Showing posts with label risk. Show all posts
Showing posts with label risk. Show all posts

Monday, February 18, 2019

Here We Go - Get Ready for the Breakout Pattern Setup

We are writing this post today with a few forward-looking expectations while attempting to warn traders that some extended rotation is likely to enter the markets over the next 30+ days. If you’ve been following our research, you’ll know that we’ve been calling these move months in advance of other researchers and analysts. Our September 17, 2018 research post highlighting our Adaptive Dynamic Learning predictive modeling system suggested the U.S. stock markets were poised for a massive price rotation followed by a very unique price setup that we are experiencing now.

Currently, the YM (Dow Futures Contracts) are leading the pack on a dramatic upside breakout move. This is likely a result of the US government spending bill that is recently working its way towards approval and the fact that this new spending bill clears the way for at least 8+ months of uninterrupted market optimism (or at least we hope). This 300+ point upside move clearly breaks price highs and puts the U.S. stock market, at least the Dow/Blue-Chips, back into “new high trending mode”. As many of you are likely aware, our Fibonacci price study teaches us that price must ALWAYS seek to establish new price highs or new price lows AT ALL TIMES. Thus, these new price highs are a very strong indication that the upside trend is dominant and should continue for a while.



Additionally, we want to highlight what we believe will be a similar price pattern to 2015/2016 in the U.S. markets – a multiple Price Wedge formation that could ultimately set up another price leg (which we believe will be higher, to the upside, at this time).

In the next article “PART II” pay close attention to the charts and images as we are attempting to clearly illustrate how and why price rotation is about to hit the US markets and why you need to be prepared for this move.

We continue to read that large amounts of capital are sitting on the sidelines or have been pulled from the markets over the past 12+ months. We understand this as the rotation in early 2018 frightened many investors and the continued sideways price action, global market concerns and geopolitical issues have caused international investors to want to protect their investments from risk – thus they move their capital into cash. We get it. But we also believe the next breakout in the U.S. markets will be a great opportunity for skilled traders to identify and prepare for an incredible profit potential no matter which way the market breaks up or down because technical analysis allows us to closely follow the direction of the market.

The amount of capital that is sitting on OUTSIDE the markets, currently, represents a massive amount of resources that could re-enter the markets when traders/investors decide the timing is right. We’ve termed this a “Capital Shift”.

In simple terms, it reflects capital/cash moving from one market to another or from actively invested to cash, then back to actively invested. Our belief is that capital operates in a manner to always protect itself from risk while attempting to identify suitable returns. The best environment for capital is always a relatively safe investment with protective values and a high probability of decent returns. Therefore, this massive amount of capital not being deployed in the global markets will, at some time, re-enter the markets and will likely increase pricing valuations.

How and when will this capital re-enter the markets? What will price activity look like and how will we know when the timing is right for our own strategic deployment of our trading capital? Continue reading to learn why we believe we are only 30~45 days away from an incredible trading setup. You won’t want to miss this one.

Please take a minute to visit The Technical Traders to learn how we can help you find and execute better trade in 2019 and stay ahead of these market moves. We are confident that you will find our Daily Video, Detailed Market Research, Proprietary Research Tools and Detailed Trading Signals will help you make 2019 an incredibly successful year.

Chris Vermeulen
Technical Traders Ltd.


Stock & ETF Trading Signals

Wednesday, August 2, 2017

Could There Be a Reversal Coming to the Major U.S. Markets?

Technically speaking, this week could be very important for the major U.S. equity markets. There is an appearance of a “TOPPING PATTERN” forming. I am now awaiting confirmation by the actions of the equity markets, this week. Expect downward pressure beginning this month of August of 2017.

The Only Chart You Need To See!



There is currently limited upside potential in the SPX relative to potential downside for the months of August, September and the early part of October 2017.

There are signs for the short, intermediate and longer term trends returning for the best six months of trading officially inaugurated in November of 2017! This is the timing framework when ‘The Next Runaway Leg Up In The Stock Market Will Resume.’

In last weeks’ market action as the profit taking rotation out of the high-tech sector rotated into the Dow Industrials, it reflected

a more defensive approach while being invested in “Blue Chips” during which time it achieved a new high. Sector rotation increased especially noticeable in the transports and technology sectors that were leading the markets higher. If they continue lower, more sectors will join the decline. I am expecting a coming pop in the VIX on Aug 4, Aug 23, Sept 11 or 12 and finally Sept 28 or 29. 2017. There was a flight to safety in the Yen as well as a strengthening of the price of Gold, Silver, Bitcoin and WTI Crude Oil.

An Unusual Anomaly

Over the past couple of weeks, there was this unusual Anomaly which occurred, as you can see in the chart below. It now makes me more cautious about our long understanding of “risk interconnectivity”.

How can the equity, gold, silver, crude oil and bitcoin markets ALL go HIGHER together?

Tune in every morning for my video analysis and market forecasts at The Gold & Oil Guy to know where the main ‘asset classes’ are headed tomorrow, this week, and next month.



In short, the major equities trend remains to the upside but its likely to take shape in a slow grinding process with downward pressure starting in August fora couple months.

Be sure to follow my daily pre-market video forecasts and ETF trades by visiting here at The Gold and Oil Guy

Chris Vermeulen


Stock & ETF Trading Signals

Tuesday, May 9, 2017

Bubba’s Proprietary "Anchor Spread Trade"

Every time you lose money in the market, someone on the other side of the trade is grinning their fool head off because they won and you let them do it. Discover how savvy insiders make sure every trade is won before it’s even placed. And you can do it too!

Todd “Bubba” Horwitz is a renowned floor trader, market maker and senior analyst who is frequently interviewed by FOX News, CNBC, Bloomberg Networks and other media giants. Horwitz just released a power packed special report no trader should be without. And today, you can download it here for FREE

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See you in the markets,
The Stock Market Club

P.S. You’ll also gain access to an exciting 10 minute video revealing an easy way to create instant cash flow on a shoestring budget. Get FREE eBook and Watch Video Here

Option and stock investing involves risk and is not suitable for all investors. Only invest money you can afford to lose in stocks and options. Past performance does not guarantee future results. The trade entry and exit prices represent the price of the security at the time the recommendation was made. The trade record does not represent actual investment results. Trade examples are simulated and have certain limitations. Simulated results do not represent actual trading. Since the trades have not been executed, the results may have under or over compensated for the impact, if any, of certain market factors such as lack of liquidity. No representation is being made that any account will or is likely to achieve profit or losses similar to those shown.



Stock & ETF Trading Signals

Tuesday, December 6, 2016

How to Use the New Market Manipulation to Your Advantage

It's time for another one of Don Kaufman's wildly popular webinars. Don’t miss this live online seminar, How to Use the New Market Manipulation to Your Advantage, with Don Kaufman this Tuesday December 6th. at 8:00 PM New York, 7:00 PM Central or 5:00 PM Pacific.

