Have You Lost Your Mojo

Sad Mojo Jojo - Copy

Which side of the speculating-fence are you on?  Are you euphoric with gains from this rally off the low?  Thank you dumb money.

Or are you annoyed sitting in cash, position-less, and asking the market why is it not listening to you about this being a bear-market rally?  I see you smart money.

I was fortunate to have lost very little thanks to my hedges coming into 2020.  Partnered with basic risk management, returns on the year are flat.  Not great, but I’ll take the profits off the well timed trades to mitigate losses in the long-term buckets.  Bottom line, I missed this rally.

But the major indexes are up 40% off of their seppuku-inducing lows.  Are we in for more?  Is everything fixed?  Will we see new highs and then push on for an additional 30% to 40% more in gains?  I want every reader to remember just how great and unusual 2019 was for returns.

You could’ve made 30% in 2019 in your sleep with zero skill and no risk management.  We’re going to get back to back years of that?  Highly unlikely.

Is this rally legit?  Well if you sell and realize gains, then hell yeah!  But are we truly in the clear from a bear-market rally and more damage?  Who’s to say?  Just history.

Have a look at this chart that Macro-Ops put together.

Bear Market Rally Duration & Performances

Here’s another chart from BofA.  It’s already made the rounds and is dated at just over six weeks old, but have a look at the 3 columns specifically on the right.  Have a look at the dates and percentage losses that were still pending to the date of the actual, final low.

BofA Bear Rally Chart

The coast may be clear but 2020 has seen the most unusual market action in history.  I have no way of knowing if this is a bear market rally or a legit restoration of the bull that I’ve missed so far.  But my portfolio’s cash levels clearly mark where I stand.  And if the statistics above are not enough history imploring caution, then have a look at this chart near the end of the GFC in 2008/2009.

S&P 500 2008 Crash & Bounce Volatility

How many bottom-callers gave away healthy chunks of their stacks during that 6-month rundown?

The most successful, sharpest speculators on the planet are currently telling you outright where they stand on this market and it’s poor risk/reward set-up.  That has to make you pause even though the price action is the final arbiter.

People are trained to not fight the Fed, now.  Even dumb money is trained.  Everyone now “knows” that the tsunami of liquidity washing over the financial and corporate world will support equity prices.

It worked for the last 10 years.  It has to work now.  Right?

The stock markets are a discounting mechanism.  They see the future and the future is bright according to speculators, currently.

But let’s revisit the realities of the pandemic’s effects on spending and thus business earnings as well as viability to continue as ongoing concerns.

Tens of millions of people have lost their jobs regardless of whether it’s a furlough or a permanent termination.  How many people who retained their jobs have taken salary cuts of 20% to 30%, possibly permanent?  And somehow this is not going to have a long-lasting impact on business conditions?

The current, typical mindset seems to be something like this, “Just write off 2020. It’s a sunk cost. We’ll have vaccines soon. People are social distancing. And the government is propping up everyone. 2021 is definitely going to be a great year, economically, so let’s price stocks accordingly now.”

However, widespread impairments to income will lead to widespread impairments to business operations.

Have a look at the credit downgrades from Q1.

041520-SCO-Credit-Downgrades_5e9744cba4085

Bankruptcies are going to happen.  Capital will be lost.  Is that being appropriately discounted right now?

Right in line with the credit downgrades, let’s take a look at the HY option-adjusted spread.

HY Option Adjusted (May 2020)

We’re in a recession.  The BEA will report this.  And yet spreads are diving.  Well the Fed is buying HYG and JNK.  Don’t fight the Fed.

But let’s look at HY’s default rate versus debt to GDP.  You see that wide mouth?  It’s going to chomp and the likely path of convergence lies with the default rate moving upwards.

Debt to GDP vs Default Rate (May 2020)

And what about leveraged loans and CLOs?  Approximately half of the the leveraged loan market, $600 billion, is securitized via collateralized loan obligations.  Between downgrades and further business earnings impairment, wait till CLOs begin acting like 2008 CDOs.  Will it be a positive or negative for equity prices?

Let’s keep it simple and return to equities with a final look at the pure concentration of capital in this Q2 rally.  Here’s the BofA chart that’s played out by now.  It doesn’t seem to matter that capital is concentrated because this time is definitely different.

