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.

Will The Corona Virus Trigger A Recession?

As if waking up to an economic nightmare, investors see headlines like these and many others flashing across their Bloomberg terminals:

  • Facebook says Oculus headphone production will be delayed due to virus
  • Apple extends country wide store closing for another week
  • Foxconn delays iPhone production
  • Qualcomm cuts production forecast due to virus uncertainty
  • Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
  • US Steel flashes a warning of a cut in demand
  • Nike shoe production halted
  • Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
  • IEA forecasts drop in oil demand this quarter- first time in a decade

The seemingly never ending list of delays, disruptions, and cuts rolls on from retail to high technology. Even services are impacted as flights and train trips are canceled within and to and from China.  While some technology-based services are provided over the Internet service, restaurants, training, and consulting, as examples, must be performed in person.  Manufacturing operations require workers to be at the factory to produce products. Thus, manufacturing is much more acutely affected by quarantines, shutdowns, transportation disruption, and other government actions.

It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019.  For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year.  Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.

Source: The Wall Street Journal – 2/7/20

Prior to the epidemic, world trade had begun to slow as a result of the China – U.S. trade war and other tariffs.  World trade for the first time since the last recession has turned negative.

Source: Haver Analytics, The Wall Street Journal, The Daily Shot – 1/19/20

Based on severity estimates, analysts have forecasted the impact on first-quarter China GDP growth. In the chart below from Fitch Ratings, growth for first quarter drops almost in half and for year growth drops to 5.2 % if containment is delayed:

Sources: The Wall Street Journal, The Daily Shot – 2/6/20

When news of the virus first was announced, the market sustained a quick modest decline. The next day, investors were reassured by official news from China and the World Health Organization that the virus could be contained. Market valuations bounced on optimism that the world economy would see little to no damage in the first quarter of 2020.  Yet, there is growing skepticism that the official tolls of the virus are short of reality. Doctors report that at the epicenter of Wuhan that officials are grossly underestimating the number of people infected and dead. The London School of Hygiene and Tropical Medicine has an epidemic model indicating there will be at least 500,000 infections at the peak in a few weeks far greater than the present 45,000 officially reported.

The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain.  U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities.  The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %.  President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily.  It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.

Inside China, chaos in the supply chain operations is creating great uncertainty. Workers are being told to work from home and stay away from factories for at least for another week beyond the Lunar New Year and now well into late-February.  Foxconn and Tesla announced plant openings on February 10th, yet ramping up output is still an issue. It will be a challenge to staff factories as many workers are in quarantined cities and train schedules have been curtailed or canceled.  Many factories are dependent on parts from other cities around the country that may have more severe restrictions on transportation and/or workers reporting to work. Thus, even when a plant is open, it is likely to be operating at limited capacity.

On February 7th, the Federal Reserve announced that while the trade war pause has improved the global economy, it cautioned that the coronavirus posed a ‘new threat to the world economy.’  The Fed is monitoring the situation. The central bank of China infused CNY 2 trillion in the last four weeks to provide fresh liquidity.  The liquidity will help financially stretched Chinese companies survive for a while, but they are unlikely to be able to continue operations unless production and sales return to pre epidemic levels quickly.

Will the Federal Reserve really be able to buffer the supply chain disruption and sales declines in the first quarter of 2020?  The Fed already seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control and providing billions in repo financing to banks and hedge funds causing soaring prices in risk assets. While the Fed may be able to assist U.S. corporations with liquidity through a tough stretch of declining sales and supply chain disruptions, it cannot create sales or build products.

Prior to the virus crisis, CEO Confidence was at a ten year low.  Then, CEO confidence levels improved a little with the Phase One trade deal driving brighter business prospects for the coming year. Now, a possible black swan epidemic has entered the world economic stage creating extreme levels of sales and operational uncertainty.  Marc Benioff, CEO of Salesforce, expresses the anxiety many CEOs feel about trade:

 “Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Adding to the uncertainty is a deteriorating political environment in China.  During the first few weeks of December, local Wuhan officials denounced a doctor that was calling for recognition of the new virus. He later died of the disease, triggering a social media uproar over the circumstances of his treatment. Many Chinese people have posted on social media strident criticisms of the delayed government response.  Academics have posted petitions for freedom of speech, laying the blame on government censors for making the virus outbreak worse.  The wave of freedom calls is rising as Hong Kong protester’s messages seem to be spreading to the mainland. The calls for freedom of speech and democracy are posing a major challenge to President Xi.  Food prices skyrocketed by 20 % in January with pork prices rising 116 % adding to consumer concerns. Political observers see this challenge to government policies on par with the Tiananmen Square protests in 1989. The ensuing massacre of protestors is still in the minds of many mainland people. As seems to be true of many of these events that it is not the crisis itself, but the reaction and ensuing waves of social disorder which drive a major economic impact.

Oxford Economics has forecast a slowdown in US GDP growth in the first quarter of 2020 to just .6 %

Sources: Oxford Economics, The Wall Street Journal, The Daily Shot – 2/6/20

Will U.S. GDP growth really be shaved by just .4 %?  If we consider the compounding effect of the epidemic to disrupt both demand and supply, the social chaos in China challenging government authority (i.e., Hong Kong), and a lingering trade war – these factors all make a decline into a recession a real and growing possibility.  We hope the epidemic can be contained quickly and lives saved with a return to a more certain world economy.  Yet, 1930s historical records show rising world nationalism, trade wars, and the fracturing of the world order does not bode well for a positive outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg opinion warns of a U shaped recession or worse an L :

I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Can Six Myths Keep The Market Going?

Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600?  The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?

Source: Patrick Hill – 12-31-19

One reason for the disconnect is investment analysts and the media lead investors to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed policy shift) begun 30 years ago low-interest rates, low volatility, sustainable growth and muted inflation are still in place and were only interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash. GS concluded that the economy ‘was nearly recession-proof.’

The mainstream financial media also feed the Mania Phase with stories like Goldman Sachs declaring the Great Moderation is working with our economy in a ‘new paradigm’. We are to believe there will not be a recession because our policymakers have the economy under control.  Really?  With over $17 trillion of negative debt worldwide to keep the world economy going, central banks have succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:

  1. The Growth Phase of the Economic Cycle is Continuing
  2. Consumers Will Bailout the Economy
  3. The Fed Will Keep the Economy Humming
  4. If the Fed Fails Then the Federal Government Will Provide Stimulus
  5. The Trade War Won’t Hurt Global Growth
  6. The Economy and Markets Are Insulated from World Politics

Let’s look at each myth that is likely to affect portfolio and market performance in the next year.  This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.

Myth 1. The Growth Phase of the Economic Cycle is Continuing

The Fed has reported that the economy is still in ‘mid-cycle’ phase.  We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers.  The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.

Sources: The Conference Board, The Wall Street Journal, The Daily Shot – 6/14/19

In the chart below, consumers are stretched as loan default rates are rising despite a 50-year low unemployment rate. Rising delinquencies tend to signal rising unemployment and economic decline is likely in the near future.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19

Of major concern is that the manufacturing sector is now in a recession based on five months of ISM reports below the 50 % economic expansion benchmark. The overall contraction is validated as 70 % of manufacturing sub-sectors are contracting as noted in the report below.  While the US economy is primarily driven by services, the manufacturing sector has a multiplier effect on productivity, support services, and employment with high paying jobs. Note the contraction in sub-sectors is reaching levels last seen before recessions.

            Sources Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19

There are other indicators pointing to the end of the growth phase.  For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.

Myth 2.  Consumers Will Bailout the Economy

Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates.  Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt.  The Bloomberg Personal Finance Index dropped significantly in October:

Source: Bloomberg, The Wall Street Journal, The Daily Shot – 11/10/19

Car loans now span seven years on average versus five years a few years ago. Further, the new loans ‘roll in’ debt from previous car purchases due to negative equity in the owner’s trade-in vehicle.  Vehicle price increases up to 10 % over the last year for both cars and trucks add to the debt burden.  Car debt is beginning to weigh on consumers as delinquencies are climbing:

Sources: NY Federal Reserve, The Wall Street Journal, The Daily Shot – 10/29/19

Today, credit card rates are running at a ten-year peak of 17 – 22 % have seen no relief despite the Fed cutting rates.  There is a record spread between the Federal Funds rate and credit card rates as banks seek new revenue sources beyond making loans. Many consumers are turning to credit cards to pay bills to sustain their lifestyle as their wages are not keeping up with rising living costs.

