IronBridge Insights

Last week saw the fastest 10+% decline from a 52 week high in history. From peak-to-trough, the S&P 500 Index fell over 16% in 6 days. Additionally, all S&P 500 sectors declined 10% or more over the same period. This also occurred on a global scale, where every country’s stock market in the world has seen a sea of red. Even gold, precious metals, and commodities were being sold on widespread fears over the corona-virus.

“All things are subject to interpretation…whichever interpretation prevails at a given time is a function of power and not truth.”

-Friedrich Nietzsche

Portfolio Update – Is Everyone Awake Now?

It was a bloodbath last week, so let’s get right to the point. With the intensity of the latest decline, many records were broken. It was not pretty and (for the time being anyways), it will go down in the record books.

While we are caught up in the day to day volatility of the markets’ ups and downs, it is important that we also take a step back and remember that weeks like the one we just withstood is the primary reason we have built the processes we have around managing portfolios. Having a plan is so important during times of increased volatility, as these processes are put in place with the purpose of navigating through the markets, regardless of the backdrop. Having a process and plan before times like these are upon us is crucial in being able to come out the other side intact.

Part of our investment process that does not get used very often is recognizing when panic conditions exist. Various quantitative indicators we measure are designed to recognize severe and abnormal volatility. When certain criteria exists like it did last week, it is much better to not sell into the panic, and instead wait to re-evaluate as these conditions subside. The panic conditions are indeed starting to calm (at least for now), and we are now analyzing data on prudent next steps to take.

Although the severity and swiftness of the move was unprecedented, our strategies performed as expected. Here specific actions that we took for clients over the past few weeks:

• In early February, we sold all international and emerging market stock exposure and moved into long-term US Treasury bonds.
• There was an ETF that liquidated on February 14th, and was in cash prior to the move lower.
• Once the selloff began, we received sell signals on a few individual stocks, which increased cash across client portfolios.
• We sold high yield bond exposure one day after the selling began, further reducing risk.
• Following the third day of selling (that included two 1000-point down days and one 800-point down day on the Dow), our panic signals kicked in and advised us to stop making additional sells.
• By last Friday, we began adding stock exposure as well as repurchase some existing holdings near the bottom of this move.
• We also rotated out of some stocks that weren’t working well and into others that were showing more resilience and better opportunity.

Overall, we have been very pleased with how our strategies performed through all the volatility. (If you have specific questions on your account, please do not hesitate to reach out as always).

However, we are still concerned about what may happen next.

It appears as though the risks and uncertainties around the corona virus are to blame for the recent selloff. At this point, we do not think it is prudent to try to understand all the possible outcomes of what the corona virus may do. We only know that there are very bad scenarios, yet also some not-so-bad ones.

The main problem we see with diagnosing the virus outcomes is simple…what should we believe? The number of cases globally could be massively understated, as there are simply not enough testing kits to possibly test everyone who has symptoms. Also, there could be millions with the virus that are asymptomatic, or not showing any symptoms right now.

Would that be good or bad? It would be bad in that it would likely increase the panic surrounding the virus. But it may also be good in that it could make the actual mortality rate much lower than it appears now, and possibly less fatal than the flu.

Those in power across the globe are determining what information is appropriate to disseminate, and we can’t help but be skeptical about what are actual facts.

It would be difficult enough to predict how the virus may or may not spread. Trying to then predict how markets will respond to a potentially endless number of scenarios is infinitely more complex. Add to that uncertainty around the actual data, and there is a recipe for prediction disaster.

We have said many times that we simply don’t care why the market is doing what it is doing. We simply want a plan on how to handle what happens.

We want to understand the landscape and potential impacts, and we continue to monitor a variety of risks very closely. But ultimately it doesn’t matter why. This is why we rely on a process, not guesswork.

Which brings us to simply analyzing what “is” in the market right now.

First Correction since 2018

The S&P 500 fell over 16% from peak to trough in only 6 trading days. Since the decline exceeded 10%, we now have seen the first market correction since the 4th quarter of 2018. Let’s look at some of the unique characteristics of this latest fall from grace and where we may be headed from here.

The first chart below (courtesy of Bloomberg and LPL) shows just how swift this was compared to other 10% drawdowns. Officially it was the fastest decline of 10%+ from an all time high on record since the S&P 500 Index began on March 4, 1957.

This took prices all the way back to January 2018’s top (SPX 2875). At one point during this recent decline, 2 years of gains were wiped out.

The chart below shows that reality.

Do you think those January price levels are important? You bet they are! This is the quintessential definition of support and resistance levels. January 2018’s previous resistance has now become February 2020’s support. This is a key level to watch if selling resumes.

Another unique characteristic of this decline is just how widespread it was. The decline touched every single S&P 500 sector in a very negative way, offering up a little humble pie to those who rely solely on diversification to protect their portfolios from “risk”. Even the typically less volatile sectors (Consumer Staples and Healthcare) were down more than 10%. The drawdown column in the below chart shows the decline of each sector from their recent 52 week highs. Staples fell 10.56% while Energy was down a whopping 27.50%

In a week where Treasury bonds skyrocketed, it is inconceivable that Utility stocks, with the highest correlation to Treasuries and the lowest correlation to the S&P 500, still fell 12.5%! Yet, these are events we just witnessed and goes to show you cannot depend on diversification to protect you in the event of a stock market decline. If nothing else it’s likely a testament to just how stretched we had gotten on the upside.

They say that the four most dangerous words in investing are “this time is different”, yet time and time again we find unprecedented

and “different” events occurring in the markets. We think largely that quote is meant for higher level behavioral finance concepts, like fear and greed always being present in the markets; not for in-the-weed statistics like the ones above, but it’s hard to argue with the fact that actually, yes, this selloff was different.

An example of how this time was “different” was that diversifying your portfolio alone did not help you during last week’s slaughter (this is quickly becoming a common theme during selloffs). This is one reason why our strategies don’t rely solely on diversification to protect during drawdowns.

In the next chart below, international stocks also showed how widespread the selling was and how little diversification did for your portfolio. As of Monday, March 2, Every major stock market in the world had significant price drawdowns from their highs, with many down 15% or more. The median drawdown was 14.41% across the world over the last few weeks.

Another interesting aspect, and another continued knock on modern portfolio theory, the S&P 500 continues to massively out-perform the other markets around the world, even with its significant decline in February.

Anyone Hear the All-Clear Siren?

So are we all clear? Is the selloff over? If this decline is like most of the recent ones, then it would not be difficult to assume that yes, this decline is now over. The chart and statistics below, courtesy of SentimentTrader.com suggests that generally, after such a swift pullback in the markets, stocks are up over the next 6 months.

The chart and table below show the results from the other times the market fell so quickly from its all time highs. Of note, though, is one year later the average return has been flat, so that’s certainly a possibility. In addition and shown in the table, there are less than 10 data points, not near enough to try to make a statistically based gamble on the direction of the market, but if we were to accept these examples as representative then it would be safe to say we could be 1-12% higher in 6 months with a big risk we retest the lows within a year (note: we are already 5% higher after Monday’s, 3/2/2020, rally).

