August 21, 2020
By Steve Blumenthal
“The US is extremely important as it still provides the world with the most
important reserve currency. Once faith in that currency declines
and the US dollar enters a decisive multi-year bear cycle,
hell could break loose.”
– Felix Zulauf, Founder, Zulauf Consulting
As a long-time subscriber to Ned Davis Research, one of the benefits I enjoy most is the occasional emails from Ned himself. This morning’s note is about not fighting city hall. Meaning, every time there’s a problem in the markets, the President promises tax cuts and new fiscal initiatives and the Federal Reserve promises more free money and market intervention. The tax cuts and fiscal spending are funded by newly minted money, known as Modern Monetary Theory (“MMT”), AKA the Magic Money Tree.
Wherever I go—virtually, that is, due to COVID-19—that is always the focus of questions number one, two, and three. Don’t fight the Fed.
Earlier this week, I presented to an advisor team and their clients on valuations and the impact of record-high valuations on future 7- and 10-year returns. It’s a bit hard to wrap our heads around negative compounding returns, but those are the conditions we find ourselves facing today. Then came the question on MMT. What follows is my answer. We’ll take a look at what MMT means in terms of inflation, the time frame we can expect, and how to profit from it.
The MMT narrative is advancing. The Fed balance sheet we thought was outsized at $4 trillion is now $7 trillion—and I believe it’s on the way to $14 trillion. COVID-19 is providing the cover. But for every push, there is a pull. Deflation now but as William White, former head of the Bank for International Settlements put it to me a year ago, “In the end there will be inflation.” Call it three to five years from now. We’ll one day look back and wonder what in the world were we thinking. The inflation investment regime is far different from what we have known for the last 35 years.
Several weeks ago, I shared with you my notes from a research call and discussion between A. Gary Shilling and David Rosenberg. I noted the following, from David:
- David mentioned the need for recurring stimulus. No doubt we are going to be seeing much more stimulus going forward.
- There is another $3.5 trillion fiscal plan proposed in the House and a $1 trillion plan proposed in the Senate, and there is no way to stop the Fed—they are full speed ahead.
- We have an output gap of 7% between aggregate supply and aggregate demand.
- This is very consistent with a depression.
- How do you close that gap if you are an academic working at the Fed?
- The Fed has to synthetically create a negative interest rate of -14%. David doesn’t believe the Fed can go to negative interest rates, so they will do this by printing money.
- To do this, the Fed balance sheet has to go up to at least $11 trillion. So, call it another $4 trillion. Maybe we’ll just create asset bubbles the whole way through. That’s the side effect of what the Fed is trying to do for the greater good, which is to put a floor under deflation.
- If they don’t eliminate the output gap, the deflation is not going to go away.
- We have to figure out what that time frame might be.
- To get to -14%, the Fed has to take the balance sheet to $14 trillion. Maybe we create asset bubbles even more…
David said, “So I’m agreeing with Gary on the deflation front, but to a point. We know we’ve had a demand detonation, but at some point, at some point where we have herd immunity or we get a vaccine in the next twenty-four months or so, demand will stabilize.”
Deflation Now – Inflation Later
Good friend Dr. Lacy Hunt was featured in Bloomberg last Friday, August 14, in an article titled, “Longtime Bond Bull Lacy Hunt Sees One Huge Risk” by Brian Chappatta.
The header read, “The Hoisington Investment Management economist hasn’t changed his view that Treasury yields are headed lower. But a move to literal money printing could change the game.” From the article:
Lacy Hunt: The measures taken to ameliorate the recession, in terms of trying to help people in distress, while they’re popular and humane, they’ve resulted in a massive increase in the debt overhang. The pandemic will eventually go away, but the debt will remain. It’s been my view that over-indebtedness ebbs economic growth. Debt is a double-edged sword: It’s increasing current spending in exchange for a decline in future spending unless it generates an income stream to repay principal and interest.
We had four secular peaks in total debt to GDP. The 1870s, 1920s and 30s, 2008-09, and we’re going to set a new peak this year, which will take out the peak in 2008-09. The debt surge reflects both a rising debt and a decline in GDP. In the three earlier instances, the inflation rate fell very dramatically. We now have a new secular peak in debt to GDP occurring within 12 years of the prior secular peak, whereas before they were decades apart. That’s massively disinflationary.
