Is this just a correction after a strong bullish advance from November, or is the bull market ending? If you read some of the headlines, you would suspect the latter. As noted by MarketWatch last week:

“For the first time since early November 2023, less than 30% of S&P 500 stocks are trading above their 50-day moving average — a clear indicator of the current poor market’s breadth. This significant drop from the 85% observed in late March and 92% at the beginning of January highlights a dramatic reversal in market dynamics.

The 50-day moving average is often seen as a barometer for the short-term health of stocks. Falling below this level en masse suggests that a broad swath of the market is facing downward pressure. This shift comes amid escalating geopolitical tensions in the Middle East and renewed concerns over inflation, which have collectively nudged traders towards a more guarded stance in April.”

Of course, there are many “reasons” lately for the drop in stock prices. Geopolitical stress between Israel and Iran and hotter-than-expected inflation data that paused Fed rate cuts brought sellers into the market. However, none of this is shocking, as we previously noted in “Blackout Of Buybacks:”

“Notably, since 2009, and accelerating starting in 2012, the percentage change in buybacks has far outstripped the increase in asset prices. As we will discuss, it is more than just a casual correlation, and the upcoming blackout window may be more critical to the rally than many think.” – March 19, 2024

Furthermore, the “blackout” of corporate buybacks coincided with an aggressively bullish investor sentiment. As we noted in that same article:

“Investor sentiment is once again very bullish. Historically, when retail investor sentiment is exceedingly bullish combined with low volatility, such has generally corresponded to short-term market peaks.”

We will return to this chart momentarily, but given that corporate share buybacks have accounted for roughly 100% of net equity purchases over the last two decades, the blackout period combined with aggressive bullish sentiment was the recipe for a decline in asset prices.

Here is the math of net flows if you don’t believe the chart:

• Pensions and Mutual Funds = (-$2.7 Trillion)
• Households and Foreign Investors = +$2.4 Trillion
  • Sub Total = (-$0.3 T)
• Corporations (Buybacks) = $5.5T
  • Net Total = $5.2 Trillion = Or 100% of all equities purchased

Such is crucial to understand as we head into the rest of the year. It will determine whether this is just a correction within a bullish trend or something more significant.

Buyers Live Lower

In “No Cash On The Sidelines,” we discussed the importance of understanding that “market prices” are set by the demand and supply between buyers and sellers. To wit:

“As noted above, the stock market is always a function of buyers and sellers, each negotiating to make a transaction. While there is a buyer for every seller, the question is always at “what price?” 

In the current bull market, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own.

Such is the very definition of the “greater fool” theory.

However, at some point, for whatever reason, this dynamic will change. Buyers will become more scarce as they refuse to pay a higher price. When sellers realize the change, they will rush to sell to a diminishing pool of buyers. Eventually, sellers will begin to “panic sell” as buyers evaporate and prices plunge.”

In other words, “Sellers live higher. Buyers live lower.“

We can see where the buyers and sellers “live” in the following chart, which shows where the highest volume occurred.

This current correction is becoming increasingly oversold (bottom panel), which suggests a bounce is likely toward the previous support of the 50-DMA. For comparison, we can look at last year’s market correction. As noted, the bullish rally into July peaked late that month. As the market corrected, it bounced from oversold conditions, allowing investors to reduce risk and hedge portfolios. The markets will likely present investors with that opportunity soon.

Then, like today, many investors began to believe it wasn’t just a correction but something much more. However, the reality was that the “buyers lived lower.” Buyers stepped in as prices approached the October lows, coinciding with the return of corporate share buybacks.

Sentiment Is Reversing Quickly

As I said, we need to revisit the sentiment chart above. Investors’ more frothy, bullish sentiment is reversing quickly on many fronts. The chart below, the same as above, is the composite net bullish sentiment index of retail and professional investors divided by the volatility index (VIX). If this is just a market correction, the index tends to bottom between zero (0) and negative (20). With a current reading of 4.15, down from 25.99 just two weeks ago, bullish sentiment has significantly reversed.

Notably, professional investor allocations to equities recently peaked at 103.88%, which has collapsed in just two weeks to just 62.98% exposure. (Professional investors are notorious for buying market peaks.)

Also, the number of stocks on bullish “buy signals” has dropped from 80.2 to 48.2.

Furthermore, the number of stocks trading above the 50-DMA has fallen from over 80% to 37%, with money flows hitting levels lower than previous market bottom lows. Notably, with just a 5.5% correction from the recent peak (as of last Friday), much of the work of clearing the previous overbought conditions is completed.

Given the significant reversal in sentiment and short-term oversold conditions, we highly suspect the markets will provide a reflexive rally soon. However, with the number of bullish investors who got “trapped” in the selloff, any rallies will likely be met with further selling.

However, despite the current “panic” in the media headlines, this is likely just a correction within an ongoing bullish market. Such is particularly the case given that corporate share buybacks will resume in May, providing critical support for the markets heading into summer.

With that said, this correction, when complete, likely won’t be the last we see this year. Market history suggests we could see another “bumpy ride” heading into what many expect will be a somewhat contentious election.

But that is an article we will write when we get there.

Economic “reflation” is becoming the next bullish narrative as equity valuation increases continue to outpace earnings gains, at least according to Gold Sachs and Tony Pasquariello.

“If GS is correct on the big calls, the macro backdrop is set to remain friendly: the US economy should continue to grow nicely above trend — picking up speed as the year moves along — with three adjustment rates cuts along the way.  to not obscure the moral of that story: the Fed is set to ease policy … into an upswing.  while Fedspeak this week had a somewhat hawkish bent, the house view for 2024 remains intact.”

Interest rates, gold, and commodity prices have increased in the past few months. Unsurprisingly, the bullish narrative to support that rise has gained traction. Interestingly, this “reflation” narrative tends to resurface by Wall Street whenever there is a need to explain the surge in commodity prices. Notably, the last time Wall Street focused on the reflation trade was in 2009, as noted by the WSJ:

“The most talked-about investing strategy these days isn’t stuffing money in a mattress, it’s the reflation trade — the bet that the world economy will rebound, driving up interest rates and commodities prices.”

While that “reflation trade” lasted for about two years, it quickly failed as economic growth returned to 2%-ish growth along with inflation and interest rates. As shown, oil and commodity prices have a very high correlation. The critical reason is that higher oil prices reduce economic demand. As consumption falls, so does the demand for commodities in general. Therefore, if commodity prices are to “reflate,” as shown, such will depend on more robust economic activity.

As such. The reflation trade hinges on a global resurgence of economic activity, usually associated with economies recovering from a recessionary period. However, the U.S. never experienced a recession. As discussed in “Deficit Spending,” despite numerous recessionary signals, like the inverted yield curve, manufacturing data, and leading economic indicators, the economy avoided recession due to massive governmental spending. To wit:

“One explanation for this has been the surge in Federal expenditures since the end of 2022 stemming from the Inflation Reduction and CHIPs Acts. The second reason is that GDP was so grossly elevated from the $5 Trillion in previous fiscal policies that the lag effect is taking longer than historical norms to resolve.”

While economists focus on the “reflation trade,” we must answer whether the support for more substantial economic growth exists. This is the sole determining factor in whether the “reflation trade” can continue.

Is Reflation Already Behind Us?

Interest rates and inflation have ticked up recently, driving investors into gold and commodities. However, the surge in precious metals and commodities is more of a function of speculative exuberance rather than an economic resurgence. As discussed in “Speculative Warnings,”

“In other words, the stock market frenzy to “buy anything that is going up” has spread from just a handful of stocks related to artificial intelligence to gold and digital currencies.“

Notably, the gold, commodities, and interest rate surge corresponded with more robust economic growth beginning in the third quarter of last year. That uptick in economic growth defied economists’ expectations of a recession. Such was because of the massive flood of monetary support from Government spending programs. However, that monetary impulse is now reversing.

As far as the “reflation trade” is concerned, as that monetary impulse recedes, so will economic growth, as shown. Even if the economy continues to grow at 2-2.5% annualized each quarter, the annual rate of change in growth will continue to slow.

Importantly, this assumes that the Government will keep “spending like drunken sailors” over that same period. However, if they don’t, the economic growth rate will slow even more quickly without increasing monetary spending.

It is important to remember that increasing debts and deficits do not elicit stronger long-term economic growth. As debt levels rise, economic growth rates will slow as money diverts from productive investment into debt service.

That reality should be unsurprising, as this is not the first time the Government has gone “all in” on a reflation trade. As noted above, following the Financial Crisis, the Government intervened with HAMP, HARP, TARP, and a host of other spending programs to “reflate” the economy.

Let’s review what happened with interest rates, inflation, and gold and commodity trade.

Past May Be Prologue

As noted in 2009, following the “Financial Crisis” and recession, the Government and the Federal Reserve engaged in various monetary and fiscal supports to repair the economy. While the economy initially recovered from the recessionary lows, inflation, economic growth, and interest rates remained subdued despite ongoing interventions.

That is because debt and artificially low interest rates lead to malinvestment, which acts as a wealth transfer mechanism from the middle class to the wealthy. However, that activity erodes economic activity, leading to suppressed inflation and a surging wealth gap.

During that same period, commodities and precious metals rose initially as the “reflation expectation” was widespread. However, debt-driven realities quickly undermined that assessment and those investments languished relative to equities, as the flood of liquidity and low rates made equities far more attractive to investment.

While the relative performance of precious metals and commodities has picked up in recent months, this is more likely a function of “irrational exuberance” in the financial markets. As discussed previously, the surge in speculative investment activity is not uncommon to markets, and currently, many asset classes are becoming highly correlated.

However, while there is a compelling narrative around gold and precious metals from an investment perspective, those chasing that trade have had many years of terrible underperformance. While this time could be different, the “reflation narrative” will most likely fall prey to the realities of excessive debt, which will pressure Governments to cut rates once again.

If the past is potentially prologue, likely, the bullish narrative of “reflation” may once again find future disappointment. Such is particularly the case as the economics of debt and poor policy choices continue to erode the middle class further.

In the most recent report from FINRA, margin debt levels have surged as bullish investors leverage their bets in the equity market. The increase in leverage is not surprising, as it represents increased risk-taking by investors in the stock market.

We previously discussed that valuations, in the short term, reflect investor optimism. In other words, as prices increase, investors rationalize why paying more for current earnings is rational.

“Valuation metrics are just that – a measure of current valuation. More importantly, when valuation metrics are excessive, it is a better measure of ‘investor psychology’ and the manifestation of the ‘greater fool theory.’ As shown, there is a high correlation between our composite consumer confidence index and trailing 1-year S&P 500 valuations.”

The same holds for margin debt. Unsurprisingly, as consumer confidence improves, so does the speculative demand for equities. As stock markets improve, the “fear of missing out” becomes more prevalent. Such boosts demand for equities, and as prices rise, investors take on more risk by adding leverage.

