Monthly Archives: March 2015

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.

Everything Is Awesome? Time To Rethink Your ETF Asset Mix

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Less than three months ago, analysts everywhere argued a case for economic acceleration. It was almost as if financial authorities big and small had held a convention at LEGOLAND in California to declare that, “Everything Is Awesome.”

Everything is not awesome. Jobless claims hit 10-month highs, factory orders have dropped for six consecutive months, consumer spending has been waning, exports have been declining and demand for raw goods as measured by shipping rates have been notching historical lows.

In fact, the only thing that can genuinely be described as wonderful are investor account values. The Vanguard Total Stock Market ETF (VTI) remains within one percentage point of a brand new record and the Vanguard Total Bond Market ETF (BND) has been in a long-term uptrend since the start of 2014. Any traditional asset allocation mix has bolstered the wealth and well-being for those with 401ks, IRAs and brokerage accounts.

BND 18 Months

Nevertheless, there is a disconnect between investor expectations and economic realities. If one expects an economy to accelerate, one may conclude that corporations will generate more revenue and more profits, thereby justifying increasing prices for stock shares. If one expects economic deceleration – if sales and profits are not even expected to grow on a year-over-year basis – one might anticipate equity prices to remain range-bound.

However, stocks already command sky-high premiums. Moreover, the Federal Reserve appears determined to normalize interest rates which might cause the economy to grind to a halt. It follows that equities may fumble on the way to flatness, eventually pulling back 10%-15% at some point in 2015. Rare is the historical circumstance when decelerating economic activity and overvaluation did not combine to cause a stock market correction. Mix in a policy misstep by the Federal Reserve or a crisis abroad, and the probability of a bearish outcome increases.

Six years of quantitative easing (i.e., QE1, QE2, Operation Twist, QE3) and zero percent rate policy guided the U.S. economy toward an average growth rate of 2.2%. That is well below the 3% longer-term average. What is particularly disturbing about this truth is that – since QE3 ended on 10/29/14 – the overall economy has steadily weakened. What happened to the notion that the economy is “self-sustaining?”

Most folks expect the Fed to push off rate hikes into the 4th quarter, giving them reason to keep buying stocks on every modest dip from all-time peaks. Indeed, even if the economy became fragile enough to stoke recessionary fears, most seem to believe that the Fed would backtrack to the point of providing additional rounds of QE stimulus. The message? Don’t stop buying and don’t stop believing in the Fed.

On the other hand, what if central bankers stateside weigh the benefits of permitting a smaller recession today to avoid a massive speculative bubble from exploding down the road? What if letting some air out of the severely overvalued equity and debt markets now makes more sense to committee members than riding to the rescue at the first sign of fragility? After all, it is well-documented that neither Greenspan nor Bernanke – chairmen of the Fed prior to Janet Yellen’s arrival – were able to respond quickly enough to prevent the monstrous dot-com disaster (2000-2002) or the systemic financial collapse (2008-2009).

In spite of the NASDAQ 5000 headlines, other signals have been flashing yellow. Margin debt on the NYSE, a sign that investors are willing to borrow to leverage upside gains, has been declining steadily. Margin debt currently sits below a 12-month average. Similarly, the NYSE Composite has not been able to break above resistance levels set back in July.

NYSE Index

So how might one handle the high likelihood of a stock market pullback? Apply insurance principles to the investing process. A 65%-35% growth-income investor might decide that a better tactical asset allocation for the current environment would be 50%-30%-20% such that the 20% cash buffer acts as a intermediate-term insurance policy against a sharp downturn. The cash buffer might also be employed in a corrective phase; that is, one can incrementally purchase equity and debt during the pullback, averaging one’s way back to the 65%-35% target.

Others may wish to employ a multi-asset approach to stock hedging. Specifically, there are certain assets that have historically succeeded at a time when stocks are being eviscerated. Currencies like the Swiss franc, U.S. dollar and the Japanese yen – each for different reasons – tend to appreciate in stock market bears. The sovereign debt of Germany and Japan have acted as safer havens. Precious metals like gold have often seen strong demand. Finally, a wide variety of U.S. debt – munis, zero coupon, long-term treasuries, inflation-protected – were winners in the 2008 catastrophe and the 2011 eurozone crisis.

For those who wish to beat the bear without shorting or leverage, combining a wide variety of bear-bashing assets may be preferable than T-bills or cash alone. One can look to track an established index like the FTSE Custom Multi-Asset Stock Hedge Index or purchase individual ETF components with potential. For instance, inflation expectations may be non-existent, yet the iShares TIPS Bond Fund (TIP) has still provided low-risk value to its owners with a 1.3% total return in the first few months of 2015.

TIP YTD

 

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.