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Robertson: When “Stuff” Gets Real

We all can be tempted to follow the path of least resistance and in a competitive world there are always incentives to get the most bang for the buck. Often this means taking shortcuts to gain some advantage. In a forgiving world, the penalties for such transgressions tend to be small but the rewards can be significant. When conditions are extremely forgiving, shortcuts can become so pervasive that failing to take them can be a competitive disadvantage.

In a less forgiving world, however, the deal gets completely flipped around and penalties can be significant for those who take shortcuts. This will be important for investors to keep in mind as rapidly weakening economic fundamentals and increasing stress in financial markets make for far less forgiving conditions. When things get real, competence and merit matter again – and this is a crucial lesson for investors.

Leaders of companies and organizations normally receive a lot of attention and rightly so; their decisions and behaviors affect a lot people. In the best of situations, leaders can distinguish themselves by creatively finding a “third” way to resolve difficult challenges. In other situations, however, leaders can reveal all-too-human weakness by taking shortcuts, cheating, and acting excessively in their own self-interest.

One of the situations in which these weaknesses can be spotted is in whistleblower incidents. For example, the Financial Times reported on the illuminating experiences of one HR director who in successive jobs was requested to break rules by a boss:

“Told by a senior manager at a FTSE 100 business to rig a pay review to favour his allies, she refused. ‘After that, he did everything to make my life absolute hell,’ she says. Then, at the first opportunity, he fired her, claiming that she was underperforming. Warned that the company would use its resources to fight her all the way if she took legal action, she accepted a pay-off and left’.” 

“Her next employer asked her to manipulate the numbers for a statutory reporting requirement to make its performance look better. She refused, signed another non-disclosure agreement and resigned.”

As unfortunate as these experiences were, they were not isolated events. The HR director described such incidents as happening “left, right and centre”. The fact that such cases are extremely hard to prosecute in any meaningful way helps explain why they are so pervasive. Columbia law professor John Coffee describes: “It’s extremely difficult to make a case against the senior executives because they don’t get Involved in operational issues. But they can put extreme pressure on the lower echelons to cut costs or hit targets.”

Company employees aren’t the only ones who risk facing hostility for standing for what they believe is right. Anjana Ahuja reports in the FT that scientists can fall victim to the same abuses. As she points out, “Some are targeted by industry or fringe groups; others, as the Scholars at Risk network points out, by their own governments. The academic freedom to tell inconvenient truths is being eroded even in supposed strong holds of democracy.”

Ahuja noted that the Canadian pharmacist and blogger, Olivier Bernard, was chastised for “interrogating the claim that vitamin C injections can treat cancer.”  As a consequence of his efforts, “He endured death threats” and “opponents demanded his sacking.”

In yet another example, Greece’s former chief statistician Andreas Georgiou “has been repeatedly convicted, and acquitted on appeal, of manipulating data.” The rationale for such a harsh response has nothing to do with merit: “statisticians worldwide insist that Mr Georgiou has been victimised for refusing to massage fiscal numbers.” It is simply a higher profile case of refusing to be complicit in wrongdoing.

The lessons from these anecdotes also play out across the broader population. The FT reports:

“According to the [CIPD human resources survey], 28 per cent of HR personnel perceive a conflict between their professional judgment and what their organisation expects of them; the same proportion feel ‘it’s often necessary to compromise ethical values to succeed in their organisation’.”

Employees are all-too familiar with the reality that such compromises may be required simply to survive in an organization and to continue getting health insurance: “Most HR directors know colleagues who have been fired for standing their ground.”

Yet another arena in which expertise and values get compromised is politics. While political rhetoric nearly always involves exaggerations and simplifications, the cost of such manipulations becomes apparent when important issues of public policy are at stake. Bill Blain highlighted this point on Zerohedge:

“It’s as clear as a bell that Trump had no plan to address the Coronavirus before he was finally forced to say something Monday [March 9, 2020]. Until then it was a ‘fake-news’ distraction. He made a political gamble: that the virus would recede before it became a crisis, making him look smart and a market genius for calling it.”

Blain’s assessment illustrates a point that is common to all these examples: Each involves a calculation as to whether it is worth it or not to do the right thing based on merit or to take a shortcut. Each involves an intentional effort to reject/deny/attack positions that are real and valid. Evidence, expertise and professional judgment are foresworn and replaced by narrative, heuristics, and misinformation. While such tactics undermine the long-term success of organizations and societies, they can yield tremendous personal advantages. The good of the whole is sacrificed for the good of the few.