Adding to that exuberance is the increased demand for share repurchases, which has been a primary source of “buying” since 2000. As CEO confidence improves, a byproduct of increased consumer confidence, they increase the demand for share repurchases. As buybacks boost asset prices, investors take on more leverage and increase exposure as a virtual spiral develops.

However, should investors be afraid of rising margin debt?

A Byproduct Of Exuberance

Before we dig further into what margin debt tells us, let’s begin with where we are currently. There is clear evidence that investors are once again highly exuberant. The “Fear Greed” index below differs from the CNN measure in that our model measures positioning in the market by how much professional and retail investors are exposed to equity risk. Currently, that exposure is at levels associated with investors being “all in” the equity “pool.”

As Howard Marks noted in a December 2020 Bloomberg interview:

“Fear of missing out has taken over from the fear of losing money. If people are risk-tolerant and afraid of being out of the market, they buy aggressively, in which case you can’t find any bargains. That’s where we are now. That’s what the Fed engineered by putting rates at zero…we are back to where we were a year ago—uncertainty, prospective returns that are even lower than they were a year ago, and higher asset prices than a year ago. People are back to having to take on more risk to get return. At Oaktree, we are back to a cautious approach. This is not the kind of environment in which you would be buying with both hands.

The prospective returns are low on everything.”

Of course, in 2021, that market continued its low volatility grind higher as investors took on increasing margin debt levels to chase higher equities. However, this is the crucial point about margin debt.

Margin debt is not a technical indicator for trading markets. What it represents is the amount of speculation occurring in the market. In other words, margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, leverage also works in reverse, as it supplies the accelerant for more significant declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

The last sentence is the most important. The issue with margin debt is that the unwinding of leverage is NOT at the investor’s discretion. That process is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not recoup their credit lines, they force the borrower to put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen simultaneously, as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

As shown, Howard was eventually right. In 2022, the decline wiped out all of the previous year’s gains and then some.

So, where are we currently?

Margin Debt Confirms The Exuberance

As noted, margin debt supports the advance when markets are rising and investors are taking on additional leverage to increase buying power. Therefore, the recent rise in margin debt is unsurprising as investor exuberance climbs. The chart shows the relationship between cash balances and the market. I have inverted free cash balances, so the relationship between increases in margin debt and the market is better represented. (Free cash balances are the difference between margin balances less cash and credit balances in margin accounts.)

Note that during the 1987 correction, the 2015-2016 “Brexit/Taper Tantrum,” the 2018 “Rate Hike Mistake,” and the “COVID Dip,” the market never broke its uptrend, AND cash balances never turned positive. Both a break of the rising bullish trend and positive free cash balances were the 2000 and 2008 bear market hallmarks. With negative cash balances shy of another all-time high, the next downturn could be another “correction.” However, if, or when, the long-term bullish trend is broken, the unwinding of margin debt will add “fuel to the fire.”

While the immediate response to this analysis will be, “But Lance, margin debt isn’t as high as it was previously,” there are many differences between today and 2021. The lack of stimulus payments, zero interest rates, and $120 billion in monthly “Quantitative Easing” are just a few. However, some glaring similarities exist, including the surge in negative cash balances and extreme deviations from long-term means.

In the short term, exuberance is infectious. The more the market rallies, the more risk investors want to take on. The issue with margin debt is that when an event eventually occurs, it creates a rush to liquidate holdings. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral. The decline in value then triggers further margin calls, triggering more selling, forcing more margin calls, and so forth.

Margin debt levels, like valuations, are not useful as a market-timing device. However, they are a valuable indicator of market exuberance.

While it may “feel” like the market “just won’t go down,” it is worth remembering Warren Buffett’s sage words.

“The market is a lot like sex, it feels best at the end.”

Your mother likely imparted valuable investing lessons you may not have known. With Mother’s Day approaching and bullish market exuberance present, such is an excellent time to revisit the investing lessons she taught me.

Personally, when I was growing up, my Mother had a saying, or an answer, for almost everything… as most mothers do. 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, unknowingly, valuable investing lessons to keep me safe.

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 of sharing the knowledge that 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 think I did it early on 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 mid-90s, 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 vast difference between investing and speculating; knowing the difference is critical to overall success.

A solid investment strategy combines 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 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.

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.

When investing, remember that the odds of making a losing trade increase with the frequency of transactions. Just as running with a pair of scissors, do it often enough, and eventually, you could end up hurting yourself. 

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 in the city. Nonetheless, she yanked me 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 essential to understand that traffic does flow in two directions. If you only look in one direction, you will get hit sooner or later.

Many people want to classify themselves as a “Bull” or a “Bear.” The savvy 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 essential 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 wore clean underwear before an accident, you’re still likely left without clean underwear following it.

The investing lesson is: “You are only wrong – if you stay wrong.“

However, being an intelligent investor means always being prepared in case of an accident. That means simply having a mechanism 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. Many of your investment decisions will likely turn out wrong. However, cutting those wrong decisions short and letting your right decisions continue to work will make you profitable over time.

Any person who tells you about all the winning trades he has made in the market – is either lying or 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 “peer pressure.” I figured if she wouldn’t let me do what I wanted, she would bend to the will of the imaginary masses. She never did.

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

Investors buy stocks that have moved significantly off their lows in the financial markets because they fear “missing out.” This is speculating, gambling, guessing, hoping, praying – anything but investing. Generally, when the media begins featuring a particular investment, individuals have already missed the major part of the move. By that point, the probability of a decline began to outweigh the possibility of further rewards.

The investing lesson is to be aware of the “herd mentality.” Historically, investors tend to run in the same direction until that direction falters. The “herd” then turns and runs in the opposite direction. This continues to the detriment of investors’ returns over long periods.

This is also generally why investors wind up buying high and selling low. To be a long-term successful investor, you must understand the “herd mentality” and use it to your benefit – 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, 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 often be rewarded for your efforts.

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 if the media only broadcasts news revealing human depravity’s depths. Still, sometimes, I wonder if we are not due for a planetary cleansing through divine intervention.

However, back to investing lessons, 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.

To succeed in the long run, you must understand investing principles and the catalysts to make that investment profitable. Remember, when you invest in a company, you buy a piece of it and its business plan. You are placing your hard-earned dollars into the belief that 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 also embodies the “Greater Fool Theory,” which states that someone will always be willing to buy an investment at an ever higher price. The investing lesson is that, in the end, someone is always left “holding the bag.” The trick is to ensure that it isn’t you.

Also, you must be aware of this 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 than I ever dreamed of in my younger days. Since I wouldn’t say I liked doing homework, school projects were rarely 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 many “because I told you so…”

Interestingly, many investors tend to watch stocks for a very long period, never acting on their analysis but idly watching as their instinct proves correct and the stock rises in price.

The investor then feels that they 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.

The investing lesson is to be aware of the dangers of procrastination. On the way up and down, procrastination is the precursor 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 correct 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 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.

However, kidding aside, the investing lesson is that when you invest in the financial markets, it is very easy to lose sight of your intentions 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 return to the basic principle you started with. That goal was to grow your small pile of money into a much larger one.

Putting It All Together

My Dad once taught me a fundamental investing lesson as well: KISS: Keep 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 small, fractional increase in return. Unfortunately, they take disproportionate risks, often leading 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 monthly goal.
4. Calculate the 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 achievable milestones. These milestones could be quarterly, semi-annual, or annual and will help ensure 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 more significant losses than planned.
7. Develop and implement a specific strategy to sell positions during random market events or unexpected market downturns.
8. If this is more than you know how to do – hire a professional who understands essential portfolio and risk management.

There is much more to managing your portfolio than just the principles 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.

Democrats should start worrying about the level of debt and the increasing deficit. I previously discussed this issue when President Obama held the White House, when Marshall Auerback, via the Nation, wrote:

“Delivering on big progressive ideas like Medicare for All and the Green New Deal will never happen until Democrats get over their fear of red ink.”

While that article was a long and winding mess of convoluted ideas, the following excerpt was vital.

“In an environment increasingly characterized by slowing global economic growth, businesses are understandably hesitant to invest in a way that creates high-quality, high-paying jobs for the bulk of the domestic workforce. The much-vaunted Trump corporate ‘tax reform’ may have been sold to the American public on that basis, but corporations have largely used their tax cut bonanza to engage in share buybacks, which fatten executive compensation but have done nothing for the rest of us. At the same time, private households still face constraints on their consumption because of stagnant wages, rising health care costs, declining job security, poorer employment benefits, and rising debt levels.

Instead of solving these problems, the reliance on extraordinary monetary policy from the Federal Reserve via programs such as quantitative easing has exacerbated them. In contrast to properly targeted fiscal spending, the Federal Reserve’s misguided monetary policies have fueled additional financial speculation and asset inflation in stock markets and real estate, which has made housing even less affordable for the average American.”

While there is truth in that statement, and it is the same issue I have railed against previously in this blog, Mr. Auerback’s solution was seemingly simple.

“Democrats should embrace the ‘extremist’ spirit of Goldwater and eschew fiscal timidity (which, in any case, is based on faulty economics). After all, Republicans do it when it suits their legislative agenda. Likewise, Democrats should go big with deficits—as long as they are used for the transformative programs that progressives have long talked about and now have the chance to deliver.”

As I noted then, such a solution was essentially the adoption of Modern Monetary Theory (MMT), which, as discussed previously, is the assumption debt and deficits “don’t matter” as long as there is no inflation.

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy, which means government spending is never revenue constrained, but rather only limited by inflation.” – Kevin Muir

However, fast forward to the present, we tried MMT; the Democrats went big with debts and deficits and funded social programs, and the result was a massive spike in inflation and no actual increase in broad economic prosperity.

So, what went wrong?

The Non-Solution

The problem with most Democratic spending ideas on social programs and welfare, like free healthcare or college, is the lack of a crucial ingredient. That ingredient is a “return on investment.” Dr. Woody Brock previously addressed this point in his book “American Gridlock;”

“Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.“

Let me be clear. There is no disagreement about the need for government spending. The debate is about the abuse and waste of it.

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

Currently, the U.S. is “Country A.” 

The problem with the more socialistic programs that Democrats continue to pursue with deficit spending is that it exacerbates the problem. The Center On Budget & Policy Priorities data can help visualize the issue.

As of the latest annual data, through the end of Q2-2023, the Government spent $6.3 Trillion, of which $5.3 Trillion went to mandatory expenses. In other words, it currently requires 113% of every $1 of revenue to pay for social welfare and interest on the debt. Everything else must come from debt issuance.

This is why debt issuance has surged since 2008 when Congress quit using the budgeting process to allow for rampant spending.

Of course, given the massive surge in spending, revenues cannot keep up the pace, leading to a rapid increase in debt issuance and a trending deficit.

However, while Democrats keep pushing for more socialistic programs, which garners votes in election cycles, they are now faced with a problem that may be their undoing.

