# 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.

# #MacroView: The Fed Can’t Fix What’s Broken

“The Federal Reserve is poised to spray trillions of dollars into the U.S. economy once a massive aid package to fight the coronavirus and its aftershocks is signed into law. These actions are unprecedented, going beyond anything it did during the 2008 financial crisis in a sign of the extraordinary challenge facing the nation.” Bloomberg

Currently, the Federal Reserve is in a fight to offset an economic shock bigger than the financial crisis, and they are engaging every possible monetary tool within their arsenal to achieve that goal. The Fed is no longer just a “last resort” for the financial institutions, but now are the lender for the broader economy.

There is just one problem.

The Fed continues to try and stave off an event that is a necessary part of the economic cycle, a debt revulsion.

John Maynard Keynes contended that:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”

In other words, when there is a lack of demand from consumers due to high unemployment, then the contraction in demand would force producers to take defensive actions to reduce output. Such a confluence of actions would lead to a recession.

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

This number will be MUCH worse next week as many individuals are slow to file claims, don’t know how, and states are slow to report them.

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

More importantly, since the economy is 70% driven by consumption, we can approximate the loss in full-time employment by the surge in claims. (As consumption slows, and the recession takes hold, more full-time employees will be terminated.)

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

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 says a recession is here. 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 occurred.

Importantly, bear markets end when the negative deviation reverses back to positive. Currently, we have only just started that reversion process.

While the virus was “the catalyst,” we have discussed previously that a reversion in employment, and a recessionary onset, was inevitable. To wit:

“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.”

Confidence was high because employment was high, and consumers operate in a microcosm of their own environment.

“[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.

## Far From Over

Why is this important?

Hiring, training, and building a workforce is costly. Employment is the single largest expense of any business, but a strong base of employees is essential for the prosperity of a business. Employers do not like terminating employment as it is expensive to hire back and train new employees, and there is a loss of productivity during that process. Therefore, CEOs tend to hang onto employees for as long as possible until bottom-line profitability demands “leaning out the herd.”

The same process is true coming OUT of a recession. Companies are “lean and mean” and are uncertain about the actual strength of the recovery. Again, given the cost to hire and train employees, they tend to wait as long as possible to be certain of justifying the expense.

Simply, employers are slow to hire and slow to fire.

While there is much hope that the current “economic shutdown” will end quickly, we are still very early in the infection cycle relative to other countries. Importantly, we are substantially larger than most, and on a GDP basis, the damage will be worse.

What the cycle tells us is that jobless claims, unemployment, and economic growth are going to worsen materially over the next couple of quarters.

“But Lance, once the virus is over everything will bounce back.”

Maybe not.

The problem with the current economic backdrop, and mounting job losses, is the vast majority of American’s were woefully unprepared for any type of disruption to their income going into recession. As discussed previously:

“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.”

As job losses mount, a virtual spiral in the economy begins 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.

While the virus may end, the disruption to the economy will last much longer, and be much deeper, than analysts currently expect. Moreover, where the economy is going to be hit the hardest, is a place where Federal Reserve actions have the least ability to help – the private sector.

Currently, businesses with fewer than 500-employees comprise almost 60% of all employment. 70% of employment is centered around businesses with 1000-employees, or less. Most of the businesses are not publicly traded, don’t have access to Wall Street, or Federal Reserve’s bailouts.

The problem with the Government’s \$2 Trillion fiscal stimulus bill is that while it provides one-time payments to taxpayers, which will do little to extinguish the financial hardships and debt defaults they will face.

Most importantly, as shown below, the majority of businesses will run out of money long before SBA loans, or financial assistance, can be provided. This will lead to higher, and a longer-duration of, unemployment.

## One-Percenter

What does this all mean going forward?

The wealth gap is going to explode, demands for government assistance will skyrocket, and revenues coming into the government will plunge as trillions in debt issuance must be absorbed by the Federal Reserve.

While the top one-percent of the population will exit the recession relatively unscathed, again, it isn’t the one-percent I am talking about.

It’s economic growth.

As discussed previously, there is a high correlation between debts, deficits, and economic prosperity. To wit:

“The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.”

However, simply looking at Federal debt levels is misleading.

It is the total debt that weighs on the economy.

It now requires nearly \$3.00 of debt to create \$1 of economic growth. This will rise to more than \$5.00 by the end of 2020 as debt surges to offset the collapse in economic growth. Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be.

In other words, without debt, there has been no organic economic growth.

Notice that for the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Since then, the economic deficit has only continued to erode economic prosperity.

Given the massive surge in the deficit that will come over the next year, economic growth will begin to run a long-term average of just one-percent. This is going to make it even more difficult for the vast majority of American’s to achieve sufficient levels of prosperity to foster strong growth. (I have estimated the growth of Federal debt, and deficits, through 2021)

## The Debt End Game

The massive indulgence in debt has simply created a “credit-induced boom” which has now reached its inevitable conclusion. While the Federal Reserve believed that creating a “wealth effect” by suppressing interest rates to allow cheaper debt creation would repair the economic ills of the “Great Recession,” it only succeeded in creating an even bigger “debt bubble” a decade later.

“This unsustainable credit-sourced boom led to artificially stimulated borrowing, which pushed money into diminishing investment opportunities and widespread mal-investments. In 2007, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments, which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.”

In 2019, we saw it again in accelerated stock buybacks, low-quality debt issuance, debt-funded dividends, and speculative investments.

The debt bubble has now burst.

Here is the important point I made previously:

“When credit creation can no longer be sustained, the markets must clear the excesses before the next cycle can begin. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE, to tax cuts, only delay the clearing process. Ultimately, that delay only deepens the process when it begins.

The biggest risk in the coming recession is the potential depth of that clearing process.”

This is why the Federal Reserve is throwing the “kitchen sink” at the credit markets to try and forestall the clearing process.

If they are unsuccessful, which is a very real possibility, the U.S. will enter into a “Great Depression” rather than just a “severe recession,” as the system clears trillions in debt.

As I warned previously:

“While we do have the ability to choose our future path, taking action today would require more economic pain and sacrifice than elected politicians are willing to inflict upon their constituents. This is why throughout the entirety of history, every empire collapsed eventually collapsed under the weight of its debt.

Eventually, the opportunity to make tough choices for future prosperity will result in those choices being forced upon us.”

We will find out in a few months just how bad things will be.

But I am sure of one thing.

The Fed can’t fix what’s broken.

While the financial media is salivating over the recent bounce off the lows, 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.”

We aren’t there yet.

# “No One Saw It Coming” – Should You Worry About The 10-Best Days

“Panic selling not only locks in losses, but also puts investors at risk for missing the market’s best days.

Looking at data going back to 1930, Bank of America found that if an investor missed the S&P 500′s 10 best days in each  decade, total returns would be just 91%, significantly below the 14,962% return for investors who held steady through the downturns.”

But here was her key point, which ultimately invalidates her entire premise:

“The firm noted this eye-popping stat while urging investors to ‘avoid panic selling,’ pointing out that the ‘best days generally follow the worst days for stocks.’”

Think about that for a moment.

“The best days generally follow the worst days.

The statement is correct, as the S&P 500’s largest percentage gain days, tend to occur in clusters during the worst of times for investors.

Here is another way to look at this through Friday’s close. For an investor trying to catch the markets best 10-days, they wound up losing almost 30% of their portfolio, an astounding -9,254 points over the span of 3 weeks.

The analysis of “missing out on the 10-best days” of the market is steeped in the myth of the benefits of “buy and hold” investing. (Read more: The Definitive Guide For Investing.Buy and hold, as a strategy works great in a long-term rising bull market. It fails as a strategy during a bear market for one simple reason: Psychology.

I agree investors should never “panic sell,” as such “emotional” decisions are always made at the worst possible times. 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.

Such is why investors should follow an investment discipline or strategy which mitigates volatility to avoid being put into a situation where “panic selling” becomes an issue.

Let me be clear; an investment disciple does NOT ensure your portfolio against losses if the market declines. This is particularly the case when it plummets, as we’ve seen in the last couple of weeks. However, in any event, it will work to minimize the damage to a recoverable state.

## The Market Timing Myth

that when the “crash” came, the mainstream media’s response would be: “Well, no one could have seen it coming.”

Simply always being “bullish,” like Mr. Santolli, is what leads investors into being blindsided by rising risks in the market.

Yes, you can see, and predict, when risks exceed the grasp of rationality.

This brings us to the basic argument from the financial media which is simply you are NOT smart enough to manage your investments, so your only option is to “buy and hold.”

In 2010, Brett Arends wrote an excellent commentary entitled: “The Market Timing Myth” which primarily focused on several points we have made over the years. Brett really hits home with the following statement:

For years, the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go or what’s going on in the economy. ‘You can’t time the market,’ they warn. ‘Studies show that market timing doesn’t work.’

He goes on:

“They’ll cite studies showing that over the long-term investors made most of their money from just a handful of big one-day gains. In other words, if you miss those days, you’ll earn bupkis. And as no one can predict when those few, big jumps are going to occur, it’s best to stay fully invested at all times. So just give them your money… lie back, and think of the efficient market hypothesis. You’ll hear this in broker’s offices everywhere. And it sounds very compelling.

There’s just one problem. It’s hooey.

They’re leaving out more than half the story.

And what they’re not telling you makes a real difference to whether you should invest, when and how.”

The best long-term study relating to this topic was conducted a few years ago by Javier Estrada, a finance professor at the IESE Business School at the University of Navarra in Spain. To find out how important those few “big days” are, he looked at nearly a century’s worth of day-to-day moves on Wall Street and 14 other stock markets around the world, from England to Japan to Australia.

Correctly, the study did find that if you missed the 10-best days of the market, you did indeed give up much of the gains. What he also found is that by missing the 10-worst days, you did remarkably better.

(The blue highlight shows, as of Friday’s close, investors will need a more than 40% return just to get back to even.)

Clearly, avoiding major drawdowns in the market is key to long-term investment success. If I am not spending the bulk of my time making up previous losses in my portfolio, I spend more time compounding my invested dollars towards my long term goals.

Over an investing period of about 40 years, just missing the 10-best days would have cost you about half your capital gains. But successfully avoiding the 10-worst days would have had an even bigger positive impact on your portfolio. Someone who avoided the 10-biggest slumps would have ended up with two and a half times the capital gains of someone who simply stayed in all the time.

As Brett concluded:

“In other words, it’s something of a wash. The cost of being in the market just before a crash, are at least as great as being out of the market just before a big jump, and may be greater. Funny how the finance industry doesn’t bother to tell you that.”

The reason that the finance industry doesn’t tell you the other half of the story is because it is NOT PROFITABLE for them. The finance industry makes money when you are invested – not when you are in cash. Since a vast majority of financial advisors can’t actually successfully manage money, they just tell you to “stay the course.”

However, you DO have options.

A Simple Method

Now, let me clarify. I do not strictly endorse “market timing,” which is specifically being “all-in” or “all-out” of the market at any given time. The problem with market timing is consistency.

You cannot, over the long term, effectively time the market. Being all in, or out, of the market will eventually put you on the wrong side of the “trade,” which will lead to a host of other problems.

However, there are also no great investors in history who employed “buy and hold” as an investment strategy. Even the great Warren Buffett occasionally sells investments. True investors buy when they see the value, and sell when value no longer exists.

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average crossover, can be a valuable tool over the long term holding periods. Will such a method ALWAYS be right? Absolutely not. However, will such a method keep you from losing large amounts of capital? Absolutely.

The chart below shows a simple 12-month moving average crossover study. (via Portfolio Visualizer)

What should be obvious is that using a basic form of price movement analysis can provide a useful identification of periods when portfolio risk should be REDUCED. Importantly, I did not say risk should be eliminated; just reduced.

Here are the comparative results.

Again, I am not implying, suggesting, or stating that such signals mean going 100% to cash. What I am suggesting is that when “sell signals” are given, that is the time when individuals should perform some basic portfolio risk management such as:

• Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
• Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
• Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

By using some measures, fundamental or technical, to reduce portfolio risk by taking profits as prices/valuations rise, or vice versa, the long-term results of avoiding periods of severe capital loss will outweigh missed short term gains.

Small adjustments can have a significant impact over the long run.

As Brett continues:

Let’s be clear what it doesn’t mean. It still doesn’t mean you should try to ‘time’ the market day to day. Mr. Estrada’s conclusion is that a small number of big days, in both directions, account for most of the stock market’s price performance. Trying to catch the 10-biggest jumps, or avoid the 10-big tumbles, is almost certainly a fool’s errand. Hardly anyone can do this sort of thing successfully. Even most professionals can’t.

But, second, it does mean you that you shouldn’t let scare stories dominate your approach to investing. Don’t let yourself be bullied. Least of all by someone who isn’t telling you the full story.”

There is little point in trying to catch each twist and turn of the market. But that also doesn’t mean you simply have to be passive and let it wash all over you. It may not be possible to “time” the market, but it is possible to reach intelligent conclusions about whether the market offers good value for investors.

There is a clear advantage of providing risk management to portfolios over time. The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of “short-termism.”

Despite their inherent belief that they are long-term investors, they are consistently swept up in the short-term movements of the market. Of course, with the media and Wall Street pushing the “you are missing it” mantra as the market rises – who can really blame the average investor “panic” buying market tops, and selling out at market bottoms.

Yet, despite two major bear market declines, and working its third, it never ceases to amaze me that investors still believe they can invest their savings into a risk-based market, without suffering the eventual consequences of risk itself.

Despite being a totally unrealistic objective, this “fantasy” leads to excessive speculation in portfolios, which ultimately results in catastrophic losses. Aligning expectations with reality is the key to building a successful portfolio. Implementing a strong investment discipline, and applying risk management, is what leads to the achievement of those expectations.

# #MacroView: Mnuchin & Kudlow Say No Recession?

“Treasury Secretary Steven Mnuchin on Sunday downplayed the likelihood of an economic recession as the economy takes a beating from the coronavirus outbreak.

When asked on ABC’s ‘This Week’ if the US was now in an economic recession as some have suggested, Munchin said, ‘I don’t think so.’ ” – CNN

However, it wasn’t just Mnuchin making such a claim, but Larry Kudlow as well:

“I just think, in general, I would be very careful to put too much emphasis on what bond rates are doing, what interest rates are doing. Or even in the short, short run, the stock market. I think you have a lot of mood swings here and I don’t think it reflects the fundamentals.” – Larry Kudlow via CNBC

I understand they have to pander to the administration, but this is a stretch to say the least.

Let’s dig into some facts to determine our real risks.

Even before COVID-19 had infected the planet, economic data, and inflationary pressures were already weakening. This already suggested the decade long economic expansion was “running lean.”

However, the sharp decline in both 5- and 10-year “breakeven inflation rates,” are suggesting economic growth over the next couple of quarters will drop markedly. The last time there was such a sharp drop in inflation expectations at the beginning of the “financial crisis.”

Since then, the markets have been rocked as concerns over the spread of the“COVID-19” virus. The U.S. has shut down sporting events, travel, consumer activities, restaurants, bars, stores, and a host of other economically sensitive inputs. This is on top of the collapse in oil prices, which impacts a very important economic sector of the economy. (The O&G sector either directly or indirectly creates millions of jobs, has some of the highest wages, and is responsible for about 1/4th of all capital expenditures.)

However, this is just in the United States. This is a “global issue,” and the supply chains of the world are tightly interconnected. As we discussed previously:

“Given that U.S. exporters have already been under pressure from the impact of the ‘trade war,’ the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S.”

Our Economic Output Composite Indicator (EOCI) was already at levels which warned of weak economic growth. Furthermore, as shown below, even the Leading Economic Indicators (LEI) were already suggesting something was amiss long before the virus became “a thing.”

Data as of February 2020.

(The EOCI is comprised of the Fed Regional Surveys, CFNAI, Chicago PMI, NFIB, LEI, and ISM Composites. The indicator is a broad measure of hard and soft data of the U.S. economy)”

One reason we are confident the economic data will worsen near term is the correlation between the index and the annual rate of change of the S&P 500 index.

The financial markets lead the economy by about 6-months as markets begin to “price in” changes to earnings due to the outlook for economic strength. The recent plunge in the S&P 500 has deviated from the current EOCI index reading suggesting the index will decline towards recessionary levels over the next two months.

## The Question Isn’t If…

The U.S. economy, along with the bulk of the globe, is already in “recession.”

Let’s start with a bit of historical context. Since the 1800’s, the average length of an economic recession has been 18-months. Some of that length is skewed by a more agricultural-based economy at the beginning, with more modern recessions having been shorter. (We are assuming that March 2020 was the start of a new recession at one-month.)

While the average recession has been somewhat shorter in recent decades, the recessions of 1973, 1991, and 2007 have pushed those long-term averages. The chart below also shows the subsequent decline in asset prices during subsequent recessions.

Given, declines of these magnitudes only occur during recessionary periods, the recent near 30% decline is likely good confirmation a recession has begun. (However, at just one-month, it may be overly optimistic to assume it is over with already. )

## Yields Are Screaming: “Recession”

Interest rates are also a very good confirmation of recessionary periods as well.

Since 2013, I have disagreed the mainstream analysis (including Jeff Gundlach and Bill Gross) that the “bond bull market” was dead. The reality has been substantially different as rates have continued to trend lower, and recently approached our long-term target of ZERO.

“There is an assumption that because interest rates are low, the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

1. All interest rates are relative. With more than \$10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong.
2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to \$1 Trillion or more in the coming years.
3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be \$2-4 Trillion, which will push the 10-year yield towards zero.” – August 30, 2016

So, where are we nearly 4-years later?

• 23% of global debt is now supporting negative interest rates.
• The U.S. deficit has well surpassed \$1 Trillion on its way to \$2 Trillion.
• Central Banks continue to be a primary buyer of bonds as the Fed’s balance sheet has swelled back to its previous peak and the Fed recently dropped rates to zero and started a \$700 billion QE program.

Here is the relevant chart I posted in 2016. At that time rates were hitting lows of 1.6%, which was unthinkable at the time. And, where are rates, today? Approaching zero.

