It's About Jobs, Jobs, Jobs

Doug Nolan


The Wall Street Journal referred to a “a milestone” - “a major shift in how [the Fed] sets interest rates by dropping its longstanding practice of preemptively lifting them to head off higher inflation.”

The New York Times went with “a major shift in how the central bank guides the economy, signaling it will make job growth pre-eminent and will not raise interest rates to guard against coming inflation just because the unemployment rate is low.”

The Financial Times underscored a note from Evercore ISI economists: ‘They view the shift as ‘momentous and risk-friendly’, saying it ‘takes the world’s most important central bank beyond the inflation targeting framework that has dominated global monetary policy for a quarter of a century’.” “A revolutionary change to its monetary policy framework” that “could have profound consequences for the price of pretty much everything,” was how it was viewed by the Financial Review.

August 28 – Australian Financial Review (Christopher Joye): “On Thursday night the world's most powerful central bank - the US Federal Reserve - ushered in a revolutionary change to its monetary policy framework because it believes it has consistently missed its core consumer price inflation target. This new regime, which will allow the Fed to keep borrowing rates lower for longer, and tolerate periods of what would have been unacceptably high inflation, could have profound consequences for the price of pretty much everything. It also reveals the central bankers' essential conceit: that they don’t want markets to clear, or asset prices to gravitate to their natural levels, in the absence of extreme policymaking interference.”

For the most part, equities took Powell’s Jackson Hole speech in stride. Stocks rose – but they pretty much rise whenever markets are trading. Understandably, bonds were a little edgy. Ten-year Treasury yields rose six bps on the announcement to 0.75%, a 10-week high. Investment-grade corporate debt was under notable pressure. The iShares Investment Grade Corporate Bond ETF declined 0.8%, trading to the low since July 1st (down 1.1% for the week).

There is certainly an element of “the emperor has no clothes” in all this.

We know from experiences in Japan, the U.S. and elsewhere that central banks don’t control the inflation rate. The shift to an “inflation targeting” regime was ill-conceived from the start.

Rather than admit to mistakes, the global central bank community will continue frantically digging ever deeper holes.

Can we at least admit that inflation dynamics have evolved momentously over recent decades?

Could we accept that technology innovation has led to a proliferation of new types of products and related services – profoundly boosting supplies of high-tech, digitized and myriad online products?

There has also been the seismic shift to services-based output, altering inflation dynamics throughout economies. Moreover, “globalization” – especially the capacity to manufacture endless low-cost technology components and products globally – has fundamentally changed the inflation axiom “too much money chasing too few goods.”

The above noted factors have placed downward pressure on many prices, altering traditional inflation dynamics and rendering conventional analysis invalid. This contemporary “supply” dynamic has worked to offset significant inflationary pressures in other price levels (i.e. healthcare, education, insurance, housing, and many things not easily produced in larger quantities) – putting some downward pressure on consumer price aggregates (i.e. CPI).

Moving beyond the obvious, can we contemplate that ultra-loose monetary policies work to exacerbate many of the dynamics placing downward on consumer price aggregates?

Clearly, the historic global technology arms race is a prime beneficiary – but cheap money-induced over-investment impacts many industries (i.e. shale, alternative energy, autonomous vehicles, etc.). I would further argue monetary-policy induced asset price Bubbles are a powerful wealth redistribution mechanism with far-reaching inflationary ramifications (CPI vs. price inflation for yachts, collectable art and such).

Let’s be reminded that central bank monetary management traditionally operated though the banking system, where subtle changes in overnight funding rates influenced lending and Credit conditions more generally. Central bankers these days continue to expand this momentous policy experiment in using the financial markets as the primary mechanism for administering policy stimulus.

Why is it reasonable to believe that monetary policy specifically aiming to inflate securities markets will somehow simultaneously ensure a corresponding modest increase in consumer prices? It’s not. As we’ve witnessed for years now – and rather dramatically over recent months – such a policy course foremost fuels asset market speculative excess and price Bubbles.

There’s a strong case to be made that this dynamic pulls finance into the securities markets at the expense of more balanced investment spending throughout the general economy. Moreover, increasingly aggressive policy support (i.e. zero rates, QE and other emergency operations) over time exacerbates speculative excess and associated market distortions. As I posited last September when the Fed employed “insurance” rate cuts and QE with markets at all-time highs, it was throwing gas on a fire.

For now, damage wrought to Fed credibility is masked by record equities and bond prices. In the wanting eyes of the marketplace, the “inflation targeting” regime is mere pretense. Bernanke didn’t punt on the Fed’s “exit strategy” due to consumer prices.

Below target CPI was not behind Yellen’s postponing of policy normalization in the face of strengthening booms in both the markets and real economy. And Powell didn’t abruptly reverse course in December 2018 because of lagging consumer price pressure, just as CPI had nothing to do with last fall’s “insurance” stimulus measures.

Any lingering doubt the Federal Reserve has adopted a regime specifically targeting the securities markets was quashed with the $3 TN of liquidity response to March’s downside market dislocation.

It’s tempting to write, “when future historians look back…”. My ongoing commitment to weekly contemporaneous analysis of this is extraordinary period is fueled by the proclivity for historical revisionism (and the associated failure to learn from mistakes).

Just this week a Financial Times article stated the Fed’s last September stimulus measures were in response to trade war worries – neglecting to mention the decisive role played by late-cycle “repo” market instability.

That said, I do believe skilled analysts will look back and point to the destabilizing impact of prolonged ultra-loose monetary policies stoking speculative finance, distorted asset price Bubbles, and general Monetary Disorder. The fixation on consumer price indices slightly below target in the face of such historic Bubbles will be a challenge to justify.

I have argued now for a long time that Bubbles and associated maladjustment are the prevailing risks – not deflation, as argued by conventional economists. And the greater Bubbles inflate the greater the risk of collapse unleashing deflationary outcomes.

The Fed has been working on a policy review for the past year, with the outcome seemingly preordained. But to announce preference for higher prices and tolerance for persistent above-target inflation in the current backdrop is not without risk.

At $7.0 TN, the Fed’s balance sheet has ballooned sevenfold in twelve years. A traditionally conservative central banker would never take a cavalier approach with inflation after an almost $3.0 TN six-month increase in M2 “money” supply.

I’m sticking with the view that we’re in the end game to these multi-decade experiments in finance and monetary management.

I understand how $3.0 TN in Fed purchases buys some bond market tolerance. But multi-Trillion federal deficits will not be a one-year phenomenon.

The Federal Reserve has accommodated a massive expansion of Treasury securities at ridiculously low yields. Does the Fed really believe it could then accommodate rising inflation without a market backlash? Do they appreciate how an unexpected inflationary surge would wreak absolute havoc in the highly leveraged markets and economies?

The Treasury yield curve steepened markedly this week. With 30-year Treasury yields jumping 18 bps to an 11 week-high 1.50%, the spread to 3-month T-bill yields rose to 141 bps (wide since June 9th). Ten-year Treasury yields rose nine bps this week to 0.72%, with benchmark MBS yields gaining nine bps to 1.44% (6-wk high).

The dollar index declined 0.9%, nearing the low since May 2018. The Bloomberg Commodities Index jumped 2.3% to the highest level since March.

Gold increased 1.3%, and Silver jumped 3.4%. Yet gains were notably broad-based. Copper rose 2.9%, Nickel 4.6%, Aluminum 2.0%, Coffee 5.8%, Corn 5.5%, and Wheat 2.6%. WTI Crude gained 1.5%, trading this week at the high since March.

Equities continue to go nuts.

The S&P500 gained 3.3% to an all-time high, increasing y-t-d gains to 8.6%. The Nasdaq100 jumped 3.8% to a new record, boosting 2020 gains to 37.4%. It was another brutal short squeeze week, with popularly shorted stocks again outperforming.

The Bloomberg Americas Airlines Index surged 14%, and the J.P. Morgan U.S. Travel Index jumped 8.8%. The NYSE Financial Index rose 4.3%, and the NYSE Arca Computer Technology Index advanced 4.2%. Tesla gained another 8%, pushing its market capitalization to $412 billion.

Ludwig von Mises’ “Crack-up Boom.” The Fed’s new “regime” is major, profound, momentous and more. It’s not the least bit surprising – yet it is nonetheless almost unimaginable to actually witness.

The Powell Fed has given up – thrown in the towel. They’ve spent a year essentially crafting rationalization and justification in anticipation of doing little more than executing “money printing” operations for years to come. I have argued they’re trapped - and they have apparently come to the same conclusion.

Acute fragility associated with speculative Bubbles and egregious leverage now prohibit any effort to unwind recent extraordinary stimulus, not to mention raising rates or tightening monetary conditions for the foreseeable future.

It’s as sad as it is frightening. Despite the lip service, they’ve deserted the overarching financial stability mandate. Speculative Bubbles are free to run wilder. Leverage – speculative, corporate, federal and otherwise – Completely Unhinged.

Listening to Chairman Powell’s speech, my thoughts returned to Secretary of State James Baker approaching the podium to announce the beginning of the first Iraq war: “The war is about jobs, jobs, jobs.”

How would the Bush Administration justify an expensive war in the distant Middle East (removing Saddam Hussein from Kuwait) to the American people? I viewed our government in a different light from that moment forward.

Chairman Powell: “This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities… The robust job market was delivering life-changing gains for many individuals, families, and communities, particularly at the lower end of the income spectrum.”

August 28 – Bloomberg (Devon Pendleton): “It’s been one of the most lucrative weeks in history for some of the world’s wealthiest people. The net worth of Amazon.com Inc. founder Jeff Bezos topped the once-unfathomable amount of $200 billion. …Elon Musk added the title of centibillionaire when his fortune soared past $100 billion fueled by Tesla Inc.’s ceaseless rally. And by Friday, the world’s 500 wealthiest people were $209 billion richer than a week ago. Musk’s surging wealth expanded the rarefied club of centibillionaires to four members. Facebook Inc. co-founder Mark Zuckerberg, the world’s third-richest person, joined Bezos and Bill Gates among the ranks of those possessing 12-figure fortunes earlier this month. Together, their wealth totals $540 billion…”

The Fed has capitulated on its financial stability mandate as well as the increasingly grave issue of rapidly widening inequality. The Federal Reserve’s culpability for deleterious wealth inequalities and attendant social strife have been exposed. Trapped by financial Bubbles, the Fed will pay only lip service. Actually, it’s worse: Going forward, the Fed will justify precariously loose monetary policies by pointing to its determination to assist the unfortunate.

