Tag Archives: stock buybacks

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

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

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

There is just one problem.

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

John Maynard Keynes contended that:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Far From Over

Why is this important?

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

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

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

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

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

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

Maybe not.

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

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

As job losses mount, a virtual spiral in the economy begins as reductions in spending put further pressures on corporate profitability. Lower profits lead to more unemployment, and lower asset prices until the cycle is complete.

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

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

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

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

One-Percenter

What does this all mean going forward?

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

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

It’s economic growth. 

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

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

However, simply looking at Federal debt levels is misleading.

It is the total debt that weighs on the economy.

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

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

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

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

The Debt End Game

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

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

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

The debt bubble has now burst.

Here is the important point I made previously:

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

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

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

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

As I warned previously:

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

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

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

But I am sure of one thing.

The Fed can’t fix what’s broken.

While the financial media is salivating over the recent bounce off the lows, here is something to think about.

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

We aren’t there yet.

Fed Trying To Inflate A 4th Bubble To Fix The Third

Over the last couple of years, we have often discussed the impact of the Federal Reserve’s ongoing liquidity injections, which was causing distortions in financial markets, mal-investment, and the expansion of the “wealth gap.” 

Our concerns were readily dismissed as bearish as asset prices were rising. The excuse:

“Don’t fight the Fed”

However, after years of zero interest rates, never-ending support of accommodative monetary policy, and a lack of regulatory oversight, the consequences of excess have come home to roost. 

This is not an “I Told You So,” but rather the realization of the inevitable outcome to which investors turned a blind-eye too in the quest for “easy money” in the stock market. 

It’s a reminder of the consequences of “greed.” 

The Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP. (I have estimated the impact to GDP for the first quarter at -2% growth, but my numbers may be optimistic)

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, general economic activity has not, which has led to a widening of the “wealth gap” between the top 10% and the bottom 90%. At the same time, corporations levered up their balance sheets, and used cheap debt to aggressively buy back shares providing the illusion of increased profitability while revenue growth remained weak. 

As I have shown previously, while earnings have risen sharply since 2009, it was from the constant reduction in shares outstanding rather than a marked increase in revenue from a strongly growing economy. 

Now, the Fed is engaged in the fight of its life trying to counteract a “credit-event” which is larger, and more insidious, than what was seen during the 2008 “financial crisis.”  

Over the course of the next several months, the Federal Reserve will increase its balance sheet towards $10 Trillion in an attempt to stop the implosion of the credit markets. The liquidity being provided may, or may not be enough, to offset the risk of a global economy which is levered roughly 3-to-1 according to CFO.com:

“The global debt-to-GDP ratio hit a new all-time high in the third quarter of 2019, raising concerns about the financing of infrastructure projects.

The Institute of International Finance reported Monday that debt-to-GDP rose to 322%, with total debt reaching close to $253 trillion and total debt across the household, government, financial and non-financial corporate sectors surging by some $9 trillion in the first three quarters of 2019.”

Read that last part again.

In 2019, debt surged by some $9 Trillion while the Fed is injecting roughly $6 Trillion to offset the collapse. In other words, it is likely going to require all of the Fed’s liquidity just to stabilize the debt and credit markets. 

Bubbles, Bubbles, Bubbles

Jerome Powell clearly understands that after a decade of monetary infusions and low interest rates, he has created an asset bubble larger than any other in history. However, they were trapped by their own policies, and any reversal led to almost immediate catastrophe as seen in 2018.

As I wrote previously:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s.”

For quite some time now, we have warned investors against the belief that no matter what happens, the Fed can bail out the markets, and keep the bull market. Nevertheless, it was widely believed by the financial media that, to quote Dr. Irving Fisher:

“Stocks have reached a permanently high plateau.”

What is important to understand is that it was imperative for the Fed that market participants, and consumers, believed in this idea. With the entirety of the financial ecosystem more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” was the most significant risk. 

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

The Fed had hoped they would have time, and the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that had built up in the system. 

Unfortunately, they ran out of time, and the markets stopped “acting rationally.”

This is the predicament the Federal Reserve currently finds itself in. 

Following each market crisis, the Fed has lowered interest rates, and instituted policies to “support markets.” However, these actions led to unintended consequences which have led to repeated “booms and busts” in the financial markets.  

While the market has currently corrected nearly 25% year-to-date, it is hard to suggest that such a small correction will reset markets from the liquidity-fueled advance over the last decade.

To understand why the Fed is trapped, we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP; therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown previously:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

This was shown in a recent set of studies:

The “Stock Market” Is NOT The “Economy.”

Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.

“This is not economic prosperity. This is a distortion of economics.”

As I stated previously:

“If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.”

That is where we are today. 

The Federal Reserve is desperate to “bail out” the financial and credit markets, which it may  be successful in doing, however, the real economy may not recover for a very long-time. 

With 70% of employment driven by small to mid-size businesses, the shutdown of the economy for an extended period of time may eliminate a substantial number of businesses entirely. Corporations are going to retrench on employment, cut back on capital expenditures, and close ranks. 

While the Government is working on a fiscal relief package, it will fall well short of what is needed by the overall economy and a couple of months of “helicopter money,” will do little to revive an already over leveraged, undersaved, consumer. 

The 4th-Bubble

As I stated previously:

“The current belief is that QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren’t enough.”

The implosion of the credit markets made rate reductions completely ineffective and has pushed the Fed into the most extreme monetary policy bailout in the history of the world. 

The Fed is hopeful they can inflate another asset bubble to restore consumer confidence and stabilize the functioning of the credit markets. The problem is that since the Fed never unwound their previous policies, current policies are having a much more muted effect. 

However, even if the Fed is able to inflate another bubble to offset the damage from the deflation of the last bubble, there is little evidence it is doing much to support economic growth, a broader increase in consumer wealth, or create a more stable financial environment. 

It has taken a massive amount of interventions by Central Banks to keep economies afloat globally over the last decade, and there is little evidence that growth will recover following this crisis to the degree many anticipate.

There are numerous problems which the Fed’s current policies can not fix:

  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates.
  • An underemployed younger demographic.
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases

The lynchpin in the U.S., remains demographics, and interest rates. As the aging population grows, they are becoming a net drag on “savings,” the dependency on the “social welfare net” will explode as employment and economic stability plummets, and the “pension problem” has yet to be realized.

While the current surge in QE may indeed be successful in inflating another bubble, there is a limit to the ability to continue pulling forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. 

There is evidence the cycle peak has already been reached.

One thing is for certain, the Federal Reserve will never be able to raise rates, or reduce monetary policy ever again. 

Welcome to United States of Japan.

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

Pippa Stevens via CNBC recently had some advice:

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

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

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

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

Think about that for a moment.

“The best days generally follow the worst days.

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

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

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

I agree investors should never “panic sell,” as such “emotional” decisions are always made at the worst possible times. As Dalbar regularly points out, individuals always underperform the benchmark index over time by allowing “behaviors” to interfere with their investment discipline.

In other words, investors regularly suffer from the “buy high/sell low” syndrome.

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

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

The Market Timing Myth

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

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

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

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

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

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

He goes on:

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

There’s just one problem. It’s hooey.

They’re leaving out more than half the story.

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

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

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

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

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

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

As Brett concluded:

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

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

However, you DO have options.

A Simple Method

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

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

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

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

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

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

Here are the comparative results.

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

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

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

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

As Brett continues:

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

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

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

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

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

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

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

#MacroView: Mnuchin & Kudlow Say No Recession?

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

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

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

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

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

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

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

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

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

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

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

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

Data as of February 2020.

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

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

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

The Question Isn’t If…

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

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

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

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

Yields Are Screaming: “Recession”

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

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

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

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

So, where are we nearly 4-years later?

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

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

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

Via Doug Kass:

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

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

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

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

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

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

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

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

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

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

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

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

The recession will be quite severe.

As David concludes:

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

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

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

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

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

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

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

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

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

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

However, here is the math:

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

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

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

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

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

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

Fade rallies, and reduce risk accordingly. 

Fox26 Interview: The Economic Impact Of COVID-19

On Friday morning, I visiting with my friends at Fox26 in Houston to discuss the economic, market, and investing impact of COVID-19.

“Will it get worse before it gets better?

Lance Roberts, chief investment strategist with RIA Advisors, explains how the COVID-19 coronavirus is impacting our economy.”


#MacroView: Fed Launches A Bazooka To Kill A Virus

Last week, we discussed in Fed’s ‘Emergency Rate Cut’ Reveals Recession Risks” that while current economic data may not suggest a possibility of a recession was imminent, other “off the run” data didn’t agree.

We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape, even before the impact of COVID-19, and the ongoing decline of inflationary pressures longer term was already telling us just that.”

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

In the meantime, the markets have been rocked as concerns over the spread of the“COVID-19” virus in the U.S. have shut down sporting events, travel, consumer activities, and a host of other economically sensitive inputs. As we discussed previously:

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

As noted, with the U.S. now shutting down and entrenching itself in response to the virus, the economic impact will be worsened. However, given that economic data is lagging, and we only have numbers that were mostly pre-virus, the reports over the next couple of months will ultimately reveal the extent of the damage.

We suspect that it will be more significant than most analysts currently expect.

With our Economic Output Composite Indicator (EOCI) at levels which have previously warned of recessions, the “timing” of the virus, and the shutdown of activity in response, will push the indications lower.

“Given the current level of the index as compared to the 6-Month rate of change of the Leading Economic Index, there is a risk of a recessionary drag within the next 6-months.”

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

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

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

What the chart above obfuscates is the severity of the recent market rout. As shown below, in just three very short weeks, the market has reversed almost the entirety of the “Trump Stock Market” gains since he took office on January 20th.

The estimation of substantially weaker economic growth is not just a random assumption. In a post next week, I am going through the math of our analysis. Here is a snippet.

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

Doug Kass recently did the math:

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

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

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

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

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

Doug’s estimates were before to the recent collapse in oil prices, and breakeven inflation rates. With oil prices now at $30/bbl and 10-year breakeven rates to 0.9%, the math is significantly worse, and that is what the severity of the recent selloff is telling us. Over the next two quarters, we could see as much as a 3% clip off of current GDP.

This data is not lost on the Federal Reserve and is why they have been taking action over the last two weeks.

The Fed Bazooka

It’s quite amazing that in mid-February, which now seems like a lifetime ago, we were discussing the markets being 3-standard deviations above their 200-dma, which is a rarity. Three short weeks later, the markets are now 4-standard deviations below, which is even a rarer event. 

That swing in asset prices has cut the “wealth effect” from the market, and will severely impact consumer confidence over the next few months. The decline in confidence, combined with the impact of the loss of activity from the virus, will sharply reduce consumption, which is 70% of the economy.

This is why the Fed cut rates in an “emergency action” by 0.50% previously. Then on Wednesday, increased “Repo operations” to $175 Billion.

However, like hitting a patient with a defibrillator, the was no response from the market.

Then yesterday, the Fed brought out their “big gun.”  In a statement from the New York Fed:

The Federal Reserve said it would inject more than $1.5 trillion of temporary liquidity into Wall Street on Thursday and Friday to prevent ominous trading conditions from creating a sharper economic contraction.

‘These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.’

The New York Fed said it would conduct three additional repo offerings worth an additional $1.5 trillion this week, with two separate $500 billion offerings that will last for three months and a third that will mature in one month.

If the transactions are fully subscribed, they would swell the central bank’s $4.2 trillion asset portfolio by more than 35%.” – WSJ

As Mish Shedlock noted,

“The Fed can label this however they want, but it’s another round of QE.”

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

Of course, this is what the market has been hoping for:

  • Rate cuts? Check
  • Liquidity? Check

For about 15-minutes yesterday, stocks responded by surging higher and reversing half of the day’s losses. Unfortunately, the enthusiasm was short-lived as sellers quickly returned to continue their “panic selling.” 

This has been frustrating for investors and portfolio managers, as the ingrained belief over the last decade has been “Don’t worry, the Fed’s got this.”

All of a sudden, it looks like they don’t.

Will It Work This Time?

There is a singular risk that we have worried about for quite some time.

Margin debt.

Here is a snip from an article I wrote in December 2018.

Margin debt is the ‘gasoline,’ which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that ‘leverage’ also works in reverse as it provides the accelerant for larger declines as lenders ‘force’ the sale of assets to cover credit lines without regard to the borrower’s position.

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

Margin debt is NOT an issue – until it is.”

Given the magnitude of the declines in recent days, and the lack of response to the Federal Reserve’s inputs, it certainly has the feel of a margin debt liquidation process. This was also an observation made by David Rosenberg:

“The fact that Treasuries, munis, and gold are getting hit tells me that everything is for sale right now. One giant margin call where even the safe-havens aren’t safe anymore. Except for cash.”

Unfortunately, FINRA only updates margin debt in arrears, so as of this writing, the latest margin debt stats are for January. What we do know is that due to the market decline, negative free cash balances have likely declined markedly. That’s the good news.

Back to my previous discussion for a moment:

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

Given the lack of ‘fear’ shown by investors during the recent decline, it is unlikely that the recent drop in margin debt is a function of ‘forced liquidations.’ As I noted above, it will likely take a correction of more than 20%, or a ‘credit related’ event, which sparks broker-dealer concerns about repayment of their credit lines.

The risk to the market is ‘when’ those ‘margin calls’ are made.

It is not the rising level of debt that is the problem; it is the decline which marks peaks in both market and economic expansions.”

That is precisely what we have seen over the last three weeks.

While the Federal Reserve’s influx of liquidity may stem the tide temporarily, it is likely not a “cure” for what ails the market.

However, with that said, the Federal Reserve, and Central Banks globally, are not going to quietly into the night. Expect more stimulus, more liquidity, and more rate cuts. If that doesn’t work, expect more until it does.

We have already reduced a lot of equity risk in portfolios so far, but are going to continue lifting exposures and reducing risk until a bottom is formed in the market. The biggest concern is trying to figure out exactly where that is.

One thing is now certain.

We are in a bear market and a recession. It just hasn’t been announced as of yet.

That is something the Fed can’t fix right away with monetary policy alone, and, unfortunately, there won’t be any help coming from the Government until after the election.

Market Crash Reveals The “Liquidity Problem” Of Passive Investing

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

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

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

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

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

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

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

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

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

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

The index and ETF buyers? Well, they just buy.”

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

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

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

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

Reality has been far different.

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

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

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

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

Yes….it’s that psychology thing.

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

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

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

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

Until it goes in the other direction.

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

The Apple Problem

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

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

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”

Howard Marks, also noted in “Liquidity:”

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

Let me explain.

There is a statement often made by individuals about the market.

“For every buyer, there is a seller.” 

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

However, such is not actually the case.

The correct statement is:

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

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

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

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

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

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

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

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

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

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

Are you prepared?

#MacroView: Fed’s “Emergency Rate Cut” Reveals Recession Risks

Last week, I discussed in “Recession Risks Tick Up” that while current data may not suggest a possibility of a recession was imminent, other “off the run” data didn’t agree.

“The problem with most of the current analysis, which suggests a “no recession” scenario, is based heavily on lagging economic data, which is highly subject to negative revisions. The stock market, however, is a strong leading indicator of investor expectations of growth over the next 12-months. Historically, stock market returns are typically favorable until about 6-months prior to the start of a recession.”

“The compilation of the data all suggests the risk of recession is markedly higher than what the media currently suggests. Yields and commodities are suggesting something quite different.”

In this particular case, while the market is suggesting there is an economic problem coming, we also discussed the impact of the “coronavirus,” or “COVID-19,” on the economy. Specifically, I stated:

But it isn’t just China. It is also hitting two other economically important countries: Japan and South Korea, which will further stall exports and imports to the U.S. 

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

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

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

“Given the current level of the index as compared to the 6-Month rate of change of the Leading Economic Index, there is a rising risk of a recessionary drag within the next 6-months.”

That analysis seemed to largely bypass the mainstream economists, and the Fed, who were focused on the “number of people getting sick,” rather than the economic disruption from the shutdown of the supply chain.

On Tuesday, the Federal Reserve shocked the markets with an “emergency rate cut” of 50-basis points. While the futures market had been predicting the Fed to cut rates at their next meeting on March 18th, the half-percent cut shocked equity markets as the Fed now seems more concerned about the economy than they previously acknowledged.

It is one thing for the Fed to cut rates to support economic growth. It is quite another for the Fed to slash rates by 50 basis points between meetings.

It smacks of “fear.” 

Previously, such emergency rate cuts have not been done lightly, but in response to a bigger crisis which was simultaneously unfolding.

While we have spilled a good bit of digital ink as of late warning about the ramifications of COVID-19:

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

This is not a trivial matter.

“Nearly half of U.S. companies in China said they expect revenue to decrease this year if business can’t return to normal by the end of April, according to a survey conducted Feb. 17 to 20 by the American Chamber of Commerce in China, or AmCham, to which 169 member companies responded. One-fifth of respondents said 2020 revenue from China would decline more than 50% if the epidemic continues through Aug. 30..”WSJ

That drop in revenue, and ultimately earnings, has not yet been factored into earnings estimates. This is a point I made on Tuesday:

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

It is quite possible even my estimates may still be too high.

While the markets have been largely dismissing the impact of the virus, the Fed’s “panic” move on Tuesday was confirming evidence that we are on the right track.

The market’s wild correction over the past two weeks, also begins to align with the Fed’s previous rate-cutting cycles. While it initially appeared “this time was different,” as the market continued to rise due to the Fed’s flood of liquidity, the markets seem to be playing catch up to previous rate-cutting cycles. If the economic data begins to weaken markedly, we may will see an alignment with the previous starts of bear markets and recessions.

Of course, we need to add some context to the chart above. Historically, the reason the Fed cuts rates, and interest rates fall, is because the Fed has acted in response to a crisis, recession, or both. The chart below shows when there is an inversion between the Fed Funds rate, and the 10-year Treasury, it has been associated with recessionary onset. (This curve will invert when the Fed cuts rates further at their next meeting.)

Not surprisingly, as suggested by the historical data above, the stock market has yielded a negative return a year after an emergency rate cut was initiated.

There is another risk the Fed may not be prepared for, an inflationary spike in prices. What could potentially impact the economy, and inflationary pressures, is the shutdown of the global supply chain which creates a lack of supply to meet immediate demand. Basic economics suggests this could lead to inflationary pressures as inventories become extremely lean, and products become unavailable. Even a short-term inflationary spike would put the Federal Reserve on the “wrong-side” of the trade, rendering the Fed’s monetary policies ineffective.

The rising recession risk is also being signaled by the collapse in the 10-year Treasury yield, a point which I have made repeatedly over the last several years in discussing why interest rates were headed toward zero.

“Outside of other events such as the S&L Crisis, Asian Contagion, Long-Term Capital Management, etc. which all drove money out of stocks and into bonds pushing rates lower, recessionary environments are especially prone at suppressing rates further. But, given the inflation of multiple asset bubbles, a credit-driven event that impacts the corporate bond market will drive rates to zero.

Furthermore, given rates are already negative in many parts of the world, which will likely be even more negative during a global recessionary environment, zero yields will still remain more attractive to foreign investors. This will be from both a potential capital appreciation perspective (expectations of negative rates in the U.S.) and the perceived safety and liquidity of the U.S. Treasury market. 

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

A chart of monetary velocity tells you there is a problem in the economy as lower interest rates fails to spark an uptick in the flow of money.

My friend Caroline Baum summed up the Fed’s primary problem given the issue of plunging rates:

“All of a sudden, the reality of revisiting the zero lower bound, which the Fed now refers to as the effective lower bound (ELB), is no longer off in the distance. It could be right around the corner.

And this at a time when Fed officials are still saying that the economy and monetary policy are ‘in a good place’ and the fundamentals are sound. So what do policymakers do when the good place deteriorates into something mediocre, and the fundamentals turn sour?

Forward guidance, which I like to call talk therapy? Large-scale asset purchases? Unfortunately, the Fed goes to war with the tools it has, not the tools it might want or wish to have.”

Unfortunately, the Fed is still misdiagnosing what ails the economy, and monetary policy is unlikely to change the outcome in the U.S.

The reasons are simple. You can’t cure a debt problem with more debt. Therefore, monetary interventions, and government spending, don’t create organic, sustainable, economic growth. Simply pulling forward future consumption through monetary policy continues to leave an ever-growing void in the future that must be filled.

There is already evidence that lower rates are not leading to expanding consumption, business investment, or economic activity. Furthermore, while QE may temporarily lift asset prices, the lack of economic growth, resulting in lower earnings growth, will eventually lead to a repricing of assets.

