Today’s edition opens with some reflections on the notion of updating your personal “operating system”.
We’ll then move on to the US economy where we find reasons to hope today’s bull market might continue, but also a couple of fairly alarming indicators suggesting the next stop for bulls may be the abattoir.
As we head out on the trail, I’m listening to High by Sir Sly. Not sure it will resonate with some of our more mature readers, and the video is pretty bad, but I like the energy level of the song.
OPERATING SYSTEM UPGRADE
Recently, I came to the conclusion that my personal “operating system” (POPS for short) is out of date.
That’s because the operating system I’ve been using hasn’t evolved very much since I stumbled upon it as a directionless youth of 19.
The old operating system is quite straightforward.
Spend an hour or so every day studying something you find interesting and useful— and then parlay that knowledge into a fulfilling career you are passionate about.
To be sure you are getting the most out of your life, be somewhat uncompromising on the important stuff like key relationships, your work, and the place you live. If those aren’t giving you energy and making you happy, you move on. Maybe not next week or in a month, but certainly you need to take the steps to make a change within 3 to 12 months.
Otherwise you risk getting stuck in a soul-sucking rut.
This relatively simple operating system all but ensures success and, because you’ll be working at something you are passionate about, living in a place you like, and in a relationship that makes you happy, you’ll enjoy a fulfilled life.
That POS served incredibly well over the years - yet I’m now convinced it is out of date, and even counterproductive.
The system just described was, I believe to the depths of my soul, the very best operating system I could have embraced in my late teens.
However, at sixty-three years old, I’ve come to the realization that it isn’t as relevant anymore. It’s not completely useless, but it is definitely out of date and out of sync with the life I want to live.
That’s because the old POS is primarily focused on building knowledge, which, in turn, can be used to create a marketable value. That invariably leads to greater self-confidence, something I needed a big dose of in my youth.
Fast forward to today, however, and the POS results in me constantly looking for new dragons to slay, even when the heads of all the important ones are already mounted on the wall. Thus, rather than being content enjoying the fruits of my considerable labor, I still feel compelled to get out of bed well before dawn to study and work, even on the weekends.
Worse, when I find myself without work—which happens more regularly now that I have dialed back my day-to-day responsibilities—I feel as if there is something missing in my life. That leads to an itchy lack of contentedness.
To help me understand how to possibly change it, I went to see a therapist I had seen briefly decades ago. While he is retired from private practice, we had become quite friendly all those years ago, and he agreed to see me at his house.
After describing the situation to him, I asked him if it was possible to upgrade, or replace, my internal operation system. Summing up his views:
A. Some of my operating system may not be able to be modified. It may be neurological. This is the old nature versus nurture argument, but something I hadn’t previously considered. To wit, there are things that are essentially hard-wired into all of us and that we may not be able to change.
B. We are what we think. If I think I can’t change, I won’t. He said this after I expressed my belief that after most of a lifetime operating on one system, I might not be able to change.
He then asked me to do two things in order to see if change was possible. Or, more accurately, to see how much change was possible.
● Suspend my disbelief. This goes back to “We are what we think.” I may not be able to get to the “I can change” frame of mind just now, but I can definitely suspend disbelief that I can’t, and so I have.
● Identify two or three small changes I can make that might indicate I am able to modify my operating system.
Here’s what I decided so far:
1) Sleep until at least 7:00 am every day. For my entire adult life, I have leapt out of bed between 5:00 and 6:00 am (and often earlier) so I might accomplish all the things I felt I must. By sleeping to a more reasonable hour, several things have happened:
a) I begin to change a core attitude from the old operating system that I “must” do so many things each day or I have somehow failed.
b) I sleep more restfully, having given myself permission to sleep in as opposed to going to sleep each night ticking off the list of chores I must tackle first thing in the morning.
c) I condense my work and studies into more normal hours. By allowing fewer hours in the day to get my essential work done (as well as the optional stuff such as studying and creative pursuits), I leave fewer gaps where I don’t have anything to occupy me, triggering the aforementioned skittishness.