Other Times the Market Fell This Swiftly from an All Time High

Additionally, on Tuesday, March 3, the Federal Reserve also tried to come to the market’s rescue as it did its first “surprise” rate cut since 2008, a 50 basis point cut “in order to get ahead of the potential economic disruptions resulting from the Corona Virus”. This was a major surprise and the market initially liked it, up 1% on the news, but then immediately gave back all those gains and then some closing down over 2%.

Our Fed Monitor suggests this was an unnecessary move by the Fed and only means they have less ammo if a recession does eventually develop and they need to cut the remaining 1%. Our Fed Monitor is shown below through last week and reveals the 3 month Treasury rate has not really moved that much during the last month (while the longer end of the Treasury curve has been tanking). Based on our model, the Fed Funds rate was only 16 basis points above the market’s 3 month Treasury yield, right in the historical normal range between + or -20 basis points. This latest Fed move puts them near a historically low 30+ points below the market rate. It seems they may have reached for this one.

Nevertheless it is just another data point that the Fed “has the market’s back” as global central bankers continue to do all they can to keep the bull raging.

Looking Forward

What if this decline is like 1987 or 1989 or 1999, when the market saw further declines following such swift corrections from an all time high? After all, and shown in the table above, 3 of the 8 other times this occurred saw the correction fall further at some point within the next year.

The good news is we don’t have to try to guess if that will be the case. That’s one of the luxuries of having a process-driven portfolio management system. We are prepared for either outcome and we don’t have to guess what the market will do next. Besides being impossible to do, guessing what the market will do leaves a manager relying solely on luck rather than skill in navigating the markets.

If this decline is like all the other recent ones and wants to “V” bottom here (a term given to a swift decline that is immediately followed by a swift rally due to its shape of a “V” as viewed on a chart), then our client portfolios are already prepared for such outcomes.

However, if “this time is different”, and the recent decline does not hold, we have our strategies in place that will, once again, have us moving into safety and raising cash as necessary, just as they were designed to do.

On Monday, March 2, the Dow rallied the most points in its history, up over 5%, gaining back some of last week’s losses, but then those gains were half given back on Tuesday, March 3. So where do we go from here?

If you have followed our research for awhile you may remember a piece we put out entitled, “What does a Market Top Look Like?” In it we recognized a few technical readings that seemed to appear during topping processes. One of those is an initial decline that is followed by a bounce into a key resistance zone.

Right now that resistance zone is in the range of 3050 to 3120, where prices are trading as we go to print, so we are right in that first area of resistance. A rejection in price at this level, followed by a resumption of the downtrend back below last week’s and January 2018’s price high (discussed earlier) would be a bearish event and similar to other major tops that have occurred during our lifetime.

However, if price can continue to move higher from here, through the green shaded area and above the 3260 level, it is likely we have ourselves another “V” bottom, and we should look for new all time highs once again.

Invest Wisely!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

After months of very low volatility, fears over the potential negative effects of the corona-virus on the global supply chain is causing markets to take an overdue pause.  Markets underwent a large sell-off today. The Dow Jones fell 1,031 points, and the S&P 500 was down over 3.3%.

In this issue we put this decline into context, identify short-term, intermediate-term and long-term support levels, as well as analyze the potential effects of the corona-virus going forward.

“Medicine is a science of uncertainty and an art of probability.”

-William Osler (1849-1919), founding professor of Johns Hopkins Hospital

Market Update

In our last issue of IronBridge Insights, we noted the following:

“Despite threats of World War 3, impeachment proceedings, and the recent threat of a pandemic virus sweeping the globe, markets have been resilient. Earnings have been positive for the most part, and there have been no major surprises economically. Essentially the market has been saying “No Big Deal” to every potential downside catalyst.” – IronBridge Insights “The One Thing”

Well, looks like volatility finally made its return.

What are the potential causes?

1. Corona-virus. This is the most likely reason volatility has returned. We are not epidemiologists. Neither are the dozens of market analysts who are trying to predict the next phase of this potentially very harmful virus. There are supply chain disruptions occurring in China and elsewhere, and the threat of uncertainty can indeed have tangible economic effects. More on this below.
2. Earnings. An increasing number of companies are announcing that they will not meet projected earnings for this quarter. The big daddy, Apple, was the most prominent company to warn that the effects of a supply chain disruption in China will have a negative effect on its Q1 numbers.
3. Politics. Bernie Sanders is the clear front-runner to be the Democratic nominee. Some people have said that the market is selling off because of fear of Bernie’s policies on markets and the economy. Others have said that the market is selling off because a Bernie nomination increases the likelihood of another four years of the Donald. Our view is that politics should not be a major input in any investment process. There is too much emotion and not enough actual data supporting positive or negative political effects on prices. So we’ll simply let the market do what it is going to do, and adjust as our system tells us to do so.
4. The Fed. The Fed once again started printing money in September. Last week, they began slowing these purchases slightly. Is it a coincidence that volatility has returned as the Fed begins to slow down its printing machine?

Despite the other potential reasons, it appears that the likely culprit for this selloff is in-fact fears over the potential effects of the corona-virus.

First, let’s examine the current market structure before going into more about the corona-virus potential.

In the first chart below, the S&P 500 Index shows just how rapidly this market has declined. The index is now flat for the year after falling over over 5% in just three days. Monday’s decline of over 3.5% made up the bulk of this decline.

Looking across this chart, however, shows that prices are settling in where the market found support a few times in both early and late January. So where the market currently sits could very easily be a spot to make an attempt at a bounce higher.

Zooming out a bit shows that the overall trend higher from the lows of late 2018 is still very much intact.

The chart below shows the S&P 500 since late 2018. Another area of support could be the rising blue trendline. Currently, the lower trendline of the two is at the 3150-3200 level. This would suggest that prices could fall another 2-3% before finding some footing.

Declines of 5-8% are a normal course of business when investing. The problem is we don’t know when a 5% loss is going to stop and reverse, and when it is going to turn into a 20% loss.

Zooming out even further shows that the market could in fact fall much further before finding support. The blue shaded area in the chart below is roughly at the 3000 level.

A retest of this area would suggest another 7-10% decline from current levels.

Putting these support levels together on the same chart below, we now have a more comprehensive view on where the market is likely to find buyers.

Another way to view it is that we now can see where risks are increased. If these support levels do not hold, the likelihood for further price declines increase.

Charts are a very easy and basic way to visualize and interpret complex data. Price data does not care “why”. When prices fall like they did today, charts don’t give an explanation. Neither does your brokerage statement.

So far, the charts are telling us that while 5% losses are not comfortable, there has really been no major damage done to price just yet. It may very well happen, but it hasn’t happened yet.

Client Portfolios

Within client portfolios, we have been consistently over-weight technology over the past 6 months. One shift that is taking place right now is a rotation out of tech stocks and into other areas of the market. We have followed suit by making minor adjustments to portfolios to reduce the over-weight exposure to technology stocks.

The other shift that our system has given us happened about a month ago. Clients had exposure to emerging markets stocks, and our system got us out before volatility presented itself.

The main place where risks are being tangibly felt are in the emerging market equities space. Once again, the US stock market is the place to be. Our clients have zero exposure to international stocks, and it frankly doesn’t look like that will change for at least months into the future. Maybe the corona-virus fears will subside, and this area will once again be attractive, but for now our process has us avoiding that exposure.

