Where “I Bought It For The Dividend” Went Wrong

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.

Margin Call: You Were Warned Of The Risk

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 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.”

Why Gundlach Is Still Wrong About Higher Rates

Last Monday, Jeff Gundlach, famed bond fund manager and CIO of Doubleline, made an interesting comment during an interview with CNBC when he stated that the 10-year Treasury yield would top 6% by 2020 or 2021.

6% would be the highest yield since 2000.

The chart below shows Gundlach’s estimated yield as compared to the long-run range of economic growth. (Note that real GDP growth was running at 5.27% in 2000 as compared to 3.0% today which is also getting weaker.)

As I discussed last week, interest rates are a function of the economy. So, while Jeff suggests that yields are rising to 6% in the next couple of years, such would suggest an extremely strong rebound in economic growth. Unfortunately, there is no evidence currently of a major upturn in economic growth due to surging deficits, debts, demographic, and employment trends. Further productivity trends mean such an upturn in economic growth could only come from a massive surge in debt. Is that likely to happen given our indebted state already?

The biggest problem with rising rates is the negative impact from higher borrowing costs. Given that consumption makes up 70% of economic growth, and that consumers are heavily indebted, a change in rates has an immediate impact to consumption. Take a look at the chart below of the Total Housing Activity Index versus 30-year mortgage rates.

But it isn’t just housing, but everything from automobiles to iPhones. When interest rates rise to a point to where the consumer can no longer afford the payment, the buy decision changes to either a lower priced product or a postponement of the purchase. More importantly, the change to the purchase mentality (either reduction or postponement) specifically slows the rate of economic growth.

Given the structural backdrops to the economy, there is an inability to substantially increase rates of productivity, output, wage growth, savings, or consumption which would lead to stronger rates of economic growth. In fact, we are currently running some of the weakest rates of economic growth, productivity, and wages on record.

The annual rate of economic growth back in the late 70s, early 80s, was between 6 and 8 percent. Today, the long-run outlook for the economy is closer to 2% which is the terminal result of a 40-year long debt-driven expansion. Given that long-run projections of economic growth are between 1.5-2.5%, such means that the 10-year Treasury should run at about the same level. It is simply not feasible for rates to levitate to 4, 5, or 6% when economic growth is unable to support higher rates. Inflation, interest rates, wages, and economic growth are all tied to the consumer.

And the consumer is pretty much tapped out as credit card debt hits all-time highs and most Americans say they didn’t get a pay raise at their current job, or start a better paying job, in the last 12 months, according to a Wednesday survey from Bankrate.com.

“According to the poll, 62% of Americans report not getting a pay raise or better paying job in the past year – up from 52% last surveyed last year. That said, just 25% of respondents in this year’s survey said they would look for a new job in the next year.”

It’s The Deficit

So, if economic growth is going to remain weak, then what other reason would cause rates to rise?

Jeff made a valid point about the issue of the deficit suggesting such will ultimately be the catalyst for rates to rise.

This is a topic I have discussed much previously:

“While the markets have been the beneficiary of the tax cut legislation, which gave a short-term boost to corporate profitability, the economy has enjoyed a boost from the massive increases to spending from what should have been more aptly termed the ‘Bipartisan Non-Budget Act of 2018.’ Notice in the chart below the pickup in economic activity has coincided with a surge in the deficit. Spending on natural disasters and defense spending increases ‘pull forward’ future economic growth which is an illusion of an economic turn.”

Importantly, surges in budget deficits as a percentage of GDP, are normally associated with ‘recessionary’ activity in the economy. As noted, the increases in Federal spending create a temporary boost to economic growth which supports higher asset prices. Currently, the government is running one of the largest deficits, in both dollar terms, and as a percentage of GDP, in history. This is occurring at a time when the economy is ‘booming’ and deficits should be reduced for the next ‘rainy day.’”

“Furthermore, with sequester-level budget caps returning next year, the budgetary issues in Washington will become even more complicated. The last time budget-caps came into play Ben Bernanke launched QE-3 to offset the economic drag from expected reductions in government spending. However, given the recent track record of the ‘conservative’ Congress, it is highly likely spending will be increased further in the months ahead. Look for an even larger ‘C.R.’ in December when the current resolution runs out.”

Jeff’s point is one that has been made many times previously by others. The basic premise is that as the deficit expands, it will require more debt to be issued. The problem comes when the demand to purchase that debt does not keep up with the supply. Up to this point, America has been fortunate to maintain its role as the world’s reserve currency which means foreign nations hold Treasuries in their reserve accounts. But, as Jeff states, there are many countries now looking for an alternative. The problem for America comes as the status of “reserve currency” diminishes.

I both agree and disagree with Jeff on this point.

I agree that other countries are looking for alternatives to the dollar as a reserve currency. However, there are two primary reasons why this will likely not be a real threat soon:

1. If you are any other country where are you going to store your reserve currency: China, Russia, India, Brazil, the Eurozone? Many of these economies are corrupt, weak, too small, or a combination of all three.
2. When global investors are seeking “safety” from “risk,” where are they going to go?

Both of these reasons have the same foundations:

1. Liquidity: the U.S. Treasury market is vastly deep and can support billions in transactions without a major dislocation.
2. Safety: despite all of the flaws in the U.S., it is still the safest country in the world to conduct business with. While there are certainly many issues, the “rule of law” in the U.S. still provides a relative level of safety for storing capital not found in other countries.
3. Return: the rate on U.S. Treasuries is high enough to attract capital from other areas as a “safe” store of value.
4. Dollar Value: the rising U.S. dollar is attracting capital flows from weaker currencies and economies.

I have repeatedly stated that when the market rout gets bad enough, money will flow into the “safest of havens” – the U.S. Treasury. Over the past month, this is exactly what happened.

“As a result of this pre-deflationary deluge, investors have flooded into bonds and out of stocks, while within equities there were large moves into defensives via energy and tech into staples and utilities. More importantly, this month’s survey found the biggest ever one-month rotation into bonds class as investors dumped equities around the globe while bond allocations rose 23ppt to net 35% underweight….”

Jeff’s premise is that with all of the new debt needing to be issued by the government to fund their ongoing fiscal largesse, there is a risk that “our neighbors” will not be “gracious lenders” in the future. As such, the “dollar funding” issue causes rates to soar higher until “buyers” can be found.

While I am certainly not denying such is indeed the risk. There isn’t a lot of historical precedents that such is the case with a mature, strong, industrialized country. Japan, as an example, is vastly indebted with a soaring budget deficit, weak economic growth, and does not maintain a “reserve” currency status. Yet, after 30-years, interest rates have failed to rise.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth.

Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes, or that rising budget deficits means higher rates.

The real risk to the domestic economy is that Jeff is right.

If interest rates do rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “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 ongoing 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.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.

1. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
2. Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges.

Unfortunately, for the current Administration, the reality is that cutting taxes, tariffs, and sharp increases in debt, is unlikely to change the outcome in the U.S. The reason is simply that monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled. Eventually, the void will be too great to fill.

Where Are Rates Headed In 2019

So where are rates headed. Dr. Lacy Hunt of Hoisington Investment Management had a good take:

“The U.S. economy appears to be on a steadily declining path to recession and disinflation/deflation. This may seem improbable in the face of record year-over-year growth in nominal GDP over the past decade.

Significantly, U.S. monetary restraint has caused a similar slowdown in local currency money growth around the world. Additionally, velocity in Japan, the Euro area and China has been declining secularly since the late 1990s, as debt has become increasingly less productive. Since money times velocity (i.e. its turnover) determines GDP in all countries, this cumulative global economic slowdown should impact U.S. economic activity.

From the standpoint of an investment firm that started in 1980, when 30-year bond yields were close to
15%, the current 30-year treasury rate at 3% seems ridiculously low. In the near future, at 1.5%, the 3% yield will seem generous ”

I agree.

Currently, interest rates are at a level that has historically led to some sort of event. Whether it was economic, financial, or both, there is no real precedent which suggests rates could rise another 3% from here without severe ramifications. Of course, as the market declines, the demand for “safety” would ultimately push rates lower.

At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.

When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.

Weekend Reading: Last Chance For Santa Claus

So far, the month of December has sucked.

From Powell to Gundlach, to Trump, and a falling oil prices, there hasn’t been much “holiday cheer…”

However, with the market very oversold, there is still hope that “Santa Claus” could soon appear.

If we take a look back at history, going back to 1957, we find that only a small percentage of the time does the market decline for more than 4-weeks in a row without a reflexive bounce.

The red vertical bars are every 4- or more consecutive negative return weeks as compared to the S&P 500. As you will note in the statistics, out of the total period of time analyzed 57% of weeks are positive versus 43% negative. Notice that “clusters” of 4- or more negative weeks occur around market peaks and bear markets as opposed to bullish market trending periods. The last cluster of periods was during the 2015-2016 correction.

Of the total number of negative weeks, 33% were negative 4- or more weeks consecutively. However, those 4- or more negative weeks only accounted for a 14% of the total periods analyzed.

However, what about the month of December only. The chart below is the same as the chart above but looks at ONLY the months of December.

What we find is that of all the months of December going back to 1957, there have only been 9-December months that posted 4-consecutive negative weeks.

While we are currently 3-weeks into a very brutal month of December, there is still hope of an oversold bounce to “sell” into heading into the new year. There is a case to be made for this as mutual, pension, and hedge funds “dress” their portfolios for year-end reporting. However, January could well see a resumption of pressure as mangers can sell positions with still large gains and defer taxes into 2020.

Given the collapse in oil prices, the sharp rotation into bonds and rising volatility, it is highly likely that any rally over the course of the post-Christmas week should not be taken for granted.

It could well be a “gift” for investors heading into 2019.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“A good player knows when to pick up his marbles. – Anonymous

Questions, comments, suggestions – please email me.

Weekend Reading: Did The Grinch Steal The Christmas Rally?

On Tuesday, we put on a small S&P 500 trading position for an oversold bounce. At first, it didn’t work and we were almost stopped out, but a late day rally kept us in the position.

