October 7, 2022
By Steve Blumenthal
“All those factors that cause a bull market, they’re not only stopping, they’re reversing. We are in deep trouble. You don’t even need to talk about Black Swans to be worried here. To me, the risk-reward of owning assets doesn’t make a lot of sense.”
– Stanley Druckenmiller, Investor, Hedge Fund Manager, and Philanthropist
We are eight months into a bear market in equities. I’ve written about how excessive government debt, margin debt, hidden leverage, and high valuations made the system fragile. The bear market will end, as all bear markets do, when the economy is weak and economic problems are evident to everyone. At that point, central banks and policymakers will pivot, and it will be risk-back-on for equities.
My best guess is that this is a mini bear market and that it’s almost over. The bigger bear is several years away.
If I’m correct in my view that the Fed will pivot, we’ll see a second wave of inflation. Wave one has peaked; inflation is receding. Meanwhile, the Fed’s 2% target is unlikely to be achieved, but 4% to 5% is probable, and I don’t believe 4% or 5% prevents a Fed pivot. Global demographics, global geopolitics, excessive debt, inflation, and higher interest rates are hitting economies hard. Inflation forced the Fed’s hand. A hard economic landing is ahead. At some point in the next three to six months, the Fed and legislators will come back to the rescue. Markets will respond favorably. Until then, play more defense than offense: hedge equity exposure, raise cash on rallies (if you haven’t already), and prepare for the pivot.
Stanley Druckenmiller’s comments (the source of today’s intro quote) come from his CNBC Delivering Alpha interview a week ago. My views seem soft in comparison to his. Stan could be right, I could be right, or we both could be wrong.
Take in the data and come to your own conclusions. You can watch highlights from the CNBC Delivering Alpha interview by clicking on the photo.
My two-year outlook is not as dire as Stan’s, but I agree with his hard recession call for some time in 2023 and his view on the long-term challenges with government debt and entitlements.
A few years ago, Stan toured college campuses explaining the coming problem to the younger generation—the people who will be most affected. CNBC’s Joe Kernen asked Stan for an update on where we find ourselves today. Stan said we are getting to the point where the debt is so high we won’t be able to service it. If we use the CBO’s 3.80% interest cost estimate on our debt, which Stan believes is optimistic, by 2027, the interest expense alone on the government debt eats all health care spending. By 2047, it eats all discretionary spending, and by 2049 it eats all Social Security spending. The interest costs on the debt are so high that they cripple our ability to service the next generation, and Stan added he’s not even sure about the ability to support the current generation. When Stan said that, Joe Kernen’s head sunk low, leading Stan to joke that he has an extra cyanide tablet if he’d like it.
Stan thinks the system collapses sometime before 2035. This is what John Mauldin calls The Great Reset, and what Ray Dalio refers to as the end of a long-term debt supercycle. I believe we will print, monetize the debt, raise taxes, reduce benefits, and default our way out of the mess—a hodgepodge of measures we’ll brand with a sexy name, like the “Inflation Reduction Act.” What a joke. We’ve been kicking the can down the road, but at some point, the road ends. The can can’t be kicked any farther. Stan’s math makes sense. The long-term forecast remains the same: larger-than-normal recession and larger-than-normal bear market coming in the years ahead. The current bear market will look small in comparison. We are not yet at that point.
Some good news: Valuations are getting better. If I had to pick the Powell pain point, it is between 3,000 and 3,200 on the S&P 500. Why? The Median Fair Value based on more than 58 years of history is at approximately 3,050. There is never a way to know for sure, but that’s my target entry point, and while we could go lower. The key will be the timing of a Fed pivot. If the pivot occurs, it will be risk back on and a potential shot at new all-time highs. No way of knowing for sure.
The back side of this is what Stan is talking about. More monetary and fiscal juice—assuming we get it—will likely lead to an even more explosive wave of inflation (think north of 10%), and the granddaddy of bear markets. Much like in the 1970s, we’ll see a series of waves of inflation. Risk off now, risk on soon, then risk back off again in 2024–25. That’s my current working thesis. Of course, I’ve been wrong before and could be wrong again.