During this free webinar you will learn:
  • How scarcely used recent additions in market structure have forever changed how we view price movement and volatility.
  • What weekly strategy you can use to take minimal risk and produce astonishing returns surrounding predictable or manipulated movements in any stock, ETF, or index.
  • The one product that has become statistically significant in determining the next market move so whether you're a long term investor, swing trader, or intra-day trader you can get tuned into what's driving today's marketplace.
  • How you can use market efficiency to your advantage in all aspects of your investments, retirement accounts, stock and options trading accounts, futures trading and more.
  • How you can trade up to several times per week without having to continually monitor your positions, "set it and forget it" with this low risk high reward trade.
      Don's Webinars have an attendance limit that we always hit. This one will be no exception.

      Visit Here to Register Now!

      See you Tuesday night!
      The Stock Market Club




Sunday, August 21, 2016

Will The Bubble Pop Regardless if the Fed Never Raises Rates?

The current overall SPX pattern is a broadening top, which is usually a very reliable pattern. The market continues to look as though it wants to go even lower. The momentum shift, which I have been expecting, has been slow to start, however one should be prepared for this occurrence ahead of time. Nevertheless, the large divergences which I have been viewing, in my proprietary oscillators, are most real, and, once the selling starts, the momentum should quickly move to the downside.

The current market is being supported by a lack of sellers more so than aggressive buying. With investors still thinking that there is no other place to store their money, they appear to be content with leaving their money with risk on assets within a market that is pushing to all time highs. This type of mentality usually leads to large losses rather than big gains. There isn’t any real opportunity for growth in the SPX that I can see right now.

Dow Theory: Market Indexes Must Confirm Each Other
The Dow Theory was formulated from a series of Wall Street Journal editorials which were authored by Charles H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dow’s beliefs regarding how the stock market behaved and how the market could be used to measure the health of the business environment.

Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index (now Transportation Index), which were originally compiled by Dow for TheWall Street Journal. Dow created these indexes because he felt they were an accurate reflection of the business conditions within the economy, seeing as they covered two major economic segments: industrial and rail (transportation). While these indexes have changed, over the last 100 years, the theory still applies to current market indexes.

Market indexes must confirm one another. In other words, a major reversal from a bull or bear market cannot be signaled unless both indexes (generally the Dow Industrial and Transports Averages) are in agreement. Currently, They are DIVERGING, issuing MAJOR NON-CONFIRMATION HIGH the Dow Jones Industrial average. If one couples this with the volatility index, this is a warning sign and a recipe for disaster.

chart 1


The FEDs’ monetary policy over the last eight years has led to unproductive and reckless corporate behavior. The chart below shows U.S. non financials’ year on year change in net debt versus operating cash flow as measured by earnings before interest, tax, depreciation, and amortization (EBITA).

Chart 2
The growth in operating cash flow peaked five years ago and has turned negative year over year. Net debt has continued to rise, which is not good for companies.

This has never before occurred in the post World War II period. In the cycle preceding the Great Recession, the peaks had been pretty much coincidental. Even during that cycle, they only diverged for two years, and by the time EBITA turned negative, year over year, as it has today, growth in net debt had been declining for over two years. Again, the current 5 year divergence is unprecedented in financial history. Today, most of that debt is used for financial engineering, as opposed to productive investments. In 2012, buybacks and M&A were $1.25 trillion, while all R&D and office equipment spending were $1.55 trillion. As valuations rose, since that time, R&D and office equipment grew by only $250 billion, but financial engineering grew by $750 billion, or three times this!

You can only live on your seed corn for so long. Despite there being no increase in their interest costs while growing their net borrowing by $1.7 trillion, the profit shares of the corporate sector peaked in 2012. The corporate sector, today, is stuck in a vicious cycle of earnings manipulation management, questionable allocation of capital, low productivity, declining margins and growing debt levels.

Conclusion:

In short, I continue to pound on the table to help keep you and fellow investors aware that something bad, financially, is going to take place – huge events like the tech bubble, the housing collapse a few years back, and now national financial instability. Experts saw all these events coming months and, in some cases, years in advance. Big things typically don’t happen fast, but once the momentum changes direction you better be ready for some life changing events and a change in the financial market place.

Follow my analysis in real time, swing trades, and even my long term investment positions so you can survive from the financial storm The Gold & Oil Guy.com



Stock & ETF Trading Signals

Monday, March 21, 2016

Bursting the Biggest Myths in Trading

Our trading partner Don Kaufman is treating us to a free trading webinar this Tuesday evening March 29th at 8 p.m. est. Don't put off reserving your spot since Don and his team are only opening up this up for 1,000 traders.

Reserve Your Spot Here

During this free webinar Don will cover....
  • How you can give yourself the gift of time without paying extra so you can give your trade as much time as it needs
  • How you can create a trade with zero exposure to volatility so you never have to worry about volatility again 
  • How you can set your limited risk before you put on the trade so you know exactly what you're risking. Making this strategy the safest way to trade. So much for the myth that options are risky.
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  • How you can use this strategy whether you have a $2,000 account or a 6 figure account
There will be a waiting list of traders for this free class so make sure you log in 10 minutes early so you don't lose your spot.

Click Here to Get Your Reserved Seat

See you Tuesday night!
The Stock Market Club



Don Kaufman


Saturday, February 20, 2016

Is 70 the New 65?

By John Mauldin

As some of us know far too well, forecasting the future with any precision is extremely difficult. There’s at least one exception to the rule, though. Population trends show themselves decades and even centuries in advance. If we know how many people were born in a given year, we can extrapolate what the population will look like far in the future.

On the other hand, demographic forecasting still requires assumptions. At what age will people start having children, and how many will they have? How will new medical advances affect life spans? When will people start working, stop working, and enter retirement? Small changes in any of those assumptions can quickly affect population numbers.

Today’s Outside the Box wrestles with that last question. In the United States we allowed the federal government to set 65 as the retirement age by making Social Security available to most workers at that point in their lives. The retirement age is going up to 67 for the younger members of the Baby Boom generation, but even that may be too “young” to retire in the future.

We Baby Boomers were never big on conformity. Voluntarily or not, a large number of us fully intend to stay in the workforce to age 70 and beyond. If 70 is the new 65, we will see significant changes in the ways people spend their money and the kinds of investments they want.

Matthew Tracey and Joachim Fels of PIMCO outline some of the possibilities in this report. I found it very interesting, and I think you will, too.

Speaking of things changing, the weather in Texas has been nothing like anything in the past. It is mid-February and I’m having to turn the air conditioner on at night. The forecasters tell us it’s going to get into the 80s on Friday. Talking with my long-term Texas friends, none of us can remember weather like this. Cooler than normal summers, milder than normal winters. I guess it’s a good thing it’s not like this every year, because then we’d have a wave of tax refugees showing up from California. Then again, this is Texas. If we wait a bit I’m sure we’ll get our usual ice storms and other nasty stuff. Winter is coming. Maybe.

