Blog : Wealth Management

Don’t Fear the Flats…

Don’t Fear the Flats…

Is a Recession Looming Ahead? Risks and Opportunities of a Flat Yield Curve

  • Is the treasury bond yield curve sending a dangerous signal about the economy?
  • How have stocks historically performed in similar bond market environments?
  • Can the Fed balance growth, inflation and maintain its independence?
  • Should you refinance your mortgage in the present interest rate environment?

Two key issues currently facing the markets are tariffs, and the shape of the treasury bond interest rate curve.  We tackled tariffs and trade last month and dig into the yield curve messaging this month.  

The “yield curve” refers to the difference between the rate of the 10 year treasury minus the 2 year treasury rate.   The yield curve is an important economic indicator.  Why? Because, historically speaking, when the curve inverts to slope downward, (the short-term treasury rate rises above the longer-term rate) a recession is on the horizon.  

This important interest rate indicator bears watching because stocks appear to be fully priced.  Also, the biggest risk that would lead to a decline in stock prices is IF interest rates rise unexpectedly, or we have a recession that hurts earnings growth.  As such, now that the yield curve is nearing flat, a number of prognosticators are beating the doomsday recession drum.

I don’t know about you, but I am moderate skier (on the decline) and have most of my worst falls on the proverbial “last run of the day”…at the flat section at the bottom of the hill.   As such, I have been conditioned to fear the congested flats.

At the risk of stretching this metaphor beyond its useful lesson;  contrary to the mess that can occur at the bottom of the ski hill, the black diamond runs (inverted yield curve) remain most hazardous.  That said, we are clearly entering the flats, and this month we take a good hard look at whether or not that should be cause for alarm.

Do We Need Ski Patrol?

There are many theories as to why the economy dips into a recession once the yield curve inverts.  I will spare you most of the speculation surrounding these linkages. However, the most commonly accepted reason is because banks borrow (pay interest rates to their depositors) at the short interest rate and lend or make loans based on the long interest rate.  Therefore, when the short rates are higher than the long rates, the incentive to make bank loans disappears. Fewer bank lending leads to a slower or shrinking economy. More on this later.

The chart above illustrates how (since 1980) the economy has always gone into a recession (grey vertical bars) within 18 months of the yield curve (blue line) turning negative.  In fact, this relationship has held for the past 9 recessions dating back to the 1950’s. Note that flattening does NOT signal a recession – only inversion does.  

The negative yield curve is represented by the blue line dipping below the solid, horizontal black line at the “zero” mark on the left hand scale.  This was consistently the case in the 1980, 1990, 2001, and 2008 recessions.

The chart above also shows the health of the stock market (red line) relative to the shape of the yield curve.  Notice that the stock market has done quite well with the exception of the periods surrounding recessions.

Since the curve is not yet even flat, there could still be plenty of meat on the equity-returns bone and plenty of time to de-risk.

This is why we believe that while the stock market is fairly/fully priced, it will likely do just fine as long as we do not enter a recession.  Even though the chart is a bit dated, it accounts for all recessions in the past 40 years. In any event, the market has continued to run up ~35% since the end of 2016 as the yield curve has flattened from just over +1% to about +0.25% today.

Speaking of recessions, the Federal Reserve has a forward looking economic indicator that helps them keep an eye on the probability of a recession.  The current reading of this model indicates the odds of a recession occurring in the next 12 months are below 5%.

NOTE: The market has only spent approximately 36 months in recession over the past 40 years.  That equates to approximately 4 weeks per year.

These Runs Are Groomed

Let’s look at how the stock market has done when the yield curve has INVERTED.    

As the table above indicates, the market has done just fine, especially during the past three instances of the yield curve inverting, despite ultimately leading to a recession.  

In fact, those last three observations actually delivered an average return of 32%, after the yield curve inverted.  Since the curve is not yet even flat, there could still be plenty of meat on the equity-returns bone and plenty of time to de-risk.

I would never be caught uttering these infamous four words when talking about markets: “This time is different.”  However, I will say, “perhaps this cycle may not be exactly the same.”

Below is an excerpt by By Dr. Sonu Varghese via  The title of the article is “How Monetary Policy Works”…Aug 11, 2018.  

“Typically, a flattening yield curve, and eventually an inverted one, has been driven by rapidly rising short-term interest rates, while long-term interest rates rose at a much slower pace, if at all.  Yet, the mechanism that links yield curve inversions to recessions is not clear and so there is always a question of whether “this time is different” – including by Fed Chair Ben Bernanke after the yield curve inverted in 2006.

In this cycle, a lot of focus has fallen on the fact that global bond markets have been warped by unconventional monetary policy over the past several years.  Bernanke, once again, suggests that the yield curve’s power to signal a recession may have diminished because normal market signals have been distorted by regulatory changes and quantitative easing in other jurisdictions.

On the other hand, as Minneapolis Fed President Neel Kashkari points out, “this time is different” may be the four most dangerous words in economics.  He says that if the Fed continues to raise rates, not only are they risking yield curve inversion, but also contractionary monetary policy that will put the brakes on the economic recovery.  Though the question remains as to how this may happen.”

I would never be caught uttering these infamous four words when talking about markets: “This time is different.”  However, I will say, “perhaps this cycle may not be exactly the same.”

The reason most economic cycles come to an end is because increased economic activity heats up and causes inflation to rear its ugly head.

Although it is indisputable that the shape of the mountain remains the same, the snow conditions can vary greatly.

  1. At the very least, this time is more like the last three recessions (1988, 1998, 2006)  than the first two (1978 and 1980). The first two were fighting high double digit inflation with short interest rates approaching 20%; steep and icy moguls.  In fact, rates are now significantly lower than all other instances. That is a net positive for the stock market.
  2. There is much more private credit lending in the market today, particularly through hedge funds and private equity.  Increased private credit lending offsets reduced bank lending, helping to stave off recession in a flat yield curve environment.  For instance, in the table below, note how the supply of lending amounts in the Middle Market lending market has reversed from banks to private capital being offered from non-banks.  This growth in lending could be the difference in helping to keep the rails of economic growth greased, which could prove to be the difference between recession and continued economic growth.

Source:  S&P LCO

  1. Banks have diversified their operations and are not as dependent on that yield curve as they were in the past.  This is particularly due to the practice of securitizing and selling/hedging their loans.
  2. Most importantly, the FED has expanded its tool box since the Great Financial Crisis of 2008.  We have seen them introduce Quantitative Easing (QE) and remove “mark to market” accounting for banks.   Those new policies, which had not been used prior to 2008, help to favorably manipulate markets during periods of disruption.  Just the threat of returning to QE activities could buoy investor sentiment.

Let’s Hope the Fed Can Ski, Snowboard and Land Their Aerials

Can the Fed keep inflation in check without damaging growth?  That is their dual mandate.  The reason most economic cycles come to an end is because increased economic activity heats up and causes inflation to rear its ugly head.

… for the first time in several decades, a Presidential administration is challenging the independence of the Fed by suggesting that it slow its interest rate hikes.

Rising fears of increasing inflation will often lead to a flattening yield curve.  The yield curve typically flattens because the Fed becomes concerned about inflationary pressures, so they raise short term rates to tame inflation and subsequently slow the economy.  

This is why it will be important to keep an eye on inflation this cycle and see what the market is expecting.  Is the Fed ahead of the curve and keeping inflation expectations within an acceptable range (1.5-2.5%)…OR, do we see expectations growing toward deleterious levels?  

5 Year, 5 Year Forward Inflation Expectation Rate

Source: Federal Reserve Bank of St. Louis

The chart above shows the market’s inflation expectations for the 5 years that follow the next 5 years…specifically, that means years 2023-2028.  This is the inflation expectation chart that investment professionals follow most closely. At present, the Fed is doing a good job in managing their dual mandate of price stability and full employment.

That’s all well and good… except that for the first time in several decades, a Presidential administration is challenging the independence of the Fed by suggesting that it slow its interest rate hikes.  This unusual interference could impact Fed policy and ultimately the perception of their independence, which could erode its credibility.

It will [sic] also be important that inflation remains subdued to keep this economic recovery and bull market going.

Credibility is the currency of a central bank.  It is what keeps democracies from approaching banana republics, e.g. Argentina, where it is currently ski season.  The attached chart shows how the Argentine peso has declined 90% in past 10 years.  Once a central bank loses confidence, it is tough to get it back.  

Think about it, if a central bank is not independent, but rather politically aligned/influenced, what would prevent an administration from goosing the economy every election cycle without fear of inflation?  That lack of trust would lead investors to take less risk, make fewer investments, stick their money under the mattress, and ride the bunny slope.

Here’s the irony – the Fed may be forced to raise interest rates to cool the inflation caused by the double whammy of tariffs and tax cuts this late in the economic cycle.  It is important for the Fed to respond independently to inflationary threats. It will also be important that inflation remains subdued to keep this economic recovery and bull market going.

Conundrum – So, if the Fed alters the expected path of interest rate increases, market participants may suspect the Fed is being unduly influenced by the administration, which will likely damage Fed credibility.

Storm clouds have a habit of gathering quickly, causing the slopes to get icey and dangerous.  This is a time to stick to the blue slopes and not push too hard for more risk; yet it is no time to call it quits and take the gondola back down the hill.

Put on Your Snowshoes and Take a Look at Your Mortgage

The Federal Reserve can only really directly control a short term rate of interest called the Federal Funds Rate. However, the Federal Funds Rate often serves as a benchmark rate for other interest rates like LIBOR, off of which most adjustable rate loans such as ARM’s, credit cards, and bank loans, are priced. Those with ARM’s that have no plans to sell their home in the near future, may want to consider refinancing into a longer term fixed-rate loan.  Here’s why:

While the yield curve can be an excellent predictor of future economic activity, we feel other key early warning indicators need to ignite before the economy finds itself in a recession.

As these ARM’s hit their reset dates, at present the new rates won’t be much lower than those associated with long-term fixed-rate mortgages. If the yield curve actually inverts, those with an ARM could be paying more than those with a long term fixed rate mortgage.  Moreover, should interest rates fall, which we think is highly unlikely in the near to medium term, those with fixed rate mortgages can always choose to refinance lower.

As can be seen in the chart below, a few years ago, when many people took out ARM’s instead of fixed rate mortgages, the spread between the two types of loans made ARM’s more attractive. However, this spread is has been dramatically reduced, and the long term advantage of a fixed rate loan now outweighs the short term benefits of a ARM, FOR THOSE WHO DO NOT INTEND TO SELL THEIR HOMES.

Apres Ski Round-Up

History is against the economy IF the yield curve inverts, which is why this topic along with trade (last edition) are the TWO most important issues currently facing the market.

The financial press has focused on the shape of the Treasury Yield Curve for most of this year.  While the yield curve can be an excellent predictor of future economic activity, we feel other key early warning indicators need to ignite before the economy finds itself in a recession.  Stay tuned for a discussion about these key early warning signals in future reports.

See you in the lodge.

Want to Invest in Cryptocurrencies?

Want to Invest in Cryptocurrencies?

Here’s What You Need to Know

Cryptocurrency is the buzzword du jour for investors and technology enthusiasts alike.  Last month we gave an overview of cryptocurrencies and their foundational platform structure, the blockchain.  This month, Andre Huaman, Partner at Three Bell Capital, follows up our cryptocurrency primer with a detailed Q&A with cryptocurrency expert, Brayton Williams.

Brayton Williams is a Co-Founder and Managing Partner at Boost.VC.  Boost VC is a venture capital firm headquartered in San Mateo, CA, investing in cryptocurrency, virtual reality, and other emerging technologies.

Brayton and his team have been in the cryptocurrency space for over 5 years and were one of the first venture capital firms to place concentrated bets on the cryptocurrency industry. He is considered an industry expert in the cryptocurrency space.

Boost.VC is currently investing out of their 3rd fund, with $38m of committed capital. Limited Partners in Boost.VC funds include the likes of Tim Draper, Marc Andreessen, and Fidelity Investments.

Brayton Williams, Boost.VC

Andre: Thanks for being with us, Brayton.  Cryptocurrency and blockchain are fascinating to us and to many of our clients.  We are closely monitoring the activity in the space and more importantly, the potential for investment. Your expertise as an investor in the industry will help us to frame the cryptocurrency space and raise client awareness of potential benefits and drawbacks.

Brayton: Happy to be here.  This industry (blockchain/cryptocurrency) is fascinating and being in it for over five years, I have definitely witnessed both the high-net-worth crowd and larger financial institutions start monitoring cryptocurrency and begin to invest in it, as well. It is an exciting time.

Andre: What about this space is most exciting you right now?

Brayton: For the very first time, people are not only asking the question “What is money?”, but they are also exploring solutions to make money and currency better.  Of course, that was primarily driven by Bitcoin.  As people are now questioning this, they are beginning to also ask:  “Can society decentralize money? Can we remove government from money?”

And over the last 2 years, because of Bitcoin, people are questioning what else can be decentralized beyond currencies, and in particular, areas in which the government is involved. People are questioning institutions, their role in processes and business, and exploring if they can be removed from those industries.

Andre:  With this momentum, there must be some areas of concern in the blockchain space.  What about this industry is making you the most nervous and worried?

Brayton: Overall, my biggest worry is the irrational exuberance.  Market caps of many of these cryptocurrency projects are grossly over what the project has actually delivered. Many market caps are in the hundreds of millions and there is no working product.

Left and right, people are becoming self-proclaimed crypto investors and are only making money, not losing money. Most of the new market participants have never seen a downturn. This makes investors, as a whole, think investing in this industry is “easy money”.

However, they are failing to look at what is on the near to mid-term horizon. At some point in the next couple of years, we will see regulation shut down a large amount of these coin projects. We also are likely to see that many of these coins don’t serve an important purpose and like many startup companies, will fail.

Practically, I am worried about regulation.  People are not taking the regulatory bodies seriously. They think the decentralized nature of the crypto projects circumvent government authority.  This is plain wrong.

I strongly believe that in the next couple of years, laws will be put in place and government regulations and parameters will be implemented in the cryptocurrency space. Because of that, some projects will be negatively affected and may outright fail.  

Andre:  What areas, in particular, do you think the government will regulate?

Brayton: The U.S. government cares about three main things and this is where we will see them step in:

  1. Taxes (IRS). Given the decentralized nature of these coins and some of their privacy features, figuring out how to compel coin owners to self-report has been very difficult. The IRS is laser-focused on how to make sure coin owners pay their fair share of taxes.
  2. Securities Law (SEC). Many of these ICOs have issued coins that should be classified as securities and therefore subject to securities laws. Yet, most of these projects have not followed SEC guidelines on the issuances of these securities. The SEC is beginning to investigate and explore crypto projects that may have committed securities fraud or broken forms of security law. It is yet to be determined as to how they will punish these actors. We do know for a fact that cryptocurrency is a focus of the SEC.
  3. Anti-Money Laundering/Terrorism (DHS). Given some of the privacy features associated with cryptocurrencies, there is every opportunity for bad actors to utilize the coins as a way to fund terrorism, drug cartels, etc. One of Bitcoin’s first use cases was on Silk Road, the web-based black market that sold items and services ranging from heroin to hitmen, which was later shut down by a combination of the DHS and FBI. The DHS and other U.S. agencies will be focused on how to stop this technology from being used to enhance the funding of illegal activities.  

