Tag Archives: trade war

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.

Special Report: Fed Launches A Bazooka As Markets Hit Our Line In The Sand

The severity of the recent market rout has been quite astonishing. As shown below, in just three very short weeks, the market has reversed almost the entirety of the “Trump Stock Market” gains.

The decline has been unrelenting, and despite the Fed cutting rates last week, and President Trump discussing fiscal stimulus, the markets haven’t responded. In mid-February we were discussing the markets being 3-standard deviations above their 200-dma which is a rarity. Three short weeks later, the markets are now 4-standard deviations below which is even a rarer event. 

On Wednesday, the Federal Reserve increased “Repo operations” to $175 Billion.

Still no response from the market

Then on Thursday, the Fed brought out their “big gun.”

The Fed Bazooka

Yesterday, the Federal Reserve stepped into financial markets for the second day in a row, this time dramatically ramping up asset purchases amid the turmoil created by the combination of the spreading coronavirus and the collapse in oil prices. 

In a statement from the New York Fed:

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

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

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

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

As Mish Shedlock noted,

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

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

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

  • Rate cuts? Check
  • Liquidity? Check

It is now, or never, for the markets.

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

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

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

Cash was the only safe place to hide.

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

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

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

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

Special Report: Panic Sets In As “Everything Must Go”

Note: All charts now updated for this mornings open.

The following is a report we generate regularly for our RIAPRO Subscribers. You can try our service RISK-FREE for 30-Days.

Headlines from the past four-days:

Dow sinks 2,000 points in worst day since 2008, S&P 500 drops more than 7%

Dow rallies more than 1,100 points in a wild session, halves losses from Monday’s sell-off

Dow drops 1,400 points and tumbles into a bear market, down 20% from last month’s record close

Stocks extend losses following 15-minute ‘circuit breaker’ halt, S&P 500 drops 8%

It has, been a heck of a couple of weeks for the market with daily point swings running 1000, or more, points in either direction.

However, given Tuesday’s huge rally, it seemed as if the market’s recent rout might be over with the bulls set to take charge? Unfortunately, as with the two-previous 1000+ point rallies, the bulls couldn’t maintain their stand.

But with the markets having now triggered a 20% decline, ending the “bull market,” according to the media, is all “hope” now lost? Is the market now like an “Oriental Rug Factory” where “Everything Must Go?”

It certainly feels that way at the moment.

“Virus fears” have run amok with major sporting events playing to empty crowds, the Houston Live Stock Show & Rodeo was canceled, along with Coachella, and numerous conferences and conventions from Las Vegas to New York. If that wasn’t bad enough, Saudi Arabia thought they would start an “oil price” war just to make things interesting.

What is happening now, and what we have warned about for some time, is that markets needed to reprice valuations for a reduction in economic growth and earnings.

It has just been a much quicker, and brutal, event than even we anticipated.

The questions to answer now are:

  1. Are we going to get a bounce to sell into?
  2. Is the bear market officially started – from a change in trend basis; and,
  3. Just how bad could this get?

A Bounce Is Likely

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

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

Looking at the chart above, it is possible we could see a rally back to the 38.2%, or the 50% retracement level is the most probable. However, with the severity of the break below the 200-dma, that level will be very formidable resistance going forward. A rally to that level will likely reverse much of the current oversold condition, and set the market up for a retest of the lows.

The deep deviation from the 200-dma also supports this idea of a stronger reflexive rally. If we rework the analysis a bit, the 3-standard deviation discussed previously has now reverted to 4-standard deviation move below the 200-dma. The market may find support there, and with the deeply oversold condition, it again suggests a rally is likely.

Given that rally could be sharp, it will be a good opportunity to reduce risk as the impact from the collapse in oil prices, and the shutdown of the global supply chain, has not been fully factored in as of yet.

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

The triggering of the “sell signals” suggests we are likely in a larger correction process. With the “bull trend” line now broken, a rally toward the 200-dma, which is coincident with the bull trend line, will likely be an area to take additional profits, and reduce risk accordingly.

The analysis becomes more concerning as we view other time frames.

Has A Bear Market Started?

On a weekly basis, the rising trend from the 2016 lows is clear. The market has NOW VIOLATED that trend, which suggests a “bear market” has indeed started. This means investors should consider maintaining increased cash allocations in portfolios currently. With the two longer-term sell signals, bottom panels, now triggered, it suggests that whatever rally may ensue short-term will likely most likely fail. (Also a classic sign of a bear market.)

With the market oversold on a weekly basis, a counter-trend, or “bear market” rally is likely. However, as stated, short-term rallies should be sold into, and portfolios hedged, until the correction process is complete.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is much like what we saw in 2015-2016. (Noted in the chart above as well.) In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in. If the market fails to hold current levels, the 2018 lows are the next most likely target.

Just How Bad Can It Get?

The idea of a lower bottom is also supported by the monthly data.

NOTE: Monthly Signals Are ONLY Valid At The End Of The Month.

On a monthly basis, sell signals have also been triggered, but we will have to wait until the end of the month for confirmation. However, given the depth of the decline, it would likely take a rally back to all-time highs to reverse those signals. This is a very high improbability.

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

How bad can the “bear market” get? If the 4-year moving average is violated, the 2018 lows become an initial target, which is roughly a 30% decline from the peak. However, the 2016 lows also become a reasonable probability if a “credit event” develops in the energy market which spreads across the financial complex. Such a decline would push markets down by almost 50% from the recent peak, and not unlike what we saw during the previous two recessions.

Caution is advised.

What We Are Thinking

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

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

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

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

We highly suspect that we have seen the highs for the year. Most likely,,we are moving into an environment where portfolio management will be more tactical in nature, versus buying and holding. In other words, it is quite probable that “passive investing” will give way to “active management.”

Given we are longer-term investors, we like the companies we own from a fundamental perspective and will continue to take profits and resize positions as we adjust market exposure accordingly. The biggest challenge coming is what to do with our bond exposures now that rates have gotten so low OUTSIDE of a recession.

But that is an article for another day.

As we have often stated, “risk happens fast.”

Special Report: S&P 500 – Bounce Or Bull Market

Headlines from the past two days:

Dow sinks 2,000 points in worst day since 2008, S&P 500 drops more than 7%

Dow rallies more than 1,100 points in a wild session, halves losses from Monday’s sell-off

Actually its been a heck of a couple of weeks for the market with daily point swings running 1000, or more, points in either direction.

However, given Tuesday’s huge rally, is the market’s recent rout over with the bulls set to take charge? Or is this just a reflexive rally, with a retest of lows set to come?

Let’s take a look at charts to see what we can determine.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. Given that the oversold condition (top panel) is combined with a very deep “sell signal” in the bottom panel, it suggested a fairly vicious reflexive rally was likely. The question, of course is how far could this rally go.

Looking at the chart above, it is quite possible we could well see a rally back to the 32.8%, or even the 50% retracement level which is where the 200-dma currently resides. A rally to that level will likely reverse much of the current oversold condition and set the market up for a retest of the lows.

This idea of a stronger reflexive rally is also supported by the deep deviation from the 200-dma. If we rework the analysis a bit, the 3-standard deviation discussed previously has now reverted to 2-standard deviations below the 200-dma. The market found support there, and with the deep oversold condition it again suggests a rally to the 200-dma is likely.

Given that rally could be sharp, it will likely be a good opportunity to reduce risk as the impact from the collapse in oil prices and the shutdown of the global supply chain has not been fully factored in as of yet.

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

The triggering of the “sell signals” suggests we are likely in a larger correction process. With the “bull trend” line now broken, a rally back to toward the 200-dma, which is coincident with the bull trend line, will likely be an area to take profits and reduce risk accordingly.

The analysis becomes more concerning as we view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has NOW VIOLATED that trend, which suggests maintaining some allocation to cash in portfolios currently. With the two longer-term sell signals, bottom panels, now triggered, it suggests that whatever rally may ensue short-term will likely fail.

The market is getting oversold on a weekly basis which does suggest a counter-trend rally is likely. However, as stated, short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

With all of our longer-term weekly “sell signals” now triggered from fairly high levels, it suggests the current selloff is much like what we saw in 2015-2016. (Noted in chart above as well.) In other words, we will see a rally, a failure to lower lows, before the ultimate bottom is put in.

Monthly

The idea of a lower bottom is also supported by the monthly data.