In addition, consumers are increasingly working at more than one job to be sure they can pay their bills.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19

Workers need to take on multiple jobs in the gig economy. McKinsey & Company estimates that 52 million people are gig workers or a third of the 156 million person workforce. Contractors have no job security.  Gig workers often receive hourly wages with no health, retirement or other benefits. The lack of benefits means they have limited or no financial safety net in the event of an economic slowdown.

There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year.  Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years.  Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?


Myth 3.  The Fed Will Keep the Economy Humming

The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.

Sources: The Wall Street Journal, The Daily Shot – 12-30-19

We agree with their perspective that the Fed is entering an economic space where no central bank has gone before.  In the past, the Fed lowered rates when an economic downturn was evident. Just prior to earlier recession’s interest rates were at a higher starting level of at least 4 – 5 %.  Plus, today the Fed has returned to pumping liquidity into the economy via its repo operation and QE as shown below.

Sources: The Federal Reserve of St. Louis, The Wall Street Journal, The Daily Shot – 12/30/19

The International Bureau of Settlements (BIS) disclosed in their analysis of recent Fed repo operations that funding supported not only banks but hedge funds. A key concern is the nature of the hedge fund bailout. How steep is the loss being mitigated? Is there a possibility of contagion? Is more than one hedge fund involved?  Should the Fed be bailing out hedge funds that are overextended due to speculation? The Fed is already using its tools at the height of the current economic growth cycle. The Fed financial tools are too stretched to turnaround an economy in a recession from multiple financial bubbles bursting.

The Fed continues to declare that inflation is at 2.1 %, missing the reality of what consumers are actually paying for goods and services.  We find from industry research that finds inflation is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and services that consumers buy, not inflation defined by a formula to suit political needs. Using inflation lifestyle ‘cost of living’ data, which is not transparent or available for audit does not meet the foundational data needs of investors.  Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers frequently buy at Walmart and Target.  Their study showed that from June 2018 to June 2019, prices increased by about 5.5%. 

Other industry research supports inflation running at a much higher level than government figures. On a city by city basis, Chapwood has developed an index for 500 items in major metropolitan areas of the US.  Chapwood reports the average national inflation level to be about 10 %.  Note inflation is compounded; for example, in San Jose a five year average price increase of 13% is for each year. An item costing $1.00 would cost $1.13 the next year and then $1.28 the third year and so forth. It is likely workers caught in a squeeze between stagnant wages and 10 % inflation will not be able to continue to sustain present levels of economic growth.

Real inflation at 6 – 10 % has major policy, portfolio, and social implications.  For example, with the ten year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’ economy of – 4.10 %Higher inflation levels fit the financial reality of what workers, portfolio managers, and retirees are facing in managing their finances.  Many workers must take multiple jobs and develop a ‘side hustle’ to just keep up with inflation much less get ahead. For portfolio managers, they must grow their portfolio at much higher rates than was previously thought just to maintain portfolio value.  Finally, for retirees on a fixed income portfolio it is imperative they have additional growth income sources or part-time work to keep up with inflation eating away at their portfolio. For more details on our analysis of a variety of inflation, categories see our post: Is Inflation Really Under Control?

One additional assumption about Fed intervention repeated by many analysts is the Fed liquidity injections mean that corporate sales and profits will bounce back.  For some financially sensitive industries this argument may be true. For other firms with excellent credit ratings, they may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and sell products based on demand. If demand falls, low-interest loans will not increase sales.  Only new products, new channels, reduced pricing, marketing and other initiatives will revive sales.

Myth 4.  If the Fed Fails Then the Federal Government Will Provide Stimulus

European Central Bank leaders have called on European governments to provide economic stimulus for their markets.  Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector.  For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al. – 2018

Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth.  The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.

Myth 5.  The Trade War Won’t Hurt Global Growth

By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track.  Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term.  The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.

China has quietly raised the exchange rate of their currency to offset some of the impact of still in place tariffs on the U.S. economy.  The government made a major move to block US and foreign companies from providing key technical infrastructure. The technology ministry has told government agencies that all IT hardware and software from foreign firms are to be replaced by Chinese systems within three years. If the Chinese government decides to establish ‘China only’ network standards it may be difficult for US firms to even work with state-sponsored companies or private businesses that must meet China’s only standards. Apple and Microsoft would have to build two versions of their products. One version for the Chinese economy and one for the world.  A critical change is taking place in world trade which is the establishment of a two-block trading world.  China is a key growth market at a 20 % – 30 % increase in sales annually for US multinational companies. For these corporations navigating the trade war will be problematic even with the Phase One agreement.  Our post characterizing this major change in world trade can be found at: Navigating a Two Block Trading World.  

The U.S. has placed sanctions on Chinese sponsored network provider Huawei, effectively limiting the network vendor from US government and private networks.  The Phase One agreement includes the US canceling planned tariffs for December 15th in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on September 1st of last year. Yet, tariffs of 25 % remain in place on $250 billion of Chinese goods.  The Chinese have canceled retaliatory tariffs planned for December 15th and plan to increase purchases of US goods and services by $200 billion over two years. In addition, China will purchase US agriculture products at a $40 billion rate per year from a baseline of $24 billion in 2017.  If the Chinese follow through on their purchase commitments US companies should see increased sales.  However, history on Chinese purchases shows they forecast large purchases but small purchases are made.

A major trade issue has been created when the US decided not to appoint any new judges to the World Trade Organization court for disputes. The court cannot hear or make decisions on any disputes any longer; meaning countries will resort to free-for-all negotiations on trade disputes.  We expect as economies falter, nationalist policies on trade will gain more popularity and world trade will continue to decline after a slight blip up from the U.S.-China Phase One deal.

Sources: BCOT Research, The Wall Street Journal, The Daily Shot – 12/16/19

Finally, prior to the trade war global trade has been facing major headwinds. Since 2008, global firms have looked to open more international markets to sell their goods, but have met sales resistance causing revenue and profits to be flat or decline.  We expect the flattening of global sales to output to continue and eventually decline as overall world trade falls.

CEOs in a Conference Board survey rate trade as a major concern as they look at a highly uncertain economic picture.  Marc Benioff, CEO of Salesforce, described his concerns at a company all hands meeting last November:

 “Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Myth 6. The Economy and Markets Are Insulated from World Politics

Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb.  Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02.  The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf.  An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.

We saw during the negotiations for the Phase One trade deal how rumors both in China and the U.S. would send the S & P futures market up or down by 10 – 15 points depending upon whether the news was positive or negative. Algo traders would drop 30k contracts in a matter of seconds to make huge moves in SPX price, while the VIX was at 12.50, supposedly a calm market. The chart below shows how positive and negative news whipsawed the market.

Source: Liz Ann Sonders – Schwab – 12-7-19

Political news not only moves markets but the economy as well.  When the president tweets a tariff threat, consumers and industry move swiftly to buy those goods before their prices go up.  Businesses have to build the product quickly, sell it and they are left with falling sales as future purchases are pulled forward.  Business to business deals are caught up in this constant flip flop on trade policies as well. CEOs must make investment decisions to build a plant in a particular country 1 – 3 years in advance. They must calculate their allocation plans based on inadequate information and in a highly uncertain policy environment.  Often, rather than make an investment decision, executives will wait for the economic clouds to clear.

Summary:

The current bull market run has set record highs continuously.  Yet, as the saying goes: markets go up in stair steps and down in an elevator.  As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.

The prudent investor will recognize the end of the business cycle is likely underway. It is time to prepare for an economic slowdown and a resulting equity market reversion to the mean. A reversion to the mean quite often requires that markets swing beyond the mean.

