July 11, 2014
By Steve Blumenthal
I was in Denver this week presenting at a large investor forum. I shared with the audience two valuation charts I believe you will find interesting. One looks at forward PE (a measure I disfavor). The other is what Warren Buffett called “probably the best single measure of where valuations stand at any given moment” in a 2001 Fortune Magazine interview.
Often I hear the argument that the market is inexpensively priced at a current PE of just 15. Several readers responded to my recent Forbes piece challenging my view that the market is overvalued. They all pointed to the lower forward PE which is based on Wall Street analyst’s forward estimated earnings. The reason I disfavor forward PE is that Wall Street analysts have a bad habit of consistently missing the mark. The Forbes piece was titled, Stock Market’s High P/E Suggests Lower Returns Ahead.
I wish I had included the following chart in that article. It shows what happened the last time forward PE was north of 15 (as it is today). It was 15.2x at the market peak in October 2007 – a -57% decline followed. It is 15.6 today.
The simple point is that when you buy in when the market is expensively priced, forward potential return is lower and risk considerably higher. The first bullet in today’s On My Radar shows Buffet’s favorite valuation measure – Stock Market Capitalization as a Percentage of Nominal GDP. It shows a market that is more overvalued today than it was in 2007 or any other period in time dating back to 1925 (with just one exception, March 2000).
Portugal was front and center this week. It remains a debt mess in Europe. Remember Cyprus? The “Cyprus flu” appears to be spreading. The structure is now in place to do the same in Germany. Additionally, the IMF is pushing towards a 10% tax on all household assets to bail out the government. The problem is unmanageable debt.
I share the following in this week’s On My Radar:
- Stock Market Capitalization as a Percentage of Nominal GDP – Warrant Buffett’s favorite valuation measure
- Armstrong – Expropriation Is Back – Is Christine Lagarde the Most Dangerous Woman In The World?
- Germany OKs Plan to Make Creditors Prop up Banks – Think Cyprus
- From the Bank for International Settlements – An Unusual Warning to the Fed and the Global Central Banks
- Trade Signals: Risk Remains High – 07-9-2014
Stock Market Cap as a Percentage of Nominal GDP – Warrant Buffett Favorite Valuation Measure
Expropriation Is Back – Is Christine Lagarde the Most Dangerous Woman In The World?
Several excerpts: “In January 2014, the Bundesbank joined the IMF project focusing on a “wealth tax”. In its monthly report they had announced: “In the exceptional situation of an imminent state bankruptcy a one-time capital levy could but cheaper cut than the then still relevant options” if higher taxes or drastic limitations of government spending did not meet or could not be implemented.
In the latest June 2014 working paper of the IMF, they have set forth yet another scheme – extending maturity. So you bought a 2 year note? Well, the IMF possible solution would be to simply extend the maturity. Your 2 year note now becomes a 20 year bond. They do not default, you just can never redeem.
Possible remedy. The preliminary ideas in this paper would introduce greater flexibility into the 2002 framework by providing the Fund with a broader range of potential policy responses in the context of sovereign debt distress, while addressing the concerns that motivated the 2002 framework. Specifically, in circumstances where a member has lost market access and debt is considered sustainable, but not with high probability, the Fund would be able to provide exceptional access on the basis of a debt operation that involves an extension of maturities (normally without any reduction of principal or interest). Such a “reprofiling” operation, coupled with the implementation of a credible adjustment program, would be designed to improve the prospect of securing sustainability and regaining market access, without having to meet the criterion of restoring debt sustainability with high probability.”
Here is a link to The IMF’s June 2014 paper titled – The Fund’s Lending Framework and Sovereign Debt – Preliminary Considerations.
“Now the June 2014 report has a new, far-reaching proposal. This shows how lawyers think in technical definitions of words. There is no actual default if they extend the maturity. You could buy 30-day paper in the middle of a crisis and suddenly find under the IMF that 30 day note is converted to 30 year bond at the same rate.”
When you start seeing regulators put on exit penalty gates on bond mutual funds (an idea being floated at the Fed) to re-writing the rules on the ownership of government bonds, you have to wonder just how bad the problem is and where will all that fleeing money go. An argument can be made that over-bought, over-believed and overvalued US stocks may just be the beneficiary of future capital flows. More money may be forced into US stocks. A melt up may happen. We’ll keep an eye on capital flows.
