January 31, 2020
By Steve Blumenthal
“The US economy has experienced its slowest recovery from a recession in the post-World War II era,
and the longer it lasts the more evidence there is that normal cyclical patterns are missing.
And their absence means market participants shouldn’t rely on them to divine the economy’s future.”
– A. Gary Shilling (January 3, 2020)
I joined the call ten minutes late. I hadn’t been in a rush—I thought I was just going to listen in on a webinar led by the great Dr. A. Gary Shilling. But I was surprised to find that on the line was a small group of institutional investment managers having a private Q&A with Gary. If you are not familiar with Gary, he is founder and president of A. Gary Shilling & Co., Inc., an economic consultant, and publisher of INSIGHT, a monthly newsletter on the economy and investment strategy. For more than twenty years, Gary has been focused on deflation. In 1999, he wrote Deflation: How to Survive and Thrive in the Coming Wave of Deflation. And in 2010, he wrote The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. Gary is balanced, smart, and has a strong feel for what is going on.
The call was hosted by J.P. Morgan’s Wade Barnett. After the call, Wade and I spoke. We talked about what a young CFA, you, or we can learn from someone like Gary. Wade said, “It’s his experience. Gary has a feel for blending art and science. He’s a down-to-earth sage.” Sage indeed. #Experience. Can’t get that from a book.
Twenty-plus years of deflation. That’s been Gary’s major theme. And he argues that deflation continues to dominate. What does that mean in terms of the direction of interest rates and global risk assets? Today, we’ll take a look. Here you’ll find my bullet-point notes from the call, along with my thoughts and a few helpful charts.
Coffee in hand? Let’s go.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- A. Gary Shilling — Inflation or Deflation? Deflation is Winning
- What Price Tells Us — A Look at Interest Rates
- Trade Signals – Low Cash, High Margin Debt
- Personal Note – “It’s been here the whole time.”
Bullet-point notes from January 28, 2020 conference call:
A. Gary Shilling – Where we are today:
- We still have weakness in every aspect of the economy, except for the consumer. It is the only sector of the economy holding up.
- Since it is two-thirds of US GDP, it is important. No current sign of recession.
- But there is a great divide between income and assets in this country. Those at the top are in good shape; those at the bottom are not. There is polarization between the haves and have-nots. This has been going on for some time, but it has accelerated in the last decade.
- It’s one thing if your share of the overall pie is decreasing; it’s quite another if your purchasing power is decreasing—and that’s what is happening. A lot of this is due to globalization and the shift to low-cost manufacturing in other countries.
- Debts remain large, incomes are not growing, purchasing power decreases, and frustrations grow. These factors are what helped get Trump elected in 2016. They’re certainly what he is playing to this year. The same dynamics are responsible for BREXIT… voters don’t think the moderate politicians are delivering the goods. So they are going to the extremes on the left and the right. Since a reverse in globalization—and its impact on incomes—isn’t in the cards, the trend will probably continue unless we build a tariff wall around the country.
- As such, while the people at the top are in a good position (and able to buy houses, cars, etc.), 90% of people are struggling and that will continue to be the case.
- Consumer debt has been worked down to some extent, but not down to normal. If you look at consumer debt vs. after-tax income, we’re a long ways away from normal.
- The consumer remains the key piece to watch in terms of the US economy.
[SB here: This chart from Ned Davis Research (NDR) shows debt has come down since 2010 but not enough (still high, which has an impact on one’s overall ability to spend and slows overall growth):]
- Auto loans and student debt are troubling.
- Gary noted that when he wrote The Age of Deleveraging ten years ago he thought the process of deleveraging would be over by now. It isn’t. It’s frustrating because you would have expected it to clear.
- At the moment, the US economy and many other economies are plodding along—they’re not experiencing great growth, but they’re not collapsing either. The US has been the strongest of the major economies, but that isn’t saying much.
- Gary doesn’t see anything right now that will put us in recession and he noted he’s made a career out of accurately predicting recessions: He spotted the dot-com bubble in the late-1990s and the subprime problem prior to the last great recession/financial crisis in 2008.
