Tag Archives: Investment Advice

Buffett Lost $90 Billion By Not Following His Own Advice

Every year, investors anxiously await the release of Warren Buffett’s annual letter to see what the “Oracle of Omaha” has to say about the markets, economy, and where he is placing his money.

Before we blindly heed Buffett’s advice we must factor in that he has long been a source of contradiction. As Michael Lebowitz previously penned:

“The general platitudes of market and economic optimism Buffett shares in his CNBC interviews, letters to investors and shareholder meetings often run counter to the actions he has taken in his investment approach.

This year was no different as Buffett wrote in his annual letter to Berkshire Hathaway shareholders:

“If something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments. These elements, coupled with the ‘American Tailwind,’ will make ‘equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions.”

To clarify, Buffett is suggesting that over the coming decades, it will be better to be invested in equities (aka S&P 500 Index) versus Treasury bonds, given that the yield on bonds is so low.

That point doesn’t quite square with facts. Buffett is now holding his largest amount of cash in the history of the firm.

As the old saying goes: “Follow the money.” 

If Buffett thinks stocks will outperform bonds, then why is holding $128 billion in short term bonds?

There is an important distinction to be made if you choose to follow Mr. Buffett’s advice. It is true that stocks will outperform bonds over the long-term given the right starting valuations and a long enough time frame. Currently, using Warren Buffett’s favorite measure of valuations (Market Capitalization to GDP), there is a substantial risk of low returns from stocks over the next decade.

While valuations DO NOT predict market crashes, they are very predictive of future returns on investments from current levels.

Period.

I previously quoted Cliff Asness on this issue in particular:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 30x, and your long-term plan calls for a 10% nominal return on the stock market, you are assuming a best case scenario to play out in a market that is drastically above the average case from these valuations. We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Importantly, this is likely the reason that Buffett is sitting on $128 billion in historically low yielding bonds. The graph below provides further evidence using his favorite valuation indicator, market cap to GDP.

Not surprisingly, like every other measure of valuation, forward return expectations are substantially lower over the next 10-years as opposed to the past 10-years.

“Price is what you pay, value is what you get.” – Warren Buffett

Do What I Say, Not What I Do

So the question is this:

“If Warren is suggesting you should just invest in the index and hold on, why is he sitting on so much cash?”

The immediate observation is that he is just waiting on a “good deal” to come along. He has been vocal about looking for a new acquisition. However, he hasn’t done so. Why, “valuations”  are sky high.

Unfortunately, “good deals” based on valuations, and market crashes, have typically been highly correlated throughout history. As he said in his letter:

“Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater.”

Interestingly, while Buffett has been telling everyone else to buy a stock index, and avoid bonds, he has been doing exactly the opposite by “buying bonds.”

Make no mistake, Buffett is indeed a great investor, and has made a tremendous amount of money for his shareholders over the years. One of the reasons for this is that at times of market excesses he has preferred holding cash.At the time he is leaving money on the table, but that cash can be deployed when markets are panicking and value appears. Remember, Buffett had cash on hand in 2008 to lend to Goldman Sachs at 10%.

The downside to holding cash is that performance of Berkshire Hathaway is no longer outperforming the S&P in recent years. This is due to the shear “size” of the company as Buffett no longer has the luxury of making small value-based acquisitions of a few hundred million in value. Such acquisitions don’t “move the needle” in terms of returns for shareholders. Berkshire has grown to the point it has essentially become an index itself.

The chart below shows Buffett’s annual cash holdings versus the S&P 500 ($SPY) over the last several years.

So, what would have happened if Buffett had taken his own advice and invested his cash into the S&P 500 index rather than bonds. The index is highly liquid, so he could have sold the index at any time he needed cash for an acquisition, and the shares could have been lent out for an additional return on his investment.

However, the chart below shows the difference in market cap of the Berkshire Hathaway currently, with the cash invested in the S&P 500 index, as compared to the returns of the S&P 500 index. Not surprisingly, returns to shareholders improved over the last decade.

While it may not look like much on a percentage basis, the cumulative return lost to Berkshire Shareholders over the last decade was roughly $90 Billion dollars.

Or rather, a $1000 investment in 2010 would have grown to nearly $4000 versus just $3500.

Summary

As Michael Lebowitz previously wrote:

“Warren Buffett is without question the modern day icon of American investors. He has become a living legend, and the respect he receives is warranted. He has certainly been a remarkable steward of wealth for himself and his clients.

Where we are challenged with regard to his approach, is the way in which he shirks his responsibilities as a leader. To our knowledge, he is not being overtly dishonest but he certainly has a way of rationalizing what appears to be obvious contradictions. Because of his global following and the weight given to each word he utters, the fact that his actions often do not match the spirit of his words is troubling.”

Warren Buffett did not amass his fortune by following the herd but by leading it.

He is sitting on a $128 Billion in cash for a reason. Buffett is fully aware of the gains he has forgone, yet still continues his ways. Buffet is not dumb!

Before taking his advice to buy an index and hold on, you may want to consider more carefully why he is telling you to “do as I say, not as I do.” 

Market Bubbles: It’s Not The Price, It’s The Mentality.

“Actually, one of the dangers is that people could be throwing risk to the wind and this [market] could be a runaway. We sometimes call that a melt-up and produces prices too high and then if there’s a shock, you come down to Earth and that could impact sentiment. I think this market is fully valued and not undervalued, but I don’t think it’s overvalued,” Jeremy Siegel

Here is an interesting thing.

“Market bubbles have NOTHING to do with valuations or fundamentals.”

Hold on…don’t start screaming “heretic,” and building gallows just yet.

Let me explain.

I can’t entirely agree with Siegel on the market being “fairly valued.” As shown in the chart below, the S&P 500 is currently trading nearly 90% above its long-term median, which is expensive from a historical perspective.

However, since stock market “bubbles” are a reflection of speculation, greed, emotional biases; valuations are only a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.

Notice that with the exception of only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently. 

Secondly, all market crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.

For Every Buyer

You will commonly hear that “for every buyer, there must be a seller.”

This is a true statement. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.

Market crashes are an “emotionally” driven imbalance in supply and demand.

In a market crash, the number of people wanting to “sell” vastly overwhelms the number of people willing to “buy.” It is at these moments that prices drop precipitously as “sellers” drop the levels at which they are willing to dump their shares in a desperate attempt to find a “buyer.” This has nothing to do with fundamentals. It is strictly an emotional panic, which is ultimately reflected by a sharp devaluation in market fundamentals.

Bob Bronson once penned:

“It can be most reasonably assumed that markets are sufficient enough that every bubble is significantly different than the previous one, and even all earlier bubbles. In fact, it’s to be expected that a new bubble will always be different than the previous one(s) since investors will only bid up prices to extreme overvaluation levels if they are sure it is not repeating what led to the last, or previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.

I would argue that when comparisons to previous bubbles become most popular – like now – it’s a reliable timing marker of the top in a current bubble. As an analogy, no matter how thoroughly a fatal car crash is studied, there will still be other fatal car crashes in the future, even if the previous accident-causing mistakes are avoided.”

Comparing the current market to any previous period in the market is rather pointless. The current market is not like 1995, 1999, or 2007? Valuations, economics, drivers, etc. are all different from cycle to the next. Most importantly, however, the financial markets adapt to the cause of the previous “fatal crashes,” but that adaptation won’t prevent the next one.

It’s All Relative

Last week, in our MacroView, I touched on George Soros’ theory on bubbles, which is worth expanding a bit on in the context of this article.

Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.

Every bubble has two components:

  1. An underlying trend that prevails in reality, and; 
  2. A misconception relating to that trend.

When positive feedback develops between the trend and the misconception, a boom-bust process is set into motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia.

As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

The chart below is an example of asymmetric bubbles.

The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market, which can create a feedback loop between the markets and fundamentals.

This pattern of bubbles can be seen at every bull market peak in history. The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis with an overlay of the asymmetrical bubble shape.

As Soro’s went on to state:

Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions.

  • In the passive or cognitive function, the fundamentals are supposed to determine market prices. 
  • In the active or manipulative function market, prices find ways of influencing the fundamentals. 

When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

Currently, there is a strong belief the financial markets are not in a bubble, and the arguments supporting that belief are based on comparisons to past market bubbles.

It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested, and a continual drone of “bullish chatter;” the markets are poised for the unexpected, unanticipated, and inevitable event.

Reflections

When thinking about excess, it is easy to see the reflections of excess in various places. Not just in asset prices but also in “stuff.” All financial assets are just claims on real wealth, not actual wealth itself. A pile of money has use and utility because you can buy stuff with it. But real wealth is the “stuff” — food, clothes, land, oil, and so forth.  If you couldn’t buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they’re printed on (if you’re lucky enough to hold an actual certificate). 

But trouble begins when the system gets seriously out of whack.

“GDP” is a measure of the number of goods and services available and financial asset prices represent the claims (it’s not a very accurate measure of real wealth, but it’s the best one we’ve got.) Notice the divergence of asset prices from GDP as excesses develop.

What we see is that the claims on the economy should, quite intuitively, track the economy itself. Excesses occur whenever the claims on the economy, the so-called financial assets (stocks, bonds, and derivatives), get too far ahead of the economy itself.

This is a very important point. 

“The claims on the economy are just that: claims. They are not the economy itself!”

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today.

The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction is the catalyst to bring “fear” into an overly complacent marketplace.  

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” 

This “time IS different.” 

However, “this time” is only different from the standpoint the variables are not exactly the same as they have been previously. The variables never are, but the outcome is always the same.

The Next Decade: Valuations & The Destiny Of Low Returns

Jani Ziedins via Cracked Market recently penned an interesting post:

“As for what comes next, is this bull market tired? Is a crash long overdue? Not if you look at history. Stocks rallied for nearly 20 years between the early 1980s and the late 1990s. By that measure, we could easily see another decade of strong gains before the next “Big One”. Of course, the worst day in stock market history happened during that 20-year bull market in 1987, so we cannot be complacent. But the prognosis for the next 10 years is still good even if we run into a few 20% corrections along the way.”

After a decade of strong, liquidity-driven, post-crisis returns in the financial markets, investors are hopeful the next decade will deliver the same, or better. As Bob Farrell once quipped:

“Bull markets are more fun than bear markets.” 

However, from an investment standpoint, the real question is:

“Can the next decade deliver above average returns, or not?”

Lower Returns Ahead?

Brian Livingston, via MarketWatch, previously wrote an article on the subject of valuation measures and forward returns.

“Stephen Jones, a financial and economic analyst who works in New York City, tracks the formulas that several market wizards have disclosed. He recently updated his numbers through Dec. 31, 2018, and shared them with me. Buffett, Shiller, and the other boldface names had nothing to do with Jones’s calculations. He crunched the financial celebrities’ formulas himself, based on their public statements.

“The graph above doesn’t show the S&P 500’s price levels. Instead, it reveals how well the projection methods estimated the market’s 10-year rate of return in the past. The round markers on the right are the forecasts for the 10 years that lie ahead of us. All of the numbers for the S&P 500 include dividends but exclude the consumer-price index’s inflationary effect on stock prices.”

  • Shiller’s P/E10 predicts a +2.6% annualized real total return.
  • Buffett’s MV/GDP says -2.0%.
  • Tobin’s “q” ratio indicates -0.5%.
  • Jones’s Composite says -4.1%.

(Jones uses Buffett’s formula but adjusts for demographic changes.) 

Here is the important point:

“The predictions might seem far apart, but they aren’t. The forecasts are all much lower than the S&P 500’s annualized real total return of about 6% from 1964 through 2018.”

While these are not guarantees, and should never be used to try and “time the market,” they are historically strong predictors of future returns.

As Jones notes:

“The market’s return over the past 10 years,” Jones explains, “has outperformed all major forecasts from 10 years prior by more than any other 10-year period.”

Of course, as noted above, this is due to the unprecedented stimulation the Federal Reserve pumped into the financial markets. Regardless, markets have a strong tendency to revert to their average performance over time, which is not nearly as much fun as it sounds.

The late Jack Bogle, founder of Vanguard, also noted some concern from high valuations:

“The valuations of stocks are, by my standards, rather high, butmy standards, however, are high.”

When considering stock valuations, Bogle’s method differs from Wall Street’s. For his price-to-earnings multiple, Bogle uses the past 12-months of reported earnings by corporations, GAAP earnings, which includes “all of the bad stuff.” Wall Street analysts look at operating earnings, “earnings without all that bad stuff,” and come up with a price-to-earnings multiple of something in the range of 17 or 18, versus current real valuations which are pushing nearly 30x earnings.

“If you believe the way we look at it, much more realistically I think, the P/E is relatively high. I believe strongly that [investors] should be realizing valuations are fairly full, and if they are nervous they could easily sell off a portion of their stocks.” – Jack Bogle

These views are vastly different than the optimistic views currently being bantered about for the next decade.

However, this is where an important distinction needs to be made.

Starting Valuations Matter Most

What Jani Ziedins missed in his observation was the starting level of valuations which preceded those 20-year “secular bull markets.”  This was a point I made previously:

“The chart below shows the history of secular bull market periods going back to 1871 using data from Dr. Robert Shiller. One thing you will notice is that secular bull markets tend to begin with CAPE 10 valuations around 10x earnings or even less. They tend to end around 23-25x earnings or greater. (Over the long-term valuations do matter.)”

The two previous 20-year secular bull markets begin with valuations in single digits. At the end of the first decade of those secular advances, valuations were still trading below 20x.

The 1920-1929 secular advance most closely mimics the current 2010 cycle. While valuations started below 5x earnings in 1919, they eclipsed 30x earnings ten-years later in 1929. The rest, as they say, is history. Or rather, maybe “past is prologue” is more fitting.

Low Returns Mean High Volatility

When low future rates of return are discussed, it is not meant that each year will be low, but rather the return for the entire period will be low. The chart below shows 10-year rolling REAL, inflation-adjusted, returns in the markets. (Note: Spikes in 10-year returns, which occurred because the 50% decline in 2008 dropped out of the equation, has previously denoted peaks in forward annual returns.)

(Important note: Many advisers/analysts often pen that the market has never had a 10 or 20-year negative return. That is only on a nominal basis and should be disregarded as inflation must be included in the debate.)

There are two important points to take away from the data.

  1. There are several periods throughout history where market returns were not only low, but negative.(Given that most people only have 20-30 functional years to save for retirement, a 20-year low return period can devastate those plans.)
  2. Periods of low returns follow periods of excessive market valuations and encompass the majority of negative return years. (Read more about this chart here)

“Importantly, it is worth noting that negative returns tend to cluster during periods of declining valuations. These ‘clusters’ of negative returns are what define ‘secular bear markets.’” 

While valuations are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are HORRIBLE predictors of 12-month returns and should never be used in any investment strategy which has such a focus. However, in the longer term, valuations are strong predictors of expected returns.

The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-ratio. Again, valuations only appear cheap when compared to the peak in 2000. Outside of that exception, the financial markets are, without question, expensive. 

Furthermore, note that forward 10-year returns do NOT improve from historically expensive valuations, but decline rather sharply.

Warren Buffett’s favorite valuation measure is also screaming valuation concerns (which may explain why he is sitting on $128 billion in cash.). The following measure is the price of the Wilshire 5000 market capitalization level divided by GDP. Again, as noted above, asset prices should be reflective of underlying economic growth rather than the “irrational exuberance” of investors. 

Again, with this indicator at the highest valuation level in history, it is a bit presumptuous to assume that forward returns will continue to remain elevated,.

Bull Now, Pay Later

In the short-term, the bull market continues as the flood of liquidity, and accommodative actions, from global Central Banks, has lulled investors into a state of complacency rarely seen historically. As Richard Thaler, the famous University of Chicago professor who won the Nobel Prize in economics stated:

We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.

I don’t know about you, but I’m nervous, and it seems like when investors are nervous, they’re prone to being spooked. Nothing seems to spook the market.”

While market analysts continue to come up with a variety of rationalizations to justify high valuations, none of them hold up under real scrutiny. The problem is the Central Bank interventions boost asset prices in the short-term, in the long-term, there is an inherently negative impact on economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth and therefore requires ever larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and ultimately a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes and real wealth is destroyed. 
  5. Middle class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption. 
  7. Wash, Rinse, Repeat.

If you don’t believe me, here is the evidence.

The stock market has returned more than 125% since 2007 peak, which is roughly 3x the growth in corporate sales and 5x more than GDP.

It is critical to remember the stock market is NOT the economy. The stock market should be reflective of underlying economic growth which drives actual revenue growth. Furthermore, GDP growth and stock returns are not highly correlated. In fact, some analysis suggests that they are negatively correlated and perhaps fairly strongly so (-0.40).

However, in the meantime, the promise of another decade of a continued bull market is very enticing as the “fear of missing out” overrides the “fear of loss.”

Let me conclude with this quote from Vitaliy Katsenelson which sums up our investing view:

Our goal is to win a war, and to do that we may need to lose a few battles in the interim.

