Howard Marks And The Bearish Argument

Howard Marks in his latest investment letter does a wonderful job of laying out many of the issues and concerns in today's market.   Below I've laid out some of the salient points from his letter that I think might interest my readers.  He is more negative than me overall but I think my readers and clients deserve to be shown both sides of the argument.  I'm going to republish a revised copy of my latest investment letter in a few days that takes on some of these arguments.  Marks does not spare ETFs in his latest issue.  All bold print as emphasis is his.

Howard Marks Introduction To His Letter.

"Since I’ve written so many cautionary memos, you might conclude that I’m just a born worrier who eventually is made to be right by the operation of the cycle, as is inevitable given enough time.  I absolutely cannot disprove that interpretation.  But my response would be that it’s essential to take note when sentiment (and thus market behavior) crosses into too-bullish territory, even though we know rising trends may well roll on for some time, and thus that such warnings are often premature.  I think it’s better to turn cautious too soon (and thus perhaps underperform for a while) rather than too late, after the downslide has begun, making it hard to trim risk, achieve exits and cut losses.

Since I’m convinced “they” are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions – it’s time for yet another cautionary memo.  Too soon?  I hope so; we’d rather make money for our clients in the next year or two than see the kind of bust that gives rise to bargains.  (We all want there to be bargains, but no one’s eager to endure the price declines that create them.)  Since we never know when risky behavior will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us.....

Howard Marks On Today’s Investment Environment

Because I don’t intend this to be a “macro memo,” incorporating a thorough review of the economic and market environment, I’ll merely reference what I think are the four most noteworthy components of current conditions:

• The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
• In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been. 
• Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains.In general the best we can do is look for things that are less over-priced than others.
• Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

Howard Marks On U.S. Equities

The good news is that the U.S. economy is the envy of the world, with the highest growth rate among developed nations and a slowdown unlikely in the near term.  The bad news is that this status generates demand for U.S. equities that has raised their prices to lofty levels.

• The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
• The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16.  This multiple was exceeded only in 1929 and 2000 – both clearly bubbles.
• While the “p” in p/e ratios is high today, the “e” has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity.  Thus today’s reported valuations, while high, may actually be understated relative to underlying profits.
• The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – is immune to company-level accounting issues (although it isn’t perfect either).  It hit a new all-time high last month of around 145, as opposed to a 1970-95 norm of about 60 and a 1995-2017 median of about 100.
• Finally, it can be argued that even the normal historic valuations aren’t merited, since economic growth may be slower in the coming years than it was in the post-World War II period when those norms were established.

Howard Marks On Passive Investing/ETFs

Like all investment fashions, passive investing is being warmly embraced for its positives:

• Passive portfolios have outperformed active investing over the last decade or so.
• With passive investing you’re guaranteed not to underperform the index.
• Finally, the much lower fees and expenses on passive vehicles are certain to constitute a permanent advantage relative to active management.

Does that mean passive investing, index funds and ETFs are a no-lose proposition?  Certainly not:

• While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.
• The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.
• As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds.

Other Observations and Implications

As I said, most of the phenomena described above seem reasonable given the rest of what’s going on in today’s economic and financial world.  But step back for perspective and put them together, and what do we see?

• Some of the highest equity valuations in history.
• The so-called complacency index at an all-time high.
• The elevation of a can’t-lose group of stocks.
• The movement of more than a trillion dollars into value-agnostic investing.
• The lowest yields in history on low-rated bonds and loans.
• Yields on emerging market debt that are lower still.
• The most fundraising in history for private equity.
• The biggest fund of all time raised for levered tech investing.
• Billions in digital currencies whose value has multiplied dramatically.

 I absolutely am not saying stocks are too high, the FAANGs will falter, credit investing is risky, digital currencies are sure to end up worthless, or private equity commitments won’t pay off.  All I’m saying is that for all the things listed above to simultaneously be gaining in popularity and attracting so much capital, credulousness has to be high and risk aversion has to be low.  It’s not that these things are doomed, just that their returns may not fully justify their risk.  And, more importantly, that they show the temperature of today’s market to be elevated.  Not a nonsensical bubble – just high and therefore risky. 