On a monthly basis, sell signals have also been triggered. HOWEVER, these signals must remain through the end of the month to be valid. These monthly signals are “important,” and one of the biggest concerns, as noted in the top panel, is the “negative divergence” of relative strength which was only seen prior to the start of the previous two bear markets, and the 2015-2016 slog. Again, the current sell-off resembles what we saw in late 2015, but there is a risk of this developing into a recessionary bear market later this summer. Caution is advised.

What We Are Thinking

Since January we have been taking profits in positions, rebalancing portfolio risks, and recently moving out of areas subject to slower economic growth, a supply-chain shut down, and the collapse in energy prices. (We have no holdings in international, emerging markets, small-cap, mid-cap, financial or energy currently.)

We are looking for a rally that can hold for more than one day to add some trading exposure for a move back to initial resistance levels where we will once again remove those trades and add short-hedges to the portfolio.

We highly suspect that we have seen the highs for the year, so we will likely move more into a trading environment in portfolios to add some returns while we maintain our longer-term holdings and hedges.

Given we are longer-term investors, we like the companies we own from a fundamental perspective and will continue to take profits and resize positions as we adjust market exposure accordingly. The biggest challenge coming is what to do with our bond exposures now that rates have gotten so low OUTSIDE of a recession.

We will keep you updated accordingly.

Special Report: S&P 500 Plunges On Coronavirus Impact

Dow plunges 1,000 points on coronavirus fears, 3.5% drop is worst in two years

“Stocks fell sharply on Monday as the number of coronavirus cases outside China surged, stoking fears of a prolonged global economic slowdown from the virus spreading. – CNBC

According to CNBC’s logic, the economy was perfectly fine on Friday, even though the market sold off then as well. However, over the weekend, stocks are plunging because the virus is now important?

No, this has been a correction in the making for the past several weeks that we have been discussing in our weekly market updates. Here was what we posted yesterday morning:

  • As noted last week: “With the market now trading 12% above its 200-dma, and well into 3-standard deviations of the mean, a correction is coming.” That correction started last Friday.
  • Currently, there is a strong bias to “buy the dip” of every corrective action. We recognize this and given the S&P 500 hit initial support on Friday we did add 1/2 position of VOOG to the Dynamic Model. The model is underallocated to equities and has a short hedge so we are taking this opportunity to add slowly. However, we suspect there is more to this corrective action to come this week.
  • As noted previously, extensions to this degree rarely last long without a correction. There is more work to be done before the overbought and extended condition is corrected. We will look to add to our holdings during that process.

While the correction occurred all in one day, which wasn’t our preference, it nonetheless set the markets up for a short-term bounce. We highly suggest using that bounce to rebalance portfolio risks accordingly.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we rework the analysis a bit, the 3-standard deviation discussed previously is in the correction process. However, with the break of the 50-dma, uptrend channel, and triggering a short-term sell signal, the 200-dma comes into focus as important support.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk.

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

Notice that while the market has been rising since early 2016, the momentum indicators are extremely stretched. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is denoted by the trend channel. At this juncture, the market has not violated any major support points and does not currently warrant a drastically lower exposure to risk. However, if the “sell signals” are triggered, it will suggest a larger “reduction” of risk.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are closing. If they both confirm, it will suggest a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the bulls remain in control currently, which keeps our portfolios primarily allocated to equity risk. As we have noted previously, the market had triggered a “buy” signal in October of last year as the Fed “repo” operations went into overdrive. These monthly signals are “important,” but it won’t take a tremendous decline to reverse those signals. It’s okay to remain optimistic short-term, just don’t be complacent.

Don’t Panic Sell

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

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio, and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 58.2% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

  1. Move slowly. There is no rush in adding equity exposure to your portfolio. Use pullbacks to previous support levels to make adjustments.
  2. 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.
  3. Begin by selling laggards and losers. These positions are dragging on performance as the market rises and tends to lead when markets fall. Like “weeds choking a garden,” pull them.
  4. Add to sectors, or positions, that are performing with, or outperforming the broader market.
  5. 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.
  6. While the technical trends are intact, risk considerably outweighs the reward. If you are not comfortable with potentially having to sell at a LOSS what you just bought, then wait for a larger correction to add exposure more safely. There is no harm in waiting for the “fat pitch” as the current market setup is not one.
  7. If none of this makes any sense to you – please consider hiring someone to manage your portfolio for you. It will be worth the additional expense over the long term.

While we remain optimistic about the markets currently, we are also taking precautionary steps of tightening up stops, adding non-correlated assets, raising some cash, and looking to hedge risk opportunistically.

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

“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:

  • CHINA PLANS TO IMPORT U.S. WHEAT, RICE, CORN WITHIN QUOTAS

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.

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.

Navigating A Two Block Trade World

“Investors Need to Be Ready for a Two Block Trade World – U.S. and China”

On Bloomberg TV, VMware CEO, Pat Gelsinger, observed that with escalation of the trade war he sees, “two separate trading blocks forming the United States and China, we want to be a player in both and will have to adjustour strategy, investments, supply chains and operations as a result.”  He sees both countries digging in for the foreseeable future.

The evolution of a two trading block global economy has a major impact on how businesses operate in the next five to ten years.  Those with major operations in China that ship products to the U.S. will continue to be adversely affected by U.S. tariffs on Chinese goods. Growing trade headwinds also face, U.S. companies shipping goods to China. Besides tariffs, trade research shows Chinese importers will need to deal with U.S. non-tariff barriers that are not only costly but time consuming.

Here is a list of industry sectors most impacted by the trade war with businesses exports and imports to China:

Sources: U.S. Census Bureau, Marketwatch  – 6/27/19

Major software and electronics companies like Apple, with $56b in sales making up 20% of total global revenue from China, will continue to see declining sales. Apple, and other companies in the same shoes, will have to radically shift supply chains and sourcing for manufacturing.

CISCO, a global network systems manufacturer, recently reported to shareholders a 25% drop in sales of network products to both state-owned and private corporations in China. Many American manufacturers’ source components and sub-assemblies from China which are then shipped to the U.S. mainland for final manufacturing. These supply chains will have to change if they are to sustain profits.

Caterpillar, in the transportation sector, recognizes 10% of global revenue from China and has experienced a significant drop in sales.  Tariffs have significantly reduced soybean exports to China by U.S. farmers to nearly zero. The Federal Reserve in Minneapolis reports farm bankruptcies have reached 2008 levels.

These are just a few examples. Each day the list of impacted industries and companies grows longer.

What does the two block trading world mean to investors?  

The trade war seems to be here to stay. As such, agile CEOs are already planning for the U.S and China to be heavily competing for global trade.  Investors will need to assess the implications for both short and long term investments.

Short term tactical investments:

  1. Research business sectors with major exposure to imports and exports to China
  2. Identify companies with exposure to China trade and related operational vulnerabilities
  3. Identify countries that may act as bridge zones between the two blocks, ie: Australia, Singapore, and Vietnam

Long term strategic investments:

  1. Identify companies that are well-positioned to leverage quickly the now forming two block trading world
  2. Research bridge countries that are making investments in shipping infrastructure and establishing long term trade treaties with both the U.S. and China
  3. Watch the business horizon for new businesses or services that will evolve as a result of the new U.S. – China trade competition

A new global trading structure is forming fast presenting both opportunities and pitfalls for investors.  Agile investors might want to position themselves for optimal growth and income in bridge countries or firms like VMware, where the CEO is moving quickly to establish good relationships with both countries.  

Investors should also consider longer-term investments in Australian based companies or U.S. firms with major operations in Australia as a bridge country.  Many U.S. firms have regional operations headquarters in Sydney.  Sydney, positioned in the Asian region, offers a well-skilled labor force, is an open country to many immigrants from all over Asia that speak and write many languages. Further English is the main language for easy use of technical documentation and recruitment of support staff. The Australian government has been an ally of the U.S. for decades and yet has a bilateral free trade agreement with the Chinese government signed in 2015. As a bonus, the Australian economy has been in expansion for 27 straight years.  The incredibly long string of growth is likely due to a diverse economy, welcoming immigrants who start new businesses, an abundance of natural resources, located at the nexus of Asian growth and a business positive government and culture. It is these same traits that should help them thrive in a two trading block economy.

Investors should be wary of Hong Kong or China-based businesses with American ties that are not politically correct.  The Chinese economy is a state controlled managed economy of state run businesses and private businesses that run under strict guidelines.  Problems in Hong Kong go beyond the present protests. The island city has seen the CEOs of a few local businesses ‘disappear’ when making trips to mainland China. In some instances these disappearances have happened for months throwing the businesses into turmoil and dropping stock prices by 70 – 80%. 

