Tag Archives: Volatility

Black Monday – Can It Happen Again?

The 1987 stock market crash, better known as Black Monday, was a statistical anomaly, often referred to as a Black Swan event. Unlike other market declines, investors seem to be under the false premise that the stock market in 1987 provided no warning of the impending crash. The unique characteristics of Black Monday, the magnitude and instantaneous nature of the drop, has relegated the event to the “could never happen again” compartment of investors’ memories.

On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Despite varying perceptions, there were clear fundamental and technical warnings preceding the crash that were detected by a few investors. For the rest, the market euphoria raging at the time blinded them to what in hindsight seemed obvious.

Stock markets, like in 1987, are in a state of complacency, donning a ‘what could go wrong’ brashness and extrapolating good times as far as the eye can see. Even those that detect economic headwinds and excessive valuations appear emboldened by the thought that the Fed will not allow anything bad to happen. 

While we respect the bullish price action, we also appreciate that investors are not properly assessing fundamental factors that overwhelmingly argue the market is overvalued. There is no doubt that prices and valuations will revert to more normal levels. Will it occur via a long period of market malaise, a single large drawdown like 1987, or something more akin to the crashes of 2001 and 2008? When will it occur? We do not have the answers, nor does anyone else; however, we know that those who study prior market drawdowns are better prepared and better equipped to limit their risk and avoid a devastating loss.

History provides us with the gift of insight, and though history will not repeat itself, it may rhyme. While we do not think a 1987-like crash is likely, we would be remiss if we did not at least consider it and assign a probability. 

Fundamental Causes

Below is a summary of some of the fundamental dynamics that played a role in the market rally and the ultimate crash of 1987.

Takeover Tax Bill- During the market rally preceding the crash, corporate takeover fever was running hot. Leveraged Buyouts (LBOs), in which high yield debt was used to purchase companies, were stoking the large majority of stocks higher. Investors were betting on rumors of companies being taken over and were participating in strategies such as takeover risk arbitrage. A big determinant driving LBOs was a surge in junk bond issuance and the resulting acquirer’s ability to raise the necessary capital. The enthusiasm for more LBO’s, similar to buybacks today, fueled speculation and enthusiasm across the stock market. On October 13, 1987, Congress introduced a bill that sought to rescind the tax deduction for interest on debt used in corporate takeovers. This bill raised concerns that the LBO machine would be impaired. From the date the bill was announced until the Friday before Black Monday, the market dropped over 10%.

Inflation/Interest Rates- In April 1980, annual inflation peaked at nearly 15%. By December of 1986, it had sharply reversed to a mere 1.18%.  This reading would be the lowest level of inflation from that point until the financial crisis of 2008. Throughout 1987, inflation bucked the trend of the prior six years and hit 4.23% in September of 1987. Not surprisingly, interest rates rose in a similar pattern as inflation during that period. In 1982, the yield on the ten-year U.S. Treasury note peaked at 15%, but it would close out 1986 at 7%. Like inflation, interest rates reversed the trend in 1987, and by October, the ten-year U.S. Treasury note yield was 3% higher at 10.23%. Higher interest rates made LBOs more costly, takeovers less likely, put pressure on economic growth and, most importantly, presented a rewarding alternative to owning stocks. 

Deficit/Dollar- A frequently cited contributor to the market crash was the mounting trade deficit. From 1982 to 1987, the annual trade deficit was four times the average of the preceding five years. As a result, on October 14th Treasury Secretary James Baker suggested the need for a weaker dollar. Undoubtedly, concerns for dollar weakness led foreigners to exit dollar-denominated assets, adding momentum to rising interest rates. Not surprisingly, the S&P 500 fell 3% that day, in part due to Baker’s comments.

Valuations- From the trough in August 1982 to the peak in August 1987, the S&P 500 produced a total return (dividends included) of over 300% or nearly 32% annualized. However, earnings over the same period rose a mere 8.1%. The valuation ratio, price to trailing twelve months earnings, expanded from 7.50 to 18.25. On the eve of the crash, this metric stood at a 33% premium to its average since 1924. 

Technical Factors

This section examines technical warning signs in the days, weeks, and months before Black Monday. Before proceeding, the chart below shows the longer-term rally from the early 1980s through the crash.

Portfolio Insurance- As mentioned, from the 1982 trough to the 1987 peak, the S&P 500 produced outsized gains for investors. Further, the pace of gains accelerated sharply in the last two years of the rally.

As the 1980s progressed, some investors were increasingly concerned that the massive gains were outpacing the fundamental drivers of stock prices. Such anxiety led to the creation and popularity of portfolio insurance. This new hedging technique, used primarily by institutional investors, involved conditional contracts that sold short the S&P 500 futures contract if the market fell by a certain amount. This simple strategy was essentially a stop loss on a portfolio that avoided selling the actual portfolio assets. Importantly, the contracts ensured that more short sales would occur as the market sell-off continued. When the market began selling off, these insurance hedges began to kick in, swamping bidders and making a bad situation much worse. Because the strategy required incremental short sales as the market fell, selling begat selling, and a correction turned into an avalanche of panic.

Price Activity- The rally from 1982 peaked on August 25, 1987, nearly two months before Black Monday. Over the next month, the S&P 500 fell about 8% before rebounding to 2.65% below the August highs. This condition, a “lower high,” was a warning that went unnoticed. From that point forward, the market headed decidedly lower. Following the rebound high, eight of the nine subsequent days just before Black Monday saw stocks in the red. For those that say the market did not give clues, it is quite likely that the 15% decline before Black Monday was the result of the so-called smart money heeding the clues and selling, hedging, or buying portfolio insurance.

Annotated Technical Indicators

The following chart presents technical warnings signs labeled and described below.

  • A:  7/30/1987- Just before peaking in early August, the S&P 500 extended itself to three standard deviations from its 50-day moving average (3-standard deviation Bollinger band). This signaled the market was greatly overbought. (description of Bollinger Bands)
  • B: 10/5/1987- After peaking and then declining to a more balanced market condition, the S&P 500 recovered but failed to reach the prior high.
  • C: 10/14/1987- The S&P 500 price of 310 was a point of both support and resistance for the market over the prior two months. When the index price broke that line to the downside, it proved to be a critical technical breach.
  • D: 10/16/1987- On the eve of Black Monday, the S&P 500 fell below the 200-day moving average. Since 1985, that moving average provided dependable support to the market on five different occasions.
  • E: August 1987- The relative strength indicator (RSI – above the S&P price graph) reached extremely overbought conditions in late July and early August (labeled green). When the market rebounded in early October to within 2.6% of the prior record high, the RSI was still well below its peak. This was a strong sign that the underlying strength of the market was waning.  (description of RSI)

Volatility- From the beginning of the rally until the crash, the average weekly gain or loss on the S&P 500 was 1.54%. In the week leading up to Black Monday, volatility, as measured by five-day price changes, started spiking higher. By the Friday before Black Monday, the five-day price change was 8.63%, a level over six standard deviations from the norm and almost twice that of any other five-day period since the rally began.   

A longer average true range graph is shown above the longer term S&P 500 graph at the start of the technical section.

Similarities and differences

While comparing 1987 to today is helpful, the economic, political, and market backdrops are vastly different. There are, however some similarities worth mentioning.

Similarities:

  • While LBO’s are not nearly as frequent, companies are essentially replicating similar behavior by using excessive debt and leverage to buy their own shares. Corporate debt stands at all-time highs measured in both absolute terms and as a ratio of GDP. Since 2015, stock buybacks and dividends have accounted for 112% of earnings
  • Federal deficits and the trade deficit are at record levels and increasing rapidly
  • The trade-weighted dollar index is now at the highest level in at least 25 years. We are likely approaching the point where President Trump and Treasury Secretary Steve Mnuchin will push for a weak dollar policy
  • Equity valuations are extremely high by almost every metric and historical comparison of the last 100+ years
  • Sentiment and expectations are declining from near record levels
  • The use of margin is at record high levels
  • Trading strategies such as short volatility, passive/index investing, and algorithms can have a snowball effect, like portfolio insurance, if they are unwound hastily

There are also vast differences. The economic backdrop of 1987 and today are nearly opposite.

  • In 1987 baby boomers were on the verge of becoming an economic support engine, today they are retiring at an increasing pace and becoming an economic headwind
  • Personal, corporate, and public Debt to GDP have grown enormously since 1987
  • The amount of monetary stimulus in the system today is extreme and delivering diminishing returns, leaving one to question how much more the Fed can provide 
  • Productivity growth was robust in 1987, and today it has nearly ground to a halt

While some of the fundamental drivers of 1987 may appear similar to today, the current economic situation leaves a lot to be desired when compared to 1987. After the 1987 market crash, the market rebounded quickly, hitting new highs by the spring of 1989.

We fear that, given the economic backdrop and limited ability to enact monetary and fiscal policy, recovery from an episodic event like that experienced in October 1987 may look vastly different today.

Summary

Market tops are said to be processes. Currently, there are an abundance of fundamental warnings and some technical signals that the market is peaking.

Those looking back at 1987 may blame tax legislation, portfolio insurance, and warnings of a weaker dollar as the catalysts for the severe declines. In reality, those were just the sparks that started the fire. The tinder was a market that had become overly optimistic and had forgotten the discipline of prudent risk management.

When the current market reverses course, as always, there will be narratives. Investors are likely to blame a multitude of catalysts both real and imagined. Also, like 1987, the true fundamental catalysts are already apparent; they are just waiting for a spark. We must be prepared and willing to act when combustion becomes evident.

Fearing Complacency – RIA Pro UNLOCKED

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So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself” – Franklin Roosevelt March 4, 1933

Those infamous words were spoken by President Franklin D. Roosevelt at a time when the nation was mired in the great depression, and the stock market had collapsed 80% from the highs of 1929.

We argue in this article that today, fear is exactly what we should fear as a wave of complacency rules the markets.

Investors fear volatility. Low levels of implied volatility are the result of investors that are complacent and not protecting against risks. Conversely, when volatility is higher, investors tend to be anxious, concerned about the future and as such take prudent actions to hedge and protect their assets.

Based solely on today’s levels of implied volatility, the media, central bankers and uninformed cocktail chatter would have us conclude that there is little to worry about. We see things quite differently and believe current indicators offer far more reason for fear than when implied volatility is high and fear is more acute.

No Fear to be Found

The graph below is constructed by normalizing VIX (equity volatility), MOVE (bond volatility) and CVIX (US dollar volatility) and then aggregating the results into an equal-weighted index. The y-axis denotes the percentage of time that the same or lower levels of aggregated volatility occurred since 2010. For instance, the current level is 1.91%, meaning that only 1.91% of readings registered at a lower level.

Data Courtesy Bloomberg

Beyond the very low level of volatility across the three major asset classes, there are two other takeaways worth pondering.

First, the violent nature in which volatility has surged and collapsed twice since 2018. The slope of the recent advances and declines are much steeper than those that occurred before 2018. The peak -to- trough -to- peak cycle over the last year was measured in months not years as was the case before 2018.

Second, when the index reached current low levels in the past, a surge in volatility occurred soon after that. This does not mean the index will bounce higher immediately, but it does mean we should expect a much higher level of volatility over the next few months.

Investment Takeaway

Given that volatility is cheap, wise investors should take advantage of this opportunity to buy options to hedge stock, bond and dollar positions. Traders might want to consider taking our advice a step further by getting long volatility with various options strategies or by buying call options on volatility. Volatility is just another asset class into which we might allocate when it becomes cheap and sell when it becomes rich. As Chris Cole at Artemis Capital says, “it is THE asset class since it is embedded in all others.”

Reasons for Fear

The following considerations fly in the face of the high level of complacency ruling the financial markets:

  • The global economy is slowing
  • Growth in European economies is slowing dramatically, including Germany where 10-year bond yields dropped below zero for the first time since 2016.
  • China, representing 30% of global GDP growth, is weakening rapidly.
  • Domestic GDP is expected to rise by only .50% in the first quarter according to the Atlanta Fed.
  • The trade war with China, and to a lesser degree Europe, could flare up on a single tweet or statement and cause market and economic disruptions.
  • Despite being ten years into an expansion and unemployment near 50-year lows, the Fed decided that Fed Funds above the historically low rate of 2.75 over the next two years is harmful to the economy. What does the Fed know that we do not?
  • The potential for a hard BREXIT is growing by the day.
  • Political drama is heating up with an election and possible Mueller findings.

These and other factors should raise concern.  

Summary

As highlighted by the volatility graph, the three major domestic financial markets are extremely complacent. If history proves reliable, a violent reversal is a clear and present danger. Our greatest fear today is easily the apparent lack of it.

This situation reminds us of a rip-tide on a sunny, beautiful day at the ocean. The water looks relatively calm for all to enjoy without taking precautions. However, within a few steps lies a vicious underwater current capable of imposing swift and unsuspecting demise. The difference between a great day at the beach and a disaster are closer than you think.

Now is a good time to heed the warning of the lifeguard.

Fearing Complacency

So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself” – Franklin Roosevelt March 4, 1933

Those infamous words were spoken by President Franklin D. Roosevelt at a time when the nation was mired in the great depression, and the stock market had collapsed 80% from the highs of 1929.

We argue in this article that today, fear is exactly what we should fear as a wave of complacency rules the markets.

Investors fear volatility. Low levels of implied volatility are the result of investors that are complacent and not protecting against risks. Conversely, when volatility is higher, investors tend to be anxious, concerned about the future and as such take prudent actions to hedge and protect their assets.

Based solely on today’s levels of implied volatility, the media, central bankers and uninformed cocktail chatter would have us conclude that there is little to worry about. We see things quite differently and believe current indicators offer far more reason for fear than when implied volatility is high and fear is more acute.

No Fear to be Found

The graph below is constructed by normalizing VIX (equity volatility), MOVE (bond volatility) and CVIX (US dollar volatility) and then aggregating the results into an equal-weighted index. The y-axis denotes the percentage of time that the same or lower levels of aggregated volatility occurred since 2010. For instance, the current level is 1.91%, meaning that only 1.91% of readings registered at a lower level.

Data Courtesy Bloomberg

Beyond the very low level of volatility across the three major asset classes, there are two other takeaways worth pondering.

First, the violent nature in which volatility has surged and collapsed twice since 2018. The slope of the recent advances and declines are much steeper than those that occurred before 2018. The peak -to- trough -to- peak cycle over the last year was measured in months not years as was the case before 2018.

Second, when the index reached current low levels in the past, a surge in volatility occurred soon after that. This does not mean the index will bounce higher immediately, but it does mean we should expect a much higher level of volatility over the next few months.

Investment Takeaway

Given that volatility is cheap, wise investors should take advantage of this opportunity to buy options to hedge stock, bond and dollar positions. Traders might want to consider taking our advice a step further by getting long volatility with various options strategies or by buying call options on volatility. Volatility is just another asset class into which we might allocate when it becomes cheap and sell when it becomes rich. As Chris Cole at Artemis Capital says, “it is THE asset class since it is embedded in all others.”

Reasons for Fear

The following considerations fly in the face of the high level of complacency ruling the financial markets:

  • The global economy is slowing
  • Growth in European economies is slowing dramatically, including Germany where 10-year bond yields dropped below zero for the first time since 2016.
  • China, representing 30% of global GDP growth, is weakening rapidly.
  • Domestic GDP is expected to rise by only .50% in the first quarter according to the Atlanta Fed.
  • The trade war with China, and to a lesser degree Europe, could flare up on a single tweet or statement and cause market and economic disruptions.
  • Despite being ten years into an expansion and unemployment near 50-year lows, the Fed decided that Fed Funds above the historically low rate of 2.75 over the next two years is harmful to the economy. What does the Fed know that we do not?
  • The potential for a hard BREXIT is growing by the day.
  • Political drama is heating up with an election and possible Mueller findings.

These and other factors should raise concern.  

Summary

As highlighted by the volatility graph, the three major domestic financial markets are extremely complacent. If history proves reliable, a violent reversal is a clear and present danger. Our greatest fear today is easily the apparent lack of it.

This situation reminds us of a rip-tide on a sunny, beautiful day at the ocean. The water looks relatively calm for all to enjoy without taking precautions. However, within a few steps lies a vicious underwater current capable of imposing swift and unsuspecting demise. The difference between a great day at the beach and a disaster are closer than you think.

Now is a good time to heed the warning of the lifeguard.

Has The Market Entered The Bears Den?

“So now we are in a bear market, which isn’t defined by me as stocks being down 20%. A bear market is determined by the way stocks are acting.” :Jeff Gundlach- DoubleLine Capital

This article’s title is singularly the most important investment question of the day. If we are still in the bull market that began in March of 2009, we can buy and hold stocks and sleep well at night with an understanding that any losses are likely short-term in nature. If, on the other hand, we are entering a bear market, then we need to consider big changes to our longer-term portfolio allocations and alter our approach to short-term trading strategies.

Unfortunately, no one can answer the question definitively until we are in the grips of a bear market. Even then, when the market has dropped 20% or more, and long-term technical indicators turn convincingly bearish, there will be many investors who fail to realize that a new investment paradigm has begun.

Currently, valuation indicators are flashing red as they have been for a few years. Until recently this served as a stern warning but was not confirmed by technical measures of momentum. Over the last few months, this has changed, as our technical tools are, one by one, offering the same conclusion as our fundamental indicators. We would characterize the technical momentum indicators as flashing yellow and, as such, have yet to formally declare a bear market. That said we are quite suspicious and have taken appropriate risk-reducing actions.

To some, it may seem trivial to characterize the market as being bullish or bearish. There is an old saying that reminds us why it does matter: “markets take the steps up and the elevator shaft down.” Trading the stairs is quite different than trading the elevator shaft. The shaft leaves little room for error, and the volatility is punishing even if one has the right call, while the stairs are quite forgiving.

Volatility Indicator

In addition to momentum turning over and valuations that portend the potential for a large decline and years until we reclaim current levels, we are equally concerned that the tone of the market seems to be changing. Bull markets tend to trend gently higher with lessened volatility while bear markets impose sharp rallies and drops. It is this roller coaster-like behavior that has heightened our apprehension.

Sensing the change in a market’s tone is partly the benefit of years of watching markets and observing little signals that many investors do not notice. Fortunately for those with less experience or jobs in other fields, there is some science behind it too.

The first graph below shows the S&P 500 in orange with bear markets highlighted in gray. You will notice we inserted green and red numbers that correspond to related bull or bear market eras. The table below the graph uses two methods to compare volatility between bullish and bearish markets.

First, is the average 20-day difference which measures the percentage distance between the maximum and minimum intraday prices that occurred over rolling 20-day periods. The column next to it measures annualized volatility based on closing prices. The calculations are segmented for each bull and bear market.

It is worth stressing the following:

  • Bull markets last much longer than bear markets and account for a large majority of the time. The average duration of bull markets since 1970 is seven years while the average for bear markets is only one and a half years.
  • The two measures of volatility, 20 -day difference and annualized volatility during bear markets are nearly double that of bull markets. What bear markets lack in duration they make up for in volatility.

Both indicators are simply saying that prices move a lot more, up and down, in bear markets than in bull markets. That characteristic has been a very reliable indicator of a pending bear market.

