. The blue bars represent the percentage of historical P/S data that are less than the current ratio. For instance, the first bar representing the S&P 500 has a P/S ratio which is in the 85th percentile of prior instances. The orange bar next to the blue bar shows how much price would need to fall for the P/S ratio to normalize. It is important to stress this analysis assumes no decline in sales which is a poor assumption if a recession were to occur.

Data Courtesy: Zacks

As shown above, the broad stock indexes and major S&P sectors all stand in the upper third and fourth quartiles of valuations dating back to 1995.

Interestingly note that utilities, a sector investors tend to flock to during market downturns as a safe haven, currently trades at its highest valuation in at least 25 years. We also discussed this anomaly in Defense is Good, Good Defense is Better. The other two sectors mentioned in that report, consumer staples and healthcare, are trading at less egregious valuations.


Based on the fact that many of the index and sector P/S ratios are at or near those of prior peaks, we are left to select from one of two conclusions as mentioned:

  1. investors are extremely optimistic about the potential for revenue growth, or
  2. investors are complacent, caught in the grasp of bubble mentality and willing to pay historically large premiums to avoid missing out on further gains

After further deliberation, however, there is a third possibility. Perhaps the lack of viable options for investors to generate acceptable returns, have them ignoring the risks.

Khalil Mack may be a great linebacker for the Bears and return the value they paid, but as Thaler put it, they should not expect much more. On the flip side, professional sports and stock market history has proven time and time again that overpaying is more often met with disastrous underperformance.

The Next Maestro

The following article emphasizes that the perceived economic prosperity of recent decades is largely the result of political expediency. Those in charge of monetary policy have repetitively failed to act in the best interests of the public in an effort to either avoid criticism or preserve their individual status. While often ignored, this dynamic is crucial to understand to form longer term expectations for asset prices.

“I’m making records, my fans they can’t wait

They write me letters, tell me I’m great” – Joe Walsh

The modern day printing of digital dollars from thin air, literally from nothing, brings to mind a Latin phrase “ex nihilo, nihil fit” which means out of nothing, nothing comes. If that statement is true, and a moment of reflection surely produces the logical conclusion that it is true, then what do central bankers hope to accomplish by means of conjuring currency from, well, nothing? What does it further say about setting interest rates at less than nothing? If nothing can come from nothing then there is no solution in the idea that by printing dollars and inflating asset prices you can create something (a durable organic recovery). Although the net result for the economy will be nothing, the net result of those actions for individuals appears to be a redistribution of wealth in the economy. In the end, it becomes clear that the purpose of and reason for the exercise is not the good of the general public but rather advocacy of large financial institutions, political expediency and hubris. If that were not the case, then why would the Federal Reserve need to hire a veteran lobbyist (former Enron and Clinton administration employee) in navigating the use of their powers in the months following the financial crisis?

Hilltop Houses and Fifteen Cars

There is something god-like in the idea of creating something out of nothing – especially money – which fits with the progression of status among Federal Reserve (Fed) members. The idea that their stature and judgement is beyond reproach has been in play for some time.

Alan Greenspan: The absurd notion of central bankers as rock stars was popularized by Alan Greenspan. He achieved celebrity status by advancing in ways never before seen, the interventionism of the Federal Reserve. Some of his handiwork includes engineering a rapid recovery of the stock market following the Black Monday crash in 1987, the notoriety of uttering the term “irrational exuberance” in 1996, the front man on the cover of Time magazine as a member of “The Committee to Save the World”, having his name on a key market term – The Greenspan Put, and of course having a book published about him by the iconic Washington Post reporter and author Bob Woodward well before his tenure as Fed chief ended.  These are things now to which every Fed Chairman aspires – indeed, to which every central banker aspires.

Ben Bernanke: So desperate to follow suit after he stepped down as Fed Chairman in 2014, he could not wait for someone to write his story so he penned his own in the self-aggrandizing “Courage to Act”. In addition to well-paid fees for public appearances, his desperation for notoriety also extends to consulting for some of the most powerful hedge funds as well as blogging his perspectives from time-to-time. The legacy he is desperately trying to shape seems similar to the gilded stature Greenspan crafted for himself.

Janet Yellen: In her time as the Chairman, Yellen was the beneficiary of much good fortune and did nothing to make waves (or right the ship). As the New York Times reports, given her tenure presiding over a “plummeting unemployment rate and consistently low inflation, Ms. Yellen became a pop culture phenomenon.” Such hyperbole used to lobby for Janet Yellen’s rock star status is derisory. The health of the organic economy is contrived by the over-use of debt. The disparity between the rich and poor has never been wider as Yellen assisted in hollowing out the middle class by adhering to a “saver-punishing” low-rate policy. Trickle down policy of boosting asset prices is surely benefitting the wealthy but to the detriment of society.  By myopically targeting traditional measures of inflation, she took latitude to continue crisis policies to print money and is complicit in the on-going accumulation of debt. The likelihood is that the failure to normalize monetary policy years ago has sown the seeds of the next crisis. Like Bernanke, how her role is cemented in history as one of those who are “great” among central bankers too will be determined by time and economic outcome.

Jerome Powell: Will the latest chairman of the Fed, Jerome Powell, have the courage to act? Vilified in the late 1970’s and early 1980’s for raising interest rates and temporarily choking off economic activity, Fed Chairman Paul Volcker had the character to sacrifice his own popularity and accept the short-term consequences in exchange for dramatic long-term economic benefits. He did it because arresting inflation was in the best interest of the country. Mr. Powell has a choice to make. He can do what’s best for the country or he too can aim to become a “pop culture phenomenon” and keep the charade going but he cannot do both.  Time will tell.

…Before the Fall

The modern day desire for individual notoriety and legacy among central bankers belies the purpose of the role they play in shaping the business cycle. Their influence on the trajectory of the economy should be so subtle as to scarcely be perceived. As was the case with McCabe, Martin and Burns, few should recognize their names. The incongruence of this passion among the power-elite who manage the printing presses of the world’s largest economies is akin to the contrast between pride and humility. Anyone who thinks themselves qualified to manage the monetary policy of the complex system of a major economy lacks requisite humility and is too deceived by pride to be thus qualified. A proud man is always looking down on things and people and, of course, as long as you are looking down, you cannot see that which is larger – the best interests of people or democracy

A Market Valuation That Defies Comparison

Comparing current equity valuations to prior valuation peaks such as those of 2008, 1999 or any other period is commonplace, but remains an essential way of assessing current market prospects and potential risks. Currently, seven of the eight traditional valuation techniques shown by Goldman Sachs below are in the upper strata of recent history.

The graph above, courtesy Goldman Sachs, is from August 2017. Since that time it is highly likely that all of those valuation levels have risen further.

In Second to None, published March 1, 2017, we opined that simply assessing valuation techniques, as shown above, is a great starting place for investors to gauge the present status of valuations. We added that it is equally important to normalize different periods of time to make their valuations comparable based on the level of economic growth which directly supports corporate profits. The result of our analysis shows that the current level of Cyclically Adjusted Price to Earnings (CAPE) is well above the levels of every other market peak, including 1999 and 1929. Essentially, investors are willing to pay more for each unit of economic growth today than at any time in modern history.

In this article, we update the data to reflect the current GDP adjusted CAPE and take it a step further to include the cyclical nature of corporate profit margins. When both adjustments are factored in, we gain a unique perspective that demonstrates the extent to which today’s valuations are, quite literally, off the charts.

GDP Trends

While the economy cycles from recession to growth and back, the long term economic growth trend, or secular GDP, has trended lower for the better part of the last 30 years. The graphs below show the cyclical short-term nature of economic growth (left) as well as the longer term trend (right).

Data Courtesy: St. Louis Federal Reserve (FRED)

There are a number of reasons for the long-term, downward growth trend about which we have written extensively. In a nutshell, the following are the three largest factors accounting for the deteriorating trend in growth:

  • Debt – The amount of federal, corporate and individual debt has consistently risen at a pace faster than economic growth. As such, many debtors are unable to borrow further to keep spending. Others are hampered by interest payments which crowd out spending. The Federal Reserve has used extraordinary policies to force interest rates to historic lows to counter the debt burden, but their actions have only bought time and incentivized even more debt. The debt problem, which we call the Lowest Common Denominator, has only worsened.
  • Demographics – Over the last 30 years, baby boomers provided a driving force for economic growth. As this outsized generation nears retirement, they will spend less and, in many instances, become a burden on the taxpayers that support them through social security and other entitlements. Additionally, slowing population growth and tightened restrictions on immigration are reducing the number of workers and consumers that can contribute to economic growth.
  • Productivity – Partially as a result of years of poor economic, fiscal and monetary policy that dis-incentivized long-term investment in favor of consumption, the rate of productivity growth, the lifeline of economic growth is nearing zero.

It is primarily these three reasons and their longer-term projections that make us nearly certain that secular economic growth will continue to weaken in the years ahead. That does not mean there will not be periods of stronger growth. However, given that few of our nation’s leaders truly understand what drives sustainable economic growth and even fewer have the courage required to reverse the trends, we see little reason to expect change.

Given our assumption that long-term economic trends are likely to persist, we believe it is necessary to use economic growth to normalize current equity valuations to compare them to prior periods.  The following graph is an updated version of the one shown in Second to None.  It plots CAPE divided by the trailing ten-year growth rate of nominal GDP.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that the graph above and all of the graphs normalizing CAPE in this article, unlike the one presented in Second to None, are scaled by multiples of the average on the y-axis instead of the calculated number. The rationale being that the purpose of the analysis is not to provide a concrete numerical data point, but a comparative measure that allows one to relate valuations over many different economic environments. As an example the current reading is 2.86, meaning market valuations using this measure are 2.86 times higher than the average since 1956.

The two potential arguments against this type of analysis are likely from those that disagree with our longer-term growth forecast or those that agree with us but believe that we should exclude data from the financial crisis of 2008 as it was far from the norm.

For those that think economic growth will be better than the trend of the last thirty years, you should be aware that a ten-year growth rate of 8.21% is required to bring the adjusted valuation to its long-term mean. Such a ten-year growth rate has not been witnessed since 1987 and is nearly 2% greater than the average over the last 70 years.

For those that think excluding 2008 is appropriate, we calculated a seven-year CAPE divided by seven-year growth. While the current level using this time frame is not as egregious, it is two times that of the average over the last 70 years and only slightly lower than the peak established in the year 2000.  We remind those in this camp that the current economic expansion has lasted 103 months, almost twice the average since 1945. The longest expansion during this period was 120 months. No one knows when a correction will come, but we are clearly in the later stages of the cycle unless one assumes that the laws of mean reversion have been permanently suspended for both valuations and economic cycles.

Margins are Cyclical

Corporate profit margins, or the difference between sales and net profits, are considered one of the most cyclical fundamental measures that exist. The reason is that, when margins are high in certain industries, new entrants are lured to those industries by the higher margins. Conversely, when margins are low, companies exit those industries and those remaining companies can increase margins. The graph below shows the cyclical nature of corporate margins since 1948.

Data Courtesy: St. Louis Federal Reserve (FRED)

When margins are higher or lower than average, it makes sense to assume they will revert to the mean over time. Therefore, the rationale and logic for normalizing CAPE based on current margins and its historical tendency, provides a valuation level, as shown below, that is comparable to other periods.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that in the first graph showing historical margins that margins over the last 70 years appear to have broken the cyclical pattern and have stayed well above the average for an extended period. Many stock promoters believe this is a reflection of a “new normal” and cheer such a feat. They may be correct, but you might also want to consider that if margins have risen to a new level and are not cyclical anymore, the age-old incentives that drive business decisions in a free market economy no longer exist.  If that is the case, we may also want to consider that capitalism may be broken. If capitalism is in fact eroding, do you really want to pay a high premium for stocks? To help answer that question, we suggest a quick review of the gross economic inefficiencies of those nations where capitalism is not employed.

Comparative CAPE

We believe that durable longer-term economic trends and profit margins should be used to normalize CAPE and again make it comparable to prior periods. The graph below presents CAPE adjusted for both.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

The graph above highlights that valuations using this measure dwarf any prior valuation peak since at least the 1950’s. At over 350% above the mean, stock investors are currently paying significantly more for a unit of economic growth than at any time in the last 70 years. To extend the analysis, we estimated the adjusted CAPE level of 1929, as shown on the graph, and come to the same conclusion.


Most astute investors know that stock valuations are at or near historical highs. Even these investors, however, may be unaware that today’s valuations, when adjusted for the level of economic growth and heightened profit margins, defy comparison with any prior period since the Great Depression. The simple fact is that investors are paying over three times the average and almost twice as much as the prior peak for a dollar of economic growth. Furthermore, it is happening at a time when we are clearly late in the economic cycle and the outlook for growth, even if one is optimistic, is well below that required to justify such a level.  

Fundamental valuations are a great means of understanding the potential value or lack thereof in a market or individual stock. However, it is a poor short-term trading tool. There is no doubt that, in time, valuations will revert to the norm. This can occur via sharp earnings increases or slower earnings growth accompanied by years of price stagnation. It can also transpire, as it has in the past, with a sharp drawdown in equity prices. Regardless of how you think this resolves itself, we hope this valuation technique provides another helpful tool for assessing the proper risk and reward tradeoff offered by markets currently.

Second To None – A Primer

Today’s equity market valuations have only been eclipsed by those of 1929, and 1999.”

In March of 2017, we examined traditional equity valuations in a new light to help better compare today’s valuations versus those of past business cycles. In particular, we adjusted the popular price-to-earnings (P/E) ratio for economic growth trends. The logic backing the analysis is that investors should be willing to pay a larger premium if economic growth is strong, and therefore corporate earnings are higher, and vice versa if economic growth is comparatively weak. The premise is similar to the popular price-to-earnings growth (PEG) ratio commonly used by equity investors. While P/E assesses the value of a stock on the basis of trailing earnings, PEG is more forward-looking using the expected growth of earnings. Essentially, the ratio tells us how much a current investor is willing to pay for a unit of expected earnings.

This re-publication of Second to None is intended to revisit a variety of key points as a base of understanding for an upcoming article. Given the extent to which markets have moved over the past several months, updating this analysis is timely. Further, the upcoming article will broaden the discussion to include a second important driver of corporate earnings and therefore provide fresh perspectives on valuations. We are confident you will find it compelling, so stay tuned.

Given the continuing equity market rally and multiple expansion, the quote above from prior articles, had to be modified slightly but meaningfully. As of today, the S&P 500 Cyclically Adjusted Price to Earnings ratio (CAPE) is on par with 1929. It has only been surpassed in the late 1990’s tech boom.

A simple comparison of P/E or other valuation metrics from one period to another is not necessarily reasonable as discussed in Great Expectations. That approach is too one-dimensional.   This article elaborates on that concept and is used to compare current valuations and those of 1999 to their respective fundamental factors.  The approach highlights that, even though current valuation measures are not as extreme as in 1999, today’s economic underpinnings are not as robust as they were then. Such perspective allows for a unique quantification, a comparison of valuations and economic activity, to show that today’s P/E ratio might be more overvalued than those observed in 1999.

Secular GDP Trends

Equity valuations are a mathematical reflection of a claim on the future cash flows of a corporation. When one evaluates a stock, earnings potential is compared to the price at which the stock is offered. In most cases, investors are willing to pay a multiple of a company’s future earnings stream. When the prospects for earnings growth are high, the multiple tends to be larger than when growth prospects are diminished.

To forecast earnings growth for a company, one needs to do an in-depth analysis of the corporation, the economy and the markets in which it operates. However, evaluating earnings growth for an index comprising many companies, such as the S&P 500, is a relatively straight-forward task.

Corporate earnings are a byproduct of economic activity. Earnings growth can differ from economic growth for periods of time, but in the long run aggregate earnings growth and GDP growth are highly correlated.  The two graphs below offer an illustration of the durability of this relationship. The graph on the left plots three-year average GDP growth and its trend since 1952, while the graph on the right highlights the correlation of GDP to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED), Bureau of Economic Analysis (BEA) and Bloomberg

Given the declining trend of GDP and the correlation of earnings to GDP, it is fair to deduce that GDP and earnings growth trends were healthier in the late 1990’s than they are today. More specifically, the following table details key economic and financial data comparing the two periods.

Data Courtesy: St. Louis Federal Reserve (FRED), and Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

As shown, economic growth in the late 1990’s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. Trailing three- five- and ten-year annual earnings growth rates contrast the current stagnant economic growth versus the robust growth of the 90’s. Additionally, various measures of debt have ballooned to levels that are constricting economic growth and productivity. Historically low interest rates are reflective of the current state of economic stagnation.

The graph below charts price-to-earnings (CAPE) divided by the secular GDP growth (ten-year average), allowing for a proper comparison of valuations to fundamentals.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

The current ratio of CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. At the current level, it is over three times the average for the last 66 years.  Further, based on data going back to 1900, the only time today’s ratio was eclipsed was in 1933. Due to the Great Depression, GDP at that time for the preceding ten years was close to zero. So, despite a significantly deflated P/E multiple, the ratio of CAPE to GDP was extreme. Looking forward, if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35% from current levels to reach its long term average versus GDP growth.


Equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered against a backdrop of economic factors, those valuations seem relatively tame versus today. Some will likely argue with this analysis and claim that Donald Trump’s pro-growth agenda will invigorate the outlook for the economy and corporate earnings. While that is a possibility, that argument is highly speculative as such policies face numerous headwinds along the path to implementation.

Economic, demographic and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and is growing by the day. Policies that rely on more debt to fuel economic growth are likely not the answer. Until the disciplines of the Virtuous Cycle are understood and followed, we hold little hope that substantial economic growth can be sustained for any meaningful period. Given such a stagnant economic outlook, there is little justification for paying such a historically steep premium for what could likely be feeble earnings growth for years to come.

For Your Consideration

Consider the following:

  1. The current U.S. economic expansion has lasted 103 months and counting. Based on data since 1945 covering 11 business cycles, the average is 58 months and the longest was 120 months (1991-2001).
  2. The unemployment rate is at 4.1%, the lowest level since January 2001.
  3. For the first time on record, the S&P 500 produced positive total returns in each month of last year.
  4. The S&P CoreLogic Case-Shiller 20-City Home Price Index is at 203.84, the highest level since December 2006 and less than 3 points shy of the all-time high seen at the peak of the housing bubble in July 2006.
  5. Small Business Optimism is at the highest level since September 1983 and the Michigan Current Consumer Sentiment gauge is at 17-year highs.
  6. Recent corporate earnings growth is strong at 9-10% and running above the historical average (6%).
  7. Tax reform legislation reduces taxes for corporations from a statutory rate of 39% to 21%.
  8. The current U.S. Consumer Price Index is 2.1% and 1.8% excluding-food and energy.
  9. The Federal Reserve is planning to adhere to a gradual series of rate hikes and balance sheet reduction over the coming year.
  10. The market currently expects 2 to 3, 25 basis point rate hikes in 2018, which would bring the Fed Funds rate to just over 2.00%.
  11. The Federal Reserve loses 44 years of policy-making experience with the departures of Yellen, Fischer, Dudley and Lockhart.
  12. Geopolitical risks are more extensive than any year in recent memory. Problems include instability in Sub-Saharan Africa, Southern Asia and the United Kingdom as well as friction between the U.S. and North Korea, Iran, Mexico and China.

