This past week as the stock market slowly squeezed out one new all-time high after another, and the people’s House voted in favor of impeaching the current occupant of 1600 Pennsylvania Avenue, I found myself remembering how this long bull run had begun back in March of 2009. Some of my market savvy colleagues may take technical issue with the beginning date, as they may prefer to characterize this bull run leg as commencing later following the bottom of one of the corrections along the way, because there have been some serious stock market dips post the 2009 bottom.
For example, there is no question that the correction, which began in 2015, made a significant bottom in February of 2016, and the February 5, 2018 crash like decline, which wiped out the XIV Volatility ETF, was really nasty as well. Especially, if you were long any of those XIV derivative instruments, when Credit Suisse hung those owning the exotic XIV product out to dry. However, this weekly update is targeted at retail clients simply to keep them informed as to what we are doing with their wealth and why. So, pros and clients wishing to talk shop can drop by our office across the breezeway from Carmine’s anytime, and we can talk stock market for as long as you want, and perhaps longer than you want, such is our passion for what we do.
Let us just keep this simple and say that this historic economic recovery, and the coincidental bull run, began from that biblical S&P-500 low of 666 in March of 2009. And, for those wishing to know a reason, what follows works as well as any explanation from a historical point of view, and may be an echo of the period of real prosperity following World War II. You see the stock market has enjoyed a “Double Shot Of Love” (The Swinging Medallions) compliments of the Fed and the Congress, when the “Free Fallin’ (Tom Petty) bear market of 2007-2009 accelerated after the collapse of Bear Sterns, and Lehman Brothers, in the fall of 2008.
The dis-inflationary trend existing before the events of late 2008 became an outright deflation, as the equity bear market took on some of the aspects of a panic. In response to the growing crisis, the Fed liquified the system in an extraordinary effort to prevent a cascading failure of the banking system. The Fed continued to spike the banking system with liquidity for months after. Capital goes where it is treated best, and a significant percentage of the re-liquification funding flowed into the stock market, a process taking years. When it was all done, the debt to GDP ratio had reached its second highest level in history. The debt taken on as a consequence of winning WWII remains the record high debt to GDP ratio.
Deficit spending during times of commodity shortages and strong industrial and consumer demand results in inflation, a big problem the late Paul Volker, Fed chairman from 1979 to 1987, was fighting as deficit spending contributed to the already rampant inflation. This was a period before industry had the sophisticated high powered computers guiding corporations today. These days “just in time inventory” has made stock piles of basic materials for manufacturing a much smaller factor. Back then the order of the day was too many dollars chasing too few goods, which bid up the price of everything. And, we were not energy independent back then making our economy vulnerable to instability in the Middle East, as the oil cartels held us hostage. So, in that era deficit spending, which added liquidity to the banking system, tended to flow not into equities, but rather into goods and services, which in turn created galloping inflation. Volker responded by jacking up interest rates sharply, which eventually collapsed the inflationary spiral. This situation is the polar opposite of conditions today where inflation, so far, has been a non-factor resulting in too many dollars in the liquified monetary system finding a home in the equity market.
The first shot of liquidity came in the form of the massive Federal bail out of the banking system during, and following, the Great Recession of 2007-2009. And, as that infusion of excess liquidity had just about run its stimulus effect along came the 2016 election, and the second shot of stimulus hit the monetary system in the form of a massive tax cut mostly for the wealthy. This “second shot of my baby’s love” rang in with a price tag of around a trillion dollars in deficit financing. Fortunately, this second shot entered the financial system, when the United States is essentially oil independent, and the application of high powered computers with just in time inventory programs has virtually eliminated the bottlenecks of the past, which caused artificial shortages of key materials, which in turn contributed to excess liquidity bidding up the price of goods and services, and so on. The United States, and its trading partners around the world, have been able to avoid the consequences of massive, and exponentially growing deficits, because low inflation has contributed to a continuing low interest rate environment. Alas, in economics one can postpone paying the piper, but eventually the piper must be paid.
