Is It 1999? 2007? Or Both?

Authored by Lance Roberts via RealInvestmentAdvice.com,

In last week’s Technical Update, I discussed the potential for the S&P 500 to hit 2700 by Christmas. To wit:

“The current momentum behind the market advance is clearly bullish, and with the ‘smell of tax reform’ in the air, there is little to derail the bulls before year-end.

 

However, in the meantime, there seems to be nothing stopping the market from going higher. As stated in the title, the current push higher puts 2700 in sight by the time Santa fills the ‘stockings hung by the chimney with care."”

With the markets within striking distance of that target, the run to Nasdaq 7000, Dow 25000 and S&P 2700 are all but guaranteed at this juncture. More interestingly, all three will be ticking off milestone gains at some of the fastest paces in market history. In fact, the Dow has posted three all-time records just this year:

• 70 new highs,


• A 5000-point advance in a single year, and;


• 12-straight months of gains.

Just as a reminder of previous market bubbles, here is what they looked like.

As I discussed with Danielle Dimartino-Booth this morning. Not only is the current rally reminiscent of 1999, but to 2007 as well. In fact, the current bubble, as she states, is a combination of both.

As Danielle and I discussed, it seems eerily familiar.

In 1999:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth was improving 


• Interest and inflation rates were rising


• Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. (Who can forget the market greats of Enron, Worldcom & Global Crossing)


• Margin-debt / leverage was at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Dot.com stocks

In 2007:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth was improving 


• Interest and inflation rates were rising


• Debt and leverage provided a massive “buying” binge in real estate creating a “wealth effect” for consumers and high-valuations were justified because of the “Goldilocks economy.” 


• Margin-debt / leverage was at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Real Estate

In 2017:

• Fed was hiking rates as worries about inflationary pressures were present.


• Economic growth is improving because of 3-hurricanes and 2-wild fires.


• Interest and inflation rates are expected to rise


• Earnings were rising through the use of “new metrics,” share buybacks and an M&A spree. 


• Margin-debt / leverage is at the highest level on record. 


• Stock market was beginning to go parabolic as exuberance exploded in a “can’t lose market.”


• Speculative asset of choice: Bitcoin

Of course, those are just some of the similarities.

Valuations in all three cases exceeded the long-term market peaks of 23x reported earnings. Investor confidence was pushing extremes and deviations from long-term means in prices, relative-strength and moving-averages were all present.

The chart below shows the S&P 500 from 1993-present. As shown, the 100-period RSI, 3-standard deviations above the 200-dma and the 50/200 day moving average MACD line are all at historical extremes. While such readings do NOT suggest a downturn is imminent, it does suggest that risk is elevated and potential upside from current levels is likely limited.

I have combined the three periods below, scaled to 100, so you can see just how far we have currently gone.

Sure. This time could be different. It just probably isn’t.

Our Job As Investors

Again, none of this suggests the market is going to crash tomorrow. But a massive mean reversion process is coming, it is inevitable, the only question is of the timing.

As I noted last week in “The Exit Problem,” it is time to start considering sitting a little closer to the “exit.” To wit:

“Am I sounding an ‘alarm bell’ and calling for the end of the known world? Should you be buying ammo and food? Of course, not.

 

However, I am suggesting that remaining fully invested in the financial markets without a thorough understanding of your ‘risk exposure’ will likely not have the desired end result you have been promised.

 

As I stated often, my job is to participate in the markets while keeping a measured approach to capital preservation. Since it is considered ‘bearish’ to point out the potential ‘risks’ that could lead to rapid capital destruction; then I guess you can call me a ‘bear.’

 

Just make sure you understand I am still in ‘theater,’ I am just moving much closer to the ‘exit.’”

What does that mean?

I have now been in the financial markets in some capacity since prior to the crash of 1987.

Yes, I am that old.

During that time I have watched investors repeat the same mistakes over and over again. From exuberance to fear, buying high to selling low, chasing returns, and always believing this time is different, only to once again be reminded it’s not. 

As the old saying goes:

“The more things change, the more they remain the same.”

If you have been around the markets for any length of time, you can quickly spot the “pigeons at the poker table.” These are the ones that continually rationalize why prices can only go higher, why this time is different than the last, and only focus on the bullish supports. Trying to “draw to an inside straight” is not impossible, it just leads to losses more often than not. 

But therein lies an important point.

As investors, our job is NOT making the case for why markets will go up.

Read that again.

Making the case for why markets will rise is a pointless endeavor because we are already invested.

If the markets rise, terrific. We all made money, and we are the better for it. However, that is not our job.

Our job, is to analyze, understand, measure, and prepare for what will reduce the value of our invested capital. 

Period.

If we are to accumulate capital over the time-span that we have available, from today until we reach retirement, the most important thing we can do to ensure our success is not suffering a large loss of capital. 

Therefore, our job as investors is actually quite simple:

• Capital preservation


• A rate of return sufficient to keep pace with the rate of inflation.


• Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)


• Higher rates of return require an exponential increase in the underlying risk profile.  This tends to not work out well.


• You can replace lost capital – but you can’t replace lost time.  Time is a precious commodity that you cannot afford to waste.


• Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

With forward returns likely to be lower and more volatile than what was witnessed in the 80-90’s, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.

This brings up some very important investment guidelines that I have learned over the last 30 years.

• Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.


• Emotions have no place in investing.You are generally better off doing the opposite of what you “feel” you should be doing.


• The ONLY investments that you can “buy and hold” are those that provide an income stream with a return of principal function.


• Market valuations (except at extremes) are very poor market timing devices.


• Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading. Knowing what type of investor you are determines the basis of your strategy.


• “Market timing” is impossible– managing exposure to risk is both logical and possible.


• Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.


• There is no value in daily media commentary– turn off the television and save yourself the mental capital.


• Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in”.


• No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.

As an investment manager, I am neither bullish or bearish. I simply view the world through the lens of statistics and probabilities. My job is to manage the inherent risk to investment capital. If I protect the investment capital in the short term – the long-term capital appreciation will take of itself.

Bank Of America: "This Is A Sign Of Irrational Exuberance"

Two weeks ago, when discussing a recent Albert Edwards piece, we said that the word that has come to define the new normal better than all others, is "paradox", as in nothing makes sense, or rather everything makes sense if one only flips logic and reason 180 degrees. A "paradox" was on full display in the latest Bank of America Fund Managers Survey which found that once again, the percentage of respondents saying equities are overvalued hit a new record high of 45%; and yet the average cash levels continue to fall as one professional after another - whose year end bonus depends on whether they outperform the market - rush to allocate funds to equities, which most now agree are an asset bubble.

And while we call this "paradox", Bank of America has another, more familiar name for the phenomenon: "this is a sign of "irrational exuberance"."

Yet while breakneck allocation to stocks continues apace, there has been notable rotation within the sector, and as the next chart shows,  the November rotation shows buying of cyclicals and value, and selling of 2017 winners such as EM, Japan, Tech. It is unclear what is going on in December when everything appears to be bought.