The entire Federal Reserve system should carefully ponder Powell’s comments following his Jackson Hole speech: “Public faith in large institutions around the world is under pressure.

Institutions like the Fed have to aggressively seek transparency and accountability to preserve our democratic legitimacy.”

Bloomberg’s Lisa Abramowicz: “We are getting inflation in certain areas… Certainly asset prices have gotten incredibly inflated and continue to do so on the promise that the Fed will keep rates low. How concerning is this? At what point does this have to make the Fed take stock and raise rates?”

Former New York Fed President Bill Dudley: “I think they are a little bit uncomfortable with the fact that asset prices are so buoyant. But remember that is partly by design. The Fed basically did what they did in March, April, May to try to make monetary policy easy and financial conditions accommodative. And they succeeded. Now as the stock markets keeps going up and up and up, that will cause some anxiety about the Fed. But remember, stock markets go up - stock markets go down. The consequences for financial stability have historically actually been pretty modest. We had the stock market crash in 1987. Lots of economists anticipated there’d be a recession. There was no recession. So, I think buoyance in the stock market is probably less risky to the economy because there’s not a lot of people that use a lot of leverage to own stocks.”

Earth to Dudley: We’re today confronting a deviant financial structure unrecognizable to that from 1987. Have you already forgotten March’s near global financial meltdown? Why did a panicked Fed expand its balance sheet by an unprecedented $3 TN? Why has it capitulated and basically signaled to highly speculative markets that they are committed to looking the other way and just letting things run their course?

I could, once again, invoke the timeworn punch bowl analogy (spiked and overflowing endlessly). It no longer does justice.

I was thinking instead of late on Halloween evening when it’s easiest to just fill the big bowl with candies and leave distribution up to the trick or treaters. Yet most kids act responsibility, snagging one treat (OK, maybe a couple) and leaving the rest for their fellow treaters. But the thought came to mind of offering a huge bowl filled to the brim with five-dollar bills, with the instruction “Only One Per Family.”

It’s a superior metaphor for the Fed’s chosen course – but with the inviting note: “Help Yourself. First Come, First Serve – We’ll Fill the Bowl Whenever It’s Empty.”

An election to decide America’s place in the world

November’s contest will be as consequential for the world as any since Franklin D Roosevelt

Philip Stephens

Ingram Pinn illustration of Philip Stephens column ‘An election to decide America’s place in the world’
© Ingram Pinn/Financial Times


When Nancy Pelosi told the world to leave it to Americans to decide the 2020 presidential election, she had Russia and China in mind. The Speaker of the US House of Representatives noted that American intelligence shows Moscow and Beijing are already trying to interfere in the process. 

Washington’s adversaries are not alone in thinking they have a big stake in the outcome. Politicians and policymakers in just about every corner of the globe have been tuned into the campaign for months. With good reason. November’s contest will be as consequential for the world as any since Franklin D Roosevelt’s victories in the 1930s.

From a distance this looks like an election in two parts. In the first, Americans will choose who they want to govern them for the next four years.

In the second, the US will decide between engagement or retreat, whether it wants to sustain its global leadership or would prefer to look on from the sidelines in the face of rising international disorder.

If the sympathetic Fox News and the antagonistic CNN are any guide, the first part is all about the character of Donald Trump. Is he the authentic champion of the working class, or a dangerous demagogue threatening the founding principles of the republic’s democracy? The president, as mesmerising a figure for his opponents as for supporters, sets and resets the daily news agenda. You back Mr Trump or you abhor him.

If this sounds unfair on Joe Biden, the Democratic party’s presumptive nominee should not take it as so. Mr Trump is Mr Biden’s best chance of winning. True, not so long ago the economy looked set fair. It seemed a reasonable calculation that enough independent voters could sign up alongside Mr Trump’s white working-class base to get him over the line.

Line chart showing how Trump and Biden are doing in the US national polls


That was before coronavirus put up in lights Mr Trump’s trademark mendacity and incompetence and the uproar over police brutality against black Americans teased out the president’s worst prejudices.

Mr Trump lies about many things, but he cannot gainsay the tens of thousands falling victim to Covid-19 and the millions facing unemployment. Except for the ultra-rich, the answer in November to the fabled “are you better off” question will be a resounding “no”.

This week Mr Biden took a bold step by choosing California senator Kamala Harris as his running mate. The formidable Ms Harris is the first African-American woman to appear on one of the main parties’ presidential tickets. The Democrats’ policy platform will be on show at next week’s virtual convention. That said, I doubt that Mr Biden will worry too much if the campaign spotlight remains fixed on the question of Mr Trump’s fitness for office until election day. The president is flailing. Mr Biden’s route to victory is surely as no more or less than the solid, competent and moderate alternative.

The connection between this domestic debate and the second part of the election is at best tenuous. Foreign policy rarely looms large in such campaigns. This one seems unlikely to be an exception, even if Mr Trump thinks there are votes in ratcheting up pressure on China.

Vladimir Putin’s backing for Mr Trump is unsurprising. The US president seems infatuated with his Russian counterpart. China’s Xi Jinping is said to favour Mr Biden. By tradition Chinese leaders have preferred Republican “realists” over Democrats, who are more likely to pay attention to human rights. In this instance, Mr Xi may have concluded that anything is preferable to Mr Trump’s angry unpredictability.

America’s partners and allies have a bigger stake. For 75 years, most of them have prospered under a US security umbrella. Now, with the notable exception of a smattering of autocrats such as Turkey’s Recep Tayyip Erdogan or Saudi Arabia’s Mohammed bin Salman, most will cite any number of reasons for backing Mr Biden. 

Trump vs Biden: who is leading the 2020 election polls?

Use the FT’s interactive calculator to see which states matter most in winning the presidency

Mr Trump is careless of America's friends, has pulled out of the Paris climate change accord, torn up the nuclear deal with Iran, undermined Nato, and replaced trade diplomacy with tariff wars and extraterritorial sanctions. “America First” has been a repudiation of the leadership assumed by the US after the second world war.

This last point is the one that really matters — one that distinguishes this election from all the others. The Pax Americana has run its course. The redistribution of global power, notably to China, means that the shape of the order that eventually replaces it is, for now, contested territory. The US can act as the convener of the world’s democracies, or it can withdraw to watch the old system dissolve into disorder.

The last time America chose between isolationism and engagement was during the 1930s. The economic recovery launched by Roosevelt’s New Deal marked a slow, bumpy return to engagement. A decade or so later the Truman doctrine set the American goal as global leadership. The nation’s enthusiasm for foreign entanglements has waxed and waned ever since, but the organising assumption has gone unchallenged.

Now that assumption is on the ballot paper in November. Has Mr Trump’s “the world can go hang” foreign policy been a dangerous but short detour, or have Americans lost sight permanently of the many advantages they have made from international leadership? That is quite a question.

What's Driving Gold, Silver And What's Next

Peter Krauth


Summary


• Gold and Silver will head higher, but not before more consolidation, which is necessary to a healthy bull market.

• Gold mining is becoming more costly and more challenging. Along with a lack of new major discoveries, that bodes for higher prices ahead.

• The near-term technical picture suggests more time needed to work through this correction.


Gold's retreated from a record high above $2,000, and silver's off its own seven-year highs near $30.

Is that cause for concern? I doubt it.

These have been dramatic surges to new levels, brought on by a combination of low interest rates, historic money-printing raising the specter of inflation, a softer US dollar, and of course a global pandemic.

But that doesn't mean gold and silver have to continue higher in a straight line.

Instead, these gains have been so strong that a period of retracement and consolidation are not only expected, they're crucial to the continued health of this precious metals bull market.

There are several fundamental drivers that will help keep gold and silver pushing higher, which I'm going to detail for you below.

Then we'll look at these metals' prices from a technical perspective to gauge what to expect next over the near term.

Gold's Fundamental Drivers


Mining gold has never been more expensive. It's possible that costs will drop for 2020 as demand for oil has retreated, but all kinds of related goods and services that go into gold production have gone up with pandemic surcharges.


Via the Wall Street Journal:




A higher cost of production will push gold prices higher. The metal is not likely to ever be produced at a loss and, if it is, it won't be for very long.

Gold exploration budgets continue to shrink on a global basis, as gold miners suffer from recency bias. They need to see gold at its current high price for an extended period before committing more funds to find more gold.


That also pressures junior gold explorers. They've only started to enjoy a more buoyant market to raise money in the past year as gold prices have come back to life.

S&P Global Market Intelligence recently reported the industry has suffered a decade of underperformance for gold discoveries.




Major gold mines are being depleted, and there is a dearth of new discoveries being made to replace mined ounces. Those being found are lower in grade, meaning more effort is required to extract an ounce of gold.

This is all pushing explorers and miners into increasingly risky jurisdictions, which ultimately is likely to translate into higher costs as well.

While these factors all point to higher long-term precious metals prices, we still need to understand their recent action to gauge what to expect in the shorter term.

Precious Metals' Technical Picture

We can see from the gold price chart that the correction which started in August after gold peaked near $2,070 is not likely over.





Gold's RSI and MACD momentum indicators confirm the current downward trend. Initial support is likely to be around the 50-day moving average near $1,875. After that we're looking at the $1,800-$1,825 level, which is where the overhead resistance in early July meets with the rising support (green) line.

Meanwhile, GDX as a proxy for gold stocks shows a similar correction, with its RSI and MACD both confirming the ongoing correction.





For GDX, initial support is likely around the 50-day moving average near $39, then $37 which was support in mid-July and overhead resistance in mid-May.

As well, the Gold Miners Bullish Percent Index remains at an elevated level.




This indicator typically needs to get below 30, then turn upward to get a bullish signal for gold stocks. That's clearly a ways lower from the current level of 75. It suggests we need to see a considerable drop in sentiment for gold stocks before we see a Buy signal.

The technical picture for silver is similar to gold's.




Silver's downside targets are previous resistance at $24.50, $23, then $20.

Comparing the performance of silver stocks versus silver, using SIL and SLV, reveals some interesting insight.




In early August, when silver peaked, the silver stocks only moved marginally higher. That was a strong indication that silver was likely putting in a near-term peak.


Silver stocks, like gold stocks, are in a correction phase.




