Tag Archives: fixed income

Digging For Value in a Pile of Manure

A special thank you to Brett Freeze of Global Technical Analysis for his analytical rigor and technical expertise.

There is an old story about a little boy who was such an extreme optimist that his worried parents took him to a psychiatrist. The doctor decided to try to temper the young boy’s optimism by ushering him into a room full of horse manure. Promptly the boy waded enthusiastically into the middle of the room saying, “I know there’s a pony in here somewhere!”

Such as it is with markets these days.

Finding Opportunity

These days, we often hear that the financial markets are caught up in the “Everything Bubble.” Stocks are overvalued, trillions in sovereign debt trade with negative interest rates, corporate credit, both investment grade, and high yield seem to trade with far more risk than return, and so on. However, as investors, we must ask, can we dig through this muck and find the pony in the room.

To frame this discussion, it is worth considering the contrast in risk between several credit market categories. According to the Bloomberg-Barclays Aggregate Investment Grade Corporate Index, yields at the end of January 2020 were hovering around 2.55% and in a range between 2.10% for double-A (AA) credits and 2.85% for triple-B (BBB) credits. That means the yield “pick-up” to move down in credit from AA to BBB is only worth 0.75%. If you shifted $1 million out of AA and into BBB, you should anticipate receiving an extra $7,500 per year as compensation for taking on significantly more risk. Gaining only 0.75% seems paltry compared to historical spreads, but in a world of microscopic yields, investors are desperate for income and willing to forego risk management and sound judgment.

As if the poor risk premium to own BBB over AA is not enough, one must also consider there is an unusually high concentration of BBB bonds currently outstanding as a percentage of the total amount of bonds in the investment-grade universe. The graph below from our article, The Corporate Maginot Line, shows how BBB bonds have become a larger part of the corporate bond universe versus all other credit tiers.

In that article, we discussed and highlighted how more bonds than ever in the history of corporate credit markets rest one step away from losing their investment-grade credit status.

Furthermore, as shared in the article and shown below, there is evidence that many of those companies are not even worthy of the BBB rating, having debt ratios that are incompatible with investment-grade categories. That too is troubling.

A second and often overlooked factor in evaluating risk is the price risk embedded in these bonds. In the fixed income markets, interest rate risk is typically assessed with a calculation called duration. Similar to beta in stocks, duration allows an investor to estimate how a change in interest rates will affect the price of the bond. Simply, if interest rates were to rise by 100 basis points (1.00%), duration allows us to quantify the effect on the price of a bond. How much money would be lost? That, after all, is what defines risk.

Currently, duration risk in the corporate credit market is higher than at any time in at least the last 30 years. At a duration of 8.05 years on average for the investment-grade bond market, an interest rate increase of 1.00% would coincide with the price of a bond with a duration of 8.05 to fall by 8.05%. In that case a par priced bond (price of 100) would drop to 91.95.

Yield Per Unit of Duration

Those two metrics, yield and duration, bring us to an important measure of value and a tool to compare different fixed income securities and classes. Combining the two measures and calculating yield per unit of duration, offers unique insight. Specifically, the calculation measures how much yield an investor receives (return) relative to the amount of duration (risk). This ratio is similar to the Sharpe Ratio for stocks but forward-looking, not backward-looking.

In the case of the aggregate investment-grade corporate bond market as described above, dividing 2.55% yield by the 8.05 duration produces a ratio of 0.317. Put another way, an investor is receiving 31.7 basis points of yield for each unit of duration risk. That is pretty skinny.

After all that digging, it may seem as though there may not be a pony in the corporate bond market. What we have determined is that investors appear to be indiscriminately plowing money into the corporate credit market without giving much thought to the minimal returns and heightened risk. As we have described on several other occasions, this is yet another symptom of the passive investing phenomenon.

Our Pony

If we compare the corporate yield per unit of duration metric to the same metric for mortgage-backed securities (MBS) we very well may have found our pony. The table below offers a comparison of yield per unit of duration ratios as of the end of January:

Clearly, the poorest risk-reward categories are in the corporate bond sectors with very low ratios. As shown, the ratios currently sit at nearly two standard deviations rich to the average. Conversely, the MBS sector has a ratio of 0.863, which is nearly three times that of the corporate sectors and is almost 1.5 standard deviations above the average for the mortgage sector.

The chart below puts further context to the MBS yield per unit of duration ratio to the investment-grade corporate sector. As shown, MBS are at their cheapest levels as compared to corporates since 2015.

Chart Courtesy Brett Freeze – Global Technical Analysis

MBS, such as those issued by Fannie Mae and Freddie Mac, are guaranteed against default by the U.S. government, which means that unlike corporate bonds, the bonds will always mature or be repaid at par. Because of this protection, they are rated AAA. MBS also have the added benefit of being intrinsically well diversified. The interest and principal of a mortgage bond are backed by thousands and even tens of thousands of different homeowners from many different geographical and socio-economic locations. Maybe most important, homeowners are desperately interested in keeping the roof over their head

In contrast, a bond issued by IBM is backed solely by that one company and its capabilities to service the debt. No matter how many homeowners default, an MBS investor is guaranteed to receive par or 100 cents on the dollar. Investors of IBM, or any other corporate bond, on the other hand, may not be quite so lucky.

It is important to note that if an investor pays a premium for a mortgage bond, say a 102-dollar price, and receives par in return, a loss may be incurred. The determining factor is how much cash flow was received from coupon payments over time. The same equally holds for corporate bonds. What differentiates corporate bonds from MBS is that the risk of a large loss is much lower for MBS.


As the chart and table above reveal, AAA-rated MBS currently have a very favorable risk-reward when compared with investment-grade corporate bonds at a comparable yield.

Although the world is distracted by celebrity investing in the FAANG stocks, Tesla, and now corporate debt, our preference is to find high quality investment options that deliver excellent risk-adjusted returns, or at a minimum improve them.

This analysis argues for one of two outcomes as it relates to the fixed income markets. If one is seeking fixed income credit exposure, they are better served to shift their asset allocation to a heavier weighting of MBS as opposed to investment-grade corporate bonds. Secondly, it suggests that reducing exposure to corporate bonds on an outright basis is prudent given their extreme valuations. Although cash or the money markets do not offer much yield, they are always powerful in terms of the option it affords should the equity and fixed income markets finally come to their senses and mean revert.

With so many assets having historically expensive valuations, it is a difficult time to be an optimist. However, despite limited options, it is encouraging to know there are still a few ponies around, one just has to hold their nose and get a little dirty to find it.

Comparing Yield Curves

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

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

Bull or Bear Flattening

In this section, we graph the seven yield curve inversions since 1978, showing how ten-year U.S. Treasuries (UST), two-year UST and the 10-year/2 year curve performed in the year before the inversion.

Before progressing, it is worth defining some bond trading lingo:

  • Steepener- Describes a situation in which the difference between the yield on the 10-year UST and the yield on the 2y-year UST is increasing. Steepeners can occur when both securities are trending up or down in yield or when the 2-year yield declines while the 10-year yield increases.
  • Flattener- A flattener is the opposite of a steepener, and the difference between yields is declining.  As shown in the graph above, the slope of the curve has been in a flattening trend for the last five years.
  • Bullish/Bearish- The terms steepener and flattener are typically preceded with the descriptor bullish or bearish. Bullish means yields are declining (bond prices are rising) while bearish means yields are rising (bond prices are falling). For instance, a bullish flattener means that both 2s and 10s are declining in yield but 10s are declining at a quicker pace. A bearish flattener implies that yields for 2s and 10s are rising with 2s increasing at a faster pace.  Currently, we are witnessing a bullish flattener. All inversions, by definition, are preceded by a flattening trend.

As shown in the seven graphs below, there are two distinct patterns, bullish flatteners and bearish flatteners, which emerged before each of the last seven inversions. The red arrows highlight the general trend of yields during the year leading up to the curve inversion.  

Data for all graphs courtesy St. Louis Federal Reserve

Five of the seven instances exhibited a bearish flattening before inversion. In other words, yields rose for both two and ten year Treasuries and two year yields were rising more than tens. The exceptions are 1998 and the current period. These two instances were/are bullish flatteners.

Bearish Flattener

As the amount of debt outstanding outpaces growth in the economy, the reliance on debt and the level of interest rates becomes a larger factor driving economic activity and monetary and fiscal policy decisions. In five of the seven instances graphed, interest rates rose as economic growth accelerated and consumer prices perked up. While the seven periods are different in many ways, higher interest rates were a key factor leading to recession. Higher interest rates reduce the incentive to borrow, ultimately slowing growth and in these cases resulted in a recession.

Bullish Insurance Flattener

As noted, the current period and 1998 are different from the other periods shown. Today, as in 1998, yields are falling as the 10-year Treasury yield drops faster than the 2-year Treasury yield. The curve thus flattens and ultimately inverts.

Seven years into the economic expansion, during the fall of 1998, the Fed cut rates in three 25 basis point increments. Deemed “insurance cuts,” the purpose was to counteract concerns about sluggish growth overseas and financial market concerns stemming from the Asian crisis, Russian default, and the failure of hedge fund giant Long Term Capital. The yield curve inversion was another factor driving the Fed. The domestic economy during the period was strong, with real GDP staying above 4%, well above the natural growth rate.  

The current period is somewhat similar. The U.S. economy, while not nearly as strong as the ’98 experience, has registered above-trend economic growth for the last two years. Also similar to 1998, there are exogenous factors that are concerning for the Fed. At the top of the list are the trade war and sharply slowing economic activity in Europe and China. Like in 1998, we can add the newly inverted yield curve to the list.

The Fed reduced rates by 25 basis points on July 31, 2019. Chairman Powell characterized the cut as a “mid-cycle adjustment” designed to ensure solid economic growth and support the record-long expansion. Some Fed members are describing the cuts as an insurance measure, similar to the language employed in 1998.

If 1998-like “insurance” measures are the Fed’s game plan to counteract recessionary pressures, we must ask if the periods are similar enough to ascertain what may happen this time.

A key differentiating factor between today and the late 1990s is not only the amount of debt but the dependence on it.   Over the last 20 years, the amount of total debt as a ratio to GDP increased from 2.5x to over 3.5x.

Data Courtesy St. Louis Federal Reserve

In 1998, believe it or not, the U.S. government ran a fiscal surplus and Treasury debt issuance was declining. Today, the reliance on debt for new economic activity and the burden of servicing old debt has never been greater in the United States. Because rates are already at or near 300-year lows, unlike 1998, the marginal benefits from borrowing and spending as a result of lower rates are much less economically significant currently.

In 1998, the internet was in its infancy and its productive benefits were just being discovered. Productivity, an essential element for economic growth, was booming. By comparison, current productivity growth has been lifeless for well over the last decade.

Demographics, the other key factor driving economic activity, was also a significant component of economic growth. Twenty years ago, the baby boomers were in their spending and investing prime. Today they are retiring at a rate of 10,000 per day, reducing their consumption and drawing down their investment accounts.

The key point is that lower rates are far less likely to spur economic activity today than in 1998. Additionally, the natural rate of economic growth is lower today, so the economy is more susceptible to recession given a smaller decline in economic activity than it was in 1998.

The 1998 rate cuts led to an explosion of speculative behavior primarily in the tech sectors. From October of 1998 when the Fed first cut rates, to the market peak in March of 2000, the NASDAQ index rose over 300%. Many equity valuation ratios from the period set records.

We have witnessed a similar but broader-based speculative fervor over the last five years. Valuations in some cases have exceeded those of the late 1990s and in other cases stand right below them. While the economic, productivity, and demographic backdrops are not the same, we cannot rule out that Fed cuts might fuel another explosive rally. If this were to occur, it will further reduce expected returns and could lead to a crushing decline in the years following as occurred in the early 2000s.  


A yield curve inversion is the bond market’s way of telegraphing concern that economic growth will slow in the coming months. Markets do not offer guarantees, but the 2s-10s yield curve has been right every time in the last 30 years it voiced this concern. As the book of Ecclesiastes reminds us, “the race does not always go to the swift nor the battle to the strong…”, but that’s the way to bet.

Insurance rate cuts may buy the record-long economic expansion another year or two as they did 20 years ago, but the marginal benefit of lower rates is not nearly as powerful today as it was in 1998.

Whether the Fed combats a recession in the months ahead as the bond market warns or in a couple of years, they are very limited in their abilities. In 2000 and 2001, the Fed cut rates by a total of 575 basis points, leaving the Fed Funds rate at 1.00%. This time around, the Fed can only cut rates by 225 basis points until it reaches zero percent. When we reach that point, and historical precedence argues it will be quicker than many assume, we must then ask how negative rates, QE, or both will affect the economy and markets. For this there is no prescriptive answer.

Fixed Income Review – July 2019

We delayed publishing the July Fixed Income Review so we can present fresh data and comment on the surge in volatility following the Fed meeting (7/31) and new tariffs on China (8/1). 

In general, the fixed income markets were mostly sleep-walking through July in anticipation of a July 31st Federal Reserve rate cut and a much-anticipated dovish statement from the Fed.  As if on autopilot, stock markets slogged higher and credit spreads moved tighter throughout the month. Meanwhile, Treasury yields rose modestly after their dramatic declines in May and June. Indeed, as the table below reflects, Treasuries were the only major fixed-income class to lose ground on a total return basis in July. All other categories posted positive returns for the month.

In stark contrast, the ETF table below highlights some of the significant changes we have seen since the beginning of August.

Following the Federal Open Market Committee (FOMC) meeting on July 31 and the subsequent press conference delivered by Chairman Jerome Powell, the future of monetary policy was suddenly in question. For the first time in several months, the Fed failed to deliver a dovish surprise.

Part of Powell’s response to the first question in the press conference regarding the “hurdle” for further rate cuts was as follows:

“…the committee is really thinking of this as a way of adjusting policy to a somewhat more accommodative stance to further the three objectives that I mentioned. To ensure against downside risks, to provide support to the economy that those factors are pushing down on economic growth and then to support inflation. So, we do think it’ll serve all of those goals. But again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

Despite the evidence and assurances of rate cuts to provide a firebreak against any potential weakening of the economy, Powell’s reference to “a midcycle adjustment” suddenly raised doubts about their conviction for further easing.  

Given the strength of the U.S. economy, the “downside risks” he refers to are clearly emanating from foreign sources. Now add a Fed that may not be ready to cut rates further and the renewed escalation of the trade war between the U.S. and China and one has a potent cocktail for the volatility seen since the end of July.

As can be seen in the tables above, fixed-income markets in July were mostly a non-event but the first several days of August have been full of fireworks. The table below illustrates the move in U.S. Treasury yields since July 31.

Investment grade and high yield markets reacted with some displeasure to Jerome Powell’s comments and new rhetoric from the administration on trade and tariff challenges associated with China. Although the magnitude of the spread changes did not breach any meaningful technical levels, the speed of the change was rather head-snapping.

We end up in a familiar place. If we are to take the Chairman at his word and potential downside risks warrant a rate cut, it becomes even more challenging to justify the valuations investors are being asked to pay to own risky assets. Despite having posted new highs in recent weeks, the S&P 500 has produced a 3.48% annualized total return over the past 18 months along with volatility of 15.5%. High yield bonds have delivered annualized total returns of 4.80% with 12.9% volatility. Net out the most recent inflation data of 1.6% from those numbers and we struggle to understand why investors have been so enthusiastic.

Eighteen months ago, one could buy 10-year Treasuries at a 2.85% yield. The 7-10 year ETF (Ticker: IEF) has delivered 3.55% total return and with only 4.4% volatility. Needless to say, while not glamorous, the risk-free route provided returns on par with stocks and high-yield but with significantly less volatility. Given the risks Chairman Powell has outlined, might Treasuries, despite near-record low yields, be the safe place to hide in fixed income for the time being? Astute, rational investors will either figure that out on their own or the market will impose its will.

All Data Courtesy Barclays

Fixed Income Review – June 2019

As central banks have become collectively more dovish throughout 2019, monetary stimulus appears to be back in control of the economic cycle. The Federal Reserve ratcheted up their easing posture at the June Federal Open Market Committee (FOMC) meeting as one voting member dissented from the group in favor of a rate cut. There were other non-voting members even arguing for a 50 basis point rate cut on concerns about the economic outlook and still muted inflation pressures. Keep in mind this abrupt flip in policy is coming despite unemployment at near half-century lows and inflation hovering around 2.0%, the supposed Fed target.

With that backdrop in play, it is no surprise that June was a good month for all risk assets. Within the Fixed income arena, the riskiest of bonds outperformed against the spectrum of safer fixed-income products. As the table below highlights, every major category performed well with emerging markets (EM) leading the way and investment grade (IG) and high yield (HY) corporate returns close behind.

Fixed income has now completed a “round trip” from June 2018 as yields and spreads in almost every category are back below the levels observed at the same time last year. The tables below illustrate those moves in both yields and spreads.

The anticipation of what is being called “insurance rate cuts” from the Fed as well as easing measures expected from the European Central Bank (ECB), offered investors comfort that these potential actions will keep downside risk and volatility at bay. The hope is that the central bankers are sufficiently ahead of the curve in combating weaker global growth.

Despite investor optimism about the outlook as evidenced in the first half performance, risks remain. Most notably, ongoing deceleration in trade and industrial activity could worsen and bring an end to the current record-long economic U.S. expansion. The United States is surrounded by economies that are faltering, including Canada, Australia, Europe, Japan, much of southeast Asia and, most importantly, China. The Trump trade policy agenda only adds to these risks, especially for those countries dependent on exports for economic growth.

If risks do not abate, then we should expect forceful actions from central bankers. The common response of Treasury yields and the yield curve is for the short end (out to two- or three-year maturities) to drop significantly and the long end to either hold steady or fall but much less so than short rates resulting in what is called a bullish curve steepener. As we discussed in Yesterday’s Perfect Recession Warning May Be Failing You, past episodes of rate cuts illustrate this effect.

With investors complacent, yields and spreads on risky assets back to extremely rich levels, and global trouble brewing, the pleasant by-product of recent Fed rhetoric might quickly be disrupted. If so, the gains of the first half of 2019 would become a vague memory.

Apart from slowing global trade and industrial activity, keep in mind there are plenty of other potentially disruptive issues at hand including China leverage, Brexit, the contentious circumstances between the U.S. and Iran, the Italian government fighting with the European Commission on fiscal issues, Turkish currency depreciation, on-going problems in Argentina and more.

At the moment, the Fed and the ECB appear to have the upper hand on the markets, and higher yielding asset alternatives that reward an investor for taking risk are benefiting. Still, a critical assessment of the current landscape demands that investors engage and think critically about the risk-reward trade-off under current circumstances. The Fed and the ECB are not hyper-cautious and dovish for no reason at all. There is more to the current economic dynamic than meets the passive observer’s eye.

All Data Courtesy Barclays

Fixed Income Review – May 2019

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Fixed Income Review – April 2019

The positive trends of the first quarter extended into April with broad-based total return gains across nearly every major fixed-income category. Only the safest corners of the bond markets posted negative returns last month, albeit those losses were quite minor in contrast with the positive returns since the end of 2018.

Returns in April, across the spectrum of indices, were not as impressive as those seen in the first three months of the year. No one expected those types of moves nor would anyone, having enjoyed them, expect them indefinitely. The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds, especially in credit-sensitive sectors, are becoming more obvious as we will discuss below.

As mentioned, the only two modest losers in April were Treasuries and securitized products (mortgages, asset-backeds, and commercial mortgages). Otherwise, the high yield sector again won the day head and shoulders above investment grade corporates, the next closest performer. According to the heat map below, like last month, all sectors are green across all longer time frames adding emphasis to the impressive rally seen since Christmas.

We would not speculate on the likelihood of this trend continuing, as odds favor a weaker performance trajectory. That does not mean poor performance, but risks rise with prices and spreads perched at historically tight levels.