And until price actually tells us that it is time to be worried, we quite simply shouldn’t be worried. And despite today’s large selloff, the prudent course of action is to wait until sell signals are generated, and continue to look for opportunities to invest.

Corona-Virus Risks

Until the past few days, markets have generally been shrugging off the potential risks of a global pandemic due to the corona-virus.

We are not epidemiologists (people who deal with the incidence, distribution and possible control of disease). Nor do we claim to be.  But we do understand markets and economies.

In fact, we think we understand markets so well that we know the actual price movements from an outbreak of a global pandemic cannot be fully understood in advance. So we are not going to try to predict what the market’s response to risks will be.

People who make bold predictions about how markets will react are either trying to sell something or are simply fooling themselves. Usually both.

But we can definitely understand the global economic impact, and use this knowledge to apply prudent risk management strategies to our client’s hard-earned wealth.

Corona-Virus Background

We’re not going to get into details about the corona-virus background here, but if you’d like a primer, we suggest visiting the CDC website: https://www.cdc.gov/coronavirus/index.html

What are the Potential Risks of a Global Pandemic?

For our purposes, we are not going to get into the most important risk, which is the risks to lives of countless people across the globe. This is the ultimate risk, and cannot possibly be quantified. The loss to families, and society as a whole, is beyond the scope of this publication. Instead, we will focus on economic and market risks.

In our opinion, there are three categories of risks:

1. Fears that materialize into reality
2. Temporary impacts that are recovered
3. Longer-term impacts that result in a global demand shift

Each of these categories of risks apply both to markets and actual economic activity.  By categorizing risks in this way, we can begin to have “sign-posts” to determine the tangible impact of the virus.

Fears that Materialize into Reality

The financial markets are the most obvious and immediate place where fears express themselves. A 3% loss in one day is not unheard of, but it’s also not extremely commonplace either.

The chart below, from LPL finanical’s Ryan Detrick, shows how many 2% drops have happened each year since 1950. It shows that big daily losses are usually clustered within larger bear markets.

The major bear markets over the past 70 years occurred in 2008, 2000, 1987 and the 1970’s. This is exactly where the spikes on the charts occurred.

A 5% pullback from all-time highs is not a major bear market condition. However, if fears continue to mount, they could materialize in a broader, more damaging market decline.

The other primary place where fears can materialize into reality is in consumer spending habits.

In China, quarantined cities are obviously causing spending declines across large parts of the economy. Italy recently began quarantining people to reduce interactions and theoretically slow the spread of the virus. This has tangible impacts to these local economies.

There are a variety of economic indicators that measure consumer spending and consumer behavior. If the US consumer begins tightening their belts, then we could see real economic impacts from the fear of the virus.

Consumer spending data should be watched closely. Weakness in this important area will tell us if fears are becoming reality.

The question then becomes, how long might tangible economic and market risks last?

Temporary Impacts that are Recovered

If the virus is contained within weeks or months, then the most likely economic outcome is a temporary decline in activity, followed by a strong rebound to pre-crisis levels.

A major supply chain disruption is the major economic risk of the corona-virus. If goods can’t be manufactured, or if parts can’t be transported from Asia, then sales slow and the economy as a whole starts to sputter.

There have been major supply chain disruptions in the past. The chart below shows major disruptions that occurred between 2013-2018.

This chart shows that while disruptions occur, they tend to be transitory. None of the disruptions listed caused a recession.

However, if we look at the duration of these events, with the exception of ongoing cyber attacks, each of these events were very finite in nature. The West Coast Port slowdown, Hurricane Harvey, and Brexit are all very short term occurrences. Short term disruptions logically would lead to short term effects.

Short-term disruptions suggest that demand is simply pushed forward until the supply chain disruption is corrected and goods can flow through the economy in a normal fashion.

What kind of dip the economy may undergo is difficult to predict. We should expect that US GDP is somewhat weak this quarter. We know that global GDP is going to be hit hard because of the quarantines in China and other Asian countries. If the virus spreads in Europe beyond Italy, then global GDP will get hit even harder.

It is logical to assume that the longer a disruption occurs, the more likely it is to have longer-term effects.

Longer-term Impacts that Result in a Global Demand Shift

These are the major economic and market risks that corona-virus presents:

• Supply chains shut down for months or quarters.
• Consumer habits change and the demand for goods permanently decrease.
• Revenues decline not only for a quarter but for years into the future.
• Prices on stocks move lower for a much longer period of time reflecting a new paradigm of lower revenues.

These risks are unknown right now. But there are some very real, and very negative potential outcomes that could happen.

Bottom line, we view the risks of a corona-virus pandemic in the form of a statistical probability distribution.

A “normal” distribution is one that is predictable. The flu, while killing many more people each year, is fairly predictable. The CDC estimates that as many as 56,000 people die each year from the flu. This is an awful number.

But the likelihood that 56 Million people will die this year from the flu is very low, and almost impossible.

But the corona-virus has a “fat left tail”. This means that there could be a higher probability of major lives lost that go far beyond the number of people who die each year from the flu.

This is the core of the corona-virus fear. Not what is, but what might be.

Our view is that we cannot predict what will happen. If the virus spreads, there will be tangible impacts that will affect your portfolio. And if those tangible impacts exceed the amount of risks we are prudently willing to take to help our clients achieve their financial goals, then we will increase cash and move to the sidelines.

But those effects are currently not present. So we will continue to apply our process and adapt as things change.

Do not let emotion drive your investing behavior.

Invest Wisely!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

What a year 2019 has been. Despite trade wars with no resolution, weakening economic data, geopolitical uncertainty, impeachment, Brexit, and a whole list of other potential negatives, markets across the globe were strong and had very little volatility. In this issue, we review the key charts that help explain a very interesting 2019.

“Learn from yesterday, live for today, hope for tomorrow.  The important thing is not to stop questioning.”

-Albert Einstein

Charts of the Year

As the year comes to an end, it is customary to review everything that happened and attempt to put things into context.  While we will not review the entire year, we do think some major themes emerged from this year that could give us clues as to what may be in store for next year.

Most importantly, we think reviewing the year allows us to better understand bigger trends and potential changes that may appear in the coming months and years. That said, you will not find predictions in our publications, especially this one. In fact, as our interest rate chart further below shows, we view predictions as an utter waste of time and effort.

However, we do believe we can enter the new year with a set of expectations on what may come.

As the year began in 2019, the overwhelming feeling was one of uneasiness. The stock market had just completed a sharp 20% decline that took only 3 months to occur. Most people entered the year with a bit of hesitation, and an expectation that volatility would continue. We were no different.

But as happens so many times in life, but even more often in the markets, reality tends to be much different than expectations.

So without further adieu, we present the charts that represent 2019.

Stocks Emerge from 22-month Bear Market

Year-to-Date performance on various assets classes were quite phenomenal in 2019. Stocks were up anywhere from 15% to 40%, bonds were up almost double-digits, and many other asset classes showed strong performance.

However, the important feature of this year was not the numbers themselves. Performance numbers looking back only to January 1st don’t take into account the big drop that occurred immediately preceding the turn of the year.

