Tag Archives: bear

Seth Levine: COVID-19 Is Not The Last War

These are truly remarkable times in the investment markets. The speed, intensity, and ubiquity of this selloff brings just one word to mind: violence. It would be remarkable if it wasn’t so destructive. Sadly, the reactions from our politicians and the public were predictable. The Federal Reserve (Fed) faithfully and forcefully responded. Despite its unprecedented actions, it seems like they’re “fighting the last war.”

Caveat Emptor

My intention here is to discuss some observations from the course of my career as an investor and try to relate them to the current market. I won’t provide charts or data; I’m just spit-balling here. My goal is twofold: 1) to better organize my own thoughts, and; 2) foster constructive discussions as we all try to navigate these turbulent markets. I realize that this approach puts this article squarely into the dime-a-dozen opinion piece category—so be it.

Please note that what you read is only as of the date published. I will be updating my views as the data warrants. Strong views, held loosely.

The Whole Kit and Caboodle

Investment markets are in freefall. U.S stock market declines tripped circuit breakers on multiple days. U.S. Treasuries are gyrating. Credit markets fell sharply. Equity volatility (characterized by the VIX) exploded. The dollar (i.e. the DXY index) is rocketing. We are in full-out crisis mode. No charts required here

With the Great Financial Crisis of 2008 (GFC) still fresh in the minds of many, the calls for a swift Fed action came loud and fast. Boy, the Fed listen. Obediently, it unleashed its full toolkit, dropping the Fed Funds rate to 0% (technically a 0.00% to 0.25% range), reducing interest on excess reserves, lowering pricing on U.S. dollar liquidity swaps arrangements, and kick-starting a $700 billion QE (Quantitative Easing) program. The initiatives are coming so fast and so furious that it’s hard to keep up! The Fed is even extending credit to primary dealers collateralized by “a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities.” Really?!

Reflexively, the central bank threw the whole kit and caboodle at markets in hopes of arresting their declines. It’s providing dollar liquidity in every way it can imagine that’s within its power. However, I have an eerie sense that the Fed is (hopelessly) fighting the last war.

The Last War

There are countless explanations for the GFC. The way I see it is that 2008 was quite literally a financial crisis. The financial system (or plumbing) was Ground Zero. A dizzying array of housing-related structured securities (mortgage backed securities, collateralized debt obligations, asset-backed commercial paper, etc.) served as the foundation for the interconnected, global banking system, upon which massive amounts of leverage were employed.

As delinquencies rose, rating agencies downgraded these structured securities. This evaporated the stock of foundational housing collateral. Financial intuitions suddenly found themselves short on liquidity and facing insolvency. It was like playing a giant game of musical chairs whereby a third of the chairs were suddenly removed, unbeknownst to the participants. At once, a mad scramble for liquidity ensued. However, there simply was not enough collateral left to go around. Panic erupted. Institutions failed. The financial system literally collapsed.

This War

In my view, today’s landscape is quite different. The coronavirus’s (COVID-19) impact is a “real economy” issue. People are stuck at home; lots are not working. Economic activity has ground to a halt. It’s a demand shock to nearly every business model and individual’s finances. Few ever planned for such a draconian scenario.

Source: Variant Perception

Thus, this is not a game of musical chairs in the financial system. Rather, businesses will be forced to hold their breaths until life returns to normal. Cash will burn and balance sheets will stretch. The commercial environment is now one of survival, plain and simple (to say nothing of those individuals infected). Businesses of all sizes will be tested, and in particular small and mid-sized ones that lack access to liquidity lines. Not all will make it. To be sure, the financial system will suffer; however, as an effect, not a primary cause. This war is not the GFC.

Decentralized Solutions Needed

Given this dynamic, I’m skeptical that flooding the financial system with liquidity necessarily helps. In the GFC, a relatively small handful of banks (and finance companies) sat at the epicenter. Remember, finance is a levered industry characterized by timing mismatches of cash flows; it borrows “long” and earns “short.” This intermediation is its value proposition. Thus, extending liquidity can help bridge timing gaps to get them through short-term issues, thereby forestalling their deleveraging.

Today, however, the financial system is not the cause of the crisis. True, liquidity shortfalls are the source of stress. However, they are not limited to any one industry or a handful of identifiable actors. Rather, nearly every business may find itself short on cash. Availing currency to banks does not pay your favorite restaurant’s rent or cover its payroll. Quite frankly, I’m skeptical that any mandated measure can. A centralized solution simply cannot solve a decentralized problem.

Fishing With Dynamite

The speed and intensity at which investment markets are reacting is truly dizzying. In many ways they exceed those in the GFC. To be sure, a response to rapidly eroding fundamentals is appropriate. However, this one seems structural.

In my opinion, the wide-scale and indiscriminate carnage is the calling card of one thing: leverage unwinding. It wouldn’t surprise me to learn of a Long Term Capital Management type of event occurring, whereby some large(?), obscure(?), new (?), leveraged investment fund(s) is (are) being forced to liquidate lots of illiquid positions into thinly traded markets. This is purely a guess. Only time will tell.

Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, put it best:

“Something is blowing up in the world, we just don’t quite know what. It’s like if you were to go fishing with dynamite. The explosion happens under the water, but it takes a little while for the fish to rise to the surface.”

Daniel Want, 2020 03 14 Prerequisite Update pt 4

What To Do

This logically raises the question of: What to do? From a policy perspective, I have little to offer as I am simply not an expert in the field (ask me in the comment section if you’re interested in my views). That said, the Fed’s response seems silly. Despite the severe investment market stresses, I don’t believe that we’re reliving the GFC. There’s no nail that requires a central banker’s hammer (as if there ever is one). If a financial crisis develops secondarily, then we should seriously question the value that such a fragile system offers.

Markets anticipate developments. I can envision a number of scenarios in which prices reverse course swiftly (such as a decline in the infection rate, a medical breakthrough, etc.). I can see others leading to a protracted economic contraction, as suggested by the intense market moves. Are serious underlying issues at play, even if secondarily? Or are fragile and idiosyncratic market structures to blame? These are the questions I’m trying to grapple with, weighing the unknowns, and allocating capital accordingly.

As an investor, seeing the field more clearly can be an advantage. Remember, it’s never different this time. Nor, however, is it ever the same. This makes for a difficult paradox to navigate. It’s in chaotic times when an investment framework is most valuable. Reflexively fighting the last war seems silly. Rather, let’s assess the current one as it rapidly develops and try to stay one step ahead of the herd.

Good luck out there and stay safe. Strong views, held loosely.

Technically Speaking: Risk Limits Hit, When Too Little Is Too Much

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.


But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

RIA PRO: Risk Limits Hit

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?


But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Technically Speaking: On The Cusp Of A Bear Market

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

  1. The “corporate credit” markets are at risk of a wave of defaults.
  2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
  3. Stock market targets for 2020 are still too high, along with 2021.
  4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
  5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  6. Economic growth is slowing.
  7. Chinese economic data has weakened further.
  8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
  9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
  10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
  11. Valuations remain at expensive levels.
  12. Long-term technical signals have become negative. 
  13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
  14. Rising loan delinquency rates.
  15. Auto sales are signaling economic stress.
  16. The yield curve is sending a clear message that something is wrong with the economy.
  17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

  • The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
  • The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
  • The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • COVID-19 Impacts To The Global Supply Chain Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
  • The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
  • I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.


Technically Speaking: Sellable Rally, Or The Return Of The Bull?

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

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

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.


Seth Levine: Commoditizing My Framework For A New Paradigm

When it comes to investing it’s never different this time; nor, however, is it ever the same. This difficult-to-navigate paradox creates a scarcity of longevity. Today’s persistently low yield environment has upped the ante and put many marquis names out of business. To be fair, alpha’s been elusive of late. It’s not that anyone suddenly became dumb. Rather, traditional methodologies are less robust today. Perhaps adopting a commodity framework can help generate returns in these investment conditions.

Let’s face it, investment yields are scarce. Those on sovereign bonds evaporated. Corporate credit interest rates are numbingly low. Earnings yields on stocks are paltry (i.e. multiples are high). Real estate cap rates are tumbling. No matter what the cause—central banks, safe asset shortages, the proliferation of passive investing, a lack of growth, whatever—cash flows derived from invested principals are small. Unfortunately, this is the current state of the investment markets. It’s our job to play the hand.

Money Now for Money Later

Valuation lies at the heart of my investment framework … at least it did, historically. As Warren Buffett famously said, “Price is what you pay. Value is what you get.” This resonates with me; however, I’m currently rethinking my position. Price is easy to determine, just look at it. What about value?

Before answering this seemingly simple question, it’s helpful to clarify just what investing is all about. Making money, right? Well, one can make money in lots of ways. I can perform a service for my employer in exchange for a paycheck; I can bake some cookies and sell them on my corner; I can also buy a bond and earn its yield. In all cases I make money, yet in different ways. (Note, that’ll use money interchangeably with currency, despite a pet peeve).

In the first case (the job), I trade my time and labor for money. In the second (the baker), I also buy raw materials in order to produce higher value goods. In the investment case, however, I purchase an (assumed) income stream using money that I currently have in order to earn even more over the course of time; it’s money now for (more) money later. Thus, investing is the act of making money from money.

With a clear definition of investing in hand, we can get back to our question of valuation. Valuation is a way to assess the attractiveness of an investment. In other words, it’s a way to frame how much money we expect to make (or lose) in the future in return for our money today. More later for less now is the objective—risk aside.

Today, however, cash flow yields are low when compared to history. Thus, investing appears less attractive under a traditional valuation framework. Yet, the “show must go on”, especially for us professionals. We must find a way to grow our capital in spite of these challenges.

Herein lays the dilemma: What to do when one’s approach no longer applies? Abandoning discipline is simply not a satisfactory solution for serious investors. We all need investing principals to guide our actions. Luckily, my friend Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, offers some helpful advice.

Everything’s Commodity-like

In a recent client letter, Want notes that:

“When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities have minimal to no yield … , then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type trading philosophy to guide your portfolio operations – you need to focus more on capital/money flows and positioning in order to harvest the natural swings in market prices driven by the underlying behaviours of participants …”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

According to Want, traditional valuation-based frameworks are less efficacious in low yield environments. Rather, the supply and demand dynamics of capital flows matter most. I’m certainly sympathetic to that! However, I think this view can be harmonized with a valuation approach without overhauling one’s entire investment philosophy.

When everything is “commodity-like”, the final price dominates its return profile. Remember, the purpose of investing is to earn money, not to hold the underlying assets. Thus, as yields converge to zero (and below, absurd as it may be), positive returns increasingly require the selling at a higher price; or as Want puts it, to “harvest the natural swings in market prices.” In essence, all assets become “trading sardines.”

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

Seth Klarman, Margin of Safety via ValueWalk

Thus, as yields dissipate, all investment decisions converge to price speculation … even for bonds that can only return par. (Please see the Appendix at the end of the article for some illustrations.) However, valuation need not be cast aside whole cloth. Rather, it must be reframed to acknowledge that all the “value” lies in the asset’s terminal value, when it’s finally exchanged for cash—be that at maturity or an intermediate sales date.

I find Want’s framework of recasting financial assets as commodities to be clarifying. It helped me override my previously held notions of valuation and provided me with a more powerful framework with which to understand the current investment landscape.

The Commodity-like World

What might this commodity-like world look like? Well, perhaps more commoditized (pun intended). Want continues:

“… Such swings won’t always make sense to a traditional analysis paradigm, it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of inventories’ that you may or may not wish to hold at different times depending upon how capital is behaving, where the money is flowing (& why), and how participants are positioned. A more detached and objective approach to markets will be even more valuable than usual.”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

In other words, as differentiations of cash flows diminish, investment decisions increasingly shift from allocation within asset classes to allocation among asset classes. Thus, the importance of (tactical) asset allocation increases in Want’s framework.

I can see other investment implications of a more commodity-like world. Perhaps:

  • Speculation in bonds increases and investment horizons shorten as investors take a more total rate of return approach in light of falling yields; volatilities could rise
  • Equity investment time horizons extend, as higher multiples force investors to look further into the future for required growth to materialize; volatilities could fall
  • Commodities appear more attractive as storage costs become less of a relative disadvantage in a world where bonds don negative yields
  • Correlations converge as interest rate sensitivities increase
  • Security selection’s role in portfolio construction shifts to risk management as the risk of loss dominates return profiles
  • Or, I’m wrong about all of the above!

Unfortunately, we’re short on historical precedents for the current paradigm. Hence, we can only guess what impacts might materialize. However, I suspect that focusing on capital flows as Want suggests is a useful framework.

Reframing for the New Paradigm

It’s an understatement to call these challenging times for active management. Many traditional investment frameworks simply don’t work as well. Is it truly different this time?

Rather than abandon valuation in my framework, I’m reframing my decisions. Commoditizing my investment approach has brought some clarity to these confounding times.

Rather than abandon valuation in my framework, I’m reframing it. Conceptualizing “’everything’ [as] commodity-like” helps. We must speculate on all assets, plain and simple, looking to terminal values for returns. While my acceptance has been slow, commoditizing my investment framework has brought some clarity to these confounding times.

Appendix: Speculation Rises as Yields Fall

In this section I show what happens to hypothetical bond returns (using IRR) when coupons fall, maturities shorten, and when a sale occurs at a higher price prior to maturity. Note that in all cases the value shifts more towards the final payment. Thus, the incentive for speculation rises as yields fall. Assume all values are in U.S. dollars and undiscounted for simplicity. This exercise is for illustration purposes only.

Example: Initial Bond

Below is the payment stream for a hypothetical bond that matures at par in 5 years with a 10% coupon.

Note that the holder receives $150 in total payments. The final payment ($110) accounts for 73% of all value received.

Example: Falling Coupon

Here, I illustrate the payments for the same hypothetical bond but with a lower coupon of 5%.

Note that only $125 is received—due to the lower interest rate—and that the final payment ($105) accounts for a greater percentage (84%) of the total value.

Example: Shortened Maturity

Next, I show the payments for our 5% hypothetical bond but with a 3 year maturity instead of 5.

Here, only $115 is received due to 2 fewer years of coupon payments, though the IRR remains constant. As a result, the final payment occurs in year 3. It also accounts for 91% of the of the total value received.