The charts below illustrate the option-adjusted spreads (OAS) for the major categories in the corporate universe. They have all tightened dramatically since the end of the year. If we are correct that the spread tightening is largely done, then the preference would be to play for safety, and some interest carry for the next few months. In doing so, one may miss another unexpected move tighter in very risky high yield bond spreads; however, given current spread levels, one may also avoid increased odds of poor performance and possible losses.

Understanding that compounding wealth depends on avoiding large, damaging, emotional losses we would prefer to accept the risk of lower returns with high-grade securities while reducing our exposure to the riskier, more volatile sectors.

Although cheapening more dramatically than the Investment Grade (IG) sector in the fourth quarter, High Yield (junk) bonds recaptured much of that in the first four months of this year and in doing so returns junk bonds to (more than) full-value status.

The same can also be said for the lower credit sectors within the IG population. A long-term perspective offers proper context for where valuations are today relative to the past 25 years. The risk is clearly skewed to wider credit spreads and cheaper valuations (losses).

The Trend Continues

The recent tightening of spreads offers little new to discuss other than some deceleration of price and spread action. Importantly, and as recent articles have emphasized, this is a very late stage cycle rally. Risks are rising that corporate margin headwinds, slowing global economic activity, and a high bar for rate cuts given the optical strength of the economy limit the scope for price and spread gains in credit.

Overweighting lower rated credit sectors of the fixed income market is currently akin to the well-known phrase “picking nickels up in front of a steam roller.”

All Data Courtesy Barclays

Time To Recycle Your Junk

Invariably, investors who disregard where they stand in cycles are bound to suffer serious consequences” – Howard Marks

If you believe, as we do, that the current economic cycle is likely at a similar point as 2006/07, then you should consider heeding the warning of the charts we are about to show you.

The current economic cycle stretching from the market peak of 2006/07 to today started with euphoria in the housing markets and investors taking a general indifference towards risk-taking. In 2008, reality caught up with the financial markets and desperation fueled sharp drawdowns, punishing many risky assets. The recovery that began in 2009 has been increasingly fueled by investor enthusiasm. While the stock market gets the headlines, this fervor has been every bit as evident in the junk bond sector of the corporate fixed- income markets.

Has This Cycle Reached Its Tail illustrated how investor sentiment and economic activity has evolved, or cycled, over the last 12 years. We recommend reading it as additional background for this article.

The Popularity of Junk

Junk debt or non-investment grade securities also known as high yield debt will be referred to as “junk” for the remainder of this article. They are defined as corporate debt with a credit rating below the investment grade threshold (BBB-/Baa3), otherwise known as “triple B.”

Historically, buyers of junk debt were credit specialists due to the need for an in-depth understanding of the accounting and financial statements of companies that bear a larger risk of default. Extensive analysis was required to determine if the higher yield offered by those securities was enough to cushion the elevated risk of default. The following questions are just a small sample of those a junk investor would want to answer:

  • Will the company’s cash flow be sufficient to make the payments on the debt?
  • If not, what collateral does the company have to support bond holders?
  • What is the total recovery value of plant, property and other capital represented by the company?
  • Does the yield on the junk bond offer a reasonable margin of safety to justify an investment?   

Since the financial crisis, the profile of the typical junk investor has changed markedly. Gone are the days when the aforementioned specialized analysts, akin to accountants, were the predominant investors. New investors, many of whom lack the skills to properly evaluate such investments, have entered the high yield debt arena to boost their returns. We believe that many such investors are ill-prepared for the risk and volatility that tend to be associated with non-investment grade bonds when the economic cycle turns.

The advent of exchange-traded funds (ETF’s) has made investing in junk-rated debt much easier and more popular. It has opened the asset class to a larger number of investors that have traditionally avoided the sector or simply did not have access due to investment restrictions. ETF’s have turned the junk market into another passive tool for the masses.

The combination of investors’ desperate need for yield along with the ease of investing in junk has pushed spreads and yields to very low levels as shown below. While a yield of 6.40% may seem appealing versus Treasury bonds yielding little more than the rate of inflation, consider that junk yields do not factor in losses due to default. Junk default rates reached double digits during each of the last three recessions. A repeat of those default rates would easily wipe out years of returns. Even in a best-case scenario, an annual 2.5-3.5% default rate would significantly reduce the realized yield. The graph below charts yields and option-adjusted spread (OAS).

OAS measures the spread, or additional yield, one expects to receive versus investing in a like maturity, “risk-free” U.S. Treasury bond. It is important to note that spread is but one measure investors must consider when evaluating prospective investments. For example, even if OAS remains unchanged while Treasury yields increase 300bps, the yield on the junk bond also increases 300bps and produces an approximate 15% price decline assuming a 5-year duration.

Junk Debt Spreads (OAS) and Economic Data

Economic activity and corporate profits are well -correlated. Given the tenuous nature of companies in junk status, profits and cash flows are typically extremely sensitive to economic activity. The following graphs illustrate current valuations and guide where spreads may go under certain economic environments. The label R² in the graph is a statistical measure that calculates the amount of variance of one factor based on the other factor. The R², of .58 in the graph below, means that 58% of the change in OAS is due to changes in real GDP.

In the scatter plot below, each dot represents the respective intersection of OAS and GDP for each quarterly period. Currently, as indicated by the red triangle, OAS spreads are approximately 175 basis points too low (expensive) given the current level of GDP. More importantly, the general upward slope of the curve denotes that weaker economic activity tends to result in wider spreads. For instance, we should expect OAS to widen to 10% if a recession with -2.00% growth were to occur.

The following are scatter plots of OAS as contrasted with PMI (business confidence/plans) and Jobless Claims (labor market).  The current OAS versus the dotted trend line is fair given the current level of PMI and Jobless Claims. However, if the economy slows down resulting in weaker PMI and rising jobless claims, we should expect a much higher OAS. Note both graphs have a significant R².

As discussed earlier, frothy equity markets and junk spreads have rewarded investors since the financial crisis. The scatter plot below compares OAS to CAPE10 valuations. A return to an average CAPE (16) should result in an OAS of nearly 10. Assuming that such an event was to occur, an investor with a five-year junk bond could lose almost 30% in the price of the bond assuming no default. Default would harm the investor much more.

We finish up with a similar graph as we presented in Has This Cycle Reached Its Tail. A special thank you to Neil Howe for the idea behind the graph below.

The graph, using two year averages compares the U.S. Treasury yield curve and junk OAS. The yield curve serves as a proxy for the economic cycle. The cycle started with the blue triangle which is the average yield curve and OAS for 2006 and 2007. As the cycle peaked and the financial crisis occurred, the yield curve widened, and junk OAS increased significantly. Starting in 2009, recovery took hold resulting in a flattening yield curve and lower junk OAS. The current one month point denoted by the red dot shows that we have come full circle to where the cycle began over ten years ago.

Trade Idea

Given the unrewarding risk-return profile of junk bonds, we recommend investors consider reallocating from junk to investment grade corporates, mortgages or U.S. Treasuries. For those more aggressive investors, we recommend a paired trade whereby one shorts the liquid ETF’s (HYG/JNK) and purchases an equal combination of investment grade corporates (LQD) and U.S. Treasuries (IEI).

Had one put on the paired trade mentioned above in 2014, when junk yields were at similar levels, and held the trade for two years, the total return over the holding period was 16.75%. Similarly, such a trade established in January of 2007 and held for two years would have resulted in an approximate total return of nearly 38.85%.

Investment return data used in pair trade analysis courtesy of BofA Merrill Lynch US high yield and Corporate Master Total Return Indexes. Treasury data from Barclays.


Junk debt is highly correlated with economic activity and stock market returns. When potential default rates are considered with signs that the economic cycle is turning, and extreme equity valuations, investors should be highly attuned to risks. This is not to say junk bond holders will suffer, but it should raise concern about the amount of risk being taken for a marginal return at best.

If you have owned junk debt for the last few years, congratulations. You earned a return greater than those provided by more conservative fixed-income investments. That said, we strongly recommend a critical assessment of the trade. Math and historical precedence argue that the upside to holding junk debt is quite limited, especially when compared to investment grade corporate bonds that offer similar returns and expose the investor to much less credit risk.

At RIA Advisors, we have sold the vast majority of our junk bond holdings over the last month. We are concerned that the minimal spread over Treasuries does not nearly compensate our clients enough for the real risk that the current economic cycle is coming to an end.

Fixed Income Review – March 2019

The first quarter of 2019 offered one of the most powerful surges in risky asset valuations seen in history. Closing at 2506 on December 31, 2018, the S&P 500 proceeded to rise 328 points (14.37%) to 2834 in the first quarter. The near vertical leap skyward corresponds directly to the abrupt change in posture from the Federal Reserve (Fed) as they eliminated all threats of rate hikes in 2019. They took the further step of announcing a schedule to halt quantitative tightening (QT).

As might be expected, high yield credit was the best performing sector for the quarter with a total return of 7.26%. Somewhat counter-intuitively, U.S. Treasuries (+2.11%) also rallied for the quarter although they lagged all other major fixed-income sectors as shown in the table below.

For March, risk markets stalled slightly after the big run in the prior two months. Although posting returns of nearly 1%, high yield was the worst performer while investment grade was the best.

The contrast in performance between high-quality and low-quality bonds may be telling. In what could be a related issue, interest rate volatility in the U.S. Treasury market as measured by the MOVE Index spiked higher mid-month and had implications for the credit markets.

As shown in the tables below, only the BBB spread tightened slightly with all others widening by 1-3 basis points. Putting it together, despite solid total returns for the month, the spread widening tells us that corporate credit did not keep pace with falling Treasury yields in March, particularly at the end of the month.

From a macro perspective, the changes in Treasury yields and the yield curve raise broad concerns. Namely, are we nearing the end of the current expansion? As discussed in far more detail in our prior article, Yesterday’s Perfect Recession Warning May Be Failing You, the yield curve has a durable track record of signaling major changes in the economic cycle especially when it inverts (longer-term interest rates drop below short-term rates). When an inverted curve is considered with the end of a Fed rate hike cycle, the evidence becomes even more compelling. The Fed abruptly altered their outlook for monetary policy in March putting to rest any concern for further hikes. The market is now pricing for 1 or 2 rate cuts in 2019.

The last time we observed this combination of circumstances, an inverted curve and a market implying fed funds rate cuts, was ominously in late 2006. In October of last year, when the yield curve spread was decidedly positive, most economists including National Economic Council director Larry Kudlow pointed to this barometer and said we were nowhere near recession. The current market narrative now claims we should not pay too much attention to this important historical precedent. As opposed to trying to shape the narrative to suit our interests, we prefer instead to heed history. The odds are that this time is not different.

Time will tell.

All data sourced from Bloomberg and Barclays

A Traders’ Secret For Buying Munis

Believe it or not, any domestic bond trader under the age of 55 has never traded in a bond bear market. Unlike the stock market, which tends to cycle between bull and bear markets every five to ten years, bond markets can go decades trending in one direction. These long periods of predictable rate movements may seem easy to trade, especially in hindsight, but when the trend changes, muscle memory can trump logic leaving many traders and investors offside.

If you believe higher yields are upon us in the near future, there are many ways to protect your bond portfolio. In this article, we present one idea applicable to municipal bonds. The added benefit of this idea is it does not detract from performance if rates remain stubbornly low or fall even lower.  Who says there is no such thing as a free lunch?


Municipal bonds, aka Munis, are debt obligations issued by state and local government entities. Investors who seek capital preservation and a dependable income stream are the primary holders of munis. In bear markets, munis can offer additional yield over Treasury bonds, still maintain a high credit quality, and avoid the greater volatility present in the corporate bond or equity markets.

Munis are unique in a number of ways but most notably because of their tax status. Please note, munis come in taxable and tax-exempt formats but any reference to munis in this article refers to tax-exempt bonds.

Because of their tax status, evaluating munis involves an extra step to make them comparable to other fixed income assets which are not tax-exempt. When comparing a muni to a Treasury, corporate, mortgage backed security, or any asset for that matter, muni investors must adjust the yield to a taxable equivalent yield. As a simple example, if you are in a 40% tax bracket and evaluating a muni bond yielding 2%, the taxable equivalent yield would be 3.33% (2.00% / (1-40%). It is this yield that should be used to equate it to other fixed income securities.

Negative “Tax” Convexity Matters

Thus far, everything we have mentioned is relatively straight-forward. Less well-understood is the effect of the tax rate on muni bonds with different prices and coupons. Before diving into tax rates, let’s first consider duration. Duration is a measure that provides the price change that would occur for a given change in yield. For instance, a bond with a duration of 3.0 should move approximately 3% in price for every 1% change in yield.

While a very useful measure to help quantify risk and compare bonds with different characteristics, duration changes as yields change. Convexity measures the non-linear change in price for changes in yield. Convexity helps us estimate duration for a given change in yield.

For most fixed rate bonds without options attached, convexity is a minor concern. Convexity in the traditional sense is a complex topic and not of primary importance for this article. If you would like to learn more about traditional convexity, please contact us.

Munis, like most bonds, have a small amount of negative convexity. However, because of their tax status, some muni bonds have, what we call, an additional layer of negative tax convexity. To understand this concept, we must first consider the complete tax implications of owning munis.

The holder of the muni bond receives a stream of coupons and ultimately his or her invested principal back at par ($100). The coupons are tax free, however, if the bond is sold prior to maturity, a taxable capital gain may occur.

The table below illustrates three hypothetical muni bonds identical in structure and credit quality. We use a term of 1 year to make the math as simple as possible.

In the three sample bonds, note how prices vary based on the range of coupons. Bond A has the lowest coupon but compensates investors with $2.41 ($100-$97.59) of price appreciation at maturity (the bond pays $100 at maturity but is currently priced at $97.59). Conversely, Bond C has a higher coupon, but docks the holder $2.41 in principal at maturity.

For an uninformed investor, choosing between the three bonds is not as easy as it may appear. Because of the discounted price on bond A, the expected price appreciation ($2.41) of Bond A is taxable and subject to the holder’s ordinary income tax rate. The appropriate tax rate is based on a De minimis threshold test discussed in the addendum. Top earners in this tax bracket pay approximately 40%.

Given the tax implication, we recalculate the yield to maturity for Bond A and arrive at a net yield-to-maturity after taxes of 4% (2.50% + (2.50 *(1-.40). Obviously, 4% is well below the 5% yield to maturity offered by bonds B and C, which do not require a tax that Bond A does as they are priced at or above par. Working backwards, an investor choosing between the three bonds should require a price of 95.88 which leaves bond A with an after tax yield to maturity of 5% and on equal footing with bonds B and C.

Implications in a rising yield environment and the role of “tax” convexity

Assume you bought Bond B at par and yields surged 2.50% higher the next day. Using the bond’s stated duration of .988, one would expect Bond B’s price to decline approximately $2.47 (.988 * 2.5%) to $97.53. Based on the prior section, however, we know that is not correct due to the tax implications associated with purchasing a muni at a price below par. Since you purchased the bonds at par, the tax implication doesn’t apply to you, but it will if anyone buys the bond from you after the 2.5% rise in yields. Therefore, the price of a muni bond in the secondary market will be affected not just by the change in rates, but also the associated tax implications. Assuming the ordinary income tax rate, the price of Bond B should fall an additional $1.65 to $95.88.  This $1.65 of additional decline in Bond B’s price is the penalty we call negative tax convexity.

The graph below shows how +/- 2.50% shifts in interest rates affect the prices of bonds A, B, and C. The table below the graph quantifies the change in prices per the shocks. For simplicity’s sake, we assume a constant bond duration in this example.

It is negative tax convexity that should cause investors, all else being equal, to prefer bonds trading at a premium (such as bond C) over those trading at par or a discount. It is also worth noting that the tax convexity plays an additional role in the secondary market for munis. Bonds with prices at or near par will be in less demand than bonds trading well above par if traders anticipate a near term rise in yields that will shift the par bond to a discounted price.


Yields have fallen for the better part of the last thirty years, so muni investors have not had to deal with discounted bonds and their tax implications often. Because of this, many muni investors are likely unaware of negative tax convexity risk. As we highlighted in the table, the gains in price when yields fall are relatively equal for the three bonds but the negative deviation in price in a rising yield environment is meaningful. Given this negative divergence, we recommend that you favor higher coupon/ higher priced munis. If you currently own lower priced munis, it may be worth swapping them for higher priced (higher coupon) bonds.

Addendum: De minimis

The tax code contains a provision for munis called the de minimis rule. This rule establishes the proper tax rate to apply to capital appreciation. The following clip from Charles Schwab’s Bond Insights provides a good understanding of the rule.

The de minimis rule

The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.

Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).

For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).

It is important to note that some bonds are issued at prices below par. Such bonds, called original issue discount (OID), use the original offering price and not par as the basis to determine capital gains. If you buy a bond with an OID of $98 at a price of $97.50, you will only be subject to $0.50 (the difference between the OID price and the market price) of capital gains or ordinary income tax.

Monthly Fixed Income Review – February 2019

The rebound in credit markets has been remarkable since the Christmas eve lows however it appears as though the fuel for the rally, optimism of a softened stance by the Federal Reserve (Fed) and a pending trade deal with China, is being priced in multiple times over. Every time a new headline about a trade deal, or dovish Fed-speak hits the wire, the market spikes (we probably have the genius of artificial intelligence and computer-driven algorithmic traders to thank for that).

Since late December, the Fed has clearly eased their outlook for future rate hikes and balance sheet reduction but they have yet to formalize a new stance. That may be coming in two weeks, as it appears likely that at the March 20th FOMC meeting a schedule for eliminating QT will be discussed.

As things stand now, the data on which the Fed claims to be dependent, says unemployment is at a historical low 4% and inflation is hovering around their 2% target. As an aside the deflationary ghost that seems to justify the Fed’s lust for more inflation has not been seen since the 1930’s.  “Crosscurrents” that also concern the Fed as mentioned by Powell in last week’s testimony likely include the usual suspects of China and Europe.

In the month of February, similar to what we saw in January, riskier fixed-income categories outperformed higher-quality categories. The best performing categories were high yield and emerging markets. Meanwhile, treasuries and mortgages posted a negative total return for the month.

With the exception of the investment grade corporate sector, ETF performance was generally in line with the indices.

In the name of prudence, it should be obvious that the levels at which riskier credits are trading should not be compelling to discerning investors, especially as economic data and earnings guidance points to the possibility of a further slowing of the U.S. economy.

As discussed in the past, the investment grade (IG) universe is becoming more and more heavily concentrated in the BBB credit category.

This weaker credit characteristic of the investment grade universe is bearing out in its performance. In the chart below, the dark blue line shows the difference between high yield (HY) and IG option-adjusted spreads. The light blue line is the difference between HY and IG credit default swap (CDS) pricing. CDS spreads are important because these are the instruments most heavily used by broker-dealers and other institutional accounts to hedge their corporate bond holdings. The chart shows HY spreads in both cases widening by more than IG which is to be expected. However, since October 2018 when turbulence hit the markets, if we look at the CDS ratio (HY CDS divided by IG CDS), IG underperformed high yield as credit spreads widened (red line). In other words, as HY CDS (the numerator) rose through December, IG CDS (the denominator) rose comparatively by more causing the ratio to drop from 5.6 to 5.1 (see table below).

This behavior is atypical as better credit quality generally outperforms weaker credits in a spread widening environment.  Higher credit quality should widen by comparatively less keeping the ratio somewhat stable.

Since year end, IG has outperformed as the market recovered. As the table and ratio changes reflect, IG CDS is trading with a higher beta to HY CDS. How else to explain this except to observe that so much more of the index is perched dangerously close to junk ratings and at a greater risk of losing investment grade status.

Economic stagnation would likely send a sizable portion of the triple-B rated bonds into Junkville. That would then create a problem in the credit slums as a large amount of newly rated junk bonds would cause spread widening in a land that is highly sensitive given current valuations. This is our assessment as to why we have seen the recent elevated ratio volatility between IG and HY bond CDS spreads.

The bottom line is that with the uncertainty in the current outlook, the length of the current recovery and the sudden, almost irrational bounce off the Christmas Eve lows, does taking risk in the credit sector make sense? We argue no and recommend either liquidating at these valuations, moving up in credit, or sit patiently on cash. Now is not a time to acquire credit risk.