Yes, we want to make money, but it is even more important not to lose it. If the market continues to mount even higher, we will likely lag behind. The stocks we own will become fully valued, and we’ll sell them. If our cash balances continue to rise, then they will. We are not going to sacrifice our standards and thus let our portfolio be a byproduct of forced or irrational decisions.

We are willing to lose a few battles, but those losses will be necessary to win the war. Timing the market is an impossible endeavor. We don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random – as random as you’re trying to guess the next card at the blackjack table.”

For long-term investors, the reality that a clearly overpriced market will eventually mean revert should be a clear warning sign. Given the exceptionally high probability the next decade will be disappointing, gambling your financial future on a 100% stock portfolio is likely not advisable.

7-Simple Investing Rules Your Mother Taught You

When I was growing up my mother had a saying, or an answer, for just about everything…as do most mothers. Every answer to the question “Why?” was immediately met with the most intellectual of answers:

“…because I said so”.

Seriously, my mother was a resource of knowledge that has served me well over the years, and it wasn’t until late in life that I realized that she had taught me the basic principles for staying safe in the investment process.

So, by imparting her secrets to you I may be violating some sacred ritual of motherhood knowledge, but I felt it was worth the risk to share the knowledge which has served me well.


1) Don’t Run With Sharp Objects!

It wasn’t hard to understand why she didn’t want me to run with scissors through the house – I just think I did it early on just to watch her panic. However, later in life when I got my first apartment I ran through the entire place with a pair of scissors, left the front door open with the air conditioning on, and turned every light on in the house.

That rebellion immediately stopped when I received my first electric bill.

Sometime in the early 90’s, the financial markets became a casino as the internet age ignited a whole generation of stock market gamblers who thought they were investors. There is a huge difference between investing and speculating, and knowing the difference is critical to overall success.

Investing is backed by a solid investment strategy with defined goals, an accumulation schedule, allocation analysis and, most importantly, a defined sell strategy and risk management plan.

Speculation is nothing more than gambling. If you are buying the latest hot stock, chasing stocks that have already moved 100% or more, or just putting money in the market because you think that you “have to”, you are gambling.

The most important thing to understand about gambling is that success is a function of the probabilities and possibilities of winning or losing on each bet made.

In the stock market, investors continue to play the possibilities instead of the probabilities. The trap comes with early success in speculative trading. Success breeds confidence, and confidence breeds ignorance.

Most speculative traders tend to “blow themselves up” because of early success in their speculative investing habits. The speculative trader generally fails to hedge against the random events that occur in the financial markets. This is turn results in the trader losing more money than they ever imagined possible.

When investing, remember that the odds of making a losing trade increase with the frequency of transactions being made. Just as running with a pair of scissors; do it often enough and eventually you could end up really hurting yourself. What separates a winning investor from a speculative gambler is the ability to admit and correct mistakes when they occur.


2) Look Both Ways Before You Cross The Street.

I grew up in a small town so crossing the street wasn’t as dangerous as it is in the city. Nonetheless, I was yanked by the collar more than once as I started to bolt across the street seemingly anxious to “find out what’s on the other side.” It is important to understand that traffic does flow in two directions, and if you only look in one direction, sooner or later you are going to get hit.

A lot of people want to classify themselves as a “Bull” or a “Bear”The smart investor doesn’t pick a side; he analyzes both sides to determine what the best course of action in the current market environment is most likely to be.

The problem with the proclamation of being a “bull” or a “bear” means that you are not analyzing the other side of the argument and that you become so confident in your position that you tend to forget that “the light at the end of the tunnel…just might be an oncoming train.”

It is an important part of your analysis, before you invest in the financial markets, to determine not only “where” but also “when” to invest your assets.


3) Always Wear Clean Underwear

This was one of my favorite sayings from my mother because I always wondered about the rationality of it. I always figured that even if you were wearing clean underwear prior to an accident; you’re still likely left without clean underwear following it.

The first rule of investing is: “You are only wrong – if you stay wrong

However, being a smart investor means always being prepared in case of an accident. That means quite simply have a mechanism in place to protect you when you are wrong with an investment decision.

You will notice that I said “when you are wrong” in the previous paragraph. You will make wrong decisions, in fact, the majority of the decisions you will make in investing will most likely turn out wrong. However, it is cutting those wrong decisions short, and letting your right decisions continue to work, that will make you profitable over time.

Any person that tells you about all the winning trades he has made in the market – is either lying, or he hasn’t blown up yet. One of the two will be true – 100% of the time.

Understanding the “risk versus reward” trade off of any investment is the beginning step to risk management in your portfolio. Knowing how to mitigate the risk of loss in your holdings is crucial to your long-term survivability in the financial markets.


4) If Everyone Jumped Off The Cliff – Would You Do It Too?

Every kid, at one point or another, has tried to convince their Mother to allow them to do something through the use of “peer pressure.” I figured if she wouldn’t let me do what I wanted, then surely she would bend to the will of the imaginary masses. She never did.

“Peer pressure” is one of the biggest mistakes investors repeatedly make when investing. Chasing the latest “hot stocks” or “investment fads” that are already overvalued, and are running up on speculative fervor, always ends in disappointment.

In the financial markets, investors get sucked into buying stocks that have already moved significantly off their lows because they are afraid of “missing out.” This is speculating, gambling, guessing, hoping, praying – anything but investing. Generally, by the time the media begins featuring a particular investment, individuals have already missed the major part of the move. By that point, the probabilities of a decline began to outweigh the possibility of further rewards.

It is a well-known fact that the market works in what is called a “herd mentality.” Historically, investors all tend to run in one direction at one time until that direction falters, the “herd” then turns and runs in the opposite direction. This continues to the detriment of investor’s returns over long periods as shown by Dalbar investor studies.

This is also generally why investors wind up buying high, and selling low. In order to be a long-term successful investor, you have to understand the “herd mentality” and use it to your benefit – which means getting out from in front of the herd before you are trampled.

So, before you chase a stock that has already moved 100%, or more, try and figure out where the herd may move to next, and “place your bets there.” This takes discipline, patience, and a lot of homework but you will be well rewarded for your efforts in the end.


5) Don’t Talk To Strangers

This is just good solid advice all the way around. Turn on the television, any time of the day or night, and it is the “Stranger’s Parade of Malicious Intent”. I don’t know if it is just me, or the fact the media only broadcast news that reveals the very depths of human depravity, but sometimes I have to wonder if we are not due for a planetary cleansing through divine intervention.

Back to investing – getting your stock tips from strangers is a sure way to lose money in the stock market. Your investing homework should NOT consist of a daily regimen of CNBC, followed by a dose of Grocer tips, capped off with a financial advisor’s sales pitch.

In order to be successful in the long-run, you must understand the principals of investing, and the catalysts which will make that investment profitable in the future. Remember, when you invest into a company you are buying a piece of that company, and its business plan. You are placing your hard earned dollars into the belief the individuals managing the company have your best interests at heart. The hope is they will operate in such a manner as to make your investment more valuable, so that it may eventually be sold to someone else for a profit.

This is also the very embodiment of the “Greater Fool Theory,” which states that there will always be someone willing to buy an investment at an ever higher price. However, in the end, there is always someone left “holding the bag,” the trick is making sure that it isn’t you.

Also, you need to be aware that when getting advice from the “One Minute Money Manager” crew on television. When an “expert” tells you about a company you should be buying, remember he already owns it, and most likely will be the one selling his shares to you.


6) You Either Need To “Do It” (polite version) Or Get Off The Pot!

When I was growing up I hated to do my homework, which is ironic, since I now do more homework now than I ever dreamed of in my younger days. Since I did not like doing homework, school projects were almost never started until the night before they were due. I was the king of procrastination.

My Mom was always there to help, giving me a hand, and an ear full of motherly advice, usually consisting of a lot of “because I told you so…”

I find it interesting that many investors tend to watch stocks for a very long period of time, never acting on their analysis, buy rather idly watching as their instinct proves correct, and the stock rises in price.

The investor then feels that he missed his entry point, and decides to wait, hoping the stock will go back down one more time so that he can get in. The stock continues to rise, the investor continues to watch becoming more frustrated until he finally capitulates on his emotion and buys the investment near the top.

Procrastination, on the way up, and on the way down, are harbingers of emotional duress derived from the loss of opportunity or the destruction of capital.

However, if you do your homework and can build a case for the purchase, don’t procrastinate. If you miss your opportunity for the right entry into the position – don’t chase it. Leave it alone, and come back another day when ole’ Bob Barker is telling you – “The Price Is Right.”


7) Don’t Play With It – You’ll Go Blind

Well…do I really need to go into this one? All I know for sure is that I am not blind today. What I will never know for sure is whether she believed it, or if it was just meant to scare the hell out of me.

When you invest in the financial markets it is very easy to lose sight of what your intentions were in the first place. Getting caught up in the hype, getting sucked in by the emotions of fear and greed, and generally being confused by the multitude of options available, can cause you to lose your focus.

Always go back to the basic principle you started with which was to grow your small pile of money into a much larger one.

Putting It All Together

My Dad once taught me a very basic principle: KISSKeep It Simple Stupid

This is one of the best investment lessons you will ever receive. Too many people try to outsmart the market to gain a very small, fractional, increase in return. Unfortunately, they wind up taking on a disproportionate amount of risk which, more often than not, leads to negative results. The simpler the strategy is, the better the returns tend to be. Why? There is better control over the portfolio.

Designing a KISS portfolio strategy will help ensure that you don’t get blinded by continually playing with your portfolio and losing sight of what your original goals were in the first place.

  1. Decide what your objective is: Retirement, College, House, etc.
  2. Define a time frame to achieve your goal.
  3. Determine how much money you can “realistically” put toward your goal each month.
  4. Calculate the amount of return needed to reach your goal based on your starting principal, the number of years to your goal and your monthly contributions.
  5. Break down your goal into milestones that are achievable. These milestones could be quarterly, semi-annual or annual and will help make sure that you are on track to meet your objective.
  6. Select the appropriate asset mix that achieves your required results without taking on excess risk that could lead to greater losses than planned for.
  7. Develop and implement a specific strategy to sell positions in the event of random market events or unexpected market downturns.
  8. If this is more than you know how to do – hire a professional who understands basic portfolio and risk management.

There is obviously a lot more to managing your own portfolio than just the principles that we learned from our Mothers. However, this is a start in the right direction, and if you don’t believe me – just ask your Mother.

The Difference Between Investing & Speculation (10-Investing Rules)

Are you an “investor” or a “speculator?” 

In today’s market the majority of investors are simply chasing performance. However, why would you NOT expect this to be the case when financial advisers, the mainstream media, and WallStreet continually press the idea that investors “must beat” some random benchmark index from one year to the next.

But, is this “speculation” or “investing?” 

Think about it this way.

If you were playing a hand of poker, and were dealt a “pair of deuces,” would you push all your chips to the center of the table?

Of course, not.

The reason is you intuitively understand the other factors “at play.” Even a cursory understanding of the game of poker suggests other players at the table are probably holding better hands which will lead to a rapid reduction of your wealth.

Investing, ultimately, is about managing the risks which will substantially reduce your ability to “stay in the game long enough” to “win.”

Robert Hagstrom, CFA penned a piece discussing the differences between investing and speculation:

“Philip Carret, who wrote The Art of Speculation (1930), believed “motive” was the test for determining the difference between investment and speculation. Carret connected the investor to the economics of the business and the speculator to price. ‘Speculation,’ wrote Carret, ‘may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.’”

Chasing markets is the purest form of speculation. It is simply a bet on prices going higher rather than determining if the price being paid for those assets are selling at a discount to fair value.

Benjamin Graham, along with David Dodd, attempted a precise definition of investing and speculation in their seminal work Security Analysis (1934).

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

There is also very important passage in Graham’s The Intelligent Investor:

“The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all its dealings with the public. Otherwise the stock exchanges may some day be blamed for heavy speculative losses, which those who suffered them had not been properly warned against.”

Indeed, the meaning of investment has been lost on most individuals. However, the following 10-guidelines from legendary investors of our time will hopefully get you back on track.


10-Investing Guidelines From Legendary Investors

1) Jeffrey Gundlach, DoubleLine

“The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.”

This is a common theme that you will see throughout this post. Great investors focus on “risk management” because “risk” is not a function of how much money you will make, but how much you will lose when you are wrong. In investing, or gambling, you can only play as long as you have capital. If you lose too much capital but taking on excessive risk, you can no longer play the game.

Be greedy when others are fearful and fearful when others are greedy. One of the best times to invest is when uncertainty is the greatest and fear is the highest.

2) Ray Dalio, Bridgewater Associates

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

Nothing good, or bad, goes on forever. The mistake that investors repeatedly make is thinking “this time is different.” The reality is that despite Central Bank interventions, or other artificial inputs, business and economic cycles cannot be repealed. Ultimately, what goes up, must and will come down.

Wall Street wants you to be fully invested “all the time” because that is how they generate fees. However, as an investor, it is crucially important to remember that “price is what you pay and value is what you get.” Eventually, great companies will trade at an attractive price. Until then, wait.

3) Seth Klarman, Baupost

“Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”

Investor behavior, driven by cognitive biases, is the biggest risk in investing. “Greed and fear” dominate the investment cycle of investors which leads ultimately to “buying high and selling low.”

4) Jeremy Grantham, GMO

“You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.”

Successful investors avoid “risk” at all costs, even it means under performing in the short-term. The reason is that while the media and Wall Street have you focused on chasing market returns in the short-term, ultimately the excess “risk” built into your portfolio will lead to extremely poor long-term returns. Like Wyle E. Coyote, chasing financial markets higher will eventually lead you over the edge of the cliff.

5) Jesse Livermore, Speculator

“The speculator’s deadly enemies are: ignorance, greed, fear and hope. All the statute books in the world and all the rule books on all the Exchanges of the earth cannot eliminate these from the human animal….”

Allowing emotions to rule your investment strategy is, and always has been, a recipe for disaster. All great investors follow a strict diet of discipline, strategy, and risk management. The emotional mistakes show up in the returns of individuals portfolios over every time period. (Source: Dalbar)

Dalbar-2015-QAIB-Performance-040815

6) Howard Marks, Oaktree Capital Management

“Rule No. 1: Most things will prove to be cyclical.

Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.”

As with Ray Dalio, the realization that nothing lasts forever is critically important to long term investing. In order to “buy low,” one must have first “sold high.” Understanding that all things are cyclical suggests that after long price increases, investments become more prone to declines than further advances.

7) James Montier, GMO

“There is a simple, although not easy alternative [to forecasting]… Buy when an asset is cheap, and sell when an asset gets expensive…. Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance.”

“Cheap” is when an asset is selling for less than its intrinsic value. “Cheap” is not a low price per share. Most of the time when a stock has a very low price, it is priced there for a reason. However, a very high priced stock CAN be cheap. Price per share is only part of the valuation determination, not the measure of value itself.

8) George Soros, Soros Capital Management

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

Back to risk management, being right and making money is great when markets are rising. However, rising markets tend to mask investment risk that is quickly revealed during market declines. If you fail to manage the risk in your portfolio, and give up all of your previous gains and then some, then you lose the investment game.

9) Jason Zweig, Wall Street Journal

“Regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

The chart below is the 3-year average of annual inflation-adjusted returns of the S&P 500 going back to 1900. The power of regression is clearly seen. Historically, when returns have exceeded 10% it was not long before returns fell to 10% below the long-term mean which devastated much of investor’s capital.

10) Howard Marks, Oaktree Capital Management

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”

The biggest driver of long-term investment returns is the minimization of psychological investment mistakes.

As Baron Rothschild once stated: “Buy when there is blood in the streets.” This simply means that when investors are “panic selling,” you want to be the one they are selling to at deeply discounted prices. Howard Marks opined much of the same sentiment: “The absolute best buying opportunities come when asset holders are forced to sell.”

As an investor, it is simply your job to step away from your “emotions” for a moment and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but to manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

As I stated at the beginning of this missive, “Market Timing” is not an effective method of managing your money. However, as you will note, every great investor through out history has had one core philosophy in common; the management of the inherent risk of investing to conserve and preserve investment capital.

“If you run out of chips, you are out of the game.”

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

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

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

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

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

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

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

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

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

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

Delayed gratification is a thing of the past.

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

However, as Steve Liesman once stated on CNBC:

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

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

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

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

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

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

“The borrower is the slave to the lender.”

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

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

Consumption Is Function Of A Paycheck

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

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

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

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

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

Employment.

This should be a relatively obvious connection.

No job = No paycheck = No spending. 

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

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

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

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

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

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

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

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

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

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

Conclusion

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

Will it stay that way? Probably not.

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

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

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

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

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

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

How does every bear market begin?

Slowly at first, then all of a sudden. 

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

There is a disparity happening in the country.

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

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

It’s an interesting dichotomy.

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

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

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

So, who’s right?

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

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

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

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

Take a closer look at the chart above.

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

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

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

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

UofM A Better Predictor

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

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

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

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

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

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

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

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

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

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

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

As Ben Graham stated back in 1959:

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

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

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

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

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

This time will not be “different.”

