Tag Archives: Dan Nevins

We’re Gonna Need A Bigger Boat

If 2018 rings in a bear market, it could look something like the Kennedy Slide of 1962.

That was my conclusion in “Riding the Slide,” published in early September, where I showed that the Kennedy Slide was unique among bear markets of the last eighty years. It was the only bear that wasn’t obviously provoked by rising inflation, tightening monetary policy, deteriorating credit markets or, less commonly, world war or depression.

Moreover, market conditions leading up to the Slide should be familiar—they’re not too far from market conditions since Donald Trump won the 2016 presidential election. In the first year after Kennedy’s election, as in the first year after Trump’s election, inflation seemed under control, interest rates were low, credit spreads were tight, and the economy was growing. And, in both cases, the stock market was booming.

Here’s an updated look at Trump’s stock rally versus the Kennedy rally and subsequent Slide:

As you can see, we’ve now reached the chart’s critical juncture—at this time of the calendar in 1962, the post-election rally was ending, and the Slide was about to begin. Our chart begs the question: Will the similarities continue and lead us into a Trump Slide in early 2018?

Or, with less drama, you might like to hear my Q1 stock market outlook.

While it’s certainly possible Trump’s rally has run its course, I’ll argue that it’s unlikely. And to make my case, I’ll rely largely on a single indicator, one that measures monetary policy. I use the indicator to help determine whether policy is behind the curve, ahead of the curve, or somewhere in between. In this article, I’ll call it VCURVE, for “versus the curve.”

Tracking VCURVE Through 16 Market Corrections

Before I explain how VCURVE is calculated, let’s look at the history. The following chart compares VCURVE to every instance since 1954 when the stock market corrected by more than 10% and for at least two months:

The upper panel shows an especially strong correlation with stock price cycles between 1954 and 1988. All ten of that period’s market corrections coincided with an upward spike in VCURVE. Despite a few instances of delay between the change in VCURVE and the market’s reaction, the indicator’s early track record was stellar—it predicted every correction with almost no head fakes. (I say “early track record” because fed funds data is only available from 1954. I’ll modify the indicator to gain a longer history at another time.)

But the historical performance didn’t persist after the 1980s at the same exceptional standard. The lower panel shows the correlation weakening, with jumps in VCURVE becoming a fifty–fifty proposition as to whether they signal a market correction.

The reason for the weaker correlation is open to debate, but I would say it’s explained mostly by the Fed’s practice of jumping to action at any hint of market turmoil. VCURVE probably hasn’t shown the same predictive power under the FOMCs chaired by Alan Greenspan, Ben Bernanke and Janet Yellen because of the respective Greenspan, Bernanke and Yellen “puts.” Whereas VCURVE before Greenspan was as reliable an indicator as you’ll find, more recently the Fed’s plunge-protection game often wins the day.

Calculating VCURVE

All that said, even the chart’s lower panel shows an excellent market indicator. The head fakes may be more frequent, but every correction still lines up with a degree of VCURVE turbulence. And just as importantly, it’s an easy indicator to calculate. Here are the two steps:

  1. From the current fed funds rate, subtract the lowest rate since the last market correction.
  2. Add the change in inflation over the past twelve months.

The first step tells us how far along the Fed is in a tightening cycle, and the second converts that figure to a measure of where the Fed stands versus “the curve.” Consider a few possible combinations:

  • If the current tightening cycle is far along but inflation is falling, VCURVE won’t be as high as it otherwise would be, because the Fed has taken enough action to dampen inflation risks. (Policy is ahead of the curve.)
  • If the current tightening cycle is young but inflation is rising, VCURVE will be higher than it otherwise would be, because the Fed may be forced to tighten more aggressively to contain inflation risks. (Policy is behind the curve.)

So VCURVE has three qualities that make it an effective indicator. It’s conceptually relevant, easy to calculate and historically proven.

And what does it tell us today?

At first glance, the latest reading is ambiguous. It’s higher than it was between 2012 and 2015, but only modestly so at 1.6%. To glean more information, we’ll take a closer look at the indicator’s history.

Testing VCURVE Against Subsequent Real Stock Returns

The next chart shows average inflation-adjusted stock returns over three-month periods following VCURVE readings in each of seven buckets:

From the pattern shown on the chart, we can make two observations:

  1. The strongest real returns tend to follow VCURVE readings of less than 2%.
  2. Real returns don’t normally fall below zero until VCURVE jumps above 3%.

We shouldn’t bet all our chips on the exact thresholds of 2% and 3%, history not always repeating and all that, but the pattern gives us a reasonable guide to early 2018. The latest reading of 1.6% falls within a range that’s followed by real quarterly stock returns averaging over 3%—hardly a bearish signal.


More broadly, two particular risks pose the greatest threats in early 2018. First, the market may have run too hot since Trump’s election, leaving investors overextended and unable to push prices higher. An overbought market appears to partially explain the Kennedy Slide of 1962, and a similarly overbought market today could spark a profit-taking correction.

Second, the Fed’s determination to tighten policy should continue to push VCURVE higher, even as it’s not especially high today. To be sure, rate hikes alone are unlikely to make a difference until later in 2018 at the FOMC’s projected pace of twenty-five basis points every four months, but further hikes coupled with an unexpectedly large jump in inflation would be a different story. In a rising inflation scenario that shows the Fed falling behind the curve, a correction of at least 10% would be likely and we’d probably see a full bear.

Of course, plenty of other risks could gain traction as the year gets underway. See, for example, these thirty risks discussed by Deutsche Bank and ZeroHedge or these fifteen from Doug Kass and Real Investment Advice. Also, market valuation points to meager long-term returns, as I discussed in “2 Key Indicators” and then showed somewhat differently in “Charts that Might Define the Jerome Powell Era.”

On a three-month horizon, though, most of the best indicators favor continued strength. Credit markets aren’t nearly as threatening as they were before recent bears—delinquencies, credit spreads and bank lending standards are all either neutral or just mildly bearish at worst. Moreover, the real and financial economies appear settled into a “virtuous” loop of mutually reinforcing strength, as I discussed here, while the GOP’s tax cuts should help sustain that loop for awhile longer.

And lastly, the Fed’s inch-worming monetary tightening pace hasn’t accumulated enough force as of yet to push VCURVE into a danger zone. As possibly the most effective of all fundamental indicators, I don’t recommend betting against VCURVE.

All things considered, I expect market valuation to become even more expensive before the next correction takes hold. Comparing the Trump and Kennedy rallies—as in the first chart above—I expect Trump’s market to build an even bigger slide.

A Strong Signal From The Economic Dashboard

We’ve been seeing more and more commentaries discussing bad stuff that can happen when the Fed tightens policy and, as a result, the yield curve flattens. (See, for example, this piece from Citi Research and ZeroHedge.) No doubt, the Fed’s rate hikes will lead to mishaps as they usually do—in both markets and the economy. But most forecasters expect the economy to expand through next year, believing that the Fed and the yield curve aren’t yet restrictive enough to trigger a recession.

