Managing Emotions - This Is Not What You Expect

Those of you who know me likely understand by now that I typically have a different view than the Wall Street consensus. This newsletter will be no different.

It is likely that when you’ve seen a report from a financial firm stating that investors need to “manage their emotions” during periods of significant market turmoil, it really means don’t panic and sell your stocks, because things will be OK, and if you just wait long enough, the market will come back, but if you panic and sell, your portfolio, thus your financial position, will suffer irreparable damage. I guess I do not disagree with that particular point, but typically, in order to get to that situation, an investor needs to be put in a position where they are so uncomfortable with the losses they’ve already suffered, that they feel if they don’t act (by selling investments) they will not have enough money to live, and that irreparable damage has already been done. Putting an investor or anyone that I feel a reasonable

sense of attachment to through that emotional and financial distress is what I vehemently disagree with. That’s a bad emotional state from which to make major financial decisions.

I’ve also found that the pain of the last bear market has largely worn off, and most people struggle to remember the days and weeks leading up to the end of 2008 and early 2009, when we were worried about ATM’s being empty and major banks having to declare bankruptcy if they did not receive emergency bailout funding. It was truly a scary time.

Apparently, the global economic situation is/was dire enough that according to the actions of central bankers in the U.S. (Bernanke & Yellen) and globally (Draghi and Abe), it required roughly 10 years of continued quantitative easing (Trillions in money printing), interest rate suppression and emergency monetary stimulus to support the stock and bond markets and stimulate risk taking to accomplish their goal of asset and price reflation.

I believe we’re currently at a turning point. Our new central bank Chairperson, Jerome Powell, has been raising interest rates over the past two years in an attempt to “normalize” them, which

in lay person terms, means to bring them to a point where they are no longer stimulative nor are they repressive. Thus, the Fed Funds rate has gone from effectively zero, to a current target zone of 2.25% - 2.5% after a series of 0.25% rate hikes. In addition, the Fed (short for Federal Reserve Bank) has reduced the purchasing of maturing bonds it holds on its balance sheet every month, which means that a substantial buyer in the market is now missing, and without that buying pressure, interest rates have been allowed to float upwards.

December 31, 2018, supposedly also marked the end of the money printing program in Europe. In addition, Japan’s bank governors are supposedly attempting to reduce their money printing operations (although I do not believe they will ever be able to do so).

Thus, after 10 years, 2019 will mark the first year that global money printing operations in aggregate is actually reduced on an annual basis, after having printed roughly $11 trillion over the past ten years (roughly half of the entire economy of the United States). Money that has been used to purchase financial assets (bonds and stocks!) in “free and open markets”. To illustrate how involved central banks have become, in a recent

tweet by Larry McDonald of ACG Analytics, he noted that:• The U.S. Federal Reserve Bank now

owns 12.4% of total U.S. public debt.• The European Central Bank (ECB)

balance sheet exceeds 35% of Europes GDP.

• The ECB owns 9.2% of Europe’s corporate debt.

• Japan’s Central Bank’s balance sheet exceeds 70% of their GDP.

• The Bank of Japan is the top shareholder in 90% of Nikkei stocks.

• The Bank of England owns between 25% and 30% of the UK’s sovereign debt.

All of these purchases were made under the same “emergency” programs that we used, and two of the main pillars (the Fed and the ECB are now reversing course (so they say).

Thus, instead of waiting for the next crisis

to occur, and attempting to manage our friends and clients’ emotions from a position of weakness, as described in the introduction, we have taken the sometimes painful position of moving assets in portfolios largely to tactical funds, as we’ve discussed in the past. I say painful because in a strong up market, like 2017, tactical funds will typically not capture the return of the market, and as J.P. Morgan once said, “Nothing so undermines your financial judgement as the sight of your neighbor getting rich.”

One thing that makes us confident in our position is the historic overvaluation of the equity market. Even after the recent selloff in Q4, 2018, the market remains well above the levels prior to the 2007 peak, and above valuations in 1929. We believe as investors realize that the debt printing programs were not successful in promoting long-term and sustainable economic growth, and as more and more signs pile up that this bull market is coming to an end, we will likely see yet another 50% decline in stock prices, which would still not return us to the “mean value” line. Thus, to us, it makes sense to wait to deploy capital aggressively into stocks until

valuations are at least more rational.

