All posts by Rob Charette

Could the Brexit Be the Tipping Point for Stocks?

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Thanks to Great Britain, the stock market recently experienced its worst 2-day slide since last August. And unless you’ve been living under a rock for the past couple of weeks, the word “Brexit” has probably made its way into one or two of your conversations.

This is not the first—nor will it be the last—hurdle for the European Union (EU). In fact, in the summer of 2011, the buzzwords for euro-zone fragmentation were “Grexit” and “contagion.” In other words, the possibility of the EU breaking apart has been in the news for quite some time.

Keep in mind, the sinister threats to the world economy as well as financial markets are not exclusive to the United Kingdom’s recent referendum. In fact, the dangers trace their origin back to something so simple – something so obvious and prevalent – it’s a shame that the mainstream media have swept the risks under the rug.

What am I talking about? I am referring to “Peak Debt.”

Coming from a very modest upbringing in the Bronx, my grandfather (Papa) was proud of many things. Being debt-free was most definitely one of them. He often boasted that he didn’t owe any man a red cent. As far as Papa was concerned, “debt” served as a literal four-letter word as well as a figurative one.

My grandfather’s attitude towards debt was not uncommon for his generation. I remember shooting darts with him and a few of his buddies at the Elks Lodge one time, and I brought up the topic of home prices in California. They all proceeded to tell me how much they paid for their homes back in the 50s, 60s and 70s. Inflation aside, I was stunned at the modest dollar amounts. Equally compelling? Each of these men were blue-collar to the core – a retired painter, plumber and mechanic. Not only could they afford homes in Orange County, California, but they paid 100% cash for them!

They then proceeded to tell me personal stories. Each had witnessed family members and friends get into trouble with debt. The blue-collar group spoke of these debtors as if they were wayward souls, spending the rest of their days in hiding or shackled to the wall of a debtor’s dungeon.

Clearly, that old school thinking has changed over the course of a few generations. In fact, following my first legitimate paycheck, I remember my father telling me that I needed to apply for a credit card and that he would cosign for me. We did so for a credit line with a 15% APR; we did it with the sole purpose of establishing credit-worthiness – a rite of passage of sorts. After all, Equifax, Experian and TransUnion won’t even acknowledge your existence without you having a credit file.

Then came “No-Doc” and “Neg-Am” home loans. These were the types of mortgages that allowed people to place themselves deep into the debt abyss. It helped stoke one of the most epic real estate frenzies in history (and the eventual collapse beginning in late 2007.) My own family and friends were chastising me for not buying into the madness. Heck, I can recall a professor, in a college of finance nonetheless, telling me to beg, borrow and steal my way into real estate ownership.

That school of thought, in turn, has given rise to a culture that is all-too-familiar with phrases like “strategic default” and “short sale.” Even Congress has gotten into the mix by passing acts such as the Home Affordable Foreclosure Alternative Program (HAFA). Indeed, a host of alphabet soup legislation inspired by the consequences of 2008-2009 have come down the pike.

Unfortunately, all signs point to the grim reality that debt has not only become the means to a version of the American dream, debt is now an American lifestyle. No longer is debt the thing of nightmares, like how my grandfather used to speak of it. (Papa passed away in 2006.) Still, if he were around to witness it, my grandfather would’ve had a thing or three to say about individuals, corporations and governments living so far above their means. He’d have an opinion on how everyone would surely crumple under the weight of the fatal obligations.

Perhaps ironically, the epic meltdown of the global financial system may seem like it occurred eons ago. Indeed, most of us have tried to forget about real estate prices falling 40% or more from their high-water marks and the S&P 500 plummeting more than 50% in less than 18 months. Paper wealth was being vaporized six ways to Sunday.

Yet, here we are. The apocalyptic dust cloud of the Great Recession has seemingly settled. Home prices across most of the U.S. have recouped most of their former glory. Likewise, the S&P 500 has recouped losses and gone on for 30% more in paper wealth beyond the highs reached in 2007.

So why do I even bring up painful memories and insightful analogies? Because the wealth effect that has occurred over the past seven years has been built upon the same faulty foundation as in the Great Recession. And that foundation is unsustainable debt levels.

“But haven’t individuals learned their lesson?” you ask. “Haven’t they become more responsible and repaired their personal balance sheets?” That would depend on how you look at it.

Granted, household debt servicing as a percent of disposable personal income is remarkably low. In the chart below, we see that households are able to afford their lifestyles because debt servicing is as favorable as the mid-80s and mid-90s.

untitled-1Source: Federal Reserve Bank of St. Louis.

Yet, you cannot make this observation without noting that the Federal Reserve has pushed borrowing costs to some of the lowest levels in history. (See the next chart below.) By taking overnight lending rates down to zero – and by manipulating other key lending rates to record lows – households may never be able to afford their lifestyles in the absence of permanently low borrowing costs. In other words, to the extent households keep borrowing and to the extent their total debt rises, there is virtually no room left to lower existing debt servicing in the future. (And may the gods help us if borrowing rates themselves were ever to move higher!)

untitled-2Source: Federal Reserve Bank of St. Louis.

Whether it’s “same as cash financing” for our appliances, furniture and vehicles, or 30-year fixed mortgages at 3.5%, the Fed’s zero percent interest rate policy (ZIRP) may be as close to the limit on how low they may actually go. It is true that central banks around the globe have already entered the theoretical realm of negative rate policy (NIRP), but so far, negative rate policy has failed to stimulate business or consumer lending abroad. And that means, the world is only getting closer and closer to “Peak Debt.”

untitled-3Source: Federal Reserve Bank of St. Louis.

Data does support the notion that American households did make a brief effort to clean up their balance sheets after the Great Recession. Whether it was by choice or by “Chapter 11,” the chart above shows how household debt (blue line) took a modest dip following the 2008 peak of $14.6 trillion. Barely a drop in the bucket, $1 trillion was all American families managed to shed from their balance sheet. Household debt has been slowly climbing ever since.

Corporate debt (red line), on the other hand, barely even skipped a beat. Corporations took only a very brief hiatus from borrowing in late 2009. Since then, corporate America has doubled down on its borrowing. And why not? Having the means to access such affordable credit, corporations have refinanced their old obligations as well as gone on to use the money for acquiring shares of company stock (a.k.a. “stock buybacks”).

Now let’s look at the level of borrowing that has gone on at the federal level. After all, nobody teaches us how to spend beyond our means better than the U.S. government.

untitled-4Source: Federal Reserve Bank of St. Louis.

Unabated by the Great Recession, public debt (in the chart above) has continued to grow exponentially. More than 40 years of data look more like an Evil Knievel launch ramp.

Paradoxically, past and present Fed officials have argued that the Federal government has not done enough. They complain that the Federal government should spend even more.

The notion that more federal spending might be beneficial to the economy clearly depends on perspective. For one thing, total public debt grew by more than $8 trillion since the stock market lows in March of 2009, up 73% in a little more than seven years. To put that pace into perspective, it took 20 years for total public debt to grow by $8 trillion prior to that, from December of 1989 to March of 2009. In essence, the pace of Federal borrowing nearly tripled following the worst credit (borrowing) crisis since the Great Depression!

Even with the speed at which society’s debt has grown in the last seven years, it’s relatively innocuous when you consider the extraordinary pace at which the Fed has expanded its own balance sheet. Our central bank has gobbled up U.S. Treasury bonds and mortgage-backed securities (a.k.a. quantitative easing or “QE”) to help keep interest rates suppressed.

untitled-5Source: Federal Reserve Bank of St. Louis.

Let me try to make this more real for you. For every $1 of that $8 trillion in debt issued to finance the public sector during the Fed’s controversial series of bond buying QE experiments, $0.52 of it was purchased by the Fed with money it created out of thin air. Now, when a bond gets scarcer, its price goes higher. And as the price goes higher, the yield goes lower. Ergo, savers who rely on higher yields are punished, while spenders who cherish lower and lower yields get to spend.

While public debt grew by 73%, the Fed’s balance sheet swelled by a staggering 674%. When you consider the fact that the Fed ended its QE spending splurge back in December of 2014, you are talking about a 37% annualized rate over a little less than six years!

So why bring up the Fed balance sheet at all? If the stock market is up more than 200% since the lows of 2009, and real estate prices have recouped as well, someone must be doing something right, yes?

Unfortunately, excess debt spreads its tentacles out into all corners of society. The solution to a subprime bad debt crisis became, well, a whole lot more debt!

It follows that we may all begin to see the consequences of the Fed entering the ZIRP/QE rabbit hole. If they cut off the ultra-cheap credit lines, the economy and the stock market are likely to implode. Keep rates suppressed indefinitely, and the Everest-sized debt could reach the elevation of Olympus Mons! (Google it!)

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As the chart above shows, stock market growth over the past seven years has been very closely tied to the Fed’s quantitative easing programs. When the Fed expanded its balance sheet, the stock market grew. When the Fed halted its balance sheet expansion, the stock market moved sideways.

“But correlation does not imply causation!”

Yes, I know. However, when you are talking about something as supposedly random as the stock market, a correlation coefficient greater than 90% is a statistical relationship that cannot be so easily dismissed as circumstantial. Markets move for a reason. And over the past 7 years, there has been no better single explanation than Fed policy.

What we have seen in the last 18 months is more or less a “go nowhere” Fed. It follows that since the end of the Fed’s controversial QE program back in December of 2014, the stock market has pretty much gone nowhere as well.

The unfortunate fact about debt is it eventually needs to be paid back; otherwise, the whole system collapses in on itself. And if households, corporations and governments are only interested in adding on more debt in this already abnormally low interest rate environment, what happens down the road when rates cannot actually move any lower?

Japan and parts of Europe are already experimenting with negative interest rates. Try to wrap your head around that for a moment. It is equivalent to a lender paying the borrower to take out a loan. In other words, in a negative interest rate environment, you would (willingly) loan out your money just so you can get paid back less than what you loaned out. Is that really going to work in a rational society for any meaningful length of time?

