Democrats should start worrying about the level of debt and the increasing deficit. I previously discussed this issue when President Obama held the White House, when Marshall Auerback, via the Nation, wrote:

“Delivering on big progressive ideas like Medicare for All and the Green New Deal will never happen until Democrats get over their fear of red ink.”

While that article was a long and winding mess of convoluted ideas, the following excerpt was vital.

“In an environment increasingly characterized by slowing global economic growth, businesses are understandably hesitant to invest in a way that creates high-quality, high-paying jobs for the bulk of the domestic workforce. The much-vaunted Trump corporate ‘tax reform’ may have been sold to the American public on that basis, but corporations have largely used their tax cut bonanza to engage in share buybacks, which fatten executive compensation but have done nothing for the rest of us. At the same time, private households still face constraints on their consumption because of stagnant wages, rising health care costs, declining job security, poorer employment benefits, and rising debt levels.

Instead of solving these problems, the reliance on extraordinary monetary policy from the Federal Reserve via programs such as quantitative easing has exacerbated them. In contrast to properly targeted fiscal spending, the Federal Reserve’s misguided monetary policies have fueled additional financial speculation and asset inflation in stock markets and real estate, which has made housing even less affordable for the average American.”

While there is truth in that statement, and it is the same issue I have railed against previously in this blog, Mr. Auerback’s solution was seemingly simple.

“Democrats should embrace the ‘extremist’ spirit of Goldwater and eschew fiscal timidity (which, in any case, is based on faulty economics). After all, Republicans do it when it suits their legislative agenda. Likewise, Democrats should go big with deficits—as long as they are used for the transformative programs that progressives have long talked about and now have the chance to deliver.”

As I noted then, such a solution was essentially the adoption of Modern Monetary Theory (MMT), which, as discussed previously, is the assumption debt and deficits “don’t matter” as long as there is no inflation.

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy, which means government spending is never revenue constrained, but rather only limited by inflation.” – Kevin Muir

However, fast forward to the present, we tried MMT; the Democrats went big with debts and deficits and funded social programs, and the result was a massive spike in inflation and no actual increase in broad economic prosperity.

So, what went wrong?

The Non-Solution

The problem with most Democratic spending ideas on social programs and welfare, like free healthcare or college, is the lack of a crucial ingredient. That ingredient is a “return on investment.” Dr. Woody Brock previously addressed this point in his book “American Gridlock;”

“Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.“

Let me be clear. There is no disagreement about the need for government spending. The debate is about the abuse and waste of it.

John Maynard Keynes’ was correct in his theory that for government “deficit” spending to be effective, the “payback” from investments made through debt must yield a higher rate of return than the debt used to fund it.

Currently, the U.S. is “Country A.” 

The problem with the more socialistic programs that Democrats continue to pursue with deficit spending is that it exacerbates the problem. The Center On Budget & Policy Priorities data can help visualize the issue.

As of the latest annual data, through the end of Q2-2023, the Government spent $6.3 Trillion, of which $5.3 Trillion went to mandatory expenses. In other words, it currently requires 113% of every $1 of revenue to pay for social welfare and interest on the debt. Everything else must come from debt issuance.

This is why debt issuance has surged since 2008 when Congress quit using the budgeting process to allow for rampant spending.

Of course, given the massive surge in spending, revenues cannot keep up the pace, leading to a rapid increase in debt issuance and a trending deficit.

However, while Democrats keep pushing for more socialistic programs, which garners votes in election cycles, they are now faced with a problem that may be their undoing.

Debt Diverts Productive Capital

Ben Ritz for the WSJ recently penned:

“Deficits are undermining the Biden economy. In the past year, the real federal budget deficit more than doubled, from $933 billion to $2 trillion. Democrats rightly argued that spending borrowed money was a critical economic support during the Covid pandemic. But the unemployment rate the over past year has been consistently lower than any point since the 1950s.

Economists, even those on the far left who subscribe to ‘modern monetary theory,’ agree that increasing deficits in a tight labor market fuels inflation. Voters’ frustrations with inflation and the interest-rate hikes implemented to bring it under control exceed their appreciation for low unemployment, fueling disapproval of President Biden’s economic record. Deficit reduction is more important than it has been at any other time in the 21st century.”

The problem with the analysis is that while the “unemployment rate” may be low, economic disparity is high. While the massive surge in pandemic-era spending boosted economic inflation, it also created an enormous rise in inflation, unsurprisingly. That inflation surge spurred the Fed to aggressively hike rates on the short end of the yield curve, while inflation and economic growth pushed long-term rates higher.

Subsequently, higher inflation and higher borrowing costs priced out wage increases with substantially higher living costs. Unsurprisingly, the net worth of the bottom 90% of Americans has failed to improve.

The problem for the Democrats is that continuing to push socialistic programs only makes the situation worse. Yes, more “free money” to individuals sounds excellent in theory, but prices ultimately increase more. The problem is exacerbated as non-productive debt erodes economic growth, and more debt diverts productive capital into interest payments.

“Annual interest payments are already at their highest level as a percentage of gross domestic product since the 1990s. By 2028 the government is projected to spend more than $1 trillion on interest payments each year—more than it spends on Medicaid or national defense. Worse, the U.S. may be entering a vicious circle whereby higher deficits increase debt and fuel inflation, which the Federal Reserve must combat by raising interest rates, causing debt-service costs to balloon further.” – Ben Ritz

While the Democrats continue to push for more social spending programs, we have potentially reached the point where that may be no longer feasible. I agree with Ben’s view that it may be time for both Democrats and Republicans to start taking steps to restore fiscal responsibility in Washington.

The average American family is no longer supportive of new progressive policies when they believe we can’t even pay for the promises already made.

Of course, if the economy slips into a recession before the 2024 election, we could see a political rout in Washington, D.C.

The Chicago Fed National Activity Index (CFNAI) is arguably one of the most important and overlooked economic indicators. Each month, economists, the media, and investors pour over various mainstream economic indicators, from GDP to employment and inflation, to determine what markets will likely do next.

While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, the most crucial statistic, in my opinion, is the CFNAI. Investors and the press mostly ignore it, but the CFNAI is a composite index of 85 sub-components, giving a broad overview of overall economic activity in the U.S.

Since the beginning of this year, the markets ran up sharply over into July as the Federal Reserve again intervened in the markets to bail out regional banks. Then, even as the market pulled back this summer, economic growth accelerated in the 3rd quarter, according to the headlines, which should translate into a resurgence of corporate earnings. However, if recent CFNAI readings are any indication, investors may want to alter their growth assumptions heading into next year.

While most economic data points are backward-looking statistics, like GDP, the CFNAI is a forward-looking metric that indicates how the economy will likely look in the coming months.

Notably, that data does not support the recent economic report from the Bureau Of Economic Analysis (BEA), which showed the economy expanded by 4.9% in Q3.

So, what is the CFNAI telling us that is different than the BEA economic report?

Breaking Down The “Most Important Number”

Understanding the message the index is designed to deliver is critical. From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.“

The overall index is broken down into four major sub-categories, which cover:

• Production & Income
• Employment, Unemployment & Hours
• Personal Consumption & Housing
• Sales, Orders & Inventories

To better grasp these four critical sub-components and their predictive capability, I have constructed a 4-panel chart. I have compared the CFNAI sub-components to the four most common economic reports of Industrial Production, Employment, Housing Starts, and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI, I used an annual percentage change for these four components.

The correlation between the CFNAI sub-components and the underlying major economic reports is high. This is why, even though this indicator gets very little attention, it represents the broader economy. The CFNAI is not confirming the mainstream view of an “economic resurgence” that will drive earnings growth into next year.

The CFNAI is also essential to our RIA Economic Output Composite Index (EOCI). The EOCI is an even broader composition of data points, including Federal Reserve regional activity indices, the Chicago PMI, ISM, the National Federation of Independent Business Surveys, and the Leading Economic Index. The EOCI further confirms that “hopes” of an immediate rebound in economic activity are unlikely. To wit:

“As discussed in “Signs, Signs, Everywhere Signs,” numerous measures suggest a recession is forthcoming. However, that recession has yet to reveal itself. Such has led to a fierce debate between the bulls and the bears. The bears contend that a recession is still coming, while the bulls are betting more heavily on a “no landing” scenario or, instead, avoiding a recession. Even the Federal Reserve is no longer expecting a recession.

But how is a “no recession” outcome possible amid the most aggressive rate hiking campaign in history, deeply inverted yield curves, and other measures warning of its inevitability?“

There are a couple of essential points to note in this very long-term chart.

1. Economic contractions tend to reverse fairly frequently from high peaks, and those contractions tend to revert towards the 30-reading on the chart. Recessions are always present with sustained readings below the 30 level.
2. The financial market is generally correct in price as weaker economic data weighs on market outlooks. 

Currently, the EOCI index suggests more contraction will come in the coming months, which will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading into 2024.

It’s In The Diffusion

The Chicago Fed also provides a breakdown of the change in the underlying 85 components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components gives us a better understanding of the broader changes inside the index itself.

There are two points of consideration:

1. When the diffusion index dips below zero, it coincides with weak economic growth and outright recessions. 
2. The S&P 500 has a history of corrections and outright bear markets, corresponding with negative readings in the diffusion index.

The second point should not be surprising, as the stock market reflects economic growth. Both the EOCI index above and the CFNAI below correlate to the annual rate of change in the S&P 500. Again, the correlation should not be surprising. (The monthly CFNAI data is very volatile, so we use a 6-month average to smooth the data.)

How good of a correlation is it? The r-squared is 50% between the annual rate of change for the S&P 500 and the 6-month average of the CFNAI index. More importantly, the CFNAI suggests the S&P 500 should be trading lower to correspond with the economic data. Throughout its history, the CFNAI tends to be right more often than market players.

Investors should also be concerned about the current level of consumer confidence readings.

Not So Confident

The chart below is our consumer confidence composite index. It combines the University of Michigan and the Conference Board’s sentiment readings into one index. The shaded areas are when the composite index exceeds 100, corresponding with rising asset markets.

While that index has declined over the last 18 months, it remains elevated above previous recessionary levels, suggesting the economy continues to muddle along. The issue is the divergence between “consumer” confidence and “CEO’s.” The question is, who should we pay attention to?

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company that has the best view of the economic landscape. Sales, prices, managing inventory, dealing with collections, paying bills, tells them what they need to know about the actual economy?”

CEO confidence leads consumer confidence by a wide margin. Such lures bullish investors, and the media, into believing that CEO’s don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

“I’m sorry, we think you are great, but I have to let you go.” 

Despite the recent uptick in CEO confidence since October, which corresponded with strong equity market performance, confidence is hovering around pre-recessionary levels. Notably, CEO confidence is not uncommon to tick higher just before the recession is announced.

The CFNAI also tells the same story: significant consumer confidence divergences eventually “catch down” to the underlying index.

This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead if history guides the future.

Conclusion

While the media hopes for a “no recession” scenario, the data tells us an important story.

Notably, the historical data of the CFNAI and its relationship to the stock market have included all Federal Reserve activity.

The CFNAI and EOCI incorporate the impact of monetary policy on the economy in both past and leading indicators. Such is why investors should hedge risk to some degree in portfolios, as the data still suggests weaker than anticipated economic growth. The current trend of the various economic data points on a broad scale is not showing indications of recovery but of a longer-than-expected recession and recovery. 

Economically speaking, such weak levels of economic growth do not support more robust employment or higher wages. Instead, we should expect that 2024 could be a year where corporate earnings and profits disappoint investors as economic weakness continues.

In a recent post, I discussed the “3-stages of a bear market.”  To wit:

“Yes, the market will rally, and likely substantially so.  But, let me remind 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.

However, the “bear market” is only one-half of a vastly more important concept – the “Full Market Cycle.”

The Full Market Cycle

Over the last decade, the media has focused on the bull market, making an assumption that the current trend would last indefinitely. However, throughout history, bull market cycles make up on one-half of the “full market” cycle. During every “bull market” cycle, the market and economy build up excesses, which must ultimately be reversed through a market reversion and economic recession. In the other words, as Sir Issac Newton discovered:

“What goes up, must come down.” 

The chart below shows the full market cycles over time. Since the current “full market” cycle is yet to be completed, I have drawn a long-term trend line with the most logical completion point of the current cycle.

[Note: I am not stating the markets are about to crash to the 1600 level on the S&P 500. I am simply showing where the current uptrend line intersects with the price. The longer that it takes for the markets to mean revert, the higher the intersection point will be. Furthermore, the 1600 level is not out of the question either. Famed investor Jack Bogle stated that over the next decade we are likely to see two more 50% declines.  A 50% decline from the all-time highs would put the market at 1600.]

As I have often stated, I am not bullish or bearish. My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis, but reduces the possibility of catastrophic losses, which wipe out years of growth.

Nobody tends to believe that philosophy until the markets wipe about 30% of portfolio values in a month.

The 4-Phases

AlphaTrends previously put together an excellent diagram laying out the 4-phases of the full-market cycle. To wit:

“Is it possible to time the market cycle to capture big gains? Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff. The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

So, the question to answer, obviously, is:

“Where are we now?”

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.

1992-2003

The accumulation phase, following the 1991 recessionary environment, was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999. As I noted previously:

“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nation’s pension funds to own equities and the repeal of Glass-Steagall, which unleashed Wall Street upon a nation of unsuspecting investors.

The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough ‘legitimate’ deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”

The distribution phase became evident in early-2000 as stocks began to struggle.

Names like Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others, are “ghosts of the past.” Importantly, they are the relics of an era the majority of investors in the market today are unaware of, but were the poster children for the “greed and excess” of the preceding bull market frenzy.

As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future. 

Then, came the decline.

2003-2009

Following the “dot.com” crash, investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns, and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27-minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

During the mark-up phase, investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”

Once again, during the distribution phase of the market, the analysts, media, Wall Street, and rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.” 

They were disastrously wrong.

Sound familiar?

2009-Present

So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.

Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.”

Despite a year-long distribution in the market, the same messages seen at previous market peaks were steadily hitting the headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”

Well, as we warned more than once, all that was required was an “exogenous” event, which would spark a credit-event in an overly leveraged, overly extended, and overly bullish market. The “virus” was that exogenous event.

Lost And Found

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, fueled by Central Bank liquidity, it is understandable why mainstream analysis believed the markets could only go higher. What was always a concern to us was the rather cavalier attitude they took about the risk.

“Sure, a correction will eventually come, but that is just part of the deal.”

As we repeatedly warned, what gets lost during bull cycles, and is always found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline. It isn’t just the loss of financial wealth, but also the loss of employment, defaults, and bankruptcies caused by the coincident recession.

This is the story told by the S&P 500 inflation-adjusted total return index. The chart shows all of the measurement lines for all the previous bull and bear markets, along with the number of years required to get back to even.

What you should notice is that in many cases bear markets wiped out essentially all or a very substantial portion of the previous bull market advance.

There are many signs suggesting the current Wyckoff cycle has entered into its fourth, and final stage. Whether, or not, the current decline phase is complete, is the question we are all working on answering now.

Bear market cycles are rarely ended in a month. While there is a lot of “hope” the Fed’s flood of liquidity can arrest the market decline, there is still a tremendous amount of economic damage to contend with over the months to come.

In the end, it does not matter IF you are “bullish” or “bearish.” What matters, in terms of achieving long-term investment success, is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.

Last week, we saw the first glimpse of the employment fallout caused by the shutdown of the economy due to the virus. To wit:

“On Thursday, initial jobless claims jumped by 3.3 million. This was the single largest jump in claims ever on record. The chart below shows the 4-week average to give a better scale.”

This number will be MUCH worse when claims are reported later this morning, as many individuals were slow to file claims, didn’t know how, and states were slow to report them.

The importance is that unemployment rates in the U.S. are about to spike to levels not seen since the “Great Depression.” Based on the number of claims being filed, we can estimate that unemployment will jump to 15-20% over the next quarter as economic growth slides 8%, or more. (I am probably overly optimistic.)

The erosion in employment will lead to a sharp deceleration in economic and consumer confidence, as was seen Tuesday in the release of the Conference Board’s consumer confidence index, which plunged from 132.6 to 120 in March.

This is a critical point. Consumer confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their jobs.

The chart below is our “composite” confidence index, which combines several confidence surveys into one measure. Notice that during each of the previous two bear market cycles, confidence dropped by an average of 58 points.

With consumer confidence just starting its reversion from high levels, it suggests that as job losses rise, confidence will slide further, putting further pressure on asset prices. Another way to analyze confidence data is to look at the composite consumer expectations index minus the current situation index in the reports.

Similarly, given we have only started the reversion process, bear markets end when deviations reverse. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than before the “dot.com” crash.

If you are betting on a fast economic recovery, I wouldn’t.

There is a fairly predictable cycle, starting with CEO’s moving to protect profitability, which gets worked through until exhaustion is reached.

As unemployment rises, we are going to begin to see the faults in the previous employment numbers that I have repeatedly warned about over the last 18-months. To wit:

“There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear. But while most economists focus at employment data from one month to the next for clues as to the strength of the economy, it is the ‘trend’ of the data, which is far more important to understand.”

That “trend” of employment data has been turning negative since President Trump was elected, which warned the economy was actually substantially weaker than headlines suggested. More than once, we warned that an “unexpected exogenous event” would exposure the soft-underbelly of the economy.

The virus was just such an event.

While many economists and media personalities are expecting a “V”-shaped recovery as soon as the virus passes, the employment data suggests an entirely different outcome.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current cycle peaked at 2.2% in 2015, and has been on a steady decline ever since. At 1.3%, which predated the virus, it was the lowest level ever preceding a recessionary event. All that was needed was an “event” to start the dominoes falling. When we see the first round of unemployment data, we are likely to test the lows seen during the financial crisis confirming a recession has started. 

No Recession In 2020?

It is worth noting that NO mainstream economists, or mainstream media, were predicting a recession in 2020. However, as we noted in 2019, the inversion of the “yield curve,” predicted exactly that outcome.

“To CNBC’s point, based on this lagging, and currently unrevised, economic data, there is ‘NO recession in sight,’ so you should be long equities, right?

Which indicator should you follow? The yield curve is an easy answer.

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.’)”

I have dated a few of the key points of the “inversion of the curve.” As of today, the yield-curve is now fully un-inverted, denoting a recession has started.

While recent employment reports were slightly above expectations, the annual rate of growth has been slowing. The 3-month average of the seasonally-adjusted employment report, also confirms that employment was already in a precarious position and too weak to absorb a significant shock. (The 3-month average smooths out some of the volatility.)

