Tag Archives: China

Technically Speaking: The One Thing – Playing The “Bear Market” Rally.

Let’s flashback to a time not so long ago, May 2019.

“It was interesting to see Federal Reserve Chairman Jerome Powell, during an address to the Fernandina Beach banking conference, channel Ben Bernanke during his speech on corporate ‘sub-prime’ debt (aka leveraged loans.)

‘Many commentators have observed with a sense of déjà vu the buildup of risky business debt over the past few years. The acronyms have changed a bit—’CLOs’ (collateralized loan obligations) instead of ‘CDOs’ (collateralized debt obligations), for example—but once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards. Likewise, much of the borrowing is financed opaquely, outside the banking system. Many are asking whether these developments pose a new threat to financial stability.

In public discussion of this issue, views seem to range from ‘This is a rerun of the subprime mortgage crisis’ to ‘Nothing to worry about here.’ At the moment, the truth is likely somewhere in the middle. To preview my conclusions, as of now, business debt does not present the kind of elevated risks to the stability of the financial system that would lead to broad harm to households and businesses should conditions deteriorate.’ – Jerome Powell, May 2019

In other words, corporate debt is ‘contained.’”

As we concluded at that time:

“Unfortunately, while Jerome Powell may be currently channeling Ben Bernanke to keep markets stabilized momentarily, the real risk is some unforeseen exogenous event, such as Deutsche Bank going bankrupt, that triggers a global credit contagion.”

While the “exogenous event” was a “virus,” it led to a “credit event” which has crippled markets globally, leading the Federal Reserve to throw everything possible at trying to stem the crisis. With the Fed’s balance sheet set to expand towards $10 Trillion, the Federal deficit to balloon to $4 trillion, it is “all hands on deck” to stop the next “Great Depression” before it takes hold.

However, this is what we have been warning about:

“Pay attention to the market. 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 only question which remains to be answered is whether the MORE debt and monetary stimulus can fix a debt and monetary stimulus bubble?

In other words, can the Fed inflate the fourth bubble to offset the implosion of the third?

Think about the insanity of that statement, but that is what the markets, and the economy, are banking on.

We do expect that with the flood of fiscal and monetary stimulus, a “bear market rally” becomes a real probability, at least in the short-term.

How big of a rally? What should you do? These are the important points in today’s missive.

The One Thing

The “ONE Thing” you need to do TODAY, right now, is “accept” where you are.

What you had, what was lost, and the mistakes you made, CAN NOT be corrected. They are in the past. However, by hanging on to those “emotions,” we lock ourselves out of the ability to take actions that will begin the corrective process.

Let me dispel some myths:

  • “Hope” is not an investment strategy. Hanging on to some stock you lost money in waiting for it to “get back to even,” costs you opportunity.
  • You aren’t a loser. Whatever happened previously is over, and it doesn’t make you a “loser.” However, staying in losing positions or strategies will continue to cost you. 
  • Selling does NOT lock in losses. The losses have already occurred. Selling, however, gives you the ability to take advantage of “opportunity” to begin the recovery process.  

Okay, now that we have the right “mindset,” let’s take an educated guess on what happens next.

The current bear market is exhibiting many of the same “technical traits” as seen in both the “Dot.com” and “Financial Crisis.” 

In each previous case, the market experienced a parabolic advance to the initial peak. A correction ensued, which was dismissed by the mainstream media, and investors alike, as just a “pause that refreshes.” They were seemingly proved correct as the markets rebounded shortly thereafter and even set all-time highs. Investors, complacent in the belief that “this time was different” (1999 – a new paradigm, 2007 – Goldilocks economy), continued to hold out hopes the bull market was set to continue.

That was a mistake.

Also, in each period, once the monthly “sell signal” was triggered from a high level, the ensuing correction process took months to complete. This not only reset the market, but valuations as well. In both previous periods, reflexive rallies occurred, which eventually failed. While the 2008 plunge following the Lehman crisis was most similar to the current environment, there was a brief rally following the passage of TARP, which sucked investors in before the additional 22% decline in the first two months of 2009.

Most importantly, the market got very oversold early in both previous bear markets, and stayed that way for the entirety of the bear market. Currently, the market has only just now gotten to a similar oversold condition.

What all the indicators currently suggest is that while the current correction has been swift and brutal, bear markets are not resolved in a single month. 

This is going to take some time.

Bear Market Rally

Over the past couple of week’s, we have been talking about a potential reflexive bounce.

From a purely technical basis, the extreme downside extension, and potential selling exhaustion, has set the markets up for a fairly strong reflexive bounce. This is where fun with math comes in.

As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance. Such an advance will “lure” investors back into the market, thinking the “bear market” is over.

This is what “bear market rallies” do, and generally inflict the most pain possible on unwitting investors. The reasons for this are many, but primarily investors who were trapped in the recent decline will use the rally to “flee” the markets permanently.

Chart Updated Through Monday

More importantly, as noted above, “bear markets” are not resolved in a single month. Currently, there are too many investors trying to figure out where “the bottom” is, so they can “buy” it.

Bear markets do not end in optimism; they end in despair. 

Looking back at 2008, numerous indicators suggest the “bear market” has only just begun. While this does NOT rule out a fairly strong reflexive rally, it suggests that any rally will ultimately fail as the bear market completes its cycle. 

This can be seen more clearly in the monthly chart below, which looks at both previous bull and bear markets using a Fibonacci retracement. As shown, from the peak of both previous bull market “bubbles,” the market reversed 61.8% of the advance during the “Dot.com” crash, and more than 100% of the advance during the “Financial Crisis.”  

Given the current bull market cycle was longer, more levered, and more extended than both previous bull markets, a 38.2% decline is unlikely to fulfill the requirements of this reversion. Our ultimate target of 1600-1800 on the S&P 500 remains confirmed by the quarterly chart below.

The current correction process has only just triggered a quarterly sell signal combined with a break from an extreme deviation of the long-term bull-trend back to the 1930’s. Both previous bull market peaks coincide with the long-term bull trend at about 1600 on the S&P currently. Given all the stimulus being infused into the markets currently, we broaden our bear market bottom target to 1600-1800, as noted.

The technical signals, which do indeed lag short-term turns in the market, all confirm the “bear market” is only just awakening. While bullish reflexive rallies are very likely, and should be used to your advantage, this is a “traders” market for the time being.

In other words, the new mantra for the market, for the time being, will be to “Sell Rallies” rather than “Buy The Dip.”

As I have noted many times previously:

“This ‘time is not different,’ and there will be few investors that truly have the fortitude to ‘ride out’ the next decline.

Everyone eventually sells. The only difference is ‘selling when you want to,’ versus ‘selling when you have to.’”

Yes, the market will rally, and likely substantially so. Just don’t forget to take action, make changes, and get on the right side of the trade, before the “bear returns.” 

Let me conclude by reminding you of Bob Farrell’s Rule #8 from our recent newsletter:

Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend

  1. Bear markets often START with a sharp and swift decline.
  2. After this decline, there is an oversold bounce that retraces a portion of that decline.
  3. The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate.

Dow Theory also suggests that bear markets consist of three down legs with reflexive rebounds in between.

The chart above shows the stages of the last two primary cyclical bear markets versus today (the 2020 scale has been adjusted to match.)

As would be expected, the “Phase 1” selloff has been brutal.

That selloff sets up a “reflexive bounce.”  For many individuals, they will feel like” they are “safe.” This is how “bear market rallies” lure investors back in just before they are mauled again in “Phase 3.”

Just like in 2000, and 2008, the media/Wall Street will be telling you to just “hold on.” Unfortunately, by the time “Phase 3” was finished, there was no one wanting to “buy” anything.

What We Are Not Being Told About The Trade Deal

Unlike most trade deals where the terms are readily available, the details of the Phase One trade agreement between China and the U.S. will not be announced nor signed in public. Accordingly, investors are left to cobble together official comments, anonymous statements from officials, and rumors to ascertain how it might affect their portfolios.

Based on official and unofficial sources, existing tariffs will remain in place, new tariff hikes will be delayed, and China will purchase $40-50 billion in agricultural goods annually. At first blush, the “deal” appears to be a hostage situation- China will buy more goods in exchange for tariff relief.

The chart below, courtesy of Bloomberg, provides reasons for skepticism. The rumored $40-50 billion in goods is nearly double what China purchased from the U.S. in any year of the last decade. It is over four times what they bought in 2018 before the trade war started in earnest.

The commitment is even more questionable when one considers that China recently agreed to purchase agricultural products from Brazil, Argentina, and New Zealand. 

The following tweet by Karen Braun, (@kannbwx), a Global Agricultural Columnist for Thomson-Reuters, puts the massive commitment into further context.  She claims that the maximum annual totalimport of four key agriculture products, only adds up to $56 billion. As she stresses in the tweet, the figures are based on the maximum amount China bought for each respective good in any one year.

Either China will buy more agriculture than they need and stockpile a tremendous amount of agriculture, which is possible, or they have agreed to something else that is not being disclosed. That, to us, seems more likely. We have a theory about what might not be disclosed and why it may matter to our investment portfolios.

Donald’s Dollar

Given the agreement as laid out in public, what else can China can offer that would satisfy President Trump? While there are many possibilities, the easiest and most beneficial commitment that China can offer the U.S. is a stronger yuan, and thus, a weaker dollar.

The tweets below highlight Trump’s disdain for the strengthening dollar.

A weaker dollar would reduce the U.S. trade deficit by making exports cheaper and imports more expensive. If sustained, it could provide an incentive for some companies to move production back to the U.S. This would help fulfill one of Trump’s core promises to voters, especially in “fly over” states that pushed him over the top in the last election. Further, a weaker dollar is inflationary, which would boost nominal GDP and help satisfy the Fed’s craving for more inflation.

From China’s point of view, a weaker dollar/ stronger yuan would hurt their exporting sectors but allow them to buy U.S. goods at lower prices. This is an important consideration based on what we wrote on December 11th, in our RIA Pro daily Commentary:   

“In part, due to skyrocketing pork prices, food prices in China have risen 19.1% year over year. In addition to hurting consumers, inflation makes monetary stimulus harder for the Bank of China to administer as it is inflationary. From a trade perspective, consumer inflation will likely be one factor that pushes Chinese leaders to come to some sort of Phase One agreement.

Food inflation is a growing problem for China and its leadership. In part, due to the issues in Hong Kong, Chairman Xi benefits from pleasing his people. While a stronger yuan would result in some lost trade and possibly jobs, the price of the agricultural goods will be lower which benefits the entire population.

A stronger yuan is not ideal for China, but it appears to be a nice tradeoff and something that benefits Trump. This is speculation, but if correct, and recent weakness in the dollar suggests it is, then we must assess how a weaker dollar affects our investment stance. 

Investment Implications

The following table shows the recent and longer-term average monthly correlations between the U.S. dollar and various asset classes. Below the table is a graph that shows the history of the two-year running monthly correlations for these asset classes to provide more context.

Data Courtesy Bloomberg

The takeaway from the data shown above is that gold and ten-year Treasury yields have a consistent negative correlation with the dollar. This means that we would expect higher gold prices and Treasury yields if the dollar weakens. Interestingly, the CRB (broad commodities index) and Emerging Equity Markets have the most positive correlation. Oil and the S&P 500 appear to be neutral.

The S&P 500 is a broad measure, so when looking at particular stocks or sectors, it is important to consider the size of the company(s) and the global or domestic nature of the company(s). For instance, domestic large-cap companies with global sales should benefit most from a weaker dollar, while small-cap domestic companies, reliant on foreign sources to produce their goods, should perform relatively poorly.  

Summary

From the onset of negotiations, the China-US trade war has been tough to handicap. China has a lot to lose if they give in to Trump’s demands. Trump has leverage as a tariff war hits China’s economy harder than the U.S. economy. China is fully aware that the U.S. election is only 11 months away, and Trump’s re-election prospects are sensitive to the state of the economy and market sentiment. A trade victory should help Trump at the polls.

Our dollar thesis is speculation, but such an agreement is self-serving for both sides. Keep a close eye on the dollar, especially versus the yuan, as a weaker dollar has implications for all asset classes.

Technically Speaking: It’s Crazy, But We’re Adding Equity Risk

In last week’s update, I discussed the case of why it was “now or never” for the bulls to take control of the market. To wit:

  • The ECB announced more QE
  • The Fed reduced capital requirements and initiated QE
  • The Fed is cutting rates
  • A “Brexit Deal” has been reached.
  • Trump, as expected, caved into China
  • Economic data is improving
  • Stock buybacks

If you are a bull, what is there not to love? 

Despite a long laundry list of concerns, as stated, we remain equity biased in our portfolio models currently for two primary reasons:

  1. The trend remains bullishly biased, and;
  2. We are now entering into the historically stronger period of the investment year.

With the volatile summer now behind us, being underweight equities paid off. As I discussed in Trade War In May & Go Away:

“It is a rare occasion the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occurs early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

Of course, we saw corrections occur in June, August, and September with little gain to show for it.  The point, of course, is the avoidance of risk, which tends to occur more often that not during the summer months, allows us to adhere to our longer-term investment goals.

The data bears out the risk/reward of summer months:

“The chart below shows the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).”

It is quite clear that there is little advantage to be gained by being aggressively allocated during the summer months. More importantly, there are few individuals that can maintain a strict discipline of only investing during seasonally strong periods consistently due to the inherent drag of psychology, leading to performance chasing. 

Seasonal Strong Period Approaches

Readers are often confused by our more bearish macro views on debt, demographics, and deflation, not to mention valuations, which will impair portfolio returns over the next decade versus our more bullish bias toward equities short-term. That is understandable since the media wants to label everyone either a “bull” or a “bear.”

However, markets are not binary. Being a bear on a macro-basis doesn’t mean you are only allowed to hold cash, gold, and stock in “beanie-weenies.” Conversely, being “bullish” on equities, doesn’t necessarily mean an exclusion of all other assets other than equities.

As we wrote to our RIAPRO Subscribers yesterday (30-day FREE Trial) there is a definitive positive bias to the markets currently.

“We are maintaining our core equity positions for now as the bullish trend remains intact. As noted in this past weekend’s newsletter, the bulls have control of the narrative for now. With the “sell signal” reversed, there is a positive bias. However, without the market breaking out to new highs, it doesn’t mean much, especially given the market is pushing back into an overbought condition. We will wait for a confirmation breakout to add to our core equity holdings as needed.

This doesn’t mean we have “thrown in the towel.”

We remain bearish on the long-term returns due to mountains of historical evidence that high valuations, coupled with excess leverage, and slow economic growth generate low returns over very long-periods of time. However, we are also short-term bullish on equity-risk because of stock buybacks, momentum, Central Bank interventions, and seasonality. Also, sentiment has gotten short-term very negative.

Money flows have also been negative even as the market has been climbing. This is due primarily to the surge in share repurchases, but still remains a contrarian indicator.

While it may seem “crazy,” it is for these reasons, despite the longer-term bearish backdrop, that we need to “gradually” and “incrementally” increase exposure for the next couple of months. Importantly, I did not say leverage up and buy speculative investments. I am suggesting a slight increase in exposure toward equity risk, as opportunity presents itself, until we have an allocation model that both hedges longer-term risks, but can take advantage of shorter-term bullish cycles.

There is no guarantee, of course, which is why investing is about managing risk. In the short-term the bulls have control of the market, and seasonal tendencies suggest higher asset prices by year-end.

Is that a guarantee? Absolutely not.

However, statistical analysis clearly suggests probabilities outweigh the possibilities. Longer-term, statistics also state prices will take a turn for the worse. However, as portfolio managers, we can’t sit around waiting for something to happen. We have to manage portfolios for what is happening now. It is always the timing that is the issue, and history shows there will be little warning, fanfare, or acknowledgment that something has changed.

That is why we manage for “risk.” The risk of the unknown, unexpected, exogenous event which unwinds markets in a sharp, and unforgiving fashion. This risk is increased by factors not normally found in “bullishly biased” markets:

  1. Weakness in revenue and profit growth rates
  2. Stagnating economic data
  3. Deflationary pressures
  4. High levels of margin debt
  5. Expansion of P/E’s (5-year CAPE)

How To Play It

With the markets currently in extreme intermediate-term overbought territory and encountering a significant amount of overhead resistance, it is likely that the current “hope driven” rally is likely near an intermediate-term top, which could be as high as 3300.

Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.”

For individuals with a short-term investment focus, pullbacks in the market can be used to selectively add exposure for trading opportunities. However, such opportunities should be done with a very strict buy/sell discipline just in case things go wrong.

Longer-term investors, and particularly those with a relatively short window to retirement, the downside risk still far outweighs the potential upside in the market currently. Therefore, using the seasonally strong period to reduce portfolio risk, and adjust underlying allocations, makes more sense currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses. 

I know, the “buy and hold” crowd just had a cardiac arrest. However, it is important to note that you can indeed “opt” to reduce risk in portfolios during times of uncertainty.