If SIL breaks down below $45, first support is likely to be at the 50-day moving average of $42.75, followed by $40 then $37.5.

In my view near term action for precious metals is likely to remain weighed down. I also think we could see some strength in the US dollar.




The US Dollar Index trended further downward from late July. Yet that's when the RSI and MACD started showing positive divergence they've been trending upwards since.

Meanwhile, the "smart money" Commercial Hedgers appear to be betting the US Dollar has little downside, and probably some reasonable upside ahead.




Source: sentimentrader.com


To recap, the longer-term view for precious metals remains bright. The lack of sizable gold discoveries, coupled with rising costs and lower grades bodes for much higher prices.

But the near-term technical picture continues to point to lower prices or, at best, a consolidation near current levels.

I still see gold reaching for $2,200 this year and silver to edge towards $34.

GOLD IS FLAGGING OUT – BREAKOUT RALLY TARGETING $2,250 OR HIGHER IS NEXT

Chris Vermeulen
Chief Market Strategist





RESEARCH HIGHLIGHTS:

- Gold Found Support Near $1,945- Right Where We Expected

- Gold Setting Up A Pennant/Flag And Is Nearing The Apex

- Another Measured Move Is Setting Up – Targeting $2250 Or Higher

- Silver Should Rally To $36 Or Higher When Gold Breaks


Nearly every Precious Metals/Gold enthusiast that follows our work has been emailing or messaging us asking about the next rally phase for Gold. Thank you for all of your messages and supportive comments. 

If you have not been following along, please review our recent research on gold and silver price moves, the rally in platinum, and detailed 2020/2021 price forecasts for gold and silver.

After watching the VIX start to move higher last week while the S&P and Dow Jones pushed to new all-time highs, our research team has been actively studying the Pennant/Flag formation in Gold that has been setting up. 

Our “Measured Move” article suggests support near $1,945 will act as a launchpad for an upward price advance to levels near $2,150 or higher. As the momentum of this upside price move continues to build, as we’ve recently seen with the last upside price leg, we believe the $2,200~$2,250 could be the next real upside price target for Gold.

Over the past few weeks, Gold has confirmed our projected $1,945 support level by closing out near this level for multiple weeks (8/10: $1.949.80, 8/17: $1,947). We believe the ability of price to close above the $1,945 level, even though price traded below this level, shows how strong this support level really is. 

Now that Gold has started to rally near the Apex of the Pennant/Flag pattern, we believe the next upside leg could be starting.



This Daily Gold Futures chart, above, highlights the extended upward price trend and the recent downward FLAG/Pennant setup – flagging out near $1945. We believe the next upside price move could prompt a move to levels well above $2,200 to $2,250 as the momentum behind this move continues to build. 

Once Gold clears $2,200 on an upside price advance, we’ll clearly be in “new high price” territory and it will shock many investors that Gold continues to rally in the face of the US stock market rally. Something does not settle when one considers Gold suggesting massive fear underlies US stock market price levels near all-time highs. You may want to review our Dow Theory article to attempt to better understand what we believe is driving fear.

Be sure to sign up for our free market trend analysis and signals now so you don’t miss our next special report!

The Weekly Gold Futures chart below helps to pinpoint the upper price target range assuming momentum continues to build as the next breakout move takes place. Our research team believes this next leg may push up to levels just below $2,400 before stalling out again, then likely retrace to levels near $2,250~$2,275 where another sideways/flag pattern may setup. This time, the sideways/flag setup may be very quick in terms of completing, possibly only visible on intra-day charts.



We believe the next upside price rally will have begun once Gold closes above $1,985~$1,990 (near the Flag Apex). Get ready, this should be a very solid upside price move targeting $2,250 or higher.

Please pay attention to our research and how accurately our research team has deployed technical analysis over the past 3+ years tracking this move in Gold. Isn’t it time you learned how I and my research team can help you find and execute better trades? Our incredible technical analysis tools have just shown you what to expect 6+ months into the future. Do you want to learn how to profit from these huge moves? Sign up for my Active ETF Swing Trade Signals today!

If you have a buy-and-hold or retirement account and are looking for long-term technical signals as to when to buy and sell equities, bonds, precious metals,or cash then be sure to subscribe to my Passive Long-Term ETF Investing Signals to stay ahead of wild market gyrations!

Stay healthy, safe and strong!

DOW JONES UTILITIES BREAKING TREND
 
Chris Vermeulen
Chief Market Strategies



- Dow Theory suggests indices must confirm each other and volume must confirm the trend.

- The new downward trend in the Dow Utilities Index suggests indices are starting to break apart in terms of trending in unison.

- Volume recently has been trailing lower, which suggests the momentum behind these new all-time highs is weakening.

- If the Utilities Index continues to move lower and we see increased volume in the selling trend, we will consider the Dow Theory Trend component “broken” and expect a major peak/top soon after.


We know some of you are Dow Theory enthusiasts and followers. We follow the Transportation Index as a leading indicator for potential major market trends almost exclusively because of what we have learned from Dow Theory. 

If you are unfamiliar with Dow Theory, we suggest visiting Investopedia’s summary of this technical theory for a quick refresher. You can also learn more about the primary indicator in Dow Theory here. The two most important aspects of Dow Theory that we are researching today are two components:

1.- Indices Must Confirm Each Other


2.- Volume Must Confirm The Trend

My researchers and I have identified that the Dow Jones Utility Index has started to break downward in trend, breaking the recent upside price trend. This breakdown in the Utilities Index suggests the Indices are starting to break apart in terms of trending in unison. 

We have not seen increased volume in the downward trending of the Utility Index yet and we are waiting for this technical trigger to confirm the Breakdown in Dow Theory Trending by watching for the Utility Index to potentially begin a broader downside price move with increased volume.

IS DOW THEORY SIGNALING A BREAKDOWN IN TREND

Our research team is focusing on the Dow Jones Industrial Average, the Dow Jones Transportation Index, and the Dow Jones Utility Index for this article. These three charts are key to understand the broader components of Dow Theory and how the technical and trending aspects of Dow Theory work. 

We’re focusing on the Utilities Index because it is diverging from the Industrials and Transports in a big way. We just need to see some Volume support this new downtrend in the Utilities Index to begin to raise some big RED FLAGS about a major market top setting up.

Let’s start by investigating the Dow Jones Industrial Weekly Chart, below. We’ve highlighted the broader Head-and-Shoulders pattern in MAGENTA as well as drawn a YELLOW LINE across the UPPER GAP range from the February COVID-19 market collapse. We believe these levels will be critical in understanding how the markets are poised to test and potentially break above these broader market resistance levels. 

Additionally, we’ve drawn an upward sloping CYAN trend line that shows you how diligently price has continued to move higher since the bottom setup in March 2020. There has been very little recent weakness in the advance of price as new highs continue to be reached.



Volume recently has been trailing lower, which suggests the momentum behind these new all-time highs is weakening. It appears many traders are sitting on the sidelines and not participating in this upside price rally out of fear or concern that it may not be sustainable.

PRIMARY TRENDS HAVE THREE PHASES

A primary trend will pass through three phases, according to the Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move) phase, and the excess phase. In a bear market, they are called the distribution phase, the public participation phase, and the panic (or despair) phase.

It is quite possible that we have moved past the accumulation and public participation phases and are now firmly within the “excess phase” .. Or what we call the “speculative phase”.
Now we will look at the Dow Jones Transportation Index, below, which is set up somewhat similar to the Industrials. We see an extended Head-and-Shoulders pattern setup with a high price level from the Right-Shoulder acting as current resistance. 

We also see a very solid upward price trend which has accelerated higher over the past 5+ weeks on diminishing volume. At this point, we should consider the Industrials and the Transports “in alignment” with one another. The only real concern related to a weakening trend is the diminishing volume on both of these charts.




Now, we add the Dow Jones Utilities Index, below again, which sets up the entire Peaking/Topping Dow Theory technical pattern. The first thing we see in this Dow Jones Utilities Weekly chart is that the recent price trend is moving lower. This contradicts the trends of the Industrials and Transports.

Next, we see a much clearer Head-and-Shoulders pattern set up in the Utilities Index – which suggests resistance near 850 may play a big role in future price activity. Lastly, we see diminishing volume in this recent downtrend of price – which suggests “capitulation” has yet to enter this downward price trend.




Our researchers believe the only thing missing from the Utilities breakdown, which would indicate a broader market peak is setting up, is increased volume while the Utilities continue to trend lower. Once this technical pattern sets up, we believe we would have enough technical confirmation of a breakdown of the Dow Theory Trend Alignment component to warn that a major market peak/top is very near (or already happened).

What this means for skilled technical traders is that you should start “hedging” against risk and considering how to protect your open long positions. If you have not already considered how to accomplish this, we would suggest Precious Metals, Miners, Bonds and possibly small positions in Inverse ETF (such as SDS or QID). 

Hedging is a very valuable tool for skilled technical traders when trends weaken or risks become more evident in the markets. Moving capital into positions that can help protect against loss can help to balance your portfolio and reduce exposure to risk factors.

In closing, we do not have confirmation of this Dow Theory technical pattern yet. All we need to see is for the Utilities Index to continue to move lower and to see increased volume in the selling trend. Once we see this, we’ll consider the Dow Theory Trend component “broken” and we believe a major peak/top won’t be too far away. 

We suggest all of you pay close attention to these three indexes and watch for a breakdown of the primary trends in the future. This is a great way for you to understand basic Dow Theory and the how broad market trends tend to work in “alignment” or “unison”.

Hedge accordingly. We could be in for a wild ride in this breakdown confirms with increased volume. If you want to survive the trading over a long period of time, then you learn fairly quickly how important it is to protect against risk and to properly size your trades. 

While most of us have active trading accounts, what is even more important are our long-term investment and retirement accounts. Why?


Because they are, in most cases, our largest store of wealth other than our homes, and if they are not protected during the next bear market, you could lose 25-50% or more of your net worth.

The good news is we can preserve and even grow our long term capital when things get ugly (likely soon) and I will show you how. We’ve recently issued a Long-term Investment Signal for subscribers of my Passive Long-Term ETF Investing Signals.

Stay safe and have a great weekend!

