2013 US Financial Markets

The Financial Markets

In the fall of 2012 the S&P 500 came close to our forecast high (S&P- 1500)… Last year we suggested that not only was the S&P likely to reach 1500, but also speculated that renewed bullish sentiment could take us back to the old highs of 1565. When the S&P touched 1563 a couple weeks ago, I started getting client calls complimenting my prescient forecast. The rally last Thursday rally took the S&P all the way above 1590. In two days, the market has already retreated to just above 1550. That forecast turned out to be prescient, but it was far from inevitable. It was merely a valuation extreme that has only been exceeded a handful of occasions in the last 100 years. The top could have come a lot sooner, or speculators may yet prove crazy enough to take prices even higher. That said, US stocks as measured by the S&P 500 stopped being a sound investment at prices 10%-15% lower than here. No one is more surprised than me at how often my predictions regarding how much speculators will overpay for assets or the extreme fire sale prices they will accept at the bottom have proven prescient. We don’t risk much money on those forecasts.

The level of investment risk we are willing to take is simply a function of the long-term return we are likely to achieve based on the price we pay. As prices move, so does our willingness to invest. History has shown long-term return to be predictable with a high degree of confidence. If you overpay, future investment returns will be lower. If you buy at a deep discount you will produce higher returns over time. It’s that simple. We usually start buying cheap assets months before the bottom is reached, or start taking profits months before the top (even when it turns out that I manage to accurately predict the extremes). More often than not, the last 3-6 months or so before the market turns is usually frustrating for me.

Our approach differs completely from speculators that focus on predicting the short-term behavior of other financial market participants. This can be very profitable at times, but very few speculators manage to retain those profits over the long-term (although our associate Bill Mawhorter is quite good at it). We limit our pure speculation to investments made in price ranges consistent with satisfying long-term returns (we are willing to speculate in these pages, but only take action based on what actually happens to prices). When stocks get cheap (like late 2008 - early 2009) we are committed to building ever-larger positions (even if prices are still falling). When stocks get expensive (like recently) we are committed to taking profits even though prices are still rising.

For some time US Bonds have been extraordinarily overpriced. In the last few weeks, stock prices have become similarly extreme. As an investor I am scared. Purchasing overpriced assets inevitably leads to poor returns. Purchasing extremely overpriced assets can lead to debilitating losses…

Hang on to your hats and glasses. This here is the most bearish analysis I have written since 2007.

The Bernanke Illusion

By reducing short-term interest rates to zero, Ben Bernanke has successfully created the illusion that keeping your money in short-term liquid investments will result in no return at all. The illusion is driving investors to shift money into stocks and bonds at prices that are likely to produce significantly lowerrisk-adjusted returns than money market funds over the next decade. As long as speculators find greater fools to pay even higher prices, that behavior will continue to be rewarded. However, the end is near. As Warren Buffett has famously remarked, it’s only when the tide goes out that we discover who has been swimming naked. Decades ago a friend and fellow investment advisor of mine published an article on the 45 systematic errors investors make. Decades of trading markets and reading other articles on behavioral finance have led me to distill these errors down to a simple concept:

Human expectations of the future are overwhelming determined by theirexperience during the last three to five years altered only by the occasionalintroduction of radical new information.

Over the last few years the Bernanke Fed has driven interest rates ever lower. Bernanke’s propaganda combined with that recent experience have convinced investors and speculators alike that the future rate of return on money market funds and other short-term investments will remain at zero indefinitely. This is what I refer to as the Bernanke Illusion. History has shown this to be patently false.

Belief in the Bernanke Illusion has led investors and speculators alike to make investment decisions on the false assumption that future risk-free returns will remain at the rate the Fed has temporarily distorted to zero. Thirty-plus years ago when real (inflation-adjusted) money market returns were similarly distorted to abnormally high levels (20%+ as they were by Paul Volcker), future money market returns declined for decades and ultimately became abnormally low. Conversely, the current (Bernanke distorted) negative real returns will inevitably result in higher than normal future money market returns.

Over time, the return on money market funds is equal to the inflation rate.

Successful investment decisions must to be based on the prospective future returns of the asset currently being purchased. Using time-tested metrics, the relative risk-adjusted returns of various assets can be compared enabling investors to intelligently allocate assets in a way that provides solid returns. Over time, the return on money market funds is equal to the inflation rate and presents virtually no risk of loss. Therefore, the inflationrate, not 0%, becomes the return by which all other investments must be judged.

Instead, the investing public typically bases their decision on the current money market rate (which is at best randomly related to future returns) versus the recent performance of stocks and/or bonds (also not indicative of future returns). This analysis is the equivalent of betting on two coin flips where in order to win you must predict both flips correctly. If you do it long enough you will lose 3 times out of 4. Good luck with that.

Relative Valuation

Although there exist a myriad of investment alternatives, generally speaking, financial asset comparison refers to money market funds vs. stocks vs. bonds. If you assume money markets will produce the inflation rate over time (as they always have) then the question becomes, “How much extra return do I need to get from stocks or bondsto compensate me for the risks of default, bankruptcy, interest rate changes, and/or intermittent stock marketdeclines of 10-60% that occur in eight years out of ten?”

