In this issue we chart the four likely paths the market may take over the coming weeks and months, update our “Two Most Important Days” analysis, and look again at the weakness in High Yield Bonds.

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Executive Summary

Well, the “two most important days” has been stretched into “the two important weeks”, and it may even get stretched into the “two most important months”. We are approaching the one month anniversary since the markets bounced off their lows. Unfortunately, the market has little to show for it, except for a significant uptick in volatility. Since the initial rebound off the February lows, the market has been moving sideways, and essentially running in place the entire time.

Market Update

We update the S&P 500 chart from a few weeks ago and analyze recent market action.

• The market is in a neutral position, with signals neither pointing strongly bullish nor strongly bearish.
• False Breaks higher and lower keep near-term moves uncertain and risks high.

Stock Market

We identify the four most likely potential outcomes for the markets, and assign probabilities for each.

• Expectation #1: New Lows (35% Probability)
• Expectation #2: Headfake Higher then New Lows (30% Probability)
• Expectation #3: New Highs, Volatility is Over (25% Probability)
• Expectation #4: Sideways Consolidation for Weeks/Months, then New Highs (10% Probability)

Bond Market

We look again at high yield bonds, which continue to show signs of stress.

• High Yield Bonds will often move in price before stocks, making it an important market to follow and analyze.
• Recent price movements show the early signs of a longer term topping process.
• Bearish activity in this market needs to be resolved in a more bullish fashion in order for stocks to make new highs.

Over the past week we have received new buy signals in our trend model and on select stocks (primarily technology stocks). We still remain with elevated cash positions in client portfolios, but less so that on our last update. Downside risks still remain elevated, and these new positions have very little tolerance for downside movements.

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FIT Model Update: Market Correction

Some technical indicators have improved as the trauma of the quick pullback recedes (for now). Fundamental indicators have shown some signs of deterioration the past month as GDP, consumer spending, industrial production and housing statistics have all come in below expectations.

Currently, all three primary inputs are still flashing warning signs as we are, at a minimum, within a short term market correction, waiting for confirmation of the bottom. Overall conditions have improved somewhat during the past week, but structurally we still view this period as a time of elevated risk.

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Market Insights

Mixed Signals

 

In February, we anticipated a tug of war around the 50-62% retracement level, followed by a fairly quick resolution. We indeed saw the tug of war around this level, but instead of a quick resolution, we have now seen two “headfakes”.  As shown in the March 9th chart above, the first headfake occurred with a break above this level, followed by an immediate return within these levels. This is a failed bullish signal, increasing odds of a break lower.

Then, the market gave us another headfake, but this time with a break LOWER from this area, followed by an immediate return into the retracement zone. This resulted in a failed BEARISH signal, increasing the odds of a break higher.

What this tells us is that the market currently has no dominating trend with many potential outcomes, both positive and negative. We discuss the four likely scenarios below.

 

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Market Microscope

Four Possible Outcomes

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” – William Arthur Ward, American Writer

Stock Market

Now that we have recapped the past few weeks, let’s get to the more important job of looking forward. The market currently has more potential outcomes than any time in the past 3-5 years.

From a technical perspective, the strong uptrend since the February 2016 lows is being challenged. From a fundamental perspective, recent economic strength is also being challenged with various economic measures coming in lower than expected (GDP, housing, consumer spending and industrial production all had readings below expectations in the past month). The Federal Reserve is also beginning the process of shrinking their balance sheet, acting to slowly remove liquidity from markets.

Based on the readings of the many market signals we watch, as well as our deep study of previous market cycles, we anticipate there to be four primary outcomes we need to consider over the coming weeks and months.

Expectation #1: Sideways then New Lows (35% Probability)

The chart of the S&P 500 below reveals one of our two primary expectations of where the market may go right now. This is similar to what we expected in our last ‘Insights’. We put the odds of this scenario at 35%, but the total odds at 65% that the market ultimately moves below the initial panic selling from early February. A high probability for sure, but no sure thing by any means.

The chart below reveals how price today is essentially at the same levels it was at the time of our Feb 23 ‘Insights’. The market has now provided us new information, and a breakdown in price below the recent low at $2660 will shift those 35% odds higher, but for now we watch the tug of war occurring at this all-important retracement zone referenced in our “most important two days” interim report.

 

Expectation #3: New Highs, Volatility is Over (25% Probability)

The 3rd option must be given some benefit of the doubt, given how strong the market has been over the past two years, and further back since 2009. Although many technical indicators suggest another new price low must be made before a new all time high can be, absolute certainties are never an option in the financial markets and we are fully aware that bullish cases still exist.

ALERT: If you work for a large investment firm, don’t worry about the other scenarios because this is the only one that has been approved by your corporate attorneys, and the only scenario you can discuss with clients.

As many of you know we prefer not to guess where the market is headed, and instead allow price to guide us first and foremost. A price break above $2780 would help increase the odds we have seen a meaningful bottom.

The difference between Expectation 3 and Expectation 2 is what occurs after that $2780 is eventually exceeded. Will price eventually fall back down below that level which marks the upper end of the recent tug of war zone, or will bulls be able to hold the momentum into the Spring and Summer months, on to new all time highs?

 

Expectation #4: Sideways Consolidation, then New Highs (10% Probability)

Finally, the last real option is this tug of war continues for months before ultimately culminating in higher prices. If this scenario is playing out, we should not fall below February’s low.

We only give this setup a 10% chance because of how strong the initial down move was. If this were your typical sideways consolidation you would typically have had a lot of indecision on the way down, similar to how you have indecision now, on the way back up. That simply was not the case with the emphatic move lower, which keeps the odds low that this will drag on for months without conclusion.

If we take all the weighted cases we come up with a bearish expectation of 65% and a bullish one of 35%, which is roughly how we have our equities positioned currently (about 65% of our potential equity exposure is in cash).

Over the last 1.5 months our signals have had us exiting for various reasons, and seemingly with good cause as we have largely been on the sidelines during all this volatility. Some holdings were stopped out with 7%+ declines from their peaks. Other holdings were exited on Feb 5, just before the bulk of the first 1,000 point down day on the Dow. Other positions we have taken profits and redeployed.

