The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
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Climate Change & Markets

Why did Hurricane Michael intensify so quickly? And why was the Western US so hot and dry this summer? And what about climate change all across the rest of the global landscape and seascape? And what do I do with my portfolio?

Market Commentary - Cumberland Advisors - Climate Change & Markets
There are still many climate change deniers. But that cohort shrinks as more and more hard evidence overwhelms former assertions and opinions. A storm surge destroying Mexico Beach is a televised fact. So is a record low level of water in Lake Mead. These realities and a hundred others are facts reflecting climate-based causality.

Climate policy and energy policy are a current test of the ability of our political leaders and of markets to handle the challenges of cognitive epistemology. We’ve written recently about cognitive functioning, so there is no reason to repeat that discussion here. If you missed it, here’s the link: https://www.cumber.com/markets-cognitive-epistemology/.

On climate change we will refer readers to this Bloomberg link: https://www.bloomberg.com/news/articles/2018-09-26/how-the-climate-change-debate-has-shifted-not-ended-quicktake. Please take a few minutes to peruse it. And then take a very deep dive into the latest report from the Intergovernmental Panel on Climate Change (IPCC), which released its special report Global Warming of 1.5°C earlier this month. That report is available here: http://www.ipcc.ch/report/sr15/.

Now let’s look at US policy. The Trump administration has attempted to reverse America’s shift away from coal mining but with only very limited success (see https://www.cnbc.com/2018/08/23/trump-says-the-coal-industry-is-back-the-data-say-otherwise.html). Nevertheless, the Environmental Protection Agency (EPA) intends to scale back an Obama-era rule designed to cut planet-warming emissions from the nation’s power plants (see https://www.cnbc.com/2018/08/21/epa-reveals-greenhouse-gas-rule-for-power-plants-to-replace-obama-plan.html). Meanwhile, the White House has repeatedly pressured the EPA to weaken regulations regarding the release of methane gas by the oil industry. Note that methane warms the atmosphere 84 times more than carbon dioxide does: https://www.bloomberg.com/news/articles/2018-10-19/white-house-backed-drillers-over-epa-on-plugging-methane-leaks.

These and other actions by US policy makers are those of climate change deniers. Their decisions are influenced by powerful financial interests that appear to care little about the rapidly accruing costs imposed on all of us by unmitigated climate change.

My personal view is that of a climate change accepter. I think the planet is getting hotter and we are running out of time to do anything about it. I cannot understand the cognitive dissonance of the Tesla owner who feels “green” while his charging station gets its juice from a coal-fired power plant. The same “green” person pays no gasoline tax (money that goes to highway maintenance) and may well oppose a carbon tax. I think a carbon tax is needed immediately.

But policy debate is one thing, and portfolio management is another. Sometimes they require the wearing of two different hats.

An investment advisor has to take the policies made by others and apply them, even when he doesn’t like them. That is why we own an ETF designed to capture profits from the exploration and production of oil and natural gas. Our choice is centered on the domestic US arena. We’re managing risk that originates in the international arena and in the administration’s trade war agenda and in the Middle East geopolitical sphere. We’re wary of turbulence around global energy options.

So we don’t like our national energy policy – we see it as the result of cognitions and policy gone astray. But we are invested in the US energy sector. There it is.

Now for a teaser. We asked Bob Bunting for a sequel to his popular piece on hurricanes and an adaptive response to climate change (see https://www.cumber.com/guest-commentary-by-bob-bunting-its-getting-hotter/). Bob said yes. Be on the lookout for it in the next few weeks.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


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Cumberland Advisors Week in Review (Oct 15, 2018 – Oct 19, 2018)

The Cumberland Advisors Week in Review is a recap of news, commentary, and opinion from our team. They are not revised assessments and circumstances may have changed in the market from the time of original publication. We also include older commentaries our editors have determined of interest to our audience. Your feedback is always welcome.

SUMMARY OF TRADES

Cumberland-Advisors-Matt-McAleer-Market-Update-Video-Player

MARKET COMMENTARY

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RECENT TV

Fed Expected to Say Policy Will Be ‘Data Dependent,’ Cumberland’s Eisenbeis Says


Robert Eisenbeis, vice chairman of Cumberland Advisors and a former Atlanta Federal Reserve research director, talks about the central bank’s policy.

See More Recent TV

IN THE NEWS

 

IN CASE YOU MISSED IT

 

  • Q3 2018 Municipal Credit Commentary

    Patricia Healy, CFA 9/28/2018

    In addition to the SCOTUS rulings, Q2 was notable because all states passed budgets on time or nearly on time – even the states notorious for passing late budgets, such as Illinois, Connecticut, and Pennsylvania. Common threads for this phenomenon include election-year politics, good revenue growth driven by a generally improved economy, and the acceleration of tax collections in 2017 due to the Tax Cut and Jobs Act.

  • The Tale of Two Ratios: Shorter and Longer

    John R. Mousseau, CFA 9/28/2018

    In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve & US muni yield curve.

