August 17, 2018
By Steve Blumenthal
“The deflationary period we’ve been in has come to an end.”
– Louis-Vincent Gave, Founding Partner & CEO, Gavekal Research
Last March, I shared with you GaveKal Research’s “Four Quadrants Framework.” Louis-Vincent Gave presented at the March 2018 Mauldin Strategic Investment Conference and suggested that we may be in the early stages of a shift towards inflation, which tend to occur every 30-40 years and are usually caused by policy mistakes.
We are seeing rumblings of inflation in the U.S. and history suggests that we should probably expect some “policy mistakes” to come from politicians and central bankers.
So catching my eye this week was a post from Louis and his firm’s “Four Quadrants Framework” and it reminded me of the presentation he gave at the Mauldin 2018 Strategic Investment Conference. I posted a summary of it here. You can take that deeper dive if you wish; however, I’ll get to the point: What does this mean for you?
The following chart looks at the performance of four different asset classes: stocks, bond, cash and gold. Simply, asset classes do better or worse depending on the macroeconomic regime. First, let’s look at two different periods: First, on the left, the “Disinflationary Boom” from 1980 until today and, on the right, the “Inflationary Boom” from 1965 to 1980.
Here’s how to read the chart:
- Left side (Disinflation): Bonds (black line) gained most, followed by stocks (red line), cash (light blue line) and gold was the worst performer.
- Right side (Inflation): Gold gained most, followed by cash, stocks and long-dated US government bonds were the worst performer.
As you can see, the charts show very different outcomes. I think it is important to remember that these are long trends and it is not so clear exactly where we sit. Few people wanted to own bonds or stocks in the early to mid-1980’s. It was all about gold, real estate and oil – the “Inflationary Boom” winners. And if you were to a look at today’s asset allocation statistics, the majority are overweight stocks and bonds and underweight cash, commodities and gold.
At last March’s conference, Louis shared the next chart — the “Four Quadrants Framework.”
Here’s how to read the chart:
- The light blue circle highlights the current “Disinflationary Boom” regime. Stocks and bonds do best.
- Louis noted that, “This is the natural state of capitalism.”
- Also take a look at the other three regimes. For example: note the “Buy: Cash in safest currency” and “Sell: Financial assets” in the “Inflationary Bust” regime upper left hand quadrant…
- You can see the other “Buy” and “Sell” asset class recommendations by quadrant.
- Also, note the red arrow: “shifts occur every 30-40 years.” “Policy mistakes.”
- The last shift was 38 years ago…
- And note the green arrow: shorter term business cycle shifts that tend to occur every 7-10 years.
What caught my eye this week? Louis updated his Four Quadrants Framework chart and said, “For the last 30 years the world has broadly been at the bottom of our four quadrants, oscillating between disinflationary busts and disinflationary booms. We are now at a strange moment: most of the world is moving from disinflationary boom to disinflationary bust; but the US is moving towards an inflationary boom. This divergence doesn’t make portfolio construction easy.” He concluded, “A similar situation more or less prevailed in 1998-2000 and did not end happily.”
Here is the updated chart:
We are seeing a shift in the U.S. from a “Disinflationary boom” to an “Inflationary Boom.” However, and there always seems to be a however; the rest of the world is shifting to a “Disinflationary Bust.” My two cents is the current inflation pressures will be tamed by the global debt problems and the inability of pensions to meet their promised obligations. We will likely see an economic slowdown, ultimately a recession and a reset of the debt (leverage) in the system. Governments get squeezed and adopt inflationary policies to meet obligations because their other alternatives are worse. It’s not a pretty picture.
Because the shifts take a number of years, it is difficult to see the forest through the trees. The Four Quadrant Framework is brilliant. Getting it right and having the discipline to stick to your macro analysis is the key to getting the returns right. So I think what Louis is saying is spot on: “This divergence doesn’t make portfolio construction easy.” And, “A similar situation more or less prevailed in 1998-2000 and did not end happily.”
Capital Preservation and Home Runs
Stan Druckenmiller said, “The way to build long-term returns is through preservation of capital and home runs.”
I’m working on a research paper and plan to highlight the paper in a book I am working on and publishing with Forbes. One of the chapters will talk about “Capital preservation and home runs.” I believe with all that’s in me that the way to build long-term returns is through capital preservation and home runs. The home runs come infrequently and are often out of reach of most investors.
