The Cycle

April 30, 2017

This week I’ll look at the savings, retirement and asset cycle, which all have a similar lifetime. Let’s look first at asset pricing.

Long term moving averages can serve as a safety benchmark for asset prices, and a 50 month, or 4 year average, is one such average. If the price falls below that very slow moving average, there has already been a sizeable repricing of that asset and there may be more to come. It should prompt some caution or review.

Here’s a recent example.  In the summer of 2011, a basket of Brazilian stocks (EWZ) crossed below its 4 year average.  Six years later it is just nearing that long term benchmark. Its been a long hard slog for long term holders of Brazilian stocks, and supports the recommendation that an investor keep funds needed in the next five years out of the stock market.

Emerging markets (EEM, VWO, VEIEX) just crossed above their 4 year averages and are now at the same price as they were in August 2008.  This nine year “flatline” period came after a growth spurt from 2003 to 2007 when emerging market prices grew at 36% per year!  Even after nine years of no growth, an emerging market index has returned 10.5% annually in the the past 14 years.

The S&P500 has fallen below its 4 year average twice in the past three decades. Once was during the dot com bust in 2002 and the financial crisis in 2008. Each time, the index stayed below that benchmark for two or more years. During the 1969 – 1982 bear market, the SP500 fell below that benchmark four times! During that downturn, the index gained only 15% in 14 years. After adjusting for inflation, the loss was 40%,  or 3% per year.

Bond prices have been more stable and provide an anchor to a portfolio. Let’s compare the stock market to Vanguard’s total bond market index fund (VBMFX ). In the last three decades, the fund has NEVER fallen below its 4 year average. Dividend paying stock stalwarts like Johnson and Johnson (JNJ) can also serve as anchors since they fall below their benchmark less frequently than the SP500 index.  When these stable stocks do fall, the price rebounds more quickly than broader indexes because investors are attracted to fairly reliable sales and dividends.

So how does a casual investor without a charting program chart a 4 year average? has free charts available. In the example below, I input “SPY,” a popular ETF that tracks the SP500 into the “Enter A Symbol” box on the upper right portion of the screen, then I clicked the Go button. Stockcharts displayed a daily chart for this ETF with default 50 and 200 day averages. Above the chart, I clicked the selection box from Daily to Weekly and pressed the Update button. I left the default 50 and 200 averages alone. The red line is now the 200 week, or approximately 4 year average. The blue line is the 50 week, or one year, average. The chart below is an example.


This particular screen shot includes a Rate of Change indicator in the pane below the chart. Set at 100 weeks, it shows the percentage gain over two years.  Both gold (GLD) and mining stocks (XME) are struggling to get back above their 4 year averages.  You can change the symbol and compare their graphs.

In the earlier example, emerging markets had a five year spurt upwards, then a nine year flatline. Let’s look at a broad index like the SP500 in inflation adjusted dollars and we will see a similar pattern. $100K invested in the SP500 index in January 1997 was worth $183K in real dollars, real buying power, in April 2000. That was almost a doubling in real value in a small time frame. Easy money!

In 2012, twelve bruising years later, that inflation adjusted portfolio value FINALLY rose above $183K. Here is a free chart from


In the past four years, we have had another 62% spurt upwards in real value. The length of these spurts and flat periods are unpredictable, but the flat periods last longer than the spurts.

Let’s go back to the previous twenty year period, from 1977 – 1997.  In the first four years, from 1977 – 1983, the SP500 flatlined. In the following 14 years, the index grew by 570%!  (Exclamation marks for these growth spurts.)

We can see now that the strong asset price growth from 1997 to April 2000 was in addition to the extraordinary price growth from 1983 to 1997.  But doesn’t this example disprove the point I made earlier that flatline periods are longer than the growth spurts?

Let’s look back to those years before 1977 and we will see one of the reasons for that long growth period of the 1980s and 90s.  The six year flatline from 1977 – 83 was the tail end of a much longer period of flat or declining asset prices that lasted for 14 years, from 1969 through 1982. The introduction of tax deferred IRA accounts brought many individuals into the stock market during the 80s and 90s and helped to lift stock prices.  The introduction of the internet in the early 90s helped fuel a boom in asset prices much like the development of radio did in the 1920s.