I am struggling to keep up with the research my 20 some teams are developing for the chapters of The Age of Transformation. Thankfully I have a small team helping me review the research, which is on top of the research I’m doing for the five or so chapters that I’m personally writing. Plus, there’s my regular reading for doing the weekly letters and so forth. It is forcing me to sort through the pile of items in my inbox as to what is must read, what can wait, and what I just don’t have time for. I really am learning to depend on people to make sure the things that I must read get on my radar screen.

I’m going to go ahead and hit the send button, as I have to prepare for an interview with CNBC Asia on Japan and related topics. You have a great week, and I hope that wherever you are, your weather is as good as ours.

Your marveling at the speed of things changing analyst,
John Mauldin

70 Is the New 65: Demographics Still Support 'Lower Rates for Longer'

By Matthew Tracey and Joachim Fels
PIMCO.com, February, 2016

The so-called demographic cliff remains at least a decade away; meanwhile, global demographics should continue fueling the savings glut.

Is global aging about to end the savings glut? Some observers think so. More and more baby boomers are reaching retirement age, and they will soon not only save less but also start to dump their accumulated assets to fund retirement … or so the story goes. If this were true, the consequences for interest rates would be profound. The real long term equilibrium interest rate, which has been on a secular downtrend for decades partly due to strong working age cohorts saving hard for retirement, would start to rise – and what we here at PIMCO call The New Neutral might soon be history.

We strongly disagree with that thesis of an imminent demographics induced savings drought. Rather, we have argued in recent work that the global excess supply of saving over investment, which has been largely responsible for the secular decline in equilibrium interest rates, is not only here to stay but likely to increase further in the coming years for a host of reasons including demographics (see PIMCO Macro Perspectives, “No End to the Savings Glut,” September 2015). As a consequence, we continue to expect the fundamental forces of elevated desired saving to keep the equilibrium real rate depressed and to limit the extent to which other (cyclical) factors can drive up market interest rates.

However, given the popularity of the thesis that demographics will soon end the savings glut, we undertook a deep dive into the data to investigate the link among demographics, saving behavior and the demand for fixed income assets – with some surprising results. Here’s what we found.

A ‘demographic reversal?’ Not so fast!

People of the world, we’re getting old. It’s a well-known fact that, after decades of decline, the global dependency ratio – traditionally defined as the ratio of individuals younger than 15 and older than 64 to the working-age population aged 15-64 – is now rising (see Figure 1).


Some financial market observers argue that this demographic trend reversal will begin to drive interest rates higher, and soon. Why? First, a declining share of high-saving workers and a rising share of dissaving elderly will (the argument goes) erode the demand for saving – and drive interest rates higher via the savings-investment equilibrium. Second, these observers argue, a rapidly growing share of retirees will have to consume (i.e., sell down) their financial asset holdings to fund spending in retirement, and these drawdowns will create selling pressure in financial markets that pushes asset prices down and interest rates up.

Our core thesis in a nutshell: Yes, global aging may someday drive U.S. interest rates structurally higher. But “someday” remains at least a decade away – for two reasons. First, we proffer that global saving will remain stronger than many expect, supporting a low global neutral interest rate. (As investors, we care about the neutral rate because it anchors fixed income yields in the market.) Second, U.S. demographic demand for fixed income assets should remain robust until at least 2025 – and in the meantime should continue to put downward pressure on market yields, all else equal. Combine a low global “anchor” and strong domestic fixed income demand, and what do you get? Lower rates for longer in the U.S.

Continuing robust demographic demand for saving

Remember the link between saving and interest rates: In the savings-investment equilibrium, rising demand for saving pushes down the equilibrium (or neutral, or natural) rate of interest, all else equal, and vice-versa. Our task, then, is to assess how demographic changes affect aggregate saving. We find that the traditional “dependency ratio,” used in many other studies on this topic, is flawed.

We suggest two modifications to address those flaws. First, the young, considered “dependents,” contribute very little to global saving and dissaving in dollar terms (they’re “non-savers”). We therefore prefer to focus on the ratio of “Peak Savers” (mature adult workers who earn and save a lot) to “Elderly” (who save less as they age and ultimately consume their savings in retirement). Let’s preliminarily define “Peak Savers” as individuals aged 35 to 64, for two reasons:
  • People 35–64 have generally exhibited much higher savings rates than people in younger and older age groups;
  • People 35–64 earn considerably more income than people younger and older – so for any given savings rate, this age group’s saving behavior will have an outsized effect on saving and investment flows in dollar terms.
Let’s preliminarily define “Elderly” as everyone 65 and older (the traditional definition). Thus, the global Peak Savers versus Elderly ratio in Figure 2 reflects a static 35–64 Peak Saver cohort – and reveals what appears to be a demographic cliff in about year 2010. Those who argue that demographic support for saving will fall sharply in the coming years typically will try to prove their point using a ratio like this one.


But we ask: Is it sensible to define the Peak Saver and Elderly groups by the same static age ranges over long periods of time? Put differently: Might working and saving behavior evolve over time, warranting a dynamically modified dependency ratio? Seniors’ ability to work (and save) later in life should continue to rise; in our increasingly services-based “knowledge economy,” jobs are becoming less physically demanding and often require more experience, while advances in health technology boost functional age in life’s later stages. Seniors’ willingness (and incentives) to work longer also should rise along with their ability.

True, the retirement age, globally, has not kept pace with rising longevity. But policymakers are slowly catching on. In the U.S., the Social Security full benefit retirement age is increasing to 67 and will go higher still – a government incentive telling people to stay in the workforce. Meanwhile, years of low interest rates have left impending retirees playing catch up in retirement saving. More generally, around the world, longer lives must ultimately be supported by longer working lives. Anything less will prove unsustainable. Our colleague Jim Moore summed up the state of affairs (in the U.S.) in a PIMCO Viewpoint from 2012: “Work a little longer. Save a little more. Get by with a little less.1

We think this insight applies abroad as well. In fact, global trends already underway support our argument that people will work later and later in life. In many economically important geographies – notably the U.S., eurozone, UK and Japan – senior (age 65+) labor force participation has been trending higher. And China is contemplating steadily raising its retirement age in the coming years.

However, what matters most for global saving demand are those who earn the most income. Consider the U.S. as an example. Top-income-quintile households control nearly two-thirds of U.S. household income, three-quarters of household wealth and more than 80% of household financial assets. Apart from the major social ramifications of wide (and widening) income and wealth inequality, the implications for aggregate saving are critical: Rather obviously, high earners’ working and saving behavior has an outsized effect on global saving in dollar terms.