Furthermore, there is likely no help coming from fiscal policy, either. As Caroline noted:

“Fiscal-policy measures, which entail tax cuts and government spending, will be difficult to enact in this highly charged political environment. There is little evidence that the Republicans and Democrats can put partisan differences aside to work together.”

Or, as Chuck Schumer said to Ben Bernanke just prior to the “financial crisis:”

“You’re the only game in town.” 

The real concern for investors, and individuals, is the real economy.

We are likely experiencing more than just a “soft patch” currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape, even before the impact of COVID-19, and the ongoing decline of inflationary pressures longer term was already telling us just that.

The Fed already realizes they have a problem, as noted by Fed Chair Powell on Tuesday:

“A rate cut will not reduce the rate of infection. It won’t fix a broken supply chain. We get that.”

More importantly, this is no longer a domestic question, but rather a global one. Since every major central bank is now engaged in a coordinated infusion of liquidity, fighting slowing economic growth, a rising level of negative yields, and a spreading virus shutting down economic activity, it is “all hands on deck.”

The Federal Reserve is currently betting on a “one trick pony” which is that by increasing the “wealth effect,” it will ultimately lead to a return of consumer confidence, and mitigate the effect of a global contagion.

Unfortunately, there mounting evidence it may not work.

MacroView: The Ghosts Of 2018?

On Jan 3rd, I wrote an article entitled: “Will The Market Repeat The Start Of 2018?” At that time, the Federal Reserve was dumping a tremendous amount of money into the financial markets through their “Repo” operations. To wit:

“Don’t fight the Fed. That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its “QE-Not QE” operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically “Not QE” because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, ‘Mr. Market’ doesn’t see it that way. As the old saying goes, ‘if it looks, walks, and quacks like a duck…it’s a duck.'” 

As I noted then, despite commentary to the contrary, there were only two conclusions to draw from the data:

  1. There is something functionally “broken” in the financial system which is requiring massive injections of liquidity to try and rectify, and;
  2. The surge in liquidity, whether you want to call it a “duck,” or not, is finding its way into the equity markets.

Let me remind you this was all BEFORE the outbreak of the Coronavirus.

The Ghosts Of 2018

“Well, this past week, the market tripped ‘over its own feet’ after prices had created a massive extension above the 50-dma as shown below. As I have previously warned, since that extension was so large, a correction just back to the moving average at this point will require nearly a -6% decline.”

“I have also repeatedly written over the last year:

‘The problem is that it has been so long since investors have even seen a 2-3% correction, a correction of 5%, or more, will ‘feel’ much worse than it actually is, which will lead to ’emotionally driven’ mistakes.’

The question now, of course, is do you “buy the dip” or ‘run for the hills?’”

Yesterday morning, the markets began the day deeply in the red, but by mid-morning were flirting with a push into positive territory. By the end of the day, the Dow had posted its largest one-day point loss in history.”

That was from February 6th, 2018 (Technically Speaking: Tis But A Flesh Wound)

Here is a chart of October 2019 to Present.

Besides the reality that the only thing that has occurred has been a reversal of the Fed’s “Repo” rally, there is a striking similarity to 2018. That got me to thinking about the corollary between the two periods, and how this might play out over the rest of 2020.

Let’s go back.

Heading in 2018, the markets were ebullient over President Trump’s recently passed tax reform and rate cut package. Expectations were that 2018 would see a massive surge in earnings growth, due to the lower tax rates, and there would be a sharp pickup in economic growth.

However, at the end of January, President Trump shocked the markets with his “Trade War” on China and the imposition of tariffs on a wide variety of products, which potentially impacted American companies. As we said at the time, there was likely to be unintended consequences and would kill the effect of tax reform.)

“While many have believed a ‘trade war’ will be resolved without consequence, there are two very important points that most of the mainstream analysis is overlooking. For investors, a trade war would likely negatively impact earnings and profitability while slowing economic growth through higher costs.”

Over the next few months, the market dealt, and came to terms with, the trade war and the Fed’s tightening of the balance sheet. As we discussed in May 2018, the trade war did wind up clipping earnings estimates to a large degree, but massive share repurchases helped buoy asset prices.

Then in September, the Fed did the unthinkable.

After having hiked rates previously, thereby tightening the monetary supply, they stated that monetary policy was not “close to the neutral rate,” suggesting more rate hikes were coming. The realization the Fed was intent on continuing to tighten policy, and further extracting liquidity by reducing their balance sheet, sent asset prices plunging 20% from the peak, to the lows on Christmas Eve.

It was then the Fed acquiesced to pressure from the White House and began to quickly reverse their stance and starting pumping liquidity back into the markets.

And the bull market was back.

Fast forward to 2020.

“The exuberance that surrounded the markets going into the end of last year, as fund managers ramped up allocations for end of the year reporting, spilled over into the start of the new with S&P hitting new record highs.

Of course, this is just a continuation of the advance that has been ongoing since the Trump election. The difference this time is the extreme push into 3-standard deviation territory above the moving average, which is concerning.” – Real Investment Report Jan, 5th 2018

As noted in the chart below, in both instances, the market reached 3-standard deviations above the 200-dma before mean-reverting.

Of course, while everyone was exuberant over the Fed’s injections of monetary support, we were discussing the continuing decline in earnings growth estimates, along with the lack of corporate profit growth To wit:

With equities now more than 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and ‘repo’ operations starting to slow, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted above, earnings expectations declined for the entirety of 2019, as shown in the chart below. However, the impact of the ‘coronavirus’ has not been adopted into these reduced estimates as of yet. These estimates WILL fall, and likely markedly so, which, as stated above, is going to make justifying record asset prices more problematic.”

Just as the “Trade War” shocked the markets and caused a repricing of assets in 2018, the “coronavirus” has finally infected the markets enough to cause investors to adjust their expectations for earnings growth. Importantly, as in 2018, earnings estimates have not been revised lower nearly enough to compensate for the global supply chain impact coming from the virus.

While the beginning of 2020 is playing out much like 2018, what about the rest of the year?

There are issues occurring which we believe will have a very similar “feel” to 2018, as the impact of the virus continues to ebb and flow through the economy. The chart below shows the S&P 500 re-scaled to 1000 for comparative purposes.

Currently, the expectation has risen to more than a 70% probability the Fed will cut rates 3x in 2020. Historically, the market tends to underestimate just how far the Fed will go as noted by Michael Lebowitz previously:

“The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.”

Our guess is that in the next few weeks, the Fed will start using “forward guidance” to try and stabilize the market. Rate cuts, and more “quantitative easing,” will likely follow.

Such actions should stabilize the market in the near-term as investors, who have been pre-conditioned to “buy” Fed liquidity, will once again run back into markets. This could very well lift the markets into second quarter of this year.

But it will likely be a “trap.”

While monetary policy will likely embolden the bulls short-term, it does little to offset an economic shock. As we move further into the year, the impact to the global supply chain will begin to work its way through the system resulting in slower economic growth, reduced corporate profitability, and potentially a recession. (See yesterday’s commentary)

This is a guess. There is a huge array of potential outcomes, and trying to predict the future tends to be a pointless exercise. However, it is the thought process that helps align expectations with potential outcomes to adjust for risk accordingly.

A Sellable Rally

Just as in February 2018, following the sharp decline, the market rallied back to a lower high before failing once again. For several reasons, we suspect we will see the same over the next week or two, as the push into extreme pessimism and oversold conditions will need to be reversed before the correction can continue.

While 2019 ended in an entirely dissimilar manner as compared to 2018, the current negative sentiment, as shown by CNN’s Fear & Greed Index is back to the extreme fear levels seen at the lows of the market in 2018.

On a short-term technical basis, the market is now extremely oversold, which is suggestive of a counter-trend rally over the next few days to a week or so.

It is highly advisable to use ANY reflexive rally to reduce portfolio risk, and rebalance portfolios. Most likely, another wave of selling will likely ensue before a stronger bottom is finally put into place. 

Lastly, our composite technical overbought/oversold gauge is also pushing more extreme oversold conditions, which are typical of a short-term oversold condition.

In other words, in 2019 “everyone was in the pool,” in 2020 we just found out “everyone was swimming naked.” 

Rules To Follow

One last chart.

I just want you to pay attention to the top panel and the shaded areas. (standard deviations from the 50-dma)

We were not this oversold even during the 2015-2016 decline, much less the two declines in 2018.

Currently, not only is the market extremely oversold on a short-term basis, but is currently 5-standard deviations below the 50-dma.

Let me put that into perspective for you.

  • 1-standard deviation = 68.26% of all possible price movement.
  • 2-standard deviations = 95.45% 
  • 3-standard deviations = 99.73%
  • 4-standard deviations = 99.993%
  • 5-standard deviations = 99.9999%

Mathematically speaking, the bulk of the decline is already priced into the market.

“I get it. We are gonna get a bounce. So, what do I do?”

I am glad you asked.

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have outperformed during the rally.
  3. Sell laggards and losers (those that lagged the rally, probably led the decline)
  4. Raise cash, and rebalance portfolios to reduced risk levels for now.

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

  1. Determine areas where exposure needs to be increased, or decreased (bonds, cash, equities)
  2. Determine how many shares need to be bought or sold to rebalance allocation requirements.
  3. Determine cash requirements for hedging purposes
  4. Re-examine the portfolio to ensure allocations are adjusted for FORWARD market risk.
  5. Determine target price levels for each position.
  6. Determine “stop loss” levels for each position being maintained.

Step 3) Be Ready To Execute

  • Whatever bounce we get will likely be short-lived. So have your game plan together before-hand as the opportunity to rebalance risk will likely not be available for very long. 

This is just how we do it.

However, there are many ways to manage risk, and portfolios, which are all fine. What separates success and failure is 1) having a strategy to begin with, and; 2) the discipline to adhere to it.

The recent market spasm certainly reminds of 2018. And, if we are right, it will get better, before it gets worse.

Technically Speaking: Markets Start To Price In “Viral Impacts”

At the end of January, I wrote a piece titled “This Is Nuts: Why We Reduced Risk” discussing why we took profits in our portfolios. Here is the important point:

“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk.” 

At that time, we began the orderly process of reducing exposure in our portfolios:

In the Equity Portfolios, we reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)

In the ETF Sector Rotation Portfolio, we reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now.

The important sentence came next:

“We did not ‘sell everything’ and go to cash. We simply reduced our holdings to raise cash, and capture some of the gains we made in 2019. When the market corrects, we will use our cash holdings to either add back to our current positions or add new ones.”

At the time we made those changes, it appeared we were clearly wrong as the market continued to grind higher. As Howard Marks once quipped:

“Being early, even if you are right, is the same as being wrong.” 

You Can’t Time Market Corrections

From a portfolio management, and more particularly, a “risk mitigation” view, our job isn’t necessarily to hit the exact tops or bottoms, just to provide a cushion against losses. This is why we constantly measure risk, and make adjustments accordingly.

Over the last couple of weeks, we have continued to repeatedly note the extreme overbought, overly bullish, and over complacent conditions of the market. This was a point we discussed with our RIAPRO subscribers (Try for 30-days RISK FREE) in last Monday’s technical market update.

“As noted last week: ‘With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.’ But the belief is currently ‘more stimulus’ will offset the ‘virus.’

This is probably a wrong guess.

Extensions to this degree rarely last long without a correction. Maintain exposures, but tighten up stop-losses.”

That extreme deviation from the long-term mean was unsustainable. What was needed was a catalyst to cause the slide. This past weekend, the realization the “coronavirus was NOT contained,” was the trigger needed to revert that overly stretched condition.

This is the misunderstanding of portfolio management. Risk management decisions are not being “all in” or “all out.” Making extreme movements actually increases your portfolio risk due to the high probability of making a “wrong call.”

For us, risk management is like driving a car. When you drive, you are constantly making a myriad of small adjustments from adjusting your lane position, your speed, and your positioning relative to the other cars. You are also simultaneously assessing the “risks” of other drivers, the weather, unexpected obstacles, and traffic signals and signs. After years of driving, you subconsciously make all these decisions without giving it much thought, but in actuality, you did.

The same goes for portfolio management. Small adjustments made to keep the portfolio moving forward while avoiding the potential of a catastrophic accident is the goal. Sure, it is entirely possible we could get into a “fender bender,” and such should be expected. What we want to make sure of, however, is that in the event of a crash, we will walk away relatively unharmed. This is why we make sure our portfolio has a seat belt (cash), airbags (hedges), strong structural support (bonds), and we drive a little slower than the speed limit (allocation.) 

With the markets pushing into 3-standard deviations above the 200-day moving average, it was only a function of time before a correction occurred. Therefore, while we were early taking profits, the end result was reduced portfolio risk against a pending correction.

“Taking profits, and reducing risks now, may lead to a short-term underperformance in portfolios, but you will likely appreciate the reduced volatility if, and when, the current optimism fades.”

On Monday, that reduced volatility was greatly appreciated.

While our assessment of the market two-weeks ago was that risk versus reward was unbalanced, as we noted then, such can remain the case for extended periods of time.

“The problem with an economy being propped up by artificially appreciated assets is that this pendulum swings both ways. At some point, prices eventually decline. No one knows what will cause the decline:

  • Higher interest rates like in 2018,
  • A presidential tweet, when he launched the “trade war” with China.
  • The ongoing implosion of the Chinese economy is still a threat.
  • It could just be the realization by the markets that asset prices don’t grow to the sky.
  • Or, it could be triggered by an unexpected, exogenous event, which results in the markets “repricing” risk.”

As we have repeatedly stated, it was the impact of the “coronavirus” which the market has failed to account for. To wit:

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

Importantly, this decline happened BEFORE the “Wuhan virus” which suggests the virus will only worsen the potential impact.

The impact of the virus has not been factored in by the market.

Remember, it never just starts raining; clouds gather, skies darken, wind speeds pick up, and barometric pressures decline. When you have a consensus of the evidence, you typically carry an umbrella.

Is It Time To “Buy The Dip?”

With the “sell off” on Monday, the immediate reaction by investors is to jump in and “buy the dip?”

Maybe. Maybe not.

The chart below is part of the analysis we use to “onboard” new client portfolios. The purpose of this measure is to avoid transitioning a new client into our portfolio models near a short-term peak of the market. The vertical red lines suggest we avoid adding equity risk to portfolios and vice versa.

With both “sell signals” being triggered short-term, and the market breaking the 50-dma, this is not an opportune point to dramatically increase equity exposure. In other words, be careful “buying the dip,” if you are so inclined.

There are a few important points to denote in the chart above.

  1. The top and bottom signals are essentially relative strength and momentum measures. Both are currently starting to trigger “sell” signals. 
  2. With the market still very deviated above the longer-term 200-dma, and just coming out of 3-standard deviation territory, there is currently more downside risk, than upside reward. 
  3. Note that corrections, once the “sell signals” are triggered, can last from several weeks, to a couple of months. During the correction process there are often multiple opportunities (counter-trend rallies) to reduce risk and raise cash accordingly. 
  4. The last two times the market pushed into 3-standard deviation territory, the resulting corrections were fairly sharp and lasted for a couple of months.

However, with that said, on a VERY short-term basis the market is now oversold enough to elicit a short-term, reflexive, rally. This type of bounce is often termed a “dead cat” bounce, and basically suggests a one, or two, day rise that quickly fails to retest the previous low.

I have also noted that we are in the process of forming a potential “head and shoulder” topping pattern with a very clear “neckline” at yesterday’s closing price. A rally back to resistance at the previous “left shoulder, and a break of the subsequent “neckline,” would entail a decline to the 200-dma, or about 10% from the recent peak.

Given the MACD has registered a “sell signal” from a fairly high level, investors must consider the risk of further downside even if the market rallies over the next couple of days.

Don’t be fooled that a short-term reflexive rally is an “all-clear” for the bull market to resume. With the bulk of our momentum, relative strength, and overbought/sold indicators just starting to correct from recent highs, it is likely short-term rallies will be “selling opportunities” over the next couple of weeks as the market either corrects further or consolidates recent gains.

As we have detailed over the last few missives, due to the rather extreme extension of the market, a correction would likely encompass a 5-10% decline in totality before it is complete. As of today’s close the market is down 4.74% from its recent highs.

As noted in this past weekend’s missive, the Federal Reserve has begun reducing its torrid pace of liquidity, while already weak economic growth, and potentially weaker earnings growth, is at risk from the impact of the coronavirus.

From that perspective, we are continuing to maintain our higher levels of cash, and are opportunistically rebalancing portfolio risks as needed according to our investment discipline.

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

Notice, nothing in there says, “sell everything and go to cash.”

By having reduced risk, we can afford to remain patient and wait for the next opportunity.

Like our car driving analogy above, it is always the ones who are sending a text, holding a breakfast burrito with the other, and driving with one knee who always winds up in the worst possible condition.

We prefer to keep two hands on the wheel at all times.

Technically Speaking: Chasing The Market? Warnings Are Everywhere

This past weekend, we discussed the breakout to all-time highs as the belief the market is immune to risks, due to the Federal Reserve, has become pervasive. As I quoted:

“Yet as a major economic problem looms on the horizon, the cognitive disconnect between current asset prices and reality feels like the market equivalent of ‘peace for our time.’ 

For those investors who perceive the disconnect between risk assets which are priced for a rosy outcome, and the reality of the looming risks to growth and earnings, any attempt to reduce risk leads to underperformance. It is a mind-numbing exercise for investors who see the cognitive dissonance. The frantic race to accumulate securities has cast price discovery to the side.

I have never in my career seen anything as crazy as what’s going on right now, this will eventually end badly.“ – Scott Minerd, CIO of Guggenheim Investments

The current environment remind s me of when I was growing up. My father, probably much like yours, had pearls of wisdom that he would drop along the way. It wasn’t until much later in life that I learned that such knowledge did not come from books, but through experience. One of my favorite pieces of “wisdom” was:

“Exactly how many warnings do need before you figure out that something bad is about to happen?”

Of course, back then, he was mostly referring to warnings he issued for me “not” to do something I was determined to do. Generally, it involved something like trying to replicate Evil Knievel’s jump at Caesar’s Palace using a homemade ramp and a collection of the neighbor’s trash cans.


However, I always based my arguments on sound logic and data analysis:

“But Dad, everyone else is doing it.”

After I had broken my wrist, I understood what he meant.

Likewise, investors are currently rushing to get back into the market with a near reckless disregard for the consequences.

Simply because “everyone else is doing it.” 

So, before you go “hit the ramp”, there are some warning signs to consider.

Warning 1: Deviations From The Mean

There is a funny story about a “defensive driving” class where the instructor asks the class how many thought they were “above average drivers.” About 80% of the class raised their hands. The funny thing is that all of them were in the class because of traffic violations or accidents. But more to the point, 80% of drivers cannot be above average. It is mathematically impossible.

Likewise, in investing, prices must be both above, and below, the “average price” over a set period for an average to exist. To many degrees, “price” is bound by the laws of physics, the farther from the “average price” the current price becomes, the greater the reversion to, and generally beyond, the average. This is shown in the daily chart below.

Currently, the market is more than 11% above its longer-term daily average price. These more extreme deviations tend not to last an extraordinarily long time. Furthermore, reversions from these more extreme deviations tend to be rather quick.

If we view a weekly basis, we see the same warning.

At more than 12% above the long-term weekly moving average, the market is currently pushing the upper end of historical deviations. There have been higher extremes for certain, but discounting risk often doesn’t end well.

On a monthly basis, the almost 17.5% deviation is hitting levels more associated with drawdowns of 20% of more.

The important point to take away from this data is that “mean reverting” events are commonplace within the context of annual market movements. 

Currently, investors have become extremely complacent with the rally from the beginning of the year and are discounting the potential global-supply shock from the “coronavirus.” The assumption that any disruption will be met by more Central Bank intervention, and higher stock prices, is a likely a risky proposition this late into an economic cycle.

In every given year, there are drawdowns that have wiped out some, most, or all of the previous gains. While the market has ended the year higher, more often than not, the declines have often shaken out many an investor along the way.

Let’s take a look at what happened the last time the market finished a year up nearly 30%. Over the next two years, the market consolidated with a near-zero rate of return.

From a portfolio management standpoint, the markets are very extended, and a correction over the next couple of months is highly likely. While it is quite likely the year will end positive, particularly given the current momentum push, taking some profits now, rebalancing risks, and using the coming correction to add exposure as needed will yield a better result.

Warning 2 – Technical Warnings

The technical warnings also confirm our concerns about a near-term correction.