Another point is that these efforts are absolutely pervasive. They can be found across companies, academia, politics, and beyond. They can also be found in countries all across the world. In an important sense, we have been living in an environment of pervasive tolerance of such decisions.

A third point, and the most important one, is that now it is starting to matter. It appears that the real human impact of the coronavirus has shaken many people out of complacency. The types of narratives and misinformation regarding the market that had been accepted suddenly seem woefully out of place when dealing with a real threat to public health. As Janan Ganesh reports in the FT, “This year provides a far less hospitable atmosphere for such hokum than 2016”. He concludes, “Overnight, competence matters.”

True enough, but Ganesh could have gone further. Suddenly, additional traits such as courage, good judgment, and ethical behavior also matter. Overnight, carelessness and complacency have become much more costly.

All these things will become extremely important for investors as well. For example, information sources are crucial for early identification of potential problems and for proper diagnosis. Most mainstream news outlets were slow to report on the threat of the coronavirus even though it was clearly a problem in China in January. By far the best sources on this issue have been a handful of independent researchers and bloggers who have shared their insights publicly.

One form of news that will be interesting to monitor is upcoming earnings reports and conference calls. These events can provide an opportunity to learn about companies as well as to learn about management’s philosophy and decision-making.

Which companies are busily responding to the crisis by scrutinizing their supply chains and developing HR policies to ensure the safety of their employees? Which companies already had these measures in place and are simply executing on them now? Which companies are withdrawing guidance while they frantically try to figure out what’s going on? These responses will reveal a great deal about management teams and business models.

In addition, a much higher premium on merit will also place much higher premia on security analysis, valuation, and risk management. Alluring stories about stocks and narratives about the market can be fun to follow and even compelling. At the end of the day, however, what really matters is streams of cash flows.

Finally, a higher premium on merit is likely to significantly re-order the ranks of advisors and money managers. Those ridiculed as “overly cautious” and “perma bears” will emerge as valuable protectors of capital. Conversely, those arguing that there is no alternative (TINA) to equities will be spending a lot of time trying to pacify (and retain) angry clients who suffer big losses. Further, things like education, training, and experience will re-emerge as necessary credentials for investment professionals.

As the coronavirus continues to spread across the US, things are starting to get real for many investors. Suddenly, the world is appearing less forgiving as it is becoming clear that economic growth will slow substantially for some period of time. This especially exposes the many companies who have binged on debt while rates have been so low. Further, it is becoming increasingly obvious that there is very little the Fed can do with monetary policy to stimulate demand.

While the coronavirus will eventually dissipate, the increasing premium on merit is likely to hang around. The bad news is that in many cases it will be too late to avoid the harm caused by leaders and managers and advisors who exploited favorable conditions for personal advantage. The good news is that there are very competent people out there to make the best of things going forward.

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.

Probably.

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?

Probably.

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.

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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.

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Robertson: One Is The Loneliest Number

With passive funds continuing to grow share at the expense of actively managed funds and markets on a roll since late 2018, analyzing individual stocks can seem like a quaint if not downright outdated exercise. Indeed, many investors and advisors have become so deeply habituated to passive investing that they don’t even consider other alternatives. As a result, the exercise of analyzing individual stocks has become a fairly lonely pursuit.

This reality, however, also spells opportunity. While the rising tide of easy monetary policy lifted most equity boats for many years, the beneficial effects now are being shared by a decreasing number of the largest stocks. In addition, as the share of active management declines, so too do analytical efforts that keep market inefficiencies in check. A key consequence is that some much more interesting stock ideas are beginning to emerge for investors who are willing and able to rummage around in less visible parts of the market.

In a sense, it shouldn’t be surprising that individual stock opportunities are creeping up. After all, there are only a relatively few stocks with the size and liquidity requisite to be constituents in a broad array of passive funds. Pretty much by definition then, most stocks do not benefit so disproportionately from large flows of funds from price-insensitive investors. It also follows that without such support, most individual stocks are still vulnerable to eroding fundamentals to a greater or lesser extent.

And eroding fundamentals there are. Weak economic growth across the globe and repeated flirtations with yield curve inversion provide plenty of fodder to beat up on stocks with economic exposure. Companies across the energy sector have been hit, but so have those in transportation, shipping, retail, and plenty of other industries.

While poor economic news (and plenty of other uncertainty) is negative for stock prospects, it does come with a bit of a silver lining. Such clear detrimental forces induce investors to react, and in doing so, they often overreact. These types of situations are the bread and butter of valuation-based stock picking.

