We discuss the basics of Bitcoin, examine its exuberance, review our three pillars of investing, and look at whether crypto currencies are affecting other areas of the markets.

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Insights Overview

MACRO Insights: What is Bitcoin?

The big story over the past few months is the meteoric rise of Bitcoin. No doubt it’s a hot market that has captured the public’s interest. But, what is it?

PORTFOLIO Insights: The Three Pillars of Investing

There are many ways to successfully invest. The most important part of any investment strategy is the process with which decisions are made. In our view, there are three primary contributors to returns. We call these “pillars” of our investment process, and it is through this lens that we view our client portfolios.

Market Microscope: Are Crypto Currencies Affecting the Markets?

The last week of November was an extremely interesting one with two out of five trading days with significantly more volatility than the world has become accustomed to. One of these days was likely highly correlated with what was occurring in the crypto currency markets.

On Our Radar

Budget Impasse: The next drama surrounding the budget is due Dec 8 and is flying under the radar as a recent tweet by Trump suggests there will be a government shutdown to end the year unless certain negotiations are completed.

Trump Taxes: We sent out an update on the Trump tax proposal the week of Oct 30. The details are still being negotiated, but it seems likely something is passed by year end.

FIT Model Update: Uptrend

Fundamental Overview: Goldman Sachs released a report this week that looked at today’s global bond, stock, and credit market valuations. The results were not good as they proclaimed, “It has seldom been the case that equities, bonds, and credit have been similarly expensive at the same time, only in the Roaring ’20s and the Golden ’50s. All good things must come to an end…there will be a bear market eventually”.

Investor Sentiment Overview: Stocks have never risen for 13 months in a row…until Nov 2017, when stocks completed that feat for the first time ever.

Technical Overview: The recent weakness in tech has our attention, as some stocks have sold off substantially, but thus far little technical damage has been done at the sector or index levels.

Focus Chart

The Shoeshine Boy

Have you ever heard the story of the shoeshine boy?

The story goes that in 1929 one famous investor was able to exit the stock market prior to its 80% crash in price because the young boy that shined his shoes started giving him stock advice.

The thesis is that by the time the shoeshine boy starts to get in on the act, the rest of the world has too. In 2017 the price of 1 Bitcoin has risen from under $1,000 to over $10,000 as it’s peppered all over the news.

Is Bitcoin today’s shoeshine boy parallel?

Portfolio Insight

Three Pillars of Our Investment Strategy

“If you can’t describe what you’re doing as a process, you don’t know what you’re doing.”

– W Edwards Deming

There are many ways to successfully invest, but the most important part of any investment strategy is the process with which decisions are made.

In our view, there are three primary contributors to returns. We call these “pillars” of our investment process, and it is through this lens that we view our client portfolios.

The three investment pillars are:

1. Participation
2. Momentum
3. Risk Management

Let’s look at the first pillar: Participation. This is fairly simple…the goal is to participate in favorable markets. Anyone who invests in an index fund takes this approach. Don’t get too fancy, don’t overthink things, just gain exposure to a particular market in your portfolio.

Most of the time this market is US Equities. But participation also includes other areas, such as bonds, international stocks, commodities, etc. Most people focus on this part of the investment process, as witnessed in the widespread popularity of index funds over the past 10 years.

Because we have been in a good market for so many years, many people don’t think about the opposite of participation. What markets do we NOT want to participate in? Sometimes we want to avoid certain parts of the market either because they aren’t as strong as other areas, or worse, they are declining in value.

The second pillar attempts to out-pace the broader market. This is called Momentum investing. The analogy we tend to make is that an index is like a car driving down the highway at 65 mph. But the index is simply an average of all of its components. At any given time, there are “cars” that are driving 75 or 80 mph, while others are only going 35.

Momentum investing attempts to identify the investments that are accelerating past the average, and get out of those investments once this acceleration stops.

The third pillar is only applicable during times of market stress. Risk Management is not en vogue right now, but that doesn’t mean it should not be practiced. In fact, we believe risk management to be the single biggest contributor to returns over time.

The issue with risk management is that it only really gets its time to shine once every 5-10 years. But when it does, having effective risk controls is the most important tool an investor has at his or her disposal.

Much of this issue is dedicated to Bitcoin given its popularity right now. There is no question that momentum is extremely high in Bitcoin, and has been all year, and our clients could potentially earn very high returns if we allocated a certain exposure to crypto currencies and they continued to perform.

This is where we as wealth managers must make a difficult decision. We conclude that this is an area of the market we are choosing NOT to participate in. Momentum is just one of our investment pillars.

With Bitcoin moving in price sometimes 10-20% in a day, we cannot possibly apply a prudent set of risk management strategies to an asset of this nature. To us,momentum does not trump risk management.

Macro Insight

What’s the Deal with Bitcoin?

Bitcoin has been a hot topic recently. Its ascent from $1,000 to over $11,000 this year has received increased coverage on almost every news outlet, and now it is tough to leave a party without hearing somebody mention it. It now has a huge cult following, has been banned in China, and has even gained attention from hedge fund managers as they scramble to raise new funds to take advantage of the latest craze. But what in the world is Bitcoin anyways?

What is a Crypto Currency?

At is most basic form, a crypto currency is nothing more than an entry in an electronic database that no one can change without fulfilling specific conditions. Bitcoin was the first and most popular of these crypto currencies. Now, it is only one of over 1,000+ crypto currencies.

We view Bitcoin as having two separate identities:

1. It’s use as a Digital Currency
2. The Blockchain technology powering them.

How did it get started?

Bitcoin was designed to be a purely peer-to-peer version of electronic cash that could avoid being processed through a financial institution. The original software for Bitcoin is a technology called “blockchain”. It was developed by a person or group of people using the pseudonym Satoshi Nakamoto. You can view the original white paper by clicking here.

Bitcoin as a Digital Currency

Bitcoin is a digital “currency”, meaning it can only be transacted online. It has no physical form, and is not redeemable for any other commodity such as gold. Its currency value resides only in two ways: 1) the willingness of other people to use another acceptable form of payment (such as US Dollars or Euros) to “buy” someone else’s Bitcoin; and 2) the willingness of a business or individual to accept Bitcoin as a form of payment itself.

The first of these values seems widespread (at least for now) with more than 10MM+ accounts opened on Coinbase, the U.S.’s most popular website used to buy and sell crypto currencies. Bitcoin’s meteoric rise in price has helped fuel the recent demand to “get in on the action”.

But the second of the values, those willing to accept Bitcoin as payment, is still in its infancy. You can’t use a Bitcoin at Wal-Mart, for instance. The graphic below, summarized from an article from steemit.com, reveals the current locations that accept Bitcoin. Looking at the list, besides Overstock and Microsoft, the adoption by large vendors has been very slow and likely disappointing for Bitcoin enthusiasts.

Even those firms like Overstock.com and Microsoft must still convert their crypto currencies back to a more widely accepted value, for reporting and other purposes, likely leading them to immediately redeem any Bitcoins back for Dollars for all the purchases made using Bitcoin. This in and of itself brings into question Bitcoin’s relevance as a replacement currency.

How are Bitcoins Created?

One other key aspect of Bitcoin, that not all crypto currencies can claim is its supply limitation. Bitcoin has an innovative feature which caps its supply. For every new “coin” that is “mined”, the “miner” (someone with a very high powered computer) must solve harder and harder puzzles which require more and more time and/or processing power. The supply is also capped at 21MM coins, so once those 21MM coins are mined, then there will be no more created (21MM is projected to be reached by 2140).

Originally this cap on supply made it extremely attractive as a currency alternative since the currency would not be able to be diluted. However, with more than 1,000 other crypto currencies now in existence. It seems the supply of crypto as a whole is unlimited with no cap on supply, likely lessening its attractiveness as a replacement currency.

What is Blockchain Technology?

In our view, the biggest potential impact from Bitcoin is from its technology. Blockchain technology is an innovative technology that allows digital information to be distributed but not copied. Picture a spreadsheet or document that is duplicated thousands of times across a network of computers. Information is available to all users once it is shared.

In the illustration below, the initial “information” being distributed is a Bitcoin transaction. One person is selling Bitcoin, while another is buying it using a currency such as US dollars. Once the transaction is requested, it is broadcast to a broad network of computers for validation.

A transaction does not need to involve Bitcoin. It could involve contracts, public records, financial transactions, internal company documents, or any variety of information. Once verified, the transaction is time-stamped, and a new “block” of data is entered onto a digital ledger. Similar to sending an email or a fax, once it is sent it cannot be changed.

All subsequent transactions are then added to the “chain”. So once the transaction is complete and verified, the record of it cannot be altered. The theory is that by sharing transactions among many different independent users, these blocks of information cannot be modified by a single user, has transparency among all of its users, and has no single point of failure.

Are we going to invest in Bitcoin?

Bitcoin is extremely popular right now, as evidenced both by its meteoric price rise, but also by the amount of people talking about it. There are certainly some merits to it, such as the blockchain technology.

However, we believe we are witnessing a speculative fever right now in Bitcoin for a multitude of reasons: we also have heard multiple stories of young kids becoming rich by trading it; we are witnessing the price of Bitcoin go parabolic; it’s being discussed on every news channel.

We believe many investors are confusing the potential of the technology with the value of a Bitcoin. When taking into account all the considerations for a prudent investment, Bitcoin does not meet any of our standards.

In the Market Microscope section we look at some of these in more detail along with a chart of Bitcoin’s price since 2016.

Market Microscope

Do Crypto Currencies Affect other Areas of the Market?

Crypto Currencies

What do the six tickers listed have to do with one another? Here is a hint: they are all in the same industry as represented by the final ticker, which is a popular ETF for that industry.

These tickers are all semiconductor companies and the Semiconductor Holders ETF (SMH), and their prices all got crushed on Wednesday, Nov 30 as outlined in the graphic. So on a day when the S&P 500 was flat, why did these stocks fare so poorly? Our speculation is that some equities are being thought of as plays on crypto-currencies.

The thought process goes like this: many of these currencies, Bitcoin for instance, need very high computing power to mine “coins”. These coins become more attractive at higher prices as breakeven costs get lower, but they also look more unattractive as price declines. Now check out the next chart, from Coinbase, the U.S.’s most popular exchange for Bitcoins, with over 10 Million accounts.