I got a newsletter teaser this week from an outfit promoting its research. Inside the teaser was a bullet point which caught my eye. The point was that due to the creeping bull market touching new all-time highs almost daily, fund managers were responding by putting all their cash into the equity market. The teaser made a big point that although this may not be a signal that top tick had been touched in the bull market, it was nonetheless a big negative historically, as a sign that a major top may be brewing. The theory is when the financial houses, and fund managers are all in, where is the cash going to come from to power the equity market higher? This is a very good question, and the premise it is based on is sound. Unfortunately, it is a very big financial world out there containing multiple pools of asset classes, which are in flux every day. These global factors make measuring the actual availability of cash to power one market versus another a very difficult calculation. However, the observation that historically low cash on hand at funds is a warning shot that volatility may begin to rise right on schedule ahead of the election.
The bottom line on this history lesson is that the impact of deficit spending in the Volker era on the economy is very different than our current era of massive deficit spending. That difference is that in the Volker era the penalty for fiscal malfeasance was almost immediate in terms of rapidly rising interest rates. These days for all the factors previously mentioned, and more, the penalty in terms of rising interest rates has not yet occurred. In the Volker era it took Treasury rates in the high teens to quell inflation. In the current era I’ve seen numbers in print, which have made the case that a return to nominal interest rates in the five to six percent range would result in most of the revenue from the income tax being consumed by debt service. This enormous potential financial vulnerability brings to mind that radio call from Apollo 13, “Houston we have a problem”.
Alexander and I are in the risk management business. We measure and assess the risks to client wealth daily, and all our investment decisions are powered by our assessment of the trade off between risks and rewards. Recently a new client coming over to us mostly in cash wondered why we had not invested all his account, because obviously the popular indexes were touching new all time highs. This daily re-enforcement that all is well had given the new client a fear of missing out on the rally.
Yes our indicators continue to reflect an environment of demand being in the superior position to supply, yes the stock market is creeping higher almost daily, but remains less than 300 S&P 500 points above its 2018 high. Yes interest rates remain historically low, but the vulnerability (economic penalty) to even a marginal rise in rates has maybe never been greater. So the need for risk management and maintaining our discipline remains critical. In our world this means that we must buy equities for clients as the risk/reward becomes favorable. Buying equities when they carry a fat premium to value is an invitation for the client to have to wait months to get back even, should the market experience only a minor correction. When the market is touching new highs it is easy to forget that bull markets move higher in very small steps, but corrections take the express elevator down quickly wiping out months of slow appreciation. The former is driven by fluffy, and gossamer like optimism, and the latter by fear, and fear is a primal and powerful emotion relative to optimism.
When times are good it is well to remember that eventually the piper must always be paid!
TATY — A REPRESENATIVE OF A FAMILY OF STRATEGIC SUPPLY AND DEMAND INDICATORS
TATY is shown above in yellow with the S&P-500 overlaid in red and blue format. TATY finished the week at 154 with the previously mentioned negative divergence still in place. More often than not negative divergences in this indicator, which continue to linger, do result in some price weakness. TATY is telling us that while the price of the S&P-500 is touching new highs the power of the bids driving the price higher is fading. If the bid under the market continues to weaken according to TATY, then at some point the bid becomes too weak to sustain the rally, and of course a period of decline follows to re-invigorate demand. This is as normal for markets as breathing in and out is for you and I. The current negative divergence may disappear due to strengthening demand, but usually the market has to put on a bit of a “sale” to re-invigorate demand, so for now we will continue exercise patience, until there is a sign that equities are going on “sale”.
As long as TATY continues to paint out BOTTOMS in, or close to, the red zone surrounding the 140 level the probabilities favor assaults on new all-time highs. A TATY decline into the caution zone surrounding the 115 level would be a first warning that the dynamics of the supply and demand balance may be changing in favor of supply over demand. The appearance of a “Big Chill” warning would be hard evidence that Alexander and I need to begin defensive operations in client portfolios. The sequence of events necessary for the issuance of a “Big Chill” warning would likely take weeks to develop.