Thank you for engaging with us and enjoy your weekend!
Cumberland Advisors
Weekly Update
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Markets & Cognitive Epistemology

We want to open a discussion about cognitive epistemology, invoking behavioral economics and translating our conclusions into a market strategy at the end.

Market Commentary - Cumberland Advisors - Markets & Cognitive Epistemology

Epistemology is the study of how we know what we know – or really, what we think we know. Here is a precise definition: “the theory of knowledge, especially with regard to its methods, validity, and scope. Epistemology is the investigation of what distinguishes justified belief from opinion.”

Cognition is a nuanced subject. We’re influenced by our five basic senses (sight, hearing, touch, taste, smell). That is how perceiving begins.

Our brains process our perceptions into sensations and emotions and generate instinctual and intuitive, rational and irrational responses to all sorts of things. That is, we form cognitions, and they alter our behavior, sometimes guiding us to act in productive ways and other times leading us to act in ways we subsequently regret.

A skilled writer, Carole Klein wrote Overcoming Regret: Lessons from the Road Not Taken (https://www.amazon.com/Overcoming-Regret-Lessons-Carole-Klein/dp/0553089250/). I was privileged to discuss the subject with her before she died. She explained eloquently how regret is an emotion we experience after something unfortunate happens. But regret, however unpleasant, can help us to avoid repeating our mistakes if we remember accurately and reason constructively about our experience.

But therein lies another variable in the cognitive epistemology equation. How well do we remember what we experience? Isn’t our sometimes faulty memory part of the issue when it comes to determining what we really know? As a researcher and writer, I think the answer is yes. As we study questions of cognitive epistemology more deeply, we are likely to become less and less sure of our views. Are we victims of our own cognitive epistemological deficiencies? That question, too, must probably be answered with a yes if we are honest with ourselves.

We will link readers to the famous Daniel Kahneman lecture on “The Riddle of Experience vs. Memory”: https://www.ted.com/talks/daniel_kahneman_the_riddle_of_experience_vs_memory?language=en.

And here is another famous lecture on memory, by Elizabeth Loftus: https://www.ted.com/talks/elizabeth_loftus_the_fiction_of_memory/transcript.

So how should investors deal with this issue? And what do we do with the information flows in our present, emotionally charged political economy?

Here’s a case study.

I sat at dinner with a friend who is an avid Trump supporter. He defends Trump on most political issues, and he notes that Trump seems to be doing better and behaving in a more presidential manner lately. He and I then discussed climate change and the intensification of Hurricane Michael as it passed over very warm Caribbean and Gulf of Mexico water.

Sitting across the table was a harsh Trump critic. The critic’s list of issues was long and thorough. These two friends argued robustly but politely. There was mutual respect to go along with their strong opinions. Both agreed with me that it has become increasingly difficult to hold discussions of political issues in social settings.

We’re struck by how intensely the nation seems to be divided and we now offer readers two pieces to contemplate. Here is Devin Stewart on “Trump and the End of Smugness,” including an interesting section titled Bursting the “Cognitive Bubble”: https://warontherocks.com/2018/10/trump-and-the-end-of-smugness/. Trump supporters may find a surprise or two as they read this. And here is an analysis from Psychology Today entitled “The Dunning-Kruger Effect May Help Explain Trump’s Support”: https://www.psychologytoday.com/us/blog/mind-in-the-machine/201808/the-dunning-kruger-effect-may-help-explain-trumps-support.

I suspect this juxtaposition will intensify the divide.

For market agents this array of opinion on epistemological issues relating to the political economy challenges us. It certainly does me. The questions of cognitive epistemology are profound.

Meanwhile we see the quarterly earnings season unfold while we watch the Fed shrink its balance sheet and concomitantly raise its policy interest rate, trying to successfully do two challenging things at once. We also note the upward revision of federal deficit estimates.

My memory turns up no historical references for the current array of challenges. I’m trying to be careful about what I know and not allow emotions to deceive me.

We are maintaining a cash reserve. We favor sectors that seem buffered in the trade war, such as defense and domestic energy. Of course, we may make changes at any time.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Federal Reserve Independence – Under Attack Again?

The last few days, President Trump has made inflammatory and in some instances misguided remarks as to the nature of current Fed policy, its impact on the stock market and potentially on the economy.

Federal Reserve - Independence

Examples follow:

  • “It is a correction (the decline in the stock market) that I feel is caused by the Federal Reserve.”
  • “I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy.”
  • “I think the Fed is far too stringent and they are making a mistake.”
  • “The Fed is going loco and there’s no reason for them to do it.”
  • “I think the Fed is out of control.”
  • “I think what they are doing is wrong.”
  • The Federal Reserve is “my biggest threat,” President Donald Trump says.[1]

In the face of these comments, Larry Kudlow, director of the National Economic Council, tried to walk back the idea that the President has been attempting to influence Fed policy and indicated that the President was merely expressing an opinion.