On that same day, Bitcoin opened U.S. trading well above $11,000, but it proceeded to swiftly fall below $9,000, over 20% from its peak just a few hours earlier. During that time that largest exchange for Bitcoin, CoinBase, went offline as any owners of the crypto-currency were essentially held hostage. Bitcoin also wasn’t the only crypto to fall so much, most of the larger ones all fell in price.Nobody in the media was talking about how the semiconductors likely fell victim to their relationship with crypto currencies, wanted or not.

Similarly some of the run up in these semiconductor stocks are also likely because of the crypto boom that has been occurring. Over the past one year, the semiconductor holdings ETF is up over 40%, more than double that of the S&P during the same time.Live by the sword, die by the sword we suppose, as owners of semi conductor stocks, like it or not, should be paying attention to Bitcoin’s price. If it crashes, it’s likely semis will too.

Bitcoin going Parabolic

The chart below shows us Bitcoin’s price history since 2016.

On the chart we have also drawn a parabolic trendline to show the speculative nature of its price rise since March as it has moved from under $1,000 to north of $10,000.

As students of the market’s history, we recognize this chart as a big warning sign. It’s rare for prices to move parabolically, but when they do, they almost always have massive corrections once the parabolic move is finished.

The next chart reveals one example in history when there was a similar parabolic price move. In the late 1970’s inflation had gripped America, and there was no better place to see the response to that inflation than in the price of the precious metals.

Over a two month period leading into January 1980 silver’s price went parabolic, tripling in price from under $20 per ounce to over $45 per ounce. The chart shows the parabolic nature as prices increased in their rate of ascent.

However, once that crescendo was reached, prices came roaring back down. In this case prices moved back below where that parabola started. In Bitcoin’s case this would be back below $1,000.

Another example is shown next. We all remember the tech “bubble”, right? Well prices of technology stocks back then also moved in a parabola as depicted on the chart of the Nasdaq.

Once that parabola was complete, those prices also came crashing back to earth just as quickly as they rose. Stock market technical analysts recognize the increased danger in a market that has become parabolic.

Bitcoin seems to be behaving that way right now. All the talk, attention, and euphoria surrounding it only adds value to the thesis that it too will eventually come crashing back down.

Stock Market

The Dow and S&P avoided most of the fireworks this week and as mentioned in the FIT Model Conclusion from the Summary page of this report, the S&P has now set an all time record with 13 straight months of positive performance. It’s as if the stock market will never go down again (said with tongue in cheek)! The first chart below shows this bullish streak, but until we start to see that trend slowing, and then rolling over, we will continue to try to take advantage of it.

So what are we looking for right now to help us warn of the next pullback? We are watching what is known as the market’s Pivot Points to tell us what trend the market is in. Pivot Point is really just a fancy way of saying average price, and it is somewhat similar to a moving average. It’s calculation is the prior period’s (high+low+close)/3 to come up with a quick estimate of the average price paid during that period.

The next chart outlines the Monthly Pivot Point in purple. Notice that these levels “reset” every month as the period on the chart changes. With the switch from November to December, we also have a new Pivot Point to watch as we move into the final month of the year. October’s average price paid was $2560 (shown on the chart), and November’s average price paid was $2621, which is now December’s Pivot Point and the level we are watching.

Notice also how these levels have been rising along with the market ever since last November? As long as price stays above its Pivot Point, it shows us that the trend continues upward. When price starts falling below the Pivot it will warn us that the trend has slowed and the risk of a larger pullback has increased. That is the next clue we are watching to warn that the market’s nonstop ascent may be temporarily over.

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.

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 explore Investor Sentiment, look at optimism in late stage bull markets, and discuss the three major flaws of modern portfolio theory.

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Insights Overview

Portfolio Insights: The Three Flaws of Modern Portfolio Theory

Modern Portfolio Theory is one of the most widely used principles in investing and finance today. And it is terribly flawed.

Macro Insights: What exactly is Investor Sentiment?

We speak a lot to the three pillars of our market analysis – fundamentals, sentiment, and technicals – but what exactly is sentiment and how do we account for it in our strategies?

Market Microscope: Sentiment Indicators Suggest Optimism is High

There are countless ways to measure sentiment. We discuss a few, where to find them, and how to interpret them. Most sentiment measures currently suggest that optimism is very high, but that does not mean optimism and thus share prices, cannot continue higher. These indicators tend to have extended moves when optimism is high.

On Our Radar

Earnings: Earnings are largely in for the 3Q.  No major surprises.

Trump Taxes: We sent out an update on the Trump tax proposal the week of Oct 30 as we received more details around the initial proposal. Although far from being passed (Goldman Sachs is giving a compromised version a 65% chance of passing), the implications to individuals could be significant. Proper planning may help you take advantage of the coming changes.

FIT Model Update: Uptrend

Fundamental Overview: Earnings are mostly done, and the trend of the past few years continues. Tech earnings were strong, retail earnings were weak, and market valuations are high.

Investor Sentiment Overview: Sentiment continues to hover near euphoric extremes, however, history shows us this hovering can last a while before the markets change their trend. This week the VIX (a measurement of stock market volatility which often moves inversely to the markets) is at an all time low, but that doesn’t necessarily mean it is time to sell. Prior instances of VIX bottoms occurred in 1993 (7 years before the actual market peak) and January 2007 (9 months before that market top). One thing to watch for is a rising VIX Index along with a rising stock market.

Technical Overview: The trend remains up, and the technicals continue to point towards higher prices.

Focus Chart

Low VIX not a sign of a Major Top

One theme over the past few years has been the persistence of sentiment indicators reaching extreme levels. In many ways this is a warning sign that the market is indeed at levels that could form a market top.

However, a look back at the history of a few popular sentiment indicators shows us we can sit in these extreme levels for a long time before their implications ever come to fruition.

The chart below shows one such indicator, the VIX, which we discuss in more detail in the Market Microscope section.

Portfolio Insight

Three Flaws of Modern Portfolio Theory

“In theory, theory and practice are the same. In practice, they are not.” – Albert Einstein

Modern Portfolio Theory (MPT) is the preferred investment theory used by most banks and large investment firms. We believe there are flaws with MPT that are placing client assets at extreme risk. History shows MPT to be useless when markets undergo any kind of stress. We find there to be three major flaws in Modern Portfolio Theory:

1. Investors are not always Rational.

The basis of Modern Portfolio Theory is the “Efficient Market Hypothesis”. This investment theory states that stock prices always trade at their fair value, and cannot ever be over-valued or under-valued. It also states that investors always behave in rational ways, and never panic or get too excited about their investments. Markets have a long history of boom and bust cycles, from the tulip bubble in the 1600’s to the real estate bubble of the mid-2000’s.

2. Correlations Change Over Time

MPT attempts to maximize return and minimize risk by using diversification, or having different assets within a portfolio that perform differently in different market environments. The measure of how investments interact with each other is called “Correlation”. Two assets with a correlation of “one” move in exactly the same way. Conversely, assets with a correlation of “negative one” move exactly opposite of each other.

MPT makes the assumption that these correlations do not change over time, and that investments will behave in a predictable way regardless of market conditions. Not only do investment correlations change over time, they change many times throughout any given year.

The top portion of the chart to the right shows the correlation between stocks and bonds.

Over the past year, correlations have switched from positive to negative a total of 12 times! It is impossible to make a longer-term projection on how assets might interact with each other and be anywhere close to accurate. Yet, this is the cornerstone of the supposedly “diversified portfolio” being sold by large banks.

3. Mathematical Flaws

We won’t go into much detail about the math surrounding this, but MPT uses an assumption that asset returns follow a Gaussian (or normal) statistical distribution, which is not the case in real life.

There are other mathematical errors with this theory, primarily in the risk, return and volatility assumptions that are based on expected future values that simply cannot be predicted with any accuracy.

Don’t misunderstand, we believe greatly in diversification. But the diversification we believe in uses different strategies, signals and outcomes to achieve results.

Bottom line, don’t rely on Modern Portfolio Theory to achieve your financial goals.

Macro Insight

Is the Market Sentimental?

In the Overview page of every issue of ‘Insights’ we feature our FIT Model and what it is telling us about the markets. One of the key components to the FIT Model is Consumer Sentiment, but what is this oft overlooked component to the markets? Sentiment is likely the most subjective piece to a stock’s price, but at certain times, it may be the most important.

In the Overview page of the last issue of the ‘IronBridge Insights’ we brought to your attention the University of Michigan Consumer Sentiment Survey, one of the longest running consumer surveys. That survey recently reached levels last seen in 2004, suggesting consumers are the most optimistic they have been in over 10 years.

This issue we want to call attention to another popular sentiment indicator (shown below), the Conference Board’s measure of consumer confidence. That sentiment survey also helps confirm what the University of Michigan survey suggested two weeks ago…consumer confidence is again at the optimistic levels associated with prior market peaks. Notice on the chart below, from SentimenTrader, that prior extremes in confidence (blue) have generally correlated with peaks in the stock market (the top chart of the S&P aligns with the peaks in consumer confidence’s blue line).

These two surveys are subjective in nature, meaning a consumer could have one opinion one day and another opinion the next day, even though their situation may not have changed. However, another sentiment indicator also shown on the chart, is a more objective measure of how consumers feel. Have you heard any of the claims by the media that there is all of this “cash on the sidelines”?

The index shown in red, from the BEA (Bureau of Economic Analysis), reveals cash levels as a % of disposable income is actually near its all time lows. This reveals that not only are consumers subjectively optimistic, but the historically low levels of cash reveal they are also objectively putting their money where their mouth is, by either spending or investing. The final takeaway from the chart is shown by the red dots. These dots reveal that when confidence is peaking, and cash is at its lows, market tops are usually not too far away (at least based on the setup heading into 2000 and 2007).

Market Microscope

Optimists can get more Optimistic

Most investors don’t pay attention to sentiment indicators, but adding the tool to your toolbox can be beneficial, especially around key market inflection points. Extreme sentiment readings often occur before or simultaneous to major market tops and bottoms. Many of these sentiment measurements are known as coincident indicators, largely because they typically rise and fall along with stock prices, but we like to think of them as more than just coincidence. We prefer to think of them as confirmation indicators.

Famed investor Baron Rothschild is credited with coming up with the term, “buy when there is blood in the streets”. His timely suggestion came about in the early 1800s when he was making investments after the panic that followed Napoleon’s Battle at Waterloo. The quote is really just a play on investor sentiment. When investors are most panicked is when they should be buying, and, similarly, when they are most euphoric is when they should be selling. This is the essence of sentiment analysis; attempting to solve where within the panic and euphoria cycles we are.

