Surprises From Market Breadth with Record Margin Debt

Surprises From Market Breadth with Record Margin Debt

As we discussed earlier, heading into the third quarter earnings season, we have above average level of positive guidance in terms of both top line sales and earnings as well as lower-than-average negative earnings guidance. We  pointed out yesterday, however, that an uncomfortable portion of that guidance is driven by gains from a weak dollar and we are seeing signs that may be reversing course.

 

In the last quarter, companies that delivered on or beat expectations didn’t get much of a reward for their efforts. We looked at the current market conditions to get a feel for what the earnings reactions could be this reporting season.

 

Margin Debt

Margin debt has reached $550.9 billion, a record high for the second consecutive month and the sixth record high in the past eight months.  Anyone who recalls just a tad bit of market history can see that rapidly rising margin debt has preceded the beginnings of both the March 2000 and July 2007 bear markets. However, nearly one in four monthly margin debt readings since 1959 have been record highs, so to assume that a pullback is imminent based on a record high is folly at best. Instead, we like to look at the rate of change over a 12-month period. Here we can see that the rate of change recently hasn’t been nearly as dramatic as the wild moves we saw around the 2000 and 2007 crashes. This metric does not indicate a market that has been wildly laying on the leverage, despite reaching yet another record high.

Market Breadth

Another measure of the health of the market is the Advance/Decline line which has been well above its 50-day and 200-day moving average. This indicator is showing a market that appears rather robust, but the value of this indicator may lessened by the rapidly rising use of ETFs. When an investor puts money into an ETF, those funds are used to buy all the companies in the ETF indiscriminately, which can give the appearance of greater robustness than would otherwise exist.

 

To further assess breadth, we look at the ratio of equal weight versus market cap weighted for the major market indices. What we found is the S&P 500 and the Russell 2000 equal weight indices underperformed their market cap weighted indices by a material amount year-to-date. This metric indicates that the indices upward moves have been driving by larger cap high-flyers, which indicates weaker breadth than we’d like to see.

 

High Fliers Losing Some Altitude

Amazon (AMZN) tried to carve out a head and shoulders pattern this week, down by over 2% during the week, but closed the week back in the black by Friday. If it moves below the neckline where it is currently perched rather precariously, the shorts will go for the jugular and this is one of those mega cap stock that has been helping to keep the indices up. Another high flier that has driven a good portion of the market’s gains, Apple (APPL), has dropped below both its 50-day and 100-day moving averages and is now down in 13 of the last 18 days as the new product line doesn’t exactly have consumers busting down the doors.

 

Facebook (FB) is also feeling the pain with all the bad press surrounding is ad platform that Ivan and his Russian buddies have been abusing to stir up domestic strife here in the U.S. Who knew Putin’s team may not play fair! The stock suffered its worst day this week since last November, falling over 5% at one point during the week and closing below its 50-day moving average for the first time since July 6th. By week’s end the shares had moved back to neutral territory in this Teflon market, but the warning flares have been fired. Netflix (NFLX) joined in falling as much as 5.5% this week to waver right arounds its 50-day moving average.

 

With the performance of the equal weight indices below that of the market cap weighted, weakness in the big guys are cause for concern. The end of the week saw a rebound in most, such as Alphabet (GOOGL) but we’ll be watching to see if the rebound holds.

 

Another Breadth Indicator

We then looked at the percent of companies above their 50-day moving average in the S&P 500, Nasdaq and the NYSE Composite. We found that the number of stocks trading above their 50-day moving averages has been rising, so from this metric, the markets are looking to have decent breadth, which limits the damage from those high fliers weakening.

 

When assessing either the markets or a stock we always want to find confirming or discordant data points to increase our confidence. While we have conflicting indicators here, our assessment leans more towards a bullish view based on this data for the near term.