Hong Kong’s future is highly uncertain as the Chinese government is growing increasingly concerned that democracy might ‘leak’ to the mainland and thereby threaten authoritarian rule.  The Chinese government has announced the development of an ‘entites’ list of U.S. companies that Chinese firms are not to do business. American firms affiliated with these targeted firms will see significantly reduced sales. On the U.S. side, the Trump administration has gone back and forth on suppliers to Huawei and is now writing a ‘blacklist’ of Chinese firms that American companies are to end business with. Smart investors will need to keep track of U.S. and Chinese government pronouncements and policies in regard to which companies are ‘in’ and which are ‘out’. These may change by the day or week.

Monitoring markets or executive behaviors that are likely to catch government scrutiny will offer investors an early warning of which firms may soon appear on the lists. One possible new sector of scrutiny are cybersecurity companies, which provide both countries an edge in the digital economy. Both countries will want to maintain control, access and future development of digital security power.

The two trading block global economy will require careful research, constant monitoring, and quick moves as politically ‘in’ companies can become ‘out’ at the whim of government leaders in both countries.  Investments in stable countries, with firms that have a long history of bridging their business between both China and the U.S. are likely to be the best investment opportunities over the long term. Note that in any global recession, these bridge countries and companies are likely to be the first to recover from a recession.

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: 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.

1998

2006

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.” 

Maybe.

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.

Special Report: S&P 500 Plunges On Yield Curve Inversion

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

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

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

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

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

UNLOCKED RIA PRO: S&P 500 Plunges On Yield Curve Inversion

We have unlocked yesterday’s report that went out to our RIA PRO subscribers following the crash. You can subscribe at RIAPRO.NET and get 30-DAYS FREE to gain access to our portfolio models, analysis, and research.

Yesterday, the financial media burst into flames as the yield on the 10-year Treasury fell below that of the 2-Year Treasury. In other words, the yield curve became negative, or “inverted.”

“Stocks plunged on Wednesday, giving back Tuesday’s solid gains, after the U.S. bond market flashed a troubling signal about the U.S. economy.” – CNBC

According to CNBC’s logic, the economy was perfectly fine on Tuesday, notably as Trump delayed “tariffs” on China, since the yield curve was NOT inverted. However, in less than 24-hours, stocks are plunging because the yield curve inverted?

Let’s step back for a moment and think about this.

Historically speaking, the inversion of a yield curve has been a leading indicator of economic recessions as the demand for liquidity exceeds the demand for longer-term loans. The chart below shows the history of yield curves and recessions.

The yield curve has been heading towards an inversion for months, suggesting that something was “not healthy” about the state of the economy. In August 2018, I wrote, “Don’t Fear The Yield Curve?”

“The spread between the 10-year and 2-year Treasury rates, historically a good predictor of economic recessions, is also suggesting the Fed may be missing the bigger picture in their quest to normalize monetary policy. While not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker than the Fed is suggesting. (The boosts to economic growth are now all beginning to fade and the 2nd-derivative of growth will begin to become more problematic starting in Q3)

Despite the flattening slope of the yield curve, the mainstream media was consistently dismissing the message it was sending.

“There are always a lot of things to worry about in our economy — short range and long range. The yield curve, however. isn’t one of them. It just shows that some other people are worried, too. It doesn’t mean that they are right.” – James McCusker

“Contrary to what many people think, inverted yield curves don’t always sound the alarm to sell. In fact, looking at the past five recessions, the S&P 500 didn’t peak for more than 19 months on average after the yield curve inverted, along the way adding more than 22% on average at the peak,” – Ryan Detrick, LPL

In fact, an inversion is often a buying opportunity. During each of the past seven economic cycles, the S&P 500 has gained in the six-months before a yield-curve inversion.” Tony Dwyer, analyst at Canaccord Genuity.

While the nearly inverted yield curve didn’t matter on Tuesday, it suddenly mattered on Wednesday? From the WSJ:

“It was a very bad day in the stock market on Wednesday. That big rally on Tuesday after the U.S. delayed some China tariffs? Completely erased, and then quite a bit more. The Dow Jones Industrial Average fell 800 points, or 3%, and the S&P 500 dropped 2.9%.

A big factor in the selling appeared to be concern over a brief drop in the yield on the 10-year Treasury yield below the yield on the two-year. Since such yield curve inversions have tended to occur ahead of recessions, worries that the U.S. is at risk of downturn got set off.”

We have been warning for the last 18-months that despite a sharp rise in volatility, the bull market that began in 2009 had likely come to an end. To wit:

“There is a reasonably high possibility, the bull market that started in 2009 has ended. We may not know for a week, a month or even possibly a couple of quarters. Topping processes in markets can take a very long time.

If I am right, the conservative stance and hedges in portfolios will protect capital in the short-term. The reduced volatility allows for a logical approach to further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)”

The last highlighted phrase is THE most important. There is an old saying about “con men” which sums this idea up perfectly:

“Thieves run out of town. Con men walk.”

The goal of portfolio management is NOT to be forced into a liquidation event. Such doesn’t mean you must try and “time the market” to sell at the peak (which is impossible to do), but rather being aware of the risk you are carrying and exiting the market when you choose. Being put into a position, either “emotionally” or “operationally,” where you are forced to liquidate always occurs at the worst possible time and creates the greatest amount of capital destruction.

With this premise in place, let’s review the S&P 500 over several different time frames and metrics to determine what actions should be considered over the next few days and weeks.

Daily

On a daily basis, the market is back to oversold. Historically, this condition has been sufficient for a bounce. The difference, however, is the current oversold condition (top panel) is combined with a “sell signal” in the bottom panel. This suggests that any rally in the markets over the next few days should be used to reduce equity risk, raise cash, and add hedges.

If we stretch the analysis out a bit, the “megaphone” pattern becomes much more apparent. The repeated failures at the upper trend line continues to complete a “broadening topping process,” which is more suggestive of a larger, more concerning market peak.

As with the chart above, the market is oversold on a short-term basis, and a rally from current support back to the 50-dma is quite likely.

Again, that rally should be used to reduce risk. I wrote about this on Tuesday in “5-Reasons To Be Bullish (Or Not) On Stocks:”

“For longer-term investors, it is worth considering the historical outcomes of the dynamics behind the financial markets currently. The is a huge difference between a short-term bullish prediction and longer-term bearish dynamics.As Howard Ruff once stated:

“It wasn’t raining when Noah built the ark.”

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

Notice that while the market has been rising since early 2018, the momentum indicators are negatively diverging. Historically, such divergences result in markedly lower asset prices. In the short-term, as noted above, the market remains confined to a rising trend which is running along the 200-dma. At this juncture, the market has not violated any major support points and does currently warrant a drastically lower exposure to risk. However, the “sell signals” combined with negatively diverging indicators, suggest a “reduction” of risk, and hedging, is warranted on any rally.

The analysis becomes more concerning as view other time frames.

Weekly

On a weekly basis, the rising trend from the 2016 lows is clear. The market has not violated that trend currently, which suggests maintaining some allocation to equity risk in portfolios currently. However, the two longer-term sell signals, bottom panels, are close to confirming each other, and suggests a more significant correction process is forming.

The market is still very overbought on a weekly basis which confirms the analysis above that short-term rallies should likely be sold into, and portfolios hedged, until the correction process is complete.

Monthly

On a monthly basis, the concerns rise even further. We have noted previously, the market had triggered a major “sell” signal in September of last year. These monthly signals are “rare,” and coincide with more important market events historically.

These signals should not be ignored.

Don’t Panic Sell

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

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.)

However, the analysis currently suggests the risks currently outweigh potential reward and a deeper correction is the most “probable” at this juncture.

Don’t take that statement lightly.

I am suggesting reducing risk opportunistically, and being pragmatic about your portfolio and your money. Another 50% correction is absolutely possible, as shown in the chart below.

(The chart shows ever previous major correction from similar overbought conditions on a quarterly basis. A similar correction would currently entail a 53.7% decline.)

So, what should you be doing now. Here are our rules that we will be following on the next rally.

15-Portfolio Management Rules:

  • Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  • Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  • Emotionally driven decisions void the investment process.(Buy high/sell low)
  • Follow the trend.(80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  • Never let a “trading opportunity” turn into a long-term investment.(Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  • An investment discipline does not work if it is not followed.
  • “Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
  • The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  • Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  • Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short.(Bull and Bear markets are determined by their long-term trend as shown in the chart below.)
  • When markets are trading at, or near, extremes do the opposite of the “herd.”Do more of what works and less of what doesn’t.(Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  • “Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  • Strive to be a .700 “at bat” player.(No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  • Manage risk and volatility.(Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Everyone approaches money management differently. This is just our approach to the process of controlling risk.