Below is a table that lays out some of the sentiment indicators we use and how we interpret them. This, by no means, is an exhaustive list, but it does help show how we try to objectify where we are currently within the sentiment environment.

Most sentiment measures are best looked at over longer term periods. In other words, with a few exceptions, sentiment measures are rather slow moving, and thus better compared over long periods of time. Similarly, just because a sentiment measure may be at an extreme does not mean it won’t become more extreme or that a market top is imminent. This is why we don’t look at sentiment measures in isolation and refer to them as confirmations – we couple them with the fundamentals and technicals to try to get confirmation of what our other indicators are telling us.

Where are We in the Sentiment Environment?

Referring back to this graph, IronBridge has come up with a proprietary way to weight the different sentiment measurements to help us get a better feel for where we are within the overall sentiment environment.

Rydex Cash

For instance the Rydex cash cushion suggests investors are about as bullish as they have ever been (very little cash cushion with record long exposure to leveraged ETFs). We compare today’s reading with history to draw that conclusion. To us, the fact that investors are now the most leveraged they have ever been within the Rydex fund family is meaningful, especially when you consider we also had similar extreme readings in this index back in the year 2000 and in 2007, just before major market tops. This is why we score that indicator a 1 out of 10 (1 being the most bearish and 10 the most bullish).

Market Sectors

However, when we look at the different stock market sectors, we don’t see any bearish deterioration, quite the contrary, as the leading sectors today are typically the ones that outperform during bull markets. If we see this start to change we will lower that score down from an 8 out of 10 (generally bullish), but for now that measurement suggests bullishness.

Overall we are neutral in our sentiment indicators as the weighted score reveals. Many indicators are at extremes, but that does not mean a market top is imminent (more on that below).

Other Sentiment Indicators

Some other examples of subjective sentiment measures include the following:

• Telephone surveys (like the UofM sentiment survey)
• Polling (like answering Money Magazine’s annual investor questionnaire)
• The skyscraper index (the notion that most skyscrapers are either built or designed near the end of bull markets)
• The hemline index (a study suggesting the length of women’s dresses generally follows the stock market’s ups and downs)
• The popularity of passive investing versus active investing (the notion that passive investing is more preferable near the end of a bull market than near the beginning of one)
• The cover of the magazine indicator (numerous studies which suggest that when an investment theme makes it onto the cover of a major media outlet, the opportunity has likely already passed)

Objective measurements are typically measured by either Dollars, or some similar form of consistent standard. Some examples are shown next:

• How much of your portfolio is invested in stocks versus bonds versus cash? (This is an objective measure of how investors “feel” about these individual markets. It also varies greatly through time)
• How much leverage people are using to buy investments (Typically people won’t use leverage unless they think they will be able to pay it back. Therefore more leverage is usually utilized during good times more so than during bad times.)
• NYSE Margin Debt (The NYSE tracks how much margin is being used to buy stocks. Right now that measure is at an all time high, which is meaningful if you are aware that leverage is highest near market peaks and lowest near market bottoms)
• Number of covenant-lite loans. (Covenant-lite loans are typically a result of a bull market and similar to leverage their popularity coindices with bull markets)
• What the cost of portfolio insurance is (the VIX Index, for instance – more on that below)
• Number of IPOs (There is a very positive correlation between the # of IPOs and stock prices. High stock prices motivate companies to go public and “cash in”. Low stock prices cause the opposite

Another sentiment chart is shown next. Can you guess if this is an objective form or subjective form of sentiment?

That chart is of another sentiment measurement built from a monthly survey to one of the largest investment groups, the AAII (American Association of Individual Investors).

The survey asks the group members to disclose what percentage of their portfolio is weighted in stocks. Currently the cohort is 68% invested in stocks, which, as SentimenTrader has pointed out, suggests the group is rather optimistic.

When we look back at history at other times this group was this optimistic, the year 2000 and year 2007, tops were forming. However, there were also plenty of false positives, meaning that the measure hit optimistic levels, yet stocks were still higher 1 year later. This optimistic reading occurred for the first time in 1997. Stocks took 3 more years to top, but it is pretty clear that there is value in knowing when this group is optimistic and when it is pessimistic. At times it was pessimistic were some of the best buying opportunities ever.

VIX Index

The final chart is of the VIX Index. There has been talk all year about the ultra low VIX, and indeed the next chart shows us that the VIX is indeed at an all time low. Most savvy investors understand the inverse relationship between the VIX and the stock market, which is why many are pointing to the ultra low VIX as a sign of caution for equities, and they will likely be proved right at some point over the next 6 years, but that is a long time to potentially be wrong in the investment world. In some sense their warnings are warranted, but, taking a step back and looking at the history helps us build a better investment thesis.

There have been prior times when the VIX was similarly low, and in all of those cases the bottom in the VIX occurred well before an actual market top occurred. In Dec 1993, the VIX hit a low. It then took over 6 years of a rising VIX and rising market to form the next major top. Prior to the financial crisis, the VIX bottomed in January of 2007, a full 9 months before that market saw its final high.

Although a low VIX is certainly something that is associated with market tops, sometimes that low VIX can persist for months (or even years) before market prices actually respond.

Instead of seeing the low VIX and drawing the market top conclusion, a better signal may be waiting for the VIX to turn up in price (along with stocks). That convergence has been a better indicator a top was near as pointed out on the chart.

The low VIX could be construed as an early warning sign, and in that sense we should look at it as yet another signal the ingredients are in place for a market top to form, however, sometimes these ingredients can cook for months before the bear’s meal is finally ready.

That is likely the case right now with the VIX and a lot of the other sentiment indicators. Many have been extreme for months (or years) already, yet the market’s rally persists. The AAII chart above is a good example of this. Often, it reaches the optimistic zone, but that does not preclude an immediate market decline. Instead that optimism may persist as it enters the upper extremes, and then persists. It seems the real signal is when the index moves back out of optimism, down toward pessimism.

One thing is for sure, many sentiment indicators have reached levels associated with prior market tops. But, that doesn’t mean one is upon us exactly right now. Many of these indicators have had plenty of false positives over the last few years. We believe we have a framework in place to at least help warn us when and if the next major top is upon us. We don’t believe we are there yet, but we are certainly aware that the risks are and have been elevated, at least from a sentiment standpoint.

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.

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 discuss what to look for when a stock market tops, look at the topping processes in 1987, 2000 and 2007, and reveal five ways to avoid the emotional market cycle.

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Insights Overview

Portfolio Insights: 5 Ways to Avoid the Emotional Market Cycle

Markets are a collection of humans acting in both rational and irrational ways. We must remember that markets work in cycles, and we believe that being aware your own emotional responses can make you a better investor.

Macro Insights: What does a Market Top Look Like?

Market tops are a “process” as stocks don’t just fall from the sky. There are typically warning signs that help investors recognize when the risk of a major top has increased. The key is knowing where to look, what to look for, and ultimately having the discipline to listen to what the market is telling us.

Market Microscope: Is the Market Topping?

A look back at the market tops of 1987, 2000, and 2007 reveals a few interesting technical clues. The bond market also continues its roll-over as yields rise.

On Our Radar

Earnings: We are thick in earnings season as we dove into the details in our last Newsletter.  For the most part, earnings have been very strong.

Trump Taxes: There are some large implications from the potential changes to the tax codes. The changes to the corporate tax code will likely have more impact on stock prices, but individuals should also consult their CPA concerning the implications of changes. One example: If most deductions are going away, then pulling forward deductible expenses to 2017 may make sense.

FIT Model Update: Uptrend

Fundamental Overview: Technology earnings have come in strong but the S&P’s overall long term earnings growth remains weak and lagging recent price rises. This means P/E ratios remain elevated.

Investor Sentiment Overview: The University of Michigan Consumer Sentiment Indicator, a popular and long-standing measure of the consumer based on random phone calls to 500 households, hit its highest levels since 2004. This indicator is back above the 100 level for the first time since then, suggesting the consumer is now “over” the financial crisis (which took this Index down to the 55 level). The 100 level was also the starting point for the Index back in 1964. It peaked at a level of 112 in the year 2000, simultaneous with the stock market’s peak. The best way to view it is as a contrary indicator.

Technical Overview: Technicals continue to remain overweight and bullish in our FIT Model

Focus Chart

Topping Process Leading up to 2008

Nobody rings a bell at the top, but history shows us that there are plenty of warning signs leading up to major stock market peaks and large market declines. One reason for this is the herd mentality of humans. We tend to follow what others are doing, resulting in similar repeating patterns in the markets.

One key in recognizing a top is knowing what tools to be looking at and how to interpret them. The chart of the Tech Bubble to the right is discussed in detail along with a couple of other major market topping events and lays out 5 key things to look for when trying to decide if the market has topped out or not.

Nobody is able to predict the exact market top to the day, but by utilizing the appropriate tools we are able to recognize when the risk has increased of a major market drawdown.

Portfolio Insight

Know Thyself

Markets are not beholden to the laws of physics. Too many professional and individual investors use formulas to calculate the value of an investment. Here is one of the simpler examples: E(R1) = RFR + B[E(Rmkt)-RFR]. (This is a way to calculate the expected return on an investment relative to the “risk free rate”.)

While these can sometimes be useful, we believe that no formula can account for the fact that markets are a collection of human beings acting in both rational and irrational ways.

Why do stocks change value by more than 1% in a day? Or by more than 10% in a few months (up or down)? Have the underlying fundamentals of the company changed that much? Sometimes the answer is “yes”, but overwhelmingly it is because human investors are making emotional decisions about the stock.

The graphic to the below shows the typical emotional cycle of investing. As the market moves higher, investors move from optimism to excitement, and eventually to euphoria. When the cycle turns lower, investors experience anxiety, denial, fear and eventually panic and despondency.

Awareness of these characteristics can help us identify which part of the market cycle we are in currently. We believe the overall market is now somewhere between excitement and euphoria since risk management, by many, is perceived to be less important.

So how do you avoid or at least minimize the negative effects your own emotions may have on your portfolio? Here are five strategies that may help:

1. Pay attention to your emotions. Know when you are feeling nervous, excited, fearful or exuberant. When these emotions surface, try to not make a decision immediately, rather take a step back, do objective analysis, and sleep on the decision.
2. Apply a rules based approach. Try to eliminate emotions from your investment process. Develop rules and stick to those rules.
3. If you use a financial advisor, ask what rules they use. Asset allocation and rebalancing is not adequate. There must be entry and exit strategies applied. Your advisor and those running allocation models at their firm are humans too, subject to the same emotional cycles.
4. Do not get emotionally attached to an investment. It may be your favorite company, but if it’s not working, get out. You can always get back in, even if its at a different price.
5. Don’t let a small loss turn into a big loss. Sometimes an investment doesn’t work out as planned. That’s okay. As they say in golf, don’t let one bad shot affect the next one.