Also of note: the tech sector allocation appears to be rapidly declining, and in December fell to 24% overweight, "the long-term average and the lowest z-score for tech in 3½ years."

But while the "growth" narrative may be fading for now, Goldilocks remains the consensus view for the global economy, with 54% of investors surveyed expecting above-trend growth and below-trend inflation in the next 12 months, just 2% lower than last month’s record high. As BofA adds, "Goldilocks is now the consensus view for the global economic outlook" while the "below-trend growth/ inflation" outlook rose 2ppt to 27%, close to May"11 lows & a total reversal from Jun"16.

Meanwhile, the yield curve reaches its flattest levels since the GFC as net 0% investors say they don"t need fiscal stimulus, the highest since 2011.

And speaking of the yield curve, net 8% of investors surveyed expect the U.S. yield curve to flatten in 2018, the highest level in 18 months

Separately, as reported earlier, "Long Bitcoin" is again considered the most crowded trade (32%) for the second time this year, followed by Long FAANG+BAT (29%) and Short volatility (14%)

As also noted, a central bank error, i.e. "policy mistake" by the Fed/ECB continues to be the top tail risk cited by investors (23%); the top three are rounded out by a crash in global bond markets (15%) and a Chinese debt crisis (14%)

When asked about the consequences of the GOP tax bill, a whopping two-thirds of respondents, a stunning consensus for this survey, expect tax reform to result in higher bond yields and higher stocks, while only 3% think tax reform will lead to lower yields and lower stocks.

 

Also, just 7% of investors say global interest rates will be lower in the next 12 months; 77% say interest rates will rise.

Translation: one year from now stocks and yields will be far lower.

Also, in December global investors favored banks, technology, industrials, insurance and discretionary while avoiding staples, telecoms and utilities. Which means the contrarians should do the opposite.

Here is how Michael Hartnett summarizes the big picture themes from the December FMS:

• Golditrumps: consensus still smitten by Goldilocks...54% expect "high growth, low inflation" in 2018. Almost 2/3 investors believe US tax reform will induce higher stocks & rates, but fiscal stimulus has coincided with lower, not higher profit expectations, and that will need to change given EPS leads relative performance of cyclicals by 3 months (Exhibit 10).


• Pro-cyclical Consensus: Investors are long macro "boom", short "bust"; long stocks, EU/Japan/EM stocks, financials (2nd largest ever), materials (highest since 2/2012) vs short government bonds, US stocks, healthcare & utilities. Pro-cyclical consensus entrenched by US tax reform across asset classes, bar, intriguingly, leading tech sector where allocations dropped to lowest since June 2014.


• FMS Crowded Trades: ...#1 long Bitcoin (32%), #2 long FAANG+BAT (29%), #3 short volatility (14%), while expectations for a "flatter yield curve" surged (highest in 18 months), all trades vulnerable to higher inflation & aggressive ECB/BoJ Quantitative Tightening in 2018.


• Contrarian Recession Trades: ...a recessionary bust even more contrarian than inflationary boom, lower rates more contrarian than higher rates, making short equities-long bonds, short banks-long utilities, short EAFE-long US stocks the most contrarian trades of all heading into the new year.

Finally, when asked when this bubble finally ends, investors were split on the expected timing of equity markets peaking in 2018: 25% see a peak in Q1, 30% in Q2, and 28% in the second half of the year

Goldman: These Are The Three Biggest Risks Facing Stocks In 2018

When it comes to the most influential investment bank in the world, Goldman Sachs, its 2018 outlook is borderline euphoric despite the bank’s own explicit admission that valuations have never been higher. In a tortured, goalseeked analysis which we discussed last week, the bank’s chief equity strategist David Kostin said that he expects a year of “rational exuberance” catalyzed by the Trump tax cuts becoming law (some time in early 2018), leading to an upward revised year-end S&P price target of 2,850 (from 2,500 previously) and rising to 3,100 by 2020 (Kostin’s “irrationally exuberant” parallel universe sees the S&P rising above 5,000 as the equity bubble repeats the events of the late 1990s – more here).

Naturally, the chief strategist concedes that all bets are off should Trump fail to pass tax reform (or even a far less comprehensive corporate tax cut program), and the S&P is likely to tumble to 2,400 from its current all time high level above 2,600 (Kostin did not have a S&P forecast for outer years which does not implement Trump tax cut, suggesting that Goldman’s clients will be extremely disappointed, and angry, should Goldman’s 80% odds of GOP tax reform passing prove just a "little" off ).

What is more interesting, is that even in discussions of the future that do not include Goldman’s assumptions of legislative reform, or its explicit S&P forecasts, the bank is especially sanguine, and does not anticipate a bear market as a result of 2017 being a “goldilocks year” in which the world enjoyed coordinated, synchronized global growth courtesy of over $2 trillion in central bank liquidity injections but without the matching increase in inflation, which coupled with a perverse collapse in global volatility...

... has resulted in US financial conditions that have almost never been easier, and would be more indicative of three rate cuts rather than three rate increases, as has been the case.

As a result, Goldman is confident that, absent a shock, “a bear market is unlikely” despite rising risks. Here is what Goldman expects in terms of the 2018 big picture:

On the negative side, investors can point to the combination of an already mature economic cycle and a long and strong bull market (mainly driven by loose monetary policy). Valuations are also stretched in most equity markets, particularly the US. These factors, combined with the start of (albeit moderate) quantitative tightening (QT) may also be cause for some concern.

 

On the positive side, investors can be reassured by the strength and durability of the current economic cycle. While it has already been a long cycle, the unwinding of the financial crisis has also meant that, until recently, it has been sub-par in terms of strength – as is often the case following financial crises. This has been the case even in the US, where the recovery has been more robust than elsewhere and has helped to contain inflationary pressures.

Goldman is also quick to explain that since equity bull markets do not die of old age, its own bull/bear market indicator – which as we noted two months ago is at levels that preceded both the dot com and the 2007 global financial crisis – should be largely ignored:

Economic cycles and equity bull markets do not generally die of old age. Our work on bear markets shows that major drawdowns require triggers. The most severe type of bear market – the ‘structural’ bears – are a consequence of the unwinding of major economic imbalances and, typically, a financial bubble. These risks are low currently given that many of the pre-crisis imbalances have been reduced or shifted to the official sector and to central banks. Meanwhile, ‘cyclical’ bear markets are a function of the economic cycle and are nearly always triggered by a tightening of monetary policy in response to inflation pressure. While our bull/bear market indicator (Exhibit 6) is at elevated levels, this mainly reflects the strength of the current economic cycle, low unemployment and high valuations. Importantly, two of the other factors that are included in this indicator are not at elevated levels. Inflation is low and stable and, as a consequence, the yield curve remains upward-sloping. Without higher inflation, it is unlikely that we have the conditions for a recession and, therefore, a bear market.

