# 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.

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

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.

# Collecting Tolls On The Energy Express

The recent surge in passive investment strategies, and corresponding decline in active investment strategies, is causing strong price correlations amongst a broad swath of equities. This dynamic has caused a large majority of stocks to rise lockstep with the market, while a few unpopular stocks have been left behind. It is these lagging assets that provide an opportunity. Overlooked and underappreciated stocks potentially offer outsized returns and low correlation to the market. Finding these “misfits” is one way we are taking advantage of a glaring market inefficiency.

In July 2019, we recommended that investors consider a specific and underfollowed sector of REITs that pay double-digit dividends and could see reasonable price appreciation. In this article, we shed light on another underfollowed gem that also offers a high dividend yield, albeit with a vastly different fundamental profile.

## The Case for MLP’s

Master Limited Partnerships (MLPs) are similar in legal structure to REITs in that they pass through a large majority of income to investors. As such, many MLP’s tend to pay higher than average dividends. That is where the similarities between REITs and MLPs end.

The particular class of MLPs that interest us are called mid-stream MLPs. We like to think of these MLPs as the toll booth on the energy express. These MLPs own the pipelines that deliver energy products from the exploration fields (upstream) to the refiners and distributors (downstream). Like a toll road, these MLPs’ profitability is based on the volume of cars on the road, not the value of the cars on it. In other words, mid-stream MLPs care about the volume of energy they carry, not the price of that energy. That said, low oil prices can reduce the volume flowing through the pipelines and, provide energy producers, refiners, and distributors leverage to renegotiate pipeline fees.

Because the income of MLPs is the result of the volume of products flowing through their pipelines and not the cost of the products, their sales revenue, income, and dividend payouts are not well correlated to the price of oil or other energy products. Despite a different earnings profile than most energy companies, MLP stock prices have been strongly correlated to the energy sector. This correlation has always been positive, but the correlation is even greater today, largely due to the surge of passive investment strategies.

Passive investors tend to buy indexes and sectors containing stocks with similar traits. As passive investors become a larger part of the market, the prices of the underlying constituents’ trade more in line with each other despite variances in their businesses, valuations, outlooks, and risks. As this occurs, those marginal active investors that differentiate between stocks and their associated fundamentals play a lesser role in setting prices. With this pricing dynamic, inefficiencies flourish.

The graph below compares the tight correlation of the Alerian MLP Infrastructure Index (MLPI) and the State Street Energy Sector ETF (XLE).

Data Courtesy Bloomberg

Before further discussing MLP’s, it is worth pointing out the value proposition that the entire energy sector affords investors. While MLP cash flows and dividends are not necessarily similar to those companies in the broad energy sector, given the strong correlation, we must factor in the fundamental prospects of the entire energy sector.

The following table compares valuation fundamentals, returns, volatility, and dividends for XLE and the S&P 500. As shown, XLE has traded poorly versus the S&P 500 despite a better value proposition. XLE also pays more than twice the dividend of the S&P 500. However, it trades with about 50% more volatility than the index.

The following table compares two valuation metrics and the dividend yield of the top 6 holdings of Alerian MLP ETF (AMLP) and the S&P 500. A similar value story emerges.

As XLE has grossly underperformed the market, so have MLPs. It is important for value investors to understand the decline in MLP’s is largely in sympathy with the gross underperformance of the energy sector and not the fundamentals of the MLP sector itself. The graph below shows the steadily rising earnings per share of the MLP sector versus the entire energy sector.

Data Courtesy Bloomberg

## Illustrating the Value Proposition

The following graphs help better define the value of owning MLPs at current valuations.

The scatter graph below compares 60-day changes to the price of oil with 60-day changes in AMLP’s dividend yield. At current levels (the orange dot) either oil should be \$10.30 lower given AMLP’s current dividend yield, or the dividend yield should be 1.14% lower based on current oil prices. A decline in the dividend yield to the norm, assuming the dividend payout is unchanged, would result in a price increase of 13.17% for AMLP. Alternatively if oil declined about 20% in value, the current AMLP dividend yield would then be fairly priced. We consider this a significant margin of safety should the price of oil fall, as it likely would if the U.S. enters a recession in the near future.

Data Courtesy Alerian and Bloomberg

The graph below highlights that AMLP’s dividend yield is historically high, albeit below three short term spikes occurring over the last 25 years. In all three cases oil fell precipitously due to a recession or a sharp slowdown of global growth.

Data Courtesy Alerian and Bloomberg

Due to their high dividend yields and volatility, MLP’s are frequently compared to higher-yielding, lower-rated corporate debt securities. The graph below shows that the spread of AMLP’s dividend yield to the yield on junk-rated BB corporate bonds is the largest in at least 25 years. The current spread is 5.66%, which is 5.18% above the average since 1995.

Data Courtesy Alerian and St. Louis Federal Reserve

To help us better quantify the pricing of MLPs, we created a two-factor model. This model forecasts the price of MLPI based on changes to the price of XLE and the yield of U.S. Ten-year Treasury Notes. The model below has an R-squared of .76, meaning 76% of the price change of MLPI is attributable to the price changes of energy stocks and Treasury yields. Currently the model shows that MLPI is 20% undervalued (gray bars).  The last two times MLPI was undervalued by over 20%, its price rose 49% (2016) and 15% (2018) in the following three months.

The following summarizes some of the more important pros and cons of investing in MLPs.

Pros

• Dividend yields are very high on an absolute basis and versus other higher-yielding securities
• Valuations are cheap
• Earnings are growing in a dependable trend
• Balance sheets are in good shape
• Potential for stock buybacks as balance sheets improve and stock prices offer value

Cons

• Strong correlation to oil prices and energy stocks
• “Peak oil demand” – electric cars/solar
• Political uncertainty/green movement
• High volatility

## Summary

The stronger the market influence that passive investors have, the greater the potential for market dislocations. Simply, as individual stock prices become more correlated with markets and each other, specific out of favor companies are punished. We believe this explains why MLP’s have traded so poorly and why they are so cheap today.

We urge caution as buying MLPs in today’s environment is a “catching the falling knife” trade. AMLP has fallen nearly 25% over the last few months and may continue to fall further, especially as tax selling occurs over the coming weeks. It has also been in a longer-term downtrend since 2017.  We are unlikely to call the market bottom in MLPs and therefore intend to scale into a larger position over time. We will likely buy our first set of shares opportunistically over the next few weeks or possibly in early 2020. Readers will be alerted at the time. We may possibly use leveraged MLP funds in addition to AMLP.

It is worth noting this position is a small part of our portfolio and fits within the construct of the entire portfolio. While the value proposition is great, we must remain cognizant of the current price trend, the risks of owning MLPs, and how this investment changes our exposure to equities and interest rates.

This article focuses predominately on the current pricing and value proposition. We suggest that if you are interested in MLPs, read more on MLP legal structures, their tax treatment, and specific risks they entail.

AMLP does not require investors to file a K-1 tax form. Many ETFs and all individual MLPs have this requirement.

*MLPI and AMLP were used in this article as a proxy for MLPs. They are both extremely correlated to each other. Usage was based on the data needed.

# Consumers Are Keeping The US Out Of Recession? Don’t Count On It.

Just recently, Jeffry Bartash published an interesting article for MarketWatch.

“Like a stiff tent pole, consumers are keeping the U.S. economy propped up. And it looks like they’ll have to do so for at least the next year.

Strong consumer spending has given the economy a backbone to withstand spine-tingling political fights at home and abroad. Households boosted spending by 4.6% in the spring, and nearly 3% in the summer, to offset back-to-back drops in business investment and whispered talk of recession.”

That statement is correct, and considering the consumer makes up roughly 70% of economic growth, this is why you “never count the consumer out.”

The most valuable thing about the consumer is they are “financially stupid.” But what would expect from a generation whose personal motto is “YOLO – You Only Live Once.”

This is why companies spend billions on social media, personal influencers, television, radio, and internet advertising. If there is an outlet where someone will watch, listen, or read, you will find ads on it. Why? Because consumers have been psychologically bred to “shop till they drop.”

As long as individuals have a paycheck, they will spend it. Give them a tax refund, they will spend it. Issue them a credit card, they will max it out. Don’t believe me, then why is consumer debt at record levels?

This record level of household debt is also why the Fed’s measure of “Saving Rates” is entirely wrong:

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a \$2654 annual deficit that cannot be filled.”

Delayed gratification is a thing of the past.

If consumers were even partially responsible, financial guru’s like Dave Ramsey wouldn’t have a job counseling people on how to get out of the “debt trap” they got themselves into.

However, as Steve Liesman once stated on CNBC:

“Debt is always pointed out as a negative thing, when in fact debt is the great bridge between working hard and playing hard in this country.This country has been built on consumer debt.”

While the statement is clearly wrongheaded, it does show the importance of consumer spending as it relates to keeping the economy GOING.  Note, that I said “going,” and not “growing,” Take a look at the chart below:

In the 1980’s and 90’s consumption, as a percentage of the economy, grew from roughly 61% to 68% currently.  The increase in consumption was largely built upon a falling interest rate environment, lower borrowing costs, and relaxation of lending standards.

In 1980, household credit market debt stood at \$1.3 Trillion. To move consumption, as a percent of the economy, from 61% to 67% by the year 2000 it required an increase of \$5.6 Trillion in debt. Since 2000, consumption as a percent of the economy has risen by 1% over the last 19 years. To support that increase in consumption, it required an increase in personal debt of more than \$7 Trillion.

The importance of that statement should not be dismissed. It has required more debt to increase consumption by 1% of the economy since 2000 than it did to increase it by 6% from 1980-2000. The problem is quite clear. With interest rates already at historic lows, consumers already heavily leveraged and economic growth running at sub-par rates – there is not likely a capability to increase consumption as a percent of the economy to levels that would replicate the economic growth rates of the past.

