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5 Things To Ponder: Intriguing Erudition

Submitted by Lance Roberts via STA Wealth Management,

In last week's Friday reading list I discussed the concept of being an "almost fully invested bear" which was the premise of my speech at the 2015 World Economic Conference in Vancouver. (See full slide deck here).

As I stated, the presentation focused on two primary areas:

1) The leading cause of investor underperformance over time, and;

2) Signs that investing "bulls" should be paying attention to currently.

The focus on "risk management" is what consistently gets me labeled a "bear" even though portfolios remain nearly fully allocated currently.

However, as I discussed recently, there are evolving signs that market risks are beginning to climb rather significantly. Besides rising high yield rates, market volatility on the rise, and margin debt near record levels; the momentum of the market has deteriorated to the point that a monthly warning signal has been issued. To wit:

"Lastly, the long-term chart of the markets are beginning to flash warning signs that this extremely long bull-market cycle may be at risk. While it is still too early to make a more defensive call now, there are signs of significant deterioration in the overall "momentum" of the market.  In the weekly X-Factor Report, I run a model for managing 401k plans that consists of the three (3) buy/sell indicators. (Subscribe for free e-delivery)

 

The chart below shows two of the three indications on a monthly basis labeled S1 (sell signal 1) and S2 (sell signal 2). There have only been three periods since 1998 where the S1 indicator has been triggered.  The first was in late 1999 as the markets climaxed toward their peak in 2000; the second was in late 2007, and the third was in January of this year."

"Considering that market momentum is waning, deflationary pressures are rising and economic growth is slowing on several fronts (along with a rather rapid decline in corporate earnings) it certainly suggests that risks are beginning to significantly outweigh the rewards. Is this suggesting that the next major bear market is underway? No. It does suggest, however, that investors should pay much closer attention to the inherent risk in portfolios currently.

 

The S1 signal could be reversed with a very strong rally that propels the markets to new highs. While this is certainly possible, it has historically not been the case. However, the market over the last few years, due to massive Central Bank interventions, has repeatedly defied statistical analysis and historical comparisons."

I am becoming extremely concerned about the risks in portfolios due to the deterioration in the markets momentum and technical structures as of late. If this market is going to continue its "bullish advance" in the months ahead, there will have to a reversal of the "decay" that currently exists, and soon.  One thing is for certain, when the market begins the next major reversion, I have no intention of being around to participate in that decline.

This weekend's reading list is a hodge-podge of articles and reports that have caught my attention.


1) Persistent Over-Optimism About Economic Growth by Kevin J. Lansing and Benjamin Pyle via SF-FRB

"Since 2007, Federal Open Market Committee participants have been persistently too optimistic about future U.S. economic growth. Real GDP growth forecasts have typically started high, but then are revised down over time as the incoming data continue to disappoint. Possible explanations for this pattern include missed warning signals about the buildup of imbalances before the crisis, overestimation of the efficacy of monetary policy following a balance-sheet recession, and the natural tendency of forecasters to extrapolate from recent data.

 

Research has identified numerous instances of persistent bias in the track records of professional forecasters. These findings apply not only to forecasts of growth, but also of inflation and unemployment (Coibion and Gorodnichencko 2012). Overall, the evidence raises doubts about the theory of 'rational expectations.' This theory, which is the dominant paradigm in macroeconomics, assumes that peoples’ forecasts exhibit no systematic bias towards optimism or pessimism. Allowing for departures from rational expectations in economic models would be a way to more accurately capture features of real-world behavior (see Gelain et al. 2013)."

 

2) Explaining The Difference Between QE and Money Printing by Chris Brightman via Advisor Perspectives

"The Fed has ceased its program of quantitative easing (QE) and may soon begin to raise interest rates. Japan has embarked on an even more aggressive program of QE. The European Central Bank (ECB) has just begun QE. In a related development, the Swiss National Bank (SNB) recently stopped pegging the Swiss franc to the euro. Many investors are asking, “What does all this monetary turmoil mean?”

 

It’s no wonder investors are perplexed. QE’s direct and indirect effects are complex, and the fact that various polities are at different stages of implementation doesn’t make it any easier to understand the dynamics. I don’t have all the answers, but I will try to explain QE in plain language, why central banks have adopted it, and how it can affect inflation and security prices. I’ll also comment on what’s happening now."