What we will see in the next several employment reports are vastly negative numbers as the economy unwinds.

Lastly, while the BLS continually adjusts and fiddles with the data to mathematically adjust for seasonal variations, the purpose of the entire process is to smooth volatile monthly data into a more normalized trend. The problem, of course, with manipulating data through mathematical adjustments, revisions, and tweaks, is the risk of contamination of bias.

We previously proposed a much simpler method to use for smoothing volatile monthly data using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the BLS employment data deviates from the 12-month average, or rather “overstates” the reality. However, as we will now see to be the case, the BLS data will rapidly reconnect with 12-month average as reality emerges.

Sometimes, “simpler” gives us a better understanding of the data.

Importantly, there is one aspect to all the charts above which remains constant. No matter how you choose to look at the data, peaks in employment growth occur prior to economic contractions, rather than an acceleration of growth. 

“Okay Boomer”

Just as “baby boomers” were finally getting back to the position of being able to retire following the 2008 crash, the “bear market” has once again put those dreams on hold. Of course, there were already more individuals over the age of 55, as a percentage of that age group, in the workforce than at anytime in the last 50-years. However, we are likely going to see a very sharp drop in those numbers as “forced retirement” will surge.

The group that will to be hit the hardest are those between 25-54 years of age. With more than 15-million restaurant workers being terminated, along with retail, clerical, leisure, and hospitality workers, the damage to this demographic will be the heaviest.

There is a decent correlation between surges in the unemployment rate and the decline in the labor-force participation rate of the 25-54 age group. Given the expectation of a 15%, or greater, unemployment rate, the damage to this particular age group is going to be significant.

Unfortunately, the prime working-age group of labor force participants had only just returned to pre-2008 levels, and the same levels seen previously in 1988. Unfortunately, it may be another decade before we see those employment levels again.

Why This Matters

The employment impact is going to felt for far longer, and will be far deeper, than the majority of the mainstream media and economists expect. This is because they are still viewing this as a “singular” problem of a transitory virus.

It isn’t.

The virus was simply the catalyst which started the unwind of a decade-long period of debt accumulation and speculative excesses. Businesses, both small and large, will now go through a period of “culling the herd,” to lower operating costs and maintain profitability.

There are many businesses that will close, and never reopen. Most others will cut employment down to the bone and will be very slow to rehire as the economy begins to recover. Most importantly, wage growth was already on the decline, and will be cut deeply in the months to come.

Lower wage growth, unemployment, and a collapse in consumer confidence is going to increase the depth and duration of the recession over the months to come. The contraction in consumption will further reduce revenues and earnings for businesses which will require a deeper revaluation of asset prices. 

I just want to leave you with a statement I made previously:

In last Tuesday’s Technically Speaking post, I stated:

“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.”

Chart Updated Through Monday

Not surprisingly, as we noted in this weekend’s newsletter, the headlines from the mainstream media aligned with our expectations:

So, is the bear market over? 

Are the bulls now back in charge?

Honestly, no one knows for certain. However, there are 5-questions that “Market Bulls” need to answer if the current rally is to be sustained.

These questions are not entirely technical, but since “technical analysis” is simply the visualization of market psychology, how you answer the questions will ultimately be reflected by the price dynamics of the market.

Let’s get to work.

Employment

Employment is the lifeblood of the economy.  Individuals cannot consume goods and services if they do not have a job from which they can derive income. From that consumption comes corporate profits and earnings.

Therefore, for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must work at a level that provides a sustainable living wage above the poverty level. This means full-time employment that provides benefits, and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale), which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.

This erosion in jobless claims has only just begun. As jobless claims and continuing claims rise, it will lead to a sharp deceleration in economic confidence. Confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their job. 

Question:  Given that employment is just starting to decline, does such support the assumption of a continued bull market?

Personal Consumption Expenditures (PCE)

Following through from employment, once individuals receive their paycheck, they then consume goods and services in order to live.

This is a crucial economic concept to understand, which is the order in which the economy functions. Consumers must “produce” first, so they receive a paycheck, before they can “consume.”  This is also the primary problem of Stephanie Kelton’s “Modern Monetary Theory,” which disincentivizes the productive capacity of the population.

Given that Personal Consumption Expenditures (PCE) is a measure of that consumption, and comprises roughly 70% of the GDP calculation, its relative strength has great bearing on the outcome of economic growth.

More importantly, PCE is the direct contributor to the sales of corporations, which generates their gross revenue. So goes personal consumption – so goes revenue. The lower the revenue that flows into company coffers, the more inclined businesses are to cut costs, including employment and stock buybacks, to maintain profit margins.

The chart below is a comparison of the annualized change in PCE to corporate fixed investment and employment. I have made some estimates for the first quarter based on recent data points.

Question: Does the current weakness in PCE and Fixed Investment support the expectations for a continued bull market from current price levels? 

Junk Bonds & Margin Debt

While global Central Banks have lulled investors into an expanded sense of complacency through years of monetary support, it has led to willful blindness of underlying risk. As we discussed in “Investor’s Dilemma:”

“Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.”

That “stimuli” over the last decade has been Central Bank interventions. During that period, the complete lack of “fear” in markets, combined with a “chase for yield,” drove “risk” assets to record levels along with leverage. The chart below shows the relationship between margin debt (leverage), stocks, and junk bond yields (which have been inverted for better relevance.)

While asset prices declined sharply in March, it has done little to significantly revert either junk bond yields or margin debt to levels normally consistent with the beginning of a new “bull market.”

With oil prices falling below $20/bbl, a tremendous amount of debt tied to the energy space, and the impact the energy sector has on the broader economy, it is likely too soon to suggest the markets have fully “priced in” the damage being done.

Question:  What happens to asset prices if more bankruptcies and forced deleveraging occurs?

As noted above, if the “bull market” is back, then stocks should be pricing in stronger earnings going forward. However, given the potential shakeout in employment, which will lower consumption, stronger earnings, and corporate profits, are not likely in the near term.

The risk to earnings is even higher than many suspect, given that over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, but primarily through share buybacks from increased leverage. That cycle has now come to an end, but before it did it created a massive deviation of the stock market from corporate profitability.

“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 market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

It isn’t just the deviation of asset prices from corporate profitability, which is skewed, but also reported earnings per share.

The impending recession, and consumption freeze, is going to start the mean-reversion process in both corporate profits, and earnings. I have projected the potential reversion in the chart below. The reversion in GAAP earnings is pretty calculable as swings from peaks to troughs have run on a fairly consistent trend.

Using that historical context, we can project a recession will reduce earnings to roughly $100/share. (Goldman Sachs currently estimates $110.) The resulting decline asset prices to revert valuations to a level of 18x (still high) trailing earnings would suggest a level of 1800 for the S&P 500 index. (Yesterday’s close of 2626 is still way to elevated.)

The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows corporate profits as a percentage of GDP relative to the annual change in GDP. The last time that corporate profits diverged from GDP, it was unable to sustain that divergence for long. As the economy declines, so will corporate profits and earnings.

Question: How long can asset prices remain divorced from falling corporate profits and weaker economic growth?

Technical Pressure

Given all of the issues discussed above, which must ultimately be reflected in market prices, the technical picture of the market also suggests the recent “bear market” rally will likely fade sooner than later. As noted above”

“Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”

Importantly, despite the sizable rally, participation has remained extraordinarily weak. If the market was seeing strong buying, as suggested by the media, then we should see sizable upticks in the percent measures of advancing issues, issues at new highs, and a rising number of stocks above their 200-dma.

However, on a longer-term basis, since this is the end of the month, and quarter, we can look at our quarterly buy/sell indication which has triggered a “sell” signal for the first time since 2015. While such a signal does not demand a major reversion, it does suggest there is likely more risk to the markets currently than many expect.

In early 2017, I warned investors about the “I bought it for the dividend” investment thesis. To wit:

“Company ABC is priced at $20/share and pays $1/share in a dividend each year. The dividend yield is 5%, which is calculated by dividing the $1 cash dividend into the price of the underlying stock.

Here is the important point. You do NOT receive a ‘yield.’

What you DO receive is the $1/share in cash paid out each year.

Yield is simply a mathematical calculation.“

At that time, the article was scoffed at because we were 8-years into an unrelenting bull market where even the most stupid of investments made money.

Unfortunately, the “mean reversion” process has taken hold, which is the point where the investment thesis falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

In January of 2018, Exxon Mobil, for example, was slated to pay an out an annual dividend of $3.23, and was priced at roughly $80/share setting the yield at 4.03%. With the 10-year Treasury trading at 2.89%, the higher yield was certainly attractive.

Assuming an individual bought 100 shares at $80 in 2018, “income” of $323 annually would be generated.

Not too shabby.

Fast forward to today with Exxon Mobil trading at roughly $40/share with a current dividend of $3.48/share.

Investment Return (-$4000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $3334

That’s not a good investment.

In just a moment, we will come and revisit this example with a better process.

There is another risk, which occurs during “mean reverting” events, that can leave investors stranded, and financially ruined.

Dividend Loss

When things “go wrong,” as they inevitably do, the “dividend” can, and often does, go away.

• Boeing (BA)
• Marriott (MAR)
• Ford (F)
• Delta (DAL)
• Freeport-McMoRan (FCX)
• Darden (DRI)

These companies, and many others, have all recently cut their dividends after a sharp fall in their stock prices.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

“If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to grow. The total value of the portfolio will indeed fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends usually go up even when the stock market goes down.”

This comment is the basis of the “buy and hold” mentality, and many of the most common investing misconceptions.

Let’s start with the notion that “dividends always increase.”

When a recession/market reversion occurs, the “cash dividends” don’t increase, but the “yield” does as prices collapse. However, your INCOME does NOT increase. There is a risk it will decline as companies cut the dividend or eliminate it.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks; however, leading up to the financial crisis, there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

While the current market correction fell almost 30% from its recent peak, what we haven’t seen just yet is the majority of dividend cuts still to come.

Naturally, not EVERY company will cut their dividends. But many did, many will, and in quite a few cases, I would expect dividends to be eliminated entirely to protect cash flows and creditors.

As we warned previously:

“Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief ‘there is no alternative.’ The resulting ‘dividend chase’ has pushed valuations of dividend-yielding companies to excessive levels disregarding underlying fundamental weakness. 

As with the ‘Nifty Fifty’ heading into the 1970s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices, and the dividends paid out.”

Love Dividends, Love Capital More

I agree investors should own companies that pay dividends (as it is a significant portion of long-term total returns), it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

It is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently:

Dividend cuts are one of the better near-real-time indicators of the relative health of the U.S. economy. While they slightly lag behind the actual state of the economy, dividend cuts represent one of the simplest indicators to track.

In just one week, beginning 16 March 2020, the number of dividend cuts being announced by U.S. firms spiked sharply upward, transforming 2020-Q1 from a quarter where U.S. firms were apparently performing more strongly than they had in the year-ago quarter of 2019-Q1 into one that all-but-confirms that the U.S. has swung into economic contraction.

Not surprisingly, the economic collapse, which will occur over the next couple of quarters, will lead to a massive round of dividend cuts. While investors lost 30%, or more in many cases, of their capital, they will lose the reason they were clinging on to these companies in the first place.

You Can’t Handle It

EVERY investor has a point, when prices fall far enough, regardless of the dividend being paid, they WILL capitulate, and sell the position. This point generally comes when dividends have been cut, and capital destruction has been maximized.

While individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do. As noted just recently is “Missing The 10-Best Days:”

“As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. In other words, investors regularly suffer from the ‘buy high/sell low’ syndrome.”

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making. In fact, Dalbar is set to release their Investor Report for 2020, and they were kind enough to send me the following graphic for investor performance through 2019. (Pre-Order The Full Report Here)

These differentials in performance can all be directly traced back to two primary factors:

• Psychology
• Lack of capital

Understanding this, it should come as no surprise during market declines, as losses mount, so does the pressure to “avert further losses” by selling. While it is generally believed dividend-yielding stocks offer protection during bear market declines, we warned previously this time could be different:

“The yield chase has manifested itself also in a massive outperformance of ‘dividend-yielding stocks’ over the broad market index. Investors are taking on excessive credit risk which is driving down yields in bonds, and pushing up valuations in traditionally mature companies to stratospheric levels. During historic market corrections, money has traditionally hidden in these ‘mature dividend yielding’ companies. This time, such rotation may be the equivalent of jumping from the ‘frying pan into the fire.’” 

The chart below is the S&P 500 High Dividend Low Volatility ETF versus the S&P 500 Index. During the recent decline, dividend stocks were neither “safe,” nor “low volatility.” 

But what about previous “bear markets?” Since most ETF’s didn’t exist before 2000, we can look at the “strategy” with a mutual fund like Fidelity’s Dividend Growth Fund (FDGFX)

As you can see, there is little relative “safety” during a market reversion. The pain of a 38%, 56%, or 30%, loss, can be devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend-yielding stocks, the psychology is no different; a 3-5% yield, and a 30-50% loss of capital, are two VERY different issues.

A Better Way To “Invest For The Dividend”

“Buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for a discussion of chart)

So, what’s the better way to invest for dividends? Let’s go back to our example of Exxon Mobil for a moment. (This is for illustrative purposes only and not a recommendation.)

In 2018, Exxon Mobil broke below its 12-month moving average as the overall market begins to deteriorate.

If you had elected to sell on the break of the moving average, your exit price would have been roughly $70/share. (For argument sake, you stayed out of the position even though XOM traded above and below the average over the next few months.)  

Let’s rerun our math from above.

• In 2018, an individual bought 100 shares at $80.
• In 2019, the individual sold 100 shares at $70.

Investment Return (-$1000.00 ) + Dividends of $323 (Yr 1) and $343 (Yr 2)  = Net Loss of $334

Not to bad.

Given the original $8,000 investment has only declined to $7,666, the individual could now buy 200 shares of Exxon Mobil with a dividend of $3.48 and a 9.3% annual yield.

Let’s compare the two strategies.

• Buy And Hold: 100 shares bought at $80 with a current yield of 4.35% 
• Risk Managed: 200 shares bought at $40 with a current yield of 9.3%

Which yield would you rather have in your portfolio?

In the end, we are just human. Despite the best of our intentions, emotional biases inevitably lead to poor investment decision-making. This is why all great investors have strict investment disciplines they follow to reduce the impact of emotions.

I am all for “dividend investment strategies,” in fact, dividends are a primary factor in our equity selection process. However, we also run a risk-managed strategy to ensure we have capital available to buy strong companies when the opportunity presents itself.

The majority of the time, when you hear someone say “I bought it for the dividend,” they are trying to rationalize an investment mistake. However, it is in the rationalization that the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.” 

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

I have been slammed with emails over the last couple of days asking the following questions:

“What just happened to my bonds?”

“What happened to my gold position, shouldn’t it be going up?”

“Why are all my stocks being flushed at the same time?”

As noted by Zerohedge:

“Stocks down, Bonds down, credit down, gold down, oil down, copper down, crypto down, global systemically important banks down, and liquidity down…

Today was the worst day for a combined equity/bond portfolio… ever…”

This Is What A “Margin Call,” Looks Like.

In December 2018, we warned of the risk. At that time, the market was dropping sharply, and Mark Hulbert wrote an article dismissing the risk of margin debt. To wit:

“Plunging margin debt may not doom the bull market after all, reports to the contrary notwithstanding.

According to research conducted in the 1970s by Norman Fosback, then the president of the Institute for Econometric Research, there is an 85% probability that a bull market is in progress when margin debt is above its 12-month moving average, in contrast to just a 41% probability when it’s below.

Why, then, do I suggest not becoming overly pessimistic? For several reasons:

1) The margin debt indicator issues many false signals

2) There is insufficient data

3) Margin debt is a strong coincident indicator.”

I disagreed with Mark on several points at the time. But fortunately the Federal Reserve’s reversal on monetary policy kept the stock market from sinking to levels that would trigger “margin calls.”

As I noted then, margin debt is not a technical indicator that can be used to trade markets. Margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that “leverage” also works in reverse as it provides the accelerant for larger declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important and is what is currently happening in the market.

The issue with margin debt, in terms of the biggest risk, is the unwinding of leverage is NOT at the investor’s discretion.

It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) 

When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

When an “event” occurs that causes lenders to “panic” and call in margin loans, things progress very quickly as the “math” becomes a problem. Here is a simple example.

“If you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you’ve lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.“

However, when margin calls occur, and equity is sold to meet the call, the equity in the portfolio is reduced further. Any subsequent price decline requires additional coverage leading to a “death spiral” until the margin line is covered.

Example:

• $100,000 portfolio declines to $60,000. Requiring a margin call of $5000.
• You have to deposit $5000, or sell to cover. 
• However, if you don’t have the cash, then a problem arises. The sell of equity reduces the collateral requirement requiring a larger transaction: $5000/.25% requirement = $20,000
• With the margin requirement met, a balance of $40,000 remains in the account with a $10,000 margin requirement. 
• The next morning, the market declines again, triggering another margin call. 
• Wash, rinse, repeat until broke.

This is why you should NEVER invest on margin unless you always have the cash to cover.

Just 20% 

As I discussed previously, the level we suspected would trigger a margin event was roughly a 20% decline from the peak.

“If such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.

This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that ‘when’ it occurs, it will start a ‘liquidation cycle’ as ‘margin calls’ trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.

The Dow Jones provided the clearest picture of the acceleration in selling as “margin calls” kicked in.

The last time we saw such an event was in 2008.

How Much More Is There To Go?

Unfortunately, FINRA only updates margin debt with about a 2-month lag.

Mark’s second point was a lack of data. This isn’t actually the case as margin debt has been tracked back to 1959. However, for clarity, let’s just start with data back to 1980. The chart below tracks two things:

1. The actual level of margin debt, and;
2. The level of “free cash” balances which is the difference between cash and borrowed funds (net cash).

As I stated above, since the data has not been updated since January, the current level of margin, and negative cash balances, has obviously been reduced, and likely sharply so.

However, previous “market bottoms,” have occurred when those negative cash balances are reverted. Given the extreme magnitude of the leverage that was outstanding, I highly suspect the “reversion” is yet complete. 

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances, to show the relationship between reversals in margin debt and the market. Given the market has only declined by roughly 30% to date, there is likely more to go. This doesn’t mean a fairly sharp reflexive bounce can’t occur before a further liquidation ensues.