We remain largely invested in our individual equity holdings; we just got a new buy signal in our trend model, and we are 50% exposed in our sector allocations.

Overall we are very pleased with the way our portfolio strategy has performed during this volatile period, and we are confident we are ready for whatever the market throws at us next, bearish or bullish. After all, it’s better to have a plan and not need it rather than to need a plan and not have one!

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Taking a look at the chart indeed it is true that high yield is a good proxy for equities, with a few peculiarities.

First, we can see that high yield debt also sold off from its January highs, similar to equities. But we have also added two vertical lines which help support the case that high yield can be a good leading indicator. Notice that JNK topped out around one month prior to equities, in early January?  Additionally its second, lower, peak in price came a few days before equity’s ultimate peak. Secondly, and one reason we remain more bearish than bullish right now, is on the right side of the chart.

If you remember the 5 rules of a topping process discussed in our October 27, 2017 issue, then you’ll remember that steps 1-3 are a rounded top formation, a breakdown in price below key indicators, and then a backtest, and ultimately, failure of that backtest at key price levels.

Taking a look back at the chart above indeed price has rallied back to the 200 day moving average, after breaking down below it, and has thus far been rejected. This is bearish activity until proven otherwise.

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 this issue we dig deeper into the possible market outcomes following the recent volatility, explain why market corrections are not healthy, and review portfolio changes and positioning.

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Executive Summary

On Thursday, February 15, 2018 in our interim update we proclaimed “the next two days are the most important since 2016”. This is because the market was in the midst of a perfectly normal retracement in price after a swift selloff. The recent snap back rally was expected and is something that occurs after every big selloff, but what comes next in our opinion is the real key to the market’s intentions.

Historically, where price is today is where either counter-trend rallies failed and prices resumed their downtrend, or the market proved the selloff was over by powering higher through key moving averages and price levels.

Since that update, the market’s rally has continued to stall for more than a few days at its key moving averages as shown by the chart below and in more detail in our Market Microscope section. We continue to anxiously wait for the culmination of this perfectly normal counter-trend bounce as the time has come to “do or die”.

To us, nothing has been proven by the market, yet, other than the fact the short term trend of the market has indeed turned down. That fact will remain until price can regain its key moving averages, and ultimately make its next new all time high. In the meantime we remain with an elevated cash amount waiting for the market to nudge us one way or the other.

In our Portfolio Insights section we discuss the latest correction and challenge some of the popular terms, such as “healthy correction”. We also have started to reel in our fixed income holding’s credit risk. One thing we do know is that if the equity market is rolling over, so too will be the credit markets rolling over, and we are trying to get ahead of that curve, in case it too is on the horizon. The High Yield Bond market’s chart does not look healthy.

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FIT Model Update: Market Correction

For the past seven months, our signals have almost exclusively been telling us that while the fundamentals and sentiment portions of our model were showing an over-valued and over-bought market, the technical indicators still showed strength. That has now changed with the recent 10% market pullback.

Currently, all three primary inputs are now flashing warning signs as we are, at a minimum, within a short term market correction, waiting for confirmation of the bottom. In a more worse case, at the beginning of a deeper bear market. Technical conditions can change quickly, and we are watching closely.

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Market Microscope

The Market has Regained some of its Losses…Now What?

 

The second chart above shows that 2007 saw a similar setup with an initially steep selloff (a very similar to today (-10%) decline), and subsequent bounce into typical retracement levels (50% to 61.8%). Similarly moving averages were tested, but price could not sustain above them (as shown in the blue circle). Ultimately a series of lower highs were formed that were never broken out of and price fell back through all the moving averages, setting up the initial warnings of the soon to come bear market.

The stock market is in a very similar and precarious situation right now, which is why we labeled two days recently, “the most important since 2016”. Will this selloff be like 2015/2016 and breakout above the moving averages? Or, will it remain below them, poised for a retest of its lows (and potentially more downside) like 2007?

This key binary decision point is why we continue to feel we are at an extremely important market juncture here.

Shown below, the market’s recent drawdown of 10.2% has now bounced 50% and into the same key moving averages that helped guide the way in 2007 and 2015. Thus far price has been rejected at these moving averages. If Price can move above the 50 and 20 day moving averages that would be a bullish signal. However, if it remains below them, it opens the door up for another retest of the early Feb lows, at a minimum.

The next chart shows one more example for us to look at, from the year 2000. That year also saw a swift drop from its highs, followed by a bounce in prices to around 50% and into the moving averages. Notice (in blue) that price failed to overtake the 50 day moving average, which resulted in more selling, a formation of lower highs and lower lows in price, and ultimately a 2.5 year bear market.

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Portfolio Insight

“Healing is a matter of time, but sometimes also a matter of opportunity.”  – Hippocrates

Corrections are Not Healthy

It always amazes us to read the market commentary that gets recycled during different parts of the market cycle. One that we’ve read many times over the past few weeks is the ol’ “Corrections are Healthy” mantra.

There is nothing healthy about the destruction of capital.

The intentions are good by those who say this, and we understand the theory…the market has become frothy, and price declines serve to reset expectations, allow an overheated economy to cool, work off overbought conditions, allow inventories to reset, and/or value to better be found. This theory is similar to the Broken Window Fallacy, which we wrote about following the devastating hurricanes last fall (read it HERE).

But this theory neglects the real effects of market declines. One is very tangible: loss of capital. The other is more cerebral: increased uncertainty and the loss of “mental capital”. Markets and economic activity are performed by humans, and we are not rational beings at all times. (Washington DC continually reminds us of this fact.)

Mental capital includes the various behavioral finance issues that all investors experience. Once mental capital is fully expended, investors throw in the towel. This typically happens at the end of a long downtrend, which we refer to as “capitulation”, or panic selling.

Almost everyone has experienced this at some point, and if you haven’t, you probably haven’t been investing very long. It is the retiree who sold in March 2009, and is still waiting to get back in. It’s the tech investor who bought at the peak in the late 90’s and sold at the bottom in 2002. It’s the reason many people say “you can’t time the market”.

But managing risk is not about timing the market. It is about surveying probabilities. It is about investing in favorable times, and choosing to reduce risk when the odds of unfavorable times are increasing. The odds have increased that we are now entering into one of these potentially unfavorable times. Taking steps to manage risk helps protect both real and mental capital.

