April 17, 2020
By Steve Blumenthal
“For the time before this current crisis, I give practically all central banks a miserable grade.
But in the crisis they do the right thing. Well, the Fed’s rate cuts would not have been necessary,
they are of no use in the current situation.
But it is important that the central banks provide credit lines for the entire financial system and inject liquidity.
It was extremely important that the Fed opened Dollar swap lines to foreign central banks.
These swap lines are probably even too small. China and other emerging economies in particular should receive this lifeline.
The IMF will probably have to step in here, because the dimensions of the Dollar amounts required are monumental.”
– Felix W. Zulauf,
Chief Executive Officer, Zulauf Asset Management AG
It’s about debt—fingers of instability. That’s the main takeaway from the Zulauf quote above, and it is the message I share with you this week. You’ll find an excellent interview with Felix, along with a few actionable ideas in the body of this week’s post. (Caveat: Not a recommendation for you to buy or sell any security. Please consult your financial advisor about about risks, proper sizing, etc.).
Before you click through, let’s first take a look at the level of debt in the system. I know I sound like a broken record, but it bears repeating: The instability in the system is due to the massive size of debt obligations here, there, and everywhere. We are at the beginning of a process to make it go away (or reduce it to manageable levels). But it’s not such an easy thing to do.
What is most concerning about the current global situation? The debt levels in Europe and the emerging market dollar-denominated debt. The next lightning strike likely comes from one or both of these markets. It will make the $1 trillion (and perhaps soon-to-be $2 trillion) in risky junk bond paper look like pocket change.
In last week’s post, I promised you a look at debt. Let’s do that today. As you read, consider this example. Say your brother-in-law earns $100,000 per year, and over the course of the last twenty years, he built up credit card debt. He bought a house with a mortgage, and then refinanced his credit card debt by taking out a second mortgage (leaving him little net value in his real estate). Then, he somehow racked up more credit card debt.
When interest rates came down, he was able to borrow more, but he finally reached a point where lenders became less willing to lend to him. He now has $350,000 in debt.
Think about how all that credit he borrowed helped stimulate the economy as he bought some cool things. Over time, though, he reached a point where more and more of his $100,000 annual income had to be used to pay back the debt and interest charges on the debt. He can’t borrow more to spend and has less money left over each month to buy things. His personal economy slows.
And as his spending slows, the economies of those dependent on his spending slow as well. If it’s just your brother-in-law that gets into this mess, then, well, don’t lend him money when he comes knocking on your door. But when everyone gets into trouble like this at the same time, everyone’s economy slows.
That’s the problem with debt. It’s good for the economy as it expands, but bad for the economy when collectively we reach the end to how much we can reasonably borrow. This is the pickle we find ourselves in today. We’ll get through it, but not without defaults and newly created bailouts and plenty of indigestion.
My fear is well summed up in Zulauf’s conclusion: “the constant cry for help to central banks and governments whenever it rains will gradually cost us freedom and prosperity.” Kind of like moving back in with mom and dad. Their house, their rules… but likely worse. The bottom line? We better be careful.
Coffee in hand? When you click on the orange On My Radar button, you’ll link to the entire post. When you look at the debt data, don’t get stuck; simply use the charts to get a handle on the bigger picture. Factoring them into our investment thinking is a must—more debt, more risk, more volatile swings. You’ll also find the Zulauf interview, “We Have Created the Biggest Excesses in Generations,” and the latest Trade Signals post. The Zulauf piece is well worth the read, and I end with some much-needed good news.
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:
- Debt – Fingers of Instability
- Felix Zulauf – “We Have Created the Biggest Excesses in Generations”
- Trade Signals – A Look at Long-term Trend (Where We Are in the Investment Cycle)
- Personal Note – Some Good News
“Today is already the tomorrow which the bad economist yesterday urged us to ignore.”
– Henry Hazlitt, Economics in One Lesson
I’d like to begin this section with its conclusion. The debt challenges are real, large and yet to be solved. Like sub-prime in 2008, under the surface sits a number of challenges we just don’t yet know and may not fully foresee. The Fed has responded in lightning speed. Good on them and us (for now). However, we’ve nuked the global economy and I believe the disruptions are broader and deeper than we yet know. The promises we’ve made (i.e., debt) is at levels that can’t possibly be paid back. Debt is the great source of our instability. European debt, emerging market debt and corporate debt. Buy the large dips, sell the large rallies — wash, rinse, and repeat. Seek transformational businesses, high and growing dividend payers and overweight equities when valuations are attractive.