- He mentioned this because he doesn’t see anything on the horizon that rivals those last two, though he noted that you can always point to something.
[SB here again: I disagree. The misbehavior in the corporate debt market, especially high yield and the corresponding 5,000-year low in interest rates are the “mother of all bubbles.” Yet, I am in the Shilling, Rosenberg, and Hunt camp: we believe interest rates on Treasury bonds are heading lower. So, we likely have more run in the bond bull market run.]
- The Fed is on hold for now. They raised rates, got scared, backed off, and then cut rates.
- They are worried about deflation. It’s what happened in Japan for thirty years. The Fed wants higher inflation as a cushion against deflation. Not happening and they don’t know how to do it.
- We are living in a world of excess capacity and excess supply. You can’t create inflation until excess capacity and excess supply go away. And they exist in pretty much everything, everywhere. If you take Western technology and apply inexpensive Asian labor to it, then you keep prices down. Globalization/more competition means you have more capacity and a greater supply of things. No inflation. And it’s happening with services too. So you have a surplus world and it’s very hard for central bankers to deal with that.
- The Fed and other central banks are pushing on a string. They talk a brave game, but there isn’t much they can do to grow economies. Gary thinks they are recognizing we are in a deflationary world.
- As for the markets: stocks continue to grind higher. They are very expensive and continue to get more expensive. Trees don’t grow to the sky, so sooner or later something is going to happen. He doesn’t see it immediately in front of us, but you don’t know. Things are so expensive you’ve got to be careful.
- Deflation has been very favorable to long-term Treasury bond prices (lower rates means high bond market price gains). He sees no reason why that isn’t going to continue in this ongoing deflationary world.
- Low interest rates are supportive of higher stock prices, but stocks are very expensive so be careful.
- That’s how he looks at the world. No major changes to his views from six months ago. He added, you can always conjure up some kind of crisis but he doesn’t see anything major that will upset the apple cart.
- Poor savings by Baby Boomers is a real problem. We haven’t seen it pick up on a widespread basis. He does think this will pick up.
[SB here: The aging demographics in the US and developed world markets and under-saving in the US are additional deflationary pressures. The Fed won’t be able to change this dynamic. I believe inflation arrives when fiscal authorities reset the debt system, create massive infrastructure spend, and bail out the pension systems. Not going to happen soon.]
- Direction of interest rates and thoughts on inflation: Inflation is low and is going to get lower, especially when we get the next recession—and there is one out there waiting for us somewhere. The biggest driver of interest rates is inflation. Gary has looked at this since the post-war period. The correlation between inflation and Treasury bond yields is 60% and that’s a big ratio. The primary factor in determining rates is inflation.
- If you have a good handle on inflation, you have a good handle on long-term interest rates. This suggests even lower long-term rates.
- The short-term rates are dominated by the Fed. The Fed is in no mind to raise rates. The Fed is on hold, so short-term rates are likely to stay where they are now. The Fed does not want to go below zero. They have learned from Japan and the ECB. Those policies have exactly the opposite effect than what they anticipated. Since returns are lower, people save even more and spend less, so central bankers are not getting the growth they hoped for…
- Long-term rates are going to continue to decline, short-term rates are going to stay where they are until we get into a recession – then short-term rates will come down even more.
That concludes my bullet-point notes. A heartfelt thank you to JP Morgan and good friend Wade Barnett.
In the what-you-can-do category, let’s take a look at two key interest rate models.
I’ve found over the years that my fundamental view is not right all the time (that goes for everyone’s views, by the way). So, I like to combine my fundamental thinking with the cold, hard truth of what price is telling us.
Say I’m right 80% of the time. For example, I think interest rates are heading lower (deflation, demographics, etc.). What do I do when I’m wrong, how do I know, how do I shift my fixed income exposures? This is why I look to price. It tells me not what I think might happen but what is actually happening. In December 2016, twenty-five out of twenty-five Wall Street analysts said interest rates on the 10-year Treasury were going to go higher, from 2.75% to 3.25% on average. Some thought it might be 3.50%. None predicted less than 3%. Rates finished the year at 2.25%. They missed one of the best bond performing years in some time. What does one do?