The following graph is another way of adding to that point. The chart, like the first one, shows the S&P 500 and associated bull and bear markets. However, in darker gray, we added the 20 day average of the daily price changes, also called the average true range (ATR). This differs from the first graph as it measures daily closing price changes as opposed to the minimum and maximum intraday prices over 20 -day periods.

Notice again, daily price changes increase during bear markets and also during drawdowns that are not classified as bear markets. The average ATR during bull markets is 1.29% and the ATR during bear markets is significantly higher at 2.23%.

Current

As shown in the bull/bear comparison table under the first graph, volatility in the current period which started in early October looks very similar to prior bear markets. Additionally, the 20 -day average ATR has been running slightly above the bear market average over the last few weeks.

Have we entered the bear’s den?  We are not 100% sold, but the characteristics of the current environment offer compelling evidence. Each day that passes brings us closer to that determination.

From a long -term investment perspective, investors should both reduce equity holdings and favor “safer” equity holdings.

Short -term traders should understand the potential for wild profit swings. Daily and hourly price volatility will be much larger than those to which we have been accustomed. Use stop losses diligently and other risk safeguards to limit losses. At the same time, allow flexibility with those limits to allow positions in your favor to run. Take what the market gives you and make sure the market pays you for taking risk in times of extreme volatility.

Since October 3, 2018, the S&P 500 dropped 19% and regained half of it over the last two weeks. As we have shown, these wild swings do not bear the fingerprint of a bull market. Stay tuned to our daily charts, articles and portfolio actions for further confirmation that we have a loose bear on our hands.

Lastly, the table below from @oddstats highlights the extreme volatility that accompanied the last two major drawdowns.

Watch This Pattern In The S&P 500 and VIX

In the past month, the U.S. stock market has chopped all over the place while getting nowhere in the end. Many traders have been whipsawed by market’s erratic recent action as they hope for another clear trend to form instead of back and forth reversals. Interestingly, during this time, the S&P 500 has been forming a wedge pattern that indicates that another significant trend is likely ahead once the market breaks out from this pattern (up or down). If the market breaks down from this pattern in a convincing manner, another phase of the sell-off that started in October is likely to occur. On the other hand, a convincing bullish breakout from this pattern would likely indicate that the market will attempt to re-test its September highs.

SP 500

The chart below shows the VIX Volatility Index, which appears to be forming a wedge pattern that may indicate that another big move is ahead. If the VIX breaks out of this pattern in a convincing manner, it would likely lead to even higher volatility and fear (which would correspond with another leg down in the stock market). On the other hand, if the VIX breaks down from this pattern, it could be the sign of a more extended market bounce or Santa Claus rally ahead.

VIX

For now, I am watching which way these patterns break out and if the breakouts confirm each other.

 

Why Another Volatility Spike May Be Ahead

In early October, when the U.S. stock market had reached an all-time high and investor sentiment was extremely complacent, I published a warning in Forbes called “Why Another Market Volatility Surge Is Likely Ahead.” I showed three indicators that I believed pointed to an imminent volatility spike, most likely as a result of a bearish market movement. Sure enough, that volatility spike came just a couple days later as the U.S. stock market corrected very sharply. Since peaking in early-October, market volatility (as measured by the VIX Volatility Index) has calmed down a bit as U.S. stock indices staged a bounce. Unfortunately, I am concerned that this most recent period of relative calm may result in yet another volatility spike, provided there is proper technical confirmation.

The chart below shows the VIX Volatility Index, which appears to be forming a triangle pattern that may indicate that another big move is ahead. If the VIX breaks out of this pattern in a convincing manner, it would likely lead to even higher volatility and fear (which would correspond with another leg down in the stock market). On the other hand, if the VIX breaks down from this pattern, it could be the sign of a more extended market bounce or Santa Claus rally ahead.

Volatility Index

In my early-October volatility warning, one of the charts I showed was the inverted 10-year/2-year Treasury spread and how it leads the VIX by approximately three years. According to this logic, the January and October volatility spikes were only the beginning of a much larger bullish volatility cycle (ie., one that accompanies a full-blown bear market).

Yield Curve Volatility

If the VIX breaks to the upside, it would coincide with the S&P 500 testing its 2,550 to 2,600 support zone that formed at the early-2018 lows. As I’ve said in the past, if the S&P 500 breaks that support zone in a convincing manner, an even more extensive bearish move is likely to occur.

S&P 500

For now, I am watching which way the S&P 500 and VIX break out for confirmation.

Please follow me on LinkedIn and Twitter to keep up with my updates.

If you have any questions about anything I wrote in this piece or would like to learn how Clarity Financial can help you preserve and grow your wealth in the dangerous financial environment ahead, please contact me here.

Volatility Is The Price Of Admission To Financial Markets

If it feels to you as if volatility has returned to the stock market, you’re right. But, although we’ve had a bad month in October so far with a nearly 10% loss in U.S. stocks, the calm we’ve had over the past few years is more unusual. And that makes this volatility feel worse than it should.

Garden Variety Correction

Here are a few statistical facts that should put the recent volatility into perspective. First, the S&P 500 Index was up around 11% for the year at its recent peak, including dividends. Now, through Wednesday, October 24th, it’s up 0.88% for the year. That means we’ve had a garden variety correction of around 10% so far. A bear market would be a decline of 20% from the market peak, and that would mean stocks would have to drop around another 10% from here to achieve that. It’s possible that will happen, but, even if it does, we’re only halfway there at this point.

And if we do enter a bear market, that won’t be so unusual either. We haven’t had one since the financial crisis and recession of 2008, after all, and this is now the longest running bull market in history. In fact, the length of the bull market, which started in March of 2009, is what makes any volatility feel unusual – even an ordinary 10% correction.

Calm Creates Complacency

Another important statistic that makes this correction feel unusual is that the S&P 500 Index didn’t drop in a single month in 2017 as it posted a nearly 22% return for the year. That was the first time in history the index didn’t record a negative month in a calendar year, and periods marked by such calm, especially if they come during  the longest bull market in history, make investors complacent.

There is a tendency for investors to feel invulnerable after such periods, even though that kind of calm should make investors nervous about when the next bout of volatility will arrive. The human mind doesn’t work that way though. Behavioral economics has shown that we have a strong tendency toward “recency bias,” meaning we extrapolate whatever hash happened in the recent past onto the future. That often makes us nervous when we should be calm and a little too calm when we should be a little nervous.

It’s true that at the beginning of this year volatility arrived again in February and March when the stock market gave up the roughly 10% gain it achieved during the first few weeks of January. But then calm ensued, and the market marched up nearly uninterrupted to match its earlier gain from January. By the beginning of October, complacency and recency bias had set in again.

Bonds Bring Ballast

Consider also that bonds have done their job by holding steady and bringing ballast to portfolios while stocks have dropped. The Bloomberg Barclay’s U.S. Aggregate Index is down 0.55% for the month of October. It’s true that you might expect bonds to be up a little for the month. It often happens that stock market declines cause a rally in investment grade corporate and especially government bonds, so a slight decline in the main bond index is a little unusual. But it’s nothing extreme, and having a part of your portfolio so stable when the stock market is declining can be a blessing.

This leads us to consider a balanced portfolio, which usually consists of 60% stocks and 40% bonds. This classic allocation has served generations of investors well with its moderate risk/reward profile, and it happens that a domestic index balanced portfolio is down a little less than 1% for the year through October 24th. A global balanced portfolio is down more – around 4%. But that’s not catastrophic either.

Also, the historical “standard deviation” or volatility of a moderate or balanced allocation has been around 10%. That means investors can expect a range of returns within 10 percentage points in either direction around such a portfolio’s average return of 7% per year. So far, we are within that tolerance. And standard deviation isn’t perfect; it only captures most of the deviations around the average return, not all of them. There are times when balanced portfolios will have a wider range of return including losses than a 10 percentage point deviation around the average return. But we are nowhere near these larger losses yet.

Here, again, investors may be fooled by recency bias. Morningstar’s moderate allocation category has delivered a standard deviation of over 9% for 15 years, but only around 6% or one-third less for 3 years.

 

Overall, investors should remember that although October has been a bad month, the volatility we’ve experienced over the past few years is well below average. October has been a reminder that volatility is part of the “price of admission” to the financial markets.

Rules For Managing Volatility

Volatility is back. Your success as an investor is based on how you’ll deal with it. Here are some rules to help you cope.

First, reconsider your allocation. If you have 50% or 60% stock exposure in what’s often called a ‘balanced” portfolio, and you can’t handle a 5% or 10% portfolio hiccup, you’re probably in the wrong allocation. After all, a correction (stock market decline of 10%) will take your portfolio down around 5% and a bear market (stock market decline of 20% or more) will take your portfolio down 10% or more.

In 2008, balanced portfolios dropped around 20%, and that’s what I tell balanced portfolio investors to anticipate. We’ve had two 50% drawdowns in the stock market since 2000, and there’s no reason why we can’t have another one. It’s true, we may not. But we just as easily might. Now is a good time to do a gut check or reconsider your allocation.

It’s possible that you can handle more volatility, but are just unaccustomed to it right now, so it feels particularly bad. Think about what it will be like to see your portfolio down 20% or 25%. And put a dollar value on that. Most people don’t think of their money in terms of percentages. That will help you figure out if you’re reasonably allocated or not.

Second, don’t be ashamed to admit you can only handle so much volatility. Financial planners are always pushing clients to invest more in stocks. But I think they do their clients a disservice because the advisors are neglecting to consider carefully whether the clients can handle the volatility of owning stocks. Sure, planners give clients risk questionnaires. But those only go so far. Nobody really knows hows they’ll react to stress until it arrives.

Also, advisors are human, and they probably have a more attractive view of themselves and their skills than they should. That means they think they’ll be able to soothe you better than they probably will when the market goes down. Advisors like to think that they can soothe clients, but if the client wants to leave, the advisor will do what the client says rather than lose the client. So don’t let an advisor push you into more stock exposure than you can handle. The best advisors work hard to find out what the best allocation is for you; they don’t try to push you into an allocation or make you feel badly for not having more stock exposure.

Third, if you have to sell, don’t get all out of stocks with your long term money. It’s a mistake to sell everything, even if you think the market will keep going down, and it does. That’s because it will be harder to get back in. You won’t know where the bottom is (nobody ever does), and you’ll be too scared to dribble money in if you’re all out.

If you maintain some modicum of stock exposure, you’ll at least have that capturing gains when the market delivers them again. But you might be wrong about when the market will turn, so keep 25% of stock exposure as a hedge against your inability to call at bottom — or act after prices drop a lot.

Investment legend Benjamin Graham said “enterprising investors,” those who study the markets and investments carefully, can toggle between 25% and 75% stock exposure, but no more and no less on either end. You might want your bands to be more narrow depending on your age, etc… Try toggling between 60% and 30%.

Personally, I think valuations are insane, but I have for a long time. And the market just keeps running. That doesn’t mean I may not be correct eventually, but eventually can be a very long time. Have some humility. You need it in this game.

Fourth, don’t assume changing your allocation is easy . If you go down to 25% or 30% stock exposure, but that’s not really optimal for you, it may be hard to get back in. That’s because the criteria you might wait for – a cheap P/E ratio or some technical indicator – may never materialize or stick around long enough for you to act.

Fifth, even if you do get an opportunity, remember there’s never a time when “the coast is clear.” Whenever stocks drop a lot, it feels bad to buy them, even if that’s what you should be doing. That’s why having a system is so important. Simply responding to market moves in an ad hoc manner probably won’t go well.

Sixth, see an advisor if you can’t settle non an asset allocation or handle market moves well.

As Seen On Forbes: Volatility Is Surging

As seen on Forbes by RealInvestmentAdvice.com’s Jesse Colombo: “Volatility Is Surging.”

After a calm spring and summer, volatility has come back with a vengeance in October. The CBOE Volatility Index or VIX has surged from the 13s at the start of the month to nearly 23 right now, which is the largest volatility spike since the stock market correction in February. As volatility spiked, the Dow fell nearly 2,000 points since the start of October as rising interest rates spooked investors out of the frothy stock market.

Here’s what the VIX looks like right now:

VIX

While many traders and market participants were caught off-guard by the volatility spike, I specifically warned about it on October 2nd in a Forbes piece called “Why Another Market Volatility Surge Is Likely Ahead.”

Read the full article on Forbes.

High Risk in High Yield

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

  • The upside of owning this Tesla bond is 6.29% annually
  • The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
  • Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

  • What is driving HY to such returns?
  • How much lower can yields on HY debt go?
  • Is further spread tightening possible?
  • What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

  • HY yields fall to their minimum of the last three years
  • No change in yields
  • HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.

Summary

An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!

The Smart Money Are Bullish On Volatility – RIAPro

As the U.S. stock market climbs to record highs, volatility has calmed down quite a bit from its panic-induced levels earlier this year. Complacency is back as traders passively ride the stock market higher and sell volatility short once again. While it may seem as if the coast is finally clear, the “smart money” or commercial futures hedgers (who tend to be right at major market turning points) are building up another bullish position in VIX volatility futures, just like they did one year ago ahead of the market correction and volatility spike.

At the same time, the “dumb money” or large traders (who tend to be wrong at major turning points) have built up a large short position, like they did before the volatility spike. Though these positions are not quite as large as they were one year ago, they should be monitored in case they grow. The positioning of these groups of traders implies that another volatility spike is likely ahead in the not-too-distant future.

VIX

In addition, the volatility of volatility is currently at ultra-low levels, which implies that another volatility spike is likely ahead soon. The chart below shows the Bollinger Band width of the Volatility Index or VIX (in red) vs. the S&P 500 (in blue). Bollinger Band width is a way of measuring volatility of a market or financial instrument. Every time the Bollinger Band width drops to approximately 10, it foreshadows a sharp upward move in the not-too-distant future – it’s similar to a “calm before the storm.”

Bollinger Band Width

The fact that the “smart money” is bullish on volatility and that the volatility of volatility is so low is always a worrisome prospect with a stock market as bubbly as ours.

Following Signs Others Ignore : VIX

“In fact, the crowd sees hardly anything out there that might end this market party.”

Michael Santoli made the above statement during CNBC’s closing market wrap on January 26th, 2018. He had reason to throw caution to the wind as the S&P 500 closed the day up by more than 1%, setting another record high. In the first 18 trading days of 2018, the S&P 500 set 14 record highs and amassed a generous 7.50% return for the year.

As quoted, CNBC and most other financial media outlets were exuberant over the prospects for further gains. Wall Street analysts fell right in line. Despite the fact it was not even February, some Wall Street banks were furiously revising their year-end S&P 500 forecasts higher.

On January 27th, the S&P 500 closed down 0.70%, and in less than three weeks, the index fell over 10% from the January 26th high. Very few investors harbored any concern that the rare down day on the 27th was the first in a string of losses that would more than erase 2018’s gains to that point.

Looking back at the January swoon, there were a few indicators that CNBC, others in the media, and those on Wall Street failed to notice. In mid-January, we noticed an anomaly which proved to be a strong leading indicator of what was ultimately to transpire. The purpose of this article is to re-introduce you to this indicator, as it may once again prove helpful. We’ll also remind you why ignoring media and Wall Street driven hype is important.

VIX

VIX is the abbreviation for the Chicago Board of Options Exchange (CBOE) Volatility Index, which gauges the amount of implied volatility in the S&P 500 as measured by pricing in the equity options market.

When optimism runs high, investors tend to seek less downside protection and as such VIX tends to decline. Conversely, when markets are more fearful of the downside, VIX tends to rise as investors are willing to pay higher prices for protection via the options market. While not a hard and fast rule, VIX tends to be elevated in down markets and subdued in bullish markets. This historical relationship is shown below. The beige rectangles highlight recent market drawdowns and the accompanying VIX spikes.

Data Courtesy Bloomberg

Another way to show the relationship is with a scatter plot. Each dot in the plot below represents the percentage change in VIX and the associated percentage change in the S&P 500 for the prior 20 days. The data goes back to 2003. While there are outliers, the graph generally illustrates an inverse relationship, whereby a higher VIX is associated with lower S&P returns and vice versa.

Data Courtesy Bloomberg

January 10th-26th

With an understanding of volatility and its general relationship with market direction, we return to the 12 trading days leading up January 27th. The graph below charts the VIX index and the S&P 500 from January 1st to the 26th.

Data Courtesy Bloomberg

The obvious takeaway is that the VIX and the S&P rose in unison. Despite a euphoric financial media, daily record highs and a strong upward trend, investors were increasingly demanding insurance in the options markets.

The scatter plot and its trend lines below show this divergence from the norm. The orange dots represent the daily VIX and S&P changes from the 10th to the 26th while the blue dots represent every trading day from January 1, 2017, thru August 2018.

Data Courtesy Bloomberg

From January 27, 2018 to early March, the VIX was trading over 20, twice the general level that prevailed in early January and throughout most of 2017. The elevated VIX and weak market resulted in a normalization of the typical inverse relationship between volatility and equity performance, and it has stayed normal ever since. The green dots and green trend line in the graph below represent data since January 27th. The divergence and normalization can best seen by comparing the trend lines of each respective period.

Data Courtesy Bloomberg

Tracking VIX

In addition to identifying the relationship as we did in January, we must monitor this relationship going forward. We show two additional metrics for VIX and S&P 500 below that we created to alert us if the typical inverse relationship changes.

  • Running Correlation: Calculates the correlation between the VIX and the S&P 500 on a rolling 10-day The highlighted area on the line graph below shows the departure from the norm that occurred in mid-January.
  • Anomaly Count: Counts the number of days in a period in which the S&P was higher by a certain percentage and the VIX rose. In the second chart below, the blue bars represent the number of trading days out of the past 20 days when the S&P 500 rose by more than .50% and the VIX was higher.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Summary

Markets do not suddenly drop without providing hints. As we discussed in our article 1987, the devastating Black Monday 22.60% rout was preceded by many clues that investors were unaware of or, more likely, simply chose to ignore.

Currently, most technical indicators are flashing bullish signals. Conversely, most measures of valuation point to the risk of a major drawdown. This stark contrast demands our attention and vigilance in looking for any data that can provide further guidance. The VIX is just one of many technical tools investors can use to look for signals. We have little doubt that, when this bull market finally succumbs to overvaluation and the burden of imposing levels of debt, clues will emerge that will help us anticipate those changes and manage risk appropriately.

Late Cycle Dumpster Diving – RIA Pro

With the current economic expansion now nearly ten years old and the stock market days away from being the longest bull market in modern U.S. history, the only way to characterize the current environment is “late cycle”. Economic growth has recently improved, predominately thanks to a surge in fiscal spending and tax cuts but higher volatility and tighter monetary policy should raise concerns about the durability of the U.S. economy’s winning streak.

Among the asset classes that would be most affected by a change in the contours of this expansion, high yield corporate bonds (a.k.a. junk debt), those rated below BBB-, rank near the top. To analyze the risk/reward tradeoff inherent in this sector, the following article relies heavily on charts and tables of data.  You are invited to draw your own conclusions, we certainly have ours.

Current Circumstances

Despite credit concerns in the retail sector in 2017, the high yield credit sector generated a 7.30% total return for the year. The strong performance continued in the first few weeks of 2018 as witnessed by a healthy 0.60% gain. The sudden surge in equity volatility at the end of January pushed returns in to the red. Like the equity market struggling to recapture January’s all-time highs, the high yield sector is in the black but not by much, having returned only 1.26% so far this year. Interestingly however, that performance ranks first among the major fixed-income categories as everything else except municipal bonds have negative returns for the year.

