On My Radar: We Didn’t Start The Fire
August 28, 2015 By Steve Blumenthal
Harry Truman, Doris Day, Red China, Johnnie Ray South Pacific, Walter Winchell, Joe DiMaggio Joe McCarthy, Richard Nixon, Studebaker, television North Korea, South Korea, Marilyn Monroe…
We didn’t start the fire It was always burning Since the world’s been turning We didn’t start the fire No we didn’t light it But we tried to fight it
– We Didn’t Start the Fire, song by Billy Joel
Another tune stuck in my head. What a week! A whisper of hope from the Fed and bam… all is a bit better in the world again. All ‘bout that Fed.
Consider This Past Week a Portfolio Stress Test
What do we do? That’s a question we fielded regularly this past week as nervous advisors and their clients wondered if we were heading off a cliff.
Volatility, as measured by the VIX, hit a seven-year high this week. The Dow plunged 1,000 points at one point and seesawed back in a matter of hours. The big story, of course, is China. To start the week, China’s “Black Monday” sent its stock market down 8.50%, its biggest drop since 2007. At the end of the week, it was a much different story. As Reuters reports today:
“China stocks jumped more than 4 percent for a second straight day on Friday as signs of fresh support from Beijing prompted more bargain hunting following the earlier plunge that panicked global markets.”
Adding to the confusion, is the seemingly never-ending drama with The Fed. Will they or won’t they? And if they do finally raise rates, what impact will it have on the economy and investing?
Some of the Wall Street pundits say “buy the dips” – stocks that looked attractive a couple of weeks ago look like bargains now. The fact is that valuations remain far from attractive. Some say “do nothing,” which is the last thing an investor wants to hear as an apparent train wreck approaches. We think it is time to “sell the rallies”. The fundamental evidence (valuations, growth, profit margins) and now the technical evidence both look weak.
Our view from a technical perspective is that this jolt to the equity market is the first shock and marks the beginning of a new cyclical bear market. Some have noted the famous “death cross” where the S&P 500 Index’s 50-day moving average crossed below its 200-day moving average. Generally a negative for the equity markets. Technicians feel that weekly data is generally more reliable than daily data and here too the trend evidence is concerning.
As noted in the next chart, the 13-week moving average on the S&P 500 Index dropped below the longer-term 34-week trend.
Not perfect but concerning. The point is that we should be more aggressive when the cyclical trend is bullish and less aggressive when the cyclical trend is bearish. Buy the dips becomes sell the rallies. This week’s late bounce has provided a good opportunity to do just that.
Janet Yellen, Xi Jinping, Mario Draghi, QE4 we pray Margin debt, Market stress, China selling, Oil mess Kim Jong-un, South Korea, QE4, Deflation on foreign shores PE’s high, Earnings Miss, Look around – what is this We didn’t start the fire, No we didn’t light it, but we tried to fight it!
I’ve been writing for a couple of months that we are likely in a global recession. The global sovereign debt crisis is getting worse and will further depreciate global economies. Deflation is winning. Unmanageable debt is becoming obvious to most. Greece and Puerto Rico are front page today but following them will be some bigger names: Spain, Portugal, France and others.
We have borrowed from the future and that future is today. Famed hedge fund manager, Ray Dalio surprised Wall Street this week predicting the next move by the Fed will be to ease via a new QE4.
This from Dalio:
“We are not saying that we don’t believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening,” he said in an updated post on his LinkedIn account.”
“To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE,” he wrote. (Source: www.marketwatch.com)
The fact is that the U.S. bull market has run practically unabated for nearly six years. The market is over-valued, aged and due for a major correction. A decline of 10% is easy to overcome. A decline of 20% requires a 25% recovery to get back to even. It is the 40% to 50% declines that keep you from reaching your goals. Overcoming -50% takes a subsequent 100% gain. Such declines happen in recessions so it is that we must defend our portfolios against.
