May 8, 2020
By Steve Blumenthal
“We’re only down 15% from the all-time high of February 19,
and it seems to me that the world is more than 15% screwed up.”
– Howard Marks, Co-Founder and Co-Chairman, Oaktree Capital
(April 20, 2020)
When asked for his thoughts on the market, my friend and mentor Mark (not to be confused with Howard Marks) answered, “Lower. Down 30%. Here’s why, behaviors have changed. It’s like this: if you love to parachute, have 200 jumps under your belt, and on jump number 201 your chute doesn’t fully open, you hit hard and break both legs—even though the odds haven’t changed you’re probably not going to sky dive again… at least not for a long time.”
Break your legs skydiving and you’ll likely find your desire to do it again deterred. Lose your job or fear losing it for weeks or months on end, and your behavior is bound to change too.
Going into the pandemic, debt was high and savings were low—people were spending away. Your spending is another person’s income. Mark predicted, “Savings will spike. People will hoard cash.” Less spending = less money moving within the system = less income. I think my dear friend is right.
In 2019, consumption drove 90% of the economy. Normally, it’s two-thirds. A record 20.5 million jobs were lost in April. The unemployment rate jumped to 14.7%. The “real” unemployment rate, which includes workers not looking for jobs and the underemployed, surged to 22.8%.
The economic downtrend was already underway prior to the pandemic. People who never thought they could lose their jobs have been hit with the unimaginable. It’s jump number 201. What has happened will affect behaviors. More saving, less spending—even when many do get back to work. At least for the next few years.
A Mauldin Economics Over My Shoulder research letter titled, “Charles Gave: Down 16% and Still 30% Overvalued” hit my inbox a few days ago. Gave is founding partner and chairman of Gavekal. Following are the key bullet points from the note:
- The latest investment fad is to simply buy the assets central banks are supporting. Charles Gave notes this was also the theory in 1990 Japan and it didn’t end well. He foresees a similar outcome this time.
- Asset values are (or should be) equal to a future earnings stream, discounted by an appropriate interest rate.
- In February, US stocks were 40% overvalued. Values fell in March, then bounced to where they are now: roughly 30% overvalued.
- Some are arguing that the market is no longer about future earnings, but a function of the M2 money supply.
- This strategy worked well in Japan from 1982 to 1989. It stopped suddenly when profits collapsed.
- Now, US aggregate corporate profits are quite different from S&P 500 earnings. Gave believes “creative accounting” explains this divergence.
- Gave expects a downward price adjustment to correct this creative accounting, plus an adjustment to reflect a new, lower earnings level.
Bottom line: If Charles Gave is right, US stocks will retreat 30% to 35% from here, at minimum, just to reach fair value. But note too that “at minimum” part. It could go even lower and, if the Japan parallel holds, be much worse. Ned Davis Research (NDR) data plots “Median Fair Value” at 2318.29. A decline of 20.4% from S&P 500 Index level 2912.43 at April’s month-end close. About where the S&P 500 sits today.
By the way, John Mauldin’s annual Strategic Investment Conference is going virtual this year and it begins this coming Monday morning at 11am ET. Once again, the legendary David Rosenberg kicks it off. Other keynote speakers you may know include Dr. Lacy Hunt, Charles Gave, Louis Gave, Anatole Kaletsky, George Friedman, Woody Brock, Jim Bianco, Dr. Jonathan D. T. Ward, Neil Howe, Karen Harris, Ian Bremmer, Felix Zulauf, Leon Cooperman, and Peter Diamandis.
The event will be live streamed over five days: May 11, 13, 15, 19 and 21. All of the presentations will be recorded. What normally costs me about $4,000 with travel and hotel, costs about $400. My spending—or lack thereof—is someone else’s income. In this case, it’s Mauldin Economics’ income, as well as the speakers’. What about those in their ecosystem that typically make the conference hum? You can imagine the lost revenues for the hotels, video production teams, airlines, car rentals, rideshare drivers, food vendors, restaurants, bars, and so many others. This is just one conference. There are thousands that have been cancelled.
I’m sure the team at ME has a handle on what the economic impact of their spend is, but a rough guess is probably close to the 90% reduction in my out-of-pocket cost.
Do consider joining me in watching and learning. I’d enjoy hearing your feedback and questions.
There are two things I love most about John’s conference. One: John is strategic in how he chooses and brings together his speakers to stress test each other’s views. Two: the opportunity to network with investment giants and other attendees. The latter is well worth the extra 90% spend. I’ll miss that this year, but there is so much value in the virtual element. You can still register for the event here. (Please know I am not compensated in any way.) I’m really excited for the conference and looking forward to learning.