To what does the high yield sector owe this status of best performer at this point in 2018?

Technical dynamics explain most of the outperformance. High yield corporate issuers have provided much less supply in an environment where demand remains strong and despite the scare early in the year, volatility has returned to mid-January levels. Additionally, the recent boost in corporate earnings growth is providing fundamental support. Lastly, the high yield sector in general has a shorter duration (risk) profile than the investment grade sector. This combination of circumstances has helped keep high yield spreads tight to other fixed income assets, an indicator reflective of investor optimism about the economic cycle and the expectation that defaults should remain historically low.

Counter to the bullish argument, the question of broader problems potentially evolving out of the disruption currently being observed in the emerging markets should not be entirely dismissed. Emerging market economies, and for that matter many developed nations’ economies, appear to be slowing. Liquidity and lending conditions are tightening due to higher U.S. interest rates, reduction of the Federal Reserve balance sheet and rising U.S. Treasury issuance. Further, the combined effects of a stronger U.S. dollar, inflation concerns and protectionist measures being taken by the U.S., raise the overall level of uncertainty in the domestic and global economy. Although some of those concerns are peripheral to the U.S., history has proven it is a short walk to the doorstep of contagion.

High Yield Analysis

The following charts and tables provide guidance on the risk-return framework facing the high yield sector. Unless otherwise noted, data for the following charts are from Bloomberg, Barclays, Goldman Sachs and JPMorgan.

Treasury (Tsy), investment grade (IG) and high yield (HY) yields, as shown below, have been at remarkably low levels since 2011 and are now showing signs of rising in sympathy with Federal Reserve rate hikes.

The next two charts offer insight into the recent performance of high yield credit. The first illustrates total return performance by year and the second is cumulative returns since 2015. Emerging market credit is added to the second graph for further perspective.

Given the strong historical relationship with equities, the next chart highlights monthly high yield total returns and their relationship with monthly changes in equity volatility. Based on the data, a ten-point increase in the VIX index should result in a 2.50% decline in high yield returns while a ten-point decline should result in a 3.70% pick up in returns. However, with the VIX only slightly above ten and resting near historical lows, there is little reason to expect much of a pickup in returns due to falling equity volatility.

Option-adjusted spreads (OAS) reflect the difference between various credit instruments and the risk-free rate which is normally the comparable U.S. Treasury security. It not only accounts for the credit risk and interest rate risk but also factors in the optionality or risk that the issuer can call the bond at some pre-determined price. The wider (higher) the option-adjusted spread, the more risk the market attaches to the security and vice versa for tighter (lower) spreads.

The chart below shows the contrast between investment grade and high yield OAS. It also captures the price moves of the S&P 500 which are inverted on the right axis. While not at record lows, credit spreads are at very tight levels historically, which was also true in 2007 when the S&P 500 peaked.

The following chart shows the aggregate high yield index as well as a breakout of yields by credit quality. Interestingly, although yields in general are turning higher, CCC-rated bonds have been less responsive, thus the outperformance versus the other credit categories. Also note how yields on the single-B index and the aggregate high yield index have mirrored each other for the last 20+ years.

In OAS terms as shown below, spreads remain stable but the CCC’s are still trending lower (tightening – outperforming).

The continuing outperformance of the CCC-rated bonds within the high yield sector can be illustrated more specifically through the scatter chart below. Comparing the BB’s, the highest credit quality within the high yield category, with the lower-rated CCC’s reflect the significant spread tightening by the CCC’s since at least 2016.

Among the reasons for the lower quality bond outperformance may be the continuing strength of the economy which minimizes investor default concerns, as well as the reduced issuance/supply of CCC bonds relative to demand. Regardless of the reason, investors should be concerned as lower-rated bonds CCC bonds historically demonstrate much higher levels of annualized volatility, largely because they present a much higher risk of default.

A comparison of IG and HY OAS further illustrates that spread compression is not just occurring within the high yield sector but also between high yield and higher rates investment grade bonds.

The chart below combines a comparison of the spread between investment grade credit yields and those of high yield (HY minus IG yields) and the ratio of those yields (HY divided by IG yields). Both metrics are at near lows meaning HY yields are quite compressed to IG and would seem to have little room for further tightening.

The duration of a bond is a measure of price risk given a 1% (100 basis point) change in interest rates. For example, a bond with a duration of five would see the price of the bond move 5% for every 1% change in interest rates. Isolating the lowest-rated investment grade category (BBB) versus the highest-rated junk bond category shows that the BBB duration continues to migrate higher while that of the BB’s has been falling. The duration spread between the two is now near the highest levels seen since 1995.

Another useful metric to gauge relative value is yield per unit of duration. This is conceptually similar to the Sharpe Ratio. Overall investment grade credit issuance generally has a longer duration as higher quality issuers can more easily and cost effectively issue bonds with longer maturities. The long-term average (since 1989) duration for IG is 6.1 years and the average yield is 5.82% which means the average yield per unit of duration is 0.95. For high yield, the long-term average duration is 4.4 years and the average yield is 8.98% for a yield per unit of duration of 2.04.

As the table below demonstrates, current yield levels offer much less return per unit of duration risk for both IG and HY than the average. The combination of rising rates and shorter duration in HY, which helps limit the exposure of higher interest rates, may help explain why junk bonds appear more attractive using this measure relative to IG. The chart below the table offers historical context of this relationship.

As mentioned, supply and demand dynamics play an important role in relative performance as the next chart highlights. Currently, IG issuance is much heavier than HY issuance, a divergence that accelerated in 2015. The shaded area in the chart is the ratio of the notional amount of high yield bonds outstanding relative to investment grade. At 53.3% of IG outstanding, high yield supply is at the lowest relative level since 1995.

Summary

At this point in the business cycle, credit cycle and emotional cycle, the low yields and tight credit spreads in the high-yield corporate sector point toward a definitive asymmetry in risk. More bluntly, given the higher probabilities of default in high yield bonds, investors are taking on a lot of risk and are not being properly compensated for it. This can certainly continue as investing is the only business where otherwise sane individuals pile into the store to pay ever higher prices and flee as prices collapse. The current dynamics reinforce that behavior and will further ensure the alternative scenario when prices commence lower.

More importantly, the charts in this series argue that all measures of value across the full credit spectrum in absolute terms appear quite rich. Yield levels remain very low and credit spreads very tight.

This analysis argues that if an investor is going to take their chances and remain invested in corporate credit, they should do so in an “up-in-credit” manner. For example, own the double-B credits as opposed to the single-B’s and triple-C’s. Likewise, in the investment grade sector, own the double-A and single-A credit bonds as opposed to the triple-B bonds. The “give-up” in yield for moving up in credit is minimal and the added protection of better quality securities is prudent especially at this late stage in the cycle.

Without regard for how long it takes for spreads to normalize, risk management is very forgiving when valuations reach these levels. As a reminder, the diligent and patient investor is the rewarded investor who avoids large losses and continually compounds wealth.

Allocating on Blind Faith – RIA Pro

“Successful investing is about managing risk, not avoiding it.” – Benjamin Graham

Almost all passive investment strategies are based on the assumption that younger investors should hold more equities as a percentage of their total portfolio. Likewise, as they age and get closer to retirement, the allocation to fixed income assets should grow while equity holdings shrink. Target Date Funds (TDF’s), which base asset allocation solely on a specific future date, are the poster child for this strategy and demonstrate the current epitome of blind faith in passive strategies.

If such a strategy were effective, investing would be simple and we could all meet our retirement goals. Unfortunately, our investment lifespans never line up with valuation peaks and troughs. As such, any strategy that ignores expected returns and the risks associated with asset prices at each point along the investment horizon is destined for failure.

In this piece, we focus on an important graph and its construction. We illustrate that there are times, regardless of whether you are 75 or 25, that you should heavily invest in stocks and other times when bonds should take priority over stocks.

We offer a special thank you to Brett Freeze for help sourcing and compiling the data used in the graphs and tables below.

Missing the Target

Target Date Funds (TDF’s) are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in retirement plans and 529 College Savings Plans due to the known date when someone wishes to retire or send a child to college.

When TDFs are newly created, with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses, they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following charts show how Vanguard’s TDF allocations transition as the amount of time remaining until the target date declines.

The problem with these funds is that the asset allocations employed are solely a function of a specified future date, giving no consideration to the price paid for those assets. More simply, these funds completely ignore the most basic rule of investing, buy low and sell high.

Expected Returns 

To effectively explain a practical method for allocating between stocks and bonds, we have created a rather complex graph. Rather than present it now and try to explain the myriad of data points represented by the various symbols and lines, we think it is best to walk you through the construction of the graph. Viewing the various components of the graph in isolation will make it easier to interpret and shine a light on the expected outcomes for stocks and bonds.

Valuations

The following three graphs are scatter plots of popular equity market valuations and their associated returns. Specifically, the green, orange, and purple markers represent the intersection of a quarterly valuation level and the subsequent 10-year annualized total return. Instead of using the specific valuation data in the x-axis, we use each data point’s standard deviation from the mean. This allows us to more effectively compare the values of the three metrics together.

On each graph you will see a downward slanted line, which is the regression trend line of the markers (dots/diamonds). Each graph also has a vertical line representing the current valuation level. The intersection of these two lines is the expected return for the next ten years. The three graphs and the compilation of them shown last is based on nearly 75 years of data.

1. Market Cap to GDP

This valuation compares the market capitalization of the broad market to nominal GDP. Given that corporate earnings are almost entirely a function of economic growth, this ratio provides guidance on whether total market capitalization is appropriate versus GDP. Warren Buffet said this ratio “is probably the best single measure of where valuations stand at any given moment.”

The R-squared measuring correlation stands at 0.69, meaning that 69% of ten-year forward returns can be explained by the current valuation. The ten-year annualized expected total return is -1.42% as shown by the circle surrounding the intersection of the current valuation and trend line. Also note that with the exception of one quarterly instance, anytime the ratio was greater than two standard deviations above the average, the following ten years posted a negative return.

2. Tobin’s Q Ratio

James Tobin created this ratio to show the market value of all companies versus the replacement value of all those companies’ assets. When the measure is 1.0 or greater, it means the aggregate value of stocks is greater than the aggregate value of their assets.

The R-squared is 0.67, and the ten-year expected total annualized return is +2.92%.

3. Robert Shiller’s CAPE

– Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of calculating the widely popular price-to-earnings (P/E) ratio. Unlike most P/E measures which use earnings from 12 months prior or forward estimates in the denominator, this method uses an average of the last ten years of earnings. The benefit versus the shorter time frames is that it factors in longer-term earnings trends and complete economic cycles. P/E calculations using 12-months of data are exposed to short-term deviations from the earnings trend and ignore the cyclicality of economic activity.

The R-squared is 0.62, and the ten-year expected total annualized return is +3.49%.

Now we compile the data from the three graphs to get a broad picture of what these valuations portend.

We find it fascinating that the trend lines and data points for three different valuation methods are so closely aligned. While each valuation measure points to a different expected return, the broad message is clear that higher valuations imply weaker future returns and vice versa. More importantly, the current valuation levels all point to poor expected returns. Factor in inflation and the returns for all three measures are likely at or below zero.

Fixed Income Alternatives

Having seen return expectations for stocks, we now shift focus to consider the potential return on other asset classes. While there are many alternative assets in which one can invest, we chose to simplify this analysis and compare equities to the yields of liquid, high-quality fixed-income securities. The primary reason is that the U.S. Treasury note and investment-grade bonds we use are easy to acquire and guarantee a fixed ten-year return barring a default. Default risk for the bonds we selected for this analysis is very low.

The following graph combines the guaranteed yields of the bonds we selected (barring default) as compared to the equity outcomes shown above. The red dotted line in the graph represents the current yield on a risk-free ten–year U.S. Treasury (2.95%), while the aqua shaded area provides a range of yields for the corporate bonds. Beneath the graph is details of the corporate bonds selected for this analysis.

The following table compares the expected returns for equities, Treasury note, and the selected corporate bonds.

Summary

We only presented three measures of valuation in this analysis. We did not cherry pick valuations as evidenced by the table below showing our three indicators as well as five others.

For an investor who elects to continue to chase the stock market higher, do so with the understanding that the market is well overdue for a serious drawdown. If you are a passive investor and do not track day to day price changes or follow technical studies, we recommend you take this analysis seriously and formulate a plan to manage risk. 

However, doing so requires some work and effort which runs counter to current investment norms. Passive investing is “easy” and requires no effort. Plus, the fees are low. In contrast, identifying times when the market is cheap or expensive requires some work and usually cuts against popular opinion. The evidence of historical data is clear; we are all but guaranteed to achieve a better return on bonds than stocks for the next ten years.  The only question we all must answer is when should we stop following the equity herd and start following the long lesson of the history books? Despite the insistence of many popular investors and the financial media, this time is not different.

As Benjamin Graham notes in his classic book The Intelligent Investor, “Successful investing is about managing risk, not avoiding it.” Ultimately, risk is most effectively managed by being discriminating about the price paid for an asset. Target date funds and many other passive strategies intentionally disregard his advice.

Whatever it Takes

 

At the end fiat money returns to its inner value—zero.”  – Voltaire

 “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” – Mario Draghi July 26, 2012

On July 26, 2012, European Central Bank (ECB) President Mario Draghi essentially guaranteed the ECB would not allow the markets to cripple the Euro region. This shot across the bow finally remedied the instability caused by the sovereign debt crisis. The markets quickly reversed the damaging trends and uncertainty that had plagued the Euro-zone for months.

Draghi’s statement essentially boiled down to a promise that the ECB would print unlimited amounts of money to stop the “harmful” will of investors.

Fiat currency, be it dollars, euros, yen, or any other major currency today, are backed by confidence in the government, its ability to tax and the status of its economy. Importantly, however, it is also largely based on the trust and confidence in the central bank that issues those notes. If Draghi did not have the market’s trust and confidence, his statement would have been ignored, and there is no telling what might have happened to Greece or the Euro for that matter.

In September 2016, the Bank of Japan (BOJ) introduced Quantitative and Qualitative Easing (QQE) with Yield Curve Control. The new policy framework aimed to strengthen the effects of monetary easing by controlling short-term and long-term interest rates through market operations. The announcement also introduced an “inflation overshooting commitment” with the BOJ committed to expanding the monetary base until the year-over-year inflation rate “exceeds and remains above the 2 percent target in a stable manner.” Essentially, the BOJ pulled a “Draghi” and promised to do “whatever it takes” to ensure interest rates did not rise more than they wanted.

Recently, the BOJ amended the 2016 statement because bond investors were increasingly testing the central bank’s resolve. We are not claiming this just yet, but if the BOJ is losing the trust and confidence of investors, they could be the first domino in a long line that will change the markets drastically. While this discussion is certainly early, the situation bears close attention.

JAPAN

Before discussing the BOJ’s recent actions, consider the following, which demonstrates the aggressive use of monetary policy by the BOJ:

  • The BOJ cut their equivalent of the Fed Funds rate to zero in 1999 and, excluding a few minor variations, it has stayed at or below zero since then.
  • The BOJ buys and owns Japanese Treasury bonds (JGB’s), ETF’s and REITs.
  • The BOJ owns 48% of outstanding Japanese Government Bonds (JGBs)
  • The BOJ is a top-ten shareholder in over 40% of Japan’s listed companies.
  • The BOJ owns nearly 80% of domestic ETF’s.
  • The BOJ’s balance sheet is over 110% of Japan’s GDP, dwarfing the Fed (21%) and the ECB (24%).

Throughout the summer of 2016, rapidly rising interest rates became a concern for the BOJ. We say that tongue in cheek as ten-year JGB yields only rose about 0.30% over a few months and were still negative. A continuation of that trend was clearly a threat to the BOJ and, in September that year, they took decisive action to stop the assent of yields.

As discussed in the opening statement, QQE with yield control and the new inflation overshooting commitment would provide the BOJ with unlimited abilities to fight rising rates. Included with that policy modification was a limit or cap on ten-year yields at 0.10%. If that yield level were breached, they would throw the proverbial kitchen sink at the market to fight it. The graph below shows ten-year JGB yields and the effectiveness of the cap (red line).

In late July 2018, yields on ten-year JGB’s breached 0.10% on four different days. The BOJ, as they did in 2016 when rates rose, took this threat seriously. On July 31st, they amended their 2016 pronouncement to allow more flexibility in yield levels, leaving the direction of rates more in the hands of the market. This action has been clarified to mean they will increase their cap on ten-year JGB yields to 0.20%. The graph below charts the daily highs since July 1st, to better highlight the yield versus the 0.10% cap.

The BOJ owns an overwhelming majority of Japanese stocks and government bonds. Their control is significantly greater when you consider their ownership of the true float of the securities. This is incredibly important to grasp as the BOJ is quickly reaching the limit on how many more of those assets it can buy.

That is not to say that they don’t have options once they buy all the bonds and stocks the capital markets have to offer. The options become more extreme and, quite frankly, much more consequential. For example, they could take the route of the Swiss Central Bank and buy foreign stocks. They could also print money and give it directly to citizens, aka helicopter money. Both options have grave implications for their currency and greatly increase the odds of meaningful instabilities like hyperinflation.

The BOJ’s rationale for allowing greater flexibility is to address “uncertainties” related to the anticipated consumption tax hike in 2019. In our opinion, the flexibility is the BOJ’s way of whispering “Uncle”. They know they are limited in their ability to further manipulate interest rates and stock prices and do not want to tip their hand to the market. Again, if the market senses the BOJ’s tool box is empty, trust and confidence could fade quickly.

Some may say this is a first step in the BOJ taking their foot off the monetary gas pedal, and if so, we welcome and applaud such action. What seems more likely is that the market has finally sensed the BOJ’s Achilles Heel.

Summary 

Public trust and confidence is the single most important asset a central banker can possess. Without these, they are printing worthless currency and have little to no power.

Shorting Japanese bonds has been called the “widow makers trade” as one must have incredible patience and plenty of time to outlast the BOJ’s will. Thus far, anyone that has fought the BOJ has lost, hence the nickname. Japan’s problems have been brewing for decades, and despite recent signs that the BOJ is running out of weapons, we would remain reluctant to fight them.

Of greater concern to us is the macro picture that is emerging in Japan. If investors are starting to question the on-going ability of the BOJ to manage rates, it is not unreasonable to think that other central banks could be at risk. While this story will continue to play out over a long time frame, markets seem content to ignore the growing problem. Our concern is that, if you are not prepared to act when the market unexpectedly awakens, you will be the victim of the reversal of years of interest rate price controls and asset price manipulation.

Keep in mind; you can’t buy homeowners insurance once the house is on fire.

Fixed Income Update – July 2018 RIA Pro

Shrugging off economic growth, inflation and U.S. Treasury supply concerns that seem to have plagued the fixed-income markets for the past few months, most bond sectors staged a healthy rally in July as performance reflected the risk-on flavor for the month. The riskiest sectors, emerging markets and high yield (HY), performed best while the safest, Treasuries and mortgages, were the only two sectors to post monthly losses.

