Change Before You Have To

by: Eric Basmajian


The VIX is trading near it's lowest level in history.

Complacency is near a record high as the US macro picture is deteriorating.

The current level of complacency given the state of the economy and the world is what Alan Greenspan called "Irrational Exuberance".

Prepare your portfolio (this does not mean giving up all your upside, just protecting your downside).

"Change Before You Have To" - Jack Welch

I started off with a quote from Jack Welch to play off the recent popular headline regarding the complacency capital markets. With the volatility index (fear index) reaching a 9 handle and trading near the lowest level in history, it's a good idea to put some context around the historic level of complacency in what almost everyone would call a chaotic world.

With the stock market going straight up for the better part of a decade, going against the trend usually comes with barrage of ad-hominem attacks and scrutiny that causes many contrarians to throw in the towel, more so than the short term losses of the contrarian positions themselves.

As an analyst who is 100% data driven, I take no stock in feelings, sentiment or consensus positioning. I use what I feel are the best hard data indicators and look to spot very long term macro trends.

The hardest thing in markets is timing.

As Kenny Rogers said, "You've got to know when to hold 'em, know when to fold 'em and know when to walk away."

After this piece I hope to make those answers more clear but I also understand I am fighting an uphill battle. Behavioral economist Daniel Kahneman scientifically proved in his book "Thinking Fast and Slow" that the human mind favors the familiar over the true.

The familiar is the stock market never going down. I will do my best to reveal the true.

How Complacent Are We?

Everyone is aware of the record low levels of the VIX. Volatility is a highly mean reverting phenomenon; the best indicator of high volatility is low volatility...and it's pretty low.

Another troubling picture is the current short interest in most volatility instruments.

VXX is the short term VIX futures ETF and the short position is alarming. Of course some of the rise in short interest is simply due to the rise in popularity of ETFs/ETNs but that does not justify where the short interest stands today.

Source: RBC

Going back to Kahneman's psychological discovery, the familiar is volatility going down essentially every single day. Short volatility has no question made money over the past few years. The true is what you see in the chart above.

Rising speculative short interest levels have caused short squeezes in volatility that exacerbate even the smallest market moves. We are now multiples higher in short interest than the prior two events so one can only prepare for what the next short squeeze in volatility will bring. How this can unwind in an orderly fashion is for someone else to figure out.

To summarize the complacency, the VIX is at its lowest level in history and the short interest is at its highest level in history. A dangerous combination; especially when overlaid against the weak economic backdrop that we find ourselves in today.

US Economic Picture:

I will breakdown the main components of the US economy, starting with the largest portion, consumption and continue on from there. All the data will be presented across many business cycles. Doing this will make it clear where we stand today.

US Income & Consumption:

Source: BEA

Personal consumption growth is well off its highs and given the next chart on real aggregate income, it is headed lower.

Real aggregate income growth peaked in 2015 and has been sharply declining since then.

Source: BEA

This is my favorite and in my opinion the most reliable economic indicator because it literally measures to total earned dollars in the economy. (Average weekly earnings * total employees)

With wage growth falling this sharply, it is not a surprise that the recent economic data has been so weak. Yesterday, Auto sales drastically missed expectations to add to the list of recent weak economic data. If you have been following aggregate wage growth, this should not come as a surprise.

Whether people want to admit it or not, consumers are at the end of their rope, wage growth is collapsing and the fallout can be seen on Capital One's COF recent earnings report as credit card charge off are rapidly on the rise.

As we are constantly fed reports of tight labor markets, rising "average hourly earnings" and "seasonality" in the first quarter, Capital One (and most other credit card providers) have begun to see credit card charge offs surge.

If that is not enough evidence of a rapidly deteriorating consumer, look no farther than auto sales. On 5/2/2017 the preliminary auto sales number was reported to be 16.9 million SAAR, way below any of the economist estimates.

Auto sales are down 4% from a year ago. The Y/Y growth in auto sales was signaling this weakness for some time.

Source: BEA

The combination of rapidly slowing wage growth, auto sales growth that has been trending lower for over two years, and credit charge offs should have been/continue to be a major red flag and a warning sign to the health of the US consumer.

The last major category to quantify consumer health is retail sales. Retail sales growth has been trending lower of the past few years but has in fact shown a rebound in growth in the past several months.

Source: Census Bureau

The trend in core retail sales growth has been lower across each cycle, making lower highs and lower lows. The past year has shown some acceleration in core retail sales growth. That can be due to very easy comparative periods given the weakness in 2016 but that cannot be said definitively.

Again, given my view on the consumer and wage growth, I believe retail sales will weaken over the coming months but taking the data for what it is, retail sales currently are a positive.

I don't look at confidence or sentiment surveys and feel the data covered above are the main categories to look at when measuring the health of the consumer. Net, I would not be overweight the US consumer at this point.

