Placidity Trap, Dead Ahead.

June 20, 2014

Five years into this bull market. Investor enthusiasm has recently crept higher. That's worrisome.
We've no idea where the S&P 500 shall rest in five years. Nobody does. The more vociferously one claims such knowledge, the more quickly should you run. But, we believe the fundamentals continue to support an upward trajectory.
Yet, we have begun to worry.

Since the new year, market volatility as measured by the VIX has remained at lower-than-average levels. Volatility generally correlates to the level of investors' market anxiety. Low volatility, low anxiety. High volatility, high anxiety.
Counter intuitively, the best time to buy equities is during periods of high volatility and high anxiety, often representing periods of investor selling amid negative events, headlines and societal temperament. Here, the VIX usually hits a reading above 20.
Conversely, when confidence is high, headlines are sanguine, and the VIX is low -- vacillating between 11 and 14 -- one is well served to avoid putting money to work. Because sooner than later, something will shift the tectonic plates below and send us into a collective tizzy. Could be geopolitical. Economic. Perhaps an natural calamity. Doesn't matter. Once it occurs, anxiety rises. And stocks fall.
Right now, we are very calm. Too calm. Like the movie's opening scene. The attractive coeds having just arrived at the cabin in the woods. Yet, you know their celebration will be short lived. Soon to be interrupted by something less-than-celebratory.
Mind you, we are not forecasting catastrophe. Forecasts are for meteorologists and futurists. Both of whom are paid for their best assessments. Right or wrong.
Our remuneration, conversely, is earned by steering client capital away from trouble.
We happen to believe that economic and market forecasting is more difficult than weather forecasting. So, considering that the average meteorologist fails to see more than a week into the future, how can the market pundit do better? One answer lay in a segment of Nate Silver's book, The Signal And The Noise - Why So Many Predictions Fail:
"But the further out in time these models go, the less accurate they turn out to be. Weather forecasts made eight days in advance demonstrate almost no skill. And at intervals of nine or more days in advance, the forecasts were actually a bit worse than climatology."
Accordingly, good advisors are paid to tactically manage portfolios that align with client's objectives. This, so that, rain or shine, clients continue along an established path of their choosing.
Portfolio management, devoid of a plan, is a flag without a pole. Blowing hither and yon in every breeze and gale.
Today, however, our concerns are more societal in nature. You see, there are two trends occurring simultaneously that, together, appear troubling.
First, the continuation of ZIRP (zero-interest rate policy) and the ongoing debt accumulation of global central banks.
Make no mistake about it, we live in an era ruled by central banks. The Yellen era appears to hold nothing different from the Bernanke era. Market metrics and ratios are for those with too much time on their hands. Because markets are no longer a price-discovery mechanism, but liquidity reservoirs. As central banks continue to offer cheap liquidity, so financial instruments will elevate ever higher. To the detriment of bond holders and others seeking a fixed income.
So, you ask, when and how will the liquidity party end?
Well, the Congressional Budget Office estimates that the maximum potential Q1 U.S. economic output was $17.9 trillion, 4.7 percent above the actual Q1 output of $17.1 trillion. So, the economy is running just below capacity.
Also, the Fed wishes long-term inflation to be 2 percent. Consumer price inflation sits at 2.1 percent. And the personal consumption expenditures index, the Fed's preferred inflation metric, rests just below 2 percent.
Finally, the Fed initially set the unemployment target at 7 percent. Upon reaching the target, the Fed moved the target to 6.5 percent. Today, unemployment sits at 6.3 percent. And the Fed remains as dovish as ever.
Now, the Fed sits between the proverbial rock and hard place. Playing with fire in uncharted territory (love a well-placed mixed metaphor). Inflation creeps higher. But the Fed is yet to lift a finger. Even if Mrs. Yellen decided next month to raise rates to 2 percent (she would not), it would take at least nine months for the changes to work through the economy. At which point inflation could be well beyond her control.
Moreover, when and as the Fed determines to raise rates in order to mitigate rising inflation, bonds and other fixed income vehicles will be crushed underfoot. Further sticking it to seniors, retirees and other fixed income seekers.
All of which leads to our second trend. One witnessed before during similar circumstances. Alone, nothing troubling. But, against the backdrop we've just laid out, it is a accident waiting to happen.
In 2008, many of Wall Street's army of advisors failed Main Street. Buy and hold translated to cry and hope. Five years later, the market has risen like a phoenix. Main Street investors have simultaneously been deluged by the marketing efforts of web-based, do-it-yourself investment and financial management tools. And many, coupled with Buffett-eque aphorisms in their heads, have taken heed.
In Q1 2000, the stock market concluded its eighteen year bull run so frenetically that everyone believed himself a market maven. Concurrently, a slew of do-it-yourself trading platforms led the denizens of Main Street to sever their advisory relationships, eschew such outdated advice as position sizing, trailing stops and proper allocation, and go it alone. Investors levered their portfolios to the hilt, even taking equity from their homes in order to buy additional tech stocks -- most of which had no revenue, profits or futures.
Of course, the next three years brought investors to their knees. Even as their confirmation biases prevented them from selling shares that traded 80 percent beneath one-time highs.
Of course, the "overconfidence effect" established long ago that our subjective confidence in our judgments and abilities are exceedingly greater than our accuracy and talent.
Fourteen years later, nothing has changed.
We still suffer from the very biases that laid us low in 2000, and 2008. Today, as back then, investors remain driven by the conflicting emotions of fear and greed. Yet, once again, the market's growth and lack of volatility has lulled investors into a sense of serenity. And finds many reaching for do-it-yourself platforms all over again. Even as the Fed considers how to exit this liquidity driven fantasy land of its own design.
Technological innovations, having enabled so much, have led many to believe that they can manage their finances as they might their vacation planning. Only, planning one's vacation does not tap into one's very psychological essence. Doesn't invite our biases and emotional responses into the equation. As do investing and financial planning.
Imagine attaining your pilot's license right as the Federal Aviation Administration changes the rules, procedures and equipment requirements for flying. Would you take your children up?
Renowned trader William Eckhardt knew as much, explaining the impact an extended run can have on an investor's sense of confidence.
"When you're on a big winning streak, there's a temptation to think that you're doing something special which will allow you to continue to propel yourself upward. You start to think that you can afford to make shoddy decisions. You can imagine what happens next."
Or, as Humprhey Neil succinctly cautioned, "Never confuse brains with a bull market."
Two concurrent transformations. Both of which have are reshaping the investment landscape. But, when combined, do not have the happy outcome of the Reece's Peanut Butter Cup. When fused, the two produce a sort of "placidity trap." A circumstance, as we saw in the late nineties, where trusting investors transcend recent fears, reengage the market place, and -- overconfidently -- begin to assume more of the burden than their expertise might suggest. Only to have it blow up in their faces when Mr. Market decides to exact yet another heart-wrenching lesson on prudent investing and financial planning.
The Fed has moved today's financial markets beyond the frontiers of experience. The astute cannot help but wonder what Mrs. Yellen's plan is. Or, if she has one. Simultaneously, investors -- finding the onus of financial independence squarely on their shoulders -- are increasingly rocked into another bull market lullaby.
Long term, losses make you strong. Profits make you weak. And the market will, at every opportunity, disappoint the largest number of investors as frequently as possible.
Using its fiscal tonics and monetary elixirs, the Fed has managed to subdue the dragon, which presently sleeps within the mountain's bowels. Lulled into a sense of safety, those in the surrounding towns have alighted from their homes. But, at some point, the elixirs will wear off. The dragon will rise. And the townsmen will again curse themselves for having built their villages of wood and kindling.

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