Anxieties surrounding trade and tariffs were overshadowed by comments from the Federal Reserve (Fed) that were broadly very constructive for the U.S. economy. In his quarterly testimony to Congress, Fed Chairman Powell emphasized a favorable outlook due to strong labor markets and the lift from fiscal policy stimulus. Those positives outweighed the downside risk emanating from rising protectionism.

Year-to-date, only the high-yield sector is in the black, municipals are essentially flat and every other sector is posting a negative return. Although much improved in July, emerging market bonds continue to struggle but with good reason given the political and foreign exchange disruptions in many places like Turkey, Argentina, Brazil and South Africa. Somewhat strangely, the divergence between high yield and investment grade (IG) corporates persists as they represent the best and the worst performers of the year so far.

Reviewing the lower rated corporate bonds in the IG and HY corporate sectors offers an illustration of the extent to which lower-rated high yield bond valuations have outperformed lower-rated IG.

The chart above highlights the yield-to-worst (YTW) relationship between BBB-rated IG bonds and CCC-rated HY going back to the end of the recession in June 2009. To get back to the average trendline would require the CCC YTW to increase to approximately 10.75% from the current 8.39% yield. If we assume a five-year duration, such a move would entail an approximate price decline of 12%.

In terms of spread, CCC’s would need to move higher by 100 basis points to 6.50 or the BBBs would need to drop by roughly 50 basis points.

In our opinion it is worth looking into a trade whereby you are long BBB’s and short CCC’s.  What makes this idea even more compelling is the comparative credit risk advantage. According to S&P ratings analysis, roughly 40% of CCC-rated bonds will default within 3 years while the risk to BBB-rated bonds is less than 2%.

Bulls Make A Charge For The Highs

Bulls Make A Charge For The Highs

Last week, we discussed how the market managed to clear the “Maginot Line” which brings January highs into focus. The chart below is the updated analysis from last week.

Given this is a “weekly” chart, it takes much more time for signals to register. The advance over the last few weeks has taken the market back into overbought territory and was a point made last week:

“The market can most assuredly get even more overbought from current levels, but does suggest that upside is becoming more limited from current levels. However, with the weekly ‘buy signal’ triggered this past week, we must give the bulls some room to run.”

Currently, the “bulls” remain clearly in charge of the market…for now. While it seems as if much of the “tariff talk” has been priced into stocks, what likely hasn’t as of yet is rising evidence of weakening economic data (ISM, employment, etc.), weakening consumer demand, and the impact of higher rates.

While on an intermediate-term basis these macro issues will matter, it is primarily just sentiment that matters in the short-term. From that perspective, the market retested the previous breakout above the March highs last week (the Maginot line) which keeps Pathway #1 intact. It also suggests that next week will likely see a test of the January highs.

With moving averages rising, this shifts Pathway #2a and #2b further out into the August and September time frames. The potential for a correction back to support before a second attempt at all-time highs would align with normal seasonal weakness heading into the Fall. 

Currently, there is a very low risk of a deeper correction (Pathway #3). However, it is a possibility that should not be ignored at this juncture. With the administration gearing up for further tariffs against China, and China retaliating in kind, at a time when the Fed is already more aggressively tightening monetary policy, it would be remiss to ignore the risk of “something going wrong.” 

It would also be remiss to not remind you that despite the “bullish short-term view,” the long-term outlook remains decidedly bearish. With valuations elevated, price extended, and deviations near historic records, the potential for a more severe correction in prices is an absolute certainty.

The issue is that these cycles can remain both fundamentally and technically overvalued for longer than logic would dictate particularly when there are artificial influences at play. However, the message is clear for those that choose to listen. This is why it is crucially important to have a discipline and strategy in place which will manage the exposure to risk when things change in the market.


Weekly Buy Signal Is In, But Don’t Jump

In the 401k Plan Manager at the bottom of this newsletter each week, I publish the model that drives our portfolio allocations over time.

There are two important concepts to understand about this model.

  • Risk knows no age: Risk doesn’t care how old you are. It is often said that if you are 20, you should take on a lot of portfolio risk. However, if that risk is taken at the top of a market cycle, the damage to the long-term financial goals can be disastrous. We believe that our allocation to risk has nothing to do with our age, and everything to do with the potential for the loss of capital. Therefore, our allocation model is broken into two parts.
    • Allocation model is based upon current valuation levels.
      • If valuations were 10-12x earnings the target allocation levels would be primarily weighted towards equity (i.e. 80% Stocks / 20% Bonds)
      • As valuations rise behind historical extremes, target equity levels are reduced. (i.e. 60/40, 50/50, etc.)
    • The EQUITY portion of the allocation is also adjusted based on current market risk. Earlier this year, the equity risk portion of the allocation model was reduced from 100% to 75% due to a triggering of a confirmed “sell” signal. There are 4-primary indicators to the model:
      • 1st signal – short-term warning signal. Only an alert to pay attention to portfolio risk. 
      • 2nd signal – reduce equity by 25%.
      • 3rd signal – (Moving average cross-over) reduce equity by another 25%.
      • 4th signal – (Trend change) – reduce equity by another 25% and short the market.

We will be posting a live version of our indicators at RIAPro.net (currently in beta) as shown below.

The 4-signals above also run in reverse. So, when a signal reverses itself, equity risk is increased in the model as is the case this week.

With that signal in place, we must now increase our portfolio allocation model to 100% of target.

However, it is important to note these signals are based on “weekly” data and are intermediate-term in nature. Therefore, by the time these longer-term indicators are triggered, the very short-term conditions of the market are generally either very overbought, or oversold.

So, Do I Buy Or Not?

At this juncture, most individuals tend to let their emotions get the better of them and they make critical errors with their portfolios. Emotional buying and selling almost always leads you into doing exactly the opposite of what you should do.

Currently, the market has registered a “buy signal,” which means we need to be following our checklist to ensure we are making sound investment decisions:

  • What is the allocation model going to look like between asset classes?
  • How will those choices affect the volatility of my portfolio relative to the market?
  • What is the inherent risk of being wrong with my choices?
  • What is my exit point to sell as the market goes up?
  • Where is my exit point to sell if the market goes down?
  • What specific investments will I use to fill each piece of my allocation model?
  • How does each of those investments affect the portfolio as a whole as well as each other?
  • Where is my greatest and least amount of exposure in my portfolio?
  • Have I properly hedged my risk in my portfolio in case of a catastrophic event?

If you can’t answer the majority of these questions – you should not be putting your money in the market.

These are the questions that we ask ourselves every day with our portfolio allocation structures and you should be doing the same. This is basic portfolio management. Investing without understanding the risk and implications is like driving with your eyes closed. You may be fine for a while but you are going to get seriously hurt somewhere along the way.

There is NO RULE which states you have to jump into the market with both feet today. This is not a competition or game that you are trying to beat. Who cares if your neighbor made 1% more than you last year. Comparison is the one thing that will lead you to take far more risk in your portfolio than you realize. While you will love the portfolio as it rises with the market; you will rue the day when the market declines.

Being a “contrarian” investor, and going against the grain of the mainstream media, feels like an abomination of nature. However, being a successful investor requires a strict diet of discipline and patience combined with proper planning and execution. Emotions have no place within your investment program and need to be checked at the door.

Unfortunately, being emotionless about your money is a very difficult thing for most investors to accomplish. As humans, we tend to extrapolate the success or failure within our portfolios as success and failure of ourselves as individuals. This is patently wrong. As investors, we will lose more often than we would like – the difference is limiting the losses and maximizing the winnings. This explains why there are so few really successful investors in the world.

With this in mind, it doesn’t mean that you can’t do well as an investor. It just means that you must pay attention to the “risks” inherent in the market and act accordingly.

• Yes, the market is on a “buy” signal. 
• Yes, we need to add exposure as shown in the 401k plan manager below. 
• No, it doesn’t mean that you need to act immediately

However, it does mean that we need to pay close attention to developments over the next couple of weeks to be sure the “intersection” is clear and that we can proceed to the next traffic light safely. Hopefully, we can catch it “green” – if not, we will obey the signal, stop, and wait for our turn once again.

While the model is being increased back to 100% of target, we will selectively add equity exposure during short-term corrective actions in the market.

As I noted last week:

“With our portfolios nearly fully allocated, there are not a lot of actions we need to take currently as the markets continue to trend higher for now. We will continue to monitor our exposure and hedge risk accordingly, but with the weekly “buy signal” registered, we are keeping our hedges limited and are widening our stops just a bit.

As noted above, a short-term correction is needed before adding further equity exposure to portfolios. That correction likely started on Friday, and I will not be surprised to see it continue into next week. A retest of 2800 is likely at this point, which would keep Pathway #1 intact. However, a violation of that level will likely trigger a short-term sell signal, which could push the market back towards previous support at 2740. 

There is a lot of support forming at 2740, which should be supportive of the market over the next couple of months. A violation of that level suggests something has likely broken and more protective actions should be taken.”

Until that happens, we will give the markets the benefit of the doubt…for now. 


Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders


S&P 500 Tear Sheet


Performance Analysis


ETF Model Relative Performance Analysis


Sector & Market Analysis:

Last week, this section wasn’t available due to my travels. Therefore, changes in this week’s commentary is based on two week’s of data.

Discretionary and Technology – After recommending to take some profits out of the Technology sector, the $FB episode led to sell-off back to the 50-dma support. The same occurred with the discretionary sector as well. The trends for both remain very bullish right now, and the pullback provides an opportunity to rebalance sector holdings back to target weights.

Healthcare, Staples, and Utilities – after cooling briefly, money has once again flowed strongly into the sector. Healthcare, in particular, has gotten very extended and taking some profits and rebalancing back to portfolio weight makes sense. Despite the recent uptick in rates, Utilities have also continued to perform nicely after a long basing period earlier this year. Staples also continue to improve.

Financial, Energy, Industrial, and Material stocks showed a bit of improvement this past week. Industrials were the only sector in the group to climb back above its 50-dma but remains below several previous tops. While the trend for Energy remains in place, for now, we remain underweight holdings due to lack of relative performance. We currently have no weighting in Industrial or Materials as the “trade war” continues to negatively impact the companies in the sectors. The decline of the “yield curve” continues to weigh on major banks.

Small-Cap and Mid Cap continue to perform well as of late. We noted two weeks ago, that after small and mid-caps broke out of a multi-top trading range, we needed a pull-back to add further exposure. That pullback to the 50-dma happened and we added exposure to portfolios with stops at the 50-dma. On any further weakness in the markets that hold supports and we increase exposure further to get us to full target weights in our models.

Emerging and International Markets were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. Furthermore, we noted that global economic growth was slowing which provided substantial risk. That recommendation to focus on domestic holdings in allocations has paid off well in recent months. With emerging markets and international markets continuing to languish, there is no reason to ad exposure at this time. Remain domestically focused to reduce the drag on overall portfolio performance.

Dividends and Equal weight continue to hold their own and we continue to hold our allocations to these “core holdings.” 

Gold – we haven’t owned Gold since early 2013. However, we suggested three months ago to close out existing positions due to a violation of critical stop levels. We then recommended that again given the cross of the 50-dma back below the 200-dma.

That bounce came and went and gold broke to new lows. With gold very oversold on a short-term basis, if you are still long the metal, your stop has been lowered from $117 two weeks ago, to $114 this week. A rally sale point has also declined from the previous level of $121 to $117.50.

Bonds – This past week, bonds sold off on concerns of a major issuance of new bonds by the Treasury to fill the Government’s funding gap. With the 50-dma about to cross back above the 200-dma, the technical backdrop continues to build for adding bonds to portfolios. However, be patient and let’s see what happens next week. As noted previously, we remain out of trading positions currently but remain long “core” bond holdings mostly in floating rate and shorter duration exposure.

REIT’s keep bouncing off the 50-dma like clockwork. Despite rising rates, the sector has continued to catch a share of money flows and the entire backdrop is bullish for REIT’s. However, with the sector very overbought, take profits and rebalance back to weight and look for pullbacks to support to add exposure.

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

Portfolio/Client Update:

As I noted last week, the market’s improvement allowed us the ability to further increase equity exposure in portfolios in anticipation of registering a confirmed buy signal. With the retest of the “Maginot Line” this past week, we will look to further increase equity exposure on opportunity. However, given the August and September are historically weak months for the market, we will remain a bit more cautious on the how and when we increase holdings in our models.

The cluster of support at the 50- and 100-dma remains in place which limits much of the downside risk currently. However, we are quite aware of the risk stemming from “tariff talk” and further tightening of Fed policy. As we noted several weeks ago:

“While we are not raging long-term bulls, we do think that with earnings season in process the bias will be to the upside. There is a high probability of a substantive rally over the next couple of weeks.”

While that has indeed been the case, we continue to follow our “process” internally with an inherent focus on the risk to client capital.

  • New clients: We added 50% of target equity allocations for new clients. We will look to add further exposure opportunistically. 
  • Equity Model: We previously added 50% of target allocations. We “dollar cost averaged” into those holdings opportunistically. We recently added new positions to the model and will continue to look for opportunity accordingly.  
  • Equity/ETF blended models were brought closer to target allocations as we added to “core holdings.”
  • Option-Wrapped Equity Model were brought closer to target allocations and collars will be implemented.

Again, we are moving cautiously, and opportunistically, as we continue to work toward minimizing risk as much as possible. While market action has improved on a short-term basis, we remain very aware of the long-term risks associated with rising rates, excessive valuations and extended cycles.

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these action either by reducing, selling, or hedging, if the market environment changes for the worse.


THE REAL 401k PLAN MANAGER

The Real 401k Plan Manager – A Conservative Strategy For Long-Term Investors


There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.

401k-PlanManager-AllocationShift

Buy Signal Is In…

The market did trigger a weekly confirmed “buy” two week’s ago as we previously discussed. However, as noted in the main part of missive above, by the time these signals occur the market has generally gotten either overbought or oversold in the short-term.

There is “no requirement” to make immediate adjustments to your 401k plan. As you will note in the chart above, there have previously been “buy signals” which were reversed a few months later. This could well be one of those times given some the condition of the macro environment. However, for now, while we do recommend some caution, particularly if you are closer to retirement, follow the rules below:

  • If you are overweight equities – reduce international and emerging market exposure.
  • If you are underweight equities – begin increasing exposure towards equity in small steps. (1/3 of what is required to reach target allocations.)
  • If you are at target equity allocations currently, do nothing for now.

While we officially upgraded our allocation model back to 100% exposure, there is no rush to immediately begin adding additional equity risk. Do so opportunistically.

If you need help after reading the alert; don’t hesitate to contact me.


Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time.(If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don’t see your exact fund listed, look for a fund that is similar in nature.

401k-Selection-List

The Cartography Corner – August 2018

RIA Pro is pleased to introduce J. Brett Freeze, CFA and his firm Global Technical Analysis (GTA).

GTA will be providing RIA Pro subscribers his unique brand of technical analysis on a monthly basis. Brett’s analysis offers readers a truly unique brand of technical insight and risk framework.  We personally rely on Brett’s research to help better gauge market trends, their durability, and support and resistance price levels.

Going forward, we will present his analysis on a wide range of asset classes, indices, and securities. At times the analysis may agree with RIA Pro technical opinions, and other times it will run contrary to our thoughts. Our goal is not to push a single view or opinion, but provide research to help you better understand the markets. Please contact us with any questions or comments.  If you are interested in learning more about GTA’s services, please connect with them through the links provided in the article.

The link below penned by GTA provides a user’s guide and a sample of his analysis.

GTA Users Guide


The Cartography Corner

By J. Brett Freeze

The monthly analysis always starts with a review of the prior month’s analysis. After the review, a new asset(s) is analyzed and trading strategies discussed. Please enjoy the August edition of The Cartography Corner.

A Review Of July

WTI Crude Oil Futures

We will begin with a review of WTI Crude Oil Futures (CLQ8/CLU8) during July 2018. In our July 2018 edition of The Cartography Corner we wrote the following, with emphasis given to green-shaded excerpts:


In isolation, monthly support and resistance levels for July are:

  • M4             83.12
  • M3             81.26
  • M1             76.02
  • PMH          74.46                  
  • Close         74.15             
  • MTrend     68.63
  • PML           63.40             
  • M2             61.00            
  • M5             53.90

Active traders can use 74.46 as the pivot, whereby they maintain a long position above that level and a flat or short position below it.

As our subscribers know, our modus operandi is to position according to the Monthly Trend.  Our model has been long for the previous ten months.  However, as Ed Seykota (of system-trading fortune and fame) noted in his “the trading rules I live by”, rule number 5 is to “know when to break the rules”.  We sold our long position on Friday.  Our reasoning is as follows, the market achieved our weekly upside exhaustion level, to-the-penny, on Friday.  We are anticipating a two-week low in the next four to six weeks.


Figure 1 below displays the daily price action for July 2018 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  July opened by spending the first six trading sessions consolidating, with intra-day highs on three of those days breaking above June’s high at PMH: 74.46.  However, the market never settled above that level.

The following six sessions were spent with the price descending towards, and breaking, the Monthly Trend level for July at MTrend: 68.63.  As highlighted above, our focus was on anticipating a two-week low.  On Monday, July 16th, the two-week low was achieved.  The market price bottomed two sessions later at 66.44.

Over the next nine sessions, the price ascended back to (and slightly through) the Monthly Trend, MTrend: 68.63, now acting as resistance.  The market price settled the month of July at 68.76, essentially on Monthly Trend.

Figure 1:

E-Mini S&P 500 Futures

We continue with a review of E-Mini S&P 500 Futures (ESU8) during July 2018. In our July 2018 edition of The Cartography Corner, we wrote the following, with emphasis given to green- shaded excerpts:

In isolation, monthly support and resistance levels for July are:

  • M4             3000.75
  • M1             2850.25
  • PMH          2796.00
  • M2             2795.25
  • M3             2737.50        
  • Close         2721.50
  • PML          2693.25          
  • MTrend    2685.19          
  • M5            2644.75

Active traders can use 2737.50 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2685.19 as the downside pivot, whereby they maintain a flat or short position below it.

Figure 2 below displays the daily price action for July 2018 in a candlestick chart, with support and resistance levels isolated by our methodology represented as dashed lines.  July opened by promptly reversing the weakness realized in the latter-half of trading sessions in June.  On the third trading session of July, the market price settled above the pivot we isolated at M3: 2737.50.

The following five sessions were spent with the price ascending to (and through) our clustered-resistance levels isolated at M2: 2795.25 and PMH: 2796.00.  Over the next six sessions, the market price consolidated, testing those clustered-resistance levels, now acting as support.

Over the next three sessions, the price ascended to our isolated resistance level at M1: 2850.25, with the high price for the month achieved on July 25th at 2849.50.

With only four trading sessions remaining in the month, active traders had a decision to make: “Do I realize the 4% profit from adhering to the analysis or do I hold out for the upside exhaustion level?”  July’s upside exhaustion level was 150 points higher.  With the 20-day Average-True-Range of 26 points, even if each range of the remaining sessions were entirely to the upside, the market price was not likely to reach July’s upside exhaustion level.  The market price spent the final four trading sessions descending back to our clustered-pivot levels at PMH: 2796.00 and M2: 2795.25.

Figure 2:


August Analysis

We begin by providing a monthly time-period analysis of E-Mini S&P 500 Futures (ESU8).  The same analysis can be completed for any time-period or in aggregate.

