Week Ending 2/23/2018


  • Capped by a strong rally on Friday, equities finish higher by about 1/2%.
  • Earnings season continues to be exceptionally strong.
  • Deficits are exploding and neither political party cares.


It was a somewhat boring week by recent standards, but equities did advance. The US markets were up by about 0.50% and international equities increased by 0.21%. What was of some interest is that the market finished way off its highs, and close to the low of the day, from Monday through Thursday, but that changed on Friday when the market rallied into the close and ended at the day’s high. The Friday rally was attributed to a fall in the yield on the 10-year Treasury of almost 5 basis points. The S&P 500 is now up 8 of the past 10 days and has increased by 6.4% since the February 8 low.


90% of the S&P 500 have reported Q4 earnings so far and 76.5% have beaten expectations and 15% have fallen short, according to Thomson Reuters I/B/E/S. That compares to the average beat rate of about 64%. Overall, Q4 earnings should be up by 15.3% and revenue should be up by 8.2% from Q4 2016.

The graph below illustrates how earnings expectations for Q4 have been sharply rising since December.

Looking forward, 127 companies projected higher-than-expected earnings for 2018, compared to an average of 49 companies over the last 10-years. The p/e based on 2018 earnings is 17.4.


The US Treasury sold a whopping $258 billion in bonds this past week. The two-year note went for a yield of 2.25%, the highest since 2008. The supply was absorbed by the market and yields across the curve were flat for the most part. But recent sharp increases in Treasury yields have been anticipating this big increase in supply. The huge auction is just a sign of things to come, and we think a dangerous one at that. Recent tax cuts will increase the deficit by more than $1 trillion over the next decade, and you can add to that the recent budget deal, which will increase the deficit by an estimated $420 billion over that period. And all of that is before the Trump infrastructure plan.

The government is now set to borrow more as a percentage of GDP in the next fiscal year, than any year since 1945. Except in 1945 we were fighting WWII, and today we are amid a relatively strong economy and a tight job market. The deficit, in relation to GDP, should be going down, not up! And what happens during the next recession?

Bond yields tend to trend in one direction for extremely long periods, they can be generational in length. In 1946, the long bond yielded 2.25%, 35-years later in 1981, the yield was 15%. 35-years after that, in July of 2016, the 30-year bond yielded 2.1%. Today, the 30-year is at 3.16%. There is an avalanche of federal debt on the way, plus the unwinding of the Fed’s balance sheet. To state what appears obvious, over time, maybe over very long periods of time (with some interruptions along the way), interest rates will continue higher.

Both political parties are completely ignoring this long-term threat of out of control deficits. At some point, tax increases will be back on the table.


Week Ending 2/16/2018


Equities turned in their best week since 2013, rising about 4.4%. Some market participants think the correction is over, and it is back to smooth sailing from here. We are not so sure. A recent Goldman Sachs report detailed that a typical correction takes 70 trading days to trough and 88 days to recover.

The markets just completed the longest period ever without a 3% correction. We took a look at how the market performed after the next nine longest periods without a 3% correction, going out 90-days, 180-days and one year, as well as what the maximum drawdown was.


What happens after extended, non-volatile rally ends?

Two of the time periods (C and F above) had losses across the board. The period from April of 1993 until February of 1994 (C), and then the period from June of 1965 until February of 1966 (F).

If you at the percentage gain or loss in 90, 180 and 365 days, and ignore any drawdowns in between, the maximum loss was 10.96% in period F, and that was 180 days after the rally had ended.

In four of the nine examples (B, D, E, and J), the market was up in every time frame measured. The maximum gain was 26.17% one year after the end of rally E.
In two of the examples (H and I), the S&P was down in value 90-days later, but up in the longer time frames of 180-days and one year.

And in the remaining example, G, there was a gain 90-days out but losses at the end of the 180-day and one-year time periods.

The average return over the nine-time periods was -0.63% for the 90-day time-period, 2.91% for 180-days, and 6.34% for 365-days.

The median return was positive across all time frames, 0.76%, 2.04% and 5.90% for 90, 180 and 365 days.


Of the nine periods, two of them, 1966 and 1950 (F and H), were periods where the end of the rally marked the high point before a decline of 10% or more. In 1966 (F), the S&P sold off by 22%, and in 1950 (H), it declined by 14%. Make that three times as we fell 10% on this most recent decline.


We also looked at the maximum drawdown over the subsequent 12-month period. The thinking was that maybe the end of the rally does not mark the beginning of an immediate decline, but what if it leads to more volatility which is a tip-off to a larger sell-off at some point in the next 12-months.

