When To Sell...
Before it's too late - Discussion, investment conclusion & recommendations February 02, 2021
“All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. Wall Street never changes, the pockets change, the stocks change, but Wall Street never changes, because human nature never changes.” ~ Jesse Livermore
February 2, 2021 - Attention is still focused on an upcoming fiscal stimulus package and a short term jump in the economy when/if it is allowed to open back up (now that the election is over and there is talk that the “pandemic” will be declared defeated via vaccines…). But any short term economic impact will be temporary at best and certainly not caused by organic real growth. Market players are not yet bothered by the coming reality of higher taxes, more regulation, a continued recession, and, more importantly for the immediate future of short term trends, a “talking down” of expectations as to what Democrats will do with their control of the US Federal Government now that they have it. They are already talking down expectations of a March/April stimulus bill. Clearly, expectations were extremely high, and Congress has been talking down the amount of the package. Months ago, the talk was of a stimulus package of over $2Trillion. However, there is now talk of about 1/3 of that amount ( https://apnews.com/article/joe-biden-ap-top-news-coronavirus-pandemic-bb7f90e28ab160cba510df3b40723fe5 ). Expectations are for an actual fiscal “stimulus” package to pass end or April/early March 2021.
US equities prices remain horrendously overvalued, overextended, and overdue for a desperately needed correction to the still dominant long term uptrend. The return for stocks relative to bonds with negative yields is driving this — negative real yields make bonds relatively unattractive. As Bond Manager Jeffrey Gundlach explained recently in his “Just Markets” online presentation, “Although U.S. equities are in the top percentile of valuation using many metrics, they don’t appear to be expensive relative to bonds…” and of course, negative real yields punish bond investors, and, bonds have always been a place for big funds to park money, especially Treasury bonds.
Price action in equities suggests that market players have reached a point, even if only by the passage of time, where another strong does of liquidity and positive expectation (confidence) will be needed to recharge the dominant bubble theory (or “narrative”) as time runs into the Spring of 2021 and Fiscal stimulus expectations are managed lower by the US Congress. The current accepted dominant narrative is that disappointment will NOT come from the Federal Reserve: "The Federal Reserve is keeping interest rates unchanged near zero until at least 2023 and will continue to purchase bonds at a rate of $120 billion a month, according to its latest policy statement.” ( https://www.barrons.com/articles/fed-reiterates-pledges-on-near-zero-rates-and-120-billion-in-monthly-bond-buys-51611775474
As far as how extreme financial bubbles can get, anything is possible...just a few years ago, the talk of a publicly traded company having a total market cap over the magic $1Trillion mark was laughable, no one took it serious. Yet, today there are at least five publicly traded companies with a total market cap of over $1Trillion USD, and at least one with a total market cap of over $2Trillion (AAPL)… ~ NorthmanTrader
The political cycle, and actions of government need to be respected here, as it is a simple logical deduction how they will act, in light of the nature of government. A ruling party that takes control at what is the peak of the greatest financial bubble in history will most likely embrace at least a correction in prices before creating another mass re-inflation of the bubble. The reason why is simple – they don’t want a collapse to come before the next set of elections (in less that two years time). So, best to engineer or “allow” a correction to occur sometime this year and not later when it would make elections even more difficult.
For the past year, the “pandemic” (and the initial market collapse that came with it) gave politicians plenty of cover to pass legislation, but that has worn thin at this point, and equity markets are still close to all time record highs, even after last weeks drama caused a minor bout of forced liquidation among some firms that needed to cover margin requirements for losses on short positions in GME and other Reddit Board squeezes (much more on this later…)
A strong correction in equities prices in the next few months has the added benefit of causing pain/creating incentive and would create the much needed “cover” or excuse for the US Congress to pass a more massive stimulus package in the months ahead. Politicians need to trot out the usual arguments about needing to intervene to stop the potential effects of a market crash and the damage it would do to an economy that is still in recession (thanks to their policies, of course). This is just the nature of government, and it is doing what it does best (more on this below).
Some may think it’s favorable for markets that one side has control & a majority in Congress. In decades past, “gridlock was good” for the markets. For certain, the current situation is quite scary in terms of what will happen to the little that is left of our individual liberties, but recall that the majority is quite slim, and there is massive infighting within both parties.