Try to think of the things that could knock today’s market off kilter, like a surprising spike in inflation, a significant slowdown in growth, central banks losing control, or the big tech stocks running into trouble.  The good news is that they all seem unlikely.  The bad news is that their unlikelihood causes all these concerns to be dismissed, leaving the markets susceptible should any of them actually occur.  That means this is a market in which riskiness is being tolerated and perhaps ignored, and one in which most investors are happy to bear risk.  Thus it’s not one in which we should do so.

What else:

• My observations are always indicative, not predictive.  The usual consequences of the conditions I describe – like an eventual increase in risk aversion – should happen, but they don’t have to happen.
• And they certainly don’t have to happen soon.  No one knows anything about timing.Certain consequences are implied, but even if they’re going to happen, we have no way of knowing when.It feels like we’re in the eighth inning, but I have no idea how long the game will go on.
• I’m never sure of my market observations.  As you’ll see in my new book, I believe strongly that where we are in a cycle says a lot about the market’s likely tendencies, but I never state opinions on this subject with high confidence.
• As a natural worrier, I tend to be early with warnings, as described on page one.  'Nuff said.
• Finally, while my observations are uncertain and should be taken with a grain of salt, what I am sure of is that valuations and markets are elevated, and the easy money in this cycle has been made.

There is so much more to this letter and there is no way possible to cover all of it in one posting.  As I said at the top of this article I have tried to point out the parts of Mark's article that I think would interest my clients and readers.  As such, I have left many of Mr. Mark's observations out of this post on subjects like credit markets, the vix and digital currencies.  I have also left out his closing paragraph that he calls "What to Do".  I think the best thing is for you to go read the article itself.  I'm going to chew on this over the weekend and revisit some of it next week.  

Back Monday.

Link:  Oaktree CapitalManagement:  Howard Marks:  "There They Go Again...Again".

Earnings

Over on their Twitter Feed ,the folks at Bespoke Investment Group note that "since the close Tuesday, 85% of 41 S&P 500 companies have topped EPS forecasts and 66% have beat revenues". Folks, if you want to know why the stock market has been running then all you have to do is look at earnings because these have been pretty darn good so far this quarter. Positive earnings usually means that analysts take up their forward earnings estimates. That in turn makes the forward multiple on stocks look better at current prices.

This will likely not last forever but right now, especially on the earnings front, the news out of corporate America is pretty good. Also think about this. Retail and energy have been the dregs of the litter so far this year. If they start to rebound and if the rest of the corporate world stays on the same glide path then earnings could end up being much better than most are expecting even into next year. That's also without figuring any type of tax reform into the mix. That, however, is probably next years business.

Anyway, enjoy the earnings now. Also remember it's summertime and the "livin is easy"!

*Long ETFs related to the S&P 500 in both clients and personal accounts.  Currently short SPY and ETFs related to the S&P 500 in a personal account related to an options strategy not employed in client accounts.  We reserve the right to change these investments without notice on this blog or via any other form of verbal, written or electronic communication.  

In The Things Are {Still} Getting Better Department

A pick-up in tax receipts can only mean one thing that more people are working and making more money.  This is also being reflected in consumer confidence numbers.  The Consumer Confidence Index rose in July to 121.1 vs. expectations of a drop to around 116.  The Conference Board that tracks these things announced that shoppers were more upbeat than anticipated and also said jobs were "plentiful' and less hard to get.

Folks, both of these indicators are saying things are pretty good right now.  Of course nothing is perfect as income doesn't seem to be rising as fast as economists would like.  However, it's pretty hard for the pessimists to argue right now that things are bad or about to take a turn for the worse, unless something unforeseen washes over the transom.

This isn't our father's economy.

Chart Link: Businessinsider.com "The Most Important Charts In the World From the Brightest Minds on Wall Street."

Blackrock: Three Investment Themes For The 2nd Half

Below are three investment themes Blackrock thinks will assert themselves into the 2nd half of 2017. {My highlights in Green.}

Theme 1: Sustained Expansion

The current U.S. economic cycle has been unusually long, sparking market fears that it is ready to die of old age. We have a different take. The slower the pace of a recovery, the longer it takes to absorb the economic slack created in the last recession—and the longer it takes to reach full capacity and ultimately the peak that signals the cycle’s end, our analysis shows. The economy’s sluggish growth means that the current cycle has a long way to run, in our view, and its remaining lifespan can be measured in years, not quarters. The current landscape of subdued inflation and wage growth supports this.

