Trigonometry

I was at “Back to School” night last week for the kickoff to my daughter’s sophomore year of high school. Her AP Trigonometry teacher said the most profound thing. She said, “a lot of kids struggle with Trig because it’s the first math class they’ve taken that is cumulative in nature.” In prior math classes, students learn a concept, get tested on that concept and then move on. However, in Trig they have to pull together concepts from previous math classes, as well as Trig concepts that build throughout the year.

 

In that moment, it hit me. In the investing game, if you want the opportunity to earn spectacular returns, you need to ace Trig, not Algebra. As we await the Fed’s decision, Algebra students are possibly being led to slaughter, while the Trig kids know, the fate of your entire portfolio is tied to one market, the US Dollar.

 

Just like Trig, superior global investing is cumulative in nature. It is an iterative and dynamic process that requires you to distill information and then put that information together so it paints a vivid picture of what’s happening in the financial markets.

 

In short, investors who ace Trig are able to side step danger and position themselves to profit from the kids who can only do Algebra.

 

That’s why I developed my 3-G investing framework, which monitors all 3 forces, or gravities, that impact asset prices: quantitative, fundamental, and behavioral. This framework allows me to distill only the most critical data and information, and it allows me to better understand how each of those 3 gravities are influencing asset prices, in real time. Basically, my 3-G framework is a cheat sheet for Trig tests.

 

I know what you’re probably thinking, “Landon, I’ve already been to high school and I don’t intend to go back, that’s why I use diversification in my portfolio.” My friends, if you think a “diversified” portfolio put together by your Ed Jones guy is the answer, then you’re flunking Algebra and you got no shot at getting into AP Trig.

 

I hate to burst your bubble but in terms of managing market risks, “diversification” is an absolute joke. It died long ago as an effective way to manage risk in portfolios, the only problem is that most advisors haven’t figured it out yet. It’s like trends that start in California that finally make their way to the East Coast. They’ve been eating frozen yogurt in Cali since the mid 90’s; we just got it here in Virginia 6 months ago.

 

“Diversification” no longer holds up under “normal” market conditions, but more importantly, the environment we are in right now, makes the idea of diversification downright laughable. Diversification won’t save you from the policy risk of the Fed this week and I can use my 3-G framework to prove it. Specifically, I’m going to deep dive on the quantitative and fundamental gravities impacting the short-term direction of the US Dollar.

 

Relationship Status

Let me stop you before you start rattling off all of the different mutual funds and ETFs that are in your various accounts. It simply doesn’t matter, and here is why.

 

I monitor a dozen quantitative factors across several hundred markets worldwide and one of those factors is correlation. “Correlation” is just a churched up word for the relationship between and across financial markets.

 

The relationship between the markets I monitor and the US Dollar has undergone a dramatic shift in the last month. As I write this, every major market in the world has a negative relationship with the US Dollar. What do I mean by a “negative” relationship?

 

I mean that whatever direction the USD goes in, markets are going to move in the opposite direction. In fact, most markets are exhibiting the most negative relationship they’ve had to the USD, at any time, in the last 3 years! This matters because the more negative the relationship, the more dramatic the move in the opposite direction. And right now, there is nowhere to hide from a strong USD.

 

If you own equities of any flavor: US, Eurozone, Emerging Markets, hell even Canadian equities, you will get hurt if the USD moves higher. You’re probably thinking that your bond exposure will save you. Think again. US corporate bonds, US Treasuries, US high yield and emerging market debt are all negatively related to the Greenback right now. Yes, even your precious, and tax-free, US munis are moving in the opposite direction right now. And if you own commodities, I pity the fool!

 

From a correlation or relationship perspective, a strong USD is bearish for just about every market you can name and probably own in your portfolio.

 

All of this just ahead of a Fed meeting with the most policy uncertainty we have seen in a couple of years. This uncertainty is a real problem for the Algebra kids because there is no bigger catalyst for the direction of the US Dollar than Fed policy. The quantitative gravity tells us that if the USD moves higher, most markets are going to get hurt. If the USD moves lower, then the Algebra students will look smarter than they really are, for now.

 

This brings us to the Fundamental gravity driving the USD. One of the factors we monitor in this gravity, is the central banking policy of the market we are analyzing.

 

Data Driven

The Fed has stated that they are “data dependent.” If this is true, then there is no way they hike rates. I’m on record saying that the US is already in a recession and I’m just waiting for GDP to reflect this reality. The Fed hiking into the data we’ve seen recently would drive the economy off the rails. If you haven’t gotten that far in your Algebra curriculum yet, just look at what has happened to the US economy since December’s rate hike.

 

Retail sales are down 30% since December and are growing at the slowest pace in 7 years. Wage growth is down 25% and at 2 year lows. From a labor perspective, all critical measures of US employment have deteriorated substantially since December.

 

The monthly ADP and Non-Farm payroll numbers are posting about 100,000 less jobs than they were in December. The Fed’s very own Labor Market Conditions Index, which is a combo platter of 19 different labor market readings, has fallen from growth in December, to contraction now. Not only that, but the LMCI has contracted in 6 of the 8 months since the rate hike.

 

US industrial production has contracted for 12 consecutive months, which has never happened outside of a US recession in over 100 years! In August, business inventories rose and sales dropped for the 19th consecutive month.  I’m not just cherry picking, numerous measures, across both the manufacturing and service sectors, have deteriorated since December as well.

 

And finally, the one calculation that covers it all, GDP. GDP growth has fallen for 5 straight quarters and has been cut in half since December. ‘Nuff said.

 

That’s a lot more numbers than I typically like to throw around, but it’s important that you see just how much worse things are today than they were before the Fed hiked rates. We aren’t talking small, inconsequential declines in data; in many cases, the data went from growth to outright contraction.

 

However, with all of that said, it’s still possible that the Fed will hike rates this week.

 

Mandate Driven

In addition to being data dependent, the Fed has also publicly held that they are mandate driven. Specifically, they are driven by a dual mandate of low unemployment and maintaining an inflation rate above 2%. If they stick to that mandate, then they have all the ammunition they need to hike rates. If the glove fits, you must acquit.

 

Despite the fact that just about every other measure of the US labor market is worse than it was 9 months ago, the official unemployment rate has been hovering around 5%. This checks the box for the Fed’s unemployment mandate.  The latest inflation numbers came in at a smoking hot 2.3% annual rate. The official inflation rate has now been above the Fed’s mandated 2% for 10 straight months.

 

The fundamental gravity tells us that the Fed could go either way. A mandate driven Fed raises rates, causing the USD to swoon. Data driven Fed holds off, causing investors to slice and dice every letter in the Fed commentary to tease out if its dovish or hawkish.

 

Holy Grail

 

Being great at Trig isn’t the holy grail of investing that guarantees success. I have no idea if the Fed will hike this week or not. My gut tells me they don’t and that the USD’s reaction will be entirely based on whether the Fed’s commentary is deemed to be dovish or hawkish.

 

But what Trig does for us, that Algebra could never hope to do, is paint a picture of the possible outcomes this week and the most likely direction of various markets given each outcome. That’s extremely powerful and a much better way to manage risk that relying on “diversification.”

 

I can’t emphasize enough that just being spread out amongst a bunch of different funds or asset classes isn’t enough these days. If your advisor or money manager can’t explain to you how they quantify and monitor risks in an increasingly complex global economy, you’re in trouble. What’s more, if you want to position yourself to earn big boy returns, then you have to excel at Trig rather than just skate by in Algebra.