The maximum drawdowns averaged -10.61% with a median of -8.94%. The smallest drawdown was 3.55% and the largest was 22.18% over the following 12-months. Thus, in all cases except for one (J), volatility did increase to a certain extent.


If there was ever a case of the calm before the storm it was the run that started in July of 2006 and ended in February of 2007. The S&P 500 would move sideways to higher until July by +6.4%, then fall through mid-August by 9.5%, then rally to a new high by 11% into October. That would be the turning point for what would be the bear market of 2007 to 2009. In the one-year after the rally ended in February of 2007, the drawdown was 16.27%, but that was just a hint of what was to come. Ultimately, the market declined between October of 2007 and March of 2009 by 56.30%.


We looked at nine-time periods and price action over the next year. There is only one period that is similar in length to our current period, and that was the rally from 1994 to 1995 (B). In that case, the market remained positive in the three-subsequent time-frames that we measured. Three other time periods (D, E and J) all had positive returns over 90, 180 and 365 days. Two periods had negative returns over all three-time frames (C and F). In two cases, the end of the rally marked the immediate beginning of significant declines of 10% or more (F and H), including one of 22.18% (F). And then in 2007, the bear market began about 8-months later, but most of the damage was done more than 12-months after the end of the rally.

The sample size is too small draw any definitive conclusions, but there is a definite pick up in volatility after these long rallies end as shown by the drawdown numbers, and there were losses of greater than 10% in three of nine examples.


Week Ending 2/9/2018


  • Stocks fall by about 5%.
  • US equities are now down about 2.2% for the year.
  • A wild week of trading.
  • Everything you need to know about investing on one index card.
  • Volatility ETN’s crash.
  • Valuations are now somewhat reasonable.
  • US deficits are going to begin to ramp up at a time when they should be falling.


The stock market entered correction territory this week as US stocks fell by about 5% and international equities dropped by 5.25%. US equities are now down 2.2% for the year and we are back to where we were at the end of November. The yield curve steepened by 15 basis points as the 2-year note decreased by 10 basis points and the 10-year increased by 5 basis points.



It was a wild week, to put it mildly. On Monday, the SPY (S&P 500 ETF) opened down 0.72%, had a quick rally back to breakeven, and then fell throughout the rest of the day to close with a loss of 4.2% from the Friday close.


On Tuesday, the market opened down 1.6% and rallied back to close up for the day by 1.97%, that gave some glimmer of hope that the sell-off might be over.


On Wednesday, the market opened down slightly, 0.41%, and then rallied. At the Wednesday high, the SPY was up 1.2%. But from the midday on stocks fell and closed down 0.54%.


The negative close on Wednesday set up for a really rough Thursday, stocks fell almost the entire day and finished down 3.75%. That put the SPY in correction territory (a decline of 10% or more), down by 10.10% from its January 26th high.


Friday started out better, opening up by 1.28%, but the market quickly turned south and at its low, the SPY was at 252.92, that was about at 1:45 pm. And at that point, the index was down 11.75% from the January 26th closing high. The price also fell just below the 200-day moving average, a key technical level that many traders watch to judge the broad direction of the market (as in up or down). But stocks had a huge rally from that point and managed to close up by 1.5% for the day, an increase of 3.39% from the day’s low.

For the week, the SPY fell by 5.06%.


We asked in our commentary for the week ending January 26th, if this was 1987 all over again? The “effortless ease” in which the market was constantly going up reminded us of the 1987 market. That led to complacency and lots of one-way bets on low volatility and a belief that stocks would go up forever. But markets don’t work that way. Over time, they generally go up as the economy grows, but in between, there are often sell-offs, and sometimes they can be severe (much more than we have seen so far over the last week or so). The index card below, which has been floating around Twitter, kind of sums it up!


The one-way bets are perhaps best shown in the crash of the XIV. The XIV is an exchange-traded note (ETN) that essentially benefits from markets with low volatility. Low volatility was what we just came out of, we just went the through the longest period ever without a 3% correction and came up just short of the longest period ever without a 5% correction. From December 31, 2016, through its high on January 11 of this year, the XIV was up by 210%, closing at $145. On Friday, the XIV closed at $5.38, a loss of 96.3%. Just this past week, it fell 96.1%. The XIV, and volatility related products like it, are taking the blame for a lot of the market’s fall this week. Traders getting out of the XIV trade supposedly spilled over into selling equities. We wrote about the threat of this on October 15.


