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.

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

-Albert Einstein

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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.

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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.

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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.

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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.

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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.

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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.

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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!

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 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.

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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.

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.

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“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).

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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!

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 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.

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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.

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?

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“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.

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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.

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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!

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 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.

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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.

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.

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“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.

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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!

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 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.

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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.

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.

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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.

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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.

Invest Wisely!

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 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.

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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.

August has seen a massive pick up in volatility, and we are watching two key price levels to help us guide portfolios. After all, price is the single most important factor when making investment decisions.

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Two weeks ago (on August 7), as the Dow declined 800 points we published our ‘Insights’, titled “Central Bank Steamroller“, where we brought attention to 1) the increased volatility, but also 2) the things we can and cannot control in the markets.

“Focus instead on what you can control”, was the takeaway. The two most important factors you can control when making an investment are the price you pay and the price you receive when you sell.

Price matters. After all, price is what actually makes you any money or not.

Earnings, tariffs, inverted yield curves, the Fed, recession probabilities, negative interest rates, and GDP all have influences on the investment landscape. But these do not directly influence your investment portfolio. You can be 100% accurate in predicting every economic indicator, but if the price you sell is lower than the price you paid, then you still lost money. Everything else is, in a way, largely irrelevant. Would you rather be right or make money? We know our answer.

Because price is the primary determinant of whether our clients make money or not, we focus a great deal of our efforts on charts. To us, charts are exquisitely beautiful. They contain the collective wisdom of every investor in that particular market. Charts tell us without bias what price is actually doing. And price is always right.

Price doesn’t care what any of us think. It is what it is. Period. Too many investors and portfolio managers try to argue with price, and attempt to defend their own perception of what they think prices should be. This is the ultimate waste of time and effort. Worst of all, this type of thinking leads to the single biggest reason portfolios lose value: trying to justify why the market is wrong and you are right.

We purposely try to ignore much of the commentary around things that are out of our control. If information is included in commentary, do we really think that millions of market participants are collectively ignoring that information? The reality is that information is either already factored into the current price, or that the information simply doesn’t matter. Either way, price already has encountered, dissected, and adjusted for the information in question.

The chart below shows where price currently is with our annotations of where we would be a further buyer and/or a further seller. With price still stuck in between these two levels, we are remaining in a “wait and see mode”. Not making a decision is also a decision and at certain times it makes more sense to us from a reward to risk perspective to allow the market to continue to disseminate information. The choppy action of the last two weeks reveals the market is still digesting the (6.5%) move down in price off the July highs.

Once this initial decline culminated with August 5th’s 800 point Dow down day, the market recovered in a typical fashion, by bouncing back to roughly the midpoint of the move down, which also happened to be where a couple of key moving averages were hanging out.

Price remains near that level, and this is normal in a free market with buyers and sellers both competing for their own self interests. It makes sense that when the dust has settled price finds itself about midway between its recent highs and its recent lows as well as at the same level as the average price over the past 50 and 60 days. This is the average price and where buyers and sellers have settled. But, now what?

That 50% retracement area at 2940 on the S&P 500 Index acted as resistance, and we saw a second 800 point Dow down day in as many weeks on Wednesday, August 14. Notice also Friday (August 16th) of that week and this most recent Monday (August 19th) took prices back up to that level of resistance (are you sensing a pattern here?), where thus far resistance has once again held. Three times in the last 3 weeks the 2940 level has been tested with thus far an inability to overcome it. In plain English: Sellers are winning over the buyers right now.

An interesting aspect is this all looks very similar to what the market did back in May, when it also fell, bounced, and then fell again. This is one reason why we think it is very important for the market to hold its recent lows. Otherwise it risks, at a minimum, a May redux with another equal sized move lower from here. This is why we have identified 2820 as a line in the sand for us.

In the longer term chart below, we also are seeing some important developments. The market broke to new all time highs in June and July, but has now reversed, breaking below the levels of the former all time high reached in September 2018 as well as April 2019.

With price now back below those previous all time highs, the potential is now there for the entire summer move to be considered a “false breakout”, a bearish development in which the markets “trick” long term investors into buying the new highs, only to flip the script and trap them in losing positions. Even worse, the recent bounce in the markets that met resistance at the 50 and 60 day moving averages also met resistance of the two former all time highs near 2940.

Investors who bought in June or July are now underwater and trapped there with losses unless price can retake that former support that is now resistance (~2940).