Presidential effort to influence Fed policy are not new, nor are they unique to the present administration, especially during an election season. For example, the Reagan administration tried but failed to get Chairman Paul Volcker to commit to not raising interest rates in the midst of the 1984 presidential election. Similarly, with a slow economy in the election year 1992, President George H. W. Bush called on the Fed to cut interest rates, discounting concerns the Fed might have about inflation. Chairman Greenspan’s Fed did not cut rates and was seen by the President as the reason for his election loss and one-term presidency.

While these presidential attempts to influence have largely played out behind the scenes, the most egregious breakdown in Fed independence involving presidential pressure involved President Nixon and Chairman Burns in the early 1970s and it had significant negative consequences for the US economy, which played out through the end of the 1970s. Leading into the 1972 election, Chairman Burns willingly responded to the President Nixon’s pressure and manipulated FOMC policy decisions to stimulate the economy as it emerged from the 1969–1970 recession. The extent and nature of that pressure has been well documented due to the existence of the Nixon presidential tapes, which are now publicly available.[2]

In the aftermath of the 1969–1970 recession the federal funds rate declined steadily from 8.71% in January 1970 to 4.05% in January 1972, and the Fed’s discount rate was reduced from 6% to 4.5% over that period. However, at the same time, unemployment continued to increase despite an improving economy, rising from 3.9% in January 1970 to between 5.6% and 6% in the late summer and early fall of 1972.[3] Nixon was concerned about being a one-term president; and on October 10, 1971 (Conversation No. 607-11), he quipped, “I don’t want to go out of town fast.” The text of the discussion and tape played recently on national television clearly suggests that Nixon had only a rudimentary understanding of the economy or monetary policy. A month later, in another conversation, Burns reported that earlier that day (November 10, 1971) the Fed had reduced the discount rate, indicating that this stimulus would help buoy the economy. Thereafter, Burns continued to engineer additional policy stimulus and reported to Nixon on December 10, 1971, that the discount rate had been lowered ahead of the upcoming FOMC meeting and that Burns’ intention was to prod the FOMC into even more accommodative action. He stated that he aimed to “put them on notice that through this action that I want more aggressive steps taken by the Committee on next Tuesday.”[4] Burns went on to state that “Time is getting short. We want to get this economy going.”

What these and subsequent conversations clearly document is that in late 1971 and into 1972 the administration continued pressuring the Fed to expand the money supply to stimulate the economy.[5] Burns was a willing participant, effectively subordinating the Fed to presidential pressure and engaging in a rapid expansion of the money supply. Nixon not only employed jawboning but also had George Shultz put Burns on notice that appointments to the Board would be closely controlled.[6]

Burns and his tightly controlled FOMC delivered on an expansionary policy. Not only were policy rates dropped during 1972, but the Fed also engineered a very rapid increase in both the M1 and M2 money supplies. M1 growth increased from 4.51% in 1970 to 6.7% in 1971 and then to 7.56% in 1972, while M2 growth exploded even more, from 7.36% in 1970 to 11.65% in 1972. That growth continued after the election, and quarterly M1 growth was between 6.4% and 8.4% during all of 1972, while quarterly M2 growth, shown in the attached chart, ranged between 11.7% and 13.2% that year.[7]


Federal Reserve Independence – Under Attack Again - M2 Growth Chart
 

While the Burns stimulus clearly helped Nixon win the election in November 1972, the seeds were sown for a disastrous inflation. That inflation occurred with a lag, in part because President Nixon imposed a 90-day freeze on wages and prices in August 1971 that was subsequently extended to April 1974. The result was stagflation; and as the controls were gradually dismantled, prices began a disastrous climb. The money supply increases slowed gradually through 1973 and briefly bottomed out before accelerating again. The ensuing inflation continued until Chairman Volcker engineered a recession and broke the back of inflation.

The common feature of the three presidential attempts to induce the Fed to pursue expansionary policies all occurred a year or so before a national election and followed a recession and slow recovery. None of these conditions exist presently. The economy has been growing steadily, albeit slowly, since 2008. Inflation is at the FOMC’s 2% target, unemployment hasn’t been this low since the 1960s, job openings exceed the number of unemployed and wages have finally started to increase. As for policy, even with eight 25-basis-point increases in the federal funds target range, the Chicago Fed’s National Financial Conditions Index shows that conditions are as accommodative as they have been since the start of the recovery. Finally, with less than a month to the election, there is no action the FOMC could take that would impact the economy before the election.

