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posted on 12 September 2016

Monday Morning Call 12 September

Written by , Clarity Financial

Bonds Take It On The Chin?

This past week there was ample commentary suggesting interest rates were set to "soar" higher and the death of the "bond bull market" was finally here. While such commentary is always inevitable whenever rates rise for any given reason, it is hardly the case.

First of all, as I have stated previously, interest rates do not function in isolation. They are a function of economic growth over time as borrowing costs are driven by the demand for credit given the return on investment generated from borrowing activities. In other words, money isn't borrowed at 4% interest if the return on the use of those borrowed funds is 3%.

The chart below proves this.


Given that interest rates had gotten extremely oversold during the "Brexit," money poured into bonds for safety, it is not surprising to see rates have a reflexive move higher. What we saw on Friday was likely rate "shorts" being blown out of positions.

However, interest rates are now at extreme overbought levels only seen near peaks in interest movements AND pushing on the downtrend line from 2015. This will likely prove to be a decent opportunity to rebalance bond exposure to target levels in portfolios next week.

I will be adding more bonds to portfolios next week as well.


Interestingly, as I stated last week:

"With 10-year rates now back to an overbought condition (bonds now oversold), and pushing the accelerated downtrend line that began with the conclusion of QE3, the most likely movement will be down in conjunction with a 'risk-off' move in the markets."

Importantly, while interest rates could possibly tick higher to the long-term downtrend line at 2.1%, (OMG, run for the hills), the reality is the economy is not growing strongly enough to support substantially higher rates which will push the economy more quickly towards the next recession.

Of course, during recessions interest rates fall sharply which is why I still suspect, given the majority of global economies in negative territory, them to ultimately approach zero.

Watch The Dollar

While the dollar stumbled slightly this week, the uptrend in the dollar remains intact. As I noted previously higher rates in the U.S., as compared to the rest of the world, will attract inflows. Such will continue to suppress both oil prices AND earnings. To wit:

"While Central Banks have gone all in, including the BOJ with additional QE measures to bail out financial markets and banks following the 'Brexit' referendum, it could backfire badly if the US dollar rises from foreign inflows. As shown below, a stronger dollar will provide another headwind to already weak earnings and oil prices in the months ahead which could put a damper on the expected year-end 'hockey stick' recovery currently expected. "


Unlike the stock market which is pushing extreme overbought levels, the dollar is at an extreme oversold condition and has only started a potential move higher. This is something to pay very close attention to in the months ahead due to the dollar's impact on exports, earnings, and commodity prices.

As noted, with interest rates negative in many areas of the world, the push of capital into the U.S. for a higher return on reserves remains likely for now.

Model Update

S.A.R.M. Sector Analysis & Weighting

As I have been repeatedly stating over the last few weeks, as boring as it has been, there has not been enough of a correction of the current overbought condition to justify increasing equity allocations in portfolios yet. This is despite the fact the model has been adjusted higher to represent the target levels of equity exposure we want to migrate toward.

Well, guess what, we finally broke to the downside. Read the "Time To Buy Or Sell" section in the main body of this missive above.

While actual portfolio equity risk weightings remain below our target of 75% again this week, the odds of a further correction next week keeps us on hold for now until we find a short-term bottom and can redetermine risk/reward ratios.

(Note: This is an equally weighted model example and may differ from discussions of overweighting/underweighting specific sectors or holdings.)


Relative performance of each sector of the model as compared to the S&P 500 is shown below. The table compares each position in the model relative to the benchmark over a 1, 4, 12, 24 and 52-week basis.

Historically speaking, sectors that are leading the markets higher continue to do so in the short-term and vice-versa. The relative improvement or weakness of each sector relative to index over time can show where money is flowing into and out of. Normally, these performance changes signal a change that last several weeks.

As noted above, the recent spike in interest rates has now reached the top of the long-term downtrend and suggests that staples, utilities, and bonds will continue to improve in performance over the next couple of weeks. Such improvement will most likely coincide with an ongoing market consolidation or correction.


Notice in the next to last column to the right, the majority of sectors which have previously been pushing extreme levels of deviation from their long-term moving average have begun to correct those extremes. As I stated previously:

"Such deviations can not, and do not, last long historically. A resolution of those deviations has been occurring with the recent consolidation of the market which providing the necessary risk/reward rebalancing to increase model allocations in the future."