Debt Diverts Productive Capital

Ben Ritz for the WSJ recently penned:

“Deficits are undermining the Biden economy. In the past year, the real federal budget deficit more than doubled, from $933 billion to $2 trillion. Democrats rightly argued that spending borrowed money was a critical economic support during the Covid pandemic. But the unemployment rate the over past year has been consistently lower than any point since the 1950s.

Economists, even those on the far left who subscribe to ‘modern monetary theory,’ agree that increasing deficits in a tight labor market fuels inflation. Voters’ frustrations with inflation and the interest-rate hikes implemented to bring it under control exceed their appreciation for low unemployment, fueling disapproval of President Biden’s economic record. Deficit reduction is more important than it has been at any other time in the 21st century.”

The problem with the analysis is that while the “unemployment rate” may be low, economic disparity is high. While the massive surge in pandemic-era spending boosted economic inflation, it also created an enormous rise in inflation, unsurprisingly. That inflation surge spurred the Fed to aggressively hike rates on the short end of the yield curve, while inflation and economic growth pushed long-term rates higher.

Subsequently, higher inflation and higher borrowing costs priced out wage increases with substantially higher living costs. Unsurprisingly, the net worth of the bottom 90% of Americans has failed to improve.

The problem for the Democrats is that continuing to push socialistic programs only makes the situation worse. Yes, more “free money” to individuals sounds excellent in theory, but prices ultimately increase more. The problem is exacerbated as non-productive debt erodes economic growth, and more debt diverts productive capital into interest payments.

“Annual interest payments are already at their highest level as a percentage of gross domestic product since the 1990s. By 2028 the government is projected to spend more than $1 trillion on interest payments each year—more than it spends on Medicaid or national defense. Worse, the U.S. may be entering a vicious circle whereby higher deficits increase debt and fuel inflation, which the Federal Reserve must combat by raising interest rates, causing debt-service costs to balloon further.” – Ben Ritz

While the Democrats continue to push for more social spending programs, we have potentially reached the point where that may be no longer feasible. I agree with Ben’s view that it may be time for both Democrats and Republicans to start taking steps to restore fiscal responsibility in Washington.

The average American family is no longer supportive of new progressive policies when they believe we can’t even pay for the promises already made.

Of course, if the economy slips into a recession before the 2024 election, we could see a political rout in Washington, D.C.

The Chicago Fed National Activity Index (CFNAI) is arguably one of the most important and overlooked economic indicators. Each month, economists, the media, and investors pour over various mainstream economic indicators, from GDP to employment and inflation, to determine what markets will likely do next.

While economic numbers like GDP or the monthly non-farm payroll report typically garner the headlines, the most crucial statistic, in my opinion, is the CFNAI. Investors and the press mostly ignore it, but the CFNAI is a composite index of 85 sub-components, giving a broad overview of overall economic activity in the U.S.

Since the beginning of this year, the markets ran up sharply over into July as the Federal Reserve again intervened in the markets to bail out regional banks. Then, even as the market pulled back this summer, economic growth accelerated in the 3rd quarter, according to the headlines, which should translate into a resurgence of corporate earnings. However, if recent CFNAI readings are any indication, investors may want to alter their growth assumptions heading into next year.

While most economic data points are backward-looking statistics, like GDP, the CFNAI is a forward-looking metric that indicates how the economy will likely look in the coming months.

Notably, that data does not support the recent economic report from the Bureau Of Economic Analysis (BEA), which showed the economy expanded by 4.9% in Q3.

So, what is the CFNAI telling us that is different than the BEA economic report?

Breaking Down The “Most Important Number”

Understanding the message the index is designed to deliver is critical. From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.“

The overall index is broken down into four major sub-categories, which cover:

• Production & Income
• Employment, Unemployment & Hours
• Personal Consumption & Housing
• Sales, Orders & Inventories

To better grasp these four critical sub-components and their predictive capability, I have constructed a 4-panel chart. I have compared the CFNAI sub-components to the four most common economic reports of Industrial Production, Employment, Housing Starts, and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI, I used an annual percentage change for these four components.

The correlation between the CFNAI sub-components and the underlying major economic reports is high. This is why, even though this indicator gets very little attention, it represents the broader economy. The CFNAI is not confirming the mainstream view of an “economic resurgence” that will drive earnings growth into next year.

The CFNAI is also essential to our RIA Economic Output Composite Index (EOCI). The EOCI is an even broader composition of data points, including Federal Reserve regional activity indices, the Chicago PMI, ISM, the National Federation of Independent Business Surveys, and the Leading Economic Index. The EOCI further confirms that “hopes” of an immediate rebound in economic activity are unlikely. To wit:

“As discussed in “Signs, Signs, Everywhere Signs,” numerous measures suggest a recession is forthcoming. However, that recession has yet to reveal itself. Such has led to a fierce debate between the bulls and the bears. The bears contend that a recession is still coming, while the bulls are betting more heavily on a “no landing” scenario or, instead, avoiding a recession. Even the Federal Reserve is no longer expecting a recession.

But how is a “no recession” outcome possible amid the most aggressive rate hiking campaign in history, deeply inverted yield curves, and other measures warning of its inevitability?“

There are a couple of essential points to note in this very long-term chart.

1. Economic contractions tend to reverse fairly frequently from high peaks, and those contractions tend to revert towards the 30-reading on the chart. Recessions are always present with sustained readings below the 30 level.
2. The financial market is generally correct in price as weaker economic data weighs on market outlooks. 

Currently, the EOCI index suggests more contraction will come in the coming months, which will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading into 2024.

It’s In The Diffusion

The Chicago Fed also provides a breakdown of the change in the underlying 85 components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components gives us a better understanding of the broader changes inside the index itself.

There are two points of consideration:

1. When the diffusion index dips below zero, it coincides with weak economic growth and outright recessions. 
2. The S&P 500 has a history of corrections and outright bear markets, corresponding with negative readings in the diffusion index.

The second point should not be surprising, as the stock market reflects economic growth. Both the EOCI index above and the CFNAI below correlate to the annual rate of change in the S&P 500. Again, the correlation should not be surprising. (The monthly CFNAI data is very volatile, so we use a 6-month average to smooth the data.)

How good of a correlation is it? The r-squared is 50% between the annual rate of change for the S&P 500 and the 6-month average of the CFNAI index. More importantly, the CFNAI suggests the S&P 500 should be trading lower to correspond with the economic data. Throughout its history, the CFNAI tends to be right more often than market players.

Investors should also be concerned about the current level of consumer confidence readings.

Not So Confident

The chart below is our consumer confidence composite index. It combines the University of Michigan and the Conference Board’s sentiment readings into one index. The shaded areas are when the composite index exceeds 100, corresponding with rising asset markets.

While that index has declined over the last 18 months, it remains elevated above previous recessionary levels, suggesting the economy continues to muddle along. The issue is the divergence between “consumer” confidence and “CEO’s.” The question is, who should we pay attention to?

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company that has the best view of the economic landscape. Sales, prices, managing inventory, dealing with collections, paying bills, tells them what they need to know about the actual economy?”

CEO confidence leads consumer confidence by a wide margin. Such lures bullish investors, and the media, into believing that CEO’s 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 great, but I have to let you go.” 

Despite the recent uptick in CEO confidence since October, which corresponded with strong equity market performance, confidence is hovering around pre-recessionary levels. Notably, CEO confidence is not uncommon to tick higher just before the recession is announced.

The CFNAI also tells the same story: significant consumer confidence divergences eventually “catch down” to the underlying index.

This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead if history guides the future.

Conclusion

While the media hopes for a “no recession” scenario, the data tells us an important story.

Notably, the historical data of the CFNAI and its relationship to the stock market have included all Federal Reserve activity.

The CFNAI and EOCI incorporate the impact of monetary policy on the economy in both past and leading indicators. Such is why investors should hedge risk to some degree in portfolios, as the data still suggests weaker than anticipated economic growth. The current trend of the various economic data points on a broad scale is not showing indications of recovery but of a longer-than-expected recession and recovery. 

Economically speaking, such weak levels of economic growth do not support more robust employment or higher wages. Instead, we should expect that 2024 could be a year where corporate earnings and profits disappoint investors as economic weakness continues.

In a recent post, I discussed the “3-stages of a bear market.”  To wit:

“Yes, the market will rally, and likely substantially so.  But, let me remind you of Bob Farrell’s Rule #8 from our recent newsletter:

Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend

1. Bear markets often START with a sharp and swift decline.
2. After this decline, there is an oversold bounce that retraces a portion of that decline.
3. The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate.

Dow Theory also suggests that bear markets consist of three down legs with reflexive rebounds in between.

However, the “bear market” is only one-half of a vastly more important concept – the “Full Market Cycle.”

The Full Market Cycle

Over the last decade, the media has focused on the bull market, making an assumption that the current trend would last indefinitely. However, throughout history, bull market cycles make up on one-half of the “full market” cycle. During every “bull market” cycle, the market and economy build up excesses, which must ultimately be reversed through a market reversion and economic recession. In the other words, as Sir Issac Newton discovered:

“What goes up, must come down.” 

The chart below shows the full market cycles over time. Since the current “full market” cycle is yet to be completed, I have drawn a long-term trend line with the most logical completion point of the current cycle.

[Note: I am not stating the markets are about to crash to the 1600 level on the S&P 500. I am simply showing where the current uptrend line intersects with the price. The longer that it takes for the markets to mean revert, the higher the intersection point will be. Furthermore, the 1600 level is not out of the question either. Famed investor Jack Bogle stated that over the next decade we are likely to see two more 50% declines.  A 50% decline from the all-time highs would put the market at 1600.]

As I have often stated, I am not bullish or bearish. My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis, but reduces the possibility of catastrophic losses, which wipe out years of growth.

Nobody tends to believe that philosophy until the markets wipe about 30% of portfolio values in a month.

The 4-Phases

AlphaTrends previously put together an excellent diagram laying out the 4-phases of the full-market cycle. To wit:

“Is it possible to time the market cycle to capture big gains? Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.

The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff. The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”

So, the question to answer, obviously, is:

“Where are we now?”

Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.

1992-2003

The accumulation phase, following the 1991 recessionary environment, was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999. As I noted previously:

“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 nation’s 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.”

The distribution phase became evident in early-2000 as stocks began to struggle.

Names like Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others, are “ghosts of the past.” Importantly, they are the relics of an era the majority of investors in the market today are unaware of, but were the poster children for the “greed and excess” of the preceding bull market frenzy.

As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future. 

Then, came the decline.

2003-2009

Following the “dot.com” crash, investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns, and focusing on capital preservation as the core for long-term investing.

Okay. Not really.

It took about 27-minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.” 

During the mark-up phase, investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”

Once again, during the distribution phase of the market, the analysts, media, Wall Street, and rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.” 

They were disastrously wrong.

Sound familiar?

2009-Present

So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.

Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.”