This president may, as a real estate developer, like low interest rates; but that may not be in the best interests of the economy, despite his recent assertion that he knows more than the Fed does. His claim that the Fed caused the recent stock market decline, cited in the quote at the beginning of this commentary, ignores the fact that this decline and the previous decline early in 2018 followed on the heels of the announcements of the imposition of tariffs and the declines are unlikely to be related to Fed policy moves. Jawboning the Fed but not really interfering with its independence may have an advantage. Kane(1980) argues that by leaving the Fed with a fair amount of “… ex ante discretion, elected officials leave themselves scope for blaming the Fed ex post when things go wrong.” Perhaps in anticipation of the 2020 election, this may be what the President means when he sees the Fed as his biggest threat. Fortunately, in the meanwhile Chairman Powell is secure in his position, and the members of the FOMC understand the dangers of subordinating policy to the political whims of this or any other White House.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] https://www.cnbc.com/2018/10/16/trump-says-fed-is-his-biggest-threat-because-it-is-raising-rates-too-fast.html
[2] What follows relies upon Burton Abrams, “How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes,” Journal of Economic Perspectives, Volume 20, Number 4, Fall 2006, pp. 177–188.
[3] See Abrams (2006), Table 1.
[4] See Abrams (2006), Conversation No. 16–82.
[5] Edward J. Kane, “Politics and Fed Policymaking: The More Things Change the More They Remain the Same,” Journal of Monetary Economics, Vol. 6,(1980) pp 199-211 argues that as William McChesney Martin departed the Fed and Author Burns became chairman that the money supply assumed greater importance as a tool of monetary policy.
[6]Abrams(2006), Conversation 17-5.
[7] Source: FRB St. Louis FRED database


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Hurricane Michael and Bond Portfolio Management

The devastation from Michael in terms of lives and property damage is still being assessed. Our hearts go out to those affected.

Cumberland Advisors Market Commentary

We have written (http://www.cumber.com/wildfires-abound/) about the general uptick in economic activity in a municipality after a storm or other natural disaster and the resulting maintenance of credit ratings. However, there could be a period of weakness that might or might not affect credit quality, trading levels, and ratings of affected municipalities, depending on how widespread the disaster is and the financial resiliency of the affected municipality. This resiliency depends on the availability of Federal Emergency Management Agency (FEMA) funding after a state of emergency has been declared and on insurance claims and sales tax growth from the inflow of workers and goods for rebuilding efforts. Disaster preparedness plans have improved in many jurisdictions, too. New Orleans did experience downgrades after Katrina but has since surpassed its pre-Katrina rating. The downgrades were also reflective of a city that did not have its financial house in order when the hurricane hit.

Cumberland evaluates a storm’s trajectory as early as possible, determines the municipalities that may lie in the storm’s path and compares them with bonds in our clients’ portfolios. We then sell bonds of what we see as potentially vulnerable municipalities. Although the uptick in economic activity is expected to stabilize or improve a municipality’s credit quality after rebuilding, there could be continued “headline risk” generated by media coverage of the storm damage, or financial vulnerabilities made visible in times of stress. When Michael started picking up speed and it appeared that the storm might be worse than originally thought, we embarked on the evaluation exercise and sold positions in the Panhandle that we estimated were in the storm’s path. We were able to find replacement bonds at comparable levels.

Cumberland invests mostly in AA-quality bonds that have strong, diverse and growing economic bases and good financial management, as demonstrated by large reserves and reasonable debt levels. These municipalities are less vulnerable to credit disruptions generally. We regularly review holdings, which change as new clients transfer in portfolios. We sell holdings that do not align with our credit and structuring objectives; however, we evaluate the market for an optimal time to exit positions.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Doc Holliday, Jay Powell, Donald Trump & The Piano

“Ready, Fire, Aim”?

In Understanding and Managing Public Organizations, Hal Rainey makes the point that “the intangible issues of culture, values, human relations – matters that many managers regard as fuzzy and unmanageable – can and must be skillfully managed.” The contrary approach, which is favored by many companies and government agencies, can be summarized as “ready, fire, aim.” (Understanding and Managing Public Organizations, https://books.google.com/books?isbn=0787980005)

 

Market Commentary - Cumberland Advisors - Please do not shoot the pianist. He is doing his best

Rainey’s insight will prove relevant as we consider this week’s stock market carnage.

Politico offered this explanation for the carnage:

“WHY MARKETS TANKED AND WHAT’S NEXT — The real surprise is it took this long. Wall Street has been shrugging off a rising 10-year yield, fear over the trade war with China and uncertainty surrounding the midterm election for way too long. The S&P 500 did not record a single move up or down of 1 percent by the closing bell in the third quarter. That hasn’t happened since 1963, according to LPL Financial.

“That kind of calm is what’s abnormal, not the 3 percent decline in the Dow and S&P on Wednesday and the 4 percent decline in the Nasdaq. President Trump blamed the drop in part on the Fed, saying the central bank had ‘gone crazy.’ He also referred to a ‘a correction we’ve been waiting for,’ which is a much better explanation.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Now, in order to assist the fact checkers, here is the full Trump quote:

“The Fed is making a mistake. They’re so tight. I think the Fed has gone crazy. So you could say that, well, that’s a lot of safety actually, and it is a lot of safety, and it gives you a lot of margin, but I think the Fed has gone crazy.”
(Politico, 10/11/2018, 8 AM EDT: https://www.politico.com/newsletters/morning-money/2018/10/11/why-markets-tanked-and-whats-next-370573)

Here’s our take.