I too felt rates would rise that year. My fundamental view was wrong, but the way I traded bonds was right. My go-to then was the Zweig Bond Model and it remains my go-to today. That’s because it has a high-probability win rate and a process that allows me to adapt. Bottom line: look at what price is telling you. No model is perfect. Nor is following your fundamental research. It just isn’t. You need to find a high-probability process you have confidence in and then stick to it. If yours is your gut and your gut has a high-probability win rate—and your ego doesn’t always need to be right—use it. I like price.
Chart 1: The Zweig Bond Model
I post this chart every week in Trade Signals. First, the rules. This is a price-based model that looks at both the movement in price and the movement in yields. Each of the five indicators is measured and the overall signal is based on the total model score. Each indicator gets a +1 or -1 score. Max score is +5 or -5. (I’ve enlarged the upper left-hand section of the chart for you and included it below):
Here is a look at the model:
- Note the middle section. It tallies the five rules. Each gets a point. When the total points are above zero, the model is on a buy signal (signaling lower interest rates and higher bond prices).
- The current signal is highlighted in yellow in the lower right-hand side data box.
- The model’s hypothetical performance results are in the lower left-hand side data box. Note the GPA% comparisons, time spent (% New Highs), and Max DD % (drawdown).
- Results are hypothetical. The model was created in the mid-1980s.
Chart 2: Here is a look at the same chart showing drawdown comparisons (drawdowns are the periods of loss):
- The middle section details drawdown of the model (blue line) vs. the Barclays Aggregate Total Return Index
- Focus in on the 1970’s. That was an inflationary period with rising rates. Need to limit drawdowns in rising rate cycles.
One last note on the Zweig Bond Model. It is equally informative in trading Treasury bonds as it is trading the Barclays Aggregate Bond Index. ZBM remains my go-to.
Moody’s Baa Bond Yield Momentum
New to my line-up of indicators is a process that measures the rate of change in the yield on Baa-rated corporate bonds.
Here’s the process:
- The 26-week rate of change in Baa bond yields is plotted.
- Data is sorted into three categories: Bond yields rising, bond yields falling and bonds yields neutral zone.
- Returns of the Value Line (Geometric) Index are best when the rate of change in rates is falling.
Pending approval from NDR to share the Chart. Here’s the data: When the rate of change is above a certain threshold, “rising yields,” returns for the Value Line Index (data 1965 to 1-24-2020) were a negative 10.24% annualized. Rates were in the “rising” zone 23.66% of the time. When in the neutral zone, returns were 0.47% and that happened 39.56% of the time. When in the “yields falling” zone, annualized returns were 15.19%. That happened about 36.78% of the time. Returns are best when yields are in the “yields falling” zone.
The current regime is “bond yields falling.” What we want to keep our eye on is a change in trend to rising interest rates. All risk assets are priced off the discount rate and when rates rise, risk assets come under pressure. Right now, the signal is “Yields Falling,” but coming off a near-record low and nearing “neutral.” Let’s keep watch.
I shared this next chart with you last week. It shows what happens to bonds when rates rise and fall.
January 29, 2020
S&P 500 Index — 3,276
Notable this week:
Two notable signal changes since last week’s post. The high yield signal moved to a sell from a buy. Additionally, the Ned Davis Research Daily Trading Sentiment Composite declined to 62.22 from 83.33, indicating that investors are slightly less bullish at this time. The indicator is designed to highlight short-term swings in investor psychology. You’ll find the dashboard of indicators below.
Thought you’d find the chart interesting (I did). It looks at Investor Cash and Investor Margin Debt. When cash is high and margin debt is low, investors have more available money to put to work. More buyers than sellers, prices rise. The opposite is also true. What is notable in the chart is investor behavior. Look how aggressively investors were positioned (low cash/high margin debt) in 2000. And look how that flipped to high cash/low margin in 2001-2002. Then scan forward to 2007 (low cash/high margin debt) and then scan to the panic of 2008-2009 (record high cash/low margin debt). The take-away here is that investors currently have “Low Cash/High Debt” and the number reached a record low just prior to the Q4 2018 sell-off. It remains low. Lights on!