I led last week’s On My Radar: Deflation Now, Inflation Later – The Sell of a Lifetime for Bonds with this quote from Dr. Lacy Hunt, executive vice president of Hoisington Investment Management Company: “The net effect will further worsen the debt overhang. We know from similar efforts here, in Japan, Europe, and China this provides no more than a fleeting boost to economic activity at the expense of additional weakness in future economic activity. This shift results in an even greater misallocation of capital and other resources.”
Above, Charles Gave drew a parallel to Japan. It was a lost few decades for Japan and their markets. A risk we must factor into our calculus.
Your spending is another person’s income. Look inside and ask yourself if you are going to travel as much as you did before, dine out as often, spend as much? Some will but many won’t. When we get a vaccine? Maybe. Pennsylvania just extended its lockdown in our area to June 4.
On February 21, I wrote, This is EUPHORIA, Wait for PESSIMISM. Who knew the market would peak a few days later? It was ridiculously priced then; it remains ridiculously priced today and conditions are far worse. No wonder Warren Buffett isn’t biting.
This week let’s take a close look at earnings, margin debt, and valuation indicators (including Buffett’s favorite).
Grab a coffee and find your favorite chair. The balance of this read is quick. Included are charts with explanations. I hope you find the information helpful in your work with your clients or if you are an individual or institutional investor. Thanks for reading!
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:
- Margin Debt
- Trade Signals – A Look at MACD
- Personal Note – Mauldin Economics Virtual Strategic Investment Conference, May 11-21, 2020
I mentioned that I believe individuals will spend less and save more. If consumption drives two-thirds of the economy (business and governments make up the balance), and consumption made up 90% of the U.S. GDP, then less consumption means less growth. We won’t get a quick recovery.
The following chart, courtesy of Ned Davis Research:
For non-geeks, bottom line: Earnings will not be good.
For geeks like me, this explanation from NDR:
- This chart shows a model designed to indicate the likely trend in the earnings per share reported for the S&P 500 Index. Because earnings are considered one of the key fundamental drivers of stock prices, predicting the likely trend in earnings can be important in assessing stock valuations. This model uses a variety of macro variables to indicate whether current conditions are favorable for strong, moderate, or weak growth in S&P 500 earnings.
- The top clip of the chart plots the actual “as-reported” trailing four-quarter earnings per share for the S&P 500 Index constituents, as calculated by Standard & Poor’s. This earnings series is based on the financials reported by companies in their SEC filings, and thus represent figures based on Generally Accepted Accounting Principles (GAAP). This distinguishes this series from other earnings data based on operating earnings, estimated earnings, “core” earnings, or other variations of earnings data. S&P calculates the earnings per share by summing each index component’s reported net income before extraordinary items (as defined by GAAP) and dividing the aggregate sum by the S&P 500 index divisor to yield the value of earnings per “share” of the S&P 500. The index divisor makes the earnings data comparable to the S&P 500 index value and adjusts for changes in index constituents over time. Earnings per share data are reported quarterly by S&P, while the data in the chart is plotted monthly with each quarter’s values repeated for the three months of each quarter.
- The bottom clip plots the model’s monthly readings. As with most NDR models, the model reading is scaled between 0% and 100% and reflects the percentage of the component indicators which are favorable at any given point in time. The component indicators include variables such as U.S. industrial production, the CRB Spot Raw Industrial Material Price Index, the Treasury yield curve, Institute for Supply Management (ISM) indices, corporate bond credit spreads, unemployment claims, and the trend in analyst earnings estimate revisions for the S&P 500.
- The indicators are each rated as favorable or unfavorable for earnings (or neutral in some cases), and then the readings are combined and the smoothed result is scaled from 0% to 100%. High readings (above the upper dashed line on the chart) have been associated with a stronger-than-average growth rate of earnings, while low readings (below the lower dashed line) have been associated with weak or negative earnings growth rates. The box in the chart’s upper left-hand corner shows the annualized growth rate of S&P earnings per share based on the model’s reading.
Further, there is roughly $100 trillion in global public equity markets, $300 trillion in global debt markets, and $300 trillion in global real estate. A loss in value to those assets reduces the value they provide as collateral, and thus reduces the ability to create more credit.
Money and credit expansion and the spending that expansion creates is good on the way up. At some point in the long-term debt cycle, though, it all reverses. Good on the way up, not so good on the way down. The tumor in the system is debt (and underfunded pensions).
The U.S. market is surprisingly rising, but that rise is mostly driven by just a few names. The balance of the global markets is still under pressure. A reasonable back-of-the-napkin guess is that global assets are down $40 to $50 trillion. The Fed and the central banks have a long way to go if the intention is to support the markets at all costs.