The (in)famous Doc Holliday (https://www.historynet.com/spitting-lead-in-leadville-doc-hollidays-last-stand.htm) occasionally played the piano at the legendary Silver Dollar Saloon in Leadville, Colorado. When Oscar Wilde appeared at the Tabor Opera House across the street, he would cross the street to the saloon for a drink or two after his lectures. Wilde noted that there was a sign over the piano that read: “Please do not shoot the pianist. He is doing his best.” (Source: a personal visit to the legendary Silver Dollar Saloon)

The sign over the piano could apply to today’s Federal Reserve. The Fed now has over a 100-year history. It is doing the best it can. Let’s not shoot it.

At the recent NABE conference, Fed Chairman Powell said,

“This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times. Our ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times, so as to extend the current expansion, while maintaining maximum employment and low and stable inflation.”

He added that “The economy is seeing a “remarkably positive outlook … and a modest steepening of the Phillips curve would be unlikely to cause a significant rise in inflation or demand a disruptive policy tightening. Once again the key is anchored expectations.” He welcomed the recent rise in wages and stated, “Higher wages alone need not be inflationary.” We thank Mike Englund and his team at Action Economics (www.actioneconomics.com) for capturing Powell’s quote with precision.

There is a lot of Fed-related jawboning about the recent employment report. Many folks argue that it was distorted by hurricane effects, so we need another month to gain clarity. With Hurricane Michael now added to the natural disaster list, we may hear the same chorus when the October data is compiled and released.

Meanwhile, the inflation outlook is coupled with the question of whether or not wages are trending upward and accelerating. And the negative economic effects of the Trump-Navarro trade war are only beginning to show up in the data. On a positive note the new NAFTA agreement with Canada and Mexico has reduced anxiety in markets and seems to have stabilized a trending deterioration in sentiment. That improvement (the situation is now less worse than expected) may offset the impact of the US-China lack of progress. Without a directional policy change, the China-US imbroglio could prove very serious. The fears that we articulated in our Thucydides Trap pamphlet are sadly being realized. (The pamphlet is available here in PDF form: “Lessons from Thucydides,” https://www.cumber.com/pdf/Lessons-from-Thucydides.pdf.)

Of course, for the investor the issue is, what does all this mean for future Fed policy and interest rates?

The Treasury yield curve has abruptly steepened. We expected that to happen, given the one-time influence of a special tax provision that expired in mid-September. See “Why the Yield Curve Is Flat and Why It May Steepen,” https://www.cumber.com/why-the-yield-curve-is-flat-why-it-may-steepen/. And we looked to the high-grade muni curve for some guidance. See “The Tale of Two Ratios: Shorter and Longer,” https://www.cumber.com/the-tale-of-two-ratios-shorter-and-longer/. The pricing of munis is set mostly by high-income American investors. The muni curve was steep and continues to be so. Treasury yields result from investments by both Americans and foreigners – a blend of influences. Thus the muni curve may be a better source of high-grade forecasting power. We think it deserves some respect.

So what about wages and inflation?

We updated our series of Beveridge curves. Nearly all of them point to a wage acceleration coming. (We will send any reader the 8-chart series if you provide us with a full snail-mail address.) That series depicts specific unemployment rates crossed with other indicators like job openings or quits. It tracks the last expansion period, the Great Recession and financial crisis, and the recovery since. When viewed together, the curves make a compelling case for an acceleration of the upward trend in wages and for rising inflation. Beveridge curves tell you Fed Chairman Jay Powell may soon see his “historically rare pairing” appear more normal.

My friend Michael Drury at McVean Trading had this comment following on his observation that “Wages have grown at a 3.2% apace over the past 11 months.” He expects 3.2% to continue and notes that “3.2% means wages are compensating workers for 2% inflation and 1.2% productivity growth.” Meanwhile, other economists argue about that productivity growth and ask, “Where’s the beef?”

My friend and fishing buddy Danny Blanchflower is a labor economist and ardent student of Keynes and Beveridge. Danny is a Dartmouth professor of economics, Bloomberg contributor, former Bank of England board member, and serious academic researcher. He and I have discussed the concept of NAIRU, the non-accelerating inflation rate of unemployment – in other words, the level of unemployment below which inflation rises. (For more on NAIRU see https://en.wikipedia.org/wiki/NAIRU.)

NAIRU is not observable, so it has to be estimated. Danny notes that there were periods in history when the estimate for NAIRU was as low as an unemployment rate of 1 to 2%. He cites Keynes and Beveridge for that history. He also notes how central bankers routinely miss on their estimates of NAIRU. That means they are playing the saloon piano when it isn’t tuned.