Those who forget that markets work in cycles are those that are most hurt when the cycle turns. One way to help manage the cycles is to also manage our emotions. Having rules and strategies in place before market moves helps keep the emotion out of the investment process, allowing us to have a plan regardless of the circumstances.

Macro Insight

The Anatomy of a Market Top

There is an old saying on Wall Street that “nobody rings a bell at the top”. And, we say, “thank goodness for that”, because if there were a bell rung, nobody would ever get a chance to exit before the market immediately free-fell as that bell was dinged. Instead, market tops are usually relatively slow, and calm, at least until the larger masses join in the fun. This presents opportunity for those that know their history and know what to watch for.

There are often many technical signs a potential top may be occurring as long as you know where to look. No market top is ever exactly the same, but there are a few things that typically occur before any major selling really begins.

1. The first thing to note is that the market’s price starts to fall on a minute by minute basis before it falls on a daily basis before it falls week after week after week. In short, by keeping an eye on the shorter time frames we can stay ahead of the longer trends. A one year selloff doesn’t happen without first a selloff in shorter time frames.
2. The market shows a rounded formation of price action. This is referred to as it “rolling over”.
3. The market has broken key moving averages and trendlines. It often “backtests” and fails at these key levels.
4. Market non-confirmations occur (key Indices aren’t making new highs while others are).
5. Market panics often occur from already oversold readings, certainly not from new all time highs or overbought readings.

A look at the dot-com bubble and subsequent decline helps support these findings. There certainly were technical warning signs that increased the odds of a top forming.

Market Microscope

A Further Look at Key Market Tops

All market tops have historically had a few common traits that can help keen investors better prepare for the potential price declines that eventually follow. To further validate this claim let’s also look at two other major recent market tops.

The 1987 Crash

The 1987 crash was a short lived phenomenon, but it too showed similar traits of increased risk in being long equities prior to the actual crash occurring. Similarly, the financial crisis didn’t just occur overnight. It too showed many signs of a market weakening and risk in being long equities increasing, well before any real panic periods. In other words, there were warning signs which could have helped investors recognize the increase risk in owning equities.

The chart below reveals that all 5 rules also were largely occurring prior to the 1987 crash. Analysts following the shorter terms would have seen on Wednesday, October 14, 1987 price close below a key $306 price level. Additionally that day’s price action formed a bearish pattern in and of itself with an opening price below that key support level, a rally that attempted to bring price back above it, but one that ultimately failed with price falling back down to close below $306. Thursday continued the trend and then Friday furthered the selloff.

Notice that price entered the oversold momentum levels on that Thursday, a full two days before the Monday crash. Mean-reverters may have thought this was a good time to buy, but technical analysts would have noted the breakdown below $306 kept price bearishly inclined. Friday, then closed below the 200 day moving average, another warning to get even more conservative heading into the weekend. The writing was certainly on the wall, if you were paying attention to the right indicators.

2008 Financial Crisis

Finally, further evidence that market prices do provide clues to those paying attention can be garnered by analyzing the financial crisis. Similar to the other two large declines of the past 40 years, warning signs were certainly there.

1. Price had already broken down in the shorter time frames.
2. There was a rounded top formation.
3. There was another great moving average breakdown and subsequent back test very early during the decline.
4. Other Indices topped back in July 2007, while the S&P topped in October 2007.
5. Panics occurred after large selloffs had already occurred.

What Should We Expect to Happen when the Next Top Arrives?

Will the next top look like these tops? It won’t exactly, but there are a few things we should expect.

• Prices will breakdown in the shorter time frames first. A few down days in a row will eventually lead to a down week, which will lead to a down month, and so on. Paying attention to shorter time frames will help us stay ahead of the trend.
• There will likely be a rounded top, a market that is slowly rolling over. It likely will take weeks to months to form.
• There will be a breakdown in key trendlines, supports, and/or moving averages that ideally will be backtested, with a price failure that then resumes the downtrend. This warning sign should increase our urgency when it occurs.
• There will probably be non-confirmations among the Indices. For example, the S&P may make another new all time high, but the Dow won’t.
• Finally, any major crashes within a larger decline would likely occur only after the market had been selling off already. In other words, we shouldn’t expect a new all time high one day, followed by a crash the next day.

So, where does this leave us today?

The final equity chart (shown next) reveals we probably are not at a market top here, either that or it is still too early to tell. Let’s go through the list.

1. There has been no meaningful price breakdowns on the shorter time frames. Until we see some price damage done daily, we won’t see any done weekly, monthly, or yearly.
2. There is no rounded top. In order to have a rounded top we must also have a lower price high form at some point. That has not occurred for a year, and we must see these lower price highs before that can be confirmed.
3. Price remains above all key moving averages and trendlines. Until these key levels fail, the market’s bullish trend should be expected to continue. If they do fail, that should increase our urgency of the potential for a top.
4. There are no major intermarket divergences as all the key Indices have reached new all time highs together. The bottom portion of the chart shows us the Dow Transportation Average. Right now all the major indices are aligned, making new all time highs together.

Given the data, it’s very hard to make the argument that we are witnessing a top right now. In fact, the market looks extremely bullish. That of course could change, and if we start to see price fall below the key levels identified, it would add credence to taking a more conservative stance, but until that occurs, we remain bullish.

Bonds

In our inaugural publication on July 13, 2017, we dove into the bond market and provided a backdrop as to why we are preparing for a bearish market in bonds. In this update we look at recent price action and how the short term price action is now bleeding into the longer term charts. The resumption of the trend higher in bond yields appears to continue to be intact and probable.

The next chart reveals the 10 Year Treasury yield, and how it has started to move higher again. A recent breakout in yields has ended the downtrend in place since the beginning of the year. This suggests the market is resuming its larger trend in place since early 2016 of higher yields.

The next chart shows weekly price data. It takes a longer term focus on the markets, generating data points over a week’s time rather than a day’s. The first thing to note is that yield and price are inverse of one another. When the yield rises (upper chart), the price falls, (lower chart). Similarly the big move down in 2016 on the chart to the right coincided with the big move up in yields in 2016 in the upper chart.

Since that big move down in price, bonds worked their way back to a perfect (and typical) 50% price retracement. Once that level was hit, prices fell and have now taken out the two key supports in place during the 2017 counter-trend rally. This suggests the counter-trend move is now over and the prevailing trend (lower prices/higher yields has taken back over. We continue to expect pressure on bonds and thus have moved portions of our income producing portfolio to take advantage of a rising yield environment.

In an environment of rising yields, traditional bonds tend to lose value.

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.

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 explore how cognitive biases like Anchoring and Confirmation bias affect predictions, discuss whether earnings are driving the market, and look at valuation levels that are near historical extremes.

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Insights Overview

Macro Insights: It’s Earnings Season:  When it comes to earnings, a lot of games can be played. We feel the best way to view earnings is through a long term historical perspective.

Portfolio Insights: Cognitive Biases:  Behavioral finance is the study of how certain cognitive biases affect the decision-making process of investors. There are many ways the brain tricks itself into unknowingly making mistakes. We explore “anchoring” and “confirmation” biases in our Portfolio Insights section.

Market Microscope: Just how “Overvalued” is the Market?:  The Buffett Indicator is one way to measure valuations. It’s a longer term fundamental 10 year horizon indicator that has suggested to be out of stocks for years. Rather than relying solely on fundamentals, the technicals remain the better barometer for the markets currently.

On Our Radar

Earnings:  Earnings are expected to hit another quarterly record, but as discussed throughout this issue, that doesn’t mean stocks are cheap.

Trump Taxes:  The markets have been focused on the potential for tax reform as one potential narrative for currently high valuations. It’s looking more and more likely that once again Washington will be at a stand still. Is there a tax premium currently built into share prices?

FIT Model Update: Uptrend

Fundamental Overview:  The Buffett Indicator, discussed in more detail in the Market Microscope section, reveals the market is its 2nd most overvalued ever.

Investor Sentiment Overview:  Famed economist, Richard Thaler, has won the Nobel Prize in Economics. This would probably not make headlines, except for the fact that he won the prize based on his work in a relatively “new” field of economics, known as “behavioral economics” of which a “groundbreaking” idea that humans are not rational is a key tenet. We admit being a little tongue in cheek as we bring this to your attention since we believe irrationality has always been a reality in the financial markets. If it weren’t then things like “investor sentiment” wouldn’t even exist.

Technical Overview:  Technicals continue to remain overweight in our FIT Model.

Focus Chart

Multiple Expansion vs Rising Earnings

It’s earnings season and analysts are going hoopla for the expected 22% year over year growth. We, however, are taking a step back and noticing that earnings today are barely higher than they were 3 years ago. Essentially earnings are flat, even though price has risen over 500 points since.

The chart below reveals times when the market is rising due to rising earnings and times the market is rising due to multiple expansion. Since 2014 we have seen a market that has been rising much more because of multiple expansion rather than earnings. The chart also reveals a risk of $500 S&P points as price growth has greatly outpaced earnings growth. History (and the chart) shows us that both earnings and stock prices are cyclical, and eventually prices will come back in line with earnings.

In addition, in our Market Microscope section, we discuss the “Buffett Indicator”, which also shows the market is rising much faster than GDP, which historically puts us in a very difficult place for long term investment expectations. The Buffett Indicator, for only the 2nd time in history is suggesting the stock market will have an average annual return of (-2%) for the next 10 years. In other words, the market is overvalued by at least 20%.

Portfolio Insight

Cognitive Biases

“Prediction is difficult, especially about the future.” This quote has been attributed to multiple people, including Yogi Berra, Mark Twain and Niels Bohr. We think the market environment over the past several years illustrates this quote amazingly well.

Behavioral finance is the study of how certain cognitive biases affect the decision-making process of investors. There are many ways the brain tricks itself into unknowingly making mistakes. Two of these biases are called “anchoring” and “confirmation” biases.

Anchoring describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions (Wikipedia). One example of anchoring occurs when someone makes a prediction.

The initial prediction becomes the anchor. When presented with new information that may contradict the initial prediction, the brain does not impartially assess this new information; rather, the original prediction strongly influences the next prediction. At best, the initial prediction is modified slightly. At worst, new information is discarded and the person looks for information that would help support their prediction.

