At which point do rising interest rates spark the fire? Rates are key to the equation of risk. In Friday’s On My Radar, Steve surveys what the current equity market valuations tell us about risk… and likely forward returns. Should you be playing more offense than defense or more defense than offense? Valuations can help.READ MORE
Monthly Valuation Update
Every month, Steve reviews several market valuation metrics in an effort to provide visibility into forward 7-, 10-, and 12-year returns. In this week’s On My Radar, Steve looks at Median P/E and also shares GMO’s 7-Year Asset Class Real Return Forecasts. It’s a must-read!READ MORE
What does the latest Fed rate increase mean for stocks?
The Fed raised rates last week and bond yields sank lower. Many expected the opposite reaction. If you missed last summer’s mortgage refi opportunity, I believe you are going to get another chance. Interest rates appear to be heading back down towards their July 2016 lows.
And what are the implications of Fed policy on the U.S. stock market? Ned Davis Research’s Ed Clissold pointed out in a tweet late yesterday, “Today’s #FOMC decision is a reminder that even slow tightening cycles eventually impact the stock market. #fed @NDR_Research.”
The chart Ed shared in his tweet follows. Here is how to read it:
- NDR compares market gains during slow tightening cycles (black line in chart) vs. fast tightening cycles (red line in chart) vs. non tightening cycles (green line in chart), and more.
- It looks at what happened historically to the stock market in periods when the Fed was quickly raising rates vs. slowly raising rates – like the current cycle.
- The purple line is the current Fed tightening cycle that began in December 2015.
- Note how NDR breaks out % Gain During 1st Year and % Gain During 2nd Year. We now find ourselves in year 2. Purple line (right-hand side of chart).
- Year 1 gains averaged 10.8%
- Year 2 gains averaged -1.8%
- The green line shows non-cycles… markets do better when the Fed is lowering (easing), not raising (tightening), interest rates. “Don’t fight the Fed” as they say.
Animal Spirits and the “Fear Gauge”
In Friday’s On My Radar, Steve Blumenthal wrote, “Last Monday, the VIX broke below 10 to close at 9.77, the lowest level in more than a decade. There are only three other days the index has closed at lower levels, all of them in December 1993. Investors are complacent to risk. They shouldn’t be.”
Investment consulting firm 720Global also recently wrote about market volatility in The Unseen, “Volatility: A Misleading Measure of Risk.”
As investors, we are negligent if we follow the Fed’s lead into this complacent stupor. By prodding economic growth with unproductive debt and reigniting asset bubbles, the central banks have simply done more of what created the spasms of 2008 in the first place. Despite the markets calm façade and historically low perception of risk, the vast chasm that lies between perceived risk and reality is troublesome.READ MORE
“Risk On” — U.S. Equity Market Capital Flows
Notwithstanding historically high market valuations, market flows continue into U.S. equities, specifically (see the chart below) into Large Caps and Total Market.
In certain strategies, we remain “risk on” with an allocation to equities, however you have to find something that works for you. Something that you can have full conviction in… then stick to your process. For your core portfolio allocations, you could diversify to several global ETF trading strategies.
Broad diversification is key. On the other side of the next recession is the next great equity market opportunity. It is not today.
Read more in this week’s On My Radar.ON MY RADAR
Charts of the Week
My favorite trend following indicator is something we co-created with Ned Davis Research. It looks at the underlying trends in 22 industry sectors and scores the weight of evidence on a 0 to 100 scale. Here is the chart if you haven’t seen it before (note: I post it every Wednesday afternoon in Trade Signals). The trend for equities is currently bullish.
What about bond exposure? We monitor the Zweig Bond Model.
Please refer to the March 10, 2017 post of On My Radar for an explanation of how it works.
Finally, I believe the key to investing and perhaps the most important lesson to learn is how money compounds over time. To that end, I wrote a piece called the “Merciless Mathematics of Loss.” Next is the chart and you can find the full piece here.
Charts of the Week
This week we offer several charts concerning inflation, interest rates, U.S. economic recoveries, equity market performance and equity mutual fund flows.
This chart plots U.S. economic recoveries. Note the blue line. Debt’s a major drag:
Source: Crestmont Research
Keep an eye on inflation (rising):
Year-over-year change in CPI – look at the January numbers in the far right of the chart. The most recent BLS – Bureau of Labor Statistics Annualized Inflation Rate year-over-year equals 2.5%. The Fed’s target has been reached:
Source: Advisor Perspectives
And if you were wondering what inflation looks like by category:
Here is the current probability of a Fed March interest rate hike:
Switching to equities, Ned Davis Research has something they call “Top Watch Indicators”… meaning indicators that help them spot a probable market top.
