Are Bonds Sending A Signal?

Michael Lebowitz previously penned an article entitled "Face Off" discussing the message from the bond market as it relates to the stock market and the economy. To wit:

"There is a healthy debate between those who work in fixed-income markets and those in the equity markets about who is better at assessing markets. The skepticism of bond guys and gals seems to help them identify turning points. The optimism of equity pros lends to catching the full run of a rally. As an ex-bond trader, I have a hunch but refuse to risk offending our equity-oriented clients by disclosing it. In all seriousness, both professions require similar skill sets to determine an asset's fair value with the appropriate acknowledgment of inherent risks. More often than not, bond traders and stock traders are on the same page with regard to the economic outlook. However, when they disagree, it is important to take notice."

This is an interesting point given that despite the ending parade of calls for substantially higher interest rates, due to rising inflationary pressures and stronger economic growth, yields have stubbornly remained below 3% on the 10-year Treasury.

In this past weekend's newsletter, we discussed the current "bullish optimism" prevailing in the market and that "all-time" highs are now within reach for investors.

"Currently, the "bulls" remain clearly in charge of the market…for now. While it seems as if much of the "tariff talk" has been priced into stocks, what likely hasn't as of yet is rising evidence of weakening economic data (ISM, employment, etc.), weakening consumer demand, and the impact of higher rates.

While on an intermediate-term basis these macro issues will matter, it is primarily just sentiment that matters in the short-term. From that perspective, the market retested the previous breakout above the March highs last week (the Maginot line) which keeps Pathway #1 intact. It also suggests that next week will likely see a test of the January highs."

 

"With moving averages rising, this shifts Pathway #2a and #2b further out into the August and September time frames. The potential for a correction back to support before a second attempt at all-time highs would align with normal seasonal weakness heading into the Fall. "

One would suspect with the amount of optimism toward the equity side of the ledger, and with the Federal Reserve on firm footing for further rate increases at a time where the U.S. Government is about to issue a record amount of new debt, interest rates, in theory, should be rising.

But they aren't.

As Mike noted previously:

"Given our opinions on the severe economic headwinds facing economic growth and steep equity valuations, we believe this divergence poses a potential warning for equity holders. Accordingly, we thought it appropriate to provide a few graphs to demonstrate the 'smarter' guys are not on board the growth and reflation train."

In today's missive, we will focus on the "price" and "yield" of the 10-year Treasury from a strictly "technical"perspective with respect to the signal the bond market may be sending with respect to the stock market. Given that "credit" is the "lifeblood" of the Government, corporate and consumer markets, it should not be surprising the bond market tends to tell the economic story over time.

We can prove this in the following chart of interest rates versus the economic composite of GDP, inflation, and wages.

Despite hopes of surging economic growth, the economic composite has remained in an elongated nominal range between 40 and 60 since 2011. This stagnation has never occurred in history and is a function of the massive interventions by the Government and the Federal Reserve to support economic growth. However, now those supports are being removed as the Federal Reserve lifts short-term borrowing costs and reduces liquidity support through their balance sheet reinvestments.

As I said, credit is the "lifeblood" of the economy. Think about all the ways that higher rates impact economic activity in the economy:

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates will immediately slow the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) The "stocks are cheap based on low interest rates" argument is being removed.

5) The massive derivatives and credit markets are at risk. Much of the recovery to date has been based on suppressing interest rates to spur growth.

6) As rates increase so does the variable rate interest payments on credit cards. 

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs lead to lower CapEx.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on, but you get the idea.

So, with the Fed hiking rates, surging bankruptcies for older Americans who are under-saved and over-indebted, stumbling home sales, inflationary prices rising from surging energy costs, what is the 10-year Treasury telling us now.

Short-Term

On a very short-term basis, the 10-year Treasury yield has started a potential-topping process. Given that "yield" is the inverse of the "price" of bonds, the "buy" and "sell" signals are also reversed. As shown below, the 10-year yield appears to be forming the "right shoulder" of a "head and shoulder" topping formation and is currently on a short-term "buy" signal. Such would suggest lower yields over the next couple of months.

The two signals above aren't a rarity. The chart below expands this view back to 1970. There have only been a few times historically that yields have been this overbought and trading at 3 to 4 standard deviations above their one-year average.

The outcome for investors was never ideal.