These bodies will be focused on this industry, how to best regulate it, and remove some of the bad actors in the space. And trust me when I tell you, there will be many shady characters who will be called out and punished for their fraudulent and manipulative actions in this industry.

Andre: We often hear about the “Bitcoin” or “Crypto” community. What is this community thinking about as it relates to blockchain technology and its use cases?

Brayton:  Blockchain by design eliminates the need to trust a third party. Historically, trust needed by a 3rd party cost money. Blockchain enables the removal of third parties since the blockchain itself is truth. And, because it is software, you do not pay for that third party.

Proof of ownership is the key behind the ledger and blockchain. And it is not limited to money. It relates to real estate deeds, proof of ownership of digital goods, contracts, etc…  While the rise in cryptocurrency prices has been fascinating and hard to ignore, entrepreneurs who are involved directly in this space are most excited to see blockchain positively impact the entire world and many of the daily activities and critical functions that help society function.

I should mention, in my opinion, I believe that a considerable amount of the cryptocurrencies now in circulation will eventually fail. There are too many cryptocurrencies chasing the same carrot. Some of them likely will end up getting in trouble due to fraud, misleading statements, etc. This will be a much-needed awakening for the crypto market.

Andre: Earlier, you mentioned involvement by U.S. based government agencies.   How do other nations’ governments view these currencies? Are there some that are more open to cryptocurrencies and others that are more cautious, versus the U.S.?

Brayton:  Some countries, such as Denmark, Sweden, Canada, and others, are positioning themselves as friends of the cryptocurrency space.  

I think the countries focused on creating “crypto-friendly” environments are very smart. There is a massive opportunity for any individual or group of countries to be considered the “capital of crypto”.  It would be similar to the U.S. being considered the hub of the internet and therefore reaping the benefits of being the home to the top technology companies in the world.

Should a country become the capital of cryptocurrency, it will see tens of thousands of talented engineers and professionals moving in to work on cryptocurrency and the various blockchain applications. The (tax) revenues associated with that, along with increased demand for housing, goods, etc., in those countries, will be massive and can change an entire country’s economy.

Andre: What if, in the worst case scenario, these projects are completely rejected by all governments.  If that occurs, can these currencies thrive, or even survive, outside of government acceptance, or could they be absolutely shut down?

Brayton: Yes it could survive and no it can not absolutely be shut down. Shutting down this system, from a government’s perspective, is nearly impossible. If mining became illegal, it would literally take only a handful of computers worldwide to maintain the system.

View this similarly to the gold rush. Did the government grab all the country’s gold? No. Like gold, Bitcoin is too distributed for the government to seize total control.

The only technological way that government could kill Bitcoin is if it placed more resources behind mining than currently exists within the decentralized mining system.  If the government finds a way to own 51% or more of hashing power, they could potentially freeze or alter the Bitcoin network. I think this is highly unlikely.

The U.S. government, in particular, has shown interest in wanting to learn more about cryptocurrency, blockchain, and the implications and benefits of these systems. The U.S. government and other governments recognize that these cryptocurrency projects are global and many of the blockchains are primarily maintained and supported (via miners) outside of the United States.

If one country bans a cryptocurrency from being used or mined within its jurisdiction, it does not kill the currency or its potential use cases. If anything, the outright banning of a certain cryptocurrency may, in fact, increase that cryptocurrencies value and utility.

Andre:  Moving away from regulatory risk, can you explain how one can buy a Bitcoin? And related, how can an investor be comfortable they will not be defrauded?

Brayton: With cryptocurrency, security as it relates to coin theft or a hacked wallet is generally all about keeping private keys safe. The problem is that for an average investor, being able to securely purchase and store cryptocurrency is both difficult and requires some level of technical prowess.  

Crypto security is a growing industry right now. However, the solutions are still extremely difficult for the average investor to manage.  Currently, I recommend smaller investors use Coinbase to purchase Bitcoin, as it is the easiest solution in the marketplace today.

With Coinbase and other like crypto exchanges, technically, those exchanges own the currency and the associated private keys on behalf of the purchaser. This is a major risk to all investors who purchase on these sites and something they must realize. The worst case scenario leads to Bitcoins being lost in a hack along with any other Bitcoins stored on any given exchange.

As an investor’s sophistication grows or their portfolio grows, I would begin looking into cold storage solutions. Cold storage solutions mean that you, the purchaser, truly own your cryptocurrency and the private keys. There are a variety of cold storage methods. In almost all cases, cold storage is a smarter way to store one’s cryptocurrency vs. on a public exchange.  

The trade-off between security and convenience is a big one here.

Andre: How secure is the blockchain itself? Can the software that runs these coins and projects, blockchain, be hacked? Is this an investor concern?

Brayton: The Bitcoin and Ethereum blockchains today, as we know them, are secure.  I reference these two since they are the largest and longest standing without hacks.

With that said, these are emerging technologies. They are susceptible to attacks, hacking, etc… Yet, they have proven to be virtually bulletproof so far.

Keep in mind that Bitcoin currently holds $100b+ of market value.  This provides an awful lot of incentive and temptation to crack. If someone in the world figures out a way to break Bitcoin and its code, even a fraction of it, they may have access to some of that $100b in value. You couldn’t ask for a bigger potential bounty.

Therefore, investors should realize that the blockchain is constantly being explored and prodded for weaknesses and potential errors by hackers. Every day it is not hacked adds to its credibility and security.

Andre: How easy is it to lose Bitcoin, whether it be because of technical incompetence or some other factor? What happens if I sent a Bitcoin to a wrong address or forget my wallet address and private keys?

Brayton: One of the biggest issues with the cryptocurrency space is that, because it is such a young market, most of the tools, services, and products are not user friendly. Therefore, errors on a user’s end are very possible. There are a handful of ways to lose Bitcoin:

  1. If you store on an exchange or brokerage, and that exchange is hacked, there is no government agency to bail you out for the funds that have gone missing (and most of the exchanges would cease to be in business if that happened to them).
  2. Your email, phone, and computer can be compromised which allows hackers to sign on to your exchange and brokerage accounts and steal from it.
  3. The technology interfaces are very young and technical. There is no “undo” button.  Sending money to the wrong address means it’s gone forever.
  4. One of the best methods for storing Bitcoin is a method called: cold storage.  In this method, you own and hold the individual keys associated with your Bitcoin, similar to owning the actual certificate of a stock associated with an equity.  The Bitcoin is not held on an exchange. However, because you own and control those keys (which are long lines of numbers and letters), the risk remains of losing Bitcoin. If your computer gets hacked and somebody gets access to your keys, you lose the keys, etc., you run the risk of having your Bitcoin stolen.

Bottom line: proceed with caution!

Andre:  If one of our clients decides they want to invest in the cryptocurrency space, what would you advise them to consider buying or avoiding?

Brayton: The first thing I tell individuals who want to be involved in cryptocurrency, whether it be via becoming an investor in coins, investing in the companies that are making new tokens and running projects, or investing in a crypto fund, is to actually use the currency.  

Take a very small amount of the capital you want to invest and buy Bitcoin (BTC) and Ethereum (ETH). Send fractions of amounts to other wallets, to merchants that accept the currency, and to friends and family.  The client must familiarize themselves with the technology, how it works, and how the transference of these coins works, and the power of the blockchain, before becoming an investor in it.

For a novice looking to purchase a small amount of cryptocurrency, I would buy BTC and ETH, as they are the two top market cap coins.  They are clearly the leading coins in terms of community, developer network, etc… They have different use cases and different features. From my perspective, both can be wildly successful for entirely different reasons.

For larger investors, there are a handful of investment funds available. Many of them, given the market over the last 12-24 months, are all showing impressive return metrics. My recommendation is to explore investing in funds that have the flexibility to invest both in coins/tokens and in the equity associated with some cryptocurrency companies.

Andre: Will Bitcoin always be the king of crypto? Do other currencies have a shot at occupying the top spot?

Brayton: Right now, BTC has the network effects in its favor, it was first to market, and it is truly decentralized.  It would be very hard for another coin to overcome Bitcoin, but, there could be a scenario where something takes over.

The decentralization of the coin is a critical point. All new cryptocurrencies clearly have founding teams and a founder that controls a large portion of the coin’s development and growth.  This creates centralization, which is one of the characteristics of traditional currency that cryptocurrency was supposed to eliminate.

Bitcoin is the reserve currency of crypto.  All cryptocurrencies peg their value to Bitcoin. It would take a catastrophic event for Bitcoin to be removed as the reserve cryptocurrency.

Andre:  In the 1849 gold rush, companies that provided services to the miners made large amounts of money selling pans, picks, jeans, etc..  Most of the miners themselves went bankrupt. Investing in Levis would have been a better investment than gold at the time.

How would you contrast investments in the tokens and coins of cryptocurrencies vs. companies that are utilizing blockchain technology to create services and products?  Are there parallels we should be drawing here?

Brayton: Like with any investment strategy, especially in a new and emerging market, it is totally undefined who the winner is (the coins or the projects using blockchain).

My fund, Boost.VC, has direct exposure to cryptocurrencies themselves (Bitcoin, Ethereum, Aragon, etc.) and also exposure to and investments in the equity of companies building in the crypto space (exchanges and hardware companies like Coinbase, Ledger, etc…).  

I obviously think this is a superior way to invest in the space. It is a dual approach in ownership via owning part of the actual tokens and companies. It is unclear which side will be the ultimate winner in the space – so, for the time being, we prefer to own both.

Not all tokens and coins are created equal. Some token projects accrue value on the token layer while others accrue value on the project layer. Therefore, realize that some of the tokens may never appreciate or may not need to have a value, yet, their projects may be highly successful.  

In other words, there are other tokens that do not require value or appreciation in their coins for the projects to work. Some of the coins may not rise in value at all, while the actual companies could be hugely successful.  In that scenario, it is better to own the equity in the company/project instead of the coin or token of that company.

Andre: Sometimes when looking at these projects, we hear founders of crypto projects discuss how their coins or projects are built on top of Bitcoin, Ethereum, etc. Can you please explain what that means?  Do those projects cease to exist without their underlying coin? Are they dependent on whichever major coin they choose?

Brayton: One of the hardest things about starting a new crypto project is the integrity and security of the blockchain. A coin I am very excited about, Aragon, is building out a project using blockchain that will eventually allow for decentralized government and organization models. Some call it digital jurisdiction. In order to jumpstart their project and have security and integrity associated with their coin and project, Aragon decided to build their coin on top of Ethereum and leverage the security of that ETH blockchain.

Building “on top of” reputable projects like BTC and ETH only enhance the security of those projects. Because of this phenomenon of building on top of BTC and ETH, BTC and ETH inherently become more critical in the cryptocurrency ecosystem given their association with so many other coins.

These coins can build and exist within their own blockchains, however, if their community is not large enough and the support isn’t at the level required, their blockchains will fail. Therefore, building on top of BTC and ETH is, as of now, a common decision made by new crypto projects.

Andre: Whether it be a coin or equity ownership in a cryptocurrency project, it seems like the market is inflated. Are we in a bubble? Does Bitcoin going from under $100 in 2013 to over $15,000 in December of 2017 worry you?

Brayton: Ok, Andre – short answer for you is: short-term we are in a bubble, yes. But long term, no. Cryptocurrencies will have a market cap, eventually, much larger than today.

Prices of projects today are greatly inflated compared to the status of what the projects have delivered.  Some of these projects have yet to deliver a product, yet, they are receiving $100m+ valuations. That said, there are some projects today, that if they work as the developers believe, can absolutely rise much higher than they are today as they will have major positive effects on the world’s population.

While the analogy is used often, I view an investment in Bitcoin and other cryptocurrencies as similar to investing in Amazon, Ebay, Google, at the inception of these companies and when the internet was still young and the power of it unknown. I view Bitcoin as undervalued and I would absolutely be an investor today at the current prices.

Andre: As we wrap up, any final thoughts or words you would like to share with our clients?

Brayton: Crypto is one big R&D project. Nobody knows what is going to work but we all have a shared vision for the future. We are all running experiments and hoping we find the “next big thing”.   So, view this as an absolutely risky allocation/investment, especially in many of the newer projects. 2017 brought a new asset class – cryptocurrencies. They were used for little more than speculation – eventually, these currencies must have utility or something from which to derive value or else they will rapidly drop to zero.

I think that in 2018 we will start to see the use cases emerge outside of speculation. It will be a year where crypto teams need to deliver on some of their promises related to their companies and projects.  Keep an eye on those projects that start getting real traction because they will certainly stand out.

Andre: Thanks for the time and thoughts, Brayton. We look forward to the next conversation and wish you the best of luck on your new fund!



By Jon Porter and Andre Huaman

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.” -Satoshi Nakomoto

What is Bitcoin, the Blockchain, and Why Care?

In 2008, a psuedo-anonymous individual, ‘Satoshi Nakamoto’, released a paper that described a digital currency he was developing called Bitcoin and the underlying technology that enabled Bitcoin, referenced as the blockchain.  In 2009, Satoshi released the first Bitcoin software and began further developing it with a close handful of other scientists, engineers, and cryptologists he trusted.

In 2010, Satoshi handed over the control of Bitcoin source code (some of the keys of Bitcoin) to a set of early Bitcoin adopters/engineers, and left his role as the head developer of Bitcoin.  Since then, he has yet to be identified, has not worked on or influenced the Bitcoin project, and has not transferred or spent any of his 1 million Bitcoins.

This article is the first part of a two part series in which we attempt to answer the questions:  “What is blockchain (and by proxy, cryptocurrencies), should we be investing in it, and if so, how?”  However, it is impossible to address whether we “should be investing in this, and if so how?”, without first understanding  blockchain and cryptocurrencies.

As such, this first article is dedicated to a plain English (hopefully) explanation of those technologies.  A crypto-primer, if you will.  We will explain the underlying platform for all cryptocurrencies that is blockchain technology, cryptocurrencies, and why they are important.

In part two, we will engage in a detailed Q&A with a recognized blockchain expert, in an attempt to better understand the relative risks and rewards associated with Bitcoin, blockchain and cryptocurrencies, and in so doing, provide a framework for answering the questions: “Should we invest in this, what are the risks, and what should we know about this space?”

Satoshi and the small group that began working on Bitcoin were tired of governments manipulating money supply, interest rates, and currency pricing, for their own purposes.