2) I have taken up painting. While I still write creatively, writing is something that comes naturally to me and so requires no great effort. Painting, on the other hand, requires serious focus. Painting requires that you push everything else out of your mind in order to be entirely “in the moment,” and that you really, really look at an object or a landscape. Only then will you appreciate the subtle tones of color, the details of the shapes, the lighting… aspects of the world that’s in front of you every day but that you never really “see.” (The sketch here is not mine, just a good example of the subtleties possible with even just a pencil).
3) No work on three days of the week. Those three days are set aside to walk, talk, exercise, play golf, paint, do creative writing, go to a movie, whatever. In time, it is my hope that I will be able to reduce the days I work even more, a healthy amount given my age and financial position. And a big change in my operating system.
That’s it. Three relatively simple things I can accomplish to give me confidence that I can continue to upgrade my operating system to one that accepts being more in the moment, more content in my everyday life.
So far, I’m doing pretty good with 1 and 2 of the above list, but still struggling a bit with #3 as each day I find some excuse to work.
The bottom line is that I have worked hard to get to this point in life, but the old operating system—with its focus for constantly striving for bigger goals—contains little room for standing still, for contentment.
As I get older, meeting those goals and living up to the high standards I set for myself has become harder and harder. Per the Stoics, by setting such high expectations, I am setting myself up for disappointment, internal conflict, and frustration.
I’m not sure how far I can get with upgrading my operating system, but I find the challenge to be intriguing and worth taking on. Ironically, I'm using the old operating system in attempting to upgrade it, but that's okay as I have a high degree of confidence it will help me change what can be changed.
Regardless, I believe this notion of reviewing one’s operating system and, if necessary, deliberately seeking to upgrade it has merit no matter what age a person is.
You too may find, or have already found, that what used to work as you strived for success in this life, may no longer work as you achieve that success. Or, if you are constantly striving to achieve harmony in your life, and failing, maybe your operating system needs a reboot. Something to consider.
And with that bit of self-reflection behind us, I’d like to move on to a quick deliberation about the US economy and investment markets at this unstable juncture in time.
August 1, 2017
Throughout my career in and around the investment industry—in mutual funds, banking, investment research, and running what was then the largest investment conference in the world—there have been any number of periods, like today, where a palpable fog of pending doom has settled over the markets.
During those periods, investors tend to sit on their hands, willing to forgo any real upside by leaving their hard-earned money in reasonably safe, yield-producing assets. That used to mean settling for a 5% return.
Fast forward to today. While you can theoretically find “safe” investments, you won’t find any that pay a yield much above inflation, if that.
That leaves investors with a binary choice: earn no return, or put their money into the stock market despite fears over escalating risk.
While you might have a different opinion, as I see it, the growing market risk emanates largely from those at the very top of the government.
Specifically, pretty much the entirety of the Democratic leadership, as well as a solid swath of those in the Republican party, appear determined to undercut President Trump regardless of the consequences to the economy.
And Trump himself has to take a share of the blame. Rather than sticking with the rather straightforward agenda he was elected to execute upon, he has allowed himself to be suckered into petty squabbles and not-so-petty international adventures and posturing. The inane new Russian sanctions are just the latest diversionary nonsense.
While we could debate who gets what share of the blame, the reality is that Trump’s agenda is swimming upstream against a strong current… with one arm.
Pretty much the only hope for the economy after Obama’s tepid “recovery” was a successful retooling of the economy to reduce the weight of regulations and taxes on the corporate drivers of economic growth. The only component of the economy that actually counts.
A failure of Trump’s reform agenda might well spell the end of the abnormally long bull run that has left both stocks and bonds dangerously overvalued.
Either economic growth must continue to play catch-up, or those excessive valuations will likely return to earth. And maybe sooner rather than later, given that the “trigger” in this case would be a firming up of the opinion within the investment community that Trump is a dead duck, one-term president.
Attempting to get a better perspective on where things stand, let’s start with a look at the valuations of the broad US stock and bond markets.
Our first chart shows the Price/Earnings Ratio of the S&P 500.
The current P/E for the S&P 500 is around 23, down a bit from the recent high of 24.15 in Q216, and way, way lower than the anomalous 122 posted back in June 2009.
