July 22, 2022
By Steve Blumenthal
“Because most everyone wants most everything to go up and because there is a drug called credit that produces both upswings and a byproduct depressant called debt, there is a cycle of accumulating debt liabilities and debt assets that is followed by the reducing of them that happens repeatedly and drives most everything. It is one of the biggest contributors to the “Big Cycle” that I explained much more comprehensively in my book, “Principles for Dealing With the Changing World Order,” and my YouTube video of the same title than I can explain here.”
– Ray Dalio, Founder, Co-Chief Investment Officer, and Member of the Board, Bridgewater Associates
Today, let’s zero-in again on debt, take a look at margin debt (it’s improving), and consider some fair value, “risk back on” targets on the equity markets. Some good news is that valuations in the U.S. are improving. Things are still not great, but they’re getting better. Ultimately, the idea is to get ready.
Since the “Big Cycle” is so essential to our understanding of what’s happening, Dalio suggests we turn to his book, The Changing World Order, and read chapter 3, “The Big Cycle of Money, Credit, Debt, and Economic Activity,” and chapter 4, “The Changing Value of Money.” To help you understand the key concepts captured there, I had our summer intern, Sam, summarize the chapters. You’ll find his notes below. But do consider reading the entire book; it’s excellent.
Domestic Debt Outstanding by Country and as a % of GDP
A simple rule is that when “debt as a percentage of GDP” gets above 100%, debt depresses future growth. Think of it like this: You borrowed from tomorrow to spend today (very good for economic growth), but when tomorrow becomes today, the debt burden becomes a drag on growth. A point is ultimately reached when the debt is too big and must be restructured. Dalio, and others (myself included) have long argued that the most significant challenge we face is that we are sitting at the end of a long-term debt accumulation cycle. This is nothing new to mankind; it’s just that you, me, and most people alive today haven’t been here before.
The inflation we are experiencing in the U.S. is mainly the result of printing more than 50% of all dollars ever printed in the history of the Republic in just the last two years. The Fed-created inflation has it stuck in its own trap. Raising interest rates supports a strong dollar. Rising interest also causes debt payments to rise, and also makes U.S. Treasury bonds more attractive to global investors—especially when other central banks are slow to respond. The result is that international money flows to the U.S., converted into dollars to buy Treasurys. That’s an oversimplification, of course, but it is the state of play.
I believe that the Fed will keep raising rates until something breaks. Then they’ll stop. Then they’ll give us more, then another wave of inflation, etc. Stop, start, stop, start until we have the courage to restructure the system (primarily the debt and entitlements).
We can and will reach a point at which we fix or “reset” the system. It just won’t happen until we get to the end of the road, look down into the abyss, and have the political will to come together, make hard decisions, and do what has to be done. Mauldin calls it “The Great Reset.” It will be hard, include write-offs (losses) for bondholders, lower benefits for pensioners, and higher taxes for all of us.. At some point, we will select between the lesser of two evils. Dalio is signaling where we are along this path. And how one might consider positioning assets to profit.
Particularly challenging is the crazy high level of debt in the balance of the developed world. Germany at 313% debt to GDP. Really, Germany? The UK at 445%. Boris, gone. Italy at 352%. Mario, out. The U.S. is at 349%. And this doesn’t include the unfunded entitlement programs. How far can these governments even raise rates? Not much. What a trap.
What breaks? It could be any of the countries sitting along the debt fault line.
Other countries will follow the Fed and hike rates. Europe did this last week, but they have been slower than the Fed to respond to inflation, and it is mainly because rising rates mean more pain for borrowers and can lead to large bankruptcies. More than a few companies and countries are in trouble.
The yield dispersion results in a weaker currency versus the U.S. dollar. You can see it in the above dollar chart since the Fed started hiking rates early this year. Inflation is kryptonite to central bank policies. Inflation is kryptonite to everyone. Thus, the Fed, in my view, will continue to hike until something breaks. Keep your investment defense team on the field.
A Few Good Signs: Margin Debt and Fair Value
Some good news is margin debt is well off its highs. That happens when popular stocks decline more than 50%, causing margin calls and forced selling to kick in. Call the first bear market wave down the margin debt market wave. The next will be the result of earnings compression.