Debt is a negative thing for the borrower. It has been known to be such a thing even in biblical times as quoted in Proverbs 22:7:

“The borrower is the slave to the lender.”

Debt acts as a “cancer” on an individual’s wealth as it siphons potential savings from income to service the debt. Rising levels of debt means rising levels of debt service which reduces actual disposable personal incomes that could be saved or reinvested back into the economy.

The mirage of consumer wealth has been a function of surging debt levels. “Wealth” is not borrowed but “saved” and as shown in the chart above this is a lesson that too few individuals have learned.

## Consumption Is Function Of A Paycheck

Currently, it is believed the “consumer is just fine” because they are continuing to spend at a fairly healthy clip.

However, this spending is based on “confidence” and currently, that level of confidence is at historically high levels, as shown below. (The chart below shows our composite confidence index, which combines both the University of Michigan and Conference Board measures.)

If we overlay that confidence composite with personal consumption expenditures, it is not surprising there is a reasonably high correlation.

Not surprisingly, since retail sales make up 40% of personal consumption expenditures, it also has a high correlation with consumer confidence.

Do you know what else has a high correlation with consumer confidence?

Employment.

This should be a relatively obvious connection.

No job = No paycheck = No spending.

This is a point Jeffry misses in his article when he states:

“Most Americans feel secure about their jobs and income prospects, with layoffs and unemployment at a 50-year low. They’re earning more money, saving more than they used to and are not as burdened by debt. That’s why surveys show consumer confidence remain near post 2008 recession highs.”

That is true. Confidence is high because employment is high, and consumers operate in a microcosm of their own environment. As we noted just recently:

“[Who is a better measure of economic strength?] Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis? A quick look at history shows this level of disparity (between consumer and CEO confidence) is not unusual. It happens every time prior to the onset of a recession.

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

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

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

It is hard for consumers to remain “confident,” and continue spending, when they have lost their source of income. This is why consumer confidence doesn’t “go gently into the night,” but rather “screaming into the abyss.”

Given that GDP is roughly 70% consumption, deterioration in economic confidence is a hugely important factor. The most significant factors weighing on that consumption, as noted above, are job losses which crush spending decisions by consumers.

This starts a virtual spiral in the economy as reductions in spending put further pressures on corporate profitability. Lower profits lead to more unemployment, and lower asset prices, until the cycle is complete. Note, bear markets end when the negative deviation reverses back to positive.

## Conclusion

Are consumers currently keeping the economy out of recession? You bet.

Will it stay that way? Probably not.

Records are records for a reason. It is where things end, not begin, and all economics cycle.

What CEO confidence is telling us is that we are likely nearing the end of this current cycle. Since employers are slow to hire, and slow to fire, the current slowdown in hiring is an early indication the end of the cycle is approaching.

When job losses begin to accelerate, confidence will fall very quickly, as does consumer spending, and then the markets. While the financial media is salivating over new “records” being set for this “bull market,” here is something to think about.

• Bull markets END when everything is as “good as it can get.”
• Bear markets END when things simply can’t “get any worse.”

Currently, everything is just about “as good as it can get.”

Just remember, that for every “bull market” there MUST be a “bear market.” It is part of the “full-market cycle.”

How does every bear market begin?

Slowly at first, then all of a sudden.

# CEO Confidence Plunges, Consumers Won’t Like What Happens Next

There is a disparity happening in the country.

No, it isn’t political partisanship, but rather “economic confidence.”

The latest release of the University of Michigan’s consumer sentiment survey rose to a three-month high of 96, beat consensus expectations, and remains near record levels. Conversely, CEO confidence in the economy is near record lows.

It’s an interesting dichotomy.

The chart below shows our composite confidence index, which combines both the University of Michigan and Conference Board measures. The chart compares the composite index to the S&P 500 index with the shaded areas representing when the composite index was above a reading of 100.

On the surface, this is bullish for investors. High levels of consumer confidence (above 100) have correlated with positive returns from the S&P 500.

However, high readings are also a warning sign as they then to occur just prior to the onset of a recession. As noted, apparently, consumers did not “get the memo” from CEO’s.

So, who’s right?

Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis?

Michael Arone, chief market strategist at State Street Global Advisors, recently told MarketWatch:

“I’m not sure if we’ve seen this disparity between positive consumer sentiment and negative business confidence at this level. From my perspective, something has to give. Either businesses have to be more confident, or you’re likely to see more rollover on the consumer data.”

Actually, a quick look at history shows this level of disparity is not unusual. It happens every time prior to the onset of a recession.

Take a closer look at the chart above.

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

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

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

It is hard for consumers to remain “confident,” and continue spending, when they have lost their source of income. This is why consumer confidence doesn’t “go gently into night,” but rather “screaming into the abyss.”

## UofM A Better Predictor

As noted above, our composite indicator is the average of both the University of Michigan and Conference Board measures. Of the two measures, the UofM index is the better index to pay attention to.

As shown above, while the Conference Board is near all-time highs suggesting the consumer is “strong”, the UofM measure is sending quite a different message. Not only has it turned lower, confirming the recent weakness in retail sales, but also has topped at a lower high than then previous two bull market peaks.

The chart below subtracts the UofM measure from the Conference Board index to show the historical divergence of the two measures. Importantly, the Conference Board measure is always overly optimistic heading into a recession and bear market, then “catches down” to the UofM measure.

Another way to analyze confidence data is to look at the consumer expectations index minus the current situation index in the consumer confidence report.

This measure also is signaling a recession is coming. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than prior to the “dot.com” crash. Recessions start after this indicator bottoms, which has already started happening.

Given that GDP is roughly 70% consumption, deterioration in economic confidence is a hugely important factor. The most significant factors weighing on that consumption, as noted above, are job losses which crushes spending decisions by consumers.

This starts a virtual spiral in the economy as reductions in spending put further pressures on corporate profitability. Lower profits lead to more unemployment, and lower asset prices, until the cycle is complete. Note, bear markets end when the negative deviation reverses back to positive.

Currently, the bottoming process, and potential turn higher, which signals a recession and bear market, appears to be in process.

None of this should be surprising as we head into 2020. With near record low levels of unemployment and jobless claims, combined with record high levels of sentiment, job openings, and near record asset prices, it seems to be just about as “good as it can get.”

However, that is also a point to consider, as I wrote previously:

“’Record levels” of anything are “records for a reason.”

As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

For every “bull market” there MUST be a “bear market.”

This time will not be “different.”

If the last two bear markets haven’t taught you this by now, I am not sure what will.

Maybe the third time will be the “charm.”

# Charts Both Bulls & Bears Should Consider

There has been a litany of articles written recently discussing how the stock market is set for a continued bull rally and that last year’s 20% decline was just an anomaly. The are some primary points that are common threads among each of these articles which are:  1) interest rates are low, 2) corporate profitability is high, and; 3) the Fed continues to put a floor under stocks, and 4) there is no recession in sight. Each of these arguments, while currently accurate, are based primarily on artificial influences and conjecture.

• Interest rates are low because real economic growth remains weak.
• Profitability is high due to accounting gimmicks and share repurchases.
• The Fed is verbally putting a floor under stocks but continues to extract liquidity from the market, and;
• “There is no recession in sight” argument have been famous last words historically.

While the promise of a continued bull market is very enticing it is important to remember that all markets ultimately complete a “full cycle.” Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of an indefinite bull market, you should at least consider the following charts.

It is often stated that valuations are still cheap based on forward estimates. However, as I noted on Tuesday, forward estimates are always flawed, overly estimated, and repeatedly lead to poor outcomes over time (buy high/sell low) Therefore, trailing reported earnings is truly the only measure one should use.

The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-Ratio. Both measures of valuations simply show that markets are not cheap which historically lead to lower future returns.

• Shiller’s PE Ratio – is calculated by taking the current price of the market and dividend it by the average of 10-years of reported earnings.
• Tobin’s Q Ratio – is calculated as the market value of a company divided by the replacement value of the firm’s assets.)

Most people dismiss valuations because of their inefficiency in dictating market turns. I understand.

However, valuations are NOT, and have never been, a market timing indicator. They are simply a “road map” to future returns.

On a much shorter time-frame, a look at the price of the market as compared to corporate profits give us a better clue. Currently, with the market is trading substantially above the level of corporate profits, any weakness in profit growth (which is heavily tied to economic growth) will foster a reversion in price.

Another way to look at the excess over time is by examining the inflation-adjusted S&P 500 index as compared to real profits. Note that previous extensions of price above profits have generally not ended well when profit growth reversed.

We recently proved this point by looking at the RIA Economic Composite Index as compared to the annual rate of change of the market. Not surprisingly, markets tend to perform poorly during weakening economic environments.

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

The correlation is clearer when looking at the market versus the ratio of corporate profits to GDP. (Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.) With investors paying more today than at any point in history, the next mean reversion will be a humbling event.

Another argument made lately to support the bullish meme is that retail investors all jumped out of the market. The chart below shows the percentage of stocks, bonds and cash owned by individual investors according to the American Association of Individual Investor’s survey.  As you can see, equity ownership did indeed drop from the second highest level on record. However, while many are suggesting this is “bullish,” it is worth noting that historically sharp downturns have also denoted the start of bigger declines and bear markets.

As we have noted previously, investors have been leveraging up portfolios to chase the market. The issue with margin debt is NOT the increasing levels of it. Rising leverage provides buying power to continue to push stocks higher. The issue of margin debt is when it reverses. Just as margin debt increases the rise of stock prices, the reverse is also true.

The chart below shows the history of margin debt levels versus the 12-month moving average. Over the last decade, when the 12-month moving average was violated it has previously been met with Central Bank interventions. Currently, the Fed still remains on a path of reducing accommodative policy and liquidity is being slowly drained. The decline in margin debt is an additional removal of liquidity which has previously supported higher asset prices.