Wednesday was a different picture as stocks rocketed out of the gate on more “trade talk” news with China, but that rally faded as well heading into late day as the owner of the “National Enquirer” was granted immunity in exchange for details on another Trump-related “hush money” payment.

Yesterday, the markets struggled out of the gate as economic data pointed to slowing rates of inflationary pressure and economic growth, fell into negative territory, and then ended the day flat.

This morning stocks opened down as concerns of global economic weakness rose from China.

So far, the “Santa Rally” has failed to appear and traders are beginning to wonder if they are on the “Naughty List” this year? With all of the rhetoric over trade, White House shenanigans, and weak economic data, it certainly would seem to be the case.

But, it may actually be more of the “Grinch (aka The Fed) That Stole Christmas” this year.

While the Fed’s rate hikes do indeed raise borrowing costs and slow economic growth, it is the extraction of liquidity from the markets which is most important. As shown in the chart below, the Fed is now reducing their flows by \$50 billion each month. This is in direct contrast to the billions they were injecting previously which corresponds with the markets decade-long bull market despite weak revenue growth due to a sluggish economic expansion.

But it is no longer just the Fed. On Thursday, the European Central Bank made two important announcements.

1. They will stop adding to its stock of government and corporate bonds at the end of December, and;
2. They are seeing signs of weaker inflation and economic growth.

In other words, as world markets are beginning to struggle as the driver of the decade-long bull market is being removed.

But yet, despite the market turmoil this year, which certainly got investors attention, the debate has turned to whether the decline is over or has it just begun?

Dana Lyons had an interesting point earlier this week on the bout of selling.

“Specifically, regardless of the closing performance, the past 4 days have seen the S&P 500 drop at least 1.89% each day on an intra-day basis. That is just the 11th streak of such selling pressure in the S&P 500 going back to 1960, and the first since 2008. If we relax the parameter a bit to 4 straight intraday drops of at least 1.7%, we observe 17 occurrences going back to 1960. Many of them occurred at interesting market junctures.”

“As the chart displays, several of these instances occurred in the direct vicinity of cyclical market bottoms, including 1974, 1982, 1987, 2002 and 2009. That might give bulls some hope that perhaps things have gotten so bad, i.e., rock bottom, that there’s nowhere to go but up. Although, it is probably a stretch to conclude that we are at a cyclical low right now since we were at all-time highs just about 10 weeks ago. And looking back at the chart, we see that some of the other historical events, e.g., 1974, 2001, 2008, occurred during the meat of a bear market and saw stocks just continue to fall further, going ‘subterranean’ if you will.”

I agree with Dana that it is hard to imagine we are at a cyclical low when we were just pegging all-time highs a few short weeks ago. As noted by Barbara Kollmeyer, Jeff Gundlach may have this right:

“DoubleLine founder Jeff Gundlach, who told clients Tuesday evening that the S&P 500 could take out February’s 2018 low due to a growth slowdown hitting company profits.

‘Many equity markets are down over 20%, which some people call a bear market,’ Gundlach said in his latest webcast, according to Reuters. ‘I don’t really define bear markets as a certain fixed arbitrary percentage. I think of it more as mood. And certainly, the setup for the equity markets looked like a bear market going into the middle of this year…the global equity market which is strongly in a bear market at the present time.’

Bottom line, his mood is still bearish, considering he warned us in November that stocks still hadn’t hit a ‘panic low.'”

While the Fed could certainly reduce, or even eliminate, their rate hike campaign, the extraction of liquidity is a much more problematic issue. Combined with still elevated valuation, weaker economic growth, and declining profit growth, it is highly likely that Lyons and Gundlach are correct in that the S&P 500 has yet to find a lasting bottom.

For now, “we have our stocking hung with care in hopes that Saint Nick will soon be there,” but don’t be surprised if you wind up with a “big lump of coal.”

Just something to think about as you catch up on your weekend reading list.

Watch

Danielle Dimartino-Booth – Quill Intelligence, LLC

Peter Atwater – Financial Insyghts

Research / Interesting Reads

“The market may be bad, but I slept like a baby last night. I woke up every hour and cried. – Anonymous

Questions, comments, suggestions – please email me.

The Bond Rally Was No Surprise

Nathan Vardi recently penned an article for Forbes entitled “Surprise! The Late-Year Bond Rally.”

“In August, Jamie Dimon, CEO of JPMorgan Chase & Co. and the nation’s most prominent banker, predicted the yield on the benchmark 10-year Treasury note could reach 4% in 2018. He cautioned investors to prepare for 5% or higher.

Dimon’s call was not a contrarian one. It had become conventional wisdom on Wall Street that rates were headed higher and that the Federal Reserve would be tightening monetary policy for the foreseeable future.”

Jamie Dimon wasn’t alone. There were many venerable Wall Street veterans from Bill Gross, Paul Tudor Jones, Ray Dalio, and Jeff Gundlach were also calling for higher rates. But, these calls for higher rates and the “End Of The Great Bond Bull Market” have been flowing through the media since 2013.

And that was just from January.

Of course, those headlines are not the first time we have seen such calls made. One of the biggest problems with predictions of rising 10-year bond yields, since “bond bears” came out in earnest in 2013, is they have been consistently wrong. For a bit of history, you can read some of my previous posts on why rates can’t rise in the current environment.

You get the idea.

But what is it the mainstream analysis continues to miss?

Rates Are Low, So They Must Go Up

The general view as to why rates must rise is simply because they are so low. Looking at the chart below, such would certainly make sense.

However, it is important to note that interest rates can remain low for a very long time. The two previous occasions where rates fell below the long-term median they remained there for more than 35-years. We are currently about 8-years into the current evolution.

But here is the important point.

Higher interest rates are a function of strong, organic, economic growth that leads to a rising demand for capital over time. There have been two previous periods in history that have had the necessary ingredients to support a rising trend of interest rates over a long period of time. The first was during the turn of the previous century as the country became more accessible via railroads and automobiles, production ramped up for World War I and America began the shift from an agricultural to industrial economy.

The second period occurred post-World War II as America became the “last man standing” as France, England, Russia, Germany, Poland, Japan and others were left devastated. It was here that America found its strongest run of economic growth in its history as the “boys of war” returned home to start rebuilding the countries that they had just destroyed.

It is important to note that interest rates are also a function of inflation. Inflation is a byproduct of money supply. This is the subject of an upcoming article forRIA PRO subscribersbut currently it doesn’t appear the Federal Reserve is quite willing, at least not yet, to generate inflation via the printing presses.

The U.S. is no longer the manufacturing powerhouse it once was, and globalization has sent jobs to the cheapest sources of labor. Technological advances continue to reduce the need for human labor and suppress wages as productivity increases. Today, the number of workers between the ages of 16 and 54 participating in the labor force is near the lowest level relative to that age group since the late 70’s. This is a structural and demographic problem that continues to drag on economic growth as nearly 1/4th of the American population is now dependent on some form of governmental assistance.

These are issues are only going to become worse due to long-term demographic trends not only in the U.S., but globally.

As shown below, the is a correlation between the three major components of the economy (inflation, GDP and wage growth) and the level of interest rates. Interest rates are not just a function of the investment market, but rather the level of “demand” for capital in the economy. When the economy is expanding organically, the demand for capital rises as businesses expand production to meet rising demand. Increased production leads to higher wages which in turn fosters more aggregate demand. As consumption increases, so does the ability for producers to charge higher prices (inflation) and for lenders to increase borrowing costs. (Currently, we do not have the type of inflation that leads to stronger economic growth, just inflation in the costs of living that saps consumer spending – Rent, Insurance, Health Care)

The chart above is a bit busy, but I wanted you to see the trends in the individual subcomponents of the composite index. The chart below shows only the composite index and the 10-year Treasury rate.

Let’s go back to Jamie Dimon for a moment. He stated that interest rates should be 4% which would align with economic growth rates earlier this year. However, that growth was not driven by organic factors of rising wages but rather a confluence of natural disasters. Furthermore, the increase in deficit spending also helped boost economic growth.

The issue is that the surge in deficit spending, combined with the pick up in short-term demand for construction and manufacturing processes, gave the appearance of economic growth which got both the Federal Reserve and the “bond bears” on the wrong side of the trade.

As I have stated previously, the impacts of these “one-off” inputs into the economy will continue to fade as we move into 2019.

While it is certainly hoped that the current economic expansion can last for years to come, a simple look at the last 40 years of fiscal and monetary policy suggests it won’t.

Why?

Because you can’t create economic growth when it is financed by deficit spending, credit, and a reduction in savings.

You can create the “illusion” of growth in the short-term, but the surge in debt reduces both productive investments into, and the output from, the economy. As the economy slows, wages fall, and the consumer is forced to take on more leverage and decrease their savings rate. As a result, of the increased leverage, more of their income is needed to service the debt, which requires them to take on more debt.

Which is exactly what has happened.

(The chart below shows the shortfall between the inflation-adjusted cost of living and what wages and savings will cover. The deficit is the difference that has to be made up with debt every year.)

Given that nearly 70% of current economy is driven by consumption, it only requires small moves higher in interest rates before the negative impact to economic growth is realized as capital flows are reduced. (Since interest rates affect payments, higher rates quickly impact consumption, housing, and investment which ultimately deters economic growth.)

The problem with most of the forecasts for the end of the “bond bull” is the assumption we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy.

Interest rates, however, are an entirely different matter.

The Next Crisis

Just recently, Janet Yellen discussed the issue of leverage in the economy stating that companies are taking on too much debt and could be in trouble should some unexpected trouble hit the economy or markets.

“Corporate indebtedness is now quite high and I think it’s a danger that if there’s something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector.”

Yellen also warned that the debt is being held in instruments similar to ones used to bundle subprime mortgages that led to the financial crisis a decade ago. Importantly, the investment-grade part of the bond market was \$3.8 trillion at the end of October which was 6% higher than a year ago, and BBB-rated bonds accounted for 58% of the total,

In other words, with rates rising, economic growth slowing (debt is serviced from revenues), and the health of balance sheets deteriorating (BBB is one notch above “junk”) the risk of an “event-driven” crisis is real. All it will take is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem. As stock prices decline:

• Consumer confidence falls further eroding economic growth
• The \$4 Trillion pension problem is rapidly exposed which will require significant government bailouts.
• When prices decline enough, margin calls are triggered which creates a liquidation cascade.
• As prices fall, investors and consumers both contract further pushing the economy further into recession.
• Aging baby-boomers, which are vastly under-saved will become primarily dependent on social welfare which erodes long-term economic growth rates.