As shown above, over the last sixty years, the yield on the 10 year has approximated real GDP plus inflation (shown in the chart below). Given this historical fact, we can do some basic math to determine what yields are currently predicting for the U.S. economy currently.

Via Doug Kass:

“Given ZIRP and QE policies around the globe which has pulled an extraordinary amount of sovereign debt into negative territory coupled with secular headwinds to energy prices, I have assumed that the 10 year yield will fall from 1.0x nominal GDP and average about 0.8x nominal GDP.

According to my pal Peter Boockvar, the 10 year inflation breakeven (in the tips market) stands at 1.41% this morning:

So, let’s solve for what the market expects Real GDP to be (over the next 1-2 years) with this formula:

10 Year Yield (0.744% Actual) = 0.8x (Real GDP + 1.41% Actual (inflation))

The implied U.S. Real GDP of this equation is now negative — at -0.48%. (This compares to the consensus 2020 Real GDP growth forecast of between +1.75% to +2.00%) It also implies that nominal GDP (Real GDP plus Inflation) will be only about +0.93% – substantially below consensus expectations of slightly above 3%.”

It’s markedly worse now as the collapse in oil prices has sent breakeven rates below 1%.

As we noted in “On The Cusp Of A Bear Market,” the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Mnuchin’s suggestion the economy will likely avoid “recession,” is a bit ludicrous. The data suggests an entirely different outcome. However, David Rosenberg recently put some numbers on the impact to the economy from the “economic shutdown” from the virus. To wit:

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

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

The hit to GDP can be expected to be anywhere from \$400 billion to \$600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs.

Given the average recession is 18-months, and given the severity of the economic impact, even this 12-month forecast is likely overly optimistic. However, we are still missing a LOT of data, which will come to light over the next several months.

The recession will be quite severe.

As David concludes:

“A 35% slump in global financial stocks and a similar plunge in U.S. small-cap equities cannot be wrong on this forecast. And the massive volume of leverage complicates the outlook that much more.”

I know you shouldn’t point and laugh, but you almost have to when Mnuchin and Kudlow have the audacity to suggest this is a temporary negative shock. This a collision of multiple shocks impacting an overly leveraged, overly valued, and overly bullish market simultaneously.

• Coronvirus impact
• Supply chain shutdowns
• Economy wide “closures”
• Consumer confidence collapse.
• Employment shock
• Debt crisis

The problem for the Federal Reserve is this is NOT a “financial crisis,” or a simple “business cycle” recession, that monetary policy can fix. Governments have opted for to “contain the virus” by shutting down the economy. Giving households \$1000 checks sounds great, but not if you can’t spend them. Maybe they will opt to pay down debt, but that doesn’t spur economic activity, or improve earnings, in the near term.

Of course, since stocks price in future earnings growth, and since we have a feel for the impact of the recession coming, we can guesstimate the impact to earnings.

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

The impending recession, and consumption freeze, is going to start the mean-reversion process in both corporate profits and earnings. In the following series of charts, I have projected the potential reversion.

The reversion in GAAP earnings is pretty calculable as swings from peaks to troughs have run on a fairly consistent trend. (The last drop off is the estimate to for a recession)

“Using that historical context, we can project a recession will reduce earnings to roughly \$100/share. The resulting decline asset prices to revert valuations to a level of 18x (still high) trailing earnings would suggest a level of \$1800 for the S&P 500 index.”

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

However, here is the math:

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

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

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

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

Unfortunately, both Larry Kudlow, Steve Mnuchin, and the Fed, are still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S. Furthermore, the lack of economic growth, resulting in lower earnings growth, will eventually lead to a

Yes, we are in a recession, it has just started, and we have quite a ways to go before it is over.

Fade rallies, and reduce risk accordingly.

# Market Crash Reveals The “Liquidity Problem” Of Passive Investing

When it comes to investing, it’s a losing proposition to try and be anything better than average.

If there’s no point in trying to beat the market through ‘active’ investing – using mutual funds that managers run, selecting what they hope are market-beating investments – what is the best way to invest? Through “passive” investing, which accepts average market returns ­(this means index funds, which track market benchmarks)”Forbes

The idea of “passive indexing” sounds harmless enough, buy an “index” and be an “average” investor.

However, it isn’t as simple as that, and we have spilled a lot of ink digging into the relative dangers of it. Last week, investors saw those risks first hand.

The biggest risk to investors is when “passive indexers” turn into “panic sellers.”

While the “sell-off” over the last couple of weeks was brutal, with the Dow posting some of the biggest declines in its history, as I will explain, it was exacerbated by the “passive indexing revolution.”

Jim Cramer previously penned (courtesy of Doug Kass) an interesting note on the active vs. passive conflict.

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

The former jumps on anything, right or wrong, as long as it is actionable. The latter, the index funds and ETF traders, rarely jump although they may press down harder on a bedraggled ETF, like one that includes the consumer products group.

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

The dichotomy explains a lot of the bullish action, and isn’t talked about enough.

While Jim wrote this about those “buying” ETF’s, the same is true when they begin to “sell.”

“The index and ETF sellers? Well, they just sell.”

It is often suggested that individuals who buy “passive indexes,” such as the SPDR S&P 500 Index (SPY), are they themselves “passive investors.” In other words, these individuals are willing to buy an “index” and hold it for an extended period regardless of market volatility.

Reality has been far different.

This was clear last week as the S&P 500 ETF (SPY) saw some of the biggest outflows in its history with the exception of the February 2018 market plunge as Trump announced his

The problem with individuals and “passive” investing is they are just “active” investors in a different form. They make all the same mistakes that individual stock investors make, such as “buying high and selling low,” but just using a different instrument to do it.

As the markets declined last week, there was a slow realization “this decline” was something more than another “buy the dip” opportunity. Concerns of the impact on the global supply chain, due to “COVID-19,” slowing earnings, economic growth, and a reduction of liquidity from the Federal Reserve, all culminated in a “panicked exit.”

As losses mounted, anxiety rose until individuals began to sell to “avert further losses” by selling.

Yes….it’s that psychology thing.

Individuals refuse to act “rationally” by holding their investments as losses mount.

The behavioral biases of investors are one of the most serious risks arising from ETFs as too much capital is concentrated into too few places. This concentration risk in ETF’s is not the first time this has occurred:

• In the early 70’s it was the “Nifty Fifty” stocks,
• Then Mexican and Argentine bonds a few years after that
• “Portfolio Insurance” was the “thing” in the mid -80’s
• Dot.com anything was a great investment in 1999
• Real estate has been a boom/bust cycle roughly every other decade, but 2007 was a doozy
• Today, it’s ETF’s and Bitcoin

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

While the sell-off last week was large, it was the uniformity of the price moves, which revealed the fallacy “passive investing” as investors headed for the exits all at the same time.

### The Apple Problem

Currently, there more than 1750 ETF”s trading in the U.S., with each of those ETF’s owning many of the same underlying companies. For an ETF company to “sell” you product, they need good performance. In a late-stage market cycle driven by momentum, it is not uncommon to find the same “best performing” stocks proliferating a large number of ETF’s.

For example, out of the 1750 ETF’s in the U.S., there are 175, or 10%, which own Apple (AAPL). Given that so many ETF’s own the same company, the problem of “liquidity” is exposed during a market rout. The head of the BOE, Mark Carney, 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.”

Howard Marks, also noted in “Liquidity:”

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

Let me explain.

“For every buyer, there is a seller.”

The belief has always been that if an individual wants to sell, there will always be a buyer available to execute the transaction at any given price.

However, such is not actually the case.

The correct statement is:

“For every buyer, there is a seller….at a specific price.”

In other words, when the selling begins, those wanting to “sell” overrun those willing to “buy,” so prices have to drop until a “buyer” is willing to execute a trade.

The “Apple” problem, using our example above, is that while investors who are long Apple shares directly are trying to find buyers, the 175 ETF’s that also own Apple shares are vying for the same buyers to meet redemption requests.

This surge in selling pressure creates a “liquidity vacuum” between the current price and the price at which a “buyer” is willing to step in. As we saw last week, Apple shares fell faster than the SPDR S&P 500 ETF, of which Apple is one of the largest holdings.

Secondly, the ETF market is not a PASSIVE MARKET. Today, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. Importantly, they are NOT doing it “passively.” The rise of index funds has turned everyone into “asset class pickers,” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive” choice, but rather “active management” in a different form.

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

The correction had the “perma-bulls” scrambling to produce commentary as to why markets will continue only to rise. Unfortunately, that is not the way markets actually work over the long-term, and why the basic rules of investing are REALLY hard to follow.

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

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

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

Are you prepared?

# Decoding Media Speak & What You Can Do About It

Just recently, the Institutional Investor website published a brilliant piece entitled “Asset Manager B.S. Decoded.”

“The investment chief for one institution-sized single-family fortune decided to put pen to paper, translating these overused phrases, sales jargon, and excuses into plain — and satirical — English.”

A Translation Guide to Asset Manager-Speak

• Now is a good entry point = Sorry, we are in a drawdown
• We have a high Sharpe ratio = We don’t make much money
• We have never lost money = We have never made money
• We have a great backtest = We are going to lose money after we take your money
• We have a proprietary sourcing approach = We invest in whatever our hedge fund friends do
• We are not in crowded positions = We missed all the best-performing stocks
• We are not correlated = We are underperforming while the market keeps going up
• We invest in unique uncorrelated assets = We have an illiquid portfolio which can’t be valued and will suspend soon
• We are soft-closing the fund = We want to raise as much money as we can right now
• We are hard-closing the fund = We are definitely open for you
• We are not responsible for the bad track record at our prior firm = We lost money but are blaming all our ex-colleagues
• We have a bottom-up approach = We have no idea what markets are going to do
• We have a top-down process = We think we know what markets will do but really who does?
• The markets had a temporary mark-to-market loss = Our fundamental analysis was wrong and we don’t know why we lost money
• We don’t believe in stop-loss limits = We have no risk management

The “business” of any business is to make a profit. Wall Street makes profits by building products to sell you, whether it is the latest “fad investment,” an ETF, or bringing a company public. While Wall Street tells you they are “here to help you grow your money,” three decades of Wall Street shenanigans should tell you differently.

I know you probably don’t believe that, but here is a survey that was done of Wall Street analysts. It is worth noting where “you” rank in terms of their concern, and compensation.

Not surprisingly, you are at the bottom of the list.

While the translation is satirical, it is also more than truthful. Investors are often told what they “want” to hear, but actual actions are always quite different, along with the eventual outcomes.

So, what can you do about it?

You can take actions to curb those emotional biases which lead to eventual impairments of capital. The following actions are the most common mistakes investors repeatedly make, mostly by watching the financial media, and what you can do instead.

1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrongonly in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

3) More Risk

It is often touted the more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens, it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom or top ticks.

5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected, thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position, on the way up.

6) Don’t Fight The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies, it doesn’t take into account market and investor sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company that is also a great stock.

8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

## Conclusion

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money. Focus on managing risk, market cycles and exposure.

The law of change states: Change will occur, and the elements in the environment will adapt or become extinct, and that extinction in and of itself is a consequence of change.

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.” – Tim Hodgson, Thinking Ahead Institute

Investing is not a competition.

It is a game of long-term survival.

Start by turning off the mainstream financial media. You will be a better investor for it.

I hope you found this helpful.

# The Fed Won’t Avert The Next “Crisis,” They Will Cause It.

John Mauldin recently penned an interesting piece:

“Ignoring problems rarely solves them. You need to deal with them—not just the effects, but the underlying causes, or else they usually get worse. In the developed world, and especially the US, and even in China, our economic challenges are rapidly approaching that point. Things that would have been easily fixed a decade ago, or even five years ago, will soon be unsolvable by conventional means.

Yes, we did indeed need the Federal Reserve to provide liquidity during the initial crisis. But after that, the Fed kept rates too low for too long, reinforcing the wealth and income disparities and creating new bubbles we will have to deal with in the not-too-distant future.

This wasn’t a ‘beautiful deleveraging’ as you call it. It was the ugly creation of bubbles and misallocation of capital. The Fed shouldn’t have blown these bubbles in the first place.”

John is correct. The problem with low interest rates for so long is they have encouraged the misallocation of capital. We see it everywhere throughout the entirety of the financial system from consumer debt, to subprime auto-loans, to corporate leverage, and speculative greed.

### Misallocation Of Capital – Everywhere

Debt, if used for productive purposes, can be beneficial. However, as discussed in The Economy Should Grow Faster Than Debt:

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

Currently, throughout the entire monetary ecosystem, there is a rising consensus that “debt doesn’t matter” as long as interest rates and inflation remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase,” and the massive surge in debt since the “financial crisis.”

Yes, current economic growth is good, but not great. Inflation, and interest rates, remain low, which creates an “illusion” that using debt remains opportunistic. However, as stated, rising levels of non-productive debt has negative long-term economic consequences.

Before the deregulation of the financial industry under President Reagan, which led to an explosion in consumer credit issuance, it required just \$1.00 of total system-wide debt to create \$1.00 of economic growth. Today, it requires \$3.97 to create the same \$1 of economic growth. This shouldn’t be surprising, given that “debt” detracts from economic growth as the “debt service” diverts income from productive investments and leads to a “diminishing rate of return” for each new dollar of debt.

The irony is that while it appears the economy is growing, akin to the analogy of “boiling a frog,” we accept 2% economic growth as “strong,” whereas such growth rates were previously considered near recessionary.

Another conundrum is that corporations, and financial institutions, appear to be healthier, not to mention wealthier than ever. If such is indeed the case, then why is the Federal Reserve still needing to engage in “emergency monetary measures” to support the financial markets and economy after more than a decade?

As John stated above, the Fed’s actions are only “ignoring the problems” which, combined, is a problem too large for the Federal Reserve to fix.

### The Dark Side Of Stock Buybacks

While many argue that “share buybacks” are just a method by which corporations can return cash to shareholders, there is a dark side. In moderation, repurchases can be a beneficial method for a company to deploy capital when no better options are available. (It’s the least best use of cash.)

But, as with everything in life, when taken to “excess” the beneficial effects, can become detrimental.

The rules now reward management, not for generating revenue, but to drive up the price of the share price, thus making their options and stock grants more valuable.” – John Mauldin

The problem for the Fed was, despite the best of intentions, lowering interest rates to zero did not spark a “bank lending spree” throughout the economy. Instead, the excess liquidity flowed directly back into the financial system, creating a global wealth gap, rather than supporting stronger economic growth.

The most vivid example of this “closed loop” was in corporate share repurchases. Corporations, able to borrow cheaply due to low rates, used debt and cash to repurchase shares to increase earnings per share. This was the easiest route to create “executive wealth,” rather than deploying capital in more risky endeavors. As the Financial Times penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

Importantly, as noted by the Securities & Exchange Commission:

“SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks.”

Again, buybacks may not be an issue, but when taken to excess such can have the negative side effects of inflating asset bubbles. As John Authers pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

“Stock buybacks” are only a short-term benefit. With liquid cash, or worse debt, used for a one-time benefit, there is a long-term negative return on uses of capital for non-productive investments.

### All Levered Up

Currently, total corporate debt has surged to \$10.1 trillion – its highest level relative to U.S. GDP (47%) since the financial crisis. In just the last two years, corporations have issued another \$1.2 trillion of new debt NOT for expansion, but primarily used for share buybacks.

For the last 10-years, the Fed’s “zero interest rate policy” has left investors chasing yield, and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows, and debt has allowed many “zombie companies” to remain alive.

During the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds will be decimated. When “high yield,” or “junk bonds,” begin to default in large numbers, as they always do in a recession, which is why they are called “junk bonds,” investors will face sharp losses on the one side of their portfolio they “thought” was safe.

As the credit market falls into crisis, the Fed will have to ramp up additional stimulus to bail out the financial institutions caught long with an exceeding amount of poor-quality debt. As shown below, Treasuries will gain a bid as yields fall to zero, while corporate bonds lose value.

“In just the last 10 years, the triple-B bond market has exploded from \$686 billion to \$2.5 trillion—an all-time high. To put that in perspective, 50% of the investment-grade bond market now sits on the lowest rung of the quality ladder.

And there’s a reason BBB-rated debt is so plentiful. Ultra-low interest rates have seduced companies to pile into the bond market and corporate debt has surged to heights not seen since the global financial crisis.” John Mauldin:

there is a large tranche of BBB bonds on the verge of being downgraded to “junk.” When this occurs, there will be an avalanche of selling as pension, mutual, and hedge fund managers dump bonds simultaneously into what will be an illiquid market.

### Pensions Are Broke

But it is NOT just “share buybacks” and debt, which are problems hiding in plain sight.

“Moody’s Investor Service estimated last year that the total pension funding gap in the U.S. is \$4.4 trillion. A few months ago, the American Legislative Exchange Council estimated it at nearly \$6 trillion.”

With pension funds already wrestling with largely underfunded liabilities, the aging demographics are further complicating funding problems.

The \$6 Trillion “Pension Crisis” is just one sharp market downturn away from imploding. As I wrote in “The Next Financial Crisis Will Be The Last:”

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

This \$6 trillion hit is going to come at a time where the Federal Reserve will already be at “full tilt” monetizing debt to stabilize declining financial markets to keep a “debt crisis” from spreading.

## Strike Three, You’re Out

While investors have become extremely complacent over the last decade that Central Banks have gained control of the financial markets, this is likely an illusion. There are numerous catalysts which could pressure a downturn in the equity markets:

• An exogenous geopolitical event
• A credit-related event
• Failure of a major financial institution
• Recession
• Falling profits and earnings
• A loss of confidence by corporations which contacts share buybacks

Whatever the event is, which is currently unexpected and unanticipated, the decline in asset prices will initiate a “chain reaction.”