Here’s how you view the next chart:
- When the green bars in the lower section rise above the horizontal dotted line (50), a market top is indicated.
- The vertical dotted lines and shaded area indicates the times that more than 50% of their top watch indicators signaled a market top.
- Percentage declines are indicated.
- Green bar on the far right shows where we are as of 2-14-17.
Source: Ned Davis Research
Chalk one little dot up for the active fund managers. All the money has been flowing into passive index funds and ETFs:
And all that money that chased into “high dividend papers?” In a few short months, they’ve given up six years of excess returns. I continue to be cautious on high dividend stocks due to over popularity, low interest rates and the risk of rising rates.
Diversification has been under pressure the last few years. The average university endowment lost 1.90% in 2016. However, it is best viewed over the long term and designed to achieve a certain return relative to an acceptable amount of risk. 100% allocation to stocks is for a different investor risk profile. Not wise to compare one asset class to a diversified investment plan. With that said, in case you were wondering… this is how the 10 richest universities invested their money in 2016:
“Don’t Fight the Tape or the Fed”
The number one rule many of us were taught is “Don’t Fight the Fed.” I like to add “trend” into that equation and, as you’ll see in the next chart, the math is compelling.
When the Fed raises rates (don’t fight them) and the trend turns negative, equities underperform. Focus on the red arrows. Two different time periods are measured, however, the message is the same. The big corrections come when both the Fed and trend turn negative. I wrote some time ago in On My Radar to “watch out for minus 2.” We currently sit at -1. I’ll share this chart from time to time – especially if -2 is triggered.
Here is how you read the chart:
- The top section plots the S&P 500 Index but focus on the middle section.
- NDR has a Multi-Cap Tape Composite Model to measure the technical health of the broad equity market. That model aggregates the signals of over 100 component indicators and generates a signal based on the percentage of the component indicators that are giving a bullish signal for the S&P 500. It measures momentum and trend.
- The Fed component is really an interest rate component, which measures the trend in rates by looking at the yield on the 10-year Treasury note. When the 10-week trend in yields are lower than their 70-week trend in yields, the S&P 500 has produced larger gains. When it is higher, the S&P 500 has performed poorly. It’s that simple.
- The combined indicator can produce a score of -2 (both indicators are bearish) to +2 (both bullish) and overall have done a good job historically as a risk-on/risk-off indicator.
- The current reading is -1 (data shows we need to watch out for -2): refer to the red arrows.
Source: Ned Davis Research
I hate making predictions.
I got the tech wreck and sub-prime right, but was far too early on those predictions. Importantly, the predictions below could most certainly be wrong. We live in a highly complex world. We can measure instability, we can score up risk but we can’t precisely know timing.The clear risk to me today is in the bond market.
- U.S. stocks will remain in an uptrend fueled by a strong dollar.
- Tax cuts, infrastructure spending and $2 trillion in tax repatriation will drive capital flows to the U.S.
- The European sovereign debt crisis will be the first major crack to crack. Unmanageable debt in Portugal, Italy, Greece and Spain. Include France and Germany in their dysfunctional union. Confidence in government/political leadership is lost.
- The European banks sit on the fault line. Watch the banks. Hope so… Not so sure.
- The smart money races out of EU banks to U.S. dollars and U.S. assets.
- In China, debt too is the major concern. Ghost cities lacking rental income will prove unable to support the structured debt that financed the construction. Defaults mount.
- Drastic measures are put in place to prevent the flow out capital to the U.S.
- Gates, tariffs, currency wars escalate – trade wars escalate.
- Loss of confidence in government here, there and most everywhere.
- Global and U.S. inflation become a major concern as global growth remains well below the average of the last six post-recession expansions. Click here for a great chart.
- Stagflation returns. Low growth/high inflation. Interest rates move higher with the 10-year touching 3% this year and 6% within a few short years.
- The great bond bull market is over. Bond investors lose money.
Real Implications of Reduced Pension Fund Returns
Last week, the investment staff of CalPERS — the $300 billion California pension fund — announced that they want to reduce its target of 7.5 percent annual returns. According to Chief Investment Officer Ted Eliopoulos, achieving a 7.5 percent annual return is no longer realistic. Holy cow!
The implications of this proposal, if adopted, are significant and “would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.”
Can you imagine how many people are going to be affected? Here’s the bottom line. The pension system, across our great nation, is underfunded and in trouble.READ MORE