Example: Pre-maturity Sale

In this last example, I illustrate what happens to the 5% hypothetical bond with a 5 year maturity when sold at a higher price ($105) prior to maturity (shown year 3).

There are a couple of interesting points to note. Since it was sold for $5 more than the maturity value (par), our total payments amount to $120. While this is $5 less than had it been held to maturity, the IRR increases to 7% (from 5%). The final payment now accounts for 92% of the total value received—the highest percentage of all our examples.


Note that the pre-maturity sale example had the highest return for the hypothetical, 5%-coupon bond. The sale price also dominated the return profile, illustrating how the bond became a more effective total rate of return instrument, ripe for speculation.

It’s Not 2000, But The Market Is Mighty Narrow Again

For those of us who were around in 1999-2000 looking at charts and perhaps writing about them, there is an eerie familiarity with the market of today. Back then, when indices and the Nasdaq in particular, were rallying harder each day than the last, market breadth was looking fairly weak. In other words, the big the names were soaring, forcing indexers and ETFs to buy them just to keep their weightings, and the positive feedback cycle roiled on.

I remember, looking at this stuff for BridgeNews and having to forecast where resistance levels might be based on Fibo projections or the top of some trading band. Walking by my desk, it was not unusual for me to exclaim, “This is nuts!” By that way, a much funnier TV show than “This is us”.

Now, I am in no way comparing 2000 and 2020 in any way but they did have one thing in common. Big cap, and mostly big cap tech, was powering ahead while mid-cap and especially small-cap lagged far behind.

No, that does not show up in the advance-decline line, which just managed to set a new high after its late January swoon. A colleague had a good explanation for this, saying that plenty of stocks can be rising but by smaller amounts and far below previous highs. That would certainly explain why the a/d line is rising and up/down volume is mediocre, at best.

Have you looked at a small-cap advance-decline? Not pretty.

Check out these charts:

(Click on image to enlarge)

This is the regular, cap-weighted S&P 500 vs. the equal-weighted version. The trend has been accelerating higher for months. While it is not anything near what it looked like in 1999-2000, it is still quite significant.

(Click on image to enlarge)

Here is the Nasdaq-100 ETF vs. the equal-weighted Nasdaq-100 ETF. To the moon, Alice.

(Click on image to enlarge)

And then let’s look at a mega-cap stock. This is Microsoft MSFT and it looks just as nuts. Don’t forget this is a $1.4 TRILLION stock so every gain packs on huge amounts of market cap.

What happens when this stock finally decides to pull back? It scored an as yet unconfirmed bearish reversal this week on huge volume. And look how far above it is now from its 200-day averages. Nuts!

Considering that it is a member of the Dow, the Nasdaq-100, the S&P 500 and XLK tech ETF, what do you think will happen when this huge member (keep it clean, pervs) corrects? And there is a lot of correcting room before even thinking about a change in a major trend.

There you have it. A narrow market at all-time highs, ignoring news and having utilities among the leading groups.

But don’t worry, the Fed has already committed to more quantitative easing. Whoopee! Kick that can, Jerry.

Seth Levine: The Unsurprising Repo Surprise

Have you heard? There’s trouble in the repo markets. Even casual investment market participants probably know that something’s amiss. While only a handful of investors participate in repo, this obscure corner of the investment markets rests at the epicenter of the financial system—hence all the attention. The turmoil caught many by surprise, prompting the Federal Reserve (Fed) into emergency action. However, the real surprise is, in my opinion, why this took any of us by surprise to begin with?

What is Repo

Repo is financial jargon for a repurchase agreement. While it sounds complex, repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.

If this sounds overly complicated, it’s because it is. The details, however, are unimportant for our discussion. One need only grasp that repo sits at the bottom of the financial system pyramid. It’s a primary funding source for many large institutions that comprise the plumbing of financial markets. Due to leverage, small disturbances in the repo (and other money) markets can ripple through the entire system. This is what some fear.

What Went Wrong

Repo rates dramatically spiked on September 17, 2019, more than doubling the previous day’s (using SOFR as a proxy). This is highly unusual for the most illiquid of all markets, let alone one of the most trafficked. Arbitrage should render this behavior anomalous as the rise in repo rates represented a highly profitable opportunity. Why weren’t the big banks picking up all this free money? With the Great Financial Crisis (GFC) still fresh in the minds of many, the rumor mill kicked into overdrive surmising why.

Repo rates (estimated with SOFR) unexpectedly spiked on September 17, 2019.

The cause of this unexpected rate spike is still a matter of speculation. The financial system is highly complex with innumerable inputs and outputs making it difficult to establish direct, behavioral links. However, it’s likely that routine balance sheet mismanagement by the Fed was the culprit (as discussed by George Selgin here and Zoltan Pozar of Credit Suisse here).

The Fed’s responsibilities expanded as a result of the GFC. These, and other regulatory changes, might have created some idiosyncrasies that underpinned the unexpected rise in repo rates. One is that the Fed now banks the U.S. Treasury. The Treasury used to have bank accounts with private institutions. It now keeps its money at the Fed in an account called the Treasury General Account (TGA). Another important development is the increased size of the foreign repo pool. The Fed avails its balance sheet to “about 250 central banks, governments and international official institutions.” While not new, the aptly named foreign repo pool usage is up nearly 3-fold since 2014.

The significant growth in the TGA (blue) and foreign repo pool (red) after the GFC creates new balance sheet volatility for the Fed to manage.

The chart above illustrates that both the TGA and foreign repo pool are large and volatile. They are also relatively new in their importance to the Fed from an operational perspective. Let’s not forget that while the Fed is a central bank, it’s nonetheless just a bank. Unpredictable and violent swings in account balances are difficult to manage—community, commercial, and central bank alike. Too be sure, we may later discover different reasons for the repo rate spike … but not until later.

Centralization Breeds Instability

It’s easy to get bogged down in the details when analyzing the financial system. After all, it may be the most complex one we’ve built. Thus, applying some more macroscopic principles can help in understanding the system as a whole.

Generally speaking, decentralized systems are more stable than centralized ones. We intuitively get this and can witness its widespread application throughout the man-made and natural worlds. We diversify our investment portfolios, manufacturers source from multiple suppliers, organisms spawn many offspring, and successful animals eat varied diets. Decentralization is a primary thesis for Bitcoin, breeds a fear of monopolies, and is why I find capitalism so attractive (among other reasons).

Imagine if you kept your entire net worth in a single account at a single bank and it failed (ignoring FDIC insurance, which protect against just this). Your wealth would disappear overnight. What if your investment portfolio comprised of a single stock and it went bankrupt? Such reckless behaviors are rightfully condemned. Yet, we expect differently from our financial system; why?

For some reason we believe that centralizing our monetary system reduces volatility and increases stability. Thus, the financial system is either a complete outlier or the premise is false. Modern day economies are built on the belief of the former, yet the evidence is underwhelming.

Merely a Matter of Time

I find no reason to believe that centralizing our financial system holds unique benefits. It’s just another type system. From a stability perspective, all benefit from decentralization. It follows that our financial one should too. Thus, I believe it was (is) only a matter of time until the monetary system broke (breaks) again. It happened in 2008—which I see as a run on banking collateral rather than a housing market collapse (ask me to explain in the comment section if you’re interested in my view)—and it will inevitably happen again. It has to because the future is unknowable and risks are concentrated.

It’s not that decentralization breed omniscience. No, omniscience doesn’t exist. Rather, it allows for discovery. Decentralized systems have more actors striving towards the same goals. However, all will not proceed in the same way. Inevitably, some will fail and some will succeed and to varying degrees. Diversity ensures that the failures are inconsequential to the system as a whole. Yet, we all benefit from the knowledge that those who succeed discover. Hence, human prosperity advances.

Following the GFC we changed a bunch of rules and allegedly strengthened regulations. Despite the best of intentions, these actions further homogenized behavior ensuring that the system breaks again! Remember, centralized systems are most fragile. Further centralization—which is what laws and regulations actually do—limits diversity by raising the barriers to entry (compliance costs money) and conforms incentive schemes (to comply with regulatory demands). Thus, we got fewer actors behaving in more similar fashions. The financial system became more fragile as a result, not stronger. Here we are, a decade later, and low and behold trouble’s a brewin’ in financial markets again, and in new and unforeseen ways.

Principles Bring Clarity

In the end, the presence of a central bank and the myriad of rules and regulations are counterproductive. They work to limit competition, stymie diversity, and ultimately increase frailty. Progress requires failure and centralized systems are not flexible enough to allow for this. If a centralized actor goes down, so goes the whole. “Too big to fail” is only a feature of centralized systems.

While unexpected, the breakdown of repo markets should come as no surprise. Further centralization of the financial system increased its fragility qua system. Of course, predicting how and when it might fail ex ante is nearly impossible. If the current problems were obvious they wouldn’t have escalated to this point.

That said, the inevitability of a system failure doesn’t make it an investible theme, especially for casual observers. In fact, waiting for a repeat of the GFC may be expensive in opportunity cost terms and cause one to miss out on other profitable investments. Rather, I plan to simply keep this analysis in the back of my mind. If financial markets seize up (again), I know what to look for: decentralizing, market fixes.

Following causal chains of events is one of the many challenges of macro investing. While the spike in repo rates is perplexing, proper first principles can bring some clarity. Faulty ones, however, breed only surprises.

The Real Investment Guide For The Next Decade

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

As we head into the next decade, this complete set of articles delves into the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given that market’s cycle over time, it is important to understand how markets, and investing actually work, the impact on your wealth, and what you can do about it.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.
  • Spot what’s missing: A compendium of investing wisdom from the world’s greatest investors.

Seth Levine: Why Are We So Scared

I always find this time of year to be self-reflective. Year-end provides a natural point for critiquing past performance and fitting it into a broader investing context. These holidays in particular have a way of foisting this perspective upon me, and with deep meaning. As a parent of two young kids, my holidays now kick off with Halloween. Perhaps stuck in this spirit, I find myself wondering: Why are we so scared?

I can’t seem to shake this sense that we live in a culture that’s scared. I see a number of signs across the economic, political, and investment landscapes that seem support this observation. To be sure, this is not universally true on an individual level. However, as a culture we seem to have lost our mojo, our swagger, and the confidence that fuels significant economic advancements.

Why Scared

Scared is psychological state. It connotes being afraid or frightened. Scared feelings typically arise when one feels helpless in a situation or believes he/she is unable to improve it via action. Thus, it’s closely associated with victimhood. Scared is not a feeling that accompanies independence, confidence, and capability.

By all accounts this is the best time in human history to be alive. It’s never been easier to access information, collaborators, and different perspectives, nor in such abundance. These conditions should enable self-reliance and wealth creation. They are a perfect crucible for unbounded development and prosperity.

Yet, economic independence doesn’t seem as valued today as it once was. The cultural impetus shies away from proximal challenges and looks to others for solutions—and in particular, for political solutions. This doesn’t square with the times.

In my view, this shift is a matter of confidence and self-esteem. It’s not the shirking of responsibility that’s telling; it’s the unwillingness to engage with the issues. Confident individuals face challenges head-on. Scared ones look to others. Problem solving often requires creativity, not reverting to staid and ineffective ideas. The former is a strength of the market; the latter is a politician’s. To be sure, there’s a time and place for politicians and bureaucrats to assist. However, economics is not the place and these are not the times. The obsession with finding political fixes for economic underperformance suggests to me that we lack the self-confidence to tackle it ourselves. We seem scared.

Central Bank Dependence

The clearest example of this in the investment markets is the neurotic obsession with central banks. I commonly hear people critique their ignorance and ineffectiveness only to follow with—the same people, mind you—what central bankers ought to do next. I thought central bankers were ineffective?

It’s time we stop looking to central banks for solutions. They don’t have them. In fact, I see no need for them at all. In theory, central banks were created to oversee the money supply. Dual mandates were afterthoughts. Since the money supply merely reflects economic activity, this should be a fairly mundane task and one that decentralized private banking centers performed quite well (despite the popular narrative).

Today, however, our opinions of central bankers are quite different. They are viewed as omniscient, economic alchemists. We look to central bankers to manipulate business cycles, control inflation, and prescribe prosperous economic conditions. Where did this come from and when did it become so prevalent? Central banks can’t create money let alone produce these other conditions. They fall under the purview of the productive economy and thus are products of our actions alone. The perception of central bank dependence is false and marginalizes our own economic efficacies.

Political Dependence

The central bank obsession is, in my view, part of the more general, cultural shift towards increased political dependence. This can be observed by the rise of populism writ large. From Trump’s presidency in the U.S., to Brexit, to the Five Star Party in Italy, to the yellow-vest movement in France, there’s a clamor for retrenchment within national borders. The U.S.-China trade war is just another iteration of this, justified rationalized or not.


To me, there’s a common theme to these movements. They are indicative of a reversion to tribalism, the cutting of global ties that underpin modern day prosperity, and represent a fear of “the other” mentality common in all primitive and destructive cultures.

Why is it important where the human who produced your steel resides? Seriously, why does it matter to you? If that person’s so evil the solution is simple: deal with someone else. I promise you there is no greater commercial influence than that. Just put yourself in the shoes of a business owner to see (go ahead, close your eyes and imagine).

Why are we suddenly seeking politicians to protect us from the ever-changing world? Economic issues are those of voluntary exchange and they are dynamic. Very few problems require political fixes. Seeking them indicates that one is too scared to trust his/her actions. It’s a skepticism over the power one commands in the marketplace. It’s cowardly.

The Monetary Policy—Fiscal Policy False Dichotomy

It’s often helpful to compare and contrast ideas against extreme conditions. Doing so can surface the essential issues for easier analysis. This is especially true for complex concepts such as those found in economics. Oftentimes, impacts are not obvious and secondary and tertiary effects must be considered.

In the investment markets we often hear about fiscal or monetary policy initiatives. Whenever the economy needs a boost, commentators opine that more accommodative monetary policy might be needed (such as lower interest rates). Or perhaps this particular instance requires a fiscal policy response (like lower taxes and/or greater government spending). Whatever the case may be, prescriptions are framed as being a matter of monetary policy or fiscal policy initiatives.

Nothing, in my view, illustrates cultural fear more than this false dichotomy of monetary policy—fiscal policy. They are conceptually similar and not appropriate book-ends of a conceptual dichotomy. Rather, monetary and fiscal policies are different flavors of central planning. Both seek government intervention in the economy, differing only by their preferred branch. Monetary policy utilizes central bank action while fiscal policy seeks legislative cures. They are not opposites.