Each week, we post the chart below for our RIA PRO (Try Risk-Free for 30-days) subscribers, which is a composite index of our weekly technical measures including RSI, Williams %R, Stochastics, etc. Currently, the overbought condition of the market is near points which have denoted more significant corrections.

The market/sector analysis, which is also exclusive to RIA PRO members, shows the rather extreme price deviation in Technology, Real Estate, & Utilities. Also, relative performance shows that it has primarily been those three sectors providing a bulk of the “alpha” year-to-date.  (Also, note the lower left-hand panel which shows virtually every sector back to extreme overbought.)

These are abnormalities that tend not to last long in isolation, and rotations tend to occur rather quickly.

Warning 3 – Economic Concerns

Just recently, Barbara Kolmeyer via MarketWatch discussed thoughts from Julien Bittel of Pictet Asset Management. He gives a pretty stern warning to the litany of economic bulls. To wit:

He sees a lot of similarities between what is happening now and the year 2000—the market peaked in the front half of the year, followed by a recession. Bittel has lots of charts to back up his case, such as this one showing Jolts job openings (which measures U.S. job vacancies), at the lowest since the Global Financial Crisis, often a bad omen for employment:”

“He also highlighted trouble for the U.S. long-term business cycle, ‘linked to the less-cyclical areas of the economy so it’s the credit cycle, consumer confidence and the labor markets…these dynamics are all slowing,’ he said.”

He said what makes his call so contrarian is that most economists see a 25% recession possibility, while equity markets are factoring in only a 2% chance.

‘I think investors are a bit naive going into this year, thinking that the gravy trains or rainbows will continue, but in order for that to happen earnings need to come back in a big way. A sustained move in equity markets that’s driven by multiple expansion cannot maintain itself unless you get a huge recovery in earnings.” – Julien Bittel

Speaking of an earnings recovery, that is unlikely to happen.

Warning 4 – Earnings

It is highly unlikely you are going to get a massive surge in earnings to support lofty asset prices and valuations particularly when you have a global supply-chain shock in progress. While the media has been fawning over the latest earnings season, it really isn’t what it seems.

As noted by FactSet:

“ For Q4 2019 (with 77% of the companies in the S&P 500 reporting actual results), 71% of S&P 500 companies have reported a positive EPS surprise and 67% of S&P 500 companies have reported a positive revenue surprise.”

Wow…that’s impressive and certainly would seem to be the reason behind surging asset prices.

The problem is that “beat rate” was simply due to the consistent “lowering of the bar” as shown in the chart below:

Pay attention to the two charts above.

  1. Earnings declined in 2019 and are projected to continue to decline into 2021. 
  2. Investors are not discounting the decline in earnings, and rising valuations, which will eventually become problematic.

Importantly, as I noted this past weekend:

“With equities now more than 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations starting to slow, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted above, earnings expectations declined for the entirety of 2019, as shown in the chart below. However, the impact of the “coronavirus” has not been adopted into these reduced estimates as of yet. These estimates WILL fall, and likely markedly so, which as stated above, is going to make justifying record asset prices more problematic.”

“Conversely, if by some miracle, the economy does show actual improvement, it could result in yields rising on the long-end of the curve, which would also make stocks less attractive.

This is the problem of overpaying for value. The current environment is so richly priced there is little opportunity for investors to extract additional gains from risk-based investments.”

If They Don’t “Buy & Hold” – Why Should You?

Here is the market for you, year to date:

  • S&P 500 +4.62%
    • Alphabet +13.74%
    • Microsoft +17.53%
    • Apple +10.92%
    • Amazon +15.53%
    • Tesla +91.24%

(Disclosure: We are long Apple, Amazon, and Microsoft in our equity portfolio.)

These “warning signs” are just that. None them suggest the markets, or the economy, are immediately plunging into the next recession-driven market reversion.

But as David Rosenberg previously noted:

“The equity market stopped being a leading indicator, or an economic barometer, a long time ago. Central banks looked after that. This entire cycle saw the weakest economic growth of all time coupled with the mother of all bull markets.”

There will be payback for the misalignment of funds.

Past experience suggests that future returns will be far less than historical averages suggest. Furthermore, there is a dramatic difference between investing for 30-years, and whatever time you personally have left to your financial goals. As noted yesterday, many investors are just now getting back to even.

While much of the mainstream media suggests that you should “invest for the long-term,” and “buy and hold” regardless of what the market brings, that is not what professional investors are doing.

The point here is simple.

No professional, or successful investor, every bought and held for the long-term without regard, or respect, for the risks that are undertaken. If professionals are looking at “risk,” and planning on protecting capital from mean-reverting events, then why aren’t you?

After A Decade, Investors Are Finally Back to Even

I recently discussed putting market corrections into perspective, in which we looked at the financial impact of a 10-60% correction. But what happens afterward?

During strongly advancing, and very long bull markets, investors become overly complacent about the potential risks of investing. This “complacency” shows up in the resurgence of “couch potato,” “buy and hold,” and “passive indexing” portfolios. While such ideas work as long as markets are relentlessly rising, when the inevitable reversion occurs, things go “sideways” very quickly.

“While the current belief is that such declines are no longer a possibility, due to Central Bank interventions, we had two 50% declines just since the turn of the century. The cause was different, but the result was the same. The next major market decline will be fueled by the massive levels of corporate debt, underfunded pensions, and evaporation of ‘stock buybacks,’ which have accounted for almost 100% of net purchases since 2018.

Market downturns are a historical constant for the financial markets. Whether they are minor or major, the impacts go beyond just the price decline when it comes to investors.”

It is the last sentence I want to focus on today, as it is one of the most important and overlooked consequences of market corrections as it relates to long-term investment goals.

There are a litany of articles touting the massive bull market advance from the 2009 lows, and that if investors had just held onto the portfolios during the 2008 decline, or better yet, bought the March 2009 low, you would have hit the “bull market jackpot.” 

Unfortunately, a vast majority of investors sold out of the markets during the tail end of the financial crisis, and then compounded their financial problems by not reinvesting until years later. It is still not uncommon to find individuals who are still out of the market entirely, even after a decade long advance.

This is what brutal bear markets due to investors psychologically. 

“Bear markets” push investors into making critical mistakes:

  1. They paid premium prices, or rather excessive prices, for the companies they are investing in during the “bull market.” Ultimately, overpaying for value has a cost of lower future returns, as “buying high” inevitably turns into “selling low.” 
  2. Investors Panic as market values decline. It is easy to forget during sharply rising markets the money we invest is the “savings” we are dependent on for our family’s future. Many investors who claim to be “buy and hold” change their mind after large losses. There is a point, for every investors, where they are willing to “get out at any price.”
  3. Volatility is ignored. Volatility is not always a bad word, but rising volatility coupled with large declines, eventually feeds into investor “fear and panic.”
  4. Ignoring Market Analysis. When markets are trending strongly upwards, investors start to “rationalize” why they are overpaying for value in the market. By looking for “confirmation bias,” they tend to ignore any “market analysis” which contradicts their “hope” for higher prices. The phrase “this time is different” is typically a hallmark.

“The underlying theory of buy and hold investing denies that stocks are ever expensive, or inexpensive for that matter, investors are encouraged to always buy stocks, no matter what the value characteristics of the stock market happen to be at the time.” – Ken Solow

The primary problem with “buy and hold” investing is ultimately, YOU!

The Pension Problem

During raging bull markets, individuals do two things which ultimately lead to their financial distress.

  1. Start treating the market like a casino in hopes to “getting rich quick,” and
  2. Reduce their “contributions” given expectations that high returns will “fill the gap.” 

Unfortunately, this is the same problem that plagues pension funds all across America today.

As I discussed in “Pension Crisis Is Worse Than You Think,”  it has been unrealistic return assumptions used by pension managers over the last 30-years, which has become problematic.

“Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets, and sub-par annualized returns since the turn of the century, is the expected investment return rate.

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

Pensions STILL have annual investment return assumptions ranging between 7–8% even after years of underperformance.”

However, why do pension funds continue to have high investment return assumptions despite years of underperformance? It is only for one reason:

To reduce the contribution (savings) requirement by their members.

This is the same problem for the average American faces when planning for 6-8% average annual returns on their investment strategy. Why should you save money if the market can do the work for you? Right?

This is a common theme in much of the mainstream advice. To wit:

“Suze Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

The problem with Ms. Orman’s statement is that it requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years.

That certainly isn’t very realistic.

However, under-saving is one of the primary problems which leaves investors well short of their financial goals by retirement.

The other problem, as noted above, is the most important part of the analysis overlooked by promoters of “buy and hold” investing.

Let me explain.

Getting Back To Even, Isn’t Even

Here is the common mainstream advice.

“If you had invested $100,000 at the market at the peak of the market in 2000, or in 2007, your portfolio would have gotten back to even in 2013. Since then, your portfolio would have grown to more than $200,000.

Here is the relative chart proving that statement is correct. (Real, inflation-adjusted, total return of a $100,000 investment.)

No one talks much about investors who have been in the market since the turn of the century, but it is one of the problems why so many Americans are underfunded for retirement. While Wall Street claims the market delivers 6% annual returns, or more, the annual rate of return since 2000, on an inflation-adjusted, total return basis, is just shy of 4%.

However, since most analysis used to support the “buy and hold” thesis starts with the peak of the market in 2007, that average return does indeed come in at 6.64%.

Here is the problem.

While your portfolio got back to even, on a total return basis, 6 or 13-years after your initial investment, depending on your start date, you DID NOT get back to even.

Remember your investment plan? Yes, that plan touted by the mainstream media, which says to assume a return of 6% annually?

The chart below shows $100,000 invested at 6% annually from 2000 or 2007.

So, what’s wrong with that?

An investor tripled their money from 2000 and doubled it from 2007.

Unfortunately, you didn’t get that.

Let’s overlay our two charts.

If your financial plan was based on reduced saving rates, and high rates of return, you are well short of you goals for retirement if you started in 2000. Fortunately, for investors who started in 2007, congratulations, you are now back to even.

Unfortunately, there are few investors who actually saw market returns over the last 12-years. As noted, a vast majority of investors who were fully invested into the market in 2007, were out of the market by the end of 2008. After such a brutal beating, it took years before they returned to the markets. Their returns are vastly different than what the mainstream media claims.

While there is a case to be made for “buy and hold” investing during rising markets, the opposite is true in falling markets. The destruction of capital eventually pushes all investors into making critical investment mistakes, which impairs the ability to obtain long-term financial goals. 

You may think you have the fortitude to ride it out. You probably don’t.

But even if you do, getting back to even isn’t really an investment strategy to reach your retirement goals.

Unfortunately, for many investors today who have now reached their financial goals, it may be worth revisiting what happened in 2000 and 2007. We are exceedingly in the current bull market, valuations are elevated, and there is a rising belief “this time is different.” 

It may be worth analyzing the risk you are taking today, and the cost it may have on “your tomorrow.” 

Market Downturn? Putting Corrections Into Perspective

Shawn Langlois recently penned an interesting article:

“Despite a few notable hiccups along the way, the bull market continues to prove insanely resilient.”

What was most interesting, however, was the following quote:

“Current hyper-valued extremes are likely to be followed by market losses on the order of two-thirds of the value of the S&P 500.” 

The immediate response by most individuals is a 60%+ decline is an outlandish and impossible event given ongoing Central Bank interventions.

But is it really?

The risk of a larger mean reverting event is a possibility even though such is entirely dismissed by the mainstream media under the guise of “this time is different.”  With the market trading more than 3-standard deviations above the 50-week moving average, historical reversions have tended to be more brutal. 

The chart below uses key support levels as potential reversion levels. The lows of 2018. The highs and lows of 2015-2016, and the 2007 highs.

At this juncture, a correction back to the 2018 lows would entail a 25% decline. However, if a “bear market” growls, the 2015-16 highs become the target, which is 34% lower. The lows of 2016 would require a 43% draft, with the 2008 highs posting a 52% “crash.” 

Those levels are still short of the 67% decline discussed above.

Such a level certainly seems preposterous, as Shawn quoted:

I recognize that the notion of a two-thirds market loss seems preposterous. Then again, so did similar projections before the 2000-2002 and 2007-09 collapses.”

While the current belief is that such declines are no longer a possibility, due to Central Bank interventions, we had two 50% declines just since the turn of the century. The cause was different, but the end result was the same. The next major market decline will be fueled by the massive levels of corporate debt, underfunded pensions, and evaporation of “stock buybacks,” which have accounted for almost 100% of net purchases since 2018.

Market downturns are a historical constant for the financial markets. Whether they are minor, or major, the impacts go beyond just the price decline when it comes to investors. This was a discussion I had in more detail in “Retired, Or Retiring Soon? Yes, Worry About A Correction.”

“In 2000, the average ‘baby boomer’ was around 45-years of age. The ‘dot.com’ crash was painful, but with 20-years to go before retirement, there was time to recover. In 2010, following the financial crisis, the time to retirement for the oldest boomers was depleted, and the average boomer only had 10-years to recover. During both of these previous periods, portfolios were still in accumulation mode. However, today, ONLY the youngest tranche of ‘boomers,’ have the luxury of ‘time\ to work through the next major market reversion. (This also explains why the share of workers over the age of 65 is at historical highs.) 

With the majority of ‘boomers’ now faced with the implications of a transition into the distribution phase of the investment cycle, such has important ramifications during market declines. The following example shows a $1 million portfolio with, and without, an annualized 4% withdrawal rate.”

“While a 10% decline in the market will reduce a portfolio from $1 million to $900,000, when combined with an assumed monthly withdrawal rate, the portfolio value is reduced by almost 14%. This is the result of taking distributions during a period of declining market values. Importantly, while it ONLY requires a non-withdrawal portfolio an 11.1% return to break even, it requires nearly a 20% return for a portfolio in the distribution phase to attain the same level.

Impairments to capital are the biggest challenges facing pre- and post-retirees currently. 

This is an important distinction. Most articles written about retirees, or those ready to retire, is an unrealized assumption of an indefinite timeline.

While the market may not be different than in the past, YOU ARE!”

This is an important point.

Investing is about growing your savings over time, and controlling the risk which could lead to a significant loss of principal. Taking on excruciating losses is not investing, nor is it financially feasible to do so, and still reach your retirement goals successfully. 

Putting Corrections Into Perspective

The real problem with discussing corrections is three-fold:

  1. It is has been so long since we have had a correction of magnitude, many investors have forgotten what happens, and more importantly, how they reacted previously.
  2. The majority of mainstream media advice is written or prognosticated by individuals who don’t manage money for a living, have substantial investment  capital at risk, and have never actually been through a bear market. 
  3. Given the extremely long market expansion, many investors have truly come to believe “this time is different.” 

If we put corrections into a bit of perspective, it becomes easier to visualize that damage which could, and most likely will, eventually occur.

10% Correction 

A correction of 10% is entirely normal for a market in any given year. While a 10% decline in a bit painful, such a decline from current levels would only set the market back October of 2019 when the Federal Reserve started their latest liquidity interventions.

20% Correction

A 20% correction from the recent highs is a bit more serious. The last time we came close to a 20% reset was in December, 2018. Try and remember how you felt during that decline.

Currently, a 20% decline would reset your portfolio back to where it was in December 2017, wiping out all the gains of the past two-years. While not the end of the world, your retirement is now set back by almost 4-years as you will have to make up the 30% gain from 2019 plus two-more years of lost growth.

30% Correction

A 30% correction gets much more serious. A decline of this magnitude takes you back to the beginning of 2017. While losing just 3-years of growth may not seem that bad, assuming you need 6% a year to reach your retirement goal, you will need almost 9-years to recover. (Remember, it takes 42.9% to recover the 30% loss, plus you have to make up the 6% annual gains you needed, but didn’t accrue, during each year of recovering the previous loss.)

40% Correction

Okay, this is starting to get a bit uglier. A 40% decline takes the market back to 2014 levels and has now wiped out 6-years of your gains. While a 40% decline requires a 66.7% recovery to breakeven, (10 years at 6%,) the lost accrual years are going to make it very difficult to meet retirement goals.

50% Correction

I know…I know…this can’t happen. (It just happened twice the century already.)

A 50% decline is effectively “game over” for investors at this point. A decline of this magnitude will reset the market essentially back to the market highs of 2000 and 2007. For individuals who were close to retirement in 2000, their portfolio, on an inflation-adjusted basis, will have been completely reset.

At this point, retiring is no longer an option for most.

60% Correction

A 60% correction is not entirely out of the question. As I have discussed previously, the next mean reverting event will likely be the last. Corrections of such a magnitude would reset portfolios back to 1999 levels. The devastation will be greater than investors can currently imagine and retirement goals would be erased entirely.

There are numerous catalysts which could pressure such a downturn in the equity markets:

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

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

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

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

It will be worse.

None of this will happen, you say?

Maybe? I certainly hope not.

But are you actually willing to bet your retirement on it?

MacroView: The Next “Minsky Moment” Is Inevitable

In 2007, I was at a conference where Paul McCulley, who was with PIMCO at the time, was discussing the idea of a “Minsky Moment.”  At that time, this idea fell on “deaf ears” as the markets, and economy, were in full swing.

However, it wasn’t too long before the 2008 “Financial Crisis” brought the “Minsky Moment” thesis to the forefront. What was revealed, of course, was the dangers of profligacy which resulted in the triggering of a wave of margin calls, a massive selloff in assets to cover debts, and higher default rates.

So, what exactly is a “Minskey Moment?”

Economist Hyman Minsky argued that the economic cycle is driven more by surges in the banking system, and in the supply of credit than by the relationship which is traditionally thought more important, between companies and workers in the labor market.

In other words, during periods of bullish speculation, if they last long enough, the excesses generated by reckless, speculative, activity will eventually lead to a crisis. Of course, the longer the speculation occurs, the more severe the crisis will be.

Hyman Minsky argued there is an inherent instability in financial markets. He postulated that an abnormally long bullish economic growth cycle would spur an asymmetric rise in market speculation which would eventually result in market instability and collapse. A “Minsky Moment” crisis follows a prolonged period of bullish speculation which is also associated with high amounts of debt taken on by both retail and institutional investors.

One way to look at “leverage,” as it relates to the financial markets, is through “margin debt,” and in particular, the level of “free cash” investors have to deploy. In periods of “high speculation,” investors are likely to be levered (borrow money) to invest, which leaves them with “negative” cash balances.

While margin balances did decline in 2018, as the markets fell due to the Federal Reserve hiking rates and reducing their balance sheet, it is notable that current levels of “leverage” are still excessively higher than they were either in 1999, or 2007.

This is also seen by looking at the S&P 500 versus the growth rate of margin debt.

The mainstream analysis dismisses margin debt under the assumption that it is the reflection of “bullish attitudes” in the market. Leverage fuels the market rise. In the early stages of an advance, this is correct. However, in the later stages of an advance, when bullish optimism and speculative behaviors are at the peaks, leverage has a “dark side” to it. As I discussed previously:

“At some point, a reversion process will take hold. It is when investor ‘psychology collides with ‘leverage and the problems associated with market liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite, and throwing it into a tanker full of gasoline.”

That moment is the “Minsky Moment.”

As noted, these reversion of “bullish excess” are not a new thing. In the book, The Cost of Capitalism, Robert Barbera’s discussed previous periods in history:

The last five major global cyclical events were the early 1990s recession — largely occasioned by the U.S. Savings & Loan crisis, the collapse of Japan Inc. after the stock market crash of 1990, the Asian crisis of the mid-1990s, the fabulous technology boom/bust cycle at the turn of the millennium and the unprecedented rise and then collapse for U.S. residential real estate in 2007-2008.

All five episodes delivered recessions, either global or regional. In no case was there as significant prior acceleration of wages and general prices. In each case, an investment boom and an associated asset market ran to improbably heights and then collapsed. From 1945 to 1985 there was no recession caused by the instability of investment prompted by financial speculation — and since 1985 there has been no recession that has not been caused by these factors. 

Read that last sentence again.

Interestingly, it was post-1970 the Federal Reserve became active in trying to control interest rates and inflation through monetary policy.

As noted in “The Fed & The Stability Instability Paradox:”

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 2-year rate, bad ‘stuff’ has historically followed.”

The Fed Is Doing It Again

As noted above, “Minsky Moment” crises occur because investors, engaging in excessively aggressive speculation, take on additional credit risk during prosperous times, or bull markets. The longer a bull market lasts, the more investors borrow to try and capitalize on market moves.

However, it hasn’t just been investors tapping into debt to capitalize on the bull market advance, but corporations have gorged on debt for unproductive spending, dividend issuance, and share buybacks. As I noted in last week’s MacroView:

“Since the economy is driven by consumption, and theoretically, companies should be taking on debt for productive purposes to meet rising demand, analyzing corporate debt relative to underlying economic growth gives us a view on leverage levels.”

