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Don’t Fight The Fed?

June 18th, 2020

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There is an old adage in the investment business that states “Don’t Fight The Fed.”  Martin Zweig was a famous investment manager back before most of today’s investment managers were alive or in the business – just like me except for the famous part :)  He coined this phrase when he appeared on a PBS show called Wall Street Week, and he meant was that when the Federal Reserve starts to ease or tighten monetary policy it is a powerful force that impacts the stock market that should not be ignored.

Back when Martin Zweig was alive and trading, the Fed used very traditional monetary policy moves like raising and lowering the Fed Funds Rate (the rate of interest banks pay to borrow overnight from the Fed).  Those tweaks were enough to adjust the economy from being too sluggish or too overheated toward a more middle of the road level of economic activity.  Today, we have a very different situation.

When we were in the midst of the 2007-2009 subprime mortgage loan induced stock market crash, the Federal Reserve lowered interest rates to zero percent in order to juice the economy toward recovery.  Unfortunately, it was not recovering fast enough or with enough strength, so they adopted the novel step (copied from Japan) of buying government bonds as a way to get additional liquidity into the financial markets.  What we found was that the financial markets became addicted to the liquidity, and as the Fed attempted to stop buying bonds for an extended time, the stock market would go down.  We thus entered into a vicious cycle where our financial markets became addicted to the mainlining of liquidity that found its way into the stock market.

QE

The graph above (courtesy of the Calculated Risk blog) shows you the ups and downs of the market during the six years of Quantitative Easing (the name of the program for the Fed’s bond buying activity) and how the stock market reacted when it was happening and when it ended.

You may have two questions at this point – we have addressed both over the years here on the blog, but you may be a new reader or just don’t recall the conversation, so let me give you the readers digest version:

(1)  What is the source of the liquidity?  Where does it come from?  In order to buy the government bonds, the Fed buys the bonds from investment houses by crediting their accounts for the cost of the bonds – the tricky part is that they do not have the money on hand to pay for the bonds so the in essence print the money in digital format.  This puts more money into the financial system than previously existed, expanding the liquidity in the economy; and

(2)  How does the liquidity get into the stock market to push it higher?  With interest rates so low, corporate America was able to borrow billions of dollars each year at minimal interest rates.  They would use that money to buy back their own stock from their shareholders.  Those buyback programs created demand for stock that was not otherwise there and it allowed the companies to show increasing earnings per share even though in most cases their earnings we the same or less than in previous years.  How does that work?  Here is an example:  if a company had 100 shares of stock outstanding last year and they by back 20 shares this year, there are now only 80 shares held by the public.  If last year their total earnings were $400, then their earnings per share were $4, but if this year their earnings are the same $400 then their earnings per share are $5 as they only have 80 shares to spread the earnings over.  It makes it look like the company is performing better when in fact they are stagnant.

stock-buybacks-chartThe graph above (courtesy of the Visual Capitalist blog) shows you the impact of stock buybacks on the stock market.  There has been a direct correlation between the stock market’s rise and the amount of stock being bought back by companies – in fact, in many years, the buybacks were the only reason the market was positive.

So why the trip down memory lane?  Because last September, the Fed restarted its quantitative easing program when the first sign of economic problems arose (the collapse of the Repo market, another item discussed in previous blog posts that I won’t bore you with again) and they accelerated it in the past several weeks in concert with the covid-induced economic shutdown/collapse.  However the extent of this buying spree known as QE4 (the middle graph above shows the previous cycle ended with QE3 in 2015) dwarf the previous programs.

Fed Treasuries

The graph above (from the Kass Daily Diary) shows that the Federal Reserve has bought more treasuries in this QE4 than have been issued by the Treasury Department.  Meaning that not only are they buying newly issued treasury securities, they are buying outstanding securities from individual holders all in an effort to inject liquidity into the financial system to keep us from experiencing a 1930’s-style depression.

If the top graph doesn’t convince you of the size of the QE program, then maybe the graph below (from the Kass Daily Diary) will help.

Fed Treasuries2

This graph shows you that the Federal Reserve owns 70% of all outstanding Treasury Bonds maturing in 2039 to 2041.  This is an enormous amount of money that was created out of thin air and digitally inserted into our economy.

So where does the Don’t Fight The Fed? part come in?  As you can tell from the middle chart above, the smaller in amount previous QE’s made their way into the stock market through corporate stock buybacks.  The question we have this time is whether corporations will repeat their behaviour or will they be more frugal.  The subprime mortgage market crash was a completely different economic event from the covid shutdown crash.  The current crash came from a nearly complete end to many businesses revenue streams – companies had to scramble for access to credit lines to remain open.

Gone were the days where they had cash reserves on hand to get through economic slowdowns – they had been taught that cash was a non-earning asset and that Wall Street analysts wanted to see stock repurchase programs with any excess liquidity in order to keep their stock on analyst’s Buy List.  CEO compensation was structured around stock prices continuing to move higher and if earnings are flat and cash reserves earned zero, then stock buyback programs were the only avenue to pursue.

I think we have seen a structural change in how corporations will operate.  Cash reserves will again become fashionable – and maybe even graded positively by the analysts.  Many other changes are likely in store as well:  downsizing real estate needs given the positive experience of having a large percentage of staff working from home; moving overseas manufacturing facilities back to North America where the companies have more control over their operations;  less reliance on just-in-time inventory being shipped from Asia and more reliance on keeping inventory on hand in domestic factories, to name three.

The graph at the opening of this post should be familiar to those of you who have been reading the blog over the last year.  I started posting this as the megaphone pattern developed in late 2018 and early 2019 and have updated it as the market has moved forward in time.  You will recall that after the crash, I drew in the various shaded areas to give you a feel for where the market would likely go post-crash along with weighted chances for the different scenarios.  Fortunately, we followed the scenario that I weighted 75% chance of occurring and the market bounced off that level and moved up to the Relief Rally Target Zone.  You can see I drew some arrows in on a potential path for the market over coming months, and it has adhered to that path somewhat so far.  The important thing to remember from past discussions is the importance of the Relief Rally Target Zone – this is where the battle will be fought to determine if we get a second leg down to retest the lows, if we move sideways in and out of the zone building a trading range for an extended period of time, or head higher sooner rather than later based upon the economy improving faster than anticipated.

