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Technically Speaking: The One Thing – Playing The “Bear Market” Rally.

Let’s flashback to a time not so long ago, May 2019.

“It was interesting to see Federal Reserve Chairman Jerome Powell, during an address to the Fernandina Beach banking conference, channel Ben Bernanke during his speech on corporate ‘sub-prime’ debt (aka leveraged loans.)

‘Many commentators have observed with a sense of déjà vu the buildup of risky business debt over the past few years. The acronyms have changed a bit—’CLOs’ (collateralized loan obligations) instead of ‘CDOs’ (collateralized debt obligations), for example—but once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards. Likewise, much of the borrowing is financed opaquely, outside the banking system. Many are asking whether these developments pose a new threat to financial stability.

In public discussion of this issue, views seem to range from ‘This is a rerun of the subprime mortgage crisis’ to ‘Nothing to worry about here.’ At the moment, the truth is likely somewhere in the middle. To preview my conclusions, as of now, business debt does not present the kind of elevated risks to the stability of the financial system that would lead to broad harm to households and businesses should conditions deteriorate.’ – Jerome Powell, May 2019

In other words, corporate debt is ‘contained.’”

As we concluded at that time:

“Unfortunately, while Jerome Powell may be currently channeling Ben Bernanke to keep markets stabilized momentarily, the real risk is some unforeseen exogenous event, such as Deutsche Bank going bankrupt, that triggers a global credit contagion.”

While the “exogenous event” was a “virus,” it led to a “credit event” which has crippled markets globally, leading the Federal Reserve to throw everything possible at trying to stem the crisis. With the Fed’s balance sheet set to expand towards $10 Trillion, the Federal deficit to balloon to $4 trillion, it is “all hands on deck” to stop the next “Great Depression” before it takes hold.

However, this is what we have been warning about:

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

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

The only question which remains to be answered is whether the MORE debt and monetary stimulus can fix a debt and monetary stimulus bubble?

In other words, can the Fed inflate the fourth bubble to offset the implosion of the third?

Think about the insanity of that statement, but that is what the markets, and the economy, are banking on.

We do expect that with the flood of fiscal and monetary stimulus, a “bear market rally” becomes a real probability, at least in the short-term.

How big of a rally? What should you do? These are the important points in today’s missive.

The One Thing

The “ONE Thing” you need to do TODAY, right now, is “accept” where you are.

What you had, what was lost, and the mistakes you made, CAN NOT be corrected. They are in the past. However, by hanging on to those “emotions,” we lock ourselves out of the ability to take actions that will begin the corrective process.

Let me dispel some myths:

  • “Hope” is not an investment strategy. Hanging on to some stock you lost money in waiting for it to “get back to even,” costs you opportunity.
  • You aren’t a loser. Whatever happened previously is over, and it doesn’t make you a “loser.” However, staying in losing positions or strategies will continue to cost you. 
  • Selling does NOT lock in losses. The losses have already occurred. Selling, however, gives you the ability to take advantage of “opportunity” to begin the recovery process.  

Okay, now that we have the right “mindset,” let’s take an educated guess on what happens next.

The current bear market is exhibiting many of the same “technical traits” as seen in both the “Dot.com” and “Financial Crisis.” 

In each previous case, the market experienced a parabolic advance to the initial peak. A correction ensued, which was dismissed by the mainstream media, and investors alike, as just a “pause that refreshes.” They were seemingly proved correct as the markets rebounded shortly thereafter and even set all-time highs. Investors, complacent in the belief that “this time was different” (1999 – a new paradigm, 2007 – Goldilocks economy), continued to hold out hopes the bull market was set to continue.

That was a mistake.

Also, in each period, once the monthly “sell signal” was triggered from a high level, the ensuing correction process took months to complete. This not only reset the market, but valuations as well. In both previous periods, reflexive rallies occurred, which eventually failed. While the 2008 plunge following the Lehman crisis was most similar to the current environment, there was a brief rally following the passage of TARP, which sucked investors in before the additional 22% decline in the first two months of 2009.

Most importantly, the market got very oversold early in both previous bear markets, and stayed that way for the entirety of the bear market. Currently, the market has only just now gotten to a similar oversold condition.

What all the indicators currently suggest is that while the current correction has been swift and brutal, bear markets are not resolved in a single month. 

This is going to take some time.

Bear Market Rally

Over the past couple of week’s, we have been talking about a potential reflexive bounce.

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

As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance. Such an advance will “lure” investors back into the market, thinking the “bear market” is over.

This is what “bear market rallies” do, and generally inflict the most pain possible on unwitting investors. The reasons for this are many, but primarily investors who were trapped in the recent decline will use the rally to “flee” the markets permanently.

Chart Updated Through Monday

More importantly, as noted above, “bear markets” are not resolved in a single month. Currently, there are too many investors trying to figure out where “the bottom” is, so they can “buy” it.

Bear markets do not end in optimism; they end in despair. 

Looking back at 2008, numerous indicators suggest the “bear market” has only just begun. While this does NOT rule out a fairly strong reflexive rally, it suggests that any rally will ultimately fail as the bear market completes its cycle. 

This can be seen more clearly in the monthly chart below, which looks at both previous bull and bear markets using a Fibonacci retracement. As shown, from the peak of both previous bull market “bubbles,” the market reversed 61.8% of the advance during the “Dot.com” crash, and more than 100% of the advance during the “Financial Crisis.”  

Given the current bull market cycle was longer, more levered, and more extended than both previous bull markets, a 38.2% decline is unlikely to fulfill the requirements of this reversion. Our ultimate target of 1600-1800 on the S&P 500 remains confirmed by the quarterly chart below.

The current correction process has only just triggered a quarterly sell signal combined with a break from an extreme deviation of the long-term bull-trend back to the 1930’s. Both previous bull market peaks coincide with the long-term bull trend at about 1600 on the S&P currently. Given all the stimulus being infused into the markets currently, we broaden our bear market bottom target to 1600-1800, as noted.

The technical signals, which do indeed lag short-term turns in the market, all confirm the “bear market” is only just awakening. While bullish reflexive rallies are very likely, and should be used to your advantage, this is a “traders” market for the time being.

In other words, the new mantra for the market, for the time being, will be to “Sell Rallies” rather than “Buy The Dip.”

As I have noted many times previously:

“This ‘time is not different,’ and there will be few investors that truly have the fortitude to ‘ride out’ the next decline.

Everyone eventually sells. The only difference is ‘selling when you want to,’ versus ‘selling when you have to.’”

Yes, the market will rally, and likely substantially so. Just don’t forget to take action, make changes, and get on the right side of the trade, before the “bear returns.” 

Let me conclude by reminding you of Bob Farrell’s Rule #8 from our recent newsletter:

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

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

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

The chart above shows the stages of the last two primary cyclical bear markets versus today (the 2020 scale has been adjusted to match.)

As would be expected, the “Phase 1” selloff has been brutal.

That selloff sets up a “reflexive bounce.”  For many individuals, they will feel like” they are “safe.” This is how “bear market rallies” lure investors back in just before they are mauled again in “Phase 3.”

Just like in 2000, and 2008, the media/Wall Street will be telling you to just “hold on.” Unfortunately, by the time “Phase 3” was finished, there was no one wanting to “buy” anything.

Will The Corona Virus Trigger A Recession?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Can Six Myths Keep The Market Going?

Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600?  The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?

Source: Patrick Hill – 12-31-19

One reason for the disconnect is investment analysts and the media lead investors to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed policy shift) begun 30 years ago low-interest rates, low volatility, sustainable growth and muted inflation are still in place and were only interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash. GS concluded that the economy ‘was nearly recession-proof.’

The mainstream financial media also feed the Mania Phase with stories like Goldman Sachs declaring the Great Moderation is working with our economy in a ‘new paradigm’. We are to believe there will not be a recession because our policymakers have the economy under control.  Really?  With over $17 trillion of negative debt worldwide to keep the world economy going, central banks have succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:

  1. The Growth Phase of the Economic Cycle is Continuing
  2. Consumers Will Bailout the Economy
  3. The Fed Will Keep the Economy Humming
  4. If the Fed Fails Then the Federal Government Will Provide Stimulus
  5. The Trade War Won’t Hurt Global Growth
  6. The Economy and Markets Are Insulated from World Politics

Let’s look at each myth that is likely to affect portfolio and market performance in the next year.  This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.

Myth 1. The Growth Phase of the Economic Cycle is Continuing

The Fed has reported that the economy is still in ‘mid-cycle’ phase.  We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers.  The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.

Sources: The Conference Board, The Wall Street Journal, The Daily Shot – 6/14/19

In the chart below, consumers are stretched as loan default rates are rising despite a 50-year low unemployment rate. Rising delinquencies tend to signal rising unemployment and economic decline is likely in the near future.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19

Of major concern is that the manufacturing sector is now in a recession based on five months of ISM reports below the 50 % economic expansion benchmark. The overall contraction is validated as 70 % of manufacturing sub-sectors are contracting as noted in the report below.  While the US economy is primarily driven by services, the manufacturing sector has a multiplier effect on productivity, support services, and employment with high paying jobs. Note the contraction in sub-sectors is reaching levels last seen before recessions.

            Sources Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19

There are other indicators pointing to the end of the growth phase.  For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.

Myth 2.  Consumers Will Bailout the Economy

Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates.  Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt.  The Bloomberg Personal Finance Index dropped significantly in October:

Source: Bloomberg, The Wall Street Journal, The Daily Shot – 11/10/19

Car loans now span seven years on average versus five years a few years ago. Further, the new loans ‘roll in’ debt from previous car purchases due to negative equity in the owner’s trade-in vehicle.  Vehicle price increases up to 10 % over the last year for both cars and trucks add to the debt burden.  Car debt is beginning to weigh on consumers as delinquencies are climbing:

Sources: NY Federal Reserve, The Wall Street Journal, The Daily Shot – 10/29/19

Today, credit card rates are running at a ten-year peak of 17 – 22 % have seen no relief despite the Fed cutting rates.  There is a record spread between the Federal Funds rate and credit card rates as banks seek new revenue sources beyond making loans. Many consumers are turning to credit cards to pay bills to sustain their lifestyle as their wages are not keeping up with rising living costs.

In addition, consumers are increasingly working at more than one job to be sure they can pay their bills.

Sources: Deutsche Bank, Bureau of Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19

Workers need to take on multiple jobs in the gig economy. McKinsey & Company estimates that 52 million people are gig workers or a third of the 156 million person workforce. Contractors have no job security.  Gig workers often receive hourly wages with no health, retirement or other benefits. The lack of benefits means they have limited or no financial safety net in the event of an economic slowdown.

There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year.  Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years.  Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?

Myth 3.  The Fed Will Keep the Economy Humming

The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.

Sources: The Wall Street Journal, The Daily Shot – 12-30-19

We agree with their perspective that the Fed is entering an economic space where no central bank has gone before.  In the past, the Fed lowered rates when an economic downturn was evident. Just prior to earlier recession’s interest rates were at a higher starting level of at least 4 – 5 %.  Plus, today the Fed has returned to pumping liquidity into the economy via its repo operation and QE as shown below.

Sources: The Federal Reserve of St. Louis, The Wall Street Journal, The Daily Shot – 12/30/19

The International Bureau of Settlements (BIS) disclosed in their analysis of recent Fed repo operations that funding supported not only banks but hedge funds. A key concern is the nature of the hedge fund bailout. How steep is the loss being mitigated? Is there a possibility of contagion? Is more than one hedge fund involved?  Should the Fed be bailing out hedge funds that are overextended due to speculation? The Fed is already using its tools at the height of the current economic growth cycle. The Fed financial tools are too stretched to turnaround an economy in a recession from multiple financial bubbles bursting.

The Fed continues to declare that inflation is at 2.1 %, missing the reality of what consumers are actually paying for goods and services.  We find from industry research that finds inflation is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and services that consumers buy, not inflation defined by a formula to suit political needs. Using inflation lifestyle ‘cost of living’ data, which is not transparent or available for audit does not meet the foundational data needs of investors.  Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers frequently buy at Walmart and Target.  Their study showed that from June 2018 to June 2019, prices increased by about 5.5%. 

Other industry research supports inflation running at a much higher level than government figures. On a city by city basis, Chapwood has developed an index for 500 items in major metropolitan areas of the US.  Chapwood reports the average national inflation level to be about 10 %.  Note inflation is compounded; for example, in San Jose a five year average price increase of 13% is for each year. An item costing $1.00 would cost $1.13 the next year and then $1.28 the third year and so forth. It is likely workers caught in a squeeze between stagnant wages and 10 % inflation will not be able to continue to sustain present levels of economic growth.

Real inflation at 6 – 10 % has major policy, portfolio, and social implications.  For example, with the ten year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’ economy of – 4.10 %Higher inflation levels fit the financial reality of what workers, portfolio managers, and retirees are facing in managing their finances.  Many workers must take multiple jobs and develop a ‘side hustle’ to just keep up with inflation much less get ahead. For portfolio managers, they must grow their portfolio at much higher rates than was previously thought just to maintain portfolio value.  Finally, for retirees on a fixed income portfolio it is imperative they have additional growth income sources or part-time work to keep up with inflation eating away at their portfolio. For more details on our analysis of a variety of inflation, categories see our post: Is Inflation Really Under Control?

One additional assumption about Fed intervention repeated by many analysts is the Fed liquidity injections mean that corporate sales and profits will bounce back.  For some financially sensitive industries this argument may be true. For other firms with excellent credit ratings, they may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and sell products based on demand. If demand falls, low-interest loans will not increase sales.  Only new products, new channels, reduced pricing, marketing and other initiatives will revive sales.

Myth 4.  If the Fed Fails Then the Federal Government Will Provide Stimulus

European Central Bank leaders have called on European governments to provide economic stimulus for their markets.  Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector.  For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.

Source: World Inequality Lab, Thomas Piketty, Gabriel Zucman et al. – 2018

Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth.  The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions.  Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.

Myth 5.  The Trade War Won’t Hurt Global Growth

By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track.  Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term.  The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.

China has quietly raised the exchange rate of their currency to offset some of the impact of still in place tariffs on the U.S. economy.  The government made a major move to block US and foreign companies from providing key technical infrastructure. The technology ministry has told government agencies that all IT hardware and software from foreign firms are to be replaced by Chinese systems within three years. If the Chinese government decides to establish ‘China only’ network standards it may be difficult for US firms to even work with state-sponsored companies or private businesses that must meet China’s only standards. Apple and Microsoft would have to build two versions of their products. One version for the Chinese economy and one for the world.  A critical change is taking place in world trade which is the establishment of a two-block trading world.  China is a key growth market at a 20 % – 30 % increase in sales annually for US multinational companies. For these corporations navigating the trade war will be problematic even with the Phase One agreement.  Our post characterizing this major change in world trade can be found at: Navigating a Two Block Trading World.  

The U.S. has placed sanctions on Chinese sponsored network provider Huawei, effectively limiting the network vendor from US government and private networks.  The Phase One agreement includes the US canceling planned tariffs for December 15th in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on September 1st of last year. Yet, tariffs of 25 % remain in place on $250 billion of Chinese goods.  The Chinese have canceled retaliatory tariffs planned for December 15th and plan to increase purchases of US goods and services by $200 billion over two years. In addition, China will purchase US agriculture products at a $40 billion rate per year from a baseline of $24 billion in 2017.  If the Chinese follow through on their purchase commitments US companies should see increased sales.  However, history on Chinese purchases shows they forecast large purchases but small purchases are made.

A major trade issue has been created when the US decided not to appoint any new judges to the World Trade Organization court for disputes. The court cannot hear or make decisions on any disputes any longer; meaning countries will resort to free-for-all negotiations on trade disputes.  We expect as economies falter, nationalist policies on trade will gain more popularity and world trade will continue to decline after a slight blip up from the U.S.-China Phase One deal.

Sources: BCOT Research, The Wall Street Journal, The Daily Shot – 12/16/19

Finally, prior to the trade war global trade has been facing major headwinds. Since 2008, global firms have looked to open more international markets to sell their goods, but have met sales resistance causing revenue and profits to be flat or decline.  We expect the flattening of global sales to output to continue and eventually decline as overall world trade falls.

CEOs in a Conference Board survey rate trade as a major concern as they look at a highly uncertain economic picture.  Marc Benioff, CEO of Salesforce, described his concerns at a company all hands meeting last November:

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

Myth 6. The Economy and Markets Are Insulated from World Politics

Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb.  Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02.  The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf.  An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.

We saw during the negotiations for the Phase One trade deal how rumors both in China and the U.S. would send the S & P futures market up or down by 10 – 15 points depending upon whether the news was positive or negative. Algo traders would drop 30k contracts in a matter of seconds to make huge moves in SPX price, while the VIX was at 12.50, supposedly a calm market. The chart below shows how positive and negative news whipsawed the market.

Source: Liz Ann Sonders – Schwab – 12-7-19

Political news not only moves markets but the economy as well.  When the president tweets a tariff threat, consumers and industry move swiftly to buy those goods before their prices go up.  Businesses have to build the product quickly, sell it and they are left with falling sales as future purchases are pulled forward.  Business to business deals are caught up in this constant flip flop on trade policies as well. CEOs must make investment decisions to build a plant in a particular country 1 – 3 years in advance. They must calculate their allocation plans based on inadequate information and in a highly uncertain policy environment.  Often, rather than make an investment decision, executives will wait for the economic clouds to clear.


The current bull market run has set record highs continuously.  Yet, as the saying goes: markets go up in stair steps and down in an elevator.  As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.

The prudent investor will recognize the end of the business cycle is likely underway. It is time to prepare for an economic slowdown and a resulting equity market reversion to the mean. A reversion to the mean quite often requires that markets swing beyond the mean.

