February 6, 2015
By Steve Blumenthal
In ev’ry job that must be done
There is an element of fun
You find the fun and snap!
The job’s a game
And ev’ry task you undertake
Becomes a piece of cake
A lark! A spree! It’s very clear to see that
A Spoonful of sugar helps the medicine go down
The medicine go down-wown
The medicine go down
Just a spoonful of sugar helps the medicine go down
In a most delightful way
With a fine glass of wine in hand and the fireplace lit, last night Susan and I watched Saving Mr. Banks. The story is about Walt Disney (played by Tom Hanks) persuading author P.L. Travers (played by Emma Thompson) to sign over the screen rights to her novel, Mary Poppins. A wonderful story and cleverly delivered.
Globally, deflation seems to be taking hold. “In ev’ry job that must be done, there is an element of fun”. Not sure Greece is feeling the fun, yet, in the bigger picture, Greece is just a small snowflake within a global system of questionable stability.
China’s move this past week caught everyone’s attention and, to me, the announcement is significantly material. As I was watching Saving Mr. Banks, I just couldn’t get the image of Mary Poppins singing “just a spoonful of sugar helps the medicine go down” out of my head. Here comes some more sugar. I know, corny, but hang in there with me.
We could talk about $2 to $5 trillion of emerging market debt issued in U.S. dollars and the crisis a strong dollar presents to that very large trade. There is $232 trillion in total global debt. Desperate to dig out of this hole, the race to debase is on. The global currency wars are heating up as are the risks. There will be consequences but fear not and see the opportunities that will be created.
This week, let’s take a look at what corporate earnings might be telling us and look at two most recent valuation charts. The information can tell us a lot about what future returns will likely be.
Included in this week’s On My Radar:
• Earnings Estimates Sink – Valuations Remain High
• Picking Up Signs of Economic Distress – GaveKal
• Devaluation by China is the Next Great Risk for a Deflationary World – Evans-Pritchard
• Trade Signals – Extreme Pessimism is ST Bullish for Stocks, Trend Positive – 02-4-2015
Earnings Estimates Sink – Valuations Remain High
Last October, Wall Street’s consensus estimate for 2015 earnings was $136.14. That would equate to a gain of nearly 15% in earnings for the year. In November, the estimate dropped to $134. It then dropped to $132.80 in December, $121.30 in January 2015 and $119.80 today. So much for those favorable forward PE estimates. I continue to favor median PE based on actual earnings.
So, as we look next at two market valuation charts, keep in the back of your mind the impact lower earnings will have on an already overvalued equity market. The February estimate of $119.80 will still be a year-over-year earnings gain of almost 5% but it is the speed of lower revision that bears watching.
Valuation Chart #1 is based on Price to Operating Earnings and Valuation Chart #2, a chart I frequently show, is based on Median PE (based on actual reported earnings, it is one of my favorite ways to measure whether the market is overvalued, fairly priced or undervalued).
In the first chart, note the highlighted (yellow) areas. To the right, based on reported data through January 31, 2015, the market is 3.9% away from an “Overvalued”. It is also 18.1% above the “Average Value”. The “Undervalued” target is something we’ll look for in crisis. Near that level the equity market presents great opportunity. Unfortunately, fear will rule reason and very few will be positioned or prepared to act.
Valuation Chart #1
The next chart is based on Median PE. The yellow highlight in the upper left shows the market to be overvalued at 2050.84 and fairly valued at 1535.22.
Valuation Chart #2
Based on Median PE, we are in the highest PE quintile. Meaning, forward 10-year total returns will be low. By this measure, just 4.28% annualized for stocks (yellow line).
The main point to share with your client(s) is that the market is richly priced and the E in PE is coming under pressure. Whether analyst adjustments are due to higher taxes, a strong dollar (hurting multinational businesses), the global problems of excessive debt or all of the above, with valuations high, risk is high and forward return potential is low.
What to do:
With the U.S. market richly priced, I continue to suggest a broader set of risks be included within portfolios. I favor 30-30-40 over 60-40. Overweight tactical, underweight and hedge equities and tactically manage fixed income exposure. The goal is to be in a position to take advantage of a great buying opportunity when it presents (and it will present). We can zero-in on the probable 5, 7 and 10-year forward equity returns (low today) but markets can go higher and become even more overvalued.
If one can buy-and-hold to gain a probable 4.28% in equities and 1.85% in bond (10-year Treasury) gaining a combined 60/40 return of just 3.31% before fees over the next 10 years, then I say go for it. But that is not good enough for me and it doesn’t put me in a position to take advantage that the next correction will create. It is going to get bumpy and even if an investor can stay the path, I don’t see how they will be happy at the end of the ride.
I believe it is better to include a broadly diverse set of risk streams within a portfolio, hedge equity exposure (pretty easy to do), prepare your clients for the bumps so that they will be ready for your call to act (tilt the weights back in favor of equities) when the opportunity presents in the next bear market crisis. Opportunities present in times of crisis. Have a plan in place that enables you to act.