Market Concentration (Apr. 2020)

These stocks support the work-from-home new economy so it’s all good, but let’s take a look at a SentimenTrader chart.  After all these years, SentimenTrader continues to generate so much value at such a small cost.  Literally, every player subscribes to it; even those that already have Bloomberg terminals and the best info-flow money can buy.  Chart is dated 5/13/2020.

SentimenTrader - Concentrated Rally (5-13-2020)

Not a pretty picture but we’re almost 2 weeks removed from that signal and the market is up almost another 10%.  Not trying to mine the data but I just can’t shake the nagging feeling that a selloff is imminent.  And by imminent I mean within weeks if not days, just not tomorrow.

Based on the concentration levels then it would stand to reason that the NASDAQ will truly indicate when a correction is to begin.  With the 5 stocks (FAMGA) up above representing 45% of the NASDAQ vs 20% of the S&P 500, look for weakness in the NASDAQ to indicate a trend change.

Once a correction starts, I could see 8200 as a solid support area.  This would put the NASDAQ about 13% below from current prices.  For those of you that missed this rally, some Puts on the QQQ followed by some jumping into quality long positions once that 8200 level is reached will be a good way to make up lost ground in your P&L for 2020.  This would be just above a huge price area of recent purchases, noted below in the chart.

$COMPQ Support Level

Hard to fight this rally.  I know.  But if you want to get that mojo back along with some of that lost capital, it might pay to be bold.

Another Bounce or Not

Hmmmm.  What to do in a market like this?

For your long portfolios, my advice would be to sit tight.  The odds are strong that we’re in a multi-week bounce before another little shakeout.

SPX Thru 2018 Holidays (Nov. 2018)

I’d suggest getting long after the next move downward.  Market behavior suggests a rally into 2019.  It could be the start of the final leg of the melt-up as “late-cycle” keeps getting bandied about out there.  Over the past few years, the drill seems to be a quick move down followed by the exhaustion-bounce followed by another move downward before regaining the up-trend (weekly charts).

For the contrarians, it’s hard not to look at China and energy as two obvious areas for medium-term plays.  If you play in the markets at all, I don’t need to throw up charts to illustrate the performance of both sectors of late.  Tencent and JD could be easy moneymakers.  And the energy toll roads can provide a nice yield along with cap. gains on an oil bounce over the ensuing months.

EPD has the infrastructure footprint and financial efficiencies that begs for yield-starved investors who’ve been waiting for a better opportunity for entry.  However, the company’s price remains quite steady in the $20 to $30 range.

Oil’s price action looks exhaustive.  Fundamentals appear to bear out an inexplicable magnitude of this sell-off.  If institutional traders on the wrong side are able to quickly offload positions, then there may be enough support by energy bulls to resume an up-trend without extreme volatility.  I remind energy traders of what we saw in H2 of 2016.

I liked the Starbucks story, but it quickly got white-hot before I could position with my long portfolios.

SBUX Retrace (Nov. 2018)

Based on the trajectory over the last several weeks, it wouldn’t surprise me to see a retrace down to the $56 – $58 range.  That’s a good spot to get positioned if you’ve been eyeballing this world-class caffeinator.

In the quasi-cash-equivalent area, muni-CEFs have presented recent value with their widened NAV discounts.  The discounts have come off a few points as investors have taken advantage of the historically free money and positioned accordingly.  The big question mark is interest rates.

Does the Fed raise rates next month?  If so, that could renew selling action in muni-CEFs and widen discounts again.

Interest rate tape reading has rates looking a little toppy.  Not like they’re going to topple over as we know the Fed will raise rates which will force support.  But still, I like interest rate-sensitive funds here to drive a little yield for a bit in place of sitting on excess cash.

          IIM Current NAV Discount (Nov. 2018)

          JPS Current NAV Discount (Nov. 2018)

Remember, these aren’t long-term investments.  We’re talking about using them as cash-equivalents, but their volatility makes them decidedly un-cash-equivalent.  We’re speculating on additional points on your money earned relatively conservatively.  Mind your stops.  Protection first.

The Last Gasp

As you know by now, I think we are in the final stages of the topping process in major markets.  This is going to be a multi-month affair.  I suspect the top and crash begins later next year, but so do many other pundits, pros, and bloggers which makes me leery.  There’s nothing worse than contrarian consensus by large groups in the game of speculation.

Like its predecessors, the crash won’t look like one at first.  Sure, players will get scared and react but then we’ll see a bounce off the first initial move to the downside.  This will be an opportune time to liquidate positions to make a final cash raise to either capitalize during the crash or wait for the inevitable value opportunities that will arise.