We believe that we are seeing the beginning stages of a bear market in the U.S. This is a good time to get reacquainted with the merciless mathematics of loss. We created a two page educational piece that advisors can share with their clients about how merciless a big loss can be to a portfolio. If you’d like a copy, email us at [email protected] and we’ll send it to you right away.
It’s a little-known but startling fact: The average buy-and-hold stock market investor spends 74% of his or her time recovering from cyclical downturns in the market (from 1900 – May 2015), according to Ned Davis Research.
Advisors manage portfolios to achieve desired needs. Nearly 75% of investable assets in the U.S. will be in the hands of pre-retirees and retirees by 2020 (research from Blackrock). That is a lot of money that lacks the time needed to overcome a 40+% decline. Just hang on? That works well when you have a 30-year investment runway. It doesn’t work for the ageing baby boomer with a portfolio needing to generate a monthly income. Time to recover? The runway is shorter. Just hang on… There exists a different need.
So, back to the original question – what do we do? I can tell you what we’ve been doing. With risk elevated, we’ve been hedging our equity exposure and raising cash. We believe we are now in a “sell the rallies” environment. We are tactically managing our fixed income exposure and we have a large weighting to alternatives (defined as anything other than not traditional buy-and-hold). We favor tactical strategies that have the ability to get defensive. From our perspective, liquid strategies are best.
Further, we believe there is something beautiful that happens when you combine a number of low correlating risks together within a portfolio. We believe portfolios can be built to achieve a desired return relative to an acceptable level of risk.
We favor a rules based investment process that determines how much money to allocate to equities, fixed income and alternatives. If equities are hedged and a -40% happens, the opportunity to invest is much better as forward returns will be higher. 30% equities (hedged), 30% fixed income (tactically managed) and 40% alternatives may then be switched to 60% equities (un-hedged), 20% fixed income and 20% alternatives.
Ironically, there is much less risk investing in equities after corrections; though clients don’t generally feel that way at such times. Many investors tend to buy and sell at the wrong times. Unfortunately, the evidence of such behavior is well documented.
Ultimately, it is about developing a game plan and sticking to a process. Fortunately for all of us, there are many liquid investment tools (mutual funds and ETFs) at our disposal.
These periods of heightened volatility and uncertainty act as portfolio stress tests. We have parameters for our strategies based on underlying fundamentals and technical indicators. We adjust accordingly as the market indicates. Investing is about taking risks. By including allocations to a broad set of different risks, we can better control and protect our capital.
Investors should have the same discipline. Have a plan that acknowledges the realities of our financial system – bear markets and recessions happen. They are built into the system. What goes up will come down. This market has been going up for a long stretch. When it drops, it can be precipitous and can wipe out most of your gains. Depending on where you are in your life cycle, that can be catastrophic. Many people don’t have 15+ years to recover from the kind of market wipeout we experienced in 2000 and again in 2008.
Ultimately, success in investing is not measured by how much you gain in a bull market but how much you avoid losing when the tide turns. Absent another QE “hail Mary” from the Fed, the tide may be turning. Dalio thinks we get one. Put me in that camp. Absent structural reform in the form of trillions in infrastructural rebuild and/or a major tax cut, the tide may be turning. Another QE, from my view, is in the cards. I hold less hope in structural reform. Unfortunately, we’ll need another crisis to goose our leaders in that direction.
Risk is high. For equity exposure, hedge or raise cash on rallies and let your tactical and alternative strategies follow their processes. Put in place the processes. Now is the time.
Included in this week’s On My Radar:
- Dalio on QE4
- Oil Price and HY Defaults
- Trade Signals – Weight of Evidence “SELL”, Hedge and Raise Cash on Rallies – 08-26-2015
Dalio on QE4
Dalio shared the table below which showed that the average tightening over the past 100 years was 4.4% and pointed out that the smallest was 0.5% in 1936, the same year that the U.S. was undergoing a deleveraging of the long-term debt cycle.
Here is the link to the Market Watch article.