Trends:

  • Current Settle         2817.00       
  • Daily Trend             2815.69
  • Weekly Trend         2804.50       
  • Monthly Trend        2734.92       
  • Quarterly Trend      2667.92

As can be seen in the quarterly chart above, E-Mini S&P 500 Futures have been trading higher in price since the fourth quarter of 2015 and have been “Trend Up” for eleven straight quartersStepping down one level in time-period, the monthly chart shows that E-Mini S&P 500 Futures have been “Trend Up” for three months and above Monthly Trend for ten of the past twelve months.  The futures contract settled the month of July above Monthly Trend, yet still within February’s range.  Stepping down to the weekly time-period, the chart shows that E-Mini S&P Futures have been “Trend Up” for four weeks.

Support/Resistance:

In isolation, monthly support and resistance levels for August are:

  • M4             3005.75
  • M3             2912.50
  • M1             2903.00
  • PMH          2849.50
  • Close          2817.00        
  • MTrend     2734.92
  • M2             2703.75        
  • PML           2698.50         
  • M5             2601.00

Active traders can use 2849.50 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 2734.92 as the downside pivot, whereby they maintain a flat or short position below it.

Amazon.com, Inc.

For the month of August, we shift our focus from the energy market to the equity market and in particular to Amazon.  In this analysis we provide a monthly time-period analysis of Amazon.com, Inc. (AMZN).  The same analysis can be completed for any time-period or in aggregate.

Along with a few other technology & discretionary companies, Amazon has significant influence over a variety of exchange-traded-funds and equity indices.  Michael Lebowitz’s article, Are the Markets Generals Leading us to War, highlights this influence.  As a result, we believe a correct analysis of Amazon is imperative for the broader equity market.

Our analysis suggests to us that Amazon may have peaked for the year.  On December 31, 2017, we ran our annual analysis for 2018.  The annual upside exhaustion level for Amazon is A4: 1952.82.  The highest price year-to-date is 1880.05, or within 4% of the annual upside exhaustion.  For 3Q2018, we isolated clustered-quarterly-resistance at Q1: 1908.66 and Q3: 1952.26.  The highest price thus far in the third quarter came within 1.5% of this resistance zone.

Amazon also displays parabolic properties in its price history.  In Figure 3 below, the orange line is the “model” price of Amazon using the log-periodic power law.  The work we have completed on parabolic markets, and work disseminated to us by other respected market participants, suggests that parabolic markets correct the upward-parabolic price trajectory in roughly one-third of the time it took to reach the high price. As the old market saying goes, stocks climb the stairs up and ride the elevator down.

Figure 3:

Other market participants, some smarter than us, have opposite outlooks for Amazon.  However, history proves there is symmetry in financial markets and the best we can do is put the odds in our favor.  We believe our analysis accomplishes that.

Trends:

  •  Weekly Trend        1809.09        
  •  Daily Trend            1799.69
  •  Close                        1777.44      
  •  Monthly Trend       1693.80        
  •  Quarterly Trend     1376.05

As can be seen in the quarterly chart above, Amazon has been trading higher in price since the first quarter of 2015 and has been “Trend Up” for fourteen quartersStepping down one level in time-period, the monthly chart shows that Amazon has been “Trend Up” for ten consecutive months.  Stepping down to the weekly time-period, the chart shows that Amazon has been “Trend Up” for four weeks.  Unequivocally, technical analysis of Amazon’s market price confirms a strong uptrend.

Support/Resistance:

In isolation, monthly support and resistance levels for August are:

  • M4             2125.01
  • M1             1997.00
  • PMH          1880.05
  • M3             1855.08
  • Close         1777.44         
  • M2             1721.03
  • MTrend     1693.80         
  • PML           1678.06         
  • M5             1593.02

Active traders can use 1855.08 as the upside pivot, whereby they maintain a long position above that level.  Active traders can use 1721.03 as the downside pivot, whereby they maintain a flat or short position below it.

Summary

The power of technical analysis is in its ability to reduce multi-dimensional markets into a filtered two-dimensional space of price and time.  Our methodology applies a consistent framework that identifies key measures of trend, distinct levels of support and resistance, and identification of potential trading ranges.  Our methodology can be applied to any security or index, across markets, for which we can attain a reliable price history.  We look forward to bringing you our unique brand of technical analysis and insight to many different markets.  If you are a professional market participant, and are open to discovering more, please connect with us.  We are not asking for a subscription, we are asking you to listen.

Are The Market Generals Leading Us To War?

Market Wizards, a best-selling investment book written by Jack Schwager, is a must-read for investors looking to improve their performance. Each chapter of the book provides a biography and an interview of a highly successful trader/investor. Originally published in 1989, the book is full of valuable lessons from some of the best in the business, including Paul Tudor Jones, Jim Rogers, Marty Schwartz, and Ed Seykota.

Of timely interest is a quote from William O’Neil:

Another way to determine the direction of the general market is to focus on how the leading stocks are performing. If the stocks that have been leading the bull market start to break down, that is a major sign the market has topped.”

The “leading” stocks that O’Neil mentions are commonly referred to as the “Generals.”

On the heels of recent weakness in some of today’s Generals, we examine whether these stocks are sending us a signal to seek shelter or if their lower prices are temporary and a rallying call for the troops.

FAANG Stocks

The Generals leading the market higher over the last couple of years go by the acronym of FAANG. FAANG is composed of Facebook (FB), Amazon (AMZN), Apple (APPL), Netflix (NFLX), and Google (GOOGL). To understand the outsized effect they have on the S&P 500 consider the following:

  • Per Bloomberg data, the five FAANG stocks currently account for 13.5% of the weighting of the S&P 500.
  • The combined market cap of the FAANG’s is equal to that of the smallest 252 S&P 500 constituents.
  • On average, each FAANG stock has over 13 times the effect on the S&P 500 index than the average stock in the index.

The popularity of the FAANG stocks has risen substantially over the last few years as witnessed by a futures contract and multiple ETFs that track the performance of these five stocks’. Further, the Bank of Montreal now offers 3x leveraged ETF’s (FNGU and FNGD) that triple the performance of the five stocks.

The following paragraphs provide a summary of the most recent earnings announcements and the stock price activity for each FAANG stock. This analysis will help us appreciate what is driving these stock prices over the last two weeks and by default driving the markets.

Facebook – Facebook fell over 20% on July 26, 2018, erasing almost $120 billion in market capitalization. The decline was the largest one-day loss of market value in one stock in the history of the U.S. equity markets. Interestingly, the two runners-up are Intel (INTC) and Microsoft (MSFT), both occurring in the year 2000. At the time, they were five-star Generals that ultimately led their troops over a cliff.

Largely responsible for the drop was Facebook’s second-quarter earnings announcement which reported weaker than expected revenue and daily active users as well as corporate guidance lowering those metrics in the third and fourth quarters. The stock was also downgraded by a few Wall Street analysts.

While the decline was severe, FB is still flat this year and up over 50% since January 2017.

Netflix – Netflix has fallen 7% since a lackluster earnings report on July 23, 2018. While earnings beat estimates, they only added 670,000 U.S. subscribers in the second quarter, missing projections of 1,200,000. This was the first time in five years they fell short of their user projections. Given that Netflix is trading at valuations that portend significant user growth, any signs that they are approaching product saturation should be especially concerning.

Despite the loss, Netflix is still up nearly 200% since January 2017 and over 85% this year.

Amazon – Amazon released its quarterly earnings on July 26, 2018. The stock closed the following day up about half a percent but since then has given back over 2%. While the market initially seemed to focus on a massive beat in earnings versus projections, investors seemed to gravitate to the company’s missed revenue expectations and guidance lower for the next quarter. Given that a large chunk of the bottom line EPS rise was attributable to a sub-3% tax rate, it is likely concerns over forward guidance are justified.

For the year to date, Amazon is up almost 60%, trading near its all-time high and showing few signs of weakness.

Google – Like Amazon, Google smashed earnings expectations, and the stock rose nearly 5% on the day following the announcement. Unlike Amazon, their sales also beat expectations, and they did not lower forward earnings guidance. Google is up 20% year to date and is perched near its all-time highs. Google appears to be the strongest of the Generals.

Apple – Apple’s second quarter earnings per share and sales surpassed Wall Street’s expectations and they raised revenue guidance for earnings for next quarter. The only wrinkle was iPhone sales, which account for more than half of their revenue, came up slightly short of expectations. As of writing this the stock is up 2.50% and within a few cents of its all-time high.

The following table summarizes the FAANG’s stock performance since July 1, 2018.

Summary

Some of the Generals are flashing signs of weakness. That said, two weeks and one-quarter of earnings do not make a trend. Despite large price losses for two of the Generals, the S&P 500 took these drops and earnings announcements in stride. For the week of July 23-27, in which all but one of the FAANGs released earnings, the S&P 500 was up 0.61%.

Currently, we are focused on the price action of FB and NFLX. Given the “buy the dip” reflexivity that has pervaded the market and these stocks in particular, their price action in the weeks ahead will be telling. If they remain at current levels or drift lower, we would regard this as a signal that all is not well. On the other hand, if the FAANG stocks that are struggling start to recoup losses and resume their role leading the market higher again, we will have to wait on the wisdom of William O’Neill.

QE4 – When, Not If – RIA Pro

Many market prognosticators attribute the rise in interest rates to a consensus outlook for expanded economic growth and increasing inflationary pressures. In our article, Deficits Do Matter, we took this view to task by providing market-based evidence to show that those factors only account for about a third of the increase in interest rates.  Our perspective is that the rapidly growing forecasted supply of Treasury debt coupled with limited demand from the two largest holders of Treasury securities are currently the main drivers of higher yields.

In this article we take that analysis a step further and ask a question that few seem to be considering; what if there is a recession in the coming year or two? In answering that question, from the perspective of the federal deficit and related debt issuance, the current fiscal situation is more precarious than perceived and points to a high probability that the Fed will need to re-initiate quantitative easing (QE) but for altogether different reasons than it has done so in the past.

Prior Recessions

John Maynard Keynes, a cult-like figure in the economics community, asserted that to smooth the fluctuations in the business cycle governments should run deficits when economic activity slows and surpluses when economic expansions resume. This simple concept is nothing more than the age-old “save for a rainy day” adage. Despite strict adherence to many of Keynes theories, most politicians only seem to hear the part about running deficits. Without regard for whether or not you agree with Keynes thinking, there is absolutely no logic or wisdom in the idea that debts can consistently grow faster than one’s ability to pay for them. 

The U.S. government is expected to borrow over $1 trillion per year in each of the next five years. This Congressional Budget Office (CBO) estimate is based on a host of assumptions all of which depend on a consistent nominal economic (GDP) growth rate varying closely around 3.90%. The obvious problem with this model is that even if such a growth rate is achieved quarter in and quarter out, economic growth would only be approximately $800 billion per year. In other words, the burden of debt will rise faster than the ability to fund it.  Furthermore, it seems to us more than a little short-sighted that no one is asking what if GDP growth is not as stable and optimistic as forecast. Importantly, what if the economy enters a recession?

According to the National Bureau of Economic Research (NBER), there have been 34 recessions since 1857. The longest period between any of these recessions was 120 months. The current expansion just entered its 108th month. The average period of economic expansion is 56 months or about half the length of the current expansion. From a statistical point of view, one is tempting history if they are not expecting a recession within the next 24 months.

The graph below shows the ridiculous CBO forecast of GDP growth for the next ten years. Given the degree of difficulty in projecting economic output (high) and their poor track record of forecasting it, it does not seem unfair to impose critical judgments about the feasibility of such a forecast.

The “R” Word

Investors in all asset classes should be carefully considering what will happen to the nation’s debt outstanding if the rosy economic growth forecast, which in turn is built into economic, market and deficit forecasts, turns out to be wrong.

The graph below offers some guidance in assessing how a recession might affect the amount of Treasury debt that would likely need to be issued in the event of an economic downturn.

The red dots on the graph show the peak growth rate of debt outstanding associated with each recession (gray bars) since 1967. As shown, the red dots range from an increase of debt from 9% to 22%, with an average over 15%.

To put prior increases into current context, a conservative 10% increase in debt outstanding would roughly equate to an additional $2 trillion of debt issuance per year, which is about double the current annual issuance. A 20% increase would result in about $4 trillion of new debt.  Keep in mind that these massive estimates of new debt would occur alongside declining GDP output.

QE to the Rescue

The bond market is currently reflecting some anxiety at the prospect of digesting over $1 trillion a year of debt. This concern also appears to have spread to the stock market to some degree.

Now consider how multiples of that number might affect bond yields, stock prices, and credit spreads. If $2, 3, or 4 trillion of additional debt needs to find a home, it is quite likely that interest rates would rise sharply to attract new investors. Plus, there is one other small problem. As interest rates rise, the interest expense on the debt increases and drives funding needs even higher.  This mushrooming debt issuance dynamic would crowd out investment dollars from other markets.

The flow of funds from one market to another, as stated in the preceding paragraph, is how such a problem would resolve itself if free market forces were left to their own devices. Unfortunately, the government has a history of manipulating interest rates and allowing debt to build at faster rates than economic growth portends. While this buys temporary tranquility, the result is accumulating risk and consequences.

During the financial crisis, QE helped the Fed accomplish their goals of stabilizing the equity markets and the banking sector. After the crisis, they initiated two more rounds of QE despite calmer markets and economic expansion. Through these actions, they removed over $3.5 trillion of government debt and mortgage-backed securities from public markets. By erasing this supply of securities/debt, investors were forced into other investment options. This tool not only made the government appear fiscally sound in what amounted to monetary policy creep into fiscal policy, but benefited all asset classes.

No Spare Tire

Despite recent rate hikes, there is very little room for a traditional monetary policy response in the event of a downturn. Add to that the recent fiscal policy actions that will ratchet deficits higher and the United States finds itself with limited fiscal space to combat a recession. This confluence of events argues that the U.S. economy is now driving without a spare tire. It also suggests that if the economy stalls, the likelihood of central banks reviving QE among other unconventional policies is high.

Summary

At this point, we are clearly observing a transition of U.S. policy away from reliance on monetary measures toward that of fiscal policy. This is not, however, an even-handed exchange. There is overlap as the Fed gradually reduces liquidity and Congress and the executive branch pass tax cuts and a newly expanded budget. It will be messy and fraught with risk as markets have begun to imply.

The growth of debt is not unique to the Trump administration as government debt doubled under each of the last two presidents. As this debt burden extends beyond our ability to repay it, the consequences become more apparent, and the risks for both stocks and bonds rise. Despite the lack of concern from many in the financial media and Wall Street, the diagnosis is only getting worse and the treatment more extraordinary and experimental.

The debasement of the currency which results from acute fiscal and monetary imprudence has meaningful ramifications for all investments. Investors should consider investment options that are likely to retain purchasing power when said purchasing power is being destroyed by the central banks and other government authorities. To mention a few which have a precedence of performing well, commodities and natural resource stocks, Treasury inflation-protected securities (TIPS) and precious metals. There is also the other side of this equation which stresses what to underweight, short or avoid altogether. We would argue that anything currently leading the market higher (financials and technology stocks), and therefore seriously overvalued, is a good thing to reduce or sidestep altogether.

In closing and to further emphasize the points above, former New York Fed President Bill Dudley often speaks of keeping extraordinary policies in the Fed “toolkit.” Specifically, he stated that QE would be “useful to have in the toolkit for those times when the short-term interest rate tool may not be available,” adding that the Fed is “quite likely” to require large-scale asset purchases again because real rates will remain low due to slow productivity and labor-force growth. He also shared that “if LSAPs (large-scale asset purchases) are indeed not effective, then the Fed may need to take other measures.” What these “other measures” may be is anyone’s guess but arriving at plausible conclusions would require even more radical creative thought.

The only question in our mind is when, not if, QE4 will be initiated.

Everyone Hears The Fed…But Few Listen

Announcing RIA Pro

After several long months of research, development and input from our loyal readers and subscribers, we are pleased to announce RIA Pro, a new subscription service by Real Investment Advice and 720Global. 

As gratitude for your patience we are providing all Real Investment Advice readers access to this RIA Pro article which discusses the growing misconception that Chairman Powell’s Fed is as investor friendly as Yellen and Bernanke were.

Currently the site is up for a limited number of BETA test users. If all goes well, as we suspect, it will be released to everyone shortly.

RIA Pro will have exclusive articles covering important aspects of the market such as this one, as well our model portfolios, daily commentary, videos, market data, charts, analysis, and A LOT more.

Our objective is to help serious investors avoid losing half their wealth in the next downturn and position for the next big investment opportunity.


Everyone Hears the Fed but Few Listen

See no evil, hear no evil, speak no evil

Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve’s (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.

Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market’s dovish expectations will be proven right, or if their unwillingness to heed the Fed’s warnings will cost them dearly.

Trump vs. Powell

As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell.  His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President’s request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed’s independence is likely to be tested.

Divergent Views

Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump’s pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market’s expectations and the Fed’s plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they’ve said they would.

The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.

The red dashed line shows investors had slightly higher expectations for the Fed Funds rate than the rate that came to fruition from 2014 through 2016.  Conversely, the green dashed line shows that investors have been too low in their estimates of future Fed Funds rates by approximately 0.25% on average since January 2017.

The next graph looks forward and compares Fed Funds futures to the Fed Funds rate expectations for each member of the FOMC. Each dot represents a Fed members’ expectation for the average Fed Funds rate for that particular year. The red triangle denotes the FOMC average for the year. To contrast, the orange boxes represent the average of Fed Funds futures, or the markets expectation for the average fed funds rate, for each year. The differences between market based expectations and FOMC expectations are 0.20%, 0.46%, and 0.63% for 2018, 2019 and 2020 respectively.

A New Curve – A New Narrative

In our recently issued article, The Mendoza Line, we explained that the Fed introduced the validity of using a “New” yield curve versus the customary 2s/10s yield curve at the most recent FOMC meeting. The article points out that an inversion of the customary 2s/10s yield curve has preceded economic recessions with resounding accuracy.

Currently, the 2s/10s yield curve is flattening rapidly and causing the media and investors to take note. The “New” curve has been meandering over the last few years and does not suggest the same caution.

The article’s takeaways include the following:

  • The Fed has much more control over the shape of the new curve than the traditional curve.
  • “The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign.”
  • “If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?”

We believe the Fed is using the “New” curve to try to calm investors’ recession concerns and encourage them to raise their expectations for future Fed Funds levels.

The graph below from the article compares the downward slope of the 2s/10s curve to the slightly upward slope of the Fed’s New Curve.

Why the Fed is more Hawkish than investors

We believe there is one crucial reason why the Fed is resolute to raise rates more than the market believes. During the last seven recessions, the Fed Funds rate was lowered on average by 7.18%, as shown in the table below. While the last recession of 2008 only saw Fed Funds decline by 5.26%, the Fed introduced a $3.6 trillion bond-buying program known as QE.

If a recession were to start this year or next, with Fed Funds trading between 2% and 3%, the Fed would be significantly limited in their ability to lower interest rates and boost economic activity. The Fed is quite likely providing themselves more room to lower rates in the future, and thus are intent on getting the fed funds rate higher than what the market believes.