So while the Goldman “base” case”, which also happens to be the optimistic return scenario in which the S&P rises another 250 points, or roughly 10%,  over the next 12 months (paradoxically resulting in a PE that is roughly 20x even as the Fed hikes rates another 4 times, in the process likely inverting the yield curve, and central banks collectively slowing the annual pace of liquidity injections by  $1 trillion) is clear, the above bolded text lays out what Blankfein’s strategists see as the biggest threat to their scenarios for the coming year: inflation.

But besides rising inflation and/or inflation expectations, Goldman sees two other risks to its otherwise “rationally euphoric” outlook for the coming year. In sum, Goldman believes these are the three biggest risks to stocks in the coming year:

• A bull squeeze.


• A short correction.


• A rise in inflation expectations.

Addressing the first point, also perhaps known as the “crack up boom", or market melt-up case, Goldman’s European strategist Peter Oppenheimer writes that the bank has “heard frequently from clients in recent time about the lack of an exuberant surge in stock prices that is so often synonymous with market peaks.” He notes that  investors fear that they could be left behind in the last ditch “surge of optimism as interest rates stay low and growth expectations continue to build and are further boosted by US tax reform.” To this Oppenheimer counters that “there are plenty of factors, particularly valuation, to suggest a market fall is more likely.” He makes the point by showing that we have now seen the second-longest period since 1929, at least for the S&P 500, of returns without a correction of 5% or more.

Yet even in admitting that a correction (or bear market) is long overdue, Goldman’s advice to clients is simple: don’t sell, to wit:

Even with risks of a correction or bear market, we think the best action is to stay fully invested, as we have found that anticipating market peaks by selling the market too early can be very ‘expensive’ in terms of forgone returns. For example, on average an investor who sells equities just 3 months prior to a peak (in the US) misses a 7% rise in prices; this is around the same amount as an investor who remains fully invested would lose in the first 3 months of a bear market.

Naturally, the above assumes a garden variety correction, and not some of the cataclysmic market corrections predicted by the likes of Fasanara Capital, Marko Kolanovic and others (such as this website), who anticipate a historic collapse, one which could lead to a comprehensive and indefinite market shut down as liquidity is drained in a post central banker backstop world. Goldman then makes a more relevant point, namely that any initial crash will likely see a sharp rebound in the early days of the bear market:

We also find that nearly all bear markets start with a correction, followed by a powerful bounce that offers investors an opportunity to sell later, assuming of course that they recognise this is an opportunity to sell rather than buy.

Here, too a caveat is warranted: the “powerful bounce” envisioned by Goldman is the result of shorts rushing to cover their positions and providing a natural downside buffer to the market. This may well not happen during the next bear market as Goldman itself showed that short positions among the hedge fund community are approaching record low levels, as the market’s relentless grind higher over the past year has crushed all but the most dedicated bears.

This brings us to the next risk, inflation, and as Goldman suggests, “for a correction to turn into something more sustained – a deeper and longer bear market –think inflation needs to rise, pushing up interest rates and increasing the risks of recession."

As Exhibit 23 shows, there is a very substantial divide between inflation measured in the real economy (consumer prices, wages and commodity prices) since the start of QE in 2009 and inflation in asset prices. Anything that pushes up inflation is likely to result in higher rates. In our central case this is likely to moderate inflation in financial assets (prevent valuations from rising), while in a more extreme case, if inflation rises too sharply interest rates would also need to ‘normalise’ more radically than current markets imply.

The chart Goldman refers to is also the one we showed two months ago when a very confused Janet Yellen said the Fed no longer appears to have a grasp on “low inflation.” As Goldman, and we, showed, inflation is only low in the real economy.  In the financial economy, measured by asset prices, inflation has never been higher.

To be sure, Goldman’s point is valid: if and when inflation seeps out of asset prices and into real economy prices, perhaps as the velocity of money undergoes an unexpected spike (for reasons still unknown) ultimately leading to a sharp rise in wages, the Fed will be forced to catch up aggressively by tightening  monetary conditions far more than the Fed (via the dots) or certainly the market anticipates currently. This, however, brings a scary tangent: on Saturday, Citi’s Hans Lorenzen speculated that the Fed may be paralyzed even in the face of runaway “real world” inflation, as at least “some central bankers Citi has spoken to” admit they are afraid they have lost control over the market and its “reaction function” expectations. This is the world that result in hyperinflation in both the real and financial economies, and potentially culminates with the collapse of both fiat money and conventional monetary economics, unleashing the next global financial crisis as previewed recently by Deutshce Bank’s Jim Reid, and to a similar extent, JPM’s Marco Kolanovic.

Yet in its attempt to avoid a client panic and preempt selling, Goldman comes up with an ingenious loophole: yes, the stock market may crash as it has never been more overvalued, but if it does, it will drag down all other asset prices with it, unleashing a catastrophic liquidation waterfall across all markets. To wit:

In an environment where higher inflation expectations push up bond term premia, we would expect a correction across asset markets. While equity markets are expensive relative to history, so are most asset classes (Exhibit 24 and 25), which means they all are vulnerable to falling together, leaving few places to hide.

And there it is: Goldman admits markets have never been more overvalued, Goldman concedes that the market is long overdue for a correction if not bear market crash (something SocGen had the temerity last week to suggest will happen in 2018), it warns that should Trump’s tax reform not pass the market will tumble, it cautions that if inflation finally does pick up  - which ironically is precisely the Fed’s goal in its attempt to inflate away the world’s record debt load – equities will likely crash… but here’s the punchline: don’t sell because just where are you going to put your money, or as Oppenheimer puts it, “equity markets are expensive relative to history, so are most asset classes which means they all are vulnerable to falling together, leaving few places to hide.”

As a result, according to Goldman’s “logic”, it is not even worth bothering hiding. Well, there is one alternative: 

For multi-asset investors, holding cash as a hedge against an overweight equity position remains a favoured strategy as an inflation-led bear market in equities would affect most financial assets, leaving few places to hide.

Or maybe not cash: judging by the meteoric rise in digital currencies, not only do traders disagree with Goldman’s unique brand of “logic”, but it is increasingly cryptocurrencies – and not cash – that is seen as the hedge to a systemic crash which could take down the very fiat monetary system that created it in the first place.

David Stockman Exposes "The Illusion Of Growth"

Authored by David Stockman via The Daily Reckoning,

The Wall Street Journal published a superb example of hopium recently in a sunny-side-up story entitled “U. S. Manufacturing Rides Rising Tide, Buoyed by Global Growth, Optimism.”

Indeed, this lazy cheerleading excuse for journalism captured the sum and substance of why the punters keep buying the dips despite troubles gathering all around.

That is, as the tax bill falters, the crusade to remove the Donald from office gathers strength, the Fed moves into balance sheet normalization and instability breaks out all over the world from the Persian Gulf to the Korean peninsula.

You would think the title says it all, but the WSJ was not nearly done. It cited a 156,000 pick-up in manufacturing employment since last November, rising energy and commodity prices as evidence of a booming global economy and double digit growth in business investment earlier this year, among other things.