We won’t make a full-year 2018 forecast here, but we’ll share one of our “dashboard” charts that supports the consensus view for at least the first half of the year. With one methodological change to a chart we published in August, we’ll look at the following indicators, which together have an excellent track record predicting the business cycle:

The idea is that the economy tends to turn over when investors lose money, borrowers find it hard to obtain financing, business earnings weaken, and banks struggle with a flat or inverted yield curve. Here’s a history of all four of those indicators in the quarter before and the quarter of the last nine business cycle peaks, although with less data for lending standards, which the Fed began surveying for the first time in mid-1990:

With that history as our background (in charcoal gray), our dashboard highlights the most recent data, along with our fourth quarter estimates for asset price gains and S&P 500 earnings growth:

In our view, the above chart is the best way to judge recession risks—with a strong reminder of how current conditions compare to the conditions that shaped past business cycles. That comparison looks favorable as of mid-December, just as it did in August. Here are our takeaways, moving from right to left along the chart:

  • Although the yield curve is likely to become more recessionary as the Fed continues to tighten, it’s not yet as flat or inverted as it normally is at business cycle peaks.
  • Business earnings aren’t yet recessionary, either, although gains over the last four quarters reflect depressed earnings in 2015 and 2016, which isn’t quite as bullish a signal as it would be if earnings had risen consistently over that period.
  • Outside of the commercial real estate sector, lending conditions aren’t constraining borrowing growth, and even CRE lending conditions aren’t restrictive when compared to the last three business cycle peaks.
  • Asset gains have been stellar over the past four quarters, far above the flat or declining performance that nearly always precedes business cycle peaks.

We think the last point is the most convincing. Of all the “rules” in economics, the rule that asset prices lead the business cycle is as reliable as any, and they’re a long way from recessionary as of this writing. In fact, if Q4’s gains match the average gains over the past four quarters, real asset gains for 2017 will reach 25% of personal income. That’s three months of personal income from asset gains alone—hardly an environment where households stop spending and the economy slips into recession.

But eventually, monetary tightening will have greater effects, and the outsized asset gains of recent years will become more burden than boon. That’s notwithstanding Janet Yellen’s FOMC press conference on Wednesday, where she downplayed risks posed by soaring asset prices. Yellen’s parting words are certainly welcoming of debate, and we recommend the responses here, as well as this recent report from the Office for Financial Research. But for this article, we’ll just couple our bullish economic view for H1 2018 with a chart we first shared last week:

Although the chart includes only seven business cycles to keep it readable, the full history shows asset gains, adjusted for inflation, jumping above those of any other cycle since the Fed began recording gains in 1947. It paints a bigger picture behind the “virtuous” loop that’s currently fueling the economy and thus far impervious to the Fed’s snail-pace tightening. And we think it describes the greatest challenge Yellen’s successor will face, although not an immediate challenge. In our view, the tightening we’ve seen to date is still too new and too tepid to threaten the usual damage, especially with the dashboard readings above and with fiscal policy set to loosen. But further out, we suggest trusting the history of how long-running virtuous loops normally unwind.

2-Charts That Will Define The Fed’s “Jerome Powell” Era

In September, we proposed a theory of the Fed and suggested that the FOMC will soon worry mostly about financial imbalances without much concern for recession risks. We reached that conclusion by simply weighing the reputational pitfalls faced by the economists on the committee, but now we’ll add more meat to our argument, using financial flows data released last week. We’ve created two charts, beginning with a look at cumulative, inflation-adjusted asset gains during the last seven business cycles:

According to the way that the Fed defines its policy approach, our first chart stamps a giant “Mission Accomplished” on the unconventional policies of recent years. Recall that policy makers explained their actions with reference to the portfolio balance channel, meaning they were deliberately enticing investors to buy riskier assets than they would otherwise hold. Policy makers hoped to push asset prices higher, and they seem to have succeeded, notwithstanding the usual debates about how much of the price gains should be attributed to central bankers. (See one of our contributions here and a couple of other papers here.) But whatever the impetus for assets to rise, it’s obvious that they responded. In fact, judging by the data shown in the chart, policy makers could have checked the higher-asset-prices box long ago, and with a King Size Sharpie.

Consider the measure on the vertical axis, percent of personal income. From the risky asset trough in Q1 2009 through Q3 2017, households accumulated asset gains, in real terms, equivalent to 139% of personal income. (Nominal gains were much greater, but we used the CPI to deduct the amount of purchasing power that households lost on their asset holdings. Also, we defined asset holdings as the four biggest categories that the Fed computes gains for—equities, mutual funds, real estate, and pensions.)

In other words, households are enjoying an investment windfall that amounts to nearly sixteen months of personal income, which is larger than the windfalls accrued in any other business cycle since the Fed began tracking asset gains in 1947. Not only that but the gap continues to widen—as of this writing, we’re likely approaching 145% of personal income and well clear of the previous peak of 128% from the 1991–2001 expansion.

Getting back to policy priorities, the chart seems to tell us that asset prices no longer need boosting. The Fed’s pooh-bahs proved they could boss the investment markets, and they’ve almost certainly moved on to new endeavors.

Bull, bear, or donkey?

But record asset gains are just one of the reasons the Fed’s priorities are likely to be changing. To describe another reason, we’ll first show that policy makers may wield a King Size Sharpie but that it’s not a Permanent Marker:

As you can see, our second chart looks like the first, except that we pinned the tails on the asset price donkeys. We tacked on the down halves of each cycle, showing that the portfolio balance channel has a reverse mode.

So what should we make of the result that asset price cycles, adjusted for inflation, have ended with busts that reverse a large portion and often the entirety of the prior booms?

According to our beliefs about how investment markets work, the up and down phases of asset cycles are closely connected. Also, monetary stimulus influences both phases at the same time. It helped fuel the giant gains of recent expansions, but it also helped create the imbalances that led to giant losses. And after the accelerated advances of 2016-17, it’s fair to wonder if today’s imbalances are approaching the extremes of 2000 and 2007. Even some FOMC members are gently acknowledging that risk.

But we think the committee members are even more concerned than you would know by just reading their meeting minutes. We expect financial imbalances to become their biggest worry, bigger than the risk of recession, which should matter less and less to the central bankers’ reputations as the business cycle expansion continues to lengthen. In fact, a garden variety recession would barely affect their legacies at all by mid-2019, when the expansion, if still intact, would become the longest ever. By that time, the FOMC’s greatest reputational threat would be another financial market debacle, which would suggest that manipulating asset prices maybe wasn’t such a good idea, after all. In other words, the committee’s reputational calculus will change significantly during Jerome Powell’s first few years as chairperson.

All that said, Powell probably wants a recession-free economy in, say, his first year or two in the position. Moreover, he’ll certainly stress continuity with his predecessors’ policies. But once he becomes comfortable in the job, the Fed’s priorities will look nothing like they did under Janet Yellen and Ben Bernanke. Instead of fueling asset gains, Powell’s biggest challenge will be containing imbalances connected to prior gains. He and his peers will aim to avoid pinning another oversized tail on the donkey—or at least to manage the fallout from said tail—and that’s a challenge that could very well define his regime.

Learning From The 1980’s

Forget about big hair, Ray-Bans, and Donkey Kong. Don’t even think about Live-Aid, Thriller, and E.T. Above all else, the 1980s were the gravy days of the money supply aggregates.

Beginning in late 1979, the Fed built its policy approach around the aggregates—primarily M1 but occasionally M2, and policy makers also monitored M3 while experimenting with M1B and, later, MZM. But those were just the “official” figures. Economists and pundits debated the Fed’s preferred measures while concocting their own home-brewed variations.

Notably, the Fed allowed interest rates to fluctuate as much as necessary to achieve its money growth targets. Fluctuate they did—rates soared and dipped wildly as a direct result of the Fed’s policy. The world, meanwhile, watched the action as attentively as a Yorkie watches breakfast, studying every wiggle in every M. Missing one wiggle could have meant the difference between exploiting the volatility that the Fed unleashed or being sunk by that same volatility.

And to make sense of it all, the world looked to the most famous economist of his day, Milton Friedman. By converting a large swath of his profession to his strict brand of Monetarism, Friedman more than anyone else had triggered the monetary frenzy.

But then, almost as quickly as the frenzy blew in, it blew right back out. With none of the Ms living up to their billings as economic indicators, the Monetarists drifted from view. Not in five minutes but in five years, give or take a couple, their period of fame was over. Friedman’s reputation as an economics savant fell particularly hard—his highly publicized forecasts proved inaccurate in each year from 1983 to 1986. And the Fed once again redesigned its approach, first deemphasizing and eventually dropping its money growth targets.