 

3) Investment Lessons From The Poker Table by Dr. Ben Hunt via Advisor Perspectives

"Hunt introduced game theory in the context of poker. To be successful, one needs to play the player and not the cards. Having been dealt the same cards, an intelligent player will make different decisions playing against a table of off-duty Las Vegas card dealers than he would against a table of 'half-inebriated dentists,' Hunt said. Thinking about the cards as the fundamentals of investments, the player should focus on the other market participants along with their strategies and incentives. Hunt offered the old adage, 'If you have been playing cards for 30 minutes and you don’t know who the sucker is, it is you.' Hunt said this is true in markets as well. An understanding of game theory, along with an understanding of the players and games that are played in the markets, will help investors avoid being that sucker.

 

The central concept of game theory is strategic interaction while making decisions under uncertainty, Hunt said. Decisions are not made in a vacuum, but in the context of other players also making decisions to advance. To illustrate the spectrum of risk, Hunt quoted former Secretary of Defense Donald Rumsfeld’s infamous statement regarding the lack of evidence linking the Iraqi government with the supply of weapons of mass destruction to terrorist groups in 2002:

 

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”

 

In the spectrum of risk, certainty includes the 'known knowns,' risk includes the 'known unknowns,' and uncertainty includes the 'unknown unknowns.' All modern economic theory is based on decision-making under risk where potential outcomes can be identified with probabilities assigned.  With regard to investment decisions in the current environment characterized by central bank interventions, Hunt said that the use of 'econometrics is not wrong, but is less useful in an environment of uncertainty than it is in an environment of risk.' Given the high degree of uncertainty, the lessons learned from game theory and history provide additional insights for success in today’s markets."

Read Also:  Dow Theory Sell Signal Explained by Matthew Kerkhoff via Financial Sense

Read Also: The Market Is Weaker Than It Looks by Anthony Mirhaydari via Fiscal Times

 

4) Fed's Preferred Inflation Measure Takes A Dive by Tim Duy via Tim Duy's Fed Watch

"It is hard to see how the Fed can be confident that inflation with trend back to target when looking at these numbers. They need some acceleration in wage growth to justify their intentions to begin normalizing policy, and even with such acceleration, I think their case is fairly weak in the context of the current inflation environment. If they make a case, they will base it on these three pillars:

  1. With unemployment nearing 5%, they have reached their employment mandate.
  2. Monetary policy is exceptionally accommodative even if they raise interest rates.
  3. Failure to raise rates invites asset bubbles.

Bottom Line: Below trend inflation as the economy nears full-employment is a very uncomfortable position for the Federal Reserve. It will be interesting to see how Federal Reserve Chair Janet Yellen navigates these waters at the upcoming Congressional testimony."

 

5) The Consequences Of Monetary Policy Are Unknown by Paul Singer via Zero Hedge

"Conditions in the global economy are clearly abnormal. The policymaker response to those conditions is extraordinary, with minimal focus on an all-out push for higher growth. Instead, the primary focus is on boosting “inflation” with repeated doses of bondbuying, stock-buying and super-low interest rates. We cannot appreciate why policymakers are not jumping up and down clamoring for structural pro-growth reforms and policies, and why there is a compliant consensus that the only policy that is possible is more monetary easing. Apparently, most politicians are happy to leave the hard economic and policy decisions to their central banks instead of introducing legislation to properly address the world’s economic problems."

Read Also: Signs Of Economic Distress In The US by GaveKal Research


Bonus Read: Great Investors Admit Their Mistakes by Morgan Housel via Motley Fool

"A trait you'll see among the world's best investors is the willingness -- even desire -- to talk about their mistakes. They analyze what went wrong, why they were mistaken, and how they can learn from their errors so they don't repeat them.

 

Everyone makes mistakes, but they seem to grasp what most of us have a hard time admitting: It's your (and my) fault."


"Dogs have no money. Isn’t that amazing? They’re broke their entire lives. But they get through. You know why dogs have no money? .. No Pockets.” – Jerry Seinfeld

Have A Great Weekend