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“The Dominant Risk For Wall Street” May Be Manifesting In Small Caps

A good deal of attention has already been paid to the growing divergence between small cap and large cap stocks so far this year. The former have seen a small decline while the latter have risen about 8%. But I’ve seen very little commentary regarding WHY this might be happening. Of the many divergences the market has seen recently I think this one may be the most significant as the small caps could be the “canary in the coal mine” for the broader market.

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It all comes back to what I have argued amounts to a bubble in corporate profit margins. Jeremy Grantham has used a 2-standard deviation event as one benchmark for a bubble. Using that definition, it’s hard to argue that profit margins are not currently in a bubble.

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Warren Buffett also weighed in on unsustainably high margins back in 1999:

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.

Note that margins are now nearly twice the 6% level that Buffett considered a long-term upper threshold. Now I haven’t heard him say anything about current levels of profit margins (and I’d love for somebody to ask!) but I think his logic is still valid. At some point, the pendulum will have to swing the other way and profits will revert to some extent.

Like the price divergence between small and large caps, the forces behind the scenes here have also been the subject of much ink. It’s that 99% versus the 1% thing. You see over the past few years as the economy has slowly recovered in the wake of the financial crisis companies have seen their revenues grow but have been reluctant to add to their employee base. The result is that a larger and larger portion of these revenues fall to the bottom line. This goes on for a period of five years and, voila! Record profit margins. The 1% (owners of these companies) celebrate while the 99% stagnate.

Until now…

There are signs recently that this dynamic is shifting. After all, you can only milk your current employee base so much before they become overextended and your product or service suffers or you can’t meet the growing demand, etc. At some point in the recovery or expansion process you have to start adding employees AND paying your current employees a little better in order to retain them.

And it’s beginning to look like this is exactly what’s starting to happen. As the BLS reported a couple of weeks ago, job openings are improving pretty dramatically. July saw a 22% gain year-over-year. And as we learned today, real wage growth spiked in August by the largest amount in years.

This is fantastic news for the 99%. It looks like more jobs and better pay are finally on the way. And it’s exactly the result the FOMC, with their albeit super-blunt tools, have been trying so hard to create. As Pimco’s Paul McCulley writes:

But as Martin Luther King intoned long ago, the arc of the universe does bend toward justice. And as I wrote in July, I think it will do so with the Fed letting the recovery/expansion rip for a long time, fostering real wage gains for Main Street. This implies that the dominant risk for Wall Street is not bursting bubbles, but rather a long slow grind down in profit’s share of GDP/national income.

But do bubbles usually unwind in a “long slow grind down”? Maybe. But sometimes they burst. Either way, this is not so good for the 1% and those record-high profit margins. And we’re seeing this happen already in what area of the market? You guessed it – the small caps and “middle market” companies. Sober Look reports:

While over 50% of [middle market] companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

It’s been six consecutive quarters now that these smaller companies have experienced, “margin compression.” UBS recently confirmed this data noting the recent plunge in EBIT margins at small cap companies.

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Chart via Business Insider

Make no mistake, this epic stock market rally has been built on the back of this profits boom. It’s been the source of much of the earnings growth we’ve seen and inspired investors to bid valuations to what has historically been rarified air. Should profits decline it would mean already extended valuations are even more inflated than they currently appear and would remove a major underpinning of the bull market.

What I worry about even more, however, is the amount of risk that has been assumed recently based upon the expectation that profit margins will remain at these record levels indefinitely. As Sober Look recently reported, leveraged buy out valuations are at heights not seen at any other time during the past 14 years. More importantly the amount of debt in relation to targets’ EBITDA is also at a record:

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Chart via Sober Look

If EBITDA at more than half of these companies is actually declining now these multiples will soon look even more inflated than they already do and the massive amount of debt used in buying them is at risk even greater risk of becoming unsustainable than it originally appears.

Speaking of the “massive amount of debt,” It’s important to note that the volume of leveraged loans has far surpassed it’s highs of 2007…

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Chart via Dallas Fed

…and the risk controls embedded in these loans has fallen dramatically as covenant-lite’s share of overall issuance is now twice what it was prior to the financial crisis.