Debt – Fingers of Instability
Let’s first take a look at various debt levels across the globe. Vigorous research suggests when debt-to-GDP grows to be north of 90%, economies slow. That has most certainly been the case in the U.S. since 2000.
Remember that 90% number and then look at the size of the problem. Just how much can the Fed print to paper over this much debt. I’m keeping my eye on two developing crises that the Fed has less control over:
- Eurozone – $60.4 trillion, which translates into 463.7% debt-to-GDP. Tell me what happens if Italy says arrivederci to the EU? France is at 513.4% debt-to-GDP. And the impact on the banks and the impact on any bank in the world who has counterparty risk tied to a Eurozone bank. And keep the words “bail in” top of mind. That’s where the deposits take the hit. Not good if JPM has a derivative trade and/or loan with/to Deutsche Bank on its books.
- Emerging Market Debt – especially the EM dollar-funded debt (see EM debt section further below).
Yellow highlights in the next chart are mine. Data mostly through 12-31-2019. Look at this from 30,000 feet. The idea here is to give you a sense of the enormity of the debt problem.
Recall the hypothetical brother-in-law story I told above. That brother-in-law has really gotten himself into a problem.
Debt, when it reaches a certain level, slows growth. The math facts are detailed in the lower section of next chart:
- Red arrow shows where we are today. Green arrow shows growth is highest when debt-to-GDP is low.
- Growth is lowest when debt is high (makes sense, right?)
- Can this go on? Yes. But zero-bound interest rates no longer work. We are nearer to the end of the debt supercycle. Could COVID-19 be the excuse to reset the system, meaning monetize debt?
Next let’s look at Mortgage Debt, Student Loan Debt, Auto Loan Debt, Credit Card Debt and Other Consumer Debt.
Mortgage debt is challenging its 2007 highs. Student loans are off the charts. Auto loans are 50% higher than in 2007. Credit card debt is higher, as are other forms of consumer debt. We are in far worse shape than we were, debt-wise, just prior to the great financial crisis in 2007:
Total Household Debt: $16 Trillion
Mortgage Debt – $10.6 Trillion
Ted Tozer, president of Ginnie Mae, said in 2015, “… Today almost two-thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights and all of these things have created a new and challenging environment for Ginnie Mae. … In other words, the risk is a lot higher and business models of our issuers are a lot more complex. Add in sharply higher annual volumes, and these risks are amplified many times over. … Also, we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks…”
The mortgage lenders provide the liquidity in the market for you and me to buy real estate. “Mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen.” Recall that it was the mortgage crisis that nearly brought down the world’s strongest capital market in 2008. “Most sophisticated financial engineering…” This is about leverage and when the capital dries up, prices of homes and other real estate declines. Sub-prime part II? No wonder the Fed is creating special vehicles to buy this Wall Street engineered stuff.
Auto Loan Debt – $1.19 Trillion
Since the highest point before the Great Recession, the auto loan debt has increased by just over 70 percent—from a total of $700 billion to about $1.2 trillion. What is more, the standards of these car loans are so low that they resemble the standards that were being followed before the last recession in the housing market.
Further, according to the WSJ, approximately 33% of people who traded in cars to buy new cars during the first nine months of 2019, had negative equity. That compares to 28% five years ago and 19% ten years ago. Those borrowers owed $5,000 on average after they traded in their cars.
The incentive to do this came from, you guessed, the Fed’s policy of ultra-low interest rates. Can you see how debt grows and the quality on the auto loan debt gets worse?
Let’s take a look at corporate debt next.
U.S. Corporate Debt – $10 Trillion
Corporate debt has also increased by about 67 percent since the end of the Great Recession, from about $6 trillion to $10 trillion in just 10 years. The last time corporate debt increased like this was during the 1990s and that was followed by the dot-com bubble. Remember the many zombie companies in 1999. They got wiped out in the recession that followed. The bonds defaulted.