Danny uses something he calls the U-7, which quite simply is the U-6 unemployment rate minus the U-5 unemployment rate. He is trying to find a marginal shift that signals the turning point where NAIRU is reached and the upward pressure from accelerating wages influences inflation. If we use his back-of-the-envelope approach (he has serious research on this), we can estimate that NAIRU may be as low as a 3% unemployment rate, given the present structure of the US labor force. (For a full description of the various US unemployment rates and the methods of data collection, see “How the Government Measures Unemployment,” https://www.bls.gov/cps/cps_htgm.htm.) Furthermore, as the national statistics gravitate toward this 3% NAIRU estimate, regional and state statistics are tending to confirm the trend. Great work on the state data is performed by Philippa Dunne and Doug Henwood. I suggest serious readers check out the October 4th edition of TLR on the Economy. If you are interested, send me an email with your contact information, and I will ask Philippa to send you a copy of that research.

We have taken Danny’s U-7 concept and developed some measures and estimates of the impact of the changes in the U-7 on things like the Consumer Price Index, average hourly wages, and JOLTS (the job openings portion of the labor data). What we are seeing in every series is a trend toward rising wages and rising inflation. It is hard to discern the exact month of acceleration in these series, but there seems to be some consistency. We will send any reader who gives us a snail-mail address a set of our U-7 charts. Researchers now have a road map if they want to develop their own statistics.

Let’s sum this up after we thank those journalists and friends and colleagues cited here. Please remember that anyone who is writing and publishing publicly is under repeated attack these days, as the Constitution’s First Amendment protections seem threatened by political forces unlike those we have seen in American history in recent decades.

We think the president’s attack on the Fed was wrong. It hurts his political party. It hurts the country. And it helped tank the markets. The Trump-Navarro US-China trade war is worsening, and markets don’t like it. Markets now fear that Trump has undone the beneficial effects of his repatriation policy, tax cuts, and deregulation initiative. What started out on a positive path is now a war between the two largest economies of the world. That war now seems to be intensifying. Remember: In a shooting war the guns are pointed at each other; in a trade war the guns are pointed inward. Nobody wins.

The warning on the saloon piano was apt. Don’t shoot the player who is doing his best. (And especially don’t try to shoot the player if it is Doc Holliday.)

Mr. President. You will do what you want. That is continually made very clear by your behavior. The country will determine who is loco. And history will report the results.

We are allocated toward domestic weights in our US ETF managed accounts. We have a cash reserve. We are in a correction.

Positions in portfolios can change at any time.

David R. Kotok
Chairman and Chief Investment Officer
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VIX Inversion

VIX, the “fear gauge,” measures S&P 500 near-term volatility by using options that expire in 23–37 days. Therefore, the VIX we often discuss is the 1-month volatility index. However, the Chicago Board Options Exchange (CBOE) also publishes 3-month (VIX3M) and 6-month (VIX6M) volatility indexes, which are less well known.

Market Commentary - Cumberland Advisors - VIX Inversion

The 3-month and 6-month VIX indexes are usually higher than the 1-month VIX. Similarly, those VIX futures with various expirations tracking short- and long-term VIX movements also remain in contango most of the time. The reason is that the uncertainty inherent in the long term requires a risk premium compared to the short term, comparable to the term premium in fixed-income. Another feature of the different volatility indexes is that the 1-month VIX is more volatile than the 3-month and 6-month indexes.

What if these three volatility indexes break the so-called contango position and become inverted? It doesn’t happen often, and the first time it occurred in 2018 was on Monday, February 5th. Subsequently, the market dropped to 2532.69 on the following Friday, February 9th. To put that move in perspective, the S&P 500 had just hit an all-time high of 2872.87 two weeks before the correction. So is VIX inversion a bearish signal?

Let’s begin with some VIX inversion history (Chart 1). We adopt a strict definition of VIX inversion as follows: 1-month VIX > 3-month VIX > 6-month VIX. We count the turning point of an inversion only, excluding a run of continuous inversions. The VIX indexes are examined from 2008 forward. Since then, 2012, 2013, and 2017 are the only years without any VIX inversion. Noticeably, the average return of the S&P 500 was 23.41% for those 3 years, in contrast to 5.40% for the other years. Among the years with VIX inversions, there are about four inversions on average in each year.

Chart 1. Volatility Indexes Since 2008. Source: CBOE
At first look, VIX inversion might appear to be a non-bullish sign, but we have found a bullish silver lining in the pattern. The inversion per se suggests that the market perceives the 3-month and 6-month trends to be positive. As the result in Table 1 confirms, the 3-month and 6-month returns following the turn to a VIX inversion are higher than the contango cases. Particularly, the 6-month spread is almost 183 bps. Moreover, last time the VIX inverted in October was in 2014, which had a 6.99% 3-month return and 11.74% 6-month return.
Table 1. 3- and 6-Month Returns After VIX Inversion. Data source: Bloomberg

Lastly, betting on VIX inversion does not appear to be a tradable strategy, as it does not happen often. Therefore, you are not likely to trade it successfully.*Data updated on October 5, 2018.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
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Another Italian Drama – Why It Matters

Government deficit out of control, irresponsible government policies, tumbling bond prices and bank share prices, threat of rating-agency downgrades, political instability – we have seen similar Italian dramas in the past that, in the end, did not lead to serious financial market contagion. Nevertheless, there are reasons to be concerned that this time the impact could be more adverse for European and global markets.

