Quantcast
Channel: Bond ETFs – ETF Expert
Viewing all 56 articles
Browse latest View live

This Stock Market Bull Does Not Believe In ‘Peak Stimulus’

0
0

When central banks create money to underwrite a worldwide credit boom, do people become prosperous? Or does the electronic money creation encourage excessive borrowing that steals from future well-being?

Consider the $10.75-plus trillion that central banks created in response to the U.S. financial crisis of 2008 and the subsequent economic stagnation across the globe. Monetary policy authorities primarily acquired “IOU” assets (e.g., sovereign debt, corporate bonds, etc.) to depress interest rates. The ultra-low rates stimulated unbridled borrowing from the financial system by households, businesses as well as governments.

2017-06-07_major-central-banks

Some of the borrowed money at ultra-low rates went toward the maintenance of living standards; some of it went toward capital expenditures including the hiring of human resources. Yet a bulk of the explosion in credit made its way into total return assets like stocks, junk bonds and real estate. The ensuing price gains for total return assets formed the basis for a prodigious wealth effect.

Unfortunately, the perceived prosperity may prove to be ephemeral. Why? Because the growth of debt is proceeding at a much quicker pace than the growth of economies themselves.

According to the Institute of International Finance (IIF), debt held by households, governments, financials and non-financial corporations in developed markets jumped from $128 trillion to $160 trillion in the last decade alone. Putting that in context? Developed economies increased their leverage from 348% debt-to-GDP to 390%.

global-debt

The picture may be even murkier for emerging markets. Due in large part to record-setting credit expansion in China, ’emergers’ have levered up from 146% debt-to-GDP in 2006 to 215% by the end of 2016. When you combine emerging economies with mature ones, credit inflation/debt expansion is proceeding at twice the pace of economic growth.

Can the current credit boom continue without incident? I seriously doubt it. For one thing, global interest rates cannot move lower indefinitely to offset ever-increasing debt loads. The leverage is increasing much faster than the income available for servicing obligations.

Secondly, adverse changes in ‘credit impulse’ may lead to the reversal of the wealth effect. What is credit impulse? The change in new credit issued as a percentage of gross domestic product (GDP). According to UBS, the change in new credit issued as a percentage of GDP has plummeted 6% from its peak in 2016.

credit-impulse

Think about it. Central bank policy makers have readily acknowledged economic reliance on credit-fueled consumption and investment. So what happens when we really do reach a point of credit saturation?

Data suggest that it is already taking place in areas like commercial real estate (CRE). Brick-n-mortar retailers are shutting down thousands of shops. Meanwhile, scores of billion dollar property projects do not currently have enough tenants to fill the space. Both of these forces — retail closings and empty commercial buildings — are happening at a time when banks appear to be lending less.

cre-us-bank-lending-1

Might this put commercial real estate (CRE) under enormous pressure? What happens when the short-term CRE loans need to be rolled over into new loans? The artificially low cost of credit that pushed U.S. commercial property prices toward astronomical valuations is beginning to look like ‘malinvestment.’

What about cryptocurrencies like bitcoin? Sensible investment or wild speculation?

bitcoin
Naysayers see no risk of credit saturation. Key borrowing costs remain low. And they see a world where easy access to low rate borrowing will remain in perpetuity. After all, how can there be malinvestment when FANG stocks – Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google/Alphabet (GOOG) – are making people rich.

Speaking of FANG, Bank of America recently revealed that 71% of mutual fund managers are overweight the acronym’s components. And why not? Each is up anywhere from 25% to 33% in 2017 alone. Yet maybe… just maybe… we’re witnessing speculation as opposed to investing. Large-cap growth funds like iShares Russell 1000 Growth (IWF) do not typically outperform small-cap value funds like iShares Russell 2000 Value (IWN) by 1500 basis points (15%) in less than six months time.

large-cap-growth-versus-small-cap-value

It is certainly true that bullish market momentum can persist far longer than risk managers dream possible. I sounded an early alarm to reduce riskier asset exposure on December 18, 2014 when the Federal Reserve settled its last money creating, credit-fueling bond purchase (a.k.a. “QE3”). We downshifted moderate growth-and-income clients from their target allocation of 70% widely diversified stock to 50% high quality stock; we downshifted from a target allocation of 30% widely diversified income to 25% investment grade income, leaving us with 25% in cash equivalents.

The downshift worked well through two harrowing corrections.

spx-two-corrections

One might even say that it worked well across the 22-month period leading into the November election.

spx-22-months

On the other hand, both the ECB and the BOJ announced significant electronic money creation/quantitative easing experiments in the first few months of 2016. What’s more, the Federal Reserve telegraphed that it favored raising overnight lending rates only once, as opposed to its original plan for four hikes. Outside of a few election fears, the S&P 500 has hardly looked back.

since-shifting

I underestimated the global impact of the European Central Bank (ECB), the Bank of England (BOE), the Swiss National Bank (SNB) and the Bank of Japan (BOJ). As seen in the chart below, central bank asset purchases actually accelerated in the first quarter of 2016 through May of 2017, providing the desired support for stock prices and stopping bearish price depreciation (2/2016) in its tracks.

central-bank-asset-purchases

A buying opportunity with cash may have been missed, yet a 50/25/25 allocation did not significantly underperform 70/30. The difference between the allocations has only been 4% since mid-December of 2014 when one employs index fund proxies like Vanguard Total Stock Market (VTI), iShares Corporate Bond (LQD) and Guggenheim Enhanced Short Duration (GSY). Risk-adjusted performance returns are quite similar.

Going forward, investors still need to weigh the upside potential for reward against the real risk of financial loss. Is it probable that we have already witnessed a stimulus peak? And if so, what does that mean for severely overvalued stocks?

june-valuation

At the very least, there is a great deal of uncertainty surrounding the big time sources of electronic credit creation today (i.e., ECB, BOJ, BOE). According to Mohamed A. El-Erian, the Bank of England (BOE) wants to tighten and “…the European Central Bank (ECB) may be compelled to follow.” If the Fed does not backtrack on its current promises to hike rates as well as to unwind its balance sheet, the investment community may not remain sanguine about overvalued equities or economic stagnation.

One final thought: Friedrich Hayek published Monetary Policy and The Trade Cycle in 1932. In it, he wisely opined, combating a financial crisis with a manipulated credit expansion “…is to attempt to cure the evil by the very means which brought it about.” Leveraging ourselves to the hilt did not foster enduring prosperity; rather, we are delaying an inescapable reversal of fortune.

net-worth-to-gdp

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.


Are Stocks Adequately Compensating You For The Risk Of Financial Loss?

0
0

Few predict that a recession is imminent. On the flip side, how should one reconcile the fact that the treasury yield curve is flatter than it has been since 2007? A diminishing spread between 30s and 2s has a history of alerting market watchers to economic difficulties.

At the start of the current recovery in June of 2009, the spread between the longest-term maturities and shorter-term maturities clocked in at a relatively robust 3.5%. The yield curve was noticeably steep. Eight years later? The spread is down in the area of 1.3%.

30s-and-2s

Granted, 1.3% does not represent yield curve inversion. That’s when the spread between key maturities falls below zero. What’s more, inversion preceded 7 of the last 7 recessions. (Note: As infallible as that may sound, the inversion between 30s and 2s came roughly 21 months before the 12/07-6/09 Great Recession.)

Nevertheless, the flattening of the yield curve makes it challenging to argue that economic growth is solid. On the contrary. Analyst expectations for key economic information have rarely missed as badly. In fact, you have to go back to the sovereign debt crisis in 2011 for similar levels of weakness in the hard data.

economic-surprise

So what is the rationale for the Federal Reserve to tighten policy rates and push up borrowing costs on shorter-term lending rates? It cannot be a fear of wage growth overheating. After all, both the energy complex and retailers will be forced to let go of a significant portion of the labor force.

It cannot be economic acceleration, as annual GDP dipped from 2.6% in 2015 to 1.6% in 2016. Similarly, GDP in the first quarter of 2017 was only 1.2%. With a modest pickup in Q2, the country may be able to grow at its “same-old, same-old” sub-par annualized 1.9%-2.0% since 2009.

If neither the economy nor wage inflation are about to shift into higher gears, are Janet Yellen and her Fed colleagues simply expressing optimism on fuller employment? Please. They know quite well that if you do not count workers who stop looking for work altogether, one can manipulate ‘headline’ unemployment results. The truth is better represented by labor force participation — a 62.7% rate that is stuck in the 1970s.

lfp

There are more headwinds. Both auto loan defaults and student loan defaults are rising. Corporate bankruptcies are also on an upswing. And for those who follow Altman’s Z-Score used to predict corporate bankruptcies, average Z-Scores are lower today than they were back in 2007. (Note: Lower scores imply a greater likelihood of distress.)

sears-j-c-penney-30-companies-that-might-disappear-in-2017

The Federal Reserve has been telling us for years that it bases its decisions on the data. And yet the data have not supported their monumental shift from ‘easy-money’ advocates to ‘tighten-the-rein’ mouthpieces.

A cynic might say that Fed members are being political. I’m not sure. Still, there is an awfully big coincidence in the policy shift occurring in conjunction with the election of Trump.

From my vantage point, I think the shift has more to do with trying to play catch-up. Federal Reserve members know that after eight years, a recession is extremely likely to arise in the not-too-distant future. The more that the Fed moves overnight lending rates away from the zero bound and the more that they reduce their balance sheet, the more ‘firepower’ they might have to return to conventional rate cutting and unconventional asset purchases.

Complacent investors may choose to take all of the above-mentioned information and interpretation in stride. Why worry? Be very happy with record stock prices.

Unfortunately, excessive exuberance does not typically pan out in the investing arena. Consider Bespoke Investment Group’s Irrational Exuberance Indicator. According to Bespoke strategist George Pearkes, “When the resulting reading is negative, it means investors find the market’s valuation attractive but they don’t think the market is going to go up. When the resulting reading is high, it means investors expect the market to go up, but they don’t like the market’s valuation.”

The best time to be a buyer, of course, is when the indicator falls below zero. Huge buying opportunities at attractive prices occurred in the first quarter of 2009 and in the summer of 2011. Today? You might not find a more telling example of unbridled euphoria. (Buy, buy, buy! Or, reduce your exposure?)

irrational-exuberance-indicator

Another concern? Since the March peak, large-cap stock benchmarks have managed to tack on another 2% in price gains. However, fewer and fewer individual stocks trade in long-term uptrends; that is, fewer companies are trading above their 200-day moving averages, suggesting that market breadth continues to deteriorate.

bpnya

Perhaps the most frequent comment from excited bulls who disagree with my cautionary stance — approx 50% stock for moderate growth-n-income clients, 25% investment grade debt and 25% cash equivalents — is my unwillingness to accept the unassailable benefits of low rates. Oh, I accept their influence in creating a wealth effect alright. What I don’t accept is the idea that ultra-low borrowing costs render stock valuations irrelevant.

To wit, the U.S. experienced 20 years of a very similar rate environment (i.e., 1935-1954). Yet today’s low rates are supporting price-to-earnings (P/E) and price-to-sales (P/S) ratios that are DOUBLE what they were back in those two decades. In that period, valuations were about HALF of what they are today, and not just on things like profits and revenue. Tobin’s Q? Buffett’s Market-Cap-to-GDP? Both of those heralded valuation measures imply stocks would need to fall as much as 50%, just to bring valuations back to the 1935-1954 mean.

multipl-10-year-treasury

Perhaps more importantly, low rates did not terminate bear market price depreciation in those 20 years. Bears occurred in 1937-1938 (-49.1%), 1938-1939 (-23.3%), 1939-1942 (-40.4%) and 1946-1947 (-23.2%). Keep in mind, history tends to blame the 1937-1938 mauling on Fed policy error (i.e., ill-advised tightening.).

It is true that I went on the record in 2010, expressing dissatisfaction for a second round (QE2) of electronic money printing to buy bonds. QE1? It was necessary to stop the financial crisis and credit crunch, even though the Fed itself created the conditions for the housing bubble/subprime. Yet stimulus for years and years thereafter?

Reflated asset prices forged a wealth effect. I know I feel a whole lot wealthier. Yet the wealth effect did very little (if anything) for economic growth and wage inflation.

I have said it before and I will say it again: The global central bank cartel that controls both the access to money and the cost of money represents a tyranny of good intentions. The hope that a massive asset rally (e.g., stocks, bonds, real estate, etc.) would encourage or find its way into economic growth and wage growth never quite materialized.

What will materialize? The asset boom will eventually become an asset blunder. Booms that have little rationale in the fundamentals eventually turn downward.

It follows that the question each investor will need to answer is, “Do my prospects for reward adequately compensate me for the genuine risk of financial loss?” If you’re like me, and you determine that the potential for reward does not adequately compensate you for the real possibility of substantial financial loss, then trim your allocation to higher-risk assets.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Think The Fed Will Have Your Back Forever? Think Again

0
0

I have a confession to make: I love confessions. I spent countless hours in the late 1990s listening to sports radio dissect Mark McGuire’s acknowledgement of steroid use. And who did not get chills reading Perry Smith’s account of the Clutter family murders in Capote’s In Cold Blood?

However, the admission of transgression that captivated me the most over the last decade did not receive the kind of attention it likely deserved. Richard Fisher corroborated (January, 2016) that the Federal Reserve front-loaded a tremendous asset rally starting in 2009. The former President of the Federal Reserve Bank of Dallas candidly explained that committee members, himself included, set out to create a wealth effect, regardless of how mal-investments would reverse the effect in future years.

