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In 1991 Billy and Akaisha Kaderli retired at the age of 38. Now, into their 3rd decade of this financially independent lifestyle, they invite you to take advantage of their wisdom and experience.

Lance Roberts - Real Investment Report

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Bulls Make A Break For It

Let’s pick up with where we left off last week:

“There wasn’t any “bad news,” so to speak, so the “mediocre” news is that despite the solid rise in the markets from Tuesday’s low, we remain very range bound between the 100-dma and the closing highs over the last couple of weeks as shown below. The tan shaded area is the current consolidation process from the March highs.”

This past week, that breakout did occur and pushed prices, as expected, to the first level of resistance which resides at the late February highs.

As shown, there is a significant amount of overhead resistance between 2780 and 2800 which may present a challenge in the short-term to a further advance. However, I suspect any weakness next week will likely provide a decent opportunity to increase equity exposure modestly. 

 

 

 

 

This idea aligns with the updated the“pathway analysis” from last week.

We had previously given pathway #1, #2a and #2b a 70% probability of coming to fruition. The tracking of pathway #1 also negates pathway #3 entirely for now. 

More importantly, the market is sitting at the critical juncture of either a continuation of pathway #1 toward all-time highs, or a correction of some sort to retest support and confirm this past week’s breakout. A corrective retest that provides a better entry point to increase exposure is the most preferable of outcomes. 

There are plenty of catalysts next week to provide the markets the necessary catalyst for a short-term sell-off.

  • The Fed will hike rates next week, however, their press conference will be closely watched for more “hawkish” undertones.
  • Next week, the Trump Administration will announce $50 billion in “tariffs” on Chinese products. The ongoing trade war remains a risk to the markets in the short-term. 
  • Any unexpected “back-of-the-napkin” policy the White House takes which surprises the market.
  • Ongoing liquidity concerns with respect to Italy or Deutsche Bank.

For now, the market has “priced in” most of the “known” risks to some degree. What hasn’t been “priced in” is unexpected economic weakness, a credit related event, or a new geopolitical risk currently not on the horizon. These things happen, and while the current backdrop is very positive for stocks currently, not paying attention to the risks has very negative consequences.

Adding Exposure

As we have noted previously, it is the “end of the week” data which drives our portfolio allocation models and strategy. Using weekly data reduces the “volatility” of the day-to-day price movements and reduces both emotional mistakes and portfolio turnover. As longer-term investors, we are more interested in overall market trends rather than short-term trading victories.

This past week the market cleared the 61.8% Fibonacci retracement from the recent lows which removes a major barrier in reaching previous market highs.

Also, the market held to its accelerated “bullish trend line” from the 2015 lows. Despite the recent corrective action, nothing “bearish” has occurred which is why we only mildly reduced our overall equity exposure. The break above resistance this past week, now allows us to additional increase exposure in portfolios further.

A Word Of Caution

There are only a couple of issues at the moment which keep us mildly heavier in cash. The sharp rise in asset prices this past week, as shown above, was due to a massive “short squeeze” in equities. It was particularly seen on Friday in the most beaten down sectors of retail and staple stocks that have roared back to life. The rally could well be short-lived given the underlying fundamentals that plague these sectors currently has not changed.

Secondly, the weekly “sell signal” has not been reversed as of yet. While the signal will likely be reversed in the next week or so, if the markets continue to advance, it is worth giving the signal the “benefit of the doubt” currently. If you go back and look at the 2015-2016 correction process, which was ended by massive globally coordinated Central Bank interventions, the weekly signal turned positive for a few months before failing into the next correction.

Currently, we do not have globally coordinated Central Bank interventions occurring, rather they are withdrawing their support. The Fed is about to ramp up their balance sheet reductions from $30 to $40 billion a month pulling further liquidity from the markets. The ECB and Japan have also started tapering back.

Also, as Zerohedge discussed on Friday:

Over the past month, US Investment Grade credit has steadily underperformed its corresponding equities, punctuated by a significant credit widening yesterday. Despite CDX IG 5Y widening 3bps yesterday afternoon to 67bps, there was little SPX reaction and only a modest rise in the VIX. “

Benchmarking the divergence:

“We estimate the equities corresponding to the names in the CDX IG Series 30 are up 3.5% in the past month while a risk equivalent investment in CDX IG 5Y is down 2.8% (selling protection at 12x hedge ratio).

Relative to volatility over the past year, credit has underperformed equity by 3.1 standard deviations over the past 2, 4, 6 and 8 weeks when compared to these same rolling periods over the past year.

This compares to a 2.7 standard deviation dislocation when we last wrote about a similar divergence in January.”

What might this mean for forward equity returns? 

“Over the past year, when credit has underperformed equity by an average of 1 standard deviation over a 2, 4, 6 and 8 week period (12% of observations), equity was down an average of -2.3% over the subsequent month. When credit OUTperformed equity by more than 1 standard deviation over a 2, 4, 6 and 8 week period on average (8% of observations), equity was up an average of 2.4% over the subsequent month.”

Goldman’s suggestion:

“We see this difference as significant and leads us to favor de-risking strategies in equities.”

I don’t disagree with Goldman’s analysis, which begs the question “why increase equity exposure further?”

It’s a good question.

The answer is simple, because our strategy, discipline, and models require us too.

There is a more than reasonable risk the markets could well rally to all-time highs only to fail once again.

While the “bulls” will be quick to suggest the markets are set to run indefinitely higher, the reality is that we remain very late in the current cycle, rates are rising, liquidity is being extracted and valuations are elevated. While any one of those issues has proved problematic for stocks in the past, the combination of all of them are a toxic brew longer-term. This is particularly the case with a market that is at extremes rarely seen in market history.