We really are in interesting times.
Germany OKs Plan to Make Creditors Prop up Banks
In summary: Germany’s cabinet Wednesday approved plans to force creditors into propping up struggling banks beginning in 2015, one year earlier than required under European-wide plans that set rules for failing financial institutions.
The new bail-in rules are part of a package of German legislation on the European banking union–an ambitious project to centralize bank supervision in the euro zone and, when banks fail, to organize their rescue or winding-up at a European level.
Germany “leads the way” in Europe by implementing European rules quickly and “creates instruments that allow the winding-down of big systemically relevant institutions without putting the financial stability at risk,” the country’s finance ministry said in its draft bill seen by The Wall Street Journal.
From the Bank for International Settlements – An Unusual Warning to the Fed and the Global Central Banks
“Financial markets have been exuberant over the past year, at least in advanced economies, dancing mainly to the tune of central bank decisions. Volatility in equity, fixed income and foreign exchange markets has sagged to historical lows. Obviously, market participants are pricing in hardly any risks. In advanced economies, a powerful and pervasive search for yield has gathered pace and credit spreads have narrowed. The euro area periphery has been no exception. Equity markets have pushed higher. To be sure, in emerging market economies the ride has been much rougher. At the first hint in May last year that the Federal Reserve might normalize its policy, emerging markets reeled, as did their exchange rates and asset prices. Similar tensions resurfaced in January, this time driven more by a change in sentiment about conditions in emerging market economies themselves. But market sentiment has since improved in response to decisive policy measures and a renewed search for yield. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.
In the countries that have been experiencing outsize financial booms, the risk is that these will turn to bust and possibly inflict financial distress. Based on leading indicators that have proved useful in the past, such as the behaviour of credit and property prices, the signs are worrying.
Term and risk premia can only be compressed up to a point, and in recent years they have already reached or approached historical lows. The risk is that, over time, monetary policy loses traction while its side effects proliferate. These side effects are well known (see previous Annual Reports). Policy may help postpone balance sheet adjustments, by encouraging the evergreening of bad debts, for instance. It may actually damage the profitability and financial strength of institutions, by compressing interest margins. It may favour the wrong forms of risk-taking. And it can generate unwelcome spillovers to other economies, particularly when financial cycles are out of synch. Tellingly, growth has disappointed even as financial markets have roared: the transmission chain seems to be badly impaired. The failure to boost investment despite extremely accommodative financial conditions is a case in point.
Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back. When policy responses fail to take a long-term perspective, they run the risk of addressing the immediate problem at the cost of creating a bigger one down the road. Debt accumulation over successive business and financial cycles becomes the decisive factor.
In contrast to what is often argued, central banks need to pay special attention to the risks of exiting too late and too gradually. This reflects the economic considerations just outlined: the balance of benefits and costs deteriorates as exceptionally accommodative conditions stay in place. And political economy concerns also play a key role. As past experience indicates, huge financial and political economy pressures will be pushing to delay and stretch out the exit.
The current weakness of aggregate demand may suggest the need for further monetary stimulus or for easing the pace of fiscal consolidation. However, these policies are likely to be either ineffective in current circumstances or unsustainable: taking a long-term perspective, they may simply succeed in bringing forward spending from the future rather than increasing its overall amount over the long run, while leading to a further rise in public and private debt. Instead, the only way to boost demand in a sustainable manner is to raise the production capacity of the economy by removing barriers to productive investment and the reallocation of resources. This is even more important in the face of declining productivity growth.
The benefits of unusually easy monetary policies may appear quite tangible, especially if judged by the response of financial markets; the costs, unfortunately, will become apparent only over time and with hindsight. This has happened often enough in the past. And regardless of central banks’ communication efforts, the exit is unlikely to be smooth. Seeking to prepare markets by being clear about intentions may inadvertently result in participants taking more assurance than the central bank wishes to convey. This can encourage further risk-taking, sowing the seeds of an even sharper reaction. Moreover, even if the central bank becomes aware of the forces at work, it may be boxed in, for fear of precipitating exactly the sharp adjustment it is seeking to avoid. A vicious circle can develop. In the end, it may be markets that react first, if participants start to see central banks as being behind the curve. This, too, suggests that special attention needs to be paid to the risks of delaying the exit. Market jitters should be no reason to slow down the process.