Oil Price and HY Defaults
$40 oil is a big concern. $30 dollar oil is an even bigger concern. If you are interested in some of the implications, I share several notes in this section.
According to BMI Research cited by Bloomberg, there is:
- $72 billion in oil-related debt maturing this year,
- $85 billion in 2016 and $129 billion in 2017, and a total of
- $550 billion in bonds and loans through 2020
This is a problem because while paying annual interest is one thing and easily manageable, rolling over debt when it is yielding over 10% – as is the case for over 168 global companies, or triple last year’s number – is virtually impossible. It is an even bigger problem when considering the recent surge in energy company net debt/EBITDA (shown below in red) which has recently hit an all-time high, surpassing the oil sector crisis of 1999, dragging energy sector credit risk and spreads with it to all-time highs.
Crude hit a low of $38.50 and rallied to $42.56 yesterday.
From Bloomberg, some earnings metrics are already breaching the lows of the 2008 financial crisis. The profit margin for the 108-member MSCI World Energy Sector Index, which includes Exxon Mobil Corp. and Chevron Corp., is the lowest since at least 1995, the earliest for when data is available.
Source: Oil Industry Needs Half a Trillion Dollars to Endure Price Slump
The drop in the price of oil from approximately $110 a barrel to $40 is a 64% drop. That’s an extreme move that has only happened three times in the past 70 years.
$40 dollar oil is one thing but even at $60 the damage to junk bonds and a lot of other markets can be significant. According to Jim Rickards, $60 is the number that a lot of industry insiders believe the price of oil will gravitate towards.
When I look at the various systemic risks, I’ve noted: sovereign debt, emerging market debt and a coming pension crisis but oil is another potential trigger. Since I’m a high yield junk bond guy, oil is on my radar.
There have been trillions spent of exploration, drilling and infrastructure. Think of the fracking sector. As noted above, $72 billion in oil-related debt maturing this year, $85 billion in 2016 and $129 billion in 2017. Forget $40 oil, even $60 oil is a problem.
So the question with this potential systemic risk is who holds the risk? The easy answer is the high yield bond investor who bought the bonds but it may be your bank, a foreign bank, an ETF, a hedge fund, etc.
In a private research letter, Rickard’s explained it this way:
The Problem, Explained…
Suppose I’m an oil exploration company. Let’s say I borrowed a couple of hundred million dollars to drill for oil using fracking technology. The bank — the lender, bond investor or whoever — says: “Well, Jim, you just borrowed $200 million. How are you going to pay me back?”
And I’d say: “Well, I’m going to sell my oil at $80 a barrel.”
To which the bank says: “How do I know that’s true?”
So, I go to Morgan Stanley, JP Morgan or Citibank and I buy what’s called a “swap contract.” It’s a kind of derivative. Citibank basically agrees to pay me the difference between $80 and the actual price of oil. If oil goes to $50 and I have a swap contract with Citibank that guarantees me $80, they have to pay me the $30 difference. That way, I’ve locked in the $80 price.
That’s not a free lunch. Oil producers give away the upside. If crude prices go to $150, they might have to pay the lenders the difference. But oil companies try to protect their downside.
Oil companies are protected because when oil goes to $50, they can call up the bank and say: “Hey, bank, send me the other $30 a barrel because we have a deal.”
In that case, the bank will have to send it to them. Through the derivative contract the loss now moves over to the bank. It’s not the oil company that suffers the loss. This is the case with the global financial system today — you never know where the risks end up. So the first iteration is that some of the oil companies — not all of them — have shifted their risk over to the banks by doing these derivative contracts.
You might be saying to yourself: “Aha, so the banks are going to have all the losses.” Not necessarily. The banks are just middlemen. They might have written that guarantee to an oil company and have to pay the $30 difference in my example.
But the bank may have also gone out and sold the contract to somebody else. Then it’s somebody else’s responsibility to pay the oil company. Who could that somebody else be? It could be an ETF — and that ETF could be in your portfolio. This is where it gets scary because the risk just keeps getting moved around broken up into little pieces.