Booting up to Speed…

Never in our collective investment management careers have we had so many people ask about the same topic, at the same time.  Blockchain has clearly moved out of the realm of theoretical, and firmly into the reality of the here and now. It has serious potential implications to the way certain transactions are processed, and the systems that support them.

Why did blockchain technology suddenly become mainstream?  In one sense, and on the surface, it is because of the rapid rise in value of certain cryptocurrencies, mainly Bitcoin.  When something goes up 1000% in one year, it acts as its own marketing machine, which turns into a self-fulfilling prophecy.  People take notice.

However, one must dig deeper into the origins of blockchain to really understand why it was invented in the first place.  The advent and proliferation of blockchain technologies was in response to the types of governmental currency manipulations detailed in our November Blog.

Satoshi and the small group that began working on Bitcoin were tired of governments manipulating money supply, interest rates, and currency pricing, for their own purposes.  Their response was to write code that would create an entirely new digital-only currency, Bitcoin,  that was immune to manipulation, and whose pricing was set not by a centralized government. Rather, the price was set by the parties engaged in the creation and then later distribution and ultimately the marketplace trading of Bitcoin itself.

In order to understand how this came about, and how Bitcoin and other cryptocurrencies are structured, one must first understand blockchain technology.

What is a Blockchain?

The terms “blockchain” and “cryptocurrency” are neither interchangeable nor synonymous, yet both rely heavily on one another. Blockchain is a public database and transaction processing technology.

Imagine a spreadsheet, containing information about transactions and data, that is duplicated thousands of times across a network of multiple different computers. And then imagine that this network, which tracks transactions and other forms of data,  is regularly updating and validating those changes to this spreadsheet. This is blockchain.

Breaking it down into its fundamental components, a blockchain is:

  • A peer-to-peer database (with copies of the database replicated across multiple computers),
  • of transactions (between two or more parties)
  • split into blocks (with each block containing details of the transaction such as the seller, the buyer, the price, the contract terms, and other relevant details),
  • which are validated by the entire network via encryption by combining the common transaction details with the unique digital signatures of two or more parties.

Full stop.  Now go back, and re-read each of those bullet points slowly and methodically, until you are comfortable with each part.  This is the foundation upon which everything that follows, including cryptocurrencies, is built.

The heart of blockchain’s potential lies in the unique properties of a distributed database and how it can improve transparency, security, and efficiency.

How Does Blockchain Work?

When an individual chooses to join a blockchain network, they can download a copy of the blockchain software onto their computer.  Each computer, or peer, in the network has a full copy of the blockchain, which is nearly impossible to manipulate or change.  When a computer has the full copy of blockchain downloaded and installed, it becomes what is referred to as a “node.”

The heart of blockchain’s potential lies in the unique properties of a distributed database and how it can improve transparency, security, and efficiency. Historically, organizations used databases as central data repositories to support transaction processing and computation. Control of the database rested with its owner (a company’s servers, hardware, etc) who managed access and updates, limiting transparency, scalability, and the ability for outsiders to ensure records were not manipulated. A distributed database, which blockchain is, was practically impossible because of a myriad of technological limitations. But advances in software, communications, and encryption now allow for a distributed database spanning multiple organizations and individuals.

In its purest form – as used by Bitcoin to create and track units of the cryptocurrency – blockchain is a shared digital ledger of transactions recorded and verified across a network of participants in a tamper-proof chain that is visible to all.  Permissioned or private variations add a layer of privileging to determine who can participate in or view a particular chain.

Blockchain how it works

Blockchain’s Primary Benefits

So why is everyone so excited about this new type of decentralized database technology?  Why is everyone saying this is the “next biggest thing since the Internet?”  Because blockchain technology, for many types of transactions, blows traditional databases out of the water in terms of security, transparency, and efficiency.


Blockchain relies on encryption to validate transactions and activity by verifying the identities of parties involved in a transaction. Further, each person on the system has a unique, encrypted, “digital signature” identifying the person; like a digital fingerprint of sorts.  This ensures that a “false” transaction cannot be added to the blockchain without the consent of the parties involved.

While discussed in greater detail in the “mining” section below, in order for a transaction to be completed, a complex mathematical calculation known as a “hash” is performed each time a transaction is initiated. The transaction data, including the digital identities of the parties involved in the transaction, what is being transferred, and all previous transaction history, is verified by the complex network of computers. This process ensures that no fraud, double spending, or other erroneous actions or transactions are taking place.

And because the network is decentralized and maintained by thousands and thousands of computers, no one party has a monopoly or the ability to alter or manipulate transaction data or future transactions.

The fact that the current state of the blockchain depends on previous transactions ensures that a malicious actor cannot alter past transaction data. In effect, every time a new transaction occurs and is completed, the network of computers that maintain the blockchain are all updated to reflect the new transaction and its place in the database.


By its very nature, blockchain is a distributed database that is maintained and synchronized among multiple nodes – for example, by multiple parties who transact with each other frequently.

In addition, transaction data must be consistent between parties in order to be added to the blockchain in the first place. This means that by design, multiple parties can access the same data (in some cases locally within their organizations).

This significantly increases the level of transparency versus conventional systems that might depend on multiple “siloed” databases behind firewalls that are not visible outside a single organization.

In practice, at any time, one can to go online and search the transaction history of any Bitcoin wallet that exists. While the person’s name may not be known, the unique ID that holds their cryptocurrency can be found publicly along with seeing on what dates that person either sent or received cryptocurrency. So, while transparent, there is also a layer of privacy.


Conceptually, it seems counterintuitive that maintaining multiple copies of a database with blockchain would be more efficient than a single, centralized database.

However, in most real-world practical applications, multiple parties already maintain duplicate databases containing information about the same transactions. In many cases, the data pertaining to the same transaction is in conflict – resulting in the need for costly, time-consuming reconciliation procedures.

Employing a distributed database system like blockchain across multiple organizations can substantially reduce the need for manual reconciliation, thus driving considerable savings across organizations.

In addition, in some cases, blockchain offers the potential for organizations to develop common or “mutual” capabilities that eliminate the need for duplication of the same effort among multiple organizations.

Although the world of digital currencies may seem completely novel, almost every single one of us has used a form of digital currency:  credit cards.  No physical money is actually ever exchanged, but ledgers of who owns and owes what are transferred digitally.  The primary difference is that cryptocurrencies, in particular, Bitcoin, are not secured by people, trust, or a centralized database, but rather by the mathematical underpinnings of the blockchain which we discussed above.

…cash is exchanged for the cryptocurrency at an online exchange, and the rights to the cryptocurrency are transferred across the network to the new owner.  Technically, the parties are merely exchanging the rights to a digital block on the blockchain.

Cryptocurrency?  Does Webster know about this?

“Cryptocurrencies” are simply a type of digital asset that leverages blockchain technology in order to create, store, and trade the currency (each unit of a cryptocurrency is called a “coin” or “token”). The name “cryptocurrency” is derived from the fact that these types of currencies use cryptography to secure the transactions and control the creation of new coins within the same blockchain.  Bitcoin is an example of a cryptocurrency.

Cryptocurrencies don’t move around as do conventional currencies or money.  Rather they stay fixed on the public ledger called a “blockchain.”  When it comes to blockchain, remember to think of a “ledger” as a giant Excel spreadsheet that tracks who owns what cryptocurrency and who is trading what amounts of a particular cryptocurrency at any given time.  Except this particular ‘Excel spreadsheet’ is instantaneously updated, everyone who is participating in the cryptocurrency has a full and accurate copy on their computer at all times, and it is nearly impossible to hack.

As a result, people don’t “exchange” coins, they simply change ownership of a particular part of the blockchain ledger.  Anyone with access to the blockchain can check ownership by checking the public ledger.

In such a transfer, cash is exchanged for the cryptocurrency at an online exchange, and the rights to the cryptocurrency are transferred across the network to the new owner.  Technically, the parties are merely exchanging the rights to a digital block on the blockchain.  Nothing physical is moving or is held  (contrast this to gold).

The new owner can choose to hold the cryptocurrency, or theoretically convert it to cash or exchange it for other cryptocurrencies.  We say theoretically because there has to be someone on the other side of that transaction willing to buy your ‘coin’ with cash or exchange it for other types of coins.  More on that potential pitfall in part 2 next month.

As we’ve discussed, because of the way cryptocurrencies work, the blockchain ledger makes it difficult to commit fraud.  One can’t spend someone else’s coin, because everyone knows who owns them (based on the public ledger).  One can’t spend the same coin twice, because the network keeps the ledger up to date and there’s only one ledger.  If the same person tried to spend the same coin twice, everyone would know because the ledger is visible across every blockchain participant and the transaction would be stopped by the system.

When launching a new cryptocurrency, one of the critical decisions is to choose the “mining” method.

How do Cryptocurrencies Store Value?

There are now over 2000 cryptocurrencies on the market, such as Ethereum, Monero, and ZCash, with more coming every day.  So it is imperative to pay attention to how these cryptocurrencies intend to retain their value, if they are to act as surrogates for money.

Recall from your high school economics classes that “money” must possess six key traits:

  1. A medium of exchange
  2. Portable
  3. Durable
  4. Divisible
  5. Fungible, and drumroll….
  6. A store of value

From what we have reviewed above, it is readily apparent that blockchain technology enables cryptocurrencies to satisfy the first 5 requirements of money.  It is the last requirement, that it be a “store of value” to which we now turn our attention.

Remember that just like any currency, cryptocurrencies are only as valuable as those that are trading them believe them to be.  Merchants accept dollars in exchange for goods because they have faith that the paper money, or the credit card ledger that corresponds to that paper money, is a store of value, and can be exchanged for other things of value.

It is therefore critical to understand exactly how a blockchain system creates additional coins, incentivizes participants to maintain the system, and is a mechanism with the potential to maintain and increase value.

Mining Cryptocurrencies

When launching a new cryptocurrency, one of the critical decisions is to choose the “mining” method.  Every cryptocurrency is forced to choose between two methods; ‘Proof of Work’ or ‘Proof of Stake’.  Coins can only use one and the method they choose depends on a variety of factors including on which blockchain they are building, the goals and objectives of the project, and the goals for their community.

Proof of Work (“PoW”)

One of the core events that must continuously take place in order to maintain the cryptocurrency ecosystem and blockchain is “mining.”

Approximately every 10 minutes, a number of Bitcoin transactions are grouped together into what is called a “block.”  These transactions might be a son sending Bitcoin to his grandmother or a financial institution buying cryptocurrency for the first time. Regardless, these crypto transactions are grouped together into a consolidated block.

These blocks, each containing multiple pending transactions, are turned into a mathematical problem/puzzle. In order for these transactions to be approved, verified, and completed within the blockchain, those math problems must be correctly solved.

Insert miners.  Miners, which are effectively very powerful computers, compete to be the first to solve the math problem. Once the first miner solves the problem, it announces to the network that it has been solved. Other miners then verify the equation is correctly answered.

Once verified for accuracy, the transactions represented in the block are allowed to be completed and added to the public ledger on the blockchain.  The grandmother receives her Bitcoin and the client receives his or her cryptocurrency.  The miner who found the solution and answered the equation for the block is rewarded by being given the cryptocurrency they are mining for.

So, miners are rewarded in cryptocurrency. This mining process, which is happening at all times, is the function that not only upholds the integrity of the blockchain, but also distributes newly minted cryptocurrency into the ecosystem at a predetermined rate.

The cryptocurrency mining reward, and therefore the value of the associated coins, is required as it acts as an incentive for the miners to utilize their computing power, electricity, and time to mine.  If Bitcoin was worth $0, why would people volunteer and/or be in the business of mining? Why would they have their supercomputers run 24/7, solving math problems, when being rewarded nothing? Without value in the underlying coin, miners would have no reason to utilize their resources to support the system (hence, why Bitcoin and other true cryptocurrencies need value).

The above is how mining works for Bitcoin, the most reputable and oldest standing cryptocurrency.  As of late, a new style of mining, called “proof of stake” has entered the field as a positive alternative to proof of work.

Even as traditional IPOs have slowed to a historical trickle, there were almost 300 Initial Coin Offerings (ICOs) in 2017, with a total of over $3.7B raised.

Proof of Stake (“PoS”)

Proof of stake is another way a blockchain can validate and approve blockchain transactions. Unlike PoW, where the winner of the block reward is determined based on computing power and the ability to solve mathematical problems, PoS currencies approve transactions by utilizing resources from current owners of the coin, who publicly “stake” their coins in order to help validate the system.

In PoS, owners of the coins are semi-randomly selected to create or “forge” blocks, validate them, and approve their inclusion in the blockchain. The more coins you have, the higher chance you have of being chosen by the system to forge the block.  This process is less energy intensive than PoW and rewards current users for owning a portion of the coins.

PoS helps avoid several downsides of PoW, including:

  • Reduces need for expensive hardware
  • Reduces energy spent on powering the hardware
  • Faster and more efficient validations
  • More loyalty amongst coins

Some potential PoS downsides include:

  • Reduced security
  • Small group of owners taking over system

The industry is still debating which type of mining system is best.  However, we have examples of both in the cryptocurrency marketplace today and expect the discussion to continue.  When a new cryptocurrency is developed, it is required to choose either PoS or PoW. That decision determines a major part of how the new cryptocurrency will operate.

How long before traditional credit cards and checks, built on outdated 1970’s era technology and security, are obliterated by blockchain the same way email replaced snail mail?  The answer:  not as long as you might think…

Is ICO the new IPO?

Initial Coin Offerings (ICO) have become a popular way to fund both cryptocurrency projects and the companies that promulgate them.  An ICO is an event whereby a new blockchain/cryptocurrency project sells part of its cryptocurrency tokens to early adopters and investors in exchange for money.

Even as traditional IPOs have slowed to a historical trickle, there were almost 300 ICOs in 2017, with a total of over $3.7B raised.  There are more planned for 2018 with the estimated total amount to be raised topping $5B.

Funds raised for Blockchain

Essentially, ICOs are a fundraising mechanism.  The ICO usually takes place before the project is completed, and helps fund the expenses undertaken by the founding team until launch.  Similar to IPOs (hence the name), ICOs are used to sell a “stake” and raise money. Both have investors who see the potential of a particular project or coin and risk their capital for a potential reward.

While we will discuss the potential hazards of ICOs, and there are many, in part two  next month, we would be remiss not to mention that many recent ICOs have resulted in scams, fraud, and misleading projects.

When will Blockchain Technology Really be Adopted?

Consider this:  credit cards typically take between 2-3% in transaction fees for every purchase made.  Blockchain and cryptocurrencies can take far less due to the efficiency of digital ledger technology.

Similarly, when someone writes a physical check, you take it to the bank, physically deposit it, and wait for the check to clear based on your bank’s verification.  That process is slow, usually taking a few days for a check to “clear” and funds to hit your account, or the check might bounce.