The most important occurrence in our opinion was that the market went through the 3rd mini-bear market since the 2009 lows, and have only recently broken out of that sideways trend.

The chart above shows the S&P 500 Index since the 2009 lows. There have been 3 sideways markets that were almost identical in length. In each, prices fell almost the same amount as well, each one falling roughly 20% from peak-to-trough.

It has only been two months since we broke out of this range. So despite a very strong year, the market could have much more room to run higher in the months ahead.

Long Term Charts Look Similar to the 10-Year Chart

While not necessarily representative of 2019, it is interesting to view just how similar long-term charts can appear to shorter-term ones.  The chart below shows the S&P 500 index (and stock data representative of the index prior to its inception) since 1880. Yes, this is a 140 years of stock market data.

People Aren’t Very Good at Predictions

For whatever reason, people like to predict the future. And for the most part, they simply aren’t very good at it. This is a theme we have come back to time and again, and it didn’t let us down this year.

The chart below shows the Wall Street Journal’s Survey of Economists as to where interest rates would be at the end of 2019. The best economists in the world were asked to participate in this survey, and represent all the major financial institutions.

The results speak for themselves.

It’s All about the Fed

If you don’t look at any other chart in this report, look at this one. The Fed has started a binge of asset purchases and is flooding the market with liquidity once again. The current rate of increase of liquidity injections far exceeds the pace during the rapidly expanding “QE3” in 2012 and 2013.

Yield Curve is No Longer Inverted

Inverted yield curves have been the single best predictor of recessions in the past 100 years. During a brief period of time this past summer, this was THE major development in global financial markets.

The period of time when the curve was inverted is shown below in the red circle. This was one of the shortest inversions on record, and almost immediately began to normalize.

Since the Fed stepped in, the yield curve has continued to normalize and is now at levels far from inversion.

2019 Year in Search by Google

Lastly, we usually don’t share things that aren’t market related, but Google’s “Year in Search” is quite impressive and is worth the two minutes. If nothing else to get a nice warm feeling about humanity in the face of what seems to be incessant and totally incoherent stream of nonsense about the world around us.

As we wrap up the last few business days of the year, we once again would like to wish you and your loved ones a safe and happy holiday season.

Invest Wisely and Happy Holidays!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

As we continue the discussion of economic reality versus market reality from our previous Insights issue, we also look at the various illusions that are present in the investing world. This includes the illusion of one of the most over-used and misunderstood concepts in wealth management…the idea of diversification.

“Reality is but an illusion, albeit a very persistent one.”

-Albert Einstein

Weak Economic Data vs Strong Markets, Part 2: The Illusion Continues

In the last ‘IronBridge Insights’ we discussed the massive schism that was occurring between the stock market and the economic fundamentals around the world. (Read it HERE.) That continues through today. We believe this is just more proof as to why having a strategy that is adaptive to the changing market conditions will be key to future investment success. A strategy that actually pays attention to the market will be ever more necessary as we can’t rely on the economics and fundamentals to be near as predictable as the academia and portfolio pie charts suggest or would like them to be.

Why do we have deteriorating fundamentals but a stock market at all time highs? Have you seen the latest CEO confidence numbers? They are miserable. The chart below shows CEO confidence has cratered back to financial crisis levels. In addition, all kinds of companies are reporting dismal earnings. Just this week Home Depot was the next victim, now with 3 consecutive negative quarters while trimming full year forecasts. The economics and fundamentals continue to weaken yet the market remains near all time highs. Why is this?

The problem lies with the question. We should not be asking all of these “whys”. The “whys” will never be figured out, not with any certainty anyways. Instead of continually wondering “why’, instead we should turn our focus to what actually matters, focusing on the “what is”. The “what is” is the fact the markets have all recently made new all time highs. This has occurred in spite of of an inverted yield curve, a supposed trade war that may never end, and a backdrop of significant fundamental and economic deterioration.

Another way to think of this is illusion versus reality.

The illusion is a deteriorating and weak environment that infers significant price contraction, but the reality is a strong stock market that keeps providing price gains.  If the market is strong then why are we bothering with all of these other distractions?

The market is what matters to your portfolio. The fact of the matter is the markets are near all time highs and are not supporting the narrative of a weaker and deteriorating economic backdrop (at least not yet).

The Illusion of Diversification

The illusions in today’s markets are not only found when comparing economic data to market strength. The illusion goes across asset classes. Again, we are less concerned with the “why”, and more concerned with “what is”. (However, we have a strong suspicion that the global central banks are a big reason “why” many of the strange things we see today exist.)

Let’s look at the illusion in bonds. The 10 Year Treasury yield is below 2% right now (1.8% to be exact). How do you think bonds will perform over the next 2, 5, 10, or 30 years? The illusion is a bond market that has historically done pretty well. The reality is the starting point of the measuring stick matters greatly.

The table below, from economist Robert Shiller, reveals that bonds have returned on average 5.0% per year…not bad. But the starting point matters a lot when it comes to returns as the price one pays is the single most important factor affecting one’s returns, and right now with bonds near all time low yields, bond prices are near all time high prices.

Notice how bonds performed historically when the 10 Year Yield (3rd to last column) averaged 3.0% or below. The only times in history we saw this were the 30s, 40s, and 50s (and thus far in this decade), long before diversified portfolios were being pushed upon the public. The average return for bonds during those 3 decades were under 2.5% per year. With the 10 year at just 1.8% today, do we really think bonds are going to give us much bang for our buck? The answer is no, so why should you dedicate a static 20%,30%, or even 40% or more of your portfolio to that asset class?

There will still be times when bonds will be a good asset class to own, even with rates this low. The chart below shows that even in a low rate environment, bonds are still very cyclical. The chart below compares equities as represented by the S&P 500’s ETF SPY, compared to the long term Treasury bond, revealing the cyclicality of the most boring of asset classes.

Although stocks largely have been more attractive since 2009, there certainly were times it was more attractive to own bonds rather than stocks, like 2014-2016 and more recently since 4Q 2018.

With cyclicality like this, it is tough to justify owning a set % of bonds at all times like most portfolio managers advise. Instead it makes sense to have a strategy that can move your assets to what is working. Overweighting stocks since 2009 (and underweighting bonds) and during intermittent periods in between has been much more appropriate than setting an allocation to bonds (or any asset class) and forgetting it. At a minimum you greatly improve your risk management, and likely also your returns.

Source: IronBridge Private Wealth

Below are some more excerpts from a client presentation we did that focus on the traditional static portfolio illusion versus the cyclical markets reality. The illusion is you need all assets all the time to have a diversified portfolio. The reality is you need only certain assets during certain times to achieve much better risk adjusted returns. Over time you also will achieve the same diversification (or better) as you actually get non-correlated and inversely correlated holdings when you need them most (like more bonds and cash in 2008 than stocks) rather than positively correlated holdings when you need them least (like bonds and stocks today when they are both going up in price).

In fact, the benefits of diversification itself are largely a fallacy.

Its illusion is safety but the reality is a diversified portfolio is often very risky. It’s extra risky when you need less risk, and less risky when you need more risk.

The place to be in the investment markets over the past decade has been U.S. stocks, so in addition to the heavy weighting of bonds, why has your advisor had you 5%,10%, even 20% allocated to international stocks instead of U.S. equities during the entirety of that period? They will claim it’s all part of some diversification need, but doing so likely had you significantly underperforming with more risk (volatility), the opposite of what diversification is supposed to do for you.