Monthly Fixed Income Review – January 2019

Blowing the Call

Before reviewing January returns in the fixed-income markets, we digress for a moment to raise important questions about the character and integrity of financial markets nudged and cajoled by Federal Reserve (Fed) officials.

In the recent National Football League (NFL) playoff games, there were several occasions where poor or missed calls by the referees influenced the outcome of the game. Despite all of the technology, cameras, camera angles and new “Play Review” rules, NFL commissioner Roger Goodell acknowledged a significant and obvious missed call in the Rams-Saints game but said the game is, after all, “officiated by humans”. Fans and announcers, outraged at the errors, charged Goodell with avoiding the important issues on the matter and some have gone so far as to say Super Bowl LIII was “tainted”.

And yet in financial markets, we continually speak of the referees at the Fed as an omnipresent force that needs to be called upon to influence outcomes. In doing so, the Fed regularly chooses winners and losers in the capital markets with obvious intent. Is there a difference between the NFL referees and the Fed? Yes, of course, the economy and the welfare of the nation is infinitely more important than a football game. Is it proper? Legal? Most investors assume so since it is carried out at the Fed on a daily basis just as enthusiastically as it is at the Peoples Bank of (communist) China. Now for the hard question: Is it in the best interest of the public? The answer: No, it is not.

The January edition of our fixed income review reveals just as much about these nefarious interventions by the Fed in bond markets as we observed in equity markets over the past month. Our perspective and characterization of those interventions is out of consensus as most people see no harm (and great help) in the outside influences brought to bear. The problem is that whether immediately recognized or not, the Fed’s involvement in manipulating outcomes to their preference similarly damages their integrity and that of our markets and economy.

The difference is that the NFL, although not entirely owning up to the problem publicly, understands what is at stake and will likely take corrective action to minimize these issues in the future. The Fed does precisely the opposite delving ever deeper into the business of manipulating economic outcomes as if it is their obligation. For the Fed, their tone-deaf perspective presents far bigger problems for the dollar, interest rates, the deficit and a multitude of other matters that will reveal themselves gradually – and then suddenly – over time.

January Performance Overview

The change in the Fed’s policy posture between the December 19, 2018 and the recent January 30th FOMC meeting is stark. They went from a Fed intent on raising rates two to three more times in 2019 and having balance sheet normalization on “autopilot” to implying that they will remain on “hold” in terms of rates hikes and moderating the pace of balance sheet reduction. The dovish shift appears to have put to rest any concerns of overtightening, the primary narrative behind fourth quarter turbulence. Markets clearly started to believe in the Fed shift in later December and the positive momentum in risk sentiment carried markets through January.

For the month of January, every credit sector posted positive returns led by the riskiest categories of high yield, emerging markets and investment grade.

The story was the same for ETFs but with a few large variances from index performance owing to the uneven nature of flows quickly re-entering the riskiest classes.

January Market Move

A lot was made of the fact that December was the worst month of December for the stock market since the 1930’s. Using the same concept and to further highlight the strength of fixed income returns in January 2019, we compared last month with other Januarys over the past 30 years. Investment grade and high yield posted the third best month dating back to 1989 and emerging markets posted their fourth best since 1993 (earliest data available).

Drilling down a little deeper within the investment grade category, we chose to look at the spread tightening that occurred in the banking, technology and energy sectors in January. The chart below shows the three sectors with the broad aggregate IG option-adjusted spread. The black vertical line marks December 31, 2018.

Using similar context, the chart below highlights the price movements of the leveraged loan index since January 2016. Again, the black vertical line denotes December 31, 2018.


What the charts above reflect is the radical spread and price moves that took place as the Fed flipped their language and posture surrounding both future rate hikes and discussion about the pace of balance sheet normalization. What this suggests to us is not that the Fed is “data dependent” as they claim, but that they are entirely focused on assuaging market turbulence when it appears. Although anyone who watches sports cringes when a referee blows a call, no one is more humiliated than the referee himself. With the Federal Reserve, however, intentionally altering the game appears to be their daily objective.

All data courtesy: Barclays

Monthly Fixed Income Review – September 2018

September’s surge higher in benchmark interest rates set the stage for a challenging month in the fixed-income markets. In our broad asset class categories, as shown below, there were two exceptions as high yield and emerging markets had a solid month of performance. On a year-to-date basis, only the high-yield sector is positive. Similar performance data was observed in the popular ETF’s for these sectors as shown in the second table.

Short term interest rates continue to march higher in response to the hawkish message being telegraphed by the Federal Reserve (Fed). At the same time, the long end of the yield curve remains range-bound although in September yields moved back to the upper end of that range with 10-year U.S. Treasury note yielding 3.06% and the 30-year U.S. Treasury bond at 3.21%. The move across the term structure of interest rates was parallel and for the first time since February, the 2-10s yield curve did not flatten. The chart below illustrates this shift in rates across the Treasury curve for the month of September.

The Federal Open Market Committee (FOMC) meeting at the end of the month produced few surprises and maintains that the Fed Funds target rate will top out between 3.25-3.50% in early 2020. The trajectory of Fed rate hikes suggests another move in December, three rate hikes in 2019 and one more in 2020. If maintained, that path means that interest rates at the short end of the yield curve will continue to rise and argues for an inverted yield curve in the not too distant future. Although an inverted yield curve has in the past implied a looming recession, Fed Chairman Powell and his colleagues on the FOMC are not yet expressing any concerns.

With that backdrop, it seems plausible that the outlook for fixed-income remains challenging as rising interest rates will continue to keep pressure on returns. At the same time, the consensus view is that the economy will remain strong which should be supportive of credit markets. Evidence of this dynamic is showing up in the performance differential between high yield credit and most other fixed-income sectors. As discussed in prior months, part of the performance in high yield is due to falling supply, a shorter duration profile and other technical factors.

The chart below shows the differential between spreads on BBB-rated credits, the lowest rung of the investment grade universe, and BB-rated credit, the highest rung of junk debt. Amazingly, at a mere 73 basis points, that difference is now very close to the historic low levels observed in the heady months leading up to the financial crisis of 2008. It is also over 100 basis points below the average for the last 12 years.

Emerging market (EM) credit bounced back from a poor August but the rebound seems unlikely to be durable. There remain a multitude of factors which urge caution including tight U.S. dollar funding conditions, on-going trade tensions as well as macro problems in several EM countries. Furthermore, this backdrop is creating the need for counter-measures (rate hikes) by the central banks of affected countries. While that may help matters in the near term as was the case in September, it may also create adverse conditions in terms of the outlook for economic growth. Capital outflows remain a significant risk until some of these issues are meaningfully relieved.

All Data Courtesy Barclays

Seeking Alpha Exclusive Interview

On September 7th we were one of three investment professionals interviewed on Seeking Alpha’s Marketplace about the markets, the Federal Reserve and other topical issues. Please enjoy our contribution to the conversation.


The Fed’s annual Jackson Hole Symposium is over; what should investors look out for now?

For the near term, interest rates will continue their steady, gradual rise, says Chairman Powell. Our authors agree.

The markets’ trajectory keeps going up – when will it fall, and what will be the catalyst?

Look for opportunities in high yield and China.

With the Federal Reserve’s 2018 Jackson Hole Economic Symposium now over, markets continuing to hit new highs, and the economy seemingly humming on all cylinders (lots of people are employed, corporate profits are strong, and the Q2 gross national product was just north of 4%), we thought it would be a good time to check in with some of our macro-minded experts on Marketplace to get their take on interest rates, inflation, and where the economy might be headed next (just how close are we to a recession, anyway?). The authors we spoke to agree that rates will continue to rise gradually and steadily in the near term; that inflation risk, while small at this point, would be problematic for investors; and that, as common sense would dictate, the timing and severity of recessions is tough to pin down. They also propose some timely investing ideas to consider in the current environment, including high-yield instruments and a contrarian play on Chinese stocks. To find out more about how our authors are thinking about the current state of the economy and what investors should be watching for, keep reading.

Seeking Alpha: Federal Reserve Chairman Jerome Powell said at Jackson Hole that he expects rate hikes to continue. Do you foresee the two planned additional hikes coming this year? When do you think the Fed will stop raising interest rates?

Lance Roberts: The Fed under Jerome Powell has been very clear that they intend to keep raising rates at a gradual but steady pace. Real rates remain very low and stimulative relative to the extent of the economic recovery. That should fuel rising levels of inflation, especially given the recent rounds of fiscal stimulus at a time of full employment. The current circumstance offers further incentive for the Fed to maintain the path of rate hikes. Powell likely wants to build room to employ traditional monetary policy stimulus while the economy is giving him the latitude to do so. Ultimately, the stock market is the Fed’s barometer on terminal Fed Funds and will tell Powell when enough is enough.

SA: Why are market expectations different from the Fed’s expectations, according to the Fed’s most recent dot plot?

LR: We recently wrote extensively about this divergence in an article we penned for our Marketplace community: “Everyone Hears The Fed… But Few Listen.” One of the key takeaways from the article was as follows: “Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.” In short, since the financial crisis, the market has become accustomed to a Fed that has failed to deliver on rate hike promises. That seems to have changed with plain-speaking Chairman Powell.

SA: What’s the deal with inflation? Is the Fed being too complacent about inflation risk and their ability to “control it” at all costs? What are the odds of inflation upside?

LR: Yes! Yes! And who knows. First, it is important to clarify that rising prices are a symptom of inflation caused by too much money in the economic system. Given the actions of central bankers over the past 10 years, there is no question that condition exists on a global scale as never before. The manifestation has been different in this cycle than in the past and is showing itself in asset prices as opposed to the costs of goods and services. The biggest risk, albeit small at this point, is the combination of inflation and recession (stagflation). In this event, the Fed would be forced to reduce liquidity and raise rates. This is a scenario that has not been witnessed in decades and would be a difficult combination for most stock/bond investors.

SA: There’s a chart we saw recently that shows the S&P 500 steadily climbing to dizzying heights over the past decade. At what point do you think the Fed tightening will derail the S&P 500 and the bull market?

LR: Market valuations are clearly at historical peaks. It is being driven largely by behavioral tendencies and importantly central bank liquidity. As the Fed further reduces liquidity and the ECB and BOJ begin to take similar steps, the odds increase that equity markets falter. We are already seeing the effects of reduced liquidity in Turkey and other emerging market nations. That said, picking a date is a fool’s game as this market seems to be very good at ignoring reality.

SA: Recession: are we there yet? How close (or far) are we from an economic slump?

LR: We have had some close calls since 2010, especially in late 2015 and early 2016, but central bank intervention has delayed the rhythm of these cycles. In the same way, however, that suppressing forest fires eventually result in even more uncontrollable outbreaks, this seems to be a similar likelihood for the global economy. Debt (and leverage) is the lowest common denominator as a determinant for a recession and, again, the level of interest rates will eventually be the trigger. Rate hikes naturally are bringing us closer to that point, but the trigger is unknowable. Watch real rates, the yield curve, and credit spreads.

SA: The US dollar is key for many asset classes and critical for potential emerging market issues. What’s your outlook for the US dollar both near and long term?

LR: Given the global demand dynamics and the pressures being imposed by a Fed that maintains a path of rate hikes, the dollar should sustain it recent strength and continue to move higher in the short to intermediate term. Long term, the dollar outlook is problematic due to the amount of U.S. debt outstanding, the extent of money printing that will likely have to occur in order to avert a default and the converging global efforts by major economies (especially China) to reduce their reliance on dollar-based transactions.

SA: What would you say to investors who are looking to protect themselves against potential market and inflation risks?

LR: We own house and car insurance for events that are highly unlikely. Why shouldn’t we consider owning financial insurance, especially when the risks of a significant drawdown are substantial? As Falstaff said in Shakespeare’s King Henry the Fourth, “Caution is preferable to rash bravery.”

Monthly Fixed Income Review – August 2018

Monthly Fixed Income Review – August 2018

Interest rate and credit markets in the U.S. continued to demonstrate resilience in August despite rising global problems. With the exception of emerging market (EM) credits, all major fixed-income sectors registered positive returns for the month. The constructive momentum from July carried over and picked up steam in August. Meanwhile, EM gave back most of the prior month’s gain.

Data Courtesy Barclays

U.S. Treasuries – As the best performer of the month, the largest gains in the sector were in the long maturities of the yield curve. This is a reflection of the character of the persistent curve flattening. Maturities beyond 10 years had a total return for the month of between 1.33% and 1.64% while the 1-3 year sector was up only 0.33%. For the moment, the Treasury market is shrugging off the heavy supply pipeline needed to fund growing deficits.

Corporates – Strength in corporate fundamentals on display in the Q2 earnings parade no doubt played a role in last month’s performance. Investment grade (IG) performance again lagged that of the high yield sector for the third month in a row but supply dynamics largely help explain the divergence. High yield issuance fell for the 7th straight month while merger and acquisition driven issuance is fueling supply in the investment grade sector. Despite a typically quiet week heading into the Labor Day holiday, IG new issuance for the month was heavy at $86.5 billion, the third largest August on record. Looking ahead, those trends are likely to continue as September is normally the second largest issuance month behind May.

Emerging Markets – Fixed-income securities came under the same withering pressure that EM currencies and equity markets have seen since April. So far, there appear to be no signs of the stress letting up as the Trump administration and strengthening U.S. dollar continue to apply pressure. EM credit returns have been negative in six of the eight months this year and the word on every investor’s mind at this stage is “contagion”. The chart below offers a detailed look at the breakout of EM returns by broad geography and the progression of stress since the beginning of the year.

Data Courtesy Barclays  (EMEA – Europe/Middle East/Africa)

Even though the risks seem concentrated in just a few countries (Turkey, Argentina, Brazil, South Africa), the concern is that investors begin to treat all developing countries the same and reduce risk on a wholesale basis. It traditionally begins, as we are now observing, with weakness spreading across the more vulnerable EM countries and eventually engulfs even the stronger hands. If that scenario develops as it did beginning in 1997, it will bring with it a multitude of opportunities to acquire quality assets in those countries that are being unjustifiably beaten down. Those would include the stronger exporters with current-account surpluses like South Korea and Taiwan.

The following table provides returns for selected ETF’s that mirror the major fixed income asset classes.

Data Courtesy Barclays

Running On Empty

We would like to introduce you to Sam and his finances. Currently, Sam does well for himself, earning $100,000 a year. Sam loves the good life, and to maintain it he consistently spends more than he earns. To fund this continual budget shortfall, he borrows money. The graph below shows his rising income (green) and accumulating debts (red) since 1966.

Unfortunately, Sam is not a hypothetical person. Sam, as represented in the graph above, is really Uncle Sam. The graph proportionately scales U.S. tax revenue and government debt outstanding data to Sam’s current income of $100,000. Currently, annual tax revenue stands at $1.908 trillion while the total amount of government debt outstanding is $21.090 trillion.

To further emphasize the growing divergence between tax revenue and debt outstanding, consider that debt grew by 6.26% and revenue shrank by 6.03% over the last year. While the recent decline in revenue is largely a function of the new tax legislation and may not last, the long-term trends are not encouraging. Over the last five and ten years, tax revenue increased annually by 2.22% and 2.09% respectively, while debt outstanding increased by 4.69% and 8.37% annually.

If the graph above were truly the financial situation of a guy named Sam, we would confidently tell you he went bankrupt 20 years ago. Fortunately for us, Uncle Sam or the U.S. government is not just any guy named Sam. The U.S. has had very little trouble borrowing well beyond its means. The U.S. dollar, acting as the world’s reserve currency, has enabled fiscal imprudence and is more of a curse than a blessing.

Consider the graph below, showing the ratio of tax revenue to the debt outstanding. Currently, for every dollar of debt there are only nine cents of revenue to cover it.

Interest Expense

Interest rates have been in a multi-decade declining trend. In 1981 the ten-year Treasury yield was approaching 15%, and today, even after rising 1%, it stands at a paltry 2.90%. This trend lower in rates greatly benefited the government’s finances as the interest expense on debt remained relatively low. In the third quarter of 1997, the interest expense on $5.413 trillion of debt was $367 billion. In the third quarter of 2009, the interest expense was an identical $367 billion despite outstanding debt more than doubling to $11.909 trillion over the prior twelve years. Over that period, the yield on the ten-year U.S. Treasury Note declined from 6.57% to 2.74%.

Over the last ten years, interest expense has been less contained, in large part because interest rates cannot decline nearly as much as they did in prior years to offset the increase in debt.  In the second quarter of 2009, the ten-year yield was 3.32%, or about 0.40% higher than the current rate. Despite the slight drop in yield, interest expense has grown by over 50% in this time frame as the amount of debt outstanding has risen substantially.

The Congressional Budget Office (CBO) expects government debt outstanding to rise by over $1 trillion per year for each of the next four years. At the same time, neither we nor the CBO expect to see interest rates decline meaningfully. However, and of grave concern, the possibility of higher rates is real. Given the outlook for rising debt and flat to rising interest rates, interest expense will continue to make Uncle Sam’s financial problems even more daunting.


Judging by historically low-interest rates, investors, ourselves included, are not concerned that the U.S. government will default. Given the government has a printing press, we see little reason for such a concern.

That said, we are greatly worried that the growing imbalance between debt outstanding and the means to pay it off will encourage further reckless monetary policy. The Federal Reserve has been complicit in this scheme by keeping rates artificially low. Further, they have used QE to manipulate interest rates lower when investors were not willing to help. As such, the financial imbalance, which will likely only worsen appreciably, leaves little doubt in our mind that policy tools such as QE and negative interest rates will be used when the fiscal imbalances become more obvious to investors.

The Weaponization of the Dollar

The Uncivil Civil War discussed the sanguine approach many investors take towards equity risk despite clear signs of domestic political turbulence. The article put the upcoming elections and the growing political divisions amongst the populace into context with market risks.

While we read plenty of politically related articles and many more investment related articles, we have found precious few that bridge the gap and gauge the effect politics has on markets. The intersection of markets and politics is important and should be followed closely, especially with a mid-term election months away. As so eloquently described by the late Charles Krauthammer, “You can have the most advanced and efflorescent cultures. Get your politics wrong, however, and everything stands to be swept away. This is not ancient history. This is Germany 1933.

In this article, we readdress politics and markets from an international perspective. In particular, we focus on suspicions we have regarding Donald Trump’s negotiation tactics and goals for the U.S. relationship with Turkey.

Emerging Markets and the Dollar

China, Turkey, and Iran are all classified as emerging markets. While the classification is broad and includes a diverse group of countries, these countries have many things in common. One is that their currencies, for the most part, are not liquid or highly valued. Thus, they heavily rely on the world’s reserve currency, the U.S. dollar, to conduct international trade.

As an example, when Pakistan buys oil from Qatar, they transact in U.S. dollars, not rupees or riyals. To facilitate trade efficiently, these countries must hold excess dollars in reserve. In almost all cases, emerging market nations rely on U.S. dollar-denominated debt for their transactional needs.

Dollar-denominated debt is currently the cause of much economic pain for Turkey. To understand why, we present a simplified example. Suppose on January 1, 2018, a Turkish corporation borrowed $100 million U.S. dollars with an agreement to pay it back with interest of 5% on August 15th, 2018. The company, as is typical, converts the loaned dollars to Turkish Lira.  On August 15, 2018, the company will convert the Lira back to dollars in order to pay the principal and interest due on the loan.

The following graph charts the Turkish Lira versus the Dollar over the life of the loan.

On January 1, 2018, one U.S. Dollar was worth 3.79 Lira. Over the next eight months, the U.S dollar appreciated significantly versus the Lira such that one U.S. dollar was worth approximately 5.81 Lira. As such, the company will now need 5.81 Lira to purchase each dollar it needs to repay the loan. Due to the strengthening of the U.S. dollar versus the Lira over the time period of the outstanding loan, the company would need 584,282,000 Lira to pay back what was originally a 378,750,000 Lira loan. In other words, the true all-in cost of borrowing was not 5% but 54%.