Regrettably, the powers that be didn’t recognize the debt frenzy for what it was leading into 2008. We all ended up learning some pretty powerful lessons…some more painfully so than others. Yet, here we are again.

If you are worried about your current investment portfolio given the direction of Fed policy, debt levels, as well as the overall stock market, you may want to consider the benefits of the FTSE Custom Multi-Asset Stock Hedge (MASH) Index. We created the MASH index to help us track non-stock investments that have historically proven to be an adequate hedge against downside stock volatility.

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We are currently offering a managed account service that tracks the MASH index. The cost for this service is free for the remainder of 2016. The annual fee returns to 0.35% in 2017.

Please give us a call if you’d like to learn more.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Why You Should Already Be Investing in the MASH Index

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For nearly a decade, the US Federal Reserve (the “Fed”) kept overnight lending rates near zero percent. The reason? Policy leaders wanted to inspire a wealth effect in stocks and real estate. Since deviating from its extremely accommodative course, however, the Fed is now entering rough, uncharted waters.

Whereas central banks all around the globe are still devoted to extreme accommodation through exceptionally low borrowing rates, the Fed stepped in the opposite direction back on December 16th. What did they do? They raised the overnight lending rate by a quarter of a point (0.25%). Since then, large-cap stocks (S&P 500) have corrected by 11%. Likewise, mid-cap stocks (S&P 400) are down roughly 13% and small-cap stocks (Russell 2000) have fallen by more than 16%.

Even those investors who married themselves to beloved “FANG” stocks (Facebook, Amazon, Netflix & Google) are finding it difficult to navigate the volatile seas. In fact, FANG stocks have collectively fallen more than the market at large. These are the companies whose share prices have defied gravity. These are the corporations whose lofty valuations weren’t supposed to matter.

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Ironically enough, FANG stocks have managed to fall an average of 21%. That’s technically a bear market for the popular quartet!

So are fundamental valuations finally coming back into vogue? Absolutely. They always do.

It happened to investors who explained away the tech bubble prices as the “New Economy” norm back in 2000. It also happened to those investors who dismissed the ridiculously high property prices leading into 2007. The pendulum always loses momentum before swinging in the opposite direction. Tragically, investors often find themselves relearning lessons in physics via their investment portfolio.

The justification for extremely high valuations over the past couple of years has always been explained away with zero percent interest rates. If I had a tax-free nickel for every time I heard an analyst, pundit or casual couch investor use the zero percent interest rate excuse to dismiss high price-to-earnings (P/E) ratios, I would use the hundreds of millions in tax-free wealth to acquire a small tropical island. Instead, here I am… writing articles to say, “Get your head out of that dark hole and invest in the MASH Index.”

Here is the key conundrum for investors: Even if the Fed controls the shortest end of the yield curve, what happens when those T-bills, certificate of deposits (CDs), and savings accounts begin paying a little more than just the measly bread crumbs we’ve grown so accustomed to? Won’t that entice investors to move out of those riskier stock assets that they felt compelled to buy before, especially if there is increased volatility and uncertainty in stock markets themselves?

Perhaps you still find yourself in the “it’s just a quarter of a point” camp. Fair enough. But one cannot ignore the super-sized increase in volatility since the December 16th Fed meeting, as well as the failed rallies since the Fed’s last QE3 bond purchase back in late 2014. Insignificant or not, policy direction matters to currencies, commodities, debt instruments and equities, even when the shift itself seems miniscule.

Additionally, one cannot dismiss the dramatic rebound in stocks since 2009 without giving central bank policy changes a big-time tip of the cap. The correlation between central bank intervention and stock market rallies have been rather dramatic. And just in case your memory is not what it used to be, here’s a review of that correlation.

January 2009 to April 2010

The start of 2009 also marked the start of the zero interest-rate policy (ZIRP) era. In a bid to rescue an economy trapped in a death spiral, the Fed took its overnight lending rate from 5.25% in June of 2006 down to the “zero bound” by December of 2008. Yet, those 10 consecutive rate cuts that ushered in the ZIRP era still weren’t enough to curtail the wealth destruction brought on by the collapse in real estate and the subprime catastrophe.

At the tail end of 2008, the Fed announced that it was calling in the cavalry. With rates already at zero percent, the central bank introduced a form of stimulus known as quantitative easing (QE). QE is simply the Fed opening up its wallet, which is filled with electronic dollar credits. (Note: That’s a fancy way of saying that they created money out of thin air to buy bonds so that interest rates would move dramatically lower.) As a result, the Fed’s balance sheet tripled in size. Nearly $1.5 trillion of US Treasuries and mortgage-backed securities were acquired and interest rates did indeed drop. The S&P 500 responded by rallying 80% off of March 2009 lows through April of 2010.

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May 2010 to August 2010

Unfortunately, Wall Street quickly sniffed out the Fed’s goal to bring QE1 to an end. The S&P 500 responded with a 13% drop into June and remained range bound through the end of August.

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September 2010 to October 2010

Still not satisfied at the pace in which the economy was improving, the Fed announced that it would resume QE1. With a newly revised goal to increase its balance sheet to $2 trillion, the Fed began buying even more US Treasuries at roughly a $30 billion per month clip.

The S&P 500 responded with a 17% rally through the end of October.

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November 2010

However, with the end of QE1, the rally began to stall out in November.

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December 2010 to April 2011

Still not satisfied with the pace of recovery, the Fed then announced a second round of quantitative easing (QE2). A total of $600 billion in US Treasuries would be added to the Fed’s balance sheet by the end of June 2011. The stock market received a new head of steam. The S&P 500 rallied 16% through the end of April.

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May 2011 to September 2011

After a few failed attempts at recapturing the April highs, the S&P 500 faced the unknowns of a fast approaching end to QE2. Unfortunately, that would amount to just one of the threats investors faced. A second, even larger, wave of trouble was rolling in from across the Atlantic.

The word “contagion” should refresh your memory of that particular period known as the Eurozone Crisis. The fear of the European Union (EU) allowing Greece to default on its debt obligations, resulting in its ultimate exit from the EU, led many to speculate that there would be even bigger European countries to follow. After all, the balance sheets of Spain, Portugal and Italy were not much better than Greece’s.

The fear of contagion netted the S&P 500 a 19.9% drop from the April highs.

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October 2011 to March 2012

In September, the Fed announced “Operation Twist.” Also known as QE2.5, Operation Twist was simply a way for the Fed to continue acquiring Treasury bonds without opening up its wallet. Quite simply, the Fed sold the short-term Treasury bonds it already owned and rotated the proceeds into new long-term Treasury bonds.

Likewise, the Eurozone Crisis fears began to feed even more central bank stimulus from across the pond. In October 2011, the Bank of England announced that it would undertake more QE, adding £75 billion to its balance sheet. Additional Bank of England stimulus came in February of 2012 as well. The S&P 500 rallied another 24%.

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April 2012 to May 2012

Deals between the EU and Greece continued to go back and forth with no resolve. No real tangible solution, in which all parties agreed, seemed to be within sight. Renewed fears of a Greek exit (or “Grexit”) from the EU flared up once again. In fact, in May of 2012, the National Bank of Greece warned that an exit from the EU was a very real possibility. The market lost its legs once again.

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June 2012 to August 2012

Leading into June, considerable fears surrounded the future of the EU and the fate of the euro should Greece default on its debt obligations. However, Mario Draghi, President of the European Central Bank (ECB), swooped in to save the day. He made a public pledge to do “whatever it takes” to rescue Greece and preserve the euro. The S&P 500 turned higher yet again.

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September 2012 to November 2012

Even with a Eurozone Crisis subsiding, the market rally was short lived. Stocks waffled once again. Not only had the GDP growth rate not yet captured its pre-recession levels, it began to fall.

Still not satisfied with the economic (and jobs, stock, real estate, etc.) recovery, the Fed announced a new stimulus program in September. QE3, or “QE-Infinity” as it became more affectionately known, was an open-ended asset purchase program in which the Fed purchased Treasury bonds and mortgage-backed securities at a rate of $40 billion per month.

The markets failed to respond. The stimulus was viewed as not being a big enough commitment. In fact, the S&P 500 dropped by roughly 8% from the point the Fed announced QE3.

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December 2012 to September 2014

Not satisfied with the market’s response to QE3, the Fed announced a “shock & awe” increase to its QE3 stimulus program in December. It would more than double its monthly asset purchases from $40 billion to $85 billion.

The markets rocketed to new all-time highs. The S&P 500 climbed nearly 44% without as much as a hiccup.

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October 2014 to Current

The Fed announced the retirement of QE3 at the end of October 2014 and finished its last asset purchase in mid-December of 2014. After accumulating roughly $4.5 trillion in assets since it began its emergency-level stimulus programs nearly six years prior, the Fed finally reached the point at which it felt the economy could stand on its own two feet. Or could it?

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As the chart above shows, the equity markets have yet to prove that a meaningful rally can exist without an extremely accommodative Fed. That hypothesis is further supported by the direction the markets have headed since the December 16th rate hike.

And therein lies a second critical conundrum for investors. Are we dealing with an equity market that is coming to terms with a less accommodative Fed? Since all previous rallies following the Great Recession have come on the heels of some sort of central bank intervention, can we have a stock market rally despite a Fed that has become stingier?

If not, what is working in this current environment? The MASH index is working. It is working quite well, in fact.

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As the chart above delineates, the MASH index is outperforming the S&P 500 by more than 17% since the December 16th Fed meeting. Where the S&P 500 is down 11%, the MASH index is up 6%.

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If you’d like to discuss hedging your portfolio against stock risk, please give us a call at (888) 500-4279. Likewise, if you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, please click here to send us your contact information.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

The Stock Market Sets a New Record in 2016

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If you’ve been paying attention to your investment account balances, you’re probably scratching your head. What record could the stock market have set already? Just a handful of days into the New Year?

Well, you’ve just lived through the worst start to any January in the history of the Dow Jones Industrial Average (DJIA). It’s the first time that the market has ever posted -6% in its opening week… ever. And that’s going all the way back to 1896. That’s 120 years!