Can you afford another 10 years of underperforming with more risk? The easiest example is 2008 when a very diversified portfolio still fell over 30% in value as advisors mimicked deer in headlights, offering the oh so helpful advice of “staying the course”. How did they actually manage your portfolio during that time period and since? We question what it is exactly these advisors are “managing” except their own pocketbooks.

Do you really need to have international stocks and bonds and small caps and value and growth and financial stocks and REITs in your portfolio at all times? To us this is a cop out and a surefire way to tell an advisor doesn’t really “manage” your portfolio. After all there are plenty of computers that can (and do) do this at much cheaper prices.

At best it doesn’t work, at worst it is disingenuous. At a minimum your portfolio is at the mercy of the market at all times and almost certainly no less risky.

The chart below shows a similar chart as the one above, just comparing the S&P 500 now versus emerging market equities.

Source: IronBridge Private Wealth

U.S. stocks have tripled the returns of emerging markets since 2010, and done so with much less volatility.

Again, why does your advisor have you still exposed to emerging markets at roughly the same percentage you have always been exposed to them? Are they actually building correlation tables and calculating co-variances and doing the analysis to prove they are providing risk protection (of course they are not), or is it more likely they are doing so because it is the industry’s standard cop out?

Don’t get us wrong we are not saying emerging markets are done and should be forgotten, we just want to make sure there is a dynamic plan that will help identify when that time has come.

Indeed, there may be a time when U.S. stocks are doing horribly and emerging markets are doing wonderfully. The tables could certainly turn and you deserve something better than a static exposure that underperforms on the way up and also leaves you over exposed on the way down.

You don’t have to be allocated to all assets at all times. Having any emerging market exposure during the last decade has significantly hurt one’s portfolio.

The final chart below provides examples of the portfolios we are advising against. These are the standard “pie chart” portfolios that 99% of advisors suggest to their clients. Notice the upper left reveals a constant allocation to the various asset classes?

There is 6%-25% of suggested full time exposure to international equities right now, and if you ask why, the answer will be to diversify for diversification’s sake, or something along the lines of “foreign equities add value for diversification reasons”.

The chart above showing just how much better U.S. stocks have done compared to international equities reveals this not to be true. In fact it is untrue from the returns perspective as well as from the risk perspective since international and emerging market equities tend to also be more volatile than U.S. equities. Diversification for diversification’s sake is one of finance’s biggest fallacies.

Since our last ‘Insights’ we have followed our own advice and are now fully allocated. We even have a little international and small cap exposure. Why? Not because we always do, but because we have a system in place to take advantage of the things that are working and stay away from the things that are not. We don’t have to be victims of the market’s whims. To do so we need to stay away from the portfolios that set it and forget it, rebalance it to a set % of asset allocation quarterly, and are only reviewed when preparing for a client meeting.

We haven’t owned international equities in client portfolios in a long time, and as mentioned we have a small exposure right now. That could change and we will be happy to either shift it back to domestic equities or increase the allocation internationally, within each of our client’s pre-determined risk thresholds. We are not beholden to a pie chart and thus we are not at the market’s mercy.

Invest Wisely!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

There is an old saying that the stock market has predicted 10 of the last 7 recessions. (Meaning stocks are more volatile than actual economic data.) But what happens when it’s the economic data that is showing weakness, while the markets continue to show strength? This is the situation today.

So who will win the battle between weak economic data and a strong stock market?

“I deal in facts, not forecasting the future. That’s crystal ball stuff. That doesn’t work.”

-Peter Lynch, Investor

Update: What Will the Fed do Next?

A few weeks ago in this publication we focused on the Federal Reserve’s recent, and controversial, decision to cut interest rates by “just” 25 basis points. To us the 25 basis point cut was no surprise as we concluded:

“The Fed simply follows the rate that the market sets. Period.”

The Fed is meeting next week. Let’s take a look once again into our crystal ball, the ole’ 3 month Treasury Bill, to see what the Fed is likely to do.

We feel pretty comfortable stating that the Fed will most likely cut another 25 basis points. The updated chart below shows the Fed Funds Rate is now 27 basis points behind the 3 month Treasury (as of 10-22-19), leaving them enough space to satisfy the market with another rate cut.

Note: In the chart below, if the green line is below the red line, we expect a cut. If it is above the red line, we expect rates to remain unchanged.

If the discrepancy between the Fed funds and the 3 month continues to widen then it would open up room for them to cut a full 50 basis points, but at this point, the odds are of another 25 basis point cut when the Reserve Board meets October 29 and 30.

Weak Economic Data vs Strong Markets

Markets are complex. A cornerstone of our investment philosophy is that they are so complex, in fact, that predicting them is almost impossible. Success at predicting is more a function of the probability of getting a guess right.

But understanding the overall environment at least lets investors factor in the broader conditions that exist in markets.

Single data points don’t tell you much about an investing environment. But when big themes start to emerge, we’d better pay attention. This is happening right now in economies globally. But it is happening with the backdrop of a stock market less than 1% from its all-time-high.

The first real big economic red flag that has occurred in 2019 has been the numerous inversions of the yield curve.

Discussed in the Sept 11 ‘insights’ (found here), this ominous sign has never previously occurred without a recession following at some point in the future.

But, as we discussed back in our March 29 publication (found here), the key to forecasting a recession is not necessarily when the inversion occurs, but instead when the curve starts to steepen after an inversion.

The chart below is an update of the yield curve spread between the 10 year treasury Bond and 3 month Treasury Bill. It indeed shows, after a brief stint in negative territory, the yield curve is now no longer inverted. The 10 year yield is now 10 basis points above the 3 month yield. It was when this inversion ended that the real fireworks began during the last two recessions. So unless this time is different (famous last words), then indeed we should be on high alert of a recession within the next 6-12 months, especially if the curve continues to steepen.

One caveat is we have never witnessed an inversion in the United States with interest rates so extremely low, so maybe that puts this inversion in its own category.

Nonetheless, this chart suggests that caution is warranted, and we need to be on close watch for a market and economic turn lower.

In addition to the yield curve inversion, more recently some dismal ISM Manufacturing numbers were printed, with that index now at its lowest level since the financial crisis and below the 50 level for only the 4th time in 10 years.

For reference, “ISM” stands for the Institute for Supply Management. This organization has been around since 1915, and conducts a survey of more than 300 firms in the attempt to measure changes in production levels from month-to-month. They conduct surveys on both manufacturing data and on services data. Companies that sell “stuff” to people are included in the manufacturing index, and companies that provide services such as technology or healthcare are included in the ISM Services index.

The chart below of most recent ISM Manufacturing survey shows that respondents are currently the most negative they have been since 2008. A move below 50 is correlated with manufacturing contraction.

This chart also suggests caution.

A few days later a disappointing ISM Services number followed, just above the 50 level on the Purchasing Managers Index for the services segment of the economy and the 3rd lowest reading since the financial crisis.

Again, it’s hard not to look at these economic indicators and not feel negative about where the economy is heading.