With the Fed tightening monetary policy, and an errant Administration fighting a battle it can’t win, the timing of the next recession has likely been advanced by several months.

The real crisis comes when there is a “run on pensions.” With a large number of pensioners already eligible for their pension, the next decline in the markets will likely spur the “fear” that benefits will be lost entirely. The combined run on the system, which is grossly underfunded, at a time when asset prices are dropping  will cause a debacle of mass proportions. It will require a massive government bailout to resolve it.

But it doesn’t end there. Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well.

As debts and deficits swell in the coming years, the negative impact to economic growth will continue. At some point, there will be a realization of the real crisis. It isn’t a crash in the financial markets that is the real problem, but the ongoing structural shift in the economy that is depressing the living standards of the average American family. There has indeed been a redistribution of wealth in America since the turn of the century. Unfortunately, it has been in the wrong direction as the U.S. has created its own class of royalty and serfdom.

But most importantly, that is how interest rates remain low for a very long-time.

While there is little left for interest rates to fall in the current environment, there is no ability for rates to rise before you push the economy back into recession. Of course, you don’t have to look much further than Japan for a clear example of what I mean.

The “bond rally” was no surprise.

REITs: Slightly Better Than Broad U.S. Market, But Still Not Cheap

When I wrote an article on REITs for the Wall Street Journal in early 2017, I used a research report from Research Affiliates in Newport Beach, CA to argue that the asset class was overpriced and poised to deliver 0%-2% or so real returns for the next decade.

My article sparked a lot of mail and controversy. One reader reply underneath my article on the WSJ website said “Among equity REITs traded on stock exchanges there has literally never been a 10-year period in the history of REIT investing when real total returns averaged 0% per year (or worse) as [John Coumarianos’s] approach predicts.”

Another letter, which the Journal published as a reply to my article, from Brad Case of the National Association of Real Estate Investment Trusts (NAREIT) strangely had the exact same language about REITs never producing such a poor 10-year return as the letter written by someone of another name under the column on the website. Case’s formal, published letter went on to say, “The current REIT stock price discount to net asset value suggests that returns over the next 10 years may exceed inflation by around 8.15 percentage points per year on average.”

The decade isn’t up, but now, two years in, let’s see how things are going for REITs. Also, what’s the forecast today? Have things improved? After we assess recent returns, let’s go through the forecast again to see if things look any better now.

Not A Great Two Years For REITs

In 2017, two major REIT index funds – the Vanguard REIT Index fund and the iShares Cohen & Steers REIT Index ETF — produced a nearly 5% return each.  Considering that the CPI (consumer price index) was up 2.1% in 2017, that’s about a 3% real or inflation-adjusted return.

In 2018, the iShares fund delivered a 5.29% return through October, while the Vanguard fund delivered a 2.03% return through October. So far inflation is running at an estimated 2.2% for the year, according to the Minneapolis Fed. That means REIT real returns for 2018 are in the 0%-3% range, depending on which index you use. For both 2017 and 2018, we are a far cry from Case’s 8.15% real return forecast.

Start With Dividend Yield

The analysis advocated by Research Affiliates was simple. First, start with “net operating income” (NOI) or rent minus basic expenses. NOI a good indication of the cash flow a property or a collection of properties are delivering. Investors take this number and divide by the price of a property to determine what they call a “capitalization rate.” In effect, that resembles an earnings yield (earnings divided by price) of a stock. Mutual fund investors can substitute dividend yield of a REIT-dedicated fund.

For my original article, the dividend yield of most REIT index funds and ETFs was around 4%. Now it’s closer to 3%. The iShares Cohen & Steers REIT ETF yields less than 3.2% right now, while the Vanguard REIT Index fund lists a current effective yield of 3.23% and a yield adjusted for return of capital and capital gain distributions over the past two years at 2.13%.

Upkeep

The second component of a return forecast is a property upkeep component. Real estate requires capital – not only for the initial purchase, but also for maintaining the property. Things are always breaking and obsolescence always threatens landlords who must update kitchens, bathrooms, and other aspects of their properties. It’s true that with some property types, tenants are responsible for some upkeep and improvement, but that isn’t always the case. Research Affiliates figures 2% of the cost of the property per year, is a decent round number to use in a return forecast. Unfortunately, that wipes out most of the 3% dividend yield investors are currently pocketing.

So far, we are running at a 0 or 1% real annualized return for the next decade.

Price Change

The last component of real estate valuation and return forecasting is the most speculative. Where will properties trade in a decade? Nobody knows for sure, but Research Affiliates estimated in early 2017 that commercial property was priced 20% above its long term trend. If prices remained at that level, investors would capture the 4% yield minus the 2% annual upkeep or 2% overall. If prices reverted to trend, investors would have to subtract enough from net operating income adjusted for upkeep to bring future returns down to 1.4%.

Currently on the Research Affiliates website, the firm forecasts REITs to deliver a 2% annualized real return for the next decade. That’s about where the forecast stood at the beginning of 2017. It’s worth noting that although that’s a low return, it’s actually a better forecast than the firm has for U.S. stocks, which it thinks won’t deliver any return over inflation for the next decade.

Gut Check

It’s often useful to take multiple stabs at valuation. So, in the spirit of providing a gut check, I supplemented this dividend-upkeep-price analysis with a simple Price/FFO (funds from operations) analysis. REITs have large, unrealistic depreciation charges, rendering net income a mostly useless metric. FFO, which adjusts net income for property sales and depreciation is a more accurate cash flow metric. FFO isn’t perfect either because it doesn’t account for different debt loads of different companies and because it doesn’t account for maintenance costs, but it’s a uniform metric that almost all REITs publish.

Of the top-20 holdings of the Vanguard Real Estate Index fund VGSIX, Weyerhaeuser and CBRE didn’t publish FFO metrics. The average of the other 18 companies was 20. That’s a pretty high multiple for REITs, which are slow growth stocks.

Weekend Reading: Which Yield Curve Really Matters?

So, have you heard the one about the “flattening yield curve?”

It almost sounds like the start of a bad joke because there have been so many discussions during this past year on it. However, it has been largely dismissed under the “this time is different” scenario as trailing economic data has remained strong and the recent stock market struggles are believed to only be temporary.

As I discussed yesterday, however, it is quite likely the message being sent by the bond market should not be dismissed. Bonds are important for their predictive qualities which is why analysts pay an enormous amount of attention to U.S. government bonds, specifically to the difference in their interest rates. This data has a high historical correlation to where the economy, stock, and bond markets are generally headed in the longer-term. This is because volatile oil prices, trade tensions, political uncertainty, the strength of the dollar, credit risk, earnings strength, etc., all of which gets reflected in the bond market and, ultimately, the yield curve.

But which yield curve really matters?

It depends on whom you ask?

“The rate on the 2-year has already jumped above the shorter-term 5-year note, a move that suggests the ‘economy is poised to weaken,’ DoubleLine Capital’s Jeffrey Gundlach told Reuters in an interview on Tuesday. Gundlach, a noted bond investor, has been warning investors to be cautious.” – CNBC

“Michael Darda, the chief economist at MKM Partners, says people may be too focused on the wrong data. ‘Recession forecasting is fraught with difficulty, so it’s important that we don’t make it more difficult than it has to be by focusing on the wrong indicators, or, at a minimum, less reliable one. It is the difference between the 10-year and the 1-year that everyone should worry about.” – CNBC

“While inversions have been reliable recession indicators in the past, the most important relationship — between the 3-month and 10-year government notes — is not inverted and thus hasn’t triggered the likelihood of a contraction ahead.” – CNBC

Wait, so which is it?

My answer is a bit different. When I am looking at technical indicators for the market it is not just “one” signal I am looking at, but several. The reason is that sometimes a single indicator can provide a “false” signal.

For example, the 200-dma has had several violations which did NOT lead to bigger declines. Therefore, there have been numerous articles questioning the efficacy of that moving average as an indicator. However, if you combine the 200-dma with a couple of other indicators to “confirm” the signal being sent, then some of the false readings can be removed.

This same premise applies to the yield curve.

While the 3-5 yield spread is currently in negative territory, it has not been confirmed by other yield spreads across the spectrum. As shown in the chart below, the best signals of a recessionary onset have occurred when a bulk of the yield spreads have gone negative simultaneously. However, even then, it was several months before the economy actually slipped into recession.

However, as I addressed previously, as with all measures, technical or otherwise, it is the trend of the data which is more important to your outlook than the actual number itself.

It is correct that the longer-dated yield curve has not turned negative as of yet.  However, the market is already beginning to adjust to the reality the economy is beginning to weaken, earnings are at risk, valuations are elevated, and the support from Central Banks has now reversed.

So, which one am I watching?

All of them.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“Successful investing is anticipating the anticipation of others. – John Maynard Keynes

Questions, comments, suggestions – please email me.

Misdiagnosing The Risk Of Margin Debt

This past week, Mark Hulbert wrote an article discussing the recent drop in margin debt. To wit:

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

Margin debt is the total amount investors borrow to purchase stocks, which historically has risen during bull markets and fallen during bear markets. This total fell more than 6% in October, according to a report last week from FINRA. We won’t know the November total until later in December, though I wouldn’t be surprised if it falls even further.

A number of the bearish advisers I monitor are basing their pessimism at least in part on this plunge in margin. It’s easy to see why: October’s sharp drop brought margin debt below its 12-month moving average. (See accompanying chart.)”

“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 disagree with Mark on several points.

First, margin debt is not a technical indicator which can be used to trade markets. Margin debt is the “gasoline,” which as Mark correctly states, 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. The issue with margin debt, in particular, is that 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.