Like him or not, BlackRock’s CEO Larry Fink told Bloomberg’s Sridhar Natarajan this week that the coronavirus pandemic has already cost corporate America dearly and the worst is yet to come. Fink predicted more bankruptcies and higher taxes on a call with clients of a wealth advisory firm. He sees the U.S. corporate tax rate as high as 29% next year, up from 21% today. This would be to help pay for the government rescue efforts.
The other thing recessions do is correct the episodes of creative accounting. Yes, they are not always serving in the best interest of others… This from Louis Gave (h/t @SoverLook):
Bottom line: High unemployment, less spending, more saving, higher costs (as many move away from China and bring supply chains closer to home), higher taxes… lower earnings!
The lower “E” in the P/E ratio is the reality that will pull markets back to and perhaps below the 56-year Median Fair Value level. More on that in the “Valuation” section below.
We are not yet out of the woods. I continue to expect a retest of the March low.
Here is how to read the next chart:
- First, note how high margin debt is compared to prior points in history.
- At the end of Q1, margin debt was $479 billion. It was $416 trillion at the top of the market in 2007 and $299.9 trillion at the top of the tech bubble in 2000.
- The middle section tracks margin debt back to 1966 and compares it to a six-month smoothed moving average. When margin debt is above the dotted black line, people are using it to buy more stock and the buying demand pushes prices higher. When margin debt is below it, people are selling stocks and paying down the margin debt.
- Note the bottom data box: above the line smoothing stocks do best and below the smoothing stocks do worse.
- We are currently below the smoothed moving average line.
Bottom line: Margin debt is dangerous. It is always high when markets are near their highs. Recessions correct aggressive and bad behaviors. Margin calls and resulting forced selling and would-be buyers backing away lead to market dislocations. Margin debt is always low near market lows.
Today, the trend in margin debt is not favorable for equity prices. It’s turned lower—caution is advised.
Each month, by habit, I review my dashboard of favorite valuation indicators. Please know that they are all poor timing indicators—frankly, I’ve tested everything I can think of and I’ve found nothing that helps with short-term or intermediate-term trading.
The value comes in assessing the probable returns over the coming 5, 10, and 12 years. When hamburger prices are high, you get less meat for your money. When they’re low, you get more meat for your money. Buffett said something along those lines and added that it’s only in the stock market that people want to buy when prices go up, and back away when prices go down.
Channeling our inner Warren, let’s first look at his favorite indicator.
The Buffett Indicator
Market Cap-to-GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001, he remarked in a Fortune magazine interview that, “It is probably the best single measure of where valuations stand at any given moment.”
With the Q1 GDP Advance Estimate, we now have an updated look at the popular “Buffett Indicator”—the ratio of corporate equities-to-GDP. The current reading is 156.3%, up from 156.0% the previous quarter.
Here is a more transparent alternate snapshot over a shorter timeframe using the Wilshire 5000 Full Cap Price Index divided by GDP. We’ve used the St. Louis Federal Reserve’s FRED repository as the source for the stock index numerator (WILL5000PRFC). The Wilshire Index is a more intuitive broad metric of the market than the Fed’s rather esoteric “Nonfinancial corporate business; corporate equities; liability, Level.” We’ve noticed some folks use lagging GDP figures to estimate the current Buffett indicator figures—in other words, people have used the current numerator and the lagging GDP figure in the calculation, which is not accurate. We have chosen to use data from the same time period (currently Q4 2019) for all series.
Source: Advisor Perspectives
Median P/E – Median Fair Value 2,318.29
I share this chart with you frequently. It’s updated through April 30, 2020.
Here is how to read the chart:
- The 56.2-year median P/E is 17.3. That number is the middle P/E out of the 505 stocks that make up the S&P 500 Index. P/E ratios are based on actual reported earnings and not future Wall Street analyst guesstimates. NDR calls it “Median Fair Value.”
- The middle section plots the monthly Median P/E over time dating back to 1964 (orange line). It was 21.7 at the end of April.
- I like how NDR then sorts the data in zones that range from Bargains to Very Overvalued.
- The green dotted line shows the 56.2-year Median P/E and based on that, NDR plots how far the April month-end index close of 2912.43 is from Median Fair Value. Essentially, a drop of 20.4% from 2912.43 takes us back to Fair Value.
- Again, look at the orange line. Over time valuations move above and below fair value. Look how attractive the buying opportunity was in 2009.
- A retest of the March low is a pretty good level to consider upping exposure to equities. And it is possible that a move to “Undervalued” may happen. That’s at 1607.66 and would equate to a similar opportunity that presented in 2009. Keep these targets in mind…
I could share many more but let’s call it a day and revisit again in early June.