If the highest earners are working (and saving) later in life, we should pay attention. Witness the dramatic rise in labor force participation within the top income quintile (Figure 3): Over 60% of top-quintile individuals in the 65–74 age group are employed or seeking work, a 19-percentage-point increase in participation over the 15 years through 2013. 2 Moreover, participation among top-income-quintile seniors 75 and older has more than doubled over the same period.4,/sup>

What about seniors’ late life saving behavior? Consider the top two income quintiles, collectively accounting for about 80% of U.S. personal income. Based on 2014 data from the BLS’s Consumer Expenditure Survey, these high earners exhibit no decline in savings rates as they enter retirement (due in part to a strong bequest motive and high conservatism). In Figure 4, note how high and consistent these top earners’ savings rates remain even in their late 60s and 70s.


(Aside: We find it curious that savings rates, based on the BLS’s Consumer Expenditure Survey, do not become negative for lower income quintile seniors even in their late 70s. We suspect that other data sources may show a negative savings rate for these elderly groups, likely due to methodological differences in data collection. Our focus here, however, is on age-related trends in saving behavior rather than savings rates themselves.)

To recap: The most impactful seniors are working (and saving) later in life as functional age and the duration of retirement both increase.3 Therefore, our preferred measure of the demographic support for saving is a dynamic, not static, ratio that accounts for the trend toward longer working lives. Let’s revisit our Peak Savers versus Elderly ratio from Figure 2. In decades past, age 64 may well have been the sensible upper bound for the Peak Saver group.

But what about the coming decades? In Figure 5, we have added a dynamic ratio (red line) that assumes seniors work roughly five years later in life in 2050 than they did in 2000. In other words, our age definition of “Peak Saver” evolves dynamically from 35–64 in 2000 to 35–69 by 2050, and consequently our definition of “Elderly” evolves dynamically from 65+ to 70+ over the same period.


What a different picture the dynamic ratio paints! It suggests that demographic support for saving could well be as strong a decade from now as it has been in recent decades – and illustrates the extent to which traditional static ratios may be flawed.

We concede that our dynamic ratio forecast is only a guess as to what the future may look like if current trends persist. But there is some method to the madness. For example, the reason we start to phase the 65- to 69 year olds into our Peak Saver group specifically in 2000 is that senior labor force participation began to rise rapidly in that year (after two stagnant decades).

Our five years later in life by 2050 employment assumption is slightly more arbitrary, but reasonable given that, globally, the largest increases in retirement age likely lie ahead of us. And our dynamic ratio does not account for the rising share of seniors 70+ who remain working, introducing an element of conservatism to our assumptions. So while our dynamic ratio embeds some simplifying assumptions, to be more scientific risks missing the forest for the trees.

Almost regardless of the assumptions used, if you define a dependency ratio dynamically – based even loosely on observable trends – you are likely to paint a very different (and more accurate) picture of the future than you will paint using a static ratio.

What about the rest of the world? It appears we’ve made an argument about global demographics supported mainly with U.S. data. However, publicly available data for other economically significant regions does not permit as granular an analysis as we have shown for the U.S. We do have reason to believe similar trends are occurring outside the U.S.: Elderly labor force participation is rising in Europe, the UK and Japan, and some countries – including China – are contemplating raising the retirement age.

In Japan, whose demographic cliff materialized many years ago, senior labor force participation has been trending higher, and as a result the labor force shrank only about 0.8% over the past decade even as the “working-age population” (aged 15 to 64) fell almost 9%. Patterns like this one are likely to repeat in other aging countries as societies adapt to meet their demographic challenges.

Bottom line: The people who move the needle most in saving demand, the highest earners, are the people working and saving later in life. This trend should be a tailwind for saving demand in the years to come that will push the global demographic cliff at least a decade into the future – and support a low global neutral interest rate, per the savings-investment equilibrium. 70 is the new 65!

U.S. household (demographic) demand for fixed income assets: a decade-long tailwind for bonds

We’ve just argued that demographics should help keep the global neutral rate low over the coming decade – which means that market yields in the U.S. should have a low “anchor.” But waves of baby boomers are retiring (albeit, as we have argued above, increasingly later), and many will eventually draw down (i.e., sell) their financial asset holdings to fund late life consumption. Are we fast approaching the point when boomer drawdowns create selling pressure in fixed income markets that pushes interest rates higher? Or might U.S. aging (boomers included) actually bolster the (net) demand for bonds and help maintain a low ceiling for market yields?

Consider two key observations.
  • First, as we should expect, investors generally de-risk away from equities and toward fixed income with age – most aggressively once they reach their 60s (and beyond).5
  • Second, individual asset accumulation and drawdown patterns vary significantly by income level. In the U.S., individuals in the lowest income quintile tend to sell their limited financial assets beginning in their 50s and completely exhaust their assets by, or before, death (relying on social assistance to meet their basic needs in life’s latest stages). Middle-income individuals tend to draw down financial assets beginning in their 60s but not at a rate that would deplete their assets before death. Individuals in the highest income quintile, however, are shown to have rising financial asset balances until roughly age 80 (after which they decline only very gradually). In other words, for top-income-quintile individuals, portfolio drawdowns don’t tend to begin until roughly age 80 (an important point). 

The highest earners have historically been able to fund retirement consumption from income (generally employment income, investment portfolio income and annuitized income), “leaving their financial assets virtually untouched.”6Here’s the key: Top-income-quintile households own over 80% of U.S. household financial assets. Consider how significantly this group’s future asset accumulation and drawdown profile will impact financial markets!

Back to our question about whether U.S. demographics will be a headwind or tailwind for bond flows in the years ahead. For starters, we assess when (demographics-driven) bond buying might peak relative to bond selling. We define “Bond Buyers” as individuals aged 60–74 and “Bond Sellers” as individuals 80 and older.

These age definitions are somewhat arbitrary, but they’re based on the two previously introduced empirical observations about households in the top quintile of the U.S. income distribution (which hold over 80% of U.S. household financial assets):
  1. Bond buying tends to peak during individuals’ 60s and early 70s (aggressive de-risking);
  2. Bond selling tends to peak in the years after age 80 (as individuals sell down their financial assets to fund consumption in retirement).
Figure 6 shows the ratio of Bond Buyers to Bond Sellers, which we use to gauge when net demographic buying demand might theoretically peak. On this metric, U.S. demographic demand for bonds should continue to rise in the next five years or so before peaking and may still be as strong in 2025 as it is today. (Our age definitions are based on patterns observed among U.S. households, so we focus primarily on the blue U.S. line in the figure. We include a global version of the Buyers versus Sellers ratio as well – the green line – which reveals an even later potential peak in global demographic demand for bonds.7


Our interpretation of this Buyers versus Sellers ratio assumes that each buyer exerts about the same influence on markets as each seller, an assumption that may be conservative given high-earning sellers draw down their portfolios only very gradually, whereas buyers likely will be de-risking aggressively in their 60s and early 70s. We “stress test” this assumption and result with scenario analysis in the Appendix.