Overall, we see the world in a synchronized and sustained economic expansion that is slower than previous cycles. Growth in the world’s major developed economies is cruising at a rate that is slightly above the trend in place since the financial crisis. The BlackRock GPS—which combines traditional economic indicators with big data signals such as web searches and text mining of corporate conference calls—suggests a higher growth rate over the coming 12 months than currently reflected in consensus estimates.

We see interest rates and bond yields rising only gradually in the sustained expansion. This provides a favorable backdrop for equities and bodes well for the momentum style factor (stocks that have been trending higher), in our view.

Theme 2: Rethinking Risk

The history of volatility is one of long stretches of calm punctuated by brief moments of crisis, with low volatility surprisingly persistent. Our research suggests that breaks to a high-volatility regime rarely occur without the economic expansion coming to an end. We see the probability of a volatility regime shift as low—as long as the economy remains stable and systemic financial vulnerabilities are kept in check.

Low volatility does mask risks unique to fixed income markets, in our view. Volatility spikes can be led by financial, rather than economic, events. We see evidence of these financial risks in pockets of credit but not in the broader market. Poor liquidity in credit markets makes it tough to exit positions quickly and could worsen any sell-off. Rising corporate leverage could exacerbate these risks. Risk management is key as long-run investment success depends on avoiding catastrophic drawdowns.

Result: We see a risk that many investors today are under-risked. Portfolio insurance should focus on the risk of a sharp rise in bond yields that results in a decline in the valuation of broad assets.

Theme 3: Rethinking Returns

Historical market returns may be a poor guide to the future. Structural factors such as aging populations, poor productivity growth and high debt levels mean historically low government bond yields are likely here to stay. This is an important reason why the Federal Reserve is treading cautiously in raising rates and other central banks appear slow to follow that path. We expect long-term bond yields to rise gradually over the next five years but to stay well below historical averages.

We believe structurally lower growth and interest rates mean that comparing valuation metrics to past levels may not be a good guide to the future. We do not see equity valuation metrics falling back to historical means in an environment where earnings are staging a sustained recovery and long-term rates are low. In the final analysis, we believe investors are being paid to take equity risk against the backdrop of low rates. The earnings yield (earnings per share divided by the share price, or the inverse of the price-to-earnings ratio) gauges the attractiveness of equities versus bond yields. It still looks attractive versus bond yields. This is especially the case for non-U.S. equities, including emerging markets, in our view.

The bottom line: The global expansion is chugging along, deflation fears and near-term political risks look to have faded, and financial market volatility is subdued. We believe this provides fertile ground for modest gains in risk assets such as international and emerging market equities. Read more {at Blackrock's} full Global Investment Outlook Midyear 2017.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Link:  Blackrock: Three Investment Themes Shaping The 2nd Half.

Back Tuesday.

The World in Pictures {07.19.17}

Here is the negative side of the student loan argument from Rick Rieder, Global Chief Investment Officer of Fixed Income, Blackrock:

"This {student loan} crisis has under-appreciated negative side effects for the US economy as a whole. Most significantly, student loans are making it harder for first-time home buyers to afford their own home, with more than 70% of would-be first-time buyers saying student loan debt is delaying their home purchase, according to the National Association of Realtors. As a result, the homeownership rate in the US has fallen each of the last six years despite a solid economic recovery, according to the US Census Bureau, with the biggest impact coming from the 25-34 year old cohort as seen in the chart above. 

The student loan burden is not just curtailing young adults’ home buying; it is weakening their consumption in general, posing a major headwind to US economic growth. In addition to the direct economic impact, the student loan crisis could also worsen the class divide. Home ownership levels at age 30 are much lower among those with college debt than those without, and when faced with today’s high college costs coupled with the prospect of taking on significant debt, more students from lower-income households may choose not to attend college, worsening their outlook for employment and wage income over the course of their career. The bottomline: This crisis is likely to be a major drag on the US economy for years to come if it remains unaddressed, and an elegant fiscal-policy solution is needed, the sooner the better."