Turkey’s public and private sector dollar denominated loans outstanding are currently estimated to be around $500 billion. Turkish borrowers must grapple with repaying outstanding dollar-denominated loans by using more Lira to acquire the necessary dollars, and with the fact that interest rates, as set by Turkey’s central bank, have risen from 8% to 17.75%. To make matters even worse, the annualized rate of inflation is estimated to be over 100% in Turkey. Needless to say, dollar appreciation versus the Lira is bringing the Turkish economy to its knees.

Enter Donald Trump

Donald Trump, who authored a book entitled “The Art of the Deal,” takes great pride in his negotiating skills. Readers of this book know he highly values leverage in negotiations. As the President of the United States, Trump clearly has enormous leverage to change the global landscape. In the case of trade negotiations, we have seen repeated threats of tariffs against Mexico, Canada, Europe, and China. We believe the goal is to force these countries to renegotiate prior trade treaties or remove tariffs. For Trump, the leverage is the threat, which does the heavy lifting by forcing countries to negotiate or face still retaliatory tariffs or other penalties.

We suspect that Trump may also be using dollar appreciation to force nations, especially emerging markets, to comply with his demands. If you are looking for clues, consider the following Tweet from Donald Trump (8/16/2018): “Money is pouring into our cherished DOLLAR like rarely before.” Based on his bragging it seems Trump has few qualms about the recent strength of the U.S. dollar.

Regardless of the causes of the recent ascent of the U.S. dollar versus most other currencies, there is little doubt that Trump is using the dollar as a negotiating tactic to get what he wants.

There are a few reasons that Trump would manipulate the dollar, verbally or in actuality, to bring Turkey to the negotiating table. While we have no unique insight, the following reasons should be considered:

  • Turkey opposes U.S. sanctions on Iran and vows to ignore them
  • Turkey sits at a strategically important geographic intersection surrounded by Europe and Asia through which much east-to-west international trade passes
  • If in a position to provide Turkey with a bailout, the administration can slow the growing de-dollarization trend

The bottom line is that it is likely that Trump is angling to sway Turkey towards stronger relationships with the U.S. in order to influence its relationship with China, Russia, and Iran. Keep in mind China’s One Belt One Road (OBOR) project, thought of as a new silk road, would provide increased economic competition and harm to America’s economic interests. China relies on Turkey’s participation to complete this project.  As we put the finishing touches on this article, we also learned that Turkey, Iran, and Russia are in talks to schedule a trilateral summit.

Domestic Concerns

There is a healthy debate to be had about whether or not the dollar is being used as a negotiating lever. Since we may never know the answer, we focus on the potential outcomes if it is. If the dollar does strengthen further, how might it affect economic activity and assets?

The following graph, courtesy David Rosenberg at Gluskin Sheff, shows the recent decline of many assets that are sensitive to the value of the U.S. dollar.

Of the assets above, only oil and U.S. homebuilders are having much effect on the U.S. economy or the performance of domestic investments. We think these losses will be broader-based globally and involve the US stock and bond markets if the dollar continues to appreciate. The following are potential domestic issues that could be brought about by further strengthening of the U.S. dollar:

  • Deflation
  • Worsening trade deficit, possibly prompting tougher sanctions and tariffs
  • Reduced corporate earnings
  • Contagion from a banking crisis in emerging markets spreading to domestic banks

When those and other economic headwinds become more evident, it is likely all markets will react. That reaction may move from asset class to asset class sequentially, as we are currently observing, or it may hit all assets at once in a sudden cascade of revaluation.


As we wrote this article, the U.S. stock market is showing some signs of weakness. Earnings-per-share forecasts for the S&P 500 have risen by 18% this year but the index is up only 6%. This might be an acknowledgment by investors of the international and domestic problems associated with dollar strength, or it may be something else entirely like liquidity constraints. If the market continues to stagnate as the dollar moves higher, we should turn our attention to the Administration for signs of rising concern over the value of the U.S. dollar.

If in fact they do change their stance on the “cherished DOLLAR”, we would take this as a signal that either the domestic pain of a rising dollar has reached its threshold, or Turkey is acquiescing to U.S. demands. If the dollar fails to respond to verbal or direct manipulation, then it would be clear the market has another agenda and our concerns would be much graver.

For additional context on the role of the U.S. dollar in the global economy, we recommend our prior article Triffin Warned Us.

Late Cycle Dumpster Diving – RIA Pro

With the current economic expansion now nearly ten years old and the stock market days away from being the longest bull market in modern U.S. history, the only way to characterize the current environment is “late cycle”. Economic growth has recently improved, predominately thanks to a surge in fiscal spending and tax cuts but higher volatility and tighter monetary policy should raise concerns about the durability of the U.S. economy’s winning streak.

Among the asset classes that would be most affected by a change in the contours of this expansion, high yield corporate bonds (a.k.a. junk debt), those rated below BBB-, rank near the top. To analyze the risk/reward tradeoff inherent in this sector, the following article relies heavily on charts and tables of data.  You are invited to draw your own conclusions, we certainly have ours.

Current Circumstances

Despite credit concerns in the retail sector in 2017, the high yield credit sector generated a 7.30% total return for the year. The strong performance continued in the first few weeks of 2018 as witnessed by a healthy 0.60% gain. The sudden surge in equity volatility at the end of January pushed returns in to the red. Like the equity market struggling to recapture January’s all-time highs, the high yield sector is in the black but not by much, having returned only 1.26% so far this year. Interestingly however, that performance ranks first among the major fixed-income categories as everything else except municipal bonds have negative returns for the year.

To what does the high yield sector owe this status of best performer at this point in 2018?

Technical dynamics explain most of the outperformance. High yield corporate issuers have provided much less supply in an environment where demand remains strong and despite the scare early in the year, volatility has returned to mid-January levels. Additionally, the recent boost in corporate earnings growth is providing fundamental support. Lastly, the high yield sector in general has a shorter duration (risk) profile than the investment grade sector. This combination of circumstances has helped keep high yield spreads tight to other fixed income assets, an indicator reflective of investor optimism about the economic cycle and the expectation that defaults should remain historically low.

Counter to the bullish argument, the question of broader problems potentially evolving out of the disruption currently being observed in the emerging markets should not be entirely dismissed. Emerging market economies, and for that matter many developed nations’ economies, appear to be slowing. Liquidity and lending conditions are tightening due to higher U.S. interest rates, reduction of the Federal Reserve balance sheet and rising U.S. Treasury issuance. Further, the combined effects of a stronger U.S. dollar, inflation concerns and protectionist measures being taken by the U.S., raise the overall level of uncertainty in the domestic and global economy. Although some of those concerns are peripheral to the U.S., history has proven it is a short walk to the doorstep of contagion.

High Yield Analysis

The following charts and tables provide guidance on the risk-return framework facing the high yield sector. Unless otherwise noted, data for the following charts are from Bloomberg, Barclays, Goldman Sachs and JPMorgan.

Treasury (Tsy), investment grade (IG) and high yield (HY) yields, as shown below, have been at remarkably low levels since 2011 and are now showing signs of rising in sympathy with Federal Reserve rate hikes.

The next two charts offer insight into the recent performance of high yield credit. The first illustrates total return performance by year and the second is cumulative returns since 2015. Emerging market credit is added to the second graph for further perspective.

Given the strong historical relationship with equities, the next chart highlights monthly high yield total returns and their relationship with monthly changes in equity volatility. Based on the data, a ten-point increase in the VIX index should result in a 2.50% decline in high yield returns while a ten-point decline should result in a 3.70% pick up in returns. However, with the VIX only slightly above ten and resting near historical lows, there is little reason to expect much of a pickup in returns due to falling equity volatility.

Option-adjusted spreads (OAS) reflect the difference between various credit instruments and the risk-free rate which is normally the comparable U.S. Treasury security. It not only accounts for the credit risk and interest rate risk but also factors in the optionality or risk that the issuer can call the bond at some pre-determined price. The wider (higher) the option-adjusted spread, the more risk the market attaches to the security and vice versa for tighter (lower) spreads.

The chart below shows the contrast between investment grade and high yield OAS. It also captures the price moves of the S&P 500 which are inverted on the right axis. While not at record lows, credit spreads are at very tight levels historically, which was also true in 2007 when the S&P 500 peaked.

The following chart shows the aggregate high yield index as well as a breakout of yields by credit quality. Interestingly, although yields in general are turning higher, CCC-rated bonds have been less responsive, thus the outperformance versus the other credit categories. Also note how yields on the single-B index and the aggregate high yield index have mirrored each other for the last 20+ years.

In OAS terms as shown below, spreads remain stable but the CCC’s are still trending lower (tightening – outperforming).

The continuing outperformance of the CCC-rated bonds within the high yield sector can be illustrated more specifically through the scatter chart below. Comparing the BB’s, the highest credit quality within the high yield category, with the lower-rated CCC’s reflect the significant spread tightening by the CCC’s since at least 2016.

Among the reasons for the lower quality bond outperformance may be the continuing strength of the economy which minimizes investor default concerns, as well as the reduced issuance/supply of CCC bonds relative to demand. Regardless of the reason, investors should be concerned as lower-rated bonds CCC bonds historically demonstrate much higher levels of annualized volatility, largely because they present a much higher risk of default.

A comparison of IG and HY OAS further illustrates that spread compression is not just occurring within the high yield sector but also between high yield and higher rates investment grade bonds.

The chart below combines a comparison of the spread between investment grade credit yields and those of high yield (HY minus IG yields) and the ratio of those yields (HY divided by IG yields). Both metrics are at near lows meaning HY yields are quite compressed to IG and would seem to have little room for further tightening.

The duration of a bond is a measure of price risk given a 1% (100 basis point) change in interest rates. For example, a bond with a duration of five would see the price of the bond move 5% for every 1% change in interest rates. Isolating the lowest-rated investment grade category (BBB) versus the highest-rated junk bond category shows that the BBB duration continues to migrate higher while that of the BB’s has been falling. The duration spread between the two is now near the highest levels seen since 1995.

Another useful metric to gauge relative value is yield per unit of duration. This is conceptually similar to the Sharpe Ratio. Overall investment grade credit issuance generally has a longer duration as higher quality issuers can more easily and cost effectively issue bonds with longer maturities. The long-term average (since 1989) duration for IG is 6.1 years and the average yield is 5.82% which means the average yield per unit of duration is 0.95. For high yield, the long-term average duration is 4.4 years and the average yield is 8.98% for a yield per unit of duration of 2.04.

As the table below demonstrates, current yield levels offer much less return per unit of duration risk for both IG and HY than the average. The combination of rising rates and shorter duration in HY, which helps limit the exposure of higher interest rates, may help explain why junk bonds appear more attractive using this measure relative to IG. The chart below the table offers historical context of this relationship.

As mentioned, supply and demand dynamics play an important role in relative performance as the next chart highlights. Currently, IG issuance is much heavier than HY issuance, a divergence that accelerated in 2015. The shaded area in the chart is the ratio of the notional amount of high yield bonds outstanding relative to investment grade. At 53.3% of IG outstanding, high yield supply is at the lowest relative level since 1995.


At this point in the business cycle, credit cycle and emotional cycle, the low yields and tight credit spreads in the high-yield corporate sector point toward a definitive asymmetry in risk. More bluntly, given the higher probabilities of default in high yield bonds, investors are taking on a lot of risk and are not being properly compensated for it. This can certainly continue as investing is the only business where otherwise sane individuals pile into the store to pay ever higher prices and flee as prices collapse. The current dynamics reinforce that behavior and will further ensure the alternative scenario when prices commence lower.

More importantly, the charts in this series argue that all measures of value across the full credit spectrum in absolute terms appear quite rich. Yield levels remain very low and credit spreads very tight.

This analysis argues that if an investor is going to take their chances and remain invested in corporate credit, they should do so in an “up-in-credit” manner. For example, own the double-B credits as opposed to the single-B’s and triple-C’s. Likewise, in the investment grade sector, own the double-A and single-A credit bonds as opposed to the triple-B bonds. The “give-up” in yield for moving up in credit is minimal and the added protection of better quality securities is prudent especially at this late stage in the cycle.

Without regard for how long it takes for spreads to normalize, risk management is very forgiving when valuations reach these levels. As a reminder, the diligent and patient investor is the rewarded investor who avoids large losses and continually compounds wealth.

Wicksell’s Elegant Model

“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.” Mickey Mantle

The word discipline has two closely related applications. Discipline may refer to the instruction and nurturing of an individual. It can also carry the connotation of censure or punishment. The purpose of discipline, in either case, is to sustain integrity or aim toward improvement. Although difficult and often painful in the moment, discipline frequently holds long-lasting benefits. Conversely, a person or entity living without discipline is likely following a path of self-destruction.

The same holds true for an economic system. After all, economics is simply the study of the collective decision-making of individuals with regard to their resources. Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses.

In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal. If I can borrow at 2% and there appear to be many investments that will return more than that, I am less likely to put forth the same energy to find the best opportunity. Indeed, at that low cost, I may not even use borrowed money for a productive purpose but rather for a vacation or bigger house, the monetary equivalent of using water to hose off the patio. Less rigor is applied when rates are low, thus raising the likelihood of misallocating capital.

Happy Talk

In November 2010, The Washington Post published an article by then Federal Reserve (Fed) Chairman Ben Bernanke entitled What the Fed did and why: supporting the recovery and sustaining price stability. In the article, Bernanke made a case for expanding on extraordinary policies due to still high unemployment and “too low” inflation. In summary, he stated that “Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

To minimize concerns about the side effects or consequences of these policies he went on, “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated.” In his concluding comments he added, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” During her tenure as Fed Chair, Janet Yellen reiterated those sentiments.

Taken in whole or in part, Bernanke’s comments then and now are both inconsistent and contradictory. Leaving the absurd counterfactuals often invoked aside, if asset purchases were in 2010 “unfamiliar as a tool of monetary policy,” then what was the basis for knowing concerns to be “overstated”? Furthermore, what might be the longer-term effects of the radical conditions under which the economy has been operating since 2009? What was the basis of policy-makers’ arguments that extraordinary policies will not breed unseen instabilities and risks? Finally, there is no argument that the Fed has “the tools to unwind these policies,” there is only the question of what the implications might be when they do.

In the same way that no society, domestic or global, has ever engaged in the kinds of extraordinary monetary policies enacted since the Great Financial Crisis (GFC), neither has any society ever tried to extract itself from them. These truths mandate that the uncertainty about the future path of the U.S. economy is far more acute than advertised.

Even though policy-makers themselves offered no evidence of having humbly and thoroughly thought through the implications of post-GFC policies, there is significant research and analysis from which we can draw to consider their implications apart from the happy talk being offered by those who bear no accountability. Looking back on the past 60+ years and observing the early stages of efforts to “unwind” extraordinary policies offers a clearer lens for assessing these questions and deriving better answers.

The Ghost of Irving Fisher

Irving Fisher is probably best known by passive observers as the economist whose ill-timed declaration that “stock prices have reached a permanently high plateau” came just weeks before the 1929 stock market crash. He remained bullish and was broke within four weeks as the Dow Jones Industrial Average fell by 50%. Likewise, his reputation suffered a similar fate.

Somewhat counter-intuitively, that experience led to one of his most important works, The Debt-Deflation Theory of Great Depressions. In that paper, Fisher argues that overly liberal credit policies encourage Americans to take on too much debt, just as he had done to invest more heavily in stocks. More importantly, however, is the point he makes regarding the relationship between debt, assets and cash flow. He suggests that if a large amount of debt is backed by assets as opposed to cash flow, then a decline in the value of those assets would initiate a deflationary spiral.

Both of those circumstances – too much debt and debt backed by assets as opposed to cash flow – certainly hold true in 2018 much as they did in 2007 and 1929. The re-emergence of this unstable environment has been nurtured by a Federal Reserve that seems to have had it mind all along.

Even though Irving Fisher was proven right in the modern-day GFC, the Fed has ever since been trying to feed the U.S. economy at no cost even though extended periods of cheap money typically carry an expensive price tag. Just because the stock market does not yet reflect negative implications does not mean that there will be no consequences. The basic economic laws of cause and effect have always supported the well-known rule that there is no such thing as a free lunch.

Cheap Money or Expensive Habit?

Interest rates are the price of money, what a lender will receive and what a borrower will pay. To measure whether the price of money is cheap or expensive on a macro level we analyze interest rates on 3-month Treasury Bills deflated by the annualized consumer price index (CPI).  Using data back to 1954, the average real rate on 3-month T-Bills is +0.855% as illustrated by the dotted line on the chart below.

When the real rate falls below 0.20%, 0.65% below the long-term average, we consider that to be far enough away from the average to be improperly low. The shaded areas on the chart denote those periods where the real 3-month T-Bill rate is 0.20% or below.

Of note, there are two significant timeframes when real rates were abnormally low. The first was from 1973 to 1980 and the second is the better part of the last 18 years. The shaded areas indicating abnormally low real interest rates will appear on the charts that follow.

The chart below highlights real GDP growth. The post-war average real growth rate of the U.S. economy has been 3.20%. Based on a seven-year moving average of real economic growth as a proxy for the structural growth rate in the economy, there are two distinct periods of precipitous decline. First from 1968 to 1983 when the 7-year average growth rate fell from 5.4% to 2.4% and then again from 2000 to 2013 when it dropped from 4.1% to 0.9%. Interestingly, and probably not coincidentally, both of these periods align with time frames when U.S. real interest rates were abnormally low.

Revisiting the words of Ben Bernanke, “Easier financial conditions will promote economic growth.” That does not appear to be what has happened in the U.S. economy since his actions to reduce real rates well below zero. Although the 7-year average growth rate has in recent years risen from the 2013 lows, it remains below any point in time since at least 1954.

Similar to GDP growth in periods of low rates, the trend in productivity, shown in the chart below, also deteriorates. This evidence suggests something contrary to the Fed’s claims.

Despite what the central bankers tell us, there is a more convincing argument that cheap money is destructive to the economy and thus the wealth of the nation. This concept no doubt will run counter to what most investors think, so it is time to enlist the work of yet another influential economist.

Wicksell’s Elegant Model

Knut Wicksell was a 19th-century Swedish economist who took an elegantly simple approach to explain the interaction of interest rates and economic cycles. His model states that there are two interest rates in an economy.

First, there is the “natural rate” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working age population and the growth in productivity. The chart of the 7-year moving average of GDP growth above serves as a reasonable proxy for the structural economic growth rate.

Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand. Although it is difficult to measure these terms with precision, they are generally accurate. As John Maynard Keynes once said, “It is better to be roughly right than precisely wrong.”

According to Wicksell, when the market rate is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

If the market rate rises above the natural rate of interest, then no smart businessman would be willing to borrow at 5% to invest in a project with an expected return of only 2%. Furthermore, no wise lender would approve it. In this environment, only those with projects promising higher marginal returns would receive capital. On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

To further refine what Wicksell meant, consider the poor growth rate of the U.S. economy. Despite its longevity, the post-GFC expansion is the weakest recovery on record. As the charts above reflect, the market rate has been below the natural rate of the economy for most of the time since 2001. Wicksell’s theory explains that healthy, organic growth in an economy transpires when only those who are deserving of capital obtain it. In other words, those who can invest and achieve a return on capital higher than that of the natural rate have access to it. If undeserving investors gain access to capital, then those who most deserve it are crowded out. This is the misallocation of capital between those who deserve it and put it to productive uses and those who do not. The result is that the structural growth rate of the economy will decline because capital is not efficiently distributed and employed for highest and best use.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.


As central bankers continue to espouse policies leading to market rates well-below the natural rate, then, contrary to their claims, structural economic growth will fail to accelerate and will actually continue to contract. The irony is that the experimental policies, such as those prescribed by Bernanke and Yellen, are complicit in constraining the growth the economy desperately needs. As growth languishes, central bankers are likely to keep interest rates too low which will itself lead to still lower structural growth rates. Eventually, and almost mercifully, structural growth will fall below zero. The misallocated capital in the system will lead to defaults by those who should never have been allocated capital in the first place. The magnitude and trauma of the ensuing financial crisis will be determined by the length of time it takes for the economy to finally reach that flashpoint.