To us, it is very important the market holds its 200 day moving average and red trendlines shown in both charts above. The short term trend has already turned down, but a break of the intermediate term support would further increase the probability that a larger selloff is in the works. If the market moves below its 200 day moving average for example, chances increase that we could see a decline similar to the October-December 2018 pullback, and ultimately see prices fall 20-30% from the peak in July.

We are prepared for whatever scenario the market throws at us and we have already significantly increased our cash positions during the 5% pullback we have seen in August. We are prepared to continue that move into cash if $2820 breaks.

In the more bullish scenario, we have identified some individual stocks and ETFs to add to our client portfolios in the event the market has once again found a bottom and wants to move higher. A break above $2940, as the first chart calls out, would help identify the more bullish scenario.

Until either one of these price zones gives way, we don’t see any reason to be impatient right now. The safety that cash has provided our clients during multiple 800 point Dow down days has a very real and beneficial effect on volatility and returns for our clients.

As the late Tom Petty so eloquently put it, “Waiting may be the hardest part”, but during volatile times such as these, it’s much nicer to do that waiting while in cash rather than other instruments froth with turbulence and deviations.

When it comes to investing, price is what matters most. Price is what makes your account go up and it is what makes your account go down. Having a plan and process around price makes sense to us. Hopefully it makes sense to you too!

Invest Wisely!

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 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.

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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.

Central banks have been the dominant factor in global markets for well over a decade now. It’s important to avoid getting steamrolled by their actions, good or bad. Recognizing what is in your control can help both financially and emotionally when markets become volatile.

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“Control your own destiny, or someone else will.”

-Jack Welch

Volatility is back.

Last week, the Federal Reserve met and cut interest rates by 0.25%. This is exactly what the market was anticipating, but markets sold off when Jerome Powell hinted that the Fed wouldn’t be quite as aggressive with future rate cuts. The market proceeded to fall 3.5% from last Wednesday to Friday.

Then over the weekend, the Chinese central bank devalued its currency relative to the US Dollar. This led to another 3% decline in stocks on Monday. The Dow Jones had its 6th biggest point decline in history.

Why did we see so much volatility over the past week?

Two words: Central Banks.

Central banks have dominated the investment landscape over the past decade. You only need to see one chart to explain everything that has happened in the markets since the global financial crisis.

The chart below, courtesy of Yardeni Research, shows the combined assets of the Federal Reserve, the European Central Bank, and the Bank of Japan, plotted against the S&P 500 index.

You can throw out everything else you hear or read about the markets. THIS is what is driving asset prices. Period.

We are living in an age where central banks are the dominant force in global markets. So much so that across the globe, there is now $15 Trillion worth of bonds that have a NEGATIVE YIELD, as shown the in chart from Bloomberg below.

This means that people are literally paying to own these bonds. It’s like putting a $100 bill in a safety deposit box, paying the bank $1.00 each year to hold it, and keeping it there for up to 50 years.

This sounds crazy to us. But this is reality. (And has all the ingredients for a major asset bubble, but we’ll save that for another day.)

What do textbooks tell us about this kind of environment? Nothing. This doesn’t exist in textbooks. But we don’t need textbooks to identify the most important theme in today’s investment world: don’t get run over by the steamroller.

You can get run over by not being prepared for volatility. You can also get run over by missing out on a multi-year run in the stock market.  In order to not get run over, you must first identify what you can and can’t control.

What CAN we control?

First, let’s recognize that there are varying levels of “control”. If you are selling your home, you can’t control the interest rate environment, or how many people are moving to/from your city. But you can make your house as appealing as possible by doing strategic face-lifts to make it more attractive to a potential buyer.

So let’s identify things in three categories: No Control, Partial Control and Full Control.

Investment-related items where we can exert No Control:

• The Federal Reserve
• Direction of the markets
• When the next recession will occur
• Earnings reports
• Economic data
• Asset class performance
• Interest rates
• Performance of a stock
• Global politics

These are all items that are important in identifying the overall investing environment, but are not things you cannot exert any influence over, at least not directly.

Investment-related items with Partial Control:

• Private investments (board seats, marketing, process controls)
• Real estate (upgrading a property, maximizing rents, landscaping, etc)
• Local politics

These are partially in your control because you can exert effort and capital to potentially alter the outcome in your favor. But you don’t control the broad real estate market, the end user of a company’s goods and services, and what a politician ultimately decides. But you can impact some of the dynamics that could influence your outcome.

Investment-related items with Full Control:

• How much you invest (Asset Allocation)
• What you buy (Asset Selection)
• When you buy (timing of entry)
• What price you pay (determines risk and reward)
• When you sell (timing of exit)
• What price you get when you sell (maximum acceptable loss, profit taking, etc)

Going through this exercise, a funny thing stands out. Most people focus on WHAT THEY CAN’T CONTROL.