A “zombie” company is defined as “a publicly traded firm that is 10 years or older with a ratio of earnings before interest and taxes to interest expenses of below one.” Today, approximately 12% of the world’s companies are “zombie” companies versus just 2% in the 1990’s. In the U.S., 16% of companies are zombies and nearly a third of the companies in the Russell 2000 Index are zombie companies.
(Some of this information is sourced from an excellent post called, “Covid-19 Isn’t The True Culprit of the Coming Recession,” by Dr. Klajdi Bregu.)
We are likely headed for a corporate debt default crisis. But, but, but you say, “Steve, the Fed is buying junk bonds.” Sigh, I know. It angers me. The system needs to clear. Future generations are going to get stuck with the tax bill. I’m just not sure the Fed and legislators can afford to bail out the private equity guys that used the junk bond market to cash themselves out. And I’m not how much political love will exist for the corporate executive who binged on debt only to use that debt to buy back his/her own stock. A home run for those with big stock options. The cost? More debt on the corporate books.
Here is a quick look at the size of Corporate Debt in the developed world:
- Note the $19 trillion in the Eurozone vs. $10 trillion in the U.S.
- Note the debt as a % of GDP
- A default wave in Europe or Asia will roll like a tsunami to U.S. shores.
Will the Fed create a special purpose vehicle to bail out households? Reduce the debt by $4 trillion? Maybe. Why not create another special purpose vehicle and take out the full $16 trillion. That will bring our animal spirits back again. Put it on the government books and tax our kids for generations to come. Why not?
And you, wise and prudent steward of your money, you lose and your brother-in-law wins. Bet that makes you happy. And what do future generations learn?
Let’s look at one of the other big hotspots, farther out of reach of the Fed’s magic money tree: Emerging Market Debt.
Emerging Markets: $72.5 Trillion
Bullish investors are banking on the IMF and World Bank to deploy up to $1 trillion in relief to help stave off mass defaults and worst possible outcomes.
Yes, but, but: That may not be nearly enough. IIF’s data show total debt for 30 large EM countries reached $72.5 trillion in 2019, a 168% increase over the past decade.
EM countries also have around $5.5 trillion of debt coming due this year, with a sizable percentage held by investors in the industrialized world.
State of play: The emerging world is being battered on all sides by a slowdown in manufacturing, cratering oil prices and the depression of aggregate demand as a result of the COVID-19 outbreak.
The suffering expected in developed economies like the U.S. and eurozone will be compounded significantly in emerging economies, like those in Asia, Latin America and Africa, which are expected to drive the world’s growth in the coming years.
Source: Axios Markets and Fee.org
If you go to www.usdebtclock.org you’ll find a running tally of total U.S. debt. It looks like this:
Not included in the debt data shared today are promises that are made such as Social Security, Medicare and other US Unfunded Liabilities (like underfunded pensions). Look at the sum total of Assets Per Citizen vs. Liability Per Citizen.
Source: Data may not fully match data from NDR and others, but it is pretty darn close and useful overall. Kudos to the folks who put this site together.
I began this section with the conclusion. Bottom line: Debt creates the fingers of instability. Problems will flare. Some larger than others. Expect a period of time that favors market timing, active management and risk discipline. I don’t for a second believe we are out of the woods.
“A real bear market is only over when no one is interested in stocks anymore.
You must feel sick when you think of equities.
That’s when you know that the right time to buy stocks.”
– Felix Zulauf, Source
[SB here: Bold emphases below are mine.]
Felix Zulauf: “We Have Created the Biggest Excesses in Generations”
by Mark Dittli, TheMarket
The investor and market observer is a harsh critic of central banks. They ran a monetary policy that was way too loose in the upswing, thus creating a huge mountain of debt. “We have forgotten that recessions are a natural part of the business cycle”, he says in an in-depth interview.
When things get turbulent in financial markets, experience is required. Felix Zulauf has experienced many boom and crash phases in his almost fifty-year career as an investor and market observer.
In an in-depth interview, Zulauf explains how the downturn of the past few weeks should be interpreted, when and where he sees buying opportunities, and why he hopes that the Covid-19 crisis will lead to a fundamental rethinking in the financial world. “It is a disaster that our central banks have pursued a monetary policy that was far too loose during the expansion. This has fueled the excesses in debt”, said Zulauf.