Let’s turn from the long term 15+ year cycle of the stock market to the savings and retirement cycles. We spend at least forty years working. We may have just the last twenty years of our working career to save up for retirement. We hope to spend fifteen to twenty years in some stage of retirement.

We do not control when we are born nor the timing of these long term asset pricing cycles.  An awareness of these cycles may help guide us to wiser allocation choices.

The Nobel economist Robert Shiller builds an inflation adjusted ten year P/E ratio (CAPE) that is meant to smooth the ups and downs of company earnings. If I get some time next week, I may construct a 20 year ratio that corresponds to the 20 year cycle of 1) saving for retirement, 2) spending in retirement, and 3) the long term ebb and flow in the stock market.


Margin Debt

Investors meeting certain liquidity requirements can borrow money from their broker to buy assets, including stocks.  When stock prices start falling, investors without sufficient collateral in their brokerage accounts to cover the paper losses from falling stock prices may be subject to what is called a margin call.  The broker simply sells some of the client’s stock to replenish collateral.

Here’s an example and I will make the figures simple to avoid some of the complex rules involved.  An investor has $80,000 in stocks that she has bought and paid for.  She applies for a margin account with her broker who agrees to loan her $100,000 to buy other assets.  Thinking that the coming tax cuts will boost stock prices in the coming months, she buys $100,000 on margin in SPY, an ETF that replicates the SP500 index. Two weeks later, the European Union moves to disband in the coming months which makes investors very nervous and the stock market drops 20% in one day.  Yes, I told you I would make it simple.  The $80,000 in stocks that the investor owns outright is now worth $64,000 and the $100,000 of stocks she just bought on margin are worth $80,000.  The brokerage automatically sells $20,000 of the stock at the lower price to cover the shortfall in collateral. This is known as a margin call. One margin call does not create a selling wave.  Thousands of margin calls puts more downward pressure on stock prices and they continue to fall.  This again requires more selling to meet margin calls.

Because margin debt can ignite a selling frenzy in a crisis, the amount of margin debt is monitored.  Two years ago, the level of margin debt surpassed an earlier peak in 2000 at the height of the dot com bubble.  A graph from Doug Short at Advisor Perspectives shows the tight correlation between stock prices and margin debt.  After a brief decline, debt levels have again hit an all time high in real dollars.

There are a number of volatile situations around the world that could start a selling wave.  The level of debt will naturally accelerate that selling.  Now comes the news that there is a pool of margin debt that is not even reported and may add another 20 – 40% onto the reported total.  Here’s an article from Business Insider.

Guessing the Future

April 23, 2017

Human beings have an ability to foretell the future, or at least some people think so.  A more accurate description is that we predict the likelihood of future events based on past patterns.  Index funds average the predictions of buyers and sellers in a particular market.

During the recovery most active fund managers have underperformed their benchmark indexes. Standard & Poors, the creator and publisher of many indexes, provides a quick summary in their SPIVA spotlight. In the past five years, 88% of active fund managers have underperformed the SP500.  In a random world, I would expect that 50% of active fund managers would beat the index, and 50% of managers would underperform the index because the index is an average of all those buy sell decisions.

The 1% higher fees charged by active fund managers contribute mightily to this underperformance. Using long term averages, we expect that a third of active fund managers would beat their benchmark index.  The current percentage is only 12%. It is likely that the law of averages will eventually exert its pull.

Index funds mechanically rebalance regularly. Let’s look at a real life example.  The pharmaceutical giant Johnson and Johnson is a member of both the SP500 and the smaller group of core stocks that make up the Dow Jones index.  This week the company  reported first quarter revenues that were below expectations, and sellers promptly knocked 3% off the stock price.  Because most SP500 index funds are market weighted, index funds that mimic the weighting of the stocks in the index would buy and sell stocks in the index to capture these changes.

Because index funds are averaging the decisions of all stock investors, they should underperform. After all, the index funds are buying those companies that everyone else is buying, and selling companies that everyone else is selling.  Index funds are buying high and selling low, creating a drag on performance that is overcome by the lower fees charged by these funds.