If you’re wondering what’s been causing this kind of volatility, you’re not alone. Scores of theories have been making the rounds, including a beleaguered Chinese economy to renewed geopolitical concerns in North Korea to the seemingly endless collapse in the price of oil.

Me, on the other hand? I am taking my cues straight from the horse’s mouth.

CNBC’s Squawk on the Street roundtable hosts – Becky Quick, Carl Quintanilla & Simon Hobbs — interviewed former Dallas Federal Reserve President, Richard Fisher on Tuesday, January 5, 2016. Here is a dictation of that live, 7-minute interview:

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CNBC (Becky Quick): You think this [market selloff] has to do with the Fed?

Richard Fisher: Well look, I think part of this obviously has to do with concerns about growth and whether China is a leading indicator or not. But, you know, I think we have to bear in mind that what the Fed did, and I was part of that group, is we front-loaded a tremendous market rally starting in March of 2009. It’s sort of what I call the “reverse Whimpy factor.” Give me two hamburgers today for one tomorrow. And I’m not surprised at almost every single index you can look at… if you take away dividends in the S&P last year – unweighted, it was down significantly. And all the other indices were down. In terms of the 10-year bond, there was almost no movement for the year. Basically, we had a tremendous rally and I think there’s a great digestive period that’s likely to take place now and it may continue. Because again, we front-loaded, at the Federal Reserve, an enormous rally in order to accomplish a wealth effect. So, I wouldn’t be surprised at what’s happening. I wouldn’t blame it on China. We’re always looking for excuses. China is going through a transition. It’ll take a while to perfect itself, but what’s new there? There’s no news there.

CNBC (Becky Quick): Well, a 7% plunge in their [China] market is a scary thing to wake up to.

Richard Fisher: Yeah but bear in mind, I’ve been going to China since 1979. I was part of the group that negotiated with Deng Xiaoping – the normalization of our commercial claims against each other – and closed that deal on March 1st of 1979. So I think I’ve got a little bit of experience in China. I invested in China for quite a period with my fund, in the B shares market. You have to remember, Shenzhen/Shanghai are basically domestic markets. They’re trying to manipulate those markets as much as possible. Jim Kramer was right on this morning in terms of the force that they used to prevent real animal spirits from emerging. But the real issue there is their underlying economic transition and the markets are not correlated with that in China. They’re achieving it, it takes a while – transitioning from poorly-run state-owned enterprises, a bad credit system, an emphasis on volume and production to quality and consumerism and profitability. This is going to take some time. It’s a good thing. And I don’t think there’s any news there whatsoever. But again, analysts are always looking for a tripwire. The fact is, we’ve had a great market movement since 2009. It’s going to take a while to digest this. I wasn’t surprised at last year and I wouldn’t be surprised at a rather fallow performance this year as well.

CNBC (Becky Quick): Well, I guess my question, Richard, is how ugly is it going to get? There was a point yesterday where the Dow was down 467 and everyone was trying to figure out to your point, why? Does the Chinese stock market really affect us? If you do see this as a big unwind from Fed policy, which fueled a six and a half year bull market, what does it look like on the way down?

Richard Fisher: Well, I was warning my colleagues- don’t go wobbly if we have a 10-20% correction at some point. The market is still overpriced. Everybody you talked to all morning long have been warning that these markets are heavily priced. We’re trading at 19.5x earnings. We’re not having the kind of topline growth we would like to have. We’re late in the cycle. Things are richly priced. They’re not cheap. They may not be overpriced any longer but they’re certainly not cheap. So, all of the managers that I talk to in my role at Barclays, and that’s quite a few across the world, a lot of people are building cash positions. I’m talking about the long only investors – those that are taking a longer-term view – are being extremely cautious here. They’re raising their cash levels. They’re nervous about the valuations that are in the market. And they realize the old dictum from Ben Graham and Warren Buffet, “Price is what you pay, value is what you get.” And the values are very richly priced here. So, I could see significant downside. I could also see just a flat market for quite some time. Again, digesting that enormous return the Fed engineered for almost six years.

CNBC (Carl Quintanilla): Richard, this “digestive period,” does it usher in an era where assets can’t perform in the absence of accommodation? Is there something new about this? Or is it the same old cycle regarding equities and rates?

Richard Fisher: Well, first of all, I don’t think there can be much more accommodation. The Federal Reserve is a giant weapon that has no ammunition left. So, what I do worry about is it was “The Fed. The Fed. The Fed. The Fed.” For half of my tenure, which was a decade there. Everybody was looking for the Fed to float all boats. In my opinion, they got lazy. Now we go back to fundamental analysis – the kind of work that used to be done – analyzing whether or not a company truly, on its own, is going to grow its bottom line and grow its shareholder value; and price accordingly; and not just expect the tide to lift all boats. So we are going to find out, indeed, when the tide recedes we’re going to see who is wearing a bathing suit and who is not. We’re beginning to see that. You saw it in junk last year. You also saw it even in the mid-caps. You saw it in the S&P – stripped of its dividends, on an unweighted basis – you had a negative return. The only asset that really returned anything last year, again if you take away dividends, believe it or not was cash, at 0.01%! That’s a very unusual circumstance.

CNBC (Simon Hobbs): Mr. Fisher, this has been an absolutely extraordinary interview. For you to come on here and for you to say “I was one of central bankers who engineered the front-loading of the banks, and we did it to create a wealth effect.” And then to go on and tell us, with a big smile on your face, that we are “overpriced” – which is the word that you used in the market – that there will be “digestive problems.” Are you guys going to take the rap if there is a serious correction in this market? Will you equally come on and say “I’m really sorry, we overinflated the market,” which is a logical conclusion from what you’ve said so far in this interview?

Richard Fisher: Well, first of all, I wouldn’t say that. I voted against QE3. But there was a reason for doing this. Let’s be fair to the central bank. We had a horrible crisis. We had to pull it out. All of us unanimously supported that initiative under Ben Bernanke. But, in my opinion, we went one step too far… which is QE3. By March of 2009 we had already bought a trillion dollars in securities. When the market turned in that first week of March, to me, personally, as a member of the FOMC, that was sufficient. We had “launched the rocket.” And yet, we piled on with QE3, understandably, worrying – the majority did at least – that we might slide backwards. So, I think you have to be careful here, and frank, about what drove the markets. Look at all the interviews you had over the last many years since we started the QE program, the quantitative easing, and it was “The Fed. The Fed. The Fed. The European central bank. The Japanese central bank. What are the Chinese doing?” – all quantitatively driven by central bank activity. That’s not the way markets should be working. They should be working on their own animal spirits. But they were juiced up by the central banks – including the Federal Reserve – even as some of us would not support QE3. So I think you have to acknowledge reality.

CNBC (Becky Quick): Richard, we’re totally out of time. One more answer… the Fed forecasts 4 rate hikes this year. The market says it will only be half of that. Who will be right?

Richard Fisher: I thought John Williams’ interview was very good yesterday. I’d bank on that.

CNBC (Becky Quick): Well, he thought they were going to go through with their forecasts. Richard Fisher…always a pleasure. Thanks for joining us. The former president of the Dallas Fed.

Richard Fisher: Thank you.

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Front-loaded, at the Federal Reserve, an enormous rally in order to accomplish a wealth effect? That the markets are overpriced because of it? That there will be “digestive problems” because of the Fed’s actions? You can almost hear the turning of the stomachs of investors everywhere.

Mr. Fisher served as a voting member of the Federal Reserve throughout the 2008 global financial crisis. His tenure continued during the controversial Fed monetary policy programs – QE1, QE2, Operation Twist & QE3. And he made no bones about what the goal all along was… ”I think we have to bear in mind that what the Fed did, and I was part of that group, is we front-loaded a tremendous market rally starting in March of 2009.”

He continued with…

“It’s sort of what I call the “reverse Whimpy factor.” Give me two hamburgers today for one tomorrow.”

How cute. Then later in the interview, he reiterated…

“Because again, we front-loaded, at the Federal Reserve, an enormous rally in order to accomplish a wealth effect. So, I wouldn’t be surprised at what’s happening.”

Obviously, the Fed created one of the strongest stock market bulls in the history of U.S. market-based trade. The artificially infused wealth effect has allowed stock prices to recover approximately 130% of their prerecession highs and home prices have recovered 95% of theirs.

Now I’m not professing to moonlight as an economist, but I’m pretty sure every economist – from Adam Smith to Arthur Laffer – would have some reservations about “reverse Whimpy factor” economics. For starters, one has to wonder what exactly happens to a stock market that has been artificially propped up for so long. Will the artificially wealthy need to pay back Whimpy’s hamburgers once he realizes he has been hoodwinked?

If the answer is a definitive “No,” you can breathe a sigh of relief. This recent bout of volatility could be nothing more than a run-of-the-mill, corrective lull. If the answer is anything other than a definitive “No,” you should be worried… very, very worried.

It would appear that Mr. Fisher is, in fact, worried. And just in case you didn’t catch it in his interview, I will spell it out for you. His ominous message comes in the response he gives to Simon Hobbs’ question, which causes the interview to take an interesting turn.

CNBC (Simon Hobbs): Mr. Fisher, this has been an absolutely extraordinary interview. For you to come on here and for you to say “I was one of central bankers who engineered the front-loading of the banks, and we did it to create a wealth effect.” And then to go on and tell us, with a big smile on your face, that we are “overpriced” – which is the word that you used in the market – that there will be “digestive problems.” Are you guys going to take the rap if there is a serious correction in this market? Will you equally come on and say “I’m really sorry, we overinflated the market,” which is a logical conclusion from what you’ve said so far in this interview?

(Thank you, Mr. Hobbs. I’m not sure I could’ve stripped the sugar coating as well as you did.)

At this point, I think Mr. Fisher begins to feel the true weight of what he had just acknowledged. He begins to backpedal. He answers Mr. Hobbs’ question with what I call “a guilty party’s closing argument.” His response is made up of equal parts denial, “cover your a**” (aka CYA), excuses, and blame.