For More Read: “You Can’t Time The Market?”

On a positioning basis, the market has been heavily skewed into defensive positioning, which is beginning to rotate back towards more cyclical exposures. Materials, Industrials, Healthcare, Small, and Mid-Caps will likely perform better. 

This is not a market that should be trifled with, or ignored. With the current market, and economic cycle, already very long by historical norms, the deteriorating backdrop is no longer as supportive as it has been.

Our portfolios have been primarily long-biased for the last few years. While it may seem a “little crazy” to be adding “equity risk” to the markets currently, we are doing so with a very strict buy/sell discipline in place and are carrying very tight stop-losses.

There is more than a significant possibility that I will be writing in a month, or two, about why we are reducing risk. But this is just how portfolio management works. No one can predict the future, we can only manage the amount of “risk” we undertake.

Technically Speaking: Bulls Get QE & Trade, Remain “Stuck In The Middle”

“Clowns to the left of me,
Jokers to the right, here I am,
Stuck in the middle with you” – Stealers Wheels

__________________________

The lyrics seem apropos considering we have Trump, China, Mnuchin, the Fed, along with a whole cast of colorful characters making managing money a difficult prospect recently. 

However, the good news is that over the last month, the bulls have had their wish list fulfilled.

  • The ECB announces more QE and reduces capital constraints on foreign banks.
  • The Fed reduces capital requirements on banks and initiates $60 billion in monthly treasury purchases.
  • The Fed is also in the process of cutting rates as concerns over economic growth remain.
  • Trump, as expected, caves into China and sets up an exit from the “trade deal” nightmare he got himself into. 
  • Economic data is improving on a comparative basis in the short-term.
  • Stock buybacks are running on pace to be another record year.  (As noted previously, stock buybacks have accounted for almost 100% of all net purchases over the last couple of years.)

If you are a bull, what is there not to love?

However, as I noted in this past weekend’s newsletter. (Subscribe for free e-delivery)

“Despite all of this liquidity and support, the market remains currently confined to a downtrend from the September highs. The good news is there is a series of rising lows from June. With a ‘risk-on’ signal approaching and the market not back to egregiously overbought, there is room for the market to rally from here.”

As the tug-of-war between the “bulls” and “bears” continues, the toughest challenge continues to be understanding where we are in the overall market process. The bulls argue this is a “consolidation” process on the way to higher highs. The bears suggest this is a “topping process” which continues to play out over time. 

As investors, and portfolio managers, our job is not “guessing” where the market may head next, but rather to “navigate” the market for what is occurring. 

This is an essential point because the majority of investors are driven primarily by two psychological behaviors: herding and confirmation bias. (Read this for more information.)

Since the market has been in a “bullish trend” for the last decade, we tend to only look for information that supports our “hope” the markets will continue to go higher. (Confirmation Bias) 

Furthermore, as we “hope” the market will go higher, we buy the same stocks everyone else is buying because they are going up. (Herding)

Here is a perfect example of these concepts in action. The chart below shows the 4-week average of the spread between bullish and bearish sentiment according to the respected AAII investor survey. Currently, investors are significantly bearish, which has historically been an indicator of short-term bottoms in the market. (contrarian indicator)

If you assumed that with such a level of bearishness, most investors would be sitting in cash, you would be wrong. Over the last couple of months as concerns of trade, earnings, and the economy were brewing, investors actually “increased” equity risk in portfolios with cash at historically low levels.

This is a classic case of “bull market” conditioning.  

We can also see the same type of “bullish” positioning by looking at Rydex mutual funds. The chart below compares the S&P 500 to various measures of Rydex ratios (bear market to bull market funds)

Note that during the sell-off in December 2018, the move to bearish funds never achieved the levels seen during the 2015-2016 correction. More importantly, the snap-back to “complacency” has been quite astonishing. 

While investors are “very concerned” about the market (ie bearish in their sentiment) they are unwilling to do anything about it because they are afraid of “missing out” in the event the market goes up. 

Therein lies the trap.

By the time investors are convinced they need to sell, the damage has historically already been done. 

Stuck In The Middle

Currently, the market is continuing to wrestle with a rising number of risks. My friend and colleague Doug Kass recently penned a nice laundry list:

  1.  The Fed Is Pushing On A String: A mature, decade old economic recovery will not likely be revived by more rate cuts or by lower interest rates. The cost and availability of credit is not what is ailing the U.S. economy. Market participants are likely to lose confidence in the Fed’s ability to offset economic weakness in the year ahead.
  2. Untenable Debt Loads in the Private and Public Sectors: Katie Bar The Doors should rates rise and debt service increase. (As I noted all week, the corporate credit markets are already laboring and, in some cases, are freezing up).
  3. An Unresolved Trade War With China: This will produce a violent drop in world trade, a freeze in capital spending, and a quick deterioration in business and consumer sentiment.
  4. The Global Manufacturing Recession Is Seeping Into The Services Sector: After years of artificially low rates, the consumer is no longer pent up and is vulnerable to more manufacturing weakness.
  5. The Market Structure is Frightening: The proliferation of popularity of ETFs when combined with quantitative strategies (e.g., risk parity) have everyone on the same side on the boat and in the same trade (read: long). The potential for a series of “Flash Crashes” hasn’t been so high as since October, 1987.
  6. We Are at an All Time Low in Global Cooperation and Coordination: In our flat and interconnected world, what happens to global economic growth when the wheels fall off?
  7. We Are Already In An “Earnings Recession”: I expect a disappointing 3Q reporting period ahead. What happens when the rate of domestic and global economic growth slows more dramatically and a full blown global recession emerges?
  8. Front Runner Status of Senator Warren: Most view a Warren administration as business, economy and market unfriendly.
  9. Valuations on Traditional Metrics (e.g., stock capitalizations to GDP) Are Sky High: This is particular true when non GAAP earnings are adjusted back to GAAP earnings!
  10. Few Expect That The Market Can Undergo A Meaningful Drawdown: There is near universal belief that there is too much central bank and corporate liquidity (and other factors) that preclude a large market decline. It usually pays to expect the unexpected.
  11. The Private Equity Market (For Unicorns) Crashes and Burns: Softbank is this cycle’s Black Swan.
  12. WeWork’s Problems Are Contagious: The company causes a massive disruption in the U.S. commercial real estate market.

Don’t take this list of concerns lightly. 

The market rallied from the lows of December on “hopes” of Fed rate cuts, QE, and a “trade deal.” As we questioned previously, has the fulfillment of the bulls “wish list” already been priced in? However, since then, the market has remained stuck within a fairly broad trading range between previous highs and the 200-dma. 

Notice the negative divergence between small-capitalization companies and the S&P 500. This is symptomatic of investors crowding into large-cap, highly liquid companies, as they are “fearful” of a correction in the market, but are “more fearful” of not being invested if the market goes up. 

This is an important point when managing money. The most important part of the battle is getting the overall “trend” right. “Buy and hold” strategies work fine in rising price trends, and “not so much” during declines.

The reason why most “buy and hold” supporters suggest there is no alternative is because of two primary problems:

  1. Trend changes happen slowly and can be deceptive at times, and;
  2. Bear markets happen fast.

Since the primary messaging from the media is that “you can’t miss out” on a “bull market,” investors tend to dismiss the basic warning signs that markets issue. However, because “bear markets” happen fast, by the time one is realized, it is often too late to do anything about it.

The chart below is one of my favorites. It is a quarterly chart of several combined indicators which are excellent at denoting changes to overall market trends. The indicators started ringing alarm bells in early 2018, when I begin talking about the end of the “bull market” advance. However, that correction, as noted, was quickly reversed by the Fed’s changes in policy and “hopes” of an impending “trade deal.”

Unfortunately, what should have been a larger corrective process to set up the next major bull market, instead every single indicator has reverted back to warning levels.

If the bull market is going to resume, the market needs to break above recent highs, and confirm the breakout with expanding volume and participation in both small and mid-capitalization stocks which have been sorely lagging over the past 18-months.

However, with earnings and economic growth weakening, this could be a tough order to fill in the near term.

So, for now, with our portfolios underweight equity, over-weight cash, and target weight fixed income, we remain “stuck in the middle with you.”

Technically Speaking: This Is Nuts & The Reason To Focus On Risk

Since the lows of last December, the markets have climbed ignoring weakening economic growth, deteriorating earnings, weak revenue growth, and historically high valuations on “hopes” that more “Fed rate cuts” and “QE” will keep this current bull market, and economy, alive…indefinitely.

This is at least what much of the media suggests as noted recently by Rex Nutting via MarketWatch:

“‘Recessions are always hard to predict,’ says Lou Crandall, chief economist for Wrightson ICAP, who’s been watching the Fed and the economy for three decades. But after looking deeply into the economic data, he concludes that ‘there’s no reason’ for the economy to topple into recession. The usual suspects are missing. For instance, there’s no inventory overhang, nor is monetary policy too tight.”

Since the financial markets tend to lead the economy, he certainly seems to be correct. 

However, a look at the economic data indeed suggests that something has gone wrong in the economy in recent months. The latest Leading Economic Index (LEI) report showed continued weakness along with a myriad of economic data points. The chart below is the RIA Economic Composite Index (a comprehensive composite of service and manufacturing data) as compared to the LEI.

The downturn in the economy shouldn’t be surprising given the current length of the overall expansion. However, the decline in the LEI also is coincident with weaker rates of profit growth.

This also should be no surprise given the companies that make up the stock market are dependent on consumers to spend money from which they derive their revenue. If the economy is slowing down, revenue and corporate profit growth will decline also. 

However, it is this point which the “bulls” should be paying attention to. Many are dismissing currently high valuations under the guise of “low interest rates,” however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the markets and corporate profits after tax. The only other time in history the difference was this great was in 1999.

This is nuts!

Lastly, given the economic weakness, as noted above, is going to continue to depress forward reported earnings estimates. As I noted back in May, estimates going into 2020 have already started to markedly decline (primarily so companies can play “beat the estimate game,”) 

For Q4-2020, estimates have already fallen by almost $10 per share since April, yet the S&P 500 is still near record highs. 

As we discussed in this past weekend’s newsletter, it all comes down to “hope.” 

“Investors are hoping a string of disappointing economic data, including manufacturing woes and a slowdown in job creation in the private sector, could spur a rate cut. Federal funds futures show traders are betting on the central bank lowering its benchmark short-term interest rate two more times by year-end, according to the CME Group — a welcome antidote to broad economic uncertainty.” – WSJ

Hope for:

  • A trade deal…please
  • More Fed rate cuts
  • More QE

The reality, of course, is that as investors chase asset prices higher, the need to “rationalize,” a byproduct of the “Fear Of Missing Out,” overtakes “logic.” 

As we also discussed this past weekend, the backdrop required for the Fed to successfully deploy “Quantitative Easing” doesn’t exist currently. 

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, and confidence is extremely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, the backdrop could not be more diametrically opposed.”

If we are correct, investors who are dependent on QE and rate cuts to continue to support markets could be at risk of a sudden downturn. This is because the entire premise is based on the assumption that everyone continues to act in the same manner.  This was a point we discussed in the Stability/Instability Paradox:

With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the ‘instability of stability’ is now the most significant risk.

The ‘stability/instability paradox’ assumes that all players are rational and such rationality implies an avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

Simply, the Fed is dependent on “everyone acting rationally.”

Unfortunately, that has never been the case.

The behavioral biases of individuals is one of the most serious risks facing the Fed. Throughout history, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.

This time is unlikely to be different.

Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term means even further. Such is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.

The correction over the last couple of months has done little to correct these extensions, and valuations have become more expensive as earnings have declined. 

Yes,. the bullish trend remains clearly intact for now, but all “bull markets” end….always.

Given that “prices are bound by the laws of physics,” the chart below lays out the potential of the next reversion.

This chart is NOT meant to “scare you.”

It is meant to make you think.

While prices can certainly seem to defy the law of gravity in the short-term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

There are substantial reasons to be pessimistic about the markets longer-term. Economic growth, excessive monetary interventions, earnings, valuations, etc. all suggest that future returns will be substantially lower than those seen over the last eight years. Bullish exuberance has erased the memories of the last two major bear markets and replaced it with “hope” that somehow, “this time will be different.”

Maybe it will be.

Probably, it won’t be.

The Reason To Focus On Risk

Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. Higherer returns are generated from the management of “risks” rather than the attempt to create returns by chasing markets. That philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;

“As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty, we must decide and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.

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

We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Just something to consider.

Technically Speaking: The Risk To The Bullish View Of Trade Deal

In this past weekend’s newsletter, I discussed the bullish view of a trade deal with China. 

“Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.” 

This is not the first time we presented our analysis for a “bull run” to 3300. To wit:

“The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal”

While I did follow those statements up with why a “bear market” is inevitable, I didn’t discuss the issue of what happens is Trump decides to play hardball and the “trade negotiations” fall apart. 

Given Trump’s volatile temperament, this is not an unlikely “probability.” Also, there is more than just a little pressure from his base of voters to press for a bigger deal.

As I noted, China cannot agree to the biggest issues which have stalled negotiations so far:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

For China, these items are an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program. This is something that President Xi is extremely unlikely to do, particularly for a U.S. President who is in office for a maximum of 4-more years. 

Of course, if talks break down, there are two potential outcomes investors need to consider for the portfolio:

  1. Everything remains status quo for now and more talks are scheduled for a future date, or;
  2. Talks breakdown and both countries substantially increase tariffs on their counterparts. 

Given that current tariffs are weighing on Trump’s supporters in the Midwest, and both Silicon Valley and retail’s corporate giants have pressured Trump not to increase tariffs further, the most probable outcome is the first. 

No Trade Deal,  No New Tariffs

Unfortunately, that outcome does little for the market in the short-term as existing tariffs continue to weigh on corporate profitability, as well as consumption. Given that earnings are already on the decline, the benefits of tax cut legislation have been absorbed, and economic growth is weakening, there is little to boost asset prices higher. 

Therefore, under this scenario, current tariffs will continue to weigh on corporate profitability, but “hopes” for future talks will likely continue to keep markets intact for a while longer. However, as we head into 2020, a potential retracement will likely occur as markets reprice for slower earnings and economic growth.

In this environment, we would continue to expect some underperformance by those sectors most directly related to the current tariffs which would be Basic Materials, Industrials, and Emerging Markets. 

Since the beginning of the “trade war,” these sectors have lagged overall market performance and have been under-weighted in portfolios. We alerted our RIA PRO subscribers to this change in March, 2018:

“We closed out our Materials trade on potential “tariff” risk. Industrials are now added to the list of those on the “watch, wait and see” list with the break below its 50-dma. Tariff risk continues to rise and Larry Kudlow as National Economic Advisor is not likely to help the situation as his ‘strong dollar’ views will NOT be beneficial to these three sectors. Also, we reduced weights in international exposure due to the likely impact to economic growth from ‘tariffs’ on those markets which have continued to weaken again this week.”

That advice turned out well as those sectors have continued to languish in terms of relative performance since then.

Furthermore, a “no trade deal, no tariff change” outcome does little to change to the current deterioration of economic data. As we showed just recently, our Economic Output Composite Index has registered levels that historically denote a contractionary economy. 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)”

No Trade Deal Plus New Tariffs

The second outcome is more problematic.

In this scenario, Trump allows emotion to get the better of him, and he blows up at the meeting. In a swift retaliation, he reinstates the “tariffs” on discretionary goods, and increases tariffs across the board as a punitive measure. The Chinese, in an immediate retaliation levy additional tariffs as well. 

With both sides now fully entrenched in the trade war, the market will lose faith in the ability to get a “deal” done. The increased tariffs will immediately be factored into earnings forecast, and the market will begin to reprice for a more negative outcome. 

In this scenario, Basic Materials, Industrials, Emerging, and International Markets will continue to be the most impacted and should be avoided. Because of the new tariffs which will directly impact discretionary purchases, Technology and Discretionary sectors should also likely be under-weighted. 

The increase in tariffs is also going to erode both consumer and economic confidence which have remained surprisingly strong so far. However, once the consumer is more directly affected by tariffs, that confidence, along with related consumption, will fade. 

 

What About Bond Yields And Gold

In both scenarios above, a “No Trade Deal” outcome will be beneficial for defensive positioning in portfolios. Gold and bond yields have already performed well this year, but if trade talks fall through, there will be a rotation back to the “safe haven” trade as equity prices potentially weaken. This is specifically the case in the event our second outcome comes to fruition. 

While bond yields are overbought currently, it is quite likely we could see yields fall below 1%. Also, given the large outstanding short-position in bonds, as discussed recently, there is plenty of “fuel” to push rates lower.

“Combined with the recent spike in Eurodollar positioning, as noted above, it suggests that there is a high probability that rates will fall further in the months ahead; most likely in concert with the onset of a recession.”

As I noted, there is no outcome that ultimately avoids the next bear market. The only question is whether moves by the Administration on trade, combined with the Fed cutting rates, retards or advances the timing. 