The following are other concerns that may also be driving the Fed aggressiveness:

  • Surging fiscal deficits – “Fed’s Dudley Worries Tax Cuts Risk Overheating U.S. Economy”- Bloomberg
  • Tariffs –”The Latest Proposed Tariffs Would Significantly Boost Core Inflation” – Ian Sheppard
  • Employment – “Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective,” – Jerome Powell
  • Deficit Funding – Foreign holdings of U.S. Treasuries have declined over the last six Higher interest rates may be required to incentivize domestic capital to offset foreign demand.

Investment Implications

In the second part of this series we will discuss how the resolution of the market’s dovish opinion versus the Fed’s hawkish stance might affect various asset classes.

In the meantime, we share data on how equities and bonds performed during various periods following the last two yield curve inversions.

Summary

As mentioned at the opening, when the market and the Fed have a sharp difference of opinion as is currently the case, the possibility of significant market volatility increases. The Fed is leaving us few doubts that they would like to keep raising rates at a measured pace. Chairman Powell has also voiced more concern than his two predecessors with the prices of financial assets. In fact he has shown unease that some assets are in valuation bubbles.

Chairman Powell brings one distinct advantage to his new role over his three predecessors – he has an odd tendency to speak plain English. That does not eliminate the uncertainties of the economy and a possible change in plans for monetary policy, but it certainly reduces them. Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.

As stewards of capital who understand the importance of the Fed’s interactions, our obligation is to appreciate that this Chairman says what he means and, in all likelihood, means what he says. Rate hikes, although gradual in pace, are likely to keep coming.

Everyone Hears The Fed…But Few Listen – RIA Pro

 

See no evil, hear no evil, speak no evil

Currently, investors appear to be covering their eyes, ears, and mouths and ignoring the Federal Reserve’s (Fed) determination to increase interest rates. This divergence of outlooks between investors and the Fed is a stark departure from the financial crisis and the years following when the Fed and the market were on the same page regarding monetary policy.

Often such a discrepancy between the Fed and investors results in sharp changes in asset prices and heightened volatility. In this article, we analyze the current situation to predict whether the market’s dovish expectations will be proven right, or if their unwillingness to heed the Fed’s warnings will cost them dearly.

Trump vs. Powell

As we were putting the final touches on this article, President Trump sent a clear shot across the bow of the Fed and in particular Chairman Powell.  His message to Powell was simple: stop raising rates. As you read this article consider the position that Powell and the Fed are now in. If Powell walks back his hawkish stance, regardless of why, it will be regarded as acquiescing to the President’s request. On the other hand, if he ignores the President and continues to raise rates, we might see his tenure at the Fed limited. Either way the Fed’s independence is likely to be tested.

Divergent Views

Starting in 2017, the Fed took a decidedly more hawkish stance than the market was expecting. Whether this was a result of President Trump’s pro-growth campaign promises or greater confidence in economic growth and renewed inflationary pressures, we are not certain. We do know that the difference between the market’s expectations and the Fed’s plans has persisted to this day, despite the Fed raising interest rates five times over the past couple years and reducing their balance in increasingly larger amounts as they’ve said they would.

The following graphs demonstrate the prior and future divergent views. The first graph compares expectations (using fed funds futures) for the fed funds rate nine months forward versus the prevailing fed funds rate nine months later. The current reading of -0.40% denotes that Fed Funds futures were priced for a Fed Funds rate of 1.60% nine months ago while the fed funds rate is close to 2% currently.

The red dashed line shows investors had slightly higher expectations for the Fed Funds rate than the rate that came to fruition from 2014 through 2016.  Conversely, the green dashed line shows that investors have been too low in their estimates of future Fed Funds rates by approximately 0.25% on average since January 2017.

The next graph looks forward and compares Fed Funds futures to the Fed Funds rate expectations for each member of the FOMC. Each dot represents a Fed members’ expectation for the average Fed Funds rate for that particular year. The red triangle denotes the FOMC average for the year. To contrast, the orange boxes represent the average of Fed Funds futures, or the markets expectation for the average fed funds rate, for each year. The differences between market based expectations and FOMC expectations are 0.20%, 0.46%, and 0.63% for 2018, 2019 and 2020 respectively.

A New Curve – A New Narrative

In our recently issued article, The Mendoza Line, we explained that the Fed introduced the validity of using a “New” yield curve versus the customary 2s/10s yield curve at the most recent FOMC meeting. The article points out that an inversion of the customary 2s/10s yield curve has preceded economic recessions with resounding accuracy.

Currently, the 2s/10s yield curve is flattening rapidly and causing the media and investors to take note. The “New” curve has been meandering over the last few years and does not suggest the same caution.

The article’s takeaways include the following:

  • The Fed has much more control over the shape of the new curve than the traditional curve.
  • “The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign.”
  • “If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?”

We believe the Fed is using the “New” curve to try to calm investors’ recession concerns and encourage them to raise their expectations for future Fed Funds levels.

The graph below from the article compares the downward slope of the 2s/10s curve to the slightly upward slope of the Fed’s New Curve.

Why the Fed is more Hawkish than investors

We believe there is one crucial reason why the Fed is resolute to raise rates more than the market believes. During the last seven recessions, the Fed Funds rate was lowered on average by 7.18%, as shown in the table below. While the last recession of 2008 only saw Fed Funds decline by 5.26%, the Fed introduced a $3.6 trillion bond-buying program known as QE.

If a recession were to start this year or next, with Fed Funds trading between 2% and 3%, the Fed would be significantly limited in their ability to lower interest rates and boost economic activity. The Fed is quite likely providing themselves more room to lower rates in the future, and thus are intent on getting the fed funds rate higher than what the market believes.

The following are other concerns that may also be driving the Fed aggressiveness:

  • Surging fiscal deficits – “Fed’s Dudley Worries Tax Cuts Risk Overheating U.S. Economy”- Bloomberg
  • Tariffs –”The Latest Proposed Tariffs Would Significantly Boost Core Inflation” – Ian Sheppard
  • Employment – “Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective,” – Jerome Powell
  • Deficit Funding – Foreign holdings of U.S. Treasuries have declined over the last six Higher interest rates may be required to incentivize domestic capital to offset foreign demand.

Investment Implications

In the second part of this series we will discuss how the resolution of the market’s dovish opinion versus the Fed’s hawkish stance might affect various asset classes.

In the meantime, we share data on how equities and bonds performed during various periods following the last two yield curve inversions.

Summary

As mentioned at the opening, when the market and the Fed have a sharp difference of opinion as is currently the case, the possibility of significant market volatility increases. The Fed is leaving us few doubts that they would like to keep raising rates at a measured pace. Chairman Powell has also voiced more concern than his two predecessors with the prices of financial assets. In fact he has shown unease that some assets are in valuation bubbles.

Chairman Powell brings one distinct advantage to his new role over his three predecessors – he has an odd tendency to speak plain English. That does not eliminate the uncertainties of the economy and a possible change in plans for monetary policy, but it certainly reduces them. Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.

As stewards of capital who understand the importance of the Fed’s interactions, our obligation is to appreciate that this Chairman says what he means and, in all likelihood, means what he says. Rate hikes, although gradual in pace, are likely to keep coming.

The ABC’s of QE and QT – RIA Pro

Search the internet for “QE and money printing”, and you will see countless articles explaining why Quantitative Easing (QE) is or is not money printing.

Here are a few articles that we found:

  • “The Fed’s Magic Money-Printing Machine”
  • “Bernanke Admits to Congress: We are printing money, just not literally”
  • “America’s reckless money-printing could put the world back into crisis”
  • “Why Quantitative Easing isn’t printing money”

Is QE money printing or is it something else that appears to be money printing?

Some will say that the question is irrelevant, as QE ended a few years ago. We disagree, and it has nothing to do with proving our opinion on the matter right or wrong. It is extremely important to understand what QE is and is not as the reversal of QE, known as Quantitative Tightening (QT), has just begun.

By understanding the mechanics of QE, we can look forward to appreciate the effects that QT might have on the economy and the financial markets. Consider the words of Harley Bassman, a seasoned Wall Street veteran and derivatives expert: “However, I will fully support the notion that G-4 Quantitative Easing drove up asset prices; and that the removal of such money-printing will have a deleterious effect on financial assets.

What is QE?

QE is being employed around the world by central banks to support and liquefy financial markets, lower interest rates, improve banks’ capital positions and promote stronger economic growth. Each central bank has nuanced differences in their provision of QE, primarily in the type of securities they purchase, but they are very similar in what they accomplish. In this article, we focus on the Federal Reserve’s (Fed) version of QE.

To help you better understand QE, we present the sequence in which the Fed executed this policy.

1) The process started when the Fed solicited offers for specific U.S. Treasury and Mortgage-Backed Securities (MBS) from investors including banks, brokers, individuals, mutual funds, pension funds, and foreign investors. While the trades were all executed through primary dealers, the ultimate seller in many cases was not the dealer. To ascertain whether QE is money printing, consider the following questions: Did investors accept something other than cold-hard cash for their bonds? What was the source of that cash?

2) As QE progressed, the Fed removed bonds from the market and investors in those bonds were left with cash. Cash-rich investors bought new bonds, stocks, and other assets. Further, some of the proceeds from sales of securities to the Fed were likely deployed outside of the financial markets. Whether it was the original seller or the recipient of the money five transactions down the line, a portion of the Fed’s money ended up as deposits in banks.

3) The Fed wanted to ensure that the deposits created by QE were not multiplied via the creation of new loans as is almost always the case with new deposits. They worried that such an occurrence would have inflationary consequences. (For more information on how banks use deposits to create money we recommend watching this short video on the fractional reserve banking system) To incentivize banks to hold the new deposits as excess reserves, the Fed paid banks interest on excess reserves, formally known as IOER.

Banks are required to hold a portion of each deposit as reserves to ensure that there is sufficient liquidity should a large number of depositors wish to withdraw their money simultaneously. Any reserves above the Fed’s requirements are considered excess reserves. Prior to QE, banks maximized their deposit base and therefore loan potential by holding near zero excess reserves as shown in the chart below.

Data Courtesy St. Louis Federal Reserve (FRED)

Based on the sequence of events, many believe the Fed simply conducted an asset swap in which they swapped bonds for excess reserves. So, while the Fed certainly printed money to buy the bonds, one can conclude that if QE resulted in a 1 for 1 increase in excess reserves, an asset swap ultimately occurred.  The following graphs help us better define the outcomes of QE. The first graph charts the changes in the Fed’s balance sheet (i.e., QE) and the changes in excess reserves.

Data Courtesy St. Louis Federal Reserve (FRED)

Clearly, some of the Fed’s money used to buy bonds ended up in excess reserve accounts as the Fed wished. However, and this is extremely noteworthy, the chart below shows the aggregate amount of QE that did not end up as excess bank reserves.  This is the difference between the green line and the orange line in the chart above. This portion of QE ended up in the financial markets and ultimately was used to create new loans. By any definition, this is new money and helps answer our lead question. 

Data Courtesy St. Louis Federal Reserve (FRED)

Now, let’s reconsider the interest (IOER) the Fed paid banks to persuade them not to lend the money. From a bank’s perspective, the incentive to hold the money was purely financial. Given the weakened capital positions of banks in the post-crisis era, they could earn risk-free profits and bolster their capital as long as the IOER was greater than the rate they paid on deposits. The following graph shows the average of the Fed’s aggregated data on jumbo (>$100k) deposit rates and three-month CD rates as compared to the IOER rate.

Data Courtesy St. Louis Federal Reserve (FRED)

The deposit rate calculation used in the graph is likely very generous. Accordingly, banks’ profits as displayed and discussed below is likely much greater. The table below shows the average national jumbo deposit rates for a host of deposit products as published by the FDIC. As a point of reference the current IOER rate is 1.75.

Data Source FDIC

Over the course of the QE experiment, excess reserves generated significant profits for the banks. Please remember, these profits are risk free and essentially gifted to banks by the Fed. Further, these profits were reinvested in most cases on a leveraged basis into the financial markets. While we do not know how much leverage was employed, it is safe to assume it was at least 10x.In other words, every dollar earned by banks accepting low interest deposits and converting those to higher-interest paying and risk-free excess reserves   resulted in ten dollars’ worth of new investments. This further supported asset prices.

To summarize QE, the Fed purchased bonds which helped asset prices initially stabilize and over time drive them higher. Through higher asset prices, lower borrowing rates and IOER profits, the banks were recapitalized. The supply of bonds in the financial markets was reduced and interest rates were lower as a result. Economic activity benefited from lower interest rates and healthier banks.

One might be tempted at this point to use the infamous George Bush quote “mission accomplished.”

Not so Fast – QT

Regardless of whether you agree with us that QE was money creation or still think it was an asset swap, QE must appear to be a win-win. Unfortunately, this monetary panacea is being reversed in efforts to tighten monetary policy and stave off inflationary concerns.

The following bullet points highlight how quantitative tightening (QT) will likely affect the financial markets and economy:

  • Asset Prices– QE removed $3.5 trillion in bonds from the marketplace, which had a ripple effect on equities, bonds, real-estate and a host of unconventional assets such as art, cars and wine. Many of these assets rose significantly during the QE era despite economic fundamentals that were not supportive of such price increases. Equity valuations, by many measures, now stand above levels that preceded the Great Depression and are not far from those of 1999. It is pretty clear that QE and asset prices are joined at the hip. If that is the case, shouldn’t we prepare ourselves for lower asset prices as the Fed reverses the effects of QE?
  • Banks Capital Positions– According to most banking analysts, banks now have healthy levels of capital and are in a much better position to withstand a 2008 type of crisis. While we have little reason to doubt the analysts, we do wonder if the banks are prepared for an environment in which interest rates rise amid falling asset prices. Keep in mind, the collateral behind many loans are linked to financial asset prices.
  • Lower Interest Rates– Interest rates are lower than they otherwise would have been. Per the Fed’s guidance “Our model suggests that the cumulative effect of the Federal Reserve’s asset purchases results in a reduction in the 10-year Treasury yield term premium of about 100 basis points (1.00%).” (Source Fed Notes) As such, it is hard to come up with a reason why we should not expect higher rates. When one of the major holders of U.S. Treasuries and MBS initiates a well-publicized initiative of reducing their position substantially, higher yields on those securities should result.
  • Economic Growth– Given that $1.7 trillion was printed and not held as excess reserves and that money was then multiplied, the associated loan growth certainly fueled economic activity. The effect is impossible to quantify, but it is certainly positive. When the Fed reduces their balance sheet, any reduction that does not affect the level of excess reserves should have a negative economic effect as it is a withdrawal from loan provision or other acts that have positive effects on the economy. Recently, this has not been the case as excess reserves have declined at a much quicker pace than the Fed’s balance sheet.

Summary

The evidence is clear that QE was designed to recapitalize the U.S. financial system via higher asset prices. Not only did it serve this purpose but it provided banks with risk-free profits from IOER which was leveraged to increase profits and further build capital. The Fed denies this and claims its primary goal was to encourage economic growth for the benefit of all Americans. Had this truly been the case, they would not have introduced IOER and provided incentive for banks to not lend money

Regardless of your views, the Fed did accomplish something, but at what cost? In the wake of QE, lower interest rates have encouraged even more debt and asset prices that, in many cases, are well above reasonable valuations. Said differently, they re-inflated the bubble instead of allowing the free markets and a normal economic cycle to cleanse the excesses of prior years.

Given that economic growth is largely dependent on debt growth and the debt, in many instances, is backed by overvalued assets, what happens as the Fed reverses course and asset prices revert to their historical norms? We must further consider how the broad economy will withstand higher interest rates, especially if economic growth remains at current levels or declines.

The Fed is reversing course. Are you fully prepared for this?

 

 

 

 

 

The Fallacy of Macroeconomics – RIA Pro

“The hubris in economics came not from a moral failing among economists, but from a false conviction: the belief that theirs was a science. It neither is nor can be one, and has always operated more like a church. You just have to look at its history to realize that.” –Collaborative Fund

The Federal Reserve (Fed) has over 750 Ph.D. economists on staff, many of whom sport degrees from the finest universities in the world. Given such a population of experts, why does the Fed have such a poor track record forecasting economic activity? Consider the graphs below, which provide recent evidence of the Fed’s futile forecasting efforts, if you find the preceding question slightly condescending or offensive. Please note it is not just the Fed, but poor economic forecasting pervades most economists including those at the IMF and the private sector as also highlighted below.

To understand why the Fed, and most economists, fail to accurately forecast economic activity more often than not, one must only contemplate economics at its most basic level. The problems many economists have are found in the faulty theories, technical lexicon, and asinine assumptions embedded in their supposed logic. Simply, they have lost sight of what economics really is.

The most basic building blocks of economics are our individual supply and demand curves. Armed with an understanding of those basic building blocks, we highlight two errors most economists commit in trying to make economics a definitive science with known answers.

Economics 101

Consider the following perspectives of supply and demand:

  • Human beings have desires, and those desires drive decision-making. Given the desires and the means or ability to fulfill those desires, they will do so. This results in demand.
  • At the same time, to fulfill one’s desires, human beings will undertake activities that give them the means to fulfill their desires. This results in supply.

To elaborate, consider your personal economy. You have needs and desires to consume certain goods and services. Some of these are core to your survival, such as food, water, energy and shelter. Beyond necessities are desires which may include a smart phone, filet mignon, Netflix, or a yacht.  All of these items hold some unique value to you. To consume or obtain these goods and services, you need to have something of value to offer in exchange. To accrue value, we work and produce goods and services that others need and desire. The more successful and efficient one is at producing goods in demand, the more value one accumulates and therefore the more needs and desires one can fulfill. This most basic description of our personal supply and demand curves is the core of economics. It is the building block upon which billions of transactions occur every day.

Problem #1 – Singular Economy

One of the biggest complications with the study of macroeconomics is in its attempt to aggregate individual economies into a singular, larger and, hypothetical economy. In other words, economists assume we all have the same preferences, desires, motivations, and quirks. Further, these collectivized traits are modeled and used to forecast economic activity and prescribe monetary and fiscal policy. When one aggregates individual and household economies, a picture is created that may appear to be coherent. Many times, however, the 350 million unique pixels, constituting the U.S. population, paint a picture that is not accurately representative of the one economists believe to be the case.

Step back for a moment and admire the picture below of Marilyn Monroe.

 

Now move closer to the screen, zoom in, and you will realize the picture is composed of pictures of many other people, none of which are Marilyn Monroe.

Most economists do not bother to understand our unique and widely diverse opinions and preferences. Instead, they gravitate to the simplicity of assuming we all share the same “average” or “aggregate” needs, desires and means. As such they also assume we react alike to the same positive or negative economic stimulus. Those assumptions operate on the premise that human beings are rational. Were that truly the case, we venture to guess that Richard Thaler would not have recently won the Nobel Prize in economics based on his work in behavioral finance and human beings’ proclivity for irrationality.

To better understand the consequences of taking a singular, aggregate economy approach, consider how the Fed and most central banks administer monetary policy. When aggregate demand or consumption decline for a period of time, central bankers have a dependable history of lowering interest rates to incentivize consumers to borrow for houses, cars and other goods. Is such an approach logical? What if I am simply cutting back on spending because I recently splurged on a glamourous vacation? What if you stopped eating out twice a week because you are concerned about your diet? How about your neighbor who decides to be more frugal, reduce spending and increase her savings as she nears retirement? Will lower interest rates produce predictable behaviors and actions? Will lower interest benefit some while hurting others?

