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Both Pedals to the Metal

“I pretty much try to stay in a constant state of confusion just because of the expression it leaves on my face.” Johnny Depp     

“The monotony and solitude of a quiet life stimulate the creative mind.” Albert Einstein

I would like to start by apologizing for not writing my newsletters lately in their usual quarterly frequency. This has been an unusual year for many reasons, one of which is the time I have spent finishing my first book titled “Stop Overspending.” I am lucky enough to be asked the reason for my silence on the newsletter front, and this is one reason why. I will send a link to it once published, which is going to be in the next few months, and I hope you’ll enjoy reading it.

We are in an election year, at the tail end of a vulnerable 11-year economic growth cycle and an aging equity bull market, shaken by a pandemic and full of environmental disasters. It is extremely difficult to make a sense of it from a market analysis point of view as it is full of unprecedented events. If we can’t compare a data point against historical trends, what we’re left with is speculation and guesswork.

The list of events that start with the phrase “first time in history” is quite long. We have never seen the global economy and markets voluntarily shut off as swiftly as it was, for a common reason that is shared globally. Similarly, the fiscal and monetary response to this has also been unprecedented. The FED, having learned valuable lessons from the 2008 Global Financial Crisis, swiftly came to an aide, and the first time in history, purchased corporate credit to keep the bond market alive and functioning. The 33% US Gross Domestic Product drop in the second quarter, was among many unprecedented adverse economic consequences of Covid-19.

The stock markets around the globe reacted with a waterfall decline which only took 24 trading days to the bottom in the US. To gain a context, compare that to the Nasdaq tech bubble in 2002 and 2008 Global Financial Crisis, both of which took approximately 2 years to unfold.

After a few months of the Covid-19 induced economic collapse, April marked the bottom of it and so far, we have been seeing a V-shaped economic and market recovery in the US. The FED announced that the damage has been half of the initial estimates. As popularly expressed, the shape of the economic recovery, whether V, U, L, or W shaped, typically starts to form/differentiate approximately 4-5 months after the bottom is seen. In other words, the turn the economy is about to take in the next few months carries the potential to determine the overall shape of the recovery. As a result, market participants (including yours truly) are trying to figure out what next is about to unfold. Whatever happens, will likely happen with speed and volatility. These days, because of algorithmic trading and more widely used Exchange Traded Funds, what used to be once in a lifetime events such as circuit braking market moves, can be seen twice in a week.

The golden rule we all memorized after 2008 is, don’t fight the FED. Now, we can revise it and add the word “globally” somewhere in that phrase. When a total of $15 trillion is being injected in the global economy, and there is surely more to come, how bad can things turn out?

On the flip side, most data show an expensive stock market and a nervous consumer, usually not a good combination. Some people point out that we’ve only recovered roughly half of the economic fallout and there is more growth to come, a likely reason for the strong recovery in the major stock indexes. Others rightfully bring our attention to how narrow the recovery has been, simply isolated to large US growth stocks and tech giants. If you remove these two parts from the equity habitat, you’ll be left with a much less promising picture.

In summary, current conditions give signals that create faces like Johnny Depp’s, and rightfully so. Let’s look at some of this data.

The US unemployment rate prior to the Covid-19 pandemic was around 3%, which is considered as full employment. Within a matter of weeks, it jumped over to 14% and it’s now down to 8.4%. So, on the employment front, half of the damage is recovered. To those who don’t believe in the economic recovery, I suggest they look at the Purchasing Managers Indexes (PMI). A recent reading came from The Markit Flash US Manufacturing PMI at 53.5 (above 50 indicates growth), its highest level since the beginning of 2019. In English, the manufacturing sector is growing at its fastest paste in the last 18 months. When we look at services, the bigger of the two, it is at 54.6, even better. These numbers, accompanied by historically low interest and inflation rates, should translate into business optimism but because of uncertainty caused by the upcoming elections and the future possible developments in the Covid-19 pandemic, we don’t see it this time around. Speaking of low interest rates, we would be remiss if record level mortgage applications and the spike in the new and existing home purchases, as a result, weren’t mentioned here.

