Where “I Bought It For The Dividend” Went Wrong

In early 2017, I warned investors about the “I bought it for the dividend” investment thesis. To wit:

“Company ABC is priced at \$20/share and pays \$1/share in a dividend each year. The dividend yield is 5%, which is calculated by dividing the \$1 cash dividend into the price of the underlying stock.

Here is the important point. You do NOT receive a ‘yield.’

What you DO receive is the \$1/share in cash paid out each year.

Yield is simply a mathematical calculation.

At that time, the article was scoffed at because we were 8-years into an unrelenting bull market where even the most stupid of investments made money.

Unfortunately, the “mean reversion” process has taken hold, which is the point where the investment thesis falls apart.

The Dangers Of “I Bought It For The Dividend”

“I don’t care about the price, I bought it for the yield.”

First of all, let’s clear up something.

In January of 2018, Exxon Mobil, for example, was slated to pay an out an annual dividend of \$3.23, and was priced at roughly \$80/share setting the yield at 4.03%. With the 10-year Treasury trading at 2.89%, the higher yield was certainly attractive.

Assuming an individual bought 100 shares at \$80 in 2018, “income” of \$323 annually would be generated.

Not too shabby.

Fast forward to today with Exxon Mobil trading at roughly \$40/share with a current dividend of \$3.48/share.

Investment Return (-\$4000.00 ) + Dividends of \$323 (Yr 1) and \$343 (Yr 2)  = Net Loss of \$3334

That’s not a good investment.

In just a moment, we will come and revisit this example with a better process.

There is another risk, which occurs during “mean reverting” events, that can leave investors stranded, and financially ruined.

Dividend Loss

When things “go wrong,” as they inevitably do, the “dividend” can, and often does, go away.

• Boeing (BA)
• Marriott (MAR)
• Ford (F)
• Delta (DAL)
• Freeport-McMoRan (FCX)
• Darden (DRI)

These companies, and many others, have all recently cut their dividends after a sharp fall in their stock prices.

I previously posted an article discussing the “Fatal Flaws In Your Financial Plan” which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to grow. The total value of the portfolio will indeed fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends usually go up even when the stock market goes down.

This comment is the basis of the “buy and hold” mentality, and many of the most common investing misconceptions.

When a recession/market reversion occurs, the “cash dividends” don’t increase, but the “yield” does as prices collapse. However, your INCOME does NOT increase. There is a risk it will decline as companies cut the dividend or eliminate it.

During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. Yes, many of those companies were major banks; however, leading up to the financial crisis, there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

But it wasn’t just 2008. It also occurred dot.com bust in 2000. In both periods, while investors lost roughly 50% of their capital, dividends were also cut on average of 12%.

While the current market correction fell almost 30% from its recent peak, what we haven’t seen just yet is the majority of dividend cuts still to come.

Naturally, not EVERY company will cut their dividends. But many did, many will, and in quite a few cases, I would expect dividends to be eliminated entirely to protect cash flows and creditors.

As we warned previously:

“Due to the Federal Reserve’s suppression of interest rates since 2009, investors have piled into dividend yielding equities, regardless of fundamentals, due to the belief ‘there is no alternative.’ The resulting ‘dividend chase’ has pushed valuations of dividend-yielding companies to excessive levels disregarding underlying fundamental weakness.

As with the ‘Nifty Fifty’ heading into the 1970s, the resulting outcome for investors was less than favorable. These periods are not isolated events. There is a high correlation between declines in asset prices, and the dividends paid out.”

Love Dividends, Love Capital More

I agree investors should own companies that pay dividends (as it is a significant portion of long-term total returns)it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress.

It is a good indicator of the strength of the underlying economy. As noted by Political Calculations recently:

Dividend cuts are one of the better near-real-time indicators of the relative health of the U.S. economy. While they slightly lag behind the actual state of the economy, dividend cuts represent one of the simplest indicators to track.

In just one week, beginning 16 March 2020, the number of dividend cuts being announced by U.S. firms spiked sharply upward, transforming 2020-Q1 from a quarter where U.S. firms were apparently performing more strongly than they had in the year-ago quarter of 2019-Q1 into one that all-but-confirms that the U.S. has swung into economic contraction.

Not surprisingly, the economic collapse, which will occur over the next couple of quarters, will lead to a massive round of dividend cuts. While investors lost 30%, or more in many cases, of their capital, they will lose the reason they were clinging on to these companies in the first place.

You Can’t Handle It

EVERY investor has a point, when prices fall far enough, regardless of the dividend being paid, they WILL capitulate, and sell the position. This point generally comes when dividends have been cut, and capital destruction has been maximized.

While individuals suggest they will remain steadfast to their discipline over the long-term, repeated studies show that few individuals actually do. As noted just recently is “Missing The 10-Best Days:”

“As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline. In other words, investors regularly suffer from the ‘buy high/sell low’ syndrome.”

Behavioral biases, specifically the “herding effect” and “loss aversion,” repeatedly leads to poor investment decision-making. In fact, Dalbar is set to release their Investor Report for 2020, and they were kind enough to send me the following graphic for investor performance through 2019. (Pre-Order The Full Report Here)

These differentials in performance can all be directly traced back to two primary factors:

• Psychology
• Lack of capital

Understanding this, it should come as no surprise during market declines, as losses mount, so does the pressure to “avert further losses” by selling. While it is generally believed dividend-yielding stocks offer protection during bear market declines, we warned previously this time could be different:

“The yield chase has manifested itself also in a massive outperformance of ‘dividend-yielding stocks’ over the broad market index. Investors are taking on excessive credit risk which is driving down yields in bonds, and pushing up valuations in traditionally mature companies to stratospheric levels. During historic market corrections, money has traditionally hidden in these ‘mature dividend yielding’ companies. This time, such rotation may be the equivalent of jumping from the ‘frying pan into the fire.’”

The chart below is the S&P 500 High Dividend Low Volatility ETF versus the S&P 500 Index. During the recent decline, dividend stocks were neither “safe,” nor “low volatility.”

But what about previous “bear markets?” Since most ETF’s didn’t exist before 2000, we can look at the “strategy” with a mutual fund like Fidelity’s Dividend Growth Fund (FDGFX)

As you can see, there is little relative “safety” during a market reversion. The pain of a 38%, 56%, or 30%, loss, can be devastating particularly when the prevailing market sentiment is one of a “can’t lose” environment. Furthermore, when it comes to dividend-yielding stocks, the psychology is no different; a 3-5% yield, and a 30-50% loss of capital, are two VERY different issues.

A Better Way To “Invest For The Dividend”

“Buy and hold” investing, even with dividends and dollar-cost-averaging, will not get you to your financial goals. (Click here for a discussion of chart)

So, what’s the better way to invest for dividends? Let’s go back to our example of Exxon Mobil for a moment. (This is for illustrative purposes only and not a recommendation.)

In 2018, Exxon Mobil broke below its 12-month moving average as the overall market begins to deteriorate.

If you had elected to sell on the break of the moving average, your exit price would have been roughly \$70/share. (For argument sake, you stayed out of the position even though XOM traded above and below the average over the next few months.)

Let’s rerun our math from above.

• In 2018, an individual bought 100 shares at \$80.
• In 2019, the individual sold 100 shares at \$70.

Investment Return (-\$1000.00 ) + Dividends of \$323 (Yr 1) and \$343 (Yr 2)  = Net Loss of \$334

Given the original \$8,000 investment has only declined to \$7,666, the individual could now buy 200 shares of Exxon Mobil with a dividend of \$3.48 and a 9.3% annual yield.

Let’s compare the two strategies.

• Buy And Hold: 100 shares bought at \$80 with a current yield of 4.35%
• Risk Managed: 200 shares bought at \$40 with a current yield of 9.3%

Which yield would you rather have in your portfolio?

In the end, we are just human. Despite the best of our intentions, emotional biases inevitably lead to poor investment decision-making. This is why all great investors have strict investment disciplines they follow to reduce the impact of emotions.

I am all for “dividend investment strategies,” in fact, dividends are a primary factor in our equity selection process. However, we also run a risk-managed strategy to ensure we have capital available to buy strong companies when the opportunity presents itself.

The majority of the time, when you hear someone say “I bought it for the dividend,” they are trying to rationalize an investment mistake. However, it is in the rationalization that the “mistake” is compounded over time. One of the most important rules of successful investors is to “cut losers short and let winners run.”

Unfortunately, the rules are REALLY hard to follow. If they were easy, then everyone would be wealthy from investing. They aren’t because investing without a discipline and strategy has horrid consequences.

Will The Corona Virus Trigger A Recession?

As if waking up to an economic nightmare, investors see headlines like these and many others flashing across their Bloomberg terminals:

• Facebook says Oculus headphone production will be delayed due to virus
• Apple extends country wide store closing for another week
• Foxconn delays iPhone production
• Qualcomm cuts production forecast due to virus uncertainty
• Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
• US Steel flashes a warning of a cut in demand
• Nike shoe production halted
• Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
• IEA forecasts drop in oil demand this quarter- first time in a decade

The seemingly never ending list of delays, disruptions, and cuts rolls on from retail to high technology. Even services are impacted as flights and train trips are canceled within and to and from China.  While some technology-based services are provided over the Internet service, restaurants, training, and consulting, as examples, must be performed in person.  Manufacturing operations require workers to be at the factory to produce products. Thus, manufacturing is much more acutely affected by quarantines, shutdowns, transportation disruption, and other government actions.

It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019.  For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year.  Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.

Source: The Wall Street Journal – 2/7/20

Prior to the epidemic, world trade had begun to slow as a result of the China – U.S. trade war and other tariffs.  World trade for the first time since the last recession has turned negative.

Source: Haver Analytics, The Wall Street Journal, The Daily Shot – 1/19/20

Based on severity estimates, analysts have forecasted the impact on first-quarter China GDP growth. In the chart below from Fitch Ratings, growth for first quarter drops almost in half and for year growth drops to 5.2 % if containment is delayed:

Sources: The Wall Street Journal, The Daily Shot – 2/6/20

When news of the virus first was announced, the market sustained a quick modest decline. The next day, investors were reassured by official news from China and the World Health Organization that the virus could be contained. Market valuations bounced on optimism that the world economy would see little to no damage in the first quarter of 2020.  Yet, there is growing skepticism that the official tolls of the virus are short of reality. Doctors report that at the epicenter of Wuhan that officials are grossly underestimating the number of people infected and dead. The London School of Hygiene and Tropical Medicine has an epidemic model indicating there will be at least 500,000 infections at the peak in a few weeks far greater than the present 45,000 officially reported.

The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain.  U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities.  The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on \$75 billion of U.S. goods, reducing tariffs by 5 to 10 %.  President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily.  It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.

Inside China, chaos in the supply chain operations is creating great uncertainty. Workers are being told to work from home and stay away from factories for at least for another week beyond the Lunar New Year and now well into late-February.  Foxconn and Tesla announced plant openings on February 10th, yet ramping up output is still an issue. It will be a challenge to staff factories as many workers are in quarantined cities and train schedules have been curtailed or canceled.  Many factories are dependent on parts from other cities around the country that may have more severe restrictions on transportation and/or workers reporting to work. Thus, even when a plant is open, it is likely to be operating at limited capacity.

On February 7th, the Federal Reserve announced that while the trade war pause has improved the global economy, it cautioned that the coronavirus posed a ‘new threat to the world economy.’  The Fed is monitoring the situation. The central bank of China infused CNY 2 trillion in the last four weeks to provide fresh liquidity.  The liquidity will help financially stretched Chinese companies survive for a while, but they are unlikely to be able to continue operations unless production and sales return to pre epidemic levels quickly.

Will the Federal Reserve really be able to buffer the supply chain disruption and sales declines in the first quarter of 2020?  The Fed already seems overwhelmed, keeping a \$1+ trillion yearly federal deficit under control and providing billions in repo financing to banks and hedge funds causing soaring prices in risk assets. While the Fed may be able to assist U.S. corporations with liquidity through a tough stretch of declining sales and supply chain disruptions, it cannot create sales or build products.

Prior to the virus crisis, CEO Confidence was at a ten year low.  Then, CEO confidence levels improved a little with the Phase One trade deal driving brighter business prospects for the coming year. Now, a possible black swan epidemic has entered the world economic stage creating extreme levels of sales and operational uncertainty.  Marc Benioff, CEO of Salesforce, expresses the anxiety many CEOs feel about trade:

“Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”

Adding to the uncertainty is a deteriorating political environment in China.  During the first few weeks of December, local Wuhan officials denounced a doctor that was calling for recognition of the new virus. He later died of the disease, triggering a social media uproar over the circumstances of his treatment. Many Chinese people have posted on social media strident criticisms of the delayed government response.  Academics have posted petitions for freedom of speech, laying the blame on government censors for making the virus outbreak worse.  The wave of freedom calls is rising as Hong Kong protester’s messages seem to be spreading to the mainland. The calls for freedom of speech and democracy are posing a major challenge to President Xi.  Food prices skyrocketed by 20 % in January with pork prices rising 116 % adding to consumer concerns. Political observers see this challenge to government policies on par with the Tiananmen Square protests in 1989. The ensuing massacre of protestors is still in the minds of many mainland people. As seems to be true of many of these events that it is not the crisis itself, but the reaction and ensuing waves of social disorder which drive a major economic impact.

Oxford Economics has forecast a slowdown in US GDP growth in the first quarter of 2020 to just .6 %

Sources: Oxford Economics, The Wall Street Journal, The Daily Shot – 2/6/20

Will U.S. GDP growth really be shaved by just .4 %?  If we consider the compounding effect of the epidemic to disrupt both demand and supply, the social chaos in China challenging government authority (i.e., Hong Kong), and a lingering trade war – these factors all make a decline into a recession a real and growing possibility.  We hope the epidemic can be contained quickly and lives saved with a return to a more certain world economy.  Yet, 1930s historical records show rising world nationalism, trade wars, and the fracturing of the world order does not bode well for a positive outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg opinion warns of a U shaped recession or worse an L :

I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”

Patrick Hill is the Editor of The Progressive Ensign, https://theprogressiveensign.com/ writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Falling Oil Prices An Economic Warning Sign

On Tuesday morning, I got engaged in a debate on the recent decline in oil prices following my report on COT Positioning in the space. To wit:

“The inherent problem with this is that if crude oil breaks below \$48/bbl, those long contracts will start to get liquidated which will likely push oil back into the low 40’s very quickly. The decline in oil is both deflationary and increases the risk of an economic recession.”

It didn’t take long before the debate started.

“Aren’t low oil prices good for the economy? They are a tax cut for the consumer?”

There is an old axiom which states that if you repeat a falsehood long enough, it will eventually be accepted as fact.

Low oil prices equating to stronger economic growth is one of those falsehoods.

Oil prices are indeed crucial to the overall economic equation, and there is a correlation between the oil prices, inflation, and interest rates.

Given that oil is consumed in virtually every aspect of our lives, from the food we eat to the products and services we buy, the demand side of the equation is a tell-tale sign of economic strength or weakness. We can see this clearly in the chart below which combines rates, inflation, and GDP into one composite indicator. One important note is that oil tends to trade along pretty defined trends (black trend lines) until it doesn’t. Importantly, since the oil industry is very manufacturing and production intensive, breaks of price trends tend to be liquidation events which has a negative impact on manufacturing and CapEx spending and feeds into the GDP calculation.

“It should not be surprising that sharp declines in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.

We can also view the impact of oil prices on inflation by looking at breakeven inflation rates as well.

The short version is that oil prices are a reflection of supply and demand. Global demand has already been falling for the last several months, and oil prices are sending warnings that “market hopes” for a “global reflation” are likely not a reality. More importantly, falling oil prices are going to put the Fed in a very tough position in the next couple of months as deflationary pressures rise. The chart below shows breakeven 5-year and 10-year inflation rates versus oil prices.

Zero Sum

The argument that lower oil prices give consumers more money to spend certainly seems entirely logical. Since we know that roughly 80% of households in America effectively live paycheck-to-paycheck, they will spend, rather than save, any extra disposable income.

However, here is the most important part of the fallacy:

“Spending in the economy is a ZERO-SUM game.”

Falling oil prices are an excellent example since gasoline sales are part of the retail sales calculation.

Let’s take a look at the following example:

• Oil Prices Decline By \$10 Per Barrel
• Gasoline Prices Fall By \$1.00 Per Gallon
• Consumer Fills Up A 16 Gallon Tank Saving \$16 (+16)
• Gas Station Revenue Falls By \$16 For The Transaction (-16)
• End Economic Result = \$0

Now, the argument is that the \$16 saved by the consumer will be spent elsewhere, which is true. However, this is the equivalent of “rearranging deck chairs on the Titanic.”

So, let’s now extend our example from above.

Oil and gasoline prices have dropped, so Elaine, who has budgeted \$100 to spend each week on retail-related purchases, goes to the gas station to fill up.

• Elaine fills up her car for \$60, which previously cost \$80. (Savings +\$20)
• Elaine then spends her normal \$20 on lunch with her friends.
• She then spends her additional \$20 (saved from her gas bill) on some flowers for the dining room.

————————————————-
Total Spending For The Week = \$100

Now, economists quickly jump on the idea that because she spent \$20 on flowers, there has been an additional boost to the economy.

However, this is not the case. Elaine may have spent her money differently this past week, but she still spent the same amount. Here is the net effect on the economy.

Gasoline Station Revenue = (-\$20)
Flower Store Revenue = +\$20
—————————————————-
Net Effect To Economy = \$0

Graphically, we can show this by analyzing real (inflation-adjusted) gasoline prices compared to total Personal Consumption Expenditures (PCE). I am using “PCE” as it is the broadest measure of consumer spending and comprises almost 70% of the entire GDP calculation.

As shown, falling gasoline prices have historically equated to lower personal consumption expenditures, and not vice-versa. In fact higher oil and gasoline prices have actually been coincident with higher rates of PCE previously. The chart below show inflation-adjusted oil prices as compared to PCE.

While the argument that declines in energy and gasoline prices should lead to stronger consumption sounds logical, the data suggests this is not the case.

What we find is there is a parity between oil price and the economy. Like “Goldilocks,” prices which are too hot, or too cold, has a negative impact on consumption and economic growth.

