Tag Archives: TIPS

Powell’s Revelation And A TIP For Defense

I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

  • “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
  • “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
  • “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

The rest of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

Powell’s Revelation And A TIP For Defense

I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

  • “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
  • “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
  • “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

Part two of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

TIPS Mechanics

Few investors truly understand the mechanics of TIPS, so let’s review the basics.

TIPS are debt securities issued by the U.S. government.  Like most U.S. Treasury securities, TIPS have a stated maturity and coupon. Unlike other securities, the principal value of TIPS adjust based on changes in the rate of inflation. The principal value can increase or decrease but will never fall below the bond’s initial par value. The semi-annual coupon on TIPS are a function of the yield of a like-maturity Treasury bond less the expected inflation rate over the life of the security, known as the break-even inflation rate.

The tables below compare the cash flows of a typical fixed coupon Treasury bond, referred to as a nominal coupon bond, and a TIPS bond to help further clarify.

The table above shows the cash flows that an investor pays and receives when purchasing a five-year bond with a fixed coupon of 4% a year. The investor initially invests $1,000 in the bond and in return receives $40 or 4% a year plus a return of the original investment ($1,000) at maturity. In our example, the annual return to the bondholder is 4%. While the price and yield of the security will change during the life of the bond, an investor holding the bond to maturity will be guaranteed the cash flows, as shown.

The TIPS table above shows the cash flows an investor pays and receives when purchasing a five-year TIPS bond with a fixed coupon of 2% a year. Like the fixed coupon bond, the investor initially pays $1,000 to purchase the bond. The similarities end here. Every six months the principal value adjusts for inflation. The coupon payment for each period is then calculated based on the new principal value (and not on the original par value. The principal value can adjust downward, but it cannot fall below the original value. This is an important safety feature that guarantees a minimum return equal to the coupon times the original principal value.  At maturity, the investor receives the final adjusted principal value, not the original principal value. Please note that if a TIPS is bought in the secondary market at a principal value exceeding its original value, the investor can lose the premium and returns can be negative in a deflationary environment.

In the hypothetical example above and excluding reinvestment of coupon payments, an investor in the nominal bond will receive $1,200 in cumulative cash flows over the life of the security. The TIPS investor would receive $1,209.12 in cumulative cash flows.

TIPS are a bet or a hedge on the breakeven inflation rate. If realized inflation over the life of a TIPS is less than the breakeven rate the investor earns a lower return than on a nominal Treasury bond with the same coupon rate. As shown in our example, if inflation is greater than the breakeven rate, then the TIPS investor earns a higher return than a nominal Treasury bond with the same coupon.

The following charts show the return profiles under various inflation scenarios, for the fixed coupon and TIPS examples used in the tables above.

The first graph shows the real (inflation-adjusted) coupon payments at various levels of inflation and deflation. In deflationary environments, both bonds provide positive real returns with the fixed coupon bond outperforming by the 2% breakeven rate. As inflation rises above the breakeven rate, the real return on the TIPS bond increasingly outperforms the fixed bond.

The next graph shows the nominal coupons of both bonds, assuming the investor holds them to maturity. The fixed bond earns the 4% coupon through all inflation scenarios. The TIPS bond earns a constant 2% coupon through all deflationary scenarios while the coupon rises in value as inflation increases. 

At any point in a TIPS life, investors may incur mark to market losses, and if the bonds are sold before maturity, this can result in a permanent loss. Any TIPS bond held from issuance to maturity will have a real positive gain assuming the coupon is above zero, the same is not true for a fixed rate bond.

Current environment

Various inflation surveys, as well as market-implied readings, suggest investors expect low levels of inflation to continue for at least the next ten years. The following graph provides a historical perspective on inflation trends and current long term inflation expectations as measured by 5, 10, and 20-year TIPS breakeven inflation rates.

Data Courtesy: St. Louis Federal Reserve (FRED)

The rate of inflation over the last 20 years, as measured by the consumer price index, has generally been decelerating. In other words, prices are rising but at a progressively slower pace.  Since 1985, the year over year change in inflation has averaged 2.6%, and since 2015, it has averaged 1.5%.

The market determined break-even inflation rate, or the differential between TIPS yields and like maturity fixed coupon yields, for the next 5, 10, and 20 years is currently 1.39%, 1.59%, and 1.65%, respectively. Inflation expectations for the next twenty years are consistent with the actual rate of inflation for the last ten years.