Importantly, if the current pullback is a "buy the dip" opportunity, the sectors that maintain their technical underpinnings and resolve the extreme deviations from short and long-term moving averages will provide good opportunities to add to portfolios.

The two charts below graphically show the relationship of each position's performance relative to the S&P 500 Index. If we are trying to "beat the index" over time, we want to overweight sectors/asset classes that are either improving in performance or outperforming the index, and underweight or exclude everything else.


Sectors Currently Outperforming by >1%

  • Energy (Improved last week)

Sectors Currently Performing In Line <>1%

  • Industrials (weakening)

  • Financials (weakening)

  • Healthcare (improving)

  • Technology (weakening)

  • Utilities (improving)

  • Discretionary (improving)

Sectors Currently Under Performing By >1%

  • Materials (weakening)

  • Staples (improving)


Index/Other Asset Classes Out Performing S&P 500 By >1%

  • International Bonds (improving)

  • High Yield Bonds

Index/Other Asset Classes Performing In-Line With S&P 500 <>1%

  • Mid-Caps

  • Equal-Weight S&P 500 (weakening)

  • Small-Caps (weakening)

  • Dividend Stocks (improving)

  • Emerging Markets (weakening)

  • International Stocks (weakening)

  • Domestic Bonds

Index/Other Asset Classes Under Performing S&P 500 By >1%

  • REIT's (improving)

The risk-adjusted equally weighted model has been increased to 75%. However, as stated above, further consolidation in the markets is needed before making any changes.


Such an increase will change model allocations to:

  • 20% Cash

  • 35% Bonds

  • 45% in Equities.

As always, this is just a guide, not a recommendation. It is completely OKAY if your current allocation to cash is different based on your personal risk tolerance, time frames, and goals.

For longer-term investors, we still need to see improvement in the fundamental and economic backdrop to support the resumption of a long-term bullish trend. Currently, there is no evidence of that occurring.


The Real 401k Plan Manager - A Conservative Strategy For Long-Term Investors


NOTE: I have redesigned the 401k plan manager to accurately reflect the changes in the allocation model over time. I have overlaid the actual model changes on top of the indicators to reflect the timing of the changes relative to the signals.

There are 4-steps to allocation changes based on 25% reduction increments. As noted in the chart above a 100% allocation level is equal to 60% stocks. I never advocate being 100% out of the market as it is far too difficult to reverse course when the market changes from a negative to a positive trend. Emotions keep us from taking the correct action.


Godot Arrives?

As I stated last week:

"Sometimes it feels as if we are waiting for something that will never come - a reasonable entry point to increase our equity exposure. As I have been repeating over the last several weeks, sometimes it is better to "nothing" rather than to do "something" that turns out to be wrong."

This past Friday is a good example of what can happen if you "guessed wrong."

Over the past several weeks, I have continued to suggest reviewing portfolios, reducing risk, rebalancing and preparing for "whatever comes next." That advice remains this week in particular as we now begin a corrective process. On any bounce in the market early next week continue to clear up your portfolio allocation by:

  1. Tighten up stop-loss levels to current support levels for each position.

  2. Take profits in positions that have been big winners

  3. Sell laggards and losers

  4. Raise cash and rebalance portfolios to target weightings.

Given the correction we are now on the lookout for the following two outcomes into which we can take further actions.

  1. If the market pulls back to support and confirms the recent breakout is indeed a continuation of the bullish long-term trend, we can begin to increase equity risk exposure in portfolios.

  2. If the recent breakout turns out to be a "head fake," the reduction of "risk" protects the portfolio against any substantial decline.

No one knows for sure where markets are headed in the next week, much less the next month, quarter, year, or five years. What we do know is that not managing risk in portfolios to hedge against something going wrong is far more detrimental to the achievement of long-term investment goals due to the inability to recover the "time" lost getting back to even.

If you need help after reading the alert; don't hesitate to contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principal. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)


401k Choice Matching List

The list below shows sample 401k plan funds for each major category. In reality, the majority of funds all track their indices fairly closely. Therefore, if you don't see your exact fund listed, look for a fund that is similar in nature.


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