Next, we explore the demographics of U.S. financial asset ownership at a very high level. Figure 7 shows household financial asset holdings by both age and income.8


The lion’s share of the $31 trillion in U.S. household financial assets9 ($21 trillion, or about 70%) is held within – or over the next 10 years will be held within – age cohorts that typically need to grow their fixed income allocation. This $21 trillion, outlined in green in Figure 7, is expected to remain in an accumulation or de-risking phase and won’t enter a drawdown phase within the next decade (based on the age-related asset drawdown patterns we described earlier). This $21 trillion will likely be a demographic tailwind for bonds over the next decade (especially for municipal bonds given high earners’ need for tax-free income). Conversely, only about $5 trillion (approximately 15%) of household financial assets seems likely to be a headwind for bonds during this period (outlined in red).

One caveat: Many factors other than demographics influence investors’ asset allocation decisions – among them changes in valuations, evolving expectations about future asset returns, individual risk preferences, U.S. investor preference for domestic versus foreign assets, foreign investor preference for U.S. assets, and market disruptions that may trigger significant portfolio rebalancing. Our analysis here focuses only on demographic effects, holding all else equal.

Now let’s go a level deeper. In the Appendix we model the potential demographics-related asset flows we might see over time from the gradual de-risking and drawdown of household financial assets. We analyze 10 unique scenarios in order to test a range of assumptions. Our “baseline” scenario reflects a set of assumptions about de-risking behavior and asset decumulation that we think is realistic (and possibly conservative) based on historical patterns. Our modeling suggests that U.S. demographics driven fixed income inflows are likely to be almost as strong 10 years from now as we project them to be today – and that demographics may not be a material headwind for bonds until the 2030s.

How can we explain these conclusions? In our analysis, for at least the next decade, de-risking flows and rebalancing flows into fixed income more than compensate for seniors’ portfolio drawdowns. In stress testing our baseline assumptions we found it hard to come up with a plausible scenario in which U.S. demographics become a fixed income headwind within 10 years. Yet we found it easy to imagine realistic scenarios in which demographic demand for bonds remains robust for the next 15 years or more.

Consider as an example the high-earning elderly, for whom longevity risk is rising rapidly as life-extending medical technologies proliferate. High earners, historically, have been overly cautious in recalibrating their spending to meet anticipated future needs – a finding that could warrant an even more gradual asset-drawdown trajectory for this next generation of retirees than we have modeled based on historical experience. See the Appendix for our assumptions, baseline scenario modeling and alternative scenarios.

A brief aside: Our focus here has been U.S. demographics and, implicitly, U.S. fixed income. However, U.S. demographics are likely to influence global fixed income markets given U.S. households account for over 40% of global household financial assets. For context, Western Europe and Asia each account for about 25%.10

Finally, a quick note on changes in the composition of household retirement savings. The shift from defined benefit (DB) to defined contribution (DC) plans in the U.S. persists, and in our estimation U.S. DB plans hold a lower allocation to bonds than a market-average glide path suggests is optimal for DC participants.11 In aggregate, therefore, the continued shift toward DC may represent an additional tailwind for bonds in the coming years.

Bottom line on U.S. aging and the demand for bonds: Persistent demographic support for fixed income should, all else equal, drive net flows into bonds and help maintain low yields over the next decade.

‘Speed read’ and key conclusions

Some financial market observers believe in the following dramatic scenario:
  • We’ve just gone over a demographic cliff; globally, the ratio of high-saving adult workers to dissaving elderly is now declining. This demographic reversal will erode the demand for saving.
  • The global savings glut will reverse as the demand for saving falls, pushing the global neutral interest rate higher.
  • Baby boomers in the U.S. will compound the problem as they sell their financial assets (including bonds) to fund retirement consumption, driving U.S. fixed income yields higher.
In this note, we challenge traditional thinking about the timing of the feared “demographic cliff.” A demographics-induced structural rise in U.S. interest rates remains at least a decade away:
  1. Global demand for saving will remain robust, supporting a low global neutral interest rate (the “anchor” for U.S. fixed income yields):
    • Traditional dependency ratios – which use fixed, static age definitions – are flawed because they fail to account for how the world is changing.
    • U.S. elderly, especially the highest earners, are working and saving later in life. High earners matter a lot because they drive the lion’s share of global saving. 70 is the new 65.
    • Similar trends can be observed in economically significant economies outside the U.S.
    • We argue for a dynamic, not static, ratio of mature adults to elderly that does account for how working and saving behaviors are changing. Our dynamic ratio suggests that demographic support for saving may be as strong over the next decade as it has been over the past several. Possibly stronger.
    • Strong saving demand should support a low global neutral interest rate in the coming years – and should continue fueling the global savings glut.
  2. In financial markets, strong U.S. demographic demand for fixed income assets should – all else equal – help maintain low U.S. bond yields over the next decade:
    • The lion’s share of U.S. household financial assets is held within age cohorts that will need to grow their fixed income allocation over the next ten years.
    • Top-income-quintile households own over 80% of these assets, and high earners sell financial assets only very gradually in retirement to fund consumption.
    • For another decade or more, demographics should remain a net contributor to fixed income flows, as high earners’ de-risking into bonds should dominate bond outflows due to portfolio drawdowns.
Combine a low global neutral interest rate and strong domestic demand for bonds, and what do you get? Lower rates for longer in the U.S.
The authors would like to thank PIMCO colleague Jim Moore for his contributions.

Appendix: U.S. household financial assets and fixed income flows – scenario analysis