After what we observed in 2017, another year of complacency measured by record low volatility and high valuations cannot be ruled out. That said, mean reversion remains part of the natural order and every day that elapses brings us another day closer to the eventuality of a regime shift. Changes in monetary policy, fiscal policy and Fed leadership have historically been quite volatile for markets, although the term of Janet Yellen was an exception. Also, according to Eurasia Group’s Ian Bremmer, “The markets don’t recognize it. They’re hitting records on a regular basis. The global economy feels pretty good, but geopolitically we are in the midst of a deep recession.” Heightened geopolitical risks have the potential to stir up the volatility pot and markets are not priced for any of those probabilities.

Markets have remained remarkably stable despite numerous geopolitical concerns throughout the past year. Based on the information provided above, it appears as though markets may be underpricing expectations for interest rate moves given the obvious dynamics between global growth, low rates, swollen balance sheets and market valuations. Yet the paradigm of the Fed as inflation fighters has long since passed, and the concern now remains defending against the evil windmills of deflation. The new Federal Open Market Committee (FOMC) will try to remain vigilant, but any unexpected uptick in inflation may spook them into moving back toward their natural inclination as inflation fighters. Given the shifting winds of Fed policy from easier to less easy, the markets’ failure to acknowledge the risks of a quicker tightening pace and the sensitivities of the debt-bloated economy to higher interest rates, our concerns remain in the arena of some difficult changes occurring sooner rather than later.

The same divergent dynamic exists on the geopolitical side of the equation. Often characterized as exogenous risks, they can be especially combustible when markets become as complacent as they apparently are today. The important message for investors is to remain vigilant about assessing risks and avoid being lulled into the groupthink trap. This is especially true as the consensus perspective becomes increasingly one-sided. Risks and consensus have both reached extremes and should be given proper consideration.

Cause when life looks like easy street, there is danger at your door.”  – Grateful Dead

The Only Benchmark of Wealth

The New England Patriots are the winningest professional football team of the new millennia. While we could post a long list of reasons for their success, there is one that stands above the rest. In a recent interview, Patriots quarterback Tom Brady stated that they start each year with one goal; win the Super Bowl. Unlike many other teams, the Patriots do not settle for a better record than last year or improved statistics. Their single-minded goal is absolute and crystal clear to everyone on the team. It provides a framework and benchmark to help them coach, manage and play for success.

Interestingly, when most individuals, and many institutions for that matter, think about their investment goals, they have hopes of achieving Super Bowl like returns. Despite their well-intentioned ambitions, they manage their portfolios based on benchmarks that are not relevant to their goals. In this paper, we introduce a simple investment benchmark that simplifies the tracking process toward goals which if achieved, provide certitude that one’s long-term objectives will be met.

The S&P 500

Almost all investors benchmark their returns, manage their assets and ultimately measure their success based on the value of a stock, bond or blended index(s). The most common investor benchmark is the S&P 500, a measure of the return of 500 large-cap domestic stocks.

Our belief is that the performance of the S&P 500 and your retirement goals are unrelated. The typical counter-argument claims that the S&P 500 tends to be well correlated with economic growth and is a valid benchmark for individual portfolio performance and wealth. While that theory can be easily challenged over the past decade the question remains: Is economic growth a more valid benchmark than achieving a desired retirement goal?  Additionally, there are long periods like today where the divergence between stock prices and underlying economic fundamentals are grossly askew. These variances result in long periods when stock market performance can vary greatly from economic activity.

Even if we have a very long investment time frame and are willing to ignore the large variances between price and valuation, there is a much bigger problem to examine. Consider the following question: If you are promised a consistent annualized return of 10% from today until your retirement, will that allow you to meet your retirement goals?

Inflation and Purchasing Power

Regardless of your answer, we are willing to bet that most people perform a similar analysis. Compound current wealth by 10% annually to arrive at a future portfolio value and then determine if that is enough for the retirement need in mind. Simple enough, but this calculus fails to consider an issue of vital importance. What if inflation were to run at an 11% annual rate from today until your retirement date?  Your portfolio value will have increased nicely by retirement, but your wealth in real terms, measured by your purchasing power, will be less than it is today. Now, suppose you were offered annual returns equal to the annual rate of inflation (the consumer price index or CPI) plus 3%.

Based on 2017 CPI of approximately 2% for a total return of approximately 5% compared to almost 20% for the S&P 500, we venture to say that many readers would be reluctant to accept such an “unsexy” proposition. Whether a premium of 3% is the right number for you is up for debate, but what is not debatable is that a return based on inflation, regardless of the performance of popular indexes, is a much more effective determinant of future wealth and purchasing power.

To show why this concept is so important, consider the situation of an investor with plans to retire in 25 years. Our investor has $600,000 to invest and believes that he will need $1,500,000 based on today’s purchasing power, to allow him to live comfortably for the remainder of his life. To achieve this goal, he must seek an annualized return of at least 4.50%. As a point of reference, the total return of the S&P 500 is 6.60% over the past 100 years. At first blush our investor, given his relatively long time frame until retirement, might think the odds are good that the S&P 500 will allow him to achieve his retirement goal. However, his failure to factor in inflation causes his calculations to be incorrect. Since 1917, inflation has averaged 3.09%. The S&P 500 total return since 1917 including the effect of inflation is only 3.51%. The odds are not in his favor, and his oversight may ultimately leave him in a difficult situation.

The graph below shows the resulting 25 year total returns based on each monthly starting point since 1917. The red line shows our investor’s goal of 4.50%. Keep in mind that since the graph requires 25 years of data, the last data point on the graph is December 1992.

Over the time frame illustrated, the investor was subjected to anxiety-inducing random high and lows relative to his target return. His portfolio performance is a flag in the wind at the mercy of the volatility of the equity markets.

Instead of rolling the dice like an investor managing and benchmarking towards the S&P 500, why not manage your portfolio based on an index that will properly target a dollar amount of purchasing power in the future? In our prior example, achieving a benchmark of the annual rate of CPI plus 4.50% would allow our investor to retire with at least $1,500,000 in today’s purchasing power.

Inflation based indexing

Unlike benchmarking to a popularly traded equity or bond index using ETFs and mutual funds, managing to an inflation-linked benchmark is more difficult. It requires an outcome-oriented approach that considers fundamentals and technical analysis across a wide range of asset classes. At times, alternative strategies might be necessary or prudent. Further, and maybe most importantly, one must check one’s ego at the door, as returns can vary widely from those of one’s neighbors. The challenge of this approach explains why most individuals and investment professionals do not subscribe to it. It is far easier to succeed or fail with the crowd than to take an unconventional path that demands rigor.

The reward for using the proper index and successfully matching or exceeding it is certitude. The CPI-plus benchmark approach described here is far more honest and durable in its ability to compound wealth and show definitive progress. It is deliberate and does not hand over control of the outcome to the whim of the market. It also requires an investor to avoid the hype and distractions that continually surround the day-to-day movements of the stock market.


We understand the difficulty in achieving one’s financial goals, especially in today’s unique environment of low-interest rates and high stock market valuations. Why compound the difficulty by managing your wealth to the random volatility of an index or benchmark that is different from your goals? Matching the performance of the S&P 500 is cheap and easy for a reason. It is also irrelevant to compounding wealth as it ignores important aspects of the wealth management process such as avoiding large and wealth-debilitating drawdowns.

Meeting your goals requires a logical and deliberate strategy guided by a set of rules that few investors understand. There is a reason many investors and retirees are failing to meet their goals. Using a reliable but different approach will help ensure that you don’t end up as one of them.

Investment Outlook 2018

The following outlook provides our investment thoughts for the coming year. We did not include specific recommended asset allocation weightings for the major asset classes, as they will be part of Real Investment Advice premium services.  If you would like to receive pre-launch information on our new services just send us your email address.

Market Fundamentals

The confluence of improving synchronous economic global growth and hyper-inflating asset markets is urging central bankers to pause extraordinary policies and, in many cases, begin reversing them. While not obvious to most, monetary policy error has been in play since quantitative easing commenced in 2009, but the consequences will not appear until future central bank actions to raise interest rates and reduce their balance sheets affects commerce. The yield curve, credit spreads, and financial conditions can provide indications of when this may occur.

Market Fundamentals Commentary

Record highs in stocks, near-record lows in bond yields and historically tight credit spreads present significant challenges for investors. Economic data has improved, but many fundamental economic gauges remain soft relative to pre-crisis averages and inconsistent with asset price levels and valuations. Most investors do not seem at all concerned as money continues to move into risky asset classes, a classic sign of a bubble. While a defensive posture seems prudent, the technical picture remains supportive of further gains. One should respect the momentum behind these moves for the foreseeable future but be mindful that liquidity can evaporate quickly.

The primary investment theme remains “buy the dip.” That approach has worked amazingly well, a testament to the sustained strength of markets. Thanks in no small part to gradualism from the Fed on interest rate and balance sheet normalization, the blind assumption is that the favorable trajectory of risk assets can be endlessly extrapolated into the future.

There is a distinct difference between taking a defensive posture and a negative one. Remaining full-bore aggressively long at this juncture is a speculative endeavor akin to letting our kids play in the median of a busy highway. Proper care and stewardship of wealth means being protective and forward-looking to avoid large losses.

“The peer pressure and career risk of bolstering one’s defenses in a Pamplona-style bull run are palatable, but wealth is most effectively compounded by avoiding large losses not chasing returns with the irrationally exuberant. Many investors and others are stumbling confidently forward playing the role of the genius in a bull market.  The prudent manager worries about the trifles of liquidity at a time when it is so plentiful it seems unreasonable to worry.  Liquidity comes at a cost, but excess liquidity in times of crisis offers both priceless protection and clear-headed decision-making opportunities that are rare indeed.” –Liquidity Defined 12/14/2017 –The Unseen

Outlier scenario – The market is far more sensitive to changes in interest rates than currently perceived. If the Fed continues to increase the Fed Funds rate and reduce their balance sheet in response to low unemployment and moderate levels of inflation, economic activity will decline. The result is a recession that initiates the unwinding of leverage accumulated in the system compounded by and revealing many layers of hidden risks.

Federal Reserve Outlook

The Fed gets new leadership early in the year in Jerome Powell, but he appears to be using the same playbook as Janet Yellen.

  • Yield curve flattening
  • Financial conditions will eventually become less favorable
  • U.S. dollar stable at the low end of a 3-year range and supportive of future Fed policy

Federal Reserve Commentary

Given his time as a Fed board member and non-controversial positions on policy, Fed Chair nominee Jerome Powell should have no trouble being confirmed. He echoes many of Janet Yellen’s perspectives, and his demonstrated comportment is similar to that of the post-GFC era Chairmen. In the near-term, such a status quo transition is constructive for risk markets. However, the lengthy duration of the current economic cycle and the lofty valuations present when Powell assumes command make it hard to argue that the current environment is stable.

Outlier scenario – The inability of the Fed to effectively respond to a weaker economy due to elevated levels of inflation and/or a dramatically weaker U.S. dollar alters market expectations about the Fed “put” that has been in place for the past 30 years.

Bond Markets

Yield curve flatter as Fed interest rate hikes continue but inflation remains tame/below target

  • Debt levels continue to weigh on economic growth and inflation dynamics
  • Growing debt due to fiscal policy/tax cuts heightens concerns
  • Shortage of quality collateral and rate differential keeps long-term interest rates low

Bond Markets Commentary

U.S. Treasury yields are bi-polar. Short maturity yields are rising with Fed rate hikes while long-maturity yields are stable to lower. This dynamic produces a flattening of the yield curve revealing short-term optimism and long-term doubt. On an absolute basis, yields remain very low. The 2-year Treasury yield is 1.82% while the 10-year yield is 2.40%. The 2s-10s yield curve spread resides at the lowest level (0.58%) since the financial crisis of 2008.

Investors looking for income in the safety of the Treasury market will die of thirst long before achieving their targets. Accordingly, many investors are reaching for additional yield in riskier categories, namely high yield credit and dividend-paying stocks. This game has been going on for a long time. Despite the relative yield enhancement those alternatives offer, the question of whether or not an investor is appropriately rewarded for taking that risk still exists.

Non-investment grade, or “junk” bond, yields range from 4% to 10%, depending on the company and sector, with the overall average yield at about 5.75%. A bond is relegated to junk status precisely because of the elevated risk of default. At current market yields, junk bonds pose an inordinate threat of record low recovery value and terminal realized yield. Using the average yield for junk bonds of 5.75%, an average default rate of 5% and a generous recovery rate of 50%, a high yield debt portfolio is mathematically identical to a risk-free asset with a yield of 3.25%. That amounts to a risk-adjusted premium of only 0.85% over 10-year Treasuries (3.25 – 2.40). A yield pickup of less than 1% is hardly compelling, especially when one considers the downside from current valuation levels is immense.

Investors who think they get a nice yield boost from owning high yield debt are not considering the risk-adjusted outcomes. The risk-adjusted premium over Treasuries should be at least 200 to 300 basis points. Fixed income portfolio allocations should reside predominantly in the defensive havens of high-quality sovereign, well selected municipal and investment-grade corporate bonds. We recommend no allocation to junk.

Outlier scenario – Rising debt levels, inflation and global concerns over future monetary policy causes interest rates to rise as marginal buyers (Japan, China, Saudi Arabia, etc.) turn to sellers to reduce U.S. debt and U.S. dollar exposure. A disorderly rise in interest rates creates sudden distress and defaults in credit markets.

Stock markets

Markets remain supported as financial conditions are historically ultra-easy, despite the recent interest rate hikes

  • Valuations are stretched to extremes
  • Investors are conditioned to such valuations and insensitive to history
  • Momentum and lack of viable investment options helps the market retain a bid
  • Problems emerge when higher short-term rates have a constricting economic effect

Stock Market Commentary

There are several measures used to justify current valuations, but they sound similar to those used in the dot-com Tech bubble. The relationships between valuation and fundamentals, on which cash flows are ultimately based, are grossly dislocated. Markets may well move higher, but to advocate a full allocation to equities under current circumstances ignores warnings of bubbles past. Stock market cap-to-GDP, price-to-sales, margin balances, cyclically-adjusted price-to-earnings ratios (CAPE), and others argue convincingly that the stock market is either near historic valuations or well through them. Owning well-selected, single-name companies because they are fundamentally cheap, not relatively cheap, makes sense.  Otherwise, limiting general equity allocation exposures is prudent until reasonable opportunities return. We suggest setting stop losses and/or options strategies to help limit downside risk and retain any additional upside.

Outlier scenario – Realization and acknowledgment that valuations are high and concern over future returns sparks initial selling as the market begins to collapse under its own weight. This sets off a broad exodus out of risky assets for similar reasons.


Currencies remain the pressure release valve for money printing and monetary malfeasance.

  • GBP at risk to weaken further as Brexit talks continue to languish
  • Growth in Europe, slow policy response by ECB and political turmoil in Germany point to a weaker Euro
  • US dollar stable/stronger in response to GBP and EUR

FX Commentary

The precedent set since the financial crisis suggests one wants to steer away from currencies likely to be devalued for purposes of supporting and manipulating asset prices. The problem with that plan is that all developed world economies are guilty of money-printing schemes. Further, it seems inevitable that they will most likely take this short cut once again should problems re-emerge. The most dominant and liquid currencies are those most susceptible to active and intentional devaluation.

Europe’s banking system, though improving, still has significant exposures to possible defaults and therefore the potential for bank failures and government bailouts. Australia and Canada have rather large housing market bubbles that probably will not escape punishment in the next downturn. China remains both a communist regime and a pretender on the stage of free markets. The United States has somehow developed a sick pride in unconventional monetary policies and, given the U.S. dollar’s reserve currency status, will be called upon to conjure liquidity in times of distress. Given that the safest currencies tend to reside in stable nations with strong economies, it is not difficult to see why the U.S. dollar has historically been a safe-haven currency.  While muscle-memory argues that the dollar retains safe-haven status in the next crisis, other factors may come in to play and upend much of what has historically held true. Other durable alternatives include the Singapore dollar, the Norwegian krone and the Polish zloty.  Finally, the immutable status of gold as money is indisputable, despite decades of efforts from central bankers to discredit its durability. Warren Buffet was wrong to classify gold as an asset as it is the ultimate alternate currency. Given the proclivity of central bankers to print digital dollars, insurance in the form of gold and gold miners warrants consideration in a portfolio.

The Bitcoin hype is a speculative phenomenon but one well-timed as it further reflects the lack of trust in central bankers. We do not consider Bitcoin or any other crypto-currency as a replacement for gold, but we are not averse to reasonable alternatives to traditional fiat currencies.

Outlier scenario – The Federal Reserve’s willingness to print money to bailout banks following the last financial crisis raises concerns going forward about U.S. dollar stability. Those reservations cause traditional sponsors of the U.S. dollar financed economy (China, Japan, Saudi Arabia) to reduce their dollar holdings thus inciting volatility and resulting in a precipitous decline in the world’s reserve currency.


Comparative weakness in commodities and strength in equities is signaling a rare long-term buying opportunity.

  • Gold, crude oil, and copper among other key hard and soft commodities that have been relatively cheap for some time
  • Natural resources not only reflect value but act as a sound hedge against central bank interventionism
  • China’s debt growth, excess capacity, and property bubble raise concerns, putting pressure on Australia, Latin America, and Near-term commodity upside limited

Commodities Commentary

The extent to which crude oil and energy companies have languished since the 2014 peak in crude prices suggests there are opportunities in the stocks and/or bonds of those companies. That said, there is no way around doing the appropriate work to find those opportunities. Energy-related Exchange-Traded Funds (ETFs) tend to include a lot of speculative companies unfit for a defensive stance, which makes it difficult to take a generalized ETF approach. If the Fed does what they do best (print money), then natural resource companies now trading at a relative discount to other sectors of the economy stand to be terrific value plays into the future. There is certainly a risk, but the downside should be limited for the equities and bonds of good, undervalued companies.

Broadly, commodities are currently at a unique value point relative to stocks. A portfolio allocation overweight in resource companies may present some volatility but should be a good long-term position to have and add to as the economic cycle progresses.

Further, commodities provide a hedge against inflation. While not on the horizon, inflation could force central banks to halt money printing policies with severe effects for asset markets driven by those same policies. Investments in the resource/commodity sector can take the form of good equity selections or, even better, discounted bonds of companies offering above average yields to reinforce durable contracted cash flow returns.

Outlier scenario – Similar to gold, in the event of a suddenly unfolding crisis, the demand for natural resources surges as uncertainty about financial assets and central bank responses cause many to use hard and soft commodities as an alternative source of safe haven.

Emerging Markets (EM)

Dependent on trade-based commerce, EMs benefiting from synchronous global growth.

