You Choose: Potentially Get Paid to Wait or Get Punched in the Face

Boxing You Choose: Potentially Get Paid to Wait or Get Punched in the Face What makes MKAM ETF distinct is the proprietary algorithm it employs to obtain, we believe, a better measure of risk and return than the average market participant. We subscribe to the general advice that you want to be invested in stocks most of the time. However, historically, about 15% of the time, the stock market is both expensive and characterized by bad momentum. Avoiding this “red zone” allowed investors to generate most or all of S&P 500[1] returns, historically, while eliminating substantial drawdowns, defined as those significantly worse than-10%. Since our ETF’s launch in April the market, and our algorithm, hasn’t changed much. Stocks remain too expensive and yet continue to rise. Consequently, we began our life as a public ETF with 50% exposure to the S&P 500 through low-cost ETF IVV. That exposure grew to 52% at the end of August, as the stock market, and MKAM, increased in value. But otherwise, the stock market has been boringly consistent. In stark contrast, all the action is in the bond market. Fortunately, we can apply the same principles of our algorithm to the bond market. Our valuation discipline continues to favor short-term or low-duration[2] bonds. Our trend indicators continue to tell us to wait before we begin to add longer-term bonds to the portfolio, extending our duration. At the end of 2021, just before the Federal Reserve finally began the first material and sustained rate hiking cycle since the Great Financial Crisis of 2008, 3-month US Treasury Bills yielded a paltry 0.1%. This prompted Bridgewater founder Ray Dalio to pronounce “cash is trash.” Source: US Treasury, MKAM, and Vanguard In less than two years, 3-month US Treasury yields rose considerably. As we write, they pay 5.5%. Especially for being the closest instrument to risk free in the market, 5.5% is a great return. Further, it is substantially above its historical average. Cash is, once again, king. From real estate to the stock market, most assets today are still priced for the zero-interest rate world of 2009 through 2021. They offer substantially lower than normal returns. The lone exception is 3-month US Treasury bills. And MKAM ETF is flush with them. 10-Year US Treasuries are approaching their long-term average of 4.9%. They ended August at a yield of 4.1% and further spiked after the September 1st strong jobs report to 4.3%. Today, they sit only 60 basis points[3] below their long-term average. While those rates are approaching normal levels, they’re still abnormal in that the yield curve is inverted: short-term rates are above long-term rates. This defies the very concept of the time value of money. Source: US Treasury To quote the Federal Reserve[4]: “an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last eight recessions (as defined by the NBER[5]). One of the recessions predicted by the yield curve was the most recent one: The yield curve inverted in May 2019, almost a year before the most recent recession started in March 2020.” There have been two notable false recession forecasts from inverted yield curves in the past: 1966 and 1998.[5] The hope of the Federal Reserve today is to add a third false positive to the list. The goal of Federal Reserve Chair Jay Powell is to engineer a “soft landing,” whereby the economy cools enough to bring inflation under control but avoid causing the economy to enter a recession. Current market consensus implies that the Fed will be successful. In this scenario, short-term interest rates would soon fall. The current Fed “dot plot” forecasts a Federal Funds rate of 2.5% to 2.75% as inflation falls to the Fed’s 2% target. If this is accomplished, using the historical positive spread to 10-year yields, the current 4.1% 10-year yield makes total sense. There is a cogent argument, however, to be made that short-term rates will remain higher than the market expects and thus, long-term rates will continue to surprise to the upside. After 15 years we have been conditioned to believe interest rates should be lower than they were historically. But they were only brought so low to rescue the economy after the Great Financial Crisis. Further, post Covid, again a time of extreme fear, the 10-year yield hit its lowest level of 0.54%. Absent a once a hundred-year financial crisis and a once a hundred-year pandemic, why should we expect rates to be so low? A Fed Funds Rate of 3.5% and a 10-year US Treasury yield of 5% and a 30-year mortgage rate of 6% would all be exactly in line with historical averages. And, from a fundamental level, they all make sense with a healthy economy. Whether the Fed and current market consensus is correct, or contrarian points of view as typified by “bond king” Bill Gross and Calculated Risk author Bill McBride prove correct, the good news is we can rely on the other half of our algorithm: trend. Since the end of 2021, ETF IEF, consisting of 7-to-10-year US Treasuries, is down -15%. With current US Treasury yields, IEF owners from the end of 2021 will have to wait 4 years before they recover and break even. In year 5 they would finally start to earn some net income. On the other hand, a simple trend following strategy, similar, but shorter, than we use for the equity portion of our algorithm, would be down -1.25%, over the same time frame. This investor, given current yields, will be back in the black in a few months. Source: MKAM ETF and FastTrack. Red line = IEF total return, green and red line = IEF with Fast Track trend following signal, invested in IEF when trend signal is positive and money market rather than IEF, when trend signal is negative. As yields continue their rising trend, and long duration bonds continue to fall, our trend indicator remains negative. In finance there is