So far, I’d judge this as a market trying to develop a trading range.  It may be tough to see the price line on the graph but it is the combined red/black line that represents the weekly performance of the S&P 500 Index.  That line had moved nicely above the zone but is now trading back in the middle of it.  Even though we are getting some very positive economic readings from employment, manufacturing, and retail sales, it is critical to remember that these are off severely depressed levels.  We still have 45 million people unemployed (an closer to 60 million if you include small business owners who cannot reopen their businesses), we have factories operating a partial capacity if they are even open yet, and we have multiple bankruptcies and even more downsizing/store closings across the nation in the retail industry.

There is a definitely tailwind to push the market higher in the form of the largest Federal Reserve monetary policy operation in history, however the primary buyer of stocks in the form of corporate buybacks may not materialize as they once did – at least not in the short-term.  Because of this, we maintain our cautious buy invest strategy, ready to raise cash if the direction of the stock market looks to deteriorate but remaining invested for the continued recovery in stock prices.

Keep track of the blog as we will post updates as major things happen or as information becomes available pertinent to our investment management activities and our clients benchmark beating portfolio performance.

–Mark

Who’s Zoomin’ Who?

May 21st, 2020

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Graph comes courtesy of the Speculative Investor blog

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Like many of you, I am having a number of Zoom video discussions these days – more than I had imagined I would even at the beginning of this COVID shutdown.  Zoom as a company is clearly benefiting from the current state of affairs, but they are one of the few.   So in today’s blog post, I want to take a look at the impact of the COVID shutdown and the unprecedented response by the federal reserve to provide liquidity to the system to preserve the financial system to the greatest extent possible.  As of the end of April, the US True Money Supply (aka the Monetary Inflation Indicator in the graphic above) shows that the first few weeks of the money printing orgy has raised the money supply by 20%.

That number on the graph shows that in the short period that the Fed has been reacting to the economic carnage, they have printed more money than in either of the efforts to save the economy during the DotCom/September 11 Crash of 2000-2001 or the Subprime Loan Crash of 2008-2009.  By the time all of their liquidity hits the system in coming weeks or months, we should see a money supply increase that dwarfs either of the other two recent crises.

One of the tools the Fed uses to impact monetary policy is to make changes to the Fed Funds Rate.  Fed Funds have no connection to longer term interest rates as those are governed by the interplay of buyers and sellers in the bond market.  However, it is interesting to see on the previous graph that we have had a 35-year and counting downward trend in bond yields.  There is a clearly recognizable channel within which 10-year treasury rates have moved until Fed Chairman Powell began raising the Fed Funds Rate, scaring bond buyers into demanding higher yields on longer maturities

For a short time, yields moved above the downward channel causing damage to both the stock and bond markets.  Once Chairman Powell changed his positioning, rates fell precipitously in the bond market giving us a period where the yield curve inverted.

There was significant debate at the time between those who said that the inverted yield curve was forecasting a recession within the coming nine to twelve months just as it had in the past and those that said this time was different.  The common refrain from the latter crowd was that there were no signs of any cracks in the economy and that it was growing too steadily to be derailed.

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Graph comes courtesy of the Slope of Hope blog.

Economic Impact of COVID-19

Then came COVID, and the damage can be seen in the graphs below that reflect the immediate shutdown of the US economy.  In the first graph, the number of persons employed fell roughly by 35 million virtually overnight.  As the stay at home orders were leveled across the country, people deemed non-essential were told to stay home in order to prevent the spread of the virus.

Government programs were enacted that funneled money to the unemployed as direct financial support as well as to businesses to keep current staff employed, all part of the increase in money supply discussed above.  However, any staff that were unemployed but re-employed with government program money will not show up on the graph until after end of May, if at all, given the growing number corporate bankruptcies that are being announced.

Additionally, the April Help Wanted Index of Financial and Business Professionals report from the Conference Board shows that many white-collar office jobs are disappearing.  The crisis has shown that companies can get by with fewer people and less office space – say good bye to middle management, at least for the next few years.

The most recent announced unemployment rate was 14.7%.  However most people do not understand that the self-employed who have lost their businesses are not included in this calculation.  Economist Martin Armstrong states that his calculation shows that the real unemployment rate is closer to 30% when those self-employed who lost their source of income are included.

There is a calculation called U6 Unemployment that includes people that have dropped out of the workforce because they have given up on finding a job.  For the first time in history, there were more people unemployed in the US than employed.

Three big questions:  (1) are we developing a new permanent class of unemployed; (2) who will pay for Medicare and Social Security given the reduction in employment taxes; and (3) who will fill all the vacant office space and retail space after this is over?

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Graph comes courtesy of the Slope of Hope blog.

White collar and retail are not the only sectors being impacted.  The graph below shows a similar decrease in industrial production.  When factories shut down, many will not reopen due to lack of financial resources or lack of demand for their products.

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Graphs come courtesy of the Slope of Hope blog.

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The graph above shows the impact on GDP.  We are already nearing the worst levels of economic retreat seen in previous crashes.

However, a May 15th estimate from the Atlanta Fed shows a -45.2% Q/Q change.
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Taking one more swipe at how to view the economic damage, Dr. Lacy Hunt from Hoisington provided the graph below.

 

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The graph shows that per capita GDP is at the lowest since 1946 and the Great Depression. That is just an estimate through first quarter and a little bit of this quarter, but it is entirely reasonable to believe that per capita GDP could drop to the lowest level ever.

All of this tells me that the expectation of a return to pre-COVID normal life is unlikely.  There will be millions of people that will have no jobs to return to due to either downsizing or corporate bankruptcy.

The Conference Board report discussed above states that 83% of the country’s consumption comes from sectors of the country’s employment that are impacted by the virus.  That 83% of consumption equates to 56% of GDP being impacted by the virus.