Despite a year-long distribution in the market, the same messages seen at previous market peaks were steadily hitting the headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”

Well, as we warned more than once, all that was required was an “exogenous” event, which would spark a credit-event in an overly leveraged, overly extended, and overly bullish market. The “virus” was that exogenous event.

Lost And Found

There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, fueled by Central Bank liquidity, it is understandable why mainstream analysis believed the markets could only go higher. What was always a concern to us was the rather cavalier attitude they took about the risk.

“Sure, a correction will eventually come, but that is just part of the deal.”

As we repeatedly warned, what gets lost during bull cycles, and is always found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline. It isn’t just the loss of financial wealth, but also the loss of employment, defaults, and bankruptcies caused by the coincident recession.

This is the story told by the S&P 500 inflation-adjusted total return index. The chart shows all of the measurement lines for all the previous bull and bear markets, along with the number of years required to get back to even.

What you should notice is that in many cases bear markets wiped out essentially all or a very substantial portion of the previous bull market advance.

There are many signs suggesting the current Wyckoff cycle has entered into its fourth, and final stage. Whether, or not, the current decline phase is complete, is the question we are all working on answering now.

Bear market cycles are rarely ended in a month. While there is a lot of “hope” the Fed’s flood of liquidity can arrest the market decline, there is still a tremendous amount of economic damage to contend with over the months to come.

In the end, it does not matter IF you are “bullish” or “bearish.” What matters, in terms of 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.

Last week, we saw the first glimpse of the employment fallout caused by the shutdown of the economy due to the virus. To wit:

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

This number will be MUCH worse when claims are reported later this morning, as many individuals were slow to file claims, didn’t know how, and states were slow to report them.

The importance is that unemployment rates in the U.S. are about to spike to levels not seen since the “Great Depression.” Based on the number of claims being filed, we can estimate that unemployment will jump to 15-20% over the next quarter as economic growth slides 8%, or more. (I am probably overly optimistic.)

The erosion in employment will lead to a sharp deceleration in economic and consumer confidence, as was seen Tuesday in the release of the Conference Board’s consumer confidence index, which plunged from 132.6 to 120 in March.

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

The chart below is our “composite” confidence index, which combines several confidence surveys into one measure. Notice that during each of the previous two bear market cycles, confidence dropped by an average of 58 points.

With consumer confidence just starting its reversion from high levels, it suggests that as job losses rise, confidence will slide further, putting further pressure on asset prices. Another way to analyze confidence data is to look at the composite consumer expectations index minus the current situation index in the reports.

Similarly, given we have only started the reversion process, bear markets end when deviations reverse. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than before the “dot.com” crash.

If you are betting on a fast economic recovery, I wouldn’t.

There is a fairly predictable cycle, starting with CEO’s moving to protect profitability, which gets worked through until exhaustion is reached.

As unemployment rises, we are going to begin to see the faults in the previous employment numbers that I have repeatedly warned about over the last 18-months. To wit:

“There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear. But while most economists focus at employment data from one month to the next for clues as to the strength of the economy, it is the ‘trend’ of the data, which is far more important to understand.”

That “trend” of employment data has been turning negative since President Trump was elected, which warned the economy was actually substantially weaker than headlines suggested. More than once, we warned that an “unexpected exogenous event” would exposure the soft-underbelly of the economy.

The virus was just such an event.

While many economists and media personalities are expecting a “V”-shaped recovery as soon as the virus passes, the employment data suggests an entirely different outcome.

The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current cycle peaked at 2.2% in 2015, and has been on a steady decline ever since. At 1.3%, which predated the virus, it was the lowest level ever preceding a recessionary event. All that was needed was an “event” to start the dominoes falling. When we see the first round of unemployment data, we are likely to test the lows seen during the financial crisis confirming a recession has started. 

No Recession In 2020?

It is worth noting that NO mainstream economists, or mainstream media, were predicting a recession in 2020. However, as we noted in 2019, the inversion of the “yield curve,” predicted exactly that outcome.

“To CNBC’s point, based on this lagging, and currently unrevised, economic data, there is ‘NO recession in sight,’ so you should be long equities, right?

Which indicator should you follow? The yield curve is an easy answer.

While everybody is ‘freaking out’ over the ‘inversion,’it is when the yield-curve ‘un-inverts’ that is the most important.

The chart below shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving ‘risk’ to seek the absolute ‘safety’ of money markets, i.e. ‘market crash.’)”

I have dated a few of the key points of the “inversion of the curve.” As of today, the yield-curve is now fully un-inverted, denoting a recession has started.

While recent employment reports were slightly above expectations, the annual rate of growth has been slowing. The 3-month average of the seasonally-adjusted employment report, also confirms that employment was already in a precarious position and too weak to absorb a significant shock. (The 3-month average smooths out some of the volatility.)

What we will see in the next several employment reports are vastly negative numbers as the economy unwinds.

Lastly, while the BLS continually adjusts and fiddles with the data to mathematically adjust for seasonal variations, the purpose of the entire process is to smooth volatile monthly data into a more normalized trend. The problem, of course, with manipulating data through mathematical adjustments, revisions, and tweaks, is the risk of contamination of bias.

We previously proposed a much simpler method to use for smoothing volatile monthly data using a 12-month moving average of the raw data as shown below.

Notice that near peaks of employment cycles the BLS employment data deviates from the 12-month average, or rather “overstates” the reality. However, as we will now see to be the case, the BLS data will rapidly reconnect with 12-month average as reality emerges.

Sometimes, “simpler” gives us a better understanding of the data.

Importantly, there is one aspect to all the charts above which remains constant. No matter how you choose to look at the data, peaks in employment growth occur prior to economic contractions, rather than an acceleration of growth. 

“Okay Boomer”

Just as “baby boomers” were finally getting back to the position of being able to retire following the 2008 crash, the “bear market” has once again put those dreams on hold. Of course, there were already more individuals over the age of 55, as a percentage of that age group, in the workforce than at anytime in the last 50-years. However, we are likely going to see a very sharp drop in those numbers as “forced retirement” will surge.

The group that will to be hit the hardest are those between 25-54 years of age. With more than 15-million restaurant workers being terminated, along with retail, clerical, leisure, and hospitality workers, the damage to this demographic will be the heaviest.

There is a decent correlation between surges in the unemployment rate and the decline in the labor-force participation rate of the 25-54 age group. Given the expectation of a 15%, or greater, unemployment rate, the damage to this particular age group is going to be significant.

Unfortunately, the prime working-age group of labor force participants had only just returned to pre-2008 levels, and the same levels seen previously in 1988. Unfortunately, it may be another decade before we see those employment levels again.

Why This Matters

The employment impact is going to felt for far longer, and will be far deeper, than the majority of the mainstream media and economists expect. This is because they are still viewing this as a “singular” problem of a transitory virus.

It isn’t.

The virus was simply the catalyst which started the unwind of a decade-long period of debt accumulation and speculative excesses. Businesses, both small and large, will now go through a period of “culling the herd,” to lower operating costs and maintain profitability.

There are many businesses that will close, and never reopen. Most others will cut employment down to the bone and will be very slow to rehire as the economy begins to recover. Most importantly, wage growth was already on the decline, and will be cut deeply in the months to come.

Lower wage growth, unemployment, and a collapse in consumer confidence is going to increase the depth and duration of the recession over the months to come. The contraction in consumption will further reduce revenues and earnings for businesses which will require a deeper revaluation of asset prices. 

I just want to leave you with a statement I made previously:

In last Tuesday’s Technically Speaking post, I stated:

“From a purely technical basis, the extreme downside extension, and potential selling exhaustion, has set the markets up for a fairly strong reflexive bounce. This is where fun with math comes in.

As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance.

Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”

Chart Updated Through Monday

Not surprisingly, as we noted in this weekend’s newsletter, the headlines from the mainstream media aligned with our expectations:

So, is the bear market over? 

Are the bulls now back in charge?

Honestly, no one knows for certain. However, there are 5-questions that “Market Bulls” need to answer if the current rally is to be sustained.

These questions are not entirely technical, but since “technical analysis” is simply the visualization of market psychology, how you answer the questions will ultimately be reflected by the price dynamics of the market.

Let’s get to work.

Employment

Employment is the lifeblood of the economy.  Individuals cannot consume goods and services if they do not have a job from which they can derive income. From that consumption comes corporate profits and earnings.

Therefore, for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must work at a level that provides a sustainable living wage above the poverty level. This means full-time employment that provides benefits, and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale), which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.

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

Question:  Given that employment is just starting to decline, does such support the assumption of a continued bull market?

Personal Consumption Expenditures (PCE)

Following through from employment, once individuals receive their paycheck, they then consume goods and services in order to live.

This is a crucial economic concept to understand, which is the order in which the economy functions. Consumers must “produce” first, so they receive a paycheck, before they can “consume.”  This is also the primary problem of Stephanie Kelton’s “Modern Monetary Theory,” which disincentivizes the productive capacity of the population.

Given that Personal Consumption Expenditures (PCE) is a measure of that consumption, and comprises roughly 70% of the GDP calculation, its relative strength has great bearing on the outcome of economic growth.

More importantly, PCE is the direct contributor to the sales of corporations, which generates their gross revenue. So goes personal consumption – so goes revenue. The lower the revenue that flows into company coffers, the more inclined businesses are to cut costs, including employment and stock buybacks, to maintain profit margins.

The chart below is a comparison of the annualized change in PCE to corporate fixed investment and employment. I have made some estimates for the first quarter based on recent data points.

Question: Does the current weakness in PCE and Fixed Investment support the expectations for a continued bull market from current price levels? 

Junk Bonds & Margin Debt

While global Central Banks have lulled investors into an expanded sense of complacency through years of monetary support, it has led to willful blindness of underlying risk. As we discussed in “Investor’s Dilemma:”

“Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.”

That “stimuli” over the last decade has been Central Bank interventions. During that period, the complete lack of “fear” in markets, combined with a “chase for yield,” drove “risk” assets to record levels along with leverage. The chart below shows the relationship between margin debt (leverage), stocks, and junk bond yields (which have been inverted for better relevance.)

While asset prices declined sharply in March, it has done little to significantly revert either junk bond yields or margin debt to levels normally consistent with the beginning of a new “bull market.”

With oil prices falling below $20/bbl, a tremendous amount of debt tied to the energy space, and the impact the energy sector has on the broader economy, it is likely too soon to suggest the markets have fully “priced in” the damage being done.

Question:  What happens to asset prices if more bankruptcies and forced deleveraging occurs?

As noted above, if the “bull market” is back, then stocks should be pricing in stronger earnings going forward. However, given the potential shakeout in employment, which will lower consumption, stronger earnings, and corporate profits, are not likely in the near term.

The risk to earnings is even higher than many suspect, given that over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, but primarily through share buybacks from increased leverage. That cycle has now come to an end, but before it did it created a massive deviation of the stock market from corporate profitability.