Portfolio Updates

We have made two primary shifts in portfolios over the past few weeks:

1. Reduced Equity Exposure
2. Increased Credit Quality in Fixed Income

As discussed in our interim updates and our last ‘Insights’, we have had multiple sell signals in our equity exposure in the past two weeks. We stress that this is likely to be a temporary allocation shift until our models give us new buy signals. But thus far, we have not received new buy signals in any of our equity strategies that we are monitoring daily.

Our buy signals are not designed to find the absolute bottom of a correction, as it is impossible to know at the moment an ultimate market low occurs. Our buy signals are designed to invest with the wind at our back. We want the probabilities of success to be in our favor. We believe this is our most important fiduciary duties to our clients. If we are risking our clients’ capital, we must have a reason to believe the odds are in our favor that we can generate positive returns. There is a popular saying in the trading circles that, “picking bottoms is for losers”, and we tend to agree.

On the surface, if may seem counter-intuitive that higher prices present better investment opportunities. But this is exactly the case in the current market environment. While the pullback was indeed violent, the internal market stats are not currently strong enough to create conditions in which our models say “buy”. So for now, the equity markets are in “no man’s land”, which we discussed in-depth in the Market Microscope section. We currently are waiting for the market to resolve itself either higher or lower. In the meantime, we will exercise prudence and patience with our clients’ hard-earned capital.

In a perfect world we would sell near the beginning of a downtrend and reinvest below the level that we initially sold out. In that case we would continue to outperform the market, and that is certainly one of our goals. There is risk that we ultimately re-buy at slightly higher prices (called whipsaw risk), losing some ground to the market, but that is a risk we are willing to take, especially when measured against the potential downside potential. Additionally we have other strategies in place with goals of offsetting this whipsaw risk. As our clients know, we have remained largely vested in our individual security names as well as some specific sectors, which have done well during this turbulence.

Fixed Income

Fixed income, on the other hand, continues to send a very clear message: rates are moving higher.

When investing in fixed income, there are essentially two types of risks investors can take: Interest Rate Risk, and Credit Risk. There are many other nuanced ways to measure risk, but these are the two big ones.

Interest Rate Risk means that an investment’s value will change due to a change in the absolute level of interest rates (source: Investopedia). More specifically, if interest rates rise the investment will lose value, and if interest rates decline it will gain in value. Longer-dated investments have more interest rate risk than those with shorter maturities.

We have been positioning clients for a rising rate environment for many months by focusing on investments with very short maturities. We have already been minimizing interest rate risk.

However, to generate higher yields, we had been taking on some credit risk. This is the risk we have addressed more recently as we have shifted some of our fixed income funds.

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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 this issue we discuss 6 Ways to Invest late in a market cycle, explore the past week’s volatility in more detail, and offer two explanations of why the markets fell so far so fast.

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In This Issue:

MARKET RECAP: It’s All Phil’s Fault

Correlation is not causation. Just because things happen at the same time does not mean they are related. We look at two possible explanations for the market decline this past week.

PORTFOLIO Insights: 6 Ways to Invest when it’s Late in a Market Cycle

We review the characteristics of a market that is late in its cycle, and explain the six principles of investing during a late cycle environment.

MARKET MICROSCOPE: That Escalated Quickly

The VIX Index more than doubled in a 24 hour period causing some ETNs to actually close up shop. This rapid pace of the VIX’s move was unprecedented. Also, equities saw their biggest pullback since August of 2015 as one of our technical indicators has moved to a more conservative signal. Before all the fireworks we moved a portion of portfolios to cash, where it still sits.

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On Our Radar

Trump Taxes: The tax bill has passed as companies continue to dissect how changes may affect them.

Earnings: 4Q Earnings season has begun, and companies have a high bar to continue the growth seen in 2017. GAAP Reported Earnings estimates for the full year have risen another $6 to $146.

Federal Reserve: The Fed is expected to raise rates 3 more times in 2018 as the bond market has already started to price this in.

Winter Olympics: The Winter Olympics kick off this weekend in South Korea.

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FIT Model Update: Uptrend with EARLY TOPPING PROCESS

Fundamental Overview: Although the Dow Jones Industrial Average declined over 10% from its peak to its trough during this latest decline, valuations are still very stretched. By most measures it would take a bear market decline (20%+) to bring valuations back in line with historical norms. One glaring example of this is the 5 Year Treasury Note’s yield of 2.5%. This typically safer investment is providing more income than the much riskier S&P 500’s 1.8% yield.

Investor Sentiment Overview: This week showed us one risk in being in a very crowded trade as the low volatility trade finally ended. The trade was so lopsided that a popular ETN used to short volatility literally blew up when Credit Suisse “terminated” its short volatility ETN (ticker: XIV) on Tuesday morning. So many investors had piled into the short volatility trade when the volatility index (VIX) rallied over 100% from the prior day, the ETN didn’t have the funds to cover its short positions, essentially bankrupting it. Essentially the short vol traders were caught in a massive short squeeze.

Technical Overview: Friday’s (2/2), Monday’s (2/5), and Thursday’s (2/8) crashes in stock prices essentially wiped out two months of gains as prices reversed back to late November levels. Our trend strategy and sector strategies gave us some sell signals as we increased our cash exposure this week.

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Market Recap

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Portfolio Insight

How to Invest Late in a Cycle

How to Invest in a Late Cycle Environment

1. Shorten Your Time Frame (aka, Don’t Buy and Hold)

You should expect to own investments for a shorter period of time. The longer you hold an investment, the more likely it is that the next down cycle will occur while you own it. This means more careful screening of investments, and adhering to a strict exit strategy.

2. Reduce Your Tolerance for Downside Risk

Upside return potential is reduced late cycle. This doesn’t mean you can’t generate nice returns, but you must plan out strategies to get you adequate upside to compensate for your downside risk. We prefer a general 3-to-1 ratio: own investments with the potential to at least earn 3-times the upside versus the downside risk. So if we expect a 15% upside return potential, we want no more than 5% of downside risk.