American manufacturing has picked up pace over the last 12 months thanks to steady global economic growth, a rise in energy and other commodity prices, and increased business confidence.

 

Although progress isn’t being felt by all industries, makers of items ranging from bulldozers to semiconductors to food products are on the upswing as various measures of spending, sentiment and employment have climbed, while stock markets have hit record highs.

Yet every one of the trends cited in the WSJ article are less than a year-old. They coincide with the Great Coronation Boom in the Red Ponzi ( the run-up to Xi Jinping’s ascension to total power at the 19th Party Congress); represent only a minor up-tick from the 2014-2015 global deflation; and in the context of the current feeble recovery from the 2008 crisis represent nothing at all to write home about.

Indeed, I am confident that as the Red Ponzi goes into a stabilization and credit containment mode, as is already evident from the October economic data (fudged as it is), that the slight lift to global activity engendered by the latest China credit impulse will quickly fade. And with it the entire trading meme reflected in that WSJ puff piece.

But short of that yet to unfold but predictable global mini-cycle, the actual data on U.S. manufacturing output trends through September reveal nothing to smile about.

In fact, overall U.S. manufacturing production is still down 4.3% from its pre-crisis high back in December 2007, and was no higher last month than it was three years ago in November 2014.

Of course, global commodity prices did perk up during the last 18 months. Not only did they rebound off the bottom in normal cyclical fashion, but the hands of China’s central bank were more than a little evident.

When they unleashed the latest credit tsunami in early 2016, the hordes of Chinese speculators dutifully bought up all the iron ore, copper, steel, diesel fuel etc that was to be had and which could be readily financed in cash and futures markets alike.

Presently, they will be selling, too, as the post-coronation signals coming out of Beijing become unmistakably clear.

Nor is the above even the half of it. If you look at output of U.S. consumer goods, which is much less attached to the global commodity/industrial cycle, the rising tide of manufacturing output is nowhere to be seen.

In fact, consumer goods production has flat-lined for the last two years, and is still below where it was at the pre-crisis peak.

The same is true of manufacturing employment. There is no “rising tide.” Thus, between October 2007 and the April 2010 bottom, the U.S. lost 2.3 million manufacturing jobs — representing a loss of 76,000 high paying jobs per month.

By contrast, during the three years since October 2014, the U.S. has recovered about one-tenth of that loss — with manufacturing jobs expanding at a rate of  just 6,000 per month. That is to say, the WSJ was essentially trumpeting statistical noise.

We are now 120 months from the pre-crisis peak in November 2007. Yet the compound annual growth rate of manufacturing is just 0.08%. Which is to say, nothing.

By contrast, every prior peak-to-peak recovery pales that tiny beep of white noise into insignificance. Thus, between July 1981 and the July 1990 peaks, industrial production expanded at 2.18% a year during the so-called Reagan boom.

Likewise, during the Greenspan tech boom of the 1990s, the compound annual growth rate (CAGR) for industrial production was 4.02%. Even during the highly artificial and unsustainable Greenspan housing boom between December 2000 and November 2007, the index rose at a rate of 1.31% per year.

So Thursday’s industrial production number for October actually signaled that the U.S. industrial economy remains dead in the water. It is floundering in a manner that is off the historical charts — and not in a good way.

But stocks keep marching higher.

In short, financial information has been totally corrupted by the distortions of monetary central planning. Accordingly, when the third and greatest financial bubble of the 21st century collapses — and it is coming soon — it will also arrive as a great surprise.

As I keep insisting, monetary central planning systematically falsifies asset prices and corrupts the flow of financial information.

That’s why bubbles seemingly inflate endlessly and massively, and also why financial crashes and economic corrections appear to come out of the blue without warning.

Back in the winter of 1999-2000, for example, we were allegedly in the midst of a “new age economy.” The revolution in technology then underway, it was claimed, meant all historic valuation benchmarks — like P/E multiples, cash flow and book values — were irrelevant to stock prices.

Likewise, in the fall of 2007 there was nary a cloud in the economic skies. That’s because the Great Moderation led by the geniuses at the Fed had purportedly engendered a “goldilocks” economy destined to expand indefinitely.

Within months of the dotcom epiphanies, however, the highflying NASDAQ 100 crashed — eventually hitting bottom 83% below its new age heights. And 15 months after the S&P 500 reached its goldilocks peak of 1570 in October 2007 it staggered around in smoldering ruins at 670 — down 57% from its housing bubble high.

Today, the so-called stock market now consists entirely of what amounts to day traders and HST (high speed trading) machines. There is no “price discovery” in the classic sense of divining the true economic and political fundamentals. The casino has become entirely a ward of the central banks.

Needless to say, we are again on the precipice of a crash and correction that no one sees coming, but this one has an added twist.

Namely, three strikes and you are out!

What I mean, of course, is that the Fed and other central banks are out of dry powder. They are now stranded near the zero bound with bloated balance sheets that have actually reached hideous girth relative to current GDP and all historical experience — meaning they will have almost no capacity to reflate the next busted bubble, as they quickly did in 2001 and 2009.

Do yourself a favor and get out of the casino now.

Terraforming 101: How To Make Mars A Habitable Planet

Before we can journey to the stars, we must first go to Mars.

That’s Elon Musk’s philosophy, anyways – and as Visual Capitalist"s Jeff Desjardins reports, just days ago he revealed new details on his ambitions to colonize the Red Planet, including sending two cargo rockets by 2022 and four rockets (two manned, two cargo) by 2024.

In 40 to 100 years, Musk suggested that up to a million people could live there.

CHANGE OF SEASONS

As Elton John wisely noted, “Mars ain’t the kind of place to raise your kids”.

Indeed, the average temperature on Mars is −55 °C (−67 °F), dust storms are frequent and potentially deadly, and the planet has extremely low atmospheric pressure (about 1% of Earth). Because of the atmosphere and temperature swings, meaningful occurrences of liquid water on the planet’s surface are almost impossible. And while Mars is thought to have plenty of frozen water at its poles and in underground deposits, the logistics of tapping into these resources could be quite difficult.

In other words, for any meaningful and long-lasting human presence on Mars, we would likely want to alter the planet and its atmosphere to make it more habitable for human life. And while the exact mechanisms we would use to accomplish this are still up for debate, the basics behind what’s needed to achieve Earth-like conditions are actually pretty straightforward.

TERRAFORMING 101

Today’s infographic comes to us from Futurism, and it details what might need to happen on Mars to make it more accommodating to human life.

Here are two steps we could take to get Mars into the “Goldilocks Zone”, where water is liquid – and harmful ionizing radiation like x-rays, UV rays, and gamma rays are not problematic.

Greenhouse Gases
One way to ward off harmful ionizing radiation is to add a thicker layer of greenhouse gases to the atmosphere of Mars. Such an atmosphere would also allows less heat to escape, meaning warmer temperatures on the planet.