Longer-Term

Even using monthly closing data, which smooths out volatility to a greater degree, the same message appears. The chart below goes back to 1994. Each time yields have been this overbought (remember since yield is the inverse of price, this means bonds are very oversold) it is has signaled an issue with both the economy and the markets.

Again, we see the same issue going back historically. Also, notice that yields are currently not only extremely overbought, they are also at the top of the long-term downtrend that started back in 1980.

Even Longer Term

Okay, let's smooth this even more by using quarterly data closes. again, the picture doesn't change.

As I noted yesterday, the economic cycle is extremely advanced and both stocks and bonds are slaves to the full market cycle.

"The "full market cycle" will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology."

Of course, during the late stage of any market advance, there is always the argument which suggests "this time is different." Mike made an excellent point in this regard previously:

"Given the divergences shown between bond and equity markets, logic says somebody's wrong. Another possibility is that neither market is sending completely accurate signals about the future state of the economy and inflation. It is clear that bond traders do not buy into this latest growth narrative. Conversely, equity investors are buying the growth and reflation narrative lock, stock and barrel. To be blunt, with global central banks buying both bonds and stocks, the integrity of the playing field as well as normally reliable barometers of market conditions, are compromised.

This divergence between bond and equity traders could prove meaningless, or it may be a prescient warning for one or both of these markets. Either way, investors should be aware of the divergence as such a wide gap in economic opinions is unusual and may portend increased volatility in one or both markets."

While anything is certainly possible, historical probabilities suggest that not only is "this time NOT different," it will likely end the same way it always has for investors who fail to heed to bond markets warnings.

"The Market Has Two Broken Legs": Why Morgan Stanley Doubled Down On Its Bearish Call | Zero Hedge

"The Market Has Two Broken Legs": Why Morgan Stanley Doubled Down On Its Bearish Call

Last Monday, Morgan Stanley made quite a splash with its contrarian call, when in the aftermath of a handful of poor tech results, most notably from Facebook which lost as much as $150BN in market cap due to slowing user growth, the bank's chief equity strategist Michael Wilson boldly predicted that "the selling has just begun and this correction will be biggest since the one we experienced in February."

Worse, Morgan Stanley cautioned that a liquidation in tech/growth "could very well have a greater negative impact on the average portfolio if it's centered on Tech, Consumer Discretionary and small caps" due to the disproportional ownership of this group of stocks by professional and retail investors, as well as due to their outsized contribution to overall market performance since the financial crisis.

In retrospect, Wilson may have inadvertently led to just the latest short squeeze for growth stocks, because as disenchanted longs rotated into tech shorts, the Nasdaq has since surged to new all time highs, largely thanks to AAPL crossing the $1 trillion market cap threshold.

So has the market's action since Morgan Stanley's controversial call dampened the bank's bearish sentiment? Not all at all, and in a note released today, Wilson doubled down on his short tech reco, writing that "we continue to stress our defensive rotation/Tech underperformance call."

But why continue to press the downside case when price action suggests that the upward momentum remains intact? In three words: "Market on Edge" - that's how Wilson describes the price action, which he believes could go either way from here, but he is sticking with his call for Tech underperformance - while conceding that he will watch price action closely - "as we think that rolling relative earnings revisions in some areas of Tech, continued defensive leadership, breadth/price divergences, and rolling PMIs."

Meanwhile, "a breakdown in both legs of momentum" augurs poorly for Tech, growth, momentum, and the market.

Taking a step back, Wilson explains the fundamental driver behind his recent bearish shift, which he says has been shaped by the idea that "the continued tightening of global liquidity, a peak rate of change on economic and earnings growth, and a continued rise in inflation would be a difficult combination for risk assets to handle without some pain."

Markets globally (LIBOR-OIS, VIX, EM equities and debt, BTP spreads, derating in equity sectors like Fins, Industrials, Homebuilders, Transports, etc.) have been flashing yellow lights at different times this year, something which we have dubbed a "rolling bear market." Different parts of the risk complex have been hit, but at different times, leading to overall modest returns as we are still in a strong growth environment.

Meanwhile, with most sectors having been hit at least once, US Tech and Discretionary equities have remained as the holdouts - with several notable exceptions - persistently holding or expanding their multiples over the last 12 months while risk assets globally repriced.