The Case For TIPS

While most forecasts are based on the past and therefore do not predict meaningful inflation, we must remain cognizant that since the Great Financial Crisis in 2008/09, the Federal Reserve (FED) and many other central banks have taken extraordinary monetary policy actions. The Fed lowered their targeted interest rates to zero while central banks in Japan and Europe have gone even further and introduced negative interest rates. Additionally, banks have sharply increased their balance sheets. These actions are being employed to incentivize additional borrowing to foster economic growth and boost inflation. More recently, as we are now seeing with a new round of QE, it appears the Fed is now using monetary policy to help facilitate trillion-dollar Federal deficits. 

Investors must be careful with the market’s assumption that the Fed’s efforts to stimulate inflation will lead to the same inflation rates of the past decade. Further, if “warranted”, a central bank can literally print money and hand it out to its citizens or directly fund the government. These alternative methods of monetary policy, deemed “helicopter money” by Ben Bernanke, would most likely cause prices to rise significantly.   

“Too much” inflation would be a detriment to the equity and bond markets. If inflation rates greater than three or four percent were to occur, a large majority of investors would pay dearly. Such circumstances would depreciate investor asset values and simultaneously reduce their purchasing power. With this double-edged sword in mind, TIPS should be considered by all investors.

The graph below, courtesy Doug Short and Advisor Perspectives, shows that equity valuations tend to be at their highest when inflation ranges between zero and two percent. Outside of that band, valuations are lower.  Currently, the market is making a big bet that valuations can remain near historical highs and inflation will remain in its recent range.

The worst case scenario for TIPS, as shown in the graphs, is a continuation of the inflation trends of yesterday. In those circumstances, TIPS would provide a return on par with or slightly less than comparable maturity nominal Treasury bonds. Investors also need to incorporate the opportunity cost of not allocating those funds towards stocks or riskier bonds should inflation remain subdued.

For those conservative investors sitting on excess cash, TIPS can be effectively employed as a surrogate to cash but with the added benefits of coupon payments and protection against the uncertainty of inflation.  In a worst case scenario, TIPS provide a return similar to those found on money market mutual funds. In the event of deflation and/or negative rates, TIPS should outperform these funds, which could easily experience negative returns.

Summary

Markets have a long history of assuming the future will be just like the past. Such assumptions and complacency work great until they don’t.  We do not profess to know when inflation may pick up in earnest, and we do not have a good economic explanation for what would cause that to happen. That being said, monetary policy around the world is managed by aggressive central bankers with strong and misplaced beliefs about the benefits of inflation. At some point, there is a greater than zero likelihood central bankers will be pushed to take actions that are truly inflationary. While the markets may initially cheer, the inevitable consequences may be dire for anyone not focused on preserving their purchasing power.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS is tremendous. Change can happen in a hurry, and the only way to protect and or profit from it is to anticipate it. As has been said, you cannot predict the future, but you can prepare for it.

We leave you with an important quote from our recent article- Warning, No Life Guards on Duty.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

An Investor’s Desktop Guide To Trading – Part I

Read Part-II Here

Throughout history, individuals have been drawn into the more speculative stages of the financial market under the assumption that “this time is different.” Of course, as we now know with the benefit of hindsight, 1929, 1972, 1999, 2007, and most likely 2019, were not different – they were just the peak of speculative investing frenzies. Of course, if you went through one of the more recent bear market drawdowns, there is an important distinction, as my colleague John Coumarianos recently penned, “You’re Different This Time.”

“Even if you sailed through the 2007-2009 market meltdown without undue worry or panic-selling, the next downturn could prove more visceral if retirement is closer at hand and starting to seem like a realistic possibility. It’s not fun to see your portfolio drop from $500,000 to $225,000 when you’re 45. But it’s way worse to see your $1 million portfolio drop to $450,000 when you’re 55 and beginning to think serious thoughts about the when and how of your retirement. The losses are the same (in percentage terms); the ages are different.” 

So, what can you do?