There is a set of indicators that go along with this move downward and bounce that has proven efficacy as a guide.  It’s the 5 month and 10 month Exponential Moving Average (“EMA”).  Observe.

SPX - 5 & 10 Crossover (10-10-2016)

These aren’t magic indicators.  I’m not saying they are guaranteed to work.  I’m only saying they’ve proven themselves as guides when a real bear move has begun.  There are a multitude of economic and financial indicators that I also like to use along with anecdotal evidence, too.  Keeping an eye on this particular set of EMAs however can potentially keep your losses to between 10% and 15%, assuming you act.

In a bear market where there’s the potential for a halving of portfolios, I’d say 15% in losses is solid.

Volatility in the biggest asset classes will be unimaginable.  The algorithmic, high frequency trading operations in combination with central banks have broken all markets.  There will be no liquidity for the big timers when the bear begins.

HFTs are the true market makers and all algorithms are written to pull away and sell when bottoms fall out of markets.  Look at the S&P 500 in May of 2010.  That was really the first indication that markets would never liquidate in a typical fashion ever again, until HFTs are properly regulated, taxed, or removed from existence in markets.

There are plenty of examples between May of 2010 and now, but the move in the pound sterling at the start of October provides such a fine illustration.  What’s more liquid than the currency markets of the most developed and powerful Western nations?

Nothing.  And yet still we see the destructive power of HFT on any market.  Does this look normal in a power currency?

Sterling Madness (10-16-2016)

In earlier Asian trading, the intraday damage was even worse.  Observe this bit of madness.

image

These moves are a product of liquidity being immediately vacuumed from the asset classes where all the largest players play.  This will happen again and again when the markets make their final turn.

You can liken it to a hull breach for an astronaut in space without a suit on.  One second astronaut HYG is floating around the lab in a jump suit, happily conducting experiments with OPM.  But OPM in high-yield instruments in a low-yield environment can be a volatile material if not handled appropriately in a proper setting and an explosion occurs breaching the hull, sucking HYG out into the liquidity-free vacuum immediately to death.

Did I say liquidity?  I meant oxygen.

You get the point.

Coming back to what a last gasp means; it means there will be a final run in risk assets to squeeze out the final profits of this bull.  Many, including myself, have called it a melt-up, but I grow weary of the term.

Please don’t be fooled by some of the ignorance being freely proffered out there that we are in the early years of a cyclical bull, similar to 1982.  We are not.  The evidence is broad, clear, deep, and obvious.  One needn’t a fancy finance degree or years managing wealth in order to see this.

The end game is here, but not before that last gasp for profits that I keep describing.  I suspect that many of the sectors that powered this bull market prior to 2016 may reassert themselves to take us home.  Why is that?

Interest rates.  Plain and simple.

Those with access to leverage at these historically low rates will borrow capital to fund buyouts and takeovers which will drive asset prices upward.  The upward move will then draw in speculators looking to hop on the trend or front-run it.  This quest for yield whether in debt, equity, or private equity i.e. IRR, will be the fuel for the last gasp up in asset prices.

Despite what I think may happen in semiconductors or social or biotech or emerging markets as risk-on gains speed, keep your eyes on the one asset class that has taken out all comers in 2016.  The Rocky Balboa asset class for the year.  You know what I’m referring to and this is even with the recent sell-off.

2016 Performance Chart (10-16-2016)

Precious metals.  You don’t have to love them or hate them.  Opinions don’t have to be binary.  Be agnostic when speculating.  Follow the trends.  Follow the money.  More importantly, follow central banking and political lunacy.

Let’s look at one more chart that potentially validates that this bull market is long in the tooth.  It depicts the times over the last 50 years when payouts to equity investors have exceeded  profits.

Total Payouts via ZH (10-11-2016)

You can ignore what is glaringly obvious or you can prepare.

Speaking of obvious, let’s begin to wrap this post up with another pithy little ditty of a quote, this time from one of the world’s great speculators.  It’s been reprinted time and again, but it’s simple yet brilliant message is timeless.

I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up.  I do nothing in the meantime.

– Jim Rogers

I haven’t touched on trading since the summer and I just wanted to share some set-ups that appear to potentially be building little piles of money in a corner waiting to be picked up.