• Investors will begin to panic as asset prices drop, curtailing economic activity, and further pressuring economic growth.
• The pressure on asset prices and weaker economic growth, which impairs corporate earnings, shifts corporate views from “share repurchases” to “liquidity preservation.” This removes a major support of asset prices.
• As asset prices decline further, and economic growth deteriorates, credit defaults begin triggering a near \$5 Trillion corporate bond market problem.
• The bond market decline will pressure asset prices lower, which triggers an aging demographic who fears the loss of pension benefits, sparks the \$6 trillion pension problem.
• As the market continues to cascade lower at this point, the Fed is monetizing nearly 100% of all debt issuance, and has to resort to even more drastic measures to stem selling and defaults.
• Those actions lead to a further loss of confidence and pressures markets even further.

The Federal Reserve can not fix this problem, and the next “bear market” will NOT be like that last.

It will be worse.

As John concluded:

Coordinated monetary policy is the problem, not the solution. And while I have little hope for change in that regard, I have no hope that monetary policy will rescue us from the next crisis.

Let me amplify that last line: Not only is there no hope monetary policy will save us from the next crisis, it will help cause the next crisis. The process has already begun.” – John Mauldin

# The Voice of the Market- The Millennial Perspective

Those who cannot remember the past are condemned to repeat it.” – George Santayana

Current investors must be at least 60 years old to have been of working age during a sustained bond bear market. The vast majority of investment professionals have only worked in an environment where yields generally decline and bond prices increase. For those with this perspective, the bond market has been very rewarding and seemingly risk-free and easy to trade.

Investors in Europe are buying bonds with negative yields, guaranteeing some loss of principal unless bond yields become even more negative. The U.S. Treasury 30-year bond carries a current yield to maturity of 2.00%, which implies negative real returns when adjusted for expected inflation unless yields continue to fall. From the perspective of most bond investors, yields only fall, so there’s not much of a reason for concern with the current dynamics.

We wonder how much of this complacent behavior is due to the positive experience of those investors and traders driving the bond markets. It is worth exploring how the viewpoint of a leading investor archetype(s) can influence the mindset of financial markets at large.

## Millennials

The millennial generation was born between the years 1981 and 1996, putting them currently between the ages of 23 and 38. Like all generations, millennials have unique outlooks and opinions based on their life experiences.

Millennials represent less than 25% of the total U.S. population, but they are over 40% of the working-age population defined as ages 25 to 65. Millennials are quickly becoming the generation that drives consumer, economic, market, and political decision making. Older millennials are in their prime spending years and quickly moving up corporate ladders, and they are taking leading roles in government. In many cases, millennials are the dominant leaders in emerging technologies such as artificial intelligence, social media, and alternative energy.

Their rise is exaggerated due to the disproportionately large baby boomer generation that is reaching retirement age and witnessing their consumer, economic, and political impact diminishing. An additional boost to millennials’ influence is their comfort with social media and technology. They are digital natives. They created Facebook, Twitter, Snapchat, Instagram, and are the most active voices on these platforms. Their opinions are amplified like no other generation and will only get louder in the years to come.

Given millennial’s rising influence over national opinion, we examine their experiences so we can better appreciate their economic and market perspectives.

## Millennial Economics

In this section, we focus on the millennial experience with recessions. It is usually these trying economic experiences that stand foremost in our memories and play an important role in forming our economic behaviors. As an extreme example, anyone alive during the Great Depression is generally fiscally conservative and not willing to take outsized risks in the markets, despite the fact that they were likely children when the Depression struck.

The table below shows the number of recessions experienced by population groupings and the number of recessions experienced by those groupings when they were working adults, defined as 25 or older.

Data Courtesy US Census Bureau – Millennial Generation 1981-1996

About two-thirds of the Millennials, highlighted in beige, have only experienced one recession as an adult, the financial crisis of 2008. The recession of 1990/91 occurred when the oldest millennial was nine years old. More Millennials are likely to remember the recession of 2001, but they were only between the ages of 5 and 20.

Unlike most prior recessions, the recession of 2008 was borne out of a banking and real-estate crisis. Typically, recessions occur due to an excessive buildup in inventories that cause a slowing of new orders and layoffs. While the market volatility of the Financial Crisis was disturbing, the economic decline was not as severe when viewed through the lens of peak to trough GDP decline. As shown in the table below, the difference between the cycle peak GDP growth and the cycle trough GDP growth during the most recent recession was only the eighth largest difference of the last ten recessions.

Data Courtesy St. Louis Federal Reserve

One of the reasons the 2008 experience was not more economically challenging was the massive fiscal and monetary stimulus provided by the federal government and Federal Reserve, respectively. In many ways, these actions were unprecedented. When the troubles in the banking sector were arrested, consumer and business confidence rose quickly, helping the economy and the financial markets. Although it took time for the fear to subside, it set the path for a smooth decade of uninterrupted economic growth. A decade later, with the expansion now the longest since at least the Civil War, the financial crisis is a fleeting memory for many.

The market crisis of 2008 was harsh, but it did not last long. It is largely blamed on poor banking practices and real-estate speculation issues that have been supposedly fixed. Most Millennials likely believe the experience was a black swan event not likely to be repeated. One could argue there’s a large contingent of non-millennials who feel likewise.  Given the effectiveness of fiscal and monetary policy to reverse the effects of the crisis,  Millennials might also believe that recessions can be avoided, or greatly curtailed.

Half of the millennial generation were teenagers during the financial crisis and have few if any, memories of the economic hardships of the era. The oldest of the Millennials were only in their early to mid-20s at the time and are not likely to be as financially scarred as older generations. In the words of Nassim Taleb, they had little skin in the game.

No one in the millennial generation has experienced a classical recession, which the Federal Reserve is not as effective at stopping. With only one recession under their belt, and minimal harm occurring as a result of their relatively young age, recession naivete is to be expected from the millennial generation.

## Millennial Financial Markets

As stated earlier, the dot com bust, steep equity market decline, and the ensuing recession of 2001 occurred when the millennial generation was very young.

The financial crisis of 2008-2009 occurred when millennials were between the ages of 12 and 27. More than half of them were teenagers with little to no investing experience during the crisis. Some older Millennials may have been trading and investing, but at the time they were not very experienced, and the large majority had little money to lose.

What is likely more memorable for the vast majority of the generation is the sharp rebound in markets following the crisis and the ease in executing a passive buy and hold strategy that has worked ever since.

Millennial investors are not unlike bond traders under the age of 60 – they only know one direction, and that is up. They have been rewarded for following the herd, ignoring the warnings raised by excessive valuations, and dismissing the concerns of those that have experienced recessions and lasting market downturns.

## Are they ready for 2001?

The next recession and market decline are more likely to be traditional in character, i.e. based on economic factors and not a crisis in the financial sector. Current equity valuations argue that a recession could result in a 50% or greater decline, similar to what occurred in  2008 and 2001. The difference, however, may be that the amount of time required to recover losses will be vastly different from 2008-2009. The two most comparable instances were 1929 and 2001 when valuations were as stretched as they are today. It took the S&P 500 over 20 years to recover from 1929. Likewise, the tech-laden NASDAQ needed 15 years to set new record highs after the early 2000’s dot com bust.

Those that were prepared, and had experienced numerous recessions were able to protect their wealth during the last two downturns. Some investors even prospered. Those that believed the popular narrative that prices would move onward and upward forever paid dearly.

Today, the narrative is increasingly driven by those that have never really experienced a recession or sharp market decline. Is this the perspective you should follow?

## Summary

“Those who cannot remember the past are condemned to repeat it.

We would add, “those who remember the past are more likely to avoid it.”

The millennial generation has a lot going for it, but in the case of markets and economics, it has lived in an environment coddled by monetary policy. Massive amounts of monetary stimulus have warped markets and created a dangerous mindset for those with a short time perspective.

If you fall into this camp, you may want to befriend a 60-year old bond trader, and let them explain what a bear market is.

# Rising Rates Are Killing The Housing Market

Earlier this year, I penned an article entitled “The Coming Collision Of Debt & Rates” which discussed the 10-areas that rising interest rates would impact most directly. Number two on that list was housing:

“Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.”

The housing recovery is ultimately a story of the “real” employment situation. With roughly a quarter of the home buying cohort unemployed and living at home with their parents, the option to buy simply is not available.  Another large chunk of that group are employed but at the lower end of the pay scale which pushes them to rent due to budgetary considerations and an inability to qualify for a mortgage.

Even after a “decade of recovery,” the full-time employment-to-population ratios remain well below levels normally associated with a strong economy, and wage growth remains stagnant. Both of which makes home affordability an issue.

Despite much of the media rhetoric to the contrary, I have warned repeatedly that rising rates would negatively impact the housing market which was still being supported by low interest rates.

The mistake that mainstream analysts made was in the assumption that the recent increases in real estate prices were largely driven by first time home buyers creating an organic market. The reality, however, has been that market increases were being driven by speculators in the “buy to rent” game. As I noted previously:

“As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.”

“Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices ‘first-time homebuyers’ out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a ‘rush for the exits’ as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.”

You can see that a bulk of the real estate activity has occurred at the price levels of homes that make the best rental properties – between \$200,000 and \$400,000.

Importantly, you can see activity has dropped sharply over the course of the last couple of months. This is particularly the case at the very high-end and very low-end of the spectrum.

The latest data on existing and new home sales, permits, and completions show that we have likely seen the peak from the bounce in housing activity that started in 2010. It is important to remember, as we have discussed previously, that there are only a certain number of individuals that, at any given time, are actively seeking to ‘buy’ or ‘sell’ a home in the market. Furthermore, individuals buy “payments,” not “houses,” so artificially suppressed interest rates are only half of the payment equation. When home prices increase to levels that begin to price buyers out of the market – activity will slow.

The chart below is our Total Housing Activity Index which simply combines the 4-primary components of the housing market cycle – permits, completions, and sales of new and existing homes.

You will notice the last time the activity index broke is rising trend, the subsequent decline was not healthy. More importantly, both the current, and previous, “housing bubble” preceded the peak in household net worth.

In both cases, the “pin that pricked the bubble” was interest rates. As shown below, when mortgage rates rise housing activity slows as “people buy payments” rather than houses. This is because higher rates have two immediate impacts on the housing market:

1. The monthly payment rises to a level that buyers can’t afford, or;
2. Buyers stop their activity to “wait and see” if rates come back down again.

The monthly mortgage payment required for a loan has risen about 12% over the last three years as mortgage rates rose approximately 1%. The simply put houses out of reach for a vast majority of Americans already living from one paycheck to the next.

As a result, and shown below, the annual growth rate of housing activity is back into negative territory.

However, it is really how many of those “permits” turn into “completions” that matter. Currently, that ratio is sending an important warning which is suggesting more troubles ahead for the housing market as “permits” are being pulled due to lack of demand.

## At The Margin

Another “Damocles Sword” hanging over the mortgage industry is that rising interest rates will continue to kill the “refinance market.” Banks and mortgage-related companies have made huge profits over the last couple of decades as homeowners serially refinanced their homes to take out cash and refinance at a lower mortgage rate. That activity has largely ceased as a result of higher rates. We are now seeing default risk rise as adjustable rate credit lines on home equity loans begin to exceed homeowners ability to service the debt.

Furthermore, individuals were previously able to sell their existing home and “upgrade” to a newer or larger home. That upgrade was afforded by extremely low interest rates. Now, as rates rise, the “trade up” activity will greatly diminish as individuals become locked into their existing homes.

Housing is always a function of what happens at the “margins” with the activity contained to those actively searching to buy a house versus those willing, or able, to sell. But in order for MOST individuals to engage in the housing market, they need a mortgage to do so. As rates rise, that activity slows.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery.

Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. We must also remember that record low mortgage rates driven by Fed purchases of Mortgages Backed Securities (MBS) played a large role in the recovery.

Homebuilder sentiment has gone well beyond the actual level of activity. The recent turn lower is bringing that over-confidence back to reality and with that expect to see a decline in new permits and likely rise in the unemployment rate of those involved in the housing sector.

For the housing market, the recent rise in interest rates is extremely important.  There are many hopes pinned on housing activity continuing to foster the domestic economic recovery. If rates do indeed pop the current housing “bubble,” the entire economic recovery thesis will be called into question.

While the Fed has repeatedly noted the strength of the economy as a central underpinning for continuing to hike rates and tighten monetary policy, it is quite likely the damage from rising rates has already been done. Such was noted yesterday when Fed Chair Jerome Powell reversed his position on hiking rates and changed the language to suggest they were close to finished.

But the Fed’s change of tone may just be “too little, too late” as the negative impacts of increased borrowing costs with respect to both auto loans and housing have already become evident. It is only a function of time until the broader economic indicators feel the pinch.

# The Ghosts Of 2007 Are Calling

Borrowing from Mark Twain, a headline in the Chicago Tribune in 1941 said: “History May Not Repeat, But It Looks Alike.” Real or imagined that is often the case in financial markets especially when perusing historical price charts of stocks, bonds, commodities or any financial instrument for that matter. Comparing charts of some financial index or security from different time frames in search of resemblance is known as an analogue. Although one may occasionally find an uncanny similarity, it does not usually offer much in the way of influence over decision-making. Then again, there are some circumstances where charts align and we would be well-served to pay attention if not for purposes of immediate action, then as a means of allowing for better preparation.

One famous example involved hedge fund manager Paul Tudor Jones who in 1987 picked up on similarities in the price action and chart pattern of the Dow Jones Industrial Average that year and what transpired in 1929. Watching the progression of the stock market in 1987, he was convinced a market crash was coming. And come it did.

While analogues may seem contrived, the concept makes sense. Technical charts in all their forms are simply a reflection of human beings and their decisions about buying and selling. They are a visual representation of human emotion, and although difficult to predict, there is a pattern to how human beings behave in markets.

## 2006-2007

With that said, the developing price action of the S&P 500 has held our attention for several weeks. Below is a chart of the S&P 500 from two different time frames. The top frame is a chart from October 2006 to November 2007. The bottom frame is from October 2017 to the current day.

Data Courtesy Bloomberg

In early 2007 when everyone felt invincible due to home price appreciation and stock market gains, the first reports of subprime losses began to roil earnings reports for banks. Although initially disruptive, the market shrugged off those concerns and moved higher throughout spring and summer. The S&P 500 hit all-time highs in October, two months before the beginning of the recession and three months before a speech on January 10, 2008, in which Fed Chairman Bernanke stated: “The Federal Reserve is not currently forecasting a recession.”

The equity market contours have definitively changed in 2018 versus preceding years. An initial surge in equities in the opening weeks of 2018 was followed by a 10% decline and a long-absent spike in volatility. However, after the initial disruption in late January, the bull market managed to find its legs. By summer, the market was steadily rising and established new all-time highs in late September.

While the patterns do not line up perfectly, the symmetry of time, record highs, and the confluence of many potentially unstable events is certainly comparable.

## 2018

If 2006-2007 represents a proper analogue, the all-time high recently set on September 21st was the end of the great post-crisis, stimulus-fueled bull-run. It is early yet, and many prior calls for market tops lie in a graveyard full of bear bones. However, the analogue, when coupled with valuation analysis, liquidity concerns and economic data suggest that there is a likelihood that what we are observing is a topping process to the ten-year bull market.

Unlike 2007 where early disbelief around housing market excess and subprime lending finally offered easily identifiable culprits, today, like terrorism, the villains are not so easily identified. We live so deeply embedded in a world of debt and spending, a world so far away from fiscal discipline and prudence, that the tactics of ultra-low interest rates and quantitative easing now seem natural and healthy. Simply they have blinded our perspective.

Isaac Newton’s third law of physics states that “for every action, there is an equal and opposite reaction.” Years of monetary excess and the rampant speculation that resulted might be finally reversing. Regardless of whether the market is topping as the analogue warns or avoids significant declines for another year or two, investors would be well-served to be aware. The risk/reward framework is not in our favor.

# The Risk Of An ETF Driven Liquidity Crash

Last week, James Rickards posted an interesting article discussing the risk to the financial markets from the rise in passive indexing. To wit:

“Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition.

This is the problem of ‘active’ versus ‘passive’ investors.

The active investor contributes to markets while trying to make money in them.

A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery.”

Evelyn Cheng highlighted the rise of passive investing as well:

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, according to a new report from JPMorgan.

‘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,‘ Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates ‘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, he said.

‘Derivatives, quant fund flows, central bank policy and political developments have contributed to low market volatility’, Kolanovic said. Moreover, he said, ‘big data strategies are increasingly challenging traditional fundamental investing and will be a catalyst for changes in the years to come.’”

The rise in passive investing has been a byproduct of a decade-long infusion of liquidity and loose monetary policy which fostered a rise in asset prices to a valuation extreme only seen once previously in history. The following chart shows that this is exactly what is happening. Since 2009, over \$2.5 trillion of equity investment has been added to passive-strategy funds, while \$2.0 trillion has been withdrawn from active-strategy funds.

As James aptly notes:

“This chart reveals the most dangerous trend in investing today. Since the last financial crisis, \$2.5 trillion has been added to “passive” equity strategies and \$2.0 trillion has been withdrawn from “active” investment strategies. This means more investors are free riding on the research of fewer investors. When sentiment turns, the passive crowd will find there are few buyers left in the market.

When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash.”

He is correct, and makes the same point that Frank Holmes recently penned in Forbes:

“Nevertheless, the seismic shift into indexing has come with some unexpected consequences, including price distortion. New research shows that it has inflated share prices for a number of popular stocks. A lot of trading now is based not on fundamentals but on low fees. These ramifications have only intensified as active managers have increasingly been pushed to the side.”

“This isn’t just the second largest bubble of the past four decades. E-commerce is also vastly overrepresented in equity indices, meaning extraordinary amounts of money are flowing into a very small number of stocks relative to the broader market. Apple alone is featured in almost 210 indices, according to Vincent Deluard, macro-strategist at INTL FCStone.

If there’s a rush to the exit, in other words, the selloff would cut through a significant swath of index investors unawares.”

As Frank notes, the problem with even 35% of the market being “passive” is the liquidity issues surrounding the market as a whole. With more ETF’s than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp and disorderly reversal remains due to 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.

The risk of a disorderly unwinding due to a lack of liquidity was highlighted by the head of the BOE, Mark Carney.

“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.’”