Certain industries may never be the same (airlines, travel and leisure, commercial real estate, retail shopping, restaurants) and certainly will downsize at least for a few years if not permanently.

All of the reduced economic activity and employment negatively impacts corporate profits and ultimately stock prices.  Right now, the stock market is divorced from the economy.  It is moving higher based upon expectations for the country to reopen and a vaccine to be developed before year-end.  At some point, investors will begin to let the new reality sink in and examine the values that they are paying for the stocks they are buying.

In the graph below, I have plotted the S&P 500 Index (red line) over the past 20 years with the S&P 500 P/E Ratio (gray histogram).  You can see that the last two crashes showed large increases in the P/E Ratio of the collective companies in the index.  Since the current crash happened at the end of the first quarter, the company earnings reports for that quarter were not as materially impacted as we should see when the second quarter earnings reports come out in July.

If we are going to have a retest of the lows, the July-August-September timeframe would be a likely candidate.  It fits within the six-to-nine-month typical retest time and coincides with the publication of the stock market valuations based upon current stock price divided by published earnings.

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Prior to the COVID shutdown, the earnings estimate for the S&P 500 was at $165 per share for 2020.  No one knows where we they will end up at this point.  I’ve seen people estimating anywhere from $110 per share to $135 per share.  If those represent the range earnings, and if we apply a historic average P/E of 18 we get an estimated range of value for the S&P 500 of 1,980 to 2,430.  If we apply a more recent average P/E of 20 that buyers say has been justified by lower for longer interest rates, we get a range of value of 2,200 to 2,700.

Looking at today’s reading on the index, we are showing 2,971, clearly higher than either of the ranges from the post-COVID earnings estimates.

David Rosenberg’s Perspective

Famed economist David Rosenberg is very bearish on both the stock market.  He believes Q2 GDP will plunge (perhaps more than the GDP Now forecast above?  He doesn’t specify). He states that we are in a depression, a prolonged period of weak economic growth. Long-term risk is to the downside for the stock market. Over history, bear markets show a pattern of significant market plunge, a big rally that can recover half to two-thirds of the initial loss, then a grinding decline that takes the market back to the lows or lower.

Rosenberg says that the Federal Reserve’s monetary stimulus is not the same as FDR’s stimulus, this time its only government providing life support through liquidity. There is a surreal diversion between Wall Street and Main St. with most public companies surviving the crisis but with a permanently changed business model using fewer employees, many of the rest working from home, and a further reduction in overhead from downsizing office space.  Unfortunately, the bulk of small businesses will be positively impacted by the monetary stimulus and upwards of half will not reopen or will fail shortly after reopening.  He believes that 20% of the crisis-related unemployed will be permanent.

His forecast is the economy and the stock market will be in recovery through the end of 2023. His best case is for L- or reverse J-shaped recovery in the economy and stock markets. Corporate earnings will not normalize quickly given unemployment levels and consumers avoiding public places until a vaccine is widely available.  End of the recession will not happen until then. This will give consumers confidence to re-engage with physical retail businesses. Demand is key to the recovery, not just reopening the economy.

He sees a rise in the savings rate for both households and businesses.  Both will have learned their lesson on not having money on hand for an emergency.  This crisis will yield shifting consumer behavior patterns as people focus on what they need, not what they want.  Public corporations will not soon return to heavy use of stock buybacks financed by low rate borrowings to boost stock prices.

From an investment standpoint, he does not rule out negative nominal bond yields before the recession is over.  He suggests being selective in stock investments, overweight healthcare but avoid commercial real estate REITs.  He remains bullish on bonds but believes the 35 year bull market is closer to the end than ever.  His highest conviction investment is gold as a buy and hold strategy for the long haul.

Investment Strategy Summary

Here is the graph we have been keeping track of on the blog since last summer.  With today’s closing (2,971), we have finally closed above the bottom of the Relief Rally Target Zone (2,954).  This zone is key to knowing if we will break above the 200-day moving average (2,999), break through the top of the zone (3,027), and challenge the all-time high (3,393).

 

 

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The Relief Rally Target Zone is also key to knowing if we instead follow the path I drew in March: a trading range that eventually retests the lows (2,191) before moving back to new highs in 2023.  I still find it unlikely that we will move down to the Secular Bear Market Zone on the chart, but if the elevated levels of unemployment persist for the long-term, it is certainly possible.

Our strategy for investing our individual equity clients is best described as cautiously aggressive.  As discussed in earlier writings, while the market was moving to new highs during the early weeks of the year, we were raising cash and locking in gains.

When the market was in crash mode, we were aggressively buying good companies that were trading below fair value but that should recover their stock prices quickly when the crash ends (large cap technology, biotech and healthcare, consumer staples, and COVID stocks that would profit from staying at home).

As the market has approached the Relief Rally Target Zone, we have gotten incrementally cautious again, using stop losses to lock in profits in companies we purchased as the market has moved up and down on its march higher.

Now, we are watching to see what the market is telling us in terms of its future direction.  If we do break above the 200-day moving average, we will put some cash to work that was generated by the stop losses.  If we break above the top of the zone, we will put additional cash to work.  If we fail and head lower out of the zone, we will raise cash.

Famed economist John Mauldin’s recent newsletter included a quote by T. B. Macaulay writing in 1830 in reply to those in his day who were convinced that the then-current economic crisis would persist into the future:

“We cannot absolutely prove that those are in error who tell us that society has reached a turning point—that we have seen our best days. But so said all who came before us, and with just as much apparent reason… On what principle is it that, when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?’’

His point was basically that they were using linear thinking to extrapolate the current bad situation into the future, believing that the country had experienced its best days and that those in the future could not compare.  Mauldin makes the point that “real world GDP, after inflation, is up over 15X since he wrote that. The cost of a candle in 1800 that would let you read, however dimly, for one hour, was six hours of labor. Today that same amount of light costs about 3/10 of a second of human labor.”