Importantly, regardless of the level of oil prices, the only thing which increases consumer spending are increases in INCOME, not SAVINGS. Consumers only have a finite amount of money to spend. They can choose to “save more” which is a drag on economic growth in the short-term (called the “paradox of thrift”), or they can spend what they have. But they can’t spend more, unless they take on more debt.

Which is what has been occurring as individuals struggle to fill the gap between the cost of living and incomes. (Read more on this chart)

A Bigger Drag Than The Savings

Importantly, falling oil prices are a bigger drag on economic growth than the incremental “savings” received by the consumer.

The obvious ramification of the plunge in oil prices is to the energy sector itself. As oil prices decline, the loss of revenue eventually leads to cuts in production, declines in capital expenditure plans (which comprises almost 1/4th of all CapEx expenditures in the S&P 500), freezes and/or reductions in employment, not to mention the declines in revenue and profitability.

Let’s walk through the impact of lower oil prices on the economy.

Declining oil prices lead to declining revenue for oil and gas companies. Given that drilling for oil is a very capital intensive process requiring a lot of manufactured goods, equipment, supplies, transportation, and support, the decrease in prices leads to a reduction in activity as represented by Capital Expenditures (CapEx.) The chart below shows the 6-month average of the 6-month rate of change in oil prices as compared to CapEx spending in the economy.

Of course, once CapEx is reduced the need for employment declines. However, since drilling for oil is a very intensive process, losses in employment may start with the energy companies, but eventually, all of the downstream suppliers are impacted by slower activity. As job losses rise, and incomes decline, it filters into the economy.

Importantly, when it comes to employment, the majority of the jobs “created” since the financial crisis has been lower wage-paying jobs in retail, healthcare and other service sectors of the economy. Conversely, the jobs created within the energy space are some of the highest wage paying opportunities available in engineering, technology, accounting, legal, etc.

In fact, each job created in energy-related areas has had a “ripple effect” of creating 2.8 jobs elsewhere in the economy from piping to coatings, trucking and transportation, restaurants and retail.

Given that oil prices are a reflection of global economic demand, falling oil prices have a negative feedback loop in the economy as a whole. The longer oil prices remain suppressed, the negative impacts of loss of employment, reductions in capital expenditures, and declines in corporate profitability will begin to outstrip any small economic benefit gained through consumption.

Simply put, lower oil and gasoline prices may actually have a bigger detraction on the economy than the “savings” provided to consumers.

Newton’s third law of motion states:

“For every action, there is an equal and opposite reaction.”

In any economy, nothing works in isolation. For every dollar increase that occurs in one part of the economy, there is a dollars’ worth of reduction somewhere else.

Looking Beyond Apple and Microsoft

As the 1970s came to a close, six of the world’s ten largest companies were in the oil exploration, drilling, and services business. Just a few years earlier, on April 1, 1976, Steven Jobs and Steven Wozniak, two college dropouts working out of a garage, formed Apple Computers, Inc. In April 1975, Bill Gates and Paul Allen formed a company called Micro-Soft.

Four decades later, these two technology startups are the world’s largest companies, far surpassing the largest oil companies of the 1970s. In fact, the combined market capitalization of Microsoft and Apple is larger than the aggregate market cap of the domestic oil industry. Even more astounding, the combined market cap of Microsoft and Apple just surpassed the total market cap of the entire German stock market.

The table below shows the rotation of the world’s largest publically traded companies over the last fifty years. Of the companies shown below only five have been in the top ten for more than one decade.

Throughout history, most of the world’s largest companies are routinely supplanted by new and different companies from decade to decade. Furthermore, different industries tend to dominate each decade and then fade into the next decade as new industries dominate. For instance, in the 1970’s big oil accounted for six of the top ten largest companies. In the 1980’s, Japanese companies held eight of the top ten spots. In the 1990s it was telecom, the 2000s were controlled by banks and commodities, and this past decade was dominated by technology and social media companies.

Throughout history, most of the world’s largest companies are routinely supplanted by new and different companies from decade to decade. Furthermore, different industries tend to dominate each decade and then fade into the next decade as new industries dominate. For instance, in the 1970’s big oil accounted for six of the top ten largest companies. In the 1980’s, Japanese companies held eight of the top ten spots. In the 1990s it was telecom, the 2000s were controlled by banks and commodities, and this past decade was dominated by technology and social media companies.

While table offers several insights, we believe the most important lesson is that our investment strategies must focus on the future and our dependence on past strategies must be carefully considered. Today, two college dropouts in their parent’s basement fooling around with artificial intelligence, block chain, or robotics may prove to be worth more than Apple, Microsoft, or Amazon in just a few decades. The table also emphasizes the importance of selling high and rotating to that which has “value”.

To emphasize that point, we constructed the following graph. Although simple, it effectively illustrates the theme by comparing one stock looking backward and one stock looking forward as an investment strategy. The backward-looking strategy (blue line) buys the largest company at the end of each decade and holds it through the following decade. The forward-looking strategy (orange line), with the gift of 20/20 foresight, buys the company that will be the largest company at the end of the new decade and holds it for that decade.  For example, on January 1, 2010, the forward-looking strategy bought Microsoft and held it until December 31, 2019, while the backward-looking strategy bought Exxon and held it over the same period.

Due to the split-up of AT&T and poor price data, we used GM data which had the second largest market capitalization in 1969. For similar reasons, we also replaced Nippon Telephone and Telegraph (NTT) with The Bank of Tokyo. The graph is based on share price returns and is not inclusive of dividends.

The forward strategy beat the S&P 500 by over 12% a year, while the backward-looking strategy grossly underperformed with a negative cumulative annualized price return over the last 50 years. As startling as the differences are, they fail to provide proper context for the value of 50 years of compounding at the annualized rates of return as shown. If all three portfolios started with \$100,000, the backward-looking portfolio would be worth \$59,000 today, the S&P 500 worth \$3,500,000 today, and the forward-looking portfolio would be worth \$791,000,000 today.

Summary

Although no one knows what the top ten list will look like on December 31, 2029, we do know that the next ten years will not be like the last ten. The 2000’s brought two recessions and for the first time in recorded history, the 2010s brought NO recessions. Investors need to be opportunistic, flexible, creative and forward-looking in choosing investments. Investing in today’s winners is not likely to yield us the results of yesterday. It is difficult to fathom as Apple and Microsoft drive the entire market higher, but history warns that their breath-taking returns of the last decade should not be expected in the 2020’s. In fact, history and prudence argue one should sell high.

Technically Speaking: Monthly “Buy Signal” Say Bull Is Back? But For How Long?

Just recently, there have been numerous “bullishly biased” analysts and bloggers discussing the turn up in the monthly MACD indicators as a “sure sign” the bull market rally is set to continue.

While “bullish buy signals” on any long-term indicator is indeed a positive sign, there are a few “warning labels” which must also be considered. For example:

1. Since these are monthly indicators, the signal is only valid at the end of the month. Mid-month signals can be reversed by sharp price movements.
2. No one signal provides any “certainty” about future market outcomes.
3. Time frames of signals matter. Given monthly signals are long-term in nature, the signal time frames are important in providing actionable information.

So, is the bull market back?

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. You can view an unlocked version here. (We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and commodities. You can try RIA PRO FREE for 30-days)

But as longer-term investors and portfolio managers, we are more interested in the overall trend of the market. While it is fundamental analysis derives “what” we buy, it is the long-term “price” analysis which determines the “when” of the buying and selling aspects of portfolio management over the long-term.

For us, the best measures of the TREND of the market is through longer-term weekly and monthly data. Importantly, as noted above, these longer-term data signals are only valid at the end of the period. It is not uncommon for signals to be triggered and reversed during the middle of the period, which creates “false” signals, and poor outcomes. Since we are more interested in discerning changes to the overall “trend” of the market, we find monthly indicators, which are slow-moving, tend to reveal this more clearly.

In April of 2018, I penned an article entitled 10-Reasons The Bull Market Ended,” in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. Of course, 2018 turned out to be a tough year culminating in a 20% slide into the end of the year. Since then, we have daily reminders we are “close to a trade deal,” and the Fed has completely reversed course on hiking rates and extracting liquidity. In July, we published S&P 3300, The Bull Vs. Bear Case.

While volatility and sentiment have reverted back to levels of more extreme complacency, the fundamental and economic backdrop has deteriorated further.

The first chart shows the monthly buy/sell signals stretched back to 1995 (25 Years). As shown, these monthly “buy” and “sell” indications are fairly rare over that stretch. What is interesting, is that since 2015 there have been two-major sell signals, both of which were arrested by Central Bank interventions.

Importantly, while Central Bank interventions have been able to halt declines, the trade-off has been a negative divergence in overall momentum. This negative divergence in momentum suggests that the current monthly “buy signal,” if it is able to hold through the end of December, could quickly reverse if the Fed ceases, or reduces, its current monetary interventions.

With global economic growth continuing to drag, an unresolved “trade war,””Brexit,” and weaker earnings growth, the question is whether Central Banks can accommodate the markets long-enough for all of these more negative issues to be resolved?

Given that we are 10-years into a “cyclical” bull market, and have yet to complete the second half of the “full-market” cycle, there is risk to the bullish view.

I know…I know…

“But this time is different because of ‘_(fill in the blank__'”

Maybe, I certainly won’t argue the point of Central Bankers manipulating markets currently.

However, we can take those same monthly momentum indicator above back to 1950, and add two confirming monthly indicators as well. The vertical “red dashed lines” are when all three indicators have aligned which reduces false signals.

I can’t believe I have to write the next sentence, but if I don’t, I invariably get an email saying “but if you sold out, you missed the whole rally.”

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destruction of capital, the reversal of those signals were signs to “get back in.”

Investing, long-term, is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “buy signal,” which since 1950 has been a good indication of rising markets. Yes, the bull market is back! However, when these signals have existed in a “negative tren,d,” and are diverging from the market, corrections have often followed. While the most current buy signal could indeed last for 6-months to one-year, which would conform to our cyclical indications, there are several things to consider:

1. As was seen in the 1960s and 70s, “buy signals” in the negative trend led to repeated rallies and corrections until the cycle was completed at the bottom of the 1974 bear market.
2. A rising trend in the “buy signals” was more aligned with a longer-term “secular” bull market cycle which consisted of very short-term sell signals.
3. With markets very overbought on a longer-term basis, price advances could be somewhat limited.

Yes, the recent “buy” signal could turn out to be a “1995” scenario where the market rallied almost non-stop into the “Dot.com” crash, but the fundamental and technical backdrop doesn’t really support that thesis.

Furthermore, the QUARTERLY chart remain concerning given the massive extension above the long-term trend and continued overbought conditions. Historically, reversions from such extensions above the long-term trend line have not been kind to investors.

Let me be VERY clear. Both the MONTHLY and QUARTERLY signals confirm the “bull market” that began in 2009 remains intact currently.  This is why we are maintaining our long-biased exposure in portfolios. However, the current market cycle is extremely extended and is approaching a reversion within the next 12-24 months. That reversion will likely extract most of the gains of the previous bull market. As noted this past weekend, such an occurrence would be part of a normal full-market cycle.

One of the biggest reasons not to equate the current monthly “buy” signal to a “1995” type period is valuations. In 1987, valuations were low and rising at a time where interest rates and inflation were high and falling. Today, that economic and valuation backdrop are entirely reversed.

Currently, a correction from current price levels of the market to PE20 (20x current earnings) would be a 13.8% decline. However, a drop back to the long-term average of PE15 would entail a 34.8% fall, with a full-reversion to PE10, which would be required to “reset” the market, would wipe our 56.2% of the total market value.

Emotionally, the hardest thing for investors to do is to sit on their hands and avoid “risk” when the markets are rising. But this is the psychological issue which plagues all investors over time which is to “buy high” and “sell low.”

It happens to everyone.

David Rosenberg previously summed up investor sentiment very well.

“Well, the bulls certainly are emboldened, there isn’t any doubt about that. And this confidence, bordering on hubris, is proving very difficult to break. We are back to good news being good news, and bad news is also treated as good news.”

That is indeed the situation currently. “Bad news” means more Central Bank intervention, and “good news” is, well, just good news and is taken at face value with few questions. Don’t forget that “all good things do eventually end,” and being able to identify, and act, when the change comes is what separates winners from losers.

What This Means And Doesn’t Mean

At a poker table, if you have a “so so” hand, you bet less, or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is we use this rally to take some actions to rebalance portfolios to align with some the “concerns” discussed above.

• Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)
• Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.
• Move Trailing Stop Losses Up to new levels.
• Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Here is the question you need to answer for yourself. What’s worse:

1. Missing out temporarily on the initial stages of a longer-term advance, or;
2. Spending time getting back to even, which is not the same as making money?

Currently, the monthly and quarterly indicators are indeed bullish. However, it is important to remember that it takes some time for these indicators to reverse, and issue clear signals to extract cash from the market. Currently, the risk of disappointment greatly outweighs the potential for upside surprises at this juncture.

What happens next may just surprise everyone.

Collecting Tolls On The Energy Express

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

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

The Case for MLP’s

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

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

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

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

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

Data Courtesy Bloomberg

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

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

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

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

Data Courtesy Bloomberg

Illustrating the Value Proposition

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

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

Data Courtesy Alerian and Bloomberg

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

Data Courtesy Alerian and Bloomberg

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

Data Courtesy Alerian and St. Louis Federal Reserve

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

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

Pros

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

Cons

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

Summary

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Delayed gratification is a thing of the past.

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

However, as Steve Liesman once stated on CNBC:

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

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

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

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

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

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

“The borrower is the slave to the lender.”

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

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

Consumption Is Function Of A Paycheck

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

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

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

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

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

Employment.

This should be a relatively obvious connection.

No job = No paycheck = No spending.

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

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

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

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

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

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

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

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

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

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

Conclusion

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

Will it stay that way? Probably not.

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

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

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

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

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

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

How does every bear market begin?

Slowly at first, then all of a sudden.

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

There is a disparity happening in the country.

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

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

It’s an interesting dichotomy.

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

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

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

So, who’s right?

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

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

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

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

Take a closer look at the chart above.

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

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

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

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

UofM A Better Predictor

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

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

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

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

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

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

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

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

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

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

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

As Ben Graham stated back in 1959:

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

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

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

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

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

This time will not be “different.”

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

Maybe the third time will be the “charm.”

Surging Repo Rates- Why Should I Care?

A subscriber emailed us regarding our repurchase agreement (repo) analysis from Tuesday’s Daily Commentary. Her question is, “why should I care about a surge in repo rates?” The commentary she refers to is at the end of this article.

Before answering her question, it is worth emphasizing that it is rare for overnight Fed Funds or Repo rates to spike, as happened this week, other than at quarter and year ends when bank balance sheets have little flexibility. Clearly, balance sheet constraints due to the end of a quarter or year are not causing the current situation.  Some say the current situation may be due to a lack of bank reserves which are used to make loans, but banks have almost \$2 trillion in excess cash reserves. Although there may likely be an explanation related to general bank liquidity, there is also a chance the surge in funding costs is due to a credit or geopolitical event with a bank or other entity that has yet to be disclosed to the public.

Before moving ahead, let us take a moment to clarify our definitional terms.

Fed Funds are daily overnight loans between banks that are unsecured, or not collateralized. Overnight Repo funding are also daily overnight loans but unlike Fed Funds, are backed with assets, typically U.S. Treasuries or mortgage-backed securities. The Federal Reserve has the authority to conduct financing transactions to add or subtract liquidity to ensure overnight markets trade close to the Fed Funds target. These transactions are referred to as open market operations which involve the buying or selling of Treasury bonds to increase or decrease the amount of reserves (money) in the system. Reserves regulate how much money a bank can lend. When reserves are limited, short-term interest rates among and between banks rise and conversely when reserves are abundant, funding costs fall. QE, for instance, boosted reserves by nearly \$3.5 trillion which enabled banks to provide liquidity to markets and make loans at low interest rates.

Our financial system and economy are highly leveraged. Currently, in the U.S., there is over \$60 trillion in debt versus a monetary base of \$3.3 trillion. Further, there is at least another \$10-15 trillion of dollar-based debt owed outside of the U.S.

Banks frequently have daily liquidity shortfalls or overages as they facilitate the massive amount of cash moving through the banking system. To balance their books daily, they borrow from or lend to other banks in the overnight markets to satisfy these daily imbalances. When there is more demand than supply or vice versa for overnight funds, the Fed intervenes to ensure that the overnight markets trade at, or close to, the current Fed Funds rate.

If overnight funding remains volatile and costly, banks will increase the amount of cash on hand (liquidity) to avoid higher daily costs. To facilitate more short term cash on their books, funds must be conjured by liquidating other assets they hold. The easiest assets to sell are those in the financial markets such as U.S. Treasuries, investment-grade corporate bonds, stocks, currencies, and commodities.  We may be seeing this already. To wit the following is from Bloomberg:

“What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally. After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.”

A day or two of unruly behavior in the overnight markets is not likely to meaningfully affect banks’ behaviors. However, if the banks think this will continue, they will take more aggressive actions to bolster their liquidity.

To directly answer our reader’s question and reiterating an important point made, if banks bolster liquidity, the financial markets will probably be the first place from which banks draw funds. In turn, this means that banks and their counterparties will be forced to reduce leverage used in the financial markets. Stocks, bonds, currencies, and commodities are all highly leveraged by banks and their clientele. As such, all of these markets are susceptible to selling pressure if this occurs.

We leave you with a couple of thoughts-

• If the repo rate is 3-4% above the Fed Funds rate, the borrower must either not be a bank or one that is seriously distressed. As such, is this repo event related to a hedge fund, bank or other entity that blew up when oil surged over 10% on Monday? Could it be a geopolitical related issue given events in the Middle East?
• The common explanation seems to blame the massive funding outlays due to the combination of Treasury debt funding and corporate tax remittances. While plausible, these cash flow were easy to predict and plan for weeks in advance. This does not seem like a valid excuse.

In case you missed it, here is Tuesday’s RIA repo commentary:  Yesterday afternoon, overnight borrowing costs for banks surged to 7%, well above the 2.25% Fed Funds rate. Typically the rate stays within 5-10 basis points of the Fed Funds rate. Larger variations are usually reserved for quarter and year ends when banks face balance sheet constraints. It is believed the settlement of new issue Treasury securities and the corporate tax date caused a funding shortage for banks. If that is the case, the situation should clear up in a day or two. Regardless of the cause, the condition points to a lack of liquidity in the banking sector. We will follow the situation closely as it may impact markets if it continues.

