Weekly Economic Update 04-27-2018

Inventing the Impossible

You can’t beat the market. Investors have been told repeatedly it is impossible to beat the market and instead, investors are told to buy index funds. Only professional money managers can beat the market, and while luck does play a role, few managers beat the market over long periods of time. For the past year and a half, I have been trying to develop a strategy to beat the market using a formula. Over the past few weeks, I have shared some information with you and have backtested results validating that it is possible to beat the market. Before I share with you how the strategy works, I want to briefly cover what is currently going on with interest rates.

In the past I have written about how long-term bond yields are not correlated to short-term bond yields, even though both have been rising lately. The rise in bond yields is mostly due to speculators shorting Treasury bonds because they believe 1970’s inflation and higher interest rates are coming. The speculators will be wrong.

Milton Friedman, an American economist who received the Nobel Memorial Prize in Economic Sciences in 1976, developed the most comprehensive and accurate interest rate model to date. His interest rate model draws two conclusions: decelerations in the monetary base can lead to rising long-term yields in the short term, but always lead to lower long-term yields, and accelerations in the monetary base lead to higher long-term yields. When the Federal Reserve tightens the monetary base for an extended period, it leads to a decrease in the inflation rate and personal incomes, which ultimately leads to lower long-term yields.

The historic money supply data confirms Friedman’s model. Seventeen out of the last twenty-one recessions, since the early 1900’s, have been led by a deceleration in the growth rate of the money supply, or monetary base. The other four recessions occurred during periods of an accelerating money supply. There is approximately a two-year lag between the time the money supply begins decelerating and the forthcoming recession. The current deceleration of the money supply began in October 2016 and is growing at 3.76%, which is well below the 6.6% long-term average growth-rate of the money supply. Based on Friedman’s research, the recent rise in bond yields will be transitory and will lead to significantly lower yields when the next recession is in full swing.

Now, back to the impossible. Two years ago, a friend of mine asked if I could replicate an index developed by J.P. Morgan that was created for their high net worth clients. Unfortunately, I was unable to replicate it because the strategy utilized futures contracts and, at the time, I was limited to using Exchange Traded Funds (ETFs), whose returns don’t exactly correlate. While my attempt to replicate J.P. Morgan’s strategy failed, I did invent my own strategy, called Portfolio Shield™, which is far superior in my opinion.

Portfolio Shield™ is an equity strategy designed to hedge market downturns with U.S. Treasury bonds. I hired Morningstar®, the premier data and analytics company for the financial industry, to validate my strategy, and based on their backtested results, it proves that Portfolio Shield™ is one of the best equity strategies developed for the retail public. I didn’t stop there. I believed it was possible to create an even better strategy which could offer higher upside returns with less downside risk.

I set out to create the impossible:

  • The strategy must capture most of the upside return of a major stock index.
  • The strategy must eliminate most of the downside losses associated with Bear markets.
  • The strategy needs to attempt to profit from the Bear market by investing in a negatively correlated asset class.
  • The strategy needs to buy back into the index near the bottom of the market.
  • And the entire strategy must be expressed in one or more algebraic equations that would make all the trade recommendations to eliminate emotion.
  • The equations need to work on more than one index or ETF.

At the time I thought it would be impossible to create such a comprehensive strategy, but if I could get close, it would be the holy grail of investment strategies. The public buys most at the top of markets and sells near the bottom. This strategy, if successful, would do the exact opposite. Any strategy that buys at the bottom of markets and sells near the top, should be able to beat the major stock market indices with substantially less risk.

After back-testing most of the popular “timing” strategies used by investors today, I concluded those strategies had their strengths but all had at least one significant weakness. Not one of them generated significant upside return or downside protection, both of which I felt were achievable goals. I began researching a rarely used concept in finance—momentum. Most investors view momentum as a rise in price, however, true momentum is measured by the rate of change over a period.