As a money manager, we are currently long the stock market albeit at reduced levels currently. The reality is that I must maintain exposure or potentially suffer career risk. However, my job is not only to make money for my clients, but also to preserve their gains, and investment capital, as much as possible.

The bullish case is based on expectations that current trends from the last decade will continue indefinitely, such as:

1. Profit margins will only grow and never mean revert.
2. Yields will remain stable at low levels.
3. Fed rate hikes and yield curve inversions no longer matter
4. Weakness in housing, autos, and other credit sensitive ares will not impact domestic growth.
5. \$1 Trillion+ deficits won’t slow the economy.
6. Inflationary pressures will remain forever muted.
7. Political turmoil will not roil markets or inhibit consumer confidence.
8. U.S. dollar won’t appreciate to higher levels
9. The U.S. economy can remain indefinitely decoupled from the rest of world.
10. Trade wars and tariffs are a non-event.
11. Corporations will continue to be the predominant purchasers of U.S. stocks.
12. Liquidity will remain plentiful
13. The Central Bank “put” will remain in place forever.
14. This time is different.

Understanding these bullish arguments is important. But more importantly is the understanding that many of these beliefs have already begun to deteriorate and are substantially increasing the risk to investors and their capital. The markets will not rise indefinitely, and the eventual mean reversion will be more destructive than most realize.

Unfortunately, since most individuals only consider the “bull case,” as it creates confirmation bias for their “greed” emotion, they never see the “train coming.”

Hopefully, these charts will give you some food for thought.

# The Economy IS Slowing

In August of last year, I wrote an article entitled “As Good As It Gets which discussed the record levels being set by a broad swath of economic indicators. To wit:

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

In the “rush to be bullish” this a point often missed. When data is hitting “record levels” it is when investors get “the most bullish.” Conversely, they are the most “bearish” at the lows.

But as investors, such is exactly the opposite of what we should do. It is just our human nature.

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

There currently seems to be a very high level of complacency that the economy will continue its current cycle indefinitely. Or should I say, there seems to be a very large consensus the economy has entered into a “permanently high plateau,” or an era in which economic recessions have been effectively eliminated through monetary and fiscal policy.

Interestingly, it is that very belief on which the Fed is dependent.  They have voiced some minor concerns over a slowing in some of the data, yet they remain committed to trailing economic data points which suggest the economy remains robust.

But herein lies “the trap” for investors.

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

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

Again, the Fed is highly dependent on this assumption to provide the “room” needed, after a decade of the most unprecedented monetary policy program in U.S. history, to extricate themselves from it.

The Fed is dependent on “everyone acting rationally.” However, as was seen in the last two months of 2018, such may not actually be the case.

That market rout, and pressure from the White House, has caused the Fed to tilt a bit more “dovish” as of late. However, it should not be mistaken that their views have substantially changed or that they are no longer committed to the reduction of their balance sheet and hiking rates, albeit at a potentially slower pace.

There is good reason to expect that this strong [economic] performance will continue. I believe that this gradual process of normalization remains appropriate.

But that may be a mistake as I pointed out recently:

“But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy ground higher over the last few quarters, it was more of the residual effects from the series of natural disasters in 2017 than “Trumponomics” at work. The “pull forward” of demand is already beginning to fade as the frenzy of activity culminated in Q2 of 2018.

To see this more clearly we can look at our own RIA Economic Output Composite Index (EOCI) which is an extremely broad indicator of the U.S. economy. It is comprised of:

• Chicago Fed National Activity Index (an index comprised of 85 subcomponents)
• ISM Composite Index (composite of the manufacturing and non-manufacturing surveys)
• Richmond Fed Manufacturing Survey
• New York (Empire) Manufacturing Survey
• Dallas Fed Manufacturing Survey
• Markit Composite Manufacturing Survey
• PMI Composite Survey
• Economic Confidence Survey

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to U.S. economic activity, has provided a good indication of turning points in economic activity.

As shown, the slowdown in economic activity has been broad enough to turn this very complex indicator lower.

One of the components of the EOCI is the Leading Economic Index (LEI) which is a strong leading indicator of the economy as shown below.

The recent downturn in the LEI suggests economic data will likely be weaker in the quarters ahead. However, this downturn wasn’t a surprise and was something I showed would be the case in July of 2018.

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.

Another component of the EOCI is the National Federation of Small Business index. In 2018, that index peaked at a record of 108.8 and has since fallen more than 4-points in recent months. While it has been of little concern to the media, it should be noticed that at no point in history did the index peak at a record and not substantially decline over the coming months.

More importantly, notice that peaks in the optimism have previously always occurred shortly after a recession ended, not nearly a decade into an economic upturn. Such suggests the time between the current peak and the next recessionary spat could be closer than seen previously.

However, while small business owners are still “saying” they are optimistic, they are not necessarily acting that way. A look at their level of economic confidence versus their capital expenditures suggests a much more cautious stance relative to their level of “optimism.”

Currently, their level of capital expenditures has plunged back to levels more often seen during a recessionary period than a burgeoning economic upswing.

The same goes for the difference between the “expectation of sales” versus their “actual sales.”

Notice that actual sales are always less than expectations, but the current gap is one of the largest on record. More importantly, both actual and expected sales have turned lower in recent months which was during the seasonally strong Christmas shopping period.

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

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

However, while the Fed is focused on what has happened in the past, the market is focused on what will happen in the future. What the current trend of economic data suggests is that the global economic weakness, which we have been discussing for the last few months, has now come home to roost. As shown below, the EOCI index has provided a leading indication historically to market weakness. The difference between small corrections and larger declines was determined by the secular period of the market.

What shouldn’t be overlooked, is that the risk to investors is a negative impact to corporate profitability in the quarters ahead. Valuations are still a major issue for investors as corporate profits have not grown over the last 8-years. (They have only set a record recently on an “after tax” basis due to recent legislative changes.)

Of course, changing profits on the bottom line of the corporate balance sheet is not what drives the economy. That comes from consumption, and if pretax corporate profits aren’t growing, neither is revenue which is consistent with the modest rates of economic growth seen over the last decade.

This is why both the Fed, and the markets, are very dependent on “stability.” As long as no one asks the “tough questions,” the bullish thesis can continue as momentum and psychology remain intact.

Unfortunately, as seen in the last quarter of 2018, “instability” can happen very quickly leaving investors with little time to react. The recent market rout was likely a warning sign that investors should not dismiss as a “one-off” event.

• The Federal Reserve is still looking to increase rates.
• They are also committed to continuing the reduction of their balance sheet which is extracting liquidity from the financial markets.
• Even if the Fed doesn’t hike rates further, rates are still materially higher than they were two-years ago which is impinging consumers discretionary incomes.
• Earnings estimates are still too high
• China is becoming a bigger problem.
• Debt remains a substantial problem as default risks increase
• Domestic economic weakness, as shown, is gaining traction
• The Global economy is weakening at a faster pace than the US economy, and;
• Markets have begun to show their vulnerabilities.

What happens next is anyone’s guess, but erring to the side of caution currently will likely turn out to be a good decision.

# What Will Cause The Next Recession?

J. Bradford Delong wrote a very interesting article discussing the trigger for the next recession.

“Three of the last four US recessions stemmed from unforeseen shocks in financial markets. Most likely, the next downturn will be no different: the revelation of some underlying weakness will trigger a retrenchment of investment, and the government will fail to pursue counter-cyclical fiscal policy.

Over the past 40 years, the US economy has experienced four recessions. Among the four, only the extended downturn of 1979-1982 had a conventional cause. The US Federal Reserve thought that inflation was too high, so it hit the economy on the head with the brick of interest-rate hikes. As a result, workers moderated their demands for wage increases, and firms cut back on planned price increases.

The other three recessions were each caused by derangements in financial markets. After the savings-and-loan crisis of 1991-1992 came the bursting of the dot-com bubble in 2000-2002, followed by the collapse of the sub-prime mortgage market in 2007, which triggered the global financial crisis the following year.”

While I agree with Bradford’s point, I think there is a disconnect between the crises he points out and repeated behaviors which lead to those events.

Let’s review some basic realities about the economy that seems to be lost on the mainstream media.

First, this is NOT an economic cycle:

This is:

Despite the hopes the economy will continue into an everlasting expansion, such has historically never been the case. The current economic expansion, which has been driven by massive infusions of liquidity, extremely accommodative interest rate policy, and a surge in debt accumulation, is just 4-months away from setting a new record.

Secondly, while the recession prior to 1980 was driven by a super-aggressive Fed rate tightening policy, since 1950 we can find fingerprints of monetary policy in every event.

I am not saying that just because the Fed hikes rates, that a recession, or crisis, will be triggered.

What I am saying is that over the entire rate cycle, the Fed has fostered the credit driven expansion and laid the groundwork necessary for a crisis to be born.

Let’s revisit Bradford’s three specific crises.

The S&L Crisis

The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995.

However, just looking at the event we miss the bigger picture.

If we go back in time before the crisis began, we find an environment where the Federal Reserve had drastically lowered the overnight lending rates in order to spur more borrowing and economic activity coming out of the back-to-back recessions of the late ’70s and early ’80s.

Of course, in a capitalist-driven economy, as demand for loans for cars, housing, businesses, etc. rose; bankers figured out ways to continue to extend credit in order to maximize their profitability. As is always the case, greed over took prudence and many bankers relaxed risk management protocols which would ultimately cost them their jobs and in many cases the bank.

Of course, in 1979, when the Federal Reserve hiked the discount rate from 9.5% to 12%, ostensibly to quell inflation pressures, it also slowed the economy. Since the S&L’s had issued long-term loans at fixed rates lower than the now higher rate at which they could borrow the rise in rates combined with rising default rates, led to insolvency.

Probably the most famous example from the S&L Crisis period was
that of financier Charles Keating, who paid \$51 million financed through Michael Milken’s “junk bond” operation, for his Lincoln Savings and Loan Association which at the time had a negative net worth exceeding \$100 million.