The wary investor will ask hard questions of their financial advisor and review corporate reports with an eye on fundamentals. Financial success is likely to result from good risk management and implementation combined with agility to make mid-course corrections.  Investors should test their assumptions based on breaking trends that may impact portfolio performance.  At the same time, constantly flipping investments will lead to poor performance. Allocate funds to different portfolio groups based on long, medium and short term goals to keep from being emotionally swept up in temporary market swings. The key is to be prepared for the unknown, or a black swan event.  Expect the unexpected and consider the advice of market legends like Bernard Baruch:

Some people boast of selling at the top of the market and buying at the bottom – I don’t believe this can be done. I had bought when things seemed low enough and sold when they seemed high enough. In that way, I have managed to avoid being swept along to those wild extremes of market fluctuations which prove so disastrous.”

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

What We Are Not Being Told About The Trade Deal

Unlike most trade deals where the terms are readily available, the details of the Phase One trade agreement between China and the U.S. will not be announced nor signed in public. Accordingly, investors are left to cobble together official comments, anonymous statements from officials, and rumors to ascertain how it might affect their portfolios.

Based on official and unofficial sources, existing tariffs will remain in place, new tariff hikes will be delayed, and China will purchase $40-50 billion in agricultural goods annually. At first blush, the “deal” appears to be a hostage situation- China will buy more goods in exchange for tariff relief.

The chart below, courtesy of Bloomberg, provides reasons for skepticism. The rumored $40-50 billion in goods is nearly double what China purchased from the U.S. in any year of the last decade. It is over four times what they bought in 2018 before the trade war started in earnest.

The commitment is even more questionable when one considers that China recently agreed to purchase agricultural products from Brazil, Argentina, and New Zealand. 

The following tweet by Karen Braun, (@kannbwx), a Global Agricultural Columnist for Thomson-Reuters, puts the massive commitment into further context.  She claims that the maximum annual totalimport of four key agriculture products, only adds up to $56 billion. As she stresses in the tweet, the figures are based on the maximum amount China bought for each respective good in any one year.

Either China will buy more agriculture than they need and stockpile a tremendous amount of agriculture, which is possible, or they have agreed to something else that is not being disclosed. That, to us, seems more likely. We have a theory about what might not be disclosed and why it may matter to our investment portfolios.

Donald’s Dollar

Given the agreement as laid out in public, what else can China can offer that would satisfy President Trump? While there are many possibilities, the easiest and most beneficial commitment that China can offer the U.S. is a stronger yuan, and thus, a weaker dollar.

The tweets below highlight Trump’s disdain for the strengthening dollar.

A weaker dollar would reduce the U.S. trade deficit by making exports cheaper and imports more expensive. If sustained, it could provide an incentive for some companies to move production back to the U.S. This would help fulfill one of Trump’s core promises to voters, especially in “fly over” states that pushed him over the top in the last election. Further, a weaker dollar is inflationary, which would boost nominal GDP and help satisfy the Fed’s craving for more inflation.

From China’s point of view, a weaker dollar/ stronger yuan would hurt their exporting sectors but allow them to buy U.S. goods at lower prices. This is an important consideration based on what we wrote on December 11th, in our RIA Pro daily Commentary:   

“In part, due to skyrocketing pork prices, food prices in China have risen 19.1% year over year. In addition to hurting consumers, inflation makes monetary stimulus harder for the Bank of China to administer as it is inflationary. From a trade perspective, consumer inflation will likely be one factor that pushes Chinese leaders to come to some sort of Phase One agreement.

Food inflation is a growing problem for China and its leadership. In part, due to the issues in Hong Kong, Chairman Xi benefits from pleasing his people. While a stronger yuan would result in some lost trade and possibly jobs, the price of the agricultural goods will be lower which benefits the entire population.

A stronger yuan is not ideal for China, but it appears to be a nice tradeoff and something that benefits Trump. This is speculation, but if correct, and recent weakness in the dollar suggests it is, then we must assess how a weaker dollar affects our investment stance. 

Investment Implications

The following table shows the recent and longer-term average monthly correlations between the U.S. dollar and various asset classes. Below the table is a graph that shows the history of the two-year running monthly correlations for these asset classes to provide more context.

Data Courtesy Bloomberg

The takeaway from the data shown above is that gold and ten-year Treasury yields have a consistent negative correlation with the dollar. This means that we would expect higher gold prices and Treasury yields if the dollar weakens. Interestingly, the CRB (broad commodities index) and Emerging Equity Markets have the most positive correlation. Oil and the S&P 500 appear to be neutral.

The S&P 500 is a broad measure, so when looking at particular stocks or sectors, it is important to consider the size of the company(s) and the global or domestic nature of the company(s). For instance, domestic large-cap companies with global sales should benefit most from a weaker dollar, while small-cap domestic companies, reliant on foreign sources to produce their goods, should perform relatively poorly.  


From the onset of negotiations, the China-US trade war has been tough to handicap. China has a lot to lose if they give in to Trump’s demands. Trump has leverage as a tariff war hits China’s economy harder than the U.S. economy. China is fully aware that the U.S. election is only 11 months away, and Trump’s re-election prospects are sensitive to the state of the economy and market sentiment. A trade victory should help Trump at the polls.

Our dollar thesis is speculation, but such an agreement is self-serving for both sides. Keep a close eye on the dollar, especially versus the yuan, as a weaker dollar has implications for all asset classes.

“The Art Of The Deal” & How To Lose A “Trade War.”

This past Monday, on the #RealInvestmentShow, I discussed that it was exceedingly likely that Trump would delay, or remove, the tariffs which were slated to go into effect this Sunday, On Thursday, that is exactly what happened.

Not only did the tariffs get delayed, but on Friday, it was reported that China and the U.S. reached “Phase One” of the trade deal, which included “some” tariff relief and agricultural purchases. To wit:

“The U.S. plans to scrap tariffs on Chinese goods in phases, a priority for Beijing, Vice Commerce Minister Wang Shouwen said. However, Wang did not detail when exactly the U.S. would roll back duties.

President Donald Trump later said his administration would cancel its next round of tariffs on Chinese goods set to take effect Sunday. In tweets, he added that the White House would leave 25% tariffs on $250 billion in imports in place, while cutting existing duties on another $120 billion in products to 7.5%.

China will also consider canceling retaliatory tariffs set for Dec. 15, according to Vice Finance Minister Liao Min. 

Beijing will increase agricultural purchases significantly, Vice Minister of Agriculture and Rural Affairs Han Jun said, though he did not specify by how much. Trump has insisted that China buy more American crops as part of a deal, and cheered the commitment in his tweets.”

Then from the USTR:

The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”

Not surprisingly, the market initially rallied on the news, but then reality begin to set in.

Art Of The Deal Versus The Art Of War

Over the past 18-months we have written numerous articles about the ongoing “trade war,” which was started by Trump against China. As I wrote previously:

“This is all assuming Trump can actually succeed in a trade war with China. Let’s step back to the G-20 meeting between President Trump and President Xi Jinping. As I wrote then:

‘There is a tremendous amount of ‘hope’ currently built into the market for a ‘trade war truce’ this weekend. However, as we suggested previously, the most likely outcome was a truce…but no deal.  That is exactly what happened.

While the markets will likely react positively next week to the news that ‘talks will continue,’ the impact of existing tariffs from both the U.S. and China continue to weigh on domestic firms and consumers.

More importantly, while the continued ‘jawboning’ may keep ‘hope alive’ for investors temporarily, these two countries have been ‘talking’ for over a year with little real progress to show for it outside of superficial agreements.

Importantly, we have noted that Trump would eventually ‘cave’ into the pressure from the impact of the ‘trade war’ he started.

The reasons, which have been entirely overlooked by the media, is that China’s goals are very different from the U.S. To wit:

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk-off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 4-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

As noted in the second point above, on Friday, Trump caved to get the “Trade Deal” off the table before the election. As noted in September, China had already maneuvered Trump into a losing position.

“China knows that Trump needs a way out of the “trade war” he started, but that he needs something he can “boast” as a victory to a largely economically ignorant voter base. Here is how a “trade deal” could get done.

Understanding that China has already agreed to 80% of demands for a trade deal, such as buying U.S. goods, opening markets to U.S. investors, and making policy improvements in certain areas, Trump could conclude that ‘deal’ at the October meeting.”

Read the highlighted text above and compare it to the statement from  the WSJ: on Thursday:

“The U.S. side has demanded Beijing make firm commitments to purchase large quantities of U.S. agricultural and other products, better protect U.S. intellectual-property rights and widen access to China’s financial-services sector.”

What is missing from the agreement was the most critical 20%:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

These are the “big ticket” items that were the bulk of the reason Trump launched the “trade war” to begin with. Unfortunately, for China, these items are seen as an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program.

The USTR did note that the Phase One deal:

“Requires structural reforms and other changes to China’s economic and trade regime in the areas of intellectual property, technology transfer, agriculture, financial services, and currency and foreign exchange.”

However, since there is no actual enforcement mechanism besides merely pushing tariffs back to where they were, none of this will be implemented.

All of this aligns with our previous suggestion the only viable pathway to a “trade deal” would be a full surrender.

“However, Trump can set aside the last 20%, drop tariffs, and keep market access open, in exchange for China signing off on the 80% of the deal they already agreed to.”

Which is precisely what Trump agreed to.

This Is The Only Deal

This is NOT a “Phase One” trade-deal.

This is a “Let’s get a deal on the easy stuff, call it a win, and go home,” deal.

It is the strategy we suggested was most likely:

“For Trump, he can spin a limited deal as a ‘win’ saying ‘China is caving to his tariffs’ and that he ‘will continue working to get the rest of the deal done.’ He will then quietly move on to another fight, which is the upcoming election, and never mention China again. His base will quickly forget the ‘trade war’ ever existed.

Kind of like that ‘Denuclearization deal’ with North Korea.”

Speaking of the “fantastic deal with N. Korea,” here is the latest on that failed negotiation:

“Reuters reported Thursday via Korean Central News Agency (KCNA) that, even if denuclearization talks resumed between both countries, the Trump administration has nothing to offer.

North Korea’s foreign ministry criticized the Trump administration for meeting with officials at the UN Security Council and suggested that it would be ready to respond to any corresponding measures that Washington imposes. ‘The United States said about corresponding measure at the meeting, as we have said we have nothing to lose and we are ready to respond to any corresponding measure that the US chooses,’ said KCNA citing a North Korean Foreign Ministry spokesperson.”

While Trump has announced he will begin to “immediately” work on “Phase Two,” any real agreement is highly unlikely. However, what Trump understands, is that he gets another several months of “tweeting” a “trade deal is coming” to keep asset markets buoyed to support his re-election campaign.

Not Really All That Amazing

While Trump claimed this was an “amazing deal” with China, and that America’s farmers need to get ready for a $50 billion surge in agricultural exports, neither is actually the case.

China did not agree to buy any specific amount of goods from the U.S. What they said was, according to Bloomberg, was:


Furthermore, there is speculation the agreement is primarily verbal in terms of purchases, and the actual agreement of the entire trade deal will never be made public.

But let’s put some hard numbers to this.

Currently, China is buying about $10 billion of farm produce in 2018. That is down from a peak of $25 billion in 2012, which was long before the trade war broke out.

Since the trade war was started, China has sourced deals from Brazil and Argentina for pork and soybeans to offset the shortfall in imports from the U.S. These agreements, and subsequent imports, won’t be cancelled to shift to the U.S. since at any moment Trump could reinstate tariffs.

More importantly, as noted by Zerohedge on Friday, if this “deal” was as amazing as claimed, the agricultural commodity index should be screaming higher.

Importantly, even if China agrees to double their exports in the coming year, which would be a realistic goal, it would only reset the trade table to where it was before the tariffs started.

While China may have “agreed” to buy more, it is extremely unlikely China will meet such levels. Given they have already sourced products from other countries, they will import what they require.

Since most don’t pay attention to the long-game, while there will be excitement over a short-term uptick in agricultural purchases, those purchases will fade. However, with time having passed, and the focus of the media now elsewhere, Trump will NOT go back to the table and restart the “trade war” again. As I wrote on May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations. What the current administration fails to realize is that China is not operating from short-term political-cycle driven game plan.

As we stated in Art Of The Deal vs. The Art Of War:”

“While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

Trump lost the “trade war,” he just doesn’t realize it, yet.

No More “Trade Tweets?”

Since early 2018, and more importantly since the December lows of last year, the market has risen on the back of continued “hopes” of Federal Reserve easing, and the conclusion of a “trade deal.”

With the Fed now signaling that they are effectively done lowering rates through next year, and President Trump concluding a “trade deal,” what will be the next driver of the markets. While will the “algo’s” do without daily “trade tweets” to push stock markets higher?

While I am a bit sarcastic, there is also a lot of truth to the statement.

However, what is important is that while the Trump administration are rolling back 50% of the tariffs, they are not “removing” all of them. This means there is still some drag being imposed by tariffs, just at a reduced level.

More importantly, the rollback of tariffs do not immediately undo the damage which has already occurred.

  • Economic growth has weakened globally
  • Corporate profit growth has turned negative.
  • Tax cuts are fully absorbed into the economy
  • The “repo” market is suggesting that something is “broken.”
  • All of which is leading to rising recession risk.

In other words, while investors have hung their portfolios hopes of a “trade deal,” it may well be too little, too late.

Over the next couple of months, we will be able to refine our views further as we head into 2020. However, the important point is that since roughly 40% of corporate profits are a function of exports, the damage caused already won’t easily be reversed.

Furthermore, the Fed’s massive infusions of liquidity into the overnight lending market signal that something has “broken,” but few are paying attention.

Our suspicion is that the conclusion of the “trade deal” could well be a “buy the rumor, sell the news” type event as details are likely to be disappointing. Such would shift our focus from “risk taking” to “risk control.” Also, remember “cash” is a valuable asset for managing uncertainty.

With the market pushing overbought, extended, and bullish extremes, a correction to resolve this condition is quite likely. The only question is the cause, depth, and duration of that corrective process. 

I am not suggesting you do anything, but just something to consider when the media tells you to ignore history and suggests “this time may be different.” 

That is usually just about the time when it isn’t.

Is Inflation Really Under Control

Recently, analysts have been discussing the pros and cons of using negative interest rates to keep the U.S. economy growing.  Despite this, Fed Chairman Jerome Powell has said that he does not anticipate the Federal Reserve will implement a policy of negative interest rates as it may be detrimental to the economy.  One argument against negative interest rates is that they would squeeze bank margins and create more financial uncertainty. However, upon examining the actual rate of inflation we are likely already in a ‘de facto’ negative ­­interest rate environment. Multiple inflation data sources show that actual inflation maybe 5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data points to understand why there is such a divergence between the Fed assumptions that inflation is under control versus the much higher rate of price hikes consumers experience.

In October, the Bureau of Labor Statistics (BLS) reported that the core consumer price index (CPI) grew by 2.2% year over year.  The core CPI rate is the change in the price of goods and services minus energy and food.  Energy and food are not included because they are commodities and trade with a high level of volatility.  However, the Median CPI shows a ten year high at 2.96% and upward trend as we would expect, though it starts at a lower level than other inflation indicators. The Median CPI excludes items with small and large price changes.

Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19

Excluding key items that have small and large price changes is not what a consumer buying experience is like. Consumers buy based on immediate needs. When a consumer drives up to a gas pump, they buy at the price listed on the pump that day.  Consumers buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the food. Recent consumer purchase research shows that prices of many goods and services continue to increase at a rate much higher than 2.2%.

Gordon Haskett Research Advisors conducted a study by purchasing a basket of 76 typical items consumers buy at Walmart and Target.  The study showed that from June 2018 to June 2019, prices increased about 5%. 

Sources: Gordon Haskett Research Advisors, Bloomberg – 8/10/19

Walmart and Target are good proxies for consumer buying experiences. Walmart is the largest retailer in the U.S. with over 3,000 locations marketing to price-conscious consumers. Target has 1,800 locations in the U.S. and is focused on a similar consumer buyer profile, though a bit less price sensitive. Importantly, both Walmart and Target have discount food sections in their stories.

Housing has been rapidly increasing in cost as well.  Rental costs have soared in 2019 as the following chart shows a month over month shift to .45%, which is an annualized rate of 5.4%.

Sources: Bureau of Labor Statistics, Nomura – 5/13/19

The costs of other services like health care and education have increased dramatically as well. Service sectors, which make up 70% of the U.S. economy, are where wages are generally higher than in manufacturing sectors. Techniques to increase service productivity have been slow to implement due to service complexity. Without productivity gains, prices have continued to rise in most services sectors.

Sources: Deutsche Bank – 11/14/19

Medical care costs have increased by 5.2% per year, and education costs have risen 6.8 % per year. Wages of non-supervisory and production workers have fallen behind at 3.15 % increase per year. Note that the overall CPI rate significantly underestimates the rate of costs in these basic consumer services, likely due to underweighting of services in the cost of living calculation.

For many consumers, housing, utilities, health care, debt payments, clothing, and transportation comprise their major expenses. Utility and clothing costs have generally declined. While transportation, housing, and health care costs have increased.  The rate of new car annual inflation was as low as 1 percent in 2018.  Yet, according to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019. The soaring price of vehicles has caused auto loans to be extended out to 7 or 8 years, in some cases beyond the useful life of the car. 

Dealers are financing 25% of new car purchases with ‘negative equity deals’ where the debt from a previous vehicle purchase is rolled into the new loan.  The October consumer spending report shows consumer spending up by .3% yet durable goods purchases falling by .7% primarily due to a decline in vehicle purchases.  A 4.2% increase in vehicle prices year over year is unsustainable for most buyers and indicates likely buyer price resistance resulting in falling sales. The October durables sales decline could have been anticipated if inflation reporting was based on actual consumer purchasing experiences.

The trade wars with China, Europe, and other countries are contributing to significant price increases for consumer goods.  Tariffs have driven consumer prices higher for a variety of product groups, including: appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports vehicles, housekeeping supplies, and sewing equipment.

Sources: Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot – 5/13/19

In the chart above, prices increased by about 3.5% over 16 months before mid-May 2019. As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices will likely continue to rise. The President has announced new tariffs of 15% on $160 billion of Chinese consumer goods for December 15th if a Phase One deal is not signed. On December 2nd, he announced resuming tariffs on steel and aluminum imports from Argentina and Brazil and 100 % tariffs on $2.4 billion of French goods. The implementation of all these tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying inflationary trend that is being under-reported by government agencies.