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“Be willing to sacrifice anything, but compromise nothing in your quest to be the best.”
– Kobe Bryant
I met Wade Barnett when our daughters were in preschool and a lifelong friendship was born—for both dads and daughters. Funny how that works out. Wade and I talk frequently, debate the markets, discuss our children, and golf together whenever we can. Wade’s been a Dr. Shilling fan for years and I too like to follow Gary. If you’ve seen me post pictures of Stonewall, it is because of Wade that I joined. We have a standing bet. A win and I put the cash in a safe spot. And the wins do feel good. A loss and that cash goes back to Wade. In the end, it’s back and forth. While the bet is about short-term bragging rights; the real win is a lifelong friendship.
The Inside ETFs conference was productive. I intended to share some thoughts with you today, but we’ll bump that to next week. It’s a crazy pace and the biggest benefit is the networking and relationship building. The dinners were outstanding as was the red wine. I landed home late afternoon on Wednesday, passed out on the couch at 7 pm, and slept for 11 hours.
On a golf course in Florida, we heard the news about Kobe, his daughter, and their friends. Numbing. I followed Kobe since he was in high school. One of the kids on my Lower Merion Soccer Club team was also the point guard for the Lower Merion High School basketball team. Kobe, of course, led that team to a state championship. Kobe was in the gym every morning at 5:30 am working on his moves. He did it all year-round. He had the heart and the determination to seek his dreams. He did it in sport, he did it in business, and he did it with family. And he left a legend.
Bryant was one of the greatest NBA players of all time, and an icon in the sports world. In addition to his success on the basketball court, Bryant was known for a ceaseless work ethic and incredible drive. A great loss. Our hearts go out to everyone he touched, especially his “queen” (as he called his wife) and their surviving daughters.
My Brianna sent me the above quote and a selfie of the two of us on the beach early Wednesday morning. She told me that fathers are honoring Kobe and his beautiful daughter Gianna with the hashtag #GIRLDAD. Here’s mine:
It’s tough to hold back the tears.
Brianna sent me a link to some Kobe quotes. This one in particular resonated with me:
“When you make a choice and say, ‘Come hell or high water, I am going to be this,’ then you should not be surprised when you are that. It should not be something that is intoxicating or out of character because you have seen this moment for so long that … when that moment comes, of course it is here because it has been here the whole time, because it has been [in your mind] the whole time.”
“You have seen this moment for so long…” I thought about that on my drive to Penn State to watch son Kyle perform in a play. He’s a sophomore Theater and Arts Entrepreneurship student at Penn State. The show was titled, Two Years Later. It was about the death of a student, a mother’s loss, and her struggle to move on. It was written and directed by one of the seniors. We were pulled into the story and emotionally blown away. “Because it has been here the whole time, because it has been [in your mind] the whole time.”
Go hard, be crystal clear in your mind as to what you wish to achieve, then do the work… trust, let go, and do the work… and don’t be surprised when you achieve. “It’s been here the whole time.” Love that! Ever forward…
Here are a few more shots from the Inside ETFs conference (along with a link to the Nasdaq interview):
Talking about ETFs, markets, etc. with Nasdaq’s Jill Malandrino. Click here or on the photo above for the short interview.
Florida sunrise – pretty great.
VanEck dinner. Pre-wine and food. Look at all those wine glasses… A fun and engaging night.
And this guy was fantastic to listen too:
I’m rushing to get this to my editing team and then hitting the road for the two-and-a-half-hour ride home. If you haven’t done so in a while, reach out to a good friend. Grab a cold beer, talk, debate, and set a side wager that enables you to poke a little fun at each other. The victory of friendship is the win. And hug your sons. And hug your daughters.
Make the call!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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