On My Radar: An Optimist Sees The Opportunity In Every DifficultyLearn more about this firm
“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”
– Winston Churchill
Perhaps it is my early business roots that set my orientation towards a trading approach to the markets. Some of our clients take a longer-term approach, some a shorter-term approach. I believe there is a place for both. Valuation and potential forward returns for equities (low today) help shape the tactical weightings. The key is understanding the correlation between the different sets of risk one uses to create a portfolio i.e. “all the eggs in one basket” is not a good thing.
This weekly piece is about identifying the global macro risks, zeroing in on probable 10-year forward returns (low today) and identifying periods in time when risk management (hedging or raising cash) makes more or less sense to apply. Success depends on your ability to hedge and the mix of low correlating strategies held within your portfolio. No need to hedge when forward equity returns are greater than 10 to 15%. Today high valuations and high household equity ownership are signaling 2-3% annualized returns over the next ten years.
Between today and the next great equity buying opportunity, I see three significant risks that are unavoidable:
- Sovereign Debt Crisis – it’s not about Greece (but France, Spain, Portugal, etc.)
- Emerging market dollar denominated debt crisis – the strong dollar is choking the borrowers
- A coming pension crisis – low yields are starving painfully underfunded plans
Currently, the commodity market is signaling global deflation. China’s currency shot across the bow is a reaction to the global slowdown – it is telling us something. The currency wars, intended or unintended, are alive and real. Rinehart and Rogoff nailed it some years ago. Debt is a drag and the central banks’ “boo-boo” band aids are not doing the trick.
We sit, we hope and we pray for Fed rescue.
Former adviser to Dallas Fed’s Dick Fisher, Danielle DiMartino Booth, speaking in a CNBC interview slams The Fed for “allowing the [market] tail to wag the [monetary policy] dog,” warning that “The Fed’s credibility itself is at stake… they have backed themselves into a very tight corner… the tightest ever.”
Each nation, attempting to make themselves more competitive to foreign consumers, devalues their currency. Global recession is afoot. If the Fed raises rates, they risk further rise in the dollar. They are stuck. Lick the finger, stick it in the air, and take the best guess.
To this end, St. Louis Fed vice president, Stephen Williamson is critical, “There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed —inflation and real economic activity.”
Recalling Greenspan saying, “there was a flaw in my ideology.” Watch this clip – you can’t make this stuff up. Temper our expectations we must.
In a white paper titled Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay (dissecting the U.S. central bank’s actions to stem the financial crisis in 2008 and 2009), Stephen Williamson finds fault with three key policy tenets:
- He believes the zero interest rates in place since 2008 that were designed to spark good inflation actually have resulted in just the opposite.
- He believes the “forward guidance” the Fed has used to communicate its intentions has instead been a muddle of broken vows that has served only to confuse investors.
- He asserts that quantitative easing, or the monthly debt purchases that swelled the central bank’s balance sheet past the $4.5 trillion mark, have, at best, a tenuous link to actual economic improvements.
Williamson added, “But as for spurring inflation, reducing employment or otherwise generating sustained economic activity, the results, particularly for QE, are “at best, mixed”. In addition to muted inflation, gross domestic product has yet to eclipse 2.5% for any calendar year during the recovery, while wage gains and, consequently, living standards, have been mired around 2% or less. There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed—inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation.”
In Williamson’s view, that’s a product of policymakers wed to the Taylor rule, which dictates the level of interest rates in regard to economic conditions. The thinking essentially is that low rates beget low inflation, trapping central banks in zero interest rate policies (or ZIRP).
“With the nominal interest rate at zero for a long period of time, inflation is low, and the central banker reasons that maintaining ZIRP will eventually increase the inflation rate. But this never happens and, as long as the central banker adheres to a sufficiently aggressive Taylor rule, ZIRP will continue forever and the central bank will fall short of its inflation target indefinitely,” Williamson said. “This idea seems to fit nicely with the recent observed behavior of the world’s central banks.” Source: CNBC
This week has been a bloody week for the bulls. I share some ideas today on what we can do in this overvalued, aged and over-leveraged equity bull market. Importantly – let’s see opportunity.
Included in this week’s On My Radar:
- Currency Wars – Understanding What is Happening
- Focus On Commodities
- Book Value – The Market Remains Overvalued
- Trade Signals – Temperatures Rising – Ramping Up The Risk Barometer
Currency Wars – China, the IMF and SDRs
This from my friend Jim Rickards: The Yellen playbook was revealed in a speech she gave in Providence, Rhode Island on May 22, 2015. This was reported under headlines that read, “Yellen to Raise Rates This Year.”
But that’s not what she actually said. Her speech said three things:
- She will raise rates if the economy acts in accordance with her forecast.
- Her forecast is for 5% unemployment, 2.5% growth and 2.0% inflation.
- She will not wait until she hits those targets. She will act a bit early if data is trending toward them.