This also relates to another point that seems nearly forgotten. It wasn’t all that long ago that investment research was dominated by company-specific work. Before the financial crisis in 2008, Wall Street research emphasized company analyses. Investment platforms such as Motley Fool and Seeking Alpha (among others) emerged to address the widespread appetite for company-specific insights. Even casual conversations often revolved around stock tips.

While much of that activity was overdone and not especially useful, the key tenets of equity analysis remain as valid as ever. With the opportunity set beginning to open up again, now is a good time to either refresh those skills or develop them anew. More specifically, the thrust of such efforts is to identify the degree to which situational factors affect a company’s cash flow stream and then to determine if the market’s reaction is excessive.

As an example, one of the stocks I have found interesting is a small-mid cap supplier to the food and beverage industry. It has been around for a long time and sells all over the world; less than half of its revenues are in the US. Because it sells to the food and beverage industry, its revenues are fairly stable. While they don’t go up a whole lot, they don’t go down a whole lot either.

This particular company is also a leader in its industry. It dominates market share and as such, it provides significant logistical and reliability advantages to its customers. On top of all this, it is also a technology leader and finds various ways to monetize its position.

The company does have debt, but the debt level is manageable given the stability of the business and its prodigious generation of cash flow.

Based upon this description of fundamentals, how would you expect the stock to have performed? By way of comparison, the S&P 500 produced a total return of 31.5% in 2019 and finished with a trailing price/earnings multiple of 21.75. Would it be up by half as much as the S&P500? Flat? Maybe down a bit?

The reality was far harsher. Not only did the stock fail to keep up with the S&P 500 last year, it crashed on the order of 50% after a negative earnings surprise. This was interesting for two reasons. First, it was left with a price/earnings multiple in the mid-single digit range which is nearly unheard of in such overvalued markets. Second, the stock fell to a level below its lows during the Great Financial Crisis over ten years ago, despite being in a far more benign economic environment. To value buyers, this starts to sound interesting.

Obviously, not all cheap stocks will outperform and there are plenty of other factors that can come into play. Further, if economic conditions continue to erode, a number of companies will be negatively affected and could run into serious trouble. This is certainly happening in the energy industry right now.

But that’s not the point. The main point here is to recognize the world of individual stocks is becoming increasingly bifurcated. On one side is the glossy veneer of index averages regularly pushing higher. These are driven be a relatively few mega cap tech names that seem to be nearly impervious to negative news.

On the other side is a growing group of stocks that are not only vulnerable but seem to be hypersensitive to such factors. This is a different environment than a few years ago when it was extremely difficult to find any stock that was cheap. Something has changed.

This opens up new challenges and opportunities for investors. A big challenge is that the mega cap tech leaders today are unlikely to remain impervious to bad news forever. One of the great lessons of the internet boom in the late 1990s is that tech companies are not immune from economic pressures.

Many will be surprised to find out this is still true. Whether it comes in the form of reduced capital spending by companies, lower discretionary spending by consumers, or lower advertising spend as corporate budgets get squeezed, technology businesses are still very much affected by economic conditions. As it turns out, these conditions affect all their customers.

Another big challenge is that with major indexes near all-time highs and with little earnings growth to support those prices, common passive strategies are set up to deliver exceptionally poor returns over the next several years. As a result, the returns from passive investing may very well be insufficient for many investors to reach their goals. The ride over the last ten years has been terrific, but the next ten will likely be very different.

There is also opportunity, however. The best chance investors will get to realize the kinds of returns that can really help them is to return to the hard work of uncovering undervalued companies. Such an endeavor is the bread and butter of active investors and focuses on identifying cash flows and determining how sustainable they might be. Competitive advantages are important and often come in the form of less tangible attributes such as an organization’s capacity to learn and adapt. It takes a lot of work, but the opportunities exist.

While the work of toiling on individual company analyses can be a lonely endeavor, especially while passive strategies remain in the spotlight, it is also a valid way to extract decent returns from an otherwise overvalued universe of options. Indeed, such efforts may be the last best hope to realize attractive returns for some time to come.

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.

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.












David Robertson: “Best Used By”

Most people have had an experience or two with something that is out of date. Whether gulping down some spoiled milk, biting into some moldy bread, or sipping a glass of wine that has turned to vinegar, the experience tends to be shocking, unpleasant, and memorable, all at the same time. The lesson quickly learned is that you need to pay attention to how “fresh” certain things are to avoid an unpleasant experience.

The same thing happens with social norms, albeit with a longer time frame. Historical practices that were once met with widespread acceptance are today considered unreasonable and uncivil. The main point is that times change; some can adapt, but others either cannot or do not. Since business success depends on resonating with customers, employees and investors, it matters when belief systems get stale.