We hope you find something useful in it.

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

Hint For Stock Investors: Margins Matter

Sooner or later, stock prices are related to corporate profits. Anything can push stock prices around in a day, month, or year. But a stock or an ownership unit of a business ultimately has to do with how profitable that business is. When you buy a stock, you’re buying an interest in a company’s future profits, pure and simple.

Since around 2000, corporate profits as a percentage of GDP have been stellar. Accordingly, stocks have traded at prices relative to underlying earnings that can only be justified if profits will be permanently higher than they were prior to 2000. Will they be? Justin Lahart of the Wall Street Journal said no over the weekend. And that could mean bad news for stock investors.

For the first time in over two years corporate profit margins are falling, according to Lahart. Nobody knows if that’s a permanent trend, but Lahart argues that margins rose so much in the first place because of a lower share of revenues going to labor, increased global trade, lower taxes, and gains in market share.

All of these factors seem to be at risk now. Concerns about inequality might make squeezing workers further difficult politically. A trade war may change how we conduct commerce with China. And big companies with high market share that set prices and have little competition for labor are on the defensive.

Lahart’s article had three excellent charts — one showing increased net profit margin since 2010  for S&P 500 constituents (from around 8% to nearly 12.5% last year), another showing decreased employee compensation as a share of GDP since 1970 (from 58% to 53%), and the last showing decreased corporate taxes since 1975 (from more than 35% to less than 15%).

Here’s another one we constructed with data from the St.Louis Fed’s website, showing corporate profits as a percentage of GDP since 1947. The average from 1947 to 2000 was a little more than 6%, but the average since 2000 is nearly 9%.

If profit margins decline, Lahart is correct about that being bad news over the longer term for stock investors. That doesn’t mean nobody should invest in stocks. But it means investors should moderate their return expectations.

For more on the intersection of profit margins, valuations and return expectations we suggest reading our article : DIY Market Forecast.

Technically Speaking: A Look At The A/D Line

By Lance Roberts and Michael Lebowitz, CFA

In yesterday’s post on investor psychology, we discussed the issue of confirmation bias. To wit:

“As individuals, we tend to seek out information that conforms to our current beliefs. For instance, if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.”

A good example of this was a recent tweet, shown below, which stated the cumulative advance/decline (A/D) line of the NYSE Composite Index “bodes quite well for continued equity strength.” The argument is based on the lower graph which shows that the upward momentum in the cumulative A/D line has not shown any retreat despite the price consolidation of the S&P 500 (upper graph) since late January. The Tweet also points out, using red shaded bars, that the current behavior of the A/D line is not similar to how it behaved before the last three major drawdowns.

Before we analyze the tweet and graph, we think it may be helpful to provide a brief explanation of the A/D line.

“The A/D line is simply the number of advancing stocks less the number of declining stocks for a given day. The daily A/D is typically positive on up days and negative on down days. The graph above showing the cumulative A/D is simply each daily A/D figure added to the net sum of the A/D’s that preceded it. Importantly, there are occasions when the A/D line falls (more stocks down than up) but the market continues to rise. This kind of divergence can serve as a warning of a potential market correction. Conversely, when the market is trending lower and the A/D line begins to rise, it can signal a bottom and eventual turn higher.”

Here is the chart of the Cumulative Advance/Decline Line versus the S&P 500 index for a bit clearer understanding.

While technical analysis is a great way for investors to gauge market sentiment, and hopefully make more informed investment decisions, there are thousands of technical studies which can easily be turned to promote a bullish or bearish narrative to support one’s market view.

However, this is where technical studies should be carefully analyzed to ensure we are not “feeding” our own “confirmation bias.”

Before crunching numbers and looking at historical instances, we must first ask a basic question; what stocks does the NYSE Composite Index (NYA) measure? The NYA is comprised of securities that trade on the NYSE. With a little research, you will find this is not just the equity of corporations such as IBM, Google or McDonalds.

Per Paul Desmond, President of the Lowry Research Corporation:

“Since about 1990 the NYSE has allowed securities other than domestic common stocks to the trade on the NYSE. These include closed-end funds (that match the trends of bonds, not stocks) plus a proliferation of interest (rate) sensitive non-convertible preferred stocks and REITs (which mimic the movements of the bond market, rather than the stock market) plus ADRs of foreign stocks (that do not necessarily follow the trends of domestic common stocks).”

Based on his research, as of 2013, non-operating companies account for 52% of the issues trading on the NYA.

Simply put, the index, and by default, the daily or cumulative A/D of the index, does not provide a clear picture of the breadth of equities. In fact, one could argue it is every bit as much an indicator of the breadth of the fixed income markets.

Because of this composition problem we chose to analyze A/D data for the S&P 500. While the S&P 500 does include some REITs and possibly other non-operating companies, we believe that percentage to be significantly smaller than the NYA and therefore provides a clearer picture of equity breadth.

We take a different approach than the graph shown above. We plotted daily instances of the change in the S&P 500 and the associated net A/D for that day. Further, we only included instances when the S&P 500 was higher on the day. In a strong bull market, one would expect a larger than normal Net A/D on up days.

The graphs below isolate the daily instances occurring four months prior to the market peaks of 2000 and 2007 to the longer term trend occurring four years prior to each peak. Given the large number of data points, we make trend spotting easier by adding darker trend lines. The steeper the slope of the trend line, the higher the net A/D figure per percentage gain, and therefore the better the breadth. Conversely, a flatter line denotes not as many net stocks advanced on days the market rose and subsequently breadth is worse.

In the four months leading the market peaks of 2007 and 2000 the recent A/D trend line (orange) flattened versus the slope of the prior four years.

The graph below showing current data tells a similar story.

Here is another take on similar data. The chart below is the S&P 1500 Advance-Decline percent. The difference here is that instead of just the 500-largest capitalization companies in the S&P 500, it also includes 600 small-capitalization and 400 mid-capitalization companies as well. This analysis provides a much broader sense of the markets true underlying strength.

Again, we see that with roughly an equal split in participation, the overall strength of the market heading into the last half of the year may not be as robust as currently perceived.

While the “bulls” tend to take the data at face value, and extrapolate current trends into the future, investors should also consider the opposing view which suggests the outlook for the next few months is inconclusive at best. 

Battling “confirmation bias” is a difficult challenge because it forces us to consider views we absolutely disagree with. However, it also leads us into making much better decisions, not only in our portfolios, but in life.

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather

Click here to download our investment manifesto.

Technically Speaking: FOMO Overrides FOLM

In this past weekend’s missive, I stated:

“The good news is the break above the 61.8% retracement level, as we noted last week, keeps the markets intact (Pathway #1) for now. And, as suggested above, a retest of recent June highs seems very likely. However, Monday will be key to see if we get some follow through from Friday’s close.”

Well, on Monday, the markets did indeed follow through and rose towards a retest of June highs.

With the markets now back to a short-term overbought extreme, the June highs may be a challenge for the bulls in the short-term. Also, it is worth noting that since the beginning of this year, “gap up” openings for the market have tended to be within a couple of days of a short-term peak. In other words, yesterday’s “gap up” opening was likely a good opportunity to trim positions that have become overweight in portfolios. For us, those were the technology and discretionary sectors, which we have now reduced back to target portfolio allocations.

However, on a positive note, if the bulls can indeed muster a rally above the June highs, and can hold it, it will likely be an easy stretch back to the highs of the year. With the market climbing an advancing trend (higher bottoms and higher highs), our portfolios remain weighted towards equities, although we do remain underweight from target goals. If the “bull market” reasserts itself and shows stronger breadth, then further increases in allocations may be justified.

But that point is not now. Over the last month, the bullish backdrop has become markedly less clear as the list of economic and market concerns persists. This great graphic came from Mark Raepczynski on Friday:

Liz Ann Sonders also took a stab at the list of headwinds facing the bulls currently:

“More broadly, at the midpoint of the year, there continue to be both headwinds and tailwinds for the economy and the market. Trade uncertainty clearly falls in the former. As you can see in the graphic below, I have loosely connected many of these, along the lines of an ‘on the one hand…on the other hand…’ analysis.” 

With concerns rising, it is not surprising to see that investor “optimism” has dwindled in recent weeks, particularly as price volatility has risen sharply this year. The chart below shows the daily price movements of the S&P 500 from 2017 to present.

