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To Cut, Or Not To Cut…FED Is The Question

“Black holes are where God divided by zero.” – Steven Wright

 “Unbeing dead, isn’t being alive.” – E.E. Cummings

We’re living in interesting times indeed. Wherever we look, a new, better, improved version of every product, service, policy or methodology is available for a spin. Some of these trials end up becoming hugely successful, and some of them prove to be disastrous.

In 1994, three smart guys teamed up and formed a hedge fund, which combined cutting edge technology and trading algorithms to provide superior returns for large or institutional investors. They were Myron Scholes, Nobel Laureate co-originator of the Black-Scholes option trading model, a professor of Finance at Stanford, Robert Merton, an MIT professor with Nobel Memorial Prize for his contributions to Black-Scholes, and John Meriwether, head of fixed income arbitrage group at Salomon Brothers. They called their venture Long Term Capital Management (LTCM). Their strategy, coupled with option trading capabilities and hedging, was supposed to be downside proof. Who could question this, when the option trading Gods were in the house?

The first three year returns of LTCM were an impressive 21%, 43% and 41%, net of fees. The whole world of investments was in awe. These guys were surely on to something. They turned 100 dollars to 243 in just 3 years.

If you think that’s remarkable, check this one out: In two of those three years, 1996 and 1997, Russian stock market went up 5-fold. A grandmother who invested in the Russian stock market on behalf of her grandchildren, doubled LTCM’s returns in less time and with less effort. Those were some pretty good times for investors around the globe…all was good…pretty, pretty, pretty good…even great.

Then in 1998, something unexpected happened: Russian Financial crisis. LTCM lost $4.8 billion in less than four months. A private bail out was arranged by the FED, and it was liquidated in 2000. The Russian economy crashed into pieces, many stocks became worthless, the grandmother whose portfolio had handily beaten LTCM to the upside, had done the same to the downside. The end of this story, was not so pretty…not pretty at all.

 

A few years after this incident, the US stock market had experienced a domestic tech bubble burst in the Nasdaq. Following that in 2008, we had a financial crisis at global scale, during which time, John Meriwether’s next hedge fund adventure also ended up gravely.

There are those who believe in historical tendencies to rhyme, and those disagree with potentially the most hazardous four words: This time is different.

At a time when large US banks (ex: JP Morgan) announce their Q2 economic growth (GDP) estimates at 1-1.5% range, which is a message echoed by different branches of the FED (ex: Atlanta), the Federal Reserve is under pressure to cut rates and stimulate the economy in order to avoid a recession.

Monetary Theory suggests that it is the government’s role to stimulate the economy with fiscal and monetary easing tactics during slow times, and tighten the belt during times of boom to pay for the debt created during previous periods. If not, excess may form and the system may become prone to shocks.

But today, there is a new theory, called “Modern” Monetary Theory. It argues, that there is no need to worry about excess because there is only one indicator to gauge it, and it’s called the inflation rate. As long as inflation is kept at or below the target rate, more and more stimulus is justified.

Proponents of this theory are in power in the current administration and hence the reason why, after a huge fiscal stimulus in the form of tax cuts, there is now a decent chance for a rate cut by the FED in the next few months. I personally do not agree with this approach, but I don’t get calls from DC to hear my opinions, so it is prudent to study potential outcomes of a rate cut.

 

Black Hole Sun, Won’t You Come

I am not sure if perpetual stimulus packages create a black hole in the system where laws of physics don’t apply anymore or whether they can wash away recessions, but this much I do know: an undead economy doesn’t mean it’s alive and well. After a 10-year growth period, with no rate cuts since 2007, what does the potential road map of rate cuts look like? How could markets react to it?

Here is a historical perspective of the events most likely to come. There have been 16 rate cuts since WW II and in 12 of those cases stocks were up 6 months later by an average rate of 9.75%. So, in most instances, stocks favor tax cuts. The average of positive years was 15.03% and negative years -6.07%.

But this analysis fails to acknowledge a change in FED policies over the years. Before 1981, the FED had waited until the beginnings of a recession to start cutting rates, and so there are 7 cases when the rate cut came in the midst of a recession, when the stock prices were already discounted and so a road to recovery was already being paved. I would argue, those times don’t apply to our current case as right now we are not in a recession. Excluding those, stocks went up 7 out of 9 cases with an average increase of 7.06%. Even a bit muted, the above statement “…, in most instances, stocks favor tax cuts.”, still holds true.

The most important question it appears, is whether a recession follows the rate cut, because that seems to be the driver of returns that follow. With no recession after rate cuts, the average 6 months return after was 11.4% and -8.1% if a recession followed, a big difference. When I played with numbers, this is the most meaningful difference I have found, which has a similar effect on bond prices as well. If a recession follows, then bond prices continue to go up, and if not, as stocks recover, they lose steam.

One last important piece of information before I wrap this up: recency is important. The two most recent rate cuts were in 2001 and 2007. In both cases, like today, stocks were overvalued, the economy was on a growth mode for several years, and the market was concerned a recession was around the corner. Today’s set of facts, sound eerily familiar. What happened after in 2001 and 2007? Stocks went down respectively -4.3% and -11.9% within 6 months of the rate cut, because the cut wasn’t enough to avoid a recession.