In other words, the problem with passive investing is simply that it works, until it doesn’t.

## You Only Think You Are Passive

As Howard Marks, mused in his ‘Liquidity’ note:

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

What Howard is referring to is the “Greater Fool Theory,” which surmises there is always a “greater fool” than you in the market to sell to. While the answer is “yes,” as there is always a buyer for every seller, the question is always “at what price?”

More importantly, individual investors are NOT passive even though they are investing in “passive” vehicles.

Today, more than ever, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. However, they are NOT doing it “passively.”

The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive” choice, but rather “active management” in a different form.

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall – “passive indexers” will quickly become “active sellers.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic, and damaging, ending.

It is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

The reason that mean-reverting events have occurred throughout history, is that despite the best of intentions, individuals just simply refuse to act “rationally” by holding their investments as they watch losses mount.

This behavioral bias of investors is one of the most serious risks arising from ETFs as the concentration of too much capital in too few places. But this concentration risk is not the first time this has occurred:

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

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

The sell-off in February of this year was not particularly unusual, however, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time.

It should serve as a warning.

When “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.

Fortunately, while the price decline was indeed sharp, and a “rude awakening” for investors, it was just a correction within the ongoing “bullish trend.”

For now.

But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008.

The question is “which” 10% decline was it?

Regardless, it was only a glimpse at what will eventually be the “real” decline when leverage is eventually clipped. I warned of this previously:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic 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. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.”

Make no mistake we are sitting on a “full tank of gas.”

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

So, what’s your plan for when the real correction ultimately begins?

“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” – John C. Bogle.

# Party Like It’s 1992?

Last week, Mark Hulbert warned of an indicator that hasn’t been this inflated since the “Dot.com” bubble. To wit:

“It’s been more than 25 years since the stock market’s long-term trailing return was as low as it is today. Since the top of the internet bubble in March 2000, the S&P 500 has produced a 1.4% annualized return after adjusting for both dividends and inflation. “

Whoa! How can that be given the market just set a record for the “longest bull market” in U.S. history?

This is a point that is lost on many investors who have only witnessed one half of a full market cycle. It is also the very essence of Warren Buffett’s most basic investment lesson:

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

Over the last 147-years of market history, there have only been five (5), relatively short periods, in history where the entirety of market “gains” were made. The rest of the time, the market was simply getting back to even.

Where you start your investing journey has everything to do with outcomes. Warren Buffett, for example, launched Berkshire Hathaway when valuations, and markets, were becoming historically undervalued. If Buffett had launched his firm in 2000, or even today, his “fame and fortune” would likely be drastically different.

Timing, as they say, is everything.

It is also worth noting, as shown below, that valuations clearly run in cycles over time. The current evolution of valuations has been extended longer than previous cycles due to 30-years of falling interest rates, massive increases in debt and leverage, unprecedented amounts of artificial stimulus, and government spending.

This was a point I discussed last week:

“There are two important things to consider with respect to the chart below.

1. The shift higher in MEDIAN valuations was a function of falling economic growth and inflationary pressures.
2. Higher prices were facilitated by increasing levels of leverage and debt, which eroded economic growth. “

But with returns low over the last 25-years, future returns should be significantly higher. Right?

Not necessarily. As Mark noted:

“Your conclusion from this sobering factoid depends on whether you see the glass as half-full or half-empty. The ‘half-full’ camp calls attention to what happened to stocks in the years after 1992, when stocks’ trailing two-decade return regressed to the mean — and then some: equities skyrocketed, elevating their trailing 18.5 year inflation-adjusted dividend-adjusted return to 11% annualized.

This optimistic view is the most pervasive. Return estimates for the S&P 500 have steadily risen in recent months as earnings have been buoyed by massive amounts of share buybacks and tax cuts.

With earnings rising, what’s not to love?

I get it.

But I disagree, and here’s why.

Throughout history, there is an undeniable link between valuation and return. More importantly, it is the expansion, or contraction, in valuations which are directly tied to the cycles of the market. When investors are willing to “pay up” for a future stream of cash flows, prices rise. When expectations for future cash flows decline, so do prices.

For those expecting a repeat of the post-1992 period, they are likely to be disappointed. As shown, in 1992, the deviation from the long-term median price/earnings ratio (using Shiller’s CAPE) was just below 0%. This gave investors plenty of room to expand valuations as inflation and interest rates fell, consumer and government debts surged, and the general masses swept into the “Wall Street Casino.”

Today, valuations are at the second highest level in history. Despite the massive surge in earnings due to tax cuts – inflation and interest rates are low, revenue growth is weak as consumers, government, and corporations are fully leveraged, and households are “all in” the equity pool.

This is an important point which should not be overlooked.

The bullish premise has been that since tax cuts will cause a surge in earnings which we reduce valuations back to their long-term average. However, such is true as long as prices don’t increase during the period earnings are rising. But such as NOT been the case. Currently, the market has continued to “price in” those earnings increases keeping valuations elevated.

As noted by Mark:

“Unfortunately, the CAPE today is back to within shouting distance of where it stood at the top of the internet bubble. It reached 44.2 then, and is 33.2 today. At no time in U.S. history other than the internet bubble has the CAPE been as high as it is now.”

## CAPE Is B.S.

It is not surprising that during periods of valuation expansion that investors eventually come to the conclusion that “this time is different.” The argument goes something like this:

“Sure, the CAPE ratio is elevated but had you sold, you would have missed out on this booming bull market.”

That statement is 100% true.

However, it grossly misunderstands the “value” of “valuations.”

Valuations are not, and have never been, useful as a market timing indicator. Valuations should not be used as a “buy” or “sell” indicator in a portfolio management process.

What valuations do provide is a very clear understanding of what future expected returns will be over the next 10-20 years. Bill Hester wrote a very good note in this regard in response to critics of Shiller’s CAPE ratio and future annualized returns:

We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns.

It is also the same over 20-year periods even on a rolling 20-year real total-return basis.

“Even on a 20-year real total return basis, there was a negative return period. But while the three other periods were not negative after including dividends, when it comes to saving for retirement, a 20-year period of 1% returns isn’t much different from zero.”

There is also a reasonable argument that due to the “speed of movement” in the financial markets, a shortening of business cycles, changes to accounting rules, buyback activity, and increased liquidity, there is a “duration mismatch” between Shiller’s 10-year CAPE and the financial markets currently.

Therefore, in order to compensate for the potential “duration mismatch” of a faster moving market environment, I recalculated the CAPE ratio using a 5-year average as shown in the chart below.

The high correlation between the movements of the CAPE-5 and the S&P 500 index shouldn’t be a surprise. However, notice that prior to 1950 the movements of valuations were more coincident with the overall index as price movement was a primary driver of the valuation metric. As earnings growth began to advance much more quickly post-1950, price movement became less of a dominating factor. Therefore, you can see that the CAPE-5 ratio began to lead overall price changes.

A key “warning” for investors, since 1950, has been a decline in the CAPE-5 ratio which has tended to lead price declines in the overall market. The two most recent declines in the CAPE-5 also correlated with drops in the market in 2015-2016 and the beginning of 2018.

To get a better understanding of where valuations are currently relative to past history, and why this is likely NOT 1992, we can look at the deviation between current valuation levels and the long-term average.

The importance of deviation is crucial to understand. In order for there to be an “average,” valuations had to be both above and below that “average” over history. These “averages” provide a gravitational pull on valuations over time which is why the further the deviation is away from the “average,” the greater the eventual “mean reversion” will be.

The first chart below is the percentage deviation of the CAPE-5 ratio from its long-term average going back to 1900.

Currently, the 76.15% deviation above the long-term CAPE-5 average of 15.86x earnings puts valuations at levels only witnessed two (2) other times in history – 1929 and 2000. As stated above, while it is hoped “this time will be different,” which were the same words uttered during each of the two previous periods, you can clearly see that the eventual outcomes were much less optimal.

However, as noted, the changes that have occurred Post-WWII in terms of economic prosperity, changes in operational capacity and productivity warrant a look at just the period from 1944-present.

Again, as with the long-term view above, the current deviation is 61.8% above the Post-WWII CAPE-5 average of 17.27x earnings. Such a level of deviation has only been witnessed one other time previously over the last 70 years as we headed into the “Dot.com” peak. Again, as with the long-term view above, the resulting “reversion” was not kind to investors.

Is this a better measure than Shiller’s CAPE-10 ratio?

Maybe, as it adjusts more quickly to a faster moving marketplace. However, I want to reiterate that neither the Shiller’s CAPE-10 ratio or the modified CAPE-5 ratio were ever meant to be “market timing” indicators.

Since valuations determine forward returns, the sole purpose is to denote periods which carry exceptionally high levels of investment risk and resulted in exceptionally poor levels of future returns.

Currently, valuation measures are clearly warning the future market returns are going to be substantially lower than they have been over the past ten years. Therefore, if you are expecting the markets to crank out 10% annualized returns over the next 10 years for you to meet your retirement goals, it is likely that you are going to be very disappointed.

Does that mean you should be all in cash today? Of course, not.

However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next “reversion” when it occurs.

My client’s have only two objectives:

1. Protect investment capital from major market reversions,  and;
2. Meet investment returns anchored to retirement planning projections.

Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.

Or, you can just hope it all works out.

For 80% of Americans, it just simply hasn’t been the case.

# The Ingredients Of An “Event”

This past week marked the 10th-Anniversary of the collapse of Lehman Brothers. Of course, there were many articles recounting the collapse and laying blame for the “great financial crisis” at their feet. But, as is always the case, an “event” is always the blame for major reversions rather than the actions which created the environment necessary for the crash to occur. In the case of the “financial crisis,” Lehman was the “event” which accelerated a market correction that was already well underway.

I have noted the topping process and the point where we exited the markets. Importantly, while the market was giving ample signals that something was going wrong, the mainstream analysis continued to promote the narrative of a “Goldilocks Economy.” It wasn’t until December of 2008, when the economic data was negatively revised, the recession was revealed.

Of course, the focus was the “Lehman Moment,” and the excuse was simply: “no one could have seen it coming.”

But many did. In December of 2007 we wrote:

“We are likely in, or about to be in, the worst recession since the ‘Great Depression.'”

A year later, we knew the truth.

Throughout history, there have been numerous “financial events” which have devastated investors. The major ones are marked indelibly in our financial history: “The Crash Of 1929,” “The Crash Of 1974,” “Black Monday (1987),” “The Dot.Com Crash,” and the “The Financial Crisis.”

Each of these previous events was believed to be the last. Each time the “culprit” was addressed and the markets were assured the problem would not occur again. For example, following the crash in 1929, the Securities and Exchange Commission, and the 1940 Securities Act, were established to prevent the next crash by separating banks and brokerage firms and protecting against another Charles Ponzi. (In 1999, legislation was passed to allow banks and brokerages to reunite. 8-years later we had a financial crisis and Bernie Madoff. Coincidence?)

In hindsight, the government has always acted to prevent what was believed to the “cause” of the previous crash. Most recently, Sarbanes-Oxley and Dodd-Frank legislations were passed following the market crashes of 2000 and 2008.

But legislation isn’t the cure for what causes markets to crash. Legislation only addresses the visible byproduct of the underlying ingredients. For example, Sarbanes-Oxley addressed the faulty accounting and reporting by companies like Enron, WorldCom, and Global Crossing. Dodd-Frank legislation primarily addressed the “bad behavior” by banks (which has now been mostly repealed).

While faulty accounting and “bad behavior” certainly contributed to the end result, those issues were not the cause of the crash.

Recently, John Mauldin addressed this issue:

“In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

While the idea is correct, this assumes that at some point the markets collapse under their own weight when something gives.

I think it is actually a little different. In my view, ingredients like nitrogen, glycerol, sand, and shell are mostly innocuous things and pose little real danger by themselves. However, when they are combined together, and a process is applied to bind them, you make dynamite. But even dynamite, while dangerous, does not immediately explode as long as it is handled properly. It is only when dynamite comes into contact with the appropriate catalyst that it becomes a problem.

“Mean reverting events,” bear markets, and financial crisis, are all the result of a combined set of ingredients to which a catalyst was applied. Looking back through history we find similar ingredients each and every time.

## The Ingredients

Leverage

Throughout the entire monetary ecosystem, there is a consensus that “debt doesn’t matter” as long as interest rates remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase” and has fostered a massive surge in debt in the U.S. since the “financial crisis.”

Importantly, debt and leverage, by itself is not a danger. Actually, leverage is supportive of higher asset prices as long as rates remain low and the demand for, rates of return on, other assets remains high.

Valuations

Likewise, high valuations are also “inert” as long as everything asset prices are rising. In fact, rising valuations supports the “bullish” thesis as higher valuations represent a rising optimism about future growth. In other words, investors are willing to “pay up” today for expected further growth.

While valuations are a horrible “timing indicator” for managing a portfolio in the short-term, valuations are the “great predictor” of future investment returns over the long-term.

Psychology

Of course, one of the critical drivers of the financial markets in the “short-term” is investor psychology. As asset prices rise, investors become increasingly confident and are willing to commit increasing levels of capital to risk assets. The chart below shows the level of assets dedicated to cash, bear market funds, and bull market funds. Currently, the level of “bullish optimism” as represented by investor allocations is at the highest level on record.

Again, as long as nothing adversely changes, “bullish sentiment begets bullish sentiment” which is supportive of higher asset prices.

Ownership

Of course, the key ingredient is ownership. High valuations, bullish sentiment, and leverage are completely meaningless if there is no ownership of the underlying equities. The two charts below show both household and corporate levels of equity ownership relative to previous points in history.

Once again, we find rising levels of ownership are a good thing as long as prices are rising. As prices rise, individuals continue to increase ownership in appreciating assets which, in turn, increases the price of the assets being purchased.

Momentum

Another key ingredient to rising asset prices is momentum. As prices rice, demand for rising assets also rises which creates a further demand on a limited supply of assets increasing prices of those assets at a faster pace. Rising momentum is supportive of higher asset prices in the short-term.

The chart below shows the real price of the S&P 500 index versus its long-term bollinger-bands, valuations, relative-strength, and its deviation above the 3-year moving average. The red vertical lines show where the peaks in these measures were historically located.

## The Formulation

Like dynamite, the individual ingredients are relatively harmless. However, when the ingredients are combined they become potentially dangerous.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, in the short-term, this particular formula does indeed remain supportive for higher asset prices. Of course, the more prices rise, the more optimistic the investing becomes as it becomes common to believe “this time is different.”

While the combination of ingredients is indeed dangerous, they remain “inert” until exposed to the right catalyst.

These same ingredients were present during every crash throughout history.

All they needed was the right catalyst.

The catalyst, or rather the “match that lit the fuse,” was the same each time.

## The Catalyst

In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became “active,” monetarily policy-wise. As shown in the chart below, when the Fed has embarked upon a rate hiking campaign, bad “stuff” has historically followed.

With the Fed expected to hike rates 2-more times in 2018, and even further in 2019, it is likely the Fed has already “lit the fuse” on the next financially-related event.

Yes, the correction will begin as it has in the past, slowly, quietly, and many investors will presume it is simply another “buy the dip” opportunity.

Then suddenly, without reason, the increase in interest rates will trigger a credit-related event. The sell-off will gain traction, sentiment will reverse, and as prices decline the selling will accelerate.

Then a secondary explosion occurs as margin-calls are triggered. Once this occurs, a forced liquidation cycle begins. As assets are sold, prices decline as buyers simply disappear. As prices drop further, more margin calls are triggered requiring further liquidation. The liquidation cycle continues until margin is exhausted.

But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

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

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

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

All the ingredients for the next market crash are currently present. All that is current missing is the “catalyst” which ignites it all.

There are many who currently believe “bear markets” and “crashes” are a relic of the past. Central banks globally now have the financial markets under their control and they will never allow another crash to occur. Maybe that is indeed the case. However, it is worth remembering that such beliefs were always present when, to quote Irving Fisher, “stocks are at a permanently high plateau.”

# As Good As It Gets

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

I was reminded of that quote recently as I was reading a great piece by Tim Duy:

“Federal Reserve Chairman Jerome Powell took to the podium at the annual Jackson Hole monetary conference, delivering a message of support for the central bank’s policy of ongoing gradual interest-rate increases. This policy stance is less about commitment to estimates of key policy variables such as the natural rate of interest and more about data dependence. Unfortunately, Powell left the unsettling feeling that monetary policy can be summarized as ‘We plan to keep hiking until something breaks.’”

Tim makes a great point.

I have spilled a lot of digital ink discussing the problems with monetary policy in the past, and in particular, with the Fed’s rate hiking campaigns. The results have always been, without exception, either poor or disastrous.

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 10-year rate, bad ‘stuff’ has historically followed.”

The same applies to stock market investors as well. As I wrote previously,

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

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

It is just human nature.

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

Despite the best of intentions, a vast majority of the “bullish” crowd today have never lived through a real bear market. You know such is true when you read a comment like this:

“What all equity investors need to do — is to be mentally prepared for a temporary (maximum 2 year) 33-50% drop. 90% drops like the Great Depression aren’t going to happen ever again. You may have a 50% drop but it will come back in two years max.”

Two charts show the ignorance in that statement.

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

Another comment showed equal ignorance of market dynamics.

“A common fallacy is that ‘every bullish trend results in an equally bearish trend,’ or that bull and bear market seesaw EQUALLY, like yin and yang. But nothing is further from the truth. Bull Markets last 6 TIMES LONGER and rise 10 TIMES HIGHER than bear markets do.”

Yes, they do seesaw and, for the most part, are almost always equal in nature. (a 100% gain and 50% loss are the same thing) For every bull market, there will be a bear market. But, as shown above, it is clearly not the case that bull markets rise 10x higher than bear markets fall.

Market participants never act rationally. Neither do consumers.

## The Instability Of Stability

This is the problem facing the Fed.

Currently, there is a very high level of complacency with a strong belief in the motto “The Fed can do no wrong.”  Or should I say, there seems to be a very large consensus the markets have entered into a “permanently high plateau,” or an era in which price corrections in asset prices have been effectively eliminated through monetary policy.