The wary investor will ask hard questions of their financial advisor and review corporate reports with an eye on fundamentals. Financial success is likely to result from good risk management and implementation combined with agility to make mid-course corrections.  Investors should test their assumptions based on breaking trends that may impact portfolio performance.  At the same time, constantly flipping investments will lead to poor performance. Allocate funds to different portfolio groups based on long, medium and short term goals to keep from being emotionally swept up in temporary market swings. The key is to be prepared for the unknown, or a black swan event.  Expect the unexpected and consider the advice of market legends like Bernard Baruch:

Some people boast of selling at the top of the market and buying at the bottom – I don’t believe this can be done. I had bought when things seemed low enough and sold when they seemed high enough. In that way, I have managed to avoid being swept along to those wild extremes of market fluctuations which prove so disastrous.”

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

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.”

Will Monetary or Fiscal Stimulus Turnaround the Next Recession?

A recession is emerging with interest rate curves inverted, the end of the business cycle at hand, world trade falling, and consumers and businesses beginning to pull back on spending.  The question is: will monetary or fiscal stimulus turn around a recession? 

In this post, we find both stimulus alternatives likely to be too weak to have the necessary economic impact to lift the economy out of a recession. Finally, we will identify the key characteristics of a coming recession and the implications for investors.

Our economy is at the nexus of several major economic trends formed over decades that are limiting monetary and fiscal options. The monetary policy of central banks has caused world economies to be abundant in liquidity, yet producing limited growth. Central bankers in Japan and Europe have been trying to revive growth with $17 trillion injections using negative interest rates.  Japan can barely keep its economy growing with an estimate of GDP at .5 % through 2019. The Japanese central bank holds 200 % of GDP in government debt.  The European Central Bank holds 85 % of GDP in debt and uses negative interest rates as well. Germany is in a manufacturing recession with the most recent PMI in manufacturing activity at 47.3 and other European economies contracting toward near-zero GDP growth.  

Lance Roberts notes that the world economy is not running on a solid economic foundation if there is $17 trillion in negative-yielding debt in his blog, Powell Fails, Trump Rails, The Failure of Negative Rates. He questions the ability of negative interest policies to stabilize world economies,

You don’t have $17 Trillion in negative-yielding sovereign debt if there is economic and fiscal stability.”

Negative interest rates and extreme monetary stimulus policies have distorted financial relationships between debt and risk assets. This financial distortion has created a significantly wider gap between the 90 % and the top 1 % in wealth.

Roberts outlines in the six panel chart below how personal income, employment, industrial production, real consumer spending, real wages, and real GDP are all weakening in the U.S.:

Source: RIA – 8/23/19

Trillions of dollars of monetary stimulus have not created prosperity for all. The chart below shows how liquidity fueled a dramatic increase in asset prices while the amount of world GDP per money supply declined by about 25 %:

Sources: The Wall Street Journal, The Daily Shot – 9/23/19

Low interest rates have not driven real growth in wages, productivity, innovation, and services development that create real wealth for the working class. Instead, wealth and income are concentrated in the top 1 %. The concentration of wealth in the top one percent is at the highest level since 1929. The World Inequality Report notes inequality has squeezed the middle class between emerging countries and the U.S. and Europe. The top 1 % has received twice the financial growth benefits as the bottom 50 % since 1980:

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

There are several reasons monetary stimulus by itself has not lifted the incomes of the middle class. One of the big causes is that stimulus money has not translated into wage increases for most workers.  U.S. real earnings for men have essentially been flat since 1975, while earnings for women have increased though basically flat since 2000:

Source: U.S. Census Bureau – 9/10/19

If monetary policy is not working, then fiscal investment from private and public sectors is necessary to drive an economic reversal.  But, will the private and public sector sectors have the necessary tools to bring new life to an economy in decline?

Wealth Creation Has Gone to the Private Sector

The last 40 years have seen the rise of private capital worldwide while public capital has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al – 2018

Essentially, world banks and governments have built monetary and fiscal economic systems that increased private wealth at the expense of public wealthThe lack of public capital makes the creation of public goods and services nearly impossible. The development of public goods and services like basic research and development, education and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  

Why is building high levels of private capital a problem?  Because, as we have discussed, private wealth is now concentrated in the top 1 %, while 70 % of U.S GDP is dependent on consumer spending.  The 90 % have been working for stagnant wages for decades, right along with diminishing GDP growth.  There is a direct correlation between wealth creation for all the people and GDP growth.

Corporations Are Not In A Position to Invest

Some corporations certainly have invested in their businesses, people, and technology.  The issue is the majority of corporations are now financially strapped.  Many corporate executives have made profit allocation decisions to pay themselves and their stockholders well at the expense of workers, their communities and the economy. 

S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Source: Real Investment Advice

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

In 2018 stock buybacks at $1.01 trillion were at the highest level they have ever been since buybacks were allowed under the 1982 SEC safe harbor provision decision. It is interesting to consider where our economy would be today if corporations spent the money they were wasting on boosting stock prices and instead invested in long term value creation.  One trillion dollars invested in raising wages, research, and development, cutting prices, employee education, and reducing health care premiums would have made a significant impact lifting the financial position of millions. This year stock buybacks have fallen back slightly as debt loads increase and sales fall:

Source: Dow Jones – 7/2019

Many corporations with tight cash flows have borrowed to purchase shares, pay dividends and keep their stock price elevated causing corporate debt to hit new highs as a percentage of GDP (note recessions followed three peaks):

Source: Federal Reserve Bank of Dallas – 3/6/2019

Corporate debt has ballooned to 46 % of GDP totaling $5.7 trillion in 2018 versus $2.2 trillion in 2008.  While the bulk of these nonfinancial corporate bonds have been investment grade, many bond covenants have become weaker as corporations seek more funding. Some bondholders may find their investment not as secure as they thought resulting in significantly less than 100 % return of principal at maturity.

In a recession, corporate sales fall, cash flow goes negative, high debt payments become hard to make, employees are laid off and management tries to hold on.  Only a select set of major corporations have cash hoards to ride out a recession, and others may be able obtain loans at steep interest rates, if at all.  Other companies may try going to the stock market which will be problematic with low valuations.  Plus, investors will be reluctant to buy stock in negative cash flow companies.

Thus, most corporations will be hard pressed to invest the billions of dollars necessary to turnaround a recession. Instead, they will be just trying to keep the doors open, the lights on, and maintain staffing levels to hold on until the day sales stop falling and finally turn up.

Public Sector is Also Tapped Out

In past recessions, federal policy makers have turned to fiscal policy – public spending on infrastructure projects, research development, training, corporate partnerships, and public services to revive the economy.  When the 2008 financial crisis was at its peak the Bush administration, followed by the Obama government pumped fiscal stimulus of $983 billion in spending over four years on roads, bridges, airports, and other projects. The Fed funds interest rate before the recession was at 5.25 % at the peak allowing lower rates to have plenty of impact. Today, with rates at 1.75-2.00 %, the impact will be negligible. In 2008, it was the combined massive injection of monetary and fiscal stimulus that created a V-shaped recession with the economy back on a path to recovery in 18 months. It was not monetary policy alone that moved the economy forward.  However, the recession caused lasting financial damage to wealth of millions. Many retirement portfolios lost 40 – 60 % of their value, millions of homeowners lost their homes, thousands of workers were laid off late in their careers and unable to find comparable jobs.  The Great Recession changed many people’s lives permanently, yet it was relatively short-lived compared to the Great Depression.

As noted in the chart above, public sector wealth has actually moved to negative levels in the U.S. at – 17 % of national income.  Our federal government is running a $1 trillion deficit per year.  In 2007, the federal government debt level was at 39 % of GDP. The Congressional Budget Office projects that by 2028 the Federal deficit will be at 100 % of GDP

Source: CBO – 4/9/19

We are at a different time economically than 2008. Today with Federal debt is over 100% of GDP and expected to grow rapidly. The Feds balance sheet is still excessive and they formally stopped reducing the size (QT).  In a recession federal policymakers will likely make spending cuts to keep the deficit from going exponential. Policy makers will be limited by the twin deficits of $22.0 trillion national debt and ongoing deficits of $1+ trillion a year, eroding investor confidence in U.S. bonds. The problem is the political consensus for fiscal stimulus in 2008 – 2009 does not exist today, and it will probably be even worse after the 2020 election. Our cultural, social and political fabric is so frayed as a result of decades of divisive politics it is likely to take years to sort out during a recession. Our political leaders will be fixing the politics of our country while searching for intelligent stimulus solutions to be developed, agreed upon and implemented.