When taking an alternative route, our goal is for portfolios to have low correlation with the stock market on a daily basis. This is where managing emotions comes in. While it was great to see portfolios largely hold their own during the particularly difficult 4th quarter of 2018, which did reach a 20% drop from peak to trough in the S&P 500, those same portfolios have not capitalized on a lot of the bounce early in the year.

Different tactical fund managers have their own methods associated with their strategies, and their “wavelength” might be longer than the average investor. Because longer and intermediate trends have begun to turn down in the U.S. market (the 200 day moving average, a very commonly followed technical indicator, for the S&P 500 turned from positive sloping to negative sloping back in November, and remains negative today, February 1st), some tactical managers may be more reserved in attempting to catch a bounce in the markets until other indicators give them the “all clear” signal. This keeps them out of harm’s way, if the bounce is simply a short term phenomenon which leads to the market rolling over and testing new lows.

Throughout this year I anticipate that there will continue to be volatility in the markets associated with the promise of more stimulus (or at least the walking back of current tightening of financial policy) contrasted by a continued slowing in the global economy. At different points in time,

We refer to the valuation chart above frequently in reviews. This shows that stocks are still 2 standard deviations above mean values, or 97% more expensive than all other times

since 1900.

depending upon the news cycle and catalyst, each is likely to garner a greater share of investors’ attention, thus causing the expected volatility.

We currently hold the smallest position to core equities (stocks) and to fixed income (bonds) that we have had in our portfolios ever - in over twenty years. The middle is filled with strategies that have flexibility to invest both long (makes money when a market is rising) and/or short (makes money when a market is falling) in a variety of different markets, from equities, to bonds, to commodities such as oil. In addition, we’ve held a tactical position in gold that will likely be sold if we feel that a crisis will spur a significant inflow to the US dollar as a safe haven (gold tends to fall temporarily when the dollar rises). We’ve spent a tremendous amount of time before the next crisis building relationships with asset managers of many different types of strategies who have long tenures and have been successful through both of the prior two major downturns. We currently have a stable of very seasoned fund managers who have very flexible fund mandates and the tools to change a downturn into a potential opportunity.

Because of this, we are not frightened of what lies ahead if, as we believe will occur, a significant bear market unfolds. Instead, we look forward to opportunities that may present themselves as markets reset to realistic valuations, and then to establishing more traditional positions in many new and interesting industries that are working to solve some of the many challenges we face in the world today.

We’ve waited quite a while for the market to turn. It already seems that Central Bankers are concerned about the market action over the past quarter, and are beginning to back away from rate hikes. They seem determined not to let the market go down without a fight. Just last week, Jerome Powell, our Fed chair, signaled the market that he will likely be less aggressive in reducing the Fed’s balance sheet, thus continuing pressure for interest rates to stay lower for longer. In addition, Mario Draghi, in a press conference, discussed

the additional “tools” he feels the European Central Bank (ECB) has to fight another crisis.

The Fed is likely the only Central Bank with room to ease. Current rates are of major central banks are:

U.S. Fed: 2.5%Bank of England: 0.75%European Central Bank: 0%Bank of Japan: -0.1%

Let’s use some common sense here. Doesn’t it seem strange that if all was well in this recovery and banks were recapitalized that 1) the head of the ECB is discussing tools to fight a crisis, 2) the U.S. Fed is walking back their multi-year plan of reducing their balance sheet after just one down quarter for the markets, 3) the Secretary of Treasury is calling banks to discuss market turmoil, and 4) The Bank of China is aggressively easing in their financial system to stimulate growth? Seems like a whole lot of “emergency policy” will continue to be used as the global economies slow.

Wall Street Journal headline on December 23, 2018

What we have been going through over the past decade has been a slow motion monetary system train wreck. We have a combination of global trade imbalances, improper mechanisms for currency value appreciation/depreciation, and a massive increase in global debt, particularly in developed economies where social promises have greatly outpaced the ability to fund them, among a host of other issues. What does this mean for you as an investor and as a currency holder? We believe the following will unfold in the markets in the coming years:

• Central Banks globally will begin fighting a downturn, as they recently have, with words and promises to keep markets afloat.

• The natural progression of the business cycle will continue, and we will see global growth continue to slow, corporate earnings decline, defaults increase, and problems arise that will cause the markets to attempt to move downward to adjust.

• The fight between Central Banks and the markets are likely to cause volatility to increase, with rapid selloffs and then rebounds as the bankers institute additional measures to support markets.