If we invert margin debt to the S&P 500, you can see the magnitude of both previous market declines and margin liquidation cycles. As stated, this data is as of January, and margin balances will be substantially lower following the recent rout. I am just not sure we have “squeezed” the last bit of blood out of investors just yet. 

You Were Warned

I warned previously, the idea that margin debt levels are simply a function of market activity, and have no bearing on the outcome of the market, was heavily flawed.

“By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is ‘gasoline waiting on a match.’

When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying ‘collateral,’ the forced sale of assets will reduce the value of the collateral, triggering further margin calls. Those margin calls will trigger more selling, forcing more margin calls, so forth and so on.

That event was the double-whammy of collapsing oil prices and the economic shutdown in response to the coronavirus.

While it is certainly hoped by many that we are closer to the end of the liquidation cycle, than the beginning, the dollar funding crisis, a blowout in debt yields, and forced selling of assets, suggests there is likely more pain to come before we are done.

It’s not too late to take actions to preserve capital now, so you have capital to invest later.

As I wrote in Tuesday’s missive “When Too Little Is Too Much:”

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

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

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

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

You can’t “buy low,” if you don’t have anything to “buy with.”

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

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

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

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

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

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

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

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

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

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

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

So, why do I tell you this?

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

Two Things

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

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

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

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

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

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

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

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

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

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

It is now, or never, for the markets.

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

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

Cash was the only safe place to hide.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

However, here is the math:

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

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

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

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

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

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

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

When Too Little Is Too Much

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

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

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

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

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

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

Probably.

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

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

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

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

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

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

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

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

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

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

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

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

So, why do I tell you this?

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

Two Things

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

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

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

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

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

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

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

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

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

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

It is now, or never, for the markets.

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

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

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

Cash was the only safe place to hide.

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

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

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

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

On Monday morning, we took some action.

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

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

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

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

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

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

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

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

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

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

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

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

However, here is the math:

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

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

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

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

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

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

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

When Too Little Is Too Much

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

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

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

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

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

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

Probably.

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

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

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

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

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

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

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

I could go on, but you get the idea.

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

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

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

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

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

On The Cusp Of A Bear Market

Let me start by making a point.

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

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

Bull and bear markets today are better defined as:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here is the important point.

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

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

• Patience is one of the most valuable attributes in investing.

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

• The idea is to buy when the probability is greatest that the market is going to advance.

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

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

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

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

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

Save

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

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

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

Chart updated through Monday

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

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

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

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

Importantly, read that last sentence again.

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

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

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

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

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

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

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

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

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

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

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

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

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

Rally To Sell

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

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

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

For now look for rallies to be “sold.”

The End Of The Bull

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

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

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

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

Let me be clear.

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

Please read that last sentence again. 

Bulls Still In Charge

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

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

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

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

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

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

Step 1) Clean Up Your Portfolio

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

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

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

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

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

Stay alert, things are finally getting interesting.

Save

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.

What is most fascinating is that so many individuals invest hard earned capital based on these manipulated numbers. The failure to understand the “quality” of earnings, rather than the “quantity,” has always led to disappointing outcomes at some point in the future. 

As Drew Bernstein recently penned for CFO.com:

“Non-GAAP financials are not audited and are most often disclosed through earnings press releases and investor presentations, rather than in the company’s annual report filed with the Securities and Exchange Commission.

Once upon a time, non-GAAP financials were used to isolate the impact of significant one-time events like a major restructuring or sizable acquisition. In recent years, they have become increasingly prevalent and prominent, used by both the shiniest new-economy IPO companies and the old-economy stalwarts.”

Back in the 80’s and early 90’s companies used to report GAAP earnings in their quarterly releases. If an investor dug through the report they would find “adjusted” and “proforma” earnings buried in the back.

Today, it is GAAP earnings which are buried in the back hoping investors will miss the ugly truth.

These “adjusted or Pro-forma earnings” exclude items that a company deems “special, one-time or extraordinary.” The problem is that these “special, one-time” items appear “every” quarter leaving investors with a muddier picture of what companies are really making.

An in-depth study by Audit Analytics revealed that 97% of companies in the S&P 500 used non-GAAP financials in 2017, up from 59% in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades.

This growing divergence between the earnings calculated according to accepted accounting principles, and the “earnings” touted in press releases and analyst research reports, has put investors at a disadvantage of understanding exactly what they are paying for.

As BofAML stated:

“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power. 

Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant, and since 2013, the number has been on a steady rise.

So, why do companies regularly report these Non-GAAP earnings? Drew has the answer:

“When management is asked why they resort to non-GAAP reporting, the most common response is that these measures are requested by the analysts and are commonly used in earnings models employed to value the company. Indeed, sell-side analysts and funds with a long position in the stock may have incentives to encourage a more favorable alternative presentation of earnings results.”

If non-GAAP reporting is used as a supplemental means to help investors identify underlying trends in the business, one might reasonably expect that both favorable and unfavorable events would be “adjusted” in equal measure.

However, research presented by the American Accounting Association suggests that companies engage in “asymmetric” non-GAAP exclusions of mostly unfavorable items as a tool to “beat” analyst earnings estimates.

How The Beat Earnings & Get Paid For It

Why has there been such a rise is Non-GAAP reporting?

Money, of course.

“A recent study from MIT has found that when companies make large positive adjustments to non-GAAP earnings, their CEOs make 23 percent more than their expected annual compensation would be if GAAP numbers were used. This is despite such firms having weak contemporaneous and future operating performance relative to other firms.” – Financial Executives International.

The researchers at MIT combed through the annual earnings press releases of S&P 500 firms for fiscal years 2010 through 2015 and recorded GAAP net income and non-GAAP net income when the firms disclosed it. About 67 percent of the firms in the sample disclose non-GAAP net income.

The researchers then obtained CEO compensation, accounting, and return data for the sample firms and found that “firms making the largest positive non-GAAP adjustments… exhibit the worst GAAP performance.”

The CEOs of these firms, meanwhile, earned about 23 percent more than would be predicted using a compensation model; in terms of raw dollars. In other words, they made about $2.7 million more than the approximately $12 million of an average CEO.

It should not be surprising that anytime you compensate individuals based on some level of performance, they are going to figure out ways to improve performance, legal or not. Examples run rampant through sports from Barry Bonds to Lance Armstrong, as well as in business from Enron to WorldCom.

This was detailed in a WSJ article:

“One out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings.”

This rather “open secret” of companies manipulating bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting instruments to flatter earnings is not new.

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“

Manipulating earnings may work in the short-term, eventually, cost cutting, wage suppression, earnings adjustments, share-buybacks, etc. reach an effective limit. When that limit is reached, companies can no longer hide the weakness in their actual operating revenues.

There’s a big difference between companies’ advertised performance, and how they actually did. We discussed this recently by looking at the growing deviation between corporate earnings and corporate profits. There has only been one other point where earnings, and stock market prices, were surging while corporate profits were flat. Shortly thereafter, we found out the “truth” about WorldCom, Enron, and Global Crossing.

The American Accounting Association found that over the past decade or so, more companies have shifted to emphasizing adjusted earnings. But those same companies’ results under generally accepted accounting principles, or GAAP, often only match or slightly exceed analysts’ predictions.

“There are those who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken analysts and investors by surprise each quarter … for almost two decades. This view strains credulity.” – Paul Griffin, University of California & David Lont, University of Otago

After reviewing hundreds of thousands of quarterly earnings forecasts and reports of 4,700 companies over 17 years, Griffin and Lont believe companies shoot well above analysts’ targets because consistently beating earnings per share by only a penny or two became a red flag.

“If they pull out all the accounting tricks to get their earnings much higher than expected, then they are less likely to be accused of manipulation.” 

The truth is that stocks go up when companies beat their numbers, and analysts are generally biased toward wanting the stock they cover to go up. As we discussed in “Chasing The Market”, it behooves analysts to consistently lower their estimates so companies can beat them, and adjusted earnings are making it easier for them to do it.

For investors, the impact from these distortions will only be realized during the next bear market. For now, there is little help for investors as the Securities and Exchange Commission has blessed the use of adjusted results as long as companies disclose how they are calculated. The disclosures are minimal, and are easy to get around when it comes to forecasts. Worse, adjusted earnings are used to determine executive bonuses and whether companies are meeting their loan covenants. No wonder CEO pay, and leverage, just goes up.

Conclusion & Why EBITDA Is BullS***

Wall Street is an insider system where legally manipulating earnings to create the best possible outcome, and increase executive compensation has run amok,. The adults in the room, a.k.a. the Securities & Exchange Commission, have “left the children in charge,” but will most assuredly leap into action to pass new regulations to rectify reckless misbehavior AFTER the next crash.

For fundamental investors, the manipulation of earnings not only skews valuation analysis, but specifically impacts any analysis involving earnings such as P/E’s, EV/EBITDA, PEG, etc.

Ramy Elitzur, via The Account Art Of War, expounded on the problems of using EBITDA.

“One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA, and that cash flow information is not as important. It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health.”

The article is worth reading and chocked full of good information, however, here are the four-crucial points:

1. EBITDA is not a good surrogate for cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading to a false sense of liquidity.
2. Superficial common garden-variety accounting ratios will fail to detect signs of liquidity problems.
3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
4. EBITDA, just like net income is very sensitive to accounting manipulations.

The last point is the most critical. As Charlie Munger recently stated:

“I think there are lots of troubles coming. There’s too much wretched excess.

I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.

It’s ridiculous. EBITDA does not accurately reflect how much money a company makes, unlike traditional earnings. Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”

In a world of adjusted earnings, where every company is way above average, every quarter, investors quickly lose sight of what matters most in investing.

“This unfortunate cycle will only be broken when the end-users of financial reporting — institutional investors, analysts, lenders, and the media — agree that we are on the verge of systemic failure in financial reporting. In the history of financial markets, such moments of mental clarity most often occur following the loss of vast sums of capital.” – American Accounting Association

Imaginary worlds are nice, it’s just impossible to live there.

This past week saw a couple of interesting developments.

On Wednesday, the Fed released the minutes from their January meeting with comments which largely bypassed overly bullish investors.

“… several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to  high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances-including overvaluation and excessive indebtedness-could amplify an adverse shock to the economy …”

“… many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks…”

The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles across multiple asset classes. They are also aware that the majority of the policy tools are likely ineffective at mitigating financial risks in the future. This leaves them being dependent on expanding their balance sheet as their primary weapon.

Interestingly, the weapon they are dependent on may not be as effective as they hope. 

This past week, Japan reported a very sharp drop in economic growth in their latest reported quarter as a further increase in the sales-tax hit consumption. While the decline was quickly dismissed by the markets, this was a pre-coronovirus impact, which suggests that Japan will enter into an “official” recession in the next quarter.

There is more to this story.

Since the financial crisis, Japan has been running a massive “quantitative easing” program which, on a relative basis, is more than 3-times the size of that in the U.S. However, while stock markets have performed well with Central Bank interventions, economic prosperity is only slightly higher than it was prior to the turn of century.

Furthermore, despite the BOJ’s balance sheet consuming 80% of the ETF markets, not to mention a sizable chunk of the corporate and government debt market, Japan has been plagued by rolling recessions, low inflation, and low-interest rates. (Japan’s 10-year Treasury rate fell into negative territory for the second time in recent years.)

Why is this important? Because Japan is a microcosm of what is happening in the U.S. As I noted previously:

“The U.S., like Japan, is caught in an ongoing ‘liquidity trap’ where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments, and risk begins to outweigh the potential return.

Most importantly, while there are many calling for an end of the ‘Great Bond Bull Market,’ this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can’t increase in one country while a majority of economies are pushing negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.”

As my colleague Doug Kass recently noted, Japan is a template of the fragility of global economic growth. 

“Global growth continues to slow and the negative impact on demand and the broad supply interruptions will likely expose the weakness of the foundation and trajectory of worldwide economic growth. This is particularly dangerous as the monetary ammunition has basically been used up.

As we have observed, monetary growth (and QE) can mechanically elevate and inflate the equity markets. For example, now in the U.S. market, basic theory is that in practice a side effect is that via the ‘repo’ market it is turned into leveraged trades into the equity markets. But, again, authorities are running out of bullets and have begun to question the efficacy of monetary largess.

Bigger picture takeaway is beyond the fact that financial engineering does not help an economy, it probably hurts it. If it helped, after mega-doses of the stuff in every imaginable form, the Japanese economy would be humming. But the Japanese economy is doing the opposite. Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible.

While financial engineering clearly props up asset prices, I think Japan is a very good example that financial engineering not only does nothing for an economy over the medium to longer-term, it actually has negative consequences.” 

This is a key point.

The “Stock Market” Is NOT The “Economy.”

Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.

“This is not economic prosperity.

This is a distortion of economics.”

From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3-consecutive rounds of “Quantitative Easing” or “Q.E.” During that period, average real rates of economic growth rates never rose much above 2%.

Yes, asset prices surged as liquidity flooded the markets, but as noted above “Q.E.” programs did not translate into economic activity. The two 4-panel charts below shows the entirety of the Fed’s balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed’s balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in “QE” programs, not to mention trillions in a variety of other bailout programs, to create a relatively minimal increase in economic data. Of course, this explains the growing wealth gap, which currently exists as monetary policy lifted asset prices.

The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1. In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system, QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness. The ECB’s QE program, which was implemented in 2015 to support concerns of an unruly “Brexit,” had an effective ratio of 1.5:1. Not surprisingly, the latest round of QE, which rang “Pavlov’s bell,” has moved back to a near perfect 1:1 ratio.

Clearly, QE worked well in lifting asset prices, but as shown above, not so much for the economy. In other words, QE was ultimately a massive “wealth transfer” from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.

But Will It Work Next Time?

This is the single most important question for investors.

The current belief is that QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren’t enough. This was a point made in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled “Gauging The Ability Of The FOMC To Respond To Future Recessions.” 

The conclusion was simply this:

“Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances.”

In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications the U.S. economy maybe be heading towards the next recession. 

Interestingly, David compared three policy approaches to offset the next recession.

1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance. 

In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed’s balance sheet.

Does the Fed see a recession on the horizon? Is this why there are concerns about valuations?

Maybe.

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures.

In 2008, when the Fed launched into their “accommodative policy” emergency strategy to bail out the financial markets, the Fed’s balance sheet was running at $915 Billion. The Fed Funds rate was at 4.2%.

If the market fell into a recession tomorrow, the Fed would be starting with a $4.2 Trillion balance sheet with interest rates 3% lower than they were in 2009. In other words, the ability of the Fed to ‘bail out’ the markets today, is much more limited than it was in 2008.”

But there is more to the story than just the Fed’s balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.

Importantly, QE, and rate reductions, have the MOST effect when the economy, markets, and investors are extremely negative.

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

Such was the case in 2009. Not today.

This suggests that the Fed’s ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.

Summary

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade, and there is rising evidence that growth is beginning to decelerate.

Furthermore, we have much more akin with Japan than many would like to believe.

• A decline in savings rates
• An aging demographic
• A heavily indebted economy
• A decline in exports
• Slowing domestic economic growth rates.
• An underemployed younger demographic.
• An inelastic supply-demand curve
• Weak industrial production
• Dependence on productivity increases

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

While another $2-4 Trillion in QE might indeed be successful in keeping the bubble inflated for a while longer, there is a limit to the ability to continue pulling forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.

If the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the “wealth effect” will be larger than currently imagined. The Fed’s biggest fear is finding themselves powerless to offset the negative impacts of the next recession. 

If more “QE” works, great.

But as investors, with our retirement savings at risk, what if it doesn’t.

In September 2017, when the Trump Administration began promoting the idea of tax cut legislation, I wrote a series of articles discussing the fallacy that tax cuts would lead to higher tax collections, and a reduction in the deficit. To wit:

“Given today’s record-high levels of debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.

The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – higher.”

That was the deficit in September 2017.

Here it is today.

As opposed to all the promises made, economic growth failed to get stronger. Furthermore, federal revenues as a percentage of GDP declined to levels that have historically coincided with recessions.

Why Does This Matter?

President Trump just proposed his latest $4.8 Trillion budget, and not surprisingly, suggests the deficit will decrease over the next 10-years.

Such is a complete fantasy and was derived from mathematical gimmickry to delude voters to the contrary. As Jim Tankersley recently noted:

The White House makes the case that this is affordable and that the deficit will start to fall, dropping below $1 trillion in the 2021 fiscal year, and that the budget will be balanced by 2035. That projection relies on rosy assumptions about growth and the accumulation of new federal debt — both areas where the administration’s past predictions have proved to be overconfident.

The new budget forecasts a growth rate for the United States economy of 2.8 percent this year — or, by the metric the administration prefers to cite, a 3.1 percent rate. That is more than a half percentage point higher than forecasters at the Federal Reserve and the Congressional Budget Office predict.

It then predicts growth above 3 percent annually for the next several years if the administration’s economic policies are enacted. The Fed, the budget office and others all see growth falling below 2 percent annually in that time. By 2030, the administration predicts the economy will be more than 15 percent larger than forecasters at the budget office do.

Past administrations have also dressed up their budget forecasts with economic projections that proved far too good to be true. In its fiscal year 2011 budget, for example, the Obama administration predicted several years of growth topping 4 percent in the aftermath of the 2008 financial crisis — a number it never came close to reaching even once.

Trump’s budget expectations also contradict the Congressional Budget Office’s latest deficit warning:

“CBO estimates a 2020 deficit of $1.0 trillion, or 4.6 percent of GDP. The projected gap between spending and revenues increases to 5.4 percent of GDP in 2030. Federal debt held by the public is projected to rise over the ­coming decade, from 81 percent of GDP in 2020 to 98 percent of GDP in 2030. It continues to grow ­thereafter in CBO’s projections, reaching 180 percent of GDP in 2050, well above the highest level ever recorded in the United States.”

“With unprecedented trillion-dollar deficits projected as far as the eye can see, this country needs a serious budget. Unfortunately, that cannot be said of the one the President just submitted to Congress, which is filled with non-starters and make-believe economics.” – Maya Macguineas

Debt Slows Economic Growth

There is a long-standing addiction in Washington to debt. Every year, we continue to pile on more debt with the expectation that economic growth will soon follow.

However, excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman, and a litany of others brought down by surging debt levels and simple “greed.” Households, too, have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

But this lack of a “story,” is what has led us to the very doorstep of “Modern Monetary Theory,” or “MMT.” As Michael Lebowitz previously explained:

“MMT theory essentially believes the government spending can be funded by printing money. Currently, government spending is funded by debt, and not the Fed’s printing press. MMT disciples tell us that when the shackles of debt and deficits are removed, government spending can promote economic growth, full employment and public handouts galore.

Free healthcare and higher education, jobs for everyone, living wages and all sorts of other promises are just a few of the benefits that MMT can provide. At least, that is how the theory is being sold.”

What’s not to love?

Oh yes, it’s that deficit thing.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For government “deficit” spending to be effective, the “payback” from investments made must yield a higher rate of return than the interest rate on the debt used to fund it. 

Examples of such investments range from the Hoover Dam to the Tennessee River Valley Authority. Importantly, “infrastructure spending projects,” must have a long-term revenue stream tied to time. Building roads and bridges to “nowhere,” may create short-term jobs, but once the construction is complete, the economic benefit turns negative.

The problem for MMT is its focus on spending is NOT productive investments but rather social welfare which has a negative rate of return. 

Of course, the Government has been running a “Quasi-MMT” program since 1980.

According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2019, the Federal Government spent $4.8 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.6 Trillion was financed by Federal revenues, and $1.1 trillion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.6 Trillion, or roughly 99% of the total revenue coming in. 

There is also clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz previously showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten-year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight the change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.”

“The plot of the 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line) is telling.”

“This reinforces the message from the other debt-related graphs – over the last 30-years the economy has relied more upon debt growth and less on productivity to generate economic activity.

The larger the balance of debt has become, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Since 2008, the economy has been growing well below its long-term exponential trend. Such has been a consistent source of frustration for both Obama, Trump, and the Fed, who keep expecting higher rates of economic only to be disappointed.

The relevance of debt growth versus economic growth is all too evident. When debt issuance exploded under the Obama administration, and accelerated under President Trump, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years, from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been higher. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

The End Game Cometh

Over the last 40-years, the U.S. economy has engaged in increasing levels of deficit spending without the results promised by MMT.

There is also a cost to MMT we have yet to hear about from its proponents.

The value of the dollar, like any commodity, rises and falls as the supply of dollars change. If the government suddenly doubled the money supply, one dollar would still be worth one dollar but it would only buy half of what it would have bought prior to their action.

This is the flaw MMT supporters do not address.

MMT is not a free lunch.

MMT is paid for by reducing the value of the dollar and ergo your purchasing power. MMT is a hidden tax paid by everyone holding dollars. The problem, as Michael Lebowitz outlined in Two Percent for the One Percent, inflation tends to harm the poor and middle class while benefiting the wealthy.

This is why the wealth gap is more pervasive than ever. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.

As I stated above, the U.S. has been running MMT for the last three decades, and has resulted in social inequality, disappointment, frustration, and a rise in calls for increasing levels of socialism.

It is all just as you would expect from such a theory put into practice, and history is replete with countries that have attempted the same. Currently, the limits of profligate spending in Washington has not been reached, and the end of this particular debt story is yet to be written.

But, it eventually will be.

“I am thrilled to report to you tonight that our economy is the best it has ever been.” – President Trump, SOTU

In the President’s “State of the Union Address” on Tuesday, he used the podium to talk up the achievements in the economy and the markets.

• Low unemployment rates
• Tax cuts
• Job creation
• Economic growth, and, of course,
• Record high stock markets.

While it certainly is a laundry list of items he can claim credit for, it is the claim of record-high stock prices that undermines the rest of the story.

Let me explain.

The stock market should be a reflection of actual economic growth. Since corporate earnings are derived primarily from consumptive spending, corporate investments, and imports and exports, actual economic activity should be reflected in the price investors are willing to pay for the earnings being generated.

For the majority of the 20th century, this was indeed the case as corporate earnings were reflective of economic activity. The chart below shows the annual change in reported earnings, nominal GDP, and the price of the S&P 500.

Not surprisingly, as the economy grew at 6.47% annually, earnings also grew at 6.68% annually as would be expected. Since investors are willing to a premium for earnings growth, the S&P 500 grew at 9% annually over that same period.

Importantly, note that long-term economic growth has averaged 6% annually. However, as shown in the lower panel, economic growth has been running below the long-term average since 2000, but has been substantially weaker since 2007, growing at just 2% annually.

The next chart shows this weaker growth more clearly. Since the financial crisis, economic growth has failed to recover back to its long-term exponential growth trend. However, reported earnings are exceedingly deviated from what actual underlying economic growth can generate. This is due to a decade of accounting gimmickry, share buybacks, wage suppression, low interest rates, and high corporate debt levels.

The next chart looks at the deviation by looking at the market itself versus long-term economic growth. The S&P 500 and GDP have been scaled to 100, and displayed on a log-scale for comparative purposes.

The current growth trend of the economy is running well below its long-term exponential trend, but the S&P 500 is currently at the most significant deviation from that growth on record. (It should be noted that while these deviations from economic growth can last for a long-time, the eventual mean reversion always occurs.)

The Spending Mirage

Take a look at the following chart.

While the President’s claims of an exceptionally strong economy rely heavily on historically low unemployment and jobless claims numbers, historically high levels of asset prices, and strong consumer spending trends, there is an underlying deterioration which goes unaddressed.

So, here’s your pop quiz?

If consumer spending is strong, AND unemployment is near the lowest levels on record, AND interest rates are low, AND job creation is high – then why is the economy only growing at 2%?

Furthermore, if the economy was doing as well as government statistics suggest, then why does the Federal Reserve need to continue providing the economy with “emergency measures,” cutting rates, and giving “verbal guidance,” to keep the markets from crashing?

The reality is that if it wasn’t for the Government running a massive trillion-dollar fiscal deficit, economic growth would actually be recessionary.

In GDP accounting, consumption is the largest component. Of course, since it is impossible to “consume oneself to prosperity,” the ability to consume more is the result of growing debt. Furthermore, economic growth is also impacted by Government spending, as government transfer payments, including Medicaid, Medicare, disability payments, and SNAP (previously called food stamps), all contribute to the calculation.

As shown below, between the Federal Reserve’s monetary infusions and the ballooning government deficit, the S&P 500 has continued to find support.

However, nothing is “produced” by those transfer payments. They are not even funded. As a result, national debt rises every year, and that debt adds to GDP.

Another way to look at this is through tax receipts as a percentage of GDP.  If the economy was indeed “the strongest ever,” then we should see an increase in wage growth commensurate with increased economic activity. As a result of higher wages, there should be an increase in the taxes collected by the Government from wages, consumption, imports, and exports.

See the problem here?

Clearly, this is not the case as tax receipts as a percentage of GDP peaked in 2012, and have now declined to levels which historically are more coincident with economic recessions, rather than expansions. Yet, currently, because of the artificial interventions, the stock market remains well detached from what economic data is actually saying.

Corporate Profits Tell The Real Story

When it comes to the state of the market, corporate profits are the best indicator of economic strength.

The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, the markets can certainly seem to “remain irrational longer than logic would predict,” but it never lasts indefinitely.

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham

As shown, when we look at inflation-adjusted profit margins as a percentage of inflation-adjusted GDP, we see a clear process of mean-reverting activity over time. Of course, those mean reverting events are always coupled with recessions, crises, or bear markets.

More importantly, corporate profit margins have physical constraints. Out of each dollar of revenue created, there are costs such as infrastructure, R&D, wages, etc. Currently, the biggest contributors to expanding profit margins has been the suppression of employment, wage growth, and artificially suppressed interest rates, which have significantly lowered borrowing costs. Should either of the issues change in the future, the impact to profit margins will likely be significant.

The chart below shows the ratio overlaid against the S&P 500 index.

I have highlighted peaks in the profits-to-GDP ratio with the green vertical bars. As you can see, peaks, and subsequent reversions, in the ratio have been a leading indicator of more severe corrections in the stock market over time. This should not be surprising as asset prices should eventually reflect the underlying reality of corporate profitability.

It is often suggested that, as mentioned above, low interest rates, accounting rule changes, and debt-funded buybacks have changed the game. While that statement is true, it is worth noting that each of those supports are artificial and finite.

Another way to look at the issue of profits as it relates to the market is shown below. When we measure the cumulative change in the S&P 500 index as compared to the level of profits, we find again that when investors pay more than $1 for a $1 worth of profits, there is an eventual mean reversion.

The correlation is clearer when looking at the market versus the ratio of corporate profits to GDP. (Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.) 

While the media is quick to attribute the current economic strength, or weakness, to the person who occupies the White House, the reality is quite different.

The political risk for President Trump is taking too much credit for an economic cycle which was already well into recovery before he took office. Rather than touting the economic numbers and taking credit for liquidity-driven financial markets, he should be using that strength to begin the process of returning the country to a path of fiscal discipline rather than a “drunken binge” of government spending.

With the economy, and the financial markets, sporting the longest-duration in history, simple logic should suggest time is running out.

This isn’t doom and gloom, it is just a fact.

Politicians, over the last decade, failed to use $33 trillion in liquidity injections, near-zero interest rates, and surging asset prices to refinance the welfare system, balance the budget, and build surpluses for the next downturn.

Instead, they only made the deficits worse, and the U.S. economy will enter the next recession pushing a $2 Trillion deficit, $24 Trillion in debt, and a $6 Trillion pension gap, which will devastate many in their retirement years.

While Donald Trump talked about “Yellen’s big fat ugly bubble” before he took office, he has now pegged the success of his entire Presidency on the stock market.

It will likely be something he eventually regrets.

“Then said Jesus unto him, Put up again thy sword into his place: for all they that take the sword shall perish with the sword.” – Matthew 26, 26:52

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind and why wealth inequality is at levels last seen almost 100 years ago. 

REALity

 “Real” is a very important concept in the field of economics. Real generally refers to an amount of something adjusted for the effects of inflation. This allows economists to measure true organic growth or decline.

Real is equally important for the rest of us. The size of our paycheck or bank account balance is meaningless without an understanding of what money can buy. For instance, an annual income of $25,000 in 1920 was about eight times the national average. Today that puts a family of four below the Federal Poverty Guideline. As your grandfather used to say, a dollar doesn’t go as far as it used to.

Real wealth and real wage growth are important for assessing your economic standing and that of the nation.

Here are two facts:

• Wealth is largely a function of the wages we earn
• The wages we earn are predominately a function of the growth rate of the economy

These facts establish that the prosperity and wealth of all citizens in aggregate is meaningfully tied to economic growth or the output of a nation. It makes perfect sense.

Now, let us consider inflation and the role it plays in determining our real wages and real wealth.

If the rate of inflation is less than the rate of wage growth over time, then our real wages are rising and our wealth is increasing. Conversely, if inflation rises at a pace faster than wages, wealth declines despite a larger paycheck and more money in the bank.

With that understanding of “real,” let’s discuss inflation.

What is Inflation?

Borrowing from an upcoming article, we describe inflation in the following way:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The price of cars, cheeseburgers, movie tickets, and all the other goods and services we consume are chiefly based on supply and demand. Demand is a function of both our need and desire to own a good and, equally importantly, how much money we have. The amount of money we have in aggregate, known as money supply, is governed by the Federal Reserve. Therefore, the supply of money is a key component of demand and therefore a significant factor affecting prices.

With the linkage between the supply of money and inflation defined, let us revisit Powell’s recent revelation.

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.”

In plain English, Powell states that the supply of money is based on the demand for money and not the economic growth rate.  To clarify, one of the Fed’s largest liabilities currently are bank reserves. Banks are required to hold reserves for every loan they make. Therefore, they need reserves to create money to lend. Ergo, “demand for our liabilities,” as Powell states, actually means bank demand for the seed funding to create money and make loans.

The relationship between money supply and the demand for money may, in fact, be aligned with economic growth. If so, then the supply of money should rise with the economy. This occurs when debt is predominately employed to facilitate productive investments.

The problem occurs when money is demanded for consumption or speculation. For example:

• When hedge funds demand billions to leverage their trading activity
• When Apple, which has over $200 billion in cash, borrows money to buy back their stock  
• When you borrow money to buy a car, the size of the economy increases but not permanently as you are not likely to buy another car tomorrow and the next day

Now ask, should the supply of money increase because of those instances?

The relationship between the demand for money and economic activity boils down to what percentage of the debt taken on is productive and helps the economy and the populace grow versus what percentage is for speculation and consumption.

While there is no way to quantify how debt is used, we do know that speculative and consumptive debt has risen sharply and takes up a much larger percentage of all debt than in prior eras.  The glaring evidence is the sharp rise of debt to GDP.

Data Courtesy St. Louis Federal Reserve

If most of the debt were used productively, then the level of debt would drop relative to GDP. In other words, the debt would not only produce more economic growth but would also pay for itself.  The exact opposite is occurring as growth languishes despite record levels of debt accumulation.

The speculative markets provide further evidence. Without presenting the long list of asset valuations that stand at or near record levels, consider that since the last time the S&P 500 was fairly valued in 2009, it has grown 375%. Meanwhile, total U.S. Treasury debt outstanding is up by 105% from $11 trillion to $22.5 trillion and corporate debt is up 55% from $6.5 trillion to $10.1 trillion. Over that same period, nominal GDP has only grown 46% and Average Hourly Earnings by 29%.

When the money supply is increased for consumptive and speculative purposes, the Fed creates dissonance between our wages, wealth, and the rate of inflation. In other words, they generate excessive inflation and reduce our real wealth.  

If this is the case, why is the stated rate of inflation less than economic growth and wage growth?

The Wealth Scheme

This scheme works like all schemes by keeping the majority of people blind to what is truly occurring. To perpetuate such a scheme, the public must be convinced that inflation is low and their wealth is increasing.

In 2000, a brand new Ford Taurus SE sedan had an original MSRP of $18,935. The 2019 Ford Taurus SE has a starting price of $27,800.  Over the last 19 years, the base price of the Ford Taurus has risen by 2.05% a year or a total of 47%. According to the Bureau of Labor Statics (BLS), since the year 2000, the consumer price index for new vehicles has only risen by 0.08% a year and a total of 1.68% over the same period.

For another instance of how inflation is grossly underreported, we highlighted flaws in the reporting of housing prices in MMT Sounds Great in Theory But…  To wit: 

“Since then, inflation measures have been tortured, mangled, and abused to the point where it scarcely equates to the inflation that consumers deal with in reality. For example, home prices were substituted for “homeowners equivalent rent,” which was falling at the time, and lowered inflationary pressures, despite rising house prices.

Since 1998, homeowners equivalent rent has risen 72% while house prices, as measured by the Shiller U.S. National Home Price Index has almost doubled the rate at 136%. Needless to say, house prices, which currently comprise almost 25% of CPI, have been grossly under-accounted for. In fact, since 1998 CPI has been under-reported by .40% a year on average. Considering that official CPI has run at a 2.20% annual rate since 1998, .40% is a big misrepresentation, especially for just one line item.”

Those two obscene examples highlight that the government reported inflation is not the same inflation experienced by consumers. It is important to note that we are not breaking new ground with the assertion that the government reporting of inflation is low. As we have previously discussed, numerous private assessments quantify that the real inflation rate could easily be well above the average reported 2% rate. For example, Shadow Stats quantifies that inflation is running at 10% when one uses the official BLS formula from 1980.

Despite what we may sense and a multitude of private studies confirming that inflation is running greater than 2%, there are a multitude of other government-sponsored studies that argue inflation is actually over-stated. So, the battle is in the trenches, and the devil is in the details.

As defined earlier, inflation is “a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The following graph shows that the supply of money, measured by M2, has grown far more than the rate of economic growth (GDP) over the last 20 years.

Data St. Louis Federal Reserve

Since 2000, M2 has grown 234% while GDP has grown at half of that rate, 117%. Over the same period, the CPI price index has only grown by 53%. M2 implies an annualized inflation rate over the last 20 years of 6.22% which is three times that of CPI. 

Dampening perceived inflation is only part of the cover-up. The scheme is also perpetuated with other help from the government. The government borrows to boost temporary economic growth and help citizens on the margin. This further limits people’s ability to detect a significant decline in their standard of living.

As shown below, when one strips out the change in government debt (the actual increase in U.S. Treasury debt outstanding) from the change in GDP growth, the organic economy has shrunk for the better part of the last 20 years. 

Data St. Louis Federal Reserve

It doesn’t take an economist to know that a 6.22% inflation rate (based on M2) and decade long recession would force changes to our monetary policy and send those responsible to the guillotines. If someone suffering severe headaches is diagnosed with a brain tumor, the problem does not go away because the doctor uses white-out to cover up the tumor on the x-ray film.

Despite crystal clear evidence, the mirages of economic growth and low inflation prevent us from seeing reality.

Summary

Those engaging in speculative ventures with the benefit of cheap borrowing costs are thriving. Those whose livelihood and wealth are dependent on a paycheck are falling behind. For this large percentage of the population, their paychecks may be growing in line with the stated government inflation rate but not the true inflation rate they pay at the counter. They fall further behind day by day as shown below.

While this may be hard to prove using government inflation data, it is the reality. If you think otherwise, you may want to ask why a political outsider like Donald Trump won the election four years ago and why socialism and populism are surging in popularity. We doubt that it is because everyone thinks their wealth is increasing. To quote Bill Clinton’s 1992 campaign manager James Carville, “It’s the economy, stupid.”

That brings us back to Jerome Powell and the Fed. The U.S. economy is driven by millions of individuals making decisions in their own best interests. Prices are best determined by those millions of people based on supply and demand – that includes the price of money or interest rates. Any governmental interference with that natural mechanism is a recipe for inefficiency and quite often failure.

If monetary policy is to be set by a small number of people in a conference room in the Eccles Building in Washington, D.C. who think they know what is best for us based on flawed data, then they should prepare themselves for even more radical social and political movements than we have already seen.

When I was growing up, my father used to tell me I should “never take advice from anyone who hasn’t succeeded at what they are advising.” 

The most truth of that statement is found in the financial press, which consists mostly of people writing articles and giving advice on topics where they have little experience, and in general, have achieved no success.

The best example came last week in an email quoting:

“You recently suggested that you took profits from your portfolios; however, I read an article saying retirees shouldn’t change their strategies. ‘If you’ve got a thoughtful financial plan and a diversified investment portfolio, the general rule is to leave everything alone.'” 

This seems to be an entirely different approach to what you are suggesting. Also, since corrections can’t be predicted, it seems to make sense.” 

One of the biggest reasons why investors consistently underperform over the long-term is due to flawed investment advice.