Every crisis inspires someone to innovate in some way that leads to progress.  Just like the candle begat the light bulb, there is something today that will be changed forever.  As investment managers, we have to make sure that we do not fall into the buy-and-hold fallacy of those who invested all of their wealth in making candles when the demand for that product was shrinking.  The same situation came out of the economic malaise and endless recessions of the 1970’s, when many of the Nifty Fifty stocks that were buy-and-hold favorites now do not exist.  Given the speed with which science and technology advances today, we have to focus our investment choices on companies that we believe will be relevant for whatever the average holding time is for the investment objective our clients have selected.   The example of the need for Zoom to continue operating businesses, holding church services, attending school classes, and keeping current with family and friends during this time where we have been closed down shows this need to stay relevant and invested companies that provide a needed service now and in the future.

My expectation is that the technology, communication and healthcare investment sectors will continue to grow in importance to our world as well as in relative size of the available investable universe.  Our portfolios will continue to be positioned so that they provide our clients with the highest relative returns that we can generate.

During this crisis, our portfolios have outperformed their index benchmarks by 600 basis points (6%) and are quickly erasing the damage caused by the recent stock market crash.  Our active investment management has far surpassed the performance of the highly touted index funds, showing that in times of turbulent markets, having an experienced investment professional on your side looking out for your savings is crucial.

If you are invested in portfolios that remain materially underwater and under their benchmarks, we would happily discuss with you what we can do to help you preserve and grow your assets in our various investment strategies.

–Mark

 

Did We Just Get A Game Changer?

April 9th, 2020

Fed Junk

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Just when you think you have a plan set in the game of life, someone changes the rules.

Today, the Federal Reserve announced that they were going to start buying Junk Bonds.  Yes, you read that right.  They are going to buy the bonds of companies whose ability to repay the debt is in doubt.  What does that mean for the Investment Strategy I outlined for you yesterday?  In short, A LOT.

You likely recall the graph above from yesterday’s post.  Yesterday’s graph showed that I assigned a 75% that the stock market has put in a low and that we would move up to the Relief Rally Recovery Zone, then move back down to test the low before we head back to new highs; a W shaped recovery..  I also showed that I assigned a 25% chance that the coming (or more correctly the current) recession would not be a short term cyclical event and instead turn into a longer term secular event, meaning it would be a longer time for the to return to previous highs; a U shaped recovery.

I have amended the graph to show a 70% chance of a W shaped recovery and a 15% chance of a U shaped recovery, but added a 15% chance of a V shaped recovery that does not test the lows.  The fact that the fed is putting a safety net under the weakest corporations means we anticipate fewer (maybe significantly fewer) corporate bankruptcies due to the recession, which lower the inherent economic risk that the recession cause a feedback loop of corporate bankruptcies that extends the recession for a longer period.  You will see that I have added some solid green arrows to represent a potential path for the market to new highs which could be reach sooner than in the W shaped recovery’s dashed arrows.

If the terms I am using seem foreign, the past three blog posts define them for you and if you are interested you can give them a read.  The investment strategy I outlined in yesterday’s blog post remains the same as I still anticipate that the W shaped recovery will be the reality, but the Fed’s buying junk bonds really is a game changer in terms of investment and credit risk.  The only thing I am curious about is whether we should be looking at adding a position in a high yield bond fund to our fixed income portfolios – they have been rising in price over the past week or so as many investors have been anticipating this (I honestly didn’t believe this would ever occur – I figured when the Fed stated two weeks ago that they would never buy junk bonds, they meant it, but that’s just the way it is).  This will take some pondering so no action is anticipated on it at this time as the easy money has been made.

 

–Mark

Relief Rally Recovery – Will It Last?

April 8th, 2020

2020-03-31

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Even though we started the quarter on a positive note, three major items hit the news that drove stock prices down by the largest and fastest amount on record.  We all know that the corona virus has shut down much of the country and it has been one of the primary catalysts of the pullback in the stock market.  Many of us have heard about the oil production dispute between Russia and Saudi Arabia that drove down the price of oil to levels not seen since the early 2000’s – energy companies now make up just 3% of the market capitalization of the S&P 500, the smallest percentage ever.  Fewer of us have heard about the financial system liquidity crisis in Europe that has driven the value of the dollar to near record levels versus the euro and has caused our Federal Reserve to provide collateralized loans to European banks and even European Central Banks.  If you haven’t read the two previous blog posts, a few things written here are discussed more in-depth in those plog posts.

From the market’s peak on February 19th to its crash low on March 23rd, the S&P 500 was down 34%.  It has since moved 20% higher as of this writing, but it remains down 20% from the top.  In the previous blog post of March 23rd, I provided you with a graph showing that the market had sold off to five standard deviations from the 10-month moving average – move in the markets that is nearly unprecedented.  Given the dept of the crash, we should not wonder that the market has moved up as fast and furious as it has.  As you can see in the graph below, we are currently within two standard deviations of the 10 month moving average, a normal trading range.

2020-04-08

The question that everyone is asking is whether the worst is over and will the market return to its previous highs.  Bear markets in stocks rarely go straight down then straight up.  Howard Marks, a well-known investment manager, recently wrote: “In 15 bear markets since 1950, only one did not see the initial low tested within three months.  In all other cases, the bottom has been tested once or twice.”   To illustrate this statement, he provides a grid of returns for the last two bear markets as they tried to move from crash to recovery:

2000 DotCom & 9/11 Attack Crash                              2007 Subprime Mortgage Loan Crash

09/01/2000 to 04/04/2001:     -27%                            10/09/2007 to 03/10/2008:      -18%

04/04/2001 to 05/21/2001:      +19%                           03/10/2008 to 05/19/2008:      +12%

05/21/2001 to 09/21/2001:      -26%                             05/19/2008 to 11/20/2008:      -47%

09/21/2001 to 03/19/2002:      +22%                           11/20/2008 to 01/06/2009:      +25%

03/19/2002 to 10/09/2002:      -33%                           01/06/2009 to 03/09/2009:      -27%

As you can see, the typical pattern is to experience the first leg of the crash, then recover part of the loss, then make successive ups and downs as the buyers struggle with the sellers to gain ground.  Knowing this, we must be ready for the current upward move in the markets to top out and another down leg to commence.  As such, we are keeping an eye on the various indicators we follow that help us get a feel for which way the market is headed, things like valuation, breadth, momentum and trend.