  • Durability of export-led growth key to outlook
  • EM countries are hurt by US dollar strength
  • Rising short-term interest rates in the US and issues emanating from China will begin to expose a variety of EM imbalances

Emerging Markets Commentary:

Emerging market economies tend to be inherently volatile, unstable and marred by crises. Although those risks remain in play, select emerging market countries may offer comparative stability and excellent return opportunities in the next year. An improving trend in emerging market performance fully developed in 2017, and a continuation of this trend has sound historical precedence. That said, there is still plenty of risk and uncertainty especially within the context of a broad global destabilization. A portfolio allocation to EM stocks through funds tracking the MSCI Emerging Markets Index should offer a return boost if we are to have another year of low volatility. On the other hand, if 2018 proves to be turbulent, this exposure will certainly detract from returns. Dollar strength tends to play a big role in EM returns. Any sustained U.S. dollar strength, especially if accompanied by a global economic downturn, is a strong signal to exit these positions. Portfolio weighting is important, and accordingly, a modest level properly sizes the exposure relative to uncertainties.

Outlier scenario – With developed stock and bond markets fully valued due to central bank intervention, the emerging markets become a value option not found in many other categories. Fundamentals and momentum align to spur a historic rally relative to developed markets, but vigilance is important.

Squeezing the Consumer from Both Sides

The Federal Reserve raised the Federal Funds rate on December 13, 2017, marking the fifth increase over the last two years.  Even with interest rates remaining at historically low levels, the Fed’s actions are resulting in greater interest expense for short-term and floating rate borrowers. The effect of this was evident in last week’s Producer Price Inflation (PPI) report from the Bureau of Labor Statistics (BLS). Within the report was the following commentary:

About half of the November rise in the index for final demand services can be traced to prices for loan services (partial), which increased 3.1 percent.”

While there are many ways in which higher interest rates affect economic activity, the focus of this article is the effect on the consumer.  With personal consumption representing about 70% of economic activity, higher interest rates can be a cost or a benefit depending on whether you are a borrower or a saver. For borrowers, as the interest expense of new and existing loans rises, some consumption is typically sacrificed as a higher percentage of budgets are allocated to meeting interest expense.  On the flip side, for those with savings, higher interest rates generate more wealth and thus provide a marginal boost to consumption as they have more money to spend.

This article focuses on borrowers and savers to show how the current interest rate cycle is squeezing consumers. Said differently, the rising cost of borrowing is dwarfing the benefit of saving.


As mentioned but worth repeating, personal consumption accounts for the bulk of economic activity. To gauge how higher interest rates might affect individuals’ spending, we classify personal debt into the following five categories: mortgages, home equity lines, auto loans, student loans and credit card debt. The following table shows the amount of debt outstanding in each category and estimates the percentage of each loan type that has fixed interest rates and floating interest rates.

Distinguishing between fixed and floating interest rates is important, as borrowers using fixed-rate loans are largely unaffected by higher interest rates. Accordingly, we focus this analysis on floating rate debt as those borrowers and consumers will see immediate increases in their interest expenses every time the Fed raises rates.

Based on the table, approximately $2.8 trillion of consumer loans outstanding are floating rate. We calculate that every 25 basis point (0.25%) interest rate hike by the Fed will increase interest expense higher by $7 billion annually for these consumers.  Since December 2015, when the Fed began to hike interest rates, the Fed Funds rate and other interest rates to which consumer debt is frequently indexed are about 125 basis points higher. Thus on an annual basis, the additional cost of borrowing is approximately $35 billion. Looking forward, if the Fed raises rates three times in 2018 as they currently forecast, the annual interest expense will increase by another $21 billion to bring the total to $56 billion per year.

The graph below charts Fed Funds, 3-month LIBOR, and average credit card rates to show the nearly perfect correlation between Fed actions and short-term borrowing rates. 3-month LIBOR is the index most frequently used to determine floating rate interest rates.

Data Courtesy: St. Louis Federal Reserve (FRED)


To do a complete analysis of the effect of higher rates on consumption, we must look beyond the increased interest costs, as quantified above, and also consider the benefits of higher interest rates to savers. According to the Fed, personal savings equals $471 billion. The increase in interest rates should reward savers, which will help offset the economic burden related to the increase in interest expense.

Interestingly, what should happen and what has happened are two different stories. The truth of the situation is that individual savers have barely benefited from higher rates as banks and financial intermediaries are not passing on higher rates to savers. The chart below provided by WalletHub and Wolfstreet.com compares the change in the Fed funds rates and credit card interest rates to instruments of savings. Please note the table does not include the most recent increase in rates on December 13, 2017.

To confirm the data in the chart, we searched for other sources of savings rate data. Data from the FDIC reports that bank savings rates, 3-month CD’s, money market accounts and interest checking rates have increased by 0, 3, 1, and 0 basis points respectively since the Fed began raising rates two years ago.

Based on the graph and the data above, it is fair to say that borrowers have benefited by less than ten basis points (0.10%) on average despite 125 basis points (1.25%) of interest rate increases. Based on total savings of $471 billion, we can approximate the benefit to borrowers is a mere $600 million.


Consumers are being squeezed. Debt linked to short-term interest rates is rising lockstep with the Federal Funds rate while savings rates remain stubbornly low. While the dollar amounts are not massive, the transmission mechanism of the Fed’s rate hikes is acting like a tightening vice that will result in less consumption and slower economic growth.

One of the key takeaways from the Fed’s action during and following the financial crisis of 2008 has been a prolonged and intentional effort aimed at crushing savers. Near zero percent savings rates is part of the Fed’s strategy to incentive savers to move out of the security of cash and invest in riskier assets and/or consume. Even today, despite the rise in interest rates, banks accept the benefits of higher rates imposed on borrowers while refusing to adjust rates for savers. As one of the primary regulators of the financial system, the Fed could encourage a change in that behavior, but to date, no such influence has even been mentioned. Interestingly, the savings rates that banks earn on deposits at the Fed has increased lockstep with Fed Funds.

After nearly a decade of imposing its unique brand of price controls over the cost of money, the Fed admittedly is not willing to do that which is in the best interest of the general public and continues to adhere to policies that favor their primary constituents, the big banks and major corporations.

Diversification Can’t Cure Overvaluation Disease

Real Investment Advice is pleased to share with you the first of what will be many articles from Peter Cook, CFA. Peter has worked as a leader in the global investment industry for almost 30 years.  He is an expert in how business cycles interact with financial market cycles, and has applied that expertise across asset classes in both traditional and alternative portfolio management.

Main Ideas:

  1. A traditional portfolio of stocks and bonds (i.e., what almost all investors are invested in) is extremely overvalued compared to historical norms.
  2. A strategy of investing in ETFs for the stock portion of a portfolio reduces the long-run cost of investing, but does not reduce the risk of a major loss during a bear market for stocks. A cost reduction strategy is different than a risk management strategy.
  3. The benefit of diversification achieved by investing in bonds depends on the level of interest rates. If interest rates are low (high), diversification benefits will be reduced (increased).  Today, interest rates are low, so the benefit of diversification is low.

Have you ever been asked to name your favorite song of all-time?  Children have a way of asking impossible questions like that.  Answering that question is impossible because a favorite song depends on the mood, the timing, and the events surrounding the time you heard it.  Some are favorites for the melody or the performer and others because of the associated memories.  The older you get and the more memories you have, the harder it is to identify only one favorite.  The unsatisfying answer for my son when he asks about my favorite song is that many can be my favorite, for different reasons at different times.

By analogy, in the investment world it should be impossible to find a single favorite chart of data that is clearly more important than others.   But the analogy doesn’t hold, because the most important chart in the investment world is shown below.  The following pages are devoted to explaining why.

Specifically, the chart shows the valuation of the largest 15 developed market stock and bond markets compared to all valuation levels in the past 200 years.  When the blue line is low, a portfolio of stocks are bonds is cheap compared to history.  When the blue line is high, a portfolio of stocks and bonds is expensive compared to history.

Most investment portfolios are composed of stocks and bonds because the outstanding amount of stocks and bonds dwarfs the amount of other available investment opportunities.  That’s true whether you are an individual with a 401(k) plan or a pension fund which invests billions of dollars.

That reality translates, in a practical sense, to some basic potential portfolio strategies.  The most common traditional portfolio contains a 60/40 split of stocks and bonds.   Some investors will adjust the ratio based on their age and income requirements.  More sophisticated investors will add private equity, commodities, or real estate to their portfolios to take advantage of specific investment opportunities.  But in almost all cases, stocks and bonds comprise the overwhelming majority of a portfolio.

Why does that matter?  Because the chart above shows that the valuation of a portfolio of stocks and bonds today is higher than it has ever been in the past 200+ years.   That is, a portfolio of stocks and bonds is more expensive than at any time in the past 200+ years.

But instead of recognizing the risk the chart poses, investors are much more likely to be swayed into a sense of safety by the two hottest concepts in finance; index investing and diversification.  While index investing and diversification are excellent investment concepts most of the time, they can offer a misleading sense of security some of the time.  The chart’s message is that we are at a “some of the time” point in history today.

Index Investing to the Rescue?

Considering the benefits of index investing, John Bogle, who for decades has popularized index investing as the head of Vanguard Funds, was quoted in 2011 as saying….

“My rule — and it’s good only about 99% of the time, so I have to be careful here — when these crises come along, the best rule you can possible follow is not ‘Don’t stand there, do something,’ but  ‘Don’t do something, stand there!’

In this case, Bogle was extolling the virtue of building a stock portfolio and staying invested for the long-term, regardless of short-term fluctuations.  But what happens during the 1% of the time Bogle referred to?  Can index investing save an investor from the peril of an extremely expensive portfolio?  The short answer is no.  Index investing can indeed reduce the cost of investing in stocks and bonds compared to investing in mutual funds or with a financial advisor, probably by ½-1% or so per annum.  That insight has made Bogle a very wealthy man.

The good news is that if index investing can save an investor ½-1% per year, a portfolio would be worth 5-10% more over 5-10 years.   Of course, during those 5-10 years, the investor must decipher the meaning of economic, political, and financial trends and how to adjust a stock and bond portfolio accordingly.  In a world of accelerating technological change, that is no small task.  Adding to the noise, there are almost as many opinions on markets as there are commentators, which can confuse any investor.  Regardless of these nuances, people who rely on indexes to grow their portfolios are making a bet that financial advice is not worth its price.

But the bad news is that an investor can build a portfolio of stock and bond indices, which guarantees they receive a “market return,” while being completely unaware that the portfolio is being built at the highest valuation in history.   Unfortunately, the “market return” includes stock market bear phases that occur every 5 years or so, in which the stock market loses 40-50% of its value.  With stocks and bonds as expensive as they currently are, it is conceivable that a bear market could produce losses greater than 40-50%.

For example, in the case of extreme valuations for technology stocks in 2000, the Nasdaq lost 80% in the following three years.  In the case of extreme real estate valuations in 2008, many bank and real-estate investments lost 100% of their value over two years.  Are stocks perceived as “can’t miss” today, just like technology and real estate stocks were back then?

The main point is that saving ½-1% per year in cost for advice could become miniscule compared to the potential for catastrophic losses by achieving the “market return” after a period of extreme overvaluation.  This point is not just theoretical.  In fact, the broad S&P 500 index lost 50% or more twice in the past 20 years; first in 2000-2003 and again in 2007-2009.  To demonstrate the danger of building a portfolio of stock indexes when valuations are extremely high, the chart below shows how a composite of global stock market index valuations have fluctuated over the past 200 years.

Focusing on the right side of the chart, the three peaks are the peaks in stock market index valuation that occurred in 2000 (internet bubble), 2007 (real estate bubble), and today (insert your own description).  In all three cases, stock valuations were in the 90% zone, which are similar to the peak last reached in 1929. In other words, stocks in 2000, 2007, and today are more expensive than they have been for 90% of the time over the past 200 years.   After the peaks in valuation in 2000 and 2007, broad stock market indices suffered multi-year declines, creating the possibility of a repeat in the current environment.

Locking in the market return by investing in a stock market index exposes an investor to the same severe losses any other stock market investor experiences.  Many of today’s investors remember what it felt like when their stock portfolios were cut in half by 2003 and 2009, but seem oblivious to that risk today.  In summary, building an indexed portfolio of stocks is an exercise in cost reduction but certainly not an exercise in risk management.

Diversification to the Rescue?

“Aha!” says the person familiar with the benefits of portfolio diversification, “that’s why I diversify my portfolio with stocks AND bonds.  Bonds always go up when stocks decline.  Plus, it is impossible to time the market. I invest in stocks because they always go up in the long run, and I diversify with bonds, just in case something bad happens to stocks in the short run.”

The good news is that bonds tended to rise in price in the past during bear markets in stocks, which provides some badly-needed upside when stocks are experiencing severe downside risk.   In the most recent example, a portfolio of long-term government bonds rose 30% during the bear market in stocks from 2007-2009. Unfortunately, investors do not typically invest their bond portfolios solely in long-term government bonds, so only a small portion of investors achieved big gains in bonds to offset their stock market losses.

The bad news is that simple mathematics can demonstrate there is a limit to how much bonds can rise in price.  One reason that long-term bonds could generate 30% gains in 2007-2009 is that interest rates began that period at 6% in the US and fell to 2-3%.  In addition, that portfolio of long-term bonds paid interest of 6% per annum, further increasing the total return on a bond portfolio during a prolonged bear market in stocks.

Today US long-term interest rates are at 2-3%, leaving little room for bond prices to appreciate further. In Europe and Japan, interest rates are near zero or even negative, leaving no room for bond prices to appreciate further.  How low are interest rates compared to historical norms? The chart below gives us the answer.  Composite interest rates for 15 developed bond markets have never been lower in the past 200 years.

The chart above demonstrates the limited upside for bond prices in the future, based on actual 2017 prices and yields.  An investor who buys bonds to diversify in case of a downturn in the stock market is really betting on bonds becoming even more overvalued relative to their historical norms.  While there is no law stipulating that bonds can’t become even more expensive, future price gains during a bear market in stocks will be limited, and almost cannot come anywhere near the 30% achieved by long-term government bonds during 2007-2009.  The main point is that the benefits of diversifying a stock portfolio with bonds are reduced when bond yields are already very low.

Investor Behavior to the Rescue?

Unfortunately, there is more potentially bad news when investing in stocks or bonds that are extremely expensive.  Data shows most investors didn’t heed their own advice of investing for the long-term when confronted with losses during 2007-2009, or for that matter any other bear market of the past century.  When a multi-year destruction of portfolio value occurs, at some point most investors discover their point of maximum financial pain/loss and sell the stock portfolios that have created the pain/loss.  It is impossible to “buy low, sell high” when you are “selling low.”

One reason for this behavior is that other forms of pain are occurring simultaneous to stock market losses, which are associated with economic recessions.  During recessions, a business might be in jeopardy, or a job might become much less secure.  Investors, when considering those sources of financial risk, are in fact much less diversified from a stock market decline than they think.  The main point is that any diversification program should not only consider the historical interaction between stock and bond prices; it should also consider the potential for a loss of employment income during a period in which stock prices decline.


At the risk of oversimplification, the most important chart in the investing world is the chart shown below, because it shows that investment portfolios of stocks and bonds are more highly valued today than at any time in history.  That fact alone should force an investor to reduce expectations for returns on a portfolio of stocks and bonds, including the possibility of negative returns over a time-horizon of 5-10 years.

For investors who think they can avoid significant losses by using ETFs to reduce the cost of stock market investing and who diversify by buying bonds to cushion the risk of stock market losses, the following should be considered:

  • Almost all portfolios are comprised primarily of stocks and bonds, so almost all investors in 2017 are holding portfolios at extremely high valuations. Your portfolio is probably just as risky as anyone else’s portfolio.
  • Investing in portfolios at extremely high valuations increases the probability of future losses if/when valuations eventually revert to the normal levels. Valuations might continue to rise to even more extreme levels, but that is a low-probability bet.
  • An index strategy is undertaken to reduce the costs of achieving the future’s “market return,” but achieving a “market return” at a reduced cost is not the same thing as a reducing the risk of a significant decline in stock market indices.
  • Bonds are typically used to diversify a portfolio from the risk of a severe stock market decline. But the benefit of diversification is reduced when interest rates are extremely low, as they are today.
  • The concept of diversification should be expanded to consider that a loss of employment or ownership income is likely to coincide with a period in which stocks are declining.

All of the graphs courtesy of Deutsche Bank

A Question for Every Investor

Recently we received the following question from a subscriber:

“If a correction in the stock or bond markets comes, the Central Banks will buy stocks with printed money, like the Japanese Central Bank, etc. Will there ever be a shakeout of the garbage and junk in the system? I am losing all confidence.” –Ron H.

Questions like Ron’s that suggest the decay of capitalism and free markets should raise concerns for anyone’s market thesis, bullish, bearish or agnostic. What stops a central bank from manipulating asset prices? When do they cross a line from marginal manipulation to absolute price control? Unfortunately, there are no concrete answers to these questions, but there are clues.

Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).

The central banks’ goals, in general, are threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

The wealth effect is putting riches in the hands of a small minority of the population, with negligible benefits, if any, flowing to the majority of the population. Bernanke’s version of the virtuous circle, as highlighted above, is far from virtuous unless you are in the upper five to ten percent of households by wealth.  To understand how a real economic virtuous circle works, we recommend you read our article The Death of the Virtuous Cycle and watch The Animated Virtuous Cycle.

Inflation has been low since 2008 and deflation continues to be a chief concern of most central bankers. Because QE, in all cases, was focused on financial asset prices and not the prices of everyday goods and services, the inflation they aimlessly seek has not occurred.

To summarize our views, largely ineffective monetary policies are providing few economic benefits. They are increasing the debt burden and furthering socially destabilizing trends. Worse, these policies are packed with consequences that lie dormant and have yet to emerge. One of our concerns, which is being heralded as a positive, is the massive distortions in financial asset prices worldwide. Consider a few of these facts below and whether they are sustainable:

  • U.S. yields have been among the lowest ever on record dating back to 1776
  • U.S. equity valuations have risen to levels rarely observed and from this perch have always been followed by massive losses
  • Over $9 trillion in sovereign bonds yields in many European countries and Japan have negative current yields
  • European junk-grade debt now trades at yields lower than U.S. Treasuries
  • Veolia, a French BBB rated company, recently issued a 3-year bond at a yield of -.026%.
  • Italian 3-year government bonds yield -0.337%, despite the 3rd highest debt to GDP ratio of all developed nations (132%)
  • Argentina, which has defaulted 6 times in the past 100 years, issued a $2.75 billion 100-year bond paying a paltry 8% interest
  • The BOJ owns over 75% of all Japanese ETFs
  • The Swiss National Bank owns 19.2 million shares of Apple, or 3% of total shares outstanding, and $84 billion in aggregate of U.S. stocks

Yes, Ron, the central bankers have clearly crossed the line between free markets and government controlled markets. To answer your question about the “shakeout,” we must wait until the inevitable day comes and asset prices are in free-fall. When this occurs, we will learn the full extent of their support and how far they have crossed the line. We like to think the central bankers are willing to endure the short-term pain of such a situation and allow the natural cycle of economies and asset prices to run their course. The reality, however, is that the pattern of their actions in the post-financial crisis era argue that they are unlikely to relinquish their grip. To the extent that authority and power is extended to the Fed through the U.S. Congress, it does not seem likely for career politicians to urge action that may be painful in the short-term but highly beneficial in the long-term.