To the economic fallout, the fiscal response so far has been a $3 trillion stimulus package, and we know more is on the way, somewhere close to another $2 trillion. How big are these numbers? Let me put it this way: the total cost of the 20 years of war in Afghanistan and Iraq, is $3 trillion, which is now spent in a matter of months. That big…

The stock market waterfall decline was followed by the quickest recovery on record. The Dow Jones Industrial’s average bottom to new-high recovery speed is 48.6 months (Source: NDR). So, it’s roughly about 4 years. Current recovery speed? 5 months, from the end of March to mid-Aug!

That’s the pedal to the metal type of good news, but here is the catch: the current SP 500 forward price-earnings ratio (valuation measure) is only matched by the figure in 2000, which was followed by the famous tech bubble bursting bear market. That’s one reason why the breaks should be kept close by.

Should we then overweight bonds? Well, here is another first time in history type of an event, the US real interest rates went negative. So actually, compared to bonds, stocks are cheap, even with the above-stated valuations. So, should we then overweight stocks? Well, the stock market may easily reverse gears and start a W shaped trend if the market breadth (how wide the recovery is) doesn’t improve any time soon. As mentioned before, only a small number of stocks are carrying the weight. Not an easy decision to make between the two, stocks and bonds.

As I am typing these lines away in the historically weakest month of the year for the stocks (Sept), I am also getting ready to watch the first presidential debate. Stocks on average close the election year with losses if the republican incumbent loses, and strong if the opposite materializes. In the year following the election year though, the complete opposite is true. The first year of a democratic president, stocks on average recover their losses and more but may show losses with a republican president. In short, if Trump wins, stocks may move higher for a few months and then lose steam. If Biden wins, we may see a downtrend till the end of March, and see a strong uptrend, if of course, history is our guide.

In the long run though, stocks perform the best with a democratic president and a split congress, 8% on average. A republican president and a split congress annual average performance is a loss of 4.7%. So, each scenario creates its winners and losers for the short and the long term.

In short, these days, I would keep my long-term objectives close to my chest, place one foot on the gas and the other on the breaks while some cash is stashed in the trunk to be able to maneuver in any direction, as the short and near term is quite murky.

With that, I wish you to stay above all safe and healthy, and away from the Covid-19 virus spreading in our communities.

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.

 

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Once Again, It’s the End of the World

“The two most important days of your life are the day that you’re born and the day that you find out why.” – Mark Twain

“In three words I can sum up everything I’ve learned about life: it goes on.” – Robert Frost

The most popular question these days is: when will life get back to normal? The most accurate and honest answer to that is: no one knows. Especially when dealing with a novel virus with no vaccine, and the immunity levels of the people with antibodies unknown, making predictions seems like a fool’s errand, and yet, we can’t stop thinking about it because everything else depends on it. Let me present a case below, on how expectations and the outcome can fall on exactly opposite directions.

I remember 2008 vividly, as it was the biggest financial crisis at global scale since the Great Depression, and the proposed solutions were hugely speculative and polarizing. For people living in the U.S., projections for the following decade looked quite depressing. Many claimed that the 20th century was shaped by the U.S., and the 21st would be shaped by China. With stimulus packages and bail out programs, privatized gains and socialized losses, it was seen as the end of capitalism. Risky FED actions were believed to carry the potential to create hyperinflation, kill the dollar and so for many, hard assets like commodities and land values were set to sky rocket. Headlines read that 2008 was the beginning of the U.S. empire’s decline. Gothic barbarian horde broke through the city walls and nothing would be the same, ever again.

What happened in the following decade between 2010 and 2020?

The U.S. share of the global economy grew from 23% to 25%.

In 2010, 3 of the largest 10 companies in the world based on market value were American, today that number is 7.

Globally, newly issued dollar denominated debt grew from 60% to 75%.

The U.S. stock market value went up by 250%, Chinese stocks by 70%.

(Data Source: Foreign Affairs, May/June 2020 Issue, Pages 70-81)

Dollar is even stronger and more widely used today, while its competitors like the Euro and renminbi have declined in value. In the case of renminbi, without the Chinese capital controls, its value would be a wild guess.

And finally, contrary to expectations, the U.S. had its longest economic growth period in history.