Economic Recovery Is Hardly in the Bag

New readings indicate U.S. economy remains at risk of faltering

By Justin Lahart


Job seekers waited for interviews in Omaha, Neb., last month. / PHOTO: NATI HARNIK/ASSOCIATED PRESS


The stock market might be logging new highs, but the economy isn’t close to being out of the woods.

Thursday’s data make that clear.

First, the Labor Department reported that the number of people filing new unemployment-insurance claims in the week ended Saturday rose by 135,000 to a seasonally adjusted 1.1 million.

Economists had expected the tally to continue to drift lower.

The increase is disconcerting given that the incentive to file for unemployment has been reduced with the expiration at the end of July of the supplemental $600 a week benefit to unemployed workers.



What is more disconcerting, however, is the simple fact that claims remain well above where they were following the 2008 financial crisis, or any other time on record. Even with the growth in employment seen over the past few monthly jobs reports, many people remain out of work and, the claims data suggest, many businesses continue to shed jobs.

With Congress and the White House so far failing to deliver the additional stimulus that many economists thought would be in place by now, risks are rising that economic growth will begin to flag again.

Underscoring that danger, also on Thursday the Federal Reserve Bank of Philadelphia said that its index of manufacturing activity, which surveys manufacturers in its area, slipped to 17.2 in August from 24.1 in July.

That is still in positive territory, and therefore signifying expansion, but economists had expected a more mild slowdown to just 20. That follows a report from the Federal Reserve Bank of New York on Monday showing that manufacturing in New York state, too, moderated more this month than economists had expected.

With the country still in the grips of the Covid crisis, and with the additional problem of home-based schooling putting constraints on parents’ ability to get things done, the economy probably hasn’t reached the point where it can enter a sustainable recovery without additional support.

But at this point it looks as if any stimulus package won’t be approved until sometime in September, if it comes at all.

In the meantime, investors’ ability to keep ignoring the risks to the economy could be tested.

Look North: A Short History of US-Colombian Relations

For 200 years the two countries have partnered in mutually beneficial projects on a range of economic and security matters.

By: Cole Altom



Colombia is among the United States’ closest allies in the Western Hemisphere. For the past 200 years, the two countries have partnered in mutually beneficial projects on a range of economic and security matters. Any disagreements they’ve had were short-lived and relatively easily resolved. The key to understanding this unique and lasting partnership is understanding the role geography plays in their relationship.

Located on the northern coast of South America, Colombia sits on the southern base of the Caribbean Basin. The Andes’ three distinct mountain ranges run the full length of the country, covering roughly half its territory. (The other half is composed of the Amazon and Orinoco basins.)

The mountains make east-west transport difficult and expensive, while the Amazon forest in the south discourages mass settlement and development. For this reason, Colombia’s population is concentrated in mountain valleys, in disconnected cities, and along rivers and the coast.

These disjointed parts of the country are integrated through the Magdalena River; indeed, it’s estimated that three-quarters of the population lives near this river or one of its tributaries, which also facilitate the transport of goods between the interior and the Caribbean port cities of Barranquilla and Cartagena.

Colombia has access to both the Atlantic and the Pacific oceans, and the construction of the Panama Canal only increased the value of its connection to both of the continent’s coasts.

Colombia's Geography


In the 1820s, Gran Colombia (composed of present-day Colombia, Panama, Venezuela and Ecuador) had the potential to dominate the region, as did Mexico and the United States. It dominated the Caribbean Basin’s southern rim and controlled the Isthmus of Panama as well as valuable sea lanes on the Atlantic, where much of the trade with Europe was conducted.

Mexico controlled the basin’s western coast, while the United States was well on its way to consolidating its control of the northern rim, having acquired New Orleans through the Louisiana Purchase in 1803 and Florida in 1819. (The short-lived Republic of Central America, composed of present-day Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Mexico’s state of Chiapas was weak and fractured.)

Gran Colombia (1819-1830)


However, Gran Colombia’s leadership potential slowly eroded after it experienced two strategically significant territorial losses. In 1830, Venezuela and Ecuador broke away to form their own countries. Gran Colombia thus lost control over a large portion of the Caribbean Basin and strategic depth on both its coasts.

Then, in 1903, Colombia lost control over the isthmus when Panama declared its independence.

During this time, the country also experienced frequent political unrest that forced the government to focus on domestic affairs rather than engage on global issues from a position of strength.

Colombia was therefore no longer positioned to dominate the southern Caribbean Basin. A weaker version of its former self, it needed to find a strong ally that could provide both economic and security support. It could look either to the north or to the south, but its geographic orientation dictated that a northern ally was the only real option. In the early 20th century, the Colombian government introduced its “respice polum,” or “look north,” doctrine, which called on the country to orient its foreign policy toward the north, particularly the United States.

Later, the “respice similia” doctrine emerged, advocating that Colombia adopt a more horizontal approach to foreign relations, with a greater focus on South America. Even so, Colombia has largely followed the respice polum doctrine.

The few instances where it aligned with other countries ended quickly as they offered Colombia limited benefit.

Even before the downfall of Gran Colombia, however, circumstances were pushing the United States and what would become Colombia together.

In the first half of the 19th century, the U.S. and Colombia wanted to reduce the influence of European powers, namely the United Kingdom and Spain, in the Western Hemisphere. From this emerged the first treaty the United States ever signed with another country in the Americas: the 1824 General Convention of Peace, Amity, Navigation, and Commerce, also known as the Anderson-Gual Treaty.

The treaty expired after 12 years, but an updated version that also ensured trade and mutual development was signed in 1846.

Decades later, another opportunity for cooperation arose. As a bicoastal country, the United States had long wanted to construct a transoceanic canal. In the 1870s it established the Interoceanic Canal Commission, which supported building a canal, and ultimately decided that Panama – then still part of Colombia – was the most practical site for the project.

France had already tried to build a canal through Panama in the 1880s but abandoned the effort, which had proved immensely costly in terms of both money and lives.


The Caribbean


Initially, in 1902-03, the United States tried to establish a contract with Colombia to take up construction of the canal. But an eleventh-hour decision in Colombia not to ratify the deal led the U.S. to support Panama’s movement to gain independence from Colombia.

But the rupture could not last. Colombia needed secure access to the canal to access its western coasts, and the United States did not want to make a permanent enemy of a large country that could threaten the canal and influence sea lane approaches.

Washington also could not risk Colombia's partnering with another great power. What followed was the Thomson-Urrutia Treaty of 1921, which restored bilateral ties.

The treaty permitted Colombia to transport military equipment and troops, agricultural goods and industrial supplies through the canal free of charge. In exchange, Colombia recognized the borders and independence of Panama.

The United States also paid Colombia $25 million (approximately $350 million today) in damages, which was used to industrialize and improve infrastructure throughout the country. The United States benefited from this investment, since it helped drive out competing and still formidable British investment.

Since this reconciliation, U.S.-Colombian relations have continued largely intact. In the 1930s, Colombia fought a brief war with Peru and faced credit problems, which forced it to invite in U.S. companies to develop its oil resources.

During World War II, Colombia’s alignment with the United States helped keep its immediate surroundings and the canal secure. During the Cold War, the Colombian government often sided with the United States and rejected Soviet influence.

In exchange, Washington increased security and intelligence cooperation with Bogota and funded development programs through the Alliance for Progress. The timing coincided with Colombia’s recovery from a decade-long civil war known as "La Violencia."

Relations dipped in the 1970s following a decade of political violence in Colombia and growing disenchantment with the U.S. partnership, but the emergence of drug cartels and other domestic militant groups pushed Bogota to seek greater security support and cooperation from Washington.

As Colombia’s domestic situation stabilized over the 21st century, it came to play a greater role in regional security efforts, such as offering anti-narcotics training, and it is a political leader against anti-American regimes in the region.

More recently, the head of the U.S. National Security Council announced this week an investment plan worth $5 billion over three years focused on the rural development of Colombia. Though Colombia is the direct beneficiary, the goal of rural development is to curb coca production and reduce the presence and influence of criminal gangs throughout the countryside.

These groups support the region’s drug trade, which props up the government of Venezuelan President Nicolas Maduro and creates security risks along the U.S. border and within the United States. More ambitiously, there is talk that such investment lays the foundation for moving U.S. companies from China and closer to the United States and other friendly territories.

Even now, economic and security interests, as well as the dangers of faraway powers, support the long-standing and mutually beneficial relationship between Colombia and the United States.

America’s New Debt Bomb

Like in World War II, the United States is piling on debt to confront a whole-of-society crisis, raising the question of who will foot the bill in the long term. But, unlike the post-war era, the underlying conditions for robust economic recovery today are less than favorable, placing an even greater onus on wise policymaking.

Todd G. Buchholz

buchholz3_sesameGetty Images_moneydebtbomb


SAN DIEGO – The United States today not only looks ill, but dead broke. To offset the pandemic-induced “Great Cessation,” the US Federal Reserve and Congress have marshaled staggering sums of stimulus spending out of fear that the economy would otherwise plunge to 1930s soup-kitchen levels.

The 2020 federal budget deficit will be around 18% of GDP, and the US debt-to-GDP ratio will soon hurdle over the 100% mark. Such figures have not been seen since Harry Truman sent B-29s to Japan to end World War II.

Assuming that America eventually defeats COVID-19 and does not devolve into a Terminator-like dystopia, how will it avoid the approaching fiscal cliff and national bankruptcy? To answer such questions, we should reflect on the lessons of WWII, which did not bankrupt the US, even though debt soared to 119% of GDP. By the time of the Vietnam War in the 1960s, that ratio had fallen to just above 40%.

WWII was financed with a combination of roughly 40% taxes and 60% debt. Buyers of that debt received measly returns, with the Fed keeping the yield on one-year Treasuries at around 0.375% – compared to the prevailing 2-4% peacetime rates. Ten-year notes, meanwhile, yielded just 2%, which actually sounds high nowadays.

These US bonds, most with a nominal value of $25 or less, were bought predominantly by American citizens out of a sense of patriotic duty. Fed employees also got in on the act, holding competitions to see whose office could buy more bonds. In April 1943, New York Fed employees snapped up more than $87,000 worth of paper and were told that their purchases enabled the Army to buy a 105-millimeter howitzer and a Mustang fighter-bomber.

Patriotism aside, many Americans purchased Treasury bonds out of a sheer lack of other good choices. Until the deregulation of the 1980s, federal laws prevented banks from offering high rates to savers. Moreover, the thought of swapping US dollars for higher-yielding foreign assets seemed ludicrous, and doing so might have brought J. Edgar Hoover’s FBI to your door.