• Interest rates will be reduced in the U.S., likely to zero (again) or below, in which case your bank deposits will be charged an interest rate.

• The idea behind this is to penalize savers and force them to either spend or invest money, accomplishing the bankers’ goals of 1) circulating money through the economy or 2) propping up risk assets (stocks, bonds and real estate).

• Negative rates have already been tested in Europe. In fact, the ECB has discontinued printing physical €500 notes because it was less expensive for people to convert bank deposits to cash and store currency in a safe deposit box than to hold money in bank accounts. The headlines have pointed to a use of high denomination currency by criminals as justification to discontinue

them.•A continued move to a “cashless” society, thus forcing deposits in to the banking system.•Sweden is leading the charge, where currently roughly only 1% of transactions are cash based.•Global regulators are clamping down on crypto currency as an alternative vehicle to sovereign money.•India has banned 85% of its physical currency and is rapidly moving to a cashless society.

• Ultimately, a bear market in stocks and bonds playing out, due to a lack of confidence in central bankers ability to reflate the system.

During the next bear market, we will heavily employ strategies in the portfolio with the flexibility described earlier. Ultimately, however, we see governments getting involved in the fight to reflate assets. They will need to do this, because as the velocity of money slows through the system, revenues are not generated through capital gains taxes and corporate (and corporate executive bonus) earnings. We believe there will be a move toward significant government spending programs globally, such as infrastructure, and even a restructuring of current “welfare” systems to a new strategy that distributes money to a majority of the population, called Universal Basic Income, or UBI, (see Wikipedia: https://en.wikipedia.org/wiki/Basic_income ), as

As reported by Forbes on June 28, 2017

well as a push toward a new economic concept called Modern Monetary Theory (MMT in financial circles).

Again, from Wikipedia, “MMT claims that the word "borrowing" is a misnomer when it comes to a sovereign government's fiscal operations, because what the government is doing is accepting back its own IOUs, and nobody can borrow back their own debt instruments.[34] Sovereign government goes into debt by issuing its own liabilities that are financial wealth to the private sector. "Private debt is debt, but government debt is financial wealth to the private sector."[35]

In this theory, sovereign government is not financially constrained in its ability to spend; it is argued that the government can afford to buy anything that is for sale in currency that it issues (there may be political constraints, like a debt ceiling law). The only constraint is that excessive spending by any sector of the economy (whether households, firms or public) has the potential to cause inflationary pressures.”

Ultimately and essentially, this theory, which is being bantered about in the highest circles of economic elites, states that government deficits do not matter, and that government debt is actually a form of wealth.

Whether under these names or an equivalent, we are fairly certain that you will likely hear both during the next presidential election cycle, as our government searches for ways to maintain confidence in the system. Once we see signs of these programs taking hold, which we feel would be the second major reflation operation (after our Quantitative Easing programs of the last decade), we will likely add strategies that increase holdings in the following assets:

• Precious metals

• Real Estate

• Stocks - particularly ones that own physical assets and infrastructure such as railroads, power companies, etc.

Bonds, particularly long-term bonds, would be avoided in this environment.

Implementation of MMT would surely cause inflation to rise, likely via currency devaluation. Inflation has been quite stable for some period, as the deflationary forces of an emerging market middle class and the move to globally outsource manufacturing have put downward price pressures on many goods and services over the past 15 or more years, counteracting many of the typical inflationary pressures we would have seen without those forces. Now, in an environment where that system has been optimized, but debts have become large, we believe there will be a period of above average inflation after the next financial downturn, as governments implement new and unique ways to maintain system stability.

Based on our nascent potential bear market unfolding, increased central bank emergency monetary policy, and ultimately more debt printed by governments, we do feel that managing emotions will be critical to one’s financial well being. Our game-plan is to continue to monitor how this process plays out, being very mindful of both the risks and opportunities that each phase presents. Because our investment strategy is not hamstrung to being “long-only”, we feel there will be ample opportunity through the various cycles of change.

In the immortal words of Bob Dylan, as sung in the early 60’s, “The times they are a changing.” https://youtu.be/e7qQ6_RV4VQ As far as we can tell, they sure are.

Eileen Monahan

Principal44 North Financial Partners

2 Cotton Street, Suite 200, Portland, ME 04101 Tel (207) 319-7374 | Fax (207) 319-7388 bprichard@44nfp.com | www.44northfp.com

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