The problem I’ve witnessed over more than 30 years is that the laws of behavioral finance catch up with most investors. I’ll be evidencing that in my book and happy to share some of those charts with you if you’d like to see them. Here is my simple logic to address the behavior problem. I like to think in terms of three buckets: Savings, Core Investing and Alternative Return Opportunities.
- Savings: Savings is not investing. This is for emergency liquidity: a car, a future house, or some other shorter-term need. There are ways to maximize the return on this money in a tax efficient way. The point is to think about your savings different from your investments.
- Core Investing: Work with an advisor to design a plan that is appropriate for your risk tolerance and investment time horizon. If you are a moderate investor, build a portfolio in a way that can achieve a reasonable return while minimizing your risk of loss. Seek growth opportunities while maintaining a level of protection in down markets. A moderate total portfolio might target a 5% to 10% return objective with a downside that may keep you losses at less than 10% on your total portfolio. If you invest 80% of your money in a smart core investing approach, in a few short years that money will likely grow back to 100%. That leaves you some room to seek a select few other alternative return opportunities. You may want 50% core or 90% core, depending on what fits your risk level and time frame.
- Alternative Return Opportunities: These are private opportunities (outside the public markets) with potential (but certainly not guaranteed) upside. Think biotech, health care, real estate, technology, etc. The idea is that if you are confident in your core investment portfolio allocation of 80% of your wealth getting you back to 100%, it will enable more confidence and hopefully less emotional stress in buying and holding a handful of other return drivers that may make a real difference to your personal wealth. I tend to think in terms of private companies, real estate development projects, maybe a small technology company or a company in an industry ripe for disruption. Biotech, plant biology, health care, medical technology, real estate, etc.
I’ll be writing more about this and, for future letters, will set up a sign-up page so that you can be aware of the various opportunities we think are worth your attention. The SEC has net worth rules around certain investments so you’ll need to keep that in mind.
My point is that I believe you can do both: capital preservation and “home runs.” Alternative investment opportunities come infrequently and require longer hold times, but if you get your risk/reward and liquidity game plan right, I believe you’ll have a much better chance of sticking to your game plan and reaching your goals – and avoid the stress and emotional roller coaster.
Please shoot me a note if you’d like to learn more.
Grab a coffee and find your favorite chair. I wrote about Turkey and the potential impact on EU banks and my two cents on how the “Great Reset” unfolds… Note: this is why “Core Investing” to me today is a “Participate and Protect” strategy. Capital preservation and home runs. I’m holding tight on my “alternative return drivers” as I believe they will be largely unaffected by the next great market dislocation.
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Included in this week’s On My Radar:
- Trade Signals — Turkey Crisis, EU Banks and the ECB
- Personal Note — A Good Cold IPA
Trade Signals — Turkey Crisis, EU Banks and the ECB
S&P 500 Index — 2,807 (08-15-2018)
Economies move from periods of stability to periods of instability. Debt is the common denominator. In last week’s On My Radar, I shared a chart that showed the debt-GDP levels in various countries. You can find that post here. Page down to the chart with the “we are here” red arrow. I bought two Apple MacBooks today on a 12-month zero interest plan. Put $2k of more debt on the Blumenthal personal balance sheet. Good for the economy today but I’ll have to pay it back within 12 months to avoid interest charges. At some point, corporations, individuals, and governments borrow too much and can no longer borrow. And budgets get squeezed with needed income to cover the additional payments. In the bottom of the ninth inning at business cycle ends, recession ensues, defaults spike and the systems reset. The strong survive and opportunities present. Business cycles are in the late innings most everywhere.
You might say, ‘But Steve, the economy is looking strong…” My answer is that it looked strong in 1999 and early 2000. It looked strong in 2007… the housing market had never been better. We are seeing cracks, risk is high, the system is unstable… “What do you think the commodity markets are telling us about the economic outlook?” good friend, David Rosenberg, shared via tweet two days ago (next chart). Let’s keep our lights on. I share a few thoughts next.
Where might we see the first cracks?
I believe and have written that it likely comes from emerging markets first and we may be seeing the early innings of that today. Many financed their debt in U.S. dollars. The shock can come when the dollar moves higher. Simply, if you borrowed $1 million and the dollar goes up 10%, you have to pay back $1,100,000. We are now seeing cracks in emerging markets. Turkey is in crisis. It’s currency is down over 50%. “Over 90 percent of Turkish external debt is denominated in foreign currency, and the debt path is susceptible to exchange rate movements.” Debt analysis on page 55 from this IMF report.