Mr. Zulauf, equity markets have suffered a sharp fall in March. Have you ever experienced a crash like this?
The intensity reminds me of 1987, but the speed is without precedent. It is unique that stock markets collapse by more than 30% within two weeks, straight from their historical high. But then again, the fundamental situation is also unique. I’ve been in business for almost fifty years, but I’ve never seen the global economy shut down so quickly. Many people still do not realize the enormous economic damage caused by the measures to contain the Covid-19 pandemic. The world will not be the same after this.
Is the economic damage larger than in the aftermath of the 2008 global financial crisis?
Yes. 2008 was primarily a real estate and banking crisis that spread to industry sectors through contagion effects. Most of the service sectors remained unharmed, though. This time, all sectors are affected, especially services. Tourism, restaurants, hairdressers, countless small businesses: if they have to close for two months, their cash flow dries up and they cannot survive. That is probably unique in history. According to estimates by the Ifo Institute in Munich, such closure leads to a loss of economic output of 7 to 11% after two months and up to 20% after three months. The decline will be determined by the duration of the restrictions. All in all, the economy will experience a brutal fall in the first half of the year. If authorities around the world act wisely, we’ll see a stabilization in the second half of the year.
Don’t you expect a V-shaped recovery of the economy when the worst part of the pandemic is over?
No, because the recession is starting a domino process. All the excesses from the expansion of the past ten years come to the surface now. Remember: The level of total debt in the world today, compared to economic output, is more than twice as high as in 2007. We have created the biggest excesses in generations. This debt is now increasing the downward pressure. In addition, the global economy was already in a slowdown mode even before the Covid-19 shutdown. You could see that the economy was slowing down in 2020, so it was right to start the year with an underweight in equities and an overweight in bonds. Then came the Covid-19 shock. And on top of all that, we saw the beginning of a new price war in the oil market in early March.
Isn’t a lower oil price good for the global economy?
No, not in this case. The shale oil industry in the United States is practically bankrupt. These companies have more than $900bn in debt outstanding. Risk premiums in the high yield segment, where investors for years have not paid attention to the balance sheet quality of debtors, are skyrocketing now. This eats its way through the financial system, jeopardizes the refinancing of many companies and thus also affects the real economy. Once again, this shows how dangerous an excessive build-up of corporate debt is.
Central banks are pumping liquidity into the system, governments are setting up support programs. Is this useful?
Fiscal policy measures can only take effect when the restrictions are lifted and people are allowed to move again. Afterwards they have a supportive and later a stimulating effect. The gigantic amounts that central banks are pumping into the system have to be imagined as follows: They plug the huge deflationary hole that the Covid-19 crisis has torn open, and they prevent the meltdown of our financial system. In that sense, that’s the right policy to follow. If the economy then normalizes, these liquidity injections can have an inflationary effect. Of course central banks believe that they could skim off this liquidity again, but they have shown in the last cycle that this remained a pious wish.
Are these support programs even necessary, in your view?
During the crisis: yes. In principle, however, fiscal policy should be balanced over the cycle; increase government debt in the crisis and then reduce it in the expansion. But apart maybe from Switzerland, nobody adheres to this principle. Take France, for example: They haven’t had a balanced budget for almost forty years. They don’t even know what a surplus is. The same principle applies to monetary policy: It is a disaster that our central banks have pursued a monetary policy that was far too loose during the expansion. This has fueled the excesses in debt. The problem with central banks really starts with the fact that a handful of people think they can control the economy. This is presumptuous. It is this attitude that weakens our market economy system. Recessions are a natural part of the business cycle. Companies who make negligent mistakes must be punished and eliminated. As a society, we have to endure that there are not only fair weather phases, but also recessions from time to time. If we can no longer accept this, then we cannot be saved. Then we will just pave the way to a planned economy with a long-term decline in prosperity.
What grade do you give the central banks for their performance?