Keep an eye on these sectors, either short or long:

Short:  sugar, energy(big 3), US dollar, and technology

Long:  grains, bouncing precious metals, and the pound sterling

Despite your opinions, never forget about counter-trend rallies, even in the face of what appears to be an unstoppable trend.

Are You Prepared?

Fear sells.  It’s one of those unfortunate, steadfast truths of life.  Just look at the rise of politicians like Trump and the other fear mongers around the world.  Look at the news.  People love to be scared.

Fear is not what I’m selling.  Rational thinking.  Clear analysis.  Proper asset allocation.  But mostly, cognizance and comprehension.  These are concepts being sold in today’s post.

I wanted to take some time to break down how I think this current economic-business-investment cycle, which started off of the 2009 lows, reaches its peak.  This post may be a bit lengthy, so consider yourself duly warned.  Read it in chunks if the need to go catch a virtual critter or watch some naked dating is simply eating at you like a heroine withdrawal.

In a world where blog readers want the meaning of the universe in under 800 words, this post will take some time to layout how arguably the most important component of the banking system works.  Specifically, I want to visit swaps, repo, and the collateral needed to fund the whole party.  I want to explain for the people that don’t know; the lay people.  People that have no idea about finance, accounting, and economics.  People that watched The Big Short and have an inkling but need a legitimate breakdown of what’s really going on in the financial system.

What’s most annoying for me about the investment fear mongering today is that there’s no clear how or why we can expect a major market crash across all asset classes.  Numerous potential causes are cited.  Some say extended valuations.  Others say central bank intervention has lost it’s efficacy.  Still, others say a black swan will reveal itself to cause entire markets to be re-priced.

These are rational, true hypotheses and I agree that all three will hasten a great crash, but the fact of the matter is they all fall under the umbrella of debt.  Debt was taken off of the private balance sheets(publicly traded entities) and shifted to the public balance sheets(sovereigns).  All the owners of associated derivatives tied to that debt were either made whole or have continued to utilize the current system to keep the party going.

Worldwide debt levels are and will be the cause of the next crash.  Debt sits like a boa constrictor with its coils wrapped around the world, slowly squeezing the economic life out of all markets.  Think of the snake in The Jungle Book cartoon with its mesmerizing eyes.  “Trust in meeeeeee.”  Debt beckoned and the world heeded the call, only now there’s no escape and it’s getting harder and harder to breathe.

This is sort of a revelation for some who are just beginning to truly understand the error of the central banking cabal’s ways.  The negative rates.  The buying of investment grade assets and equities with taxpayer funds.  The backstopping of public, systemically dangerous banks with taxpayer funds.  The waterfall of money creation.  The thought process that more debt on top of debt will somehow cure a situation caused by excess debt.

At this point of the post, any pros reading this are probably rolling their eyes and thinking “Go buy another gold bar you doomsday schmuck.”

No matter.  I want my friends, family, and financially unsophisticated to gain some insight.

Where’d all this debt come from?  It went from the private coffers to the public coffers.  From the publicly-held, systemically important financial institutions (“SIFI”) to the central banks.  And now that the developed sovereigns are sitting on all of it and then some from the 2008 system-save, the SIFIs have continued their unaccountable ways and the financial system is sauntering closer to the edge.

There’s nobody for the central banks to turn to.  There isn’t an intergalactic central bank out on the edge of the solar system just waiting to be a lender of last resort to planets where the dominant sentient species decides to fuck the whole financial system up.

Why did every single SIFI have to survive (except for Lehman, of course) after 2008?  If the banking system blows up, there’s zero way to process sales transactions?  People aren’t going to continue buying at Wal-Mart, Amazon, Kroger, and other retailers?  Oil won’t be burned?  Businesses will never hire and never expand again?  Tightening the belt is not the same as eliminating altogether, but that’s not the picture painted by the players in control.

Just ask Charlie Munger or any other uber-wealthy and they’ll tell you how close the whole American system was to utter annihilation.  It’s easy to take that stance when you have rainy day cash in the billions just waiting for an investment yielding 10% with a 100% government backstop.

The people that constantly state not to bet against American resiliency and determination, did just that by supporting SIFI bail-outs.

But those who lean towards the Austrian school of economic thinking, have long had a grasp on the consequences of current central banking Keynesian policies.  And those consequences are now beginning to painfully avail themselves to a larger and larger percentage of the world’s population.

