Why Stock Markets Crash

By Path Financial President and Chief Investment Officer Raul Elizalde

todays imageWatching how paint dries is not most people’s idea of fun. Nor is watching a sandpile grow, grain by grain. Or is it?

Scientists are not like most people. Some became quite intrigued by what happens to a sandpile as it grows. Their exploration led to break-through insights about stock market risk.

The bottom line: As a sandpile grows, all sort of sand “avalanches” take place, but it is impossible to predict how big or how often they occur. Sometimes a few grains roll down the slope, while occasionally a large avalanche carves a big section of the sandpile. The size and frequency of those avalanches, mathematically speaking, bear a notable resemblance to the size and frequency of earthquakes, solar flares, river floods, forest fires, and stock market returns. Intriguingly, all of them have defied attempts at prediction. The question is why.

    Are market crashes inevitable?

One disconcerting aspect is that large avalanches, epic earthquakes or giant forest fires do not seem to be very special: They appear to be just less frequent, scaled-up versions of small ones. If this is true, then a stock market crash may not be special at all, but merely a larger-than-usual down day, and just as unpredictable. This would present a big challenge to traditional investment methods.

The sandpile study was introduced in a 1987 paper by Per Bak, Chao Tang and Kurt Wiesenfeld, three scientists working at the Physics Department at the Brookhaven National Laboratory. Ironically, the paper was presented to Physical Review Letters a few months before the stock market crash of October 1987, still today the largest ever one-day drop. The title was “Self-Organized Criticality” and falls within a branch of mathematics known as Complexity Theory, which studies how systems can organize themselves into unexpected behaviors arising from the interaction of its smallest and seemingly independent components.

The crucial point of their paper was that sandpile avalanches could not be predicted, and not because of randomness (there was no random component in their model) or because the authors could not figure out how to come up with equations to describe it. Rather, they found it impossible in a fundamental sense to set up equations that would describe the sandpile model analytically, so there was no way to predict what the sandpile would do. The only way to observe its behavior was to set up the model in a computer and let it run.

Likewise, stock prices have defeated all forecasting efforts, and may well belong to the same set of basic unpredictability. While occasionally somebody may seem to be on the right side of an investment ahead of a big move, this is a far cry from actually forecasting such move with any kind of precision in terms of timing and size. For each “hunch” that is successful, a myriad others fail. Despite anecdotes, there seems to be no clear evidence that investors who get a big move “right” are anything but lucky.

    Can we tell if a bubble is about to burst?

Other scientists disagree with this notion, and note that market crashes are indeed “special.” Professor Didier Sornette, for example, a physicist at the Swiss Federal Institute of Technology, argued that a market crash is not simply a scaled-up version of a normal down day but a true outlier to market behavior. In fact, he claims that ahead of critical points the market starts giving off some clues. His work focuses on interpreting these clues and identify when a bubble may be forming and, crucially, when it ends.

He made the interesting observation that bubbles do not necessarily form in steady, long bull markets. For a bubble to form, price gains have to accelerate at a “super-exponential” rate.

It is well documented that prices tend to go up faster before a crash. This may seem counter-intuitive, but it makes sense in terms of “rational expectations.” For investors to remain invested in a market that is becoming more risky, prices have to rise faster in order to compensate for the growing probability of a crash. Otherwise, people would exit the market earlier and a bubble would never form.

This also means that it is a mistake to think of investors as a bunch of clueless, greed-driven lemmings falling off a cliff during a market crash. For example, during the real estate boom of the mid-2000s people kept buying homes despite an abundance of media articles pointing out that the property market was swept in a mania. There was no question, even then, that the market was overheated. So why did people continue to buy homes?

In Professor Sornette’s model, a bubble is a market heading to a critical point. But a crash is not the only possible post-crisis outcome: Prices can also stop rising and reach a higher plateau. It is precisely because of the small but real probability that a bubble will not crash but simply stop growing that it is rational for some investors to stay in the market, even when if they think that it has gone too far, too fast.

The critical point where bubbles end happens as investors begin to think that the rally is over. It is when this opinion travels deep into the system and becomes generalized that the system ends up in a crash. The paradox here is that a crash is often (and mistakenly) characterized as “market chaos.” In fact, it is the opposite: a crash reflects a highly ordered market, when everyone does the same thing (i.e. sell). A truly “chaotic” market is one where everyone is doing something different, interactions offset each other and price volatility remains low.