Evidently, the prices for goods and services that consumers experience are vastly different from what the federal government reports and uses to establish cost of living increases for programs like Social Security. So, why is there a disconnect between the government CPI rate of 2.2% and consumer reality of inflation at approximately 5%?  The raw data that the Bureau of Labor Statistics (BLS) uses to calculate the CPI rate is not available to the public.  When a Forbes reporter asked the BLS why the data was not available to the public the BLS response was companies could ‘compare prices’. This assumption does not make sense as companies can compare prices on the Internet, in stores, or find out from suppliers. The ‘basket of consumer items’ approach was discontinued in the 1980s for a ‘cost of living’ index based on consumer buying behaviors. There was political pressure to keep the inflation rate low. If real inflation figures were reported the government would have to increase payments to Social Security beneficiaries, food stamp recipients, military and Federal Civil Service retirees and survivors, and children on school lunch programs.  Over the past 30 years the BLS has changed the calculation at least 20 times, but due to data secrecy there is no way to audit the results. The BLS tracks prices on 80,000 goods and services based on consumer spending patterns, not price changes on goods and services per se.  For example, if consumers substitute another item for a higher-priced one it is discontinued in the calculation. 

Economist John Williams has calculated inflation rates based upon the pre-1980s basket approach versus the cost of living formula used by BLS today.  His findings show a dramatically higher rate of inflation using the 1980s formula.

Source: Shadow Government – 10/2019

His calculation using the earlier basket formula sets the present inflation rate at nearly 10%.  Based on our research on various price reporting services, we think the real consumer inflation rate is probably about 5 to 6%.

The implications of this gap between real inflation and reported inflation rates are profound and far-reaching.  Federal Reserve complacency about a low inflation rate to justify a low Fed Funds rates is called into question. In fact the economic reality of today is we are living in a 3.25%  ‘de facto’ negative interest rate environment where the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity pumping into the economy, based in part on low inflation, is overheating risk assets while providing support for corporate executives to take on debt at decade record levels.

Building the economic framework on erroneous inflation data versus the reality for consumers and businesses lead to massive financial dislocations. This economic bubble is unsustainable and will require a brutal recession to rebalance the economy.  As part of a possible soft ‘landing’ policy, the BLS could make price data available to all economists. Full data access will provide an opportunity for objective comments and feedback based on other consumer price research.

The Fed actually focuses on the even lower Personal Consumption Expenditure rate of 1.6% reported by the Bureau of Economic Analysis for October. The Fed prefers the PCE rate because a consumer survey technique is used, while economists prefer the CPI, which is more granular so it is easier to identify goods and services categories that are driving inflation. Using unrealistically low inflation assumptions leads to misguided policy decisions and perpetuation of the myth that inflation is under control. Yet, in fact inflation it is out of control due to extremely low Fed interest rates, liquidity injections, and trade war tariffs.

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

Technically Speaking: It’s Crazy, But We’re Adding Equity Risk

In last week’s update, I discussed the case of why it was “now or never” for the bulls to take control of the market. To wit:

  • The ECB announced more QE
  • The Fed reduced capital requirements and initiated QE
  • The Fed is cutting rates
  • A “Brexit Deal” has been reached.
  • Trump, as expected, caved into China
  • Economic data is improving
  • Stock buybacks

If you are a bull, what is there not to love? 

Despite a long laundry list of concerns, as stated, we remain equity biased in our portfolio models currently for two primary reasons:

  1. The trend remains bullishly biased, and;
  2. We are now entering into the historically stronger period of the investment year.

With the volatile summer now behind us, being underweight equities paid off. As I discussed in Trade War In May & Go Away:

“It is a rare occasion the markets don’t have a significant intra-year correction. But it is a rarer event not to have a correction in a year where extreme deviations from long-term moving averages occurs early in the year. Currently, the market is nearly 6% above its 200-dma. As noted, such deviations from the norm tend not to last long and “reversions to the mean” occur with regularity.”

Of course, we saw corrections occur in June, August, and September with little gain to show for it.  The point, of course, is the avoidance of risk, which tends to occur more often that not during the summer months, allows us to adhere to our longer-term investment goals.

The data bears out the risk/reward of summer months:

“The chart below shows the gain of $10,000 invested since 1957 in the S&P 500 index during the seasonally strong period (November through April) as opposed to the seasonally weak period (May through October).”

It is quite clear that there is little advantage to be gained by being aggressively allocated during the summer months. More importantly, there are few individuals that can maintain a strict discipline of only investing during seasonally strong periods consistently due to the inherent drag of psychology, leading to performance chasing. 

Seasonal Strong Period Approaches

Readers are often confused by our more bearish macro views on debt, demographics, and deflation, not to mention valuations, which will impair portfolio returns over the next decade versus our more bullish bias toward equities short-term. That is understandable since the media wants to label everyone either a “bull” or a “bear.”

However, markets are not binary. Being a bear on a macro-basis doesn’t mean you are only allowed to hold cash, gold, and stock in “beanie-weenies.” Conversely, being “bullish” on equities, doesn’t necessarily mean an exclusion of all other assets other than equities.

As we wrote to our RIAPRO Subscribers yesterday (30-day FREE Trial) there is a definitive positive bias to the markets currently.

“We are maintaining our core equity positions for now as the bullish trend remains intact. As noted in this past weekend’s newsletter, the bulls have control of the narrative for now. With the “sell signal” reversed, there is a positive bias. However, without the market breaking out to new highs, it doesn’t mean much, especially given the market is pushing back into an overbought condition. We will wait for a confirmation breakout to add to our core equity holdings as needed.

This doesn’t mean we have “thrown in the towel.”

We remain bearish on the long-term returns due to mountains of historical evidence that high valuations, coupled with excess leverage, and slow economic growth generate low returns over very long-periods of time. However, we are also short-term bullish on equity-risk because of stock buybacks, momentum, Central Bank interventions, and seasonality. Also, sentiment has gotten short-term very negative.

Money flows have also been negative even as the market has been climbing. This is due primarily to the surge in share repurchases, but still remains a contrarian indicator.

While it may seem “crazy,” it is for these reasons, despite the longer-term bearish backdrop, that we need to “gradually” and “incrementally” increase exposure for the next couple of months. Importantly, I did not say leverage up and buy speculative investments. I am suggesting a slight increase in exposure toward equity risk, as opportunity presents itself, until we have an allocation model that both hedges longer-term risks, but can take advantage of shorter-term bullish cycles.

There is no guarantee, of course, which is why investing is about managing risk. In the short-term the bulls have control of the market, and seasonal tendencies suggest higher asset prices by year-end.

Is that a guarantee? Absolutely not.

However, statistical analysis clearly suggests probabilities outweigh the possibilities. Longer-term, statistics also state prices will take a turn for the worse. However, as portfolio managers, we can’t sit around waiting for something to happen. We have to manage portfolios for what is happening now. It is always the timing that is the issue, and history shows there will be little warning, fanfare, or acknowledgment that something has changed.

That is why we manage for “risk.” The risk of the unknown, unexpected, exogenous event which unwinds markets in a sharp, and unforgiving fashion. This risk is increased by factors not normally found in “bullishly biased” markets:

  1. Weakness in revenue and profit growth rates
  2. Stagnating economic data
  3. Deflationary pressures
  4. High levels of margin debt
  5. Expansion of P/E’s (5-year CAPE)

How To Play It

With the markets currently in extreme intermediate-term overbought territory and encountering a significant amount of overhead resistance, it is likely that the current “hope driven” rally is likely near an intermediate-term top, which could be as high as 3300.

Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.”

For individuals with a short-term investment focus, pullbacks in the market can be used to selectively add exposure for trading opportunities. However, such opportunities should be done with a very strict buy/sell discipline just in case things go wrong.

Longer-term investors, and particularly those with a relatively short window to retirement, the downside risk still far outweighs the potential upside in the market currently. Therefore, using the seasonally strong period to reduce portfolio risk, and adjust underlying allocations, makes more sense currently. When a more constructive backdrop emerges, portfolio risk can be increased to garner actual returns rather than using the ensuing rally to make up previous losses. 

I know, the “buy and hold” crowd just had a cardiac arrest. However, it is important to note that you can indeed “opt” to reduce risk in portfolios during times of uncertainty.

For More Read: “You Can’t Time The Market?”

On a positioning basis, the market has been heavily skewed into defensive positioning, which is beginning to rotate back towards more cyclical exposures. Materials, Industrials, Healthcare, Small, and Mid-Caps will likely perform better. 

This is not a market that should be trifled with, or ignored. With the current market, and economic cycle, already very long by historical norms, the deteriorating backdrop is no longer as supportive as it has been.

Our portfolios have been primarily long-biased for the last few years. While it may seem a “little crazy” to be adding “equity risk” to the markets currently, we are doing so with a very strict buy/sell discipline in place and are carrying very tight stop-losses.

There is more than a significant possibility that I will be writing in a month, or two, about why we are reducing risk. But this is just how portfolio management works. No one can predict the future, we can only manage the amount of “risk” we undertake.

Technically Speaking: Bulls Get QE & Trade, Remain “Stuck In The Middle”

“Clowns to the left of me,
Jokers to the right, here I am,
Stuck in the middle with you” – Stealers Wheels


The lyrics seem apropos considering we have Trump, China, Mnuchin, the Fed, along with a whole cast of colorful characters making managing money a difficult prospect recently. 

However, the good news is that over the last month, the bulls have had their wish list fulfilled.

  • The ECB announces more QE and reduces capital constraints on foreign banks.
  • The Fed reduces capital requirements on banks and initiates $60 billion in monthly treasury purchases.
  • The Fed is also in the process of cutting rates as concerns over economic growth remain.
  • Trump, as expected, caves into China and sets up an exit from the “trade deal” nightmare he got himself into. 
  • Economic data is improving on a comparative basis in the short-term.
  • Stock buybacks are running on pace to be another record year.  (As noted previously, stock buybacks have accounted for almost 100% of all net purchases over the last couple of years.)

If you are a bull, what is there not to love?

However, as I noted in this past weekend’s newsletter. (Subscribe for free e-delivery)

“Despite all of this liquidity and support, the market remains currently confined to a downtrend from the September highs. The good news is there is a series of rising lows from June. With a ‘risk-on’ signal approaching and the market not back to egregiously overbought, there is room for the market to rally from here.”

As the tug-of-war between the “bulls” and “bears” continues, the toughest challenge continues to be understanding where we are in the overall market process. The bulls argue this is a “consolidation” process on the way to higher highs. The bears suggest this is a “topping process” which continues to play out over time. 

As investors, and portfolio managers, our job is not “guessing” where the market may head next, but rather to “navigate” the market for what is occurring. 

This is an essential point because the majority of investors are driven primarily by two psychological behaviors: herding and confirmation bias. (Read this for more information.)

Since the market has been in a “bullish trend” for the last decade, we tend to only look for information that supports our “hope” the markets will continue to go higher. (Confirmation Bias) 

Furthermore, as we “hope” the market will go higher, we buy the same stocks everyone else is buying because they are going up. (Herding)

Here is a perfect example of these concepts in action. The chart below shows the 4-week average of the spread between bullish and bearish sentiment according to the respected AAII investor survey. Currently, investors are significantly bearish, which has historically been an indicator of short-term bottoms in the market. (contrarian indicator)

If you assumed that with such a level of bearishness, most investors would be sitting in cash, you would be wrong. Over the last couple of months as concerns of trade, earnings, and the economy were brewing, investors actually “increased” equity risk in portfolios with cash at historically low levels.

This is a classic case of “bull market” conditioning.  

We can also see the same type of “bullish” positioning by looking at Rydex mutual funds. The chart below compares the S&P 500 to various measures of Rydex ratios (bear market to bull market funds)

Note that during the sell-off in December 2018, the move to bearish funds never achieved the levels seen during the 2015-2016 correction. More importantly, the snap-back to “complacency” has been quite astonishing. 

While investors are “very concerned” about the market (ie bearish in their sentiment) they are unwilling to do anything about it because they are afraid of “missing out” in the event the market goes up. 

Therein lies the trap.

By the time investors are convinced they need to sell, the damage has historically already been done. 

Stuck In The Middle

Currently, the market is continuing to wrestle with a rising number of risks. My friend and colleague Doug Kass recently penned a nice laundry list:

  1.  The Fed Is Pushing On A String: A mature, decade old economic recovery will not likely be revived by more rate cuts or by lower interest rates. The cost and availability of credit is not what is ailing the U.S. economy. Market participants are likely to lose confidence in the Fed’s ability to offset economic weakness in the year ahead.
  2. Untenable Debt Loads in the Private and Public Sectors: Katie Bar The Doors should rates rise and debt service increase. (As I noted all week, the corporate credit markets are already laboring and, in some cases, are freezing up).
  3. An Unresolved Trade War With China: This will produce a violent drop in world trade, a freeze in capital spending, and a quick deterioration in business and consumer sentiment.
  4. The Global Manufacturing Recession Is Seeping Into The Services Sector: After years of artificially low rates, the consumer is no longer pent up and is vulnerable to more manufacturing weakness.
  5. The Market Structure is Frightening: The proliferation of popularity of ETFs when combined with quantitative strategies (e.g., risk parity) have everyone on the same side on the boat and in the same trade (read: long). The potential for a series of “Flash Crashes” hasn’t been so high as since October, 1987.
  6. We Are at an All Time Low in Global Cooperation and Coordination: In our flat and interconnected world, what happens to global economic growth when the wheels fall off?
  7. We Are Already In An “Earnings Recession”: I expect a disappointing 3Q reporting period ahead. What happens when the rate of domestic and global economic growth slows more dramatically and a full blown global recession emerges?
  8. Front Runner Status of Senator Warren: Most view a Warren administration as business, economy and market unfriendly.
  9. Valuations on Traditional Metrics (e.g., stock capitalizations to GDP) Are Sky High: This is particular true when non GAAP earnings are adjusted back to GAAP earnings!
  10. Few Expect That The Market Can Undergo A Meaningful Drawdown: There is near universal belief that there is too much central bank and corporate liquidity (and other factors) that preclude a large market decline. It usually pays to expect the unexpected.
  11. The Private Equity Market (For Unicorns) Crashes and Burns: Softbank is this cycle’s Black Swan.
  12. WeWork’s Problems Are Contagious: The company causes a massive disruption in the U.S. commercial real estate market.

Don’t take this list of concerns lightly. 

The market rallied from the lows of December on “hopes” of Fed rate cuts, QE, and a “trade deal.” As we questioned previously, has the fulfillment of the bulls “wish list” already been priced in? However, since then, the market has remained stuck within a fairly broad trading range between previous highs and the 200-dma. 

Notice the negative divergence between small-capitalization companies and the S&P 500. This is symptomatic of investors crowding into large-cap, highly liquid companies, as they are “fearful” of a correction in the market, but are “more fearful” of not being invested if the market goes up. 

This is an important point when managing money. The most important part of the battle is getting the overall “trend” right. “Buy and hold” strategies work fine in rising price trends, and “not so much” during declines.

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

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

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

The chart below is one of my favorites. It is a quarterly chart of several combined indicators which are excellent at denoting changes to overall market trends. The indicators started ringing alarm bells in early 2018, when I begin talking about the end of the “bull market” advance. However, that correction, as noted, was quickly reversed by the Fed’s changes in policy and “hopes” of an impending “trade deal.”

Unfortunately, what should have been a larger corrective process to set up the next major bull market, instead every single indicator has reverted back to warning levels.

If the bull market is going to resume, the market needs to break above recent highs, and confirm the breakout with expanding volume and participation in both small and mid-capitalization stocks which have been sorely lagging over the past 18-months.

However, with earnings and economic growth weakening, this could be a tough order to fill in the near term.

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

Technically Speaking: This Is Nuts & The Reason To Focus On Risk

Since the lows of last December, the markets have climbed ignoring weakening economic growth, deteriorating earnings, weak revenue growth, and historically high valuations on “hopes” that more “Fed rate cuts” and “QE” will keep this current bull market, and economy, alive…indefinitely.

This is at least what much of the media suggests as noted recently by Rex Nutting via MarketWatch:

“‘Recessions are always hard to predict,’ says Lou Crandall, chief economist for Wrightson ICAP, who’s been watching the Fed and the economy for three decades. But after looking deeply into the economic data, he concludes that ‘there’s no reason’ for the economy to topple into recession. The usual suspects are missing. For instance, there’s no inventory overhang, nor is monetary policy too tight.”

Since the financial markets tend to lead the economy, he certainly seems to be correct. 

However, a look at the economic data indeed suggests that something has gone wrong in the economy in recent months. The latest Leading Economic Index (LEI) report showed continued weakness along with a myriad of economic data points. The chart below is the RIA Economic Composite Index (a comprehensive composite of service and manufacturing data) as compared to the LEI.

The downturn in the economy shouldn’t be surprising given the current length of the overall expansion. However, the decline in the LEI also is coincident with weaker rates of profit growth.

This also should be no surprise given the companies that make up the stock market are dependent on consumers to spend money from which they derive their revenue. If the economy is slowing down, revenue and corporate profit growth will decline also. 

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

This is nuts!

Lastly, given the economic weakness, as noted above, is going to continue to depress forward reported earnings estimates. As I noted back in May, estimates going into 2020 have already started to markedly decline (primarily so companies can play “beat the estimate game,”) 

For Q4-2020, estimates have already fallen by almost $10 per share since April, yet the S&P 500 is still near record highs. 

As we discussed in this past weekend’s newsletter, it all comes down to “hope.” 

“Investors are hoping a string of disappointing economic data, including manufacturing woes and a slowdown in job creation in the private sector, could spur a rate cut. Federal funds futures show traders are betting on the central bank lowering its benchmark short-term interest rate two more times by year-end, according to the CME Group — a welcome antidote to broad economic uncertainty.” – WSJ

Hope for:

  • A trade deal…please
  • More Fed rate cuts
  • More QE

The reality, of course, is that as investors chase asset prices higher, the need to “rationalize,” a byproduct of the “Fear Of Missing Out,” overtakes “logic.” 