For the time before this current crisis, I give practically all central banks a miserable grade. But in the crisis they do the right thing. Well, the Fed’s rate cuts would not have been necessary, they are of no use in the current situation. But it is important that the central banks provide credit lines for the entire financial system and inject liquidity. It was extremely important that the Fed opened Dollar swap lines to foreign central banks. These swap lines are probably even too small. China and other emerging economies in particular should receive this lifeline. The IMF will probably have to step in here, because the dimensions of the Dollar amounts required are monumental.
Why is that?
Over the past decade, a huge mountain of Dollar denominated debt has been built up outside the U.S., especially in emerging markets, and particularly in China. According to the BIS, these loans increased from $5.8 trillion to more than $12 trillion between 2009 and 2019. When the crisis hits, short-term loans are often not extended because lenders turn risk-averse. Then debtors have to scramble to buy Dollars in the market. As the Dollar rises, the debt in the debtor’s home currency increases, which in turn increases the pressure on them even more. Weak economies such as Turkey, Brazil and South Africa are caught in a vicious cycle. That’s why I’ve been warning for some time about investing in emerging markets, including China. They just have a huge Dollar debt problem.
Do you expect a “Lehman Moment” in this crisis, the collapse of a major market player?
In every crisis there are companies that perish. It won’t be any different this time. Given the excessive indebtedness in the corporate sector, one would have to expect some spectacular bankruptcies. But given the speed with which central banks have acted—much faster than in 2008—this will no longer threaten the financial system per se.
Is there a risk of a banking crisis?
With so much stress in the financial system, there is always this danger. In this regard, I am most concerned about Europe, because it has the structurally weakest economy and the weakest banking system. With the rigid regime of the single currency, the weaker members of the Eurozone won’t have the benefit of a devaluation in their currency. The one factor you have to look at today is corporate debt as a percentage of GDP. In the U.S., this metric is currently at 75%, in Germany at 95%, Italy at 100%, Switzerland at 120% and in France at 200%. I’m worried about Italy and Spain, but I’m even more worried about France and its banks. In the last cycle, the French turned the big wheel in lending and completely exaggerated. I doubt that European banks have enough capital to be able to absorb bad debts. I think a nationalization of some banks in the Eurozone will be inevitable.
Is the Euro at risk again?
The Eurozone is facing an important test. The Euro is a misconstruction. The Northern group has so far—understandably—resisted any communitization of debt. But if the Northern Euro members continue to do so in the current crisis, the weak states in the South will not be able to avoid introducing capital controls. Otherwise they will suffer a flight of capital to the North, and their banks will collapse. If, on the other hand, they agree to a communitization of debt, then the previously strong countries like Germany or the Netherlands will be dragged down by the weak and with them the entire continent. The move to a centralized state economy like in France would then be inevitable, and prosperity would decrease across Europe. The coming months will be crucial for the future of Europe.
What’s next for equity markets?
Stock markets are at the beginning of a bottoming process. The packages of measures taken by the authorities support the trust of market participants. This is a process of several weeks, and setbacks to the lows of late March or even slightly below cannot be ruled out.
What will trigger these setbacks?
In April, companies will report their numbers for the first quarter. Then you will see the first concrete signs of the economic damage. The outlook for the companies will be bleak because they have no visibility at all over the course of business. It is also unclear when the debt problems in China and other emerging countries will surface. Both could provoke setbacks in equity markets. Also, should the pandemic curves not flatten out as quickly as we assume today, markets will dive again. Over the course of the coming weeks, we should gradually gain more visibility, and after that a sustained recovery in equities can begin.
How long will this recovery last?
That will depend on developments in the real economy and the behavior of authorities. I would question whether investor confidence and animal spirits will come back so quickly. We also don’t know what will happen to the pandemic next winter. I am currently assuming that the greatest damage to the markets is behind us at the moment, that we will continue to see large fluctuations for some time and then stock prices will rise towards the end of the year. My expectations for afterwards depend on new information.
When would you buy stocks again?
If you can live with fluctuations, you can buy during the setbacks in the next few weeks. A lot of negatives are priced in, and central banks support the system. But consider: If you look at the Stoxx 600, the index with the 600 largest European companies, it has largely been in a sideways movement with large fluctuations for the past 20 years. This is a challenging environment, and I expect that to continue.
How do you deal with it as an investor?