Some argue that Fisher’s confession was not particularly earth-shattering. After all, many market observers understood what the Fed had been trying to accomplish from the get-go. The Fed manipulated borrowing costs lower and increased capital at member financial institutions so that those banks would lend money to households, businesses and governments. The demand for risk-on assets from stocks to higher-yielding debt to real estate skyrocketed.

It is worth noting that Fisher implicated other central banks as well. With regard to what drove the remarkable bull market in stocks, he said, “It was, the Fed, the Fed, the Fed, the European Central Bank, the Japanese Central bank… all quantitatively driven by central bank activity. That’s not the way markets should be working.”

Keep in mind, global stocks had been coming unglued in January of 2016. Large-capitalization U.S. stocks had dropped into a 10%-plus correction. Smaller company U.S. stocks had breached a 20% demarcation line. And non-U.S. equities had plummeted more than 20% from their peaks.

veu-2016

So what did central banks do? The European Central Bank (ECB) as well as the Bank of Japan (BOJ) increased their quantitative easing asset purchases dramatically. Meanwhile, the Fed abandoned plans for four rate hikes in 2016, opting for a single one in December.

Once again, central bank policy had stopped rapid price depreciation in its tracks. In fact, ever since global central banks ratcheted up the electronic money creation, riskier assets across the world have catapulted higher to 52-week peaks or all-time records.

central-bank-asset-purchases

Putting some of what has been taking place into perspective, the Swiss National Bank (SNB) owns close to $80 billion in U.S. stocks (June, 2017). That’s up from $63 billion at the beginning of the year. That makes the land of luxury watches and high quality chocolate the eighth largest public shareholder of U.S. equities. They own more publicly traded shares of Facebook (FB) than founder, Mark Zuckerberg. And they’d have to be one of the largest owners of Apple (AAPL) as well.

Below is a representation of the SNB’s Q1 purchases over the prior quarter. The purchasing activity across all of these stocks is nothing short of amazing. Why wouldn’t stocks go higher as long as central banks are directly (and indirectly) acquiring U.S. stocks? Equally compelling? Get a gander of the blue bars on Facebook (FB), Apple (AAPL), Amazon (AMZN) and Google/Alphabet (GOOG). The quarter-over-quarter jump in these “FAANG” stocks go a long way toward explaining their remarkable price run-up in 2017.

snb-q1-holdings

Perhaps unfortunately, there aren’t enough people asking what happens when central banks reduce their holdings. It is almost as if investors have been lulled into a false sense of security that central bank manipulation of equity prices, the cost of capital (i.e., borrowing costs) and the amount of capital (i.e. liquidity) will always be favorable to them.

Let’s consider an example in the arena of borrowing costs. High-yield bond investors currently do not believe that central banks will ever let key borrowing rates move meaningfully higher. For that matter, they are not currently concerned about defaults in the energy or retail sectors, in spite of below-$50-per-barrel crude and 1000s of brick-n-mortar store closings. In fact, junk-rated corporate bonds are on track for record-setting demand in 2017.

junk-stupid Whereas the historical spread between high yield junk bonds and comparable Treasuries is roughly 5.5%, the BofA Merrill Lynch US High Yield Option-Adjusted Spread is a meager 3.7%. That’s negligible reward for a whole lot of risk of financial loss.

The pervasive belief is that price gains can go on indefinitely as long as central banks continue their support. One sees it in repressed volatility that has been mimicking the onset of the 2007 financial crisis. One sees it in leverage ratio extremes like corporate debt-to-GDP.

 

wall-st-journal

The big picture that many may be overlooking is the probability of central bank policy error. For one thing, the Fed has picked up its pace on hiking the overnight lending rate and has talked openly about reducing its balance sheet. Other central banks like the Bank of England and the European Central Bank have been dropping hints about less accommodating monetary policies.

It follows that investors would have to believe in an unblemished transition from monetary policy authorities to political leadership worldwide – a hand-off that simultaneously embraces less liquidity alongside economic acceleration. I don’t see it. Neither does the International Monetary Fund (IMF). If anything, we’re more likely to see the same-old, sub-par 2% GDP in the U.S. That could be troublesome in an asset reflation world that has been entirely dependent on seemingly endless stimulus.

Another potential issue? Central bank support may become less politically acceptable. In the U.S. alone, three-fifths of Americans have seen their inflation-adjusted household income decline in the 21st century. Meanwhile, the inflation-adjusted income for the top 20% is at an all-time high. Household net worth by quintiles show similar disparities.

wealth-inequality

It follows that 21st century Fed policy of keeping rates extremely low for extended periods may eventually be viewed as unacceptable transfers of wealth from the poor to the rich. Should that be the case, Fed policy makers may feel compelled to continue tightening, even into the next recession, before eventually looking to accommodate once more.

Bottom line? When riskier asset prices decline, the very same credit flow that helped support higher prices disappears. That credit crunch exacerbates the depreciation. And yet, the notion that a Fed backstop will hold prices up at that time is not a slam dunk. The Fed’s vice chairman has already warned that “Elevated asset valuation pressures today may be indicative of rising vulnerabilities tomorrow.” In other words, folks, you may very well be on your own.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

How Much Longer Should Stock Investors Dance Near The Fire Pit?

0
0

American consumers are financially strained. One indication? Card defaults rose from 2.81% back in November to 3.53% in May. Meanwhile, the expansion of credit by cards as well as by autos has slowed to the point of contraction.

credit-contracting

Some would have you believe that low headline unemployment (4.4%) is translating into increased consumption and increased demand for goods or services. Yet tepid GDP data demonstrate otherwise. One explanation is that nominal wage growth would need to grow in the 3.5%-4.0% range to compensate for the loss of purchasing power from inflation. However, wages have struggled to make any progress over the last 18 months.

wage-growth-stinks

If things were any better in the corporate world, you would not know it from federal tax receipts. They are shrinking on a year-over-year basis. Keep in mind, tax receipts would be indicative of faster or slower income creation. The recent slowdown, then, points to economic fragility.

fed-tax-receipts

“But Gary,” you protest. “Corporate earnings growth is all that matters. That’s what investors pay for.”

Really? GAAP Earnings per share for the S&P 500 came in at $100.29 (3/31/2017). It was $100.20 on 12/31/2013. That is three years and three months without a modicum of corporate earnings improvement.

What did improve, then? The S&P 500’s price. It rose 28% over three years and three months without genuine growth in sales or profits.

One might make a case that U.S. stocks gained significant ground over the three-plus year period because borrowing costs moved lower. This allowed corporations to borrow by the fistful and to finance stock buybacks. In spite of modest demand, prices rose because the supply of shares had become scarce.

tnx-3-years-6-months

The notion may have merit. On the flip side, borrowing costs have been rising over the last 12 months. If the lowering of absolute yields and/or a downward trajectory of key rates explained stock price appreciation in the absence of meaningful earnings per share (EPS) growth, a reversal in those trends might be expected to cause the stock bull to stagger. It hasn’t.

There is another plausible explanation. Central banks (e.g., European Central Bank, Swiss National Bank, Bank of Japan, etc.) had continued to engage in extraordinary levels of unconventional easing, creating electronic currency credits to purchase market-based assets directly and indirectly. The liquidity injections from foreign central banks did as much for stock price appreciation as the Federal Reserve’s QE3 program that continued up through mid-December of 2014.

Even this second “justification” of elevated stock prices is not entirely adequate. The Fed has raised overnight lending rates three times in the last six months; it has even identified a potential plan for reducing its $4.5 trillion balance sheet. Meanwhile, other central banks around the globe have been openly talking about tapering monetary stimulus. Yet a corrective phase for the S&P 500 has not emerged.

If one accepts the idea that the direction of interest rates (lower) and the direction of central bank policy (easing) drove stock prices higher in the absences of earnings growth, why are the directional shifts taking place today (i.e., higher rates, monetary policy tightening) being ignored? With consumers as well as corporations borrowing less?

bank-lending-2017Some would have you believe that the answers reside in more recent corporate earnings growth data. Nonsense. Earnings per share (EPS) projections for Q2 are in the neighborhood of 6.0%-6.5%, though half may be attributable to a tenuous rebound in the energy sector. (Note: It is tenuous because the earnings recovery will be temporary if sub-$50-per-barrel of crude becomes the norm.)

Ex-energy? The collective growth of earnings will be closer to 3.0%-3.25%. In fact, analysts are forecasting 1.3% or less EPS growth for five of the 10 economic sectors. Two segments will likely post negative results.

sector_eps

Perhaps more troubling than over-hyped earnings success is the message that the bond market has been sending to the Federal Reserve; that is, bonds do not believe that the economy is vibrant enough for Fed tightening, either in the overnight lending rate of 1% or in a reduction of its balance sheet.

Consider the 10-year Treasury bond yield in the context of the Fed Funds Rate (FFR) since the first of three hikes (December, 2016). Rather than push the 10-year yield higher as the Federal Reserve had hoped, the 10-year yield has actually fallen. What’s more, the spread between the overnight lending rate (FFR) and the 10-year Treasury is nearly as low as it has been at any other point in the eight-plus years of economic recovery. In a nut shell, the economy just isn’t strong enough to withstand the recent Fed desire to keep tightening the reins.

bonds-lower-with-fed-raising

For my moderate growth-n-income clients, I have maintained a 50% allocation to high quality equity for years. That is down from 65%-70% widely diversified stock in the earlier stage of the bull market (3/2009-12/2014). Indeed, the overwhelming evidence — direction of monetary policy, key rate spreads in bond land, the peaking of the credit (borrowing) cycle, extreme stock valuations — favors an element of caution.

So why continue to dance near the fire pit at all? The market technicals remain favorable. As long as the NYSE Advance Decline Line (AD) remains in an uptrend, and as long as the S&P 500 remains above key trendlines like the 200-day moving average, stock assets are likely to offer total return value. Nevertheless, market watchers ought to be keenly aware of the risks of ongoing price depreciation should the benchmark fall below the 2300 level.

spx-july

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Time in the Market, Not Timing the Market? Catchy Phrase Ignores Key Evidence

0
0

There is a reason why Warren Buffett regarded market-cap-to-GDP as “…the best single measure of where valuations stand at any given moment.” The reason? Its relationship with 10-year forward returns for stock prices. And right now, stock market capitalization as it relates to the U.S. economy is projecting negative returns for U.S. stock prices.

market-cap-forecast-gdp

It is also true that Mr. Buffett has, in recent years, distanced himself from the valuation approach called the “Buffett Indicator.” Is it because he stopped believing that valuations matter? Probably not. In fact, the Oracle of Omaha is holding onto more cash than at any other quarter in the last decade.

warren

If market-cap-to-GDP is no longer in Warren Buffett’s good graces, do other valuation measures explain why he is holding onto record levels of cash in Berkshire Hathaway (BRK.B)? Hard to say. With the exception of tech bubble euphoria, U.S. stocks have never been more expensive on price-to-sales ratios (P/S), price-to-earnings ratios (P/E), dividend yield or Tobin’s Q.

Indeed, market-cap-to-GDP merely confirms what Mr. Buffett knows to be true. The higher the price one pays, the lower one’s return over time. Similarly, the lower the price one pays, the higher one’s return over time.

valuation-market-cap

“But Gary,” you protest. “Nobody can time the market. Even Warren Buffett thinks people should buy-n-hold.”

In truth, Mr. Buffett is a market timer. He buys, sells, rebalances, increases his stakes, decreases his stakes and even completely divests from particular companies according to his discipline. He just does not think that others can time the market effectively.

Maybe he’s right. Maybe they can’t.

On the other hand, “market timing” with nothing more than a 10-month simple moving average and the 10-year Treasury has outperformed buy-n-hold with less risk.

This is worth repeating. Market timing with the 10-month simple moving average has outperformed buy-n-hold over the last 90 years. It has done so on a head-to-head basis. And more importantly for risk managers, it has done so on a risk-adjusted basis via standard deviation and the Sharpe ratio.

bh_v_mt

To the untrained eye, the head-to-head result for compounded growth might steal the spotlight. It shouldn’t. The real payoff is that the trend-following discipline minimizes portfolio volatility and reduces portfolio drawdown.

In other words, wouldn’t you sleep better at night if the exposure you have to stocks does not suffer as much as the market might suffer in a bearish turn of events? Believe it or not, you could have avoided the bulk of stock market losses from the 2000-2002 tech bubble and the 2008-2009 financial collapse. (Note: My counseling on how to lose less before the 2000 “tech balloon” let me leave the firm that I had been working for to create my own Registered Investment Adviser with the SEC in the early 2000s.) Equally compelling for risk managers, you could have sidestepped 1998’s Asia currency crisis as well as 2011’s Eurozone sovereign debt crisis.

10-month-200-day

Granted, Meb Faber’s trend-following technique served up a few “whipsaws” in 1999 and 2004. No investing discipline is flawless. Yet even limiting one’s exposure to equities throughout 2015 and during a chunk of 2016 proved more sensible than holding-n-hoping stocks would recover.

Trend-following has always been a big part of how I have managed assets. Being mindful of the 200-day moving average, for example, played an important role in my advising others to lighten up on stocks prior the tech wreck in 2000-2002 and the subprime disaster in 2008.

In the opposite vein, it has played a large role in my maintaining at least a 50% allocation to stocks for my moderate growth-n-income client base. Granted, I lowered that allocation from 65%-70% to 50% on a weakening economic backdrop, a shift in Fed monetary policy toward tightening as well as fundamental overvaluation hitting 2-sigma extremes. Nevertheless, the technical picture is undeniably favorable such that, according to my discipline, 50% equity exposure is still warranted.