Let me explain.

Corrections & Bear Markets Matter

It certainly seems logical, by looking the 120-year chart of the market, that one should just stay invested regardless of what happens. Eventually, as the financial media often suggests, the markets always get back to even. One such chart is the percentage gain/loss chart over the long-term, as shown below.

This is one of the most deceptive charts an advisor can show a client, particularly one that is close to, or worse in, retirement.

The reality is that you DIED long before ever achieving that 8% annualized long-term return you were promised. Secondly, math is a cruel teacher.

Visually, percentage drawdowns seem to be inconsequential relative to the massive percentage gains that preceded them. That is, until you convert percentages into points and reveal an uglier truth.

It is important to remember that a 100% gain on a $1000 investment, followed by a 50% loss, does not leave you with $1500. A 50% loss wipes out the previous 100% gain, leaving you with a 0% net return.

For retirees, this is a critically important point.

In 2000, the average “baby boomer” was around 45-years of age. The “dot.com” crash was painful, but with 20-years to go before retirement, there was time to recover. In 2010, following the financial crisis, the time to retirement for the oldest boomers was depleted, and the average boomer only had 10-years to recover. During both of these previous periods, portfolios were still in accumulation mode. However, today, only the youngest tranche of “boomers,” have the luxury of “time” to work through the next major market reversion. (This also explains why the share of workers over the age of 65 is at historical highs.) 

With the majority of “boomers” now faced with the implications of a transition into the distribution phase of the investment cycle, such has important ramifications during market declines. The following example shows a $1 million portfolio with, and without, an annualized 4% withdrawal rate. (We are going into much deeper analysis on this in a moment.)

While a 10% decline in the market will reduce a portfolio from $1 million to $900,000, when combined with an assumed monthly withdrawal rate, the portfolio value is reduced by almost 14%. This is the result of taking distributions during a period of declining market values. Importantly, while it ONLY requires a non-withdrawal portfolio an 11.1% return to break even, it requires nearly a 20% return for a portfolio in the distribution phase to attain the same level.

Impairments to capital are the biggest challenges facing pre- and post-retirees currently. 

This is an important distinction. Most articles written about retirees, or those ready to retire, is an unrealized assumption of an indefinite timeline.

While the market may not be different than it has been in the past. YOU ARE!

Starting Valuations Matter

As I have discussed previously, without understanding the importance of starting valuations on your investment returns, you can’t understand the impact the market will have on psychology, and investor behavior.

Over any 30-year period, beginning valuation levels have a tremendous impact on future returns.

As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.

This is far less than the 8-10% rates of return currently promised by the Wall Street community. It is also why starting valuations are critical for individuals to understand when planning for both the accumulation and distribution, phases of the investment life-cycle.

Let’s elaborate on our example above.

We know that markets go up and down over time, therefore when advisors use “average” or “annualized” rates of return, results often deviate far from reality. However, we do know from historical analysis that valuations drive forward returns, so using historical data, we calculated the 4-periods where starting valuations were either above 20x earnings, or below 10x earnings. We then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis. 

The results were not surprising.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was actually not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market that ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900, which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

“Price is what you pay. Value is what you get.” 

To create our variable return assumption model, we averaged each of the 4-periods above into a single total return, inflation-adjusted, index. We could then see the impact of $1000 invested in the markets at both valuations BELOW 10x trailing earnings, and ABOVE 20x. Investing at 10x earnings yields substantially better results.

Starting Valuations Are Critical To Withdrawal Rates

With a more realistic return model, the impact of investing during periods of high valuations becomes more evident, particularly during the withdrawal phase of retirement.

Let’s start with our $1 million retirement portfolio. The chart below shows various “spend down” assumptions of a $1 million retirement portfolio adjusted for an 8% annualized return, the impact of inflation at 3%, and the effect of taxation on withdrawals.

By adjusting the annualized rate of return for the impact of inflation and taxes, the life expectancy of a portfolio grows considerably shorter. Unfortunately, this is what “really happens” to investors over time, but is never discussed in mainstream analysis.

To understand “real outcomes,” we must adjust for variable rates of returns. There is a significant difference between 8% annualized rates of return and 8% real rates of return. 

When we adjust the spend down structure for elevated starting valuation levels, and include inflation and taxes, a far different, and less favorable, outcome emerges. Retirees will run out of money not in year 30, but in year 18.

With this understanding, let’s revisit what happens to “buy and hold” investors over time. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually, and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually and “stuffed in a mattress.”

The red line is 10% compounded annually. While you don’t get compounded returns, it is there for comparative purposes to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisor’s promise of 10% annual returns for retirement, you aren’t going to make it.

Questions Retirees Need To Ask About Plans

What this analysis reveals is that “retirees” SHOULD be worried about bear markets. 

Taking the correct view of your portfolio, and the risks being undertaken is critical when entering the retirement and distribution phase of the portfolio life cycle.

Most importantly, when building and/or reviewing your financial plan, these are the questions you must ask and have concrete answers for:

• What are the expectations for future returns going forward given current valuation levels? 
• Should the withdrawal rates be downwardly adjusted to account for potentially lower future returns? 
• Given a decade long bull market, have adjustments been made for potentially front-loaded negative returns? 
• Has the impact of taxation been carefully considered in the planned withdrawal rate?
• Have future inflation expectations been carefully considered?
• Have drawdowns from portfolios during declining market environments, which accelerates principal bleed, been considered?
• Have plans been made to harbor capital during up years to allow for reduced portfolio withdrawals during adverse market conditions?
• Has the yield chase over the last decade, and low interest rate environment, which has created an extremely risky environment for retirement income planning, been carefully considered?
• What steps should be considered to reduce potential credit and duration risk in bond portfolios?
• Have expectations for compounded annual rates of returns been dismissed in lieu of a plan for variable rates of future returns?

 If the answer is “no” to the majority of these questions. then feel free to contact one of the CFP’s in our office who take all of these issues into account. 

Yes, not only should you worry about bear markets, you should worry about them a lot.

In the past, we discussed how “Capitalism” was distorted by Wall Street. We’ve also reviewed some of the “myths” of capitalism, which are used to garner “votes” by politicians but are not really true. Most importantly, we discussed the fallacy that “more Government” is the answer in creating equality as it impairs economic opportunity.

I want to conclude this series with a discussion on the fallacy of socialism and equality, and provide a some thoughts on how you can capitalize on capitalism.

Envy was once considered to be one of the seven deadly sins before it became one of the most admired virtues under its new name, “social justice."

— Thomas Sowell (@ThomasSowell) October 17, 2019

Socialism Requires Money

The “entire premise” of the socialist agendas assumes money is unlimited. Since there is only a finite amount of money created through taxation of citizens each year the remainder must come from the issuance of debt.

Therefore, to promote an agenda which requires unlimited capital commitments to fulfill, the basic premise has to be “debt doesn’t matter.” 

Enter “Modern Monetary Theory” or MMT.

Kevin Muir penned “Everything You Wanted To Know About MMT” which delves into what MMT proposes to be. To wit:

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy which means government spending is never revenue constrained, but rather only limited by inflation.”

In other words, debts and deficits do not matter as long as the Government can print the money it needs, to pay for what it wants to pay for.

“Deficits are self-financing, deficits push rates down, deficits raise private savings.” – Stephanie Kelton

It is the proverbial “you can have your cake and eat it too” theory. It just hasn’t exactly worked out that way.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For that answer, we can turn to Dr. Woody Brock, an economist who holds 5-degrees in math and economics and is the author of “American Gridlock” for the answer.

“The word ‘deficit’ has no real meaning. 

‘Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the ‘deficit’ over time.’

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.

For government “deficit” spending to be effective, the “payback” from investments made through debt must yield a higher rate of return than the interest rate on the debt used to fund it.

The problem, for MMT and as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, which creates jobs (infrastructure and development) to primarily social welfare, defense, and debt service which has negative rates of return.

In other words, the U.S. is “Country A.” 

However, there is clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz recently showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.”

“The graph below plots 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).”

“This reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.”

As noted above, since the bulk of the debt issued by the U.S. has been unproductively squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater, and continues to grow.

MMT is not a free lunch. MMT is paid for by reducing the value of the dollar, and is a hidden tax by reducing the purchasing power of everyone holding dollars. The problem is that inflation tends to harm the poor and middle class, but benefits the wealthy.

While MMT promises “free college,” “healthcare for all,” “free childcare,” and “jobs for all” with no consequences, it will deliver inflation, generate further wealth/income inequality, and greater levels of social instability and populism.

How do we know this? Because it is the same outcome seen in every other country that endeavored in programs of unbridled debts and deficits.

MMT sounds great at the conversational level, but so does “communism” and “socialism.”

In practice, the outcomes have been vastly different than the theory.

Why Wealth Inequality Is A Good Thing

Just recently, Aaron Back accidentally made the case for why we should foster “capitalism” over “socialism.” 

Fixed it:

"The introduction of capitalist reforms to Communist China has lifted hundreds of millions out of poverty, but it had a drawback: rising income inequality." https://t.co/tsAHyUdeEl

— Aaron Back (@AaronBack) October 1, 2019

What Aaron exposed in his rush to jump on the “inequality bandwagon” was what capitalism provided. Let’s break down his statement:

1. Introduction of capitalism lifts millions out of poverty. (This is a good thing)
2. Yes, inequality was created as those that took advantage of capitalism prospered versus those that didn’t. (How capitalism works)
3. If capitalism lifted millions out of poverty, which suggests everyone was poor under communism. 

Point 3 is the most important.

“Capitalism gets its power—and has created the greatest increase in social welfare in history—from embracing human ingenuity and the positive forces of innovation, open markets and competition. Perhaps the greatest strength of free markets is their ability to nimbly adjust to new ideas and situations and find the most efficient system. Markets are always looking to do things better. We can apply that same logic to capitalism itself to improve capitalism further so that it can provide even greater social welfare.” – Daniel LaCalle

Let me clarify something for you.

The ‘American Dream’ isn’t going into debt to buy a home. The ‘American Dream’ is the ability for ANY person, regardless of race, religion, or means, to achieve success, and in many cases great success, through hard work, dedication, determination, and sacrifice.

Capitalism Is The Worst, Except For All The Rest

One thing is for certain. Life isn’t fair.

“The rich have everything, and all I have is a mountain of student debt and a crappy job.”

Capitalism isn’t perfect as Howard Marks recently noted:

“Capitalism is an imperfect economic system, because differential performance in the pursuit of economic success – as well as luck – results in there being (a) some people who are less successful as well as some who are more and (b) a few who are glaringly successful.

I’m 100% convinced that the capitalist system has produced the most aggregate gains for our society, exceptional overall progress, and a better life for most. 

In the same way, I’m convinced that capitalism is the worst economic system . . . except for all the rest.”

Capitalism is the only system that will provide you the ability to achieve unbridled success.

Yes, the Government can pay for anything you want. The problem is that it requires those who are succeeding to pay for it.

Think about it.

Do you want to work hard, sacrifice, and take on an exceeding amount of risk to achieve success only to pay for those who don’t?

This is why socialism always fails.

“The greater good can only be achieved by making the good greater.” – Daniel LaCalle

“Only those that risk going too far can possibly find out how far one can go.” – T.S. Eliot

Well, this certainly seems to be the path that the Federal Reserve, and global Central Banks, have decided take.

Yesterday, the Fed lowered interest rates by a quarter-point and maintained their “dovish” stance but suggested they are open to “allowing the balance sheet to grow.” While this isn’t anything more than just stopping Q.T. entirely, the markets took this as a sign that Q.E. is just around the corner.

That expectation is likely misguided as the Fed seems completely unconcerned of any recessionary impact in the near-term. However, such has always been the case, historically speaking, just before the onset of a recession. This is because the Fed, and economists in general, make predictions based on lagging data which is subject to large future revisions. Regardless, the outcome of the Fed’s monetary policies has always been, without exception, either poor, or disastrous.

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 2-year rate, bad ‘stuff’ has historically followed.”

The idea of pushing limits to extremes also applies to stock market investors. As we pointed out on Tuesday, the risks of a liquidity-driven event have increased markedly in recent months. Yet, despite the apparent risk, investors have virtually “no fear.” (Bullish advances are supported by extremely low levels of volatility below the long-term average of 19.)

“First, “record levels” of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution.”

In the “rush to be bullish” this a point often missed. When markets are hitting “record levels,” it is when investors get “the most bullish.” That is the case currently with retail investors “all in.”

Conversely, they are the most “bearish” at the lows.

It is just human nature.

“What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.” – T.S. Eliot

The point here is that “all things do come to an end.” The further from the “mean” something has gotten, the greater the reversion is going to be. The two charts below illustrate this point clearly.

Bull markets, with regularity, are almost entirely wiped out by the subsequent bear market.

Despite the best of intentions, market participants never act rationally.

Neither do consumers.

The Instability Of Stability

This is the problem facing the Fed.

Currently, investors have been led to believe that no matter what happens, the Fed can bail out the markets and keep the bull market going for a while longer. Or rather, as Dr. Irving Fisher once uttered:

“Stocks have reached a permanently high plateau.”

Interestingly, the Fed is dependent on both market participants, and consumers, believing in this idea. As we have noted previously, 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.”

The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.

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, as noted above, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.

• In the early 70’s it was the “Nifty Fifty” stocks,
• Then Mexican and Argentine bonds a few years after that
• “Portfolio Insurance” was the “thing” in the mid -80’s
• Dot.com anything was a great investment in 1999
• Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
• Today, it’s ETF’s and “Passive Investing,” and levered credit.

As noted Tuesday, the risk to this entire house of cards is a credit-related event.

“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 suggest 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. 

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. That is, until suddenly, and often without warning, it all goes “pear\-shaped.”

In November and December of last year, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time. While, that rout was quickly forgotten as markets stormed back to all-time highs, on “hopes” of Central Bank liquidity and “trade deals.”

The difference today, versus then, are the warning signs of deterioration in areas which pose a direct threat to everyone “acting rationally.” 

“While yields going to zero] 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.’” 

Risk is clearly elevated as the Fed is cutting rates despite the “economic data” not supporting it. This is clearly meant to keep everyone acting rationally for now.

The problem comes when they don’t.

The Single Biggest Risk To Your Money

All of this underscores the single biggest risk to your investment portfolio.

In extremely long bull market cycles, investors become “willfully blind,” to the underlying inherent risks. Or rather, it is the “hubris” of investors they are now “smarter than the market.”

Yet, the list of concerns remains despite being completely ignored by investors and the mainstream media.

• Growing economic ambiguities in the U.S. and abroad: peak autos, peak housing, peak GDP.
• Political instability and a crucial election.
• The failure of fiscal policy to ‘trickle down.’
• An important pivot towards easing in global monetary policy.
• Geopolitical risks from Trade Wars to Iran 
• Inversions of yield curves
• Deteriorating earnings and corporate profit margins.
• Record levels of private and public debt.
•  More than $3 trillion of covenant light and/or sub-prime corporate debt. (now larger and more pervasive than the size of the subprime mortgages outstanding in 2007)

For now, none of that matters as the Fed seems to have everything under control.

The more the market rises, the more reinforced the belief “this time is different” becomes.

Yes, our investment portfolios remain invested on the long-side for now. (Although we continue to carry slightly higher levels of cash and hedges.)

However, that will change, and rapidly so, at the first sign of the “instability of stability.” 

Unfortunately, by the time the Fed realizes what they have done, it has always been too late.

Since August of 1978, there have been seven instances where the yields on ten-year Treasury Notes were lower than those on two-year Treasury Notes, commonly referred to as “yield curve inversion.” That count includes the current episode which only just occurred. In all six prior instances a recession followed, although in some cases with a lag of up to two years.

Given the yield curve’s impeccable 30+ year track record of signaling recessions, we think it is appropriate to compare the current inversion to those of the past. In doing so, we can further refine our economic and market expectations.

Bull or Bear Flattening

In this section, we graph the seven yield curve inversions since 1978, showing how ten-year U.S. Treasuries (UST), two-year UST and the 10-year/2 year curve performed in the year before the inversion.

Before progressing, it is worth defining some bond trading lingo:

• Steepener- Describes a situation in which the difference between the yield on the 10-year UST and the yield on the 2y-year UST is increasing. Steepeners can occur when both securities are trending up or down in yield or when the 2-year yield declines while the 10-year yield increases.

• Flattener- A flattener is the opposite of a steepener, and the difference between yields is declining.  As shown in the graph above, the slope of the curve has been in a flattening trend for the last five years.

• Bullish/Bearish- The terms steepener and flattener are typically preceded with the descriptor bullish or bearish. Bullish means yields are declining (bond prices are rising) while bearish means yields are rising (bond prices are falling). For instance, a bullish flattener means that both 2s and 10s are declining in yield but 10s are declining at a quicker pace. A bearish flattener implies that yields for 2s and 10s are rising with 2s increasing at a faster pace.  Currently, we are witnessing a bullish flattener. All inversions, by definition, are preceded by a flattening trend.

As shown in the seven graphs below, there are two distinct patterns, bullish flatteners and bearish flatteners, which emerged before each of the last seven inversions. The red arrows highlight the general trend of yields during the year leading up to the curve inversion.  

Data for all graphs courtesy St. Louis Federal Reserve

Five of the seven instances exhibited a bearish flattening before inversion. In other words, yields rose for both two and ten year Treasuries and two year yields were rising more than tens. The exceptions are 1998 and the current period. These two instances were/are bullish flatteners.

Bearish Flattener

As the amount of debt outstanding outpaces growth in the economy, the reliance on debt and the level of interest rates becomes a larger factor driving economic activity and monetary and fiscal policy decisions. In five of the seven instances graphed, interest rates rose as economic growth accelerated and consumer prices perked up. While the seven periods are different in many ways, higher interest rates were a key factor leading to recession. Higher interest rates reduce the incentive to borrow, ultimately slowing growth and in these cases resulted in a recession.

Bullish Insurance Flattener

As noted, the current period and 1998 are different from the other periods shown. Today, as in 1998, yields are falling as the 10-year Treasury yield drops faster than the 2-year Treasury yield. The curve thus flattens and ultimately inverts.

Seven years into the economic expansion, during the fall of 1998, the Fed cut rates in three 25 basis point increments. Deemed “insurance cuts,” the purpose was to counteract concerns about sluggish growth overseas and financial market concerns stemming from the Asian crisis, Russian default, and the failure of hedge fund giant Long Term Capital. The yield curve inversion was another factor driving the Fed. The domestic economy during the period was strong, with real GDP staying above 4%, well above the natural growth rate.  

