Category Archives: FED


The Important Insights From The FOMC Minutes No One Is Talking About

  • The FED’s “protect the market at all costs” attitude minimizes the risk of a severe bear market but increases the risk for an inflationary environment.
  • Trade deficits and low productivity are not good signs for the long-term, no matter the positive data from the labor market.
  • Until the focus shifts from central banks to real structural reforms, sluggish GDP growth could easily turn into a recession.


There are more important insights that can be gained by going through the FOMC minutes than by just reading the news about an eventual interest rate increase. An interest rate increase of 0.5% won’t change much. It will give the news something to talk about for two weeks and from then onwards it will be business as usual. Structural risks and what the FED is ready to do or not do in the case of turmoil is what will determine our investing returns.

The Patient Needs Stronger Medicine

The FOMC minutes start with a discussion about the implementation of a monetary framework, clearly stating that since the 2009 crisis, heavier intervention is needed to stabilize the markets and the economy. Before the crisis, a few rate cuts or increases and minimal market asset purchases were enough to reach stability. This can be clearly understood by having a look at the FED’s balance sheet. It increased fivefold from 2009 to 2014.

figure 1 fed balance sheet
Figure 1: FED’s total assets. Source: FRED.


For investors, this is important because it tells us that the FED will use all the tools at its disposal to keep the economy and markets stable. This minimizes the risks of a severe bear market as capital injections will be immediate, but it also increases the risks for an inflationary environment.

The Economy & Inflation

The economy shows mixed signs. On one hand it is doing very well with the latest jobless claims data at only 262,000, extending the period below 300,000 to 76 weeks which is the longest since the 1970s. On the other, weak manufacturing data, a trade deficit and growth from consumption alone keep the FED from decisively increasing rates.

The unfortunate thing is that adding jobs is easier than solving structural issues. With low productivity and a trade deficit, it is difficult to expect miracles from the U.S. economy in the long term, which again indicates that some international diversification and inflation protection should be welcome in the long term.

Inflation is still only at 1% indicating that something isn’t working as planned. Low interest rates and lots of cheap capital have spurred investments which increases the supply of goods, sending prices down, not up. Such a situation enables the FED to keep rates low and sustain the economy, but nobody knows how long such a situation will last. The FED is just postponing the reach of the 2% inflation target, which is now set for beyond 2018.

The sluggish GDP growth forecast and an economy relying on easy-to-hire jobs and consumer spending indicates that monetary easing did what it can do and now it is time for something else to step in. Structural reforms, lowering student debt and investing in infrastructure might be reasonable ideas, but until the focus is on monetary policy, the risk is high that this slow growth will turn into a recession.

The Situation in Europe

The European central bank released its policy meeting minutes a day after the FED. Europe is still a few years behind the U.S., asset purchases and direct financing programs are the norm but have no influence on inflation or economic growth. Inflation in the EU zone is at 0.8% while industrial production is contracting and GDP growth is below 1%. For the ECB, the good news is that unemployment has decreased from 10.2% to 10.1% and youth unemployment is “only” at 20%.

Similar data clearly indicates that other actions are necessary for the reach of sustainable economic growth. The terrible unemployment rate signals severe structural issues that cannot be amended by monetary policy. At least the situation in the U.S. looks much better after taking a look at Europe.


Everyone expects miracles from central banks, but those miracles only work for a short while. Hopefully structural reforms will enable future economic growth. Until then, we have two situations on our hands as investors.

  • Situation Number 1 – Central banks will intervene at any sign of market and economic weakness with more stimulus, minimizing the risks for long term investments. This means that we can stay long, but we have to be careful to watch for the point in time when the majority of people in the markets understand that monetary policies do not suffice.
  • Situation Number 2 – Global economies are not that healthy, especially in Europe. Severe structural reforms are necessary in order to create real growth, not just financially engineered growth.

The primary conclusion then, is that you can stay long and grasp eventual price declines for rebound trades as central banks state that they will do whatever is necessary to keep things stable. In the longer term, as monetary policy is not working, watch out for the moment when somebody yells: “The emperor is naked.”



The U.S. Dollar: Should You Stick To It Or Diversify Now?

  • The dollar has been positively correlated with stocks for the last 4 years which is unusual.
  • Potential FED interest rate increases don’t make international diversification a great idea right now.
  • Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.


On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

figure 1 bloomberg news

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

figure 2 fred dollar stocks
Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

figure 3 long term dollar
Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how ChinaIndia and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.


U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

figure 4 cny usd
Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.



Signs of Fragility in the Economy Point to an Impending Bear Market. What To Do Now To Protect Yourself.

  • The last jobs report was good news but it also indicates higher costs and full employment.
  • An “easy to hire, easy to fire” mentality is in the air.
  • Healthcare, cash or short term trades should be the best options in this situation.


Last week the Nasdaq and S&P 500 reached yet another record high. Aggressive central bank stimulation pushes investors to disregard risks and look for any kind of yield or growth. Not looking at risk is the worst thing an investor can do, but they also shouldn’t fight the trend.

Even from a long term perspective the market is irrationally valued, and no one can know how long it will stay that way. Being in cash might seem logical but a 0.1% return looks much worse than the S&P 500’s 8.9% year-to-date return.

Today, we are going to analyze earnings as 86% of S&P 500 companies have reported them, but first take a look at Friday’s jobs report which sent mixed signals.