Inflation: The Fed’s False Flag

Don’t piss down my back and tell me it’s raining” –Clint Eastwood/The Outlaw Josey Wales

On April 30, 2019, one day before the Federal Reserve’s FOMC policy-setting meeting, the Wall Street Journal published an article by Nick Timiraos and Paul Kiernan entitled Inflation Is Likely to Fuel Discussions as Fed Officials Meet. We quickly recognized this article was not the thoughts of the curious authors but more than likely indirect Fed messaging.

Similar to a trial balloon, conveyances like the one linked above allow the Fed to gauge market response to new ideas and prepare the markets and public for potential changes in policy.

Based on numerous articles published over the last two weeks, we are under growing suspicion that the Fed wants us to believe we need more inflation. For their part, the Fed in the May 1, 2019, FOMC policy statement changed language from the prior statement to highlight that inflation is not running at their 2% target but it is “running below” their goal.

Is declining inflation a legitimate concern or a false flag meant to provide cover to lower rates?

Selling Deflation

The WSJ article published the day before the FOMC policy meeting has the Fed’s fingerprints all over it. The gist of the article is that inflation is running below the two percent goal and therefore needs to be addressed.

The following quotes come from that article:

• Lower inflation remains the fly in the ointment.
• Officials worry that the failure to hit the inflation target could undermine its credibility over time, which could cause consumers and businesses to expect lower inflation in the future, which in turn could cause price pressures to weaken further.
• If officials grew concerned that the (inflation) shortfall was persistent, some could push for lowering rates.

Not to be outdone, Neil Irwin of the New York Times, in discussing how the Fed might fight the next recession, stated:

“In the near term, any changes are likely to tilt policy in the direction of having lower interest rates for longer periods, with the aim of getting inflation to more consistently average 2 percent (it has been consistently below that level for years).”

These and a slew of comments from Fed officials, the media and market prognosticators lead us to believe the Fed is now using a lack of inflation to justify lowering interest rates.

First quarter 2019 GDP was just reported at 3.2% and has grown in each of the last 12 quarters, an unprecedented string of consecutive increases in GDP growth. The unemployment rate and jobless claims are at or near 50-year lows. Despite the solid economic growth and strong labor market, the amount of monetary and fiscal stimulus being employed is immense as we have documented on numerous occasions. Fed Funds at 2.5%, while off of the zero bound, is still well below rates of the prior 50 years. The Fed’s balance sheet, despite some run-off, is still four times larger than where it stood pre-financial crisis.

Since the economy and labor markets are strong and monetary policy very easy, inflation appears to be the only factor that the Fed could use to justify adopting an easier policy stance.

The Smoking Gun

Before considering inflation data, it’s worth reviewing the Fed’s thoughts about inflation as it relates to monetary policy. On October 2, 2018, Chairman Powell stated the following:

From the standpoint of contingency planning, our course is clear: Resolutely conduct policy consistent with the FOMC’s symmetric 2 percent inflation objective, and stand ready to act with authority if expectations drift materially up or down.

Given the statement above, is Inflation or inflation expectations materially changing?

Below are six charts to help you decide if inflation or inflation expectations are moving materially lower. If not, is inflation the Trojan horse that allows the Fed to lower rates despite any reasonable rationale?  All of the data for the graphs below are sourced from Bloomberg.

Fed’s Own Inflation Measures

The following two graphs are inflation indicators that the Fed created. They are designed to reduce temporary blips in the prices of all goods and services within the CPI and GDP reports. The Federal Reserve believes these measures present a more durable reading that is not as subject to transitory forces as other inflation measures.

Summary

Have inflation “expectations drift(ed) materially up or down?”

Looking at the ebbs and flows of inflation and inflation expectations of the last three years, we see no consistent change in the trend. As for the dreaded fear of deflation, the United States has not experienced it since the Great Depression in the 1930’s. In our opinion, this recent talk about lower inflation is a sad case of the Fed manufacturing a story to justify easier monetary policy.

We conclude with a message for the Federal Reserve- If you want to lower rates then lower rates, but please do not feign concern about inflation trends that are non-existent as cover for such moves. You preach transparency, so be transparent.

UNLOCKED: The Curious Case of Rising Fuel Prices and Shrinking Inflation

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On Friday, April 26, 2019, the market was stunned with a much stronger than expected 3.2% rate of first-quarter economic growth. Wall Street expectations were clearly off the mark, ranging from 1.3-2.3%. The media took this as a sign the economy is roaring. To wit, a headline from the Washington Post started “US Economy Feels Like the 1990s.”

Upon first seeing the GDP report, we immediately looked with suspicion at the surprisingly low GDP price deflator.  The GDP price deflator is an inflation measure used to normalize GDP so that prior periods are comparable to each other without the effects of inflation.

The Bureau of Economic Analysis (BEA) reports nominal and real GDP. Real GDP is the closely followed number that is reported by the media and quoted by the Fed and politicians. Since the GDP price deflator is subtracted from the nominal GDP number, the larger the deflator, the smaller the difference between real and nominal GDP.

The BEA reported that the first quarter GDP price deflator was 0.9%, well below expectations of 1.7%. Had the deflator met expectations, the real GDP number would have been about 2.4%, still high but closer to the upper range of economists’ expectations.

Fueling the Deflator

Like Wall Street, we were expecting a deflator that was in line or possibly higher than its recent average. The average deflator over the last two years is 2.05%, and it is running slightly higher at 2.125% over the last four quarters. Our expectation for an average or above average deflator in Q1 2019 were in large part driven by oil prices which rose by 32% over the entire first quarter. Due to the price move and the contribution of crude oil effects on inflation, oil prices should have had an unusually high impact on inflation measures in the first quarter of 2019.

Per the American Automobile Association (AAA), gas prices in the United States rose from \$2.25 per gallon in January to \$2.75 by the end of March, a gain of 22%. Gasoline RBOB futures, the most commonly quoted contract for wholesale gasoline prices, tell a similar story, rising from \$1.30 per gallon to \$1.83 over the quarter, for a gain of 41%.

With a good amount of digging through the BEA website, we learned that despite the substantial rise in the price of oil and gasoline in the first quarter, the BEA actually reported a decline in fuel prices. The BEA, which uses data from the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) report, reported that fuel prices fell on average by 7.8% during the quarter. The table below for fuel prices (BLS code CUSR0000SETB) from the BLS is the direct input used to account for energy prices within the GDP deflator.

The BLS is not wrong; they are just using a three-month average, and therefore their data lags by three months. Essentially, the fuel price data feeding the first quarter GDP deflator is from the fourth quarter of 2018. During this period, the price of oil and gas fell precipitously.

With a little back of the envelope math, we conclude that had the price of oil been unchanged the deflator would have been approximately 1.45%, and Real GDP growth would have been 2.75%. Had the price risen, instead of fallen, by 7.8% the deflator would have been 1.99%, and GDP would have been 2.20% and on par with expectations. Had it risen more than 7.8%, Real GDP would have been even lower.

Implications

The BEA is not cooking the books. However, by this methodology using old data, sharp changes in fuel prices will result in flawed quarterly data. This problem is self-correcting. For instance, the sharp decline in oil prices in the fourth quarter which helped lower the deflator in the first quarter will be offset when the surge in first quarter oil prices weigh on second-quarter GDP. The graph below shows Gasoline RBOB futures to highlight the recent volatility in gasoline prices.

It is not just the deflator that concerns us about second-quarter GDP. In this weekend’s newsletter, The Bull Is Back… But Will It Stay? we stated the following:

Almost 50% of the increase in GDP came from slower imports and a massive surge in inventories which suggests slower consumer consumption which comprises roughly 70% of economic growth. In other words, future GDP reports will also likely be weaker. (Net Trade and Inventories was 1.68% of the 3.2% rise.)”

The ratio of inventory to sales has steadily climbed over the last 12 months. If consumption stays weak, we should see companies backing off on inventory stocking. Rising inventories increase GDP and falling inventories have the opposite effect. As a result and as stated above “future GDP reports will also likely be weaker.”

Looking ahead, we are confident that the second quarter GDP deflator will be 2% or higher. We also believe that if consumption remains frail, companies will slow their inventory growth.  While difficult to predict as we are only a month into the quarter, these two important factors are likely to weigh on second-quarter GDP. Keep in mind, these are only two of thousands of factors, but they play an outsized role in determining GDP.

Currently, and subject to change as more economic data is released, we have a strong suspicion that the positive surprise in the Q1 report will be followed with an equally surprising weak Q2 report. As stock markets probe new record highs, the question for investors is, will the market care?

Quick Take: The Curious Case of Rising Fuel Prices and Shrinking Inflation

On Friday, April 26, 2019, the market was stunned with a much stronger than expected 3.2% rate of first-quarter economic growth. Wall Street expectations were clearly off the mark, ranging from 1.3-2.3%. The media took this as a sign the economy is roaring. To wit, a headline from the Washington Post started “US Economy Feels Like the 1990s.”

Upon first seeing the GDP report, we immediately looked with suspicion at the surprisingly low GDP price deflator.  The GDP price deflator is an inflation measure used to normalize GDP so that prior periods are comparable to each other without the effects of inflation.

The Bureau of Economic Analysis (BEA) reports nominal and real GDP. Real GDP is the closely followed number that is reported by the media and quoted by the Fed and politicians. Since the GDP price deflator is subtracted from the nominal GDP number, the larger the deflator, the smaller the difference between real and nominal GDP.

The BEA reported that the first quarter GDP price deflator was 0.9%, well below expectations of 1.7%. Had the deflator met expectations, the real GDP number would have been about 2.4%, still high but closer to the upper range of economists’ expectations.

Fueling the Deflator

Like Wall Street, we were expecting a deflator that was in line or possibly higher than its recent average. The average deflator over the last two years is 2.05%, and it is running slightly higher at 2.125% over the last four quarters. Our expectation for an average or above average deflator in Q1 2019 were in large part driven by oil prices which rose by 32% over the entire first quarter. Due to the price move and the contribution of crude oil effects on inflation, oil prices should have had an unusually high impact on inflation measures in the first quarter of 2019.

Per the American Automobile Association (AAA), gas prices in the United States rose from \$2.25 per gallon in January to \$2.75 by the end of March, a gain of 22%. Gasoline RBOB futures, the most commonly quoted contract for wholesale gasoline prices, tell a similar story, rising from \$1.30 per gallon to \$1.83 over the quarter, for a gain of 41%.

With a good amount of digging through the BEA website, we learned that despite the substantial rise in the price of oil and gasoline in the first quarter, the BEA actually reported a decline in fuel prices. The BEA, which uses data from the Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) report, reported that fuel prices fell on average by 7.8% during the quarter. The table below for fuel prices (BLS code CUSR0000SETB) from the BLS is the direct input used to account for energy prices within the GDP deflator.

The BLS is not wrong; they are just using a three-month average, and therefore their data lags by three months. Essentially, the fuel price data feeding the first quarter GDP deflator is from the fourth quarter of 2018. During this period, the price of oil and gas fell precipitously.

With a little back of the envelope math, we conclude that had the price of oil been unchanged the deflator would have been approximately 1.45%, and Real GDP growth would have been 2.75%. Had the price risen, instead of fallen, by 7.8% the deflator would have been 1.99%, and GDP would have been 2.20% and on par with expectations. Had it risen more than 7.8%, Real GDP would have been even lower.

Implications

The BEA is not cooking the books. However, by this methodology using old data, sharp changes in fuel prices will result in flawed quarterly data. This problem is self-correcting. For instance, the sharp decline in oil prices in the fourth quarter which helped lower the deflator in the first quarter will be offset when the surge in first quarter oil prices weigh on second-quarter GDP. The graph below shows Gasoline RBOB futures to highlight the recent volatility in gasoline prices.

It is not just the deflator that concerns us about second-quarter GDP. In this weekend’s newsletter, The Bull Is Back… But Will It Stay? we stated the following:

Almost 50% of the increase in GDP came from slower imports and a massive surge in inventories which suggests slower consumer consumption which comprises roughly 70% of economic growth. In other words, future GDP reports will also likely be weaker. (Net Trade and Inventories was 1.68% of the 3.2% rise.)”

The ratio of inventory to sales has steadily climbed over the last 12 months. If consumption stays weak, we should see companies backing off on inventory stocking. Rising inventories increase GDP and falling inventories have the opposite effect. As a result and as stated above “future GDP reports will also likely be weaker.”

Looking ahead, we are confident that the second quarter GDP deflator will be 2% or higher. We also believe that if consumption remains frail, companies will slow their inventory growth.  While difficult to predict as we are only a month into the quarter, these two important factors are likely to weigh on second-quarter GDP. Keep in mind, these are only two of thousands of factors, but they play an outsized role in determining GDP.

Currently, and subject to change as more economic data is released, we have a strong suspicion that the positive surprise in the Q1 report will be followed with an equally surprising weak Q2 report. As stock markets probe new record highs, the question for investors is, will the market care?

Technically Speaking: Running On Empty

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Running On Empty

“Running On Empty” was an iconic song about life on the road as a traveling musician. The 1977 live recording, which became a 1978 hit for Jackson Browne, is considered one of true representatives of Heartland Rock, and a concert favorite.

When Jackson Browne was interviewed about the song by Rolling Stone Magazine, at the time he was recording the album “The Pretender” he said:

I was always driving around with no gas in the car. I just never bothered to fill up the tank because — how far was it anyway? Just a few blocks.

“Running on, running on empty
Running on, running blind
Running on, running into the sun
But I’m running behind”

Those lyrics are not so far and apart from where we are in the markets today.

As we discussed this past weekend, everyone is in the car driving along with no worries about how much “gas is in the tank.”

Yes, since investors did sell the December lows, they are now buying the February-March highs. But to Doug’s point, investors are still heavily weighted towards equity.”

More importantly, they are getting long at a time where volatility has once again become extremely low which has historically led to negative outcomes.

“Lastly, market ‘complacency’ is back to levels which have denoted short-term corrections in the market previously with near record levels of short-volatility positioning.”

After four months on advances in the market, investors have once again been lured back into the belief that markets are a “one way trip higher.”

As noted by the Wall Street Journal on Monday:

“Sentiment is incredibly bullish. So many people are chasing performance now.” – Nancy Davis, CIO at Quadratic Capital Management.

She is right.

Currently, momentum and growth stocks are substantially outperforming value oriented stocks.

But investors are paying an excruciatingly high premium for that performance. Michael Lebowitz recently ran the analysis for our RIA PRO subscribers (Get A FREE 30-Day Trial)

Growth Stocks vs. Value Stocks

• Price/Sales: 8x more
• Price/Book: 16x more
• Price/Cash Flow: 7x more
• Dividend Yield: 5% less yield.

More importantly, our “Greed/Fear Gauge,” which is based on allocation exposure, is back to historically high levels.

Investors are current extremely optimistic that even with the fuel gauge warning light glaring red, that passing the “last chance” gas station won’t be a problem.

Maybe, they are right.

However, historically, and as shown in the chart below, when markets have previously been this overbought combined with negative divergences in momentum, short-term outcomes have been less than optimal.

Let me clear, this does not mean the markets are about to “crash.”

It simply suggests that after an incessant run higher, asset prices are likely going to correct which will provide a better “risk/reward” entry point for investors.

But it also doesn’t rule out a much deeper correction either.

As I noted on Friday:

“The overbought condition (top panel) is now back to where was the last time we were registering ‘all-time highs.’ Currently, that signal has flattened out to the point where it is dangerously close to crossing lower. Any additional weakness this week will likely trigger a sell signal.”

Importantly, it is where we close the week that matters. A break that is reversed by the end of the week doesn’t register as a valid signal.

I will update this chart this coming weekend and discuss the next set of actions as necessary.

Running On Hope

When you are “running on empty,” it requires a lot of “hope” you can make it to the next gas, or charging, station before the engine quits running.

The same is true with the markets. The current advance is not built on improving economic or fundamental data. It is built simply on “hope.”

• Hope the economy will improve in the second half of the year.
• Hope that earnings will improve in the second half of the year.
• Hope that oil prices will trade higher even as supply remains elevated.
• Hope the Fed will not raise interest rates this year.
• Hope that global Central Banks will “keep on keepin’ on.”
• Hope that the US Dollar doesn’t rise.
• Hope that China will keep stimulating.
• Hope that a “trade deal” will be concluded soon.
• Hope that high-yield credit markets remain stable

I am sure I forgot a few things, but you get the point.

“There’s a whole lotta’ hope goin’ on round here.”

However, with valuations expensive, markets overbought, volatility low, and sentiment pushing back into more extreme territory, there are a lot of things which can go wrong. While stocks above their 200-dma have surged from their recent nadir, the negative divergence, light trading volume, and narrowness of the rally leaves a lot to be wished for.

The overriding message is that fundamentals are not driving the current rally.

Prices are are dictating policy.

The sharp decline in prices in 2018 set the Fed against the White House.

You can deny it. You can rail against it. You can call it a conspiracy.

But in the “other” famous words of Bill Clinton: “What is…is.”

The markets are currently betting the economy will begin to accelerate later this year. The “hope” that Central Bank actions will spark inflationary pressures and economic growth is a tall order to fill considering it hasn’t worked anywhere previously. If Central Banks are indeed able to keep asset prices inflated long enough for the fundamentals to catch up with the “fantasy” – it will be a first in recorded human history.

My logic suggests that sooner rather than later somebody will yell “fire” in a very crowded theater.

When that will be is anyone’s guess.

In other words, this is probably a “trap.”

But as I wrote previously:

“Over the next several weeks, or even months, the markets can certainly extend the current deviations from long-term mean even further. But that is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market ‘holdouts’ back into the markets.”

Unfortunately, for most investors, they are likely stuck at the very back of the theater.

With sentiment currently at very high levels, combined with low volatility and excess margin debt, all the ingredients necessary for a sharp market reversion are currently present.

Just to clear, I am not calling for the “end of the known universe.”

I am simply suggesting that remaining fully invested in the financial markets without a thorough understanding of your “risk exposure” will likely not have the desired end result you have been promised.