It’s not that the U.S. is the only bad apple of the bunch. In fact the U.S. was the lone good apple in what seemed a bad international bunch, for years, that is until now.

The below report shows industrial production has slowed across the globe as the U.S. (blue line) is now showing year over year industrial production slowing as well.

So not only are things weakening in the U.S. but they now join the rest of the world in a potential economic contraction.

But, here is the issue we have with all of this economic deterioration.

If things are looking so poor economically right now, why haven’t the stock markets priced things in and headed lower?

That’s what conventional wisdom suggests should occur, and to us, that is the most important thing to look at. Why hasn’t the stock market “led” all these economic indicators by falling too? After all the stock market is the top leading economic indicator.

One of the most dangerous words in finance is “why”. Why can get us in a lot of trouble. Why doesn’t my dog listen to me? Why did my three year old just start screaming as loud as he can for apparently no reason? Why is the sky blue (well maybe we finally figured out this one)?

Our suggestion, spend less time pondering the whys of this world, especially when it comes to investments, and focus instead on the what is.

Here’s one example as to why trying to fit “why” into the market’s narrative is a dangerous game.

• Friend 1, “Why is the Fed cutting rates again?”
  • Friend 2, “Because the economy is slowing again”
• Friend 1, “Why is the Economy slowing again?”
  • Friend 2, “Because the velocity of money is slowing”
• Friend 1, “Why is the velocity of money slowing?”
  • Friend 2, “Because borrowing from banks has slowed”
• Friend 1, “Why has borrowing slowed?”
  • Friend 2, “Because spending and hiring is slowing”
• Friend 1, “Why is the stock market still up then?”
  • Friend 2, “I don’t know, let’s short it”

So should we just go short here because the economy is falling apart? This same conversation could have easily been had in August 2019 when the S&P 500 was 5% lower than it is today, just as it can just as easily occur right now, in October 2019, around 1% from new all time highs. It also could have easily been had after the last rate cut of the last rate cutting cycle, Dec 16, 2008, when virtually all economic indicators were looking poor during the depths of the financial crisis but also happened to occur near the market’s generational lows in price.

The point is: deteriorating economics can and have occurred throughout history, but that doesn’t mean the stock market has to or will fall.

We think it’s more important not to ponder the “why” this is occurring, but instead accept the reality of the situation as what is and then go from there.

That reality is the stock market is not pricing in a recession, not yet anyways, and we must respect that and forget the whys or why nots. Does the fact the yield curve has inverted and the ISM Manufacturing and Service indicators are falling actually lose you money? Again, let’s focus on the facts that actually matter to you and your account. The whys and why nots just do not matter, but the price of the stock market does matter.

The stock market thus far has not fallen on this bad economic news, and that matters most. Price-wise it remains range bound, still below July’s all time highs and above August’s six-month lows, as it has largely been range-bound since April 2019 now trying, once again, to bust through its upper resistance.

Our updated key price levels are highlighted above. These are the levels we are watching to get 1) either fully allocated yet again or 2) scale back our holdings.

We followed our own advice and did indeed add to exposures recently when the market broke out of its August range, but we still also have some cash on the sidelines through our Tactical Strategy as we wait for prices to overcome overhead resistance (new highs) and offer us better reward to risk ratios (a concept we discussed in more detail in the second half of our last ‘Insights’, The Fed’s Secret Indicator).

In the meantime the market has continued the chop it has been in since April as we wait patiently for its outcome.

Invest Wisely!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

What if we told you that we knew what the Fed was looking at in their meetings? That we knew their secret? It would take the guesswork out of trying to predict what the Fed was going to do. Well, it may just be hiding in plain sight.

“Secrets aren’t secret.  They’re just hidden treasures waiting to be exploited.”

The Fed’s Secret Indicator

This week the Federal Reserve Bank of the United States did something that surprised absolutely no one. They cut their Fed Funds rate (the rate that they charge banks to borrow) another 25 basis points. This had been telegraphed to exhaustion, and the only real unknown coming out of the meeting was what will happen in the near future.

Chairman Powell did not help this uncertainty as he pushed back on every question asked of him about the Fed’s next move. It is worth noting the Fed was the most divided they have been in recent history, with 3 members opposing the 25 basis point cut. So it seems, even the Fed doesn’t know what it is going to do over the coming months (spoiler alert: we do!).

The Fed has two official mandates: price stability in the overall economy and maximum employment. Since 2008, the Fed has done two things to attempt to achieve these mandates: control short-term interest rates and print money to help boost asset prices.

We won’t get into the merits or criticisms of various Quantitative Easing programs the Fed has done over the past 10 years. Instead, let’s focus on how the Fed “controls” short-term interest rates.

The Fed looks at a tremendous amount of data. Economic numbers, employment information, and endless data on global markets.  They must have a process on how to analyze all of this information, right? They have dozens of PhD economists who know how to interpret all of this data and use it to formulate a comprehensive and effective strategy to determine what they should do at their next meeting.

They definitely have employees that should be able to do the work. The Federal Reserve has over 17,000 employees with an annual payroll in excess of $3.5B per year. (Read the Federal Reserve Annual Report HERE.)

The main question is…why?

Many of their employees serve in the regulatory arm that governs various banking institutions. We get that.  But setting the Fed Funds rate doesn’t need to be a primary function. In fact, we don’t think the Fed is actually doing ANYTHING when it comes to setting rates.

We know their secret.

And unfortunately, it’s not very exciting.

The Fed simply follows the rate that the market sets. Period.

Our apologies if we got you too excited about their secret. (Editor’s note…If you did get too excited, then you probably need to get out more).

This is one primary reason why they are continuously behind the curve and cannot prevent recessions or business cycles. They would admit they “look at a lot of different indicators”, but the reality is they only need to look at one…the US Treasury market.

Looking back over the past 25 years, the Treasury market has consistently moved ahead of the Fed. The chart below, courtesy of McClellan Financial Publications, shows how the 2-Year Treasury yield led the Fed Funds rate during each and every turning point, as well as the majority of the time in between.

Shouldn’t the Fed Funds rate be LEADING market rates?

It sure does look like market rates are ahead of the Fed.

But what if the short-term treasury markets are in fact following the Fed? After all, the Fed has regularly scheduled press conferences, and various members speak about interest rates and the economy in between meetings. Maybe the Fed is guiding the short-term rates?

Again, we don’t think so. To make the point, let’s look closer at 2008. Why did the Fed need to have 3 unscheduled/ emergency rate cuts during the financial crisis (which still did not help prevent the worst recession since the Great Depression)? If they actually set interest rate policy instead of following it they would have just moved the Fed Funds rate to 0% during their October 2008 meeting rather than waiting until December of that year to do so. Or at a minimum, the short-term Treasury rates should quickly adjust once the Fed announced their rate cut. But that didn’t happen.

Maybe they thought things would get better. The more likely scenario is that they realized the treasury markets were pricing in far worse outcomes than their “experts” though. In fairness to them, they do have something to worry about that the bond market doesn’t necessarily have to worry about…politics. The Fed is supposed to be non-political, but they absolutely have to worry about the optics of their policies, US Senate oversight, and overall public perception. In reality, the perception problem is most likely as important to their jobs as being correct in their policy decisions. Nevertheless, the Fed is continuously behind the eight ball because they must follow the bond market for their signals.