If you review the graph at the top of the page, you will see a depiction of the current market.  I have annotated it to show you the depth of the loss and the current recovery, but I’ve also included various levels and a potential pathway for the stock market that is our game plan on how to play the potential ups and downs by raising and reinvesting cash to manage risk and to maximize returns.

You can see that our first level to watch for a Relief Rally Recovery is in the 2800 to 3000 area of the S&P 500 – this is a move off the lows that I’ve assigned a 75% chance of happening.  I have also assigned a 25% chance that things economically and virus-wise could get worse from here and you can see the lower level of that trading range noted on the graph.

I have three zones marked on the graph, the first of which is the Relief Rally Recovery Zone where I expect us to rally to in this first leg up off the bottom.  The two bottom levels of each are given a 75% chance and a 25% chance of a bottom in this bear market.  Each range is denoted by their likelihood of either a short-term cyclical bear market or a more extended secular bear market (see previous blog post for more in depth discussion).  Right now we have assigned a 75% chance of a short-term cyclical bear market that will lead to new highs – but if we are locked down in the stay at home policy for a longer time than currently anticipated, the recession we move into would be longer and deeper than expected currently and a longer-term secular bear market would ensue that could take a longer time to move back to new highs.

We are fast approaching the area of the graph I have noted as Relief Rally Target Zone, with the market currently at 2750 as I write this.  Our assessment is that once we get into or near this area, we will pull back a bit then head higher in a series of up and downs that will eventually lead to a test of the February low ultimately followed by a move to new market highs – but the moves up and down will likely look much like the bear market gains and losses detailed above in the two most recent bear market crashes.

Obviously, no one knows were the market will go – in fact, despite the overwhelming historic precedent for the market testing the crash low, we could have a market that does go straight back up to the old highs.  We must be prepared for any scenario that the market throws at us.  By watching the various indicators, we follow, we have a good idea what to do based upon the behavior of other investors.  The indicators are just a graphic representation of investor sentiment and the actions they take in the market which help us determine when they move from a herd of buyers to a herd of sellers and back again.

These indicators are why we have been writing to you about our risk management process that raises money as the market gets over-valued.  It allows us to have cash on-hand to invest when the market goes down and be a buyer when everyone else is a seller.

As the market turned the corner at year-end, we started adding stop loss orders on many of our holdings.  We had accumulated such nice gains that we didn’t want to give them up in case of a market correction.  Those started to hit as the market went down, automatically raising cash for us that allowed us to be a buyer of equities at levels lower than we had seen just weeks prior.  Did we catch the absolute low?  Yes and no – yes we were a buyer on March 23rd, the day of the low, but we were also a buyer on other days after the market crash began.

Our stock market risk management process of raising cash then reinvesting it when the market goes down allowed us to out-perform our benchmarks by over two percent in many of our strategies.  It also gave us the opportunity to employ a new investment strategy that repositions our clients’ stock portfolios to areas of the market that should prosper if the current stay at home policy to confront the Corona Virus drives the economy into recession.

That stock portfolio strategy we have implemented focuses on high growth companies that should continue to make money during economic downturns – things like technology companies focusing on cloud related products and biotech companies focusing on critical disease prevention and treatment – as well as defensive companies that provide products and services that we all use no matter what the economy does – staples like food and beverages plus utilities like water and electricity.  The strategy reduces exposure to energy, industrials, and materials (except gold) and it repositions financials from banks into companies that have little interest rate risk exposure.

The three causes of the crash detailed above didn’t just impact the stock market – the bond market was also impacted.  Bond yields crashed to historic lows as bond prices soared higher.  Bonds are viewed as a safe space to hide from volatility in the stock market, so as the stock market correction started to gain steam, the money that came out of stocks went into bonds.  Couple that with money coming out of Europe that was fleeing negative interest rates there turned into a tidal wave of cash coming at the bond market.   This led us to employ a new bond market strategy.

The bond market strategy we have implemented focuses on short-term high-quality bonds and adjustable rate bonds.  This strategy is driven by rates being at all-time lows yielding significant interest rate risk.  To manage this risk, bonds need to be positioned so that potentially rising rates do not cause losses to principal value of the bonds.  Short-term bonds and adjustable rate bonds have lower interest rate risk for investors and as such are the preferred choice when rates really have only one direction to go – up.

–Mark

Nearing A Turning Point

March 23rd, 2020

S&P Bollinger Band Std Dev

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Just a quick update on the market.

I put together a Volatility Comparison that goes back to early 1987 to determine if we have ever seen a stock market this volatile.

In the graph above, I’ve charted the S&P 500 since March, 1987.  I’ve added bands around the price line that represent how many standard deviations from the 10-month moving average has the market been at the various material low points over the years.  Standard deviation is a statistical term that measures the amount of variability or dispersion around an average. Standard deviation is also a measure of volatility. Generally speaking, dispersion is the difference between the actual value and the average value. The larger this dispersion or variability is, the higher the standard deviation (i.e., higher volatility).  The smaller this dispersion or variability is, the lower the standard deviation (i.e., lower volatility).

What do we take away from this chart?  The current crash is five standard deviations away from the 10-month moving average.  In the past 33 years, we have only been four standard deviations away three times – we have never been five standard deviations away from the 10-month moving average.  That type of reading tells you that we are nearing or past the point of a Relief Rally beginning.

Remember from our graph that we discussed in last week’s blog post, the price range for this to be considered a secular bear market is  from 2350 to 2116 on the S&P 500 Index.  Today we are at 2285, right in the middle of this range and in prime position for a rally to begin any day now.

Don’t lose hope and feel that the market will go down forever – all of the technical signs point to this crash moving into a relief rally phase soon.  That is when we will execute the next phase of our investment strategy (see last week’s post for that detailed discussion).  That is the best news we’ve seen on the charts in quite awhile!