“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

It isn’t just the deviation of asset prices from corporate profitability, which is skewed, but also reported earnings per share.

The impending recession, and consumption freeze, is going to start the mean-reversion process in both corporate profits, and earnings. I have projected the potential reversion in the chart below. The reversion in GAAP earnings is pretty calculable as swings from peaks to troughs have run on a fairly consistent trend.

Using that historical context, we can project a recession will reduce earnings to roughly $100/share. (Goldman Sachs currently estimates $110.) The resulting decline asset prices to revert valuations to a level of 18x (still high) trailing earnings would suggest a level of 1800 for the S&P 500 index. (Yesterday’s close of 2626 is still way to elevated.)

The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows corporate profits as a percentage of GDP relative to the annual change in GDP. The last time that corporate profits diverged from GDP, it was unable to sustain that divergence for long. As the economy declines, so will corporate profits and earnings.

Question: How long can asset prices remain divorced from falling corporate profits and weaker economic growth?

Technical Pressure

Given all of the issues discussed above, which must ultimately be reflected in market prices, the technical picture of the market also suggests the recent “bear market” rally will likely fade sooner than later. As noted above”

“Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”

Importantly, despite the sizable rally, participation has remained extraordinarily weak. If the market was seeing strong buying, as suggested by the media, then we should see sizable upticks in the percent measures of advancing issues, issues at new highs, and a rising number of stocks above their 200-dma.

However, on a longer-term basis, since this is the end of the month, and quarter, we can look at our quarterly buy/sell indication which has triggered a “sell” signal for the first time since 2015. While such a signal does not demand a major reversion, it does suggest there is likely more risk to the markets currently than many expect.

The Bear Still Rules

This past week, we published several pieces of analysis for our RIAPro Subscribers (30-Day Risk Free Trial) discussing why this was a “bear market rally” to be sold into. On Friday, our colleague, Jeffery Marcus of TP Analystics, penned the following:

1. The long term bull pattern that existed since the 3/9/09 is over. That means the pattern of investors confidently buying every decline is over.
2. The market became historically oversold on 3/23 using many metrics, and that oversold condition coincided with the long term support area of S&P 500 2110-2180.
3. The short-covering and rebalancing had a lot to do with the size and speed of the 3-day rally.  Also, we know the lack of  ETF liquidity played a huge role as well as algorithmic trading.
4. Technically the market can still go up 6.9% higher from here to hit the 50% retracement level (3386 – 2237 = 1149/2 = 574 + 2237 = 2811….2811/2630 = +6.9%.) I would not bet on it.
5. The market only sustains a rally once there is light at the Coronavirus tunnel. 
6. I do not think the S&P 500 will hit a new high this year. Maybe not in 2021, either.

His analysis agrees with our own, which we discussed with you last week.

“The good news is the markets are now more extremely oversold on a variety of measures than at just about any other point in history.

Warning: Any reversal will NOT BE the bear market bottom. It will be a ‘bear market’ rally you will want to ‘sell’ into. The reason is there are still many investors trapped in ‘buy and hold’ and ‘passive indexing’ strategies that are actively seeking an exit. Any rallies will be met with redemptions.

Most importantly, all of our long-term weekly ‘sell signals’ have now been triggered. Such would suggest that a rally back to the ‘bullish trend line’ from 2009 will likely be the best opportunity to ‘sell’ before the ‘bear market’ finds its final low.”

Last week’s chart updated through Friday’s close.

While the recent lows may indeed turn out to be “the bottom,” I highly suspect they won’t. Given the sell signals have been registered at such high levels, the time, and distance, needed to reverse the excesses will require a deeper market draw.

As Jeff Hirsch from Stocktrader’s Alamanc noted:

“While we are all rooting for the market to find support here so much damage has been done. A great deal of uncertainty remains for the economy and health crisis. This looks like a bear market bounce. 

History suggests that we are in for some tough sledding in the market this year with quite a bit of chop. When the January Barometer came in with a negative reading, our outlook for 2020 began to diminish as every down January since 1950 has been followed by a new or continuing bear market, a 10% correction, or a flat year. Then another warning sign flashed when DJIA closed below its December closing low on February 26, 2020 as the impact of this novel coronavirus began to take its toll on Wall Street.

In the March Outlook, we presented this graph of the composite seasonal pattern for the 22 years since 1950 when both the January Barometer as measured by the S&P 500 were down, and the Dow closed below its previous December closing low in the first quarter. Below is a graph of DJIA, S&P 500 and NASDAQ Composite for 2020 year-to-date as of the close on March 25. Comparing 2020 market action to these 22 years, suggests a choppy year ahead with the potential for several tests of the recent low.”

“The depth of this waterfall decline may be too deep for the market to rebound quickly. This bear market also put this year’s Best Six Months (November-April) at risk of being negative. The record of down Best Six Months is not encouraging and it reminds us of a salient quote from the Almanac from an old market sage,

‘If the market does not rally, as it should during bullish seasonal periods, it is a sign that other forces are stronger and that when the seasonal period ends those forces will really have their say.’— Edson Gould (Stock market analyst, Findings & Forecasts, 1902-1987)'”

On a short-term basis, the market is also suggesting some risk. The daily chart below shows the market rallied to, and failed at, the first level of the Fibonacci retracement we outlined last week, suggesting profits be taken at this level. While there are two remaining targets for the bear market rally, the probabilities weigh heavily against them. (This doesn’t mean they can’t be achieved, it is “possible,” just not “probable.”)

Furthermore, with the “Death Cross” triggering on Friday (the 50-dma crossing below the 200-dma), this will put further downside pressure on any “bear market” advance from current levels.

Given the magnitude, and multiple confirmations, of these signals, it is far too soon to assume the “bear market” is over. This is particularly the case, given the sell-off is less than one-month-old.

Bear markets, and recessions, tend to last 18-months on average.

The current bear market and recession are not the results of just the “coronavirus” shock. It is the result of many simultaneous shocks from:

• Economic disruption
• Surging unemployment
• Oil price shock
• Collapsing consumer confidence, and
• Most importantly, a “credit event.”

We likely have more to go before we can safely assume we have turned the corner.

In the meantime, use rallies to raise cash. Don’t worry about trying to “buy the bottom.” There will be plenty of time to see “THE” bottom is in, and having cash will allow you to “buy stocks” from the last of the “weak hands.” 

The Bear Still Rules

This past week, we published several pieces of analysis for our RIAPro Subscribers (30-Day Risk Free Trial) discussing why this was a “bear market rally” to be sold into. On Friday, our colleague, Jeffery Marcus of TP Analystics, penned the following:

1. The long term bull pattern that existed since the 3/9/09 is over. That means the pattern of investors confidently buying every decline is over.
2. The market became historically oversold on 3/23 using many metrics, and that oversold condition coincided with the long term support area of S&P 500 2110-2180.
3. The short-covering and rebalancing had a lot to do with the size and speed of the 3-day rally.  Also, we know the lack of  ETF liquidity played a huge role as well as algorithmic trading.
4. Technically the market can still go up 6.9% higher from here to hit the 50% retracement level (3386 – 2237 = 1149/2 = 574 + 2237 = 2811….2811/2630 = +6.9%.) I would not bet on it.
5. The market only sustains a rally once there is light at the Coronavirus tunnel. 
6. I do not think the S&P 500 will hit a new high this year. Maybe not in 2021, either.

His analysis agrees with our own, which we discussed with you last week.

“The good news is the markets are now more extremely oversold on a variety of measures than at just about any other point in history.

Warning: Any reversal will NOT BE the bear market bottom. It will be a ‘bear market’ rally you will want to ‘sell’ into. The reason is there are still many investors trapped in ‘buy and hold’ and ‘passive indexing’ strategies that are actively seeking an exit. Any rallies will be met with redemptions.

Most importantly, all of our long-term weekly ‘sell signals’ have now been triggered. Such would suggest that a rally back to the ‘bullish trend line’ from 2009 will likely be the best opportunity to ‘sell’ before the ‘bear market’ finds its final low.”

Last week’s chart updated through Friday’s close.

While the recent lows may indeed turn out to be “the bottom,” I highly suspect they won’t. Given the sell signals have been registered at such high levels, the time, and distance, needed to reverse the excesses will require a deeper market draw.

As Jeff Hirsch from Stocktrader’s Alamanc noted:

“While we are all rooting for the market to find support here so much damage has been done. A great deal of uncertainty remains for the economy and health crisis. This looks like a bear market bounce. 

History suggests that we are in for some tough sledding in the market this year with quite a bit of chop. When the January Barometer came in with a negative reading, our outlook for 2020 began to diminish as every down January since 1950 has been followed by a new or continuing bear market, a 10% correction, or a flat year. Then another warning sign flashed when DJIA closed below its December closing low on February 26, 2020 as the impact of this novel coronavirus began to take its toll on Wall Street.

In the March Outlook, we presented this graph of the composite seasonal pattern for the 22 years since 1950 when both the January Barometer as measured by the S&P 500 were down, and the Dow closed below its previous December closing low in the first quarter. Below is a graph of DJIA, S&P 500 and NASDAQ Composite for 2020 year-to-date as of the close on March 25. Comparing 2020 market action to these 22 years, suggests a choppy year ahead with the potential for several tests of the recent low.”

“The depth of this waterfall decline may be too deep for the market to rebound quickly. This bear market also put this year’s Best Six Months (November-April) at risk of being negative. The record of down Best Six Months is not encouraging and it reminds us of a salient quote from the Almanac from an old market sage,

‘If the market does not rally, as it should during bullish seasonal periods, it is a sign that other forces are stronger and that when the seasonal period ends those forces will really have their say.’— Edson Gould (Stock market analyst, Findings & Forecasts, 1902-1987)'”

On a short-term basis, the market is also suggesting some risk. The daily chart below shows the market rallied to, and failed at, the first level of the Fibonacci retracement we outlined last week, suggesting profits be taken at this level. While there are two remaining targets for the bear market rally, the probabilities weigh heavily against them. (This doesn’t mean they can’t be achieved, it is “possible,” just not “probable.”)

Furthermore, with the “Death Cross” triggering on Friday (the 50-dma crossing below the 200-dma), this will put further downside pressure on any “bear market” advance from current levels.

Given the magnitude, and multiple confirmations, of these signals, it is far too soon to assume the “bear market” is over. This is particularly the case, given the sell-off is less than one-month-old.

Bear markets, and recessions, tend to last 18-months on average.

The current bear market and recession are not the results of just the “coronavirus” shock. It is the result of many simultaneous shocks from:

• Economic disruption
• Surging unemployment
• Oil price shock
• Collapsing consumer confidence, and
• Most importantly, a “credit event.”

We likely have more to go before we can safely assume we have turned the corner.

In the meantime, use rallies to raise cash. Don’t worry about trying to “buy the bottom.” There will be plenty of time to see “THE” bottom is in, and having cash will allow you to “buy stocks” from the last of the “weak hands.” 