In practical terms, this means that if we see, say, 5.2% unemployment, 2.3% growth and 1.8% inflation with momentum toward the 5%, 2.5%, 2% trifecta, then she will raise rates quickly. So there’s the model.
Recent unemployment has been at 5.3% the last several months. GDP growth for the first half of the year was approximately 1.5%. The Atlanta Fed GDP tracker is showing 1% growth for the third quarter as of early August. And inflation is moving lower not higher. The Fed’s preferred measure of inflation, personal consumption expenditures, is just 0.3% year-over-year. Well, below the Fed’s 2% target.
Jim’s view and I agree, “The time to raise rates was 2009-2012. Bernanke blundered by not doing so. The Fed missed an entire rate cycle. If they had raised then, they could cut now. But they didn’t, and they can’t.”
There is more going on with currency positioning than just the beggar thy neighbor desperation policies to spur growth. China wishes to join the world money basket that is printed by the IMF (International Monetary Fund). The basket is called the Special Drawing Right or SDR.
For years, China has pegged its currency to the dollar. If the Fed tightens (raises rates), by default China tightens too. The U.S. essentially controls who enters the SDR basket. Think of it as a potential alternative currency to the dollar. The balance of the world wants to move in that direction. The U.S. has insisted that China peg the yuan to the dollar in exchange for allowing China entry into the SDR currency basket.
The U.S. dollar has been strong. U.S. interest rates are higher than the balance of the developed world. For example, the 10-year Treasury bond is yielding 2.05% today compared to our global competitors’ comparable 10-year rates: German Bund at 0.59%, UK at 1.69%, France at 0.93%, the Netherlands at 0.77%, Switzerland at -0.24%, Italy at 1.83%, Spain at 2.00%, Portugal at 2.56% and Greece at 9.24% (but forget about Greece).
Asia, Japan at 0.36%, Hong Kong at 1.60%, Australia at 2.57%, Singapore at 2.55%, South Korea at 2.28% and India at 7.77%. Source: Bloomberg
Which capital markets on the planet are the most developed with the broadest market participation (diverse sets of players)? Advantage U.S.
Talk up the dollar or raise rates? The U.S. becomes even more attractive. Where is global capital going to seek return? Add in a sovereign debt crisis and loss of confidence in government – the smart capital exits. Forget return, safety is sought.
The U.S. and China account for roughly 30% of global GDP. China’s move in the face of desired entry into the SDR basket is telling us that global growth is in trouble.
Commodity prices are down some 60% (note forecast in the next section) and emerging market currencies are getting destroyed relative to the dollar. Brazil, Turkey, Malaysia.
It is estimated that some $9 plus trillion was borrowed by foreign borrowers with those loan prices in dollars. If your home country currency drops by 33%, that $9 trillion debt is now $12 trillion. Back at a time when it was cheaper to borrow from a U.S. lender (U.S. rates were lower than say, the lending rates in Brazil) it looked like a good idea. Now in crisis. Expect defaults.
You can see why the Bank of International Settlements (BIS) and the IMF are pressing for the Fed to remain on hold or perhaps lower rates (though lowering from zero is tough to do).
This from Morningstar: “Stock Selloff Accelerates On Global Growth Fears – U.S. stocks extended this week’s sharp losses with a renewed selloff on Friday as worries about global growth, fueled by carnage in China’s stock market persists.”
This is all getting very interesting.
Focus On Commodities
The dying commodity super-cycle remains the most important influence throughout the commodity complex. It is the factor that trumps all others, still in 2015.
- This has been the case for the last four years, and we suspect it stays that way for a while, knowing that the average bear lasts about 20 years (see the chart).
- A bear super-cycle is essentially a black hole, sucking in most commodity related situations. Avoiding it is nearly impossible.
- Fighting it is futile. Commodity prices and investors alike eventually succumb.
- From the moment we began studying commodity super-cycles, we were struck by the repeatedly sharp moves during the transition from bull to bear. Each parabolic rise was met with a thundering crash, obliterating all parabolic gains and then some. No exceptions.
- The early bear years are consistently the hardest on commodity prices as this is the time that the black hole churns at max strength.
- And with no yield to buffer the fall, commodity prices lose ground fast and persistently. Welcome to how commodity super-cycles die.
Book Value – The Market is Overvalued
I touched on valuation a few weeks ago and ran across this quote from Ned Davis in one of his recent posts:
“Book value used to be fairly easy to calculate, but with all the creative accounting, buybacks, mergers, and changes to the lists of stocks, the numbers are very hard to calculate. Perhaps as important, we have had a change to the composition of our economy with more service and social media companies and less manufacturing, which some argue have less need for net assets (thus higher price/book value).
In any case, S&P recently reported actual book value for 2014, which was far lower than earlier estimates. This sent price/book values somewhat higher, as featured on S0775 (below). We reanalyzed the chart with the revised data, added in a linear regression which shows the potential upward drift in the indicator, and still we are in a zone that has proven problematic historically.