This premonition was supported by recent statements from the October 2017 Federal Reserve minutes and appointed Fed Chairman Jerome Powell respectively. Fed Minutes:

“In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances,” further “They worried that a sharp reversal in asset prices could have damaging effects on the economy.” Jerome Powell, in prepared remarks to Congress stated: “(the Fed) will respond with force to threats to the nation’s stability.”

Putting two and two together, one can quickly figure out that falling asset prices and the “damaging effects” they will inflict on the economy will not be tolerated by the Fed. 

Ron, while we cannot answer your question with certainty, we are relatively confident the Fed and other central banks’ influence on markets will only increase in time as they continue to perpetuate the debt and economic problems they helped create. Naturally, the next question for consideration is to what extent markets may be bigger than the Fed? That is an article for another day.

We love reader questions. Please submit them to us and we will be happy to respond.

The Spurious Math Of A Tax Cut Rally

The term “priced in” is a phrase used frequently by Wall Street and the financial media. This expression is used to describe how much the price of stock or a market has accounted for an anticipated event. For example, consider a pharmaceutical stock that has risen 50% over the last few days on the prospects of getting regulatory approval for a new drug. If the collective “market” deems that the stock should increase a total of 100% if the drug is approved, then we can say the “market” has “priced in” a 50% chance the drug will be approved.

The term “market”, as used above, is vague. It is meant to represent the consensus view. Importantly to investors, it represents potential opportunity when an investor has a view that differs from the consensus.  If you were 100% certain the drug in the prior example would be approved, you could make a 50% gain on the stock if proven correct.

This article is a follow-up to one published November 29, 2017, Corporate Tax Cuts – The Seen and the Unseen. In that piece, we provided an analysis of the proposed corporate tax reduction that lies within the pending tax reform bill. We pointed out that, while investors appear focused on the benefits to corporations, they are grossly negligent ignoring the negative economic effects that higher individual taxes will have on consumption (70% of GDP) and the adverse influence of an additional $1.5 trillion deficit.

In this piece, we consider how the consensus is quantifying the positive effect the tax bill should have on stocks. Specifically, we discuss what is “priced in” to the market. This example, unlike that of the drug maker, is not black and white. However, by explaining how market projections are created, we offer guidance on how much the market has priced in for corporate tax cuts. This in turn offers investors a non-market opinion on what the corporate tax cut is worth and a basis to take appropriate actions.

To be clear, our view of the implications of this legislation are likely negative to GDP and therefore corporate earnings. That said, we also want to understand how the consensus views the proposal in order to form an opinion about how the market may trade. In due time the consequences of poorly constructed tax reform will appear but in the meantime, 720Global does not set the market price, the consensus does.

Corporate Tax Cuts

Since at least 1947, historical data has provided sufficient evidence to show that corporate tax reductions, subsidized by federal deficits and individual taxpayers, have resulted in slowing GDP growth. Accordingly, we believe that the current proposal will follow the path of prior tax reductions and result in weaker economic growth and ultimately lower corporate earnings than would have occurred without the legislation.

While our opinion, as stated above and detailed in the previously referenced article, differs widely from the “market”, we thought it might be helpful to provide a framework using the logic of most investors to value the corporate tax reduction.  The following paragraph from the article reviews our findings.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone should increase by almost $200 billion, while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%. Holding everything else constant, this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level.

We recently read an article in which the Swiss investment firm UBS claims “Stocks could surge 25% if the Republican tax bill passes.” Given the juxtaposition between the paragraph above and the UBS forecast, we wanted to walk you through the math and let you judge for yourself what investors think the tax cut is worth.

Valuation Math

The graph below compares corporate earnings with a tax cut (green line) to one without the cut (red line).  As a reminder, corporate earnings will be affected by the changes in the effective tax rate not the statutory rate. As such, we base our analysis on an expected decrease in the effective tax rate from the current level of 22% to 10%, and assume earnings in both cases grow at 5% a year.

The present value of the difference between the two lines above is the likely approach that most investors are using to price the value added from the tax plan. In turn, the present value figure of that differential yields a dollar premium that can then be added to the current price of the S&P 500 to arrive at an expected price after the tax cut. Based purely on the earnings shown in the graph, an investor looking to receive those cash flows would be indifferent between paying the current price for current earnings and paying the current price plus $285 per share or 2925 for the earnings benefiting from the tax cuts. The current price of the S&P 500 is 2640. Thus, investors that believe the tax cut will reduce the effective tax rate by 12% should expect the S&P 500 to increase by approximately 11%.

In order to validate our findings above, we take a different approach and quantify how the change in earnings would affect the price to earnings ratio (P/E). Currently, the one year trailing earnings for the S&P 500 are $107 per share and the P/E is 24.63. If earnings increased by 12% due to tax cuts, the P/E would decline to 21.99. If the market were to price in the increased earnings under the assumption that valuations are unchanged, the price of the S&P 500 would need to increase 12% to bring P/E back to its current level. This different approach delivers a very similar result.

Starting Line

Thus far, the analysis seems relatively straight forward, however there is another major concern when gauging how much of the tax bill is priced in to the market. We need to ask, “When did the market begin to price in the benefits of tax relief for corporations?”  Obviously it is impossible to pinpoint a date, but we selected three possibilities to show why this matters. The table below uses the night before the Presidential election, the date Congress began debating tax reform and the current date. The current price of 2640 allows us determine how much the S&P 500 has priced in.

As shown above, those that believe the tax deal has not been priced in and its passage will increase corporate valuations by 12% ought to expect a full adjustment in the price of the index from current levels. On the flip side, those that similarly believe the tax bill will boost valuations but believe this has been known by the market since the day Donald Trump was elected might expect a decline of 9.59%. They would argue the market has priced in a corporate tax reduction and then some. Another option is that in addition to tax cuts, the market is giving some consideration to other Trump policies that may be beneficial to the market such as regulatory reform. Although we try to isolate and quantify the effects of tax cuts, there are clearly many other dynamics in play.


UBS believes stocks are worth 25% more than current levels if proposed tax cuts become law. While we do not know how they arrived at such a large number, we can use our analysis above to solve for possible answers. Based on the framework of our analysis, it is likely that UBS thinks corporations will reap the entire 12% tax benefit and corporate earnings will grow 1.25% faster due to broad economic benefits stemming from the bill. Their assumption also implies that none of the 25% is priced in. In other words, the true gains due to the tax bill are likely even higher.

UBS clearly presumes the tax cut will benefit the corporate bottom line due to a decreased tax burden and will also spur economic growth. As we discussed in the aforementioned article, there is no precedent for such a claim. History does not support UBS’s case, nor does common sense. We also remind you that UBS makes money selling stocks. Despite spurious math, as a for-profit financial institution, their interests are well-served by pitching the idea of a big post-tax cut rally.

If you believe like we do that the benefits to corporate earnings are being grossly overestimated by the consensus you are at a distinct advantage. This does not mean you must sell all stocks and short the market immediately. It does however require you to proceed with caution, for when reality catches up with the consensus, market valuations could be at risk.

To reiterate a point we made in the prior article:

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them.”

Corporate Tax Cuts – The “Seen” & “Unseen”

Since Donald Trump was elected President, the S&P 500 has rallied over 21% or nearly 500 points. In our opinion, a good portion of the gain is attributable to his promise, as well as congressional efforts, to reform the tax code. In particular, the proposed sharp reduction in the corporate tax rate has the equity market’s attention. At first blush, the simple logic driving equity investors appears reasonable. Appearances, however, can be deceiving, and history is littered with failed investors that banked on a faulty thesis. As such, instead of tripping head first into that same category, we decided to assume nothing and look at the proposed reduction in the corporate tax rate and historical data to better understand how the legislation might affect the economy and corporate earnings.

Corporate Tax Rates

The graph below highlights the statutory and effective corporate tax rates since 1947.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The statutory tax rate is the legally mandated rate at which corporate profits are taxed. As shown above, the rate has been consistent over the last 75 years except for one significant change as a result of the Tax Reform Act of 1986.

The effective corporate tax rate is the actual tax rate companies’ pay. One can think of the statutory rate as similar to the MSRP sticker price on a new car. It provides guidance on cost but consumers always pay something less. The effective tax rate, like the “discounted” price one pays for a car, is the actual percentage of profits that corporations remitted to the government. This rate is calculated by dividing a company’s tax payments by their pre-tax profit. Deductions of all sorts reduce the pre-tax profit, thus creating a difference between the statutory and effective tax base and therefore the amount paid. For purposes of this article, we aggregate corporate tax receipts and corporate profits to calculate an effective rate for all corporations.

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone, should increase by almost $200 billion while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%.  Holding everything else constant this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level. It is impossible to assess how much of the gain since the election is due to tax reform expectations and how much is due to other factors, but we wager a good portion of it has been based on the promise of tax reform.


While the math and logic above seem sound, we can turn to historical data to understand the relationship between taxes and economic growth and profits. In doing this, we can better forecast the actual effects that lower corporate taxes might have on economic growth and corporate profits.

The graph below compares the effective corporate tax rate to the running three-year average GDP growth rate. The dotted trend lines smooth the data to allow for a clearer comparison.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As is clearly observable, GDP has trended lower at a very similar pace as the effective corporate tax rate. The graph below puts the data in a scatter plot format to evaluate the statistical relationship between corporate tax rates and economic growth rates.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The R² shown above (.3552), a statistical measure of correlation, is far from perfect, but there is a reason to believe that lower effective tax rates may partially explain the weakening trend in GDP growth.  Based on statistical regression, every 1% decrease in the effective tax rate should diminish GDP growth by 0.12%. 

The President, his economic team, and lawmakers are selling the tax bill with claims that a reduction in corporate taxes will boost economic growth. Based on data from the last 75 years, that has never been the case. In fact, the average annualized GDP growth rate in the five years before the major statutory tax reduction in 1986 was 3.90%. In the five years following the tax cut, the average annualized growth was reduced by more than half to 1.93%.

Next, we show a scatter plot comparing effective tax rates to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As measured by a R² of .051, the graph above shows that over the last 75 years, there has been no measurable relationship between effective corporate tax rates and corporate profit growth.

Who Pays

The historical evidence above tells a different story than the bill of goods being sold to citizens and investors.  Corporate tax rates are positively correlated with economic growth which means that lower corporate tax rates equate to slower economic growth. Further, there is strong evidence that corporate profits are largely unaffected by tax rates.

Investors buying based on the benefits of the tax proposal appear shortsighted. They value the benefits of corporate tax cuts, but they are grossly negligent in recognizing how the tax cuts will be funded.  

The tax bill, as it is currently proposed, will increase the deficit by $1.5 trillion over ten years. As such, the government will borrow an additional $1.5 trillion on top of current projections of approximately $1 trillion per year.

When the government borrows money to fund a fiscal deficit they effectively crowd out investment that could have funded the real economy. Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.


As is often the case in economics and investing, there is a “seen” and an “unseen.” The “seen” is widely visible and, right or wrong, generally represents a consensus agreement about reality. The “unseen,” while equally important, largely goes under-appreciated. In time, it is the “unseen” that will affect economic growth rates and corporate earnings. It is the “unseen” that investors must grasp if they are to be successful. In this case, the “unseen” is the massive federal deficit. Its burden on the economy prevents traditional forms of stimulus from having their desired effects.

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We would argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them. 

Keep Calm and Carry On

“Before long, we will all begin to find out the extent to which Brexit is a gentle stroll along a smooth path to a land of cake and consumption.” – Mark Carney, Bank of England Governor

In 1939, the British Government, through the Ministry of Information, produced a series of morale-boosting posters which were hung in public places throughout the British Isles. Faced with German air raids and the imminent threat of invasion, the slogans were aimed at helping the British public brave the testing times that lay ahead. The most enduring of these slogans simply read:

 “Keep Calm and Carry On.”

Ironically, it was the only one of the series that was never actually displayed in public as it was reserved for a German invasion that never transpired. Today, the British Government may wish to summon a fresh propaganda strategy to address a new threat on the horizon, that of the eventuality of Brexit.

The Kingdom Divided

The United Kingdom (UK) is in the process of negotiating out of all policies that, since 1972, formally tied it to the economic dynamics of the broader western European community. Since the unthinkable Brexit vote passage in June 2016, the unthinkable has now become the undoable. The negotiations, policy discussions, logistical considerations and legal wrangling are becoming increasingly problematic as they affect every industry in the UK from trade and finance to hazardous materials, produce, air travel and even Formula 1 racing.

The worst case scenario of a disorderly or “hard” Brexit, whereby no deal is reached by the March 2019 deadline, is the most extreme for investors along the spectrum of potential outcomes. A deadlock, which is unfortunately the most likely scenario, would result in tariffs on trade between the UK and the European Union (EU). Such an outcome would result in a rapid deterioration of British economic prospects, job losses and the migration of talent and businesses out of the country. Even before the path of Brexit is known, a number of large companies with UK operations, including Barclays Bank, Diageo, Goldman Sachs, and Microsoft, are discussing plans to move or are already actively moving personnel out of Britain. Although less pronounced, the impact of a “hard” Brexit on the EU would not be positive either.

The least damaging Brexit outcome minimizes costs and disruption to business and takes the form of agreement around many of the key issues, most notably the principle of the freedom of movement of labor. The current progression of events and negotiations suggests such an agreement is unlikely. The outcome of negotiations between the UK and the EU will be determined by politics, with the UK seeking to protect its interests while the EU and its 27 member states negotiate to protect their own.

To highlight the complexities involved, the challenges associated with reaching agreements, and why a hard Brexit seems most likely, consider the following:

  • Offering an early indication of the challenges ahead, German Prime Minister Angela Merkel stated that she wants the “divorce arrangement” to be agreed on before terms of the future relationship are negotiated. The UK has expressed a desire for these negotiations to run concurrently
  • A withdrawal agreement (once achieved) would need to be ratified by the UK
  • A withdrawal agreement would have to be approved by the European Parliament
  • A withdrawal agreement would have to be approved by 20 of the 27 member states
  • The 20 approving states must make up at least 65% of the population of the EU or an ex-UK population of 290 million people
  • If the deal on the future relationship impacts policy areas for which specific EU member states are primarily responsible, then the agreement would have to be approved by all the national parliaments of the 27 member states

The summary above shows that the unprecedented amount of coordination and negotiation required within the 27 member states and between the EU Commission, the EU Council and the EU Parliament, to say nothing of the UK.

The “do nothing and see what happens” stance taken by the British and the EU would likely deliver a unique brand of instability but one for which there is a precedent.

The last time we observed an economic event unfold in this way, investment firm Lehman Brothers disappeared along with several trillion dollars of global net worth. Although the Lehman bankruptcy was much more abrupt and less predictable, a hard Brexit seems likely to similarly roil global markets. The “no deal” exit option, which is the path currently being followed, threatens to upend the intricate and endlessly interconnected system of global financial arbitrage. Markets are complacent and seem to have resigned themselves to the conclusion that since no consequences have yet emerged, then they are not likely.

Lehman Goes Down

In late 2007 and early 2008, as U.S. national housing prices were falling, it was becoming evident that the financial sector was in serious trouble. By March of 2008, Bear Stearns was sold to JP Morgan for $2 per share in a Fed-arranged transaction to stave off bankruptcy. Bear Stearns stock traded at $28/share two days before the transaction and as high as $172 per share in January 2007. Even as evidence of problems grew throughout the summer of 2008, investors remained complacent. After the Bear Stearns failure, the S&P 500 rallied by over 14% through mid-May and was still up over 3% by the end of August following the government seizure of Fannie Mae and Freddie Mac. While investors were paying little attention, the solvency of many large financial entities was becoming more questionable. Having been denied a Federal Reserve backstop, Lehman failed on September 15, 2008 and an important link in the global financial system suddenly disappeared. The consequences would ultimately prove to be severe.

On September 16, 2008, the first trading day after Lehman Brothers filed for bankruptcy, the S&P 500 index closed at 1192. On September 25, just 10-days later, it closed 1.43% higher at 1209. The market, in short time, would eventually collapse and bottom at 666 in six short months. Investors’ inability to see the bankruptcy coming followed by an inability to recognize the consequences of Lehman’s failure seems eerily familiar as it relates to the current status of Brexit negotiations.

If all efforts to navigate through Brexit requirements are as complicated and difficult as currently portrayed, then what are we to expect regarding adverse consequences when the day of reckoning arrives? Is it unfair to suspect that the disruptions are likely to be severe or potentially even historic? After all, we are not talking about the proper dissolution of an imprudently leveraged financial institution; this is a G10 country! The parallel we are trying to draw here is not one of bankruptcy, it is one of disruptions.

As it relates to Brexit, Dr. Andreas Dombret, member of the executive board of the Deutsche Bundesbank, said this in a February 2017 speech to the Bank of International Settlements –

“So while economic policy will of course be an important topic during negotiations, we should not count on economic sanity being the main guiding principle. And that means we also have to factor in the possibility that the UK will leave the bloc in 2019 without an exit package, let alone the sweeping trade accord it is seeking. The fact that this scenario would most probably hurt economic activity considerably on both sides of the Channel will not necessarily prevent it from happening.”


On June 23, 2016, the day before the Brexit vote, the FTSE 100 closed at 6338. After a few hours of turbulence following the surprising results, the FTSE recovered and by the end of that month was up 2.6%. Today, the index is up 17.5% from the pre-Brexit close. The escalating risks of a hard exit from the EU clearly are not priced into the risky equity markets of Great Britain.

Data Courtesy: Bloomberg

Conversely, what has not recovered is the currency of the United Kingdom (chart below). The British Pound Sterling (GBP) closed at 1.4877 per U.S. dollar on June 23, 2016, and dropped by 15 points (-10%) to 1.33 by the end of the month following the Brexit vote. Over the past several months the pound has fallen to as low as 1.20 but more recently it has recovered to 1.33 on higher inflation readings and hawkish monetary policy language from Bank of England (BoE) governor Mark Carney. Despite following through on his recent threats to hike interest rates, the pound has begun to again trend lower.

Data Courtesy: Bloomberg

Carney has voiced concern over Brexit-induced inflation by saying that if global integration in recent decades suppressed price growth then the reduced openness to foreign markets and workers due to Brexit should result in higher inflation. This creates a potential problem for the BoE as a disorderly exit from the EU hurts the economy while at the same time inducing inflation. Such a stagflation dynamic would impair the BoE’s ability to engage in meaningful monetary stimulus of the sort global financial markets have become accustomed since the financial crisis. If the central bankers lose control of inflation, QE becomes worthless.

Some astute observers of the currency markets and BoE pronouncements argue that Carney’s threat of rate hikes are aimed at halting the deterioration of value in the pound and preventing a total collapse of the currency. That theory is speculative but plausible when analyzing the chart. Either way, whether the pound’s general weakness is driven by inflation concerns or the rising risks associated with a hard Brexit, the implications are stark.