My comment:  I agree on part of this argument in that the over one trillion dollars of student loan debt that is being paid back is money that isn't being spent somewhere else.  I'm not sure it's actually a crisis yet due to the amount of debt the average student carries {around $30,000}.   Millennials having yet been buying homes but I suspect that's about to change as they enter their prime child rearing years.  Also, I think some of the student loan burden could be issued if the interest rates they were being charged were lowered.  I find the argument that students should be charged over six percent on debt that they for the most part can't discharge in bankruptcy hard to swallow.  Index that rate to something like 50 basis points over the 10-year treasury and I think you'd see a pick-up in economic spending and growth.


Link:  Businessinsider.com The Most Important Charts In the World From the Brightest Minds on Wall Street.

The World In Pictures {07.18.17}

We had some problems publishing last week but now we're back in the saddle.  We've discussed in the past the issue of student loans today and tomorrow I'm going to present two opposing views of the issue.  On one side there is this.....

Above is the argument that student loan debt is manageable.   66% of student loan debt is in the $25-$30,000 range, about the same amount somebody might pay for a mid-level car.   The larger amounts of debt, for the most part, belongs to students going on for graduate degrees.  This of course makes sense.  Somebody studying to be a doctor is likely taking on more debt with the hope that the advanced degree leads to a higher earnings stream later in life.  

Viewed in this regard, student loan debt should be a manageable event for most partaking in the program, especially if they are smart and proactive on how they pay the money back.

We'll take a look at the more negative aspects of this tomorrow.

Businessinsider.com The Most Important Charts In the World From the Brightest Minds on Wall Street.

What Could Go Wrong? Valuations and an Economic Slowdown

By Christopher R. English, President of Lumen Capital Management, LLC

You’ve probably heard the terms “bull market” and “bear market” thrown around by the media. In simple terms, a bear market occurs when stock prices fall and buyers disappear. Bull markets experience rising prices and increased demand for equities. The bullish case for stocks gets a lot of media hype and occasionally those that think the world is coming to an end also hit the airwaves. Both make for good headlines, even if reality often lies more in the middle. I am not currently bearish although I think we at some point are due for a correction. However, I think it is only fair share the bearish arguments, especially since I usually talk about the positive side of things. In a two part series this month, we’re going to focus on letting the bears share their side of what could go wrong in the markets and I'll give my counter-view to their arguments. 

Bears Versus Corrections

It is important to understand that at some point we will again experience a market correction. These are vastly different than bear markets. A typical market correction is a short-term event, usually lasting around two-six months. On average, market volatility runs around 14%, which means that in a given year, stocks will usually experience some sort of correction between 10-20%. Even though we haven’t experienced a correction in a few years, we shouldn’t ignore the fact that they occur and are a normal corrective part of the market’s process. A secular bear market, on the other hand, usually is a multi-year event where stocks historically lose 30-50% of their value, and we don’t always know when we’ve hit the bottom. To buy into the secular bear market scenario is to usually a bet on a significant economic shift. That is much different than your typical correction. I’ll be listing in the next two articles in order of highest probability by our estimation would could potentially trigger a secular bear market. 

Reasons For A Market Decline

We all know that markets are unstable, but in our current economic situation, what could cause a future market decline? 

Decline Due To Valuation

Markets have traded at elevated valuation levels now for years. Investors have justified this by pointing to the lack of alternative places to invest assets and the very low interest rate environment we’ve been in. But this year has brought rising interest rates, with the Federal Reserve announcing the newest quarter-point rate hike on June 14th.

Higher interest rates increase the possibility of cash leaving equity markets that are historically extended and looking for alternative places to invest if interest rates become more competitive. The bad news for the bulls is that a decline to market levels where stocks have historically been seen as cheap would probably today mean a correction of greater than 20%. That also assumes we’re not correcting because of a decline in earnings. In that case, markets could experience a much deeper correction.

My counterpoint: There is no gloss to hide the ugly truth that stocks are historically expensive. The counterpunch to that argument is currently, corporate earnings have been growing at the fastest rate in years. In addition, these earnings are muted by the depressed value of energy companies due to the global sell-off in oil. As long as earnings continue to grow, markets have the potential to advance. In regard to interest rates, probability suggests bonds will likely only begin to compete with stocks once we see the 10-year U.S. Treasury break the 3% level, while rates have been recently rising, we are not yet near that important level. 

