Investing Insights

August 2017: Post-Election Executive Summary

I. BULL-TO-BEAR TRANSITIONS AND SEVERE MARKET CORRECTIONS: HOW THEY HAPPEN

Economic Cycle

II. CURRENT ECONOMIC BACKDROP

  1. The current unemployment rate is 4.3%.
  2. The Federal Reserve has tightened the money supply by raising interest rates three times in the last year and is expected to continue doing so over the next year.
  • Major institutions have been increasing their cash reserves.
  • Retail and day traders are all in and are highly leveraged on margin.
  • Inflation has not yet shown its tentacles, but commodities and emerging markets appear to have entered new bull markets after having under-performed US and European equities over the last 5 years. At the same time, it appears that the 30-year bond bull market is over and this should become more evident as inflation starts to rise.
  • Even though Donald Trump has not yet been able to make good on his major economic plan, the economy has been improving on its own accord. Most likely, inflation expectations will rise if his infrastructure and tax plans make it through. Corporate profit margins are at all-time highs, but this will not be sustainable if wages rise. Employee wages on the whole have not followed profit margins so far. It’s an area to keep an eye on. If wages go up, corporate profit margins may decline.
  • III. MARKET BACKDROP

    1. Stock market overvaluation is at its highest level in history other than during a short period in March of 2000. We all remember how that turned out.
    2. Market trading is vastly different from what it was only five years ago.
      • Today, the bulk of daily market trading volume is robotic, high frequency, dark pool, and algorithmic trading.
      • Actual humans are rarely involved in these operations.
      • If and when there is any crisis of confidence with investors and traders due to an exogenous event, the likely scenario would be a reversal of the algorithms’ bullish bias and increased volatility. Previous examples of their volatility include “Black Monday” of 1987, when the S&P500 fell 22% in one day and 35% in three weeks, as well as the flash crashes of May 2010 and August 2015. These were all within the context of bull markets, but were painful nevertheless.
      • The Federal Reserve has announced plans to sell back the five trillion dollars of bonds it acquired via quantitative easing. Nobody knows how this can be accomplished without resulting in much higher interest rates. Add monetary tightening via other methods and a possible loss of confidence due to an exogenous event and the result may be a market decline of unknown length and proportion.
      • Didier Sornette, an acknowledged mathematical expert on market bubbles and crashes, states that another crash is inevitable:
        • There are fundamental structural flaws in our financial and economic systems which were aggravated by the Federal Reserve’s unprecedented need to rescue the financial markets two times in the last seventeen years.
        • These flaws have remain unfixed.

    IV. CURRENT STRATEGY

    1. Hold some cash reserves.
    2. New investments are going into commodities and emerging markets which are currently undervalued relative to US and European markets.
    3. The media has been splashing the airwaves daily with news of all time highs in the Dow Jones Industrials.
      • There are only thirty stocks in this index and it is easily moved by increases in just a few high priced stocks like Boeing and McDonald’s. Also, many major indexes (i.e., S&P 500 and Nasdaq 100) are constructed in a way that allows movement in just a few overvalued mega-cap stocks (e.g., Amazon, Facebook, Google) to make it appear that everything is wonderful. This is the same situation seen just prior to the market top of 2000.
      • No one knows how long the current situation can last. The major indexes continue to hold up on the surface, but there’s been internal deterioration over the last year.

    V. CURRENT ASSESSMENT OF MARKETS

    1. Interest rates increasing. This is bad.
    2. Sector rotation is taking place. Not all sectors are going up in tandem.
    3. Prices are hanging in there, but advancement has been minimal compared to the major indexes two years ago.

    January 2017: Factors Affecting Long Term Success in the Markets

    I. MONETARY LIQUIDITY

    1. Loose = Good
    2. Tight = Bad

    Both a and b usually take time to be reflected in stock prices.

    II. MOMENTUM (RATE OF CHANGE)

    1. Upward and Expanding = Good
    2. Downward and Declining = Bad

    Both a and b usually take time to be reflected in stock prices.

    III. REVERSION TO THE MEAN

    1. Bull markets start at the depths of despair when everyone wants out of the market. Extreme fear is good.
    2. Bear markets start when greed is rampant and everyone wants in. Consumer confidence is high and unemployment numbers are the lowest in a long time. Greed is bad for the long term health of the markets.
    3. What goes up usually comes back down, and vice versa.

    IV. HOW DO BULL AND BEAR MARKETS END?

    1. Bull markets end when the news media and similar sources are hailing how good things are and how they will continue. Wall Street experts come out of the woodwork and dole out predictions way up in the stratosphere. There’s a general feeling of optimism. Bull markets usually end when prices creep up over an extended period, but with very little gain to show for it. At the same time, long term momentum has been declining.
    2. Bear markets end when the same sources are lamenting how bad things are. Economic and stock market experts come out of the woodwork to tell the world that things will be getting worse. Bear markets often end when there’s a final thrust lower in prices, but momentum shows a divergence and is creeping up.

    V. CURRENT ASSESSMENT OF MARKETS

    1. Interest rates increasing. This is bad.
    2. Sector rotation is taking place. Not all sectors are going up in tandem.
    3. Prices are hanging in there, but advancement has been minimal compared to the major indexes two years ago.

    December 2016: Executive Summary

    I. MARKET OVERVIEW

    1. Our Investment Philosophy: Reversion to the Mean.
    2. 35-year-old bond bull market is likely over. Higher interest rates expected over next decade. Long-term Treasury bond down 20% in the last couple of months.
    3. If interest rates start to rise, then equity markets will most likely decline as bonds become more attractive versus equities.
    4. Any decline in stocks due to higher interest rates may be countered by real growth in the economy resulting from post-election fiscal stimuli.
    5. At this point, nobody knows what is coming. It will take at least 4-6 months to ascertain post-election market trends.
    6. Republicans are traditionally fiscally conservative. If so, then some of Trump’s fiscal stimulus measures may be dampened.
    7. If fiscal stimulus does occur, then expect stocks to rise in 2017. Under this scenario, expect higher interest rates and significantly lower bond prices in 2018-2020.
    8. Stock market valuations are at extremes based on many valuation methodologies and higher than all other market peaks other than 1999-2000.
    9. So far, the post-election rally is following a similar pattern to what ensued after Reagan won. First there was a rally followed by a big decline. It took a few years before the full benefit of Reagan’s fiscal stimulus became realized. Reagan also had the combined advantages of declining interest rates and disinflation. Fiscal stimulus under Trump will be fighting headwinds from higher interest rates and inflation.

    II. WHERE WE ARE IN THE CYCLE

    1. This bull market is extended beyond the typical length in history.
    2. Why – Quantitative Easing = Monetary Liquidity = Money Printing from Fed.
    3. Wealth Effect and Why - Effects on Financial and Other Assets.
    4. End of Quantitative Easing = Tightening of Monetary Liquidity.
    5. Higher interest rates already here since summer 2016.

    III. ECONOMIC FUNDAMENTALS

    1. Economic growth appears adequate and should improve for next year or so if fiscal stimulus materializes.
    2. Strong dollar has been impacting corporate earnings.
    3. That should continue if interest rates rise unless Europe and Japan follow with higher rates.