    Real-life and computer simulations

A truly stunning result of these investigations is that the real-life frequency and size of market returns bear a notable resemblance to what is obtained by running very simple computer models. This also goes for earthquakes, solar flares, forest fires, and river floods: most of the simulations yield similar results to real life where events are frequent but small, but occasionally some gigantic one appears from nowhere.

spot the fake

Whether Professor Sornette is right or not that a critical point can be anticipated, the entire concept of market self-organization deals a blow to the “fundamental” approach to investing in equity markets – the idea that opinion-based research can lead to investment success when it seems quite apparent that outcomes cannot be predicted even when initial conditions are known.

While this is a radical statement, some investors seem to agree – they have been abandoning active mutual funds for years, while embracing index-tracking ETFs. This is rational because if markets are truly unpredictable, then it is a waste to pay any manager for their forecasts when they are unlikely to beat an index other than by luck.

    Hindsight is not foresight

One of the best illustrations of the trouble with “fundamental” analysis appears in the book Ubiquity by Mark Buchanan (another physicist interested in complexity theory). He imagines how an analyst of the sandpile world might write about an avalanche:

“The trouble began a week ago in the West, where in the early evening a single grain of sand fell on a portion of our pile that was already very steep. This triggered a small avalanche, as a few grains toppled downhill toward the East. Unfortunately, the pile hasn’t been managed properly in the West, and these few grains entered into another region of the pile that was also already steep. Soon more grains toppled and throughout the night the avalanche grew in size; by the next morning, it was well out of control. In retrospect, there is nothing surprising. One fateful grain falling a week ago led to a chain of events that swept catastrophe across the pile and into our own backyard here in the East. Had the Western authorities been more responsible, they could have removed some sand from the initial spot, and then none of this would have happened. It is a tragedy that we can only hope will never be repeated.”

This is a remarkable passage because it resembles closely what one would read in an opinion-based analysis of a market event. The confusing illusion, of course, is that hindsight narratives of this kind could offer anything towards avoiding, let alone preventing, future disasters. In reality, no amount of knowledge of a sandpile system can possibly produce a usable forecast of the size and location of a major avalanche. It may be the same with a stock market crash.

It is not a big surprise, however, that many investors today remain interested in the forecasts of financial analysts regardless of their success. Humans in the past consulted oracles, crystal balls and tea leaves. It’s in our nature: As the proverb goes, “tell me a fact, and I’ll learn; tell me a truth, and I’ll believe; but tell me a story and it will live in my heart forever.” We are attracted to story-telling, and when it comes to investing we seem to be searching for the most compelling narratives about the unknowable future, regardless of how accurate they turn out to be.

    What investors can do

To be sure, we have made progress on many fronts. The weather, for example, is a system where we can now produce short-term, usable forecasts. But other systems have, at least so far, remained maddeningly unpredictable, such as earthquakes, forest fires, and stock markets. Their complexity keeps them out of our reach.

This does not mean that successful investing is impossible; only that the more we learn about market behavior, the more it seems that trying to deal with uncertainty is more important than pretending that we can have any certainty. More precisely, managing risk seems to be a better approach to investing than concocting forecasts on asset returns. This could mean, for example, finding ways of identifying when market participants start to align on one side of a trade by measuring correlations, or measuring returns to flash a warning when they start growing at “super-exponential” rates.

These are difficult concepts, and it is doubtful that investors will embrace them anytime soon. But it seems safe to assume that traditional investment approaches will continue to do little to protect investors from catastrophes that keep showing up from time to time.


This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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New Crisis Is Brewing 10 Years After Last One And Why That’s No Surprise

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageThe financial crisis of 2008-2009 was no ordinary crisis. It brought the U.S. banking system to its knees, destroyed millions of jobs, and nearly caused the break-up of the Eurozone. And this is just a short list of the damage it caused. Given how bad it was, it may have been reasonable to expect that we would now have a system in place to prevent another debacle. But ten years have passed and the idea that we have learned our lessons seems at best quaint and at worst laughable.

One of the most basic lessons not learned is that a massive buildup of debt tends to end in a serious financial crisis. Even a small liquidity event that gets in the way of rolling over higher and higher amounts of debt eventually brings down the whole edifice.

