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Category: Chart of the Week

Alarm Bells are Ringing! Could we be Entering Recession Territory?

By Brad Lamensdorf and John Del Vecchio
The yield curve is inverting, which means that long-term interest rates might start to trade below short-term interest rates. If the past is any indicator of the future, it could mean that we are staring a recession in the face. If investors are concerned about the economy, they may prefer to hold longer-term treasuries that yield less than short-term treasuries. Obviously, this makes no sense in a perfect world. But, in the real, world if investors think a recession is coming they don’t want to own short-term treasuries that ultimately will see their yield fall. They’d rather get locked into a lower rate now that may end up being higher when short-term rates tank as the result of a recession.

A look at the chart below shows that the recent trend between the 10-year treasury and the 2-year treasury (blue line) is nosediving toward the zero line. The grey shaded areas in the chart show past recessions. Typically, when the yield curve implodes, a recession has been close by.

It’s not always immediate. Look back at the 1990’s, when it took a while for a recession to rear its ugly head. The wealth effect from the boom in technology may have shielded some of the impact of the negative yield curve, but eventually the economy got bit. Bit hard.

Now you can see that we are trending down to multi-year lows. The difference today is that there’s a boatload of leverage in the system. Leverage is great while it’s working…until it isn’t. Then some bad things can happen.

For example, many financial institutions set up trades, called derivatives, that depend on a positive interest rate carry (blue line above trending up) to be profitable. These trades may have been set up a couple of years ago, and the bank may have misjudged the future of the yield curve. As these trades go against them, it does huge damage to their balance sheet. Not only are they no longer profitable, but the addition to leverage adds fuel to the fire. There’s a reason why Warren Buffett has called these type of trades “financial weapons of mass destruction”. We could see another wave of massive write-downs or bank failures just like we saw 10 short years ago, for many of the same reasons. People have short memories!

Another scenario is that short-term loans on long-term assets could lead to the consistency of payments to a bank to fluctuate wildly. Let’s say someone owns a building that is financed with short-term loans that are often refinanced because rates have trended lower, and the building generates $100,000 in rent. If the economy gets hit by a recession, the building owner might see his cash flow evaporate as tenants go under and close up shop. Now the bank might get stuck with a default. Meanwhile, the bank can’t borrow money at short-term rates and loan it out longer-term for higher rates. Loan growth slows and margins take a hit. The result is bad all around.

The concern is that “this time it’s different” and there won’t be problems. It’s never different this time. Human nature never changes. What’s more is that we cannot believe the economic growth or job statistics reported by the government. There’s all sorts of voodoo math in those figures. We should all position our investments accordingly.

Chart of the Week 05-07-2018

Should You Sell in May and Go Away?


By John Del Vecchio

There’s an old market saying to “sell in May and go away”. Over time, a heavy seasonal pattern of stronger stock price performance from the late fall to early spring has developed. But, just blindly following a Wall Street maxim can also be a good way to have money picked from your pocket.
It turns out that this old Wall Street maxim is right on the button. The chart below illustrates the performance between stock price performance from November – April (blue line) and May – October (red line).
The difference is stark.
$1,000 invested from November – April returns $79,100 while $1,000 invested from May – October yielded just $2,201.
Obviously, we have just entered May so this seasonal pattern of lower stock prices is just under way. There’s no guarantee that this pattern will hold this year. However, it’s worth noting that we are living amongst one of the longest bull markets in history. Increasingly, market performance is being driven by just a handful of stocks such as, Netflix, Facebook, and Alphabet (Google). Meanwhile, below the surface of the indexes there’s plenty of weakness in individual stocks.
Given that the market is long in the tooth and divergences among stocks are forming, it may pay well to heed the advice to sell in May and go away. For a while at least.

The One Metric That Could Trigger a Bear Market

By John Del Vecchio

Chances are, if you watch the talking heads on TV, they are drooling all over themselves about the Federal Reserve and what actions members plan to take on interest rates. It’s the Fed this and the Fed that.

But, the interest rate that really matters is LIBOR. LIBOR stands for the London Interbank Offered Rate. It’s a really, really important rate.

Here’s why…

When investors borrow money and use their portfolio as collateral, the loan is often priced at LIBOR plus some base interest rate. For example, the loan might be priced at LIBOR plus 1%. Importantly, these loans are not priced on the federal funds rate.

