A View From The Top, Don’t Assume Rates Are Headed Higher, And Joe Maddon
It’s very timely to be discussing the big picture outlook for stocks and bonds, given the weakness in equities since the late September peak. The weekly and monthly trends are in a very different place than where they were in January. We’ll be illustrating that and more with relevant charts, and what likely is ahead of us.
The consensus has been that interest rates are headed higher, given Federal Reserve policy. We’ll be talking about why you shouldn’t necessarily count on that, depending on the type of bond one is talking about.
Finally, there will be some notes about cyber security issues we’ve discussed, some tax related news, and a cool story about a terrific evening that I was part of recently.
The View From The Top
Since September 20, major stock indexes representing domestic and foreign equities have fallen between -10% to -15% to closing lows on Friday, December 7. Though similar in scope to the drop which began in late January and ended in early February of this year, the technical backdrop is much different. As shown on the charts below, courtesy of www.decisionpoint.com, stocks rebounded to make higher highs in the fall, but these highs were not confirmed by momentum, such as the PMO in the bottom clip (price momentum oscillator).
The top chart is a weekly version of the S&P 500 Index. At this writing, this index and the Dow Jones Industrials have not yet taken out their early February lows, but other major indexes have, such as the S&P Midcap Index, S&P Smallcap Index, the EFA (Europe Far East) and the Vanguard Total International Stock Index. This is typical late cycle behavior, with small and mid caps leading the way down, and large companies usually the last to join. The early February lows are approximately at 2550 for the S&P 500 and about 23,500 for the Dow Jones Industrials.
You can see that the cyclical bull market trend line from February 2016 has already been broken. It’s likely the lows mentioned above will be broken, perhaps sooner rather than later. Then what?
Chart support appears to be around the 2100 level on the S&P 500 Index, which was the area of the 2016 summer highs. This area could be a magnet, given that it is also in the vicinity of the secular bull market trendline shown below in the S&P 500 monthly chart. Bouncing off of that trendline would be a natural outcome, and would represent a decline from the peak of about -28%.
Keep in mind a few things. Just as there is no foolproof method of predicting how high stocks might rise in a bull market, the same is true of forecasting how long, or how deep a stock market decline will be. All we know is that the environment is more negative today than it was in February.
This is supported by several external technical models that we pay attention to. James Stack of InvesTech Research does really good research and has been through various market cycles. He created a Negative Leadership Composite and took the backtest all the way to 1962. The current reading on this indicator has been associated with a bear market 88% of the time.
Even Ned Davis Research is suggesting we are in a cyclical global bear market, but since they do not expect a recession in the United States, feel the decline should end by mid-year, with a bottom likely by March or April, followed by double-digit gains for 2019. That would be a Merry Christmas for the optimists. For the pessimists, just remember, anything can happen, including another -50% plus decline.
Rates Aren’t Necessarily Going Higher
Just one month ago, the yield on the 10-year Treasury Note hit 3.23% (up from 2.40% at year-end), and bond bears were declaring victory, as a chart breakout seemed confirmed. Yet, today the yield sits at 2.85%, a drop of 38 bps (basis points) in just four weeks, and officials from the Federal Reserve Board are now waffling on how many times they may raise rates in 2019. What happened?
The Fed began raising interest rates from 0% in late 2015, and they are now in full tightening mode, by allowing up to $50 billion of bonds mature and roll off their books each month. Given that the Fed increased their balance sheet by some $4 trillion, it will take several years to shrink it back to normal. They have been quite deliberate in the process, as this “experiment” has never been done before.
There is evidence that the process, with Fed Funds at the 2.25% level, is already having a negative effect, with housing stocks down -30%, mortgage rates at their highest levels in 7 years, and a stock market which is having a problem competing with a guaranteed 3% plus yield.
Keep in mind there is more outstanding debt today than at any time in history, supposedly in the neighborhood of $4 trillion. With rates having increased some 1% in the past 12-18 months, that equates to an extra $400 billion of interest payments. Now you know why President Trump has been upset that the Fed has been raising rates.
If you believe the economists, the U.S. economy is as strong as ever, with record low unemployment. If things are so great, though, why did stocks celebrate two weeks ago when the Fed hinted that they may be slowing future interest rate increases? The stock market is only down -10% from its peak, and already the Fed is worried. They are in the proverbial “rock and a hard place.” If they continue to raise rates, a recession is almost certain to follow. And if they don’t, they are signaling that things aren’t so good.
So, I’m not convinced that interest rates are going much above 3.20% on the 10-year Treasury Note. Where we’d love to see them go higher is in the high yield bond market, and that seems to be starting, thanks to the rapid drop in oil prices as well as stocks. The farther stocks decline, the bigger bargain they will be, along with high yield bonds.