Citibank, for example, might write $5 billion of these derivatives contracts to many different oil producers. But then, they may take that $5 billion in contracts and break it into thousands of smaller contracts or $10 million chunks and spread that risk around to many different junk bond funds, ETFs or other smaller banks.
When many oil producers went for loans, the industry’s models showed oil prices between $80 and $150. $80 is the low end for maybe the most efficient projects, and $150 is, of course, the high end.
But no oil company went out and borrowed money on the assumption that they could make money at $50 a barrel. So suddenly, there’s a bunch of debt out there that producers will not be able to pay back with the money they make at $50 a barrel. That means those debts will need to be written off. How much? That’s a little bit more speculative.
I think maybe 50% of it has to be written off. But let’s be conservative and assume only 20% will be written off. That’s a trillion dollars of losses that have not been absorbed or been priced into the market.
Go back to 2007. The total amount of subprime and Alt-A loans was about $1 trillion. The losses in that sector ticked well above 20%. There, you had a $1 trillion market with $200 billion of losses.
Here we’re talking about a $5 trillion market with $1 trillion of losses from unpaid debt — not counting derivatives. This fiasco is bigger than the subprime crisis that took down the economy in 2007.
I’m not saying we’re going to have another panic of that magnitude tomorrow; I’m just trying to make the point that the losses are already out there. Even at $60 per barrel the losses are significantly larger than the subprime meltdown of 2007. We’re looking at a disaster. On top of those bad loans, there are derivatives.
Right now, some of the producers are shrugging, saying: “We went out and borrowed all this money on the assumption of $80, $90, $100 oil. But we also sold our oil production forward for a few years at $90 so we’re fine.”
That’s not true in every case, but it is true in many cases. The problem with derivatives, however, is that you don’t know where the risk ends up. I don’t know where it is, the Federal Reserve doesn’t know where it is and neither do the bank regulators. The banks might know their piece of it, but they don’t know the whole picture.
That means we have to keep digging and digging. The losses out there are larger, potentially, than the subprime crisis. The losses could actually be bigger than the sector’s borrowings because you can create derivatives out of thin air. Even scarier, they could be in your portfolios, too.
Jim is a friend and I like the way he thinks. I’m a subscriber to his letter. I am not compensated in anyway by Jim or any of his affiliates. Aggressive investors can learn more about the Jim Rickards’ Strategic Intelligence service here.
Trade Signals – Weight of Evidence “SELL”, Hedge and/or Raise Cash on Rallies – 08-26-2015
Investor pessimism has reached extreme levels – expect a bounce. That’s the positive news. If you are not hedging your equity exposure, then it may make sense to raise cash on the coming rally. Use rallies to raise cash.
Find a process that works for you and stick to it. I favor a weight of evidence approach and the current evidence continues to signal that risk is high and equity exposure should be hedged. We believe that the best portfolios incorporate a broad set of diverse risks that include long-term exposure to stocks. Risk is high.
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: Sell Signal
- CMG NDR Large Cap Momentum Index: Sell signal
- 13/34 Week EMA on the S&P 500 Index: Sell signal
- NDR Big Mo: Remains in a Buy Signal
- Volume Demand is greater than Volume Supply: Sell signalfor Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullishfor stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullishfor stocks)
- Don’t Fight the Tape or the Fed: Neutral signal
- U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Signaling No Recession
- The Zweig Bond Model: The Cyclical Trend for Bonds is Bullish
Click here for the link to all of the charts.
Concluding thoughts
Signaling the Fed’s next non-move: Speaking on the New York-area economy Wednesday, William Dudley said that when asked about the potential impact of Fed policy due to the recent stock market volatility, “From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago.”
If the Fed raises rates next week. Look out. I remain of the view that they will not raise rates in 2015.
With kind regards,
Steve
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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