The Fed Turned Gravity Back On, Investors Continue to Float

Investors Float On The Fed Turned Gravity Back On, Investors Continue to Float “So I’ll meet you at the bottom, if there really is oneThey always told me “When you hit it, you’ll know it”But I’ve been falling so long, it’s like gravity’s goneAnd I’m just floating,” Drive by Truckers Interest rates fell steadily for decades. They were completely turned off between 2009 and 2021. Housing values soared. Cryptocurrency was created. GameStop “mooned.” Over the past year and a half, the Federal Funds Rate quickly rose from 0% to 5%+. Gravity has been turned back on, yet investors are still floating. Stock market values remain elevated and continue to defy the bears, while the trends remain solidly positive. At times like this, I am glad I turned over my investment allocation decisions to an algorithm. My head wants to exit the US stock market entirely, my heart wants full exposure, our algorithm splits the difference with a 50% allocation. The other 50% earns 5%+ in risk-free US Treasuries. Source MKAM ETF We currently remain in the yellow zone for markets, where investors can still participate, but should proceed with caution. The market was in the yellow zone 21% of the time in the modern post Greenspan era, according to our model. The trends remain 100% solid, while expected returns are below what we require to take the extra risk to be found in the stock market. This period does stand out from the past 15 years, however. Now, we can earn real interest while we wait for expected stock market returns to improve. We want to avoid entering the red zone when serious market drawdowns occur. We are not there yet, but we will keep you posted when we enter dangerous territory. The US stock market remains too expensive according to all models with demonstrated predictive power. While US Treasury Bills now offer significantly more than their historical average and US Treasury bonds are about 20% shy of their long time average, stocks remain poised to deliver half of their historical returns. Yet, the stock market’s prospective standard deviation remains the same at 17% with higher odds of a large drawdown. Source: MKAM ETF Why would investors be content to accept mediocre stock returns when they can get the same guaranteed returns from the US Government in short-term bonds? We can strain to come up with some logical explanations. But we believe the best answer is simply inertia and emotions. It is very hard to sit out of a raging bull market that has been outperforming expectations for nearly 15 years. Each time the market falters, like falling 30%+ in Covid, and then recovers, it encourages investors to take more risk. We imagine in time rationality will kick in and more investors will realize that we have left the world of ZIRP (zero interest rate policy) and TINA (there is no alternative) behind. That we are once again in a world of real interest rates, and gravity. After all, recently, the Bank of England surprised markets with a half  point increase in their benchmark rate. And the Fed keeps telling everyone who will listen they intend to keep rates higher for longer. When will the market switch from prioritizing emotions to rationality? Or switch from optimism to pessimism? We don’t have to wonder or worry. Every day, we simply check our algorithm. Keep Me Informed Please enter your email address to be notified of new content, including market commentary and special updates. Thank you for your interest in the MKAM Funds. 100% Spam-free. No list sharing. No solicitations. Opt-out anytime with one click.

Robust Errors

Robust Errors Robust Errors “For the robust, an error is information,” Nassim Nicholas Taleb The Vanguard Capital Markets Model® currently projects S&P 500 annualized returns of 5% over the next decade. This compares poorly with the historical 10% average annual return for the index. To make matters worse, expected volatility is still unchanged at 17%. While risk is projected to be the same for investors, returns are expected to be half as good. Why does Vanguard expect returns between 2023 and 2033 to be worse than average? Because valuations are elevated. Any measure you scrutinize that has demonstrated predictive power is currently priced materially higher than average: price-to-sales; market cap-to-GDP; Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE); etc. But does this information about the future help us in the short term? “Valuations… are not predictive over the shorter term. Yes, over the long run valuations are predictive of performance. But you can have extended valuations for an extended period of time. And the reality is that the biggest issue most investors face is not participating in the equity market,” Kristina Hooper, Invesco, Chief Global Strategist on Blomberg Surveillance 1/20/20 Conventional Wall Street wisdom, we’ll let you be the judge of what that is worth, says that long-term forecasts tell you nothing about the short term. At MKAM ETF we see things differently. How can we have useful models that forecast performance a decade from now, but tell you nothing about the short or intermediate term? After all, to get to 2032, you travel through 2024, 2025, 2026, etc. We believe that the journey you have already partially completed informs the rest of the trip. Consider that five years ago, Shiller’s CAPE was 31.2. This is higher than the CAPE that has warranted the historical average of 10% per year annualized returns the S&P 500 has averaged over time. Further, it was above the 26.1 average in the post Greenspan era, from 1988 through today. It would be reasonable to expect the next decade of returns to be lackluster for investors who paid a premium to own stocks on May 31, 2018.   Source: Robert Shiller Contrary to expectations, the S&P 500 has generated 11% per year returns since then, even higher than the historical average. In fact, in just five years, the S&P 500 has already earned all the returns the CAPE model forecasted over the next decade, given its starting valuation. The next five years must generate negative returns for the prediction of five years ago to prove accurate. To us, the error of the previous forecast is not wrong, it is useful information. A similar analysis of CAPE predictions of 7, 8, and 9 years ago leads you to the same conclusion. The S&P 500 has already pulled forward future returns into what is now the past. In a world where investors can get 5% returns on their cash, it seems prudent for risk-conscious investors to reduce their exposure to the S&P 500. MKAM ETF remains 50% exposed to the stock market and 50% in short-term US Treasury Bills earning 5%. The allocation to the stock market comes from our trend discipline only. While the stock market remains in a bullish mood, we continue to participate partway in the gains. However, heeding accurate model forecasts that are only part way towards completing their full cycles has us watching the exit with one eye. For investors that seek to avoid large drawdowns, we suggest taking the right lessons from the best valuation models at our disposal. Better to learn from one error, than to make Keep Me Informed Please enter your email address to be notified of new content, including market commentary and special updates. Thank you for your interest in the MKAM Funds. 100% Spam-free. No list sharing. No solicitations. Opt-out anytime with one click.