That persistence of performance seems out of place to us and creates an obvious potential pain point for markets. If we  are right, and Tech gets its turn on the volatility roller coaster, its market weighting, crowded positioning and overweight in growth and momentum strategies mean the pain will likely spread beyond just the Tech sector.

But what about continued strong earnings?

Here Wilson notes that while he previously thought that earnings might be the catalyst for the tech trade to unwind, the message there has been mixed, with management saying little to nothing about tariff risks other than that:

1. it is too early to see an impact,
2. impacts are still not really known as the bigger tariff implementations are still ahead, or
3. that tariffs will not be a problem as prices will be passed along or absorbed by increased efficiencies.

Wilson believes statements 1 and 2 are accurate, but is skeptical that statement 3 – price/cost absorption – will be as easy to carry out as is being represented. He also adds that regardless of what he believes, "it is clear the market has, for the most part, not treated tariff risks as a negative catalyst" at least not in the US: after all China's stocks are just a fraction away from 2018 lows, and already deep in a bear market.

At the same time, the message on fundamentals has been more mixed after Facebook and Netflix showed that strong earnings results "were not written in stone in the FAANG complex, and seemed to validate our thesis." However, what failed to materialize was contagion. This was helped by Amazon, which had a stellar quarter that surpassed even bullish expectations on profitability, but even here Morgan Stanley saw warning signs and notes that "the poor price follow through after such a strong print was a sign of exhaustion and stretched positioning, in line with our call that the upside drivers from here are not clear."

What about Apple? Here, not even Wilson can find anything to criticize, noting that ASPs rising and strong services growth gave us the world's first $1Tr company. Well, he did find something to criticize, pointing out that "while the message from Apple will be interpreted by many to mean that all is right with Tech, and that we should just pack it up and move on from our Tech underperformance call. However, we believe there is still more to the story and can't help but think that Apple hitting $1 Trillion could be a meaningful historical marker for a tradable top when we look back at this period."

As a result of the above skepticism, Wilson and Morgan Stanley double down on their call for further tech pain:

We are sticking with our underweight Tech call as we think that rolling relative earnings revisions in some areas of Tech, continued defensive leadership, breadth/price divergences, rolling PMIs, and a breakdown in both legs of momentum all augur poorly for Tech, growth, momentum, and the overall market.

To support his point, Wilson then lays out several recent observations in the sector, starting with:

Software/Services Relative Earnings Revisions Have Turned Lower.

While the Tech sector has continued to deliver solid results, the relative revisions have rolled over quite hard for the sector, led by Software & Services, which includes internet stocks like Facebook and Google but not Netflix and Amazon (Exhibit 1).

Defensive Leadership Is Continuing.

Defensive leadership has still been dominant in the market. Apple helped Tech lead last week but the defensive leadership trend we have been commenting on was on full display last week with REITs, Staples, Utilities, and Health Care leading the market (Exhibit 2). While Tech rebounded last week, it is being supported by fewer stocks.

Breadth Is Diverging From Price.

Tech/Growth breadth continued to deteriorate. Exhibit 3 shows the percent of Nasdaq numbers making new 52-week highs versus the Nasdaq composite price level. We know there are issues with comparing stationary to nonstationary series, but nevertheless we make two simple observations: 1) Since we started our defensive rotation call in June, the number of stocks making new highs has been in a clear downward channel with lower lows and lower highs and 2) the index price level has continued to press to near new highs. In other words, fewer and fewer stocks are carrying the burden of lifting the market, a sign of exhaustion and, in our view, a bad signal for further price gains.

PMIs Rolling.

The big misses in PMIs this week, which were among the worst in several years. July was only the 2nd time in the history of the ISM Services report (1997+) that Business Activity, New Orders, and Backlog Orders all dropped 5 or more points m/m. We have to go back to the print following 9-11 for the last such occurrence. We have been warning that Tech is more exposed to PMI weakness than what has been priced in and the substantial turn lower this month does not bode well for next month or the rest of the year as the comparisons get considerably more difficult.

Momentum - Hard to Walk With Two Broken Legs: Wilson saved his greatest concern for last. In it, he shows how a sector neutral index of 12-month long short momentum has been performing over the last year. Tech and other growth stocks have been persistent drivers of the  long side of this index given their remarkably steady performance.  This is the same concern as Nomura voiced two weeks ago when the bank warned that "the most important trade of the past decade is now reversing." "

What makes us cautious on this uptrend now are the drivers of the two recent moves lower. The first leg lower was defensives outperforming – the performance laggards and short leg of the index. The second leg down has been led by weakness in Tech and growth – the performance leaders and the long side of the index.