The good news is that the crash is not imminent.  I know this because investor psychology dictates that we have a last-gasp, melt-up in the broader stock market.  Not to mention, everybody is currently inclined to say that the game is over right now.  Sell everything!

As I’ve said before, bull markets don’t end with everyone staring right at it while expressing their negative sentiments.  We’ll need that final push upward in the S&P 500 to the range of 2,400ish.  Who knows?  Maybe even higher, but about 10% to 15% higher than 2,125 which proved to be such a strong area of resistance.

If you’re strong of gut, stay positioned to the top.  If prudence guides your investment principals then it is way past time to have begun increasing cash levels.

When nobody’s looking, something’ll go down over a weekend; a major event or perhaps some sort of Western government proclamation.  And on Monday, panic will likely ensue to get the real party started.

It’s been suggested that it will be the banking system, specifically a major bank such as Deustche Bank or an institution of similar magnitude that will stop the music.  I disagree.

I think it’s going to be a country.  Either via a currency policy error or an outright repudiation of debt or both or some other ill fated decision involving a SIFI, but I suspect a major developed country will be the entity that kills the dance music via a one in “ten-thousand year” tail-event.

The system-altering crash is not going to happen tomorrow.  Crashes are like being pantsed.  A pantser doesn’t pull down the trousers of the victim while the potential pantsee is looking them right in the eye.  No.  A pantser waits until the pantsee is not looking and in a position for considerable embarrassment before striking fast to yank down the pantsee’s trousers, inflicting maximum damage to the victim’s psyche.

That’s a market crash in a nutshell.

So investment portfolio’s are safe for now, but let me share some charts just to get readers’ old fear-juices flowing.  Gotta break the monotony of my prattling.

It’s critical when making comparisons to previous market-tops to only go back about 18 years, because that’s when true financialization took over the world with the passing of Graham-Leach-Bliley.  That gave immeasurable power to the banking system and set us on the path we’re currently on.  Everything before that was during an entirely different era.  Sure, you could point to 1971’s USD unhitching and the creation of the credit destiny or 1986 and the MBS birth or Greenspan’s run, but the lead-up to the Dot.com crash is my preferred beginning comparison point.

The first chart I’d like to share is the divergence between earnings in the S&P 500 and the performance of the S&P 500 on a monthly chart with the Ultimate Oscillator (“ULT”).   You’ve probably already seen this one in some iteration around the web.  Am I the only one that thinks that divergence in earnings and the index’s price action looks a little off?

GAAP Earnings Recession and the Ultimate Ossy (8-2-2016)

Yes, the index is sitting right at new highs while earnings continue downward, but look at the ULT.  The depth and duration the indicator is hitting has only been seen two other times in the last 20 years…subsequent to the 2000 and 2008 market crashes.  And yet here we are at highs across multiple financial assets classes and no recession in sight.

PHEW!!!  We’re good then.  End of post.

Actually, let’s look at another chart, courtesy of SentimenTrader.  Want to know what those red arrows indicate?  Then buy a subscription to Jason Goepfert’s site.  It just may be the best research value available.  SentimenTrader’s value is so good that I’d liken it to a stock with a $5 billion dollar market cap that trades for less than the cash on it’s balance sheet.  It’s that undervalued.

Margin Debt - S&P 500 Within 1% and MD More than 10% (July 2016)

Those arrows indicate each time in the last 25 years that the S&P 500 was within 1% of its all-time high and margin debt was more than 10% below its all-time high.  Definitely ominous, but ultimately may mean nothing, however I’m willing to bet that this signal is far from meaningless.

Feel reassured about your current asset allocation yet?  I’ll wager that you don’t have nearly enough exposure to the precious metals space.

Ready for another scary picture?

Back in May of this year, Michael Harris of the Price Action Lab shared a post about his Bear Market Probability indicator (“BMP”).  You can see that over the last 20 years and for the last two major market meltdowns, the BMP was highly accurate.

Bear Market Signal - PAL (5-17-2016)

In 2000 and 2007, the BMP would have gotten you out with plenty of time to spare to take profits and shift your portfolio allocations accordingly.  Each time the indicator has cleared a probability of 0.90, a true bear market followed shortly there after.  Our current market cleared 0.90 in late summer last year just before all the fireworks.  I don’t think it’s a false signal in the least.  The BMP’s efficacy is proven.

The bear-market delay is in all likelihood due to ridiculously low interest rates and accommodative monetary policy by the developed players of the world.  But the bear will be staved off for only so long and not very long at that.