This Appendix details the assumptions used in our baseline scenario for U.S. (demographics-driven) fixed income flows and offers a number of alternative scenarios.
Baseline scenario assumptions:
  • Financial asset portfolios consist of two asset types (for simplicity): “risk assets” (excluding fixed income) and fixed income.
    • Long-term annual risk asset return: 5% nominal.
    • Long-term annual fixed income return: 2.5% nominal.
  • Investors de-risk their portfolios into fixed income over time according to a market-average glide path,12 interpolated as necessary. (We conservatively assume that de-risking into fixed income ceases at age 75 and that investors’ asset allocations remain constant thereafter. This assumption is driven by a lack of available data on market-average glide path allocations for ages older than about 75.)
  • Each year, top-income-quintile households re-optimize to draw down 50% of their financial assets by the end of their planning horizon, beginning at age 80 and ending at age 95. (50% may be a conservatively high drawdown percentage.)
  • Each year, households in the bottom four income quintiles re-optimize to draw down 75% of their financial assets by the end of their planning horizon, beginning at age 65 and ending at age 90. (75% may be a conservatively high drawdown percentage.)
  • Financial asset drawdowns occur proportionally across risk assets and fixed income. (This assumption is fair to conservative, given there is evidence that people draw down their riskiest assets first.13)
  • Financial asset portfolios do not exist in perpetuity; mortality effects (based on the most recent mortality tables from the Society of Actuaries) lead to bequests that generate “re-risking” flows from fixed income into risk assets.14
Alternative scenarios:
Each alternative scenario represents a modification relative to our baseline scenario.
  • Alternative 1: De-risking into fixed income proves significantly faster than expected (ultimate fixed income allocation of 50% is reached 10 years earlier than baseline glide path suggests).
  • Alternative 2: De-risking into fixed income proves significantly slower than expected (ultimate fixed income allocation of 50% is not reached until 10 years after baseline glide path suggests).
  • Alternative 3: Seniors 50+ ultimately de-risk much less significantly than baseline glide path suggests (fixed income allocation reaches 15% at age 50, per glide path, but then flat-lines for 10 years before gradually increasing to a level only half that suggested by baseline glide path, i.e., a terminal allocation of 25% instead of 50%).
  • Alternative 4: Annual fixed income returns equal annual risk asset returns, such that market-return-driven rebalancing flows no longer support fixed income (5% annual nominal return assumed for both asset types). (This scenario has a natural hedge property; if ex ante fixed income returns ever were expected to equal ex ante risk asset returns, the relative attractiveness of fixed income probably would increase on a risk-adjusted basis, likely triggering non-demographics-related reallocations into fixed income – which we have not modeled here.)
  • Alternative 5: Top-income-quintile households re-optimize each year to ultimately draw down 75% of their financial assets by the end of their planning horizon, while households in the bottom four quintiles re-optimize to draw down 100% (for both groups, a far higher drawdown percentage than is likely).
  • Alternative 6: Top-income-quintile households commence drawdowns a full decade earlier than history suggests is likely, i.e., at age 70 (if anything, as life expectancies and planning horizons lengthen, one might expect drawdowns to begin later).
  • Alternative 7: A combination of alternatives 5 and 6 (i.e., a highly conservative mix of assumptions).
  • Alternative 8: Households commence drawdowns five years later and lengthen their planning horizon by five years (optimistic, but plausible given rising longevity risk and rising labor force participation among the high-earning elderly).
  • Alternative 9: Top-income-quintile households re-optimize to draw down 25% of their financial assets by the end of their planning horizon (instead of 50%), consistent with a high bequest motive and historical excess conservatism during retirement.
The chart below shows our estimate of future demographics-driven U.S. household fixed income flows by scenario. These projections are NOT meant to be interpreted as forecasts of the actual dollar volume of flows, in part because the $31 trillion stock of household financial assets used to model these flows omits certain large asset pools (see our technical note further on). So focus on the trends depicted, not on the dollars.


As you can see in the chart, across almost all of our scenarios demographics remain a fixed income tailwind for the next 10 years, and in most scenarios longer. Note that this analysis may lean conservative in that we have modeled potential flows based only on the existing stock of financial assets. Yet every year, mature adult workers (especially the high income earners) will invest some portion of their savings in financial assets, including bonds, both inside and outside their retirement plans. These flows, all else equal, represent a tailwind for all financial assets that we haven’t attempted to model.

Finally, a technical note on our primary source for U.S. household financial asset data: the Federal Reserve’s 2013 Survey of Consumer Finances. To our knowledge, there are two primary sources for U.S. household balance sheet detail: the Federal Reserve’s Survey of Consumer Finances (“SCF”), a triennial survey of a cross-section of U.S. households, and the U.S. national flow of funds accounts. We use the SCF, which is widely used in Federal Reserve analysis, academic research at major economic research centers, and private financial industry analysis and writings. The SCF is, to our knowledge, unparalleled in its demographic granularity across age groups, income quintiles and other key variables.

Significant differences are worth highlighting between the SCF and the household balance sheet data contained in the U.S. national accounts. Of note, the 2013 SCF excludes about $19 trillion in DB pension entitlements and $2.4 trillion in assets of nonprofit institutions. As a result of these and certain other omissions, the SCF identifies a materially lower total value for U.S. household financial assets than the national accounts identify. The question, for us, is whether there is any reason to think that the omissions made by the SCF, notably DB pension entitlements, will bias our results. 

We see no obvious bias. At a high level, DB pension plan asset allocations tend to be a function more of the level of interest rates and plan funding status than of the age profile of plan beneficiaries. Also, as we’ve argued in the body of our note, as the U.S. shifts from defined benefit to defined contribution schemes we may see additional support for fixed income given that DB plans seem to allocate less to bonds than a market average glide path suggests is optimal for DC participants. For these reasons, we think using a source that excludes DB pension entitlements likely leads us – if anything – to underestimate demographics-related fixed income demand over the next decade.

See the recent research paper linked below, from the Federal Reserve, for a more detailed explanation of the differences between SCF data and data from the U.S. national flow of funds accounts, as well as a defense of the use of SCF data in economic research: http://www.federalreserve.gov/econresdata/feds/2015/files/2015086pap.pdf