 

Volatility

 

What about that wacky VIX that appears to be on a IV drip of some sort of powerful sedative? No matter what gets thrown at it, the index continues to be like Fonzi. The recent Commitments of Traders report from the CFTC revealed that the net speculative short position on the VIX has once again reached a new record high at 171,187 futures and options contractions, taking out the prior 158,114 peak in early August. This is a 63% increase! Talk about the calm before the storm. Yeah, we know, been saying that for a while. This has been a seriously impressive run!

 

Of all the days the VIX has been below 10 since its inception, 70% those have been in 2017. We can’t help but shake our heads, (and remember to stock up on Alka Seltzer) when we consider the likely impact on the markets when the reversion to the mean rule kicks in.

 

Given the lack of volatility, investors seem to be going all in. The last week’s Market Vane report found that the bullish share has reached the highest level in the current bull market. The last time it was this high was in June 2007.

 

The bottom line is while equities are clearly expensive at these levels, the market breadth looks decent and volatility is still hitting the snooze button. The disconnect between fundamentals, historical norms and the current market is likely to at some point result in some seriously dramatic moves.  However, we’ve all seen that expensive stocks can get even more expensive and for at least the near term, we are not seeing any clear catalyst for a pullback that would get the attention of this seemingly Teflon market.

Calm Before the Storm?

Calm Before the Storm?

While D.C. is full of fireworks over health care and Russians, the Treasury is scrambling to pay the bills, yet the markets are peacefully awash in Xanax. The spread between the 6-month and 3-month Treasury bills is now pricing in a potential technical default, but given that the rest of the Treasury market looks unaffected, the expectations would be for a quick resolution.

The Treasury yield curve over the past week has adjusted to reflect this pricing. How weird is that to see?

Got to love pricing in a technical default of the U.S. government, not exactly an everyday occurrence, while the VIX has closed below 10 for 6 consecutive days. To put that in perspective, going back to January 1, 1990, the average for the CBOE S&P 500 Volatility Index (VIX) has been 19.5 and the median 17.6. As of yesterday, the average for 2017 has been 11.5 and the median 11.3! In the past 27+ years, the index has fallen below 10 all of 23 times, but 57 percent of those occurrences have been in 2017!

In the past 27+ years, the VIX has fallen below 10 all of 23 times, but 57 percent of those occurrences have been in 2017!

Beware of reversion to the mean.

Treasury volatility is also hitting record lows. Apparently, there is nothing to see here. Thank God it’s Friday.

^CBCB1USTNV Chart

^CBCB1USTNV data by YCharts

 

What The Financial News Isn’t Telling You That You Need to Know

What The Financial News Isn’t Telling You That You Need to Know

Investors as a group are notorious for chasing returns, which means everyone piles into whatever has been working best lately and more often than not tends to be late to the party. The catch this time around is whatever has been working best lately is whatever has gone up in price the most. All this is completely antithetical to the mantra, “Buy low and sell high,” as that requires selling that which was been performing stupendously and buying that which has been getting gut punched like Rocky did my Mister T in the first half of Rocky 3. Imagine hearing that kind of advice on mainstream financial TV!

 

In our defense, we humans are genetically programmed to buy high and sell low because that’s what you do when you follow the herd and rely on headlines for insight. Remember, our ancestors were the ones that had the good sense to run deep in the crowds when that sabre-toothed tiger got the munchies.

With that in mind, recall that yesterday we talked about how investors have been choosing passively managed funds over active funds at an accelerating rate in a market that has gained more in the past three months, (S&P 500 up 7.6 percent) than in the two years prior to the election, (S&P 500 up 3.3 percent).

That move up has been oddly calm, with the S&P 500 having moved less than 1 percent intraday now for 40 consecutive trading days. That is the longest streak in at least thirty-five years! As Real Vision Television founder Raoul Pal likes to say, suppressed volatility invariably leads to hyper-volatility.  The following chart shows just how low volatility has been relative to historical norms.

 

The VIX is currently just slightly above the lowest levels we’ve seen in the past twelve years and is well below the average over that time frame. This stands in stark contrast to the level of global economic policy uncertainty and the current P/E valuation accorded to the S&P 500.