How long before traditional credit cards and checks, built on outdated 1970’s era technology and security, are obliterated by blockchain the same way email replaced snail mail?  The answer:  not as long as you might think…

Although blockchain is still nascent from an adoption standpoint, the horse appears to have left the stable.  Most of the experts expect to see early-stage technical prototypes within the next two years, with limited market adoption in 2-5 years, and broader acceptance in 5-10 years.

However, a variety of industries could begin to implement blockchain-based identity and reputation management systems in relatively short order.  They extend from identity theft, real estate contracts, insurance, and more.  In capital markets, expect to see a series of early prototypes over the next two years on a limited scale and with limited numbers of participants.

Broader market acceptance is likely to take as much as 10 years given the regulatory oversight required and a large number of market participants in large-scale markets such as cash equities in the US.

Summing Up

Blockchain, as a technology, is eventually going to fundamentally change the way many types of complex transactions are processed.  And, in the more immediate sense, blockchain technology has enabled the creation of a myriad of cryptocurrencies which are challenging the way we think about money and currencies across the board.

This primer to next month’s deeper dive is designed to help understand the key terms and concepts that form the framework for blockchain and cryptocurrencies.  Next month we will take this newfound knowledge and, through Q&A with a cryptocurrency expert, attempt to answer the questions “should we invest in this, and if so, how?”

Until then!

Three Bell Capital – Forbes #1 Emerging Wealth Advisor

Three Bell Capital – Forbes #1 Emerging Wealth Advisor

A letter from the CEO:

Happy New Year! As we officially kick off 2018, I wanted to share some very exciting news about Three Bell Capital. Thanks to our dedicated team, loyal clients, and innovative partners, Three Bell Capital was recently named the #1 Emerging Wealth Management Firm in the U.S. by RIA Channel on the Forbes list of Top 100 Emerging Wealth Management Firms.

Over the past six years, we have carefully assembled a team of talented, experienced, intelligent professionals, to provide the best possible service and advice to our private wealth management and corporate retirement plan clients.

As a result, our team has the distinct honor of working with some of the most prolific entrepreneurs and innovative companies in the world. By taking on all aspects of our clients’ financial lives, we enable them to focus their time and energy on their entrepreneurial endeavors and bringing game-changing services and technologies to market, while generating lasting wealth for their families.

We could not effectively assume the comprehensive role that we do, without the help and expertise of our carefully-vetted network of professional advisors, which include CPA’s, tax advisors, estate planning attorneys, insurance specialists, mortgage agents, and investment bankers.

As we head into 2018 as the #1 Emerging Wealth Management Firm in the U.S., we are incredibly grateful for our clients’ trust, our partners’ support, and our team’s hard work, and we look forward to continued shared successes in 2018.

From the article:

“Based in Silicon Valley, Three Bell Capital works with many entrepreneurs and start up businesses. Their focus on alternative wealth building strategies coupled with delivery of comprehensive planning services has served their clients well. Three Bell Capital is also almost 100% referral-based.”  READ MORE

Happy new year!

–– Jon

Three Bell Capital - Jon Porter Signature

Forbes’ Julie Cooling recently spoke with our CEO Jon Porter. Watch the interview!

There are certain disclosures that apply to awards and recognitions. Read about those here.

A View of the Economy: Coming and Going

A View of the Economy: Coming and Going

“You Can’t Know Where You Are Going Until You Know Where You’ve Been” ~ Maya Angelou

As an institutional asset manager, I often compared quantitative investment management to driving through the rear-view mirror.  The view looking backward offers clear 20/20 vision that allows investors to update their inputs and dial settings while relying on objective analysis and eliminating emotion.  The problems arise around corners or “inflection points” in the economy… where we tend to “oversteer”.  The quantitative approach has both positive and negative aspects.

On the other hand, fundamental management is akin to driving while looking through the front windshield during a rainstorm with broken wipers and bugs plastered to the glass.  This provides a somewhat blurry vision of what is coming, but at least the view is forward, providing the ability to course correct – typically more subjectively.  Once again, there are positive and negative characteristics associated with this style of investment management.

The “Holy Grail” is to be able to merge these two completely different, time-tested approaches.  Today, we will look backward with perfect hindsight and use what we learn to clean our screen for a clearer view of what lies ahead.

2017 In Rear View – Where We Have Been

Season’s Greetings – The US stock market has already put together 13 consecutive months of positive returns… an all-time record!  

Key Market Indicators and Market Review:

YTD % Return as of 12/21/2017

S&P 500 (Large Cap Core) +22.2

Russell 2000 (Small Cap Core+14.8

Russell 1000 Growth (Large Cap Growth) +30.5

Russell 1000 Value (Large Cap Value) +13.0

MSCI All Country World Index ex-US +25.2

EEM (Emerging Market Equity) +33.5

AGG (Bloomberg IG bond)  +2.9

JNK (High Yield Bond)  +5.5

In 2017, the markets enjoyed strong returns around the globe.  The strongest returns were found in emerging markets equities (EEM), followed by the MSCI All Country World Index ex-US, and then a still strong US Large Cap stock market (S&P 500).  This return pattern was very much a reflection of economic strength relative to expectations… the international economy showed a larger pick-up in growth rates relative to the US.

The bond market earned its coupon as interest rates more or less “marked time”, with 10 year US Treasury bonds yielding 2.1-2.5% throughout the year.  We did see the high yield (JNK) market do better than investment grade bonds (AGG) as credit spreads tightened.  However, we are now very near record tight credit spreads, so the risk/return outlook is unfavorable for High Yield debt from these levels.

Within the US, we saw a return to a strong ‘Growth’ market (Russell LC Growth) over the ‘Value’ sector (Russell LC Value).  This was predominantly a reflection of a weaker US dollar and stronger growth overseas. The large multinational ‘Growth’ companies were best positioned to benefit from strength in overseas economies.  We once again saw Small Cap stocks lag Large Cap stocks. Looking forward, Value and Small Cap (RUY) stocks appear inexpensive relative to Large Cap Growth and could benefit most from potential changes to the tax policy.

Three Market Drivers in 2017-

  • Markets climbing a wall of worry
  • Anticipating tax reform
  • Relatively easy comparables for earnings and GDP vs 2016

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects…

Climbing the Wall of Worry

An old adage says “The stock market climbs a wall of worry”. This simply means that as the stock market rises as a whole there are more and more investors that believe the existing rally will come to an end. But, the higher it goes, the more greed takes over and more and more investors jump on board and continue to invest.  The more this behavior continues, the more prices continue to rise, thus fueling the rally and creating a self-fulfilling prophecy.  

At some point, the rally becomes based more on price movement than fundamental value of the underlying stock.  And as the other saying goes, “the bigger they are, the harder they fall.”  The higher up the worry wall the market climbs, the more precipitous the drop when the market loses its footing.

Right now, there are three primary “worries” that comprise the current wall.  We are paying particularly close attention to Geopolitics, Rising Interest Rates, and Valuation.

Geopolitics/Black Swan Events-

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects that are often included in this category.  

These outcomes are impossible to score. However, it appears clear that our allies are increasingly disillusioned with our role and our enemies are more emboldened and on alert.  The ‘end of the world clock’ has never been closer to midnight (other than 1953, when the US and the Soviet Union were both testing their first Thermonuclear devices…aka H-Bomb).

Optimists will say the US has done quite well since the time that Elvis first hit the stage, thank you.  The pessimist will say that we are on borrowed time.  The realist will say that the risks are real and we never know when the market will decide to price those risks.  All that said, the risks do seem to be rising.

However, somewhat inexplicably, the market continues its climb over each headline risk, as we have enjoyed the longest period of prolonged lack of volatility in the history of the stock market.  

Eventually, volatility will return to the market as the mean reverts, and we believe that could translate into substantial downside risk.  However, in the meantime, the market continues to climb ever higher.  

Rising Interest Rates-

Now that the Fed has begun to raise interest rates and allow the reserves accumulated through their Quantitative Easing program (last month’s blog) to unwind, investors are concerned that rates will normalize back toward 4-5%.  As 10 year US Treasury rates hold steady in the 2.1-2.5% range, investors are living with the risk and climbing over this worry, for now.

economic uncertainty chart

Notice the chart above from the National Bureau of Economic Research that shows the overall risk for a potential Global Economic Policy misstep.  The policy uncertainty index charts uncertainty through news articles, changes in political control, changes in tax policy, monetary policy, and dispersion in economic estimates.  

The chart graphically depicts what is meant by “climbing a wall of worry”.  The actual policy uncertainty is now even higher than that realized during the GFC (Great Financial Crisis).   Indeed, the market has risen in near lock-step fashion with the uncertainty index, which is counterintuitive to what investors would normally expect.  


No matter how we analyze market valuations, the market is at or near record high values, which has been the case for the past year.  That said, valuations alone aren’t a catalyst for a market decline.  However, valuations will determine future rates of returns which makes when you invest almost as important as in what you invest.   

From current price levels, history suggests that investors can expect approximately 2-4% annual real (after inflation) returns over the next 10 years.  

Also, the scale of the ultimate market correction (although there is nothing that states market prices MUST correct) will be impacted by the severity of the over-valuation.  So far, the market is happily rationalizing the record price levels and continues to grind higher.

The truth is that the current actual effective corporate tax rate averages 24% (not 35%)


Waiting for tax reforms reminds me of the iconic Heinz Ketchup commercial in the 1970’s that shows the young boy patiently waiting for his prized ketchup bottle to delicately and deliciously drip mouthwatering, flavor-filled, tomato sauce all over his burger, as Carly Simon melodiously sings “Anticipation” (Ann-ti-ci-Pay-Aay-Shun) in the background…mmmmm?  Well, this is the same scene as investors await their precious, promised tax cuts.

The market has been running on the promise of lower taxes since the election.  The administration has done a great job of selling the merits of a lower corporate tax rate from 35% to 20%.  The truth is that the current actual effective corporate tax rate averages 24% (not 35%).   When considering the level of anticipation in this tax policy, my mind races to the old adage, “buy the rumor, sell the news.”

We will dig further into the specifics of tax policy in a future blog since the final bill has passed and we know what we’re dealing with.  For now, suffice it to say… it will be a net positive for the corporate world (more so than for individuals), but likely much less so than conventional wisdom suggests.

 Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Global Pick-up and Easy Comps    

The US Real (inflation-adjusted) GDP growth rate looks likely to rebound to 2.5+% in 2017 after falling below 2% in 2016. In fact, after growing at an average 2.3% rate from 2013-2015, the US economy actually slowed to 1.8% in 2016.   

The deceleration in 2016 was largely due to a stronger US dollar and lower government spending.  The stronger currency in 2016 hurt competitiveness and compressed revenues and earnings when translated back into US dollars.  The government spending cutbacks in 2016 came from a Republican Congress that was intent on maintaining a deficit hawk image.  That image has since been tossed aside, now that we have a Republican administration.  

The third temporary cause for a 2017 bounce in GDP growth is an accumulation of business inventories, which basically borrows from future growth.  Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Lastly, a more positive and sustainable component of GDP growth was the pick-up in global economies and markets.  This was a far larger contributor of higher US GDP growth than anything the new administration created domestically.  The global economy showed signs of life in 2017, growing at a 3.5%+ rate after habitually slogging along below 3% since the Great Recession.  The stronger global economic growth, coupled with a weaker US dollar, finally helped US trade, on the margin.

Overall, business and personal GDP growth have been steady at about 2.25% over the past 5-7 years, with government spending, net trade deficit, and inventory accumulation providing volatility around that number.  The true test will be if the rate of GDP growth continues up over 3%, or levels-out in the 2-2.5% range that has become the norm since the Great Recession.

This “easy comparable” syndrome, which occurred due to a decent bounce in 2017 GDP growth coming off a subdued 2016, reminds me of what happens during college football bowl games each year.  During college bowl season, we find out which conferences benefitted from easy competition during the regular season.  Those conferences eventually get exposed.  As an alum of the University of Illinois, I was particularly scarred by the 1984 Rose Bowl game.  I witnessed my beloved Illini (then favored by 18 points) get trounced 46-9 by UCLA after leaving the “easy comps or competition” of the Big 10 conference.  

This year’s economy not only feasted on easy 2016 comps, but with the global economy kicking in more aggressively combined with a weak currency and inventory builds, it is as though we got an extra scholarship for a top recruit to aid in our battle this year.  The “comps” are about to get more challenging.

Is it obvious that the snow has not been spectacular here in Tahoe and I have spent too much time watching college football?

2018 Through The Windscreen – Where Are We Going?

Looking ahead to 2018, we see three themes that will shape the contour of the economy and the markets:  

  • Fiscal Policy (taxes and deregulation),
  • Monetary Policy (interest rates and currency)  
  • Productivity (particularly as it relates to wages).

Let’s examine each in turn with an eye towards how they might influence global economies and markets.

 All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

Fiscal Policy – Stepping On The Gas

The role of government within the economic realm in a capitalist society is to 1) Create and maintain a legal framework for fairness, confidence, and incentives to prosper,  2)  Provide infrastructure to help facilitate trade, improvements to health, safety, training, and education, and 3)  Enforce regulations to deter abuses.  

After that, get out of the way.

Keynsian economists actually argue that the government should also strive to stimulate the economy through deficit spending/tax cuts during times of economic weakness, while similarly harnessing growth during times of economic overheating.  This toggling of stimulative and restrictive fiscal policies act as a governor to prevent the economy from careening too far in any one direction.  

The raising and lowering of taxes is one such toggle.  Ideally, taxes are to be raised in times of prosperity to save for a rainy day.  All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

New Tax Policy

Let’s not sugarcoat this.  That tax reform process was sub-optimal and seemed rushed.  Most Senators, including Republicans, weren’t even given enough time to review the new tax law prior to voting on the initial bill.   Senator John McCain made it clear that he did not think it went well.

When President Ronald Reagan’s Republican party reformed tax policy in 1986 there were 33 public hearings with dozens of scorings by the Congressional Budget Office (CBO).  The bill passed 90-10 in the Senate.  

Even still, that program led to an explosion in public debt following a massive shot in the arm to the markets.  Yet the broader economy never benefited in terms of “above trend” economic growth throughout the Reagan/H.W. Bush years.  

Throughout this year’s tax reform process, there were no public hearings and the Senate used “reconciliation” to avoid needing 60 votes.  As such, the bill passed with a straight-up partisan 51-48 vote.  This tax reform bill received scary scorings from the (CBO) for its impact on the deficit.  

The CBO claims the recently approved tax bill will lead to increasing the Federal debt by $1.5T over the next 10 years. This is the case even under rosy, non-recessionary economic growth assumptions.  Think about that.  Even after 9 years of non-recessionary growth (second longest in history), the CBO scored this bill assuming no recession for the next 10 years and it is STILL expected to add to the deficit.  That means that the deficit will surely soar in the likely event that we do have a recession within the next 10 years.

The fiscally conservative Republican Party that once protected against swelling deficits appears to be conspicuously absent from the Congressional floor.