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered “bearish” to point out the potential “risks” that could lead to rapid capital destruction; then I am unabashedly a “bear.”

But I have been through three previous bear markets and lived to tell about.

However, just to be very clear, I am still in “theater;” I am just moving much closer to the “exit.”

(Follow up read on how to approach the market: The 80/20 Rule Of Investing)

BONUS: For all you youngsters who have never seen a bear market or heard of Jackson Browne:

Technically Speaking: Drive For Show

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Drive For Show

In golf there is an old axiom:

“Drive for show. Putt for dough.”

This past weekend, Tiger Woods completed a comeback on Sunday by capturing his fifth Master’s title and his 15th major tournament win. It was a victory that snapped a decade-long championship drought and instantly returned him to the top of the sports world.

While his drives were some of the best on display, it was his final two-putt, likely the greatest bogey of his career, which put him 13-under par clinching the title.

Yes, Tiger Woods is back at “all-time” highs.

Congratulations!

However, Tiger Woods’ journey back to the peak of the golfing world after being outside of the top 1000 in 2017 is not only a major accomplishment but a story of tragedy along the way.

Many wrote off Woods’ career as the injuries took their toll on his form, world ranking, and quality of life along with a high profile divorce, a bit of a scandal, and personal issues. However, despite the odds, Tiger Woods is back with a story that the world had resigned itself to never seeing again.

In many ways, investors over the last decade have endured much the same.

Investors were on top of the game in 1999, as the markets soared higher. There seemed to be nothing that could stop the advance despite high valuations and questionable accounting metrics. However, after 13-years in the “investment wasteland,” investors finally got back to even had they held onto their S&P index fund and religiously dollar cost averaged (DCA) into it.

Unfortunately, there were very few who did.

As repeated studies have shown, while “buy and hold” investing sounds like a workable plan, the fallacies of “being human” tend to deviate it from our goals. For Tiger Woods, it was his human frailties, both physically and emotionally, which deviated him from his dominance in golf. For investors, it is much the same as our emotions of “greed” and “fear” destroy the best laid of plans.

A recent study by DALBAR, a financial research firm, has shown how the general temptation for investors to buy and sell at the wrong times repeatedly results in the investor losses. (Chart courtesy of American Funds)

As we discussed in our recent weekly newsletterthis same behavior was on display during the December sell-off in the markets. To wit:

“Many investors are finally getting back to even, assuming you didn’t ‘sell the bottom’ in December, which by looking at allocation changes, certainly appears to be the case for many.”

“Not surprisingly, historically speaking, investors had their peak stock exposure before the market cycle peaks. As the market had its first stumble, investors sold. When the market bounces, investors are initially reluctant to chase it. However, as the rally continues, the ‘fear of missing out or F.O.M.O’ eventually forces them back into the market. This is how bear market rallies work; they inflict the most pain possible on investors both on the bounce and then on the way back down.”

As the markets near their all-time highs, investors are finally wading back into the markets. As Chris Matthews noted for MarketWatch:

“But individual investors are once again wading into the market, indicating renewed bullishness in surveys and flow data released in recent days.

The latest E-Trade StreetWise survey, released Friday, showed 58% self-directed investors calling themselves ‘bullish’ on the stock market in the second quarter of this year, a 12 percentage-point increase from the first quarter, when a 54% majority indicated they were ‘bearish’ in their stock market outlook.”

Rising markets are exciting.

“Drive For Show”

The most exciting part of golf is watching the Pro’s “drive for show.” A hushed silence falls over the crowd as the golfer looks down the fairway at the distant flag. You can almost hear the breathing stop as the backswing begins. The camera chases the ball as it flies through the air as the excitement builds that it will land on the green.

It is the same with investors.

With all eyes focused on the market as it flies higher, it’s exhilarating.

Currently, with markets rising on hopes the Federal Reserve is returning to more “accommodative” ways and consistent headlines of a conclusion to “Trump’s Trade War,” there seems to be nothing that can stop the market’s advance. “Hope” is an incredibly virulent toxin that blocks the “logic pathways” of investor intellect. One of the clues of its presence is the belief that “this time is different.”

However, it is when the “ball lands on the green” the real work begins.

The most challenging aspect of golf, and where it counts the most, is minimizing the number of strokes required to “putt” the ball into the cup. Those most skilled are the ones who win more often than not.

In investing it is much the same. As markets approach major important inflection points, it is the skill of mitigating risk and repositioning portfolios which reduces the number “strokes” in the investment game.

Since the December swoon, most investors have forgotten the pain they felt, and the “fear of losing” has once again been replaced with the “Fear of Missing Out.” However, while many investors spent their time “driving for show,” bond investors won by consistently “putting for dough.”

This is where we are today.

“Putting For Dough”

Currently, the market is as extended as it has been at other major points throughout history with a similar backdrop of slowing earnings and economic growth, higher interest rates, and geopolitical stresses. Also, complacency is back as volatility continues to subside as the “fear of a correction” has subsided substantially since the December lows.

Also, as shown in the next chart, the negative “cross over” is still intact AND it is doing so in conjunction with an extreme overbought weekly condition and a “negatively diverging” moving average divergence/convergence (MACD) indicator. This combined set of “signals” has only been seen in conjunction with the previous market peaks. (The corrections of 2012 and 2015-16 were offset by massive amounts of Central Bank interventions which are not present currently.)

Clearly, the “drive for show” is now behind us.

As we prepare for the “putt,” it is time to focus on the “lay of the green.”

In the short-term the market remains bullishly biased and suggests, with a couple of months to go in the “seasonally strong” period of the year, that downside risk remains limited. Importantly, while downside risks are somewhat limited, this doesn’t mean there is a tremendous amount of upside reward either.

Currently, our portfolio allocations:

• Remain long-biased towards equity risk
• Have a balance between offensive and defensive sector positioning
• Are tactically positioned for a trade resolution (which we will sell into the occurrence of.)

However, the analysis also keeps us cautious with respect to the longer-term outlook. With the recent inversion of the yield curve, deteriorating economic data, and weaker earnings prospects going forward, we are focused on risk management and capital controls. As such we are:

• Continuing to carry slightly higher levels of cash
• Overweight bonds
• Have some historically defensive positioning in portfolios.
• Continue to tighten-up stop-loss levels to protect gains, and;
• Have outright hedges ready to implement when needed.

In your own portfolio, there are simple actions you can take to improve your chances of “sinking the putt.”

1. Trim positions that are big winners in your portfolio back to their original portfolio weightings. (ie. Take profits)
2. Sell underperforming positions. If a position hasn’t performed during the rally over the last three months, it is weak for a reason and will likely lead the decline on the way down.
3. Positions that performed with the market should also be reduced back to original portfolio weights. Hang with the leaders.
4. Move trailing stop losses up to new levels.
5. Review your portfolio allocation relative to your risk tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.
6. Look to reposition portfolio composition from “risk” toward “safety.” Look to reduce assets specifically tied to economic growth and increase holdings in assets which tend to be more defensive in nature.
7. If you just don’t know what to do – cash is the best alternative. With cash now yielding more than the S&P 500, holding cash IS an option until you figure out what to do. Remember, investing is about making a bet where the potential for reward outweighs the risk of loss. If you can’t find that opportunity right now, cash is the best alternative until you do.

How you personally manage your investments is up to you. I am only suggesting a few guidelines to rebalance portfolio risk accordingly. Therefore, use this information at your own discretion.

Technically Speaking: Do You Really Want To Be Out?

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Do You Really Want To Be Out?

That was a comment made several times last week with respect to the markets stellar first quarter performance.

“The S&P 500 is on track for its best quarter in a decade, up roughly 12 percent. And if history is any indication, the index could be set for more gains for the rest of the year.

In nine of the 10 previous times since 1950 that the S&P returned more than 10 percent in the first quarter, it went on to post double-digit gains for the year, according to LPL Financial’s Ryan Detrick. The one exception was 1987, when the market crashed on Black Monday.”CNBC

As we noted in this past weekend’s newsletter:

“Friday wrapped up the first quarter of 2019, and it was the best quarterly performance since 2009. As shown in the chart below, if you bought the bottom, you are ‘killing it.’”

“Most likely, you didn’t.”

Despite all of the media ‘hoopla’ about the rally, the reality is that for most, they are simply getting back to even over the last year.”

“That is, assuming you didn’t ‘sell the bottom’ in December, which by looking at allocation changes, certainly appears to be the case for many.”

So, back to our question, why would you want to be out of the market?

Here is the problem with the Detrick’s analysis above:

• 1986 – Reagan passes massive tax reform which boost stocks into 1987.
• 1987 – The market crashes.
• 1991 – The market rallies sharply coming out of recession.
• 1998 – After Long-Term Capital Management is bailed out, and the “Asian Contagion” is resolved stocks rally as the “Dot.com” bubble inflates (2-year later, investors were wishing they hadn’t bought in)
• 2012 – QE from the Fed boost stocks early in the year and Operation Twist supports asset prices through the end of the year. Balance sheet continues to expand with interest rates at ZERO.
• 2013 – In the wake of the “Fiscal Cliff” the Fed launches QE-3 to offset the risk of a government contraction in spending which turns out not to be a problem. Stocks soar on a flood of liquidity.

As I have notated on the chart below, it is important to compare the context behind historical market actions rather than just making a blanket assumption.

Case in point was the huge January rally in 2018. Headlines rang out that the January “boom” pointed to bigger gains through the rest of the year. After all, “so goes January, so goes the year.”

The year finished lower by over 4%.

So, basing investment decisions solely on previous price action without the relevant context and can lead to poor outcomes.

While it is certainly hopeful that a strong first quarter will lead to further gains for the rest of the year, the current macro backdrop is not nearly as supportive as it was previously.

• Rates are no longer zero.
• Liquidity is still being extracted through September and will stabilize, not increase.
• Economic growth is no longer-strengthening.
• Confidence has peaked
• Geopolitical tensions are rising
• Earnings growth has peaked.
• Valuations are no longer reasonable and rising, but excessively valued.
• Inflation and interest rates are no longer falling.

Well, you get the idea.

Furthermore, leading economic indicators are also signaling some concern. The chart below shows the 3-month average percentage change relative to GDP. (Try RIAPRO for 30-days FREE with code PRO30)

Yes, this current test of the “recession” warning line could turn out to be another 2012 or 2015-16 event, but as noted above, the Fed is no longer directly engaged in supplying liquidity and the Fed Funds rate is no longer zero.

Of course, assuming there is “no recession in sight” is historically what has preceded previous recessions. Coincidently, it is also the subject of a recent Bloomberg article:

“In 1966, four years before securing the Nobel Prize for economics, Paul Samuelson quipped that declines in U.S. stock prices had correctly predicted nine of the last five American recessions. His profession would kill for such accuracy.”Simon Kennedy & Peter Coy, Bloomberg

While there are many suggesting that based on current economic data there is “no recession” in sight, therein lies the risk as noted previously:

“The problem with making an assessment about the state of the economy today, based on current data points, is that these numbers are ‘best guesses’ about the economy currently. However, economic data is subject to substantive negative revisions in the future as actual data is collected and adjusted over the next 12-months and 3-years. Consider for a minute that in January 2008 Chairman Bernanke stated:

‘The Federal Reserve is not currently forecasting a recession.’

In hindsight, the NBER called an official recession that began in December of 2007.”

For investors, while the first quarter of the year was a massively strong reflex rally from the lows, the risk of expecting asset prices to continue to rise unabated may prove disappointing. This is particularly the case as the factors which drove that first quarter performance are unlikely to repeat in the months ahead.

In December there was:

• Deeply negative sentiment of the markets
• Asset prices were stretched to the downside
• The Fed surprised the markets with a very dovish reversal
• The White House surprised the markets with statements a “Trade Deal” was near.
• Oil prices had declined to lows, were oversold, and prime for a rally.

Today:

• The markets are no longer fearful as shown our RIA PRO Technical Index
• Asset prices are now stretched back to the upside
• Economic data has bounced but remains weak
• The Fed has more room to disappoint than not with future announcements. While many are expecting a rate ease later this year, such is unlikely to happen before data materially worsens.
• There has been no “trade deal” completion
• Oil prices are overbought and extended to the upside.

This was also the subject of a WSJ article by Ira Iosebashvili on Monday:

“Investors hoping for stocks’ rally to keep up the first quarter’s pace may be headed for a disappointment. Big climbs in the S&P 500 have tended to slow or even reverse in the three months following a first-quarter rally of 10% or more, according to Dow Jones Market Data.”

“Often, the gains pause as investors grow wary that prices have risen too high, or concerned that the expectations driving the rally won’t pan out. Some investors tend to lock in profits after a particularly good quarter, pushing markets lower.

Earnings are another factor that could pressure stocks. Some investors are worried that a slowing U.S. economy is already weighing on corporate bottom lines and clouding the case for share prices to keep rising. S&P 500 companies are expected to report a nearly 4% drop in first-quarter earnings from a year earlier, according to FactSet.”

“But if I did get out now, I might miss some of the upside.”

Such is really a personal choice, but as I stated earlier this year, there is a very high probability the bulk of the gains for this year have already been made.

However, the emotions of “greed” and “fear” are extremely powerful forces which consistently lead to poor outcomes over longer-term periods. As Michael Lebowitz and I discussed in our VideoCast last week, there is a time to be a contrarian and Howard Marks, the head of Oaktree Capital Management, just recently sold his entire firm. Howard is the ultimate contrarian investor and the message should not be readily dismissed.

This was the same message Sam Zell sent when he sold EQ Office to Blackstone Group in 2006 for \$36 billion in the largest leveraged buyout in history at the time. Or, just as timely was when Bobby Shackouls, the CEO of Burlington Resources, sold to Conoco Phillips. Both occurred just prior to the “Financial Crisis” and the crash in oil prices.

Were they just lucky, or did they see something the rest of us didn’t?

There was “no recession in sight” at the time. The economy was growing, stock market prices were rising, and it was a “Goldilocks economy.”

But to this point was David Rosenberg’s missive yesterday which stated quite elegantly:

“I have to say, that from a contrarian perspective, when an article like ‘Investors Rush To Buy Up Stocks’ appears on the very front page of the Wall Street Journal, you know a whole lot of good news is in the price. It conjures up the image of two of Bob Farrell’s famous Ten Market Rules to Remember: #5 – the public buys the most at the top and the least at the bottom, and #9 – when all the experts agree something else is going to happen.”

While hindsight is pretty clear about what happens given the current environment of weak economic and profit growth, combined with high valuations, and deteriorating technical underpinnings, the ultimate outcome could take months to develop.

And because a warning doesn’t immediately translate into a negative consequence, it is quickly dismissed. It is akin to constantly running red lights and never getting into an accident. We begin to think we are skilled at running red lights, rather than just being lucky. Eventually, the luck will run out.

So do you want to be out? Most will say “no.”

Just for the record, we aren’t “out” either.

But if you are waiting for someone to tell you the recession has officially started, it really won’t matter much anyway.

Technically Speaking: Are We Going To New Highs?

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Are We Going To New Highs?

I recently received the following email:

“Are we going to hit new highs you think, or is this a setup for the real correction?”

The answer is “yes” to both parts.

Thank you for reading. See you next week.

You still here?

Fine, let me explain then.

The “price” of the financial markets are ultimately driven by one thing and one thing only: “expectations.”

Yes, fundamentals, valuations, interest rates, etc. all play an important role, but it is ultimately “expectations” of “the herd” which moves prices. Currently, valuations on stocks are at the second highest level on record, but “expectations” are that a continued “low interest rate environment” can support economic growth allowing stocks to “grow” into their valuations.

This is why Wall Street begin using “forward operating earnings,” which are complete nonsense, to justify high valuations and, you guessed it, “expectations.” (Operating earnings are essentiallymade up” earnings without any of the “bad stuff” included.)

For more on this valuation read a recent article we wrote on the topic titled Price to Forecasted Hope.

The problem, historically speaking, is when those “expectations” are disappointing as shown below.  There are three important things worth pointing out:

1. The top panel is GAAP earnings (what companies REALLY earn) and nominal GDP.
2. The black vertical line is when the markets begin to “sniff out” something is not quite right.
3. The red bars are when “expectations” are disappointed.

While “expectations” were indeed disappointing in 2015-2016, the long-term rising trend line was never violated. Secondly, the current warning signal (black vertical line) is in place, but “expectations” have not yet been disappointed.

As I discussed yesterday, one of the biggest problems facing investors is that many have never recovered from the previous two bear markets. While “this time may seem different,” the reality is such is probably not the case.

Let’s review the periods just prior to the onset of the last two bear markets to see if there are any similarities to today’s environment.

1998-2000

Leading up to 2000, the Internet was changing the world. Companies like E*Trade brought investing to the mainstream public and now everybody was a “professional investor.” Despite silly little hiccups like Long-Term Capital Management and the “Asian Contagion,” the markets rocketed higher as expectations were that “clicks per page” had changed the investing dynamic forever. “Buy the dip,” and “Buy and hold” were the investing mantras of the day as retail investors loaded up on risk.

The economy was strong, employment was high, and corporate earnings were soaring as the advent of “operating, or proforma, earnings” established its place in the Wall Street lexicon. It’s was, for all intents and purposes, a “new era.”

The change came in late July of 2000 as stocks recovered from previous dips but failed to reach new highs. The deterioration in price momentum was signaling that something was changing as the Fed had been aggressively tightening monetary policy. By December of 2000, the “buy the dip” mantra and “buy and hold” investing were no more.

The “all-time” high printed in 2000 would not be seen again for 7-years.

2006-2008

Fast forward to 2006. After the crushing of investors portfolios from 2000-2002, much of the damage had been corrected.

“See, if you had just bought and held, you would be fine.”

“Buy and hold” and “dollar cost averaging” investment strategies had once again returned to the media headlines. With mortgage rates low and a litany of no cost/low-cost options for getting a mortgage, or using the mortgage as an A.T.M., Wall Street had found a new avenue for liquidity in the “real estate market.”

Once again it seemed as if nothing could go wrong as the flood of liquidity in the system allowed for asset prices to rise. As the market consistently rang out new highs through 2006 and 2007, it was believed once again this “time was different.”

