December 11, 2015
By Steve Blumenthal
“You are driving forward and the road you are on ends. You have come to what the British call a T-Junction. You can transition to one of two alternatives. But you cannot stay on the road you are on. One alternative is good. It is a hand off from central banks to a broader more holistic policy (political) response. If that happens it will unlock a ton of cash from the sidelines. Particularly on the balance sheet of corporations. Cash that so far has been used defensively can be used offensively.
If that happens, fundamentals validate asset prices. That is one way out of the T-Junction. It requires our politicians to get their act together… turbo charged by cash and turbo charged by amazing innovations that are going on.
But there is the other way out of the T-Junction. Our politicians do not step up. Central banks are still willing to do something but they become less effective. Asset prices start moving back down to match fundamentals and illiquidity issues means that asset prices overshoot on the downside.
The probability of these two outcomes are relatively equal. I hate saying that. I’d much rather tell you it is not that way but I can’t.”
– Mohamed El-Erian
I spent a few days earlier in the week in Scottsdale, Arizona. I was invited to present on portfolio positioning and best execution at the 20th annual IMN Global Indexing and ETF Conference. One of the big highlights for me was El-Erian’s keynote presentation.
Today, I share with you my notes from El-Erian’s speech. He is humble, balanced and brilliant. I have listened to my recording of his presentation several times. Stop-start-rewind-replay-rinse-repeat. Fun for me and well worth the effort.
In short, he puts the odds for a good outcome at 50/50 saying he, “hates to say that.”
It is important to understand the monetary, political and geopolitical forces at play and what it all means to our collective wealth.
Following up on last week’s OMR post (beautiful deleveraging or ugly deleveraging), I reflected on the various players and their conflicted motivations, politicians, central banks, investors, negative interest rates, debt, tax structures, probable global capital flows and human behaviors. El-Erian’s presentation was important. Boy, do I wish I could teach as well as he does. He is masterful at simplifying the complex. I’m a big fan.
I believe you will really like today’s piece. My hope is that you’ll better understand the complexities immediately in front of us and do some things within your portfolio that help you to better prosper.
El-Erian puts the odds at 50/50. My guess is more like 25/75 (betting that politicians have a hard time getting their act together absent a crisis); however, as he points out your outcome doesn’t have to be a bad one. As I said to my PT (physical therapist) Mike early this morning, it’s time to be playing defense.
El-Erian shares a number of good ideas. Grab that coffee and jump on in (it is a quick read).
Included in this week’s On My Radar:
- Mohamed El-Erian’s Keynote Presentation – 2016 Outlook & The T Junction
- Trade Signals – HY Bonds Are Breaking Down
Mohamed El-Erian’s Keynote Presentation – 2016 Outlook & The T Junction
The central banks have been the only game in town. When Bernanke went unconventional with monetary policy in August 2010 (QE2 and then Operation Twist then QE3 later on) the Fed was no longer targeting dysfunction markets (they were fine) they were targeting macroeconomic outcomes. Bernanke said then “it is all about the benefits, costs and risks”.
The longer you stay unconventional (and Bernanke had no idea he would stay unconventional for so long), the more the benefits come down and the costs and risks go up. Central banks do not like being the only game in town. They do not like manipulation markets. They do not like the extent to which markets have become disconnected from fundamentals, but they simply do not know how to get out of it.
So we have to now think about what are these unintended consequences of this world we live in.
Here is an example: you, the patient, come to me (and I’m the central bank) and tell me you are not feeling well. The crisis put me in the ICU and I’ve come out of the hospital but I cannot run. I tell you the problem is you are structurally impaired. You don’t have a good running model. Your corporate tax system is messed up. You haven’t invested enough in infrastructure, your labor market needs to be retooled and you have pockets of indebtedness all over the place. And income inequality has meant that you have inefficient aggregate demand. You have structural impairments and I can’t really help you for I’m not in the business of structural reforms.
You ask, “Who can help me?” I reply, “The politicians can help you. They have the tools. They can empower the system to reform corporate taxation, to invest in infrastructure, to retool the labor markets, to deal with debt overhang.”
But we all look at the politicians and they are frozen.
So I, as the central bank, have a moral and ethical obligation to help you until they all get their acts together. I give you a little more medicine (QE2) and it buys you time. After about a year, you come back and tell me, you know, I felt better for a while, but now I’m not feeling so good. So what do I do? I give you QE3.
The European Central Bank (ECB) is doing the same thing. The Bank of Japan is doing the same thing.
I’m giving you the wrong medicine and I’m doubling your dose. Why? Not because I’m a bad doctor, but because I have an obligation to do whatever I can until the other people who have the right medicine start stepping up to their responsibility. But you as the patient will start worrying about the side effects (unintended consequences) of long-term reliance on the wrong kind of medicine.
That is where we are and that is what 2016 is all about. So run this forward for the next three years and this is where it gets very controversial.