While we will begin slowly increasing our exposure to equities back to target allocations starting next week, we do so with a risk-management process in place.

We encourage you to do the same.

If you don’t have one, it might be time to develop one.

Are You Being “Shamed” Into Excess Risk?

by John Coumarionos

How an advisor should talk to clients and what rhetoric leads to big sales are often at odds. It can be death to an advisory business if the advisor is negative. Although this isn’t universally true, clients tend to want reassurance from an optimistic advisor. That’s why economist Andrew Smithers refers to broker happy talk as stockbroker economics.” The two rules of stockbroker economics are:

1. All news is good news, and;

2. It’s always a good time to buy stocks.

On the role of news, a strong economy fills clients will all the optimism and willingness to buy what they need. A weak economy simply prompts a broker to say that falling interest rates and future rising profits are good for stocks, never mind that profits and prices had only moved in tandem 54% of the time when Smithers wrote his 2006 article. On the second rule, nothing has succeeded as well as what Smithers’ calls the “bond yield ratio,” another name for which is the “Fed Model.” That model compares bond yields to the earnings yield of the stock market (the reciprocal of the P/E ratio or E/P). This ratio worked from 1977 to 1997, but didn’t from 1948 to 1968. Using the full dataset shows no relationship between bond yields and earnings yields, according to Smithers.

Other forms of nonsense used to support the second rule include using a current P/E ratio to appraise stocks. Of course, a current P/E ratio has little ability to forecast long-term returns. It sometimes shows stocks are expensive when they are actually cheap, and vice versa.

A third piece of nonsense that Smithers doesn’t mention is the assertion that all forecasting is bunk. But while forecasting next year’s returns might be bunk, metrics like the Shiller PE and Tobin’s Q have strong records in forecasting future long-term returns. Even if the Shiller PE has been elevated for the past 25 years, the S&P 500 Index has delivered tepid returns (5.4% annualized) from 2000 through 2017.

All of this means the first rule for investors judging their advisors is whether their advisors engage in too much happy talk – especially about future returns. If an advisor says a balanced portfolio should deliver a 7% annualized return for the next decade with starting 10-year U.S. Treasury yields at 3% and stocks at a 32 CAPE, be wary.

Second, investors should avoid advisors who avoid making forecasts to the point where they disparage anyone who does. That’s because it’s not hard to make a bond forecasts. With high-quality bonds, yield-to-maturity will get you close to the total return. Although stocks are harder, the Shiller PE can help, and the more it’s stretched by historical standards, the more accurate it gets. No advisor should be dogmatic about pinpointing future returns; anyone who thinks they can be precise is crazy. But it’s also outlandish to expect long-term historical returns from the stock market when valuations are as stretched as they are today. Stock market forecasts are hard, but don’t let your advisor squirm out of them completely.

Making a forecast is also necessary for constructing a financial plan. And while it’s true that an accurate forecast doesn’t have to be available just because advisors and clients need one, decade-long projections are easier, if imperfect, than guessing what next year’s market move might be. And when the Shiller PE stretches to more extreme levels, low future returns become more likely. When you hear an advisor making fun of something, that should raise warning flags.

We think advisors with integrity aren’t afraid to tell clients stocks are expensive even when it might hurt the advisor’s business. An advisor constructing a financial plan owes you an honest assessment about future returns. Currently, the Shiller PE is at 32. And while nothing is impossible, it’s very unlikely that stocks will deliver more than a 2% real annualized return for the next decade.

Third, consider if your advisor goes beyond the risk questionnaire he gives you. Nearly every financial advisory firm has a risk questionnaire that it gives to prospects and clients. The questionnaire often has many questions about how much risk the investors think they can handle and what portion of their assets they’d like to put at risk in exchange for possibly getting a higher return than a low-risk investment will deliver. But risk questionnaires ask about percentages, and most people don’t think in percentages. Consider if your advisor asks you how you might feel if you opened up your statement and your account was down by a certain dollar amount. That’s more meaningful than a percentage question. Consider it a positive thing if your advisor pursues this line of questioning a bit, including asking you how you felt and how you reacted to the market plunge in 2008.

 

 

 

 

Risk often boils down to how much of a portfolio decline a client can tolerate before selling out. This is important because it shows how investors do themselves damage. The tendency should be to buy stocks when they get cheaper, not sell them. But investors rarely think of buying when the prices of their holdings are declining.

Advisors have other ways of trying to train clients about how to treat price declines in their portfolios. Many advisors focus on long term asset class returns, trying to persuade investors that they can overcome declines if they have the willpower to stay the course and not be discouraged. Other advisors do the opposite, focusing on how severe declines can be and trying hard to get clients into allocations that they can live with at the outset and to prepare them for the difficulty that lies ahead in the inevitable downturns.

The advisors who emphasize long-term returns often come close to shaming clients into owning stocks. In my experience, that has made some clients feel inadequate for not wanting to assume more risk – or have encouraged clients to take more risk than they would have for fear of being deemed inadequate in the eyes of the advisor.

Make sure your advisor isn’t shaming you into owning more stocks than you’d like.

Lance Roberts

The views and opinions expressed by Lance Roberts are not necessarily those of Retire Early Lifestyle.

About the Authors

 
Billy and Akaisha Kaderli are recognized retirement experts and internationally published authors on topics of finance, medical tourism and world travel. With the wealth of information they share on their award winning website RetireEarlyLifestyle.com, they have been helping people achieve their own retirement dreams since 1991. They wrote the popular books, The Adventurer’s Guide to Early Retirement and Your Retirement Dream IS Possible available on their website bookstore or on Amazon.com.

Retire Early Lifestyle appeals to a different kind of person – the person who prizes their independence, values their time, and who doesn’t want to mindlessly follow the crowd.

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