A 10 handle on the VIX also seems a bit low given the risks that are evident above.


On the labor front, nonfarm payrolls, Job openings and new hires give a comprehensive picture on the job market.

Similarly to income growth, nonfarm payroll growth peaked at the same time, early 2015, and has been decelerating since then.

Job openings are also weakening at a noteworthy pace.

New hires are negative year over year and again, peaked in 2015.

All three labor market indicators are saying the same thing. The peak in labor growth is in the rear view mirror and while there still may be growth, it will continue to decelerate until the end of this business cycle.


About 90% of the housing market is existing home sales. As seen in the chart below, EHS on a year over year basis were falling years before the crash and were negative well before panic set in. Looking at the data in this way it is almost hard to imagine how investors missed it...

Source: NAR

Currently we see EHS trending slightly lower. Not nearly the magnitude of the last cycle but the 12MMA (red line) is sloped slightly negative over the last year and given how late the business cycle is and how weak wage growth is, it is a prudent time to walk away or at the very least not put additional money into housing.

Source: NAR

The median sales price, similarly to EHS, was plummeting and negative Y/Y many months before the recession. Home prices growth is well off its peak in late 2014 but has flat lined in recent months. The median home price growth chart above is neither bullish nor bearish and would be a neutral reading in my models.

The last measure that does a good job of measuring the health of the housing market is private residential construction spending. Again, the peak and massive decline was overwhelmingly evident prior to the last cyclical downturn.

Source: Census Bureau

Today the slope of residential construction spending growth is very negative and not a positive sign for housing construction.

Of course there are dozens of housing indicators but the three used above are in my opinion the most comprehensive and give a very honest snapshot of the housing/construction market.

On balance the three charts above are showing a slowdown in housing. It does not indicate an immediate crash but it certainly suggests the peak in home growth is in.

So What Do You Do?

All the main indicators used above to measure the overall health of the entire US economy are showing a similar picture. A recession is not imminent but the peak of the business cycle is in and we are very close to the end of the cycle. No one can say for sure when the cycle will end and when the next recession will come (unless you believe we will never have a recession again, or that this expansion will last >10 years) but using the common analogy, we are in the 8th or 9th inning of this business cycle based on my analysis.

For those investors who think there is still upside and want to run this risk of riding the last one or two innings, hoping to pull out the day before, good luck.

For those who agree and realize equity market gains have been above average for some time and that the business cycle is very close to the end, what is there to do?

You do not have to give up all your upside in order to protect your portfolio.

At this stage, the best portfolio structure is something similar to the "All weather portfolio" made popular by Ray Dalio.

Roughly this portfolio consists of:

25% Stocks

20% Intermediate Term Bonds

45% Long Term Bonds

10% Gold

This portfolio protects you in nearly all environments. If bonds go down (rates up) this is either due to growth, in which your stocks will do well, or inflation, an environment good for gold.

You may be surprised at the results of this portfolio and how well it protects you without sacrificing much upside.

Below are the annual returns of this exact portfolio back tested from 1985.


The most important thing in prepping for the end of a business cycle is the draw downs. Recovering from a 50% drawdown takes 100% gains to recover so the best way to compound wealth is to limit draw downs which this portfolio does phenomenally well.

Below is the rolling 3-year and 5-year returns of this portfolio and the results are tremendous for wealth preservation.


Here is a total snapshot of the portfolio back test.


The important points to note are that over time, this portfolio returned 9.11% annualized vs. 10.8% for the S&P 500. The worst year was -4.28% vs. -37.04% for the S&P 500.

Also, the volatility was less than half that of the S&P 500.

The best year for this portfolio was 29.5% so the assumption that a bond heavy portfolio does not have potential for big gains is simply not true.

Using this portfolio as a foundation can lead to tremendous outperformance over the long term if you get defensive, such as I am suggesting, towards the later stages of the business cycle (which I think is hard to argue given the charts above) and shift more equity heavy during the beginning stages of the business cycle.

The average 10% annualized stock market return that most pundits talk about can easily jump to 15%-18% if the massive draw downs are limited.

This portfolio can be tweaked to fit your preferences. For example the equity portion can be replaced with stocks you like vs. just simply an S&P 500 ETF.

I will track the performance of my version of the all weather portfolio using the following ETFs.

25% SCHD (I am using this over SPY for extra defense)

20% IEF

45% TLT

10% GLD

I will start the portfolio as of May 1, 2017 and use total return (dividends included).

I will also update this portfolio weekly as I analyze all the macro data that comes out.

For updates to this portfolio, asset allocation rotation and real-time analysis of all major economic data, please follow my SA page.

Disclosure: I am/we are long TLT, IEF, GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.