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

Maybe the third time will be the “charm.”

No, Bonds Still Aren’t Overvalued!

Interest rates have plunged lately as concerns about a recession in the U.S. economy have risen. This has led many media commentators to suggest the bonds are now wildly overvalued. To wit:

“When evaluating the desirability of government bonds as a long-term investment, it’s imperative to compare the prevailing yields of bonds with the earnings yields for stocks.” 

While this is a common comparison, it is also wrong. Let’s compare the two:

Earnings Yield:

  • “Earnings yield” is the inverse of P/E ratios and only tells you what the yield is currently, not what the future will be.
  • Investors do not “receive” an “earnings yield” from owning stocks. There is no “yield payment” paid out to shareholders, it is simply a mathematical calculation.
  • There is no protection of principal.

Treasury Yield:

  • Investors receive a specific, and calculable to the penny, “yield” which is paid to the holder.
  • A Government guaranteed return of principal at maturity.

As we noted previously, it is essential to align expectations and investing requirements. Stocks have liquidity, and potential return (or loss), but no safety of principal. Treasuries have a stated return, and a high degree of safety. However, in order to guarantee the stated return, Treasuries must be held to maturity and may not be liquid if that is your goal.

For most investors, completely discounting the advantage of owning bonds over the last 20-years has been a mistake. By reducing volatility and drawdowns, investors were better able to withstand the eventual storms which wiped out large chunks of capital. Some may look at the graph below and say ‘hey, but in the end bonds and stocks are now at the same point’. True, but the heart burn and risk taken with stocks was needless. It is also worth pointing out that stocks are once again grossly overvalued and a large drawdown is probable in the coming years.

All risk, all the time, has repeatedly led to bad outcomes for investors unwilling to evaluate the benefits of owning fixed income because they are comparing a “phantom yield” to a “real yield.”

Valuations

However, this does not answer the question of “valuation” as it relates to bonds. For that analysis, we need to look at three factors:

  1. Economic growth and inflation
  2. Current trader positioning
  3. Relative yields

(We are specifically focusing on the U.S. Treasury market since this is the market which is specifically affected by monetary policies.)

In April 2017, I wrote an article discussing “Why Bonds Aren’t Overvalued.”  As I stated then:

“I agree that stocks are indeed overvalued. Since investors pay a price for what they believe will be the future value of cash flows from the company, it is possible that investors can misjudge that value and pay too much. Currently, with valuations trading at the second highest level in history, it is not difficult to imagine that investors have once again overestimated the future earnings and cash flows they might receive from their invested capital.”

“However, bonds are a different story.”

Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. Therefore, bond buyers are very coherent of the price they pay today, for the return they will get tomorrow.

Since the future return of any bond, on the date of purchase, is calculable to the 1/100th of a cent, a bond buyer is not going to pay a price that yields a negative yield to maturity. (This is assuming a holding period until maturity. A negative yield might be purchased on a trading basis if benchmark rates are expected to decline further and/or in a deflationary environment.) “

In other words, it is very difficult for a bond to be tremendously “overvalued” as rates are ultimately set by the supply and demand for credit. As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be seen in the chart below. (I have included debt, which I will discuss momentarily.)

We can clean up the chart by combining inflation, wages, and economic growth into a single composite for comparison purposes.

As you can see, the level of interest rates is directly tied to the strength of economic growth and inflation. Since wage growth is what allows individuals to consume, which makes up roughly 70% of economic growth, the level of demand for borrowing is directly tied to the demand from consumption. As demand increases, businesses then demand credit for increases in capital expenditures or production. The interest rates of loans are driven by demand from borrowers. Currently, as shown below, the level of demand is consistent with the interest rates currently being charged. (Also: note the sharp drop in activity over the last several months which has been previously consistent with recessionary onsets)

The debt is also an important determinant of the “fair value” of interest rates. In an economy that is dependent on debt for consumption (70% of GDP), if interest rates rise, consumption immediately falls given the inability to afford higher payments. As I noted last week:

“This is why the “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3200 annual deficit that cannot be filled.”

Since “borrowing costs” are directly tied to the underlying economic factors that drive the NEED for credit; interest rates, and therefore bond values can not be overvalued.

Furthermore, since bonds have a finite value at maturity, there is little ability for overvaluation in the “price paid” for a bond as compared to its future “finite value” at maturity.

Still Way To Many Bond Bulls

Another signal that bonds are potentially still “undervalued” can be seen by looking at the Commitment of Traders report to see the net positioning on U.S. Treasuries.

I discussed this previously:

“[June 2019] The reversal of the net-long positioning in Treasury bonds will likely push bond yields lower over the next few months. This will accelerate if there is a ‘risk-off’ rotation in the financial markets in the weeks ahead.

However, as shown in the chart below, despite the sharp drop in rates, traders are still betting on a surge in rates and the net-short positioning on the 10-Year Treasury is at the second-highest level on record. Combined with the recent spike in Eurodollar positioning, as noted above, it suggests that there is a high probability that rates will fall further in the months ahead; most likely in concert with the risks of a recession.”

“The chart below looks at net-short positioning ONLY when net-short contracts exceed 100,000. Since peaks in net-short contracts generally coincide with peaks in interest rates, it suggests there is more room for rates to fall currently.”

Despite rates falling to multi-year lows, traders are still at some of the most extreme net-short positioning on rates in history. This net short positioning provides “fuel” for further price increases in bonds, and declines in rates, as traders are ultimately forced to cover their positioning.

Since “over-valuation” is mostly a function of sentiment, given the extreme short-positioning in bonds suggests that bonds are still “under-valued” from an investment perspective. When the short-positioning is reversed, rates are going to quickly approach zero at which point it will be fair to say bonds are “fully valued.” 

All Rates Are Relative

Lastly, rates are ultimately directly impacted by the strength of economic growth and the demand for credit. While short-term dynamics may move rates, ultimately the fundamentals, combined with the demand for safety and liquidity, will be the ultimate arbiter. 

When you have $17 Trillion in negatively yielding sovereign debt, money will flow to the bonds with the highest, and safest, yield. Today, the sovereign debt with the highest yield, and most safety, is the U.S. Treasury.

As money flows into the U.S. Treasuries for safety, security, and return, from both domestic and foreign purchasers, yields are driven lower. (This will be exacerbated by the short-squeeze in bonds as noted above.)

Take Japan, for example. Rates can’t rise in one country, while a majority of global economies are pushing low to negative rates. This is simply a function of monetary flows which will find the highest, safest, and most liquid yield. Therefore, given the global status of the U.S.. Treasury as a “safe haven,” the Treasury is “undervalued” relative to the other relatively stable sovereign bonds which currently all sport substantially lower yields.

Not unlike Japan, the U.S. faces many of the same demographic and economic challenges which suggest that yields are not only “undervalued,” but will approach full valuation during the next recession.

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

Conclusion

The problem with the statement that “bonds are in a bubble,” is the assumption we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect “payments,” increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth. 

Given the current demographic, debt, pension and valuation headwinds, the future rates of growth are going to be low over the next couple of decades. Even the Fed’s own “long run” economic growth rates currently run below 2%.

Bonds are at a minimum “fairly valued,” but most likely “under-valued” based on the factors set out above.

While there is little room left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates continue to trade in a flat line over the next decade.

Of course, that line will be closer to zero than not.

Don’t believe me? You don’t have to look much further than Japan for your answer.

America’s Debt Burden Will Fuel The Next Crisis

Just recently, Rex Nutting penned an opinion piece for MarketWatch entitled “Consumer Debt Is Not A Ticking Time Bomb.” His primary point is that low per-capita debt ratios and debt-to-dpi ratios show the consumer is quite healthy and won’t be the primary subject of the next crisis. To wit:

“However, most Americans are better off now than they were 10-years ago, or even a few years ago. The finances of American households are strong. 

But, that’s not what a lot of people think. More than a decade after a massive credit orgy by households brought down the U.S. and global economies, lots of people are convinced that households are still borrowing so much money that it will inevitably crash the economy.

Those critics see a consumer debt bomb growing again. But they are wrong.”

I do agree with Rex on his point that the U.S. consumer won’t be the sole cause of the next crisis. It will be a combination of household and corporate debt combined with underfunded pensions, which will collide in the next crisis.

However, there is a household debt problem which is hidden by the way governmental statistics are calculated.

Indebted To The American Dream

The idea of “maintaining a certain standard of living” has become a foundation in our society today. Americans, in general, have come to believe they are “entitled” to a certain type of house, car, and general lifestyle which includes NOT just the basic necessities of living such as food, running water, and electricity, but also the latest mobile phone, computer, and high-speed internet connection. (Really, what would be the point of living if you didn’t have access to Facebook every two minutes?)

But, like most economic data, you have to dig behind the numbers to reveal the true story.

So let’s do that, shall we?

Every quarter the Federal Reserve Bank of New York releases its quarterly survey of the composition and balances of consumer debt. (Note that consumers are at record debt levels and roughly $1 Trillion more than in 2008.)

One of the more interesting points made to support the bullish narrative was that record levels of debt is irrelevant because of the rise in disposable personal incomes. The following chart was given as evidence to support that claim.

Looks pretty good, as long as you don’t scratch too deeply.

To begin with, the calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households.

More importantly, the measure is heavily skewed by the top 20% of income earners, needless to say, the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%.

(Note: all data used below is from the Census Bureau and the IRS.)

Furthermore, disposable and discretionary incomes are two very different animals.

Discretionary income is what is left of disposable incomes after you pay for all of the mandatory spending like rent, food, utilities, health care premiums, insurance, etc.

From this view, the “cost of living” has risen much more dramatically than incomes. According to Pew Research:

“In fact, despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”

But the problem isn’t just the cost of living due to inflation, but the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.

  • Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. 
  • Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58.000.

So, while the “median” income has broken out to highs, the reality for the vast majority of Americans is there has been little improvement. Here are some stats from the survey data which was NOT reported:

  • $306,139 – the difference between the annual income for the Top 5% versus the Bottom 80%.
  • $148,504 – the difference between the annual income for the Top 5% and the Top 20%.
  • $157,635 – the difference between the annual income for the Top 20% and the Bottom 80%.

If you are in the Top 20% of income earners, congratulations.

If not, it is a bit of a different story.

Assuming a “family of four” needs an income of $58,000 a year to just “make it,” such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.” 

This is why the “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3200 annual deficit that cannot be filled.

Record levels of consumer debt is a problem. There is simply a limit to how much “debt” each household can carry even at historically low interest rates.

Data Skew

While Rex’s analysis is not incorrect, the data he is using in his assumptions is being skewed by the “wealth and income” gap in the top 20% of the population. This was a point put forth in a study from Chicago Booth Review:

“The data set reveals since 1980 a ‘sharp divergence in the growth experienced by the bottom 50 percent versus the rest of the economy,’ the researchers write. The average pretax income of the bottom 50 percent of US adults has stagnated since 1980, while the share of income of US adults in the bottom half of the distribution collapsed from 20 percent in 1980 to 12 percent in 2014. In a mirror-image move, the top 1 percent commanded 12 percent of income in 1980 but 20 percent in 2014. The top 1 percent of US adults now earns on average 81 times more than the bottom 50 percent of adults; in 1981, they earned 27 times what the lower half earned.

Given this information, it should not be surprising that personal consumption expenditures, which make up roughly 70% of the economic equation, have had to be supported by surging debt levels to offset the lack wage growth in the bottom 80% of the economy.

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

This anomaly was also noted in the study:

“Government transfer payments have ‘offset only a small fraction of the increase in pre-tax inequality,’ Piketty, Saez, and Zucman conclude—and those payments fail to bridge the gap for the bottom 50 percent because they go mostly to the middle class and the elderly. Pretax income of the middle class (adults between the median and the 90th percentile) has grown 40 percent since 1980, ‘faster than what tax and survey data suggest, due in particular to the rise of tax-exempt fringe benefits,’ the researchers write. ‘For the working-age population, post-tax bottom 50 percent income has hardly increased at all since 1980.’”

Here is the point that Rex missed. There is a vast difference between the level of indebtedness (per household) for those in the bottom 80%, versus those in the top 20%. 

Of course, the only saving grace for many American households is that artificially low interest rates have reduced the average debt service levels. Unfortunately, those in the bottom 80% are still having a large chunk of their median disposable income eaten up by debt payments. This reduces discretionary spending capacity even further.

The problem is quite clear. With interest rates already at historic lows, the consumer already heavily leveraged, and wage growth stagnant, the capability to increase consumption to foster higher rates of economic growth is limited.

With respect to those who say “the debt doesn’t matter,” I respectfully argue that you looking at a very skewed view of the world driven by those at the top.

The Next Crisis Will Be The Last

For the Federal Reserve, the next “financial crisis” is already in the works. All it takes now is a significant decline in asset prices to spark a cascade of events that even monetary interventions may be unable to stem.

However, to Rex’s credit, households WILL NOT be the sole catalyst of the next crisis.

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

But, consumers will “contribute their fair share.” Consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt. When the recession hits, the reduction in employment will further damage what remains of personal savings and consumption ability. The downturn will increase the strain on an already burdened government welfare system as an insufficient number of individuals paying into the scheme is being absorbed by a swelling pool of aging baby-boomers now forced to draw on it. Yes, more Government funding will be required to solve that problem as well. 

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

The good news is that it can all be solved by the issuance of more debt.

The bad news comes when there are no buyers willing to continue to fund fiscal irresponsibility.

The next “crisis,” will be the “great reset” which will also make it the “last crisis.”

The $6 Trillion Pension Bailout Is Coming

Fiscal responsibility is dead.

This past week, Trump announced he had reached an agreement with Congress to pass a continuing resolution which will suspend the debt ceiling until July 2021.

The good news is that it will ONLY increase spending by just $320 billion. 

What a bargain, right?

It’s a lie.

That is just the “starting point” of proposed spending. Without a “debt ceiling” to constrain spending, the actual spending will be substantially higher.

However, the $320 billion is also deceiving because that is on top of the spending we have already committed. As I noted just recently:

“In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues, and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in.” 

Do some math here.

The U.S. spent $986 billion more than it received in revenue in 2018, which is the overall “deficit.” If you just add the $320 billion to that number you are now running a $1.3 Trillion deficit.

Sure enough, this is precisely where I forecast we would be in December of 2017.

“Of course, the real question is how are you going to ‘pay for it?’ On the ‘fiscal’ side of the tax reform bill, without achieving accelerated rates of economic growth – ‘the debt will balloon.’

The reality, of course, is that is what will happen because there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.”

More importantly, Federal Tax Revenue is DECLINING. Such was NOT supposed to be the case, as the whole “corporate tax cut” bill was supposed to lift tax revenues due to rising incomes.

More spending, less revenue, equals bigger deficits, which equates to slower economic growth.

“Increases in the national debt have long been squandered on increases in social welfare programs, and ultimately higher debt service, which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

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

“The irony is that debt driven economic growth, consistently requires more debt to fund a diminishing rate of return of future growth. It now requires $3.02 of debt to create $1 of real economic growth.”

Over the next 12-18 months, spending will expand, and the deficit will quickly approach $2 Trillion. 

But, here’s the worse part: The projected budget deficits over the next couple of years are coming at the end of a decade-long growth cycle with the economy essentially at full employment. This is significant because, while budget deficits can be helpful in recessions by providing an economic stimulus, there are good reasons we should be retrenching during good economic times, including the one we are in now.

As William Gale stated:

“As President Kennedy once said, ‘the time to repair the roof is when the sun is shining.’  Instead, we are punching more holes in the fiscal roof. The fact that debt and deficits are rising under conditions of full employment suggests a deeper underlying fiscal problem.”

During the next recession, revenue will drop sharply, deficits will explode, and the Government will be forced into another round of bailouts.

Congress is already committing you to pay for it.

The $6 Trillion Bailout

I previously penned an article discussing the “Unavoidable Pension Crisis.” 

An April 2016 Moody’s analysis pegged the total 75-year unfunded liability for all state and local pension plans at $3.5 trillion. That’s the amount not covered by current fund assets, or future expected contributions, or investment returns at assumed rates ranging from 3.7% to 4.1%. Another calculation from the American Enterprise Institute comes up with $5.2 trillion, presuming that long-term bond yields average 2.6%.

Since then, we have gotten some updated estimates. Surely, after 3-years of surging stock market returns things have gotten markedly better, right?

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

Apparently, not.

Don’t worry, Congress has your back. 

In “The Next Financial Crisis Will Be The Last” I stated:

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

Fortunately, Congress has made some movement to get ahead of the problem with the Rehabilitation for Multiemployer Pensions Act. The legislation, if passed, is an attempt to address the multi-trillion dollar problem of unfunded pension plans in America.

By the way, this isn’t JUST an American problem, it is a $70-Trillion global problem, as noted recently by Visual Capitalist.

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…

The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

This is why Central Banks globally are terrified of a global downturn. The pension crisis IS the “weapon of mass destruction” to the global financial system, and it has started ticking.