So, it is probably fair to say that the U.S. had a golden decade by most macro factors. The biggest contributor to economic growth is productivity. The biggest contributors to productivity are innovation and the ratio of working age population. In both counts, the U.S. has a huge advantage compared to its rivals, so the golden era can continue in the next decade as well. The threat to this is our own road blocks to it, such as stopping immigration, a source of working age generations, or trade wars.

Today, the mood is similar. The novel corona virus has shut down economies globally. Many speculate that it will take years to come back from this, consumption habits are changed for good, the way business is done will change, governments are piling on to unsustainable amounts of debt, a second and third wave in the pandemic will inflict an even larger damage, our privacy is irreparably compromised, and nothing will ever be the same.

I disagree. As for what is fundamentally and truly human, nothing will change, and life will go on. This experience may actually remind us of what that means. As for the details, it is impossible to guess, as the decade following 2008 has shown us. This much can be said about economic crisis and the market reaction though: the speed of a decline, is usually a good indicator of the speed of the recovery as well. This time around it will most likely take longer given the cyclical nature of a virus but even so, the global concerted reaction to contain it, is something we have never seen before either.

The Roadmap Ahead

In the next 12-24 months, we will witness life slowly getting back to normal. I am sure of it. How? It will either get back to normal, or we will adapt to the new normal, feel like everything is normal, and move on. Do you want proof?

During the 2008 debacle, Larry Kudlow had a show on CNBC called Face the Nation. He famously criticized the Obama administration for the stimulus packages and bail out programs of the time, called it the Bailout Nation (maybe he wasn’t the first person to use it, but he made it famous, I think). Today, he is the Director of the U.S. National Economic Council under the Trump administration, introducing programs dwarfing Obama plans in size, and yet, you don’t hear a huge out cry. Why? Because the Modern Monetary Theory, which simply says print money until you hit inflation, has become the new normal since 2008 even for those who were against it. After a few years of hesitation, it is widely accepted today, including by the fiscally conservative Germany. Similarly, a new normal will enter to our lives and we will move on until the next crisis. Another example in our lifetimes is 9/11. It was supposed to kill the airline industry, as nobody would fly under the new stricter rules, and yet what happened? Airline travel sky rocketed in the years that followed.

After claiming that it is impossible to know the future, here is my attempt to draw a roadmap for what is to follow. After all, it’s my job to do so, and I hope you find value in it. There are 3 stages to normalization. Starting with the virus, then the economies, and the markets.

First normalization will (have to) start on the virus containment. The initial step of “Hammer” i.e. Shelter in Place have been successful, and the curve is flattened in many places, even in Italy and Spain. Next, we will do the “Dance”, meaning, slowly open up our communities to economic activity. This will probably start as early as May or June, and will gradually expand until September, by which date, without a strong second waive, we will probably see even large sporting events to be on the list to resume. In the absence of a vaccine, which is highly debatable to be available to masses before early 2021, this gradual and controlled exposure to the virus is needed to gain herd immunity. In 2021, we will likely see a vaccine in mass production and by the summer of 2021, either as a result of herd immunity, or a vaccine, life will get back to normal for the most part.

 

The adverse economic impact of the virus has likely hit the bottom. In May, we will start getting April numbers and this will make us feel like the worst has yet to come, but even now, based on some current indicators, such as mortgage applications, gas purchases, air travel, businesses slowly opening up in parts of the world, local construction activity, we can extrapolate that gradual improvement in the economy will follow the easing of lockdowns. Will it be a V or U shape recovery? It depends on the economic structure of the area in question. Production related activities may see a V shape recovery, which means normalization by the end of 2020, or early 2021. Service related industries though, by their nature will take longer, all the way to the end of 2021. For instance, pent up demand for cars can be met with increased production, but lost revenues in a restaurant, school, hotel or a hairdresser aren’t recovered as easily because you won’t eat two meals to make up for the lost time. So, countries and areas where the service industry is the main economic activity, we will likely see a U or a square root shaped recovery or somewhere in between. In the U.S., services represent a larger part of the economy, so mid or second half of 2021 is probably a more realistic expectation for the U.S. to go back to pre-corona levels.