It is when an “event” causes lenders to “panic” that margin becomes problematic. As I discussed just recently:

“If the 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 last time we saw such an event was here:”

Importantly, note in the chart above, the market had two declines early in 2008 which “reduced” margin debt but did NOT trigger “margin calls.” That event occurred when Lehman Brothers was forced into bankruptcy and concerns over counter-party risk caused banks to cut their “risk exposure” dramatically.

Like early 2008, the recent declines have not sparked any real semblance of “fear.” The VIX, Interest Rates, and Gold have yet to demonstrate that a change from “complacency” to “fear” has occurred.

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).

What is immediately recognizable is that reversions of negative “free cash” balances has led to serious implications for the stock market. With negative free cash balances still at historically high levels, a full mean reverting event would coincide with a potentially disastrous decline in asset prices as investors are forced to liquidate holdings to meet “margin calls.”

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances so the relationship between increases in margin debt and the market. It is not hard to imagine what a reversion to positive cash balances would do to the stock market.

As stated, the data goes back to 1959. However, prior to 1980 margin debt, along with every other form of debt, was not widely utilized both due to high borrowing costs and a “post-depression era” mentality about debt. Nonetheless, the chart below tracks the percentage growth in debt relative to the S&P 500 (both have been adjusted for inflation).

The next chart is the same as above but is only from 1959-1987 so you can more clearly visualize the impact of margin debt on asset prices.

(Most people have forgotten there were three back-t0-back bear markets in 1960’s-1970’s as interest rates were spiking higher. The 1974 bear market was the one that simply wiped everyone out!)

Again, what we find is a correlation between asset prices and margin debt. When margin growth occurs extremely quickly, which coincides with more extreme investor exuberance, corresponding unwinds of the debt has been brutal.

Let’s go back to Mark’s original discussion with respect to the 12-month average. If we take a longer-term look at the data we find that breaks of the 12-month moving average has provided a decent signal to reduce equity risk in portfolios (blue highlights). Yes, as with any indicator, there are times that it doesn’t work (purple highlights). However, more often than not, reducing equity risk when the 12-month moving average was broken saved you when it counted the most.

It’s All Coincident

Mark is absolutely correct that “margin debt” is a “coincident” indicator. Such should not be surprising since rising levels of margin debt are considered to be a measure of investor confidence. Investors are more willing to take out debt against investments when shares are rising and they have more value in their portfolios to borrow against. However, the opposite is also true as falling asset prices reduce the amount of credit available and assets must be sold to bring the account back into balance.

I both agree, and disagree, with the idea that margin debt levels are simply a function of market activity and have no bearing on the outcome of the market.

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 which 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 further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.

Given the lack of “fear” shown by investors during the recent decline, it is unlikely that the recent drop in margin debt is a function of “forced liquidations.” As I noted above, it will likely take a correction of more than 20%, or a “credit related” event, which sparks broker-dealer concerns about repayment of their credit lines.

The risk to the market is “when” those “margin calls” are made.

It is not the rising level of debt that is the problem, it is the decline which marks peaks in both market and economic expansions.

Currently, the “bullish bias” remains intact and the recent volatility in the market has not shaken investors loose as of yet. Therefore, it is certainly understandable why so many are suggesting you should ignore the recent drop in margin debt.

But history suggests you probably shouldn’t.

Weekend Reading: The Powell Put

All it took was two 10% stock market corrections in a single year and some heavy “browbeating” from President Trump to reverse Jerome Powell’s hawkish stance on hiking interest rates.

On Wednesday, Powell took to the microphone to give the markets what they have been longing for – the “Powell Put.” During his speech, Powell took to a different tone than seen previously and specifically when he stated that current rates are “just below” the range of estimates for a “neutral rate.” This is a sharply different tone than seen previously when he suggested that a “neutral rate” was still a long way off.

Importantly, while the market surged higher after the comments on the suggestion the Fed was close to “being done” hiking rates, it also suggests the outlook for inflation and economic growth has fallen. With the Fed Funds rate running at near 2%, if the Fed now believes such is close to a “neutral rate,” it would suggest that expectations of economic growth will slow in the quarters ahead from nearly 6.0% in Q2 of 2018 to roughly 2.5% in 2019.

Such will also correspond with a drop in inflationary pressures, as we noted previously, which is already occurring with the drop in energy prices.

More importantly, falling oil prices are going to put the Fed in a very tough position in the next couple of months as the expected surge in inflationary pressures, in order to justify higher rates, once again fails to appear. The chart below shows breakeven 5-year and 10-year inflation rates versus oil prices.”

But here was the key comment that suggests the recent blasting by President Trump hit home:

Powell says moving too fast would risk shortening U.S. expansion, moving too slow could risk higher inflation and destabilizing financial imbalances.”

President Trump has been adamant that Powell’s aggressiveness was jeopardizing the economic recovery.

More interesting was when Powell reiterated they see no major asset class, however, where valuations appear far in excess of standard benchmarks”

I am not sure which benchmarks the Fed looks at exactly.

The real risk to the market is not valuations at historically high levels by virtually every measure, but rather the risk of a credit related event due to the impact of higher rates on an abundance of lower-rated corporate debt.

Nonetheless, in the short-term, the “bulls” got their Christmas wish as noted by Bloomberg economists

“Tim Mahedy and Yelena Shulyatyeva:

‘Powell’s comment that rates are just below neutral is a step back from his comments earlier in the fall implying the FOMC still has a ways to go. This could be the first sign that the pace of rate hikes is set to slow next year.’

However, not all economists got the same dovish message as noted by Greg Robb via Marketwatch.

“I really don’t think he was dovish, not really. He didn’t say inflation was weaker or the economy was weaker than we thought. It is a bit of a market overreaction.” -Paul Ashworth, chief U.S. economist at Capital Economics.

“The Fed has said they wanted to go above neutral. If they wanted to be neutral, they could have walked that back. He gave no hint of a pause in December.” – Avery Shenfeld, chief economist at CIBC

All the “bulls” need now is for President Trump to “cave in” on his demands on China, a problem he created in the first place, at this weekends G-20 summit. I would expect a deal that is well short of any original objective as China agrees to issues which are economically unimportant to them. However, such will “look like a win” for the Trump administration and should clear the way for “Santa to visit Broad and Wall.”

After that, it’s anyone’s guess, but the real issues plaguing the economy and the markets have not been resolved.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

There is nothing like price to change sentiment. – Helene Meisler

Questions, comments, suggestions – please email me.

The End Of The Tax Cut Boost

Last week, I touched on the issue of corporate profits and tax cuts. While the promise was that tax cuts were going to a massive boost to economic growth, the reality has been quite different. To wit:

“The benefit of a reduction in tax rates is extremely short-lived since we compare earnings and profit growth on a year-over-year basis.

In the U.S., the story remains much the same as near-term economic growth has been driven by artificial stimulus, government spending, and fiscal policy which provides an illusion of prosperity. For example, the chart below shows raw corporate profits (NIPA) both before, and after, tax.”

“Importantly, note that corporate profits, pre-tax, are at the same level as in 2012.  In other words, corporate profits have not grown over the last 6-years, yet it was the decline in the effective tax rate which pushed after-tax corporate profits to a record in the second quarter. Since consumption makes up roughly 70% of the economy, then corporate profits pre-tax profits should be growing if the economy was indeed growing substantially above 2%.”

The reality is that what earnings growth there has actually been, as shown above, was indeed derived from tax cuts but also through the extensive use of share buybacks. While the mainstream media, and the Administration, initially rushed to claim that tax cuts would lead to surging economic growth, wages, and employment, such has yet to be the case. Instead, companies have used their tax windfall to repurchase shares instead.

The lack of corporate profit since 2012 is just another version of the same story we have previously discussed when analyzing quarterly earnings. As noted in our recent report following the end of the Q2-2018 reporting period:

“Since the recessionary lows, much of the rise in ‘profitability’ has come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks; revenue growth, which is directly connected to a consumption-based economy, has remained muted.”

Here is the real kicker. Since 2009, the reported earnings per share of corporations has increased by a total of 391%. This is the sharpest post-recession rise in reported EPS in history. However, the increase in earnings did not come from a commensurate increase in revenue which has only grown by a marginal 44% during the same period. This is an important point when you realize only 11% of total reported EPS growth actually came from increased revenues.

While stock buybacks, corporate tax cuts, and debt-issuance can create an illusion of profitability in the short-term, the lack of revenue growth the top line of the income statement suggests a much weaker economic environment over the long-term.

More importantly, as stated, the benefit of tax cuts lasts just one year before it is absorbed by annual comparisons. As shown below, when the effective tax rate dropped during the Bush administration from 31.48% to 19.87%, an 11.61% decline,  the surge in corporate profits faded after the first year. During the Obama Administration, the effective tax rate fell again from 24.01% to just 13.73%, a reduction of 7.28%, providing a short-term profit surge as the economy began to recover from the “Financial Crisis.”

Interestingly, the most recent tax cut from the Trump Administration has had very little impact on the effective tax rate only reducing it from 19.32% to 16.17%, or just a decline of 3.15%. While profits did increase, the very low adjustment to the effective tax rate is likely why the effect of the tax cut boost has faded so quickly this time. The tax refunds were not boosted either, but anyway here are some ideas on how to spend yearly tax refund.

Going forward increasing margins will become tougher as steadily increasing labor costs, weaker global economies, higher interest costs, tariffs, and a stronger dollar weigh on bottom line profitability.

Earnings Set To Decline

With share buyback activity already beginning to slow, the Federal Reserve extracting liquidity from the financial markets, and the Administration continuing their “trade war,” the risk to extremely elevated forward earnings estimates remains high. We are already seeing the early stages of these actions through falling home prices, automobile sales, and increased negative guidance for corporations.

If history, and logic, is any guide, we will likely see the U.S. economy pushing into a recession in 2019 particularly as the global economy continues to weaken. This is something both domestic and global yield curves are already screaming is an issue, but few are listening. As noted last week, we can already see this in the MSCI World Market Index as well.

“While it has been believed the U.S. can ‘decouple’ from the rest of the world, such is not likely the case. The pressure on global markets is a reflection of a slowing global economy which will ultimately find its way back to the U.S.”