This is not a revelation. Even the Tulip Mania of the 1630s that ended up in a crash was fueled by a huge increase in leverage created by tulip “futures.” Most recent debacles such as the 1982 Latin American debt crisis, the 1990 Savings & Loan crisis, the 1990 Japan crash and the 1997 Asian crisis can all be traced to out-of-control credit growth. And, of course, the 2008 crisis had at its core an exponential chain of leverage built around mortgage derivatives.

In the aftermath of the 2008 crisis, a river of ink was spilled to condemn the runaway debt spiral that led to it. It is remarkably ironic, then, that as we crawl out of ten painful years of struggle and recovery, even the most outspoken fiscal hawks of that time now seem unconcerned that debt is growing apace once more.

This is, alas, not surprising. As Prof. Richard Kindleberger from MIT put it in his 1978 classic book “Manias, Panics and Crashes” some time has to pass after a crisis “before investors have sufficiently recovered from their losses and disillusionment to be willing to take a flyer again.” Ten years, it seems, qualifies as enough time for the party to resume.

Despite an economy that by all measures has recovered well, if not spectacularly, the U.S. has just decided to unleash a large and most likely unnecessary fiscal stimulus that will bloat public debt and fiscal deficits. But government is not alone in abandoning prudence. The private sector, spurred by rock-bottom interest rates, has gorged on debt. This is true not only in the U.S. but also across the globe.

Three areas, in particular, point to areas where credit expansion may be growing at unhealthy rates.

Fiscal deficits

The Congressional Budget Office projects the fiscal deficit to double to 5% of GDP from 2015 levels, and federal debt, as a result, to grow to nearly 100 percent of GDP by 2028 from the current 75%. And these are just projections; the actual deficit numbers for this year are looking even worse. Indeed, the 2018 FY projection (which ends in September) is for a deficit of $804BN, but we already racked up $898BN in the eleven months that ended in August.


Private debt

Corporations everywhere took advantage of interest rates at all-time lows, borrowing as much as they could in the last few years. Many companies in the U.S. used the proceeds to buy back their own stocks.


The amounts are staggering. According to a report by the McKinsey Global Institute, corporate bonds around the world issued by non-financial companies have almost tripled since 2007 from $4.7 TN to $11.7TN. Of particular concern is that the largest credit category of overall corporate debt (loans, bonds and credit lines) and the one that grew the fastest is BBB, sitting just above the edge of “junk.”


Most of the outstanding corporate debt instruments (Includes bonds, loans, and revolving credit facilities rated by S&P Global Ratings from financial and non-financial issuers) are at the bottom of the investment grade tier.S&P Global Fixed Income Research, Path Financial LLC

Higher interest rates or a slower economy may affect the ability of any given company to service, roll over or repay that debt, which then leads to a downgrade into the “non-investment grade” (i.e. junk) category. This, in turn, forces some bondholders to liquidate their holdings. If this goes beyond an isolated event, the risk of downgrades snowballing into a liquidity crisis becomes real.

Margin debt

The 1929 stock market crash was driven, in part, by a speculative mania that relied heavily on borrowed funds to buy stocks. While today’s margin debt levels are a far cry from those heady days when it reached more than 8% of GDP, it is now at its highest level in decades.


History shows that beyond a certain level, debt burdens become too heavy to bear. It is not clear what that level might be, when it will happen, or how severe a crisis could get.

There are some mitigating factors today, such as a less-interconnected global economy (yes, there is an upside to less globalization) that limits avenues of contagion, and a better-capitalized banking system that seems better prepared to deal with a systemic crisis.

In addition, the relatively fast economic growth that the U.S. is experiencing, although brought about by the same fiscal expansion that is bloating debt levels, offers a good opportunity to get serious and put in place policies that can help us deal better with future crises. This is to say that it is not yet too late to avert a repeat of the 2008 disaster – if only we embrace the lessons of the past.


This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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This Is Not the Longest Bull Market Ever

By Path Financial President and Chief Investment Officer Raul Elizalde

bear and bull for blogMany media stories declared that the stock market broke the record for longevity on August 22, 2018. This would be quite an achievement if it were true. Alas, it is not.