In short, rate cuts are good for stocks, if a recession doesn’t follow. But because we have had a long growth period and see asset price inflation, both of which are commonalities with the last two cases, I would use caution. If stocks will go up, historically one beneficiary group has been dividend grower stocks. If you have high stock allocation, I wouldn’t use this as an opportunity to go full on stocks, but if you’ve been on the sidelines, some dividend payer exposure to take advantage of a rally after the rate cut could be a boost to your 2019 returns. I hear comments from smart folks arguing that all this information is already baked in the cake as the markets are anticipating a rate cut, and a rally has already happened as a result. According to this view, without a cut, markets may be disappointed, and with it, satisfied with the status quo. They do have a point, so…curb your enthusiasm.

Thank you for reading my newsletter. I hope you’ve found it a fun read and informative. Please feel free to reach me with questions and comments on bbakan@shieldwm.com.

 

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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Pour Some Sugar On me

“Three o’clock is always too late or too early for anything you want to do.” Jean-Paul Sartre

“It is easier to find men who will volunteer to die, than to find those who are willing to endure pain with patience.” Julius Caesar

Current market conditions remind me of a scene from the 2000 Ridley Scott movie Gladiator, (https://www.youtube.com/watch?v=FI1ylg4GKv8) in which, the protagonist Maximus (Russel Crowe), a Roman army general turned gladiator, walks out of a wooden cage filled with other fighters, all paying their respects to him, while some so fearful that they can’t control their urine. After killing four opponents in one session, Maximus throws his sword at the spectators, filled with disgust of their enthusiasm towards violence, shouting his famous line “Are you entertained?”.

These days, anyone willing to go out of their wooden cage/comfort zone and invest in stocks, must have the strength and stamina of Maximus, and so I salute them. The same day well respected economists like the Nobel laureate Joseph Stiglitz are warning about a looming recession, stocks keep going up. In my opinion, the line “Are you entertained?” is well deserved due to the limits the US Government is willing to go to keep this sugar high alive. At some point, the proverbial can that has been kicked down the road in the form of government debt and deficit, will have to be addressed. At that time though, likely at a much higher cost.

Those who have been on the sidelines must be scratching their heads and wondering, if it is too late to get in. Will they ever see an opportunity to buy stocks at lower prices?
To add fuel to the fire, FED chairman Jerome Powell comes on the stage, and sings the popular Def Leppard song, crowned as the title of this article. Although, probably a correction is due here. Mr. Powell isn’t adding fuel to the fire, he has started the fire, or maybe is the fire.

FED Driven Rally Still Alive

For those who like to get a quick answer, the reasons why the stock market has been going up lately are: the FED pause on raising rates, and corporate stock buy backs.

Coming into 2019, many have expected to see FED rate increases, and in January when Jerome Powell announced a pause in that action, he had opened the flood gates that probably even Noah himself wasn’t expecting to see happen.

Not only the FED, but also the Bank of Japan and European Central Bank, have stopped their quantitative tightening programs. In fact, don’t be shocked to see if we go back to quantitative easing roll outs by the end of this year. Why? Because the global economy continues to slow down and by then it may need a lift. There is a reason why China has rolled out a 1.5 trillion Yuan stimulus package.

Why did the FED halt? Being data driven, the FED has reached both of its mandates: low inflation and full employment. The US economy is in much better shape than its global partners, but still, at least as far as the FED is concerned, the economy rate isn’t strong enough to justify further rate increases. The signs of this can be seen in low inflation rate and bond yields. In fact, the market is probably pricing a rate cut as a result. I, personally doubt a rate cut is in the cards because the FED needs to be able to use that ammunition when fighting a recession. Japan and Europe are much closer to that scenario, and hence the reason why, their central banks are also on a wait and see mode instead of tightening.

The Bureau of Economic Analysis have reported a US GDP first quarter growth rate of 3.2%. If you’re one that judges a book by its cover, this is of course good news, but for those who like to play Sherlock Holmes, it is due to inventory build-up and improving trade, both of which may have hard time contributing to future growth. If you don’t believe me, ask the FED. Their 2019 annual growth estimate is 2.1%. To reach that average, growth in the following quarters have to be much less than 3.2%.

The second reason why the stock prices have been going up, is the record level corporate stock buy backs. The 2017 tax laws allowed US corporations to repatriate close to $700 billion dollars. Yes, you’ve read that right, and no, it is not a typo. Now, you’d think that money would/should go to capital expenditures, research and development, and new hires…but I’m sorry you’d be wrong. Those freshly received funds went into stock buy backs, which not only increases stock prices, but also improves price earnings ratios as there are now less stocks available for purchase. In English, it means publicly traded companies are not investing in their businesses, or paying down their debt, and debt they have, but they’re buying back their stocks and helping their stock prices go up. If part of your compensation is received in your company stock, you might be happy to see this, but as for the sustainability of the rally, it raises some legitimate questions.