3. It’s Okay to Miss Out on some Upside to Avoid Big Downside

One of the risks of late cycle investing is called getting “whipsawed”. This is where you own a position, get an exit signal, only to get another buy signal shortly afterward, resulting in a potential sell and then a soon after repurchase. In order to mitigate whipsaw risk it is important to structure exit and re-entry signals so that the potential loss is less than the potential loss of holding the position through the volatile periods.

4. Don’t Rely on Asset Allocation

We have mentioned this is many of our previous reports. Asset allocation does not work when markets undergo stress. And the past week has definitely shown stress in markets with the Dow Jones down 1000pts not one, but TWO days this week.

Here is the performance of various asset classes from peak to trough from their recent highs:

• US Stocks (Large Cap, S&P 500): Down 11.82%
• US Stocks (Small Cap, Russell 2000): Down 11.21%
• International Stocks (EAFA Index): Down 12.58%
• Emerging Market Stocks: Down 13.87%
• Corporate Bonds: Down 5.47%
• US Treasury Bonds: Down 8.08%
• Gold: Down 4.16%
• Oil: Down 9.6%
• Bitcoin: Down 69.1%
• Euro (Ticker:FXE): Down 2.6%
• Emerging Market Sovereign Debt (Ticker: PCY): Down 6.4%
• Mortgage Bonds (Ticker: MBG): Down 4.3%
• Reits (Ticker:REIT): Down 13.3%
• Manhattan, NYC Apartment Rental Costs: Down 3.6%
• U.S. Dollar (Ticker: UUP): Up 2.4%

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Market Microscope

That Escalated Quickly

One month ago we took a look at the extremely calm markets and one measurement of its serenity, volatility. In that issue we discussed the sleeping VIX. It seems Rip Van Winkle has awoken from his slumber! In that same issue we reiterated our stance that we were in a rising yield environment where we projected a 10 year Treasury approaching 3.0%. That has already come to fruition.

Late Cycle Investing:

A persistent theme over the past year has been the record low volatility. Back on August 11, 2017 we discussed this as we proclaimed, “a low VIX should not be something necessarily celebrated, but instead should be treated more as a red flag as market tops almost always are associated with periods of low volatility”. In addition charts were provided showing the record low volatility and the record amount of speculative short VIX contracts (which have now contributed to the extraordinary VIX move discussed in more detail below).

The chart below is similar to the one we provided in our January 12, 2018 ‘Insights’. In that issue we showed 4 prior times the VIX was near all time lows. 3 of those 4 preceded meaningful market pullbacks, and we now have a 5th occurrence, which also is in the process of marking a meaningful market pullback with the S&P and Dow falling over 10% from their highs. Low VIX levels are associated with market tops, not market bottoms. Similarly a low VIX is also associated with being late in the cycle, as the chart below helps show. Low VIX levels typically occur prior to market tops and market tops are by definition late in the market’s cycle, so a low VIX helps us confirm we are indeed late in the cycle.

But a low VIX also tells us more. A depressed VIX means volatility expectations are low, and thus tolerance for any elevated volatility should also be low. Contrastingly, in a high volatility environment larger price moves are expected, and thus should be tolerated more openly. We keep our tolerance for volatility low by keeping our stop losses and exit signals tighter than we would earlier in a cycle, when increased volatility expectations suggest allowing more tolerance for price moves. Those tighter stops have helped us move some portions of the portfolio to cash, ahead of a lot of the fireworks and whatever may be on the near horizon.

Volatility:

Well that escalated quickly! If you haven’t heard, this past week we witnessed an unprecedented move in volatility as the S&P 500’s Volatility Index (the VIX) skyrocketed over 100% in just one day. Not to get too technical but the VIX Index measures the underlying cost of volatility in an S&P 500 Index Option contract. In short it tracks the cost traders are willing to pay for volatility uncertainty, and on Monday that cost skyrocketed.

The chart below shows the recent history of the VIX along with the S&P 500 Index as well as a popular Exchange Traded Note (ETN) which allowed traders to participate on the short side of the VIX trade (owners profited when the VIX declined in price and lost when the VIX rallied in price).

The chart below shows that not once over the past year did the VIX close above the $18 level. That all changed on Monday, February 5, 2018 when the VIX more than doubled as the Dow Simultaneously fell over 1,000 points.

The move higher in the VIX was so unprecedented, that one exchange traded note (ETN), ticker: XIV, is having to liquidate whatever assets they have left as they couldn’t cover all the losses absorbed during the rout. For all intents and purposes the fund was caught in a massive short squeeze in the price of volatility which ultimately bankrupted them.

If there is a positive perspective to this story perhaps it is that the S&P was only down 7.5% from its peak to its trough since hitting its all time high two weeks ago. Some experts have suggested that similar moves higher in the VIX in the past would have sent the S&P down 15% or more.

The other silver lining is that our trend model gave us our first sell signal since August as we moved a portion of our portfolios to cash before most of the fireworks started. We remain with a somewhat elevated cash position as we continue to monitor the situation.

What this also means is volatility is likely here to stay, at least for a little while, as revealed on Thursday, February 8, 2018 when the Dow had its 2nd 1,000+ point drop in under one week. When extremely popular funds blow up, it can take some time for the dust to settle.

Stock Market:

Volatility has certainly picked up, but how much damage has actually been done to the markets?

The chart below shows the same chart as discussed in our update two weeks ago with the S&P 500 (in orange) along with the prior month’s average price (in purple).

The bottom indicator reveals the percentage distance price is away from its prior month average, and the takeaway from that discussion was that the market (at 6% above the prior month’s average price) had only been that stretched above its average price 9 times over the past 7 years with seven of those nine instances resulting in a flat to down market at some point within the next few months.

In other words, putting new money to work at those stretched prices had an elevated amount of risk associated with it. The market has since heeded to that historical precedent and indeed pulled back to levels that are now over 7% lower than January’s average price (and down 10% from the all time high). So, once again that signal turned out to be a beneficial one, and we are now in the midst of the market’s first meaningful pullback in almost two years. But does this mean the bull market is over?

The chart below reveals the longer terms have not yet been affected by the recent short term market gyrations. The short term trend has broken down after the 10% pullback in the markets, but the intermediate and longer term trends remain intact. This is why we remain with some equity exposure at this juncture. However, further deterioration in price would have us continue our trend of raising cash.