“The problem with debt, of course, is it is leverage that has to be serviced by underlying cash flows of the business. While asset prices have surged to historic highs, corporate profits for the entirety of U.S. business have remained flat since 2014. Such doesn’t suggest the addition of leverage is being done to ‘grow’ profits, but rather to ‘sustain’ them.”

Over the last decade, the Federal Reserve’s ongoing liquidity interventions, zero interest-rates, and maintaining extremely “accommodative” policies, has led to substantial increases in speculative investment. Such was driven by the belief that if “something breaks,” the Fed will be there to fix to it.

Despite a decade long economic expansion, record stock market prices, and record low unemployment, the Fed continues to support financial speculation through ongoing interventions.

John Authers recently penned an excellent piece on this issue for Bloomberg:

“Why does liquidity look quite so bullish? As ever, we can thank central banks and particularly the Federal Reserve. Twelve months ago, the U.S. central bank intended to restrict liquidity steadily by shrinking the assets on its balance sheet on “auto-pilot.” That changed, though. It reversed course and then cut rates three times. And most importantly, it started to build its balance sheet again in an attempt to shore up the repo market — which banks use to access short-term finance — when it suddenly froze up  in September. In terms of the increase in U.S. liquidity over 12 months, by CrossBorder’s measures, this was the biggest liquidity boost ever:”

While John believes we are early in the global liquidity cycle, I personally am not so sure given the magnitude of the increase Central Bank balance sheets over the last decade.

Currently, global Central Bank balance sheets have grown from roughly $5 Trillion in 2007, to $21 Trillion currently. In other words, Central Bank balance sheets are equivalent to the size of the entire U.S. economy.

In 2007, the global stock market capitalization was $65 Trillion. In 2019, the global stock market capitalization hit $85 Trillion, which was an increase of $20 Trillion, or roughly equivalent to the expansion of the Central Bank balance sheets.

In the U.S., there has been a clear correlation between the Fed’s balance sheet expansions, and speculative risk-taking in the financial markets.

Is Another Minsky Moment Looming?

The International Monetary Fund (IMF) has been issuing global warnings of high debt levels and slowing global economic growth, which has the potential to result in Minsky Moment crises around the globe.

While this has not come to fruition yet, the warning signs are there. Globally, there is roughly $15 Trillion in negative-yielding debt with asset prices fundamentally detached for corporate profitability, and excessive valuations on multiple levels.

As Desmond Lachman wrote:

“How else can one explain that the risky U.S. leveraged loan market has increased to more than $1.3 trillion and that the size of today’s global leveraged loan market is some two and a half times the size of the U.S. subprime market in 2008? Or how else can one explain that in 2017 Argentina was able to place a 100-year bond? Or that European high yield borrowers can place their debt at negative interest rates? Or that as dysfunctional and heavily indebted government as that of Italy can borrow at a lower interest rate than that of the United States? Or that the government of Greece can borrow at negative interest rates?

These are all clear indications that speculative excess is present in the markets currently.

However, there is one other prime ingredient needed to complete the environment for a “Minsky Moment” to occur.

That ingredient is complacency.

Yet despite the clearest signs that global credit has been grossly misallocated and that global credit risk has been seriously mispriced, both markets and policymakers seem to be remarkably sanguine. It would seem that the furthest thing from their minds is that once again we could experience a Minsky moment involving a violent repricing of risky assets that could cause real strains in the financial markets.”

Desmond is correct. Currently, despite record asset prices, leverage, debt, combined with slowing economic growth, the level of complacency is extraordinarily high. Given that no one currently believes another “credit-related crisis” can occur is what is needed to allow one to happen.

Professor Minsky taught that markets have short memories, and that they repeatedly delude themselves into believing that this time will be different. Sadly, judging by today’s market exuberance in the face of mounting economic and political risks, once again, Minsky is likely to be proved correct.

At this point in the cycle, the next “Minsky Moment” is inevitable.

All that is missing is the catalyst to start the ball rolling.

An unexpected recession would more than likely due to trick.

Technically Speaking: Market Bounce, January, & The Super Bowl.

In this past weekend’s newsletter, we stated the market was likely to bounce due to the short-term oversold condition which existed following Friday’s rout. To wit:

“With a ‘sell signal’ clearly triggered (lower panel), it suggests, on a short-term basis, we are likely to see a ‘tradeable bounce.’ However, until the signal reverses, any short-term bounce should probably be ‘sold into.’

Make no mistake, there is currently downside risk below the 50-dma to both the 38.2% and 50% Fibonacci retracement levels. From recent peaks, such a correction would entail a 5-8% decline, which is well within the normal range of a market correction within an ongoing bullish trend.”

Chart updated through Monday’s close.

The market failed at the bottom of the broken trend line yesterday, which suggests this “short-term” bounce is likely an opportunity to rebalance risks into.

With the fallout of the “coronavirus” being written off very quickly, under the assumption the outcome will be equivalent to the SARS epidemic in 2003, such is likely a mistake. As I wrote previously:

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

With global growth already slow, and the U.S. dragging its feet along at roughly 2% annual growth, there isn’t much room to absorb the impact of an event that potentially curtails consumption. 

Given that China, which is roughly 4x the size of global GDP today versus 2003, it occupies a central place in many supply chains used by other manufacturing countries, including pharmaceuticals, and is a voracious buyer of raw materials and other commodities, including oil, natural gas, and soybeans. That means that any economic hiccups for China this year, coming on the heels of its worst economic performance in 30 years, will have a bigger impact on the rest of the world than during past crises.

The was a point made by Mohamed El-Erian, on Monday, who stated the outbreak was going to take a major toll on the Chinese economy and hurt global growth. 

“For a long time I thought the market sentiment was so strong that we could overcome a mounting list of economic uncertainty. But the coronavirus is different. It is big. It’s going to paralyze China. It’s going to cascade throughout the global economy. Importantly, it cannot be countered by central bank policy. 

Investors ‘need to decide if they want to opt for more of the same, by continuing to implement an investment playbook that has served them well, or if they want to treat the viral outbreak for what it is — a big economic shock that could derail global growth and shake markets out of their ‘buy-the-dip’ conditioning.”Mohamed El-Erian

On Monday, the reflexive bounce was primarily supported by “market chatter” the Fed may be forced to extend their current “Not QE” through June, and/or lower rates. El-Erian is likely correct that this is not an event “monetary band-aids” can fix. 

Furthermore, his comments run similar to our own in that the long-running play of dismissing downbeat fundamentals on expectations central banks will be able to ride to the rescue could prove misguided in the current environment. What the current “bullish bias” is potentially missing is that while the effects of the deadly outbreak are substantial in China, and will cascade not only through the world’s second-largest economy, it will also slow global growth. A weaker China is not only a problem for Europe, but also for the U.S. where exports account for about 40% of corporate profits. 

Importantly, the multi-year gap between elevated asset prices and weaker economic conditions is becoming increasingly unsustainable. This is shown in the chart below:

The problem with pulling forward future consumption, is that it leaves a void which eventually must be filled, which requires more interventions to do so. Ultimately, that void becomes too vast.  

So Goes January…

January was a complete bust. After rocketing higher on “Fed Fuel,” the entire month’s gains were wiped out by January 31st.

It reminded me of January 2018, as the S&P 500 was surging higher following the passage of “tax cuts.” The markets were extrapolating earnings estimates to ridiculous levels in the hopes tax cuts would lead to an earnings and economic recovery. As I wrote then, such was never going to happen:

“The same is true for the myth that tax cuts lead to higher wages. Again, as with economic growth, there is no evidence that cutting taxes increases wage growth for average Americans. This is particularly the case currently as companies are sourcing every accounting gimmick, share repurchase or productivity increasing enhancement possible to increase profit growth.

Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.

The chart below shows the run up from October to the January peak in 2018. That rally pushed the S&P 500 to 3-standard deviations above the 200-dma, just as the end of the month was approaching. Then, in just a few short days, the entire gain of January evaporated.

The chart below is the S&P 500 from October 2019 to present. Again, we see the market pushing into 3-standard deviation territory, then wiping out the entire gain of January in just a few days.

While I am not suggesting the market will test the 200-dma as it did in 2018, it is a possibility, particularly if the “coronavirus” worsens, or economic impacts begin to become visible. 

However, the reversal of the January gain to a loss does bring up the old Wall Street axiom:

“So goes January…So goes the year.” 

The January barometer was devised by Yale Hirsch in 1972 and has only registered ten major errors since 1950, for an 85.7% accuracy ratio. As noted by StockTraders Almanac:

“Of the ten major errors Vietnam affected 1966 and 1968. 1982 saw the start of a major bull market in August. Two January rate cuts and 9/11 affected 2001. The market in January 2003 was held down by the anticipation of military action in Iraq. The second worst bear market since 1900 ended in March of 2009, and Federal Reserve intervention influenced 2010 and 2014. In 2016, DJIA slipped into an official Ned Davis bear market in January. Including the eight flat years yields a .743 batting average.”

This year’s combination of a positive Santa Claus Rally and First Five Days with a full-month January loss has only occurred 11-times (including this year) since 1950. In the previous 10-occurrences, the S&P 500 was down six times in February with an average loss of 1.5%. However, over the remaining 11 months of the year, S&P 500 advanced 80% of the time with an average gain of 7.4%. Full-year performance was positive 70% of the time, but with an average gain of 2.9%.”

While there are many other factors that could drive the market higher this year, from the election to more Central Bank interventions, there is a growing chorus of indications which suggest we are nearing the end of current cycle. With negative yielding debt back on the rise, numerous yield spreads re-inverting, slower economic growth, and weaker earnings, the ability to sustain high valuations is going to become more challenging. 

Don’t Forget The Super Bowl

The Kansas City Chiefs won “Super Bowl LIV” in a stunning fourth-quarter rally to beat the San Francisco 49ers, which triggered the “Super Bowl Indicator” suggesting a weaker market. (This is a purely coincident indicator, but, given it was the Chiefs’ first Super Bowl championship in 50 years, maybe there is something about odd things happening when everyone else thinks they won’t.)

If you aren’t familiar with the indicator, it says that if the winning team of National Football League’s (NFL) championship game is from the National Football Conference (NFC), then stocks will have a bull market that year. If a team from the American Football Conference (AFC) wins, then it will be a bear market.

The Chiefs are from the AFC, meaning the indicator predicts a bear market this year and the predictor has been right 40 out of 53 games, a 75% success rate. While the last four years have been wrong, statistics suggest odds have increased for the indicator to be correct this year.

Here’s a breakdown of the 20 Super Bowl winners, of the last 53 Super Bowls, and how the S&P 500 has done following their victories:

While investors should never use a “coincident” indicator such as this to manage money, it is interesting nonetheless.

Portfolio Positioning

Yesterday, as we discussed with our RIAPro Subscribers (30-Day Risk-Free Trial) we slightly reduced our holdings in Utilities and Real Estate to raise some cash ahead of what we suspect will be a fairly short-lived rally. The goal is to use a pullback to rebalance exposures and look for a more “washed out” level to take on some “opportunistic” holdings. 

One such area where there is a tremendous amount of “negative sentiment” is in the energy sector. While it isn’t time to start adding exposure, we may be getting a decent “trading setup” here soon. Also, after previously reducing our holdings in some of our Technology, Healthcare, and Communications holdings, we may get the opportunity to rebuild our long-term core holdings at better risk/reward levels. 

While this year could indeed turn out to be a negative year, it doesn’t mean there won’t be some decent trading opportunities along the way. This is portfolio management.

However, make no mistake that we are nearing the end of an exceedingly long bull market cycle, and the eventual “reversion to the mean” will be a brutal event.

While it is easy to dismiss such an outcome under the guise of “this time is different because of the Fed,” every single “bear market” previously came on the heels of similar beliefs. In 1987, it was “Portfolio Insurance.” In 2000, it was the “Internet.”  In 2007, it was the “Goldilocks Economy.” 

Today will not be different, but the eventual outcome will be the same.

The Rotation To Value Is Inevitable

In late 1999, it was stated that “investing like Warren Buffett was the same as driving ‘Dad’s ole’ Pontiac.” The suggestion, of course, was that “value” investing was no longer a viable investment strategy in the new “dot.com” economy where “growth” was all that mattered. After all, in the “new world,” it was indeed “different this time.” 

Less than a year later, investors wished they had adhered to Warren Buffett’s strategy of buying value as the “Dot.com dream” emerged as a nightmare for many unwitting individuals.

However, it wasn’t just stocks either. In 2007, individuals were chasing the “momentum” in the real estate market as individuals left their jobs to pursue riches in housing and were willing to “pay any price” under the assumption they would be able to sell higher. Of course, it was long after then Fed Chairman Ben Bernanke uttered the words “the subprime market is contained,” the dreams of riches evaporated like a “morning mist.” 

As Warren Buffett once quipped, “price is what you pay, value is what you get.”  

Throughout market history, investors have repeatedly abandoned this simple principle during periods where bull market advances seemed to defy logic. Ultimately, those investors paid a dear price for their speculation as the reality of “overpaying for value” led to poor financial outcomes.

As we have noted in a series of articles posted at RIAPRO.net, we believe the market is on the precipice of another monumental shift from “growth” to “value,” and as repeatedly seen in the past will blindside most investors.

Value vs. Growth

The market’s surge higher since the financial crisis, which has been driven by massive fiscal and monetary policies, have been nothing short of extraordinary. Currently, the S&P 500 is trading at the greatest deviation from its long-term exponential growth trend in history.

This is occurring at a time where market prices are advancing while corporate profitability has been flat since 2014.

While we have previously discussed the unparalleled use of monetary policy to push markets higher, massive fiscal spending designed to keep economic growth positive, and how corporations have shunned future growth with a preference for the short-term incentive of “share repurchases.”

As Michael Lebowitz, CFA previously noted:

“As a result of these behaviors and actions, we have witnessed an anomaly in what has historically spelled success for investors. Stronger companies with predictable income generation and solid balance sheets have grossly underperformed companies with unreliable earnings and over-burdened balance sheets. The prospect of majestic future growth has trumped dependable growth. Companies with little to no income and massive debts have been the winners.”

This was much the same as we saw in late 1999 as companies with no earnings, no revenue, and no real strategy for growth exploded higher in a speculation fueled buying frenzy.

This underperformance of “value” relative to “growth” is not unique. What is unique is the current duration and magnitude of that underperformance. To say unprecedented is almost an understatement.

The graph below charts ten-year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data point representing 2018, covering the years 2009 through 2018, stands at negative 2.86%. This indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.

The data for this analysis comes from Kenneth French and Dartmouth University.

There are two important takeaways from the graph above:

  • Over the last 90 years, value stocks have outperformed growth stocks by an average of 4.44% per year (orange dotted line).
  • There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.

It is important to understand that it is “investor speculation” which drives these deviations in returns between growth and value. Of course, when things ultimately go “pear-shaped,” the return to value tends to be a swift event. The chart below overlays important periods in market history where “value” became “valued.”

The chart below shows the difference in the performance of the “value vs growth” index versus a pure growth index. Both are based on a $100 investment. While value investing will always provide consistent returns, there are times when growth outperforms value and vice versa. What is important to note are the periods when “value investing” has the greatest outperformance as noted by the “blue shaded” areas.

Given that we are statistically, and logically, very likely nearing the end of the current cycle, it is even more crucial to grasp what decades of investment experience tells us about the future.

When the cycle turns, we have little doubt the value-growth relationship will revert back to its long-term mean. Importantly, seldom do such reversions stop at the mean.

“To better understand why this is so important, consider what happens if the investment cycle turns and the relationship of value versus growth returns to the average over the next two years. In such a case, value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.”Michael Lebowitz

History Doesn’t Repeat

It is often noted that history doesn’t repeat, but it often rhymes, particularly when it comes to financial markets. It is not a question of if the rotation to value will occur, it is only a function of when.

However, this is the risk that investors take on currently in the market. Chasing markets is the purest form of speculation. Ultimately, it is a pure bet on prices going higher rather than determining if the price being paid for those assets are selling at a discount to fair value.

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

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

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

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

While the current market advance seems to be unstoppable, this was the attitude seen by investors at every prior market in history. As Howard Marks once stated:

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

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

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

The rotation from “growth” to “value” is inevitable. It will occur against a backdrop of devastation for the majority of investors quietly lulled into the extreme sense of complacency years of monetary interventions have provided.

The only question is whether you will be the buyer of “value” at a time when everyone else is selling “growth?”

MacroView: The Fed’s View Of Valuations May Be Misguided

On Wednesday, the Federal Reserve concluded their January “FOMC” meeting and released their statement. Overall, there was not much to get excited about, as it was virtually the same statement they released at the last meeting.

However, Jerome Powell made a comment which caught our attention:

“We do see asset valuations as being somewhat elevated” 

It is an interesting comment because he compares it to equity yields.

“One way to think about equity prices is what’s the premium you’re getting paid to own equities rather than risk-free debt.”

As we have discussed previously, looking at equity yield, which is the inverse of the price-earnings ratio, versus owning bonds is a flawed and ultimately dangerous premise. To wit:

“Earnings yield has been the cornerstone of the ‘Fed Model’ since the early ’80s. The Fed Model states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield, you should invest in stocks and vice-versa.”

The problem here is two-fold.

1. You receive the income from owning a Treasury bond, whereas there is no tangible return from an earnings yield. For example, if we purchase a Treasury bond with a 5% yield and stock with an 8% earnings yield, if the price of both assets remains stable for one year, the net return on the bond is 5% while the return on the stock is 0%. Which one had the better return?  Furthermore, this has been especially true over the last two decades where owning bonds has outperformed owning stocks. (Data is total real return via Aswath Damodaran, NYU)

2. Unlike stocks, bonds have a finite value. At maturity, the principal is returned to the holder along with the final interest payment. However, while stocks may have an “earnings yield,” which is never received, stocks have price risk, no maturity, and no repayment of principal feature. The risk of owning a stock is exponentially more significant than owning a “risk-free” bond.

This flawed concept of risk, as promoted by the Federal Reserve, also undermines their view of current valuations.

I have spilled an enormous amount of “digital ink” discussing the importance of valuations on future returns for investors, and most recently, why high starting valuations are critically important to individuals at, or near, retirement.

“Over any 30-year period, beginning valuation levels have a tremendous impact on future returns. As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.”

Not surprisingly, valuations are often dismissed in the short-term because there is not an immediate impact on price returns. Valuations, by their very nature, are not strong predictors of 12-month returns. This was a point made by Janet Yellen in 2017:

“The fact that [stock market] valuations are high doesn’t mean that they’re necessarily overvalued. For starters, high valuations don’t portend lackluster returns in the near term. History shows that valuations provide no reliable signal as to what will happen in the next 12 months.”

That is correct. However, over long periods, valuations are strong predictors of expected returns, which is what matters for investors.

As my friends over at Crescat Capital, Kevin Smith and Tavi Costa, recently penned:

“The problem is that P/E, even Shiller’s cyclically adjusted P/E ratio (CAPE), is a potential value-trap measure in the current economy because of three issues:

  1. Profit margins are unsustainably high today, not only within this business cycle but compared to other business cycles making P/E ratios understated;
  2. The P/E ratio completely ignores debt in its valuation, not a good idea at a time when corporations have record leverage; and
  3. The most common measures of total market P/E use the mean rather than median company valuation which understates the average company’s multiple today by putting more weight on bigger, more profitable companies – the median better captures the valuation of the breadth of the market.

We believe median enterprise value to sales is one of the best measures to understand the extent of the bubble in the stock market today compared to history. By looking at sales and not earnings, we control for today’s likely fleeting, record-high profit margins. And because EV includes debt as well as equity in the total valuation of the company, it properly reflects the valuation of the business. Finally, our focus on the median company’s valuation illustrates the breadth of the valuation extreme in the market today.”

Let’s break down Crescat’s important points visually.

Since the economy is driven by consumption, and theoretically, companies should be taking on debt for productive purposes to meet rising demand, analyzing corporate debt relative to underlying economic growth gives us a view on leverage levels.

As Scott Minerd, CIO of Guggenheim Investments tweeted on Friday:

The problem with debt, of course, is it is leverage that has to be serviced by underlying cash flows of the business. While asset prices have surged to historic highs, corporate profits for the entirety of U.S. business have remained flat since 2014. Such doesn’t suggest the addition of leverage is being done to “grow” profits, but rather to “sustain” them. 

