The Ultimate Strategy
For those of you who read my weekly updates, I usually tell a story or discuss a relevant aspect of the global economy. Due to the holiday season, I have several partially written pieces, but none that were completed. Part of this is due to the holidays, the other part is because I have spent quite a bit of time working on the next momentum algorithm that I’ve mentioned in prior updates.
While I was hoping to share with you that I had a breakthrough with the algorithm, it turned out that there was an error in the numbers I was crunching on Christmas Eve. It totally ruined what was going to be a huge year-end announcement, that I developed an even better algorithm than I did for Portfolio Shield™. Instead, I am sharing with you what I am attempting to accomplish. You may have read in prior updates that I am trying to create something that is impossible, but if you saw a chart of the data, you’d see the solution is there – once I figure out how to write a formula to take advantage of it!
But before I get into the new algorithm, I’ve included a link below to a recent interview by Dr. Lacy Hunt who is an institutional portfolio manager and former Senior Economist for the Federal Reserve Bank of Dallas. In this 30-minute interview, Dr. Hunt explains the structural problems that are facing our economy. He covers economic growth, unemployment, the money supply, the new tax plan and several other topics. His interview is featured in the video, available on audio, and in print. Dr. Hunt isn’t interviewed very often, nor does he write more than once a quarter, so anytime I can learn from him, I do. As you read this I will have read through his report at least three times – it’s that good.
In addition, if you haven’t looked at the monthly Portfolio Shield™ investment detail report or the website for the strategy – both are also linked below—I would encourage you to do so. Portfolio Shield™ is an equity strategy that has a mechanism to reduce downside risk when the stock market becomes volatile. While Portfolio Shield™ can reduce market risk, it was not designed to eliminate market risk nor was it designed to profit on a stock market decline. Putting those aside, it’s an excellent strategy. While I was developing the strategy and pouring through the underlying data, it became obvious to me that the potential exists to build an even better strategy. So, I set forth to see if I could create it.
I also set some lofty goals for the new algorithm: It would have to identify that a security is near the bottom of a trend to signal a buy recommendation; it would have to know when a security is near a peak to signal a sell recommendation; it would have to know when an appropriate time to short a security (shorting is profiting on a fall in prices) without taking extreme levels of risk; and it would have to be a nearly universal strategy, meaning this algorithm should be designed to work on many different types of investments.
It also doesn’t help that I picked a very difficult security, a U.S. Treasury bond fund, as my benchmark security. The reason it’s difficult is that bond prices can fluctuate wildly, whereas the S&P 500 generally has long periods where it rises before falling off a cliff. Assuming I can make this work on a bond fund, it should work on just about any other security in the marketplace. If I can, it would just be a matter of building a spreadsheet to track the data from a wide variety of securities to find the optimal investments, which I can easily do. That data would theoretically tell me which are the most optimal securities, based on momentum, from which the portfolios could be adjusted for investments. Potential returns from such a strategy should be rather impressive, which is why I continue to devote time to this effort.
Video Topic of the Week – The Consumer
The consumer makes up 70% of our economy. With savings levels near historic lows, debt levels at historic highs and confidence near historic highs, will the consumer keep driving the economy or are they tapped out? Tune in this week to get my opinion.
Chart of the Week – Consumer Sentiment
This week we will take a deep dive into the University of Michigan consumer sentiment survey data to see how it compares to various sectors of the market.
Portfolio Shield™ Update
No updates this week. Monthly rebalance set for Tuesday.
2017 was a year of overvalued markets and optimism that are unlikely to carry into 2018. I spent quite a bit of time this year developing Portfolio Shield™ and working on the new momentum strategy that I shared with you in the first part of this update. I also spent time trying to deepen my understanding of what moves markets and why.
Most people would assume that stocks move based on fundamentals or profits or earnings or valuations. And they do, but that’s not what really moves markets. Markets are moved by liquidity, which is created by increasing the money supply, and optimism, which is found in consumer sentiment reports.