The fact of the matter is that broad prescriptive policies are aimed at the average. The average may represent a decent percentage of the population at times, and such policy may produce expected results.  Other times, the average may represent a much smaller percentage of the total and produce feeble results. Currently, the “average” find themselves heavily indebted and approaching retirement. Should policy be tailored to their situation? If so, how will such policy affect the individual economies of the millennials that are starting to save, buy houses and have children?

The Fed’s policy reaction to the Great Financial Crisis of 2008 was to reduce the Fed Funds rate to near zero and quadruple the size of the money supply via the purchase of U.S. Treasury debt and Mortgage Backed Securities (MBS). Those citizens and organizations that were able to take advantage of low interest rates and increase their financial leverage benefited handsomely. The other 80% or so of the nation, living pay check to pay check and dependent upon paltry savings accounts earning nothing have clearly seen little benefit. One must question whether the post crisis monetary policy considered the unique circumstances of the population at large or those of a select few. Using Keynesian methods and armed with invalid counter-factual rationalizations, post-crisis monetary policy does not appear to have considered the ways in which the crisis itself altered economic circumstances and individual decision-making. Then again, why would it? The constituents and interests of the central bankers are not those of the general public, it is financial institutions to whom they are beholden.

The bottom line is, given the vast age, social and geographical diversity of this nation, we should not be shocked that the extraordinary monetary stimulus applied since the 2008 Financial Crisis has largely failed to deliver a durable economic recovery. Monetary policy has always been a blunt instrument but in the post-crisis decade, it has had especially poor efficacy and high margin of error, the consequences of which are still pending.

Problem #2 – Keynesian Economics

A second problem with modern economics is the exclusive reliance on the Keynesian school of thought. Keynesianism, based on the work of John Maynard Keynes, is the principal economic theory taught in our schools, practiced by economists and used to prescribe monetary policy by the world’s central bankers. It stresses that economic activity is predominately dependent on aggregate demand for goods and services. When economic growth does not meet expectations, Keynesian policy responses include greater fiscal spending, lower interest rates or other fiscal and monetary action designed to boost consumption. This one-sided view fails to capture the benefit of creating value through productive activities or, in other words, the means which allow us to consume.

To help you appreciate the benefit of creating value, we elicit the National Geographic Channel’s Life Below Zero. The documentary tracks the lives of several people that live largely independent, “off-the-grid”, in the wilds of Alaska. Of particular interest is Glenn Villeneuve, who does not appear to rely on help from the outside world, nor many of the innovations of modern society, including electricity and power tools. Assessing Glenn’s daily activities, we better illustrate the measurement of a personal economy. While this example does not represent the norm, it does provide a microcosm of a simple economy to allow us to illustrate the fallacy of an economic perspective focused on consumption.

A typical day for Glenn involves some of the following activities in which he produces goods: hunting, trapping, fishing, sourcing water, and chopping lumber. Other parts of his day are spent consuming prior production such as eating, drinking, sleeping, and warming up by a fire. The first set of activities involves productive endeavors that add economic value. The second set of activities involves consuming the value he created. Note that there is also an intermediate stage in which the value he created is stored (saved) for future consumption.

Throughout the show, Glenn consistently extols efficiency or the benefits of using the least amount of energy and the most amount of ingenuity to add value to his camp. After watching an episode or two, a viewer quickly realizes that without this supply side mindset Glenn would quickly exhaust his resources and become a victim of the harsh Alaskan climate.

Most of our days are quite different than Glenn’s, but nevertheless they are filled with similar pursuits. We sit at a desk providing legal services, picking grapes from a vine, building houses and millions of others jobs in which we create value. While most of us do not “eat what we kill” and consume the value we create directly, we earn the value in the form of currency. As a store of that value, currency then affords us a medium of exchange for something we need or want when it suits us.

Just as portrayed in Glenn’s example, the harder we work and the more innovative and productive we are, the more value we create. It is in this straightforward incentive that the prosperity of a populace grows and scarcity is diminished. For related 720Global research on this important concept we recommend reading The Death of the Virtuous Cycle and watching our short video The Animated Virtuous Cycle.

Given the prior discussion we ask you if it makes sense that economic measurement and incentives are so heavily tilted towards the consumption of value. Consider again Glenn’s activities in the eyes of Keynesians. Given the emphasis on consumption, they would count how much he ate, slept and the extent to which he was able to heat his cabin as economic progress. His GDP would not properly capture the value of catching 30 salmon, bagging an 800-pound moose or innovative means of preserving those resources. If a Keynesian wanted to boost Glenns’s economic well-being, why would they focus on his consumption? Give him a rifle, a chainsaw or other productivity-enhancing tools to generate value. In other words, Glenn cannot go in debt to nature to pull his consumption forward in the event of a shortage. For him, a deficit equals starvation.

#1 + #2 = Poor Economic Policy

When one logically thinks through what a personal economy actually entails and considers the faulty reliance on the singular aggregation of our economies and a consumption driven mindset, they can begin to understand why economists consistently struggle to forecast economic activity and prescribe constructive policy. They have put the economic cart before the horse and are trying to convince the rest of us that it makes sense. Unfortunately, these errors do not only result in bad forecasting but pathetic monetary and fiscal policy which tramples innovation and productivity resulting in stagnant economic growth, wealth inequality and onerous debt burdens.

It should be clear that the straight-forward approach discussed here is not favored by the banks, economists and Wall Street professionals being paid handsomely to dole out Keynesian advice. That said, it is the economic school of thought that best captures the most relevant aspects of the economy. The logical thought process applied here is what is required if we are to ever properly diagnose our problems, employ policies that actually combat the current economic malaise and relieve the burdens and social unrest that are choking off prosperity.

 

 

 

It’s Not Too Early To Be Late

The golden rule of investing is buy low and sell high. While great advice, it is extremely difficult to accomplish with precision. Because of the perceived impossibility of timing peaks and troughs, many investment professionals prefer a buy and hold approach. They claim that, over time, stocks produce respectable average returns, so why attempt to pick peaks and troughs. We firmly disagree as taking a passive approach and riding the ups and downs in the market guarantees that investors will spend large periods of time recovering losses and not compounding wealth. Because of these losses, buy and hold portfolio returns usually fall far short of average market returns. For more on this reality, see the graph and article linked in the postscript below the article summary.

Prudent investment management argues that one should reduce risk when the market is not providing ample returns to take on risk and conversely one should assume more risk when the potential returns reward it. If an investor has $100,000 to invest, is he or she better served being fully invested in an index fund with that index valuation at or near all-time highs or being under-invested with a 30-40% allocation to cash? Cash may have a low return profile, but it bears no risk of loss and represents enormous opportunity at some point in the future. As we have stated before, risk is not a number produced by a formula or model; it is the exposure of hard-earned wealth to loss. Invested capital is always exposed to some level of risk, but an investor can decide whether the assumed risk is high or low. A passive approach surrenders all control over that important decision to the whims of the market.

Using various methods, one can establish that current valuations are indeed at or near all-time highs. In most cases the high water marks were established in 1929 or 1999. With the benefit of hindsight, every investor in those prior eras would have sold their stock allocations immediately, put their money in cash or bonds, and re-allocated back to equities when valuations normalized.

The benefit of hindsight is useful only to the extent that we are willing to heed the ample evidence of past cycles. Frederick the Great once said, “What is the good of experience if one does not reflect?” Given current equity valuations and their implied risk/return proposition, history is sending clear signals that investors should reduce their exposure to stocks and other risky assets.

This article looks back at 1929 and 1999 and analyzes how investors that sold several years ahead of the peaks fared. As you will see, an active approach to managing risk, even if very early and simple, can be much more rewarding than doing nothing.

**We selected the two time periods for comparison not because they represent the largest equity drawdowns in modern financial market history but because they had valuations most similar to today. Some will claim this approach to be fearmongering, but the fact is that valuations always revert to their mean over time. Assuming this time-tested, most basic law of finance is as true today as it has been throughout human history. 1929 and 1999 provide a comparable risk/return framework and important guidance for investors in 2018.

1999

Following a recession in late 1990 and the first half of 1991, the U.S. economy entered a ten-year stretch of continuous economic growth, the longest in modern history. During this period, the S&P 500 produced a total return of over 380% or about 20% annually.  While the economy was humming along at a healthy pace, the growth of stock prices was not totally a function of economic and earnings growth. In fact, the bulk of the rise was due to a significant expansion in valuations. For example, had the cyclically-adjusted price-to-earnings (CAPE) ratio remained at its 1990 level of 17.05, which is similar to the long-term average, the S&P would have only risen about 75% and not 380%. The graph below charts the rise of the S&P 500 and CAPE from 1990 to its peak in 2000.

Data Courtesy: Robert J. Shiller

Now let’s consider how an active investor would have fared if they exited the stock market and bought bonds in August of 1997, three full years before the ultimate peak. We chose this point as CAPE, at that time registering 32.60, was the highest in recorded history, having just surpassed the level observed on the eve of the Great Depression.

The illustration below compares total returns from a portfolio that fully exited the stock market in August of 1997 and used the proceeds to buy a Ten-year U.S. Treasury bond versus a passive portfolio that remained in equities.

Data Courtesy: Robert J. Shiller

As shown, the active investor exhibited prudence, albeit three years too early. They forfeited over 60% of equity market gains from the remainder of 1997 through mid-2000. Despite foregoing these returns, the active portfolio’s cumulative returns far surpassed those of the passive investor once valuations reverted to their mean. In fact, the buy and hold portfolio had the same portfolio balance in 2003 as it did in 1997, despite receiving dividends from its equity positions throughout that period.

Following the three-year decline beginning in March 2000, an active investor would have likely reallocated in some proportion to stocks from bonds as valuations normalized. In this example, however, we keep the active portfolio in bonds to show how even the most basic, one-time act of active management can protect returns. By 2006, the passive portfolio returns once again surpassed those of the active portfolio. This outperformance lasted about two years, but the cumulative return on the passive portfolio would again fall to near zero in early 2009.

Needless to say, the passive investor had a wild ride but lost 12 years of time in which wealth could have compounded. The active investor that sold stocks and bought bonds three years too early certainly felt “seller’s remorse” during the last innings of the rally, but was likely gratified at their longer-term cumulative performance relative to the passive investor.

1929

From 1921 to 1929, the S&P 500 gained 485% or about 22% annually.  Like the 1990’s, the growth of stock prices was not totally a function of economic and earnings growth. Had the cyclically-adjusted price-to-earnings (CAPE) ratio only risen to its long-term average of 16.87 as it was in 1927, the S&P 500 would have risen only about 260% during this period.

At the market peak in September of 1929, the CAPE valuation stood at 32.56, which is on par with the current CAPE.

To keep the 1929 analysis similar to the one performed above for 1999, we assume the active investor sold three years before the market top.

In this example, the active investor sold their stocks and bought a ten-year Treasury note in 1926. Similar to the late 1990’s, those three years would have been tough for our active investor to stomach. The graph below shows a nearly 150% rally in the S&P 500 in the three years leading to the market’s peak. Despite lagging by nearly 150% in the early-going, the active investor was ahead of the passive investor on a cumulative basis for the ensuing 23 years beginning in 1931.

Data Courtesy: Robert J. Shiller

Again, if one were truly taking an active approach, the investor would have bought back stocks when CAPE reverted to its mean and cumulative returns would have further distanced themselves from the passive portfolio.

Summary

Since 2009, the S&P 500 has risen 412%. Like the 1920’s and 1990’s, much of the increase is based on massive valuation expansion and not fundamental strength in the economy or earnings. Similar to the two prior periods, this era will end with a reversion of valuations back to or below the mean.

The point of this analysis is that unless you are:

  • Confident that you can call the top (no one can),
  • Know when to get out (few actually do), and
  • Importantly are willing to sell and forgo gains,

We suggest you begin to take precautionary actions today. This does not mean sell all of your stocks and buy bonds. It does mean you should actively manage your portfolio. As risks increase, both technically and fundamentally, allocate away from stocks.  By taking this approach, an investor will avoid loses and have funds available which can be put to use when valuations normalize and prices are significantly lower.

We do not doubt that, if you take our advice today, you will be early and will leave some profits on the table. At the same time, it seems highly likely that your portfolio will be in much better shape over the course of the cycle.

The following wisdom of Howard Marks masterfully sums up our thoughts on “risk management”:

“If you refuse to fall into line in carefree markets like todays, it’s likely that, for a while, you’ll (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs. In my experience, times of laxness have always been followed eventually by corrections in which penalties are imposed. It may not happen this time, but I’ll take that risk.” 

______

Postscript: Difference Between Average and Actual Returns

The following graph from The Myths of Stocks for the Long Run – Part IV, shows how volatility and drawdowns create a large gap between the average return (red area) and the real return (blue area) over a period.

 

Booming Profits

Better to be paralyzed from the neck down than the neck up.” – Charles Krauthammer

It is easy to be upbeat about the stock market. Currently, as second quarter earnings are being released, the S&P 500 is expected to post a second consecutive quarter of earnings growth in excess of 20%. The first two quarters of 2018 will show the strongest two consecutive quarters of growth since 2010, when earnings were recovering from the fallout of the financial crisis. The recent strength in corporate profits is attributable, in large part, to the federal tax overhaul late last year, but there are other factors contributing as well. The U.S. economy is showing strength, employment data remains strong and consumer spending is upbeat.

Although recent economic output has been encouraging, the Federal Reserve and other forecasters expect it to slow once again as the effects of recent policy pass through the system. In other words, the profit growth from tax reductions is a one-time benefit. It lacks sustainability and comes with the additional challenge of higher levels of government debt in the long-run.

The current expansion has defied all critics and now stands as the second longest in post-WWII history. Somewhat counter-intuitively, this is not a point of encouragement. The reason is that, over the long-term, aggregate earnings can only grow as fast as sales and sales growth is typically similar to that of the growth of the economy overall. So, to draw on the wisdom of Milton Friedman, earnings cannot break loose from economic gravity. Using that fundamental logic as a common-sense guide and cautiously assuming consensus growth forecasts are in the ball park, corporate profits likely peaked in the first half of 2018.

Wall Street forecasters often get caught up in the new narrative flavor of the month and decide somehow that the laws of financial physics should be suspended. Forecasting earnings growth that constantly exceeds sustainable GDP growth is, of course, preposterous. Furthermore, stock markets allow us to participate in the growth of existing enterprises, but GDP growth is also comprised of the creation of new enterprises through entrepreneurial capitalism. Based on that important dynamic, real corporate earnings and dividends should grow at roughly half the rate of economic growth. As you can see, proper consideration of these facts raises important and serious questions about both earnings and equity valuations.

Nobody likes to see a good party end, but when hard-earned wealth is at risk, it is advisable to heed warnings and protect current gains. Earnings will revert back to their true (meaning pre-tax reduction) growth rate, which will obviously limit future equity gains. Despite an economy that has struggled to grow much above 2%, U.S. corporations have enjoyed a remarkably long period of support through zero-interest-rate-policy (ZIRP), low labor costs, and a weak U.S. dollar. If we can agree that there is no such thing as a free lunch, there is a cost to those benefits and it appears to be showing up in populism. That introduces a variety of important uncertainties regarding policy and financial circumstances. For a more thorough analysis on these issues please read The Uncivil Civil War.

If we are to evaluate equities in accordance with their duration as an asset (30+ years), then one time benefits lasting a quarter or two should be properly discounted and put in context of the longer term picture. As the valuation sirens are wailing, like at other former peaks, equity investors and the market are guilty of neglect.

The Mendoza Line: Is The Fed’s New “Yield Curve” Professional Grade?

In professional baseball, there is a performance standard called the Mendoza Line, a term coined in 1979 and named after Mario Mendoza, a player that struggled to hit consistently throughout his career. The standard or threshold is a batting average of .200. If a player, other than a pitcher, is batting less than .200, they are not considered to be of professional grade.

Investors’ also have a Mendoza Line of sorts. This one, the yield curve, serves as an indicator of future recessions. Since at least 1975, an inverted yield curve, which occurs when the 2yr U.S. Treasury note (UST 2) has a higher yield than the 10yr U.S. Treasury Note (UST 10), has preceded recessions. Currently, the 2s/10s yield curve spread has been flattening at a rapid pace and, at only 0.33% from inversion, raises concerns that a recession might be on the horizon.

Interestingly, the Federal Reserve (Fed) recently introduced the merits of a new yield curve formula to supplement the traditional curve and better help forecast recession risks. Might it be possible the Fed has brought this new curve to the market’s attention as it does not like the message the traditional curve is sending? Given that the Fed Funds rate remains very low despite recent increases, is it possible the Fed is desperately attempting to increase the monetary ammo available for the next recession?

Regardless of the Fed’s intentions and whether the market takes the Fed’s bait and buys into a new recession warning standard, understanding the differences between the traditional curve and the new curve provides valuable insight into what the Fed’s reaction function might be regarding enacting monetary policy going forward.

Traditional 2s/10s Curve

*In this article we solely refer to traditional yield curve represented by UST 2 and UST 10. There are other curves that use different maturities and credits which provide value as well. 

The yield on the UST 10 not only reflects the supply and demand for ten-year government debt securities but importantly embedded in its yield are investors’ expectations for inflation and growth. These expectations are influenced to some degree by the Fed’s monetary policy stance.

The UST 2, on the other hand, is much more heavily influenced by the Fed Funds rate set by policy-makers and less so by long-term growth and inflation expectations.

Therefore, the UST 10 provides information about how borrowers and lenders view future economic activity and inflation, while the UST 2 affords us insight into how the Fed might change interest rates in the future. It is this intersection of the Fed’s interest rate policy and the heavy reliance on debt to fuel economic activity that makes the 2s/10s yield curve an especially compelling indicator today.

The graph below charts the correlation between Fed Funds rate expectations, as quantified by the rolling 8th Fed Funds futures contract, and benchmark maturity Treasury securities. The 8th Fed Funds contract denotes market expectations for eight months forward. It is the longest contract available without compromising price consistency due to illiquidity.

* = interpolated data

Data Courtesy: Bloomberg 

From 2000 to the present, the correlation of UST 2 and Fed funds futures is a positive 0.80. In other words, 80% of the price change of the UST 2 is explained by expectations for future rates of the fed funds rate. As shown, correlation declines as the time to maturity increases. The relationship between the UST 10 and Fed funds future is .56, which is significant but less dependent on Fed Fund expectations than the UST 2.

The difference between how investors price UST 2 versus UST 10 help us contrast expectations for economic growth/inflation and monetary policy. When the curve inverts, the market is warning us that the Fed’s monetary policy is restrictive or in market terms, tight or hawkish. In such an environment banks are not very willing to lend as their cost of borrowing does not provide enough profit margin to cover credit losses and meet profit thresholds. Conversely, when the curve spread is wide and monetary policy is deemed easy or dovish, banks are in a much better position to extend credit.

While there are many explanations for why the curve is flattening rapidly, the consensus seems to be that inflation and the long-term economic growth outlook for the future are benign despite a recent spurt in economic activity. In fact, the Fed’s long-term projected rate of economic growth is only 1.90%. Fed Funds are currently 1.75-2.00% and expected to increase at least two or three more times. The combination of views necessarily flattens the yield curve and importantly makes lending less profitable.