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Chart via Dallas Fed

So it looks as if we may have more built up risk on the debt side of things than we did prior to the financial crisis. If margins are actually beginning to revert, as the small cap/middle market is suggesting, at 2-standard deviations above their long-term average, they potentially have a very long way to fall. And with so much risk betting against this possibility the fallout could be dramatic.

Perhaps this is why spreads have finally begun to widen just a bit over the past few months in the high-yield market.

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Chart via Charlie Bilello

All in all, this is clearly a very complex system with various intermarket relationships. But we are seeing some signals that point to the fact that the Fed may be close to achieving it’s goals of increasing employment and wages. While this is good news for the labor force, it’s bad news for companies and investors because the resulting margin compression would remove the main driving force of this bull market along with causing potential problems (defaults) in the high-yield bond market. So keep your eyes on the small caps; there are big implications in that divergence everyone’s looking at.

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On The “Sioux And The Buffalo”

My recent piece, “The New Wolves Of Wall Street,” struck a nerve. I think it taps into both advisers’ insecurities and investors’ worries about not getting what they pay for. Good. That’s what I was going for.

Before I follow up on that piece, though, let me make a couple of things clear. First, there are some truly wonderful advisers out there. My experience, however, tells me they are more the exception than the rule. As WSJ’s Jason Zweig tweeted this morning many, “treat clients like Sioux treated the buffalo.”

Second, I’m not criticizing either the RIA model or index funds right now (though these aren’t without their own problems). All in all, they are a net positive for individual investors because they reduce conflicts of interest and bring down costs. I’m focused on the problems that arise when you put the two together.

Ultimately, this discussion is focused on the massive underperformance individual investors experience in their own portfolios on a consistent basis:

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Most pundits like to blame this on the fact that individual investors are just “dumb money.” Indeed, there is a “behavior gap” that causes investors to become euphoric with the crowd and buy at the wrong time and then panic in the midst of a bear market and sell at precisely the wrong time. This is human nature.

What the wolf doesn’t want you to know, however, is that he’s just as much to blame for your underperformance as your caveman brain is (see “Where’s Wall Street’s Blame In The Buy High Sell Low Game?“). In fact, even if he does a perfect job managing your natural instincts along with his own, he’s going to cost you big time – like half of all of your profits over the long run, big time.

So the problem as I see it two-fold. Both the “behavior gap” and obscene fees are significant contributors to the problem of massive underperformance. Addressing the first part is a good start. But ignoring the second part or – even worse – pretending, as an adviser, to pursue a low-cost approach while charging predatory fees is counterproductive, at best.

In fact, I’ll take it a step further. An adviser who is recommending passive index funds should not charge a “management fee” at all. Management fees are just that – fees for managing investments. If you’re not managing investments – you’re just overseeing a passive portfolio – you don’t deserve a management fee. Period.

Investment advice like this is valuable, though. Investors deserve to be educated about how their biases screw up their investment plans. And I think there’s a huge opportunity for advisers interested in doing this the right way.

Investment advice like this should be compensated just like all the other “advice” given by professionals out there – attorneys, accountants, therapists, etc. – on an hourly rate. Get paid for the advice you’re giving. Nothing more – nothing less. What would you say to your CPA if, instead of his hourly rate, he asked you for 2% of all your money every year for the rest of your life just for doing your taxes?

Too many “advisers” simply gather assets, charge their management fee for a one-time recommendation and then just ride the gravy train. And can you blame them? Under a management fee structure this is the overwhelming financial incentive. They maximize their profits by bringing in as much money as possible to charge a perpetual management fee on and then do as little management or advising as possible.

If advisers were compensated for the time they spent actually advising rather than the amount of assets they gathered then that’s how they would spend their time. This would much better align investor needs with adviser incentives. And it would also help keep human advisers relevant in the era of the robo-adviser. Somebody’s going to see the light here and seize this opportunity, I’m sure.

Still, I believe that the vast majority of investors are capable of overcoming the “behavior gap” on their own. They certainly don’t need pay an annual tithe to have it managed for them. My hope is that this helps inspire them to help themselves. And there are some wonderful role models out there like Stephanie Mucha.

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The New Wolves Of Wall Street

Wall Street is in the midst of some pretty massive change right now. And I’m talking about Wall Street as it relates to Main Street. I’m talking about how individual investors are being courted (hunted) and cared for (killed) by the new wolves of Wall Street.