This process of seeking information that supports a certain point of view is called “confirmation bias”. New information is more easily accepted if it confirms the thesis, while contradictory information is more readily dismissed.

We see this type of behavior all the time. It is most obvious in today’s political climate, but it is very prevalent in finance as well. And its prevalence is not by clients and investors like the market analysts would lead us to believe. In fact, we believe it happens most often by the research departments at large financial institutions.

We recently read a report from a large bank about their year-end predictions for 2018. There must be an award somewhere for fastest to publish next years guess. The report predicted the market would be at the end of 2018 exactly where it was on the publication date.

They may be 100% accurate in their prediction, and predict the year-end number to the penny. We have no idea. We do believe that if they are wrong, they will only slightly change their 2018 target as the year progresses. And if they are REALLY wrong, they will say that there was no way to predict such an outcome from occurring, even if there were signs all along.

We also see anchoring bias in earnings estimates. The chart below by Alhambra Investment Partners shows how earnings predictions are reliably optimistic at the beginning of each year. The blue lines show that predictions are even anchored to the previous year’s projections!

There is one predictor of the market that we as investors should pay attention to…the market itself. It is always right, and the price is always the price, regardless of how over-valued or under-valued it may seem. It does things it “shouldn’t” do all the time, and just as often doesn’t do things it “should”.

One of our goals at IronBridge is to remove as much emotion as possible from investment decisions, and let data drive our actions as we strive to understand how we may be mis-understanding the markets. We think listening to the market rather than trying to tell it what to do is a better strategy, but of course, we’re probably biased.

Macro Insight

Show Me the Money

The first month of every quarter brings us earnings season. This is the time companies report their quarterly earnings from their just completed 3 month quarters. Firms have 45 days to report, but many of them cluster their reporting around the same time similar companies report. This past week, for instance there were 9 S&P 500 companies reporting earnings; 6 of the 9 were banks. However, only 5% of S&P companies have reported 3Q 2017 earnings. In this issue we look at some takeaways from earnings seasons.

The top portion of the table below lays out the current S&P 500 earnings picture with the current reporting season highlighted in yellow. The quarter ended September is expected to bring $29.80 in reported earnings per share, taking the trailing 12 months earnings to $108.43. This is year over year growth of almost 22%, a very good number. Couple that with an S&P 500 price of $2,519 and it results in a Price to Earnings ratio of 23.5x, which remains very high from a historical perspective.

The remainder of the table shows the longer history of earnings which helps put the current situation into context. The $108 in earnings will be an all time record high. But, if we look at a few of the prior all time highs, the $108 becomes less impressive.

Notice that back in the same quarter in 2014 earnings were $105.96. In other words, here we are three years later, and earnings are only $2.50 higher, or around 2.3% growth during that time. This equates to less than 1% earnings growth annually over the past 3 years, and if we adjust for inflation, it becomes negative real growth.

Additionally, with only 5% of constituents reporting, the $108 remains far from a lock. It’s entirely plausible that the $108 is not reached. This would make today’s exuberance surrounding record earnings even more questionable.

Notice in the table the 2018 expected earnings are a whopping $134 per share? Ignore any future estimates as it is a habit for Wall Street to grossly overestimate future earnings. It helps them fill a narrative to sell valuations, but future earnings have a very consistent habit of starting out way too high, only to be worked backward as the period gets closer. More on this “phenomenon” can be found here, but needless to say there are some conflicts of interest surrounding earnings estimates as the higher earnings estimates, the lower future P/E ratios are. The chart shows how “if” earnings do reach the $130s, P/E ratios at today’s prices would indeed fall to 19x. We won’t hold our breath.

In the Market Microscope section we expand on earnings, P/E ratios, and estimates and how they have impacted share prices historically. It seems there are times when earnings matter more, and times when earnings matter much less. can you guess which period we are in now?

One clue is the fact P/E ratios have remained elevated above 20x for 3 years straight now. Another was alluded to earlier. From a peak earnings to peak earnings perspective, growth just has not been there.

In the Market Microscope we look at a popular valuation technique as well as the historical relationship between earnings and share prices. The conclusion remains: valuations are very lofty.

Market Microscope

Just How Over-Valued is the Market?

A famous valuation quote from Warren Buffett states, “the price you pay determines your rate of return”, and while Wall Street and the media would like us to stay focused on the big 22% expected jump in year over year earnings, we look past the short term and recognize the longer term risks in a market that remains priced too high based on fundamentals. This is why we also use technical and sentiment analysis to make investment decisions.

Is the Market Overvalued?

The “Buffett Indicator” got its name, of course, from Warren Buffett, but it got its fame from being the one indicator Warren Buffett turns to to decipher the market’s valuation question. “Is the market over or under valued?” The Buffett Indicator is shown below as built by Jesse Felder, of the ‘Felder Report’.

This indicator takes the market capitalization of equities (price x shares) and divides that number by the GDP of America. The ratio, he proposes, is a good barometer of whether equities are over or under priced.

The chart goes back to the 1950s and does reveal the market currently is the 2nd most expensive it has ever been, when compared to GDP, and heading higher. This surpasses the valuations leading up to the financial crisis (which saw a P/E ratio peak in 3Q 2007 at 19.4x earnings compared to today’s 23.5x). The only other time this ratio was more extreme was during the 1990s .com bubble.

Additionally, Mr. Felder runs the Buffett indicator through a statistical test of its predictive power using actual 10 year average returns. Impressively the indicator does do a wonderful job predicting 10 year actual returns. What does it say now?

The Buffett Indicator is showing an expected annual return of (-2.9%) over the next 10 years. It’s also only the 2nd time in history it has predicted a negative 10 year expected return. The only other time negative returns were predicted was during the latter stages of the Tech Bubble, which actually came to fruition as the blue line on the graphic reveals the negative real returns during the period of 1998 through 2008. This means that today’s buy and hold investors, based on this indicator, should expect to lose money in the stock market over the next 10 years.

Notice too that since the year 2000 expected 10 year annual returns have never been above 10%? Based on the Buffett Indicator, valuations have been historically high for over 2 decades, not offering value investors as good of real long term investment potential as the past. Compare the 2000s to the 50 years prior. The indicator offered multiple periods throughout the 50s and 80s with 10%+ expected annual returns. Those days have been long gone as investors must now navigate public markets that have been perpetually overvalued.

Zooming into the last 20 years we have built our own indicator which helps show us what kind of near term risk we could have in this market. The following chart indexes the S&P price growth compared to the S&P’s earnings growth over that period. Price is shown in red with earnings in blue. We can learn a few things:

1. Earnings and prices have generally risen and fallen together. This makes sense since earnings are supposed to be a driver of share prices. The chart of the last 20 years reveals that, yes, generally share prices and earnings rise and fall together, but there are times this isn’t true.
2. Similar to the Buffett Indicator, which shows us when the market’s price gets ahead of GDP we also see times when the market’s price gets ahead of company earnings. This occurred during the .com bubble and is pointed out on the graphic. This also is occurring now.
3. The market’s price and earnings were highly correlated and generally rose together during the mid and late 2000s and from 2010 through 2014. This chart supports the fact that the financial crisis’s price meltdown was at least somewhat driven by falling earnings. Whereas the .com price meltdown was more likely, at least initially, a mean reversion since price growth got so far ahead of earnings growth. However, once price started to fall, earnings also eventually started to fall as well, compounding the pressure on prices.
4. Today’s situation looks more like the .com bubble than the financial crisis. Earnings are essentially where they were 3 years ago, yet the S&P’s price is over $500 points higher. This equates to a roughly 25% risk of decline for the S&P to get back in line with earnings and is highlighted in orange on the graphic. But, one other thing we can learn from the chart is that price and earnings tend to over and under shoot their mean reversions. If we were to see a decline in the S&P start soon, it is likely earnings would also eventually start to decline. This would exacerbate the current $500 point gap between the S&P and where earnings suggest the S&P should be.
5. One final thought on the chart and another way to interpret it. Really this chart is getting back to price to earnings ratios. Another way to look at the potential downside risk is to see that back in September of 2014 the S&P had a P/E ratio of 18.61x on earnings of $106. Since then the S&P’s earnings are essentially flat (up 2.3% in 3 years) yet price is over $500 higher, resulting in a current P/E of 23.54x. The S&P’s price has risen almost entirely due to multiple expansion rather than earnings growth, and this has occurred in an environment where interest rates are actually rising (if they were declining, one could potentially justify multiple expansion). There is risk that the P/E reverts back to that 18.61x level, and $108 of earnings * 18.61= an S&P of $2000.

What does it all mean? By almost every fundamental measure markets are over valued and have been overvalued for years, yet price has continued to rise. This is similar to what occurred during the .com bubble. Fundamentals have suggested a top for years, but clearly that has not worked, at least not over the short term. Investors need more tools in their toolbox than just traditional fundamental analysis if they want to be successful over both the short and long terms. This is why we also use technical as well as sentiment analysis to help us navigate the markets. During certain times these techniques carry a lot more weight in the market’s actions than fundamentals. We think one of those times is now.

Some technical analysis is discussed next.

Equity Technicals

The chart below is one of hundreds we follow each week, but we like this one right now because it provides a succinct picture of 4 key short term (days to weeks) and intermediate term (weeks to months) technical indicators for the market.

But before we get into the chart, let’s take a step back and discuss why we even care about technical analysis and put so much weight on it?

Simply put, because technical analysis focuses on price first and foremost and price is what makes us money or not. Fundamental analysis on the other hand largely focuses on earnings, which may or may not be correctly reflected through price and thus may or may not actually affect the performance of our investments, especially over the shorter time frames.

Case in point: the Buffett Indicator has suggested being short stocks for two years now (the expected negative 10 year returns), yet the market has continued to rise, rather substantially. Valuations are stretched, but can get even more stretched before succumbing to their more natural state. At some point GDP and earnings will likely carry more weight in the markets’ price decisions, but for the past few years, that has not been the case. Technical analysis, on the other hand, has largely been beneficial in navigating the markets as the trend has largely been up and the charts have largely shown that. 