Given the exposure of both discretionary and quant investors to the momentum factor, Wilson thinks that lingering weakness here "could feed on itself and invite further rotations, which will not be good for price momentum leaders –i.e. Tech and other leading growth stocks exhibiting strong price momentum on a trailing 12-month basis – or the market, given these stocks' dominant weighting in the overall index."

“Hidden Debt Loophole Could be Widespread”: Fitch | Wolf Street

"Hidden Debt Loophole Could be Widespread": Fitch

Use of this financial instrument has ballooned. No one knows to what extent because there's no disclosure. But it was a "key contributor" to the sudden collapse of outsourcing giant Carillion.

As regulators and stiffed creditors were poking through the debris of collapsed outsourcing giant Carillion – once employing 43,000 people worldwide – they found that the UK company had hidden much of its debts. And Fitch Ratings warned that this "technique" – a "debt loophole" – may be "widespread" in the US and Europe.

Carillion provided services to governments. It didn't manufacture anything, didn't have a lot of assets, and didn't have a lot of debt – at least not disclosed on its books. Net debt on its balance sheet amounted to £219 million. But Fitch estimates that it had an additional financial debt of £400 million to £500 million.

This debt was hidden by a "technique commonly referred to as reverse factoring," Fitch says. And it was "a key contributor to Carillion's liquidation."

This "reverse factoring" – part of supply chain financing – allowed Carillion to hide a debt of £400 million to £500 million in "other payables," such as money owed suppliers. There were indications that something was off: Over a four-year period, "other payables" had nearly tripled, from £263 million to £761 million. According to Fitch, "This appears largely to have been the result of a reverse factoring program."

But this was financial debt owed to banks – not trade accounts payable.

Any disclosure?

Almost none. Fitch explained in the report (press release here):

There was one passing reference to the company's early payment program in the non-financial section of the accounts, but nothing in the audited financial statements and no numbers.

The only clue to the scale of the supply chain financing was the growth in "other payables," the implications of which do not appear to have been appreciated by many in Carillion's broader stakeholder group.

Carillion was no exception. Disclosure rules are "complex" and "highly dependent on specific circumstances, auditor, and jurisdiction," Fitch says:

Promotional literature in the field regularly cites as a benefit the fact that supply chain financing – and reverse factoring in particular – can be shown as accounts payable rather than debt. Companies borrow cash while avoiding its inclusion in financial covenants or debt reported on the balance sheet.

A review of a number of companies with supply chain financing program shows precious little by way of disclosure.

Reverse factoring programs are aggressively marketed by banks and specialized financial institutions in the supply chain finance industry. And this lack of disclosure requirements is one of the key selling points.

How much reverse factoring is going on?

"We believe the magnitude of this unreported debt-like financing could be considerable in individual cases and may have negative credit implications," Fitch says. But due to lacking disclosures, no one knows the magnitude.

Greensil, which provides supply-chain financing and claims to have financed $30 billion to date, estimates in its promotional literature that about $3.5 trillion globally is tied up in working capital. But not all of it can be leveraged in supply-chain finance.

Fitch tried to estimate if "reverse factoring" is increasing. It looked at a sample of 337 companies and found that the metric "payable days" – the average number of days companies were stringing out their suppliers – had grown by 17% since 2014, to 96 days in 2017.  Fitch believes that in 2017 alone, payables days rose 6%.

"Assuming all of this increase was reverse factoring, then this could be as much as $327 billion additional reverse factoring since 2014" among the 337 companies, Fitch said. That's an average increase of about $1 billion per company in the sample.

But not all of this growth is reverse factoring. Other dynamics play a role too, including the "ongoing cash management efforts by the companies in the sample, with supplier terms being squeezed."  But due to lacking disclosures, it's "impossible for a third party to tell one way or another."

How does reverse factoring work?

Supply chain finance in general describes working capital management techniques with which a company extracts financial benefits from its supply chain. The "most publicized" of these techniques is reverse factoring. Fitch explains how it works and the reasons for doing it:

Company A, the buyer, purchases goods in the normal course of business from company B [often not rated or junk rated]. Company A, typically a large well-rated corporate, will arrange a reverse factoring program with a financial institution.

