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%.

Politics

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.

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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?

first graph

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.

second graph

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.

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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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How to Handle the Flash Crash of 2018

path flash crashAfter a meteoric rise, the stock market lost more than 6% in only two days. Why did this happen, and where do we go from here?

At the close of Monday, February 5 2018, the S&P 500 gave up more than all the year’s gains. Put in perspective this is not a large move: the index is roughly back to where it was just a couple of months before. Also, there are no clear fundamental reasons behind the decline: both the economy and corporate earnings are strong, unemployment is low, and the global economy is in good shape.

Some reasons behind the sharp fall are most likely technical, such as the high levels of margin debt, elevated P/E ratios, side-effects brought about by the purchase of insurance by some market participants, and so on. These kind of factors rarely portend a large, structural move to the downside.

There are, however, some fundamental weaknesses in the system. The most important is the enormous increase in private sector debt that both households and non-financial corporations have accumulated in the last few years. When and if interest rates rise too much or beyond a certain threshold, a much more serious credit-driven problem can materialize and evolve into a full-fledged crisis that could profoundly affect markets. The quick rise in interest rates last week may therefore have something to do with the stock market move, but we think that rates are not yet close to trigger widespread credit problems.

As we described in a recent newsletter, the recent tax cut is another reason for concern. This is because coming at a time of full employment it can cause the economy to overheat and inflation to climb, driving the Federal Reserve to tighten monetary policy. This could trigger the kind of credit crisis we fear.

Additionally, the tax cut is likely to create a large increase of public debt, which would limit options to fight the next inevitable recession and thus turn a normal deceleration of the economy into a more serious downturn.

We believe, however, that we are not yet at the edge of recession or a negative credit event. The swift market fall seems due, instead, to the kind of technical factors that we mentioned earlier. If so, it could be useful to explore what happened in similar situations in the past when stocks had technically-driven two- or three-day declines of more than 6-7%.

We looked at the history of the S&P 500 since its inception and we identified nine such instances, from the “Kennedy Slide” of 1962 to the China-driven volatility of August 2015. We did not include the Crash of 2008 because it was not a mere technical decline but the result of serious fundamental concerns about the viability of the banking system. While technical factors could have exacerbated the 2008-2009 market rout, they were clearly not the cause.
path image for post
In all these instances we observed that after a few days, weeks or months the market recovered virtually all the lost ground. While the market fell more than 6% twice during the bear market of 2000-2003, it also found full relief soon after, even if it eventually resumed its downward march.

In conclusion, it seems that it rarely pays to sell immediately after a sharp two- or three-day move. Waiting for markets to stabilize instead appears to be a better strategy, because prices eventually tend to rebound even if they keep falling later on. This appears to be the case especially after climbing for a while, as can be seen in the charts of 1987, 1989, 1997, 1998, 2000, 2011 and 2015.

Even though we are concerned about the longer-term market outlook due to the stretched credit conditions, we think that investors who want to reduce their exposure to risk assets will not have to wait long before the market reaches a better point if they want to sell.

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Raul cropped for facebookRaul 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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Can the stock market triple by 2026?

damWe often hear these days that stocks are overpriced and due for a correction. Despite the fact that the S&P 500 is hitting all-time highs after climbing 250% in eight years, it’s clear that the rally has not quite captured the heart of investors. Analysts were never really convinced either and have issued similar warnings for years. Meanwhile, the bull market marches on.

Is it too late to join in? That is certainly a risk: it is a well-known fact that investors abandon caution at the worst possible times. But when the current rally is put in context with past performance, the case for extreme caution loses some of its potency. Stocks have been known to climb far more than the 250% registered since 2009, such as when they soared 1,000% between 1942-1966 and 1982-2000. Both rallies eventually died, of course, but false calls that the end was nigh were issued many times before the bull-slaying busts finally arrived.

Booms can be confoundingly persistent. The ten-fold rise from 1982 to 2000, for example, did not ebb gradually: instead, it sped up in the mid-1990s as investors became increasingly bullish and optimistic.

Conversely, busts come along with violence, often just after people stop recognizing that markets can do just that. In the late 1990s, for example, nobody could foresee the brutal 3-year bear market that started in March 2000.

Market crashes are a feature of how markets behave, and have always been around. The 2008-09 financial crisis or the 2000 dot-com crash, for example, were no more devastating than the Crash of 1929, or the long-forgotten Panic of 1873 that forced the first stock market closure.

These booms and busts come in unpredictable cycles of different duration. Nobody has a way of forecasting market turns.

But about 90 years ago an intriguing pattern of market behavior developed, and it has held remarkably well to this day. It goes like this: weak stock market returns in a 17-year period follow 17 years of very high returns, and vice versa. This might be nothing else than a coincidence, and we do not know whether it will hold in the future. But the cycle is quite clear.

can the S&P 500 triple chart

In 1929, for example, stocks had returned a remarkable 13.4% average in the previous 17 years, the highest it had been up until that point, and investors were euphoric. But in the next 17 years stocks yielded a miserly 1.3% per year including dividends. Fast forward to 1942: stocks had returned less than 4% during the prior 17 years but went on to yield a stunning 18% annual average return during the next 17.

Since then, the market pendulum has swung between despair and euphoria, taking market returns from trough to peak. It seems that just when optimism reaches its highest point a new era begins, marked by low returns, and affirming the dictum that investor sentiment is best seen as a contrarian indicator.

Despite the market strength, conditions today can hardly be described as “euphoric”. Political dysfunction, global terrorism, rogue states and the rise of global protectionism are just some of the concerns discussed in today’s news. Sentiment is rather weak, illustrated by the prevalent idea that the stock market is too high and ripe for a fall. And the past 17-year average market return has been low by historical standards.