Inverted Yield Curve

Back in March of this year, bond yields have displayed an inverted curve. Usually, the longer the maturity date of a bond, the higher its yield. In rare occasions, this relationship may reverse and when that happens, many interpret it as a strong recession warning sign. In the last 50 years, there have been 9 similar cases and in 7 of them, with an average of 12 months lead time, a recession did in fact materialize. Does it mean we shall see a recession in the US in the next 12 months? Highly unlikely. Forward looking indicators are weakening, but they are still pointing to (albeit slow) growth. The inverted yield curve has formed because bond investors expect the US to follow the rest of the world and like Europe and Japan, feel recessionary pressures soon. I, humbly disagree. With FED on pause, and 2107 tax cuts, the possibility of that scenario has been pushed to late 2020 or 2021.

Let’s not forget, we have seen two waterfall declines in stock prices in 2018, and closed the year with an approximate 8% loss in major US stock indices. So, the economic slow-down rhetoric isn’t delusional. It’s just that the policy response to it has been effective. The confusion arises because the US and the global economies are out of sync. While the US is growing, the world has been slowing down. In the next 12 months, we may see this relationship reversed. If this materializes and if the US dollar reverses its long-time uptrend, international investments, both in stocks and bonds, may start to look attractive.

If you’re looking for a counter argument, look at CEO and CFO confidence indexes. They both point to a recession. The top executives have been exceedingly pessimistic about the earnings potential of their companies. But judging by solid consumer confidence, strong financial conditions, improving housing sector, low interest rates and a dovish FED, I would caution for slower days ahead, but not for a recession.

What’s Next?

When you look at the “US stock market”, represented by large indices such as the S&P 500 or Dow 30, the picture looks peachy, but that can be misleading. Usually, strong market performance is led by small caps, financials, and emerging market stocks, with globally 80% of markets above their 50-day moving averages while yields rising. This time around, none of the above boxes have been checked. That being said, stocks tend to close the year on a positive note after a strong first quarter. As for the fundamentals, a mediocre earnings season is already priced in.
Given the tune the FED chairman has been playing, certain sectors such as tech and communication, energy, consumer discretionary and dividend paying quality stocks may still have legs for an up-trend. At all-time highs though, I would look for down periods and/or times of pull back to add exposure to these areas. In fact, I would like to leave you with this consideration: Complacency has reached levels usually seen before a correction. So yes, unfortunately it is a mixed bag of data in front of us.

Thank you for reading my newsletter. I hope you’ve found it a fun read and informative. Please feel free to reach me with questions and comments on bbakan@shieldwm.com.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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2019…And the Plot Thickens

“Get your facts first, then you can distort them as you please.” Mark Twain

“There cannot be a crisis next week, my schedule is already full.” Henry Kissinger

According to the Chinese calendar, 2019 is going to be a Pig year and since it is a water animal, it can be as murky and confusing as a mud pile, or as clear as Lake Tahoe. Today, I will attempt to turn the murkiness of the current market conditions into a clearer picture. My goal is to share relevant facts without distorting them, and make useful and actionable forecasts…so, let’s start.

Quick Wrap Up of 2018

Last year presented a typical case of a late cycle, a nowhere to hide scenario for most investors. Major asset classes, like stocks, bonds, commodities and precious metals, either lost money, or at best stayed even. In hind sight, had you bought a 1-year CD in Jan 2018, you would have beaten most professional money managers.

The usual suspects are trade wars with China, FED tightening, the Brexit mess and fears around a maturing economic and market bull cycle.

While this is true for the US, which seemed to have decoupled from the rest of the world, the global picture is bleaker. Industrial countries like Germany, Austria and Japan have posted negative economic growth numbers towards the year end, Australia’s real estate bubble had burst, emerging market stocks lost over 30% from peak to trough, and political uncertainty had been elevated.

As a result, even though year-end numbers don’t look too dreadful, we saw two waterfall declines during the year, the latter pushing major indexes to a bear territory. This downtrend, as usual, hit the winners of the previous cycle’s big winners the most, and those who argued President Trump was good for stocks, remained quiet for the big part of 2018.

A Roadmap for 2019

For the reasons mentioned above, the risk aversion levels have been elevated, and as a result, yields dropped, helping fixed income valuations recover. A case in point can be the 1-year high valuation of a popular investment grade corporate bond Exchange Traded Fund, symbol LQD.

But if risk aversion levels are elevated, what is the cause of the recent rally in the stock market? Two potential reasons:

1 – Technical: It isn’t unusual for initial panic selling to follow a bounce back, but only to retest the initial lows after.

2 – Fundamental: FED chairman Jerome Powell’s words on a “patient” FED has triggered the oversold rally.

Is it sustainable? Highly unlikely. Why?

Because even with a patient FED, the monetary base is still in Quantitative Tightening mode, not only in the US, but in more than 50% of the central banks across the globe.