 

In the after math of the fastest and deepest Dow Jones decline in the first quarter, we also saw the third fastest recovery attempt on record. Most U.S. stock indices retraced half of their losses, which was unexpected in such a short amount of time. This tells us a few things. For one, there are enough investors out there who see this recent drop as a buying opportunity. Second, most of the panic selling is done. Third, if the initial March 23 lows is to be tested, it will probably be a shallower drop, and fourth, it will likely be a tougher climb up from here as we’re getting close to hitting resistance levels. It looks like the stock market is a bit of ahead of its self, which can result with either a pause or decline from here, but either way, stocks are already trying to price in the recovery scenarios mentioned above. In the last 13 similar waterfall declines, on average, it took a little longer than a year for a full market recovery. Now, after a month or so, we’re already half way there, which tells me, volatility is here to stay until the “irrational exuberance” dissipates. For those looking for a date for a full recovery, from the get go, my potential target has been the first quarter of 2021 and I am sticking with it. Everyday things change dramatically. When I first verbalized this to clients, it seemed awfully optimistic, but now, it sits better with other supporting data. If you are wondering why the difference between the market and the economic target, it’s because of the forward leaning nature of stocks, leading the economy on average by 6 months.

 

Let’s also not forget that this is an election year and if the economy takes as long as it is predicted to for a full recovery, with high unemployment and the economy in a recession, the uncertainty around the political climate can also create a headwind for the stocks. This is another reason why for my first quarter 2021 target for stocks’ full recovery. Now, if we rush into easing the Shelter in Place too soon and create the conditions for a second waive, all bets are off as it is an uncharted territory.

In summary, starting with the virus, then the economy and lastly the markets, it looks like the worst is behind us. Now it’s time to lick our wounds and move forward from here. Specific to investments, the hard part is not to jump too quickly because if this uptrend continues, it will likely be with pull backs along the way and opportunities. If it doesn’t continue though, March 23 was only a month ago so caution is still warranted.

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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Hind Sight is Twenty Nineteen

“You are in pretty good shape for the shape you are in.” Dr. Seuss

“It isn’t the mountains ahead to climb that wear you out, it is the pebble in our shoe.” Muhammad Ali

 

In this last newsletter of the year, I think it is suitable to start with a story involving Dionysus, the god of wine, ritual ecstasy and theater, as most of us will likely be engaged in a related activity in one shape or form, joining the spirit of the season.

According to Greek mythology, Dionysus’ foster father Silenus gets lost in the woods and brought to the Phrygian King Midas by peasants who found him. Midas recognizes Silenus, takes good care of him and delivers him to Dionysus after a few days of his stay. Dionysus, delighted with the kindness Midas had shown, offers him a reward for whatever he wished for. As a result, Midas was given the gift of turning everything he touched into gold, hence the expression “the Midas’ touch”. Although this gift does turn out to be problematic as Midas inadvertently turns his daughter into gold, that is not the part we will be focusing on today.

I thought of Midas because in 2019, almost all investments turned into gold, including gold, which is odd (further explained) especially given the fears of a recession and a strong bear sentiment seen in the beginning of the year.

We closed 2018 with a 20% loss in major US stock indexes and many questioned, as markets being a forward-looking indicator, whether or not we were headed for a 2008 like period. (I have to add a side bar here, because of this loss in 2018, 2019 returns look inflated. If you look at 2-year returns, you will get a better picture of your investment performance). To see strong market performance in investments that usually move in opposite directions, is unusual to say the least. In the case of gold for instance, which usually zigs when stocks zag, it had a decent year as many investors flocked to safety and turned to an inflation hedge at a time of low interest rates.

The usual worries that tend to weigh on markets didn’t matter much. Low cash, high stock allocations, high valuations, low economic growth, low unemployment and high political uncertainty was more than balanced with company buybacks and FED rate cuts. According to Goldman Sachs, in 2019 companies invested almost a trillion dollars (with a T) in their common shares. Where did this money come from? Two sources: tax breaks and repatriation from overseas funds. How much longer can this go on? May be not forever and not at this rate, but at least for another year albeit at a lower rate. As for the FED, we will most likely see a wait and see mode with very limited moves in either direction. With low inflation rates and strong political pressure, a dovish stand wouldn’t surprise anyone, but even so, a pause in rate cuts is more likely.

What to expect from 2020?