Richard Fisher: Well, first of all, I wouldn’t say that. [denial] I voted against QE3. [CYA] But there was a reason for doing this. Let’s be fair to the central bank. We had a horrible crisis. [excuses] We had to pull it out. All of us unanimously supported that initiative under Ben Bernanke. But, in my opinion, we went one step too far… which is QE3. [more CYA] By March of 2009 we had already bought a trillion dollars in securities. When the market turned in that first week of March, to me, personally, as a member of the FOMC, that was sufficient. We had “launched the rocket.” [even more CYA] And yet, we piled on with QE3, [blame] understandably, worrying – the majority did at least – that we might slide backwards. [more excuses] So, I think you have to be careful here, and frank, about what drove the markets. Look at all the interviews you had over the last many years since we started the QE program, the quantitative easing, and it was “The Fed. The Fed. The Fed. The European central bank. The Japanese central bank. What are the Chinese doing?” – all quantitatively driven by central bank activity. [more blame]

Clearly, at this point, Mr. Fisher is not feeling too confident about what transpired while he was a voting member of the FOMC. He then follows up his response with some ominous remarks about the markets.

He continued with…

That’s not the way markets should be working. They should be working on their own animal spirits. But they were juiced up by the central banks – including the Federal Reserve – even as some of us would not support QE3. [one more CYA for good measure] So I think you have to acknowledge reality.

We have to “acknowledge reality?” What does that mean, exactly? Are you telling us that the piper (or in this case, Whimpy) finally needs to be paid? If so, how much can we expect the markets to fall to get back to where they are “working on their own animal spirits” again?

Earlier in the interview Mr. Fisher brings up the point by which traditional fundamental analysis shows the pricey nature of stocks. Specifically, he points out the fact that the S&P 500 is currently trading at roughly 19.5x TTM earnings. This is well above the historical TTM P/E average of 14.6. For the S&P 500 to be in line with its fair value historical average? The S&P 500 would have to fall to 1550 – a 27% decline from the S&P 500’s record highs.

The bad news is that analysts are already revising their year-end earnings estimates down for 2016. If earnings do stagnate, the S&P 500 might not drop to a fair value average… the market could fall even further. 1500? 1450? 1400? Coincidentally, that would put the market right about where it traded just prior to the announcement of QE3, a proposition Mr. Fisher says he vehemently opposed.

What’s more? The market is currently trading where it was nearly 20 months ago, in May of 2014. There has only been one other period during the bull market cycle where the market struggled to advance for a similar length of time: January of 2010 – September of 2011. And that period included the Eurozone Crisis.

So what’s the difference between then and now? Back then, the Fed was nowhere near raising its target rate. Furthermore, the Fed was only halfway to its $4.5 trillion balance sheet.

Today? The Fed has stopped spending money and has already begun raising the target rate.

Unless the Fed decides to change course and reverse its current monetary policy direction (moving from tightening to loosening), we can expect the markets to continue to find it difficult to ratchet higher. Previous periods of market weakness were met with some form of Fed accommodation, but you may not want to bet the farm on the Fed saving the day this time around.

Just listen to Mr. Fisher:

“I don’t think there can be much more accommodation. The Federal Reserve is a giant weapon that has no ammunition left.”

This revelation brings up one final point. Albeit at a snail’s pace, the Fed’s concerted effort to tighten borrowing costs while simultaneously keeping the artificial wealth effect afloat may be an act of desperation. Only time will tell.

If you think Mr. Fisher’s interview warrants some consideration with regard to your investments, consider the chart below. It represents a comparison between the S&P 500 and our FTSE Custom Multi Asset Stock Hedge (MASH) index.

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As you can see, since the Fed’s announcement to raise its overnight lending rate by one quarter of one percent back on December 16th, the MASH index has outperformed the market by 10.7%. Where the S&P 500 has fallen by 8.8%, the MASH index has risen by 1.9%.

If you’d like to discuss hedging your portfolio against stock risk, please give us a call at (888) 500-4279. Likewise, if you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, please click here.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

The Fed Giveth and the Fed Taketh Away

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“The FOMC decided today to keep its target range for the federal funds rate at 0 to 0.25 percent.”

Since the December 2008 Federal Open Market Committee (FOMC) meeting nearly seven years ago, the above-described policy guidance has been a mainstay in every subsequent statement. For those of you who may not have kept count, that is 61 meetings in a row.

The next FOMC meeting is only a few weeks away. Market participants have their ears glued to the rails of the interest rate train. Meanwhile, Wall Street remains infatuated with the direction and the pace of the Fed’s interest rate locomotive. For investors and Wall Street alike, the upcoming December 16th junction is no different. I take that back… it may be a little different.

As of November 24th, Fed funds futures place a 74% likelihood that the Fed committee members will support at least a 25 basis point (0.25%) hike to the Fed funds target. Clearly, there is a high probability that policy guidance coming out of meeting number 62 will be drastically different than what we’ve grown accustomed to over time.

So why is Wall Street so captivated by the possibility of a measly quarter point rate hike? The chart below shows the direct effect that Fed policy has had on the equity market and the U.S. economy since the “Great Recession.”

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As you can see, the Fed’s first economic lifeline was dropping the Fed funds target rate (the orange line) from roughly 5.25% in 2007 all the way down to zero by December of 2008. When the equity markets and economy failed to respond, the Fed then tossed a second economic lifeline by acquiring U.S. Treasuries and mortgage-backed securities – vis-à-vis quantitative easing (the purple line). Only after rates were at zero percent and the Fed’s balance sheet began to swell did the economy and markets begin to improve.

Nearly seven years later, the Fed funds rate is still at zero percent. The Fed balance sheet has ballooned to $4.2 trillion – roughly 9x its size prior to the first round of quantitative easing (QE1). And thanks to “Mr. Fed,” stocks have catapulted more than 200% off of the March 2009 lows in one of the longest bull market runs in history.

Now, while the Fed may only be starting with a paltry quarter point hike at inception, a directional shift (a.k.a. “tightening”) for the central bank of the United States may result in a directional shift for stocks. After all, an ultra-accommodating Fed stoked the stock fire in the first quarter of 2009.

Also, there’s a reason that I included the GDP Annual Growth Rate (the blue line) in the above chart. Not only are investors facing a shift in the direction of the Fed’s policy – from loosening to tightening – stocks must now overcome valuation considerations.

As the chart demonstrates, the Fed managed to yank GDP out of the recessionary pyres in 2009. The problem? The chart also shows that, throughout the economic “recovery,” GDP growth has never quite recovered its pre-recession levels.

An economy that fails to grow at a rate commensurate with pre-recession levels? In spite of a soaring stock market? In spite of rocketing real estate prices? Even with $4.2 trillion added to the Fed balance sheet? In fact, GDP is presently growing at half of its historical average, whereas stocks continue to trade as if economic growth has been performing adequately.

The net result is that stock valuations, or how overpriced they may be, are off the rails. There are only three other times in history when total stock market capitalization relative to GDP (Market Cap-To-GDP) has reached similar extremes – right before the Great Depression in 1929, the dot-com bubble in 2000, and the financial crisis in 2007.

Some folks are dismissing traditional stock valuations. Their reasoning? The metrics only hold water when interest rates are closer to normal levels. They say, “Overpriced, underpriced. Who cares when the borrowing costs are ridiculously low?”

Naturally, there are those who will rationalize their way into a “New Economy” or a new way to value stocks, particularly when greed obscures one’s vision. Nevertheless, the Fed’s directional shift toward tightening coupled with subpar GDP growth brings those old-school valuation methods back to the forefront.

Indeed, if the Fed’s multiple lifelines – QE1, QE2, Operation Twist, QE3 – acted as tailwinds for stock prices since March of 2009, shouldn’t one anticipate the directional shift of tightening to act as a headwind? In fact, the two other times in history when the Fed began raising borrowing costs into a decelerating economic backdrop were quickly followed by stock bears.

Stocks may have already seen the start of the bull market’s demise. After all, it has been more than six months since the S&P 500 has managed to reach a new high. Six months.

Perhaps now is the time to seek ways to help protect your investment portfolio from the inevitable bear mauling. Or, perhaps you are already sitting on a portfolio filled with cash, and you do not know what to do. Now may be the time to pursue a viable investment strategy that can take advantage of a precipitous drop in stock prices.

If you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, give us a call at 888-500-GARY (4279). Additionally, please click here to inquire about investing in the MASH index via our website.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Is This Bull Heading out to Pasture?

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On Wednesday, August 19, 2015, the S&P 500 pushed back below 2,090.57. Why is 2,090.57 relevant? That happens to be the 2014 year-ending high reached back on 12/29/2014. In other words, nearly 8 months (163 trading days and counting) have passed by with nothing to show for it.

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What’s more? On Thursday, August 20, 2015, the S&P 500 fell below 2,061.75. Why is 2,061.75 relevant? That happens to be the bottom of the 7% trading range the S&P 500 had been trading within since 12/29/2014. And not only was that the tightest sideways range since the beginning of the bull market (March of 2009), it was the tightest range for that long of a stretch in more than two decades!

Thirdly, on Friday, August 21, 2015, the S&P 500 fell below 1,992.37. Why is 1,992.37 relevant? That was where it was trading exactly one year ago to the day. In other words, not only is the market negative on the year, it is now down year-over-year.

Also, this recent bull has been averaging a recent high every six to seven trading days. As of the August 24 close, it has been 65 days (and -11.2%) since the S&P 500 made a new high. In fact, on only four separate occasions has this bull (now six-and-a-half years old) experienced stretches between cycle highs that were longer:

1. From 09/14/2012 to 01/04/2013 (75 days) and included a drop of 8%.
2. From 04/02/2012 to 09/06/2012 (109 days) and included a drop of 10%.
3. From 04/23/2010 to 11/04/2010 (136 days) and included a drop of 16%.
4. From 04/29/2011 to 02/24/2012 (207 days) and included a drop of 19%.

Was that lengthy period of consolidation the proverbial calm before the storm? With the market now down year-to-date and year-over-year, have we already witnessed this business cycle’s peak? Likewise, could we be on a fast track to scenarios #3 and #4 above? Or are we facing something much more ominous?