As FINRA (the Financial Industry Regulatory Authority) has noted, the longest run belongs to the 12 1/2-year period running from October 1987 through March 2000. The current bull market, which started in 2009, will need to run through 2021 to break that record.

Part of the problem is that defining a bull market is difficult.

A bull market is loosely understood as a period during which stocks keep going up without falling more than 20%. What, then, are we to make of the period between July 16 and October 11, 1990, when the S&P 500 fell 19.9% from its peak? Some analysts round the plunge up to 20% and declare that day the end of that bull market, which then makes the current rally the longest. But those are not quite the “rules”, at least according to FINRA.

Another problem is that is not easy to define a “bear market” either. Does a bear market start right after the 20% decline is reached, or is it measured from the previous high? After the 20% plunge, most analysts backtrack to the day of the previous high and mark that date as the beginning of the bear market. But doing so leaves a weird intermediate period that is part both of a bull and a bear market, as in the graph below. So when does the bull market actually end?


All-time highs are perhaps more meaningful milestones. For the S&P 500, that was the close of 2872.27 on January 26, 2018 and it is still the highest at the time of this writing. But one could also make the case that such level should be adjusted for inflation, for example, or that the intra-day high, not the close, should be viewed as the record.

And whether the market index is really a good proxy for the whole market is hard to say, especially when companies like Amazon, Apple or Alphabet account for such large percentage of the index itself. The market index could be reaching a record level just on the advance of a few large companies, rather than on a general tide lifting all stocks.

The simple fact is that the stock market has been going up for quite a while, but no milestone was reached on August 22, 2018 that has any meaning – not more meaning, in fact, than when market indices reach a round number, like 25,000 for the DJIA or 2800 for the S&P 500. Those are just numbers.

A more important measurement may be the longevity of economic growth. According to the designation of expansions and contractions of the National Bureau of Economic Research (NBER), the U.S. economy has been growing since June 2009.

At 110 months, the current expansion is the second longest in the nation’s history, after the 120-month growth streak recorded between March 1991 and March 2001. The economy will have to grow past June 2019 to surpass it, and there are many questions about whether it can get that far.

Whether the stock market has gone up longer than ever is a question neither relevant not answerable with any precision. What is more important is that the longer it goes, the closer the time when it will meet its inevitable end.

Unfortunately, market participants tend to see higher prices and bull-market longevity as a sign that staying in the game is more important than protecting gains. This could be imprudent. Given that investors are at the mercy of whatever the market does, they should remember that not falling into complacency is one of the few things that they can actually control.


This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Here’s Why Stocks Should Be Higher, And Why They Are Not

By Path Financial President and Chief Investment Officer Raul Elizalde

Photographer: Michael Nagle/Bloomberg

Photographer: Michael Nagle/Bloomberg

The stock market is close to record highs, and given how well everything seems to be going, they should have blasted through those records. Consider this:

• The latest quarterly GDP growth release was the highest since 2014.
• Initial jobless claims as a percentage of total civilian employment are at an all-time low.
• Interest rates are still hovering around the low end of a 100-year range.
• The percentage of companies reporting positive earnings per share surprises is the highest since Standard and Poors started tracking that metric 10 years ago.
• Company repurchases of their own stocks and cash dividends per share are at record levels

Despite these excellent conditions, stocks have been unable to rise above the January highs. Unless they do it soon, it may be time to consider whether stock prices have reached a cyclical peak.

What is keeping stocks from going higher? The only reasonable answer is that the market does not believe today’s conditions are sustainable. Here are some possible reasons:

A global trade war

According to a great number of observers this is probably the biggest threat to global growth. It started when the U.S. imposed tariffs on Chinese imports in late January, and it has escalated since then between the U.S. and China, but eased between the U.S. and other partners in the West, like Canada and the European Union.

Data, however, does not show any negative effect from the trade tensions. Research company FactSet compared second-quarter earnings growth for companies that generate more than 50% of sales outside the U.S. against those that generate more than 50% of sales domestically. The first group (with more global exposure) had 32% larger growth (29.4% to 22.2%). Revenue was even more lopsided, with the first group showing 57% larger growth (13.5% to 8.6%). This is not, however, some kind of proof that trade sanctions are actually a boon for global trade. Rather, it could mean that, anticipating escalation, global companies tried to squeeze through more activity during the second quarter in case tensions get worse later on.