The Price Action Lab (“PAL”) software is another incredible value readily available for market research.  I am not a subscriber however their software packages provide a window of access to the plebs of the world who want to see and know how the pro’s find trading opportunities.  If you are statistically inclined and serious about trading your account or OPM, then PAL software can help you find an edge.

Additionally, the PAL blog is not only insightful but pretty funny.  Harris consistently puts technical analysts, like myself, and over-exuberant quants in their place.  Great site.  Great content.  I plug it and SentimenTrader often.  Read’em.

Let’s look at a few more charts to really get you thinking that the end of this bull market just may be near.  Afterwards, we’ll segue to the plumbing of liquidity within the financial system.

The following two charts are courtesy of the Leuthold Group.  The top chart depicts the percent of publicly traded companies with rising YoY earnings per share.  Not too healthy looking.  And you can see what happened the last time we crossed under the 55 line in 2008.

Two Signs of Recession - Leuthold (Q2 2016)

The bottom chart is the HWOL via The Conference Board.  As for the indicator’s composition,

The Conference Board Help Wanted OnLine®Data Series (HWOL) measures the number of new, first-time online jobs and jobs reposted from the previous month for over 16,000 Internet job boards, corporate boards and smaller job sites that serve niche markets and smaller geographic areas.”

Just more compelling, supporting evidence of what’s in store for the world-wide financial system.

This next chart is a little dated from the end of last year but these common valuation ratios still stand in the same over-valued condition.  Observe how close to the top these values in the PE, PS, and PB existed.

Valuation Ratios - FPA Crescent (12-31-2015)

SPX Dates Lining up Crescent Valuation Chart (August 2016)

The common denominator is once again debt.  Easy money policies and the continued backstopping of all markets via sovereign debt issuance is really the only thing holding confidence together.  Once the confidence goes and liquidity dries up, you’re going to wish you’d heeded charts like the ones in this post.

The last chart selling market fear illustrates loan issuance drying up in the commercial and industrial space in the US.  The Federal Reserve releases a survey of Senior Loan Officers every quarter and what we are currently seeing is 4 straight quarters of tightening loan standards in the commercial and industrial space.  This is something only seen at the outset of recessions, literally.

ZH - Fed Senior Loan Officer Survey C&I Q2 2016

Care to guess why these condition exist and yet we are “not” in a recession in the US?  That’s right.  Excess debt issuance.  Cheap money backstops.  And a cost of capital that has been perverted for far too long.

The charts all paint a clear picture.  Ignore them at your own risk.  Is a crash imminent?  No, but you better be socking away some cash for value opportunities and you better be taking profits on positions that are starting to run out of steam anyways.

Let’s move on to the banking system.  No, let’s take a break.  My next post will be on the banking system and how it will exacerbate the shock to the financial system when whatever sovereign does what it’s going to do.  Specifically, I’ll expound on liquidity.  How it works and why every pro in the world already knows the danger it presents when it dries up.

Are you fearful?  Based on average portfolio construction out there, the average investor is not nearly scared enough.  Remember asset allocation only works over long durations.  Diversification in the short term is just as susceptible as any other investment approach.  Sure, the strategy is to offset so you lose less than the stock market as a whole.  But if you’re near retirement, there’s not a lot of solace in thinking about how well asset allocation models hold up over several decades.

You know what also holds up over the decades?  Intelligent trend following and value.  Craftily insert risk assets that can carry your portfolio returns when times get rough.  Don’t give in to the fear and don’t give up on the markets as new highs are being hit but now is the time to start questioning all your allocations in preparation.

Standby for part 2 on liquidity within the banking system.

Should the Investing Public Be Worried if Some of the Biggest Banks are Genuinely Scared?

Questions of investing and speculating always require context within time-frame. Players in all asset classes, professional or not, approach the game from their own perspective.

Traders surfing the waves of volatility may be looking only days or weeks out. Investment managers overseeing a growth-oriented portfolio may be looking ahead months or quarters while a value-oriented portfolio manager may be looking years out. The 401k-watching worker bee may be wringing their hands at every market move and every ignorant headline despite the fact that they have 30 more income-earning years left before retirement.

The game is tougher than ever even for the professionals and it’s difficult to decide a course of action with the information overload coming at market players. Determining what’s noise and what is actually valuable information is critical in making the right moves within your portfolio.