Once it has been on-boarded into the program and negotiated terms with the bank, B will be able to submit the invoices it has issued to A, once A has validated (or confirmed) them, to the bank for accelerated payment. It could get paid after 15 days rather than its usual 60 days.

The supplier benefits because it gets quicker access to cash but at the lower borrowing cost associated with the stronger credit rating of its customer.

The buyer benefits because reverse factoring allows it to borrow without disclosing it as debt:

As part of this process, the bank will also often allow company A longer to pay the invoice than B would have accepted without the supply chain finance arrangement. So rather than paying in 60 days it may pay only after 120 days. This is effectively using a bank to extend payment terms….

Thus, the buyer is borrowing 120 days of its accounts payable from the bank, while the bank pays the supplier. None of this debt that the buyer owes the bank shows up as "debt" on the buyer's balance sheet but remains in "accounts payable" or "other payables." The money borrowed from the bank becomes cash inflow on the cash-flow statement. And the highly touted figure "cash" increases. Hallelujah.

How does Fitch treat reverse factoring — if it's disclosed?

If a company provides "sufficient and reliably consistent disclosure," Fitch adds the dollar amount resulting from an extension in "payable days" – for example from 60 days to 180 days – to the amount of the debt.

If the buyer has $100 million in unpaid invoices after an extension of payables days from 60 days to 180 days, Fitch assumes that 120 days of that outstanding invoice amount, or 66.7%, is due to a reverse factoring program. It would therefore treat $66.7 million of that $100 million as financial debt, rather than trade payables, and adjust its credit metrics accordingly.

But that increase in financial debt might put the buyer in violation of its debt covenants or impact negatively other credit metrics that would increase its costs of borrowing. Hence, this "sufficient and reliably consistent disclosure" is precisely what few companies do. And this financial debt remains hidden in trade accounts payable.

Creditors and shareholders are at risk without knowing it – see Carillion

The fact that this financial debt is not disclosed, "combined with the potentially serious consequences where companies' use of factoring programs goes unnoticed, is cause for concern," Fitch says tersely.

"As seen in the case of Carillion, reverse factoring could have a potentially large impact on vulnerability to default for specific issuers, making awareness critical."

Cash obtained via reverse factoring is particularly fragile because when this company gets into financial distress, the bank simple cancels the reverse factoring program, and the company will have to come up with funding to pay down its accounts payable to the terms agreed to with suppliers.

To use our example above, the buyer would have to come up with $66.7 million to pay down its payables from 180 days to 60 days – and this would happen as the buyer is already under financial stress, just when it can no longer borrow money at survivable rates. This is how reverse factoring increases the likelihood of a sudden default and Carillion-style collapse.

"Sectors that are large users of reverse factoring include consumer packaged goods, telecommunications, chemicals, retail, and aerospace," Fitch says.

"Risk Is Risk... Risk Knows No Age"

Risk Knows No Age

"If you are a young investor, you need to take on as much risk as possible. The more risk you take, the greater the reward."

This is actually a false statement.

Let's start with the definition of "risk" according to Merriam-Webster:

1: possibility of loss or injury : peril

2: someone or something that creates or suggests a hazard

3a : the chance of loss or the perils to the subject matter of an insurance contract; also : the degree of probability of such loss

3b : a person or thing that is a specified hazard to an insurer

3c : an insurance hazard from a specified cause or source 

4: the chance that an investment (such as a stock or commodity) will lose value

Nowhere in that definition does it suggest a positive outcome for taking on "risk."

In fact, the more "risk" assumed by an individual the greater the probability of a negative outcome. We can use a mathematical example of "Russian Roulette" to prove the point.

The number of bullets, the prize for "surviving," and the odds of "survival" are shown:

While there are certainly those that would "eat a bullet" for their family, the point is simply while "more risk" equates to more reward, the consequences of a negative result increases markedly.

The same is true in investing.

At the peak of bull market cycles, there is a pervasive, cancerous dogma communicated by Wall Street and the media which suggests that in the long run, stocks are a "safe bet," and risk is somehow mitigated over time.

This is simply not true.

Blaise Pascal, a brilliant 17th-century mathematician, famously argued that if God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn't exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.