Higher rates

The U.S. Federal Reserve has remained firm in its intention to raise rates twice more this year and three times in 2019. This, in turn, has strengthened the U.S. dollar by more than 9% since January – a side effect that is likely to deepen the U.S. trade deficit and exacerbate trade tensions that are already running high. It will also increase the cost of consumer debt such as mortgages.

Waning global growth

The global economy is slowing down. According to the latest IMF World Economic Outlook, “Growth projections have been revised down for the euro area, Japan, and the United Kingdom, reflecting negative surprises to activity in early 2018.” Emerging markets have been hit hard in the last few months, in particular Turkey, whose currency plunged this week, and Venezuela, which is struggling with runaway hyperinflation running at 83,000%.


The political landscape remains complicated. The U.S. midterm elections in November have the potential of changing the policy outlook significantly if, as some predict, the Democratic Party takes control of the U.S. Congress. Additionally, a report on Russian interference in the U.S. elections that Special Counsel Robert Mueller is expected to release in the coming month will certainly weigh on sentiment. Since the investigation has been shrouded in secrecy, any announcement will come as a surprise and has the potential to move markets.

These are just some of the most obvious concerns, but there are others, such as mounting public debt and ballooning fiscal deficit, and a slowdown in real estate sales due to combination of higher home prices, higher mortgage rates and stagnant wages.

Stocks, therefore, are caught up between excellent conditions today and worries about next year’s outlook. This being the case, even if current economic data continues to excel, any break above the record stock prices of January may prove to be short-lived unless the medium-term outlook improves substantially.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Personal Finance Tips for Millennials

By: Oxana Saunders

pigAs Millennials are getting ready to outnumber Baby Boomers by 2019, many young people are still struggling with basic financial concepts. Unless they have a taken finance courses or are fortunate to have parents who made it their priority to get them up to speed on the financial aspects of life, they may run into difficulties that, with a little planning, can be easily avoided.

The article from TaxAct.com, linked below, shares a few relatively easy and simple steps that you can take to improve your financial outlook. If you feel that you need some guidance on your personal finances, please contact us for a free consultation.


6 Investing & Financial Tips for Millennials

Oxana Saunders Vice President Path FinancialOxana Saunders is the Vice President of Path Financial, LLC. She may be reached at 941.894.2571 or oxana@pathfinancial.net.

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Investors Are Main Lenders To U.S. Businesses, But May Not Understand Risks

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageFaced with regulatory constraints and stricter guidelines, bank lending to businesses declined since the financial crisis. The business sector filled the void by issuing bonds, which were quickly swallowed by yield-seeking investors. This amounted to a transfer of lending risk out the banking sector and into the investor class. This is good news for the banks, which are now in better shape, especially in the U.S.. The bad news is that, unlike banks, the investor class has no safeguards if something should go wrong. Also unlike banks, the average bondholder is ill-prepared to ascertain credit risk. And there are signs that the risks bond investors face are increasing.

There is no doubt that the role of investors as lenders to businesses has become more prominent. In the U.S., for example, companies in the non-financial sectors now have well over twice as many bonds than loans outstanding. In Europe, although bonds are not a widespread source of private sector financing, the proportion of bonds still nearly doubled with respect to loans since the financial crisis.

first graph

Another reason to worry is that U.S. corporate bonds rated at BBB by Standard and Poors represent the largest group by far, at 37% of all non-financial corporate bonds outstanding, or $2.7 trillion. This is a credit rating category at the very bottom of the “investment grade” ladder. Bonds downgraded from this BBB category fall to the “non-investment grade” land where many investors are forbidden from entering. Thus, a downgrade that pushes a bond across that divide triggers selling that can drive the bond price even lower.

There is a large wave of bonds maturing in the next five years, which could be as large as $10 trillion globally according to the McKinsey Global Institute report. These bonds will be replaced with new ones that would be more costly if they are issued at higher rates than the ones maturing. This is likely to be the case, since interest rates are going up. Bonds at the threshold of investment grade quality could easily fall into the “junk” world.

There is also the issue of bond liquidity. The McKinsey report reminds us that “buying and selling corporate bonds often requires a phone call to a trading desk at an investment bank, and there is little transparency on the price the buyer is quoted”, a feature that can seriously curtail bond liquidity if a credit event were to take place.