The temptation to postpone adjustment can prove irresistible, especially when times are good and financial booms sprinkle the fairy dust of illusory riches. The consequence is a growth model that relies too much on debt, both private and public, and which over time sows the seeds of its own demise. More generally, asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap. Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent. In this context, economists speak of ‘time inconsistency’: taken in isolation, policy steps may look compelling but, as a sequence, they lead policymakers astray.
The risks of failing to act should not be underestimated.”
Source: Bank of International Settlements via http://hussmanfunds.com/wmc/wmc140707.htm
Trade Signals: Sentiment Remains Extreme – 7-9-2014
The cyclical trend remains bullish for both the equity and fixed income markets. Investor Sentiment remains convincingly in the extreme optimism zone.
Click here for a link to Wednesday’s Trade Signals.
The debt challenges remain and we are in an overbought, over-believed and overvalued market environment. QE has driven investors into riskier assets. Cash levels are low and margin debt is at a record high. Risk is high. But, and I mean a very big BUT, there is an opportunity if we position ourselves correctly.
I told the crowd in Denver that there are two kinds of individuals looking to make money: an investor or a speculator. The speculator has to be right on both his call, timing and positioning of his bet. The investor is focused on making money. Being right or making money.
When equity risk is high, I believe it is best to overweight your portfolio to include a handful of tactical strategies. I’ve been sounding the debt warning and policy response concerns for some time now. Despite this ominous backdrop and, frankly, my personal view on current risk, price momentum has pointed correctly towards equity and other more aggressive asset class exposures.
We all look for the great market call. The get rich call. Deflation or inflation? Timing a market top? This is impossible to do consistently. Being right? Hussman, Dalio, Paulson, Hunt, Mauldin, Shiller, Shilling, Grantham? How do you allocate and size your investment risks? The good news is you don’t need to be right all the time.
Disciplined tactical strategies seek to position in line with market leadership. They have the flexibility to move to safer asset classes when leadership points in that direction. When risk is high in equities, tilt your weightings and overweight tactical. When a crash does materialize you may be in a far better position to take advantage of the outstanding opportunity that the decline will bring. When risk is low, tilt back to overweight equities.
After my presentation an investor asked me what he should do with a large equity position. “Hedge it with a put option strategy,” I said. Fortunately for him, his advisor has experience with options. It just makes sense to have the insurance in place.
The good news is, just like the post-2008 crisis, an opportunity will present itself again. Make sure you’re in a position to act. As they would have said in the 70’s and are probably saying in Colorado today, “debt’s a drag man” (pun intended). I believe we are in “A Debt Trap”. Risk is high today. Weight your set of portfolio risks accordingly.
Denver is majestically framed by the mountains to its west. What a view and what a nice feeling. The city is alive and well. I stayed near the downtown baseball park and took in a game (though I did sneak out early to catch the World Cup semi-final).
Chicago is up next. Then to Venus, Florida and two days at Ned Davis Research.
Have a wonderful weekend.
With warm regards,
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods.
CMG Global Equity FundTM and CMG Tactical Futures Strategy FundTM: Mutual Funds involve risk including possible loss of principal. An investor should consider the Fund’s investment objective, risks, charges, and expenses carefully before investing. This and other information about the CMG Global Equity FundTM and CMG Tactical Futures Strategy FundTM is contained in each Fund’s prospectus, which can be obtained by calling 1-866-CMG-9456. Please read the prospectus carefully before investing. The CMG Global Equity FundTM and CMG Tactical Futures Strategy FundTM are distributed by Northern Lights Distributors, LLC, Member FINRA. NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Hypothetical Presentations: To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the model if the model had been used during the period to actually mange client assets; and, (3) CMG’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model. Please Also Note: Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (i.e. S&P 500 Total Return or Dow Jones Wilshire U.S. 5000 Total Market Index) is also disclosed. For example, the S&P 500 Composite Total Return Index (the “S&P”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. Standard & Poor’s chooses the member companies for the S&P based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The historical performance results of the S&P (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10 year period would decrease a 10% gross return to an 8.9% net return. The S&P is not an index into which an investor can directly invest. The historical S&P performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet, his/her investment objective(s). A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professionals.
Written Disclosure Statement. CMG is an SEC registered investment adviser principally located in King of Prussia, PA. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at (http://www.cmgwealth.com/disclosures/advs).