Magnetic Field
A strong magnetic field on Earth is something else that makes life easier. Earth’s solid inner core, composed primarily of iron, creates this field when the planet spins – and it deflects cosmic rays and other harmful types of radiation.

One interesting solution to solve this problem on Mars would to have a magnetic field generator in front of the planet at all times, deflecting any such rays coming from the sun.

THE REALM OF POSSIBILITY

While terraforming is still a mixture of theory and science fiction at this point, we do know some of the major problems that have to be solved for attaining a habitable environment – and it will be interesting to see how plans around Mars develop as the prospect of colonization becomes more real.

You need to live in a dome initially but over time you could terraform Mars to look like Earth and eventually walk around outside without anything on.

… So it’s a fixer-upper of a planet.

– Elon Musk

Gold: Take Profits at $1330, Beware the London Spoof

Update 12:45pm - if we do not hold the  $1312- 1310 area in spot there is a lot of trouble ahead.

The 60 minute is looking at an inflection point in the area:

 

 Breaking $1312 on the 60 minute chart puts us outside the  bottom band, and would likely increase all BBand widths implying accelerated downside movement, aka a reversal. Inflection point to say the least.

 Meanwhile the daily shows the same area as an outright negation of today"s momentum higher.?The Upper BBand comes in near $1312 currently. A settlement inside that adds fuel to the 60 minute chart above

Expect more profit taking if we get below this area. Pray some buyers have not gone to the market and are waiting for this dip to buy in. If stops exist, expect Commercials to gun for them here.

Take Profits Now

posted originally on marketslant.com

Big players like Soros and Druckenmiller use liquidity events to get out of massive  positions all the time. This is another example of where these types  may sell into strength. That does not mean the market will not continue higher afterwards. it does mean profit protection is mandated when gorillas like these are entering a room. If we do not close weaker today, beware the London Open for a large profit booking as the past has shown us. Many continue to call this a spoof,  and sometimes it genuinely is. We think Friday"s Comex activity was one to shake out momo longs and help commercials cover some shorts. But it is prudent to accept that some  of those big orders seen during London hours are genuine  profit taking by players not worried about $5.00  when  they are booking $55 in 2 months

 Yesterday, via Moor Analytics we gave you the road map ahead. Admittedly we did not think  it would happen so quickly:

August 21st : We wanted a bull flag

 We  wanted a bull flag to form starting with a selloff early last week, as opposed to the one at week"s end, and said as much on Aug 21st;

Ideally, over the next 3-5 days: we wanted to see Gold fill the Comex gap underneath, and in the process shaking out some weak longs and luring some shorts to pile in. First touching the $1285 area, close with a positive settlement on a lower day. Then we could see a nice orderly rally out of a bull flag. But so far that is not the case. Instead we have more buying at the top end of a range that has earmarkings of Friday"s behavior.

Aug 28th: We got the Bull Flag

Our time frame was good. Our order of events was not. The rally / dump 2 Fridays ago did spook us, but last Friday"s sell-off and rally undid that. The Comex gap got filled underneath as we wanted, and the market closed positive on the 25th, leaving a tail of sellers trapped below.  Happy to be wrong timing wise here about the momo money bailing.  

Michael Moor"s Next Steps:

From yesterday"s post

Paraphrased with our comments in italics

• Areas of possible exhaustion for this move up come in at 13143-237 and 13466-556 - We have moved through the first area of congestion overnight


• Take profits in the $1330- $1332 first time up, reverse on a break above with a $1336 target - Some profits  should be taken  on speculative portfolios long from  the $1285 area or lower. We do not think  trailing stops will serve specs well here.


•  Buy to cover shorts in the $1321 area first time down. - if you are getting short in the $1330 area with a $1332 stop, we like this advice


• There are multiple  resistance numbers that may be broken early, only to serve as accelerators  of profit taking on a re-piercing lower - This may be a strong hands to weak hands day

For additional information contact: Moor Analytics

Our 2 Cents

Comex Futures now have a Gap between $1317.80 and $1318.90. To those who ignore gaps as Gold is a globally continuous market, we get it. But to those who trade in one time zone, they remain relevant when applied consistently. We"d be hesitant to buy that gap if tested because of our own volatility based trading style, and would rather buy it upon a break under adnarally back through $1321.

Bollinger Bands show us that if one were playing the momentum game it is prudent to remain long until a settlement occurs  within the outer band. This comes  in currently at $1321 now, and is  consistent with Moor"s levels. Any breaking of that level, especially late in the day does not give us a good risk reward in which to buy. We"d rather  short in the gap  with a stop-loss and reversal set at  $1321 for a day trade. 

Today:

1. Take some profits near $1330-1332 if you were long from the $1285- 90 range


2. Take more profits if the area of $1346 is reached


3. Leave a tail in the form of long calls or a small position that wont kill  you on a $20 move lower overnight.


4. Buy $1321 area for a bounce back to $1328- $1330. Risk a $1317 print


5. Short here at $1325 with a buy stop on new highs with a target of $1301 ( do not take home  if  out of  the money on close)

interactive spot chart HERE

Gold is Goldilocks regardless of the next $50 move... keep the faith and let the momo guys create short term opportunities for you now.

"How Do We Get To The Next Crisis": An Interview With Raoul Pal And Julian Brigden

With the dollar index now 10 points below its recent cycle highs from early January, nervous dollar bulls are starting to reevaluate their initial assumption that this would be a short-term pullback, and many are worried that this could be the start of a new secular bear market. In this week’s MacroVoices podcast, host Erik Townsend invited two of the show’s most popular guests, Raoul Pal and Julian Brigden, two well-respected analysts whose research commands high fees from institutional investors, to discuss complacent equity markets, the timing of the next correction and whether US interest rates will “back up” another 50 basis points.

Townsend started by asking his guests to emphasize areas where they disagree to try and help listeners develop a better understanding of how the two analysts formulate their ideas about markets. But their discussion soon turned to the US dollar, which has been exasperating for the three longtime dollar bulls.

Pal admitted that the dollar’s persistent weakness was beginning to make him nervous as he"s been losing money on his dollar trades for a dangerous stretch. However, he believes the “underlying basis for why the dollar bull market should still be in play” is still there.

“Raoul: My view, like yours, is bullish dollars. Now, the problem is we’ve only had two dollar bull markets in history, one in the early 80s and one in the late 90s. So we have a very small data sample to look at the behavior of dollar bull markets. But what I did notice is no dollar bull market has had a weekly close down more than 10%. Once it goes more than 10% it’s generally a reversal. So that’s a kind of—not so much a line in the sand but a guideline for me.

Now, we’re very much there now. We’re at 9.5% negative on a weekly basis. So it’s starting to make me concerned. There’s plenty of support levels around here as well. I use DeMark Indicators and they are counting towards a reversal. We know that the market positioning is very high. So for me it’s really crucial that the dollar does hold.