The potential for major disappointment is increasing, in our view. The post election rally of the last three months was undoubtedly driven by fiscal stimulus expectations, and the Biden admin & Democrats were not shy about (initially) putting out some massive numbers in the $Trillions, including an infrastructure package. If & when market players turn their focus to a clearer view of what will likely be a disappointing stimulus (if they every finish their unconstitutional impeachment of a private citizen…) and the increases in taxation that is undoubtedly coming, that could potentially be a catalyst for a significant correction (10-20%) in equities.
“It’s important to understand that Fed easing “supports” the stock market only by affecting investor psychology. The Fed buys interest-bearing securities and replaces them with zero-interest base money. That’s it. Instead of holding savings in the form of a Treasury security, someone holds their savings in the form of a bank balance. The fact that they have a zero-interest bank balance instead of a low-interest Treasury bill doesn’t mean they change their consumption or retirement plans. It just means someone in the economy has more psychological discomfort, because every dollar of base money created by the Fed has to be held by someone at every moment in time until it is retired…You can try to get “out of” cash by buying stocks, but only by bidding up stock prices enough for a seller to accept the cash in return. Yes, you now own more stocks, but your cash is now held by that seller. There are no “sidelines.” Every security is held, exactly as before. Nothing has changed except the owners. The problem is that the psychological impulse to own something other than cash, regardless of price, has created a situation where stock market valuations have been bid up to levels that imply negative S&P 500 total returns for well over 12 years….” (John Hussman, 01/31/2021 https://www.hussmanfunds.com/comment/mc210201/)
At this point in the financial cycle tail hedges are vital (when aren’t they?)…even something as simple as cheap out of the money puts (10-15%) one month out (vertical spreads on the QQQ or SPY can be done for a reasonable price if one does not want to pay for the long side alone, the short side can help with the cost and of course can be covered in the event that prices do tank.
For many, the big challenge as usual is while waiting for the market cycle to bottom and valuations and LT expected returns to return to buyable levels, how do you generate a reasonable return. Because valuations are currently at the worst levels in all of history, traditional portfolios (60% equities of that in equities) currently show negative returns over a decade long period if you were to buy & hold today. If you manage your own money, there is nothing wrong with keeping a large portion in cash equivalents, as cash has option value. Currently, I would argue that the option value of cash is high, and allows you to exploit opportunities when they arise. As someone that has gotten wiped out financially more than once and made several comebacks, I can tell you from experience that not losing anything is better than being overaggressive is a major Achilles heel for many market players (and has destroyed many fortunes throughout history). A cash position provides flexibility — it also requires the ability to think beyond the present moment, in terms of a market cycle that inevitable completes itself on both the upside & downside.
“Investing is the art of positioning capital so as to profit from future developments.” ~ Howard Marks
Volatility is increasing and will continue to increase over the foreseeable future, both quantitatively in terms of measures like the VIX, and also qualitatively as far as the ideas that market players act on change based on the confidence they have in these different narratives. The changes in confidence in the narratives is quickly reflected in prices (and the algos that react to them, also programmed and reflective of what people believe). So being able to utilize cash to exploit short and intermediate opportunities is a good position to be in. A traditional long portfolio should have 0 funds net long in US equities at this point in a passive traditional portfolio, because the price you pay matters greatly for long term returns! Quantitatively, markets have never been in a worse position as far as expected returns, by many measures — the data and articles on that topic is beyond the point of diminishing returns - this stock bubble is extreme, and it will inevitably revert as they always do.