(SB here: When debt goes up, growth goes down. In other words, if you incur more debt, you can spend today, but you have to pay it back tomorrow. Your personal economy eventually slows because you have less money left over to spend on things). Lacy added,
When the Fed initiated QE1, QE2 and QE3, folks said those policies were very inflationary. There is a liquidity effect of what the Fed is doing, and the liquidity effect can be very powerful over the short term. But ultimately the increase in the money supply did not follow through after the rounds of Fed purchases of government securities because the banks couldn’t utilize the reserves, they didn’t have the capital base to make the loans, they had to charge a risk premium in an environment in which the risk premium was rising very dramatically and the borrowers couldn’t pay the risk premium. There was no secondary follow-through in terms of money supply growth, and the velocity of money fell and the growth rate fell back after a transitory rise. And I don’t really see this as any different.
Keep in mind, when the Fed comes in barrels open like this, the program initially looks successful because it unblocks what problems existed in the markets. But it’s the job of the economist to understand the unintended consequences. When the Fed comes in and they have this tremendous success, which gives the appearance that the inflation process is starting, they thwart a couple of important mechanisms that make the free enterprise system work: creative destruction and moral hazard. The first-round effects of the Fed look effective, and they’re widely hailed, but they make the economy even more overleveraged than it was before and credit is allocated to those who are not really in a position to generate economic growth from it. We’ve seen numerous similar programs in Japan and Europe and it looks like the central bank has the capability to do whatever it takes. They certainly have the ability to calm and reliquify markets, but those actions then compound the underlying problem, which is the extreme over-indebtedness. You get a transitory boost, you get a liquidity effect, but that liquidity effect runs out very quickly.
To my way of thinking, the government expenditure multiplier is slightly negative after three years. It’s slightly positive for a while, but that period of time only lasts for one to two quarters. Then the debt dynamics take hold and the growth rate falls back and the inflation rate goes with it. In the meantime, this period of weak economic growth is becoming ever-extended, and that has consequences of its own.
BC: This is usually the point at which I ask, how do we get out of this?
LH: The problem is people want a financial transaction to cover the problem. They want greater levels of debt — in other words, we’re going to try to solve an indebtedness problem by taking on more debt. Japan has tried many, many heroic measures to try to pull themselves out. Great results were promised.
The production function says GDP is determined by technology interacting with land, labor and capital. If you overuse one of the factors of production, such as debt capital, initially GDP will rise. You continue to overuse that factor of production, GDP flattens out; and if you continue to overuse that factor, GDP declines. More is not more — more is less.
Brian Chappatta asked Lacy about the rise of MMT within economics and the proposals for the Fed to give money directly to individuals. Lacy’s reply:
The great risk is that we become dissatisfied with the way things are, and either de jure or de facto, the Federal Reserve’s liabilities are made legal tender.
The Federal Reserve as it’s constituted today can lend but it cannot spend. Now, they’ve done some things that are different from what the Federal Reserve Act said under the exigent circumstances clauses, but so far they’re lending. They’re not directly funding the expenditures of the government in any meaningful way. But there are folks who want to use the Fed’s liabilities for that purpose.
When the Fed buys government securities, all that really happens is you switch to the government having a one-day liability which the banks are holding. And those deposits that the banks own, which have gone up sharply as a result of the Fed buying, are not legal tender. Now, the banks could use them to make loans, but they’re not doing that. Loans are coming off very sharply because you have to have this interplay between the banks and their customers, and the risk premium has to be accounted for.
There are folks who want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off. However, in very short order, everyone would be totally miserable because no one would want to hold money. You would trigger Gresham’s Law — people would only want to hold commodities they can consume and commodities that can be traded for others.
But there is that risk that you could use the Fed’s liabilities to pay directly. The Bank of England has made a small move in that direction — they say it’s temporary. There are others that want to try that because they’re frustrated with the fact that issuing the debt is not getting the job done. So we could significantly alter the whole structure of the U.S. economy. But if you use the Fed’s liabilities for directly funding goods and services, the consequences could be very extreme and very quick.
Lacy concluded, “The inflation rate is going to be trending down and there is possibly a much greater risk of deflation than inflation.” He remains invested in long-duration Treasury Bonds.
The U.S. has an extraordinary economic privilege, as the dollar serves as the world’s reserve currency. Globally, most goods are traded for dollars. Currently, the U.S., Japan, the EU, and China have the money printing presses running full speed. Every push (“MMT”) has a pull (“defaults and inflation”). Add the trend in the U.S. dollar to your watch list. In case it helps, I’ll be adding a chart I’m watching to Trade Signals (next week’s post). You’ll find the chart in the section titled “The Dollar and What it Means for Your Portfolio” below.