What Will the Next Recession Look Like?

We don’t know when the next recession will come. Yet, present trends do tell us what the structure of a recession might look like, as a deep U- shaped, slow recovery measured in years not months:

  • Corporations Short of Cash – Corporations already strapped are short on cash, will lay off workers, pull back spending, and are stuck paying off huge debts instead of investing.
  • Federal Government Spending Cuts – The federal government caught with falling revenues from corporations and individuals, is forced to make deep cuts first in discretionary spending and then social services and transfer funding programs. The reduction of transfer programs will drive slower consumer spending.
  • Consumers Pull Back Spending – Consumers will be forced to tighten budgets, pay off expensive car loans and student debt, and for those laid off seeking work anywhere they can find a job.
  • World Trade Declines – World trade will not be a source of rebuilding sales growth as a result of the China – US trade war, and tariffs with Europe and Japan.  We expect no trade deal or a small deal with the majority of tariffs to stay in place. In other words, just reversing some tariffs will not be enough to restart sales. New buyer – seller relationships are already set, closing sales channels to US companies. New country alliances are already in place, leaving the US closed out of emerging high growth markets.  A successor Trans Pacific Partnership (TPP) agreement with Japan and eleven other countries was signed in March, 2018 without the US. China is negotiating a new agreement with the EU. EU and China trade totals 365 billion euros per year. China is working with a federation of African countries to gain favorable trade access to their markets.
  • ­Pension Payments in Jeopardy – Workers dependent on corporate and public pensions may see their benefits cut from pensions, which are poorly funded today with markets at all-time highs. GE just announced freezing pensions for 20,000 employees, the harbinger of a possible trend that will  reduce consumer spending
  • Investment Environment Uncertain – Uncertainty in investments will be extremely high, ‘get rich quick’ schemes will flourish as they did in 2008 – 2009 and 2000.
  • Fed Implements Low Rates & QE – The Fed is likely to implement very low interest rates (though not negative rates), and QE with liquidity in abundance but the economy will have low inflation, and declining GDP feeling like the Japanese economic stasis – ‘locked in irons’.

Implications for Investors

The following recommendations are intended for consideration just prior or during a recession with a sharp decline in the markets, not necessarily for today’s markets.

Cash – It is crucial to maintain a significant cash hoard so you can purchase corporate stocks when they cheapen. The SPX could decline by 40 – 50 % or more when the economy is in recession.  Yet, good values in some stocks will be available.  At the 1500 level, there is an excellent opportunity to make good long term growth and value investments based on sound research.

CDs – as Will Rogers noted during the Depression, “I’m more interested in Return of my Capital than Return on my Capital”, a prudent investor should be too.  CDs are FDIC insured while offering lower interest rates than other investments. Importantly, they provide return of capital and allow you to sleep at night.

Bonds – U.S. Treasuries certainly provide safety, return of principal, and during a recession will provide better overall returns than high-risk equity investments. Corporate bonds may come under greater scrutiny by investors even for so-called ‘blue chips’ like General Electric. The firm is falling on hard times with $156 billion in debt. GE is seeking business direction and selling off assets. The major conglomerate’s bonds have declined in value by 2.5 % last year with their rating dropped to BBB. Now with new management the price of GE bonds is climbing up slightly.

Utilities – are regulated to have a profit.  While they may see declining revenues due to less energy use by corporations and individuals, they still will pay dividends to shareholders as they did in 2008.  Consumer staple companies are likely to be cash flow strained; most did not pay dividends to investors during the 2008 – 2009 recession. REITs need to be evaluated on a company by company basis to determine how secure their cash streams are from leases. During the 2008 – 2009 downturn, some REITs stopped paying dividends due to declining revenues from lease defaults.

Growth & Value Equities– invest in new sectors that have government support or emerging demand based on social trends like climate change: renewables, water, carbon emission recovery, environmental cleanup. From our Navigating A Two Block Trade World – US and China post, we noted possible investments in bridge companies between the two trade blocks; services, and countries that act as bridges like Australia. Look for firms with good cash positions to ride out the recession, companies in new markets with sales generated by innovations, or problem solving products that require spending by customers.  For example, seniors will have to spend money on health services. Companies serving an increasingly aging population with innovative low cost health solutions are likely to see good demand and sales growth.

The intelligent investor will do well to ‘hope for the best, but plan for the worst’ in terms of portfolio management in a coming recession.  Asking hard questions of financial product executives and doing your own research will likely be keys to survival.

In the end, Americans have always pulled together, solved problems, and moved ahead toward an even better future. After a reversion to the mean in the capital markets and an economic recession things will improve.  A reversion in social and culture values is likely to happen in parallel to the financial reversion. The complacency, greed, and selfishness that drove the present economic extremes will give way to a new appreciation of values like self-sacrifice, service, fairness, fair wages and benefits for workers, and creation of a renewed economy that creates financial opportunities for all, not just the few.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

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.

Navigating A Two Block Trade World

“Investors Need to Be Ready for a Two Block Trade World – U.S. and China”

On Bloomberg TV, VMware CEO, Pat Gelsinger, observed that with escalation of the trade war he sees, “two separate trading blocks forming the United States and China, we want to be a player in both and will have to adjustour strategy, investments, supply chains and operations as a result.”  He sees both countries digging in for the foreseeable future.

The evolution of a two trading block global economy has a major impact on how businesses operate in the next five to ten years.  Those with major operations in China that ship products to the U.S. will continue to be adversely affected by U.S. tariffs on Chinese goods. Growing trade headwinds also face, U.S. companies shipping goods to China. Besides tariffs, trade research shows Chinese importers will need to deal with U.S. non-tariff barriers that are not only costly but time consuming.

Here is a list of industry sectors most impacted by the trade war with businesses exports and imports to China:

Sources: U.S. Census Bureau, Marketwatch  – 6/27/19

Major software and electronics companies like Apple, with $56b in sales making up 20% of total global revenue from China, will continue to see declining sales. Apple, and other companies in the same shoes, will have to radically shift supply chains and sourcing for manufacturing.

CISCO, a global network systems manufacturer, recently reported to shareholders a 25% drop in sales of network products to both state-owned and private corporations in China. Many American manufacturers’ source components and sub-assemblies from China which are then shipped to the U.S. mainland for final manufacturing. These supply chains will have to change if they are to sustain profits.

Caterpillar, in the transportation sector, recognizes 10% of global revenue from China and has experienced a significant drop in sales.  Tariffs have significantly reduced soybean exports to China by U.S. farmers to nearly zero. The Federal Reserve in Minneapolis reports farm bankruptcies have reached 2008 levels.

These are just a few examples. Each day the list of impacted industries and companies grows longer.

What does the two block trading world mean to investors?  

The trade war seems to be here to stay. As such, agile CEOs are already planning for the U.S and China to be heavily competing for global trade.  Investors will need to assess the implications for both short and long term investments.

Short term tactical investments:

  1. Research business sectors with major exposure to imports and exports to China
  2. Identify companies with exposure to China trade and related operational vulnerabilities
  3. Identify countries that may act as bridge zones between the two blocks, ie: Australia, Singapore, and Vietnam

Long term strategic investments:

  1. Identify companies that are well-positioned to leverage quickly the now forming two block trading world
  2. Research bridge countries that are making investments in shipping infrastructure and establishing long term trade treaties with both the U.S. and China
  3. Watch the business horizon for new businesses or services that will evolve as a result of the new U.S. – China trade competition

A new global trading structure is forming fast presenting both opportunities and pitfalls for investors.  Agile investors might want to position themselves for optimal growth and income in bridge countries or firms like VMware, where the CEO is moving quickly to establish good relationships with both countries.  

Investors should also consider longer-term investments in Australian based companies or U.S. firms with major operations in Australia as a bridge country.  Many U.S. firms have regional operations headquarters in Sydney.  Sydney, positioned in the Asian region, offers a well-skilled labor force, is an open country to many immigrants from all over Asia that speak and write many languages. Further English is the main language for easy use of technical documentation and recruitment of support staff. The Australian government has been an ally of the U.S. for decades and yet has a bilateral free trade agreement with the Chinese government signed in 2015. As a bonus, the Australian economy has been in expansion for 27 straight years.  The incredibly long string of growth is likely due to a diverse economy, welcoming immigrants who start new businesses, an abundance of natural resources, located at the nexus of Asian growth and a business positive government and culture. It is these same traits that should help them thrive in a two trading block economy.