While pension plans in the United States are guaranteed by a quasi-government agency called the Pension Benefit Guarantee Corporation (PBGC), the reality is the PBGC is already nearly bust from taking over plans following the financial crisis. The PBGC is slated to run out of money in 2025. Moreover, its balance sheet is trivial compared to the multi-trillion dollar pension problem.

The proposal from Congress is simply to use more debt. According to the new legislation, whenever a pension plan runs out of funds, Congress wants the pension plan to borrow money in order to keep making payments to beneficiaries.

Think about that for a moment. 

Who would loan money to an insolvent pension fund?

Oh, that would be you, the taxpayer.

In other words, the Government wants you to bail out your own retirement fund.

Genius.

But it’s going to get far worse.

We Are Out Of Time

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached or will reach retirement age between 2011 and 2030. And many of them are public-sector employees. In a 2015 study of public-sector organizations, nearly half of the responding organizations stated that they could lose 20% or more of their employees to retirement within the next five years. Local governments are particularly vulnerable: a full 37% of local-government employees were at least 50 years of age in 2015.

The vast majority of these individuals, when they retire, will depend on their pension (if they are in the 15% of the population that has one, and Social Security for a bulk of their living expenses in retirement.

The problem is that pension funds aren’t going to be able to keep their promises. Social Security, according to its own annual report, will run out of money in 15 years. Medicare has a massive underfunded problem as well.

But yet, the current Administration believes our outcome will be different.

More debt, and lack of any budgetary controls, will somehow lead to surging levels of economic growth despite no historical evidence of that being the case.

The reality is that the U.S. is now caught in the same liquidity trap as Japan. With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs. Combine this with:

  • A decline in savings rates to extremely low levels which depletes productive investments
  • An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
  • A heavily indebted economy with debt/GDP ratios above 100%.
  • A decline in exports due to a weak global economic environment.
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases to offset reduced employment

The combined issues of debt, deflation, and demographics will continue to push the U.S. closer to the “point of no return.”

As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

It’s an unsolvable problem.

It will happen.

It will devastate many Americans.

It is just a function of time.

“Demography, however, is destiny for entitlements, so arithmetic will do the meddling.” – George Will

But here is the real question that needs to be answered:

“Who is going to buy all the debt?”

10 Illustrated Truths About Investing & The Markets

Over the last eighteen months, stocks have whipsawed within a massive trading range as “trade wars,” “tariffs,” and monetary policy actions from the Fed have lit up headlines. Despite the strong rally from the beginning of the year, investors are no better off today than they were at the beginning of 2018.

Does this mean the bull market is over? Or, is it just a pause before a continuation higher? Has the Federal Reserve figured out how to “end recessions?” Or, has the low interest rate environment over the last decade spurred another credit bubble?

Honestly, no one knows for sure where we are within the current cycle, but it is understood it will end.

As a portfolio manager, I must stay invested during rising markets as our clients need returns in order to meet their investment goals. However, I must also protect that capital from major drawdowns which inflict far greater damage to financial goals than temporary underperformance.

This is a point missed by most individuals who take on far greater risks than they realize when chasing markets higher. It is also why we spend the majority of our time pointing out the relevant risks to capital.

Pointing out risks, analyzing those risks, and developing an “odds based” approach based on those risks is what guides our asset protection strategies within our long-biased portfolios. While ignoring those risks may lead to great gains in the short-term, the long-term destruction of capital combined with lost time is irreparable.

This is why we write the way we do. It is our “homework” behind our investment management strategies. Here are ten thoughts about investing and markets to consider. (I have provided links to relevant articles for more in-depth explanations.)


1. Markets are cyclical.  Bull markets are a process. Bear markets are an event.

Read: A Different Way To Look At Market Cycles

2. Diversification has become less beneficial as markets have become highly correlated.

Read: I Bought It For The Dividend

3. Follow the trend of the market. Have a simple method to define the direction of the trend and follow it accordingly. Being a bull during a bearish trend doesn’t work well.

Read: Portfolio Strategies For The Long Run

4. We will all be wrong from time to time. Staying wrong is problematic.

Read: The Math Of Loss

5. There is no “law” that says you have to remain “fully invested” at all times. Sometimes, cash is the best hedge against uncertainty.

Read: Eternal Bullishness & Willful Blindness

Also Read: Valuations, Returns & The Real Value Of Cash

6. Understanding the real meaning of “risk” and how to control it always leads to better outcomes. Professional gamblers know when “not to bet” on a losing hand.

Read: 15-Risk Management Rules For Every Investor

7. No one is right all the time. However, there are basic investing rules. that if followed. tend to reduce the loss of capital associated with being wrong.

Read: An Investors Desktop Guide To Trading

8. The markets are driven by the “herd” mentality which swings from optimism to pessimism driven by headlines and narratives. Excess optimism and excess pessimism denote the points where the most money is lost or made.

Read: 5-Universal Laws Of Human (Investment) Stupidity

9. Valuations do matter.

Read: 7-Measures Suggests A Decade Of Low Returns

10. Understanding the importance of “time” is critical to investing success. While capital can always be regained, the loss of time cannot. 

Read: Strike Three: The Next Bear Market Ends The Game

These are just reminders to keep you grounded in the reality of how money, and investing, REALLY work over the long-term. While it is easy to get lost in the excitement of the moment, the brutal return to reality has always been a costly lesson to re-learn.

The 5-Laws Of Human Stupidity & How To Be A “Non-Stupid” Investor

This past weekend, I was digging through some old articles and ran across one that needed to be readdressed on “human stupidity” as it relates to investing.

The background was a study done in 1976 by a professor of economic history at the University of California, Berkeley. Carol M. Cipolla published an essay outlining the fundamental laws of a force he perceived as humanity’s greatest existential threat: Stupidity.

Stupid people, according to Cipolla, share several identifying traits:

  • they are abundant,
  • they are irrational, and;
  • they cause problems for others without apparent benefit to themselves

The result is that “stupidity” lowers society’s total well-being and there are no defenses against stupidity. According to Cipolla:

“The only way a society can avoid being crushed by the burden of its idiots is if the non-stupid work even harder to offset the losses of their stupid brethren.”

Of course, if we look at the world around us today, watch or read the diatribe produced by financial and news outlets, or pay attention to politics, it certainly seems that since the advent of the “smartphone” and “social media” the percentage of “stupidity” has clearly risen. (Either that, or we are just more aware of the massive amount of “stupidity” around us. Thankfully, it seems to be contained primarily in Florida.)

We can’t really do much about the seemingly rising level of “general stupidity,” however, we can apply Cipolla’s five basic laws of human stupidity to investing and the mistakes investors repeatedly make over time.

Law 1: Always and inevitably everyone underestimates the number of stupid individuals in circulation.

“No matter how many idiots you suspect yourself surrounded by you are invariably low-balling the total.” – Cipolla

In investing, the problem of investor “stupidity” is compounded by a variety of biased assumptions that are made.  Individuals assume that when the media publishes something, the superficial factors like the commentator’s job, education level, or other traits suggest they can’t possibly be stupid. We, therefore, attach credibility to their opinion as long as it confirms our own.

This is called “confirmation bias.”

If we believe the stock market is going to rise, then we tend only to seek out news and information that supports our view. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this previously in why “Media Headlines Will Lead You To Ruin.”

As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”

This is why “social media” has become such a pervasive problem in the spread of misinformation as individuals huddle into their own “echo chambers” which excludes both intelligent debates and, in many cases, actual facts. It is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.

Law 2: The probability that a certain person be stupid is independent of any other characteristic of that person.

Cipolla posits stupidity is a variable that remains constant across all populations. Every category one can imagine—gender, race, nationality, education level, income—possesses a fixed percentage of stupid people.

When it comes to investing, ALL investors, individual and professionals, are subject to making “stupid” decisions. As I discussed recently:

“A recent survey from Ally Invest showed much the same:

‘The bullish sentiment by investors, which doubled between Q1 and Q2 of this year, appears, in part, supported by the majority of respondents’ belief that interest rates will remain unchanged this year (67%) and the government will sign economic trade agreements that will help drive the markets higher (61%).

Other major market drivers cited by respondents include positive year-over-year earnings (26%), low unemployment rate (24%), lack of inflation (18%), and tax reform (15%).’

E*Trade also recently released survey data showing:

  • Bullish sentiment returns. Bullishness rose 12 percentage points since last quarter to once again represent the majority of investors at 58 percent.
  • Investors believe there’s more room for the bull market to run. Two-thirds of investors say they think the bull market has a year or more to go (66%), up seven percentage points from last quarter.
  • The majority gave the US economy a passing grade. Investors who gave the economy an “A” or “B” grade rose 9 percentage points this quarter, to 64%.
  • Volatility concerns remain. Investors who believe volatility will stay the same was up by 8 percentage points from Q1.

You get the idea. Just 8-weeks after panic selling lows in December of 2018, investors are once again “back in the pool.”

Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted, I need to do it too.

In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives market excesses during advances and declines.

As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.

Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against those who are being “stupid.”

Law 3. A stupid person is a person who causes losses to another person or to a group of persons while himself deriving no gain and even possibly incurring losses.

Consistent stupidity is the only consistent thing about the stupid. This is what makes stupid people so dangerous. As Cipolla explains:

“Essentially stupid people are dangerous and damaging because reasonable people find it difficult to imagine and understand unreasonable behavior.

Throughout history, investors are constantly drawn into investment strategies, promoted by a wide variety of “industry professionals,” which ultimately leads to losses in the end. This point was clearly made in a recent article by Jason Zweig entitled: “Whatever You Do, Don’t Read This Column.”

“Investors believe the darnedest things.

In one survey, wealthy individuals said they expect their portfolios to earn a long-run average of 8.5% annually after inflation. With bonds yielding roughly 2.5%, a typical stock-and-bond portfolio would need stocks to grow at 12.5% annually in order to hit that overall 8.5% target. Net of fees and inflation, that would require approximately doubling the 7% annual gain stocks have produced over the long term.

Individuals aren’t the only investors who believe in the improbable. One in six institutional investors, in another survey, projected gains of more than 20% annually on their investments in venture capital — even though such funds, on average, have underperformed the stock market for much of the 2000s.

Although almost nothing is impossible in the financial markets, these expectations are so far-fetched they border on fantasy.”

Cipolla is absolutely right, and despite the historical realities of investing, both the individual and the professional will ultimately suffer losses. As shown in the chart below, there is no evidence which shows markets can compound high levels of growth rates from current valuation levels. (For more detail on forward returns read “Valuations Matter”)

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

“Unless you have contracted ‘vampirism,’ then you do NOT have 90, 100, or more, years to invest to gain “average historical returns.” Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have about 30-35 years to reach their goals. If that period happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are severely diminished.

What drives those 12-15 year periods of flat to little return? Valuations.

Just remember, a 20-year period of one-percent returns is indistinguishable from ZERO with respect to meeting savings goals.”

Individuals who experienced either one, or both, of the last two bear markets, now understand the importance of “time” relating to their investment goals. Individuals that were close to retirement in either 2000, or 2007, and failed to navigate the subsequent market draw downs have had to postpone their retirement plans, potentially indefinitely.

But yet despite the losses incurred by both professionals and individuals, just a decade after the largest financial crisis since the “Great Depression,” individuals are piling on excessive risk once again under the guise “this time is different.” 

Talk about stupid.

Despite the mainstream media’s consistent drivel investors should just “passively index” and forget about actually managing the risk of catastrophic capital loss, the reality is that investors “buy high and sell low” for a reason.

“Greed” and “Fear” are far more powerful in driving our investment decisions versus “Logic” and “Discipline.” 

As Jason states:

“The traditional explanations for believing in an investing tooth fairy who will leave money under your pillow are optimism and overconfidence: Hope springs eternal, and each of us thinks we’re better than the other investors out there.

There’s another reason so many investors believe in magic: We can’t handle the truth.”

All of which leads us to:

Law 4: Non-stupid people always underestimate the damaging power of stupid individuals. In particular non-stupid people constantly forget that at all times and places and under any circumstances to deal and/or associate with stupid people always turns out to be a costly mistake.

Lot’s of “non-stupid people” are currently suggesting the next correctionary event will be mild, most likely no more than 20%. The idea is based upon the belief the Federal Reserve, and Central Banks globally, will quickly come to the rescue of a failing market and investors will quickly react by once again jumping back into the market.

However, as we have seen repeatedly throughout history, “stupid” people tend to do exactly the opposite during a crisis than what “non-stupid” people expect.

Then there are the “perennial bulls” who keep telling investors to “hang on, keep putting money in, you’re a long-term investor, right?” These are the ones who never see the bear market destruction until well after the fact and then simply say “well, no one could have seen that coming.” 

Non-stupid people are conservative. They analyze the risk of loss and conserve capital during declines. Make sure you are surrounding yourself with those that understand the “math of loss.” 

As Howard Marks stated above, sometimes being a contrarian is lonely.

When we underestimate the stupid, we do so at our own peril.

This brings us to the fifth and final law:

Law 5: A stupid person is the most dangerous type of person.

Following the “herd,” has always ended badly for investors. In every full-market cycle, there is an inevitable belief “this time is different” for one reason or another.

It isn’t. It has never been. And this time will not be different either.

However, what has always separated out the great investors from everyone else, is they have acted independently of the “herd.” They have a discipline, a strategy and a driving will to succeed.

They don’t “buy and hold.” They buy cheap and sell expensive. They avoid losses at all costs and they deeply understand the relationship of risk to reward.

They are the “non-stupid.”

These are the ones you want to follow.

Not the ones screaming at you on television telling you to “buy, buy, buy.”

Just remember that for every full-market cycle our job is to not only participate in the first-half of the cycle as prices rise, but to avoid the avoid the devastation during the second-half.

“Non-stupid” investors don’t spend a bulk of their time getting back to even.

“Getting back to even” is an investing strategy better left to the “herd.”

Has The Fed Done It? No More Recessions?

“Wow!”

That is all I could utter as my brain spun listening to an interview with Chamrath Palihapitiya on CNBC last week.

“I don’t see a world in which we have any form of meaningful contraction nor any form of meaningful expansion. We have completely taken away the toolkit of how normal economies should work when we started with QE. I mean, the odds that there’s a recession anymore in any Western country of the world is almost next to impossible now, save a complete financial externality that we can’t forecast.”

It is a fascinating comment particularly at a time where the Federal Reserve has tried, unsuccessfully, to normalize monetary policy by raising interest rates and reducing their balance sheet.  However, an almost immediate upheaval in the economy, not to mention reprisal from the Trump Administration, brought those efforts to a halt just a scant few months after they began.

A quick Google search on Chamrath revealed a pretty gruesome story about his tenure as CEO of Social Capital which will likely cease existence soon. However, his commentary was interesting because despite an apparent lack of understanding of how economics works, his thesis is simply that economic cycles are no longer relevant.

This is the quintessential uttering of “this time is different.” 

Economists wanting to get rid of recessions is not a new thing.

Emi Nakamura, this years winners of the John Bates Clark Medal honoring economists under 40, stated in an interview that she:

“…wants to tackle some of her fields’ biggest questions such as the causes of recessions and what policy makers can do to avoid them.”

The problem with Central Bankers, economists, and politicians, intervening to eliminate recessions is that while they may successfully extend the normal business cycle for a while, they are most adept at creating a “boom to bust” cycles.

To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.  You can see the length of the economic recoveries in the chart below. I have also shown you the subsequent percentage market decline when they ended.

Currently, employment and wage growth is fragile, 1-in-4 Americans are on Government subsidies, and the majority of American’s living paycheck-to-paycheckThis is why Central Banks, globally, are aggressively monetizing debt in order to keep growth from stalling out.

Despite a surging stock market and an economy tied for the longest economic expansion in history, it is also is running at the weakest rate of growth with the highest debt levels…since “The Great Depression.”  

Recessions Are An Important Part Of The Cycle

I know, I get it.

If you mention the “R” word, you are a pariah from the mainstream proletariat.

This is because people assume if you talk about a “recession” you mean the end of the world is coming.

The reality is that recessions are just a necessary part of the economic cycle and arguably an crucial one. Recessions remove the “excesses” built up during the expansion and “reset” the table for the next leg of economic growth.

Without “recessions,” the build up of excess continues until something breaks. The outcomes of previous attempts to manipulate the cycles have all had devastating consequences.

In the current cycle, the Fed’s interventions and maintenance of low rates for a decade have allowed fundamentally weak companies to stay in business by taking on cheap debt for unproductive purposes like stock buybacks and dividends. Consumers have used low rates to expand their consumption through debt once again. The Government has piled on debts and increased the deficit to levels normally seen during a recession. Such will only serve to compound the problem of the next recession when it comes.

However, it is the Fed’s mentality of constant growth, with no tolerance for recession, has allowed this situation to inflate rather than allowing the natural order of the economy to perform its Darwinian function of “weeding out the weak.”

The two charts below show both corporate debt as a percentage of economic growth and total system leverage versus the market.

Do you see the issue?

The fact that over the past few decades the system has not been allowed to reset has led to a resultant increase in debt to the point it has impaired the economy to grow. It is more than just a coincidence that the Fed’s “not-so-invisible hand” has left fingerprints on previous financial unravellings.