However, when it comes to GAAP earnings per share, which have been heavily manipulated by massive levels of “share buybacks,” the deviation between what investors are paying for earnings is the largest on record, far surpassing the “Dot.com” bubble era.

“The average investor does not need an advanced finance degree to understand these valuation points. It is a worthy endeavor to avoid getting caught up in the popular delusions associated with late-cycle market euphoria. We believe investors will need a good grounding in valuation and business cycle analysis to reject the common buy-the-dip advice that is soon to become prevalent in the still early stages of what is likely to become a brutal bear market.” Crescat Capital

As I stated above, what price-to-earnings (P/E) ratios tell us is that high valuations lead to lower future returns over time. However, what Jerome Powell misses in comments that valuations are elevated, but not concerning, is that it isn’t just P/E’s which are elevated.

“Below is another way to visualize the current market valuation extremes to understand the risks of a severe market downturn ahead. Here we look at each sector of the S&P 500 and compare its valuation today to compared to prior market peaks in the tech and housing bubbles in 2000 and 2007. We can see that an unprecedented 8 out of 11 sectors are at top-decile, historical valuations illustrating the breadth of the current market excess.” – Crescat Capital

“Below we show the gamut of measures currently at record high fundamental valuation for the market at large based on their historical percentile ranking. Data for MAPE and CAPE ratios go back prior to 1929! The other measures are based on the entire history of available data which goes back at least two and half business cycles:” – Crescat Capital

Low Interest Rates Support Higher Valuations

This is where we generally hear a common refrain from the mainstream media:

“Low levels of interest rates justify higher valuations.” 

To analyze the relative value argument, let’s look at the interaction of interest rates and stock valuations over the broad sweep of time. As shown, extremely high stock market valuations occurred in 1929, 2000, and recently. However, interest rates were extremely low only once (recently) during those three occurrences. If low interest rates coincide with extremely high stock valuations only one time out of three, then it is obvious that low interest rates do not cause, or justify, high stock valuations. Yet “low interest rates justify high stock valuations” is one of the certainties of the current mainstream narrative.

Source:  Robert Shiller, multipl.com.  Data through June 2017.

If we isolate the times when interest rates were extremely low, the 1940s and currently, we find in the 1940s stock valuations were low. So, the statement that low interest rates justify high stock valuations is only supported by one event….now.

A better understanding is achieved by the relative value argument that extremely high interest rates coincide with extremely low stock market valuations, which occurred in 1921 and 1981. Although a sample size of two observations is not enough to draw a statistically-significant conclusion, at least it is two events with the same outcome.

The historical relationship between extremes in stock market valuations with extremes in interest rates is as follows:

  • Extremely high interest rates, which have occurred twice, coincided with low stock market valuations.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates; today.
  • If extremely low interest rates do not justify extremely high stock market valuations, then a rise in rates should not necessarily cause a decline in stocks, but rising rates do lead to market corrections and bear markets.

Crescat Capital also weighed in on this point as well:

“A common argument today is that low interest rates justify today’s high equity valuations. That is not true at all. When low interest rates are due to low growth and excessive debt, as is the case today, no valuation premium is justified.”

Make No Mistake

Jerome Powell clearly understands that a decade of monetary infusions and low interest rates has created an asset bubble larger than any other in history. However, they are trapped by their own policies as any reversal leads to the one outcome they can’t afford – a broad market correction.

As I wrote previously:

“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s.”

This is the problem facing the Fed.

Currently, investors have been led to believe that no matter what happens, the Fed can bail out the markets and keep the bull market going for a while longer. Or rather, as Dr. Irving Fisher once uttered:

“Stocks have reached a permanently high plateau.”

Interestingly, the Fed is dependent on both market participants, and consumers, believing in this idea. With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the most significant risk.

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

The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.

Simply, the Fed is dependent on “everyone acting rationally.”

The problem comes when they don’t.

“SARS” Versus “Wuhan”: The Difference Between “Now & Then”

A week dominated by headlines of a spreading respiratory virus has had investors recalling pandemics past, from SARS in 2003 to the Ebola scare six years ago. While the “Wuhan” virus, or known scientifically as “nCoV,” is still in its infancy, it is closely tracking both the infection and, unfortunately, death rates of the SARS virus.

However, the question everyone wants an answer to is: “what does the virus mean for the markets?”

Will it derail the longest bull market in U.S. history? Or, is it nothing to worry about?

If you read the mainstream media, the answer seems to be the latter. To wit:

“However, gauged by the market’s performance during the onset of other infectious diseases, including SARS, or severe acute respiratory syndrome, Ebola and avian flu, Wall Street investors may have little to fear that this disease will sicken a U.S. stock market that finished 2019 with the best annual return in years and has kicked off 2020 at or near all-time highs.” – MarketWatch

With the stock market perched near all-time highs, it is understandable investors are quick to dismiss the potential ramifications of the virus very quickly. There is also plenty of anecdotal evidence to support the bullish claims as well. The chart below is the S&P 500 index versus its exponential growth trend with a history of the more important viral outbreaks notated.

Throughout history, markets have always seemed to bounce back from deadly viral outbreaks. However, long-term charts tend to obfuscate the damage done to investors who have a much shorter investment time horizon.

Currently, the more prominent comparison is how the market performed following the “SARS” outbreak in 2003, as it also was a member of the “corona virus” family.

Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed.

At least it seems that way.

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

Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the “risk” was already removed from asset prices and economic growth.

Today’s economic environment could not be more opposed.

Currently, asset prices are near historic highs along with investor sentiment and overall market optimism. The chart below is our composite “fear/greed” gauge, which is comprised of professional and retail asset allocations to equities. (Importantly, this is NOT a measure of how investors “feel” about the market, it is how they are allocated to it.)

Real personal consumption expenditures and consumer confidence had also reverted during the recession in 2001-2002, so there was sufficient “pent-up” demand to offset the economic and market impact from the SARS outbreak. Currently, consumer confidence remains near highs as consumption has remained strong enough to sustain 2% economic growth.

There is also the issue that China, which is ground zero for the “Wuhan virus,” is a substantially larger portion, and economically more important, than it was in 2003.

This is an important point recently noted by Johnson & Palmer of Foreign Policy:

“China itself is a much more crucial player in the global economy than it was at the time of SARS, or severe acute respiratory syndrome, in 2003. It occupies a central place in many supply chains used by other manufacturing countries—including pharmaceuticals, with China home to 13 percent of facilities that make ingredients for U.S. drugs—and is a voracious buyer of raw materials and other commodities, including oil, natural gas, and soybeans. That means that any economic hiccups for China this year—coming on the heels of its worst economic performance in 30 years—will have a bigger impact on the rest of the world than during past crises.

That is particularly true given the epicenter of the outbreak: Wuhan, which is now under effective quarantine, is a riverine and rail transportation hub that is a key node in shipping bulky commodities between China’s coast and its interior.

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

As I noted this past weekend, the commodity complex is suggesting something went awry with the economy in January.

“There are a few indicators which, by their very nature, should be signaling a surge in economic activity if there was indeed going to be one. Copper, energy prices, commodities in general, and the Baltic Dry index, should all be rising if economic activity is indeed beginning to recover. 

Not surprisingly, as the “trade deal” was agreed to, we DID see a pickup in commodity prices, which was reflected in the stronger economic reports as of late. However, while the media is crowing that “reflation is on the horizon,” the commodity complex is suggesting that whatever bump there was from the “trade deal,” is now over.”

Importantly, this decline happened BEFORE the “Wuhan virus” which suggests the virus will only worsen the potential impact.

Furthermore, given the “ink is barely dry” on the newly signed trade deal, any economic slowdown would likely make it very difficult for China to meet its overly ambitious purchase targets. However, the collapse of soybean prices in January already suggests they aren’t purchasing any great amounts.

Though stock markets recovered their stride following Monday’s rout, the risks of a deeper market correction remains. For investors, markets both domestically and globally are trading at historically high valuations. However, valuations aren’t a problem, until they are. As Michael Lebowitz recently penned:

“Consider that in 1929 valuations were similar to where levels stand today across a wide variety of metrics. Many valuation-based forecasts predict returns of plus or minus a few percent annualized over the next ten years. The following table contrasts current valuations versus prior periods.”

While investors try rationalize high valuations using a number of faulty comparisons, such as forward-operating earnings, low-interest rates, or low-inflation, there is little historical evidence to support that high-valuations are justified by such measures.

However, as David Lafferty recently noted in a Bloomberg interview:

“The thing that worries me is that there’s so much optimism priced in, and people are worried about valuation. But valuation, in and of itself, isn’t a catalyst. So in that vacuum, people tend to look for catalysts and maybe some type of epidemic or pandemic becomes the excuse they’ve been looking for to either profit-take or sell down assets that they think are expensive.

The problem with a more significant market correction, spawned by a repricing of valuations due to slower economic growth, is that it creates a downward spiral.

“A big market correction would severely impact global growth this year, the International Monetary Fund and ratings agencies have warned. The hit to U.S. consumers alone would likely dampen spending and could halve GDP growth, bringing U.S. growth to levels last seen during the financial crisis a decade ago. And companies already burdened with a record level of high-yield debt would be even more exposed after a market downturn, creating the possibility of a wave of defaults that could further undermine confidence.” – Johnson & Palmer via Foreign Policy

While it certainly is not clear how much worse the outbreak will become, or how long it will last, the epidemic could last well into the summer. While a short-term disruption during the Lunar New Year holiday is one thing; half a year of interrupted trade and canceled travel in at least swathes of the world’s second-biggest economy is potentially much more damaging.

With the economic expansion peaking, the market overly extended and excessively bullish, and fundamentals strained, there is a vast difference between “now” and “then.” It also just might be the message that plunging commodity prices and falling bond yields are already sending.

Technically Speaking: “Coronavirus” Triggers Overdue Market Correction

Over the last few weeks, we have discussed the outsize market advance driven by the Fed’s massive liquidity injections into the market. As we discussed with our RIAPRO subscribers (30-day RISK FREE Trial) we stated:

“If it appears to you that the recent rally is an anomaly, your thoughts do not deceive you. The graph below shows that recent returns divided by annualized volatility (risk) have been running higher than at any time since the financial crisis.

This standard calculation of return per unit of risk is technically called the Sharpe Ratio. The ratio has been sitting around 2.0 for most of January. To put that into context, the current reading is about 4 sigma (standard deviations) from the norm, an event that should statistically occur in one day out of every 43 years. Since January first, there have been 5 daily readings that were greater than 4 sigmas!”

Not surprisingly, due to that extreme reading the correction on Monday was the largest we have seen since the Federal Reserve started intervening into the financial market in mid-October of last year.

This analysis, along with several other posts over the last couple of weeks, detailed our concerns about inherent market risk and why we reduced portfolio exposure a couple of weeks ago. To wit:

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

  • In the Equity Portfolios, we reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)
  • In the ETF Sector Rotation Portfolio, we reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now. 
  • The Dynamic Portfolio was allocated to a market neutral position by shorting the S&P index itself.

Let me state clearly, we did not ‘sell everything’ and go to cash. We simply reduced our holdings to raise cash, and capture some of the gains we made in 2019. When the market corrects we will use our cash holdings to either add back to our current positions, or add new ones.”

While I received a lot of emails and comments questioning why would we “sell out of the market” and “go to cash,” such was NOT the case. We did raise our cash position from 5% to 12%. Just prior to increasing cash, we had previously added defensive exposure in fixed income, gold, gold miners, and REIT’s. However, we still maintain the majority of our long equity exposures currently.

You Can’t Time Market Corrections

At the time we made these changes, it appeared we were clearly wrong as the market continued to grind higher. As Howard Marks once quipped:

“Being early, even if you are right, is the same as being wrong.” 

However, from a portfolio management, and more particularly, a “risk mitigation” view, our job isn’t necessarily to hit the exact tops or bottoms, just to provide a cushion against losses.

During the last couple of weeks, we have noted the extreme overbought, overly bullish, and over complacent conditions of the market. Here is an updated chart of the S&P 500 from two weeks ago when we discussed taking profits.

With the markets pushing into 3-standard deviations above the 200-day moving average, it was only a function of time before a correction occurred. Therefore, while we were early taking profits, the end result is it reduced portfolio risk against a pending correction. As I wrote then:

“While the markets could certainly see a push higher in the short-term from the Fed’s ongoing liquidity injections, the gains for 2020 could very well be front-loaded for investors. 

Taking profits and reducing risks now may lead to a short-term underperformance in portfolios, but you will likely appreciate the reduced volatility if, and when, the current optimism fades.”

When discussing portfolio management, it is often suggested that you can’t “time the market.”

That statement is correct.

You can not effectively, and repetitively, get “in” and “out” of the market on a timely fashion. I have never suggested that an investor should try and do this. However, I have discussed managing risk by adjusting market exposure at times when “risk” outweighs the potential for further “reward.”

While our actions are almost always misunderstood, and labeled as “bearish,” I am actually neither bullish or bearish. In our practice, we follow a very simple set of rules, which forms the core of our portfolio management philosophy which focuses on capital preservation and long-term “risk-adjusted” returns.

As long-term investors, we don’t worry about short-term rallies, we only need to worry about the direction of overall market trends, and focus on capturing more of the positive and less of the negative. This philosophy stems from Baron Nathan Rothschild’s view:

“You can have the top 20% and the bottom 20%, I will take the 80% in the middle.”

While our assessment of the market two-weeks ago was that risk versus reward was unbalanced, such can remain the case for extended periods of time.

The problem with an economy being propped up by artificially appreciated assets is that this pendulum swings both ways. At some point, prices eventually decline. No one knows what will cause the decline;

  • Higher interest rates like in 2018,
  • A presidential tweet, when he launched the “trade war” with China.
  • The ongoing implosion of the Chinese economy is still a threat.
  • It could just be the realization by the markets that asset prices don’t grow to the sky.
  • Or, it could be triggered by an unexpected, exogenous event, which results in the markets “repricing” risk. 

The “coronavirus” was the exogenous event the markets had not priced into its view.

Is It Time To “Buy The Dip?”

With the “sell off” on Monday, the immediate reaction by investors is to jump in and “buy the dip.” This would seem to be the logical action given the Federal Reserve is still supplying liquidity to the market currently.

Maybe not.

The chart below is part of the analysis we use to “onboard” new client portfolios. The purpose of this measure is to avoid transitioning a new client into our portfolio models near a short-term peak of the market. The vertical red lines suggest we avoid adding equity risk to portfolios and vice versa.

There are a few important points to denote in the chart above.

  1. The top and bottom signals are essentially relative strength and momentum measures. Both are currently still on “buy” signals and the current “sell off” has not reversed those signals as of yet. 
  2. With the market still very deviated above the longer-term 200-dma, and just clearing out of 3-standard deviation territory, there is currently more downside risk, than upside reward. 
  3. Note that corrections, once the “sell signals” are triggered can last from several weeks, to several months. During the correction process there are often multiple opportunities to reduce risk and raise cash accordingly. 
  4. The last two times the market pushed into 3-standard deviation territory, the resulting corrections were fairly sharp and lasted for several months.

However, on a VERY short-term basis the market is indeed oversold, and is testing the breakout of the upward trending trading range from last year. Given the MACD has registered a “sell signal” from a fairly high level, investors must consider the risk of further downside even if the market rallies over the next couple of days.

Don’t be fooled that a short-term reflexive rally is an “all-clear” for the bull market to resume. With the bulk of our momentum, relative strength, and overbought/sold indicators just starting to correct from recent highs, it is likely short-term rallies will be “selling opportunities” over the next couple of weeks as the market either corrects further or consolidates recent gains.

As we have detailed over the last few missives, due to the rather extreme extension of the market, this is likely the beginning of a correction which could encompass a 5-10% decline in totality before it is complete.

The problem for investors is they tend to make to critical mistakes in managing portfolios.

  • Investors are slow to react to new information (they anchor), which initially leads to under-reaction but eventually shifts to over-reaction during late-cycle stages.
  • Investors are ultimately driven by the “herding” effect. A rising market leads to “justifications” to explain over-valued holdings. In other words, buying begets more buying.
  • Lastly, as the markets turn, the “disposition” effect takes hold and winners are sold to protect gains, but losers are held in the hopes of better prices later. 

With the Federal Reserve reducing slowing its torrid pace of liquidity, still weak economic growth, and potential for weaker than expected earnings growth, the risk remains to the downside currently.

From that perspective, we are continuing to maintain our higher levels of cash, and we will use reflexive rallies in the short-term to rebalance portfolio risk as needed according to our investment discipline.

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

Notice, nothing in there says, “sell everything and go to cash.”

As Michael Lebowitz previously noted:

“The point being made here is essential; risk management is generous. Based on the past 100 years of market data, there is no evidence that long-term returns are penalized by taking a defensive investment posture at high valuations. Investors today do not need to ‘buy and hold’ stocks and remain heavily invested when expected returns are paltry. The historical record, though imprecise, affords an excellent map for navigating and managing risk.”

By having reduced risk, we can afford to remain patient and wait for the next opportunity. Much like a professional baseball player, by reducing risk we create an environment that is “emotionally” controllable and we can exercise patience until a “fat pitch” comes along.

One thing is for certain, swinging at every pitch, won’t get you into the “hall of fame.” 

MacroView: Elites View The World Through “Market Colored” Glasses

It is easy to suggest the economy is booming when your net worth is in the hundreds of millions, if not billions, of dollars, or when your business, and your net worth, directly benefit from surging asset prices. This was the consensus from the annual gaggle of the ultra-rich, politicians, and media stars in Davos, Switzerland this past week.

As J.P. Morgan Chase CEO Jamie Dimon told CNBC on Wednesday the stock market is in a “Goldilocks place.” 

Of course, it is when you bank receives an annual dividend from the Federal Reserve’s balance sheet expansion. This isn’t the first time I have picked on Dimon’s delusional view of the world. To wit:

“This is the most prosperous economy the world has ever seen and it’s going to be a very prosperous economy for the next 100 years. The consumer, which is 70% of the U.S. economy, is quite strong. Confidence is very high. Their balance sheets are in great shape. And you see that the strength of the American consumer is driving the American economy and the global economy. And while business slowed down, my current view is that, no, it just was a slowdown, not a petering out.”  

Jamie Dimon during a “60-Minutes” interview.

If you’re in the top 1-2% of income earners, like Jamie, I am sure it feels that way.

For everyone else, not so much. Here are some stats via the WSJ:

The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.”

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A full 33% of that gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

The problem that is missed is that the “stock market” is NOT the “economy.”

This is a point President Trump misses entirely when he tweets:

“Stocks are hitting record highs. You’re welcome.”

As discussed earlier this week, 90% of the population gets little, or no, direct benefit from the rise in stock market prices.

Another way to view this issue is by looking at household net worth growth between the top 10% and everyone else.

Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population. This is not economic prosperity. This is simply a distortion of economics.

Another example of President Trump’s misunderstanding of the linkage between the economy and the stock market was displayed in his presser on Wednesday.

“Now, had we not done the big raise on interest [rates], I think we would have been close to 4% [GDP]. And I – I could see 5,000 to 10,000 points more on the Dow. But that was a killer when they raised the [interest] rate. It was just a big mistake.”President Donald Trump via CNBC

That is not actually the case. From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3-consecutive rounds of “Quantitative Easing” or “Q.E.” During that period average real rates of economic growth rates never rose much above 2%.

Yes, asset prices surged as liquidity flooded the markets, but as noted above “Q.E.” programs did not translate into economic activity. The two 4-panel charts below shows the entirety of the Fed’s balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed’s balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in “QE” programs, not to mention trillions in a variety of other bailout programs, to create a relative minimal increase in economic data. Of course, this explains the growing wealth gap which currently exists. Furthermore, while the Fed did hike rates slightly off of zero, and reduce their bloated balance sheet by a negligible amount, there was very little impact on asset prices or the trajectory of economic growth.

Not understood, especially by the Fed, is that the natural rate of economic growth is declining due to their very practices which incentivize non-productive debt. While QE and low rates may boost growth a little and for a short period of time, they actually harm future growth.

The Goldilocks Warning

While Jamie Dimon suggests we are in a “Goldilocks economy,” and President Trump says we are in the “Greatest Economy Ever,” such really isn’t the case. Despite a severe economic slow down globally, Dimon believes the domestic economy will continue to chug along with not enough inflation to push the Fed into hiking rates, but also won’t fall into a recession.

It is a “just right” economy, which will allow corporate profits to grow at a strong enough rate for stocks to continue to rise at 8-10% per year. Every year, into eternity.