Anyone who has successfully tried to identify good stocks has made good money in this sideways movement. And anyone who has managed to time the cycle – something that has been frowned upon in the wealth management industry for years – has also made money. So anyone who has done exactly what the wealth management industry has proven to be unable to do, and which is why it says it is the wrong approach, has been successful. But all those in Europe who have followed the buy and hold strategy as preached by most asset managers and major banks are sitting on poor results. Only in the U.S. did the market manage to reach a new high—but only thanks to the questionable, loan-financed share buybacks of many companies. I doubt that this will continue in the future.
Are you fundamentally negative on equities?
No, absolutely not. When you buy shares of a good company, you purchase a share of productive capital. Good companies can always adapt to the environment and generate more income for the investor over time than a normal fixed-income asset. There are always spurts of one to two decades on the stock exchanges, where stocks can grow strongly thanks to low valuation and a generally benign market constellation. You have to be there. But there are also long periods in which this is not the case, such as during the time between the mid-Sixties and the early Eighties. Today, we are headed towards more and more government intervention and less and less freedom and free markets. This is not a climate for structurally increasing prosperity. And over time, this expresses itself in financial markets. That’s why I advise investors to behave opportunistically.
What do you buy when you buy?
The order of my preferences is the United States, followed by emerging markets, and finally Europe. Europe simply has the most problems because the economic area is suffering from the misconstruction of the Euro and the EU. Emerging markets can recover, but it is too early because there are still many problems to be addressed. I have the most confidence in the United States because the economic system there is more free and flexible.
And which sectors in the U.S. do you buy?
The Information Technology and Healthcare sectors have weathered the crash best. These are probably the sectors that will be the focus of purchases in the next upswing. Cyclical stocks will only be attractive again when there is a clear economic recovery.
So would you buy the growth stocks again—the Googles, Amazons and Apples of this world—that were the leaders of the previous bull market?
Yes, certainly with a view over the next six months. Then we’ll have to judge what comes next. From this perspective, we are not at the end of a real bear market today, because that would only be the case if the leaders of the old bull market had been discredited and thrown out of the portfolios. We are not that far today. We have just had the longest economic expansion in the history of the United States, and we have had a stock market boom of more than ten years. A cycle like this does not end with a mere month-long correction. A real bear market is only over when no one is interested in stocks anymore. You must feel sick when you think of equities. That’s when you know that the right time to buy stocks for the long term has arrived.
What about bonds?
Yields for high quality borrowers have receded under fluctuations for almost forty years. We have now reached the end of a generation cycle in terms of returns. Bonds either have to be sold today or only have short maturities, which no longer brings any benefits in terms of returns. European bonds are most at risk because of the risks in the Euro that I have outlined. I would avoid them.
Is the forty-year bond bull market over?
Fiscal authorities and central banks are running programs that will have an inflationary effect over time. Accordingly, interest rates will rise again, first at the long end and after a few years also at the short. We will have an inflationary economic policy that will drive up inflation but not prosperity. This is bad for normal fixed income investments.
Will this be a favorable environment for gold?
Gold is an unproductive asset. Its price depends on the trust that investors have in the policies of the authorities. I expect the new decade to be beneficial for gold prices because central banks will continue to devalue our paper currencies, and confidence in policymakers will decrease. Gold should therefore be represented in every portfolio.
Do you think the current crisis will change the way investors behave?
I hope so. We should actually know that life is a risk. As a society, as a company and as an investor, you have to be prepared for crises and setbacks. It is clear that our healthcare system was not prepared for such a crisis. And only now do we realize that 70% of the basic elements for the pharmaceutical industry come from China. This is insane. I am a supporter of free trade, but today’s crisis shows the fragility of our wide-ranging supply chains. What also concerns me is the short-term thinking of managers who have inflated their companies with debt to finance share buybacks. It is simply negligent. These managers should be fired. There is a lack of personal responsibility everywhere, not just among managers. Our entire society has forgotten how to take responsibility. We have forgotten that life consists of setbacks and that you have to have safety margins for difficult times. We live in a spoiled society where people think they are entitled to a wonderful life. Well, this right does not exist in reality. And the constant cry for help to central banks and governments whenever it rains will gradually cost us freedom and prosperity.