As discussed in the introduction, intentionally low-interest rates as directed by the Fed is reflective of negligent monetary policy which encourages the sub-optimal use of debt. Given the longevity of this neglect, the activities of the market have developed a muscle memory response to low rates. Adjusting to a new environment, one that imposes discipline through higher rates will logically be an agonizing process. Although painful, the U.S. economy is resilient enough to recover. The bigger question is do we have Volcker-esque leadership that is willing to impose the proper discipline as opposed to continuing down a path of self-destruction? In the words of Warren Buffett, chains of habit are too light to be felt until they are too heavy to be broken.


Allocating on Blind Faith – RIA Pro

“Successful investing is about managing risk, not avoiding it.” – Benjamin Graham

Almost all passive investment strategies are based on the assumption that younger investors should hold more equities as a percentage of their total portfolio. Likewise, as they age and get closer to retirement, the allocation to fixed income assets should grow while equity holdings shrink. Target Date Funds (TDF’s), which base asset allocation solely on a specific future date, are the poster child for this strategy and demonstrate the current epitome of blind faith in passive strategies.

If such a strategy were effective, investing would be simple and we could all meet our retirement goals. Unfortunately, our investment lifespans never line up with valuation peaks and troughs. As such, any strategy that ignores expected returns and the risks associated with asset prices at each point along the investment horizon is destined for failure.

In this piece, we focus on an important graph and its construction. We illustrate that there are times, regardless of whether you are 75 or 25, that you should heavily invest in stocks and other times when bonds should take priority over stocks.

We offer a special thank you to Brett Freeze for help sourcing and compiling the data used in the graphs and tables below.

Missing the Target

Target Date Funds (TDF’s) are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in retirement plans and 529 College Savings Plans due to the known date when someone wishes to retire or send a child to college.

When TDFs are newly created, with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses, they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following charts show how Vanguard’s TDF allocations transition as the amount of time remaining until the target date declines.

The problem with these funds is that the asset allocations employed are solely a function of a specified future date, giving no consideration to the price paid for those assets. More simply, these funds completely ignore the most basic rule of investing, buy low and sell high.

Expected Returns 

To effectively explain a practical method for allocating between stocks and bonds, we have created a rather complex graph. Rather than present it now and try to explain the myriad of data points represented by the various symbols and lines, we think it is best to walk you through the construction of the graph. Viewing the various components of the graph in isolation will make it easier to interpret and shine a light on the expected outcomes for stocks and bonds.


The following three graphs are scatter plots of popular equity market valuations and their associated returns. Specifically, the green, orange, and purple markers represent the intersection of a quarterly valuation level and the subsequent 10-year annualized total return. Instead of using the specific valuation data in the x-axis, we use each data point’s standard deviation from the mean. This allows us to more effectively compare the values of the three metrics together.

On each graph you will see a downward slanted line, which is the regression trend line of the markers (dots/diamonds). Each graph also has a vertical line representing the current valuation level. The intersection of these two lines is the expected return for the next ten years. The three graphs and the compilation of them shown last is based on nearly 75 years of data.

1. Market Cap to GDP

This valuation compares the market capitalization of the broad market to nominal GDP. Given that corporate earnings are almost entirely a function of economic growth, this ratio provides guidance on whether total market capitalization is appropriate versus GDP. Warren Buffet said this ratio “is probably the best single measure of where valuations stand at any given moment.”

The R-squared measuring correlation stands at 0.69, meaning that 69% of ten-year forward returns can be explained by the current valuation. The ten-year annualized expected total return is -1.42% as shown by the circle surrounding the intersection of the current valuation and trend line. Also note that with the exception of one quarterly instance, anytime the ratio was greater than two standard deviations above the average, the following ten years posted a negative return.

2. Tobin’s Q Ratio

James Tobin created this ratio to show the market value of all companies versus the replacement value of all those companies’ assets. When the measure is 1.0 or greater, it means the aggregate value of stocks is greater than the aggregate value of their assets.

The R-squared is 0.67, and the ten-year expected total annualized return is +2.92%.

3. Robert Shiller’s CAPE

– Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of calculating the widely popular price-to-earnings (P/E) ratio. Unlike most P/E measures which use earnings from 12 months prior or forward estimates in the denominator, this method uses an average of the last ten years of earnings. The benefit versus the shorter time frames is that it factors in longer-term earnings trends and complete economic cycles. P/E calculations using 12-months of data are exposed to short-term deviations from the earnings trend and ignore the cyclicality of economic activity.

The R-squared is 0.62, and the ten-year expected total annualized return is +3.49%.

Now we compile the data from the three graphs to get a broad picture of what these valuations portend.

We find it fascinating that the trend lines and data points for three different valuation methods are so closely aligned. While each valuation measure points to a different expected return, the broad message is clear that higher valuations imply weaker future returns and vice versa. More importantly, the current valuation levels all point to poor expected returns. Factor in inflation and the returns for all three measures are likely at or below zero.

Fixed Income Alternatives

Having seen return expectations for stocks, we now shift focus to consider the potential return on other asset classes. While there are many alternative assets in which one can invest, we chose to simplify this analysis and compare equities to the yields of liquid, high-quality fixed-income securities. The primary reason is that the U.S. Treasury note and investment-grade bonds we use are easy to acquire and guarantee a fixed ten-year return barring a default. Default risk for the bonds we selected for this analysis is very low.

The following graph combines the guaranteed yields of the bonds we selected (barring default) as compared to the equity outcomes shown above. The red dotted line in the graph represents the current yield on a risk-free ten–year U.S. Treasury (2.95%), while the aqua shaded area provides a range of yields for the corporate bonds. Beneath the graph is details of the corporate bonds selected for this analysis.

The following table compares the expected returns for equities, Treasury note, and the selected corporate bonds.


We only presented three measures of valuation in this analysis. We did not cherry pick valuations as evidenced by the table below showing our three indicators as well as five others.

For an investor who elects to continue to chase the stock market higher, do so with the understanding that the market is well overdue for a serious drawdown. If you are a passive investor and do not track day to day price changes or follow technical studies, we recommend you take this analysis seriously and formulate a plan to manage risk. 

However, doing so requires some work and effort which runs counter to current investment norms. Passive investing is “easy” and requires no effort. Plus, the fees are low. In contrast, identifying times when the market is cheap or expensive requires some work and usually cuts against popular opinion. The evidence of historical data is clear; we are all but guaranteed to achieve a better return on bonds than stocks for the next ten years.  The only question we all must answer is when should we stop following the equity herd and start following the long lesson of the history books? Despite the insistence of many popular investors and the financial media, this time is not different.

As Benjamin Graham notes in his classic book The Intelligent Investor, “Successful investing is about managing risk, not avoiding it.” Ultimately, risk is most effectively managed by being discriminating about the price paid for an asset. Target date funds and many other passive strategies intentionally disregard his advice.

Whatever it Takes


At the end fiat money returns to its inner value—zero.”  – Voltaire

 “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” – Mario Draghi July 26, 2012

On July 26, 2012, European Central Bank (ECB) President Mario Draghi essentially guaranteed the ECB would not allow the markets to cripple the Euro region. This shot across the bow finally remedied the instability caused by the sovereign debt crisis. The markets quickly reversed the damaging trends and uncertainty that had plagued the Euro-zone for months.

Draghi’s statement essentially boiled down to a promise that the ECB would print unlimited amounts of money to stop the “harmful” will of investors.

Fiat currency, be it dollars, euros, yen, or any other major currency today, are backed by confidence in the government, its ability to tax and the status of its economy. Importantly, however, it is also largely based on the trust and confidence in the central bank that issues those notes. If Draghi did not have the market’s trust and confidence, his statement would have been ignored, and there is no telling what might have happened to Greece or the Euro for that matter.

In September 2016, the Bank of Japan (BOJ) introduced Quantitative and Qualitative Easing (QQE) with Yield Curve Control. The new policy framework aimed to strengthen the effects of monetary easing by controlling short-term and long-term interest rates through market operations. The announcement also introduced an “inflation overshooting commitment” with the BOJ committed to expanding the monetary base until the year-over-year inflation rate “exceeds and remains above the 2 percent target in a stable manner.” Essentially, the BOJ pulled a “Draghi” and promised to do “whatever it takes” to ensure interest rates did not rise more than they wanted.

Recently, the BOJ amended the 2016 statement because bond investors were increasingly testing the central bank’s resolve. We are not claiming this just yet, but if the BOJ is losing the trust and confidence of investors, they could be the first domino in a long line that will change the markets drastically. While this discussion is certainly early, the situation bears close attention.


Before discussing the BOJ’s recent actions, consider the following, which demonstrates the aggressive use of monetary policy by the BOJ:

  • The BOJ cut their equivalent of the Fed Funds rate to zero in 1999 and, excluding a few minor variations, it has stayed at or below zero since then.
  • The BOJ buys and owns Japanese Treasury bonds (JGB’s), ETF’s and REITs.
  • The BOJ owns 48% of outstanding Japanese Government Bonds (JGBs)
  • The BOJ is a top-ten shareholder in over 40% of Japan’s listed companies.
  • The BOJ owns nearly 80% of domestic ETF’s.
  • The BOJ’s balance sheet is over 110% of Japan’s GDP, dwarfing the Fed (21%) and the ECB (24%).

Throughout the summer of 2016, rapidly rising interest rates became a concern for the BOJ. We say that tongue in cheek as ten-year JGB yields only rose about 0.30% over a few months and were still negative. A continuation of that trend was clearly a threat to the BOJ and, in September that year, they took decisive action to stop the assent of yields.

As discussed in the opening statement, QQE with yield control and the new inflation overshooting commitment would provide the BOJ with unlimited abilities to fight rising rates. Included with that policy modification was a limit or cap on ten-year yields at 0.10%. If that yield level were breached, they would throw the proverbial kitchen sink at the market to fight it. The graph below shows ten-year JGB yields and the effectiveness of the cap (red line).

In late July 2018, yields on ten-year JGB’s breached 0.10% on four different days. The BOJ, as they did in 2016 when rates rose, took this threat seriously. On July 31st, they amended their 2016 pronouncement to allow more flexibility in yield levels, leaving the direction of rates more in the hands of the market. This action has been clarified to mean they will increase their cap on ten-year JGB yields to 0.20%. The graph below charts the daily highs since July 1st, to better highlight the yield versus the 0.10% cap.

The BOJ owns an overwhelming majority of Japanese stocks and government bonds. Their control is significantly greater when you consider their ownership of the true float of the securities. This is incredibly important to grasp as the BOJ is quickly reaching the limit on how many more of those assets it can buy.

That is not to say that they don’t have options once they buy all the bonds and stocks the capital markets have to offer. The options become more extreme and, quite frankly, much more consequential. For example, they could take the route of the Swiss Central Bank and buy foreign stocks. They could also print money and give it directly to citizens, aka helicopter money. Both options have grave implications for their currency and greatly increase the odds of meaningful instabilities like hyperinflation.

The BOJ’s rationale for allowing greater flexibility is to address “uncertainties” related to the anticipated consumption tax hike in 2019. In our opinion, the flexibility is the BOJ’s way of whispering “Uncle”. They know they are limited in their ability to further manipulate interest rates and stock prices and do not want to tip their hand to the market. Again, if the market senses the BOJ’s tool box is empty, trust and confidence could fade quickly.

Some may say this is a first step in the BOJ taking their foot off the monetary gas pedal, and if so, we welcome and applaud such action. What seems more likely is that the market has finally sensed the BOJ’s Achilles Heel.


Public trust and confidence is the single most important asset a central banker can possess. Without these, they are printing worthless currency and have little to no power.

Shorting Japanese bonds has been called the “widow makers trade” as one must have incredible patience and plenty of time to outlast the BOJ’s will. Thus far, anyone that has fought the BOJ has lost, hence the nickname. Japan’s problems have been brewing for decades, and despite recent signs that the BOJ is running out of weapons, we would remain reluctant to fight them.

Of greater concern to us is the macro picture that is emerging in Japan. If investors are starting to question the on-going ability of the BOJ to manage rates, it is not unreasonable to think that other central banks could be at risk. While this story will continue to play out over a long time frame, markets seem content to ignore the growing problem. Our concern is that, if you are not prepared to act when the market unexpectedly awakens, you will be the victim of the reversal of years of interest rate price controls and asset price manipulation.

Keep in mind; you can’t buy homeowners insurance once the house is on fire.

Fixed Income Update – July 2018 RIA Pro

Shrugging off economic growth, inflation and U.S. Treasury supply concerns that seem to have plagued the fixed-income markets for the past few months, most bond sectors staged a healthy rally in July as performance reflected the risk-on flavor for the month. The riskiest sectors, emerging markets and high yield (HY), performed best while the safest, Treasuries and mortgages, were the only two sectors to post monthly losses.

Anxieties surrounding trade and tariffs were overshadowed by comments from the Federal Reserve (Fed) that were broadly very constructive for the U.S. economy. In his quarterly testimony to Congress, Fed Chairman Powell emphasized a favorable outlook due to strong labor markets and the lift from fiscal policy stimulus. Those positives outweighed the downside risk emanating from rising protectionism.

Year-to-date, only the high-yield sector is in the black, municipals are essentially flat and every other sector is posting a negative return. Although much improved in July, emerging market bonds continue to struggle but with good reason given the political and foreign exchange disruptions in many places like Turkey, Argentina, Brazil and South Africa. Somewhat strangely, the divergence between high yield and investment grade (IG) corporates persists as they represent the best and the worst performers of the year so far.

Reviewing the lower rated corporate bonds in the IG and HY corporate sectors offers an illustration of the extent to which lower-rated high yield bond valuations have outperformed lower-rated IG.

The chart above highlights the yield-to-worst (YTW) relationship between BBB-rated IG bonds and CCC-rated HY going back to the end of the recession in June 2009. To get back to the average trendline would require the CCC YTW to increase to approximately 10.75% from the current 8.39% yield. If we assume a five-year duration, such a move would entail an approximate price decline of 12%.

In terms of spread, CCC’s would need to move higher by 100 basis points to 6.50 or the BBBs would need to drop by roughly 50 basis points.

In our opinion it is worth looking into a trade whereby you are long BBB’s and short CCC’s.  What makes this idea even more compelling is the comparative credit risk advantage. According to S&P ratings analysis, roughly 40% of CCC-rated bonds will default within 3 years while the risk to BBB-rated bonds is less than 2%.

Bulls Make A Charge For The Highs

Bulls Make A Charge For The Highs

Last week, we discussed how the market managed to clear the “Maginot Line” which brings January highs into focus. The chart below is the updated analysis from last week.

Given this is a “weekly” chart, it takes much more time for signals to register. The advance over the last few weeks has taken the market back into overbought territory and was a point made last week:

“The market can most assuredly get even more overbought from current levels, but does suggest that upside is becoming more limited from current levels. However, with the weekly ‘buy signal’ triggered this past week, we must give the bulls some room to run.”

Currently, the “bulls” remain clearly in charge of the market…for now. While it seems as if much of the “tariff talk” has been priced into stocks, what likely hasn’t as of yet is rising evidence of weakening economic data (ISM, employment, etc.), weakening consumer demand, and the impact of higher rates.

While on an intermediate-term basis these macro issues will matter, it is primarily just sentiment that matters in the short-term. From that perspective, the market retested the previous breakout above the March highs last week (the Maginot line) which keeps Pathway #1 intact. It also suggests that next week will likely see a test of the January highs.

With moving averages rising, this shifts Pathway #2a and #2b further out into the August and September time frames. The potential for a correction back to support before a second attempt at all-time highs would align with normal seasonal weakness heading into the Fall. 

Currently, there is a very low risk of a deeper correction (Pathway #3). However, it is a possibility that should not be ignored at this juncture. With the administration gearing up for further tariffs against China, and China retaliating in kind, at a time when the Fed is already more aggressively tightening monetary policy, it would be remiss to ignore the risk of “something going wrong.” 

It would also be remiss to not remind you that despite the “bullish short-term view,” the long-term outlook remains decidedly bearish. With valuations elevated, price extended, and deviations near historic records, the potential for a more severe correction in prices is an absolute certainty.

The issue is that these cycles can remain both fundamentally and technically overvalued for longer than logic would dictate particularly when there are artificial influences at play. However, the message is clear for those that choose to listen. This is why it is crucially important to have a discipline and strategy in place which will manage the exposure to risk when things change in the market.

Weekly Buy Signal Is In, But Don’t Jump

In the 401k Plan Manager at the bottom of this newsletter each week, I publish the model that drives our portfolio allocations over time.

There are two important concepts to understand about this model.

  • Risk knows no age: Risk doesn’t care how old you are. It is often said that if you are 20, you should take on a lot of portfolio risk. However, if that risk is taken at the top of a market cycle, the damage to the long-term financial goals can be disastrous. We believe that our allocation to risk has nothing to do with our age, and everything to do with the potential for the loss of capital. Therefore, our allocation model is broken into two parts.
    • Allocation model is based upon current valuation levels.
      • If valuations were 10-12x earnings the target allocation levels would be primarily weighted towards equity (i.e. 80% Stocks / 20% Bonds)
      • As valuations rise behind historical extremes, target equity levels are reduced. (i.e. 60/40, 50/50, etc.)
    • The EQUITY portion of the allocation is also adjusted based on current market risk. Earlier this year, the equity risk portion of the allocation model was reduced from 100% to 75% due to a triggering of a confirmed “sell” signal. There are 4-primary indicators to the model:
      • 1st signal – short-term warning signal. Only an alert to pay attention to portfolio risk. 
      • 2nd signal – reduce equity by 25%.
      • 3rd signal – (Moving average cross-over) reduce equity by another 25%.
      • 4th signal – (Trend change) – reduce equity by another 25% and short the market.

We will be posting a live version of our indicators at RIAPro.net (currently in beta) as shown below.

The 4-signals above also run in reverse. So, when a signal reverses itself, equity risk is increased in the model as is the case this week.

With that signal in place, we must now increase our portfolio allocation model to 100% of target.

However, it is important to note these signals are based on “weekly” data and are intermediate-term in nature. Therefore, by the time these longer-term indicators are triggered, the very short-term conditions of the market are generally either very overbought, or oversold.

So, Do I Buy Or Not?

At this juncture, most individuals tend to let their emotions get the better of them and they make critical errors with their portfolios. Emotional buying and selling almost always leads you into doing exactly the opposite of what you should do.

Currently, the market has registered a “buy signal,” which means we need to be following our checklist to ensure we are making sound investment decisions:

  • What is the allocation model going to look like between asset classes?
  • How will those choices affect the volatility of my portfolio relative to the market?
  • What is the inherent risk of being wrong with my choices?
  • What is my exit point to sell as the market goes up?
  • Where is my exit point to sell if the market goes down?
  • What specific investments will I use to fill each piece of my allocation model?
  • How does each of those investments affect the portfolio as a whole as well as each other?
  • Where is my greatest and least amount of exposure in my portfolio?
  • Have I properly hedged my risk in my portfolio in case of a catastrophic event?

If you can’t answer the majority of these questions – you should not be putting your money in the market.

These are the questions that we ask ourselves every day with our portfolio allocation structures and you should be doing the same. This is basic portfolio management. Investing without understanding the risk and implications is like driving with your eyes closed. You may be fine for a while but you are going to get seriously hurt somewhere along the way.

There is NO RULE which states you have to jump into the market with both feet today. This is not a competition or game that you are trying to beat. Who cares if your neighbor made 1% more than you last year. Comparison is the one thing that will lead you to take far more risk in your portfolio than you realize. While you will love the portfolio as it rises with the market; you will rue the day when the market declines.

Being a “contrarian” investor, and going against the grain of the mainstream media, feels like an abomination of nature. However, being a successful investor requires a strict diet of discipline and patience combined with proper planning and execution. Emotions have no place within your investment program and need to be checked at the door.