Impact of the New Tax Policy-

The reality is that the effective US corporate tax rate is already 24% (not the 35% quoted by the administration).  This means there will be winners and losers among sectors, as we move to a flat 21% for corporations.  For example, Amazon’s effective rate is currently 38% (winner), while Nvidia only pays an effective 13% rate (loser).

The biggest benefit realized from the proposed tax policy will be the eventual repatriation of US earnings/cash by US-based corporations from overseas accounts.  This should help spur mergers/acquisitions, stock buybacks and increase dividends.  The jury is still out on whether we will see higher wages and increased capital expenditures.

Our view is that any benefit of lowering the corporate tax rates will be offset by higher debt levels down the road.   The new tax bill should provide short-term gains for the stock market at the expense of long-term challenges to our deficit.  Sadly, this appears to be the modus operandi for both sides of the aisle in our modern day Congress.  


Deregulation will help certain industries (domestically oriented financials, retail, energy, and segments of healthcare), while likely hurting others (multi-nationals).  Unfortunately, the short-term gains will not come without potential long-term pain down the road.  

Take for example the subprime credit crisis of 2008-2009.  The subprime crisis was largely a byproduct of deregulation by both political parties that created a system that encouraged moral hazard.  

Moral hazard exists when a person or entity engages in risk-taking behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome.  Think Bank Bailouts!  

All of this was allowed so politicians could curry political favors from industry lobbyists and industry titans.  It certainly feels as though some of the deregulation programs currently getting passed increase the risk of re-visiting some of those horrendous ethical dilemmas that almost took down our capital markets.

Ethics aside, deregulation in the energy sector will help our trade deficit as we move from a net importer to a net exporter of oil.  This large swing in global energy markets will correspondingly put upward pressure on the USD, thus ultimately pressuring earnings of large multinational U.S. domiciled corporations. This policy entanglement exemplifies the potential unexpected impact and unintended consequences in unrelated portions of the economy.  

Another example will be the rollback of Dodd-Frank and the Volker Rule in the Financial industry.  Deregulation in financials will likely ease lending restrictions, which should lead to higher industry profits and potentially place upward pressure on inflation.  An uptick in structural inflation would not be ideal this late in the economic cycle.  Not only that, but deregulation will likely lead to more instability in our nation’s banks.

Our view is that Deregulation may ultimately end up having a larger initial upward impact on future economic growth than the total net impact of tax reform.  We also expect that there will be long-term consequences associated with these short-term gains.

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.

Monetary Policy – Pumping The Brakes

The Federal Reserve Bank (the “Fed”) is the banker’s bank.  It is charged with oversight of the banking industry and maintaining solvency while managing interest rate and liquidity conditions for our economy.  

Similar to fiscal policy, the Fed operates counter-cyclically to economic activity.  Since the Great Recession began in 2008, the Fed has done most of the heavy lifting to keep the economy moving.  It will now be charged with offsetting the net effects of the new tax policy, while also attempting to maximize full employment, stabilizing financial conditions, and maintaining price stability.

Interest Rate Policy

The Fed raised interest rates three times in 2017 from 0.75% to 1.5%.  Looking forward, the market is pricing-in ONE .25% interest rate increase in 2018, while the Fed is expecting THREE more .25% hikes (based on their published “dot plot”).  

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.  The Fed has a number of balls in the air as it tries to stay ahead of potential inflation created by the tax policy from this low level of unemployment, while also making sure the markets don’t get spooked as they begin to wean themselves off their “drug of choice” (cheap money).

Complicating the Fed’s job will be the swearing in of a new Fed Chairman to replace Janet Yellen in February 2018.  My mind races back to 1987 when the markets tested the then-new Fed Chairman, Alan Greenspan, after he replaced Paul Volker.  The markets collapsed in October of that year, eventually leading Greenspan to turn on the monetary hoses, reflating the stock market.  It will be no surprise if the markets test the new Fed Chairman relatively early in their term.

The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting…. that means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

US Dollar

Be careful for what you wish.  More advantageous trade terms aggressively negotiated through a more transactional and less strategic approach will likely lead to less trade and higher prices, despite a stronger USD.  As Charles Plosser, former Philly Fed President and CEO, stated at an event that I attended earlier this year… “higher prices and weaker economic growth are a Central Banker’s nightmare”.  A stronger dollar further complicates the Fed’s ability to fight potential inflation through higher interest rates.

Productivity – Smoother Ride, Same mpg

Artificial Intelligence (AI), Machine Learning (ML), Blockchain, Robotics, and Innovation – those are the buzz-words and themes that will continue to grow in 2018 and beyond.  

Interestingly while all of these concepts are almost universally viewed as positive, ultimately these trends will put downward pressure on wages. The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting.  

That means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

I realize that many readers live in the Silicon Valley and will want to argue with this statement.  So, I promise to dedicate a future article on this topic to flesh out the evidence from an economic perspective.

The consensus opinion is that populism will not fix stagnant wages.  The simple fact is that innovation will continue to put downward pressure on wages for most of the population.  The shareholder class (equity owner) is much more inclined to benefit from today’s trends than the stakeholder class (employee)…regardless of which political party is in power.

Best reason to be bearish is there is no reason to be bearish. ~Michael Hartnett

WILD CARD ALERT:  There is little debate that the economy, and the stock and bond markets have greatly benefited from low inflation and low volatility.  In fact, in addition to the S&P 500 setting records for consecutive monthly gains, the stock market is similarly setting records for low volatility almost daily.  Most market commentators agree that the record low volatility and record high market prices are inexorably intertwined as one grinds lower and the other grinds higher.  

There are many factors that contribute to these idyllic economic underpinnings, which have correspondingly helped create an environment of low-interest rates and high earnings multiples.  Due to overcapacity in the global production markets, it is unlikely we will see a significant unexpected rise in inflation that negatively impacts interest rates, volatility, and stocks prices.  

In fact, the consensus view is for inflation and volatility to drift just a bit higher than current, but still at comfortably low levels.  As Bank of America Merrill Lynch’s strategist, Michael Hartnett, recently put it, the “best reason to be bearish is there is no reason to be bearish.” Contrarian much?  That said, consensus is so strong against a surprise increase in inflation that it could be quite detrimental to all financial assets… if we were to see the “whites of its eyes”.

This is important because passing tax policy this late in the economic cycle coupled with individually negotiated trade “deals,” increases the odds of higher than expected inflation.  As such, we feel it is prudent to consider some form of inflation protection (which is cheap) in addition to allocating to truly diversified alternative asset classes.

Unwrapping our Review and Outlook

The economy and markets have been on cruise control due to artificially suppressed interest rates through Quantitative Easing (QE) policies by the world’s Central Bankers.  The US economy also benefited from easy comparisons coming off a weak 2016 and a bounce back in the global economy.

Looking ahead, we have fiscal policy being applied at a strange time, given the maturity of this economic recovery.  Normally, we would expect a pro-growth tax policy coming out of a recession, not 9 years into a recovery.  This will likely accelerate the world’s Central Banks to move to a more restrictive stance.  All of this will finally introduce a bit more uncertainty into the markets.   

In fact, it is time to let the markets determine winners and losers, rather than use artificially suppressed interest rates to prevent business failures. Not everyone gets a ribbon anymore.  The bottom line suggests that given all of the uncertainties and moving pieces in the global economy, stocks look better positioned than bonds at this juncture, but many alternative investments offer the most favorable risk-return payoff.

My forecasting goggles indicate that an increase in uncertainty in Monetary Policy coupled with growing tensions in the geopolitical landscape will create a negative market-month at some point in 2018; i.e. the record consecutive winning streak for the market will come to an end in 2018.  How’s that for a prediction…too bold?

Happy Holidays,

Financial Alchemy – The Great Experiment

Financial Alchemy – The Great Experiment

Unwinding the Fed’s Quantitative Easing Program

The Great Experiment is unwinding. The U.S. Federal Reserve Central Bank (Fed) is beginning to reverse its Quantitative Easing (QE) program, a 2009 policy created in response to the worsening financial crisis known as the Great Recession.  Since its very conception, QE was considered a controversial, unconventional, and some would say experimental, monetary policy.

QE occurs when a Central Bank purchases a predetermined amount of government bonds or other securities from the market in an attempt to lower interest rates, increase asset prices, and stabilize the economy.

In total, Central Banks across the globe followed the US Fed’s lead and combined to purchase more than $20T in assets under the QE umbrella.  This coordinated effort had a massive effect on asset prices and interest rates across the globe.  

This monetary policy experiment (QE) had no historical precedent and was the financial equivalent of other controversial lab experiments like GMOs (genetically modified organisms), stem cell research, or genome sequencing/editing: praised by some and scorned by others.  Hence, Quantitative Easing became know as “The Great Experiment”.

Proponents of QE credit it with stabilizing the economy and pulling the United States out of the Great Recession.  Critics claim the effects have increased income inequality, inhibited our return to historical economic growth rates and dramatically increased the chances of future policy missteps.

We’ are about to find out if the old adage “don’t fight the Fed”, which was true on the way up, will hold true in reverse. After more than eight years of QE variations, the Fed finally began to move from QE to QT (Quantitative Tightening) just a few weeks ago.

While the Fed actually ended its bond-buying program in early 2015, they never removed the increased reserves created through this activity.  The Fed is now allowing its bonds to mature without reinvesting the proceeds, and thus those reserves will gradually be removed from the monetary system.

In this edition of “Cutting through the Noise” we review some of the more dramatic effects created by QE that are captured in our “Three Favorite Charts” below and discuss how QE, and its present unwinding, is likely to impact both the economy and capital markets.

Tools And Materials For The QE Experiment

How quantitative easing works

The process described in Steps 1, 2 and 3 above is quite straight-forward. In a nutshell, the Fed buys government bonds and mortgages, which pushes up prices of those securities while pushing down interest rates.  

These lower rates inspire economic activity, while simultaneously encouraging investors to take more risk in securities that offer higher returns than the bonds bought by the Fed.  The net effect is that the money created by the Fed to buy bonds is ultimately re-deployed into riskier assets by the investment community.  

If all of this feels more like market manipulation rather than the ‘free market pricing’ of the cost of money or interest rates; Guess what?  It is!  Prior to its own QE implementation, the U.S. openly criticized other governments for similar behaviors through the IMF, World Bank, and World Trade Organization.  

Immunization or Mutation

U.S. hypocrisy aside, The Goal stated in the above chart is unambiguous and the results are irrefutable.  Since this process began on March 9, 2009, the stock market is up almost 400%, mortgage rates declined more than 3%, and spreads on high yield junk bonds compressed by 15-20% to historic lows, making corporate borrowing much more affordable. These very impressive results helped inflate consumer confidence and jumpstart the economy.

Thus far, the QE experiment is a success on many levels and was necessary at the depths of the recession to avoid total economic collapse.  However, we will never know if (once the economy survived the initial free fall with the help of extensive government programs such as QE) it would be in better shape today had the government backed off such aggressive intervention and allowed more businesses to fail, thereby removing more debt through bankruptcies, and bringing about more business investment in the subsequent recovery.

That question will be the topic of white papers for generations.  Managing this unwind will determine whether the Fed can claim ultimate victory with their Great Experiment or if they created a Frankenstein economy.

The Risks highlighted in the chart above are a bit more debatable.  To be sure, the risks were somewhat avoided because other global Central Banks implemented the same policies as the Fed.  This coordinated global liquidity program prevented the U.S. dollar from falling on a relative basis.  A weaker dollar is often considered a precursor to inflation because a weaker currency leads to paying more for imported products or “importing inflation”.

At the end of the day, it is easy to conclude that the “Goal” of QE was accomplished, and to this date, the risks mostly avoided.  That said, it’s likely the task of unwinding this experiment will get a bit more complicated… all the more so with a new Fed Governor set to take the helm from Janet Yellen next February.

Let’s See What Those Central Bankers Created In The Lab!

Now that we have discussed how QE actually works, let’s take a look at the impact of this program on various segments of the capital markets.  

Favorite Chart #1 – The chart below illustrates the direct impact QE had on stock prices.  The blue line represents the assets purchased through global Central Bank QE operations (RHS).  The red line shows how the S&P 500 responded to these excess reserves being pumped into the capital markets.  WOW.  We have seen ETFs (designed to tightly track a specified index) in certain illiquid markets that exhibit a lower correlation.  This is strong evidence that equity investors benefited from QE.

European central bank bank of japan federal reserve vs s&p 500

This does not necessarily mean that the stock market is about to fall or even that it has to fall at all.  It does suggest this may be a great time to take some profits or consider other avenues for excess returns going forward.

Favorite Chart #2 – European High Yield bonds trade at lower interest rates than U.S. Treasuries or the first time EVER!   Shown below is the Euro High Yield non-financial bond index (blue line) vs the U.S. Treasury bond (white line). Not surprisingly, Euro High Yield bonds traded with much higher interest rates through most of the last cycle, because as expected, High Yield bonds carry more risk.  

BOA US treasury vs BOA Euro High Yield

In late 2008 / early 2009 we see that interest rates on riskier bonds increased to historically wide spreads vs U.S. Treasuries during the depths of the Great Recession. Once the QE policies kicked in 2009, credit spreads began to tighten again.   

However, fast forward to 2016 and look what happened in the Euro Junk bond market.  Once the Fed stopped buying bonds in 2015 and the ECB ramped up their QE or bond-buying activities, we saw High Yield bond interest rates in Euro decline to the same level or lower than U.S. Treasury bonds.  This is crazy!  

How can Junk bonds in Euro trade with the same implied risk as U.S. Treasuries??  This single, irrational data point highlights how the effects of QE have simply gone too far and must recede at some point.

That said, the Fed has begun to let some of their bonds roll off (QT), which is their plan to reverse the effects of QE. However, the BOJ and ECB (and possibly China) will continue their QE operations, so some of these relationships could get even crazier.  

Investors need to be aware of how we got here, because some of those principal drivers are about to reverse.  This policy reversal is likely to reverse the price patterns of many securities that benefited from QE on the way up.

What Effect Did QE Have On Passive vs. Active Managers?  

Favorite Chart #3 – Let’s look at a less direct impact of QE as seen in the chart below.  This chart displays the impact of investors indiscriminately buying passive equity investments rather than actively managed investments after the onset of QE.

Active manager vs all assets

Active managers were clearly outperforming across the board until shortly after QE “goosed” the markets in 2009, which led to initial outperformance from passive products coming off the market bottom.  The longer that paradigm persisted, the more and more investment dollars shifted from active to passive.  At this point, active funds have given up all of their previously accrued outperformance and an additional 3+% to passive funds.

This process has a self-fulling effect, whereby active managers that suffer redemptions must sell their “active” positions, thus putting downward pressure on those active exposures.  This money then goes to passive indexes/ETFs, which continue to funnel into the same basket of market cap leaders.  