Works consulted
  • Mercedes Aguirre and Brendan McFarland, “2014 Asset Allocations in Fortune 1000 Pension Plans,” Towers Watson, October 2015.
  • Robert Arnott and Denis Chaves, “Demographic Changes, Financial Markets, and the Economy,” Financial Analysts Journal Volume 68 Number 1, 2012.
  • Charles Bean et al., “Low for Long? Causes and Consequences of Persistently Low Interest Rates,” Geneva Reports on the World Economy 17, International Center for Monetary and Banking Studies, October 2015.
  • Lisa Dettling et al., “Comparing Micro and Macro Sources for Household Accounts in the United States: Evidence from the Survey of Consumer Finances,” Finance and Economics Discussion Series 2015-086, Washington: Board of Governors of the Federal Reserve System, 2015.
  • “The Eurosystem Household Finance and Consumption Survey,” Statistical Paper Series No 2, European Central Bank, April 2013.
  • “2013 Survey of Consumer Finances (SCF),” Federal Reserve, September 2014.
  • Michael Gapen, “Demand for safe havens to remain robust,” Barclays Equity Gilt Study, February 2013.
  • Michael Gavin, “Population dynamics and the (soon-to-be-disappearing) global ‘savings glut,’” Barclays, February 2015.
  • Charles Goodhart et al., “Could Demographics Reverse Three Multi-Decade Trends?” Morgan Stanley, September 2015.
  • Dr. Michaela Grimm et al., “Allianz Global Wealth Report 2015,” Allianz SE, August 2015.
  • Markus Lorenz et al., “Man and Machine in Industry 4.0: How Will Technology Transform the Industrial Workforce Through 2025?” Boston Consulting Group, September 2015.
  • Dr. Susan Lund, “The Impact of Demographic Shifts on Financial Markets,” McKinsey Global Institute, June 2012.
  • “Pension Markets in Focus,” The Organisation for Economic Co-operation and Development, 2015.
  • James Poterba et al., “The Composition and Draw-Down of Wealth in Retirement,” NBER Working Paper 17536, October 2011.
  • Karen Smith et al., “How Seniors Change Their Asset Holdings During Retirement,” Center for Retirement Research at Boston College Working Paper 2009-31, December 2009.
1 PIMCO Viewpoint “What’s Your Number at the Zero Bound”, by Dr. James Moore, 2012.
2 2013 represents most current data available.
3 Our argument would be even stronger if we could show that the personal savings rate among high-earning seniors in their late 60s and early 70s has been increasing over time (parallel to the rise in labor force participation). However, the BLS has advised us that a comparison between 2014 data and prior-year data may be misleading due to recent changes in survey methodology.
4 From 2000 to 2050, our dynamic ratio – mechanically – is a weighted average of two individual static ratios (35–64 versus 65+ and, separately, 35–69 versus 70+); the weights change each year to reflect our assumption about rising longevity.
5 See, for instance, “The Impact of Demographic Shifts on Financial Markets” (McKinsey Global Institute, 2012).
6 “How Seniors Change Their Asset Holdings During Retirement” (Smith et al, 2009).
7Validity of global Buyers versus Sellers Ratio depends on the extent to which asset accumulation-drawdown patterns among the high-earning elderly outside the U.S. mirror the patterns observed among U.S. elderly. We have not explored this question empirically and include the global ratio only for interest and context.
8 See Appendix for a technical note on our choice of the Federal Reserve’s Survey of Consumer Finances for U.S. household financial asset detail.
9 U.S. household financial assets, as depicted in the Federal Reserve’s 2013 Survey of Consumer Finances, total $31 trillion across all age groups.
10 Source: Allianz Global Wealth Report, 2015.
11 For color on U.S. DB pension plan asset allocations, see, for example, the OECD’s “Pension Markets in Focus” (2015) and Towers Watson’s “2014 Asset Allocations in Fortune 1000 Pension Plans” (2015).
12 Source: NextCapital.
13 See “Demographic Changes, Financial Markets, and the Economy” (Arnott and Chaves / CFA Institute, 2012).
14 For simplicity, we assume that anyone who dies younger than age 65 bequeaths assets to a spouse of comparable age (i.e., no change in asset allocation) while those who die at or after age 65 bequeath assets to someone (presumably children) 30 years younger (i.e., a generation earlier in risk tolerance). We recognize that not every elderly person bequeaths assets to a younger heir; some assets are passed on to charitable organizations and friends or other family members of comparable age, for instance. We assume, arbitrarily, that 50% of financial assets are passed to younger heirs. Our general results are not particularly sensitive to changes in these assumptions.

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The article Outside the Box: 70 Is the New 65 was originally published at mauldineconomics.com.


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Sunday, June 14, 2015

Free Webinar: Small Lot Trading Strategies for Options Traders

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Friday, February 27, 2015

A Math Free Guide to Higher and Safer Returns

By Andrey Dashkov

I can make you instantly richer, and safely, by explaining a finance concept with a story about a dog.

There’s a hole in your pocket you probably don’t know about. You may feel instinctively that something is wrong, but unless you look in the right place, you won’t find the problem. The money you’re losing doesn’t appear in the minus column on your account statements, but you’re losing it nevertheless.

Frustrated? Don’t be. I’m going to tell you where to look and how to stop the drainage.

Volatility is every investor’s worst enemy. Over time, it poisons your returns. Unlike a 2008 style market drop, though, volatility poisons them slowly. There’s no obvious ailment to discuss with friends or hear about on CNBC. You only see it when you compare how much you lost to how much you could have earned—and looking back at your own mistakes is not a pleasant thing to do.

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So instead let’s imagine two fictional companies: X-Cite, Inc., an amusement park operator with a volatile stock price that adventurous investors love; and Glacial Corp., a dull, defensive sloth of a corporation whose stock returns are consistent but often lower than those of its more glamorous counterpart.

Average return on both companies’ stocks was 5% for the past five years, but Glacial’s was less volatile. Safety is comfortable, but doesn’t higher volatility mean higher potential returns? Sometimes, but not always. When you accept high volatility, your returns might be higher at times, but they also might be lower. In other words, higher volatility generally means greater risk.

Nothing new so far, but the oft-overlooked point is that boring stocks make you richer over time.
The chart below shows each stock’s annual return over a five year period.


At first glance, Glacial Corp. appears to be the loser. It underperformed X-Cite in four out of five years. Both stocks returned 5% on average during these years, and X-Cite was almost always voted the prettiest girl in town. But for Year 3, it would be easy to persuade investors to buy X-Cite stock. Few would give Glacial a second glance.

Hold for the punchline: X-Cite, the stock your broker would have a much easier time selling you (before you read this article), would actually make you poorer. Let me explain.

I won’t get into any supercharged math here. Glacial is better because it makes you richer eventually. After five years, the total return on X-Cite is 25%. Not bad. Glacial? 27%. If you invested $10,000 in both (assuming no brokerage fees or taxes), at the end of Year 5 you would have earned $2,507 on X-Cite or $2,701 on Glacial.

Year-End Account Balance
X-Cite, Inc.
Glacial Corp.
Year 1
$10,500
$10,300
Year 2
$11,550
$11,021
Year 3
$10,164
$10,801
Year 4
$10,875
$11,341
Year 5
$12,507
$12,701
Total return
25%
27%


Where does the extra $194 come from? It comes from lower volatility. Although X-Cite looks like a winner most of the time, it has a higher standard deviation of returns. Note that X-Cite’s stock price dropped 12% in Year 3. The following year it increased 7%, while Glacial Corp.’s stock price only increased 5%—yet Glacial is still worth more from Year 3 onward. Why? X-Cite’s 7% jump is based on the previous year’s low.

But I promised to keep this note math-free, so imagine a person walking a dog instead. The shorter the leash, the less space the dog has to run around. The longer the leash, the more erratic the dog’s path will be. Standard deviation measures how much data tend to scatter around its mean—the path. As we just saw, low standard deviation also pays you money.

I could stop right here and hope that you take this lesson to heart, but I won’t. As much as I love describing finance concepts using clever company names and dogs, I want you to start making money right now.

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The article A Math-Free Guide to Higher and Safer Returns was originally published at millersmoney.com.


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Saturday, November 15, 2014

New Video: How You Can Profit with ETFs from the Unexpected Move in the Dollar

You've seen us talking about a new Options strategy that John Carter was working on recently...and he is finally sharing it with us.