Unfortunately, being emotionless about your money is a very difficult thing for most investors to accomplish. As humans, we tend to extrapolate the success or failure within our portfolios as success and failure of ourselves as individuals. This is patently wrong. As investors, we will lose more often than we would like – the difference is limiting the losses and maximizing the winnings. This explains why there are so few really successful investors in the world.

With this in mind, it doesn’t mean that you can’t do well as an investor. It just means that you must pay attention to the “risks” inherent in the market and act accordingly.

• Yes, the market is on a “buy” signal. 
• Yes, we need to add exposure as shown in the 401k plan manager below. 
• No, it doesn’t mean that you need to act immediately

However, it does mean that we need to pay close attention to developments over the next couple of weeks to be sure the “intersection” is clear and that we can proceed to the next traffic light safely. Hopefully, we can catch it “green” – if not, we will obey the signal, stop, and wait for our turn once again.

While the model is being increased back to 100% of target, we will selectively add equity exposure during short-term corrective actions in the market.

As I noted last week:

“With our portfolios nearly fully allocated, there are not a lot of actions we need to take currently as the markets continue to trend higher for now. We will continue to monitor our exposure and hedge risk accordingly, but with the weekly “buy signal” registered, we are keeping our hedges limited and are widening our stops just a bit.

As noted above, a short-term correction is needed before adding further equity exposure to portfolios. That correction likely started on Friday, and I will not be surprised to see it continue into next week. A retest of 2800 is likely at this point, which would keep Pathway #1 intact. However, a violation of that level will likely trigger a short-term sell signal, which could push the market back towards previous support at 2740. 

There is a lot of support forming at 2740, which should be supportive of the market over the next couple of months. A violation of that level suggests something has likely broken and more protective actions should be taken.”

Until that happens, we will give the markets the benefit of the doubt…for now. 

Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

S&P 500 Tear Sheet

Performance Analysis

ETF Model Relative Performance Analysis

Sector & Market Analysis:

Last week, this section wasn’t available due to my travels. Therefore, changes in this week’s commentary is based on two week’s of data.

Discretionary and Technology – After recommending to take some profits out of the Technology sector, the $FB episode led to sell-off back to the 50-dma support. The same occurred with the discretionary sector as well. The trends for both remain very bullish right now, and the pullback provides an opportunity to rebalance sector holdings back to target weights.

Healthcare, Staples, and Utilities – after cooling briefly, money has once again flowed strongly into the sector. Healthcare, in particular, has gotten very extended and taking some profits and rebalancing back to portfolio weight makes sense. Despite the recent uptick in rates, Utilities have also continued to perform nicely after a long basing period earlier this year. Staples also continue to improve.

Financial, Energy, Industrial, and Material stocks showed a bit of improvement this past week. Industrials were the only sector in the group to climb back above its 50-dma but remains below several previous tops. While the trend for Energy remains in place, for now, we remain underweight holdings due to lack of relative performance. We currently have no weighting in Industrial or Materials as the “trade war” continues to negatively impact the companies in the sectors. The decline of the “yield curve” continues to weigh on major banks.

Small-Cap and Mid Cap continue to perform well as of late. We noted two weeks ago, that after small and mid-caps broke out of a multi-top trading range, we needed a pull-back to add further exposure. That pullback to the 50-dma happened and we added exposure to portfolios with stops at the 50-dma. On any further weakness in the markets that hold supports and we increase exposure further to get us to full target weights in our models.

Emerging and International Markets were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. Furthermore, we noted that global economic growth was slowing which provided substantial risk. That recommendation to focus on domestic holdings in allocations has paid off well in recent months. With emerging markets and international markets continuing to languish, there is no reason to ad exposure at this time. Remain domestically focused to reduce the drag on overall portfolio performance.

Dividends and Equal weight continue to hold their own and we continue to hold our allocations to these “core holdings.” 

Gold – we haven’t owned Gold since early 2013. However, we suggested three months ago to close out existing positions due to a violation of critical stop levels. We then recommended that again given the cross of the 50-dma back below the 200-dma.

That bounce came and went and gold broke to new lows. With gold very oversold on a short-term basis, if you are still long the metal, your stop has been lowered from $117 two weeks ago, to $114 this week. A rally sale point has also declined from the previous level of $121 to $117.50.

Bonds – This past week, bonds sold off on concerns of a major issuance of new bonds by the Treasury to fill the Government’s funding gap. With the 50-dma about to cross back above the 200-dma, the technical backdrop continues to build for adding bonds to portfolios. However, be patient and let’s see what happens next week. As noted previously, we remain out of trading positions currently but remain long “core” bond holdings mostly in floating rate and shorter duration exposure.

REIT’s keep bouncing off the 50-dma like clockwork. Despite rising rates, the sector has continued to catch a share of money flows and the entire backdrop is bullish for REIT’s. However, with the sector very overbought, take profits and rebalance back to weight and look for pullbacks to support to add exposure.

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio/Client Update:

As I noted last week, the market’s improvement allowed us the ability to further increase equity exposure in portfolios in anticipation of registering a confirmed buy signal. With the retest of the “Maginot Line” this past week, we will look to further increase equity exposure on opportunity. However, given the August and September are historically weak months for the market, we will remain a bit more cautious on the how and when we increase holdings in our models.

The cluster of support at the 50- and 100-dma remains in place which limits much of the downside risk currently. However, we are quite aware of the risk stemming from “tariff talk” and further tightening of Fed policy. As we noted several weeks ago:

“While we are not raging long-term bulls, we do think that with earnings season in process the bias will be to the upside. There is a high probability of a substantive rally over the next couple of weeks.”

While that has indeed been the case, we continue to follow our “process” internally with an inherent focus on the risk to client capital.

  • New clients: We added 50% of target equity allocations for new clients. We will look to add further exposure opportunistically. 
  • Equity Model: We previously added 50% of target allocations. We “dollar cost averaged” into those holdings opportunistically. We recently added new positions to the model and will continue to look for opportunity accordingly.  
  • Equity/ETF blended models were brought closer to target allocations as we added to “core holdings.”
  • Option-Wrapped Equity Model were brought closer to target allocations and collars will be implemented.

Again, we are moving cautiously, and opportunistically, as we continue to work toward minimizing risk as much as possible. While market action has improved on a short-term basis, we remain very aware of the long-term risks associated with rising rates, excessive valuations and extended cycles.

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these action either by reducing, selling, or hedging, if the market environment changes for the worse.


The Real 401k Plan Manager – A Conservative Strategy For Long-Term Investors

There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.


Buy Signal Is In…

The market did trigger a weekly confirmed “buy” two week’s ago as we previously discussed. However, as noted in the main part of missive above, by the time these signals occur the market has generally gotten either overbought or oversold in the short-term.

There is “no requirement” to make immediate adjustments to your 401k plan. As you will note in the chart above, there have previously been “buy signals” which were reversed a few months later. This could well be one of those times given some the condition of the macro environment. However, for now, while we do recommend some caution, particularly if you are closer to retirement, follow the rules below:

  • If you are overweight equities – reduce international and emerging market exposure.
  • If you are underweight equities – begin increasing exposure towards equity in small steps. (1/3 of what is required to reach target allocations.)
  • If you are at target equity allocations currently, do nothing for now.

While we officially upgraded our allocation model back to 100% exposure, there is no rush to immediately begin adding additional equity risk. Do so opportunistically.

If you need help after reading the alert; don’t hesitate to contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time.(If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don’t see your exact fund listed, look for a fund that is similar in nature.


The Cartography Corner – August 2018

RIA Pro is pleased to introduce J. Brett Freeze, CFA and his firm Global Technical Analysis (GTA).

GTA will be providing RIA Pro subscribers his unique brand of technical analysis on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework.  We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

Going forward, we will present his analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide

The Cartography Corner

By J. Brett Freeze

The monthly analysis always starts with a review of the prior month’s analysis. After the review, a new asset(s) is analyzed and trading strategies discussed. Please enjoy the August edition of The Cartography Corner.

A Review Of July

WTI Crude Oil Futures

We will begin with a review of WTI Crude Oil Futures (CLQ8/CLU8) during July 2018. In our July 2018 edition of The Cartography Corner we wrote the following, with emphasis given to green-shaded excerpts:

In isolation, monthly support and resistance levels for July are:

  • M4             83.12
  • M3             81.26
  • M1             76.02
  • PMH          74.46                  
  • Close         74.15             
  • MTrend     68.63
  • PML           63.40             
  • M2             61.00            
  • M5             53.90

Active traders can use 74.46 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

As our subscribers know, our modus operandi is to position according to the Monthly Trend.  Our model has been long for the previous ten months.  However, as Ed Seykota (of system-trading fortune and fame) noted in his “the trading rules I live by”, rule number 5 is to “know when to break the rules”.  We sold our long position on Friday.  Our reasoning is as follows, the market achieved our weekly upside exhaustion level, to-the-penny, on Friday.  We are anticipating a two-week low in the next four to six weeks.

Figure 1 below displays the daily price action for July 2018 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  July opened by spending the first six trading sessions consolidating, with intra-day highs on three of those days breaking above June’s high at PMH: 74.46.  However, the market never settled above that level.

The following six sessions were spent with the price descending towards, and breaking, the Monthly Trend level for July at MTrend: 68.63.  As highlighted above, our focus was on anticipating a two-week low.  On Monday, July 16th, the two-week low was achieved.  The market price bottomed two sessions later at 66.44.

Over the next nine sessions, the price ascended back to (and slightly through) the Monthly Trend, MTrend: 68.63, now acting as resistance.  The market price settled the month of July at 68.76, essentially on Monthly Trend.

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures (ESU8) during July 2018. In our July 2018 edition of The Cartography Corner, we wrote the following, with emphasis given to green- shaded excerpts:

In isolation, monthly support and resistance levels for July are:

  • M4             3000.75
  • M1             2850.25
  • PMH          2796.00
  • M2             2795.25
  • M3             2737.50        
  • Close         2721.50
  • PML          2693.25          
  • MTrend    2685.19          
  • M5            2644.75

Active traders can use 2737.50 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2685.19 as the downside pivot, whereby they maintain a flat or short position below it.

Figure 2 below displays the daily price action for July 2018 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  July opened by promptly reversing the weakness realized in the latter-half of trading sessions in June.  On the third trading session of July, the market price settled above the pivot we isolated at M3: 2737.50.

The following five sessions were spent with the price ascending to (and through) our clustered-resistance levels isolated at M2: 2795.25 and PMH: 2796.00.  Over the next six sessions, the market price consolidated, testing those clustered-resistance levels, now acting as support.

Over the next three sessions, the price ascended to our isolated resistance level at M1: 2850.25, with the high price for the month achieved on July 25th at 2849.50.

With only four trading sessions remaining in the month, active traders had a decision to make: “Do I realize the 4% profit from adhering to the analysis or do I hold out for the upside exhaustion level?”  July’s upside exhaustion level was 150 points higher.  With the 20-day Average-True-Range of 26 points, even if each range of the remaining sessions were entirely to the upside, the market price was not likely to reach July’s upside exhaustion level.  The market price spent the final four trading sessions descending back to our clustered-pivot levels at PMH: 2796.00 and M2: 2795.25.

Figure 2:

August Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESU8).  The same analysis can be completed for any time-period or in aggregate.


  • Current Settle         2817.00       
  • Daily Trend             2815.69
  • Weekly Trend         2804.50       
  • Monthly Trend        2734.92       
  • Quarterly Trend      2667.92

As can be seen in the quarterly chart above, E-Mini S&P 500 Futures have been trading higher in price since the fourth quarter of 2015 and have been “Trend Up” for eleven straight quartersStepping down one level in time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three months and above Monthly Trend for ten of the past twelve months.  The futures contract settled the month of July above Monthly Trend, yet still within February’s range.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P Futures have been “Trend Up” for four weeks.


In isolation, monthly support and resistance levels for August are:

  • M4             3005.75
  • M3             2912.50
  • M1             2903.00
  • PMH          2849.50
  • Close          2817.00        
  • MTrend     2734.92
  • M2             2703.75        
  • PML           2698.50         
  • M5             2601.00

Active traders can use 2849.50 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2734.92 as the downside pivot, whereby they maintain a flat or short position below it.

Amazon.com, Inc.

For the month of August, we shift our focus from the energy market to the equity market and in particular to Amazon.  In this analysis we provide a monthly time-period analysis of Amazon.com, Inc. (AMZN).  The same analysis can be completed for any time-period or in aggregate.

Along with a few other technology & discretionary companies, Amazon has significant influence over a variety of exchange-traded-funds and equity indices.  Michael Lebowitz’s article, Are the Markets Generals Leading us to War, highlights this influence.  As a result, we believe a correct analysis of Amazon is imperative for the broader equity market.

Our analysis suggests to us that Amazon may have peaked for the year.  On December 31, 2017, we ran our annual analysis for 2018.  The annual upside exhaustion level for Amazon is A4: 1952.82.  The highest price year-to-date is 1880.05, or within 4% of the annual upside exhaustion.  For 3Q2018, we isolated clustered-quarterly-resistance at Q1: 1908.66 and Q3: 1952.26.  The highest price thus far in the third quarter came within 1.5% of this resistance zone.

Amazon also displays parabolic properties in its price history.  In Figure 3 below, the orange line is the “model” price of Amazon using the log-periodic power law.  The work we have completed on parabolic markets, and work disseminated to us by other respected market participants, suggests that parabolic markets correct the upward-parabolic price trajectory in roughly one-third of the time it took to reach the high price. As the old market saying goes, stocks climb the stairs up and ride the elevator down.

Figure 3:

Other market participants, some smarter than us, have opposite outlooks for Amazon.  However, history proves there is symmetry in financial markets and the best we can do is put the odds in our favor.  We believe our analysis accomplishes that.


  •  Weekly Trend        1809.09        
  •  Daily Trend            1799.69
  •  Close                        1777.44      
  •  Monthly Trend       1693.80        
  •  Quarterly Trend     1376.05

As can be seen in the quarterly chart above, Amazon has been trading higher in price since the first quarter of 2015 and has been “Trend Up” for fourteen quartersStepping down one level in time-period, the monthly chart shows that Amazon has been “Trend Up” for ten consecutive months.  Stepping down to the weekly time-period, the chart shows that Amazon has been “Trend Up” for four weeks.  Unequivocally, technical analysis of Amazon’s market price confirms a strong uptrend.


In isolation, monthly support and resistance levels for August are:

  • M4             2125.01
  • M1             1997.00
  • PMH          1880.05
  • M3             1855.08
  • Close         1777.44         
  • M2             1721.03
  • MTrend     1693.80         
  • PML           1678.06         
  • M5             1593.02

Active traders can use 1855.08 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 1721.03 as the downside pivot, whereby they maintain a flat or short position below it.


The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight to many different markets.  If you are a professional market participant, and are open to discovering more, please connect with us.  We are not asking for a subscription, we are asking you to listen.

Are The Market Generals Leading Us To War?

Market Wizards, a best-selling investment book written by Jack Schwager, is a must-read for investors looking to improve their performance. Each chapter of the book provides a biography and an interview of a highly successful trader/investor. Originally published in 1989, the book is full of valuable lessons from some of the best in the business, including Paul Tudor Jones, Jim Rogers, Marty Schwartz, and Ed Seykota.

Of timely interest is a quote from William O’Neil:

Another way to determine the direction of the general market is to focus on how the leading stocks are performing. If the stocks that have been leading the bull market start to break down, that is a major sign the market has topped.”

The “leading” stocks that O’Neil mentions are commonly referred to as the “Generals.”

On the heels of recent weakness in some of today’s Generals, we examine whether these stocks are sending us a signal to seek shelter or if their lower prices are temporary and a rallying call for the troops.

FAANG Stocks

The Generals leading the market higher over the last couple of years go by the acronym of FAANG. FAANG is composed of Facebook (FB), Amazon (AMZN), Apple (APPL), Netflix (NFLX), and Google (GOOGL). To understand the outsized effect they have on the S&P 500 consider the following:

  • Per Bloomberg data, the five FAANG stocks currently account for 13.5% of the weighting of the S&P 500.
  • The combined market cap of the FAANG’s is equal to that of the smallest 252 S&P 500 constituents.
  • On average, each FAANG stock has over 13 times the effect on the S&P 500 index than the average stock in the index.

The popularity of the FAANG stocks has risen substantially over the last few years as witnessed by a futures contract and multiple ETFs that track the performance of these five stocks’. Further, the Bank of Montreal now offers 3x leveraged ETF’s (FNGU and FNGD) that triple the performance of the five stocks.

The following paragraphs provide a summary of the most recent earnings announcements and the stock price activity for each FAANG stock. This analysis will help us appreciate what is driving these stock prices over the last two weeks and by default driving the markets.

Facebook – Facebook fell over 20% on July 26, 2018, erasing almost $120 billion in market capitalization. The decline was the largest one-day loss of market value in one stock in the history of the U.S. equity markets. Interestingly, the two runners-up are Intel (INTC) and Microsoft (MSFT), both occurring in the year 2000. At the time, they were five-star Generals that ultimately led their troops over a cliff.

Largely responsible for the drop was Facebook’s second-quarter earnings announcement which reported weaker than expected revenue and daily active users as well as corporate guidance lowering those metrics in the third and fourth quarters. The stock was also downgraded by a few Wall Street analysts.

While the decline was severe, FB is still flat this year and up over 50% since January 2017.

Netflix – Netflix has fallen 7% since a lackluster earnings report on July 23, 2018. While earnings beat estimates, they only added 670,000 U.S. subscribers in the second quarter, missing projections of 1,200,000. This was the first time in five years they fell short of their user projections. Given that Netflix is trading at valuations that portend significant user growth, any signs that they are approaching product saturation should be especially concerning.

Despite the loss, Netflix is still up nearly 200% since January 2017 and over 85% this year.

Amazon – Amazon released its quarterly earnings on July 26, 2018. The stock closed the following day up about half a percent but since then has given back over 2%. While the market initially seemed to focus on a massive beat in earnings versus projections, investors seemed to gravitate to the company’s missed revenue expectations and guidance lower for the next quarter. Given that a large chunk of the bottom line EPS rise was attributable to a sub-3% tax rate, it is likely concerns over forward guidance are justified.

For the year to date, Amazon is up almost 60%, trading near its all-time high and showing few signs of weakness.

Google – Like Amazon, Google smashed earnings expectations, and the stock rose nearly 5% on the day following the announcement. Unlike Amazon, their sales also beat expectations, and they did not lower forward earnings guidance. Google is up 20% year to date and is perched near its all-time highs. Google appears to be the strongest of the Generals.

Apple – Apple’s second quarter earnings per share and sales surpassed Wall Street’s expectations and they raised revenue guidance for earnings for next quarter. The only wrinkle was iPhone sales, which account for more than half of their revenue, came up slightly short of expectations. As of writing this the stock is up 2.50% and within a few cents of its all-time high.

The following table summarizes the FAANG’s stock performance since July 1, 2018.


Some of the Generals are flashing signs of weakness. That said, two weeks and one-quarter of earnings do not make a trend. Despite large price losses for two of the Generals, the S&P 500 took these drops and earnings announcements in stride. For the week of July 23-27, in which all but one of the FAANGs released earnings, the S&P 500 was up 0.61%.

Currently, we are focused on the price action of FB and NFLX. Given the “buy the dip” reflexivity that has pervaded the market and these stocks in particular, their price action in the weeks ahead will be telling. If they remain at current levels or drift lower, we would regard this as a signal that all is not well. On the other hand, if the FAANG stocks that are struggling start to recoup losses and resume their role leading the market higher again, we will have to wait on the wisdom of William O’Neill.

QE4 – When, Not If – RIA Pro

Many market prognosticators attribute the rise in interest rates to a consensus outlook for expanded economic growth and increasing inflationary pressures. In our article, Deficits Do Matter, we took this view to task by providing market-based evidence to show that those factors only account for about a third of the increase in interest rates.  Our perspective is that the rapidly growing forecasted supply of Treasury debt coupled with limited demand from the two largest holders of Treasury securities are currently the main drivers of higher yields.