Predictions of what earnings will be, where the market will end the year, where interest rates are headed…these are all factors out of people’s control (unless you’re on the Federal Reserve board or the Twitter-in-Chief). There’s no telling much time and effort is spent analyzing things that are at best an educated guess, and ultimately don’t impact the profitability of your portfolio!

Instead, one should focus primarily on what is within your own control. At IronBridge, we spend time developing and improving processes to help identify where our clients should be invested, how much risk to take given our clients’ individual circumstances, and how to tactically gain exposure to areas with higher probabilities of investment success.

By focusing on what you can control, you take two important steps.

First, you realize that you don’t have to be a victim of all the ups and downs of the market.

How many times have you been told to “stay the course”? In a bull market, this advice can pay off and make complete sense. But even in long bull markets, there can be 20% and 30% drops, that ultimately recover but waste the most precious commodity of all…time.

But markets aren’t always in a bull market. There are times when 20, 30 or even 40 years go by with little to no returns. And that’s not factoring in inflation. More often than not, “stay the course” is the response of a financial advisor that has no idea what he or she is doing, and ultimately is not doing any real “management” of a portfolio.

They haven’t focused on the items that are in their control. They haven’t done the work to identify entry and exit prices, or set maximum losses across the portfolio, or have a proven and repeatable process to identify what to own and when.

There is no perfect system, but that’s not the objective. A reliable and repeatable system is the goal.

Second, when you don’t ride every up-and-down in the markets, you realize that you can become more a opportunistic investor.

If you’re not constantly invested at all times, you have dry powder (aka, cash). When you have cash, you can both preserve wealth and be selective when markets get volatile. This is the most common feature of the best investors of all time. Warren Buffet doesn’t stay invested at all times. Jeff Bezos just sold $3B worth of Amazon stock. The best investors on the planet realize what they control, and none of them have a pie chart they stick to through thick and thin.

By taking steps to systematically increase cash in your portfolio, you can then embrace volatility, not be frightened by it. Because now it presents opportunities, not threats.  So in the current market environment, more than ever before in history, it becomes about being tactical.

There are areas of the markets, like bonds that we discussed above, that have a very high likelihood of showing negative returns for decades into the future. You don’t have to remain invested there. International stocks is an excellent example of an asset class that has been embraced by most investment advisors, but shouldn’t have been.

Emerging market stocks have been the focal point of both large and small firms over the past decade. We have seen countless portfolios that have anywhere from 10% to 30% exposure to international stocks. An allocation to this area has consistently hurt.

The chart below shows the most common ETF that invests in emerging markets, ticker EEM. Emerging market stocks are currently at the same level they were in 2006.

International stocks will eventually have their day in the sun, but could be especially vulnerable going forward given the heightened state of the trade war between the US and China. Our signals have consistently avoided any exposure to international investments for this very reason.

Bottom line, US Stocks are in year 11 of the bull market. They could easily continue higher for years into the future, but could also see a massive decline similar to that of 2008.

What will happen? Who knows. But as long we focus on what we can control, adapt as circumstances change, and keep strict controls on exposures in portfolios, the odds are in our favor that we can handle whatever the markets throw at us next.

Invest Wisely.

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 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.

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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.

There are three primary components to market analysis: fundamentals, quantitative/technical analysis, and sentiment.

Sentiment analysis, sometimes known as behavioral finance, can play a major part in the market’s movements. Investors are emotional, and understanding the emotional status of the market can give insights into both the current and future market conditions.

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“All through time, people have basically acted and reacted the same way in the market as a result of greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis. Over and over, with slight variations. Because markets are driven by humans and human nature never changes.”

-Jesse Livermore, Famed American Investor

Back on June 11 we looked at the markets and thought of the famous term, “climbing the wall of worry or sliding down the slope of hope“, and although we didn’t go into the broader topic of sentiment then, that famous saying is rooted by terms more in line with one’s emotions rather those more traditionally associated with the markets. The words worry and hope are descriptors of emotions and much more likely to be found as topics of discussion in a psychology textbook than in finance curriculum. But history teaches us that, although typically given less attention by the general public, sentiment and emotions are a major component to markets, personal life, and the business environment in general. We think it may even be a primary driver of business cycles.

Have you ever made an impulse buy? That’s an example of an emotional decision, and similar emotions to purchase can also affect investors. Have you ever bought a stock because you were afraid of missing out on gains? Notice “afraid” is an emotion and buying something out of fear could also be considered an impulsive action.