We know you get busy and don’t check our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything you might have missed.

The Week In Blogs

________________________________________________________________________________

Our Latest Newsletter

________________________________________________________________________________

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

________________________________________________________________________________

The Best Of “The Lance Roberts Show

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The 2020 Investment Summit is coming April 2nd. – A “socially distant” investment summit and outlook from our special guests covering the markets, outlook for the economy, and what you should be doing with you money now.

IT’S FREE – But We Need Your Email Address To Send You The Link To This Exclusive Event

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Our Best Tweets Of The Week

See you next week!

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk,” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

‘On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.’

Importantly, we did not ‘sell everything’ and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

On Friday/Monday, our ‘limits’ were breached, which required us to sell more.”

There are a couple of important things to understand about our current equity exposure. 

To begin with, we never go to 100% cash. The reason is that “psychologically” it is too difficult for clients to start “buying” when the market finally bottoms. Seeing the market begin to recover, along with their portfolio, makes it easier to fight the fear the market is “going to zero.”

Secondly, and most importantly, at just 10% in current equity exposure, the market could literally fall 100% and our portfolios would only decline by 10%. (Of course, given we still have 90% of our capital left, we can buy a tremendous amount of “free assets.”)

Of course, the market isn’t going to zero.

However, let’s map out a more realistic example. 

In this week’s MacroView, we discussed the “valuation” issue

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

However, here is the math:

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

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

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

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

The answer to the question is simply this:

“When is it time to start buying the market? When you do NOT want to.”

Bond Market Implosion

At the moment, the Federal Reserve is fighting a potentially losing battle – the bond market. 

• After cutting rates to zero and launching QE of $700 billion – the markets crashed. 
• The ECB starts an $800 billion QE program, and the markets fail to move. 
• The Fed injected liquidity into money markets, the credit market, and is buying municipal bonds. 
• And the market crashed more. 

The Fed has literally turned on a “garden hose” to extinguish a literal “bon(d)fire.” 

This was no more evident than their action this past week to revive a program from the financial crisis called the Primary Dealer Credit Facility (PDCF) to bailout hedge funds and banks. Via Mike Witney:

“The Fed is reopening its most controversial and despised crisis-era bailout facility, the Primary Dealer Credit Facility. The facility’s real purpose is to transfer the toxic bonds and securities from failing financial institutions and corporations (through an intermediary) onto the Fed’s balance sheet.

The objective of this sleight of hand is to recapitalize big investors who, through their own bad bets, are now either underwater or in deep trouble. Just like 2008, the Fed is now doing everything in its power to save its friends and mop up the ocean of red ink that was generated during the 10-year orgy of speculation that has ended in crashing markets and a wave of deflation. Check out this excerpt from an article at Wall Street on Parade. Here’s an excerpt:

“Veterans on Wall Street think of the PDCF as the cash-for-trash facility, where Wall Street’s toxic waste from a decade of irresponsible trading and lending, will be purged from the balance sheets of the Wall Street firms and handed over to the balance sheet of the Federal Reserve – just as it was during the last financial crisis on Wall Street.”

– (“Fed Announces Program for Wall Street Banks to Pledge Plunging Stocks to Get Trillions in Loans at ¼ Percent Interest” Wall Street on Parade)

In other words, the PDCF is a landfill for distressed assets that have lost much of their value and for which there is little or no demand. And, as bad as that sounds, the details about the resuscitated PDCF are much worse.”

If you have any doubt how bad it is in the bond market, just take a look at what happened to both investment grade and junk bond spreads. (Charts courtesy of David Rosenberg)

As they say: “That clearly ain’t normal.” 

More importantly, the “Bear Market” won’t be over until the credit markets get fixed.

Hunting The Bear

It was a pretty stunning week in the market. Over the last 5-days, the market declined an astonishing, or should I say breathtaking, 15%. The last time we saw a one week decline of that magnitude was during the “Lehman” crisis. (Of course, with hedge funds blowing up all week, this is precisely what the Fed has been bailing out.)

Since the peak of the market at the end of February, the market is now down a whopping 32%.

Surely, we are close to a bottom?

Let’s revisit our daily and weekly charts for some clues as to where we are, what could happen next, and what actions to take.

On a daily basis, the market is extremely stretched and deviated to the downside. Friday’s selloff smacked of an “Oriental Rug Company” where it was an “Everything Must Go Liquidation Event.” 

Remember all those headlines from early this year:

Well….

This selloff completely reversed the entire advance from the 2018 lows. That’s the bad news.

The good news is the markets are now more extremely oversold on a variety of measures than at just about any other point in history. 

Such a reversal, particularly given the “speed and magnitude” of the decline, argues for a “reversal” of some sort. 

Warning: Any reversal will NOT BE the bear market bottom. It will be a “bear market” rally you will want to “sell” into. The reason is there are still many investors trapped in “buy and hold” and “passive indexing” strategies which are actively seeking an exit. Any rallies will be met with redemptions.

As noted above, bear markets do not end with investors wanting to “buy” the market. They end when “everyone wants to sell.” 

And, NO, investors are “not different this time.” 

This “bear market” rally scenario becomes more evident when we view our longer-term weekly “sell signals.”  As we warned last week:

“With all of our signals now triggered from fairly high levels, it suggests the current selloff is not over as of yet. In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in.” 

Unfortunately, we have yet to see any attempt at a sustained rally. 

More importantly, with the failure of the markets to hold lows this week, both of our long-term weekly “sell signals” have now been triggered. Such would suggest that a rally back to the “bullish trend line” from 2009 will likely be the best opportunity to “sell” before the “bear market” finds its final low.

Where will that low likely be:

Let’s update our mapping from last week:

1. A retest of current lows that holds is a 27% decline. – Failed
2. A retest of the 2018 lows, which is most likely, an average recessionary decline of 32.8% – Current
3. A retest of the 2016 lows, coincident with a “credit event,” would entail a 50.9% decline.  – Pending Possibility.

Given the magnitude, and multiple confirmations, of these signals, it is far too soon to assume the “bear market” is over. This is particularly the case, given the selloff is less than one-month old.

Bear markets, and recessions, tend to last 18-months on average.

The current bear market and recession are not the result of just the “coronavirus” shock. It is the result of many simultaneous shocks from:

• Economic disruption
• Surging unemployment
• Oil price shock
• Collapsing consumer confidence, and
• A “credit event.”

We likely have more to go before we can safely assume we have turned the corner.

In the meantime, use rallies to raise cash. Don’t worry about trying to “buy the bottom.” There will be plenty of time to see “THE” bottom is in, and having cash will allow you to “buy stocks” from the last of the “weak hands.” 

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk,” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

‘On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.’

Importantly, we did not ‘sell everything’ and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

On Friday/Monday, our ‘limits’ were breached, which required us to sell more.”

There are a couple of important things to understand about our current equity exposure. 

To begin with, we never go to 100% cash. The reason is that “psychologically” it is too difficult for clients to start “buying” when the market finally bottoms. Seeing the market begin to recover, along with their portfolio, makes it easier to fight the fear the market is “going to zero.”

Secondly, and most importantly, at just 10% in current equity exposure, the market could literally fall 100% and our portfolios would only decline by 10%. (Of course, given we still have 90% of our capital left, we can buy a tremendous amount of “free assets.”)

Of course, the market isn’t going to zero.

However, let’s map out a more realistic example. 

In this week’s MacroView, we discussed the “valuation” issue

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

However, here is the math:

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

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

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

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

The answer to the question is simply this:

“When is it time to start buying the market? When you do NOT want to.”

Bond Market Implosion

At the moment, the Federal Reserve is fighting a potentially losing battle – the bond market. 

• After cutting rates to zero and launching QE of $700 billion – the markets crashed. 
• The ECB starts an $800 billion QE program, and the markets fail to move. 
• The Fed injected liquidity into money markets, the credit market, and is buying municipal bonds. 
• And the market crashed more. 

The Fed has literally turned on a “garden hose” to extinguish a literal “bon(d)fire.” 

This was no more evident than their action this past week to revive a program from the financial crisis called the Primary Dealer Credit Facility (PDCF) to bailout hedge funds and banks. Via Mike Witney:

“The Fed is reopening its most controversial and despised crisis-era bailout facility, the Primary Dealer Credit Facility. The facility’s real purpose is to transfer the toxic bonds and securities from failing financial institutions and corporations (through an intermediary) onto the Fed’s balance sheet.

The objective of this sleight of hand is to recapitalize big investors who, through their own bad bets, are now either underwater or in deep trouble. Just like 2008, the Fed is now doing everything in its power to save its friends and mop up the ocean of red ink that was generated during the 10-year orgy of speculation that has ended in crashing markets and a wave of deflation. Check out this excerpt from an article at Wall Street on Parade. Here’s an excerpt:

“Veterans on Wall Street think of the PDCF as the cash-for-trash facility, where Wall Street’s toxic waste from a decade of irresponsible trading and lending, will be purged from the balance sheets of the Wall Street firms and handed over to the balance sheet of the Federal Reserve – just as it was during the last financial crisis on Wall Street.”

– (“Fed Announces Program for Wall Street Banks to Pledge Plunging Stocks to Get Trillions in Loans at ¼ Percent Interest” Wall Street on Parade)

In other words, the PDCF is a landfill for distressed assets that have lost much of their value and for which there is little or no demand. And, as bad as that sounds, the details about the resuscitated PDCF are much worse.”

If you have any doubt how bad it is in the bond market, just take a look at what happened to both investment grade and junk bond spreads. (Charts courtesy of David Rosenberg)

As they say: “That clearly ain’t normal.” 

More importantly, the “Bear Market” won’t be over until the credit markets get fixed.

Hunting The Bear

It was a pretty stunning week in the market. Over the last 5-days, the market declined an astonishing, or should I say breathtaking, 15%. The last time we saw a one week decline of that magnitude was during the “Lehman” crisis. (Of course, with hedge funds blowing up all week, this is precisely what the Fed has been bailing out.)

Since the peak of the market at the end of February, the market is now down a whopping 32%.

Surely, we are close to a bottom?

Let’s revisit our daily and weekly charts for some clues as to where we are, what could happen next, and what actions to take.

On a daily basis, the market is extremely stretched and deviated to the downside. Friday’s selloff smacked of an “Oriental Rug Company” where it was an “Everything Must Go Liquidation Event.” 

Remember all those headlines from early this year:

Well….

This selloff completely reversed the entire advance from the 2018 lows. That’s the bad news.

The good news is the markets are now more extremely oversold on a variety of measures than at just about any other point in history. 

Such a reversal, particularly given the “speed and magnitude” of the decline, argues for a “reversal” of some sort. 

Warning: Any reversal will NOT BE the bear market bottom. It will be a “bear market” rally you will want to “sell” into. The reason is there are still many investors trapped in “buy and hold” and “passive indexing” strategies which are actively seeking an exit. Any rallies will be met with redemptions.