In this article we take that analysis a step further and ask a question that few seem to be considering; what if there is a recession in the coming year or two? In answering that question, from the perspective of the federal deficit and related debt issuance, the current fiscal situation is more precarious than perceived and points to a high probability that the Fed will need to re-initiate quantitative easing (QE) but for altogether different reasons than it has done so in the past.

Prior Recessions

John Maynard Keynes, a cult-like figure in the economics community, asserted that to smooth the fluctuations in the business cycle governments should run deficits when economic activity slows and surpluses when economic expansions resume. This simple concept is nothing more than the age-old “save for a rainy day” adage. Despite strict adherence to many of Keynes theories, most politicians only seem to hear the part about running deficits. Without regard for whether or not you agree with Keynes thinking, there is absolutely no logic or wisdom in the idea that debts can consistently grow faster than one’s ability to pay for them. 

The U.S. government is expected to borrow over $1 trillion per year in each of the next five years. This Congressional Budget Office (CBO) estimate is based on a host of assumptions all of which depend on a consistent nominal economic (GDP) growth rate varying closely around 3.90%. The obvious problem with this model is that even if such a growth rate is achieved quarter in and quarter out, economic growth would only be approximately $800 billion per year. In other words, the burden of debt will rise faster than the ability to fund it.  Furthermore, it seems to us more than a little short-sighted that no one is asking what if GDP growth is not as stable and optimistic as forecast. Importantly, what if the economy enters a recession?

According to the National Bureau of Economic Research (NBER), there have been 34 recessions since 1857. The longest period between any of these recessions was 120 months. The current expansion just entered its 108th month. The average period of economic expansion is 56 months or about half the length of the current expansion. From a statistical point of view, one is tempting history if they are not expecting a recession within the next 24 months.

The graph below shows the ridiculous CBO forecast of GDP growth for the next ten years. Given the degree of difficulty in projecting economic output (high) and their poor track record of forecasting it, it does not seem unfair to impose critical judgments about the feasibility of such a forecast.

The “R” Word

Investors in all asset classes should be carefully considering what will happen to the nation’s debt outstanding if the rosy economic growth forecast, which in turn is built into economic, market and deficit forecasts, turns out to be wrong.

The graph below offers some guidance in assessing how a recession might affect the amount of Treasury debt that would likely need to be issued in the event of an economic downturn.

The red dots on the graph show the peak growth rate of debt outstanding associated with each recession (gray bars) since 1967. As shown, the red dots range from an increase of debt from 9% to 22%, with an average over 15%.

To put prior increases into current context, a conservative 10% increase in debt outstanding would roughly equate to an additional $2 trillion of debt issuance per year, which is about double the current annual issuance. A 20% increase would result in about $4 trillion of new debt.  Keep in mind that these massive estimates of new debt would occur alongside declining GDP output.

QE to the Rescue

The bond market is currently reflecting some anxiety at the prospect of digesting over $1 trillion a year of debt. This concern also appears to have spread to the stock market to some degree.

Now consider how multiples of that number might affect bond yields, stock prices, and credit spreads. If $2, 3, or 4 trillion of additional debt needs to find a home, it is quite likely that interest rates would rise sharply to attract new investors. Plus, there is one other small problem. As interest rates rise, the interest expense on the debt increases and drives funding needs even higher.  This mushrooming debt issuance dynamic would crowd out investment dollars from other markets.

The flow of funds from one market to another, as stated in the preceding paragraph, is how such a problem would resolve itself if free market forces were left to their own devices. Unfortunately, the government has a history of manipulating interest rates and allowing debt to build at faster rates than economic growth portends. While this buys temporary tranquility, the result is accumulating risk and consequences.

During the financial crisis, QE helped the Fed accomplish their goals of stabilizing the equity markets and the banking sector. After the crisis, they initiated two more rounds of QE despite calmer markets and economic expansion. Through these actions, they removed over $3.5 trillion of government debt and mortgage-backed securities from public markets. By erasing this supply of securities/debt, investors were forced into other investment options. This tool not only made the government appear fiscally sound in what amounted to monetary policy creep into fiscal policy, but benefited all asset classes.

No Spare Tire

Despite recent rate hikes, there is very little room for a traditional monetary policy response in the event of a downturn. Add to that the recent fiscal policy actions that will ratchet deficits higher and the United States finds itself with limited fiscal space to combat a recession. This confluence of events argues that the U.S. economy is now driving without a spare tire. It also suggests that if the economy stalls, the likelihood of central banks reviving QE among other unconventional policies is high.


At this point, we are clearly observing a transition of U.S. policy away from reliance on monetary measures toward that of fiscal policy. This is not, however, an even-handed exchange. There is overlap as the Fed gradually reduces liquidity and Congress and the executive branch pass tax cuts and a newly expanded budget. It will be messy and fraught with risk as markets have begun to imply.

The growth of debt is not unique to the Trump administration as government debt doubled under each of the last two presidents. As this debt burden extends beyond our ability to repay it, the consequences become more apparent, and the risks for both stocks and bonds rise. Despite the lack of concern from many in the financial media and Wall Street, the diagnosis is only getting worse and the treatment more extraordinary and experimental.

The debasement of the currency which results from acute fiscal and monetary imprudence has meaningful ramifications for all investments. Investors should consider investment options that are likely to retain purchasing power when said purchasing power is being destroyed by the central banks and other government authorities. To mention a few which have a precedence of performing well, commodities and natural resource stocks, Treasury inflation-protected securities (TIPS) and precious metals. There is also the other side of this equation which stresses what to underweight, short or avoid altogether. We would argue that anything currently leading the market higher (financials and technology stocks), and therefore seriously overvalued, is a good thing to reduce or sidestep altogether.

In closing and to further emphasize the points above, former New York Fed President Bill Dudley often speaks of keeping extraordinary policies in the Fed “toolkit.” Specifically, he stated that QE would be “useful to have in the toolkit for those times when the short-term interest rate tool may not be available,” adding that the Fed is “quite likely” to require large-scale asset purchases again because real rates will remain low due to slow productivity and labor-force growth. He also shared that “if LSAPs (large-scale asset purchases) are indeed not effective, then the Fed may need to take other measures.” What these “other measures” may be is anyone’s guess but arriving at plausible conclusions would require even more radical creative thought.

The only question in our mind is when, not if, QE4 will be initiated.

Everyone Hears The Fed…But Few Listen

Announcing RIA Pro

After several long months of research, development and input from our loyal readers and subscribers, we are pleased to announce RIA Pro, a new subscription service by Real Investment Advice and 720Global. 

As gratitude for your patience we are providing all Real Investment Advice readers access to this RIA Pro article which discusses the growing misconception that Chairman Powell’s Fed is as investor friendly as Yellen and Bernanke were.

Currently the site is up for a limited number of BETA test users. If all goes well, as we suspect, it will be released to everyone shortly.

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Everyone Hears the Fed but Few Listen

See no evil, hear no evil, speak no evil

Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve’s (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.

Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market’s dovish expectations will be proven right, or if their unwillingness to heed the Fed’s warnings will cost them dearly.

Trump vs. Powell

As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell.  His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President’s request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed’s independence is likely to be tested.

Divergent Views

Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump’s pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market’s expectations and the Fed’s plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they’ve said they would.

The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.

The red dashed line shows investors had slightly higher expectations for the Fed Funds rate than the rate that came to fruition from 2014 through 2016.  Conversely, the green dashed line shows that investors have been too low in their estimates of future Fed Funds rates by approximately 0.25% on average since January 2017.

The next graph looks forward and compares Fed Funds futures to the Fed Funds rate expectations for each member of the FOMC. Each dot represents a Fed members’ expectation for the average Fed Funds rate for that particular year. The red triangle denotes the FOMC average for the year. To contrast, the orange boxes represent the average of Fed Funds futures, or the markets expectation for the average fed funds rate, for each year. The differences between market based expectations and FOMC expectations are 0.20%, 0.46%, and 0.63% for 2018, 2019 and 2020 respectively.

A New Curve – A New Narrative

In our recently issued article, The Mendoza Line, we explained that the Fed introduced the validity of using a “New” yield curve versus the customary 2s/10s yield curve at the most recent FOMC meeting. The article points out that an inversion of the customary 2s/10s yield curve has preceded economic recessions with resounding accuracy.

Currently, the 2s/10s yield curve is flattening rapidly and causing the media and investors to take note. The “New” curve has been meandering over the last few years and does not suggest the same caution.

The article’s takeaways include the following:

  • The Fed has much more control over the shape of the new curve than the traditional curve.
  • “The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign.”
  • “If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?”

We believe the Fed is using the “New” curve to try to calm investors’ recession concerns and encourage them to raise their expectations for future Fed Funds levels.

The graph below from the article compares the downward slope of the 2s/10s curve to the slightly upward slope of the Fed’s New Curve.

Why the Fed is more Hawkish than investors

We believe there is one crucial reason why the Fed is resolute to raise rates more than the market believes. During the last seven recessions, the Fed Funds rate was lowered on average by 7.18%, as shown in the table below. While the last recession of 2008 only saw Fed Funds decline by 5.26%, the Fed introduced a $3.6 trillion bond-buying program known as QE.

If a recession were to start this year or next, with Fed Funds trading between 2% and 3%, the Fed would be significantly limited in their ability to lower interest rates and boost economic activity. The Fed is quite likely providing themselves more room to lower rates in the future, and thus are intent on getting the fed funds rate higher than what the market believes.

The following are other concerns that may also be driving the Fed aggressiveness:

  • Surging fiscal deficits – “Fed’s Dudley Worries Tax Cuts Risk Overheating U.S. Economy”- Bloomberg
  • Tariffs –”The Latest Proposed Tariffs Would Significantly Boost Core Inflation” – Ian Sheppard
  • Employment – “Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective,” – Jerome Powell
  • Deficit Funding – Foreign holdings of U.S. Treasuries have declined over the last six Higher interest rates may be required to incentivize domestic capital to offset foreign demand.

Investment Implications

In the second part of this series we will discuss how the resolution of the market’s dovish opinion versus the Fed’s hawkish stance might affect various asset classes.

In the meantime, we share data on how equities and bonds performed during various periods following the last two yield curve inversions.


As mentioned at the opening, when the market and the Fed have a sharp difference of opinion as is currently the case, the possibility of significant market volatility increases. The Fed is leaving us few doubts that they would like to keep raising rates at a measured pace. Chairman Powell has also voiced more concern than his two predecessors with the prices of financial assets. In fact he has shown unease that some assets are in valuation bubbles.

Chairman Powell brings one distinct advantage to his new role over his three predecessors – he has an odd tendency to speak plain English. That does not eliminate the uncertainties of the economy and a possible change in plans for monetary policy, but it certainly reduces them. Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.

As stewards of capital who understand the importance of the Fed’s interactions, our obligation is to appreciate that this Chairman says what he means and, in all likelihood, means what he says. Rate hikes, although gradual in pace, are likely to keep coming.

Everyone Hears The Fed…But Few Listen – RIA Pro


See no evil, hear no evil, speak no evil

Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve’s (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.

Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market’s dovish expectations will be proven right, or if their unwillingness to heed the Fed’s warnings will cost them dearly.

Trump vs. Powell

As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell.  His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President’s request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed’s independence is likely to be tested.

Divergent Views

Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump’s pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market’s expectations and the Fed’s plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they’ve said they would.

The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.

The red dashed line shows investors had slightly higher expectations for the Fed Funds rate than the rate that came to fruition from 2014 through 2016.  Conversely, the green dashed line shows that investors have been too low in their estimates of future Fed Funds rates by approximately 0.25% on average since January 2017.

The next graph looks forward and compares Fed Funds futures to the Fed Funds rate expectations for each member of the FOMC. Each dot represents a Fed members’ expectation for the average Fed Funds rate for that particular year. The red triangle denotes the FOMC average for the year. To contrast, the orange boxes represent the average of Fed Funds futures, or the markets expectation for the average fed funds rate, for each year. The differences between market based expectations and FOMC expectations are 0.20%, 0.46%, and 0.63% for 2018, 2019 and 2020 respectively.

A New Curve – A New Narrative

In our recently issued article, The Mendoza Line, we explained that the Fed introduced the validity of using a “New” yield curve versus the customary 2s/10s yield curve at the most recent FOMC meeting. The article points out that an inversion of the customary 2s/10s yield curve has preceded economic recessions with resounding accuracy.

Currently, the 2s/10s yield curve is flattening rapidly and causing the media and investors to take note. The “New” curve has been meandering over the last few years and does not suggest the same caution.

The article’s takeaways include the following:

  • The Fed has much more control over the shape of the new curve than the traditional curve.
  • “The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign.”
  • “If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?”

We believe the Fed is using the “New” curve to try to calm investors’ recession concerns and encourage them to raise their expectations for future Fed Funds levels.

The graph below from the article compares the downward slope of the 2s/10s curve to the slightly upward slope of the Fed’s New Curve.

Why the Fed is more Hawkish than investors

We believe there is one crucial reason why the Fed is resolute to raise rates more than the market believes. During the last seven recessions, the Fed Funds rate was lowered on average by 7.18%, as shown in the table below. While the last recession of 2008 only saw Fed Funds decline by 5.26%, the Fed introduced a $3.6 trillion bond-buying program known as QE.

If a recession were to start this year or next, with Fed Funds trading between 2% and 3%, the Fed would be significantly limited in their ability to lower interest rates and boost economic activity. The Fed is quite likely providing themselves more room to lower rates in the future, and thus are intent on getting the fed funds rate higher than what the market believes.

The following are other concerns that may also be driving the Fed aggressiveness:

  • Surging fiscal deficits – “Fed’s Dudley Worries Tax Cuts Risk Overheating U.S. Economy”- Bloomberg
  • Tariffs –”The Latest Proposed Tariffs Would Significantly Boost Core Inflation” – Ian Sheppard
  • Employment – “Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective,” – Jerome Powell
  • Deficit Funding – Foreign holdings of U.S. Treasuries have declined over the last six Higher interest rates may be required to incentivize domestic capital to offset foreign demand.

Investment Implications

In the second part of this series we will discuss how the resolution of the market’s dovish opinion versus the Fed’s hawkish stance might affect various asset classes.

In the meantime, we share data on how equities and bonds performed during various periods following the last two yield curve inversions.


As mentioned at the opening, when the market and the Fed have a sharp difference of opinion as is currently the case, the possibility of significant market volatility increases. The Fed is leaving us few doubts that they would like to keep raising rates at a measured pace. Chairman Powell has also voiced more concern than his two predecessors with the prices of financial assets. In fact he has shown unease that some assets are in valuation bubbles.

Chairman Powell brings one distinct advantage to his new role over his three predecessors – he has an odd tendency to speak plain English. That does not eliminate the uncertainties of the economy and a possible change in plans for monetary policy, but it certainly reduces them. Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.

As stewards of capital who understand the importance of the Fed’s interactions, our obligation is to appreciate that this Chairman says what he means and, in all likelihood, means what he says. Rate hikes, although gradual in pace, are likely to keep coming.

The ABC’s of QE and QT – RIA Pro

Search the internet for “QE and money printing”, and you will see countless articles explaining why Quantitative Easing (QE) is or is not money printing.

Here are a few articles that we found:

  • “The Fed’s Magic Money-Printing Machine”
  • “Bernanke Admits to Congress: We are printing money, just not literally”
  • “America’s reckless money-printing could put the world back into crisis”
  • “Why Quantitative Easing isn’t printing money”

Is QE money printing or is it something else that appears to be money printing?

Some will say that the question is irrelevant, as QE ended a few years ago. We disagree, and it has nothing to do with proving our opinion on the matter right or wrong. It is extremely important to understand what QE is and is not as the reversal of QE, known as Quantitative Tightening (QT), has just begun.

By understanding the mechanics of QE, we can look forward to appreciate the effects that QT might have on the economy and the financial markets. Consider the words of Harley Bassman, a seasoned Wall Street veteran and derivatives expert: “However, I will fully support the notion that G-4 Quantitative Easing drove up asset prices; and that the removal of such money-printing will have a deleterious effect on financial assets.

What is QE?

QE is being employed around the world by central banks to support and liquefy financial markets, lower interest rates, improve banks’ capital positions and promote stronger economic growth. Each central bank has nuanced differences in their provision of QE, primarily in the type of securities they purchase, but they are very similar in what they accomplish. In this article, we focus on the Federal Reserve’s (Fed) version of QE.

To help you better understand QE, we present the sequence in which the Fed executed this policy.

1) The process started when the Fed solicited offers for specific U.S. Treasury and Mortgage-Backed Securities (MBS) from investors including banks, brokers, individuals, mutual funds, pension funds, and foreign investors. While the trades were all executed through primary dealers, the ultimate seller in many cases was not the dealer. To ascertain whether QE is money printing, consider the following questions: Did investors accept something other than cold-hard cash for their bonds? What was the source of that cash?

2) As QE progressed, the Fed removed bonds from the market and investors in those bonds were left with cash. Cash-rich investors bought new bonds, stocks, and other assets. Further, some of the proceeds from sales of securities to the Fed were likely deployed outside of the financial markets. Whether it was the original seller or the recipient of the money five transactions down the line, a portion of the Fed’s money ended up as deposits in banks.

3) The Fed wanted to ensure that the deposits created by QE were not multiplied via the creation of new loans as is almost always the case with new deposits. They worried that such an occurrence would have inflationary consequences. (For more information on how banks use deposits to create money we recommend watching this short video on the fractional reserve banking system) To incentivize banks to hold the new deposits as excess reserves, the Fed paid banks interest on excess reserves, formally known as IOER.

Banks are required to hold a portion of each deposit as reserves to ensure that there is sufficient liquidity should a large number of depositors wish to withdraw their money simultaneously. Any reserves above the Fed’s requirements are considered excess reserves. Prior to QE, banks maximized their deposit base and therefore loan potential by holding near zero excess reserves as shown in the chart below.

Data Courtesy St. Louis Federal Reserve (FRED)

Based on the sequence of events, many believe the Fed simply conducted an asset swap in which they swapped bonds for excess reserves. So, while the Fed certainly printed money to buy the bonds, one can conclude that if QE resulted in a 1 for 1 increase in excess reserves, an asset swap ultimately occurred.  The following graphs help us better define the outcomes of QE. The first graph charts the changes in the Fed’s balance sheet (i.e., QE) and the changes in excess reserves.

Data Courtesy St. Louis Federal Reserve (FRED)

Clearly, some of the Fed’s money used to buy bonds ended up in excess reserve accounts as the Fed wished. However, and this is extremely noteworthy, the chart below shows the aggregate amount of QE that did not end up as excess bank reserves.  This is the difference between the green line and the orange line in the chart above. This portion of QE ended up in the financial markets and ultimately was used to create new loans. By any definition, this is new money and helps answer our lead question. 

Data Courtesy St. Louis Federal Reserve (FRED)

Now, let’s reconsider the interest (IOER) the Fed paid banks to persuade them not to lend the money. From a bank’s perspective, the incentive to hold the money was purely financial. Given the weakened capital positions of banks in the post-crisis era, they could earn risk-free profits and bolster their capital as long as the IOER was greater than the rate they paid on deposits. The following graph shows the average of the Fed’s aggregated data on jumbo (>$100k) deposit rates and three-month CD rates as compared to the IOER rate.

Data Courtesy St. Louis Federal Reserve (FRED)

The deposit rate calculation used in the graph is likely very generous. Accordingly, banks’ profits as displayed and discussed below is likely much greater. The table below shows the average national jumbo deposit rates for a host of deposit products as published by the FDIC. As a point of reference the current IOER rate is 1.75.