Even when small west coast banks and two Bear Stearn’s hedge funds collapsed due to their investments in risky “mortgage-backed” instruments, it was quickly ignored by investors as then Fed Reserve Chairman Ben Bernanke soothed the markets with docile tones of a “Goldilocks Economy.”

After a stumble in July of 2007, the market came roaring back, ignoring the growing mortgage and real-estate issues and surged back to hit all-time highs.

That was the last all-time high that would be seen for another 6-years.

2017-Present

Of course, there are many investors, and more importantly financial advisors, who were not in the markets during those previous two periods. Many individuals simply sold out of the markets, or lost most everything, and never returned. Many financial advisors quit the business and started a different profession.

So, for many the bull market of the last decade seems to be “normal.” Once again, “buy the dip” and “buy and hold” are once again “a thing.” More importantly, “this time is different” because the “Central Banks have the market’s back.”

But is it?

In reviewing the chart above, there are certainly many similarities between the current market backdrop and those previous bull market peaks. There are also an abundance of risks which Doug Kass noted on Monday:

“I continue to be of the view that 2018 marked the beginning of the end of the 10-year Bull Market and that an important top was in the process of being established last year.

‘Tops are a process, bottoms are an event.’

Consider the following fundamentally based issues and concerns I raised back then (and that still have value, and have been updated in boldface):

• Downside Risk Dwarfs Upside Reward
• Global Growth Is Less Synchronized .
• FAANG’s Dominance Represents an Ever-Present Risk
• Market Structure Is One-Sided and Worrisome. Machines and algorithms rule the day; they, too, are momentum-based on the same side of the boat.
• Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt.
• Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks.
• Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very bad ramifications, which shortly may be discounted in lower stock prices, especially as it relates to the servicing of debt — a subject I have written about often.
• China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data.

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” – Benjamin Graham

He is correct.

However, while the “risks” are abundant, they don’t matter until they do. As I noted in last week’s Technical Update:

“The ‘animal spirits,’ which were awakened by consecutive rounds of financial stimulus on a global scale, has enticed investors into the belief that all risks of a market cycle completion have been removed. The problem, as I have discussed previously, is this optimism comes at a point in history diametrically opposed to when President Reagan instituted many of the same conservative policies.

It is this exuberance that reminded me of the following ‘investor psychology’ chart.”

“The third (current) full-market cycle is only 39-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not?”

As Doug concluded:

“The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility (based on fundamental and technical input) that the market may be making an important market top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward versus risk is. This calculus and taking advantage of the discrepancy between price and intrinsic value trumps everything else that I do in determining market value.

My investment process points me to conclude that, at current prices, downside risk substantially eclipses upside reward.”

This was the case in 1999 and 2007 as well.

The “Goldilocks economy,” the “permanently high plateau,” and “buy and hold” all died at the altar of price reversions.

• Yes, the markets could absolutely rally to, or near, all-time highs.
• It could also well be the last “all-time” high you see for the next 6-10 years.

Technically Speaking: A Different Way To Look At Market Cycles

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A Different Way To Look At Market Cycles

In this past weekend’s newsletter we noted the issues of similarities between the current market environment and previous market peaks in the past. To wit:

“It isn’t just the economy that is reminiscent of the 2007 landscape. As noted above, the markets also reflect the same. Here are a couple of charts worth reminding you of.

Notice that at the peaks of both previous bull markets, the market corrected, broke important support levels and then rallied to new highs leading investors to believe the bull market was intact. However, the weekly ‘sell signal’ never confirmed that rally as the ‘unseen bear market’ had already started.”

“Currently, relative strength as measured by RSI on a weekly basis has continued to deteriorate. Not only was such deterioration a hallmark of the market topping process in 2007, but also in 2000.”

“The problem of suggesting that we have once again evolved into a “Goldilocks economy” is that such an environment of slower growth is not conducive to supporting corporate profit growth at a level to justify high valuations.”

My friend and colleague Doug Kass penned an important note about the current market backdrop on Monday:

“‘Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits-a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.’ – John Maynard Keynes

The markets, confounding many, have vaulted higher from the Christmas Eve lows with nary a selloff.

This morning, let’s briefly explore the catalysts to the advance and consider what might follow:

1. Liquidity (and financial conditions) have improved, as Central Bankers, to some degree, have reversed their tightening policies. Interest rates and inflationary expectations have moved lower than expected, providing hope for an elongated economic cycle that has already been a decade in duration and appeared to be “long in the tooth.”
2. Market structure (and the dominance of price following products and strategies like ETFs, CTAs and Risk Parity and Volatility Trending/Targeting) exacerbated the trend lower into late-December. The breadth thrust and reversal in price momentum contributed to the post-Christmas rally. As I have previously noted, in an investment world dominated by the aforementioned products that worship at the altar of price momentum – ‘buyers live higher and sellers live lower.’ This phenomenon has exaggerated market moves and has created an air of artificiality and absence of price discovery (on both the upside and the downside).
3. Corporate buybacks – abetted by tax reform introduced 15 months ago – provided another reason for a strong backdrop for higher stock prices.
4. As a result of the above factors (and others) animal spirits rose and valuations expanded.

These four conditions have offset the deceleration in the rate of global economic growth and U.S. corporate profit growth.”

He is correct, the “animal spirits,” which were awakened by consecutive rounds of financial stimulus on a global scale, has enticed investors into the belief that all risks of a market cycle completion have been removed. The problem, as I have discussed previously, is this optimism comes at a point in history diametrically opposed to when President Reagan instituted many of the same conservative policies.

It is this exuberance that reminded me of the following “investor psychology” chart.

This chart is not new, and there are many variations similar to it, but the importance should not be lost on individuals as it is repeated throughout history. At each delusional peak, it was always uttered, in some shape, form or variation, “this time is different.”

Of course, to the detriment of those who fell prey to that belief, it was not.

As I was studying the chart, something struck me.

During my history of blogging and writing newsletters, I have often discussed the importance of full-market cycles.

“Long-term investment success depends more on the WHEN you start investing. This is clearly shown in the chart below of long-term secular full-market cycles.”

“Here is the critical point. The MAJORITY of the returns from investing came in just 4 of the 8 major market cycles since 1871. Every other period yielded a return that actually lost out to inflation during that time frame.”

By looking at each full-cycle period as two parts, bull and bear, I missed the importance of the “psychology” driven by the entirety of the cycle. In other words, what if instead of there being 8-cycles, we look at them as only three?

This would, of course, suggest that based on the “psychological” cycle of the market, the bull market that began in 1980 is not yet complete.

Notice in the chart above the CAPE (cyclically adjusted P/E ratio) reverted well below the long-term in both prior full-market cycles. While valuations did, very briefly, dip below the long-term trend in 2008-2009, they have not reverted to levels either low or long enough to form the fundamental and psychological underpinnings seen at the beginning of the last two full-market cycles.

Long-Run Psychological Cycles

It is from that basis, and historical time frames, that I have created the following thought experiment of examining the psychological cycle overlaid on each of the three full-cycle periods in the market.

The first full-market cycle lasted 63-years from 1871 through 1934. This period ended with the crash of 1929 and the beginning of the “Great Depression.”

The second full-market cycle lasted 45-years from 1935-1980. This cycle ended with the demise of the “Nifty-Fifty” stocks and the “Black Bear Market” of 1974. While not as economically devastating to the overall economy as the 1929-crash, it did greatly impair the investment psychology of those in the market.

The third (current) full-market cycle is only 39-years in the making. Given the 2nd highest valuation levels in history, corporate, consumer and margin debt near historical highs, and average economic growth rates running at historical lows, it is worth questioning whether the current full-market cycle has been completed or not?

The idea the “bull market” which begin in 1980 is still intact is not a new one. As shown below, a chart of the market from 1980 to the present, suggests the same.

1. The long-term bullish trend line remains
2. The cycle-oscillator is only half-way through a long-term cycle.
3. On a Fibonacci-retracement basis, a 61.8% retracement would almost intersect with the long-term bullish trend-line around 1200 suggesting the next downturn could indeed be a nasty one.

Again, I am NOT suggesting this is the case. This is just a thought-experiment about the potential outcome from the collision of weak economics, high levels of debt, and valuations and “irrational exuberance.”

It’s All Asymmetric

A second supporting theory of full market cycles was George Soros’ take on bubbles.

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

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said:

‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’

Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

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

The chart below is an example of asymmetric bubbles.

Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view.  Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.  As Soros stated:

“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”

The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis.  I then took a look at the markets prior to each major market correction and overlaid the asymmetrical bubble shape as discussed by George Soros.

There is currently much debate about the health of financial markets. Have we indeed found the “Goldilocks economy?” Can prices can remain detached from the fundamental underpinnings long enough for an economy/earnings slowdown to catch back up with investor expectations?

The speculative appetite for “yield,” which has been fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”

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

In the long term, it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the current levels of asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to, once again, lose a large chunk of their net worth.

It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run is telling much the same story.  History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.

It is critically important to remain as theoretically sound as possible as a large majority of investors have built their portfolios on a foundation of false ideologies.

The problem is when reality collides with widespread fantasy.

Technically Speaking: Will The Next Decade Be As Good As The Last?

In this past weekend’s newsletter we stated:

“This short-term oversold condition, and holding of minor support, does set the market up for a bounce next week which could get the market back above the 200-dma. The challenge, at least in the short-term remains the resistance level building at 2800.

That bounce occurred on Monday which allowed us to add some trading positions to our portfolios. We update all of portfolios regularly at RIA PRO (Try now for FREE for 30-days with Code: PRO30)

Our job as portfolio managers is simple:

1. Protect investment capital, and; (Long-term view)
2. Take advantage of opportunity when it presents itself. (Short-term view)

The blending of the short and long-term views is the difficult part for readers to understand.

“If you have a long-term bearish view on future market returns, how can you be increasing equity exposure?”

Because, as rule #2 states, our job is to make money when we can while avoiding the long-term risk of capital destruction. As such, we must marry the long-term views with short-term opportunities which don’t necessarily always align.

For example, the media was full of commentary over the weekend discussing the market’s 10th anniversary.

“The U.S. bull market turned 10-years old Saturday, underscoring the resilience of a rally that has persisted despite tepid global growth, anxieties about central bank policies, and mounting trade tensions.” – WSJ

Yes, March 9th marked the 10-year mark of a bull market that started on that same day in 2009. Although there have been a few bumps along the way, the long-term bullish trend has remained intact.

“So, why can’t it just continue for another 10-years?”

It’s a important question and investors should review the catalysts of the last decade.

In 2009, valuations had reverted to the long-term average, asset prices got extremely oversold, and investor sentiment was extremely negative. These are all the ingredients necessary for a cyclical bull market which David Rosenberg detailed on Monday:

“Yes, this was indeed the third strong run-up in the S&P 500 on record with a total return increase of 400%. But in inflation-adjusted dollars, the \$30 trillion expansion was a record, taking out the \$25 trillion surge in real terms from December 1987 to March 2000.

As David details, the supports for the ensuing rally were abnormal in many aspects.

The government bailed out insolvent banks.

• There were two massive fiscal stimulus programs separated by 8-years.
• The Fed funds rate was ZERO for eight years, and repeated intervention into the marketplace boosted the Fed’s assets six-fold. How could asset values not be influenced by the central bank taking \$4.5 trillion of ‘safe’ securities out of the public market?
• Because there were no investable opportunities, cloud computing and AI aside, there was no capital deepening cycle. Cash flows (from tax relief too) were diverted to stock buybacks and dividend payments. The share count of the S&P 500 hit two-decade lows alongside two crazes – buybacks and M&A.
• The Fed’s policies ignited the mother of all leverage cycles in the corporate sector. And it’s not all just about BBB-rated bonds. It’s about private equity, which experienced a massive credit bubble this cycle as well.
• The WSJ mentions ‘anxieties’ about central banks even though they have been the best friend to the investing class than they have ever been in modern history.
• The article also posited that the 10-year bull run confronted “mounting trade tensions.” Well, in truth, by the time these tensions began, in early 2018, over 90% of the bull markets was behind us.
• What sort of market has but 4-companies accounting for 9% of the total return of this 10-year cycle; and 20 of the S&P 500 representing 30% of the total return gain? Answer- a highly concentrated one.

Importantly, this is what happened.

The challenge for investors will be what happens next.

Currently, there is an overwhelming “hope” that what happened over the last 10-years will continue over the next ten. This is a psychological tendency known as “recency bias,” and is one of the biggest behavioral mistakes investors make when it comes to investing.

However, history suggests that the opposite is true more often than not. As I wrote previously:

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

It should be remembered that when records are broken, that was the point where previous limits were reached.  Also, just as in horse racing, sprinting or car races, the difference between an old record and a new one are often measured in fractions of a second.

Therefore, when a ‘record level’ is reached it is NOT THE BEGINNING, but rather an indication of the PEAK of a cycle. Records, while they are often broken, are often only breached by a small amount, rather than a great stretch. While the media has focused on record low unemployment, record stock market levels, and record confidence as signs of an ongoing economic recovery, history suggests caution. For investors, everything is always at its best at the end of a cycle rather than the beginning.”

It isn’t just the stock market hitting record levels in terms of time, but also the economy. According to WSJ’s Alan Blinder:

“Only two economic expansions since 1854 have lasted longer than 100 months, and none have lasted more than 120 months. If the current expansion lasts into July, it will be the longest in history.”

While the old Wall Street axiom is that “bull markets don’t die of old age,” old age usually brings most things closer to the end. As I showed previously in “Is The Market Predicting A Recession?” stocks usually peak, and trough, ahead of the economy.

As John Murphy noted last week for StockCharts:

• The bull market that ended in March 2000 preceded an economic downturn by a year.
• The October 2007 stock market peak preceded the December economic peak by two months.
• The March 2009 stock upturn led the June economic upturn by three months.
• Historically, stocks usually peak from six to nine months ahead of the economy. Which is why we look for possible stock market peaks to alert us to potential peaks in the economy that usually follow. And we may be looking at one.

The weekly chart below shows the S&P 500 hitting an all-time high last September before falling nearly 20% into the end of 2018. While the first two months of 2019 has seen an impressive surge back to its November highs, the market is starting to build a pattern of lower highs, and lower bottoms. More importantly, both relative strength and the MACD indicators are trending lower and negatively diverging from the markets price action.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes. (See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days with code PRO30)

John continues by looking at the monthly chart of the S&P 500 going back 10-years to the start of the bull market.

“The uptrend is still intact. The sharp selloff that took place during the fourth quarter of 2018 stayed above the rising trendline drawn under its 2009, 2011, 2016 lows. That’s the good news. What may not be so good are signs that long-term momentum indicators are starting to weaken. The two lines in the upper box plot the monthly Percent Price Oscillator (PPO). [The PPO is a variation of MACD and measures percentage changes between two moving averages].

The PPO lines turned negative during the second half of last year when the faster red line fell below the slower blue line. And they remain negative. [The red histogram bars plotting the difference between the two PPO lines also remain in negative territory below their zero lines (red circle)]. Secondly, and maybe more importantly, the 2018 peak in PPO is lower than the earlier peak formed at the end of 2014. That’s the first time that’s happened since the bull market began. In technical terms, that creates a potential ‘negative divergence’ between the PPO lines and the S&P 500 which hit a new high last September.

This raises the possibility that the ten-year bull market may have peaked in the fourth quarter and is now going through a major topping process. If the bull market in stocks is nearing an end, that could start the clock ticking on the nearly ten-year expansion in the U.S. economy. That might not prevent it from setting a new record for longevity this July, but it might diminish its chances for celebrating the eleventh anniversary in the summer of 2020.”

These same negative divergences can be seen in the monthly chart below going back to 1995. Whenever the long-term bull trend lines have been broken from a topping process, with negative divergences, and monthly sell signals, it has been coincident with more major market topping processes.

Sure, this time could be different for a whole variety of reasons, but those generally fall into the category of “hope” rather than a systematic and disciplined approach to investing.

Even after the recent correction, long-term extensions and deviations remain at historically high levels which, historically speaking, have not been extremely kind to investors. But valuations, despite the recent correction, are still pushing 30x earnings as well.

As Brett Arends recently noted:

“From the viewpoint of long-term investment, major risks remain according to some long-term strategists. Yes, conventional wisdom on Wall Street tells you that stocks are likely to gain an average of around 9% a year. And yes, that’s based on the historical average going back at least to the 1920s. But, say some financial historians, that’s a misreading of the past. Stocks, they say, typically produced ‘average’ returns if you bought them at roughly ‘average’ valuations in relation to things like net assets and net income. And U.S. stock valuations today, they warn, are anything but average. According to price-to-earnings or ‘PE’ data tracked by Yale University finance professor and Nobel Prize winner Robert Shiller, the S&P 500 is about 75% above its historic average valuation. ‘

But it isn’t just the technical backdrop of the market that is completely reversed but also the fundamental and economic one. As I showed in “QE – Then, Now & Why It May Not Work:”

With the fundamental and technical backdrop no longer as supportive, valuations still near the most expensive 10% of starting valuations, and interest rates higher, the returns over the next decade will likely be disappointing.

However, that’s the long-term view and valuations are a “horrible” timing device. This is why we use a specific set of price indications over varied time frames to determine short-term risk versus reward.

Currently, the markets are rallying, so we need to participate.

As investors, we have to make money when “the cards are hot.” But just as important is knowing when it is time to “fold and step away from the table.”

I know it seems completely implausible today, but over the next decade there will be many who will have wished they had sold today.

Technically Speaking: Monthly Chart Review Yields Bearish Signals

With the month of February now officially in the books, we can take a look at our long-term monthly indicators to see what they are telling us now.

Is the bull market back?

That’s the answer we all want to know.

Each week on RIA PRO we provide an update on all of the major markets for trading purposes.

(See an unlocked version here. We also do the same analysis for each S&P 500 sector, selected portfolio holdings, and long-short ideas. You can try RIA PRO free for 30-days with code PRO30)

However, as longer-term investors and portfolio managers, we are more interested in the overall trend of the market. While it is fundamental analysis derives “what” we buy, it is the long-term “price” analysis which determines the “when” of the buying and selling aspects of portfolio management over the long-term.

For us, the best measures of the TREND of the market is through longer-term weekly and monthly data. Importantly, when using longer-term data these signals are only valid at the end of the period. It is not uncommon for signals to be triggered and reversed during the middle of the period which creates “false” signals and poor outcomes. Since we are more interested in discerning changes to the overall “trend” of the market, we find monthly indicators, which are slow moving, tend to reveal this more clearly.