I think the underlying case for why the dollar bull market should still be in play is still there. But what we need is some sort of change of sentiment within the market, whether it’s either a renewed belief in much faster rate rises in the US or it’s weaker economic growth. The dollar has a kind of smile where it rallies in either/or but falls when we’re in the Goldilocks phase, which we’ve been having recently. So I’m looking at that.

I’m obviously nervous on my view because it has been going against me. And I’ve been in the trade for a long, long time now so, in Euro terms it’s about 148 and a half. So I’m now really finessing the idea does it move further than here?

If we look at the previous dollar bull markets they tend to go much further, so it would tend to suggest there’s maybe another 15 or 20% upside in the dollar over time. I also look at—and something we’ll probably talk about later—the comparison between this dollar bull market and the dollar bull market leading into the 90s is remarkably similar. The pattern almost fits exactly. And that was the period going into 1999 where we had a correction in the dollar. At that time it went about 8.5% and then it turned around and started rallying as economic growth started falling and rates started easing off a bit. The Europeans at the time were raising rates still. And that whole scenario, we saw actually the dollar go much, much higher. And so that’s what I’m looking for. If I’m wrong, the world’s a different place, and there’s a number of trade opportunities from that. But I still remain a dollar bull but a nervous one.”

Brigden says he remains a committed dollar bull, and sees the greenback rising in either one of two scenarios: the greenback will climb as equities and bond price fall in a "risk off rally" where the dollar becomes the haven asset. His other "risk on" case involves the dollar and stocks climbing alongside yieds. Hoping to avoid confusion with his fund"s long-Europe trades, Brigden also said it"s important to specify what exactly one means when they"re talking about going long, or shorting the dollar.

“Julian: So I think one of the things—and I would concur pretty much with everything that Raoul said—I think one of the observations that I would make is that we’ve got to be a little bit careful of what we call a dollar. Because I think there’s a great temptation to look at some of the dollar indexes, in particular the Euro, and say, well, that’s indicative of what the dollar is doing. And I don’t really believe that is the case.

I think we have been as a shop very bullish, and I think it was on your show, Erik, talking about how we saw the growth pickup coming in Europe. We were singularly bullish, the dollar backing end of April beginning of May, for our clients—sorry, singularly bullish, Euro end of April beginning of May, for our clients. And that was on the break of—we started to see break above 108 in the Euro. In actual fact, we just advocated 24 hours ago to start taking profits in those long Euro positions.

But the point is that things like the DXY are essentially Euros. I mean, they’ve got some Swiss Francs in there, some Swedish Krona, and those are both pegged effectively to the Euro. So you really, I think you have to be a bit careful.

I think what we’ve seen a lot this year is a repricing of the growth-inflation story in Europe. And I think that’s one of the reasons why the dollar has been underperforming. So I’m not quite as concerned about this 10% line in the sand. I think Raoul makes some good observations on that, but I would say that I think to get the next kicker we need to see some developments in story here in the US.

We’re either going to have to see a—and this is my fear—we’re going to see a risk-off dollar rally. So you could have a situation where you can get a correction in bond markets and a correction in equities, and you can actually get the dollar rising because it’s a safe haven vehicle. Or we move into the latter half of the year, we get the Fed to start to shrink the balance sheet—I talked to your listeners about this before—I think that’s potentially a very bullish event. And particularly as well in early 2018 if we get the Trump tax cut.

And my sources in D.C. tell me that still the odds—even though Trump doesn’t seem to be able to put his trousers on straight any day of the week—that the odds are somewhere around 65-70% that we get a tax deal. And it will definitively include repatriation. So I think, to me, I’m still in that structural bull environment for the dollar. But it—we may have quite a few months to wait still. And in that interim, I think what we’re doing is just repricing the Euro.”

Turning the conversation to equities, Brigden said the US market is showing signs of a "classic bubble," meanwhile, rising interest rates and a hoped-for reversal in the dollar would remove two of the fundamental cases for being long equities.

“Just because we’d had this incredibly good run, we think that a lot of the outperformance of the European stock market had been predicated on Euro weakness and also low bond yields. And both of those we think are in the process of changing. So we scaled back our belief in this European outperformance trade at this stage.

I think the US equity market, we seem to be going through this game of rotation. And once again, to differentiate between markets, you know, in the same way that you can’t look at the dollar as just a single thing. What we’ve got is we’ve had up until the last week or so really very aggressive outperformance by a relatively narrow group of stocks. And those stocks—and you know we’ve talked about it in a number of publications—are increasingly looking like what I would call a classic bubble, and I think I’ve talked on your show about a classic bubble. It’s just chart pattern we look for, Erik.”

Meanwhile, Pal said “there are opportunities” in equities among the ongoing changes in underlying market conditions:

“Raoul: Well, for me, I would like go back to the business cycle. You know, we looked at it last year and the business cycle weakened significantly, gained traction again, and bounced again. I mean, it’s done this a couple of times now. It’s tiresome, but it is what it is. Because I much prefer it when we get to the bottom of a cycle—we know when to invest etc. But waiting for this is slightly painful.

But until economic growth weakens in any meaningful way, the equity market will continue to grind higher, volatility will remain low, until something changes. Now there is—and that’s structural volatility. There are opportunities—and I think Julien will talk a bit about this—for spikey volatility where there is an opportunity for a risk-off, which may not be pervasive and may not last very long. We won’t get anything that lasts long and we won’t get a structural shift in volatility until the business cycle weakens.”

Pal also believes that interest rates could head back toward 3% in the medium term if President Donald Trump manages to pass tax reform.

“Raoul: Yeah, again, we need to talk about path and we need to talk about time horizons. So, for me, the path is—I’m less interested in—I think it’s a pretty benign environment for US rates. Yes, if Trump does manage to pass something in terms of economic stimulus in terms of some sort of fiscal policy or taxation, whatever it may be, then can rates back up a bit? Yeah.

But, for me, I’m indifferent from a backup in rates from, you know, 225 where they are today at ten years, to, 275. Fifty basis points I don’t really care, because I think the risk reward is that, at the bottom of the business cycle—which we’ve identified has to come and will come within the next call it 18 months—the bottom of the business cycle should see bond yields at 50 basis points or even less. So that makes, even with a backup in yields to let’s say 275, it still makes it kind of a five for one risk reward.

So, for me, I look through the speed bumps and look at the horizon. The horizon for me is 50 basis points at the bottom of the next business cycle, which has to come. Well, it doesn’t have to come, but the probability is extremely high that it comes in the next 18 months or two years.”

Brigden said that while Pal may be correct, he wasn"t comfortable with the time frame, saying it could take longer for bond yields to start moving higher again. But the more important question is when will we see the next market crisis commence, and how will we get there. That"s the key topic of discussion in the next section:

“Julian: Yeah, it is Erik. I mean, it’s certainly in the next, shall we say, six months. And I think it’s—Raoul and I talk about this a lot and it’s one of the things that I think we believe is one of the strengths of the product: we tend to sort of chew through our stories. And our views are structurally very, very similar, but often our timelines are slightly different in how we get there.