The Buffett Indicator
With the Q1 GDP Third Estimate and the June close data, we now have an updated look at the popular “Buffett Indicator”—the ratio of corporate equities to GDP. The current reading is 197.3%, down from 205.1% in the previous quarter. Source: AdvisorPerspectives
Bottom line: Better, not yet great. A good target to keep top of mind is somewhere between 100% and 150%.
A lot is going on in the following chart, and it too can help us set attractive investment opportunity targets. First things first: The P/E 10 ratio is a valuation measure for equities that uses real per-share earnings over 10 years. The P/E 10 ratio also uses smoothed real earnings to eliminate net income fluctuations.
Think of P/E 10 and the ten-year smoothing of actual reported earnings of the S&P 500 companies compared to the price of the S&P 500 Index. We’ve got data back to 1870. There are many valuation measurements, but this is a popular one.
Here’s how to read the chart:
- The June 2022 month-end P/E 10 ratio was at 29.1 (yellow highlight).
- The navy blue line shows the P/E 10 over time.
- The gray line in the upper section is the price of the S&P 500 Index over time. Note how it moves above and below the red trend line over long periods of time.
- NDR’s median PE based on actual reported earnings puts “fair value” on the S&P 500 Index at around 3,000. While it’s not a perfect correlation, I think that it is probably close to the current level of the top red line in the chart.
- If that is your “risk-back-on” point for the S&P 500 Index, I believe it’s a point where the market could return 8% to 10% annually for the subsequent 10 years.
- Just note that the market could move below the red line (undervalued) and be there for an extended period of time.
- The bottom section of the chart plots the P/E 10 Ratio. Anything under 21 is a good “risk-back-on” target. The lower the valuation entry point, the higher the subsequent returns will be.
Bottom line: Not yet time to pounce.
Grab that coffee and find your favorite chair. More from Dalio below. . I find it fascinating that you and I have access to research from Bridgewater and other firms wishing to help the world better understand the dynamics at play… as well as potential solutions. The Trade Signals charts continue to signal a bear market for equities and gold. The bond market looks to be setting up for a nice trade. I’m watching the Zweig Bond Model closely. The current economic state: high debt, high inflation, falling economy…recession is near. Thanks for reading. I do appreciate the time you give me each week.
For discussion purposes only. Talk with your investment advisor. Not a recommendation to buy or sell any security.
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Notes on The Big Cycle of Money, Credit, Debt and Economic Activity (thanks, Sam!)
Money and credit are the biggest single influence on the rise & decline of wealth & power; they’re essential to how the world works
Debt eats equity, money feeds the hunger of debt, and the central banks can produce money
Money, credit, debt, and economic activity are inherently cyclical
In the credit creation phase, demand for goods, services, and investment assets (and production of them) are strong. In the debt paying back phase, it is weak.
- It’s important to watch individuals, companies, governments, and economies’ income statements & balance sheets to imagine what will likely happen
- The biggest problem now is that individual, company, organization, and government incomes are low in relation to expenses, and liabilities are large relative to asset values
- Reserve currency is excellent for some time because of the great borrowing and spending power it provides, but the status creates too much borrowing power, to a point where debts become too large to be paid back, leading to currency devaluation
It’s important to see that:
- Most money and credit have no intrinsic value,
- They’re just entries in the accounting system that can be easily changed,
- The purpose of the system is to help allocate resources efficiently to boost productivity, and
- The system periodically breaks down, with all currencies being destroyed or devalued
Money and credit ≠ wealth. To create more wealth, one must be more productive.
There are two economies: real and financial; both are key to understanding what will happen:
- Real economy: goods and services produced and demanded
- Financial economy: tightening/easing of money and credit to slow/boost demand in the real economy
Money and credit are stimulative when they’re given out and depressing when they have to be paid back; that’s what makes money, credit, and economic growth cyclical:
- Short-term cycles of ups and downs typically last eight years; timing depends on how long it takes a stimulant to raise demand to the point where the real economy’s capacity to produce is limited
Long-Term Debt Cycle (approx. 50 to 70 years)
A) Begins with no/low debt and “hard money,” e.g gold coins
- Gold, silver, nickel all have intrinsic value, and are easily shaped for coins
- There’s no credit component with hard money, but it has high credibility
B) Claims on “hard money” (notes/paper money)
- Notes are linked to claims on gold, silver, nickel, etc.