There are four key indicators on the chart:

1. Moving Averages – Moving averages help smooth out price action. On the chart we have two moving averages, the 60 day and the 200 day moving averages. When price is above its 60 day moving average, it reveals the short term trend is bullish, and when price is above its 200 day moving average, it reveals the intermediate term trend is higher. Additionally, when the 60 day moving average is above the 200 day moving average it shows the short term trend’s momentum is stronger than the 200 day…all of which is bullish. Price has remained above both of these averages throughout the last 11 months.
2. Pivot Points – Pivot Points are a trend indicator and are shown by the horizontal blue lines that adjust each month. October’s Pivot Point is $2495 while November’s is currently $2544 (but is fluid until the calendar officially switches over to November). When price is above the Pivot Point (which it is now), it’s a sign that price today is above last month’s average price. That’s a bullish sign. Additionally, when the Pivot Points are rising, that’s also a bullish sign since the average monthly price is also rising.
3. Momentum Divergences – When price is rising but momentum indicators, such as the RSI Indicator at the bottom of the graphic, are not, it presents a case of waning interest by market participants. On the chart, shown by the red trendlines, there was a divergence that was forming during the price move from the March high to the July high. As prices made new all time highs, momentum was not confirming the trend. This presented a small problem for the market, which it wound up fixing with the August pullback. The pullback flushed out the weak hands and momentum has rejoined price now with an overbought reading accompanying the new price high in September and October. This excessive momentum now presents another short term problem the market will likely need to work out.
4. Extremes – When price moves too far too fast, that can also be small issue for the market since shorter term focused market players are more likely to take some money off the table once momentum has slowed. Notice on the chart, highlighted by the red ellipses, there have been 3 overbought scenarios over the last 11 months. The scenario back in December lead to a sideways market that lost more time rather than price, however, the overbought condition in March resulted in a larger pullback as well as a two month period of net sideways market action. The overbought readings helped identify when price was ripe for a stall, and we are at that point again today with the overbought status now on the market.

Although the technicals reveal an overbought market condition, the uptrend remains intact. Overall the chart is bullish as price remains above its moving averages and Pivot Points as well as in a trend of rising Pivot Points and moving averages. We may see some short term weakness given the overbought condition, but it’s not expected to damage the currently bullish picture.

The technicals continue to paint a bullish picture, and as a result we remain fully vested. At some point this market will rollover, and when it does the technicals should also help warn us that the risk of a larger pullback is upon us.

When we couple the technicals with fundamentals and prevailing sentiment we get a much better picture of the overall health of the market. Using fundamentals alone would not have been a good strategy over the last few years, and there will be times when relying on technicals alone also won’t be an ideal strategy.

For now we lean on the technicals and allow price to be our guide first and foremost as we continue to be participants in this bull market.

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.

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.  

Introducing a new way to diversify portfolios based on market cycles. Plus, September is historically the worst month for stocks, but not this year. And we take a deep dive into how bonds and interest rates affect stock prices.

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Insights Overview

Macro Insights:  Did you know that September is historically the worst month for the stock market? Not this year. It’s never a good idea to base decisions on statistics alone, but the 4th quarter is historically the most bullish period for stocks.

Portfolio Insights:  A frequent topic of conversation within our firm is how poorly traditional asset allocation models address real portfolio risk. We believe one of the most overlooked aspects of portfolio management is diversifying your timeframe, or how long you own an investment.

Market Microscope: The bond market had a busy week with seemingly no real catalyst. However, the charts helped us get ahead of the recent change in trend as the odds continue to increase the market has resumed a trend of rising yields. There are a few ETFs that capitalize on rising yields.

On Our Radar

Politics: Capital Hill has now shifted its focus to a revamping of the tax code as President Trump released his latest version on September 27.

Federal Reserve: The Federal Reserve met September 19 & 20 as they confirmed one more rate hike will likely occur in December as well as providing a schedule of the planned selling of their investments starting in Oct. The pace of the selling is slow in the grand scheme of things, but it will be interesting to see how the bond market responds.

FIT Model Update: Uptrend

Fundamental Overview: The popular economist Robert Shiller recently proclaimed in a news article that the stock market looks today “like it did prior to the 13 other bear markets”. His criteria included 1) high valuations, specifically a CAPE ratio above 22.1, 2) >13.3% year over year earnings growth, and 3) low volatility.

Investor Sentiment Overview: The week of September 18 saw the smallest range in the S&P 500 in over 40 years as the Index moved within a price range of less than 0.5%. The prevailing theme of all time low volatility continues.

Technical Overview: The markets continue to largely move higher and we continue to participate in the trend. As long as the technical signs remain bullish, we will remain vested. A key level we are watching for the month of October is S&P $2485. As long as it holds we will remain fully vested.

Focus Chart

Years that End in 7

Some statistics suggest the 4th quarter is the strongest quarter of the year for stocks. Other statistics, such as those portrayed in the graphic below, suggest the market could have a very difficult fourth quarter. Years that have ended in 7 for some reason have been very bad years for the stock market, especially the 4th quarter.

Could a similar fate be awaiting us this year?

Statisticians will tell you that having less than 30 data points makes it virtually impossible to accept a conclusion using statistics alone, so this chart probably shouldn’t carry much weight in market analysis.

In the Macro Insights as well as the Market Microscope sections we take a look at some of these statistics as we enter into the 4th quarter. Our conclusion is that market statistics are nice and often fun to talk about, but they are not very strong support for an investment thesis.

Portfolio Insight

Adjust Time Frames Based on Market Cycle

We met with a new potential client this week who had accumulated a large balance in their savings account. This family has been very successful, are incredibly intelligent, and pay attention to markets. But they have a quandary: What do you do with cash now?

They were nervous that if they invested in stocks this late in the cycle, they would risk losing a substantial amount of their principle. However, they were also concerned about having a large part of their portfolio being stagnant and remaining in cash. This is very common after witnessing the current expansion.

A frequent topic of conversation within our firm is how poorly traditional asset allocation models address real portfolio risk. We believe one of the most overlooked aspects of portfolio management is diversifying how long you own an investment. This time frame diversification must change based on where we are in the current market cycle.

When addressing the question of cash, and portfolio strategy in general, we believe a different approach is required. This approach is intuitive, but not implemented by the average portfolio manager or investor. This approach adds a layer of diversification that specifically addresses how long investors should own an investment within their portfolio.

The chart below shows the S&P 500 from the 2009 low separated into three phases: Early Cycle, Mid-Cycle and Late Cycle. We have identified a few of the characteristics typical of each cycle’s behavior.

Early in the cycle (think 2009 or 2010), you must anticipate having positions that are more volatile, because the market and economy are typically emerging from a recession, investors nerves are frayed, and there is uncertainty whether the early recovery will continue. Early in the market and economic cycle, the risk of loss is HIGHER over a 1-year timeframe than a 5-year timeframe, because the chances of recovery are substantially higher after seeing a large market loss and economic recession. Your timeframe over which you expect to earn profits must be extended.

Late Cycle investing is just the opposite. The risk of loss late in a cycle is much LOWER over a 1-year timeframe than a 5-year timeframe, because the chances of another recession increase as timeframes are increased. Late in the cycle, investors should reduce the length of time they expect to hold investments, and have multiple exit strategies in place.

We believe we are late in this market cycle. We would not be surprised if a major top happened next month, but we would also not be surprised if it happened 5 years from now. By diversifying your expectations, particularly about how long you may own any particular investment, we believe you can more confidently invest in any part of the cycle.

Macro Insight

‘Tis the Seasonality

Any change or pattern that repeats over the course of a year can be said to be seasonal. Historically September has been the worst performing month, averaging a loss of (-1.1%) over the last 20 years. During that span only 45% of Septembers have seen positive returns. However, 2017 was having nothing to do with that historical trend as this year’s September has been one of the better ones, up 1.4% (at least through 9/27).

The chart below looks at how often each month was positive, and the average return for each month over the past 20 years. First, across the top of each bar is the percentage of months that a particular month saw a positive return. September was positive just 45% of the time. October, however, has had positive returns 74% of the time, the 2nd most reliable month of the year.

Second, the numbers in the bottom of each bar reveals the average monthly return during this 20 year span. September’s average return over the last 20 years has been a loss of (-1.1%), the worst of all months. The opposite can be said for the next 3 months which boast some of the most bullish statistics of the year.

Going back even further, to 1950, reveals a similar outcome. September returns on average were down (-0.67%) with positive returns just 29 of the 67 years. However, the 4th quarter has a positive trend when going back to 1950 as well. Since 1950, the S&P in October is up on average 0.76%, November it has been up an average 1.38%, and December up an average 1.54%. So all together the 4th quarter historical average return was 3.5%.

Do we make portfolio based decisions based on statistics alone? No, of course not and neither should anyone, but we are fully aware that the market is entering its sweet spot known as the “best seven months” which runs from October through April.

Why is this the case? We really don’t know, but we do know that any one year is not bound to statistical averages so neither are we. If September 2017 doesn’t prove to us how a data point can buck a historical trend, then perhaps October of 2008 and October of 1987 can teach us something. These months saw a (-17%) decline and (-22%) decline, respectively, even though October is the strongest month on average historically.

You are likely to hear a lot about the “best seven months” in the mainstream media over the coming weeks. Just remember that statistics are more of a guide rather than a rule. We use multiple signals to help warn us if we are to see a 4th quarter that is going to look more like the average or move contrary to it. For more on seasonality, check out the Market Microscope section which looks at the market’s typical pattern combining the 11 years since 1900 that all ended in 7 (1907, 1917, 1927, 2007, etc). It suggests a significantly different outcome to the year.

Market Microscope

The Hidden Relationship between Stocks & Bonds

What do Rising Interest Rates Really Mean? First, let’s look at the bond market to see why we think bonds are a timely topic today.

On Wednesday, September 27, we saw a relatively large move in the bond market, with no real apparent catalyst. The media, not surprisingly didn’t give it much coverage, but it is something we had been watching and expecting. Treasury prices, especially the longer dated ones, fell sizable. TLT, an ETF that tracks the 20+ year Treasury bond market, fell 1.5% on the day and followed through with another 0.5% decline the following day. Why do we think this is important? Because it is conceivable that bonds have renewed their falling price/rising yield trend that started back in July 2016.

The next chart shows how bond prices indeed peaked back in July 2016, fell 18% rather swiftly into December 2016, and have since been clawing their way back. However, that rally has now stalled and the first leg of a 3 legged stool may have just cracked, as labeled 1,2,3 on the chart. Price has broken below the uptrend in place all of 2017, revealing a change in short term price momentum from up to down.

Trend Remains Down for Bonds

A change in the trend of bond prices is important for a number of reasons, but most importantly to investors is the 1) direct impact it has on bonds and also 2) the direct and indirect impact bond yields have on stocks. Stewards of finance spend a lifetime learning the intricacies between the bond and stock markets, so we are just going to be able to scratch the surface in this report, but hopefully it will provide us a better understanding of the risks (and rewards) that could come from a trend change in the bond market.