In an article last fall in the Kiplinger newsletter, Steven Goldberg makes the case for a mix of both index and active funds.  Research shows that active fund mangers do better when an index does poorly.  It’s worth a read.

The index fund giant Vanguard is featured in a NY times article. John Bogle founded Vanguard based on his thesis that a passive approach to investing and low fees would reward most investors over the long term.


Correlation, not Causation

When the stock market crashed in 1929, the unemployment rate was less than 3%.  A booming economy during the 1920s lifted demand for labor, while severe immigration restrictions enacted in 1924 reduced the supply of workers.


The unemployment rate was 6% when the market crashed in October 1987 and again in September 2008. There seems to be a weak connection between unemployment and severe market crashes.  However, there is a consistent correlation between the change in number of unemployed and the start of recessions.


A yearly increase in the number of unemployed on a percentage basis indicates a fundamental weakness in the economy.  Sometimes, the change reverses as it did in early 1996, at the start of the dot com boom, or in the mid-eighties after a downturn in oil and housing exposed a banking scandal. These two periods are circled in blue in the graph above.

Often the economy continues to weaken, more people lose their jobs, GDP falters and the economy slides into depression.

Because we cannot rely on just one indicator as a warning signal, we can chart the amount of production generated by each person in the labor force.  The civilian labor force includes both those who are working and those who are actively looking for work.  A growth rate below 1% indicates some weakness.  Using both the change in unemployment and the change in production helps filter out some of the noise.

While production growth may be faltering, the current unemployment level is not worrying.


Pay Attention to the Pros

Institutional buyers and sellers of Treasury bonds will usually let the rest of us know when they are worried about a recession.  In a middling to healthy economy, Treasury buyers will demand a higher interest rate for a longer dated bond.  Subtracting the interest rate on a shorter term two year bond from a long term ten year bond should be positive.  In a “normal” environment, a 10 year bond might have an interest rate of 3% and a two year bond an interest rate of 1%.  The difference of 2% would be expected.  However, a negative result indicates that buyers want more interest from short term bonds because they are more concerned about short term risks.  As we can see in the chart below, a negative result precedes a recession by 12 to 18 months.  The current difference shows no indication of concern.

Guessing the future is not divination, nor is it perfect.  Retail investors may not have the time or expertise to estimate future risk, but we can study those who make it their business to manage risk.

The Long Game

April 16, 2017

Happy Easter!

Successful investing requires a far sighted vision. At the end of each year Vanguard sends its customers their long term outlook. This last one contained a few caveats: “the investment environment for the next five years may prove more challenging than the previous five, underscoring the need for discipline, reasonable expectations, and low-cost strategies.”

Vanguard’s ten year estimate of annualized returns is about 8% for non-US equities, 6.5 – 7% for the US stock market, 5% for REITs (real estate) and commodities, and 2% for bonds.

Vanguard’s team projects that a diversified portfolio of 60% stocks/ 40% bonds will return 5.6% annually over the next ten years. An agressive 80/20 mix they estimate at a 6.6% return, and a very conservative 20/80 mix at about 3.3%. Insurance companies typically adopt this safe approach. (Source)



Investors near or in retirement must often turn to their investments for supplemental income. Annuities are sold as a safe “set it and forget it” solution, but they come with upfront fees and currently pay low interest.

In early 2008, before the fianncial crisis, a 65 year old man could get an average annuity (the average of a 10 year and life) for 5.5% a year. That provided a guaranteed income that was more than the classic 4% “safe” withdrawal rate for retirees. That 4% withdrawal rule would normally ensure that a retiree did not run out of money before they died.

The average annuity rate for that same age is now half that interest rate (Source). For an investment of $100K, a 67 year old male living in Colorado can get a lifetime annuity of $7212 per year (CNN Annuity Calculator) For 14 years, the insurance company providing the annuity is essentially returning the investor’s money to them. If that male investor lived for 20 years till age 87, they would receive a total of $144K, an annual return of only 1.84%. If the retiree lived to 97, their annualized return would increase to 2.5% over the thirty year period. Clearly, an investor is paying for safety.