The Dot.Com Bubble

While the “dot.com” bubble is often thought of as a one-off event caused by speculative excess, there was actually much more going on at the time.

Many have forgotten the names of Enron, WorldCom, Global Crossing, and other booming tech companies which were riff with financial shenanigans at the time which ultimately led to the passage of the Sarbanes-Oxley Act.

However, again, we can’t look at just the event itself but need to go back prior to the event to understand the groundwork that was laid.

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

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

Of course, it wasn’t long until the Federal Reserve, again concerned about the prospect of rising inflation and an overheating economy, started hiking rates. As monetary policy became more restrictive, the cost of capital rose, and the economy slowed.

It wasn’t long before the system came unglued.

The Great Financial Crisis

In response to the “Dot.com” crisis, the Federal Reserve once again drastically lowered interest rates to spur economic growth.

This was also the point where the Bush Administration, along with the Alan Greenspan headed Federal Reserve, decided that “everyone” should own a home. Lending standards were relaxed and a variety of new mortgage structures were introduced by Wall Street in the quest to make money.

Over the next several years, as lending rates declined, and everyone wanted to buy into the surging housing market, Wall Street packaged mortgages into exotic instruments allowing them to sell the mortgages to investors. The cycle continued with ever increasing demand from home buyers and demand from investors.

As the housing market boomed, the stock market fully recovered from the “dot.com” crash, and with the economy booming, the Federal Reserve, now under the leadership of Ben Bernanke, decided to start tightening monetary policy in the belief that inflation was an imminent threat from an overheating economy.

But there were no pressing concerns as it was believed that “subprime mortgage loans were contained” and the ongoing “Goldilocks economy” would continue uninterrupted.

They weren’t and it didn’t.

If you are interested in this crisis we urge you to read or watch The Big Short by Michael Lewis

While each of these events were much more complex than what I have outlined here, there were many others along the way like the Russian Debt Default, The Asian Contagion, and Long-Term Capital Management, which all shared important commonalities between them.

In each case we find that prior to the event the Federal Reserve was loosening monetary policy to spur economic growth following a preceding economic downturn. They did this to halt the downturn but in doing so failed to allow the system to clear itself over time.

Looser monetary policy, and continuing relaxation of regulations led to excessive greed by the primary players in the market which was supported by a rising level of speculative frenzy and easy access to capital by investors.

In other words, instead allowing the system to clear the previous build up of excesses, the Federal Reserve intervened to keep that process from happening. As a result, each crisis has been worse than the one before it because the debt and leverage in the system continues to mount.

As shown in the chart below, whenever the Federal Reserve previously loosened monetary policy, debt as a percentage of the economy surged. Naturally, when monetary policy was reversed, things tended to go bad…and generally very quickly.

Since 1980, the eventual and inevitable unwind of an overly levered system was met by a drastic drop in the Fed Funds rate to stimulate debt induced consumption and spur economic activity. The problem, is that each effort by the Fed to limit the impact to the system has required a lower interest rate than the one that preceded.

With rates near the lowest level on record still, the next event will once again require dramatic measures to stem the unwinding of a decade long, debt supported, economic cycle.

But this is where Bradford gets it absolutely right about the cause of the next recession.

“Specifically, the culprit will probably be a sudden, sharp ‘flight to safety’ following the revelation of a fundamental weakness in financial markets. “

Of course, such has always been the case when it comes to the financial markets.

However, the risk of a recession has continue to rise in recent months with plenty of warnings already showing up from a near-inverted yield curve, declining economic momentum, low nominal and real bond yields, and struggling stock prices

The problem, as Bradford notes, is the next financial cataclysm may well fall outside of the capability of the Federal Reserve and Government to neutralize.

“If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts. As for more unconventional policies, the Fed most likely will not have the nerve, let alone the power, to pursue such measures.”

As a result, for the first time in a decade, Americans and investors cannot rule out a downturn. At a minimum, they must prepare for the possibility of a deep and prolonged recession, which could arrive whenever the next financial shock comes.”

He is absolutely correct in his assessment of the impact of the next fiscal problem. When it comes, it will be totally unexpected, unanticipated, and unprepared for by investors. Such has always been the case through out history.

But there is one thing that all these crises have in common.

A belief by the Federal Reserve that inflation is going to be problem and that they can control inflation through monetary policy.

This time will be no different.

# The Problem With Wall Street’s Forecasts

Over the last few weeks, I have been asked repeatedly to publish my best guess as to where the market will wind up by the end of 2019.

Here it is:

“I don’t know.”

The reality is that we can not predict the future. If it was actually possible, fortune tellers would all win the lottery.  They don’t, we can’t, and we aren’t going to try.

However, this reality certainly does not stop the annual parade of Wall Street analysts from pegging 12-month price targets on the S&P 500 as if there was actual science behind what is nothing more than a “WAG.” (Wild Ass Guess).

The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.

Ed Yardeni published the two following charts which show that analysts are always overly optimistic in their estimates.

This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average.

Most importantly, the reason earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term…remember that.

The McKenzie study noted that on average “analyst’s forecasts have been almost 100% too high” which leads investors into making much more aggressive bets in the financial markets which has a general tendency of not working as well as planned.

However, since “optimism” is what sells products, it is not surprising, as we head into 2019, to see Wall Street once again optimistic about higher markets even after massively missing 2018’s outcome.

But, that was so last year.

For 2019, analysts have outdone themselves on scrambling to post the most bullish of outcomes that I can remember. Analysts currently expect a median projected return of 23.66% from the 2018 close.

No…seriously. This is what Wall Street is currently expecting despite the fact that foreign and domestic economic data is weakening, corporate profit growth is likely peaking, trade wars are heating up and the Federal Reserve is tightening monetary policy. As Greg Jensen, co-chief investment officer of Bridgewater Associates, the biggest hedge fund in the world, recently stated:

“The biggest theme developing is that you are going to have significantly weaker growth, near recession-level growth in 2019, based on our measures, and the markets are generally not pricing that in.

Although the movement has been in that direction, the degree of [ the market’s decline] is still small relative to what we are seeing in terms of the shifts in likely economic conditions.  2019 will be a year of weaker growth and central banks struggling to move from their current tightening stance to easing and finding it difficult to ease because they have very little ammunition to ease.”

All of this should sound very familiar if you have been reading our work over the past year.

The problem with the year-end “guesses” above is they are based on “forward operating earnings estimates” which is another set of severely flawed “WAG’s” on top of a “WAG.”

Let me explain.

First, operating earnings are at best a myth, and mostly a lie. As opposed to reported earnings, operating earnings are essentially “earnings if everything goes right with all the bad stuff excluded.”

Secondly, operating earnings are cooked, baked, and fudged in more ways than you can imagine to win the “beat the estimate gaime.” The Wall Street Journal confirmed as much in a 2012 article entitled “Earnings Wizardry” which stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting gimmicks to either increase or depress, earnings.

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb. What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.”

Since company executives are highly compensated by rising stock prices, it should not be surprising to see 93% of the respondents pointing to “influence on stock price” and “outside pressure” as reasons for manipulating earnings.

Note: For fundamental investors, this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.

This was brought to the fore in 2015 by the Associated Press in: “Experts Worry That Phony Numbers Are Misleading Investors:”

“Those record profits that companies are reporting may not be all they’re cracked up to be.

As the stock market climbs ever higher, professional investors are warning that companies are presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they’re doing better than they really are.

What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.

Here were the key findings of the report:

• Seventy-two percent of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year.
• For a smaller group of the companies reviewed, 21 percent of the total, adjusted profits soared 50 percent or more over net income. This was true of just 13 percent of the group in the same period five years ago.
• From 2010 through 2014, adjusted profits for the S&P 500 came in \$583 billion higher than net income. It’s as if each company in the S&P 500 got a check in the mail for an extra eight months of earnings.
• Fifteen companies with adjusted profits actually had bottom-line losses over the five years. Investors have poured money into their stocks just the same.
• Stocks are getting more expensive. Three years ago, investors paid \$13.50 for every dollar of adjusted profits for companies in the S&P 500 index, according to S&P Capital IQ. Now, they’re paying nearly \$18.

These “gimmicks” to boost earnings, combined with artificially suppressed interest rates and massive rounds of monetary interventions, unsurprisingly pushed asset prices to historically high levels. However, as noted, the boost to “profitability” did not come from organic economic growth. As I showed previously:

“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.”

## Way Too Optimistic

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 risks to extremely elevated forward earnings estimates remain 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 to which few are listening.

Currently, analysts’ 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 45-days the estimates for the end of 2019 have fallen by more than \$14/share. The downside risk remains roughly \$10/share lower than that and possibly much more if a recession hits.

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 12/31/18 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 end of the boost from tax cuts has arrived.

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 leave 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, as expected, economic and earnings reports are now showing markedly weaker projections. Apple (AAPL) is just the first of many companies that will confirm this in the coming weeks.

It is all just as we predicted.

The problem when it comes to blindly invest in markets without a thorough understanding of underlying dynamics is much the same as playing “leapfrog with a unicorn,” eventually, there is a very negative outcome.

As we head into 2019, all of the anecdotal evidence continues to suggest weaker markets rather than a surging recovery.

But, that is just a guess.

As I said, I honestly “don’t know.”

What I do know is that I will continue to manage our portfolios for the inherent risks to capital, take advantage of opportunities when I see them, and will allow the market to “tell me” what it wants to do rather than “guessing” at it.

While I read most of the mainstream analyst’s predictions to get a gauge on the “consensus.”  This year, more so than most, the outlook for 2019 is universally, and to many degrees, exuberantly bullish.

What comes to mind is Bob Farrell’s Rule #9 which states:

“When everyone agrees…something else is bound to happen.”

# The Biggest Threat To The Market – Loss Of Confidence

Yesterday, saw a record surge in the markets.