The Jobs Report

On Friday, the U.S. Bureau of Labor Statistics reported an increase in total non-farm payroll employment of 255,000 in July. The unemployment rate was unchanged at 4.9 percent which is great news for the economy but not so much for investors because it indicates that we are close to full employment. The unemployment rate has stabilized at 4.9% and wages have started to increase (2.6% over the year). Higher wages mean higher costs which have a negative effect on margins and earnings.

figure 1 unemployment rate
Figure 1: Unemployment rate. Source: Bureau of Labor Statistics.

Apart from the reach of full employment and higher wages, the fact that businesses prefer to hire more than to invest in equipment signals that corporations are not so optimistic about the future. They easily hire but know that they can fire with the same ease, if necessary. If you buy equipment, you are stuck with it in most cases.

figure 2 employment equipment
Figure 2: Lower equipment spending in favor of labor. Source: Bloomberg.

The “easy to hire and fire” effect is even more pronounced by the increase in the number of people forced to work part-time for economic reasons, which rose from 5.84 million to 5.94 million.

All of the above means that job numbers are fragile and can quickly shift in the opposite direction. This, along with slow GDP growth, will probably keep the FED on hold or result in minimally increased rates to hold off inflation.

S&P 500 Earnings

The second quarter of 2016 is the fifth consecutive quarter with a decline in earnings.

figure 3 earnings growth
Figure 3: S&P 500 earnings growth rate. Source: FACTSET.

The S&P 500 reported sales were flat in comparison to Q2 2015 which means that the increased hiring does not create growth but is necessary to merely keep up with the competition.

Analysts have postponed expected earnings growth to Q4 2016, which doesn’t mean much as they had expected earnings growth for this and for the next quarter. So, as always, analysts’ expectations have to be taken with a grain of salt.

From a sector perspective, consumer discretionary was the best performer with earnings growth of 10.7% which is logical seeing that consumer spending is the only growth segment of the U.S. GDP. But as consumer discretionary is not essential, any kind of bad news or tightening credit might quickly turn this trend around.

For investors interested in not taking on much risk if a bear market hits us, the healthcare sector continued its good news. Healthcare earnings grew 4.9% and revenue grew 9%. As we know that the global population is getting older, especially in the developed world we can expect demand for healthcare to stay stable, or fall the least in a recession or bear market. Therefore, finding good healthcare investments is essential for a defensive portfolio that is still open to growth in this bull market but limits the potential downside if things take a turn for the worse.

figure 4 sector
Figure 4: S&P 500 Earnings growth by sector. Source: FACTSET.

All other sectors are exposed to negative volatility because consumers are going to save on all things except for food and healthcare. With oil prices around $40 we cannot expect an earnings pickup in the energy sector.

The most important factor for long term investors is valuation. Lower earnings and higher prices have brought the current S&P 500 PE ratio to 25.25. If the FED is forced to increase rates due to high employment rates, corporate earnings will be further pressured downwards by the high debt levels and tightening credit will lower consumer spending.

figure 5 multpl
Figure 5: S&P 500 PE ratio continues to grow. Source: Multpl.


We are in a situation where the S&P 500 is consistently breaking new highs while there have been 5 consecutive quarters of declining earnings, slow GDP growth, lower productivity and where bank credit, the main factor for GDP growth, is about to tighten due to increased interest rates and full consumer indebtedness.

We cannot know for how long such a surreal situation will last, but as smart investors we have to be prepared for the worst and still try to grasp the benefits of the upside. As Warren Buffett has $66 billion in cash on his balance sheet, we might to also want think about having cash on hand just in case a bear market comes that will enable us to buy the bargains. As earnings yields are at 4%, that would be the opportunity cost for holding cash but we can hold cash for 5 years and still break even if a bear market comes along. It is difficult to mentally accept such a strategy as we are in the 7th year of this bull market, but some returns have to be sacrificed in order to lower risks.

Another option for diversification is to use a part of your portfolio for well-placed short term trades. The S&P grew minimally in the last two years but in the meantime it gave great trading opportunities. With stop losses and by knowing what you are doing, you can limit the time you are invested, thus lower the risk of being caught in a bear market while still creating healthy returns on the liquid part of your portfolio.

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Euphoria & Denial Point to the Last Days of the Bull Market

  • Risks are cumulating and getting bigger.
  • U.S. GDP growth is slower than expected, earnings and oil prices continue to decline.
  • Japan is unable to grow while BREXIT risks are still unfolding.


It is difficult to find good news lately. The last really good news was the June jobs report when 287,000 jobs were added. Since then, most of the news seems dismal, however, it has yet to have a negative impact on financial markets. It’s as though investors are just hoping for something good to happen in the future. As hopes are an immaterial human feeling, they should not be the base for investment decisions.

In this article we are going to analyze what’s pushing the S&P 500 to new highs. Are we in a state of euphoria about stocks or are the valuations and price increases rational?

GDP News

The U.S. economy was expected to grow 2.5% in Q2 2016, but it only grew 1.2% (seasonally adjusted). U.S. economic growth for 2016 is currently at 1% which is the weakest start of a year since 2011. Saving the economy from a recession is consumer spending which increased by 4.2%.

Low interest rates create cheap money which fuels two trends, growth in both consumer spending and the S&P 500. Consumer loans have increased at a faster pace than consumer spending which makes it clear that spending growth is fueled by debt.

figure 1 consumer loans
Figure 1: Consumer loans at all commercial banks (blue) and consumer spending (green). Source: FRED.