“Furthermore, given the markets never reverted to any meaningful degree, higher prices combined with weaker earnings growth, has left the markets very overvalued, extended, and overbought from a historical perspective.”

Our long-term quarterly indicator chart has aligned to levels that have previously denoted more important market tops. (Chart is quarterly data showing 2-standard deviations from long-term moving averages, valuations, RSI indications above 80, and deviations above the 3-year moving average)

While we laid out the “bullish case” of 3300 over the weekend, it would not be wise to dismiss the downside risk given how much exposure to the “trade meeting” is currently built into market prices. 

We are assuming that Trump wants a “deal done” before the upcoming election, which should also help temporarily boost economic growth, but there remains much that could go wrong. An errant “tweet,” a “hot head,” or merely a breakdown in communications, could well send markets careening lower.

Given that downside risk outweighs upside reward at this juncture by almost 3 to 1, in remains our recommendation to rebalance risk, raise some cash, and hedge long-equity exposure in portfolios for now. 

This remains a market that continues to under-price risk.

Technically Speaking: How To Safely Navigate A Late Stage Bull Market

In this past weekends newsletter, I discussed the issues surrounding “dollar cost averaging” and “buy and hold” investing. That discussion always raises some debate because there is so much pablum printed in the mainstream media about it. As we discussed:

“Yes, a ‘buy and hold’ portfolio will grow in the financial markets over time, but it DOES  NOT compound. Read this carefully: “Compound returns assume no principal loss, ever.”

To visualize the importance of this statement, look at the chart below of $100,000, adjusted for inflation, invested in 1990 versus a 6% annual compound rate of return. The shaded areas show whether the portfolio value exceeds the required rate of return to reach retirement goals.”

“If your financial plan required 6% “compounded” annually to meet your retirement goals; you didn’t make it.”

Does this mean you should NEVER engage in “buy and hold” or “dollar-cost averaging” with your portfolio?

No. It doesn’t.  

However, as with all things in life, there is a time and place for application. 

As shown above, when markets are rising, holding investments and adding to them is both appropriate and beneficial as the general trend of prices is rising. 

There is a reason why not a single great trader in history has “buy and hold” as an investment rule. Also, when it comes to DCA, the rule is to never add to losers…ever. 

17. Don’t average trading losses, meaning don’t put ‘good’ money after ‘bad.’ Adding to a losing position will lead to ruin. Ask the Nobel Laureates of Long-Term Capital Management.” – James P. Huprich

That reason is the permanent impairment of investment capital. By investing fresh capital, or holding current capital in risk assets, during a market decline, the ability of the capital to create future returns is destroyed.

“17. Don’t focus on making money; focus on protecting what you have.” – Paul Tudor Jones

Investing is about growing capital over time, not chasing markets. 

This is also why all great traders in history follow the most simplistic of investing philosophies:

“Buy that which is cheap, sell that which is dear” – Ben Graham

It’s Getting Very Late

When trying to navigate markets, and manage your portfolio, you have to have a reasonable assumption of where you within the investment cycle. In other words, as Jim Rogers once quipped:

“It’s hard to buy low and sell high if you don’t know what’s low and what’s high.”

This is the problem that most individuals face during late-stage bull market advances. Following a “bear market,” most individuals have been flushed out of the markets, and conversations of “armchair investing methods” vanish from the financial media.

However, once the “bull market” has lasted long enough, it becomes believed that “this time is different.” It is then you see the return of concepts which are based on the assumption:

“If you can’t beat’em, join’em.” 

That is where we are today and we have created a whole bunch of sayings to support the idea of why markets can’t fall:

  • BTFD – Buy The F***ing Dip
  • TINA – There Is No Alternative
  • The Central Bank Put
  • The Fed Put
  • The Trump Put

You get the idea.

However, there is little argument that valuations are expensive on a variety of measures, as noted by Jill Mislinksi just recently.

Importantly, markets are also grossly extended on a technical basis as well. The chart below shows the S&P 500 on a quarterly basis. Note that the index is pushing rather extreme levels of extension above its very long-term moving average, and is more overbought currently than ever before in history. 

Note that a reversion to its long-term upward trend line would take the market back to 1500 which would wipe out all the gains from the 2007 peak. Such a correction would also set back portfolio returns to about 2% annualized (on a total return basis) from the turn of the century.

As a portfolio manager, however, I can’t sit in cash waiting for a “mean-reverting” event to occur. While we know with absolute certainty that such an event will occur, we don’t know the “when.” Our clients have a need to grow assets for retirement, therefore we must navigate markets for what “is” currently, as well as what “will be” in the future. 

The question then becomes how to add equity exposure to portfolios particularly if one is in a large cash position currently.

How To Add Exposure In A Late Stage Bull Market

The answer is more in line with the age-old question:

“How do you pick up a porcupine? Carefully.”

Here are some guidelines to follow:

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market. (We detail these every week at RIAPRO.)
  1. Move “stop-loss” levels up to current breakout levels for each position. Managing a portfolio without “stop-loss” levels is like driving with your eyes closed.
  1. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” if the current market setup is not viable.
  2. There is nothing wrong with CASH. In investing, if you don’t know what to do for certain, do nothing. There is nothing wrong with holding extra cash until you see the “fat pitch.”
  3. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

The current rally is built on a substantially weaker fundamental and economic backdrop. Thereforeit is extremely important to remember that whatever increase in equity risk you take, could very well be reversed in short order due to the following reasons:

  1. We are moving into the latter stages of the bull market.
  2. Economic data continues to remain weak
  3. Earnings are beating continually reduced estimates
  4. Volume is weak
  5. Longer-term technical underpinnings are weakening and extremely stretched.
  6. Complacency is extremely high
  7. Share buybacks are slowing
  8. The yield curve is flattening

It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis. We will see what happens over the next couple of weeks. 

However, the longer-term dynamics are turning more bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

While it is certainly advisable to be more “bullish” currently, like picking up a “porcupine,” do so carefully.

Technically Speaking: The Risk Of A Liquidity Driven Event

Over the last few days, the internet has been abuzz with commentary about the spike in interest rates. Of course, the belief is that the spike in rates is “okay” because the market are still rising. 

“The yield on the benchmark 10-year Treasury note was poised for its largest weekly rally since November 2016 as investors checked prior concerns that the U.S. was careening toward an economic downturn.” – CNBC

See, one good economic data point and apparently everything is “A-okay.” 

Be careful with that assumption as the backdrop, both economically and fundamentally, does not support that conclusion. 

While the 10-year Treasury rate did pop up last week, it did little to reverse the majority of “inversions” which currently exist on the yield curve. While we did hit the 90% mark on August 28th, the spike in rates only reversed 2 of the 10 indicators we track. 

Nor did it reverse the most important inversion which is the 10-year yield relative to the Federal Reserve rate. 

However, it isn’t the “inversion” you worry about. 

Take a look at both charts carefully above. It is when these curves “un-invert” which becomes the important recessionary indicator. When the curves reverse, the Fed is aggressively cutting rates, the short-end of the yield curve is falling faster than the long-end as money seeks the safety of “cash,” and a recession is emerging.

As I noted in yesterday’s missive on the NFIB survey, there are certainly plenty of warning signs the economy is slowing down. 

 In turn, business owners remain on the defensive, reacting to increases in demand caused by population growth rather than building in anticipation of stronger economic activity. 

What this suggests is an inability for the current economy to gain traction as it takes increasing levels of debt just to sustain current levels of economic growth. However, that rate of growth is on the decline which we can see clearly in the RIA Economic Output Composite Index (EOCI). 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)”

“When you compare this data with last week’s employment data report, it is clear that recession” risks are rising. One of the best leading indicators of a recession are “labor costs,” which as discussed in the report on “Cost & Consequences Of $15/hr Wages” is the highest cost to any business.

When those costs become onerous, businesses raise prices, consumers stop buying, and a recession sets in. So, what does this chart tell you?”

There is a finite ability for either consumers or businesses to substantially sustain higher input costs in a slowing economic environment. While debt can fill an immediate spending need, debt does not lead to economic growth. It is actually quite the opposite, debt is a detractor of growth over the long-term as it diverts productive capital from investment to debt service. Higher interest rates equals higher debt servicing requirements which in turns leads to lower economic growth.

The Risk Of Liquidity

In the U.S., we have dismissed higher rates because of a seemingly strong economy. However, that “strength” has been a mirage. As I previously wrote:

“The IIF pointed out the obvious, namely that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. Amusingly, by doing so, this makes rising rates even more impossible as the world’s can barely support 100% debt of GDP, let alone 3x that.”

That illusion of economic growth has kept investors blind to the economic slowdown which is already occurring globally. However, with global bond yields negative, the US Treasury is the defacto world’s risk-free rate. 

If global bond yields rise, by any significant degree, there is a liquidity funding risk for global markets. This is why, as I noted this past week, the ECB acted in the manner it did to increase liquidity to an already illiquid market. The reason, to bail out a systemically important bank. To wit:

We had previously stated the Central Banks are going to act to bail out systemically important banks which are on the brink of failure – namely, Deutsche Bank ($DB) Not surprisingly, this was the same conclusion Bloomberg finally arrived at:

“Deutsche Bank AG will benefit the most by far from the European Central Bank’s new tiered deposit rate. Germany’s largest lender stands to save roughly 200 million euros ($222 million) in annual interest paymentsthanks to a new rule that exempts a big chunk of the money it holds at the ECB from the negative rate the central bank charges on deposits. That’s equivalent to 10% of the pretax profit the analysts expect the bank to report in 2020, compared with an average of just 2.5% for the EU banks included in the analysis.”

When you combine rising yields with a stronger U.S. dollar it becomes a toxic brew for struggling banks and economies as the global cost of capital rising is the perfect cocktail for a liquidity crunch.

Liquidity crunches generally occur when yield curves flatten or invert. Currently, as noted above, the use dollar has been rising, as the majority of yield curves remain inverted. This is a strong impediment for economic growth as funding costs are distorted and the price of exports are elevated. This issue is further compounded when you consider the impact of tariffs on the cost of imports which impacts an already weak consumer. 

Yes, for now the US economy seems to be robust, and defying the odds of a slowdown. However, such always seems to be the case just before the slowdown begins. It is likely a US downturn is closer than most market participants are predicting.

If we are right, this is going to leave the Federal Reserve in a tough position trying to reverse rates with inflation showing signs of picking up, unemployment low, and stocks near record highs.

Concurrently, bond traders are still carrying one of the largest short positions on record, leaving plenty of fuel to drive rates lower as the realization of weaker economic growth and deteriorating earnings collide with rather excessive stock market valuations. 

How low could yields go. In a word, ZERO.

While that certainly sounds implausible at the moment, just remember that all yields globally are relative. If global sovereign rates are zero or less, it is only a function of time until the U.S. follows suit. This is particularly the case if there is a liquidity crisis at some point.

It is worth noting that whenever Eurodollar positioning has become this extended previously, the equity markets have declined along with yields. Given the exceedingly rapid rise in the Eurodollar positioning, it certainly suggests that “something has broken in the system.” 

You can see this correlation to equities more clearly in the chart below. 

Did Something Break?

The rush by the Central Banks globally to ease liquidity, the ECB restarting the QE, and the Federal Reserve cutting rates in the U.S. suggest there is a liquidity problem somewhere in the system. 

Ironically, as I was writing this report, something “broke.” 

“Rising recession concerns in August – manifesting in the form of an inverted yield curve, cash hiding in repo, and a slow build in UST supply – kept secured funding pressures at bay. However, the dollar funding storm we warned about has just made landfall as the overnight general collateral repo rate, an indicator of secured market stress and by extension, dollar funding shortages, soared from Friday’s close of 2.25% to a high of 4.750%, a spike of 250bps…” – Zerohedge

This is likely just a warning for now.

Given the disproportionate role of quant-driven strategies, leveraged traders, and the compounded risk of “passive strategies,” there is profound market risk when rates rise to quickly. If the correlations that underpin the multitude of algo-driven, levered, risk-parity portfolios begin to fail, there is more than a significant risk of a disorderly reversion in asset prices. 

The Central Banks are highly aware of the risks their policies have grown in the financial markets. Years of zero interest rates, massive liquidity injections, and easy financial standards have created the third asset bubble this century. The problem for Central Bankers is the bubble exists in a multitude of asset classes from stocks to bonds, and particularly in the sub-prime corporate debt market.

As Doug Kass noted on Monday, roughly 80% of loan issuers have no public securities (which serves to limit financial disclosure) and 62% of junk issuers have only 144A bonds.

Source: JPM, Bloomberg Barclays, Prequin

However, here is the key point:

“While a paucity of financial disclosure is not problematic during a bull market for credit, it is a defining feature of a liquidity crisis during a bear market. Human beings are naturally inclined towards fear–even panic–when they are unable to obtain the information they deem critical to their (financial) survival.” – Tad Rivelle, TCW

As noted, liquidity is the dominant risk in the multitude of “passive investing products” which are dependent upon the underlying securities that comprise them. As Tad notes:

“There is yet another feature of this cycle, that while not wholly unique will likely play a major supporting role in the next liquidity crisis: the passive fund. Passive funds are the epitome of the low information investor. 

Anyone wonder what might happen should passive funds become large net sellers of credit risk? In that event, these indiscriminate sellers will have to find highly discriminating buyers who–you guessed it–will be asking lots of questions. Liquidity for the passive universe–and thus the credit markets generally–may become very problematic indeed.”

The recent actions by Central Banks certainly suggests risk has risen. Whether this was just an anomalous event, or an early warning, it is too soon to know for sure. However, if there is a liquidity issue, the risk to “uniformed investors” is substantially higher than most realize. As Doug concludes:

“Never before in history have traders and investors been so uninformed. Indeed, some might (with some justification) say that never before in history have traders and investors been so stupid!

But, the conditions of fear and greed have not been repealed — and will contribute to bouts of liquidity changes that range from, and alternate between, where ‘anything goes’ and ‘nothing is believed.’

Arguably, stock and bond prices have veered from the real economy as the cocktail of easing central banks and passive investing strategies produce a constant bid for financial assets, suppresses volatility and, in the fullness of time, will likely cause a liquidity ‘event.’ 

While the absence of financial knowledge, disclosure and the general lack of skepticism are accepted in a bull market, sadly in a bear market (when everyone is “on the same side of the boat,”) it is a defining feature of a liquidity crisis.”

While those in the mainstream media only focus on the level of the S&P 500 index to make the determination that all is right with the world, a quick look from behind the “rose colored” glasses should at least give you a reason pause. 

Risk is clearly elevated, and investors are ignoring the warning signals as markets continue to bid higher.

We saw many of the same issues in 2008 when Bear Stearns collapsed. 

No one paid attention then either.

Technically Speaking: Just How Long Will Markets Keep “Buying” It?

In this past weekend’s newsletter, I broke down the bull/bear argument dissecting the issues of cash on the sidelines, extreme bearishness, equity outflows. However, even though the economic and fundamental environment is not supportive of asset prices at current levels, the primary argument supporting asset prices at current levels is “optimism.” 

“The biggest reason for last week’s torrid stock market rally was rekindled “optimism” that the escalating trade war between the US and China may be on the verge of another ceasefire following phone conversations, fake as they may have been, between the US and Chinese side. This translated into speculation that a new round of tariffs increases slated for this weekend may not take place or be delayed.” – MarketWatch

This, of course, has been the thesis of every rally in the market over the past year. Sven Heinrick summed this up well in a recent tweet. 

However, the “ceasefire” did not happen, and at 12:00 am on Sunday, the Trump administration slapped tariffs on $112 billion in Chinese imports. Then, one-minute later, at 12:01 am EDT, China retaliated with higher tariffs being rolled out in stages on a total of about $75 billion of U.S. goods. The target list strikes at the heart of Trump’s political support – factories and farms across the Midwest and South at a time when the U.S. economy is showing signs of slowing down.

Importantly, the additional tariffs by the White House target consumers directly:

“The 15% U.S. duty hit consumer goods ranging from footwear and apparel to home textiles and certain technology products like the Apple Watch. A separate batch of about $160 billion in Chinese goods – including laptops and cellphones – will be hit with 15% tariffs on Dec. 15.  China, meanwhile, began applying tariffs of 5 to 10% on U.S. goods ranging from frozen sweet corn and pork liver to bicycle tires on Sunday.

The slated 15% U.S. tariffs on approximately $112 billion in Chinese goods may affect consumer prices for products ranging from shoes to sporting goods, the AP noted, and may mark a turning point in how the ongoing trade war directly affects consumers. Nearly 90% of clothing and textiles the U.S. buys from China will also be subjected to tariffs.” – ZeroHedge

This is only phase one. On December 15th, the U.S. will hike tariffs on another $160bn consumer goods and Beijing has vowed retaliatory tariffs that, combined with the Sunday increases, would cover $75 billion in American products once the December tariffs take effect. 