Decline Due To A Slowing Economy

The markets could also sniff out an economic slowdown causing investors to worry that the economy is running out of steam. This would call into question corporate earnings and again could potentially impact valuations. There are some signs currently pointing to this, such as rising consumer debt and rising default rates, also student loan debt now has grown to over one trillion dollars, while new car sales seem to be peaking. 

We are close to what economists consider full employment, but wage growth has been tepid for many and consumers seem to be unwilling to spend like they have in the past. Based on some of this data one could make the argument that it wouldn’t take much to drop us into a stagnant or contracting economy. Additionally, rising interest rates could put the brakes on economic growth.

One of the best predictive signals for economic contraction is when short-term interest rates yield more than bond yields on longer-dated maturities. This yield curve inversions means investors will likely buy short-term bonds instead of bonds that don't come due for many years. For example, why lend money at 2% out 15 years when you can lend at 3% for less than five years? When this happens, investors have less incentive to lend money, starving the credit markets of the fuel that keeps the economy afloat. This has been a predictor of the previous seven regressions, going all the way back to the 1960s. We are much closer to an inversion today than we were a few years ago.

My counterpoint: The problem with this argument is that for every negative economic statistic there are others that show the economy is growing. Gasoline for example is as cheap this summer as we have seen in years and food inflation remains subdued. Housing starts are healthy and I would argue that rising interest rates at this point should be construed as a positive outlook on the economy. The cost of money typically doesn't rise if the economy is soft. Finally I continue to argue that many of our current economic statistics do not adequately measure growth or how our more knowledge based economy is evolving. To me then, probability suggests that economic growth is potentially stronger than statistics sometimes suggest

Regardless of what happens, remember that the economy always goes through cycles and if you are committed to a long-term strategy, you don’t need to lose sleep. If you are concerned about how your investments will fare if the markets undergo a correction or a dive, call my office at 708.488.0115 or email us at lumencapital@hotmail.com. We will continue this series below.

About Chris

Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing him at lumencapital@hotmail.com.

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What Could Go Wrong? Politics, Crises, and Machine Trading

By Christopher R. English, President of Lumen Capital Management, LLC

This is the final article in a series that covers the bearish argument for stocks. While there are plenty of factors that could cause the markets to become more chaotic, I've tried to feature the most prevalent events that could lead to something more than a simple correction for stocks. I've been discussing these in what I believe is the most highly probable to least likely to occur. In our last letter we talked about two things that could result in a bear market: valuation declines and an economic slowdown. Today, we’re going to turn our attention to three more factors that could lead to a long-term secular bear market. 

Decline Due To Political Chaos

Politics can greatly affect the markets. There is a bearish argument that President Trump is such a divisive and polarizing figure that his administration will ultimately wreak havoc on the economy and the markets. Those touting this argument believe stocks have rallied since the election because investors have been energized by the pro-business policies of the Trump Administration. However, the counterpoint to this is that the ongoing political gridlock in Washington and any potential political crisis from the ongoing investigation into Russian manipulation of our elections means that these pro-business policies are in danger. Not to mention the polarizing nature of the President himself. The belief is that stocks could fall precipitously if any of these worries become reality. Many worry that Trump’s scandals will rival Watergate and the economic fallout if this occurs could be just as negative.

Before I continue though I want you to know that I do not write about politics and I always attempt to divorce politics from my understanding of the economy. As such, I strive to only write about how I believe the political process and system will affect my client's investments. In this regard, it is irrelevant to me who is President or who controls the Congress. You have to play with the hand you're dealt when investing money, regardless of whomever you might prefer to see as President or whatever are your political beliefs. 

Therefore, and solely in context with what I said in the preceding paragraph, let's discuss the role the media is so far playing in their confrontations with the President. In our current political climate, the media is playing a significant role in our reactions to the President. The press hates Mr. Trump, particularly the coastal-based media outlets. The only president the so-called “4th Estate” has perhaps loathed more is Richard Nixon. The President seems to return the favor with the exception of those outlets that are biased towards him. Mr. Trump made the media look bad during his campaign by exposing their biases along with WikiLeaks and in an era where there are more news outlets than ever, more traditional news organizations risk being made to look irrelevant by newer means of communication. As a result, traditional media outlets are trying to do everything they can to destroy the President. Some of this is obviously personal but the real reason is that the President and his allies are perceived as mortal threats to traditional media's existence. 

