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False Alarm (For Now)

   In the last update, we had many indications that the markets were angling toward the typical summer correction following the age-old pattern of “Sell in May, and go away”. Surprisingly, we saw a surge higher in prices last week that took our indicators off the brink and gave this hard-charging uptrend another breath of air. At the same time, the economy and markets are now giving us some early clues regarding a potential recession (in 2018). Finally, I’ll finish with some high-level thoughts on real estate versus other options in terms of long-term rates of return.


Net Exposure Increased Again – False Alarm


     One could argue that we should just ignore technical signals during a bull market. After all, the most productive investment strategy during a bull market is to just stay 100% invested in a diversified group of securities and forget about it. That is all well and good in theory. Ben Carlson, of AWealthOfCommonSense.com, wrote this in his blog about why just sticking with a diversified portfolio over time is so difficult. He argues, as we do, that a diversified portfolio is hard to stick with given all the comparisons to a stock market that is running away to higher highs nearly every week. Of course, a diversified portfolio holds things other than stocks like bonds, commodities, real estate, etc.


Ben said it well;



  •    --  U.S. stock market valuations are high and interest rates are low. This has been true for a number of years but that doesn’t make dealing with this scenario any easier.
  •    --  There have never been more fund or product choices available to tempt advisors and investors alike from making portfolio additions or changes.
  •    --  Many wealthy people make their money by placing concentrated bets in business. It can be difficult for advisors to change a client’s mindset from what it takes to build a fortune to what it takes to preserve a fortune. 
  •    --  Investors want what they can’t have. They mostly want strategies that work in every environment, fixate on short-term market moves, obsess over the performance of people doing better than they are and would rather focus on what’s working now versus what works over the long haul. Needless to say, this is at odds with reasonable investment advice that doesn’t work all the time.
  •    --  Diversification is hard. 


     I’ll add one of my own. Diversification doesn’t matter, until it does. Meaning bear markets have a nasty way of surprising everyone and wiping out at least 60% of the previous bull market’s gains in relatively short order (Investech Research). Those who fail to stay diversified or have no risk management systems in place, like our Net Exposure model, will simply make money and then lose it, rinse and repeat. Are we close to such an event? Yes. What does close mean? It means that the probability of a bear market materializing at any time from these levels is significant. But, as we’ve seen since elections, prices can still move higher nonetheless. Tick tock.


Small Caps, Transportation, and Breadth in Gear


     Some of the components of our Net Exposure model have been stubbornly sitting in negative territory but as of last week, most moved tentatively back into bullish mode. Small Caps and the Transportation sectors are often seen as a confirming group for market trends as a whole. Both have been sorely lagging the broad US stock market, until last week, when both saw a great deal of buying enthusiasm. If, and when, both break out to new highs, we can say that the bull market uptrend is still alive. The new strength is healthy and welcome but not yet enough to say, all is well. Also for several weeks, we have seen the FANG stocks literally carry the entire market on their backs while the rest of the index components traded below the peaks made in March. An index like the S&P 500 is capitalization weighted so it is quite easy for mega-cap tech companies to drive the index higher without much participation from any other components. An easy way to observe this is to watch a chart of the Equally Weighted S&P 500. Again, finally, last week we saw the equally weighted version of the S&P 500 also break out to new highs (green bar on the right side), thus confirming the move. This is a form of “market breadth” and the first sign of real confirmation we have seen since March 1st. The odds of a summer correction or the beginning of a bear market are now statistically lower than they were a few short weeks’ ago.




     Back to our Net Exposure model, these developments are good and have given us reason to get back to a fully invested position after only a few days of carrying a bit of cash. From a sentiment perspective, bullishness is also off the highs again, which gives us a little more confidence that prices can still go higher. Fundamentally, there are few new developments worth noting. Homebuilder starts continue to come in soft. Auto sales look like they have peaked now (except Ford trucks), and employment numbers were surprisingly weak last month. These are the additional signs of weakness in the economy that contradicts the story of unbridled consumer strength and business optimism. These are not acute or massive signs, but worthy of our attention in the aggregate. We’ll be watching the ratio of leading indicators to coincident indicators closely in the coming weeks. All is not as it seems regarding the story of a strongly growing economy and the recent strength in the bond market is echoing that statement. I have no doubt that the Fed will raise interest rates again this month as they tend to lag most trends in the economy by several months or quarters. But, with GDP sitting just above zero, they must be a bit nervous, behind closed doors and away from the public eye. I can almost imagine they have their meeting, and then finish with a winking agreement regarding their spin to the public. “We know what’s really going on, but what should we tell the public?” Ok, I’ll try not to be such a curmudgeon.


Real Estate and Other Options


     I’m going to reference another piece from Ben Carlson, but from way back in April of 2014. It would worth your time to read this




It would also be worth your time to subscribe to Ben’s free commentary. He’s bright and I like his stuff.


In this blog, you’ll see this chart. Spend a minute with it.




     These are high-level numbers looking at calendar decades of returns. What you’ll notice is that housing prices generally track the returns of cash (or money market rates). For those who have taken a few macro econ classes, you know that cash or money market rates also tend to track inflation. Thus, this is an excellent time to repeat and remind ourselves of this long-standing fact; Real Estate prices tend to track inflation in terms of a rate of return +/- about 1%. Now take a look at the current Schiller Home Price Index: Year over Year % change





     You’ll see a few things. The first is that when price appreciation, year over year moves above 10%, it becomes highly unstable, as it was back in the late 80’s and near 2005 and more recently in 2014. Now, remember, we’re looking at the rate of change on a rolling 12-month basis. These numbers are going to peak before actual prices peak because things tend to slow down before they change directions. Real estate is a slow-moving animal so lead times can be as much as two years. Now, look at the recent peak in the 12-month rate of change. By the eye, I’m going to say it happened around mid-2014. So, unless we see a dramatic increase in the Year over Year % change in real estate prices now, like right now, I’m going to expect to see an actual price peak in the near future. Finally, you might notice the current rate of change itself as mid 5%. I’m going to get myself in trouble with my realtor friends for saying this but when the real annualized rate of change (return) in the value of your home is less than the commission charged to sell it (6%), it seems we should all be a little critical of this transaction cost. I can say that after two decades of fee compression where the public thinks that any management fee is too much. Why are we not as critical about a 6% real estate commission on one of our largest centers of household wealth? If ever there was an industry ripe for automation, it is the real estate transaction business. I’m SHOCKED that the internet has not cut into this business yet… it will. 


All good stuff to keep in mind as we make short and long term decisions about what to do with our hard earned money.


Until next time


Sam Jones