Data Source FDIC

Over the course of the QE experiment, excess reserves generated significant profits for the banks. Please remember, these profits are risk free and essentially gifted to banks by the Fed. Further, these profits were reinvested in most cases on a leveraged basis into the financial markets. While we do not know how much leverage was employed, it is safe to assume it was at least 10x.In other words, every dollar earned by banks accepting low interest deposits and converting those to higher-interest paying and risk-free excess reserves   resulted in ten dollars’ worth of new investments. This further supported asset prices.

To summarize QE, the Fed purchased bonds which helped asset prices initially stabilize and over time drive them higher. Through higher asset prices, lower borrowing rates and IOER profits, the banks were recapitalized. The supply of bonds in the financial markets was reduced and interest rates were lower as a result. Economic activity benefited from lower interest rates and healthier banks.

One might be tempted at this point to use the infamous George Bush quote “mission accomplished.”

Not so Fast – QT

Regardless of whether you agree with us that QE was money creation or still think it was an asset swap, QE must appear to be a win-win. Unfortunately, this monetary panacea is being reversed in efforts to tighten monetary policy and stave off inflationary concerns.

The following bullet points highlight how quantitative tightening (QT) will likely affect the financial markets and economy:

  • Asset Prices– QE removed $3.5 trillion in bonds from the marketplace, which had a ripple effect on equities, bonds, real-estate and a host of unconventional assets such as art, cars and wine. Many of these assets rose significantly during the QE era despite economic fundamentals that were not supportive of such price increases. Equity valuations, by many measures, now stand above levels that preceded the Great Depression and are not far from those of 1999. It is pretty clear that QE and asset prices are joined at the hip. If that is the case, shouldn’t we prepare ourselves for lower asset prices as the Fed reverses the effects of QE?
  • Banks Capital Positions– According to most banking analysts, banks now have healthy levels of capital and are in a much better position to withstand a 2008 type of crisis. While we have little reason to doubt the analysts, we do wonder if the banks are prepared for an environment in which interest rates rise amid falling asset prices. Keep in mind, the collateral behind many loans are linked to financial asset prices.
  • Lower Interest Rates– Interest rates are lower than they otherwise would have been. Per the Fed’s guidance “Our model suggests that the cumulative effect of the Federal Reserve’s asset purchases results in a reduction in the 10-year Treasury yield term premium of about 100 basis points (1.00%).” (Source Fed Notes) As such, it is hard to come up with a reason why we should not expect higher rates. When one of the major holders of U.S. Treasuries and MBS initiates a well-publicized initiative of reducing their position substantially, higher yields on those securities should result.
  • Economic Growth– Given that $1.7 trillion was printed and not held as excess reserves and that money was then multiplied, the associated loan growth certainly fueled economic activity. The effect is impossible to quantify, but it is certainly positive. When the Fed reduces their balance sheet, any reduction that does not affect the level of excess reserves should have a negative economic effect as it is a withdrawal from loan provision or other acts that have positive effects on the economy. Recently, this has not been the case as excess reserves have declined at a much quicker pace than the Fed’s balance sheet.


The evidence is clear that QE was designed to recapitalize the U.S. financial system via higher asset prices. Not only did it serve this purpose but it provided banks with risk-free profits from IOER which was leveraged to increase profits and further build capital. The Fed denies this and claims its primary goal was to encourage economic growth for the benefit of all Americans. Had this truly been the case, they would not have introduced IOER and provided incentive for banks to not lend money

Regardless of your views, the Fed did accomplish something, but at what cost? In the wake of QE, lower interest rates have encouraged even more debt and asset prices that, in many cases, are well above reasonable valuations. Said differently, they re-inflated the bubble instead of allowing the free markets and a normal economic cycle to cleanse the excesses of prior years.

Given that economic growth is largely dependent on debt growth and the debt, in many instances, is backed by overvalued assets, what happens as the Fed reverses course and asset prices revert to their historical norms? We must further consider how the broad economy will withstand higher interest rates, especially if economic growth remains at current levels or declines.

The Fed is reversing course. Are you fully prepared for this?






The Fallacy of Macroeconomics – RIA Pro

“The hubris in economics came not from a moral failing among economists, but from a false conviction: the belief that theirs was a science. It neither is nor can be one, and has always operated more like a church. You just have to look at its history to realize that.” –Collaborative Fund

The Federal Reserve (Fed) has over 750 Ph.D. economists on staff, many of whom sport degrees from the finest universities in the world. Given such a population of experts, why does the Fed have such a poor track record forecasting economic activity? Consider the graphs below, which provide recent evidence of the Fed’s futile forecasting efforts, if you find the preceding question slightly condescending or offensive. Please note it is not just the Fed, but poor economic forecasting pervades most economists including those at the IMF and the private sector as also highlighted below.

To understand why the Fed, and most economists, fail to accurately forecast economic activity more often than not, one must only contemplate economics at its most basic level. The problems many economists have are found in the faulty theories, technical lexicon, and asinine assumptions embedded in their supposed logic. Simply, they have lost sight of what economics really is.

The most basic building blocks of economics are our individual supply and demand curves. Armed with an understanding of those basic building blocks, we highlight two errors most economists commit in trying to make economics a definitive science with known answers.

Economics 101

Consider the following perspectives of supply and demand:

  • Human beings have desires, and those desires drive decision-making. Given the desires and the means or ability to fulfill those desires, they will do so. This results in demand.
  • At the same time, to fulfill one’s desires, human beings will undertake activities that give them the means to fulfill their desires. This results in supply.

To elaborate, consider your personal economy. You have needs and desires to consume certain goods and services. Some of these are core to your survival, such as food, water, energy and shelter. Beyond necessities are desires which may include a smart phone, filet mignon, Netflix, or a yacht.  All of these items hold some unique value to you. To consume or obtain these goods and services, you need to have something of value to offer in exchange. To accrue value, we work and produce goods and services that others need and desire. The more successful and efficient one is at producing goods in demand, the more value one accumulates and therefore the more needs and desires one can fulfill. This most basic description of our personal supply and demand curves is the core of economics. It is the building block upon which billions of transactions occur every day.

Problem #1 – Singular Economy

One of the biggest complications with the study of macroeconomics is in its attempt to aggregate individual economies into a singular, larger and, hypothetical economy. In other words, economists assume we all have the same preferences, desires, motivations, and quirks. Further, these collectivized traits are modeled and used to forecast economic activity and prescribe monetary and fiscal policy. When one aggregates individual and household economies, a picture is created that may appear to be coherent. Many times, however, the 350 million unique pixels, constituting the U.S. population, paint a picture that is not accurately representative of the one economists believe to be the case.

Step back for a moment and admire the picture below of Marilyn Monroe.


Now move closer to the screen, zoom in, and you will realize the picture is composed of pictures of many other people, none of which are Marilyn Monroe.

Most economists do not bother to understand our unique and widely diverse opinions and preferences. Instead, they gravitate to the simplicity of assuming we all share the same “average” or “aggregate” needs, desires and means. As such they also assume we react alike to the same positive or negative economic stimulus. Those assumptions operate on the premise that human beings are rational. Were that truly the case, we venture to guess that Richard Thaler would not have recently won the Nobel Prize in economics based on his work in behavioral finance and human beings’ proclivity for irrationality.

To better understand the consequences of taking a singular, aggregate economy approach, consider how the Fed and most central banks administer monetary policy. When aggregate demand or consumption decline for a period of time, central bankers have a dependable history of lowering interest rates to incentivize consumers to borrow for houses, cars and other goods. Is such an approach logical? What if I am simply cutting back on spending because I recently splurged on a glamourous vacation? What if you stopped eating out twice a week because you are concerned about your diet? How about your neighbor who decides to be more frugal, reduce spending and increase her savings as she nears retirement? Will lower interest rates produce predictable behaviors and actions? Will lower interest benefit some while hurting others?

The fact of the matter is that broad prescriptive policies are aimed at the average. The average may represent a decent percentage of the population at times, and such policy may produce expected results.  Other times, the average may represent a much smaller percentage of the total and produce feeble results. Currently, the “average” find themselves heavily indebted and approaching retirement. Should policy be tailored to their situation? If so, how will such policy affect the individual economies of the millennials that are starting to save, buy houses and have children?

The Fed’s policy reaction to the Great Financial Crisis of 2008 was to reduce the Fed Funds rate to near zero and quadruple the size of the money supply via the purchase of U.S. Treasury debt and Mortgage Backed Securities (MBS). Those citizens and organizations that were able to take advantage of low interest rates and increase their financial leverage benefited handsomely. The other 80% or so of the nation, living pay check to pay check and dependent upon paltry savings accounts earning nothing have clearly seen little benefit. One must question whether the post crisis monetary policy considered the unique circumstances of the population at large or those of a select few. Using Keynesian methods and armed with invalid counter-factual rationalizations, post-crisis monetary policy does not appear to have considered the ways in which the crisis itself altered economic circumstances and individual decision-making. Then again, why would it? The constituents and interests of the central bankers are not those of the general public, it is financial institutions to whom they are beholden.

The bottom line is, given the vast age, social and geographical diversity of this nation, we should not be shocked that the extraordinary monetary stimulus applied since the 2008 Financial Crisis has largely failed to deliver a durable economic recovery. Monetary policy has always been a blunt instrument but in the post-crisis decade, it has had especially poor efficacy and high margin of error, the consequences of which are still pending.

Problem #2 – Keynesian Economics

A second problem with modern economics is the exclusive reliance on the Keynesian school of thought. Keynesianism, based on the work of John Maynard Keynes, is the principal economic theory taught in our schools, practiced by economists and used to prescribe monetary policy by the world’s central bankers. It stresses that economic activity is predominately dependent on aggregate demand for goods and services. When economic growth does not meet expectations, Keynesian policy responses include greater fiscal spending, lower interest rates or other fiscal and monetary action designed to boost consumption. This one-sided view fails to capture the benefit of creating value through productive activities or, in other words, the means which allow us to consume.

To help you appreciate the benefit of creating value, we elicit the National Geographic Channel’s Life Below Zero. The documentary tracks the lives of several people that live largely independent, “off-the-grid”, in the wilds of Alaska. Of particular interest is Glenn Villeneuve, who does not appear to rely on help from the outside world, nor many of the innovations of modern society, including electricity and power tools. Assessing Glenn’s daily activities, we better illustrate the measurement of a personal economy. While this example does not represent the norm, it does provide a microcosm of a simple economy to allow us to illustrate the fallacy of an economic perspective focused on consumption.

A typical day for Glenn involves some of the following activities in which he produces goods: hunting, trapping, fishing, sourcing water, and chopping lumber. Other parts of his day are spent consuming prior production such as eating, drinking, sleeping, and warming up by a fire. The first set of activities involves productive endeavors that add economic value. The second set of activities involves consuming the value he created. Note that there is also an intermediate stage in which the value he created is stored (saved) for future consumption.

Throughout the show, Glenn consistently extols efficiency or the benefits of using the least amount of energy and the most amount of ingenuity to add value to his camp. After watching an episode or two, a viewer quickly realizes that without this supply side mindset Glenn would quickly exhaust his resources and become a victim of the harsh Alaskan climate.

Most of our days are quite different than Glenn’s, but nevertheless they are filled with similar pursuits. We sit at a desk providing legal services, picking grapes from a vine, building houses and millions of others jobs in which we create value. While most of us do not “eat what we kill” and consume the value we create directly, we earn the value in the form of currency. As a store of that value, currency then affords us a medium of exchange for something we need or want when it suits us.

Just as portrayed in Glenn’s example, the harder we work and the more innovative and productive we are, the more value we create. It is in this straightforward incentive that the prosperity of a populace grows and scarcity is diminished. For related 720Global research on this important concept we recommend reading The Death of the Virtuous Cycle and watching our short video The Animated Virtuous Cycle.

Given the prior discussion we ask you if it makes sense that economic measurement and incentives are so heavily tilted towards the consumption of value. Consider again Glenn’s activities in the eyes of Keynesians. Given the emphasis on consumption, they would count how much he ate, slept and the extent to which he was able to heat his cabin as economic progress. His GDP would not properly capture the value of catching 30 salmon, bagging an 800-pound moose or innovative means of preserving those resources. If a Keynesian wanted to boost Glenns’s economic well-being, why would they focus on his consumption? Give him a rifle, a chainsaw or other productivity-enhancing tools to generate value. In other words, Glenn cannot go in debt to nature to pull his consumption forward in the event of a shortage. For him, a deficit equals starvation.

#1 + #2 = Poor Economic Policy

When one logically thinks through what a personal economy actually entails and considers the faulty reliance on the singular aggregation of our economies and a consumption driven mindset, they can begin to understand why economists consistently struggle to forecast economic activity and prescribe constructive policy. They have put the economic cart before the horse and are trying to convince the rest of us that it makes sense. Unfortunately, these errors do not only result in bad forecasting but pathetic monetary and fiscal policy which tramples innovation and productivity resulting in stagnant economic growth, wealth inequality and onerous debt burdens.

It should be clear that the straight-forward approach discussed here is not favored by the banks, economists and Wall Street professionals being paid handsomely to dole out Keynesian advice. That said, it is the economic school of thought that best captures the most relevant aspects of the economy. The logical thought process applied here is what is required if we are to ever properly diagnose our problems, employ policies that actually combat the current economic malaise and relieve the burdens and social unrest that are choking off prosperity.




It’s Not Too Early To Be Late

The golden rule of investing is buy low and sell high. While great advice, it is extremely difficult to accomplish with precision. Because of the perceived impossibility of timing peaks and troughs, many investment professionals prefer a buy and hold approach. They claim that, over time, stocks produce respectable average returns, so why attempt to pick peaks and troughs. We firmly disagree as taking a passive approach and riding the ups and downs in the market guarantees that investors will spend large periods of time recovering losses and not compounding wealth. Because of these losses, buy and hold portfolio returns usually fall far short of average market returns. For more on this reality, see the graph and article linked in the postscript below the article summary.

Prudent investment management argues that one should reduce risk when the market is not providing ample returns to take on risk and conversely one should assume more risk when the potential returns reward it. If an investor has $100,000 to invest, is he or she better served being fully invested in an index fund with that index valuation at or near all-time highs or being under-invested with a 30-40% allocation to cash? Cash may have a low return profile, but it bears no risk of loss and represents enormous opportunity at some point in the future. As we have stated before, risk is not a number produced by a formula or model; it is the exposure of hard-earned wealth to loss. Invested capital is always exposed to some level of risk, but an investor can decide whether the assumed risk is high or low. A passive approach surrenders all control over that important decision to the whims of the market.

Using various methods, one can establish that current valuations are indeed at or near all-time highs. In most cases the high water marks were established in 1929 or 1999. With the benefit of hindsight, every investor in those prior eras would have sold their stock allocations immediately, put their money in cash or bonds, and re-allocated back to equities when valuations normalized.

The benefit of hindsight is useful only to the extent that we are willing to heed the ample evidence of past cycles. Frederick the Great once said, “What is the good of experience if one does not reflect?” Given current equity valuations and their implied risk/return proposition, history is sending clear signals that investors should reduce their exposure to stocks and other risky assets.

This article looks back at 1929 and 1999 and analyzes how investors that sold several years ahead of the peaks fared. As you will see, an active approach to managing risk, even if very early and simple, can be much more rewarding than doing nothing.

**We selected the two time periods for comparison not because they represent the largest equity drawdowns in modern financial market history but because they had valuations most similar to today. Some will claim this approach to be fearmongering, but the fact is that valuations always revert to their mean over time. Assuming this time-tested, most basic law of finance is as true today as it has been throughout human history. 1929 and 1999 provide a comparable risk/return framework and important guidance for investors in 2018.


Following a recession in late 1990 and the first half of 1991, the U.S. economy entered a ten-year stretch of continuous economic growth, the longest in modern history. During this period, the S&P 500 produced a total return of over 380% or about 20% annually.  While the economy was humming along at a healthy pace, the growth of stock prices was not totally a function of economic and earnings growth. In fact, the bulk of the rise was due to a significant expansion in valuations. For example, had the cyclically-adjusted price-to-earnings (CAPE) ratio remained at its 1990 level of 17.05, which is similar to the long-term average, the S&P would have only risen about 75% and not 380%. The graph below charts the rise of the S&P 500 and CAPE from 1990 to its peak in 2000.

Data Courtesy: Robert J. Shiller

Now let’s consider how an active investor would have fared if they exited the stock market and bought bonds in August of 1997, three full years before the ultimate peak. We chose this point as CAPE, at that time registering 32.60, was the highest in recorded history, having just surpassed the level observed on the eve of the Great Depression.

The illustration below compares total returns from a portfolio that fully exited the stock market in August of 1997 and used the proceeds to buy a Ten-year U.S. Treasury bond versus a passive portfolio that remained in equities.

Data Courtesy: Robert J. Shiller

As shown, the active investor exhibited prudence, albeit three years too early. They forfeited over 60% of equity market gains from the remainder of 1997 through mid-2000. Despite foregoing these returns, the active portfolio’s cumulative returns far surpassed those of the passive investor once valuations reverted to their mean. In fact, the buy and hold portfolio had the same portfolio balance in 2003 as it did in 1997, despite receiving dividends from its equity positions throughout that period.

Following the three-year decline beginning in March 2000, an active investor would have likely reallocated in some proportion to stocks from bonds as valuations normalized. In this example, however, we keep the active portfolio in bonds to show how even the most basic, one-time act of active management can protect returns. By 2006, the passive portfolio returns once again surpassed those of the active portfolio. This outperformance lasted about two years, but the cumulative return on the passive portfolio would again fall to near zero in early 2009.

Needless to say, the passive investor had a wild ride but lost 12 years of time in which wealth could have compounded. The active investor that sold stocks and bought bonds three years too early certainly felt “seller’s remorse” during the last innings of the rally, but was likely gratified at their longer-term cumulative performance relative to the passive investor.


From 1921 to 1929, the S&P 500 gained 485% or about 22% annually.  Like the 1990’s, the growth of stock prices was not totally a function of economic and earnings growth. Had the cyclically-adjusted price-to-earnings (CAPE) ratio only risen to its long-term average of 16.87 as it was in 1927, the S&P 500 would have risen only about 260% during this period.

At the market peak in September of 1929, the CAPE valuation stood at 32.56, which is on par with the current CAPE.

To keep the 1929 analysis similar to the one performed above for 1999, we assume the active investor sold three years before the market top.

In this example, the active investor sold their stocks and bought a ten-year Treasury note in 1926. Similar to the late 1990’s, those three years would have been tough for our active investor to stomach. The graph below shows a nearly 150% rally in the S&P 500 in the three years leading to the market’s peak. Despite lagging by nearly 150% in the early-going, the active investor was ahead of the passive investor on a cumulative basis for the ensuing 23 years beginning in 1931.

Data Courtesy: Robert J. Shiller

Again, if one were truly taking an active approach, the investor would have bought back stocks when CAPE reverted to its mean and cumulative returns would have further distanced themselves from the passive portfolio.


Since 2009, the S&P 500 has risen 412%. Like the 1920’s and 1990’s, much of the increase is based on massive valuation expansion and not fundamental strength in the economy or earnings. Similar to the two prior periods, this era will end with a reversion of valuations back to or below the mean.

The point of this analysis is that unless you are:

  • Confident that you can call the top (no one can),
  • Know when to get out (few actually do), and
  • Importantly are willing to sell and forgo gains,

We suggest you begin to take precautionary actions today. This does not mean sell all of your stocks and buy bonds. It does mean you should actively manage your portfolio. As risks increase, both technically and fundamentally, allocate away from stocks.  By taking this approach, an investor will avoid loses and have funds available which can be put to use when valuations normalize and prices are significantly lower.

We do not doubt that, if you take our advice today, you will be early and will leave some profits on the table. At the same time, it seems highly likely that your portfolio will be in much better shape over the course of the cycle.

The following wisdom of Howard Marks masterfully sums up our thoughts on “risk management”:

“If you refuse to fall into line in carefree markets like todays, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk.” 


Postscript: Difference Between Average and Actual Returns

The following graph from The Myths of Stocks for the Long Run – Part IV, shows how volatility and drawdowns create a large gap between the average return (red area) and the real return (blue area) over a period.