The true opposite to central planning is economic liberty. Thus, the proper spectrum, in my view, has economic freedom on one side (deregulation and less controls) and central planning—i.e. fiscal and monetary policy, which are greater controls—on the other. One side reflects independence and confidence while the other forceful paternal shelter. Considering monetary or fiscal policy actions only rejects self-reliance as an option altogether. It’s a scared perspective.

Pacifying Investment Decisions

I also see the shift to passive investment strategies to fit into the fear of independence theme. To be sure, there are virtues of passive investing. Track records and fees relative to active management are compelling enough. But are these the sole motives?

Source: Morningstar

What if a fear of underperforming popular indices or standing out plays a part? Speculating on the future often yields wrong outcomes; it’s part and parcel with investing. As a colleague of mine is fond of saying, “we’re not bootstrapping treasuries.” By this he means that earning returns requires taking risks. Sometimes things don’t pan out as planned and losses occur. The trick, of course, is to minimize the losses; not neurotically seek to avoid them.

Are allocators more concerned with finding the comfort of consultants’ consensus rather than investing according to their own observations? Could career risk play a part in this trend? Are we too scared of being wrong to invest in themes that might play out over longer time horizons?

Share Buybacks Are Safest

What about share buybacks? Much has been made about the magnitude at which corporations have repurchased their shares. Why is this happening at such an unusually high level?

Source: 13D Research

To be sure, I take no issue with share repurchases and see them as a legitimate use of capital. However, even accretive buy-backs have short-lived impacts. They last only a year when year-over-year comparisons are made. Why aren’t businesses investing in projects that could yield multi-year benefits? Are executives simply playing it safe, too scared to commit capital to projects that might fail? Are the majority of shareholders really so shortsighted?

Scared As An Investment Theme

It’s easy to roll your eyes at this article and dismiss it as another meme. However, my intention is neither to seek scapegoats nor to emotionally vent. Rather, I’m interested in exploring whether this behavior is part of a larger cultural phenomenon of fear. If so, the next downturn could push us further from economic liberty and more towards political controls. This would surely have investment implications.

Of course, there is no such thing as “we.” We is just an aggregation of “I’s.” Thus the real question is: Why am I so scared? While an uncomfortable, if not antagonistic question to ask, it’s critical to understanding this emergent theme.

The world is in constant flux. No one should appreciate this more than investors. Change is the essence of our jobs—to profit from the movements in asset prices. Prices don’t move in stagnant conditions.

Yet, as a culture we seem terrified by change. I find this puzzling since we’ve never been better equipped to adapt and capitalize from it. Those investors who embrace change will survive and thrive. Those who don’t could perish from this business. What could be scarier than that?

Offense/Defense Index Looking Better

But technical analysts like ratios, too, and one of them is telling us that this bull market is not over yet.

Many years ago, a technical analyst named Boris Simonder, with whom I’ve lost touch, showed me his offense/defense index, which he created from a proprietary classification of stocks deemed part of the “offense,” such as technology, and stocks deemed part of the “defense,” such as consumer staples. I adapted it to use standard SPDR ETFs and have been following it ever since.

Here’s the formula:

( XLK * XLY ) / (XLP * XLV)

or, if you prefer:


That’s tech and consumer discretionary in the numerator and consumer staples and health care in the denominator.  And you may have noticed that it is an expansion on simpler XLY / XLP ratio many analysts now use.

We can argue on the specifics and you may think you want to substitute utilities for health care or some other tweak. Go ahead and float that boat but for this missive, I’ll stick with what’s been doing OK for me.

Anyway, take a look at this chart:

That’s a nice coiling pattern for my version of the offense/defense index. And you might think that we’re in a small decline within that pattern right now. I agree. But stochastics applied to the ratio shows a higher low on the last price swing lower. For regular stocks and indices, that suggests a bit of internal strength and there is no reason why it should not apply here.

Of course, we have to wait for the actual breakout to declare the bulls to be in charge but this is certainly a better picture than that of the traditional discretionary / staples ratio:

This also looks like resistance is at hand and it shows no encouragement in stochastics. Perhaps the lack of lower low in Sep/Oct is bullish but I’d like to see the index hold near the trendline and then make the breakout attempt.

Consider this one more, albeit small, bit of evidence that this bull market is not over yet.

A Somewhat Bullish Market Commentary

Let’s just put the lead where it should be. Stocks are resilient and short-term dip notwithstanding; they are likely to be higher before the end of the year.

Here’s the evidence in bullet form.

  • The NYSE advance/decline is hovering at all-time highs.
  • Three-month bill yields are dropping hard. The Fed will cut rates one more time this year.
  • Financials are holding tight near resistance thanks to the “uninverting” of the yield curve. You can argue with me on that point later.
  • Trade deals are getting done (Japan) so China will feel the heat. I do not buy the argument that the Chinese are waiting out the current administration (i.e. impeachment or failed reelection). They know better than that.
  • Sector rotation is a healthy sign. Chart below of value and growth.
  • Retail is not dead. Chart below.

Of course, it’s not all great. I’d like to see more stocks hitting new highs and small caps, which started to perk up nicely, have eased back.

Now let’s talk about those headlines.

  • Impeachment inquiry. This may or may not hurt the orange fella but it is likely to seal the deal for Elizabeth Warren on the blue side. Wall Street has already vocalized that it will crumble for President Warren.
  • Softening economic numbers. Nothing stays that good forever. The U.S. is still the best game in town. Why else is the U.S. dollar at a 2 ½ -year high? Yeah, we’ve got positive bond yields but we’ve also got a growing economy. By the way, the UUP bullish dollar ETF is at an 11-year high.
  • What the heck happened to gold? After a major, long-term upside breakout in June and a nice rally to resistance in August, it is now overstaying its welcome as a correcting market. That pesky dollar, right? Well, gold priced in euros has been flat for more than a month, too.
  • And while I’m using such foul language, what the heck happened to bitcoin? It was supposed to get a boost from all this economic turmoil. And when I say foul language, I mean bitcoin.

So, unless something big and bad happens, I’m still a stock market fan.

In the spirit of Warner Wolf, CMT, let’s go to the charts.

(Click on image to enlarge)

Important support for big cap indices.

(Click on image to enlarge)

Important support for the Transports (yes, this is a chart of DJTA, not what eSignal labeled it).

(Click on image to enlarge)

Rotation value from growth.

(Click on image to enlarge)

Retail ice age seems to be enjoying a little market climate change.

(Click on image to enlarge)

There you go. A new low.

Your move Chairman Powell.

Negative Rates Are Destructive But Profitable

“Remember that Time is Money.”

Benjamin Franklin, Advice to a Young Tradesman

It’s unfortunate that such genius identifications as the above have long been forgotten by the economic community. First penned in 1748, Benjamin Franklin makes the connection between human effort—or rather the application of human effort towards productive work—and the effect/product, i.e. wealth. We measure this increase in prosperity, of course, in terms of money. Thus, “Time is Money” (or rather, time is potential money). They are one in the same since time is the one truly scarce resource with which all living creatures have to work.

However, you’d never know this by a look at today’s markets. Negative interest rates are now common place and widely accepted as a policy tool. In fact, a tradition of thought is being established as a means of “normalizing” them. Pushing deeper into negative territory seems all but a foregone conclusion. No longer is the absurdity and devastation of such policies discussed. No longer discussed is that negative interest rates negative human life.

Negative Interest Rates Negate Human Life

“Negative interest rates negative human life” is a bold statement, I know, but I stand by it. I suspect “Big Ben” would too. We both understand what economics is all about. It has nothing to do with fine tuning commercial activities for some nebulous greater good. Rather, economics is about individual, human happiness. It’s about making the most of our time on this planet; to use our time, effort, and brainpower to maximize the human experience while it lasts. The better use of time we make—via productivity—the more wealth can be created, the more comfortable and fulfilling our lives, and the better the existence we can enjoy. Hence, time is money in a pure, genuine, and profound way.

This is why negative interest rate policies (NIRP) are so pernicious and beyond absurd, irrespective of whether or not they saved the collapsing financial system in 2008. NIRP implies contractions on such fundamental scales that they cannot be beneficial. Specifically, that either: 1) your time and efforts are valueless (or worse, destructive), or; 2) your currency is valueless. In other words, action is detrimental to survival; time is not money, and; one’s currency choice is not important. None could be more obviously false.

Time and Effort Are Valuable

Your time and effort are valuable. Fundamentally, these are your survival tools. If time and effort were not valuable then there would be no need to ever take any action of any sort. You’d be better served to lay curled up in the fetal position than to attempt to work. This is clearly false. Human survival (and thriving beyond this basic need) requires one to produce and trade for values. This requires action; hence time and effort are valuable.

Time is Money

If time were not money then no one would work, full stop. Why toil if the fruits of one’s labor did not exceed the effort and time spent while working? Humans work for the purpose of survival; however we’re lucky that civilization has sufficiently advanced such that immediate survival is no longer of primary concern for much of the developed world.

Instead of concerning ourselves with food and shelter, human effort can be diverted towards life enhancements. Today, engineers make software, artists make films, ride-sharing drivers transport us, and financiers fund dreams. Without people working on such projects there would be none of the results. There’d be no Ubers and iPhones and movies and biotechnology and office buildings without men and women applying their time towards these endeavors.

If time were not money why on earth would anyone work? Surely there would be better ways to spend one’s only truly scare resource of time. Simply doing nothing and conserving energy would be an evolutionary advantage. Why work if there are no values to gain?

Working to lose would favor not working or acting at all. This is the absurdity of negative interest rates. To apply capital only to lose it—i.e. NIRP—would favor not applying capital in the first place. Thus, NIRP’s existence implies a contrived construct to exist, not one grounded in natural law.

Sound Money Is Universally Desired

Another possibility of NIRP is that it says something negative about the currency and not necessarily output. The currency is depreciating over time. But this too is nonsensical. Why would anyone use a depreciating currency given the choice? In fact, no one ever chooses such inferior currency, looking at history. These circumstances typically arise with a healthy dose of force. Poor currencies are typically foisted upon an unwilling population and they typically don’t last; no one wants to lose value in a transaction. If a currency cannot serve as a reliable unit of account, the populace will eventually find something that can—officially or unofficially sanctioned.

Thus, people will flock to the best currency option available so long as they are not forced to choose otherwise by regulation and statute. This in part explains the U.S. Dollar’s dominance in international financial transactions. True it’s the “reserve currency” but it’s the reserve currency for a reason and the dominance of the U.S. Navy is not one. Rather, the respect for the rule of law, deep capital pools, and established and incentivized institutions are what likely preserves the U.S. Dollar’s reserve status. Don’t kid yourself; an IMF mandate for settling trade in renminbi would yield no (material) results. Economic actors will act according to their best interests, factoring in the price of non-compliance. Thus, the “bag-holders” are always those compelled to hold depreciating currency.

Sweet Siren’s Song

The challenge with negative and low rates is just how profitable they can be to trade. Hence, they should not be ignored, in my view. I introduced the chart below nearly a year ago. It illustrates how much return potential is embedded in the 10 year U.S. Treasury bond (USTs) expressed as a function of its current yield (see here for a more detailed description). As yields have fallen, the appreciation/depreciation potential has dramatically increased. No longer are USTs boring, yield providing investment vehicles. In the environments of NIRP and ZIRP (zero interest rate policy) they are now total-rate-of-return vehicles ripe for speculation and outperformance.

Today’s Bizarre State of the World

These dynamics gave us the current state of the world. Investors cheer the stupidity of NIRP because they yield profits. The more ZIRP, NIRP, and QE (quantitative easing) the more capital gains can be reaped despite no detectable economic benefits produced. Hence, investors cheer the nonsensical which policymakers mistake as as endorsements. A self-reflective loop is established.

Many claim that NIRP, ZIRP, and QE saved the failing financial system. This, however, is mere conjecture. We simply don’t know what would have arisen from the ashes, better or worse. Counter-factual claims cannot be empirically debated.

Thus to claim that NIRP is beneficial displays one’s bias and, in my view, is grounds for mistrust on non-objectivity. This is particularly true since we can see how truly absurd the theoretical construct for NIRP is. Time is money and freely exchanging citizens desire sound currency, these we know as fact. Arguing to the contrary in papers or by inciting tradition can’t negate these.

So long as the academic and political will favors the incumbent policies they will likely be entrenched. The IMF recently published their playbook for the next economic slowdown and NIRP plays prominently. Economics (true economics) illustrate why these next rounds will also fail to stoke economic activity.

There’s no breaking the link between time and money and the desirability for sound currency. These are universal truths. That said, bond math illustrates that trading “rates” in such an absurd environment can be lucrative, at least for the time being. Thus, I find it useful to know both: the absurd and the trading potential. Profitably trading won’t negate the deleterious effects of NIRP, but it can help preserve one’s capital for better, more intellectually sound times.

The Lunacy Of The Dow

I’ve been on Twitter (TWTR) quite a few times railing against the Dow Jones Industrial Average and its price-weighted calculation. And, of course, I am not alone. This index presents a distorted view of any given day’s events although most of the time its foibles are hidden in the performance of the rest of the market.

Let’s look at today, September 11, 2019. I am writing at about 2:30 in the afternoon and the Dow itself is up roughly 137 points on the day. All of that gain, and I mean all of it (within my writer’s margin of error) is attributable to three stocks and number three in that group is good for only 10 points.

That means for all practical purposes, only two stocks are responsible for the Dow’s gain. All the others more or less cancel each other out.

Right now, Boeing (BA) is up 3.4%. That’s a pretty substantial gain but since the stock carries such a high dollar price (381), that percentage yields a 12 point (rounded) gain. And that 12 points translate, through the magic of the Dow’s divisor, into 83 points for the DJIA, itself.

Boeing alone is responsible for the 83 of the Dow’s 127-point gain at this hour.

Apple (AAPL), fresh on the heels of its big tech reveal (no thanks, I do not need a phone with three camera lenses) is up 2.5% or 6 points. That’s 38 Dow points.

And for those of you keeping score, the third stock was Caterpillar (CAT), up 1.2% for 10 Dow points.