To me, it is a measure of confidence in U.S. authorities. I could be wrong, but I do believe that when confidence in the dollar is lost, that’s when rates rise and inflation gets out of control. I think the price movement in the dollar will signal to us the shift from deflation to inflation. Therefore, the trend in the dollar is important.
One last add to this week’s missive, which I hope you find helpful. Years ago, when I was a young financial advisor at Merrill Lynch, I’d listen to Bob Farrell’s monotone voice as he presented his views on the market. Those were the old stockbroker days. We sold stocks and earned a commission, and Bob was the master.
In the mid-1980s, no one believed in buy-and-hold. The 1966-1982 bear market had everyone thinking you had to be a trader to make money. The largest producers in the firm were “stockbrokers,” and focused on ten to twelve positions.
Meanwhile, about once a month, the old timers would trade out of one stock and into another. Institutions paid six cents per share in commission and retail investors paid even more. If you were a good stock picker, you did ok. The old timers told me to listen to everything Bob Farrell had to say. I left Merrill in the late 1980s, but I’d follow Bob in the press and his views were frequently quoted in Barron’s. Around 2001, I found myself in NYC, pitching my high-yield leveraged hedge fund to a hospital foundation investment committee. I walked into the room and there was Mr. Farrell sitting at the head of the large conference table. He was the chairman of that investment board. To tell you I was nervous is an understatement. The student had met the master teacher.
I was able to get a few minutes with Bob after the presentation. I let him know how much he and his insights meant to me. He simply smiled in his humble and kind way. I won the allocation, but the real win was time with my teacher. That was a good day.
You’ll find a section titled “Bob Farrell’s Ten Rules” below. Something to keep in mind as we walk further down the MMT road. You’ll also find a little more discussion on the dollar along with a helpful chart.
Grab that coffee and find your favorite chair. Thanks for reading and have a wonderful weekend!
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:
- The Dollar and What It Means to Your Portfolio
- Bob Farrell’s Ten Rules
- Trade Signals – S&P 500 Sets New Record
- Personal Note – It’s Broken and Maybe That’s Good News
“A study by Hirschman Capital shows that out of 51 cases of government debt breaking above 130% of GDP since 1800, fifty governments have defaulted. The only exception, so far, is Japan. We mention this because the IMF expects US Government Debt to hit 141% by the end of this year.”
– Felix Zulauf, Founder, Zulauf Consulting
The quote came to me in a research note this week.
I think we are following the Japanese path, and thus it may be years before we experience a default. But who really knows? We could have a global event sooner.
Defaults can come in different forms: The most likely is a currency debasement that would probably lead to rising inflation. And it could come in outright debt defaults: something I think is most probable in Europe (due to their flawed political structure). If that occurs, we will see a rush of money to the U.S., further extending the dollar’s reserve status.
But when you look at 50 of the 51 cases, free money (MMT) has usually led to hyperinflation. Then, the system breaks and a new one is formed. Debts are reset and we move forward. That’s the path we are on and my best guess is we’ll figure it out this decade. John Mauldin’s “The Great Reset” thesis. It’s getting real, and it will be bumpy.
Zulauf put it this way, “But now, we see an increasing number of industrialized nations running into the same problem, including the US. The US is extremely important as it still provides the world with the most important reserve currency. Once faith in that currency declines and the US dollar enters a decisive multi-year bear cycle, hell could break loose. It would remove any potential discipline from many central banks around the world and they would simply follow that path of reckless liquidity creation. Thus, the world runs the risk of a major monetary crisis, massive currency debasements and currency reforms in the coming years, which would be expressed in rising prices of real assets (expressed in such debasing currencies).”
Martin Armstrong sees a monetary crisis cycle starting in 2021 and a sovereign debt crisis in 2022. I don’t agree with all of his views, but he does have a firm grasp on global capital flows and I find the system he has programmed fascinating. You can follow him here. (Not a recommendation to buy or sell any security.)
The point at which confidence is lost will show up in the dollar. Money will flee and seek its best opportunity. Again, let’s keep an eye on the dollar. The current monthly trend is pointing lower (red arrow, lower section, right hand side). A double top appears to be in place (2018 and 2020). A break below the 2008 low would be a major warning.
Real assets are the beneficiary. Commodities, agriculture, real estate, and precious metals.