Investors should be wary of Hong Kong or China-based businesses with American ties that are not politically correct.  The Chinese economy is a state controlled managed economy of state run businesses and private businesses that run under strict guidelines.  Problems in Hong Kong go beyond the present protests. The island city has seen the CEOs of a few local businesses ‘disappear’ when making trips to mainland China. In some instances these disappearances have happened for months throwing the businesses into turmoil and dropping stock prices by 70 – 80%. 

Hong Kong’s future is highly uncertain as the Chinese government is growing increasingly concerned that democracy might ‘leak’ to the mainland and thereby threaten authoritarian rule.  The Chinese government has announced the development of an ‘entites’ list of U.S. companies that Chinese firms are not to do business. American firms affiliated with these targeted firms will see significantly reduced sales. On the U.S. side, the Trump administration has gone back and forth on suppliers to Huawei and is now writing a ‘blacklist’ of Chinese firms that American companies are to end business with. Smart investors will need to keep track of U.S. and Chinese government pronouncements and policies in regard to which companies are ‘in’ and which are ‘out’. These may change by the day or week.

Monitoring markets or executive behaviors that are likely to catch government scrutiny will offer investors an early warning of which firms may soon appear on the lists. One possible new sector of scrutiny are cybersecurity companies, which provide both countries an edge in the digital economy. Both countries will want to maintain control, access and future development of digital security power.

The two trading block global economy will require careful research, constant monitoring, and quick moves as politically ‘in’ companies can become ‘out’ at the whim of government leaders in both countries.  Investments in stable countries, with firms that have a long history of bridging their business between both China and the U.S. are likely to be the best investment opportunities over the long term. Note that in any global recession, these bridge countries and companies are likely to be the first to recover from a recession.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

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.

Yes, We Are In Another Tech Bubble

Technology has touched our lives in so many ways, and especially so for investors. Not only has technology provided ever-better tools by which to research and monitor investments, but tech stocks have also provided outsized opportunities to grow portfolios. It’s no wonder that so many investors develop a strong affinity for tech.

Just as glorious as tech can be on the way up, however, it can be absolutely crushing on the way down. Now that tech stocks have become such large positions in major US stock indexes as well as in many individual portfolios, it is especially important to consider what lies ahead. Does tech still have room to run or has it turned down? What should you do with tech?

For starters, recent earnings reports indicate that something has changed that deserves attention. Bellwethers such as Amazon, Alphabet and Apple all beat earnings estimates by a wide margin. All reported strong revenue growth. And yet all three stocks fell in the high single digits after they reported. At minimum, it has become clear that technology stocks no longer provide an uninterrupted ride up.

These are the kinds of earnings reports that can leave investors befuddled as to what is driving the stocks. Michael MacKenzie gave his take in the Financial Times late in October [here]:

“The latest fright came from US technology giants Amazon and Alphabet after their revenue misses last week. Both are highly successful companies but the immediate market reaction to their results suggested how wary investors are of any sign that their growth trajectories might be flattening.”

Flattening growth trajectories may not seem like such a big deal, but they do provide a peak into the often-tenuous association between perception and reality for technology. Indeed, this relationship has puzzled economists as much as investors. A famous example arose out of the environment of slowing productivity growth in the 1970s and 1980s [here] which happened despite the rapid development of information technology at the time. The seeming paradox prompted economist Robert Solow to quip [here],

You can see the computer age everywhere but in the productivity statistics.”

The computer age eventually did show up in the productivity statistics, but it took a protracted and circuitous route there. The technologist and futurist, Roy Amara, captured the essence of that route with a fairly simple statement [here]:

“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Although that assertion seems innocuous enough, it has powerful implications. Science writer Matt Ridley [here] went so far as to call it the “only one really clever thing” that stands out among “a great many foolish things that have been said about the future.”

Gartner elaborated on the concept by describing what they called “the hype cycle” (shown below).

The cycle is “characterized by the ‘peak of inflated expectations’ followed by the ‘trough of disillusionment’.” It shows how the effects of technology get overestimated in the short run because of inflated expectations and underestimated in the long run because of disillusionment.

Amara’s law/ the hype cycle

Source: Wikipedia [here]

Ridley provides a useful depiction of the cycle:

“Along comes an invention or a discovery and soon we are wildly excited about the imminent possibilities that it opens up for flying to the stars or tuning our children’s piano-playing genes. Then, about ten years go by and nothing much seems to happen. Soon the “whatever happened to …” cynics are starting to say the whole thing was hype and we’ve been duped. Which turns out to be just the inflexion point when the technology turns ubiquitous and disruptive.”

Amara’s law describes the dotcom boom and bust of the late 1990s and early 2000s to a tee. It all started with user-friendly web browsers and growing internet access that showed great promise. That promise lent itself to progressively greater expectations which led to progressively greater speculation. When things turned down in early 2000, however, it was a long way down with many companies such as the e-tailer Pets.com and the communications company Worldcom actually going under. When it was all said and done, the internet did prove to be a massively disruptive force, but not without a lot of busted stocks along the way.

How do expectations routinely become so inflated? Part of the answer is that we have a natural tendency to adhere to simple stories rather than do the hard work of analyzing situations. Time constraints often exacerbate this tendency. But part of the answer is also that many management teams are essentially tasked with the effort of inflating expectations. A recent Harvard Business Review article [here] (h/t Grants Interest Rate Observer, November 2, 2018) provides revealing insights from interviews with CFOs and senior investment banking analysts of leading technology companies.

For example, one of the key insights is that “Financial capital is assumed to be virtually unlimited.” While this defies finance and economics theory and probably sounds ludicrous to most any industrial company executive, it passes as conventional wisdom for tech companies. For the last several years anyway, it has also largely proven to be true for both public tech-oriented companies like Netflix and Tesla as well as private companies like Uber and WeWork.

According to the findings, tech executives,

“…believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages.”

An important implication of this capital availability is,

“The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects …”

Another key insight is, “Risk is now considered a feature, not a bug.” Again, this defies academic theory and empirical evidence for most industrial company managers. Tech executives, however, prefer to, “chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside.”

Finally, because technology stocks provide a significant valuation challenge, many tech CFOs view it as an excuse to abdicate responsibility for providing useful financial information. “[C]ompanies see little value in disclosing the details of their current and planned projects in their financial disclosures.” Worse, “accounting is no longer considered a value-added function.” One CFO went so far as to note “that the CPA certification is considered a disqualification for a top finance position [in their company].”

While some of this way of thinking seems to be endemic to the tech industry, there is also evidence that an environment of persistently low rates is a contributing factor. As the FT mentions [here], “When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions.”

John Hussman also describes the impact of low rates [here]:

“The heart of the matter, and the key to navigating this brave new world of extraordinary monetary and fiscal interventions, is to recognize that while 1) valuations still inform us about long-term and full-cycle market prospects, and; 2) market internals still inform us about the inclination of investors toward speculation or risk-aversion, the fact is that; 3) we can no longer rely on well-defined limits to speculation, as we could in previous market cycles across history.”

In other words, low rates unleash natural limits to speculation and pave the way for inflated expectations to become even more so. This means that the hype cycle gets amplified, but it also means that the cycle gets extended. After all, for as long as executives do not care about “judiciously allocating capital”, it takes longer for technology to sustainably find its place in the real economy. This may help explain why the profusion of technology the last several years has also coincided with declining productivity growth.

One important implication of Amara’s law is that there are two distinctly different ways to make money in tech stocks. One is to identify promising technology ideas or stocks or platforms relatively early on and to ride the wave of ever-inflating expectations. This is a high risk but high reward proposition.

Another way is to apply a traditional value approach that seeks to buy securities at a low enough price relative to intrinsic value to ensure a margin of safety. This can be done when disillusionment with the technology or the stock is so great as to overshoot realistic expectations on the downside.