Show your clients the 10-Year S&P 500 Total Returns based on the PE Quintiles (data from 1926-2014). The game plan is to get overweight equities in Quintile’s 1 and 2. In the meantime, seek growth and risk protect.
Next up “weak signs continue to mount”.
Picking Up Signs of Economic Distress In The U.S.
Yes, the U.S. economy is picking up pace. Yes, unemployment is low and yes, inflation remains low. But this means that the Fed will likely make a preemptive move and raising rates are generally not a positive nor will the further strength in the U.S. be good for U.S. large company earnings.
Add trillions in emerging market debt (priced in dollars) to my worry list. If the dollar goes up 20% and EMs have borrowed $5 trillion, they now owe $6 trillion. This is what keeps me up at night. It’s a bit of a “rock and a hard” place for the Fed and our global trading partners.
I ran across the following posted this week on the GaveKal blog. Take a look at how closely the S&P 500 index has historically tracked the economic growth data. We are seeing separation today (a rising stock market and declining data).
Recent U.S. economic data has been disappointing. While perhaps statistical noise, more weak signs continue to mount. Let’s start with the durable goods orders reported recently. The headline stat is a very volatile series because aircraft and/or military orders can be quite lumpy. With that said, there has been a big drop in total durable goods orders in the last six months. Historically, using monthly data, the level of total durable goods orders has an 82% correlation with the S&P 500.
Many remove transportation items from the report to smooth out fluctuations and get a better read on core durable goods orders. We don’t see much of a statistical difference, as the level of non-transport durable goods also has an 82% correlation with the S&P 500.
The Citigroup Economic Surprise Index is a short-hand way to keep track of all economic data. It is calculated as a diffusion index and generally oscillates between -100 and 100. In a different way to look at this indicator, we calculate a moving sum as a proxy for the level of economic activity. The moving sum peaked in February 2014 and has been declining since. In looking back over the last ten years, we’ve never seen such a big divergence in the direction of these two series.
Devaluation by China is the Next Great Risk for a Deflationary World
I totally enjoy the way Ambrose Evans-Pritchard writes. He is an International Business Editor of The Daily Telegraph and has covered world politics and economics for 30 years based in Europe, the U.S. and Latin America. He is deeply connected, understands the capital flows and has a good pulse on what seems to be most important. I also believe he has a really good grasp on probable human behavioral tendencies. I read him frequently and quote him often. Here comes another spooful of sugar from China.
I’ve taken several paragraphs from the piece (highlights are mine).
China is trapped. The Communist authorities have discovered, like the Japanese in the early 1990s and the U.S. in the inter-war years, that they cannot deflate a credit bubble safely.
A year of tight money from the People’s Bank and a $250bn crackdown on shadow banking have pushed the Chinese economy close to a debt-deflation crisis.
Wednesday’s surprise cut in the Reserve Requirement Ratio (RRR) – the main policy tool – comes in the nick of time. Factory gate deflation has reached -3.3pc. The official gauge of manufacturing fell below the “boom-bust” line to 49.8 in January.
Haibin Zhu, from JP Morgan, says the 50-point cut in the RRR from 20pc to 19.5pc injects roughly $100bn into the system.
This will not, in itself, change anything. The average one-year borrowing cost for Chinese companies has risen from zero to 5pc in real terms over the past three years as a result of falling inflation. UBS said the debt-servicing burden for these firms has doubled from 7.5pc to 15pc of GDP.
Yet the cut marks an inflection point. There will undoubtedly be a long series of cuts before China sweats out its hangover from a $26 trillion credit boom. Debt has risen from 100pc to 250pc of GDP in eight years. By comparison, Japan’s credit growth in the cycle preceding its Lost Decade was 50pc of GDP.
The People’s Bank may have to cut all the way to zero in the end – a $4 trillion reserve of emergency oxygen – but to do that is to play the last card.
Here is the meat of Evans-Pritchard’s piece (highlights are mine):
How much of this is new money remains to be seen but there is no doubt that Beijing is blinking. It may be right to do so – given the choice of poisons – yet such a course stores up even greater problems for the future. The China Development Research Council, Li Keqiang’s brain-trust, has been shouting from the rooftops that the country must take its post-debt punishment “as soon possible”.
China is not alone in facing this dilemma as deflation spreads and beggar-thy-neighbor currency wars become the norm. Fifteen central banks have eased monetary policy so far this year.
Denmark’s National Bank has cut rates three times in two weeks to -0.5pc in an effort to defend its euro-peg, the latest casualty of the European Central Bank’s €1.1 trillion quantitative easing. The Swiss central bank has been blown away.
Asia is already in a currency cauldron, eerily like the onset of the 1998 crisis. The Japanese yen has fallen by half against the Chinese yuan since Abenomics burst upon the Pacific Rim. Japanese exporters pocketed the windfall gains of devaluation at first to boost margins. Now they are cutting prices to gain export share, exporting deflation.
China’s yuan is loosely pegged to a rocketing US dollar. Its trade-weighted exchange rate has jumped 10pc since July. This is eroding the wafer-thin profit margins of Chinese companies and tightening monetary conditions into the downturn.