I was able to model and chart momentum, but creating an algebraic equation to trigger the buy and sell signals seemed impossible. For months on end, every new equation I tried was met with failure. There were times I wanted to quit, but every time I stepped away, I was lured back with a new idea. Unfortunately, none of them worked until I ran across my personal notes for Portfolio Shield™, where I had written down a formula that I didn’t end up using. That formula ended up being a perfect fit for this strategy.

I’ve attached two PDF’s to this e-mail for you to download which show the back-tested results against the S&P 500 (20 years) and the Nasdaq-100 (15 years). The normal response is, “How is this possible?” The secret to investing is to buy low and sell high. Most investors do the exact opposite. Few investors or their advisors have an established trigger point of when to sell their equity positions to reduce or eliminate downside risk. Given the financial services industry has told investors they cannot time markets, the proper view is to refute the existence of my new strategy. I can assure you it is real and Morningstar® has fully validated the return and risk metrics.

What makes annual momentum special, is it predicted the 2000-02 and 2008-09 recessions, which is why I wanted to develop a strategy around it.

The annual momentum strategy invests in equities when annual momentum is positive. Most major indices, such as the S&P 500 or Nasdaq-100 tend to have long, multi-year periods where annual momentum is positive. As long as annual momentum is positive, the strategy remains fully invested, allowing investors to enjoy all of the upside return of an index.

When annual momentum turns negative, the strategy recommends selling all the equity positions to buy U.S. Treasuries. Historically, when stock prices fall, bond prices rise. By selling out of equities when annual momentum turns negative, the strategy reduces the losses normally associated with Bear markets. The benefit of buying bonds is the strategy has the opportunity to generate a positive return during a period when most investors are losing money. But the true magic of the strategy happens when markets bottom.

When annual momentum begins rising from a negative position, the strategy recommends buying back into the index. Based on my data, annual momentum begins turning upwards within two to four weeks of a major market bottom. Market bottoms are the single greatest opportunity an investor has to generate huge returns for their portfolio. Unfortunately, few investors have cash at market bottoms and even fewer have the desire to invest after stocks have taken a major loss.

By examining the back-tested results, investing at market bottoms can be highly profitable.

The S&P 500 strategy outperformed the S&P 500 by +71.76% between 2000-02 and by +55.83% between 2008-09.

The Nasdaq-100 strategy outperformed the Nasdaq-100 by +66.32% in 2001-02 and by +63.40% in 2008-09.

On a total return basis, the S&P 500 annual momentum strategy generated a +960.3% return over a 20-year period versus +139.8% for the S&P 500.

On a total return basis, the Nasdaq-100 annual momentum strategy generated a +1,415.7% return over a 15-year period versus +546.1% for the Nasdaq-100.

Returns shown do not reflect any advisory or transaction fees.

I tested the strategy against several Exchange Traded Funds (ETFs) and the results are consistent – annual momentum outperforms the corresponding ETF over time. However, the strategy performs the best on the highest performing indices or sectors. My original plan was to create a strategy that would rotate through a variety of asset classes where annual momentum is in an uptrend. But since most asset classes are highly correlated to the major stock indices, my tests show that a rotational strategy would not generate higher returns than the two strategies I’m sharing with you now.

By design, annual momentum eliminates the need for diversification. Diversification exists because investors and investment advisors do not want to bother selling when markets fall, so they accept a lower rate of return when equities are rising for the perception their risk will be reduced when equities fall. The big problem with diversified portfolios is most of them took large losses in 2008-09 due to the high correlation between equities, international equities and corporate bonds, which are the most common asset classes in diversified portfolios.

The annual momentum strategy allows investors to enjoy the upside return of equities with the peace of mind knowing it has a triggering event that eliminates any further downside risk by recommending when equity positions need to be sold. By changing how risk is managed within a portfolio, investors have the potential to reap higher returns than they might normally generate from a diversified portfolio.

While annual momentum in the major equity indices is still positive, implementing the strategy today would have everyone investing in equities as annual momentum is falling. When the time is appropriate the strategy will be implemented, but for those in the legacy portfolios, we will still pursue other opportunities as I have previously mentioned.