Within just the States, the level of political uncertainty is also well above the median, reaching the 82nd percentile!

 

So we have volatility at exceptionally low levels with significantly heightened policy uncertainty both in and outside the U.S., yet stocks are trading at historically very pricey levels according to a wide range of metrics. The chart below shows the S&P 500 Cyclically Adjusted Price-Earnings Ratio (CAPE) going back all the way to 1881. According to this metric, stocks have only seen these levels just prior to the 1929 crash and the dotcom bust.

 

As of 12/30/2016, (the latest date for which comparative data is available) the U.S. was quite expensive on a relative basis, with a CAPE of 26.4, the third highest in the world, trailing behind Denmark at 33.3 and Ireland at 31.2. The CAPE of the U.S. was trading at a 60% premium over developed Europe and an 89% premium over emerging markets.

If we look at trailing-twelve-month price to cash flow ratio, as of 12/30/2016, the U.S. was trading at a 25% premium to developed Europe and a 41% premium to emerging markets.

If we look at trailing-twelve-month price to sales ratio, as of 12/30/2016, the U.S. was trading at a 73% premium to developed Europe and a 46% premium to emerging markets.

If that doesn’t have you convinced that we are in heady territory, BMI Research recently pointed out that the technicals in the U.S. market are setting up for some seriously unattractive returns over the next three months based on historical norms.

 

The bottom line is investing is all about probabilities and with stocks in the U.S. at such lofty level with a whole lot of perfection expectation priced in, the downside risk relative to upside potential is something that ought to not be ignored.

So the question is, what could push U.S. equities higher aside from P/E ratios moving further out into the stratosphere? Check back tomorrow for our discussion on just that.

Volatility – It's here!

Volatility – It's here!

In my firm’s newsletter last month I pointed out that the S&P 500 had been showing some technical signs of weakness, with the index falling below its 50-day moving average and with the 50-day moving average plateauing at that time.  I also pointed out the lack of breadth, with the number of stocks making new 52-week highs declining while the number making 52-week lows was rising, all while the index continued to move up, which makes for an unstable market.  I’ve frequently commented on the unusually low levels of volatility, which is likely due to actions taken by central bankers, but can’t last forever and typically leads to heightened future volatility – it’s here!

The technical breakdowns and suppressed volatility came to a head over the past few weeks.  On August 25, the 3-day sum of the prices of the S&P 500’s distance from its 50-day moving average, (which is a measure of just how much recent prices differ from the recent past averages) almost beat its biggest day in history – May 15th, 1940.

On that day in 1940 the German Blitzkrieg moved into northern France, German troops occupied Amsterdam with General Winkelman surrendering, General Dutch Persbureau was captured by the Nazis and the Dutch troops surrendered to the Nazi’s, beginning what was to be 5 years of occupation for that nation.  So yeah, last time around it was a pretty bad day.  The chart below illustrates just how dramatic the moves were relative to norms!

2015-08-28 Rolling 3 Day SD from 50DMA

 

On Monday 8/24 the markets experienced their biggest two and three day declines since the start of this bull  market. Tuesday 8/25 was the worst four day rate of change since the start of the bull market. There wasn’t a Mylanta, Zantac, Pepto or Tums to be found on shelves in Manhattan, with the Dow Jones Industrial Average getting hit the hardest, down 12.1% since the start of the year while the S&P 500 was down 9.29% and the NASDAQ was down 4.85%.

2015-08-25 US Indices

Just when all seemed lost, on Wednesday things started to turn around, with the S&P gaining more than on 99.3%  of all days in its history! So, yeah, it was a pretty good day. Thursday the S&P 500 was up the most over any two-day period during the recent bull market and was up more over the past five days than in 98.7% of all days in its history! By Friday the Dow Jones Industrial Average closed the week down 6.6% since the start of the year while the S&P 500 was down 3.4% and the NASDAQ was actually up 1.95%.