Brokers have now become an endangered species as the model has been attacked on two sides by fee-only investment advisers (aka, RIAs) and discount brokers advocating a DIY approach. And now there’s a third entrant attacking both the brokers and RIAs: robo-advisers. All in all this evolution is good for investors as it ultimately brings down costs.

But don’t underestimate greed’s resilience and its willingness and ability to adapt. As they say, “the more things change, the more the stay the same.” Many brokers are making the switch to RIAs. In fact, they’re doing it in droves (witness the growth of the likes of LPL Financial). Changing your title and even your business plan, however, won’t magically turn a wolf into a sheep but it does make him harder to identify.

Make no mistake. There are plenty of wolves left on Wall Street. They just don’t call themselves wolves anymore. In fact, they do everything in their power to look like innocent, cuddly sheep. They setup as RIAs now. Many even preach a low-cost, passive or index-based approach to investing, aligning themselves with the likes of Burton Malkiel, Warren Buffett and Jack Bogle, some of the most respected names in the business.

It’s the ultimate hypocrisy. You see, while they preach a low-cost approach and may actually use low-cost products like index ETFs, they’ll charge you an arm and leg for the privilege – as much as 2% per year. As Meb Faber put it, “you’re a predator if you’re charging 2% commissions and or 2%+ fees for doing nothing.” I’m sure the wolves, who normally brag about ‘eating what they kill,’ would take this as a compliment. Meb continues,

Anything more than 0.5% or so on top of fund fees is either paid a) out of ignorance, which is not always the investor’s fault or b) as a tax for being irresponsible.  For the latter I mean a fee to keep you out of your own way of chasing returns and doing something stupid, much in the same way someone pays Weight Watchers or any other diet advice program when you know what you should be doing (eat less, exercise more).

I’d say that anything more than 0.25% for “managing” a passive portfolio of index ETFs these days is obscene (it’s not even really “managing” if it’s passive – more like “overseeing”). And there are plenty of advisers charging nearly ten times that amount. And what’s the money for? What are you paying these fees for year after year? Because if the funds themselves do all the work and merely need to be rebalanced a couple of times it might take 15 minutes per year.

At the end of the day, you’re paying for the pleasure of their company. And that 2% fee might not seem like much but it really adds up over time. As Albert Einstein famously said, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Over 40 years, on $100,000 initial investment, that 2% fee you’re paying compounds into roughly $2 million. Even Kate Upton‘s company is not worth that much.

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That chart above shows the growth of $100,000 over 40 years assuming a rate of return of 9.68% for the index fund (the return over the past 40 years) and 7.68% for the investor paying 2% to his adviser. The DIY guy ends up with a little over $4 million and the guy with the wolf, I mean adviser, ends up with a little less than $2 million. That’s right, the wolf ends up eating over half of your profits.

So when I call these fees “predatory” or “obscene” this is why. Wolves preaching a low-cost, passive approach and charging these fees represent the height of hypocrisy – or the height of greed – take your pick.

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The Only Guy On The FOMC With Any Experience Actually Managing Risk Is Sounding The Alarm

Below is a compilation I put together using excerpts from Richard Fisher’s speeches this year (emphasis mine):

There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call “beer goggles.” This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy. Here are some of the developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat:

  • Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.
  • Dividend payouts financed by cheap debt that bolster share prices.
  • The “bull/bear spread” for equities now being higher than in October 2007.
  • Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s.
  • The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999….
  • Margin debt that is pushing into all-time records.
  • In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight.
  • “Covenant lite” lending becoming robust – surpassing even the 2007 highs – and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. I have been involved with the credit markets since 1975. I have never seen such ebullient credit markets. From 1989 through 1997, I was managing partner of a fund that bought distressed debt, used our positions to bring about changes in the companies we invested in, and made a handsome profit from the dividends, interest payments and stock price appreciation that flowed from the restructured companies. Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy. The big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.

The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability. We must watch these developments carefully lest we become responsible for raising the ghost of irrational exuberance.

Why isn’t anyone listening?

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Seeing The Forest For The Trees

Yesterday morning I came across a piece over at Harvard Business Review titled, “To Make Better Decisions, Combine Datasets.” I began reading it and realized that’s exactly the key to investment success and what I’ve tried to do with my market timing model: combine a variety of predictive datasets to create a holistic forecasting and timing model.