As we also discussed this past weekend, the backdrop required for the Fed to successfully deploy “Quantitative Easing” doesn’t exist currently. 

The critical point here is that QE and rate reductions have the MOST effect when the economy, markets, and investors have been ‘blown out,’ deviations from the ‘norm’ are negatively extended, and confidence is extremely negative.

In other words, there is nowhere to go but up.

Such was the case in 2009. The extremely negative environment that existed, particularly in the asset markets, provided a fertile starting point for monetary interventions. Today, the backdrop could not be more diametrically opposed.”

If we are correct, investors who are dependent on QE and rate cuts to continue to support markets could be at risk of a sudden downturn. This is because the entire premise is based on the assumption that everyone continues to act in the same manner.  This was a point we discussed in the Stability/Instability Paradox:

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 an avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

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

Unfortunately, that has never been the case.

The behavioral biases of individuals is one of the most serious risks facing the Fed. Throughout history, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.

This time is unlikely to be different.

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

The correction over the last couple of months has done little to correct these extensions, and valuations have become more expensive as earnings have declined. 

Yes,. the bullish trend remains clearly intact for now, but all “bull markets” end….always.

Given that “prices are bound by the laws of physics,” the chart below lays out the potential of the next reversion.

This chart is NOT meant to “scare you.”

It is meant to make you think.

While prices can certainly seem to defy the law of gravity in the short-term, the subsequent reversion from extremes has repeatedly led to catastrophic losses for investors who disregard the risk.

There are substantial reasons to be pessimistic about the markets longer-term. Economic growth, excessive monetary interventions, earnings, valuations, etc. all suggest that future returns will be substantially lower than those seen over the last eight years. Bullish exuberance has erased the memories of the last two major bear markets and replaced it with “hope” that somehow, “this time will be different.”

Maybe it will be.

Probably, it won’t be.

The Reason To Focus On Risk

Our job as investors is to navigate the waters within which we currently sail, not the waters we think we will sail in later. Higherer returns are generated from the management of “risks” rather than the attempt to create returns by chasing markets. 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.”

We must be able to recognize, and be responsive to, changes in underlying market dynamics if they change for the worse and be aware of the risks that are inherent in portfolio allocation models. The reality is that we can’t control outcomes. The most we can do is influence the probability of certain outcomes which is why the day to day management of risks and investing based on probabilities, rather than possibilities, is important not only to capital preservation but to investment success over time.

Just something to consider.

Technically Speaking: The Risk To The Bullish View Of Trade Deal

In this past weekend’s newsletter, I discussed the bullish view of a trade deal with China. 

“Assuming we are correct, and Trump does indeed ‘cave’ into China in mid-October to get a ‘small deal’ done, what does this mean for the market. 

The most obvious impact, assuming all ‘tariffs’ are removed, would be a psychological ‘pop’ to the markets which, given that markets are already hovering near all-time highs, would suggest a rally into the end of the year.” 

This is not the first time we presented our analysis for a “bull run” to 3300. To wit:

“The Bull Case For 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • Trade Deal”

While I did follow those statements up with why a “bear market” is inevitable, I didn’t discuss the issue of what happens is Trump decides to play hardball and the “trade negotiations” fall apart. 

Given Trump’s volatile temperament, this is not an unlikely “probability.” Also, there is more than just a little pressure from his base of voters to press for a bigger deal.

As I noted, China cannot agree to the biggest issues which have stalled negotiations so far:

  • Cutting the share of the state in the overall economy from 38% to 20%,
  • Implementing an enforcement check mechanism; and,
  • Technology transfer protections

For China, these items are an infringement on its sovereignty, and requires a complete abandonment the “Made in China 2025” industrial policy program. This is something that President Xi is extremely unlikely to do, particularly for a U.S. President who is in office for a maximum of 4-more years. 

Of course, if talks break down, there are two potential outcomes investors need to consider for the portfolio:

  1. Everything remains status quo for now and more talks are scheduled for a future date, or;
  2. Talks breakdown and both countries substantially increase tariffs on their counterparts. 

Given that current tariffs are weighing on Trump’s supporters in the Midwest, and both Silicon Valley and retail’s corporate giants have pressured Trump not to increase tariffs further, the most probable outcome is the first. 

No Trade Deal,  No New Tariffs

Unfortunately, that outcome does little for the market in the short-term as existing tariffs continue to weigh on corporate profitability, as well as consumption. Given that earnings are already on the decline, the benefits of tax cut legislation have been absorbed, and economic growth is weakening, there is little to boost asset prices higher. 

Therefore, under this scenario, current tariffs will continue to weigh on corporate profitability, but “hopes” for future talks will likely continue to keep markets intact for a while longer. However, as we head into 2020, a potential retracement will likely occur as markets reprice for slower earnings and economic growth.

In this environment, we would continue to expect some underperformance by those sectors most directly related to the current tariffs which would be Basic Materials, Industrials, and Emerging Markets. 

Since the beginning of the “trade war,” these sectors have lagged overall market performance and have been under-weighted in portfolios. We alerted our RIA PRO subscribers to this change in March, 2018:

“We closed out our Materials trade on potential “tariff” risk. Industrials are now added to the list of those on the “watch, wait and see” list with the break below its 50-dma. Tariff risk continues to rise and Larry Kudlow as National Economic Advisor is not likely to help the situation as his ‘strong dollar’ views will NOT be beneficial to these three sectors. Also, we reduced weights in international exposure due to the likely impact to economic growth from ‘tariffs’ on those markets which have continued to weaken again this week.”

That advice turned out well as those sectors have continued to languish in terms of relative performance since then.

Furthermore, a “no trade deal, no tariff change” outcome does little to change to the current deterioration of economic data. As we showed just recently, our Economic Output Composite Index has registered levels that historically denote a contractionary economy. 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)”

No Trade Deal Plus New Tariffs

The second outcome is more problematic.

In this scenario, Trump allows emotion to get the better of him, and he blows up at the meeting. In a swift retaliation, he reinstates the “tariffs” on discretionary goods, and increases tariffs across the board as a punitive measure. The Chinese, in an immediate retaliation levy additional tariffs as well. 

With both sides now fully entrenched in the trade war, the market will lose faith in the ability to get a “deal” done. The increased tariffs will immediately be factored into earnings forecast, and the market will begin to reprice for a more negative outcome. 

In this scenario, Basic Materials, Industrials, Emerging, and International Markets will continue to be the most impacted and should be avoided. Because of the new tariffs which will directly impact discretionary purchases, Technology and Discretionary sectors should also likely be under-weighted. 

The increase in tariffs is also going to erode both consumer and economic confidence which have remained surprisingly strong so far. However, once the consumer is more directly affected by tariffs, that confidence, along with related consumption, will fade. 


What About Bond Yields And Gold

In both scenarios above, a “No Trade Deal” outcome will be beneficial for defensive positioning in portfolios. Gold and bond yields have already performed well this year, but if trade talks fall through, there will be a rotation back to the “safe haven” trade as equity prices potentially weaken. This is specifically the case in the event our second outcome comes to fruition. 

While bond yields are overbought currently, it is quite likely we could see yields fall below 1%. Also, given the large outstanding short-position in bonds, as discussed recently, there is plenty of “fuel” to push rates lower.

“Combined with the recent spike in Eurodollar positioning, as noted above, it suggests that there is a high probability that rates will fall further in the months ahead; most likely in concert with the onset of a recession.”

As I noted, there is no outcome that ultimately avoids the next bear market. The only question is whether moves by the Administration on trade, combined with the Fed cutting rates, retards or advances the timing. 

“Furthermore, given the markets never reverted to any meaningful degree, higher prices combined with weaker earnings growth, has left the markets very overvalued, extended, and overbought from a historical perspective.”

Our long-term quarterly indicator chart has aligned to levels that have previously denoted more important market tops. (Chart is quarterly data showing 2-standard deviations from long-term moving averages, valuations, RSI indications above 80, and deviations above the 3-year moving average)

While we laid out the “bullish case” of 3300 over the weekend, it would not be wise to dismiss the downside risk given how much exposure to the “trade meeting” is currently built into market prices. 

We are assuming that Trump wants a “deal done” before the upcoming election, which should also help temporarily boost economic growth, but there remains much that could go wrong. An errant “tweet,” a “hot head,” or merely a breakdown in communications, could well send markets careening lower.

Given that downside risk outweighs upside reward at this juncture by almost 3 to 1, in remains our recommendation to rebalance risk, raise some cash, and hedge long-equity exposure in portfolios for now. 

This remains a market that continues to under-price risk.

Technically Speaking: How To Safely Navigate A Late Stage Bull Market

In this past weekends newsletter, I discussed the issues surrounding “dollar cost averaging” and “buy and hold” investing. That discussion always raises some debate because there is so much pablum printed in the mainstream media about it. As we discussed:

“Yes, a ‘buy and hold’ portfolio will grow in the financial markets over time, but it DOES  NOT compound. Read this carefully: “Compound returns assume no principal loss, ever.”

To visualize the importance of this statement, look at the chart below of $100,000, adjusted for inflation, invested in 1990 versus a 6% annual compound rate of return. The shaded areas show whether the portfolio value exceeds the required rate of return to reach retirement goals.”

“If your financial plan required 6% “compounded” annually to meet your retirement goals; you didn’t make it.”

Does this mean you should NEVER engage in “buy and hold” or “dollar-cost averaging” with your portfolio?

No. It doesn’t.  

However, as with all things in life, there is a time and place for application. 

As shown above, when markets are rising, holding investments and adding to them is both appropriate and beneficial as the general trend of prices is rising. 

There is a reason why not a single great trader in history has “buy and hold” as an investment rule. Also, when it comes to DCA, the rule is to never add to losers…ever. 

17. Don’t average trading losses, meaning don’t put ‘good’ money after ‘bad.’ Adding to a losing position will lead to ruin. Ask the Nobel Laureates of Long-Term Capital Management.” – James P. Huprich

That reason is the permanent impairment of investment capital. By investing fresh capital, or holding current capital in risk assets, during a market decline, the ability of the capital to create future returns is destroyed.

“17. Don’t focus on making money; focus on protecting what you have.” – Paul Tudor Jones

Investing is about growing capital over time, not chasing markets. 

This is also why all great traders in history follow the most simplistic of investing philosophies:

“Buy that which is cheap, sell that which is dear” – Ben Graham

It’s Getting Very Late

When trying to navigate markets, and manage your portfolio, you have to have a reasonable assumption of where you within the investment cycle. In other words, as Jim Rogers once quipped:

“It’s hard to buy low and sell high if you don’t know what’s low and what’s high.”

This is the problem that most individuals face during late-stage bull market advances. Following a “bear market,” most individuals have been flushed out of the markets, and conversations of “armchair investing methods” vanish from the financial media.

However, once the “bull market” has lasted long enough, it becomes believed that “this time is different.” It is then you see the return of concepts which are based on the assumption:

“If you can’t beat’em, join’em.” 

That is where we are today and we have created a whole bunch of sayings to support the idea of why markets can’t fall:

  • BTFD – Buy The F***ing Dip
  • TINA – There Is No Alternative
  • The Central Bank Put
  • The Fed Put
  • The Trump Put

You get the idea.

However, there is little argument that valuations are expensive on a variety of measures, as noted by Jill Mislinksi just recently.

Importantly, markets are also grossly extended on a technical basis as well. The chart below shows the S&P 500 on a quarterly basis. Note that the index is pushing rather extreme levels of extension above its very long-term moving average, and is more overbought currently than ever before in history. 

Note that a reversion to its long-term upward trend line would take the market back to 1500 which would wipe out all the gains from the 2007 peak. Such a correction would also set back portfolio returns to about 2% annualized (on a total return basis) from the turn of the century.

As a portfolio manager, however, I can’t sit in cash waiting for a “mean-reverting” event to occur. While we know with absolute certainty that such an event will occur, we don’t know the “when.” Our clients have a need to grow assets for retirement, therefore we must navigate markets for what “is” currently, as well as what “will be” in the future. 

The question then becomes how to add equity exposure to portfolios particularly if one is in a large cash position currently.

How To Add Exposure In A Late Stage Bull Market

The answer is more in line with the age-old question:

“How do you pick up a porcupine? Carefully.”

Here are some guidelines to follow:

  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. (We detail these every week at RIAPRO.)
  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.
  1. 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” if the current market setup is not viable.
  2. There is nothing wrong with CASH. In investing, if you don’t know what to do for certain, do nothing. There is nothing wrong with holding extra cash until you see the “fat pitch.”
  3. 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.

The current rally is built on a substantially weaker fundamental and economic backdrop. Thereforeit is extremely important to remember that whatever increase in equity risk you take, could very well be reversed in short order due to the following reasons:

  1. We are moving into 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
  8. The yield curve is flattening

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 being built to warrant taking 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. “

While it is certainly advisable to be more “bullish” currently, like picking up a “porcupine,” do so carefully.

Technically Speaking: The Risk Of A Liquidity Driven Event

Over the last few days, the internet has been abuzz with commentary about the spike in interest rates. Of course, the belief is that the spike in rates is “okay” because the market are still rising. 

“The yield on the benchmark 10-year Treasury note was poised for its largest weekly rally since November 2016 as investors checked prior concerns that the U.S. was careening toward an economic downturn.” – CNBC

See, one good economic data point and apparently everything is “A-okay.” 

Be careful with that assumption as the backdrop, both economically and fundamentally, does not support that conclusion. 

While the 10-year Treasury rate did pop up last week, it did little to reverse the majority of “inversions” which currently exist on the yield curve. While we did hit the 90% mark on August 28th, the spike in rates only reversed 2 of the 10 indicators we track. 

Nor did it reverse the most important inversion which is the 10-year yield relative to the Federal Reserve rate. 

However, it isn’t the “inversion” you worry about. 

Take a look at both charts carefully above. It is when these curves “un-invert” which becomes the important recessionary indicator. When the curves reverse, the Fed is aggressively cutting rates, the short-end of the yield curve is falling faster than the long-end as money seeks the safety of “cash,” and a recession is emerging.

As I noted in yesterday’s missive on the NFIB survey, there are certainly plenty of warning signs the economy is slowing down. 

 In turn, business owners remain on the defensive, reacting to increases in demand caused by population growth rather than building in anticipation of stronger economic activity. 

What this suggests is an inability for the current economy to gain traction as it takes increasing levels of debt just to sustain current levels of economic growth. However, that rate of growth is on the decline which we can see clearly in the RIA Economic Output Composite Index (EOCI). 

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to GDP and LEI, has provided strong indications of turning points in economic activity. (See construction here)”

“When you compare this data with last week’s employment data report, it is clear that recession” risks are rising. One of the best leading indicators of a recession are “labor costs,” which as discussed in the report on “Cost & Consequences Of $15/hr Wages” is the highest cost to any business.

When those costs become onerous, businesses raise prices, consumers stop buying, and a recession sets in. So, what does this chart tell you?”

There is a finite ability for either consumers or businesses to substantially sustain higher input costs in a slowing economic environment. While debt can fill an immediate spending need, debt does not lead to economic growth. It is actually quite the opposite, debt is a detractor of growth over the long-term as it diverts productive capital from investment to debt service. Higher interest rates equals higher debt servicing requirements which in turns leads to lower economic growth.

The Risk Of Liquidity

In the U.S., we have dismissed higher rates because of a seemingly strong economy. However, that “strength” has been a mirage. As I previously wrote:

“The IIF pointed out the obvious, namely that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. Amusingly, by doing so, this makes rising rates even more impossible as the world’s can barely support 100% debt of GDP, let alone 3x that.”

That illusion of economic growth has kept investors blind to the economic slowdown which is already occurring globally. However, with global bond yields negative, the US Treasury is the defacto world’s risk-free rate. 

If global bond yields rise, by any significant degree, there is a liquidity funding risk for global markets. This is why, as I noted this past week, the ECB acted in the manner it did to increase liquidity to an already illiquid market. The reason, to bail out a systemically important bank. To wit:

We had previously stated the Central Banks are going to act to bail out systemically important banks which are on the brink of failure – namely, Deutsche Bank ($DB) Not surprisingly, this was the same conclusion Bloomberg finally arrived at:

“Deutsche Bank AG will benefit the most by far from the European Central Bank’s new tiered deposit rate. Germany’s largest lender stands to save roughly 200 million euros ($222 million) in annual interest paymentsthanks to a new rule that exempts a big chunk of the money it holds at the ECB from the negative rate the central bank charges on deposits. That’s equivalent to 10% of the pretax profit the analysts expect the bank to report in 2020, compared with an average of just 2.5% for the EU banks included in the analysis.”

When you combine rising yields with a stronger U.S. dollar it becomes a toxic brew for struggling banks and economies as the global cost of capital rising is the perfect cocktail for a liquidity crunch.

Liquidity crunches generally occur when yield curves flatten or invert. Currently, as noted above, the use dollar has been rising, as the majority of yield curves remain inverted. This is a strong impediment for economic growth as funding costs are distorted and the price of exports are elevated. This issue is further compounded when you consider the impact of tariffs on the cost of imports which impacts an already weak consumer. 

Yes, for now the US economy seems to be robust, and defying the odds of a slowdown. However, such always seems to be the case just before the slowdown begins. It is likely a US downturn is closer than most market participants are predicting.

If we are right, this is going to leave the Federal Reserve in a tough position trying to reverse rates with inflation showing signs of picking up, unemployment low, and stocks near record highs.

Concurrently, bond traders are still carrying one of the largest short positions on record, leaving plenty of fuel to drive rates lower as the realization of weaker economic growth and deteriorating earnings collide with rather excessive stock market valuations. 

How low could yields go. In a word, ZERO.

While that certainly sounds implausible at the moment, just remember that all yields globally are relative. If global sovereign rates are zero or less, it is only a function of time until the U.S. follows suit. This is particularly the case if there is a liquidity crisis at some point.

It is worth noting that whenever Eurodollar positioning has become this extended previously, the equity markets have declined along with yields. Given the exceedingly rapid rise in the Eurodollar positioning, it certainly suggests that “something has broken in the system.” 