These tariffs, of course, are striking directly at the heart of economic growth. The trade was has ground the global economy to a halt, sent Germany into a recession, and is likely slowing the U.S. economy more than headline data currently suggests.

Yet, “optimism” that “a trade deal is imminent” is keeping stocks afloat. For now.


As we discussed previously, the President has now trained the markets to respond to his “tweets.” 

“Ring the bell. Investors salivate with anticipation.”  

However, despite the rally last week, the markets are still well confined in a very tight consolidation range.

As I noted recently:

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

The biggest risk, is what happens when the market quits “buying the rumor” and starts “selling the news?”

Fed To The Rescue

There is another level of “optimism” supporting asset prices. 

The Fed.

It is widely believed the Fed will “not allow” the markets to decline substantially. This is a lot of faith to place into a small group of men and women who have a long history of creating booms and busts in markets. 

And, as JP Morgan noted over the weekend:

“Positive technical indicators and monetary easing will likely outweigh the uncertainty of the U.S.-China trade war and the “wild card” of developments in tariff negotiations. We now advise to add risk back again, tactical indicators have improved. Admittedly, the next trade move is the wild card to all of this, but we think that the hurdle rate for any positive development is quite low now.”

Currently, there is a 100% expectation of the Fed cutting rates at the September meeting.

The belief currently, is that lower interest rates will result in higher asset prices as investors will once “chase equities” to obtain a “higher yield” than what they can get in other “safe” assets. 

After all, this is indeed what happened as the Federal Reserve kept interest rates suppressed after the financial crisis. However, the difference between now, and then, is that individuals are currently fully invested in the financial markets. 

“Cash is low, meaning households are fairly fully invested.” – Ned Davis

In other words, the “pent up” demand for equities is no longer available to the magnitude that existed following the financial crisis which supported the 300% rise in asset prices. 

More importantly, when the Fed has previously engaged in a “rate cutting” cycle when the “yield curve” was inverted, which signals something is wrong economically, the outcomes for investors have not been good.

This last point is an issue for investors specifically. Investing is ultimately about buying assets at a discounted price and selling them for a premium. However, so far in 2019, while asset prices have soared higher on “optimism,” earnings and profits have deteriorated markedly. This is show in the attribution chart below for the S&P 500.

In 2019, the bulk of the increase in asset prices is directly attributable to investors “paying more” for earnings, even though they are “getting less” in return.

The discrepancy is even larger in small capitalization stocks which don’t benefit from things like “share repurchases” and “repatriation.” 

Just remember, at the end of the day, valuations do matter. 

September Seasonality Increases Risk

“The month of September has a reputation for being a bad month for the stock market. After the October 1987 Crash, the month of October carried a bad rep for years, but more recently we are told that it’s really September we have to watch out for.” – Carl Swenlin

The month of September has closed higher fifty-percent of the time, but the average change was a -1.1% decline, making September the worst performing month in the 20-year period. More importantly, September tends to be weaker when it follows a negative August, which we just had.

However, these are all averages of what has happened in the past and things can, and do, turn out differently more often than we expect. This is why I prefer to just rely on the charts to suggest what may happen next. 

I discussed previously that money is crowding into large-capitalization stocks for safety and liquidity. Carl Swenlin showed this same analysis in his chart below.

Investors should be very aware about the deviation in performances across asset markets. Historically, this is more of a sign of a late-stage market topping process rather than a “pause that refreshes the bull run.” 

This is particularly the case when this crowding of investments is occurring simultaneously with an inverted yield curve. 

On a purely technical basis, when looking at combined monthly signals, we see a picture of a market in what has previously been more important turning points for investors. 

Sure, this time could turn out to be different. 

Since I manage portfolios for individuals who are either close to, or in retirement, the risk of betting on “possibilities,” versus “probabilities,” is a risk neither of us are willing to take. 

Let me restate from last week:

“Given that markets still hovering within striking distance of all-time highs, there is no need to immediately take action. However, the continuing erosion of underlying fundamental and technical strength keeps the risk/reward ratio out of favor. As such, we suggest continuing to take actions to rebalance risk.

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

We are closer to the end of this cycle than not, and the reversion process back to value has historically been a painful one.”

Remember, it is always far easier to regain a lost opportunity. It is a much more difficult prospect to regain lost capital. 

8-Reasons To Hold Some Extra Cash

Over the past few months, we have been writing a series of articles that highlight our concerns of increasing market risk.  Here is a sampling of some of our more recent newsletters on the issue. 

The common thread among these articles was to encourage our readers to use rallies to reduce risk as the “bull case” was being eroded by slower economic growth, weaker earnings, trade wars, and the end of the stimulus from tax cuts and natural disasters. To wit:

These “warning signs” are just that. None of them suggest the markets, or the economy, are immediately plunging into the next recession-driven market reversion.

However, The equity market stopped being a leading indicator, or an economic barometer, a long time ago. Central banks looked after that. This entire cycle saw the weakest economic growth of all time couple the mother of all bull markets.

There will be payback for that misalignment of funds.

As I noted on Tuesday, the divergences between large-caps and almost every other equity index strongly suggest that something is not quite right.  As shown in the chart below, that negative divergence is something we should not discount.

However, this is where it gets difficult for investors.

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

This is why we have been suggesting raising cash on rallies, and rebalancing risk until the path forward becomes clear. Importantly:

“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.”

With no trade deal in sight, slowing global growth, a Fed that doesn’t appear to want to cut rates aggressively, and weakness in markets continuing to spread, it is now time to take some actions.

Time To Take Some Action

Investors tend to make to critical mistakes in managing their portfolios. 

  • Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late-cycle stages.
  • Investors are ultimately driven by the “herding” effect. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
  • Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

The last point is relevant to today’s discussion. Investors tend to identify very “specific” price targets to take action. For example, in the chart above, the 50-dma, our previous target, currently resides at roughly at 2950. 

The mistake is only taking action if a specific target is met. If the price target isn’t precisely reached, no action is taken. As prices begin to fall, investors start hoping for a “second shot” at the price target to get out. More often than not, investors wind up disappointed.

As Maxwell Smart used to say: “Missed it by that much.” 

In our own portfolio management practice, technical analysis is a critical component of the overall process, and carries just as much weight as the fundamental analysis. As I have often stated:

“Fundamentals tell us WHAT to buy or sell, Technicals tell us WHEN to do it.”

In our methodology, technical price points are “neighborhoods” rather than “specific houses.” While a buy/sell target is always identified BEFORE a transaction is made, we will execute when we get into the general “neighborhood.”

We are now in the “neighborhood” given both the recent struggles of the market, the deteriorating technical backdrop, and our outlook over the next several months for further acceleration of the trade war. 

This all suggests that we reduce equity risk modestly, and further increase our cash hedge, until such time as there is more “clarity” with respect to where markets are heading next. 

This brings me to the most important point.

8-Reasons To Hold Cash

In portfolio management, you can ONLY have 2-of-3 components of any investment or asset class:  Safety, Liquidity & Return. The table below is the matrix of your options.

The takeaway is that cash is the only asset class that provides safety and liquidity. Obviously, this comes at the cost of return.  This is basic. But what about other options?

  • Fixed Annuities (Indexed) – safety and return, no liquidity. 
  • ETF’s – liquidity and return, no safety.
  • Mutual Funds – liquidity and return, no safety.
  • Real Estate – safety and return, no liquidity.
  • Traded REIT’s – liquidity and return, no safety.
  • Commodities – liquidity and return, no safety.
  • Gold – liquidity and return, no safety. 

You get the idea. No matter what you chose to invest in – you can only have 2 of the 3 components. This is an important, and often overlooked, consideration when determining portfolio construction and allocation. The important thing to understand, and what the mainstream media doesn’t tell you, is that “Liquidity” gives you options. 

I learned a long time ago that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.

Here are my reasons why having cash is important.

1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash. 

2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are highly correlated. 

4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong as we have seen two declines of over -50%…just in the last 19-years. Keep in mind, it takes a +100% gain to recover a -50% decline.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also merely transfers the “risk of being wrong” from one side of the ledger to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long, and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.” 

8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms. 

Importantly, I want to stress that I am not talking about being 100% in cash. 

I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.

With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important. 

Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.

Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.

Technically Speaking: Market Risk Is Rising As Retail Sends Warning

I noted in this past weekend’s newsletter the pick up in volatility over the last few weeks has made investing in the market difficult.

On Friday, the market plunged on new Trump was going to increase tariffs on China. Then on Monday, the markets rallied on comments from President Trump that China was ready to talk.

“China called last night our top trade people and said ‘let’s get back to the table’ so we will be getting back to the table and I think they want to do something. They have been hurt very badly but they understand this is the right thing to do and I have great respect for it. This is a very positive development for the world.” – President Trump, via CNBC

You simply can’t trade that kind of volatility. This was a point made to our RIAPRO subscribers last week:

When you are ‘unsure’ about the best course of action, the best course of action is to ‘do nothing.’”


As we discussed previously, the President has learned that his comments will move markets. Given the shellacking of the markets on Friday, and what was looking to be a dismal open Monday morning, Trump’s comments to boost the markets weren’t surprising.

What the market disregarded were the comments from China:

As I penned last week, the markets have now been “trained” by Trump.

“Ring the bell. Investors salivate with anticipation.”  

However, despite the rally yesterday, the markets are still well confined in a very tight consolidation range.

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

This is why we have been suggesting raising cash on rallies, and rebalancing risk until the path forward becomes clear.

“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.”

Let me restate from this past weekend’s missive where we are positioned currently:

“Over the past few months, we have reiterated the importance of holding higher levels of cash, being long fixed income, and shifting risk exposures to more defensive positions. That strategy has continued to work well.”

  • We have remained devoid of small-cap, mid-cap, international and emerging market equities since early 2018 due to the impact of tariffs on these areas.
  • For the same reasons we have also reduced or eliminated exposures to industrials, materials, and energy
  • With the trade war ramping up, there is little reason to take on additional risk at the current time as our holdings in bonds, precious metals, utilities, staples, and real estate continue to do the heavy lifting.”

As I noted previously, if you are told you have to “buy and hold” a little of everything to be diversified, then what are you paying an advisor for? There are plenty of “robo-advisors” that will gladly clip a fee from you to do something you can easily do yourself.

However, be warned. There are currently high correlations between asset classes, which suggests that when the next bear market ensues there will be few places to hide. What goes up together, will come down together as well. Being “diversified,” in the traditional sense, isn’t going to help you.

Markets Send Warning Signals

While large-cap stock indexes (S&P 500, Dow Jones, and Nasdaq) have maintained a reasonably steady state over the past 18-months, such is not the case across the broader market. As I noted previously, share repurchases have provided much of the lift for large-capitalization stocks over the last couple of years. 

“Corporate share buybacks currently account for roughly all ‘net purchases’ of U.S. equities in recent years. To wit:

“It is likely that 2018/2019 will be the potential peak of corporate share buybacks, thereby reducing the demand for equities in the market. This ‘artificial buyer’ explains the high degree of complacency in the markets despite recent volatility. It also suggests that the ‘bullish outlook’ from a majority of mainstream analysts could also be a mistake. 

If the economy is weakening, as it appears to be, it won’t be long until corporations redirect the cash from ‘share repurchases’ to shoring up operations and protecting cash flows.”

With portfolio managers needing to chase performance, the easiest, and safest, place to allocate capital is in highly liquid, large capitalization companies which are being supported by share repurchases. Despite trade turmoil, Fed disappointment, and weaker economic, and earnings growth, stocks still remain elevated and confined within the longer-term bullish trend.

However, once you step outside the large-capitalization universe, a very different picture emerges.

Since small and mid-capitalization companies don’t engage in massive share repurchase programs, and are directly impacted by early changes to consumer spending and tariffs. As such, it is not surprising that performance has been lagging that of its large-cap brethren.

Small-Cap 600 Index

Mid-Cap 400 Index  

The same issue applies to international markets as well, where economic growth has been markedly weaker than in the U.S. 

MSCI All-World (Ex-US) Index

Given the consumer makes up about 2/3rds of the U.S. economy, low unemployment, and retail sales data is often cited as reasons to be “bullish” on equities. However, as shown in the chart below, the ratio between consumer “discretionary” and “staples” companies suggests there is an emerging weakness in the retail sector.

As Tomi Kilgore noted for MarketWatch, 

“One way to gauge the real strength of the consumer is to measure how much they spend on what they want (discretionary items) relative to what they need (staples). The consumer discretionary sector is highly sensitive to what the overall stock market is doing, and to worries about economic growth and contraction.

To see this relationship in real time is through comparing consumer discretionary stocks, by way of the SPDR Consumer Discretionary Select Sector exchange-traded fund (XLY), to the consumer staples sector, as tracked by the SPDR Consumer Staples Select Sector ETF (XLP).”

Historically, when the S&P 500 is on a monthly sell signal, with an inverted yield curve, and discretionary stocks are underperforming staples, it has been a leading indicator of a recessionary economy and bear market. 

As Tomi goes on to note:

“That by itself might lead one to believe that worries about the economy are overdone, until a chart of consumer confidence is placed side-by-side with a chart of retail stocks, as tracked by the SPDR S&P Retail ETF (XRT).”

As one might expect, those charts usually move in tandem. But sometimes they move in opposite directions for short periods of time, and when they do, it’s the stocks that have been the leading indicator.

And the retail sector should still matter to investors, because when the XRT has diverged from the broader market at key turning points, it has been the XRT that has led the way.

Slow At First, Then All Of A Sudden

What all of this suggests is that “risk” is building in the markets.

However, risk builds slowly. This is why the investment community often uses the analogy of “boiling a frog.” By turning up the heat slowly, frogs don’t realize they are being boiled until its too late. The same is true for investors who make a series of mistakes as “risk” builds up slowly. 

  • Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late-cycle stages.
  • Investors are ultimately driven by the “herding” effect. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
  • Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

The end effect is not a pretty one.

When the buildup of “risk” is finally released, the explosion happens all at once leaving investors paralyzed trying to figure out what just happened. Unfortunately, by the time they realize they are the “frog,” it is too late to do anything about it.

With President Trump on a warpath with China, increasing tariffs (a tax on businesses), at a time when economic growth and corporate profits are weakening, raises our concern over the amount of equity exposure we are carrying in the markets. 

Given that markets still hovering within striking distance of all-time highs, there is no need to immediately take action. However, the continuing erosion of underlying fundamental and technical strength keeps the risk/reward ratio out of favor. As such, we suggest continuing to take actions to rebalance risk.

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

We are closer to the end of this cycle than not, and the reversion process back to value has historically been a painful one. 

Technically Speaking: This Is Still A “Sellable Rally”

In last Tuesday’s “Technical Update,” I wrote that on a very short-term basis the market had reversed the previously overbought condition, to oversold.

This could very well provide a short-term ‘sellable bounce’ in the market back to the 50-dma. As shown in the chart below, any rally should be used to reduce portfolio risk in the short-term as the test of the 200-dma is highly probable. (We are not ruling out the possibility the market could decline directly to the 200-dma. However, the spike in volatility and surge in negative sentiment suggests a bounce is likely first.)”

Chart updated through Monday’s close

This oversold condition is why we took on a leveraged long position on the S&P 500, which we discussed with our RIAPRO subscribers last Thursday morning (30-Day Free Trial).:

“I added a 2x S&P 500 position to the Long-Short portfolio for an ‘oversold trade’ and a bounce into the end of the week.”

I followed that statement up, saying we would hold the position over the weekend as:

“Given the President is fearful of a market decline, we expect there will be some announcement over the weekend on ‘trade relief’ to support the markets.”

That indeed came to pass as the President announced he extended the ability of U.S. companies to sell product to Huawei for another 90-days. (China gave up nothing in return.) Furthermore, the President re-engaged against the Fed on Twitter:

Neither point is positive over the longer-term. As noted on Monday, investors are continuing to pay near-record prices for deteriorating corporate profits.

“Despite a near 300% increase in the financial markets over the last decade, corporate profits haven’t grown since 2011.”

This Is Still A “Sellable Rally.” 

On Monday, we closed out 25% of our long trading position. We will also continue to sell into any further rally as the market challenges overhead resistance. The rest of our portfolios remain defensive, hedged, and are carrying an overweight position in cash.

The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a “topping process.” 

My colleague Charles Hugh Smith summed this up nicely on Monday:

“As the saying goes, a market-topping is not an event, it’s a process. There are a handful of historically useful characteristics of topping markets:

  1. Declining volume / liquidity
  2. Increasing volatility–major swings up and down that increase in amplitude and frequency
  3. Inability to break decisively above previous resistance (i.e. make sustainable new highs in a stairstep that moves higher).

We see all these elements in the S&P 500 over the past few years. A healthy, stable advance in 2017, led to a manic blow-off top that crashed in February of 2018, setting off a period of high volatility.

This set up another stable advance that was shorter than the previous advance, and also steeper. This led to the multi-month period of instability that concluded in a panic crash in December 2018.