While US equity markets were open to investors (the Dow Jones Industrial Average actually rallied after 1942), brokers’ commissions were hefty, and only about 2% of American families owned stocks. Investing in the stock market seemed best-suited for Park Avenue swells, or for amnesiacs who forgot the 1929 crash. By contrast, a majority of American households own equities today.

In any case, US household savings during WWII were up – and largely in bonds. But Treasury paper bore a paltry yield, a distant maturity, and the stern-looking image of a former president. How, then, was the monumental war debt resolved? Three factors stand out.

First, the US economy grew fast. From the late 1940s to the late 1950s, annual US growth averaged around 3.75%, funneling massive revenues to the Treasury. Moreover, US manufacturers faced few international competitors. British, German, and Japanese factories had been pounded to rubble in the war, and China’s primitive foundries were far from turning out automobiles and home appliances.

Second, inflation took off after the war as the government rolled back price controls. From March 1946 to March 1947, prices jumped 20% as they returned to reflecting the true costs of doing business. But, because government bonds paid so much less than the 76% rise in prices between 1941 and 1951, government debt obligations fell sharply in real terms.

Third, the US benefited from borrowing rates being locked in for a long time. The average duration of debt in 1947 was more than ten years, which is about twice today’s average duration. Owing to these three factors, US debt had fallen to about 50% of GDP by the end of Dwight Eisenhower’s administration in 1961.

So, what’s the lesson for today? For starters, the US Treasury should give tomorrow’s children a break by issuing 50- and 100-year bonds, locking in today’s puny rates for a lifetime.

To those who would counter that the government might not even be around in 50 or 100 years, it is worth noting that many corporations have already successfully auctioned long-term bonds of this kind. When Disney issued 100-year “Sleeping Beauty” bonds in 1993, the market scooped them up. Norfolk Southern enjoyed a similar reception when it issued 100-year bonds in 2010. (Imagine, buying century bonds from a railroad.) And Coca-Cola, IBM, Ford, and dozens of other companies have issued 100-year debt.

Notwithstanding the fact that many institutions of learning have been compromised by the pandemic, the University of Pennsylvania, Ohio State University, and Yale University also have issued 100-year bonds. And in 2010, buyers even grabbed Mexico’s 100-year bonds, despite a history of devaluations stretching back to 1827. More recently, Ireland, Austria, and Belgium all issued 100-year bonds.

To be sure, a longer duration will not be enough to solve the debt problem; the US also desperately needs to reform its retirement programs. But that is a discussion for another day.

Finally, what about the post-war experience with inflation? Should we try to launch prices into the stratosphere in order to shrink the debt? I advise against that. Investors are no longer the captive audience that they were in the 1940s. “Bond vigilantes” would sniff out a devaluation scheme in advance, driving interest rates higher and undercutting the value of the dollar (and Americans’ buying power with it). Any effort to inflate away the debt would result in a boom for holders and hoarders of gold and cryptocurrencies.

Unlike military campaigns, the war against COVID-19 will not end with a bombing raid, a treaty, or a celebrations in Times Square. Rather, the image we should bear in mind is of a ticking time bomb of debt. We can defuse it, but only if we can win the battle against policy inertia and stupidity. This war won’t end with a bang, but it very well could end in a bankruptcy.


Todd G. Buchholz, a former White House director of economic policy under President George H.W. Bush and managing director of the Tiger Management hedge fund, was awarded the Allyn Young Teaching Prize by the Harvard Department of Economics. He is the author of New Ideas from Dead Economists and The Price of Prosperity.

The great decoupling

The Trump administration wants a US-China commercial Split

Wrenching Chinese and American corporate worlds apart would hurt everyone




During his term in office, Donald Trump has often bashed China while occasionally praising its leader, Xi Jinping. Similar two-mindedness characterises his administration. China hawks, led by Robert Lighthizer, his trade representative, and Mike Pompeo, the secretary of state, have tussled for influence with more dovish figures such as Steven Mnuchin, the treasury secretary, who have tried to prevent a rupture between the two giants. Companies and investors from both countries have watched the contest closely.

In the past 18 months the hawks have been ascendant. Now, blaming China for spreading the covid-19 virus that has pushed America and the rest of the world into recession, thus helping to dent the president’s chances of re-election in November, they have prevailed.

On August 6th Mr Trump issued two startling executive orders giving American firms 45 days to unwind all commercial relations with ByteDance, the Chinese owner of TikTok, a video-sharing app popular with youngsters, and with WeChat, a Chinese messaging and payments super-app widely used by Chinese around the world to communicate with those back home (see China section).

The previous day Mr Pompeo unveiled a “Clean Network” policy to protect America’s telecoms infrastructure and services against “aggressive intrusions by malign actors, such as the Chinese Communist Party”.

This would extend to other Chinese firms, including mobile providers, the sanctions with which America has tried to cripple Huawei, China’s telecoms-equipment giant. In response to a harsh new security law in Hong Kong Mr Trump has stripped the Chinese territory of its special status on immigration and trade. And a presidential working group has declared that in order to trade on an American stock exchange, Chinese companies must give American regulators unfettered access to their books.

All this marks an escalation in the economic war between the two countries. The fallout could be gargantuan. Deutsche Bank reckons that lost revenues in China, the expense of moving factories out of the country and compliance with the Chinese and American technospheres’ diverging standards could cost global technology firms $3.5trn over the next five years. A large chunk of that burden would fall on American firms. The question is, how bad can things get?

It is tempting to dismiss it all as pre-election theatre. Tom Wheeler, a former regulator and venture capitalist now at the Brookings Institution, a think-tank, calls Mr Trump’s moves “showbiz in lieu of substance”. Mr Wheeler has a point. But rhetoric can have real-world consequences. And in some ways Mr Trump is going beyond mere play-acting.

First, explains an American lawyer involved in federal trade and security cases, the International Emergency Economic Powers Act grants the president powers to protect America against an “unusual and extraordinary threat”. These powers are largely undefined but extremely broad. Hardliners sense that a window of opportunity for action will close soon and so have decided, in the lawyer’s words, to “advance their agenda before November”.

Second, many of the Trump administration’s anti-Chinese actions may be hard to unwind, even if president’s challenger, Joe Biden, wins the White House for the Democrats in November. As facts on the ground have changed, Sino-American commercial relations have undergone fundamental change in the past two years, says Edward Tse of Gao Feng, a consultancy.

If the hardline efforts to wrench the two economies further apart succeed, Chinese firms will suffer. A mainland tech entrepreneur stranded in America by covid-19 says his American partners remain keen to do business, but his lawyers warn of two to three years of tension. The TikTok case is so arbitrary, he says, that “no foreign entity in America is fully safe.”

The flows of Chinese foreign direct investment (fdi) and venture capital into America have declined (see chart). The Committee on Foreign Investment in the United States, a federal body, has come under increasing pressure to scupper Chinese takeovers. A tougher audit regime for American-listed firms—which enjoys rare bipartisan support in Congress—would mean that about $1trn in Chinese companies’ market capitalisation “will have to start thinking about a new home”, says Arthur Kroeber of GaveKal, an advisory firm.



The Chinese would not be the only victims. American firms have robust and growing businesses in China, where they generate about 5% of global sales. Despite trade tensions American fdi in China actually rose in 2019. Before the pandemic Nike’s Chinese sales of sporting goods had grown by double digits for 22 straight quarters. gm sells more cars in China than in America. Tesla may make between 25% and 40% of its electric cars in China next year, reckons Bernstein, a research firm.

Mr Kroeber estimates American firms have over $700bn in assets in China and book about $500bn a year in domestic sales there. A new survey of members by the us-China Business Council, which represents big American firms, reveals that more now consider China a top strategic priority (16%) and top-five priority (83%) than did in 2019. Few plan to decamp from China.

America Inc, in other words, has a lot on the line. James McGregor of apco, a consulting firm, says that Americans risk forsaking a market to European, South Korean or Japanese rivals. Wall Street could get squeezed by the push to delist Chinese firms. So far this year American banks raked in $414m in fees helping Chinese firms with initial public offerings and follow-on share sales, up by nearly a quarter from a year ago.

The biggest victim of decoupling would be America’s tech giants, many of which rely heavily on Chinese demand, as well as on Chinese suppliers. China represents over a quarter of global sales in sectors ranging from electronic components to internet software to semiconductors (see chart). Qualcomm, a chip giant, earns about two-thirds of its worldwide revenues in China and is lobbying furiously to soften sanctions against Huawei, a big client.

Greater China (which includes Taiwan) makes up around 15% of Apple’s global revenues. If Mr Trump’s executive order forces American firms to halt all dealings with WeChat’s parent, Tencent, then Apple will be forced to block Weixin, WeChat’s local version. If that happens, Chinese smartphone users would choose Weixin over iPhones. Ming-Chi Kuo, a seasoned Apple-watcher, warns that a harsh ban could lead to a global decline in iPhone sales of as much as 25-30%.




The new troubles reported by one executive at a big American chemicals firm may be a straw in the wind. China has been a great market for his company, he says, and the government at the national and provincial level remains solicitous and supportive.

But local rivals have started making appeals to his Chinese clients. “Why would you buy products from an American firm at this time?” they ask. Why indeed.

America’s largest shopping mall owner gets a new tenant: itself

Simon Property Group has bought two famous retail chains in the space of a week

Alistair Gray


© REUTERS


Simon Property Group became one of America’s largest shopping mall landlords under Mel and Herb Simon, brothers and co-founders. Under Mel’s son, David, it is also becoming a sizeable tenant.

Through a series of unconventional deals that show how an unfolding crisis in bricks and mortar retail is transforming old business models, the real estate company is helping to salvage big names in the US clothing sector.

A Delaware judge on Friday gave the green light to Simon to become part-owner of Brooks Brothers, the two centuries-old menswear retailer that was tipped into bankruptcy last month by the coronavirus pandemic.

Just days earlier, the property group — together with its BlackRock-controlled partner Authentic Brands, a licensing specialist that owns Sports Illustrated magazine — was given the go-ahead to buy Lucky Brand, the California-based jeans retailer, out of Chapter 11.

Setting out the rationale last week, David Simon, chairman and chief executive, said: “There’s just nothing out there that says you can’t make smart investments outside of your core businesses.”