The next chart below shows what we consider to be the best leading indicator of the Fed Funds rate…the 3 month Treasury bill’s interest rate. The first chart below is zoomed into 2008 to further the discussion.

The 3 month Treasury rate is at the bottom of the chart, and the Fed Funds rate itself in shown the middle section. The top portion is the difference between the two. Notice the significant lag between the two, especially in September of 2008?

This lag is shown more clearly in the top portion of the chart. During the majority of 2008, the Fed Funds rate was higher than the 3 month Treasury bill, oftentimes much higher. This meant they were chasing the 3 month bill all the way down.

In short, the Fed easily could have justified cutting more throughout 2008, but for whatever reason, they didn’t. By September of 2008, the Fed’s rate was over 2% higher than the 3 month Treasury bill’s rate, highlighting how policy could not keep up with the reality of the situation.

In 2008, the Fed was obviously slow to recognize what needed to be done, and took its cue from the market.

Now let’s fast forward to today as we have seen two 25 basis point cuts over the past two months. The next chart zooms into the last 3 years.

Notice a pattern? Every time the 3 month Treasury yield was 20 basis points above the Fed Funds rate, the Fed raised rates at their next meeting.

But then it changed. In June of this year, the difference between the Fed Funds rate and the 3 month Treasury dipped below 20 basis points (and stayed below longer than a few days). In our view, this was the catalyst that sent the Fed cutting interest rates on July 31 (effective in August).

We also should note this spread never got more than 40 basis points wide, and is the reason why the Fed did not cave to the President’s calls to cut 50 basis points at the time.

But what about this most recent September announcement where they cut an additional 25 basis points? This was the most controversial one in recent history (at least from the Fed’s internal Committee’s perspective with 2 members voting for no change and 1 voting for a 50 bp cut).

The most recent cut was also justified, and so was the size of it at 25 basis points. This is shown by the chart above that reveals with the effective rate between 2.00% and 2.25% the spread between it and the 3 month Treasury was once again over 20 basis points wide. Today it is spot on with just 1 basis point difference.

So what will the Federal Reserve do at the October meeting? Based on the 3 month Treasury they won’t do anything (not unless the market causes a major shift in that interest rate). This will more than likely make a number of people unhappy. The Commander in Chief for one, but also there is currently a 65% chance of another rate cut in October. These folks may be disappointed as well.

Investment firms will put in way too much effort and gnashing their teeth over trying to predict the Fed’s next move, when in reality all we need to do is watch the 3 month Treasury for any signals that may suggest otherwise.

If the difference between the 3 month rate and Fed Funds rate is large enough, they will cut. If not, they won’t. Thanks for playing.

In the meantime, we will make the suggestion that the Fed should simply announce that the Fed Funds rate will be pegged to the 3-month Treasury. That would save us all quite a bit of time and energy, and most likely improve the odds that the Fed can actually accomplish its dual mandates.

Stock Market Update: Buy High, Sell Higher?

It seems we were well on our ways to finally breaking out to new all time highs when the Fed’s lack of future transparency threw a wrench into that plan. Immediately on the Fed’s announcement Wednesday, September 18 the market sold off. It recovered by the end of the day but has since tread sideways as price remains between recent support and all time highs resistance.

After all was said and done, the stock market remained within a couple of percent of new all time highs, as we continue to wait for a breakout to new all time highs before we allocate more capital to equities. This essentially means we are willing to buy at higher prices, what why is this?

The chart below is the same one we have discussed the past few ‘Insights’, but we have added some trading math to help show why sometimes it is better to buy high rather than buy low.

Doesn’t it seem counter-intuitive to wait for higher prices before adding exposure to equities? We have been ingrained to think that buying low and selling high is the appropriate chain of events, however, that certainly is not always the case. The reason is because of the risk side of the equation. Sometimes there is less risk when purchasing at a higher price.

The chart below helps explain this philosophy, but in general, we look for at a minimum a 3:1 return to risk ratio on every position we buy. What this means is we are looking for a security that has equal chance of rising at least three times what it could decline.

In the example below the reward to risk ratio is significantly improved if we wait for new highs before buying. Note in yellow the math around buying right now and the summary of that trade in yellow in the bottom right. A 3.6x reward to risk ratio is not bad, and is one reason why we added some positions in early September. That ratio was improved when price was closer to those August levels, so what we added in September had a reward to risk ratio around 5.0x.

Buying right now there is a hypothetical potential 8% gain, but a potential 2.2% loss. That 2.2% loss is identified by the next logical level of support (where price spent all of August). This is the likely level price would pull back if it were to fall from here. Although still a decent trading opportunity (with a reward to risk ratio of 3.6x), it is not as good an option as the navy blue, buy later, option.

If we wait to buy on a breakout, we can then utilize the all time high at $3025 as the next logical support zone, resulting in risk of only 0.6% in buying once that breakout occurs. Waiting to buy results in us missing out on 1.7% (0.6% +(8.0%-6.9%)) of potential upside, but it also results in us potentially not losing 1.6% (2.2%-0.6%). Waiting for a breakout before buying offers an 11x reward to risk ratio in this scenario, which is a lot more attractive than a 3.6x ratio.

That said, we have added stock exposure to client portfolios over the past month, as certain investments did meet our 3-to-1 principle. But the remaining cash will be allocated if the market does indeed break to new all-time highs.

Sometimes it does make more sense to wait for higher prices before buying with the primary reason being the risk that can be avoided by doing so. Buying low and selling high sometimes is not as good as buying high and selling higher.

Invest Wisely!

 Our clients have unique and meaningful goals.

We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.

Contact us for a Consultation.

Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.

In investing there are three major disciplines that attempt to analyze the factors that drive investment performance. We take a look at the primary components we are watching in each of these three key areas in the markets to get clues as to what is next.

We remember the heroes and first responders who selflessly rushed in to save lives and recover victims during the tragic events of 9/11, and hope that we never forget the attitude of service and gratitude that emerged following that awful day.

There are three broad disciplines investment decisions fall into. Virtually all investors are aware of one of them, fundamental analysis. Many are also aware of a second financial discipline, technical analysis. However, very few investors are aware of the third discipline, sentiment analysis.

Even fewer utilize all three disciplines in their investment techniques.

The reality is these disciplines combine to create the current market price, and if you are looking at just one thing, you are likely to miss some major component to the markets. In this update we take a look at one important factor in each of these realms that has caught our attention.

The most traditional discipline of the three is fundamental analysis. It’s what is taught in business school, and it is what most investors primarily utilize when making their investment decision. Investopedia defines fundamental analysis as, “a method of measuring a security’s intrinsic value by examining related economic and financial factors”. Examples include the state of the economy, industry conditions, company financials, and a company’s management. But again, if you study just fundamentals, then you are likely missing some major pieces to the markets.

This reality can be proven at any given second because fundamentals change, on average, much slower than price does. By that definition alone price cannot be solely driven by fundamentals, otherwise it would be dead in the water when the fundamentals weren’t changing. The reality is prices are moving all the time because of peoples’ expectations and/or thoughts, and that is no longer in the realm of fundamental analysis. Have you ever owned a stock and watched as an earnings report hit the wire? Revenues were off the charts, profits were off the charts, and the outlook was amazing, only to watch as the stock fell in price? This happens all the time, and cannot be explained by fundamentals alone so we also look at two other financial disciplines.