Given the years of “ultra-accommodative” policies following the financial crisis, the majority of the ability to “pull-forward” consumption appears to have run its course. This is an issue that can’t, and won’t be, fixed by simply issuing more debt which, for last 40 years, has been the preferred remedy of each Administration. In reality, most of the aggregate growth in the economy has been financed by deficit spending, credit creation, and a reduction in savings.

In turn, this surge in debt reduced both productive investments into, and the output from, the economy. As the economy slowed, and wages fell, the consumer was forced to take on more leverage which continued to decrease the savings rate. As a result, of the increased leverage, more of their income was needed to service the debt.

Since most of the government spending programs redistribute income from workers to the unemployed, this, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources from productive investment to redistribution.

All of these issues have weighed on the overall prosperity of the economy and what has obviously gone clearly awry is the inability for the current economists, who maintain our monetary and fiscal policies, to realize what downturns encompass.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, is clearly wrong. It has not happened in four decades. What is missed is that things like temporary tax cuts, or one time injections, do not create economic growth but merely reschedules it. The average American may fall for a near-term increase in their take-home pay and any increased consumption in the present will be matched by a decrease later on when the tax cut is revoked.

This is, of course, assuming the balance sheet at home is not broken. As we saw during the period of the “Great Depression” most economists thought that the simple solution was just more stimulus. Work programs, lower interest rates, government spending, etc. did nothing to stem the tide of the depression era.

The problem currently is that the Fed’s actions halted the “balance sheet” deleveraging process keeping consumers indebted and forcing more income to pay off the debt which detracts from their ability to consume. This is the one facet that Keynesian economics does not factor in. More importantly, it also impacts the production side of the equation since no act of saving ever detracts from demand. Consumption delayed, is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers.

The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 40-years of an insidious slow moving infection that has destroyed the American legacy.

Here is the most important point.

“Recessions” should be embraced and utilized to clear the “excesses” that accrue in the economic system during the first half of the economic growth cycle.

Trying to delay the inevitable, only makes the inevitable that much worse in the end.

The “R” Word

Despite hopes to the contrary, the U.S., and the globe, will experience another recession. The only question is the timing.

As I quoted in much more detail in this past weekend’s newsletter, Doug Kass suggests there is plenty of “gasoline” awaiting a spark.

  • Slowing Domestic Economic Growth
  • Slowing Non-U.S. Economic Growth
  • The Earnings Recession
  • The Last Two Times the Fed Ended Its Rate Hike Cycle, a Recession and Bear Market Followed
  • The Strengthening U.S. Dollar
  • Message of the Bond Market
  • Untenable Debt Levels
  • Credit Is Already Weakening
  • The Abundance of Uncertainties
  • Political Uncertainties and Policy Concerns
  • Valuation
  • Positioning Is to the Bullish Extreme
  • Rising Bullish Sentiment (and The Bull Market in Complacency)
  • Non-Conformation of Transports

But herein lies the most important point about recessions, market reversions, and systemic problems.

What Chamrath Palihapitiya said was both correct and naive.

He is naive to believe the Fed has “everything” under control and recessions are a relic of the past. Central Banks globally have engaged in a monetary experiment hereto never before seen in history. Therefore, the outcome of such an experiment is also indeterminable.

Secondly, when Central Banks launched their emergency measures, the global economies were emerging from a financial crisis not at the end of a decade long growth cycle. The efficacy of their programs going forward is highly questionable.

But what Chamrath does have right were his final words, even though he dismisses the probability of occurrence.

“…save a complete financial externality that we can’t forecast.”

Every financial crisis, market upheaval, major correction, recession, etc. all came from one thing – an exogenous event that was not forecast or expected.

This is why bear markets are always vicious, brutal, devastating, and fast. It is the exogenous event, usually credit related, which sucks the liquidity out of the market causing prices to plunge. As prices fall, investors begin to panic sell driving prices lower which forces more selling in the market until, ultimately, sellers are exhausted.

It is the same every time.

While investors insist the markets are currently NOT in a bubble, it would be wise to remember the same belief was held in 1999 and 2007. Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.

This time will not be different. Only the catalyst, magnitude, and duration will be.

My advice to Emi Nakamura would be instead of studying how economists can avoid recessions, focus on the implications, costs, and outcomes of previous attempts and why “recessions” are actually a “healthy thing.” 

Boomers Are Facing A Financial Crisis

There is a “crisis” brewing in America which will affect more Americans than the subprime crisis in 2008.

What is it?

It’s the pension and retirement crisis.

According to a recent report from the National Retirement Planning Week the three “legs” of the retirement “stool” are Social Security, private pensions and personal savings. None are in great shape.

  • The average Social Security check is $14,000 a year, hardly a cushy retirement.
  • 23% of boomers ages 56-61 expect to receive income from a private company pension plan; and,
  • 38% of older boomers expect a pension.
  • 45% of boomers have ZERO savings for retirement.

I previously discussed the pension issue in the “Unavoidable Pension Crisis.” To wit:

“Using faulty assumptions is the lynchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system.”

This is a critically important point to understand as it is why a vast majority of Americans are trapped in the same “quicksand” as pension funds and don’t realize it.

For years, Wall Street has espoused the “myth of compounded average returns.” This is the same myth which has not only infected pension funds, but has led to the same false sense of future financial security in personal retirement planning nationwide. An article from IBD further perpetuates this myth:

J.P. Morgan says ‘enough’ means the nest egg is big enough to have at least an 80% chance of surviving 30 years in retirement.’ 

The financial firm’s number crunchers also assume that, before retirement, you keep kicking in 10% of your income each year to your nest egg. In addition, they assume that your retirement portfolio grows an average of 6% a year before retirement and 5% a year in retirement.

And there it is.  The biggest mistake you are making in your retirement planning by buying into the “myth” that markets “compound returns” over time.

They don’t. They never have. They never will.

The chart below shows a compounded return rate of at 4-8% with $5000 annual dollar cost averaging (DCA) contributions made monthly (as noted above 10% of $50,000 which is roughly the median wage), and using variable rates of return from current valuation levels. (Chart assumes 35 years of age to start saving and expiring at 85)

Just as with “pension funds,” the issue of using above average rates of return into the future suggests one can “save less” today because the “growth” will make up for the difference.

Unfortunately, it just doesn’t work that way.

Financial Insecurity

While we can argue about market returns, compounding rates, etc., in order for any of that to matter we have to assume Americans have money, or savings, to invest to begin with.

A new report by Forbes states that 23% (nearly one in four) Americans are saving not even one penny from their paychecks.

As part of its 2019 Savings Survey, First National Bank of Omaha examined Americans’ habits, behaviors, and priorities when it comes to saving, monthly spending, and retirement planning. The findings showed that nearly 80% of Americans live paycheck to paycheck.

The 2018 Planning & Progress Study gathered data in an online survey from over 2000 Americans over the age of 18. In that survey, they found:

  • 78% said they were “extremely” or “somewhat” concerned about affording a comfortable retirement.
    • 33% of baby boomers have between $0 and $25,000 of retirement savings
  • 46% admitted to taking no steps to prepare for the likelihood they could outlive their retirement.

Medium reported that:

“According to a survey from Gallup, 43 percent of adults between the ages of 50 and 64 expect to rely on Social Security during retirement. This number has been steadily increasing since 2001. However, only 24 percent of respondents in the 2018 Planning & Progress Survey believe it’s extremely likely that Social Security will even be available when they plan to retire.”

That fear is likely not so misplaced as Reason noted:

Social Security will be insolvent and unable to pay the full value of promised benefits by 2035—that’s one full year later than previously expected—and Social Security’s costs will exceed its income by 2020, according to a new report published Monday by the program’s trustees.

At the end of 2018, Social Security was providing income to about 67 million Americans. About 47 million of them were over age 65, and the majority of the rest were disabled. If nothing changes, the Social Security Trust Fund will be fully depleted by 2035 and the program would impose across-the-board cuts of 20 percent to all beneficiaries.”

Meanwhile, demographics are blowing up the basic premise of how Social Security is funded. There were 2.8 workers for every Social Security recipient in 2017. That’s down from 3.3 in 2007, and that’s way down from the 5.1 workers per beneficiary that existed in 1960.

Furthermore, the two programs function mostly as a giant conveyor belt to transfer wealth from the young and relatively poor to the old and relatively rich, allowing the average person (who now lives to be 78) more than a decade of taxpayer-funded retirement. As  I have shown previously, welfare now makes up the highest percentage of disposable personal incomes in history despite record low unemployment, rising wage growth, and the longest economic expansion in U.S. history.

Those entitlement programs are also the primary drivers of our national debt, which just hit $22 trillion, and the deficit, despite tax reform is now pushing in excess of $1 Trillion, which has never been seen during an economic expansion.

Won’t Or Can’t

Asking people to save “more” really isn’t an option.

The lack of savings, of course, is directly related to the rising cost of living versus the lack of wage growth over the last 35-years which led to a massive surge in debt to maintain the standard of living.

Fidelity provided some further insights into the savings problem which shows it permeates Boomers, Generation X’ers, and Millennials:

“Generation X is squarely in middle age and beset on all sides by bills. Many in Generation X have dependents at home—84% in the survey said they have at least one. They may also still be paying off their own student debts—just more than one in four survey respondents from Generation X says he or she is still paying for his or her own education. 

There are all kinds of money problems, but the solutions are generally the same: Save more, spend less, or find a higher-paying job—or maybe all three. But this is easier said than done.”

The massive shortfall in “savings” is going to be a problem in the future.

But everyone saves money in their 401k plan?

A report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.

Here are some additional findings from the report:

  • Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
  • The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
  • Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.

The Unsolvable Problem

A survey from Bankrate.com touched on the issue.

“13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.”

The cost of living has risen much more dramatically than incomes. According to Pew Research:

“In fact, despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”

But the problem isn’t just the cost of living due to inflation, but the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.

  • Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. 
  • Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58.000.

The chart below shows the “disposable income” of Americans from the Census Bureau data. (Disposable income is income after taxes.)

So, while the “median” income has broken out to all-time highs, the reality is that for the vast majority of Americans there has been little improvement. Here are some stats from the survey data which was NOT reported:

  • $306,139 – the difference between the annual income for the Top 5% versus the Bottom 80%.
  • $148,504 – the difference between the annual income for the Top 5% and the Top 20%.
  • $157,635 – the difference between the annual income for the Top 20% and the Bottom 80%.

If you are in the Top 20% of income earners, congratulations. If not, it is a bit of a different story.

Assuming a “family of four” needs an income of $58,000 a year to just “make it,” such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.” 

The “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3200 annual deficit that cannot be filled.

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

The mirage of consumer wealth has not been a function of a broad increase in the net worth of Americans, but rather a division in the country between the Top 20% who have the wealth and the Bottom 80% dependent on increasing debt levels to sustain their current standard of living.

With the vast amount of individuals already vastly under-saved and dependent on social welfare, the next major correction will reveal the full extent of the “retirement crisis” silently lurking in the shadows of this bull market cycle.

For the 75.4 million “boomers,” about 26% of the entire population heading into retirement by 2030, the reality is that only about 20% will be able to actually retire.

The rest will be faced with tough decisions in the years ahead.

The good news is that if Alexandria Ocasio-Cortez is correct, none of this will be a problem if climate change kills everyone in the next 12 years.

Auto Sales Aren’t Nearly As Strong As Reported

Steve Goldstein recently reported for MarketWatch that closely watched auto sales were leading economists to be more confident in their economic outlook for the rest of the year. To wit:

“Motor vehicle sales reached a seasonally adjusted annual rate of 17.45 million in March, up from 16.57 million in February, according to data from Autodata. That’s the highest reading in three months and represents a recovery from a downbeat start to the year. The MarketWatch-compiled consensus expectation was for a 16.8 million rate.”

Jim O’Sullivan of High-Frequency Economics also made a similar point.

“The data reinforce our view that the slowing in retail sales through February was exaggerated.”

Of course, the March retail sales report out last week was led primarily by a pickup in auto sales as well as gasoline prices. (About 60% of the entire increase in retail sales came from these two components.)

There is an interesting dichotomy currently occurring within the economy. While consumer confidence, as reported by the Census Bureau, soared to some of the highest levels seen since the turn of the century, the hard economic data continues to remain quite weak. As noted by Morgan Stanley just recently:

“Compare the New York Federal Reserve Bank’s current 1Q GDP tracking vs ours – FRBNY is currently tracking 1Q GDP at 3.0% versus us around 1%. The difference is larger than usual and is being driven by the fact that the New York Fed incorporates soft data into its tracking (attempting to tie it econometrically to GDP, a very hard thing to do especially in real-time). Our method translates the incoming hard data into its GDP equivalent. Note that the Atlanta Fed’s GDPNow tracking also focuses on hard data and is currently tracking 1% for 1Q GDP.”

Since then, estimates for Q1-GDP have drifted higher, but the point is the same and the stunning divergence can be seen in the chart attached to that same article which shows the difference between the “hard” and “soft” data specifically. (courtesy Zerohedge)

What is currently expected by those with a more “bullish bias” is the hard data will soon catch up with the soft data. However, optimism may be misplaced if the recent CFO survey is any indication:

The survey generated responses from more than 1,500 chief financial officers, including 469 from North America, and showed that:

  • 67% of those surveyed predicted the U.S. economy would be in recession by the third quarter of 2020,
  • 84% believe a recession will have begun by the first quarter of 2021; and,
  • 38% of respondents predicted a recession by the first quarter of next year.

Event Horizon

Economic cycles do not last indefinitely.

While fiscal and monetary policies can extend cycles by “pulling forward” future consumption, such actions create an eventual “void” that cannot be filled. In fact, there is mounting evidence the “event horizon” may have been reached as seen through the lens of auto sales.

I recently discussed this point with my friend Simon Constable specifically. but the entire Video Cast is excellent.

He is right.

Following the financial crisis the average age of vehicles on the road had gotten fairly extended so a replacement cycle became more likely. This replacement cycle was accelerated when the Obama Administration launched the “cash for clunkers” program which reduced the number of “used” vehicles for sale pushing individuals into new cars.

Combine replacement needs with low interest rates, easy financing, and extended terms and you get a sales cycle as shown below. The problem, as always, is there are only a finite number of people to sell to and once they have bought a car, they aren’t coming back for a while.

This is why auto sales are very cyclical in nature. Not surprisingly, due to the cyclical nature of autos, sales tend to flatten and decline as an economic recession approaches. (Note: When auto sales are reported each month they are annualized. The bar chart shows the over/underestimation of auto sales each month as compared to what actually occurred on an annual basis.)

While the media touts the “jump in auto sales,” it is a far different story when compared to the increase in the population. With total sales only slightly eclipsing the previous record, given the increase in the population, this is not the victory the media wishes to make it sound. In fact, the current level of auto sales on a per capita basis is only back to where near the bottom of recessions with the exception of the “financial crisis.” 

Furthermore, the annual rate of auto sales has slowed dramatically and is approaching levels normally associated with more severe economic weakness.

But slowing auto sales is only one-half of the problem. The problem for automakers is, as always, they continue to produce inventory even though demand is slowing. The cars are then shifted to dealers which have to resort to increasing levels of incentives to get the inventory sold. However, eventually, this is a losing game.

The chart below shows the current 12-month average of the annual rate of change in auto sales as compared to the inverted inventory-sales ratio. As you can see, there is a correlation to rising auto inventories and declines in auto sales. The current data suggests further weakness in auto sales coming.

With more and more dealers offering special incentives to lure buyers as demand slows, we are back to seeing commercials of “employee discounts,” “zero down at signing,” and “additional cash bonuses.” There is a limit to the level of incentives that dealers can provide to move inventory. Eventually, the inventory overhang will be problematic.

Data suggests that is happening now according to the Houston Chronicle:

“New car sales locally and nationally are falling as interest rates have soared and automakers have pulled back on incentives. Interest rates on new financed vehicles averaged 6.4 percent in March, the highest in a decade, according to Edmunds, a California-based automobile data provider.”

Subprime Returns

As we discussed in “People Buy Payments,” Americans are drowning in auto loan debt and changes in interest rates matter…a lot. A new report from the California Public Interest Research Group, or Cal-PIRG, finds the average car loan has increased 75% over the last decade. In all, Americans owe roughly $1.2 trillion in auto loans.

“Americans are taking out more loans, they are taking out much larger loans, and they are taking those loans out for a longer period of time,” said Emily Rusch, executive director for Cal-PIRG.

Given the lack of wage growth, consumers are needing to get payments down to levels where they can afford them. Furthermore, about 1/3rd of the loans are going to individuals with credit scores averaging 550 which carry much higher rates up to 20%. In fact, since 2010, the share of sub-prime Auto ABS origination has come from deep subprime deals which have increased from just 5.1% in 2010 to 32.5% currently. That growth has been augmented by the emergence of new deep sub-prime lenders which are lenders who did not issue loans prior to 2012.