The stock market is driven not just by fundamentals or sentiment or technicals alone but by all of them in concert with one another. It follows then that an investor should try to incorporate each of them into her investment process in order to maximize its effectiveness.

And this is where I think many investors get lost. They try to focus on only one of these three. Fundamentals alone may work over the long run but cheap stocks can always get much cheaper in the short-term or they could just be cheap for a very good reason (I’ve learned this lesson more than a few times). Sentiment can also be very helpful but the crowd isn’t always wrong and markets can ‘stay irrational longer than you can stay solvent.’ And, as many traders know, the ‘trend is only your friend until it comes to an end.’

What I’ve found in my 20+ years of observing and trading markets is that looking at the forest, by putting all of these together, rather than the trees alone is absolutely crucial to making good decisions. So I thought it might be fun to look at the individual components of the model to see not only what they are saying about the markets but how they might be misleading when taken on their own.

For my fundamental component I use Buffett’s favorite valuation yardstick, total market capitalization-to-GDP. On its own it has roughly an 83% negative correlation with future 10-year returns in the stock market (based on 65 years worth of data). This means higher levels for this indicator are correlated with lower future returns and vice versa. Here’s what it looks like over the past 65 years or so:

Screen Shot 2014-09-05 at 9.38.05 AMEven considering the fact that the internet bubble has pushed the average higher over the past ten or fifteen years, this measure still suggests stocks are priced significantly above their historical range. Based on its high correlation with future returns this suggests investors should expect a very low return from present levels over the next decade.

BUT… this has been the case for most of the past 20 years! An investor looking at this measure alone might have sat out a couple of major bear markets but also would have missed a couple of the most massive bull markets in history! So it’s probably not smart to use this measure in isolation. Adding other related asset classes (like bonds – we’ll come back to that) and other, unrelated indicators should help give a bit more clarity.

My sentiment measure tracks the percent of household financial assets invested in equities. Believe it or not this measure is even more highly negatively correlated with future returns than Buffett’s valuation measure above (closer to 90% – hat tip, Jesse Livermore). Here’s what it looks like over the same time frame:

Screen Shot 2014-09-04 at 12.54.35 PMIt’s also currently sitting significantly above its long run average suggesting returns should be far below average going forward. As I mentioned this is a better forecasting mechanism than the fundamental measure but even if the incredible euphoria of the internet bubble got you out of the stock market you may not have gotten back in over the past 15 years because we haven’t seen anything like the pessimism witnessed at the 1982 low.

Finally, I’ve added a third component to the model, inspired by Doug Short: a simple trend regression model based on Robert Shiller’s data going back nearly 150 years. With a negative correlation of roughly 74%, it’s not quite as effective at forecasting future returns as these other two but I think adding it, as a third independent component based on a very long-term trend, helps to make the model more robust. So here’s what the S&P 500 looks like relative to a regression trend line over the full time period:

Screen Shot 2014-09-04 at 1.01.27 PMOnce again this indicator shows the stock market to be trading very close to the top of its historical range. Still, like the fundamental model this one might have had you sitting out of the stock market for perhaps the past 20 years!

So even though we have three independent models we need a way to put them together and then to put them into some sort of context. What I’ve done is used each indicator individually to create a 10-year forecasting model. Then I’ve simply averaged them together each quarter. All told, the combination results in a correlation to future 10-year returns of about 90%. Here’s a chart of the model’s forecast returns as compared to actual 10-year returns for the stock market:

Screen Shot 2014-09-04 at 1.05.21 PMWhere the model is farthest off the mark (where you see the yellow line far above the blue line) is in the late 80’s early 90’s. Stocks surged further and faster during the internet bubble than the model forecast they would. Removing those years, the model’s correlation value rises to about 94%.