Inflation or Deflation?: The debate rages…. We are also past the point of diminishing returns with respect to consuming articles on whether we will be experiencing inflation or deflation. To sum it up - there is no doubt that the average American has been experiencing PRICE inflation in their living expenses such as rent, food, and the other vital things one needs to survive. It is common knowledge that government stats do not accurately capture price inflation (it is also common knowledge that is by design because they have strong incentives to do that!). Whether it is the box of cereal that has decreased it’s quantity or weight by 30% but keeps the same price ( called “shrinkage” or sometimes called “value deflation) or if it is utility bills, the net result is that your Dollars buy less than they used to. To add insult to injury, quality and variety have both decreased (https://www.nytimes.com/2020/09/02/business/inflation-worse-pandemic-coronavirus.html)
There is also this (dated yesterday, February 1, 2021): “Inflation Galore at Manufactures, amid Massive Shifts in Demand, Supply-Chain Snags, Shortages, Lack of Shipping Capacity. And They’re Passing it On….And the Fed has said it will ignore inflation for a while, that it will allow it to overshoot, and only when it overshoots persistently for some unknown amount of time and becomes “unwelcome” inflation – “unwelcome” for the Fed – that it will try to tamp down on it….” Read the full article here: https://wolfstreet.com/2021/02/01/inflation-galore-at-manufactures-amid-massive-shifts-in-economy-supply-chain-snags-shortages-lack-of-shipping-capacity/
“There is inflation in the real world...the FED provides inflation in asset prices for the wealthy & for the rest of us it’s cost of living increases for daily living…” ~ Northman Trader
There is, of course, the good kind of deflation that does still manage to work from entrepreneurial efforts and advances in technology in markets that are relatively free.
So, when we talk about “Deflation” here, we are mainly referring to it from the perspective of policymakers at the Federal Reserve, Treasury, Federal Government, and the quasi governmental agencies & think tanks that defend them, and they have a totally different focus — they only care about financial assets, and stuff like this:
And…money is created when it is loaned into existence by banks….and money vanishes when debt defaults. Debt repayments to banks destroy money, this is a problem IF you are a central banker (or a politician trying to get re-elected during a recession caused by you own policies).
The Federal Reserve creates reserves for the Banking Cartel members in exchange for debt (either Treasuries or (even if it’s not legal, Corporate Bonds) via “quantitative easing.” The reserves that are created are not “legal tender” for spending. Reserves, not money, are “created out of thin air…”. This is why many consider quantitative easing to not be inflationary…
“the FED is not printing or creating money out of thin air as they cannot and only banks can create money by lending. QE is not money printing but the FED is taking assets and their corresponding income streams from the real economy and crediting banks reserves accounts with IOUs increasing their reserves and the monetary base. Banks can borrow against these but this stays in the FED system and never enters the real economy. “
If the incentive to hold excess reserves goes away, what happens? According to the Federal Reserve:
““In normal times, excess reserves aren’t profitable, as they don’t earn a return. Instead of holding cash as excess reserves, banks could lend those funds and earn interest. However, after the 2008 recession, the Federal Reserve started paying interest on excess reserves (IOER). By altering the incentives for commercial banks to extend loans or hold excess reserves, the Fed is able to use the IOER as an additional monetary policy tool. The federal funds rate can be thought of as the interest rate at which financial institutions make short-term loans to each other.
Here, we see that the federal funds rate tracks the IOER very closely. When banks have excess liquidity or reserves, they can choose whether to lend those reserves to other banks (at the federal funds rate) or deposit them at the Fed (and earn the IOER). Banks aren’t willing to lend to each other if the federal funds rate is substantially lower than the IOER, and so the two rates move closely together.” “ https://fredblog.stlouisfed.org/2018/06/paying-interest-on-excess-reserves
The “wild card” is if the laws were changed such that the Federal Reserve was able to DIRECTLY create and spend money, for example if Congress made excess reserves actual legal tender. That would be a game changer, and also speed up the eventual collapse of the monetary system, as a lack of sound money is one of the biggest long term institutional problems the USA faces.
There is fuel in the monetary system for more price inflation, and policymakers have, over time backed themselves into a corner… Given the deficits, debts & unfunded liabilites, & additional stimulus bills, etc they will pass, they will only create more of that monetary fuel. But the octane level of the fuel has declined dramatically as there is simply too much debt in the US & global financial system — debt has been overused and abused and it’s far less effective (it’s marginal revenue product has declined dramatically…)
There really much that policymakers can do at this point…
“Sizeable debt financed Federal fiscal operationsin 2009 and 2018 produced only transitory spurts in economic activity. Also, these failed fiscal efforts occurred under the leadership of both of the major political parties. This indicates that the weak multipliers are not the result of political leadership, but the nature of the debt financed…” Hoisington Investment Management, 4th Quarter 2020 Review & Outlook
But the arguments for “Deflation” (again, financial deflation from the perspective of policymakers, not the perspective of middle class shoppers that actually pay living expenses) are there, and it’s not just that policymakers would welcome (even quietly encourage?) a deflationary scare (for the rest of us it would look more stagflationary with little if any growth and rising prices).