Such was not surprising given the extreme oversold condition in the market. More importantly, throughout market history, the biggest bull rallies have occurred during bear markets.

Yesterday’s relief rally was simply that.

As shown in the chart below, following the breakdown of the market from its consolidation pattern in October and November, the market plunged 20% from its previous all-time highs. Despite the massive surge in stocks yesterday, all the market managed to do was recoup 2-days of losses.

From the previous peak in early December, the market has yet to even achieve a 38.2% retracement of that decline. It would not be surprising to see this rally try and recoup a full 61.8% of the decline over the next several weeks.

However, that may not even be enough to solve the biggest risk to the market currently.

In 2010, as Ben Bernanke was preparing to unleash the second round of “Quantitative Easing” upon the economy, he noted specifically the goal was to increase the “wealth effect” in order to assist the nascent economic recovery that was underway.

What exactly does that mean?

“The wealth effect is a theory suggesting that when the value of equity portfolios are on the rise because of accelerating stock prices, individuals feel more comfortable and confident about their wealth, which will cause them to spend more.” – Investopedia

This targeting of the “wealth effect” became known as the Fed’s “Third Mandate” which remains alive and well today as recently noted by Bill Dudley during a speech at the BIS Annual General Meeting:

“As I see it, financial conditions are a key transmission channel of monetary policy because they affect households’ and firms’ saving and investment plans and thus influence economic activity and the economic outlook.”

Over the last decade, successive rounds of both monetary and fiscal policy in the U.S. has created an inflation of asset prices to historic levels.

The problem, as I have shown previously, is that it failed to translate across the broader economic spectrum as intended. Instead, it simply boosted the wealth of the wealthiest 10% of Americans.

This was also shown in a recent study by the World Economic Forum on negative wealth. To wit:

“With respect to assets, we ask respondents how much money is in their defined contribution plan(s)—including 401(k), 403(b), 457 or thrift savings plans—and Individual Retirement Arrangement accounts, which cover the most common channels through which Americans save for retirement. We also ask the respondents about their total savings and investments, such as money in their checking accounts, stocks, and other financial instruments they may possess. Homeowners are asked to self-appraise the current value of their home. Finally, we ask for self-appraised valuations of any additional land, businesses, vehicles, or other assets the respondent’s household may own. The measure of total assets is then the sum of financial wealth, retirement wealth, home value, and other assets.”

So, what did the results show after a decade of booming asset prices?

“The chart below displays, in the leftmost column, the average and median asset and debt levels for households with non-negative wealth. The next three columns display the same statistics separately for each tercile of negative-wealth households, for example, the second column illustrates the data for those with the least negative wealth and the final column reflects households with the most negative wealth. The very low median levels of assets for all negative-wealth households are readily apparent, as are the large average and median debt amounts among households with larger negative wealth.”

The lack of distribution of wealth across the economy explains why growth, outside the short-term impact of natural disasters and deficit spending, has remained so weak.

“More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of just 0.5%.

Economic growth matters, and it matters a lot.

As an investor, it is important to remember that in the end corporate earnings and profits are a function of the economy and not the other way around. Historically, GDP growth and revenues have grown at roughly equivalent rates.”

## Wealth Effect Runs In Reverse

Of course, the problem for the Fed, who are now in the process of reversing a decade of monetary stimulus, is when the “wealth effect” reverses. As noted by my friend Doug Kass:

“The prospects for economic and profit growth are waning in the face of the rapid drop in stock prices.

According to Wilshire Associates, the U.S. stock market fell by \$2.1 trillion last week.

That loss in value is more than 10% of the 2017 U.S. Gross Domestic Production (GDP) of \$19.3 trillion. (Our domestic GDP represents approximately 31% of world GDP). The loss in value from the September 2018 market top is well in excess of \$5 trillion, representing about 25% of projected 2018 U.S. GDP.

The fixed income’s message of slowing economic and profit growth has been resounding — and until recently has been dismissed by most who were intoxicated by rising equity prices and favorable (but lagging) economic data.

Given the steady drumbeat of disappointing high-frequency economic data that suggest consensus growth expectations are too optimistic and underscores the fragile state of the domestic economy, this is a particularly untimely period for stocks to crater.

The economy — from a rate of change standpoint — is now at a critical point. No doubt a lot of damage to forward 2019 economic growth has already occurred and will result in a reduction in consensus profit forecasts.”

Of course, Doug is absolutely correct and we have already been consistently warning about the downdraft in forward earnings expectations which still remain way too elevated. As shown below, the forward estimates for 2019 have already fallen by more than \$13/share and will likely hit our target of \$146 by early next year.

By the way, that decline will wipe out the entire benefit of the “tax cuts.”

But that decline in profitability should not be surprising given the decline in confidence among consumers. Our friends at Upfina recently penned an interesting piece on this point:

“The consumer expectations index minus the current situation index in the consumer confidence report is signaling a recession is coming

We are reviewing where consumer spending is headed by showing the differential between expectations and the current situation. As you can see from the chart below, the current differential is worse than the last cycle, but still higher than the 1990s cycle. Recessions come after this indicator bottoms, and there isn’t much room for it to fall further.”

The chart below is a slightly different variation of Upfina’s which shows the composite index of both University of Michigan and the Conference Board measures of confidence. However, the results are virtually the same with the difference between forward expectations and current conditions ringing in at levels that have normally preceded recessions.

Given that GDP is roughly 70% consumption, deterioration in economic confidence is a hugely important factor. Rising interest rates which bite into discretionary cash flows, falling house and stock prices, and job losses weigh heavily on spending decisions by consumers. Reductions in spending reduce corporate profitability which leads to lower asset prices, so forth, and so on, until the cycle is complete.

None of this should be surprising, of course, as we head into 2019. We saw record low levels of unemployment and jobless claims. Record high levels of sentiment on many different measures. However, as I wrote in August of this year:

“’Record levels” of anything are “records for a reason.’

Remember:

• Bull markets END when everything is as “good as it can get.”
• Bear markets END when things simply can’t “get any worse.”

Currently, we are in the early stages of the transition from “bull” to “bear.”

As investors begin to understand the magnitude of their losses in “dollar” terms, the impact to confidence will become an important headwind for the market. With higher rates already curtailing home and auto purchases, falling asset values will likely start to weigh more significantly on other purchasing decisions.

This was a point made by Bloomberg yesterday:

“The outlook [for additional rate hikes], however, is likely to be tempered by market volatility as falling stocks hurt consumption by reducing household wealth. Business confidence is damaged as volatility rises, the cost of capital increases, and uncertainty over government policies — be it a trade war or an assault on the Fed — forestalls investment.”

Confidence drives everything.

Which also continues to suggest the risk of a recessionary onset in 2019 has risen markedly in recent months.

In other words, it is quite likely the recent roar of the “bear” is not the last we are going to hear.

# Are Energy Stocks Cheap?

Oil prices have collapsed again from nearly \$80 per barrel this past summer to under \$50 per barrel now. Big price declines in the commodity always beg the question if there are any cheap stocks in the oil patch.

Let’s start with the domestic behemoth, ExxonMobil (XOM). It’s down from a high of nearly \$90 per share this year to a little below \$70. It’s trading at a P/E ratio of around 13, a Price/Sales ratio of around 1 and a Price/Book ratio of around 1.6. It’s also yielding well more than 4%. Those seem like reasonable multiples, but let’s move to a cash flow analysis.

The firm has averaged around \$10 billion of free cash flow for the past five years, and that includes \$14 billion year-to-date and \$14.7 billion in 2017. Let’s say the firm averages only \$10 billion per year for the next five years. Then let’s say it produces \$15 billion in the sixth year and grows at the rate of inflation after that. If we apply a 10% discount rate to those numbers, we arrive at a company worth around \$300 billion or a little more than its current market capitalization. In other words, the firm doesn’t have to perform better than it has recently to argue that its current price matches its value. Any improvement in free cash flow would mean its fair value is higher, and also that it should trade that way in a few years. If you have a little time, ExxonMobil should be a good bet if you make it one of a few stocks.

A smaller integrated company, Cenovus (CVE) looks attractive too. It trades at a P/E ratio of less than 5,  Price/Sales ratio of 0.52 and a Price/Book ratio of 0.62. It also yields around 2%. The stock has dropped from more than \$10 per share earlier this year to less than \$7 now.

Cenovus has averaged around d \$300 million of free cash flow for the past five years. Let’s say it maintains that for the next five. Then let’s assume it can get to \$400 million in the sixth year and grow at the rate of inflation after that. If we apply an 8% discount rate to those conservative numbers, we get a fair value of more than \$9 billion. The stock has an \$8.6 billion market capitalization now. Just as in the ExxonMobil case, we’re assuming that the company doesn’t improve very much over the next five years.

Last, let’s consider the largest oilfield services company, Schlumberger (SLB). The stock trades at a P/E of 34, a Price/Sales of 1.6, and a Price/Book ratio of 1.43. It yields around 5.3%.

That P/E ratio seems high, but the stock has average around \$5.2 billion of free cash flow for the past five years. If it continues to do that for the next five, jumps to \$5.5 billion in year six, and then grows at the rate of inflation, we get a company worth over \$100 billion if we apply an 8% discount rate. The company’s market capitalization is currently a little over \$50 billion.

# The Market Is Set For A Rally…To Sell Into

In April of this year, I wrote an article discussing the 10-reasons the bull market had ended.

“The backdrop of the market currently is vastly different than it was during the ‘taper tantrum’ in 2015-2016, or during the corrections following the end of QE1 and QE2.  In those previous cases, the Federal Reserve was directly injecting liquidity and managing expectations of long-term accommodative support. Valuations had been through a fairly significant reversion, and expectations had been extinguished. None of that support exists currently.”