The reason I ask is because stock valuations are just off of levels that were recently hovering right around all-time highs. Specifically, the cyclically adjusted price-earnings ratio, or CAPE ratio, was recently at levels only seen three other times since 1881 – the years surrounding 1929, 1999 and 2007. And if you were to look up the word ominous in the dictionary, all three of those periods in history could accurately be used in a sentence. Could we be facing our fourth dose of an ominous reality predicated on those previous valuations and periods that followed?

With Monday’s (8/24/2015) continuance of the knee-jerk reaction, the market has finally moved into a 10% retracement phase (aka a corrective period). Prior to that there had not been a single run-of-the-mill correction in 923 trading sessions (44 months). That figure is extraordinary when considering the market averages a corrective period every 18 months or so. The stretching rubber band metaphor comes to mind when such a long period of growth transpires without much in the way of even a 10% hiccup. As the general rule of thumb implies, the longer and further a market trends in one direction, the swifter and more violent its recoil is in the opposite direction.

So far, the past few trading days have experienced quite the recoil and accompanying sting. This has also caused many investors to consider some stinging revelations. Does this bull still have legs to stand on? Or is it finally heading out to pasture after six-and-a-half years? Or, perhaps, will the rubber band snap back in such an epic fashion that the market craters into earth in a near extinction event for the bulls?

Using data for the Dow Jones Industrial Average, we are currently in the 35th business (bull/bear) cycle since 1900. The average cycle length has been 3 years with a mean annual return of 8%. However, don’t let that positive average annual return fool you. In fact, 12 of those previous 34 cycles ended with the index trading 20% lower, on average, than where it started the cycle. That’s right. There was a 35% chance that the bear in the business cycle not only stripped all of the meat from the bull’s bones, it buried those bones deep underground! (Obviously, those instances represent previous craters.)

The reality is, curiosity may kill cats, but volatility kills bulls. With the VIX now trading at levels not seen since the Eurozone Crisis in the summer of 2011, the cautionary flags are waving. Although a VIX spike above 20 is not uncommon, a trend above 20 should be duly noted by stockholders. Historically speaking, an intermediate-term trend above 20 for the VIX signals a high likelihood that a meaningful, and extended, reversal is in the making. Yet, it’s an indicator that also usually provides investors with ample opportunity to limit their losses.

Granted, a panic-driven stampede for the exits is never advisable. However, you should be considering options to protect what you have amassed over the past six years. The market has already set itself back one full year. If history is any indication, there’s a notable chance you could be set back even further if you don’t have a plan to protect. After all, the average bear market is -32%. If we are already in the throes of history’s average bear, we are only a third of the way to the bottom.

If you have no clear discipline or strategy to limit your portfolio’s volatility and drawdown, you are probably already dealing with hints of doubt on what to do from this point forward.

Just considering what has transpired in the past week – with the breaching of those previously mentioned price points – one is not left with much in the way of positive vibes from stocks. The market has been far removed from the price behavior we have grown accustomed to.

Yet, with this recent batch of volatility hot out of the oven, not all investors have been negatively affected. For example, those asset classes that make up the FTSE Custom Multi-Asset Stock Hedge (MASH) index – an index we, here at Pacific Park Financial, Inc., created in conjunction with FTSE-Russell – has weathered the volatility quite admirably. The following chart contains the trailing returns of the S&P 500 and the MASH index through 8/24/2015.

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As you can see, MASH’s 1-Week, 1-Month and 3-Month outperformance differentials over the S&P 500 were 12.1%, 11.8% and 12.5%, respectively.

Perhaps a look beyond stocks is finally warranted.

If you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, give us a call at 888-500-GARY (4279). Additionally, please click here to inquire about investing in the MASH index via our website.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Investing’s Hatfields & McCoys

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I recently had a conversation with a portfolio manager on the concept of active portfolio management, or as he put it, “market timing.” The particulars of our discussion covered benign topics such as risk tolerance and diversification. Nevertheless, a pleasant exchange on the merits of the FTSE Custom Multi-Asset Stock Hedge Index (MASH) quickly morphed into an argument. It became so ugly, in fact, that I found myself picturing a vengeful Ran’l McCoy, musket in hand, banging on my office door.

The lessons that he taught me? One, it is not possible to enlighten a steadfast “buy, hold-n-hoper” on the benefits of active portfolio management. And two, if you tactically allocate assets as a way to protect client portfolios, you’re the enemy of the “hold-n-hope” business model. (The more I think about it… his interest in how we manage money may have started with a client leaving him to join our family here at Pacific Park Financial, Inc.)

In any event, it is obvious that I do not have the persuasive powers to change the mind of a headstrong devotee. (For the sake of this story, let’s refer to him as Mr. McCoy.) So if you’re an intractable zealot of the “buy, hold-n-hope” investment faith, please stop reading now. What is the old saying? You can lead a horse to water?

I would like to summarize the conversation that I had with Mr. McCoy. But first, let’s be clear about something. Just because an investor or a money manager takes measures to protect a portfolio from catastrophic losses, it does not mean he/she is an evil “market timer.” I like to explain it in the context of a road trip. If you’re driving down a dark country road and an ominous fog suddenly rolls in, should you not become a bit more alert? Perhaps you might even ease off the accelerator pedal? That is what a responsible and seasoned driver would do. Active portfolio management is no different. You simply prepare for the possibility of danger.

Mr. McCoy’s response:

“Well, what happens when you take your foot off of the accelerator only to realize that there was nothing to worry about? You just wasted time and energy for no reason.”

Mr. McCoy was making a point about missing out on opportunity. Indeed, if you slow down or stop driving, you may not even reach your destination. Similarly, the downside in taking precautionary measures with your investments is the possibility that you might spend a bit more time and energy yielding to hazards that never materialize.

On the other hand, what is the downside in Mr. McCoy’s position? What if he doesn’t take his foot off of the accelerator and there just so happens to be a fallen tree around the bend? Now his road trip just turned into a nightmare. In fact, the damage may be so disastrous, Mr. McCoy may never be able to get in a vehicle ever again! In contrast, the worst thing that happened on my road trip is that I arrive at my destination a bit later than I originally anticipated. But I am still getting there!

Although my point made sense to him, Mr. McCoy debated the merits of comparing a road trip with the need to generate adequate investment returns. And I suppose no comparison is foolproof. Yet, I contend that there are a number of valid points that emanate from my example.

First, Mr. McCoy prefers keeping a portfolio on “cruise control” while completely ignoring the real possibility of adverse consequences in doing so. Granted, there may be a widely accepted speed limit for driving just as there is a widely accepted age-based allocation for investing. Then again, the posted speed limit is meant to be obeyed when road conditions are optimal. Unfortunately, road conditions can change drastically due to surface or weather conditions; the presence of unusually irresponsible drivers can alter the roadway as well. Investing carries the same risks of danger. Indeed, buy-n-hold — placing one’s future retirement on “cruise control” — offers little insurance against the real possibility that financial markets fall to unimaginable lows.

Also, investing is a function of the relationship between the risk of loss and the possibility of financial reward. A responsible investor should strive to keep that risk-reward relationship at an appropriate level at all times. If we fail to do so, we create emotional traps that hinder the pursuit of financial freedom. And since the markets don’t trade at a constant, the relationship between risk and reward is not constant either. Thus, sometimes it’s better to be invested in certain things in certain periods, and at other times, it is preferable if you are not invested in certain things. A portfolio on “cruise control?” Well, it does not even attempt to address the risk of loss, let alone the time-tested measures that point to extreme levels of risk in an investment arena.

Mr. McCoy chimes in at this juncture, attempting to explain that his auto-pilot approach does deal with risk. “That’s why we diversify with bonds.” Perhaps ironically, Mr. McCoy does not even know what diversification actually means, though his assumption is that it means a little bit of this and a little bit of that. This assumption is commonplace in Wall Street. So let me clear this up right now. Owning different asset classes such a stocks, bonds, currencies, commodities and real estate may mean you own a diverse group of assets, but it has nothing to do with diversification in the world of risk management. When it comes to the risk of loss, diversification means that you own assets that are not correlated to one another, or in mathematics, their correlation hovers around zero (0). If stocks, commodities, real estate and bonds begin moving in lock-step with one another — which at risky times they do — everything can fall apart simultaneously.

Can you be at risk for severe losses with 65% in stocks and 35% in bonds? You sure can. There are periods, usually in crises and breakdowns, when most assets in the financial markets “go to one (1).” That means they are all highly correlated or, undiversified. And the result? Monstrous loss of principal. In other words, many different asset classes could go down the toilet all at the same time. After all, they have in the past. When an investor faces this “nowhere to hide” scenario, a static asset allocation model won’t help you. An active management approach that seeks shelter in highly uncorrelated assets and/or cash equivalents can.

Lastly, just like with driving a car, investing always comes with the risk of loss. Yet, just because some risks are inherent, those risks are not necessarily unavoidable. We all have an ability to maneuver around obstacles, to slow down, to speed up, and so forth. So why wouldn’t we take advantage of those options so that our road trip is as safe as it can possibly be? Unless we have a crystal ball, or unless we enjoy the extreme highs and lows of the gambler’s “let it ride” mentality, there is no good reason.

Here is where Mr. McCoy believed that he arrived at a “gotcha moment.” Since nobody can predict what will and won’t ultimately happen in the markets, isn’t it smarter to rely on a static asset allocation rather than attempt to “guess” when bad stuff will transpire? He then proceeded to discuss historical data about missing out on the best days as well as other evidence on how “you can’t time the market.”

Well, I decided to go to actual historical data at this point. For instance, let’s say that you happened to invest in stocks for the very first time on October 9, 2007. After all, stocks were on a healthy run for quite some time. Surely it would make sense to put money to work during a healthy uptrend. If you’re unfamiliar with this particular date, it was the closing high that was set just prior to the start of what would be defined as the Financial Collapse of 2007-2008. It was also a few months prior to the beginning of the Great Recession.