And my concern is I can ultimately see Raoul’s right, I mean, I think we could get another very nasty downturn. I think we could get a—you know, it’s hard to argue against the sort of structural deflationary trends or disinflationary trends that you see globally. The question is how do you get to that next crisis? Do you sort of go quietly into the night, and we walk in one day and ISM stands at 45, and everybody says, wow, QE doesn’t work. Or do you get there a different way?

And my inclination is I believe we’ll actually get there a slightly different way. And at the moment the biggest risk that I see in markets is this chasm between, as I said, equity market pricing and bond pricing. And with that you can throw in Vol. And my biggest fear is that we’re going to get to the next crisis, not via immediate economic weakness, but actually via strength.

And it isn’t so much in the US. As I said, I think there’s a chance that we get a burst of very aggressive activity. That’s sometime in 2018 if we get this Trump stimulus through.

But when I look at the world, actually, my biggest fear—and I think this is interesting for US listeners of yours, because generally Americans don’t look too broadly at the rest of the world, they tend to be very focused certainly in financial networks, they tend to be very focused on what’s going on in the US—I actually think the biggest risk is Europe. I look at European growth models—and we’ve talked about this—but these things continue to strengthen. And the inflation picture, actually, I think is just really going to rip.

And I was reading today how one of my peers was talking about how, for the fourth time, ECB’s going to have to upgrade their growth forecasts. Well, I just think they’re going to have to keep upgrading and upgrading their growth forecasts. And what I fear is that we’re on the cusp of a repeat of events that we saw in the spring of 2015. So, if you remember, at that point ECB had launched QE in the end of 2014, the DAX had ripped higher, and bund yields were locked at zero. And then, one day we walked in and the bund market finally said, screw this, I am repricing because what’s the point of holding bunds at zero, if the DAX is going through the stratosphere.”

Both men are also worried about how shifting demographics, notably how the aging baby boomer generation will impact markets. With the largest-ever wave of retirees set to leave the workforce in the next few years, equity markets are facing a terrifying transition: When millions of buyers are, for the first time, forced to sell.

You can listen to the podcast in full below:

Breaking Down The Bull Market Thesis

Authored by Lance Roberts via RealInvestmentAdvice.com,

Stocks Rise Following Breakout

In last week’s missive “Bulls Run On Yellen’s Easy Money,” I addressed the breakout and why we increased equity exposure modestly in portfolios.

“However, this changed this past week as Yellen uttered the two magic words: ‘EASY MONEY.’

Okay, it wasn’t exactly two words. It was actually:

‘Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.’

In other words, by saying that interest rates would not have to rise much further, the markets translated that to ‘lower interest rates for longer,’ confirming the Federal Reserve will remain “highly accommodative” to the markets so, therefore, ‘buy stocks.’

And with that, the robots leaped into action pushing markets OUT of the month-and-a-half long trading range of just 1.5%. This push to new highs, as noted above, also triggered a short-term ‘buy signal,’ at the bottom of the chart, which suggests this rally should continue higher over the next week, or so, heading into the month of August.” 

“With the break above 2452 on Friday, assuming it will hold above that level into next week, it will provide an opportunity to increase short-term equity allocations in portfolios. However, be mindful, this is VERY short-term in nature and could be quickly reversed – so manage your risk accordingly.”

As stated, this analysis is VERY short-term in nature. Price trends are currently positive which keeps portfolios long-biased for the time being. However, while our portfolios are “bullishly” positioned for the short-term, we remain much more pessimistic about the longer-term return dynamics.

I want to spend the rest of this weekend’s missive analyzing the ongoing bull thesis that has been pushed out by the media recently.

---

Analyzing The Bull Thesis

Michael Santoli via CNBC

“Exactly a decade ago, it was time for investors to start worrying, even as stocks sat at record highs and the signs of onrushing danger were far from obvious.”

I am not so sure that warning signs weren’t obvious. Starting in mid-2007, the market began to struggle to make gains and initial “sell signals” were given as internal measures began to deteriorate.

Furthermore, as shown in the chart below, the “financial crisis” was not a sudden event. Had investors been paying attention to the market, rather than listening to the advice of “buying the dips” or Fed Chairmen declaring “subprime is contained” and “it’s a Goldilocks economy,” there were three separate opportunities to step aside BEFORE the Lehman event ever occurred.  

Yet, in 2007, much like today, individuals were being told to disregard much of the same evidence that existed then as they are today. Let’s take a look at a few of the arguments being made currently.

Earnings Growth Is Driving The Markets

The bulls currently have the “wind at their backs” as the continued “hope” the Trump administration will foster an age of deregulation, infrastructure spending and tax cuts which will boost corporate earnings in the future. Shortly after the election in 2016, Jack Bouroudjian via CNBC wrote:

“Let’s be clear, this market run up to the 20K level has a much more solid foundation for valuation. We are not looking at a P/E which has been stretched beyond historical norms as was the case in 1999, nor are we looking at a dot com bubble ready to implode. On the contrary, between digestible valuations and the prospects of real pro-growth policies, we have the foundation for a run up in equities over the course of the next few years which could leave 20K in the dust.”

The problem is 9-months later there has been no advancement on that legislative agenda while the markets have surged more than 18% since the election. As I discussed previously, the market has already priced in the expected earnings growth from the “promised” Trump agenda which puts the market in danger of disappointment.

“Given that stocks have surged based on ‘hopes’ of deeper tax cuts, a tax cut only roughly half of previous estimates certainly puts valuations at risk. Once again, the market has already priced in earnings growth through 2018, making disappointment a much higher probability.”

“Considering that forward estimates are generally overstated by 33% on average, the risk is high of disappointment.  As shown below, there was a $10 difference between what earnings were expected to be in 2017 at the beginning of 2016 and today. Furthermore, forward earnings have only risen by $4.15/share for the end of 2018. Yet, as shown, above prices have more than priced in that future growth.“

However, as Dr. Lacy Hunt recently discussed, this may not be the case.

“Considering the current public and private debt overhang, tax reductions are not likely to be as successful as the much larger tax cuts were for Presidents Ronald Reagan and George W. Bush. Gross federal debt now stands at 105.5% of GDP, compared with 31.7% and 57.0%, respectively, when the 1981 and 2002 tax laws were implemented. Additionally, tax reductions work slowly, with only 50% of the impact registering within a year and a half after the tax changes are enacted. Thus, while the economy is waiting for increased revenues from faster growth from the tax cuts, surging federal debt is likely to continue to drive U.S. aggregate indebtedness higher, further restraining economic growth.

However, if the household and corporate tax reductions and infrastructure tax credits proposed are not financed by other budget offsets, history suggests they will be met with little or no success. The test case is Japan. In implementing tax cuts and massive infrastructure spending, Japanese government debt exploded from 68.9% of GDP in 1997 to 198.0% in the third quarter of 2016. Over that period nominal GDP in Japan has remained roughly unchanged. Additionally, when Japan began these debt experiments, the global economy was far stronger than it is currently, thus Japan was supported by external conditions to a far greater degree than the U.S. would be in present circumstances.”