It mostly fell on “deaf ears” as the market rallied back to highs. But the “worries” of the market have continued to mount despite the speculative rally. As Barbara Kollmeyer penned yesterday morning:

The markets have enough to worry about these days, right? With major U.S. indexes in or near bear territory, a government shutdown underway and the White House falling over itself to assure us no one is firing Fed Chief Powell, Treasury Secretary Steven Mnuchin gobsmacked market participants by revealing that he made a weekend call from a beach in Mexico to the country’s six biggest banks, presumably to assure Wall Street that there’s ample liquidity sloshing around in the financial system.”

I can only presume the phone call between President Trump and Steve Mnuchin went something like this:

Trump: Hey, Steve. This market is bad. I mean it’s really bad…really bad. You need to do something to make it go up. I mean really go up.

Mnuchin: No problem. I’ll just call my buddies and tell them they need to start buying. You know, we can always hit up the “Plunge Protection Team” if we need too.

Trump: The what? Oh yeah…I’ve heard of those guys. Yeah, you do that. We need this market to go up really big. I mean really big. I got a whole big pile of s*** going on here, my ratings are down, and I need the market to go up. I mean go up a lot. You make that happen, okay. Cuz that a**hole Powell ain’t helpin’ me one bit.

Mnuchin: Check…I’m on it.

Of course, the only real reason that you would call the 6-major banks, and meet with the “Plunge Protection Team,” would be in the event there was a real concern about the financial stability of the markets. It didn’t take long for the markets to figure out there may be a real liquidity problem brewing out there (aka Deutsche Bank) and as Mark Decambre penned Monday afternoon:

“The S&P 500 index fell by 2.7% Monday, marking the first session before Christmas that the broad-market benchmark has booked a loss of 1% or greater — ever.”

## My Christmas Wish

If we take a look back at the markets over the last 20-years, we find that our weekly composite technical gauge has only reached this level of an oversold condition only a few times during the time frame studied. Such oversold conditions have always resulted in at least a corrective bounce even within the context of a larger mean-reverting process.

What this oversold condition implies is that “selling” may have temporarily exhausted itself. Like a raging fire, at some point the “fuel” is consumed and it burns itself out. In the market, it is much the same.

You have always heard that “for every buyer, there is a seller.”

While this is a true statement, it is incomplete.

The real issue is that while there is indeed a “buyer for every seller,” the question is “at what price?”

In bull markets, prices rise until “buyers” are unwilling to pay a higher price for assets. Likewise, in a bear market, prices will decline until “sellers” are no longer willing to sell at a lower price. It is always a question of price, otherwise, the market would be a flat line.

Again, what the weekly composite indicator suggests is that “sellers” have likely exhausted themselves to the point that “buyers” are likely starting to outnumber “sellers” to the point that prices will rise, at least temporarily.

This also highlights the importance of long-term moving averages. Again, as noted above, given that prices rise and fall due to participant demand, long-term moving averages provide a good picture of where demand is likely to be found. When prices deviate too far above, or below, those long-term averages, prices have a history of reverting back to, or beyond, that mean.

Currently, the market has started a mean reversion process back to the 200-week (4-year) moving average. As you will notice, with only a couple of exceptions, the 200-week moving average has acted as a long-term support line for the market. When the market has previously confirmed a break below the long-term average, more protracted mean-reverting events were already in process.

Currently, the bulls remain in charge for the moment with the market sitting just a few points above the long-term average. A weekly close below 2346 on the S&P 500 would suggest a deeper decline is in process.

The same goes for the 60-month (5-year) moving average. With the market currently sitting just above the long-term trend support line, the “bull market” remains intact for now.

Again, a monthly close below 2251 would suggest a more protracted “bear” market is underway.

## How Much Of A Bounce Are We Talking About

Looking a chart of weekly closes, the most likely oversold retracement rally would push stocks back toward the previous 2018 closing lows of 2620-2650.

On a monthly closing basis, however, that rally could extend as high as 2700.

From yesterday’s closing levels that is a 12.7% to 14.8% rally.

A rally of this magnitude will get the mainstream media very convinced the “bear market” is now over.

It likely won’t be.

The one thing about long-term trending bull markets is that they cover up investment mistakes. Overpaying for value, taking on too much risk, leverage, etc. are all things that investors inherently know will have negative outcomes. However, during a bull market, those mistakes are “forgiven” as prices inherently rise. The longer they rise, the more mistakes that investors tend to make as they become assured they are “smarter than the market.”

Eventually, a bear market reveals those mistakes in the most brutal of fashions.

It is often said the religion is found in “foxholes.” It is also found in bear markets where investors begin to “pray” for relief.

Very likely, there are many investors who have learned of the mistakes they have made over the past several years. Therefore, any rally in the market over the next few weeks to a couple of months will likely be met with selling as investors look for an exit.

Here is the other problem, there is currently no supportive backdrop for stocks on the horizon:

• Earnings estimates for 2019 are still way too elevated.
• Stock market targets for 2019 are also too high.
• The Federal Reserve is still targeting higher rates and continued balance sheet reductions.
• Trade wars are set to continue
• The effect of the tax cut legislation will disappear and year-over-year comparisons revert back to normalized growth rates.
• Economic growth is set to slow markedly next year.
• Chinese economic growth will likely weaken further
• European growth, already weak, will likely struggle as well.
• Valuations remain expensive
• The collapse in oil prices will weigh on inflation targets and economic activity (CapEx)

You get the idea.

There are a lot of things that have to go “right” to get the “bull market” back on track. But there is a whole lot more which is currently going wrong.

As I wrote in “The Exit Problem”  last December:

“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’ which 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.’”

After having sold a big chunk of our equity holdings throughout the year, and having been a steady buyer of bonds (despite consistent calls for higher rates), my “Christmas Wish” is for one last oversold rally to “sell” into.

The most likely outcome for 2019 is higher volatility, lower returns, and a still greatly under-appreciated risk to capital.

But, for the bulls, it’s now or never to make a final stand.

Just remember, getting back to even is not the same as growing wealth.

# It’s Now Or Never For The Bulls

In April of this year, I wrote an article discussing the 10-reasons the bull market had ended.

“The backdrop of the market currently is vastly different than it was during the ‘taper tantrum’ in 2015-2016, or during the corrections following the end of QE1 and QE2.  In those previous cases, the Federal Reserve was directly injecting liquidity and managing expectations of long-term accommodative support. Valuations had been through a fairly significant reversion, and expectations had been extinguished. None of that support exists currently.”

It mostly fell on “deaf ears” as the market rallied back to highs. But the “worries” of the market have continued to mount despite the speculative rally. As Barbara Kollmeyer penned yesterday morning:

The markets have enough to worry about these days, right? With major U.S. indexes in or near bear territory, a government shutdown underway and the White House falling over itself to assure us no one is firing Fed Chief Powell, Treasury Secretary Steven Mnuchin gobsmacked market participants by revealing that he made a weekend call from a beach in Mexico to the country’s six biggest banks, presumably to assure Wall Street that there’s ample liquidity sloshing around in the financial system.”

I can only presume the phone call between President Trump and Steve Mnuchin went something like this:

Trump: Hey, Steve. This market is bad. I mean it’s really bad…really bad. You need to do something to make it go up. I mean really go up.

Mnuchin: No problem. I’ll just call my buddies and tell them they need to start buying. You know, we can always hit up the “Plunge Protection Team” if we need too.

Trump: The what? Oh yeah…I’ve heard of those guys. Yeah, you do that. We need this market to go up really big. I mean really big. I got a whole big pile of s*** going on here, my ratings are down, and I need the market to go up. I mean go up a lot. You make that happen, okay. Cuz that a**hole Powell ain’t helpin’ me one bit.

Mnuchin: Check…I’m on it.

Of course, the only real reason that you would call the 6-major banks, and meet with the “Plunge Protection Team,” would be in the event there was a real concern about the financial stability of the markets. It didn’t take long for the markets to figure out there may be a real liquidity problem brewing out there (aka Deutsche Bank) and as Mark Decambre penned Monday afternoon:

“The S&P 500 index fell by 2.7% Monday, marking the first session before Christmas that the broad-market benchmark has booked a loss of 1% or greater — ever.”

## My Christmas Wish

If we take a look back at the markets over the last 20-years, we find that our weekly composite technical gauge has only reached this level of an oversold condition only a few times during the time frame studied. Such oversold conditions have always resulted in at least a corrective bounce even within the context of a larger mean-reverting process.

What this oversold condition implies is that “selling” may have temporarily exhausted itself. Like a raging fire, at some point the “fuel” is consumed and it burns itself out. In the market, it is much the same.

You have always heard that “for every buyer, there is a seller.”

While this is a true statement, it is incomplete.

The real issue is that while there is indeed a “buyer for every seller,” the question is “at what price?”

In bull markets, prices rise until “buyers” are unwilling to pay a higher price for assets. Likewise, in a bear market, prices will decline until “sellers” are no longer willing to sell at a lower price. It is always a question of price, otherwise, the market would be a flat line.

Again, what the weekly composite indicator suggests is that “sellers” have likely exhausted themselves to the point that “buyers” are likely starting to outnumber “sellers” to the point that prices will rise, at least temporarily.

This also highlights the importance of long-term moving averages. Again, as noted above, given that prices rise and fall due to participant demand, long-term moving averages provide a good picture of where demand is likely to be found. When prices deviate too far above, or below, those long-term averages, prices have a history of reverting back to, or beyond, that mean.

Currently, the market has started a mean reversion process back to the 200-week (4-year) moving average. As you will notice, with only a couple of exceptions, the 200-week moving average has acted as a long-term support line for the market. When the market has previously confirmed a break below the long-term average, more protracted mean-reverting events were already in process.

Currently, the bulls remain in charge for the moment with the market sitting just a few points above the long-term average. A weekly close below 2346 on the S&P 500 would suggest a deeper decline is in process.

The same goes for the 60-month (5-year) moving average. With the market currently sitting just above the long-term trend support line, the “bull market” remains intact for now.