The effect of driving more and more money into the largest stocks based on market capitalization had a derivative effect of also driving down volatility.  Guess what, lower volatility leads algorithmic asset allocators to also push more money to stocks.  Lather, Rinse, Repeat…and so on.

Just like the crazy relationship described earlier with the Euro Junk bond yields trading below Treasury yields, this passive craze will likely reverse at some point as the buoyancy offered through QE recedes.

We have seen this before, markets are cyclical and the drivers of market performance ebb and flow.  One cycle that we expect to reverse at some point is the consistent outperformance of passive over active investments.  Not only is the main driver of this phenomenon about to reverse, but active management tends to outperform late in the cycle.

As The Globe Continues To Spin, The Fed Begins To Unwind…

Going forward, it will be interesting to dissect the result of the Fed tapering QE while Congress gets busy implementing fiscal stimulus through tax cuts.  This could break in a number of directions…

The Fed suggests that it will be like watching ‘paint dry’; while others speculate this will lead to a de-synchronized global economy resulting in wild currency swings, higher interest rates and a return to a more normal business cycle that ultimately careens off the tracks.  

The truth will no doubt be found somewhere in between.  Let’s remember this is probably the first step in the eventual return to increased uncertainty in our markets and ultimately more volatility.  That is a good thing. Volatility creates opportunity.

Let’s hope global Central Bankers slowly turn down their Bunsen burners and allow the effects of this simmering experiment to slowly subside.  The free markets have a fine record without the need to put the economy on chronic steroids, and it’s now time to wean it off the performance enhancing monetary policies.

Extra Credit:  

While QE was successful in stabilizing the economy during the Great Recession, it was not the single greatest government policy that helped prevent the economy from the slipping into depression in March of 2009.  

The monetary effects of QE were amplified atop the fiscal effects of TARP (Troubled Asset Relief Program).  TARP was QE’s equivalent on the fiscal side, which was implemented by the Bush and Obama Administrations in conjunction with Congress.  These programs included purchases of mortgage-backed securities along with bailouts for the banking and auto industries.

All that said, the single greatest policy change that occurred on that fateful March 9th morning in 2009 was the removal of ‘Mark-to-market’ accounting for the banks.  This policy not only removed the need for banks to value their loans (and underlying collateral) at market value, but actually allowed them to value their loan portfolio at the purchase price.  The ultimate result was that banks no longer needed to sell assets to reduce risk and thus, removed downward pressure across all assets at our darkest hour.

The combination of all three of these policies (QE, TARP, and removal of ‘Mark to market’) undoubtedly kept our economy out of the dustbin of history and allowed us to eventually regain momentum.  Going forward, it is likely that the government will revert to using its full bag of tricks, or create new tricks in the lab, to avoid a similar collapse in the future.  It will be interesting to see to what degree the government allows the economy to return to a ‘free market’ and how much they continue to use policy tools as political weapons.



Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and do not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Think Alternative(ly)… Invest Different

Think Alternative(ly)… Invest Different

By: Bill Martin
Senior Managing Director and Investment Strategist

With both stock and bond markets priced for perfection, it is time to look for asset classes that can provide true diversification to lower risk and increase returns.


Apple, Inc. taught us the power and promise available through embracing change, if we only learn to ‘Think Different’.  We believe that has never been more appropriate and applicable than right now for the financial markets.  In an homage to that timeless Apple precept, we encourage investors to look beyond the typical herd mentality for answers and find “alternative” sources of excess returns.  With the bond market offering record low yields and the stock market trading at record high earnings multiple valuations, we try to answer the question… what’s an individual investor to do?

We’ve all heard it our entire investing lives:  diversification is the key to stable, long-term investment returns.  OK, great, but diversification into what exactly?  It’s entirely possible to diversify into a terrible investment and in so doing, do yourself a disservice.  Logically, diversification into just “different” investments, in and of itself, is not going to help investment returns, particularly in the event of a substantial market correction.

Historically, for many investors, diversification has meant spreading assets across different segments of the stock market, with a portion of the allocation going to smaller more nimble growth-oriented companies, some to larger more established value-oriented companies, and then splitting that up across both domestic and international exposure.  The resulting pie chart shows a wonderfully diverse array of colored pie wedges, creating the illusion that we have accomplished our diversification objectives (at least graphically).

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”

However, when markets experience severe declines, the returns of these various sectors tend to homogenize and drop at the same rate.  This is what we refer to as “correlation.”  During the Great Recession, even if you had all of your fixed income allocation in US Treasuries you still experienced a drawdown of -20% or more.  That number was closer to -40-50% if you were 100% in stocks and bonds that did not contain Treasuries… no matter if you were in US or International, investment grade corporates, or high yield bonds.

So, when we think about true diversification, and the benefits we are supposed to realize from that concept, we must find investments that are not correlated to the larger stock and bond markets, and are capable of generating positive returns regardless of any form of precipitous correction, market decline or increase in interest rates.

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”  By using alternative investments, it is possible to design an “all-weather” investment portfolio where each individual component of the allocation is making money in a way which is both divorced from the broader stock and bond markets, and at the same time different from the other investments within the portfolio.

In this edition of Cutting Through the Noise, we investigate how to use alternative investments as a key component to portfolio construction to achieve stable non-correlated, long-term returns, and why it is particularly important to do so now given where we are in the current market cycle.

Low Expected Returns for Stocks and Bonds and the Need for Diversification

In order to understand the importance of incorporating alternatives into your portfolio, we must first understand the current challenges of the two traditional primary asset classes:  stocks and bonds.  As you will see below, neither are poised for outsized gains, and instead both are set to experience significant headwinds.

Bond Market Headwinds

In the fixed income world, we earn the interest income from the bonds we hold, plus or minus any increase or decrease in the underlying value of the bond holdings.  The biggest driver of increases or decreases of bond prices are interest rates, namely, what is the present interest rate vs the rates when the bonds we hold were issued.

As interest rates rise, the price of a bond portfolio tends to depreciate, and vice versa.  This is because in a rising interest rate environment, new bonds are being issued which pay higher coupon rates than those that are held in the current portfolio.  Thus, if those bonds were to be liquidated in that environment, they would need to be discounted to account for the lower coupon payments.

So, where are we in this cycle?  Gradually lower and lower interest rates due to global Central Bank bond buying programs (“Quantitative Easing”) has driven interest rates to levels previously not seen.  From this level (see chart below),

there is more risk than return available in the bond market.

Based on the chart above, we believe that its more likely interest rates will rise from where they are now… versus fall.  If this is in fact accurate, the best case is for bond investors to earn the income associated with the bond coupon and hold those bonds to maturity to eliminate interest rate risk and resulting pricing fluctuations.  This puts returns anywhere between 2-5%, depending on how much credit risk an investor is willing to accept.

Stock Market Headwinds

As a result of these artificially suppressed interest rates, investors have sought higher returns elsewhere and have correspondingly pushed stock prices to near historical high valuation multiples – particularly when considering the low level of economic growth in the underlying economy.

In order to understand where the headwinds exist in the stock market, we need to start with the general understanding that the more an investor pays for earnings, the lower their expected return.  We have a nice chart that illustrates that point below.

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward. 

Time to get outside of the box…

The market is currently trading at earnings multiples that are higher than any other time in our history, except for a few months in 2000.  As such, we believe P/E multiples are unlikely to expand much further and are instead much more likely to contract.

This, coupled with muted GDP (around 2%), means that earnings growth is also likely to be muted which creates overwhelming risks to the downside for the stock market.  Historically, the 10 years after the stock market trades at these levels, the result is a paltry 1% annual growth (see our CAPE blog for more in depth analysis).

Key Takeaway

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward.  Interest rates are more likely to rise than fall dramatically hurting bonds, and earnings multiples are more likely to revert to the mean and compress hurting stocks.

As a result, we believe traditional portfolios that have relied solely on these two asset classes for diversification and returns are, at best, going to suffer mediocre returns for the foreseeable future, and at worst (particularly in the case of the stock market) suffer severe declines in asset values.

Time to get outside of the box…

What are Alternative Investments and What Do They Do?

The intent of considering alternative investments is to maximize the odds of increasing our total investment return profile, while reducing the risks that are stacked against us if we invest only in the public stock and bond markets.

The chart below illustrates some of the high level key differences between alternative and traditional investments:

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities. 

We are all very familiar with the “Traditional” row on the top of the chart – buy stocks and bonds and hope they go UP…that is what is meant by “Market Direction Sensitive” in the last column in the top row above.

In the “Alternatives” row on the lower part of the chart we see options beyond just stocks and bonds which, very generally, include all asset classes other than long stocks, bonds, and cash. Specifically, Alternatives include funds that trade long/short equity, real estate, private equity, life settlements, venture capital, commodities, merger arbitrage, specialized debt, and much, much more.

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities.

The triangle chart below provides a conceptual framework that illustrates the potential benefits of combining various alternative investments.  Specifically, alternative investment portfolios should include an intelligent combination of fund strategies that generate outsized uncorrelated returns, deliver inflation protection, and provide hedged downside protection thru “true diversification.”

…many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.” 

Impact of Alternatives on Portfolio Returns

We wouldn’t be looking at this important asset class if it didn’t deliver demonstrable benefits.  However, we must start with a caveat:  most alternatives are packaged as “hedge funds” and most hedge funds have lagged the broader stock market recently.  As such, many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.”

“… alternatives have shown the ability to both lower risk AND increase return.”

To that we have three comments:

  1. Returns are time period dependent. As such, many hedge funds did their jobs well and looked dominant vs index funds and ETFs leading up to and through the financial crisis.  They “hedged” against negative returns.  That’s what they do.  Now that the market has run to historically high valuations (see above), would you rather stay almost entirely in long only stocks and bonds or consider diversifying to hedge some of the downside?


  1. There are many types of hedge funds, ranging from “conservative” to “aggressive” and everything in between, and many of them do not simply “hedge” stock or bond market risk. In fact, some of them are completely off the grid, don’t have anything to do with stocks or bonds, and can perform well regardless of what the broader stock or bond markets do.


  1. Keep an open mind as we avoid driving through the rearview mirror. Investing is not easy and the truest long term successful strategy is to be contrarian.  Many alternatives and hedge strategies are built to capitalize on this phenomenon.

We have two very important graphs to examine below.  The key take-away is that alternatives have shown the ability to both lower risk and increase return.  This is despite following a record bull market run facilitated by the world’s central bankers.  History suggests that the risk-return benefits of alternatives will be even higher in the intermediate future.

The first graph shows the risk and return for a typical “balanced” 60% stock and 40% bond portfolio.  The stock portion is invested 2/3 domestically and 1/3 internationally.  The return of that balanced portfolio has been 7.94% with an annualized volatility of 8.81%.  This portfolio is said to have a simplified Sharpe ratio (return/volatility) of .90.

This simplified Sharpe ratio is an efficiency evaluation metric to indicate how much return your portfolio gets per unit of risk.  The benefit of lower volatility is that it will typically help investors from selling at the wrong time.  It is always important to keep that number as low as possible.

The next graph below shows the benefit of allocating 50% of the portfolio to Alternatives, while keeping the remaining 50% in the 60/40 stock bond mix cited above.  The return increases to 9.33%, while risk declines to 7.28.  This configuration delivers a 1.28 Sharpe ratio, or a 42.4% increase in efficiency.  Greater returns, less risk.  Check!

“… investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.  At market peaks, these segments actually add risk rather than reduce risk.  We call this Di-worse-ification.”

These graphs clearly illustrate the benefit of adding alternatives into a portfolio otherwise comprised entirely of stocks and bonds.  The alternative investments into which we are currently deploying capital should have an even more dramatic positive effect, as they have higher expected returns with lower downside risk than the examples used in the above graphs.

Summary: Utilize Alternative Investments to Provide True Portfolio Diversification, NOT Di-worse-ification!

As we began by postulating, most investors seek to diversify their return patterns by going into more and different public market sectors.  While this can be helpful, investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.

At market peaks, these segments actually add risk rather than reduce risk.  We call this phenomenon, “Di-worse-ification”: the act of unknowingly constructing a highly correlated portfolio.  The dangers of diworseification are highest at low levels of interest rates, tight credit spreads and elevated earnings multiples.  Strike 1, 2 and 3.

We want to highlight the benefits of including completely different asset classes with different return drivers, such as some of the broad categories mentioned in the segments above.  The potential benefits and opportunities of including alternative assets have never been greater.

With the stock and bond markets both priced for near perfection, the greatest risk is that stock and bond markets continue to trade together. This means higher interest rates will bring lower bond prices.  Higher rates will also bring commensurately lower earnings multiples and lower stock prices.  In that event, diversification into traditional asset classes will not mitigate risk or stem investment losses.

That said, we see plenty of opportunity to reduce an investor’s risk profile, while increasing potential returns. Investors need to expand their selection universe to include new ‘alternatives’. This month we introduced the benefits of including alternatives in a well-diversified portfolio. Next month we will dig deeper into specific alternative investment opportunities.


Let’s Get Ready to Ruummbllllle!

Let’s Get Ready to Ruummbllllle!

By: Bill Martin
Senior Managing Director And Investment Strategist

Active investing is under siege by a proliferation of passive investments. Must there be only one winner in this fight?

In last month’s edition of Cutting Through the Noise, we took a good look under the hood of passive investment vehicles, and concluded that, while they have a number of positive attributes such as low cost, broad based market exposure, and tax efficiency, there are also growing and often unseen potential perils that should not be ignored.

In this month’s blog, we are going to examine some of the positive attributes of active management, and illustrate why continuing to tactically allocate to certain active managers in concert with passive investments, is a sound investment strategy, particularly in light of where the market is currently trading.

Specifically, we are going to cover how:

  1. It still makes sense to use passive investment vehicles for exposure to efficient and liquid markets, such as Large Cap equities, but
  2. There are market segments such as Fixed Income, Small Cap equities, emerging markets and certain style sectors, where boutique active managers tend to outperform passive investments, particularly late in a market cycle, and
  3. Newly emerging “smart-beta” funds are helping to bridge the gap between passive and active management, and merit consideration in the construction of a balanced, all-weather portfolio.

Let’s take the first jab…

Active Vs. Passive Equities:  Judges’ Decision, Not A Knock-Out

Active management has been the undisputed champion of the mutual fund world for decades.  However, that title belt has been challenged in the past few years by the unprecedented asset flows from active to passive funds.  In fact, the estimated asset split in domestic equity funds is expected to weigh in at roughly a 50%/50% split by the end of 2017.  This is setting up as a real heavy weight fight for assets going forward.  Let’s go ringside…

In this corner, wearing the white trunks – When coupled with their recent stretch of out-performance relative to active asset managers, passive funds have taken on an almost mythical, ubiquitous and omnipotent aura – taking money from active managers in all sectors.  However, as we discussed in depth last month, the self-fulfilling nature of money shifting from active to passive investments has led to a massive, momentum-driven bubble building behind the larger index names that are creating crowded trades with the potential to dwarf the necessary price discovery elements of active management.  All of this could ultimately lead to more volatility, less liquidity, and market dislocation.