In the media, there is a select group of investors and portfolio managers that are revered for the knowledge and success. While we idolize these investors for their respective “genius,” we can also save ourselves time and money by learning from their wisdom and their experiences. That wisdom was NOT inherited, but was birthed out of years of mistakes, miscalculations and trial-and-error. Most importantly, what separates these individuals from all others was their ability to learn from those mistakes, adapt, and capitalize on that knowledge in the future.

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

Importantly, you will notice that many of the same lessons are repeated throughout. This is because there are only a few basic “truths” of investing that all of the great investors have learned over time.

The next major down market cycle is coming, it is just a question of when? These rules can help you navigate those waters more safely, because “you’re different this time.”


10-Trading Rules From Todd Harrison

1. Respect price action but never defer to it.

2. Discipline always trumps conviction. Following a set discipline removes the emotional bias of conviction.

3. Opportunities are made up far easier than lost capital.

4. Emotion is the enemy of trading.

5. It’s far better to “zig” when others “zag.”

6. Be adaptive to the market. Failure to adapt leads to extinction.

7. Maximize reward relative to the risk taken.

8. Perception is reality in the marketplace.

9. When “unsure” – trade small or not at all.

10. Don’t let bad trades turn into investments.


21-Trading Rules From Paul Tudor Jones 

1. When you are trading size, you have to get out when the market lets you out, not when you want to get out.

2. Never play macho with the market and don’t over trade.

3. If I have positions going against me, I get out; if they are going for me, I keep them.

4. I will keep cutting my position size down as I have losing trades.

5. Don’t ever average losers.

6. Decrease your trading volume when you are trading poorly; increase your volume when you are trading well.

7. Never trade in situations you don’t have control.

I don’t risk significant amounts of money in front of key reports since that is gambling, not trading.

8. If you have a losing position that is making you uncomfortable, get out. Because you can always get back in.

9. Don’t be too concerned about where you got into a position.

10. The most important rule of trading is to play great defense, not offense.

11. Don’t be a hero. Don’t have an ego.

12. I consider myself a premier market opportunist.

13. I believe the very best money is to be made at market turns.

14. Everything gets destroyed a hundred times faster than it is built up.

It takes one day to tear down something that might have taken ten years to build.

15. Markets move sharply when they move.

16. When I trade, I don’t just use a price stop, I also use a time stop.

17. Don’t focus on making money; focus on protecting what you have.

18. You always want to be with whatever the predominant trend is.

19. My metric for everything I look at is the 200-day moving average of closing prices.

20. At the end of the day, your job is to buy what goes up and to sell what goes down so really who gives a damn about PE’s?

21. I look for opportunities with tremendously skewed reward-risk opportunities.


25-Trading Rules From Jim Cramer

1. Bulls, Bears Make Money, Pigs Get Slaughtered

2. It’s OK to Pay the Taxes

3. Don’t Buy All at Once

4. Buy Damaged Stocks, Not Damaged Companies

5. Diversify to Control Risk

6. Do Your Stock Homework

7. No One Made a Dime by Panicking

8. Buy Best-of-Breed Companies

9. Defend Some Stocks, Not All

10. Bad Buys Won’t Become Takeovers

11. Don’t Own Too Many Names

12. Cash Is for Winners

13. No Woulda, Shoulda, Couldas

14. Expect, Don’t Fear Corrections

15. Don’t Forget Bonds

16. Never Subsidize Losers With Winners

17. Check Hope at the Door

18. Be Flexible

19. When the Chiefs Retreat, So Should You

20. Giving Up on Value Is a Sin

21. Be a TV Critic

22. Wait 30 Days After Preannouncements

23. Beware of Wall Street Hype

24. Explain Your Picks

25. There’s Always a Bull Market


Bernard Baruch’s 10 Investing Rules

1. Don’t speculate unless you can make it a full-time job.

2. Beware of barbers, beauticians, waiters — of anyone — bringing gifts of “inside” information or “tips.”

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don’t try to buy at the bottom and sell at the top. This can’t be done — except by liars.

5. Learn how to take your losses quickly and cleanly. Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.

6. Don’t buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to the greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don’t try to be a jack of all investments. Stick to the field you know best.


 James P. Arthur Huprich’s Market Truisms And Axioms

1. Commandment #1: “Thou Shall Not Trade Against the Trend.”

2. Portfolios heavy with under-performing stocks rarely outperform the stock market!

3. There is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again, mostly due to human nature.

4. Sell when you can, not when you have to.

5. Bulls make money, bears make money, and “pigs” get slaughtered.

6. We can’t control the stock market. The very best we can do is to try to understand what the stock market is trying to tell us.