- Easier to create credit than hard money
C) Increased debt
- Eventually, there are more claims on hard money than there is hard money, or too much debt
D) Then we get debt crises, defaults, devaluations (e.g., Nixon taking U.S. off gold standard)
E) Conversion to fiat money
- No hard money creates the risk of too much money: Debt, assets, and liabilities are created in relation to the amount of goods and services being produced in a particular economy
- Happening now in greater amounts now than at any time since WWII
F) Fight back into hard money
- Economic stress, wealth gaps, high taxes, and political unrest caused by debt crises make people want to move back to hard assets and other countries (and their currencies) a necessity compelling governments to move back to a form of hard currency to rebuild people’s faith
- Type 1: stimulating money and credit growth by lowering interest rates
- Type 2: printing of money and buying of financial assets (mostly gov. bonds and high-quality debt)
- Type 3: reserve currency’s central government increasing borrowing and targeting spending/lending to where they want it to go with the central bank creating money and credit and buying debt to fund these purchases
Debt cycle diagram
Ray Dalio: “The Changing Value of Money” Notes
- Printing and devaluing money is the easiest way out of a debt crisis
- All currencies devalue and die, causing that currency’s cash and bonds to devalue/wipe out
- Levers to pull to bring debt and debt-service levels down relative to income and cash-flow levels required to service one’s debts:
- Spending less
- Debt defaults and restructurings
- Transfers of money and credit from the wealthy to the non-wealthy (e.g., raise taxes)
- Print money and devalue it (most common and less painful than other methods)
- People need to pay attention to currency risks
- It is most important for currencies to devalue against debt since the goal of printing is to reduce debt burdens
- When money and credit supply increase, it can facilitate the flow of money and credit into productivity/profits, increasing real stock prices, or it can hurt actual returns of “cash” and debt assets, driving flows out of assets and into other currencies or inflation-hedge assets and causing a decline in value of a currency
- Government will choose to prevent real interest rates from rising by printing money and buying cash and debt assets (reinforces the bad returns of holding “cash”) instead of letting real interest rates rise
- There are systemically beneficial currency devaluations and systemically destructive ones that can damage a credit/capital allocation system (but are necessary to wipe out debt to create new monetary order)
- Big currency devaluations tend to be more episodic than evolutionary and occur as relatively abrupt declines during debt crises, separated by periods of currency stability during prosperity.
- A currency devaluation ≠ currency losing reserve currency position
- Losing reserve currency status comes from chronic, large devaluations
- History has shown that there are very large risks in holding interest-earning cash currency as a store hold of wealth, especially late in debt cycles
- Usually leading up to a currency devaluation…
- There are more claims on the central bank than there is hard money
- Net central bank reserves start falling prior to the actual devaluation
- Devaluations came alongside significant debt problems, often related to war spending
- Usually, central banks respond initially by not increasing the supply of money so short-term rates forestall devaluation when being sold
- Strategy is too painful, so they then devalue
- Usually leading up to a country losing reserve currency status…
- There is an established loss of economic and political primacy to an upcoming rival
- There are large, growing debts that the central bank monetizes by printing money and buying gov. debt and a weakening of the currency in a self-reinforcing run from the currency that can’t be stopped because the fiscal and balance of payments deficits are too big.
Not a recommendation to buy or sell any securities. See important disclosures below.
Trade Signals: Bear Market Trend Intact
July 22, 2022
S&P 500 Index — 3,948
Notable this week:
No significant changes this week.
The Dashboard of Indicators follows next.
Click HERE to see the Dashboard of Indicators and all the updated charts 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.
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Personal Note – Denver
I’m in Denver today visiting my son Matt. We are golfing at Cherry Creek Country Club tomorrow afternoon. I’m really looking forward to handing Matt another $20. Seems it is the way, even when he gives me strokes. But the time spent together is priceless!
It is hot here in Denver, but the lack of humidity much of the country is experiencing makes it tolerable. I hope you are staying safe and cool.
Wishing you a great week!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Forbes Book – On My Radar, Navigating Stock Market Cycles. Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.
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.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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