Anyone who has studied economics will tell you that the economy works in credit cycles, when money is cheap and prospects good, people take on credit and spend it. But one can only take on so much credit, and all banks want their money back sooner or later. When sentiment shifts, a credit contraction arises and consumer spending falls. As this is inevitable, the only justification for the current hope of increased GDP growth can be explained with the most dangerous words for investors: “this time is different.”

figure 2 credit cycle
Figure 2: Credit cycle. Source: Loomis Sayles.

As we are in the expansion part of the credit cycle, a recession is going to hit us as soon as we reach the downturn part of the credit cycle because consumer loans are the only thing still boosting growth.

figure 3 gdp contributors
Figure 3: Contributions to Q2 economic growth. Source: Wall Street Journal.

If it wasn’t for consumer spending fueled by cheap loans, the U.S. economy would most likely already be in a recession.

The S&P 500

With economic growth largely missing expectations you would assume the S&P 500 would tank, but that’s not what happened Friday when the economic data was released. On the contrary, the S&P 500 reached a new intraday high at 2177 points. The main reason for the new S&P 500 high is hope of future economic growth, the same economic growth that didn’t realize itself in this quarter.

Another reason stocks have continued to rise has been the Q3 2016 expected corporate earnings growth, but that also vanished like the above described economic growth. As most companies have issued negative guidance we cannot expect higher earnings in Q3 2016.

figure 4 positive guidance
Figure 4: Q3 2016 earnings guidance for the S&P 500. Source: FACTSET.


It would appear the FED is also somewhat in denial about the true state of the U.S. economy and S&P 500 earnings, and is holding on to the hope of increasing interest rates as soon as the economy shows signs of strength, be we’ve been hearing the same story for a while now.

Last week the FED left the door open for interest rate increases as the economy seemed to be improving, but this was before Friday’s GDP debacle. With growth being lower than expected, the FED will probably continue with its status quo policy. As we now know that the only thing pushing the economy higher is consumer spending fueled by consumer debt, any interest rate increases would be detrimental for the economy and push it into the downturn part of the cycle because higher interest rates would increase the cost of debt.

Data on jobs, consumer spending and inflation will be available before the FED’s next meeting in September so we will closely watch that in order to see if the FED will eventually move, highly unlikely after the latest GDP debacle.

Global Situation

The BREXIT had only a short-term effect on markets as investors soon focused on other things and hoped that it would not have any long term effects. But any BREXIT effects won’t be seen in economic data for a few years as it will take the UK at least two years to exit the EU, if not four.

figure 5 brexit
Figure 5: Soon forgotten BREXIT. Source: Google.

News from Japan was also not that good. As economic targets have not been reached, the Bank of Japan decided to double the annual amount it uses to buy exchange traded funds, from ¥3 trillion to ¥6 trillion ($57 billion). This is only a modest increase to Japan’s easing policy, measured in hundreds of trillions, and brings us to the conclusion that Japan is out of monetary policy ammo. Even with constant increases in monetary easing, Japan has experienced a 0.5% deflation in June and slower consumer spending. This should be a warning sign for the U.S. as it is clear that easing has its limits.


All the above indicates that we are currently in the denial phase of a stock market cycle. We have had a bull market for 7 years now and no one wants to look at the above data as it indicates a turn in the credit cycle, lower business spending and earnings, a strong dollar and global uncertainties with the UK, Japan and China. We will analyze the situation in China soon as it requires a special article.

figure 6 stock market cycle
Figure 6: Stock market cycle. Source: The Gold and Oil Guy.

Not to mention oil prices coming close to $40 dollars per barrel, which will push energy earnings down, again.

All of the cumulating risks we’ve discussed send a strong message. Investors have to start thinking about risks and rewards. In the late stage of a bull market, many are overweight stocks, which means they can expect a beating if any of the above mentioned risks trigger a bear market. The options are to increase one’s cash in order to have liquidity when a market decline comes, or to own more uncorrelated asset classes. I’ve written more on this in our recent article on Ray Dalio’s strategy.

For stocks, simply ask yourself, how much are you willing to risk for a 4% long term expected yield?



The Economic News is Very Good, But Keep An Eye On the FED and GDP This Week

  • Housing is showing inflationary signs but still offers an opportunity to profit from the rising trend as a downturn is unlikely and not expected in the short term.
  • Amidst all the positive news, manufacturing turned negative. Yet despite this, stock valuations keep going up, increasing the risk.
  • In the week ahead: the FED’s decision and GDP data. It looks like stable weather in the near future.


The last sequence of economic data was very positive. In this article we are going to discuss the important data coming out this week and analyze the information released last week. Then we’ll combine it with the current situation on the market and, as always, analyze the risks and rewards.


Existing home sales came in at 5.5 million which is the highest in the last 10 years. This is great news and indicates a continuation of the positive trend in the real estate market. Distressed sales from foreclosures are at 6%; down from last year’s 8%.

figure 1 home sales
Figure 1: Existing home sales since 2013. Source: FRED.

Some might think that a new housing bubble is being created. Unfortunately, a clear answer to that can only be given in hindsight. There are several worrying factors, but every bull market climbs the wall of worry. The most alarming factor is that the number of people renting is growing which may indicate that many are already priced out of the market.