I would also add that the recent drop in earnings estimates likely means 2015 book value estimate will be lower than the estimate below. The market is overvalued.”
Periods of overvaluation become more concerning when you look just a little bit deeper beneath the surface. This from the great Art Cashin,
“Such environments raise the not-so-fine art of financial engineering to a “botox state”. It’s no secret that companies have been gorging themselves on share buybacks and mergers and acquisitions, non-productive but highly lucrative endeavors. When combined, the results are magnificent – costs are cut, profits juiced and bonus season becomes the most wonderful time of the year.”
Botox state – well said brother.
During the week, I often post a chart or two to our advisor blog page (something I view as important/interesting). I posted the Price to Book chart this past Wednesday. You can sign up to receive weekly updates and/or access the page here.
Trade Signals – Temperatures Rising – Ramping Up The Risk Barometer (Wednesday 8-19-15 Blog Post)
I’m moving up the level of risk due to several factors: One is a change in signal on volume demand vs. volume supply. Selling pressure is dominating buying demand, which is a concern in a period of low liquidity. Valuations remain stretched and the cyclical bull market is aged.
Trend evidence is positive but deteriorating. Sentiment is in the Extreme Pessimism zone which is historically bullish for equities. I lean towards giving upside the benefit of the doubt; however, I recommend to stay hedged on your equity exposure and include a number of other risk streams (such as liquid alternatives – which I define as anything other than traditional stock and bond buy-and-hold) in your portfolio(s).
Remember that overcoming a 20% decline takes a gain of 25%. That is a lot easier to achieve than overcoming a 50% decline which will take a 100% subsequent gain to get back to even. The math of loss is painful. It is time to risk protect.
As a quick aside: 20% out-of-the-money put options on the S&P 500 Index would cost about 33 bps to hedge that equity exposure – using December 2015 SPY put options. This would limit your loss to approximately 20% below the current level.
Call us if you have any questions and we can discuss what you own and share with you a few suggestions.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
- Volume Demand is Greater than Volume Supply: Sell Signal for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks)
- Don’t Fight the Tape or the Fed: Neutral signal
- U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Currently Signaling No U.S. Recession
- The Zweig Bond Model: The Cyclical Trend for Bonds is Bullish
Click here for the link to all of the charts.
It’s the $9 trillion in dollar denominated loans that is high on my worry list. China is telling us something about global growth: “watch what they are doing vs. what they are saying”. The higher the dollar, the greater the debt crisis outside the U.S. for those loans taken out by borrowers from Brazil, Turkey, Korea, Taiwan, Europe, China and others that must be paid back in dollars.
Commodities, as noted, are in a long-term secular bear market. Commodities are signaling global deflation.
The market is overvalued (second only to the March 2000 high) but the trend evidence, though weakening, has not yet crossed lower unless one’s measure is the cross of the S&P 500 Index’s 50-day MA line below its 200-day MA line (known as the death cross).
With risk high, to me it makes sense to spend a little bit of money and buy out-of-the-money put options. Overcoming a -10% or -20% is much easier than overcoming a -40% or -50%. One needs a 25% gain to recover from a 20% loss; however, a 100% gain is required to get back to even after a 50% loss. 20% out-of-the-money puts are not too expensive when implemented over the course of a year. Approximately a 1% annual insurance cost yet there are ways to reduce that expense and accomplish the same.
Additionally, there are mutual funds and tactical approaches that are not dependent on a bull market in stocks. Such strategies tend to generate return at the same time and/or at different times than stocks. You want to find proven managers with sound processes that may drive return in a way that has low correlation with the market. Combine two such things together and you have a far more efficient set of risks.
Frankly, I believe a train wreak is coming (something in the -40% to -50% range) but we need not get run over. Such losses tend to come during recessions. We tend to get one or two recessions per decade. They happen and we may be nearing the next.
The cyclical bull is aged, overvalued and over-believed. Better we make sure we are defensively positioned to be able to act on the next great buying opportunity. Shift back to over-weight equities then. Remove the need to hedge – then. Until then, stay with the trend, hedge your long-term focused equity exposure and include a number of low correlating diverse sets of investment risks (stocks, bonds and alternatives – defined as anything other than traditional stock and bond buy and hold). I continue to favor 30% equities (hedged), 30% fixed income (tactically managed) and 40% alternatives.
Ideas include: global macro mutual funds with experienced managers, managed futures funds with experienced managers, currency related mutual funds with experienced managers, tactically trade fixed income (high yield trend, tactical fixed income) and include tactical all asset strategies and other strategies that have the flexibility to position defensively. A mix of a number of diverse low-correlating strategies combined together is a nice way to seek growth yet do so in a diversified defensive way.
Something powerful happens when you combine two or more low correlating strategies together. To better understand this, I wrote a white paper titled “Understanding Correlation and Diversification”. If you are interested in reading it, you can access it here or email us if you’d like to learn more. I hope you find it helpful in your work with your clients.
With kind regards,
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
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