In April of last year, I penned an article entitled “10-Reasons The Bull Market Ended” in which we discussed the yield curve, slowing economic growth, valuations, volatility, and sentiment. While volatility and sentiment have gone back into complacency, the fundamental and economic backdrop has deteriorated further. Had you heeded our warning then, you could have saved yourself some pain.

As of February’s end, despite the recent rally over the last two months, the market is still 4.8% lower than the previous peak. It also remains marginally lower than the January high. Despite the 12.5% rally over the last two months (open to close), the rally has only repaired the damage of the December decline.

(Fun with numbers: it took a 12.5% advance to repair a 10.2% decline. This is why measuring performance in percentage terms is deceiving.)

More importantly, note the MONTHLY SELL SIGNAL registered in the bottom panel of the chart above.

Given that monthly data is very slow moving, longer-term signals can uncover changes to trend which short-term market rallies tend to obfuscate.

The next chart shows the monthly buy/sell signals stretched back to 1999. As you will see, these monthly “buy” and “sell” indications are fairly rare over that period. During that period, only the 2015-2016 signal didn’t evolve into a deeper correction as Central Bank interventions flooded the markets with liquidity to stem the risk of a disorderly “Brexit” and slower economic growth.

Currently, we are once again facing slower global economic growth, the potential of a disorderly “Brexit” and Central Banks trying to reverse policy back to a more “accommodative” stance. Therefore, if Central Banks can support prices long-enough for economic data to trough and recover (data is cyclical) allowing earnings to rebound, the monthly signals will reverse putting the markets back into a “bullish” trend.

However, until those signals reverse, it tends to pay to “err to the side of caution.”

“But this time is different because of ‘_(fill in the blank__'”

Well, we can take those same monthly indicators and review them going back to 1950. I have added two confirming monthly indicators as well, so the vertical “red dashed lines” are when all three indicators have aligned which reduces false signals.

I can’t believe I actually have to write the next sentence, but if I don’t I invariably get an email saying “but if you sold out, you missed the whole rally.”

What should be obvious is that while the monthly “sell” signals have gotten you out to avoid more substantial destructions of capital, the reversal of those signals were signs to “get back in.” Investing, long-term is about both deployment of capital and the preservation of it.

Currently, the monthly indicators have all aligned to “confirm” a “sell signal” which since 1950 has been somewhat of a rarity. Yes, the recent signal could turn out to be a “1987” scenario where the market rallied immediately back and reversed the signals back to a “buy” a few months later. Or this could be the beginning of a more substantial corrective process over the course of many months.

The risk of ignoring the longer-term signal currently is the risk of a loss of what has been gained during the current reflexive rally. Yes, while waiting for the signal to reverse will equate to short-term underperformance, the long-term risk-adjusted returns have been more than enough to satisfy retirement planning goals which is why we started investing to begin with.

One of the biggest reasons not to equate the current monthly “sell” signal to a “1987” type period is valuations. In 1987, valuations were low and rising at a time where interest rates and inflation were high and falling. Today, that economic and valuation backdrop are entirely reversed. Currently, a correction from current price levels of the market to PE20 (20x current earnings) would be another 7.3% decline. However, a drop back to the long-term average of PE15 would entail a 30% decline and a reversion to PE10, which would be required to “reset” the market, would be a 53.9% fall.

Still not convinced?

I get it.

Emotionally, the hardest thing for investors to do is to sit on their hands and avoid “risk” when the markets are rising. But this is the psychological issue which plagues all investors over time which is to “buy high” and “sell low.”

It happens to everyone.

This is why we use technical signals to help reduce the “emotional” triggers which lead to poor investment decisions over the long-term. As I have noted before, the following chart is one of my favorites because it combines a litany of confirming signals all into one monthly chart.

Despite the recent rally, which has pushed prices back above their longer-term moving average, the longer-term trends of the signals remain “non-confirming” of the recent rally.

David Rosenberg summed up the current state of affairs very well yesterday:

“Well, the bulls certainly are emboldened, there isn’t any doubt about that. And this confidence, bordering on hubris, is proving very difficult to break. We are back to good news being good news and bad news is also treated as good news.”

He is right, but the technical signals, which do indeed lag short-term turns in the market, have not confirmed the bullish attitude. Rather, and as shown in the chart above, the negative divergence of the indicators from the market should actually raise some concerns over longer-term capital preservation.

What This Means And Doesn’t Mean

What this analysis DOES NOT mean is that you should “sell everything” and “hide in cash.”

As always, long-term portfolio management is about “tweaking” things over time.

At a poker table, if you have a “so so” hand, you bet less or fold. It doesn’t mean you get up and leave the table altogether.

What this analysis DOES MEAN is that we need to use this rally to take some actions to rebalance portfolios to align with some the “concerns” as discussed above.

1) Trim Winning Positions back to their original portfolio weightings. (ie. Take profits)

2) Sell Those Positions That Aren’t Working. If they don’t rally with the market during a bounce, they are going to decline more when the market sells off again.

3) Move Trailing Stop Losses Up to new levels.

4) Review Your Portfolio Allocation Relative To Your Risk Tolerance. If you are aggressively weighted in equities at this point of the market cycle, you may want to try and recall how you felt during 2008. Raise cash levels and increase fixed income accordingly to reduce relative market exposure.

Could I be wrong? Absolutely. But what if the indicators are warning us of something greater?

What’s worse:

1. Missing out temporarily on the initial stages of a longer-term advance, or;
2. Spending time getting back to even, which is not the same as making money.

For the majority of investors, the recent rally has simply been a recovery of what was lost last year. In other words, while investors have made no return over the last year, they have lost 1-year of their retirement saving time horizon.

The decline was small this time.

Currently, the risk of disappointment greatly outweighs the potential for upside surprises at this juncture and the market may already be telling us such is the case.

Yes, if the market reverses back into a more bullish trend, we will miss some of the initial upside but portfolios can be quickly realigned to participate with a much higher reward to risk ratio than what currently exists.

If I am right, however, the preservation of capital during an ensuing market decline will provide a permanent portfolio advantage going forward. The true power of compounding is not found in “the winning,” but in the “not losing.”As I noted in yesterday’s trading rules:

Opportunities are made up far easier than lost capital.” – Todd Harrison

Technically Speaking: Sell Today? Risk Vs. FOMO

The market is downright bullish.

There is little reason to argue the point given the bullish trend since the December 24th lows. Of course, such is not surprising given the Fed’s dovish turn from tightening monetary policy to quietly putting the “punch bowl” back on the table.

But yet, this rally is occurring at a time where Europe’s earnings growth rates for the just reported Q4-period stands at a -1% annualized, which is the lowest since Q2-2016, and the U.S. is on the verge of an earnings recession as well as declining economic data.

Something doesn’t quite jive. As Morgan Stanley’s Mike Wilson noted (via Zerohedge):

“The US is also about to enter an earnings recession, ironically after one of the strongest years for corporate profits on record, the picture of American companies is not much better. Not only is an above average number of companies issuing negative EPS guidance for Q1 2019 (of the 93 companies providing official guidance, 68 or 73%, have issued negative EPS guidance), but consensus EPS for Q1 is now deep in the red. According to Factset, the average Wall Street forecast now projects Q1 earnings per share to decline by 2.7% Y/Y, worse than a consensus -0.8% forecast drop three weeks ago, and starkly lower than the +3% EPS growth expected for Q1 at the start of the year.”

“In a troubling twist, this EPS drop is taking place even as companies continue to buyback record amounts of stock (according to BofA’s client tracker, corporate repurchases are running 98% YTD compared to the same period last year when as a reminder, total announce buybacks topped a record \$1 trillion). More perplexing is that the EPS drop will take place even as S&P500 revenue is still expected to post a solid 5.2% Y/Y growth, suggesting that profit margins peaked some time in 2018 and are now declining, as the following chart from FactSet shows.”

As noted, the economic data is also deteriorating markedly in recent weeks as shown in the latest GDP NowCast from the Atlanta Fed.

Of course, if you have been reading our missives, this drop in the forecast was already evident by the sharp decline in our composite EOCI index.

(The index is comprised of the CFNAI, Chicago PMI, ISM Composite, All Fed Manufacturing Surveys, Markit Composite, PMI Composite, NFIB, and LEI)

As shown, over the last six months, the decline in the LEI has been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. The downturn in the LEI predicted the current economic weakness back in July of 2018 and suggests the data will likely continue to weaken in the months ahead. As of January, the 6-month percentage change was at ZERO and will likely go negative in the next quarter.

The next chart is the EOCI index versus GDP. As we have noted several times previously, the bump in economic growth was from 3-massive hurricanes and 2-devastating wildfires in late 2017. The effect of those natural disasters has quickly dissipated as expected and GDP growth, which is a lagged indicator, will quickly follow.

But despite the underlying economic and fundamental data, the markets have surged back to extremely overbought, extended, and deviated levels.

The chart table below is published weekly for our RIA PRO subscribers (use code PRO30 for a 30-day free trial)

You will note that with the exception of bond prices, every market and sector is more than 5% above its 50-day moving average and year-to-date performance is pushing more historic extremes both in price and in extreme overbought conditions.

Those overbought conditions are more prevalent in the chart below. On virtually every measure, markets are suggesting the fuel for an additional leg higher in assets prices is extremely limited.

The markets are not immune to the “laws of physics.” While the price action is indeed bullish in the short-term, the shorter-term moving averages act like “gravity” on prices. Given the current extension and deviation above the 50-dma the odds of a pullback, before a continued advance, is a high probability.

The same is shown in the chart below. Note the current overbought conditions are the same has they have been previously just prior to a corrective action.

Furthermore, investor complacency has quickly returned to the markets despite the fact investors just took a beating last year.

Importantly, record levels of complacency have been previously associated with short-term market peaks rather than the beginnings of bull markets. Unsurprisingly, VIX call buyers have gone on a shopping spree to lock in profits on recent gains as, despite hopes to the contrary, the risk of a price correction has risen markedly.

Here is the point to all of this.

As shown in the table below, it is very likely that if you sold everything today, and went to cash, that you would miss little over the balance of the year. In other words, the bulk of the gains have likely already been made for the year.

“What? I might miss out on a move higher?”

Yes, but at what risk?

Investing is alway about measuring risk versus reward. Currently, the risk to investors is a correction over the next couple of months followed by a rally into year end which culminates in a total return which is LESS than where you are today.

I know. That is a hard concept to grasp when the media is telling you to not only stay invested, but you better “buy more” now as the “bull market is back.”

I can’t disagree that the long-term trend of the market remains bullish, which is why we continue to have portfolios allocated toward equity risk. As shown below, the market has recently touched on the 3-year moving average confirming the longer-term bull trend of the market. The same occurred in 2015-2016 prior to global central banks leaping into action to flood the system with liquidity in advance of the “Brexit” referendum.

With the current advance already approaching historically high deviations from the long-term mean, again, the risk of a correction greatly outweighs the possibility of a continued advance.

While the intermediate-term market remains bullishly biased, the longer-term monthly dynamics are worrisome. From a purely technical perspective, the monthly backdrop for equities remains bearish and despite the sharp rally over the last two months, the market remains below its long-term bullish trend line. If the current rally fails beneath the long-term trend line, which is being tested now, such has been the hallmark of the change from a bullish to bearish market and suggests much more defensive positioning.

It is also worth noting that on a monthly basis the rally in the market has done little to reverse the declining relative strength of the market (top panel) or the monthly “sell signal” (bottom panel) which both suggest portfolios should remain hedged currently.

“History is replete with examples of major recoveries following big sell-offs, many of which turn out to be head fakes otherwise known as bear market rallies. At the end of the trading day, it’s still fundamentals that should drive investing decisions.”- Danielle DiMartino-Booth

As shown above, I agree with that view which is why, for now, we are holding a higher than normal level of cash. Slightly higher levels of cash in portfolios, not to mention hedges, certainly won’t detract significantly from portfolio performance in the short-term but provide an opportunity to take advantage of panicked sellers later.

Investing is ultimately about understanding the risk to invested capital at any given time. As noted previously, the risk currently outweighs the potential for reward by a significant margin. As Danielle concluded:

“This may be a bear market rally for the ages, but that shouldn’t imply investors should do anything other than rent it. Owning it promises to end in tears.”

Technically Speaking: You Carry An Umbrella In Case It Rains

With the markets closed yesterday, it gives us a chance to review the short, intermediate, and long-term signals the markets are currently sending.

Brett Arends recently wrote an excellent piece for MarketWatch with respect to investors feeling like they “missed out,” on the recent rally. To wit:

“Sure, if you’d bought and held you’d have been sitting in stocks during the boom since Jan. 1. But you’d also have been sitting in stocks when they tanked last quarter. The Dow has risen more than 2,000 points this year, but it fell more than 3,000 in the fourth quarter. Even after the rally, the Standard & Poor’s 500 is still 6% below last September’s peak. The average level on the S&P 500 during 2018 was 2,744, says FactSet. The level today: 2,745. It’s a wash. Meanwhile, the rest of the world has done even worse. The MSCI All Country ex-US index is still 12% below its 2018 average.”

This is an important point, because it is the “psychological” drivers, like the “Fear of Missing Out (F.O.M.O)” and “Get Me The F*** Out (G.M.T.F.O),” which are the primary cause of investing mistakes over time.

But, the recent rally sure “feels” like the worst is over as the Fed “Put” seems to be back on the table.

Or is it?

The following six charts are each identical in their design. The only difference is the time frame of the data being analyzed from Daily to Weekly, to Monthly. For our purposes, we use the three time frames for making different determinations:

• Daily – “warning signals” – Like a “yellow light” at an intersection, it suggests whether an extra-layer of caution should be applied or not.
• Weekly – portfolio allocation changes with respect to equity risk.
• Monthly – understanding whether the overall “trend” of the market changed. (While a “rising tide lifts all boats,” the opposite is also true.)

As shown below, you can see that the daily indicator provides an abundance of signals. While many are timely in suggesting you should have less risk in the markets, there are also plenty of false signals along the way as well. Currently , the “sell signal” has been, and remains, in place since late September of 2018. But the recent rally suggests this signal could soon reverse if the rally persists.

The following series of charts come courtesy of RIA PRO. (Get a free 30-day trial with code PRO30)

Likewise, the secondary, or confirming indicator, is also suggesting “caution” with respect to chasing the market currently. But, as I stated above, these very short-term indicators are like “yellow lights at a busy intersection.” As investors we have a choice, “slow down” or “step on the gas.

But which action do you take? The recent rally certainly “feels” like you should “shove your foot in the carburetor” and “hang on for the ride.”

This is why we use confirming indicators. Like any good process, we want to have one signal “confirmed” by others which increase the probability of getting more accurate signals over time.

(Note: I said “probability” of “more accurate” signals over time. There are no “perfect” indicators or processes that work 100% of the time. It is the discipline of adhering to a process dogmatically over time, even when it seems broken, which has the highest probability of success.)

Even on a “weekly” basis, there can be a lot of signals, and as stated above, “false” signals are not uncommon. Currently, as the purple highlight shows, despite the recent rally, the signal suggests a higher level of caution currently.

But could it just be a “false signal?” Maybe. The signal in 2011 and 2012 were certainly false signals due to the interventions of massive rounds from “QE” from the Fed. However, given the Fed is only potentially pausing the reduction of, and not injecting, liquidity, the current “signal” is likely worth giving more weight to.

Stepping back to a monthly basis, we can “confirm” the daily, and weekly, signals further. Again, as with all signals, you can get some false indications, but those were small prices to pay for the “savings” when the signals were right as during 2018.

Currently, the ONLY signal which is NOT confirming the other five is the long-term month indicator which continues to confirm the current “bull market” trend from the 2009 lows remains intact.

This last indicator is why our portfolios remain primarily allocated to equity risk currently (although the first 5-signals have us running at reduced levels of equity risk, higher cash levels, and fixed income at targets.)

Currently, as Brett notes, the current rally has all of the “earmarks” of a “bull rally in a bear market.”

“Yes, certainly, the biggest “up” days on the market have historically accounted for a big chunk of long-term returns.

‘One of the most common rhetorical bulwarks in the defense of buy and hold investing is to demonstrate the effects of missing the best 10 days in the market, and how that would affect the compounded return to investors. This is perhaps one of the most misleading statistics in our profession.’ Meb Faber , Cambria Investments

The reasons? Most of the biggest ‘up’ days took place during bear markets, when the smart move was to be on the sidelines, he says. Oh, and missing the worst days was just as good for your wealth as catching the best ones, he found. From 1928 through 2010, he calculated, the 1% best days gained you, on average, 4.9% each. What about the worst 1% of days? They cost you about 4.9% each.'”

While we looked at daily, weekly, and monthly indications, taking a look at “quarterly” data can give us clues as to the “real risk” investors are taking on at any given time. Is this the beginning of a major bull market cycle? Or, are we nearing the end of one? How you answer that question, given the relatively short time frame of the majority of investors (hint – you don’t have 100-years to reach your goals), can have an important impact on your outcome.

As I wrote in “Investors Are Dealt A Losing Hand:”

“The problem for investors is that since fundamentals take an exceedingly long time to play out, as prices become detached “reality,” it becomes believed that somehow “this time is different.”

Unfortunately, it never is.

The chart of the S&P 500 is derived from Dr. Robert Shiller’s inflation adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data I have calculated:

• The 12-period (3-year) Relative Strength Index (RSI),
• Bollinger Bands (2 and 3 standard deviations of the 3-year average),
• CAPE Ratio, and;
• The percentage deviation above and below the 3-year moving average.
• The vertical RED lines denote points where all measures have aligned”

Even after the recent correction, long-term extensions and deviations remain at historically high levels which, historically speaking, have not been extremely kind to investors. But valuations, despite the recent correction, as still pushing 30x earnings as well. As Brett noted:

“From the viewpoint of long-term investment, major risks remain according to some long-term strategists. Yes, conventional wisdom on Wall Street tells you that stocks are likely to gain an average of around 9% a year. And yes, that’s based on the historic average going back at least to the 1920s. But, say some financial historians, that’s a misreading of the past. Stocks, they say, typically produced ‘average’ returns if you bought them at roughly ‘average’ valuations in relation to things like net assets and net income. And U.S. stock valuations today, they warn, are anything but average.

