Month: August 2021

Excessively indebted societies must periodically deleverage bad debt to avoid an otherwise certain social and economic downfall. Central planners have two options when managing a highly indebted economy: allow painful bear markets and recessions to deleverage the system, which is deflationary (falling prices), or attempt to control a high inflation rate while keeping real interest rates negative over a long period, such that price increases in the economy outrun government debt, thereby lowering the debt/GDP ratio, which is inflationary (rising prices). Which option will the Fed pursue at this year’s Jackson Hole Symposium, what might the official narrative be, and what does that mean for the financial markets going forward?

The Fed doesn’t directly control the U.S. markets or economy because the dollars it supplies get deposited as bank reserves. In other words, the Fed can create new dollars, but it can’t force banks to lend them, or people and businesses to borrow and spend them. For this reason, the Fed has far less power over the economy and financial markets than most people understand. What the Fed does control is psychology and policy expectation, and by controlling the narrative, it can persuade market participants to do its bidding. The Fed’s narrative has been consistent since the 2008 Financial Crisis: rates will remain low, money-printing will back-stop the economy and markets to prevent the dreaded deflationary deleveraging, and inflation will be allowed to run higher, so borrow more money, take more risk, and buy more stocks! The Fed has staked itself in the inflationary deleveraging camp.¹

In the end, the Fed’s ability to effectively manage an inflationary deleveraging of our market system depends on market participants believing the narrative. To pull that off, it must occasionally convince Mr. Market the economy is strong enough to withstand the withdrawal of the Fed’s monetary heroin. Expect a heavy dose of that ‘idea’ to circulate the news today, but do not expect essential policies to change; remember, the goal is to deleverage the system through inflation.

While the Fed’s inflation policy results in persistently high asset prices, commonly referred to as “The Wealth Effect”, in reality it is “The Illusion of Wealth Effect”, which recently played out in Venezuela, as the cost of living outpaces asset appreciation and as the dollar becomes the final release valve for the dreaded, though unavoidable, deleveraging of our highly indebted society.² Every time the market doubts the Fed’s narrative deflation will take hold, so market crashes will occur as this scenario plays out. There will also be significant unintended consequences to innocent bystanders, most notably America’s middle class.

Think about it. Shaun

“The rich rules over the poor, and the borrower is slave of the lender.” ~Proverbs 22:7

1, 2 The Stansberry Digest, Daniela Cambone’s interview with George Gammon, August 25, 2021

The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial. The economic forecasts set forth in this commentary may not develop as predicted.

All investing involves risk including the possible loss of principle. No strategy insures success or protects against loss.

Asset allocation does not ensure a profit or protect against loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

There are many reliable signals which indicate an approaching multi-year stock market peak. Early warnings include excessive speculation among novice investors, high valuations, and high levels of margin investing, signals all flashing red today. Mid warnings include weakness in small cap stocks, which appear to be rolling-over now, and in transportation stocks, which have been falling since May, as well as declining market breadth. The Advance/Decline Line shows how broadly stocks are participating in a market advancement, and is the primary gauge of market breadth.¹ The 7’Th of Bob Farrell’s 10 Rules of Investing states “Markets are strongest when they are broad, and weakest when they narrow to a handful of blue-chip names”.² Strong market breadth is critical to sustain an advancing bull market, but declining breadth, such as is occurring in some U.S. sectors (and foreign markets) today, reveals a bull market losing steam. What does this development suggest about the lifespan of the ongoing bull market? Might it reveal characteristics of the inevitable bear market to follow? How should investors prepare?

Advance/Decline Line charts for the NASDAQ, RUSSELL 3000, AND RUSSELL MICRO indexes all show declining trend-lines, while those of the DOW JONES, S&P 500, and RUSSELL 1000 seem to reveal a topping pattern.³ It’s noteworthy the trend-line for Hong Kong’s HSI, Singapore’s STI, Malaysia’s KLSE, and China’s Shanghai SE are all in free-fall,⁴ suggesting whatever market event looms is likely to be a global event.

An interesting study done in 2019 by Lowry Research on major market tops over the past 90 years revealed two consistent phenomena: the longer the major indexes advanced on deteriorating breadth, the longer it took for stocks to reach bottom from the peak, and the longer each ensuing bear market lasted. The longest divergence by far was the 24 months preceding The Crash of 1929, in which case the DOW JONES took 3 years to find bottom, and 25 years to fully recover. The shortest divergence was 1 month, and the average was 9 months.⁵ If our present case falls within the parameters of this impressive study, a) the present bull market can continue for two more years, b) but could end at any moment, and c) we are likely within 9 months of a major, multi-year peak in stocks. This is consistent with the forecast of many top investors today.