In support of a continued uptrend is that fact that home inventory is low as housing starts are at 1.18 million, which is still subdued when compared to the historical average of around 1.5 million, but much higher than it has been over the last 7 years.

figure 2 housing starts
Figure 2: Housing starts. Source: FRED.

According to Bloomberg, another worry is that many homes are being purchased by “mom and pop” investors with less experience, while institutional investors are ducking out of the market. Institutional investors used to account for 50% of investor foreclosure purchases, but in June that number fell to 38%. More troublesome is institutional investors now only make up 2.5% of the market, down from 9.8% in 2013.

Similarly to the situation we had in 2007, more and more foreclosed homes are bought by amateur speculators, which may be over-inflating the market.

figure 3 third party investors
Figure 3: Third-party investors auction home purchases. Source: Bloomberg.

Housing is cyclical and at some point in the future we will see another down market, but the above mentioned worries do not indicate an immediate decline, which means there is still money to be made in the uptrend. Investors might want to look at building and building materials companies that are trading below their real values and still feeling the consequences of the great recession. But beware of the risks, the downturn will eventually arrive. It might be a soft landing as more new homes are built which smooths out the price increases, or a hard landing similar to the one we saw in 2009.

The S&P/Case Shiller home price index will be published today, and prices are still expected to grow at 5.5% year over year which is very high for housing markets, but if low interest rates continue we might see a few more years of such increases.

The S&P 500

The recent S&P 500 breakout is strengthening on the positive housing data and jobless claims at 43 year lows.

figure 4 jobless claims
Figure 4: Jobless claims. Source: FRED.

So far, 25% of S&P 500 companies have reported positive earnings surprises, further fueling the stock market. Earnings are not growing, but 68% of companies have reported earnings above estimates. As of this weekend, the S&P 500 earnings decline for Q2 2016 was expected to be at -3.7%, and unfortunately, expectations for earnings in Q3 2016 have been constantly falling over the last several months.

According to Factset, Q3 2016 will be the sixth consecutive quarter with declining earnings (-0.1%). Positive analysts don’t expect a return to earnings growth until Q4 2016, but the below figure shows how quickly analysts’ forecasts can change.

figure 5 expected earning growth rate
Figure 5: Expected S&P 500 Q3 2016 earnings growth rate. Source: Factset.

With positive economic news and declining earnings, it is difficult to know where the market goes from here. From a fundamental perspective, the market is getting riskier and investors are paying more for lower returns. The current S&P 500 price earnings ratio has now surpassed 25, indicating that in the long term you should not expect stock returns to be higher than 4%.

figure 6 multpl
Figure 6: S&P 500 PE ratio. Source: Multpl.

Reaching full employment means that companies will have to pay more for employees, and thus have higher costs, which should put more pressure on earnings. This should spur inflation, but we will know more on Wednesday when the FED issues its Monetary policy statement.

The Real Economy

As always, life for the FED will be difficult. Low jobless claims, higher house prices and a higher S&P 500 are all good, but there is always the fear that those are just asset inflation repercussions.

The Philly Fed Manufacturing business outlook survey has turned negative again. As manufacturing is the basis of a healthy and sustainable economy, this might push the FED to postpone rate increases, but we might hear a more positive tone.

figure 6 diffusion index
Figure 7: Current and future general activity indexes. Source: Philadelphia FED.

No matter what the FED says, the week will be overshadowed by Friday’s publication of the preliminary data on GDP. A big rebound is expected given the positive economic activities happening in the last few months. GDP is forecasted to grow at 2.5% in Q2 2016.

figure 7 forecasted gdp
Figure 8: Forecasted GDP. Source: Wall Street Journal.


The current environment is one full of positive news and positive expectations which is very good, but as savvy investors we must always look at ways to protect ourselves. More and more indicators are signaling that we are getting closer to the end of the real economic growth period and entering a bubble period.

House flippers are inflating house prices, stocks are reaching new highs even as earnings are declining—and still expected to decline further—while the real manufacturing economy is not growing. All this mixed data indicates that we are close to a recession and a bear market, but the good times could still last for a while as the FED continues to keep interest rates low. We will watch this week’s news releases and earnings carefully and update you on the new developments. Stay tuned.



Higher Interest Rates Aren’t A Given, But Investors Should Prepare Anyway. Find Out Why.

  • Rates cannot go lower but higher rates would destroy wealth and lead to a recession.
  • The FED is in a difficult position and rhetoric shifts can be expected.


It is every central banker’s target, the elusive 2% rate of inflation. We cannot know when, but should expect that it will be achieved and prepare accordingly. Since rising interest rates help to keep inflation in check, once the target is reached, as strange as it sounds, rates should also rise to compensate. This article is going to analyze what is happening, what will probably happen, and how it will affect investments.

Current Situation

The current situation is one of persistently low interest rates on a global scale. The U.S. recently increase short-term rates by a negligible amount, while Japan and Europe continue with their easing policies.

figure 1 historical interest rates
Figure 1: Interest rates in Japan, Europe and U.S. Source: FRED.

Once inflation reaches the 2% target, inevitable consequence will be higher interest rates since it is the only option that prevents inflation from escalating. It’s hard to imagine now, but with all central banks hell-bent on achieving their “goal,” it will become a reality, maybe sooner than most expect. It might take central banks putting money directly into our hands via “helicopters,” but eventually the target will be reached and we will see interest rates come back to normal historical levels.