“Recent dire warnings about practices in the subprime car loan industry have drawn comparisons to the 2008 mortgage crisis. In an interview with Bloomberg TV in 2017, investor Steve Eisman—who famously profited off the financial crisis by betting against the market—singled out the auto loan industry. ‘We are in an environment where credit quality has never been this good in anyone’s lifetime, with the one exception of subprime auto,’ said Eisman.

Those lending patterns are now being repeated: Many Wall Street lenders have been pushing auto loans aggressively on subprime borrowers on iffy terms. These loans are then spun up into bonds and sold to investors hungry for auto-loan-backed securities.”

While there has been much touting of the strength of the consumer in recent years, it has been a credit-driven mirage. With income growth weak, debt levels elevated, and rent and health care costs chipping away at disposable incomes, in order to make payments even remotely possible, terms are often stretched to 84 months.

The eventual issue is that since cars are typically turned over every 3-5 years on average, borrowers are typically upside down in their vehicle when it comes time to trade it in. Between the negative equity of their trade-in, along with title, taxes, and license fees, and a hefty dealer profit rolled into the original loan, there is going to be a substantial problem down the road. As noted by Reuters:

Typically, car dealers tack on an amount equal to the negative equity to a loan for the consumers’ next vehicle. To keep the monthly payments stable, the new credit is for a greater length of time. 

Over the course of multiple trade-ins, negative equity accumulates. Moody’s calls this the ‘trade-in treadmill,’ the result of which is ‘increasing lender risk, with larger and larger loss-severity exposure.’ 

To ease consumers’ monthly payments, auto manufacturers could subsidize lenders or increase incentives to reduce purchase prices, though either action would reduce their profits, the report said.”

With more sub-prime auto loans outstanding currently than prior to the financial crisis, defaults rising rapidly and a large majority with negative equity in their vehicles, swapping out to a new car is becoming a near impossible option.

The Federal Reserve recently reported the number of borrowers with auto loans more than 90-days delinquent shot up by 1.5 million in the fourth quarter, reaching a total of 7 million — the highest mark ever in absolute numbers, though not as a percentage of the auto-loan market, which has ballooned over the past seven years.

Consumer pain tends to be a leading indicator for broader economic struggles: An increase in delinquencies could signify waning consumer health, foreshadowing a drop in confidence and an overall spending slowdown, which affects nearly every industry.

As reported by Business Insider:

“Bad consumer loans could also inflict losses on major institutions invested in the loans, which are packaged up and sold as asset-backed securities (ABS). That has the potential, if it gets out of hand, to create systemic risk, as we saw with mortgage-backed loans in the last crisis.

So ugly consumer data is a siren alerting investors, trauma-scarred from the mortgage meltdown, to the next proverbial canary in the coal mine.

The surge in auto defaults has been a source of both confusion and consternation. The Fed called the development surprising, and Goldman Sachs analysts referred to it as “something of a puzzle,” given the broader economic and labor-market strength, and the lack of distress in other consumer credit products, such as mortgages and credit cards.”

While the “cash for clunkers” program by the Obama Administration caused a massive surge in used vehicle prices due to the rapid depletion of inventory at the time, much of that inventory has now been rebuilt. Now, used vehicle prices are dropping sharply, as the market is flooded with off-lease vehicles and consumer demand is weakening.

As noted above, the issue of the trade-in treadmill” is a major issue for auto lenders as default risk continues to increase. Per Moody’s:

The percentage of trade-ins with negative equity is at an all-time high, as is the average dollar amount of that negative equity. Lenders are increasingly faced with the choice of taking on greater risk by rolling negative equity at trade-in into the next vehicle loan. We believe they are increasingly taking this choice, resulting in mounting negative equity with successive new-car purchases.”

And sales of new automobiles isn’t nearly as robust as media headlines purport.

Given the importance of automobiles to the domestic manufacturing sector of the economy, it is becoming apparent the sales of autos to consumers has reached an important inflection point.

The previous recessionary warnings from autos was dismissed until far too late. It is likely not a good idea to dismiss it this time. 

The Myths Of Stocks For The Long Run – Part XII

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

CHAPTER 12 – 181 Lines of Wisdom

Over the last 30-years, I have endeavored to learn from my own mistakes and, trust me, I have paid plenty of “stupid-tax” along the way. However, it is only from making mistakes, that we learn how to become a better investor, advisor or portfolio manager.

You have now read our opinions on buy and hold. Before we conclude we thought you should hear the views of investing legends.

The following is a listing of investing tips, axioms and market wisdom from some of the great investors of our time. Importantly, as you review this invaluable knowlege, compare how these investing legends approach investing as compared to your methodologies, those of your advisor, or what you are told daily by the media.

Can you spot what’s missing?


Bob Farrell’s 10-Investing Lessons

  1. Markets tend to return to the mean over time.
  2. Excesses in one direction will lead to an opposite excess in the other direction.
  3. There are no new eras – excesses are never permanent.
  4. Exponential rising and falling markets usually go further than you think.
  5. The public buys the most at the top and the least at the bottom.
  6. Fear and greed are stronger than long-term resolve.
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chips.
  8. Bear markets have three stages.
  9. When all the experts and forecasts agree – something else is going to happen.
  10. Bull markets are more fun than bear markets.

12 Market Wisdoms From Gerald Loeb

  1. The most important single factor in shaping security markets is public psychology.
  2. To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.
  3. Accepting losses is the most important single investment device to insure safety of capital.
  4. The difference between the investor who year in and year out procures for himself a final net profit, and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.
  5. One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine times out of ten the leaders of an advance are the stocks that make new highs ahead of the averages.
  6. There is a saying, “A picture is worth a thousand words.” One might paraphrase this by saying a profit is worth more than endless alibis or explanations. . . prices and trends are really the best and simplest “indicators” you can find.
  7. Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.
  8. Willingness and ability to hold funds uninvested while awaiting real opportunities is a key to success in the battle for investment survival.-
  9. In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement, and the very momentum of the trend itself tends to perpetuate itself.
  10. Most people, especially investors, try to get a certain percentage return, and actually secure a minus yield when properly calculated over the years. Speculators risk less and have a better chance of getting something, in my opinion.
  11. I feel all relevant factors, important and otherwise, are registered in the market’s behavior, and, in addition, the action of the market itself can be expected under most circumstances to stimulate buying or selling in a manner consistent enough to allow reasonably accurate forecasting of news in advance of its actual occurrence.
  12. You don’t need analysts in a bull market, and you don’t want them in a bear market

Jesse Livermore’s Trading Rules Written in 1940

  1. Nothing new ever occurs in the business of speculating or investing in securities and commodities.
  2. Money cannot consistently be made trading every day or every week during the year.
  3. Don’t trust your own opinion and back your judgment until the action of the market itself confirms your opinion.
  4. Markets are never wrong – opinions often are.
  5. The real money made in speculating has been in commitments showing in profit right from the start.
  6. As long as a stock is acting right, and the market is right, do not be in a hurry to take profits.
  7. One should never permit speculative ventures to run into investments.
  8. The money lost by speculation alone is small compared with the gigantic sums lost by so-called investors who have let their investments ride.
  9. Never buy a stock because it has had a big decline from its previous high.
  10. Never sell a stock because it seems high-priced.
  11. I become a buyer as soon as a stock makes a new high on its movement after having had a normal reaction.
  12. Never average losses.
  13. The human side of every person is the greatest enemy of the average investor or speculator.
  14. Wishful thinking must be banished.
  15. Big movements take time to develop.
  16. It is not good to be too curious about all the reasons behind price movements.
  17. It is much easier to watch a few than many.
  18. If you cannot make money out of the leading active issues, you are not going to make money out of the stock market as a whole.
  19. The leaders of today may not be the leaders of two years from now.
  20. Do not become completely bearish or bullish on the whole market because one stock in some particular group has plainly reversed its course from the general trend.
  21. Few people ever make money on tips. Beware of inside information. If there was easy money lying around, no one would be forcing it into your pocket.

21 Rules Of Paul Tudor Jones

  1. When you are trading size, you have to get out when the market lets you out, not when you want to get out.
  2. Never play macho with the market and don’t over trade.
  3. If I have positions going against me, I get out; if they are going for me, I keep them.
  4. I will keep cutting my position size down as I have losing trades.
  5. Don’t ever average losers.
  6. Decrease your trading volume when you are trading poorly; increase your volume when you are trading well.
  7. Never trade in situations you don’t have control.
  8. If you have a losing position that is making you uncomfortable, get out. Because you can always get back in.
  9. Don’t be too concerned about where you got into a position.
  10. The most important rule of trading is to play great defense, not offense.
  11. Don’t be a hero. Don’t have an ego.
  12. I consider myself a premier market opportunist.
  13. I believe the very best money is to be made at market turns.
  14. Everything gets destroyed a hundred times faster than it is built up.
  15. Markets move sharply when they move.
  16. When I trade, I don’t just use a price stop, I also use a time stop.
  17. Don’t focus on making money; focus on protecting what you have.
  18. You always want to be with whatever the predominant trend is.
  19. My metric for everything I look at is the 200-day moving average of closing prices.
  20. At the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?
  21. I look for opportunities with tremendously skewed reward-risk opportunities.

 Bernard Baruch’s 10 Investing Rules

  1. Don’t speculate unless you can make it a full-time job.
  2. Beware of barbers, beauticians, waiters — of anyone — bringing gifts of “inside” information or “tips.”
  3. Before you buy a security, find out everything you can about the company, its management, and competitors, its earnings and possibilities for growth.
  4. Don’t try to buy at the bottom and sell at the top. This can’t be done — except by liars.
  5. Learn how to take your losses quickly and cleanly. Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.
  6. Don’t buy too many different securities. Better have only a few investments which can be watched.
  7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.
  8. Study your tax position to know when you can sell to greatest advantage.
  9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.
  10. Don’t try to be a jack of all investments. Stick to the field you know best.

 James P. Arthur Huprich’s Market Truisms And Axioms

  1. Commandment #1: “Thou Shall Not Trade Against the Trend.”
  2. Portfolios heavy with underperforming stocks rarely outperform the stock market!
  3. There is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.
  4. Sell when you can, not when you have to.
  5. Bulls make money, bears make money, and “pigs” get slaughtered.
  6. We can’t control the stock market. The very best we can do is to try to understand what the stock market is trying to tell us.
  7. Understanding mass psychology is just as important as understanding fundamentals and economics.
  8. Learn to take losses quickly, don’t expect to be right all the time, and learn from your mistakes.
  9. Don’t think you can consistently buy at the bottom or sell at the top. This can rarely be consistently done.
  10. When trading, remain objective. Don’t have a preconceived idea or prejudice. Said another way, “the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes.”
  11. Any dead fish can go with the flow. Yet, it takes a strong fish to swim against the flow. In other words, what seems “hard” at the time is usually, over time, right.
  12. Even the best looking chart can fall apart for no apparent reason. Thus, never fall in love with a position but instead remain vigilant in managing risk and expectations. Use volume as a confirming guidepost.
  13. When trading, if a stock doesn’t perform as expected within a short time period, either close it out or tighten your stop-loss point.
  14. As long as a stock is acting right and the market is “in-gear,” don’t be in a hurry to take a profit on the whole positions. Scale out instead.
  15. Never let a profitable trade turn into a loss, and never let an initial trading position turn into a long-term one because it is at a loss.
  16. Don’t buy a stock simply because it has had a big decline from its high and is now a “better value;” wait for the market to recognize “value” first.
  17. Don’t average trading losses, meaning don’t put “good” money after “bad.” Adding to a losing position will lead to ruin. Ask the Nobel Laureates of Long-Term Capital Management.
  18. Human emotion is a big enemy of the average investor and trader. Be patient and unemotional. There are periods where traders don’t need to trade.
  19. Wishful thinking can be detrimental to your financial wealth.
  20. Don’t make investment or trading decisions based on tips. Tips are something you leave for good service.
  21. Where there is smoke, there is fire, or there is never just one cockroach: In other words, bad news is usually not a one-time event, more usually follows.
  22. Realize that a loss in the stock market is part of the investment process. The key is not letting it turn into a big one as this could devastate a portfolio.
  23. Said another way, “It’s not the ones that you sell that keep going up that matter. It’s the one that you don’t sell that keeps going down that does.”
  24. Your odds of success improve when you buy stocks when the technical pattern confirms the fundamental opinion.
  25. As many participants have come to realize from 1999 to 2010, during which the S&P 500 has made no upside progress, you can lose money even in the “best companies” if your timing is wrong. Yet, if the technical pattern dictates, you can make money on a short-term basis even in stocks that have a “mixed” fundamental opinion.
  26. To the best of your ability, try to keep your priorities in line. Don’t let the “greed factor” that Wall Street can generate outweigh other just as important areas of your life. Balance the physical, mental, spiritual, relational, and financial needs of life.
  27. Technical analysis is a windsock, not a crystal ball. It is a skill that improves with experience and study. Always be a student, there is always someone smarter than you!

James Montier’s 7 Immutable Laws Of Investing

  1. Always insist on a margin of safety
  2. This time is never different
  3. Be patient and wait for the fat pitch
  4. Be contrarian
  5. Risk is the permanent loss of capital, never a number
  6. Be leery of leverage
  7. Never invest in something you don’t understand

10-Trading Rules From Todd Harrison

  1. Respect price action but never defer to it.
  2. Discipline always trumps conviction. Following a set discipline removes the emotional bias of conviction.
  3. Opportunities are made up far easier than lost capital.
  4. Emotion is the enemy of trading.
  5. It’s far better to “zig” when others “zag.”
  6. Be adaptive to the market. Failure to adapt leads to extinction.
  7. Maximize reward relative to the risk taken.
  8. Perception is reality in the marketplace.
  9. When “unsure” – trade small or not at all.
  10. Don’t let bad trades turn into investments.

25-Trading Rules From Jim Cramer

  1. Bulls, Bears Make Money, Pigs Get Slaughtered
  2. It’s OK to Pay the Taxes
  3. Don’t Buy All at Once
  4. Buy Damaged Stocks, Not Damaged Companies
  5. Diversify to Control Risk
  6. Do Your Stock Homework
  7. No One Made a Dime by Panicking
  8. Buy Best-of-Breed Companies
  9. Defend Some Stocks, Not All
  10. Bad Buys Won’t Become Takeovers
  11. Don’t Own Too Many Names
  12. Cash Is for Winners
  13. No Woulda, Shoulda, Couldas
  14. Expect, Don’t Fear Corrections
  15. Don’t Forget Bonds
  16. Never Subsidize Losers With Winners
  17. Check Hope at the Door
  18. Be Flexible
  19. When the Chiefs Retreat, So Should You
  20. Giving Up on Value Is a Sin
  21. Be a TV Critic
  22. Wait 30 Days After Preannouncements
  23. Beware of Wall Street Hype
  24. Explain Your Picks
  25. There’s Always a Bull Market

10-Rules From Richard Bernstein

  1. Income is as important as are capital gains. Because most investors ignore income opportunities, income may be more important than are capital gains.
  2.  Most stock market indicators have never actually been tested. Most don’t work.
  3. Most investors’ time horizons are much too short. Statistics indicate that day trading is largely based on luck.
  4. Bull markets are made of risk aversion and undervalued assets. They are not made of cheering and a rush to buy.
  5. Diversification doesn’t depend on the number of asset classes in a portfolio. Rather, it depends on the correlations between the asset classes in a portfolio.
  6. Balance sheets are generally more important than are income or cash flow statements.
  7. Investors should focus strongly on GAAP accounting, and should pay little attention to “pro forma” or “unaudited” financial statements.
  8. Investors should be providers of scarce capital. Return on capital is typically highest where capital is scarce.
  9. Investors should research financial history as much as possible.
  10. Leverage gives the illusion of wealth. Saving is wealth.

David Rosenberg’s 13-Rules For Economists

  1. In order for an economic forecast to be relevant, it must be combined with a market call.
  2. Never be a slave to the data – they are no substitutes for astute observation of the big picture.
  3. The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.
  4. Fall in love with your partner, not your forecast.
  5. No two cycles are ever the same.
  6. Never hide behind your model.
  7. Always seek out corroborating evidence
  8. Have respect for what the markets are telling you.
  9. Be constantly aware with your forecast horizon – many clients live in the short run.
  10. Of all the market forecasters, Mr. Bond gets it right most often.
  11. Highlight the risks to your forecasts.
  12. Get the US consumer right and everything else will take care of itself.
  13. Expansions are more fun than recessions (straight from Bob Farrell’s quiver!).

Our Own Investing Rules

  1. Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

But, did you spot what was missing?

Every day Wall Street and the financial media push the narrative of passive investing, indexing and “buy and hold.” Yet while these methods are good for Wall Street, as it keeps your money invested at all times for a fee, it is not necessarily good for your future investment outcomes. 

You will notice that out of 181 lines of investment advice, not one of the greatest investors of the last 100 years have “buy and hold” as a rule.

So, the next time that someone tells you the “only way to invest” is to buy an index and just hold on for the long-term, you just might want to ask yourself what would a “great investor” actually do. More importantly, you should ask yourself, or the person telling you, “WHY?”