In the end, it really comes down to investment positioning. For wealth-preservation purposes, I lean toward understanding what could blow me up and protecting against such risks. In the “what you can do about it” category: 4.19% yielding one-year Treasury Bills make cash no longer trash, and having some gives you optionality. If you must be invested in equities, there are smart ways to hedge your equity exposure other than owning cap-weighted index funds. Tail risk protection with put options is a good idea. There are funds/ETFs that give you equity market exposure with built-in managed put option processes to protect the downside. I also like well-collateralized short-term private credit, trading strategies, and absolute return strategies instead of owning low-yielding bonds, bond funds, and bond ETFs.
We’ll take a deeper look at equity market valuations next week. They are getting better, and we may get a swing at a good pitch soon.
A reminder that my comments are NOT a recommendation for you to buy or sell any security. Please talk with your advisor about needs, goals, time horizons, and risk tolerance.
To get a better understanding of the complexity of the system, my partner, John Mauldin, wrote a masterpiece last week. If you are not reading Mauldin’s free weekly macroeconomic letter, you can sign up here. Here’s last week’s:
Currency Crescendo, by John Mauldin
Big problems usually begin as small problems. We see that in nature, where small disturbances become hurricanes, and we see it in the economy, too. So, it shouldn’t surprise us if the economic disturbances of the last years compound into something bigger.
Going into 2020, we already had over a decade of global monetary and fiscal foolishness. QE as a monetary policy tool became widespread worldwide. That was compounded by the insanity of zero interest rate policies (ZIRP) and even negative rates, which massively hurt savers, not to mention pension funds, and caused all sorts of malinvestments.
Among the many ill effects of these policies, one of the most pernicious was to widen the distance between upper- and lower-income groups. Wealth disparity was and is one of the main results of a decade of misguided monetary policy. And now we’re having to pay the price for it, not just in the US but all over the world. Then we had COVID—both its direct effects on health and the labor force, and additional negative effects from the lockdowns and other countermeasures.
Then yet more negative effects as the economies of the world struggled to recover from the disruptions. On top of all that, we have the Russia-Ukraine War and the food/energy crisis it sparked. In music we have a term “crescendo.” Technically, the crescendo is a gradual increase in volume, which can last a long time. It’s a process, not a single moment. Similarly, the economic volume has been getting steadily louder. The crescendo is approaching its peak, but we have no idea whether that peak will be next year or several years down the road.
This dark symphony was never going to end without sparking a currency crisis, one which allows countries to blame other countries as the source of their own internal problems. We will see that it’s not always the case. Now, with the US dollar strengthening and others crashing, the crisis is drawing closer.
Currencies are the economy’s backbone. They carry the signals that make everything else possible. Currency values are also moving targets, particularly since they are no longer tied to gold or any other fixed benchmark. The market rules. It decides how many dollars (or euros, yen, etc.) your asset is worth, and it also decides how much each dollar is worth.
Here in the US, we have the luxury of (usually) not having to think about all this. The dollar is the world’s unit of account, giving us the “exorbitant privilege” of settling transactions in our own currency. That’s why we run such huge trade deficits. Our role in the global ecosystem is to import goods and export the dollars that enable global trade.
The US dollar has a critical role around the world that has little connection with the US economy. Vast quantities of dollars are in circulation around the world. Developing countries receive dollars by exporting goods, which they then use to buy imports (often food and energy) from other developing countries. They also borrow US dollars, which they have to pay back from their own currencies being exchanged.
Now follow the bouncing ball. When US imports drop (relative to exports), it means the US exports fewer dollars. The supply of dollars outside our border falls, raising the value of each such dollar vs. other currencies. That’s a problem for the people, businesses, and governments that rely on dollars to pay each other.
When the dollar strengthens in this way, imports to the US are cheaper for Americans. Similarly, our dollars go further when we visit other countries. Nice but it has another side. Foreigners now find it more expensive to buy American exports or visit here. US manufacturers become less competitive against imports. A strong greenback isn’t necessarily great for everyone in the US… but it can be devastating for other countries.
Currency crises occur from time to time. They’re never fun but central banks and fiscal authorities deal with them. But they never address the structural issues that spark these crises.
In Code Red, my 2013 book with Jonathan Tepper, I said this house of cards would end badly at some point. I fear that point is near.
Remember the PIIGS? That was an acronym for the five highly indebted European governments (Portugal, Ireland, Italy, Greece, Spain) whose problems threatened the euro currency a decade ago.