7. Understanding mass psychology is just as important as understanding fundamentals and economics.

8. Learn to take losses quickly, don’t expect to be right all the time, and learn from your mistakes.

9. Don’t think you can consistently buy at the bottom or sell at the top. This can rarely be consistently done.

10. When trading, remain objective. Don’t have a preconceived idea or prejudice. Said another way, “the great names in Trading all have the same trait: An ability to shift on a dime when the shifting time comes.”

11. Any dead fish can go with the flow. Yet, it takes a strong fish to swim against the flow. In other words, what seems “hard” at the time is usually, over time, right.

12. Even the best looking chart can fall apart for no apparent reason. Thus, never fall in love with a position but instead remain vigilant in managing risk and expectations. Use volume as a confirming guidepost.

13. When trading, if a stock doesn’t perform as expected within a short time period, either close it out or tighten your stop-loss point.

14. As long as a stock is acting right and the market is “in-gear,” don’t be in a hurry to take a profit on the whole positions. Scale out instead.

15. Never let a profitable trade turn into a loss, and never let an initial trading position turn into a long-term one because it is at a loss.

16. Don’t buy a stock simply because it has had a big decline from its high and is now a “better value;” wait for the market to recognize “value” first.

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

18. Human emotion is a big enemy of the average investor and trader. Be patient and unemotional. There are periods where traders don’t need to trade.

19. Wishful thinking can be detrimental to your financial wealth.

20. Don’t make investment or trading decisions based on tips. Tips are something you leave for good service.

21. Where there is smoke, there is fire, or there is never just one cockroach: In other words, bad news is usually not a one-time event, more usually follows.

22. Realize that a loss in the stock market is part of the investment process. The key is not letting it turn into a big one as this could devastate a portfolio.

23. Said another way, “It’s not the ones that you sell that keep going up that matter. It’s the one that you don’t sell that keeps going down that does.”

24. Your odds of success improve when you buy stocks when the technical pattern confirms the fundamental opinion.

25. As many participants have come to realize from 1999 to 2010, during which the S&P 500 has made no upside progress, you can lose money even in the “best companies” if your timing is wrong. Yet, if the technical pattern dictates, you can make money on a short-term basis even in stocks that have a “mixed” fundamental opinion.

26. To the best of your ability, try to keep your priorities in line. Don’t let the “greed factor” that Wall Street can generate outweigh other just as important areas of your life. Balance the physical, mental, spiritual, relational, and financial needs of life.

27. Technical analysis is a windsock, not a crystal ball. It is a skill that improves with experience and study. Always be a student, there is always someone smarter than you!


James Montier’s 7 Immutable Laws Of Investing

1. Always insist on a margin of safety

2. This time is never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. Be leery of leverage

7. Never invest in something you don’t understand

Is The Stock Market As Confused As You Are About A Recession?

Last week, Barron’s ran an article entitled “The Stock Market Is Just As Confused About A Potential Recession As You Are?” To wit:

“Investors have long used where we are in the economic cycle to decide which stocks to buy and sell. New research from Nomura’s Joseph Mezrich flips that on its head by showing how investors can use stock performance to help determine where we are in the cycle. Too bad the market is sending mixed messages right now.”

But let’s be clear here; no one wants the party to end. So, despite a struggling stock market over the last year, slowing economic growth, and a collapsing yield curve, there are still plenty of articles suggesting you should just ignore it all and remain invested.

“Economist Ryan Sweet of Moody’s Analytics has a message for his fellow economists who are predicting a recession in the next year: ‘The Fed isn’t going to kill this expansion.'” – Ryan Sweet of Moody’s Analytics

But then he goes on to make an interesting statement:

“Recessions are typically caused by one of two things, he says: Imbalances develop in the economy or financial system (like a bubble in the stock market or in housing), or the Federal Reserve panics and raises interest rates too much in response to unexpected inflation caused by an overheating economy. Neither of those triggers is present.”

Uhm….okay…maybe Ryan just doesn’t get out of the house much but saying there isn’t a bubble in the stock market is like saying Mount Everest is just a mountain.