You can see this correlation to equities more clearly in the chart below. 

Did Something Break?

The rush by the Central Banks globally to ease liquidity, the ECB restarting the QE, and the Federal Reserve cutting rates in the U.S. suggest there is a liquidity problem somewhere in the system. 

Ironically, as I was writing this report, something “broke.” 

“Rising recession concerns in August – manifesting in the form of an inverted yield curve, cash hiding in repo, and a slow build in UST supply – kept secured funding pressures at bay. However, the dollar funding storm we warned about has just made landfall as the overnight general collateral repo rate, an indicator of secured market stress and by extension, dollar funding shortages, soared from Friday’s close of 2.25% to a high of 4.750%, a spike of 250bps…” – Zerohedge

This is likely just a warning for now.

Given the disproportionate role of quant-driven strategies, leveraged traders, and the compounded risk of “passive strategies,” there is profound market risk when rates rise to quickly. If the correlations that underpin the multitude of algo-driven, levered, risk-parity portfolios begin to fail, there is more than a significant risk of a disorderly reversion in asset prices. 

The Central Banks are highly aware of the risks their policies have grown in the financial markets. Years of zero interest rates, massive liquidity injections, and easy financial standards have created the third asset bubble this century. The problem for Central Bankers is the bubble exists in a multitude of asset classes from stocks to bonds, and particularly in the sub-prime corporate debt market.

As Doug Kass noted on Monday, roughly 80% of loan issuers have no public securities (which serves to limit financial disclosure) and 62% of junk issuers have only 144A bonds.

Source: JPM, Bloomberg Barclays, Prequin

However, here is the key point:

“While a paucity of financial disclosure is not problematic during a bull market for credit, it is a defining feature of a liquidity crisis during a bear market. Human beings are naturally inclined towards fear–even panic–when they are unable to obtain the information they deem critical to their (financial) survival.” – Tad Rivelle, TCW

As noted, liquidity is the dominant risk in the multitude of “passive investing products” which are dependent upon the underlying securities that comprise them. As Tad notes:

“There is yet another feature of this cycle, that while not wholly unique will likely play a major supporting role in the next liquidity crisis: the passive fund. Passive funds are the epitome of the low information investor. 

Anyone wonder what might happen should passive funds become large net sellers of credit risk? In that event, these indiscriminate sellers will have to find highly discriminating buyers who–you guessed it–will be asking lots of questions. Liquidity for the passive universe–and thus the credit markets generally–may become very problematic indeed.”

The recent actions by Central Banks certainly suggests risk has risen. Whether this was just an anomalous event, or an early warning, it is too soon to know for sure. However, if there is a liquidity issue, the risk to “uniformed investors” is substantially higher than most realize. As Doug concludes:

“Never before in history have traders and investors been so uninformed. Indeed, some might (with some justification) say that never before in history have traders and investors been so stupid!

But, the conditions of fear and greed have not been repealed — and will contribute to bouts of liquidity changes that range from, and alternate between, where ‘anything goes’ and ‘nothing is believed.’

Arguably, stock and bond prices have veered from the real economy as the cocktail of easing central banks and passive investing strategies produce a constant bid for financial assets, suppresses volatility and, in the fullness of time, will likely cause a liquidity ‘event.’ 

While the absence of financial knowledge, disclosure and the general lack of skepticism are accepted in a bull market, sadly in a bear market (when everyone is “on the same side of the boat,”) it is a defining feature of a liquidity crisis.”

While those in the mainstream media only focus on the level of the S&P 500 index to make the determination that all is right with the world, a quick look from behind the “rose colored” glasses should at least give you a reason pause. 

Risk is clearly elevated, and investors are ignoring the warning signals as markets continue to bid higher.

We saw many of the same issues in 2008 when Bear Stearns collapsed. 

No one paid attention then either.

Technically Speaking: Just How Long Will Markets Keep “Buying” It?

In this past weekend’s newsletter, I broke down the bull/bear argument dissecting the issues of cash on the sidelines, extreme bearishness, equity outflows. However, even though the economic and fundamental environment is not supportive of asset prices at current levels, the primary argument supporting asset prices at current levels is “optimism.” 

“The biggest reason for last week’s torrid stock market rally was rekindled “optimism” that the escalating trade war between the US and China may be on the verge of another ceasefire following phone conversations, fake as they may have been, between the US and Chinese side. This translated into speculation that a new round of tariffs increases slated for this weekend may not take place or be delayed.” – MarketWatch

This, of course, has been the thesis of every rally in the market over the past year. Sven Heinrick summed this up well in a recent tweet. 

However, the “ceasefire” did not happen, and at 12:00 am on Sunday, the Trump administration slapped tariffs on $112 billion in Chinese imports. Then, one-minute later, at 12:01 am EDT, China retaliated with higher tariffs being rolled out in stages on a total of about $75 billion of U.S. goods. The target list strikes at the heart of Trump’s political support – factories and farms across the Midwest and South at a time when the U.S. economy is showing signs of slowing down.

Importantly, the additional tariffs by the White House target consumers directly:

“The 15% U.S. duty hit consumer goods ranging from footwear and apparel to home textiles and certain technology products like the Apple Watch. A separate batch of about $160 billion in Chinese goods – including laptops and cellphones – will be hit with 15% tariffs on Dec. 15.  China, meanwhile, began applying tariffs of 5 to 10% on U.S. goods ranging from frozen sweet corn and pork liver to bicycle tires on Sunday.

The slated 15% U.S. tariffs on approximately $112 billion in Chinese goods may affect consumer prices for products ranging from shoes to sporting goods, the AP noted, and may mark a turning point in how the ongoing trade war directly affects consumers. Nearly 90% of clothing and textiles the U.S. buys from China will also be subjected to tariffs.” – ZeroHedge

This is only phase one. On December 15th, the U.S. will hike tariffs on another $160bn consumer goods and Beijing has vowed retaliatory tariffs that, combined with the Sunday increases, would cover $75 billion in American products once the December tariffs take effect. 

These tariffs, of course, are striking directly at the heart of economic growth. The trade was has ground the global economy to a halt, sent Germany into a recession, and is likely slowing the U.S. economy more than headline data currently suggests.

Yet, “optimism” that “a trade deal is imminent” is keeping stocks afloat. For now.

As we discussed previously, the President has now trained the markets to respond to his “tweets.” 

“Ring the bell. Investors salivate with anticipation.”  

However, despite the rally last week, the markets are still well confined in a very tight consolidation range.

As I noted recently:

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

The biggest risk, is what happens when the market quits “buying the rumor” and starts “selling the news?”

Fed To The Rescue

There is another level of “optimism” supporting asset prices. 

The Fed.

It is widely believed the Fed will “not allow” the markets to decline substantially. This is a lot of faith to place into a small group of men and women who have a long history of creating booms and busts in markets. 

And, as JP Morgan noted over the weekend:

“Positive technical indicators and monetary easing will likely outweigh the uncertainty of the U.S.-China trade war and the “wild card” of developments in tariff negotiations. We now advise to add risk back again, tactical indicators have improved. Admittedly, the next trade move is the wild card to all of this, but we think that the hurdle rate for any positive development is quite low now.”

Currently, there is a 100% expectation of the Fed cutting rates at the September meeting.

The belief currently, is that lower interest rates will result in higher asset prices as investors will once “chase equities” to obtain a “higher yield” than what they can get in other “safe” assets. 

After all, this is indeed what happened as the Federal Reserve kept interest rates suppressed after the financial crisis. However, the difference between now, and then, is that individuals are currently fully invested in the financial markets. 

“Cash is low, meaning households are fairly fully invested.” – Ned Davis

In other words, the “pent up” demand for equities is no longer available to the magnitude that existed following the financial crisis which supported the 300% rise in asset prices. 

More importantly, when the Fed has previously engaged in a “rate cutting” cycle when the “yield curve” was inverted, which signals something is wrong economically, the outcomes for investors have not been good.

This last point is an issue for investors specifically. Investing is ultimately about buying assets at a discounted price and selling them for a premium. However, so far in 2019, while asset prices have soared higher on “optimism,” earnings and profits have deteriorated markedly. This is show in the attribution chart below for the S&P 500.

In 2019, the bulk of the increase in asset prices is directly attributable to investors “paying more” for earnings, even though they are “getting less” in return.

The discrepancy is even larger in small capitalization stocks which don’t benefit from things like “share repurchases” and “repatriation.” 

Just remember, at the end of the day, valuations do matter. 

September Seasonality Increases Risk

“The month of September has a reputation for being a bad month for the stock market. After the October 1987 Crash, the month of October carried a bad rep for years, but more recently we are told that it’s really September we have to watch out for.” – Carl Swenlin

The month of September has closed higher fifty-percent of the time, but the average change was a -1.1% decline, making September the worst performing month in the 20-year period. More importantly, September tends to be weaker when it follows a negative August, which we just had.

However, these are all averages of what has happened in the past and things can, and do, turn out differently more often than we expect. This is why I prefer to just rely on the charts to suggest what may happen next. 

I discussed previously that money is crowding into large-capitalization stocks for safety and liquidity. Carl Swenlin showed this same analysis in his chart below.

Investors should be very aware about the deviation in performances across asset markets. Historically, this is more of a sign of a late-stage market topping process rather than a “pause that refreshes the bull run.” 

This is particularly the case when this crowding of investments is occurring simultaneously with an inverted yield curve. 

On a purely technical basis, when looking at combined monthly signals, we see a picture of a market in what has previously been more important turning points for investors. 

Sure, this time could turn out to be different. 

Since I manage portfolios for individuals who are either close to, or in retirement, the risk of betting on “possibilities,” versus “probabilities,” is a risk neither of us are willing to take. 

Let me restate from last week:

“Given that markets still hovering within striking distance of all-time highs, there is no need to immediately take action. However, the continuing erosion of underlying fundamental and technical strength keeps the risk/reward ratio out of favor. As such, we suggest continuing to take actions to rebalance risk.

  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.

We are closer to the end of this cycle than not, and the reversion process back to value has historically been a painful one.”

Remember, it is always far easier to regain a lost opportunity. It is a much more difficult prospect to regain lost capital. 

8-Reasons To Hold Some Extra Cash

Over the past few months, we have been writing a series of articles that highlight our concerns of increasing market risk.  Here is a sampling of some of our more recent newsletters on the issue. 

The common thread among these articles was to encourage our readers to use rallies to reduce risk as the “bull case” was being eroded by slower economic growth, weaker earnings, trade wars, and the end of the stimulus from tax cuts and natural disasters. To wit:

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

However, 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 couple the mother of all bull markets.

There will be payback for that misalignment of funds.

As I noted on Tuesday, the divergences between large-caps and almost every other equity index strongly suggest that something is not quite right.  As shown in the chart below, that negative divergence is something we should not discount.

However, this is where it gets difficult for investors.

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

This is why we have been suggesting raising cash on rallies, and rebalancing risk until the path forward becomes clear. Importantly:

“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.”

With no trade deal in sight, slowing global growth, a Fed that doesn’t appear to want to cut rates aggressively, and weakness in markets continuing to spread, it is now time to take some actions.

Time To Take Some Action

Investors tend to make to critical mistakes in managing their 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. 

The last point is relevant to today’s discussion. Investors tend to identify very “specific” price targets to take action. For example, in the chart above, the 50-dma, our previous target, currently resides at roughly at 2950. 

The mistake is only taking action if a specific target is met. If the price target isn’t precisely reached, no action is taken. As prices begin to fall, investors start hoping for a “second shot” at the price target to get out. More often than not, investors wind up disappointed.

As Maxwell Smart used to say: “Missed it by that much.” 

In our own portfolio management practice, technical analysis is a critical component of the overall process, and carries just as much weight as the fundamental analysis. As I have often stated:

“Fundamentals tell us WHAT to buy or sell, Technicals tell us WHEN to do it.”

In our methodology, technical price points are “neighborhoods” rather than “specific houses.” While a buy/sell target is always identified BEFORE a transaction is made, we will execute when we get into the general “neighborhood.”

We are now in the “neighborhood” given both the recent struggles of the market, the deteriorating technical backdrop, and our outlook over the next several months for further acceleration of the trade war. 

This all suggests that we reduce equity risk modestly, and further increase our cash hedge, until such time as there is more “clarity” with respect to where markets are heading next. 

This brings me to the most important point.

8-Reasons To Hold Cash

In portfolio management, you can ONLY have 2-of-3 components of any investment or asset class:  Safety, Liquidity & Return. The table below is the matrix of your options.

The takeaway is that cash is the only asset class that provides safety and liquidity. Obviously, this comes at the cost of return.  This is basic. But what about other options?

  • Fixed Annuities (Indexed) – safety and return, no liquidity. 
  • ETF’s – liquidity and return, no safety.
  • Mutual Funds – liquidity and return, no safety.
  • Real Estate – safety and return, no liquidity.
  • Traded REIT’s – liquidity and return, no safety.
  • Commodities – liquidity and return, no safety.
  • Gold – liquidity and return, no safety. 

You get the idea. No matter what you chose to invest in – you can only have 2 of the 3 components. This is an important, and often overlooked, consideration when determining portfolio construction and allocation. The important thing to understand, and what the mainstream media doesn’t tell you, is that “Liquidity” gives you options. 

I learned a long time ago that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.

The great thing about holding extra cash is that if I’m wrong, I simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.

Here are my reasons why having cash is important.

1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash. 

2) 80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.

3) The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are highly correlated. 

4) Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong as we have seen two declines of over -50%…just in the last 19-years. Keep in mind, it takes a +100% gain to recover a -50% decline.

5) 80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again. 

6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also merely transfers the “risk of being wrong” from one side of the ledger to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long, and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.

7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.” 

8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms. 

Importantly, I want to stress that I am not talking about being 100% in cash. 

I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.

With the political, fundamental, and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important. 

Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.

Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.

Technically Speaking: Market Risk Is Rising As Retail Sends Warning

I noted in this past weekend’s newsletter the pick up in volatility over the last few weeks has made investing in the market difficult.

On Friday, the market plunged on new Trump was going to increase tariffs on China. Then on Monday, the markets rallied on comments from President Trump that China was ready to talk.

“China called last night our top trade people and said ‘let’s get back to the table’ so we will be getting back to the table and I think they want to do something. They have been hurt very badly but they understand this is the right thing to do and I have great respect for it. This is a very positive development for the world.” – President Trump, via CNBC

You simply can’t trade that kind of volatility. This was a point made to our RIAPRO subscribers last week:

When you are ‘unsure’ about the best course of action, the best course of action is to ‘do nothing.’”


As we discussed previously, the President has learned that his comments will move markets. Given the shellacking of the markets on Friday, and what was looking to be a dismal open Monday morning, Trump’s comments to boost the markets weren’t surprising.

What the market disregarded were the comments from China:

As I penned last week, the markets have now been “trained” by Trump.

“Ring the bell. Investors salivate with anticipation.”  

However, despite the rally yesterday, the markets are still well confined in a very tight consolidation range.

  • The “bulls” are hoping for a break to the upside which would logically lead to a retest of old highs.
  • The “bears” are concerned about a downside break which would likely lead to a retest of last December’s lows.
  • Which way will it break? Nobody really knows.

This is why we have been suggesting raising cash on rallies, and rebalancing risk until the path forward becomes clear.

“The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a ‘topping process.’ As the saying goes, a market-top is not an event; it’s a process.”

Let me restate from this past weekend’s missive where we are positioned currently:

“Over the past few months, we have reiterated the importance of holding higher levels of cash, being long fixed income, and shifting risk exposures to more defensive positions. That strategy has continued to work well.”

  • We have remained devoid of small-cap, mid-cap, international and emerging market equities since early 2018 due to the impact of tariffs on these areas.
  • For the same reasons we have also reduced or eliminated exposures to industrials, materials, and energy
  • With the trade war ramping up, there is little reason to take on additional risk at the current time as our holdings in bonds, precious metals, utilities, staples, and real estate continue to do the heavy lifting.”

As I noted previously, if you are told you have to “buy and hold” a little of everything to be diversified, then what are you paying an advisor for? There are plenty of “robo-advisors” that will gladly clip a fee from you to do something you can easily do yourself.

However, be warned. There are currently high correlations between asset classes, which suggests that when the next bear market ensues there will be few places to hide. What goes up together, will come down together as well. Being “diversified,” in the traditional sense, isn’t going to help you.

Markets Send Warning Signals

While large-cap stock indexes (S&P 500, Dow Jones, and Nasdaq) have maintained a reasonably steady state over the past 18-months, such is not the case across the broader market. As I noted previously, share repurchases have provided much of the lift for large-capitalization stocks over the last couple of years. 

“Corporate share buybacks currently account for roughly all ‘net purchases’ of U.S. equities in recent years. To wit:

“It is likely that 2018/2019 will be the potential peak of corporate share buybacks, thereby reducing the demand for equities in the market. This ‘artificial buyer’ explains the high degree of complacency in the markets despite recent volatility. It also suggests that the ‘bullish outlook’ from a majority of mainstream analysts could also be a mistake. 

If the economy is weakening, as it appears to be, it won’t be long until corporations redirect the cash from ‘share repurchases’ to shoring up operations and protecting cash flows.”

With portfolio managers needing to chase performance, the easiest, and safest, place to allocate capital is in highly liquid, large capitalization companies which are being supported by share repurchases. Despite trade turmoil, Fed disappointment, and weaker economic, and earnings growth, stocks still remain elevated and confined within the longer-term bullish trend.

However, once you step outside the large-capitalization universe, a very different picture emerges.

Since small and mid-capitalization companies don’t engage in massive share repurchase programs, and are directly impacted by early changes to consumer spending and tariffs. As such, it is not surprising that performance has been lagging that of its large-cap brethren.

Small-Cap 600 Index

Mid-Cap 400 Index  

The same issue applies to international markets as well, where economic growth has been markedly weaker than in the U.S. 