After much angst, European leaders kicked the can down the road again. They could do so because the PIIGS economies, while large, weren’t so large as to be unmanageable. Then-European Central Bank President Mario Draghi gave us this famous (infamous?) line:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Last week brought flashbacks to that period when Draghi, who left ECB and then became Italy’s prime minister, lost his job as voters handed the government to a more center-right party (though hardly “the most far right since Mussolini” as scores of newscasts repeated).
But the bigger flashback was in the UK where the Bank of England said it would halt a bond market crash by purchasing government debt at “whatever scale is necessary.”
Whatever it takes, whatever is necessary… Central bankers, accustomed to creating liquidity from thin air, think their words can do miracles. And to be fair, sometimes they can. It worked for Draghi. But the UK is quite a bit bigger than any of the PIIGS were back then.
The UK certainly has challenges. The main one is that it runs a US-like trade deficit but lacks a US-like currency. I know, sterling was once the global reserve. It’s not anymore. This year that problem got worse as the UK lost most of its exports to Russia and had to pay a lot more for imported food and energy.
Not so long ago, the UK was actually exporting energy products, thanks to North Sea oil and gas production. That’s no longer the case thanks to growing domestic demand, along with trade policy and environmental restrictions. The country still has a lot of reserves it could tap if policies changed… which the new Truss government wants to do. That will help but will also take time.
The immediate problem is inflation—considerably worse than we see in the US. Energy prices are a particular sore spot but not the only one. The higher interest rates with which the BOE is fighting inflation also raise housing costs. Many variable-rate mortgages are resetting higher with monthly payments rising sharply. UK homeowners can’t refinance as easily as we can in the US. Food prices are climbing. The peasants are restless, and Parliament is listening.
Last week the new Chancellor Kwasi Kwarteng announced a “mini-budget” package with a variety of tax cuts, subsidies, and benefits designed to ease the pain. Some of it has been rather breathlessly compared to Reagan and Thatcher policies. That’s a stretch, but the UK hasn’t seen this sort of thing recently. Actually, rates are just back to where they were in 2012. Not a Thatcher-type cut.
Markets reacted by pushing the pound sharply lower, almost to parity with the dollar. Why? Traders apparently believe the new program will drive government deficits much higher, worsening inflation and pushing interest rates up even more. That, the theory goes, will spark a flight out of the pound before the plan’s tax cuts and other growth provisions can help.
As of Friday, the pound was roughly back where it was before Kwarteng’s announcement that so upset the markets. Turns out that tax cuts weren’t all that much, and the rather large energy subsidies are politically required.
As for the bond market fireworks, it turns out that UK pensions couldn’t meet their long-term obligations at 1% return on British government bonds. Not to worry. London’s clever investment bankers helped pensions leverage up in a rather aggressive way (similar to Long Term Capital Management) but no one considered what would happen if rates were to ever actually rise. As Samuel Rines wrote yesterday:
“The fundamental cause of the UK’s issues are the war / energy prices and the disjointed policy reactions. That is not the FOMC’s problem.”
In fairness, the Bank of England was both raising rates and engaging in quantitative tightening at the same time. I was critical of Bernanke when he did this, when Powell did it, and I still say that you do not conduct a two-variable money policy. Either cut rates or reduce your balance sheet, just not at the same time. It turns out the Bank of England had to reverse its policy in order to keep the country’s pension fund system intact. The circumstances in the UK are different than in the US or Europe, but the principle is the same.Unfortunately, the bigger problem is beyond the UK’s control. The US dollar has become what Louis Gave calls a “wrecking ball” to the global economy. Momentum will eventually bring it back in our direction. One final note on the UK. The long-term policy of Truss’s that would make a huge difference? If the UK actually becomes energy independent and once again an exporter. That is possible, given their reserves. Now that would be an economic game changer and create much-needed high-paying jobs. We will see. “Every Choice Is Bad” The pound sterling’s meltdown isn’t happening in a vacuum. The Japanese yen also deteriorated in recent weeks for similar reasons, though Japan has its own issues too. The dollar’s sharp rise is affecting everything this year.
Worse, this is a problem no one can easily solve. It’s not an unintended consequence of someone’s policy. It’s the post-WW2 global monetary system doing exactly what it evolved to do.