But maybe the Monetarists came closer to explaining the economy than their critics allowed?

Maybe the best indicator—I’ll call it “MDuh”—was somehow hidden in plain sight?

Those are the arguments I’ll make in this article, and I’ll back each one with up-to-date data. I’ll propose a way of thinking that’s considered common sense in some circles even as it’s blasphemous within the mainstream core of the economics profession. And I’ll explain why MDuh was the true lesson of Friedman’s research.

Before we get to MDuh, though, there are two things you should know about Friedman and his co-researcher Anna Schwartz (if you didn’t already know them). First, they relied on data, not theory, when they shaped their version of Monetarism. They found a strong historical correlation between money growth and economic activity, and they also found that money growth predicts activity. They published those results in a groundbreaking 1963 book, A Monetary History of the United States, 1867–1960.

Second, to their credit they never claimed to understand the monetary “transmission mechanism,” meaning the reasons the historical correlations were as strong as they were. But they offered their best guess, which lined up with prevailing Monetarist thinking. They believed that “there is a fairly definite real quantity of money that people wish to hold” and that our continual efforts to adjust money holdings to those fairly definite levels are the business cycle’s driving force.  (See here for source.)

The Glaring but Rarely Acknowledged Problem with M1 and M2

The second point above explains why Monetarists defined the aggregates as they did. They defined each aggregate according to the characteristics that might influence the “fairly definite real quantity of money that people wish to hold.” But the characteristics they believed important, such as liquidity, stability, and value as a medium of exchange, led to unreliable indicators, as shown in the chart below:

The chart compares the most popular Monetarist measures, M1 and M2, to two measures that I created, MDuh and NBL. I’ll define MDuh and NBL in just a moment. I’ll first offer an explanation for why M1 and M2 lost their pre-1980s mojo as GDP correlates. And to do that, I’ll need to review a fallacy that underpins not only Monetarism but all of mainstream macro.

Mainstream theory relies on the false premise that bank loans are no different to other loan types. It ignores the reality that bank loans are unique, because banks are the only institutions that create deposits (money) while delivering loan proceeds. Bank borrowers receive money that banks create from thin air, and that brand new money has powerful effects. It boosts spending without requiring prior saving, meaning it’s mostly additive to economic activity. That is, it doesn’t have a large “crowding out” effect on other spending—bank-created money flows directly into nominal GDP. It might affect prices, real growth, or a combination of prices and real growth, depending on how the new money is spent. But it’s important to remember that the new money connects to a bank loan. The money–GDP correlation is merely a byproduct of a lending–GDP correlation. Bank lending, not money, is the driving force.

Back to M1 and M2: Why did those highly touted measures lose their strong correlations to GDP, whereas MDuh didn’t?

I would say it’s because they lost their connections to bank lending. The economists who created them made both additions to and subtractions from bank-created money, whereas I made no such adjustments when I calculated MDuh. I didn’t bother with the differences between checking, savings, and time deposits, and I didn’t bother with money that’s not created by banks, such as money market funds. In other words, I didn’t bother with the characteristics of money that absorb the attention of mainstream economists—liquidity, stability, and value as a medium of exchange. For what it’s worth, I doubt that people maintain definite money holdings, as the Monetarists claimed.

MDuh depends on a single question: Is a potential MDuh component initiated by a private entity with the legal authority to create money, meaning either a commercial bank or a similar deposit-taking institution? If the answer is yes, I include the component in MDuh. Otherwise, I don’t. By using only that criterion, I’m estimating the amount of new money that banks pump into the economy when they make loans and buy securities. Not surprisingly, MDuh correlates almost perfectly with net bank lending—the correlation between 1959 and 2016 was 0.97. And net bank lending, as you might have guessed, is “NBL” in the chart above.

To say it again, banking realities tell us that bank lending, not money, is the business cycle’s driving force, as shown by the data in my chart.

Why Friedman and Schwartz Were Almost “On The Money”

Now for the irony.

Over the 94-year period covered in Friedman and Schwartz’s Monetary History, data only existed for a few types of money. The authors couldn’t separate different types of bank accounts as finely as statisticians do today. They couldn’t measure any non-currency, non-bank-created money that may have existed over the period of study. In other words, they couldn’t add and subtract the various components of the Ms that disconnect them from bank lending.

So MDuh is far from an original measure. It consists of currency in circulation plus bank deposits less bank reserves, which is equivalent to the measure Friedman and Schwartz used in their book for the period until the Fed’s inception in 1913 (there were no central bank–held reserves) and almost equivalent thereafter. Their monetary history could have just as accurately been called “The History of MDuh.” In effect, their study of MDuh triggered the 1980s monetary frenzy in the first place.

(The only discrepancy between MDuh and Friedman–Schwartz is my adjustment for bank reserves, which isolates private sector–supplied credit by excluding deposits that arise though the Fed’s open market operations. Without the adjustment for bank reserves, MDuh would mix apples with oranges. It would combine private sector lending, which is pro-cyclical, with the Fed’s lending, which is intended to be counter-cyclical. Private sector lending is more strongly correlated to GDP, as you would expect.)

In an ideal world, Friedman and Schwartz’s followers would have recognized that MDuh mostly demonstrates the connections between business cycles, inflation, and bank credit cycles. But that’s not what happened. They stuck to their training, which told them that bank loans are identical to other types of lending. And then they obsessed over how to define money supply, as if economic insight comes down to whether to include, say, overnight repos in your favorite M. By so doing, they moved further and further from MDuh.

Next Steps for Those Who See Things as I Do

As mentioned above, my conclusions probably sound like common sense to many of you, even as they conflict with mainstream macro. You might wonder if you can exploit that discrepancy, and I explain how in my book Economics for Independent Thinkers (website here, Amazon link here).

For now, though, I’d say the next time your favorite analyst breaks down M1 or M2, comment politely that those indicators emerged from long-standing fallacies about money and banking. Suggest that maybe people don’t fine-tune their money holdings to a “fairly definite” level as Monetarist theory requires. Or, even if they do, the desired money holdings wouldn’t propel the economy in the same way bank loans do. And then ask her to look at MDuh instead. Or, better yet, ask her to look at net bank lending and be done with it. Money, while occasionally interesting, mostly sows confusion among those who study it.

Author’s note: I plan to post a follow-up or two with more detailed statistics, including correlations with real growth, and I’ll also consider the economics profession’s response to critiques such as mine. The follow-ups are unlikely to be widely published— but they WILL BE published here at Real Investment Advice so check back frequently. Also, for more on the realities of banking and how they differ from textbook theory, see this Bank of England report.

The Dangers Of A “Get It While You Can” Mentality

There is a wide disconnect between the current market’s focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

“I’d say get it while you can, yeah
Honey, get it while you can, yeah
Hey hey, get it while you can
Don’t you turn your back on love, no, no

Don’t you know when you’re loving anybody, baby
You’re taking a gamble on a little sorrow
But then who cares, baby
‘Cause we may not be here tomorrow, no.”

–Janis Joplin, “Get It While You Can

We live in a not-so-brave world in which time frames have been increasingly compressed, owing in part to the impact of technology on human behavior. It is as if almost everyone these days has ADHD, or attention-deficit hyperactivity disorder.

This short-term behavior permeates our society as physical human interaction is diminished in a world of Twitter, Instagram and Snapchat.