After turning his beloved daughter into gold, heartbroken Midas will most likely stay away from markets in 2020, but even so, a volatile and yet profitable year in the capital markets is expected. This is not painting a rosy picture by any means as I will discuss in more detail later but in short, as global economy recovers and yields move higher, stocks are poised for a year with single digit returns on major indices where as bonds may struggle with their negative correlation to yields (bond values go down when yields rise).

Those who have been holding their breaths for a recession will turn blue if they haven’t already done so, as the U.S. Gross Domestic Product (GDP) growth is expected to be around 2%. Not great, but not a recession either, which seems to be the story of the last decade; sluggish growth. Economies in Europe and Emerging markets may play some catch up as a result of pent up demand and central banks all across the world stimulating growth. So, even though valuations are still elevated, earnings growth is expected to continue. This can also be seen in the steady uptrend in the Purchasing Managers Index (and other leading indicators) pointing to improving production in the U.S. On the valuation front, those focused on absolute ratios like price to earnings, price to sales etc…have been blindsided by reasonable relative valuations compared with bond yields coupled with low unemployment.

Inflation expectations are muted across the globe, 2% range in the U.S. This will continue to pressure yields but with global economy improving, wage growth in the U.S. and low unemployment rates, yields may rise modestly. This move in yields may prove to be significant in bond and bond proxy prices as we have seen a bubble-like activity in this section of the market. So those who have been playing safe with bonds and bond proxies and have been handsomely rewarded on a risk/reward basis, may see their fortunes reverse. So, what to do then? Dividend stocks may be the refuge for income and especially in a total return (growth + income) basis. If not for an entire portfolio, but for diversification purposes.

International stocks may have an edge in 2020 not only because of (past due) catching up and better valuations, but also a weakening dollar against major currencies, especially in the Emerging Market space. Given the (now certain) Brexit process in Europe and UK, not knowing how amicable this divorce will be, it is hard to gauge currency moves, but purely on valuations, Europe is more attractive than the U.S. In the UK, depending on how different scenarios play out such as Scotland leaving the union or not, hard versus soft landing, the market performances are less predictable.

China and Russia, along with other Emerging Markets may see improvements in economic growth and GDP, especially Russia with rising (or stabilizing) oil and natural gas prices.

On US sectors, potential tailwinds exist for energy, healthcare, financials, consumer and tech sectors. This is due to rising oil prices for energy, discounted valuations due to political risks for healthcare, flat yield curve for financials, rising incomes for the consumer and a mega bull trend for tech sectors are set to play out in 2020.

If you haven’t heard already, we will have presidential elections in the U.S. The third impeached president in the history of the U.S. will face a Democrat challenger. Historically, in the years when the incumbent president loses, markets tend to be weaker, sluggish, even negative. Election years in general tend to be volatile and weak in the first half of the year, and recover in the second half and after elections as uncertainty dissipates. As seen in Brexit, markets prefer bad news over the unknown.

So, if you add this all up, a trading strategy may be to get your shopping list together and start getting in during February-September period. OR, as some strategist suggest, buy on Jan 1 and forget about it until Dec 31, depending on your taste of risk, and how much time you have for speculation.

CEOs’ Balancing Act

You may see this as the pebble in your investment shoe, but CEO confidence is one reliable indicator of recessions and down markets. Currently it is down at levels last seen in 1980, 1991, 2001 and 2008, ALL coinciding or followed by a recession. This is not a new development either as CEO confidence has been dropping for the last 2 years. So, while improving global economy is an underlying waive supporting stocks, this one pebble is one hell of a pain hard to ignore. With other late cycle jitters in the U.S. economy and markets, it tells me not to lose sight of risk in allocations, even though a more risk on sentiment is in the air. One way you can do this is by overweighting large stocks as opposed to mid and small, as they tend to experience bigger losses if a downtrend resume.

One last positive note before we part ways: US is in a unique spot with favorable demographic trends, mainly among the highest spending ages of 35 to 49. This is now the fastest growing segment of the population and will support sectors that are in this group’s focus for the foreseeable future. So, even if we get a bad year or two in the next few years, we have valid reasons to hope for a recovery after. That’s for the long-term investors with a secular view.

Happy Holidays

I wish you all a great time with your families while finishing up 2019, and a prosperous 2020.

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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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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