The “Business Confidence” Index is one way the government tries to track market sentiment. There are many of these indices out there, with one displayed below, but generally they are surveys provided by economists to business owners to attempt to get a “feel” for the business environment.

Confidence, after all, is a subjective state of mind, not an objective measurement found on a profit and loss statement. Economists have even figured out that, although they are not generally called out in their “ceteris paribus” models, confidence and emotions are a very important part of the business cycle. The index depicted below shows that confidence, too, moves in a cyclical nature. High at times, and low at other times.

Is sentiment currently elevated or is it depressed?

Like most things, it depends. If a person just got a new job, is making a lot of money, is happy with their life, and is “optimistic” about their future projections, they are probably more likely to buy a car, a house, a stock, etc.

On the flip side, if one just lost their job, had no income, and was overly pessimistic about their situation, would they be more likely to buy stocks or sell stocks?

2008 is a perfect example of the emotional psychology that comes along with stock market analysis. Very few thought about buying stocks on the way down during the financial crisis, and thus we saw nearly a 60% decline in the markets. There were probably other factors at play, but mood and lack of confidence were certainly major components.

Back in June in our “Wall of Worry” Newsletter, we noticed a negative sentiment backdrop at the time. The news was largely negative and there were countless reasons from the talking heads not to invest in stocks. Since then, however, the S&P has rallied to new all time highs. Sentiment was low, and that was a pretty good indicator that we could be bullish. But things change and the markets’ sentiment ebbs and flows now suggest a little more caution here.

Famous Trader Sir John Templeton is credited as coining the term, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria”.

The saying goes on…”The time of maximum pessimism is the time to buy, and the time of maximum optimism is the best time to sell”. This quote sums up sentiment analysis and what equation we are trying to solve. Are we currently at a time of pessimism, skepticism, optimism, or euphoria is a question we ask ourselves regularly.

One reason why many investors may stray away from sentiment analysis is because it’s not really that easy. Let’s elaborate. It’s easy to measure revenues and fundamentals (it’s just math), but it’s extremely hard to measure emotions, which are much more subjective and vary from person to person.

One’s optimism may be elevated, but is it high compared to anothers? If we told you we were super optimistic about stocks, and another portfolio manager said they were pretty optimistic, it’s entirely possible that the pretty optimistic manager could actually be more bullish than the super optimistic one. How? The super optimistic manager may have a bearish inclination or personality, so a super optimistic outlook may only mean a 50% allocation to equities whereas a pretty optimistic allocation by the other manager may mean a 70% allocation to equities. Have you ever met a “negative nancy”? If they told you they were really happy to be at a party would they be more happy than a more bubbly personality’s “pretty happy” to be at a party? Maybe, but maybe not, and thus we introduce the problem with surveys, with a jab at surveys in the cartoon below.

Surveys, such as those about business confidence, are one way to try to get a bearing on sentiment. But these surveys are influenced by an individual’s personal experiences or inclinations that particular day, week, or year.

There’s a risk of inconsistency. There can be a tremendous amount of bias in surveys and many of the traditional ways to try to measure sentiment.

This bias is certainly a reason to try to take the subjectivity out of emotional analysis and attempt to objectify it. It’s also a reason why many investors aren’t that versed in sentiment analysis. After all is said and done, the analysis itself still carries a level of subjectivity to it.

Extreme pessimism can always get more extreme just as optimism can always get more euphoric.

To us this is no different than the extremities in many other areas of finance, such as fundamental analysis (bond yields are at all time lows but could still go lower), valuations (expensive can always get more expensive), or technical analysis (oversold and overbought can always get more oversold or more overbought). Despite its subjectivity, we find sentiment analysis to be extremely valuable and a key component in measuring the longer term potential of investments.

Jason Geopfert at SentimenTrader.com is one of the partners we use for sentiment data. They, as much as anyone we have encountered, do a fantastic job of objectifying the subjective field of sentiment analysis. One way they do this is by utilizing objective data sources in the first place. There are plenty of ways to measure sentiment beyond potentially biased surveys. Some examples of the more objective indicators they provide include:

• Margin debt utilized by investors (how much leverage are investors taking?)
• The number of put options being bought compared to call options (how bearish or bullish are investors?)
• The amount of cash in accounts (how much cash is available to invest in the markets?)
• Insiders buying or selling (What is the “smart” money doing?)
• Volume and Open Interest (Is there increased or decreased activity?)