Interestingly, it is that very belief on which the Fed is dependent. With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the 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 as it provides the “room” needed, after more than 9-years of the most unprecedented monetary policy program in U.S. history, to try and extricate themselves from it. The Fed is dependent on “everyone acting rationally.”

As I noted in last week’s newsletter, Fed Chairman J. Powell is depending upon the everyone buying into the current narrative he provided:

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

However, there are concerns about the durability of that backdrop as “everything is as good as it can get.”

To understand this 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.

Currently, the index has peaked from it’s second highest level on record. In every previous period where the index achieved current levels, it had been near the peak of that economic cycle.

It is also worth noting the 6-month average of the Leading Economic Index (LEI) has recently turned down and this index reliably leads the EOCI by a couple of months.

The Citi and Bloomberg Economic Surprise indices, which also tend to lead our EOCI have turned sharply lower following the recent “natural disaster recovery” surge from late last year. This was the point I made recently:

“But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy grinds 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.”

It is here we find the biggest potential risk for the Fed.

There are already signs that forward economic activity may be significantly weaker than currently expected. Yet the Fed is making policy decisions based on the current trend of activity. As Tim notes:

“This raises the bar for a pause. Powell and his fellow policy-makers need to see a definite change in the numbers that leads them to believe that economic activity has moderated and financial conditions have sufficiently tightened to justify the pause. In other words, they are not inclined to take a leap of faith and pause as they hit neutral to assess the impact of past tightening. They need to see a reason to stop tightening.”

The Fed operates on current economic data as it comes in. However, all economic data is revised in the future, and when those revisions become sharply negative, the results aren’t good. For example, in December of 2007, no one believed the U.S. economy was in a recession. However, after a near 50% plunge in asset prices and the worst economy since the “Great Depression,” the NBER officially stated in December of 2008 the recession had started a year earlier. Such was not an outlier event, but rather the norm for NBER recession dating.

As Tim notes:

“The worst-case scenario is that something actually needs to break before the Fed stops tightening. This is a possibility because of the long and variable lags in the policy process. The Fed could keep on hiking well past when it should stop, or fail to reverse course quickly enough, because the data has yet to catch up with a slowdown already occurring under the surface. This is arguably how expansions end.”

I would disagree with Tim on the last sentence.

It should have read: “This is how expansions end.”

As shown below, when you overlay our EOCI index with the Fed funds rate, we see that every rate hiking campaign denoted the “beginning of the end” of every expansion period. Unfortunately, as Tim notes, by the time the data is revised, it will be well after the point at which the Federal Reserve should have stopped their rate hike campaign.

Unsurprisingly, when the Fed eventually “breaks something,” the downturns in the EOCI index also coincide with a stock market contraction as well.

## The Single Biggest Risk To Your Money

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

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

“In reality, if one listens to the business media (presumably one of the guiding sources of investor opinion) there is little recognition of any negatives these days. There is, to most of the media, no ‘wall of worry’ at all. Here are a few of my concerns – not one of which was the subject of discussion in the business media today:

• Growing economic ambiguities in the U.S. and abroad: peak autos, peak housing, peak GDP.
• Political instability and a crucial midterm election.
• The failure of fiscal policy to ‘trickle down.’
• An important pivot towards restraint in global monetary policy.
• An unprecedented lack of coordination between super-powers.
• Short-term note yields now eclipse the S&P dividend yield.
• A record levels of private and public debt.
•  Near \$3 trillion of covenant light and/or sub-prime corporate debt. (eerily reminiscent of the size of the subprime mortgages outstanding in 2007)

What, me, worry?”

At the moment, there certainly seems to be no need to worry.

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

Yes, everything certainly is “as good as it can get.”

But therein lies the single biggest risk to the Fed and your portfolio.

“Bull markets” don’t die of pessimism – they die from excess optimism.

Unfortunately, by the time the Fed realizes what they have done, it will be too late.

# 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.

# This Cycle Will End – The Simple Math Of Forward Returns

In this past weekend’s newsletter, I discussed the potential for an end to the current bull market cycle. It was not surprising that even before the “digital ink was dry,” I received emails and comments questioning the premise.

It is certainly not surprising that after one of the longest cyclical bull markets in history that individuals are ebullient about the long-term prospects of investing. The ongoing interventions by global Central Banks have led to T.T.I.D. (This Time Is Different) and  T.I.N.A. (There Is No Alternative) which has become a pervasive, and “Pavlovian,” investor mindset. But therein lies the real story.

The chart below shows every economic expansion going back to 1871 and the subsequent market decline.

This chart should make one point very clear – this cycle will end.

However, for now, there is little doubt the bullish bias exists as individuals continue to hold historically high levels of equity and leverage, chasing yield in the riskiest of areas, and maintaining relatively low levels of cash as shown in the charts below.

There are only a few people, besides me, that discuss the probabilities of lower returns over the next decade. But let’s do some basic math.

First, the general consensus is that stocks will return:

• 6%-8%/year in real (inflation-adjusted) terms,
• plus or minus whatever changes we see in valuation ratios.

Plug in the math and we get the following scenarios:

1. If P/E10 declines from 30X to 19X  over the next decade, equity returns should be roughly 3%/year real or 5%/year nominal.
2. If P/E10 declines to 15X, returns fall to 1%/year real or 3%/year nominal.
3. If P/E10 remains at current levels, returns should be 6%/year real or 8%/year nominal.

Here is the problem with the math.

First, this assumes that stocks will compound at some rate, every year, going forward. This is a common mistake that is made in return analysis. Equities do not compound at a stagnant rate of growth but rather experience a rather high degree of volatility over time.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.

Here is another way to view the difference between what was “promised,” versus what “actually” happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960’s to present and extrapolates those returns into the future.

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long-term.

The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return.

The chart below shows the S&P 500 as compared to annualized returns and the average of market returns since 1900.  Over the last 118 years, the market has NEVER produced a 6% every single year even though the average has been 6.87%.

However, assuming that markets have a set return each year, as you could expect from a bond, is grossly flawed. While there are many years that far exceeded the average of 6%, there are also many that haven’t. But then again, this is why 6% is the “average” and NOT the “rule.”

Secondly, and more importantly, the math on forward return expectations, given current valuation levels, does not hold up.  The assumption that valuations can fall without the price of the markets being negatively impacted is also grossly flawed. History suggests, as shown in the next chart, that valuations do not fall without investment returns being negatively impacted to a large degree.

So, back to the “math” to prove this is true.

If we assume that despite the weak economic growth at present, the Federal Reserve is successful at getting nominal GDP back up to a historical growth rate of 6.3% annually. While this is not realistic if you look at the data, when markets are near historical peaks, assumptions tend to run a bit wild. Unfortunately, such assumptions have tended to have rather nasty outcomes. But I digress.

If we use a market cap / GDP ratio of 1.25 and an S&P 500 dividend yield of just 2%, what might we estimate for total returns over the coming decade using John Hussman’s formula?

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually.

We can confirm that math by simply measuring the forward TOTAL return of stocks over the next 10-years from each annual valuation level.

Forward 20-year returns do not get a whole lot better.

But even if you are optimistic, and you do manage to eek out forward returns of 5-6% over the next 20-years, you will never reach your financial goals due to the inherent destruction of capital along the way. (See “You Should Never Time The Market?”)

John Hussman once penned:

Extraordinary long-term market returns come from somewhere. They originate in conditions of undervaluation, as in 1950 and 1982. Dismal long-term returns also come from somewhere – they originate in conditions of severe overvaluation. Today, as in 2000, and as in 2007, we are at a point where ‘this’ is like this. So ‘that’ can be expected to be like that.”

Nominal GDP growth is likely to be far weaker over the next decade. This will be due to the structural change in employment, rising productivity which suppresses real wage growth, still overly leveraged household balance sheets which reduce consumptive capabilities and the current demographic trends.

Most mainstream analysis makes sweeping assumptions that are unlikely to play out in the future. The market is extremely volatile which exacerbates the behavioral impact on forward returns to investors and the most recent Dalbar Study of investor behavior shows this to be the case. Over the last 30-years, the S&P 500 has had an average return of 10.16% while equity fund investors had a return of just 3.98%.

So much for the 6% return assumptions in financial plans.

This has much to do with the simple fact that investors chase returns, buy high, sell low and chase ethereal benchmarks. (Read “Why You Shouldn’t Benchmark Your Portfolio”) The reason that individuals are plagued by these emotional behaviors is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.

Sure, it is entirely possible the current cyclical bull market is not over…yet.

Momentum driven markets are hard to kill in the latter stages particularly as exuberance builds. However, they do eventually end. That is unless the Fed has truly figured out a way to repeal economic and business cycles altogether. As we enter into the ninth year of economic expansion we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to build a bigger economic void in the future by pulling forward consumption through its monetary policies.

Will the market likely be higher a decade from now? A case can certainly be made in that regard. However, if interest rates or inflation rise sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same.

“History repeats itself all the time on Wall Street”  – Edwin Lefevre

# Recession: When You See It, It Will Be Too Late

“There are no signs of recession. Employment growth is strong. Jobless claims are low and the stock market is up.”

This is heard almost daily from the media mainstream pablum.

The problem with a majority of the “analysis” done today is that it is primarily short-sighted and lazy, produced more for driving views and selling advertising rather than actually helping investors.

For example:

“The economy is currently growing at more than 2% annualized with current estimates near 2% as well.”

If you are growing at 2%, how could you have a recession anytime soon?

Let’s take a look at the data below of real economic growth rates:

• January 1980:        1.43%
• July 1981:                 4.39%
• July 1990:                1.73%
• March 2001:           2.30%
• December 2007:    1.87%

If you look at each of those dates, the economy was clearly growing. But each of those dates is the growth rate of the economy immediately prior to the onset of a recession.

You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”

I myself was rather brutally chastised in December of 2007 when I wrote that:

“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”

Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis (BEA), the recession was officially revealed. Unfortunately, by then it was far too late to matter.

It is here the mainstream media should have learned their lesson. But unfortunately, they didn’t.

The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.

There are three lessons that should be learned from this:

1. The economic “number” reported today will not be the same when it is revised in the future.
2. The trend and deviation of the data are far more important than the number itself.
3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

For example, the level of jobless claims is one data series currently being touted as a clear example of why there is “no recession” in sight. As shown below, there is little argument that the data currently appears extremely “bullish” for the economy.

However, if we step back to a longer picture we find that such levels of jobless claims have historically noted the peak of economic growth and warned of a pending recession.

This makes complete sense as “jobless claims” fall to low levels when companies “hoard existing labor” to meet current levels of demand. In other words, companies reach a point of efficiency where they are no longer terminating individuals to align production to aggregate demand. Therefore, jobless claims naturally fall.

But there is more to this story.

## Less Than Meets The Eye

The Trump Administration has taken a LOT of credit for the recent bumps in economic growth. We have warned this was not only dangerous, credibility-wise, but also an anomaly due to three massive hurricanes and two major wildfires that had the “broken window” fallacy working overtime.

“The fallacy of the ‘broken window’ narrative is that economic activity is only changed and not increased. The dollars used to pay for the window can no longer be used for their original intended purpose.”

If economic destruction led to long-term economic prosperity, then the U.S. should just regularly drop a “nuke” on a major city and then rebuild it. When you think about it in those terms, you realize just how silly the whole notion is.

However, in the short-term, natural disasters do “pull forward” consumption as individuals need to rebuild and replace what was previously lost. This activity does lead to a short-term boost in the economic data, but fades just as quickly.

A quick look at core retail sales over the last few months, following the hurricanes, shows the temporary bump now fading.

The other interesting aspect of this is the rise in consumer credit as a percent of disposable personal income. The chart below indexes both consumer credit to DPI and retail sales to 100 starting in 1993. What is interesting to note is the rising level of credit card debt required to sustain retail sales.

Given that retail sales make up roughly 40% of personal consumption expenditures which in turn comprises roughly 70% of GDP, the impact to sustained economic growth is important to consider.

Furthermore, what the headlines miss is the growth in the population. The chart below shows retails sales divided by the current 16-and-over population. (If you are alive, you consume.)

Retail sales per capita were previously on a 5% annualized growth trend beginning in 1992. However, after the financial crisis, the gap below that long-term trend has yet to be filled as there is a 23.2% deficit from the long-term trend. It is also worth noting the sharp drop in retail sales per capita over just the last couple of months in particular.

Since 1992, as shown below, there have only been 5-other times in which retail sales were negative 3-months in a row (which just occurred). Each time, the subsequent impact on the economy, and the stock market, was not good.

So, despite record low jobless claims, retail sales remain exceptionally weak. There are two reasons for this which are continually overlooked, or worse simply ignored, by the mainstream media and economists.

The first is that despite the “longest run of employment growth in U.S. history,” those who are finding jobs continues to grow at a substantially slower pace than the growth rate of the population.

If you don’t have a job, and are primarily living on government support (1-of-4 Americans receive some form of benefit) it is difficult to consume at higher levels to support economic growth.

Secondly, while tax cuts may provide a temporary boost to after-tax incomes, that income boost is simply being absorbed by higher energy, gasoline, health care and borrowing costs. This is why 80% of Americans continue to live paycheck-to-paycheck and have little saved in the bank. It is also why, as wages have continued to stagnate, the cost of living now exceeds what incomes and debt increases can sustain.

As I have discussed several times during the 4th-quarter of 2017:

Very likely, the next two quarters will be weaker than expected as the boost from hurricanes fade and higher interest rates take their toll on consumers. So, when mainstream media acts astonished that economic growth has once again slowed, you will already know why.”

Not surprisingly the economic data rolling in has been exceptionally weak and the first quarter GDP growth is now targeted at less than 2% annualized growth.

However, it is not only in the U.S. the economic “bump” is fading, but globally as well as Central Banks have started to remove their monetary accommodations. As noted by the ECRI:

“Our prediction last year of a global growth downturn was based on our 20-Country Long Leading Index, which, in 2016, foresaw the synchronized global growth upturn that the consensus only started to recognize around the spring of 2017.

With the synchronized global growth upturn in the rearview mirror, the downturn is no longer a forecast, but is now a fact.

The chart below shows that quarter-over-quarter annualized gross domestic product growth rates in the three largest advanced economies — the U.S., the euro zone, and Japan — have turned down. In all three, GDP growth peaked in the second or third quarter of 2017, and fell in the fourth quarter. This is what the start of a synchronized global growth downswing looks like.”

“Still, the groupthink on the synchronized global growth upturn is so pervasive that nobody seemed to notice that South Korea’s GDP contracted in the fourth quarter of 2017, partly due to the biggest drop in its exports in 33 years. And that news came as the country was in the spotlight as host of the winter Olympics.

Because it’s so export-dependent, South Korea is often a canary in the coal mine of global growth. So, when the Asian nation experiences slower growth — let alone negative growth — it’s a yellow flag for the global economy.

The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

You can see the slowdown occurring “real time” by taking a look at Personal Consumption Expenditures (PCE) which comprises roughly 70% of U.S. economic growth. (It is also worth noting that PCE  growth rates have been declining since 2016 which belies the “economic growth recovery” story.)

The point here is this:

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.”

While there may currently be “no sign of recession,” there are plenty of signs of “economic stress” such as:

The shift caused by the financial crisis, aging demographics, massive monetary interventions and the structural change in employment which has skewed the seasonal-adjustments in economic data. This makes every report from employment, retail sales, and manufacturing appear more robust than they would be otherwise. This is a problem mainstream analysis continues to overlook but will be used as an excuse when it reverses.

While the calls of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

As Howard Marks once quipped:

“Being right, but early in the call, is the same as being wrong.”

While being optimistic about the economy and the markets currently is far more entertaining than doom and gloom, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

Is there a recession currently? No.

Will there be a recession in the not so distant future? Absolutely.

But if you wait to “see it,” it will be too late to do anything about it.

Whether it is a mild, or “massive,” recession will make little difference to individuals as the net destruction of personal wealth will be just as damaging. Such is the nature of recessions on the financial markets.

# Is The Dot.Com Bubble Back?

Let me start out by saying I hate market comparisons.

While history certainly does “rhyme,” they are never the same. This is especially the case when it comes to the financial markets. Chart patterns may align from time to time, but such is more a function of pattern-fitting than anything else.

However, when it comes to fundamentals, standard-deviations, extensions, etc., it is a different story. A recent article by Ryan Vlastelica brought this to mind.

“While the strategy of investing in internet-related companies will likely always be first associated with the dot-com era, the long-lived bull market has proved to be just as strong a period for a sector that has influenced nearly every aspect of the economy.

Friday marks the ninth anniversary of the financial crisis bottom, and since that period—by one measure, the start of the current bull market—internet stocks have been among the best performers on Wall Street.”

“’The current tech rally is possibly the greatest investment story ever told,’ wrote Vincent Deluard, global macro strategist at INTL FCStone, who was speaking about the sector broadly, and not these ETFs in particular. He noted that the MSCI World Technology Index has added \$5.7 trillion in market capitalization since February 2009, ‘when the entire sector amounted to just \$1.5 trillion.’”

Since Ryan was probably in elementary school during the “Dot.com” era, and many current fund managers weren’t managing money either, it is easy to dismiss “history” under a “this time is different” scenario. Even the ETF’s used as an example of the “this time is different” scenario didn’t even exist prior to the “dot.com  bubble” (The QQQ didn’t come into existence until 1999)

Unfortunately, while the names of the companies may have changed, the current “dot.com boom” is likely more than just a “rhyme” with the past.

## Investors Once Again Being Misled

From a fundamental basis, there is a difference between today and the “Dot.com days of yore.” In 1999, “dot.com” companies were all bunched together and few actually made money. Fast forward to 2018, and the division between an “internet company” and every other company is now invisible. In fact, companies like Apple and Amazon are no longer even classified as “technology” companies but rather consumer goods companies.

But nonetheless, fundamentals don’t discriminate between classifications, and once again investors are paying excessively high prices for companies that generate very little, if any, profit.