Since the divergence between falling market breadth and rising index levels has only just begun in the present cycle, there is no way to know how long the bull might run, how long the fundamental downtrend of the coming bear market might last, or how many months or years the recovery to all-time highs will require, but further indications will surface when the coming top is recognized in hindsight. Stay diversified with proper asset allocation, use proper position-sizing, incorporate a chaos hedge, carry a bigger cash position, avoid over-reacting, and dollar cost average the whole bust/recovery cycle, in what will likely be a classic and painful, yet healthy and cleansing bear market presenting wonderful opportunities to patient investors.

Think about it, Shaun.

“Markets tend to return to the mean over time. Excesses in one direction will lead to an opposite excess in the other direction. There are no new eras; excesses are never permanent. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. The public buys the most at the top and the least at the bottom. Bear markets have three stages: sharp down, reflexive rebound and a drawn-out fundamental downtrend. When all the experts and forecasts agree, something else is going to happen. Bull markets are more fun than bear markets.” ~Bob Farrell’s Rules of Investing (Rule Numbers 1-5, 8-10)

“Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.” ~Eccliastes 11:2

1,5 Lowry White Paper, “How Severe Will The Next Bear Market Be?”, April 2, 2019
2 Stock Charts, “Bob Farrell’s 10 Rules”, August 6, 2021

https://school.stockcharts.com/doku.php?id=overview:bob_farrell_10_rules

3,4 Market In Out, Stock Screener, August 6, 2021

https://www.marketinout.com/chart/market.php?breadth=advance-decline-line

Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC

The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial.

Dollar cost averaging requires continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.

All investing involves risk including the possible loss of principle. No strategy assures success or protects against loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The U.S. central bank (‘the Fed’), in its attempt to maintain power and credibility while simultaneously diluting the currency faster than during WW II, is desperate to convince consumers and investors inflation is transitory and will soon moderate. The mere threat of “tapering” bond purchases, a controlled way for ‘the Fed’ to raise interest rates in an attempt to slow inflation by restricting loan growth, quickly brought Wall Street into subjection to the narrative. But with soaring producer and consumer prices, emerging dollar alternatives, and notable investors sounding the inflation alarm, what are the basic arguments, which way do the facts lean, and how can investors protect themselves in both scenarios?

The transitory inflation argument rests most securely on the “marginal utility of debt” (MUD) thesis, most notably defended by excellent economist, Lacy Hunt, of Hoisington Investment Management, which suggests the economy’s ability to grow diminishes as an excessive debt load siphons off an increasing percentage of otherwise productive capital to unproductive debt-service payments, miring the economy in disinflation.¹ Though Hunt admits a crisis of confidence in the currency, manifested in surging money velocity, or the rate at which dollars change hands, can at some point subvert the transitory inflation/MUD argument, he doesn’t believe it has, and firmly expects an imminent return to disinflationary conditions.

Rising prices are more persuasive than theories presented by well-educated economists for legendary investor, Stan Druckenmiller, Stansberry Research’s Doc Eifrig, Tradesmith’s Keith Kaplan, and many other top investors today. The persistent inflation argument suggests that when the money supply is increased without a corresponding increase in the amount of goods and services in the economy, price increases will result: since ‘the Fed’ can’t stop printing money without crashing the economy and financial markets, inflation is here to stay. Tradesmith Daily recently reported the following YOY price increases: car rentals 87%, used cars 45%, gasoline 45%, hotel rooms 17%, and fruit 7%.² Doc Eifrig recently reported a 200% jump in oil prices, 300% for lumber (since 2020), and 40% for paper, as he released his “New Era Playbook” for what he clearly sees as a lasting inflationary environment.³

The truth is both arguments are viable. Many complicated factors affect price trends, and money velocity, a largely subjective phenomenon, and therefore one difficult to perceive, will ultimately judge the matter. As top investor, Warren Buffet, astutely reveals, inflation is a hidden tax, and an inflationary environment introduces new rules to investing: 1) the purchasing power of a company’s retained earnings will be scrutinized, 2) the impact of inflation and taxes on a company’s bottom line will be examined, 3) companies with strong free cash flow will be favored, and 4) companies able to pass inflationary costs to consumers will be preferred.⁴ Yet another advantage to the purchase of great businesses, namely capital-efficient, dividend-paying, dividend- increasing, industry-dominating companies, at reasonable prices, is their resilient advantage during inflationary periods. Investors may also be wise owning an inflation/chaos hedge or two, a higher cash position than normal, and by keeping a watchful eye on positions vulnerable to persistent inflation, like high multiple tech stocks and high yield corporate bonds.

Think about it. Shaun