–Mark

How To Manage A Stock Market Crash

March 19th, 2020

S&P Downtrend Line Graph

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We have seen unprecedented volatility in the stock and bond markets over the past several weeks.  The stock market has fallen faster and more violently than at any time since 1987.   Given that, I thought it would be instructive to take a visual look at the markets, so here are some graphs to help illustrate what has been happening.   The graph above shows the dramatic crash in prices – I’ve drawn in a downtrend line that needs to be broken so that we can get on the road to recovery with a Relief Rally.

After that, we will discuss the three major issues happening that are impacting the markets:  (1) European Financial System Liquidity that has led to an unreasonably strong US Dollar, (2) the Corona Virus and (3) the Oil War between Saudi Arabia and Russia.

 

S&P 500 Index

Let’s start with a review of a graph we last saw in a blog post from November.

S&P Forecast Graph Original

In a post from earlier in the year, I debuted an initial version of the above graph, and explained the primary pattern the market was taking (hat tip to Sven Henrich who used a very similar chart to identify the pattern).   This chart pattern is called a Megaphone and defines the outer boundaries of the potential stock market action.  You can either have a move up that breaks above the upper boundary at 3100 on the index or a move down that breaks the lower boundary at 2200 on the index.

In an August post, I added the two possible paths that the market could take:  (1) an orange dotted line that I called the Path to 3300, and (2) a pink dotted line that I called the Path to 2100.

In a November post I included the graph above that shows that we did break above upper boundary at 3100. I mentioned that the target I had was a measured target of 3300.  I also said that if we can break above 3300 and sustain that with a 3% move higher to 3400 we could see a major move higher into 2021 (3% is important as it is my investing Rule of 3 for breaking support and resistance).  As of November, we were well on our way to 3300.

On the graph below, we have an updated version of this chart with further annotations that shows:

  1. The market topped out at 3393 early this year, but not breaking above the 3400 resistance level established by the Rule of 3.  It has since crashed to the 2250 level, just above the bottom of the Megaphone and 2200 lower boundary and 2100 measured target.
  2. You will see that I’ve annotated in peach color an area of the chart between 2150 and 2350 that I call the Cyclical Bear Market Target Zone. I estimate that there is a 75% chance the correction/crash will bottom out somewhere in this zone and begin a move higher to the green color area Relief Rally Target Zone between 2850 and 3050 on the index.
  3. Once we get the relief rally, we should see a trading range develop between the two zones, but with an ultimate retest of the low before the market finally takes off to new All Time Highs in 2022.  I’ve drawn in some black and red arrows showing a hypothetical path the market could take.
  4. The stock market has a mind of its own, so I never like to say that it MUST do one thing or another. But I’m firmly in the camp of this being a cyclical bear market, rather than a secular bear market. Historically, cyclical bear markets within secular bull markets tend to be devastating, but very short-term in duration. Most last 3-6 months and average falling in the 20%-30% range. Q4 2018 was a perfect example of a cyclical bear market. Two of the three catalysts for this crash are more cyclical in nature (Corona Virus and Oil War) so I am giving the cyclical bear the 75% chance of being where we land.

S&P Forecast Graph 5yr

But what if the third of the three catalysts (European Financial System Liquidity) cannot be contained by the Fed’s Repo action?  Then we have a chance for a Secular Bear Market which takes much longer to resolve.  I am giving it a 25% chance of happening if this turns out to be a secular bear market.

But what if I am wrong and all three are more secular in nature and cannot be resolved in coming months?  Then we have the chance of either a Generational Bear Market (like the malaise between 1967 and 1981 where it took 14 years for the market to make a new high), or even worse a Centennial Bear Market (like 1929 to 1956 where the market took 27 years to make a new high).  You will find those in the next graph in gray colored areas.

The graph below is tough to read because it is so stretched out (you will most likely want to double click on it for a readable version), but it covers the past 12 years back to the 2008 Subprime Loan Crash.  The two zones to watch for are the Generational Bear Market Zone between 1250 and 1050 on the index and the Centennial Bear Market between 666 and 869 on the index.  It was important to stretch the graph back in time so we could determine the origin of the historic areas of support and resistance that form these two gray zones.

S&P Forecast Graph

I have rated both of these as unlikely because:  (1) I believe that the Corona Virus will run its course given that so many pharma companies are working on a cure and vaccine, one or more will be brought to market in an expedited time frame to beat this disease, and (2) Russia’s economy cannot sustain oil prices at $20 per barrel so they will be forced to play nice with Saudi Arabia and the Oil War will end.

Unfortunately, I do not believe the European Financial System Liquidity problem can be fixed in the short-term.  Their use of Keynesian Economics to justify:  (1) forcing the European Banks to buy the sovereign debt of the lesser financially solvent European nations with the artificial designation of Zero Risk Weight in their capital calculations – there is no market to liquidate that debt when liquidity problems arise because buyers will not touch it, and (2) negative interest rates that have wreaked havoc on European Banks’ net interest margins has led to a huge liquidity crisis because investors moved much of their investment capital into US Treasuries, thereby sending our own rates to historic lows in this flight to safety, instead of depositing cash into the banks.

Our Federal Reserve stepped in to fill the void left by the big US Banks when they shut off the European Banks’ access to overnight lending in the Repo market.  Our banks determined that the European Banks represented an unreasonable risk of default and ended their overnight loan program even though it was secured under the Repo contract.  Unfortunately, this issue has turned from a short-term fix as described by the Fed in October 2019 to an intermediate to potentially permanent problem as the issues in Europe have worsened.  Certain of the European countries have ended negative rates on their debts but it does not look like the market has responded to that action and there is a general feeling that the European Central Bank has lost control of the European economies.

Ultimately, the cash moving out of Europe will move into US stocks and drive our market back to new highs, much like happened in the fourth quarter of 2019 and January 2020.