The gods know, I have taken a great deal of heat from several anonymous content providers for a tactical asset allocation shift toward slightly less equity exposure. Even though my clients are primarily retirees and near-retirees. Even though job growth as well as GDP has been slowing. Even though Grantham Mayo Van Otterloo & Company (GMO) researched 40 bubbles and discovered that asset prices reverted back to long-term averages in EVERY “two standard deviation” occurrence (a.k.a. “bubble”). Even though a two-sigma extreme exists right now, and it exists across nearly every valuation measure one can conjure up.

Like ‘sheeples,’ detractors consistently battle my observations on three fronts: (a) market timing is ‘stupid’, (b) low rates justify endless price appreciation, and (c) current prices at record highs prove that different opinions are worthless. In this article, I demonstrated how market timing has been effective for disciplined trend-followers. Meanwhile, in countless previous commentary, I demonstrated how similar ultra-low rates for a 20-year period (1935-1954) did not prevent four painful bear markets (-49.1%, -23.3%, -40.4%, and -23.2%). And traditional valuation metrics in that period were HALF what they are today.

Do record highs for the primary benchmarks at this moment invalidate my opinions on managing risk? I will say it once more, the higher the price one pays for an investment today, the lower the long-term future return. There are 150 years of data to back that up.

More critically, the massive amount of debt accumulation does little more than rob future investment gains to bring them into the present. The future is certain to see a reversion toward economic growth itself.

stocks-versus-gdp-growth

Perhaps obviously, there are a number of ways that asset prices and GDP can get back in sync. Stocks could grow at a slower pace than GDP, allowing GDP to “catch up” over a long period of time. Or stocks could stagnate for many years without a big downturn while GDP chugs along.

More likely, however, stock prices would have to fall somewhat precipitously to come into contact with GDP growth. And if there’s a recession with GDP data, that would imply a more dramatic fall for stock prices to realign with the long-term GDP trend.

I am not saying that everything in the world must go to pieces or that a crash is inevitable. A bear market is inevitable, but a crash is not.

I am saying that people are taking far too much risk in relation to their reward prospects. That may work for awhile. That may appear beneficial for months or a few more years. Still, a running tally of political dysfunction, peak credit/slowdown in bank lending, terrible fundamentals, slowing economic trends across job growth and GDP and the possibility of central bank tightening do not scream, “Buy, buy, buy!”

What does tell one to buy more? Or at least hold onto what they’ve got? Favorable technicals. As long as those remain, it is likely that I will remain committed to a 50% stock allocation, 25% investment grade income allocation and a 25% cash equivalent allocation. Some of those cash equivalents yield near 1.5% right now.

What might cause me to reduce stock exposure further? If the S&P 500 fell below its 200-day MA and/or 10-month SMA. In the same vein, a breakdown in market internals such as the NYSE Advance Decline Line (NYAD) would require my attention.

nyad-again

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Surging Corporate Profits? Not For The Rest Of This Economic Cycle

0
0

Are corporate earnings genuinely wonderful? It may depend on your perspective. For example, after-tax corporate profits have grown at an annualized pace of less than 1% over the last 5 years. You won’t find many 5-year periods that have been as anemic as that.

weak-profits

In the same vein, earnings per share (EPS) growth has been equally unimpressive. Yet stock prices have been climbing with or without corporate earnings support.

earnings-growth-chart-1

One could make a case that corporate profits are just now hitting their stride. Indeed, one might assert that the only thing of importance is earnings acceleration since the fourth quarter of 2016.

Unfortunately, the notion that things are dramatically improving is a “fish story.” Consensus EPS projections for the 3rd quarter have already been slashed; analyst cuts to estimates have been the largest in two-and-a-half years.

q3-not-so-rosy

Other measures of corporate profitability demonstrate that a profit explosion to the upside is unlikely. For instance, return on equity, which considers how much profit companies generate with the money that shareholders provide, is hitting post-World War II lows.

roe-pathetic

If corporate profitability is really going to improve in the coming quarters, we’d likely need to see an acceleration on the economic front. Credit expansion would need to pick up rather than slow down. Regrettably, in spite of attractive borrowing costs, banks are lending less to businesses than at any point in the current recovery.

loans-dried-up

Meanwhile, job growth in key regions of the country have slowed to a crawl. Consider the Northern California counties that serve as the epicenter for high-paying tech jobs – San Francisco, San Mateo, Santa Clara, Alameda, Contra Costa and Marin. Every last one of these feeders to the Bay Area and Silicon Valley have seen job growth weaken considerably. (Note: The chart below is for Santa Clara County, which includes Silicon Valley stalwarts like Palo Alto, Sunnyvale and San Jose.)

us-jobs-ba-santa-clara-county-employment-growth-2017-06

Credit is the lifeblood of an economy, and it is slowing. Job growth is essential to household consumption, and it is decelerating. Even one of the biggest sources of stock price appreciation in the eight-year, four-month, bull market – a source that goes by the name of “stock buybacks” – is losing steam.

buy-bye-buybacks

The buyback slowdown may be critical to monitor. Over the past eight years, stock share buybacks have significantly reduced the number of shares available in the secondary marketplace. With less shares available for purchase, companies have made their earnings per reduced-number-of shares appear halfway decent. What would corporate profitability actually look like were it not for the reduction in supply of available shares?

Ironically enough, at a time when economic indicators are not particularly encouraging, where corporate profits are likely to face significant headwinds, the investment herd is showing signs of wayward euphoria. Bullish sentiment at Investors Intelligence rocketed to 57.8% bullish versus 16.7% bearish. Similarly, cash allocations as a percentage of assets are hitting record lows. (Note: It should come as no surprise that when cash allocations hit a peak of 21% in February of 2009, one would have benefited from a generational buying opportunity.)

b-of-a-cash-levels

There’s more. Margin debt, an indication of confidence in bullish price movement, is substantially above 2000 and 2007 levels. Equally compelling? Investor credit balances. The bars in the chart below are green (positive credit balance) when investors are not using leverage; their cash accounts exceed the margin debt and the cash in margin accounts. The bars are red when those cash account cash balances are far less than the sum of the margin debt and the cash in margin accounts. Interestingly enough, investors have never been quite so leveraged or quite so euphoric.

leverage-margin-debt

Investor fearlessness. Job growth abatement. Credit growth sluggishness. And corporations that are, in reality, struggling to achieve bottom-line profitability. Do these things constitute a recipe for sustainable stock price appreciation going forward?

Granted, it may not matter at the moment. Central bank liquidity has encouraged excessive leverage, extraordinary speculation and untoward malinvestment. What’s more, the risk of asset values collapsing across the globe has placed the world’s central banks in a stranglehold; that is, they must maintain ultra-easy monetary policies, and they must do so without a viable exit strategy.

central-bank-asset-purchases

It follows that the biggest risk of losing money in stocks today has little to do with corporate profits. It has to do with the possibility of central bank policy error. Overnight lending rates could be raised too quickly or too slowly; unconventional asset purchases could be liquidated too quickly or too slowly, where the electronic monetary credits created out of thin air could be withdrawn too quickly or too slowly.

The Federal Reserve tightened borrowing costs too quickly in 1937. Even though it had been eight years after the 1929 financial crisis, the actions proved detrimental to asset prices. The Dow logged a -49.1% price evisceration in less than 13 months time.

1937-bear

One way or another, the globally interconnected central banking system will make a major mistake. It will do something that jostles investor confidence. Then, policy makers will try to undue the harm via taking a 180 degree turn in the opposite direction. Participants won’t bite. Riskier asset prices will continue to fall. And the notion that central banks can backstop any downturn with endless liquidity injections will fall by the wayside.

It’s not that a 50% bearish outcome is pre-ordained. A bearish retreat of 20%-35% is just as likely as a 35%-50% mauling. Perhaps more so. Nevertheless, there will come a time when seats might not be available to those who played musical chairs for too long.

I continue to maintain the same growth-n-income profile for moderate growth-n-income clients, ever since the end of 2014/start of 2015. Specifically, we are holding 50% high quality equity, 25% investment grade income and 25% cash equivalents.

What would it take for me to make a tactical asset allocation decision to reduce stock exposure even further? A definitive weakening of market internals alongside a significant trendline breach. In particular, the NYSE Advance/Decline (AD) Line would need to break down and the S&P 500 would need to close below its monthly 10-month moving average.

10-month-200-day

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Signs That Investors May Be Shying Away From Indiscriminate Risk

0
0

You may never have heard of Robert Rodriguez. For that matter, you probably did not know that he retired in December from California-based First Pacific Advisors (FPA). Yet he is the only mutual fund manager ever to win the Morningstar Manager of the Year award for a stock fund and for a bond fund.

In a recent interview, Mr. Rodriguez revealed that he has virtually zero exposure to stocks in his personal accounts. Liquidity? More than 65% via short-term Treasury-type securities.

Wow! And critics think that my 50% high quality stock/25% investment grade income/25% cash equivalent allocation is too ‘bearish.’

Those that have followed Mr. Rodriguez’ venerable career know that he practices what he preaches. As a value investor, he knows that stocks have historically grown at an average pace of 1.14 times the rate of earnings growth. What’s more, he sees trouble when stocks are growing five times more rapidly than earnings per share growth.

stocks-grow-5x-faster-than-earnings

One of his sharpest barbs attacked the Federal Reserve. In essence, he scoffed at the notion that the central bank of the United States could avoid monumental policy error. After all, the institution has missed nine straight years of economic forecasts.

He also chimed in on the ‘FANG’ phenomenon. He said, “We’ve seen this act before. If you didn’t own the Nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying ‘net’ stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks.”

Last week, I compared the FANG phenomenon to the ‘four horsemen’ of the late 1990s and the ‘Nifty 50’ of the early 1970s. Dissents from comment providers were plentiful. It is as though many do not believe that great companies can hit growth limits that adversely impact their stock values. Similarly, many do not understand what happens to the most leveraged stocks when margin calls occur.

margin-debt-inverted

At the moment, of course, the absence of widespread fear is deafening. Around the edges, however, weakening market internals are worth monitoring.

For instance, divergences between higher quality debt and credit-questionable junk debt have been materializing. On average, junk bond investors get roughly 3.7 percentage points of additional yield over comparable Treasuries. Spreads had been tighter, and now they are widening. A widening gap tends to be a ‘risk-off’ indication.

junk

In a similar vein, the percentage of stocks holding above a 200-day moving average is declining. This implies weak breadth across the stock universe where fewer and fewer names are holding up the big-name benchmarks. Historically, if more and more individual securities dip below key trendlines, the benchmarks tend to buckle.

bpnya

Equally worthy of note? Divergences have appeared in equity leadership. Specifically, the proportion of individual issues setting new highs as opposed to new lows has been decreasing.

ny-hi-low

There’s more. There’s a widening rift between market capitalization, as large-cap performance has been decimating small-cap performance. Additionally, the split between growth-oriented stocks and value-oriented stocks is getting larger.

Perhaps one of the easiest ways to visualize what is happening is with a price ratio. The iShares Russell 2000 Small Cap Value (IWN):iShares Russell 100 Growth (IWF) price ratio has been in virtual free-fall since the start of 2017.

iwn-iwf-price-ratio

The evidence takes one right back to Mr. Rodriguez’ contention that more and more money is piling into fewer and fewer stocks. And, when this has happened in the past, riskier market-based securities often fell apart.

Granted, there are few obvious technical downtrends across industry sectors. The ‘losers’ have been losing for quite some time, from retail to telecom to energy. On the flip side, why are so many so quick to dismiss consequential segments of an economy? Do they not recall what happened as the term ‘ex-financial’ made the rounds in 2007?

From where I sit, it is difficult to dismiss energy from an earnings perspective. Most of the so-called growth that analysts have been projecting in S&P 500 earnings per share has relied on a global recovery in the energy patch. Yet stabilization for energy corporations is not the same as expansion.

Equally concerning? Consumers. Some analysts are extremely quick to dismiss record levels of household debt. They focus on low borrowing costs as though they will remain low indefinitely. They forget that headline unemployment is a lagging indicator that trails the economic cycle. And they ignore the reality that record levels of household net worth exist within the top 10%, where the overwhelming majority of Americans have not seen improvement in median real income since 1999.

record-borrowing

In sum, folks have to borrow to maintain a semblance of a standard of living. So what happens when banks lend less? What happens when credit card limits do not get extended? What happens when the credit cycle tightens as opposed to expands?

I am not advocating that one abandon all riskier holdings in favor of cash equivalents or physical assets. I respect the heck out of Robert Rodriguez, but I also respect the heck out of the closing monthly price on the 10-month moving average and the Advance/Decline (A/D) Line. It follows that a break down on my favorite technical indicators would be required before I reduce my equity allocation from 50% to 30%.

nyad-yeah

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

The Years 2000 And 2017: There’s A Whole Lot Of Rhyming Going On

0
0

This week, CNBC’s Kelly Evans interviewed one of the most well-respected billionaire hedge fund managers in history, Julian Robertson. The co-founder of Tiger Management discussed global central bank collusion to depress interest rates and the subsequent creation of a bubble. “A bubble in the stock market?” the journalist clarified. Robertson replied, “Yes, ma’am.”

Billionaires from the investing world do not sport perfect track records. Nevertheless, when the .0001% speak, investors should take notice.