With the Fed on a path to get us to a 5% fed funds rate (my “prediction”), the other central banks need to recognize this. Powell is not responsible for fixing the chaos that passes for monetary policy in Europe. The value of the euro or the pound is not his remit. (As an aside, technically the value of the dollar is the Treasury’s responsibility. Treasury Secretary John Connally quipped to French authorities who complained about Nixon shutting the gold window, “The dollar is our currency, but it’s your problem.”)
A significant number of people believe the Fed should stop raising rates because the rest of the world is having problems. I strongly disagree. First off, the Fed is not responsible for Europe, Japan, or emerging markets. Its mandates are US price stability and US employment. There has long been speculation about which mandate is more important. At least for the time being, it seems that inflation trumps employment.
Other major central banks have been raising rates too, though less aggressively than the Fed. This partially explains the currency differential. There are multiple reasons for currency rate fluctuation but interest rates are quite important. Complaining the dollar is too strong while holding your own rates below 2% makes little sense.
Just for the record, the BOE’s policy rate is still at 2.25%, the ECB is 0.75%, China is at 3.65%, and Japan is still at negative rates of (minus) -0.1%. Christine Lagarde is telegraphing another 0.75%, which Germany has basically signed off on as inflation is 10% there as it is in much of Europe. Again, just for the record, I recognize that Europe and the United Kingdom have far worse problems with inflation and their economies than the US.
The dollar’s problems will come home, too. They are simply taking time to develop. GMO’s Ben Inker has a fascinating study of currency valuations vs. equity market changes. He goes through a lot of detail but basically, undervalued currencies help local stocks while overvalued currencies hurt. And guess whose currency is most overvalued? Ben adds, “Today’s strong USD looks, in the end, to be our currency and our problem.”
STEVE HERE: Mauldin shows a few more charts and dissects what Ben wrote. He then concludes:
I keep saying how past mistakes leave policymakers with no good choices now. That applies pretty much everywhere but especially to the Federal Reserve. Their post-2008 stimuli established the conditions that gave us today’s inflation. Now they must tighten to fight that inflation, but the tightening is driving the dollar up, with all kinds of negative consequences.
Now every choice is bad. The Fed can’t stop tightening too soon or inflation will take over. But if they continue tightening, they’ll generate not just a US recession but a global one, in an economy more leveraged, more fragile, and more interconnected than ever.
This could go many different directions. I doubt we will escape without at least one major sovereign debt default and/or currency devaluation. Europe will have “defaults” but they will be “managed.” Remember Greece? European management meant a lengthy depression for the Greeks.
Compounding the problems created by the ECB, many European countries likely will have to spend giant sums this winter subsidizing energy bills, and perhaps still need rationing and other unpopular measures.
From there, all this crosses outside the bounds of economics. It becomes political, social, and geopolitical. Financially-oriented analysis fails when leaders have to do things that make no financial sense.
In that regard, the mid-November G20 Summit meeting in Bali, Indonesia, could prove very interesting. Exactly who will attend is unclear; some don’t want to be seen with Putin, who himself may not want to leave Russia. Still, it’s possible Biden, Xi, and Putin will all be present, plus many other top leaders: Macron, Scholz, Modi, Kishida, MBS, Erdogan, and Truss could be in the same room.
I, for one, will enjoy seeing Macron and new Italian leader Giorgia Meloni on the same stage, if she is able to form her government by then. They haven’t been on the best terms. But that would be a sideshow to potentially much bigger things. If there’s going to be a new Plaza Accord or something similar, this would be the setting to unveil it.
What they agree on, if anything, may not be the best answer. But it will be the answer we get.
That concludes John’s excellent explanation of what is going on in the currency markets, the result of Fed policy and the rapid rise in interest rates.
Since your first cup is likely downed, grab a refill and read on. Former Dallas Federal Reserve President Richard Fisher was on CNBC recently, and he was very clear. I provide short notes and a link below. And you’ll find a new section, which I’m calling “Random Tweets.” They’re in no particular order. Just stuff I’m keeping On My Radar. Thanks for reading. Appreciate you for sharing your time with me.
(Reminder, this is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only).
If you are not signed up to receive the free weekly On My Radar letter,
you can sign up here.