Just after the “dot.com” bust, I wrote a valuation article quoting Scott McNeely, who was the CEO of Sun Microsystems at the time. At its peak, the company was trading at 10x its sales. (Price-to-Sales ratio) In a Bloomberg interview Scott made the following point.

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees.That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at \$64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

How many of the following “dot.com” companies do you currently own which are currently carrying price-to-sales in excess of 10x?  (Price-to-Sales above 2x becomes expensive. If I included companies with P/S of 5x or more, the list was just too expansive for this post.)

As noted above, there were only 3-ETF’s that existed just prior to the “dot.com” bubble -SPY, QQQ, and DIA. In order to do some better comparative analysis, I had to dig to find a technology-based mutual fund that existed back in 1990. Not surprisingly, there were very few but the T. Rowe Price Science and Technology (PRSCX) fund fit the bill and tracks the technology index very closely.

When we compare the fund to Shiller’s CAPE ratio, not surprisingly, since Technology makes up a quarter of the S&P 500 index, there is a high correlation between Technology and overall market valuation expansion and contraction.

As was the case in 1998-2000, the fund exploded higher as exuberance over the transformation of the world was occurring before our eyes. Investors globally were willing to pay “any price” to “get in on the action.”  Currently, investors are once again chasing returns in the “FANG” stocks with little regard to underlying value. The near vertical ramp in the fund is reminiscent of the late 1990’s as valuations continue to escalate higher.

The chart below shows this a bit more clearly. It compares the fund to both the RSI (relative strength index) and inflation-adjusted reported earnings of the S&P 500 on a QUARTERLY basis. Using quarterly data smooths volatility of these measures over time.

A couple of interesting points arise.

1. The RSI of the market is as overbought today as it was leading up to the “Dot.com” crash and more overbought today than just before the “financial crisis.”
2. Despite massive stock buybacks and cost reductions through wage and employment suppression, reported earnings have only grown by a little more than \$11 / share since the peak of the market in 2007. In other words, despite the ongoing bullish commentary about how great earnings are, they have actually only achieved a 1.14% annualized rate of growth.

Of course, investors have disregarded the lack of real earnings growth. The valuation surge is also shown in the analysis below. I have taken the price of the fund and divided by the inflation-adjusted reported earnings of the S&P 500, or a modified “P/E” ratio. While not a strictly apples-to-apples comparison, the point is that since Technology makes up roughly 25% of the market, it is a big driver of the “P” and not a huge contributor to the “E.”

Again, on this basis, investors are once again paying a high price for poor fundamental quality in the “hope” that someday the fundamentals will catch up with the price. It has never been the case, but one can always “hope.”

## Is The Dot.Com Bubble Back?

Whether you believe there is a “bubble” in the Technology stocks, or the markets, is really not important. There are plenty of arguments for both sides.

At the peak of every bull market in history, there was no one claiming that a crash was imminent. It was always the contrary with market pundits waging war against those nagging naysayers of the bullish mantra that “stocks have reached a permanently high plateau” or “this is a new secular bull market.”  (Here is why it isn’t.)

Yet, in the end, it was something unexpected, unknown or simply dismissed that devastated investors.

This is why the discussion of “this time is not like the last time” is largely irrelevant.

Individuals no longer “invest” to become a “shareholder” in a publicly traded business. The “quaint concept” of “valuations” died with the mainstreaming of investing during the 1990’s as the “Wall Street Casino” opened for business.

Today, investors only think in terms of speculating on “electronically traded bits of paper” in the hopes the value will rise over time. The problem, of course, is they are never told when to “sell” to capture that valuation increase which is the most critical aspect of the investment process. Instead, individuals continue to “bet” the “greater fool” will always appear.

For now, the “bullish case” remains alive and well. The media will go on berating those heretics who dare to point out the risks that prevail, but the one simple truth is “this time is indeed different.”

“When the crash ultimately comes the reasons will be different than they were in the past – only the outcome will remain same.”

Eventually, like all amateur gamblers in the Las Vegas casinos, the ride is a “blast while it lasts” but in the end, the “house always wins.”

# Sex, Money & Happiness

“Sex” and “Money” are probably two of the most powerful words in the English language. First, those two words got you to look at this article.  They also sell products, books, and services from “How To Have Better Sex” to “How To Make More Money” — ostensibly so you can have more of the former.

Unfortunately, they are also the two primary causes of divorce in the country today.

But “happiness,” is also an interesting word because it is ultimately derived from the ability to obtain money and the lifestyle with which it will afford.

Researchers at Purdue University recently studied data culled from across the globe and found that “happiness” doesn’t rise indefinitely with income. In fact, there were cut-off points at which more annual income had a negative effect on overall life satisfaction.

So, what’s that number? In the U.S., \$65,000 was found to be the optimal income for “feeling” happy.

While the media jumped on the headline, given median national incomes are closing in on \$60,000, they should have actually read the rest of the study.

The income figure is per individual.

So to calculate the required income number for “happiness” you must multiply that number by the square root of the household size. So, what’s the number for a couple, or a family of three or four?

• \$65,000 x √2 = \$92,000/year
• \$65,000 x √3 = \$112,000/year
• \$65,000 x √4 = \$130,000/year

That is an entirely different message from what most have been led to believe. An income of \$130,000/year is far above the average incomes from most Americans currently and ability to maintain the basic lifestyle is becoming ever more problematic.

In the U.S., despite higher levels of low income (now there’s an oxymoron), inflation-adjusted median incomes have remained virtually stagnant since 1998.

However, the chart above is grossly misleading because the income gains have only occurred in the Top 20% of income earners. For the bottom 80%, they are well short of the incomes needed to obtain “happiness.”

For most American “families”, who have to balance their living standards to their income, the “experience” of “happiness” is more of a function of “meeting obligations” each and every month.

Today, more than ever, the walk to the end of the driveway has become a dreaded thing as bills loom large in the dark crevices of the mailbox. If they can meet those obligations, they are “happy.” If not, not so much.

## The Financial Crisis Mindset

In my opinion, what the study failed to capture was the “change” in what was required to achieve “perceived” happiness following the “financial crisis.”

Just as with “The Great Depression,” individuals forever altered their feelings about banks, saving and investing after an entire generation had lost “everything.” It is the same today as sluggish wage growth has failed to keep up with the cost of living which has forced an entire generation into debt just to make ends meet.

As the chart below shows, while savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of “disposable income” for that same group. As a consequence, the inability to “save” has continued.

So, if we assume a “family of four” needs an income of \$132,000 a year to be “happy,” such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.”

The “gap” between the “standard of living” and real disposable incomes is more clearly 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 \$7000 annual deficit that cannot be filled.

The mirage of consumer wealth has been a function of surging debt levels which was accumulated during the credit boom. The problem is the debt simply can’t be disposed of through ordinary means.

• Many can’t sell their house because they can’t qualify to buy a new one
• The cost to rent is now higher than current mortgage payments in many places
• There is no ability to substantially increase disposable incomes because of deflationary wage pressures; and,
• Despite the mainstream spin on recent statistical economic improvements, the burdens on average American families are increasing namely in the things they can’t control health care, energy, and housing.

Nothing brought this to light more than the recent release of the Fed’s Report on “The Economic Well-Being Of U.S. Households.” The overarching problem can be summed up in one chart:

This isn’t just about the “baby boomers,” either.

Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents. In turn, parents are now part of the “sandwich generation” that are caught between taking care of kids and elderly parents. The rise in medical costs and health care goes unabated consuming more of their incomes.

More importantly, despite economic reports of rising employment, low jobless claims, surging corporate profitability and continuing economic expansion, the percentage of government transfer payments (social benefits) as compared to disposable incomes have surged to the highest level on record.

## More Money

Of course, by just looking at household net worth, once again you would not really suspect a problem existed. In the Fed’s latest Flow of Funds report, the Fed revealed households currently held \$112.4 trillion in assets with just a modest \$15.4 trillion in liabilities, which brought the net worth of the average US household to a new all-time high of \$96.9 trillion. The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.

However, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans.

Despite the mainstream media’s belief that surging asset prices, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy, it has really been anything but. Given the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same – “if you are wealthy – life is good.”

The illusion by many of ratios of “economic prosperity,” such as debt-to-income ratios, wages, assets, etc., is they are heavily skewed to the upside by the top 20%. Such masks the majority of Americans who have an inability to increase their standard of living.

While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.

Of course, when couples are stressed financially, they also become stressed “sexually.”

## Less Sex

Not surprisingly, the “financial stress” in American households is leading to other factors which are fueling the “demographic” problem in the future. The equation is very simple – when individuals are stressed over finances they are less active sexually.

This was shown in a recent study by the National Bureau of Economic Research. Ahead of the past three US recessions, the number of conceptions began to fall at least six months before the economy started to contract. As the FT notes, while previous research has shown how birth rates track economic cycles, the scientific study is the first to show that fertility declines are a leading indicator of recessions.

Daniel Hungerman, economics professor at the University of Notre Dame and one of the report’s authors, said

“It is ‘striking’ that the drop in pregnancies was evident before the recession that came after the 2007 financial crisis, since it has traditionally been argued that this slump had been hard to predict.”

The analysis used data on the 109 million births in the US between 1989-2016 to examine how fertility rates changed through the last three economic cycles — in the early 1990’s, the early 2000’s, and the late 2000’s. A similar pattern emerged in all three cases.

In other words, less sex with the intent to procreate.

“One way to think about this is that the decision to have a child often reflects one’s level of optimism about the future,” says Kasey Buckles, another Notre-Dame professor and co-author of the study. Research published through the NBER is often conducted by academics at their own universities.

To the researchers’ surprise, they found that falls in conceptions were a far better leading indicator of recessions than many commonly used indicators such as consumer confidence, measures of uncertainty, and purchases of big-ticket items such as washing machines and cars.

Of course, this decline in fertility, fuels one of the primary problems facing the U.S. over the next 30-years – the decline in the ratio of workers per retiree or “demographics.”  As retirees are living longer (increasing the relative number of retirees), and lower birth rates (decreasing the relative number of workers.) the “support ratio” is falling sharply.

The problem for American families today, despite media commentary to the contrary, is simply the inability to maintain their current standard of living. When incomes remain stagnant, or falls, due to job loss or reduction in pay, the impact on the budget at home is significant when there are already very low saving rates and the inability to access a tight credit market. The recent surge in consumer debt, with little relative increase in overall personal consumption expenditures, shows this to be the case. For Main Street, the economy remains mired at sub-par growth rates ten-years into a post-recessionary environment.

These financial strains are pervasive and continue to weigh on families and their relationships. While it is true that “money can’t buy happiness” try asking a couple who are working multiple part-time jobs just to “get by” about how “happy” they are.

# Common Trading Mistakes Investors Must Avoid

The recent stock market correction, and subsequent rally, revealed the many mistakes that investors consistently make when managing their money. Emotionally driven decisions almost always turn out badly and ultimately impair the long-term investment goals individuals are attempting to achieve.

Given that individuals are consistently promised investing in the financial markets is the only way to financial success, it is worthwhile to review the common mistakes most investors make. After all, if investing is “so easy,” why are the majority of American’s so broke?

Let’s dig into the myths, the mistakes and the steps to redemption.

Financial pundits across the country consistently promote the myth that one simply buys a basket of ETF’s, or individual stocks, and returns will compound at 8, 10 or 12% a year,

Nothing could be further from the truth.

On a nominal basis, it is true that if one bought an index, and held it for 20-years, they would have most likely made money. Unfortunately, making money, and reaching financial goals, are two ENTIRELY different things.

“The chart below shows the difference between two identical accounts. Each started at \$100,000, each had \$625/month in additions and both were adjusted for inflation and total returns. The purple line shows the amount of money required, inflation-adjusted, to provide a \$75,000 per year income to Bob at a 3% yield. The only difference between the two accounts is that one went to “cash” when the S&P 500 broke the 12-month moving average in order to avoid major losses of capital.”

For the majority of Americans, investing has never worked as promised.

The problem, as I have discussed many times previously, is that most individuals cannot manage their own money because of ‘short-termism.’

Despite their inherent belief that they are long-term investors, they are consistently swept up in the short-term movements of the market. Of course, with the media and Wall Street pushing the ‘you are missing it’ mantra as the market rises – who can really blame the average investor ‘panic’ buying market tops and selling out at market bottoms.”

Sy Harding summed this point up in his excellent book “Riding The Bear:”

“No such creature as a buy and hold investor ever emerged from the other side of the subsequent bear market.”

Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10% (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experienced net outflows of investor money. Fear is a stronger emotion than greed.

The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear). People will still sell out, usually at the very bottom, and almost always at a loss.

The only way to avoid the “buy high/sell low” syndrome –  is to avoid owning stocks during bear markets. If you try to ride a bear market out, odds are you’ll fail.

And if you believe that we are in a new era where Central Bankers have eliminated bear market cycles, your next of kin will have my sympathies.

Let’s look at some of the more common trading mistakes to which people are prone. Over the years, I’ve committed every sin on the list at least once and still do on occasion. Why? Because I am human too.

### 1) Refusing To Take A Loss – Until The Loss Takes You.

When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.

There is no shame in being wrongonly in STAYING wrong.

This goes to the heart of the familiar adage: “let winners run, cut losers short.”

Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in dead, or underperforming, money.

### 2) The Unrealized Loss

From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!

Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.

People are reluctant to sell a loser for a variety of reasons. For some, it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping and waiting for a loser to come back and save your fragile pride is just plain stupid.

Realize that your loser may NOT come back. And even if it does, a stock that is down 50% has to put up a 100% gain just to get back to even. Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly.

### 3) More Risk

It is often touted that they more risk you take, the more money you will make. While that is true, it also means the losses are more severe when the tide turns against you.

In portfolio management, the preservation of capital is paramount to long-term success. If you run out of chips the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, even if it earns nothing in a “ZIRP” world.

This gives you liquid cash to buy opportunities and keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency:”

This is the emergency that always occurs when you have the least amount of cash available – (Murphy’s Law #73)

If investors are supposed to “sell high” and “buy low,” such would suggest that as markets become more overbought, overextended, and overvalued, cash levels should rise accordingly. Conversely, as markets decline and become oversold and undervalued, cash levels should decline as equity exposure is increased.

Unfortunately, such has never actually been the case.

### 4) Bottom Feeding Knife Catchers

Unless you are really adept at technical analysis, and understand market cycles, it’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down a lot doesn’t mean it can’t go down further. In fact, a major multi-point drop is often just the beginning of a larger decline. It’s always satisfying to catch an exact low tick, but when it happens it’s usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”

Nobody, and I mean nobody, can consistently nail the bottom tick or top tick.

### 5) Averaging Down

Don’t do it. For one thing, you shouldn’t even have the opportunity, as a failing investment should have already been sold long ago.

The only time you should average into any investment is when it is working. If you enter a position on a fundamental or technical thesis, and it begins to work as expected thereby confirming your thesis to be correct, it is generally safe to increase your stake in that position.

### 6) You Can’t Fight City Hall OR The Trend

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it’s usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you.

It doesn’t make sense to counter trade the prevailing market trend. Don’t try and short stocks in a strong uptrend and don’t own stocks that are in a strong downtrend. Remember, investors don’t speculate – “The Trend Is Your Friend”

### 7) A Good Company Is Not Necessarily A Good Stock

There are some great companies that are mediocre stocks, and some mediocre companies that have been great stocks over a short time frame. Try not to confuse the two.

While fundamental analysis will identify great companies it doesn’t take into account market, and investor, sentiment. Analyzing price trends, a view of the “herd mentality,” can help in the determination of the “when” to buy a great company which is also a great stock.

### 8) Technically Trapped

Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators are working, and keep on working.

But always be aware of the fact that as market conditions change, so will the efficacy of indicators. Indicators that work well in one type of market may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions change.

There is no “Holy Grail” indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.

### 9) The Tale Of The Tape

I get a kick out of people who insist that they’re long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by listening to financial television.

Watching “the tape” can be dangerous. It leads to emotionalism and hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed. Turn off the television, get to a quiet place, and then calmly and logically execute your plan.

Don’t let tax considerations dictate your decision on whether to sell a stock.  Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.

“If you are paying taxes – you are making money…it’s better than the alternative”

## Steps to Redemption

Don’t confuse genius with a bull market. It’s not hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part. The market whips all our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.

Managing risk is the key to survival in the market and ultimately in making money.  Leave the pontificating to the talking heads on television. Focus on managing risk, market cycles and exposure.

STEP 1: Admit there is a problem… The first step in solving any problem is to realize that you have a problem and be willing to take the steps necessary to remedy the situation

STEP 2: You are where you are It doesn’t matter what your portfolio was in March of 2000, March of 2009 or last Friday.  Your portfolio value is exactly what it is rather it is realized or unrealized.  The loss is already lost and understanding that will help you come to grips with needing to make a change.

STEP 3:  You are not a loser… You made an investment mistake. You lost money. It has happened to every person that has ever invested in the stock market and anyone who says otherwise is a liar!

STEP 4:  Accept responsibility… In order to begin the repair process, you must accept responsibility for your situation. Continue to postpone the inevitable only leads to suffering further consequences of inaction.

STEP 5:  Understand that markets change… Markets change due to a huge variety of factors from interest rates to currency risks, political events to geo-economic challenges. Does it really make sense to buy and hold a static allocation in a dynamic environment?

The law of change states:  that change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change.

Therefore, even if you are a long-term investor, you have to modify and adapt to an ever-changing environment otherwise, you will become extinct.

STEP 6:  Ask for help… Don’t be afraid to ask or get help – yes, you may pay a little for the service but you will save a lot more in the future from not making costly investment mistakes.

STEP 7:  Make change gradually… Making changes to a portfolio should be done methodically and patiently. Portfolio management is more about “tweaking” performance rather than doing a complete “overhaul.”

STEP 8:  Develop a strategy… A goal-based investment strategy looks at goals like retirement, college funding, new house, etc. and matches investments and investment vehicles in an orderly and designed portfolio to achieve those goals in quantifiable and identifiable destinations. The duration of your portfolio should match the “time” frame to your goals. Building an allocation on 80-year average returns when you have a 15-year retirement goal will likely leave you in a very poor position.