MSCI All-World (Ex-US) Index

Given the consumer makes up about 2/3rds of the U.S. economy, low unemployment, and retail sales data is often cited as reasons to be “bullish” on equities. However, as shown in the chart below, the ratio between consumer “discretionary” and “staples” companies suggests there is an emerging weakness in the retail sector.

As Tomi Kilgore noted for MarketWatch, 

“One way to gauge the real strength of the consumer is to measure how much they spend on what they want (discretionary items) relative to what they need (staples). The consumer discretionary sector is highly sensitive to what the overall stock market is doing, and to worries about economic growth and contraction.

To see this relationship in real time is through comparing consumer discretionary stocks, by way of the SPDR Consumer Discretionary Select Sector exchange-traded fund (XLY), to the consumer staples sector, as tracked by the SPDR Consumer Staples Select Sector ETF (XLP).”

Historically, when the S&P 500 is on a monthly sell signal, with an inverted yield curve, and discretionary stocks are underperforming staples, it has been a leading indicator of a recessionary economy and bear market. 

As Tomi goes on to note:

“That by itself might lead one to believe that worries about the economy are overdone, until a chart of consumer confidence is placed side-by-side with a chart of retail stocks, as tracked by the SPDR S&P Retail ETF (XRT).”

As one might expect, those charts usually move in tandem. But sometimes they move in opposite directions for short periods of time, and when they do, it’s the stocks that have been the leading indicator.

And the retail sector should still matter to investors, because when the XRT has diverged from the broader market at key turning points, it has been the XRT that has led the way.

Slow At First, Then All Of A Sudden

What all of this suggests is that “risk” is building in the markets.

However, risk builds slowly. This is why the investment community often uses the analogy of “boiling a frog.” By turning up the heat slowly, frogs don’t realize they are being boiled until its too late. The same is true for investors who make a series of mistakes as “risk” builds up slowly. 

  • 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. 

The end effect is not a pretty one.

When the buildup of “risk” is finally released, the explosion happens all at once leaving investors paralyzed trying to figure out what just happened. Unfortunately, by the time they realize they are the “frog,” it is too late to do anything about it.

With President Trump on a warpath with China, increasing tariffs (a tax on businesses), at a time when economic growth and corporate profits are weakening, raises our concern over the amount of equity exposure we are carrying in the markets. 

Given that markets still hovering within striking distance of all-time highs, there is no need to immediately take action. However, the continuing erosion of underlying fundamental and technical strength keeps the risk/reward ratio out of favor. As such, we suggest continuing to take actions to rebalance risk.

  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.

We are closer to the end of this cycle than not, and the reversion process back to value has historically been a painful one. 

Technically Speaking: This Is Still A “Sellable Rally”

In last Tuesday’s “Technical Update,” I wrote that on a very short-term basis the market had reversed the previously overbought condition, to oversold.

This could very well provide a short-term ‘sellable bounce’ in the market back to the 50-dma. As shown in the chart below, any rally should be used to reduce portfolio risk in the short-term as the test of the 200-dma is highly probable. (We are not ruling out the possibility the market could decline directly to the 200-dma. However, the spike in volatility and surge in negative sentiment suggests a bounce is likely first.)”

Chart updated through Monday’s close

This oversold condition is why we took on a leveraged long position on the S&P 500, which we discussed with our RIAPRO subscribers last Thursday morning (30-Day Free Trial).:

“I added a 2x S&P 500 position to the Long-Short portfolio for an ‘oversold trade’ and a bounce into the end of the week.”

I followed that statement up, saying we would hold the position over the weekend as:

“Given the President is fearful of a market decline, we expect there will be some announcement over the weekend on ‘trade relief’ to support the markets.”

That indeed came to pass as the President announced he extended the ability of U.S. companies to sell product to Huawei for another 90-days. (China gave up nothing in return.) Furthermore, the President re-engaged against the Fed on Twitter:

Neither point is positive over the longer-term. As noted on Monday, investors are continuing to pay near-record prices for deteriorating corporate profits.

“Despite a near 300% increase in the financial markets over the last decade, corporate profits haven’t grown since 2011.”

This Is Still A “Sellable Rally.” 

On Monday, we closed out 25% of our long trading position. We will also continue to sell into any further rally as the market challenges overhead resistance. The rest of our portfolios remain defensive, hedged, and are carrying an overweight position in cash.

The reason we suggest selling any rally is because, until the pattern changes, the market is exhibiting all traits of a “topping process.” 

My colleague Charles Hugh Smith summed this up nicely on Monday:

“As the saying goes, a market-topping is not an event, it’s a process. There are a handful of historically useful characteristics of topping markets:

  1. Declining volume / liquidity
  2. Increasing volatility–major swings up and down that increase in amplitude and frequency
  3. Inability to break decisively above previous resistance (i.e. make sustainable new highs in a stairstep that moves higher).

We see all these elements in the S&P 500 over the past few years. A healthy, stable advance in 2017, led to a manic blow-off top that crashed in February of 2018, setting off a period of high volatility.

This set up another stable advance that was shorter than the previous advance, and also steeper. This led to the multi-month period of instability that concluded in a panic crash in December 2018.

Since then, advances have been shorter and steeper, suggesting a more volatile era. Three advances to new highs have all dropped back to (or below) the highs of January 2018. In effect, the market has wobbled around for 18 months, becoming more volatile after every rally.”

Adding to his comments, you can also see that bullishness by investors still remains aggressive even as the market trades below its accelerated trendline.

Here is a closer look.

There repeated failures along the previous uptrend line suggests a change of trend is potentially underway. As Charles notes, “topping processes” are a function of time, and previous violations of the bullish trend were clear warnings for investors to become more cautious.



You will notice that in each previous case, the “bullish story” was the same.

However, the primary warning signs to investors were also the same:

  • A break of the longer-term bullish trend line
  • A marked rise in volatility
  • A yield curve declining, and ultimately, inverting as the Fed cuts rates.

The last point we discussed in more detail in this past weekend’s missive:

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

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

In other words, while a bulk of the mainstream media keeps pointing to 1995 as “the” example of when the Fed cut rates and the market kept rising afterward, it is important to note the yield curve was NOT inverted then. However, when the Fed did begin to aggressively cut rates, which collided with the inverted yield curve, the “bear market” was not too far behind.

Lastly, Helene Meisler wrote yesterday: 

“Over the course of the last week, we saw the TRIN reach 2.10 a week ago on Aug. 12, followed by an extraordinary reading of 3.72 a few days later on last Wednesday. At the time, I explained that we don’t often get over 2.0, so a reading at almost 4.0 was literally “off the charts.”

This brings us back to the 10-day moving average, which as you can see, has skyrocketed to over 1.50. The first thing to note is that this is higher than it got even in the fourth-quarter decline. It’s more than the January and February 2018 decline as well. In fact, we have to go all the way back to 2015 and 2016 to see the kind of selling we saw last week, using this indicator. I have boxed those off in red on the left side of the chart.

Notice that these types or readings don’t occur often and they tend to occur in violent markets. All the way on the left, in July 2015, you can see this indicator reached over 1.50. The S&P 500 enjoyed a rally– a small one, but still a rally. But then you can see we came back down.

The second spike up that took the indicator to just over 1.70 arrived in August of 2015, which was accompanied by the plunge you see in the S&P of nearly 10%. Now squint even further, and you can see the rally in September – off that August low — and how we came back down in late September and early October to form a “W” in the S&P.

All of those instances are examples of a rally and back down again. I’m sure if I went back in time I could find a few examples when this indicator got this high and did not rally and come back down, but this is more typical as you can see.

All of this data supports the idea of a “sellable” rally for now.

Could that change? 

Certainly, and if it does, and our “onboarding” model turns back onto a “buy signal,” we will act accordingly and increase equity risk in portfolios. However, for now, the risk still appears to be to the downside for now.

“But the Central Banks won’t let the markets fall.” 


But that is an awful lot of faith to put into a few human beings who spent the majority of their lives within the hallowed halls of academia. 

There is a rising probability that Central Banks are no longer as effective is supporting asset markets as they once were. As noted by Zerohedge yesterday:

“The Fed meeting on July 31st was a sell the news event because it had been so telegraphed, and priced. The fact that the Fed arguably disappointed with only a 25bps cut means they are now behind the curve; until they get in front of it, multiples are unlikely to expand again. The Fed put expired on July 31st.”

If you disagree, that is okay.

However, given we are now more than 10-years into the current bull market cycle, here are three questions you should ask yourself:

  1. What is my expected return from current valuation levels?  (___%)
  2. If I am wrong, given my current risk exposure, what is my potential downside?  (___%)
  3. If #2 is greater than #1, then what actions should I be taking now?  (#2 – #1 = ___%)

How you answer those questions is entirely up to you.

What you do with the answers is also up to you.

Ignoring the result, and “hoping this time will be different,” has never been a profitable portfolio strategy. This is particularly the case when you are 10-years into a bull market cycle.

Technically Speaking: Stocks In A Bloodbath, Look For A Sellable Rally

On Monday, stocks took a beating from rising trade tensions as China put the brakes on imports of agricultural products following Trumps latest tariff threat. As noted by the WSJ:

“So much for a trade deal any time soon.

Monday’s pain for U.S. investors was foretold late Sunday evening. The Chinese yuan sank below 7 per dollar and hit an all-time low in offshore trading Monday with local officials blaming the depreciation on President Trump’s decision last week to extend tariffs to almost all Chinese imports. Mr. Trump responded on Twitter, accusing China of engaging in currency manipulation.

The result was a mess across global markets. The Dow Jones Industrial Average fell 766 points while the S&P 500 and Nasdaq Composite fell about 3% and 3.5%, respectively.”

Before we get into the charts, let me just remind you what we have been saying about Trump’s “trade war” for more than year now:

May 24, 2018:

China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.”

June 19, 2018:

“The U.S.- China confrontation will be a war of attrition: while China has shown a willingness to make a deal on shrinking its trade surplus with the U.S., it has made clear it won’t bow to demands to abandon its industrial policy aimed at dominating the technology of the future.”

May 7th, 2019

  1. China is playing a very long game. Short-term economic pain can be met with ever-increasing levels of government stimulus. The U.S. has no such mechanism currently, but explains why both Trump and Vice-President Pence have been suggesting the Fed restarts QE and cuts rates by 1%.
  2. The pressure is on the Trump Administration to conclude a “deal,” not on China. Trump needs a deal done before the 2020 election cycle AND he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk off electoral losses rise. China knows this and are willing to “wait it out” to get a better deal.
  3. China is not going to jeopardize its 50 to 100-year economic growth plan on a current President who will be out of office within the next 5-years at most. It is unlikely as the next President will take the same hard-line approach on China that President Trump has, so agreeing to something that won’t be supported in the future is doubtful.”

June 29th, 2018

“China has been attacking the “rust-belt” states, which are crucial to Trump’s 2020 re-election, states with specifically targeted tariffs. (Now accelerated with the decision to stop imports altogether.)

While Trump is operating from a view that was a ghost-written, former best-seller, in the U.S. popular press, XI is operating from a centuries-old blueprint for victory in battle.”

There were many more articles in between, but you get the idea.

This has always been a war Trump can’t win. China’s ability to take a tremendous amount of short-term pain for a long-term gain will be more than President Trump counted on when he thought “trade wars are easy to win.” They aren’t, and the economic pain will likely be more than he bargained for.

The markets are beginning to sense this as well, particularly as the White House escalates the situation by labeling China a “currency manipulator.” 

In the short-term, traders are now turning their focus back to the Federal Reserve for help. More rate cuts, however, are not likely going to be enough to solve the pressure to corporate profits, which will accelerate as the trade war escalates. 

Technical Update

Over the past couple of week’s, we have been talking about a potential correction. While the media was quick to jump on Trump’s “China threats” as the reason for the selloff, those actions were just the “catalyst that lit the fuse.”

As I this past weekend:

“[Over the last two weeks] the market is rallying in anticipation of more Central Bank easing. The markets are momentarily detached from weaker earnings growth, weaker economic growth, and a variety of other market-related risks. 

In the very short-term, the market is grossly extended and in need of some correction action to return the market to a more normal state. As shown below, while the market is on a near-term “buy signal” (lower panel) the overbought condition, and near 9% extension above the 200-dma, suggests a pullback is in order.”

Chart Updated Through Monday

We had also warned previously the current extension of the market, combined with overbought conditions, was due for a reversal.

On a very short-term basis the market has reversed the previously overbought condition to oversold. This could very well provide a short-term “sellable bounce” in the market back to the 50-dma. As shown in the chart below, any rally should be used to reduce portfolio risk in the short-term as the test of the 200-dma is highly probable.

(We are not ruling out the possibility the market could decline directly to the 200-dma. However, the spike in volatility and surge in negative sentiment suggests a bounce is likely first.)

As I noted in this past weekend’s newsletter, we have been taking actions within our portfolios to prepare for this correction and sharing those actions with our RIAPRO subscribers (30-Day Free Trial).

July 22nd Portfolio Update: This morning action was taken and we took profits on 10% of 11 of our equity holdings. All of these positions had gains in excess of 20% since January 1st.

Here is the unlocked report  

Those actions played well with the S&P declining by roughly -3.00% on Monday as our Equity and ETF portfolios only declined by –0.93% and –1.04% respectively.

Monthly Signals Remain Bearish

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

Interestingly, despite recent “all-time” highs in the S&P 500, the monthly signal have all aligned to “confirm” a “sell signal.” Since 1950, such an alignment has been somewhat of a rarity. The risk of ignoring the longer-term signal currently is that it may be signaling a more important topping process remains intact.

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

What This Means And Doesn’t Mean

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

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

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

What this analysis DOES MEAN is that we need to use any short-term rally over the next few days to take some actions to rebalance “risks.”

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

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

3) Move Trailing Stop Losses Up to new levels.

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

While I certainly expect the White House to “tweet” out a statement confirming “trade talks are still ongoing,” or comments from Fed Reserve officials that “more rate cuts are likely,” the damage to the economy from tariffs are already in the works. With both earnings and corporate profits under pressure, this may be the start of a bigger corrective process like we witnessed in 2018.

But, there is always the possibility that I am wrong and the markets turn around and rally back to all-time highs.

If that happens, and the bullish trend resumes, then we will adjust our allocation models up and take on more equity risk.

But as I have asked before, what is more important to you as an individual?

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

For the majority of investors, the recent rally has simply been just recovery of previous losses from 2018.

Currently, there is not a great deal of evidence supportive of a longer-term bull market cycle. The Fed cutting rates is “NOT” bullish, it actually correlates to much more negative long-term outcomes in the market.

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

This is a good time to review those trading rules:

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

Jeremy Grantham’s Best Long-Term Advice For Investors

Over the weekend, I was reviewing some old commentary and stumbled across a piece from 2012 which contained an excerpt from Jeremy Grantham who is the famed investor at GMO.

I have spoken, and written many times in the past, that the media and Wall Street alike promotes the bullish and optimistic views not because it is correct – but because it sells product. There is no value in telling the retail investor the truth about the risks in the market because investors would pull money out of the market which would reduce Wall Street’s profitability. In other words, the bullish and optimistic marketing machines are good for their bottom line – just not necessarily yours.  This is one of the primary points that Jeremy Grantham brought out in his commentary.

This is a read which is well worth your time and consideration. It speaks to the very issues that we address most often about understanding the long-term risks to your portfolio, investment rules, and the legacy that we are leaving to our children.

It was refreshing and enlightening in 2012. It is just as important and educational today. I have added illustrations to support his points.

Advice From Uncle Polonius

by Jeremy Grantham, GMO

For individual investors setting out on dangerous investment voyages.

Believe in history. In investing Santayana is right: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away. You absolutely must ignore the vested interests of the industry and the inevitable cheerleaders who will assure you that this time it’s a new high plateau or a permanently higher level of productivity, even if that view comes from the Federal Reserve itself. No. Make that, especially if it comes from there. The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens. Here’s how.

Neither a lender nor a borrower be.” If you borrow to invest, it will interfere with your survivability. Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor’s critical asset: patience. (To digress, excessive borrowing has turned out to be an even bigger curse than Polonius could have known. It encourages financial aggressiveness, recklessness, and greed. It increases your returns over and over until, suddenly, it ruins you. For individuals, it allows you to have today what you really can’t afford until tomorrow. It has proven to be so seductive that individuals en masse have shown themselves incapable of resisting it, as if it were a drug. Governments also, from the Middle Ages onwards and especially now, it seems, have proven themselves equally incapable of resistance. Any sane society must recognize the lure of debt and pass laws accordingly. Interest payments must absolutely not be tax deductible or preferred in any way. Governments must apparently be treated like Polonius’s children and given limits. By law, cumulative government debt should be given a sensible limit of, say, 50% of GDP, with current transgressions given 10 or 20 years to be corrected.) But, back to investing …

Don’t put all of your treasure in one boat. This is about as obvious as any investment advice could be. It was learned by merchants literally thousands of years ago. Several different investments, the more the merrier, will give your portfolio resilience, the ability to withstand shocks. Clearly, the more investments you have and the more different they are, the more likely you are to survive those critical periods when your big bets move against you.

Be patient and focus on the long term. Wait for the good cards. If you’ve waited, and waited some more, until finally a very cheap market appears, this will be your margin of safety. Now all you have to do is withstand the pain as the very good investment becomes exceptional. Individual stocks usually recover, entire markets always do. If you’ve followed the previous rules, you will outlast the bad news.

Try to contain natural optimism. Optimism has probably been a positive survival characteristic. Our species is optimistic, and successful people are probably more optimistic than average. Some societies are also more optimistic than others: the U.S. and Australia are my two picks. I’m sure (but I’m glad I don’t have to prove it) that it has a lot to do with their economic success. The U.S. in particular encourages risk-taking: failed entrepreneurs are valued, not shunned. But optimism comes with a downside, especially for investors: optimists don’t like to hear bad news. Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III. Been there, done that! And in a real stock bubble like that of 2000, bearish news in the U.S. will be greeted like news of the bubonic plague; bearish professionals will be fired just to avoid the dissonance of hearing the bear case, and this is an example where the better the case is made, the more unpleasantness it will elicit. Here again it is easier for an individual to stay cool than it is for a professional who is surrounded by hot news all day long (and sometimes irate clients too). Not easy, but easier.