Since then, advances have been shorter and steeper, suggesting a more volatile era. Three advances to new highs have all dropped back to (or below) the highs of January 2018. In effect, the market has wobbled around for 18 months, becoming more volatile after every rally.”

Adding to his comments, you can also see that bullishness by investors still remains aggressive even as the market trades below its accelerated trendline.

Here is a closer look.

There repeated failures along the previous uptrend line suggests a change of trend is potentially underway. As Charles notes, “topping processes” are a function of time, and previous violations of the bullish trend were clear warnings for investors to become more cautious.

1998

2006

You will notice that in each previous case, the “bullish story” was the same.

However, the primary warning signs to investors were also the same:

  • A break of the longer-term bullish trend line
  • A marked rise in volatility
  • A yield curve declining, and ultimately, inverting as the Fed cuts rates.

The last point we discussed in more detail in this past weekend’s missive:

“While everybody is “freaking out” over the “inversion,” it is when the yield-curve “un-inverts” that is the most important.

The chart below, shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving “risk” to seek the absolute “safety” of money markets, i.e. “market crash.”)”

In other words, while a bulk of the mainstream media keeps pointing to 1995 as “the” example of when the Fed cut rates and the market kept rising afterward, it is important to note the yield curve was NOT inverted then. However, when the Fed did begin to aggressively cut rates, which collided with the inverted yield curve, the “bear market” was not too far behind.

Lastly, Helene Meisler wrote yesterday: 

“Over the course of the last week, we saw the TRIN reach 2.10 a week ago on Aug. 12, followed by an extraordinary reading of 3.72 a few days later on last Wednesday. At the time, I explained that we don’t often get over 2.0, so a reading at almost 4.0 was literally “off the charts.”

This brings us back to the 10-day moving average, which as you can see, has skyrocketed to over 1.50. The first thing to note is that this is higher than it got even in the fourth-quarter decline. It’s more than the January and February 2018 decline as well. In fact, we have to go all the way back to 2015 and 2016 to see the kind of selling we saw last week, using this indicator. I have boxed those off in red on the left side of the chart.

Notice that these types or readings don’t occur often and they tend to occur in violent markets. All the way on the left, in July 2015, you can see this indicator reached over 1.50. The S&P 500 enjoyed a rally– a small one, but still a rally. But then you can see we came back down.

The second spike up that took the indicator to just over 1.70 arrived in August of 2015, which was accompanied by the plunge you see in the S&P of nearly 10%. Now squint even further, and you can see the rally in September – off that August low — and how we came back down in late September and early October to form a “W” in the S&P.

All of those instances are examples of a rally and back down again. I’m sure if I went back in time I could find a few examples when this indicator got this high and did not rally and come back down, but this is more typical as you can see.

All of this data supports the idea of a “sellable” rally for now.

Could that change? 

Certainly, and if it does, and our “onboarding” model turns back onto a “buy signal,” we will act accordingly and increase equity risk in portfolios. However, for now, the risk still appears to be to the downside for now.

“But the Central Banks won’t let the markets fall.” 

Maybe.

But that is an awful lot of faith to put into a few human beings who spent the majority of their lives within the hallowed halls of academia. 

There is a rising probability that Central Banks are no longer as effective is supporting asset markets as they once were. As noted by Zerohedge yesterday:

“The Fed meeting on July 31st was a sell the news event because it had been so telegraphed, and priced. The fact that the Fed arguably disappointed with only a 25bps cut means they are now behind the curve; until they get in front of it, multiples are unlikely to expand again. The Fed put expired on July 31st.”

If you disagree, that is okay.

However, given we are now more than 10-years into the current bull market cycle, here are three questions you should ask yourself:

  1. What is my expected return from current valuation levels?  (___%)
  2. If I am wrong, given my current risk exposure, what is my potential downside?  (___%)
  3. If #2 is greater than #1, then what actions should I be taking now?  (#2 – #1 = ___%)

How you answer those questions is entirely up to you.

What you do with the answers is also up to you.

Ignoring the result, and “hoping this time will be different,” has never been a profitable portfolio strategy. This is particularly the case when you are 10-years into a bull market cycle.

The Prospects of a Weaker Dollar Policy- RIA Pro

This version, for RIA Pro subscribers, contains a correlation table at the end of the article to help better quantify short and longer term relationships between the dollar and other financial assets.

“Let me be clear, what I said was, it’s not the beginning of a long series of rate cuts.”- Fed Chairman Jerome Powell -7/31/2019

“What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world….” – President Donald Trump – Twitter 7/31/2019

With the July 31, 2019 Fed meeting in the books, President Trump is up in arms that the Fed is not on a “lengthy and aggressive rate-cutting” path. Given his disappointment, we need to ask what else the President can do to stimulate economic growth and keep stock investors happy. History conveys that is the winning combination to win a reelection bid.

Traditionally, a President’s most effective tool to spur economic activity and boost stock prices is fiscal policy. With a hotly contested election in a little more than a year and the House firmly in Democratic control, the odds of meaningful fiscal stimulus before the election is low.

Without fiscal support, a weak dollar policy might be where Donald Trump goes next. A weaker dollar could stimulate export growth as goods and services produced in the U.S. become cheaper abroad. Further, a weaker dollar makes imports more expensive, which would increase prices and in turn push nominal GDP higher, giving the appearance, albeit false, of stronger economic growth.

In this article, we explore a few different ways that President Trump may try to weaken the dollar. 

Weaker Dollar Policy

The impetus to write this article came from the following Wall Street Journal article: Trump Rejected Proposal to Weaken Dollar through Market Intervention. In particular, the following two paragraphs contradict one another and lead us to believe that a weaker dollar policy is a possibility. 

On Friday, Mr. Kudlow said Mr. Trump “ruled out any currency intervention” after meeting with his economic team earlier this week. The comments led the dollar to rise slightly against other currencies, the WSJ Dollar index showed.

But on Friday afternoon, Mr. Trump held out the possibility that he could take action in the future by saying he hadn’t ruled anything out. “I could do that in two seconds if I wanted to,” he said when asked about a proposal to intervene. “I didn’t say I’m not going to do something.”

Based on the article, Trump’s advisers are against manipulating the dollar lower as they don’t believe they can succeed. That said, on numerous occasions, Trump has shared his anger over other countries that are “using exchange rates to seek short-term advantages.”

As shown below, two measures of the U.S. dollar highlight the substance of frustrations being expressed by Trump. The DXY dollar index has appreciated considerably from the early 2018 lows but is still well below levels at the beginning of the century. This index is inordinately influenced by the euro and therefore not 100% representative of the true effect that the dollar has on trade. The Trade-weighted dollar which is weighted by the amount of trade that actually takes place between the U.S. and other countries. That index has also bounced from early 2018 lows and, unlike DXY, has reached the highs of 2002.

Data Courtesy Bloomberg

Trump’s Dollar War Chest

The following section provides details on how the President can weaken the dollar and how effective such actions might be.

Currency Market Intervention

Intervening in the currency markets by actively selling US dollars would likely push the dollar lower. The problem, as Trump’s advisers note, is that any weakness achieved via direct intervention is likely to be short-lived.

The US economy is stronger than most other developed countries and has higher interest rates. Both are reasons that foreign investors are flocking to the dollar and adding to its recent appreciation. Assuming economic activity does not decline rapidly and interest rates do not plummet, a weaker dollar would further incentivize foreign flows into the dollar and partially or fully offset any intervention.

More importantly, there is a global dollar shortage to consider. It has been estimated by the Bank of International Settlements (BIS) that there is $12.8 trillion in dollar-denominated liabilities owed by foreign entities. A stronger dollar causes interest and principal payments on this debt to become more onerous for the borrowers. Dollar weakness would be an opportunity for some of these borrowers to buy dollars, pay down their debts and reduce dollar risk. Again, such buying would offset the Treasury’s actions to depress the dollar.  

Instead of direct intervention in the currency markets, Trump and Treasury Secretary Steve Mnuchin can use speeches and tweets to jawbone the dollar lower. Like direct intervention, we also think that indirect intervention via words would have a limited effect at best.

The economic and interest rate fundamentals driving the stronger dollar may be too much for direct or indirect intervention to overcome.

From a legal perspective intervening in the currency markets is allowed and does not require approval from Congress. Per the Wall Street Journal article, “The 1934 Gold Reserve Act gives the White House broad powers to intervene, and the Treasury maintains a fund, currently of around $95 billion, to carry out such operations.” The author states that the Treasury has not conducted any interventions since 2000. That is not entirely true as they conducted a massive amount of currency swaps with other nations during and after the financial crisis. By keeping these large market-moving trades off the currency markets, they very effectively manipulated the dollar and other currencies.

Hounding the Fed

The President aggressively chastised Fed Chairman Powell for not cutting interest rates or ending QT as quickly as he prefers. Lowering interest rates to levels that are closer to those of other large nations would potentially weaken the dollar. The only problem is that the Fed does not appear willing to move at the President’s pace as they deem such action is not warranted. We believe the Fed is very aware that taking unjustifiable actions at the behest of the President would damage the perception of their independence and, therefore, their integrity.

To solve this problem, Trump could take the controversial and unprecedented step of firing or demoting Fed Chairman Powell.  In Powell’s place he could put someone willing to lower rates aggressively and possibly reintroduce QE. These steps might push financial asset prices higher, weaken the dollar, and provide the economic pickup Trump seeks but it is also fraught with risks. We have written two articles on the topic of the President firing the Fed Chairman as follows: Chairman Powell You’re Fired and Market Implications for Removing Fed Chair Powell.

It is not clear whether the President can get away with firing or even demoting Chairman Powell. We guess that he understands this which may explain why he has not done it already. If he cannot change Fed leadership, he can continue to pressure the Fed with Tweets, speeches, and direct meetings. We do not think this strategy can be effective unless the Fed has ample reason to cut rates. Thus far, the Fed’s mandates of “maximum employment, stable prices, and moderate long-term interest rates” do not provide the Fed such justification.

Getting Help Abroad

One of the core topics in the U.S. – China trade talks has been the Chinese Yuan. In particular, Trump is negotiating to stop the Chinese from using their currency to promote their economic self-interests at our expense. As of writing this, the U.S. Treasury deemed China a currency manipulator. Per the Treasury: “As a result of this determination (currency manipulator), Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Said differently, the U.S. and other nations can now manipulate their currency versus the Chinese Yuan.

It is plausible that Trump might pressure other countries, including our allies in Europe and Japan as well as Mexico and Canada, to strengthen their respective currencies against the dollar. Trump can threaten nations with trade restrictions and tariffs if they do not comply. If tariffs are enacted, however, all bets are off due to the economic inefficiencies of tariffs or trade restrictions. To the President’s dismay, such action weaken the economy and scare investors as we are seeing with China. 

Threats of trade actions, trade-related actions, or trade agreements might work to weaken the dollar, but such tactics would require time and pinpoint diplomacy. Of all the options, this one requires longer-term patience in awaiting their effect and may not satisfy the President’s desire for short-term results.

Summary

Before summarizing we leave you with one important thought and certainly a topic for future writings. Globally coordinated monetary policy is morphing into globally competitive monetary policy. This may be the most significant Macro development since the Plaza Accord in 1985 when the Reagan administration, along with other developed nations (West Germany, France, Japan, the UK), coordinated to weaken the U.S. dollar.

With the Presidential election in about 15 months, we have no doubt that President Trump will do everything in his power to keep financial markets and the economy humming along. The problem facing the President is a Democrat-controlled House, a Fed that is dragging their feet in terms of rate cuts, weakening global growth, and a stronger U.S. dollar.

We believe the odds that the President tries to weaken the dollar will rise quickly if signs of further economic weakness emerge. Given the situation, investors need to understand what the President can and cannot do to spike economic growth and further how it might affect the prices of financial assets.

On the equity front, a weaker dollar bodes well for companies that are more global in nature. Most of the companies that have driven the equity indices higher are indeed multi-national. Conversely, it harms domestic companies that rely on imported goods and commodities to manufacture their products. The price of commodities and precious metals are likely to rise with a weaker dollar. A weaker dollar and any price pressures that result would likely push bond yields higher.

The relationships between the dollar and various asset classes are important to monitoring how intentional changes in the value of the dollar may impact all varieties of asset classes. The addendum below quantifies short and longer-term correlations.

Addendum – Short & Long-term Asset Correlations

The following tables present short term daily correlations and longer-term weekly correlations between the dollar and several asset classes and sub-asset classes. The correlation data for each asset quantifies how much the price of the asset is affected by the price of the dollar. A positive correlation means the dollar and the asset tend to move in similar directions. Conversely, a negative relationship means they move in opposite directions. We highlighted all relationships that are +/- .30. The closer the number is to 1 or -1, the stronger the relationship. CLICK TO ENLARGE

The Prospects of a Weaker Dollar Policy

“Let me be clear, what I said was, it’s not the beginning of a long series of rate cuts.”- Fed Chairman Jerome Powell -7/31/2019

“What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China, The European Union and other countries around the world….” – President Donald Trump – Twitter 7/31/2019

With the July 31, 2019, Fed meeting in the books, President Trump is up in arms that the Fed is not on a “lengthy and aggressive rate-cutting” path. Given his disappointment, we need to ask what else the President can do to stimulate economic growth and keep stock investors happy. History conveys that is the winning combination to win a reelection bid.

Traditionally, a President’s most effective tool to spur economic activity and boost stock prices is fiscal policy. With a hotly contested election in a little more than a year and the House firmly in Democratic control, the odds of meaningful fiscal stimulus before the election is low.

Without fiscal support, a weak dollar policy might be where Donald Trump goes next. A weaker dollar could stimulate export growth as goods and services produced in the U.S. become cheaper abroad. Further, a weaker dollar makes imports more expensive, which would increase prices and in turn push nominal GDP higher, giving the appearance, albeit false, of stronger economic growth.

In this article, we explore a few different ways that President Trump may try to weaken the dollar. 

Weaker Dollar Policy

The impetus to write this article came from the following Wall Street Journal article: Trump Rejected Proposal to Weaken Dollar through Market Intervention. In particular, the following two paragraphs contradict one another and lead us to believe that a weaker dollar policy is a possibility. 

On Friday, Mr. Kudlow said Mr. Trump “ruled out any currency intervention” after meeting with his economic team earlier this week. The comments led the dollar to rise slightly against other currencies, the WSJ Dollar index showed.

But on Friday afternoon, Mr. Trump held out the possibility that he could take action in the future by saying he hadn’t ruled anything out. “I could do that in two seconds if I wanted to,” he said when asked about a proposal to intervene. “I didn’t say I’m not going to do something.”

Based on the article, Trump’s advisers are against manipulating the dollar lower as they don’t believe they can succeed. That said, on numerous occasions, Trump has shared his anger over other countries that are “using exchange rates to seek short-term advantages.”

As shown below, two measures of the U.S. dollar highlight the substance of frustrations being expressed by Trump. The DXY dollar index has appreciated considerably from the early 2018 lows but is still well below levels at the beginning of the century. This index is inordinately influenced by the euro and therefore not 100% representative of the true effect that the dollar has on trade. The Trade-weighted dollar which is weighted by the amount of trade that actually takes place between the U.S. and other countries. That index has also bounced from early 2018 lows and, unlike DXY, has reached the highs of 2002.

Data Courtesy Bloomberg

Trump’s Dollar War Chest

The following section provides details on how the President can weaken the dollar and how effective such actions might be.

Currency Market Intervention

Intervening in the currency markets by actively selling US dollars would likely push the dollar lower. The problem, as Trump’s advisers note, is that any weakness achieved via direct intervention is likely to be short-lived.

The US economy is stronger than most other developed countries and has higher interest rates. Both are reasons that foreign investors are flocking to the dollar and adding to its recent appreciation. Assuming economic activity does not decline rapidly and interest rates do not plummet, a weaker dollar would further incentivize foreign flows into the dollar and partially or fully offset any intervention.

More importantly, there is a global dollar shortage to consider. It has been estimated by the Bank of International Settlements (BIS) that there is $12.8 trillion in dollar-denominated liabilities owed by foreign entities. A stronger dollar causes interest and principal payments on this debt to become more onerous for the borrowers. Dollar weakness would be an opportunity for some of these borrowers to buy dollars, pay down their debts and reduce dollar risk. Again, such buying would offset the Treasury’s actions to depress the dollar.  

Instead of direct intervention in the currency markets, Trump and Treasury Secretary Steve Mnuchin can use speeches and tweets to jawbone the dollar lower. Like direct intervention, we also think that indirect intervention via words would have a limited effect at best.

The economic and interest rate fundamentals driving the stronger dollar may be too much for direct or indirect intervention to overcome.

From a legal perspective intervening in the currency markets is allowed and does not require approval from Congress. Per the Wall Street Journal article, “The 1934 Gold Reserve Act gives the White House broad powers to intervene, and the Treasury maintains a fund, currently of around $95 billion, to carry out such operations.” The author states that the Treasury has not conducted any interventions since 2000. That is not entirely true as they conducted a massive amount of currency swaps with other nations during and after the financial crisis. By keeping these large market-moving trades off the currency markets, they very effectively manipulated the dollar and other currencies.