As noted above, bear markets do not end with investors wanting to “buy” the market. They end when “everyone wants to sell.” 

And, NO, investors are “not different this time.” 

This “bear market” rally scenario becomes more evident when we view our longer-term weekly “sell signals.”  As we warned last week:

“With all of our signals now triggered from fairly high levels, it suggests the current selloff is not over as of yet. In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in.” 

Unfortunately, we have yet to see any attempt at a sustained rally. 

More importantly, with the failure of the markets to hold lows this week, both of our long-term weekly “sell signals” have now been triggered. Such would suggest that a rally back to the “bullish trend line” from 2009 will likely be the best opportunity to “sell” before the “bear market” finds its final low.

Where will that low likely be:

Let’s update our mapping from last week:

1. A retest of current lows that holds is a 27% decline. – Failed
2. A retest of the 2018 lows, which is most likely, an average recessionary decline of 32.8% – Current
3. A retest of the 2016 lows, coincident with a “credit event,” would entail a 50.9% decline.  – Pending Possibility.

Given the magnitude, and multiple confirmations, of these signals, it is far too soon to assume the “bear market” is over. This is particularly the case, given the selloff is less than one-month old.

Bear markets, and recessions, tend to last 18-months on average.

The current bear market and recession are not the result of just the “coronavirus” shock. It is the result of many simultaneous shocks from:

• Economic disruption
• Surging unemployment
• Oil price shock
• Collapsing consumer confidence, and
• A “credit event.”

We likely have more to go before we can safely assume we have turned the corner.

In the meantime, use rallies to raise cash. Don’t worry about trying to “buy the bottom.” There will be plenty of time to see “THE” bottom is in, and having cash will allow you to “buy stocks” from the last of the “weak hands.” 

We know you get busy and don’t check our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything you might have missed.

The Week In Blogs

________________________________________________________________________________

Our Latest Newsletter

________________________________________________________________________________

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

________________________________________________________________________________

The Best Of “The Lance Roberts Show

________________________________________________________________________________

Video Of The Week A

Michael Lebowitz, CFA and I dig into the financial markets, the Fed’s bailouts, and what potentially happens next and what we are looking for. (Also, our take on corporate bailouts, and why, I can’t believe I am saying this, we mostly agree with Elizabeth Warren.)

________________________________________________________________________________

Our Best Tweets Of The Week

See you next week!

I have been slammed with emails over the last couple of days asking the following questions:

“What just happened to my bonds?”

“What happened to my gold position, shouldn’t it be going up?”

“Why are all my stocks being flushed at the same time?”

As noted by Zerohedge:

“Stocks down, Bonds down, credit down, gold down, oil down, copper down, crypto down, global systemically important banks down, and liquidity down…

Today was the worst day for a combined equity/bond portfolio… ever…”

This Is What A “Margin Call,” Looks Like.

In December 2018, we warned of the risk. At that time, the market was dropping sharply, and Mark Hulbert wrote an article dismissing the risk of margin debt. To wit:

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

According to research conducted in the 1970s by Norman Fosback, then the president of the Institute for Econometric Research, there is an 85% probability that a bull market is in progress when margin debt is above its 12-month moving average, in contrast to just a 41% probability when it’s below.

Why, then, do I suggest not becoming overly pessimistic? For several reasons:

1) The margin debt indicator issues many false signals

2) There is insufficient data

3) Margin debt is a strong coincident indicator.”

I disagreed with Mark on several points at the time. But fortunately the Federal Reserve’s reversal on monetary policy kept the stock market from sinking to levels that would trigger “margin calls.”

As I noted then, margin debt is not a technical indicator that can be used to trade markets. Margin debt is the “gasoline,” which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that “leverage” also works in reverse as it provides the accelerant for larger declines as lenders “force” the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important and is what is currently happening in the market.

The issue with margin debt, in terms of the biggest risk, is the unwinding of leverage is NOT at the investor’s discretion.

It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) 

When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

When an “event” occurs that causes lenders to “panic” and call in margin loans, things progress very quickly as the “math” becomes a problem. Here is a simple example.

“If you buy $100,000 of stock on margin, you only need to pay $50,000. Seems like a great deal, especially if the stock price goes up. But what if your stock drops to $60,000? Suddenly, you’ve lost $40,000, leaving you with only $10,000 in your margin account. The rules state that you need to have at least 25 percent of the $60,000 stock value in your account, which is $15,000. So not only do you lose $40,000, but you have to deposit an additional $5,000 in your margin account to stay in business.“

However, when margin calls occur, and equity is sold to meet the call, the equity in the portfolio is reduced further. Any subsequent price decline requires additional coverage leading to a “death spiral” until the margin line is covered.

Example:

• $100,000 portfolio declines to $60,000. Requiring a margin call of $5000.
• You have to deposit $5000, or sell to cover. 
• However, if you don’t have the cash, then a problem arises. The sell of equity reduces the collateral requirement requiring a larger transaction: $5000/.25% requirement = $20,000
• With the margin requirement met, a balance of $40,000 remains in the account with a $10,000 margin requirement. 
• The next morning, the market declines again, triggering another margin call. 
• Wash, rinse, repeat until broke.

This is why you should NEVER invest on margin unless you always have the cash to cover.

Just 20% 

As I discussed previously, the level we suspected would trigger a margin event was roughly a 20% decline from the peak.

“If such a decline triggers a 20% fall from the peak, which is around 2340 currently, broker-dealers are likely going to start tightening up margin requirements and requiring coverage of outstanding margin lines.

This is just a guess…it could be at any point at which “credit-risk” becomes a concern. The important point is that ‘when’ it occurs, it will start a ‘liquidation cycle’ as ‘margin calls’ trigger more selling which leads to more margin calls. This cycle will continue until the liquidation process is complete.

The Dow Jones provided the clearest picture of the acceleration in selling as “margin calls” kicked in.

The last time we saw such an event was in 2008.

How Much More Is There To Go?

Unfortunately, FINRA only updates margin debt with about a 2-month lag.

Mark’s second point was a lack of data. This isn’t actually the case as margin debt has been tracked back to 1959. However, for clarity, let’s just start with data back to 1980. The chart below tracks two things:

1. The actual level of margin debt, and;
2. The level of “free cash” balances which is the difference between cash and borrowed funds (net cash).

As I stated above, since the data has not been updated since January, the current level of margin, and negative cash balances, has obviously been reduced, and likely sharply so.

However, previous “market bottoms,” have occurred when those negative cash balances are reverted. Given the extreme magnitude of the leverage that was outstanding, I highly suspect the “reversion” is yet complete. 

The relationship between cash balances and the market is better illustrated in the next chart. I have inverted free cash balances, to show the relationship between reversals in margin debt and the market. Given the market has only declined by roughly 30% to date, there is likely more to go. This doesn’t mean a fairly sharp reflexive bounce can’t occur before a further liquidation ensues.

If we invert margin debt to the S&P 500, you can see the magnitude of both previous market declines and margin liquidation cycles. As stated, this data is as of January, and margin balances will be substantially lower following the recent rout. I am just not sure we have “squeezed” the last bit of blood out of investors just yet. 

You Were Warned

I warned previously, the idea that margin debt levels are simply a function of market activity, and have no bearing on the outcome of the market, was heavily flawed.

“By itself, margin debt is inert.

Investors can leverage their existing portfolios and increase buying power to participate in rising markets. While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is ‘gasoline waiting on a match.’

When an event eventually occurs, it creates a rush to liquidate holdings. The subsequent decline in prices eventually reaches a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying ‘collateral,’ the forced sale of assets will reduce the value of the collateral, triggering further margin calls. Those margin calls will trigger more selling, forcing more margin calls, so forth and so on.

That event was the double-whammy of collapsing oil prices and the economic shutdown in response to the coronavirus.

While it is certainly hoped by many that we are closer to the end of the liquidation cycle, than the beginning, the dollar funding crisis, a blowout in debt yields, and forced selling of assets, suggests there is likely more pain to come before we are done.

It’s not too late to take actions to preserve capital now, so you have capital to invest later.

As I wrote in Tuesday’s missive “When Too Little Is Too Much:”

“With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

The good news is that a great ‘buying’ opportunity is coming. Just don’t be in a ‘rush’ to try and buy the bottom. 

I can assure you, when we ultimately see a clear ‘risk/reward’ set up to start taking on equity risk again, we will do so ‘with both hands.’ 

And we are sitting on a lot of cash just for that reason.”

You can’t “buy low,” if you don’t have anything to “buy with.”

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

• Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
• Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

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

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

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

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

However, here is the math:

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

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

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

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

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

• 20x Earnings = -16% (Total decline from peak = – 40%)
• 18x Earnings = –24.5% (Total decline from peak = – 46%)
• 15x Earnings = -37.1% (Total decline from peak = – 55%)
• 13x Earnings = –45.5% (Total decline from peak = – 61%)
• 10x Earnings = –58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

• Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
• Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

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

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

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

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

However, here is the math:

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

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

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

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

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

• 20x Earnings = -16% (Total decline from peak = – 40%)
• 18x Earnings = –24.5% (Total decline from peak = – 46%)
• 15x Earnings = -37.1% (Total decline from peak = – 55%)
• 13x Earnings = –45.5% (Total decline from peak = – 61%)
• 10x Earnings = –58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?

Probably.

But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Trading The Bounce

In January, when we discussed taking profits out of our portfolios, we noted the markets were trading at 3-standard deviations above their 200-dma, which suggested a pullback, or correction, was likely.

Now, it is the same comment in reverse. The correction over the last couple of weeks has completely reversed the previous bullish exuberance into extreme pessimism. On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. Given the oversold condition (top panel) is combined with a very deep “sell signal” in the bottom panel, it suggests a fairly vicious reflexive rally is likely as we saw on Friday.

The question, of course, is where do you sell?

Looking at the chart above, it is possible for a rally to the 38.2%, or 50% retracement levels. However, with the severity of the break below the 200-dma, the 61.8% retracement level, where the 200-dma now resides, will be very formidable resistance. With the Fed’s liquidity push, it is possible for a strong “Phase 2” rally. Our plan will be to reduce equity exposure at each level of resistance and increase our equity hedges before the “Phase 3” mauling ensues. 

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into allocation models. (Vertical black lines are buy periods)

“But Lance, how do you know that Friday wasn’t THE bottom?”

A look at longer-term time-frames gives us some clues.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is not over as of yet. In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in. 

I have mapped out the three most logical secondary bottoms for the market, so you can assess your portfolio risk accordingly. 

1. A retest of current lows that holds is a 27% decline.
2. A retest of the 2018 lows, most likely, is an average recessionary decline of 32.8%
3. A retest of the 2016 lows, coincident with a “credit event,” would entail a 50.9% decline. 

Given the weekly signals have only recently triggered, we can look at monthly data to confirm we still remain confined to a “bearish market” currently. 

