January 21, 2021
By Steve Blumenthal
“I don’t think the Federal Reserve and this leadership has the stamina
to act decisively. In order to turn the market around to a more
non-inflationary attitude, you have to shock the market.
You can’t raise interest rates bit by bit.”
– Dr. Henry Kaufman,
Former Vice Chairman of Salomon Brothers
The book titled On Money and Markets: A Wall Street Memoir by Dr. Henry Kaufman sits on my shelf. Kaufman was a key Wall Street figure in the 70s and 80s. His projections about interest rates, bond performance, unemployment, and government debt impacted monetary policy in more than one presidential administration. His voice was powerful and would immediately move the markets.
Former Federal Reserve Chairman Paul Volcker wrote the forward for Kaufman’s book. Volcker was a giant who had the conviction, the gut, and the fight to whip inflation. It’s worth a read and will give you a better understanding of why the Federal Reserve has gained so much power and what it means for investors.
This morning, Netflix’s disappointing earnings sent the stock down more than 20%. The Nasdaq is down ~12% from its peak. With the Fed’s bond-buying program set to end March 15 and signaling higher interest rates, I reflected on Dr. Kaufman’s quote.
Hat tip to @JesseFelder. I follow Jesse on Twitter, and he shared Kaufman’s quote earlier this week. The “stamina to act decisively.” That pretty much sums it up. Stress is present in the equity markets.
There is valuable information in the price of an asset, and its price (high or low) helps us understand the return we are likely to receive. Once a month, I scan through a list of my favorite market valuation charts. Where are we today? What does that tell us about possible forward returns? At which point will you get a better return on your money? Let’s see if we can set some logical targets.
Valuation posts are always fun for me. You’ll see that current levels are off the charts and, as you’ll also see (in the Trade Signals section further below), markets are sitting on a powder keg of record-high margin debt. Leverage is always the bad actor.
Grab a coffee and find your favorite chair. Take a deep breath and channel your inner Sir John Templeton. I see a “buy when everyone else is selling” opportunity approaching on the not-too-distant horizon. We’ll consider a few logical targets.
January 2022 Starting Valuations and What They Tell us About Coming Returns
I like to think of valuations in terms of degrees of reward and risk because they can give us an excellent sense of today’s starting conditions (current valuations) and the coming three-, five-, seven-, nine-, 10-, and 11-year returns. You’ll see below that the outlook is for negative annualized returns over the coming years.
Following is a selection of my favorite charts. We’ll review current market valuations and see what the data tells us about probable coming 10-year annualized returns.
We will start with my favorite, Median Price-to-Earnings (P/E). I lead with it because it sets some pretty good risk-to-reward targets for us to consider. When markets dislocate, the level of fear is great, and at some point, margin calls kick in, and buyers back away. As I said, leverage is always the bad actor. I believe that setting a target helps me to remain calm, focused, and ready to act. The forced unwinding of margin debt and other Wall Street created leveraged structures (SWAPs, etc.) causes markets to V bottom. Crashes happen because of the forced unwinding of leveraged investment positions.
If you have 500 stocks in the index, Median P/E is the price-to-earnings ratio of the one stock in the middle of the 500 stocks data set. I like this process, as it tends to wash out some of the accounting gimmicks corporations play.
Here’s how to read the chart:
- The 57.7-year median P/E average is 17.4. The Median Fair Value dotted green line in the middle of the chart.
- The orange line plots each month-end median P/E number going back to 1964.
- You can see that the orange line rises above and below the green dotted line over time. Infrequent moves take the market to the “overvalued” line. And there were only a few times in history when valuations moved above the “very overvalued” line.
- In statistics, the standard deviation measures movement above and below a long-term trend. 1SD moves happen infrequently, and 2SD even more rarely. You’ll see that Ned Davis Research (NDR) plots those lines in the chart as well.
- Now, focus on the bottom data box. A 36% decline is necessary for the market to correct back to “fair value.” NDR calculates the current “fair value” in the S&P 500 Index to be 3,050.
- Over a long period of time, you can see that Median P/E has moved above and below the Median Fair Value line.
- Game plan-wise, 3,050 seems to be an excellent target to buy stocks/reduce hedges.