I caution you on this not because I want to influence your views or because I am trying to make a political statement, but because the press will distort almost every aspect of whatever economic plan this administration puts forward. Instead of letting sensationalized headlines rile you up, pay attention to how the market reacts, not on any given day, but over a series of weeks. If the plan is economically promising, stocks should react positively. 

For example, any overhaul of the tax code is going to have winners and losers. Who do you think will complain the loudest? The cries of anguish from the losers will be presented in a manner that appeals to the base instincts of their audience. They won't tell us anything about the long-term potential positives that might result from the changes but will focus only on what they don’t like. Those changes, and how they will impact the economy, must be our litmus test in regards to the markets. Regardless of whether the changes are good or bad, they are what will drive market returns in the years to come. 

Watergate Part Two?

The Trump/Watergate analogy has been thrown around all too often lately. While it’s too soon to know how things will play out with the President’s issues, I will caution you against relying too heavily on the Watergate similarities. Watergate occurred against a backdrop of runaway inflation, largely stemming from the Arab oil embargo after the 1973 Arab-Israeli war and a slumping economy. Whatever the ultimate resolution to the President’s problems is, the economic situation does not resemble that period of our history in the least.

The Unexpected

Let’s be real, things happen outside of our control on a regular basis. When a crisis occurs, there is a domino effect, impacting various aspects of our lives. This can be true even for events seemingly far away. Take for example the 2011 Fukushima nuclear disaster that resulted from an earthquake and tsunami. That event initially seemed confined to Japan but it took on international significance as the reactors in the plant melted down. Energy companies in any manner connected to nuclear power suffered as a result and markets remained stagnant for months as the world saw lower economic growth out of Japan, it is a given that things like international crises, wars, and natural disasters will happen in the future. The unknown is always the timing. Something could happen tomorrow, not until next year, or never. 

A geopolitical event or an unexpected shock, such as a destabilizing natural disaster, would likely lead to a market decline, but there’s not much we can do about it. We monitor these occurrences to the extent we can and take into account the most likely events that could happen. But one cannot invest assets worrying about when the sky will fall. That is as true when stocks are expensive as when they are cheap.

Economic Scandals and Asset Bubbles

Very few people will ever forget the bank scandals that occurred in 2007 and 2008. The excess and abuse of authority from these institutions rocked our economy and led to the largest economic contraction since the Great Depression. The financial services industry is much more heavily regulated today than it was a decade ago. It is impossible to assert that there will never be another scandal or financial collapse but the probability of that occurring right now is much less than it was back then. Banks are required to carry higher reserves today and face scrutiny in a more comprehensive manner. Their improved capital structures resulted in every bank passing the most recent Federal Reserve stress test. That is the first time this has ever happened since the tests began. If there is an issue with banks it will likely be in some overseas market. US financial institutions should be in a much better position to weather a problem today than even a few years ago. 

Technology companies have been some of the best-performing assets since 2009. Unlike the early 2000s, their rally is hardly about speculation in tiny stocks nobody has ever heard about with no earnings or growth prospects. There is also no similar widespread national speculation in assets like housing, which kicked off the last recession. Credit standards have been too tight to have a replay of our previous crisis. The only place this has been evident in the high-end housing market with the influx of foreign money such as in Manhattan or Miami Beach and that seems to be correcting on its own with no seeming national impact. Just because things are different now doesn’t mean we couldn’t see a financial issue of some sort, but at this point, it’s not the obvious trigger. 

Machine-Trading 

Finally, let’s discuss the possibility of issues with algometric or computer trading leading to a sudden and violent decline in stocks. We can’t discount the idea that an algorithmic-induced trading panic could occur. We have seen short-lived flash crashes resulting from issues related to machine-based trading that ran amok. The first of these occurred on Monday, October 19, 1987. That event has been largely attributed to computer programs related to so-called “portfolio insurance” relentlessly selling down the market for over a 20% one-day loss. The most recent of these was May 6th, 2010, when stocks lost around 10% in a very short period of time. I would say there is a certain probability that we could experience another of these at some point. While regulations have been put in place to try and stem this sort of panic selling, the only way one will ever know their effectiveness is to see what happens when they are tested. It is possible that some of the machine dominated trading could find a way to trade around these regulations. 