For those with higher risk tolerances, I am developing a version that takes an inverse position (or short position) against the index it is tracking. Its returns are even higher!

This is truly a revolutionary strategy and I hope you are excited as much as I am for what the future might hold for us all!

Legacy Portfolio Update – U.S. Dollar is About to Rally

Recently I’ve noticed an odd correlation between the U.S. Dollar and U.S. Treasuries. Normally they are inversely correlated, but lately, they appear to be correlated. The dollar took a huge plunge and bonds did as well, but I believe the dollar and bonds are on the cusp of a major reversal. This week I watched an interview with Alex Gurevich, the CIO of HonTe Investments, who is an expert in late-cycle indicators. In his interview, he showed that towards the end of the business cycle, the dollar and bonds become joined at the hip.

What I also find interesting is my annual momentum indicator has flagged the dollar as a buy, even though it has traded flat for the past couple weeks. As of Wednesday, annual momentum on U.S. Treasuries is near a buy signal, which validates Gurevich’s research.

I also pulled my annual momentum data on the REIT, Telecommunications and Utilities sectors – all flagged a buy signal this week. It is not prudent to immediately buy on a daily momentum signal, which is why I’m targeting next week as an entry point. I charted the U.S. Dollar versus all three sectors, and REITs and Telecommunications have the strongest correlation to the dollar!

Gold and silver are generally inversely correlated to the dollar, as are the associated mining stocks, but correlations can change. Momentum is building on the miners and prices appear to be holding.

Here’s what I find very interesting – market participants are heavily positioned opposite Gurevich’s research. If the dollar begins to rally, stock prices will fall, bond prices will rally, which will lead to a massive short squeeze across those asset classes. This is called opportunity.

I’ve put together an allocation of gold and silver miners, telecommunications, REITs, Utilities and the dollar. Probably next week, if the trend begins to develop, I will begin trading in slowly, then increasing the positions as the trend continues. If one of those sectors moves opposite, I’ll just drop it from the portfolios.

According to Gurevich, there is a huge bond rally coming, which is extremely consistent with my research that bond yields should fall as the money supply decelerates. I’ll try to cover as much of this thesis in the video portion and charts, then review over the weekend before executing any trades next week.

Q&A with Steve – Your Questions Answered

  1. What happened to the stock market on Monday?

Equities tried to rally, but succumbed to the liquidity drain and closed down. Trading volumes remain extremely low. The Wall Street Journal reported Monday that traders and money managers are having difficulty trading due to the lack of liquidity and volume. With most investors on one side of the ship, risk can come quick.

Ten-year Treasury yields rallied just below 3%, but on news that Australia’s inflation came in lower than expected, yields began to fall in overnight trading.

The Fed still needs to destroy $30 billion per their planned balance sheet unwind before the end of the month, which will be a huge drain on liquidity. The U.S. Treasury is also scheduled to auction $96 billion of new debt, which is the largest weekly auction since 2014. This auction will reposition a huge amount of liquidity out of the economy and into the Federal Reserve banking system. I expect both to be a major headwind against stock prices.

  1. What happened to the stock market on Tuesday?

Equity markets sold off with weak volume on the news that 10-year Treasury yields touched 3%. While I can’t say the specific reason for this, equity markets tend to get spooked when interest rates rise. The bigger issue is that volume was low. If major stock indices can fall 1.5-2.0% on weak volume, wait until there is actually selling. Low volume means there were more sellers than buyers, but in a Bull market, this means there are very few buyers left.

The U.S. Treasury auctioned off $32 billion of two-year bonds today which is pulling liquidity from the markets. There is a 5-year Treasury auction on Wednesday and a 7-year Treasury auction scheduled for Thursday. The public wanted a tax cut and soon they will figure out there is a huge cost for a deficit-financed tax cut.

Treasury yields did rise a bit, but one the Richland Fed Manufacturing survey showed a massive drop in new orders as input prices rise. This is evidence the public is rejecting higher prices which will ultimately lead to lower bond yields.