Even politics is subverted to the short term. For example, politicians are elected and almost the next day they have begun to campaign and raise money for their next election. Another example of the short-term orientation and subversion of longer-term thinking is seen in President Trump’s impulsive, possibly dangerous and seat-of-the-pants tweeting, which is now being “normalized,” as an expression of delivering policy that in the past has been conducted in a far more contemplative way. Or even in Anthony Weiner’s sexting!

Nowhere is the compression of time frames more apparent than in the investment business, where it seems that everyone has become a day trader.

As it is said, market opinions are like noses — everyone has one!

The business media spends most of their time asking the talking heads questions that are likely to be responded to without much rigor because it’s easier looking at a price chart or monitoring “unusual call activity” in making short-term trading decisions than employing fundamental analysis that is time-consumptive and laborious.

Among the usual questions:

  • Where are interest rates going by year-end?
  • What is the next 50-handle move in the S&P Index?
  • How will XYZ Co.’s shares respond to this afternoon’s earnings report?
  • What is the next move in the U.S. dollar, the price of oil, in soybeans or in the emerging market space?

The limited discussion and consideration of intermediate to longer-term prospects — such as whether we are pulling investment returns forward — may be a technologically influenced event or may be the desire, as Janis Joplin reminded us all, of “getting it while we can.”

Or it might be the byproduct of the continuing eight-year bull market in which dips are ever bought.

Regardless, current prices always must be measured and judged not only by the next near-term variable (such as interest rates, earnings and the price of oil), but also by the assessment of the intermediate to longer term.

And it is the longer term that to me and to some others is where the greatest concerns lie for investors today.

These longer-term concerns seem to have been ignored by most market participants and by the machines, algorithms and ETFs, which have been fueled by large inflows that have translated into the virtuous market cycle I recently wrote about in “Active vs. Passive Conflict, and Why All Dips Are Bought.”

Stated simply, passive investing is agnostic to long-term fundamentals such as private market value and secular earnings growth projections. One can spend weeks discussing these profound headwinds and challenges, and I will follow up on them in the time ahead by expanding on my non short-term concerns. However, here are the four leading issues as seen in my eyes with a big, big assist from my friend, Outside the Box’s rigorous John Mauldin (the first two issues):

* Uncle Sam’s Unfunded Promises: The Trump administration’s tax plan is not a plan. It is a melange of ideas put forth without precision or arithmetic. Any possible supply-side benefits of the tax proposal must be weighed against the dampening impact of future deficits on economic growth

* Pension Storm Warning 

* The Screwflation of the Middle Class: A longstanding concern of mine, the continued income and wealth gap and the likely continued failure of “trickle-down economics,” holds important and adverse social, political and economic ramifications.

* The Fed’s Role and Its Effect on the Markets The bullish cabal is taking an incredible leap of faith that the Fed’s tightening cycle is going to be without hiccup and essentially have been brainwashed by not just the Fed but by the actions of all central banks in believing that every slip-up will be fully rectified. The central banks believe they have cured the diseases called “bear market” and recession and convinced us that we are in a new paradigm. I would argue that this is likely a big mistake, as evidenced by the numerous policy boners by the Fed in the last one to two decades.

Bottom Line

“A bull market is like sex. It feels best just before it ends.” Warren Buffett

We live in a world of instant gratification.

Basing investments on short-term influences and worshiping at the altar of price momentum can be profitable, but it obscures our attention from long-term trends, many of which are potentially quite adverse.

The long term can be seen as a collection of short terms; the long term is little discussed as the investment debate principally is governed by questions regarding near-term market and price movements, in which market participants try to “get it while they can.”

There is a wide disconnect between the current market’s high valuations and focus on short-term influences and the long-term and worrisome trends in pension obligations, spiraling debt, the wealth/income gap and the Fed’s ability to extricate itself from its large balance sheet.

The Active Vs. Passive Conflict: Why All Dips Are Bought

“At this time 85 years ago, Yale economist Irving Fisher was jubilant. ‘Stock prices have reached what looks like a permanently high plateau,’ he rejoiced in the pages of The New York Times. That dry pronunciation would go on to be one of his most frequently quoted predictions — but only because history would record his declaration as one of the wrongest market readings of all time.” -Time Magazine, “The Worst Stock Tip In History

In Jim “El Capitan” Cramer’s opening missive today he analytically addresses the active vs. passive conflict, which helps explain the market’s steady bullish action. As Jim writes:

“The answer is that there are two kinds of sellers in this market: hedge fund sellers, who react off of research, and portfolio shufflers, who buy and sell ETFs and index funds.

The former jump on anything, right or wrong, as long as it is actionable. Sure, if PepsiCo (PEP) has an organic growth shortfall, as we said could happen in our Action Alerts PLUS bulletins last week about PEP, it could get hammered. That’s a change in the margin of a bad group. But most of the  ‘valuation’ calls analysts make, shy of catalysts, only produce hedge fund jumps.

The latter, the index funds and ETF traders, rarely jump although they may press down harder on a bedraggled ETF, like one that includes the consumer products group.

But there are two kinds of buyers. The opportunistic buyers and the index buyers. The opportunists think that the downgrades are noise and give them a chance to buy high quality stocks with the money that comes in over the transom.

The index and ETF buyers? Well, they just buy.

The dichotomy explains a lot of the bullish action, and isn’t talked about enough. You see the sellers off those research calls? They were either shorts, or people who hadn’t done their homework, because nothing really happened to justify their actions.

But the buyers?

They lurk and wait and pounce.”

I am in basic agreement with Jim but would differ a bit in my interpretation of why dips are bought and how sustainable that buying is.

ETFs and index funds, when faced with a constant and large inflow of funds, are always rebalancing and buying, which is why all dips are purchased. But sizable net inflows may not be seen over time as a constant state, because at some point there will be outflows and that steady dip buying and demand for stocks could disappear almost immediately. To be sure, attempts to give reasons why investor sentiment, now buoyant (see the latest CNN Fear & Greed Index), may erode have fallen on deaf ears this year. But ebbs and flows are a more natural condition of the markets, and as sure as night follows day, the outflows at some point will return. And if ETFs sell, who will be left to buy?

Second, another source of dip buying, as mentioned below (and not covered by Jimmy), are the quant funds that are influenced by a conditioning in the algorithms to buy weakness. That buying has nothing to do with fundamentals, as machines are agnostic to the value — or lack of value — inherent in the income statement, balance sheets and replacement values of the constituent stocks. And, of course, traders who worship at the altar of price momentum are now following the dip buying of quant funds.

Third, money is coming out of active managers in favor of passive investing (i.e., ETFs and quants). Many high-profile and successful managers have closed. Hedge funds — the catalyst for fundamental-based selling that Jim describes — no longer hold the sort of influence that they have in the past.

The Virtuous Circle

The dominance and impact of these three constituents — inflows into ETFs, an expansion in quants’ influence and the contraction taking place in hedge funds — explain a lot about the dip buying that has existed over the last year and the current virtuous circle of demand versus supply.

I recently added up some other reasons for the dip buying.

From my perch, stocks continue to be buoyed by some of the following conditions:

* Massive injections of liquidity from the world’s central bankers

* Passive investing (quants and ETFs) are now dominating markets (at nearly 40%) at the margin

* Machines and algorithms, as well as many individual investors, are behaving differently as they are now programmed and conditioned to buy the dips

* 17% of the listed shares outstanding have been retired in corporate stock repurchases since the Generational Low in March, 2009.

* More than half of the listed companies on the exchanges have disappeared over the last eight years

* We have a Bull Market in Complacency

–Kass Diary, “A Bull Market in Complacency”

Sell The “FANG’s”

I expect comparisons between the FANG stocks and Dr. Evil of the Austin Powers film series to be an ongoing investment storyline over the next year given these digital gatekeepers’ increased dominance over the U.S. economy. This idea might receive a lot more play in U.S. political and antitrust circles — and produce more legal challenges — than most investors currently presume.