From a technical view, in similar cases of 2000 and 2015, a bear market rally followed the initial waterfall decline, then a retest of the initial lows, and the resumption of the next bull cycle after capitulation. If we are experiencing anything like the years mentioned above, it wouldn’t be surprising to see more volatility for the next 6 months, and a recovery to follow after.

The Economy and Market Implications

The most recent Economist issue (Jan 26th-Feb 1st) cover probably says it all: Slowbalisation. Currently, the US economy is doing just fine, but the future is pointing to a slower growth. Here, we need to be clear with our terminology. Slow growth doesn’t mean a recession, recession doesn’t mean a depression, and depression doesn’t mean a crisis (don’t want to upset Henry Kissinger). The US economy seems to be far from a recession, but Leading Economic Indicators (LEI) signal for a slower growth. The US Q4 Gross Domestic Product (GDP) growth rate will likely be announced around 2.7%, much lower than the 3.4% in Q3.

I have looked up past periods of extremely low unemployment, and in all cases (1953, 1957, 1970 and 2000) a recession had followed. When I look at current valuations and sentiment, I liken it to the conditions of 2000, which was followed by a recession in 2001.

According to the IMF and OECD, global economy is expected to grow at a rate of 3.5% in 2019, isn’t that great? Not really. Global economy almost never experiences a recession in its most technical sense, which is negative growth two quarters in a row. The only exception to this since World War II was in 2008. According to OECD definitions, global growth rates below 3% is considered recessionary. The IMF is much stricter and conservative in this matter. But when we include the World Bank estimates as well, we can conclude that a global economic recession is not likely in 2019. According to Ray Dalio, the manager of the largest hedge fund in the world, 2020 will be when the rubber will hit the road, and he may very well be proven right.

So, one might ask, if unemployment, sentiment, valuations and stock market action remind us of past periods which were followed by a recession, why is this time expected to be different? Maybe it won’t be, but one tailwind for the US economy is credit conditions. The US is a debt driven consumer economy and as long as there is room for more borrowing, and the cost of carrying loans hasn’t started hurting new purchases, one lesson I have learned from being a market participant for many years, is to never discount the US consumer’s appetite for consumption. The recent rise in oil prices have improved corporate loan quality (these are highly leveraged businesses and they make a huge impact on the web of corporate financing) and the spillover effect is the improved loan quality.

Due to rising risk aversion, a shift from stocks to bonds, and fears of an economic slow-down, 10 year treasury yield unexpectedly dropped form 3.2% to 2.7%. Lower yields relieve the FED from its highly anticipated rate increases this year, and allow it to be more patient as Jerome Powell puts it. Another data point that makes me question the probability of rate increases, is the low inflation rate of around 2%. After years of quantitative easing, low unemployment, rising wages and economic growth, one would surely expect higher inflation. So, why not this time? Because most likely, the name of this uncharted territory is called the Amazon Effect. Each time the price of a particular good goes up, someone somewhere steps up to the plate and provides it at a cheaper cost online. The jury is still out in this discussion but automation and globalization have been a huge weight on inflation and even after 10 years after the 2008 debacle, deflation is still more of a serious threat to economies than inflation.

It would be a sin to not talk about China when discussing the global economy. I have already mentioned the problems Germany and Japan are in, but the biggest contributor to global economic growth has lately been producing forward looking indicators (PMI) pointing to a contraction in growth as well.

One bright star in this gloomy sky, has surprisingly been the UK, but I believe it is due to production that is pulled forward as a preparation for the Brexit approaching fast (or not…who knows?).

As market volatility rises and global economy starts looking gloomier, safe heavens like gold, Japanese Yen and Swiss Franc may benefit and so by definition, dollar may fall, which also may make non-dollar denominated investments more attractive, i.e. international stocks and bonds.

Summary

If this downside correction will look anything like past similar cases, valuations and investor sentiment need to drop a lot more before setting the conditions for the next bull cycle, and it is fair to expect a retest of the lows within the first half of the year and a recovery in the second. So, it’s probably wise to start the year defensive, and to switch and switch gears in the second half. In US sectors, chose non-cyclical and defensive areas like consumer staples, utilities and health care during the first half and switch to more cyclical sectors like tech, consumer discretionary and financials in the second. All of the information above are educated guesses, and your personal goals and risk profiles have to be added to the mix. So, what ever you do, tread carefully and consult with a professional.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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It’s Official: Correction is Here

 

 

“Nature abhors a hero. For one thing, he violates the law of conservation of energy. For another, how can it be the survival of the fittest when the fittest keeps putting himself in situations where he is most likely to be creamed?” – Solomon Short (David Gerrold’s alter ego, a Star Trek writer)

 

The late September, early October market highs in stocks, may be this year’s all-time high in stock values. This is not due to the US economy doing poorly, or companies reporting dismal results. The stock market is forward looking, and so with rising input, financing and labor costs, along with a slowing down of global trade, European Union troubled with Brexit and Italy, China still on controlled slow down mode, equity investors are having a hard time finding bright spots. One thing is for sure, that the volatility is back and major indexes have touched the correction territory.