The current period is somewhat similar. The U.S. economy, while not nearly as strong as the ’98 experience, has registered above-trend economic growth for the last two years. Also similar to 1998, there are exogenous factors that are concerning for the Fed. At the top of the list are the trade war and sharply slowing economic activity in Europe and China. Like in 1998, we can add the newly inverted yield curve to the list.

The Fed reduced rates by 25 basis points on July 31, 2019. Chairman Powell characterized the cut as a “mid-cycle adjustment” designed to ensure solid economic growth and support the record-long expansion. Some Fed members are describing the cuts as an insurance measure, similar to the language employed in 1998.

If 1998-like “insurance” measures are the Fed’s game plan to counteract recessionary pressures, we must ask if the periods are similar enough to ascertain what may happen this time.

A key differentiating factor between today and the late 1990s is not only the amount of debt but the dependence on it.   Over the last 20 years, the amount of total debt as a ratio to GDP increased from 2.5x to over 3.5x.

Data Courtesy St. Louis Federal Reserve

In 1998, believe it or not, the U.S. government ran a fiscal surplus and Treasury debt issuance was declining. Today, the reliance on debt for new economic activity and the burden of servicing old debt has never been greater in the United States. Because rates are already at or near 300-year lows, unlike 1998, the marginal benefits from borrowing and spending as a result of lower rates are much less economically significant currently.

In 1998, the internet was in its infancy and its productive benefits were just being discovered. Productivity, an essential element for economic growth, was booming. By comparison, current productivity growth has been lifeless for well over the last decade.

Demographics, the other key factor driving economic activity, was also a significant component of economic growth. Twenty years ago, the baby boomers were in their spending and investing prime. Today they are retiring at a rate of 10,000 per day, reducing their consumption and drawing down their investment accounts.

The key point is that lower rates are far less likely to spur economic activity today than in 1998. Additionally, the natural rate of economic growth is lower today, so the economy is more susceptible to recession given a smaller decline in economic activity than it was in 1998.

The 1998 rate cuts led to an explosion of speculative behavior primarily in the tech sectors. From October of 1998 when the Fed first cut rates, to the market peak in March of 2000, the NASDAQ index rose over 300%. Many equity valuation ratios from the period set records.

We have witnessed a similar but broader-based speculative fervor over the last five years. Valuations in some cases have exceeded those of the late 1990s and in other cases stand right below them. While the economic, productivity, and demographic backdrops are not the same, we cannot rule out that Fed cuts might fuel another explosive rally. If this were to occur, it will further reduce expected returns and could lead to a crushing decline in the years following as occurred in the early 2000s.  

Summary

A yield curve inversion is the bond market’s way of telegraphing concern that economic growth will slow in the coming months. Markets do not offer guarantees, but the 2s-10s yield curve has been right every time in the last 30 years it voiced this concern. As the book of Ecclesiastes reminds us, “the race does not always go to the swift nor the battle to the strong…”, but that’s the way to bet.

Insurance rate cuts may buy the record-long economic expansion another year or two as they did 20 years ago, but the marginal benefit of lower rates is not nearly as powerful today as it was in 1998.

Whether the Fed combats a recession in the months ahead as the bond market warns or in a couple of years, they are very limited in their abilities. In 2000 and 2001, the Fed cut rates by a total of 575 basis points, leaving the Fed Funds rate at 1.00%. This time around, the Fed can only cut rates by 225 basis points until it reaches zero percent. When we reach that point, and historical precedence argues it will be quicker than many assume, we must then ask how negative rates, QE, or both will affect the economy and markets. For this there is no prescriptive answer.

I recently wrote about the “F.I.R.E.” movement and how it is a byproduct of late-stage bull market cycle. It isn’t just the “can’t lose” ideas which are symptomatic of bullish cycles, but also the actual activities of investors as well. Not surprisingly, the deviation of growth over value has become one of the largest in history.

This divergence of the “performance chase” should be a reminder of Benjamin Graham’s immortal warning:

“The investor’s chief problem, and even his worst enemy, is likely to be himself.” 

With valuations elevated, prices at record highs, and the current bull market the longest in U.S. history, it seems like a good time to review the 5-most dangerous psychological biases of investing.

The 5-Most Dangerous Biases

Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. 

From Dalbar’s 2018 study:

“In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months.”

Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.

Here are the top-5 of the most insidious biases investors are falling into RIGHT NOW!

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend only to seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate to be told we are wrong, so we tend to seek out sources which tell us we are “right.”

Currently, individual investors are “fully” back in the market despite a fairly decent bruising in 2018. Historically, this has not turned out well for individuals, but given that “optimism sells,” it is not surprising to see the majority of the mainstream meeting touting a continuation of the bull market.

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

2) Gambler’s Fallacy

The “Gambler’s Fallacy” is one of the bigger issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

This is one of the key issues that affect an investor’s long-term returns. Performance chasing has a high propensity to fail, continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.” 

I traced out the returns of large capitalization stocks (S&P 500) and U.S. Fixed Income (Barclay’s Aggregate Bond Index) for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns.

So, what’s hot in 2019, we detail this each week for our RIAPRO subscribers (30-day FREE TRIAL)

Currently, money is chasing Technology, Discretionary, and Communications, with Energy, Healthcare, and Bonds lagging. From a contrarian viewpoint, with “Value” dramatically underperforming “Growth” at this juncture of the investment cycle, there may be a generational opportunity soon approaching.

3) Probability Neglect

When it comes to “risk-taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.” 

The statistical probabilities of winning the lottery are astronomical. In fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. However, it is the “possibility” of instant wealth that makes the lottery such a successful “tax on poor people.”

As humans, we tend to neglect the “probabilities,” or rather the statistical measures of “risk,” undertaken with any given investment, in exchange for the “possibility” of gaining wealth. Our bias is to “chase” stocks, or markets, which already have large gains as it is “possible” they could move higher. However, the “probability” is that a corrective action will likely occur first.

With markets currently well deviated above long-term historical means, and valuations elevated, the possibility is greatly outweighed by the probability of a mean-reverting event first.  The following chart is derived from Dr. Robert Shiller’s inflation-adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data is calculated:

• The 12-period (3-year) Relative Strength Index (RSI),
• Bollinger Bands (2 and 3 standard deviations of the 3-year average),
• CAPE Ratio, and;
• The percentage deviation above and below the 3-year moving average. 
• The vertical RED lines denote points where all measures have aligned

Over the next several weeks, or even months, the markets could certainly extend the current deviations from long-term mean even further drive by the psychology of the “herd.” But 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.

Probability neglect is another major component to why investors consistently “buy high and sell low.”

4) Herd Bias

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions, but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted, I need to do it too.

“If all your friends jump off a cliff, are you going to do it too?” – said by every Mother in history.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets the “herding” behavior is what drives market excesses during advances and declines.

As noted above, the “momentum chase” currently is good example of “herding” behavior. As Michael Lebowitz noted recently:

“The graph below charts ten year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.”

“There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.

When the cycle turns, we have little doubt the value-growth relationship will revert. In such a case value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.”

Moving against the “herd” is where investors have generated the most profits over the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.

5) Recency Bias

Recency bias occurs when people more prominently recall, and extrapolate, recent events and believe that the same will continue indefinitely into the future. This phenomenon frequently occurs in with investing. Humans have short memories in general, but memories are especially short when it comes to investing cycles.

As Morningstar once penned:

“During a bull market, people tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. Investors thereby increase risk taking and may not think about diversification or portfolio management prudence. Then a bear market hits, and rather than be prepared for it with shock absorbers in their portfolios, investors instead suffer a massive drop in their net worths and may sell out of stocks when the market is low. Selling low is, of course, not a good long-term investing strategy.”

This bias in action looks a lot like the chart below.

During bull markets, investors believe that markets can only go up – so “buy the dip” becomes a “can’t lose” investment strategy.  This bias also works in reverse during bear markets. Investors become convinced the market will only go lower which eventually leads them to “panic selling” the lows.

Recency bias is the primary driver behind the “Buy High/Sell Low” syndrome.

Everyone’s A Genius

The last point brings me to something Michael Sincere once penned:

“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”

Michael’s point is very apropos, particularly today, it’s currently “high-fives and pats on the back.” 

The market’s ability to seemingly recover from every setback, and to ignore fundamental issues, has led investors to feel “bulletproof” as investment success breeds overconfidence.

The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations, and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done the realization of those “risks” occurs.

For investors, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle lasts twice as long as the bearish “down” cycle, the majority of the previous gains are repeatedly destroyed.

The damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’  The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.”

We are only human, and despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases which inevitably leads to poor decision making over time. This is why all great investors have strict investment disciplines they follow to reduce the impact of their emotions.

At market peaks – everyone’s a “Genius.”Save

Save

Save

Save

Debt allows a consumer (household, business, or government) to pull consumption forward or acquire something today for which they otherwise would have to wait. When the primary objective of fiscal and monetary policy becomes myopically focused on incentivizing consumers to borrow, spend, and pull consumption forward, there will eventually be a painful resolution of the imbalances that such policy creates. The front-loaded benefits of these tactics are radically outweighed by the long-term damage they ultimately cause.

Due to the overwhelming importance that the durability of economic growth has on future asset returns, we take a new approach in this article to drive home a message from our prior article The Death of the Virtuous Cycle. In this article, we use two simple examples to demonstrate how the Virtuous Cycle (VC) and Un-Virtuous Cycle (U-VC) have benefits and costs to society that play out over time.

The Minsky Moment

Before walking you through the examples contrasting the two economic cycles, it is important to put debt into its proper context. Debt can be used productively to benefit the economy in the long term, or it can be used to fulfill materialistic needs and to temporarily stimulate economic growth in the short term. While both uses of debt look the same on a balance sheet, the effect that each has on the borrower and the economy over time is remarkably different.

In the course of his life’s work as an economist, Hyman Minsky focused on the factors that cause financial market fragility and how extreme circumstances eventually resolve themselves. Minsky, who died in 1996, only recently became “famous” as a result of the sub-prime mortgage debacle and ensuing financial crisis in 2008. 

Minsky elaborated on his “stability breeds instability” theory by identifying three types of borrowers and how they evolve to contribute to the accumulation of insolvent debt and inherent instability.

• Hedge borrowers can make interest and principal payments on debt from current cash flows generated from existing investments.
• Speculative borrowers can cover the interest on the debt from the investment cash flows but must regularly refinance, or “roll-over,” the debt as they cannot pay off the principal.
• Ponzi borrowers cannot cover the interest payments or the principal on debt from the investment cash flows, but believe that the appreciation of the investments will be sufficient to refinance outstanding debt obligations when the investment is sold.

Over the past 20 years, investors have been witness to a remarkable sequence of bubbles. The first culminated when an abundance of Ponzi borrowers concentrated their investments in the equity markets and technology stocks in particular. Technology companies, frequently with operating losses, raised capital through stock and debt offerings from investors who believed excessive valuations could expand indefinitely.

The second bubble emerged in housing. Many home buyers acquired houses via mortgages payments they could in no way afford, but believed house prices would rise indefinitely allowing them to service their mortgage obligations via the extraction of equity.

Today, we are witnessing a broader asset price inflation driven by a belief that central banks will engage in extraordinary monetary policy indefinitely to prop up valuations in the hope for the always “just around the corner” wealth effect. Equity markets are near all-time highs and at extreme valuations despite weak economic growth and limited earnings growth. Bond yields are near the lowest levels (highest prices) human civilization has ever seen. Commercial real estate is back at 2007 bubble valuations and real assets such as art, wine, and jewelry are enjoying record-setting bidding at auction houses.

These financial bubbles could not occur in an environment of weak domestic and global economic growth without the migration of debt borrowers from hedge to speculative to Ponzi status.

Compare and Contrast

The tables below summarize two extreme economic models to exhibit how an economy dependent upon “Ponzi” financing compares to one in which savings are prioritized. In both cases, we show how the respective financial decisions influence consumption, profits, and wages.

Table 1, below, is based on the assumption that consumers spend 100% of their wages and borrow an additional amount equivalent to 10% of their income annually for ten years straight. The debt amortizes annually and is therefore retired in full in 20 years.  

Assumptions: Debt is borrowed each year for the first ten years at a 5% interest rate and ten year term, corporate profits and employee wages are 7% and 3% of consumption respectively, annual income is constant at $100,000 per year. 

Table 2, below, assumes consumers spend 90% of wages, save and invest 10% a year, and do not borrow any money. The table is based on the work of Henry Hazlitt from his book Economics in One Lesson.  

Assumptions: Productivity growth is 2.5% per year, corporate profits and employee wages are 7% and 3% of consumption respectively.

Table 1 is the U-VC and Table 2 is the VC. The tables illustrate that there are immediate economic benefits of borrowing and economic costs of saving. For example, in year one, consumption in Table 1 rises as a result of the new debt ($100,000 to $108,705) and wages and corporate profits follow proportionately. Conversely, table 2 exhibits an initial $10,000 decline in consumption to $90,000, and a similar decline in wages and corporate profits as a result of deferring consumption on 10% of the income that was designated for saving and investing.

After year one, however, the trends begin to reverse. In the U-VC example (Table 1), when new debt is added, debt servicing costs rise, and the marginal benefits of additional debt decline. By year eight, debt service costs ($10,360) are larger than the additional new debt ($10,000). At that point, without lower interest rates or larger borrowings, consumption will fall below the income level.

Conversely, in the VC example (Table 2), savings and investments engender productivity growth, which drives wages, profits, and consumption higher.

The graphs below highlight the consumption and wage trends from both tables.

As illustrated in both graphs, the short term justification for promoting the U-VC is prompt economic growth. Equally important, the reason that savings and investments in the VC are admonished is that they require discipline and a period of lesser growth, profits, and wages.

Debt-fueled consumption is an expedient measure to take when economic growth stalls and immediate economic recovery is demanded. While the marginal benefits of such action fade quickly, a longer-term policy that consistently encourages greater levels of debt and lower debt servicing costs can extend the beneficial economic effects for years, fooling many consumers, economists and business leaders into believing these activities are sustainable.

In the tables above, it takes almost seven years before consumption in the VC (Table 2) is greater than in U-VC (Table 1).  However, after that breakeven point, the benefits of a VC become evident as economic growth compounds at an increasing rate, quickly surpassing the stagnating trends occurring under the U-VC.

In the real world, VC or U-VC economies do not exist. Economies tend to exhibit characteristics of both cycles. In the United States, for example, some consumers and corporations are saving, investing, and generating productive economic gains. Productivity gains from years past are still providing benefits as well.  However, over the past 30 years, consumers have increasingly opted to borrow and consume in a Ponzi-like manner and neglect savings. In other words, the U.S. economy has increasingly favored “Ponzi” debt-fueled consumption and denied the benefits of savings and the VC. Then again, U.S. leadership has only encouraged these behavioral patterns through imprudent fiscal and monetary policies.

The U.S. and many other countries are once again approaching what has been deemed the Minsky Moment.  Similar to 2008, this is the point when debt becomes unserviceable and a sharp increase in defaults is unavoidable. Will the Federal Reserve be able to once again reignite “Ponzi” borrowing to suspend that outcome?

Summary

The U.S. and many other countries are forced to deal with the consequences of economic policy actions, borrowing, and consumption behaviors from years past. While the present economic situation is troubling, leadership is obligated to reflect on past choices and move forward with changes that are in the best interest of the country and its entire population. As our title suggests, we can continue to try to pull consumption forward and further harm future growth, or we can save and reward future generations with productivity gains resulting in greater economic growth and prosperity. 

Shifting direction, and “paying forward,” via more savings and investments and the deferral of some consumption, comes with immediate negative consequences to wages, profits, and economic growth. Nothing worth having is easy, as the saying goes. However, over time, the discipline is rewarded, and the economy can be on a more sustainable, prosperous path.

These economic concepts, tables, and graphs extend an accurate diagnosis of the “Death of the Virtuous Cycle.” They are intended to help investment managers better understand the costs and benefits of saving versus borrowing from a macroeconomic perspective. If successful in that endeavor, the substance of this article will afford managers better ideas about how to navigate a very uncertain investment landscape. The implications for the sustainability of economic growth and therefore long term asset returns are profound and the bedrock of all investment decisions. 

One of the most highly debated topics over the past few months has been the rise of Modern Monetary Theory (MMT). The economic theory has been around for quite some time but was shoved into prominence recently by Congressional Representative Alexandria Ocasio-Cortez’s “New Green Deal” which is heavily dependent on massive levels of Government funding.

There is much debate on both sides of the argument but, as is the case with all economic theories, supporters tend to latch onto the ideas they like, ignore the parts they don’t, and aggressively attack those who disagree with them. However, what we should all want is a robust set of fiscal and monetary policies which drive long-term economic prosperity for all.

Here is the problem with all economic theories – they sound great in theory, but in practice, it has been a vastly different outcome. For example, when it comes to deficits, John Maynard Keynes contended that:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”

In other words, when there is a lack of demand from consumers due to high unemployment, then the contraction in demand would force producers to take defensive actions to reduce output. Such a confluence of actions would lead to a recession.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Unfortunately, as shown below, economists, politicians, and the Federal Reserve have simply ignored the other part of the theory which states that when economic activity returns to normal, the Government should return to a surplus. Instead, the general thesis has been:

“If a little deficit is good, a bigger one should be better.”

As shown, politicians have given up be concerned with deficit reduction in exchange for the ability to spend without constraint.

However, as shown below, the theory of continued deficit spending has failed to produce a rising trend of economic growth.

When it comes to MMT, once again we see supporters grasping onto the aspects of the theory they like and ignoring the rest. The part they “like” sounds a whole lot like a “Turbotax” commercial:

The part they don’t like is:

“The only constraint on MMT is inflation.”

That constraint would come as, the theory purports, full employment causes inflationary pressures to rise. Obviously, at that point, the government could/would reduce its support as the economy would theoretically be self-sustaining.

However, as we questioned previously, the biggest issue is HOW EXACTLY do we measure inflation?

This is important because IF inflation is the ONLY constraint on debt issuance and deficits, then an accurate measure of inflation, by extension, is THE MOST critical requirement of the theory.

In other words:

“Where is the point where the policy must be reversed BEFORE you cause serious, and potentially irreversible, negative economic consequences?”

This is the part supporters dislike as it imposes a “limit” on spending whereas the idea of unconstrained debt issuance is far more attractive.