And in this corner, wearing the dark trunks – Although active managers have taken quite a few punches losing asset flows to passive investment vehicles, don’t count them out just yet.  This month, we look to provide a head to head comparison between active and passive funds within the equity and Fixed Income asset classes separately, with the intention of leaving you with a better understanding of how and where to find the best investment options within each market segment.

Oh My… What do we have here?  It looks like Vanguard, the indexing powerhouse and proselytizer, admits that active investment management deserves to have a dog in this fight.  It appears that Vanguard is getting set to roll out a fund line-up of actively managed ETF funds. Interesting.

A more fitting segue does not exist to compare historical performance of active vs. passive investment choices.

Let’s take an empirical look at how active managers have performed relative to indexes in the core space through time.

The green line represents the performance of active managers against their benchmark index.  The flat yellow line represents the average number of times when the index beat active managers, measured over a 25 year time period.  When the green line dips below the yellow line, active managers are outperforming the index, and vice versa.  Hence, from the perspective of active managers, the higher the solid green line the worse they performed relative to their benchmark.  In general, Small Cap active managers have slightly outperformed their benchmarks throughout time, while active managers in Large Cap space have moderately underperformed over this period, NET of fees.  This has not been the passive fund knock-out of active managers many may have expected.

These charts tell us two very important things:

  1. Active managers outperform their indexes a greater percentage of time in less efficient market segments. This is evidenced by the fact that Large Cap active managers only outperformed their benchmark 45% of the time, whereas Small Cap active managers outperformed by 55%, and
  2. Active managers tend to out-perform late in a cycle and well into a recession. This is indicated by the dark shaded areas on the chart where you see the green line drop precipitously and stay low until the end of the recessionary period, indicating a prolonged period of active management out-performance.

This merits careful consideration, as we believe we could be nearing the point where the market could turn south due to fears of increased interest rates or an outright recession.  If that is indeed where we are in the market cycle, rotating active managers into the allocation makes a lot of sense.

Boutique Managers Punch Above Their Weight Class

“… boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.”

Let’s narrow this discussion from active vs. passive funds and focus more acutely on the active “boutique manager” sub-group.  A boutique firm is one where the portfolio manager (“PM”):

  1. Has a major equity stake in the firm, often with their name on the door
  2. Specializes in a specific type of investment
  3. Does not try to cover all bases and style boxes
  4. Has the freedom to go where the markets dictate in search of value
  5. Isn’t subject to the tyranny of sales incentives that can unduly influence strategy
  6. Doesn’t not get moved off of funds to more profitable funds, after proving themselves
  7. Is heavily invested alongside shareholders, and
  8. Is more interested in raising returns than assets.

With boutique managers, the incentive structure outlined above drives long-term, multi-generational out-performance.  The ownership structure available at many boutique firms encourages an entrepreneurial risk-taking environment built around an investment-centric franchise.  This is key because it keeps good PMs in place and removes the allure for them to leave for greener pastures following short-term underperformance.

The AMG chart below graphically displays some of the benefits/characteristics of the boutique asset management structure.

Of course, all these positive attributes are meaningless if they don’t lead to superior performance.  The “Figure 9: Boutique Excess Returns:” chart below provides evidence that boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.

“When utilizing active managers for the Large Cap space, we lean toward managers that can ‘go anywhere’ and are not confined to a particular ‘style box’ market segment.”

This chart highlights that boutique managers generated out-performance over their stated benchmarks to the tune of 141 bps per year, on average, between 1994-2014.  Indeed, these numbers are even greater when one looks beyond the US Large/Mid Cap market segment.  This is not a surprise.  It has long been contended that Large Cap companies are over-followed by analysts, which creates a very efficient market with less opportunity to outperform due to almost complete information parity.

As such, the richest out-performance opportunities tend to lie near the market sectors with the most dispersion and least correlation.  This leads us to look to areas like Small Cap and international (especially emerging markets) when looking for active managers.

When utilizing active managers for the Large Cap space, we lean toward managers that can “go anywhere” and are not confined to a particular “style box” market segment.  These types of managers can be paired with index funds in the Large Cap space to smooth the ride for one’s investment portfolio, particularly through a down-cycle.  Examples of this type of manager include Peter Lynch, Warren Buffet, Bill Miller, and Sir John Templeton.  They are all managers that may call themselves “value” shoppers, but are bold enough to skate to where the puck is going to be (or which way the jaw is turning), as opposed to where it has been.

The boutique structure (yes, Peter Lynch was early enough at Fidelity that his Magellan fund was treated as an autonomous boutique fund) gives latitude for Buffet to buy Coke as a Value stock in the 1970’s, because he believed the intrinsic value of the brand was not yet appreciated by the market.  He was right.  The same happened for Bill Miller’s AOL play and other tech names in the 1990’s, and Peter Lynch’s financial and consumer stocks in the 1980’s.  Sir John was early to identify rapidly growing emerging markets as great values in the international markets.  Good managers just buy good companies and don’t worry about fitting them into a style box or sales deck narrative.

“Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.”

The next chart shows the enormous payoff that can occur when one is willing to look under the hood to find a good manager and veer away from the risk-averse managers typically found at larger mutual fund complexes.  The 20 year numbers below are telling in the extreme.  The top-decile boutique manager has beaten their benchmark after fees by over 1100 bps per year!  In fact, simply using a top quartile manager led to more than 700 bps of out-performance over the illustrated period.

Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.   This is the market risk we discussed last month, which stems from ever increasing flows into passive strategies that are creating crowded trades, driving asset prices up beyond where they likely should be, and setting the stage for a wicked reversal.

Passive vs. Active Funds: Heavyweight Vs. Middleweight

When we turn our attention from actively managed equity strategies to actively managed Fixed Income strategies, we see marked out-performance by active Fixed Income managers.  This is primarily because passive Fixed Income vehicles:

  1. Allocate a disproportionate amount to the largest debt issuers, which are currently all US Government securities, and they have abysmal yields at present and can lead to a lack of diversification
  2. Increase interest rate sensitivity because of heavy allocation to Treasuries
  3. Are forced to sell high quality performing bonds when changes to the underlying index are made that mean the fund’s holdings no longer meet the index’s inclusion criteria
  4. Usually this type of planned selling results in the worst possible trade execution and pricing on that day as a larger than normal sell volume hammers down bid prices.

Below, we see that the median active Fixed Income manager has out-performed passive investments, such as ETFs and index funds (net of fees) over almost every time period (1, 3, 5 & 7 year returns), as illustrated by 100% of the red dots being above the horizontal line marked 50. While the 10-year red dot appears to the left of the vertical 50, demonstrating under-performance vs. the underlying index, it still appears solidly above the horizontal “peer group” line, indicating better 10-year performance than the ETFs and index funds, net of fees.

“Yes, the passive investments can actually be more expensive than some of their active counterparts.”

This is an important point… ETFs and index funds appearing in many of the higher risk segments of the market (such as high yield), have such high fees and costs that they are uncompetitive with active funds and their underlying indexes.  Let that one sink in for a moment.  Yes, the passive investments can actually be more expensive than some of their active counterparts.

“Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.”

The chart that follows highlights the challenges that occur within the ETF market once providers move outside highly liquid market sectors.  What you see is how certain high yield bond ETFs performed compared to their underlying indexes, after all expenses and fees.  Not that great.  On average, the ETFs under-performed across the spectrum by over -2% per year.

It is important to highlight that the opportunities for out-performance by active managers in the Fixed Income world only increase as an investor steps out of the risk curve or finds a solid, unconstrained, boutique bond manager to handle the bulk of the Fixed Income portion of their portfolio.

Lastly, the two charts below graphically display the challenges that the high yield bond ETF market will face when flows ultimately reverse.  Also, while the liquidity problems are the most pronounced in the high yield bond market, the lack of liquidity impacts all ETF markets (stocks and bonds) globally to some extent, outside of large cap stock and U.S government bond index based funds.

With that caveat out of the way, what the two graphs below display is that while money has poured into the high yield ETF bond market, the counterparties (“dealers”) that actually provide liquidity when someone sells their ETF shares, have backed away. In fact, it appears they are climbing out of the ring.  This results in the systemic erosion of the indispensable function that the active market plays in price discovery and liquidity, which we discussed in last month’s blog.  The chart on the right is the most striking example of how the ETF craze has impacted this very important function. As dealer inventories decline from above 12% to below 1%, trading volume thins considerably. It will be interesting to watch what happens when panic grips the market and everyone wants their money back at approximately the same time.  Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.

There May Be a New Contender Entering the Ring: Smart Beta Funds

In the last few years, a new type of investment vehicle called “Smart Beta” has gained in popularity and aims to blend the best aspects of passive and active management.  Smart Beta funds are ETF’s that passively track an index, but instead of allocating the underlying positions according to market capitalization alone, they are weighted according to various other factors such as a company’s dividends, free cash flow, earnings, or volatility.  Smart Beta is designed to take advantage of the tax and cost efficiencies of passive investments, but select the underlying investments included in the ETF based on a stated qualitative and quantitative characteristics and data points.

In the Bloomberg chart below, we can see a traditional market cap weighted S&P 500 ETF (SPXT), compared to a Smart Beta S&P 500 ETF (SPXQUT) who’s selection criteria is based upon earnings quality, predictability, sustainability, and balance sheet strength.  The results are stunning.  One can’t help but think of Buffet’s claim that he would rather buy a wonderful company at a fair price than a decent company at a cheap price when viewing the performance of SPXQUT.

However, as compelling as Smart Beta funds can be, investors must pay particular attention to each fund’s ranking/weighting methodology.  Most Smart Beta funds, once the qualitative overlay has been applied, still rank asset weights based on market cap weights, thus making these funds more like the underlying S&P 500 index than the characteristic they are trying to exploit.  We prefer a more equal weighting format when considering Smart Beta funds (as displayed by ticker SPXQUT in the Bloomberg slide above), which more acutely focuses on getting the pure Smart Beta characteristics into the portfolio in a targeted fashion.

This is but one example of many different types of Smart Beta portfolios. Baskets of these types of examples can be utilized to shape a portfolio’s contour through an economic cycle. Smart Beta helps achieve exactly this, but in a cost effective, diversified manner.

“It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.”

And Now, The Judge’s Card

Think about this…if we are indeed coming out of a period of orchestrated, Central Bank led, artificially suppressed interest rates, coincident with historically low volatility – do you necessarily want all your money in investments/funds (passive, for the most part) that have most acutely benefitted from those policies. Or, would you prefer to take some of the profits off the table, and prepare for what should prove to be a different environment as the Central Banks look to drain their own swamp of excess reserves?

We may be about to enter a new round in the fight for returns, where the recent past will not be a prologue.  It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.

Bottom line, a good active, boutique manager (top 1/3) will significantly beat an index through a full market cycle, particularly on a risk-adjusted basis in a lesser efficient market sector.  The difficulty lies in finding those good managers.  The answer is not to buy a manager that has only recently out-performed, but rather to pick a manager with a good long-term track record, who may have only recently fallen out of favor, but is very likely to recover and continue along the same successful long term trajectory.

Focus your manager search on the boutique arena, particularly within more illiquid and less efficient market segments, and lean towards active management for the Fixed Income portion of your portfolio.  Doing so will help ensure your investment plan “floats like a butterfly and stings like a bee” through the full market cycle.


Better To Be Seen Than Herd:  Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Better To Be Seen Than Herd: Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Learn About Active vs. Passive Investment Vehicles Here.

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital

Although index and exchange-traded funds (“ETF’s”) have been around for 25+ years, money has absolutely poured into these investment vehicles (and conversely out of actively-managed funds) in the nine years following the 2008 Financial Crisis.

Many investors and investment companies that provide or allocate to these passive ETF’s and index funds, do so with an almost religious fervor, believing wholeheartedly that it is “impossible to beat the market”, so one should just “own the market” and give up on active investment strategies and vehicles entirely.

“…ETF’s are not Olympic-caliber investments. They are participation ribbons.”

The rationale for this mentality is understandably alluring. Passive investment vehicles are typically cheaper to own, highly tax efficient, and post-Financial Crisis, have generally outperformed active investments on the upside net of fees. Not only that, but the proliferation of “roboadvisors” has made it very easy for investors to create and manage their own passive investment allocations without any professional advice or assistance, further lowering costs.

So, if all it takes to be an Olympic-caliber investor is to create a set it and forget it, auto-rebalanced ETF allocation, and just let it ride for all time, why wouldn’t everyone simply do so? Because ETF’s are not Olympic-caliber investments. They are participation ribbons.

In this edition of Cutting Through the Noise, we take a good, hard, honest look at some of the serious and almost universally underappreciated potential pitfalls associated with passive investment vehicles:

  1. Market cap weighting can lead to price anomalies and a lack of price discovery which could inflame an already overvalued market,
  2. Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects, and
  3. ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously.

Let’s dive in…

How Did We Get Here?

In order to appreciate the oft-hidden flaws inherent in passive investment vehicles, you must first understand the history behind how we got here, namely why did passive investment vehicles exponentially proliferate over the last decade?

Following the Financial Crisis, stock index funds and ETFs, with their low fees and unfettered upside exposure, responded immediately and positively when the Fed and US Government brandished double-barreled fiscal and monetary bazookas and more or less forced the stock market higher with a combination of ultra-low interest rates and financial stimulus.

“This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.”

By contrast, during that same time frame, active managers were exercising prudence, still reeling from the recent, dramatic and rapid drop in portfolio values. As a result, they were maintaining higher levels of cash and allocating to higher-quality, fundamentally sound securities.

The net result was that indexes led almost all active fund managers coming off the 2009 market bottom, and actively managed funds, with their comparatively higher fees and more conservative investment strategies, have yet to close the gap. This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.

How quickly we forget that active management had significantly outperformed through the down market, and that sort of critical analysis and resultant positioning is rapidly becoming more and more relevant in this relatively overvalued market.  We will take a deeper look into the historical performance comparing active and passive investing styles next month.

“The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings.”

The chart below illustrates the asset flows with startling clarity, with passive vehicles (index funds and ETFs) taking in about $1.4 trillion, and active funds losing approximately $1.2 trillion over the past 10 years:

Let’s consider an example that illustrates the negative effects this transition can and has had on active managers’ ability to properly value underlying fund investments.

Assume a money manager has to pick between two nearly identical companies within the same industry. One is included in the S&P 500, while the other is not. Active managers will typically buy the cheaper company that is not in the index, because they are getting the same earnings stream with similar management quality, at a cheaper price. The company that is included in the index, however, ends up being priced substantially higher, not because its better, but because it is included in an index to which capital is being allocated.