Also, with respect to his point that the Fed isn’t going to kill this expansion, well that too may also be a bit myopic. As shown, the Fed has been hiking rates to offset the specter of inflation which doesn’t exist to any great degree and have likely gone too far. We suspect this, because the recent reversal in policy is akin to what we have see repeatedly in the past. The Fed tends to stop hiking interest rates when they realize they have caused problems within the economy, like a sudden downward shift in housing, autos, and asset prices.

Sound familiar?

The problem with all of the mainstream claims that there is “no recession in sight” is those claims are based on analysis of unrevised and lagging economic data. 

This is an incredibly important point.

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

“The Federal Reserve is not currently forecasting a recession.”

In hindsight, the NBER, eleven months later, announced that the official recession began in December of 2007.

“But if the Federal Reserve can’t predict a recession, no one can.”

Well, that isn’t necessarily correct. For example, let’s take a look at the data below of real (inflation-adjusted) economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession (this is historically revised data). If Ryan had been making his comments about the economy in 1957, it would have sounded much the same way.

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.07% on an inflation-adjusted basis, there is no recession in sight.” 

You will note in the table above that in 6 of the last 9 recessions, real GDP growth was running at 2% or above.

At those points in history, there was NO indication of a recession “anywhere in sight.” 

But the next month one began.

So, is the market really sending mixed messages?”

The Market Isn’t Confused

This is also likely a mistaken assumption. In reality, it may just be the unwillingness of “eternally optimistic” individuals to pay attention.

Take a look at the chart below. The green dots mark the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances the S&P 500 peaked and turned lower prior to the recognition of a recession. 

In other words, the decline from the peak was “just a correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in the waiting for the data to catch up.

So, if you really can’t count on economic data to “alert” you to the onset of a recession, what can you use. 

Well, by looking at the chart above, it is clear the stock market leads economic downturns. Also, as we have written about previously, so do yield curve inversions. The chart below combines both which shows this is indeed the case. In every prior instance going back to 1980, the stock market began to peak as the yield curve began to invert.

Also, when the Fed Funds rate exceeds the 10-year Treasury, that too has been a pretty strong indication of both market problems and the onset of a recession. Currently, the spread between those two particular rates (at the time of this writing) is +0.0%.

But even this warning has been met with criticism. Just recently, Dallas Fed President Robert Kaplan stated, with respect to the potential for the Fed to lower interest rates:

“I’d need to see an inversion of some magnitude and/or some duration, and right now we don’t have either. If you see an inversion that goes on for several months…that’s a different kettle of fish, but we’re not there yet.”

The problem for the Fed is in the waiting. A look back at the charts above show there are only two occasions going back to the 1970’s where the yield curve inverted and it didn’t lead to a recession. The problem with “patience” is that by the time the Fed does act, it will likely be too late which has historically always been the Fed’s problem.

Furthermore, the “yield curve inversion” is NOT the illness of the market, rather it is the symptom of virus infecting the economic environment. David Rosenberg just recently penned a rather exhaustive list.