For better and worse, the financial news has been rife with examples of rich and powerful people being discredited by their statements and/or behaviors. This has happened to such a degree that it looks like a pattern. The cases are too numerous to dismiss as anomalous.

One of the more recent incidents involved Ken Fisher, who runs a firm with over $100 billion and is worth $3.6 billion himself. At a financial conference, zerohedge reported, he “shocked attendees when he compared gaining a client’s trust to ‘trying to get into a girl’s pants’.”

Those comments alone might have been easy to pass over. Offensive, sure. But they could have been dramatized, or taken out of context, or just not that important. Fisher, however, decided to eliminate any possible doubt that he really meant what he said when he added:

I have given a lot of talks, a lot of times, in a lot of places and said stuff like this and never gotten that type of response.

As such, the comments were revealing in a couple of ways. First, the absence of any real contrition indicated he stood behind what he said. He did, however, seem disappointed that he had lost the respect of a lot of people.

Most importantly, he seemed genuinely surprised that anyone might take issue with his comments. That surprise was most likely caused by having fallen dangerously out of date with social norms, and that says something about Fisher.

In a very different example, Jorge Paolo Lemann, head of the private equity firm 3G Capital made comments at a conference last year that also demonstrated a disconnect with the real world, albeit in a very different way. The Financial Times reported Lemann’s comments at the time:

I’ve been living in this cosy world of old brands, big volumes, nothing changing very much,” he said. “You can just focus on being efficient and you’ll do OK. And, all of a sudden, we’re being disrupted in all ways.

The idea that food and beverage products are “not changing very much” seems almost laughably out of touch. Anyone who ever eats out, goes to restaurants or bars, goes to the grocery store, watches tv, follows social media, or interacts with other people is overwhelmed by the amount of change in the food and beverage industry. It is no secret that younger customers want different things.

It is also no secret that these changes have been developing for many years, as has disruption in the food and beverage industry. As a result, Lemann’s perception that disruption happened “all of a sudden” says more about him than about the market. Specifically, his beliefs about the “cosy world of old brands” had become seriously outdated.

To Lemann’s credit, he admitted that he felt like “a dinosaur”, so at least he eventually came around to realizing this. It did not come easily, however. It took a shocking rejection of his underlying assumptions about the market, in the form of poor financial results, for him to eventually change his views. Rather than observing gradual change over time, it was more like getting hit with a 2×4 upside the head.

Yet another example is that of Christine Lagarde, the new head of the European Central Bank. Shortly before her term began, the FT reported on comments made primarily to a European audience. In particular, she declared:

We should be happier to have a job than to have our savings protected.

In one sense, it is understandable that Lagarde might want to establish continuity with ECB policy, even if it is problematic in many respects. In proclaiming what people should prefer, rather than listening to what people actually do prefer, however, she also revealed a degree of arrogance and condescension that come across as passé in today’s more egalitarian ethos.

It may be tempting to write off these examples as just some innocuous bits of disappointing behavior. It’s not like it is illegal to have outdated beliefs, and there are certainly plenty of scandals involving illegal activities among the wealthy and powerful class to grab our attention. Further, outdated beliefs can even be a bit humorous when revealed unintentionally.

It would be a mistake to dismiss such incidents, however. For one, these are not isolated incidents but rather are emblematic of widespread behaviors and belief systems. The incidents reported are indicative of similar instances that happen every day. The FT describes the landscape:

In decades prior, Mr Fisher’s remarks may have elicited a warm hum of laughter from the usual greying, male crowd. He may even have impressed some would-be allocator in charge of a family office or endowment with his maverick touch. Not so today. Instead, this has ended up being a costly mistake.

Another problem is that many leaders seem unaware of how completely their personal belief systems fail to comport with those of society as a whole. To be fair, the belief systems of a society are moving targets; they change over time.

The Economist explains,

Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart.” A key factor is that the composition of society changes due to demographics. The Economist explains, “many socially conservative old people have died, and their places in the polling samples have been taken by liberal millennials.” 

While there have always been generational differences, part of what makes today’s differences so interesting is the magnitude and breadth of those differences. The generation of Millennials is much more diverse than the Baby Boom or Silent generations. Millennials, as a group, are also far better educated. It’s no wonder that significant political differences exist.