According to price-to-earnings or ‘PE’ data tracked by Yale University finance professor and Nobel Prize winner Robert Shiller, the S&P 500 is about 75% above its historic average valuation. ‘

Today, with valuations still near the most expensive 10% of starting valuations, 10-year forward returns will likely be very disappointing.

But, valuations are a “horrible” investment timing device. Which is why we use a specific set of price indications over varied time frames to determine short-term risk versus reward.

Currently, the markets are rallying. so we have to pay attention to what is happening now. As investors, we have to make money when the “sun is shining.” But that doesn’t mean to do it with reckless abandon, and as Brett pointed out, the same things that caused the sell-off in 2018, still exist currently.

• Economic slowdowns in China and Europe
• Rising interest rates
• Looming conflicts between a Democratic Congress and President Trump
• Weaker corporate earnings.

(You wouldn’t lay on the beach butt naked on a blistering summer day without any sunscreen would you? You could, but the consequences could be painful.)

The same is true for investing. Currently, the markets are rallying on a lot of “hope” and short-term “optimism.” However, longer-term fundamental and technical indicators are suggesting investors take some cautionary measures.

This doesn’t mean sell everything and hide in cash. But it does suggest adding some portfolio hedges, raising cash levels a bit, and holding fixed income.

You may appreciate having an umbrella if it begins to rain.

Technically Speaking: Stuck In The Middle With You

In this past weekend’s missive, we discussed the market stalling at the 200-dma. To wit:

“We said then the most likely target for the rally was the 200-dma. It was essentially the level at which the ‘irresistible force would meet the immovable object.'”

“What will be critically important now is for the markets to retest and hold support at the Oct-Nov lows which will coincide with the 50-dma. A failure of that level will likely see a retest of the 2018 lows.”

“A retest of those lows, by the way, is not an “outside chance.” It is actually a fairly high possibility.  A look back at the 2015-2016 correction makes the case for that fairly clearly.”

“But even if a retest of lows doesn’t happen, you should be aware that sharp market rallies are not uncommon, but almost always have a subsequent retracement.”

Importantly, as I expanded to our RIA PRO subscribers:

We are likely going to have another couple of attempts next week as the bulls aren’t ready to give up the chase just yet. We are continuing to watch the risk carefully and have been working on repositioning portfolios over the last couple of weeks.

As noted, we lifted profits at the 200-dma and added hedges to the Equity and Equity Long/Short portfolios.”

On Monday, the markets rallied a bit out of the gate over continuing hopes of a “trade deal” between the U.S. and China but fell back to even by the end of the day. With earnings season now largely behind us, the “bulls” are going to need improving economic data and relief from Washington to provide continued support for the rally.

This morning, futures are once again pointing higher on news that a proposal is ready to be sent to the President providing just \$1.4 billion for border “security,” no wall, to avert another Government shut down. It is highly likely the bill will be rejected by the President and he will start talking about the use of a “national security” issue to fund the building of the wall. This will divide Congress even more than it is already almost ensuring NO legislation passes before the end of the President’s first term.

Also, talks are once again starting with China over trade. This is also buoying markets in the short-term in hopes of a resolution to reduce the impact of tariffs on businesses. Hopes for a noteworthy “deal” remain extremely slim at this point.

But those two issues are actually relatively minor as other issues, as noted on Saturday, will actually bear much more weight on the market going forward.

• Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go. In fact, as of now, the consensus estimates are suggesting the first year-over-year decline since 2016.
• Stock market targets for 2019 are way too high as well.
• Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
• Larry Kudlow said the U.S. and China are still VERY far apart on trade.
• Trump has postponed his meeting with President Xi which puts the market at risk of higher tariffs.
• There is a decent probability the U.S. Government winds up getting shut down again after next week over “border wall” funding.
• The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
• Economic growth is slowing as previously stated.
• Chinese economic has weakened further since our previous note.
• European growth, already weak, will likely struggle as well.
• Valuations remain expensive

Of course, despite those more macro-concerns, the market has had a phenomenal run from the “Christmas Eve” lows and has moved above both the Oct-Nov lows and the 50-dma. This is clearly bullish in the short-term for investors. With those levels of previous resistance now turned support, there is a little cushion for the bulls to hold on to.

The biggest hurdle for a bullish advance from current levels is the cluster of resistance sitting just overhead. Sven Heinrich noted the market remains stuck below the collision of the 200-day, the 50-week, and the 15-month moving averages.

As shown, this set up previously existed back in late 2015 and early 2016. The initial challenge saw the market actually break back above the cluster of resistance, which “sucked the bulls” back into the market before setting new lows.

The correction, that was then in process, was cut short by massive infusions of global liquidity as I discussed yesterday:

“Global Central banks had stepped in to flood the system with liquidity. As you can see in the chart below, while the Fed had stopped expanding their balance sheet, everyone else went into over-drive.”

Another concern for a further rally is that investor allocations never got extremely bearish. The chart below compares the S&P 500 to various measures of Rydex ratios (bear market to bull market funds)

Note that during the recent sell-off, the move to bearish funds never achieved the levels seen during the 2015-2016 correction. More importantly, the snap-back to “complacency” has been quite astonishing. The next chart puts it into a longer-term perspective for comparison.

Despite the depth of the decline, and the belief that the “bear market” of 2018 is now complete, it is worth noting the reversion in investor positioning has not even begun to approach levels seen during an actual “bear market.”

But stepping back to the long-term trends, when managing money the most important part of the battle is getting the overall “trend” right. “Buy and hold” strategies work fine in rising price trends, and “not so much” during declines.

The reason why most “buy and hold” supporters suggest there is no alternative is because of two primary problems:

1. Trend changes happen slowly and can be deceptive at times, and;
2. Bear markets happen fast.

Since the primary messaging from the media is that “you can’t miss out” on a “bull market,” investors tend to dismiss the basic warning signs that markets issue. However, because “bear markets” happen fast, by the time one is realized, it is often too late to do anything about it.

So, you just have to ride it out. You don’t have any other option. Right?

The chart below is one of my favorites. It is a monthly chart of several combined indicators which are excellent at denoting changes to overall market trends. The indicators started ringing alarm bells in early 2018 which is when I begin talking about the end of the “bull market” advance.

Currently, every single monthly indicator, as of the end of January, is currently suggesting downward pressure on the market. The only signal which has yet to confirm is the cross of the 15-month and 21-month moving averages. The 21-month moving average has pretty much been both support and/or resistance, to the overall trend of the market for the past 25-years. At present, the market is “trapped in the middle” between those two monthly averages.

If the bull market is going to resume, the market needs to break above the 15-month moving average and rally enough to reverse the torrent of sell-signals running across the complex of price indications. With earnings and economic growth weakening, this could be a tough order to fill in the near term.

So, for now, with our portfolios underweight equity, over weight cash and fixed income, we remain “stuck in the middle with you.”

Technically Speaking: Too Fast, Too Furious

On December 25th, I penned “My Christmas Wish” where in I stated that is was “now or never” for the bulls to make a stand.

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

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

You have always heard that ‘for every buyer, there is a seller.’

While this is a true statement, it is incomplete.

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

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

We now know where the buyers were willing to start buying again.

Let’s take a look at that same technical indicator just one month later.

Now, let me remind you this is a WEEKLY indicator and is therefore typically very slow moving. The magnitude of the advance from the December 24th lows has been breathtaking.

Short-term technical indicators also show the violent reversion from extreme oversold conditions back to extreme overbought.

The McClellan Oscillator also swung from record low readings to record high readings in the same time frame as well.

But it isn’t just the technical change that has had a violent reversion but also the rush back into equities by investors.

Oh wait, that didn’t actually happen.

As noted by Deutsche Bank’s Parag Thatte noted recently:

“While the S&P 500 rallied +15% since late December, equity funds have continued to see large outflows. As Thatte elaborates, “US equity funds in particular have continued to see large outflows (-\$40bn) since then, following massive outflows (-\$77bn) through the sell-off from October to December.”

This confirms our concern the recent rally has primarily been a function of short-covering and repositioning in the markets rather than an “all-out” buying spree based on a “conviction” the “bull market” remains intact.

David Rosenberg recently confirmed the same:

“Let’s go back to December for a minute. This was the worst December since 1931, mind you, followed by the best January since 1987. This is nothing more than market that has gone completely manic.

To suggest that there is anything fundamental about this dead-cat bounce in equities is laughable. This is an economy, and a market, that couldn’t even sustain a 3% yield on the 10-year T-note. It sputtered at the thought of the Fed taking the funds rate marginally above zero on a ‘real’ basis, even as it feasted on unprecedented stimulus for a such a late-cycle economy.

Yes, Powell et al. helped trigger this latest up-leg, not just at last week’s meeting, but in the lead-up to the confab as well. The Fed has been crying uncle for weeks now.”

As I discussed previously, this also highlights the importance of long-term moving averages.

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

Well, as we now know, the market found support at the 200-week (4-year) moving average. As you will notice, with only a couple of exceptions, the 200-week moving average has acted as a long-term support line for the market. When the market has previously confirmed a break below the long-term average, more protracted mean-reverting events were already in process. Currently, the “bull case” remains intact as that long-term average has held…so far.

However, just because the initial test of the trend has held, it doesn’t mean the correction is over. As was seen in late 2015 and early 2016, the market held that trend during two sequential tests of the lows. While the bulls remain in charge for the moment, it will be whether the bulls can successfully manage a retest of lows without breaking the long-term trend.

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

Again, a monthly close below 2280 would suggest a more protracted “bear” market is underway.

The Bounce Hits Our Targets

As I noted in the Christmas report, we were looking for an oversold retracement rally to push stocks back toward the previous October-November closing lows of 2600-2650. The rally has hit, and slightly exceeded those original estimates.

But, we also said that on a monthly basis the rally could extend as high as 2700 which is roughly where January closed.

And, not surprisingly, it all turned out precisely as I stated:

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

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

It is too early to suggest the “bear market of 2018” is officially over.

But, the rally has simply been “Too Fast, Too Furious,” completely discounting the deteriorating fundamental underpinnings:

• Earnings estimates for 2019 have sharply collapsed as I previously stated they would and still have more to go.
• Stock market targets for 2019 are way too high as well.
• Despite the Federal Reserve turning more dovish verbally, they DID NOT say they actually WOULD pause their rate hikes or stop reducing their balance sheet.
• Trade wars are set to continue as talks with China will likely be fruitless.
• The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
• Economic growth is slowing as previously stated.
• Chinese economic has weakened further since our previous note.
• European growth, already weak, will likely struggle as well.
• Valuations remain expensive

You get the idea.

But more importantly, as recently noted by Sven Henrich, it also resembles much of what was seen at the previous two bull market peaks.

“Note the common and concurrent elements of the previous two big market tops (2000, 2007) versus now:”

• New market highs tagging the upper monthly Bollinger band on a monthly negative RSI (relative strength index) divergence — check.
• A steep correction off the highs that breaks a multi-year trend line — check.
• A turning of the monthly MACD (Moving Average Convergence Divergence) toward south and the histogram to negative — check.
• A correction that transverses all the way from the upper monthly Bollinger band to the lower monthly Bollinger band before bouncing — check.
• A counter rally that moves all the way from the lower Bollinger band to the middle Bollinger band, the 20MA — check.
• A counter rally that produces a bump in the RSI around the middle zone, alleviating oversold conditions — check.
• All these events occurring following an extended trend of lower unemployment, signaling the coming end of a business cycle — check.
• All these events coinciding with a reversal in yields — check.
• All these events coinciding with a Federal Reserve suddenly halting its rate hike cycle — check.

The rally we “wished” for on Christmas has come to fruition. However, it isn’t a rally to become overly complacent in as there remain significant challenges coming from weaker economic growth, rising debt levels, and slowing earnings growth.

But as I concluded in this past weekend’s missive:

“While markets can certainly remain extended for much longer than logic would predict, they can not, and ultimately will not, stay overly extended indefinitely.

The important point here is simply this. While the Fed may have curtailed the 2018 bear market temporarily, the environment today is vastly different than it was in 2008-2009.  Here are a few more differences:

• Unemployment is 4%, not 10+%
• Jobless claims are at historic lows, rather than historic highs.
• Consumer confidence is optimistic, not pessimistic.
• Corporate debt is a record levels and the quality of that debt has deteriorated.
• The government is already running a \$1 trillion deficit in an expansion not half that rate as prior to the last recession.
• The economy is extremely long is a growth cycle, not emerging from a recession.
• Pent up demand for houses, cars, and other durables has been absorbed
• Production and Services measures recently peaked, not bottomed.

In other words, the world is exactly the opposite of what it was when the Fed launched “monetary accommodation”previously. Logic suggests that such an environment will make further interventions by the Fed less effective.

The only question is how long will it take the markets to figure it out?”

I suspect not too much longer.

Technically Speaking: Can The Fed’s Reversal Save The Bull?

As we discussed in this past weekend’s missive:

A WSJ article suggesting that the Fed would not only stop hiking interest rates but also cease the balance sheet reduction which has been extracting liquidity from the market.

In mid-2018, the Federal Reserve was adamant that a strong economy and rising inflationary pressures required tighter monetary conditions. At that time they were discussing additional rate hikes and a continued reduction of their \$4 Trillion balance sheet.

All it took was a rough December, pressure from Wall Street’s member banks, and a disgruntled White House to completely flip their thinking.”

This is a change for Jerome Powell, who was believed to be substantially against Fed interventions, shows his worst fear being realized – being held “hostage” by the markets. A look at Fed meeting minutes from 2013 was his recognition of that fear.

“I have one final point, which is to ask, what is the plan if the economy does not cooperate? We are at \$4 trillion in expectation now. That is where the balance sheet stops in expectation now.  If we have two bad employment reports, the markets are going to move that number way out. We’re headed for \$5 trillion, as others have mentioned.  And the idea that President Kocherlakota said and Governor Duke echoed— that we ’re now a captive of the market — is somewhat chilling to me.”

This week, the Fed meets to discuss their next policy moves. If the Fed announces a reduction/elimination of future rate hikes and/or a reduction/elimination of the balance sheet reduction, stocks will likely find a bid.

At least in the short-term.

Longer-term the markets are still dealing with an aging economic growth cycle, weakening rates of earnings growth, and rising political tensions. But from a technical basis, they are also dealing with a break of long-term trend lines and very major “sell” signals.

The problem for the Fed is that while ceasing rate hikes and balance sheet reductions may be a short-term positive, monetary policy is already substantially tighter than it was at the lows. In other words, “stopping” tightening is not the same as “easing.”

Back To The Future – 2015/2016

We have seen a similar period previously. During the 2015-2016 correction, the Fed had just announced it’s intent to start hiking rates and had stopped reinvesting liquidity into the markets. (Early tightening.)

The market plunged sharply prompting several Fed Presidents to make announcements reminding markets they still remained extremely “accommodative.”

The market rallied back closing in on previous highs. It certainly looked as if the bulls had regained control of the market. Headlines declared the “correction” was over. But, it wasn’t.

The retest of lows, and setting of new lows, happened over the next 60-days. With concerns over the impact of the upcoming “Brexit” vote, the Fed Chairman Janet Yellen coordinated with global Central Banks to provide liquidity to support global markets in the event of a disorderly “break up.”

In November of that same year, Donald Trump was elected to office with promises of deregulation, tax cuts, and massive infrastructure spending projects which provided an additional boost to equities into the end of the year.

Those promises combined with massive Central Bank stimulus led to one of the longest bull market runs in history with virtually no volatility.

So, here we are today.

The Trump Administration successfully passed tax cut legislation for corporations in December of 2017. Subsequently, stocks surged at the beginning of 2018 as bottom line earnings were expected to explode.

However, that surge also marked the “blow off” top of the rally.

As the Administration launched its “Trade War” with China. Stocks fell in February. However, the markets were able to regain their footing in April as the first look at earnings, post tax-cuts, had soared.

Then came October. The ongoing tariffs on goods being shipped, along with a stronger dollar, began to weigh on corporate outlooks. But it was the Fed, who was in the process of tightening monetary policy, uttered the words that spooked the markets.

“We are still a long-way from the ‘neutral rate.'” – Jerome Powell

Despite evidence of an already slowing economy, and the yield curve almost inverted, the idea the Fed would remain consistent in hiking interest rates and reducing their balance sheet further weighed on investor confidence.

The “Fed Put” was gone.

Market Dependent

Despite commentary from the Fed they were only “data dependent,” all it took was a 20% correction from the highs to change their minds. But not just the Fed’s.

While the WSJ is reporting a change in attitude from the Fed on the reduction of their balance sheet, the White House, which has pinned their measurement of success to stock prices, took prompt action.

The Secretary of the Treasury made announcements assuring the markets of stability and pushing for banks to put liquidity back into the markets. The Trump Administration has repeatedly assured the markets that “trade talks” are going well and “deal” is close to being done.

For now, the markets have bought into the “rhetoric” and have rallied sharply from the lows.

“Mr. Market” clearly has control over both fiscal and monetary policy. “Data dependency” has been relegated to the “dust bin of history.”

So, is the bull back?

Or, is the market, despite all of the support, set to retest lows as seen in early 2016?

Bryce Coward, CFA recently studied all the previous similar declines:

“We’ve cataloged all 20 uninterrupted 15% declines in the post-war period and documented what has happened afterward, as well as the type of market environment in which those declines have taken place. By uninterrupted decline, we mean a waterfall decline of at least 15% without an intermediate counter-trend rally of at least 5%. Some bullet points describing the rallies following those declines are below:

• The average counter-trend rally following a 15% waterfall decline is 11.9% (11% median) and it takes place over 21 trading days on average (median 11 days).
• The rallies end up retracing 57% of the decline on average (median 52%).
• The average of those bear markets have a peak-to-trough decline of 33% (median 29%)
• The duration of those bear markets is 284 trading days on average (median 139 days)
• In 16 of 19 instances (excluding the decline we just witnessed), a recession was associated with the bear markets.
• Waterfall declines of at least 15% have only taken place in bear markets.
• 100% of the time the low resulting from the waterfall decline was retested, and in 15 of 19 cases a new lower lower was made.”

What do these data say about the current counter-trend rally?