Cumberland Advisors Market Commentary - Bill Witherell, Ph.D.

The populist coalition government of the anti-establishment Five Star Movement and the far-right League party, formed in late May, surprised markets last week by sharply increasing its government budget deficit targets for 2019–2022, including the Five Star election promise of a “citizenship income,” a form of universal basic income, and the League’s promise of tax cuts. The projected budget deficit of 2.4% of GDP for each of the next three years is three times the 0.8% deficit target for 2019 agreed with the European Commission last year, with improvements to 0.0% predicted for 2020 and a 0.2% surplus for 2021. The Italian government has to submit a draft budget to the European Commission no later than October 15. Tensions will likely increase between the European Commission and Italy over the fiscal measures included in this budget. Comments from the Commission already signal that they consider the draft budget to be incompatible with the stability and growth pact. Reactions of some of the eurosceptics within the government to the mounting pressure from Brussels are stoking market fears of increasing political strife.

A period of continued and possibly increased bond market volatility is looking increasingly likely. This could have negative effects on market liquidity and depth. The volatility limits many investors have on the assets in their portfolios would reduce market demand. Adding to this prospect, the European Central Bank (ECB) is expected to end its net asset purchases at year’s end. Since the beginning of this ECB program, the ECB has purchased 360 billion euros of Italian government bonds. The end of net purchases will coincide with a projected increase in the Italian government’s funding needs. That combination will lead to an increased supply of Italian bonds to the private sector.

It is unclear just how strongly the Commission will wish to pressure Italy because of that country’s backtracking on its commitment to structural fiscal consolidation; however, it is the market reaction that is of greatest concern to us. The Italian sovereign debt market is the third-largest sovereign debt market in the world. Developments in this market matter to both European and global markets. The government’s aggressive loosening of its fiscal stance, together with policies that are not growth-friendly, will increase concerns about the sustainability of Italy’s sovereign debt. Both Moody’s and S&P are expected to update their Italian debt ratings by the end of this month. Currently Moody’s rating for Italy is Baa2 (negative credit watch) and S&P’s rating is BBB (stable outlook). A rating downgrade would likely accentuate the reduction in bond prices that has occurred since last Friday. Calculations by Brown Brothers Harriman using current information imply that a rating of BBB- would be appropriate, a two-notch downgrade. BBB- is the minimum rating for bonds to be considered “investment grade.”

The 3.29% yield on the benchmark 10-year bonds at the closing on Monday, October 1, was the highest closing yield of the year – indeed, Italian bonds were at their weakest in four years. The closing spread over the German yield was 2.83 percentage points, which was not as great as the 3.25 percentage point reached during the summer following the emergence of the populist government. On Tuesday Italian bond prices continued to fall, with the yield rising another 10 basis points. The German-Italian spread increased further as German yields declined.

Wednesday Italian bonds recovered slightly, with the 10-year yield easing 6 basis points. The Italian government slightly revised their budget deficit estimates to -2.2% of GDP in 2020 and  – 2.0% in 2021. The basic situation remains the same and neither the European Commission nor the markets are likely to be moved. The good news is thus far there are no signs of contagion to other debt markets. Should that change, pressure on Brussels and on Italy would mount. The euro is under pressure from these developments, as well as difficulties in the Brexit negotiations, retracing some 50% of its recent rally.

The most immediate concerns about these developments relate to Italy’s banking sector. Declining values in the Italian bond market erode the balance sheets of Italian banks. At the end of last year Italian government bonds were reported to account for about 10% of Italian bank assets. In the second quarter of this year Italian banks increased their holdings of Italian government debt by more than 40 billion euros as foreign investors fled the market. Italian banks are thought to hold over $440 billion in Italian bonds. They are not the only banks at risk. French banks still hold some $319 billion in Italian bonds. German banks have reduced their holdings to $95 billion.

The Italian Economy Minister, Giovanni Tria, has argued that Italy will still be able to reduce debt over the next three years, as higher growth rates in those years would result from the government’s policies. Tria, a nonpolitical technocrat, is widely considered to be the adult in the inexperienced government. But he was unable to deter the populist government from the imprudent, expansive draft budget it released. As the budget has not yet been finalized, Tria may be able to achieve some final moderating changes, if the government becomes concerned about the risk of a crisis and a possible snap election.