From the closing high on October 9, 2007 to the closing low on March 9, 2009, the S&P 500 dropped 57%. Likewise, an investment in the SPDR S&P 500 ETF (SPY) would have garnered -55% thanks to dividend reinvestment. So, in this example, your very first experience with investing in stocks netted you -55% over the span of 17 months. And although the S&P 500 eventually recouped those losses four-plus years later, you spent more than five years of your life watching a substantial investment do absolutely nothing except cause you grief and anxiety!

That’s not all. You may think that it was normal for the S&P 500 to take just four years to reclaim that 123% for one to break even; however, it was anything but typical. The markets have historically taken roughly a decade to make an inflation-adjusted rebound from a 55% loss. You just so happened to catch a break from the U.S. Federal Reserve’s emergency stimulus measures of electronic money creation and zero percent overnight lending rates. Without the controversial policies that have forced savers to gamble in higher-yielding bonds and stocks, an investor could not have dreamed of recovering from the financial collapse this quickly, if ever!

Mr. McCoy argued that the ride would not have been that bad, since nobody would prudently be 100% invested in stocks. I explained that even if your stock allocation only represented 50% of your portfolio, which would be a conservative allocation by anybody’s measure, it still wouldn’t have been easy to stomach 30%, 35%, 40% losses. Remember, many correlations can go to 1, and many bondholders of higher yielding debt, even investment grade debt, lost 15%-30% in those holdings. Not everyone had shifted their allocation to U.S. treasury bonds alone, and certainly not static buy-n-holders who likely held subprime mortgage bonds, foreign bonds, convertible bonds, high yield junk bonds and a host of non-stock assets that also lost a ton of money.

When you’re living in the moment, not knowing what the future holds, and your only saving grace is that your investments may eventual recover, or “at least I didn’t own 100% stocks,” you’re not left with warm and fuzzy feelings. Why would someone want to stick with a strategy of doing nothing — simply holding-n-hoping — as one looks out into the future?

Mr. McCoy was becoming increasingly irate with me. He insisted that active allocators of assets could make even worse decisions, either “trading one’s self out of the market” and/or “giving into hazards that never come to pass.” Is he right? In part. Those types of instances are known as whipsaw trades, where you sell to protect against the risk of loss, only to buy back in the future with little gain or even a small loss for one’s efforts.

Consider the possibility that you have a series of negative trading events. You could find yourself with a number of trades that lost 5%. You could wind up with -5% every time the market boy cries wolf. According to Mr. McCoy, most of the time you will be better off not trading at all — simply holding onto your investment through the volatility. Trying to avoid some emotional hardship was, in his words, “pointless and futile.”

Before I continue, there is an important point to discuss that Mr. McCoy unwittingly brought up here. He unintentionally made the connection between investing and emotions. Clearly, Mr. McCoy realizes that investing does not occur in a vacuum. We are all emotional creatures and our money is very important to us. It follows that our money affects our emotional well-being rather dramatically. In fact, there are actually studies that have shown an inverse relationship between stock market returns and hospital admissions. When stocks go down, hospital admissions go up, particularly for psychological conditions like anxiety and panic disorders, as well as depression.

So what is the point of investing at all if it’s just going to negatively affect other aspects of our life? Well, as with the preservation of our emotional well-being, investing happens to be a necessity for most folks to achieve financial freedom in retirement. Since we have to do it, we ought to find a happy medium that keeps our emotions and our investments in check.

This brings us back to the reduction of emotional hardship, which Mr. McCoy described as pointless and futile. Really? Even if you used the -5% whipsaw trades described earlier, and you used it as the basis for loss on one’s entire portfolio, you would need a series of occurrences that produced 16 losing events in a row on your portfolio. Luckily, I already know the statistical probability of such “streaks of bad luck.” After all, I’ve run literally hundreds of models with almost every, and any, variation of a trading rule you could possible imagine.

For example, one of the simplest active management techniques I’ve modeled is trading on the 200-day simple moving average (SMA) — where you buy when the price breaks above the 200-day SMA and you sell when the price drops below the 200-day SMA. Even making sure that the daily price execution is a worst-case scenario, where buys are executed at intraday highs and sells are executed at intraday lows, a streak of bad luck of such magnitude has not occurred at any time within the intraday price data that I have. And that’s going back more than 50 years! It has NEVER happened!

Heck, buy and holders have been mauled by four bear markets just in the last 15 years alone… and one of those was a -57% doozy! Even if you think the last 15 years were an anomaly, the long-run historical average still suggests that you should expect a bear market — with an average drop of about 30% — to occur, on average, about every three to four years. To me, that’s enough “fallen trees around the bend” to warrant some sensible action. This is especially true if you once believed that you could remain quite content on driving the posted speed limit no matter the road conditions.

We’ve probably all experienced at least one catastrophe with an investment in our lifetime. Do you really believe you will always have the earned income and days on the planet to make up for another disaster? If there’s one thing that defines our personal growth it’s the ability to learn from our mistakes. It follows that a fallen tree in our path should be enough for one to recognize that there is a better way.

Naturally, Mr. McCoy was not about to throw in the towel. He circled back to his contention that actively managing assets leads to missed opportunity. His argument is quite popular in the “buy, hold-n-hope” bag of rebuttals. The mantra? The reason buy-n-hold works so well is that you are guaranteed to participate in the best market days. Any active allocation of assets can make no such guarantee.

Does Mr. McCoy have a leg to stand on? Well, take any historical period of at least three to four years and calculate how your investment would’ve done had you missed the 10 best market days within that period. As you will see, the outperformance of a buy-n-hold would be dramatic. (SHOCKER! Miss the best 10 days or garner the best 10 days, and you see a difference.)

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Unfortunately for Mr. McCoy (and all buy-n-hold proponents), he did not consider another guarantee. You see, as a buy-n-hold-n-hoper, you are also guaranteed to participate in the 10 worst days. That’s not necessarily a guarantee for a tactical asset allocator. So, since Mr. McCoy was so willing to give me the benefit of the doubt on missing the 10 best days to be invested, I figured I’d provide him with the data that shows the importance of avoiding the 10 worst days. The below chart shows what actually matters the most.

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As you can see, psychological benefits aside, there is something to be said about the importance of missing the down days. The data summary (see the table below) also supports the notion that missing the down days is far more beneficial than participating in the up days. Average out the S&P 500’s 10 best and 10 worst trading days in the period covered by the above chart and you get a negative number (-0.14%). This negative number suggests that the 10 worst days were down more drastically than the 10 best days were up.

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Yet, as Mr. McCoy once again pointed out, it is next to impossible to predict when those good and bad days are going to occur. No person since the dawn of investing has been able to predict the direction of a market with any meaningful degree of certainty. This will never change. So, instead of possibly spinning your wheels at deciding whether you should be in or out, and instead of simply settling with a strategy that holds on through thin and thick, why not pursue an approach that represents a “happy medium?” Why not hedge your portfolio volatility by introducing a tool that is designed to be just that… a hedge against stock volatility? After all, limiting volatility can help you accomplish your financial goals, as well as make the journey less erratic — thereby preserving your emotional well-being.

I presented Mr. McCoy with my alternative. Perhaps we could work the MASH Index into the bigger picture? What might the chart look like if we invested in the MASH index during the 10 best AND 10 worst days? If the results demonstrated improvement beyond the hold-n-hope results, the MASH component would be beneficial as a means to ensuring that a hold-n-hoper did not miss out on the opportunity that Mr. McCoy was so adamant about.

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As the above chart shows, working the MASH index into a buy-n-hold strategy demonstrated improvement above buy-n-hold alone. Additionally, by providing a reduction in volatility, a concerted effort is being made to alleviate the emotional strain of being invested during hazardous periods of time. All else being equal, if the MASH index made the buy-n-hold ride much less bumpy, wouldn’t it be a worthy addition to any portfolio?

Mr. McCoy wasn’t convinced that a less volatile portfolio could outperform. Luckily, I had already run the numbers. Not only was the inclusion of the MASH index providing less volatility to a stock portfolio, but the MASH Index showed little to no correlation to stocks when they hit those “rough patches.” That is the essence of genuine diversification!

How exactly did the “stats” turn out? The MASH index provided a much smaller standard deviation than that of the S&P 500. Keep in mind, a “standard deviation (σ)” is a method for measuring the volatility of an investment. One standard deviation (1σ) represents a range in which the investment trades approximately 68% of the time, two standard deviations (2σ) represents a range in which an investment trades approximately 95% of the time, and three standard deviations (3σ) represents a range in which an investment trades approximately 99% of the time.

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As the table above shows, the day-to-day trading range for the S&P 500 was at least 2x that of the MASH index at each measurement. For example, the S&P 500’s three standard deviation (3σ) reading meant that it traded within an 11.39% day-to-day range 99% of the time from 7/1/2011 to 4/30/2015, as opposed to MASH trading in a narrower band of 4.49%. The larger the trading range, the more volatile the investment is.

That’s not all. Remember the previous table which summarized the S&P 500’s 10 best and 10 worst days? Well, that was only a piece of a much more compelling story regarding correlation between stocks (the S&P 500) and the MASH index.

I wanted to look at more than just the 10 best/10 worst days. So I decided to look at the 10 best/10 worst weeks, months and 3-month periods. I chose to investigate the same information for the MASH index. (See the table below.)

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If avoiding the down periods is a predominant attribute of successful investing, the “Worst Low” and the “Average” columns under the S&P 500 and the MASH sections should lead to some eye-opening revelations. First, the “Worst Lows” were much more stable and manageable with the MASH index, as compared to the S&P 500. Second, the “Average” of the 10 best/worst periods are positive across the board for MASH. This insinuates that MASH’s 10 best periods were up more drastically than the 10 worst periods were down. This is in stark contrast to the S&P 500.

Mr. McCoy was listening, of course, but he was becoming increasingly agitated. I couldn’t help myself. I still had more to show him.

