Stormy Seas

December 23, 2018

by Steve Stofka

For the past two months, the stock market’s volatility has doubled from late summer levels. The Fed announced its intent to continue raising interest rates in 2019 at least two times, and the market nosedived in response. It had been expecting a more dovish policy outlook from Chair Jerome Powell.

What does it mean when someone says the Fed is dovish, or hawkish? Congress has given the Fed two mandates: to manage interest rates and the availability of credit to achieve low unemployment and low inflation. That goal should be unattainable. In an economic model called the Phillips curve, unemployment and inflation ride an economic see-saw. One goes up and the other goes down. To rephrase that mandate: the Fed’s job is to keep unemployment as low as possible without causing inflation to rise above a target level, which the Fed has set at 2%.

There are periods when the relationship modeled by the Phillips curve breaks down. During the 1970s, the country experienced both high unemployment and high inflation, a phenomenon called stagflation. During the 2010s, we have experienced the opposite – low inflation and low unemployment, the unattainable goal.

Convinced that low unemployment will inevitably spark higher inflation, the Fed has been raising interest rates for the past two years. The base rate has increased from ¼% to 2-1/2%. The thirty-year average is 3.15%. Using a model called the Taylor Rule, the interest rate should be 4.12% (Note #1).  After being bottle fed low interest rates by the Fed for the past decade, the stock market threw a temper tantrum this past week when the Fed indicated that it might raise interest rates to average over the next year. Average has become unacceptable.


In weighing the two factors, unemployment and inflation, the Fed is dovish when they give greater importance to unemployment in setting interest rates. They are hawkish when they are more concerned with inflation. The Fed predicts that unemployment will gradually decrease to 3.5% this coming year. Unemployment directly affects a small percentage of the population. Inflation affects everyone. The Fed’s current policy stance is warily watching for rising inflation.

The stock market is a prediction machine that not only guesses future profits, but also other people’s guesses of future profits. As the market twists and turns through this tangle of predictions, should the casual investor hide their savings in their mattress?

These past five years may be the last of a bull market in stocks; 2008 – 2012 was the five-year period that marked the end of the last bull period that began in 2003 and ran through most of 2007. Here are some comparisons:

From 2014-2018, a mix of stocks returned 7.7% per year (Note #2). A mix of bonds and cash returned 1.96%. A blend of those two mixes returned 4.91% per year.

From 2008-2012, that same stock mix returned just 2.66% per year. The bond and cash mix returned 5.5%, despite very low interest rates. A blend of the stock and bond mixes returned 5.26%.

For the ten-year period 2008 thru 2017, the stock mix earned 7.7%. The bond and cash mix returned 3.54% and the blend of the two gained 6.35% annually. On a $100 invested in 2008, the stock mix returned $13.5 more than the blend of stocks and bonds. However, the maximum draw down was wrenching – more than 50%. The $100 invested in January 2008 was worth only $49 a year later. Whether they needed the money or not, some people could not sleep well with those kinds of paper losses and sold their stock holdings near the lows.

The blend of stock and bond mixes lost only a quarter of its value in that fourteen-month period from the beginning of 2008 to the market low in the beginning of March 2009. The trade-off between risk and reward is an individual decision that weighs a person’s temperament, their outlook, and the need for to tap their savings in the next few years.

A rough ride in stormy seas tests our mettle. During the market’s rise the past eight years, we might have told ourselves that our stock allocation was fine because we didn’t need the money for at least five years.  If we are not sleeping because we worry what the market will do tomorrow, then we might want to lower our stock allocation. Sleeping well is a test of our portfolio balance.


1. The Atlanta Fed’s Taylor Rule calculator
2. Calculations from Portfolio Visualizer: 30% SP500, 30% small-cap, 20% mid-cap, 20% emerging markets. Bond mix: 70% intermediate term investment grade bonds, 30% cash. The blend of the two was half of each percentage: 15% SP500, 15% small-cap, 10% mid-cap, 10% emerging markets, 35% bonds, 15% cash.