Pascal concluded, given that we can never prove whether or not God exists, it's probably wiser to assume he exists because infinite damnation is much worse than a finite cost.

A recent comment from a reader further confirms what many investors to believe about risk and time.

"The risk of buying and holding an index is only in the short-term. The longer you hold an index the less risky it becomes."

So according to our reader, the "risk" of losing capital diminishes as time progresses.

First, risk does not equal reward. "Risk" is a function of how much money you will lose when things don't go as planned. The problem with being wrong, and facing the wrath of risk, is the loss of capital creates a negative effect to compounding that can never be recovered.

As we showed previously, let's assume an investor wants to compound investments by 10% a year over a 5-year period. The table below shows what happens to the "average annualized rate of return" when a loss is experienced.

The "power of compounding" ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe. 

The problem with following Wall Street's advice to be "all in – all the time" is that eventually you are going to be dealt a losing hand such as in our example above. During bull market advances, prices rise in part due to earnings growth but also because investors are willing to pay more for a dollar of earnings than they were in the past. This is called multiple expansion and it is the hallmark of almost every bull market. Periods where price gains were largely the result of excessive multiple expansion, such as the 1920's and 1990's, were met with devastating losses when valuations normalized. The losses simply brought prices back to, or even below, levels which were commensurate with earnings.

The longer we chase a market where multiples are expanding well past norms, the greater the deviation from earnings and the greater the risk. As multiples expand, investors unwittingly escalate the inherent risk more than they realize which exposes them to greater damage when markets go through an eventual reversion process.

Even in healthy markets with fair valuations, risks exist. But in markets with high valuations the risk of a reversion increases as time marches on.

Here is another way to view how "risk" increases over time. Currently, valuations stand at levels similar to those of 1929 and not far behind those of 2000. Lets examine the current cost of "buying insurance" (put options) on the S&P 500 exchange-traded fund ($SPY). If the "risk" of ownership actually declines over time, then the cost of "insuring"the portfolio should decline as well. Why then, as shown below, does the cost of insurance rise over time?

As you can see, the longer the period our "insurance" covers, the more "costly" it becomes. This is because the risk of an unexpected event which creates a loss in value rises the longer an event doesn't occur.

Furthermore, history shows that large drawdowns occur with regularity over time.

In early 2017, Byron Wien was asked the question of where we are in terms of the economy and the market to a group of high-end investors. To wit:

"The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion."

His point is that markets rotate between bullish and bearish phases. When he made that statement he was simply saying the current economic recovery and the bull market are very long in the tooth. As shown below why shouldn't we expect a market decline to follow, it has every other time?

The "full market cycle" will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology.

"There are two halves of every market cycle. "

"In the end, it does not matter IF you are 'bullish' or 'bearish.' The reality is that both 'bulls' and 'bears' are owned by the 'broken clock' syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being 'right' during the first half of the cycle, but by not being 'wrong' during the second half."

But as Mr. Pascal suggests, even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire. Rolling the investment dice while saving money by skimping on insurance may give us a shot at amassing more wealth, but the RISK of failure, and possibly a devastating failure, increase substantially.

Duration Matching

In the bond market the concept of "duration matching" is commonplace. If I have a specific target date, say 10-years in the future, I don't want a portfolio of bonds maturing in 20-years. By matching the duration of the bond portfolio to my target date, I can immunize the portfolio against increases in interest rates which would negatively affect the principal value in the future.

Unfortunately, in the equity markets, and particularly given the advice of the vast majority of mainstream analysis suggesting that all individuals should "buy and hold" indexed based investments over the long-term, the concept of duration matching is disregarded.

Stocks are considered to be going concerns and therefore have no maturity, therefore the question of "duration matching" a stock portfolio becomes problematic. However, the problem can be somewhat solved through a combination of both allocation and risk management.

Over the years, I have done hundreds of seminars discussing how economic, fundamental and market dynamics drive future outcomes. At each one of these events, I always take a poll asking participants how long they have from today until retirement. Not surprisingly, the average is about 15 years.

The reason is obvious. For most in their 20's and 30's, they are simply not making enough money yet to save aggressively nor or is that a focus. During the 30's and early 40's, they are buying a house, raising kids, and paying for college – again, not a lot of money left over to save. For most, it is the mid-40's and early 50's where the realization to save and invest for retirement becomes a priority. Not surprisingly, this is the dynamic that we see across most of the country today in survey's showing the majority of individuals VASTLY under-saved for retirement.