Wade Pfau is a CFP whom I have cited in previous blogs. Here he compares the advantages and disadvantages of investments vs. insurance. He makes an argument that an annuity that covers one’s essential needs allows a person to take more risk with the rest of their portfolio. The potentially higher return from the investment side of the portfolio can thus make up for the lower returns of the annuity, an insurance product. He does caution, however, that most annuities do not protect against inflatiion. A investor who needed $1000 extra dollars in monthly income in 2017, would need more than $2000 in 30 years at a 2.5% inflation rate.

Managed Payout?

One alternative is a managed payout fund. The Vanguard Managed Payout Fund VPGDX lists the fund’s holdings as 60% stocks with an almost 20% allocation to alternative strategies. Alternatives vary in volatility depending on the intent of the investment but let’s treat them as though they were mostly a stock, giving the fund a simple effective allocation of 75% stock, 25% bonds. This fund lost 43% from April 2008 through March 2009, less than the 50% loss of the SP500 index but not by much. A broad composite of bonds (BND) actually gained 3% in price during that time. Here is some info from the investing giant Black Rock on alternative investments.

The return of the fund since its inception in April 2008 is 4.28%. Vanguard’s broad bond composite fund VBMFX, with far less risk, had a ten year return of 4.12% and gained value during the financial crisis. Although some mutual funds have trade restrictions, the prospectus on this fund lists no such restrictions, so that one could set up a monthly withdrawal from the fund.

A Vanguard target date 2030 fund (VTHRX), which has an allocation of 70% stocks, 30% bonds, had a ten year return of 5.31%. That fund lost 45% during the eleven month downturn in 2008-2009, slightly more than the Managed Payout Fund.  The additional 1% annual return is the reward for that slightly greater drawdown. A 1/4 of that additional 1% return can be attributed to lower fees.

The advantage of a Managed Payout Fund – simplicity and regularity of income flows – does not outweigh the disadvantages of volatility and some tax inefficiency. An investor could conveniently set up a monthly withdrawal from a broad based bond fund and enjoy the same return with much greater safety of principal, lower fees, and control over the withdrawal amount, if needed.

When it comes to retirement income, most investors would prefer the simple arithmetic of our grade school years.  Both Social Security and traditional defined benefit pension programs use that kind of math.  Each year, a retiree gets ‘X’ amount that is adjusted for inflation.  No choices needed.  However, most employees today have defined contribution, not benefit, plans. A retiree owns their savings, the capital base used to generate that monthly income, and it is up to the retiree to  navigate the winding channel between risk and return.

Dance of Debt

April 9th, 2017

Last week I wrote about the dance of household, corporate and government debt. When the growth of one member of this trinity is flat, the other two increase. Since the financial crisis the federal debt has increased by $10 trillion. Let’s look at the annual interest rate that the Federal government has paid on its marketable debt of Treasuries. This doesn’t include what is called interagency debt where one part of the government borrows from another. Social Security funds is the major example.

In 2016, the Federal government paid $240 billion in interest, an average rate of 1.7% on $14 trillion in publicly held debt. Only during WW2 has the Federal government paid an effective interest rate that is as low as it today. World War 2 was an extraordinary circumstance that justified an enormous debt. Following the war, politicians increased taxes on households and businesses to reduce the debt. Here is a graph of the net interest rate paid by the Federal government since 1940.


In 2008, before the run up in debt, the interest rate on the debt was 4.8%. If we were to pay that rate in 2017, the interest would total $672 billion, more than the defense budget. Even at a measly 3%, the interest would be $420 billion.  That is $180 billion greater than the interest paid in 2016.  That money can’t be spent on households, or highways, or education or scientific research.

The early 1990s were filled with political arguments about the debt because the interest paid each year was crippling so many other programs. Presidential candidate Ross Perot made the debt his central platform and took 20% of the vote, more than any independent candidate since Teddy Roosevelt eighty years earlier. Debt matters. In 1994, Republicans took over Congress after 40 years of Democratic rule on the promise that Republicans would be more fiscally responsible. In the chart below, we can see the interest expense each year as a percent of federal expenses.