Jason and his team also utilize popular, but more subjective, survey sources such as:

• NAAIM
• AAII
• Conference Board

In addition, they categorize sentiment more broadly into ten categories (we’ll go into the numbers in a bit).

• Optix – Analysis of ETFs and their underlying holdings
• Volatility – What volatility measures are implying about the market
• Options – What options traders are doing with their money
• Breadth – What the market internals are showing
• Surveys – What surveys are suggesting about confidence
• COT (Commitment of Traders) – What the speculators and hedgers are doing
• Hedging -What’s the level of hedging going on
• Cash – How much cash is on the sidelines
• Insiders – What Insiders at companies are doing with their own shares
• Rydex – What Rydex Fund’s investors are investing in

In each of these 10 categories they have a number of indicators that they have gathered data and tracked as an index over years and in many cases over decades. Because the site has a long history of indexed data they can also identify when these indicators are at various “extremes”. We think pictures indeed can be worth a thousand words, so below is the index of these aggregated indicators at “extremes”.

The SentimenTrader “% at Extremes” chart above reveals a few things pertaining to sentiment.

1. The red line shows 38% of their indicators are currently posting an “Optimism Extreme”, which should be looked at as a bearish signal.
2. The green line reveals 0% of indicators are currently posting a “Pessimistic Extreme”, which is also bearish (it’s a sign of excessive optimism/euphoria to have zero pessimism anywhere).
3. 38% is historically a high number and is near the range reached at prior market tops. Recently, the May 2019 top coincided with 49% of their sentiment indicators near extremities, but the September 2018 top coincided with a peak of just 40% of their indicators near bullish extremes.
4. 0% at pessimistic extremes is also a number associated with market tops. The chart helps reveal this. Notice the lows of 2018 were associated with pessimistic readings of 40%+ of indicators but market tops saw the % of pessimistic indicators drop near or to 0%.
5. Point 3 is a good example of the subjectiveness that still exists in sentiment data, even after objectifying this data. Is 38% a high enough number to mark a top? It’s happened before, but then again, so has 49%, so there could be more rally to go before ultimately topping out. It doesn’t have to though.
6. Based on their indicators the market is in an optimistic state. History suggests the market is likely closer to a top than a bottom.

Next is a breakdown of where each of the 10 sentiment categories currently stand. All but one are in the “very bearish” range.

One final chart we want to show is the same “% at extremes” chart as above for the 2007-2009 period. The only difference being the index in blue is the % of optimistic extremes less the % of pessimistic extremes. With the current reading of 38% optimistic extremes and 0% pessimistic, this indicator also has a value of 38% today.

Interestingly, the 2006-2007 period saw a similar level of optimistic extremes near the market tops as we have seen recently with a peak reading of 42% in late 2006, a second peak reading of 38% in June of 2007, and then a final peak, at the October 2007 stock market peak, of just 21%, reached again in December 2007, just before the bulk of the financial crisis occurred.

Sentiment was deteriorating in 2007, and this deteriorating nature of sentiment is also something analysts could (and should) take note of as it helps solidify another popular saying, “market tops are a process”.

Sentiment was deteriorating for a year prior to the ultimate stock market peak in 2007, but more importantly, sentiment was peaking when the stock market was peaking and troughing when the stock market was troughing.

It’s pretty clear to us that sentiment, emotions, behavioral finance, whatever you want to call it, is an extremely valuable tool.

Even during the 2008 crisis, when stocks were on their way to a 40%+ decline, spikes in optimism coincided with market tops as the chart above shows. May and August 2008 stand out. And, on the opposite end of the spectrum July and October 2008 also reveal a level of peak pessimism that helped align with those temporary market bottoms.

The market’s mood, indeed, does matter, and right now that mood is optimistic, potentially to an extreme. It’s certainly elevated to levels that have marked previous tops, so we are cognizant of that and watching for any prolonged downturn in stock prices.

Does it mean we are about to embark on another 2007 and 2008?

No, as sentiment remains a subjective tool where extremes can always get more extreme. But it does mean we should continue to monitor the situation intently. As a result we have continued to tighten the stop loss prices of our holdings to help us stay ahead of any potential trend change, just in case sentiment is once again leading the market and showing signs of another market top.

The good news is, if we are topping now or in the near future, we can also look for an extreme reading of pessimism to help identify an increased likelihood we are witnessing a bottom, just as December 2018’s reading of pessimism moved above 40% of indicators. A similar move would likely help mark at a minimum a near term bottom, as exemplified by both the recent time series as well as the one from the 2006-2009 period.

Invest Wisely.

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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.

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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.