Ugly January

January 17, 2016

The ever-strengthening dollar and growing inventories of crude led to a plunge in the price of a barrel of West Texas Intermediate (WTI) which fell below $30.  I remember hearing some analyst on Bloomberg about a year ago saying that oil prices could go as low as the $20 range.  HaHaHaHa!  A popular basket of oil stocks, XLE, is about half of it’s July 2014 price, falling 25% in the past two months and almost 10% in the two weeks. Here’s a tidbit from the latest Fact Set earnings brief: “On September 30, the estimated earnings decline for the Energy sector for Q1 2016 was -17.7%. Today, it stands at -56.1%.”  Ouch!

Volume in energy stocks this week was more than double the three month average.  It smells like capitulation, that point when a lot of investors have left the theater.  Investors who do believe that the theater is on fire, as it was in 2008, should probably stay away.

What the heck is going on?  This Business Insider article from June 2015 (yes, six months ago) explains and forecasts the money outflows from China and emerging markets.  Pay particular attention to #4. This Bloomberg article from this week confirms the capital flight from China as investors anticipate a further devaluing of the yuan.

4th quarter earnings reports will begin in earnest in the following week.  If there are disappointments, that will magnify the already negative sentiment.


Death Cross

No, it’s not the title of a Fellini movie.  The merits of technical analysis can be more controversial than a Republican Presidential debate, but here goes.   The 50 day average of the SP500 crossed above the 200 day average, a Golden Cross, at Christmas, then crossed back below the longer average this week, a Death Cross.  A Golden Cross is a positive sign of investor sentiment.  The Death Cross is self-explanatory.  A crossing above, then below, happens infrequently – very infrequently.  The last two times were in 1960 and 1969 and the following months were negative.  After January 1960, the market stayed relatively flat for a year.  In June 1969, it marked the beginning of an 18 month downturn.  There was an almost Golden Cross followed by a Death Cross in May 2002.  A similar 18 month downturn followed.

Longer term investors might use a 6 month short term average and an 18 month longer average, selling when the 6 month crosses below the 18 month, buying back in when the one month (or 6 month average in the case of more volatile sector ETFs) crosses back above the longer average. Like any trading system, one takes the risk of losing a small amount sometimes but avoids losing big.

Trading signals are infrequent using monthly average prices.  Note that the sharp downturn of the 1998 Asian financial crisis did not trigger a sell signal.  The six month average of the SP500 as a broad composite of investor sentiment is above the 18 month average but several sectors have been sells for several months: Emerging markets (June and July 2015), Energy stocks (January 2015), and European stocks (August 2015).  Industrials (XLI) have taken a beating this month and will probably give a sell signal at the end of the month.

John Bogle, founder of Vanguard, recommends that long term investors look at their statement once a year and rebalance to meet their target allocation, one that is suitable for their age, needs and tolerance for risk.  In that case, don’t look at your January statement.  As I wrote a few weeks ago, it could look ugly.



In 1998, the Boskin Commission estimated that the Consumer Price Index (CPI) over-estimates the rate of inflation by an average of 1.1%. In 2000, the NBER (the agency that determines recessions) revised their methodology and their estimate of the over-statement to .65%.  In 2006, Robert Gordon, a member of the original committee, re-examined subsequent CPI data and the methods used by the committee.  His analysis re-asserted that the over-statement was at least 1%.

Although this academic debate might seem arcane, the implications are enormous, particularly in an election year.  Presidential contender Bernie Sanders is gaining momentum on Hillary Clinton (HRC) by repeatedly asserting that the inflation-adjusted incomes of working families have declined since 1973.  Although Mr. Sanders makes no proposals to stimulate economic growth, he has many redistribution plans to achieve economic justice.  If inflation has been overstated for the past few decades, then Mr. Sanders’ argument is logically weak but emotionally strong.  More importantly, neither side of the political aisle can even agree on a common set of facts.  The other side is not evil, or stupid, or disingenuous. The disagreement over methodology is legitimate and ongoing.