Hounding the Fed

The President aggressively chastised Fed Chairman Powell for not cutting interest rates or ending QT as quickly as he prefers. Lowering interest rates to levels that are closer to those of other large nations would potentially weaken the dollar. The only problem is that the Fed does not appear willing to move at the President’s pace as they deem such action is not warranted. We believe the Fed is very aware that taking unjustifiable actions at the behest of the President would damage the perception of their independence and, therefore, their integrity.

To solve this problem, Trump could take the controversial and unprecedented step of firing or demoting Fed Chairman Powell.  In Powell’s place he could put someone willing to lower rates aggressively and possibly reintroduce QE. These steps might push financial asset prices higher, weaken the dollar, and provide the economic pickup Trump seeks but it is also fraught with risks. We have written two articles on the topic of the President firing the Fed Chairman as follows: Chairman Powell You’re Fired and Market Implications for Removing Fed Chair Powell.

It is not clear whether the President can get away with firing or even demoting Chairman Powell. We guess that he understands this which may explain why he has not done it already. If he cannot change Fed leadership, he can continue to pressure the Fed with Tweets, speeches, and direct meetings. We do not think this strategy can be effective unless the Fed has ample reason to cut rates. Thus far, the Fed’s mandates of “maximum employment, stable prices, and moderate long-term interest rates” do not provide the Fed such justification.

Getting Help Abroad

One of the core topics in the U.S. – China trade talks has been the Chinese Yuan. In particular, Trump is negotiating to stop the Chinese from using their currency to promote their economic self-interests at our expense. As of writing this, the U.S. Treasury deemed China a currency manipulator. Per the Treasury: “As a result of this determination (currency manipulator), Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Said differently, the U.S. and other nations can now manipulate their currency versus the Chinese Yuan.

It is plausible that Trump might pressure other countries, including our allies in Europe and Japan as well as Mexico and Canada, to strengthen their respective currencies against the dollar. Trump can threaten nations with trade restrictions and tariffs if they do not comply. If tariffs are enacted, however, all bets are off due to the economic inefficiencies of tariffs or trade restrictions. To the President’s dismay, such action weaken the economy and scare investors as we are seeing with China. 

Threats of trade actions, trade-related actions, or trade agreements might work to weaken the dollar, but such tactics would require time and pinpoint diplomacy. Of all the options, this one requires longer-term patience in awaiting their effect and may not satisfy the President’s desire for short-term results.

Summary

Before summarizing we leave you with one important thought and certainly a topic for future writings. Globally coordinated monetary policy is morphing into globally competitive monetary policy. This may be the most significant Macro development since the Plaza Accord in 1985 when the Reagan administration, along with other developed nations (West Germany, France, Japan, the UK), coordinated to weaken the U.S. dollar.

With the Presidential election in about 15 months, we have no doubt that President Trump will do everything in his power to keep financial markets and the economy humming along. The problem facing the President is a Democrat-controlled House, a Fed that is dragging their feet in terms of rate cuts, weakening global growth, and a stronger U.S. dollar.

We believe the odds that the President tries to weaken the dollar will rise quickly if signs of further economic weakness emerge. Given the situation, investors need to understand what the President can and cannot do to spike economic growth and further how it might affect the prices of financial assets.

On the equity front, a weaker dollar bodes well for companies that are more global in nature. Most of the companies that have driven the equity indices higher are indeed multi-national. Conversely, it harms domestic companies that rely on imported goods and commodities to manufacture their products. The price of commodities and precious metals are likely to rise with a weaker dollar. A weaker dollar and any price pressures that result would likely push bond yields higher.

The statistical relationships between the dollar and other asset classes are important to quantify if in fact the dollar may become an economic tool for the President. A full spectrum of those relationships over various timeframes may be found in an addendum to this article for RIA Pro subscribers. Give us a try. All new subscribers receive a 30 day free trial to explore what we have to offer and view the addendum.   

Technically Speaking: Stocks In A Bloodbath, Look For A Sellable Rally

On Monday, stocks took a beating from rising trade tensions as China put the brakes on imports of agricultural products following Trumps latest tariff threat. As noted by the WSJ:

“So much for a trade deal any time soon.

Monday’s pain for U.S. investors was foretold late Sunday evening. The Chinese yuan sank below 7 per dollar and hit an all-time low in offshore trading Monday with local officials blaming the depreciation on President Trump’s decision last week to extend tariffs to almost all Chinese imports. Mr. Trump responded on Twitter, accusing China of engaging in currency manipulation.

The result was a mess across global markets. The Dow Jones Industrial Average fell 766 points while the S&P 500 and Nasdaq Composite fell about 3% and 3.5%, respectively.”

Before we get into the charts, let me just remind you what we have been saying about Trump’s “trade war” for more than year now:

May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.”

June 19, 2018:

“The U.S.- China confrontation will be a war of attrition: while China has shown a willingness to make a deal on shrinking its trade surplus with the U.S., it has made clear it won’t bow to demands to abandon its industrial policy aimed at dominating the technology of the future.”

May 7th, 2019

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 5-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

June 29th, 2018

“China has been attacking the “rust-belt” states, which are crucial to Trump’s 2020 re-election, states with specifically targeted tariffs. (Now accelerated with the decision to stop imports altogether.)

While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

There were many more articles in between, but you get the idea.

This has always been a war Trump can’t win. China’s ability to take a tremendous amount of short-term pain for a long-term gain will be more than President Trump counted on when he thought “trade wars are easy to win.” They aren’t, and the economic pain will likely be more than he bargained for.

The markets are beginning to sense this as well, particularly as the White House escalates the situation by labeling China a “currency manipulator.” 

In the short-term, traders are now turning their focus back to the Federal Reserve for help. More rate cuts, however, are not likely going to be enough to solve the pressure to corporate profits, which will accelerate as the trade war escalates. 

Technical Update

Over the past couple of week’s, we have been talking about a potential correction. While the media was quick to jump on Trump’s “China threats” as the reason for the selloff, those actions were just the “catalyst that lit the fuse.”

As I this past weekend:

“[Over the last two weeks] the market is rallying in anticipation of more Central Bank easing. The markets are momentarily detached from weaker earnings growth, weaker economic growth, and a variety of other market-related risks. 

In the very short-term, the market is grossly extended and in need of some correction action to return the market to a more normal state. As shown below, while the market is on a near-term “buy signal” (lower panel) the overbought condition, and near 9% extension above the 200-dma, suggests a pullback is in order.”

Chart Updated Through Monday

We had also warned previously the current extension of the market, combined with overbought conditions, was due for a reversal.

On a very short-term basis the market has reversed the previously overbought condition to oversold. This could very well provide a short-term “sellable bounce” in the market back to the 50-dma. As shown in the chart below, any rally should be used to reduce portfolio risk in the short-term as the test of the 200-dma is highly probable.

(We are not ruling out the possibility the market could decline directly to the 200-dma. However, the spike in volatility and surge in negative sentiment suggests a bounce is likely first.)

As I noted in this past weekend’s newsletter, we have been taking actions within our portfolios to prepare for this correction and sharing those actions with our RIAPRO subscribers (30-Day Free Trial).

July 22nd Portfolio Update: This morning action was taken and we took profits on 10% of 11 of our equity holdings. All of these positions had gains in excess of 20% since January 1st.

Here is the unlocked report  

Those actions played well with the S&P declining by roughly -3.00% on Monday as our Equity and ETF portfolios only declined by –0.93% and –1.04% respectively.

Monthly Signals Remain Bearish

Given that monthly data is very slow-moving, longer-term signals can uncover changes to the trend which short-term market rallies tend to obfuscate.

Interestingly, despite recent “all-time” highs in the S&P 500, the monthly signal have all aligned to “confirm” a “sell signal.” Since 1950, such an alignment has been somewhat of a rarity. The risk of ignoring the longer-term signal currently is that it may be signaling a more important topping process remains intact.

The technical signals, which do indeed lag short-term turns in the market, have not confirmed the bullish attitude. Rather, and as shown in the chart above, the negative divergence of the indicators from the market should actually raise some concerns over longer-term capital preservation.

What This Means And Doesn’t Mean

What this analysis DOES NOT mean is that you should “sell everything” and “hide in cash.”

As always, long-term portfolio management is about “tweaking” things over time.

At a poker table, if you have a “so so” hand, you bet less or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is that we need to use any short-term rally over the next few days to take some actions to rebalance “risks.”

1) Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)

2) Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.

3) Move Trailing Stop Losses Up to new levels.

4) Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

While I certainly expect the White House to “tweet” out a statement confirming “trade talks are still ongoing,” or comments from Fed Reserve officials that “more rate cuts are likely,” the damage to the economy from tariffs are already in the works. With both earnings and corporate profits under pressure, this may be the start of a bigger corrective process like we witnessed in 2018.

But, there is always the possibility that I am wrong and the markets turn around and rally back to all-time highs.

If that happens, and the bullish trend resumes, then we will adjust our allocation models up and take on more equity risk.

But as I have asked before, what is more important to you as an individual?

  1. Missing out temporarily on the initial stages of a longer-term advance, or;
  2. Spending time getting back to even, which is not the same as making money.

For the majority of investors, the recent rally has simply been just recovery of previous losses from 2018.

Currently, there is not a great deal of evidence supportive of a longer-term bull market cycle. The Fed cutting rates is “NOT” bullish, it actually correlates to much more negative long-term outcomes in the market.

If I am right, however, the preservation of capital during an ensuing market decline will provide a permanent portfolio advantage going forward. The true power of compounding is not found in “the winning,” but in the “not losing.”

This is a good time to review those trading rules:

Opportunities are made up far easier than lost capital.” – Todd Harrison

Technically Speaking: The Drums Of Trade War – Part Deux

In June of 2018, as the initial rounds of the “Trade War” were heating up, I wrote:

“Next week, the Trump Administration will announce $50 billion in ‘tariffs’ on Chinese products. The trade war remains a risk to the markets in the short-term.

Of course, 2018 turned out to be a volatile year for investors which ended in the sell-off into Christmas Eve.

As we have been writing for the last couple of weeks, the risks to the market have risen markedly as we head into the summer months.

“It is a rare occasion when the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occur early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

“With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.”

Well, that certainly didn’t take long. As of Monday’s close, the entirety of the potential 5-6% decline has already been tagged.

The concern currently, is that while the 200-dma is critical to warding off a deeper decline, the escalation of the “trade war” is going to advance the timing of a recession and bear market. 

Let me explain why.

The Drums Of “Trade War”

On Monday, we woke to the “sound of distant drums” beating out the warning of escalation as China retaliated to Trump’s tariffs last week. To wit:

“After vowing over the weekend to “never surrender to external pressure,” Beijing has defied President Trump’s demands that it not resort to retaliatory tariffs and announced plans to slap new levies on $60 billion in US goods.

  • CHINA SAYS TO RAISE TARIFFS ON SOME U.S. GOODS FROM JUNE 1
  • CHINA SAYS TO RAISE TARIFFS ON $60B OF U.S. GOODS
  • CHINA SAYS TO RAISE TARIFFS ON 2493 U.S. GOODS TO 25%
  • CHINA MAY STOP PURCHASING US AGRICULTURAL PRODUCTS:GLOBAL TIMES
  • CHINA MAY REDUCE BOEING ORDERS: GLOBAL TIMES
  • CHINA ADDITIONAL TARIFFS DO NOT INCLUDE U.S. CRUDE OIL
  • CHINA RAISES TARIFF ON U.S. LNG TO 25% EFFECTIVE JUNE 1

China’s announcement comes after the White House raised tariffs on some $200 billion in Chinese goods to 25% from 10% on Friday (however, the new rates will only apply to goods leaving Chinese ports on or after the date where the new tariffs took effect).

Here’s a breakdown of how China will impose tariffs on 2,493 US goods. The new rates will take effect at the beginning of next month.

  • 2,493 items to be subjected to 25% tariffs.
  • 1,078 items to be subject to 20% of tariffs
  • 974 items subject to 10% of tariffs
  • 595 items continue to be levied at 5% tariffs

In further bad news for American farmers, China might stop purchasing agricultural products from the US, reduce its orders for Boeing planes and restrict service trade. There has also been talk that the PBOC could start dumping Treasuries (which would, in addition to pushing US rates higher, also have the effect of strengthening the yuan).”

The last point is the most important, particularly for domestic investors, as it is a change in their stance from last year. As we noted when the “trade war” first started:

The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”

Clearly, China has now put those options on the table, at least verbally.

It is essential to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. As you can see, there is a high correlation between fluctuations in the Yuan and treasury activity.

One way for China to both penalize the U.S. for tariffs, and by “the U.S.” I mean the consumer, is to devalue the Yuan relative to the dollar. This can be done by either stopping the process of sanitizing transactions with the U.S. or by accelerating the issue through the selling of U.S. Treasury holdings.

The other potential ramification is the impact on interest rates in the U.S. which is a substantial secondary risk.

China understands that the U.S. consumer is heavily indebted and small changes to interest rates have an exponential impact on consumption in the U.S.. For example, in 2018 interest rates rose to 3.3% and mortgages and auto loans came to screeching halt. More importantly, debt delinquency rates showed a sharp uptick.

Consumers have very little “wiggle room” to adjust for higher borrowing costs, higher product costs, or a slowing economy that accelerates job losses.

However, it isn’t just the consumer that will take the hit. It is the stock market due to lower earnings.

Playing The Trade

Let me review what we said previously about the impact of a trade war on the markets.

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

While the markets have indeed been more bullishly biased since the beginning of the year, which was mostly based on “hopes” of a “trade resolution,” we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the acceleration a “trade war.” 

In June of 2018, I did the following analysis:

“Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

The red dashed line denoted the expected 11% reduction to those estimates due to a “trade war.”

“As a result of escalating trade war concerns, the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners will be greater than anticipated. In a nutshell, an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Fast forward to the end of Q1-2019 earnings and we find that we were actually a bit optimistic on where things turned out.

The problem is the 2020 estimates are currently still extremely elevated. As the impact of these new tariffs settle in, corporate earnings will be reduced. The chart below plots our initial expectations of earnings through 2020. Given that a 10% tariff took 11% off earnings expectations, it is quite likely with a 25% tariff we are once again too optimistic on our outlook.

Over the next couple of months, we will be able to refine our view further, but the important point is that since roughly 50% of corporate profits are a function of exports, Trump has just picked a fight he most likely can’t win.

Importantly, the reigniting of the trade war is coming at a time where economic data remains markedly weak, valuations are elevated, and credit risk is on the rise. The yield curve continues to signal that something has “broken,” but few are paying attention.

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. We have also cut our holdings in basic materials and emerging markets as tariffs will have the greatest impact on those areas. Currently, there is a cluster of support coalescing at the 200-dma, but a failure at the level could see selling intensify as we head into summer.

The recent developments now shift our focus from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple. However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the current market environment.

Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that you will outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs, the decline will destroy most, if not all, of the returns accumulated over the last decade.

China understands that Trump’s biggest weakness is the economy and the stock market. So, by strategically taking actions which impact the consumer, and ultimately the stock market, it erodes the base of support that Trump has for the “trade war.”

This is particularly the case with the Presidential election just 18-months away.

Don’t mistake how committed China can be.

This fight will be to the last man standing, and while Trump may win the battle, it is quite likely that “investors will lose the war.” 

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Technically Speaking: “‘Trade War’ In May & Go Away.”

Over the weekend, President Trump decided to reignite the “trade war” with China with two incendiary tweets. Via WSJ:

“In a pair of Twitter messages Sunday, Mr. Trump wrote he planned to raise levies on $200 billion in Chinese imports to 25% starting Friday, from 10% currently. He also wrote he would impose 25% tariffs ‘shortly’ on $325 billion in Chinese goods that haven’t yet been taxed.

‘The Trade Deal with China continues, but too slowly, as they attempt to renegotiate,’ the president tweeted. ‘No!’”

This is an interesting turn of events and shows how President Trump has used the markets to his favor.

In January of 2018, the Fed was hiking rates and beginning to reduce their balance sheet but markets were ramping higher on the back of freshly passed tax reform. As Trump’s approval ratings were hitting highs, he launched the “trade war” with China. (Which we said at the time was likely to have unintended consequences and would kill the effect of tax reform.)

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

As I updated this past weekend:

But even more important is the impact to forward guidance by corporations.

Nonetheless, with markets and confidence at record highs, Trump had room to play “hard  ball” with China on trade.

However, by the end of 2018, with markets down 20% from their peak, Trump’s “running room” had been exhausted. He then applied pressure to the Federal Reserve to back off their policy tightening and the White House begin a regular media blitz that a “trade deal” would soon be completed.

These actions led to the sharp rebound over the last 4-months to regain highs, caused a surge in Trump’s approval ratings, and improved consumer confidence. In other words, we are now back to exactly the same point where we were the last time Trump started a “trade war.” More importantly, today, like then, market participants are at record long equity exposure and record net short on volatility.