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Bond Market:

Another persistent theme we have been following is the continued deterioration of the bond market. We first wrote about this expectation in our inaugural ‘Insights’, published July 13, 2017, and since then the bond market has seen a fairly swift move higher in yields (and lower in price).

The next chart is one we published in October with our projection of a move toward 3% on the 10 Year Treasury. Updated we see that the target yield discussed then has already been reached as the 10 Year moves toward the 3% level.

Remember a higher bond yield affects not just bond prices, but it also affects equities prices. If you are looking for yield, why would you buy the S&P 500 with a yield of just 1.75%, when you can get a safer Treasury Bond that pays above 2%?

The September 29, 2017 ‘Insights’ went more in depth as to how bond yields affect stock prices, but suffice it to say that a rising yield environment is not good for bonds, it is not good for stocks, and it is not good for commodities (which provide no return and actually cost money to carry).

Another reason to be concerned about rising bond yields is the chart below from the Federal Reserve.

There is a persistent thought on Wall Street that corporate balance sheets are “stronger than they have ever been”. But, this is simply not true.

The chart below shows that debt to non-financial corporations sits at an all time high approaching $14T. This means there is now $3T more in debt today on corporate balance sheets than there was preceding the financial crisis.

This may not be such a huge problem in a low interest rate environment, but as interest rates rise, these corporations will be refinancing at higher rates, increasing interest expense and lowering earnings.

The reality is corporations have used the low interest rate environment to essentially lever up their balance sheets, using the increased debt to buyback shares and fund other short term priorities. Eventually this will probably come back to haunt, after 5 years when their debt comes due, they don’t have the cash to pay it back, and they must refinance.

Or they just convince Philadelphia to keep working.

 

 

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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 will be the real effects of the new tax legislation?

In this issue we discuss what companies may do with the extra funds from the tax cut, look at the announcements made thus far, and take another look at the hot stock market.

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In This Issue:

PORTFOLIO Insights: What will Companies do with the Projected Tax Savings, and How will it Impact your Portfolio?

There are five likely ways corporations will use any savings from the tax reform. We discuss the most likely one in more depth.

MARKET MICROSCOPE: What is the Impact from the Tax Cut?

One persistent theme with the Trump tax cuts has been around the savings that will occur at the corporate level. No doubt there will be some savings, but how much really? One stat we have seen shows that of 25 companies that have reported their expected tax savings, those savings were 8.7%.

MARKET MICROSCOPE: US Stocks: To the Moon!

The stock market has been incredibly strong. The S&P 500’s hot start to the year, by one measurement, suggest a cool down over the next few months.

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On Our Radar

Trump Taxes: The tax bill has passed as companies continue to dissect how changes may affect them. We take a deeper look at tax savings expectations in our Market Microscope.

Earnings: 4Q Earnings season has begun, and companies have a high bar to continue the growth seen in 2017.

Federal Reserve: The Fed is expected to raise rates 3 more times in 2018 as the bond market has already started to price this in.

Davos Economic Forum: The economic minds of the world met this week in Switzerland. One of their efforts is to coordinate global growth. President Trump’s more protective agendas have been a hot topic of discussion.

Government Shutdown: The government shutdown was a non-event and it likely will continue to be uneventful unless there is a more prolonged shutdown.

Economy: 4Q GDP rose by 2.6%, well below estimates above 3%. However, this is a preliminary number and will be revised in the near future.

January Barometer: Have you ever heard the saying, “so goes January, so goes the year”? This adage is a result of the statistical tendency for the full year market performance to follow the month of January’s. If January is positive, then typically the rest of the year was…at least until 1985. Since then the market’s full year performance has had little statistical correlation to how January performed.

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FIT Model Update: Uptrend

Fundamental Overview: Many year end S&P price targets are already being hit as we expect the banks to readjust these targets higher. When prices rise quicker than earnings, P/E ratios also rise. This is what we are seeing today with a trailing 12 month price to earnings ratio (P/E) now above 25x, resulting in an earnings yield of 4% (E/P). With 5 Year Treasuries now pushing 2.5% it’s only a matter of time before a corporate bond yields more than its equity counterpart, flipping the reward to risk paradigm.

Investor Sentiment Overview: The latest sentiment measurement to join the club of extremity is the amount of leverage being used to buy equities. Rydex funds was one of the first mutual fund families to offer leveraged funds. The current ratio of leveraged long dollars to leveraged short dollars has gone parabolic, now almost 4x as much, and the largest spread in its history.

Technical Overview: The S&P 500 is up over 6% thus far in January, well above the average price paid of $2,658 in December. This is the farthest distance from the prior month’s average since March 2016. Back then returns one month later were positive, but 3 months later they were flat. Discussed in more detail in the Market Microscope, since 2009, 7 of the last 9 times the market was this stretched resulted in zero to negative gains at some point within the following 3 months.

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Portfolio Insight

Tax Changes are Affecting Corporate Profits

Second, companies tend to buyback the most shares near market peaks while buying the least amount of shares near market bottoms. In other words, a higher market LEADS to increased buybacks, and a lower market LEADS to decreased buybacks. In some ways this makes sense, as economic downturns lead to reduced cash on corporate balance sheets. Corporations simply don’t have the cash to do buybacks. But, how do you explain the extreme amount of buybacks at the opposite end of the spectrum?

Why do companies buy back their most shares at their highest prices and valuations?

Notice the most share buybacks ever was in the 3Q of 2007, the exact same time as the top of the markets, and just before the average share price fell 50%+. This was the exact wrong time to buyback shares, yet CEOs and boards, etc did it anyways, to an extreme! They certainly weren’t putting shareholder dollars to good use then. It would have been better for them to pay attention to valuations and wait for a better buying opportunity, like in 2008 or 2009, when almost no company was doing buybacks.

There have also been periods where increased buybacks did not lead to higher stock prices. In the chart above, increased buybacks in 2011 did not result in a higher market. In fact, the market was flat for most of 2011 and 2012. Again in 2014 and 2015, increased share repurchases occurred when the market was flat to down. Conversely, the decrease in buybacks in both dollar value and number of companies in 2016 did not lead to lower markets. In fact, both 2016 and 2017 were excellent years for stocks. It appears to us that increased buybacks are something that happens in conjunction with prevailing market trends, not a leading indicator, but more of a confirming or lagging one.