The investors listed here are not alone. There are numerous investors and portfolio managers revered for the knowledge and success. While we idolize these individuals for their respective “genius,” we can also save ourselves time and money by learning from their wisdom and their experiences. Their wisdom was NOT inherited, but was birthed out of years of mistakes, miscalculations, and trial-and-error. Most importantly, what separates these individuals from all others was their ability to learn from those mistakes, adapt, and capitalize on that knowledge in the future.

Experience is an expensive commodity to acquire, which is why it is always cheaper to learn from the mistakes of others.

There are only a few basic “truths” of investing and all great investors have learned them over time. We are not preaching alternative strategies, as we hope you learned we are just standing on the shoulders of geniuses.

I hope you will find the lessons as beneficial as I have over the years and incorporate them into your own practices.

Tax Cuts A Year Later – Did They Deliver As Promised?

Leading up to and following the passage of the Tax Cuts and Jobs Act (Trump Tax Cuts) I wrote a lot of analysis on the fallacy of tax cuts, why tax cuts wouldn’t change corporate behavior, and why tax cuts are an ineffective method of improving economic growth.

I received a lot of push back on my views then the “mainstream” analysis was the tax cuts would jump start economic growth. Of course, with 2017’s Q1 economic growth coming in at a meager 0.7% annualized, it would certainly seem to be needed. But as I questioned then:

“Do tax reductions lead to higher economic growth, employment and incomes over the long-term as promised?”

Speaking to NBC’s Meet the Press, VP Mike Pence argued at the time he was confident that eventually, the deficit would decline as it would be overcome by surging economic “growth” thanks to the tax cuts it will fund.

As I wrote then, such was unlikely to be the case due to fact that tax-rate reductions are quickly absorbed into the economy. For example:

    • Year 1: GDP = $1 Trillion 
    • Taxes Are Reduced Which Puts $100 Billion Into The Economy.
    • Year 2: GDP = $1 Trillion + $100 Billion = $1.1 Trillion or 10% GDP Growth
      • Going Into Year-3 There Are No New Tax Cuts And All Spending From Previous Year Remains
    • Year 3: GDP = $1.1 Trillion + $0 = $1.1 Trillion or 0% GDP Growth

As shown in the chart below, changes to tax rates have a very limited impact on economic growth over the longer term.

Furthermore, it was believed that tax cuts would lead to a boom in employment. The chart below shows the corporate tax rate versus employment back to 1946. Corporate tax levels create employment change at the margin. If you look at the chart you will notice that when corporate tax rates are reduced employment did marginally increase but only for a short period of time. The problem for the “Trump Tax Cuts” is that they were introduced at a time when the economy was already running near full employment. Not surprisingly, the change to employment over the last year has been minimal tied primarily to population growth.

What drives employment is sustainable economic growth that leads to higher wages, increased aggregate demand and higher rates of production. In other words, employment adjusts over time to respond to the strength and direction of the economy rather than the movements in tax rates. The chart below shows economic growth versus employment. 

Do not misunderstand me. Tax rates CAN make a difference in the short run when coming out of a recession as it frees up capital for productive investment at a time when recovering economic growth and pent-up demand require it. However, as I stated previously, given the economy was already growing near maximum capacity, the boost from tax cuts was mostly mitigated.

Over the long term, it is the direction and trend of economic growth that drives employment. The reason I say “direction and trend” is because, as you will see by the vertical blue dashed line, beginning in 1980, both the direction and trend of economic growth in the United States changed for the worse.

Yes, as I noted previously, Reagan’s tax cuts were effective because they were “timely” due to the economic, fiscal, and valuation backdrop which is diametrically opposed to the situation today.

“Importantly, as has been stated, the proposed tax cut by President-elect Trump will be the largest since Ronald Reagan. However, in order to make valid assumptions on the potential impact of the tax cut on the economy, earnings and the markets, we need to review the differences between the Reagan and Trump eras. My colleague, Michael Lebowitz, recently penned the following on this exact issue.

‘Many investors are suddenly comparing Trump’s economic policy proposals to those of Ronald Reagan. For those that deem that bullish, we remind you that the economic environment and potential growth of 1982 was vastly different than it is today.  Consider the following table:'”

The differences between today’s economic and market environment could not be starker. The tailwinds provided by initial deregulation, consumer leveraging, declining interest rates, and inflation provided huge tailwinds for corporate profitability growth. The chart below shows the ramp up in government debt since Reagan versus subsequent economic growth and tax rates.

As noted, rising debt levels are the real impediment to longer-term increases in economic growth. When 75% of your current Federal Budget goes to entitlements and debt service, there is little left over for the expansion of the economic growth.

The tailwinds enjoyed by Reagan are now headwinds for Trump. 

Tax Cuts Don’t Reduce The Deficit

So, back to Vice-President Pence’s belief that tax cuts will eventually become revenue neutral due to expanded economic growth, Peter Baker via the NYT recently made the same point:

“While a corporate tax rate cut of the dimension Mr. Trump envisions would reduce tax revenues by more than $2 trillion over the next 10 years, Mr. Mnuchin noted that an increase in economic growth of a little more than one percentage point would generate close to the same amount. The goal, he said, was to produce a sustained national growth rate of 3 percent, instead of the 1.8 percent now projected over the next decade.”

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

As noted above, there are massive differences between the economic and debt related backdrops between the early 80’s and today.

The Committee For A Responsible Federal Budget at the time analyzed Trump’s proposed tax plan and came away with the following analysis:

Based on what we know so far, the plan could cost $3 to $7 trillion over a decade– our base-case estimate is $5.5 trillion in revenue loss over a decade. Without adequate offsets, tax reform could drive up the federal debt, harming economic growth instead of boosting it.”

The revenue loss is already occurring as shown in the chart below.

The true burden on taxpayers is government spending, because the debt requires future interest payments out of future taxes. As debt levels, and subsequently deficits, increase, economic growth is burdened by the diversion of revenue from productive investments into debt service. 

As expected, lowering corporate tax rates certainly helped businesses increase their bottom line earnings, however, it did not “trickle down” to middle-class America. As noted by Jesse Colombo:

“‘In 1929 — before Wall Street’s crash unleashed the Great Depression — the top 0.1% richest adults’ share of total household wealth was close to 25%, today, the that same group controls more wealth than the bottom 50% of the economy combined.”

Not surprisingly, focusing tax cuts on corporations, rather than individuals, only exacerbated the divide between the top 1% and the rest of the country as the reforms did not focus on the economic challenges facing us. 

  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Financialization 
  • Global debt

These challenges will continue to weigh on economic growth, wages and standards of living into the foreseeable future.  As a result, incremental tax and policy changes will have a more muted effect on the economy as well.

As investors, we must understand the difference between a “narrative-driven” advance and one driven by strengthening fundamentals. The first is short-term and leads to bad outcomes. The other isn’t, and doesn’t. 

Where Tax Cuts Worked

The one place that tax cuts did work, as we expected, was in the expansion of corporate share buybacks. According to a recent New York Times analysis:

“Cheerleaders for the tax cut argued that the heart of the law — cutting and restructuring taxes for corporations — would give the economy a positive bump, giving companies incentives to invest more, hire more workers and pay higher wages.

Skeptics said that the money companies saved through tax cuts would merely increase corporate profits, rather than trickling down to workers.

JPMorgan Chase analysts estimate that in the first half of 2018, about $270 billion in corporate profits previously held overseas were repatriated to the United States and spent as a result of changes to the tax code. Some 46 percent of that, JPMorgan Chase analysts said, was spent on $124 billion in stock buybacks.”

“The flow of repatriated corporate cash is just one tributary in what has become a flood of payouts to shareholders, both as buybacks and dividends. Such payouts are expected to hit almost $1.3 trillion this year, up 28 percent from 2017, according to estimates from Goldman Sachs analysts.”

While wages did rise marginally over the last, due more to tightness in the labor market rather than tax cuts, corporations failed to share the wealth. In fact, the ratio of profits to workers wages have materially worsened since the enactment of tax cuts. 

Summary

Despite the commentary to the contrary, the reality is, as we predicted over a year ago, that tax cuts in a late stage economy would have little, if any, real impact. 

The spurt of economic growth in the first half of 2018 came from the impact of three massive hurricanes and two major wildfires in late 2017 which led to a surge in spending for reconstruction. That input has now faded and economic growth rates are beginning slow. 

The fiscal health of the United States is deteriorating fast, as revenues have declined sharply. The federal budget deficit — the gap between what the government collects in revenues and what it spends — is approaching nearly $1 trillion. It’s highly unusual for deficits and borrowing needs to grow this much during periods of prosperity. 

As noted in the NYT article:

“Corporate tax revenues are down one-third from a year ago. Federal revenues as a whole ran $200 billion behind the Congressional Budget Office’s forecast for the 2018 fiscal year — even though economic growth was faster than the C.B.O. expected. The nonpartisan Committee for a Responsible Federal Budget reports that nominal federal revenues are down by at least 3.6 percent since the tax cuts took effect.”

Other than creating a massive windfall to corporate bottom lines, tax cuts not only failed to improve the economic prosperity for the vast majority of Americans, but has now entrenched the economy into a deeper “fiscal hole” than we were when Trump took office. 

As a “fiscal conservative,” my concern continues to be the entire lack of fiscal responsibility in Washington D.C. There was a time when politicians at least acted like they were concerned about the budget but that process was clearly abandoned a decade ago. 

While schemes and tricks to get votes may work in the short term, the long-term consequences are already playing out in real-time. 

Why do you think “socialism” has become a “thing” in what once was considered the greatest capitalist economy on the planet?

The “There Is No Recession In Sight” Chartbook

Yesterday, Michael Lebowitz wrote an interesting piece discussing the “yield curve” and the message it is sending. To wit:

“Recently, Wall Street and the Financial Media have brought much attention to the flattening and possible inversion of the U.S. Treasury yield curve. Given the fact that an inversion of the 2s/10s Treasury yield curve has predicted every recession over the last forty years, it is no wonder that the topic grows in stature as the difference between the 2-year Treasury yield and the 10-year Treasury yield approaches zero. Unfortunately, much of the discussion on the yield curve seems to over-emphasize whether or not the slope of the curve will invert. Waiting on this arbitrary event may cause investors to miss a very important recession signal.”

Mike is right. The problem is that when the yield curve INITIALLY inverts, or comes close to inverting, there won’t be a “recession” immediately noticeable in the data. This is because, as discussed previously, while the calls of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000 or 2007 either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done. As you notice in the chart above, the yield curve predicted each recession, but the yield curve was already rising sharply by the time the recession was officially announced. 

But is there anything to fear currently? 

Not according to Treasury Secretary Steve Mnuchin:

“We see no indications whatsoever of a recession on the horizon. The administration’s efforts to cut taxes, slash regulations and overhaul trade deals have had a very strong impact on the U.S. economy.”

Since I am not the Treasury Secretary of the United States, who am I to argue. Therefore, I simply present some charts for you to consider with respect to whether a “recession cometh” or not.

(Some of the graphs below were shared with RIA Pro subscribers in the Chart of the Day section. For more information please visit us at RIA Pro. Use code PRO30 for a 30-day free trial.)


















As David Rosenberg stated yesterday:

“I love to read the bloggers out there who say ‘a slowdown isn’t a recession.’ Someone should remind them of Newton’s laws of motion. A slowdown doesn’t morph into a recession when there is some exogenous postive shock that turns the tide. And when it isn’t about the Fed easing policy, then it is another Central Bank, like the ECB and BOJ in 2016.

Initial jobless claims are a leading economic indicator and have already risen enough to suggest that recession odds have gone from close to 0% a year ago to around 40% today. Not a base case, but the direction is not something the bulls should be crowing about.”

No recession in sight? 

Maybe? But if you wait for someone to tell you the recession has started, it really won’t matter much anyway. 

As my friend Doug Kass noted in his missive yesterday:

“It remains my view that the weight of slowing global economic growth, untenable debt levels, political turmoil and policy issues/concerns could ultimately produce much lower stock prices than are present today.”

Charts Both Bulls & Bears Should Consider

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Economy IS Slowing

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

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

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

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

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

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

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

But herein lies “the trap” for investors.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What Will Cause The Next Recession?

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

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

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

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

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

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

First, this is NOT an economic cycle:

This is:

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

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

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

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

Let’s revisit Bradford’s three specific crises.

The S&L Crisis

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

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

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

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

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

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

The Dot.Com Bubble

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

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

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

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

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

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

It wasn’t long before the system came unglued.

The Great Financial Crisis

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

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

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

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

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

They weren’t and it didn’t.

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

The Common Threads

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This time will be no different.

The Problem With Wall Street’s Forecasts

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

Here it is:

“I don’t know.”

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

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

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

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

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

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

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

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

But, that was so last year.

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

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

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

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

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

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

Let me explain.

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

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

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

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

Cooking-The-books-2

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

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

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

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

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

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

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

Here were the key findings of the report:

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

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

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

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

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

Way Too Optimistic

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

If history, and logic, is any guide, we will likely see the U.S. economy pushing into a recession in 2019 particularly as the global economy continues to weaken. This is something both domestic and global yield curves are already screaming is an issue, but to which few are listening.

Currently, analysts’ forward earnings estimates are still way too lofty going into 2019. As I noted in the recent missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019. In just the last 45-days the estimates for the end of 2019 have fallen by more than $14/share. The downside risk remains roughly $10/share lower than that and possibly much more if a recession hits.

As stated, beginning in 2019, the estimated quarterly rate of change in earnings will drop markedly and head back towards the expected rate of real economic growth. (Note: these estimates are as of 12/31/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

The end of the boost from tax cuts has arrived.

Since the tax cut plan was poorly designed, to begin with, it did not flow into productive investments to boost economic growth. As we now know, it flowed almost entirely into share buybacks to boost executive compensation. This has had very little impact on domestic growth.

The “sugar high” of economic growth seen in the first two quarters of 2018 has been from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. These activities simply pull forward “future” consumption and have a very limited impact but leave a void which must be filled in the future.

Nearly a full year after the passage of tax cuts, we face a nearly $1 Trillion deficit, a near-record trade deficit, and, as expected, economic and earnings reports are now showing markedly weaker projections. Apple (AAPL) is just the first of many companies that will confirm this in the coming weeks.

It is all just as we predicted.

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

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

But, that is just a guess.

As I said, I honestly “don’t know.”

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

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

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

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

The Biggest Threat To The Market – Loss Of Confidence

Yesterday, saw a record surge in the markets.

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

Yesterday’s relief rally was simply that.

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

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

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

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

What exactly does that mean?

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

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

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

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

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

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

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

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

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

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

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

Economic growth matters, and it matters a lot.

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

Wealth Effect Runs In Reverse

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Remember:

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

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

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

This was a point made by Bloomberg yesterday:

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

Confidence drives everything.

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

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

The Market Is Set For A Rally…To Sell Into

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

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

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

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

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

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

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

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

Mnuchin: Check…I’m on it.

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

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

That’s the bad news.

My Christmas Wish

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

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

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

While this is a true statement, it is incomplete.

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

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

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

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

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

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

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

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

How Much Of A Bounce Are We Talking About

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

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

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

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

It likely won’t be.

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

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

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

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

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

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

You get the idea.

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

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

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

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

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

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

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

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

It’s Now Or Never For The Bulls

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

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

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

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

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

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

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

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

Mnuchin: Check…I’m on it.

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

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

That’s the bad news.

My Christmas Wish

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

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

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

While this is a true statement, it is incomplete.

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

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

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

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

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

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

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

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

How Much Of A Bounce Are We Talking About

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

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

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

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

It likely won’t be.

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

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

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

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

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

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

You get the idea.

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

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

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

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

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

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

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

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

Why The Secular Bear Market In Oil Prices Remains

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

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

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

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

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

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

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

The conclusion was not what most were hoping for.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Headwinds For Oil Remain

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

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

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

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

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

Then there is the demand side of the equation.

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

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

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

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

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

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

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

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

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

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

GE – “Bringing Investment Mistakes To Life”

Last week, General Electric (GE) did something that many never thought would happen. They slashed their dividend to just $0.01 per share.

We are talking about GE. A company which has been bringing “good things to life” for well over 100-years.

There is an important lesson to be learned here by investors who have long bought into the myth of:

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

First of all, let’s clear up something.

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

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

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

Yield is simply a mathematical calculation.

This is an important point which will become much clearer in just a moment.

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

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

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

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

Uhm…that isn’t actually true. But it is a comment which drives to the heart of the “buy and hold” mentality and, along with it, many of the most common investing misconceptions.

GE “Bringing Investing Mistakes To Life”

Here is why this distinction between yield and dividend is important. If a company pays a $1.00 dividend/share and is priced at $20/share then the “yield” is 5%. If the price of the stock, and your invested capital, declines by 50% you still ONLY receive $1.00/share but the “yield” increases to 10%.

The problem comes that when a company loses a significant chunk of its value, it is because there are fundamental issues with the company.

Case in point with General Electric.

“I only buy companies that regularly increase their dividends.”