Investment Implications
Since our last update on October 27, as expected our risk model for high yield bonds had turned negative, so almost all of that capital has now been in short duration bond funds for six weeks. Unlike the SELL our model had in February, this time, prices are responding to the downside, and we don’t expect any changes soon. We’ll touch on yields and drawdowns in some of the detail below.
Within our equity allocations, four of our 8 risk models remain in positive mode, dictating a 50% position. Should the current weakness of the past week persist, we would expect a reduction to the 25%-35% level fairly soon, given the position of a couple of the models.
This is a good time to re-visit comments made by Ben Graham, author of The Intelligent Investor. Graham is considered the father of fundamental analysis, and he wrote, “the best way to measure your investing success is not by whether you’re beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
This is why we use a dynamic process that adjusts to market conditions. The vast majority of our clients don’t want to sit through a period where stocks lose -40% to -60% of their value, and do nothing but “hope” they come back. The strategy must be one that you can live with through thick and thin. Human nature does not change, and it’s likely once again that buy and hold investors will abandon that strategy only after a significant decline.
Some Recent Data
Thus far in 2018, the stock market has experienced two -10% plus declines. The most recent has been from September 20 to December 7, and below are the drops in four main stock market categories:
S&P 500 Index (large caps) -10.13%
S&P Midcap Index -12.95%
S&P Smallcap 600 Index -16.20%
Vanguard Total International Index -10.89%
Since TABR’s tactical equity allocations have been at 50% or a bit less since early April, we thought we’d examine how our various strategies have held up in the recent drop. See below.
TABR Bond Account -1.03%
TABR Conservative Account -3.32%
TABR Moderate Account -4.26%
TABR Dividend Stock Account -5.22%
TABR Passive Index Account -6.37%
For context, note that the Conservative account has a maximum of 35% stocks, and the Moderate account a maximum of 50%. The Dividend Stock account has a minimum of 40% stocks and the Passive Index account is always fully invested, with a traditional 60% in stock and 40% in bonds. Note that the losses in the Passive Index account were nearly 50% greater than in the Moderate account.
What I’ve noticed is with stocks only down about -10%, it’s really hard to discern the value of risk management. That simply will not be evident during -10% declines. The value will be when the -10% declines turn into something much greater. We THINK this is going to be that scenario, but we don’t KNOW. If the tape breaks down as we have noted certain areas above, our models will get more negative, and we’ll likely have equity exposure of 25% or less, and the disparities above will become very different. The market will tell us, and we don’t need to know “what do you think about 2019?”
Meanwhile, consider this. At its present allocation, our typical Conservative account has a total yield of about 2.9%. That includes the stock allocations, cash, everything. That’s not a bad place to be as we wait for whatever the market has to offer.
Cyber Security and Social Security
Being protective of one’s data has become increasingly important in today’s digital world. The latest large data breach was a week or so ago, when Marriott announced that 500 million Starwood members information was compromised.
Not only have we recommended credit freezes for clients, but also suggested it is a good practice to establish your own personal account with Social Security, even if you are already receiving benefits.
A couple of months ago, one of our clients in conversation with Steve Medland noted that he had received a letter in the mail from SSA (Social Security Administration) wanting to confirm that he was changing the bank account where his monthly check was being deposited. The problem was, he wasn’t changing banks.
Someone had obviously hacked his information, and was hoping to re-direct the benefits. Thankfully, there is a process in place to protect against such efforts, but it could have been totally prevented by having your own personal log-in. If you don’t have your own account, and fraudsters have your personal information, they can create a personal account by imitating you.
Don’t think it can’t happen to you. Because it obviously can. At some point, I expect two-factor authentication to become the norm to access data, not the exception.
A Warning On Your 2018 Taxes
Depending on what you invest in, this may be a year where you both incur a loss of portfolio value and owe capital gains taxes. I can tell you that the vast majority of our clients will be in this position, so beware as you begin to tackle taxes in early 2019. How can this be, you may ask?
This simply has to do with the concept of realized and unrealized capital gains. One’s portfolio can go from $500,000 to $550,000 in a given year, a gain of 10% in this example. But, if they didn’t sell anything, and received $10,000 in dividends and interest, the remaining $40,000 would be termed “unrealized gains.”
That is because from a tax aspect, they are not gains until you sell. As you well know, those gains could continue to grow, or they can also disappear.
In our case, we’ve had two years in a row of pretty decent gains (2016 and 2017), but our stock market risk models began to turn negative in the first quarter of this year, so a number of sells took place in longer term positions. This is what it’s all about when it comes to risk management and protecting capital. You cannot protect capital if you don’t sell.
Here’s a real example. We looked at one of our client accounts that had about $700,000 of market value in December 2018. There was $19,500 of dividend income in 2017, along with $14,000 in realized capital gains, and entering 2018, the account had $44,000 in unrealized gains.