Since the beginning of the year, the S&P has declined ~7% and, at the time of this writing, sits at 4,440. An extreme correction will take the stock market down to 2,054, a decline of 56.9% from December 31, 2021, S&P 500 Index price close of 4,766. We can’t rule out such a move.
If that happens, back up your cash truck and go “all in.” Risk will be extreme and the airwaves filled with fear, but in reality, it will be least—and future returns will offer a high potential reward.
Next, let’s look at price-to-sales. Here is how to read the chart:
- Note the regression to trend line in the center section of the chart.
- The orange line tracks the month-end price-to-sales ratio back to 1979. You can see it moves above and below the dotted trend line.
- The bottom section (light blue line) plots the percentage above or below the trend line. You can see it is way up in the nosebleed section. Extremely high above its long-term trend.
- Lastly, the bottom data boxes plot the average percent gains per annum in various zones. The gray shaded areas highlight the current state.
Cyclically-Adjusted P/E aka Shiller P/E
Current Shiller P/E = 36.74 (it was 39.3 at the end of December 2021)
Here’s how to read the chart:
- Grab a glass of vodka and avoid sharp objects…
- Top section is the Shiller P/E
- Middle and Bottom Clips are Mid Cap and Small Cap Indices
Fortunately, there is a way for us to quantify the above in terms of coming 10-year returns. In the following chart, NDR sorts the 10-year averaged P/Es into quintiles and then shows us what the subsequent real (meaning after inflation) 10-year annualized returns turned out to be.
Here’s how to read the chart:
- At 39.3, we are clearly in the “most expensive 20%” zone on the right-hand side of the chart. Note the far right-hand bar in the chart.
Stock Market Value to Gross Domestic Income
According to the feedback I’ve received over the years, the next chart is one of the more popular ones I share.
Here is how to read the chart:
- The extent to which the market is overvalued or undervalued is determined by how far above or below the trend the ratio of stock market capitalization to total U.S. gross domestic income is.
- The bottom section (light blue line) shows how far above or below the long-term trend.
- The data box in the upper left shows the subsequent one-, three-, five-, seven-, nine-, and 11-year annualized returns.
- Bottom line: We are in the “top quintile.” Expect negative returns. We’ll get much better returns when the light blue line moves to the middle zone (bottom section in the clip).
- The best-annualized returns when the light blue line moves into the “bottom quintile.” That may not happen.
Stocks as a Percentage of Household Financial Assets
Yellow circles show prior periods of extreme stock ownership – note 1966, 2000, 2007, and 2021.
Green arrows show equity ownership at bear market bottoms. Investors behave badly.
Household Financial Assets as a Percent of Personal Disposable Income
The chart is pretty intuitive. Note the levels in 2000, 2007, and today.
Household Equity Percentage and Subsequent Rolling 10-year Returns
The following chart is one of my top favorites.
Here is how to read the chart:
- The solid blue line tracks the household equity percentage.
- The orange dotted line plots the subsequent 10-year annualized achieved returns.
- Bottom line: when ownership is highest, subsequent returns are weak. Note the high correlation between ownership and the actual outcome.
- Based on the current level, probable returns (before inflation) are an annualized -0.30% (approx.)
Rolling 10-year Returns and U.S. Household Allocations
The bottom left-hand data box gives us a good sense of the historical range in returns. That is, the lowest 10-year annualized outcome, the highest 10-year annualized outcome, and the overall average 10-year annualized result.
Various Other Valuation Measurements
Source: NDR – See Important Disclosures Below
I hope this gives you a good sense of the stock market’s beginning of the year starting conditions. You may have noticed a few differences in the data, such as the 12-31-21 Shiller P/E number. Minor differences. My guess is the data was pulled from a few different sources—no change in the ultimate conclusion.
The Trade Signals section is next. I believe you’ll find the margin debt discussion interesting.
Trade Signals – Zweig Bond Model, Margin Debt Rate-of-Change and Global Recession Model Signaling Caution
January 19, 2022
Posted each Wednesday, Trade Signals looks at several of my favorite equity markets, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
“Listen to the cold bloodless verdict of the market.