STEP 9:  Learn it…Live it…Love it… Every move within your investment strategy must have a reason and purpose, otherwise, why do it? Adjustments to the plan, and the investments made, should match performance, time and value horizons. Most importantly, you must be committed to your strategy so that you will not deviate from it in times of emotional duress.

STEP 10:  Live your life… The whole point of investing in the first place is to ensure a quality of life at some specific point in the future. Therefore, while you work hard to earn your money today, it is important that your portfolio works just as hard to earn your money for tomorrow.

I hope you found this helpful.

“The great economist John Maynard Keynes once said: ‘Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.’” – John Coumarianos

The whole idea of “efficient markets” and “random walk” theories play out well on paper, they just never have in actual practice. The reality is investors make repeated emotional mistakes which are ultimately driven by the very volatility they are supposed to withstand.

These emotional mistakes, as I have discussed repeatedly in the past, are the biggest reason for underperformance by investors. These behavioral biases can be broadly defined as Loss Aversion, Narrow Framing, Anchoring, Mental Accounting, Lack of Diversification, Herding, Regret, Media Response, and Optimism.

When prices rise on a consistent basis, investors begin viewing stocks as a “no lose proposition which simply deliver high-rates of return over the long-term. The reality has actually been quite different. The chart below shows the real, total return, (inflation and dividends included) versus it’s annualized rate of return using a geometric average.

It took nearly 14-years just to break even and 18-years to generate just a 2.93% compounded annual rate of return since 2000. (If you back out dividends, it was virtually zero.) This is a far cry from the 6-8% annualized return assumptions promised to “buy and hold” investors.

But such a low rate of return should not have been surprising.

What drives stock prices (long-term) is the value of what you pay today for a future share of the company’s earnings in the future. Simply put – “it’s valuations, stupid.”

Instead of magical lottery tickets that automatically and necessarily reward those who wait, stocks are ownership units of businesses. That’s banal, I know, but everyone seems to forget it. And it means equity returns depend on how much you pay for their future profits, not on how much price volatility you can endure.

Stocks are not so efficiently priced that they are always poised to deliver satisfying returns even over a decade or more, as we’ve just witnessed for 18 years. A glance at future 10-year real returns based on the starting Shiller PE (price relative to past 10 years’ average, inflation-adjusted earnings) in the chart above tells the story. Buying high locks in low returns and vice versa.

Generally, if you pay a lot for profits, you’ll lock in lousy returns for a long time.

While volatility is the short-term price dynamics of “fear” and “greed” at play, in the long-term it is simply valuation. Despite the recent correction, valuations are once again pushing more extreme levels which suggest lower future forward returns.

With valuations at levels that have historically been coincident with the end, rather than the beginning, of bull markets, the expectation of future returns should be adjusted lower. This expectation is supported in the chart below which compares valuations to forward 10-year market returns.”

“The function of math is pretty simple – the more you pay, the less you get.”

As a long-term investor, we experience short-term price volatility as “opportunity,” and high prices as “risk.” With economic growth to remain weak, and valuation expansion elevated, the risk of high prices has risen sharply.

## Nothing But “Net”

This brings me to one of the biggest myths perpetrated by Wall Street on investors. Individuals are often shown some variation of the following chart to support the claim that over the “long-term” the stock market has generated a 10% annualized total return.

The statement is not entirely false. Since 1900, stock market appreciation plus dividends have provided investors with an AVERAGE return of 10% per year. Historically, 4%, or 40% of the total return, came from dividends alone. The other 60% came from capital appreciation that averaged 6% and equated to the long-term growth rate of the economy.

However, there are several fallacies with the notion the markets will compound over the long-term at 10% annually.

1) The market does not return 10% every year. There are many years where market returns have been sharply higher and significantly lower.

2) The analysis does not include the real world effects of inflation, taxes, fees and other expenses that subtract from total returns over the long-term.

3) You don’t have 146 years to invest and save.

The chart below shows what happens to a \$1000 investment from 1871 to present including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)

As you can see, there is a dramatic difference in outcomes over the long-term.

From 1871 to present the total nominal return was 9.15% versus just 6.93% on a “real” basis. While the percentages may not seem like much, over such a long period the ending value of the original \$1000 investment was lower by millions of dollars.

Importantly, the return that investors receive from the financial markets is more dependent on “WHEN” you begin investing with respect to “valuations” and your personal “life-span”.

Following on with the point above, with valuations currently at one of the highest levels on record, forward returns are very likely going to be substantially lower for an extended period. Yet, listen to the media, and the majority of the bullish analysts, and they are still suggesting that markets should compound at 8% annually going forward as stated by BofA:

“Based on current valuations, a regression analysis suggests compounded annual returns of 8% over the next 10 years with a 90% confidence interval of 4-12%. While this is below the average returns of 10% over the last 50 years, asset allocation is a zero-sum game. Against a backdrop of slow growth and shrinking liquidity, 8% is compelling in our view. With a 2% dividend yield, we think the S&P 500 will reach 3500 over the next 10 years, implying annual price returns of 6% per year.”

However, there are two main problems with that statement:

1) The Markets Have NEVER Returned 8-10% EVERY SINGLE Year.

Annualized rates of return and real rates of return are VASTLY different things. The destruction of capital during market downturns destroys years of previous capital appreciation. Furthermore, while the markets have indeed AVERAGED an 8% return over the last 117 years, you will NOT LIVE LONG ENOUGH to receive the same.

The chart below shows the real return of capital over time versus what was promised.

The shortfall in REAL returns is a very REAL PROBLEM for people planning their retirement.

2) Net, Net, Net Returns Are Even Worse

Okay, for a moment let’s just assume the Wall Street “world of fantasy” actually does exist and you can somehow achieve a stagnant rate of return over the next 10-years.

As discussed above, the “other” problem with the analysis is that it excludes the effects of fees, taxes, and inflation. Here is another way to look at it. Let’s start with the fantastical idea of 8% annualized rates of return.

8% – Inflation (historically 3%) – Taxes (roughly 1.5%) – Fees (avg. 1%) = 2.5%

Wait? What?

Hold on…it gets worse. Let’s look forward rather than backward.

Let’s assume that you started planning your retirement at the turn of the century (this gives us 15 years plus 15 years forward for a total of 30 years)

Based on current valuation levels future expected returns from stocks will be roughly 2% (which is what it has been for the last 17 years as well – which means the math works.)

Let’s also assume that inflation remains constant at 1.5% and include taxes and fees.

2% – Inflation (1.5%) – Taxes (1.5%) – Fees (1%) = -2.0%

A negative rate of real NET, NET return over the next 15 years is a very real problem. If I just held cash, I would, in theory, be better off.

However, this is why capital preservation and portfolio management is so critically important going forward.

There is no doubt that another major market reversion is coming. The only question is the timing of such an event which will wipe out the majority of the gains accrued during the first half of the current full market cycle. Assuming that you agree with that statement, here is the question:

“If you were offered cash for your portfolio today, would you sell it?”

This is the “dilemma” that all investors face today – including me.

# Housing Recovery? Or Another Fed Driven Inflation?

Last week, John Coumarianos penned an interesting piece discussing the surge in home prices over the last few months. To wit:

“The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet it seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.”

He is right.

Low rates, weak economic growth, cheap and available credit, and a need for income has inflated the third bubble of this century.

John makes a very interesting point of the potential for the recent bump in housing numbers to be part of the global asset chase.

While, there has been much hoped placed on the “housing recovery story” over the last few years, the hopes of a stronger housing-driven economic recovery has failed to emerge. But, in just the last few months, there has been, at last, an uptick in some of the data.

Is the improvement the beginning of “the” long-awaited housing recovery? Or, is it just the final inflation of a combined asset bubble driven by excess liquidity, cheap credit and a “yield chase” of epic proportions?

Let’s look at the data.

## At The Margin

The problem with much of the mainstream analysis is that it is based on the transactional side of housing which only represents what is happening at the “margin.”  The economic importance of housing is much more than just the relatively few number of individuals, as compared to the total population, that are actively seeking to buy, rent or sell a home each month.

To understand what is happening in terms of “housing,” we must analyze the “housing market” as a whole rather than what is just happening at the fringes. For this analysis, we can use the data published by the U.S. Census Bureau which can be found here.

## Total Housing Units

In an economy that is roughly 70% driven by consumption, it is grossly important that the working age population is, well, working.  More importantly, as discussed in “Yellen, Employment & Policy Errors

“This also explains why the labor force participation rate, of those that SHOULD be working (16-54 years of age), remains at the lowest levels since the early 1980’s. This chart alone should give Ms. Yellen pause in her estimations on the strength of the underlying economy.”

To present some context for the following analysis, we must first have some basis from which to work from. Our baseline for this analysis will be the number of total housing units which, as of Q4-2017, was 136,912,000 units. The chart below shows the historical progression of the seasonally adjusted number of housing units in the United States.

(Note: Importantly, despite data released by the marketing arms of the real estate which suggests that millions of units are being built each year. The reality is that from Q1 of 2009 until Q4 of 2017, there has been a TOTAL increase of just 5,911,000 units. This equates to an average increase of just 657,000 units per year.)

During that same period, the population of the U.S. grew by over 21,125.000 or an average of 2.35 million people per year. More importantly, since in order to own a home, one must have a job, those counted as having a job grew by almost 17-million during the same period.

Rising employment and population growth are strong drivers for the housing sector. After all, people have to live somewhere, right? But when we take a look at what homes are being sold, we see a deterioration in the percentage of homes being sold to those that comprise 80% of income and wage earners and an increase in those that belong to the top 20%.

Furthermore, there continues to be far more houses in the “process” stage (permits, starts and completions) than actual homes being sold.

This activity at “the margin” is further obfuscated by the seasonal adjustment, and annualization, of the data in the monthly reports. However, by analyzing the Census Bureau data of how many homes are sitting vacant, owner-occupied or being rented, we can obtain a much clearer picture of the real strength of the housing market and the purported recovery.

## Vacancy Rate

Out of the total number of housing units, some are vacant for a variety of reasons. They are second homes for some people that are only used occasionally. They are being held off-market for one reason or another (foreclosure, short sell, etc.), or they are for sale or rent. The chart below shows the total number of homes, as a percentage of the total number of housing units which are currently vacant.

If a real housing recovery were underway, the vacancy rate would be falling sharply rather than hovering only 0.5% below its all-time peak levels.

## Owner Occupied Housing

Another sign that a “real” housing recovery was underway would be an increase in actual home-ownership. The chart below shows the number of owner-occupied houses as a percentage of the total number of housing units available. See the problem here?

There are two important points here.

The first is the recent uptick in “occupied” housing doesn’t equate with the reported rise in home sales shown above.

Secondly, while owner-occupied housing as finally ticked up, it coincides with the recent jump in interest rates which is likely forcing buyers into the market temporarily. However, since rates have everything to do with “payments,” the bounce is likely ephemeral if rates do indeed rise further.

## Home Ownership

The reality is that there has been little recovery in housing. With nine years of economic recovery now in the rearview mirror, it is clear that the average American is not recovering as evidenced by the lowest level of home ownership since the 1980’s. The recent uptick, as stated above, coincides with a sharp acceleration in debt as interest rates have begun to pressure buyers.

However, the recent reports of sales, starts, permits, and completions have all certainly improved in recent months. Those transactions must be showing up somewhere, right?

As John notes, prices are rapidly rising in the “hotbed” areas. As the “Buy-to-Rent” game drives prices of homes higher, it reduces inventory and increases rental rates. This in turn prices out “first-time home buyers” who would become longer-term homeowners, hence the low rates of homeownership rates noted above. The chart below shows the number of homes that are renter-occupied versus the seasonally adjusted homeownership rate.

Speculators have flooded the market with a majority of the properties being paid for in cash and then turned into rentals. This activity drives the prices of homes higher, reduces inventory and increases rental rates which prices “first-time homebuyers” out of the market.

The recent rise in the home-ownership rate, and subsequent decline in renter-occupied housing, may an early sign of rental investors, aka hedge funds, beginning to exit the market. If rates rise further, raising borrowing costs, there could be a “rush for the exits” as the herd of speculative buyers turn into mass sellers. If there isn’t a large enough pool of qualified buyers to absorb the inventory, there will be a sharp reversion in prices.

There is no argument that housing has indeed improved from the depths of the housing crash in 2010. However, that recovery still remains at very weak historical levels and the majority of drivers used to get it this point have begun to fade. Furthermore, and most importantly, much of the recent analysis assumes this has been a natural, and organic, recovery. Nothing could be further from the truth as analysts have somehow forgotten the trillions of dollars, and regulatory support, infused to generate that recovery. More importantly, homebuilder sentiment has gone well beyond the actual level of activity.

The point here is that while the housing market has recovered – the media should be asking ‘Is that all the recovery there is?’

The housing recovery is ultimately a story of the “real” unemployment situation that still shows that roughly a quarter of the home buying cohort are unemployed and living at home with their parents. The remaining members of the home buying, household formation, contingent are employed but at lower ends of the pay scale and are choosing to rent due to budgetary considerations. This explains why the 12-month moving average of household formation, used to smooth very volatile data, is near its lowest levels going back to 1955.

While the “official” unemployment rate suggests that the U.S. is at full employment, the roughly 94-million individuals sitting outside the labor force would likely disagree. Furthermore, considering that those individuals make up roughly 50% of the 16-54 aged members of the workforce, it is no wonder that they are being pushed to rent due to budgetary considerations and an inability to qualify for a mortgage.

The risk to the housing recovery story remains in the Fed’s ability to continue to keep interest rates suppressed. As stated above, individuals “buy payments” rather than houses, so each tick higher in mortgage rates reduces someone’s ability to meet the monthly mortgage payment. With wages remain suppressed, and a large number of individuals either not working or on Federal subsidies, the pool of potential buyers remains contained.

The real crisis is NOT a lack of homes for people to buy, just the lack wage growth to be able to afford to. Of course, that probably says more about the “real economy” than just about anything else.

# There Will Be No Economic Boom

Last week, Congress passed a 2-year “continuing resolution, or C.R.,”  to keep the Government funded through the 2018 elections. While “fiscal conservatism” was just placed on the sacrificial alter to satisfy the “Re-election” Gods,” the bigger issue is the impact to the economy and, ultimately, the financial markets.

The passage of the \$400 billion C.R. has an impact that few people understand. When a C.R. is passed it keeps Government spending at the same previous baseline PLUS an 8% increase. The recent C.R. just added \$200 billion per year to that baseline. This means over the next decade, the C.R. will add \$2 Trillion in spending to the Federal budget. Then add to that any other spending approved such as the proposed \$200 billion for an infrastructure spending bill, money for DACA/Immigration reform, or a whole host of other social welfare programs that will require additional funding.

But that is only half the problem. The recent passage of tax reform will trim roughly \$2 Trillion from revenues over the next decade as well.

This is easy math.

Cut \$2 trillion in revenue, add \$2 trillion in spending, and you create a \$4 trillion dollar gap in the budget. Of course, that is \$4 Trillion in addition to the current run rate in spending which continues the current acceleration of the “debt problem.”

But it gets worse.

As Oxford Economics reported via Zerohedge:

The tax cuts passed late last year, combined with the spending bill Congress passed last week, will push deficits sharply higher. Furthermore, Trump’s own budget anticipates that US debt will hit \$30 trillion by 2028: an increase of \$10 trillion.”

Oxford is right. In order to “pay for” all of the proposed spending, at a time when the government will receive less revenue in the form of tax collections, the difference will be funded through debt issuance.

Simon Black recently penned an interesting note on this:

“Less than two weeks ago, the United States Department of Treasury very quietly released its own internal projections for the federal government’s budget deficits over the next several years. And the numbers are pretty gruesome.

In order to plug the gaps from its soaring deficits, the Treasury Department expects to borrow nearly \$1 trillion this fiscal year. Then nearly \$1.1 trillion next fiscal year. And up to \$1.3 trillion the year after that.

This means that the national debt will exceed \$25 trillion by September 30, 2020.”

You can project the run rate quite easily, and it isn’t pretty.

Of course, “fiscal responsibility” left Washington a long time ago, so, what’s another \$10 Trillion at this point?

While this issue is not lost on a vast majority of Americans that “choose” to pay attention, it has been quickly dismissed by much of the mainstream media, and Congressman running for re-election, by suggesting tax reform will significantly boost economic growth over the next decade. The general statement has been:

“By passing much-needed tax reform, we will finally unleash the economic growth engine which will more than pay for these tax cuts in the future.”

Don’t dismiss the importance of \$25-30 Trillion in U.S. debt. It is larger than the debts of every other nation in the world – combined.

## Congress Killed The Economic Boom

While it truly is a great “talking point,” the reality is it just isn’t true.

As I have shown previously, there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.

Even Congressman Kevin Brady, Chairman of the House Ways and Means Committee, confirmed the same.

Deficits, and deficit spending, are HIGHLY destructive to economic growth as it directly impacts gross receipts and saved capital equally. Like cancer – running deficits, along with continued deficit spending, continues to destroy saved capital and damages capital formation

Debt is, by its very nature, a cancer on economic growth. As debt levels rise it consumes more capital by diverting it from productive investments into debt service. As debt levels spread through the system it consumes greater amounts of capital until it eventually kills the host. The chart below shows the rise of federal debt and its impact on economic growth.

The reality is that the majority of the aggregate growth in the economy since 1980 has been financed by deficit spending, credit creation and a reduction in savings. This reduced productive investment in the economy and the output of the economy slowed. As the economy slowed, and wages fell, the consumer was forced to take on more leverage to maintain their standard of living which in turn decreased savings. As a result of the increased leverage more of their income was needed to service the debt – and with that, the “debt cancer” engulfed the system.

The Austrian business cycle theory attempts to explain business cycles through a set of ideas. The theory views business cycles:

As the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”

The problem that is yet not recognized by the current Administration and mainstream economists is that the excessive deficits and exponential credit creation can no longer be sustained. The process of a “credit contraction” will eventually occur over a long period of time as consumers and governments are ultimately forced to deal with the deficits.