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Wednesday, September 10, 2014

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Monday, August 18, 2014

Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John Mauldin


Risk premiums. I don’t know anyone who seriously maintains that risk premiums are anywhere close to normal. They more closely resemble what we see just before a major bear market kicks in. Which doesn’t mean that they can’t become further compressed. My good friend John Hussman certainly wouldn’t argue for such a state of affairs, and this week for our Outside the Box we let John talk about risk premiums.

Hussman is the founder and manager of the eponymous Hussman Funds, at www.Hussmanfunds.com. Let me offer a few cautionary paragraphs from his letter as a way to set the stage. I particularly want to highlight a quote from Raghuram Rajan, who impressed me with his work and his insights when we spent three days speaking together in Scandinavia a few years ago. At the time he was a professor at the University of Chicago, before he moved on to see if he could help ignite a fire in India.

Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that “some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say ‘we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.’ It’s the same old story. They add ‘I will get out before everyone else gets out.’ They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time.”

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this, because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.

Yesterday evening, another astute market observer in the form of my good friend Steve Cucchiaro, founder of Windhaven, joined a few other friends for an entertaining steak dinner; and then we talked long into the night about life and markets. It is difficult to be “running money” at a time like this. The market is clearly getting stretched, but there is also a serious risk that it will run away for another 10 or 15%. If you are a manager, you need to be gut-checking your discipline and risk strategies. If you’re a client, you need to be asking your manager what his or her risk strategy is. It’s not a matter of risk or no risk but how you handle it.

What is your discipline? What non-emotional strategy instructs you to enter markets and to exit markets? Is it all or nothing, or is it by sector? Are you global? If so, do you have appropriate and different risk premiums embedded in your strategies? Just asking…. John’s piece today should at least get you thinking. That’s what Outside the Box is supposed to do.

It’s an interesting week around the Mauldin house. All the kids were over Sunday, and we grilled steaks and later ended up in the pool, shouting and horsing around, all of us knowing that three of the seven would be off to different parts of the country the next day. I know that’s what adult children do, and as responsible parents we all want our children to be independent, but the occasion did offer a few moments for reflection. Sunday night we just told stories of days past and laughed and tried not to think too much about the future.

A friend of mine just came back from California and Oregon complaining about the heat. Dallas has been rather cool, at least for August. If this weather pattern somehow keeps up (and it won’t), I can see lots of tax refugees streaming into Texas from California.

Tomorrow (Thursday) my mother turns 97, and we will have an ambulance bring her to the apartment, where she wants to have her birthday party. She is bedridden but is absolutely insisting on this party, so my brother and I decided to let her have her way. Which isn’t any different from the way it’s always been. Have a great week.

You’re rich in family and friends analyst,
John Mauldin, Editor
Outside the Box

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Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John P. Hussman, Ph.D.
Through the recurrent bubbles and collapses of recent decades, I’ve often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.

The past several years of quantitative easing and zero interest rate policy have not bent that Iron Law at all. As prices have advanced, prospective future returns have declined, and the “risk premiums” priced into risky securities have become compressed. Based on the valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90%), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only about 2% annually over the coming decade. See Ockham’s Razor and The Market Cycle to review some of these measures and the associated arithmetic.

What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision. For example, if a “normal” level of short-term interest rates is 4% and investors expect 3-4 more years of zero interest rate policy, it’s reasonable for stock prices to be valued today at levels that are about 12-16% above historically normal valuations (3-4 years x 4%). The higher prices would in turn be associated with equity returns also being about 4% lower than “normal” over that 3-4 year period. This would be a justified response. One can demonstrate the arithmetic quite simply using any discounted cash flow approach, and it holds for stocks, bonds, and other long-term securities. [Geek's Note: The Dornbusch exchange rate model reflects the same considerations.]

However, if investors are so uncomfortable with zero interest rates on safe investments that they drive security prices far higher than 12-16% above historical valuation norms (and at present, stocks are more than double those norms on the most reliable measures), they’re doing something beyond what’s justified by interest rates. Instead, what happens is that the risk premium – the compensation for bearing uncertainty, volatility, and risk of extreme loss – also becomes compressed. We can quantify the impact that zero interest rates should have on stock valuations, and it would take decades of zero interest rate policy to justify current stock valuations on the basis of low interest rates. What we’re seeing here – make no mistake about it – is not a rational, justified, quantifiable response to lower interest rates, but rather a historic compression of risk premiums across every risky asset class, particularly equities, leveraged loans, and junk bonds.

My impression is that today’s near-absence of risk premiums is both unintentional and poorly appreciated. That is, investors have pushed up prices, but they still expect future returns on risky assets to be positive. Indeed, because all of this yield seeking has driven a persistent uptrend in speculative assets in recent years, investors seem to believe that “QE just makes prices go up” in a way that ensures a permanent future of diagonally escalating prices. Meanwhile, though QE has fostered an enormous speculative misallocation of capital, a recent Fed survey finds that the majority of Americans feel no better off compared with 5 years ago.

We increasingly see carry being confused with expected return. Carry is the difference between the annual yield of a security and money market interest rates. For example, in a world where short-term interest rates are zero, Wall Street acts as if a 2% dividend yield on equities, or a 5% junk bond yield is enough to make these securities appropriate even for investors with short horizons, not factoring in any compensation for risk or likely capital losses. This is the same thinking that contributed to the housing bubble and subsequent collapse. Banks, hedge funds, and other financial players borrowed massively to accumulate subprime mortgage-backed securities, attempting to “leverage the spread” between the higher yielding and increasingly risky mortgage debt and the lower yield that they paid to depositors and other funding sources.

We shudder at how much risk is being delivered – knowingly or not – to investors who plan to retire even a year from now. Barron’s published an article on target-term funds last month with this gem (italics mine): “JPMorgan's 2015 target-term fund has a 42% equity allocation, below that of its peers. Its fund holds emerging-market equity and debt, junk bonds, and commodities.”

On the subject of junk debt, in the first two quarters of 2014, European high yield bond issuance outstripped U.S. issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the “reach for yield” provoked by zero interest rate policy. The discomfort of investors with zero interest rates allows weak borrowers – in the words of the Financial Times – “to harness strong investor demand.” Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.




Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that "some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say 'we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.' It's the same old story. They add 'I will get out before everyone else gets out.' They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time."

While we’re already observing cracks in market internals in the form of breakdowns in small cap stocks, high yield bond prices, market breadth, and other areas, it’s not clear yet whether the risk preferences of investors have shifted durably. As we saw in multiple early sell offs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.

As I’ve frequently observed, the strongest expected market return/risk profile is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage is likely to follow. Some of it will be on virtually no news at all, because that normalization is baked in the cake, and is independent of interest rates. All that’s required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.

Remember: this outcome is baked in the cake because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the sell offs with renewed speculation, but there’s no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We don’t believe that risk has been permanently removed from risky assets. The belief that it has is itself the greatest risk that investors face here.

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