Again, a monthly close below 2251 would suggest a more protracted “bear” market is underway.

## How Much Of A Bounce Are We Talking About

Looking a chart of weekly closes, the most likely oversold retracement rally would push stocks back toward the previous 2018 closing lows of 2620-2650.

On a monthly closing basis, however, that rally could extend as high as 2700.

From yesterday’s closing levels that is a 12.7% to 14.8% rally.

A rally of this magnitude will get the mainstream media very convinced the “bear market” is now over.

It likely won’t be.

The one thing about long-term trending bull markets is that they cover up investment mistakes. Overpaying for value, taking on too much risk, leverage, etc. are all things that investors inherently know will have negative outcomes. However, during a bull market, those mistakes are “forgiven” as prices inherently rise. The longer they rise, the more mistakes that investors tend to make as they become assured they are “smarter than the market.”

Eventually, a bear market reveals those mistakes in the most brutal of fashions.

It is often said the religion is found in “foxholes.” It is also found in bear markets where investors begin to “pray” for relief.

Very likely, there are many investors who have learned of the mistakes they have made over the past several years. Therefore, any rally in the market over the next few weeks to a couple of months will likely be met with selling as investors look for an exit.

Here is the other problem, there is currently no supportive backdrop for stocks on the horizon:

• Earnings estimates for 2019 are still way too elevated.
• Stock market targets for 2019 are also too high.
• The Federal Reserve is still targeting higher rates and continued balance sheet reductions.
• Trade wars are set to continue
• The effect of the tax cut legislation will disappear and year-over-year comparisons revert back to normalized growth rates.
• Economic growth is set to slow markedly next year.
• Chinese economic growth will likely weaken further
• European growth, already weak, will likely struggle as well.
• Valuations remain expensive
• The collapse in oil prices will weigh on inflation targets and economic activity (CapEx)

You get the idea.

There are a lot of things that have to go “right” to get the “bull market” back on track. But there is a whole lot more which is currently going wrong.

As I wrote in “The Exit Problem”  last December:

“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’ which 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.’”

After having sold a big chunk of our equity holdings throughout the year, and having been a steady buyer of bonds (despite consistent calls for higher rates), my “Christmas Wish” is for one last oversold rally to “sell” into.

The most likely outcome for 2019 is higher volatility, lower returns, and a still greatly under-appreciated risk to capital.

But, for the bulls, it’s now or never to make a final stand.

Just remember, getting back to even is not the same as growing wealth.

# Why The Secular Bear Market In Oil Prices Remains

In 2013, I began warning about the risk to oil prices due to the ongoing imbalances between global supply and demand. Those warnings fell on deaf ears as it was believed that “oil prices could only go higher from here.”

It didn’t take long for those predictions to play out. In May of 2014, I wrote:

“While it is likely oil prices could get a bit of a bump from a decline in the U.S. dollar, ultimately it will come down to the fundamentals longer term. It is quite clear that the speculative rise in oil prices due to the ‘fracking miracle’ has come to its inglorious, but expected conclusion…It is quite apparent that some lessons are simply never learned. “

Of course, as with all things, particularly when it comes to commodities, it doesn’t take long for speculation to once again grab hold and drive prices higher in the short-term despite the long-term fundamental problems which still exist.

In September of 2017, I wrote a piece reviewing those fundamentals.

“I have been getting a tremendous number of emails as of late asking if the latest rally in oil prices, and related energy stocks, is sustainable or is it another ‘trap’ as has been witnessed previously.

As regular readers know, we exited oil and gas stocks back in mid-2014 and have remained out of the sector for technical and fundamental reasons for the duration. While there have been some opportunistic trading setups, the technical backdrop has remained decidedly bearish.”

The conclusion was not what most were hoping for.

While there is hope the production cuts will continue into 2018, a bulk of the current price gain has likely already been priced in. With oil prices once again overbought on a monthly basis, the risk of disappointment is substantial.”

Well, here we are wrapping up 2018 and the prices of both energy-related shares and oil have been disappointing.

The expected decline in oil prices is more important than just the relative decline in share prices of energy-related stocks. As I wrote previously, energy prices are highly correlated to economic activity. To wit:

“Oil is a highly sensitive indicator relative to the expansion or contraction of the economy. Given that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness.

The chart below combines interest rates, inflation, and GDP into one composite indicator to provide a clearer comparison to oil prices. One important note is that oil tends to trade along a pretty defined trend…until it doesn’t. Given that the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which have a negative impact on the manufacturing and CapEx spending inputs into the GDP calculation.”

“As such, it is not surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.”

Since then, the price of oil has declined further as economic weakness continues to gain traction globally. Despite the occasional rally, it’s hard to see the outlook for oil is encouraging on both fundamental and technical levels. The charts for WTI remain bearish, while the fundamentals remain basically “Economics 101: too much supply, too little demand.” The parallel with 2014 is there if you want to see it.

The current levels of supply potentially create a longer-term issue for prices globally particularly in the face of weaker global demand due to demographics, energy efficiencies, and debt.

Many point to the 2008 commodity crash as THE example as to why oil prices are destined to rise in the near term. The clear issue remains supply as it relates to the price of any commodity. With drilling in the Permian Basin expanding currently, any “cuts” by OPEC have already been offset by increased domestic production. As I stated previously, any rise in oil prices beyond \$55/bbl would likely make the OPEC “cuts” very short-lived which indeed turned out to be the case.

As noted in the chart above, the difference between 2008 and today is that previously the world was fearful of “running out” of oil versus worries about an “oil glut” today. The issues of supply versus price become clearer if we look further back in history to the last crash in commodity prices which marked an extremely long period of oil price suppression as supply was reduced.

The problem with the recent surge in oil prices was that it was being driven by speculative excess. As I noted in “Everyone Is On The Same Side Of The Boat:”

“Of course, the cycle of rising oil prices leading to increased optimism which begets bullish bets on oil continues to press prices higher. However, it is also the exuberance which has repeatedly set up the next fall. As shown below, bets on crude oil prices are sitting near the highest levels on record and substantially higher than what was seen at the peak of oil prices prior to 2008 and 2014.”

When I wrote that in May of this year (2018), it received a lot of criticism about my misunderstanding of global demand and explanations of why oil prices could only go higher.

It didn’t take long for reality to take hold.

## The Headwinds For Oil Remain

In 2008, when prices crashed, the supply of into the marketplace had hit an all-time low while global demand was at an all-time high. Remember, the fears of “peak oil” was rampant in news headlines and in the financial markets. Of course, the financial crisis took hold and quickly realigned prices with demand.

Of course, the supply-demand imbalance, combined with suppressed commodity prices in 2008, was the perfect cocktail for a surge in prices as the “fracking miracle” came into focus. The surge of supply alleviated the fears of oil company stability and investors rushed back into energy-related companies to “feast” on the buffet of accelerating profitability into the infinite future.

The problem currently, and as of yet not fully recognized, is the supply-demand imbalance has once again reverted. With supply now at the highest levels on record, and global demand growth weak due to a rolling debt-cycle driven global deflationary cycle, the dynamics for a repeat of the pre-2008 surge in prices is unlikely.

The supply-demand problem is not likely to be resolved over the course of a few months either. The current dynamics of the financial markets, global economies, and the current level of supply is more akin to that of the early-1980’s. Even if OPEC does continue to reduce output, it will continue to be insufficient to offset the increases from shale field production.

Since oil production, at any price, is the major part of the revenue streams of energy-related companies, it is unlikely they will dramatically gut their production in the short-term. The important backdrop is extraction from shale continues to become cheaper and more efficient all the time. In turn, this lowers the price point where production becomes profitable increases the supply coming to market.

Then there is the demand side of the equation.

For example, my friend Jill Mislinski discussed the issue of a weak economic backdrop.

“There are profound behavioral issues apart from gasoline prices that are influencing miles traveled. These would include the demographics of an aging population in which older people drive less, continuing high unemployment, the ever-growing ability to work remote in the era of the Internet and the use of ever-growing communication technologies as a partial substitute for face-to-face interaction.”

The problem with dropping demand, of course, is the potential for the creation of a “supply glut” that leads to a continued suppression in oil prices.

The headwinds to higher oil prices from the demand side come in a variety of forms:

• Weak economic global growth over the last decade which will remain weak going forward
• Slow and steady growth of renewable/alternative sources of energy
• Technological improvements in energy production, storage and transfer, and;
• A rapidly aging global demographic

Add to those issues that over the next few years EVERY major auto supplier will be continuously rolling out more efficient automobiles including larger offerings of hybrid and fully electric vehicles.

All this boils down to a long-term, secular, and structurally bearish story.

With respect to investors, the argument can be made that oil prices have likely found a long-term bottom in the \$40 range. However, the fundamental tailwinds for substantially higher prices are still vacant. OPEC won’t keep cutting production forever, the global economy remains weak, efficiencies are suppressing demand.

Furthermore, given the length of the current economic expansion, the onset of the next recession is likely closer than not. A recession will negatively impact oil prices (which are driven by commodity traders) and energy investments as the proverbial “baby is thrown out with the bathwater.”

This is where we will be looking for long-term bargains in the space.

# Here’s What To Watch As Oil’s Liquidation Sell-Off Continues

Last week, I wrote a piece in which I warned about the risk of a sharp liquidation sell-off in the crude oil market as speculators are forced to jettison their massive 500,000 futures contract long position. Since then, crude oil continues to sell off very hard and was down nearly 8% on Tuesday alone. Crude oil is an economically sensitive asset and may be selling off as it prices in the rising risk of a recession in the not-too-distant future.

West Texas Intermediate (WTI) crude oil broke below its key \$65 support level at the start of this month and tested the \$55 support level during Tuesday’s sell-off. There is a good chance of a short-term bounce at the \$55 level. If WTI crude oil eventually closes below the \$55 support level in a decisive manner, it would likely foreshadow further weakness.