First, let’s take one more look at the bond market to see why we are increasing the odds that the next leg down in bond prices is upon us. The next chart zooms into the last 11 months and reveals that the long term Treasury bond rallied in 2 equidistant trends off the March and May lows.

Beginning in July, the third move of that uptrend did not match the speed of the prior two trends. This is revealed on two sections of the chart above. First, price was not able to reach the parallel trend channel line shown in blue that was formed from the prior two peaks, and second, through the use of a momentum indicator shown at the bottom of the graphic. Although price wasn’t able to reach the trend channel target, price did squeak a new high in August. However, it was on lesser momentum as measured by the RSI indicator. Lower momentum in and of itself is not that big of a deal, especially since price came back down in September and appeared to hold its lower trend channel support, however, a breakdown of that support this week increases the risk that this rally in bonds that started back in December may be over.

A falling bond market means that yields are rising, and if you are an income investor, could mean you are losing out, primarily through the opportunity cost of not being able to buy bonds that now offer a higher yield than was previously obtained. This is one way that falling bond prices affect investors. An example may help.

Bond Prices Fall as Yields Rise

Say you buy a 5 year bond right now that pays 5% yield. You plan to hold to maturity and collect the yield. In one year a very similar bond is issued, but it is now paying 6%. In such a scenario it is likely your bond price has now fallen to account for the fact that an investor could now buy essentially the same bond, but get a higher yield. Why would an investor buy the 5% bond now when they could get 6% instead? Price thus drops on the 5% bond to compensate. Meanwhile, you, the owner of the 5% bond, are stuck with a bond paying you below market yields. You could sell the bond, but you would lose in price what you would then gain in yield buy reinvesting in the higher yielding bond. Falling bond prices and thus higher bond yields means you would miss out on the opportunity for higher returns, so you lose that opportunity, or spread, during a rising rate environment. The two charts below help show how moves in yield affect prices. A 2% rise in interest rates would typically result in a 10% drop in a 5 year bond’s price.

Geek Out with the Finance Nerds

The 2nd way falling bond prices affect portfolios is a more indirect way through equities.

First off, if a firm has any debt its earnings are generally decreased when interest rates rise. This is because the cost to service such debt, the interest rate, is incresing. The graphic below is from Whole Food’s (ticker:WFM) Fiscal Year 2016 profit and loss statement. Notice that as of September 2016 WFM was paying $41MM in interest expense each year? After digging into their annual report we discovered this interest equates to the 5.2% yield they pay on their $1B loan due in 2025. What happens to this number if in 2025 Whole Foods must refinance at a 10.4% rate (essentially a doubling of interest rates)? Their interest expense would then become $82MM, up from 5% to almost 10% of their pre-tax profit. Rising interest rates directly affect profits negatively for most companies that have to borrow to fund their businesses.

In our opinion, even more important than the direct effect rising yields have on equities is the indirect effect they have on stock prices. If interest rates double in two years, Whole Foods won’t have to worry about that for another 7 years (their bond isn’t due to be paid back until 2025), however, they will have to worry about that if they need any more money between now and then. In reality, the indirect effect the doubling of interest rates would have on their share price is likely much more important to their share price than the interest expense they pay. Here’s why:

The next chart reveals something finance geeks (like us) are very familiar with. It represents the calculation of the Discount Rate used when “discounting future cash flows back to today” in order to come up with a present value for the company’s share price. Here’s how it works: As an investor you want some sort of return on your equity. Let’s assume that bond yields are 5% and equity return expectations are 10%. If 50% of a firm’s capital structure is made up of debt and the other 50% is equity and the company pays no taxes, the Weighted Average Cost of Capital (WACC), as demonstrated to the right, would be 7.5%.

So what happens to the equation if interest rates double to 10%? The knee jerk answer would be to adjust the bond yield portion of the same equation to derive a WACC of 10% (10%*50%+10%*50%). However, this would be incorrect as the cost of equity actually must always be higher than the cost of debt, because of the liquidation, legal, and payment pecking orders debt has over equity. In other words, the “cost of equity” is dependent on the cost of debt, making the cost of debt the most important factor in deriving a discount rate (discount rate is also known as IRR-internal rate of return, expected return, or cost of capital). Furthermore, there are arguments to be made that the relationship between the cost of debt and the cost of equity is not linear and in many ways becomes exponential, but for this example lets just assume that a doubling of the cost of debt results in the doubling of the cost of equity as well.

Using the Whole Foods financial statements we built a table comparing these two scenarios. When there was a 7.5% cost of capital that then doubles to 15%, we see a share price that is cut in half by 51%…all because of an increase in the cost of capital. Per the opening of this section, a doubling of interest rates results in an ~5% drop in earnings through direct increased interest costs (which we have actually ignored in this analysis), but that same doubling of interest rates actually has a much more profound effect on the share price through its indirect effects by means discounting the future. The same Net Income delivers a much lower share price, all because of a change in the interest rate.

The table below helps reveal the “hidden” interest rate risk (note that growth rates assumed were backed into based on the $47 per share purchase price paid by Amazon for Whole Foods on June 16, 2017).

If interest rates have started another round of rising, then they should eventually lead to higher discount rates and increased interest expenses. This in turn will then lead to lower equity prices. Even in the scenario as laid out in the example where earnings manage to maintain their levels, in a rising interest rate environment share prices feel pressure. This is probably one of the biggest hidden risks to the long-term bull market nobody is talking about, as a rising interest rate environment is not a good environment for stock prices.

One other way to think about this is through the lens of a stock versus bond investment decision. Imagine a world where you could get a U.S. Treasury Note that yielded 10% per year, guaranteed (would be nice, huh?). It would be tough not to choose to invest in U.S. Treasuries at 10%. In order to not invest there and instead invest in equities you would need to expect returns that are likely significantly greater than 10% (so, thus, the discount rate also increases). As interest rates move up in yield it makes bonds more appealing from an investment standpoint, adding to the pressure on U.S. stocks. It’s hard to find a time in history where rising interest rates were actually good for equities. Given the context above, it’s easy to see why it’s tough for equities to excel in such an environment.

US Equities

Seasonality: Interesting, but Not a Part of Decision-Making

In the Macro Insights section we discussed how statistics can be fun to talk about, but can also be dangerous to use for investing purposes. Shown on the next page, courtesy of Tom McClellan who has created numerous technical indicators and writes a popular technical focused newsletter called ‘The McClellan Market Report’, is a very similar example using historical averages to project what the market might do in the future..the difference is the data in the following chart is only from years that end in the number 7. It also concludes the exact opposite of what the statistical analysis in the Macro Insights section concluded.

For some reason, going back over 100 years, the years that have end in 7 have collectively had a very difficult time, especially in the final half of the year. It could be because of the presidential election and political cycle or because of larger, underlying cyclical currents in the markets, but regardless the why, the contrasting chart shown below and based around similar market return statistics provides some great talking points on the validity of statistics. Analyzing these charts certainly supports the popular saying that “you can say anything with statistics”.

On one hand, as was discussed in the Macro section, we look at the S&P since 1950 and we see a 4th quarter that historically has done very well. But, on the other hand we look at the market during all the years ending in 7 and we see a very difficult 4th quarter looking back at us. These examples help solidify our position of not allowing statistics to drive our investment thesis.

Now, onto the chart below.

From October 3 to the end of the year (the 4th quarter) in the years ending in 7 resulted in an average loss of over 10%. This is in stark contrast to our earlier research which suggested a 3.5% average gain during this period. To reconcile the two we must recognize that the years that do not end in 7 were much better on average than those years that end in 7. The interesting parallel McClellan makes to the below chart is that the run up in stocks thus far this year has performed fairly similar to the average performance of all the years that end in 7. But the real takeaway from his analysis is the risk that is directly in front of us at we turn the page to October.

Those that are familiar with the history of the markets will recognize that the 1987 crash occurred in October, and that may be an anomaly, so McClellan does us a favor and disregards that year (the blue line). Even if we exclude 1987’s crash we notice that stocks still on average fell over 5% during the month of October in years that end in 7.

So what does it all mean?

Should we put all our money to cash before the inevitable October crash of 2017 occurs? Or, should we put all our cash into stocks in preparation for the inevitable 3.5% 4Q 2017 returns that will occur? Doesn’t this kind of feel like the battle of wits confrontation in the movie ‘The Princess Bride’ paraphrased below? Man in Black: “Alright, where is the poison? The battle of wits has begun! It ends when you decide and we both drink, and find out who is right…and who is dead. Vizzini: “But, it’s so simple…I clearly cannot choose the wine in front of you…but, I clearly cannot choose the wine in front of me…but I simply cannot choose the wine in front of you…so I clearly cannot choose the wine in front of me” Statistics like these are nice for cocktail parties, but usually not reliable enough to drive investment decisions.

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.

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.  

Despite hurricanes, floods, fires and threats of nuclear war, markets continue their relentless push higher. In this issue we analyze the economic impact after previous hurricanes, discuss why financial stocks are leading the markets, and feature a discussion on how we construct portfolios.

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Insights Overview

Macro Insights: Is there an economic silver lining with hurricanes and other catastrophes? The Broken Window Fallacy reminds us that most of the time the economics surrounding catastrophes are zero sum.

Portfolio Insights: We “lift the hood” on investment strategy to give an overview on how we construct portfolios, as well as give current positioning in each of our subcomponent sleeves.

Market Microscope: Do hurricanes affect the markets? We look at the economic affect of previous hurricanes for the answer. The markets continue to give us mixed signals as price continues to rise but on weaker and weaker internals. Eventually this will result in a more meaningful pullback, but until that occurs the trend remains higher.

On Our Radar

North Korea: Tensions are still high, and seem to change every few days. However, markets continue to remain calm even when tensions escalate.

FIT Model Update: Uptrend

Fundamental Overview:  The Bank of Japan now owns over 74% of all ETF assets in that country. This means the Japanese Central Bank is the largest owner of equities in Japan. This also likely means price discovery may be lost as they likely are a buyer at any price. The Swiss National Bank is performing a similar role. Central Banks no doubt are distorting markets.

Investor Sentiment Overview: The popular University of Michigan sentiment index just posted an all time high reading of 65% of investors being optimistic that stock prices will be higher in 12 months. The only other times readings this high were in 2015 and 2017, both preceding meaningful pullbacks.

Technical Overview: The market continues to sing a similar tune. New highs are being made in a handful of stocks, which is lifting the indices, but breadth and other measures of market health are not showing as strong of signals.