Within the past few months, the list of billionaire bull market dissenters has continued to grow. George Soros has been selling stocks throughout the summer in favor of gold. Jeffrey Gundlach suggested that investors begin “moving toward the exits.” Howard Marks warned that buying into concepts regardless of price (e.g., ‘FAANG,’ Canadian real estate, etc.) is the “…absolute hallmark of a bubble.” And while Warren Buffett preaches the virtues of buy-n-hold, his active raising of cash aligns with his desire to sell higher when others are greedy.

warren

Most rear-view mirror thinkers concur that the dot-com collapse of 2000 represented stock market insanity. In fact, after the NASDAQ 100 lost 80% of its value and the S&P 500 plummeted 50% from its peak, people acknowledged having suffered through the bursting of a stock market ‘bubble.’

Leading into the turn-of-the-century, however, few spoke about extreme valuations in terms of eventual disaster. On the contrary. The New Economy represented a supercharged shift in technology that ‘justified’ ridiculous prices for questionable profits and modest sales.

Here in September of 2017, the masses are once again disregarding the dozen or more traditional metrics of extraordinary overvaluation, justifying them on a simplistic ultra-low-rate criterion. Although most of those metrics (e.g., market cap-to GDP, earnings, book, Q ratio, etc.) may still place 2000 as the most overblown balloon in history, the fact that 2017 comes in second place should hardly serve as solace. Indeed, to the extent revenue matters, investors currently pay the highest S&P 500 price-to-sales ratio and highest median price-to-sales ratio in history.

sp-price-to-sales-sept-2017

Well, what about unabashed euphoria? Aren’t 2017 investors less bullish than they were back in 2000? On the surface, perhaps. However, cash allocations have rarely been lower (per the American Association of Individual Investors) and stock allocations have rarely been higher.

With respect to the latter, household allocation to equity as a percentage of financial assets hit a record of 64% during dot-com mania. At the end of March (2017) it was roughly 53%, though estimates place more recent data (Q2 June) at 55%.

total-household-equity-exposure

Is the current stock market exposure as a percentage of financial assets as out of whack as it was back in 2000? No. And from a wildly bullish perspective, stocks might have plenty of room for growth. On the flip side, abnormally large percentages in the 21st century have already preceded two bear market maulings of 50%-plus. Why is it encouraging to see the development of a third blister, even if the inflammation can become more inflamed prior to infection?

“But Gary,” you protest. “In 2000, interest rates were so much higher.” Yes. Want to know what else was higher in 2000? Productivity, gross domestic product (GDP), the labor force participation rate as well as the homeownership rate. Want to know what was lower? Household debt, government debt and corporate debt.

In other words, the 2000 tech stock bubble and the 2017 all-asset bubble (stocks, bonds, real estate) have dissimilar origins, with today’s frothiness emanating from globally coordinated central bank monetary policy. Yet they both share excesses in total household equity exposure as well as sparsity in cash allocation.

cash-allocation

Meanwhile, according to Gallup, investor optimism in 2017 has hit 2000 illogical extremes. Sixty-eight percent of folks now say that they are optimistic about the stock market’s performance during the next year. The 68% data point ties the record for the question (1/2000). Additionally, the full Wells Fargo/Gallup Investor and Retirement Optimism Index, which incorporates a variety of economic factors, hit its highest level (138) since September of 2000.

us-investor-optimism-2017-09

In truth, sentiment indicators often poll different segments of the population. For example, the American Association of Individual Investors (AAII) survey that polls retail investors weekly is not flashing warning signs on excessive enthusiasm. (Note: Their cash allocation levels are telling a different story.)

On the flip side, Investors Intelligence and the Association of Active Investment Managers (NAAIM) poll the professional ranks. Both have seen spreads between bullishness and bearishness exceed levels once associated with the year 2000. Not a whole lot of bears, you might say.

bull-bear

In aggregate, 2000 and 2017 share similarities in valuation extremes, an absence of pessimism, low cash levels and high household equity allocations. They also share business cycle lengths that many would describe as ‘long in the tooth.’ As the 3rd longest expansion in history, perhaps the current expansion is closer to completion than tax-cut infused acceleration.

business-cycle-length

Do I believe that stocks will collapse by the same amount in the exact same manner? No. Like a hurricane or an earthquake, bear market wealth destruction differs in magnitude, length and side effects. And much like a hurricane or earthquake, the question is not ‘if,’ but ‘when.’

History rarely repeats itself in precisely the same manner. Yet it rhymes. Oh how it rhymes! It follows that counting on the Federal Reserve to limit your portfolio pain in the next bear may not be the most sensible approach.

fed-can-prevent-anything

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.


If Familiarity Breeds Contempt, What Do Debt And Complacency Breed?

0
0

Back in 1999, low inflation and fabulous headline unemployment (<5%) warranted a Federal Reserve overnight lending rate of 5.0%. Today, low inflation and desirable headline unemployment (<5%) come with $3.75 trillion in electronic money credits still on the central bank’s balance sheet and a Fed Funds Rate of a mere 1.25%. That is 375 basis points lower than it was with similar economic fundamentals less than two decades ago, not to mention a whole lot of “electronic money printing” since the financial crisis in 2008.

A great many economists agree that the excesses leading into the 2008 financial crisis occurred, in large part, due to keeping interest rates too low for too long. Leverage through exceptionally easy access to low borrowing costs became rampant in residential real estate.

This time around, though, a decade of near-zero rate policy and trillions in asset purchases via quantitative easing (QE) have yet to result in asset price disaster or economic catastrophe. On the contrary. Keeping rates much lower for much longer have enabled the U.S. government to borrow trillions more than it might otherwise have, companies to saddle their balance sheets with never-before-seen debt levels, and consumers to supplement stagnant wages with an assortment of credit (e.g., credit cards, auto, student, home equity, other, etc.).

Some might argue that the loan quality is not as bad as it was when “liar loans” and “negative am” ruled the roost. There is some truth in that. At this juncture, the consequences of corporate excess have only been felt in the energy and retail sectors.

radio-shack

On the other hand, similar signs of silliness have resurfaced. For instance, before the financial crisis in 2008, leveraged loans became disproportionately large relative to other types of corporate loans. Here in 2017? The speculative reach for higher yields alongside corporate willingness to borrow has once again led to a disproportionate mix of offerings.

levraged-loans

This is just one of the phenomena associated with artificially suppressed yields and ultra-easy access to cheap credit. Another? The swapping of stock liability for debt liability that has left corporations more leveraged than they’ve ever been in history.

felder-swap

Perhaps ironically, the stock-for-debt swap only tells half the story. When public corporations used the debt dollars to remove stock liability from their books, the reduction in share count made stocks more scarce. A lack of supply coupled with flat demand or increased demand contribute to price appreciation.

Another way to look at what has transpired is to compare corporate debt percentage increases to earnings per share gains and stock price appreciation. Since the end of the first quarter of 2011, corporate borrowing has surged by approximately 50%. That helped GAAP-based earnings per share (EPS) climb 28%.

Did stocks only rise 28%? Hardly. Stock prices have rocketed 88% over the six-and-a-half years since. In other words, debt helped stock prices a whole lot more than corporate profitability.

us-corporate-debt

Rightly or wrongly, the investment community is showing little fear. Record low cash levels solidify the likelihood that there is plenty of comfort placing so much faith in stocks and other higher-yielding instruments. When a larger percentage of money is in the safety of cash, it tends to be associated with risk aversion; when nearly all of it is ‘working,’ that tends to be a sign of risk-seeking.

Would this sentiment indicator alone imply that a bear market for riskier debt and/or stocks is imminent? No. Nevertheless, a quick peek back at the cash levels associated with 1999-2000 hint at a comparable complacency.

record-cash

Still, complacency may unwind a bit in the month ahead. The CBOE VIX Volatility Index (VIX) tends to elevate in the month of October.

october-can-be-volatile

Equally compelling? A whole lot of people in 2017 have been pouring money into Inverse VIX exchange-traded products to short volatility. (See the light blue line below.) Right now, though, there are as many dollars speculating in leveraged long VIX exchange-traded products as there are in the short camp. (See the silver line below.) This has not really been the case since the last stock market correction of 10%-plus in January of 2016 — 20-plus months ago.

vix-etps-1_0

Some money may be ‘betting’ that stretched valuations require a reality check. The cyclically adjusted price-to-earnings ratio (PE10) has only looked worse in 1929 and 2000. In fact, Robert Shiller recently said that “…the U.S. stock market looks a lot like it did at the peaks before most of the country’s 13 previous markets.” 

Granted, valuations like Shiller’s PE10 cannot predict the timing of a bear. On the flip side, according to Shiller, higher-than-average real earnings growth and lower-than-average stock price volatility occurred in every year leading up to a bear market’s origin. In other words, exceedingly high market valuations coupled with lower-than-average volatility and higher-than-average real earnings growth came before all 13 of the 20%-plus price depreciation episodes.

pe10

Should you think about playing it safer? That is a personal choice. I downshifted risk from 70% stock/30% income to 50% stock/25% income/25% cash equivalents a number of years ago.

What I would say is that I prefer growth at a reasonable price. Companies like Gilead (GILD) and Apple (AAPL) at 10x and 13x operating cash flow respectively are priced reasonably for the growth provided. In contrast, I may or may not like the businesses of Facebook (FB) and (AMZN). Yet 26x or 27x or 28x operating cash flow? Most, if not all, future growth may be ‘priced in’ already. Other than their presence in a core index fund holding, it is hard to ‘justify’ growth at ridiculous prices.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Don’t Put All Of Your Eggs In The ‘Tax Cuts Are Coming’ Basket

0
0

It does not matter what you call it or how you explain it. The Trump trade. A tax reform rally. Heck, you can attribute the longest uptrend in history without a 3% pullback to global quantitative easing (QE). It makes very little difference. Stocks have been stupendous.

numb-1-streak-without-3

Does a record number of trading days without a 3% correction mean anything? Not in isolation. The second-longest streak occurred between January 1995 and January 1996. And yet, back then, the phenomenal ’90s stock bull was only in the fifth inning of a record-breaking stretch (10/1990-3/2000).

On the other hand, the dearth of selling activity today is occurring at a moment when investors are more leveraged than ever before. They have never been more confident in future stock performance. The average cash allocation is the lowest on record, even lower than it was at the peak of dot-com euphoria (1/2000). Meanwhile, previous periods of relative equanimity – trading session with less than a 5% correction – preceded major financial crises and severe stock bears.

numb-2-a-5-drawdown

There’s more. A number of investors have been piling on the ‘no-vol’ train by shorting the CBOE S&P 500 Volatility Index (VIX). Shorting VIX futures has been so profitable for so long, they’ve become like pigs eating at the trough. And now, the positioning appears to represent a few too many people standing on one side of a crowded boat.

numb-5-shorting-volatility

As if these issues were not enough, some market anomalies simply defy sensibility. For example, would you acquire a corporate bond of a junk-rated European corporation if it yields LESS THAN a comparable U.S. Treasury bond yield? Probably not. Nevertheless, world central bank distortions have created this exact scenario.

euro-junk-bond-yield-2017-09-29-v-treasuries

Some of these concerns might be ameliorated by ultra-low borrowing costs, but not all of them. For one thing, the popular 10-year yield has pushed to the upper limit of an intermediate-term range.

bond-bond-yields

For another, earnings reports that have recently exceeded ‘lowered-bar’ expectations have done little to reduce extreme overvaluation. The median stock trades in the 98% of historical valuations. (Note: When one compares the 20 years between 1935 and 1954, he/she finds several decades with ultra-low interest rates at an average valuation that is HALF of what it is here in October of 2017.)

gs-valuation-1_0

Indeed, an examination of earnings growth over the past three-and-a-half years since the start of 2014 tells us that earnings have NOT been the main force in driving prices higher. In reality, asset prices have climbed 35% since the start of 2014, whereas earnings have managed a whopping 2%.

earnings-puuuhhhhlease

As I indicated earlier, it may not matter what has been causing the unbridled enthusiasm for risk taking. Earnings improvement over the 2015-2016 earnings recession may be a factor. Corporate tax cut hopes, investor exuberance and the ‘fear of missing out’ may be playing a part. Global repression of borrowing costs as well as the electronic printing of monetary credits may be influential as well. Regardless, to the extent you’ve been participating, your portfolio has been gaining ground.

Still, there are more than a few indications that the sailing in future months may be far from smooth. For instance, if the SPDR Gold Trust (GLD) experienced ‘lower lows’ across five bearish years of price depreciation, what can we say about the 20 months of ‘higher lows?’ Has precious metal demand ratcheted up due to generalized diversification, or is the desire to own gold a reaction to massive electronic money creation by global central banks since January of 2016?

gold-gold

gold

To the extent that the second longest bull run (3/2009-10/2017) in history is a function of ultra-easy monetary policies around the globe, investors may be in for more trouble than they are able to envision. Right now, some central banks are gearing up to ‘taper’ the amount of assets that they purchase with new electronic monetary credits. Similarly, the U.S. Federal Reserve has expressed a desire for quantitative tightening (QT) — a plan to let old bonds mature without reinvesting the electronic credits. In other words, if quantitative easing (QE) stimulated the economy as well as pushed asset prices higher through a ‘wealth effect,’ wouldn’t the opposite process (QT) slow the economy?

Supposedly, ‘fiscal stimulus’ via tax cuts will offset any drag from monetary tapering and/or monetary tightening. Perhaps this scenario is plausible. However, a leap of faith might be required. First of all, a change in the marginal tax bracket from 35% to 20% for corporations may be far less stimulative than many hope. The typical company currently pays about 24% after deductions, not 35%. If the tax package closes additional loopholes to justify cutting the marginal bracket down to 20%, the benefits of lowering the marginal bracket will be further minimized.