With the table reset, President Trump now has “room to operate” heading into the 2020 election cycle.

The problem, is that China knows time is short for the President and subsequently there is “no rush” to conclude a “trade deal” for several reasons:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. As I have stated before, China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 5-years at most. It is unlikely, the next President will take the same hard line approach on China that President Trump has, so agreeing to something that is unlikely to be supported in the future is unlikely. It is also why many parts of the trade deal already negotiated don’t take effect until after Trump is out of office when those agreements are unlikely to be enforced. 

Even with that said, the markets rallied from the opening lows on Monday in “hopes” that this is actually just part of Trump’s “Art of the Deal” and China will quickly acquiesce to demands. I wouldn’t be so sure that is case.

The “good news” is that Monday’s “recovery rally” should embolden President Trump to take an even tougher stand with China, at least temporarily. The risk remains a failure to secure a trade agreement, even if it is more “show” than anything else.

Importantly, this is all coming at a time when the “Seasonal Sell Signal” has been triggered.

Sell In May

Let’s start with a basic assumption.

I am going to give you an opportunity to make an investment where 70% of the time you will win, but by the same token, 30% of the time you will lose. 

It’s a “no-brainer,” right? But,  you invest and immediately lose.

In fact, you lose the next two times, as well.

Unfortunately, you just happened to get all three instances, out of ten, where you lost money. Does it make the investment any less attractive? No. 

However, when in comes to the analysis of “Sell In May,” most often the analysis typically uses too short of a time-frame as the look back period to support the “bullish case.” For example, Mark DeCambre recently touched on this issue in an article on this topic.

“‘Sell in May and go away,’ — a widely followed axiom, based on the average historical underperformance of stock markets in the six months starting from May to the end of October, compared against returns in the November-to-April stretch — on average has held true, but it’s had a spotty record over the past several years.”

That is a true statement. But, does it make paying attention to seasonality any less valuable? Let’s take Dr. Robert Shiller’s monthly data back to 1900 to run some analysis. The table below, which provides the basis for the rest of this missive, is the monthly return data from 1900-present.

Using the data above, let’s take a look at what we might expect for the month of May

Historically, May is the 4th WORST performing month for stocks with an average return of just 0.29%. However, it is the 3rd worst performing month on a median return basis of just 0.52%.

(Interesting note:  As you will notice in the table above and chart below, average returns are heavily skewed by outlier events. For example, while October is the “worst month” because of major crashes like 1929 with an average return of -0.29%, the median return is actually a positive 0.39%. Such makes it just the 2nd worst performing month of the year beating out February [the worst].)

May and June tend to be some of weakest months of the year along with September. This is where the old adage of “Sell In May” is derived from. Of course, while not every summer period has been a dud, history does show that being invested during summer months is a “hit or miss” bet at best.

Like October, May’s monthly average is skewed higher by 32.5% jump in 1933. However, in more recent years returns have been primarily contained, with only a couple of exceptions, within a +/- 5% return band as shown below.

The chart below depicts the number of positive and negative returns for the market by month. With a ratio of 54 losing months to 66 positive ones, there is a 46% chance that May will yield a negative return.

The chart below puts this analysis into context by showing the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).

A Correction IS Coming

Based on the historical evidence it would certainly seem prudent to “bail” on the markets, right? No, at least not yet.

The problem with statistical analysis is that we are measuring the historical odds of an event occurring in the near future. Like playing a hand of poker, the odds of drawing to an inside straight are astronomically high. However, it doesn’t mean that it can’t happen.

Currently, the study of current price action suggests that the markets haven’t done anything drastically wrong as of yet. However, that doesn’t mean it won’t. As I discussed this past weekend:

“While the market did hold inside of its consolidation pattern, we are still lower than the previous peak suggesting we wait until next week for clarity. However, a bit of caution to overly aggressive equity exposure is certainly warranted.I say this for a couple of reasons.

  1. The market has had a stellar run since the beginning of the year and while earnings season is giving a “bid” to stocks currently, both current and forecast earnings continue to weaken.
  2. We are at the end of the seasonally strong period for stocks and given the outsized run since the beginning of the year a decent mid-year correction is not only normal, but should be anticipated.”

With the markets on “buy signals” deference should be given to the bulls currently. More importantly, the bullish trend, on both a daily and weekly basis, remains intact which keeps our portfolio allocations on the long side for now.

However, a correction is coming. This is why we took profits in some positions which have had outsized returns this year, rebalanced portfolio risk, and continue to carry a higher level of cash than normal.

As I noted last week:

“The important point to take away from this data is that “mean reverting” events are commonplace within the context of annual market movements. 

Currently, investors have become extremely complacent with the rally from the beginning of the year and are quick extrapolating current gains through the end of 2019.

As shown in the chart below this is a dangerous bet. In every given year there are drawdowns which have historically wiped out some, most, or all of the previous gains. While the market has ended the year, more often than not, the declines have often shaken out many an investor along the way.”

Let’s take a look at what happened the last time the market started out the year up 13% in 2012.

Here are some other years:

2007

2010

2011

Do you really think this market will continue its run higher unabated?

It is a rare occasion the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occurs early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity. 

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. Again, this is why we discussed taking profits and rebalancing risk in our portfolios last week.

I am not suggesting you do anything, but it is just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

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Trying To Be Consistently “Not Stupid”

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

As described in a recent article, Has This Cycle Reached Its Tail, an appreciation for where the economy is within the cycle of economic expansion and contraction is quite important for investors. It offers a gauge, a guidepost of sorts, to know when to take a lot of risk and when to take a conservative approach.

This task is most difficult when a cycle changes. As we are in the late innings of the current cycle, euphoria is rampant, and everyone is bullish. During these periods, as risks are peaking, it is very challenging to be conservative and make less than your neighbors. It is equally difficult taking an aggressive stance at the depths of a recession, when risk is low, despair is acute, and everyone is selling.

What we know is that a downturn in the economy, a recession, is out there. It is coming, and as Warren Buffett’s top lieutenant Charlie Munger points out in the quote above, successful navigation comes down to trying to make as few mistakes as possible.

The Aging Expansion

In May 2019, the current economic expansion will tie the expansion of 1991-2001 as the longest since at least 1857 as shown below. 

Since gingerly exiting the financial crisis in June 2009, the economy has managed to maintain a growth trajectory for ten years. At the same time, it has been the weakest period of economic growth in the modern era but has delivered near-record gains in the stock market and significant appreciation in other risk assets. The contrast between those two issues – weak growth and record risky financial asset appreciation make the argument for caution even more persuasive at this juncture.

Although verbally reinforcing his optimistic outlook for continued economic growth, Federal Reserve (Fed) Chairman Jerome Powell and the Federal Open Market Committee (FOMC) did not inspire confidence with their abrupt shift in monetary policy and economic outlook over the past three months.

The following is a list of considerations regarding current economic circumstances. It is a fact that the expansion is “seasoned” and quite long in the tooth, but is that a reason to become cautious and defensive and potentially miss out on future gains? Revisiting the data may help us avoid making a mistake or, in the words of Munger, be “not stupid.”

1. Despite the turmoil of the fourth quarter, the stock market has rebounded sharply and now sits confidently just below the all-time highs of September 2018. However, a closer look at the entrails of the stock market tells a different story. Since the end of August 2018, cyclically-sensitive stocks such as energy, financials, and materials all remain down by roughly 10% while defensive sectors such as Utilities, Staples and Real Estate are up by 7%.

2. Bond markets around the world are signaling concern as yields are falling and curves are inverting (a historically durable sign of economic slowdown). The amount of negative yielding bonds globally has risen dramatically from less than $6 trillion to over $10.5 trillion since October 2018. Since March 1, 2019, 2-year U.S. Treasury yields have dropped by 35 basis points (bps), and 10-year Treasury yields have fallen by 40 bps (a basis point is 1/100th of a percent). 2-year Treasury yields (2.20%) are now 0.30% less than the upper-bound of the Fed Funds target rate of 2.50%. Meanwhile, three-month Treasury-bill yields are higher than every other Treasury yield out to the 10-year yield. This inversion signals acute worry about an economic slowdown.

3. Economic data in the United States has been disappointing for the balance of 2019. February’s labor market added just 20,000 new jobs compared with an average of +234,000 over the prior 12months. This was the first month under +100,000 since September 2017. Auto sales (-0.8%) were a dud and consumer confidence, besides being down 7 points, saw the sharpest decline in the jobs component since the late innings of the financial crisis (Feb 2009), reinforcing concerns in the labor market. Retail sales and the Johnson Redbook retail data also confirm a slowing/weakening trend in consumer spending. Lastly, as we pointed out at RIA Pro, tax receipt growth is declining. Not what one would expect in a robust economy.

4. As challenging as that list of issues is for the domestic economy, things are even more troubling on a global basis. The slowdown in China persists and is occurring amid their on-going efforts to stimulate the economy (once again). China’s debt-to-GDP ratio has risen from 150% to 250% over the past ten years, and according to the Wall Street Journal, the credit multiplier is weakening. Whereas 1 yuan of credit financing used to produce 3.5 yuan of growth, 1 yuan of credit now only produces 1 yuan of growth. In the European Union, a recession seems inevitable as Germany and other countries in the EU stumble. The European Central Bank recently cut the growth outlook from 1.9% to 1.1% and, like the Fed, dramatically softened their policy language. Turbulence in Turkey is taking center stage again as elections approach. Offshore overnight financing rates recently hit 1,350% as the Turkish government intervened to restrict the outflow of funds to paper over their use of government reserves to prop up the currency.

5. The Federal Reserve (and many other central banks) has formalized the move to a much more dovish stance in the first quarter. On the one hand applauding the strength and durability of the U.S. economy as well as the outlook, they at the same time flipped from a posture of 2-3 rate hikes in 2019 to zero. This shift included hidden lingo in the recent FOMC statement that appears to defy their superficial optimism. The jargon memorialized in the FOMC statement includes a clear signal that the next rate move could just as easily be a cut as a hike. Besides the dramatic shift in rate expectations, the Fed also downgraded their outlook for growth in 2019 and 2020 and cut their expectations for unemployment and inflation (their two mandates). Finally, in addition to all of that, they formalized plans to halt balance sheet reductions. The market is now implying the Fed Funds rate will be cut to 2.07% by January 2020.

Summary

Based on the radical changes we have seen from the central bankers and the economic data over the past six months, it does not seem to be unreasonable to say that the Fed has sent the clearest signal of all. The questions we ask when trying to understand the difference between actions and words is, “What do they know that we do not”? Connecting those dots allows us to reconcile the difference between what appears to be an inconsistent message and the reality of what is written between the lines. The Fed is trying to put a happy face on evolving circumstances, but you can’t make a silk purse out of a sow’s ear.

The economic cycle appears to be in the midst of a transition. This surprisingly long expansion will eventually end as all others have. A recession is out there, and it will make an appearance. Our job is not guessing to be lucky; it is to be astute and play the odds.

Reality reveals itself one moment at a time as does fallacy. Understanding the difference between the two is often difficult, which brings us back to limiting mistakes. Using common sense and avoiding the emotion of markets dramatically raises one’s ability “to be consistently not stupid.” A lofty goal indeed.

China Continues To Pile Debt On Top Of More Debt

Like many countries, China attempted to rein in its debt growth over the past couple years, but ultimately gave up and is now back to piling on even more debt. Bloomberg reports

For almost two years, the question has lingered over China’s market-roiling crackdown on financial leverage: How much pain can the country’s policy makers stomach?

Evidence is mounting that their limit has been reached. From bank loans to trust-product issuance to margin-trading accounts at stock brokerages, leverage in China is rising nearly everywhere you look.

While seasonal effects explain some of the gains, analysts say the trend has staying power as authorities shift their focus from containing the nation’s $34 trillion debt pile to shoring up the weakest economic expansion since 2009. The government’s evolving stance was underscored by President Xi Jinping’s call for stable growth late last week, while on Monday the banking regulator said the deleveraging push had reached its target.

“Deleveraging is dead,” said Alicia Garcia Herrero, chief Asia Pacific economist at Natixis SA in Hong Kong.

As I’ve been warning, China has been experiencing a powerful credit bubble over the past decade (see the chart below). China’s leaders inflated the credit bubble in order to supercharge economic growth during and after the global financial crisis in 2008/2009. China’s credit-driven economy has become one of the main growth engines of the global economy, which has scary implications because it’s even more evidence that the global economic recovery is predicated on debt.

China’s aggressive credit expansion is a major contributor to the global debt explosion over the past couple decades. Global debt has increased by $150 trillion since 2003 and $70 trillion since 2008:

China’s credit bubble is very similar to Japan’s economic bubble in the late-1980s. For many years, Japan’s economic growth seemed unstoppable and many people believed that Japan would overtake Western economies in short order. Of course, Japan’s growth miracle came to a screeching halt in the early-1990s when the country’s bubble burst. By ramping up debt so aggressively (which borrows economic growth from the future), China is following in the same footsteps as Japan and will soon experience the downsides of debt-fueled growth.

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China Is Unlikely To Become The World’s Largest Economy Anytime Soon

Business Insider published a piece this week called “China’s hopes of becoming the world’s largest economy are hitting a major roadblock“:

China’s economy is growing at its slowest pace in nearly three decades, and some economists say the worst is yet to come.

Growth potential in China is expected to slow to 5.5% from the current level of 6.5% between 2021 and 2025, according to new estimates from analysts at JPMorgan. That could fall to 4.5% by 2030, a pace that would make it difficult to surpass the US as the largest economy. 

“This means that China will remain the second largest economy much longer than expected,” the analysts said in a research note Wednesday. “The transition to slower potential growth could be volatile and requires balancing reforms to move to a more domestically driven growth model with deleveraging and public-sector restructuring.”

Officials in Beijing have sought to shore up confidence through a series of stimulus measures rolled out in recent months, including tax cuts, changes to the amount of cash banks must hold as reserves, and various incentives to boost spending.

But those programs could have little room to expand in an economy that has struggled to crack down on relatively high levels of debt in recent years. In 2018, China’s debt-to-gross-domestic-product ratio climbed above 250%.

A January New York Times piece explains how China is no longer the growth engine that it once was:

For years, no matter what was happening elsewhere, global companies bet billions upon billions of dollars that China’s consumers would keep spending money.

Now, just when the world economy could use their financial firepower, they are no longer so quick to open their wallets.

The latest sign of a slowdown in spending in China came Wednesday, when Apple unexpectedly slashed its financial forecast, citing disappointing iPhones sales in the country. The weakness followed reams of other data — declining car sales, lagging retail spending, a slumping property market, a tougher job market — that suggest Chinese consumers may be losing their once unshakable confidence.

That could have a big impact on a world looking for engines of growth, on companies that counted on China’s continuing expansion and on global investors who have long viewed China as a steady source of profits.

As I have been warning for several years, China is experiencing a credit and asset bubble like Japan was in the 1980s. China’s powerful credit expansion in the past decade (as the chart below shows) is one of the main reasons why the global economy recovered from the Great Recession. China’s credit bubble of the past decade will prove to be a one-shot deal – in the next global economic downturn, there won’t be another large economy like China to binge on debt and create a temporary growth party that bails everyone else out.

An economic stagnation or slowdown in China is the least of our worries, I’m afraid. I am worried about a full-blown popping of their credit and asset bubble (like Japan in the early-1990s), which would reverberate around the world. In that scenario, Western exports to China would plunge, commodity-exporting economies from Australia to emerging markets would suffer, and the global economy would experience another severe recession if not an outright depression. The world has played with fire over the past decade and it’s just a matter of time before we all pay the price.

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RIA Pro Economic Update

Tracking global and domestic economic conditions and forming future expectations of economic activity plays a large role in our investment and risk management process. As such we update you on current global and domestic economic trends.

China

China is the world’s second-largest economy and, per the IMF, responsible for nearly 30% of global growth. On January 20, 2019, China reported its GDP rose 6.6% in the fourth quarter. While the growth rate may appear strong, it is the weakest since the first quarter of 2009 and continues a gradual trend lower. The weakening GDP growth has been further confirmed via various purchasing manager surveys, trade data and auto sales which point to a further slowing of growth.

Given their size, growing at such an outsized rate in the future is near impossible. Making matters worse, much of the credit stimulus used to promote activity in years past is becoming a headwind to growth. We expect growth to continue slowing in China which will weigh on global economic activity. In the short run, there are two wild cards we are following closely. First, how will trade negotiations affect China’s economy? Second, will China flood the economy with monetary and fiscal stimulus as they did in 2015/2016 to avoid a further slowdown? As we have seen repeatedly since 2008, the amount and type of stimulus that China applies to their economy and markets are of great importance to global financial markets.