Look at the chart below. The blue line is 3-month LIBOR. Over the past 30 years, LIBOR has trended down. However, recent history tells a much different story.

It’s been rising steadily from the ashes to multi-year highs. Nearly every day it is getting more and more expensive to maintain these lines of credit that wealthy investors have been using.

How much credit is out there borrowed against stock portfolios? Trillions of dollars.

You see, people with portfolios of liquid assets get access to these credit lines. That means people who own stocks. Often you must have more than $1 million in stocks and bonds to get access to LIBOR-plus loans. These are the one percenters.

They can buy a new house or finance a large purchase of an illiquid asset by using their portfolio as collateral. These assets might be boats, planes, fine wine, or investable art.

You name it.

The rub is that the banks don’t ask you what you’re going to use the money for. You just can’t use it to buy more stocks. Anything else is fair game. Want to have a great time in Montreal this weekend? No problem! Just tap into the line of credit. Need to charter private plane for a round of golf at Pebble Beach? The bank will be more than happy to let you tap the line of credit.

The problem is, as interest rates creep up and more portfolios have been used to finance asset purchases, it could create a huge storm if stocks and bonds take even a minor dip. Montreal is fun, but that money has been spent. Hopefully that round of golf wasn’t full of three putts. There’s an old saying that you can always buy a boat but you can’t sell one. And, that’s the problem. Shedding assets when everyone else is feeling pain leads to terrible deals for the seller.

If stock prices slide, the borrower could get margins calls. They have to sell stock. But, they also have to reduce their leverage because they can only borrow so much against the portfolio. Everything unravels at once. This accelerates the selling pressure. What should be down 10% in normal markets might be down 30% in a highly levered market.

Each day, we get closer to the tipping point…

This Red Flag is Worse than the Financial Crisis

By John Del Vecchio
Subprime auto loan delinquencies are now higher than during the financial crisis in 2008-09. As you can see from the chart below, the 60+ day delinquencies rate for subprime auto loans has surged in recent years and is approaching 6%.

Looser credit standards might be to blame for the rise in delinquencies. Haven’t we seen this movie before with mortgage lending standards? That’s right, it was a horror film that ended badly and resulted in trillions of dollars in bailouts.

Any Joe Schmoe could buy a house well beyond his means? You make $35,000 in a retail job? No problem, here’s a $700,000 house. All you have to do is sign on the dotted line and take out an equity loan on an asset you have no equity in.

Human nature is a funny thing. It never changes. We are right back to the loose lending standards that we experienced years ago. It’s like the lesson of tremendous pain was never learned.

This crisis might not be as bad as the housing crisis in that autos are not quite the big-ticket expense as a house. However, if your car is repossessed, you might have trouble showing up for work.

The trend in delinquencies does indicate that a portion of the consumer market is feeling some pain. They’re being left behind in the “recovery”. Of course, government statistics such as the unemployment rate use a lot of adjustments and, in the end, are just made up numbers.

The risk is that this starts to spread. Initial pain by the weakest credits could creep up the latter. Eventually companies will feel the pinch and we will start to see this pain show up in other parts of the economy.

What are Professional Investors Signaling About the Next Market Move?

By John Del Vecchio

The National Association of Active Investment Managers (NAAIM) conducts a survey of its members and reports the average U.S. equity exposure among the group.

This survey has been a great contrary indicator in the past. Collectively, professional managers are terrible allocators. Individual investors are too. As a group, they tend to be too heavily weighted into stocks near highs and not have nearly enough exposure on when stocks are bottoming.

Recently, the market took a dive, and investors for the first time in years were rudely reminded that stocks sometimes do go down! As a result, more than a few people got scared.

Below is a chart of the exposure courtesy of NAAIM.

As you can see, as the market was rocketing higher, so was the exposure. But, the dips in February and March brought down the exposure dramatically from 120% in December, 2017 to under 50% in March, 2018.

What a move!

This is a good contrary indicator. Under normal circumstances a short-term bottom may be in. However, we have been operating in anything but normal circumstances. In the 50% range, the average annual returns are about 7.5%. That’s good but not great. We want to see something under 25% when the returns more than double current expectations.

It’s also important to remember than valuations are stretched as well. And, we are entering earnings season so anything can happen with individual stocks as they report their quarterly results.
While sentiment has become more reasonable, we still have a bit to go before backing up the truck and buying stock. Let’s wait and see where the next dip takes us.

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