2015-08-28 US Indices

The market movement was so wild that the CBOE Volatility Index (VIX), a popular measure of implied volatility of the S&P 500 index options, rose 217% from August 14th to August 24thLast week alone it rose by 120%, which is the biggest rise in history! This was even more dramatic that what we experienced during the financial crisis! 

VIX

Market volatility has been like a 5-year old, locked in a tiny room, furiously chowing down on last year’s Halloween booty. The lock finally gave way and all you could do was let him have his tantrum!

One reason for the wild swings has been the absence of liquidity, which in a downward moving market simply means sellers can’t find a buyer… at any price.  This was in no small part due to the unintended consequences of Dodd-Frank a situation that many have been warning about for years to no avail.  While it became popular to malign proprietary trading by the banks post-financial crisis, that same proprietary trading has in the past provided the market with willing buyers, the banks, during times of market turmoil, which helped provide a price floor.  The new rules in Dodd-Frank prohibit much of such activity, so when folks panic, there is no one available on the bank trading desks to buy what investors are desperate to sell – the floor is no longer there. This time, it really is different.

All that got investors seriously nervous, with the daily outflows from equity funds hitting their highest levels since 2007 as folks panicked and sold, sold, sold.  For the entire week ending August 28th, nearly $30 billion left the equity markets which is the worst since Band of America Merrill Lynch has been recording data back in 2002.

All those that sold though, missed out on the turnaround in the second half of the week. The mid-week ThisWayThatWayturnaround was likely induced by a combination of New York Fed President Dudley’s comments that a September rate hike was “less compelling” than it was a few weeks prior, the actions taken by China to reflate its markets, and overall investor selling fatigue – markets never go straight down. We continue to be amazed at the continued contradictory statements coming out from the various Fed officials!   We still think that more volatility is more likely than not and suspect that the current shake out isn’t over quite just yet, but remember investing is always about probability, there are no certainties.

So, is this is just a correction within an ongoing bull market or has a new cyclical bear market begun? Only time will tell which is truly the case.  What we can say with a high level of confidence is that the initial decline in either case, will typically lead to a subsequent bounce and ultimately retest previous lows.  The big question is whether, with economic growth rates slowing and deflationary pressures building, will the Fed again intervene by postponing rate hikes and possibly even injecting liquidity as it has done for every prior market downturn during this cycle?  More on that later!

What caused such a rapid and large decline? 

Most people are pointing to the correction in China, both the economy and stocks, as the cause of the recent rout, but we think that is too simplistic. While we think it may have been the catalyst, the proverbial straw that broke the camel’s back, there are other realities that have been making a correction increasingly likely:

  • The discrepancy between earnings and top line revenue that has been going on for quite some time
  • Slowing global growth

China's Crashing Markets

Every Monday morning I have the great pleasure of speaking with Matt Ray on America’s Morning News and try to break down the latest market developments for listeners.  On August 24th we talked about the recent pullback in the U.S. markets, rising volatility, and China’s crashing markets and what it may mean for the U.S.

Click here to listen to our discussion.

What Deleveraging?

What Deleveraging?

2014-11-19 Global DebtWhat deleveraging?

China, the nation that helped bull the global economy out of the last financial crisis, is slowing markedly. China is also facing a debt problem. From 2002 to 2008, China’s total debt/GDP ratio was fairly stable and remained below 150%, but is now about 250%. It is possible that China’s debt issues may be contained within the real estate sector, which is the most troublesome part of the Chinese economy. It remains to be seen whether that distress bleeds into the broader economy. For now, corporate credit conditions in China still remain stable.

 

For that matter, debt across the world in both developed and emerging economies has once again reached new highs, making for a highly leveraged global economy, which as we’ve seen before makes for heightened volatility. The chart at right illustrates the magnitude of the debt.

 

As we’ve mentioned before in these pages, corporations have been pushing everything they can to get earnings from cutting costs as much as possible to avoiding internal investments so much so that by now, according to the Commerce Department, the average age of fixed assets, such as plants and factories, is about 22 years-old, the oldest average going back to 1956. That doesn’t sound to us like a set of solid fundamentals for a high-flying market.