But with the occupancy rate of Simon properties at its lowest level in a decade, the worry on Wall Street is that keeping retailers afloat with its own cash is a desperate attempt to prevent bigger areas of the malls from lying empty.

Line chart of Occupancy rate (%) showing More units lie vacant in Simon properties

Simon has a low profile outside US property and retail, yet it played an influential role in developing the country’s urban geography through the late 20th century.

Started as Melvin Simon & Associates in Indianapolis in 1960, the company was central to a national building boom as families flocked to the suburbs. The Simons earned a reputation in real estate circles as “the Marx Brothers of Malls”.

Today the real estate investment trust is the country’s biggest mall owner, with a portfolio comprising large centres including King of Prussia in Pennsylvania, Sawgrass Mills in Florida and Del Amo Fashion Center in California.

Sought-after occupants such as Apple and Sephora have helped the malls attract affluent shoppers and allowed Simon to cope better than distressed peers with the rise of ecommerce, although Gap, Victoria’s Secret, Macy’s and other out-of-favour retail brands are also among its largest tenants.


The coronavirus crisis is threatening to have a lasting impact. Mr Simon said the 2008 financial meltdown “pales in comparison” to the pandemic.

While more than 90 per cent of Simon’s tenants have reopened from lockdown, footfall remains slower than usual and many remain unable or unwilling to pay rent.

Simon has collected only 73 per cent of July payments.

Bar chart of Anchor and in-line tenants by sq ft (m) showing Struggling and bankrupt chains among Simon's biggest tenants

A wave of retail bankruptcies — including of some of Simon’s most important mall anchors and tenants, such as the department store chains JCPenney and Neiman Marcus — is adding to the pressure.

Chapter 11 allows retailers to easily get out of lease agreements.

The company cut its dividend for the second quarter by 38 per cent, suspended more than $1bn of development projects and temporarily reduced staff salaries by as much as 30 per cent.

Wall Street is sceptical about the prospect of a rebound: shares have dropped 53 per cent so far this year to leave them trading at the lowest level since 2009.

Against that backdrop, it is clear why Simon wants to avoid more gaps in its malls. Having secured the purchase of two national chains within the space of a week, Simon is estimated to part-own about 400 stores in its own properties, according to data compiled by Green Street Advisors before the pandemic.

Simon bought fast fashion purveyor Forever 21 out of bankruptcy earlier this year along with Authentic Brands and another large mall owner, Brookfield Property Partners. The company also has interests in sporty brand Nautica and youth outfitter Aéropostale.



Mr Simon said such deals allowed it to buy the retailers’ merchandise, brand value and other assets on the cheap, and the company expected to recoup quickly what it invested. “It’s a sideline business,” he added, noting that the sums the company was spending equated to a small proportion of its near-$21bn market capitalisation.


Yet old property hands are watching closely the implications both for Simon and its rivals, especially as it eyes yet more rescue bids. Vince Tibone, retail sector head at commercial property advisers Green Street, said there were questions about whether the unusual ownership structure put other landlords at a disadvantage.

In cases where the retailers have stores that are located close to each other, Simon may have an incentive to keep those in its own properties open but close others, thus hurting rivals’ footfall.

“If you’re preventing these retailers from liquidating, that helps the whole industry, but yes, there are competitive concerns about how you make store closure decisions,” Mr Tibone said.



Running clothing chains is also an altogether different business to managing the real estate and collecting the rent.


Even if it left day-to-day operations to partners or sector specialists, Mr Tibone added, some investors questioned whether it was wise for Simon itself to be owning retailers. “It’s justifiable, but it’s concerning to some investors that it’s outside their core business.”

Such gripes are dismissed by Mr Simon. Critics of the strategy were “probably the same people that told Amazon to stay in the book business”, he said. He also noted the economic benefits of salvaging businesses that would otherwise face liquidation, saying Simon was helping to save 4,000 jobs at Brooks Brothers.

Neil Saunders, managing director and retail analyst at GlobalData Retail, said: “These retailers and their management teams didn’t do a very good job. Why shouldn’t Simon and their partners do better? They also have a better chance of success than private equity, which has an absolutely abysmal track record in retail.”



Simon has signalled willingness to do more such deals and, according to a person familiar with the matter, it is in the running to acquire, along with Brookfield, the department store chain JCPenney out of bankruptcy.

JCPenney would be a bigger and “much more risky” proposition, Mr Saunders added. “It’s going to need a huge amount of investment to turn it round.”

“Give us just time to prove our thesis right,” Mr Simon said. “At the end of the day, if we screw up, we will have lost a de minimis amount of money.”

S&P 500: Flying In The Danger Zone

James Emanuel


Summary

- S&P 500 continues to outpace nearly every other stock index and asset class both domestic and international, but has it lost touch with reality?

- Passive funds have destroyed the efficiency of the markets.

- Central bankers have dug themselves into a hole so deep that there is no way out.

- Political manipulation has distorted the market with no tangible economic benefit.

- A perfect storm lays ahead caused by a rare combination of economic factors. We explore how investors can protect themselves against a major price correction.

The S&P 500 Pendulum Swings Too Far




In the face of adversity the S&P 500 (SPX) continues to hit new highs and to outpace the underlying growth of its constituent companies. So what? People are getting rich quickly; what’s the problem?

I’ll explain the problem in this article. It’s a huge problem, and you ought to be concerned. I will also explain the action that you might want to consider in order to mitigate the consequential risk.

Forget that the U.S. economy shrank by an annual rate of 32.9% between April and June, its sharpest contraction since the second world war. Forget that the official unemployment rate is 11%. Forget that over 200,000 people in the U.S. have died from COVID-19 and that 300,000 will be dead by December. The only news that seems to matter is that the stock market has hit another all-time high!

Really? What kind of world are we living in?



US GDP, Source: US Bureau of Economic Analysis


The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. More than $11.2 trillion is indexed or bench-marked against the S&P 500. The index includes 500 leading companies and captures approximately 80% of available U.S. market capitalization. Therefore, it is quite representative of the entire stock market.

Intuitively, one would be forgiven for thinking that a stock market index and GDP should grow at a similar pace, but the S&P 500 is a price index in contrast to a total return index. Said differently, it does not include dividends, which explains why since 1871 the index has under-performed the overall economy. It also explains why it ought to always under-perform the economy. However, not only has the S&P500 recently been keeping up with the economy, in 2019 it outpaced it by a whopping 787%.

The index logged an increase of 31.5% in 2019. By comparison, the combined businesses that make up the index saw their revenues and profits climb by only 4% per share, less in dollar terms due to fewer shares outstanding at the year end because of buy-backs, but don't get me started on that subject! Using the logic that stock prices track earnings over time, this appears to be an unsustainable situation.

You may be thinking to yourself that 2019 was an extraordinary year and that the market will mean revert over the longer term, but you would be wrong. The index continues to nudge all time highs despite COVID-19 having created an economic recession so deep that we have not experienced anything on this scale since the great depression of 1929. More particularly, the pace of growth seems to be accelerating. In July 2020, the monthly return of the S&P 500 was 5.51%, which is 66% on an annualized basis. Even without the coronavirus-induced recession, this is historically excessive as becomes evident when you compare it to a monthly return of 1.31% a year earlier and against the long-term monthly average of 0.45%.

Does any right thinking individual honestly believe that 80% of listed US companies by market capitalization increased in value by 5.51% during the month of July having already increased in value by 31.5% during 2019? If this continues, investors will double their money every 18 months. On that basis, do you think that this is sustainable?

Price growing faster than value? Yes. Price well in excess of value. Yes, also.

In my decades of stock market investing, I have never experienced anything like this before. It is irrational beyond belief. It is almost as though the S&P 500 is operating in some form of parallel universe.

Corrections in markets are the mechanism by which irrational prices normalize. They happen periodically, and an investor needs to be prepared with risk mitigation hedges in place. There are a number of risk management strategies that you might like to consider - more on this later in the article.

The Fabulous Five and Tech Euphoria

May I remind you of the immortal words of the great Benjamin Graham when he said that even the best companies at the wrong price make for a poor investment. On that basis, I would argue that the S&P 500 is full of wonderful companies at the wrong price.

Despite nascent growth in profits for the index during 2019 prior to the pandemic, there was plenty of profit among the big tech businesses. However, even among the “Fabulous 5”, which is made up of Apple (AAPL), Microsoft (MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Amazon (AMZN) and Facebook (FB), not one of these companies was able to grow sales or profits by a rate matching the 31.5% appreciation in the index.

Against the backdrop of the Fabulous 5 being unable to grow profit at 31.5%, would it surprise you to learn that all five outperformed the index and grew in price by far more than 31.5%! The Fab 5 are great companies, no doubt, but good value at any price? I think not.

Let us consider the longer term contribution of the Fabulous Five companies to the performance of the S&P 500 index as a whole. In the decade to 10th February 2020, the sales of these five companies had grown from 1.9% to 7.9% of total sales generated by index constituents. At the same time, profits from this group of five grew from 6.5% to 14.1% of all profit generated by members of the index.

Based on this information, how would you price these five companies relative to the total value of the index? Are they worth 7.9% of the index value based on their top line revenue contribution, or perhaps 14.1% of the index value based on their earnings contribution? Surely, not more than 14.1%?

Would it surprise you to learn that they are priced at almost 25% of the entire value of the index? Five companies out of five hundred or 1% of constituents by number are priced at 25% of the value of the index! Can that be justified or has their price run ahead of their intrinsic value?

If we assume that they should not be priced at more than 14.1% of the value of the index, then at 25% of the value of the index, one might argue that they are more than 43% overvalued.

Even if the price can be explained on the basis of expected future growth, then a 43% price premium means that their future success is already priced in. Said differently, if they perform in line with very high expectations, then their intrinsic value will eventually catch up with their price, which means little or no further upside over the next decade for anyone investing today. Conversely, if these companies underperform expectations, then they have a long way to fall back to reality.

These five companies are, to a very great extent, responsible for the S&P 500 having run so far ahead of reality.

And to make matters a whole lot worse, there is talk of Tesla (TSLA) being included in the S&P 500 soon. This is a company that currently trades on a price to earnings ratio of 900 and which on any rational measure is one of the most overpriced companies in the world. If it is included in the S&P 500, it will only exacerbate the problem of the index being out of touch with reality, and it will increase the risk profile for those investing in anything bench-marked to the S&P 500 index.