Let’s turn again to corporate debt. As I showed last week, corporate debt has doubled in the past ten years.


In December, the analytics company FactSet reported (PDF) that the net debt to earnings ratio of the SP500 (ex-financials) had set another all time high of 1.88. Debt is almost twice the amount of earnings before interest, taxes, debt and amortization (EBITDA). Some financial reporters (here, for example ) use the debt-to-earnings ratio for the entire SP500, including financial companies. Financial companies were highly leveraged with debt before the crisis. In the aftermath and bailout, deleveraging in the financial industry effectively hides the growth of debt by non-financial companies.

What does that tell us? Unable to grow profits at a rate that will satisfy stockholders, corporations have borrowed money to buy back shares. Profits are divided among fewer shares so that the earnings per share increases and the price to earnings (profit), or P/E ratio, looks lower. Corporations have traded stockholder equity for debt, one of the many incidental results of the Fed’s zero interest rate policy for the past eight years.

Encouraged by low interest rates, corporations have gorged on debt. In 2010, the pharmaceutical giant Johnson and Johnson was able to borrow money at a cheaper rate than the Federal government, a sign of the greater trust that investors had in Johnson and Johnson at that time.

Other financial leverage ratios are flashing caution signals, prompting a subdued comment in the latest Federal Reserve minutes ( PDF ) “some standard measures of valuations [are] above historical norms.” Doesn’t sound too concerning, does it?

Each period of optimistic valuation is marked by a belief in some idea. When the bedrock of that idea cracks, doubts grow then form a chasm which swallows trillions of dollars of marketable value.

The belief could be this: passively managed index funds inevitably outperform actively managed funds. What is the difference? Here’s  a one-page comparison table. In 1991, William Sharpe, creator of the Sharpe ratio used to evaluate stocks, made a simple, short case for the assertion that passive will outperform active.

During the post-crisis recovery, passive funds have clearly outperformed active funds. Investors continue to transfer money from active funds and ETFs into index funds and ETFs. What happens when a smaller pool of active managers make buy and sell decisions on stocks, and an ever larger pool of index funds simply copy those decisions? The decisions of those active managers are leveraged by the index funds. Will this be the bedrock belief that implodes? I have no idea.

Market tensions are a normal state of affairs. What is a market tension? A conflict in pricing and risk that makes investors hesitate as though the market had posed a riddle. Perhaps the easiest way to explain these tensions is to give a few examples.

1. Stocks are overvalued but bond prices are likely to go down as interest rates rise. The latest minutes from the Fed indicated that they will start winding down their portfolio of bonds. What this means is that when a Treasury bond matures, they will no longer buy another bond to replace the maturing bond. That lack of bond purchasing will dampen bond prices. Stocks, bonds or cash? Tension.

2. Are there other alternatives? Gold (GLD) is down 50% from its highs several years ago. Inflation in most of the developing world looks rather tame so there is unlikely to be an upsurge in demand for gold. However, a lot of political unrest in the Eurozone could drive investors into gold as a protection against a decline in the euro. Tension.

3. What about real estate? After a run up in 2014, prices in a broad basket (VNQ) of real estate companies has been flat for two years. A consolidation before another surge? However, there is a lot of debt which will put pressure on profits as interest rates go up. Tension.

In the aftermath of the financial crisis, we discovered that financial companies, banks, mortgage brokers and ordinary people resolved market tensions through fraud, a lack of caution, and magical thinking. Investors can only hope that there is enough oversight now, that the memories of the crisis are still fresh enough that plain old good sense will prevail.

During the present seven year recovery there have been four price corrections in the Sp500 (Yardeni PDF). A correction is a drop in price of 10 – 20%. The last one was in the beginning of 2016. Contrast this current bull market with the one in the 2000s, when there was only one correction. That one occurred almost immediately after the bear market ended in the fall of 2002. It was really just a part of the bear market. From early 2003 till the fall of 2007, a period of 4-1/2 years, there was no correction, no relief valve for market tensions.