For those unfamiliar with Austin Powers, Mike Myers’ character Dr. Evil is a parody of the James Bond villains. He hatches schemes to take over the world with his sidekick Mini-Me and his cat Mr. Bigglesworth. He’s also assisted by Number 2 (played by Robert Wagner), who fronts for his evil corporation, Virtucon Industries. A natural businessman, Number 2 is often more concerned about the financial aspects of world domination than in world domination itself. That sounds a lot like the FANG stocks — Facebook, Amazon , Netflix and Alphabet/Google.

Now, the FANG shares have been slipping recently despite Wednesday’s strength. However, investor sentiment remains almost universally optimistic as it relates to the intermediate term for these names.

Here are just two examples of that enthusiasm:

  • Based on expectations of the FANGs’ glorious future and continued popularity, the Intercontinental Exchange this week announced an early November launch of a “FANG+” ETF. This will combine the FANGs with other hot stocks like Alibaba, Nvidia and Tesla.
  • Some, like my pal Tom Lee of Fundstrat Global, remain ecstatic about the FANGs’ future prospects. In an early June CNBC appearance, Tom explained why, despite having an overall bearish market view, he thinks the FANGs can add nearly 50% over 2017’s second half — and then continue to soar in 2018 and beyond.

Most investors and traders are generally unconcerned about the FANGs’ recent weakness, seeing near-term declines as just another brief speed bump towards an investment pot of gold.

Why The FANGs Might Lose Their Bite

“So, is this it? The end of FANG and company?

I can tell you the news clip files are filled with FANG obituaries and each one seems as cogent as the previous epitaphs.

That’s why I like to have one foot in the rocket ship and another in the terrestrial.

Call me old-fashioned, but when the stock of Facebook gets crushed as it did today, I am more attracted to it than when it’s soaring. I feel the same way about the stock of Alibaba or Nvidia or Electronic Arts (EA). Sure, they might be cheaper tomorrow. That’s the risk you take. But these stocks didn’t get where they were a week ago by alchemy.

They got there because the companies are doing phenomenally and I don’t see anything that tells me they won’t.

I just see profit-taking in the winners and a love of the losers. Own some of both, in a portfolio not just diversified by sector but by riskiness, and you’ll do just fine.” — Jim “El Capitan” Cramer, Rocket-Ship Stocks Look Better When They Return to Earth, Sept. 25, 2017

While I’ve recently shorted both FB and AMZN, I’ve never been a serial basher of FANGs. I’m not one of those who have (as Jim related above) issued frequent FANG epitaphs. As George Lindsay said on Wall Street Week with Louis Rukeyser decades ago, “I am not one of those 600 boys.” (You can listen to him here at the 2:15 mark.)

I realize that calling market tops (or bottoms) for individual stocks, specific sectors or the market as a whole is generally an audacious pursuit and a fool’s errand. It’s also mathematically dangerous, and next to impossible, as there will only be one “generational low” every few decades, and zero “generational tops.” Time is not on forecasters’ side when it comes to projecting a stock’s top.

Generally speaking, stocks also have a gravitational pull higher over time as population and output rise in a secular sense. And while stocks often get out of sync — particularly to the downside — they have a knack at recovering.

As the late great Louis Rukeyser once noted:

The robins will sing,
The crocuses will bloom,
Babies will gurgle,
And puppies will curl up into your lap and go to sleep.
Even when the stock market is temporarily insane.

— Louis Rukeyser, Wall Street Week

My pal Byron Wien of the Blackstone Group often expands on Rukeyer’s view by frequently reminding me that contrary to Lord Keynes (“in the long run, we are all dead”), “disasters have a way of not happening.”

And of course, investors these days are more conditioned than ever to buy any dip thanks to market’s massive liquidity injections and the increased role of passive and machine-based investing (i.e., ETFs and quants).

It’s also important to remember that the FANGs aren’t one stock, but four separate companies serving different customers and end markets. But these companies have grown so dominant and disruptive — to competitors, entire industries and real-estate and the labor markets — that their political and antitrust touch points represent an ever-growing threat to their growth plans and business models.

Concern Abounds

I’ve recently turned more negative on two FANG components — Amazon and Facebook, as well as the Nasdaq and technology in general. That’s why I’m shorting AMZN and FB and have gone long on both the ProShares UltraShort QQQ and the ProShares UltraPro Short QQQ, which are 2x and 3x inverse plays on the Nasdaq 100.

Here are my current views and game plans for each of the FANG components:

  • Facebook. I see more government intervention and regulation ahead. Recommendation: Short on a trading basis.
  • Amazon. AMZN’s growth plans might be stifled going forward by government regulation. Political and antitrust forces represent an existential threat to the company’s horizontal- and vertical-expansion plans. Click here and here to see more of my views. Recommendation: Short on an investment and trading basis.
  • Netflix. I would avoid NFLX, but high short interest precludes selling it short. Remember, Adam Sandler will eat before Netflix shareholders do. Recommendation: Avoid. Here and Here
  • Alphabet/Google. Alphabet’s dominance in the search-engine space (coupled with consumer reliance on Google) leaves the company vulnerable to government interference. I’m negative on the stock, but not short. Recommendation: Avoid.     

Still, as Jim “El Capitan” Cramer wrote in a thoughtful piece on Monday, it’s possible that the FANGs are simply falling back to Earth (as they have in the past) and might be poised to rebound. Others opine that different sectors or stocks might pick up the slack for the market if the FANGs don’t.

In fact, there’s a growing view that even if I’m correct on the FANG being vulnerable, that won’t impact the overall market. This reminds me of something Helene “The Divine Ms. M” Meisler recently wrote:

“TV folks say the market is healthy without the FANG names. Of course, they said it was healthy when it was just the FANGs.”

However, I suppose that’s a subject for another day. Suffice to say, the consensus sentiment on the market and the FANG remains very upbeat.

But remembering that consensus market views need not be wrong (as the crowd usually outsmarts the remnants), let me outline my deeper concerns for the FANGs.

Existential Threats Abound

Amazon is the titan of 21st century commerce. In addition to being a retailer, it is now a marketing platform, a delivery-and-logistics network, a payment service, a credit lender, an auction house, a major book publisher, a producer of television and films, a fashion designer, a hardware manufacturer and a leading host of cloud-server space.

Although Amazon has clocked staggering growth, it generates meager profits, choosing to price below-cost and expand widely instead. Through this strategy, the company has positioned itself at the center of e-commerce and now serves as essential infrastructure for a host of other businesses that depend upon it. Elements of the firm’s structure and conduct pose anticompetitive concerns — yet it has escaped antitrust scrutiny.

— Lina M. Khan, Amazon’s Antitrust Paradox, Yale Law Journal

I used to make presentations to CFA societies in various cities, and the one chart I always presented was called “Characteristics of a Good Stock.” These included growth, free cash flow, barriers to entry and the hope that the government would leave the firm alone. This is pretty much “Buffett 101,” with the caveat that you had to buy a good stock on the cheap.

Now, while Amazon and Netflix have had free-cash-flow and valuation issues, they and the other FANGs have had consistently dynamic top-line growth — and steadily produced deepening competitive “moats” that have expanded the barriers to entry in their markets. And until recently, government interference wasn’t a major concern.

But that might be about to change. The FANGs’ profound innovation and pervasive influence over the economy have rendered a lot of antitrust laws antiquated. Stated simply, these companies are ahead of the regulators — but that, too, might be about to change.

Moreover, the FANGs have no friend in the White House, as seen most recently by this tweet Wednesday from President Trump:

Now, after meeting with several politicians and bureaucrats more than three decades ago, I wrote in a research note that Washington “is too pessimistic a place for one person to follow.” That probably still applies.