Japan

Japan, the world’s third-largest economy, has been experiencing weakness for over a year. In fact, the first and third quarters of 2018 both saw negative GDP growth. High levels of debt and poor demographics do not bode well for economic growth in Japan. Currently, the World Bank expects +0.8 and +0.5% GDP growth for 2019 and 2020 respectively. These forecasts have been routinely revised lower.

Of recent events, it worth highlighting that business confidence in December fell to a six-year low and a new consumption tax hike is having the expected negative effects. Additionally, a combination of weaker economic activity among major trading partners and the relative strength of the yen is harming exports.  The odds of a recession in the coming quarters is high.

Germany

Germany is the world’s fourth-largest economy and the largest in the euro region. Over the last six months, soft and hard data has been notably weaker. A recent string of poor data is behind the government’s revision of Germany’s forecasted GDP from 1.8% to 1.0% in late January and similar revisions by the IMF and Ifo Institute.

German GDP fell by 0.2% in the third quarter marking the first decline since 2014. Expectations for the fourth quarter stand at +0.2%. A decline in the fourth quarter (reported 2/14/19) would mark an official recession.

It is worth also adding that the weakness is being felt throughout the euro region. The weakness of European economies has been and continues to catch economic forecasters by surprise. The Citi Eurozone Economic Surprise Index which compares economic forecasts versus actual economic data was negative in January and was negative for most of the last year. On January 31st Italy posted a negative fourth quarter GDP number. The surprising data, follows a negative third quarter, and officially puts Italy in a recession.

United States

Currently formulating economic expectations for the United States is very difficult. Before the government shutdown, there were signs from “soft” economic data points that growth was slowing. “Soft” refers to surveys and opinions about the activity that companies are seeing. These reports tend to be subjective and not always reliable. Hard data like retail sales, employment, and durable goods reports, can take 6-weeks to three months for release from the time the activity occurred. Given the time delays and the fact that some hard data releases have been delayed due to the shutdown, we are forced to depend more than usual on soft data while other economic reports catch up.

Soft data has been running, pardon the pun, soft recently.  The graph below is based on a composite index of 12 data points many of which are soft. As shown below in red, the soft data index appears to have reversed course.

One of the components of the index above is the Leading Economic Index (LEI) which, as shown alongside GDP below, is sending a similar message.

Based on weak global growth trends and the soft domestic data, we have lowered our expectations for economic growth in the first half of 2019. Our confidence is heightened by the fact that the growth benefits of the tax cut stimulus and a significantly larger Federal deficit in 2018 will not have the same incremental impact going forward.

While the government shutdown was unpleasant for the country, the effects will likely not be felt to any large degree outside the beltway. If GDP growth is weaker than expected for the first quarter, rest assured many will use the government shutdown as a scapegoat. The truth is that a weaker GDP report is likely signaling something more concerning.

Markets tend to be forward-looking so it is possible that with the market decline in the fourth quarter, slower economic activity may already be priced in. Looking ahead, the biggest question in our mind is whether the slowdown is temporary or presaging a recession. The jury is still out, but the Chinese economy and the relevance of trade talks on their economy is probably the most important factor to that outcome.

The Coming Collision Of Debt & Rates

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.

China Is Winning The “Trade War” Without Firing A Shot

This past weekend, the Administration announced a tentative deal with China to temporarily postpone the burgeoning “trade war.” While the details of the deal are yet to be worked out, the concept is fairly simple – China will reduce the existing “trade deficit” by over $200 billion annually with the U.S. by reducing tariffs and allowing more goods to flow into China for purchase. On Monday, the markets reacted positively with industrial and material stocks rising sharply as it is expected these companies will be the most logical and direct beneficiaries of any deal.

Unfortunately, there are several reasons the whole scenario is quite implausible. Amitrajeet Batabyal recently explained the problem quite well.

“With China, the U.S. imports a whopping $375 billion more than it exportsHow could it whittle that down to $175 billion? There are three ways.

  • First, China could buy more U.S. goods and services.
  • Second, Americans could buy less Chinese stuff.
  • Finally, both actions could happen simultaneously.

The kinds of Chinese goods that Americans buy tend to be relatively inexpensive consumer goods, so even a dramatic decline is likely to have only a trivial impact on the deficit. And since China explicitly controls only one lever — its imports — it’ll have to buy a lot more American-made things to achieve this goal.

For this to happen, without upsetting other trade balances, the American economy would have to make a lot more than it currently produces, something that isn’t possible in so short a time frame.”

While the Administration will be able to claim a “trade victory” over a deficit reduction agreement, such is unlikely to lead to more economic growth as promised.

If we assume China does indeed spend an additional $200 billion on U.S. goods, those purchases will increase flows into the U.S. dollar, causing dollar strengthening relative to not only the Yuan but also other currencies as well. Since U.S. exports comprise about 40% of domestic corporate profits, a stronger dollar will counter the benefits of China’s purchase as other foreign importers seek cheaper goods elsewhere.

For China, a stronger dollar also makes imports to their country more expensive. To offset that, China will need to “sell” more of its U.S. Treasury holdings to “sanitize” those transactions and stabilize the exchange rate. This is not “good news” for Treasury Secretary Steve Mnuchin who would lose the largest foreign buyer for U.S. Treasuries.  This particularity problematic with the national debt expected to increase by at least one trillion dollars in each of the next four years.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to 2011. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (The vertical dashed lines denote similar rate increases previously.)

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. From 2014-2016China was dumping U.S Treasuries, and converting the proceeds back into Yuan, in an attempt to stem the outflows and resulting depreciation of their currency. Since 2016, China has been buying bonds as the Yuan has appreciated.

If China does indeed increase U.S. imports, the stronger dollar will increase the costs of imports into China from the U.S. which negatively impacts their economy. The relationship between the currency exchange rate and U.S. Treasuries is shown below.

With respect to the “trade deficit,” there is little evidence of a sustainable rise in inflationary pressures. The current inflationary push has come primarily from the transient effect of a disaster-related rebuilding cycle last year, along with pressures from rising energy, health care, and rental prices. These particular inflationary pressures are not “healthy” for the economy as they are “costs” which must be passed along to consumers without a commensurate rise in wages to offset them.

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed U.S. bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has only been one previous period when this relationship failed which was in 2007 and 2008.

With the Chinese financial system showing signs of increasing stress, any threat which devalues the currency will lead to further selling of Treasuries. Rising import costs due to a forced “deficit balancing,” will likely have more of a negative impact to the U.S. than currently believed.

Sum-Zero Game

While much of the mainstream media continues to expect a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then productivity, population, wage and consumer debt growth become key inputs into that equation. Unfortunately, productivity is hardly growing in the U.S. as well as in most developed nations. Further, wage and population growth remain weak as consumers remain highly leveraged. This combination makes a surge in economic growth highly unlikely particularly as rate increases reduce the ability to generate debt-driven consumption.

With unemployment rates near historic lows and production measures near highs, the problem of meeting Chinese demand will be problematic. As Amitrajeet states:

“That’s because when a nation’s economy is using its resources to produce goods efficiently, economists say that it has reached its production possibility frontier and cannot produce more goods.”

This makes Chinese promises largely illusory given the structural hurdles in China to allow for increased purchases of American exports much less the sheer amount of goods the United States would have to produce to meet Beijing’s demand.

As stated, with the United States economy already running near its full productive capacity, it is virtually impossible to produce enough new goods to meet Chinese demands, especially in the short term.

Sure, the United States could stop selling airplanes, soybeans and other exports to other countries and just sell them to China instead. Such actions would indeed shrink the United States trade deficit with China, but the trade deficit with the entire world would remain unchanged.

In other words, it’s a sum-zero game.

More importantly, if the U.S. cannot deliver the goods and services needed by China the entire agreement is worthless from the start. More importantly, China’s “concessions,” so far, are things it had planned to do anyway. As noted by Heather Long via the Washington Post:

“The Chinese have one of the fastest-growing economies and middle classes in the world. Chinese factories and cities need more energy, and its people want more meat. It’s no surprise then that China said it was interested in buying more U.S. energy and agricultural products. The Trump administration is trying to cast that as a win because the United States will be able to sell more to China, but it was almost certain that the Chinese were going to buy more of that stuff anyway.

What Trump got from the Chinese is ‘the kind of deal’ that China would be able to offer any U.S. president,’ said Brad Setser, a China expert at the Council on Foreign Relations. ‘China has to import a certain amount of energy from someone and needs to import either animal feed or meat to satisfy Chinese domestic demand.’

China has been buying about $20 billion worth of U.S. agricultural products a year and $7 billion in oil and gas, according to government data. Even if China doubled — or tripled — purchases of these items, it won’t equal anywhere near a $200 billion reduction in the trade deficit.”

But where China really won the negotiation was when the United States folded and agreed to suspend “trade tariffs.” While the current Administration is keen on “winning” a deal with China, without specific terms (such as a defined amount of increased purchases from the U.S. and the ability to meet that demand) the “deal” has little meaning. China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.

“Yes, it’s good for both sides not to be in a trade war, but the Chinese had more to lose economically from the tariffs. The Trump administration rolling back its $150 billion tariff threat against China is a good ‘get’ for the Chinese.”

As with all things, there are always two sides to the story. While the benefits of reducing the trade may seem like a big win for America, reality could largely offset any benefits. If the goal was simply to be seen as the winner, Trump may have won the prize. But, it will likely be China laughing all the way to the bank.

Trump’s Volley – Hoover’s Folly?

“You load sixteen tons, what do you get?
Another day older and deeper in debt
Saint Peter don’t you call me ’cause I can’t go
I owe my soul to the company store” 
– Sixteen Tons by Tennessee Ernie Ford

Shortly following Donald Trump’s election victory we penned a piece entitled Hoover’s Folly. In light of Trump’s introduction of tariffs on steel and other selected imports, we thought it wise to recap some of the key points made in that article and provide additional guidance.

While the media seems to treat Trump’s recent demands for tariffs as a hollow negotiating stance, investors are best advised to pay attention. At stake are not just more favorable trade terms on a few select products and possibly manufacturing jobs but the platform on which the global economic regime has operated for the last 50 years. So far it is unclear whether Trump’s rising intensity is political rhetoric or seriously foretelling actions that will bring meaningful change to the way the global economy works. Either as a direct result of policy and/or uncharacteristic retaliation to strong words, abrupt changes to trade, and therefore the role of the U.S. Dollar as the world’s reserve currency, has the potential to generate major shocks in the financial markets.

Hoover’s Folly

The following paragraphs are selected from Hoover’s Folly to provide a background.

In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business-friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.  

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

The Other Side of the Story

The President recently tweeted the following:

Regardless of political affiliation, most Americans agree with President Trump that international trade should be conducted on fair terms. The problem with assessing whether or not “trade wars are good” is that one must understand the other side of the story.

Persistent trade imbalances are the manifestation of explicit global trade agreements that have been around for decades and have historically received broad bi-partisan support. Those policies were sponsored by U.S. leaders under the guise of “free trade” from the North American Free Trade Agreement (NAFTA) to ushering China in to the World Trade Organization (WTO). During that time, American politicians and corporations did not just rollover and accept unfair trade terms; there was clearly something in it for them. They knew that in exchange for unequal trade terms and mounting trade deficits came an implicit arrangement that the countries which export goods to the U.S. would also fund that consumption. Said differently, foreign countries sold America their goods on credit. That construct enabled U.S. corporations, the chief lobbyists in favor of such agreements, to establish foreign production facilities in cheap labor markets for the sale of goods back into the United States.

The following bullet points show how making imports into the U.S. easier, via tariffs and trade pacts, has played out.

  • Bi-partisan support for easing multi-lateral trade agreements, especially with China
  • One-way tariffs or producer subsidies that favor foreign producers were generally not challenged
  • Those agreements, tariffs, and subsidies enable foreign competitors to employ cheap labor to make goods at prices that undercut U.S. producers
  • U.S. corporations moved production overseas to take advantage of cheap labor
  • Cheaper goods are then sold back to U.S. consumers creating a trade deficit
  • U.S. dollars received by foreign producers are used to buy U.S. Treasuries and other dollar-based corporate and securitized individuals liabilities
  • Foreign demand for U.S. Treasuries and other bonds lower U.S. interest rates
  • Lower U.S. interest rates encourage consumption and debt accumulation
  • U.S. economic growth increasingly centered on ever-increasing debt loads and declining interest rates to facilitate servicing the debt

Trade Deficits and Debt

These trade agreements subordinated traditional forms of production and manufacturing to the exporting of U.S. dollars. America relinquished its role as the world’s leading manufacturer in exchange for cheaper imported goods and services from other countries. The profits of U.S.-based manufacturing companies were enhanced with cheaper foreign labor, but the wages of U.S. employees were impaired, and jobs in the manufacturing sector were exported to foreign lands. This had the effect of hollowing out America’s industrial base while at the same time stoking foreign appetite for U.S. debt as they received U.S. dollars and sought to invest them. In return, debt-driven consumption soared in the U.S.

The trade deficit, also known as the current account balance, measures the net flow of goods and services in and out of a country. The graph below shows the correlation between the cumulative deterioration of the U.S. current account balance and manufacturing jobs.

Data Courtesy: St. Louis Federal Reserve (NIPA)

Since 1983, there have only been two quarters in which the current account balance was positive. During the most recent economic expansion, the current account balance has averaged -$443 billion per year.

To further appreciate the ramifications of the reigning economic regime, consider that China gained full acceptance into the World Trade Organization (WTO) in 2001. The trade agreements that accompanied WTO status and allowed China easier access to U.S. markets have resulted in an approximate quintupling of the amount of exports from China to the U.S.  Similarly, there has been a concurrent increase in the amount of credit that China has extended the U.S. government through their purchase of U.S. Treasury securities as shown below.

Data Courtesy: St. Louis Federal Reserve and U.S. Treasury Department

The Company Store

To further understand why the current economic regime is tricky to change, one must consider that the debts of years past have not been paid off. As such the U.S. Treasury regularly issues new debt that is used to pay for older debt that is maturing while at the same time issuing even more debt to fund current period deficits. Therefore, the important topic not being discussed is the United States’ (in)ability to reduce reliance on foreign funding that has proven essential in supporting the accumulated debt of consumption from years past.

Trump’s ideas are far more complicated than simply leveling the trade playing field and reviving our industrial base. If the United States decides to equalize terms of trade, then we are redefining long-held agreements introduced and reinforced by previous administrations.  In breaking with that tradition of “we give you dollars, you give us cheap goods (cars, toys, lawnmowers, steel, etc.), we will most certainly also need to source alternative demand for our debt. In reality, new buyers will emerge but that likely implies an unfavorable adjustment to interest rates. The graph below compares the amount of U.S. Treasury debt that is funded abroad and the total amount of publicly traded U.S. debt. Consider further, foreigners have large holdings of U.S. corporate and securitized individual debt as well. (Importantly, also note that in recent years the Fed has bought over $2 trillion of Treasury securities through quantitative easing (QE), more than making up for the recent slowdown in foreign buying.)

Data Courtesy: St. Louis Federal Reserve

The bottom line is that, if Trump decides to put new tariffs on foreign goods, we must presume that foreign creditors will not be as generous lending money to the U.S. Accordingly, higher interest rates will be needed to attract new sources of capital. The problem, as we have discussed in numerous articles, is that higher interest rates put a severe burden on economic growth in a highly leveraged economy. In Hoover’s Folly we stated: Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

It seems plausible that a trade war would result in potentially controversial intervention from the Federal Reserve. The economic cost of higher interest rates would likely be too high a price for the Fed to sit idly by and watch. Such policy would be controversial because it would further blur the lines between monetary and fiscal policy and potentially jeopardize the already tenuous independent status of the Fed.

Importantly, this is not purely a problem for the U.S. Still the world’s reserve currency, the global economy is dependent upon U.S. dollars and needs them to transact. Any disruption in economic activity as a result of rising U.S. interest rates, the risk-free benchmark for the entire world, would most certainly go viral. That said, for the godless Communist regimes of China and Russia, a moral barometer is not just absent, it is illegal. Game theory, considering those circumstances and actors, becomes infinitely more complex.

Summary

Investors concerned about the ramifications of a potential trade war should consider how higher interest rates would affect their portfolios. Further, given that the Fed would likely step in at some point if higher interest rates were meaningfully affecting the economy, they should also consider how QE or some other form of intervention might affect asset prices. While QE has a recent history of being supportive of asset prices, can we assume that to be true going forward?  The efficacy of Fed actions will be more closely scrutinized if, for example, the dollar is substantially weaker and/or inflation higher.

There will be serious ramifications to changing a global trade regime that has been in place for several decades. It seems unlikely that Trump’s global trade proposals, if pursued and enacted, will result in more balanced trade without further aggravating problems for the U.S. fiscal circumstance.  So far, the market response has been fidgety at worst and investors seem to be looking past these risks. The optimism is admirable but optimism is a poor substitute for prudence.

In closing, the summary from Hoover’s Folly a year ago remains valid:

It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue. Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention to trade conflicts and their consequences can escalate quickly.