Margin Debt – What and Why

Margin Debt – What and Why

If you’ve been listening to CNBC or reading any of the main financial publications, you’ve probably heard talk about the significance, (or insignificance based on the speaker’s perspective) of margin debt. Last week the NYSE released its latest data on margin debt which increased for the seventh straight month. January was also the fifth straight month that margin debt hit a record high. This is unsurprising in a market that has run up so much.

Margin debt refers to the amount of money investors borrow against their investment portfolio in order to invest even more money. For example, I have $1,000 invested in shares of company X. I borrow $400 from Schwab against that investment and put the $400 into an ETF. Now if my shares of Company X drop in value enough, Schwab may issue a “margin call” which means I need to put more money into my account so that the ratio between the value of my account and the amount of money I borrowed stays at or below a specified value.

 

You can think of margin debt a bit like a home equity loan. During the housing boom of the later 1990s and 2000s, home prices kept going up like views of Ellen DeGeneres’ Oscar selfie. Homeowners took out home equity lines of credit, refinanced with a larger mortgage or took out a second mortgage to exchange their increased levels of equity for cash. This eventually made home price more volatile as many people had less than even 5% equity in their home so that when their home’s current market price dropped by more than 5%, they had nothing invested and many chose to walk-away.

The concern with rising levels of margin debt is that a downturn in the markets can induce higher volatility and make for an even sharper downturn as investors race to sell investments to cover their margin calls. With a margin call, an investor can’t just walk away the way many did with their homes. They have to keep a specified amount in their account, like being required to maintain a minimum of 15% equity in your home. Here’s how it works:

Home Value Debt Equity Equity Ratio
Buy a home for $100, borrowing $80 (for simplicity assume an interest only mortgage) $100 $80 $20 20%=20/100
Home values rise the following two years by 25%. $125=(100*1.25) $80 $45 36%=45/125
Borrow extra $20 against the home. $125 $100 $25 20%=25/125
Home prices fall 12% $110=(125*0.88) $100 $10 9%=10/110
Additional funds paid to bank to return minimum ratio $110 $93.5 $16.5 15%=16.5/110

The homeowner would have to give the bank an additional $6.50 to get the ratio back to the required minimum. This is essentially how margin debt works.

Bottom Line: While the specific level of margin debt or the fact that the metric has reached a new high may not be a direct indicator of a bubble in security prices, it is indicative of two things:

1.      The belief that security prices are more likely to rise than fall in the near future.  (A reasonable person wouldn’t borrow an additional $20 against their home if they thought the price was going to fall significantly.)

2.      A downturn in prices is likely to be more volatile than it would be with a lower level of debt as investors are forced to sell to cover their margin accounts. 

This warrants portfolio construction that is suited to help minimize such volatility.

Volatility Returns

Volatility Returns

Since Fed Chairman Ben Bernanke’s testimony before Congress on May 22nd concerning tapering its current QE programs, the markets have been rockin’ and rollin’ and trending downwards, yet we keep hearing the pundits say this year’s stock market gains have nothing to do with QEInfinity. Just what turnip truck do they think we all fell off? The 10-Year Treasury note yield has risen from 1.8% to 2.5%, a nearly 80% increase in interest rates. Volatility has increased as well with the percentage of days the S&P trading range exceeds 1% rising substantially.

Date Range Percent of days S&P trading range exceeded 1%
May 22nd – July 5th 70%
April 45%
March 25%
February 32%
January 5%

 


 

 

 

 

 

 

 

Bottom Line: The Fed fueled run up in stock prices may have reached an interim peak. We expect increasing market gyrations in the coming quarters, which could provide some attractive entry points.

Where's the Boogeyman?  Rising Volatility?

Where's the Boogeyman? Rising Volatility?