Why is this? Because the Dow is calculated by adding up all the changes on the day for the 30 stocks within and then dividing by some engineered number that is less than one. That means a one-point move in any stock, regardless of the stock’s actual price, results in a greater than one point move in the Dow itself.

Now, on days when the high-priced stocks such as Boeing, Apple, and Caterpillar have very small changes, the Dow Industrials will be in step with the other major market indices. But there are times, lots of times when the Dow will be higher on the day and every other major is lower.

Of course, the media will report that the market was up because they focus on the Dow. It does not matter (most of the time) that everything else was lower. Sure, you might hear a more advanced talking head say the market was mixed but that is an easy cop-out.

Here’s a recent tweet of mine – $BA responsible for 102 of the Dow’s 98-point gain.

Why? Because most everything else was lower or flat.


A one-point change in UnitedHealth (UNH) is treated the same as a one-point move in Pfizer (PFE). At a price of 233, United’s one-point is good for 0.4%.  That’s just noise. Meanwhile, a one-point move in Pfizer at 37 is 2.7%.

Which stock had a more important day?

You know.

Fun with Fractions

And then comes the real fun. Every time they change the Dow, they have to change the divisor to keep the continuity of the historical price record. And every time a Dow stock splits, they have to do it again.

With each change, the divisor seems to get smaller and smaller and anyone who knows math just a little knows that the smaller the divisor (the bottom of the fraction) gets, the larger the value of the result gets.

By all means, track the Dow. It’s not always misleading and I personally more quickly absorb the level of the overall market and change on the day when I look at it, warts and all. However, if you want to really know what happened in the market, you need to look at a bunch of diverse indices, such as the Nasdaq, Russell and S&P 500. Toss in a few sector indices or ETFs, too.

The cheese may stand alone* but the Dow really cannot.

* Hi-ho, the derry-o, the cheese stands alone.

Having Your Cake & Eating It Too

One of the more interesting aspects of our social and investment landscape is how little appetite many people have for bad news. Problems can be so messy and hard after all; who wants to deal with them? Boris Johnson catered to this reality in the UK when he said his policy on cake is “Pro having it, and pro eating it.” Why make difficult choices when they can be obviated with a rhetorical flourish?

Not only do people not want to hear bad news, though, but often they work actively to ignore or reframe it. This makes a difficult investment environment even more so by inviting opportunists to exploit such tendencies by misrepresenting things. While following proclamations that are too good to be true will inevitably produce pain for many investors, it will also create opportunities for others.

One thing that can be objectively said about the investment landscape is that interest rates are low on an absolute and historical basis. As a result, it is fair to say that “easy” investment options like buying Treasury bonds that yield well more than the inflation rate are just not available to today’s investors. If you want anything like the returns of past years, you are going to have to take on more risk.

This is the mild account of the investment landscape. The harsher version was provided by a “luminary of one of America’s largest family offices” in the Financial Times:

It is the hardest investing climate I have ever seen in my career in public markets now.

There simply are not abundant opportunities in publicly traded financial assets like stocks and bonds. As a result, the vast majority of investors are “exposed to the vagaries of low interest rates.”

Low rates force ordinary investors into a difficult trade-off: They must either accept the vagaries of low interest rates or forego the potentially higher returns of risky assets altogether. Temptation often tips the scales. As the FT describes, “eagerness to outperform benchmarks is likely to push investors into the riskiest and least liquid areas.” 

It is easy to get a sense of deja vu.

It was just over ten years ago when low rates were driving persistent demand for yield which compelled efforts to manufacture yield and disguise risk. As Zwirn, Kyung-Soo Liew, and Ahmad explain in their paper, “This Time is Different but it will End the Same Way“, the same basic risks exist today. The only difference is that some of the specifics are different:             

  1. “Lack of market-making and other regulatory changes that will impede price discovery in the next downturn
  2. Masking of the deterioration of underlying collateral and ‘rearview mirror’ analysis
  3. New versions of the old games played by the rating agencies
  4. Explosion in Asset-Liability mismatched structures
  5. Regulatory changes in compliance of financial institutions.”

The outcome, however, is unlikely to be very different:

“Wrapping fixed-income securities into ETFs does not solve the problem of the lack of exchange-traded markets for fixed-income securities. It only hides the lack of liquidity of the underlying constituents.”

John Dizard addressed the issue in the FT

“Because we no longer have the banks doing market-making, we have created the conditions for liquidity mismatching. We need to do better analysis of both sides of the balance sheet and not confuse listed assets with liquid assets, since in a crisis, liquidity and even pricing is uncertain.” 

Stephanie Pomboy of MacroMavens summarized the situation as well as anyone:

In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid.

In important respects, it is odd that after investors got beaten down so badly in the GFC that they would expose themselves to the same kind of beating again. Why are they behaving so foolishly?

Why are they repeating the same mistakes?

Rana Foroohar throws out one idea in the FT:

“My answer to the question of why we haven’t yet seen a deeper and more lasting correction is that, until last week, the market had been willfully blind …”

According to Foroohar, investors have been blind to “the fact that there will be no trade deal between the US and China” and blind to the reality “the Fed’s decade-long Plan A — blanket the economy with money, and hope for normalisation — has failed.”

Ben Hunt and Rusty Guinn from Epsilon Theory have also picked up on this oddity in investor behavior. They believe that many important issues don’t garner more attention because they never hit the radar of mainstream media. In Does it make a sound“, Rusty Guinn describes serious topics like the Jeffrey Epstein case and the protests in Hong Kong are unlikely to fade “because they don’t exist.”  He explains,

“There is no narrative, no common knowledge in the US about these [Hong Kong] protests. American media have largely stopped covering them.”

Mainstream media does not consider them newsworthy – so they don’t cover them – so they don’t exist in any meaningful sense for most people.

For curious people and concerned investors, the pervasiveness of willful blindness is as cringe-worthy as it is astonishing. Why don’t people push back? Why don’t people demand better coverage, better information? Guinn has a hypothesis for that too. In “The Country HOA and Other Control Stories“, Guinn describes: 

Even when we know something is a story written for us, that we are being told how to think or feel about something to serve someone else’s purposes, there is a visceral, emotional part of us that wants to believe it. Needs to believe it. We yearn to see it as an echo of some truth rather than a construction, and when some paltry data emerges to confirm it, it becomes almost irresistible.

Indeed, it is nice to believe stories. The Fed has our back. The economy just needs some time to get back to normal. High debt levels don’t have serious long-term consequences. Modern companies have such abundant growth prospects that they don’t need to focus on profitability. 

However, these are all just stories. As Mohamed El-Erian recently warned in the FT, the believability of some stories is now being seriously tested: “Long spoiled by the comforting support of central banks, investors are getting a feel for what it would be like when economic concerns rather than central bank monetary policies take a bigger role in determining asset prices.”

More specifically, El-Erian highlights two different narratives that deserve fresh consideration:

“With recent developments, however, investors need to seriously reconsider two other widely held hypotheses: that trade tension is temporary and reversible; and that a more indebted global economy would navigate them without serious setbacks.”

Additionally, cracks are now beginning to appear to the narrative that “Everything is OK” in ways that echo the problems with Bear Stearns hedge funds in early 2008. John Mauldin describes one such early warning indicator:

“Some bond issues have been bought in their entirety by a small handful of high-yield bond funds. The problem is that the company that issued these bonds has defaulted on them. Not just missed a payment or two, but full default. Their true value, if the funds tried to sell them, might be 25–30% of face if they actually traded, according to the people who told me this. But the funds still value them at the purchase price of $0.95 on the dollar.”

This can happen because the funds have not tried to sell the bonds and therefore there is no “mark-to-market” price. The important lesson for investors is that the loss has already been incurred; it just hasn’t been recognized yet. This creates what will be very disappointing news for unwary investors. Their returns are already down; they just don’t know it yet. 

Higher yielding sovereign bonds are also suffering severe losses. Argentina’s markets got hammered on a single day in August on the basis of a single primary election. As the FT reported, “the biggest loser was the $11.3 billion Templeton Emerging Markets Bond Fund, which fell by 3.5%, a drop that has continued on Tuesday as the selling was nowhere near done. That was its largest daily drop since the October 2008 global financial crisis.” 

Nor was this a one-off blip that could easily be recovered. In the last month conditions in Argentina eroded to the point where it defaulted on a number of short-term bonds and implemented capital controls to buy time to restructure. In short, a lot of pain will be felt by investors.

Other cracks are appearing as well. Asset managers such as Woodford Investment Management and H2O Asset Management have had difficulty meeting surging redemption requests due to a proliferation of illiquid investments in their funds. This highlights another interesting nuance of the current environment. During the GFC, banks suffered the greatest liquidity crises; this time it may be money managers that have the biggest liquidity problems.

Regardless, the overarching point for investors to understand is that you don’t get to have your cake and eat it to. John Mauldin describes the investment consequences of those who try:

“More money is going to be lost by more people reaching for yield in this next high-yield debacle than all the theft and fraud combined in the last 50 years.”

Unfortunately, investors are unlikely to get much help from mainstream commentators and advisers. For example, Schwab sent out a note trying to calm investors after a big down day in early August by encouraging them to “Maintain a long-term view on investing”. The note advised:

“It’s important to remember that timing the market is virtually impossible and that it’s generally better to maintain a long-term perspective on investing. Market fluctuations, such as those we’re experiencing, should not alter your overall investment strategy, unless your financial plan has changed.”

The problem is, there is a lot of truth to the statement, so it sounds plausible enough to not be challenged very seriously. What the statement does not do, however, is consider the possibility that recent volatility might be providing useful new information. Nor does it acknowledge the inherently flawed financial system that undermines what constitutes long-term financial planning. The ultimate message is that most investors don’t want to hear those things, so you won’t hear them from major channels.

Despite such obstacles, it is still distinctly possible to navigate the investment landscape successfully. In doing so, it is useful to keep in mind that we’ve seen this movie before. There is no need to overthink things; it will end the same way. A day will come when liquidity freezes and prices start dropping in chunks rather than small increments. Many investors will be shocked, and many will be in denial. 

In such an event, however, there will also be opportunity. Mauldin describes: 

My own goal is to be a buyer, not a seller, whenever it [a liquidity crisis] occurs. For now, that means holding cash and exercising a lot of patience. If I’m right, the payoff will be a once-in-a-generation chance to buy quality assets at pennies or dimes or quarters on the dollar. I think the next selloff in high-yield bonds is going to offer one of the great opportunities of my lifetime. In a distressed debt market, when the tide is going out, everything goes down. Some very creditworthy bonds will sell at a fraction of the eventual return.”

This highlights an underappreciated aspect of investing: One person’s gain is another’s loss. On one hand, it is hard to tolerate low returns and harder yet to do so when commentators and advisers encourage complacency. As a result, it is easy to fall prey to lies and misrepresentations – like being able to get decent yields with the same amount of risk. Most people want to have their cake and eat it too, but that is usually a formula for losing money.

On the other hand, because it is so hard to resist such temptations, few succeed. As a result, enormous opportunities get created for the few who are diligent and disciplined enough to do so. They only come along a few times in your life, though, so you need to be prepared. That preparation involves incorporating the deep structural flaws of the financial system as a risk factor, actively seeking out information outside the channels of mainstream media, and holding cash and exercising a lot of patience”.


Inverted Yield Curve Is Actually Bullish

My favorite meme following last week’s yield curve inversion was captioned, “I survived the yield curve inversion.”

My favorite tweet (from @jfahmy) was, “The next Jobs Report should be very strong with the 50,000 “Yield Curve Experts” that were added this week.”

Last Wednesday, the day the Dow dropped 800 points, the yield curve inverted for a few hours. There is a lot to unpack in that sentence, so let’s get to it.

First, I have to briefly define what the heck a yield curve is so if you already know, skip the next three paragraphs.

The Explanation

The curve is a representation, or plot, of the yield on bonds from the same issuer across all maturities for which it is issued. Typically, we talk only about the yield curve of U.S. Treasuries, although they do exist for many sovereign debt markets. Analysts looking at the U.S. version have the luxury of a robust curve with maturities running from three and six months, to one, two, five, seven, 10, 20 and 30 years.

The normal yield curve is upward-sloping, meaning that yields on shorter maturities are lower than yields on longer maturities. Investors are paid more to take the risk of loaning their money for longer periods of time.

When the curve is flat or downward-sloping, that’s when we think the economy is running into trouble. The downward-sloping curve is called the inverted curve. This frequently appears a year or longer before recession begins, but as they say, the inverted yield curve has predicted 15 of the last 10 recessions. In other words, it does not always work.

Inversion Therapy

OK, now that our more sophisticated readers are back with us, the curve got somewhat funky in April when the five-year yield dipped below the 3-month yield. Then in May, the three-month yield was above the seven year and then above the 10-year.

Some pundits called the three-month to 10-year condition the inverted yield curve. My opinion is that was questionable, at best. Why? See next paragraph.

For most of June, only the three-month was out of whack, which we can partially blame on the Federal Reserve’s rate policy. Everything else looked to be a regular, upward-sloping yield curve.

Then one grey day it happened (Jackie Paper came no more.) On August 14, the two-year ticked above the 10-year to create the dreaded inversion. The financial media went nuts. Recession is coming! Recession is coming!

However, within hours, the curve un-inverted. Was recession averted? Did that temporary inversion mean anything at all? And the real question, does a positive 10 basis point spread (0.10 percentage points) mean something all that different from a negative 10 basis-point spread? And if the economy is going to go into the pooper, shouldn’t the inversion last for weeks and months, not just hours?

How it Got There Matters

Just like knowing how a stock got to its current price, we should know how the yield curve got to its inverted state, albeit a temporary one.

I’m not a bond maven but I did notice that the 10-year yield dropped like a stone recently and that is what seemed to have driven the inversion. We’ll get to the why that happened later.

After posing the question to a group of pros, I got the answer from a real bond maven, Michael Krauss, the former Managing Director and Head of Global Fixed Income Technical Analysis and U.S. Equity Technical Analysis at JP Morgan Securities.

It turns out that my observation was right (blind squirrel, I know). It does matter how the yield curve got flat or inverted. What Krauss said was that the steep drop in the 10-year yield and a slower drop in the two-year yield was called a “bull flattener.”