So how should you factor in the tax changes into your portfolio?

Given how strong the market has been in the past few months, it may have already been priced into your portfolio. But as we get more clarity into which sectors and companies will benefit most from the tax changes the market will reward and punish as it sees fit. Instead of trying to predict what will happen with the tax law changes and how they affect the market’s prices, we have designed strategies to listen to these changes and adapt as necessary.

Near term, the trend of the market is higher, and will be until proven otherwise by a breakdown in its price, but as we discuss in our next section, the market is also very stretched and may be due to take a bit of a breather. That does not mean you should move to cash. It means you should have a strict risk management policy for your holdings and be prepared to take profits if and when the trends change.

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Market Microscope

Higher Prices Due to Tax Cuts?

The recent changes to the tax code, specifically the corporate side, have received a lot of attention lately. The hype surrounding the changes, in some ways seems to be just that as we are not seeing that significant of a jump in 2018’s earnings expectations, at least not yet. It could be a case where companies are still trying to figure out the impacts, or it could be a case of companies with the good news simply barking the loudest.

Earnings & Taxes

Was December 2017’s 1.5% and January 2018’s 6%+ stock market returns driven by the passing of the tax code revisions? Perhaps. What about 2017’s full year S&P 19% return? Was such a great return a result of expected future tax savings for investors? That’s certainly a possibility, but unfortunately it is impossible to tell exactly why the market has rallied as it has, just as it is impossible to ever prove exactly why the market does what it does. However, what we can look into with a little more conviction is the amount of tax savings the market is expecting as a result of these revisions. If the tax savings are real then it is likely they are providing some benefit to the markets.

We received the following graphic from a research analyst that was proposing significant improvements in future company earnings, and rightly so. Thus far 25 of the 500 S&P companies have proclaimed they would see an 8.7% benefit to their bottom lines because of the tax law changes. If that holds across the board, an 8.7% jump in earnings would be great news for the market. But, that would require the 475 other companies to also raise their estimates.

The graphic hints at the reality of the situation. At least thus far, only a few of the 500 largest companies will see great benefit from the tax law changes, but 475 others either will not, don’t know yet, or aren’t communicating their expectations yet.

If we do the math, the graphic to the right equates to a weighted expected bump in Earnings per Share, or “EPS” of 1.6%, which is nice, but we would hardly consider it justified for the hype that has surrounded it.

The concern is the much anticipated tax revision in reality will benefit just a small percentage of the S&P while the rest see little real benefit (as depicted by the chart) and the 1.6% weighted average calculation.

It could also be a case of companies with good news barking the loudest (or soonest) while those companies with little (or negative) news remain mum. That may be a best case scenario as we wait to see if there are any more positive announcements, but thus far it seems the bang from the tax buck may not be as great as expected.

The next two graphics below show in detail what most already know; that the U.S. statutory tax rate is the high point on the scale, and most companies don’t pay near that rate. The U.S. Corporate tax rate did not used to be 35%, as implied. It actually was an average 29%.

The graphic below tracks the effective tax rate of the 500 largest companies through time. The effective rate in 2016 was already down to 29% (and trending lower), so at a maximum the tax savings would be at most 8% on average (29% less the new 21% rate).

The next graphic provides a little more detail around industry. Biotechs already had an effective tax rate of 20%, so it is likely they see little benefit as a group from the changes. REITS and energy related companies may end up paying more. Standard and Poor’s does a great job consolidating all the company earnings estimates from all of the projections made by analysts which are available every day on their website.

Standard & Poor’s data is updated as estimates change and actual earnings replace estimates. Today’s 2018 earnings estimates are highlighted in the final chart to show the full year estimate as of January 24 of GAAP earnings of $139.67.

The table to the right starts with what were October’s 2018 full year estimates, and then December’s, and finally today’s.

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Stock Market

The chart below shows the S&P 500 (in orange) along with the prior month’s average price (in purple) since 2011. The bottom indicator reveals the percentage distance price is away from its prior month average. The indicator is a kind of momentum indicator that helps reveal overbought and oversold conditions.

Price as of 1/25/2018 is now 7.01% above December’s average price, and this is interesting because price being this far from the average has only occurred a few times since 2011.

Shown on the chart are vertical lines which reveal the prior times price rose 6% or more above the prior month’s average price. This has occurred 9 times during this timespan. What is interesting is what the market did following these readings.

7 out of 9 times the market made no positive ground or was lower at some point in the following three months. These occurrences are shown in green. The other two false signals resulted in 1) the market rallying for more than 3 months more, but then eventually pulling back to the price levels of the initial signal 6 months later. The other signal, in early 2013, was simply one that did not work.

Another takeaway from the chart is with prices now over 7% above their prior month’s average, today joins just 3 other occurrences in that same 7 year span (2011’s, 2015’s, and 2016’s). All three of these instances resulted in the market being flat to down from those levels at some point within the following 3 months.

So, what does it mean? It means the market is stretched here. It has probably run too far too fast and could succumb to the powers of mean reversion. It also does not necessarily mean a market decline is around the corner. Note this indicator reading >7% occurred prior to the largest pullback during the timespan, the late 2015 top that culminated with the 2016 low, but the market being more than 7% away from the prior month’s average price also occurred in 2011, resulting in just a small pullback of a few percent.

We remain bullish but are watching signals like this to help us apply rigor around when we allocate new capital to the markets. Blindly buying when the market is already 7% beyond its prior month’s average price has not been a historically great decision, so we don’t mind having some patience here and letting the market provide us a better reward to risk profile.

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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. \n *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.   “,”m”:[{“s”:0,”n”:”c”,”v”:”#333333ff”,”e”:798},{“s”:0,”n”:”fc”,”v”:”Regular”,”e”:798},{“s”:0,”n”:”f”,”v”:”Arimo”,”e”:798},{“s”:0,”n”:”s”,”v”:9,”e”:798}]}”>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.  

We’re not sure if it’s the cold weather, the post-holiday blues, or just too much Federal Reserve eggnog, but the markets are as calm now as at any point in history.

In this “Slumber Issue”, we wonder if investors are falling asleep at the wheel, do our best not to wake up Rip Van Winkle, and discuss an inconvenient truth about diversification.