The New Curve

What if your local weatherman forecasted weather not based on atmospheric conditions and other scientific data but instead on his own forecast. “I dreamt it will rain in three days, therefore my forecast is for rain in three days.” His prediction method, if uncovered, would probably lead him to seek a new career.

The weatherman’s forecast is a good way to describe the new yield curve the Fed has recently publicized. This curve is calculated by comparing the current three-month rate for Treasuries versus what that rate is expected to be six quarters from now. The forward rate is calculated using the current rate and the interpolated rate on 1.50- and 1.75-year Treasury notes. Do not get caught up in the complexity of the math but in laymen’s terms the curve is simply a forecast of what the market thinks the Fed will do. Let that bit of recursive logic resonate before reading on.

Said differently, the Fed imposes unnatural control over the shape of the new curve. Consider again the correlation table above. For Treasury securities with two years to maturity or less, expected Fed policy has a strong influence on yield. Therefore, by saying they intend to hike interest rates, the Fed also influences the shape of their new yield curve metric. The logic behind the new curve logic confounds what they claim is a pure insight into expectations for a recession.

The Fed is not coy about making that clear as witnessed in the most recent FOMC minutes:

The staff noted that this measure (new yield curve) may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons.

Click Here for more information on their new curve. 

Comparing Curves

The following graph compares the traditional 2s-10s curve and the new curve with recessionary periods represented by gray bars.

Data Courtesy: Bloomberg

As shown above, the orange line representing the traditional curve and the new curve in blue are well correlated and have both dependably warned of recession about a year or two before the beginning of previous recessions.

Closer inspection of the last six years, as shown below, however, yields a very different story.

The traditional 2s-10s curve spread is falling at a decent pace and has been in decline for the better part of the last five years. Conversely, the new curve has been in a slight uptrend over the same period. Clearly, the curves are sending different messages.

Calling Foul on the Fed

There is one key difference between the two curves that is vital to appreciate. The Fed has much more control over the shape of the new curve versus the traditional curve. For instance, if the Fed promises more rate increases and continues to deliver on said promises, there is a high likelihood the new curve will stay positively sloped. The traditional curve, as shown earlier, is much less influenced by the Fed directly. Instead, it is quite likely the traditional curve, in that situation, would continue to flatten and invert as further rate hikes are thought to have a dampening effect on economic growth and inflation. Per the Federal Reserve –“Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession.”

We believe the Fed is introducing this new curve to provide cover to allow them to keep raising rates. The trend and impending signal from the traditional curve is leading investors to second guess the Fed and their tightening campaign. The traditional curve could cause investors to lose confidence in the Fed. Given the state of excessive asset valuations built largely on confidence in the Fed, this presents a big problem. If, on the other hand, investors buy into the new curve and its upward sloping shape, might they be persuaded a recession is not in sight and their confidence in the Fed will remain strong?

It’s important to remind you why the Fed may be particularly anxious about raising rates. During the last two recessions Fed Funds reductions of 5.25% and 5.50% were required to stabilize the economy. Additionally, in 2008/09 the 5.25% rate cut wasn’t enough, and the Fed introduced QE which quintupled the size of their balance sheet. With Fed funds currently at 1.75-2.00%, the Fed has much less ability to stimulate the economy if economic growth were to slow.

Summary

In baseball, .200 is the line in the sand. It is widely accepted and understandably so given over 150 seasons of baseball. In economics, a flat or inverted 2s/10s yield curve is the line in the sand. It is widely accepted and its validity is broadly discussed in prior Fed research. Changing the Mendoza line to say .150% would allow some current substandard players to achieve “professional grade,” but the quality of players would remain the same. Likewise, changing the markets recession warning may change the perspective of some investors but will it nullify a recession?

The Fed may not like the market’s perceptions and implications of a flatter yield curve but changing it to one of their liking is not likely to alter reality. Importantly, if the goal of the current Fed is to convey a message that allows them to raise rates further, they may have found a good alternative. Our question is, however, in the name of transparency, why not just say that is the objective rather than sacrifice integrity?

Regardless of whether the Fed’s version of the economic Mendoza Line changes, we simply urge caution based on the signals of the traditional curve. Redefining key measurements of economic conditions may alter the eventuality of a recession but it will not make long-term expansions or contractions in the economy any more or less likely. It will only confuse and conflict Fed members charged with dispensing prudent policy.

We leave you with recent thoughts from the Federal Reserve on the value of the traditional 2s/10s yield curve:

“Forecasting future economic developments is a tricky business, but the term spread (traditional 2s/10s yield curve) has a strikingly accurate record for forecasting recessions. Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession. –March 2018 Economic Forecasts with the Yield Curve Federal Reserve of San Francisco.

The Uncivil Civil War: Economic and Market Implications of Political Transformation

Come senators, congressmen
Please heed the call
Don’t stand in the doorway
Don’t block up the hall
For he that gets hurt
Will be he who has stalled
There’s a battle outside
And it is ragin’.
It’ll soon shake your windows
And rattle your walls
For the times they are a-changin’

The Times They Are A-Changin’ – Bob Dylan

America’s populace is politically divided in a way that has not been seen in decades. The growing rift is rapidly changing the landscape in Washington D.C. and has major implications for the nation. Amazingly, as voters from different parties espouse views that are worlds apart, they share a strikingly similar message.

This article considers the juxtaposition of colliding worldviews and the unified message that voters across the political spectrum are sending. While many investors are aware of the political change afoot, it seems that very few have considered how said changes might affect the economy and financial markets. In this article, we share some of our thoughts and encourage you to give the topic more consideration going forward.

Given the importance of the subject, this article will likely be the first of several discussing the intersection of politics and markets.

The Changing Faces in Congress

Speaker of the House Paul Ryan and Congressmen Bob Corker and Jeff Flake are a few of the well-established Republicans not seeking reelection. While each has their reasons, it appears the prospect of losing re-election played a significant role in their decision making. Is this a case of “playing not to lose” as opposed to “playing to win”? Political capital can be delicately converted to monetary capital only if a politician, in or out of office, plays his or her cards wisely.

This is not just a story about Republican discontent. In New York’s Democratic 14th Congressional District primary, Alexandria Ocasio-Cortez, a totally unknown candidate months ago, recently upset incumbent Joseph Crowley, the fourth-ranking Democrat in Congress and possible successor to Nancy Pelosi as the Democratic House leader. Crowley has represented New York since 1999, most recently as a representative of the Bronx and Queens.

Ocasio-Cortez is a 28-year old Latino woman who was tending bar only a year ago. She ran on campaign promises that were decidedly left of the mainstream Democratic agenda represented by Crowley. Her political stance was not surprising given her support for Bernie Sanders during the last Presidential primary and her membership in the Democratic Socialists of America.

While there are many messages 14th District voters are sending us; we believe there are two that are representative of voters of both parties throughout the country.

  1. Voters appear to prefer political views that are less centrist and offer a change from the status quo of the existing parties.
  2. Voters are looking to buck established party leaders in favor of someone different.

The Washington Post, in an article about Ocasio-Cortez’s victory, summed up these messages well – “Many of the key Democratic House primaries this year have been competitions over biography, with a premium given to those who break new ground or remove old barriers.”

Economic and Market Implications

Assuming this trend continues, the implications for the economy and the financial markets will become increasingly important to follow. While the topic for another article, simply consider the massive social changes that occurred in the late 1960’s and early 1970’s. Those changes had profound and lasting effects on culture and society as well as the economy, monetary policy, fiscal policy and the financial markets.

The following provides a summary of factors worth considering as this new era of politics takes hold:

Deficit – Despite a Republican-controlled Congress and President, the size of the fiscal deficit is surging. Current forecasts by the Congressional Budget Office (CBO) estimate that Treasury debt will increase by over $1 trillion a year for the next four years. While it seems that the Democrats and Republicans cannot agree on much, they currently seem to agree on increased government spending. Given a President that is not averse to debt financing and deficit spending and a slew of politicians concerned about future elections, collectively they may opt for more spending to please their constituents. Given the importance of retaining (or not losing) power, the tendency towards higher fiscal deficits will continue regardless of which party controls the House and Senate. Discipline of any form appears outdated in the halls of Congress and certainly not a popular political platform.

Recession and stock market crash response – During the great financial crisis of 2008/09, extreme fiscal and monetary stimulus were employed to right the economy and stabilize the markets. In just three years from 2009-2011, a timeframe spanning the recession and immediate recovery, the aggregate fiscal deficit was $4.006 trillion. In those three years, the government accumulated a deficit that equaled that of the 22 years immediately prior.  The Fed’s monetary policy response was even more brazen. They lowered the Fed Funds rate to zero which helped push longer-term bond yields to historically low levels. Further, they introduced QE and purchased over $4 trillion of U.S. Treasury, Agency and Mortgage-Backed Securities.

Our concerns for the next recession and stock market drawdown are twofold. First, will the Fed acquiesce with unprecedented monetary policy as they did repeatedly during and well after the financial crisis and recession?   Second, will the vastly different political views of Congress and the likely infighting make negotiations on fiscal bailouts harder than those that occurred in 2008 and 2009?

Under Jerome Powell’s leadership, the Fed appears less concerned with financial asset prices than did the leadership of his immediate predecessors. Further, inflationary aspects of fiscal deficits may make them more apprehensive about easy policies that can have inflationary impulses. One of the key signals for a change in monetary policy came when outgoing New York Fed President William Dudley gave a speech on January 11 characterizing three to four rate hikes in 2018 as “gradual.” Although there was no immediate market response, within two weeks the stock market convulsed. The market has yet to regain those losses and the Fed thus far has not walked back Dudley’s comments.

The fiscal situation could also become problematic if the political parties continue down the path of discordance.  Either party might be willing to push or block emergency fiscal stimulus to affect the President’s reelection chances heading into the 2020 presidential campaign.

Geopolitical – The changes occurring in our political system are closely monitored by other nations. While some nations are experiencing similar changes, especially in Europe and the United Kingdom, we have little doubt that our allies, our enemies, and everyone in between will try to capitalize on the situation. Trade and the dollar’s status as the world’s reserve currency are the foremost concern. We believe many nations want to unseat the U.S. dollar as the world’s reserve currency. Trade tariffs and fair trade negotiations are likely fueling the desire even more so. Will political change and the possibility of a stalemate in Congress provide these nations an opportunity to reduce their reliance on the dollar? The implications, as discussed in Triffin Warned Us, are massive.

Public/Corporate confidence and spending habits – Consumers tend to spend when they are most confident about their own financial situation and that of their nation. As the political issues collide and political rhetoric from both sides increase, will consumers’ confidence waver?

Alternatively, what if current consumer spending has less to do with confidence and is largely based not on what they want to spend but what they need to spend? Food, gas, healthcare, housing, and education are all making unreasonable demands on consumer spending habits. These expenditures are being funded by dis-savings and credit as opposed to rising salaries and wages. The evidence for this lies in the concurrent rise in consumer credit data and decline in household savings. The demand for political change is not coming from the elite that profited from corporatism and speculation, but in large part from the majority being left behind. These are the marginal consumers and play a large role in determining the pace and quality of economic activity.

Similarly, what of the confidence of corporate executives? We suspect that as political differences become acuter and the future less predictable, executives will hold back on investments in new projects, plants, equipment or employees.

Summary

Currently, the market seems indifferent to the recent wave of political upheaval. The relative stability in the economy and strong performance of stocks over the last few years is likely mesmerizing many investors.  We believe investors should consider that the changes in the political landscape may only be in its infancy. Whether the recent move towards political divergence is a fad or the start of something much larger is anyone’s guess. However, we believe the increasing influence of millennials at the expense of baby boomers will have impacts which we are just starting to see.

Given that equity markets are perched at extreme valuations, implying that the risks are significant and future returns well below normal, we believe the political unknowns and the associated risks they carry are among the reasons to maintain a conservative investment stance.

The following video   https://www.youtube.com/watch?v=tEczkhfLwqM provides a historical perspective of how Congress has become increasingly divided over the last 80 years. While it stops in the year 2013, the differences have only widened since then.

Monthly Fixed Income Report – June 2018

Monthly Fixed Income Update – June 2018

At the half-way point of 2018, there are a multitude of interesting stories to cover in the fixed income markets. Beginning with June’s performance, the headline remains the divergence in performance between investment grade (IG) and high yield (HY) credit. From a total return standpoint, junk bonds (HY) were the best performing sector for the first six months while IG was only kept out of the fixed income cellar by the poor performance of emerging markets (EM).

**Please note there was an error which has since been corrected in the May performance table. For reference, May’s corrected table is shown below June’s.

June’s Performance:

May’s Corrected Performance:

The primary culprit for IG underperformance versus HY is heavy supply from merger and acquisition-related issuers in the healthcare, food & beverage and retail sectors so far this year. At the same time, HY supply has been on the decline.

The performance of the high yield sector also stands out against the poor performance of EM bonds as the comparative spread between the two are back near multi-year lows.

The emerging market index total return has been negative in 5 of the first 6 months of 2018. Turbulence in EM is more troubling than the supply-related problems seen in IG. Federal Reserve (Fed) rate hikes and the slowing/reversal of easy monetary policies in the developed world has led to meaningful investment outflows from emerging markets. In conjunction with the Fed policy shift, elections in Mexico, Brazil and Turkey as well as the continued escalation of global trade tensions, have been disruptive. As long as central banks, politics and trade remain concerns, it seems reasonable to continue to expect EM assets to struggle.

The Aggregate Index declined for the month of June due to the poor performance of investment grade corporates. Like IG, it has been negative in 4 of the first 6 months of the year. Apart from the fluctuations in high yield and emerging markets, other sectors rose only slightly for the month.

Credit markets in general remain rich on an absolute and relative basis as yields are low, spreads are tight and thus offering a low ratio of return per unit of risk. Despite the outlook for three to four more Federal Reserve rate hikes, tighter financial conditions and the macro uncertainties associated with global trade, investors seem content sticking with a horse that has been a proven winner for so long. That said, the underlying quality of credit is poor and the risk-reward fulcrum seems clearly skewed toward the “risk” side of the equation.

It is worth mentioning that over the last thirty years IG and U.S. Treasuries have provided investors a reasonable hedge in times when equity markets declined. The S&P 500 remains nearly 5% below the record highs of January and does not appear nearly as strong as in 2017 despite improving corporate earnings. History tells us that we should expect flows into the more durable fixed income sectors to increase if the equity market shows continued weakness.

Weak Dollar Policy and Commodities

Many political pundits will tell you that President Trump won the election, in part, on the promise of a rebirth in the manufacturing sector. His initial strategy to reduce the trade deficit centers on negotiating new tariffs and renegotiating existing trade agreements. These volatile discussions with other nations, often accompanied by threats, will likely continue and the outcomes are far from certain. If the President is unable to satisfactorily adjust the trade terms with our partners, he could resort to a weak U.S. Dollar policy that has frequently been employed throughout modern history. As a current point of reference, the Chinese Yuan has weakened by about 5% over the last two months. This is likely an effort to reduce the effect of new tariffs.

The U.S. Dollar is the world’s reserve currency and is used in a majority of global trade. The value of the dollar versus the currency of other nations is a primary variable that drives the prices of goods traded amongst nations. When oil, copper, corn and most other commodities are traded between nations they are typically quoted in units per dollar. In addition to analyzing the supply and demand dynamics for a specific commodity, investors in the commodity sector should also assess the value of the dollar.

In this article, we focus on the correlations of numerous commodities to the dollar. Understanding these relationships will prove helpful if a weak dollar policy is utilized by the administration.

For a more thorough perspective on the dollar and the forces that help drive its direction, please read Our Two Cents on the Dollar.

Dollar/Commodity Correlations

The table below depicts the correlation between various commodities and the U.S. dollar.

Data Courtesy Bloomberg

In the table above, the correlation between each commodity and the U.S. dollar index is aggregated by commodity sector and time frame. In organizing the table this way, we can ascertain which specific commodities and/or sectors have strong or weak correlations to the dollar. This may present useful investment or hedging strategies in the event the U.S. dollar weakens in the future.

A correlation of +/- 1.00 implies a perfect relationship between changes in the price of the commodity and the value of the dollar. As shown above, almost all of the short and long-term correlations have a negative sign indicating an inverse relationship. For most commodities, the price falls when the dollar is strengthening and rises when the dollar is weakening. Statisticians consider a correlation of +/-0.70 to be significant, but anything over +/-0.35 denotes a statistically meaningful relationship. While none of the commodities have a longer-term correlation above +/- 0.70, here are some important observations:

  • Precious metals (gold and silver) have shown a durable negative correlation (-0.52 and -0.47 respectively) to the dollar over the long term. In the short run, the correlation for gold has been statistically significant. As John Pierpont Morgan once said, “gold is money,” and somewhat true to his wisdom that gold is in itself a currency, it is not surprising that gold has the strongest correlation to the dollar of all the commodities shown.
  • While the industrial metals tend to have a low correlation with the dollar over the long run, nickel and copper, in particular, have recently demonstrated a higher negative correlation to the dollar than their long-term trends. The price of these metals typically correlates well with global economic activity. As we have seen for the last month, a strong dollar tends to dampen foreign economic activity.
  • The energy sector also has a strong negative correlation over the last year to the dollar. The relationship is even more pronounced over the last month. Interestingly, the price of Brent and Crude oil (WTI) have diverged from their typical correlation to each other. We suspect this short-term divergence will revert to the normal relationship over the coming year.
  • Grains and soft commodities tend to have a slight negative correlation over longer periods but have bucked that trend recently with slightly positive correlations to the dollar.
  • Lean hogs and feeder cattle appear to have little correlation to the dollar over the short and long-term.

Summary

Trump’s campaign promised fair trade and a resurgence in U.S. manufacturing. While there are many ways he may accomplish this task, the most expeditious would be a weak dollar policy. As we have seen, negotiations can be tricky, complex and time-consuming. With a mid-term election in a few months and the 2020 presidential campaign commencing shortly thereafter, the President’s patience may wear thin. If Trump were to effectively implement a weak dollar policy, the benefits he promised voters are more likely to be apparent, even if they are only cosmetic. Investors can prepare for currency depreciation, which is frequently the expedient and often the preferred tactic of politicians.

As anticipated, gold is the best hedge against a weaker dollar. The negative correlation between gold and the dollar should not be surprising given gold’s history as a currency itself. Pronounced dollar weakness, especially weakness prompted by an acknowledged policy targeting it, would most likely result in rising gold prices. Silver also plays a role as a store of value, but silver, unlike gold, has many industrial uses which tend to reduce its correlation to the dollar. The energy sector may also provide a good hedge to dollar weakness, but if that weakness is accompanied by declining economic activity, the reduced demand for energy could overwhelm the benefits it provides as a dollar hedge.  Grains, meats, and other soft commodities tend to be even less of a dollar hedge. Supply and demand dynamics, frequently including hard to predict weather patterns, play a larger role in their pricing than other commodities.

Investors may be tempted to buy ETF’s that focus on a broad grouping of commodities as a dollar hedge. Although important in its influence over commodities, the U.S. dollar is but one of many factors that drive prices. The multitude of dynamics that determine commodity prices means there are no quick and easy answers to determining an effective hedge in the event of a weakening dollar. Awareness of these relationships and the extent to which they are aligned with or diverging from long-term trends is, however, a powerful analytical tool in the rigor of determining an optimal strategy.