As stated, forward earnings estimates are still way too lofty going into 2019. As I noted in the recent missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019. In just the last 30-days the estimates for the end of 2019 have fallen by more than \$10/share. The downside risk remains roughly \$14/share lower than that.

As stated, beginning in 2019, the estimated quarterly rate of change in earnings will drop markedly and head back towards the expected rate of real economic growth. (Note: these estimates are as of 11/1/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

The issue to focus on will be the ongoing impact of rising interest rates on major drivers of debt-driven consumption such as housing and auto sales. Combine that with a late stage economic cycle colliding with a Central Bank bent on removing accommodation and you have a potentially toxic brew for a much weaker outcome than currently expected.

The end of the boost from tax cuts has arrived.

But such was always going to be the case. As noted in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

Since the tax cut plan was poorly designed, to begin with, it did not flow into productive investments to boost economic growth. As we now know, it flowed almost entirely into share buybacks to boost executive compensation. This has had very little impact on domestic growth. The “sugar high” of economic growth seen in the first two quarters of 2018 has been from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. These activities simply pull forward “future” consumption and have a very limited impact but leaves a void which must be filled in the future.

Nearly a full year after the passage of tax cuts, we face a nearly \$1 Trillion deficit, a near-record trade deficit, and empty promises of surging economic activity.

It is all just as we predicted.

So, while many of the mainstream punditry continue to take victory laps touting the success of the Trump agenda, the reality is that the pro-growth policies were launched too late within this economic cycle. Since the administration chose to utilize both fiscal and monetary policy tools during the economic boom, it will only ensure the next recessionary drag will likely be larger, and last longer, than most expect.

Weekend Reading: Why This Isn’t “THE” Bear Market…Yet

After two significant corrections during 2018, this has to be the beginning of a “bear market,” right?

It certainly is possible given the headwinds that are starting to weigh on corporate outlooks such as ongoing trade wars, weaker revenue growth, a strong dollar, and higher interest rates. However, despite these concerns, there are three things which suggest the necessary psychological change for a more meaningful “mean reverting” event has yet to occur.

Interest Rates

During previous market declines, where “fear” was a prevalent factor among investors, money rotated from “risk” to “safety” which pushed Treasury bond prices higher and rates lower. Despite two fairly strong corrections in 2018, bonds have not attracted the “flight to safety” as investors remain complacent about the future prospects of the market.

VIX

A look at the Volatility Index (VIX) confirms the same as the bond market. Despite the two corrections, the VIX never spiked to levels consistent with “fear” that a correction was in process. Currently, the VIX remains below the average level of the index going back to 1995 and during the “October massacre” failed to even rise above the level seen in February of this year.

Gold

Another “fear trade” which has failed to show any fear is that precious yellow metal. Again, despite two major corrections, gold has failed to find buyers in a “safe haven” trade. In fact, despite consistent calls that gold was needed to offset inflation, it has failed to find any support from investors who continue to chase market returns.

Here is the point – the pickup in volatility this year should have dislodged investors out of their “passive investment slumber.” Yet, there is no anecdotal evidence that such has been the case. There are two possible outcomes from this current situation:

1. The majority of investors are correct in assuming the two recent corrections are just that and the bull market will resume its bullish trajectory, or;
2. Investors have misread the corrections this year and have simply not yet lost enough capital to spark the flight to safety rotations.

Historically speaking, the “herd” tends to be right in the middle of the advance at very wrong at the major turning points.

There is mounting evidence that we may indeed be at the beginning of one of those turning points in the market. If that is the case, investors are likely going to find themselves once again on the wrong side of history.

The “real” bear market hasn’t started yet. When it does we will likely see traditional “safe haven” investments telling us so. It will be worth watching gold and rates for clues as to when the masses begin to realize that “this time is indeed different.”

Just something to think about as you catch up on your weekend reading list.

Watch

Interview with Mike “Mish” Shedlock

Research / Interesting Reads

Treat their incessant optimism, in the future, with skepticism. Watch what they do not what they say.” – Doug Kass

Questions, comments, suggestions – please email me.

Weekend Reading: American Gridlock & Why Mid-Terms Don’t Matter

With some bit of relief, I am glad to see the mid-term elections now behind us as another cloud of uncertainty is removed. However, in reality, I suspect the outcome of the elections will have much less impact on the markets than most currently think.

Barbara Kollmeyer penned a note earlier this week for MarketWatch:

“For financial markets, one takeaway mattered above all others in the midterm election—no curveballs.

And that’s basically what was delivered as pundits who got it so wrong in 2016, correctly forecast the end of one-party rule this time. With Dems calling the shots in the House, we could see no end to investigations, subpoenas and possibly impeachment talk and a hard push for POTUS to cough up those tax returns.

All that may slow down President Donald Trump’s MAGA plans.”

While that is entirely true, I think the markets are going to quickly look past the now “gridlocked” Congress to the more important drivers of the market – earnings and share buybacks.

As I noted in yesterday’s missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019.

More importantly, beginning in 2019, the quarterly rate of change in earnings will drop markedly and head back towards the expected rate of real economic growth. (Note: these estimates are as of 11/1/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

So, really, despite all of the excitement over the outcome of the mid-terms, such is really unlikely to mean much going forward. The bigger issue to focus on will be the ongoing impact of rising interest rates on major drivers of debt-driven consumption such as housing and auto sales. Combine that with a late stage economic cycle colliding with a Central Bank bent on removing accommodation and you have a potentially toxic brew for a much weaker outcome than currently expected.

Of course, the one thing that a “gridlocked” Congress can likely agree on is “more spending.” While there will likely not be any funding approved for “boarder walls,” immigration reform, or further defense spending, they can probably reach an agreement for an “infrastructure spending” bill. The problem, as President Obama found out when he tried it, is that:

“Shovel ready jobs weren’t all the shovel ready.”

Furthermore, most of the things that will likely be funded are “pet projects” from Congressional members which have very low returns on investment. As Woody Brock wrote 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.”

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

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

The problem, as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, that create jobs (infrastructure and development) to primarily social welfare, defense and debt service which has a negative rate of return.  According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending.

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

As Dr. Brock aptly stated in his speech:

“Today we are borrowing our children’s future with debt. We are witnessing the ‘hosing’ of the young.’”

So, yes, the markets may love a “gridlocked Congress” as the restriction of “Trumponomics” will remove some of the daily angsts. However, longer-term, the trend of spending, deficits, and demographics will continue to weigh heavily on American prosperity.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“Stupidity has a knack of getting its way.” – Albert Camus

Questions, comments, suggestions – please email me.

10 Stocks With Growing Dividends

In the recent report “GE – Bringing Investment Mistakes To Life,” I discussed the basic investor fallacy of “I bought it for the dividend.”

However, most importantly, as I noted:

“While I completely agree that 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. During the next major market reversion, we will see much of the same happen again.”

As you may already suspect, by looking out our portfolios on the site, we have a preference for high-quality names that also provide dividends. Normally, we screen our database of over 8000 stocks for companies which fit several fundamental and value factors to ensure we are buying top-quality names. However, for today’s purpose of a specific dividend focus, we are looking primarily for companies which are members of the S&P 500 index and have a history of growing their dividends over the last 5-years, a declining payout ratio relative to their earnings per share, and we are taking only the top 10 highest rated stocks.

The criteria for our Dividend screen are:

• Market Capitalization > \$1 Billion
• Index Constituency: Must Be A Member of the S&P 500 Index
• Dividend Yield > 1%
• 5-Year Dividend Growth Rate > 0
• Change In Payout Ratio < 0
• Zack’s Investment Ranking = Top 10

The table below are the 10-candidates which resulted from the latest screening.

The combination of these fundamental measures should yield an excess return over the market during the previous 5-year time frame. The table below assumes that over the last 5-years you bought all 10-stocks and rebalanced them semi-annually.

Over the 21-quarterly rebalancing periods, the portfolio had an annualized return of 14.9% versus the 12.1% for the market. This 2.6% annual outperformance versus the S&P 500 is shown in the charts below.

Even though interest rates have risen from the lows of last year, the price of money has been persistently lower in this economic cycle than it has been in the past. This factor continues to provide support for income-yielding stocks as many investors, including the growing population of retirees, are seeking more stable, fixed income-like returns.

The risk of this strategy is that valuations for many companies, including higher dividend payers, have expanded much more than normal, and is reminiscent of the “Nifty-Fifty” period in the late 1970’s.

While investing in dividend yielding stocks certainly provides an additional return to portfolios, as “GE” should have reminded you, stocks are “not safe” investments. They can, and will lose value, and often much more than you can withstand.

This is why for our “safe money” we continue to use rallies in interest rates to buy bonds which provide both higher rates of income and safety of principal.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

With valuation and safety being a top concern for investors, especially with markets signaling more troubling technical trends, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discount to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries. We think these names are more likely to offer investors both the yield they are looking for and are currently trading at prices that provide a reasonable margin of safety.

Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

Weekend Reading: October Exposed The Passive Problem

I have written about the “problem with passive” previously which mostly fell on “deaf ears.” Such should not be surprising after one of the longest advances in market history with virtually no volatility in 2017.

However, as they say, “payback is a bitch.”

This year started off with a January rush higher followed immediately by a 2-week sell-off that wiped out the entire advance. But then it was over, and the market began to stair step higher ultimately reaching all-time highs.

Once again, the “buy and hold” and “passive indexing” mantras were seemingly proved right.

And then the month of October arrived and stocks plunged more in one month (-7.4%) as compared to the decline from the closing highs in January to the lows of March (-6.5%).  (As noted, it is important that November musters a fairly strong rally to keep the monthly MACD sell signal from triggering. Such would denote a much more negative backdrop for stocks in the months ahead.)

Over the last couple of months, we have repeatedly warned our readers that a pickup in volatility in October was highly likely due to the strong advances made by the markets during the preceding summer months. At the beginning of September I penned:

“However, there are plenty of warning signs that the “good times” are nearing their end, which will likely surprise most everyone.”