It’s a military tactic to know what not to do before everything else, because most importantly, you have to be alive to win battles and wars, and small mistakes can be deadly. In this market environment: don’t try be a hero. Unless you’re a thrill seeker, do not try to time a bottom and get in a concentrated position, because that low may be proven to be not low enough.

General Outlook

The US economy is currently doing well with a 3.5% GDP growth, but the World economy is pointing to a contraction in a year or two. The latest OECD Euro Area Composite Leading Indicator is at 99.6, and anything below 100 signals future negative growth. The US has been the lonely figure on the dance floor and usually when that happens, either the music stops, or more people join the dance. It seems like the former to play out coming into 2020. Or alternatively, growth may slow down to a 2% rate.

In the developed world, unemployment rates are below what would historically create inflation, and the US inflation rate is at 2.1%. Lower inflation rate is attributed to lower commodity prices, technological advancements and globalization, but the signs of a rising inflation have started to appear. This will be truer in the US, especially if the US dollar has peaked and commodities have bottomed.

The US bond prices are in a bear market with yields at current levels. The FED is no longer deemed accommodating, but rather on a neutral position. Combined, this puts pressure on stock prices as relative valuations become less attractive.

A recession in the next 6-12 months is a low probability, but is this good enough? Stocks tend to lead the economy by 6-12 months, so to say that the economy will survive next year may not be a compelling argument for equity investors.

In short, stock investors are confused about the future of corporate earnings. They haven’t given up on stocks yet, but there are serious questions and this doubt creates a tug of war. President Trump’s unwarranted comments on FED actions, and his tariff wars are only making things worse.

For those looking for a silver lining, here is a decent one: stocks typically climb a wall of worry. A case in point, in 1968, Martin Luther King Jr. and J.F. Kennedy were assassinated, USSR invaded Czechoslovakia, there were riots across the country, and the S&P 500 Index had risen 7%. The absence of worry, overly confident investors and frenzy usually is a better indicator of a waterfall decline. When investor worry about a bear market in stocks, that is usually a cause of volatility, but not a full out bear, especially during a time of strong economic growth. As mentioned before, this doesn’t mean go out and try to catch a falling knife, but rather adjust your portfolios for a volatile environment until the dust settles, which may take a few months.

More Warning Signs

There are other concerns for equity investors. The growth sector leaders have also been the leader of weakness, while defensive sectors have shown stronger resistance. This is a typical risk off move. The question is its sustainability. From here, the market usually either sees opportunities in growth areas and this trend reverses itself, or it turns into a bear market.

Rising bond yields, which since 2008 have been associated with a strengthening economy, started to spook stock investors. Globally yields are still low, there is still plenty of liquidity, so one might be skeptical of this analysis. The point I am trying to make, is that higher yields create a double whammy. Higher financing costs and rising relative valuations may have come to a point of hurting stocks.

Usually in a rising rate environment, bank stocks offer a place to hide, as a steepening yield curve translates into higher bank profits. Unfortunately, not this time, not so far. Global worries have been pressuring the long end of the yield curve while FED rates have been pushing up the short end, creating a flatter yield curve, and as a result hurting bank stocks.

Year End Rally and Elections

One action to look forward to in an annual cycle, is the year-end rally. Especially after the mid-term elections, the expectation of political certainty and a stimulus package push stock prices up. This year, the stimulus package, in the form of tax cuts, have already been priced in. In addition, the chance of political uncertainty with a divided government, is also a probable outcome. So, we may see a rather muted Santa Claus this year, if at all.

Tariffs

This is an easy one: tariffs are bad, period. It raises costs for everyone, and hurts economies. If you don’t believe me, ask the people it was supposed to help, like Ford and Harley Davidson. They are forced to lay off workers or go offshore as a result of higher input prices. This, if insisted, can wipe off all the benefits of tax cuts, and we would be stuck with a historic budget deficit with no upside. China is the second largest economy in the world, and the US exports to China is a little less than exports to Germany, UK and France combined. But more importantly, tariffs hurt business confidence, which may lower future capital expenditures, a key driver of economic activity.

Stock Buybacks and Capital Investments

A big supporter of stock prices has been corporate buy backs. How big you say? $560 billion big in the last 12 months trailing June 2018, an all-time high (Source: S&P Capital IQ). The question is, can or will it continue? For reasons shared above, corporations may put a halt to this, or slow it down. With the uncertainty created by tariffs, lower CEO confidence may elevate risk aversion and cash positions.

On the Plus Side

The good news is, a lot of this is already baked in the cake. The question is, how much more bad news is in the pipeline? Usually bear markets follow extreme optimism. Volatility index at 25, and when Nasdaq records daily 4% losses, that’s a hard one to argue for. The recent price action to the downside may be a process of shaking loose ends, creating better valuations and attracting new buyers. Let’s not forget; the FED may not be accommodating, but it is not restrictive either. Its neutral position is accompanied by still  easy central bank policies in Japan, UK and Europe. In addition, the credit conditions index, which is probably the most important factor in a debt driven economy, is not signaling capitulation to a level of a looming recession.