 

US Treasuries

The problems in Europe have significantly impacted our treasury market, driving yields down to record low levels.  Here is a graph of the 10 year US Treasury Note Yield for the past two years:

Treasury Yield Graph

You can see that 10-year Treasury yields were fairly flat until August 2018.  Then money started to move out of Europe into treasuries, driving the yield down from 3.2% to the 1.5% area where they plateaued until January 2020.  The Fed’s Repo action stabilized things and provided the liquidity the European Banks needed for that four-month plateau, then it proved to be inadequate.   Money again began to flow out of Europe driving the yield down to 0.34%.

We have since rebounded to the 1.1% area based upon the Fed’s multi-trillion dollar intervention in both the Repo market and the Commercial Paper market (which had also started to freeze up), as well as their interest rate cuts returning to their ZIRP levels of pre-2018.

 

Our Strategy

Stock Market Strategy

I have written on the blog in previous posts that as the market moved higher in 2019, we got increasingly more conservative with our clients’ investment portfolios.   Valuations continued to expand, driving the market higher, while corporate earnings fell compared to 2018.  That is not a sustainable market situation and prudent investment management dictated that we raise cash and buy bonds.

When the crash began in February, we started investing those funds in both index ETF’s and individual company stocks.  We have been buying all the way down and still have some liquid cash that we continue to add to the market at these low levels.  Our plan is to be fully invested prior to the Relief Rally starting.

Based upon the most likely scenario for the market discussed above, we anticipate a bounce higher to the Relief Rally Zone (2850 to 3050 on the index) before a retest of the lows.  As we near that Relief Rally Zone, we will again get more conservative by raising cash ahead of the potential retest of the lows.  If the retest does not happen and the V shaped recovery moves the market above the zone, we will reinvest the cash we raised in anticipation of a move back to the 3300 level on the index.

Bond Market Strategy

In the time frame between September 2019 and January 2020, as the drop in treasury yields began to plateau, we reduced bond portfolio duration by selling our longer duration bond funds and adding to short-term and floating rate bond funds.

When we moved below 0.5% on the US Treasury, we liquidated all the longer duration bond funds in favor of short-term treasury bond funds.  The exception to this is the allocation to two actively managed fixed income mutual funds that have a good history of managing interest rate risk and holding onto any other short-term bond funds in client accounts.  We also maintained exposure to a few longer duration holdings in accounts where we have income beneficiaries that live off the income distributions from their trusts.  Finally, we did not change anyone’s ladder of individual bonds, other than to reinvest maturities as appropriate.

 

Summary

As the stock market tries to find a bottom in our cyclical bear market zone and the bond market tries to find appropriate yield levels across the yield curve, we believe we have positioned client portfolios to take advantage of what we see coming in the most likely scenario.  If that does not happen, we will adjust portfolios according to what is happening in the market.  As I have written multiple times in the past in blog posts, invest what you see, not what you believe.

We don’t invest our politics or our fears of the unknown.  We work to quantify the known data and the observable chart patterns so that our clients profit to the greatest extent possible.  No one is ever right 100% of the time in the investment business, but we strive to be right more often than our competition and consistently accomplish that.