If and when something like this occurs, it will be important to understand the events surrounding the situation. When an event happens out of the blue with no other economic or breaking political news, it will likely be short-lived, with the natural arbitrage of the markets stepping in as buyers likely swoop in to pick up perceived bargains. No matter how frightening it may seem to investors, make sure to keep a calm head. If there is no fundamental upset to the economy in these situations, it is best to stick to your investment plan. The fact that machine-trading crashes are so few and far between likely means that while the occurrence is a real possibility, it is also rare. Additionally, markets recover from these things relatively quickly when there is no change to the overall investment or economic climate. 

As much as we’d like to, we can’t prepare for every possible economic situation. What we can do is create a portfolio that fits your unique risk/reward parameters that should over time help you cope with the inevitable ups and downs of the market. Are you worried about where you stand and think your portfolio needs another look? Call my office at 708.488.0115 or email us at lumencapital@hotmail.com.

The next article in this series will come later this summer and is going to be about what I believe is the greatest long term potential I see in regards to both stocks and the world economy for the next decade. Stay tuned!

Back Friday.

About Chris

Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios 

that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing him at lumencapital@hotmail.com

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The World In Pictures {07.06.17}

Note the explosive population growth of Sub-Saharan Africa vs. Europe out to 2050.  Many are quick to point out all the negatives associated with this, in particular as it comes to immigration into Europe.  Yet there is another more positive side to this story that the Economist noted in an article from a few years ago.  This part of the story may not pan out.  But we should not overlook the possibility that Africa's population growth might possibly lead to accelerated economic growth on the continent.  Note that thirteen of the top twenty cities by the year 2100 are projected to be in Africa.

"As societies grow richer, and start to move from high fertility to low, the size of their working-age population increases. The effect is a mechanical one: they have fewer children; the grandparents' generation has already died off; so they have disproportionately large numbers of working-age adults. According to a study by the Harvard Initiative for Global Health*, the share of the working-age population will rise in 27 of 32 African countries between 2005 and 2015.

The result is a “demographic dividend”, which can be cashed in to produce a virtuous cycle of growth. A fast-growing, economically active population provides the initial impetus to industrial production; then a supply of new workers coming from villages can, if handled properly, enable a country to become more productive. China and East Asia are the models. On some calculations, demography accounted for about a third of East Asia's phenomenal growth over the past 30 years. 

Africa's people are its biggest asset. One day, its workforce could be as lusty and vital as Asia's—especially compared with that of necrotic Europe. But there is nothing inevitable about the ability to cash in the demographic dividend. For that to happen, Africa will have to choose the right policies and overcome its many problems. If a country fails to address those problems, then the demographic dividend could become a burden. Instead of busy people at work, there will be restless, jobless young thugs; instead of prosperity, there will be crime or civil unrest."

Back early next week.

Link:  The Economist, "The Baby Bonanza"

The World In Pictures {Boomers}

Today's graph comes from David Rosenberg, Chief Economist and Strategist for the Canadian Investment Firm Gluskin Sheff and deals with the inevitable age progression of the baby boomers through the general population turnpike.   The comments after the graph are from the article.

"This is where the power and influence still reside, and nothing is going to stop the inevitability that nearly two million of this critical demographic group will be turning 70 annually for the next 15 years. And they are very likely to make it to 85 or even older with medical advancement. 

This has crucial implications for the financial markets because it is when you turn 70 that you undertake the most profound asset mix shift since you were in your 30s and loaded up on equities — when you turn 70, preservation of capital and cash flows becomes much moreimportant, and yet in a world where 'safe yield' has become extremely scarce, the investment challenges for the aging but not yet aged boomers are going to be daunting, to say the least."  

My comment:  Boomers are still the most economically dominate generational cadre but will likely be surpassed in the next 5-10 years by the Millennials.  There are almost as many of them as there are Boomers.  

Back Thursday as I'll be out the next few days celebrating the holiday.  Happy 4th of July to all and God Bless the United States of America!

Link:  Businessinsider.com The Most Important Charts In the World From the Brightest Minds on Wall Street.