Gold may already be telling us something. Here’s a look at gold via the SPDR Gold Shared ETF, ticker symbol GLD:
Don’t peg gold as simply an inflationary asset, though it does tend to do well in inflationary cycles. It is also a place where money flows when confidence in governments is lost. We are in a deflationary cycle currently. With that in mind, look at the move in gold since 2019.
Notable too is Warren Buffett’s purchase of shares of Barrick Gold.
I do believe it is time for gold and have had it in our client total portfolio models for some time. I favor a 5% to 10% allocation to gold in most portfolios. But I don’t yet think it’s time to switch portfolios to inflation plays. It’s just time to start thinking, get prepared, and put a game plan in place. More on this in future letters.
Courtesy of StockCharts – By the way, StockCharts is an inexpensive and excellent chart service. You can sign up for a free trial here.
Bob Farrell is a Wall Street veteran who draws on some 50 years of experience in crafting his investing rules. After finishing a masters program at Columbia Business School, he launched his career as a technical analyst with Merrill Lynch in 1957. Even though Mr. Farrell studied fundamental analysis under Graham and Dodd, he turned to technical analysis after realizing there was more to stock prices than balance sheets and income statements. He became a pioneer in sentiment studies and market psychology. His 10 rules on investing stem from personal decades of experience with dull markets, bull markets, bear markets, crashes, and bubbles. In short, Bob Farrell has seen it all and lived to tell about it.
Markets tend to return to the mean over time.
Translation: Trends that get overextended in one direction or another return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average. The chart below shows the S&P 500 over a 15-year period with a 52-week exponential moving average. The blue arrows show several reversions back to this moving average in both uptrends and downtrends. The indicator window shows the Percent Price Oscillator (1,52,1) reverting back to the zero line.
Excesses in one direction will lead to an opposite excess in the other direction.
Translation: Markets that overshoot on the upside will also overshoot on the downside, kind of like a pendulum. The further it swings to one side, the further it rebounds to the other side. The chart below shows the Nasdaq bubble in 1999 and the Percent Price Oscillator (52,1,1) moving above 40%. This means the Nasdaq was over 40% above its 52-week moving average and way overextended. This excess gave way to a similar excess when the Nasdaq plunged in 2000-2001 and the Percent Price Oscillator moved below -40%.
There are no new eras – excesses are never permanent.
Translation: There will be a hot group of stocks every few years, but speculation fads do not last forever. In fact, over the last 100 years, we have seen speculative bubbles involving various stock groups. Autos, radio, and electricity powered the roaring 20s. The nifty-fifty powered the bull market in the early 70s. Biotechs bubble up every 10 years or so and there was the dot-com bubble in the late 90s. “This time it is different” is perhaps the most dangerous phrase in investing. As Jesse Livermore puts it:
A lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.
Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
Translation: Even though a hot group will ultimately revert back to the mean, a strong trend can extend for a long time. Once this trend ends, however, the correction tends to be sharp. The chart below shows the Shanghai Composite ($SSEC) advancing from July 2005 until October 2007. This index was overbought in July 2006, early 2007 and mid-2007, but these levels did not mark a top as the trend extended with a parabolic move.
The public buys the most at the top and the least at the bottom.
Translation: The average individual investor is most bullish at market tops and most bearish at market bottoms. The survey from the American Association of Individual Investors is often cited as a barometer for investor sentiment. In theory, excessively bullish sentiment warns of a market top, while excessively bearish sentiment warns of a market bottom.
Fear and greed are stronger than long-term resolve.
Translation: Don’t let emotions cloud your decisions or affect your long-term plan. Plan your trade and trade your plan. Prepare for different scenarios so you will not be taken by surprise with sharp adverse price movement. Sharp declines and losses can increase the fear factor and lead to panic decisions in the heat of battle. Similarly, sharp advances and outsized gains can lead to overconfidence and deviations from the long-term plan. To paraphrase Rudyard Kipling, you will be a much better trader or investor if you can keep your head about you when all about are losing theirs. When the emotions are running high, take a breather, step back and analyze the situation from a greater distance.
Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
Translation: Breadth is important. A rally on narrow breadth indicates limited participation and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small- and mid-caps (troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.
Bear markets have three stages – sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
Translation: Bear markets often start with a sharp and swift decline. After this decline, there is an oversold bounce that retraces a portion of that decline. The decline then continues, but at a slower and more grinding pace as the fundamentals deteriorate. Dow Theory suggests that bear markets consist of three down legs with reflexive rebounds in between.
When all the experts and forecasts agree – something else is going to happen.