Check back on this blog as we will be posting updates to our strategy as the situation develops.

~~~~~~~~~~~~~~~

For those of you who like scary movies, the second video below comes from the book adaptation of Stephen King’s The Stand.  For those of you who do not like scary movies, here is a concert video from 1977 of the same song.

—Mark

 

Financial Market Update

March 16th, 2020

Screen Shot 2020-03-16 at 7.20.55 PM

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I wanted to update everyone on what has been happening and what we have been doing in the face of this unprecedented drop in the stock market.

We have officially entered bear market territory after an 11 year bull market.  Even though this has been very painful to go through – I personally have gotten very little sleep as I have been getting up in the night to watch the close of the Asian markets and opening of the European markets – its become apparent that the trading algorithms employed on Wall Street that drove the market to historic valuations over the past couple of years have turned against us and driven stock prices down to 2017 levels.

As I write this on Monday evening, the Futures are pointing higher.  This may persist until morning and give us a positive day or something in news may change things.  Either way, I thought it important to give you the three stages of a bear market.  The following was published by Tony Dwyer and I saw no reason to not just quote him.  In the discussion of the three stages, he compares the current market to both 2008’s Subprime Loan Crash and the 1987 Portfolio Insurance Crash:

1. “Panic – This happens toward the end of the initial crash, like what happened in 10/1987, 08/2011, and currently. The SPX was down 33% and 18% at the panic lows in 1987 and 2011, respectively. At last week’s low, the SPX was down 26.9%. You only know where the initial panic low is AFTER you have seen the multi-week rally.

2. “Relief – This develops after the crash with a violent multi-week reflex rally as investors are simply glad it stopped crashing. The relief rally in 1987 and 2011 recouped 30% and 40% of the losses from peak to panic low, respectively. This would suggest a bounce-back range in the SPX of 2750-2850 over coming weeks.

3. “Demoralization – This occurs when the market tests the panic low as the realization of weaker economic and corporate news is released, similar to what took place leading into the 12/1987 and 10/2011 test of the lows in those two market crashes, respectively.”

Managing an investment portfolio is a process.  When the market reaches all time highs, you reduce your market exposure and raise cash so you can invest lower when a correction occurs.  As I’ve written on the blog in past articles, we were very prudent to have cash on hand over the past couple of years when fundamentals (like earnings growth) were ignored by the algorithms and stock valuations pushed ever higher.  Fortunately, as the market has been falling, we have invested in some of our favorite companies, funds, and index funds at cheaper prices than we saw at the top of the market.

We continue to make purchases in our managed accounts, but we are anticipating that we are nearing the end of the Panic stage as discussed above and should be moving into the Relief stage soon.  As the market nears the 2750 level (and hopefully the 2850 level) we will be raising cash again so that we have resources on hand to buy our favorite investments for client portfolios.

Corrections and crashes are part of the investment process, but long-term success with your investment means that you need to not panic when the market goes down, even if it goes down significantly.  The Corona Virus will negatively impact corporate earnings for two to four quarters of 2020 and possibly 2021.  Stock prices are a function of corporate earnings, and mathematically from a discounted cash flow valuation, two quarters of earnings is only 5% of the total calculation while four quarters of earnings is only 10% of the total calculation.  A stock market correction of 30% like 1987 or 40% like 2008 undervalues company’s future earnings in a material way.

Warren Buffet, one of the greatest stock investors of all time, has said repeatedly over the years that the best time to buy is when there is blood in the streets and stock prices have been slashed to a fraction of their real value based upon future earnings.  This is one of those times that “uncle” Warren looks forward to in order to buy quality companies at a significantly discounted value.  That is exactly what we have been doing on behalf of our clients by raising cash when the stock market was making new highs and reinvesting it as the market has fallen.

There is no way to specifically say when the bottom of the correction might occur, but when stocks are valued downward significantly and you can buy a quality company whose earnings will return to a normalize growth rate at 17.95 price to earnings ratio (the current P/E for the S&P 500) from a 24 P/E just a month ago, this is a buying opportunity even if the market goes down some more.

Screen Shot 2020-03-16 at 8.14.01 PM

To give us some perspective, this graph shows you the S&P 500 since 1986.  I’ve annotated the major market disruptions so that you can see that sitting tight has always been the right decision.  Selling at the bottom of a correction or crash means you miss out on the recovery stage and lock in a permanent loss of capital.    To stress this point even more, below is a graph of the S&P 500 since 1922.

Screen Shot 2020-03-16 at 8.18.45 PM

Managing the volatility in the stock market is part of the process of investing.  If you are fortunate to have cash on hand, whether you are Warren Buffet or one of our clients, you can buy shares of stock, mutual funds, or ETF’s at discounted prices and over the long term benefit from the growth of corporate earnings and the stock valuations associated with it.

One of the hardest things to do is to remain calm and seeing clearly in the face of a stock market showing you paper losses.  However history shows that buying during corrections as we have been doing for clients produces very positive results over the long term.

Stay calm and let us do the worrying for you.

A Technical Look At the Stock Market

December 3rd, 2019

2019-12-03

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I thought it would be instructive to look at the technical picture for the S&P 500 since we are at a crucial point in determining whether there will be a new bull market leg in our future or something less positive.

The graph above is one I shared last month with our investment committee but updated for recent market action.  I have been keeping track of this technical pattern since the summer and have been updating this graph accordingly.  The chart depicts two different patterns, a megaphone pattern and a rising wedge pattern.  You can see that the megaphone pattern had been in existence since the beginning of the January, 2018 correction and the rising wedge pattern began with the end of the December 2019 correction.

What I was watching for was a break above the top of the megaphone when we got to the July 2019 all-time high on the S&P 500 Index.  What we got instead was a break below the bottom of the rising wedge and several weeks of the market moving higher but not with a move strong enough to return to the wedge.

During the August pullback, I drew in two potential paths for the market: (1) the Path to 3300 (orange lines), and (2) the path to 2100 (pink lines) since both were possibilities at the time given the uncertainty of the economy.  Note that I have added some commentary on the graph that might be useful in helping to understand my reading of the market action.

Since August, the Fed has cut rates and started to expand its balance sheet.  Those two sources of easy money and liquidity have driven stock prices higher, to new all-time highs on the S&P 500 Index.  Despite not being able to move back above the bottom of the rising wedge, the Fed’s intervention has powered the market higher to follow the orange path to 3,300.  There is an entirely separate discussion to be had on the reason for the increase in liquidity (problems in the Repo market being one) that could ultimately move the market to the 2100 level on the index, but that is dependent upon many factors that are not quite in play yet (e.g., possible negative resolution of the trade wars, impact of negative interest rates in Europe, a recession, election of a president that could scare investors, unforeseen geopolitical issues, etc.).   Remember what I’ve written on the blog many times – invest what you see, not what you believe.  Today we see that the Fed’s liquidity program is good for the stock market in the intermediate term so it is critical to have a plan to profit from it.

On 11/20/2019, I wrote this to our investment committee:  “we have now reached a critical technical level for the index.  Yesterday, we closed above the black horizontal line I drew at 3,118.82 (a 3120.46 close) however today we are trading below it.  This horizontal line represents a level of 3% above the July closing high and for a new bull market leg higher to 3,300, we need to either close above it for three consecutive market days or to pullback to the July high of 3,027.98 and then break above the 3,118.82 level in a move toward 3,300.”   You can see on graph above that since then the index has fallen back to the top of the megaphone pattern (the rising green line) and we are most likely headed toward the July all-time high – we may not make it all the way back there since the expansion of the Fed’s balance sheet is a powerful tool, pushing money into the stock market, but this should give us a chance to put some funds to work a prices a bit cheaper than we have seen the past several weeks.

It looks like the odds are on the market continuing to move higher after a brief pullback, with a subsequent move to 3,300-ish on the index.  How did I get 3300 as a target?  I am old school – we learned to do measured targets in the days before all of the technology brought technical analysis to the masses.   We get our measured target from the graph above by finding the point difference from December 2018 low on the index, 2400-ish on the index, and the low from the breakdown of the rising wedge lower boundary, 3000-ish on the index, and adding half the difference to 3000-ish.  In other words, it is:

Measured Target =((3,000 – 2,400) x 0.5) + 3000 = 3300

Yes, it is old school but it has served me well over the years in managing clients’ portfolios, so no reason to give up on the process.

The break above the July high led to increasing equity exposure to banks, tech, biotech, and cyclicals which should all benefit from a liquidity driven market risk increase while reducing cash and fixed income investments.

Additionally, with the Federal Reserve now saying that their 2% inflation target is being set aside and that they will allow inflation to move above 2% should also be good for gold, commodities (Energy extraction, refining and transporting;  Agricultural growing and processing;  and Metals – mining and production), in addition to banks.

Our current strategy has been to reduce consumer staples and defensive stocks as the market has been juiced higher by Fed liquidity.  We have slowly been adding to the industries that should benefit from Fed liquidity.  We will take advantage of the sell-off to the July highs by adding to current positions or starting new ones in targeted companies that we want to own but did not previously want to pay the valuations seen at the top of the market.

I’ll be back on the blog with updates as the current change in the market picture plays out.

–Mark

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