The good news is the process of “clearing” the market will eventually allow resources to be reallocated back towards more efficient uses and the economy will begin to grow again at more sustainable and organic rates.

Today, however, expectations of a return to economic growth rates of the past are most likely just a fairy tale. The past 9-years of stock market returns have been fueled by trillions of dollars of support and direct injections into the financial system – that support is not sustainable in the long run. While the injections have kept the economy from falling into a depression in the short term – the unwinding of that support will suppress economic growth for many years to come.

There is no way to achieve the necessary goals “pain-free.”  The time to implement austerity measures is when the economy is running a budget surplus and is close to full employment. That time was two Administrations ago when the economy would have slowed but could have absorbed and adjusted to the restrictive measures. However, when things are good, no one wants to “fix what isn’t broken”. The problem today is that with a high dependency on government support, high levels of underemployment and rising budget deficits, the implementation of austerity measures will only deter future economic growth, which is dependent on the very things that need to be “fixed”.

The processes that fueled the economic growth over the last 30 years are now beginning to run in reverse, and when combined with the demographic shifts in the U.S., the impact could be far more immediate and prolonged than the media, economists, and analysts are currently expecting. Sacrifices will have to be made, the economy will drag on at subpar rates of growth, individuals will be working far longer into their retirement years and the next generation of Americans will lead a far different life than what the currently retiring generation enjoyed.

It is simply a function of the math.

# A Warning Shot For Passive Investing

Last week, investors received a “warning shot” about the dangers of “passive indexing.”

While the idea of “passive indexing” sounds harmless enough, we have spilled a lot of ink on this site digging into the relative dangers of it.

The biggest risk to investors is when “passive indexers” turn into “panic sellers.”

We witnessed it all first-hand last week.

The “sell off” proved our previous premise of the flaws of “passive investing.”

“While it is believed ETF investors have become ‘passive,’ the reality is they have simply become ‘active’ investors in a different form. As the markets decline, there will be a slow realization ‘this decline’ is something more than a ‘buy the dip’ opportunity. As losses mount, the anxiety of those ‘losses’ mounts until individuals seek to ‘avert further loss’ by selling.”

I have also stated that while “robo-advisors” are the new “shiny toy” for the markets to play with, and inexperienced investors to be lured into, when a crash does come, individuals will not be willing to just “ride it out.” To wit:

“The websites of two of the country’s biggest robo-advisers — Wealthfront Inc. and Betterment LLC — crashed on Monday as the S&P 500 Index sank. Complaints quickly spread across Reddit and other internet sites from people who had trouble logging onto their accounts.”

Yea….it’s that psychology thing.

Individuals just simply refuse to act “rationally” by holding their investments as they watch losses mount.

This behavioral bias of investors is one of the most serious risks arising from ETFs as the concentration of too much capital in too few places. But this concentration risk in ETF’s is not the first time this has occurred:

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

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing.

Until it goes in the other direction.

While the sell-off last week was not particularly unusual, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time.

Such a uniform sell-off is indicative of what we have been warning about for the last several months. For price chasing investors, last week’s plunge should serve as a warning.

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

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

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

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

As we have previously discussed, 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.

## That Wasn’t THE Crash…

Fortunately, while the price decline was indeed sharp, and a “rude awakening” for investors, it was not a “crash.”

It was just a correction within the ongoing “bullish trend.”

For now.

But nonetheless, the media has been quick to repeatedly point out the decline was the worst since 2008.

The question is “which” 10% decline was it?

From the amount of “digital ink” being spilled to telling investors “not to worry,” and given the fact markets remain in their currently “bullish trend,” this was probably the first. Regardless, as shown above, it was only a glimpse at what will eventually be the “real” decline when leverage is eventually clipped. I warned of this previously:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic 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. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.”

“Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.”

Make no mistake we are sitting on a “full tank of gas.”

## Don’t Just Stand There

One of the biggest problems facing investors is ultimately when “something goes wrong.” When this happens, the initial response is paralysis, followed by a bit of panic, before ultimately falling prey to the host of emotional mistakes that repeatedly plague investors time and again.

Currently, I do not believe that we have begun the next major corrective cycle just yet. There is simply too much momentum and bullish psychology in the market. Last week, the majority of the questions I received were not about “selling,” but rather is “now the time to ‘go all in?'”

The correction was most likely only that, for now.

However, this should be a clear “warning shot” to investors who have piled into ETF’s in the hopes indexing will offset the penalties of not paying attention to the risk they have taken on.

“While passive indexing works while all prices are rising, the reverse is also true.”

Importantly, it is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are still heavily stacked against substantial market gains from current levels.

In the near term, over the next several months, or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that, there is no guarantee.

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.”

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

The correction had the “perma-bulls” scrambling to produce commentary as to why markets will continue to only rise. Unfortunately, that is not the way markets actually work over the long-term and why the basic rules of investing are REALLY hard to follow.

If investing was as easy as the media and Wall Street portray it to be, then everyone would be wealthy from investing. Right?

The vast majority aren’t because investing without a discipline and strategy has horrid consequences.

So, what’s your plan for when the real correction ultimately begins?

# The Fed’s Dependence On Stability

Last week, I discussed how the Federal Reserve will likely be the culprits of whatever sparks the next major financial crisis. To wit:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 10-year rate, bad ‘stuff’ has historically followed.”

This past week, as Ms. Yellen relinquished her control over the Federal Reserve to Jerome Powell, the Fed stood by its position they intend to hike rates 3-more times in 2018.

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

The Fed is highly dependent on this assumption. After more than 9-years of the most unprecedented monetary policy program in human history, they are now trying to extricate themselves from it. The Fed is dependent on “everyone acting rationally,” particularly as they try to reduce their balance sheet. The first attempt was seen in January.

Well…sort of…but not really.

While the Fed did “reduce” their holding by \$28 billion in January, it followed an increase of \$21 billion in December. Which brings up several questions?

1. Was the ramp up/run down just a test of the market’s stability?  (Seems likely.)
2. With the market throwing a “conniption fit” last week, will the Fed rethink their balance sheet reduction program? (Probably)
3. More importantly, with the government on the verge of another “shut down” this coming week due to the expiration of the “continuing resolution” from three weeks ago, will the Fed continue its current path in the face of an event that could lead to fiscal instability?  (Probably not)

We will soon find out.

The chart below shows the cumulative weekly changes to the Fed’s balance sheet versus bond issuances by the Treasury to fill the deficit requirements. You can see the big spikes in issuances following repeated “debt ceiling” debates which were funded by “continuing resolutions.”

Given the current tenuous political environment in Washington, D.C., not to mention the poisonous  partisan divide between parties, there is a high probability next week could result in another potential “government shutdown” as funding is held up to extract political gain. Such could certainly roil the markets more.

In such an environment, if the Fed continues their \$30 billion balance sheet reduction program, they are “assuming” that “rational players” will step in to “buy” bonds keeping rates from spiking too quickly. The Fed most certainly understands the risks of sharply rising rates and the impact on the economy, and a bond market dislocation is “the weapon of mass destruction” they certainly want to avoid being launched.

I highly suspect we will see the Fed re-engage in their ongoing “reinvestment” cycle to stabilize markets until an impasse is reached by legislators in Washington.

But herein lies the risk.

The Fed is very likely walking into a trap of their own making.

With the recent spate of stronger economic data driven primarily by several natural disasters, the Fed is assuming that real, organic, economic growth is stronger than it is. While they point to macro-data points, like wages and employment, as a reason to lift interest rates to head off a potential overheating of the economy, the problem is when you break the data down to look at the real situation of the majority of Americans that drive the economy.

As I showed in this past weekends newsletter:

“Despite a rampant rise in the markets, the recent spate of economic growth has been due to massive natural disasters across the lower third of the U.S. The impetus from those rebuilding efforts are now running their course and we are already seeing a weakness in the numbers.

But wages are crushing it, and employment is booming?

Yes, wages are rising but only for the top 20% of workers.”

“And employment in the key demographic is not.”

Here is the problem for the Fed.

• The Federal Reserve is hiking the short-end of the yield curve, which hits variable-rate borrowers,
• At the same time, the longer-end is spiking higher, which reduces demand for borrowing for CapEx, investment and longer-dated loans, like mortgages, which is already seen in declining loan demand.
• Add to this the reduction in liquidity support for the market, and you have all the ingredients for something to go horribly wrong.

As I said last week:

“But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

All holdings.

The next bear market will not be like the last.

It will be worse because it will be spread across the entire financial ecosystem. Pensions, welfare, markets, debt, real estate and savings.”

But these are all assumptions that should not come to pass as long as “everyone remains rational.”

Unfortunately, historically speaking, such has not been the market’s “strongest trait.”

# The Fed Will Ignite The Next “Financial Crisis”

There seems to be a very large consensus the markets have entered into a “permanently high plateau,” or an era in which price corrections in asset prices have been effectively eliminated through fiscal and monetary policy.

Partnering with this fairytale like mindset is an overwhelming sense of complacency. Throughout the entire monetary ecosystem, there is a rising consensus that “debt doesn’t matter” as long as interest rates remain low. Of course, the ultra-low interest rate policy administered by the Federal Reserve is responsible for the “yield chase” which has fostered a massive surge in debt in the U.S. since the “financial crisis.”

As Ray Dalio, CEO of Bridgewater, recently noted:

“We’re in a perfect situation, inflation is not a problem, growth is good, but we have to keep in mind the part of the cycle we’re in.”

Yes, current economic growth is good, but not great. Inflation and interest rates currently remain low which creates an environment in which using debt remains opportunistic. But rising debt levels has a negative economic consequence. As shown, prior to the deregulation of the financial industry under Ronald Reagan, which led to an explosion in consumer credit issuance, it required just \$1.25 of total system-wide debt to create \$1.00 of economic growth. Today, it requires \$3.83 to create the same \$1 of economic growth. This shouldn’t be surprising, given that “debt” detracts from economic growth as the required “debt service” diverts income from savings and productive investment leading to a “diminishing rate of return” for each new dollar of debt.

However, debt levered economic cycles are a function of the ability to draw forward future consumption. But there is a finite limit to the “positive” effect of a debt-driven economic cycle.

Eventually, the “bill” must be paid.

This particular debt-levered economy has been supported by the ongoing, and seemingly never-ending, monetary stimulus being injected by Central Banks.

Therein lies the conundrum.

Since, “quantitative easing” programs are the Central Bank’s “emergency measures” for supporting the financial system during crisis events, then why are Central Banks still engaged in these programs nearly a decade later?

This is particularly worth asking given the widespread belief we are in a powerful “synchronized global recovery.”

Dalio is right.

“We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws.”

Yes, indeed. Everything does seem to be firing on all cylinders.

Official unemployment rates, jobless claims, and layoffs are all running near historic lows while a variety of production measures are running near record highs. As I stated last week:

“Economically speaking, things have rarely been better. The monthly Citigroup Economic Surprise index is hitting levels not seen 2004 and 2012. We can also confirm Citigroup’s index by comparing it to the Economic Output Composite Index which is also registering its highest levels since 2004 as well.

##### (The EOCI is comprised of the CFNAI, Chicago PMI, LEI, NFIB, ISM, and Fed regional surveys.)”

What could go wrong?

## Broke, More Broke & Levered Up

According to the June 2017 snapshot from the Social Security Administration, nearly 61.5 million people were receiving a monthly benefit check, of which 68.2% were retired workers. Of these 41.9 million retirees, more than 60% count on their Social Security to be a primary source of income.

Of course, that dependency ratio is directly tied to financial insolvency of the vast majority of Americans.  According to a Legg Mason Investment Survey, US “baby boomers” have on average \$263,000  saved in defined contribution plans. But that figure is less than half of the \$658,000 they say they will need to retire. As noted by GoBankingRates, more than half of Americans will retire broke.

This is a huge problem that will not only impact boomers in retirement, but also the economy and the financial markets. It also demonstrates just how important Social Security is for current and future generations of seniors.

While the financial media incessantly drone on about the rise of the stock market, the problem is that most Americans did not have the financial capacity to participate after two devastating bear markets particularly after following Wall Street advice.

As the cost of living is affected by the rising food, energy and healthcare prices without a compensatory increase in incomes – more families are forced to turn to underfunded government assistance in order to survive.

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. The black line represents the sum of the underlying sub-components.  While unemployment insurance has tapered off after its sharp rise post the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise.

Importantly, for the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

As millions of baby boomers begin to retire another problem emerges as well. Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold. There is a twofold problem caused by these successive crops of boomers heading into retirement:

1. Each boomer has not produced enough children to replace themselves which leads to a decline in the number of taxpaying workers. It takes about 25 years to grow a new taxpayer. We can estimate, with surprising accuracy, how many people born in a particular year will live to reach retirement. The retirees of 2070 were all born in 2003, and we can see and count them today.
2. The decline in economic prosperity, that we have discussed extensively, caused by excessive debt, reduction in savings, declining income growth due to productivity increases and the shift from a manufacturing to service-based society will continue to lead to lower levels of taxable incomes in the future.

As millions of “baby boomers” approach retirement, more strain is put on the fabric of the welfare system. The exact timing of this crunch is less important than its inevitability.

### Pensions Are Broke

But it is NOT just the “social security” pension system that is at risk, but rather ALL pensions upon which retirees are dependent on. This problem is not something born of the last “financial crisis,” but rather the culmination of 20-plus years of financial mismanagement.

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at \$3.5 trillion. That’s the amount not covered by current fund assets, future expected contributions, and investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with \$5.2 trillion, presuming that long-term bond yields average 2.6%.

With employee contribution requirements extremely low, averaging about 15% of payroll, the need to stretch for higher rates of return have put pensions in a precarious position and increases the underfunded status of pensions.

With pension funds already wrestling with largely underfunded liabilities, the shifting demographics as noted above are further complicating funding problems.

Lastly, and a point clearly missed by Ms. Yellen in her quest to dismiss financial crisis risks, is the \$3 Trillion “Pension Crisis” that is just one sharp market downturn away from imploding. The cresting of the “baby boom” generation now puts these massively underfunded pensions at risk of a “run on assets” during the next downturn which could send the entire system into chaos. Of course, this problem can be directly traced to the malfeasance of pension fund managers, and pension boards, which used excessively high return rates to lower costs of contributions.

By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system.

It is the same problem for the average American who plans on getting 6-8% return a year on their 401k plan, so why save money. Which explains why 8-out-of-10 American’s are woefully underfunded for retirement.”

The unfunded obligations of approximately \$4-\$5 trillion, depending on the estimates, would have to be set aside today such that the principal and interest would cover the program’s shortfall between tax revenues and payouts over the next 75 years.

That ain’t gonna happen.

When the next major bear market comes growling, the “financial crisis” won’t be secluded to just sub-prime auto loans, student loans, and commercial real estate. The real crisis comes when there is a “run on pensions” when the “fear” prevails that benefits will be lost entirely.

As George Will recently wrote:

“The problems of state and local pensions are cumulatively huge. The problems of Social Security and Medicare are each huge, but in 2016 neither candidate addressed them, and today’s White House chief of staff vows that the administration will not ‘meddle’ with either program. Demography, however, is destiny for entitlements, so arithmetic will do the meddling.”

### All Levered Up

American corporations are levered to the hilt with total corporate debt surging to \$8.7 trillion – its highest level relative to U.S. GDP (45%) since the financial crisis. In just the last two years, corporations have issued another \$1 trillion of new debt NOT for expansion but primarily for share buybacks to boost bottom line earnings per share.

Note: This is also why “repatriation” won’t lead to massive economic growth, wages or employment. Instead, it will largely go to share buybacks, dividends, and executive compensation, none of which promote innovation, the lifeline for future economic growth.

For the last 9-years, the Fed’s “zero interest rate policy” has left investors chasing yield and corporations were glad to oblige. The end result is the risk premium for owning corporate bonds over U.S. Treasuries is at historic lows.

I have written for some time that during the next market reversion, the 10-year rate will fall towards “zero” as money seeks the stability and safety of the U.S Treasury bond. However, corporate bonds are an entirely different issue. When “high yield,” or “junk bonds,” begin to default in great numbers, as they always do in a recession, which is why they are called “junk bonds” to begin with, investors will face sharp losses on the one side of their portfolio they “thought” was supposed to be safe.

Let the panic selling begin.

As shown below, when the rout begins, the yields on junk bonds sharply deviate from that of the U.S. Treasury bond. Again, the 10-year Treasury rate is not going higher anytime soon, but everything else likely will.

Of course, as investors begin to get battered by the “volatility and junk bond storms,” the subsequent decline in equity valuations triggers “margin calls.”

As the markets decline, there will be a slow realization “this decline” is something more than a “buy the dip” opportunity. As losses mount, the anxiety of those “losses” mount until individuals seek to “avert further loss” by selling.

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.

Importantly, don’t mistake record margin debt levels as people borrowing against their portfolio just to make larger investment bets. In reality, they are also using leverage to support their lifestyle as well, after all, as long as stocks keep rising it’s like “free money.”  Right?

This is shown in both the level of debt used to support the standard of living and the relationship between real, inflation-adjusted, margin debt and economic growth.

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

## The Fed Has Lit The Fuse

In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became “active,” monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 10-year rate, bad “stuff” has historically followed.

With the Fed expected to hike rates 3-more times in 2018, it is likely the Fed has already “lit the fuse” on the next financial crisis-related event.

But the risk to investors is NOT just a market decline of 40-50%.

While such a decline, in and of itself, would devastate the already underfunded 80% of the population that is currently woefully under-prepared for retirement, it would also unleash a host of related collapses throughout the economy as a rush to liquidate holdings accelerates.

All holdings.

The next bear market will not be like the last.

It will be worse because it will be spread across the entire financial ecosystem. Pensions, welfare, markets, debt, real estate and savings.

I could be wrong.

Hopefully, I am.

But isn’t it worth having a plan in place just in case I’m not?

“Strategy without tactics is the longest path to victory; tactics without strategy is the noise before defeat.” Sun Tzu, The Art of War