May 6, 2020
S&P 500 Index — 2,883 (open)
Notable this week:
The recession charts, with the exception of the Employment Trends Index, are updated this week. You’ll find them in the recession watch chart section (when you click the Trade Signals link if you are reading this in OMR or page down below if you are reading the TS post). I will have the Employment Trends Index updated next week post the most recent month-end data. As you may know, employment fell off a cliff in March and I’m sure the decline accelerated lower in April. Bottom line: the US economy is in recession. The greatest investment challenges come in recession. This one is likely to be longer and deeper than the previous two recessions. Focus on risk management. We are not yet out of the woods.
In viewing the Dashboard of Trade Signals indicators, you’ll see that signals continue to favor government bonds and gold. I believe it is important to diversify to several different trading strategies and then let the processes work for you. No single indicator is perfect. When combined in a portfolio, they generally work well together. It has the effect of systematically scaling down market risk exposure and then scaling back in as the weight of trend evidence improves. The Ned Davis Research CMG U.S. Large Cap Long/Flat Index remains in a buy signal, as does the NASDAQ Index 200-day MA rule. Volume Supply vs. Demand, the S&P 500 Index 200-day MA rule and the S&P 500 50-day vs. 200-day MA cross is in a sell. Investor sentiment remains bearish, which is a short-term positive for equities.
A Look at MACD
The S&P 500 Index is testing the upper end of its trading range at 2,950 as shown in the following chart. The lower section plots a short-term MACD trading signal. Moving Average Convergence Divergence (MACD) is a technical trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. I like to keep an eye on the weekly and monthly MACDs, both of which are bearish. The short term has done a good job of late – turning negative (red arrow) near the market peak and turning positive (green arrow) near the market bottom. I’ve inserted an orange arrow showing the short-term MACD is about to cross lower, signaling a sell. We’ve rallied back to a high probability technical level that in my view holds. I remain of the view that we will test the March lows.
Here is a look at the monthly MACD:
The Zweig Bond Model remains in a buy signal, suggesting long exposure to high quality bonds (lower yields), the CMG Managed High Yield Bond Program remains in a sell signal and the intermediate-term trend in gold remains bullish.
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.
I’ll be spending much of next week glued to my computer. Watching, listening, and taking notes.
John Mauldin is CMG’s chief economist and co-portfolio manager of the CMG Mauldin Smart Core and Mauldin Portfolios platform. I have been attending his Strategic Investment Conference for nearly 15 years. The SIC has always been the highlight of my year. This year, I’ll be watching it from the comfort of my home, with access to the video recordings and the transcripts in case I have a time conflict.
I appreciate the Monday, Wednesday, Friday conference schedule. Good friend David Rosenberg kicks off the event at 11:10 am ET Monday. Sam Rines is on at noon, Lacy Hunt at 12:35 pm, Renè Javier Aninao at 4:30 pm, and good friend Ben Hunt at 4:55 pm.
Charles Gave, Louis Gave, and Anatole Kaletsky from Gavekal Research kick off Wednesday’s show at 10 am ET. Jim Bianco is on at 2:20 pm, followed by a panel on monetary policy and debt—a debate that includes Bianco, Lacy Hunt, Ben Hunt, and Woody Brock.
A few weeks ago, I was confused on the Fed response in terms of size and economic impact. I called Lacy Hunt. No one knows the Federal Reserve Act better than Lacy. He worked at the Fed, taught many Fed economists, served as chief economist for several major banks and—most important—he runs money. Lacy set me straight. I wouldn’t have formed such a valuable relationship with him if it weren’t for John.
This year’s conference is loaded with a dream team of economists, geopolitical thinkers, technology and futurist experts, and sociological and political insiders. They will be covering everything happening not only in the investment world, but also in the political, geopolitical, social, and technological worlds. John has ever so skillfully crafted the conversations to uncover how were going to get through the next six months and what the post-vaccine world will look like. I find the panel discussions most interesting, as ideas and convictions are stress tested in real time by some of the world’s greatest thinkers.
Here is the link to the letter in which John tells you more about his conference and provides a registration link to the Virtual SIC 2020. Please note: Mauldin Economics is John’s other business, run and managed by Olivier Garret and Ed D’Agostino. CMG is not affiliated with Mauldin Economics and neither I, nor CMG, are compensated in any way.
It looks like a cold front is hitting the Northeast. I’ve had the same person cut my hair for more than 20 years. Elijah has become a dear friend. When you drive down the road, take a look at all the small businesses. There are millions of them—hair and nail salons, thrift stores, restaurants, retail stores, bike shops, car dealerships, auto repair, and more… Closed for business due to the pandemic. We’ll reopen, we’ll recover, but it will be slow, as behaviors will change.
Elijah texted me the other day and said he is making a few house calls. With five men and two women at home on Team Blumenthal, all of whom are in great need of a cut, we booked tomorrow afternoon. I’ll be providing the red wine. A celebration is in order.
Have a great weekend!
We will win! Stay safe, stay well, hang tough!
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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