  1. The Fed turned TOO dovish, taking out not one, but both pledged rate hikes for this year and trimming its GDP forecasts.
  2. The stock market didn’t mind the futures market pricing out future tightening, but discounting rate cuts means the Fed DOES see something nefarious around the corner. Market-based odds of the next move being a policy easing have jumped to 58% from 30% a week ago and 5% a month ago! Remember, the best time to “buy” the market is on the last rate cut, not the first one.
  3. The 10-year/3-month yield curve finally inverted, albeit fractionally, for the first time since August 2007. This  is not an infallible indicator, but predicts recessions with 85% accuracy. 
  4. Not only has the yield curve inverted, but the composition of the drop in bond yields should be a worry sign to equity investors. While inflation expectations have receded to 1.9% (for 10-year break-evens,) fully 85% of the slide in Treasury yields has come from the “real rate,” which has collapsed to a mere 0.55%. The bond market is thus looking the stock market straight in the eye and saying “this rough patch in the economy and recession in corporate profits ain’t no one-quarter wonder.” 
  5. The President has sought to pick a fight with Jay Powell by nominating his long-time supporter Stephen Moore to the Fed as Governor. If this happens, one can expect dissension to rise at the Central Bank. Moore is such a hypocrite that he penned a paper in 2014 criticizing the Fed for its QE largesse and for not raising rates – and now he’s been openly insulting to Jay Powell (going so far as to call for his resignation) for doing what Moore was clamoring for a half-decade ago. One more step towards trying to politicize the institution. (A strong case here for gold.)
  6. In addition to the uncertainty now at the Fed – Neel Kashkari is not being shy that a policy misstep has been made as he second-guesses even his 2.5% estimate of the “neutral” funds rate. We have a fiscal situation in the USA that also is destabilizing and clearly crowding out private investment. In Feburary, the budget deficit hit a record $234 billion, which is pure insanity (up 9% from a year ago). In all of 2006, the gap was $248 billion. In 2007, the peak of growth in the last cycle, the annual deficit was $161 billion – lower than the past month. When I started in the business in 1987, the annual deficit that year was $150 billion. Now, we do more than that in just one month. And, this level of debt-laden government intervention in the economy is really worth of a forward P/E mulitple that up until recently was pressing against 16x?
  7. The flat-to-inverted yield curve is killing the banks. The S&P 500 Financials were crushed 5% last week; the regional banks were down 9.4%. The KBW Nasdaq Bank Index suffered its biggest one-week loss since 2016.
  8. The Atlanta Fed is down close to zero percent on Q1 growth and the NY Fed sees the first half of the year at 1.4%, or half of the 2018 pace.

He had multiple more points in his “must read” daily missive, but you get the idea.

Nonetheless, we are still told to disregard the warnings because this “time is different.”

To wit:

“‘Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not,’ because the normal market signals have been distorted by, ‘regulatory changes and quantitative easing in other jurisdictions…everything we see in terms of the near-term outlook for the economy is quite strong.’”Former U.S. Fed Chair Ben Bernanke, July 2018

“I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed…the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider.” Former U.S. Fed Chair Janet Yellen’s final press conference, December 2017

Of course, given the track record of the Fed, maybe you should think differently.

With valuations at 30x trailing 10-year earnings, the risk to capital is quite substantial. As Larry Berman recently discussed for BNN Bloomberg:

“The P\E in a recession trough is probably between 11-13 times earnings. Earnings tend to fall about 15-20 per cent in an average recession. This one is probably worse than average largely due to the massive increase in leverage over the cycle suggest the downturn would be longer and deeper. If earnings fall by 30 per cent and the multiple is 11x, the S&P trough value is around 1,300. The optimistic scenario is a 15 per cent decline in earnings and a 13X multiple puts the S&P 500 around 1850. As an FYI, earnings fell by about 50 per cent in 2008-09 recession. Bottom line is a BIG Bear market for equities is likely and passive ETF portfolios will tend to disappoint.”

He is right. During “average” recessions stocks reprice forward expectations by 30% on average. However, given the massive extensions in markets over the last decade, Larry’s targets above suggest a 50% decline is possible.

Don’t Ignore The Warning

During the entirety of 2007, the trend of the data was deteriorating and the market had begun to struggle to advance. The signs were all there that “something had broken” but the “always bullish” mainstream media encouraged investors to simply ignore it as it “was different this time.” Unfortunately, by the time the annual data revisions had been released by the Bureau of Economic Analysis (BEA), it was far too late to matter.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced.

In 2007, the market warned of a recession 14-months in advance of the recognition. 

Today, you may not have as long as the economy is running at one-half the rate of growth.

However, there are three lessons to be learned from this analysis:

  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.

We do know, with absolute certainty, this cycle will end.

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.” 

Being optimistic about the economy and the markets currently is far more entertaining than doom and gloom. However, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

The market, and the yield curve, are trying to tell you something very important.

Is The Market Predicting A Recession?

There has been lot’s of analysis lately on what message the recent gyrations in the market are sending.

Is this just a correction in an ongoing, and seemingly never-ending, bull market?

Maybe. Anything is possible.

Or, is the financial market starting to pick up on what we have been warning about for the last several months which is simply higher rates, slowing global growth, and trade wars are going to impact the economy?

The consensus is that with the current spat of strong economic growth, unemployment and jobless claims at record lows, and confidence near record highs, there is simply no way the economy is even close to starting a recession. Furthermore, with economic growth slated to come in at 3.4% for the 3rd-quarter, this is further evidence a recession is “nowhere in sight.” 