So we know what the individual readings look like. What’s the model saying about future returns from here? As the chart below shows, the model forecasts a return of just 1.2% per year over the next decade:

Screen Shot 2014-09-04 at 1.10.16 PMTo add some context, in addition to the 10-year forecast I’ve put the yield of the 10-year treasury note on the chart, as well. Investors don’t look at potential returns in a vacuum; they compare potential returns of different opportunities, many times looking at the “risk-free” rate of treasury notes in the process. This next chart shows the difference between the model’s forecast return and the yield on the 10-year treasury note:

Screen Shot 2014-09-04 at 1.17.48 PMWhen the blue line is above zero, stocks offer the better return; when it’s below, bonds do. And as I’ve shown before in “How To Time The Market Like Warren Buffett” this timing model works very well. Just buy whatever asset class is more attractive – trading only once per year – and you’ll kill a buy-and-hold approach.

I think this alone is validation of a multi-disciplinary approach. But adding one more super-simple component makes it that much more effective: before we go and sell our stocks because bonds are more attractive, we want to make sure we don’t sell too early in a bull market or buy to early in a bear market. As the chart above shows this model would have had you sell your stocks and shift into bonds all the way back in April of 1996 and then miss all the gains of the next 3 1/2 years.

Adding a very simple trend-following approach solves this problem (hat tip, Meb Faber). Rather than sell right when bonds become more attractive it’s much more advantageous to wait for the trend to end. And as a representation of the trend, we can simply use a 10-month moving average. Below is a chart of the S&P 500 and this moving average:

Screen Shot 2014-09-04 at 1.23.36 PMTo be clear we’re not trend followers all the time with this model. We buy-and-hold until the model tells us that stocks are not attractively priced and then we become pure trend followers. Once the model tells us stocks have become less attractive than bonds we wait for the S&P 500 to close at least 1% below its 10-month moving average at which point we sell our stocks and sit in cash, buy bonds or even short stocks (the latter generates the best returns over the period studied).

Should the index at any point close back above its 10-month moving average by at least 1% we buy stocks again. Like I said, so long as stocks are less attractive than bonds we are pure trend followers. Only when the model suggests stocks are once again more attractively priced than bonds AND the trend has turned up (as indicated by a monthly close above the 10-ma) do we buy stocks and abandon trend-following for buy-and-hold.

Ultimately what this produces is a combination buy-and-hold/trend-following model that owns stocks roughly 80% of the time and seeks to avoid major bear markets precipitated by high valuations, high levels of bullishness and prices extended far above their regression trend. It doesn’t avoid losses entirely, though.

The model didn’t recommend a move out of stocks prior to the 1987 crash which resulted in a decline of roughly 26% (its largest drawdown). It did, however manage to avoid the ’73-’74, ’00-’02 and ’08-’09 bear markets, the latter producing about a 50% decline. In fact, this is where all of the model’s outperformance is generated: in recognizing these major turning points fairly early on – essentially giving a warning signal – and then switching from buy-and-hold to trend-following when that strategy is more effective.

The next chart shows the results of three different investors. The first is a simple buy-and-hold strategy (blue line). The second goes to cash when the model indicates (red). The third, rather than going to cash, shorts the index (green):

Screen Shot 2014-09-04 at 1.50.13 PMClearly there is significant benefit to abandoning buy-and-hold for a trend-following approach when our model suggests stocks are unattractively priced. Over the period the investor who just sits out major bear markets in cash ends up with twice as much as the investor who holds through the entire decline. And the investor who gets short, in turn, fares far better still.

I truly believe these superb results, hypothetical though they be, can be attributed to the holistic nature of the model. It combines datasets that are valuable independent of one another into something greater than its parts.

As of now, the model is telling us that stocks have once again become unattractive relative to bonds. However, the uptrend is still in tact. So it’s probably valid to be bearish for fundamental, sentiment and regression reasons. But the trend is also a valid reason to be bullish – even if it is the only reason. So I’m still looking at the market through a bearish lens right now but I’ll be watching for a monthly close at least 1% below the index’s 10-month moving average for the trend to validate the fundamentals and sentiment.

For reference I’ve put up all the spreadsheets, calculations and charts I used on a public Google Drive sheet here: Market Timing Model. I’ll be updating it as new data comes in.

Finally, I need to make the same disclaimer I’ve made over and over again during this series: because this is a hypothetical model that doesn’t incorporate taxes, transaction fees, etc. it is not representative of any real returns. It is merely for educational purposes. Clearly, past performance may not be indicative of any future results.