The US economy may extend its growth past 2019. The notion that this has been the longest expansion, is looking at the wrong side of the equation, as it also has been the slowest. The longest GDP growth period in the US was during 1991-2001, 120 months of straight growth. The current cycle is 113 months old, but much more importantly: the aggregate GDP growth during the longest cycle, was 42.6%. The current cycle GDP growth is 22.3%. So, there is still a lot of room to grow for a tie breaker.

Summary

Recessions start because of over investment and dropping demand as a result. Bear markets in equities lead recessions by a few quarters, and usually start with very few buyers left to invest. Both conditions occur during extreme optimism. Currently, we lack this ingredient to call for a full-on bear around the corner. But even still, for the reasons outlined above, equity prices may need to go through a re-balancing phase and create even more pessimism before igniting the next thrust to new highs. Until then, there is nothing wrong with playing defense.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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…And Now, The End Is Near?

“The sun is gone, but I have a light.” – Kurt Cobain

 

For years now, market participants have been arguing on whether or not “the” market top has been seen. So far, those who had suggested “a” market top yes, but not “the” market top have won the argument and prevailed. That being said, “this time”, both economically and market wise, it appears likely that we are in the later stages of a growth and bull cycle.

This conclusion may be easier to reach compared to the timing of a correction that could follow it. I am watching multiple “big money” sources, and all I see is a wide spread agreement on a tiring up trend, but hugely different projected time lines of a reversal.

Well then, what do we do now?

The Sun is Gone

Since 2008 global financial crisis, central bank balance sheets have grown from 3-5 trillion dollars to 15-20 trillion, China included. This 12-15 trillion created out of thin air did pull the global economy out of a deep hole and some but, has also created a dependency on easy money.

In short, FED driven expansion days are over. We all need to tattoo this on our chests backwards so we can read it in the mirror as a reminder every morning…and drop our habits developed in the last 9 years relying on it. Party bowl is gone and it’s time to sober up.

The direct effect of easy money policies has been stretched valuations in most asset classes. You can see this in your stock portfolios, real estate and speculative investments.

The good news is, that the global economy is still growing, valuations came down a bit from highs due to the drop in Feb-March of this year and forward earnings are closer to historical averages. Plus, just because the monetary easing has stopped and tightening has been resumed, it doesn’t mean liquidity has dried up. There is still plenty of cash hovering around globally.

You might ask: How much longer can the economies grow, and what if forward earnings disappoint?

The answers are: Probably not for much longer, and a correction would only be natural.

But I Have a Light

Yes, the FED sun is gone, but there is still plenty of light. The global growth is in tact and a recession isn’t an evident threat in the short term. Pro-growth policies are gaining traction, interest rates are still low, consumer and business confidence are high. On the cons side, populist rhetoric and policies, trade wars and anti-immigrant sentiment raise political risks, which can override the positives rapidly.

Just when the volatility has risen, inflation is looming, currency fluctuations are hurting trade, oil price is up and FED is in a tightening mode, the last thing markets need is irresponsible and short sighted political outbursts.

Had I just focused on newspaper headlines, I would say liquidate all your holdings and start planting tomatoes cause a third world war is looming. Luckily, there are plenty of reliable indicators suggesting that things are not that bad.

Here is a critical question in that regard: which single data point has the highest probability of predicting a recession in the US? Like any other question in finance, you’ll get many different answers to this but I agree with Ray Dalio, the manager of the largest hedge fun in the world, Bridgewater. He argues that the debt service ratio is the most important single data point as we live in a debt driven consumer economy. The end of a growth cycle usually comes with a debt service ratio high enough to hurt consumption. In other words, once the interest payment on the loan starts hurting new purchases, that’s when the party ends. Business cycles and equity markets are driven by this phenomenon. Without further ado, let me share with you that current debt service ratio in the US is at all-time lows, consumer balance sheets are healthy and household net-worth is at all-time highs.

What’s the Game Plan?

It’s a military rule, that strategic mistakes can not be remedied by tactical moves. Meaning, if you have your longer-term objectives, plans and action items lined up ineffectively, short term shifts can not bring ultimate success. So, first lesson from this is to make sure that you, or your financial advisor, wealth manager, financial planner etc…understand your long-term goals and your portfolios are adjusted accordingly.

The key thing here is to focus on asset classes more carefully then securities within in it, because 70% of a portfolio’s returns come from asset allocation decisions.

Once your asset allocation (stock, bonds, cash, alternatives) fits your long term strategic goals, then in the next 12-18 months, each time you see a high in the stock market, consider using that as an opportunity to lower your risk exposure from stocks to bonds, from international to domestic equity, from cyclicals to non-cyclicals.

Most likely, before the bear market hits, selling your long-time winners, triggering capital gains taxes and investing in potentially low performing investments won’t “feel right”, but once the bear market losses start creeping in on your statements, that feeling speedily reverses.

As far as the timing goes, it is close to impossible to know when the bear will attack, but it’s probably fair to say that sometime within the next year or 2020. We may see a seasonal summer weakness ahead, higher volatility approaching the mid term elections, and a recovery during the seasonal Santa Claus rally.