This is where Jamie’s delusion becomes most evident. As shown in the chart below, since 2014, the S&P 500 index has soared to record heights, yet corporate profits for the entire universe of U.S. corporations have failed to rise at all. This is the clearest evidence of the disconnect between the markets and the real economy.

Note: It is worth mentioning the last time we saw a period where corporate profits were flat, while stock market prices surged higher was from 1995-1999. Unfortunately, as is repeatedly the case throughout history, prices “catch down” with profits and not the other way around.

Interestingly, in the rush to come up with a “bullish thesis” as to why stocks should continue to elevate in the future, many have forgotten the last time the U.S. entered into such a state of “economic bliss.”

“The Fed’s official forecast, an average of forecasts by Fed governors and the Fed’s district banks, essentially portrays a ‘Goldilocks’ economy that is neither too hot, with inflation, nor too cold, with rising unemployment.” – WSJ Feb 15, 2007

Of course, it was just 10-months later that the U.S. entered into a recession, followed by the worst financial crisis since the “Great Depression.”

The problem with this “oft-repeated monument to trite” is that it’s absolute nonsense. As John Tamny once penned:

A “Goldilocks Economy,” one that is “not too hot and not too cold,” is very much the fashionable explanation at the moment for all that’s allegedly good. “Goldilocks” presumes economic uniformity where there is none, as though there’s no difference between Sausalito and Stockton, New York City and Newark. But there is, and that’s what’s so silly about commentary that lionizes the Fed for allegedly engineering “Goldilocks,” “soft landings,” and other laughable concepts that could only be dreamed up by the economics profession and the witless pundits who promote the profession’s mysticism.

What this tells us is that the Fed can’t engineer the falsehood that is Goldilocks, rather the Fed’s meddling is what some call Goldilocks, and sometimes worse. Not too hot and not too cold isn’t something sane minds aspire to, rather it’s the mediocrity we can expect so long as we presume that central bankers allocating the credit of others is the source of our prosperity.”

John is correct. An economy that is growing at 2%, inflation near zero, and Central banks globally required to continue dumping trillions of dollars into the financial system just to keep it afloat is not an economy we should be aspiring to.

The obvious question we should be asking is simply:

“If we are in a booming economy, as supposedly represented by surging asset prices, then why are Central Banks globally acting to increase financial stimulus for the market?”

The problem the Fed and other central banks confront is that, when market levels are predicated on ever-cheaper cash being freely available, even the faintest threat that the cash might become more expensive or less available causes shock waves.

This was clearly seen in late 2018, when the Fed signaled it might increase the pace of normalizing monetary policy, the markets imploded, and the Fed was forced to halt its planned continued shrinking of its balance sheet. Then, under intense pressure from the White House, and still choppy markets, they reduced interest rates to bolster asset markets and stave off a potential recessionary threat.

The reality is the Fed has left unconventional policies in place for so long after the “Financial Crisis,” the markets can no longer function without them. Risk-taking, and a build-up of financial leverage, has now removed their ability to “normalize” financial policy without triggering destructive convulsions.

Given there is simply too much debt, too much activity predicated on ultra-low interest rates, and confidence hinging on inflated asset values, the Fed has no choice but to keep pushing liquidity until something eventually “pops.”

Unfortunately, when trapped in a “Goldilocks” economy, realities tend to become blurred as inherent danger is quickly dismissed. A recent comment from another “Davos elite,” Bob Prince, who helps oversee the world’s biggest hedge fund at Bridgewater Associates, made this clear.

“The tightening of central banks all around the world wasn’t intended to cause the downturn, wasn’t intended to cause what it did. But I think lessons were learned from that and I think it was really a marker that we’ve probably seen the end of the boom-bust cycle.”

No more “booms” and “busts?”

Thomas Palley had an interesting take on this:

The US is currently enjoying another stock market boom which, if history is any guide, also stands to end in a bust.

For four decades the US economy has been trapped in a ‘Groundhog Day’ cycle in which policy engineered new stock market booms to cover the tracks of previous busts. But as each new boom ameliorates, it does not recuperate the prior damage done to income distribution and shared prosperity.”

Well, except for those at the top, as Sven Henrick concluded last week:

“In a world of measured low inflation and weak wage growth easy central bank money creates vast price inflation in the assets owned by the few making the rich richer, but also enables the taking on ever higher debt burdens leaving everyone else to foot the ultimate bill.

There are two guarantees in life: The rich get obscenely rich, everybody else gets to carry ever more obscene public debt levels.”

That is the measured outcome of the central bank easy money dynamic that has been with us now for decades, but has taken on new obscene forms in the past 10 years with absolutely no end in sight.”

While the elites are certainly taking in the “view through market colored” glasses, the reality is far different for most.

It is true the bears didn’t eat “Goldilocks” at the end of the story, but then again, there never was a sequel either.

Technically Speaking: Extreme Deviations & Eventual Outcomes

The good news is that with the market closed yesterday, the extreme extensions of the market did not get any more extreme. Also, it doesn’t change our analysis much from this past weekend’s missive either:

“This week, the market pushed those deviations even further as the S&P 500 has now pushed into 3-standard deviation territory above the 200-WEEK moving average.”

“There have only been a few points over the last 25-years where such deviations from the long-term mean were prevalent. In every case, the extensions were met by a decline, sometimes mild, sometimes much more extreme.”

As we discussed, there is a potential the current “momentum” push, due to the Fed’s ongoing “NotQE,” which could drive markets higher in the short-term.

“With the Federal Reserve’s ongoing ‘Not QE,’  it is entirely possible the markets could continue their upward momentum towards S&P 3500, and Dow 30,000. Clearly, the ‘cat is out of the bag’ if CNBC even realizes it’s the Fed:

‘On Oct. 11, the central bank announced it would begin purchasing $60 billion of Treasury bills a month to keep control over short-term rates. The magnitude of the purchases resembles the quantitative easing program the Fed conducted during and after the financial crisis.’

‘The increase in the Fed’s balance sheet has been in near lockstep with the stock market’s climb. The balance sheet has expanded 10% since October, while the S&P 500 shot up 12%, including notching its best fourth quarter since 2013.’”

There is much debate between the Fed, and their supporters, and virtually everyone else, about the implications of the Fed’s actions. The “Heisenberg Report” did a good job summing up our view on the issue:

“Neel Kashkari’s take is a bit different, as is Mary Daly’s. The whole ‘debate’ is somewhat silly. Both sides are being disingenuous. It’s not ‘QE.’ It probably will be, eventually, but for right now, the Fed isn’t buying coupons. And irrespective of any knock-on effects for risk assets, the overarching intent is to avoid another short-term funding squeeze by reestablishing an abundant reserves regime with a buffer. That, as opposed to a goal of compressing risk premia, driving investors out the risk curve and down the quality ladder to foster the wealth effect.

On the other hand, the idea that the distinction matters is a bit dubious. Regardless of what the overarching goal is, liquidity provision is liquidity provision and there’s a signaling effect too. Call it a ‘chart crime’ if you like, but I’d be more inclined to say that ‘it is what it is'”

He’s correct, and as he notes, even those sophisticated enough to be “short” something, are probably “net long” currently.

This is precisely our positioning, and why we discussed “taking profits” last week. While we are certainly not opposed to “shorting the market” to hedge our portfolio risk, the continued flood of liquidity by the Fed makes shorting a challenging proposition in the short-term. Therefore, our best option to reduce risk was to simply “ease back on the gas” by reducing position weights in the most egregiously “overbought” areas.

Most likely, this will be an exercise we repeat as long as the Fed is continuing to push liquidity into the market.



The Higher We Go…

At present, there is seemingly little to stop the markets from pressing higher, particularly once the push hits “rarefied air.” Weak fundamental and economic data is readily dismissed “hopes” those “soft spots,” will soon strengthen to catch up with price. More often than not, it is usually the opposite, which occurs.

The chart below shows the S&P 500 index versus its 200-WEEK moving average and the historical percentage deviation between the two. The chart assumes the market will continue to push higher through the end of the “seasonally strong period,” and attain the 3500 level by June. 

Historically, when the market becomes deviated from its 4-year (200-week) moving average by 20% or more, as it is currently, corrections have tended to follow. Some corrections were minor, such as the “Crash of 1987”,  the “LTCM crisis” in 1988, or the 2015-2016 “Taper Tantrum.” Other corrections from such deviations were much more severe such as the “Crash of 1974”, the “Dot.com Bust”, or the “Financial Crisis” of 2008.

The same deviation mismatch can be seen in the 60-month (5-year) moving average. At 3500, the S&P 500 will achieve a deviation only seen 3-times prior, which preceded the “Crash of 1987″, the “Dot.com Bust,” and the 2015-2016 “Taper Tantrum.”

The defining aspect of whether corrections were “mild” or “severe” really came down to whether the valuations were expanding from “cheap to expensive,” or if they were “expensive heading towards cheap.” At 30x trailing reported 10-year average earnings, and price-to-sales above 2x (the highest level on record for the S&P 500), it is hard to suggest that valuations are cheap. 

Our favorite way to look at the data is with our QUARTERLY analysis that combines both valuation, relative strength, and deviations into one chart.

There is little to suggest that investors who are extremely “long equity risk” in portfolios currently won’t eventually suffer a more severe “mean reverting event.” 

While valuations and long-term deviations suggest problems for the markets ahead, such can remain the case for quite sometime which always leads investors to believe “this time is different.” Because of the time required for long-term data to revert, monthly and quarterly data is more useful as a guide to manage allocations and longer-term exposures. In other words, this data is not useful as a short-term market-timing tool.

However, even the short-term data, has now reached more extreme technical levels which DO suggest caution. The chart below is our RIAPRO (Try 30-Days Risk Free) Technical Composite which combines short-term relative strength, momentum, and deviation into one indicator.

At 98.48, corrections from short-term market peaks tend not to be far off. In January of 2018, as the “tax cut” bill took effect, stocks were soaring in January pushing the technical composite to a similar level. It is worth remembering, the market dropped 10% heading into the first two weeks of February.

Currently, the market feels much like what we saw in early 2018, and a similar correction is likely in the short-term. However, longer-term it will be a reduction in corporate “share repurchases,” which will be a bigger factor in the sustainability of the market’s advance.

Clearly, the Federal Reserve is doing whatever it can to keep markets stable. With economic growth already fragile, a more serious correction in prices would collapse consumer confidence, lead to rising unemployment, and foster the onset of a full-blown recession. Such would be problematic for the Fed to counter, particularly if the trillions of dollars at play in leveraged hedge funds begin to lock up.

However, I agree with Wolf Richter’s recent comment.

In my decades of looking at the stock market, there has never been a better setup. Exuberance is pandemic and sky-high. And even after today’s dip, the S&P 500 is up nearly 29% for the year, and the Nasdaq 35%, despite lackluster growth in the global economy, where many of the S&P 500 companies are getting the majority of their revenues.

Mega-weight in the indices, Apple, is a good example: shares soared 84% in the year, though its revenues ticked up only 2%. This is not a growth story. This is an exuberance story where nothing that happens in reality – such as lacking revenue growth – matters, as we’re now told by enthusiastic crowds everywhere.

He’s right. The only period in history where we have seen a similar “set-up” was in 1999.

While we do realize this time “IS” different, we also know the “outcomes” will ultimately be the same. This is why we continue to look for opportunities to reduce risk, raise exposures to cash, and are ready to respond to market changes as they occur.

Yes, we are underperforming the market this year, but (to adapt a phrase from Popeye), we will gladly pay that price today for a “hamburger” on Tuesday.

MacroView: 2020 Market & Investment Outlook

On Tuesday, Michael Lebowitz and I held private events with our high net worth clients to review our investment strategy and outlook for the rest of the year. The purpose of these events was to provide clarity on portfolio allocation, weightings,  and the risks that could potentially lead to large losses of capital.

As we noted in last weekend’s newsletter, we recently took profits in our various portfolio strategies to raise cash slightly, and reduce excess portfolio risk. Given our portfolios are already hedged with early exposures to value positioning, gold, and short-duration Treasuries, there currently isn’t a need to become overly defensive given the ongoing, liquidity fueled, momentum of the markets. 

Currently, the bullish exuberance, extreme complacency, and technical deviations are issuing warning signs which investors should NOT readily dismiss. These are the issues we cover in the following video presentation:

  1. The “risks” to the current “bullish view,” 
  2. Why we reduced risk in portfolios
  3. The importance of valuations
  4. The Fed’s ongoing liquidity programs.
  5. Future expected returns, and more.

If you have any questions, please email us.


 

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

John Mauldin recently penned an interesting piece:

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

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

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

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

Misallocation Of Capital – Everywhere

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

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

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

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

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

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

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

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

The Dark Side Of Stock Buybacks

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

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

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

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

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

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

Importantly, as noted by the Securities & Exchange Commission:

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

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

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

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

All Levered Up

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

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

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

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

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

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

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

Pensions Are Broke

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

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

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

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

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

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

Strike Three, You’re Out

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

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

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

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

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

It will be worse.

As John concluded:

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

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

Technically Speaking: This Is Nuts – Part Deux

In this past weekend’s newsletter, we discussed the exceedingly deviated price, and overbought conditions, not to mention valuations, as key reasons why we slightly reduced risk in our portfolios.

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

In the Equity Portfolios, we reduced our weightings in some of our more extended holdings such as Apple (AAPL,) Microsoft (MSFT), United Healthcare (UNH), Johnson & Johnson (JNJ), and Micron (MU.)

In the ETF Sector Rotation Portfolio, we reduced our overweight positions in Technology (XLK), Healthcare (XLV), Mortgage Real Estate (REM), Communications (XLC), Discretionary (XLY) back to portfolio weightings for now.”

Not surprisingly, I received more than a few emails chastising me for “bailing on the bull market, which is clearly going higher.” 

Such is hardly the case. We simply reduced our weighting in some of the companies which have had substantial gains over the last year. We remain primarily long-biased in our portfolios, but given the extreme technical overbought, and deviated conditions, it was prudent to raise some cash and protect our gains.

However, it wasn’t just the conditions we discussed which have us concerned about the markets in the short term. Investor positioning has also reached rather extreme levels. As Bob Farrell once wrote:

“When all experts agree, something else is bound to happen.”

Currently, with investors all extremely long equity exposure, the risk of a correction has become elevated.

Our composite “fear/greed” indicator, which is comprised of investor positioning, shows much the same as “bullish sentiment” has become rather extreme.

Every week, we provide RIAPRO subscribers (Try Free for 30-Days) with the latest updated technical composite score as well. This composite gauge combines extension, deviation, and momentum into a single weekly measure. Readings above 90 (Currently 92.31) are always associated with corrective actions in the market.

With all of these conditions aligned, the “probability” of a short-term correction has increased. Given that risk outweighs reward in the short-term, we decided it was prudent to reduce the numerator of that equation.

Why We Reduced Risk

It may seem irrational that we would reduce our risk exposure as the market continue to rise. Less exposure to equities, means less upside performance of the portfolio, or rather, “opportunity cost.” As I noted:

While the markets could certainly see a push higher in the short-term from the Fed’s ongoing liquidity injections, the gains for 2020 could very well be front-loaded for investors. Taking profits and reducing risks now may lead to a short-term underperformance in portfolios, but you will likely appreciate the reduced volatility if, and when, the current optimism fades.”

However, the problem for the majority of investors is the inability to predict whether the next correction will be just a “correction” within an ongoing bull market advance or something materially worse. Unfortunately, by the time most investors figure it out – it is generally far too late to do anything meaningful about it. 

By reducing risk now it provides us three benefits for the future.

  1. Less equity risk, and higher cash levels, lowers the volatility of the portfolio which will allow us to navigate a correction process, and protect our investment capital.
  2. It gives us capital to reinvest back into positions we currently own at better prices; or,
  3. Buy new positions which have corrected in price.

While it is entirely true that “you can not time the market,” you can do some analysis and make deliberate changes to avoid problems.

As shown below, price deviations from the 50-week moving average have been important markers for the sustainability of an advance historically. Prices can only deviate so far from their underlying moving average before a reversion eventually occurs. (You can’t have an “average” unless price trades above and below the average during a given time frame.)

Notice that price deviations became much more augmented heading into 2000 as electronic trading came online, and Wall Street turned the markets into a “casino” for Main Street.

At each major deviation of price from the 50-week moving average, there has either been a significant correction or something materially worse. Currently, the deviation from the 50-week moving average is the second-highest level in history, next to the 1999 “dot.com” mania.

How bad could it be?

Measuring The Mean Reversion 

Given the current momentum of the market, combined with the Fed’s ongoing liquidity interventions, we only expect a correction of 5-10% to reset the overbought, optimistic, and deviated markets. Such a correction can be used to increase equity exposure and bring equity holdings back to target weights.

However, there is a risk of a larger mean reverting event, yet this is a possibility completely dismissed by the mainstream media under the guise of “this time is different.” 

With the market trading more than 3-standard deviations above the 50-week moving average, historical reversions have tended to be more brutal. I have laid out support levels below.

At this juncture, a correction back to the 2018 lows would entail a 25% decline. However, if a “bear market” growls, the 2015-16 highs become the target which is 34% lower. The lows of 2016 would require a 43% draft, with the 2008 highs posting a 52% “crash.” 

That can’t happen you say?

We had two 50% declines since the turn of the decade, and the next major market decline will be fueled by the massive levels of corporate debt, underfunded pensions, and evaporation of “stock buybacks,” which have accounted for almost 100% of net purchases since 2018.

Then there is also the other possibility as noted by technical analyst J. Brett Freeze, CFA:

“The Wave Principle suggests that the S&P 500 Index is completing a 60-year, five-wave motive structure. If this analysis is correct, it also suggests that a multi-year, three-wave corrective structure is immediately ahead. We do not make explicit price forecasts, but the Wave Principle proposes to us that, at a minimum, the lows of 2009 will be surpassed as the corrective structure completes.”

Anything is possible, and if he is right, such a decline will eclipse the 85% decline of the Dow following the 1929 peak when stocks last reached what seemed to be a “permanently high plateau.”

We Play The Probabilities

The probability is that we will see the 5-10% correction which will be used to increase our exposure.

Just don’t dismiss the possibilities.

“You play the probabilities; but prepare for the possibilities.”

No one knows with certainty what the future holds which is why we must manage portfolio risk accordingly and be prepared to react when conditions change.

While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

As such, let me remind you of the 15-Risk Management Rules I have learned over the last 30-years:

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

The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999. How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.

This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently. This is just the way we do it.

MacroView: Has The Fed Trapped Itself?

“Don’t fight the Fed”

That’s how I started out last week’s “Macroview.”

“That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its ‘QE-Not QE’ operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically ‘Not QE’ because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, ‘Mr. Market’ doesn’t see it that way. As the old saying goes, ‘if it looks, walks, and quacks like a duck…it’s a duck.'” 

As we discussed, there is something “broken” in the financial system when it requires massive injections of capital to maintain sufficient liquidity. This was a point noted by Curvature Securities’ Scott Skyrm in his daily “Repo Market Commentary” via Zerohedge:

“Indeed, something appears amiss, because the total overnight and term Fed RP operations on Friday were greater than on year end! On year-end, the Fed had pumped a total of $255.95 billion into the market verses $258.9 billion on Friday.”

When these excessive “Repurchase Operations” initially began in late September, we were told they were to meet corporate tax payments. The issue with that excuse is that corporate tax payments come due every quarter and are easy to forecast weeks in advance. Why was last October’s payment period so different? But, following October 15th, the “repo” operations should have been no longer needed, however, the funding not only continued, but grew.

As the end of the year approached, we were told liquidity was needed to meet “the turn,” as 2019 ended, and 2020 began. Once again, this excuse falls short as, without exception, every year ends on December 31st. So, after nearly a decade of NO “repo” operations, as shown below, what is really going on?

What is clear, is the Fed may be trapped in their own process, a point made by Mark Cabana of BofAML:

“It seems implausible to me that the Fed will be able to stop their repo operations by the end of January.”

The Fed’s New Liquidity Trap

We previously discussed the “liquidity trap” the Fed has gotten themselves into, along with Japan, which will plague economic growth in the future. To wit:

“The signature characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.

Our “economic composite” indicator is comprised of 10-year rates, inflation (CPI), wages, and the dollar index. Importantly, downturns in the composite index leads GDP.

The Fed’s problem is not only are they caught in an “economic liquidity trap,” where monetary policy has become ineffective in stimulating economic growth, but are also captive to a “market liquidity trap.”