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All Eyes On The Bond Market

The most critical asset class in the world right now might just be the US bond market, as represented by the 10-year treasury note yield. So far this year bonds have performed very well as this rate has declined – foiling the best laid plans of all the bond bears (and there have been loads of them). But the bulls can’t quite plan their victory parade just yet because right now this critical interest rate is sitting at a critical technical level, a crossroads, actually.

The downtrend for this rate is well-established. It might be the longest tenured trend, in fact, of any major asset class out there right now. Here’s a look a the monthly chart:

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Clearly it’s not even close to breaking above that upper downtrend line that dates back to the mid-1980’s. So anyone making the case for higher interest rates is swimming upstream.

But take a look at the weekly chart and it’s a little bit different story:

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After briefly breaching the 2.25% level during the height of the financial crisis and then testing it again in the fall of 2010 this rate finally broke down to new lows during the summer of 2011. It wallowed below that key level for a couple of years before regaining it during mid-2013 – along with breaking the downtrend line on that time frame – in a year that amounted to a walloping for long bond holders.

Much has been made of the weakness in rates/strength in bonds since then but, in actual fact, the action over the past few months has only amounted to a 50% retracement of the surge in rates from last year. And that area between 2.25% and 2.4% serves once again as key technical support. A closer look at a daily time frame shows what might be described as a bull flag (for the price action year-to-date) that has taken the rate right to the 50% retracement of the 2013 rise:

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In any case the action this year has been corrective rather than implusive, as Elliott Wave aficionados would say, suggesting yet higher rates are in order. However, the trend is still pointing lower on all of these time frames so there’s something both bulls and bears can point to right now.

All in all, this 2.3%ish level serves as a technical line in the sand. Until it breaks meaningfully one way or the other bulls and bears are at a stalemate. Once it does break out, though, it could have major implications for both the stock market (in terms of relative valuations) and the economy (in terms of leading indicators).

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The Problem With Index Funds

I was glad to see on Friday someone (Yahoo! Finance Editor-in-Chief, no less) concur with my concerns over the growth of index-based investing strategies (see “One reason I’m worried about the rise of the robo-adviser“). In a piece appropriately titled, “Pride cometh before the fall: indexing edition,” Aaron Task writes:

Was ‘owning the index’ a good idea in 2000, when ~50% of the S&P 500 was in tech?

Was ‘owning the index’ a good idea in 2008, when 40% of the S&P 500 was in financials?

No, of course it wasn’t.

But that’s exactly what you did if you followed an index-based approach. So while index investing is probably better than many of the alternatives that doesn’t mean it doesn’t have its own problems. And being valuation agnostic is probably its biggest problem.

You see when you buy an index fund you put more money into the largest companies in the index and less money into the smallest, regardless of their valuations. So when investors bid tech stocks to the moon and they become the largest component of the index (as in 2000) they carry a larger weight in the index and, in turn, you end up buying a lot of them. In effect, you become greedy when others are greedy rather than becoming fearful, as Buffett would recommend (he also recommends indexing, though, so go figure).

And taken to the extreme, the growing popularity of index-based investing could possibly be the cause of yet another stock market bubble. When a growing class of buyers is willing to continue buying regardless of how high prices rise then valuations can conceivably rise infinitely (Sound familiar? Indiscriminate buying of internet stocks in 2000? Indiscriminate buying of housing in 2007?).

What index-based strategies don’t want you to know is that ‘the price you pay DETERMINES your rate of return.’ Pay too high a price and you literally guarantee yourself horrible returns. Forget owning too much of one sector within the index; was it a good time to buy stocks at all at March of 2000 or October of 2007? Hell, no. Sky-high valuations were a big reason for that. And we may have already reached that point once again (Jesse Livermore recently wrote a wonderful piece on the topic – see “Why is the Shiller CAPE so high?“).

Finally, I personally see the growing popularity of index-based investing as a good thing for individual investors over the long-term but also as a potential contrarian indicator over the intermediate-term.

Aaron again:

The pendulum has swung way too far where everyone thinks all you have to do is index and you’re going to do better [than actively managed funds].

Once the pendulum has swung so far that many investors come to believe that all you have to do is buy the index and it’s all peaches (cap gains) and cream (dividends) then it’s probably time to look out below. I just don’t know if we’re there yet.

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