Then I reiterated that point two weeks later. To wit:

“While we are long-biased in our portfolios currently, such doesn’t remain there is no risk to portfolios currently. With ongoing “trade war” rhetoric, political intrigue at the White House, and interest rates pushing back up to 3%, there is much which could spook the markets over the next 45-days.”

The chart below only shows months where the market lost more than 5%. You will notice clusters of losses during the centers of major bear markets such as 1974, 2000, and 2008.

So, with October behind us, the market should march back to all-time highs. Right? Maybe not, as this time is not like last time.

• The Fed is hiking rates versus either lowering or keeping them at zero.
• The Fed is reducing rather than increasing their balance sheet.
• The current Administration is insisting on a “trade war” which slows global growth.
• The economic cycle is mature rather than recovering.
• Record levels of debt at risk of rising rates versus a re-leveraging cycle with ultra-low rates.
• A mature housing, auto, and consumption cycle versus a recovery.
• Global central bank interventions have begun to taper versus expansion
• Peak earnings growth versus expansion
• Peak valuations versus expanding valuations

While the sell-off this past month was not particularly unusual, it was the break of material levels of support which was different. Furthermore, the uniformity of the price moves revealed the fallacy “passive investing” as investors headed for the door all at the same time. Such a uniform sell-off is indicative of what we have been warning about for the last several months and should serve as a warning.

“With everyone crowded into the ‘ETF Theater,’ the ‘exit’ problem should be of serious concern. Unfortunately, for most investors, they are likely stuck at the very back of the theater.

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your ‘risk exposure’ will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered ‘bearish’ to point out the potential ‘risks’ that could lead to rapid capital destruction; then I guess you can call me a ‘bear.’

Just make sure you understand I am still in ‘theater,’ I am just moving much closer to the ‘exit.’”

Despite the best of intentions, individual investors are NOT passive even though they are investing in “passive” vehicles. When these market swoons begin, the rush to liquidate entire baskets of stocks accelerate the decline making sell offs much more violent than what we have seen in the past.

This concentration of risk, lack of liquidity, and a market increasingly driven by “robot trading algorithms,”  reversals are no longer a slow and methodical process but rather a stampede with little regard to price, valuation, or fundamental measures as the exit becomes very narrow.

October was just a “sampling” of what will happen to the markets when the next bear market begins.

Oh, I almost forgot, the other problem with the whole “passive investing” mantra is that “getting back to even” is not a successful investment strategy to begin with.

#YouHaveBeenWarned

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“You get recessions, you get stock market declines. If you don’t understand that’s going to happen, then you are not ready and you will not do well in the markets” – Peter Lynch

Questions, comments, suggestions – please email me.

Weekend Reading: Recession Risk Rising

In yesterday’s post, we discussed the importance of the S&P 500 as a leading indicator of recessions in the U.S.

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are “best guesses” about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

My friend David Stockman from Stockman’s ContraCorner (a must-read site) sent me an email on Thursday morning stating:

“On your topic of today regarding recession recognition, here’s another point about after-the-fact revisions. NF payrolls were revised down by about 500,000 per month during the September-February 2008 plunge:”

The point here is that while CURRENT economic data points are positive, there are numerous ancillary data points which suggest the economy is already weakening. My colleague, Richard Rosso, sent me this note on the Fed’s alternative GDP calculation called GDP Plus:

“GDPplus is the Federal Reserve Bank of Philadelphia’s measure of the quarter-over-quarter rate of growth of real output in continuously compounded annualized percentage points. It improves on the Bureau of Economic Analysis’s expenditure-side and income-side measures.  Currently, it is showing GDP at 4.0% annual growth with both GDI and GDP-Plus running at 2.0% or less.”

Historically, when GDP has deviated above both GDP-Plus and GDI, GDP has eventually “caught-down” with the rest of the data.

Currently, it is currently believed that the U.S. can remain an island of economic growth in a world struggling with weakness. As shown in the Ned Davis Research chart below, recession risk on a global scale has now surged above 70.

What does that mean?

“Readings above 70 have found us in recession 92.11% of the time (1970 to present).  Several months ago, the model score stood at 61.3.  It has just moved to 80.04.  Expect a global recession.  It either has begun or will begin shortly.  Though no guarantee, as 7.89% of the time since 1970 when the global economic indicators that make up this model were above 70, a recession did not occur.”Stephen Blumenthal

As we discussed yesterday, the dynamics of the market have now changed in a manner which suggests that “something has broken” in both the outlook for the economy and earnings.

While we have had corrections in the past, those corrections have not violated important long-term trends which have remained solidly intact since the 2009 lows. However, this past week, those violations began to occur. Over the long-term, trends are important to consider. The chart below shows the market versus a 75-week moving average. During bullish trends, the market trades above that average. During bearish trends, it’s the opposite.

With the market starting to violate that long-term support, it is worth paying attention to the risk of the market currently.

However, this does not mean you should “panic sell” the market currently. So far, this has been an expected, while painful, pickup in volatility as we discussed in our weekly missives. Most importantly, while the risks of a more meaningful mean reversion are rising, the market does not historically go straight up or down. Therefore, the change of the market’s tone from bullish to bearish does change the trading backdrop from buying dips to selling rallies.

Use rallies to reduce risk, rebalance portfolios, and raise cash for whatever happens next. If the market stabilizes, there are lots of great companies on “sale” currently. If the market declines further, you will appreciate the reduced volatility.

Just something to think about as you catch up on your weekend reading list.

Most Read On RIA

• Is The Market Predicting A Recession? by Lance Roberts
• Higher Rates Are Crushing Investors by Michael Lebowitz
• The #MAGA Market Trendline Is Broken by Jesse Colombo
• An Open Letter To Larry Kudlow by Doug Kass
• Average Stock Is Overvalued: Between Tremendously & Enormously by Vitaliy Katsenelson
• Fed’s Survey Of Economic Un-Well Being by Richard Rosso
• An Investor’s Desktop Guide To Trading by Lance Roberts

Research / Interesting Reads

“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected..” – George Soros

Questions, comments, suggestions – please email me.

10-Fundamentally Strong Value Stocks Hitting Our Radar

Trying to find value in an over-valued market is difficult to say the least. This becomes even more problematic when we discuss the issue within the reality of a late-stage economic cycle and the potential for an economic recession.

So, in looking for opportunity at a time where there is a rising unfavorable economic and earnings backdrop, we turned to our database to screen for stocks with a very strict set of fundamental guidelines.

In order for a company to become a watch list candidate it must have:

• Five-year average returns on equity (ROE) greater than 15%;
• Five-year average returns on invested capital (ROIC) greater than 15%;
• Debt-to-equity (D/E) less than or equal to 80% of the industry average;
• Five-year average pretax profit margin (PM) 20% higher than the industry average;
• Current price-to-book value multiples(P/B) below historical and industry multiples;
• Current price-to-cash flow (P/CF) ratios below the industry average

Out of the universe of more than 6,500 issues, only 10 passed the test.

This should immediately ring some alarm bells on the market as a whole with respect to valuations and the risk being undertaken by investors in general.

However, here are the 10 top stocks we are adding to our watch list currently.

**While REMI made the screening list, it is excluded from consideration due to being under \$5/share.

Below I am providing a brief snapshot of each for your own review.

CL

SNBR

DENN

PZZA

• Warning:  The company is facing numerous class action lawsuits which could have an adverse effect on the company.

ANIK

CBPO

TARO

REMI

• Warning: This is a sub-\$5 stock and is extremely high risk. It is not suitable for investors or our portfolios.

LII

BA

Importantly, just because these companies cleared a screen, such is only the first step in determining if it should be added to an investment portfolio. Each company must be evaluated not only on it fundamental merits but its price trends as well. They should also be evaluated relative to other holdings in your portfolio, your own personal risk tolerance, and your investment objectives.

Disclaimer: As always, you must do your homework BEFORE making any investment. The information contained herein should not be construed as investment advice or a solicitation to buy or sell any security. Past performance is no guarantee of future results. Use of this information is at your own risk and peril.

Weekend Reading: Tax Cuts Saved The Economy?

IBD recently penned an article touting the success of the recent tax cuts from the Trump administration.

“The Treasury Department reported this week that individual income tax collections for FY 2018 totaled \$1.7 trillion. That’s up \$14 billion from fiscal 2017, and an all-time high. And that’s despite the fact that individual income tax rates got a significant cut this year as part of President Donald Trump’s tax reform plan.”

Hold on a second.

A \$14 billion increase on \$1.68 Trillion in receipts is a very paltry 0.8% increase. This is the 8th LOWEST rate of increase in the history of data and is more representative of population growth rather than the success of tax cuts bringing in more revenue.

In fact, when looking at Federal Receipts on an annualized basis, growth in receipts as of the end of Q2 has fallen by more than 4% annually. Importantly, throughout history, negative growth rates in Federal receipts have been associated with recessionary periods in the economy rather than expansions.

But IBD in their effort to support the Trump tax cuts continues:

“Critics of the Trump tax cuts said they would blow a hole in the deficit. Yet individual income taxes climbed 6% in the just-ended fiscal year 2018, as the economy grew faster and created more jobs than expected.”

Well first, as we have shown previously, the tax cuts DID INDEED blow a hole in the deficit. Currently, the deficit is rapidly approaching \$1 Trillion and will exceed that level in 2019.

To IBD’s point, the economy has grown faster than expected and jobs have increased (but not more than expected.)

“Yes, the economy was booming in fiscal 2018. But it probably wouldn’t have been booming without the tax cuts.

Actually, no.

It wasn’t Trump’s tax cuts that led to this growth but, as we discussed recently with Danielle Dimartino-Booth, it came from a “sugar-high” created by 3-massive Hurricanes in 2017 which have required billions in monetary stimulus, created jobs in manufacturing and construction, and led to an economic lift. We saw the same following the Hurricanes in 2012 as well.

However, these “sugar highs” are temporary in nature. Fortunately, for the economic bulls, a bit of reprieve has come from Hurricanes Florence and Michael which will provide some continued boost to economic growth into Q2 of 2019.