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In This Issue:

PORTFOLIO Insights: An Inconvenient Truth about Diversification

Are bonds and stocks inversely correlated? Most financial professionals will tell you that bonds provide safety to your portfolio during times of market stress; we disagree.

MACRO Insights: Have Investors Fallen Asleep at the Wheel?

The stock market’s volatility hit a new all time low as the market hit another all time high. Is low volatility something to be worried about or something that should be celebrated?

Market Microscope: Don’t Wake Up Yet, Rip Van Winkle

Today’s unprecedentedly low level of volatility has many market observers concerned. Indeed low volatility is a late cycle phenomenon, however, it does not necessarily mean a market top is just around the corner. There have been extended periods of low volatility in the past.

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On Our Radar

Trump Taxes: The tax bill has passed as companies continue to dissect how changes may affect them. The theme should be one-time impairments from tax-deferred assets, along with plans for future stock buybacks and dividends. We should learn more about tax effects on companies during earnings season.

Great Start: The S&P 500 is off to its best start in 30 years…since 1987.

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FIT Model Update: Uptrend

Fundamental Overview: Earnings season will begin in full force over the coming weeks. Retail will be in the spotlight after a good 4th quarter for many of those stocks’ prices.

Investor Sentiment Overview: Numerous surveys and other sentiment indicators continue to set records for stock market optimism. Adding to this growing list, the Investors Intelligence subscription service recently published the number of bullish advisors compared to bearish advisors has now hit 4.8:1. This marks the most bullish that cohort has been in 31 years.

Technical Overview: The market has kicked off one of the strongest starts ever as the S&P was up over 3% after the first 6 days of trading in 2018. The last time stocks started the year off this well was also 31 years ago.

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Focus Chart

The VIX is Sleeping Like Rip Van Winkle

The VIX Index is a key measure of expected near-term volatility in stocks, based on the prices of certain options on the S&P 500 Index. A low reading is a sign that investors believe the risk of a near-term decline is low, and a high reading reflects the fear of a near-term market decline.

However, the VIX index, like other investor sentiment readings, tend to be contrarian signals. In other words, a low VIX is more reflective of a high point in stocks, while a high VIX typically accompanies a bottom.

The S&P 500’s measure of volatility has been hovering at or near record lows for the past six months. The monthly average of the VIX has now fallen below 10 for the first time ever, and this has many concerned. The chart below reveals the extremely low level of the VIX, and a low VIX has indeed typically coincided with stock market tops.

But, just because the VIX has made a new all time low, and the stock market has simultaneously made a new all time high, does not necessarily mean the stock market’s trend of low volatility and higher prices will soon end.

A deeper look at volatility reveals there have been four prior periods where volatility was behaving similarly. Two of those periods did indeed see market pullbacks shortly after, but the other two periods saw the equity markets continue higher for months and years before ultimately succumbing to a change in trend.

Until proven otherwise, volatility is showing more signs of a Rip Van Winkle continuing its slumber than a Sleeping Bear about to abruptly awake.

 

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Portfolio Insight

An Inconvenient Truth about Diversification

Modern-day diversification is based on periods in Green. This happens a mere 11% of time! If this only occurs 11% of the time, then why is the prevailing thought of pie chart diversification so rampant on Wall Street? There are a few reasons, but one of them is also shown by the chart.

During the past 20 years there has been a flight to safety whenever stocks fell in price. In other words, there is a recency bias being played out.

In reality over 50% of the time there is a slight correlation, and 30% of the time there is a high, positive, correlation between stock prices and bond prices. In other words, when stocks fall bonds also fall.

There are many ways to manage risk in portfolios, but diversification is inadequate.

So what’s our answer to the question? I wish we knew when it will end. But we are not afraid to invest at these levels because we have already planned our exit strategies and know exactly what we will do for our clients when this bull market does change.

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Macro Insight

Have Investors Fallen Asleep at the Wheel?

Suppose you are driving in a car on an interstate in a rural part of the country using cruise control set at 70 mph. Traffic is light, and you never have to touch your gas or your brake…until you start getting closer to the city.

Then your smooth ride is over. You certainly can no longer use your cruise control, and you likely must partake instead in white knuckle driving. There was zero volatility, now there is too much of it, and driving has become more dangerous.

The stock market currently is on cruise control going 70 mph in the rural part of the country and not having to bother with the gas or the brakes. But, too little volatility can also be dangerous. When you are able to just set the cruise control and sit back and relax while driving, it’s easy to get lulled to sleep, and if you have ever driven through West Texas then you have probably personally experienced this risk.

That is where we find ourselves in the market today, with the risk of being lulled to sleep, wondering how long that slumber may last.

Shown in the chart below with the blue line is the S&P 500’s volatility index ($VIX), inverted. It is inverted to align volatility with stock prices as the black line represents the S&P 500 during the same 30 year period. Notice that these two indices generally move in the same direction.

Currently, that blue line is at its highest level ever (the VIX is at its lowest level ever), which reveals the market has been driving on a rural road with its cruise control set for a very long time. Is the market now lulled to sleep by the lack of volatility?

The chart reveals a few key things which we will discuss in more detail in the Market Microscope section next:

1. Volatility moves in cycles, and we are indeed late cycle.
2. This low of volatility for this long is not the norm.
3. Volatility is negatively correlated with the market. Lower volatility = higher markets
4. Volatility can continue to fall, but the longer that occurs the less likely it continues. There is a zero bound.

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Market Microscope

Don’t Wake up Yet, Rip Van Winkle

The VIX has hit an all time low, but how long can this low volatility persist? We look at a few indicators to help tell us when this bout of low volatility will be ending. The bond market also enjoyed relatively low volatility over the past few years, but that looks like it has now changed as more and more investors are noticing the change in trend in yields.

The VIX may be in single digits, and it may seem that it has been muted for a very long time, but in reality, the 2nd half of the chart reveals some intricacies of this VIX decline are actually not unprecedented.

(Graphic Content Warning: the following few paragraphs get in the investment weeds, but there is more to the report afterwards so stay with us)

The middle section of the above graphic reveals the “Average True Range” (ATR) which is a measure of the average monthly high to low range for the prior 12 months. In a lot of ways it shows us the “volatility of volatility”.