But looking at the correction in 2015, let’s remember that the recovery at year end was reversed during the following January in 2016. This time around, that reversal to the downside has the potential to has a longer duration. To be fair though, the worst year in a 4-year presidential cycle is the current second year and the best year is the third, which will be next year in 2019, so there is still some things to be hopeful about.

The Key Factor

I was working at a bank during the Nasdaq bubble and at a money management firm during the Global Financial Crisis in 2008. In both cases what I have observed is, that from trough to peak, a buy and hold equity portfolio recovered its losses 5 and 4 years respectively (based on S&P 500 returns). For a risk adjusted, diversified and rebalanced portfolio, that time span was halved.

More importantly, those who got out at the wrong time, missed the fast run up following the drop. So, in other words, your stocks, bonds, cash and alternatives asset allocation, shouldn’t force you to sell at the worst possible time.

In fact, those are the times, in hindsight, appear to be the best times to start buying. The key is to be able to stay invested for the long term.

 Summary

A peak in the economy and equity markets might be near. Timing the reversal of the uptrend is extremely difficult, if not impossible. So in the next year or so, you might want to consider lowering your risk levels during up swings to a level that will not force you to sell during the correction

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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It May Get Worse Before It Gets Better

“Life can only be understood backwards; but it must be lived forwards.” – Soren Kierkegaard, 1813-1855, Philosopher

One piece of the profit/loss puzzle of investments that is so easy to see in hindsight, is that market pull backs, or corrections present investment opportunities. The bigger the drop, the better the opportunity. Therefore, in theory, a successful investor would be happy to see market lows, but that’s not how the story goes for a variety of reasons. The hard part is how to keep your cool and implement this wisdom in the midst of crisis, fear and while losing the market value of your invested funds.

Has the market bottomed? Is it time to buy? If you act too soon to buy, you may find yourself catching a falling knife. If too late, you’ll risk missing the profit train and kick yourself, thinking “I knew I should have bought it then.”, only to repeat this pattern again. Plus, what if this is the beginning of the next bear cycle? How do you know?

“Don’t fight the trend” and “be wary of extremes” both offer sound advice, but how do you reconcile these seemingly conflicting strategies?

Bring it Home

After a steep uptrend till Jan 26th, within two weeks major stock indexes lost over 10%, stepping in correction territory by Feb 8th. From there, prices bounced back up, gaining more than half of their losses by March 9th, only to visit the same low point as of this newsletter is written, at the end of March.

First, you have to use every opportunity to learn and evaluate your actions of the past. It is not too late to go back and see what you’ve missed. In fact, it’s mandatory for future success. If you can’t make sense of what has happened in hindsight, how can you live it forward?

You could have lowered stock exposure, re-balanced to your target weights, limited exposure to higher risk (beta) investments, and potentially raised some cash when the market was significantly overvalued and way above trend lines (some charting and technical analysis come in handy here). Probably towards the end of last year or the beginning of this year was the sweet spot. Yes, this is in hind sight but it does have some forward-looking remedies embedded.

If you believe this is the beginning of the next bear cycle, it’s never too late to start selling. (I am in the temporary and healthy pull back camp, which I will talk about next).

Second, you have to decide for your investments, whether or not the uptrend is still intact. What you’ll do next shall differ significantly from an investor who is convinced that a bear trend has emerged.

Even though political risks have risen and the volatility has come back, the global economy is in its strongest phase since 2008, and central banks are still accommodating. There is very little to no inflation for the most part, and employment numbers are strong (at least in developed economies), so recent moves are probably healthy and needed pullbacks. In fact, the down trend may have to get worse before it gets better. It is true that economies and markets can and do act differently sometimes, but not for too long.

Recent pullbacks have happened so fast in either direction, the volatility didn’t leave enough time for investors to shake up their complacency. The counter intuitive aspect of markets is that excessive enthusiasm is a bearish sign, and the opposite is also true. This is where and how you can aim to reconcile the question we’ve raised above, of how to be friendly with the trend but wary of extremes. Balance, is the key to all…

Just as too much voracity brings over-bought conditions, extreme doubt usually brings over-sold. Now, comes the hard part: for this reason, you almost want to see things get bad enough to get greedy again, and so far, I don’t see it. By the time you read this letter, capitulation may have occurred, but as of now, even though shaken, investors are not fearful, yet.

Last two points, 1 – Bull markets don’t die of old age and can resist recessions. Two of the last long term (secular) bull markets were between 1949-1966 and 1982-2000, 17 and 18 years respectively. Our current bull cycle is now 10 years old. 2 – The stock market is a leading economic indictor and usually signals economic recessions. Currently, a recession is a low probability event, and so by reverse engineering, a bear stock market.

In short, we may see a bit more volatility and down pressure before the next uptrend resumes, but when viewed as a technical pullback within the later stages of a bull market, recent action is/was probably a needed shake up.