Over a 10-year period, the relative returns on stocks and bonds are highly predictable. Investors who believe, as I do, that inflation will average 3% to 3.5% over the next decade should require expected returns in other assets to be higher than that as compensation for the risks cited previously. No one really knows what the future inflation rate will be, but at any point in time, the prices of stocks and bonds reflect market expectations of what the inflation rate will be. These same expectations are reflected in something called the TIPS spread. The TIPS spread is the difference in yield between conventional TBonds and TIPS (inflation protected treasury bonds). For the sake of simplicity, we’ll compare 10-year maturities.

10-year TBonds have recently yielded approximately 2.5% more than inflation protected bonds of similar maturity. It doesn’t matter whether this inflation forecast is accurate, only that stock and bond prices should have accounted for this same information. Proper valuation metrics on stocks and bonds also provide similarly reliable ten-year predictions of stock and bond returns based on the anticipated future stream of earnings. Any single stock or bond may vary wildly from the mean, but long-term returns on asset classes are a predictable story. Valuation metrics described by Benjamin Graham and David Dodd over 75 years ago (expected returns based on bond yields, defaults, and normalized earnings) have proven surprisingly accurate.

Lets do a quick and dirty comparison of the expected 2.5% money market return (10 year) with other assets at current prices. In the next issue I will go into a whole lot more detail on each asset, beginning with TBonds.


10-year TBonds are the simplest comparison. Like money market funds, they have only a negligible risk of default. The recent yield of 1.7%-2.05% range is much lower (when it should be higher) than the expected 10-year money market yield. In exchange for lower returns you also get a big risk of principal loss in the event rates rise at a time you need to sell sometime in the next ten years.

Corporate Bonds

Corporate bonds provide yields as much as 3.5% higher if you take the risk of high yield (aka junk) bonds, as hoards of investors have recently. In exchange for that extra yield, investors get the same interest rate risk of TBonds plus a historical default rate of 5% per year (of which only 50% is recovered). Add to that most junk bonds are currently trading at 105 while the issuing companies that are unlikely to default have the right to pay them off at 103 and hand you a 2% loss. The prices of high yield bonds move up and down almost as much as stocks over the course of the business cycle. That’s a whole lot of risk for an average projected risk-adjusted return under 3%. Money Markets seem a clear winner vs. holding a portfolio of bonds.


Stock prices fluctuate wildly, doubling over a few years or falling 10% to 60% in eight years out of ten. If you are among the clever few who manage to buy at the bottom and sell at the top you will make a bunch of money. History demonstrates that only a tiny percentage of investors end up with better returns than the market over any ten year period. Professor Harry Shiller (who more famously than us predicted the housing crash) and others have created metrics that are highly predictive of 10-year future stock market returns. Currently those historically accurate metrics indicate the S&P 500 will return 3%-5% annually over the next decade from current levels. A 4% annual return doesn’t seem like a lot of compensation for the risk of an asset that has dropped in value over 50% twice in the last dozen or so years. Money market funds win again.

In the next issue I will expand on the outline presented in our forecast issue of why I expect the key metrics of stocks prices (corporate earnings and price/earnings ratios) to decline in 2013 despite the early rally. I plan to debunk the prevailing myths that stocks will inevitably rise as a result of the great rotation, oceans of cash on the sidelines, hoards of corporate cash, and rising earnings as a result of an expanding US economy.

When combined with the underlying metrics the fallacy of prevailing thought produces a compelling case that the risk of an imminent cyclical decline in stock prices is extreme. Whether or not stocks continue to make new highs in the near future, I expect US stock prices to decline 15%-20% from current levels this year and as much as 35% sometime in the next couple of years. Similarly, I expect negative returns from bond funds (aside from a short lived rally when stocks fall) over that same time frame. I can’t remember ever being this negative on both stocks and bonds.

As a result, our portfolio is concentrated in funds that mimic money market returns. We have reduced our portfolio exposure to US stocks and bonds to the lowest level in decades. While our overall posture is extremely defensive, we have a substantial position in mutual funds holding Japanese stocks. Japan is the best performing major stock market recently and we expect that trend to continue. We also have a small, but growing position in Gold Mining funds (our long standing forecast that gold prices can fall to $1400/ounce has already been realized and we now expect to see $1250-1300 before the next bull market) as well as small position in funds holding European and Latin American stocks.

Clyde Kendzierski

Chief Investment Officer

Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and Clyde Kendzierski believe this information in the commentary to be accurate and reliable, however, inaccuracies may occur.

Investors should consider the charges, risks, expenses, and their personal investment objectives before investing. Please see FSG’s ADV Part 2A containing this and other information. Read it carefully before you invest.

Past performance is a poor indicator of specific future returns. It, however, may be useful in your evaluation of how FSG performs in different market environments. Investors have the ability to achieve results similar to benchmark indices by investing in an index fund or Index-tracking ETF, typically with lower fees.

© Financial Solutions Group


Read more commentaries by Financial Solutions Group