When Uncle Sam gets involved, it’s impossible to predict an outcome or its magnitude. But one thing is certain — with rare exceptions, government involvement with an industry won’t be positive for the companies that are impacted.

Backlash From Washington

Now, a well-received recent book by Franklin Foer called World Without Mind details some nasty effects of the FANGs’ relentless growth. One that I’ve previously discussed in my diary is that every competitor who collects ad dollars is playing a less-than-zero-sum game with the FANGs.

As Foer writes in his book:

“Back in the seventies, Herbert Simon, the Nobel-winning economist, took these inchoate sentiments and explained them rigorously: ‘What information consumes is rather obvious. It consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention.'” — Franklin Foer, World Without Mind: The Existential Threat of Big Tech

I suggest reading this book if you own any FANG stocks, as the companies’ conflicts with competitors and regulators are now arising.

For example, Facebook under intense scrutiny for perhaps helping Russia manipulate the 2016 U.S. presidential election.

Similarly, the push by Amazon into food retailing, prescription-drug distribution and auto-parts sales is also attracting interest. These businesses are all very employment intensive, and competitors’ employees all have senators, House members and votes. Perhaps that’s why AMZN has quietly hit a correction mode and has pulled back some 11% from its high.

Now, it’s important to remember when analyzing government policies that there are typically three lags involved:

  • The Recognition Lag
  • The Action Lag
  • The Impact Lag

We are now at the Recognition Lag, but we could be moving into the Action Lag — and might see the Impact Lag in the fullness of time. If the FANGs are destined to face regulatory problems, we might only be in the early innings of such an issue.

It seems like politicians are slowly recognizing that there’s a problem with the FANGs. If so, new interpretations of antitrust laws (possibly coupled with new antitrust laws as well) seem like they’re on tap. London officials’ recent decision to ban Uber could well be the FANGs “canary in the coal mine,” as was Bear Stearns’ failure in March 2008.

I certainly don’t have all of the answers here, but I hope I’ve presented some good ways to frame and consider these issues.

Getting the answers right could be the investment issue of the next few years.

The Bottom Line

To summarize:

  • FANG valuations are elevated and incorporate the general perception that there’s little threat to the companies’ business models. However, the FANGs and other leading tech companies are likely to get caught in the government’s crosshairs in the years ahead.
  • The FANGs now face existential political and antitrust threats that could inhibit, slow down and/or make growth more expensive and less profitable.

Personally, I would avoid the FANGs until the issue of government intervention (which is likely only in the early innings) gets sorted out.

To paraphrase Dr. Evil,

“The billions that the consensus expects to make on FANGs may turn into millions.”

So, I’d use this week’s market strength to consider reducing exposure to Facebook, Amazon, Netflix and Alphabet/Google.

Position: Long QID, SQQQ (large); Short AMZN, FB, QQQ

Investors Seemingly Learned Nothing From History

“‘A bull market is like sex. It feels best just before it ends.'” – Warren Buffett

Excuse me for being redundant, but the following Jim Rogers quote that I posted yesterday underscores Mark Twain’s famous quote that “history doesn’t repeat itself, but it often rhymes”:

“When things are going right, we all need a 26-year-old. There’s nothing better than a 26-year-old in a great bull market especially in a bubble. They’re fearless. They don’t know. It will never end. They will tell you why it will never end. They know that it cannot end and will never end. So in the bull market, you’ve got to have a 26-year-old. But when they end you don’t want the 26-year-old around… they make a lot of money. They don’t know why they made money. So they don’t know why they lose money. They don’t know what happened. -Jim Rogers on Realvision

Back in 1997 I wrote this editorial in the Other Voices section of Barron’s that echoed Rogers’ recent quote.

In the difficult business of piling up a fortune everyone has an infallible strategy and a set of assumptions, technical and./or fundamental, that leads them to investment nirvana.

But it is never easy. The rules change and so do the players.

From my perch I steadily have listened to the irrational being rationalized as the bulls declare, with straight-faced confidence, that valuations in the 95% decile should be ignored because a synchronized global expansion will “earn out” from these extended metrics.

This confidence is expressed despite a plethora of possible adverse outcomes, particularly in the interconnected world in which we live.

The positive outcome of steadily expanding global growth coupled with low inflation and equally low interest rates may yet prove to become reality. Geopolitical friction may subside. Political partisanship in Washington, D.C, may succumb to cooperation, leading to the initiation of tax and regulatory reform and the repatriation of overseas corporate cash. The Orange Swan may wake up and reject the extreme influences of the Republican right. Trump may stop threatening a war with North Korea in a ping-pong of outrageous and provocative tweets. The rate of growth in real GDP may expand to 3% and we may be in another new paradigm of uninterrupted growth. S&P profits will grow at a rate of 8% annually, ad infinitum. Natural disasters will be a thing of the past and global warming concerns are nonsensical. The North Korean Rocket Man may be all hat and no cattle. The proliferation of ETFs, which in number now exceed the number of listed equity securities, and the ever-present quant strategies that are ignorant of fundamentals may not yield a “flash crash,” easily accommodating any selling waves. Every dip will continue to be bought. And interest rates and inflation may be in a permanent stage of adolescence.

But, I am blinded by a sense of history, and the belief that few of the conditions in the last paragraph are likely to be met.

In our flat, interconnected and network world, the odds favor less stability over more stability.

To this observer the markets’ dominos are exhibiting signs of falling around all over — in consumer packaged goods, in (T)FANG, in retail and elsewhere. Yet the selective memory of the talking heads in the business media emphasize the narrowing field of outperforming stocks (e.g., Nvidia Corp. (NVDA) and Deere & Co. (DE) ) that have been working, failing to see those falling dominoes around them.

Fear and Doubt Have Left Wall Street

The ever-present risk to the contrarian is that, over the short term, the past literally is repetitive and the crowd typically outsmarts the remnant. Tuesdays always follow Mondays and Wednesdays follow Tuesdays. But as we extend time cycles, history seems to move from repeating itself to rhyming with the past.

History undoubtedly teaches lessons about investment, but it does not say which lesson to apply when. “Find value, always” is as good a precept as any, but value is subjective and its definition is liable to change. In highly speculative markets, value means, to most, “it is going up.”

Stay abreast because in bull markets there is rarely a clear demarcation between progress and fantasy. I remain of the strong belief that we are in a Bull Market in Complacency that likely ends poorly and that has reduced the upside and has expanded the potential market downside.

To the bullish cabal the market “feels” great now (for, as Warren Buffett says, it is because, like sex, if feels best at or near the end), but after an eight-year bull market it may be time to consider the investment contrary. As James Surowiecki wrote in “The Wisdom of Crowds”:

“Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise.”

Investment returns likely have been pulled forward by central bank liquidity, low interest rates and passive investing. However, over the next five years returns may be substandard at best, but more likely, negative. At worse, we face an incipient bear market.

As expressed in yesterday’s opener, the nature of and players in the investment business have changed. This helps to explain the Teflon nature of the S&P 500 Index.

But as Grandma Koufax used to say, “my matzah brei doesn’t grow to the sky,” and every day we move closer to a Minsky Moment.

The salutary environment perceived by many today may be transitory and weak in foundation.

The potential political, geopolitical, economic and market outcomes are many, and a clear and market-friendly path is not certain.

Bottom Line

The name of the game is money. It was Lord Keynes who first saw that the handling of it is a game. Most discussions of money and investing speak only of economics and statistics, but that’s only a part of the game. The other part is people, individually and together, the emotional investor and the irrational crowd.