As Mr. Skrym noted:

“The problem with the broken repo market, and the Fed’s respective Repo operations, is similar to the problem observed with QE, and the Fed’s balance sheet in general, over the past decade. The market has gotten addicted to the easy Fed liquidity.” 

This can be seen in the chart below.

Whenever the Fed, or other Global Central Banks, have engaged in “accommodative monetary policy,” such as QE and rate cuts, asset prices have risen. However, as denoted by the “red” shaded areas, when those activities are not present, asset prices have declined.

In short, the market has become addicted to QE, and like any drug addict, when the drug was taken away in 2018, as the Fed hiked rates and reduced their balance sheet in an attempt to normalize policy, the market dropped by nearly 20%.

To understand why this is important we have to go back to what Ben Bernanke said in 2010 as he launched the second round of QE:

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

I highlight the last sentence because it is the most important. Consumer spending makes up roughly 70% of GDP, therefore increased consumer confidence is critical to keeping consumers in action. The problem is the economy is no longer a “productive” economy, but rather a “financial” one. A point made by Ellen Brown recently:

“The financialized economy – including stocks, corporate bonds and real estate – is now booming. Meanwhile, the bulk of the population struggles to meet daily expenses. The world’s 500 richest people got $12 trillion richer in 2019, while 45% of Americans have no savings, and nearly 70% could not come up with $1,000 in an emergency without borrowing.

Central bank policies intended to boost the real economy have had the effect only of boosting the financial economy. The policies’ stated purpose is to increase spending by increasing lending by banks, which are supposed to be the vehicles for liquidity to flow from the financial to the real economy. But this transmission mechanism isn’t working, because consumers are tapped out.”

If consumption retrenches, so does the economy.

When this happens debt defaults rise, the financial system reverts, and bad things happen economically.

For this reason the Federal Reserve has been engaged in an ongoing campaign to “avoid the pain” experienced during the financial crisis. This was a question asked of Janet Yellen during her semi-annual Humphrey-Hawkins testimony by Rep. Edward Royce. I am going to break this down for clarity.

“ROYCE: I’m worried that the Federal Reserve has created a third pillar of monetary policy, that of a stable and rising stock market. And I say that because then-Chairman Bernanke, when he appeared here, stated repeatedly that, ‘the goal of QE was to increase asset prices like the stock market to create a wealth effect.’”

As stated, Ben Bernanke clearly states the goal of Q.E. was to increase asset prices. As Royce continues he clearly identifies the Fed’s “new liquidity trap:”

“ROYCE: That seems as though that was goal. It would stand to reason then that in deciding to raise rates and reduce the Fed’s QE balance sheet standing at a still record $4.5 trillion, one would have to be prepared to accept the opposite result, a declining stock market, and a slight deflation of the asset bubble that QE created.

Yet, every time in the past three years when there has been a hint of raising rates and the stock market has declined accordingly, the Fed has cited stock market volatility as one of the reasons to stay the course and hold rates at zero.

Read the last paragraph again.

Royce understands that in order to normalize monetary policy, and return markets to a more normal state of operation, some pain would have to be expected.

So, what was Yellen’s response.

YELLEN: It is not a third pillar of monetary policy. We DO NOT target the level of stock prices. That is not an appropriate thing for us to do.”

Yes, the Fed absolutely targets the financial markets with their policies. However, as Royce notes above, it will require a level of pain to wean the markets off of ongoing liquidity. In 2018, the Fed learned their lesson of what would happen as the small adjustment to monetary policy they did make resulted in a market decline of nearly 20%, yield curves inverted, and threats of a recession rose.

They aren’t willing to make that mistake again. The subsequent policy reversal pushed the markets to new record highs, which has been a function of  valuation expansion due to the lack of improvement in underlying fundamentals and earnings.

The Inextricable Problem

The problem is that stopping the current “repo” operations is that it could well spark another “repo market crisis,” especially with $259 billion in liquidity pumped currently. Notably, that is even more than what was at year end to fulfill “the turn.”

The BIS recently explained why these operations lift asset prices.

Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly. Thus, any sustained disruption in this market, with daily turnover in the U.S. market of about $1 trillion, could quickly ripple through the financial system. The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).

You really have to ask what is going on here. Wall Street veteran Caitlin Long provided a clue.

U.S. Treasuries are the most rehypothecated asset in financial markets, and the big banks know this. [They] are the core asset used by every financial institution to satisfy its capital and liquidity requirements, which means that no one really knows how big the hole is at a system-wide level.

This is the real reason why the repo market periodically seizes up. It’s akin to musical chairs – no one knows how many players will be without a chair until the music stops.

As ZeroHedge noted, this isn’t just a bank issue.

Hedge funds are the most heavily leveraged multi-strategy funds in the world, taking something like $20 billion to $30 billion in net assets under management and levering it up to $200 billion. As noted by The Financial Times:

“Some hedge funds take the Treasury security they have just bought and use it to secure cash loans in the repo market. They then use this fresh cash to increase the size of the trade, repeating the process over and over and ratcheting up the potential returns.”

So….it’s a hedge fund problem, right?

Probably.

“The repo-funded [arbitrage] was (ab)used by most multi-strat funds, and the Federal Reserve was suddenly facing multiple LTCM (Long-Term Capital Management) blow-ups which could have started an avalanche. Such would have resulted in trillions of assets being forcefully liquidated as a tsunami of margin calls hit the hedge funds world.”

Think “Lehman crisis” multiplied by a factor of four.

The Fed’s position is they must continue inflating a valuation bubble despite the inherent, and understood, risks of doing so. However, with no alternative to “emergency measures,” the Fed is trapped in their own process. The longer they continue their monetary interventions, the more impossible it becomes for the Fed to extricate itself without causing the crash they want to avoid.

Stated simply, the longer the Fed avoids normalizing monetary policy, and weaning the “crack addicted” markets off of their “liquidity drug,” the bigger the “reversion” will be “when,” not “if,” it occurs.

The only question is how much longer can Jerome Powell continue “pushing on a string.”

Technically Speaking: Markets Dismiss Iran As The Fed “Put” Remains

You would think that with the U.S. taking out a top Iranian commander, threats of military action flying between the U.S. and Iran, not to mention the Selective Service” website crashing over concerns of World War III, the markets would be in full “sell” mode.

If you thought that would be the case, you were wrong.

Here is the market from the beginning of the year through yesterday’s close.

The dismissal by the market of the situation with Iran suggests only a couple of things:

  1. The market sees no inherent risk from Iran other than a lot of “saber rattling,” or
  2. Given the Federal Reserve’s recent transition to a “do anything” monetary policy stance, all “risks” are being dismissed under the assumption the Fed has become a “cure all” for any market ill.

Since this is a technical post on the financial markets and investing, I won’t get into all the risks inherent from a conflict with Iran. However, if we assume there are indeed “risks” with Iran, then it becomes apparent the market is betting on the Fed.

As I noted in this past weekend’s missive, the Fed has been dumping massive amounts of liquidity into the system over the last few weeks. To wit:

“But concerns over potential Iranian conflict quickly abated as the markets returned their focus to the Federal Reserve, and the continued pump of monetary liquidity into the markets. 

Currently, we are told there is ‘nothing to worry about’ concerning the financial system. Maybe, but the amount of liquidity being injected dwarfs all previous injections by massive proportions.

Those injections continue to run unabated currently, which has lulled the markets into a more extreme state of complacency. This can see in the low reading of bearish investors and the suppressed levels of the put/call ratio. Both suggest there is “no fear” of a market correction currently. (h/t Soberlook)

Here is the investor conundrum.

With the market currently on registering of the monthly buy signals, which confirmed the bull market in the S&P 500 had resumed following the 2018 Fed/Trade induced sell-off, there is also the risk of a short-term correction. Previously, when the market was this extended, deviated from longer-term means, and excessively bullish, a correction has always occurred. The problem for investors is maintaining patience in the process.

The chart below shows the issues. When the market becomes more than 2-standard deviations above the 200-WEEK (4-year) moving average, you have gotten a correction, or a deeper mean-reverting event. However, since this a weekly chart, those corrective processes can take some time to occur. This lures investors into thinking “this time is different,” just before an event has tended to reduce their investment capital

Optimistically Cautious Short-Term

In the short-term, our outlook remains optimistically cautious due to the aforementioned ongoing liquidity injections from the Federal Reserve. As we noted to our RIAPro Subscribers yesterday (Try Free For 30-Days):

“The markets remain positively biased but have gotten overly extended in the short-term. We suggest remain long current holdings, but take profits and rebalance risks in positions accordingly. We will likely have a much better entry point in the next couple of months to ‘buy’ into.”

While we remain optimistic on stocks over the next couple of months, as we are in the “seasonally strong period” of the year, there are several risks which need monitoring closely.

The most obvious risk is a reversal of the Fed’s monetary policy. Currently, the Fed’s balance sheet has almost entirely reversed last year’s decline. Subsequently, changes in the S&P 500 have closely tracked weekly changes to the Fed’s balance sheet. As noted last week:

Of course, it should be expected that if the Fed reverses those flows, then equities will likely follow suit.

Secondly, ultimately, will be valuations.

Yes, I know that “valuations” do not seem to matter currently, however, it is important to realize they will eventually matter, and they will matter a lot.

Currently, the S&P 500 trading roughly 20x current reported earnings estimates of $161.87 per share for the end of 2020, based on data from S&P Dow Jones. Going back to the year 1988, on average, the S&P 500 trades for around 16x times trailing earnings estimates. But it isn’t just P/E ratios which are rich. As we discussed yesterday, multiple measures of the markets are trading at levels which have denoted much lower rates of returns going forward.

What this suggests is that for equities to see a continued, and significant, advance in 2020, it will require investors to continue paying higher prices for equity ownership. While this may seem to make sense in a “low-interest rate” world, historically overpaying for earnings growth has often turned out poorly.

In other words, what investors are betting on is that earnings will catch up with price. However, currently, there is no evidence such will be the case as earnings have been repeatedly ratcheted lower since April 2019.

As shown in the chart below, earnings for the entire 2020 period started at $174.29/share. At that time, the beginning of April, the S&P 500 was trading at 2892. While the forward P/E seemed reasonable at 16.5x earnings, which was roughly equal to the long-term average, this assumed earnings estimates were correct. However, with the S&P 500 trading, as of yesterday’s close, at 3246, estimates for 2020 have fallen to just $161.87. That $12 decline in estimates, combined with a 354 point (an 11.8% advance) in the market, brings that forward P/E multiple to a rather expensive 20.05x reported earnings.

Of course, the risk to investors is that earnings growth fails to recover as we head further into 2020. Currently, there is evidence from the manufacturing, employment and wage data which suggests such could indeed be the case.

The Path Ahead

What is clear is that the path ahead for stocks is much less certain than a year ago when we were coming off deeply depressed sentiment levels, and the Fed was rapidly reversing monetary policy from “tightening” to “easing.”  With equities now 30% higher than they were then, the Fed mostly on hold in terms of rate cuts, and “repo” operations slated to end in the next couple of months, it certainly seems that expectations for substantially higher market values may be a bit optimistic.

Furthermore, as noted, if signs of economic improvement don’t start to lift expectations for earnings growth into the last half of the year, it could prove problematic given current valuations.

However, if the economy does show improvement, it could result in yields rising on the long-end of the curve, which could also make stocks less attractive. This would effectively keep a lid on just how much risk some investors will be willing to take, and the price they are willing to pay.

One thing is for certain, the sharp rise in stocks in 2019 has left prices at levels that already seem expensive on numerous measures. As such it will required investors to take on increasing levels of risk if prices are going to push higher this year. While this is certainly not an improbability given the current levels of complacency and optimism, it is just worth noting that outcomes of such endeavors have always been poor.

There is one true axiom of the market which is always forgotten.

“The market has a habit of sucking investors in to inflict the most pain possible.”

Just make sure you aren’t one of them.

If you feel you must chase the markets currently, then at least do it with a set of guidelines to follow in case things turn against you. We printed these a couple of weeks ago, but felt there are worth mentioning again.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market.
  1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
  2. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

While we remain optimistic on the markets currently, we are also taking precautionary steps of tightening up stops, adding non-correlated assets, raising some cash, and looking to hedge risk opportunistically.

Just because it isn’t raining right now, doesn’t mean it won’t. Nobody has ever gotten hurt by keeping an umbrella handy.

MacroView: Will The The Market Repeat The Start Of 2018?

“Don’t fight the Fed”

That is the current mantra of the market as we begin 2020, and it certainly seems to be the right call. Over the last few months, the Federal Reserve has continued its “QE-Not QE” operations, which has dramatically expanded its balance sheet. Many argue, rightly, the current monetary interventions by the Fed are technically “Not QE” because they are purchasing Treasury Bills rather than longer-term Treasury Notes.

However, “Mr. Market” doesn’t see it that way. As the old saying goes, “if it looks, walks, and quacks like a duck…it’s a duck.” 

Those liquidity flows most notably have been chasing the largest of large caps – namely Apple (AAPL) and Microsoft (MSFT). As Ed Dowd noted, there are many similarities between now and the last time the Fed was fighting a perceived liquidity shortage before the “turn of the century” over concerns of “Y2K.”

But here is what jumped out at me.

Going back to 2016, as the world faced a “Brexit” crisis, the Fed, ECB, and the BOE all joined forces to provide liquidity to the markets. Then, just before the 2016 election, as the world was concerned a “Trump Election” would crash the market, the Fed provided a huge boost of liquidity. All along the way, each dip in the market was met by liquidity support.

Currently, we are being told there is “nothing to worry about” with respect to the financial system. Maybe, but the amount of liquidity being injected dwarfs all previous injections by massive proportions.

You can see the issue more clearly looking at a rolling 4-week change to the Federal Reserve’s balance sheet.

So, despite commentary to the contrary, there are only two conclusions to draw from the data:

  1. There is something functionally “broken” in the financial system which is requiring massive injections of liquidity to try and rectify, and;
  2. The surge in liquidity, whether you want to call it a “duck,” or not, is finding its way into the equity markets.

January 2018 Redux

“The exuberance that surrounded the markets going into the end of last year, as fund managers ramped up allocations for end of the year reporting, spilled over into the start of the new with S&P hitting new record highs.

Of course, this is just a continuation of the advance that has been ongoing since the Trump election. The difference this time is the extreme push into 3-standard deviation territory above the moving average which is concerning.” – Real Investment Report Jan, 5th 2018

At the beginning of 2018, following the passage of “tax reform,” the market was pushing 3-standard deviations of the 50-dma. It eventually pushed 3-standard deviations above the 200-dma before it came crashing back to earth. The second time it pushed the same deviation was in October of 2018, which was again followed by a marked decline.

Currently, that push into a 3-standard deviation extreme is once again present. Does that mean a sharp correction is coming? Not necessarily. However, it does suggest gains are likely limited in the short-term.

As I stated in 2018:

“That extension, combined with extreme overbought conditions multiple levels, has historically not been met with the most optimistic of outcomes. But, as I will discuss next, “exuberance” of this type is not uncommon during a market ‘melt-up’ phase.”

Currently, “exuberance” has returned with a vengeance, as noted by my friend and colleague Doug Kass:

“2019 ended in an entirely dissimilar manner compared to the way that 2018 ended. (As an example the CNN Fear & Greed Index was under 10 a year ago, its at 90 this week).

Despite a continued manufacturing recession, ongoing weakness in many global economies, political discord (and a Presidential impeachment), little resolution of the U.S./China trade differences and a flat year for S&P profits – valuations exploded (from 14.5x to nearly 19x) as confidence in an extended domestic economic recovery was heightened.”

But it isn’t just sentiment which has gotten extraordinarily extended, but also investor positioning on many levels both individual and professional.

Lastly, our composite technical overbought/oversold gauge has also hit extremes.

In other words, “everyone is in the pool,” including the “life guards.” 

While the levels of exuberance are quite astonishing, it certainly isn’t surprising. This is what has been witnessed during previous market “melt-ups” throughout history. Jeremy Grantham of GMO previously wrote an excellent piece on market “melt-ups” and potential outcomes. To wit:

“As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. 

The classic examples are not just characterized by higher-than-average prices. Price alone seems to me now to be by no means a sufficient sign of an impending bubble break. Among other factors, indicators of extremes of euphoria seem much more important than price.

Let’s look at what is missing in the way of psychological and technical signs of a late-stage bubble and what is beginning to fall into place. On the topic of classic bubbles, I have long shown Exhibits 1 and 2. They recognize the importance of a true psychological event of momentum increasing to a frenzy. That is to say, acceleration of price.

Grantham is certainly very correct in his analysis. As shown in the chart below, the reversion of oversold, to extreme overbought (top panel in blue) has been extremely rapid. Historically speaking, such extreme overbought, overconfident, and extended markets tend not to stay that way for long.

From S&P 3300 to 3500, & Back Again

While we penned our initial target for the bull cycle at 3300 in July, given the extreme level of Federal Reserve monetary interventions, I certainly WOULD NOT rule out the possibility of a further melt up to 3500.

It is a possibility which must be considered. However, you must also balance that possibility with the probability of an eventual reversion. As noted by George Soros’ “Theory of Reflexivity:”

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.”

Asymmetric-bubbles

In the latter stages of the advance, money simply chases price. This is the point in the cycle where everything rises regardless of fundamental underpinnings or value.

2019 was such a year.

Eric Parnell recently noted the same:

“It’s a marshmallow world for capital markets as we enter 2020. Name the asset class, and it had a stellar year in 2019. U.S. stocks? Up over +30%. Stocks across the rest of the world? Higher by more than +20%. Investment grade corporate bonds? Up nearly +20%. High yield bonds? +14%. Long-Term US Treasuries? +15%. Gold and silver? +16% each. Even long struggling commodities posted high single-digit returns this year. If you were allocated to risk assets in 2019, you likely enjoyed a good year.”

However, as Eric notes, when everything is “as good as it can get,” that only leaves one other option.

“Past performance can present future challenges. Most significantly, such universally good returns are difficult to maintain. Typically, capital markets assign winners and losers even when the % stimulus is pumping full throttle as it is today. So whether such good times can continue in 2020 across all asset classes remains to be seen, but investors are well served to consider what categories may be best positioned to continue to climb and those that may be set to take a breather in the year ahead.”

In particular, stocks are facing increasingly challenging headwinds from sluggish economic growth, to weaker earnings growth. Currently, economists are predicting economic growth below 2% in 2020, as noted by FactSet:

“While the odds of a near-term recession appear to have diminished, growth is projected to slow in the coming quarters due to a weaker global outlook and reduced global trade flows. U.S. economic growth is expected to continue to slow into 2020, with analysts surveyed by FactSet projecting 2.3% annual growth in 2019 followed by 1.8% in 2020.”

Despite the S&P 500 being up 353% (total return since January 1st, 2009), economic growth has been the weakest in history.

This is why the differential between GAAP earnings and corporate profits is going to be a major challenge for investors going forward.

This was a point Eric noted:

“Stocks are facing a slowing corporate earnings problem in 2020. Quarterly GAAP earnings on the S&P 500 declined by more than -6% on a year-over-year basis in 2019 Q3. This marked the first quarterly year-over-year decline since 2015 Q4 and 2016 Q1 when oil prices were cascading to the downside and the U.S. economy appeared headed toward recession were it not for a major monetary policy intervention stick save.

Thus, corporate earnings growth is not only slowing, but it may be set up to disappoint in the coming quarters.”

As such, stocks will likely once again be reliant on both multiple expansion and share buybacks for further gains in 2020. However, there are limits to just how many shares a company can repurchase given balance sheet constraints of both liquid cash and debt levels.

The bullish case does remain as both fiscal and monetary stimulus remains excessively abundant. Given the recent passage of another $1.4 trillion continue resolution to increase spending without the constraint of a “debt ceiling,” and the Fed continuing with monetary interventions, the amount of money sloshing around the system has to go somewhere.

This is why, despite excessive technical deviations, extraordinary complacency, and extreme bullishness, we remain allocated toward equity risk in portfolios currently.

But, these words were the same as 2018 opened for trading. Just a few weeks later, as Trump launched the “trade war,” exuberance was replaced with pessimism as stocks wiped out all the gains for the month.

What could trip up the markets this January?

In a word, “much.” 

2020: The Futility Of Predictions & Understanding The Risk

“Predictions Are Difficult…Especially When They Are About The Future” – Niels Bohr

We can’t predict the future. If we could, fortune tellers would win all of the lotteries. They don’t, we can’t, and we are not going to try to.

However, we can analyze what has happened in the past, weed through the noise of the present, and discern the possible outcomes of the future. The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the unexpected and random events they inevitability occur.