Mutual funds – the largest holders of corporate bonds – can easily withstand the first wave of redemptions with their cash holdings, but because many funds hold similar positions, a selling wave could pose a problem when everyone is on the same side of the trade. Both practitioners and academics like Caitlin Dannhauser of Villanova University and Saeid Hoseinzade of Suffolk University have studied this point in depth.

A liquidity crisis is more likely today, when trading desks at investments banks that used to hold large bond positions are now restricted from doing so. Bond holdings of primary dealers, for example, have steadily declined and are now about a fifth of what they were before the financial crisis, even as the outstanding amount of bonds more than doubled.

Investors are now much more exposed to business lending risk because of their large holdings of corporate bonds, a risk that will increase if economic conditions suffer. While the economy is currently firing on all cylinders, it is vulnerable to the tightening efforts of the Federal Reserve, a slowing global economy and the risk that today’s trade disputes could turn into a full-scale global trade war.

Any of these issues could push some corporate bonds over the non-investment-grade category, severely affecting bond prices. While it is unlikely that bond weakness could turn into a broad crisis, bondholders will be hurt. They need to pay close attention to the risks they face, especially because nobody will be there to help them if their investments sour.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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2 Reasons Why Demand For Stocks Will Fall

By Path Financial President and Chief Investment Officer Raul Elizalde

today imageTwo sources of demand that contributed to driving up stock prices are going away.

Strong buying came in the last few years from the very companies who issued those stocks. Finding it cheaper to borrow money than pay dividends, they issued a large number of corporate bonds and used the proceeds to buy back significant portions of their outstanding shares.

Alongside companies buying stocks were retail investors who just wanted income, but could not find it anywhere as interest rates hovered around historical lows for years.

There are indications, however, that both reasons for buying stocks are becoming less compelling.

To begin with, there are fewer shares. This was the logical result of having interest rates at historical lows, which resulted in companies buying back stocks. This gave more fuel to an already booming stock market.

today first graph

According to the Fed, a net value of $3.1 trillion of corporate equity was retired by repurchases and mergers & acquisitions since 2011. This enormous amount is comparable to the entire GDP of Germany. The number of shares in the S&P 500 calculated by Standard & Poors shows the same trajectory as the Fed data. And the first quarter of this year set a new buyback record, even as rates rose.

But the feverish pace of repurchases may be starting to ease.

today second graph

The 2-year US Treasury rate is now above the average dividend yield of S&P 500 companies. Some companies may still be able to issue bonds at cheaper rates than their dividends, but the margins are getting thinner and fewer can still do this profitably. This may be the reason why the portion of companies retiring more than 4% of their outstanding stock fell to its lowest level since tracking started in 2014. If rates continue to climb, we believe that this portion will fall further.

Additionally, conservative retail buyers who had gravitated to stocks as the only source of income are now able to access the safety of bonds that offer higher yields. While rates are still relatively meager by historical standards, they are now at least at par with inflation. Investors who until recently had no choice other than dividend stocks to produce income may be warming up to bonds, thus reducing another source of demand for stocks.

Stocks went up for various reasons in addition to corporate buybacks and dividend-seeking retail investors, but there is no doubt that both have played an important role in driving up prices. As rates return to more normal historical levels, these two sources of demand may well evaporate. While this may not be enough to sink the market, at the very least it paves the way for higher volatility in the months ahead.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Park Your Money in Four ETFs To Cut Market Exposure

By Path Financial President and Chief Investment Officer Raul Elizalde

raul imageFrom time to time investors look at reducing their market exposure and “parking” their money safely. Some choose plain cash, but cash has a negative real rate – it does not grow, and inflation eats away at its value.

Some ETFs can provide stability and a moderate return with very low exposure to market risk. While no investment is completely safe (even cash under a mattress can catch fire) these ETFs have solid sponsors, large portfolios and plenty of liquidity. Each one has different characteristics, so using them in combination may be better than settling on any single one.

SHY, for example, has $14 billion of U.S. Treasury notes and bonds with maturities between 1 and 3 years. Its liquidity is excellent and its sponsor, BlackRock’s iShares, is one of the strongest financial institutions around. Because all its holdings are in fixed-rate instruments, its value declines when interest rates go up. Quality is unmatched: the assets are backed by the full faith and credit of the United States Government.