Eyeballing the chart, it’s clear that current valuations are on the higher side, yet nowhere near the elevated numbers seen ahead of the last two recessions.
And bonds? Here’s the chart for 10-Year US Treasury Bond Yields.
While 10-year Treasury rates have rebounded since hitting all-time lows about a year ago, they are clearly range bound, and the downtrend is intact.
So, on a big-picture basis, the US stock market is fully valued and bonds significantly overvalued.
Those realities do not mean a crash is imminent: history has shown that both markets can remain overvalued for years. This is especially true if investors are optimistic that a paradigm shift is underway. In this case, the Trump reforms.
Of course, when we talk about the economy, we are talking about a complex system with an almost infinite number of variables. One of those variables is the overall indebtedness of US consumers. If they are up to their necks in debt, they are unable to spend, a direct hit to the all-important corporate earnings.
Given the Fed’s recent shift toward a more hawkish stance, further increases in rates—and the cost of borrowing as well as servicing existing debts—hold the potential to wreak havoc on the economy.
We hear a lot about personal debt in the US, but how dire is the situation?
It may surprise you to learn that the level of debt has been solidly trending down since the Great Recession. The chart here shows Household Debt to GDP.
More importantly, in terms of an economic outlook, the next chart shows the amount of money households spend to service their debt as a percentage of disposable income. Of course, this data has been impacted by the Fed’s zero-interest-rate policy, but the fact remains that the debt burden on the average American has been greatly reduced since the last recession.
That brings us to one of the more important leading indicators, Real Disposable Personal Income. To state the obvious, the more free cash people have, the more they buy and the better the corporate earnings. As you can see from the chart below, even adjusted for inflation, people are doing just fine, on the whole.
There’s another bullish factor at work, ironically because of the trouble Trump is having making headway. That factor is the recent weakness in the US dollar, which you can see in the chart here.
An article this week on MarketWatch summed up the impact of the dollar turnaround.
According to Goldman Sachs, “dollar weakness contributed to a 14% rise in earnings per share during [the first quarter], the highest pace of growth since 2011.” The second-quarter reporting season is still ongoing, but whereas the U.S. dollar index fell 1.6% over the first quarter, it dropped 4.9% over the second, suggesting the earnings boost could be larger.
All of these indicators point to a far less fearful outlook for the US economy, and by extension, the stock market.
However, it’s always important to look at the flip side.
There is a long list of reasons for concern about the economic/investment outlook. Here’s a quick run-through of just a few that have caught my eye of late.
Velocity of money. The velocity of money moving through the US economy is in a state of collapse and is now at the lowest level since the Great Depression of the 1930s.
The velocity of money is influenced by a combination of factors. A low level of velocity can result from money being injected into the economy by the Fed, a slowdown in GDP growth, investors cutting back spending and boosting savings, etc.
While the collapse in velocity would seem highly deflationary and portend an economic hard landing, it is worth glancing again at the chart and noting that the velocity of money has been falling since the early 1980s, and trending at the low end of the range for the last decade.
At some point, it seems likely that the sludge-like circulation of money through the economy will gum up the works, but it is impossible to know how long that will take.
Shiller’s P/E calculations show the US stock market is significantly above the historical mean. The following chart is from GuruFocus.com (an excellent service, BTW). Shiller’s more nuanced approach to calculating P/E finds the broader stock market dangerously elevated. Being time efficient, I’ll just paste in the GuruFocus comments on the indicator.
Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio increased to 30.60, approximately 82.1% higher than the historical mean of 16.8. The Shiller P/E would be twice the historical mean if it increases another 3%.
So, based on Shiller’s calculations, both the US stock and bond markets are extremely overvalued. Watch out below?
Time between recessions. The average time between recessions is about six years, and only rarely have recession-free periods lasted more than seven years—only twice in the last 70 years, not including the current recession. The last recession officially ended in Q309, meaning we are at about eight years and counting.
Fed rate hikes. Out of the 13 cycles of Fed rate hikes since 1950, 10 have been followed in short order by recessions. According to Forbes, the three exceptions came early in the business cycle, which is the opposite of the case today.