Tria has sought to assure the European Commission that Italy will have more latitude going forward, pointing to his projections of a pickup in economic growth in the next several years. We do not find his forecasts convincing, particularly in view of the government’s reversal of some supply-side reforms. He forecast growth of 1.6% in 2019 and 1.7% in 2020. Growth was 1.6% in 2017. This year the economy looks likely to achieve no better than a 1% advance. Next year’s growth is forecast by the European Commission at only 1.1% and could well be less.

Italy’s economy grew at about a 1.0% rate in the first half of this year. According to Markit, the Italian economy appears to have stagnated in the third quarter. The manufacturing sector has weakened through the year with overall growth relying increasingly on a still strong service sector. Domestic demand is weak with depressed real incomes. Forward-looking indicators suggest very little growth in the fourth quarter.

Italy’s equity market has suffered from the above developments. The iShares MSCI Italy ETF, EWI, is down 5.60% over the five days through October 2, a period when Eurozone stocks, as measured by the iShares MSCI Eurozone ETF, EZU, fell 2.27% and the euro slipped 1.83%. Banks account for 30% of EWI’s weight, which means that this ETF is strongly affected by developments in Italy’s banking system and hence in Italy’s bond market. Italy’s banking stocks have suffered significant losses. At Cumberland Advisors we continue to be underweight the Eurozone in our International and Global portfolios, and we do not hold the Italy-specific ETF, EWI.

William Witherell, Ph.D.
Chief Global Economist
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Puerto Rico – Third Quarter 2018 Review

As the third quarter comes to a close, a fragile sense of optimism for the future of the Commonwealth of Puerto Rico has blossomed. It has arisen not just from the resolve of its people in the wake of Hurricane Maria but also from important milestones that have been reached in the long restructuring of Puerto Rico’s debt, starting with the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). Economic conditions are beginning to improve.

We now sit a year removed from one the worst natural disasters in the Commonwealth’s history, Hurricane Maria. The monumental storm shattered the lives of the citizens of Puerto Rico, causing billions of dollars in damages and contributing to the deaths of thousands. Today, the people of Puerto Rico remain entrenched in the long, arduous process of recovery and rebuilding. Billions of dollars are set to flow to the Commonwealth, but only a fraction of those funds has been received to date. Eventually, infrastructure will be rebuilt; quick patches will be replaced by permanent fixes; and time will help to heal those who have lost loved ones or their homes or livelihoods.

On the restructuring front we have seen a number of important developments. These include restructuring proposals for the Puerto Rico Sales Tax Financing Corporation (COFINA) and the Puerto Rico Electric Power Authority (PREPA), as well as the continuing Title IV restructuring of the Government Development Bank (GDB) and ongoing negotiations for the possible Title IV restructuring of the Puerto Rico Aqueduct and Sewer Authority (PRASA).

One of the most important milestones to date remains the formal agreement among the Federal Oversight Management Board (FOMB), the government of Puerto Rico, and both senior and junior creditors, as well as monoline insurers, to restructure COFINA’s existing debt. The restructuring of COFINA, at a massive $17.6 billion, would rank among the largest in municipal history. As part of the arrangement, COFINA bondholders have agreed to give up a portion of sales tax revenues to the Commonwealth: 53.65% of the pledged sales tax base amount on a “first dollar” basis would back new COFINA securities, while 46.35% would flow through to the Commonwealth. The disclosed terms would see existing bondholders receive new senior lien bonds secured by a 5.5% sales-and-use tax (SUT), with recoveries of 93% for senior bondholders and 56% for subordinate bondholders. Now supporting the agreement are prominent general-obligation bondholders Aurelius Capital Management and Six PRC Investments LLC. Although the support of such significant players is a welcome sign, it by no means signifies a “done deal.” Unknowns remain, including the treatment of interest payments held in escrow for senior and subordinate bondholders.

The restructuring of PREPA represents another important milestone for Puerto Rico. Under the terms, creditors would receive two series of bonds. The first tranche will provide a recovery of 67.5%, and the second tranche will be a “hope” note at a recovery rate of 10%. Combined, this would be a total recovery of 77.5%, assuming full payment of the “hope” note. The terms have not been enticing enough to bring monoline insurers on board, so we wait for further developments.

In addition to the restructuring proposals for COFINA and PREPA, the restructuring of the GDB continues to move forward. The GDB announced on September 24 that it had received enough votes from creditors to move forward with the territory’s only Title IV restructuring to date. This would cover some $4.2 billion in debt.

These events represent important steps forward for the Commonwealth. Coupled with improving economic conditions, they lead me to the optimism I alluded to in my opening. We urge caution, though, as execution risks remain high. There are no certainties until the plans have been finalized and Judge Swain has given them her blessing.

In the wake of recent developments, uninsured debt has risen dramatically from depressed absolute levels. We consider the movements speculative, as significant risks and hurdles remain. Insured debt has risen as well in response to the positive developments. We continue to favor carefully selected insured debt and believe it can offer an attractive value for clients.

 

Shaun Burgess
Portfolio Manager & Fixed Income Analyst
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