A Smoother Ride

A Smoother Ride Well I’m accustomed to a smooth rideOr maybe I’m a dog who’s lost it’sbiteI don’t expect to be treated like a fool no moreI don’t expect to sleep through the nightSome people say a lie’s a lie’s a lieBut I say whyWhy deny the obvious child?-Paul Simon, “Obvious Child” The S&P 500[1] reached an all-time high of 4,793 on December 29, 2021. Soon after the market achieved this milestone, the Federal Reserve began their well-telegraphed program of raising interest rates. While the Fed attempted to end their Great Financial Crisis induced zero interest rate policy (ZIRP) in 2018, only to relinquish as markets deteriorated quickly, this time their hand was forced by the first serious inflation in 40 years. Source: US Treasury The stock market fell as a result. At one point, the market was down by -25%. After a somewhat sustained market rally, the stock market closed -13% below its all-time high on 4/28/2023. Source: S&P Global After the Federal Reserve raised the Federal Funds rate from 0% at the end of 2021, to 5% today, Treasury Bills are the one asset class currently offering expected returns greater than their historical averages. While an investor in US-Treasury Bills historically earned 3.7% per year, today they can receive 5.2% for lending their money to the US Government for 3 months. The downward sloping yield curve is the bond market’s vote that the Fed has overdone it and the economy cannot stay healthy with a 5% risk-free rate. The 10-Year US Treasury yield sits at 3.4% compared to a historical average of 4.9%. Still below average, but materially better than the paltry 1.5% on 12/31/2021. That financial institutions like Silicon Valley Bank rushed in to earn 1.5% instead of waiting for 3.6% was a big reason why they went bust. They weren’t the only ones who grew impatient. Source: “Triumph of the Optimists”, Dimson and Marsh; US Treasury; Vanguard Similarly, expected returns in the stock market have improved markedly, but remain well below historical averages. After generating returns above historical averages for the past 7-to-10 years, the market stands poised to generate below average returns over the next decade.There are two ways that 5.4% can get back to the historically observed 10% return. Firstly, earnings growth can simply outpace S&P 500 price appreciation to the point that the price on the market is eventually justified by the fundamentals. Or, the market can take a significant downturn to get much cheaper quickly. For example, if the S&P 500 fell by approximately -30% before the end of the year, the expected return would rise to the historical average. How likely is it that the market would fall by 30% versus slowly growing into its current, inflated price? The stock market fell by that much or more in the DotCom Crash of 2001; the Great Financial Crisis of 2008; and the Covid crash of 2020. The ending of 13 years of ZIRP seems equally momentous.We don’t know for certain which path the market will take to start to offer higher returns. Or, even if it ever will. Butwe do know that the risk that it will fall by an unacceptable amount for our investors remains above average.Investors maintaining half of their normal stock market exposure makes sense to us. Being able to generate 5% in US Treasuries with virtually no risk and almost no volatility is superior to us than attempting to earn the same in the stock market with much higher volatility.The stock market’s optimism disagrees with the pessimism of the bond market. We are inclined to believe the bond market. But we are not doctrinaires. We are open to the idea that the stock market is correct. Consequently, it makes sense to maintain some exposure to the stock market, especially when that exposure is governed by trend. Historically, trend following has done a good job of getting out of the market early during pronounced corrections.It is historically unusual that you can receive the same expected returns in 3-month US Treasury Bills as you can in the S&P 500. We do not expect this situation to last for very long. Until then, it’s wise for investors to tread carefully. And demand greater returns for taking more risk. [1] Standard and Poor’s 500 (S&P 500) is an index of the 500 largest U.S. public companies. It measures companies’ size by their market capitalization. Keep Me Informed Please enter your email address to be notified of new content, including market commentary and special updates. Thank you for your interest in the MKAM Funds. 100% Spam-free. No list sharing. No solicitations. Opt-out anytime with one click.