Again, there is no evidence that increasing debts or deficits, inflation or not, leads to stronger economic growth.

However, there is plenty of evidence which shows that rising debts and deficits lead to price inflation. (The chart below uses the consumer price index (CPI) which has been repeatedly manipulated and adjusted since the late 90’s to suppress the real rate of inflationary pressures in the economy. The actual rate of inflation adjusted for a basket of goods on an annual basis is significantly higher.) 

Of course, given the Government has already been running a “quasi-MMT” program for the last 30-years, the real impact has been a continued shift of dependency on the Government anyway. Currently, one-in-four households in the U.S. have some dependency on government subsidies with social benefits as a percentage of real disposable income at record highs.

If $22 trillion in debt, and a deficit approaching $1 trillion, can cause a 20% dependency on government support, just imagine the dependency that could be created at $40 trillion?

If the goal of economic policy is to create stronger rates of economic growth, then any policy which uses debt to solve a debt problem is most likely NOT the right answer.

This is why proponents of Austrian economics suggest trying something different – less debt. Austrian economics suggests that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which causes resources to be reallocated back towards more efficient uses.

Time To Wake Up

For the last 30 years, each Administration, along with the Federal Reserve, have continued to operate under Keynesian monetary and fiscal policies believing the model worked. The reality, however, has been most of the aggregate growth in the economy has been financed by deficit spending, credit expansion and a reduction in savings. In turn, the reduction of productive investment into the economy has led to slowing output. As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings. As a result of the increased leverage, more of their income was needed to service the debt.

Secondly, most of the government spending programs redistribute income from workers to the unemployed. This, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources toward redistribution and away from productive investment.

In its essential framework, MMT suggests correctly that debts and deficits don’t matter as long as the money being borrowed and spent is used for productive purposes. Such means that the investments being made create a return greater than the carrying cost of the debt used to finance the projects.

Again, this is where MMT supporters go astray. Free healthcare, education, childcare, living wages, etc., are NOT a productive investments which have a return greater than the carrying cost of the debt. In actuality, history suggests these welfare supports have a negative multiplier effect in the economy.

What is most telling is the inability for the current economists, who maintain our monetary and fiscal policies, to realize the problem of trying to “cure a debt problem with more debt.”

This is why the policies that have been enacted previously have all failed, be it “cash for clunkers” to “Quantitative Easing”, because each intervention either dragged future consumption forward or stimulated asset markets. Dragging future consumption forward leaves a “void” in the future which must be continually filled, This is why creating an artificial wealth effect decreases savings which could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the end result, has been clearly wrong. It hasn’t happened in 30 years.

MMT supporters have the same view that if the government hands out money it will create stronger economic growth. There is not evidence which supports such is actually the case.

It’s time for those driving both monetary and fiscal policy to wake up. The current path we are is unsustainable. The remedies being applied today is akin to using aspirin to treat cancer. Sure, it may make you feel better for the moment, but it isn’t curing the problem.

Unfortunately, the actions being taken today have been repeated throughout history as those elected into office are more concerned about “satiating the mob with bread and games” rather than suffering the short-term pain for the long-term survivability of the empire. In the end, every empire throughout history fell to its knees under the weight of debt and the debasement of their currency.

It’s time we wake up and realize that we too are on the same path.

I was digging through some old charts over the weekend and stumbled across this gem from AlphaTrends which explains the “best time to buy stocks.”

“Is it possible to time the market cycle to capture big gains?

Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff.

The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

So, the question to answer, obviously, is:

“Where are we now?”

I’m glad you asked.

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.

1992-2003

The accumulation phase, following the 1991 recessionary environment was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999.

As I noted last week:

“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nations pension funds to own equities and the repeal of Glass-Steagall which unleashed Wall Street upon a nation of unsuspecting investors.

The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough “legitimate” deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”

The distribution phase became evident in early-2000 as stocks began to struggle.

While the names of Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others are “ghosts of the past,” relics of an era the majority of investors in the market today are unaware of, they were the poster children for the “greed and excess” of the preceding bull market frenzy.

As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future. 

Then, came the decline.

2003-2009

Following the “dot.com” crash investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27 minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

During the mark-up phase investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”

Once again, during the distribution phase of the market, the analysts, media, Wall Street, and a rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.” 

They were disastrously wrong.

Sound familiar?

2009-Present

So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.

Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.” Despite a year-long distribution in the market, the same messages seen at previous market peaks have been steadily hitting headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”

Lost And Found

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, which only seems to go up, you can certainly understand why mainstream analysis continues to believe the markets can only go higher.

What is concerning is the rather cavalier attitude the mainstream media takes about bear markets.

“Sure, a correction will eventually come, but that is just part of the deal.”

What gets lost during these bullish cycles, and is found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline.

Let’s look at the S&P 500 inflation-adjusted total return index in a different manner. The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.

What you should notice is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the previous bull market advance. This is shown more clearly when we look at a chart of bull and bear markets in terms of points.

Whether or not the current distribution phase is complete, there are many signs suggesting the current Wyckoff cycle may be entering its final stage of completion. 

Let me remind you of something Ben Graham said back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.” 

While “passive indexing” sounds like a winning approach to “pace” the markets during an advance, it is worth remembering that approach will also “pace” the decline.

The recent sell-off should have been a wake-up call to just how quickly things can change and how damaging they can be.

There is no difference between a 100% gain and a 50% loss.

(For the mathematically challenged: If the market rises from 1000 to 2000 it is a 100% gain. A fall from 2000 to 1000 is a 50% loss. Net return is 0%)

Understanding that investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of how devastating corrections can be on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins,” there is a huge difference between just making money and actually reaching your financial goals.

• * Beware of investment fads and the experts that deliver endorsing pablum in the business media
• * They are not your allies in delivering good investment returns — they are harmful to your investment well being

“Thus hath the candle singd the moath.”
– William Shakespeare, The Merchant of Venice

This morning the price of bitcoin is down by another 10%: the price is flirting with $10,000 after trading at around $20,000 a few months ago.

The phrase “like a moth to a flame” is an allusion to the well known attraction that moths have to bright lights.

The word moth was used in the 17th century to refer to someone who was apt to be tempted by something that would lead to their downfall.

So it is with many in the business media, who too often, like Wall Street offering up conflicted research recommendations, seek audience over intelligence by parading experts (in the latest fad, like cryptocurrencies) and, too wittingly become the enemy of the average and uninformed investor. These experts, with memorized sound bytes, will always sound confident and rarely express the notion of risk. But, many of that audience will learn, like The Wizard of Oz, that they’re simply delivering an odious pablum –– bland or insipid intellectual fare and entertainment.

Those outlets that are inundated by crypt talk know who they are — like Warren Buffett, I prefer to criticize by category (and praise by name). (As evidence to the preoccupation, just take a quick look at the Twitter threads of some of the leading business media shows — they are overwhelmed by crypto chatter and nonsensical and hyperbolic opinions.)

Popular investment fads often too quickly become unprofitable investment endeavors — dot.com stocks in 1999 and housing/banking stocks in 2007 come to mind.

Ultimately the frequency of media coverage will diminish coincident with the fads’ price declines (and investors/traders lost interest). While the business media may shamelessly move on (unlike research firms and money managers who deliver poor investment advice, will face little retribution), your portfolio could be permanently impaired by what Joe Granville used to call “the bagholders’ blues.”

I may be wrong in my ursine view of bitcoin, et al, and though I no longer have any position (See Tales of the Crypt (Issue IX), I have written tens of thousands of words on the subject, discussing both the potential rewards but also, importantly, the risks as I saw them:

* There’s A Sucker Born Every Minute
* Res Ipsa Idiot

Many in the business media may ultimately forget their current preoccupation with crypto and drop coverage if my negative forecasts continue to be realized — but not until lots of money is lost in the process.

More

Not to worry, when enough time transpires, the same experts will be trotted back onto the business media with another investment idea in hand — just as the case is now, some nine years after The Great Recession and near 80% drops in their portfolios.

Some may say “time heals all wounds.”

But I disagree, as this elephant never forgets.

“The market does not know you exist. You can do nothing to influence it. You can only control your behavior.”

– Alexander Elder

It is up to each trader/investor to evaluate reward vs. risk of each investment — as many in the business media and the talking heads and commentators will not necessarily address upside compared to downside particularly in the trade du jour.

These days I am too often reminded of Benjamin Disraeli’s quote:

“What we have learned from history is that we haven’t learned from history.”

“For many, it will be increasingly difficult to navigate a market dominated by the overly popular ETFs and quant (volatility-trending and risk-parity) strategies that worship at the altar of price momentum. It is also because the ‘buy the dip’ mentality remains indelibly etched on the forehead of most investors and traders that the Pavlovian reaction won’t die easily.

Favoring the bulls is the diminished number of publicly held companies outstanding (from more than 7,600 in 2000 to 3,800 in 2017), a 17% reduction in the float of the remaining companies via corporate buybacks, and still-abundant liquidity. And on top of this, as previously mentioned, is the market’s participants confidence in buying the dips.” – Kass Diary, The Bull Wont Die Easily (November, 2017)

In trying to understand the relentless “Bull Market” advance since the Trump Election fourteen months ago I am reminded of what I wrote above in November, 2017.

These words were underscored in Jim “El Capitan” Cramer’s “Four Reasons Stocks Keep Going Up,” written at the end of yesterday’s trading session, in which he discusses the important structural changes that have led to the popularity of passive investing (ETFs) and in the share count drop caused by a near decade of aggressive corporate buybacks.

Of course there are numerous other reasons (some Jim details further) like the employment of large liquidity infusions from central bankers around the world, optimism about the cut in corporate taxes, the reductions of business regulations (around the fringe), sustained lower interest rates, etc.

As I have also written, investment vision is always 20/20 when viewed in the rear view mirror.

These past observations don’t really help us project the future — though I did touch on some of my concerns in yesterday’s opening missive, “Blinded By a Sense of History” (with some updates in parentheses):

“It is a mania shared by philosophers of all ages to deny what exists and to explain what does not exist.” – Jean-Jacques Rousseau

I have no clue how long it will continue:

* What I am certain about is that liquidity, which has buoyed our markets for years, is starting to be reduced. (Central Bankers are reversing course and beginning to contract their balance sheets)

* What I am fairly certain about is that we are at sentiment and valuation extremes — at least based on history. (And every day these measures grow more stretched)

* Interest rates are likely headed higher, posing — at some point — a potential risk and alternative to stocks. (The ten year US note yield rose above 2.50% this morning)

* I expect no further major legislative initiatives coming out of Washington, D.C. — specifically on the infrastructure front — and a further deterioration in the relationship between the Republicans and Democrats as we move toward key midterm elections. (My expectation is that the House goes Democrat while the Senate stays Republican.)

* As to the Administration, their belief appears to be that the benefit of world leadership is not worth the costs — which runs the risk of a policy mistake in the year ahead.

* As well, though markets have not been yet unnerved even with the White House having gotten bitten by a Wolff this past week, there exists the possibility that the Special Counsel’s
activities could be market unfriendly.

* And I am of the view that the earnings and economic growth expectations will, once again, be disappointing in 2018-19. (Earnings revisions higher have been material (in large measure from tax cuts) but I see mid year as a pivot point of slowing, not accelerating growth)

The markets seem to be moving back to being one with more concentrated leadership — as technology and the FAANGs (a large percent of the S&P Index) have regained their strength. Small caps, supposed tax cut beneficiaries, are lagging. Again, historically these are not positive signposts but it can continue, I have learned, far longer than I anticipated.

The speculation in cryptocurrencies and blockchain and penny stocks is yet another thin reed indicator of a mature Bull. And so is the self confidence and hubris seen in the business media.

Risk assets, like stocks, are called risk assets because they have risk — though you wouldn’t know it from the recent action in which fear and doubt has left the Exchanges.

But, wrong is wrong — and I continue to see ghosts that few market participants are viewing, blinded by a sense of history.

My strategy, given that the markets have clearly moved so much higher than my baseline expectations — is to become more trading oriented and to maintain high cash levels.

As described in my Diary, I see few longs that meet my standards of purchase.

As the market moves almost parabolically, I have recently begun to more aggressively short strength while keeping my stops fairly tight. (Day or days trades.)

Recently, with the exception of the last day of the year in which I profited, this has been a losing proposition.

Wash, rinse, repeat.

My view through the windshield (and the future) has been dramatically worse than my view through the rear view mirror (and the past) as stocks have marched ever higher without the sign of any meaningful pause.

While Grandma Koufax used to say, “Dougie, matzah doesn’t grow to the sky,” the investment trees are like redwoods these days.

“TIME is the most important factor in determining market movements and by studying the past records of averages or individual stocks you will be able to prove for yourself that history does repeat and that by knowing the past you can tell the future.”  W.D. Gann, 1939

The analysis and forecasts presented in this article are based on the analytical framework of W.D. Gann.  Gann is an investing legend, labeled as genius by many financial historians.  He reportedly accumulated $50 million in profits during his trading career.  His superior track record and those of others using his methods argues that, regardless of our opinion of his methodology, we should heed the advice of his work.

A more detailed explanation of his analytical framework is included in the last section of this article.

Forecast: 2018-2020

The Dow Jones Industrial Average forecast, in the graph above, is based upon the natural 20-year cycle that Gann identified.  The lines in the graph show the projected monthly cumulative percentage returns from the peak level.  The yellow line is the average scenario and the aqua line is the pessimistic scenario.  The graph provides monthly estimates for 2018.  The last data point represents June 2020, which covers the entire 30-month period from December 2017.

My average scenario forecasts a -15.29% price return for 2018.  The cumulative price return is forecast to bottom in June 2020 at -20.39%, at which time an extended rally should ensue.

My pessimistic scenario forecasts a -32.90% price return for 2018.  The cumulative price return is forecast to be little-changed in June 2020 at -31.23%, at which time an extended rally in should ensue.

20-Year Cycle: Timing Analysis

The New York Stock Exchange (NYSE) began trading operations in 1792.  However, the natural cause of the 20-year cycle first occurred in 1801.  Accordingly, a proper analysis of the 20-year cycle must begin with 1801 as a starting point.  The explanation for this is provided in the section entitled The Natural Cause of the 20-Year Cycle.

The 20-year cycles, from the inception of the NYSE, consist of the following time periods: 1. 1801-1820, 2. 1821-1840, 3. 1841-1860, 4. 1861-1880, 5. 1881-1900, 6. 1901-1920, 7. 1921-1940, 8. 1941-1960, 9. 1961-1980, 10. 1981-2000, and the current cycle 11, 2001-2020.  Due to limitations of acquiring historical data, the data set of the Dow Jones Average used in this analysis consists of monthly closing prices beginning in January 1901, the sixth 20-year cycle.

To use the data effectively and prepare a forecast, I compare the progression of the current 20-year cycle (2001-2020) with the previous five 20-year cycles, beginning in 1901.  The following five graphs display the comparisons.  Price levels are indexed to 1.00 in month 1 of the cycles and, although not labeled on the graphs, that is the scale of the Y-axis.

As seen in the preceding graphs, the current 20-year cycle has some similarities and some differences with the five previous 20-year cycles.  Based on that visual analysis alone, the individual correlations are not strong enough to base investment decisions on.

Undeterred by the results from the individual comparisons, I built a composite 20-year cycle.  The components of the composite 20-year cycle are the five historical individual 20-year cycles shown in the preceding graphs.  The composite 20-year cycle averages those five cycles and, importantly, does not include data from the current 20-year cycle.  The following graph displays the composite 20-year cycle overlaid with the current 20-year cycle.  Price levels are indexed to 1.00 in month 1 of the cycles and, although not labeled on the graphs, that is the scale of the Y-axis.  Significant peaks and troughs are labeled as points 1-7 on both cycles.

While the correlation of the current 20-year cycle to the composite 20-year cycle is strong, you may have noticed that the current 20-year cycle is progressing faster through peaks and troughs than the composite 20-year cycle.  As a result, I “shift forward” (move to the right) the line of the current 20-year cycle by 22 months.  With the data shifted, the timing of the peaks, troughs, and congestions are virtually identical.  As displayed, the graph and data suggest that December 2017 is the peak of the current 20-year cycle.

20-Year Cycle: Price Return Analysis

The second step in this analysis is to compare the actual price returns for the identified 20-year cycles.  To do so, I identified the seven peaks and troughs within each respective 20-year cycle (points 1-7).  This allows for the comparison of the differences in duration between the pivot points of the composite 20-year cycle and the current 20-year cycle.  The following table maps points 1-7 with the appropriate month in the cycle and with the actual months for individual 20-year cycles:

With the actual dates signifying the composite peak and trough for each historical cycle, I then calculated the percentage price returns between each point in the composite 20-year cycle for each historical cycle.  This allows for comparison of differences in the magnitude of the price moves from point to point.  The following table contains the results.

The final step in this analysis and, the most important in preparing my forecast, is to identify what happened once point 7, the final peak of each 20-year cycle, was reached.  Not only did I look at the following twelve months, but I continued the analysis into the beginning of the ensuing cycle (point 2 of the new 20-year cycle).

Using the dates identified as point 7 in the preceding tables, I calculated cumulative percentage returns from the peak price level for each 20-year cycle.  For the first year, these are calculated monthly.  The final observation is labeled “Average Peak + 30 Months”, which is point 2 of the following cycle.  Historically, after the low at point 2 is reached a rally begins which is extended in both price and time.  The following table contains the results.

In 4 out of 5 historical 20-year cycles, 80% of the sample, the cumulative percentage returns from the peak price level is negative in every month of the first 12 months following the peak.

In 5 out of 5 historical 20-year cycles, 100% of the sample, the cumulative percentage returns from the peak price level is negative 30 months following the peak.

One historical 20-year cycle, 1961-1980, stands out in the forward-return table due to its positive returns.  The forward returns in this period include the months from January 1980 to June 1982.  Five unique factors contribute to these positive returns:  1. demographic tailwind (the baby boomers were entering their prime earning and spending years), 2. tax-deferred retirement savings accounts were legally created in 1978, 3. mutual funds were relatively new and experiencing tremendous growth, 4. financial deregulation and, 5. consumer credit expansion was beginning in earnest.

To prepare my Dow Jones Industrials forecast, the average scenario uses the average historical experience, excluding the 1961-1980 20-year cycle.  The demographic and legislative factors listed above that bolstered returns in the early 1980’s are now largely turning into headwinds.  Also, I hold the belief that financial deregulation and the resulting financial engineering has reached its zenith.  Additional financial deregulation will have minimal benefits going forward.  Lastly; consumers, state governments, and the federal government have accrued outstanding debt levels so large that make the continued growth of debt increasingly challenging.