When they talk about an inverted yield curve, most people think of the “bear flattener” variety, where short rates rise quickly and long rates do not. This is where the Fed sees something overheating in the economy or the ugly head of inflation rearing so it clamps down on easy money. This tends to lead to a slowing of the economy and weakness in the stock market.

However, the bull flattener means something entirely more positive. It could mean sentiment for a stronger economy is strong. Or that investors are piling into longer-term bonds. The latter seems to be the case as money from around the world is pouring into U.S. bonds.

Why? Because trillions of dollars’ worth of global government bonds have negative yields. Negative!

Of course, money will flow to the best return and that is in good ol’ America. We also can see that in the strong U.S. dollar, which everyone needs to buy U.S. bonds.

Don’t believe me. Former Fed Chief said the same thing.

Mutual funds specializing in bonds are also seeing record inflows of money.

Superforecasting A Bear Market

There’s an ongoing debate about whether or not the U.S. is approaching a recession. As an investor, this question is of utmost importance. It is precisely at these times when fortunes can be made and lost. There’s no shortage of pundits with strong opinions in both the affirmative and negative camps armed with plausible narratives and supporting data sets. How to decide which side to take? Applying some proven forecasting methods to historical data can help bring clarity to this question.

Forecasting is tricky business. It’s really hard to do well consistently, especially in investing.

Fortunately for us, Philip Tetlock has made a study of forecasting. In the book Superforecasting: The Art and Science of Prediction (aka Superforecasting) he and coauthor Dan Gardner share their findings of a multi-year study aimed to discover the best forecasters, uncover their methods, and to determine if forecasting skills could improve. There are many great lessons conveyed in the book. We can thus apply them to our problem at hand: the question of whether or not the U.S. will enter a recession.

The Lessons

By running a series of geopolitical forecasting tournaments, Tetlock and Gardner discovered a group of elite forecasters and uncovered their best practices. Ironically, specialized knowledge played little role in their success. Rather, it was their approach.

Superforecasting had a profound impact on me. I took away a more concretized framework for dealing with predictions. Rather than feeling my way through a situation, Superforecasting gave me a method I could apply. Well-devised forecasts share four characteristics:

  1. They’re probabilistic
  2. They start with a base rate formed by an “outside view”
  3. They’re adjusted using the specifics of the “inside view”
  4. They’re updated as frequently as required by incoming facts, no matter how small the increments

Think Probabilistically

The best forecasters (aka Superforecasters) made predictions in a probabilistic manner. In other words, outcomes weren’t binary—i.e. something would or would not occur. Rather, the Superforecasters ascribed a probability to a forecast. For example, they would assign a 30% chance to the U.S. entering a recession rather than saying it was unlikely. This precision is important.

Establish a Base Rate Formed by an “Outside View”

Before making a prediction, the Superforecasters first established a base rate informed by an “outside view.” A base rate is merely a starting probability. It will later be adjusted. An outside view, as introduced in his book Thinking, Fast and Slow by Daniel Kahneman, is a perspective that looks for historically analogous situations for guidance.

To establish a base rate using an outside view, we should first look at previous recessions and periods where economic conditions were similar. How often did conditions deteriorate into recessions? What events tended to precede them? This should give us starting point.

Adjust Using the “Inside View”

After establishing a base rate using an outside view, the Superforecasters adjusted it by taking an inside view—another Kahneman concept. An inside view is a perspective that only considers the situation at hand. It ignores historical precedents and seeks to induce an outcome using only the current facts. In a sense, every situation is treated as unique.

Thus, the Superforecasters considered both the historical context and idiosyncratic characteristics to inform their predictions. In a lot of ways this resembles using deductive and inductive reasoning in concert with each other; a practice I condone. To follow with our example, a Superforecaster would adjust their 30% recession base rate up or down based on current economic and market conditions. It might be increased due to the prospect of a trade war; it might be reduced based on strong jobs data.

Frequently Updated

Lastly, the Superforecasters frequently adjusted their forecasts. They constantly updated their probabilities, even in increments that seemed insignificant if warranted by new information. While this might sound trite, Tetlock and Gardner found it to be a key component of accuracy. Thus, forecasts might be changed with each presidential tweet in our ongoing example.

Establishing a Recession Base Case

Armed with an improved forecasting method, I applied it to the recession question. I ditched my bullish or bearish perspective and established an outside view base rate. Here, I illustrate my process using two of the most hotly debated metrics: the Institute for Supply Management’s Purchasing Manager’s Index (PMI) and the U.S. Treasury yield curve (YC), defined by the 10 year U.S. Treasury bond minus the Federal Funds Rate.

I compiled monthly data through July 2019. I then looked at the frequency of negative monthly returns for the S&P 500 index (SPX) after a specific threshold was breached. For the PMI I used its latest reading of 51.2. For the YC I looked at periods of inversion (i.e. when the spread was zero and below). Once these months were identified, I calculated the SPX’s return over the following 1 month, 3 months, 6 months, 12 months, and 24 months.

Note that I analyzed SPX returns and not whether or not a recession occurred. As an investor, my only concern is if asset prices will rise or fall, not recessions as such. It just so happens that recessions and falling stock prices coincide; but it’s the values that we ultimately care about, not recessions.

Findings From PMI Data

Below is my analysis of SPX returns for when the PMI historically reached these levels (51.2). Note that my data covered 858 months for my 1 month sample period and 835 months when looking at 24 month returns (i.e. 23 less data points). The PMI was 51.2 or below in 322 of those months, or ~38% of the time across sample periods. During these instances, successive SPX returns were negative for 14% of the months using a 24-month time horizon and 35% of the months using a 1-month one. Thus, 29% is a reasonable base rate for taking a bearish stance on the SPX over a 6 month time horizon using an outside view of PMI data.

Also, note that the longer the negative return environment persisted the larger the average losses.

Here is a similar table examining YC inversions. Both the instances and magnitudes of negative SPX returns appear to be higher for this data set. A base rate of 52% seems reasonable for taking a bearish stance on the SPX over a 6 month time horizon for this data set.

Findings From Combined PMI & YC Data

It’s an even rarer occurrence for the YC to invert when the PMI is 51.2 or below. This happened in just 65 months out of the past 780, or 8% of the time. SPX returns were negative 28% to 55% of the time depending on one’s timeframe, with 3 month displaying the highest frequency. We could use a 46% base rate for a 6 month time horizon. While losses were less frequent using this dual-signal than the YC alone, they were also more severe. Average drawdowns ranged from 4.3% to 31.4%.

Calibrating Your Grizzly

This analysis affords us two advantages. First, it removes the binary guesswork in trying to predict a recession. We no longer need to make a definite call on whether returns are likely to be higher or lower under the current conditions; we can take a more nuanced, probabilistic approach. Secondly, we can establish a starting base rate that is grounded in historical data.

According to the best practices discussed in Superforecasting this is just the first two steps in creating a robust forecast. The base rate requires adjusting by considering an inside view of today’s economic and market landscapes. It must also be updated as new information materializes.

The conditions examined (a PMI lower or equal to 51.2 and an inverted YC) were recently triggered. History suggests that we’re in a serious position. In the past, SPX returns were negative nearly half the time over the succeeding 3 to 12 months. To be sure, using just two signals is not an exhaustive process. However, it was a good first step in helping me calibrate my bearish instincts.

I’ll leave it to you, the reader, to apply your own inside view of the markets to this base rate. Ultimately, we must determine the extent to which “it’s different this time.” While forecasting is guesswork by definition, Superforecasting provided me with a useful framework to apply to all investing situations. Hopefully I’ll do so profitably.

Unmasking The Voodoo Yield Curve

To normal people, the typical response might be, “What in the name of the almighty are you talking about?

To market geeks likes us, it means the yield curve is as flat as its been since just before the financial crisis and recession.

Still not getting it? Not to worry, you are still normal. The panic in pundit hearts is that a flat yield curve suggests a recession is near. No, not tomorrow, but sometime in the next year or so.

Lazy are we are, we use the spread between the 10-year U.S. Treasury note and the 2-year note as the proxy for the whole curve. The whole curve is actually all the key Treasury rates from three and six months all the way out to 30-years.

Basic Curvology

Normally, these VooDoo articles are mostly time agnostic. However, the current state of the yield curve allows us to cover all sorts of things so I am going to go with it. It will keep, however, once the curve gets more benign again.

Here’s a picture of what everyone calls a normal yield curve (source: StockCharts.com). It is upward sloping as we go from short-term rates to long-term rates. The idea is that investors get paid more to take more risk. And since these are supposedly default-risk free U.S. Treasuries, that risk is interest rate risk. Having your money exposed, i.e. locked up, in longer maturities puts you at risk for rates going higher and your principle going lower.

You know, bond prices and yields move inversely to one another. If you want more, you’ll have to use the google because that will take me too far off track here.

Anyway, that’s the way the world works when things are, ahem, normal. But since the financial crisis and the artificial lowering of short-term rates by they who shall remain nameless (the Fed), this is what the yield curve looked like for the past few years.

Note it still has that nice upward slope. The difference is that the left side (the short end of the curve) starts near zero.  Don’t forget, this was smack in the middle of a rip-roaring bull market is stocks so the economy was humming along, albeit at rather low growth.

Next, look at it today.

Most of it is still upward sloping but something is still pretty different in the short-end. The three-month rate is above the 10-year rate. And the two-year is closing in on the 10-year.

I still call this “somewhat” inverted. You still get paid more to take time risk but you get even more to hold cash (T-bills are pretty much cash equivalents). That’s not good.

Now check out what it looked like when it was really inverted just before the stock market peaked and the first major market shock hit is mid-2007. Now that’s inverted.

Where do we go now?

If I knew that, I’d be writing my novel, not a post here. However, there are a few things we can discuss.

The Fed is in a bind. Although the economy is still is pretty good shape, the yield curve DEMANDS they lower their rates. If they do, the curve normalizes a bit and buys us time. Here, if the long-end of the curve falls, too, then we are in deep Chobani. That would mean businesses do not want to borrow for major projects. And home buyers would not be buying, pressuring mortgage rates lower and the rest of long rates lower by extension (tail wags dog but you get the idea).

What if we make long bonds less attractive to foreign buyers with a plunging U.S. Dollar? It’s a bit of chicken or egg but that would lower demand and lower bond prices means higher yields.  Too bad the global economy is stinko and the best place for growth is right here.

Higher commodities prices via the lower dollar and, unfortunately for reality, improved global growth. A little inflation would push long rates higher.

And finally, since all of that, except for the Fed, is pie in the sky, what if we got a good deal with China, signed the USMCA (new-NAFTA) and decided to put country above party?


We could get the first two, although the second would need a little element of the third.

What’s the real deal with the curve?

The upward sloping yield curve means banks can borrow at low, short-term rates and lend at higher long-term rates. The bigger the spread, the more money they make and the more they want to lend.

Banks, then, should do well with a steep curve. If they don’t, then we got problems.

Inflation keeps the long-end higher because borrowers want to be paid for the risk they take that the money they lend will be worth less when they get it back in 10-, 20- or 30-years. If there is inflation and the long-end stays low, then we got problems.

What if the curve stays flat and there is inflation? Then we got problems. Anyone here old enough to remember the term “stagflation?” A stagnant economy and higher prices.

And now for another bit of current events. A good chunk of the world now has negative interest rates on their debt. You give them money and they give you less back. I suppose that would be great in a deflationary environment, and yes, then we got problems. But right now, I think this is a policy tool, put in place by economic tools, yes, I said it, to ty to stimulate global economies.

Here’s a thought, make them more business friendly and let them be free.

The good news is that if the curve really inverts, the problems don’t really start for a while, and probably not until the curve un-inverts again. You can use the google to read more from real experts on the topic.

And if the U.S. goes negative, there goes the entire saving class.

But for now, the yield curve is simply the plot on a yield vs. maturity chart that shows us where rates are.

It’s Not Gold That’s Getting Me Nervous

The recent breakout in gold got a lot of people excited. How many mummified gold bugs were reanimated, saying, “See, I told you all of that money printing was going to push prices higher!”

Thanks, 49er, that’s not why gold is rising.

Rather than obsess over the why’s and whatnot, let’s take a slightly deeper dive into what is happening. From there, we can draw some conclusions and from what I see, the rest of the year may not be so kind for the economy and for stocks.

I’ve posted charts of gold already so let’s just stipulate that the yellow metal broke out from six-year base in June. It immediately fell into a new trading range before breaking out again this past week.

Was it China’s move to devalue? Probably. But again, the why is not my thing. All I know is that gold moved into a bullish trend until it tells us otherwise.

If gold is rallying, it makes sense that the other precious metals are rallying. And they are. Silver moved nicely since a June breakout of its own, albeit that breakout was not from any major base.

Curious. Now let’s look at a chart comparing gold and silver.

(Click on image to enlarge)

As you can see, the two tracked fairly well until 2016. I don’t know what happened then and I really don’t care. All I see is that the two-headed in different directions.

And yes, both have short-term breakouts. However, only gold as a long-term breakout.

I’m not much of a gold/silver ratio guy although it seems on the surface that silver is the better bet right now. But then again, silver is less precious that gold and by that I mean it is far more sensitive to the economy. It has far more uses in industry.

Does that mean we have an economic red flag? Maybe.

Now let’s look at platinum. Remember the good old days when platinum was hundreds of dollars more per out than gold? With gold now in the $1500 area, it is 70% or so higher than platinum.

(Click on image to enlarge)

The overlay chart shows the same story as with silver. Gold it up, platinum is down, only with no short-term breakout at all.

Again, platinum has far more uses in industry than gold. Another red flag? Or at least the same one?

If we are talking economics, we have to look at copper. Blah, blah, PhD. in economics. We all know.

(Click on image to enlarge)

This chart is copper on its own. The ratio of copper to gold is just pure downhill and has been for two years. Actually, take away the post-election bounce and it’s been down since 2006.

As we can see in the chart, copper formed a nice support over the past year and change and seems to be bouncing off it this week. But even so, this is not a bullish chart.

This one is a red flag, too, although it’s been a red flag for quite some time. A breakdown would not be a good omen for the economy.

And finally, let’s look at industrial metals stocks.

(Click on image to enlarge)

Just lousy. You don’t need any fancier analysis from me.  But what I should say is that this group is at the base of the economy. If it stumbles, the rest of the economy built on top of it can fall.

Is there good news?