You should recall that I presented the notion that the MASH index had little-to-no correlation to stocks when stocks hit those “rough patches.” So I defined those “rough patches” in the recent past for Mr. McCoy. Between 7/1/2011 and 4/30/2015, the S&P 500 has experienced four instances where it fell by more than -6.66%, which corresponds to the 10-worst trading days in the table above.

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As you can see, my data showed that by instituting a non-correlated, less volatile option like the MASH index, an investor could’ve improved the performance of his or her portfolio. Investors need not be relegated to holding-n-hoping stock assets without any type of parachute.

“So… in summary, Mr. McCoy, not only can a more proactive approach to investing reduce the emotional strain of watching your money disappear by 30%, 40% or 50%, you can minimize the financial stress as well. And since one’s overall return is directly related to one’s time as a participant, one can also save a bunch of years by avoiding the potential hazards in the roadway.”

[PHONE CLICK]

“Mr. McCoy…are you still there??? Mr. McCoy???”

If you are interested in learning more about the FTSE Custom Multi-Asset Stock Hedge (MASH) Index and whether it is appropriate for your portfolio, give us a call at 888-500-GARY (4279). Additionally, please click here to inquire about investing in the MASH index for FREE for the remainder of 2015.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Money for Nothing and Risk for Free?

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“The FOMC decided today to keep its target range for the federal funds rate at 0 to 0.25 percent.”

Since the December 2008 Federal Open Market Committee (FOMC) meeting, the above-described policy guidance has been a mainstay in every subsequent statement. That’s 56 meetings in a row for those of you who may not be keeping score.

What does it mean when committee members explain that the Federal Reserve will “keep its target range for the federal funds rate at 0 to 0.25 percent?” In essence, the Fed is simply setting the rate at which the biggest and most creditworthy banks may lend to one another.

Isn’t this a bit like borrowing money for nothing? You bet! Think of the banking system as a giant pyramid of credit, with the Federal Reserve sitting at the top. By setting the rate at which the largest banks lend to one another, the Fed creates a ripple effect in borrowing that resonates throughout the pyramid. Consumers like you and I sit at the very bottom of that pyramid.

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It follows that for 56 meetings, over six-plus years, borrowers have had it pretty easy. And who has been borrowing? Corporations have borrowed “on the cheap” to buy back stock, increasing demand for a dwindling supply of shares and pushing prices to all-time record highs. Consumers have borrowed cheaply to finance and refinance mortgages as well as to maintain standards of living that are not being maintained by inflation-adjusted declines in wages.

Disturbingly, the Fed has expressed a desire to raise bank-to-bank lending rates in 2015. When they do raise the target, it will effectively tighten the lending gears, potentially crippling the demand to borrow and making it less affordable for businesses and corporations to take on new debt. It also makes it more challenging to service the old debt, as higher rates will need to be paid on the old debt’s interest.

From the debtor’s (borrower’s) perspective, ultra-low rates are viewed as positive. We get to buy more houses, cars, LED televisions, iPads, stocks (on margin) – we can acquire more stuff than we otherwise would not be able to afford if the borrowing costs were much higher. Indeed, consumption patterns of borrowing-n-buying and the effect that those patterns have on the overall economy can be traced back to Fed policy.

From the creditor’s (lender’s) perspective, however, ultra-low interest rates are dreadful. After all, if you lend your money to a company for five years, shouldn’t you be paid a reasonable amount of interest for the risk that you are taking? Unfortunately, in today’s world, you’d be lucky to get 1.5%-1.75%, or less than the overall rate of inflation. Without a doubt, when the Fed favor’s borrowers – to this extent and to this length of time – conservative investors and savers suffer. The CDs and investment-grade debt that used to yield a comfortable 3%-6% disappears, and similar returns can only be pursued in far riskier junk bonds.

From “Risk-Free” To “Free Risk”

Risk-free CDs would have paid you 4-5% eight years ago. CDs and investment grade bonds could have been laddered to provide many retirees predictable and reliable cash flow in retirement. When was the last time that you witnessed a bank offering a 5% CD? Where do you go today to get that kind of return?

Unfortunately, everyday folks have been forced by the U.S. Federal Reserve to invest in far riskier assets than ever before. Higher-yielding junk bonds. Dividend paying stocks. Heck, a 2% dividend yield may not even cut it, so many have resigned themselves to investing in the broader U.S. stock market to maintain a standard of living. Hence, demand for stocks goes up and, just as Economics 101 teaches us, so too do the prices of stocks.

Not surprisingly, the current bull market in stocks entered its seventh year this past March. Throughout the years, the Federal Reserve combined zero percent interest rate policy with emergency measures (i.e., quantitative easing) to further decrease longer-term borrowing costs. Six months ago, however, the emergency stimulus of quantitative easing (QE) ended. What’s more, the Fed is mulling over how and when to raise rates here in 2015.

Does that mean the tide in stocks could shift because the Fed is expected to raise rates? Perhaps. But you shouldn’t hold your breath. The rising interest rate story has been so popular for so long, it begins to sound more like a fairy tale. The truth is, if the Federal Reserve pushes up its overnight target lending rate, it would likely cause borrowing costs to rise for highly indebted states (e.g., Illinois, California, etc.) and highly indebted countries (e.g., Brazil, Italy, Spain, etc.). Those would be interest payment hikes that those states and countries would struggle to afford.

Okay, but with rates already this low, how on earth could they move any lower? Well, the world now has “negative interest rates.” That’s right… negative interest rates! Crazy as it sounds, there are several European central banks that have cut rates well below zero, including Switzerland, Sweden and Denmark. It is a bid to lower the value of respective currencies to remain competitive as well as a desperate attempt to punish banks and bank depositors that are hoarding cash. After all, an economy cannot grow unless consumers are spending.

Now I’m not saying that we will ever reach that same level of desperation that we are seeing in Europe. On the other hand, interest rates have been moving lower for 34 years – nearly three-and-a-half decades – and there’s very little reason to expect the trend to change now. Not only do the credit spreads between U.S. sovereign debt and foreign sovereign debt need to contract, but the U.S. government and U.S. households may not be capable of handling anything but incredibly low interest rates.

So, where will the Fed take rates by the end of this year? Although it’s difficult to say, there is some writing on the wall. In December of 2014, the Fed officials’ median estimate on the federal funds rate at the end of 2015 was 1.125%. In other words, Fed officials were expecting to raise the overnight lending rate by a quarter of a point (0.25%) in four or five out of the eight FOMC meetings scheduled in 2015. Reality quickly altered that view, however. It took only three months’ worth of weak economic data for those same Fed officials to slash their median estimate from 1.125% to 0.625%.

So with two FOMC meetings already in the books without a rate hike, Fed officials are now expecting only two rate hikes by year’s end. Can you begin to see how certain addictions are nearly impossible to break?

How Long Can The Bull Market Carry On?

With that said, the idea that ultra-low rate policy can forever push riskier assets like higher-yielding bonds and stocks higher is misguided. Granted, the Fed’s monetary policy has been the single most important factor in driving the prices of stocks, bonds and real estate upward. Yet ultra-low borrowing costs is only a means to an end, not the “end-all-and-be-all.” What is the “end-all-and-be-all” in the world of successful investing? CONFIDENCE.

Confidence allows stocks to hang out at historically high valuations in spite of weak corporate earnings, negligible wage growth and decelerating gross domestic product (GDP). To put it another way… if I told you that we would need to keep the overnight lending rate at 0% for another six years, plus inject another $3 trillion in electronic dollar stimulus to keep the economy afloat, would you have the same confidence as you have developed over the previous six years?

The S&P 500 has climbed more than 200% already. Clearly, stock investors have been supremely confident that the Fed can and will do whatever it takes to keep recessionary pressures at bay. Every previous round of QE has been proof of that fact. Nevertheless, there will come a day when the Fed will misstep (e.g., move to slowly, move to quickly, move too far, not move enough, etc.) where confidence in the smartest people in the world begins to wane.

Gary and I frequently discuss the options that we think the Fed has with regard to monetary policy. Whether they take interest rates higher, keep them low, or inject another round of QE, investor confidence can keep the bull market alive. Sooner or later, though, the Fed will appear out of touch and/or look desperate; sooner or later, a serious policy misstep is likely to tilt the pinball machine.

Think the Fed’s powers of persuasion are unstoppable? Think again. Many recall how the Greenspan-led Fed raised rates too erratically and too quickly leading up to the 2000 dot-com disaster. Others should remember that the Fed raised rates 17 times in an orderly fashion, too slowly to curb housing speculation. And when it was clear to nearly everyone that the economy was in a serious slump, the Fed had been way behind the curve by not lowering rates sooner and quickly enough; the 2008 financial collapse decimated trillions in wealth.

This is not to say that bad things would not have happened had the Fed played their cards perfectly. On the contrary, bad things would have happened for one reason or another, to one degree or another. The take-home here is the reality that the Fed is not infallible, nor is confidence in the central bank a permanent state in the collective conscience of investors.

Let’s keep in mind, the S&P 500 has been struggling to eclipse the highs set on March 2. If that does not change quickly, the bull may be heading out to pasture sooner than many are anticipating.

Am I predicting the end of the second longest bull market in over a century? Hardly. As an investor and money manager, I need to consider the ramifications of risky behavior shifting toward risk aversion. It may be time for you to consider those ramifications as well.

If you’re looking for a strategy that may protect your portfolio from a sharp reversal of fortune, get acquainted with the FTSE Custom Multi-Asset Stock Hedge (MASH) Index. Give us a call at 888-500-GARY (4279) or click here to learn more on how you can invest in the MASH index for FREE for the remainder of 2015.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Are You Seeing the Forest for the Trees?

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At the beginning of last week, the FTSE Multi-Asset Stock Hedge (MASH) Index bypassed the S&P 500 in year-to-date (YTD) performance. The substantial pullback in stocks that occurred on Wednesday, March 25, 2015, added fuel to the fire. Specifically, the S&P 500 is struggling to keep its head above water, while the MASH index is up 2.4% YTD.

Which components are primarily responsible for the MASH index’s outperformance?  There are 10 components that, historically speaking, effectively hedge against stock risk. Only one—German Bunds—is trailing the S&P 500. (See below.)