What’s interesting about sentiment is that virtually nobody talks about it, yet the correlations to the stock market are rather impressive! The reason is simple: Wall Street believes that if the public is optimistic that it will lead to increased spending, which in turn drives fundamentals, valuations, earnings, and profits.
The consumer sentiment data is intriguing because when it bottoms, stocks bottom shortly thereafter. When it peaks and starts to fall, stocks peak shortly thereafter and start to fall. Which could, if time allows, lend to the creation of a strategy that buys equities when sentiment is rising and buys bonds when sentiment is falling.
The University of Michigan Sentiment Survey shows that consumer sentiment is among the second highest level in history. There was a brief time going into the stock market peak of 2000 where it was higher, but all other points show consumer sentiment peaking at current levels. For those who think that buying equities right now is a good idea unless you believe sentiment is going to match or eclipse the 2000 high, this would be a bad time to buy stocks. Based on sentiment alone, this would be a good time to start rotating into government bonds, physical metals (or the miners) and agricultural commodities. Those sectors tend to perform strongly when sentiment is falling.
The University of Michigan survey only comes out once a month, while the Conference Board releases their data weekly. While I can’t chart the Conference Board data, because they charge several thousand dollars for it, their most recent data shows that consumer confidence is waning. Sure enough, the stock market is showing signs of peaking. As you can see, the correlation is strong.
In the updates from the past couple weeks, I likely mentioned that seasonality for gold, silver and government bonds is strong, meaning that they start outperforming around the first part of any year. The reason for that is as simple as the consumer confidence data. After overspending into the holiday season, consumers start retrenching and cleaning up their personal balance sheets early in the year. This year will likely be the same, as consumers weigh record levels of debt, rising credit card payments, higher health insurance premiums, higher property taxes, higher automobile insurance, higher consumer prices, the tax cut, a near historically low savings rate, and falling real wages. Those issues alone show that the American consumer is tapped out and likely to cut spending.
Should the American consumer cut spending, a problem will be created for American corporations which also have historic record levels of debt and falling profit margins. Those expecting big pay raises next year, may be disappointed. Corporations will face higher minimum wage laws in many states, plus higher borrowing costs. With short-term interest rates rising, corporations are forced to raise prices, which so far, the consumer has been rejecting. This is creating the setup for stagflation, which is any period of rising prices with falling wages.
This brings us back to precious metals, specifically gold and silver mining stocks that entered a bull market in late 2015. This was obvious by the near 100% price move in an 8-month period, but the indicator was the huge amount of trading volume that happened in the early part of the rally. When an asset class enters a bull market, it commonly has three periods of price increases with the second phase usually being the largest of the three. Since gold’s rally, it has been in a 16-month slump. Many “experts” have been saying that the forthcoming move in gold and silver will be a generational move of huge proportions. If the last move for the mining stocks was 100% and the second wave is usually larger, that sets up the opportunity for monster returns which I am prepared to benefit.
I believe the gold and silver markets are close to this breakout move. There may be one final move down in prices, which would confirm the work of Peter Brandt who is a classical price chartist. If his research is correct, there is one last move down and that’s where we enter. Based on recent trading volumes, there is a strong probability that his interpretation of the charts is correct. Given that most of the “big money” traders are out for the holidays, it won’t be until next week we see where they are going to take prices. Either way, I stand ready to jump on this opportunity. Even if the coming price move doesn’t exceed the initial 100% move, prices stand a strong chance of returning to their 2016 high, which would represent somewhere along the lines of a +50% move. I think that’s something we’d all be happy to see in our statements.
For the same reason gold performs well, so do government bonds. Interest rates are a function of demand and when demand falls, so do interest rates. With commercial and industrial loan growth nearly contracting on a year-over-year basis and consumer confidence starting to fall, interest rates should fall as well. Keep in mind that during every recession long-term government bond yields fall to new all-time lows. That would suggest our bond investments are likely to see double-digit returns in the coming downturn.
As I have mentioned previously, agricultural commodities perform very well during periods of stagflation, which is any period of rising prices and falling real wages. In the past, this sector has led gold and government bonds, and has generated huge returns in a short period of time. This is why we have and continue to hold a small part of the portfolios in agricultural commodities. Plus, if you read any book on the history of monetary policy, in nearly every instance when the money printing schemes failed, agricultural commodities boomed.