FLOT, also from iShares, has $10 billion of floating-rate securities issued mostly by corporations with an average maturity of about 2 years. These underlying instruments pay interest that moves with market rates, so they tend to benefit when rates climb. Like SHY, it is a very liquid ETF.

CSJ is another iShares ETF. It resembles SHY in that it contains $11 billion in fixed-rate instruments with maturities between 1 and 3 years, but it is mostly comprised of corporate securities, which pay higher rates than the US Treasuries in SHY. Like SHY, its value tends to drop when rates go up. Roughly 16% of its portfolio is made up of supranational and government-guaranteed bonds.

Finally, SPSB is an ETF sponsored by State Street’s SPDRs, another very strong sponsor. Like CSJ, it contains corporate bond holdings between 1 and 3 years. However, there are no supranational or government-guaranteed bonds among its $4 billion in assets, which results in a higher return than CSJ but also higher volatility. Both CSJ and SPSB offer plenty of liquidity with very narrow bid-ask spreads, but their daily volumes are smaller than SHY or FLOT.

We ran a few combinations of these ETFs using approximately seven years of data, looking for an optimal blend of low volatility, high return and minimal drawdowns (i.e. declines from peaks) for that period. A mix that seems to satisfy these elements is a 65% FLOT, 10% SHY, 15% CSJ and 10% SPSB allocation rebalanced monthly, as shown in the graph below. Drawdowns and volatility were minuscule. Returns were moderate, as one would expect for a cash alternative, but accelerated in the last two years as rates rose.

graph one

We tried including other short-term and floating-rate ETFs such as BSV (Vanguard’s short-term bond ETF) and FLRN (State Street’s SPDR Floating Rate) but we found no measurable contribution to the portfolio metrics achievable with the four ETFs we focused on.

While this mix worked well in the past, the optimal blend going forward may contain a larger proportion of FLOT if rates rise, or a smaller proportion of CSJ and SPSB if credit spreads widen along with lower equity prices.

A word of caution: ETFs, like any instrument, can be subject to liquidity constraints. Unlike a mutual fund, owning an ETF does not give the holder direct ownership to the underlying instruments. A serious market dislocation can affect corporate bonds spreads and cause FLOT, CSJ, or SPSB to experience significant price drops or a wide gap between market value and net asset value.

However, barring the unknowable effects of abnormal market conditions, which in any case tend to be temporary, these ETFs offer investors an attractive alternative to cash.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Earnings Forecasts Optimism Could Spell Trouble for Market

By Path Financial President and Chief Investment Officer Raul Elizalde

photoStock prices depend on future earnings expectations. The current consensus is for earnings per share (EPS) to grow through the end of 2019 by about 30% to record highs. These are risky forecasts: if numbers come out short, stock prices will take a hit. Can investors rely on these forecasts?

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Operating earnings estimates from hundreds of analysts pooled by Standard and Poors’ Capital IQ show that optimism about earnings is strong. This is noteworthy because observers are also contemplating the possibility of a slowdown, or even a recession, in 2019.

The enthusiasm may be due in part to the strong acceleration of operating EPS growth that started in mid-2016. Remarkably, a related set of numbers – corporate profits before tax from the U.S. Bureau of Economic Analysis (BEA) – lack the same vitality. The BEA numbers, in fact, have more or less stalled since 2010, and there is little indication that they are ready to take off.

To be sure, the two sets are quite different. The S&P numbers only pertain to public companies belonging to the S&P 500, while the BEA numbers are intended to cover all corporations, public or not. Additionally, while both figures are calculated before tax, various other accounting items are treated differently.

Nevertheless, the rate of growth for both tends to move in the same direction, with peaks and troughs reached at the same time, as in 1994, 2003-04 and 2010-11. One key observation would be whether the gap between the BEA numbers and operating earnings narrows or widens at the end of the second quarter. If both measures continue to diverge, the chance that operating EPS will achieve the 2019 targets will diminish.

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It is important to point out that the strong earnings growth rates of 2003-04 and 2010-11 were possible because of the low starting points caused by prior recessions. In comparison, the strong rate projected for 2019 would have to be reached after almost 10 years of expansion. It may be harder for earnings to accelerate from the current high base.