What is equally evident, as shown below, is the laissez-faire attitude of the FTSE as opposed to the caution and reality being priced in by the currency markets. In Lehman’s case, the stock market was similarly complacent while the ten year Treasury yield dropped by nearly 2.00% from June 2007 to March 2008 (from a yield of 5.25% to 3.25%) on growing economic concerns and a flight-to-quality bid.

Data Courtesy: Bloomberg

A Familiar Problem

As discussed above, the Bank of England may find itself in a predicament where it is constrained from undertaking extreme measures due to inflation concerns or even being forced to tighten monetary policy despite an economic slowdown. Those actions would normally serve to support the pound. Further, if the prospect of a hard Brexit continues to take shape, capital flight out of the UK may overwhelm traditional factors. In efforts to prevent the disorderly movement of capital out of the country, the BoE may be required to hike interest rates substantially. Unlike the resistance of equity markets to bad news, the currency markets are more inclined, due to their size and much higher trading volume, to fairly reflect the dynamics of the economy and the central bank in a reasonable time frame.

Our perspective is not to presume a worst case scenario but to at least entertain and strategize for the range of possibilities. Equity markets, both in the UK and throughout the world, transfixed by the shell game of global central bankers’ interventionism, are clearly not properly assessing the probabilities and implications of a hard Brexit.

All things considered, the pound has rallied back to the high end of its post-Brexit range which seems to suggest the best outcome has been incorporated. If forced to act against inflation, the Bank of England will be hiking rates against a stagnant economy and a poor economic outlook.  This may provide support for the pound in the short term but it will certainly hurt an already anemic economy in the midst of Brexit uncertainty.


Timing markets is a fool’s errand. Technical and fundamental analysis allows for an assessment of the asymmetry of risks and potential rewards, but the degree of central bank interventionism is not quantifiable. With that premise in mind, we can evaluate different asset classes and their adherence to fundamentals while allowing a margin of error for the possibility of monetary intervention. After all, if central banks print money to inflate asset prices to create a wealth effect, some other asset should reveal the negative effects of conjuring currency in a fiat regime – namely the currency itself. In the short term, it may appear as though rising asset prices create new wealth, but over time, the reality is that the currency adjustments off-set some or all of the asset inflation.

Investors should take the time, while it is available, to consider the gravity of the disruptions a hard Brexit portends and look beyond high flying UK stocks to the more telling movement of the British pound. Like with Lehman and the global financial system in 2008, stocks may initially be blind to the obvious. Although decidedly not under the threats present during World War II, the British Government and the EU lack the leadership of that day and will likely need more than central banker propaganda to weather the economic storm ahead.

Keep calm and carry on, indeed.

Three Easy Pieces

If someone told you that the President of the United States in 2028 would be a Democrat and a woman from the state of New York, could you guess who it might be? We highly doubt it. In 1998, ten years before being elected president, Barack Obama had just been re-elected to the Illinois State Senate and was on no one’s radar as a Presidential candidate. In fact, had you been told at that time an African-American Democrat from Illinois would be president in 2008, it’s likely you would have assumed that two-time democratic presidential nominee Jesse Jackson would be the 44th President. In 1990, George W. Bush had just bought the Texas Rangers baseball club and was still four years from becoming Governor of Texas. In 1983, Bill Clinton was ten years out of law school and serving his second term as Governor of Arkansas. We could keep going down the line of presidents, and you would realize that even armed with some key details about the future, it would be extremely difficult to predict who a future president might be.

Stock investing is a little different. If you know the future level of three simple data points, you can calculate to the penny the price of any stock or index in the future and the exact holding period return. This precise prediction will hold up regardless of wars, economic activity, natural disasters, UFO landings or any other event you can dream up.

Unfortunately, those three data points are not readily available but can be inferred using historical trends, future expectations and logic to project them. With projections in hand, we can develop a range of price and return expectations for an index or an individual stock. In this paper, we provide an array of projections based on those factors and provide return expectations for the S&P 500 for the next ten years.

Factor 1: Dividends

Dividends are an important and often overlooked component of stock returns. To emphasize this point, an investor guaranteed a 3% dividend yield based on the current price, receives a 30% gain (non-compounded) in ten years. In other words, the investor has at least a 30% cushion to guard against price declines over a ten-year period.  That is what Warren Buffett refers to as a “moat,” and it is a wonderful benefit of investing in dividend-paying stocks.

The scatter plot graphed below compares the S&P 500 dividend yield to the Ten-year U.S. Treasury Note yield since 1980.  This historic backdrop helps project the S&P 500 dividend yield for the next ten years.

Data Courtesy: St. Louis Federal Reserve (FRED)

From 1980-1999, Treasury yields and dividend yields behaved alike. The trend line above, covering these years, has a statistically significant R-squared of 0.84 (84% of the move in dividend yields can be explained by moves in the 10-year yield). Since the year 2000, that relationship has all but disappeared. The R-squared for the post-financial crisis era is a meaningless .02.

Around the year 2000, dividend yields appear to have hit a floor ranging from 1-2%, despite a continued decline in Treasury yields. The reason for this is that many companies want to entice investors with higher dividend yields. As such, they raised dividends to keep the dividend yield relatively attractive. Had the regression of the 1980-1999 era held, dividend yields would be below 1% given current Treasury yields.

The graph above makes forecasting the future dividend yield relatively easy. As long as Ten-year U.S. Treasury yields stay below 5-6%, we expect dividend yields will range from 1-2%. Accordingly, we simplify this analysis and assume an optimistic 2% dividend yield for the next ten years.

Dividend Yield – Base/Optimistic/Pessimistic = 2%

Factor 2: Earnings

Over the long-term, earnings are well correlated to economic growth. Our ten-year analysis easily qualifies as long-term. Over shorter periods, there can be sharp variations due to a variety of influences such as regulatory policies and tax policies all of which influence profit margins. To arrive at reasonable expectations for earnings growth, we first consider economic growth. The following chart plots the declining trend in GDP growth since 1980.  Given the burden of debt, weak productivity growth and the obvious headwinds from demographics, we think it is likely the trend lower continues.

Data Courtesy: St. Louis Federal Reserve (FRED)

Next, we consider S&P 500 earnings growth rates. Earnings growth over the last three years, ten years and since 1980 are as follows: 3.18%, 4.38%, and 5.93% respectively. Given the economic and earnings trends, we believe a 3% future earnings growth rate for the next ten years is fair, 5% is optimistic, and 1% is pessimistic.

Earnings Growth – Base/Optimistic/Pessimistic = 3.00%/5.00%/1.00%

Factor 3: Valuations

Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of valuation as it averages earnings over ten year periods. In doing so, it avoids short-term volatility of earnings and provides a more consistent baseline reflective of a company’s or indexes true earnings potential.  Currently, the CAPE of the S&P 500 sits in rare territory, as shown below. In fact, outside of the late 1990’s tech boom, there were only two months since 1881 when the Shiller CAPE was higher than today’s level – August and September of 1929.

CAPE has a history of extending well above and below its mean. Importantly, it also reverts to its mean after these long stretches of time. It does not seem unreasonable to expect that, over the next ten years, it will again revert to its mean since 1920 of 17.29. An optimistic scenario for 2028 is a CAPE reading of one standard deviation above the mean at 24.77. The pessimistic case is, likewise, one standard deviation below the mean at 9.70. Further, as shown below, we also present an outlook assuming CAPE stays at its current level of 31.21.

The graph below shows CAPE and the three forecasts along with the current level.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

CAPE – Base/Optimistic/Pessimistic = 17.29/24.80/9.70

What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm and 720Global/Real Investment Advice

As shown in the graph and table above, only scenarios 8 through 12 have a higher return than the ten year U.S. Treasury Note. Of those, three of the five assume that CAPE stays at current levels. Scenario 8, shaded yellow, has a negligible positive return differential.


The bottom line is that, unless one has a very optimistic view on earnings growth and expects valuations to remain elevated beyond what historical precedent argues is reasonable, the upside is limited, and the downside is troubling. The odds favor that a risk-free investment in a 10-year Treasury note will provide a better return through 2028 with less volatility. With current 10-year note yields at roughly 2.25%, that should emphasize the use of the term “troubling.”

The lines in the graph above are smooth, giving the appearance of identical returns each period. Markets do not work that way. These projections do not consider the path taken to achieve the expected total return and they most certainly will not be smooth. The best case scenario, and the one least likely to occur is for volatility to remain low. This would generate the most orderly path. Given that the post-crisis VIX (equity market volatility index) has averaged 17.7, current single-digit levels are an aberration and it does not seem unreasonable to expect more volatility in the future.

Even if one of the scenarios plays out exactly as we describe, the path to that outcome would be very choppy. For instance, if the worst case scenario played out, an investor may lose 60-80% of value in a matter of one or two years. However they would most likely have better than expected annual returns in the years following.

In a follow up to this article we will take this thought a step further and discuss the so-called path of returns. We show you the expected and actual path of returns from 2005 to 2015 and argue that an investor armed with the three factors, and a little discipline, may have generated much better returns than those earned by investors using a buy and hold approach.

S&P 500 Monthly Valuation Analysis: 10-31-17

Real Investment Advice is pleased to introduce J. Brett Freeze, CFA, founder of Global Technical Analysis. Going forward on a monthly basis we will be providing you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. 

If you are interested in learning more about their services, please connect with them.


We believe that the chief determinant of future total returns is the relative valuation of the index at the time of purchase.  We measure valuation using the Price/Peak Earnings multiple as advocated by Dr. John Hussman.  We believe the main benefit of using peak earnings is the inherent conservatism it affords: not subject to analyst estimates, not subject to the short-term ebbs and flows of business, and not subject to short-term accounting distortions.  Annualized total returns can be calculated over a horizon period for given scenarios of multiple expansion or contraction.

Our analysis highlights expansion/contraction to the minimum, mean, average, and maximum multiples (our data-set begins in January 1900) .  The baseline assumptions for nominal growth and horizon period are 6% and 10 years, respectively.  We also provide graphical analysis of how predicted returns compare to actual returns historically.

We provide sensitivity analysis to our baseline assumptions.  The first sensitivity table, ceterus paribus, shows how future returns are impacted by changing the horizon period.  The second sensitivity table, ceterus paribus, shows how future returns are impacted by changing the growth assumption.

We also include the following information: duration, over(under)-valuation, inflation adjusted price/10-year real earnings, dividend yield, option-implied volatility, skew, realized volatility, historical relationships between inflation and p/e multiples, and historical relationship between p/e multiples and realized returns.

Our analysis is not intended to forecast the short-term direction of the SP500 Index.  The purpose of our analysis is to identify the relative valuation and inherent risk offered by the index currently.

Predicted Returns

Predicted Return: Sensitivity Analysis

Price to Peak Earnings

As of 10/31/2017:  Price/Peak Earnings 23.6

To get at the significance of the P/E, you have to start by understanding that stocks are not a claim to earnings anyway.  Stocks are a claim to a future stream of free cash flows – the cash that can actually be delivered to shareholders over time after all other obligations have been satisfied, including the provision for future growth.  Knowing this already tells us a lot.  For example, price/earnings ratios based on operating earnings are inherently misleading, since that “earnings” figure does not deduct interest owed to bondholders nor taxes owed to the government.   This isn’t to say that P/E ratios are useless, but it’s important for the “E” chosen by an investor to have a reasonably stable relationship to what matters, which is the long-term stream of free cash flows.  For that reason, our favored earnings measure for market valuation (though it can’t be used for individual stocks) is “peak earnings” – the highest level of net earnings achieved to date.  (Excerpted from Dr. John Hussman)


As of 10/31/2017:  Duration 53.5 years

In the case of equities, duration measures the percentage change in stock prices in response to a 1% change in the long-term return that stocks are priced to deliver. So we have a basic financial planning concept.  If a buy-and-hold investor with no particular view about market conditions or future returns wishes to have a fairly predictable amount of wealth at some future date, that investor should hold a portfolio with a duration that is roughly equal to the investment horizon.  (Excerpted from Dr. John Hussman)


As of 10/31/2017:  Overvalued by 107.2%

Inflation Adjusted PE

As of 10/31/2017:  Real Price to 10-Year Real Earnings 31.1x

Dividend Yield

As of 10/31/2017: Dividend Yield 1.87%

Option Implied Volatility

VIX measures 30-day expected volatility of the S&P 500 Index.  The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months.   “Near-term” options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration.

As of 10/31/2017:  10-Day EMA 10.44

Option Skew

The CBOE SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk.   The price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150.   A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible.   As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant.

As of 10/31/2017:  10-Day EMA 137.64

Realized Volatility

As of 10/31/2017:  6.34%

Inflation and PE Multiples

Lower levels of inflation are rewarded with higher earnings multiples.

Higher levels of inflation are punished with lower earnings multiples.

Inflation and PE Multiples

Lower levels of volatility are rewarded with higher earnings multiples.

Higher levels of volatility are punished with lower earnings multiples.

PE Multiples and Realized Returns

Lower valuations are rewarded with higher realized returns.

Higher valuations are punished with lower realized returns.

As of 10/31/2017:  Price to Peak Earnings 23.6x  Average: 12.6x

The Roach Motel – Something Wicked Part II

In Something Wicked This Way Comes, we provided an in-depth look at how stock repurchases are distorting McDonald’s (MCD) earnings per share and making the company look more profitable than it truly is. When such financial wizardry is considered alongside the growing popularity of passive investment strategies and overall sense of market euphoria, we have a better appreciation for why MCD trades at a valuation higher than fundamentals suggest would be appropriate.

We thought it would be helpful to extend this analysis to the entire S&P 500 to see if we can uncover other companies demonstrating fundamental and valuation divergences similar to MCD.

Who Else?

Similar to the MCD analysis, we evaluated changes in fundamentals, equity price and valuation data over the last five years for most companies that comprise the S&P 500. The data below, summarizing our broad findings, is based on 475 of the 505, S&P 500 companies. 30 companies were omitted from the analysis due to insufficient data.

  • 141 companies, or about 30% of the S&P 500, had annualized five-year sales growth rates of 1% or less.

Of these 141 companies:

  • The average stock price gain over the five year period was +68%.
  • 106 of the companies had a stock price increase of 25% or more that was concurrent with falling revenue.
  • The average number of shares outstanding declined by 2%. This data point is misleading as many energy companies within this group issued shares to bolster capital when the price of oil declined sharply in 2014/2015.
  • The average amount of debt outstanding increased 70%
  • The valuation ratio of market capitalization to sales increased 73%.

The table below isolates companies which had five year revenue declines of greater than 10%, price increases greater than 20%, declines in shares outstanding and increased debt outstanding.

Data Courtesy: Bloomberg

The company-specific data and the averages for this group highlight the extreme divergences that exist between poor fundamental data and current price and valuation. The list of companies showing these characteristics extend well beyond what we show here, these are just the most egregious examples.

In the table below, we highlight a few other larger, well-known companies. While these companies did not match all of the criteria for the table above, they do have price and valuation changes that are inconsistent with their revenue growth.

Data Courtesy: Bloomberg

A few comments about the tables above:

  1. Note that all of the companies are large firms from a wide range of industries and thus well represented in many passive indexes.
  2. Despite flat to negative revenue growth for at least five years, they have all experienced respectable price and valuation increases.
  3. In most cases, the companies have increased their debt outstanding while decreasing shares outstanding. It is likely the debt in many of these companies is being used to some degree to repurchase stock.
  4. For the most part, the companies are mature and therefore likely have low to mid single-digit revenue and earnings growth prospects.

Disclaimer: The analysis performed on the companies listed was not as extensive as that from the prior article on MCD. Some of these companies may have new products or promising innovation that justifies their price and valuation increases despite the poor fundamentals. However, we believe the MCD problem is at play in most of these companies.


There are good companies with bad stocks and bad stocks of good companies. What we lay out here is not an indictment of specific companies but a reality check on stock valuations. This analysis highlights a host of companies that appear to have prices that are well above a fair fundamental value. This does not mean the prices of these companies cannot continue to rise and further defy financial gravity. It does mean that, over time, these companies must either grow revenue and earnings at significantly faster rates than they have or their share prices will fall as their valuations likely revert to historical norms.

The popularity of passive investing and unawareness of the effects of buybacks are complicit in boosting the price of many undeserving companies to eye-watering valuations. We suspect passive strategies will continue to attract a larger than normal percentage of investment dollars as long as these blind momentum strategies work. Given the tremendous financial incentives to executives we think stock buybacks will continue as well. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed. When this occurs, those managers and investors employing active approaches will greatly outperform those with passive strategies.

Who is 720Global?

720Global and Real Investment Advice (RIA) have been collaborating to bring investors unique market insight for two years. On October 9th, 720Global and RIA officially became partners in these efforts. As such, we want to help RIA readers appreciate 720Global’s economic and investment perspective.

Since 2015, 720Global has written nearly 100 articles, produced an important video and participated in a multitude of other events such as conferences and podcasts. While our articles span a wide range of topics, they all adhere to a core set of themes. To maintain consistency in our logic and avoid too much focus on any one topic, we track a “family tree of articles.” At the top of the tree are four “granddaddy” themes. These are major categories under which almost any topic we seek to explore will fit. The offspring of the major themes, so to speak, are core articles used to describe important concepts related to the theme. Progressively moving down the tree, articles tend to focus on a smaller subset of the theme. More granular, these articles may focus on a specific company, news event or a specific economic data point. In amalgamation, the articles provide a comprehensive understanding of the theme and offer examples, trading ideas, and introduce related concepts. This helps readers become more knowledgeable and apply critical thinking on the road to becoming informed investors.

The paragraphs below briefly describe the core (“granddaddy”) themes. At the end of each paragraph are sample articles and links. For a list and summary of every article 720Global has written, please contact us at mplebow@720global.com.

Theme 1 – Economics

Economics attempts to describe and quantify the production, distribution, and consumption of goods and services. Understanding economic data, trends and forces are of utmost importance to properly evaluate almost every type of investment. Economics is frequently sold to the public as a complex and sophisticated science, one best left for Ph.D.’s to study, describe and manage. We disagree. Economics is simply the study of human behavior and decision making. Our core economics articles distill the “science” to its basic foundations and deconstruct common myths. In some articles, we review traditional economic approaches to help readers understand the economy as presented, often erroneously, by the financial media, Wall Street, and the government.

Articles we’ve written on economics and economic principals include:

The Death of the Virtuous Cycle

Animated Virtuous Cycle

Lowest Common Denominator: Debt

The Illusion of Prosperity

Theme 2 – Portfolio Management and Investment Strategy

Articles about this theme address all investment classes, including specific advice for some asset classes as well as actionable investment ideas.

We never forget that investment management is a series of processes and beliefs used to preserve and compound wealth. Throughout history, markets repeatedly teach the durability of cycles and that periods of superior returns are followed by periods of subpar returns and vice versa. Changes in trend can happen when least expected and result in wealth-destroying losses or wealth-enhancing opportunities for investors. Accordingly, we believe a patient, conservative posture in times like today, when valuations portend future losses, is just as important as aggressiveness when value is presented. Wealth is built over the long term by adhering to a game plan, even if it is not the popular strategy. We subscribe to the motto:

Risk is not a number. Risk is simply overpaying for an asset.”