The chart below is a composite “investor sentiment” index or rather how investors “feel” about the current investing environment.

Clearly, the “exuberance” of the market has given way to more “concern” since the beginning of the year, but given sentiment remains elevated, there is little to suggest real “fear” is present.

In other words, as I discussed this past weekend, despite the rise in “fear,” investors are not willing to “do” anything about. Or rather, F.O.M.O. (fear of missing out) still trumps F.O.L.M. (fear of losing money.)

“With valuations elevated and earnings expectations extremely lofty, the risk of disappointment in corporate outlooks is elevated. Furthermore, despite those who refuse to actually analyze investor complacency measures, both individual and institutional investors remain heavily weighted towards equity risk. In other words, while investors may be “worried” about the market, they aren’t doing anything about due to the ‘fear of missing out.’”  

“This is the perfect setup for an eventual ‘capitulation’ by investors when a larger correction occurs as overexposure to equities leads to ‘panic selling’ when losses eventually mount.”

Overall, the market continues to quickly discount the various risks facing the market. But almost as quickly as one is “priced in,” another emerges. With “trade wars” now live, “Brexit” running into trouble and the November elections in the U.S. quickly approaching, there are plenty of concerns which still lay ahead.

Also, we continue to be concerned about the lack of overall “breadth” of the rally, which was also noted by Jim Bianco, on Monday.

“The next chart shows the impact the so-called FAANMG stocks — Facebook Inc., Apple Inc., Amazon, Netflix Inc., Microsoft Corp., and Google parent Alphabet Inc. — have had on the S&P 500 Index since November 2017. These six stocks alone pushed the S&P 500 up 2.66 percent. The other 494 stocks were collectively down 0.40 percent. Overall, the S&P 500 was up 2.26 percent.”

We have seen this in our own data. Each week in the newsletter, I provide the relative performance of various sectors in our portfolio model to the S&P 500 index. When sectors are above trending positively, and the short-term moving average is above the long-term moving average, the sectors are on “buy” signals.  When the majority of sectors are on “buy signals” and the market is rising, it suggests the overall “breadth” of the rally is strong and the market should be bought. 

This is what the relative performance of the model was one year ago at the beginning of July, 2017.

Here is what it looks like today.

The deterioration in sector performance is indicative of a late stage market cycle, rising risks, and declines in risk/reward backdrop.

Combine the weakening performance backdrop with a market back to overbought conditions, following an abbreviated rally, and you can understand why we remain more cautionary on the intermediate-term outlook. 

As Helene Meisler noted Monday:

“Friday’s breadth continued the strength we’ve been seeing. This makes it six consecutive green days for breadth.

Since prior to this string of positive breadth readings we had seen breadth alternate positive and negative every other day for two weeks, it’s not going to be easy to pinpoint the day we get overbought. However, I can note that we will be maximum overbought Friday, July 13.”

“Last week we used the Nasdaq Momentum Indicator to pinpoint Tuesday as the day we got oversold. If I use this same method to find the overbought time frame it’s far too wide to be of use. For example, it shows an overbought reading sometime between this Tuesday and next Tuesday.

Then if we use the “what if” for the McClellan Summation Index we discover that it will currently take a net differential of -1,900 (advancers minus decliners) to turn the Summation Index from up to down. In 2017 this indicator was of no help but in 2018 once this gets to the point it needs -2,000 we have been overbought. It’s hard to pinpoint the day using this method but it’s likely that if the market’s breadth is strong on Monday this will go down under -2,000.”

“Thus the conclusion is that in the latter part of this week we should reach an overbought condition.

The number of stocks making new highs on the NYSE increased. It’s nothing to write home about but at least it increased.

Finally, I would note that while anecdotally sentiment seems to have turned bullish, it is not yet evident in the indicators. The put/call ratio was 100% on Friday and while that may have been “weekend” related, long-time readers will know I prefer not to rationalize an indicator.”

We remain cautious for now until the investing risk/reward scenario improves enough to warrant additional equity exposure.

Could we miss some of the rally before that occurs? Sure.

We have no problem with that. Opportunities to take on additional market risk come along about as often as a taxi cab in New York City. However, for us, the “fear of missing out” is much less important than the “fear of losing money.” Spending our time working to recoup losses is a process we prefer to avoid.

“When it comes to investing, it is important to remember that no investment strategy works all the time, but having some strategy to manage risk and minimize loss is better than no strategy at all.”

Click here to download our investment manifesto.

Technically Speaking: 2nd Half Starts With A Fumble Recovery

On Monday, the market opened the 2nd half of the year with a fumble as Wall Street continues to wrestle with the uncertainty stemming from the White House with regards to tariffs, geopolitical risks, and economic growth. After a sloppy open with the S&P 500 down 14 points, investors managed to grab the ball and run it back for an 8-point gain. However, the participation and volume left much to be desired.

Stepping back to the beginning of the year, Barron’s penned an outlook for 2018 suggesting the markets would climb 7% in 2018 fueled by strong earnings growth. While it certainly seemed that way coming out of the gate in January, the markets have since struggled to maintain breakeven with the market only rising 1.67% for the 6-month period ending in June.

Bonds have had a rough go of it this year as well. While bonds have lost roughly 3% in price so far this year, bonds have continued to be the “go to” asset class during market sell-offs. Despite predictions of surging interest rates this year, which has been the case for the last several years, rates have remained mired below 3% as economic growth struggles to gain traction.

For investors, performance so far this year has fallen well short of expectations. Year-to-date, a typical 60/40 stock bond portfolio, on a capital appreciation basis only, has returned:

(1.67% * .60) + (-3.07% * .40) = 1% – 1.2% = -0.2% YTD.

Throw in dividends and interest income and basically, you only performed slightly better than a money market account with a whole lot more price volatility and implied risks.

The big winner so far this year has been oil prices. Oil prices are up more than 20% since the beginning of the year due to concerns over supply disruption, Iran, and OPEC. Optimism has led commodity traders to run up net long positioning on oil to some of the highest levels ever on record.

Importantly, as I recently discussed in “Bulls Keep It Together,”

The chart below shows oil prices as compared to a composite index of real GDP, interest rates and the consumer price index (CPI). As shown, the recent uptick in economic growth, inflation, etc. coincides with the recent surge in energy prices.”

“There is also a very high correlation between the direction of oil prices and the S&P 500 index. This is particularly the case since the 2016 lows as oil prices have made up a bulk of the surge in corporate earnings during that time.”

“There are four threats to oil prices in the near term:

  1. A surge in the U.S. Dollar which would likely coincide with a “trade war.” 
  2. A reversal by OPEC countries to start sharply increasing production.
  3. A continued surge in supply (shale) in the midst of global economic weakness.
  4. More rhetoric from the current Administration that “oil prices are too damn high.”

With commodities traders, all crowded on the ‘same side of the boat’ a reversal could be sharp. All that is really needed is a technical breakdown that spooks oil traders to flee for the exits. The last few times ‘sell signals’ have been registered in combination with extreme overbought and overly exuberant positioning, the outcomes have not been good.”

While there is a decent correlation between the direction of energy prices and the markets, it is something to follow as we move into the last half of the year. Higher energy prices, in the short-term, push inflation, retail sales, and other economic data higher. However, in the longer-term, higher energy prices are a tax on the consumer and contributes to a drag on corporate earnings, economic growth and ultimately the market.

Earnings

Speaking of earnings, earnings have come in short of expectations as well. In January, analysts expected the S&P 500 to show reported earnings of $114.45 for Q4 of 2017 and $119.05 for Q1 of 2018. Reality proved a bit disappointing as results came in at $109.88 and $115.23 respectively. You should expect these numbers to revised substantially lower as we progress into the back half of the year.

As I discussed in “The Risk To Estimates:”

“Since then, analysts have gotten a bit of religion about the impact of higher rates, tighter monetary accommodation, and trade wars. As I wrote yesterday, 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’).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.”

“However, the onset of a ‘trade war’ could reduce earnings growth by 11% which would effectively wipe out all of the benefits from the recent tax reform legislation.

As you can see, the erosion of forward estimates is quite clear and has gained momentum in the last month.” 

While analysts continually push estimates lower, so companies can beat them, valuations remain extremely elevated. As of the end of June, the S&P 500, based on Shiller’s CAPE ratio, was trading at 31.68 times. Despite sharply rising earnings, valuations remain extremely elevated relative to long-term historical norms.