I have long been pounding the table on building cash reserves while staying invested in the markets. I’ve also stated that I thought the downturn of late 2015 was the start of the next major bear market. I think that dip and recovery in 2015 was the bear waking up and the poor start in 2016 is investor realization of that bear. However, because everybody now sees it, the markets aren’t going to execute a full-frontal stage-dive. That’s not how these things work, right?

I think we get a recovery into new highs followed by another much smaller correction and consolidation potentially followed by another new high. After that, I suspect all the bull energy will be fully used up and the bear will begin in earnest. Remember, these are simply my suspicions based on behavioral observation of the markets; nothing more than forecasts of potential outcomes.

It’s been a long time since I’ve hit readers with some good old chartporn, but I’m in the mood to throw a bunch of squiggly pics out there to possibly help the reader better assess the market situation in 2016. Observe a 20-year, monthly chart of the S&P 500 along with some relevant indicators.

clip_image001[6]

Observe the long-term breakdowns in the indicators matching the actions of 2008 and 2000. Does that mean crisis is imminent? Nope, but I do think it reinforces my call that a new bear has started. Notice also in 2001 and 2008, we saw strong support and a bounce off of the 50-month moving average. Too many technicians are looking for that and thus too many algorithmic shops will be front running ahead of that signal, blowing out orders to drive the market higher.

I suspect this bounce we are currently in the midst of may be a bit stronger than people realize. Market players have been so used to the V-recoveries and yet they’ve already forgotten what they can be like. It appears that players are numb to the potential of a multi-week to multi-month V-bounce from the January 2016 lows. Despite what I surmise about a stronger than expected bounce, nobody can blame investors for either running for the hills or shoving their heads into the sand.

We’ve already seen the peak in net profit margins for this business cycle in the largest US corporates at the same time that markets continue to be overvalued, despite the corrective moves in December and January. Observe the following chart courtesy of ZH via Thomsen Reuters via Barclays. It depicts how the recession fuse has likely been lit.

clip_image002[6]

And with recession generally comes a bear market correction. Or is it the other way around?

Regarding overvaluation, have a look at this comparison chart from AQR depicting market returns based on various starting points of the Shiller P/E. AQR is the shop that Cliff Assnes, billionaire hedge fund manager, founded and runs.

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This coincides with GMO valuation models for future returns based on current valuations. There are plenty of Shiller P/E naysayers who believe that the indicator is bunk. The fact of the matter is that evaluating a normalized 10-year look at P/E ratios is a simple and intelligent way of quickly gauging valuation levels compared to prior periods. Of course every period in history possesses its own specific circumstances as the backstory of the valuation levels, but the raw Shiller P/E paints a clear picture for equity performance going forward.

Besides I don’t see or hear anybody calling Bob Shiller a dumb man. Despite what you may think of his ratio, Shiller is a respected academic even within the professional financial community.

Let’s take a look at a chart from one of every perma-bull’s favorite bear-shaped piñata, Dr. John Hussman. Unfortunately, Hussman catches a lot of flak. Less so after admitting to his analytical mistakes coming out of 2011 but I think he catches a bad rap for simply calling it how he sees it. Hussman’s analysis is based on a quantitative and thorough study of the markets. Can the same be said of a vast majority of the financial blogosphere? No it cannot, including myself. Observe the Hussman Hindenburgs. They nailed the current action coming into Q4 of 2015.

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The criterion of the Hussman Hindenburg is detailed in the upper left corner of the chart. Dr. Hussman’s Hindenburg indicators proved to be quite prophetic in 1999 while essentially nailing the top in 2007. For your own long-term holdings, ignore these signals at your own risk. Dr. Hussman, like Dr. Shiller, is respected amongst fellow financial professionals. Have a look at Research Affiliates’ (“RA”) own analysis on current valuation levels.

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In a research piece they published in July of 2015, RA evaluates the differences in relative valuation metrics (CAPE, Hussman, Tobin) and absolute valuation metrics. They came to the following conclusion.

Our answer to the question “Are stocks overvalued?” in the U.S. market is a resounding “Yes!” Our forecast for core U.S. equities is a 0.8% annualized real return over the next decade. The 10-year expected real return for emerging markets equity, however, is much higher at 5.9% a year. The return potential of the nondeveloped markets is so high, in fact, that the valuation models, warts and all, paint a very clear picture.

May want to rethink that lack of EM exposure going forward, depending on your time-frame.