Articles we’ve written on portfolio management and investment strategy include:

A Shot of Absolute: Fortifying a Traditional Investment Portfolio

Limiting Losses

Protecting Your Blind Side

Something Wicked This Way Comes – Analysis of McDonalds

A Peak Above All Others

Theme 3 – Monetary and Fiscal Policy

Central banks and governments, both domestic and foreign, are increasingly playing a larger role in “steering” economic activity. While this interventionism can have positive economic effects and promote their immediate objectives, these actions have consequences. In many cases, the costs of poor policy accumulate over time. Unfortunately, few are able to recognize the potential pitfalls as focus always seems to be on the near-term benefits. We frequently discuss fiscal and monetary policy to help our readers see the potential benefits and understand the potential consequences that lie ahead.

Articles we’ve written on monetary and fiscal policy include:

The Fed’s Definition of Price Stability is Likely Different From Yours

Clarity or Confusion

Chasing the Dragon 

The Fifteenth of August

Theme 4 – Behavioral Finance

At their core, economic activity and financial market fluctuations are driven by individuals pursuing their own interests and the whims of human decision making. At times, decision making is rational, as assumed by most economic and market models. Other times, as history repeatedly shows, humans make irrational decisions. Maintaining a view on the mindset of investors, policy makers and the population can provide a distinct advantage. By recognizing what seems plausible or unrealistic about economic activity, one can ascertain which investments may do well or poorly.

Articles we’ve written on behavioral finance include:

Perception versus Reality

Bubbles and Elevators

Play the Game to Win

Our core purpose is to enhance our client’s ability to preserve and generate real wealth by identifying, understanding and applying basic truths and coherent logic to the global economic and financial system. 720Global’s articles provide unique insight and candor that is often lacking in financial research.

Please do not hesitate to email us with any questions or comments. 

Something Wicked This Way Comes: McDonalds – A Bear in a Bull Costume

As Halloween nears, kids are choosing costumes to transform themselves into witches, baseball players and anything else they can imagine. In the spirit of Halloween, we thought it might be an appropriate time to describe the most popular costume on Wall Street, one which many companies have been donning and fooling investors with terrific success.

Having gained over 65% in the last two years, the stock of McDonald’s Corporation (MCD) recently caught our attention. Given the sharp price increase for what is thought of as a low growth company, we assumed their new line of healthier menu items, mobile app ordering, and restaurant modernization must be having a positive effect on sales. Upon a deeper analysis of MCD’s financial data, we were quite stunned to learn that has not been the case. Utility-like in its economic growth, MCD is relying on stock buybacks and the popularity of passive investment styles to provide temporary costume as a high-flying growth company.

Stock Buybacks

We have written six articles on stock buybacks to date. While each discussed different themes including valuations, executive motivations, and corporate governance, they all arrived at the same conclusion; buybacks may boost the stock price in the short run but in the majority of cases they harm shareholder value in the long run. Data on MCD provides support for our conclusion.

Since 2012, MCD’s revenue has declined by nearly 12% while its earnings per share (EPS) rose 17%. This discrepancy might lead one to conclude that MCD’s management has greatly improved operating efficiency and introduced massive cost-cutting measures. Not so. Similar to revenue, GAAP net income has declined almost 8% over the same period, which rules out the possibilities mentioned above.

To understand how earnings-per-share (EPS) can increase at a double-digit rate, while revenue and net income similarly decline and profit margins remain relatively flat, one must consider the effect of share buybacks. Currently, MCD has about 20% fewer shares outstanding than they did five years ago. The reduction in shares accounts for the warped EPS. As noted earlier, EPS is up 17% since 2012. When adjusted for the decline in shares, EPS declined 7%. Given the 12% decline in revenue and 8% drop in net income, this adjusted 7% decline in EPS makes more sense. MCD currently trades at a trailing twelve-month price to earnings ratio (P/E) of 25. If we use the adjusted EPS figure instead of the stated EPS, the P/E rises to 30, which is simply breathtaking for a company that is shrinking. It must also be noted that, since 2012, shareholder equity, or the difference between assets and liabilities, has gone from positive $15.2 billion to negative $2 billion. A summary of key financial data is shown later in this article.

In addition to adjusting MCD’s earnings for buybacks, investors should also consider that to accomplish this financial wizardry, MCD relied on a 112% increase in their debt. Since 2012, MCD spent an estimated $23 billion on share buybacks. During the same period, debt increased by approximately $16 billion. Instead of repurchasing shares, MCD could have used debt and cash flow to expand into new markets, increase productivity and efficiency of its restaurants or purchase higher growth competitors. MCD executives instead manipulated EPS and ultimately the stock price. To their good fortune (quite literally), the Board of Directors and shareholders appear well-deceived by the costume of a healthy and profitable company. Over the last three years, as shown below, compensation for the top three executives has soared.

Source: MCD 2017 proxy statement (LINK)

The following table compares MCD’s fundamental data and buyback adjusted data from 2012 to their last reported earnings statement.

Data Source: Bloomberg and MCD Investor Relations

The graph below compares the sharp increase in the price of MCD to the decline in revenue over the last five years.

Data Courtesy: Bloomberg

Passive Influence

The share price of MCD has also benefited from the substantial increase in the use of passive investment strategies.

Active managers carefully evaluate fundamental trends and growth prospects of potential investments. They typically sell those investments which appear rich and overvalued while buying assets which they deem cheap or undervalued. When there is a proper balance among investing styles in a market, active investors act as a policeman of sorts, providing checks and balances on valuations and price discovery. Would an active investor buy into a fast food company with minimal growth prospects and rapidly rising debt, at a valuation well above that of the general market and long-term averages? Likely no, unless they knew of a greater fool willing to buy it at a higher price.

On the other hand, passive managers focus almost entirely on indexes and are typically less informed about the underlying stocks they are indirectly buying. They are indiscriminate in the deployment of capital allocating to match their index usually on the basis of market capitalization. Such a myopic style rewards those indexes exhibiting strong momentum. When investors buy indexes, the stocks comprising the index, good and bad, rise in unison. Would a passive investor buy into a fast food company with minimal growth prospects and rapidly rising debt at a valuation well above that of the general market and long-term averages? Yes, they have no choice because they manage to an index that includes that company.

When the marginal investors in a market are largely passive in nature, active managers are not able to effectively police valuations, and their influence is diminished. During such periods, indexes and their underlying stocks rise, regardless of the economic and earnings environment.  As the saying goes “a rising tide lifts all boats,” even those that are less seaworthy, such as MCD.


We warn investors that, when the day after Halloween occurs for MCD and other stocks trading well above fair value, investors might find a rotten apple in their portfolio and not the chocolatey goodness they imagined.

Buybacks will continue to occur as long as executives reap the short-term benefits, stock prices rise, money is cheap, and investors remain clueless about the long-term harm buybacks inflict on value. We suspect passive strategies will also garner a larger than normal percentage of investment dollars as long as these blind momentum strategies work. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed.

Building wealth on faulty underpinnings is a strategy ultimately destined for failure. We urge investors to understand what they are buying and not be mesmerized by past gains or what the “market” is doing. Simply, when a stock rises above fair valuations, future returns are sacrificed.






Saying It Slowly Doesn’t Help

The most fundamental basis for economics is human decision-making. Satisfying needs and wants creates demand. Engaging in a vocation to provide a good or service of value to others generates supply. The intersection of the two is a market.

This week we introduce the unique insight of Mark McElroy. Mark is a friend of 720Global who often provides valuable input on our article concepts, their structure and occasionally challenges their validity. Now, with some minor arm-twisting, he challenges the status quo of economics – the profession, the pedigrees and their intentions. 

In Saying It Slowly Doesn’t Help, he doesn’t challenge the PhD economists so much as he takes the rest of us to task. If human decisions are the basis for economics then aren’t we all obligated to be economists at some level? His casual but intentional arms-length observer status poses the question: why is economics so difficult?

Saying It Slowly Doesn’t Help

“The quality of ideas seems to play a minor role in mass movement leadership. What counts is the arrogant gesture, the complete disregard of the opinion of others, the singlehanded defiance of the world.”Eric Hoffer, The True Believer

To communicate about economics is to describe the mirror as if it were a commodity. Economics is a tricky subject. It schemes and dodges—just try to sneak up on a mirror. For all the numbers, parentheses, red and black, boxes and columns, economics is mostly narrative. The digits and bytes of the trade are stand-ins for our resources or assets that are stand-ins for our fears, hopes, memories, hungers and regrets.  Economics is the overly eager attempt to hold at arms-length what we don’t want to see up close. Quantifying the narrative is like measuring a joke. But, it must be done.  It should be done.  Honestly, it needs to be done because no one is alone.

If such twaddle seems impractical, you’re in large company. I get it. That doesn’t necessarily mean you should be off the hook for thinking practically (critically) regarding how we talk about ourselves, our resources, and our guiding principles–economics.  Our collective want for information about economics is huge. Really huge. Cable, Twitter, whatever offers a 24/7 stream of info about economics to more and more people.  Evidently being in a flood doesn’t make one a hydrologist (that was weak, I apologize).  For all the volume of economic info/data available, one would expect we could be fairly proficient in discussing/communicating the basics of economics. Given the rise of six year financing plans for Toyota Corollas, I’m gonna go out on a limb and call BS on the notion that we know how to talk about it effectively. Clearly. Honestly.

If you fancy yourself an economist (and everyone should), it may be of comfort to realize economists are not the only ones in this “we have much to say and struggle to be understood” syndrome.  Scientists find themselves there, too. Scientists are studying themselves and the scientific assumptions regarding how to communicate about science. Tired of being picked last for kickball in the public square, scientists are aiming their magnified gaze upon themselves and are coming around to a counter-intuitive notion.  The more scientists try to correct and inform the public discourse, the less impact they have.  Saying it (you know, smart stuff) with more detail and credentials not only doesn’t work, it makes things worse. Tim Requarth in Slate wrote it like this:

[T]he way most scientists think about science communication—that just explaining the real science better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

I think he meant this:

[T]he way most scientists economists think about science economic communication—that just explaining the real science economics better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

Okay, he clearly did not mean that, but it would have been great if he did. Go read his article in full and play this parlor game. Every time you see “science” or some version of it, replace it with “economics” or some version of it.  It pretty much holds up.

Economics should be natural for us to communicate, but it isn’t. Who doesn’t know what a mirror looks like?  Economics is discussed ad nauseam as if it were an elusive concept that only a few have glimpsed (yep, just like Bigfoot) when it should be as natural as falling off a bike. Why is that?

I have a guess. Something as simple and natural as discussing the priorities and principles around which we value and exchange our assets has been made complex, confusing, and somehow has justified cable news panels with snooty people using phrases I can’t spell (of which there are many)—all this is the handiwork of a cottage industry (institution) committed to sustaining the confusion for profit, prestige, or because they miss satisfaction of taking names in third grade.

SIDEBAR: I am in a sustained lover’s quarrel with an institution that now spans 30+ years. Institutions of all flavors are the same in that their original spark, purpose or mission always becomes overwhelmed by its desire for self-perpetuation. To be clear, when I refer to the cottage industry proliferating the confusion regarding economics as an “institution,” it is meant as no compliment. If you have finished watching the paint dry and are intrigued by the whole institution thing, check out the work of Eric Hoffer, The True Believer: Thoughts on the Nature of Mass Movements.  SIDEBAR CLOSED

If economics remains confusing for me (as is religion and healthcare), I am less likely to experience contentment (or faith or health). Admittedly, though, the institutions that keep economics (and other matters) an ivory tower topic have a willing accomplice in me.  It is a co-dependence. Somewhere deep down I need as a way coping for that topic to be at arms-length.  At arms-length, I can see economics as a collection of digits, theories, and fractional transactions en masse. I am then spared the need to contemplate the basics of economics: stewardship, community, contentment, and charity.

Honestly, it needs to be done because no one is alone.

Mark McElroy, PhD @B40MKM is a writer, farmer, and management consultant with leadership roles in nonprofit and technology/information companies.





Protecting Your Blind Side

The following article was published for premium subscribers of 720Global’s The Unseen on July 28, 2017. 720Global is sharing it exclusively with readers of Real Investment Advice.  Despite being two months “seasoned”, the rationale for hedging equity market exposures are even more relevant today. For more information on The Unseen please contact info@720global.com.

Protecting your Blind Side

The price of protecting quarterbacks was driven by the same forces that drove the price of other kinds of insurance: it rose with the value of the asset insured, with the risk posed to that asset.”  -Michael Lewis, The Blind Side

Counter-intuitively, that is often not the case in the capital markets. The more asset valuations and risk rise, the more implied volatility tends to drop and therefore the cost of insuring financial assets typically fall. As the S&P 500 index nears the sumptuously round number of 2500 and valuations surpass levels preceding the Great Depression, the price of options to protect investors is deeply discounted.  Provide valuable insight

The lead quote from Michael Lewis is in reference to NFL Hall of Famer Lawrence Taylor, otherwise known as LT, a defensive end for the New York Giants. LT was an exceptional player who not only threatened an opposing team’s offensive prowess but more importantly, the health of their quarterback. The Blind Side, by Michael Lewis, documented how teams were forced to pay dearly for insurance against this threat. The insurance came in the form of soaring salaries for strong left tackles who protect right handed quarterbacks from the so called “blind side” from which players like LT were attacking. The sacrifices teams made to shield their most valuable asset, the quarterback, limited the salaries that could be spent on players to boost their offensive fire power. LT taught general managers an important lesson -protecting your most important asset is vital in the quest for success.

Growing your wealth through good times and preserving it in bad times are the key objectives of wealth management. At times when the markets present “LT”-like threats, prudence argues for both a conservative posture and protection of assets.

While many investors continue to ignore the lopsided risk/return proposition offered by the equity markets, we cannot. Sitting on one’s hands and avoiding the equity market is certainly an option and one which we believe might look better over time than most analysts think. That said, it is not always a viable option for many professional and individual investors. Some investors have a mandate to remain invested in various asset classes to minimum required levels. In other cases, investors need to earn acceptable returns to help themselves or their clients adhere to their financial goals. Accordingly, the question we address in this article is how an investor can run with the bulls and take measures to avoid the horns of a major correction.

Risk vs. Reward

There are two divergent facts that make investing in today’s market extremely difficult.

  1. The market trend by every measure is clearly Any novice technician with a ruler projected at 45 degrees can see the trend and extrapolate ad infinitum.
  2. Markets are extremely overvalued. Intellectually honest market analysts know that returns produced in valuation circumstances like those observed today have always been short-lived when the inevitable correction finally arrives.

In The Deck is Stacked we presented a graph that showed expected five-year average returns and the maximum drawdowns corresponding with varying levels of Cyclically-Adjusted Price-to-Earnings (CAPE) ratios since 1958. We alter the aforementioned graph, as shown below, to incorporate the odds of a 20% drawdown occurring within the next five years.

Over the next five years we should expect the following:

  1. Annualized returns of -.34% (green line)
  2. A drawdown of 27.10% from current levels (red line)
  3. 76% odds of a 20% or greater correction (yellow bars)

In a recent article, 13D Research raised an excellent point quoting Steve Bregman of Horizon Kinetics:

There is no factor in the algorithm for valuation. No analyst at the ETF organizer—or at the Pension Fund that might be investing—is concerned about it; it’s not in the job description. There is, really, no price discovery. And if there’s no price discovery, is there really a market?”

If, as Bregman states, the market is awash with investors, traders and algorithmic robots that do not care about fundamentals or value, is there any reason to think the market cannot continue to ignore fundamentals and run higher? While such a condition can easily endure and propel prices to even loftier valuations, the precedent of prior bubbles dictates this does not end well. At some point, the reality of economic fundamentals which underlie prices reassert themselves. Accordingly, in the following section, we present a few hedging strategies that allow one to profit if the market keeps charging ahead and at the same time limit losses and/or profit if financial gravity reasserts itself.


There are an infinite number of options strategies that one can deploy to serve all kinds of purposes. Even when narrowing down the list to purely hedging strategies one is left with an enormous number of possibilities. In this section, we discuss three strategies that involve hedging exposure to the S&P 500. The purpose is to give you a sense of the financial cost, opportunity cost, and loss mitigation benefits that can be attained via options.

Option details in the examples below are based on pricing as of July 24, 2017.

Elementary Put Hedge

This first option strategy is the simplest option hedge one can employ. A put provides its holder a right to sell a security at a given price. For instance, if you own the S&P 500 ETF (SPY) at a price of 100 and want to limit your downside to -10% you can buy a put with a strike price of 90. If SPY drops below 90, the value of the put will rise in line, dollar-for-dollar with the loss on SPY, thus nullifying net losses beyond 10%. Devising a similar strategy to manage a basket of stocks, ETF’s or mutual funds is more complicated but similar.

To help visualize what a return spectrum might look like on a portfolio hedged in this manner consider a simple scenario in which one owns the S&P 500 (SPY) and hedges with SPY options.  The following assumptions are used:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 and a cost of $9.15 per share and total cost of $915 per option. (Each option is equal to 100 shares)

The graph below provides the return profile of the long SPY position (black) and three hedged portfolios for a given range of SPY prices. The example provides three different hedging options to show what under-hedged (2 options), perfectly-hedged (4 options) and over-hedged (8 options) outcomes might look like.

Note the breakeven point (yellow circle) on the hedged portfolios occurs if SPY were to decline 10% to $221 per share. The cost of the options in percentage terms is shown on the right side of the breakeven point. It is the difference in returns between the black line and the dotted lines. Conversely, the benefit of the options strategies appears in the percentage return differentials to the left of the breakeven point. (Additional cost/benefit analysis of these strategies is shown further in the article) In this example, we assume the options are held to the expiration date. Changes in other factors such as time to expiration, rising or falling volatility, and intrinsic value will produce results that do not correspond perfectly with the results above at any point in time other than at the expiration date.


The elementary option strategy was straightforward as it only involved buying a one-year put option. Like the first strategy, a collar entails holding a security and buying a put to hedge the downside risk. However, to reduce the cost of the put option a collar trade requires one to also sell (write) a call option. A call option entitles the buyer/owner to purchase the security at the agreed upon strike price and the seller/writer of the option to sell it to them at the agreed upon strike price. Because the investor is selling/writing an option, he is receiving payment for selling the option. Incorporating the call option sale in a collar strategy reduces the net cost of the hedge but at the expense of upside returns.

To help visualize what the return spectrum might look like with a collared portfolio that owns the S&P 500 (SPY) and hedges with SPY options, consider the following assumptions:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 at the cost of $9.15 per share and total cost of $3,660. (Each option is equal to 100 shares)
  • Sell/write SPY call options with a strike price of $270, expiration of 9/21/2018 at the cost of $3.75 per share and total benefit of $1,550.

As diagramed below, a collar strategy literally puts a collar or limit around gains and losses.

Writing the call option reduces the net hedging cost by $1,550, limits losses to 9% but caps the ability to profit if the market increases at 7.21%.