Applying value investing to tech stocks comes with its own hazards, however. For one, several factors can obscure sustainable levels of demand for new technologies. Most technologies are ultimately also affected by cyclical forces, incentives to inflate expectations can promote unsustainable activity such as vendor financing, and debt can be used to boost revenue growth through acquisitions.

Further, once a tech stock turns decidedly down, the corporate culture can change substantially. The company can lose its cachet with its most valuable resource — its employees. Some may become disillusioned and even embarrassed to be associated with the company. When the stock stops going up, the wealth creation machine of employee stock options also turns off. Those who have already made their fortunes no longer have a good reason to hang around and often set off on their own. It can be a long way down to the bottom.

As a result, many investors opt for riding the wave of ever-inflating expectations. The key to succeeding with this approach is to identify, at least approximately, the inflection point between peak inflated expectations and the transition to disillusionment.

Rusty Guinn from Second Foundation Partners provides an excellent case study of this process with the example of Tesla Motors [here]. From late 2016 through May 2017 the narrative surrounding Tesla was all about growth and other issues were perceived as being in service to that goal. Guinn captures the essence of the narrative:

“We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands.” In this narrative, “there were threats, but always on the periphery.”

Guinn also shows how the narrative evolved, however, by describing a phase that he calls “Transitioning Tesla”. Guinn notes how the stories about Tesla started changing in the summer of 2017:

“But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries.”

This meant the narrative shifted to something like, “The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this?” As Guinn describes, “The narrative was still positive, but it was no longer stable.” More importantly, he warns, “This is what it looks like when the narrative breaks.”

The third phase of Tesla’s narrative, “Broken Tesla”, started around August 2017 and has continued through to the present. Guinn describes,

“The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles.”

Finally, Guinn concludes, “Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.” Once this happens, there is very little to inhibit the downward path of disillusionment.

Taken together, these analyses can be used by investors and advisors alike to help make difficult decisions about tech positions. Several parts of the market depend on the fragile foundations of growth narratives including many of the largest tech companies, over one-third of Russell 2000 index constituents that don’t make money, and some of the most over-hyped technologies such as artificial intelligence and cryptocurrencies.

One common mistake that should be avoided is to react to changing conditions by modifying the investment thesis. For example, a stock that has been owned for its growth potential starts slowing down. Rather than recognizing the evidence as potentially indicative of a critical inflection point, investors often react by rationalizing in order to avoid selling. Growth is still good. The technology is disruptive. It’s a great company. All these things may be true, but it won’t matter. Growth is about narrative and not numbers. If the narrative is broken and you don’t sell, you can lose a lot of money. Don’t get distracted.

In addition, it is important to recognize that any company-specific considerations will also be exacerbated by an elemental change in the overall investment landscape. As the FT also noted, “But this month [October] can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals.” This turning point has significant implications for the hype cycle: “Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.”

Yet another important challenge in dealing with tech stocks that have appreciated substantially is dealing with the tax consequences. Huge gains can mean huge tax bills. In the effort to avoid a potentially complicated and painful tax situation, it is all-too-easy to forego the sale of stocks that have run the course of inflated expectations.

As Eric Cinnamond highlights [here], this is just as big of a problem for fiduciaries as for individuals:

“The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill.”

Don’t let tax considerations supersede investment decisions.

So how do the original examples of Amazon, Alphabet and Apple fit into this? What, if anything, should investors infer from their quarterly earnings and the subsequent market reactions?

There are good reasons to be cautious. For one, all the above considerations apply. Further, growth has been an important part of the narrative of each of these companies and any transition to lower growth does fundamentally affect the investment thesis. In addition, successful companies bear the burden of ever-increasing hurdles to growth as John Hussman describes [here]:

“But as companies become dominant players in mature sectors, their growth slows enormously.”

“Specifically,” he elaborates, “growth rates are always a declining function of market penetration.” Finally, he warns,

“Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.”

For the big tech stocks, wobbles from the earnings reports look like important warning signs.

In sum, tech stocks create unique opportunities and risks for investors. Due to the prominent role of inflated expectations in so many technology investments, however, tech also poses special challenges for long term investors. Whether exposure exists in the form of individual stocks or by way of major indexes, it is important to know that many technology stocks are run more like lottery tickets than as a sustainable streams of cash flows. Risk may be perceived as a feature by some tech CFOs, but it is a bug for long term investment portfolios.

Finally, tech presents such an interesting analytical challenge because the hype cycle can cause perceptions to deviate substantially from the reality of development, adoption and diffusion. Ridley describes a useful general approach: “The only sensible course is to be wary of the initial hype but wary too of the later scepticism.” Long term investors won’t mind a winding road but they need to make sure it can get them to where they are going.

Give Me An “L” For Liquidity

After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.

It wasn’t that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms,

“Central banks are pitiless executioners of long-lived booms and monetary policy has shifted.”

Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.

Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.

Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don’t even notice it. Because investors have been living in a sea of liquidity, they don’t even notice it. As he notes,

“The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets.”

Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.

One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes,

“But everything for me has never been about earnings. It’s never been about politics. It’s always about liquidity.”

Not earnings or politics, but liquidity. 

While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes,

“we’ll [the Fed will] be shrinking our balance sheet $50 billion a month,” and, “at the same time, the ECB will stop buying bonds.”

Cole describes the same phenomenon in his terms,

“Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.” 

Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]:

“In terms of global liquidity, it’s currently falling at the fastest rate that we’ve seen since 2008 …”

For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out,

“It’s going to be the shrinkage of liquidity that triggers this thing.” He goes on, “And my assumption is one of these hikes- I don’t know which one- is going to trigger this thing. And I am on triple red alert because we’re not only in the time frame, we’re in the part …” He continues, “There’s no more euro ECB money spilling over into the US equity market at the end of the year …”

Or, as Zerohedge reported [here],

“We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air).”

As the Economist notes,

“Shifts in America’s monetary stance echo around global markets,” and there is certainly evidence this is happening. Cole notes, “The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing.” 

Howell also chimes in, 

“You’re also seeing emerging markets central banks being forced to tighten because of the upward shock to the US  dollar.” He concludes, “Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment.”

The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that “Emerging markets face a dollar double whammy” in the Financial Times [here]. He describes, “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts.” He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes,

“The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world.”

As a result, there are a lot of crosscurrents that confound simple analysis.

For example, Zerohedge reports [here],

“When ‘QT’ [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased …” The story continues, “The markets evidently never ‘missed’ the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions.” 

Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights “the huge amounts of money of flight capital that have come into the US over the last four years” and quantifies it as “something like $4 trillion.”

But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, “This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk.” However, by the end of September, “the interbank market’s cross-currency ‘basis swap’ for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp.” Dizard summarizes the likely consequences:

“That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery.”

Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, “China has shown no appetite for buying further US dollar assets over the last 18 months.” He concludes,

“We think they’ve now stopped. And they’re redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending.”

Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes,

“What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector.”

Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: “The banks’ woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market.”

This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.

In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here],

“With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.”

Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, “we’re kind of at that stage of the cycle where bombs are going off,” which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says,

“And until the bombs go off in the developed markets, you would think the tightening will continue.”

Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says,

“Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” He also warns, “[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.

In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war:

“We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a — a defeat for the free world — that was related to the rise of China — and it was a total misreading of a pivotal event — which cost us very dearly.” 

In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.

Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.

A recent story in P&I [here] articulated the challenge well: 

“Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.” More specifically, “The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity” 

This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet:

“You know the drill. In face of market volatility, keep calm and stay the course.”

“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions. 

If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects “a crisis to occur between 2019 and 2021,” a market decline has very different information content.  

Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here],

“Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market.”

Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments,

“You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.” 

Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller’s own actions. As he puts it,

“I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%.”

Based on what he is seeing now, he is ready to pounce:

“I … kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities … and that’s because margins are at an all time record. We’re at the top of the valuation on any measures you look, except against interest rates …”

So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.

Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: 

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents.”

So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily. 

Do You Believe In Magic

Like so many things, magic can have different meanings. Many times, it is regarded as something special that defies easy explanation. Sometimes it also includes elements of nostalgia as in the Lovin’ Spoonful’s “It makes you feel happy like an old-time movie.” Positive, serendipitous experiences are often described as mystical, remarkable, or “magical”.