Felix W. Zulauf is founder and owner of Zulauf Asset Management, based in Baar, Switzerland, offering investment advice for clients worldwide. He has spent almost fifty years in the professional investment business. He served as a member of the famed Barron’s Roundtable for thirty years.
April 8, 2020
S&P 500 Index — 2,715
Notable this week:
Let’s take a look at long-term trend growth. In the middle section of Chart 1 below, you see a long-term growth trend line (middle section of the chart (dashed blue line)). Just think of it as the approximate 10.01% annualized return the S&P 500 Index has produced over a very long period time. In this chart, data is plotted back to 1928. I like to think of this line as the point in the market cycle where the market is fairly valued. Meaning, I expect a 10.01% return over the coming ten years or so. The bottom section of the chart plots the deviation from the long-term trend and Ned Davis Research sorts the data into quintiles. Think of it as a measure that tells us how far we are away from the long-term growth trend. The market is deemed expensively priced when price is far above the dashed, diagonal long-term growth trend line (again, middle section) and it is deemed inexpensively priced (best return potential) when price is well below the long-term trend line. So where are we today? Simply look at the red “We were here” arrow, the orange “We are here” arrow and the green “We’d Be Better Off Here.” NDR then does something that is very useful, they show what the subsequent gains were for investors when the market was in the Top Quintile ($100,000 gained just 9.86% 5-years later on average growing to $109,860) vs. when the market was in the bottom Quintile ($100,000 gained 123.68% 5-years later on average growing to $223,680).
I’m not suggesting the price of the S&P 500 Index will drop to the bottom quintile. I just don’t know what will happen. What I’m saying is the best buys come when the odds are more heavily stacked in your favor. That point is when the price of the S&P 500 is at or below the long-term growth trend line. Price continues to sit above that line. 2,370 is the current median fair value on the S&P 500 based on over 50 years of price-to-earnings data. Let’s approximate the fair value line in the chart above to be somewhere in the 2,200 to 2,400 area. I believe that is the area in which coming 10-year annualized returns of approximately 10% may be achieved. If we get to 1,600 in the S&P 500, I intend to get aggressively overweight to equities. We don’t know how the current crisis will play out, how deep the pockets of the Fed may be, how strong and willing and how long support from elected officials may be or whether we have to “Stay at Home” for 2, 3 or more weeks. We have no idea as to the hit to the leverage (debt) that exists in the system. Many unknowns. I don’t believe we are out of the woods. I’m using valuation as a baseline to aid me in my weighting decisions. I am confident we’ll get through this and if we buy when value is good, we’ll have a far better chance for successful returns than if we buy when value is not good.
The Zweig Bond Model remains in a buy. Investor sentiment remains bearish (which is short-term bullish for equities). No change in the equity trend 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.
“When you come to the end of your rope, tie a knot and hang on.”
– Franklin Roosevelt
“To succeed in life, you need three things: a wishbone, a backbone, and a funny bone.”
– Reba McEntire
Just before bed, I did something I shouldn’t have done. I checked my phone. And I’m glad I did. Some good news on my CNBC app: “Dow futures rally after Gilead coronavirus drug reportedly shows effectiveness.”
And this from Bloomberg news, “While scientists around the world are hard at work on a vaccine, there are signs that a treatment for those worst hit by the virus may be emerging. A report on a Chicago trial of Gilead Sciences Inc.’s drug remdesivir—previously used to treat Ebola patients—pointed to promising signs, with patients showing ‘rapid recoveries in fever and respiratory symptoms.’”
I hope you are hanging in there. It won’t be a V-shaped recovery… it will likely be a WWW-shaped recovery due to the debt mess. Yet we will recover and eventually get back to business, teaching and learning along the way.
With the golf courses closed, it looks like I’m going to take a shot at repairing some bricks on our backyard patio. Yup, it’s a dumb idea. But after watching a YouTube video or two, how hard can it be? There are more than a few things to get done around the house and Dad needs a distraction. I feel like I’ve been on a non-stop work hamster wheel. News feed after news feed. And most of it is not good. It’s nice to see the tide is turning.
Go Gilead and the thousands of scientists in the fight! Tie a knot and hang on… We will win.
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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