Second, the political leadership is adamant about serving up a ‘middle class tax cut’ as well as neutralizing any breaks for top earners. For better or worse, the top 20% who pay 88% of all federal tax revenue will not have additional dollars to consume anymore than they already do. (How, then, would the economy grow even faster?) A ‘middle class tax cut’ may be a good thing… maybe a wonderful thing. Yet the household savings is just as likely to go into paying down debt levels as it is for consumption.

The point? Investors may be placing a little too much faith in the notion that the eventual tax package – comprehensive or otherwise – can be massively stimulative for economic growth. Can it really fire up the weakening job growth picture, as well as withstand quantitative tightening (QT)?

graphic-5-job-growth-slowing-a-lot

Bottom line? Stocks may continue to perform well in spite of fundamental and technical concerns. That said, I am holding a lower-than-normal allocation to stocks (e.g., 50%-55%) and to investment-grade debt (e.g., 20%) for my retiree and near-retiree client base. Whereas the rest of the investment community may want to have a 5% cash cushion, I am fine with a 20%-25% cash cushion that yields just 1.3%-1.5%. Not only will it reduce portfolio volatility when volatility returns, it will also be deployed when I can scoop up bargain assets at discounted prices.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Managing Assets When Markets Become Irrationally Effervescent

0
0

When I co-hosted a national talk radio show in 2000, tech stock inquiries came furious and fast. JDSU or Sun Micro? Powerwave or Cisco? Webvan or theGlobe.com?

Few expressed concern about a recession. Few wondered if they might lose money by investing in the New Economy’s Internet favorites. Even fewer callers believed that they might want to take less risk rather than more.

Granted, tech stocks may not be as wildly overvalued as they were in 2000. That said, the U.S. stock market as a whole is beginning to look a lot like it did in previous bubbles.

market-cap-to-gdp-november

Speculative excess is certainly not confined to the equity arena. Consider the crypto craze. Bitcoin began the year at roughly $950. At last check, it chimed in at $10,950. Wait, $10,600. Hold on, $11,200.

“You don’t understand cryptocurrency potential,” supporters tell me. “Bitcoin and blockchain technology must be viewed through a different prism entirely.” Really?

bitcoin-2

Real estate prices in a number of major metro areas are getting way ahead of themselves as well. The 3.75%-4% 30-year fixed here in the 2010s may justify higher home prices than previous decades, since homebuyers are essentially buying a monthly payment. But how much more? Portland, Dallas, Denver, Seattle and San Francisco Bay Area homes all carry price tags that are 20%-45% higher than they were during the housing bubble peak in 2007.

Keep in mind, the incredibly easy access to 5.75%-6% mortgages in the mid-2000s was a major component in 2007’s housing bubble and eventual bursting. With existing home sales turning negative on a year-over-year basis, here in 2017 and the masses expressing little worry about their property values, might one be wise to approach the asset class with a bit of caution going forward?

home-sales

Perhaps mortgage obligations and the overall expenses associated with homeownership are less onerous than they were in 2007. On the flip side, households are saddled with more debt than ever. Should asset prices from stocks to real estate depreciate in the future (and they will), those entrenched obligations would weigh heavily.

household-debt-yikes-2

Even with asset prices rocketing to all-time highs on a monthly basis since the election, cracks in the ability to pay back debts are emerging. The delinquency rate for subprime auto loans originated by auto-finance lenders has reached a seven-year high. And U.S. credit card spending has outstripped incomes for more than two years already.

chart-5-spending-versus-income

Business lending is also declining, down to 2.48% from 2.79% the prior quarter and down 7.67% from the prior year. The fact that nonfinancial companies in the S&P 500 have a debt-to-adjusted earnings ratio of more than 1.5, as opposed to 0.7 to 0.8 for the majority of the post-recession period, suggests that banks may be fearful of lending even more money to corporations.

Meanwhile, U.S debt-to-GDP has remained elevated at more than 100% for five years. That’s far greater than it was before the financial crisis; it is far greater than at any point since World War II, when there was a brief spike beyond the 100% level.

us-debt-to-gdp

The current debt might be “sustainable” from a theoretical standpoint, should interest rates never move meaningfully higher. Yet the Federal Reserve continues to push shorter term maturities higher even as intermediate and longer-term maturities barely budge. That has been pushing the yield curve toward an undesirable and precarious flattening.

Sure, the yield curve may not invert, signaling the probability of recession. However, it is troubling to recognize that tax cut enthusiasm originally sent the spread from 1% up to 1.3%, only to see it drop down to less than 0.6%. In other words, expectations for economic growth are rather subdued., in spite of the Federal Reserve’s confidence.yield-curve-flattening

From the start of the current bull cycle in the first quarter of 2009 through the end of 2014, we placed many of our near-retiree and retiree client base near the top of their risk profiles; that is, many had a tactical allocation of 70% widely diversified stock and 30% widely diversified income. Exchange-traded trackers such as iShares S&P 500 (IVV) and iShares ACWI All-World ACWI Index (ACWI) have been mainstays.

For nearly three years now, however, we have advocated for 50% higher quality stock, 25% higher quality income and 20%-25% cash equivalents. The allocation proved beneficial in the 22 months prior to the election when stocks move sideways for nearly two years; it proved less rewarding since the election more than 12 months ago.

While we have seen slightly less reward by taking slightly less risk in the latter stages of the current bull cycle, we will remain on hold. As it stands, price appreciation alone has taken stocks up to 57%-60%. And we do not intend to incorporate additional risk into retiree and near-retiree accounts until bearish price depreciation allows us to snatch up bargains.

There’s more. If the monthly close on the 10-month SMA finishes below its trendline, we would reduce our exposure to risk assets substantially. This is the technical trigger that helped me sidestep the bulk of bear market losses in the tech wreck (2000-2002) and the financial crisis (2008-2009).

ivy-10-month-sma

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

If You Bought The Tax Reform Rumors, Will You Be Selling The Tax Cut News?

0
0

Since the Great Recession, each time that the U.S. economy bogged down, the U.S. Federal Reserve began printing additional electronic dollar credits to acquire billions in assets (a.k.a. “quantitative easing” or “QE”). And the efforts were primarily responsible for pushing interest rates lower, as well as stock and real estate prices higher.

Take a look at the blue line in the chart below. It represents the electronic money printing activity of central banks across the world. Not only did stocks surge ahead at every U.S.-inspired QE juncture (e.g., QE1, QE2, QE3, etc.), but globally coordinated QE activity actually accelerated in 2016 and 2017. (See the orange oval.)

chart-3-total-cb-assets

More than anything else, including the prospect for U.S. tax reform, stock price appreciation has been a function of central bank monetary credits ending up in riskier assets (e.g., stocks, bonds, etc.). On the other hand, global QE is set to decelerate dramatically in 2018. For example, our Fed is stopping the reinvestment of electronic money credits into new asset purchases and the institution plans on eliminating $420 billion from its balance sheet. Similarly, the European Central Bank (ECB) is slowing down its acquisition of below-investment-grade corporate bonds in its tapering process; they’re going to be removing $500 billion in “accommodation.”

The removal of nearly $1 trillion in asset price support in 2018 is hardly insignificant. Over the last nine years, stock price appreciation has been robust when the slope of the blue line above has steepened. In contrast, stocks have tended to struggle in periods when the slope of the blue line flattened.

Researchers at Bank of America have elaborated on the analysis. They identified each market shock since the start of 2013. In so doing, they found that central banks like the Fed intervened to protect markets in every instance up until the Brexit vote. Ironically enough, since the Brexit vote in July of 2016, investors have conditioned themselves to expect the central bank backstop (a.k.a. “Fed put”) and to buy every market dip.

market-shock-bofa

The current buy-the-dip mentality has been remarkable. In spite of irrationally effervescent valuations, the MSCI All-Country World Index has risen every month for 12 consecutive months. The string of monthly gains has never happened before in the history of the global stock benchmark.

never-say-never

Many believe that Republican-led tax reform is a phenomenal positive for bull market continuation stateside. Indeed, there’s little doubt that stock investors have been buying the proverbial rumor since the November 2016 election. The question is, should people consider selling the actual news of passage?

Granted, greater profits at public companies will make their way into dividends, mergers and buybacks. Yet there’s little evidence to suggest that the domestic economy will improve dramatically.

Take a look at the graph below. At least one bit of research shows that real GDP per capita does not grow at a faster clip when associated with higher or lower federal tax revenue (as a percentage of GDP). Tax reform might be inconsequential. In other words, even if tax reform produces a lot of stimulus out of the gate, it may not be a sustainable force.

taxesandgrowth

What’s more, in the last six economic expansions, the initial GDP growth rate tended to be very similar to the growth rate down the road. In essence, there’s little evidence to suggest that the slowest domestic expansion on record (2009-2017) is going to catapult from its anemic 2%-2.5% average to a permanently higher plateau of 3%-3.5% for a sustained period. For a quarter or two? Sure. For another 5-10 years without a recession? Not a chance.

ecoonmic-expansion

One thing’s for certain: The Treasury bond market does not support notion that tax reform will light the domestic economy on fire.  Immediately following the November 2016 election, the difference between 10-year Treasury bonds and 2 Year Treasury bonds spiked from 1% to 1.35%. The implication at that time? Tax reform should stimulate economic growth beyond post-Great-Recession levels.

Now consider the yield curve chart below. Since the inception of the year, however, the spread between intermediate maturities (10 years) and short maturities (2 years) has been whittled down to a mere 0.53%. If the bond market believed in the longer-term viability of current tax reform efficacy, the spread would stay elevated or widen, rather than compress.

10s-minus-2s

The fact that the Federal Reserve is raising its overnight lending rate and seeing little reaction from the yields of intermediate and longer-term bonds is an indication that bond investors do not believe in the strength of the economic outlook going forward. In truth, the spread between key Treasury bond rates sits at a decade low. Should the spread turn negative, a phenomenon known as “yield curve inversion,” fears of recession would creep into everyday conversation.

“But Gary,” you argue. “You just don’t get the enormously positive impact of corporate tax cuts.” Well, we may have to agree to disagree.

Consider an effective tax rate for public corporations at 25% (statutory rate 35%). Now let’s bring the statutory bracket down to 20% per the bill in Congress. And let’s let the effective rate move 10% lower than the statutory sticker price, or 10% effective. (Not sure the effective will actually be this low, but let’s run with it.) The upshot for after-tax cash flow would work out to a 20% boost (.90/.75=20%).

And how much has the S&P 500 risen since the November election? 25%-plus? It follows that most of the tax benefits have already been priced into the market at a time when market overvaluation rivals 1929 and 2000.

chart-1-market-cap-to-gdp-november

Bottom line? With the central banks reining in the easy money and tax reform largely priced into stock price appreciation, you might want to have a risk reduction plan at the ready. As I discuss frequently, my exit strategy involves the monthly close on the 10-month simple moving average. You should use it in some capacity. Not only did it help me sidestep the bulk of stock losses in the tech bubble (2000-2002) and the financial crisis (2008-2009), but it has outperformed buy-n-hold with less risk for 90 years.

image-buy-no-hold

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Speculative Frenzy Smells More And More Like 2000

0
0

Scores of extremely bullish investors insist that the financial markets today do not resemble the technology stock craze near the tail end of the late 1990s. That position is getting more difficult to defend.

For example, market capitalization to GDP is a long-term stock valuation indicator with a high correlation (0.89) to subsequent 10-year returns. The valuation tool is frequently referred to as the “Warren Buffett Indicator.” The reason? In 2001, the Oracle of Omaha dubbed it as “…the best single measure of where valuations stand at any given moment.”

buffett-at-march-2000

My eyesight may be faltering in my 51st year of life. Nevertheless, I am fairly certain that the breach of 140% by the Buffett Indicator in December of 2017 is very similar to the one that occurred in March of 2000.

There was a feeling then, as there is right now, that one had to invest his/her cash somewhere. Then, cash equivalents might only have been rewarding savers with 5%. (What people would not give for a risk-free 5% right now.) Yet that was deemed idiotic when stocks delivered 18%-20% in the “New Economy.”

In 2017, cash equivalents might provide 1.5%. “An unacceptable return,” many allege. “That just loses to inflation.” Stocks deliver 8%-10% over time, so why would you consider anything else?

It follows that many have been throwing in the cash towel. The stock-to-cash ratio at 5.0 in 2017 is extremely similar to the ratio during late ’90s insanity.

all-in-slash-cash

In the same vein, the average allocation to cash by investors in 2017 is actually slightly lower today than it was in 2000. Granted, the data does not imply that stocks must collapse from this moment forward. Yet it would be foolish to ignore circumstances that are undeniably analogous.

cash-cash

Let’s take the resemblance between the two periods one step further. Special purpose acquisition companies (a.k.a. “SPACs”) hit a global issuance record this year. What are SPACs? These are publicly-listed corporations that raise money from investors for an undefined business.

In other words, companies with no profits or specific prospects have raised $14 billion in blank check funding. These newly listed shares simply accumulate gobs of dollars from the speculative and the hopeful, all in a blind faith attempt for the money to earn more than cash equivalents. blank-check

Blank check funding? Does that not evoke a whiff of the previous century’s New Economy elation? Meanwhile, bitcoin fanaticism in 2017 certainly sparks memories of 1999’s dotcom delirium.

bitcoin-3

There is some irony in the fact that a number of measures are still below the “2000 peak.” For instance, household equity as a percentage of total financial assets has reached its second highest level ever (36.3%). Yet the absolute peak hit 42% at the 2000 pinnacle.