‘Tis the Season of the Ditch. It is also worth mentioning that, historically, September is the month in which the US stock market is most likely to crash, with October coming in second. While this is not a particularly sophisticated metric, when looking at the fundamentals, it never hurts to take into account investor psychology, and the meme about a crash in the fall is a persistent one.
THE BIG NEGATIVE
The bearish variables above could be considered piles of dead brush surrounding investment markets. As to the match that will burn the house down, per my comments a moment ago, my candidate is the clear fact the US president is being tripped up by the Democrats at every turn, in no small part thanks to the active support of quislings in his own party. Thus, the odds of his pro-business agenda being passed are shrinking daily.
Absent reforms, we are left with a stagnating economy, a crumbling healthcare system, and the persistent tangle of Obama-era regulations. Add into the mix a pall of uncertainty over trade with major partners (Mexico, China, Canada, Europe), and the stage appears set for a conflagration.
At which point Trump’s many detractors will gloat that they were right all along that Trump—and by extension, his pro-business agenda—was doomed to fail. Even though they are the ones holding the bloody knife.
That these same politicos and pundits claim to care for the average working stiff while actively advocating policies that accelerate the destruction of the middle class and trap the poor in poverty is the height of hypocrisy, and their self-serving actions border on treason.
While one can gain some small satisfaction by wishing a plague on all their houses, there is pitifully little we as individuals can do to counter the entrenched interests running the show.
Therefore, we need to look to our own.
While no one can say with any degree of certainty where the US markets will head next, let alone a year or two down the road, the trillions of dollars invested in US stocks and bonds have to go somewhere.
For example, if the Fed were to blindly continue tightening rates and unwinding QE, which I doubt they will, they could trigger large outflows from US bonds, some percentage of which will flow into stocks. As there is about $30 trillion parked in US bonds, a bond exodus could have a major impact.
The correlation between interest rates and stock prices is tenuous at best, but there have been many periods in history where stocks rose hand in hand with interest rates. That supports the thesis that when money flows out of bonds, a significant percentage moves into stocks.
Even so, the simple fact remains that both stocks and bonds are overvalued, and the risks to the markets extend far beyond rising rates and include any number of potential black swans.
But, by definition, those events are unpredictable and out of our control.
Therefore, the best strategy for a core portfolio is to diversify your assets geographically and across a number of asset classes, being sure to include a decent allocation to tangibles such as real estate, precious metals, and cash.
By taking this simple, though not always easy, approach (thanks to the government’s deliberately annoying laws related to offshore investing), you shouldn’t have to be overly concerned about a correction, even a steep one.
As far as making money on your money, I continue to believe that equities have to be a core holding. But only if you adopt an unswerving bias toward undervalued companies. Because, yes, the S&P 500 may be overvalued, but within that index are any number of great stocks selling at great prices. Focusing on these stocks will soften the blow of any serious broad market sell-off and ensure you have a shopping list to refer to when values get even better.
I know that all sounds hokey, but that doesn’t make it wrong. Like flying or playing golf, when it comes to investing, boring is exactly what you’re striving for.
Let’s start with gold. Not as the “always-there” gold holdings everyone should own as insurance, but as a speculation.
While gold has shown some life of late—as it should, given the plunge in the dollar—I would have expected more. I have no idea what it will take for gold to break higher and hold its gains, but as gold typically does well in a crash, I am adding to my gold position on dips.
And as a serious speculation (i.e., I entered the trade knowing it is likely to result in a loss unless something dramatic happens), last week I bought a call option on GDX, the gold stock ETF.
Given how far the US dollar has fallen of late, this is a risky trade as a rebound in the dollar, even if temporary, would send gold lower.
However, should Mr. Market come to believe Trump is done, a pretty decent possibility at this juncture, then the dollar should generally trend down and precious metals work higher over the next year.
As for the broad US stock market, with the help of a friend who is more options-savvy than I, last week I also bought long-dated, out-of-the-money put options on SPY.
We structured the options so they’ll pay off big if there is a 10% or bigger move in the underlying instrument. The idea is for the puts to help absorb the blow of a sharp sell-off, providing me with more ammunition to parlay into the best-of-the-best value stocks on my personal shopping list.