The weekly chart shows how WTI crude oil recently broke below its uptrend line that started in early-2016 (just like the S&P 500 did), which is a worrisome sign.

As I’ve been pointing out since the start of this year, crude oil futures speculators or the “dumb money” (the red line under the chart) have built a massive long position in WTI crude oil of just under 500,000 net futures contracts. There is a very real risk that these speculators will be forced to liquidate if the sell-off continues, which would greatly exacerbate the sell-off.

After going sideways for five months, the U.S. dollar has recently resumed its rally that started in the spring. On Monday, the U.S. Dollar Index broke above its key 97 resistance level that formed at the index’s peak in August. If the index manages to stay above this level, it may signal even more strength ahead. The dollar is strengthening because U.S. interest rates have been rising for the past couple years, which makes the U.S. currency more attractive relative to foreign currencies.

The U.S. Dollar Index is very important to watch due to its significant influence on other markets, particularly commodities and emerging market equities. Bullish moves in the U.S. dollar are typically bearish for commodities (including energy and metals) and emerging markets, and vice versa. If the U.S. Dollar Index continues to rise after Monday’s breakout, it would spell even more pain for commodities and EMs.

For now, I am watching how WTI crude oil acts at its key \$55 support level and if the U.S. dollar’s Monday breakout holds.

If you have any questions about anything I wrote in this piece or would like to learn how Clarity Financial can help you preserve and grow your wealth, please contact me here.

# Is A Crude Oil Liquidation Event Ahead?

West Texas Intermediate (WTI) crude oil is down approximately 20% since the start of October, putting it into bear market territory. Crude oil’s rout is due largely to reduction of the severity of the sanctions placed by the U.S. on Iran as well as the financial market and economic fears that have resurfaced in the past month.

WTI crude oil broke below the key \$65 per barrel level, which is now a resistance level, which is a sign of technical weakness. Crude oil would need to close back above this level in a convincing manner in order to negate this breakdown.

The weekly crude oil chart shows how WTI crude oil broke below its uptrend line that started in mid-2017. If the breakdown remains intact, the next key level and price target to watch is the \$55 support level that formed at the late-2016/early-2017 highs.

As I’ve been pointing out since the start of this year, crude oil futures speculators or the “dumb money” (the red line under the chart) have built a massive long position in WTI crude oil of just under 500,000 net futures contracts. There is a very real risk that these speculators will be forced to liquidate if the sell-off continues, which would greatly exacerbate the sell-off.

Crude oil is an economically sensitive asset and may be selling off as it prices in the rising risk of a recession in the not-too-distant future.

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.

# Here’s What To Watch In Crude Oil Right Now

After experiencing weakness in February and March, crude oil spiked to three-year highs in April due to geopolitical fears associated with the Syria bombing campaign as well as falling inventories. Earlier today, President Trump tweeted that OPEC was to blame for “artificially Very High!” crude oil prices, which he said are “No good and will not be accepted!” In this piece, we will look at key technical levels and other information relevant for understanding crude oil prices.

Since the summer of 2017, crude oil has been climbing a series of uptrend lines, but broke below one of these lines during the market rout of early-February 2018. WTI crude oil broke above its \$66-\$67 resistance last week, which is a bullish technical signal if it can be sustained. If WTI crude oil breaks back below this level, however, it would be a bearish sign.

A major reason for skepticism about crude oil’s recent rally is the fact that the “smart money” or commercial futures hedgers currently have their largest short position ever – even larger than before the 2014/2015 crude oil crash. The “smart money” tend to be right at major market turning points. At the same time, the “dumb money” or large, trend-following traders are the most bullish they’ve ever been. There is a very good chance that, when the trend finally changes, there is going to be a violent liquidation sell-off.

Similar to WTI crude oil, Brent crude has been climbing a couple uptrend lines as well. The recent breakout over \$71 is a bullish sign, but only if it can be sustained; if Brent breaks back below this level, it would give a bearish confirmation signal.

It is worth watching the U.S. Dollar Index to gain insight into crude oil’s trends (the dollar and crude oil trade inversely). The dollar’s bearish action of the past year is one of the main reasons for the rally in crude oil. The dollar has been falling within a channel pattern and has recently formed a triangle pattern. If the dollar can break out of the channel and triangle pattern to the upside, it would give a bullish confirmation signal for the dollar and a bearish signal for crude oil (or vice versa). The “smart money” or commercial futures hedgers are currently bullish on the dollar; the last several times they’ve positioned in a similar manner, the dollar rallied.

The euro, which trades inversely with the dollar and is positively correlated with crude oil, is also worth watching to gain insight into crude oil’s likely moves. The “smart money” are quite bearish on the euro, which increases the probability of a pullback in the not-too-distant future. The euro has been rising in a channel pattern and has recently formed a triangle pattern. If the euro breaks down from this channel, it would give a bearish confirmation signal, and would likely put pressure on crude oil (or vice versa).

There has been a good amount of buzz about falling inventories and the reduction of the oil glut, but this week’s inventories report of 427.6 million barrels is still above average for the past 5 to 10 years. In addition, U.S. oil production continues to surge and recently hit an all-time high of 10.5 million barrels per daily.

For now, the short-term trend in crude oil is up, but traders should keep an eye on the \$66-\$67 support zone in WTI crude oil and the \$71 support in Brent crude oil. If those levels are broken to the downside, then the recent bullish breakout will have proven to be a false breakout. Traders should also keep an eye on which way the U.S. dollar and euro break out from their triangle and channel patterns.

# 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.

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.

# Technically Speaking: The 80/20 Rule Of Investing

Over the weekend, I discussed the market’s breakout to the upside and the increase in equity exposure in client’s portfolios. As I stated:

The short-term analysis of the market remains broadly positive with both the ongoing bullish trend and recent break above 2500 remaining intact through the close on Friday.

As shown below, the market is pushing a short-term ‘buy’ signal. However, now at 2-standard deviations above the 75-dma, as seen previously, the market likely has limited upside from here.”

“The breakout, of course, was driven by continued hopes of tax cuts/reforms from the White House as details of the latest proposal from the House Ways and Means Committee were released this week.  (Click Here For Details & Analysis)

More importantly, since the March 9th, 2009 lows, the bull market has surged more than 268% with no decline greater than 20% along the way. Importantly, the correction in early 2016, did not violate the trend line from the 2011 lows which keeps the current market defined to a singular bull market.”

## Buying Because I Have To. You Don’t.

After discussing that we had increased exposure to portfolios last week due to the breakout, and added new money, I received several emails questioning the move. To wit:

“With the markets clearly overvalued, and as you say, excessively extended and bullish, why are you buying? As you have often stated, the risk of loss outweighs potential return.”

That is absolutely correct.

However, there is a difference between views of long-term fundamentally driven potential outcomes and short-term emotionally driven realities.

Importantly, as a portfolio manager, I am buying the breakout because I have to. If I don’t, I suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the market.

As noted in the chart above, the markets have returned more than 260% since the 2009 lows in the second-longest bull market on record. Yes, it is still just one bull market.

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

If you went to cash now, the odds are EXTREMELY high that in the years ahead you will far outpace investors who remain invested. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last 9-years.

So, if you buy the “breakout,” do so carefully. Keep stop losses in place and be prepared to sell if things go wrong.

For now, things are certainly weighted towards the bullish camp, however, such will not always be the case.

I have also received quite a few emails asking how to add exposure to the market, particularly if in a large cash position currently. The answer is more in line with the age-old question:

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

Here are some guidelines to follow:

1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
1. Add to sectors, or positions, that are performing with, or outperforming, the broader market. (See last week’s analysis for suggestions.)
1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
1. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

## The “Rothschild 80/20” Rule

When discussing portfolio management, it is often suggested that you can’t “time the market.”

That statement is correct.

You can not effectively, and repetitively, get “in” and “out” of the market on a timely fashion. I have never suggested that an investor should try and do this. However, I HAVE discussed managing risk by adjusting market exposure at times when “risk” outweighs the potential for further “reward.”

While I am often tagged as ‘bearish’ due to my analysis of economic and fundamental data for ‘what it is’ rather than ‘what I hope it to be,’ I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focuses on capital preservation and long-term ‘risk-adjusted’ return.”

Here is my point. As a long-term investor, I don’t need to worry about short-term rallies. I only need to worry about the direction of the overall market trends and focus on capturing the positive and avoiding the negative.

As Baron Nathan Rothschild once quipped:

“You can have the top 20% and the bottom 20%, I will take the 80% in the middle.”

This is the basis of the 80/20 investment philosophy and the driver behind the risk management process.

While you may not beat the market from one year to the next, you will never have to suffer the “time loss” required to “get back to even.” In the long run, you will win.

As shown in the table below, a \$100,000 investment in the S&P 500 returns a far lower value than the “Rothschild 80/20 Rule” model. This is even if I include a ridiculous 2% management fee.

Here is a chart to illustrate the deviation more effectively. (Capital appreciation only.)

Yes, it’s only a bit more than a hundred thousand dollars worth of difference, but the reduced levels of volatility allowed investors to emotionally “stick” to their discipline over time. Furthermore, by minimizing the drawdowns, assets are allowed to truly “compound” over the long-term.

An easy way to apply this principle is to use a simple moving average crossover. In the chart below, you are long equities which the S&P 500 index is above the 12-month moving average, and you switch to bonds when the S&P 500 falls below the 12-month average.

No, it’s not perfect every time. But no measure of risk management is.

But having a discipline to manage risk is better than not having one at all.

Get it. Got it. Good.

## Cracks In The Bull Market Armor

While we did increase exposure to the market in portfolio last week, as the bullish trend does currently persist, there is growing evidence of “cracks” appearing.

With the Fed now on track to begin reducing support for the market, and a real possibility that “tax reform” will fail to materialize anytime soon, the possibility of a trap getting sprung on unwitting investors is rising.

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

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