With analysts once again hoping for a “hockey stick” recovery in earnings in the months ahead, it is worth noting this has always been the case. Currently, there are few, if any, Wall Street analysts expecting a recession at any point the future. Unfortunately, it is just a function of time until the recession occurs and earnings fall in tandem.

Valuations

Another argument often used to support the “bullish” meme is that valuations aren’t as high as they were in 2000. While that is true, there is a vase fundamental difference between now and then. In 2000, as valuations surged toward 42x CAPE earnings, there were MANY technology companies with negative earnings which skewed the valuation measure. Most of the companies are now gone, or the ones that survived finally begin generating earnings.

While valuations are NOT a good market timing indicator, and are not predictive of the end of a bull market advance, by all historical measures, they are expensive. Most importantly, while high valuations certainly aren’t predictive of bear market onsets, they are HIGHLY predictive of very low returns in the future. 

One of the other arguments to justify higher valuations has been that interest rates are so low. Okay, let’s take the smoothed P/E ratio (CAPE-10 above) and compare it to the 10-year average of interest rates going back to 1900.

Importantly, the statement of “lower future returns” is very misunderstood. Based on current valuations the future return of the market over the next decade will be in the neighborhood of 2%. This DOES NOT mean the average return of the market each year will be 2% but rather a volatile series of returns (such as 5%, 6%, 8%, -20%, 15%, 10%, 8%,6%,-20%) which equate to an average of 2%.

Sentiment Is Bullish

Of course, as discussed previously, investor behavior makes forward long-term returns even worse.

The bulls have continually argued the “retail” investor is going to jump into the markets at any moment which, with all the “cash on the sidelines,” will keep the bull market alive. The chart below suggests they are already in. At 30% of total assets, households are committed to the markets at levels only seen near peaks of markets in 1968, 2000, and 2007.  I don’t really need to tell you what happened next.

Furthermore, as I have discussed repeatedly in the past, there is NO “cash on the sidelines” to begin with. To wit:

“Every transaction in the market requires both a buyer and a seller with the only differentiating factor being at what PRICE the transaction occurs. Since this must be the case for there to be equilibrium to the markets there can be no ‘sidelines.’

Furthermore, despite this very salient point, a look at the stock-to-cash ratios also suggest there is very little available buying power for investors current.”

There is no cash on the sidelines.

Furthermore, the dearth of “bears” is a significant problem. With virtually everyone on the “buy” side of the market, there will be few people to eventually “sell to.” The hidden danger is with much of the daily trading volume run by computerized trading, a surge in selling could exacerbate price declines as computers “run wild” looking for vacant buyers.

This thought dovetails into the “hyperextension” of the market currently. Since price is a reflection of investor sentiment, it is not surprising the recent surge in confidence is reflected by a symbiotic surge in asset prices.

The chart below shows the deviation above the 3-year moving average. Importantly, at the peak of the previous two bull markets, the deviation never pushed into the 3-standard deviation range as it is currently. This suggests there is VERY little room left to the upside before some corrective action occurs.

The problem, as always, is sharp deviations from the long-term moving average always “reverts to the mean” at some point. The only questions are “when” and “by how much?”

---

Managing Past The Noise

There are obviously many more arguments for both camps depending on your personal bias. But there is the rub. YOUR personal bias may be leading you astray as “cognitive biases” impair investor returns over time.

“Confirmation bias, also called my side bias, is the tendency to search for, interpret, and remember information in a way that confirms one’s preconceptions or working hypotheses. It is a systematic error of inductive reasoning.”

Therefore, it is important to consider both sides of the current debate in order to make logical, rather than emotional, decisions about current portfolio allocations and risk management.

Currently, the “bulls” are still well in control of the markets which means keeping portfolios tilted towards equity exposure.  However, as David Rosenberg recently penned, the markets may be set up for disappointment. To wit:

“So we have a sluggish U.S. economy on our hands with growth revisions to the downside. We have a situation where some investors see the softness enduring long enough that Fed funds futures are now pricing in less than 50-50 odds that Yellen et al make another rate move by year-end. Yet the Fed is signaling that it will begin to shrink the balance sheet by the fourth quarter, with no economic liftoff.

The political backdrop is rife with gridlock — unbelievably, there is still hope among investors that tax reform is coming by 2018. At the same time, evidence is mounting that the Dems have a serious shot of taking the House next year. We have a White House that, with the help of inside leaks and the media, continues to find itself embroiled in controversies. And health care reform, which was always pledged to be the first item to be done, is looking more and more like a pipe dream. When hasn’t governing been complicated? It took the Gipper five years and endless bottles of scotch with Tip to get tax reform legislated in 1986!

We have heightened geopolitical risks from North Korea and China has instructed the U.S. that it will not be pressured to invoke sanctions against its unstable satellite.

We have a central bank chief who looks to be a lame duck…a recent WSJ survey found that economists only peg her odds of staying on past February 2018 at 20.8%. Just more uncertainty to deal with.”

Currently, there is much “hope” things will “change” for the better. The problem facing President Trump, is an aging economic cycle, $20+ trillion in debt, an almost $700 billion deficit, unemployment below 5%, jobless claims at historical lows, and a tightening of monetary policy and 80% of households heavily leveraged with little free cash flow. Combined, these issues alone will likely offset most of the positive effects of tax cuts and deregulations.

Furthermore, while “bearish” concerns are often dismissed when markets are rising, it does not mean they aren’t valid. Unfortunately, by the time the “herd” is alerted to a shift in overall sentiment, the stampede for the exits will already be well underway. 

Importantly, when discussing the “bull/bear” case it is worth remembering that the financial markets only make “record new highs” roughly 5% of the time. In other words, most investors spend a bulk of their time making up lost ground.

The process of “getting back to even” is not an investment strategy that will work over the long term. This is why there are basic investment rules all great investors follow:

1. Sell positions that simply are not working. If they are not working in a strongly rising market, they will hurt you more when the market falls. Investment Rule: Cut losers short.


2. Trim winning positions back to original portfolio weightings. This allows you to harvest profits but remain invested in positions that are working. Investment Rule: Let winners run.


3. Retain cash raised from sales for opportunities to purchase investments later at a better price. Investment Rule: Sell High, Buy Low

These rules are hard to follow because:

1. The bulk of financial advice only tells you to “buy”


2. The vast majority of analysts ratings are “buy”


3. And Wall Street needs you to “buy” so they have someone to sell their products to.

With everyone telling you to “buy” it is easy to understand why individuals have a such a difficult and poor track record of managing their money.

Trying to predict the markets is quite pointless. The risk for investors is “willful blindness” that builds when complacency reaches extremes. It is worth remembering that the bullish mantra we hear today is much the same as it was in both 1999 and 2007.

Again, I don’t need to remind you what happened next.