The FED forecasts its funds rate to be between 2% and 3.5% in 2017. If achieved, it means that all other interest rates, from bond yields to mortgages, will be higher than that. A plausible scenario is that 10-year bond yield is 1.5% higher than the fed funds rate and the expected stock yield 2% above that.

figure 2 FED forecast
Figure 2: FED’s funds rate forecast. Source: Federal Reserve.

Such an evolution means that a lot of things are going to change in financial markets.

Implications of Higher Interest Rates

It’s pretty simple, rates go up, asset prices go down. The consequence is less wealth which leads to lower consumption which leads to a recession. This forecast is unpleasant but is also a reality. Hopefully, the economy will be ready for higher rates.

One consequence of higher rates is that mortgage rates will also be higher. Usually, the 30-year fixed mortgage rate is a few percentage points above the federal funds rate. If you do not have a fixed mortgage, or are unable to buy now while rates are low, your future monthly payments will be higher, leaving less money for investments and consumption.

figure 3 fed and mortgage
Figure 3: 30-year fixed mortgage rate and federal interest rate. Source: FRED.

Higher mortgage rates might influence a decline in home prices. Figure 4 below shows that declining mortgage costs have supported a continuous rise in home prices.

figure 4 mortgage rates and home prices
Figure 4: Home price index and mortgage rates. Source: FRED.

As interest rates go up, so will bond yields. Consequently bond prices must fall. It’s that simple. As bond yields go up, expected stock yields rise as well since stocks are considered riskier and carry a premium. The current expected yield from stocks is around 4% given a PE ratio of 24.85 for the S&P 500. If we add 2% to the expected yield from stocks, we get to 6% which implies a PE ratio of 16.6. Given the current earnings, a PE ratio of 16.6 would mean the S&P 500 would trade at 1447, which is 33% below current values.

In addition to declining asset prices, due to higher expected yields, many corporations have taken advantage of the low rate environment to borrow money. If interest rates go up, financing costs will follow which will lower corporate earnings. Lower corporate earnings means less investments and less investments mean less economic activity.  Therefore, the S&P 500 could drop even further.

On a positive note, savers will appreciate higher rates as they have been getting almost nothing for the past 7 years. Higher yields will also benefit Insurance companies that live off of their float and pension funds that are desperate for higher yields.

Is the Above Scenario Possible?

When this scenario begins to play out, investors will get the short end of the stick as higher rates will directly translate into lower asset prices. This shouldn’t come as a big surprise for investors, since the total U.S. net wealth is $80.3 trillion, of which $37.1 trillion is in real estate and $28.7 is in equity. In total, 80% of U.S. wealth is concentrated in assets whose value is strongly correlated to interest rates.

Higher interest rates mean less wealth, less wealth means less consumption and less consumption leads to a recession. Therefore, it will be very difficult for the FED to implement the forecasted interest rate increases without inflicting a lot of pain on U.S. households.

And then there is the issue with the dollar. Higher interest rates mean a stronger dollar, unless Europe and Japan coordinate their rate increases simultaneously. A stronger dollar means less exports and, again, less economic activity.


It’s possible, given the above scenario, that buy and hold investors won’t fare as well as medium term traders and active investors might, since the FED will be forced to see saw back and forth with interest rates. Maybe we will see a rate increase in the coming months, but those rate increases will have a negative effect on the economy and household wealth, and the FED will be forced to lower rates again. The implications of this back and forth rhetoric can already be seen in the 6-month U.S. 10-year treasury note yield chart, where yields have experienced constant up and down movements in relation to nothing more than market sentiment surrounding expectations of higher yields.

figure 5 yield
Figure 5: U.S. 10-year treasury note yield in the last 6 months. Source: FRED.



Watch Out: The FOMC’s Current Stance Could Impact Your Portfolio in the Long Term

  • Bonds are becoming riskier as yields are falling.
  • Inflation is at 1.2% and very likely to get higher as full employment is approached.
  • The FOMC predicts stability which could create a great environment for traders.


On July 6 the Federal Open Market Committee (FOMC) June meeting minutes were released. As they give clear insight into how the controllers of our monetary policy think, it is very important to analyze the minutes in order to better position one’s portfolio and also execute short- and medium-term trades. The FOMC gave a clear indication of their expectations in relation to future GDP growth, unemployment, inflation and its federal funds rate. All of the mentioned indicators will have different effects on various investments.

Summary & Indications for Investors

“Prudent to wait” are three words that summarize the FOMC meeting. For investors this means that you should prepare for anything as the FOMC doesn’t know what will happen.


In more detail, the low treasury yields is what worries the FOMC. As investors shun foreign sovereign debt and repatriate their cash, U.S. yields go down. This decline in U.S. yields is not only caused by global political and economic turmoil—think Europe with BREXIT and Italian banks, and Brazil—but also by the FOMC’s indecision.

Yields went up when the FOMC increased interest rates back in December and forecasted three more increases during 2016, which obviously will not happen. This change in policy has pushed yields down again.

figure 1 u.s. yield
Figure 1: U.S. treasury 10-year yield. Source: Bloomberg.

With consumer price inflation at 1.2% with projections at around 2% in 2017 and a yield of 1.36% on the 10-year note, buying 10-year treasuries doesn’t protect your capital. Such an artificially created situation by the FED is unfair towards savers.