But on rare occasions, try hard to be brave. You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks – extreme loss of clients and business – does not exist for you. So, if the numbers tell you it’s a real outlier of a mispriced market, grit your teeth and go for it. This goes against the natural psychological behaviors of humans.

Resist the crowd: cherish numbers only. We can agree that in real life as opposed to theoretical life, this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. Watching neighbors get rich at the end of a bubble while you sit it out patiently is pure torture. The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time). Then hero-worship the numbers and try to ignore everything else. Ignore especially short-term news: the ebb and flow of economic and political news is irrelevant. Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies, let alone the broad asset classes that you should concentrate on. Leave those complexities to the professionals, who will on average lose money trying to decipher them

Remember too that for those great opportunities to avoid pain or make money – the only investment opportunities that really matter – the numbers are almost shockingly obvious: compared to a long-term average of 15 times earnings, the 1929 market peaked at 21 times, but the 2000 S&P 500 tech bubble peaked at 35 times! Conversely, the low in 1982 was under 8 times. This is not about complicated math!

In the end it’s quite simple. Really. GMO predicts asset class returns in a simple and apparently robust way: we assume profit margins and price earnings ratios will move back to long-term average in 7 years from whatever level they are today. We have done this since 1994 and have completed 40 quarterly forecasts. (We started with 10-year forecasts and moved to 7 years more recently.) Well, we have won all 40 in that every one of them has been usefully above random and some have been, well, surprisingly accurate. These estimates are not about nuances or PhDs. They are about ignoring the crowd, working out simple ratios, and being patient. (But, if you are a professional, they would also be about colossal business risk.) These forecasts were done with a robust but simple methodology. The problem is that though they may be simple to produce, they are hard for professionals to implement. Some of you individual investors, however, may find it much easier.

This above all: to thine own self be true.” Most of us tennis players have benefited from playing against non-realists: those who play to some romanticized vision of that glorious September day 20 years earlier, when every backhand drive hit the corner and every drop shot worked, rather than to their currently sadly atrophied skills and diminished physical capabilities. And thank Heavens for them. But doing this in investing is brutally expensive. To be at all effective investing as an individual, it is utterly imperative that you know your limitations as well as your strengths and weaknesses. If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late, or getting out early, is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head.

Good luck. Uncle Polonius

Let’s Be Like Japan

There has been a lot of angst lately over the rise in interest rates and the question of whether the government will be able to continue to fund itself given the massive surge in the fiscal deficit since the beginning of the year.

While “spending like drunken sailors” is not a long-term solution to creating economic stability, unbridled fiscal stimulus does support growth in the short-term. Spending on natural disaster recovery last year (3-major hurricanes and two wildfires) led to a pop in Q2 and Q3 economic growth rates. The two recent hurricanes that slammed into South Carolina and Florida were big enough to sustain a bump in activity into early 2019. However, all that activity is simply “pulling forward” future growth.

But the most recent cause of concern behind the rise in interest rates is that there will be a “funding shortage” of U.S. debt at a time where governmental obligations are surging higher. I agree with Kevin Muir on this point who recently noted:

“Well, let me you in on a little secret. The US will have NO trouble funding itself. That’s not what’s going on.

If the bond market was truly worried about US government’s deficits, they would be monkey-hammering the long-end of the bond market. Yet the US 2-year note yields 2.88% while the 30-year bond is only 55 basis points higher at 3.43%. That’s not a yield curve worried about US fiscal situation.

And let’s face it, if Japan can maintain control of their bond market with their bat-shit-crazy debt-to-GDP level of 236%, the US will be just fine for quite some time.”

That’s not a good thing by the way.

Let’s Be Like Japan

“Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the ‘painkilling’ effect wears off, U.S. and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.” – Keiichiro Kobayashi, 2010

While Kobayashi will ultimately be right, what he never envisioned was the extent to which Central Banks globally would be willing to go. As my partner Michael Lebowitz pointed out previously:

“Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).”

The belief was that by driving asset prices higher, economic growth would follow. Unfortunately, this has yet to be the case as debt both globally and specifically in the U.S. has exploded.

“QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.”

Not surprisingly, the massive surge in debt has led to an explosion in the financial markets as cheap debt and leverage fueled a speculative frenzy in virtually every asset class.

The continuing mounting of debt from both the public and private sector, combined with rising health care costs, particularly for aging “baby boomers,” are among the factors behind soaring US debt. While “tax reform,” in a “vacuum”  should boost rates of consumption and, ultimately, economic growth, the economic drag of poor demographics and soaring costs, will offset many of the benefits.

The complexity of the current environment implies years of sub-par economic growth ahead as noted by the Fed last week as their long-term projections, along with the CBO, remain mired at 2%.

The US is not the only country facing such a gloomy outlook for public finances, but the current economic overlay displays compelling similarities with Japan in the 1990s.

Also, while it is believed that “tax reform” will fix the problem of lackluster wage growth, create more jobs, and boost economic prosperity, one should at least question the logic given that more expansive spending, as represented in the chart above by the surge in debt, is having no substantial lasting impact on economic growth. As I have written previously, debt is a retardant to organic economic growth as it diverts dollars from productive investment to debt service.

One only needs to look at Japan for an understanding that QE, low-interest rate policies, and expansion of debt have done little economically. Take a look at the chart below which shows the expansion of the BOJ assets versus the growth of GDP and levels of interest rates.

Notice that since 1998, Japan has not achieved a 2% rate of economic growth. Even with interest rates still near zero, economic growth remains mired below one-percent, providing little evidence to support the idea that inflating asset prices by buying assets leads to stronger economic outcomes.

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

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.

This is the same problem that Japan has wrestled with for the last 25 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:

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

The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows becoming a net drag on “savings,” the dependency on the “social welfare net” will continue to expand. The “pension problem” is only the tip of the iceberg.

If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.

Japan, like the U.S., is caught in an on-going “liquidity trap”  where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.

More importantly, while there are many calling for an end of the “Great Bond Bull Market,” this is unlikely the case for two reasons.

  1. As shown in the chart below, interest rates are relative globally. Rates can’t rise in one country while a majority of global economies are pushing low to negative rates. As has been the case over the last 30-years, so goes Japan, so goes the U.S.
  2. Increases in rates also kill economic growth which drags rates lower. Like Japan, every time rates begin to rise, the economy rolls into a recession. The U.S. will face the same challenges. 

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

But hey, let’s just keep doing the same thing over and over again, which hasn’t worked for anyone as of yet, but we can always hope for a different result. 

What’s the worst that could happen?  

All Markets Are Cyclical – When Will This One End?

I always enjoy reading John Stepek’s work at MoneyWeek. Just recently he addressed the question of where are we in the current market cycle. To wit:

“In his latest memo to clients, [Howard Marks] outlines his basic philosophy and how it affects Oaktree’s investment process at the moment. Marks’ basic point – which appears pretty self-evident, though you’d be surprised by how many people try to deny it – is that markets move in cycles.

The tricky part is trying to work out when the cycle is going to turn.”

This is a fascinating point as it is not just individuals who try and deny that markets, and the economy, move in cycles but also the Federal Reserve and Government agencies. As I noted last week, the Congressional Budget Office is currently estimating the next 10-years of growth in the economy at a steady 2%.

Given this is already approaching the longest economic growth cycle in history, at the lowest rate of growth, and with the Federal Reserve hiking rates, it is highly unlikely the economy will remain “recession free” for another decade. It is also important to note the CBO didn’t predict the recessions in 2001-2002 or in 2008. In fact, in 2000 the CBO predicted the U.S. would be running a $1 Trillion surplus by 2010. They were only off by $2 Trillion when 2010 finally rolled around.

What is clear is that both markets and the economy do not only cycle, but cycle together.

However, knowing when these cycles will occur isn’t that simple. As John notes:

“Of course, it’s not that simple. You might know that winter is coming; you’ll also know when it’s here. But can that knowledge tell you when the first snow will fall – or if it will fall at all?

And there’s your problem right there. Markets might be cyclical but timing them is almost impossible. You might know that the equivalent of an asset-market winter is coming. But you don’t know when it will hit and you don’t know how severe it will be.

So – to put it bluntly – what is the use of a theory of market cycles if it can’t tell you when to invest and when to pull out?”

That is absolutely correct. But it also the same analysis given for valuations.

Just like market and economic cycles, valuations are a horrible “timing” indicator. But like cycles, valuations are simply an indication of expected returns in the future.

As Marks noted there is no magic formula, or timing device, that can tell you “go to cash now” or “go all in today”. However, it is quite obvious that when valuations are elevated, and interest rates are rising, taking on excessive portfolio risk will have a very low future return.

The same goes for market and economic cycles. Today, there are plenty of warning signs which suggest we are nearer the top of this particular cycle versus than not.

As I noted previously:

“Timing, as they say, is everything.

It is worth noting that valuations clearly run in cycles over time. The current evolution of valuations has been extended longer than previous cycles due to 30-years of falling interest rates, massive increases in debt and leverage, unprecedented amounts of artificial stimulus, and government spending.”

No matter how you look at the markets currently, there are substantial signs of excess:

  • Corporate leverage is at all time highs
  • Margin debt is a record levels
  • Investor allocations to equities are pushing record levels
  • Investor allocations to cash are at record lows
  • Investor confidence is at record levels
  • Economic confidence is at record levels
  • Rates are rising
  • Jobless claims are at record lows
  • Stock valuations are at the second highest level in history

Marks also cited several points as well:

  • Private equity funds are raising record amounts of money to invest
  • A record proportion of loans are now classed as “covenant-lite” (ie, few if any protections for the lenders)
  • The quality of debt is deteriorating, and;
  • Investors are paying ever-higher multiples for increasingly-indebted companies.

All of these signs suggest an economy, and a market, that is fully matured with investors are behaving imprudently. In other words, things are as “good as they can get,” which happens at the end of a cycle rather than the beginning.

So, How Long Until This Cycle Ends?

Throughout history, interest rates are at the heart of every cyclical recovery and decline. As I discussed in “Did Something Just Break?”:

“With housing and auto sales already a casualty of higher rates, it won’t be long before it filters through the rest of the economy. The chart below shows nominal GDP versus the 24-month rate of change (ROC) of the 10-year Treasury yield. Not surprisingly, since 1959, every single spike in rates killed the economic growth narrative.”

I urge you not to fall prey to the “This Time Is Different” thought process.

Despite the consensus belief that global growth is gathering steam, there is mounting evidence of financial strain rising throughout the financial ecosystem. The recent spurt of economic growth has been a direct result of massive fiscal stimulus which will fade, wage growth has been weak, and job growth remains below the rate of working-age population growth.

While the talking points of the economy being as “strong as an ox” is certainly “media friendly,” the yield curve, as shown below, is telling a different story. While the spread between 2-year and 10-year Treasury rates has not fallen into negative territory as of yet, they are certainly headed in that direction.

Of course, the yield curve has been a strong predictor of the end of economic and market cycles. As such can it provide us with a clue as to when this cycle is likely to end? As Jesse Colombo recently noted in Forbes:

At the current rate the yield curve is flattening, many economists estimate that the yield curve may invert as soon as December 2018, so we will use that time frame for this exercise. It took an average of 9.7 months between the time that the yield curve inverted and the stock market peaked, which means that the current bull market would peak in September 2019. It also took an average of 5 months between historic market peaks and the start of recessions, which means that the next U.S. recession would start in February 2020, assuming the current cycle follows the historic average perfectly.”

Jesse’s analysis fits with the expectations of two-thirds of economists predictions on the timing of the next recession:

Two-thirds of business economists in the U.S. expect a recession to begin by the end of 2020, while a plurality of respondents say trade policy is the greatest risk to the expansion, according to a new survey.

About 10 percent see the next contraction starting in 2019, 56 percent say 2020 and 33 percent said 2021 or later, according to the Aug. 28-Sept. 17 poll of 51 forecasters issued by the National Association for Business Economics on Monday.

Forty-one percent said the biggest downside risk was trade policy, followed by 18 percent of respondents citing higher interest rates and the same share saying it would be a substantial stock-market decline or volatility.”

See, nothing to worry about for another 12-months.

Not so fast.

A Funny Thing Happened On The Way To The Recession

The majority of the analysis of economic data is short-term focused with prognostications based on single data points. For example, let’s take a look at the data below of real economic growth rates:

  • January 1980:        1.43%
  • July 1981:                 4.39%
  • July 1990:                1.73%
  • March 2001:           2.30%
  • December 2007:    1.87%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession.

You will remember that during the entirety of 2007, the majority of the media, analyst, and economic community were proclaiming continued economic growth into the foreseeable future as there was “no sign of recession.”

I myself was rather brutally chastised in December of 2007 when I wrote that:

“We are now either in, or about to be in, the worst recession since the ‘Great Depression.’”

Of course, a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis was the recession officially revealed. Unfortunately, by then it was far too late to matter.

The chart below shows the S&P 500 index with recessions and when the National Bureau of Economic Research dated the start of the recession.

There are three lessons that should be learned from this:

  1. The economic “number” reported today will not be the same when it is revised in the future.
  2. The trend and deviation of the data are far more important than the number itself.
  3. “Record” highs and lows are records for a reason as they denote historical turning points in the data.

Here is the important point.

When will this cycle end? No one really knows for sure.

Will it end? Absolutely. 

The recent spike in rates, combined with rising oil prices, is a toxic brew for a heavily indebted consumer both domestically and globally. The recent rise in rates has already accelerated the timing of the next recession and it is now only a function of time until “something breaks.” 

As Mr. Stepek concludes:

“Be defensive when everyone else is being aggressive. 

Why? So that when the time comes when there are lots of opportunities but hardly any money around (and it will come, because markets are cyclical and winter eventually arrives again), you’ll be in a position to take advantage.

And keep an eye on corporate debt. That’s where we’ll see the strains first.”

While the call of a “recession” may seem far-fetched based on today’s economic data points, no one was calling for a recession in early 2000, or 2007, either. By the time the data is adjusted, and the eventual recession is revealed, it won’t matter as the damage will have already been done.

But then again, “no one could have seen it coming.” Right?

The Two Biggest Threats To This Bull Market

This bull market seems unstoppable.

Regardless of short-term events, investors have quickly looked beyond those risks to in a bid to push stock prices higher. For example, in February of this year the markets dove roughly 10% as “trade wars” became a “thing.”  Over the next two months, the markets vacillated coming to grips with what “Trump’s war with China” would actually mean. Last week, the Administration announced a further $200 billion in tariffs against China, China cancels talks with the U.S., and China imposes similar tariffs against the U.S. – and the market barely budges..

Seemingly, nothing can derail this bull market which is now the “longest in history” by some counts.

However, in my opinion, the two biggest threats to the bull market may very well be the two issues which are the most visible currently – tariffs and interest rates.


One of the biggest drivers of the “bullish thesis” is the explosion in earnings due to the tax cuts passed in December of 2017. However, the issue is that tax cuts only provide a very short-term benefit and, since we compare earnings on a year-over-year basis, growth will drop back towards the growth rate of the economy next year.

For now, the issue has been overlooked due to the surge in earnings from the changes to the tax code as well as the massive surge in repatriated dollars from overseas due to that lower tax rate. As shown by the Federal Reserve:

“Balance of payments data show that U.S. firms repatriated just over $300 billion in 2018:Q1, roughly 30 percent of the estimated stock of offshore cash holdings. For reference, the 2004 tax holiday, which provided a temporary one-year reduction in the repatriation tax rate, resulted in $312 billion repatriated in 2005, of an estimated $750 billion held abroad.”

Of course, while it was expected to go to CapEx and wages, it went to share buybacks instead.

The top 15 firms account for roughly 80 percent of total offshore cash holdings, and roughly 80 percent of their total cash (domestic plus foreign) is held abroad. Following the passage of the TCJA in late December 2017, share buybacks spiked dramatically for the top 15 cash holders, with the ratio of buybacks to assets more than doubling in 2018:Q1.”

Not surprisingly, since buybacks reduce the number of shares outstanding, bottom line EPS surged sharply despite a quarterly decline in revenues/share which slumped from $329.59/share in Q4 to $320.39/share in Q1. 

While the bull market thesis continues to be that earnings expansion will justify higher valuations, such may not be the case. Tariffs, which are a “tax on profits,” could effectively eliminate the majority of the temporary benefits provided by tax cuts to begin with.

“As I wrote recently, the estimated reported earnings for the S&P 500 have already started to be revised lower (so we can play the “beat the estimate game”) but an ongoing trade war could effectively wipe out the entire benefit of the tax cut bill. For the end of 2019, forward reported estimates have declined by roughly $9.00 per share.”

But it isn’t just this year where estimates are falling, but into 2019 as well. The chart below shows the changes in estimates a bit more clearly. It compares where estimates were on January 1st versus April, June, and September 1st. Currently, optimism is exceedingly “optimistic” for the end of 2019.

However, those estimates are likely to be revised down sharply in the months ahead as the number of S&P 500 companies issuing negative EPS guidance is now the highest since 2016.

The more tariffs that are laid on companies which do international business, the more likely we are going to see further decreases in earnings expectations. This is particularly the case given the divergence between the U.S. and the global economy.

“The trade war is now a reality. The recently announced imposition of US tariffs on a further $200 billion of imports from China will have a material impact on global growth and, even though we have now included the 25 percent tariff shock in our GEO [Global Economic Outlook – Ed.] baseline, the downside risks to our global growth forecasts have also increased.” – Fitch Chief Economist Brian Coulton.

Of course, the other issue that will weigh on corporate profitability and earnings is interest rates.

Interest Rates Matter

Yesterday, the Fed hiked interest rates for a third time this year and is set to raise again by the end of the year. With the Fed Funds rate now at 2%, it is equivalent to the Fed’s long-term outlook of the economy and inflation. More importantly, the Fed removed the word “accommodative” from their statement which also suggests they may be nearing the “neutral rate policy setting.” 

Nonetheless, markets have continued to discount the risk of rising rates.