But magic can also have negative connotations. Common phrases such as “sleight of hand” and “smoke and mirrors” emphasize the misdirection of our attention, often for the purpose of gaining advantage. Increasingly, these types of “magic” infest investment analyses and financial statements and in doing so, belie underlying fundamentals. Just as hope is not a strategy, belief is not an investment plan.

One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.

In the tech bust of 2000, for example, investors learned that some companies inflated revenues through vendor financing. Some backdated options to retain high levels of compensation for key staff. Many used alternative metrics such as growth in “eyeballs” to embellish visions of growth while de-emphasizing real progress and costs.

Similar phenomena existed in the financial crisis of 2008. Exceptionally low interest rates boosted mortgage originations above sustainable levels. “No income, no assets” (NINA) mortgages allowed a large number of people to take out mortgages who were wholly unqualified to do so. Structured credit products boosted growth by creating a perception of manageable risk.

In both cases, there was a period of time during which people thought they were wealthier than they actually were, because they had not yet learned of the deceptions. Renown economist John Kenneth Galbraith thought enough of this phenomenon to develop a theory about it. John Kay describes it [here]: “Embezzlement, Galbraith observed, has the property that ‘weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.’ Galbraith described that increase in wealth as ‘the bezzle’.”

Charlie Munger went on to expand and generalize the theory: “This psychic wealth can be created without illegality: mistake or self-delusion is enough.” Kay notes that “Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.”

As any magician knows, there are lots of ways to create illusions. For better and worse, the current investment landscape is riddled with them. One of the most common is to create a story about a stock or an industry. Investment “stories” are nothing new. In the late 1990s and early 2000s the story was that the internet was going to transform our lives and create enormous growth. In the financial crisis of 2008 the story was that low rates and low inflation created a “goldilocks” environment for global growth. Both stories, shall we say, overlooked some relevant factors.

New stories are popping up almost as reliably as weeds after summer rains. Zerohedge highlighted [here], “Back in December 2017 it was ‘blockchain.’ Now, the shortcut to market cap riches, and a flurry of speculative buying, is simply mentioning one word: ‘cannabis’.” If you are curious what a story stock looks like, take a look at the price action of cannabis company TLRY over the last month. After you do, try formulating an argument that the market prices reflect only fundamental information and no illusion.

Daniel Davies, author of Lying for Money, points out one overlooked, but highly relevant aspect of the cannabis story [here]: “Despite the “bright future of legalized pot”, he says, “The US Securities and Exchange Commission has already prosecuted several companies which appeared to be less interested in selling weed to the public and more interested in selling stock owned by the founders for cash.” As is often the case, the whole story is often more complicated and less alluring.

Stories are conjured about more than just exciting new stocks and industries, however. Sometimes they define a narrative about the economy or the market as a whole. One such story describes the economy as finally getting back on track and resuming its historical growth trajectory of 3 – 4%. It’s a nice, appealing story with significant tones of nostalgia.

It is also a story that is less than entirely realistic, however. The FT cites JPMorgan analysis [here]: “Jacked up on tax cuts, a $1.3tn spending bill, easy monetary policy and a weakening dollar, Wall Street and the US economy have enjoyed their own version of a ‘sugar high’.”

John Hussman describes how the discrepancy between real growth and perceived growth arises [here]: “The reason investors imagine that growth is running so much higher than 2-3% annually is that Wall Street and financial news gurgles about quarterly figures and year-over-year comparisons without placing them into a longer-term perspective.” He explains, “The way to ‘reconcile’ the likely 1.4% structural growth rate of GDP with the 4% second quarter growth rate of real GDP is to observe that one is an expected multi-year average and the other is the annualized figure for a single quarter, where a good portion of that figure was driven by soybean exports in anticipation of tariffs.”

Further, he reveals that fundamental drivers have actually languished during the huge run-up in the market: “[W]hen we measure peak-to-peak across economic cycles, annual S&P 500 earnings growth has averaged less than 3% annually since 2007, while S&P 500 revenue growth has averaged less than 2% annually.”

Tax cuts provide an especially interesting component of the investment landscape. Not only did the cuts in corporate tax rates quickly and substantially increase earnings estimates in financial models, they also provided a powerful signal to many investors that finally there is a business-friendly administration in the White House.

The reality, again, is more complicated and less sanguine, however. For one, the tax cuts came along with higher fiscal deficits, the cost of which will be borne in the future. Secondly, and importantly, the tax cuts did not come as a singular benefit but rather as part of a “package” of public policy.

The FT reported [here]: “At a meeting in Beijing late last year, US business executives tried to explain their concerns about imposing tariffs on Chinese exports to a group of visiting Trump administration officials.” It continued, “The meeting was held after President Donald Trump’s state visit to Beijing and the congressional passage of a large tax cut for corporate America. The executives, who had expected a polite exchange of views, were shocked by the officials’ robust response. One of the attendees reported that they were told, “your companies just got a big tax cut and things are going to get a lot tougher with China — fall in line”.

The attendee summarized, “The message we are getting from DC is ‘you’re just going to have to buck up and deal with it’.” Lest this be perceived as a one-off misunderstanding, it is completely consistent with Steve Bannon’s analysis of the situation reported [here], “Donald Trump may be flexible on so much stuff, but the hill he’s willing to die on is China.”

While “story stocks” and “tax cuts” and record growth” tend to steal headlines, they aren’t the only things that can engender perceptions that differ from reality. Sometimes the most powerful sources of misunderstanding are also the most mundane — because they garner so little attention.

While accounting in general is often overlooked because the subject is dry and technical, it also provides the measures and rules of the game by which financial endeavors are evaluated. But those rules, their enforcement, and the economic landscape have changed considerably over the years.

One big issue is the increasing use of non-GAAP metrics in earnings presentations. As I discussed in a blog post [here], the vast majority of S&P 500 firms present non-GAAP metrics in their earnings releases. Further, as the FT reported, “Most of those non-GAAP numbers make the company look better. Last year a FactSet study found that the average difference between non-GAAP and GAAP profits reported by companies in the Dow Jones Industrial Average was 31 per cent, up from 12 per cent in 2014.” A key takeaway, I noted, is that “non-GAAP financial presentations can play a significant role in cleaving perception from underlying investment reality.”

Another issue is that intellectual capital presents special accounting challenges and is far more important to the economy today than it used to be. The Economist reports [here]: “Total goodwill for all listed firms world-wide is $8tn, according to Bloomberg. That compares to $14tn of physical assets. Dry? Yes. Irrelevant? Far from it.” Further, one-half of the top 500 European and top 500 American firms by market value “have a third or more of their book equity tied up in goodwill.”

The Economist also reports, “Just as the stock of goodwill sitting on balance-sheets has become vast, so have the write-downs. For the top 500 European and top 500 American firms by market value, cumulative goodwill write-offs over the past ten years amount to $690bn. There is a clear pattern of bosses blowing the bank at the top of the business cycle and then admitting their sins later.” Because “the process of impairment is horrendously subjective,” the numbers for reported assets have become less defensible.

In addition, investors need to be on the watch for even more than clever numbers games and accounting obfuscation. The reliability of corporate audits has also been declining for a variety of reasons — which should reduce investors’ confidence in them.

As the FT reports [here], the original purpose of audited numbers was “to assure investors that companies’ capital was not being abused by overoptimistic or fraudulent managers.” However, Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee, assesses, “But the un-anchoring of auditing from verifiable fact has become endemic.”

An important part of the “un-anchoring” process involves the increasing acceptance of fair value accounting, which was implemented (ostensibly) to provide more useful information to investors: “From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.” “The problem with fair value accounting,” according to one audit professional, “is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.” Yet another case of diminished verifiability.

At the same time as the reliability of audited numbers was decreasing, so too was the accountability for the audits. “[A]uditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of ‘tick box’ rules designed to achieve mechanistic ‘neutral’ outcomes.” Professor Karthik Ramanna calls it a process “that is tantamount to a stealthy ‘socialisation or collectivisation of the risks of audit’.” In other words, don’t expect auditing firms to pay when their work fails, expect investors to pay.