It’s never quite this simple. Right now, there is good news as market breadth is still fairly positive. And even though there have been a few brushes with Hindenburg-like divergences, the advance-decline is still right up there. Tech is still in a leadership role.

Let’s also not forget the market is still only a few percent off all-time highs and above its December 2018 trendline. It’s also above its 2009 trendline, albeit with room to fall.

True, small caps are lagging. But they’ve been lagging most of the year.

And the yield curve does not look so healthy. The 2-10 is not inverted but the 3mo-10yr is getting a lot of panties in a bunch. The problem, however, seems to get started after the curve inverts and then goes back to normal so that pushes problems out into the future.

The wild card is a deal with China. If that happens, chances are the stock market zooms higher, at least for a while. The real question is whether this is actually priced into the market already, save for the initial euphoria rally. After that cools, we’ll have to see if metals change.

But for the evidence on the table now, I would not push my luck in stocks. I’m not completely heading for the hills, either, but preparing for a rough market is a good idea.

Dollars & Nonsense – Part 2

Investing is hard enough that there isn’t much room for unforced errors, yet many investors allow themselves to get distracted and miss important things. For long-term investors this mistake often manifests itself by getting caught up in day-to-day news stories and losing perspective on key structural factors.

One such key factor is the global monetary system. Part 1 of “Dollars and nonsense” provided the basics of how the system works and what has changed. Part 2 takes those ideas further to show how understanding the monetary system is essential for successfully navigating the current investment landscape.

One of the striking features of the economy since the Global Financial Crisis (GFC) is the tendency to have a near-death experience every two or three years. Then, just as soon as things get serious, troubles quickly recede as if a magic wand had been waved over them. Indeed, the one lesson that has been learned best is to look past “risks” in the markets and to “buy the dip” (BTD).

This zeitgeist was captured perfectly in the Financial Times in relation to Brexit, but it is widely applicable:

The bounceback plus the monetary response have combined to create a Pavlovian response to risk. If there is a shock, central banks will step in; if there is a dip, momentum buyers will emerge. Put the two together and risk is priced out before it can be priced in.

There actually has been a magic wand of sorts and it has come in the form of monetary policy. Asset purchases by major central banks are especially powerful in boosting liquidity because they create base money from which even more money may be created through bank lending and other activities. 

As a result, asset purchases have a multiplier effect and can therefore be powerful tools for avoiding existential market risks due to lack of liquidity. They can also be useful in “buying time” to allow underlying conditions to improve. Indeed, this has happened several times since the GFC.

While these policies can produce short-term benefits that appear “magical”, as with most things in life, they come with longer term consequences. After ten years of such policies, the consequences are becoming increasingly visible. 

Foremost among these is the harm caused to the banking system by persistently low rates. Banks make money on the spread between funds (deposits) and loans. When rates drop below zero, it creates real stress for banks as noted in the FT:

But in the long term, negative rates are unambiguously problematic for lending. Retail deposits are fixed at zero and cannot be moved lower; the public, understandably, will not accept it. Cutting rates below zero puts banks’ profit and loss statements in a vice. No amount of hedging can offset the grip of a large chunk of funding stuck at zero and the ECB deposit rate being pushed further into the abyss. As time goes by, the vice tightens.

Evidence of the “vice tightening” is becoming increasingly apparent in Europe and Japan where rates have been held lower for longer. The Economist describes: 

People with very different ideas about the role of central banks and the fundamental drivers of the economy can nevertheless agree that, in the long term, low rates produce financial instability.

Given such dire consequences of radical monetary policy, it is curious why central bankers seem so inclined to take the risk. While there are certainly many reasons, some history provides useful perspective.

Across much of the world after World War II, there was very strong economic growth as soldiers returned home, factories converted to making consumer goods, and consumer demand took off. By the late 1960s, however, things were slowing down. This happened “just as governments had promised their citizens a substantial share of the high anticipated future growth,” as Raghuram Rajan notes in his book, The Third Pillar. He explains:

These countries also made two important sets of commitments that will continue to reverberate into the future. They made substantial promises of social security to their populations. Many also expanded immigration, and over time, emphasized their respect for civil rights of both their minority and immigrant populations. These were commitments made by prosperous confident societies based on projections of continuing strong growth.

As it turned out, the significant incremental entitlements such as Medicare amounted to bad promises. They were made in the context of a postwar landscape that was characterized by a great deal of public trust in the Allied governments that had won the war. As such, those governments were also given a great deal of latitude in regulating economies and markets.

It quickly became evident, however, that such promises could not be honored unless the historically higher levels of growth could be restored. Confronted with such challenges, sentiment shifted in favor of market forces over state forces (Rajan’s work focuses on the dynamic relationship among the competing forces of markets, state, and community). 

The combination of high entitlement costs, structurally slowing growth, and increasing acceptance of risky market forces helps explain much of what has happened economically and politically in the last fifty years. Many policy developments since then can be explained in the context of trying to compensate for overly generous entitlements by engaging in risky or unproven strategies to boost growth.

It was from this environment that much of the shadow banking and eurodollar systems evolved. According to a Federal Reserve Bank of New York report on “Shadow banking“, the new system revolves around the activities of securitization and wholesale funding with the process of credit intermediation being “performed through a daisy-chain of non-bank financial intermediaries in a multi step process”. As a result of these developments:

“The nature of banking has changed from a credit-risk intensive, deposit-funded, spread-based process, to a less credit-risk intensive, but more market-risk intensive, wholesale funded, fee-based process.” 

This expansion and evolution of the monetary system brought important changes. As the FRB report describes, the flow of credit was no longer dependent on banks only, “but on a process that spanned a network of banks, broker-dealers, asset managers and shadow banks—all under the umbrella of FHCs [Financial holding companies] …” An important consequence of this development was that money supply expanded beyond the traditional definitions such as “M2” to also include non-traditional shadow money.

Further, as non-bank financial companies have become progressively more important in the provision of liquidity, their balance sheets have become progressively more important as risk factors. If their balance sheets shrink, then liquidity goes down. Alhambra Partners describes how the process unfolds:

Compressing and negative swap spreads: balance sheet capacity at a premium; US banks cut back on US$ activities outside the US; foreigners buy less and even outright sell their US$ holdings; and US$ money markets exhibit terrible breakdowns of hierarchy. Classic tight money symptoms, only officials cannot define nor locate the money which might be tight.

As a result, central bankers have exceptionally little capacity to manage liquidity in these cases.

Another phenomenon that arose out of the shifting political winds in the 1970s and 1980s was an increase in global trade. Indeed, increased trade was an explicit goal in the formation of the European Union with the ultimate objective of also boosting growth. That trade needed to be financed, however, and the shadow banking and eurodollar systems emerged to meet those needs.

As Gillian Tett describes in the FT, “Companies need hefty amounts of working capital to run their supply chains, and about two-thirds of this typically comes from their own resources, with the other third coming from bank and non-bank finance.” The important lesson is that if you want to understand the global economy, you had better study “financial channels in tandem with ‘real’ economic trends.”

One need look no further than the GFC to see a link between financial channels and economic trends. Tett observes, “Research suggests that the pre-2007 credit bubble not only created a house price boom, but also helped create a trade and GVC [global value chain] bubble too.” 

Further, financial channels are driven by the US dollar as Martin Wolf points out in the FT, “One traditional issue is the reliance on the US dollar in the global monetary system.” When dollars are easily available bubbles form, but when dollar liquidity dries up so too does associated economic activity. Wolf forecasts a continuation of negative trends: “A depressingly familiar issue is the future of the trading system. Global liberalisation has halted.” 

Another related “feature” of monetary system has been the demand it has created for US Treasuries. Russell Napier describes in the FT:

“The roughly $10tn rise in world foreign exchange reserves between 1999 and 2014 resulted in the forced purchasing of US Treasuries. Foreign central bankers owned 13 per cent of the Treasury market in 1995, but held a third of it by 2014.”

This wave of buying had the effect of depressing rates. As Napier describes, “This monetary system thus provided a funding holiday for global savers, freeing them to focus on funding the private sector instead.”

“What could be better for global investors than a monetary system that depressed the global risk-free rate while boosting growth through an explosive rise in the money supply of emerging markets, particularly China?”

Conversely, what could be worse for global investors than a monetary system that inflates the global risk-free rate while choking liquidity in emerging markets? As Napier describes, this scenario is unfolding:

“Since then [2014], as foreign exchange reserves have stopped climbing, funding the US government has fallen to savers, not central bankers. Foreign central bank ownership of US Treasuries has fallen from a third five years ago to just under a quarter today. Savers must take up the funding slack, while also buying Treasuries being sold by the Federal Reserve. This structural shift in demand for Treasuries comes as supply is boosted by the Trump administration’s fiscal policy. Savers now have to fund the US government, and to do so they have to either sell other assets or save more.” These dynamics have “negative implications for economic growth.”

Putting all of this together creates a very different impression of today’s investment dynamics. Much of what has happened in terms of monetary and fiscal policy the last fifty years has ultimately been an effort to cope with unaffordable entitlements granted at the end of a long run of economic prosperity. With that understanding, it is easier to see the rapid increase in debt levels and the philosophical preference for market forces (despite higher risks) more as desperate attempts to forestall the inevitable reckoning than as well-reasoned policy.

In this context, the expanded and increasingly market-driven monetary system is yet one more desperate attempt to grow out of unaffordable promises. Nonetheless, this flawed and crisis-prone system is now a pre-eminent investment factor. Jeffrey Snider hinted at this in an interview with Macrovoices when he argued that the Great Financial Crisis is more properly labeled “the Great Global Monetary Crisis.” 

Napier also highlights the importance of the monetary system as an investment factor:

While many investors are fretting over what stage of the business cycle we are in, the global monetary system is collapsing — with a whimper initially, but ultimately a bang.

In short, the US dollar based global monetary system is a key structural issue that long-term investors need to factor into their strategy. From this perspective, it is clearer to see how both significant deflation and inflation are real possibilities in the not-too-distant future. As a result, a top priority should be to appropriately calibrate exposure to financial assets to one’s investment horizon. Failure to do so is the one thing that can cause real harm to retirement plans.

In the meantime, central bankers can temporarily alleviate liquidity droughts by expanding their balance sheets and probably will try to provide short-term relief. What they can’t do is meaningfully improve the configuration of the system without creating significant glitches in liquidity. It is nonsense to believe that central banks can keep markets afloat forever simply by continuing to add liquidity.

The increasingly global nature of the monetary system also presents a special challenge for US investors. Whereas factors affecting dollar liquidity used to be confined to the US, increasingly the system is global and interconnected and incorporates various feedback loops. As a result, factors affecting dollar liquidity can pop up in lots of places. 

This presents a very different situation than in the early 1970s when Treasury Secretary John Connally famously (and arrogantly) told complaining European finance ministers, “The dollar is our currency, but your problem.”

Today, US dollar still reigns supreme relative to other fiat currencies (and therefor crucial for funding growth), but the US economy is a smaller part of the global total. At the same time, the Fed has considerably less control over US dollar liquidity which feeds back into lower global growth when it contracts.

Now the dollar is everybody’s problem.

Dollars & Nonsense Market Review

If there was one message to be taken away from the first half of 2019, it was that the Fed still reigns supreme in the minds of investors as to what drives markets. After a remarkably strong first quarter during which the Fed flipped its position on rate increases, performance remained very respectable in the second even though fundamentals began eroding and the yield curve inverted. 

Such attention to plans for rate decreases belies another reality that is far more important for long-term investors. The global financial system has grown in complexity and this complicates the Fed’s ability to control US dollar liquidity. High levels of government debt further impinge on its ability to nurture economic growth. Now, after ten years of interventionist monetary policy, it is a good time for investors to turn their focus away from the nonsense of short-term machinations and to start considering the longer-term consequences.  

For many investors and analysts, money is a dull subject that wreaks of tedium and only serves to distract from more interesting investment analysis. As Chris Martenson describes in his Crash Course,

“Money is something that we live with so intimately on a daily basis that it probably has escaped our close attention.” 

This is potentially a blind spot for many investors. For those who may have learned about money and money supply in a college economics class years ago, things have changed a lot and the global financial system has evolved considerably. For those who never paid much attention to the subject, liquidity has become a more important component of the overall investment equation.

In order to fully understand some of the changes, it helps to refresh the basics. For starters, Martenson captures the essence of money with a practical notion:

Money is a claim on human labor. With a very few minor exceptions, pretty much anything you can think of that you might spend your money on will involve human labor to bring it there. I say it’s a claim rather than a store, because the human labor in question might have happened in the past, or it might not have happened yet.

Wikipedia provides a good account of how those claims come into existence with a definition of money supply:

“The money supply of a country consists of currency (banknotes and coins) and, depending on the particular definition used, one or more types of bank money (the balances held in checking accounts, savings accounts, and other types of bank accounts). Bank money, which consists only of records (mostly computerized in modern banking), forms by far the largest part of broad money in developed countries.”

Money is originally created by the Fed or another central bank. As Martenson describes,

“Money is created … [when] the Federal Reserve buys a Treasury bond from a bank.”

In this case, the money “literally comes out of thin air” as the money is created simply by the act of the Fed buying the debt. In order to validate the message, Martenson quotes the Federal Reserve publication, “Putting it Simply”:

When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn.  When the Federal Reserve writes a check, it is creating money.”

The money the Fed creates then serves as the foundation from which bank lending can further expand money supply. Since banks are only required to maintain a fraction of loans outstanding in reserve, any loans in excess of those reserves constitutes money creation. In short, “money is loaned into existence.”

This constitutes the basic traditional perspective of money and money supply. Banks are responsible for the bulk of money supply through the provision of credit. This system tends to be procyclical, but those tendencies are checked by close regulatory scrutiny and the ability of regulators to shut down banks when they become insolvent.

As shadow banking emerged, however, it became harder to track and control money supply because operations occurred primarily outside of the authority of banking regulators. Wikipedia provides a good working definition of shadow banking that was given by Ben Bernanke:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions — but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper [ABCP] conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies”

Cross Borders Capital elaborates on the concept of shadow banking in its report, “Why has global liquidity crashed again?“:

“What shadow banks do is to transform these bank assets and liabilities by re-financing them in longer and more complex intermediation chains”

As a result, the overwhelming practical effect of shadow banking is not so much to provide new sources of credit, although that can happen, but rather to “increase the elasticity of the traditional banking system.