Bloomberg created an index that replicates a collar strategy. Bloomberg’s collar index (CLL) assumes that an investor holds the stocks in the S&P 500 index and concurrently buys 3-month S&P 500 put options to protect against market declines and sells 1-month S&P 500 call options to help finance the cost of the puts. As options expire new options are purchased. The percentage returns of the S&P 500 and CLL indexes from 2007 and 2008 are graphed below.

Data Courtesy: Bloomberg

Note that the CLL and SPY returns were well correlated until the latter part of 2008. At this point, when volatility spiked and the markets headed sharply lower, the benefits of the collar were visible.

**Bloomberg assumes a different collar structure than we modeled and described above.

Sptiznagel’s Tail Strategy

Mark Spitznagel is a highly successful hedge fund manager and the author of a book we highly recommend called “The Dao of Capital.” Spitznagel uses Austrian school economic principles and extensive historical data to describe his unique perspectives on investing. In pages 244-248 of the book, he presents an options strategy that served him well in periods like today when valuations foreshadowed significant changes in market risk. The goal of the strategy is not to hedge against small or even moderate losses, as in the first two examples, but to protect and profit from severe tail risk that can destroy wealth like the recent experiences of 2000 and 2008.

Sptiznagel’s strategy hedges a market long position with put options expiring in two months. On a monthly basis, he sells the put options and buys new options expiring in two months. The strike price on his options are 30% below current prices. To replicate his strategy and compare it to the ones above we assume the following:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase 82 SPY put options (equivalent to .50% of the portfolio value) with a strike price of $175 (30% out of the money), expiration of 9/15/2017 (2 months) at a cost of $.06 per share and total cost of $492. (Each option is equal to 100 shares)
  • For purposes of this example, new options are purchased when the current options mature every two months (Spitznagel sells and buys new options on a monthly basis).
  • We also assume this hedge was already in place for a year resulting in an accrued trade cost of $2,952 (6 *$492) to date.

The graph below highlights the cost benefit analysis.

The strategy graphed above looks appealing given the dazzling reward potential, but we stress that the breakeven point on the trade is approximately 30% lower than current prices. While the cost difference to the right of the breakeven point looks relatively small, the axis’s on the graph have a wide range of prices and returns which visually minimizes the approximate 6% annual cost. Similar strategies can be developed whereby one gives up some gains in a severe drawdown in exchange for a lower cost profile.

Cost/Benefit Table

The tables below compare the strategies detailed above to give a sense of returns and a cost/benefit analysis across a wide range of SPY returns.

The option strategies in this article are designed for the initial stages of a decline. Pricing of options can rise rapidly as volatility, a key component of options prices, increases. The data shown above could be vastly different in a distressed market environment. These options strategies and many others can be customized to meet investor’s needs.


We insure our cars, houses, health and our lives. Why is the idea of hedging ones wealth rarely considered especially considering the cost of that protection actually falls as the market becomes more vulnerable? Given current market valuations along with a 76% chance of a 20%+ drawdown, we urge clients to consider implementing a defensive strategy of insuring your portfolio.  Although option strategies compress returns, they serve to “defend the perimeter” in the event of a severe market correction. These strategies and many others like them yield peace of mind and the ability to respond clinically in the event of turmoil as opposed to reacting emotionally.

The rather simple examples in this article were created to give you a sample of the costs and benefits of hedging. When devising a hedging strategy, it often helps to draw a picture of an ideal but realistic return spectrum. From that point, a spreadsheet model can be used to try to create the desired return profile using available options.

In addition to options strategies, there are other means of hedging a long portfolio such as structured notes, volatility funds, and short funds. Portfolio construction is also an important natural means of mitigating exposure to losses. While the topic for future Unseen articles, they are ideas worth exploring and comparing to options strategies.  Hedging and options analysis is a complex field limited only by imagination and market liquidity. If you have questions, feel free to reach out to us to explore these or other ideas that may be better suited for you.





VIDEO: The Illusion of Prosperity

Yesterday, I posted the article “The Illusion Of Prosperity.”

As I wrote, and discuss in the following video, the issues clearly illustrate that the U.S. consumer has steadily relied on increasing amounts of debt to maintain an artificial standard of living. Through the use of credit, personal and government, U.S. households have pulled forward future consumption. The weight of those outstanding obligations serves as a wet blanket on current and future economic growth.

The financial crisis in 2008 fractured the economy in ways that are clearly evident today. Addressing the troubling debt burden has been postponed through extraordinary stimulus, but the problem has only grown in size. This proves that a debt problem cannot be solved by using more debt.

Special thank you to Lance Roberts at Real Investment Advice for providing data and the concept behind this presentation.  

The Illusion of Prosperity

For the last 50 years, the consumer, that means you and me, have been the most powerful force driving the U.S. economy. Household spending now accounts for almost 70% of economic growth, about 10% more than it did in 1971. Household spending in the U.S. is also approximately 10-15% higher than most other developed nations.

Currently, U.S. economic growth is anemic and still suffering from the after-shocks of the financial crisis. Importantly, much of that weakness is the result of growing stress on consumers.  Using the compelling graph below and the data behind it, we can illustrate why the U.S. economy and consumers are struggling.

Data Courtesy: St. Louis Federal Reserve (FRED) and Lance Roberts

The blue line on the graph above marks the difference between median disposable income (income less taxes) and the median cost of living.  A positive number indicates people at the median made more than their costs of living. In other words, their income exceeds the costs of things like food, housing, and insurance and they have money left over to spend or save. This is often referred to as “having disposable income.”  If the number in the above calculation is negative, income is not enough to cover essential expenses.

From at least 1959 to 1971, the blue line above was positive and trending higher. The consumer was in great shape. In 1971 the trend reversed in part due to President Nixon’s actions to remove the U.S. dollar from the gold standard. Unbeknownst to many at the time, that decision allowed the U.S. government to run consistent trade and fiscal deficits while its citizens were able to take on more debt. Other than rampant inflation, there were no immediate consequences. In 1971, following this historic action, the blue line began to trend lower.

By 1990, the median U.S. citizen had less disposable income than the median cost of living; i.e., the blue line turned negative. This trend lower has continued ever since. The 2008 financial crisis proved to be a tipping point where the burden of debt was too much for many consumers to handle. Since 2008 the negative trend in the blue line has further steepened.

You might be thinking, if incomes were less than our standard of living, why did it feel like our standard of living remained stable?

One Word – DEBT.

To help answer that question, we added the green line to the chart. This line adds consumer credit and transfer payments to the blue line. Consumer credit encompasses credit cards, lines of credit, auto loans, student loans, and other non-mortgage forms of consumer debt. Transfer payments are benefits the government bestows upon its citizens in which no goods or services are received in return. Examples include: welfare, food stamps, insurance, and medical benefits. It is important to note that, given the continual deficits run by the U.S. government, these benefits are predominately paid for with borrowed funds.

Note that the green line, unlike the blue line, remains positive and relatively stable from 1959 to 2008, 20 years longer than the blue line. The take away is that consumer and government debt filled the diverging gap between incomes and the cost of living.

The divergence between the lines halted in 2008. The financial crisis was in part the result of a consumer that had exhausted their ability to use more debt to maintain their lifestyle. Despite the lowest interest rates on record and increases in government transfer payments, the green line has not been able to recover.

The red line in the graph isolates the hockey-stick-like growth of consumer credit since the early 1990’s that was used to maintain our standard of living. Of importance, in 1990 when the blue line went negative, the pace of consumer credit growth accelerated. Since then the pace of credit growth has risen at a much faster rate than the economy and our incomes.

To impress upon you the importance of understanding the role debt has played in supporting our lifestyles, the graph below highlights the magnitude and composition of consumer credit and government transfer payments as a percentage of consumer spending. Combined they now account for 43% of all consumer spending, which in turn accounts for nearly 70% of economic growth. In other words, almost a third of economic growth is reliant on increasing debt.

Data Courtesy: St. Louis Federal Reserve (FRED)


These charts clearly illustrate that the U.S. consumer has steadily relied on increasing amounts of debt to maintain an artificial standard of living. Through the use of credit, personal and government, U.S. households have pulled forward future consumption. The weight of those outstanding obligations serves as a wet blanket on current and future economic growth.

The financial crisis in 2008 fractured the economy in ways that are clearly evident today. Addressing the troubling debt burden has been postponed through extraordinary stimulus, but the problem has only grown in size. This proves that a debt problem cannot be solved by using more debt.

Special thank you to Lance Roberts at Real Investment Advice for providing data and the concept behind this presentation.  





Chasing the Dragon

“There is no other agency of government which can overrule actions that we take.” 

– Alan Greenspan

The Federal Reserve (Fed) currently expects real economic growth for the foreseeable future to average below 2.00%. Japan, the United Kingdom, and the European region are forecasting an even more anemic pace. On numerous occasions, we have detailed the reasons the United States and many foreign nations are mired in economic stagnation. At the top of our list, is the over-reliance on debt and the burden that decades of debt-driven-consumption policies have inflicted upon economic activity. To not only accommodate existing debt, but promote more debt, Keynesian schooled central bankers have presided over extremely easy monetary policy for years. Policy has been administered through a combination of low-interest rates and more recently, as desperation escalates to keep the economic engine from sputtering, money printing.

In “How Much is too Much” we shared the following graph that plots the exponentially increasing amounts of stimulus supplied by the Fed to combat recessions and “sub-par” economic growth.

The graph above, and many others comparing the actions taken by central banks over the last 30-40 years provides sufficient scale to understand the use of the word “extraordinary” to describe policy resulting from the Great Financial Crisis of 2008.

We thought it was worthwhile to extend the study to help you fully grasp the sheer lunacy of what has taken place over the last nine years. The fascinating chart below plots the size of the Bank of England’s (BOE) balance sheet as a percentage of GDP since the year 1700.

Data Courtesy: St. Louis Federal Reserve (FRED) and Bank of England

The size of the BOE’s balance sheet is nearly equivalent to the amount of stimulus supplied by the BOE. Note the red circle highlighting the sharp increase from 1929 to 1947. This period covered three devastating events for the United Kingdom. In 1929, the Great Depression began and strangled growth worldwide. At the time, the British Pound was the reserve currency, so the stifling of global trade imposed inordinate demands on the British Pound. Approximately ten years later they were heavily involved in WWII. The UK declared war on Nazi Germany in 1939 and experienced extensive destruction to their cities and infrastructure. In 1944, as the war was nearing an end, the Bretton Woods agreement was signed which marked the beginning of the end for the pound as the world’s reserve currency.

During this tumultuous 18-year period, the BOE’s balance sheet increased 180%, marking a significant change in the trend of the prior 250 years. Now consider that, over the last eight years, the amount of stimulus supplied by the BOE has increased 251%. Given the contrast, this graph effectively conveys the seriousness of the current economic situation in the UK and is symptomatic of all developed economies. 

Given that the U.S. Federal Reserve was established in 1913, we do not have historical data comparable to what is shown in the BOE graph. That said, using various sources and the generous help of others (special thank you to Brett Freeze – Global Technical Analysis), we came up with the following chart going back to the Fed’s inception.

Data Courtesy: Global Technical Analysis and St. Louis Federal Reserve (FRED)

Like the BOE graph above, the contrast of recent growth of the Fed’s balance sheet (+428%) is nothing short of alarming. The fact that this posture has been sustained now for nearly a decade and is producing the weakest recovery on record is even more disconcerting.

The graph below shows the tremendous growth of Japan’s and Europe’s central bank balance sheets since the crisis.

Data Courtesy: Bloomberg


There is clearly something wrong when a central bank prints money in rapidly growing amounts.  Such a departure from prior trends enables other undesirable events to transpire. The Fed, Wall Street, and the media serve up complicated economic explanations for why this time is not different from the past. The evidence provided in these charts argue something is very different.

Our experiences during the Great Financial Crisis provided first-hand evidence of the instabilities caused by too much debt. The years since have been the denial of that evidence as the debt burden has only grown larger. There is little doubt that the years to come will eventually bear witness to the resolution.

The charts above illustrate that central bankers have been desperately trying to use liquidity to offset the prior excesses. However, this is not a liquidity problem it is an insolvency problem. Egregious improper use of their balance sheets has only made the prospects for resolution worse as zombie banks, companies, and consumer debt that should have been liquidated are imprudently allowed to survive.  It is just an eventuality that the Minsky moment will arrive – the time when extensive amounts of debt must be written off, losses taken and financial institutions re-capitalized. When that day arrives, the central bankers and their sledge hammers of monetary policy will not have the precision required to patch the problems yet again. At that point, they can either allow the economy to naturally deleverage in what would certainly be a painful economic event or they can print even more money in further attempts to reflate the economy. Experience has shown that the second option, while it delays the inevitable, is every bit as painful as the first. Our guess is they will select option two and desperately try to kick the can as long as possible and extend the charade of the past few years.

Like a drug addict chasing the proverbial dragon, the world’s central bankers are faced with the painful choice of rehab to break the grip of easy money or an on-going downward spiral toward economic demise.






Recently on our Twitter feed, @michaellebowitz, we introduced the hashtag #fedgibberish. The purpose was to tag Federal Reserve members’ comments that highlight desperate efforts to rationalize their inane monetary policy in the post-financial crisis era. This past week there were two quotes by Fed members and one by the head of the European Central Bank (ECB) which were highly deserving of the tag. We present them below, with commentary, to help you understand the predicament the Fed and other central banks face.

Lael Brainard

On September 5, 2017 Fed Governor Lael Brainard stated the following in a speech at the Economic Club of New York:

We should be cautious about tightening policy further until we are confident inflation is on track to achieve our target.” – “There is a high premium on guiding inflation back up to target so as to retain space to buffer adverse shocks with conventional policy.”

Let us rephrase: The Fed must be careful not to raise interest rates further until signs of inflation appear. When said inflation does pick up and it meets our target, we can then raise interest rates further. In doing so, we will then have the ability to lower interest rates when the economy hits a rough spot.

Inflation has been benign since the 2008 financial crisis. Clearly, nine years of the lowest interest rates on record have not been inflationary for the prices of goods and services that make up most standard economic inflation gauges. In fact, it is difficult to find a better real world example of deflation than the incoherence of negative interest rates manufactured by some central bankers who are begging for inflation. That said, there is a strong positive correlation between the amount of Fed stimulus and the price of financial assets. What Lael Brainard and her colleagues fail to understand is that excessive Fed policy has diverted capital away from productive investments that would generate the inflation and economic growth she and her colleagues so desperately seek to conjure. The bottom line is they do not understand the effect that eight years of excessive stimulus have had on the economy and are clearly unaware of what must be done to solve the global economic malaise.

Neel Kashkari

On September 6, 2017 Neel Kashkari from the Minneapolis Fed stated the following:

“Fed rate hikes may have done real harm to the economy.”

Kashkari senses economic weakness, which he believes is occurring as a result of the Federal Funds rate increasing from zero to 1.25% over the past 21 months. While that statement might be legitimately arguable, he is woefully negligent in helping his listeners understand why the economy is struggling despite the lowest rates in recorded history. An economy that cannot handle such a rise in the cost of money is symptomatic of a society burdened by too much debt. We posit that the economic problems the Fed aims to fix are the result of abnormally low interest rates and other stimulus of years past. These have not had the desired economic effects and have also curtailed future growth. After all, the use of debt pulls forward future consumption leaving less consumption in the future. Mr. Kashkari should consider that encouraging more debt is not the way to solve a debt burden. Either that, or he should let us in on his plan to forestall the arrival of the future from which consumption has been borrowed and payback is required.

Mario Draghi

On September 7, 2017 ECB President Mario Draghi stated:

We do not see negative effects of QE”.

We are speechless. We simply ask Mr. Draghi – if there are no negative effects of QE then why are you contemplating tapering QE? In fact, why are the European people not rioting with pitchforks for a lot more QE?

There is no doubt in our mind Draghi’s statement flat out lie will become obvious over time. Until the media and the markets awaken from their central bank induced slumber, we leave you with the infamous words of prior ECB President Jean-Claude Junker:

When it becomes serious, you have to lie.

As we put the finishing touches on this commentary, New York Federal Reserve President Bill Dudley pointed out that the longer-run effects of disasters like the recent hurricanes actually lifts economic activity. Our reply to this absurd comment is simple: #fedgibberish





Consumption Exhaustion

When people use the word catalyst to describe an event that may prick the stock market bubble, they usually discuss something singular, unexpected and potentially shocking. The term “black swan” is frequently invoked to describe such an event. In reality, while such an incident may turn the market around and be the “catalyst” in investors minds, the true catalysts are the major economic and valuation issues that we have discussed in numerous articles.

Most recently, in 22 Troublesome Facts, 720Global outlined factors that are most concerning to us as investors. As a supplement, we elaborate on a few of those topics and build a compelling case for what may be a catalyst for market and economic problems in the months ahead.

Debt Burden

Debt serves as a regulator of economic growth and is the focus of ill-advised fiscal and monetary policy. It is no coincidence that no matter what economic topic we explore, debt is usually a central theme. Illustrated in the chart below is the actual trajectory of total U.S. debt outstanding (black) through March 2017 and a calculated parabolic curve (red). The parabolic curve uses 1951 as a starting point and a quarterly 1.82% compounding factor to create the best statistical fit to the actual debt curve. If we start with the $434 billion of debt outstanding on December 1951 and grow it by 1.82% each quarter thereafter, the result is the gray line. If debt outstanding continues to follow this parabolic curve, it will exceed $60 trillion by the first quarter of 2020, or nine quarters from now.

Data Courtesy: Federal Reserve

Many economists point to the stability of debt service costs as a reason to ignore the parabolic debt chart. Despite rising debt loads, falling interest rates have served as a ballast allowing more debt accumulation at little incremental cost. While that may have worked in the past, near zero interest rates makes it nearly impossible to continue enjoying the benefits of falling interest rates going forward. Importantly, social safety net obligations, demographics, and political dynamics argue that debt growth is likely to continue accelerating as implied by the chart above. Without interest rates falling in step with rising debt burdens, debt service costs will begin to rise appreciably.

The power of compounding, extolled by Albert Einstein as the eighth wonder of the universe, is as damning in its demands as it is merciful in its generosity. Barring negative interest rates, debt service costs will be an insurmountable burden by 2020. However, if the debt trajectory slows as it did in 2008 that too will bring about painful consequences. In other words, all roads lead to trouble.

Debt growth illustrated above has been an important cog in the consumption engine in the United States. Personal consumption accounts for about 70% of Gross Domestic Production (GDP) growth. Neo-Keynesian and Modern Monetary Theory (MMT) economists argue that those who worry about government debt and deficits just don’t understand deficit finance. We worry because we understand the basic math that will limit the U.S. economy’s ability to further burden itself with debt.

Despite policymakers’ lack of regard for this burden, it is important to keep in mind that, as debt accumulates and consumers become less capable of repaying those debts, deleveraging ensues. This means that households will become unable to sustain the lifestyle to which they have become accustomed. Whether debts will be resolved through repayment or default, economic progress will falter.