To make matters worse, “There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway.” Erik Gordon, a professor at the University of Michigan Ross School of Business, highlights, “They have been able to do better with low quality than with high quality work.”

Jean-Marie Eveillaird, who accumulated an impressive record as an investment professional, summarized the effects of accounting changes in a RealVisionTV interview [here]: “[M]ost accounting numbers are estimates. And indeed, what happened in the ’90s, where there are a number … of chief financial officers decided that- with the help of some shop lawyers- decided that you could observe the letter of the regulations, and at the same time betray the spirit of the regulations, and you wouldn’t go to jail for that.”

In sum, there are a lot of different ways in which illusions about financial performance can be created and many have been getting progressively worse. Notably, they don’t even include the examples of intentional wrongdoing such as the Enron or Madoff frauds. Munger is right, “psychic wealth can be created without illegality: mistake or self-delusion is enough.”

The one thing all these examples have in common is that they are all essentially category errors. As Ben Hunt tells us [here]: “What’s a category error? It’s calling something by the wrong name.” In particular, a Type 1 category error is also called a false positive.

One opportunity for investors is pretty straightforward: Just don’t carelessly and uncritically accept a story as real fundamental information. Don’t call a narrative a fact. Don’t assign 100% value to numbers enshrouded with uncertainty. As Davies highlighted in regard to cannabis investors, “What they are not doing is asking the basic questions of securities analysts.” So ask the basic questions.

Davies also provides some useful clues as to when investors should be on special alert: “The way to identify a story-stock craze — overblown enthusiasm for a sector where there is a good tale to tell about its future — is if the justification for buying into the new hot venture is big on vision and short on detail.” For example, is the earnings presentation dominated by bullet points describing qualitative achievements or by revenue and earnings numbers accompanied by substantive explanations? If you are going to get involved with a story, a useful rule of thumb is: “the time to buy is either when very few people have heard the story, or when everyone has heard it and everyone hates it.”

In addition, the concept of the febezzle presents a fairly useful model for thinking about investment risk. Asset valuations can be thought of as being comprised of two separate components: One is based on fundamentals and reflects intrinsic value while the other is based on the febezzle and reflects illusory, or psychic, wealth. An important consequence of this is that when the illusion is shattered, the febezzle element vanishes and there is virtually nothing to prevent a quick adjustment to intrinsic value. In other words, the febezzle is much more of a binary (either/or) function than a linear one.

This matters for long term investors who are most concerned about creating a very high probability of achieving their long-term investment goals. Not only does the febezzle component subject their portfolios to sudden, substantial, and effectively permanent drawdowns, but it also defies conventional investment analysis. It is exceptionally hard to confirm that a popular illusion is being shattered, especially before everyone else does.

One signal of change, however, is volatility. Using language that closely parallels “destruction of the illusion,” Chris Cole, from Artemis Capital Management, explains [here], “Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth.” In this context, the absurdly low volatility of 2017 was ripe breeding ground for illusions. Investors believed. Higher volatility in 2018, however, suggests that some of those beliefs are becoming increasingly fragile.

Perhaps the greatest illusion of all is the belief that continued market strength confirms strongly improving fundamentals. While recent economic performance has been good, Cole rejects this view and offers an alternative explanation: “When the market is dominated by passive players prices are driven by flows rather than fundamentals.” In other words, strong market performance mainly means that more people are piling into passive funds. By doing so, they have the dangerously intoxicating effect of propagating the illusion of commensurate fundamental strength.

None of this is to suggest that stock fundamentals are strong or weak, per se. Rather, it is to suggest that, for several reasons, stock prices do not comport well with the reality of underlying fundamentals; there is less than meets the eye. As Ben Hunt warns, “It’s the Type 1 [false positive] errors that are most likely to kill you. Both in life and in investing.” If calling something real when it is not can kill you, it is hard to understand why so many people are so tolerant of mistakes and self-delusion when it comes to their investments. The question is simple: Can you handle the truth, or do you believe in magic?

The Most Important Asset Class In The World

Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned.

“As long as the music is playing, you’ve got to get up and dance,” – Chuck Prince, Citigroup

Chuck’s utterance now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke’s proclamation also sounds more like an “oopsie” than a dangerous misjudgment by a top official.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers …” 

One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.

China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF’s Sally Chen and Joong Shik Kang concluded [here],

“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”

The July 27, 2018 edition of Grants Interest Rate Observer assesses,

“Following a decade of credit-fueled stimulus, China’s banking system is the most bloated in the world.”

Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], “So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids.”

One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.

These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes:

“China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that’s 15% of China’s GDP of $12 trillion. Put another way, it’s about $2 trillion. That $2 trillion is 3% of global GDP.”

And so I can’t stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world.”

Chanos is not the only one who sees building for “speculative purposes” as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here],

“The heart of the Chinese model is malinvestment. It’s about building up non-performing loans and figuring out what to do with them.”

The WSJ’s Walter Russell Mead captured the same phenomenon [here],

“Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained. Chinese debt is the foundation of the system.”

Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China’s young consumers have:

“…rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC. Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011.”

Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, “When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1.”

The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, “the bottom line is that very serious adjustments in the economy are required … Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses.”

In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.

Once again, the landscape of Chinese debt is problematic. Russell Napier states,

“The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices.”

Zerohedge adds [here] that the Chinese central government has become “alarmed at its [shadow banking’s] vast scale, and potential for corruption.”

Further, nebulous practices are not confined to the “shadows” in China. The FT reports [here],

“These [small] banks are quite vague and blurry when it comes to investment receivables … There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”

As it happens, “Problems at small banks matter because their role in China’s financial system is growing.” While China surpassed the eurozone last year to become the world’s largest banking system, “small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.”

Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes,

“We’re constantly asked about how good Chinese data are. Is it all bad? It’s all bad, but it’s bad and different variations.” 

Chanos shared his opinion as well:

“As much as the macro stuff has intrigued me … what’s so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don’t seem to be profitable, the accounting is a joke.”

Miller makes clear what the challenge is:

“[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates.”

Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.

Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]:

“[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

That said, the “flavor” of China’s crisis will depend on uniquely Chinese characteristics. Miller identifies an important one:

“I think the problem is that people didn’t understand that this is not a commercial financial system. That’s one of the major takeaways we stress all the time. This [China’s] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other.”

In other words, China has substantial capability to manage liquidity and contagion risks.

As a result, according to Miller,

“We don’t spend a lot of time worrying about an acute crisis. If China falls and China does have the hard landing that a lot of people predicted, it’s not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They’re not going to have the same freeze-up of credit that you did in some of these other Western economies.”

That said, there are still likely to be severe consequences. Miller reports,

“China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China’s economy is, for the most part, headed towards stasis.” More specifically he says, “So I think that we’re heading towards a Chinese economy which is going to slow down quite dramatically when we’re talking about 10, 15 years time.”

Indeed, it appears that process has started. As noted [here],

“Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists.”

Throughout the process, Miller expects China to pursue a policy agenda designed to get the country “on a more sustainable track.” In particular, “that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that.” He is careful to note, however, “But it’s not easy.”

Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here]

“To take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China.”

The FT also notes [here],

“New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks” which will disproportionately affect small and mid-sized banks. Further, as reported [here], “the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market.”

The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and under-appreciated. Perhaps it is because the numbers don’t seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don’t really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.

Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here],

“There is not a snowball’s chance in hell [the Chinese weakness] will not flow through to the US stock market.”

Where does all of this leave Chanos?

“Interestingly, we’re less short China now than we have been in eight years in our global portfolio. Because the rest of the world’s catching up. Although China’s been on a tear recently, Chinese stocks over the eight years are basically flat. And I’ve noticed that some of the other stocks have sort have tripled.”

Fundamentals are important, but so are prices paid.

A major complication of figuring out China will be determining the degree to which it’s domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018:

“China’s credit-saturated economy … is the primary force behind the recent gyrations in FX. The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade.”

In other words, don’t get distracted by the smaller stuff.

Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here],

“In general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation … the current indications are more negative for global growth than positive.”

The FT goes even further [here]:

“The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting.”

Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only “safe” assets are cash and precious metals. When the sparks fly, it’s hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the “most important asset class in the world”.

Right now, that is Chinese residential real estate.

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.