Wheres-the-Boogeyman

With the markets on a roll and volatility still at record lows, my prose may at times appear overly cautious as I assess the markets, but remember that’s my job. Portfolio managers are essentially professional worriers, looking around every corner and under every data point for the hint that a major shift is on its way as our primary job is to protect. These days many of us feel like we are in a CNBC version of a thriller, with the ominous music getting louder and louder as our handsome hero approaches the dimly lit house. When is the boogeyman going to jump out!?

“For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.” J Paul Getty (Hat tip to John Hussman for helping us recall this sage sentiment.)

Looking at today’s markets, “Never have investors reached so high in price for so low a return. Never have investors stooped so low for so much risk.” Bill Gross of PIMCO on May 14th, 2013. Ouch!

On May 22nd the markets became exceptionally jittery, the boogeyman soundtrack getting a tad louder.  Concerns over a withdrawal or reduction of the Fed’s bond buying program from Ben Bernanke’s comments before Congress coupled with the minutes of the FOMC added to increasing nerves over the level of data fakery coming out of China, which has turned up the volatility volume considerably.  Keep in mind that if the stock market were to be reflective of the fundamentals and not experiencing a Fed induced bubble, why the tizzy fit at the slightest whisper that the Fed could reduce its bond buying program, a program which has seen the Fed’s balance sheet increase a mind-blowing 40% year-to-date?  Whether this is the beginning of a correction or a temporary blip remains to be seen, but the dramatic swings during the day warrant caution.  Is that the theme from Halloween I hear in the distance?

2013-06-03 NikkeiMay 22nd the Japanese Nikkei fell 7.3%, its biggest drop since the tsunami/nuclear disaster in March 2011.  Before Thursday, the Nikkei has risen 50% this year and 10% in less than two weeks.   Kudos to ZeroHedge for the chart at right which points out how similar the recent run up has been to the boom and following bust in 1987.

After the tumult in Japan, investors quickly jumped out of riskier assets. Spanish and Italian government bonds weakened, as did more-speculative currencies like the South African rand. Havens such as German government bonds and the Swiss franc gained. Gold rose.

Hong Kong’s Hang Seng dipped by 2.5%. Shanghai maintained a moderate fall at just 1.2%.  The following day all the major European markets dropped by over 2%.

2013-06-03 FedBalanceSheet
Bottom LineI doubt the past few rocky few days are the start of the correction we’ve been expecting as the primary drivers of the market run, namely Central Bankers, are still putting pedal to the metal, despite the nerves over yesterday’s FOMC meeting notes, (see charts at right).  I do think that it is likely we will continue to see volatility increase in the coming months before we see any potential significant correction. 

The Case for Optimism

A friend of mine pointed out what he considered a rather surprising contradiction between what I write in this blog and my usual cheerful and optimistic demeanor, so I thought I’d share just why I still walk around with a considerable sense of optimism.

To understand why I am in no way surprised by the behavior of most governments in response to the collapse of the financial markets and later the sovereign debt crisis, it is necessary to understand the various schools of economic thought.  If you have taken any economic courses, you were most likely taught just one school as if it were The Truth, when in fact, we are still learning.  I’ve posted in the Investing Aids section a description of these various schools of economic thought.

So why am I optimistic?

The markets are volatile and yet I still sleep well at night.

  • The S&P dropped 3.9% yesterday, which is the biggest drop since April 2009.  It is now 24% below where it was a decade ago, just after the peak of the Internet bubble.  It is just 3% above its close on the first trading day after the Sept. 11th, 2001, terrorism attacks.
  • The S&P 500 is off about 12% from a 19-month high on April 23rd.  A correction is considered a 10% retreat.  The Nasdaq Composite Index, the Dow Jones Industrial Average and S&P500 have now all erased their 2010 advances.

 

El-Erian of  PIMCO, who runs the world’s biggest bond fund, wrote “This is not a typical retracement,” in an e-mail to Bloomberg News. “We are in uncharted waters on account of several issues, including what is going on in Europe and other important structural regime changes. In economic terms, European developments are unambiguously bad for global growth.”