The last time we experienced this kind of tech frenzy was the dot com boom and bust of 2000. Only this time, it is a whole lot worse as I shall go on to explain.

Indicators of an Overvalued Market

Let us look at the peaks and troughs in the S&P500 over the past 90 years.

The peaks are in red, the troughs are in blue.


Source: Bureau of Economic Analysis, US Department of Commerce, Standard & Poor’s


The current price to sales figure of 2.4 times is a record high. It exceeds the 1929 pre-crash stock market level and is also well ahead of that seen in the irrational exuberance of the 2000 dot com boom.

Some of the increase can be attributed to higher net profit margins of circa 10.7% at present, but even if net profit margins were down at 9%, the price to sales number would still be 2.02 based on a constant earnings yield, and so, this over-valued signal is still valid.

The price to book ratio of the index currently stands at 3.82 which, while being below both the 2000 and 2007 peaks, is still high on an historic basis and certainly in red-flag territory. Why is price to book so important? It highlights how much of a premium to the equity value of a company an investor pays and so defines the earnings yield that will be achieved.

If the S&P 500 return on equity is 16% and you pay a price that is 3.82x the equity value, then the earnings yield that you will achieve on your investment will be a meagre 4.19%. That doesn’t meet the hurdle rate of any intelligent investor that I know.

Market cap to GDP became popular in recent years thanks to Warren Buffett. Back in 2001, he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment." On this measure, the market looks to be more overvalued than at any time in history, and more concerning it is higher by quite some significant margin.

The long term average is 82% and yet today we stand at 172%.

To make matters worse GDP is now falling due to the coronavirus pandemic while the S&P 500 continues to climb - see the FRED chart below which demonstrates the divergence. This will amplify the Market cap to GDP metric unless the market corrects pretty soon.

The Pendulum

The issue is that the markets act like a pendulum. If the price swings too far to the right then eventually it will swing back equally hard to the left. This cycle typically takes two years to complete before the market eventually resumes its upward trend as the chart below demonstrates. It is also noteworthy that these two-year corrective periods coincide with recessions which are shaded in blue for ease of reference.


Source: Macrotrends


Now, let us zoom out of the same chart and take it to the present day. We can see the pendulum has swung so far to the right that the dot.com crash in 2000, and the dip caused by the 2008 financial crisis appear almost insignificant in comparison.

Note also the shaded area denoting a recession in 2020 and see how the market corrected during both of the previous shaded areas! This warning signs certainly look ominous.



Source: Macrotrends


Of particular note is that, since 2009, the S&P 500 has experienced a compound annual growth rate of 14.82%, while the underlying economy has only grown at an average rate of 4.05%.

The math simply does not work. If the companies in the economy only grow GDP at 4% per year over a decade how can the value of those companies increase by almost 15% per year in the same period?

The chart below shows that, over the long term, the S&P 500 and GDP have historically been mean reverting. Before now, the largest divergence occurred in 2000 and in 2007, but you will note that on both occasions a correction brought the index back into line with the GDP growth trend.

This makes perfect economic sense, and one may anticipate that this will always be the case.

But, as you can see, never before has the market been priced so far ahead of the underlying economy as it is now.

On this basis, the sharp fall in the stock market back in March 2020 when the pandemic first struck the U.S. pales into insignificance relative to the size of the drop required to bring the index back in line with economic growth.

This suggests that the 2020 economic shock will not result in the "V" shaped recovery that many have assumed, but instead it will be a "W" shape with the second dip, which still lies ahead, being far greater than the first.


Source: Longtermtrends.net


The market last broke away from the GDP growth rate back in 2011 and an equity asset price bubble began to inflate - more on this later. For the eight years that followed the asset price bubble grew but at least both GDP and the market were trending in the same direction with a positive gradient on the curve.

But fast forward to 2020 and we now not only have a hyper-inflated stock market, but we also have divergence against the underlying economy. While GDP and the economy are contracting, as one would reasonably expect in a recession, the S&P 500 is accelerating higher.

We have a negative gradient on GDP curve and a positive gradient on the S&P curve. This is a huge red flag warning sign in my book.


Source: Federal Reserve Bank of St Louis, James Emanuel


Technical analysts have been looking at the chart above and have been suggesting that we are heading for a “double-top” shown above in orange.

For those not familiar with technical analysis, a double top usually leads to a sharp downturn after the previous high is retested but not materially breached.

Said differently, it is where the balance of buyers and sellers shifts to become top heavy, hence the impenetrable resistance level and the subsequent sell off. As such, both technical and fundamental analysts seem to be aligned in anticipating a correction imminently.

The Cause of this Extraordinary Situation

A perfect storm is defined as a particularly violent storm arising from a rare combination of adverse meteorological factors. I would suggest that in economic terms we are heading into a perfect storm due to a rare combination of economic factors.

First is central bank policy that will go down in the history books as being one of the biggest economic mistakes of all time. Second is political manipulation brought about by the slashing of corporate taxes. Third is the proliferation of passive funds which have destroyed the efficiency of markets.

Let us take each in turn.

Cause 1: Central Bank Lunacy

The Federal Reserve, along with central bankers in most developed countries, has now dug themselves into a hole so deep that there is no way out.

The solutions adopted by Central Bankers following the 2008 economic crisis have inflated an asset price bubble like no other. Equity prices and real-estate prices have shot up like sky-scrapers, but their foundations are built on sand.

How do central bankers reverse the lax monetary policy that they have pursued for way too long without the entire house of cards collapsing? The answer is that they can’t, and this is why they are now completely hamstrung.

The Fed has demonstrated a desire to reverse its quantitative easing position and also to normalize interest rates on numerous occasions over the past decade. Each attempt has failed. The economy was always considered too weak, even when the unemployment rate was down at 4%.

So, how do you reconcile the economy being too weak for a 2% interest rate environment with the S&P 500 increasing at 14.8% per year over the same period and continually hitting new highs?

The truth is that lax monetary policy of central banks has caused an asset price bubble which is sustained by cheap money rather than by economic fundamentals. More particularly, no central banker wants to see the bubble burst during their tenure and so there is a reluctance to move towards normalization which means that we are stuck with the status quo.

The explanation provided for the Central Bank intervention this year was to calm financial markets because they were threatening to become dysfunctional, which was indeed true. But acting in concert, all the world’s major central banks pumped trillions of dollars, euros, yen and pounds into their financial markets. Stock markets rallied even though this was the period when output was collapsing everywhere.

The rapid bounce in stock markets helps to give the impression that everything is under control and the economic crisis is drawing to a close. But perception is far from reality.

Ask yourself this - how many of your friends and family are in a better financial situation now than they were in 2019? How many businesses do you know that are on their knees? How many companies are laying-off staff, cutting dividends and slashing earnings forecasts?

And yet the stock market is hitting all-time highs.

Financial markets were once seen primarily as places where businesses and governments could raise capital for productive investment. However, there has been a pivot in recent years away from production towards speculative finance, most of it debt-fueled.

And worst of all is that the Central Bankers who are charged with the responsibility of mitigating systemic risks in the financial system have created the biggest risk of all.

I am not alone in my thinking. Tobias Adrian, the financial counsellor at the International Monetary Fund, said recently that emergency action by central banks had boosted asset prices and added that these “unprecedented actions could have unintended consequences, such as fuelling asset valuations beyond fundamental values simply on expectations of lasting support by policymakers”.

Watching investors in the market at the moment reminds me of the scene in the movie Rebel Without a Cause when James Dean drives at full speed towards the cliff edge. This is a dangerous game, and people will eventually get badly hurt.

Cause 2: The Trump Administration

First, I must declare that I am a British citizen living in the UK and so I have no US political allegiance. I am neither a Republican nor a Democrat. I write this section of this article based purely on observations of the economic effect of a political policy, not as an endorsement or criticism of that policy.

Without exception, every speech made by Donald Trump has a reference to the stock market. It is extraordinary that he measures his success relative to the performance of the stock market. A cynic might also say that he has so much personal wealth invested in equities that he has an ulterior motive, but let’s ignore that for now.

We have already seen how an asset price bubble was inflated by lax central bank monetary policy. The market rallied very strongly as a result from 2009 until 2015, but then, market valuations started to looked very overdone, and the market hit a plateau.

In fact, the market began to wobble as market prices appeared to have run way too far ahead of the intrinsic value of the market. Most seasoned investors anticipated a correction at that time but Donald Trump came to the rescue.

Trump’s 2016 election manifesto included a promise to slash corporate taxes, which he subsequently delivered via the Tax Cuts and Jobs Act 2017. This was an ingenious political move which amounted to a sleight of hand that would have put Penn and Teller to shame.

By slashing the corporation tax rate from 35% to 21%, corporate America instantly saw net earnings increase from 65 cents in the dollar to 79 cents.

This amounts to a 21.5% earnings boost without any improvements in the fundamentals of the economy. And since share valuations are a product of earnings, as profits increased by 21.5%, then so too did share prices as the chart below demonstrates.


Source: Macrotrends, James Emanuel


The media didn’t understand what had happened. Instead they saw Wall Street rally hard after Trump was elected and reported that Wall Street was cheering a Trump presidency!




Very clever political move Mr Trump, and great for his family investment portfolio, but not a good thing for the market in the long term.

The market was arguably overvalued in 2015/16. Now, it had been propelled into the stratosphere. At this stage, there was absolutely no correlation between the market and underlying economics as already demonstrated earlier in this article.

Of greater concern is that the increase in profitability is now fully baked into the market, and the benefits of tax cuts have mostly been competed away. So, we now have artificially inflated equity markets with no tangible economic benefit attached.

More particularly, the public debt mountain is now a staggering $25 trillion, which is 116% of GDP. Public debt was already out of control following the 2008 financial crisis, but COVID-19 has made matters a whole lot worse.

The government must repay this debt over time, and so, higher taxes are inevitable. So, what happens when the corporate tax rate goes back to 35%? Well, corporate America sees an instant hit to its bottom line and that causes at least a 17.7% stock market contraction as profits are squeezed from 79 cents in the dollar to 65 cents.

Not a very attractive prospect, but it will have to happen at some point, and it may occur soon after the November election. That political tax cut stunt in 2016/17 doesn’t look so clever now!