As the price of a bond moves inversely to its yield, the current low yield means that investors have to pay a lot for little. For example, if you invest $100,000 now in 10-year U.S. treasuries and next year the yield climbs up to 2.3% where it was a year ago, your $100,000 investment will become $59,130, which is not a great way to protect your capital, especially if you don’t plan to keep the debt until expiration.

Astute traders might want to grasp the opportunity given by the clear indications of higher inflation which should produce higher interest rates and consequently lower bond values in the medium term by shorting bonds.

On the labor side, the FOMC is worried about the low number of new payrolls added in May as the fall from 5% to the 4.7% unemployment rate was mostly influenced by a large number of people exiting the labor force. The FOMC estimates unemployment to stay in the 4.5% to 5% range in the next three years and in the longer run. This stable forecast is very strange as the unemployment rate has historically never been stable.

figure 2 unemployment rate
Figure 2: Unemployment rate from 1948. Source: FRED.

As the figure above demonstrates, since unemployment has been measured there has never been a period of stable unemployment for a longer period of time except for a one-year period in 1955 and a two-year period in 1965. Perhaps the FOMC is forgetting that the economy works in cycles. Investors should understand that the reach of full employment increases costs for corporations which should finally spur inflation. This again reinforces the above described risk of holding treasury notes and also indicates that investors should look for stocks that will perform well in an environment with higher inflation and higher interest rates. One example is energy stocks as they can raise their prices pretty quickly in relation to inflation and if they have their debt maturing in the distant future with fixed interest rates, even better.

The FOMC’s view on economic growth is a mixed one, again reinforcing the sit and wait strategy. Weakness in the mining sector is continuing, declining corporate earnings and high inventory levels lower business investments that “could portend a broader economic slowdown” according to the FOMC.

On the other hand, the committee is also optimistic due to a turnaround in energy prices and greater optimism in business surveys. So, for the FOMC, pessimism from actual figures like lower business investments, higher inventories and lower corporate earnings is equalized by survey optimism and a turnaround in energy prices. Such statements indicate high risks because even if there was a recession looming, the FOMC isn’t allowed to tell us that because such an admission has the power to influence markets. If the FOMC said that a recession would come in the next year, that recession would begin the same day of the statement and not next year.

Fed governor Daniel Tarullo stated that “This is not an economy that is running hot” and that the Fed has limited tools if the economy slows down as the interest rates are already at their minimum which increases the risks for investors.

To sum it up, the figures below are the FOMC’s forecasts and forecasted ranges for GDP, inflation and unemployment:

figure 3 fomc forecasts
Figure 3: FOMC’s forecasts. Source: FED.


As the FOMC forecasts stability on all levels, investors can expect sideways market movements because as soon as negative news like the BREXIT lowers market values, positive news like monetary interventions will push the markets higher again. If things will be as the FOMC forecasts, it will be a heaven for traders. Long term investors will see their current low yields eaten up by inflation, so a portfolio should be rebalanced accordingly.



How to Prepare Your Portfolio For The Next Recession or Stock Market Crash

  • The risks of a slowdown are higher than the upside.
  • Fundamental trends are negative in advanced economies while emerging markets show higher growth rates and are cheaper.
  • It is important to create a diversified portfolio with uncorrelated assets.


In an environment where it seems maximum potential for the U.S. economy has been reached, the St. Louis FED chief, James Bullard, has said in his most recent report that he favors only one interest rate increase through 2018, which would at best keep things stable. His view is further supported by the fact that the unemployment rate is sitting at below 5%, and the Personal Consumption Expenditures PCE inflation—measured by the Dallas FED—is at 1.84%, both of which signal that the economy has reached its maximum potential.

1 figure trimmed inflation
Figure 1: Trimmed mean PCE inflation. Source: FRED.

The scary part of the report is where Mr. Bullard describes how forecasts are made based on the current situation, which will most definitely change. What is difficult to predict is the direction of the change therefore, forecasts are bound to be incorrect and under the influence of various risks like a return to the normal Phillips curve influence where low unemployment triggers inflation, or a recession even if no current data indicates the possibility of one. Thus only an extremely positive scenario would trigger interest rate increases if fundamentals like inflation or productivity stay stable.

2 figure fed stlouis
Figure 2: St. Louis FED’s U.S. macroeconomic outlook. Source: St. Louis FED.

The conclusion is that practically anything can happen, and the FED has absolutely no idea as to where the economy will be in a year or two. Even FED Chairwoman Yellen admits that the 2013 expected interest rates of 4% for 2016 were too high and that an aging society and a slump in productivity growth will keep the subdued economic indicators persistent.

In such an uncertain environment, an investor should look at the best ways to protect his downside and maximize his upside.

Investment Ideas

Let us start with bonds where interest rates have been declining since the start of this century.


3 figure bonds
Figure 3: 10-year government bonds yields. Source: Wall Street Journal.

As bond prices are inverse to bond yields, any increase in yields would precipitate bond prices, thus bonds are currently low yield and high risk. Usually considered safe havens in recession times, bonds currently do not provide such protection as it is better to keep cash than bonds with negative interest rates. There is the option of further bond price increases, but that is a highly unlikely scenario as bond yields are at historical lows.

The Stock Market

The S&P 500 is still holding well, but does not manage to break the previous highs despite having come close several times.

4 figure s&P 500
Figure 4: S&P 500 in the last 12 months. Source: Bloomberg.