These valuation premiums continue to expand as money leaves active management in favor of indexing. That’s the self-fulfilling nature of this trade that keeps putting pressure on active managers. The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings. Thereafter, the passive fund ploughs into a stock index that chooses investments based heavily on market capitalization.

As a result, the cheap stocks get cheaper and the rich stocks get richer. The active managers’ performance has a heavy hand of downward pressure, where fund outflows beget selling their favorite stocks, which begets losses in their stocks, which begets further fund outflows. Meanwhile, the Indexers are on the virtuous side of that trade, where fund inflows mean buying more of their favorite stocks, leading to stronger performance and the subsequent fund inflows, and so on. That is, until there’s a tipping point, and the trend reverses.

“Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy.”

Passive Issue #1: Market cap weighting can lead to pricing anomalies and a lack of price discovery which can inflame an already overvalued market

As investment capital has been taken directly from actively analyzed companies and given to those that happen to hold a weight in an index somewhere, there are far fewer investors kicking the tires of companies to ferret out a competitive advantage, and many more investors who’s only job is to mimic the market as a whole.

Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy. Active investment managers seek to fundamentally and technically analyze companies in an effort to determine if that company’s stock is more likely to rise or fall, and then make investment decisions accordingly. Makes sense, right?

The majority of ETF’s and index funds eschew analysis altogether and instead use a “market-cap weighted” method of determining what companies are included in the index or ETF, which is the exact opposite of the traditional actively-managed meritocracy that has historically driven managers’ investment decisions. A computer program is used to ensure that certain parameters (like tracking a particular index) of the fund are observed, and from there the passive investment vehicles just operate according to that protocol.

So the more indexes or ETFs that a company is included in, the more ETF investment inflows will drive the company’s market capitalization higher. As a result, passive investment vehicles invest many times more money in the largest stocks than they do in the smallest stocks. Even many of the “total market” ETFs are in fact a concentrated bet on the behemoths—out of every dollar invested, as much as 90 cents is a bet on the largest stocks, saving just a dime to spread across the thousands of small- and mid-sized stocks.

Because of passive investors’ abiding and often blind faith in the efficient market, they have ploughed money into cap-weighted indexes, which deploy money into companies based upon their market value vs. stock price, competitive advantages, economic factors, or potential for appreciation. Basically, bigger is better with no critical data analytics, investment discipline, or methodology, and that defies the very purpose of markets—allocating capital to useful ideas.

“…investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.”

Passive Issue #2: Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects

Out of the 500 companies that make up the S&P 500, the 50 largest contributors to risk were responsible for just under half of the S&P 500’s risk. That means 10% of the S&P’s companies are responsible for a whopping half of the index’s expected price fluctuations. Their extreme bias toward the largest of the large-cap stocks means that a full 20 cents of every dollar is invested in the 10 largest companies in the S&P 500.

Take a look at the chart below:

So, why should this matter? As long as the stock market keeps going up and to the right, it doesn’t. But investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.

The difficulty for passive-investing devotees is that when markets decide to become narrow-minded, undiversified, and irrational, so too do their investments. During the last two bubbles—dot com and real estate—the S&P 500 bubbled right up with markets, as both the tech and financial sectors grew to nearly a third of the index before crashing down again.

The role that the “market” or “active” participants play is important in finding a fair price for stocks. Indexes use these “fair” market based prices to find levels at which to transact for the passive money that chases index returns and crowds into the same trade.

“…it’s conceivable that ETFs could find themselves in a downward spiral.”

With the current lop-sided state of cap-weighted indexes and with these indexes receiving the lion’s share of investment, it is very difficult for an investor to simultaneously practice the principals of diversification and remain devoted to passive investing. Herding into passive investments displays a deep disregard for the very principles of diversification upon which index investing was built.

Without active managers executing diligence and fairly pricing investments, those who have piled into ETFs in the last couple of years may very well be the same fickle bunch who sold their equity holdings in the 08-09 melt down. These capital destroyers can be exceedingly dangerous, as they often rotate back into the market at a high, and are likely to sell into any potential market declines.

This self-fulfilling phenomenon works in both directions, and it’s conceivable that ETFs could find themselves in a downward spiral if the confidence in overvalued markets cracks. The high valuations and concentrations of market capital in the index holdings will work against indexes, and when the market does in fact correct, the outflow from passive investment vehicles could be much more dramatic and abrupt than anything we have seen before.

Passive Issue #3: ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously

Let us turn first to the father of index investing, Vanguard founder Jack Bogle. Jack, the man who has railed against active managers for decades, recently declared that there will always be a place for active management. He pointed out here that without the role that active management plays in price discovery, passive investing in indexes and ETFs may break down at some point, “chaos” and “catastrophe” would ensue, and “markets would fail”, if passive investing strategies grew too big.

Take a moment and let that sink in. The crusader who went from the Don Quixote of the investment world to become The Don of the Index, is now waving the caution flag as the index world continues to careen out of control with new offerings under the momentum of their own growth.

To be fair, Jack seems to think we are still on relatively safe ground—blindly stuffing our cash into index funds and ETFs—until passive investing comprises approximately 75% of the entire stock market’s value. However, other market experts are less sanguine, placing the threshold closer to 50%.

In any event, as shown in the chart below, the passive world has recently passed over 30% of all financial assets and is growing quickly. At this pace, the 50% mark is easily expected to be reached within 7 years.

However, the passive investing craze has been primarily focused on the U.S. equity market with considerably less emphasis on international equity and fixed-income markets. In fact, when we look at who owns U.S. equities, as in the chart below, we find that index investors make up a very large portion of the total market. In fact, passive investments grew to 40% of all domestic equity holdings as of the end of 2016.

“…passive investing in indexes and ETFs may break down, and ‘chaos’ and ‘catastrophe’ would ensue if passive investing strategies grow too big”

And the research arm of Sanford Bernstein predicts that by next year, passive strategies will be 50% of the entire stock market. Take a look at the chart below and you can clearly see this trajectory.

It doesn’t take a PhD in applied mathematics to see that we are rapidly approaching the 50-75% range that Bogle warned could be the “catastrophic” tipping point. Although, it’s not a certainty Bogle’s threshold will be hit within the next few years, it seems clear that the warning call has evolved from “um, boss, you really might want to pay attention to this risk” to “Houston, we have a problem.”

Conclusions & Key Takeaways

Investing in Indexes like the S&P 500 and ETFs like SPY has proven to be an excellent way for most investors to get exposure to financial markets through low cost and generally tax efficient vehicles. As such, these low-cost solutions should be an important part of most investors’ financial plan.

If an ETF is well-constructed with transparent and understandable low-cost strategies that helps fill a necessary niche in a portfolio, by all means, include it. But separating the wheat from the chaff in the thousands of ETFs has become at least as important as sorting through all of the individual stocks to determine which ones to buy and sell.

However, like all things financial, one must still take care to diversify, not just by asset class, geographic region, style and market cap, but also by the type of investment vehicles and investment strategies.

This month’s blog is a clarion call to diversify beyond just the simple market cap weighted ETFs (like, SPY and AGG). ETFs have had a great run, which adds to their current popularity and future risks. Just because it is easy and appealing to buy an index does not mean they should be considered the end-all, be-all, one-stop investment shop.

Investors must consider getting exposure through active managers within certain market segments, alternative or non-correlated assets and potentially a relatively new option: smart-beta/fundamental factor funds. When money leaves the stock market (and it eventually will), and index investments are in net liquidation (and they eventually will be), the “active” market participants are likely to find better value in non-index names with similar businesses.

Next month, we will look to provide a common sense approach to mitigating some of the risks we’ve discussed in this blog and blending index investing with other sources of return to produce a reasonably cost effective approach to maximizing risk-adjusted returns.

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Navigating the Shifting Economic Winds

Navigating the Shifting Economic Winds

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital

Just as Bob Dylan grappled with life’s great questions in his 1963 hit “Blowin’ in the Wind”, we at Three Bell are asking ourselves some of the market’s big questions. For example, how many times can the prevailing winds shift before the economy will slow? The answer, my friends, is blowin’ in the wind… the answer is blowin’ in the wind.

The winds of change are howling through our political system with blustery gusts creating cross-drafts for the economy. Additionally, the risk of the occasional gale force wind from geopolitics seems to have increased. I am choosing to save all discussion of political discourse for a future blog and will focus solely on economic winds this time. Let’s just agree that there are political winds out there that are probably not fully priced into the market.

At present, the market’s momentum is being driven by short-term tailwinds related to the outlook for the President’s pro-growth policies of lower corporate and individual tax rates, the economic impact of de-regulation, and the potential for better trade deals as opposed to the negative impact of protectionism. At any particular moment, as it is now, the market may focus on the short term (next few hours, days or weeks), while at other times the market may look at long-term issues or solutions (over the next years or decades). I believe that these short-term winds are considerably less powerful than the longer term, secular winds behind the market’s success for the past 1-2 generations.

Putting aside the potential benefits from the short-term policy shifts, the major tailwinds that have driven the market to all-time highs over the last 40 years, and helped grow the economic pie, are slowly but surely turning into headwinds. It is the following three major forces that we investigate in this blog:

  • Slowing/decreasing globalization
  • Peaking/unsustainable debt levels
  • Bottomed out interest rates

This is not about tornadoes or hurricanes suddenly developing from clear skies. If you’re a golfer or a sailor, you know the wind that starts in the morning as a barely perceptible breeze and steadily builds into a stiff wind in the afternoon. Similarly, shifting economic winds will steadily build over the course of years and perhaps decades, eventually resulting in inflection points which have systemic effects on the capital markets and investment portfolios.

I do not intend to sound overly pessimistic. We humans have a great deal of input into our collective destiny, and the generally positive and indomitable human spirit coupled with new technology improvements and ongoing job training, can make adjusting to some of these newly forming headwinds more manageable.

“It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment gripping the globe or more from a lingering post-financial crisis hangover.”

Before diving into each of these developing headwinds individually, my intention is not to present a dissertation on each topic and prove unequivocally where each component has been or where each is going. Instead, I am taking a long look back at what has historically transpired, in order to develop a commonsense framework for looking forward.

With caveats out of the way…let’s erect our economic weathervane and dive into each of these headwinds!


Slowing / Decreasing Global Trade

Simply put, the US has benefitted from the effects of global trade and rising global growth. Much of this growth and benefit has accrued through providing goods and services to less developed regions. As we look back at the tail on the slope of the line in the graph below, which depicts the portion of global GDP that comes from trade, one can’t help but wonder if most of those benefits are behind us. It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment (Brexit, NAFTA withdrawal overtures, import tariffs on China, etc…) gripping the globe, or more from a lingering post-financial crisis hangover. The answer to that question will be important as we consider global trade to be more of a head, cross, or tailwind going forward.


Peaking / Unsustainable Debt Levels

We have heard about this one for years. The good news is that the US is generally in a better net debt situation than the rest of the world, on the margin. Sorry, that sounded very equivocated. The US government’s debt is in far better shape relative to the other major world economic powers. Japan, can’t buy an interest rate increase (and believe me, they’ve tried), while the Eurozone’s situation is made more precarious by the heavy debt loads of Portugal, Italy, Greece and Spain. Meanwhile, China’s creditworthiness really gets dinged if one looks through to the liabilities caused by SOE’s (State Owned Enterprises).

One also must consider that the US Dollar is still the world’s reserve currency.   Economist agree that our world reserve currency status lowers our borrowing rates because the world is eventually forced to consume in USD.  As such, there appear to be many more canaries that are flying ahead of the U.S. and they are deeper in the coal mine. Perhaps this is why the U.S. has famously earned the moniker of being the cleanest dirty shirt in the laundry or the skinniest horse at the glue factory – my apologies to my Humane Society Silicon Valley colleagues.

“There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth.”

That said, the US is not out of the storm by any means, and the more troubling aspect of our debt situation is shown in the chart below. Paul Volker summarized it quite succinctly when he said… “Our current debt may be manageable at a time of unprecedentedly low interest rates. But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending”. There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth. In part, this may already be limiting options for new fiscal policies to jump-start the economy in future recessions.

Lastly, check out the rate of total debt growth versus total GDP growth in the chart below. Over the past 35 years, the US has seen its total debt obligations grow at an 11% clip after inflation, while the real GDP growth rate is a much more moderate 3%. The net result is that we have not recognized a good return in our GDP growth rate, per dollar of debt. This is sobering as we believe any debt-propelled growth possibility is likely behind us. Going forward, our current high debt levels will reduce our borrowing capacity are therefore much more likely to be a headwind as opposed to a tailwind.

“Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown.”


Bottomed Out Interest Rates

As you can see below, even though in the short term the Fed just raised interest rates by .25% last Wednesday, the level of our interest rates is still at or near historical all-time lows. This is not to imply that rates can’t go lower, as they have in Europe and Japan. Also, given the abnormally weak, current economic realities across the globe, interest rates are not likely to skyrocket any time soon. That said, the catalyst for lowering interest rates from their present levels is likely to be bad news, such as recession or anemic growth, which would add to our debt levels at an even faster rate. In such an environment, investors and consumers pull back on spending and projects, increasing the odds of a deflationary spiral. Let’s not even go there.

The main take-away from the chart above is that gradually lower and lower rates over the past 35 years have provided a very strong and consistent tailwind to the market and the economy. At current levels, it seems unlikely that interest rates will remain a tailwind going forward. It is only a matter of time before the level of interest rates turn into a full-on headwind or at the very least, a swirling wind that proves difficult to navigate.

Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown. This is not a doomsday situation, but merely an observation that the greatest benefits of low rates are behind us. Lower rates make it easier for a company to service debt, spend more cash flow on growth related projects, buy back company stock, or pay dividends. It isn’t that those opportunities are gone, but the delta is about to change from clearly positive to neutral with a negative bias.

Lastly, low interest rates generally help stock investments look more competitive, which raises asset values and fuels consumer confidence. The key takeaway here is that much of the benefit of gradually lower interest rates has run its course.



My intention is to provide moderation and common sense to the ebullient fever of the stock market and related expectations for continued outsized gains. After repeatedly setting new record highs, the market’s valuation is now considered to be historically high (as we addressed in our 3-Part CAPE series). We believe that many of the conditions that contributed to that expensive valuation are now slowing, and likely to gradually reverse.

Gains are more difficult to come by when some of the biggest drivers of investment returns: previously increasing global trade, perpetually lower interest rates, and historically increased borrowing; reverse course and start working against the market instead of for it. The time has come for investors to start adjusting their return expectations to better reflect reality. We will continue to keep an eye on the long-term trends and update any major shifts in weather patterns as the headwinds/tailwinds narrative unfolds.

Please be clear, I am not calling for a market crash, or even a pullback necessarily. I am simply pointing out that the stock market is now running against the wind. Bob Dylan told us where to look for answers, my friends, but it’s Bob Segar’s 1980 classic, which best summarizes our view: we are now running… Against the Wind.

Here’s to getting it more right than wrong. Happy Father’s Day.

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