“it is our conclusion that U.S. fiscal multipliers are in fact negative for non- investment type of spending.... Federal fiscal operations in 2009 and 2018 produced only transitory spurts in economic activity. Also, these failed fiscal efforts occurred under the leadership of both of the major political parties. This indicates that the weak multipliers are not the result of political leadership, but the nature of the debt financed....taxing & borrowing... reduces the resources of the private sector which provides productivity growth expanding the economic ‘pie.’ The transfer of resources to the federal sector can result in a misallocation of resources reducing overall productivity and growth for the entire economic system....” ~ Hoisington Investment Management, 4th Quarter 2020 Review & Outlook
“The 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression. No one realized the problems that were building up in the economy as they used an economics that doesn’t look at debt, neoclassical economics. …” ~ comment from a public message board
So…if and when this “deflation scare” attracts the attention & focus of market players, and they act on it, and change their focus to the deflation theory — clearly that would be the major correction that would present another potential entry point for passive investors.
From the perspective of you & I and the VAST majority of the population that experience consistent price inflation, deflation is a good thing, as it increases the purchasing power of our money (Deflation is also the natural state of free markets & capitalism, neither of which exist in the USA, but that is a discussion for another time). A bout of deflation would also be welcome if you are young, wanting to purchase a home and begin investing for retirement some day — even if you could afford it, in general, “investing” in stocks or real estate when they are at all time world record highs is about the worst thing you can do for your financial health. If you invested in stocks in the late 1990s at the tech bubble peak (and held) or bought a house in 2005, it took a VERY LONG TIME for you to just break even on it (a negative return in real terms…), if you held onto it. If you are young you need a decent entry point for financial decisions…and right now is not it, in our view….
Financial repression is nothing new, but the current extremeness of it is… If you are fortunate enough to be at the front of the line to benefit from the creation of new money, then none of this bothers you, but if you are starting a family and don’t have an eight figure trust fund, or you are not a bank CEO or hedge fund manager, then you need to know how to overcome the odds, which are clearly not in your favor — this isn’t the early 1980s with double digit interest rates and general lows in markets providing an optimal entry point!…
If financial assets begin to deflate policymakers will scream DEFLATION! and scare everyone into supporting yet even more monetary & fiscal stimulus. They will consider it another economic crisis, and everyone knows that for politicians and bureaucrats, “a crisis is an opportunity…” Policymakers love it when they have excuses to stimulate, and they do not care at all about the long term consequences of their actions!
Summary & Investment Conclusion (for buy & hold traditional portfolios): *Not investment advice, for informational & educational purposes only*
Due to the most overpriced & overvalued US stock market in history, a large amount of cash equivalents is warranted. Cash & cash equivalents have option value providing the ability to exploit opportunities that may arise from increased volatility.
We suggest 0 long equity exposure to non-mining US stocks (quality mining stocks may be purchased on pullbacks - list to follow in a separate post). 25% to high quality corporate bonds and 20% to commodity type investments (physical metals/investment grade coins/mining stocks) and long the USD against the EUR (short EUR futures on globex or short EUR/USD in the spot market.
On strong rallies, aggressive investors (& traders) may short a basket of stocks (specific candidates will be discussed separately) or the QQQ or SPY via bear put spreads 3 to 4 months out (or simply buying the puts, depending on how much you are prepared to risk. If long equity exposure is absolutely necessary, look to S. Korea, Thailand & other emerging markets, as they are relatively more attractive than US equities in terms of valuation (don’t forget the consider currency effects!).
Because of the lack of long exposure, tail hedges are optional, but of course, at this point one may want to consider a “barbell” portfolio that provides exposure to the increasingly probable binary outcome between deflation & inflation.
Digital assets & cryptocurrencies will be discussed separately…
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