The S&P 500 dividend yield is 2.12% which might look tempting when compared to the extremely low bond yields, but it is meagre when compared to the historical mean of 4.39%. A return to the mean would result in a drop of 50% or more of the S&P 500 index. The conclusion here is the same as with bonds: High risk, low returns.

But there is an option with stocks that should limit the downside. Dividend stocks that will not see their cash flows affected by a slowing down in the economy are always assets toward which investors run when trouble comes. Examples can be found in telecommunication, consumer staples and healthcare.

Emerging Markets

If the reason for economic stagnation in the developed world is an aging society, slow productivity growth and emerging markets competition, a contrarian thesis would be to invest into emerging markets.

Emerging markets have a relatively young population and are currently shunned by investors as too risky amidst a commodity price slump. But no matter the current issues, the World Bank expects emerging markets and developing economies to grow at rates north of 4% in the long term, while advanced economies are expected to grow below 2%.

Currently, advanced economies are preferred by investors as they regard them as secure, but long term structural trends are strong in place even if we do not choose to see them. What China has done in the last 15 years could be the same as India is about to do. Brazil will probably also return to growth someday.

The following figure will show that the current developed world impression of asset security is mostly funded by debt which is unsustainable in the long term.

figure 5 investment position
Figure 5: U.S. net international investment position. Source: Bureau of Economic Analysis.

On top of that, emerging markets are much cheaper than developed ones according to the Cyclically Adjusted Price Earnings (CAPE) ratio which takes into account earnings from the past 10 years.

figure 6 global cape
Figure 6: Global CAPE map. Source: Star Capital.

For long term investors, the less risky option might be to dig for good investments in emerging markets with positive demographics and a strong growth outlook. Currently those investments are out of favor, but this is exactly the environment where investments give the best returns.


Gold is a doomsday investment, it protects you against inflation and is the metal that surges in difficult times. Typically as the economy does well, stocks grow and gold declines because gold has no yield. The opposite happens in turmoil.

7 figure guardian precious metals
Figure 7: Gold and stocks cycle. Source: Guardian Precious Metals.

You can invest in gold by buying it physically, through ETFs or by buying gold miner stocks.


As always, good diversification should provide sufficient downside protection but a portfolio has to be diversified with uncorrelated assets.

If you have Ford in your portfolio and then you add some Caterpillar, that is not real diversification. Gold, emerging markets, cash, and quality stocks should enable a portfolio to weather economic hardships.

Don’t forget that after every recession comes a recovery, so be ready to increase your exposure to stocks when assets are cheap, even if everyone will be thinking that there is no tomorrow.


Will There Be A Long Term Impact To The Fed’s Shift In Rhetoric?

  • A positive outlook seems more political than realistic as the FED is out of maneuvering power.
  • Keeping interest rates unchanged is the best and the only thing the FED can currently do.
  • Low interest rates will weaken the dollar, boost exports and increase corporate earnings in the upcoming earnings season.


In FED’s Chairwoman Yellen semiannual policy report, the rhetoric has significantly changed since the last report in February. In short, the full employment target is almost reached but the inflation rate is still below the targeted 2% and the expectations for the reaching of that target have been changed from short term to medium term. Further, the latest job reports show a slowdown in jobs increases which creates a bit of a scare. The FED estimates the slowdown to be transitory.

On the positive side, wages seem to be finally picking up which is a good sign for inflation. Weak data comes from the economy where the U.S. GDP grew only 0.75% in Q1 2016 on an annual basis due to the fact that the expensive dollar weighs on exports, low oil prices and weak business investments.

The FED On The Economy

On one side, Yellen says that the slowdown in employment should be only transitory and that data from one quarter does not mean much, while on the other side she states that the quarterly pickup in consumer spending and increase in household wealth will bringfurther improvements in the labor market and the economy more broadly over the next few years.

As always, in order to show the other side of the medal Yellen mentions risks like lower employment and business investments that might lower domestic demand, the general slowdown in U.S. productivity potentially continuing, a stronger slowdown in China and a possible Brexit. All of the mentioned possible scenarios might have a negative impact on investors’ perception of risk and therefore abruptly change the current stable market situation.

Monetary Policy

The FED decided to keep interest rates unchanged and even more importantly, keep the FED’s holdings of longer-term securities at an elevated level.

The most important part of the report is related to the fact that interest rates are expected to increase only gradually as the economy is too weak to withstand sharper increases. The necessary rate needed to keep the economy operating close to its full potential is low by historical standards. Only if the above mentioned uncertainties and productivity, and employment slowdowns fade will the FED increase interest rates gradually, if not, rates will remain like this for a longer period of time.

The report is concluded with the case that if the economy were to disappoint, the FED would lower its interest rates.


In relation to the potential lowering of the interest rate in adverse economic situations one might ask:

Lower the interest rate to where?

As the interest rate is at historical lows, a lowering from 0.5% to 0% doesn’t seem at all significant. It is highly unlikely that demand for houses in a recession will increase if the mortgage rate decreases from 3.75% to 3.25%. In order to be significant for the economy, interest rates have to really have an influence on demand as they had in the previous monetary interventions.

figure 1
Figure 1: FED interest rate changes. Source: Trading Economics.

Probably everyone expected that the economy would pick up like it did in the 1990s and 2000s, but it hasn’t in the last several years, at least not enough to ignite inflation or allow interest rate increases. This puts the FED in a difficult position as it has no maneuvering space if any economy shocks happen. The good news in the bad news is that a similar situation is affecting Europe, Japan and China, so the FED can keep interest rates low without severe outflows of capital.