Milton Friedman will be right once again – his interest rate theory shows that a decelerating money supply will lead to lower bond yields as the public rejects higher prices.

  1. What happened to the stock market on Wednesday?

Trading volumes picked up a bit today, but most trading is now happening in the last 30 minutes of the day due to lack of liquidity. The S&P 500 bounced off its 200-Day Moving Average for the second time. There probably won’t be a third time.

Stock prices held firm as several tech companies were due to report after the bell. Facebook met their targets and the stock is rising in after-hours trading. I bet few people know that Facebook is also buying their own stock back to help enable their CEO to sell his shares. It’s never a good a good sign when a company is buying their stock back to enable the CEO can cash out.

10-year Treasury yields in overnight trading pushed over the mythical 3% range and in trading today, tagged their high set back in 2014. With any security, there reaches a point where buyers or (in this case) sellers exhaust themselves. It’s the point where there are no more sellers or so few sellers, that buyers step in. Today’s action in yields saw a rejection of that 2014 high. At some point, there will be a reversal and with a record number of short positions against the 10-year Treasury, any reversal will see a massive short squeeze as sellers are forced out.

The 5-year Treasury auction was met with average demand. Tomorrow is the big 7-year auction which caps off $100 billion of new debt.

Agricultural commodities closed over their 200-day moving average for the first time since February. If this movement gains traction, it could set for a much larger move in agricultural commodities. Such a move would validate the head-and-shoulders reversal pattern, my annual momentum screen and the soon-to-form golden cross, which is when the 50-day moving average crosses upwards through its 200-day moving average.

  1. What happened to the stock market on Thursday?

Durable Goods orders came out strong, but excluding the highly volatile aircraft orders, Durable Goods fell 0.1% in March. This is not expected given the recent tax cut. Consumers and businesses should be spending.

Earnings season continues but trading volumes are back to their lows of 3 to 5 days ago. The last 30 minutes of trading is when the big players show up to sell. Large upward price moves back by low volume is not a sign of strength, which is why I expect stock prices to fall once earnings are done.

The last Treasury auction of the week drew a strong response from foreign bidders and bond yields fell in late afternoon trading. I suspect the peak in yields may be here.

  1. What happened to the stock market on Friday?

Not much. Trading volumes remained low. But, Treasury yields started to fall due to falling consumer spending.

  1. I heard the Dow Theory is signaling a sell?

The Dow Theory is one of the oldest timing strategies on the planet. When the Dow Transports cross below the Dow Industrials, the theory recommends selling equities. The sell signal occurred on April 9, 2018.

  1. What is driving bond yields higher if demand is waning?

Fear of inflation, but based on the deceleration of the money supply, this fear shouldn’t come to pass.

  1. But there is inflation, can’t you see it?

Yes, prices are rising, but it’s not from an increase in the money supply. The inflation you are seeing is best referred to as “cost-push inflation” where the government attempts to force wages higher by raising the minimum wage. Costs have further increased due to higher insurance premiums and debt service costs. Cost-push inflation will fail if it isn’t met with an increase in the money supply.

Companies will attempt to pass higher costs to the public, but when rejected, will leave companies with higher expenses and lower revenues. This is partially why stock prices are falling after earnings announcements. This type of inflation will lead to higher unemployment.

  1. I thought the economy was going to reflate?

Based on the movement in 10-year Treasury yields it would appear so, but real rates (inflation-adjusted rates) have not budged at all. This tells us market participants are betting on inflation by shorting bonds, but real rates are suggesting lower yields are more likely to come as the [global] economy cools off.

Video Topic of the Week – Short Squeeze

With nearly every investor piled into stocks and short bonds, the potential for a massive short squeeze is building as the global economy cools off. I’ll cover with this means to you and your money, and how we are going to invest countertrend.

Chart of the Week – GDP Growth vs Personal Savings Rate

Is this quarter’s slow down in GDP growth transitory or the beginning of a trend? The Personal Savings Rate tells us exactly where economic growth is headed. Be sure to check out this week’s charts for more insight.