Retail Sales

The chart below illustrates the components of retail sales in July 2017. Retail sales measures the dollar amount of finished goods sold as opposed to the Personal Consumption Expenditures index (PCE) which measures the price changes of consumer goods and services.

Data Courtesy: U.S. Census Bureau

As shown above, autos, department stores (general merchandise) and restaurants account for 45% of total retail sales. If any of these sectors exhibit weakness then it is challenging for another sector to offset that weakness given its relative size. If all three of these sectors soften at the same time, as is happening now, then it serves as a warning that consumption is likely to decelerate. This has been a precursor to broad economic weakness and even recession in the past. The sections below review each of these three sectors to help you assess the underlying strength or weakness of these important drivers of consumption and the economy.


Car and truck sales helped lead the economy out of the recession over the past eight years. The surge in sales to new record levels was not solely due to outright sales but was heavily nourished by extensive use of lease financing.  As shown below, auto sales appear to have peaked in late 2016, and used car prices have been in decline since 2014. Both factors raise concerns over the auto sector’s future contribution to economic growth.

Data Courtesy: Bloomberg

Because of the reliance on leasing, cars rolling off leases topped 4 million units last year and are expected to rise by 11% in 2017 and 2018 and top 5 million units by 2019. This is producing a glut of used cars on dealer lots and fueling the decline in used car prices. Projected used car prices, also known as residual value calculations, are a major component of the lease finance equation. As 11-12 million used vehicles hit the market over the next 2½ years, the stage is set for problems in the leased vehicle market and total car sales.

At their peak in February 2016, auto leases accounted for one-third of new car sales and the 6-month moving average remains above 30%. As the leasing option becomes more expensive and the used car supply continues to grow, new auto sales are likely to suffer.

Data Courtesy: Bloomberg

The impact of the used car market on leasing can be seen through the purchase versus lease analysis table shown below. A decline in used car prices (residual values) as is currently forecast dramatically alters lease payments, eliminating leasing as a lower-cost alternative. The bull, base and bear case for used car prices below is based on forecasts from Manheim/Morgan Stanley.

In response to weaker car sales, dealers have slashed prices by the most since the last recession. The auto sector, which represents over 20% of retail sales, is an important economic barometer.

Department Stores

The travails of department stores in recent months have been well-covered. Stores closings and down-sizing stems from weakness in consumer spending but has been rationalized by the “Amazon effect” and preferences for on-line shopping. As recently observed by Evergreen/GaveKal, it’s not the “Amazon Effect”, it’s the “Healthcare Spending Effect” as the average family of four pays $26,000 in healthcare costs. The other problem with the “Amazon” excuse is that, while store traffic has dropped, all department stores have functional, secure websites that consumers can access as easily as Amazon’s web site. According to the Department of Commerce, retail sales for the past 12 months totaled $4.9 trillion of which $403 billion or 8.2% were online. Amazon’s total sales of $150 billion were approximately 3% of total retail sales. Needless to say, there is more to the story than Amazon stealing market share.

On-line retailers are making it hard for department stores to maintain market share but the Amazon narrative sounds more like an attempt to downplay the real problem. Squeezed by weak income gains, higher healthcare and education costs, and the burdensome load of debt from years past, consumers simply have less money to spend and appear less inclined to spend what they do have on apparel and other department store goods.  Further, they have little propensity to borrow to consume more. Since January 2016, department store sales (year over year) declined in every month except two. A continuation of these trends has major implications for retail stalwarts like Macy’s and Nordstrom as well as commercial and retail real estate.

Data Courtesy: Bloomberg


Restaurants face similar issues as retailers with problems extending across all categories of the food service sector except the high-end segment. Restaurant same store sales have experienced 17 consecutive months of year-over-year declines. According to the July 2017 Restaurant Industry Snapshot, Black Box Intelligence reported:

These are the weakest two-year growth rates in over three years, additional evidence that the industry has not reversed the downward trend that began in early 2015.”

Adjusting for inflation further clarifies the difficulties the sector faces. Wolf Richter at Wolfstreet.com adjusted sales at food service and drinking places for inflation (as shown below) and found that sales, as reported in June 2017, are up only 22% from the post-recession lows and have been stagnant since December 2015.

Not going out to eat is one of the easiest ways to tighten a household budget. The decline in restaurant sales seems to reinforce the increasingly tepid state of consumption.

Consumer Credit Outstanding – Record Highs

Evidence of a challenged consumer drowning in debt continues to build. Credit card debt recently hit a record high at $1.02 trillion, and total consumer credit, which includes auto and education loans and excludes mortgages, is fast approaching $4 trillion.

Data Courtesy: Federal Reserve

Economist Joel Naroff, President of Naroff Economic Advisors, elaborated on the weak consumer: “One of the clearest indicators that households are spending cautiously is the softening of big-ticket purchases… households are maintaining their lifestyles by reducing their savings rate and that is likely restraining spending on discretionary goods.”


The growth of public and private debt is occurring at a rate faster than wage growth or economic growth. Debt remains the single most important factor in assessing the outlook for the U.S. economy. The business cycle has become incredibly dependent upon the credit cycle which has been hi-jacked by monetary policy. More borrowing leads to better economic growth in the short term, but eventually the music stops, debts must be repaid, and the painful process of deleveraging begins.

Central bank interventions have imprudently disrupted the normal cycle and likely extended it. Unless the Fed can somehow remove human decision-making from the equation, the swings in business cycles remains a permanent feature of the economic system no matter how disfigured from bad monetary policy. What seems to be taking place in the economy today is consumers nearing a point of maximum debt accumulation or consumption exhaustion. Their willingness or ability to take on more credit is slowing and is beginning to become a drag on consumption.

Our assessment of the amount of debt outstanding in conjunction with what we are observing on new and used car lots, at department stores and restaurants offers some indication that we may be near a turning point in the credit cycle. This does not necessarily mean that a recession is imminent but if our concerns are valid, it certainly raises the probability of an economic downturn and quite possibly a catalyst to reverse the direction of asset prices. Given these dynamics and current market valuations, we continue to urge investors to proceed with caution.






How Much Is Too Much?

The amount of monetary stimulus increasingly imposed on the financial system creates false signals about the economy’s true growth rate, causing a vast misallocation of capital, impaired productivity and weakened economic activity. To help quantify the amount of stimulus, please consider the graph below.

Data Courtesy: Federal Reserve

Federal Reserve (Fed) stimulus comes in two forms as shown above. First in the form of targeting the Fed Funds interest rate at a rate below the nominal rate of economic growth (blue). Second, it stems from the large scale asset purchases (Quantitative Easing -QE) by the Fed (orange). When these two metrics are quantified, it yields an estimate of the average amount of stimulus (red) applied during each post-recession period since 1980. It has been almost ten years since the 2008 financial crisis and the Fed is applying the equivalent of 5.25% of interest rate stimulus to the economy, dwarfing that of prior periods.

The graph highlights that the Fed has been increasingly aggressive in both the amount of stimulus employed as well as the amount of time that such stimulus remains outstanding. Amazingly few investors seem to comprehend that despite the massive level of monetary stimulus, economic growth is trending well below recoveries of years past. Additionally, as witnessed by historically high valuations, the rise in the prices of many financial assets is not based on improving economic fundamentals but simply the stimulative effect that QE and low interest rates have on investor confidence and financial leverage.

Now consider the ramifications of a Fed that continues to increase the Fed Funds rate and moves forward with plans to slowly remove QE.

** The QE stimulus is calculated based on a congressional hearing in February 2011, when Bernanke suggested that every $6.6 to $10 billion held in excess reserves has the effect of lowering interest rates by one basis point or 0.01%.Save




A Peak Above All Others

“Valuations are still well below the peak of 1999” say the bulls. They are certainly correct from an absolute basis but we caution that the current level of market euphoria is in a league of its own when compared to prior peaks on an “apples to apples” basis.

The following table compares earnings growth and implied market expectations for earnings growth from the two prior CAPE (Cyclically-Adjusted Price-to-Earnings) peaks to today. CAPE is the price of an equity index, such as the S&P 500 in this case, divided by the average of ten years of earnings adjusted for inflation. Implied market earnings growth is the rate of earnings growth required for the next ten years to return CAPE to its historical average assuming no price changes.

Earnings over the last ten years have grown significantly slower than during the prior episodes. Despite the weak trend in earnings per share (EPS) and economic growth (GDP), the market is implying earnings will grow at a much faster rate in the future. In fact, the table highlights that EPS must grow almost 4x faster in future quarters than it has over the last ten years if CAPE is to normalize without price losses. That rate is more than double what investors required in 1999.

The table above makes an assumption worth noting. The data includes implied earnings growth under the assumption that the price of the S&P 500 will not change for ten years. If we assume prices rise at the historical average of 6% per year, then the EPS growth required to normalize CAPE is nearly 9%, or 80% greater than the EPS growth experienced over the last 100 years.

In Second to None, we compared CAPE valuations to GDP trends and came up with similar results as shown below.

When one compares current valuations and supporting economic fundamentals to data that preceded damaging market corrections, they may conclude, like us, that today’s equity market valuations may very well be the most egregious observed.

Like any illness, one cannot begin to treat a condition until it is properly identified. 720Global and many other astute market observers continue to produce compelling evidence that there are a variety of economic ills and gross mis-valuations with which investors must contend. The absence of consequences to this point seems to be broadly misinterpreted as “all’s well”.  It is the medical equivalent of “the x-ray must be wrong because I feel fine.” The evidence argues otherwise just as it did in the months preceding 2000 and 2008.





Salt, Wampum, Benjamins – Is Bitcoin Next? A Primer on Cryptocurrency

Currency was first developed about 4000 years ago. Its genius was in the ability to supplant barter thus greatly improving trade and providing a better means for storing value. As illustrated in our title, currency has taken on many different physical forms through the years. Given the recent advances in technology, is it any surprise the latest form of currency resides in the ether-sphere? In this article we explore the basics of cryptocurrencies and the important innovation they support, blockchain. We also offer an idea about whether or not Bitcoin, or another cryptocurrency, can become a true currency worthy of investment.

A Primer on Cryptocurrency and Blockchain

Cryptocurrency is an independent, digital currency that uses cryptology to maintain privacy of transactions and control the creation of the respective currency. While not recognized as legal tender, cryptocurrencies are becoming more popular for legal and illegal transactions alike. Bitcoin (BTC), developed in 2009, is the most popular of the cryptocurrencies. It accounts for over half the value of the more than 750 cryptocurrencies outstanding. In this article we refer to cryptocurrencies generally as BTC, but keep in mind there are differences among the many offerings. Also consider that, while BTC may appear to be the currency of choice, Netscape and AOL shareholders can tell you that early market leadership does not always translate into future market dominance.

Before explaining how BTC is created, acquired, stored, used and valued, it is vital to understand blockchain technology, the innovation that spawned BTC. As we researched this topic, we read a lot of convoluted descriptions of what blockchain is and the puzzling algorithms that support it. In the following paragraphs, we provide a basic description of blockchain. If you are interested in learning more, we recommend the following two links as they are relatively easy to understand.

The Ultimate 3500-word guide in plain English to understand Blockchain – Mohit Mamoria

A blockchain explanation your parents could understand – Jamie Skella

Blockchain is an open database or book of records that can store any kind of data. A blockchain database, unlike all other databases, is stored real time and is accessible for anyone to view its complete history of data.

The term block refers to a grouping of transactions, while chain refers to the linkages of the blocks. When a BTC transaction is completed BTC “miners” work to solve the cryptology algorithm that will enable them to link it to the chain of historical transactions. As a reward for being the first to solve the calculation, the miner receives “newly minted” BTC. As the chain grows, the effort needed to solve and verify the algorithms increase in complexity and demand greater computing power. As an aside consider the following statement by Bitcoin Watch (courtesy Goldman Sachs):

“BTC worldwide computational output is currently over 350 exaflops – 350,000 petaflops – or more than 1400 times the combined capacity of the top 500 supercomputers in the world.”

Needless to say, a tremendous amount of computing resources and energy are being used by BTC miners, and it is still in its infancy. Could these resources be better employed in other industries, and if so, how much productivity growth is BTC leeching from the economy?

The takeaway is that blockchain is an open, real-time database that provides anonymity to its users. It is not controlled or regulated (yet) by any government. BTC miners, driven by the incentive to earn BTC, and fees at times, verify and authenticate the database. Blockchain technology is incredibly powerful and will likely revolutionize data management regardless of whether cryptocurrencies thrive or disappear.


Bitcoin Mining (Creation): New Bitcoins are created as payment to BTC miners that solve the aforementioned calculations that verify transaction data and link it to the blockchain. This ingenious reward system incentivizes miners to compete to perform these calculations, enabling the blockchain to exist. Currently there are approximately 16 million bitcoins outstanding out of a proposed limit of 21 million. As the blockchain grows, the calculations required to mine BTC and add to the chain become more complex, making each bitcoin harder and more costly to earn than the prior one.

Obtaining and Storing Bitcoin: Other than mining Bitcoin, the only other way to obtain them is via transactions and exchanges. One can earn bitcoin by selling a product or service to someone willing to pay in BTC, or one can purchase them with traditional currency through a BTC exchange. BTC can be exchanged for cash or goods and services in a similar fashion. There are reportedly over 100 BTC exchanges, and BTC ATMs are gaining in popularity.  BTC’s are stored in a so-called “wallet”. Wallets may reside on a mobile phone or a desktop computer. The decision to use one versus the other largely comes down to a trade-off between security and ease of use.

Transacting with Bitcoin: Each wallet has a unique key which serves as a personal identifier. When one wishes to transact, the buyer and seller swap their personal keys and the transaction information is posted for miners to verify and post to the blockchain. The identity of the buyer and seller is never revealed. This is one reason that black market, money laundering and tax avoidance transactions are popular on BTC exchanges. While not 100% accurate, you can think of a BTC transaction process as similar to a debit card transaction, but instead of banks verifying, approving and transferring cash to fund the transaction, miners fill that role.

Valuing Bitcoin: Valuing BTC is just like valuing any other currency. One can compare BTC to U.S. dollars or to any other currency. One can also compare the value of BTC to its purchasing power or what one may buy given a set amount of BTC. Currently, BTC is rising rapidly versus all major currencies thus its purchasing power is following suit. As marginal interest in BTC versus sovereign nation currencies increases, the rise in value could continue.

In trying to provide a succinct summary of BTC, we left out many details which you may find pertinent and/or interesting. As blockchain technology represents an important innovation and will certainly find many other uses besides cryptocurrencies, we would encourage you to apply further rigor and read beyond the scope of this article.

BTC – Currency or Investment Fad?

Since BTC started trading in July of 2010, it has risen over 51,000 percent! This meteoric rise in the price of a bitcoin, as graphed below, has certainly attracted many traders and speculators to the cryptocurrency space. While price gains are certainly drawing short term players, others are buying it for its promise as an alternative currency. It is this aspect of BTC that we believe is most relevant.

Data Courtesy: Bloomberg

BTC is a pure fiat currency, meaning it is backed by nothing tangible other than the value users ascribe. Currencies, whether fiat or hard money (backed by something tangible of value) derive value from their utility and scarcity. As the Weimar Republic and many other nations throughout history have learned, economic disasters occur when governments ignore the value proposition and recklessly print money.

The U.S. dollar, also a fiat currency, is backed by the full faith and credit of the United States as well as a small amount of gold. While some may not ascribe too much value to “faith and credit”, almost 250 years of economic progress, military might, and the most powerful tax base in the world strongly argue otherwise. The dollar is globally accepted for almost any kind of transaction, and, despite recent actions of the Federal Reserve, dollars remain relatively scarce. Put another way, even billionaire Bill Gates would stop to pick up a dollar bill laying on the ground. Visit a third world nation and notice how many vendors not only accept U.S. dollars but encourage their use over the domestic currency.

The question investors, not short term speculators, are tasked with answering is, “Will enough people value BTC to make it a respected and often used currency?” In our opinion, the most crucial information needed to answer that question is understanding how governments will respond to the rise of BTC. Gaining a sense for what is at stake for existing currencies and the economies that employ those currencies offers keen insight into the future of BTC and its ability to become more than an afterthought in global trade.

The preamble to the U.S. Constitution states the purpose of the Federal government is to:

“…form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity.”

In other words the government’s role is to protect the freedoms and liberties of its citizens. If the government has no ability to fund itself and is unable to provide defense and law enforcement it cannot uphold the Constitution. More precisely – the sovereignty of any nation, regardless of its form of government, rests upon the strength and integrity of its currency.

All transactions, and their participants, that occur with BTC are anonymous. Accordingly taxes cannot be efficiently assessed, black market transactions are made easier, and fraud can easily escape the eye of law enforcement.

If BTC continues to gain in popularity there is little doubt in our opinion the government will seek control or at a minimum the personal data from the transactions. In fact the SEC has recently opined on the matter claiming that “tokens” such as BTC can be deemed securities and may need to be formally registered. This is just a first step but given the potential threat, we envision government will impose a way to remove the secrecy BTC offers, allowing taxation and legal supervision to occur.

We strongly believe the government will not allow BTC to become a full-fledged currency, at least in its current form, but we think they are enamored with the technology. It is possible that a deeply regulated and controlled version of BTC or a new government cryptocurrency could at some point usurp the dollar as we know it today.

Before summarizing this article we leave you with a few pros and cons of BTC:


  • BTC is unregulated, allowing users to avoid taxes or any other kind of governmental, banking, and law enforcement scrutiny.
  • BTC is in limited supply which should help it to retain its value over time. We caveat that with the fact that there are many competitors, each with their own rules about creation.
  • BTC creation is not subject to the whims of central bankers that appear constantly looking to devalue their respective currencies via inflation.
  • Transacting in BTC is easy. As more sellers of goods and services accept BTC its flexibility improves.
  • Typically storing BTC is less expensive than most other national currencies as well as precious metals. Additionally, transaction fees and other banking costs are largely avoided.


  • Bitcoin is unregulated. Regulations to enforce market structure and prevent fraud are not available.
  • There are over 750 cryptocurrencies and the number is growing rapidly. Which one will emerge as the dominant currency beyond the first mover stage? Conversely, which ones will fail and leave holders with nothing?
  • BTC security is not fool proof. Wallets have been hacked on both desktop computers and mobile phones. Due to the anonymous nature of the exchanges, remediation of such actions is difficult.
  • Price volatility makes accepting BTC a risky proposition. Accordingly transaction fees are becoming popular by many merchants.
  • The energy costs and computing power associated with mining BTC is massive and will increase as the complexity of the blockchain and the number of users grow. Seemingly these resources could be put to better use.


The U.S., E.U., Japan, China and Great Brittan have devalued their currencies significantly over the past ten years. The recent success of cryptocurrencies is a meaningful sign that central banker actions have not gone unnoticed by the users of traditional currencies. While we applaud the concept of a currency that is scarce and avoids the whims of bureaucrats, we do not own, nor do we have plans to own cryptocurrencies in the future. The current market is one of significant volatility and heavy speculation. Additionally, the bigger concern is that global governments have the means to make or break cryptocurrencies. Until these powers more fully reveal their intentions on BTC, the risks are too speculative to warrant involvement.