The problem is the massive surge in unbridled deficit spending which provides a temporary illusion of economic growth but leads to long-term economic suppression.

Eventually, the debt will come due.

So, while IBD is taking a victory lap touting the success of the Trump agenda, the reality is that the pro-growth policies were launched to late within an economic cycle. This will ultimately ensure the next recessionary drag will likely be larger and last longer than most expect as both fiscal and monetary policy tools were spent during the boom, rather than saved for an eventual “rainy day.”

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

Every once in a while, the market does something so stupid it takes your breath away.” – Jim Cramer

Questions, comments, suggestions – please email me.

Weekend Reading: We Are All In….Again!

Despite the recent angst in the market over increasing interest rates, there has been little evidence of concern by investors overall. A recent report showed that investors have the LEAST amount of cash in their investment accounts…EVER.

“Individual investors drew down cash balances at brokerage accounts to record lows as the S&P 500 surged 7.2 percent in the three months ended Friday.

Cash as a percentage of assets among Charles Schwab Corp. clients in August fell to 10.4 percent, matching the level in January that marked the lowest since at least 2004.”

Of course, eight months ago the markets suffered a 10.4% decline just as investors scrambled to “get in.”

The monthly survey from the American Association of Individual Investors shows the same. Individuals are carrying some of the highest levels in history of equities, are reducing their exposure to bonds, and carrying very low levels of cash.

As Dana Lyons recently noted:

” From the Federal Reserve’s Z.1 release, we find that U.S. Households had a reported 34.3% of their financial assets invested in the equity market as of the 2nd quarter. Outside of a slightly higher reading in the 4th quarter of 2017, that is the highest level of stock investment in the 70-plus year history of the series, other than the 1999-2000 bubble top.”

Investors are once again….“all in.”

And the market once again tumbled.

The one thing we know for sure is that individual investors do exactly the opposite of what they should when it comes to investing – “buy high” and “sell low.”

Households have repeatedly learned, and then subsequently forgotten, this lesson repeatedly over the entirety of the financial market history.

The challenge, of course, it understanding that the next major impact event, market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

The reality is that the majority of investors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high, risk is dismissed for chasing returns, and value is displaced by momentum.

The recent sell-off was NOT the impact event. That event is still coming, and the discussion of why “this time is not like the last time” remains largely irrelevant. Whatever gains that investors garner in the between now and that next event by chasing the “bullish thesis” will largely be wiped away in the swift and brutal downdraft. The routs in February and October are only early warnings of how swift and brutal the actual event will be.

Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“Investors always decide to do the same thing, at the same time, and it is usually the wrong thing.” – T.R. Roberts.

Questions, comments, suggestions – please email me.

8-GARP Stocks That Are Strong Buys

In our previous article we noted that one of the biggest challenges in managing money is finding the right stocks to add to your portfolio. It is hard enough to cull through the 1500 stocks that make up the S&P 500, 400, and 600 indexes much less the more than 6,000 other securities available for investing in.

While we covered dividend income stock last time, this time we thought we would dig around stocks which are trading at a discount to expected growth or, more commonly known as, “Growth At A Reasonable Price.”

GARP investors look for companies that are somewhat undervalued (a feature of value investing) with solid sustainable growth potential (a tenet of growth investing) – an approach that attempts to avoid the extremes of either value or growth investing.

It’s worth noting that we are not talking about owning a portfolio of stocks where some are growth and some are value but rather a portfolio of stocks that on an individual basis have both value and growth characteristics. This is also not to say that you couldn’t combine our value and dividend stocks with growth and value stocks as part of an overall investment strategy.

The criteria for our GARP screen are:

• Current P/E Divided By The 5-Year Average <= 5
• Percentage Change Of Next Years Estimates Over Last 12-Weeks >= 0
• P/E Using 12-Month Forward EPS Estimates <= 15
• 5-Year Historical EPS Growth (%) >= 5
• Next 3-5 Years Estimated EPS Growth (%/Year) >= 5
• Rank = Strong Buy
• P/E Using 12-Month Forward EPS Estimate >= 8

The table below are the 8-candidates which resulted from the latest screening.

In a market that is fundamentally overvalued, buying value at a reasonable price is become more exceedingly difficult. However, in theory, buying stocks that exhibit both strong value and growth characteristics should yield an excess return over the market over time. The table below assumes that over the last 5-years you bought all the stocks yielded by the screen and rebalanced them quarterly.

(The number of holdings ranged from a low of 6 in July of 2016 to a maximum of 31 following the market rout in February of this year. The last period for the holding period was for May of 2018 which yielded 18 holdings. Following the recent run-up, the number of holdings has been reduced to 8 which is the tied with the second lowest number of holdings since 2013. Note that low holdings preceded the market routs of 2015-2016 and 2018.)

Over the 21-quarterly rebalancing periods the portfolio had an annualized return of 16.6% versus the 13.6% for the market. This 2.7% annual outperformance versus the S&P 500 is shown in the charts below.

Because a GARP strategy employs principles from both value and growth investing, the returns seen during certain market phases can be quite different that returns seen in a strict value or growth portfolio. However, as shown in the portfolio metrics, while a GARP strategy can provide outperformance over the index overtime, given proper risk management practices, but can have higher volatility because of the growth component.

By combing this strategy with a dividend-income strategy as discussed last time, it is possible to smooth out some of the volatility while still maintaining returns.

In short, the GARP strategy not only fuses growth and value stock-picking criteria, but also experiences a combination of their types of returns. While a value investor will do better in bearish conditions; a growth investor will do better in a bull market; therefore, GARP investing should be rewarded with more consistent and predictable returns.

There is no doubt we are in a full-blown bull market currently. However, valuations are suggesting that returns may be significantly lower in the future making a GARP portfolio, and potentially one combined with a dividend strategy, much more beneficial.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

One of the best known GARP investors was Peter Lynch, who has written several popular books, including “One Up on Wall Street” and “Learn to Earn.” Of course, he was an investing legend due to his 29% average annual return over his 13-year stretch from 1977-1990 as manager of the Fidelity Magellan fund. Of course, the advantage to Peter Lynch was starting his run when valuations were deeply depressed at 7-9x earnings rather than 33x today.

This is why, with valuation and safety being a top concern for our clients, especially with markets at all-time highs, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discounts to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries.

Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

Weekend Reading: Are Dividends Telling Us Something?

Earlier this week, Eddy Elfenbein has an interesting post discussing the “Bull Market In Dividends.”

“For the third quarter, dividends from the S&P 500 grew by 10.96%. That’s the strongest growth rate in more than three years. It’s the 34th quarter in a row of dividend growth.

Over the last eight years, dividends are up 234%, which is pretty close to what the S&P 500 price index has done.

Considering how simple it is, the S&P 500 has tracked a 2% dividend yield fairly closely for the last several years.”

It is an interesting point particularly when you consider that there are a lot of dividends which have been “financed” through “cheap debt.” There is also the issue of record debt issuance by companies with marginal balance sheets at best or are walking “zombies” at worst.

As John Coumarionos noted earlier this week.

“Low interest rates have allowed companies that would have otherwise gone out of business to stay alive, and this has caused a tepid recovery. Chancellor notes the cumulative default rate on junk bonds during the entire recession was 17%, or “around half the level of the two previous downturns.” And while central bankers might view this as a victory, he views it as the cause of economic weakness.

The lessons for investors are to remain vigilant about stock valuations and higher yielding bonds. At some point, the zombies will not be able to sustain themselves any longer.”

This is an interesting point when you begin to think about the long-term history of dividends and what they represent with respect to long-term market cycles.

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

First, the statement is incorrect because during market reversion “cash dividends” DO NOT increase – but the YIELD does because of the collapse in prices.

But, more to the point, that notion is only true, until it isn’t.

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%.

Of course, it wasn’t EVERY company cutting dividends by 12%. Some didn’t. Many did, and some even eliminated their dividends entirely to protect creditors. The last point is the most important. For any company shareholders are a secondary concern. However, access to the debt market is a far more important consideration when it comes to financial decision making, who gets paid, and who doesn’t.

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

As with the “Nifty Fifty” heading into the 1970’s, 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 actual dividends being paid out throughout history. The chart below shows the history of inflation-adjusted dividends and the S&P 500 going back to 1900. (Data courtesy of Dr. Robert Shiller.)

The first thing to note is the extreme deviation of real annual dividends above their long-term linear growth trend. As you will notice is that such extensions have ALWAYS mean reverted throughout history. (In other words, the best time to BUY dividend yielding companies is when the dividend has deviated well below the long-term growth trend.)

Here is another way to look at the same data. The chart below shows the percentage deviation above and below the 5-year average annual cash dividend. There are two things you should take note of.

1. When deviations have exceeded a 20% deviation it has denoted very overvalued markets.
2. Reversions below the 5-year average have been coincident with secular bear markets.

Notice that the current deviation from the 5-year average has already started to decline which is coincident with the Federal Reserve rate hike campaign. Given that much of the dividend issuance was done through cheap debt over the last decade, it is not surprising that with rising rates, the rate of dividend issuances has begun to slow.

Dividends may well already be telling us of a more troubling trend for investors is coming.

While I completely agree that 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. During the next major market reversion, we will see much of the same happen again.

It is during these times when prices collapse, and dividends are slashed, the “I bought it for the dividend plan” doesn’t work out.

EVERY investor has a point, when prices fall far enough, that 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.

Just something to think about as you catch up on your weekend reading list.

Research / Interesting Reads

“Any fool can buy a stock. It takes a smart investor to know when to sell.” – Anonymous

Questions, comments, suggestions – please email me.

10 Value-Dividend Stocks In An Overvalued Market

One of the biggest challenges in managing money is finding the right stocks to add to your portfolio. It is hard enough to cull through the 1500 stocks that make up the S&P 500, 400 and 600 indexes much less the more than 6,000 other securities available for investing in.

As you may already suspect, by looking out our portfolios on the site, we have a preference for high-quality names that also provide dividends. We do this by screening our database of stocks for several fundamental and value factors to ensure we are buying top-quality names and then refining that list down to the top-10 dividend payers. We believe that these value stocks, combined with dividends should generate an excess return versus the benchmark index over time.