I am making these moves because I do think the odds are good Trump’s agenda will fail, leading to a recession within the next year. If I am correct—and to be clear, no one really knows—you’ll also want to remember that by the time a recession is officially declared, it is usually more than halfway over.
On that point, in the research we did for our “Crash Ahead?” report, we did some back-testing and found that if you wait until 12 months after a recession is officially declared (not the official start of the recession, but the date it is confirmed by the NBER as having begun) and then move back into the market, the odds are good you’ll miss most of the risk and enjoy the bulk of the inevitable bounce.
It’s not a very sophisticated approach, but sometimes simple can work pretty well.
The bottom line, in my view, is that extra caution—especially over the next couple of months—makes sense. As does preparing a list of great stocks you want to own, but at lower prices than they trade at today. That way, should a serious correction come, you’ll be ready.
For the more proactive investors among you, particularly those with a higher tolerance for risk, using options to actively hedge your portfolio against a crash might also make sense.
Because it is in all our interests that the US economy returns to sound ground, I hope the Trump administration manages to fight off the swamp monsters trying to drag it down.
Sadly, given the power and the morally corrupt entrenched bureaucracy, the odds are long against Trump succeeding and so I am rigging my portfolio with that outcome being the most likely.
In the last edition of these musings, published May 30, I mentioned speculating by shorting the largest index ETFs for the Korean (EWY) and Mexican (EWW) markets.
In the case of Korea, the broader Korean market is already looking quite toppy and combined with what appears to be an intractable situation developing with North Korea, a waterfall crash could be in the works. Adding to the potential of this trade are newly announced taxes on businesses and the wealthy, as well as significant regulatory hurdles targeting South Korea’s overheated real estate market. So, for now, I’m holding.
In the case of the Mexican market, the thesis is that a rabid socialist/populist by the name of Andrés Obrador will win next July’s presidential election. At the time of my write-up, I mentioned it was early to short Mexico, but I was going to do so anyway in an attempt to get ahead of the trading community.
While one shouldn’t pay attention to short-term results, so far I’m underwater on both the Korean and Mexican shorts.
Of course, as speculations, the amount committed to these ideas is relatively small. It’s really just sport.
A Final Note
I wrote the following immediately after a call last week with the IRS.
(Minute 34 on hold listening to bad music and inane announcements. There is a click on the line, and a man answers.)
Hello, this is Mister Odami, how may I help you?
Yes, I received a letter saying that I hadn't cashed a check you had sent me.
Oh, well, you've called the wrong number. This number is for delinquent accounts.
But this is the number that was on the letter.
Not to worry, I will transfer you to the refunds department, and they will make sure your money is sent right along.
(Minute 61 on hold. A woman answers.)
This is Missus Smith, and my ID number is 2821287440226438. How may I help you?
Yes, I received a letter from you...
I can't hear you. Are you there?
YES, I'M HERE!!!
If you are there, I cannot hear you. Please call back at your convenience between the hours of 9:00 am and...
I'M HERE... I'M HERE. PLEASE, IN THE NAME OF ALL THAT IS SACRED, DON'T HANG UP!!
... and 4:00 pm, Monday through Friday. Thank you for your call.
The next day, I called back and spent over one hour and forty minutes on hold, during which I was transferred four times, with the transferee in each instance promising that the next voice I heard would be of someone who could actually help me.
Every one of the individuals was pleasant enough (though one sounded heavily sedated), but in the end, none of them knew how to re-issue the refund check or even the right department to help me.
The last person I spoke to admitted defeat and suggested that rather than remaining in the telephone death loop, I write a letter instead.
Who can possibly believe the insane complexity of the current US tax system is fathomable to anyone, even the people who work for the IRS? Who can possibly argue against the idea of simplifying the tax code, or stand in the way of tax reform simply because someone from the opposing party proposes it?
Scoundrels, rent-seekers, and politicians.
I could go on, but it’s time to head back out on the trail, so I will bid you farewell until next time.
As I do, I want to share with you a quote from Winston Churchill that needs to get more circulation.
Some people regard private enterprise as a predatory tiger to be shot.
Others look on it as a cow they can milk.
Not enough people see it as a healthy horse, pulling a sturdy wagon.