They most likely shouldn’t.

Rising interest rates, like tariffs, are a “tax” on corporations and consumers as borrowing costs rise. When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

The same applies for heavily levered households. With household debt is also at historic highs, rising rates eventually lead to a reversion in household net worth.

With leverage, both corporate and household, at historical peaks, the question is not “if” but “when” rising interest rates pricks the debt balloon.

As Doug Kass recently noted – rising interest rates do matter:

  1. The private and public sector have inflated debt loads today. Rising interest rates raise the cost of servicing that debt and reduce spending and productive investment.
  2. Private sector activity is importantly influenced by interest rates:
    • Rising mortgage rates and higher mortgage payments reduce home affordability and hurt home turnover and refinancings.
    • Slowing home sales and reduced refinancings hurt spending on renovations and remodeling.
    • Given record-high auto prices and the difficulty in further lengthening out already long auto loan maturities, rising interest rates will hurt auto sales by raising monthly payments.
    • Consumer, mortgage and corporate loans that are variable rate are hurt by climbing interest rates.
    • The credit markets fall when interest rates rise, serving to have a negative wealth effect on consumers and corporations that own bonds.
    • Rising interest rates impede corporate profit margins, overall profits and earnings per share
    • Debt is issued by corporations in order to buy back stock and pay dividends. Advancing rates reduce a company’s return on investment on those buybacks.
    • Corporate capital spending is partially dependent on borrowings. Higher borrowing costs could lead to lower capital spending.
  3. Public sector activity and profitability are greatly influenced by interest rates:
    • The deficit/GDP ratio will increase as interest rates rise and the expectation for lower future deficits will crumble.
  4. Dividend discount models are based on future estimates of cash flow discounted back at an appropriate interest rate:
    • Rising interest rates reduce the value of those future cash flows and, in turn, the value or worth of a company’s stock.
  5. There is now an alternative to stocks as the yield on the one-month Treasury bill (2.06%) and two-year Treasury note (2.85%) compare favorably to the S&P’s dividend yield of only 1.75%. Additional increases in interest rates will serve as an even more competitive and attractive alternative to stocks.

As I noted previously, the Fed has a bad habit of hiking rates until something breaks.

Stock Market Implications

As long as the backdrop is healthy, in this case strong earnings and economic growth, the markets can fend off attacks from higher rates and geopolitical issues. However, as tariffs attack corporate profitability, and weakens economic growth, it makes the system much more susceptible to the virus of higher rates. This will most likely expose itself as credit-related event which will be blamed for a bigger correction in the market. However, “Patient Zero” will be the Federal Reserve.

Even one of the most bullish individuals on Wall Street, Wharton finance professor Jeremy Siegel, is now turning cautious. While he isn’t abandoning his bullish backdrop for stocks, particularly since he is involved in everything from ETF’s to Robo-advisors, he suggests it is vital for investors to be aware of growing risks stemming from tariffs and interest rates which could spark a sell-off.

“This market has had a great run, and I wouldn’t be surprised to see another correction. We have some major challenges. The trade war is not yet resolved.

We’re going to see how hawkish [the Fed] is with the labor market as tight as it is. I still believe that they’re going to be on track for four increases this year. The question is how will they feel about another raise in December. And, I think between the trade situation and the interest rate situation, and then, of course, the midterms in November, there are a lot of challenges facing Wall Street.” – Trading Nation.

While Siegel only expects a sell-off like the one we saw in February of this year, the real risk is of one much deeper in nature. As noted just recently in “Ingredients Of An Event.”

“The risk to investors is NOT just a market decline of 40-50%. The real crisis comes when there is a ‘run on pensions.’ 

This is a $4-5 Trillion problem with no resolve to “fix” the problem before it occurs. This leaves a large number of pensioners already eligible for their pension at risk and the next decline will likely spur the “fear” benefits will be lost entirely. The combined run on the system, which is grossly underfunded at a time when asset prices are dropping, will cause a debacle. With consumers are once again heavily leveraged with sub-prime auto loans, mortgages, and student debt, they too will be forced to liquidate assets to meet payment demands.

All the ingredients for a more severe market correction are currently present. Between Trump’s “trade war” and the Fed insistence on hiking rates,  it certainly seems as if they are “hell-bent” on lighting the fuse.

Don’t Worry About Trump; Worry About Earnings

If you’re concerned about President Trump’s influence on the stock market you’re concerned about the wrong thing. That’s not because political leaders – and their problems — don’t influence stock prices temporarily, but because if you own stocks you should own them for their long term earnings prospects (which is why retirees should have reduced stock exposure). Stocks are ownership units of business. And although the political climate influences the business climate, a stock’s price reflects anticipation of earnings far into the future, beyond any politician’s time in office. Procter and Gamble will be selling Tide laundry detergent and Crest toothpaste long after President Trump is out of office. And that doesn’t mean you should own Procter at its current price. It just means, barring any concerns with capitalism or the stability of the country in general, Procter’s current price relative to its  long-term future cash flows is what an investor should concentrate on.

President Trump has been in office for a year and a half, and stocks have shrugged off much of the turbulence that has accompanied his administration. There have been specific policies that seem friendly toward stocks such as the tax cut. But there have also been policies that have been unfriendly to them such as tariffs. No matter, the S&P 500 Index surged nearly 22% in 2017, and is up another 9% this year as of this writing. From taking his time to fill key posts, to feuding openly with his attorney general and the press, to an investigation into his campaign’s contacts with Russia and payments to women with whom he’s had extramarital liaisons, to often betraying a lack of understanding of constitutionalism, to an erratic foreign policy that simultaneously displays abrasiveness but also a diminished role for the United States in global affairs and questionable friendliness toward obvious U.S. enemies, markets have continued rising through it all.

The last week may represent a turning point, but it’s too soon to tell. Trump’s longtime attorney Michael Cohen pleaded guilty to violating campaign finance laws in buying the silence of a pornographic film actress and former Playboy model. In the process Cohen, who taped meetings with Trump when Trump was his client, implicated the president in conspiring with him to commit the crimes.

Moreover, Trump’s former campaign chairman, Paul Manafort, pleaded guilty to 8 counts that included tax fraud and bank fraud. Although Manafort’s trial didn’t touch directly on the accusations that the Trump campaign colluded with Russia to exploit damaging information Russia had on Hilary Clinton, the income that Manafort didn’t report came from advising a pro-Russian political party in the Ukraine. Finally, the chief financial officer of the Trump Organization, Michael Weisselberg, and tabloid executive, David Pecker, were granted immunity by the Southern District of New York regarding its investigation into Cohen.

All of this may or may not lead to impeachment, but the threat looks greater now than ever before. The outpouring of emotion over the death of John McCain, with whom President Trump also openly feuded and mocked for being captured during the Vietnam War, may also push public opinion further against Trump and make impeachment more possible. Perhaps sensing his vulnerability from these recent events, Trump himself said in a recent interview that impeachment would cause the stock market to fall. “If I ever got impeached, I think the market would crash. I think everybody would be very poor. Because without this thinking (pointing to his head) you would see numbers you wouldn’t believe – in reverse.”

But will it? Alex Shepard notes in the New Republic that stocks fell in 1974 when President Nixon resigned from office, but recovered the next year. (The S&P 500 Index lost 26% in 1974 and gained 37% in 1975.) Also, the stock market rose after Bill Clinton was impeached in late 1998. (The S&P 500 Index was up nearly 29% in 1998 and another 21% in 2009.) But Shepard argues that Nixon left before impeachment and that Clinton sailed through his problems with consistently high approval ratings. Trump, by contrast, remains unpopular, and almost certainly wouldn’t leave without a fight. Therefore, Trump’s reaction to impeachment would probably be bad for markets, Shepard concludes.

Interestingly, Trump’s recent poll numbers haven’t moved much. And markets continue to surge, uninterrupted by political concerns or anything else. That should tell investors how hard it is to forecast market moves based on the political climate. President Trump just suffered his worst week in office, and the market’s aren’t registering the problems he’s facing at all.

None of this is to say that the market can’t fall on increasing political problems. But the real problem investors face is valuation – stock prices relative to earnings. Stocks are trading at higher prices relative to past earnings than they have in all but two other moments in history – 1929 and 2000. Often, political tumult can sink a market already vulnerable from high valuations. So far it hasn’t. But if you own stocks, that’s your real problem — the extent to which prices are divorced from past earnings and to which they are anticipating future earnings growth that is unachievable.

Tariff Turbulence, Mollified Market

The founder who shaped our economic system more than all the others was Alexander Hamilton. Unlike Thomas Jefferson, Hamilton favored an economy based on finance and industry rather than agriculture. And Hamilton was also in favor of tariffs

But in a recent post Matt Winesett of the American Enterprise Institute doubts that Hamilton would favor tariffs today. First, he quotes Hamilton’s biographer Ron Chernow saying that Hamilton favored free trade except when government could stimulate nascent enterprises with tariffs. The U.S. was what me might now call an “emerging” market or even a “frontier” market at the time of the founding, and tariffs could improve “American self-sufficiency, leading to a favorable trade balance and more hard currency.”

Since the U.S. has abandoned the gold standard, Winsett thinks it’s no longer necessary to worry about hard currency flows (the exchange of goods for gold). Moreover, national security isn’t threatened by free trade. Winsett notes that “the DOD only needs about 3% of current U.S. steel production to meet its needs.” This is important because even Adam Smith, who generally favored free trade, recognized that the defense of one’s country is of higher importance than “opulence,” according to Dartmouth economist Douglas Irwin’s recent book Clashing Over Commerce. But if defense isn’t imperiled, then free trade should prevail.

Winsett quotes Irwin from a recent WSJ op-ed arguing that Hamilton wanted moderate tariffs as a means of collecting revenue, not onerous ones to stop the importing of foreign goods. The government had to finance its Revolutionary War debt, after all, and wasn’t interested in imposing excessive tariffs as much as it was in collecting taxes Tariffs couldn’t be so heavy that they stopped the inflow of goods. Chernow also notes, according to Winsett, that Hamilton favored lower tariffs on raw materials to encourage manufacturing. In other words, the point wasn’t to be draconian against other nations, but to get some revenue for the government and facilitate industry.

None of this means free trade eliminates the government’s role completely. Irwin quotes Hamilton remarking on the idea that trade can be left to itself as “one of those wild speculative paradoxes, which have grown into credit among us, contrary to the uniform practice and sense of the most enlightened nations.” Still, this doesn’t mean Hamilton would have favored heavy tariffs today.

It’s possible that President Trump is interested in imposing tariffs – or interested in threatening to impose tariffs – in order to compel foreign countries into reciprocity or removing their own tariffs. This means President Trump is really a free trader. So argues Marc Thiessen, also of the American Enterprise Institute, in a recent op-ed.

However, Thiessen’s AEI colleague, Claude Barfield, disagrees, arguing that Trump’s invocation of national security to our historical allies and his compounding protection with subsidies, such as the recent $12 billion to farmers harmed by foreign tariffs, display something other than a desire for free trade. Barfield thinks Sen. Ron Johnson (R-WI) is more accurate in his assessment of Trump’s tariff subsidy as a “Soviet type of economy. .. (with) Commissars. . . . figuring out how they are going to sprinkle around the benefits.” Columnist George Will agrees with Barfield, calling Trump a socialist for seeking to create a managed economy. There is no rule for who gets subsidies, Will notes; everything is done on a whim, putting us on what economist Friedrich Hayek called the “road to serfdom.”

Of course, still another possibility is that Trump is so erratic and inconsistent that he doesn’t have a clearly defined policy goal. Not fully understanding if he wants free trade or not, and perhaps correctly perceiving that things are not as advantageous as they could be for the U.S., he argues different things at different times – national security at one moment, the quest for free trade and tariffs as a means or threat to that end at another. How financial markets remain relatively clam through inconsistent rhetoric and lack of defined policy goals is another mystery.

The Coming Collision Of Debt & Rates

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.

China Is Winning The “Trade War” Without Firing A Shot

This past weekend, the Administration announced a tentative deal with China to temporarily postpone the burgeoning “trade war.” While the details of the deal are yet to be worked out, the concept is fairly simple – China will reduce the existing “trade deficit” by over $200 billion annually with the U.S. by reducing tariffs and allowing more goods to flow into China for purchase. On Monday, the markets reacted positively with industrial and material stocks rising sharply as it is expected these companies will be the most logical and direct beneficiaries of any deal.

Unfortunately, there are several reasons the whole scenario is quite implausible. Amitrajeet Batabyal recently explained the problem quite well.

“With China, the U.S. imports a whopping $375 billion more than it exportsHow could it whittle that down to $175 billion? There are three ways.

  • First, China could buy more U.S. goods and services.
  • Second, Americans could buy less Chinese stuff.
  • Finally, both actions could happen simultaneously.

The kinds of Chinese goods that Americans buy tend to be relatively inexpensive consumer goods, so even a dramatic decline is likely to have only a trivial impact on the deficit. And since China explicitly controls only one lever — its imports — it’ll have to buy a lot more American-made things to achieve this goal.

For this to happen, without upsetting other trade balances, the American economy would have to make a lot more than it currently produces, something that isn’t possible in so short a time frame.”

While the Administration will be able to claim a “trade victory” over a deficit reduction agreement, such is unlikely to lead to more economic growth as promised.

If we assume China does indeed spend an additional $200 billion on U.S. goods, those purchases will increase flows into the U.S. dollar, causing dollar strengthening relative to not only the Yuan but also other currencies as well. Since U.S. exports comprise about 40% of domestic corporate profits, a stronger dollar will counter the benefits of China’s purchase as other foreign importers seek cheaper goods elsewhere.

For China, a stronger dollar also makes imports to their country more expensive. To offset that, China will need to “sell” more of its U.S. Treasury holdings to “sanitize” those transactions and stabilize the exchange rate. This is not “good news” for Treasury Secretary Steve Mnuchin who would lose the largest foreign buyer for U.S. Treasuries.  This particularity problematic with the national debt expected to increase by at least one trillion dollars in each of the next four years.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to 2011. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (The vertical dashed lines denote similar rate increases previously.)

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. From 2014-2016China was dumping U.S Treasuries, and converting the proceeds back into Yuan, in an attempt to stem the outflows and resulting depreciation of their currency. Since 2016, China has been buying bonds as the Yuan has appreciated.

If China does indeed increase U.S. imports, the stronger dollar will increase the costs of imports into China from the U.S. which negatively impacts their economy. The relationship between the currency exchange rate and U.S. Treasuries is shown below.

With respect to the “trade deficit,” there is little evidence of a sustainable rise in inflationary pressures. The current inflationary push has come primarily from the transient effect of a disaster-related rebuilding cycle last year, along with pressures from rising energy, health care, and rental prices. These particular inflationary pressures are not “healthy” for the economy as they are “costs” which must be passed along to consumers without a commensurate rise in wages to offset them.

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed U.S. bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has only been one previous period when this relationship failed which was in 2007 and 2008.

With the Chinese financial system showing signs of increasing stress, any threat which devalues the currency will lead to further selling of Treasuries. Rising import costs due to a forced “deficit balancing,” will likely have more of a negative impact to the U.S. than currently believed.

Sum-Zero Game

While much of the mainstream media continues to expect a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then productivity, population, wage and consumer debt growth become key inputs into that equation. Unfortunately, productivity is hardly growing in the U.S. as well as in most developed nations. Further, wage and population growth remain weak as consumers remain highly leveraged. This combination makes a surge in economic growth highly unlikely particularly as rate increases reduce the ability to generate debt-driven consumption.

With unemployment rates near historic lows and production measures near highs, the problem of meeting Chinese demand will be problematic. As Amitrajeet states:

“That’s because when a nation’s economy is using its resources to produce goods efficiently, economists say that it has reached its production possibility frontier and cannot produce more goods.”

This makes Chinese promises largely illusory given the structural hurdles in China to allow for increased purchases of American exports much less the sheer amount of goods the United States would have to produce to meet Beijing’s demand.

As stated, with the United States economy already running near its full productive capacity, it is virtually impossible to produce enough new goods to meet Chinese demands, especially in the short term.

Sure, the United States could stop selling airplanes, soybeans and other exports to other countries and just sell them to China instead. Such actions would indeed shrink the United States trade deficit with China, but the trade deficit with the entire world would remain unchanged.

In other words, it’s a sum-zero game.

More importantly, if the U.S. cannot deliver the goods and services needed by China the entire agreement is worthless from the start. More importantly, China’s “concessions,” so far, are things it had planned to do anyway. As noted by Heather Long via the Washington Post:

“The Chinese have one of the fastest-growing economies and middle classes in the world. Chinese factories and cities need more energy, and its people want more meat. It’s no surprise then that China said it was interested in buying more U.S. energy and agricultural products. The Trump administration is trying to cast that as a win because the United States will be able to sell more to China, but it was almost certain that the Chinese were going to buy more of that stuff anyway.

What Trump got from the Chinese is ‘the kind of deal’ that China would be able to offer any U.S. president,’ said Brad Setser, a China expert at the Council on Foreign Relations. ‘China has to import a certain amount of energy from someone and needs to import either animal feed or meat to satisfy Chinese domestic demand.’

China has been buying about $20 billion worth of U.S. agricultural products a year and $7 billion in oil and gas, according to government data. Even if China doubled — or tripled — purchases of these items, it won’t equal anywhere near a $200 billion reduction in the trade deficit.”

But where China really won the negotiation was when the United States folded and agreed to suspend “trade tariffs.” While the current Administration is keen on “winning” a deal with China, without specific terms (such as a defined amount of increased purchases from the U.S. and the ability to meet that demand) the “deal” has little meaning. China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.

“Yes, it’s good for both sides not to be in a trade war, but the Chinese had more to lose economically from the tariffs. The Trump administration rolling back its $150 billion tariff threat against China is a good ‘get’ for the Chinese.”

As with all things, there are always two sides to the story. While the benefits of reducing the trade may seem like a big win for America, reality could largely offset any benefits. If the goal was simply to be seen as the winner, Trump may have won the prize. But, it will likely be China laughing all the way to the bank.