“Finally, it’s here. The bad news the financial media has been searching for, doggedly, for the last six months. As stocks plunge across the planet, fears of a recession are resurfacing.

We can say this with some confidence: The stock market panic is overblown. And a US recession is not imminent.” Gwynn Guilford, Quartz

And what is the basis for Gwynn’s vote of confidence?

American growth is indeed strong. Last quarter, the US economy expanded a whopping 4.2%, in real annualized terms. Unemployment is at 48-year lows. Inflation is in check. Consumer confidence is strong. Wages are rising (if only grudgingly). Investment could be better, for sure. But the fact of the matter is, overall, things are looking pretty good right now.”

See, nothing to worry about? Obviously, the recent spasms of the market this year are really nothing more than just one of the normal market corrections which happen every now and then. The chart shows the S&P 500 going back to 1960 with some “interesting green dots.”  (Cheap trick to get you to keep reading.)

Before we get to those “interesting green dots,” we need to make a point about Gwynn’s assessment of the current economic outlook.

While Gwynn is absolutely correct about the current state of economic growth, the view is also wrong.

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

“The Federal Reserve is not currently forecasting a recession.”

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

But Gwynn goes on to state:

“And when the next recession does hit, chances are good that economic conditions will already feel quite different from the present moment.”

If Ben Bernanke did even know that we were in a recession will we?

Well, that isn’t necessarily correct. For example, let’s take a look at the data below of real (inflation-adjusted) economic growth rates:

  • September 1957:     3.07%
  • May 1960:                 2.06%
  • January 1970:        0.32%
  • December 1973:     4.02%
  • January 1980:        1.42%
  • July 1981:                 4.33%
  • July 1990:                1.73%
  • March 2001:           2.31%
  • December 2007:    1.97%

Each of the dates above shows the growth rate of the economy immediately prior to the onset of a recession. If Gwynn had been writing an article about the markets and the economy in 1957, it would have read much the same way.

“The recent decline from the peak in the market, is just that, a simple correction. With the economy growing at 3.07% on an inflation-adjusted basis, there is no recession in sight.” 

You will note in the table above that in 6 of the last 9 recessions, real GDP growth was running at 2% or above.

At those points in history, there was NO indication of a recession “anywhere in sight.” 

But the next month one began.

Let’s go back to those “interesting green dots” in the S&P 500 chart above. 

Each of those dots are the peak of the market PRIOR to the onset of a recession. In 8 of 9 instances the S&P 500 peaked and turned lower prior to the recognition of a recession. 

In other words, the decline from the peak was “just a correction” as economic growth was still strong.

In reality, however, the market was signaling a coming recession in the months ahead. The economic data just didn’t reflect it as of yet. (The only exception was 1980 where they coincided in the same month.) The chart below shows the date of the market peak and real GDP versus the start of the recession and GDP growth at that time.

The problem is in the waiting for the data to catch up.

Let’s take the chart of the S&P 500 index above, and add official recessions as dated by the National Bureau of Economic Research (NBER) and the dates at which those proclamations were made.

Prior to 1980, the NBER did not officially date recession starting and ending points.

The table below breaks down the data. For example:

  • In July 1956, the market peaked at 48.78 and started to decline. 
  • Economic growth was increasing from 0.9% and heading to 3.07% in 1957. (No sign of recession)
  • In September 1957 the economy fell into recession and the market had already fallen by almost 10%.
  • From peak to trough, the market fell 17.38%
  • Importantly, the market had warned of a recession 14-months in advance. 

You will also 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.”

At that time the trend of the data was obvious and the market was already suggesting that “something had broken.” Of course, it wasn’t until a full year later, after the annual data revisions had been released by the Bureau of Economic Analysis, that the recession officially revealed. Unfortunately, by then, it was far too late to matter.

Today, we are once again seeing many of the same early warnings. If you have been paying attention to the trend of the economic data, the stock market, and the yield curve, the warnings are becoming more pronounced. In 2007, the market warned of a recession 14-months in advance of the recognition. 

So, therein lies THE question:

Is the market currently signaling a “recession warning?”

Everybody wants a specific answer. “Yes” or “No.

Unfortunately, making absolute predictions can be extremely costly when it comes to portfolio management.