System-wide liquidity, velocity, the Fed PUT, QT, inflation, and recession. Here’s an idea, put your earbuds in and take a walk. Click and play the CNBC Kernen – Druckenmiller interview and then click this next interview with Former Dallas Fed President Richard Fisher.
you can sign up here.
The above chart is from the beginning of the year. Today the total market cap of the US market is just over $48 trillion. The approximate total market cap of the S&P 500 companies today is ~ $32 trillion. Down 24% from the peak. Meaning ~$32 trillion of $48 trillion of total US equities are in just 500 stocks. But remember, this is a cap-weighted index, and the top ten largest stocks make up ~ 27% of the $32 trillion. Back of the napkin, call it ~ $9 trillion. Of the $48 trillion in total US equity market valuation, ~ $9 trillion is concentrated in ten stocks. Ten stocks!
Keep that in mind should everyone start rushing to the exit doors at the same time.
Here is a post from a few weeks ago when mortgage rates were even lower than today’s 6.70%, but the point remains the same:
More Random Tweets next week. Please follow me on Twitter, where I do my best to highlight what I feel is most important… @SBlumenthalCMG
If you are not signed up to receive the free weekly On My Radar letter,
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Trade Signals: Not Yet Out of The Woods
October 7, 2022
S&P 500 Index — 3,644
Notable this week:
Apologies for the late post, but it may be more relevant given the unemployment news released this morning, Friday, October 7, 2022.
The data hit the wires – The unemployment rate falls to 3.5% in September, and payrolls rise by 263,000.
Good news is often bad news in this business, with investors hoping for something to turn the Powell Team dovish. That didn’t happen today.
The job market stays strong. The Fed stays strong. Markets didn’t like it. Stocks are down, and interest rates are higher.
The Dashboard of Indicators follows next. The lone positive is the level of extreme investor pessimism. You’ll see a 50% buy signal was triggered this week for the NDR CMG U.S. Large Cap Long/Flat. There is an oversold rule built into the trading model that positions the index 50% long when a certain extreme downside score is reached. When the model score falls below 35 and then rises back above 35, a 50% long position is triggered. Anything below a 50 reading signals very poor market conditions. That remains the case as the current model score as of 9-6-22 is 34.35. The model, by rule, will stay 50% invested until it rises back above a score of 50. At that time, it will move to 100% invested. Sell signals are triggered when the model drops below 50.
The other change this week is the S&P 500 Index Daily MACD Indicator moved to a buy signal. Keep your eye on gold, it traded back above $1,700 per ounce today.
The balance of the indicators remains in sell signals – mostly red arrows across the dashboard.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizons, and risk tolerances.
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Personal Note: Wild Boar
Tomorrow I’m teaming up with good friend Wade Barnett to play a 20-ball golf tournament at Stonewall. Wade introduced me to Stonewall many years ago. Our daughters were five years old then and in preschool together. We’ve been best friends since, and our daughters remain close as well. The tournament is a one-day eighteen holes tournament. Since we both play our own ball, each of us has 18 potential scores to post, which is a combined total of 36 scores. Our job is to pick the best 20 lowest scores. If Wade birdies the first hole, we post a -1 score. If I par the first hole, we have to decide right then if we take both his score and mine. If we take both, we used up 2 of our 20 picks and finish hole one at -1. In golf, the lowest score wins. If I bogie the hole, we most certainly don’t take my score. Sometimes, you find yourself late in the round and forced to take scores you may not want. It’s a fun tournament with strategy and hopefully good play involved. Usually, there’s some side money involved to keep things interesting.
One of the members, slow cooks a pig (thus the tournament name), and after the round, we all come for a cold beer and great food. The trees are beginning to turn colors, and the weather looks to be sunny with a high of 60 degrees. I sure do love the fall, and I’m really looking forward to the weekend.
Stonewall – 18th Green
I’ll be in Dallas on November 16, hosting a dinner with Mauldin and some clients. Our plan is to up the travel, which will include a number of dinners across the country. Stay tuned.
Click on the next photo to link to Spotify, where you can find last weeks On My Radar titled, “The Merciless Mathematics of Loss,” just in case you are still out for that walk, in the car, on a plane, or on a train. We should have today’s OMR published and on Spotify by Sunday.
One last tweet from Morning Brew, and I’ll wish you a fun weekend. Oh my…
Wishing you the best, and thanks again for reading!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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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