As we enter December, this account has about $15,000 of dividend income, along with about $32,000 of realized gains, but is down around -2.2% for the year in terms of “performance.” Now, there are about -$3,500 of unrealized losses in the portfolio, thanks to the recent decline.
This is simply a reminder that taxable gains and portfolio gains are not the same. There are calendar years where portfolio values rise substantially, and yet there are no capital gains. It just depends on where the market cycle is, and what action is taken. But please remember—the strategy does not exist that minimizes taxes, and maximizes protection of capital. Those two goals are incompatible. Taxes are a secondary consideration in our philosophy, and we’re honestly happy when clients are making money and paying taxes. It beats the alternative.
A Night With Joe Maddon
Growing up in Tulare, CA, I remember that in the 1960s and 1970s, Fresno was the hot stove capital of California when it came to baseball, with a very large annual event in the winter.
Well, last week, I had a terrific evening at a private hot stove gathering of around 60 people, hosted by my friend, Ron Salisbury, owner of the Cannery Restaurant in Newport Beach. The special guest was none other than Joe Maddon, current manager of the Chicago Cubs.
With Joe and his wife, Jaye, was my long-time friend, Tim Mead, who is in his 39th year with the Angels, the last 21 as Vice President of Communications. Back in 1981, all three of us were employed by the Angels. At that time, I was all of 23 years old, acting as Assistant Director of Public Relations. Tim was the Administrative Assistant for our department and our boss, Tom Seeberg, while Joe was all of 27, just beginning his career as an area scout for the team.
I left the Angels in December 1981, joining E.F. Hutton as a rookie stockbroker (that’s what they were called back then). That was one of the best decisions of my career, but I will always cherish the four years I had with the Angels, which was my dream in high school. Tim and I worked side by side for about 18 months in PR. I had started with the team as an intern in 1978, and then I in turn hired Tim as our intern in the summer of 1980.
It was a natural choice for him to take my position when I left, and he’s been there ever since, through 3 owners, and countless managers and general managers, even serving as Assistant General Manager for a period of two years. Simply put, Tim is the face of Angels baseball. He is the best in the business, liked by everyone, with a unique ability to balance the needs of the media with the interests of the team, blending professionalism with respect and integrity.
Many of you who follow baseball may think Joe was an overnight success, given his initial accomplishments as a manager with the Tampa Devil Rays (now known as the Tampa Rays). But, he worked his tail off, serving 30 years with the Angels, working his way up the ladder, finally joining the big club in 1994 and becoming an indispensable part of Mike Scioscia’s staff through 2005. As bench coach, Joe was a huge part of the Angels World Series championship team in 2002.
Though Joe achieved probable immortality in Chicago for leading the Cubs to their first World Series title in 107 years in 2016, his greatest managing job may have been leading Tampa to the World Series in 2008. Ignoring one of the smallest payrolls in baseball in combination with playing in one of the worst ballparks in the major leagues, all Joe’s team did is win. He is one of the greatest teachers of the game and of men baseball has ever known. He’s also a voracious reader and a wine aficionado.
I mean this in a very complimentary way—Joe and Tim are two regular guys who have worked their tails off and are doing extraordinary things to become the best in their profession. I also want to mention Joe’s foundation, which is called Respect 90. It provides children and families opportunities to develop championship attitudes through sports, academics and community involvement. Joe is absolutely involved in his communities (and that’s not just Chicago). In case you didn’t know, Tim is on the right in the photo below. I know—you’re used to seeing Joe in his Cubs uniform.
Material Of A Less Serious Nature
The Lone Ranger and Tonto are camping in the desert. They set up their tent and fall asleep. Some hours later, The Lone Ranger wakes his faithful friend. “Tonto, look up at the sky and tell me what you see.” Tonto replies, “Me see millions of stars.”
“What does that tell you?” asked The Lone Ranger.
Tonto pondered for a minute. “Astronomically speaking, it tells me that there are millions of galaxies and potentially billions of planets. Astrologically, it tells me that Saturn is in Leo. Time wise, it appears to be approximately a quarter past three. Theologically, it’s evident the Lord is all-powerful and we are small and insignificant. Meteorologically, it seems we will have a beautiful day tomorrow. What it tell you, Kemo Sabi?”
The Lone Ranger was silent for a moment, then exclaimed: “Tonto, you Dumb Ass, someone has stolen our tent.”
Above is Steve with wife Kim, son Conrad and their daughter, Audrey.
Here’s our son Adam, with “baby” sister Caroline (she’s 13, going on 23!).
And finally, yours truly, with wife Michelle.
We thank you for the trust you place in all of us at TABR, and wish you and your family a Merry Christmas, Happy Hanukkah and Happy New Year.
Sincerely,
Bob Kargenian, CMT
President
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