As a result, some social beliefs are changing quickly. The Economist illustrates with the example of gay marriage:

“As recently as the late 1980s, most Americans thought gay sex was not only immoral but also something that ought to be illegal. Yet by 2015, when the Supreme Court legalised same-sex marriage, there were only faint murmurs of protest. Today two-thirds of Americans support it, and even those who frown on it make no serious effort to criminalise it.”

One important consequence is that this rapid change in social beliefs is exposing a number of leaders and managers as being distinctly out of touch. Whether it be Fisher making vulgar comments to a group of financial professionals, Lemann professing how stable big food brands are, or Lagarde telling people they should prefer jobs over savings, each of these figures revealed that they have completely missed important changes happening across society.

In a sense, it is a bit sad when leaders reveal such striking shortcomings. They can seem like beached whales; potentially majestic but so desperately out of their element. One day they were swimming in a set of beliefs that they fully understood and the next, they were stranded and helpless.

This phenomenon is not harmless, however, and can affect investors in a myriad of different ways. One important way is through the boardroom. Board members are normally chosen for their business acumen, contacts, and decision-making ability, among other things. Because these qualities often tend to improve with age, most board members are more experienced.

While all those qualities are valuable, all of that experience can also engender certain belief systems that are not helpful at all. Indeed, “experience” can also engender a great number of lessons learned in past environments that are unlikely to recur in future ones. 

This can create a real problem. Whether intentionally or not, the behaviors and beliefs of board members get propagated through the entire company. This point was made clear by the Economist in summarizing Ben Horowitz’ new book: “Leaders set the tone. If they lie, shout or swear, then others will do the same.” Likewise, if they make lewd comments, ignore rapidly changing consumer preferences, or treat people as “subjects”, others will also do the same. It usually doesn’t take long for such behavior to thoroughly permeate an organization.

An excellent example of this was Uber. Back in the summer of 2017, when Uber’s board was trying to deal with the unseemly behavior of Travis Kalanick, board member David Bonderman made things worse. As the FT reported, “it took less than seven minutes before Mr Bonderman … interrupted fellow board member Arianna Huffington. As Ms Huffington was telling staff that research showed boards with one female director were more likely to appoint a second, Mr Bonderman interjected: ‘Actually what it shows is that it’s much more likely to be more talking’.” Is it any wonder that Uber had a “corporate culture known for being aggressive and sexist”?

Although many forego the opportunity, there are things investors can do to reduce such risks. Proxy statements reveal a number of “tells” that indicate which boards and which companies may be especially prone to outdated belief systems, most of which revolve around an element of insularity. For example, low board turnover, concentrated power among a few long-serving members, and boards that are “captive” to a powerful CEO/chairman are all indications of potential problems.

Another investment consequence of outdated belief systems involves the competition for talent. Perhaps no business is more affected by the clash of conflicting belief systems than that of business schools themselves.

Nitin Nohria of Harvard Business School notes in the Economist that “younger alumni and incoming classes want ‘the place of work to reflect purpose and values’.” Jonathan Levin of Stanford’s Graduate School of Business (gsb) highlights the responsibility of business schools “to recognise the societal consequences of corporate actions.” Simply put, a lot of tomorrow’s managers and leaders don’t want to work within the belief systems of some of today’s managers and leaders.

Of course, stale belief systems are not solely the purview of leaders and managers. Since belief systems tend not to change much at the individual level, once they become stale, they tend to remain stale. As the Economist notes. “It is hard to beat bias out of individuals …”

When this happens on a large scale, it can create systemic risk. For example, a lot of people have experienced enormous appreciation in financial assets over their careers. Given this powerful experience, it is easy for one to believe that it always makes sense to invest in financial assets.

This creates consequences for all investors. Price discovery becomes much more a reflection of an entrenched belief system and much less an ongoing analytical exercise. Prices become disconnected from fundamental reality.

What can cause things to change? Certainly, beliefs can change. It is possible that investors stop believing that central banks can, and will, continue to support financial asset prices. It is also possible that investors start getting more squeamish about valuations.

Sooner or later, however, the thing that will definitely cause change is demographic replacement. Older generations that have fared extremely well by owning financial assets are gradually being replaced by younger generations that have had far less positive experiences. When a tipping point is reached, attitudes towards stocks are likely to change just as quickly, and permanently, as they did with gay marriage.

In sum, outdated belief systems are a fact of life and are often harmless. The main lesson though, is that there are absolutely situations in which stale beliefs can cause extremely unpleasant experiences. Fortunately, there are ways for investors to identify the risk and manage it before it becomes a problem.

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:

XLK * XLY / XLP / XLV

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.

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Important support for big cap indices.

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

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Rotation value from growth.

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