So, according to the despair-euphoria cycle we described, current conditions seem to be consistent with strong future returns. If so, what would it mean for market levels?

The most conservative way of measuring this is to start the calculation at the trough of 2009. To arrive thus to a 17-year average total return of, say, 15%, the S&P500 would have to be around 7000 sometime in 2026, assuming dividends of about 2% per year. A 16% average annual total return would take it closer to 8000, or well above three times its current level.

This may sound unreasonably high, but as observed earlier the stock market has gone up much more than that in the past, and tenfold twice. Going from 700 in 2009 to 7000 in 2026 would not lack precedent.

Looking elsewhere for clues we note that the last 8 years saw weak economic growth, a condition proven to be cyclical; if so, we may be on the threshold of a new period of environmentally sustainable expansion aided by new technologies (think renewable energy and artificial intelligence). This could be a shot in the arm for the global economy.

We insist: it is impossible to know whether this pendulum-like cycle will hold. The stock market moves in patterns that occasionally repeat themselves for a while and then vanish, a feature common to unpredictable systems.

Even if the pattern holds, there is nothing to prevent the market from tanking and then recover to produce a strong 17-year average return by 2026. The 20%-plus Crash of October 1987, for example, happened five years into the tenfold stock rise of 1982-2000.

So the cycle we described does not say anything about where the market may be this year or the next. But those who wonder about the long term may find the idea of being in the initial stages of a really long rally quite exhilarating.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Contact Path Financial at 941.350.7904.

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Limit Stock Market Losses to Improve Long-term Returns

men putting out fireInvesting in stocks can be brutal. According to research, the S&P 500 lost at least 10% from a previous high every two-and-a-half years on average, and at least 20% every six. A 30% loss happened every 13. It has fallen 50% from a peak three times since 1954. None of these declines were, or could have been, anticipated with any kind of precision, and they certainly do not come at regular intervals. And, remarkably, losses of this magnitude contradict the models we use to describe market behavior.

For example, the largest S&P 500 one-day loss was 20.5% in October 19 1987. According to a widely used model of stock market returns (which assumes that they form a bell curve around an average) the likelihood of the 1987 loss is similar to picking the right card in a deck containing as many cards as there are atoms in the known universe. In other words, the chance that such drop could happen is essentially zero.

Clearly the problem is not that impossible events happen but that our models are inadequate. A lot of analysts have tried to come up with better ones, but so far this quest has proven fruitless. We still can’t predict markets with any meaningful accuracy. This is why markets are not so much like the weather, as they are often compared, but rather like earthquakes, which scientists now admit are unpredictable.

But here is the good news: we cannot predict earthquakes, but we know how to build earthquake-resistant structures. Likewise, we cannot predict markets but we have techniques that can help us limit losses when markets tank.

There are some very basic reasons why limiting losses is more important than producing strong returns.

A well-known example goes like this: If you lose 50% of $100 you need a 100% return on the remaining $50 to break even. This means that a large percentage loss requires a very large percentage gain for full recovery.

But a far more important example is this: If you only lose 20% of $100, you will need just 25% to bring the remaining $80 back to $100. So a small loss requires much less effort to come out from it.

This is even more important for retirees who use savings to pay for living expenses.
For example, taking $10 after a portfolio falls from $100 to $50 leaves the saver with only $40. A subsequent 100% return only takes the portfolio back to $80. That means that the $10 withdrawal turned into $20 because of its bad timing.

But when $100 only falls to $80 and $10 are taken, a subsequent 25% recovery on the remaining $70 brings the value up to $87.50. This means that the $10 withdrawal turned into $12.50—a much smaller penalty for taking money out at the worst possible time.

The moral is clear: limiting losses is an essential element in portfolio management.
Limiting losses requires some basic processes in place. The best known is diversification, or investing in a mix of assets that tend to move in different directions. But a mix that looks diversified today may not be diversified tomorrow, especially when markets take a turn for the worse. This is because in down markets investors sell everything and correlations go up sharply. Therefore, a mix that does not take into account how the market cycle changes is prone to go through periods where diversification goes away just when investors need it most.

Adapting portfolios to market conditions requires dedication, patience, and a well-designed set of rules. This is, or should be, the professional portfolio manager’s job. Some investors insist that the portfolio manager’s job is simply to beat the market by picking a high proportion of winning assets. Accordingly, they are willing to pay a premium for those managers who seem to have the hot hands. This is a bad approach, commonly known as “chasing past returns.”

Many studies show that virtually no active fund can consistently beat its benchmark, and not because of fees. According to Standard & Poor, which publishes a regular analysis of fund performance, most funds underperform their benchmarks both before and after fees.

The simple explanation is that poorly diversified funds can only outperform their benchmarks through superior forecasting. But, just like for earthquakes, forecasting the market accurately is impossible. As one academic put it:

Going back to basics, the idea “to invest successfully in the stock market, you need to know whether the market is going to go up or go down” is just wrong. (Professor David Aldous, UC Berkeley – The Kelly criterion for favorable games)

While limiting downside exposure is crucial in portfolio management, having this protection in place at all times can be frustrating. If the market keeps on rallying, the “insurance” against declines appears to be an unnecessary drag on returns, just as going through the expense of building a house that is earthquake-resistant may seem like a waste as long as there are no earthquakes.

We all have complained about paying for insurance that we don’t seem to need. This is understandable as long as disaster does not strike. But the temptation to cancel insurance can be dangerous. If you are not yet convinced this is so, please reread the first paragraph to see why having a systematic process to protect investments from losses is a good idea.

What now?

We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours.

We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success.

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