Despite the four corrections and six mini-corrections (5 – 10%) during this recovery, the inflation adjusted price of the SP500 is 50% higher than the index in the beginning of 2007, near the height of the market.  Inflation adjusted sales per share have stayed rather stable and that can be a key metric in the late stages of a bull market. The current price to sales (P/S) ratio is almost as high as at the peak of the dot com boom in 2000 and that ratio may prove to be the better guide. In a December 2007 report, Hussman Funds sounded a warning based on P/S ratios.  Nine years later, this report will help a reader wanting to understand the valuation cycles of the past sixty years.

Confidence Up

April 2nd, 2017

The Conference Board’s survey of Consumer Confidence shot up to 125, a 16 year high. Unfortunately, that previous high was set as the dot-com frenzy was nearing its end and just before the start of the 2001 recession. History could not possibly repeat itself, could it?


There have been other frenzies in the past decades: the dot-com boom of the late ’90s, the housing and consumer debt boom of the ’00s, the run up in gold prices in the ’10s, the spike in interest rates in the late ’70s – eary ’80s. In the rear view mirror, the correction seems predictable.

From 1995 – 2000, the SP500 index tripled on the giddy expectations of a new global internet economy. Here was the plan: global supply chains spread among developing countries would assemble products which would be shipped to markets around the world. The U.S. and other developed countries could steer the global economy to new heights, and rid themselves of the nasty pollution that comes from manufacturing stuff.

Then, the new global digital economy went oops…

After falling back about 40%, the index then doubled from early 2003 through 2007. During that five year period, the house price index grew 40%, more than double its annual growth rate for the past century. In the old mortgage model, a lender would take a risk on the fortunes and reliability of a single family to repay a mortgage. Now, through the power of computerized algorithms, that risk could be sliced and diced so thin and spread among so many synthetic mortgages that the risk virtually disappeared. The smart people in the financial industry had finally figured out the secret to securitized debt. Every family could now build wealth by owning a home. Oh, happy days!

Then, housing went oops….

As the financial crisis gripped most of the developed world, central banks took on vast quantities of debt and expanded the money supply to counteract a slide into a global depression. Expanding the money supply usually brings an increase in inflation, and to protect against that coming inflation, investors around the world turned to gold. From the depths of the financial crisis in early 2009 toward the latter part of 2011, a period of less than 3 years, the price of gold doubled. But inflation did not rise as expected. The central banks had simply been fighting a strong undercurrent of deflation, stronger than even they had realized.

As inflation remained low, gold went oops….

The trick is to figure out beforehand what will go oops next. The pattern is this: an increasing number of people become convinced of “X” idea and begin to take it for granted. Then some series of events undermines a belief in “X” and the stampede begins. The massive increase in sovereign debt looks like a prime candidate for default and debacle but the central banks of developed countries have many legal and financial tools at their disposal to stem any panics.

For a dominant economic power like the U.S., the “X” has traditionally been based on private debt whose value can not be easily controlled by government dictate. In the late 90s, it was technology. Most of us associate that period with wildly inflated stock prices and IPOs that jumped in price on opening day. What may have escaped our attention is that corporate debt increased by almost 60% from the beginning of 1995 to the end of 2000. When the towers came down on 9-11, corporate debt had grown 75%. From early 2002 through 2005, there was no growth in corporate debt.

As corporate debt grew in the late 90s, government debt decreased. As corporate debt growth stopped in the early ’00s, household debt and government debt surged upwards. So let’s keep our eyes on this dance of corporate, household and government debt.


Since the financial and housing crisis that began in 2008, federal govt debt has doubled, while household debt declined. It has taken eight years for household debt to finally surpass its 2008 high water mark, and is now approaching $15 trillion.

Since 2006, corporate debt has almost doubled. It is my guess that this is where the next crisis lies.


After the next crisis, we will look back and see that there was such an obvious over-confidence in that “X.”  Analysts will help us understand the details and unfolding of the crisis till we think that we can avoid it next time.  Like whack-a-mole, the next crisis will pop up from another hidey hole.  The trick is to have several smaller hammers instead of one big hammer.