To make matters worse still, over the past decade, the companies of the S&P 500 have spent more than 100% of their profits paying dividends and repurchasing shares - mostly to offset dilution that would otherwise be caused from remunerating executives with free share options.

Know this: for much of the past decade, these repurchases were made at multiples averaging about 20 times earnings, or at an earnings yield of 5% well below the average return on equity which dilutes shareholder returns.

This is financial engineering in the extreme. It has masked an enormous transfer of wealth from shareholders to company executives, so far undetected by a decade of rising stock prices.

Said differently, the boost in earnings brought about by Mr Trump has enriched a minority of top corporate executives at the expense of shareholders who have not noticed the situation because, at least on paper, their shareholdings are currently worth more.

To those shareholders, I say “wake up and take notice” because the tide is about to go out, and the corporate executive is now wearing your swim suit!

Cause 3: Passive Funds

Passive fund management now accounts for over 50% of all assets in US stock-based funds.

That is up from just around 25% a decade ago. 2005 and 2006 were the last two calendar years in which actively managed U.S. equity funds had back-to-back inflows. As the chart below shows, money has been pouring out of active funds and into passive funds on an accelerated basis.


Source: Morningstar


Passive funds track the market and the fees are lower. So what’s the problem? Allow me to explain.

The stock market has always maintained efficiency because it is democratic. The great Benjamin Graham in his critically acclaimed 1949 book The Intelligent Investor stated,

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

What he meant by this is that there is every possibility that investors may back the wrong horse in the short term, but those horses quickly lose favour, and so over the long term, the market will sort the good from the bad. So, active investing, over time, is the mechanism by which the market settles on fair valuations.

Then came the passive funds.

John Bogle founded the Vanguard Group in 1975 having found inspiration from Nobel Laureate economist Paul Samuelson’s 1974 article, “Challenge to Judgment” which argued the merits of an index tracking fund. Today, the Vanguard Group is the second largest fund manager in the world!

Passive funds did not really gain any noticeable traction until the economic crisis of 2008, and then the landscape shifted as the chart above demonstrates, supported by the chart below.




Source: Morningstar


In principle, the concept is attractive. Low fees and tracking the market take the pain out of investment decisions. But please bear in mind that a fund which tracks the market and then deducts fees will mathematically always underperform the market – so if you are seeking alpha, passive investing is not for you.

In any event, the principal of passive investing relies upon passive funds only being a small proportion of total investing activity. The theory is that active investors do all of the hard work analyzing corporations and placing their money in the most promising companies – the good investments will then be pushed to the top of the pile being more heavily weighted in the indices.

The passive funds simply piggy-back on the hard work of the active investors by tracking the index, without doing any analytical work themselves, and so avoid analytical expense whose benefit is passed on to investors in the form of lower fees. Great in principle, but then, some might argue so was Marxism! Neither is good in practice.

Allow me to explain the issue. What happens when the passive funds start to dominate? The theory completely breaks down. Now, instead of the dog wagging its tail, the tail is blindly wagging the dog.

Now, rather than the passive funds being able to piggy-back on the work of the active fund managers, instead now passive funds have created a negative feedback loop whereby they are all piggy-backing each other!

A passive investment manager allocates capital blindly. As investors deposit money into the fund on a regular savings basis, the passive fund buys shares in the constituent companies that make up the index being tracked regardless of fundamentals.

So, if one of those companies has an unrealistic price to earnings ratio the fund manager still buys it. And that pushes the price higher, and so the price to earnings ratio becomes more unreasonable. And then, the next passive fund buys it, and it goes up further, and so on and so forth, up and up and up.

This is how shares like Tesla trade on PE multiples of over 900 – no rational active fund manager would ever invest in that because it implies an earnings yield of 0.14% with a whole heap of risk attached – you would be better off buying the 10 year Treasury which yields 0.69% risk free!

Tesla is a great example of how passive funds have destroyed the efficiency of the market. Its share price is up over 800% this year, not because its business prospects have improved - in fact, its sales have been in decline since Q4 2018, but because the market knew that four straight quarters of profit would qualify it for inclusion in the S&P 500.

This would mean that the S&P 500 passive funds would all have to blindly buy it regardless of its economic fundamentals, and so the speculators tried to front-run the passive funds in order to make a fast buck. And this is what I mean by a negative feedback loop, which is caused by passive funds and which is destroying he efficiency of the market.

The other issue with passive funds is one of concentration risk. As we learned earlier, the Fabulous 5 are only 1% of the S&P 500 by number of companies, but they are 25% of the index by value. And so if you switch your investments from an actively managed fund with a diverse portfolio of good value companies into a passive S&P 500 fund, you will find that 25% of your money is invested in just five companies.

Now, multiply that by the tens of millions of investors who have switched to passive investing and you have trillions of dollars, 25% of which is now invested in only 5 companies! Is it any wonder that these companies have market caps of well over $1 trillion USD? It is not about how good these companies may be or about their future prospects, it is all about passive funds blindly inflating market prices and distorting the market.

And so you can see how passive funds have contributed to the S&P 500 being at overvalued levels that we see today. Regulators really ought to sit up and take notice because their remit is to ensure the efficient functioning of markets and to mitigate systemic risks. I would argue that they have dropped the ball on this one!

Conclusion

The S&P 500 is, by any measure, off the scale in terms of being overvalued.

My calculations suggest that fair value is in the 1,600 to 1,800 range rather than the 3,386 that it is at the time of writing. In the interests of brevity, I shan't go into my valuation methodologies, but if you are interested in equity valuation techniques, I cover them in great detail in my book "Success in the Stock Market".

However, I will add that the result of my calculations is supported by the metrics that we used at the beginning of this article. With the S&P 500 at 1,800, the Market Cap to GDP ratio would fall to 91.4%, the price to sales multiple would drop to 1.28, and price to book would be 2.03 - those are far more realistic levels. And so the suggestion is that the S&P 500 is due a correction in the order of 50%.

Is there a recent precedent for such a correction? The answer is yes. In the 1960s, there were a group of blue chip companies known as the Nifty Fifty. Back then, this group of 50 large, good quality companies like General Electric (GE) and Polaroid were rated at anything up to 100 times earnings as investors poured in regardless of price - much like Facebook, Tesla and Netflix (NFLX) today.

Eventually, the market came to its senses and a stock market crash caused a long overdue price correction. The S&P 500 fell by 39% between 1973 and 1974. The Nifty Fifty fell by a whopping 47%. It took investors in these stocks a decade to recoup their losses, and they never caught up with the broad market.

The S&P 500 has been running on steroids for the past few years, but the drugs have now run out.

We know interest rates are almost zero, and so they can’t go very much lower. There is more chance that they will move higher at some point and, as interest rates increase, so earnings yields need to increase. For this to happen, stock prices need to move lower – substantially lower.

Similarly, we have seen that net margins are historically very high. Can they go very much higher than 11% on average? Probably not, particularly in a pandemic induced recession. So, what happens when net margins are squeezed? The price to sales ratio moves lower and once again, stock prices are negatively impacted.

There are no more tax cuts on the horizon and in order to repay the national debt taxes will need to go up pretty soon. That will hit the bottom line of corporate America, reduce earnings and so negatively impact stock prices.

Government support that has helped keep businesses and workers afloat following the coronavirus shutdowns cannot last forever. There are a great many businesses and employees that will soon have their life-support turned off. The true impact of this global disaster is yet to be felt. This will send a shock-wave through the economy.

In summary, there is nothing on the horizon to drive the market higher but a great many things that will lead to it correcting.

I know that I am not the only one to have observed that the market is way overpriced. Warren Buffett is sitting on $135 billion in cash at Berkshire Hathaway (NYSE:BRK.A), and given current market valuations, he has been unable to invest it. Instead, he is waiting patiently for the correction that seems inevitable.

In their new book, Boom and Bust, Quinn and Turner note that between 1987 and 2009, there has been a stock market crash on average every six years, but we have not had a meaningful correction now for 12 years. “The global economy has essentially become a giant tinderbox, susceptible to any spark that may come its way.” The world is not exactly short of potential sparks right now.

My message to you, my fellow investors, is be careful. The Wall Street crash began on October 24th, 1929. The market subsequently lost over 88% of its value. I have often wondered what it must have felt like on October 23rd, the day before the fall. Perhaps it felt very much like it does today!

So, what are you able to do?

You could cash out at high prices and wait for prices to drop before reinvesting. Sometimes cash is king.

This may be an interesting proposition if you are invested within a tax-free wrapper, but otherwise, it is not likely to be tax efficient as selling down your entire portfolio at premium prices means a huge capital gains tax liability.

You could adopt a long/short trading strategy. This works by investing in companies within the same industry where one looks far better valued than the other.

So, for example, Toyota Motor ADR (NYSE:TM)/Toyota Motor Corporation (OTCPK:TOYOF) is trading at 9.8x earnings, while Tesla is trading at an enormous 900x earnings. If you take the view that Toyota is better value, then you would take a long Toyota position versus a short Tesla position.

If the economy recovers without a correction then Toyota may reasonably see a multiple expansion of 50% to a PE of 14.6, but Tesla is unlikely to see a 50% multiple expansion to 1,350x earnings!

So, you would profit from the differential.

If the market crashes then Tesla has much further to fall back to reality - an 80% drop in the Tesla share price would still leave it trading at a crazy 180x earnings - and this would give you a far larger gain on the short side than a 25% loss suffered on the Toyota position, which is unlikely to trade on a multiple below 7.5x.

You could take a short futures position on the index a hedge.

This means that you hold on to your long portfolio of stocks, but if the market crashes then you will make a gain on the futures which will, at least partially, cushion your losses on the stocks. The downside from here on such a short position looks limited.

You could buy an index put option.

This would allow you to profit from a collapse in the benchmark which, just like the futures, would mitigate your portfolio losses and so you would be hedged.

You might like to move out of overvalued tech stocks and into more defensive sectors such as Consumer Defensive, Healthcare, and Utilities which will be more competitively priced at the moment and will usually fare better in a downturn.

You could take a position on the index itself as a hedge or alternatively on the CBOE VIX volatility index which will spike if there is a correction.

Or you could exit equities altogether and invest in defensive assets. Many people have already done which is why the price of gold is up 50% year to date.

In summary, whatever you decide to do is better than doing nothing.

Risk management is the most important part of portfolio management.

As Warren Buffett always says, there are two golden rules when investing: "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1!"