There was once a study done of the accuracy of “predictions.” The study took predictions from a broad range of professions from psychics to weathermen. The study came to two conclusions. The first was that “weathermen” are the MOST accurate predictors of the future. The second conclusion was that the predictive ability was only accurate out to 3-days. Beyond 3-days, and the predictive ability was no better than a coin flip.

When it comes to trying to predict what will happen in the financial markets over the next year, which is an annual event, it is essentially an act of futility. Given the markets are affected by a broad spectrum of inputs from economics, to geopolitics, monetary policy, rates, and financial events, any prediction should be taken with a very high degree of skepticism.

So, with that said, here is how we are preparing for 2020.

Odds Have It

In our portfolio management practice, we begin with the basic assumption there is a 69% chance the market will finish the coming year at a level greater than where it started. That 69% probability comes from the fact that over the last 120-years, the market has (on a total real return basis) finished the year in positive territory 83 times, and negative only 37 times.

Therefore, from an “odds” perspective, markets are more likely to finish positive on any given year, than not. By starting our forecast with this basic assumption, it removes all the “guess work” of what has to go “right,” leaving us with only having to focus on the things which could potentially “go wrong.” 

At the core of our portfolio management process is a risk management thesis. That philosophy was well defined by Robert Rubin, former Secretary of the Treasury, when he said;

“As I think back over the years, I have been guided by four principles for decision making.  First, the only certainty is that there is no certainty.  Second, every decision, as a consequence, is a matter of weighing probabilities.  Third, despite uncertainty we must decide and we must act.  And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”

It should be obvious that an honest assessment of uncertainty leads to better decisions, but the benefits of Rubin’s approach, and mine, goes beyond that. For starters, although it may seem contradictory, embracing uncertainty reduces risk while denial increases it. Another benefit of acknowledged uncertainty is it keeps you honest.

“A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions.  It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference.”

The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes through the management of risks, and investing based on probabilities, rather than possibilities, which is important to capital preservation and investment success over time.

So, as we head into 2020, here is a short-list of the things we are either currently hedging portfolios against, or will potentially need to:

  1. China fails to comply with the terms of the “Phase One” trade deal which reignites the trade war.
  2. Earnings growth fails to recover, and valuations finally become a concern for the markets.
  3. Corporate profits, which have been essentially flat since 2014, deteriorate due to slower economic growth both domestically and globally.
  4. Excessively high consumer confidence converges with low levels of CEO Confidence as employment begins to weaken.
  5. Interest rates rise which trips up heavily leveraged consumers and corporations.
  6. Investors become concerned about excess valuations.
  7. A credit-related event causes a market liquidity crunch. (Convent-Lite, Leveraged Loans, BBB-rated downgrades all pose a potential threat)
  8. The Fed’s “repo-crisis” continues to grow and turns out to be something much more significant.
  9. Similar to 2016, a shocking election result.

While I am not going to address all of these concerns, I do want to touch a few that we feel are significant risks heading into the first half of the decade.

Valuations

While valuations are a terrible market timing device, they do impact long-term returns and investment outcomes. Currently, at 30x earnings, valuations are elevated, which suggests that the next decade of returns will be significantly lower than the last. Statistically, returns in the very low single digits should be expected.

However, it isn’t just PE ratios which are extended, but both Price-to-Sales and Enterprise Value to EBITDA (Earnings Before Interest Taxes Depreciation Amortization) are at or near all time highs.

Record highs in stocks, near-record lows in bond yields, and historically tight credit spreads present significant challenges for investors. Economic data has improved, but many fundamental economic gauges remain soft relative to pre-crisis averages, and are inconsistent with current asset price levels and valuations.

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

Most investors do not seem at all concerned as money continues to move into risky asset classes, a classic sign of a bubble. While a defensive posture seems prudent, the technical picture remains supportive of further gains. One should respect the momentum behind these moves for the foreseeable future, but be mindful that liquidity can evaporate quickly.

The Debt Risk

One of the common misconceptions in the market currently, is that the “subprime mortgage” issue was vastly larger than what we are talking about currently.

Not by a long shot. 

Combined, there is about $1.15 trillion in outstanding U.S. leveraged loans — a record that is double the level five years ago — and, as noted, these loans increasingly are being made with less protection for lenders and investors.

Just to put this into some context, the amount of sub-prime mortgages peaked slightly above $600 billion or about 50% less than the current leveraged loan market.

Of course, that didn’t end so well.

Currently, the same explosion in low-quality debt is happening in another corner of the US debt market as well.

As noted by John Mauldin:

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

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

The biggest risk currently is refinancing the debt as over the next 5-years, more than 50% of the debt is maturing. A weaker economy, recession risk, falling asset prices, or rising interest rates could well lock many corporations out of refinancing their share of this $5 trillion debt. Defaults will move significantly higher, and much of this debt will be downgraded to junk.

This is a problem the Fed can not fix with more liquidity.

Technically Troubling

In last week’s Technically Speaking we discussed the more extreme deviations in the market. To wit:

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.”

With these “buy signals” in place, and the market pushing higher on conclusions of “trade deals” and the election of the conservative party in the U.K. (which clears the way for Brexit), the markets rallied further toward our target of 3300.

In the short-term it is entirely feasible, particularly with the Federal Reserving pushing billions of dollars into the financial system currently, the bull market could easily eclipse our target of 3300. However, in the longer-term, virtually all of our primarily technical measures are stretched to levels normally seen near market tops rather than at the beginning of a new stretch of gains.

There are several measures used to justify current valuations, but they sound similar to those used in the dot-com Tech bubble. The relationships between valuation and fundamentals, on which cash flows are ultimately based, are grossly dislocated. Markets may well move higher, but to advocate a full allocation to equities under current circumstances ignores warnings of bubbles past.

Stock market cap-to-GDP, price-to-sales, margin balances, cyclically-adjusted price-to-earnings ratios, and others argue convincingly that the stock market is either near historic valuations, or well through them. Owning well-selected, single-name companies because they are fundamentally cheap, not relatively cheap, makes sense. Otherwise, limiting general equity allocation exposures is prudent until reasonable opportunities return. We suggest setting stop losses, and/or options strategies to help limit downside risk and retain any additional upside.

Sentiment Is Excessively Bullish

This past summer everyone was convinced a recession was near, now there is no such concern and investors are literally as “bullish” as they can get.

From a contrarian point of view, this is a fairly obvious warning to reduce risk in the market. However, the “Fear Of Missing Out,” is overriding investor logic at the moment. The recent market surge, which started coincidentally with the Fed’s restart of “QE, Not QE,” is very reminiscent of the surge in asset prices we saw at the end of 1999 as the Fed flooded the system with liquidity in advance of the potential “Y2K” issues.

As noted in our RIAPRO Daily Market Commentary:

“Today’s ‘Chart of the Day’ shows the surge in the NASDAQ index, which occurred during the last few months of 1999. Most people attribute the massive gain to the feverish pitch in the dot com bubble. We believe the real culprit was the Fed which added substantial amounts of repo liquidity to the banking sector due to concerns of Y2K and the potential for mass computer malfunctioning. Those repo funds gravitated to the financial markets.

For more, please read the following WSJ article from 1999- Federal Reserve Clears Loan Facility Linked To Y2K Computer Problems.

“The graph below shows the 10x surge in repo during late 1999 and its quick removal shortly after the New Year. Note the recent surge, on the right side of the graph, dwarfs the 1999 experience and that is before an expected $500 billion spike in repo financing over the next week or two.”

Unlike 1999, we have our doubts as to how quickly the graph normalizes, as the Fed continues to underestimate the scope of the growing overnight funding issues.

To quote Yogi Berra “it’s deja vu, all over again.”

Conclusion

Statistically speaking, the odds suggest that the market could indeed be higher in 2020. However, there are numerous risks which could derail the markets which should not be dismissed.

This is not a “bearish forecast.” It is just an assessment of trends, statistics, and probabilities given the current monetary, financial and economic backdrop.

If we are wrong, and stocks do post gains in the coming year, being more conservative will only mean a small relative under-performance in your portfolio next year.

If we are right, the preservation of capital will be far more beneficial. As we have stated previously, participating in the bull market over the last decade is only one-half of the job. The other half is keeping those gains during the second half of the full market cycle.

One of my favorite quotes is by Howard Marks and is a principle that we live by in our little shop;

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

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

As we enter into 2020 it may pay to be a little more cautious after such a large rise in the financial markets.

Let me leave you with Bob Farrell’s 10 Rules:

  1. Markets tend to return to the mean over time
  2. Excesses in one direction will lead to an opposite excess in the other direction
  3. There are no new eras — excesses are never permanent
  4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
  5. The public buys the most at the top and the least at the bottom
  6. Fear and greed are stronger than long-term resolve
  7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
  8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
  9. When all the experts and forecasts agree — something else is going to happen
  10. Bull markets are more fun than bear markets

Our job is managing risk to conserve principle and create absolute returns over time. What matters most to us is that we provide a disciplined management process suitable for our clients who seek long-term performance as measured by annualized and risk-adjusted returns, and conservation of investment principle.

We wish you a prosperous 2020.

The Stock Market Has Become A Private Club For The Elite

A recent Peter G Peterson Foundation poll, as reported by the Financial Times, revealed a statistic that we have suspected for quite some time. To wit:

“Nearly two-thirds of Americans say this year’s record-setting Wall Street rally has had little or no impact on their personal finances, calling into question whether one of the strongest bull markets in a decade will boost Donald Trump’s re-election chances.

A poll of likely voters for the Financial Times and the Peter G Peterson Foundation found 61-percent of Americans said stock market movements had little or no effect on their financial well-being. 39-percent said stock market performance had a “very strong” or “somewhat strong” impact.

The survey suggested most Americans are not aware of market movements, with just 40-percent of respondents correctly saying the stock market had increased in value in 2019. 42-percent of likely voters said the market was at “about the same” levels as at the start of the year, while 18-percent believed it had decreased.”

Another article by Shawn Langlois via MarketWatch revealed much the same discussing a recent publication from the Economic Policy Institute. That study also revealed the increasingly inadequate retirement savings of Americans, as well as the dispersion of wealth among income earners.

As Shawn penned:

“The big gap between the mean retirement savings of $120,809 and the median retirement savings is yet another example of how the rich are getting richer and the poor are getting poorer in this country.”

This isn’t anything new.

We have been reporting on this issue over the last few years, and just recently dug into current details in our discussion on the “Savings Rate.” To wit:

“The calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households. More importantly, the measure is heavily skewed by the top 20% of income earners, and even more so by the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

The reality is the majority of Americans are struggling just to make ends meet, which has been shown in a multitude of studies.

“The [2019] survey found that 58 percent of respondents had less than $1,000 saved.” – Gobankingrates.com

Such levels of financial “savings” are hardly sufficient to support individuals through retirement, much less leave enough savings to actively participate in the “booming stock market.” Such confirms the Peterson study that the “longest bull market in history” has largely bypassed a vast majority of Americans.

It also confirms why, after a decade-long bull market, that a rising trend of individuals over the age of 55 remain in the workforce. 

“Growing numbers of U.S. ­boomers—currently 55 to 73—are working beyond the traditional retirement age, going back to school, and choosing to age in place in familiar neighborhoods instead of moving to senior communities. 

For the first time in history, there are multiple generations alive together for long stretches of time.

It’s not that “Boomers” don’t want to retire, it’s because they “can’t afford to.” 

The Expanding Problem

Despite Central Bank’s best efforts globally to stoke economic growth by pushing asset prices higher, the effect has been entirely consumed by those with actual savings, and discretionary income, available to invest.

In other words, the stock market has become an almost “exclusive” club for the elite.

While monetary policies increased the wealth of those that already have wealth, the Fed has been misguided in believing that the “trickle down” effect would be enough to stimulate the entire economy.

It hasn’t.

The sad reality is that these policies have only acted as a transfer of wealth from the middle class to the wealthy and created one of the largest “wealth gaps” in human history. Via Forbes:

“‘The top 10% of the wealth distribution—the purple and green areas together—hold a large and growing share of U.S. aggregate wealth, while the bottom half (the thin red area) hold a barely visible share,’ Fed economists write in a paper outlining the new data set on inequality, which is more timely than exisiting statistics. The chart show that ‘while the total net worth of U.S. households has more than quadrupled in nominal terms since 1989, this increase has clearly accrued more to the top of the distribution than the bottom.'”

Lack Of Capital

The current economic expansion is already the longest post-WWII expansion on record. Of course, that expansion was supported by repeated artificial interventions rather than stable organic economic growth. As noted, while the financial markets have soared higher in recent years, it has bypassed a large portion of Americans NOT because they were afraid to invest, but because they have NO CAPITAL to invest with.

The ability to simply “maintain a certain standard of living” has become problematic for many, which forces them further into debt.

“The debt surge is partly by design, a byproduct of low borrowing costs the Federal Reserve engineered after the financial crisis to get the economy moving. It has reshaped both borrowers and lenders. Consumers increasingly need it, companies increasingly can’t sell their goods without it, and the economy, which counts on consumer spending for more than two-thirds of GDP, would struggle without a plentiful supply of credit.” – WSJ

I often show the “gap” between the “standard of living” and real disposable incomes. 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 $2600 annual deficit that cannot be filled. (Note: this deficit accrues every year which is why consumer credit keeps hitting new records.)

The debt-to-income problem keeps individuals from building wealth, and government statistics obscure the basic reality. We discussed this point in detail in “Dimon’s View Of Economic Reality Is Still Delusional:”

“The median net worth of households in the middle 20% of income rose 4% in inflation-adjusted terms to $81,900 between 1989 and 2016, the latest available data. For households in the top 20%, median net worth more than doubled to $811,860. And for the top 1%, the increase was 178% to $11,206,000.

Put differently, the value of assets for all U.S. households increased from 1989 through 2016 by an inflation-adjusted $58 trillion. A third of the gain—$19 trillion—went to the wealthiest 1%, according to a Journal analysis of Fed data.

‘On the surface things look pretty good, but if you dig a little deeper you see different subpopulations are not performing as well,’ said Cris deRitis, deputy chief economist at Moody’s Analytics.” – WSJ

The One Problem The Fed Can’t Fix

The problem with the Fed’s ongoing liquidity interventions is that they continue to benefit those in the top 20% of population which exacerbates the wealth gap between them and everyone else.  Importantly, the current gap between household net worth and GDP is the greatest on record, and those previous gaps were filled by reversions with the most painful of outcomes.

While such a reversion in “net worth” will have the majority of its impact at the upper end of the income scale; it will be the job losses through the economy that will further damage and already ill-equipped population in their prime saving and retirement years.

Compound that problem with the massive amount of corporate debt, which if it begins to default, will trigger further strains on the financial and credit systems of the economy.

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

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

While the stock market may be an exclusive club for its members currently, the combined issues of #debt, #deflation, and #demographics is a problem the Fed can’t fix.

It isn’t a question of “if.” It is simply a function of “when.”

The next crisis will repair the “wealth gap” to some degree only because 2/3rds of American’s never participated in the bull market to begin with.

Technically Speaking: How To Pick Up A Porcupine

Last week, I discussed the registering of the monthly buy signals, which confirmed the bull market in the S&P 500 had resumed following the 2018 Fed/Trade induced sell off. Here is a snippet of our history in this regard:

“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.”

With these “buy signals” in place, and the market pushing higher on conclusions of “trade deals” and the election of the conservative party in the U.K. (which clears the way for Brexit), the markets rallied further toward our target of 3300.

Over the last couple of weeks, we have slowly been increasing the equity allocation in portfolios toward being fully exposed.

This is because, as we have been discussing on RIAPRO (Try FREE for 30-days), the Fed’s “QE-NOT QE” was being interpreted by the markets as QE. The chart below shows the increase in the Fed’s balance sheet as compared to the rally in the market.

The recent market surge, which started coincident with the Fed’s restart of “QE, Not QE,” is very reminiscent of the surge in asset prices we saw at the end of 1999 as the Fed flooded the system with liquidity in advance of the potential “Y2K” issues.

As noted in our RIAPRO Daily Market Commentary:

“Today’s ‘Chart of the Day’ shows the surge in the NASDAQ index, which occurred during the last few months of 1999. Most people attribute the massive gain to the feverish pitch in the dot com bubble. We believe the real culprit was the Fed which added substantial amounts of repo liquidity to the banking sector due to concerns of Y2K and the potential for mass computer malfunctioning. Those repo funds gravitated to the financial markets.

For more, please read the following WSJ article from 1999- Federal Reserve Clears Loan Facility Linked To Y2K Computer Problems.

“The graph below shows the 10x surge in repo during late 1999 and its quick removal shortly after the New Year. Note the recent surge, on the right side of the graph, dwarfs the 1999 experience and that is before an expected $500 billion spike in repo financing over the next week or two.”

Unlike 1999, we have our doubts as to how quickly the graph normalizes, as the Fed continues to underestimate the scope of the growing overnight funding issues.

To quote Yogi Berra “it’s deja vu, all over again.”

Overly Extended, Bullish & Valued

While we have been adding exposure in recent weeks to participate with the rise in the markets, the issues of technical price deviations, valuations, and subsequent risk has not been forgotten. By the majority of measures that we track from momentum, to price, and deviation, the market’s sharp advance has pushed the totality of those indicators back to overbought.

These overbought conditions, combined with the more extreme deviation from the 200-dma, and the longer-term bullish trend, have led to short-term corrections.

The deviations from the longer-term bullish trend are shown below, along with the more extreme levels of complacency by investors.

Historically, when all of the indicators are suggesting the market has likely encompassed the majority of its price advance, a correction to reverse those conditions is often not far away.

For these reasons, and others, this is why the exposure we have added has been only partial holdings, that we will build into opportunistically, and have a “value tilt” to them. Currently, there are the early signs of a rotation from momentum to value in the market, which gives “value” a bit of a “defensive” posture currently.

We still remain fully weighted in our fixed income portfolios, which consist of high quality holdings and a bit shorter-duration, with a slight overweight in cash.

How To Add Exposure

Adding exposure at these levels can be a challenge, unless you just don’t care about the “risk of loss.” Since we manage money for clients who are near, or in, retirement, we care about the risk very much. So, the answer to how to add exposure at this stage of the bull cycle is the same as the answer to that age-old question:

“How do you pick up a porcupine? Carefully.”

Here are the guidelines we are following:

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  1. If you are heavily UNDER-weight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move.This could be disastrous if the market reverses sharply in the short term. Again, move slowly.
  1. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tend to lead when markets fall. Like “weeds choking a garden,” pull them.
  1. Add to sectors, or positions, that are performing with, or outperforming, the broader market.
  1. Move “stop loss” levels up to current breakout levels for each position. Managing a portfolio without “stop loss” levels is like driving with your eyes closed.
  2. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  1. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

Buying Because I Have To. You Don’t.

“So, if you believe the market is overbought, why are you buying?”

There is a difference between views of long-term fundamentally driven potential outcomes, and short-term opportunities in the markets.

Let me be VERY clear about something.

As a portfolio manager, we buy “opportunity” because we have to. If we don’t, we suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns in the market.

Think about it this way.

The markets have returned more than 300% since the 2009 lows in the longest bull market on record. Yes, it is still just one bull market. 

Assuming that you were astute enough to buy the “cherry picked” low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that in the years ahead you will far outpace investors who remain invested. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last decade. (That isn’t a theoretical assumption. It’s historical fact.)

While we may indeed be shifting exposure and taking on some additional risk, we do so very cautiously.

Cracks In The Bull Market Armor

While we did increase our exposure to the markets, as the bullish trend does currently persist, there is growing evidence of “cracks” appearing.

With the Fed flooding the system with liquidity to fund short-term repurchase operations, this is not normal and suggests that something has “broken” in the system. 

Given the current rally is built on substantially weaker fundamental and economic underpinnings, weaker earnings growth, and an exhausted consumer, increases in equity risk could very well be reversed in short order. This due to the following reasons:

  1. We are in the latter stages of the bull market.
  2. Economic data continues to remain weak
  3. Earnings are beating continually reduced estimates
  4. Volume is weak
  5. Longer-term technical underpinnings are weakening and extremely stretched.
  6. Complacency is extremely high
  7. Share buybacks are slowing

It is worth remembering that markets have a very nasty habit of sucking individuals into them when prices become detached from fundamentals. Such is the case currently and has generally not had a positive outcome.

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, technically, to warrant taking on some equity risk on a very short-term basis. We will see what happens over the next couple of weeks. 

However, the longer-term dynamics are turning more 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. “

Remember, investing is not a competition, it is a game of long-term survival.