• First, this rally has already retraced 65% of the waterfall decline (greater than average and median) and has lasted about three weeks (less than average but greater than median). This suggests upside from here may be limited in both magnitude and duration.
• Furthermore, these data strongly suggest the major index will retest the Christmas Eve low at the very least and most likely will make a new lower low in the weeks and months ahead.
• While we are not forecasting a recession at this time, waterfall declines of the magnitude just witnessed tend to take place in recessionary market environments, so we need to at least be open to that possibility.
• Finally, waterfall declines typically take place in bear markets lasting an average of 284 days (median 139 days). At just 81 days in duration, these data suggests we have bit further to run before we reach the bear market nadir. That said, there are four instances of waterfall declines taking place in short bear markets, so we don’t place much weight on this particular piece.

While the markets could certainly rally in the weeks ahead, there are significant challenges coming from both weaker economic growth, rising debt levels, and slowing earnings growth.

But most importantly, the biggest challenge in the months, and years, ahead will be the sustainability of the price deviation from long-term trends.

As Dana Lyons penned last week:

“Finally, even stock prices themselves can be considered excessive. In fact, when compared to a regression trend line on the S&P Composite going back to inception in 1871, the index price reached 122% above its long-term trend this past September. Another way of saying that is that the S&P 500 is 122% overbought. In other words, if stock prices were simply to revert to their long-term mean, the S&P 500 would be down closer to 1300 than recent highs near 2900.”

“There are certainly plenty more examples of excess in the stock market. But these few should give you an idea why, if we have entered a longer-term bear market, the oft-derided bears may end up getting the last laugh.”

Yes, this could certainly work out much like 2015-2016 if the Fed throws in the towel to appease the markets.

If they don’t, there are plenty of indications which suggest a more important mean reversion process has already begun.

Charts Both Bulls & Bears Should Consider

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fundamentally Speaking: 2019 Estimates Are Still Too High

” So far in fourth quarter reporting season, with 11 percent of the results reported for the S&P 500, three-quarters of companies have actually surprised Wall Street’s forecasters. Earnings are shaping up to be better than people expected.” CNBC

While it is a correct statement, it is also shows the problem with the “earnings silly season.”

As I noted in this past weekend’s Real Investment Report:

With earnings season underway, there is support in the short-term for asset prices but remember that earnings are only beating sharply downgraded estimates. (This is the equivalent of companies scoring a 71 after the level for an “A” was reduced from 90 to 70)”

In other words, while the media is pounding the table screaming “buy, buy, buy,” investors should take a step back and remember that investing is ultimately a function of “actual” earnings, revenues, and cash flow. Or, as Warren Buffett once quipped:

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

To explain the issue, which ultimately becomes a major problem for investors, we have to jump into a DeLorean for a quick trip back to January 1, 2018.

At that point, Wall Street analysts were predicting earnings were going to rise to \$156.75 per share by the end of 2019. With the S&P 500 trading at 2695.81 forward P/E’s were a “bargain” at just 17.19x earnings.

However, by May, analysts were chasing each other to be the highest estimate on Wall Street (bullish headlines get clicks) and pushed the 2019 number to a whopping 170.48 per share. With the market at 2734.62 at the end of May, it was time to “buy, buy, buy” as the market was “cheap, cheap, cheap” at just 16x earnings.

The only problem is that if you bought the market in June of 2018 based on its “cheapness,” it was a poor decision as forward earnings estimates turned out to be grossly wrong.

Over the last couple of years I have repeatedly produced the following chart which shows the problem with forward estimates. In just the last month, Wall Street earnings estimates fell by more than \$3 per share pushing the total decline to more than \$17 per share from the peak.

The red-dashed line is from an early 2018 where I discussed the fallacy of “tax cuts.” In reality estimates must eventually reflect real, organic, economic growth. Tax policy changes do not boost revenue growth at the top line.

Not surprisingly, such has been exactly the case, and despite a 20% correction from the peak of the market last year, consequently at a time when investors were told to “buy, buy, buy” because profits were exploding, investors are paying more today for each dollar in earnings today than they were in June, 2018.

To get a better sense of just how much those forecasts have been downwardly revised, the chart below compares where estimates were at the beginning of 2018 for the end of 2019.

In other words, equities have gotten MORE expensive over the last 6-months rather than less. However, given that bottom line earnings per share is grossly manipulated through share repurchases, accounting gimmicks, and outright “fudging,” more on this in a moment, top-line revenue gives us a much more accurate picture of the excessive prices being paid for stock ownership. Currently, investors are paying 2x sales which exceeds the peak paid in 2000.

However, investors quickly dismiss fundamental realities for the promise of future riches. Of course, this is the “modus operandi” of Wall Street to bring gamblers into the casino. As I discussed in The Problem With Wall Street Forecasts,:

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

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

Yet, even while this data is readily apparent, Wall Street analysts continue to same game of starting with wildly exuberant estimates and then lowering estimates until companies can beat them.

Since investors don’t hold analysts accountable, it is a game which is played out each quarter so that Wall Street can sell their wares. The reality is that if analysts were held to their original estimates, instead of 70-80% of companies beating estimates every quarter, it would be exactly the opposite.

As noted above, the biggest drivers to bottom line earnings has been accounting gimmicks, share repurchases, and tax cuts. Revenue growth, as a percentage of the total, has shrunk to just 14% even though reported earnings per share surged by almost \$3/share from repurchases.

However, even with the recent decline of forward estimates, they still remain far too lofty for 2019. Economic growth is slowing and, as I penned just recently (see article for composite index makeup), the domestic economy has already shown early signs of a more significant slowdown. Given that corporate profits are a function of economic activity, it should not be surprising that the rate of change of the S&P 500 is closely tied to annual changes in the Economic Output Composite Index.

The “sugar high” of economic growth seen in the first two quarters of 2018 was from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. While those activities create the “illusion” of growth by pulling forward “future” consumption, it isn’t sustainable and profit margins will follow suit very quickly.

The point here is simple, before falling victim to the “buy the market because it’s cheap based on forward estimates” line, make sure you understand the “what” you are actually paying for.

Wall Street analysts are always exuberant hoping for a continued surge in earnings in the months ahead. But such has always been the case.

Currently, there are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

Wall Street is notorious for missing the major turning points of the markets and leaving investors scrambling for the exits.

2018 should have been a wake-up call. 2019 could well be the problem.

The Economy IS Slowing

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

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

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

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

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

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

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

But herein lies “the trap” for investors.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Technically Speaking: Bull Or Bear? Comparing Views

As the trumpets sound to signal the start of earnings season, the battle between fundamentals and “hope” begins. While earnings expectations have weakened markedly in recent months, the bulls remain steadfast in their belief the market correction is now over.

As I discussed in this past weekend’s missive :

“‘The stock market just got off to its best start in 13 years. The 7-session start to the year is the best for the Dow, S&P 500 and Nasdaq since 2006.’ – Mark DeCambre via MarketWatch

While headlines like this will certainly get ‘‘clicks’ and ‘likes,’ it is important to keep things is perspective. Despite the rally over the last several sessions, the markets are still roughly 3% lower than where we started 2018, much less the 11% from previous all-time highs.

Importantly, there has been a tremendous amount of ‘technical damage’ done to the market in recent months which will take some time to repair. Important trend lines have been broken, major sell-signals are in place, and major moving averages have crossed each other signaling downward pressure for stocks.

“While the chart is a bit noisy, just note the vertical red lines. There have only been a total of 6-periods in the last 25-years where all the criteria for a deeper correction have been met. While the 2011 and 2015 markets did NOT fall into more protracted corrections due to massive interventions by Central Banks, the current decline has no such support currently.

So, while there are many headlines circulating the ‘interweb’ currently suggesting the ‘Great Bear Market Of 2018’ is officially over, I would caution you against getting overly bullish too quickly.”

However, from a portfolio management perspective it is always a valuable exercise to analyze both sides of the argument to make a better investment decision. Therefore, let’s take a look at the technical case for the markets from both a bullish and bearish perspective.

THE BULL CASE

1) Big Rallies Happen Off Big Lows

It isn’t surprising. given the magnitude of the rally following the Christmas Eve low, the “bullish bias” would quickly return. There is precedent for such exuberance as well as recently noted by Bespoke.

As they showed in their table below, whenever there has previously been a sharp fall of more than 15% in a quarter, followed by a sharp rally of at least 10% in the following days, the markets were higher in the near future.

Such a combination of events has only occurred 12 times over the past 75 years, and the market was higher 75% of the time in 3-months and higher 83% of the time in 12-months.

But note that in some of these cases these were big rallies within the context of a bear market such as the rallies in 2001 and 2008.

2) The Fed Has Gone “Dovish”

In recent weeks, the previously “hawkish” Federal Reserve has become much more “dovish” suggesting a “pause” in monetary policy is possible if needed.

This change has not gone unnoticed by the bulls. Since Fed Chair Jerome Powell used the word “patient” when referring to the Fed’s approach to hiking interest rates, stocks went straight up. Given there had seemingly been a disconnect between the Fed, the markets, and the White House, the change was a welcome support for the bulls.

It is also believed the Fed will back off of their balance sheet reductions if needed, although Jerome Powell has not made any public indication such is an option currently.

While not really a “technical measurement,” such a change in monetary policy would certainly provide support for the bulls in the near term.

The participation by stocks in the recent bullish advance has been strong enough to push the advance-decline line above the recent downtrend.

Such a rise in participation suggests the momentum behind stocks is supportive enough to push stocks to higher levels and should not be dismissed lightly.

Currently, as shown above, the short-term dynamics of the market have improved sufficiently enough to trigger an early “buy” signal. This suggests a moderate increase in equity exposure is warranted given a proper opportunity. However, to ensure that the current advance is not a “head-fake,” as repeated seen previously, the market will need to reduce the current overbought condition without violating near-term support levels OR reversing the current buy signal.

There is a good bit of work to do to satisfy those conditions, but things are indeed improving.

Let me be VERY CLEAR – this is VERY SHORT-TERM analysis. From a TRADING perspective, there is a tradeable opportunity. This DOES NOT mean the markets are about to begin the next great secular bull market. Caution is highly advised if you are the type of person who doesn’t pay close attention to your portfolio OR have an investment startegy based on “hoping things will get back to even” rather than selling.

THE BEAR CASE

The bear case is more grounded in longer-term price dynamics – weekly and monthly versus daily which suggests the current rally remains a reflexive rally within the confines of a more bearish backdrop.

1) Short-Term: Market Rally On Declining Volume

The recent market rally, while strong, occurred amidst declining volume suggesting more of a short-covering rally rather than a conviction to a “bull market” meme.

Furthermore, the rally which was one of the strongest seen in the last decade, barely retraced 38.2% of the previous decline. In order for the market to reverse the current “bearish” context, it will require a substantial move higher back above the 200-day moving average.

Given the economic and fundamental backdrop currently at play, such a rally will likely prove to be very challenging.

2) Longer-Term Dynamics Still Bearish

If we step back and look at the market from a longer-term perspective, where true price trends are revealed, we see a very different picture emerge. As shown below, the current dynamics of the market are extremely similar to those of the previous two bull market peaks. Given the deterioration in revenues, bottom-line earnings, and weaker economics, the backdrop between today and the end of previous bull markets is consistent.

In both previous cases, the market peaked in a consolidation process, broke down through longer-term major trend lines, and did so on falling momentum combined with a long-term moving average convergence-divergence (MACD) “sell” signal.

If a “bull market” were truly taking place we should see a flight from “safety” back into “risk.” As shown below, the declines in the stock-bond-ratio has been coincident with both short and long-term market corrections.

Currently, we are not seeing “risk taking” being a predominate factor at the moment. Could this change, absolutely. However, currently, despite the surge in the markets from the December lows, both Treasury yields and the stock/bond ratio have remained fairly firm.

Such continues to suggest the current market rally remains a “counter-trend rally” within the context of an ongoing correction.

What you decide to do with this information is entirely up to you. As I stated, I do think there is enough of a bullish case being built to warrant taking some equity risk on a very short-term basis.

However, the longer-term dynamics are clearly bearish. When those negative price dynamics are combined with the fundamental and economic backdrop, the “risk” of having excessive exposure to the markets greatly outweighs the potential “reward. “

Could the markets rocket higher as some analysts currently expect? It is quite possible particularly if the Federal Reserve reverses course and becomes much more accommodative.

For now the upside remains limited to roughly 80 points as compared to 230 points of downside.

Those are odds that Las Vegas would just love to give you.

What Will Cause The Next Recession?

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

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

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

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

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

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

First, this is NOT an economic cycle:

This is:

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

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

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

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

Let’s revisit Bradford’s three specific crises.

The S&L Crisis

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

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

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

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

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

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

The Dot.Com Bubble

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

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

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

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

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

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

It wasn’t long before the system came unglued.

The Great Financial Crisis

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

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

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

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

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

They weren’t and it didn’t.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This time will be no different.

Technically Speaking: Return Of The Bull Or Dead Cat Bounce

If you listen to the media, the shocking and totally unexpected downturn last was unable to be foreseen by anyone. Thankfully, it’s now over and we can get back to the roaring bull market.

Or can we?

Mark Hulbert wrote an interesting piece recently stating:

“The stock market’s recent correction has been more abrupt than you’d expect if the market were in the early stages of a major decline.

I say that because one of the hallmarks of a major market top is that the bear market that ensues is relatively mild at the beginning, only building up a head of steam over several months. Corrections, in contrast, tend to be far sharper and more precipitous.”

His view is a common pushed out in the mainstream narrative as of late, but is based on a potentially flawed assumption the bear market began in October of this past year as shown below.

The decline from “all-time” highs took many of the persistently bullish commentators by surprise.

However, the topping process began long before October and, as shown in the chart below, the market was sending a clear warning that something was amiss.

As shown, the “blow-off rally” in January formed the left-shoulder of what would eventually become a “head and shoulder” topping process. For those not into the technical “mumbo jumbo,” this pattern of prices is similar to throwing a ball up in the air. Initially, the ball has a lot of momentum as it begins it rise. However, at a point, the force of gravity slows the momentum of the rise until, for a brief moment, the ball is motionless before falling back to earth.

Markets work much the same. Eventually, the momentum of the rise in prices becomes too far extended above long-term price trends, which act like gravity, and prices “fall back to earth.” The chart below shows the previous momentum driven rise and fall of the markets.

The yellow-shaded boxes denote the points where price momentum began to struggle to move higher. The lines in the bottom pane denote the change to price-momentum from positive to negative.

It is important to note that in late 2015, and early 2016, the market had begun a topping process that should have evolved into a deeper overall correction. However, just as longer-term trend lines were being violated, global Central Banks leapt into action with a flood of liquidity to offset the risk of a disorderly “Brexit” at a time the Federal Reserve was starting to hike overnight lending rates in the U.S.

While the “Brexit” issue is still ongoing, the risk to the market never actually matured. Therefore, the flood of global liquidity only had one place to go and drove asset prices skyward over the next 18-months.

However, today, that liquidity backdrop has changed dramatically. The Fed has hiked rates from near 0% to over 2%, and are slated to do more this year, and are extracted liquidity from the markets at a rate averaging \$50 billion per month. I have shown the following chart before, but given the current environment, it is worth reviewing again.

But it isn’t just the extraction of liquidity from the markets which will likely weigh on the markets over the course of the next year. As I wrote back in April of 2018 there are 10-other reasons weighing on markets:

• Global Central Banks are reducing liquidity flows
• Global economic growth continues to weaken
• “Trade Wars” and “Tariffs” are still a threat
• Valuations remain elevated
• High-yield spreads still remain compressed
• Interest rates are still rising
• Price volatility has picked up sharply
• Investors remain aggressively allocated to equities
• Earnings estimates are still too high and on the decline.
• Debt loads remain extremely high and are vulnerable to exogenous events.

The backdrop of the market currently is vastly different than it was during the “taper tantrum” in 2015-2016, or during the corrections following the end of QE1 and QE2.  In those previous cases, as I stated, the Federal Reserve was directly injecting liquidity and managing expectations of long-term accommodative support. Valuations had been through a fairly significant reversion, and expectations had been extinguished.

None of that support exists currently.

Let me conclude with this quote from John Hussman:

“At its core, investment is about valuation. It’s about purchasing a stream of expected future cash flows at a price that’s low enough to result in desirable total returns, at an acceptable level of risk, as those cash flows are delivered over time. The central tools of investment analysis include an understanding of market history, cash flow projection, the extent to which various measures of financial performance can be used as “sufficient statistics” for that very long-term stream of cash flows (which is crucial whenever valuation ratios are used as a shorthand for discounted cash flow analysis), and a command of the basic arithmetic that connects the current price, the future cash flows, and the long-term rate of return.

At its core, speculation is about psychology. It’s about waves of optimism and pessimism that drive fluctuations in price, regardless of valuation. Value investors tend to look down on speculation, particularly extended periods of it. Unfortunately, if a material portion of one’s life must be lived amid episodes of reckless speculation that repeatedly collapse into heaps of ash, one is forced to make a choice. One choice is to imagine that speculation is actually investment which is what most investors inadvertently do. The other choice is to continue to distinguish speculation from investment, and develop ways to measure and navigate both.

At present, stock market investors are faced with offensively extreme valuations, particularly among the measures best-correlated with actual subsequent market returns across history. Investment merit is absent. Investors largely ignored extreme ‘overvalued, overbought, overbullish’ syndromes through much of the recent half-cycle advance, yet even since 2009, the S&P 500 has lost value, on average, when these syndromes were joined by unfavorable market internals.”

As I discussed previously, there is a reasonably high possibility, the bull market that started in 2009 has ended. If that is indeed the case, the current bounce, which we have been anticipating, will likely not last for long. In other words, it currently looks, and feels, like a “dead cat bounce,” in technical terms.

With the market still oversold in the short-term BUT with a confirmed “weekly sell signal” in place, I want to reiterate that portfolio management processes have now been switched from “buying dips” to “selling rallies” until the technical backdrop changes.

Therefore, use rallies to:

1. Re-evaluate overall portfolio exposures. We will look to initially reduce overall equity allocations.
2. Use rallies to raise cash as needed. (Cash is a risk-free portfolio hedge)
3. Review all positions (Sell losers/trim winners)
4. Look for opportunities in other markets