Update on 4/2/18: After today’s (Monday) deep drop, the S&P 500 index has broken it’s 200 day moving average. If you needed a bearish sign, this should be on your list. My overall claim is intact, but with a tighter leash.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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2018: A Challenging Year Might Be Ahead

“Whatever has the nature of arising, has the nature of ceasing.” – The Buddha

 

First thing first: I hope you had a wonderful Thanksgiving with your family and loved ones, and wish you a great Holiday Season, Christmas, News Year….under whatever name, shape or form you enjoy celebrating. My usual attitude I have adopted from a longtime friend is: “Is there something to celebrate? What are we waiting for?”

If you have read my previous newsletter, you might recall the above quotation and might be wondering if I have forgotten something. No, I haven’t. When I sat down to produce this quarter’s letter, I realized that I couldn’t have found a better quote, so I kept it.

As we’re approaching a new year, following a period of strong performance, many of you are probably nervous or wondering if a deep correction is due. Common questions are: Is this time to sell? Is there more room for growth? Should I invest now or wait for a downturn?

For those looking for quick answers: not yet; probably yes; and what about dollar cost averaging?

It all depends on your goals, time horizon and risk appetite. To demystify my answer, let’s dive in.

Cry Wolf

The current market regime we are in might be best described as the “most hated bull market in history.” For years, many participants have been calling for a correction and yet here we are, with solid returns.

I can not tell you how many client meetings I have had since 2011, making a bullish case, settling a client’s nerves, who had just read a report suggesting that huge losses were ahead.

There is actual research showing that some republican leaning investors had missed out on the “Obama rally”. It looks like now it is the democratic and liberal leaning investors’ turn to sit on the sidelines and watch the market that they so “hate”, to run up.

Looking at valuations and extreme optimism, is this “the” time to go out and save the shepherd from the wolves? If we do so, will we look like fools, again? There is a third way.

Don’t Throw the Baby Out with the Bathwater

There is plenty of research that shows that the majority of portfolio returns come from asset allocation decisions. In other words, whether or not you will be invested in stocks, bonds, alternatives or stay in cash, is the most important decision. The effect of security selection, is miniscule compared to this very fundamental decision.

That being said, like most things, it is not black and white. You should make buy all, or sell all decisions. Better said, fine tune your asset allocation, to fit the current investment regime.

We are not bound to decide whether to fully get out of the market, or blindly stay in it. Instead, we need to keep our eyes on current market drivers, pay close attention to our time horizon and investment goals, and make adjustments accordingly.

Current Market Drivers

I am fortunate to serve many clients who are smarter and better educated than myself. One of them once told me “I don’t get what you’re doing, it seems so complex.” Coming from a man with a PhD in computer science, I was humbled, but to tell you the truth, it isn’t all that complex, it all boils down to:

  • Markets go up because there are more buyers than sellers.

 

  • Economies grow because more money is spent this year than last.

So, the two most important components are: 1 – How much money is out there? 2 – What is the investor/consumer sentiment? In short, it’s all about the FED and psychology.

How about valuations? Research shows that valuations are better indicators for long term (5-10 year) returns, but have a terrible record for shorter term (1-3 year).

The FED, crowd psychology, the economy and politics are undoubtedly interrelated but the end-result on investments has to be separately and carefully analyzed.

We still have a friendly FED, an overly optimistic crowd, a strengthening economy and a market friendly tax bill on its way.

Not too shabby, however the key word here is “overly”. In spite of Keynes’ famous quote “Markets can stay irrational longer than you can stay solvent.” overly optimistic sentiment usually gets punished shortly after.

So…2018?

If you think I am giving mixed messages, that’s because I am. On one hand, I know that when the FED is friendly, the crowd is optimistic, the economy is strong and politicians are market friendly, fighting against this picture is foolish.

On the other hand, looking at historically high valuations, very little cash sitting on the sidelines, and extreme investor optimism, this might be the time to give the shepherd who cried wolf, the benefit of the doubt.

Action Items

How to reconcile these two sentiments?

  • Clarify the purpose of your investment. If you have a long-term goal, short term fluctuations shouldn’t scare you away from investing, but if you may need these funds within a year, this might not be the best time to get in.

 

  • Brace yourself for volatility. 2018 probably has one or two 5-10% pull back(s) built in to it. So, consider how to lower stock exposure, raise cash, or prepare yourself to ride the roller coaster, and have a 10% drop in US stocks as one of your what if scenarios.

 

  • Make sure you’re diversified. Usually, what went up the most, comes down the fastest. In the current case, it is the tech stocks. Make sure your tech stock exposure is in line with your risk appetite.

 

  • Have some international exposure. While the US FED is raising rates, European and Japanese central banks are still in their easing mode, most likely till the end of 2018. These countries, along with Emerging Markets may offer better value.

 

  • If you’re overly concentrated in any particular security, look for strategies such as put options.

 

  • Don’t be afraid of raising cash.

 

  • Watch for earnings because the market is priced for perfection and a negative surprise could be the black swan in the lake.

In Short

2018 will likely end up being a positive year, but returns may be muted and may come with volatility. So adjust your strategy accordingly.

Thanks for reading my commentary and as always, you can reach me at bbakan@shieldwm.com for questions and comments.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.

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