Far too many folks conclude that there is a ton of room for stocks to power higher because we have not reached the 2000 bubble’s level. Seriously? The second-highest stock investment level on historical record – second only to 2000’s monstrously precarious balloon – and that supports an aggressively bullish stance?

lyon-total-percentage-equity

Keep in mind, household equity allocations at these levels average 10-year subsequent returns in the neighborhood of 3.7% annualized. And that’s probably going to come with a pretty nasty bearish interlude or two in between. Buying-n-holding through those storms will undoubtedly test the psychological wherewithal of market participants.

In truth, there are positives to advance the euphoric stock buying spree. The global economy has been showing signs of improvement. Tax cuts for U.S. corporations would allow them to keep more after tax cash flow. And the price of money vis-a-vis interest rates currently remains super low.

On the flip side, as we enter 2018, there will be pressures on all three of these fronts. An entire decade of near-zero percent rate policy and electronic money printing by central banks has forged an unsustainable debt path. Specifically, debts have been growing at a far faster pace than economies themselves.

g20debt

If borrowing rates could be counted on to stay as low as they are now, as well as move lower over time, debt servicing would not necessarily be an issue. However, the U.S. Federal Reserve is looking to “normalize” with a continuing campaign to raise overnight lending rates, as well as eliminating $420 billion from its balance sheet (a.k.a. “quantitative tightening” or “QT”). By the same token, the European Central Bank (ECB) intends to slow its asset purchases (a.k.a. “tapering”), which has the same effect as removing $500 billion in liquidity injections.

In essence, $920 billion less in asset price support for 2018 matters. After all, if 2016 and 2017 represented the fastest pace of global quantitative easing (QE) in the 2008-2017 period, wouldn’t deceleration in the pace of asset purchasing act as a headwind for equities? And what about corporations that can barely cover their interest payments, if at all?

debt-debt

Equally concerning, the investment community may not be adequately prepared for the possibility that record low volatility in both stocks and bonds picks up substantially. It might take little more than a singular shock to the proverbial system for a sharp reversal in volatility, with likely contagion causing panic sell-offs in risk assets.

stock-bond-volatility-never-lower

The fact that leverage in those risk assets has never been higher alongside an investment community that remains convinced that volatility can always be suppressed is troublesome. It is almost as if the investment community has forgotten what happens to stocks when margin debt unwinds and when credit balances in margin accounts swing from negative (red) to positive (green).

margin-december

So why am I maintaining a 50%-57.5% allocation to stocks for my retiree and near-retiree client base? When an iceberg may be “Straight Ahead?” Two reasons. First, our tactical allocation has already lowered the percentage allocated to stocks and bonds such that we hold roughly 20% in cash equivalents. Our typical mix of 70% widely diversified equity and 30% widely diversified income is already more conservative.

Second, we would further preserve capital in portfolios if a technical breach occurred in the 10-month simple moving average; that is, if the monthly close on the 10-month SMA is below its trendline, we shift a much greater percentage to the safe harbor of money market accounts and other cash equivalents.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Warning: Side Effects May Include Rapid Stock Price Depreciation

0
0

Over the last decade, the most influential central banks around the world have printed electronic currency credits to acquire $14 trillion in assets. The effect on stocks, bonds and real estate? Remarkable price gains as well as records galore.

chart-1-central-banks-majors

On the other hand, quantitative easing (QE) activity by the U.S. Federal Reserve, People’s Bank of China, European Central Bank and others has created a variety of implausible circumstances. The Swiss National Bank has become one of the largest shareholders in Apple (AAPL) with nearly 20 million shares on its books. The Bank of Japan owns three-quarters of the Japanese exchange-traded funds (ETFs) in existence. And European corporate junk bonds yield less than comparable risk-free U.S. Treasuries.

euro-junk-bond-yield-2017-09-29-v-treasuries

Perhaps ironically, few seem bothered by distortions and/or oddities. On the contrary.  Active stock managers average 109% exposure to the asset class. That is not a misprint. The average exposure is greater than 100% such that active stock managers are “leveraged long.” The extreme reading is itself a rarity.

chart-2-lyons-share-leveraged-long

Retail investors are every bit as bullish as we move into 2018. According to the Michigan Consumer Survey, a record percentage of respondents expect stocks to be higher on a year-over-year basis.

Unfortunately, that may not be a good thing. More retain investors anticipate stock price increases over the next 12 months (10/2017) than they anticipated leading into the Great Recession.

chart-3-michigan

In a similar vein, consider the stock market lows following the tech wreck (2000-2002) and the financial crisis (2008-2009). The best buying opportunities occurred when investor expectations for stock growth potential were at their lowest ebb, not when survey participants were extremely optimistic.

Another sign of complacency? The S&P 500 has rarely been as “overbought” as it is at the present moment. At no time in the current bull market have we seen weekly relative strength (RSI) levels as high as they are right now.

chart-4-rsi-weekly

Excessive exuberance can also be seen in the absence of stock market volatility. Records have been set for the most consecutive trading days without so much as a 3% pullback or a 5% correction. It has been nearly 24 months since a run-of-the-mill 10% correction. And to the extent that the CBOE S&P 500 Volatility Index (VIX) lives up to its reputation as the “fear gauge,” the stock waters in 2017 have never been calmer.

volatility-vix

Is the extraordinary confidence in stocks going forward warranted? Those who point to favorable trends for the economy and for earnings believe that it is. Those who see similarities to 1999 and 2007, however, favor a more cautious approach.

It is worth remembering that in 1999 and in 2007, like 2017, the Federal Reserve was raising rates and gross domestic product (GDP) had been improving. Similarly, in each of those years, debt and leverage had been “off the charts.” Margin debt for stocks had been hitting records in 1999 and leverage to buy real estate had been reaching never-before-seen heights in 2007. Leverage in the equity markets in 2017? Eerily reminiscent.

margin-december

So what might be the proverbial tipping point? Central bank policy error. With the U.S. Federal Reserve planning to raise overnight lending rates three or four times in 2018, in addition to eliminating $420 billion from its balance sheet, the yield curve may flirt with inversion. Indeed, if the 10-year yields stays in the same general vicinity as it has since the election, and the Fed hikes two more times, the remarkably modest 50 basis point spread between “10s” and “2s” would evaporate.

50-basis-points

Not surprisingly, many are already discounting yield curve inversion as a bearish indicator for the economy or for stocks.  According to bond guru Bill Gross, however, our entire financial system depends on longer maturities yielding more than shorter maturities. Gross recently explained, “When credit is priced such that carry can no longer be profitable at an acceptable amount of leverage/risk, then the system will stall or perhaps even tip.”

If nothing else, investors might anticipate a rockier road in the year ahead. Should you have a cash buffer for buying the next 10%-plus correction? I do. Should you consider buying assets that have been overlooked and/or beaten down? I am. Consider a zero-debt, low P/E infrastructure small-cap like Argan (AGX) or a large-cap behemoth with two years of zero price appreciation like Starbucks (SBUX).

By the same token, recognize that the S&P 500 may be living on borrowed time. Think about a protection plan, whether it involves put options in an exchange-traded fund like WisdomTree S&P 500 Put Write Fund (PUTW) or reducing one’s equity exposure when the monthly close on the 10-month SMA falls below its trendline. Mathematically and financially speaking, few things are ever as important as losing significantly less in stock bears.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Nothing To Fear In The Stock Market But The Fear Of Missing Out Itself

0
0

I have quite a few clients in their eighties and a number in their late eighties. That is not particularly surprising when your client base is chock-full of retirees and near retirees.

What did surprise me a bit is a call from an 87-year old client yesterday afternoon. She called to inquire why her friends are making more money in the stock market than she has been making recently.

“Are most of your friends in their 40s or 50s?” I asked.

“No, they’re my age,” she said.

“Well, then. The advisers for your friends could be in a heap of trouble someday.”

“What do you mean?”

“I mean that we have 50% of your account in stock assets and your account is growing in value at approximately half the pace of the U.S. stock market. And while there are no flawless rules for an 87-year old’s stock allocation, most advisers might peg it closer to 33%. So in order for your friends to be making more than you in stocks, their advisers would likely be risking 60%-70% in stocks, instead of the prescribed 30%-40%. And that amount of risk taking would be seriously frowned upon by the CFP Board as well as the Securities and Exchange Commission.”

“Oh,” she said. “So then I also have too much in stocks, right?”

“If I were holding-n-hoping with your 50% stock allocation indefinitely, then yes,” I said. “However, we rebalance accounts when certain conditions are met. When the monthly market price breaks below its long-term trendline, we will reduce your stock allocation to 25%. That is how we protected you in the 2008 financial crisis.”

“I know, I know! I tell my friends all of the time how little I lost in 2008!” she said enthusiastically.

Shortly after we ended our telephone conversation, I flashed back in time to the late 1990s tech boom. Was this interaction emblematic of the greed near the peak of the 2000 bubble?

Anecdotally speaking, the 2000 bubble fostered a greater amount of ‘get-rich-quick’ scheming. What’s more, equity fascination had largely been a baby boomer demographic thing — people in their peak earning years had come to believe stock assets could not fall in value. Meanwhile, retirees in the late 1990s could earn extremely respectable returns by diversifying with risk-free Treasuries and investment grade bonds.

The difference today? Millennials, GenXers, Baby Boomers – investors in their 20s, 40s, 60s and 80s – are ubiquitous in their fear of missing out on the ultimate stock party. Even 87-year old widows.

Making matters worse, central bank rate manipulation has made it difficult to earn a reasonable return by diversifying with higher quality fixed income assets. Since the Federal Reserve began manipulating borrowing costs lower in the mid-80s, each subsequent recession has required interest rates to be much lower for much longer than the previous contraction.

lower-for-longer

With investment grade interest yielding so little, it has become stocks or bust for many folks who do not have the luxury of time. Yet a ‘bust’ is what a large percentage of older people are not prepared for.

Here in January of 2018, stocks have not pulled back 2% for five-plus months; they have not corrected a mere 3% in 15 months or 5% in 19 months. It appears as though the fear of missing out on the uptrend has become so pronounced that buyers no longer wait for the most modest of pullbacks to acquire shares lower.

Consider the relative strength index (RSI) for the Dow Jones Industrials. Matthew Yates, a Seeking Alpha contributor, demonstrated that the monthly RSI is higher than it has ever been in the past 100 years. The elusive monthly RSI reading of 90 did not even occur during the irrational exuberance leading into 1929. Yet peaks for monthly RSI values are associated with increased risks of near-term price reversals.

dow-industry-100-years

Another technical indicator, Average Directional Movement (ADX) captures the strength or weakness of a trend. Most analysts follow the heuristic that ADX readings (14-period) over 30 confirm strong uptrends. And that’s a good thing. After all, the “trend is your friend.”

However, an uptrend can jump the proverbial shark. For instance, extreme ADX readings of 56 preceded the stock market crash of 1987 as well as the financial collapse of 2008. Historic extremes in terms of trend strength, then, often precede disaster.

adx-trend

Dana Lyons of The Lyons Share points out that the current ADX reading of 70 has rocked the record books. The current uptrend’s strength is, for better or worse, incomparable.

Keep in mind, however, when one couples severely overbought levels (e.g., RSI, ADX, etc.) with the knowledge that stock market overvaluation is also pushing on a string, stock price reversion may not be far behind. If nothing else, a sharp spike in volatility might be preordained. price-to-sales-2

As if overbought, overvalued conditions were not enough to ponder, the Rydex Bull-Bear asset ratio has eclipsed even the most bullish extremes. Bullish assets currently outstrip bearish assets by a factor of 20. Imperfect sentiment indicator notwithstanding, the discovery is downright mind-boggling.

bul-bear

Not to fret, though. The melt-up in stocks implies that there is nothing to fear but fear of missing out (FOMO) itself.

stock-bond-ratio

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.


Are American Stocks Great Again?

0
0

The U.S Department of the Treasury currently forecasts that the national debt will reach the $25 trillion mark by the 3rd quarter of 2020. That’s just two and a half years from now.

What is $25 trillion among American friends? If you combine the debts of every other sovereign state on the planet, you still do not reach $25 trillion. Our nation is a serial debtor.

It is easier to dismiss the enormity of the obligation when government is capable of servicing it through ever-lower borrowing costs. Rising rates, however, alter the debt servicing narrative. Specifically, paying back the interest on the monstrous burden takes a bigger and bigger bite out of how much government can spend elsewhere.

Investors may feel that they can ignore the longer-term implications of their government accumulating trillions in annual deficits. After all, most still regard U.S. Treasuries as the highest quality debt one can acquire. On the other hand, investors are not currently appreciating the near-term ramifications for corporate profits, household spending or asset prices.

Consider residential real estate — an asset that pole vaulted through the proverbial roof on the back of 30-year fixed mortgages at 3.5%. That rate today is closer to 4.5%, and climbing.

What does this mean for the household looking to buy in Redmond, Washington? A $500,000 mortgage that had been costing $2245 per month now costs $2533 – nearly $3500 more per year. That puts a bit of a dent in the family budget.

Now consider what happens if rates continue to rise. If the 30-year fixed mortgage moves up to 5.5%, the $500,000 obligation that had been costing $2245 per month would cost nearly $2840. That’s close to $600 more per month or $7200 more per year.