Over the last 5-years GE has struggled with fundamental issues. But despite rising leverage, declining revenue, and falling returns on equity, the company increased their dividends in the previous 4-years. For those that had “bought it for the dividend,” and didn’t pay attention to the fundamental warnings, they have now not only lost 55% of their invested capital but have also watched the dividend all but disappear.

“But GE is just an anomaly. That isn’t the case for most companies.”

While I agree that “most” companies won’t cut their dividends, there will be many that will. GE is likely going to be an early indication of what will eventually be a more widespread issue in the near future.

Let me explain.

Eddy Elfenbein recently wrote about the “Bull Market In Dividends.” 

Over the last eight years, dividends are up 234%, which is pretty close to what the S&P 500 price index has done. Considering how simple it is, the S&P 500 has tracked a 2% dividend yield fairly closely for the last several years.”

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

As noted by John Coumarionos:

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

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

To John’s point, corporate leverage is at the highest level on record. This comes at a time where there has been a sharp change in the underlying interest rate environment. Historically, this has not worked out well for investors.

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

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

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

There is a high correlation between declines in asset prices and the actual dividends being paid out throughout history. The chart below shows the history of inflation-adjusted dividends and the S&P 500 going back to 1900. (Data courtesy of Dr. Robert Shiller.)

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

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

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

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

While I completely agree that investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress. During the next major market reversion, we will see much of the same happen again.

The table below shows 60-companies that are at risk during the next downturn (I reduced the list from more than 150 companies for the purposes of this article.)  The screen looked for companies with a payout ratio above 80% and an increasing change in the payout ratio over the last 3-quarters. The list below does not contain REIT’s and MLP’s as their dividend payout policies are largely mandated by securities law and therefore hard to compare to other corporations.

Important Note: I am NOT suggesting that every company that fits these parameters will slash or eliminate their dividend. I AM suggesting there are a substantial number of companies at financial risk during the next economic downturn. 

(Click here for the Top-10 Dividend Yielding Value Stocks hitting our screens now.)

There are two important lessons to be learned from General Electric (as well as numerous other companies which litter the “I bought it for the dividend” landscape of history):

  • During a recession, when revenues fall, companies will cut their dividend to protect their creditors. This is especially important at a time when corporate leverage is at historical levels.
  • The sharp decline in the stock price will precede the eventual cut to the dividend. 

The reality is that every investor has a point, when prices fall far enough, that they will capitulate and sell their position. This point generally comes when dividends have been cut and capital destruction has been maximized.

While I certainly encourage investing in companies that pay a dividend, just remember that fundamentals are always THE single most important variable of long-term returns.

General Electric is just the latest lesson to be learned, and quite possibly the first, in a long line of dominoes.

15-Risk Management Rules – RIA Pro

As Facebook and Netflix, two market darlings, fall from their graces I am reminded about “risk” and in particular something Howard Marks once wrote:

“If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money, and the other is to miss an opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive.

I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: ‘No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble’.

On the other shoulder is the devil in a red robe with his pitchfork. He whispers: ‘Do it, you’ll get rich’. In the end, the devil usually wins.

Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.

How do you avoid getting trapped by the devil?

I’ve been in this business for over forty-five years now, so I’ve had a lot of experience.  In addition, I am not a very emotional person. In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes.

Therefore, unemotionalism is one of the most important criteria for being a successful investor. And if you can’t be unemotional you should not invest your own money, period. Most great investors practice something called contrarianism. It consists of doing the right thing at the extremes which is the contrary of what everybody else is doing. So unemtionalism is one of the basic requirements for contrarianism.”

It is not surprising with markets brushing off the January/February stumble and the mainstream media trumpeting daily gains, that individuals are being swept up again in the moment.

After all, it’s a “can’t lose proposition.” Right?

This is why being unemotional when it comes to your money is a very hard thing to do.

It is times, such as now, where logic states that we must participate in the current opportunity. However, emotions of “greed” and “fear” are kicking in either causing individual’s to take on too much exposure, or worrying that risk is too high and a crash could come at any time. Emotional based arguments are inherently wrong and lead individuals into making decisions that ultimately have a negative impact on their financial health.

As Howard Marks’ stated above, it is in times like these that individuals must remain unemotional and adhere to a strict investment discipline.

RIA Portfolio Management Rules

It is from Marks’ view on risk management that I thought I would share with you the portfolio rules that drive own own investment discipline at Real Investment Advice. While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

The fundamental, economic and price analysis forms the backdrop of overall risk exposure and asset allocation. However, the following rules are the “control boundaries” for all specific actions.

  1. Cut losers short and let winner’s run. (Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Currently, the long-term bullish trend that began in 2009 remains intact. The correction that began in early 2016 was temporarily cut short by massive, and continuing, interventions of global Central Banks. The 10% decline in late January and early February, has been largely erased in large part by stock buybacks. There is a limit, of course, to the efficacy of central bank and corporate interventions.

At some point, and probably sooner rather than later, a violation of the long-term bullish trend, and a failure to recover, will signal the beginning of the next “bear market” cycle. Such will then change portfolio allocations to be either “neutral or short.”  BUT, and most importantly, until that violation occurs, my portfolios will be either long or neutral ONLY.  

Trading behavior of the market looks, and feels, like the last leg of a “melt up” as we previously witnessed at the end of 1999.  How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently.

This is just my approach and I am simply sharing my process.

I hope you find something useful in it.

Q1-Earnings Review & The Risk To Estimates

With roughly 98% of the S&P 500 having reported earnings, as of mid-June, we can take a closer look at the results through the 1st quarter of the year. During the most recent reported period, 12-month operating earnings per share rose from $33.85 per share in Q4-2017 to $36.43 which translates into a quarterly increase of 7.62%. While operating earnings are widely discussed by analysts and the general media; there are many problems with the way in which these earnings are derived due to one-time charges, inclusion/exclusion of material events, and outright manipulation to “beat earnings.”

Therefore, from a historical valuation perspective, reported earnings are much more relevant in determining market over/undervaluation levels. It is from this perspective the news improved markedly as 12-month reported earnings per share rose from $26.96 in Q4-2017 to $32.81, or a whopping 21.7% in Q1. This jump, of course, is directly related to the reduction in corporate tax rates following the passage of the “tax reform” bill in December of 2017.

However, as shown below, top-line revenue growth (sales) has also improved since the market bottom in early 2016. The issue is that while sales are indeed rising, the price investors are paying for each dollar of sales has grown exponentially since 2009. In other words, it is already well “priced in.”

Since the media focus on earnings per share (EPS), we see the same issue. Since the end of 2014, investors are paying twice the rate of earnings growth.

No matter how you look at the data, the point remains the same. Investors are currently overpaying today for a stream of future sales and/or earnings which may, or may not, occur in the future. The risk, as always, is disappointment.

Always Optimistic

But optimism is certainly one commodity that Wall Street always has in abundance. When it comes to earnings expectations, estimates are always higher regardless of the trends of economic data. The problem is that the difference between expectations and reality have been quite dramatic. 

As I wrote previously, 

“Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have ‘sharpened their pencils’ and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.”

“The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. ‘Optimism’ is, well, ‘exceedingly optimistic’ for the end of 2019.”

That was so a month-and-a-half ago.

Since then, analysts have gotten a bit of religion about the impact of higher rates, tighter monetary accommodation, and trade wars. As I wrote yesterday, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.

However, the onset of a “trade war” could reduce earnings growth by 11% which would effectively wipe out all of the benefits from the recent tax reform legislation.

As you can see, the erosion of forward estimates is quite clear and has gained momentum in the last month. 

There is no arguing corporate profitability improved in the last quarter as oil prices recovered. The recovery in oil prices specifically helped sectors tied to the commodity such as Energy, Basic Materials, and Industrials. However, such a recovery may be fleeting. There are signs currently that global economic growth is showing signs of weakening. As noted by Adem Tumerkan:

Taking the contrarian route – it’s not hard to see the market isn’t pricing in any potential global earnings issues. And this is troublesome because the risks keep adding up. The historically accurate South Korean Export Growth Indicator (SKEG) is signaling a looming global earnings recession.”

“[And] for the first time since the 2008 Great Recession, corporate bond yields have inverted.”

“…this inversion signals trouble ahead for the stock market. It means that ‘the cost of capital for corporates is now higher than the return on capital.’ Corporate Bond investors are clearly expecting a recession and deflation ahead – which will cause the prime rate to plunge…this will spill into the stock market and negatively send prices tumbling.”

Accounting Magic

Looking back it is interesting to see that much of the rise in “profitability” since the recessionary lows have come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top line revenue. As shown in the chart below, there has been a stunning surge in corporate profitability despite a lack of revenue growth. Since 2009, the reported earnings per share of corporations has increased by a total of 336%. This is the sharpest post-recession rise in reported EPS in history. However, that sharp increase in earnings did not come from revenue which has only increased by a marginal 49% during the same period.

Of course, stock buybacks have been the “go to” method for boosting earnings. According to Greg Haendel from Wealth Management:

“The largest beneficiary of repatriation spending has been the stockholder with the most utilized tool being corporate stock buybacks. Share buybacks increased during Q12018 to a record $178 billion, up from $135 billion a year ago. Further, the 24 U.S. companies with the largest foreign cash holdings accounted for two-thirds of the increase in share buybacks. There has already been $324 billion of buyback announcements year-to-date with an expected total buyback amount of $800 billion for the year. ”

Furthermore, while the majority of buybacks have been done with “repatriated” cash, it just goes to show how much cash has been used to boost earnings rather than expanding production, making productive acquisitions or returning cash to shareholders. 

Ultimately, the problem with cost-cutting, wage suppression, labor hoarding and stock buybacks, along with a myriad of accounting gimmicks, is that there is a finite limit to their effectiveness. Eventually, you simply run out of people to fire, costs to cut and the ability to reduce labor costs. 

Recently, compensation costs have been rising as the labor market has indeed grown tighter. Of course, this is what is normally seen at the end of economic cycle as rising compensation triggers a profit contraction.

While it would seem that sharply rising employee compensation would be a “good thing,” you will notice that sharply rising employee compensation, which impacts earnings growth, has historically coincided with weaker economic outcomes as higher costs erode profitability.

“It is worth noting that in both charts above, despite hopes of continued economic expansion, both employee compensation, and economic growth have continued to trend to lower since the 1980’s. This declining growth trend has been compensated for by soaring levels of debt to sustain the current standard of living.”

Economics Matter

The last chart below compares economic growth to earnings growth. Wall Street has always extrapolated earnings growth indefinitely into the future without taking into account the effects of the normal economic and business cycles. This was the same in 2000 and in 2007. Unfortunately, the economy neither forgets nor forgives.

With analysts once again hoping for a continued surge in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

The deterioration in earnings is something worth watching closely. While earnings have improved in the recent quarter, due to the benefit of tax cuts, it is likely transient given the late stage of the current economic cycle, continued strength in the dollar and potentially weaker commodity prices in the future.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

It is important to remember the bump in earnings growth will only last for one year at which point the analysis will return to more normalized year-over-year comparisons. While anything is certainly possible, the risk of disappointment is extremely high.

Pascal’s Wager Shows Why Stocks Get More “Risky” Over Time

Blaise Pascal, a brilliant 17th-century mathematician, famously argued that if God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn’t exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.

Pascal concluded, given that we can never prove whether or not God exists, it’s probably wiser to assume he exists because infinite damnation is much worse than a finite cost.

When it comes to investing, Pascal’s argument applies as well. Let’s start with an email I received this past week.

“The risk of buying and holding an index is only in the short-term. The longer you hold an index the less risky it becomes. Also, managing money is a fool’s errand anyway as 95% of money managers underperform their index from one year to the next.”

This is an interesting comment as it exposes two primary falsehoods.

Let’s start with the second comment “95% of money managers can’t beat their index from one year to the next.” 

One of the greatest con’s ever perpetrated on the average investor by Wall Street is the “you can’t beat the index game.” It is true that many mutual funds underperform their index from one year to the next, but this has nothing to do with their long-term performance. The reasons that many funds, and investors, underperform in the short-term are simple enough to understand if you think about what an index is versus a portfolio of invested capital.

  1. The index contains no cash
  2. It has no life expectancy requirements – but you do.
  3. It does not have to compensate for distributions to meet living requirements – but you do.
  4. It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  5. It has no taxes, costs or other expenses associated with it – but you do.
  6. It has the ability to substitute at no penalty – but you don’t.
  7. It benefits from share buybacks – but you don’t.
  8. It doesn’t have to deal with what “life” throws at you…but you do.

But as I have addressed previously, the myth of “active managers can’t beat their index” falls apart given time.

Larry Swedroe wrote a piece just recently admonishing active portfolio managers and suggesting that everyone should just passively invest. After all, the primary argument for passive investing is that active fund managers can’t beat their  indices over time which is clearly demonstrated in the following chart.”

“Oops. There are large numbers of active fund managers who have posted stellar returns over long-term time frames. No, they don’t beat their respective benchmarks every year, but beating some random benchmark index is not the goal of investing to begin with. The goal of investing is to grow your ‘savings’ over time to meet your future inflation-adjusted income needs without suffering large losses of capital along the way.”

It isn’t just mutual funds that regularly outperform their respective benchmarks but also hedge funds, private managers and numerous individual investors that put in the necessary time, work and effort.

But, I will admit that today, more than ever, the game is stacked against the average investor as high-speed trading takes advantage of retail investor online order flows. The proprietary trading desks, who have access to massive pools of capital, can push markets on an intra-day basis while computerized programs execute orders based on data flows. It has truly become the battle of “David and Goliath” with Wall Street armed with better technology, more resources, more information, teams of people dedicated solely to a single outcome versus – you and your computer. One can certainly understand why many individuals have given up trying to manage their investments.

But therein lies the huge conflict of interest between Wall Street and you. They need your money flowing into their products so they can charge fees. Wall Street is a business and, for them, business is good, and very profitable, as long as investors buy into the game that investing is the ONLY way to grow “rich.”

However, as investors, we must abandon the idea of chasing some random benchmark index, which really has very little to do with our own personal investing goals, and focus on the things that will make us wealth over time: spend less, save more, reduce debt (increase cash flow), grow our “human capital,” (earning power), invest and avoid major losses.

Investing and avoiding major losses brings us to the first point of the email which is “stocks become less ‘risky’ over time.”

Stocks Become Less “Risky” Over Time?

This idea suggests the “risk” of the loss of capital diminishes as time progresses.

First, risk does not equal reward. “Risk” is a function of how much money you will lose when things don’t go as planned. The problem with being wrong is the loss of capital creates a negative effect to compounding that can never be recovered. Let me give you an example.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

Math-Of-Loss-10pct-Compound-011916

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

The problem with following Wall Street’s advice to be “all in – all the time” is that eventually you are going to dealt a bad hand. By being aggressive, and chasing market returns on the way up, the higher the market goes the greater the risk that is being built into the portfolio. Most investors routinely take on more “risk” than they realize which exposes them to greater damage when markets go through a reversion process.

How do we know that risk increases over time? The cost of “insurance” tells us so. If the “risk” of ownership actually declines over time, then the cost of “insuring” the portfolio should decline as well. The chart below is the cost of “buying insurance (put options) on the S&P 500 exchange-traded fund ($SPY).

As you can see, the longer a period our “insurance” covers the more “costly” it becomes. This is because the risk of an unexpected event that creates a loss in value rises the longer an event doesn’t occur.

Furthermore, history shows that large drawdowns occur with regularity over time.

Byron Wien was asked the question of where we are in terms of the economy and the market to a group of high-end investors. To wit:

“The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion.

Importantly, it is not just the length of the market and economic expansion that is important to consider. As I explained just recently, the “full market cycle” will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology.

“There are two halves of every market cycle. 

“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’ The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.

With valuations currently pushing the 2nd highest level in history, it is only a function of time before the second-half of the full-market cycle ensues.

That is not a prediction of a crash.

It is just a fact.”

But as Mr. Pascal suggests, even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire. Rolling the investment dice while saving money by skimping on insurance may give us a shot at amassing more wealth, but with that chance of greater success, comes a risk of devastating failure.

Winning The Long Game

In golf, there is a saying that you “drive for show and putt for dough” meaning that it is not necessary to be able to drive a golf ball 300 yards down the center of the fairway – it is the short putting, measured in feet, which will win the game. In investing, it is much the same – being invested in the market is one thing, however, understanding the “short game” of investing is critically important to winning the “long game.”

When valuations rise to rarely seen levels, and the associated risks of a major drawdown increase exponentially, focus on managing the “risk” of the portfolio rather than chasing “returns.”

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

But it was Howard Marks who summed up our philosophy on “risk management” well when he stated:

“If you refuse to fall into line in carefree markets like today’s, 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.” 

Clients should not pay a fee to mimic markets. Fees should be paid to investment professionals to employ an investment discipline, trading rules, portfolio hedges and management practices that have been proven to reduce the probability a serious and irreparable impairment to their hard earned savings.

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

Personally, I choose to “believe” as I really don’t like the sound of “eternal damnation.”