If there is any question about my commitment to you, I have waived my portion of the advisory fees (which are the largest portion) for the past one-and-a-half years. I plan to continue waiving my fees for all clients until returns are back on track. My decision to do that is not typical, as most advisors charge fees regardless of outcome. I choose not to. No investment advisor will always be right. Many go through long periods of being wrong, only to be spectacularly right. Much of being right or wrong is a function of timing – being too early or too late into an investment.
I want to close out this piece by letting you know that I am fully committed to you and that I believe 2018 will be our year. My decision to waive my portion of the advisory fees was not taking lightly, but it was done as my integrity is more important than my paycheck. I make every effort to do the right thing for my clients, and I believe waiving my fees was the right thing to do.
Weekly Broad Market / Economy Commentary
The U.S. Dollar is sliding, and it lost over 10% of its value this year. A weak dollar is not a good thing, even though many think it is. A weak currency means that on a domestic level, prices are going higher and standards of living will fall. If there’s any doubt in your mind, travel to a country with a weak currency and you’ll see first-hand what life is like. A weakening currency means investors are losing faith in the United States because we will likely have to print more money to pay for the tax cuts and all of our other entitlements that are massively underfunded. Any time a country has the perceived need to print its way out of a problem, their currency falls.
Along the lines of the tax cut, any form of stimulus is not deemed to be overly simulative if it is not met with an equal reduction in spending. While the tax cuts will add a small amount of growth to our economy, over the long term they will not, unless the economy grows. Wall Street doesn’t think the tax cuts will be stimulative because the professional money managers have started selling their equity positions and interest rates are starting to fall again. If the tax cuts were believed to be simulative, stocks would continue to rise along with interest rates.
Speaking of tax cuts, China previously stated that if the United States passed tax reform that they would respond. China has recently announced incentives for foreign companies (foreign to China) to keep their money in China. China hasn’t stopped there. They are aggressively working on their yuan-for-oil plan, where yuan will be fully convertible to gold. Plus, they have opened trade negotiations wither other countries to trade in yuan, which has been initially well received. As you can see, China and other countries are looking for ways to divest themselves of having to trade in dollars, which substantiates why the dollar is falling in value.
The other reason China and other nations are looking to move away from the dollar is that this past week there have been a few dollar shortages popping up in Japan and Europe. The cost to buy dollars to trade is rising rapidly along with short-term interest rates. The Fed has had to open their swap lines to lend money directly to the Bank of Japan and the European Central Bank. Keep in mind we are in the process of contracting our money supply of dollars, so the fact that liquidity issues are popping up is not a good sign.
The only remaining question is if the large institutional money managers and hedge funds will begin selling equities in January. If they do, things are going to get interesting, and not in a good way for most investors.
What most people don’t realize is that in the housing bubble (it was actually a mortgage bubble), that Wall Street offloaded their risk to the banks. Many Wall Streeter’s come from banks or has close ties to the banks. This was a mistake. This time Wall Street has pushed all of that risk to investors. While investors think the stock market is a great investment today, when this risk comes to roost, they will find themselves trying to get out of a rapidly declining market.
Bonus (35 min):
- M2 Money Stock YoY% vs Recessions
- Commercial & Industrial Loans
- Federal Reserve Balance Sheet
- University of Michigan: Consumer Sentiment
- Home Sales
- Consumer Confidence
- Commodity Prices
- NYSE Margin Debt
- S&P 500 Pros vs Public
- S&P 500 (SPY) Chart
- 10-Year Treasury Yield (TNX) Support Levels & Price Targets
- Gold Futures (GCZ7) Technical Analysis
- Vaneck Vectors Gold Miners (GDX) Technical Analysis
- Global X Silver Miners (SIL) Technical Analysis
- iShares 7-10 Year Treasury Bond (IEF) Analysis
- PowerShares DB Agriculture (DBA) Analysis
- U.S. Dollar Index (DXY) Analysis