How might a 26.5% jump in mortgage expense hamper household spending elsewhere? How might that impact the ability and/or desire for the household to buy the home in Redmond, Washington at all?

Rising rates eventually weigh down consumption in our consumer-based economy. Equally troubling, rising rates would reduce the demand for real estate such that elevated home prices would likely fall in value. Flat or falling home prices do not benefit an economy that has largely benefited from a central bank-engineered “wealth effect.”

us-housing-case-shiller-seattle-2018-01-30

One might argue that wage gains and lower tax brackets offset some of the concerns associated with higher borrowing costs. The problem with that assertion? It disregards both the quickening in the erosion of purchasing power (inflation) as well as the American addiction to credit.

In the chart below, credit card debt is plotted alongside inflation-adjusted disposable income. Not only did credit card debt as a percentage of real disposable income skyrocket after the financial crisis, it remained elevated throughout the recovery from the Great Recession. And over the last few years, it has bumped up even higher toward 6%.

credit-card

Maybe Americans have been feeling confident that they can spend money that they do not have, especially with wages as well as asset prices on the upswing. Or maybe they have already spent the bulk of their personal savings such that they do not have another choice.

In the graphic below, we see that inflation-adjusted savings as a percentage of disposable income (DPI) has dropped to levels not seen since shortly before the financial system collapsed in 2008. Real savings as a percentage of DPI is historically low as well.

savings-as-a

Taking both charts into account, the average American’s credit card balance as a percentage of real disposable income more than DOUBLES real savings. In what universe is that beneficial? Not one where the cost of borrowing is increasing.

Let’s turn our focus to the bond and stock markets. Non-investment grade corporations could borrow at roughly 5.4% just three months ago. Today it is closer to 6.4%. Corporations, then, will have less money left over for all of the other aspects of their businesses; servicing debts will require more and more of the revenue that they generate.

fredgraph

Again, one might choose to focus on the benefits of tax reform alone. Yet. what tax cuts “gaveth,” higher borrowing costs “taketh” away. The result is a trade-off, and not one that is necessarily favorable to stock valuations.

Consider Forward Price-to-Earnings estimates as we headed into 2018. While those elevated P/E ratios had taken into account higher earnings per share based on the tax overhaul, they did not take into account significantly higher borrowing costs that might exist 12 months later. Many bank economists at the start of the year expected to see the 10-year yield in and around 2.85%-2.90% at the end of the year. We’re already there. Meanwhile, analysts have not exactly slashed their earnings picture or adjusted “cost-of-capital” valuation models.

factset

Put another way, if low rates are not nearly as low as they were before, do they still justify stocks trading in the 96th- 99th percentile of historical valuations on a bevy of measures? When does the higher cost of capital make the highest market-cap-to-GDP and highest price-to-sales ratio(s) in history relevant again?

Take a look at forward price-to-revenue in the chart below. That was BEFORE 10-year yields climbed from 2.3% to 2.9%. Maybe, just maybe, higher borrowing costs will make current S&P 500 valuations look quite ludicrous in a rear-view mirror.

price-to-sales-2

To reiterate, borrowers at all levels (i.e., household, corporate, state government, federal government) will be dealing with higher rates in the near-term. The reasons for those higher rates involve everything from extraordinary fiscal stimulus via trillion dollar deficit spending, significant changes to the tax structure, an increase in Treasury bond supply, central bank quantitative tightening (QT), a decrease in Treasury bond demand from other countries as well as inflationary pressures.

chart-2-borrowing-tnx

Investors may be unprepared for the ways in which debt, deficits and higher rates can hamper the economy; they’re certainly unprepared for what can happen to the corporate bonds and stocks that they’re invested in. After all, most were caught completely off guard by the speed at which rates were climbing and the ripple effects in the volatility space. (Note: The 10-year has hit 2.90% as I type.)

At present, the S&P 500 is reclaiming roughly half of its correction losses. Relief rallies are common in many 10%-plus pullbacks.

sp-500-2700

Nevertheless, the headwind of higher borrowing rates may make it very difficult for stocks to solidify longer-term bullish momentum. Phenomenal corporate earnings may not be enough when prices have gotten so far ahead of themselves.

What should investors look for before believing the bull? The day when Federal Reserve members cry, “Uncle.” In particular, Jerome Powell and his Fed colleagues will eventually be forced to backtrack on rate policy.

Perhaps more tantalizing, there will come a time when the Fed will reverse course altogether, implementing actions that push the 30-year fixed rate mortgage down to 2%. That may not happen until the next recession, but it’s an opportunity to start preparing for today.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

Brakes Applied To The Borrowing Tires Can Hurt Stock Investors

0
0

Mainstream media commentators regularly tell you that higher interest rates in 2018 will not threaten your portfolio. After all, they assure you, tax reform added piles of dollars to the bottom line profits of corporations as well as placed mounds of money back into the pockets of millions of households.

Can one be certain, however, that fiscal stimulus (e.g., new spending package, recent tax overhaul, etc.) will neutralize increased borrowing costs? For example, a large chunk of prospective homeowners have already dropped out of the hunt to purchase a residence.

mortgage-applications

In the last week alone, as mortgage rates pushed upward toward four-year highs, purchase applications sank 6%. Over the last few weeks, applications for mortgages tumbled 15%.

Keep in mind, this is with the 30-year fixed rate mortgage hitting 4.64% (0.6 in fees). What happens if we revisit a 5% 30-year fixed? Or 5.5%? More prospective homeowners would find themselves stretched beyond the limits of affordability, putting a damper on the demand for new and existing properties. Home prices would struggle to appreciate in value and might even begin falling in value.

At the same time, refinancing for existing homeowners would falter. That too would strain the credit growth that sits at the heart of U.S.-based economic consumption. In aggregate, if household net worth stagnates or dips, and the ability or desire to tap home equity disintegrates, equanimity about consumption would follow suit.

Granted, household and business borrowing costs might not move significantly higher from here. Stabilizing interest rates remain a possibility, even though the federal government is auctioning off more Treasury bonds and foreign country demand for our sovereign debt is waning.

Perhaps the biggest threat to stabilizing borrowing costs? The Federal Reserve is in the process of reducing its balance sheet through the process of quantitative tightening (QT). It is difficult to imagine a scenario where domestic and foreign demand picks up the entire slack on Treasury bond supply — a supply where the Fed is no longer a participant on the demand side.

6-fed-assets-since-peak

Corporations may also be forced to slow the rate of their own debt issuance. That would place a greater emphasis on their recent tax cut windfall.

Therein lies a significant question: What will corporations do with the tax cut dollars? If they continue to focus on short-term results as opposed to longer-term growth, they might further manipulate earnings per share (EPS) perceptions through stock buybacks. Reducing the share count, or supply, could keep prices elevated, even in the case of stable or modestly falling demand.

On the flip side, even with dollars going into stock buybacks from a one-time corporate tax boost, this may not be enough to sustain profit margins or year-over-year profit gains. The U.S. dollar has been weakening. Commodity price inputs have been rising. And increasing labor costs could occur in an environment that many believe to be “full employment.”

It follows that investors may be lulled into a false sense of security. They’ve come to believe that the Fed (and other central banks) can pass the Olympic torch from monetary stimulus to fiscal stimulus without incident. History, on the other hand, suggests that monetary policy error is a distinct possibility.

chart-6-fed-can-prevent-anything

While history will not repeat itself in precisely the same manner, its knack for rhyming is uncanny. In that vein, we might consider the pattern for loan delinquencies. In the early 1990s and in the early 2000s, much like today, the Fed tightened rate policy at the same time delinquencies were on the ascent.

delinquent-bank-loans

By all media accounts, the economy is on solid footing. (I am not sure why rates have been kept so low for an entire decade, nor is it clear why a massive spending bill and tax cut package became necessary for a “strong economy.” Yet I digress.) That said, gross domestic product (GDP) by itself does not significantly correlate with future stock market returns. In other words, even if investors get the acceleration in economic growth they’ve been anticipating, they may not see any reward in their portfolios, especially when borrowing costs move skyward.

It is true that we’ve seen borrowing costs rocket into the clouds before. We witnessed the infamous Fed taper tantrum back in 2013. If stocks performed admirably in that earlier environment, why couldn’t they do so in 2018?

tnx

Stocks could perform wonderfully in 2018 like they did in 2013, in spite of borrowing cost woes. Still, there are significant differences. For one thing, stocks carried relatively attractive valuations five years ago compared with the present day.

factset

Another issue? Due to the extraordinary quantitative easing (QE) measures by the world’s central banks (e.g., European Central Bank, Bank of England, Bank of Japan, Bank of England, Swiss National Bank, etc.), as well as the Federal Reserve’s maintenance of existing QE levels, borrowing costs effectively moved lower from a 2013 peak through the bulk of 2017. Now that global central banks are either slowing down their QE, or out-n-out tightening like the Federal Reserve, there is a recognition that borrowing costs are unlikely to move meaningfully lower until the next recession.

In last week’s commentary, I explained that the S&P 500 was in the process of reclaiming approximately half of its losses. I also explained that relief rallies in many 10%-plus pullbacks often go on to re-test their correction lows.

spx

While there is no way to be certain that the current corrective phase will emulate earlier patterns, investors can presume that a pullback to the 200-day moving average at 2550 is a reasonable expectation for the S&P 500. Should borrowing costs continue to climb, and should the technical 200-day support fail to bolster stock buying demand, one might anticipate a deeper wound to the 9-year stock bull.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

The Most Dangerous Stock Market Ever? Either Way, Have A Plan

0
0

Today’s stock market may not be as dangerous as 2000’s dot-com euphoria or 2008’s asset balloon. Why not? Global central banks are likely to act quicker and with far more “shock-n-awe” to minimize bearish price depreciation than they did in the previous sell-offs.

Some argue that policy efforts would fail to reinvigorate yet another wealth effect because central banks are out of ammunition. I disagree. Indeed, I expect that monetary gamesmanship in the near future will result in an average 30-year fixed rate mortgage of 2% for the 2020s. Similarly, stocks will benefit immensely from borrowing cost manipulation.

Of course, nobody knows how the current bull-bear cycle will play itself out. Might the next stock bear destroy more portfolio wealth than the previous two did? If so, commentators will likely point a collective finger at extreme leverage, colossal overvaluation and multilayered computerization.

Consider the excessive leverage being employed to own equities in 2018. For one thing, margin debt is greater than at any previous moment in history. More importantly, even when accounting for inflation and subsequently comparing margin debt to the economy itself, leveraged speculation has surged to never-before-seen heights.

marign-debt

According to Jesse Felder of the Felder Report, a significant negative correlation has existed between margin debt-to-GDP and 3-year forward returns since the mid-1990s. In particular, the last two times that the ratio reached 3%, 50% stock market declines were not far behind.

On Monday, Warren Buffett chimed in on the issue. He told CNBC, “It is crazy in my view to borrow money on securities… My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage. Now the truth is — the first two he just added because they started with L — it’s leverage.”

Is it possible that the world’s most admired investor is fearful of what a titanic deleveraging would do to stock prices? More likely, he is worried about leverage as well as overvaluation.

In his annual letter to Berkshire shareholders, Mr. Buffett flat-out acknowledged that he has not been able to acquire assets at “sensible prices.” The Oracle of Omaha also explained that overvaluation is a major reason why he holds $116 billion in cash. (Note: Berkshire’s cash position sits near 22.5%. The percentage is the highest that it has been in the 9-year stock bull.)

Perhaps Warren Buffett still places some of his faith in market-cap-to-GDP. In 2001, he described the valuation indicator as “…the best single measure of where valuations stand at any given moment.”

market-cap-gdp

Investors can quibble with the efficacy of market-cap-to-GDP. They may find fault in a number of indicators on an individual basis. Yet they would have a more difficult time disregarding the totality of aggregate data. Indeed, regardless of the metric, stock overvaluation is either more severe than during the 2000 bubble (e.g., market-cap-to-GDP, price-to-sales, etc.) or a little less onerous than during the lead-in to 2000’s tech wreck.

price-to-sales-2

valuation

It is true that Buffett has since walked back his previous comments by serving up the low-rate justification for higher valuations. However, if lower borrowing costs justified extremely high valuations alone, you’d have to assume that those lower borrowing costs existed in perpetuity. On the contrary. We have seen how quickly an assumption about perpetually depressed borrowing costs can evaporate.

tnx2

The first two reasons why the next stock bear might be more ruthless than most imagine (myself included) — leverage excesses and valuation extremes — matter because they mattered before. The third reason, the complexities of computerization, is less graspable. It is almost like sitting on a boat on a lake where a black swan lives, yet you simply have not seen the bird on the water.

Data indicate that, in 2018, a mere 10% of equity trading volume is coming from human decision-making. Where does the other 90% come from — the activity that is moving the Dow, S&P 500 and NASDAQ? It is high-frequency trading run by algorithms that buy and sell stock in microseconds.

Why might algorithmic stock trading be problematic? According to a 2015 briefing that one can find at the New York Fed’s web site, it causes market disruptions and heightened volatility. The report also opined that algorithmic trading increases the potential for systemic risk to propagate across asset classes.

Put another way, computer algorithms do not give a darn whether they’re paying a bargain price of $50 per share or a nonsensical price of $5000 per share. And they sure don’t care about those who have mortgaged their accounts to buy on margin.