One of the key differences between shadow banks and traditional banks is that shadow banks do not have access to funding via customer deposits. As a result, shadow banks are entirely reliant upon wholesale funding. In other words, their operations depend entirely on capital markets, which at times can be quite volatile.

Another important monetary development, that emerged alongside shadow banking, has been the Eurodollar system. Wikipedia defines Eurodollars as “time deposits denominated in U.S. dollars at banks outside the United States”. Jeffrey P. Snider, from Alhambra Partners, has discussed the Eurodollar system extensively [here] and [here] and emphasizes that the Eurodollar system is “much broader than the standard definition” and is not “a technically precise term”. 

Snider instead describes Eurodollars as a “system of interbank liabilities” that real economy participants use “in order to accomplish real-world activity.” In other words, it includes “the transformation of banking into a wholesale model often free of deposits altogether.”

The Eurodollar system is especially notable because:

[It] is a system that operates in the shadows and creates supply of US dollars and creates all kinds of complex transactions in US dollars that the US central bank, the Federal Reserve doesn’t really know about because it’s outside of their regulatory purview.” Further, “the use of these Eurodollars is theoretically unlimited.

A very basic takeaway from all of this, then, is that the monetary system has expanded beyond the traditional model of fractional reserve banking. Therefore, it is important to understand the ways in which shadow banking and the Eurodollar system are different in order to understand the implications for money supply and monetary policy. 

One of those ways in which things have changed is, as the Federal Reserve Bank of New York’s report “Money, liquidity, and monetary policy” notes, “the growing importance of the capital market in the supply of credit.” More specifically, 

“The balance sheet growth of broker-dealers provides a sense of the availability of credit. Contractions of broker-dealer balance sheets have tended to precede declines in real economic growth, even before the current turmoil. For this reason, balance sheet quantities of market-based financial intermediaries are important macroeconomic state variables for the conduct of monetary policy.”

The Eurodollar system and shadow banks also differ from fractional reserve banking in that they operate outside the “regulatory purview” of central banks. This makes it far harder for central banks to monitor their activity and even harder to control it. As a result, the mechanics of liquidity, and therefore of monetary policy, have also changed. Cross Borders Capital notes:

“Liquidity is consequently a more general concept than textbook money supply measures because it extends beyond traditional domestic retail deposit-taking banks into cross-border and wholesale-funded shadow banks … Textbook economics also fails to understand the inherent system-wide risks because it sees every credit as a debt (debit) and every debt as a credit.”

The risks are amplified because “wholesale funding is collateral-based and highly pro-cyclical, and it has the potential to feed-back negatively on to the funding as well as the lending activity of traditional banks.” In other words, the addition of shadow banking and the Eurodollar system to the traditional banking system is like adding cocaine to a human body. It amps things up in the short-term, but also makes them more erratic and precarious in the longer-term. As Jeffrey Snider describes, “This [Eurodollar] is a dysfunctional system, so we’re not really positive about any of this stuff.”

At this point it is fair to ask, “Why discuss shadow banking and the Eurodollar system now?”

These phenomena have been around for many years and have been reported before for those curious enough to dig into the minutiae. For the last ten years, though, it hasn’t mattered. Liquidity has been ample enough and long-term consequences distant enough that the best thing to do has been to completely disregard risk. In the process, many investors have learned exactly the wrong lessons and risk being seriously wrong in the not-too-distant future.

Now, with substantially higher government (and corporate) debt outstanding, with the recession-fighting capacity of central banks vastly reduced, and with the end of a business cycle approaching, the equation has changed. Understanding the mechanics of liquidity and the constraints it places on monetary policy will be crucial for investors to understand in order to weather adversity.

One important lesson is that low rates are not an unalloyed good as many believe. Lower rates can temporarily ease the burden of interest payments for indebted entities and lower rates can temporarily encourage risk-taking. 

Lowering rates cannot create wealth, however, and John Hussman explains well the limited efficacy of doing so:

“Tinkering with security valuations doesn’t create aggregate “wealth” – it simply takes future returns and embeds them into current prices. Long-term ‘wealth’ is largely unchanged, because the actual wealth is in the future cash flows that will be delivered to investors over time, and once a security is issued, somebody has to hold it at every point in time until that security is retired. The only thing elevated investment valuations do is provide an opportunity for current holders to receive a transfer of wealth by selling out to some poor schlub who pays an excessive price for the privilege of holding the bag of low future returns over time.

In addition, the effectiveness of low rates as stimulative monetary policy is contingent on beginning debt levels. As Van Hoisington and Lacy Hunt write in their second quarter review and outlook, a drop in real yields would be a “stimulant to economic activity”, but only in the event “debt levels were considerably lower.” 

As is, in the presence of relatively high levels of debt, low rates ultimately constrict economic activity. They describe the mechanics:

When real yields are low or negative, investors and entrepreneurs will not earn returns in real terms commensurate with the risk. Accordingly, the funds for physical investment will fall, and productivity gains will continue to erode as will growth prospects.

In other words, accelerating government debt is like a noose on an economy. You might be able to create some space with low rates that can provide some breathing room and some temporarily good news. Longer term, however, natural forces will eventually cause the economy to choke.

Another consequence of keeping rates too low over a long period of time is that it encourages yield-seeking behavior and risks unleashing the shadow and Eurodollar beasts that are “theoretically unlimited”. Even though this was a big part of the problem in the 2008 financial crisis, many investors seem to be overlooking the potential for trouble now. The system has not changed in any material way.

So how should investors handicap markets and monetary policy? 

The Financial Times reports, “The financial crisis has left many of us hypnotised by existential risks to the banking system.”

Indeed, much of the monetary policy implemented by major central banks since has been aimed at averting just such an existential event.

Such priorities, however, have created something of a Faustian bargain. Each time monetary authorities intervene to lower rates or to provide additional liquidity, they help prevent a sudden freeze-up in the financial system. In doing so, however, they also create longer term problems. Among those problems, in the words of Steven Alexopoulos, JPMorgan’s regional bank analyst, is “a near perfect environment for banks to have let down their guard and become less sensitive to risk.”  

As the economic recovery gets into the late innings and as more indicators suggest slowing growth, it is useful to remember that “regular non-crisis, non-fatal credit downturns hurt like hell too and this one might be worse than most.” Or, in more vivid terms:

Last time we had a heart attack, so this time it will be cancer.”

Whether the prognosis for economic “cancer” is correct or not, there are some overarching lessons for long-term investors. One is that placing too much faith in the Fed and short-term ructions from monetary policy comes at the expense of preparing for longer-term consequences. Also, the condition of a high level of government debt constrains the effectiveness of monetary policy. Finally, all of this is happening in a financial system that has greater systemic risk.

All signs point to lower exposure to risk assets. 

Kahn: 6-Ways To Prepare For The Next Market Decline

This article was originally published at Kiplinger and submitted by Michael Kahn

The U.S. economy is putting up some impressive numbers in GDP, jobs and wages, but many pundits fear that a slowdown is pending. Trade-war fears with China and the European Union remain front and center in the news. And the yield curve is threatening to invert, meaning short-term interest rates may be moving higher than long-term rates. That’s often a sign of pending recession on its own.

By some measures, the current expansion is now 10 years old, making it one of the longest on record. That seems ancient, but there’s no rule that says it can’t continue. Australia is in its 28th consecutive year of economic growth.

Even so, all good things do eventually come to an end. And for the U.S. (and for Australia, for that matter), economists are looking for slowdowns. Even the Federal Reserve has indicated it is ready to lower short-term interest rates to combat any problems that may arise.

Professional investment managers may look to sell a good deal of their holdings to step aside as the market falls. However, for most individuals, timing the market by selling when conditions seem dicey, and buying back when conditions firm up, is a big mistake. Even the pros don’t always get it right, and they have armies of analysts and rooms full of technology at their disposal.

Here are six ways to prepare for the next stock market decline. The key is to make smaller adjustments to your portfolio to reduce risk and still be ready to participate when the market resumes its upward march.

Sell Speculative Stocks

Investors often have stocks in their portfolios that come with a bit more risk than they might like. What might have seemed like a good idea – think General Electric (GE) in 2015 – may have been all smoke and mirrors. The market has a way of punishing these types of companies when times get shaky.

Uber-investor Warren Buffett famously said,

“You only find out who is swimming naked when the tide goes out.”

A bull market tends to hide the sins of weak companies; when the bear comes knocking, they are the first to get hit.

Even if they’re not a disaster-in-waiting like GE was, some companies just may not have the financial resources to withstand a prolonged period of hard times. They might have too much debt on their books. Or they might be in a cyclical business, such as steel or oil drilling, that will seriously contract should the economy stumble. Perhaps you have shares in a company where legal battles, instead of their increasing market share, dominate their headlines.

If you are getting nervous about the health of the stock market, lighten up on some of these weaker positions.

Here’s a quick test: Any stock that hit a 52-week low in April or May as the Standard & Poor’s 500 hit a 52-week (and all-time) high probably will not fare well on a market swoon. The same goes for stocks at 52-week lows at today’s highs.

Raise More Cash

Raising more cash simply means reducing the overall size of your invested portfolio. This could mean selling speculative stocks, as mentioned above, but keeping the proceeds in a money market fund.

It also could mean cutting each sector of your portfolio by a fixed percentage.

Let’s say you have four mutual fund positions – a large-cap growth fund, a small-cap fund, a growth-and-income fund and an international stock fund. (It really does not matter what they are but this is a typical illustration of how investors might diversify across stock categories.) If you trim each fund by 5% or 10%, keeping the proceeds in cash, you have reduced your risk without having to worry about which individual holding to sell. Of course, the percentage is up to you.

Just remember that this is a tweak of your portfolio. You are not timing the market, pe se, because you will remain largely invested.

Give More Weight to Defensive Sectors

If you do not want to take any money out of the market, you still can reduce your risk by shifting more money away from aggressive sectors and into defensive ones.

Aggressive sectors typically include technology, consumer discretionary and arguably financials. Defensive sectors typically include consumer staples, healthcare and utilities.

What makes a sector defensive is that its businesses are less affected by economic swings. Their products and services enjoy relatively stable demand and are the last that a consumer might give up in hard times. This includes food, medicine and soap. That big vacation and flat-screen TV would be examples of discretionary items that are often the first to get cut from a budget.

Defensive sectors lower your portfolio risk, but this comes with a price: When the market recovers, aggressive sectors usually outperform. The good news is that you still will be invested and should see gains without having to worry about timing your re-entry.The strategy could be as simple as adding a small portion of Select Sector SPDR exchange-traded funds (ETFs) in consumer staples (XLP), health care (XLV) or utilities (XLU).

Raise Allocation to Bonds

Portfolios benefit from owing a percentage of bonds or other fixed-income investments. While bonds typically do not offer the same capital appreciation potential as stocks, their relative price stability and income streams can offset weakness in stocks.

One rule of thumb for a diversified portfolio across different asset classes is 55% stocks, 35% bonds and 10% cash. Of course, this will look a little or very different depending on your risk tolerance and how close you are to retirement.

But let’s just say that you did not get this advice and you are all in stocks. The easiest thing to do is to sell a portion of your stocks and buy high-quality corporate bonds, Treasury bonds or a mutual fund that invests in them. Remember: We previously looked at raising 5% or 10% cash. Taking that money and moving it to a bond fund would go a long way toward reducing your portfolio’s volatility and smoothing your returns over time.

Perhaps a Touch of Gold

If you follow the typical method of allocating your money across asset classes, you might hold 5% or 10% in gold or other precious metals instead of cash.

Gold does not pay interest or dividends. What it does offer is a hedge against several headwinds, including inflation, economic calamity or war. None of these seem imminent, but if you are truly worried about the economy pulling back in a big way, a little gold would help you sleep better at night.

That could be worth the price, right there. But we can probably do better.

Gold stocks – that is, mining companies that seek out the yellow metal – are intimately tied to the price of gold but they still are stocks. They can pay dividends, though most pay very little. But they do have price appreciation potential, and that means you can remain fully invested, if that is your choice.

Shifting some money to gold stocks is very similar to shifting money into other defensive areas. Gold is different enough to warrant its own consideration.

Don’t Panic!

Remember why you invested in the first place. You are trying to build wealth over time, not try to trade in and out of the market based on trade wars, interest rates, tweets or punditry. That means you will necessarily have to weather a few storms, but over time, the stock market (and investing in general) is the greatest wealth-building machine out there.

For most investors, controlling risk is more important than trying to catch every wiggle in the market. If you stick in solid companies within the major trends in the world – life-changing technology, aging-population health care or new energy – and allocate a small portion for that potential home run, you will be able to have a long, successful career as an investor.


Control your risk. The rest will take care of itself.

One Man’s Treasure: The Perception Versus Reality Of Equities

Stocks have an almost mythical aura about them for many investors. Conceptually, stocks tend to produce higher returns than many other asset classes and therefore feature prominently in many retirement plans. Practically, stocks have provided terrific returns for many through their working years and into retirement.

The proposition of investing in stocks, however, has changed over the years. In many cases, perceptions have not kept up with this reality. As a result, many investors still consider stocks to be a “treasure,” while others are increasingly seeing them as “trash.”

To any analyst who follows publicly traded stocks, it is obvious that there are a lot fewer of them around than there used to be. A 2018 NBER report highlighted the phenomenon:

There are fewer firms listed on U.S. exchanges than 40 years ago. In 1976, the United States had 4,943 firms listed on exchanges. By 2016, it had only 3,627 firms.” The report reveals that this decline is a fairly recent phenomenon. Having increased steadily through to the listing peak in 1997, the number of listed stocks has fallen sharply since then, as “the number of listings dropped every year since 1997, except for 2013.

The reasons for the decline are also revealing. The single biggest reason has been the high level of merger and acquisition activity in recent years, but a slower pace of initial public offerings (IPOs) has also contributed. As a result of these coincident phenomena, “the size of listed firms has grown sharply.”

The whole size distribution of listed firms has shifted so that average market capitalization and median market capitalization accounting for inflation increased by a factor of 10 from 1975 to 2015.

Not only are public firms much larger than they used to be, fewer of them have long roads of growth still ahead of them.