David Woo, from Bank of America, says Beijing may be forced to join the currency wars to defend itself, even though this variant of the “Prisoner’s Dilemma” leaves everybody worse off. “We view a meaningful yuan devaluation as a major tail-risk for the global economy,” said.
If this were to happen, it would send a deflationary impulse worldwide. China spent $5 trillion on fixed investment last year, more than Europe and America combined, increasing its overcapacity in everything from shipping to steels, chemicals and solar panels, to even more unmanageable levels.
A yuan devaluation would dump this on everybody else. It would come at a moment when Europe is already in deflation at -0.6pc and when Britain and the U.S. are fast exhausting their inflation buffers as well.
Such a shock would be extremely hard to combat. Interest rates are already zero across the developed world. Five-year bond yields are negative in six European countries. The 10-year Bund has dropped to 0.31. These are no longer just 14th century lows. They are unprecedented.
My own guess is that we would have to tear up the script and start printing money to build roads, pay salaries and fund a vast New Deal. This form of helicopter money, or “fiscal dominance”, may be dangerous, but not nearly as dangerous as the alternative.
China faces a Morton’s Fork. Li Keqiang has made it his life’s mission to stop his country drifting into the middle income trap. He says himself that the investment-led model of past 30 years is obsolete. The low-hanging fruit of catch-up growth has been picked.
For two years he has been trying to tame the state’s industrial behemoths, and trying to wean the economy off credit. Yet virtuous intent has run into cold reality. It cannot be done. China passed the point of no return five years ago.
Here is the link to the full article.
A spoonful of sugar helps the medicine go down – though I’m not sure how much sugar is left in the global bag of tricks. The imbalances are unprecedented.
Trade Signals – Extreme Pessimism (ST Bullish for Stocks), Trend Remains Positive – 02-4-2015
My college soccer coach used to always teach us that “soccer is a game of opposites”. Fake left to move right. That part everyone knows. Where it got complicated (and frustrating for a coach) was tactical positioning in response to the ongoing activity in the game. We respond to patterns and to be successful, movement often needed to be opposite of what at first seemed logical. Such response opened space and created opportunity.
I think many of the rules to successful investing appear opposite of what one might think at first glance. “Buy when everyone else is selling” is a pretty good “opposite” rule to follow. Simply, we should be wary at crowd extremes.
The bull market is aged, valuations are high and both daily and weekly investor sentiment are neutral. This week I post a special chart that measures consumer comfort (here, too, the evidence says to be cautious – hedged).
- Note that when consumers are “Excessively Optimistic” the annual gain for the S&P 500 Index is a negative 0.90% (orange arrow).
- When “Extreme Pessimism,” the S&P 500 gains 12.3% per annum. Evidence that investing is indeed a game of opposites.
As you see in the following chart, we sit at the highest level of optimism dating back to 1986 (yellow circle).
Special Chart #1 – Bloomberg Consumer Comfort Index and the S&P 500 Index
Another concern is that investors are largely all in on equities. We may see a pickup in foreign flows as well as some additional buying from the creative global central bankers; however, in special chart #2, the evidence is not bullish when investors are fully invested in equities. Investors are just 3% away from the equity ownership highs reached in 2000 and 2007 (top clip in blue). Also concerning is the record low level of cash (bottom clip in red).
Special Chart #2 – Bloomberg Consumer Comfort Index and the S&P 500 Index
Included in this week’s Trade Signals (the usual weekly charts):
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains
- Volume Demand Continues to Better Volume Supply – Remains Bullish for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Neutral Optimism (short-term neutral for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term bullish for stocks)
- The Zweig Bond Model: The Cyclical Trend for Bonds Remains Bullish
Click here for the full piece.
A spoonful of more snow is on the way to the Northeast late this weekend and into next week. Fortunately for me, Florida is up next. I’m visiting Ned Davis Research early next week – hopefully I’m able to squeeze in a round of golf. Later in February, my management team and I, along with good friend and business coach Jim Ruff are meeting in Park City, Utah for our quarterly meeting. This off-site trip is one of the many things Jim encouraged us to implement to get away from distractions and set focus on the most important firm priorities. Park City is within driving range for Jim. It is so helpful to have him sit with us and share his wisdom.
Jim was president of Oppenheimer Funds and has been such a great help over the years. I’m looking forward to skiing with him and his wife Nancy.
I wonder if Jim truly knows the impact he has had on my life and the lives of our CMG family. I tell him so but he is too beautifully humble to hear. I remember him saying to me once, “you just don’t know what you don’t know… I’ll help teach you”. Imagine having a Jack Welch to lean on and learn from. I am so grateful. I really had no idea how much I didn’t know. I sit excited to learn more.
Dallas, then Arkansas and New York follow in early March and I think I’m going to try to get to John Mauldin’s late April conference this year. The lineup of speakers looks outstanding. Envestnet’s Chicago conference is coming up in early May and we’ll be sending the team. Let me know if you’ll be attending.
I’m having great fun and I hope you are as well. Wishing you the very best.
Have a great weekend.
With kind regards,
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
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