That’s what priced based indicators accomplish.”
– Ned Davis,
Founder, Ned Davis Research (NDR)
The most widely watched measurement of interest rates, the yield on the 10-year Treasury note, hit 1.87% yesterday, the highest since January 2020.
- The S&P 500 index is down about 4% so far this year — the worst annual start since 2016.
As noted last week, the Zweig Bond Model (named after the great Marty Zweig) moved to a sell. Ned Davis and Marty created an NDR version of the model in the mid-1980s. Many years ago, I asked NDR to recreate the index for me and I review it weekly. It is a priced-based indicator that looks at what price (based on real buyers and sellers – supply and demand) is telling us is happening. In essence, they try to establish how potential changes in market forces (supply and demand) might impact the price of a security. Like everything in the investment business, it’s about probabilities. No indicator is perfect. In my experience, the ZBM is not to be ignored.
A sharp rise in interest rates in early 2022 is the key reason the stock market is down. Inflation recently hit 7% year-over-year and the Fed is ending its bond purchase program and indicating higher rates. Inflation and higher interest rates are kryptonite to stocks.
There is notable deterioration in the equity market models. The longer-term trend models, while weakening, remain in buys. When the NDR CMG Long/Flat signal drops below 50, we will trade the S&P 500 Index ETF exposure we have in that strategy to cash. An early trend signal to watch is the S&P 500 Index Daily MACD Indicator. It’s been in a sell for several weeks. The overall message is to focus on downside risk management – play more defense than offense.
With valuations high and investor margin debt extremely high, the risk of loss is high. Leverage is always the bad actor and the cause of extreme market dislocations. Just ask anyone you know who has ever had a margin call. If you fund your account with $100,000 and borrow on margin another $100,000, you can buy $200,000 in stock. If the market goes down 30%, your account is down $60,000 making your account worth $140,000, your margin debt remains at $100,000 plus interest costs, and your total account value is worth $40,000. With $100,000 in margin debt, your debt-to-equity ratios don’t work for your broker. Either put more cash into your account or be forced to sell. If this happens to your co-worker, bad on him. If it happens when everyone is levered up, you can see how it might impact the markets as a whole. Leverage is always the bad actor and largely the reason why markets crash. Fortunately, we can measure the degree of risk (the current state of play).
One of the charts I keep On My Radar is the rate-of-change in margin debt. I think of it as “a canary in the coal mine” indicator. You can see that it takes a lot of patience to follow as it signals infrequently. Every Wednesday morning I have the same routine. I scan through my list of various market indicators. NDR updates the rate-of-change in the outstanding margin debt chart each month. It fired its first sell signal since late 2007 at the end of November. Note the prior sell signals in late-2007 and early 2000. There is a lot of fun data in the chart. Signals are generated the red line (the 15-month rate-of-change in margin debt) drops from a high level below the upper dotted green line. That line was breached. Lights on!
Here is a look at overall margin debt as a percentage of GDP. The main point here is to see just how high margin debt has become relative to U.S. GDP. Consider the current level to historical levels. The most recent reading is off the charts. Bottom line: There is a lot of leveraged gambling in play. The above chart serves as an early warning. The chart below shows us the size of the potential risk.
There is more that has happened this week. Of note, adding to the overall indicator weakness this week is “The Don’t Fight the Tape or the Fed” indicator moved to a -1 signal, and the Global Recession Probability Indicator is signaling high global recession risk. There have been just six such signals since 2000. The last high global recession signal was 9-30-2018. There is no sign of recession in the U.S. (see recession indicator section below). Gold is in a bullish buy signal.
Click HERE to see the Dashboard of Indicators in Wednesday’s Trade Signals post.
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.
Personal Note – Sushi
Susan is ordering sushi for dinner and good friends are coming over. Some red wine is in my future to which I have a confession to make. The UPS guy told me no one in the neighborhood orders more red wine than you do. I smiled and told him, “It’s pretty good too.” I see a nice bottle of red coming his way soon.
It’s been a good week for me and I hope you as well. Red wine and sushi are up next. Can’t wait…
Wishing you a fun week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Consider buying my newly published Forbes Book, described as follows:
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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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