This matters because stock returns are asymmetric. While you can lose all your investment, you can only lose the amount of that investment. On the other hand, it is possible to make many, many times the size of an original investment on the upside. As a result, it is quite possible that one or two big winners in a portfolio can more than compensate for several underperformers.

For this reason, the big winners over time have become legendary for their contributions to outperformance. Tom Braithwaite touched on this in the Financial Times where he recounted the example of Cisco going public in 1990 with less than $100m of revenues. It then went on to become the first company to reach $500bn of market capitalization. Early investors in Microsoft, Apple and Amazon had similar experiences. Just one or two of these stocks could overcome a lot of weak performers in a portfolio.

Recent vintage IPOs, however, are featuring companies that mostly have waited much longer to go public and therefore afford less opportunity for growth for public shareholders. Braithwaite notes, “Today, with the help of a vast influx of sovereign wealth money and mutual funds not wanting to overpay at IPO, companies can delay until they are big enough to command the sort of valuation that Snap achieved this year $20bn.”

The recent IPO of Uber is emblematic of the trend. Just ahead of its IPO, the company reported revenues of $11.27 billion in 2018, a level that amounts to over 110 times as much as Cisco had when it went public.

As the Uber example also plainly reveals, when firms go public today, they are increasingly doing so without any profits to show. While the companies that do IPO may be leaders in their field, they are still unseasoned and subject to substantial risks. The FT reported on a study by Jay Ritter, a business professor at the University of Florida, which noted,

in 1980 only 25 per cent of US companies had negative earnings when they came to market. Last year, it was 80 per cent.

The trend in lack of profitability has also permeated the markets more broadly. To be sure, it is normal that some group of companies will be unprofitable for various reasons such as cyclical downturns, idiosyncratic events, or new business launches. However, the NBER report shows that the current prevalence of unprofitable companies is unusually high:

The fraction of firms with earnings losses in a given year has increased substantially. In 1975, 13 percent of firms had losses. In contrast, 37 percent of firms had losses in 2016.

All of this has led to a market that is considerably more concentrated than it used to be. The NBER report continued:

“As a result, earnings have become more concentrated. In 2015, the top 200 firms by earnings had total earnings exceeding the total earnings of all public firms combined. In other words, the total earnings of the 3,281 firms that were not in the top 200 firms by earnings were negative.

The net result is an almost shocking lack of diversity of profits.

In aggregate, the data reveal striking changes in the composition of the market. There are a lot fewer public companies to choose from, a much higher proportion of them lose money, IPOs don’t provide anywhere near the same type of upside potential, and aggregate earnings are massively concentrated. In short, the Economist reports,

“A smaller number of older, bigger firms dominate bourses.” 

Many of the compositional changes also go hand in hand with a weaker competitive landscape. The Economist highlighted the persistence of unusually high profits as one important signal of trouble:

“High profits across a whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning off wealth than creating it afresh, such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall of demand.” Rising profits, then, “coupled with an increasing concentration of ownership … means the fruits of economic growth are being hoarded.”

There are plenty of other signs of weaker competitive conditions if one cares to look. For example, one would expect relatively high returns in an uncompetitive economy and lower returns in a very competitive one. The data reflect poorly on US businesses:

“Though American companies now make a fifth of their profits abroad, their naughty secret is that their return-on-equity is 40% higher at home.” 

In addition, there are indications that competition has also been stunted by way of laws and regulations. The Economist notes that “business spending on lobbying doubled over the period [1997 to 2012] as incumbents sought to shape regulations in ways that suited them.” Sometimes, big firms have simply leveraged their ability to “influence and navigate an ever-expanding rule book.

“Regardless, the effect has been to reduce “the rate of small company creation in America … close to its lowest mark since the 1970s.”

Weaker competition gets manifested in other ways too. “In some industries – banking is a case in point – rent-seeking will result in high pay to an employee elite instead.” Sometimes lower accountability results. Historically, when chief executives have gotten sacked, it has been for poor performance. More recently, however, the FT reports that an unusually high “39 percent of departures of chief executives] were due to ethical issues.” 

A good summary of the trend comes from another NBER report: “After 2000 … the evidence suggests inefficient concentration, decreasing competition and increasing barriers to entry, as leaders become more entrenched and concentration is associated with lower investment, higher prices and lower productivity growth.

“The obvious conclusion,” the Economist reports, “is that the American economy is too cosy for incumbents.” For all the legendary importance of Adam Smith’s “invisible hand” of competition, the report states that it is “oddly idle” in America. As a result, power has shifted from away from shareholders of public companies.

This suggests something even more important is happening. Gillian Tett at the FT goes so far as to call into question the very purpose of public capital markets:

“In the 20th century, it was often assumed that public markets were the epitome of financial capitalism; indeed, the idea was so deeply ingrained that policymakers and financiers tended to assume that financial evolution went in one direction: from private to public.

But today the trend towards private finance is being driven by ‘pull’ and ‘push’ factors. On the one hand, private equity, real estate and debt investments have often offered better returns than public equity in the past decade … At the same time, the raison d’etre for public markets is faltering. They used to be seen as a more democratic and inclusive form of capitalism.

The Economist also addresses similar issues.

“Mr Mauboussin notes that 40 years ago a pension fund could get full exposure to the economy by owning the S&P 500 index and betting on a venture-capital fund to capture returns from startups. Now a fund needs to make lots of investments in private firms and in opaque vehicles that generate fees for bankers and advisers. “

As a result, according to the FT:

“Ordinary Americans are being deprived of opportunities to invest early in the next big winners … But only wealthy individuals can invest in individual private companies before the IPO.” In other words, the opportunities that used to be shared widely across public markets are now the reserve of the privileged few.

One can argue that the democratic aspect of public markets is more than just challenged; in many ways a mockery is being made of it. Steve Case, the founder of AOL and CEO of Revolution, a venture capital company, noted in the FT, “companies used to go public to actually raise operating capital.” Since companies needed scarce capital in order to grow, raising that capital normally sent a signal that attractive growth potential existed.

Now, however, “the goal of an IPO is all too often for investors to ‘exit’ with as high a valuation as possible.” As such the signal provided by an IPO is almost exactly the opposite. Now an IPO signals the end of a growth thrust, not the beginning of one, and it is pawned off on the least discriminating of investors, i.e., public ones.

These insights facilitate a vastly different narrative for the stock market. What was once a reasonably accessible and diversified universe of companies that provided good exposure to a strong economy has now devolved into something considerably less attractive. Now the universe is comprised of a combination of old companies trying to hive off the greatest possible profits from dying industries and younger companies taking flyers on unproven and unprofitable businesses with shareholder money.

Additionally, given that these changes have occurred at the same time as passively managed funds have massively increased their share of the market, it is hard to escape the possibility that passive investing has at least exacerbated some of these developments. The lack of meaningful pushback by passive shareholders against management teams creates a vacuum of accountability from which many forms of bad behavior can thrive.

In light of all the changes that have occurred in the stock market over the last few decades, it is very fair to say that it is much less attractive than it used to be. But it is also possible to speculate further. What if public stocks now are the leftovers, the dregs that nobody else wants? What if public stocks have become the detritus of the investment world?

To be fair, the claim is extreme. There are still good public companies out there, although many of the stocks are overvalued. Nonetheless, such a consideration has significant implications for investors.

One is that things change. As attractive as stocks may have been forty years ago, they represent a different proposition today, especially at today’s record high valuations. As such, it does not make sense to treat them as static entities in a portfolio context.

Relatedly, the constantly changing market creates an opportunity for active management and a risk for passive management. As history shows in abundance, stock returns are not magical entitlements. Some periods are great while others are devastating. Investors who do not adapt to changing conditions put themselves at great risk.

Finally, part of the aura associated with public markets has been due to their strong link with the economy. As the NBER report states, however,

“Large firms no longer employ all that many people in America: The domestic employee base of the S&P 500 is only around a tenth of total American employment.”

As a result, the real economic impact of public firms has moderated considerably. Investors now need to consider a broader set of signals in order to get a good pulse on the overall economy.

So, time flies, things change, and investors have a choice. They can either look backwards and revel in the “glory days” of stocks or they can adapt to a new reality in which publicly traded stocks are just far less attractive than they used to be. Things will change again and someday there will be another golden age for stocks. For now, however, it is best to be extremely discriminating.

Recovering Perma-Bear At A Crossroad

Hello, my name is Seth and I’m a recovering perma-bear. (Hi Seth.) It’s true that I used to think that doom was inevitably just another quarter or two away. I was hyper-aware of the business cycle and the encroachment of government into the free markets. Thus, I concluded that growth would end soon. From an investment perspective I was simply wrong. It’s only now that I know that I lacked a robust process—a way of making sense of the investment landscape so that I could act profitably; that investing is mostly about managing losses; and that human ingenuity can overcome lots of adversity.

I’m better now, truly. Yet, I find myself terrorized by the current economic landscape in the U.S. It appears to be weakening. Due to my affliction predisposition, I am mindful of confirmation bias. Herein lies my conundrum. What’s a recovering bear to do at such a crossroad?

There’s only rightful action to take; look at the objective facts, stripped of opinion.

Below is a shortlist of interesting charts that, in my opinion, characterize the economic landscape. To be sure, there is an endless, complex list that one can examine. However, my purpose here is not to make a call on the economy, per se. Rather, it’s to fortify my process; to look for confirming and refuting evidence. This blog, after all, is like my therapy. Thus, I will keep things simple and look at five sets of data for both the bullish and bearish cases.

Some Bearish Facts

To me, there is no better economic signal than the yield curve. While there are plenty of pundits with plenty of reasons for why one should discount its bearish message, explaining away the data is precisely what I’m trying to avoid. The simple fact is that inversions (and subsequent steepenings) have strong correlations with forthcoming recessions (importantly, not causation). They don’t, however, time them well. The yield curve first inverted in March. This is nothing to ignore.

The economy is often touted as strong. However, the trend in corporate profits reveals otherwise. They actually peaked in the third quarter of 2014 and have been declining ever since. Note that last year’s tax cuts did in fact reverse the trend on an after tax basis (red line), but no benefit to pretax earnings (blue line) are evident. Since economic activity is strictly a function of production, corporate profits are the best measure, in my view, of the economy’s health. Note that this is different and more robust than the oft-cited S&P 500 earnings per share metrics

The trend in ISM’s manufacturing Purchasing Managers’ Index (PMI) is another negative item. It has a long history as a leading indicator of business cycles. We can see below that manufacturing PMIs have trended sharply lower for both the U.S. and elsewhere. This likely portends weakening conditions ahead.

Employment trends are also cited as a strength of the economy. However, it is a lagging indicator. Initial jobless claims provide a more real-time snapshot. Here, we can observe two facts. The first is that initial claims are at extremely low levels. While this appears bullish, they might have recently bottomed. A reversal in trend—which is too early to call just yet—would be troublesome.

Purchases of big ticket items, such as cars, can also provide some economic insight. Declining auto sales are more data that paint a gloomy economic picture. Of note, they have plateaued for both new (the first chart below) and used cars (the second chart below). True, they are coming off high levels, and used car sales rebounded as of late (not shown); but declines are declines nonetheless.

Some Bullish Facts

To be sure, not every data set is negative. Perhaps the most obvious, positive signal is the U.S. stock market. Equities are discounting mechanisms. If investors were truly worried that a change in corporate fortunes were upon us then this sentiment should be reflected in equity prices. Sitting near the at-time-highs suggests that investors are not concerned.

Retails sales are also strong. While no economy, including the U.S., is “consumer led” (I’m sorry, consumer spending makes up 70% of GDP which is only a proxy for economic output, not an actual measure of it), a drop in spending would logically follow a drop in economic production. Here too, we see continued year-over-year expansion of demand.

While manufacturing PMIs are trending lower and flirting with contractionary levels, ISM’s U.S. service sector PMI points to continued growth. This tempers the former’s negative read since the service sector is the larger of the two.

ISM’s Non Manufacturing PMI indicates future growth is likely.

source: tradingeconomics.com

As noted above, employment trends are still positive. Unemployment remains low and has yet to bottom. Furthermore, worker compensation is on the rise. These also suggest that economic conditions remain favorable.

However, the most bullish signal to me is that being bearish is commonplace. Growth scares tend to catch people by surprise. Thus, today’s setup does not seem conducive to producing the kind of negative shock that leads to market selloffs. As shown below, most investors are already defensively positioned.

Looking Both Ways

So there you have it, a bunch of facts about the economy and markets. While I come out bearish, the purpose of this is article is not to convince you of my position. Rather it’s to present some commonplace data in order to overwhelm my own inherent biases.

Does a weakening economy mean recession? Hardly so. However, if one mentally models economies and markets as carry trades (as I explain here and more thoroughly in this report beginning on page 7) it becomes evident why even slowing of growth matters. But even if a recession were obvious and evident, we investors care about asset prices, not recessions as such. Thus, profitable trading might entail positioning in counterintuitive ways.

The first step to recovery is admitting that you have a problem. I suffered from a major case of perma-bear-itis. Building a process is just the second rehabilitating step. Progress comes piecemeal. Thus, this recovering perma-bear intends to thoroughly look both ways before venturing out across the investment crossroads.

Gold At The Top Of A Huge Base

This article was originally published Friday, June 14th, but with Thursday’s big rally and gold hitting a 5 ½-year high, many people believe that this was a major upside breakout. I’ll start with the updated chart, which does not convince me – yet – that a breakout is in place. Of course, new information can change that view but we cannot trade based on what has not happened yet.

The daily chart is even more stretched. So, given this new information, the case for a major breakout is now in play but I need to see how the market reacts to its short-term condition. I’m not a buyer today, barring fresh geopolitical news, but a modest pullback to test the breakout would be a better way to play.

And just for further mud, the U.S. dollar index may be on the verge of a short-term breakdown, which will support gold. This is far from confirmed.

Here is the original piece, written a week before the attempted breakout.

A name-brand fund manager now calls for a recession soon and is buying gold. A name-brand invstment bank thinks that economic conditions today are worse than they were during the financial crisis.

Naturally, we would expect the metals markets, with their safe-haven statuses, to be rip roaring higher. But they really are not.

True, gold has looked pretty strong over the past few weeks thanks to tariffs and trade wars. And it even got the benefit of a short-term trendline breakdown in the U.S. dollar late last month for a little extra juice.

But in the bigger picture, it has not yet really broken out.