Focus Chart

Interest Rates are Driving Financial Stocks

There was some relief in the financial sector this week once the verdict on Irma’s damage was better known. However, we must be very careful not to confuse causation and correlation. The more relevant driver of financials this week was likely interest rates, which have started to move higher. Higher yields tend to benefit the financial sector, specifically banks and insurance companies. This primarily has to do with the funding components of their businesses that rely on higher yields for lending.

Macro Insight

Beware: The Broken Window Fallacy

What economic impacts will Hurricanes Harvey and Irma have?

The broken window fallacy gets its name from a story developed by the French economist, Frederic Bastiat, to help explain why breaking a window does not increase economic activity. The story is about a son who inadvertently breaks a window. His father must find a glazier to repair the window as the town onlookers conclude that breaking windows must be good for the economy since the glazier will receive new funds which he then can use to buy more goods.

The key to the story is the townspeople are missing an inherent and “unseen” third party. Money went to the glazier but at the expense of some other third party. The income helps the glazier, but it hurts the other third party that otherwise would have received the funds. In other words, the money is just taken from one pocket and put into another.

Bastiat takes his theory a step further. He concludes that actually replacing a window, a home, or many other things destroyed during catastrophes or war is actually a net negative drain on the economy. He argues war destroys not only the existing capital, but accumulated capital built up over years. It also forces investment into specific areas that otherwise may not have been the best investment option. A home is a good example of this. Approximately 63% of homes in the U.S. are owner occupied. These homes aren’t used to create an income stream, they are used to survive. Money put into an owner occupied home does little to actually stimulate the economy. It takes income that otherwise could have been spent or invested elsewhere and puts it into a largely unproductive asset of the economy. The theory argues that spending money on non-productive assets, such as an owner occupied home, may actually be a net negative for the economy as capital is parked in an unproductive vehicle.

With Hurricanes Harvey and Irma forcing their destruction upon millions, the fallacy is again in the spotlight. The victims of the storms are all now “forced” to reinvest in their homes. The money they spend on their homes is money that could have been spent or invested elsewhere, in more productive assets. Many will also borrow to fund this spending, which may on the surface suggest a boon to the economy, but this just takes money from the pocket of the future and puts it into the pocket of today. There may be some short term benefit, but it’s a burden as that loan is repaid. At a minimum disasters have a net neutral affect on the economy, but more likely they may actually be a drag on it.

So should we expect the economic impacts of Hurricanes Harvey and Irma to be a boon for the U.S. economy? It’s not likely, and a research study focused on the hotel industry performed by CBRE and summarized above reveals this unlikelihood. It should be noted they admit that quantifying the full impacts of disasters (both measurable and immeasurable) is impossible, but their attempt reveals the inconclusiveness. In two cases the GMP (Gross Metro Product) during the quarter of the event was higher than the prior year’s average, but in the other two examples, the GMP was lower. If we see a jump in Houston’s GMP this quarter as a result of Harvey, it is likely that jump will come at the expense of either 1) other nearby cities where workers have migrated from or 2) will be offset in outer periods as required maintenance and other upgrades to houses are just pulled forward to today and/or in the case of debt, repaid at a later date.

Portfolio Insight

A Peek into Portfolio Construction

IronBridge client portfolios are divided into six distinct and separate strategies that we call “sleeves”. Each sleeve has a unique purpose and investment universe. Exposure to these sleeves vary depending on portfolio objective and risk tolerances. Here is an overview of our strategies:

INCOME: This sleeve has two goals: income and preservation of capital. In this portion of portfolios we attempt to hire best-in-class managers who invest only in the fixed income markets, or bonds. We use various analysis tools to understand their exposure and compare them against their peers.

TACTICAL INCOME: Here we look for income-generating investments that may or may not be bonds. Our universe in this sleeve consists of fixed income, floating rate securities, preferred stocks, high dividend stocks, convertible bonds, among others. We have a disciplined strategy to give us buy and sell signals.

TACTICAL MODEL: Our tactical exposure is the most flexible part of client portfolios. This subcomponent is the ultimate “wind at our back” strategy that we discussed in our previous Insights issue. Within this sleeve we can invest in US stocks, international stocks, bonds, cash or commodities, as well as use various hedging strategies to manage risk. However, we only own 5 positions at any given time, and a position must meet stringent criteria to knock another position off the list. Again, we have defined exits on any position owned within this sleeve.

CORE EQUITY: This is our blue-chip stock exposure. We like fundamentally sound companies with strong balance sheets who are leaders in their sector. Again, we use strict buy/sell discipline to identify which stocks to purchase and when to sell. These stocks are easily recognizable by any investor.

PROPRIETARY SECTOR ROTATION STRATEGY: Our sector rotation sleeve is where we attempt to generate alpha, or relative outperformance versus the S&P 500. We have developed a proprietary mathematical process that attempts to identify the outperforming sectors, and we strictly focus on these sectors. Sectors include various industries such as technology, consumer staples, financial companies, materials, energy, etc.

PROPRIETARY LONG/CASH STRATEGY: Our final sleeve is our proprietary risk-managed index strategy. At any given time we are either long the S&P 500 using low cost ETFs or are in cash. This is a strategy that Chad Karnes has been using for many years and we have a high degree of confidence in the ability to participate in larger up-trends while avoiding large draw-downs or losses.

So that’s nice, but how are we actually invested? The chart below shows our current positioning in each sleeve. We also show how each sleeve can potentially be invested in it’s maximum and minimum risk exposure. This structure advances prevailing asset allocation theory by truly diversifying portfolios.

Market Microscope

How Markets React to Hurricanes; Dancing Until the Music Stops

The market continues its persistent grind upward as we enter into the final quarter of the year. There remain many concerning developments, but most important to us is price, and price continues in its uptrend, at least for now. Small cap stocks remain lagging the large caps, which again have broken out to new highs. We also like owning the financials here as the bond market may be picking up in volatility.

How Stocks React to Hurricanes:

It’s impossible to prove that correlation equals causation, but given our knowledge of the broken window fallacy and how catastrophes generally aren’t a net positive for the economy, our bet is that they also don’t really affect the stock market. The graphic from USA Today helps solidify the net neutral effect that natural disasters have on stock prices.

Why would Hurricane Ike have such a profound negative effect on the market while Hurricanes Katrina and Sandy had the exact opposite effect? The summation at the bottom shows us that the median return of the market 6 months after a hurricane is 4.5%. This is the same median return of the market for any given 6 month period. It seems hurricanes have little to no effect on the stock markets.

Financials

One sector that has seen a turnaround recently is the financials. Many suggest the relief rally that occurred this week in the sector was a result of Hurricane Irma’s less abrasive track across Florida. Major cities were largely spared, and thus insurers and other banks breathed a sigh of relief. However, this assumption is likely incorrect. What if we were to suggest that the Hurricane had little, if any, affect on the stock market?

How can we make such an extreme suggestion? For one, by analyzing the chart below.

The chart displays two price indices, one, XLF (the red and black candlesticks), which tracks the change in price of the financial sector, and another, $TNX (the orange line), which tracks the yield on the 10 Year Treasury note. The bottom portion of the graphic tracks the statistical correlation between these two price indices. The 10 day correlation between the two is an extremely high 89%. This tells us that the financial stocks are moving very much in line with Treasury yields.

This has generally been the case all year as the correlation has remained above 0, and often reaching toward the 90th percentile.

In our inaugural Insights, published July 13, 2017 (which is published on our website) we discussed the potential for a rising yield environment going forward. If that indeed is occurring and if yields do continue to climb here then it is likely, given the high correlation, that financial stocks will also benefit. We have been adding financials to our portfolios to take advantage of this change in the bond market’s trend.

On the other hand, there is certainly some merit to the assumption that banks should benefit, at least over the short term, in a rising interest rate environment. The market seems to be reacting to that potential, and the high correlation between financials and Treasury yields suggests that financial firms’ stock prices instead are being driven by the broader macro trend of rising U.S. Treasury rates rather than shorter term hurricane hiccups.

US Equities

Small Caps continue to Underperform Large Caps

The market’s sideways price action continues into September as some indices remain stuck in the same price range seen all year. The first chart below shows the Small Cap Index, which tracks 2000 of the smaller publicly traded companies. It’s one of those indices that has been underperforming the S&P 500 all year, up just 5% compared to the S&P’s 11% year to date performance. The attempted breakout into new all time highs in July lasted only one week as prices fell back to their 200 day moving average. Since it has rallied back but now faces the big hurdle of overcoming those prior price highs above $1430.

Is Your Breadth Any Better?

In our last issue we discussed the market’s bad breadth. We’re afraid that situation has not improved as the number of S&P 500 stocks above their respective 50 day moving averages (in short and intermediate term uptrends) is at just 64%. This on its own may not be so concerning, but when you couple it with the fact that the S&P has just made another new all time high and is above its own 50 day moving average by 40 points, it shows just how much the market’s returns are reliant on just a handful of larger companies and sectors in the indices.

The next chart reveals that reality, but we’d like to draw your attention to the entirety of the chart. New all time highs have been made multiple times this year. But notice how the new highs made back in January saw around 80% of constituents trading above their respective 50 day moving averages. New highs again were made in March with over 75% of stocks trading above their 50 day moving average. New highs in June resulted in a fewer 73% of stocks trading above their own 50 days (sensing a trend here yet?)

Notice on the chart that the red and black line over the year has formed a series of lower high points while the S&P, in navy, continues to make new highs. This trend of declining breadth was discussed last issue and unfortunately it continues through today. Every small pullback that has occurred thus far in 2017 has resulted in fewer and fewer stocks rebounding above their own 50 day moving averages. We suspect the latest rally will end seeing the amount of stocks above their 50 day moving averages peak somewhere south of 75%. If that does not occur and this indicator can get back above 75% then it would be a welcome sign that the market’s rally has regained its momentum and may offer us more upside potential. Until then we must conclude that although the market keeps rising, there will come a time when there won’t be enough stocks left in uptrends to continue to carry the broader market’s trend. This chart is one of many we use to help us stay abreast of the market’s moves. Right now its one of the many reasons we continue to keep a cautious posture.

Dancing Until the Music Stops

Below, the Dow chart shows us the new price highs being made in the broader indices. Although breadth remains a concern, price comes first and foremost, and price continues to make new highs. Notice too price remains above its key averages. As long as it does, it suggests even though we remain cautious, we also remain in a bullish trend and thus invested long.

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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.