Note: In the table above, the time span between the market signal and the recession onset has been greatly compressed since 1973 when the NBER started dating recessions. This is due to the fact that when the NBER looks back they are seeing data after “revisions” by the BEA. Therefore, the data aligns more closely with what the market was signaling PRIOR TO the economic revisions.

There are three lessons to be learned from this analysis:

  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.

We do know, with absolute certainty, when this cycle will end.

“Economic cycles are only sustainable for as long as excesses are being built. The natural law of reversions, while they can be suspended by artificial interventions, cannot be repealed.” 

While there may currently be “no sign of recession,” there are plenty of signs of “economic stress” such as:

Being optimistic about the economy and the markets currently is far more entertaining than doom and gloom. However, it is the honest assessment of the data, along with the underlying trends, which are useful in protecting one’s wealth longer-term.

The best advice I have is the same as a recent quote from John Stepek:

“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.

The market may already be trying to tell you something.

Inflation Or Deflation? And How to Cope With Both.

The following is a slightly adjusted email I’ve sent to clients concerned about inflation lately. Sometimes retail investors have legitimate fear and anticipate economic trends correctly, but sometimes they don’t It’s striking how many investors have been gripped by inflation fears recently. Please understand that different clients have different needs, and not all portfolios are the same.

—–

Dear Client — I’ve been thinking about the problem of increasing inflation, and preparing for it. Here’s a run-down of the major asset classes, and how they typically respond to inflation (or have been responding to rising rates and inflation fears lately).

Bonds – except the shortest term bonds or the most cash-like bonds – their value declines because they’re paying a fixed dollar return and, sort of by definition, are not keeping up with inflation. But short term bonds and cash are decent choices. Short term bonds and cash instruments like money markets just tend to pay higher and higher interest rates when rates are going up. In our own portfolios, we use short-duration bonds, floating rating investments and CD’s for liquidity needs as they mature quickly to capture new, higher rates when rates move up.

We’re seeing those yields move up now as the yield on the 2-year US Treasury is up to 2.5% or so. That doesn’t sound like much, but it’s a huge jump from where it was a year or two ago TIPS (Treasury inflation-protected bonds) also protect against inflation. Their principal gets adjusted according to the consumer price index (CPI), which is the main indicator of inflation.

Stocks tend to produce better-than-inflation returns over long periods of time, but not necessarily when inflation is running at its highest clip, and not necessarily from high starting valuations (such as we have now). Stocks didn’t do well in the 1970s, for example. Over time companies pass through higher costs, but that’s not always reflected in the stock prices immediately. That’s because higher interest rates tend to send all financial asset prices down. And that’s probably why the stock market has been more volatile this year.

REITs act mostly like stocks in the long run. (And they are, in fact, stocks or ownership units.) They will pass through the higher costs over time by charging higher rents, but that won’t necessarily be reflected in stock prices immediately. And the truth is we’ve already had a lot of rent inflation since the financial crisis that hasn’t been captured in the official inflation numbers in my opinion. Residential rents have been skyrocketing for a long time now. They’ve been in such a long cycle that they are actually slowing down a lot in NYC and SF.  I think REITs are just to expensive now, and they are reacting badly this year to inflation fears. They’ve tended to trade more like long-term bonds in recent years, which they do from time to time, and have faltered every time rates have moved up this year. That doesn’t bode well for how they might perform if we get higher inflation. Early this year, when rates were moving higher (inflation fear), REITs stumbled badly. Only when rates stopped going up, did REITs recover a bit. The following graph shows that REITs have been more volatile than Treasuries, but have moved somewhat in line with them this year.

That leaves commodities. In standard asset allocation models, around 5% of the portfolio in normally allocated to commodity type funds. However, over time, commodities don’t do so well though, so manage commodity exposure very carefully. A bet on commodities is, in some sense, a bet against human ingenuity, after all.

Last, keep in mind the economy is still kind of tepid, despite the very low unemployment numbers. The Labor Force Participation Rate is low, and middle class incomes aren’t rising. The most interesting question is whether we’ll get deflation because of a sluggish economy (and we haven’t had a recession in a while) or inflation because of the reasons you state – a lot of money printing, growing deficits, and tariffs. We have to be prepared for different scenarios, and we’ve structured the portfolio to withstand a variety of outcomes.