But let’s not confuse fundamentals not being the holy grail with them not being important. Fundamentals do matter, and one thing we are watching right now is the inverted yield curve.

The Fundamental Clock is now Ticking: The Yield Curve Inversion

You can’t call yourself an investor and not know that the yield curve has recently inverted. It’s all over the news and has historically been a major fundamental warning sign as there has never been a recession that didn’t first see at least some portion of the yield curve invert.

In other words, it has a perfect record of predicting a recession (although the statisticians in the room would point out there have only been 10 instances since 1950 and 5 since 1975, so the sample size is extremely small). Let’s just assume, though, this time is not different, and since a vast majority of the yield curve has inverted, the clock is now ticking toward a recession.

So what does that mean for the stock market?

Bank of America points out the average time between a 2 and 10 Year inversion and recession is 16 months. But, the dispersion is wide. Over the past 5 recessions the shortest time frame from inversion to actual official recession (2 consecutive quarters of GDP contraction) was 14 months (the 2000 stock market top and 2001 recession), but the longest has been 34 months (1998’s inversion and 2001 recession).

To make things even more unpredictable and convoluted, the stock market’s reaction is similarly as disperse. The chart below reveals prior periods when at least 60% of the Treasury curve inverted going back to the late ’70s.

The 1978 and 1989 inversions offered great 2 and 3 year returns, but getting there was a roller coaster. However, the two more recent inversion episodes resulted in more dire longer term results, with generational 3 year drawdowns of 40%+.

We think the lesson here is you cannot make investment decisions around fundamentals alone. After all, which fundamental data point from the table above would you choose? Would you choose the bullish one year 1978 or 1989 post-inverted yield curve returns, or would you choose the post-inversion 2000 and 2006 negative 3 month returns as your guide?

The yield curve has inverted and that probably means a recession will come at some point, but that does not mean the stock market won’t continue to rise for some unknown period in the future. This is but one small piece to the super complex stock market, and making a decision based solely on the yield curve seems silly to us.

Let’s look at the pressing issues in the other two finance disciplines.

What we are Watching Technically: A Break Out of the August Range

In our last ‘Insights’, “The Price is Always Right”, we discussed price and how price is a major component to what we look at when making our buy and sell decisions. The reason is we believe all of the fundamental data, the first discipline, is largely embedded in price already. Why spend so much time and effort on fundamentals if focusing instead on the technicals already includes the fundamentals? That seems like a more efficient use of one’s time to us.

The study of price, otherwise known as technical analysis is defined by Investopedia as, “a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.” When bets are placed on the future of a security, for whatever reason, it is reflected in price. Examples of technical analysis include trends, momentum, relative strength, and supports & resistance levels.

An update to the chart discussed in our last ‘Insights’ is shown below. The great thing about this chart is the inverted yield curve is already included in it. In fact all known information as well as expectations are baked into this chart of price!

In our last issue we pointed to two levels that would get us more bullish as well as more bearish. Since then price has moved above the point of being “more bullish” and as a result we have decreased our cash exposure to around 25% (down from 35%). A move back into the range, and certainly below the “Bearish” level would have us back to 35%+ cash, but a continued move higher from here would have us continue to decrease our cash exposure.

We don’t need to complicate things with all these scenarios and what ifs around the yield curve, price will show us the way in whatever scenario plays out and right now we are marginally bullish as long as that $2850-$2930 August price zone is not revisited.

An Update on Sentiment: Mixed Messages

Sentiment analysis is the third prevalent pillar of the financial markets, and it is the least understood.

Sentiment analysis is defined as, “the overall attitude of investors toward a particular security or financial market. It is the feeling or tone of a market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market.” Examples include surveys, margin loan levels, hedging activities, and market breadth.

Sentiment is an interesting study because the majority of the time there may not be much that sentiment is telling us, as it is very subjective by nature. However, sentiment extremes tend to make their appearance just at the right time, typically when market trends are at or near extremes themselves. In other words, sentiment can help raise red flags, especially near market tops and bottoms.

The problem with sentiment, on the other hand, is that it is highly subjective and tough to measure across time, cycles, and generations. The good news is, price also is inclusive of sentiment as people’s overall attitudes toward the market are already reflected in the prices that are agreed upon.

Sentiment red flags were raised and discussed most recently in our July 23 ‘Insights’ titled, “Feeling Sentimental”. In that issue we discussed the % of sentiment indicators we follow showing excess optimism, which was over 40% at the time, raising a red flag the market was overbought. That week the market topped as we remain below those levels still today. So, in that case, the extreme sentiment readings indeed did help prepare us for an eventual change in the direction of price.

For more information on sentiment and how we use it you can check out our previous publications including June 11, when we recognized all the negative sentiment in the media that just wasn’t showing up in price, in our March 30, 2018 issue as breadth was deteriorating as the market rallied, ultimately resulting in that fourth quarter’s 20% decline, and finally back on November 10, 2017, when we dove into sentiment, discussing a plethora of different sentiment signals we follow.

The chart above tracks a popular and long running survey of a large group of investors known as the American Association of Individual Investors. This chart measures the spread between those that answer the survey bullishly less those that answer it bearishly, revealing that a majority of members who answered the survey recently are bearish, with a net 17% bearish response. This is one of the lowest readings ever!

This data is only useful in context, though, and the history of the survey’s results provides that much needed context. This history suggests this indicator to be generally contrarian in nature, translated to mean when the members are net bearish, that typically aligns more with market bottoms than market tops, and when the cohort is net bullish, some sort of market top is typically being formed.

This is not always the case, though, and here in lies some of the subjectivity of the survey and issues with sentiment in general largely discussed in that July 23 ‘Insights’. The people that are members today are not the same ones that were members 30 years ago, adding some complexity to the consistency of the timeline. In addition it’s entirely possible the membership of AAII has aged along with the service, changing the demographic and potentially the outlook along with age. There has been a net trend toward bearishness since the early 2000s after all, which would be an interesting case study in and of itself.

Still it is probably a meaningful data point that this cohort is as bearish now as they were at the lows of 2015 and the lows of December of last year, both times which did align with significant market bottoms. Thus, we should give this survey a bullish slant as this cohort is indeed more often than not most bearish at market bottoms than market tops. It’s bearishness today skews bullishly for the market’s potentials.

Again, the great thing about technical analysis is the AAII cohort’s opinion is already included in price. If price continues higher from here, it’s likely that all those pessimists had already sold. But if it continues lower from here, then it’s likely one of those times when this cohort correctly predicted the coming trouble, like they did near the top of 2007 as well as the leading up the the 2011 drawdown.

For now, we will continue to watch price action and let it be our guide. Fundamentals and sentiment can certainly help in your investment decision making, but we think the all-inclusiveness of technical analysis provides much more bang for your “time” buck.

After all, would we make an investment decision based solely on the yield curve inverting? Or, would we buy the market here just because the AAII group is significantly bearish? The answers to these two questions are a resounding “no”. But we would buy this market if it is moving higher and sell this market if it is moving lower.

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Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.  Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.