Trend Review

As I have discussed many times in the past, we are long-term investors. However, we do manage the risk in the short-term to avoid more important market reversions that could negatively impact long-term capital appreciation. “Getting back to even” is not an investment strategy we wish to employ – neither should you.

Daily

As I noted in this past weekend’s missive:

“The market failed twice in trying to climb back above the 61.8% Fibonacci retracement level which kept the market confined to the same tight trading range we saw in May. Because of the breakdown on Monday, we DID NOT increase equity exposure in portfolios as of yet. With 50% of portfolios currently in cash and fixed income, the damage from last week’s sell-off was mostly mitigated. (This is the advantage of cash and fixed income in a volatile market.)”

On Monday, the market maintained support at the 50% retracement level and was also able to climb back above the 50-dma. With a “sell signal” currently firmly in place, the pressure on asset prices in the short-term is negative. Going into the last half of the year, I have laid out the potential trading range of the market based on current levels.

Improving earnings, a resolution to the current “trade war,” and some relaxation of geopolitical risks could certainly give the bulls what they need in the short-term to rally the markets higher. Currently, despite the volatility of the first half of the year, “bullish optimism” remains well intact. However, a confirmed break of major support will reflect a “changing of attitudes” which will likely coincide with some unexpected exogenous event.

My partner, Michael Lebowitz has a slightly more bearish short-term opinion but in the longer run, which I will discuss, we are on the same page. He believes direction will be determined when the market breaks out of the yellow shaded area below. A break above the box accompanied by new record highs would likely signal a resumption of the bull market. Unfortunately, Michael fears the market will break out to the downside over the course of the next six months and provide confirmation that a topping process for the ten-year bull market is in place. In the meantime, the market will likely use 2700 as a line of support and then resistance.

Weekly

For portfolio management purposes, we prefer weekly data as it smooths out the daily volatility of the markets. Subsequently, the reduced volatility removes some of the “head fakes” and “whipsaws” which can occur during mid-week due to the increased speed at which information, and trading activity, flows through the market.

More importantly, weekly data tends to reveal the trend of the market. As portfolio managers, our job is to participate with the trend as long as that trend is moving in a positive direction. Breaks of the trend, and changes in the trend, are the drivers which lead to more significant changes in overall portfolio allocation models.

As we have repeatedly addressed in our reports, we remain weighted towards equity risk in portfolios currently as the overall trend remains positive. However, the markets are currently testing the accelerated bullish trend from the 2016 lows. A confirmed break will likely lead to roughly a 21.5% correction from this year’s highs to the bullish trend line from the 2009 lows. Such a break will trigger further reductions of equity risk in portfolios, an increase of cash and addition of portfolio hedges.

Monthly

Monthly data is good for understanding major turning points and overall market risk. However, in our opinion, monthly data moves too slowly to minimize portfolio risk properly. While we focus on the weekly data to manage portfolio and allocation risk, we certainly watch the monthly data to look for early warning signs of potential trend changes. The chart below shows the S&P 500 with a variety of indicators attached. When the majority of the indicators align, they have previously provided the “weight of evidence” needed to support more major changes to allocation models. 

Currently, there are several indicators aligning to confirm more “risk” to the market over the next several months. However, since this is monthly data, we won’t know for sure until the data updates at the end of July.

Conclusion

With the first 6-months of the year behind us, performance has been markedly less than Wall Street was expecting. If the market is going to churn out 7-10% by the end of this year, the march higher needs to get underway soon.

I am reminded of a great quote by Axel Merk:

Prepare yourself for volatility. It is the norm of the market. Focus on what you can control – margin of safety. By doing that you will be ready for most of the vicissitudes of the market, which stem from companies taking too much credit or operating risk.

Finally, don’t give up. Most people who give up do so at a time where stock investments are about to turn. It’s one of those informal indicators to me, when I hear people giving up on an asset class. It makes me want to look at the despised asset class, and see what bargains might be available.

Remember, valid strategies work on average, but they don’t work every month or year. Drawdowns shake out the weak-minded, and boost the performance of value investors willing to buy stocks when times are pessimistic.”

When it comes to investing it is important to remember that no investment strategy works all the time, but having some strategy to manage risk and minimize loss is better than no strategy at all.

Click here to download our investment manifesto.

Technically Speaking: The Beer Bet

In this past weekend’s newsletter, I laid out my positioning for a short-term rally back to recent highs and why we were looking to “modestly” increase exposure. To wit:

“That is what we got this past week as the market retested the most recent breakout above the Fibonacci 61.8% retracement level twice.

While the weekly ‘buy signal’ did NOT trigger this week, keeping our allocation model at 75%, we have been adding exposure over the last few weeks as the market continued to break out of consolidations. As we stated previously, we were looking for the following setup to add equity exposure to portfolios.

  • A retracement back to previous support that did not violate it
  • An oversold condition on a short-term basis.
  • An opportunistic setup for a continuation of our investment pathway #2a

As shown in the chart below, all three requirements were fulfilled this week. Therefore, on Thursday and Friday, we did increase equity exposure and will look to add more on any weakness in the markets early next week.”

Over the weekend, my friend Doug Kass disagreed with my view:

In yesterday’s post, he clarified his reasoning behind his view of more trouble ahead for the market.

“Meanwhile, the partisanship in Washington, D.C. – on both sides of the pew – has never been more pronounced and a disquieting backdrop of animus and hostility reins. The impact of this condition on consumer and business confidence remain unknown.

Valuations are contracting, stocks are beginning to ignore good results (e.g., Micron Technology (MU) ) and the risks of policy (both fiscal and monetary) miscues are rising — at a time in which monetary policy around the world is pivoting towards tightening.

Meanwhile, the benefits of the corporate tax reduction is trickling up and not trickling down.

I was long as the S&P Index rose in early June. but I moved back into a net short exposure (via defined risk (SPY) puts and with a short (QQQ) ) at mid-month as signs of global economic ambiguities multiplied, investor optimism grew and the threat of policy mistakes increased — and the downside risks were heightened as measured against upside reward.

  • Market Downside: 2400 to 2450
  • ‘Fair Market Value’: 2500
  • Trading Range: 2550-2750 to 2800
  • Current S&P Cash (Adjusted for this morning’s future drop): 2735 

Here are the current reward versus risk parameters (based upon the -15 handle drop in S&P futures, 2735 S&P equivalent):

  1. There are 310 points of downside risk against only 65 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450). This is an overwhelmingly negative reward vs risk ratio (5:1). 
  2. Compared to ‘fair market value,’ (2500) there are 235 points of downside risk versus only 65 points of upside reward. That’s a negative 4:1 ratio. 
  3. Against the expected trading range, there are 185 handles of downside risk and only 65 points of upside reward (to the top end of the anticipated trading range). That’s a 3:1 adverse ratio. 

There are more Shades of 1999 and signposts that FAANG may have peaked, while we face a new regime of volatility reflecting a host of factors and the possibility of increased economic and market outcomes (many of which are adverse).

A changing market complexion is occurring coincident with global monetary tightening – making equities and other long-dated assets less attractive as the risk-free rate of return expands.”

I don’t disagree with Doug’s outlook at all. Although, we did place a friendly wager on a very short-term outcome.

While I have indeed maintained a bit more bullish stance as of late due to a confluence of factors, I have also consistently recognized the risks which remain. As I wrote this weekend:

“There is risk to the outlook, however. With the short-term sell signal triggered last week, it does keep us cautious. However, as we have seen previously, such a signal can be reversed quickly. Also, with the 50-dma crossing above 100-dma, further support for a continued bullish advance is back in place.

Importantly, while we are indeed more ‘bullishly inclined’ at the moment, and are willing to give the bulls a bit of ‘running room,’ we have moved stops up. We are also keeping our tolerance for losses restricted as downside risk continues to outweigh reward over the intermediate term.

We still remain slightly overweight in cash, and underweight equities, as the late-cycle risk and trade issues remain heavily prevalent.”

Doug won the bet yesterday as the market cracked the 100-dma and certainly raises the risk profile of market currently. However, while the breakdown yesterday is certainly concerning, there is a confluence of support at the 100-dma which coincides with the 50- and 75-dma as well. Also, there is a rising trend line from the March lows which provides additional support at current levels. With the market oversold, the bulls must make a stand here and defend these levels. 

Because of the breakdown on Monday, we DID NOT increase equity exposure in portfolios as of yet. With 50% of portfolios currently in cash and fixed income, the damage from yesterdays sell-off was mostly mitigated. (This is the advantage of cash and fixed income in a volatile market.)