The criteria for our Fundamental Value Dividend screen are:

• Market Cap > \$1 Billion
• Dividend Yield > Top 10
• Return On Equity > 15%
• Price To Sales <= 1.5x
• EPS Growth Over The Last 3-Years > 0

The table below are the 10-candidates which resulted from the latest screening.

You will note that we recently added CVS Health (CVS) to both the Equity and the Equity/ETF models.

As I stated, the combination of these fundamental measures should yield an excess return over the market over time. The table below assumes that over the last 5-years you bought all 10-stocks and rebalanced them quarterly.

Over the 21-quarterly rebalancing periods the portfolio had an annualized return of 15.6% versus the 13.8% for the market. This 1.80% annual outperformance versus the S&P 500 is shown in the charts below.

Even though interest rates have risen from the lows of last year, the price of money has been persistently lower in this economic cycle than it has been in the past. This factor continues to provide support for income yielding stocks as many investors, including the growing population of retirees, are seeking more stable, fixed income-like returns.

The risk of this strategy is that valuations for many companies, including higher dividend payers, have expanded much more than normal, and is reminiscent of the “Nifty-Fifty” period in the late 1970’s.

While investing in dividend yielding stocks certainly provides additional return to portfolios, just remember that stocks are “not safe” investments. They can and will lose value during a market decline.

This is why for our “safe money” we continue to use rallies in interest rates to buy bonds which provide both higher rates of income and safety of principal.

(Subscribe to our YouTube channel for daily videos on market-moving topics.)

With valuation and safety being a top concern for investors, especially with markets at all-time highs, we continue to believe that the best way for investors to generate capital is to invest in quality businesses trading at a reasonable discounts to their intrinsic value. As such, we focus on names which still maintain a reasonable valuation, are consistently growing, and are well founded in their industries. We think these names are more likely to offer investors both the yield they are looking for and are currently trading at prices that provide a reasonable margin of safety.

Disclaimer: Nothing in this post should be construed as an offer to buy or sell any securities. This content is for informational purposes only. Past performance is no guarantee of future results. Use at your own risk and peril.

Quick Take: The Risk Of Algos

Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’

Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’

Mike ‘Wags’ Wagner: ‘Just remember never won a World Series .’ – Billions, A Generation Too Late

My friend Doug Kass made a great point on Wednesday this week:

“General trading activity is now dominated by passive strategies (ETFs) and quant strategies and products (risk parity, volatility trending, etc.).

Active managers (especially of a hedge fund kind) are going the way of dodo birds – they are an endangered species. Failing hedge funds like Bill Ackman’s Pershing Square is becoming more the rule than the exception – and in a lower return market backdrop (accompanied by lower interest rates), the trend from active to passive managers will likely continue and may even accelerate this year.”

He’s right, and there is a huge risk to individual investors embedded in that statement. As JPMorgan noted previously:

Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.

While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.

As long as the algorithms are all trading in a positive direction, there is little to worry about. But the risk happens when something breaks. With derivatives, quantitative fund flows, central bank policy and political developments all contributing to low market volatility, the reversal of any of those dynamics will be problematic.

There are two other problems currently being dismissed to support the “bullish bias.”

The first, is that while investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.

Yes, margin debt does increase as asset prices rise. However, just as the “leverage” provides the liquidity to push asset prices higher, the reverse is also true.

The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:

“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.

‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”

When the “robot trading algorithms”  begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”

But therein lies the “risk of the robots.”

What happens when these algo’s reverse course and begin to “sell the rallies” in unison?

I don’t want to be around to find out.

You Were Warned: MLP’s & “I Bought It For The Dividend”

In early 2016, I warned investors about the dangers of Master Limited Partnerships (MLP’s) and chasing dividend yields. To wit:

One of the big issues starting in 2016 will be the reversions of MLP’s. Many investors jumped into MLP’s believing them to be a ‘no-brainer’ investment for income with little or no price risk. As I have suggested many times over the last few years, this was ALWAYS a false premise. In 2016, many companies that spun-off pipelines in the form of MLP’s, will ‘revert’ them back into the parent company as they can buy the asset back very cheaply, boosting cash flows of the parent company, during a period of weak commodity prices. This will leave MLP investors who just ‘bought it for the dividend,’ receiving back much less than they invested to begin with.”

That prediction continues to come to fruition with the latest announcement by Tallgrass Energy Partners. Via Bloomberg:

“Tallgrass Energy GP, LP announced late on Monday it would buy out the public unit-holders owning about two-thirds of its master limited partnership, Tallgrass Energy Partners, LP. It’s the latest MLP to be shuffled off and a good example of why the ranks are thinning in this once-beloved corner of the market.

Tallgrass Energy Partners listed in 2013, when the combination of yield and growth — predicated on the resurgence in U.S. oil and gas production — offered by MLPs had them in high demand. The general partner, Tallgrass Energy GP, listed two years later, when oil’s bear market had started but MLPs hadn’t yet fallen out of favor. That followed soon after.”

The “yield” is the problem.

“Tallgrass actually avoided cutting its quarterly distributions in the downturn, making it a relatively rare beast and explaining much its outperformance. But those high distributions evidently didn’t inspire enough confidence — and just became a high cost of capital instead.”

But it isn’t just Tallgrass, but most MLP’s. The “yields” reflected by MLP’s are actually understatements of the true cost of equity. Once prices fall, both on the MLP and with the underlying commodity, the entire premise of “raising capital cheaply” gets called into question. It then becomes much more opportunistic to “revert” the MLP back into the parent company.

This is the point where a common“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.

Tallgrass Energy Partners pays out an annual dividend of \$3.86 and is currently priced at \$39.24 (as of this writing) which translates into a yield of 9..84%. (3.86/39.24)

Let’s assume an individual bought 100 shares at \$50 in 2017 which would generate a “yield” of 7.72%.

Investment Return (39.24 – 50 = -10.76) + Dividend of \$3.86  = Net Loss of \$6.90

“The terms — laid out in a perfunctory seven-slide deck — are as austere as you might expect in a deal where the limited partners don’t get to vote. The parent offered a nominal premium of about 1 percent to Tallgrass Energy Partners’ minority unitholders. The exchange ratio of two shares for each unit was essentially in line with the average since the general partner listed.”

That’s not a great deal, but better than a “sharp stick in the eye.”

Here is the important point. You do NOT receive a “yield.”

“Yield” is just a mathematical calculation.

The “yield” can, and often does, go away.

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:

“‘The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process.’

This statement puzzles me. 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 increase. It is true that the total value of the portfolio will fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends are a wonderful thing, Lance. Dividends usually go up even when the stock market goes down.

This comment drives to the heart of the “buy and hold” mentality and, along with it, 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. Well, that is until the cash dividend is cut or is eliminated entirely.

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%.

Of course, not EVERY company cut dividends by 12%. Some didn’t. But many did, and some even eliminated their dividends entirely, to protect cash flows and creditors.

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 dividend yielding companies to excessive levels disregarding underlying fundamental weakness.

As with the “Nifty Fifty” heading into the 1970’s, 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 actual dividends being paid out throughout history.

While I completely agree that 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.

In fact, it is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently, the economy may not be as “strong as an ox” currently:

March 2018 saw the second-largest ever number of dividend cuts be declared by U.S. firms and funds in a single month. The month’s 92 dividend cuts reported was just one shy of the record 93 cuts that were recorded during the ‘Great Dividend Raid of 2012.””

Here are the dividend numbers as we know them for March 2018 today:

• There were 4,392 U.S. firms that issued some kind of declaration regarding their dividends in March 2018, which is up significantly from February 2018’s 3,493 and the year-ago March 2017’s 4,041. This figure is also the third highest number on record, coming behind December 2017’s 4,506 and December 2015’s 4,422.
• In March 2018, there were 36 U.S. firms that announced that they would pay an extra, or special, dividend. That figure is slightly down from the 38 firms that made similar declarations in both February 2018 and back in March 2017.
• 167 U.S. companies declared that they would increase their dividends in March 2018, which is down from 322 in February 2018, but up significantly from the 141 that boosted their dividends in March 2017. For the first quarter of 2018, a total of 807 dividend rises were recorded, which ranks third for any quarter’s total of dividend increases, behind March 2014’s 819 and March 2015’s 812.
• The 92 dividend cuts reported for March 2018 is up substantially from the 20 that were recorded in February 2018 and also from the 76 recorded back in March 2017, when the distress in the U.S. oil and gas industry was bottoming.
• 9 U.S. firms omitted paying dividends in March 2018, the same as in February 2018, but which is up from the 2 firms that did a year earlier in March 2017.”

During the next major market reversion, as prices collapse, so will the dividend payouts.

This is when the “I bought it for the dividend plan” doesn’t work out.

Why?

Because EVERY investor has a point, when prices fall far enough, that 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.

Psychology

Of course, while individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do.

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making.

Ultimately, when markets decline, there is a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, so does the related anxiety until individuals seek to “avert further loss” by selling. It is generally believed that dividend yielding stocks offer protection during bear market declines. The chart below is the Fidelity Dividend Growth Fund (most ETF’s didn’t exist prior to 2000), as an example, suggests this is not the case.

As you can see, there is little relative “safety” during a major market reversion. The pain of a 38% loss, or a 56% loss, is 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.

Buy & Hold Won’t Get You There Anyway

Most importantly, as it relates to this discussion, is the “fact” that “buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for discussion of chart)

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.

While many studies show that “buy and hold,” and “dividend” strategies do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits. Furthermore, with valuations and market correlations at extremely elevated levels, the next major market correction will be equally unkind to all investors.

In the end, those who utter the words “I bought it for the dividend” are simply trying to rationalize an investment mistake. However, it is in the rationalization 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.

Tallgrass won’t be the last MLP, or corporation, to cut dividends. When the next major mean-reverting begins, you can “lie” to yourself for a while that you are fine with just the dividend. Eventually, when you have lost enough capital, and the dividend is cut or eliminated, you will eventually sell.

It happens every time.

But, you have been warned…again.