Translation: This rule fits with Farrell’s contrarian streak. When all analysts have a buy rating on a stock, there is only one way left to go (downgrade). Excessive bullish sentiment from newsletter writers and analysts should be viewed as a warning sign. Investors should consider buying when stocks are unloved and the news is all bad. Conversely, investors should consider selling when stocks are the talk of the town and the news is all good. Such a contrarian investment strategy usually rewards patient investors.
10. Bull markets are more fun than bear markets.
Translation: Wall Street and Main Street are much more in tune with bull markets than bear markets.
Like all rules on Wall Street, Bob Farrell’s 10 rules are not intended to be considered hard and fast or set in stone. There are exceptions to every rule. Nevertheless, these rules will benefit you as a trader or as an investor by helping you to look beyond the latest news headlines or your gut emotions. Being aware of sentiment can prevent traders from selling near the bottom and buying near the top, which often goes against our natural instincts. Human nature causes individual investors and traders to often feel most confident at the top of a market. At the same time, they often feel most pessimistic or cautious at market bottoms. Awareness of these emotions and their potential consequences is the first step towards conquering their adverse effects.
Source: StockCharts.com. To read our investment psychology article about 11 of the most common cognitive biases affecting investors and traders in financial markets, click here.
August 19, 2020
S&P 500 Index — 3,392 (open)
Notable this week:
“The rally has more to do with asset inflation, which is fueled by all the liquidity
and all the continued support in the economy as well as the weakening dollar.”
– Patrick Leary, Chief Market Strategist at Incapital
Extreme Investor Optimism continues. No changes in the equity, fixed income and gold signals since last week.
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.
“It’s always darkest before the dawn.”
– Thomas Fuller
On My Radar focuses on macro-risks and opportunities. In taking an honest look within, I know the themes may seem a bit scary to the average investor. But I come at wealth management with a simple perspective: It’s too hard to earn money and too easy to lose it. I want to safely grow my wealth; I don’t want to lose it! Thus, I’m uber-focused on risk.
It’s been a hard time for the world. COVID-19 has changed everything. It has caused many small businesses to shutter. And it has accelerated money creation, goosed fiscal support, and pissed off a lot of people.
Many, including me, feel the two-party political system is broken. I’m a registered Republican, but I’m really a Constitutionalist who loves our country. I’ll vote for who I feel can lead us best, regardless of party affiliation.
Now, please hold the emails. I have no intention of projecting my beliefs onto you or others. My aim is just to share where I’m coming from. We have some very healthy and fun debates at our dinner table. Susan and I share similar views, but with six voting children, we are not all on the same page. And that’s a good thing. Discourse is healthy.
I feel much of today’s leadership is bought and sold, and that we are nearing a tipping point. The divide between the haves and have-nots is so wide, and anger has reached a boiling point. Maybe the good news is that we are nearing a moment that will open us to positive change. Where we say, no more! We can do better. And we fix it. Kind of Schumpeter’s creative destruction moment. Maybe not this election, and maybe not the next, but it’s near. When something breaks, it opens up the opportunity to fix it.
(Creative destruction, sometimes known as Schumpeter’s gale, is an economic concept that has been associated with Austrian economist Joseph Schumpeter since the 1950s. According to Schumpeter, the “gale of creative destruction” describes the “process of industrial mutation that continuously revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”)
Many years ago, I ran against Charlie Dent for president of our fraternity. Charlie was my roommate at Penn State. Fortunately, the right guy won. Charlie went on to have a long and successful career in politics, most recently serving a U.S. congressman. He retired last year. I hope his leadership aspirations remain. I’m biased, I love my friend Charlie. And I’m proud of him. This week on CNN:
I have no idea what the answers are when it comes to mending our political system, but I do believe that collectively we can come to a better place. Please know I appreciate and respect that your views may differ from mine, and I welcome compassionate dialogue, decency, and a mind open to compromise. We are better together even if we don’t see eye to eye on all things. The greater the challenge, the greater the opportunity. It’s broken only for now. Ever forward…
Yesterday, I helped moved sons Matt and Kyle into their college apartments. The move was easier than anticipated and I’m happy for the boys. Stepson Connor is moving back to college this Sunday. The plan is a hybrid learning approach with some in-person classes and some online learning. Like many schools, I think PSU will go 100% virtual. I told the boys, “COVID-19 will pass; follow the guidelines and enjoy your friends. Years from now, you’ll look back and see the virus as a small bump in the road.”
Stay healthy and have a fun weekend.
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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