The good news, if you want to call it that, is the cluster of support, as noted above, is now critically important. A break below these levels brings Doug’s lower ranges into view very quickly with the first real test coming at the 200-dma.

With this idea in mind, I updated the pathway chart above to take into account these potential outcomes.

Pathway #1: Given the recent tendency for bulls to rush in to “buy the dips,” the current oversold condition on a short-term basis provides enough “fuel” to support a rally back to recent highs. (30%)

Pathway #2a: Given both the short-term oversold condition AND the confluence of support at the 100-dma, the market is able to rally back to 2740 remains confined to a tight trading range between the 100-dma and 2740. (30%)

Pathway #2b: follows the path of #2a but fails to hold support at the 100-dma and quickly falls to test support at the 200-dma. The market will be deeply oversold at that point, so a rally back to the 100-dma is probable. If the market fails to move above 100-dma then a break below the 200-dma becomes probable and brings Pathway #3 into focus.  (40%)

And just like the first rule of “Fight Club” – we do not talk about “Pathway #3.” 

Actually, we will, we just aren’t there yet.

Should a break of the 200-dma occur we will be discussing much more about the onset of a cyclical bear market, risk reduction, and hedging. While I remain “hopeful” the market can regain its stability and continue to quickly compensate for Trump’s trade rhetoric, “hope” is not an investment strategy.

As I stated previously, these “pathways” are how we assess the risk of potential outcomes in a market that is experiencing much higher levels of price volatility than what we have seen previously. As longer-term investors, we “hope” to invest capital that will grow over time, but given the rising risks of a late stage market cycle, reductions in market liquidity, and tighter monetary policy we maintain a focus on capital preservation.

There is a strong rising bullish trendline from the 2016 lows which coincides with both the short and long-term moving averages. This provides fairly strong support for the market on an intermediate-term basis which keeps us allocated to equities currently.

Any confirmed break below 2710 on a weekly basis, a break which fails to recover, will most likely signal the onset of a protracted bear market. With no real support, until you reach the long-term bullish trendline from 2009, there is roughly 500-points of downside risk. I certainly don’t plan to “hold” equities “long” during such an event.

For now, I continue to allow excess cash and bonds to continue to offset the short-term volatility.

One thing is for sure, things are starting to get much more interesting. As I stated a couple of weeks ago, we are still giving the “bulls the benefit of the doubt” momentarily, however:

“…we do so with a risk-management process in place. We encourage you to do the same. If you don’t have one, it might be time to develop one.”

Or find someone to do it for you.

Now, I just have to figure out how to get a case of beer across state lines.

Technically Speaking: The Drums Of “Trade” War

In last week’s Technical Update, I discussed the risks to our short-term bullish view. To wit:

“Next week, the Trump Administration will announce $50 billion in “tariffs” on Chinese products. The ongoing trade war remains a risk to the markets in the short-term.

With global economic growth slowing, trade war risks rising, and liquidity being extracted, there is a rising possibility that tighter global monetary policy will lead to a credit-driven event. This is particularly the case given the rate at which corporations have been gorging themselves on cheap debt to take cash out of their balance sheets for the benefit of their executives and shareholders.”

On Monday, we woke to the “sound of distant drums” beating out the warning of a pending trade war as China vowed to retaliate to the $50 billion in tariffs imposed by the Administration on Friday. To wit:

“Global stocks and US index futures are a sea of red this morning amid growing concerns over the escalating trade war between China and the U.S., which on Friday launched tit-for-tat $50BN in tariffs, coupled with the growing risk that Merkel’s government is on the edge of collapse.

Global trade is (once again) back at the top of the wall of worry, with investors afraid that the confrontation between the U.S. and China can escalate out of control, hitting both the global economy and corporate earnings. On Friday, China immediately responded after President Donald Trump slapped tariffs on $50 billion of imports, putting an additional 25 percent levy on $34 billion of U.S. agricultural and auto exports starting July 6.

Analysts expect the U.S.- China confrontation to 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.

Looking ahead, Reuters reported the US may impose higher tariffs on an additional $100bn of Chinese imports. If this triggers another round of actions from China, then this second round of trade war will likely be much more damaging for both sides. According to DB, this could reduce China’s GDP growth by 0.3% of GDP, but importantly, the US tariff list will likely include big item consumer goods such as phones, computers, TVs etc, which could mean a lot more workers in China and US consumers would be negatively affected.”

This morning, U.S. futures plunged lower after President Trump called for $200 Billion more in Chinese tariffs and China vowed to “hit back.” 

Further action must be taken to encourage China to change its unfair practices, open its market to United States goods and accept a more balanced trade relationship with the United States,” – President Trump

Bloomberg reported:

  • CHINA SAYS TO HIT BACK IF U.S. ROLLS OUT NEW TARIFF LIST
  • CHINA MOFCOM SAYS U.S. TARIFF DECISION AGAINST MARKET RULES
  • CHINA WILL TAKE STRONG COUNTERMEASURES IF U.S. ISSUES NEW LIST
  • CHINA COMMERCE MINISTRY SAYS IF U.S. PUBLISHES ADDITIONAL IMPORTS TARIFF LIST, CHINA WILL HAVE TO ADOPT COMPREHENSIVE MEASURES TO FIGHT BACK FIRMLY: RTRS

The only silver lining in all of this is that so far, China hasn’t invoked the nuclear options: dumping FX reserves (either bonds or equities), or devaluing the currency. If Trump keeps pushing, however, both are only a matter of time.”

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

Playing The Trade

While the markets have indeed been more bullishly biased in recent weeks, we have couched our short-term optimism with an ongoing view of the “risks” which remain. An escalation of a “trade war” is one of those risks, the other is a policy error by the Federal Reserve which could be caused by the onset of a “trade war.” 

Wall Street is ignoring the impact of tariffs on the companies which comprise the stock market. Between May 1st and June 1st of this year, 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”).  For the end of 2019, forward reported estimates have declined by roughly $6.00 per share.

However, the red dashed line denotes an 11% reduction to those estimates due to a “trade war” as noted by Barclays Bank yesterday:

“As a result of escalating trade war concerns, Barclays recently estimated the impact in the worst-case scenario of an all-out trade war for US companies across sectors and US trading partners.

In a nutshell, the bank calculated that an across-the-board tariff of 10% on all US imports and exports would lower 2018 EPS for S&P 500 companies by ~11% and, thus, completely offset the positive fiscal stimulus from tax reform.”

Combine a “trade war” with a Federal Reserve intent on removing monetary accommodation, both through higher rates and reduction in liquidity, and the market becomes much more exposed to an unexpected exogenous event which sparks a credit-related event. (Of course, it isn’t just the Fed, but also the BOJ and ECB.)

While our longer-term analysis remains more negative, due to both price extension and valuation issues, on a short-term basis, the markets remain confined to the uptrend that began back in April. Our “pathways” currently remain intact as #2a now seems to be the probable outcome currently. (I have cleaned up the chart to only show the two most probable paths currently.)

With the market weakness yesterday, we are holding off adding to our equity “long positions” until we see where the market finds support. Currently, there is a cluster of support coalescing at the 100-dma. The 50-dma is set to cross back above the 100-dma this week, and the downtrend line from the March highs also resides at that juncture.

If the markets retrace to that cluster of support, we suspect the market will be sufficiently oversold enough for a reflexive bounce by the end of the month. Again, going back to the pathway chart above, the most probable outcome currently remains a continued sideways and choppy market.

For now.

However, longer-term there is little indication the markets have a substantial amount of upside from current levels. As shown in the chart below, the parabolic advance from the 2015-2016 lows have pushed indicators to extremes on many levels. More importantly, we are very close to registering a “sell signal” (bottom panel) at a level higher than previously witnessed at the “dot.com” peak.

The warning from the chart above also coincides with the deterioration in the breadth of participation of stocks as well.

I want to be exceedingly clear that while our outlook on a short-term basis is more optimistic due to recent market action, the longer-term setup remains very bearish for long-term investors.

Simply, this is no longer a “buy and hold” market environment.

The focus now must shift from “risk taking” to “risk control.” “Capital preservation strategies” now replace “capital growth strategies,” and “cash” now becomes a favored asset class for managing uncertainty.

As a portfolio manager, I must manage short-term opportunities as well as long-term outcomes. If I don’t, I suffer career risk, plain and simple.

However, you don’t have to. If you are truly a long-term investor, you have to question the risk being undertaken to achieve further returns from the second longest bull-market in history.