I continue to see more research on growing problems with Chinese borrowers who borrowed in U.S. dollars. I’d speculate that many borrowers lack the sophistication to hedge out their currency risk. And who owns Turkish debt? If you follow me on Twitter, I tweeted earlier this week that there are big concerns for several European Banks who have lent to Turkish businesses and individuals. Watch the banks…
My two cents on how the “Great Reset” may unfold: Emerging Markets falls first, then Europe (fractured/incomplete EU – Italy’s debt really matters – the key will be confidence. Watch confidence as lost confidence will set off a Sovereign Debt Crisis), then Japan and/or China, then, and to a lesser extent, last in line is the United States. There is no way the U.S. avoids recession if the balance of the world is in recession. We are just in the very early innings and there is no way to know how and when this will all play out…
Quick point of optimism: I don’t believe you have to sit on the tracks in front of the oncoming train. I see opportunities ahead and hope you do as well. Let’s just not get run over on the way to the opportunities. For now, as you’ll see in the charts below, our U.S. equity market trend signals remain positive. The uptrend has not yet been broken.
When collective confidence in central bankers and politicians fail, we will see a rush to the dollar (much like we are seeing a little bit of today). It’s about global capital flows. It’s about people preserving what they have… A pattern somewhat similar to the late 1920s. Perhaps that capital moves into U.S. equities. Likely, makes sense, maybe, don’t know.
Let me add this note I saw today from Marty Armstrong, “The European Central Bank is instructing banks to restrict the conversion of Euros to dollars. The Euro has fallen to 113006. Once again, the dangerous game here is when we cross that line of demarcation between CONFIDENCE in government and the REALIZATION that there is nobody in control but the free markets. Once all the talk and all the promises are no longer considered to be worth listening to, that is when the monetary crisis begins to really shake the foundations. We are moving closer to that point of no return.” Confidence… I think he is right.
Now with all that said, our primary equity market indicator remains in a buy signal. The above could most certainly scare me out of the market but I favor a price-based weight of evidence approach. “Listen to the cold bloodless verdict of the market… that’s what price-based indicators accomplish,” Ned Davis once said and I believe that truism remains today. I’m sticking to the NDR CMG Large Cap Long/Flat Index and diversifying to a handful of trading strategies.
Read further and you’ll see below that the overall trend evidence remains moderately bullish. The Ned Davis Research (NDR) CMG Large Cap Long/Flat Index, continues to signal 80% exposure to large-cap stocks. Also signaling risk-on is that the 13-week shorter-term moving average trend line remains above the longer-term 34-week MA line and volume demand continues to be stronger than volume supply. As for the bond markets, the Zweig Bond Model remains in a sell, suggesting risk of higher interest rates. It has been a good indicator for me over the years and has done a good job YTD. The HY bond market remains bullish — the CMG Managed High Yield Bond Program’s signal remains in a buy signal. Gold remains in a confirmed down trend — sell signal.
I continue to expect the next several months to be challenging. Stay alert and risk minded. Stick to your plan. Mine: Participate and protect… seek growth opportunities while maintaining a level of protection in down markets.
Important note: 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.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is firstname.lastname@example.org. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note — A Good Cold IPA
I’m going to ask your forgiveness for what I’m sure are far too many grammatical errors in today’s post. I depend so much on my edit team. My long time editor, Linda had a family emergency, and my back-up editors are on vacation. Andrew is competing in Florida at an over 40 national soccer tournament and Todd is away in Canada with family. I have to say I’m totally lost without them.
I’m rushing to get this posted in time and then find my way to a cold Funk Citrus IPA and my new number 1. It’s well-earned after moving sons Matt and Kyle to Penn State for the fall semester. Kyle was a breeze… freshman, clean dorms, bedding and cloths. Matt on the other had a U-Haul packed with old furniture, bed, desks, tables, and chairs.
Packing the truck was relatively easy. The problem was the off-campus rental house… three narrow floors, dusty, dirty, small and very old. Not sure how that house is standing; however, Matt and his roommates love it. Remember your college digs? And trying to scrape together a few bucks for Saturday night? Looking back, I wouldn’t have wanted anyone to steal that experience from me and I bet you feel the same way. The best times of our lives…
I’m in NYC next week and Denver the following. Hard to believe we are more than half way through August. I do hope you are enjoying some summer down time.
All the best!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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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.
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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