“It’s difficult trading Treasuries right now because we are trading almost solely on European political risk,” said Donald Ellenberger, who oversees about $6 billion as co-head of government and mortgage-backed securities at Federated Investors in Pittsburgh. “I do think that it’s safe to say that a lot of people have underestimated how far down yields could fall from a problem that started in a relatively tiny country.”

So in other words, it is impossible to tell exactly where we are headed over the short to medium term.  I like the visual presented in the PIMCO May 2010 Secular Outlook, “The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, having already used its spare tire(s).”

What can we expect?

  • We have unsustainable debt at all levels, federal, state and household.  This debt must be paid down in order to have a healthy economy, the term typically used here is deleveraging.  We are a nation with an adjustable-rate mortgage dangerously close to or greater than our home’s worth and an unstable paycheck.  Think of living that way, or perhaps you sadly already are.  It is terrifying and nearly impossible to imagine taking the kind of calculated risks that lead to real wealth creation when living under those conditions.
  • We face frightening demographic transitions with the largest generations across the developed world heading into retirement, creating a shrinking buyer pool, and placing another unsustainable burden on the much smaller, younger generations to pay for the debt left behind and the ever growing government-created entitlement programs.
  • Despite the current climate of low inflation, the remarkable expansion of the monetary base is likely to cause higher inflation eventually.
  • Governments are likely to respond to the pressures they face by raising taxes which is always a headwind to growth.
  • We are facing a great deal more government intervention in the markets which creates instability as the rules of the game will be changed often.  The unpredictable nature of this behavior does not provide the stability markets require for sustained growth.  Business leaders are more likely to hunker down than expand when they are unsure if the new rules that will be put in place will harm or help them.
  • We face a political environment in which wars and terrorist attacks are increasingly likely.

 

All this leads me to expect increased volatility, meaning more of the markets racing up then down, with increased frequency.  A miracle could occur, governments could somehow get the Goldilocks scenario, but that’s pretty unlikely.

So why am I optimistic?

I look at the world in two ways, first as an investor and second as a citizen.

As an advisor and an investor myself, I am excited because all this volatility provides opportunity.  We’ve watched as the popular theories of investing such as the Efficient Market Hypothesis, Buy and Hold, and standard allocations according to Modern Portfolio Theory did little to help protect and grow portfolios over the past decade, yet most are still implementing those same strategies hoping this time it will be different.  More than ever, investment portfolios need to be positioned to protect from market downturns and even take advantage of them, while still providing upside potential.  A portfolio of this nature will most likely not ride the top of the market wave when things go up, but it will also not experience the gut-wrenching slides either.  This stability is more likely to produce better long-term results.  With a portfolio like this, the market roller coasterride doesn’t threaten personal financial stability, which frees one up to watch it all as a citizen.

As a citizen, I watch it all with a great sense of optimism as the logical conclusion of decades of overspending and over-promising come to their natural conclusion.  Households know that if they spend more than they take in, they have to borrow, which means in future years, more of their income will go to paying interest and paying down their debt than towards consumption.  Governments have behaved for decades as if some magical fairy dust will evaporate their debts as the years pass so that year after year they can spend more than they take in, borrowing more and more, without ever facing the consequences.  We’ve also watched as nations have seen there is a limit to how much taxation and government control can be placed on an economy before it falters.  Continually increasing taxes eventually leads to lower tax receipts and stifles the economy.  Onerous regulatory environments like the one in Greece kills entrepreneurialism, the lifeblood of any economy.

There are two simple lessons nations across the world are facing:

  1.  Don’t spend what you don’t have.
  2. There is a limit to how much taxation and government control an economy can withstand.

 

I have great optimism because if people everywhere understand this and have the confidence to pressure their governments into behaving responsibly, if people ask every time government promises something, “How will we pay for it?” our economies can once again thrive and hopefully these lessons will not be quickly forgotten.  I watch people across the United States and Europe, asking the tough questions and refusing to accept the obtuse responses that used to suffice.  As my mother always says, “That which does not kill us makes us stronger.”  This will not kill us.