1. U.S. Dollar 7.05
2. 25+ Year Zero Coupon U.S. Treasury Bonds 6.06
3. Swiss Franc 3.46
4. 10-20 Year U.S. Treasury Bonds 2.51
5. Inflation-Protected U.S. Treasury Bonds 1.48
6. Gold 1.3
7. Japanese Yen 0.47
8. Japanese Government Bonds 0.34
9. National AMT-Free Municipal Bonds 0.23
10. 10.5+ Year German Bunds (1.04)

There are a couple of clear standouts in the component-by-component analysis. First, longer-maturity U.S. Treasury bonds have been superstars on the back of lower long-term interest rates. Although the Federal Reserve has been clear on the direction that they’d like to take their target (which affects the shortest end of the yield curve), the ongoing theme is one where rates on the long end of the yield curve continue to fall.  Investors with allocations in longer-term treasuries have been handsomely rewarded.

The idea that long-term interest rates have been falling for 15 months has been highly unpopular in the media, yet highly rewarding for our clients here at Pacific Park Financial, Inc. My colleague, Gary Gordon, president of Pacific Park Financial, Inc., not only wrote about investing in those ETFs which would benefit from falling long-term rates, he allocated client dollars to those ETFs back at the start of 2014. Those allocations are part and parcel of the multi-asset stock hedging strategy that MASH represents.

How unpopular was the idea that interest rates would fall, not rise, in 2014? Bloomberg regularly conducts a survey amongst top economists on the direction of interest rates. Their survey revealed that 100% of economists expected interest rates – as determined by the U.S. 10-Year Treasury – would rise from 2.86% at the time of the survey to 3.41% over the next 12 months. The 10-year actually finished at 2.17%, and multi-asset stock hedgers with exposure to 10-20 year treasuries and 25+ treasuries were richly rewarded.

Certainly, the presumption that interest rates would rise in 2014 was logical. After all, the Fed began dropping hints in May of 2013 that they would have to begin weaning the U.S. economy off quantitative easing (a.k.a. buying bonds with electronic dollar credits to hold rates down). And those hints worked! A “taper tantrum” was born such that the 10-Year shot up 140 basis points from 1.63% to a multi-year high of 3.03%. (See the chart below)

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Surely, if bond market yields were soaring – and the Federal Reserve planned on tapering its bond buying to depress rates – the U.S. economy was ready to stand on its own two feet, right? After five years of zero percent rates and emergency level QE stimulus? Indeed, nearly every prominent voice began to describe the U.S. economy as “self-sustaining.”

So why on earth did we believe interest rates would fall, not rise, in 2014? Why do we still believe that rates will continue to fall, rather than rise?

For starters, the central bank of the United States primarily affects the short end of a 0-30 year yield curve. It does so by setting a target, intra-bank, overnight lending rate. However, when the Fed raises its target on the “zero” years side of the equation, investors who do not believe the economy is self-sustaining tend to gravitate to securities with a reputation as safe, long-term U.S. treasuries. Whereas the popular belief at the time had been that short-term and long-term yields would rise all along the curve – whereas the feeling was one that the economic picture was brightening – our conviction was that the global and domestic prospects were weakening. It followed that we believed efforts to push short-term rates higher would only encourage investors to seek shelter in longer-maturity yields.

Are we saying that the yield curve would get flatter and flatter? Possibly invert in spots? That a recession might be just around the bend? Yes. You read that correctly.

If the labor force continues to shrink, wage growth continues to decelerate, if corporate earnings continue to weaken, the market will demand the safety of long-term U.S. treasuries. There’s nothing the Fed can do to stop it. In fact, the Federal Reserve might even make things worse. They know that a rapid rise on the short end of the yield curve could, conceivably, push the U.S. economy into recession. That’s why all of the talk about rising rates amounts to little more than chatter.

From our perspective, a strong showing for bonds could be a theme that lasts for years to come. Consider that an equivalent yield on a German 10-year bund—let alone a Spanish bond (yes, the sovereign debt of beleaguered Spain)—is less than the U.S. 10-year. Where should a safety-seeking investor go if not the U.S.?

In truth, our conviction regarding lower interest rates, not higher ones, is not particularly hard to grasp. Take a look at the chart of the 10-year going back to the early 1980s. Can you spot the trend?

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If you think that falling interest rates since the early 1980s will somehow reverse direction, then you’ll need to take into account one more trend: government spending. Decade after decade, government spending has gone up. In fact, where interest rates have fallen by roughly 88% since the early-80s, the U.S. debt as a function of economic output (GDP) has more than doubled!

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Why is it important to talk about government spending? Well, take a look at the chart below. If you take the data back as far as it will go – back to 1926 – interest rates are inversely correlated to government debt. When government spending decreases, interest rates go up. When government spending increases, interest rates go down.

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In essence, interest rates will not bottom out until and unless our government debt peaks like it did in the 1940s. The way the U.S. is spending today – with reckless abandon – there is little probability that government spending will be curtailed to bring our debt-to-GDP ratio back down to more sustainable levels. It follows that interest rates will not make genuine moves higher as long as public debt (accounts payable) exceeds economic output via our GDP (accounts receivable).

Think about it. If your monthly credit card bill is higher than your monthly income, what do you do? Any effort to pay off your debt goes from futile to hopeless. Unlike the average Joe, Uncle Sam has the power to tax its citizens to potentially increase short-term revenue, although that approach can ultimately limit economic output. That leaves one last hope for the U.S. government—the Federal Reserve. The Fed can create money out of thin air to purchase bonds and push down interest rates (its “credit card APR”). In fact, the Federal Reserve’s dirtiest little secret is that interest rates NEED to be kept low in order for the U.S. government to service its monstrous obligations.

Bloomberg’s annual surveys of top economists notwithstanding, investors need to see the forest for the trees. Longer-term interest rates are more likely to fall than rise. And that’s a trend we’ve been telling investors about for 15 months now.

The other half of the MASH story is the U.S. dollar. It’s not hard to see why the almighty greenback has shot to the moon since hitting near-historic lows in May of 2014.

As the chart below shows, the U.S. Federal Reserve began slowing down its third round of quantitative easing (a.k.a. QE3) on a monthly basis back on December of 2013. The Fed finished the tapering process by October of 2014. In a manner of speaking, the U.S. finally curtailed its electronic money printing endeavor.

Shortly thereafter, Japan and Europe began their own quantitative easing parties. First, Japan dropped its bombshell to electronically print yen for the purpose of purchasing its country’s bonds and stocks. Then in January of this year, Europe unveiled its mammoth electronic euro printing at an estimated €1 trillion (up from an anticipated €600-700 billion).

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The net effect of Japan and Europe—and a whole host of other sovereign central banks now engaged in currency devaluing policies around the globe—have caused the dollar to soar against those global currencies. Alas, the currency wars could wind up being the proverbial straw that broke the stock market camel’s back.

Could a significantly stronger dollar cripple U.S. corporate profits? It is already happening, with first quarter earnings estimates turning negative for the first time since 2009. With median stock P/E ratios and median stock P/S ratios at their highest levels in recorded history – with stocks more expensive than they’ve ever been before – what is your plan for protecting against a severe bear?

Please click here to learn more about the MASH index.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.

Bracing Your Portfolio for Impact

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After spending most of January and a good part of February in negative territory, the S&P 500 rallied through March 2nd to set all-time record highs. Shortly thereafter, on the other hand, volatility returned to the mix. For example, on Tuesday, March 10th, the S&P 500 turned negative for 2015 after logging its second worst performance of the year. What’s more? So far in the month of March, the S&P 500 has failed to log two consecutive up days.

Now Gary and I don’t want to be a boy who cried wolf, but we feel that the stock market is exceptionally likely to see a pullback in the very near future. And it could get ugly. Considering the fact that we have not seen a significant stock sell-off since Greece stoked the Eurozone Crisis flames in the summer of 2011, many may forget what it’s like to endure an 18.8% plunge in prices over a few short months. Or worse… a monstrous 55% decline over 1 ½ years (2007-2009).

Unfortunately, the news for stocks is not improving. Gary and I recently conducted a historical study of popular price statistics used to gauge stock valuations. The premise? At which point did over-inflated balloons come crashing back down to earth? And how do those previous occurrences compare with today’s stock valuations?

We compared the current median price-to-earnings (P/E) and price-to-sales/revenue (P/S) with previous points in history. Notably, we were interested in those periods of time that led up to the point in which stocks cratered into the ground—periods like 1929, 1973, 1987, 2000 and 2007. Our conclusion? Those fundamental metrics put the current price of stocks at loftier levels, on average, than all of those previous periods which led to some of the biggest market catastrophes ever!

The bad news does not end there. Being the numbers geek that I am, I crunched some statistical figures to provide me with perspective on the probability of our current bull market cycle’s continuation. Does it still have legs?

Bull Markets

Looking at data for the Dow Jones Industrial Average (DJIA) going back to 1900, we are currently in the 35th bull market cycle. The average bull has lasted 795 days with an average cycle growth of 90%. The current bull market for stocks in the Dow? It currently stands at 2,184 days and 179% (as of the most recent high set back on 3/2/15). According to these stats, there is only a 2% chance that the current bull market will continue beyond 2,224 days.

Could we have already started the 35th bear market since 1900? Well, if the March 2nd highs are not revisited within the next 30 days or so, the likelihood is extremely high that the second longest bull market in history has concluded.

Bear Markets

If the bull really has run its course – if the bear is gearing up to maul – then you need to take immediate action to protect your dollars. The average bear market drop is 32% and lasts roughly one year. Can you really afford to lose ONE-THIRD of your portfolio’s value over the next 12 months?

If you recognize the absolute necessity of protecting your wealth, then get acquainted with the FTSE Custom Multi-Asset Stock Hedge (MASH) Index. The MASH index is a tool that Gary and I developed to help protect our clients from the inevitable bear that looms on the horizon. Please click here to learn more about the MASH index.

 

Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. StockHedgeIndex.com is created independently of any advertising relationship.