Long Term Outlook

Keeping the interest rates unchanged is probably the only thing the FED can do at this moment as there are no clear indications in where the economy is going. The current home sales are at a nine-year high, but this again does not change the structural problems like the low productivity because with a sold home no value is created, only on paper due to the increased asset prices further fuel the asset bubble. The median house price increased by an astonishing 4.7% compared to last year.

The low interest rates will weaken the dollar in relation to other currencies and thus make U.S. exports more attractive. Also, corporate earnings will be higher when translated to dollars which should have a good impact in the upcoming earnings season.

figure 2 dollar
Figure 2: Dollar index has been falling in the last 6 months. Source: Bloomberg.

But, the structural issues are still lingering behind the good news and sooner or later, hopefully later, will have an impact.

The FED will continue in trying to keep things stable which is remarkable, and no one can know how long the FED will succeed in this. Perhaps even for years as it has already been doing this for more than 7 years.


Time To Get Smart About Stock Picking – Find Out Why

  • An aging population diminishes GDP growth and US GDP growth is bound to further decline.
  • Fertility rates are at an historical minimum and the labor force participation is falling.
  • Corporate earnings growth is correlated to GDP growth.


One of the worries for the stock market apart from interest rates and a slump in commodity prices is baby boomers retiring and selling their stocks in order to fund retirement. As the fertility rate is falling, the worry is that there will be less people standing in line to buy those shares.

This article is going to elaborate on the current situation by analyzing the most important takeaways from the National Center for Health Statistics (NCHS) latest births report, demographic trends and their impact on GDP, and corporate earnings.

The Data

As we all know, the birth rate per 1,000 women aged from 15 to 44 is falling, but something often disregarded is that the number of births is still very high.

1 figure number vs rate
Figure 1: Birth rate vs number of births. Source: NCHS.

The all-time peak in the number of births was reached in 2007 and has been slowly declining since, but it is still relatively high when compared to the 1970s. This high number alongside immigration makes the demographic picture of the US positive. The number of inhabitants is growing at a constant rate.

2 figure US population
Figure 2: US population. Source: Trading Economics.

A growing population is essential for a healthy economy as it enlarges the labor force, provides a larger domestic market for the economy and encourages competition. The high number of new born babies does not mean that the fertility rate is the same; the larger base of people keeps the newborn numbers high but the fertility rate is decreasing.

3 figure birth per woman
Figure 3: Births per woman aged 15-44. Source: Wall Street Journal.

The lower fertility rate brings to another well-known issue: population aging and worries about ‘demographic time bombs.’ One of the biggest fears is that the future generations will fail to meet pension requirements from an ever increasing number of retired workers.

Not only that, research from the Center for the Study of Aging (CSA) has shown that for every 10% increase in the fraction of the population aged 60+, a 5.7% decrease in GDP per capita can be expected as the labor force diminishes. The number of Americans aged 65 and above is expected to double by 2060.

4 figure population selection
Figure 4: Percentage of US population in selected age groups. Source: Population Reference Bureau.

According to the CSA research mentioned above, the increase from 15% to 21% of population being older than 65 in the next 15 years should diminish US GDP per capita by around 20%. With the population expected to grow only 11% from now to 2030, the aging population will remove 10% of US GDP in the next 15 years. With increased global competition and increased US debt, we should not expect big US GDP gains.

The aging issue has already been having a negative effect on the US labor force participation for almost two decades.

5 figure us labor force participation rate
Figure 5: US labor force participation rate. Source: Trading Economics.

This trend perfectly coincides with the slowing down of US GDP growth, confirming the thesis that an aging population diminishes the labor force and consequently, economic growth. The US GDP average growth rate has been 1.85% per year since the beginning of this century while the average for the 1990s was 3.38%, 1980s 3.16%, 1970s 3.3% and 1960s 4.46%.

Effect on Portfolio

Investors today should not expect the same returns in the next 50 years as the investors in the second part of the last century had enjoyed. The second part of the 20th century had an average yearly GDP growth of 3.72%, thus double the average GDP growth in this century as the population and the labor force were constantly increasing. Such an environment made it easy for companies to grow and find new opportunities.

This half century trend is now in reverse mode. Curiously enough, the year 2000 was exactly the end of the past trend and the beginning of the new trend. S&P 500 corporate earnings in the 1990s were growing at a geometric average of 6.6%, while earnings in this century grew at only 3.7% per year. This almost 50% decline in earnings growth is perfectly correlated with the 50% decline in GDP growth.

Buybacks and international growth are seemingly not enough to contrast the decline in US GDP growth.


Unfortunately, the FED can’t do much to fight the negative demographics trend. Monetary policies can have an effect but in the long term, productivity is what matters and with less workforce, productivity eventually declines. Declines in productivity bring increased debt levels as the previous standard is kept and investments are made with the hope of economic improvements. A similar situation is affecting Germany but in order to fight the trend, Germany allows a million immigrants (more than 1% of the German population) to enter and work in Germany per year.

With negative demographic trends we cannot expect high growth levels from the general US economy which brings to the conclusion that investments in mutual funds or the general market which were great for the 20th century will not do well in this century as the general economic situation does not allow similar corporate general performances. This will be the century of smart stock picking investment strategies.