On a monthly basis, sell signals have been triggered. However, these signals are NOT VALID until the end of the month. However, given the depth of the decline, it would likely require a rally back to all-time highs to reverse those signals. This is a very high improbability.

Assuming the signals remain, there is an important message being sent, as noted in the top panel. The “negative divergence” of relative strength has only been seen prior to the start of the previous two bear markets, and the 2015-2016 slog. While the current selloff resembles what we saw in late 2015, there is a risk of this developing into a recessionary bear market later this summer. The market is holding the 4-year moving average, which is “make or break” for the bull market trend from the 2009 lows.

However, we suspect those levels will eventually be taken out. Caution is advised.

What We Are Thinking

Since January, we have been regularly discussing taking profits in positions, rebalancing portfolio risks, and, most recently, moving out of areas subject to slower economic growth, supply-chain shutdowns, and the collapse in energy prices. This led us to eliminate all holdings in international, emerging markets, small-cap, mid-cap, financials, transportation, industrials, materials, and energy markets. (RIAPRO Subscribers were notified real-time of changes to our portfolios.)

There is “some truth” to the statement “that no one” could have seen the fallout of the “coronavirus” being escalated by an “oil price” war. However, there have been mounting risks for quite some time from valuations, to price deviations, and a complete disregard of risk by investors. While we have been discussing these issues with you, and making you aware of the risks, it was often deemed as “just being bearish” in the midst of a “bullish rally.” However, it is managing these types of risks, which is ultimately what clients pay advisors for.

It isn’t a perfect science. In times like these, it gets downright messy. But this is where working to preserve capital and limit drawdowns becomes most important. Not just from reducing the recovery time back to breakeven, but in also reducing the “psychological stress,” which leads individuals to make poor investment decisions over time.

As noted last week:

“Given the extreme oversold and deviated measures of current market prices, we are looking for a reflexive rally that we can further reduce risk into, add hedges, and stabilize portfolios for the duration of the correction. When it is clear, the correction, or worse a bear market, is complete, we will reallocate capital back to equities at better risk/reward measures.”

We highly suspect that we have seen the highs for the year. Most likely, we are moving into an environment where portfolio management will be more tactical in nature, versus buying and holding. 

Take some action on this rally. 

If this is a “Phase 2” relief rally of a bear market, you really don’t want to be around for the “final mauling.”

Trading The Bounce

In January, when we discussed taking profits out of our portfolios, we noted the markets were trading at 3-standard deviations above their 200-dma, which suggested a pullback, or correction, was likely.

Now, it is the same comment in reverse. The correction over the last couple of weeks has completely reversed the previous bullish exuberance into extreme pessimism. On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. Given the oversold condition (top panel) is combined with a very deep “sell signal” in the bottom panel, it suggests a fairly vicious reflexive rally is likely as we saw on Friday.

The question, of course, is where do you sell?

Looking at the chart above, it is possible for a rally to the 38.2%, or 50% retracement levels. However, with the severity of the break below the 200-dma, the 61.8% retracement level, where the 200-dma now resides, will be very formidable resistance. With the Fed’s liquidity push, it is possible for a strong “Phase 2” rally. Our plan will be to reduce equity exposure at each level of resistance and increase our equity hedges before the “Phase 3” mauling ensues. 

The following chart is a longer-term analysis of the market and is the format we use for “onboarding” our clients into allocation models. (Vertical black lines are buy periods)

“But Lance, how do you know that Friday wasn’t THE bottom?”

A look at longer-term time-frames gives us some clues.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is not over as of yet. In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in. 

I have mapped out the three most logical secondary bottoms for the market, so you can assess your portfolio risk accordingly. 

1. A retest of current lows that holds is a 27% decline.
2. A retest of the 2018 lows, most likely, is an average recessionary decline of 32.8%
3. A retest of the 2016 lows, coincident with a “credit event,” would entail a 50.9% decline. 

Given the weekly signals have only recently triggered, we can look at monthly data to confirm we still remain confined to a “bearish market” currently. 

On a monthly basis, sell signals have been triggered. However, these signals are NOT VALID until the end of the month. However, given the depth of the decline, it would likely require a rally back to all-time highs to reverse those signals. This is a very high improbability.

Assuming the signals remain, there is an important message being sent, as noted in the top panel. The “negative divergence” of relative strength has only been seen prior to the start of the previous two bear markets, and the 2015-2016 slog. While the current selloff resembles what we saw in late 2015, there is a risk of this developing into a recessionary bear market later this summer. The market is holding the 4-year moving average, which is “make or break” for the bull market trend from the 2009 lows.

However, we suspect those levels will eventually be taken out. Caution is advised.

What We Are Thinking

Since January, we have been regularly discussing taking profits in positions, rebalancing portfolio risks, and, most recently, moving out of areas subject to slower economic growth, supply-chain shutdowns, and the collapse in energy prices. This led us to eliminate all holdings in international, emerging markets, small-cap, mid-cap, financials, transportation, industrials, materials, and energy markets. (RIAPRO Subscribers were notified real-time of changes to our portfolios.)

There is “some truth” to the statement “that no one” could have seen the fallout of the “coronavirus” being escalated by an “oil price” war. However, there have been mounting risks for quite some time from valuations, to price deviations, and a complete disregard of risk by investors. While we have been discussing these issues with you, and making you aware of the risks, it was often deemed as “just being bearish” in the midst of a “bullish rally.” However, it is managing these types of risks, which is ultimately what clients pay advisors for.

It isn’t a perfect science. In times like these, it gets downright messy. But this is where working to preserve capital and limit drawdowns becomes most important. Not just from reducing the recovery time back to breakeven, but in also reducing the “psychological stress,” which leads individuals to make poor investment decisions over time.

As noted last week:

“Given the extreme oversold and deviated measures of current market prices, we are looking for a reflexive rally that we can further reduce risk into, add hedges, and stabilize portfolios for the duration of the correction. When it is clear, the correction, or worse a bear market, is complete, we will reallocate capital back to equities at better risk/reward measures.”

We highly suspect that we have seen the highs for the year. Most likely, we are moving into an environment where portfolio management will be more tactical in nature, versus buying and holding. 

Take some action on this rally. 

If this is a “Phase 2” relief rally of a bear market, you really don’t want to be around for the “final mauling.”

We know you get busy and don’t check our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything you might have missed.

The Week In Blogs

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Our Latest Newsletter

________________________________________________________________________________

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

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The Best Of “The Lance Roberts Show

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Video Of The Week A

Danny Ratliff, CFP and Lance Roberts, CIO discuss the importance of having a process during a market decline, and the importance of financial advisor to ensure you don’t make emotionally driven mistakes.

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Our Best Tweets Of The Week

See you next week!

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

1. The “corporate credit” markets are at risk of a wave of defaults.
2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
3. Stock market targets for 2020 are still too high, along with 2021.
4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
6. Economic growth is slowing.
7. Chinese economic data has weakened further.
8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
11. Valuations remain at expensive levels.
12. Long-term technical signals have become negative. 
13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
14. Rising loan delinquency rates.
15. Auto sales are signaling economic stress.
16. The yield curve is sending a clear message that something is wrong with the economy.
17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

• The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
• The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
• The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

“Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

• Downside Risk Dwarfs Upside Reward. 
• Global Growth Is Less Synchronized
• Market Structure Is One-Sided and Worrisome. 
• COVID-19 Impacts To The Global Supply Chain Are Intensifying
• Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
• Peak Buybacks
• China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
• The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
• The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

• Patience is one of the most valuable attributes in investing.

• Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
• Success means making profits and avoiding losses.
• Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
• The trend is your friend.
• The problem with most people who play the market is that they are not flexible.
• Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
• I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
• To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!

• The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.

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Back To Selling Rallies

“At market extremes you are trading nothing but psychology. So…is it time to sell panic? Or is the hysteria just beginning?  What’s your time frame? What’s your pain threshold? Volatility has exploded as liquidity has vanished. Bid/offer spreads are wide but not deep. Credit spreads are widening. Here are some stats from the past week:

• The 10 year UST yield has dropped from ~1.6% to ~0.8% in just 12 trading sessions.
• Gold is up ~$100,
• WTI is down ~$12 (a 4 year low,)
• S&P is down ~500 points, and
• The US Dollar Index has tumbled from a 2 year high to a 1 year low.
• The CNN Fear/Greed barometer is at 5.“ – Victor Adair, Polar Futures Group

I have been in this business for a long-time and have rarely seen moves this extreme in a two-week period. For the average investor, it is nearly impossible to stomach. It is times like these, which we have repeatedly warned about, that “buy and hold” strategies become “How Do I Get Out?”

Last week, we discussed the risk with our RIAPro Subscribers (30-Day Risk-Free Trial):

The “equity exposure” in our portfolio models is driven by a series of “weekly signals” which we use to control risk. Importantly, it requires a “confirmation” of the indicators to adjust risk exposure in portfolios accordingly. 

On Friday, the markets confirmed that risk exposure in portfolios should be reduced lower for now. Fortunately, we have been reducing risk over the last 6-weeks, as noted above, but the signals have now confirmed our previous actions were correct. If the market breaks the 2-year moving average, we will need to substantially reduce risk further. 

As I said above, I am reprinting our rules from last week to use on any rally into the “sell zone” over the next week.

These are the same rules we use to reduce the risk in our portfolio management process, with the exception of #7.

We know you get busy and don’t check our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything you might have missed.

The Week In Blogs

________________________________________________________________________________

Our Latest Newsletter

________________________________________________________________________________

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

________________________________________________________________________________

The Best Of “The Lance Roberts Show

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Video Of The Week

Mike Lebowitz and I dig into the wild market swings, COVID-19, and what, if anything, the Fed can do about it.

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Our Best Tweets Of The Week

See you next week!

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

“Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

1. Tighten up stop-loss levels to current support levels for each position.
2. Take profits in positions that have been big winners
3. Sell laggards and losers
4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

1. Determine areas requiring new or increased exposure.
2. Determine how many shares need to be purchased to fill allocation requirements.
3. Determine cash requirements to make purchases.
4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
5. Determine entry price levels for each new position.
6. Determine “stop loss” levels for each position.
7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.

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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.

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.”

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.” 

We know you get busy and don’t check our website as often as you might like. Plus, with so much content being pushed out every week from the RIA Team, we thought we would send you a weekly synopsis of everything you might have missed.

The Week In Blogs

________________________________________________________________________________

Our Latest Newsletter

________________________________________________________________________________

What You Missed At RIA Pro

RIA Pro is our premium investment analysis, research, and data service. (Click here to try it now and get 30-days free)

________________________________________________________________________________

The Best Of “The Lance Roberts Show

________________________________________________________________________________

Video Of The Week

Mike Lebowitz and I dig into the market, COVID-19, and what, if anything, the Fed can do about it.

________________________________________________________________________________

Our Best Tweets Of The Week

See you next week!

Earnings Worse Than You Think

Just like the hit series “House Of Cards,” Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C.