Shall we move on to a couple of less orthodox indicators of potential trouble in the markets? Observe the two following charts which pertain to income as opposed to valuation or price action. In the first one, created by McClellan, we get an interesting correlation to total tax receipts for the US government as compared to US GDP.

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Notice that in 2000, the US crossed the 18% threshold and stayed there awhile before rising even higher at the beginning of the market selloff. For the GFC of 2007, America almost got to 18% but not quite and we still literally almost vaporized the entire financial system. Currently, we’ve reached 18% but that may or may not mean anything. In each previous occurrence, tax receipts stayed at the level for months or even years so this is an indicator worth watching but only in conjunction with many others.

Interestingly, federal tax receipts as a percentage of GDP currently reached 18% right before the markets began selling off last year. Repeat after me. Correlation is not causation, but the timing is still interesting.

The other chart that doesn’t get a lot of coverage but is very well known is net worth of US households and non-profit organizations as a percentage of disposable personal income. You can find it courtesy of our friendly Federal Reserve Bank of St. Louis and their FRED tool. The grey vertical bars in the FRED charts denote recessions.

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It’s been a clear indicator in 5 of the last 6 recessions and we also had that annoying fakeout in 1987. Much like the prior graph, this particular chart should be coincident with additional economic indicators if one is attempting to forecast potential economic as well as investment outcomes.

I want to move on to a particular area that everyone should be concerned about and that is nonperforming loans (“NPL”) at major banks. Not just at US banks but around the world. China’s commercial banks have raised fear levels in even the most seasoned professional investors due to their NPL levels increasing so drastically in 2015. I’ve long stated how debt levels in Italy have the potential to dismantle a good portion of the financial system because the Mediterranean Boot is such a key economic cog in the European Union. Some of the biggest commercial banks in Italy are on the verge of toppling during a period where now the ECB is less amenable to the previously used “bad bank” options. The pressure is beginning to mount for Italy’s leadership to formulate a strategy around potential bank failures.

You might be inclined to observe the following chart and think all is at least well for the US.

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But take a look at the following chart in commercial-only loan performance and begin to understand why the total situation looks toppy from the economy to the markets.

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For the record, commercial loans comprise approximately $2 trillion of the outstanding debt within the banking system. It is clear to see that a bottoming and an upturn occurred before the last 3 recessions and market dislocations. Now we are currently in the early innings of an upturn in NPL. If commercial loan performance behaviorally adheres to what we saw in the prior two recessions, we will see at least an additional 2% of total commercial loans become impaired assets. That’s potentially between an additional $40 billion to $50 billion at minimum that banks will have to provision for. No easy task in light of current leverage levels and collateral utilization across the repo and derivative space.

This is especially concerning because of the systemic importance of each bank to the entire financial system. Just look at the consolidation that has occurred since 1990.

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Couple this concentration with a lack of regulation allowed by Gramm-Leach-Bliley and you can see that debt impairment at the banks is not going to have a happy ending. And if you think Dodd-Frank was the answer to all of our problems, I might stop laughing sometime in March.

What would work to alleviate a lot of the financial pressures around the world in the short term is a weaker dollar. I don’t say that as a proponent of a weaker dollar. Rather, I am stating that currency exchange due to a weaker USD could help sugarcoat revenue reporting across international corporates. It would relieve pressure in the management of reserves for countries with an excess of US treasuries. The oil price could stabilize temporarily but it is well-documented that abundant supply and less-than-expected demand is still the story. Commodities could lift and thus commodity producing countries who are already fighting with their reserves issue could see a double-positive impact. All these effects would be temporary as world debt levels are at unsustainable levels and a bear market for all assets has potentially already arrived. It just has yet to completely sink its claws and fangs entirely into the world’s financial system.

Coming back to the initial question behind this post. Should the investing public be scared? Maybe not scared. Let’s call it aware. They should be aware of all the happenings that are occurring right now. Cash levels should be raised. Certain assets should be paired down depending on losses, gains, and risk exposure. More importantly it’s time to take stock in your own investing psyche. If you are building cash levels, will you have the courage to act at the appropriate time? That’s what raising cash boils down to. Do you have an understanding of the intrinsic valuation levels of specific asset classes that will motivate you to put cash to work?

Aside from brushing up on your ability to properly assess valuations, take a look inside yourself and evaluate your ability to deploy cash when fear is running rampant and the nadir of multiple markets appears to be nowhere in sight.

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