Plenty of research throws doubt on the ability of analysts to predict earnings far in advance, and this is borne by the evidence. According to Standard & Poors, only 9% of analysts were able to forecast current quarter EPS correctly in the last five years. Most forecasts exceeded the actual numbers, or came out short.

This is not surprising. Not only there are many exogenous, unpredictable factors affecting earnings, but also the accounting input needed to make forecasts is hopelessly complex. As Mike Thompson, S&P Investment Advisory chairman said on a recent TV interview, “you almost need forensics to understand some of the accounting that goes on to get to EPS.”

So is the current projection for the next seven quarters of earnings achievable? Yes, it is, but that is not saying much. Any projection is possible. One as optimistic as the current one may also need a generous serving of luck to come true.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Why 2019 Recession Is Possible Despite Unemployment At 50-Year Lows

By Path Financial President and Chief Investment Officer Raul Elizalde

path imageBy most measures, employment is as strong as it has ever been. For example, initial unemployment claims as a percentage of the labor force are by far the lowest since records started. The May 2018 unemployment rate dropped to 3.8%, a level touched only once since 1969 – on April 2000, just as the stock market peaked before a 30-month-long bear market and the economy fell into a recession.

Strong economic indicators are always welcome, but they do not guarantee that growth can be sustained. Take retail sales, for example: they are now at a record high, but they were also at record highs just before the two previous recessions. How can this be?

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Forecasting the economy is just as difficult as forecasting the stock market. Economists are very good at explaining what already happened and why, but not so at predicting what will happen next.

They know this. Prakash Loungani, an economist at the IMF, showed in a study that professional forecasters missed 148 out of 153 world recessions. This is not surprising: Economic indicators very rarely flash any warnings before a recession actually arrives. Economic downturns seem to come unexpectedly.

Regardless of the difficulties, analysts are always looking for clues. One measure that has received attention as a predictor of future recessions is the shape of the yield curve. It seems that when longer-term rates drop below short-term rates, a recession often follows. But this is also true for unemployment claims: a recession seems to follow whenever they drop below 300,000.

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This is a difficult set of facts to rationalize. On one hand, it is easy to speculate that when longer-maturity rates drop below shorter rates it is because the market expects future economic activity to weaken. On the other hand, explaining why strong levels of employment precede a recession is not easy, even though it is also appears to be true.

While the yield curve today is not yet at levels associated in the past with approaching recessions, this may be due to technical reasons that could have moved the threshold upwards, such as negative rates still widespread elsewhere. But unemployment levels are well beyond recession-preceding thresholds, and in any case both indicators are moving in a direction that should cause concern.

Still, it is not obvious why economic indicators often show their best performance before the economy takes a turn for the worse. One explanation could be that it is difficult to rein in distortions when the economy is firing on all cylinders.

Sometimes this is due to politics. When the economy is sluggish, policymakers in charge are accused of ineptitude or lack of concern. To prevent this, they tend to stimulate growth regardless of consequences, and the strategy eventually backfires.

Other times, imbalances happen without blunt policy interventions, such as when asset values take off and build a bubble. Policymakers are leery of taking the punchbowl away when everybody seems to be getting rich, even though that is precisely what they should be doing. But bad policy is often good politics.

Are there any such dangers lurking in the US economy today?

To many, stock market valuations appear overstretched. In addition, the combination of a huge tax cut, a spending increase and an aggressive trade stance adopted by the Trump administration, while intended to keep the expansion going, may not end up well.

The Fed could raise rates too quickly, for instance, if it thinks that the economy is running the risk of overheating or inflation pressures start to mount. Given the enormous amount of private debt built up after years of rock-bottom rates, this could drive some debtors to insolvency and trigger a broad crisis.

Another scenario would be that lower taxes and higher spending cause public debt levels and budget deficits to explode, forcing a drastic reversal of policy that could choke growth. This is not idle speculation. Virtually nobody that has looked carefully at the details of current fiscal policy, among them the Congressional Budget Office, the Tax Policy Center and the Joint Committee on Taxation, believes that the current largesse could create enough growth and pay for itself.

The U.S. expansion may be close to its end just because of old age, given that it has lasted almost nine years and is now the second longest in U.S. history. While economic indicators are strong, they were also strong just before past recessions. And anyone who thinks that a recession is unlikely should keep in mind that it also seemed unlikely to professionals trained to predict recessions 148 out of the last 153 times.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.


Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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