My pessimistic scenario uses the minimum percentage returns identified in the preceding table.  Arguably, that may turn out to be conservative as my fundamental valuation model, alone, suggests a -65% decline is warranted.

Scientific & Mathematical Foundation:

Standing on the Shoulders of Genius

In his book How To Make Profits in Commodities, W.D. Gann makes the statement that everything in existence is based on exact proportion and perfect relation.  He also states that, in nature, there is no chance because mathematical principles of the highest order are at the foundation of all things.  “As Faraday said, there is nothing in the universe except mathematical points of force.”

Michael Faraday (1791-1867) was one of the most influential scientists in history.  He discovered the principles underlying electromagnetic induction, diamagnetism, and electrolysis.  Faraday also established that magnetism could affect rays of light and that there was an underlying relationship between the two.  This led him to study the magnetic properties of the Earth’s atmosphere.  Faraday realized that magnetic energy emerges from the Sun and each of the planets in our solar system.  Further, he explained how these planetary magnetic energies interact with one another, directly affecting how much of the Sun’s magnetic energy reaches the Earth’s atmosphere.  He referred to these magnetic energies as “magnetic lines of force”.  These lines are similar to the idea of Pythagoras’ strings.

Pythagoras of Samos (570 BC-495 BC) was a Greek philosopher and mathematician.  He is credited with many mathematical and scientific discoveries including the Pythagorean Theorem, Pythagorean Tuning, the five regular solids, the Theory of Proportions, the Sphericity of the Earth, and the identity of the planet Venus.  He exerted a profound impact on the philosophies of Plato, Aristotle, and, through them, Western philosophy.  Pythagoras believed that the universe was connected by strings.  The strings were connected to the spirit world at the top and to the Earth below.

W.D. Gann studied the works of both Pythagoras and Faraday.  He frequently referred to “natural law” in his writings.  For example, in his 1929 Stock Forecast Gann stated:

“It is natural law.  Action equals reaction in the opposite direction.  We see it in the ebb and flow of the tide and we know from the full bloom of summer follows the dead leaves of winter.”

What Gann was referring to was his belief, based upon the work of Faraday (which was influenced by Pythagoras), that as the planets in our solar system move through their orbits around the sun, the interaction of their magnetic lines of force changes the amount of magnetic energy from the Sun that reaches the Earth’s atmosphere.  These changes affect every naturally occurring event on Earth, including weather, crop growth, and human psychology.  Because of his belief, Gann spent his life researching how the positions of the individual planets and how the angular relationships of the planets relative to one another affected financial markets.  Gann is also well known for his use of his number sequences in the form of squares, circles, and hexagons.  These number sequences follow a defined mathematical relationship to one another.  It is apparent from this discussion that Gann was both a scientist and a mathematician.  He was financially successful in the application of his research, as evidenced by his published books, students of his correspondence courses, and his now famous 1909 interview in Ticker and Investment Digest.  He reportedly accumulated $50 million in profits during his trading career.

The Natural Cause of the 20-Year Cycle

As I stated on page three, the 20-year cycle has a natural cause.  This natural cause is the conjunction of the planets Jupiter and Saturn.  A planetary conjunction occurs when the difference in longitude between to planets is zero degrees.  If you were looking up into the night sky, the Earth, Jupiter, and Saturn would appear to be in a straight line.  The actual amount of time between the conjunction of Jupiter and Saturn varies from slightly under 20 years to slightly over 20 years.  From the list of historical 20-year cycles presented on page three, a conjunction occurred in the first year of the cycle every time.  This explains why I used 1801 as the starting point of the first 20-year cycle.  Using an ephemeris you can identify the location of each planet, and their angular relationships to one another, throughout history and infinitely forward in time.  The next conjunction of Jupiter and Saturn will occur on December 21, 2020, signifying the start of the twelfth 20-year cycle.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight to many different markets.  If you are a professional market participant, and are open to discovering more, please connect with us.

We are not asking for a subscription, we are asking you to listen. 

“The opening crawl is the signature device of every numbered film of the Star Wars series, an American epic space opera franchise created by George Lucas. It opens with the static blue text, ‘A long time ago in a galaxy far, far away….’, followed by the Star Wars logo and the crawl text, which describes the backstory and context of the film. The visuals are accompanied by the “Main Title Theme“, composed and conducted by John Williams.

The sequence has been featured in every live-action Star Wars film produced by Lucasfilm with the exception of Rogue One. Although it retains the basic elements, it has significantly evolved throughout the series. It is one of the most immediately recognizable elements of the franchise and has been frequently parodied.

Each film opens with the static blue text, “A long time ago in a galaxy far, far away….”, followed by the Star Wars logo shrinking in front of a field of stars. Initially the logo’s extremities are beyond the edge of the frame. While the logo is retreating, the “crawl” text begins, starting with the film’s episode number and subtitle (with the exception of the original release of Star Wars – see below), and followed by a three-paragraph prologue to the film. The text scrolls up and away from the bottom of the screen towards a vanishing point above the top of the frame in a perspective projection. Each version of the opening crawl ends with a four-dot ellipsis, except for Return of the Jedi which has a three-dot ellipsis. When the text has nearly reached the vanishing point, it fades out, the camera tiltsdown (or, in the case of Episode II: Attack of the Clones, up), and the film begins.” –Star Wars Opening Crawl, Wikipedia

As Mel Brooks wrote in the opening crawl of his parody “Spaceballs“:

Once upon a valuation warp. . . .

In a market very, very, very, very far away, there lived a ruthless race of beings known as … Momentum Investors.

Chapter Eleven

The evil leaders of momentum investing, having foolishly overestimated economic and profit growth and taken valuations to an extreme, have revised a secret plan to take every breath of reason from their reason- loving neighbor, Value Investing.

Today is Halloween. Unbeknownest to the consensus, but knownest to us, danger lurks in the stars above..

If you can read this, you don’t need glasses.

But I am getting ahead of myself, so let me start from the beginning:

Episode I: THE PHANTOM MENACE

“Turmoil has engulfed Planet Investors, upending rational investing. The statutory corporate tax rates to outlying star systems are in dispute.

Hoping to resolve the matter with a tax-free repatriation of overseas cash, the White House has stopped all shipping to the small planet of Maine.

While the Congress of the Republic endlessly debates this alarming chain of events, the Supreme Tweeter has secretly dispatched two of his warriors (Mnuchin and Cohn), his guardians of low taxes for the nobles in the galaxy, to settle the conflict….”

Episode II: ATTACK OF THE CLONES

“There is unrest in the Galactic Senate. As several establishment Republicans have declared their intentions to leave the Republic.

This separatist movement, under the leadership of the mysterious Count Flake, has made it difficult for the limited number of warriors to maintain peace and order in the galaxy.

Senator Collins, the former Queen of Maine, is returning to the Galactic Senate to vote on the critical issue of creating an ARMY OF THE REPUBLIC to assist the overwhelmed Jedi….”

Episode III: REVENGE OF THE SITH

“Twitter War! The Republic is crumbling under attacks by the ruthless Sith Lord, Robert Mueller. There are heroes on both sides. Evil is everywhere.

In a stunning move, the fiendish aging droid leader, General Bernie Sanders (not to be confused with the Evil Colonel Sandurz), has swept into the Republic capital and kidnapped Chancellor McConnell, leader of the Galactic Senate.

As the Separatist Droid Army attempts to flee the besieged capital with their valuable hostage, two other Jedi Knights lead a desperate mission to rescue the captive Chancellor….”

Episode IV: A NEW HOPE

“It is a period of investor strife. Rebel spaceships, striking from a hidden base, (with price-earnings ratios ever expanding and dips ever bought) have won their first victory against the evil Galactic Empire (despite the robotic and fake impressions coming out of Facebook and Twitter) .

During the battle, Rebel spies managed to steal secret plans to the Empire’s ultimate weapon, the Death Star AMAZON, an armored space station with enough power to destroy an entire planet (and/or markets).

Pursued by the Empire’s sinister agents, Princess Kamala races home aboard her starship (on the Left Coast), custodian of the stolen plans that can save the markets and instill value and common sense to the galaxy….”

Episode V: THE EMPIRE STRIKES BACK

“It is a dark time for the Rebellion. The Death Star Amazon has not yet been destroyed and Imperial troops have driven the Rebel forces from their hidden base and pursued them across the galaxy.

Evading the dreaded Imperial Starfleet (of Generals Kelly, H.R. McMaster and Mattis) , a group of freedom fighters led by Luke Booker has established a new secret base on the remote ice world of California.

The evil lord Paul Ryan, obsessed with finding young Booker, has dispatched thousands of remote probes (and quant strategies) into the far reaches of space, continuing to boost investor confidence and buoy the S&P Index….”

Episode VI: RETURN OF THE JEDI

“Luke Booker has returned to his home planet of Newark in an attempt to rescue his party from the clutches of the vile gangster Bannon the Hutt and from (unregulated and growing power/value) of the sinister FANGS.

Little does Luke know that the Galactic Empire has secretly begun construction on a new armored space station even more powerful than the first dreaded Death Star, AMAZON.

When completed, this ultimate weapon will spell certain doom for the small band of rebels and short sellers struggling to restore freedom and common sense to investors…”

Episode VII: THE FORCE AWAKENS 

“Luke Booker has vanished. In his absence, the sinister DARTH PUTIN has risen from the ashes of the Empire (and Facebook/Twitter) and will not rest until Booker, the last Jedi (and market complacency), have been destroyed.

With the support of the REPUBLIC, Princess Kamala Harris leads a brave RESISTANCE. She is desperate to find her brother Luke Booker and gain his help in restoring peace and justice and reasonable valuations to the galaxy.

Princess Kamala has sent her most daring pilot on a secret mission to PLANET DNC, where an old ally (Princess Elizabeth) has discovered a clue to Luke’s whereabouts….”

Hopefully, to find out the market outcome, we may only have to wait for next month’s (Dec. 15) release of Episode VIII, “The Last Jedi.”

But the wait could be as long as Dec. 20, 2019, with the release of the still-untitled Episode IX.

“Your eyes can deceive you. Don’t trust them.” – Obi-Wan Kenobi

It’s scary out there — after all, it’s Halloween.

Trick or treat?

Regardless of market outcomes, “May the Schwartz be with (all of) you.”

“Cause when life looks like Easy Street, there is danger at your door” – Grateful Dead

On numerous occasions, we have posited that equity investors appear to be blinded by consistently rising stock prices and the allure of minimal risks as portrayed by record low volatility. It is quite possible these investors are falling for what behavioral scientists diagnose as “recency bias”. This condition, in which one believes that the future will be similar to the past, distorts rational perspective. If an investor believes that tomorrow will be like yesterday, a prolonged market rally actually leads to a perception of lower risk which is then reinforced over time. In reality, risk rises with rapidly rising prices and valuations. When investors’ judgement becomes clouded by recent events, instead of becoming more cautious, they actually become more aggressive in their risk-taking.

In our premier issue of The Unseen, 720Global’s premium subscription service, we quantified how much riskier financial assets are than most investors suspect. The message in, The Fat Tail Wagging the Dog, is that extreme historical price changes occur with more frequency than a normal distribution predicts. Reliance upon faulty theories laced with flawed assumptions can lead investors to take substantial risks despite paltry expected returns.

In this article, we further expand on those concepts and present a simple framework to help readers understand the spectrum of risks that equity holders are currently taking.

Risk Spectrum

When one assesses risk and return, the most important question to ask is “Do my expectations for a return on this investment properly compensate me for the risk of loss?” For many of the best investors, the main concern is not the potential return but the probability and size of a loss.  A key factor to consider when calculating risk and return is the historical reference period. For example, if one is to estimate the risk of severe thunderstorms occurring in July in New York City, they are best served looking at many years of summer meteorological data for New York City as their reference period. Data from the last few weeks or months would provide a vastly different estimate. Likewise, if one is looking at the past few months of market activity to gauge the potential draw down risk of the stock market, they would end up with a different result than had they used data which included 2008 and 2009.

No one has a crystal ball that allows them to see into the future. As such the best tools we have are those which allow for common sense and analytical rigor applied to historical data. Due to the wide range of potential outcomes, studying numerous historical periods is advisable to gain an appreciation for the spectrum of risk to which an investor may be exposed. This approach does not assume the past will conform to a specific period such as the last month, the past few years or even the past few decades. It does, however, reveal durable patterns of risk and reward based upon valuations, economic conditions and geopolitical dynamics. Armed with an appreciation for how risk evolves, investors can then give appropriate consideration to the probability of potential loss.

Measuring Risk

The graph below plots the percentage price change of the S&P 500 that one would expect at each respective date given a 3-standard deviation price change. The data is computed based on price changes from the preceding six months. Essentially, the graph depicts expected outcomes for those solely relying on recency biased risk management approaches.  (On a side note, a 3-standard deviation price change should have occurred 14 times over the 17 year period based on a normal distribution. In reality, it happened 249 times!)

Data Courtesy: Bloomberg

Currently, if one is basing their risk forecast on the last six months of price data, they should anticipate that a “rare” 3-standard deviation change will result in a price change of 7.11% (green line). Accordingly, the table below applies a range of readings from the graph above to create an array of potential draw downs. The historical data is applied to the current S&P 500 price to provide current context.

We caution you, major draw downs are frequently much greater than a 3-standard deviation event.

Summary

As mentioned earlier, the best investment managers obsess not about what they hope to make on an investment but what they fear they could lose. At this juncture, current market dynamics offer a lot of reasons one should be concerned. For those who rest assured that the future will be representative of the immediate past, you likely already stopped reading this article. For those who recognize that regime shifts to higher volatility tend to follow periods when risk is under-appreciated, valuations are high and economic growth feeble, this framework should be a beneficial guide to better risk management. Although the timing is uncertain, we are confident that it will pay handsome dividends at some point in the future.

Save

Save

Save

Save

“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.

With the markets closed on Monday, there really isn’t much to update you on “technically” from this past weekend’s missive. The important point, if you haven’t read it, was:

“The failure of the market to rotate to the “risk on” trade should not be lightly dismissed.  A healthy breakout of the market should have been accompanied by both an increase in trading volume and leadership from the “smaller and riskier” stocks in the market. The chart below is the Russell 2000 Index as compared to the S&P 500 Index.”

You can see this exuberance in the deviation of the S&P 500 from its long-term moving averages as compared to the collapse in the volatility index. There is simply “NO FEAR” of a correction in the markets currently which has always been a precedent for a correction in the past. 

The chart below is a MONTHLY chart of the S&P 500 which removes the daily price volatility to reveal some longer-term market dynamics. With the markets currently trading 3-standard deviations above their intermediate-term moving average, and with longer-term sell signals still weighing on the market, some caution is advisable.

While this analysis does NOT suggest an imminent “crash,” it DOES SUGGEST a corrective action is more likely than not. The only question, as always, is timing.  

However, this brings me to something I have addressed in the past but thought would be a good reminder as we head into the summer months:

“The most dangerous element to our success as investors…is ourselves.”

The Formula To Buy High / Sell Low

This past week, Mark Yusko and I had the following exchange on Twitter.

Great point…A formula for why individuals always lose: Speculation + Psychology + Media Hype – Lack Of Discipline = Buy High/Sell Low https://t.co/MoU2aFddQM

— Lance Roberts (@LanceRoberts) May 27, 2017

The point here is quite simple. Individuals, especially in very late-stage cyclical bull markets, tend to get “sucked” into the markets primarily due to the Wall Street and media driven hype which feeds the “fear of missing out (FOMO).”  As I noted previously:

“The longer a bull market exists, the more it is believed that it will last indefinitely.”

The chart below shows the long-term view of the market with its inherent full-market (combined secular bull and bear) cycles exposed.

The idea of full market cycles is important to understand as this is precisely how the formula functions. In the latter stages of the bull market cycle, as “exuberance” eventually sucks the last of the holdouts back in, the “buy high” side of the equation is fulfilled. The second half of the full-market cycle will complete the process.

Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain. 

George Dvorsky once wrote that:

“The human brain is capable of 10¹⁶ processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.

Here are the top-5 of the most insidious biases which keep you from achieving your long-term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “5-Laws Of Human Stupidity” and in “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

The issue of “confirmation bias” also creates a problem for the media. Since the media requires “paid advertisers” to create revenue, viewer or readership is paramount to obtaining those clients.  As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to “confirm” their current beliefs.

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

2) Gambler’s Fallacy

The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

“Past performance is no guarantee of future results.”

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

This is one of the key issues that affect investor’s long-term returns. Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.”

I traced out the returns of the S&P 500 and the Barclay’s Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. “Performance chasing” is a major detraction from investor’s long-term investment returns.

Of course, it also suggests that analyzing last year’s losers, which would make you a contrarian, has often yielded higher returns in the near future. Just something to think about with “bonds” as one of the most hated asset classes currently.

3) Probability Neglect

When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.” As individuals, we tend to lean toward what is possible such as playing the “lottery.”  The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. It is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.”

As investors, we tend to neglect the “probabilities” of any given action which is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is that most of the gains are likely already built into the current move and that a corrective action will occur first.

Robert Rubin, former Secretary of the Treasury, once stated;

“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.”

Probability neglect is another major component to why investors consistently “buy high and sell low.”

4) Herd Bias

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, they if I want to be accepted I need to do it too.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives market excesses during advances and declines.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.

5) Anchoring Effect

This is also known as a “relativity trap” which is the tendency for us to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for.  However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we assume that the next home purchase will have a similar result.  We are mentally “anchored” to that event and base our future decisions around a very limited data.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that event. Therefore, we become anchored to that stock as opposed to one that lost value. Individuals tend to “shun” stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right?

This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then that they panic “sell” and are now “anchored” to a negative experience and never buy shares of ABC again.

This is ultimately the “end-game” of the current rise of the “passive indexing” mantra. When the selling begins, there will be a point where the pain of “holding” becomes to great as losses mount. It is at that point where “passive indexing” becomes “active selling” as our inherent emotional biases overtake the seemingly simplistic logic of “buy and hold.”  

Conclusion

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets?

As individuals, we are investing our hard earned “savings” into the Wall Street casino. Our job is to “bet” when the “odds” of winning are in our favor. Secondly, and arguably the most important, is to know when to “push away” from the table to keep our “winnings.”

Save