In truth, the implications are more straightforward than the algorithms themselves. When computers are all buying at the same time, you get a melt-up. Nobody seems to mind when that occurs. Yet the time will come when algorithmic programs simultaneously sell. The melt-up becomes a melt-down that will not stop in modest correction-like fashion. The declines in price would eventually trigger margin calls that lead to forced liquidation of shares. At that point, neither human participants nor algorithms will be “buying the dip.” Like a snowball rolling down a mountain and picking up ferocious speed, a negative feedback loop of selling would morph into panic for human beings. The only desire will be the desire to protect capital.

The most recent corrective activity may have been an algorithmic shot across the bow – one that concerned Federal Reserve members greatly. Consider the recent trajectory of the Fed’s balance sheet. The Fed is supposedly engaging in quantitative tightening (QT) to reduce its balance sheet, not quantitative easing (QE) to increase its balance sheet. Yet more than $14 billion was added during the worst of the recent sell-off.

qe-againA $14.1 billion increase in the Fed’s balance sheet? Seriously? Granted, one should not expect balance sheet reduction to go in a straight line downward. Yet a week-over-week increase in that neighborhood defies logic. Indeed, monetary policy buying activity may have helped to get algorithms back on the buying track and to prevent the possibility of a wave of margin calls.

If there is good news for do-it-yourself investors, you can employ a phenomenally successful approach to managing these risks (i.e., excessive leverage, massive overvaluation, algorithmic trading). Employ the monthly close of the 10-month moving average.

There is nothing magical about the trend-following technique itself. Hedge funds and Registered Investment Advisers (myself included) use key trendlines. (So do the “algos.”) What is a little different about the monthly close is that it significantly reduces the occurrence of whipsaws, or unrewarding protection signals.

chart-6-10-month-january

Is the monthly close on the 10-month SMA perfect? No. Has it beaten buy-n-hold with less risk (e.g., beta, standard deviation, etc.) over the last 90 years? Yes. Did it help money managers like myself sidestep the bulk of the carnage in the 2000-2002 tech wreck and the 2008-2009 financial collapse. Absolutely.

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

If Consumers Stop Spending, Stocks And Real Estate Will Slide

0
0

Here is an economic data point that you will not hear about in the mainstream financial media: U.S. wage growth in 2017 had been the weakest since 2010. In fact, labor costs rose a paltry 0.35% on a year-over-year basis.

Are higher wages for workers, then, right around the bend? Some believe that the tighter labor market is about to spark wage inflation. Yet it seems that this could be wishful thinking. Actual inflation has shown up in housing costs (e.g., rent, repairs, etc.), groceries and medical care, less so in employee pay.

wage-growth

Might recent tax reform lead to higher employee compensation? It is possible, but not necessarily probable.

Consider corporate announcements in 2018. Plans to buy back shares of stock have surged 22%. In contrast, plans for capital expenditures – the acquisition, upgrading or maintenance of property, equipment, plants and so forth – rose a meager 3%. It stands to reason that, if companies have limited interest in “CapEx” investment for longer-term growth, then they may not be particularly eager to invest in human resource retention and development.

Granted, the wave of stock buybacks set to hit financial markets throughout 2018 may keep stocks from cratering. They’ve been a tremendous tailwind throughout the 9-year bull. On the other hand, the last time corporate buybacks rocketed to all-time highs was in 2007 – the year that the financial crisis began.

buyback-buyback

One question that investors may wish to ask themselves is whether or not wage gains will be strong enough in the months ahead. Why? With the average American’s credit card balance as a percentage of real disposable income more than DOUBLE his/her real savings, wage gains will be necessary to keep the spending spree alive. Remember, personal consumption represents 70% of U.S. economic growth.

High credit card balances and low saving rates notwithstanding, the combination of tax cuts and wage gains may be potent enough to bolster consumer spending in the near-term. Still, how long would it take before higher borrowing costs force households to use any additional monies to pay down debt?

chart-num-4-household-debt

The relationship between debt levels, borrowing costs (rates) and spending holds true for governments too. Granted, the U.S. federal government and the U.S. Federal Reserve are capable of creating currency as well as manipulating interest rates. Nevertheless, there is only so much debt and deficit that a country can rack up before buyers of “IOU” debt expect higher yields as compensation for the risk they are taking.

The reality on U.S. debt is quite an eye-opener. A number of estimates for 2017 found that 80% of all federal government revenue went to interest on our debt and individual payments (e.g., Medicare, Medicaid, Social Security, unemployment benefits, welfare, etc.). Estimates suggest that in 2027, interest on federal debts alongside government-promised payments to individuals will take up 100% of revenue.

So how will the federal government spend on anything else? Infrastructure? The national defense? Transportation, education, government employment? The primary way that it will spend on anything other than debt interest payments and payments to individuals will be through the issuance of still more debt (a.k.a. “deficit spending”).

chart-num-5-deficits

The U.S. government is on a path where it must issue more and more “IOU” Treasury bonds to finance its spending desires. This increases the supply of U.S. Treasuries. It also means that, all things being equal, domestic and foreign investors may require higher yields from those Treasuries to compensate for additional credit risk.

And that’s not the only reason higher borrowing costs are a near-term threat to the well-being of the U.S. consumption-based economy. In an effort to better position itself for QE4, QE5 and negative interest rate policy (NIRP) for the next recession, the Federal Reserve is attempting to nudge interest rates upward; it is refraining from acting as a net buyer of U.S. Treasury bonds. This reduces the demand for U.S. Treasuries. If foreign and domestic demand for U.S. Treasuries does not pick up enough slack, interest rates (and corresponding borrowing costs) may rise much faster than the Federal Reserve hopes for.

The attempt to unload tens of billions, then hundreds of billions, and eventually trillions of dollars, however, will create recessionary pressure. The higher borrowing costs climb, the less people will be able to spend. In a similar vein, lower-credit-quality companies will have trouble financing their operations. Asset prices from real estate to stocks might slide. And a “reverse wealth effect” could mark the end of the current expansion.

fredgraph

As it stands, stock market participants are already pondering what higher borrowing costs will mean for everything from the business of real estate to the consumer-based economy at large. One needs to look no further than the breakdown in homebuilder stocks.

xhb-2018

Few seem to ponder the possibility, even a likelihood, that the worst is yet to come for assets like stocks and real estate. Assets have skyrocketed with little resistance since 2011 on trillions upon trillions of global central bank liquidity. And now that it is being removed, albeit at a snail’s pace, we should expect the addiction to ultra-low borrowing costs to dissipate without incident?

Most commentators in the media have dismissed the bursting of bubbles in short volatility and cryptocurrencies as inconsequential. On the flip side, the 50% price evisceration in “cryptos” like bitcoin may be more meaningful than most recognize. Similarly, the doubling of S&P 500 VIX volatility may be more relevant than most appreciate. Indeed, these may be warning signs on the inevitable consequences of speculative excess.

marign-debt

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

The S&P 500 and Stephen Hawking: A Theory on “Peak Everything”

0
0

The NASDAQ served up an annualized return of 66% in its final two years of dot-com mania. Only after the balloon had burst did people begin to question the lunacy of paying 10x revenue for the privilege of being a shareholder.

Ironically enough, since early 2016, the top 10 growth names in tech collectively produced an annualized return of 67%. That’s right. The NYSE FANG+ Index has topped turn-of-the-century craziness.

peak-fang-bubble

For the current bull-bear cycle, then, we may be witnessing peak FANG fanaticism. Components of the NYSE FANG+ Index like Facebook (FB), Netflix (NFLX), Twitter (TWTR) and Nvidia (NVDA) currently sport mind-boggling price-to-revenue (P/S) ratios of 13.3, 12.3, 10.9 and 15.3!

How zany are price-to-sales ratios above 10? For one thing, the S&P 500’s forward P/S above 2.0 is already the most expensive in history. And that includes the tech bubble at the start of 2000.

price-to-sales-2

In the same vein, if one employs traditional valuation thinking, a P/S of 10 implies that a company need deliver 100% of its revenue stream for each year across a decade to provide a 10-year payback. Even with massive tax cut relief and exceptionally attractive borrowing terms, even with share buybacks by the boatload, it is virtually impossible to deliver 100% of corporate revenue stream back to shareholders for 10 consecutive years.

Investors should not pretend that they’re investing in the longer-term profitability of FANG+ components either. Amazon (AMZN) has been struggling with its cumulative profits and free cash flow for its entire existence. Pretending that the world’s second largest company by market capitalization justifies its forward price-to-earnings (P/E) ratio of 186 because it has transformed business as we know it is preposterous.

In truth, during the current bull-bear cycle, the stock shares of great companies have been getting pushed exponentially higher by machines that employ algorithmic trading. When the bear portion of the cycle hits, the “algos” will crush the overly leveraged FANG+ zealots.

What’s more, a bearish turn may not be far away. Peak FANG+ extremism is one sign. Another in the current bull-bear cycle? Peak corporate debt.

Consider the S&P 500 (ex financials). The median company’s net debt to earnings before interest, tax, depreciation and amortization (EBITDA) has hit a 50-year high.

net-debt-to-ebidta

It is not like we didn’t see corporate leverage creating a problem in the last two stock disasters (i.e., 2000, 2008). In fact, excessive borrowing preceded the previous three recessions (i.e., 1990-91, 2000-2002, 2008-2009).

corporate-debt-to-gdp

Many corporations simply could not resist the lure of extremely cheap money that global central banks made possible since the 2008 financial crisis. The problem now? The Federal Reserve is simultaneously hiking overnight lending rates as well as allowing its balance sheet to erode so that borrowing costs become more expensive. Similarly, the European Central Bank (ECB) is buying less assets; the tapering is akin to tightening in that borrowing costs around the globe will be more costly.

It follows that sharp increases in key borrowing rates is a risk to corporations that must continually reissue more bonds. As interest rates rise, their costs to service interest expense goes up. That may divert money away from dividends and/or buybacks. It may also take a toll on capital expenditures for growth as well as hinder profitability and profitability perceptions (earnings per share).

Peak corporate debt. Peak FANG fanaticism. Not surprisingly, both may be a function of peak central bank support in the current bull-bear cycle.

Creating tens of trillions in electronic currency credits has been the greatest coordinated experiment in the history of finance. And while there is much debate about the efficacy of worldwide monetary policies, there’s little debate on the exceptionally high correlation between global stock performance and the expansion of global central bank balance sheets.

global-cbPerhaps it is not particularly shocking, then, to see world stock markets struggle with direction in Q1 of 2018. A number of influential researchers have projected balance sheet contraction to begin here in Q1 of 2018. And unless recessionary pressures build very quickly, central banks are likely to continue tapering and tightening in an effort to achieve a more “normal” borrowing environment.

So if central bank support has peaked, should we be concerned that economies themselves have peaked in this current bull-bear cycle? Quite possibly.

Take a look at real estate. Refinancing just hit a nine-year low. Meanwhile, with property prices surpassing the all-time highs of the housing bubble on a nominal basis, many prospective homeowners can no longer afford payments because of higher mortgage costs. And if the Federal Reserve continues along its tightening path, it’s difficult to imagine home buying rates getting cheaper in the near-term.

Maybe you think that the recent tax cut package is going to push economic growth into the stratosphere. Yet even the Federal Reserve has dramatically downshifted its own projections for Q1 U.S. economic growth (GDP). It seems that the nine-year economic recovery will still be anchored near an annual average growth rate of 2%, not 3%. Higher borrowing costs from tighter monetary policy are likely to offset the fiscal stimulus of government spending.

gdpnow-forecast-evolution

Granted, one of the major sources of economic well-being is confidence. And right now, businesses report extraordinary levels of positiveness. Consumers too.

However, this is precisely what tends to happen at peaks. After all, is unemployment more likely to keep falling below the 4% level, or is it more likely to be a point of inflection? If the answer is the latter, history would tell us that recessionary pressures are not that far off.

chart-2-ur-and-recession-inception

By way of review, we may be dealing with peak economic well-being, peak central bank support, peak corporate debt as well as peak FANG fanaticism in the current bull-bear cycle. It is also conceivable that we have already seen peak political/geo-political cooperation.

Think about it. The potential threats in the political/geo-political realm are greater than we had in years past. Will trade wars between world economies escalate? Probably not. Nevertheless, you might want to dust off the history books with respect to Smoot-Hawley tariffs during the Great Depression.

Even without a trade war, the notion that central banks will stay in sync with one another is questionable. Whereas the European Union and the United States may be able to remain on the same page, Japan has trillions of yen-denominated reasons not to play nice in the global sandbox.

Specifically, the Bank of Japan’s “yield control” policy of printing as much yen as necessary to make sure that its 10-year government bond remains anchored at 0% may not sit well with other countries. Other nations may view endless yen creation as a way to gain an unfair advantage in exporting goods.

Trade wars. Currency wars. This is not even accounting for the possibility that the Mueller investigation becomes decidedly ugly for Trump’s agenda. Even more challenging? The mid-term elections could swing the balance of power in Congress.

In sum, I look at the current environment in the context of what I call, “peak everything.” And if you’re like me — if you believe that we’re closer to “peak everything” than not– you’re going to want to reduce some of the risk of participation. That means higher quality credit over lower quality credit. It also means a little less stock share speculation and a little more low-debt, strong-balance sheet stock share admiration.

For ETF investors, that might mean favoring iShares Quality Factor (QUAL) over reaching for yield in iShares High Dividend Yield (HDV). Similarly it might mean favoring PowerShares High Quality (SPHQ) over higher yielding equity in PowerShares High Yield Equity (PEY).

qual-hdv

Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.

 

 

Viewing all 56 articles
Browse latest View live




Latest Images