SAMMY — A REPRESENATIVE OF A FAMILY OF TACTICAL SUPPLY AND DEMAND INDICATORS
SAMMY is shown above in the second chart alone, and below with the SPXL 3X leveraged S&P-500 ETF overlaid. SAMMY has an superb record of identifying re-surging demand after evidence has arrived that sellers have spent their fury, and exhausted their propensity to sell. SAMMY is key for us to decide to be aggressive buyers after sellers have driven the price of equities into deep discount to “value”. These favorable conditions identified by the TATY strategic family of indicators in combination with the SAMMY family of tactical indicators almost always result in low risks purchases in the equity markets.
SAMMY exists to register resurgent demand as it is happening, and as such is virtually worthless for any other purpose. However, investors will notice that SAMMY is also sporting a negative divergence to the price of the SPXL ETF. And, like the negative divergence in the TATY indicator, it may disappear if demand strengthens. However, it almost always takes some decline in the price to re-invigorate demand enough to erase the negative divergence. We are prepared to be buyers as long as TATY signals the strategic big picture remains favorable for demand over supply, and SAMMY then flashes a buy signal once evidence that a significant price decline has ended.
THE BOTTOM LINE
Today’s update walked investors through a comparative between the situation existing in the Volker inflation era and today’s interest rate environment. The conditions vis-à-vis the implications for the impact of rising interest rates on the economy, and by inference the stock market, could not be any more different. In the Volker era it took huge moves in rates to quell raging inflation. Today a relatively modest increase in nominal rates has the potential to deliver a very dangerous blow not only to the economy of the United States, but globally due to the massive debt accumulated by our nation, and others. The United States in particular is vulnerable to decisions by China, which owns massive amounts of our Treasury bonds (debt). The looming election, and the risks attached to the Congress’ fiscal malpractice, make risk management a paramount concern for our client portfolios.
Anecdotal information about low cash balances in funds may mean the fuel required to drive equity prices higher could be beginning to run low. We shall watch our proprietary indicators carefully for evidence that the bull trend is moving from fatigued to something more serious. And finally, if conditions worsen and volatility increases sharply and dramatically, then the environment for “buy and hold” investors will become predatory, and extremely dangerous to the wealth of buy and hold investors. However, such an environment is actually a boon to those nimble few, which are prepared to navigate the acceleration in price change attendant with bear markets. Alexander and I believe that increased volatility equals increased opportunity to exceed the performance of the popular stock indexes, and the potential to increase the wealth of our clients significantly.
Finally, Happy Holidays to all!
Regards, DISCLAIMER: Optimist Capital LLC, does not guarantee the accuracy and completeness of this report, nor is any liability assumed for any loss that may result from reliance by any person upon such information. The information and opinions contained herein are subject to change without notice and are for general information only. The data used for this report is from sources deemed to be reliable, but is not guaranteed for accuracy. Past performance is not a guide or guarantee of future performance. Optimist Capital LLC, and any third-party data providers, shall not have any liability for any loss sustained by anyone who relied on this publication’s contents, which is provided “as is.” Optimist Capital LLC disclaim any and all express or implied warranties, including, but not limited to, any warranties of merchantability, suitability or fitness for a particular purpose or use. Our data and opinions may not be updated as views or information change. Using any graph, chart, formula or other device to assist in deciding which securities to trade or when to trade them presents many difficulties and their effectiveness has significant limitations, including that prior patterns may not repeat themselves continuously or on any particular occasion. In addition, market participants using such devices can impact the market in a way that changes the effectiveness of such device. The information contained in this report may not be published, broadcast, re-written, or otherwise distributed without prior written consent from Optimist Capital LLC.