The ATR measurement reveals the prior 12 months VIX has had an average “range” of 6.1 points. This is low, but, interestingly, this is not the lowest that range has been.

There have been extended periods where the VIX’s ATR has been below 6 points, as highlighted in green. During these periods, the volatility of volatility was even lower than it is today. But we also see that during those highlighted green sections when the ATR was below 6, the VIX was at or very near its low price for the cycle. There indeed had been very little further decline in volatility once the ATR reached 6 as the start of each green section was at or near the low in the VIX, but that didn’t mean stock prices started to fall.

When we look at what followed the dates that the ATR fell below 6, we gain a little more insight. The first occurrence preceded the 1994 market 10%+ pullback, so it was a pretty good signal that a market top was near.

The second occurrence, however, occurred in the midst of the tech bubble, from 1994 – 1997, which ultimately lead to 1998’s pullback, but the low ATR lasted for 3 years prior to that outcome. The VIX was low, and it started to move higher, but at a slow enough pace to keep the ATR below 6 for 3 years.

During the mid-2000’s the volatility of volatility also stayed below the 6 level. This reading lasted for two years, before volatility started to pick up again in 2006. More recently, in 2014, the ATR of the VIX approached 6 and volatility immediately reversed, coinciding with the last meaningful pullback we have seen, 2015’s.

With a current ATR reading of 6.1, we are approaching that level again. However, given we have two examples of the VIX’s ATR falling below 6, and staying there for months/years, we should not look at the VIX here and its ATR at 6 and assume we are witnessing a market top, like, for instance, in 2015.

As history teaches us, we could continue in this low volatility environment for awhile, or, like the tech bubble, we could actually see a bottom in the VIX, yet see the market and the VIX both rise together for a few more months/years.

Finally, the bottom part of the chart is another measure of volatility’s volatility. The 12 month rate of change (ROC) measures the price today with the price from 12 months ago. Before the VIX bottoms and starts to move higher, its 12 month rate of change typically starts to also move higher. More importantly, though, the large spikes in the ROC that occurred along with large spikes in the VIX only happened after the ROC had been slowly moving higher. In other words large spikes in the VIX didn’t just happen overnight; there was a building up of the VIX prior.

What history teaches us is we should not expect a massive monthly VIX spike to occur out of nowhere. We should first start to see a gradual pick up in overall volatility by first seeing the ROC continue to steadily move higher. This could be combined with an ATR that moves back above the 6 points level. That’s when historically large prolonged spikes higher in the VIX and larger selloffs in stocks have occurred.

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Penny Stocks

Ultimately, a low VIX is a sign of investor complacency. A different way to look at this complacency is to look at trading volumes in the most aggressive areas of the market. Historically, penny stocks (or stocks that trade for under $5/share, and not on one of the major stock exchanges), have been the place where investors have gone to “hit a home run”.

During the late 1990’s tech bubble, speculators were being fined for spreading false rumors in America Online chat rooms about virtually unknown penny stocks. Jonathan Lebed was one of them. He was 15 years old, and was charged with security manipulation by the SEC.

But, whatever happened to penny stocks? The only ones today that garner any attention are those like the Long Island Iced Tea company, which, after a name change to Long Blockchain Corp, is now supposedly in the Bitcoin mining business.

Or, Kodak (remember the camera company?) which quadrupled its stock price from $3 to over $13 when its management suggested they would use crypto as a tool to help manage digital property rights. Kodak’s recent price spike is shown below.

But beyond the Bitcoin mania, today we largely hear nothing about penny stocks. Like volatility, today’s lull in penny stock activity is unprecedented.

The next chart reveals a virtual standstill over the past two years in the dollar volume traded in penny stocks. Penny stocks historically have been the bastion of speculative pride, where the gutsiest of speculators could strike it rich, but today it seems that cohort has either disappeared or moved on to other means of speculation (Bitcoin perhaps?). Compare today’s dollar volume, under $50MM/month, to the late ’90’s $25B+/month. Volatility in penny stocks is virtually non-existent.

For all intents and purposes, the penny stock market has dried up, helping confirm the extremely low volatility in the broader market as even the most speculative of speculators are seemingly taking it easy.

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Bond Market

We have discussed the coming rise in bond yields numerous times over the past year, and this past week that thesis started gaining attention from some of the better known bond fund managers.

Bill Gross, of Janus, was one of them as he utilized a similar chart to the one we provided in our 2018 Outlook and is updated below to proclaim that the bond bull market of the past 35 years “is over”. He also published his latest musings where he is calling for a “0-1%” annual return on bonds for the foreseeable future. Can you imagine a world where bonds return 1% or less and stock prices are also declining?

We can, and we are fully preparing for such an environment when, unfortunately, the traditional “pie chart” diversification fails investors when they need it most. Many investors are going to get a wake up call when they realize the bond portion of their portfolio is not providing them the diversification they thought they had. The Portfolio Insights section of this update provides a great analysis showing just how little bonds do protect when stocks decline.

 

Recent examples of rising bond prices during stock market selloffs are the exception more so than the norm, and our 9/29/17 IronBridge Insights also laid out why this has to be the case economically. As interest rates rise, the cost of capital also rises, and when the cost of capital rises, equity prices must come down, representing a fundamental rule of finance of falling bond prices and falling equity prices.

One way to mitigate the risk of a rising rate and falling bond price environment is instead of owning bonds that have fixed rates, own floating rate bonds, which will return more yield as rates rise. This is similar to also owning floating rate CDs and shorter duration Treasuries that you can then re-roll into higher rates as the overall rate environment rises. Could you imagine being locked into a 2% 10 Year Treasury bond if the 10 year Treasury yield is at 6% in two years? That’s a very real possibility that we would prefer to avoid.

With the 10 Year now creeping toward its 2017 highs, and the mainstream media now talking about the end to the bond bull it is likely we are nearing a short term pause in the move higher in yields. However, we expect the longer-term trend in bond yields to remain up and are looking at any rallies in bonds as ones to be sold. 3% on the 10 Year remains a good short term target in 2018 as the technical chart above suggests.

We hope the move higher in yields remains a calm and measured one. We also hope risk’s Rip Van Winkle slumber continues for a while longer.

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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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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.