And it again might be the market scene that is often (as it was in 2000 and 2007) seen only in kids’ eyes or in the eyes of older investors who behave like 26-year-olds at or near the end of every significant bull market cycle:

“‘See, see,’ said the Great Winfield. ‘The flow of the seasons ! Life begins again! It’s marvelous! It’s like having a son! My boys! My kids!'” -Adam Smith, “The Money Game”

Do some reading over the weekend as it appears that the only thing many investors have learned from history is that they haven’t learned from history.

The Scent Of Group Stink Is As Strong As In 2000 & 2007

By Doug Kass

* In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are? –Kass Diary

Another provocative missile launched by North Korea and another apparent terrorist attack in London, England, are, once again, overnight and early-morning features of our reality as investors and as citizens.

The S&P futures fell a meaningless four handles from the time of the events, indicating even the machines and algorithms couldn’t care less about much of anything impacting equities!

“Nothing succeeds like success.” –Alexandre Dumas

“Group stink” runs thick these days, as Dumas, a 19th century French writer, noted.

To this observer, our markets’ resilience is all too reminiscent of former Citigroup CEO Chuck Prince, who kept on dancing because the music was still playing.

To me, the indomitable market is more a function of lemming-like behavior in a market, economy and profit setting that is far less secure and strong than many subscribe to.

Group stink is a powerful force in the markets, especially when the machines and algorithms and the ever-constant inflows into popular passive funds and ETFs dominate the investment backdrop. These factors exacerbate short-term trends and may contribute to the perpetuation of an ill-conceived perception of a daunting and inexhaustible virtuous market cycle.

Golfer Tom Watson once wrote, “Sometimes thinking too much can destroy your momentum.” And most investors and traders, in a reactionary mode, seem to prefer to adopt such a strategy. But, I vividly remember the positive and incessant price momentum in early 2000 and late 2007 that appeared impossible to divert until, all at once, an important change in price trend occurred, seemingly overnight. The market consequences were ugly.

There is now a near-universality of view that stocks will move higher and that any dip is to be bought. Even the threat of a potential nuclear attack now brings on a market yawn.

The one-way action and lack of volatility have resulted in some of the greatest hedge-hoggers giving back tons of money (e.g., Seth Klarman’s Baupost) and/or closing down completely (as chronicled here and here.)

If some of the greatest minds can’t deliver alpha, we possibly should consider that things have gone awry and think about accepting something that Grandma Koufax used to say: “Dougie, something is rotten in Flatbush.”

As I recently wrote in “The Market Band Plays On, But You Won’t Catch Me Humming Its Mindless Tune”:

Throughout the last six months I have expressed the view that the S&P 500 Index was in the process of making an important top and that risk was being underpriced.

Throughout the last month I have grown more bearish than I have been in several years. That negative outlook is reflected in the extreme condition that, beyond indirect holdings in my hedge fund, I am in the unique position of owning no individual equities in my personal account.

That’s a statement of conviction in view.

In “Dark Conditions Totally Eclipse Anything We’ve Seen in Decades” I outlined my concerns:

* Markets: The dominance and popularity of passive investing — most notably ETFs and volatility-trending and risk-parity strategies — are relatively new to the market’s picture. I contend that the lack of price discovery from these influences may have spoiled stock charts and partially ruined the ability of some to rely on technical analysis.

* Valuations: Most valuation metrics are at least in the 95% decile, an occurrence that typically has coincided over history with the end of maturing bull markets or in the ninth inning of speculative eras.

* Corporate Profits: With the largest spread between GAAP and non-GAAP earnings in history, never has such liberal use of accounting standards been accepted by the masses of market participants.

* Central Banks: With $19 trillion ($1.5 trillion added in 2017 alone) in central bank assets, monetary authorities never have had such influence as they have in the past few years. Like quantitative strategies, the outsize role of central banks is new and its impact is great. It also has diminished price discovery. As I recently wrote, the “Debt Opioid Addiction Could Turn Ugly Fast.”

* Economic: As the years go by it is increasingly clear that, despite the unprecedented role of central bankers reducing interest rates, secular global growth prospects have been reduced relative to the last several decades. Moreover, The Screwflation of the Middle Class has resulted in an income and wealth gap that has not improved over the last three to five years.

* Politics: The Orange Swan is a new factor, as articulated here and here. Like him or hate him, President Trump is unlike any POTUS in history. Another aspect of politics that is different is the degree of animus in Washington, D.C. There has never been such partisanship. Ever.

* Geopolitical: Markets have never been as exposed to such geopolitical acts and risks. Specifically, it has been 53 years since we faced a nuclear risk.

Respectfully, unlike some others, I belief the cause of the recent market indigestion — and possible future market drawdowns — likely has very little to do with seasonality or the month of August, nor will it likely be a function of the historical weakness often seen in September and October.

The market’s issues run deeper and my concerns are based on both technical and fundamental grounds.

They have to do in part with the uncertainty surrounding various political, geopolitical, economic, market and monetary policy issues, many of them with potentially adverse outcomes. At least to me, the macroeconomic does impact Bristol-Myers Squibb (BMY) and Amazon (AMZN) and General Motors (GM) .

My concerns also have to do with the message of the bond market (this morning, the yield on the 10-year U.S. note is down by nearly five basis points to 2.11%), which indicates to me that the trajectory of domestic GDP growth and corporate profits is likely to disappoint for the fourth consecutive year.

Further adding to my concerns is the role of passive investing as the dominant influence on the markets. ETFs that rebalance daily and quantitative strategies such as volatility trending and risk parity exacerbate short-term moves and are, too often, the tail that wag the market dog. As I have asked, if the machines decide to sell, who is left to buy?

In part, these strategies have elevated valuation metrics above the 95% decile, alarming far too few market participants. Unfortunately, markets that are priced to perfection are vulnerable to exogenous shocks such as an Orange Swan, a missile aimed at Japan, a severe hurricane or a monetary policy mistake.

Meanwhile, there were technical breaks developing, starting with the outsize performance gains from the anointed FANG stocks. These conditions also were generally ignored by the bullish cabal.

Group Stink has ruled the day — a condition often seen historically at or near market tops.

As I have written, the thing to fear is the lack of fear itself.

Few commentators and talking heads in the business media, many of whom counseled the lemmings who stood strong in equities in both early 2000 and late 2007, have been willful participants in the Bull Market in Complacency and have contributed to the potential of a Minsky Moment.

My bearishness also reflects my view that the business cycle is mature and that there are Peaks Everywhere. Most notably, low interest rates have pulled forward sales in various sectors. Industries such as housing, where affordability again has been stretched, and autos, where the cycle has peaked, are samples of my concerns. Meanwhile, the retail industry has been eviscerated, with ugly consequences for real estate and employment, by a Dark Star named Amazon, a recent target of my disaffection.

Nearly three weeks ago on Aug. 10, I wrote “To Heck With the Crowd, I Remain Manifestly Bearish,” which underscored my multiple concerns (as they specifically relate to North Korea, see my boldfaced first question below that gnaws at me every morning).

It stated in part:

“I won’t tell you that the world matters nothing, or the world’s voice, or the voice of society. They matter a good deal. They matter far too much. But there are moments when one has to choose between living one’s own life, fully, entirely, completely – or dragging out some false, shallow, degrading existence that the world in its hypocrisy demands. You have that moment now. Choose!” –Oscar Wilde

Sometimes you need to sit alone on the floor in a quiet room in order to hear your own voice and not let it drown in the noise of others.

I am sitting on that floor now, and thinking — and shorting more.

Too many traders and investors think they know what will happen in the markets. They establish one, specific price target, usually clothed in certainty.

But the most successful traders and investors work with probabilities of outcomes.

I continue to maintain a historically high net short exposure because I believe we face numerous political, geopolitical, economic and market outcomes that could end badly — very badly.

After yesterday’s “fire and fury” (“TV-tough”) statement by President Trump regarding North Korea, I repeated five of my concerning questions:

* In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?