Assuming that you were astute enough to buy the 2009 low, and didn’t spend the bulk of the bull market rally simply getting back to even, you would have accumulated years of excess returns towards meeting your retirement goals. 

If you went to cash now, the odds are EXTREMELY high that you will far outpace investors who remain invested in the years ahead. Sure, they may get an edge on you in the short-term, and chastise you for “missing out,”  but when the next “mean reverting event” occurs the decline will destroy most, if not all, of the returns accumulated over the last 9-years.

All I am suggesting, is that if you continue to ride this particular “bull,” do so carefully. Keep stop losses in place, and be prepared to sell when things go wrong.

For now, things do indeed remain weighted towards the bullish camp, however, such will not always be the case, and that could be sooner than most expect.

Trump’s Volley – Hoover’s Folly?

“You load sixteen tons, what do you get?
Another day older and deeper in debt
Saint Peter don’t you call me ’cause I can’t go
I owe my soul to the company store” 
– Sixteen Tons by Tennessee Ernie Ford

Shortly following Donald Trump’s election victory we penned a piece entitled Hoover’s Folly. In light of Trump’s introduction of tariffs on steel and other selected imports, we thought it wise to recap some of the key points made in that article and provide additional guidance.

While the media seems to treat Trump’s recent demands for tariffs as a hollow negotiating stance, investors are best advised to pay attention. At stake are not just more favorable trade terms on a few select products and possibly manufacturing jobs but the platform on which the global economic regime has operated for the last 50 years. So far it is unclear whether Trump’s rising intensity is political rhetoric or seriously foretelling actions that will bring meaningful change to the way the global economy works. Either as a direct result of policy and/or uncharacteristic retaliation to strong words, abrupt changes to trade, and therefore the role of the U.S. Dollar as the world’s reserve currency, has the potential to generate major shocks in the financial markets.

Hoover’s Folly

The following paragraphs are selected from Hoover’s Folly to provide a background.

In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business-friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.  

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

The Other Side of the Story

The President recently tweeted the following:

Regardless of political affiliation, most Americans agree with President Trump that international trade should be conducted on fair terms. The problem with assessing whether or not “trade wars are good” is that one must understand the other side of the story.

Persistent trade imbalances are the manifestation of explicit global trade agreements that have been around for decades and have historically received broad bi-partisan support. Those policies were sponsored by U.S. leaders under the guise of “free trade” from the North American Free Trade Agreement (NAFTA) to ushering China in to the World Trade Organization (WTO). During that time, American politicians and corporations did not just rollover and accept unfair trade terms; there was clearly something in it for them. They knew that in exchange for unequal trade terms and mounting trade deficits came an implicit arrangement that the countries which export goods to the U.S. would also fund that consumption. Said differently, foreign countries sold America their goods on credit. That construct enabled U.S. corporations, the chief lobbyists in favor of such agreements, to establish foreign production facilities in cheap labor markets for the sale of goods back into the United States.

The following bullet points show how making imports into the U.S. easier, via tariffs and trade pacts, has played out.

  • Bi-partisan support for easing multi-lateral trade agreements, especially with China
  • One-way tariffs or producer subsidies that favor foreign producers were generally not challenged
  • Those agreements, tariffs, and subsidies enable foreign competitors to employ cheap labor to make goods at prices that undercut U.S. producers
  • U.S. corporations moved production overseas to take advantage of cheap labor
  • Cheaper goods are then sold back to U.S. consumers creating a trade deficit
  • U.S. dollars received by foreign producers are used to buy U.S. Treasuries and other dollar-based corporate and securitized individuals liabilities
  • Foreign demand for U.S. Treasuries and other bonds lower U.S. interest rates
  • Lower U.S. interest rates encourage consumption and debt accumulation
  • U.S. economic growth increasingly centered on ever-increasing debt loads and declining interest rates to facilitate servicing the debt

Trade Deficits and Debt

These trade agreements subordinated traditional forms of production and manufacturing to the exporting of U.S. dollars. America relinquished its role as the world’s leading manufacturer in exchange for cheaper imported goods and services from other countries. The profits of U.S.-based manufacturing companies were enhanced with cheaper foreign labor, but the wages of U.S. employees were impaired, and jobs in the manufacturing sector were exported to foreign lands. This had the effect of hollowing out America’s industrial base while at the same time stoking foreign appetite for U.S. debt as they received U.S. dollars and sought to invest them. In return, debt-driven consumption soared in the U.S.

The trade deficit, also known as the current account balance, measures the net flow of goods and services in and out of a country. The graph below shows the correlation between the cumulative deterioration of the U.S. current account balance and manufacturing jobs.

Data Courtesy: St. Louis Federal Reserve (NIPA)

Since 1983, there have only been two quarters in which the current account balance was positive. During the most recent economic expansion, the current account balance has averaged -$443 billion per year.

To further appreciate the ramifications of the reigning economic regime, consider that China gained full acceptance into the World Trade Organization (WTO) in 2001. The trade agreements that accompanied WTO status and allowed China easier access to U.S. markets have resulted in an approximate quintupling of the amount of exports from China to the U.S.  Similarly, there has been a concurrent increase in the amount of credit that China has extended the U.S. government through their purchase of U.S. Treasury securities as shown below.

Data Courtesy: St. Louis Federal Reserve and U.S. Treasury Department

The Company Store

To further understand why the current economic regime is tricky to change, one must consider that the debts of years past have not been paid off. As such the U.S. Treasury regularly issues new debt that is used to pay for older debt that is maturing while at the same time issuing even more debt to fund current period deficits. Therefore, the important topic not being discussed is the United States’ (in)ability to reduce reliance on foreign funding that has proven essential in supporting the accumulated debt of consumption from years past.

Trump’s ideas are far more complicated than simply leveling the trade playing field and reviving our industrial base. If the United States decides to equalize terms of trade, then we are redefining long-held agreements introduced and reinforced by previous administrations.  In breaking with that tradition of “we give you dollars, you give us cheap goods (cars, toys, lawnmowers, steel, etc.), we will most certainly also need to source alternative demand for our debt. In reality, new buyers will emerge but that likely implies an unfavorable adjustment to interest rates. The graph below compares the amount of U.S. Treasury debt that is funded abroad and the total amount of publicly traded U.S. debt. Consider further, foreigners have large holdings of U.S. corporate and securitized individual debt as well. (Importantly, also note that in recent years the Fed has bought over $2 trillion of Treasury securities through quantitative easing (QE), more than making up for the recent slowdown in foreign buying.)

Data Courtesy: St. Louis Federal Reserve

The bottom line is that, if Trump decides to put new tariffs on foreign goods, we must presume that foreign creditors will not be as generous lending money to the U.S. Accordingly, higher interest rates will be needed to attract new sources of capital. The problem, as we have discussed in numerous articles, is that higher interest rates put a severe burden on economic growth in a highly leveraged economy. In Hoover’s Folly we stated: Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

It seems plausible that a trade war would result in potentially controversial intervention from the Federal Reserve. The economic cost of higher interest rates would likely be too high a price for the Fed to sit idly by and watch. Such policy would be controversial because it would further blur the lines between monetary and fiscal policy and potentially jeopardize the already tenuous independent status of the Fed.

Importantly, this is not purely a problem for the U.S. Still the world’s reserve currency, the global economy is dependent upon U.S. dollars and needs them to transact. Any disruption in economic activity as a result of rising U.S. interest rates, the risk-free benchmark for the entire world, would most certainly go viral. That said, for the godless Communist regimes of China and Russia, a moral barometer is not just absent, it is illegal. Game theory, considering those circumstances and actors, becomes infinitely more complex.

Summary

Investors concerned about the ramifications of a potential trade war should consider how higher interest rates would affect their portfolios. Further, given that the Fed would likely step in at some point if higher interest rates were meaningfully affecting the economy, they should also consider how QE or some other form of intervention might affect asset prices. While QE has a recent history of being supportive of asset prices, can we assume that to be true going forward?  The efficacy of Fed actions will be more closely scrutinized if, for example, the dollar is substantially weaker and/or inflation higher.

There will be serious ramifications to changing a global trade regime that has been in place for several decades. It seems unlikely that Trump’s global trade proposals, if pursued and enacted, will result in more balanced trade without further aggravating problems for the U.S. fiscal circumstance.  So far, the market response has been fidgety at worst and investors seem to be looking past these risks. The optimism is admirable but optimism is a poor substitute for prudence.

In closing, the summary from Hoover’s Folly a year ago remains valid:

It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue. Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention to trade conflicts and their consequences can escalate quickly.