Chart Courtesy Of Motley Fool

As you can see, the median American household will struggle to fund retirement..

There are two problems facing investor outcomes.

First, you don't have 100+ years to invest in the market to get the "average" long-term returns.

Second, your "long-term" investment horizon is simply the time you have between today and when you retire. As I stated above, for most people that is about 15 years.

So, for argument sake, let's be generous and assume you have 20-years from today until retirement. As we discussed previously, we know that based on current valuations in the market, forward real total returns in the market will likely be, on average, fairly low to negative. 

What this chart clearly shows is the "WHEN" you invest is crucially more important than "IF" you invest in the financial markets. In regards to the current market environment consider this chart from Brett Freeze.

Based on 70 years of history, there has never been a period in which the ratio of market cap to GDP (red vertical dotted line) has been this high and returns over the next ten years were positive.

This is where the concept of "Duration Matching" in equity portfolios becomes important.

Given a 15 to 20-year time horizon for most individuals, investing when market valuations were elevated resulted in a loss of principal value during the time frame heading into retirement. In other words, most individuals simply "ran out of time" to reach their retirement goals. This has been the case currently for those 15-20 years ago that were planning to retire currently. Those plans have now been greatly postponed.

This is also the case for those with a 10-20 year horizon who put their trust into a "buy and hold" portfolio and disregard both valuations and risk.

When building a portfolio model, an investor must take into consideration the actual "time-frame" to retirement and the relative valuation level of the market at the beginning of the investing time frame.

For example, for an individual with a 15-year time frame to retirement and elevated market valuations, a portfolio model might resemble the following:

Note: The equity portion is "managed for downside risk protection" which we will explain in an upcoming chapter, which means that during certain periods the exposure to equities is reduced substantially.

The portfolio is designed to deliver a "total return" including capital appreciation to adjust the value of the individual's "savings" for inflation, interest income and dividend yield. Each of these components is critical to achieving long-term investing success. While we can build a portfolio of bonds with a specific maturity, we have no such option in equities. This is where "risk management" must be used as a substitute. 

Let's compare the portfolio above with an all-equity portfolio in a market environment that is either +/- 10% in a given year.

Assume: Equity delivers a 2% dividend yield and taxable bonds deliver 3% in interest income.

The 50% recapture on the balanced portfolio means that we assume risk mitigation techniques will reduce losses by 50% relative to the decline of the S&P 500 index.

As you can see, managing a portfolio against downside can greatly increase future outcomes of the time frame an individual has until retirement. We regularly post a real-time model in the weekly newsletter since 2007 which adjusts a 60/40 allocation model for risk.  By reducing the amount of time required to "get back to even" long-term returns can be improved to reach projected retirement goals.

Disclaimer: All information contained in this article is for informational and educational purposes only. Past performance is not indicative of future results. This is not a solicitation to buy or sell any securities. Use at your own risk and peril. No recommendations are being made or suggested.

Should you invest in the markets? Yes.

However, the allocation model used must adjust for both the time horizon to your financial goals and corresponding valuation levels.

If you are 20-years old and buy into the top of a market cycle, you could likely find yourself 20-years toward your retirement goal without much progress. Conversely, if you are 45-years, or older with valuations elevated, fundamental and economic prospects weak, and the majority of the previous bull-market behind you; managing your portfolio as if you were a 20-year old will have significantly negative outcomes. 

As I stated above, the problem with equities is that they never mature. Unlike bonds where a specific rate of return can be calculated at the time of purchase, we can only guess at the future outcome of an equity-related investment. This is why some form of a "risk management" process must be adopted particularly in the latter years of the savings and accumulation time frame. 

While it is always exhilarating to chase markets when they are rising, cheered on by the repetitious droning of the "buy and hold" crowd, when markets reverse those cheers turn to excuses. You are likely familiar with "no one could have seen the crash coming" and "you're a long-term investor, right?" 

The problem is that the "long-term" of the market and the "long-term" of your retirement goals are always two VERY different things.

There is only one true fact to remember:

"All bull markets last until they are over." – Jim Dines

You see, risk has no age.

Risk is risk.