* With the G-8’s geopolitical coordination at an all-time low, how slow and inept will the reaction be if the wheels do come off?

* Remember when the big argument in favor of President Trump was that he was a dealmaker who knew how to get things done? That was when he was doing real estate deals. Now he has to deal with 535 other politically partisan legislators in Congress on their own real estate turf.

* Does the administration have the depth of experience, understand the extent of the legwork and organization required for passing legislation, or have a coherent idea or shared vision of what it wants to achieve and what problems it means to solve?

* If President Trump can’t easily put through a health care package, what does that mean for more difficult regulatory reforms and his tax and fiscal policy?

I then repeated my top 10 market concerns.

Bottom Line

“I wanted a perfect ending. Now I’ve learned, the hard way, that some poems don’t rhyme, and some stories don’t have a clear beginning, middle, and end. Life is about not knowing, having to change, taking the moment and making the best of it, without knowing what’s going to happen next. Delicious Ambiguity.” –Gilda Radner

Market views are like noses — everyone seems to have one!

To me, investors are complacent, numerous outcomes of all breeds (many of them adverse) seem possible, the business cycle is mature, machines and algorithms have undue market influence (and if the movie goes into reverse, selling rather than buying remains an existential market threat), valuations are at an historical extreme and thus make markets vulnerable to external shocks, and the market’s technical condition has been deteriorating for months.

And, in 2017, our interconnected, flat and networked world is unsafe on numerous fronts.

And, as I have expressed, after a lengthy period of quiet, volatility and uncertainty are likely to be great again.I plan to continue to err on the side of conservatism and I continue to maintain a skeptical view of the market’s reward compared to risk and the limited upside relative to downside.

But, as described in “Fearlessly Make Uncertainty and Volatility Your Friends!,” I also intend to capture alpha by being opportunistic, both from a trading and investing perspective.


As it is said, we live in interesting (and challenging) times, influenced by a set of relatively new circumstances and actors that have led to a Bull Market in Complacency — and the risk of a Minksy Moment — in which numerous outcomes, many of them adverse, are possible.

Today, as I did in early 2000 and in the late summer of 2007, I pay heed to Woody Allen, who said:

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”

Be alert, consider the contrary and think about sitting out some of the market’s dances, perhaps before your legs are chopped off.

Riding The Slide: What The Next Bear Market Looks Like

Editor’s Note: All of us at Real Investment Advice are proud to welcome Daniel Nevins, CFA to our growing list of outstanding contributors. He has invested professionally for 30-years, including more than a decade at both J.P. Morgan and SEI Investments. He is perhaps best known for his behavioral economics research, which was included in the curriculum for the Chartered Financial Analyst® program and earned him recognition as one of the founders of goals-based investing. He has an economics degree from the Wharton School of Business and a degree from the University of Pennsylvania’s engineering school. 

Even as the Fed’s decision makers are beginning to worry less about recession and more about bubbly stock prices, we’re not yet moved by their attempts to curb the market’s enthusiasm. After all, the fed funds rate sits barely above 1%, which not too long ago qualified as a five-decade low. And other indicators, besides interest rates, aren’t exactly predicting the next bear, either. Inflation is subdued, credit spreads are tight, banks are mostly lending freely and the economy is growing, albeit slowly. It just doesn’t feel as though we’re close to a major market peak.

All that being said, we’re not so much about feelings as we are about delving into history (nerds that we are) and seeing if there’s anything we can learn. Let’s look at the last 90 years to see if any bear markets began under similar conditions to those today.

We’ll consider thirteen bears, as listed in the table below. (Our list may be different to yours, mainly because we use Robert Shiller’s monthly average S&P 500 prices, instead of daily prices, but also because we reset the cycle whenever the market falls 20% from a peak or rises 20% from a trough.)

Next we narrow the list by excluding bears that began during recessions, because we don’t think the economy is recessing as I write this (or recessing imminently—see here.) That removes the first three bears—those that began in 1929, 1930 and 1932. Every other bear began as the economy was expanding, which explains why market peaks are so difficult to predict.

We also exclude the bear that crossed the 20% threshold in June 1940 and can’t be separated from geopolitics. Hopefully, modern geopolitical risks won’t explode as they did then, but we can always return to the “WWII bear” if WWIII breaks out (presuming we’re alive and blogging).

After the exclusions, nine bears remain. We examine each one to determine how many were predicted by rising inflation, one of the strongest bear-market indicators. Rising inflation erodes purchasing power, invites monetary restraint and unsettles both lenders and investors. Judging by the next chart, it helped trigger at least seven of the nine bears:

The chart shows seven bears emerging from an inflation “shock” of 3% or more (referring to an increase from twelve months before a market peak to when stocks reached the bear market threshold of –20%). In each of those cases, it seems pointless to attempt to draw parallels to today. Inflation is currently below 2% and down almost a percent from January. Without an inflation shock in sight, we shouldn’t rely on the seven “inflation bears” to predict the future.

That leaves two bears we haven’t yet considered. In one of the two—the bear that began in August 2000—inflation contributed to the market’s reversal, but monetary policy and credit conditions were more telling. Policy rates rose, credit spreads widened and bank lending standards tightened—all before the market peak. Market conditions at that time were quite different to those today, as shown in the table below (which also includes the October 2007 peak for added context):

In other words, twelve of the original thirteen bears emerged from some combination of recession, inflation, world war, monetary tightening, and troubles in credit markets. In each case, market conditions were uglier than they appear now. The twelve bears tell us to be optimistic—they’ll continue to hibernate until conditions worsen. But we’ve yet to consider the 1962 bear, which finally supplies a potential match for today.

The lead-up to the 1962 bear looks eerily similar to 2017. Commentators called it the Kennedy Slide. Before the Slide, the market hadn’t fallen 20% on a month-average basis since 1946. And the bull gathered speed after JFK won the presidency. Sound familiar? Here’s a chart comparing the S&P 500 (SPY) in the three years after Kennedy’s election to the first ten months after Donald Trump’s election (there’s a joke somewhere in the respective trajectories, but we would like to keep our G rating):


The Kennedy Slide offers a reasonable guide to how a future bear could develop if key indicators remain benign. Consider that the Slide defied four fundamentals you wouldn’t normally associate with falling stock prices:

  • Inflation was subdued, peaking at 1.3%.
  • Monetary policy was close to neutral, with the discount rate at 3%.
  • Growth was strong, reaching 7.4% in Q1 1962 and 4.4% in Q2, after Q4/Q4 growth of 6.4% in 1961.
  • Credit spreads were testing 18-month lows of just above 1% (for the Moody’s Baa Corporate versus the 10-year Treasury).

Surely those cozy fundamentals explain the market’s rocket-fast recovery. Stocks reached a new all-time high in September 1963, just 21 months after the prior high. That’s the shortest period on record from one all-time high through a bear market to the next all-time high—faster even than the recovery from the 1987 crash.

And what might 1962 tell us about the future?

Well, as of now, inflation, monetary policy, growth and credit are only marginally less cozy than they were then. If that continues, we would bet on a rapid recovery from a Trump Slide, should one occur. But it’s important for inflation, monetary policy, growth and credit to remain nonthreatening. Any of those fundamentals could change rapidly, and they tend to correlate. (We expect monetary policy to be a particular risk within a couple of years, as discussed here.) Should the four fundamentals deteriorate, we would ignore the 1962 bear and turn to other bears for clues about what happens next. Considering the unprecedented period of monetary stimulus, we would then expect an ill-tempered bear, one that might resemble the bears that began in 1930, 2000 and 2007.

When we pass the next market peak, in other words, four key fundamentals should tell us whether we’ll “ride the slide” or experience something much worse.