As we see it, here are the catalysts for this sell-off:

  • Overdue for a correction, this set up complacency and one-sided bets on the market moving higher.
  • The threat of higher inflation, triggered by the increase in hourly wages on February 2.
  • The Fed beginning to unwind the balance sheet, a slow movement from quantitative easing to quantitative tightening.
  • Ballooning deficits at a time when deficits should be decreasing (see below).


If there is any good news, it is that all of a sudden, market valuations have become much more reasonable. A combination of falling stock prices and higher earnings have the current forward p/e at about 16.9, as of the Friday close, a level not seen since 2016.

The Morningstar measure of the median fair value of stocks that it analyzes, was as high as 1.11 recently, indicating the median stock was overvalued by 11%. Today, the ratio is 0.99, indicating the median stock is now undervalued by 1%!


A distinguishing characteristic of this correction, compared to all of the others since 2007, is that the primary fear is not an economic downturn, but an accelerating economy that unleashes inflation and leads to higher interest rates, although you can make the case that such a scenario would lead to a downturn at a future point. But for now, the economy continues to look very strong. The most recent estimates of growth for Q1 from the Atlanta Fed’s GDPNow model are 4.00% and from the New York Fed’s NowCast is 3.35%. Those estimates can certainly change, but for now they indicate accelerating growth for this quarter.


One area that does have us concerned over the long run is the complete disregard by our government in dealing with our budget deficit. The recent tax cuts will add an estimated $1 trillion or so in deficits over the next 10-years. And as if that wasn’t enough, a spending bill passed this week, as part of the legislation to keep the government funded, adds an additional $300 billion in deficit spending. And almost nobody in Congress cares, and the White House certainly doesn’t.





Week Ending 2/2/2018


  • The markets took a tumble as US and international stocks fell by about 4%.
  • Interest rates moved significantly higher.
  • The sell-off has been way overdue.
  • A strong jobs report shows the economy is in good shape.
  • And earnings estimates continue to be high.


The equity markets took a tumble around the world. US stocks dropped by 3.88% on the week and international stocks fell by 4.04%. The longest streak of all-time without a 3% sell-off ended at 448 calendar days.

Fast increasing interest rates put an end to the rally. The 10-year treasury bond now yields 2.78%, the most since January of 2014. The 30-year cracked the 3% barrier, closing at 3.01% on Friday.

Higher interest rates are having a gravitational pull on the price/earnings ratio, bringing it down. The problem is not earnings, earnings estimates continue to be strong. It is the amount that investors are willing to pay for those earnings have declined, resulting in the sell-off

Why are interest rates going higher? Ironically good news in the economy means higher wages which translates into higher inflation. The worst day of the week was on Friday after a strong jobs report that showed the biggest increase in wages since June of 2009 (see below). In other words, the good economic news was bad market news.

There is also the impact of the unwinding of the balance sheet. As the Fed lets bonds mature, it is effectively taking money out of the system. That means less demand for bonds which requires higher rates to entice investors.

There are other forces at play also. The biggest one might be that we were just due for a sell-off. Not just due, but way overdue. It has now been 585 calendar days since the last 5% sell-off. That is just 8-days shy of the all-time record which occurred between December of 1957 and August of 1959. There was also extreme positive sentiment in the market. Volatility has been at all-time lows, indicating almost no fear of a sell-off.

And then you have the political mess in Washington. Investors and traders simply ignored our dysfunctional political system while the market was in a one-way mode up, but that will be harder now. The release of the Republican memo alleging surveillance abuse, despite the objections of the Justice Department and the FBI, indicate that our political mess is getting worse, not better. And let’s not forget that the government has until Thursday to continue to fund the government before the next shutdown.

So, we have what is likely the beginning of some kind of sell-off. Whether it ends on Monday or continues on for a while we have no way of knowing, but we suspect it will go somewhat deeper. This is part of normal market behavior. There is no sign, at least now, of a recession soon, and the economy and earnings estimates are solid.


Nonfarm payroll increased by 200,000, the preceding two months were revised downward by 24,000. Average hourly earnings were up by 0.3% month over month and 2.9% year over year. That was this biggest increase since June of 2009 and might have led to higher inflation fears that spooked the market during Friday’s selloff. The average workweek fell to 34.3 from 34.5 hours. The unemployment rate remains at 4.1%.


The global economy continues to be in solid shape. The manufacturing PMI came in at 54.4, down 0.1 point, but a strong number. Anything above 50 is considered expansionary. 94% of countries are in expansion territory, close to the November high. But it appears that growth in PMI is leveling off.


Amazon, JP Morgan, and Berkshire Hathaway announced they would join forces to try to tackle the problem of healthcare costs.