(SB here – note that you’ll next find a repeat of the first few paragraphs, shared in the intro above, in order to stay in good flow with Mohamed’s presentation)
“You are driving forward and the road you are on ends. You have come to what the British call a T-Junction. You can transition to one of two alternatives. But you cannot stay on the road you are on. One alternative is good… It is a hand-off from central banks to a broader more holistic policy (political) response. If that happens it will unlock a ton of cash from the sidelines. Particularly on the balance sheet of corporations. Cash that so far has been used defensively can be used offensively.
If that happens, fundamentals validate asset prices. That is one way out of the T-Junction. It requires our politicians to get their act together… turbo charged by cash and turbo charged by amazing innovations that are going on.
But there is the other way out of the T-Junction. Our politicians do not step up. Central banks are still willing to do something but they become less effective. Asset prices start moving back down to match fundamentals and illiquidity means that asset prices overshoot and they pull asset prices down further.
The probabilities are relatively equal right now. I hate saying that. I’d much rather say it is this one but it is very hard to say what will happen. It is really hard to argue that one road dominates another.
So what should you do?
Remember, one road is a really good one. (It’s the handoff. Structural and tax reform). You validate asset prices, you normalize the system and a lot of what we learned about diversified portfolio allocations, about how products behave, how ETFs behave, smart beta… All the stuff works really well in that world.
The other one is very different. Where correlations break down, where suddenly products behave in a very unexpected fashion. (SB here: I.e. The Third Avenue High Yield Fund Closure announcement today – Third Avenue Focused Credit Fund is barring investor withdrawals while it liquidates).
The key thing is not to get paralyzed. Let me tell you what behavior finance tells you what we will do when we are faced with a bi-modal challenge. Like this T-Junction. Let me tell you what behavioral finance says about what will happen. As an example, you turned up at this conference because the average expectation was that it would be held and it would be interesting. There were tails. There was a left tail that the conference could be cancelled and no one told you and you flew all the way to Phoenix to find out the conference was cancelled. There was a right tail that you ended up with a really good keynote speaker, but you didn’t bet on that (lots of laughter).
You bet on the average and that is how we conduct our lives. (SB here: Average is high probability that the outcome comes out somewhere in the middle of the distribution curve. Tail events are those that very infrequently occur – far left and far right of chart).
That is not the world that is facing us. The world that is facing us is bi-modal. It is the T-Junction. (SB: no high probability middle and no fat tails just one big tail or one beautiful soft landing).
So let me tell you what behavior finance tells us about this. Part of this audience will not even recognize what is facing us. Why should you? You hardly ever see it. So you get what is called a “blind spot.” And we all have blind spots.
Another part of the room is going to recognize it but become fundamentally uncomfortable with it. So from recognition to internalizing it will turn into something else. It will turn into something much more comforting. When someone tells you something you don’t want to hear you’d be amazed at how often you turn it, in your mind, into something you really do want to hear. That is how we are built.
Another part of the room is going to fall into the trap that even the most successful companies fall into. That is called active inertia. You recognize it is bi-modal, you recognize you have to do something different, you start getting all excited, you get active but you end up doing what you were doing before. (You settle back to what you are comfortable with and know.)
So part of us will have a blind spot, part of us will redefine in a way we want to hear and part of us will have active inertia. Only a small number of us will recognize that we have to do things different and act.
So what do we need to do as we near the T-Junction? First and foremost, we’ve got to be very nimble. Do not commit your liquidity too early or too cheaply. Liquidity is going to be absolutely king as you get more clarity on how this is going to play out.
Secondly, understand that volatility is going to come back in a big way and understand what volatility does to human behavior. Try to build in mechanisms that help you to deal with this volatility.
Third, remember that volatility can be a good thing. Why? Because it allows you to pick up good names at low prices. There are going to be lots of opportunities that come with very unusual volatility events.
Fourth, if you want to generate returns, then you have to think a lot more serious about smart-beta, alpha overlays and going to places to where central banks have not made asset prices ridiculously expensive. It is hard, but it is our reality.
Fifth, there will be totally unhinged markets where they will stop functioning. We have three today:
- The oil market is completely unhinged
- The high-yield market is completely unhinged
- Emerging market currencies are completely unhinged
These unhinged markets will provide opportunity if you can lock up your capital for a very long time. (SB: or tactically successful). But expect these markets to behave in ways that have nothing to do with the fundamentals.
Sixth, diversified portfolios are a necessary but not sufficient condition for risk management. Why? Because correlations will break down. Therefore, something that is completely against conventional wisdom becomes conventional wisdom.
- Cash becomes an important part of asset allocation. Because it is the only way you can mitigate the correlation breakdowns we are going to go through.
Do not commit too much too early. You want to maintain flexibility all the way up to the neck of the T.
Finally, your starting position matters a great deal. (SB: here is a link to my chart in Tuesday’s WSJ – email me if you don’t subscribe and I’ll send it to you). So don’t underestimate that at some points there is more risk and at some points there is less risk.
El-Erian concludes: “What about the more general issues? The world we are looking at, this notion of a T-Junction and this notion of unpredictable return variances (volatility and liquidity issues) means that you have to learn from the best companies that deal in worlds that change very quickly.
What do they do? They are willing to disrupt themselves. Disrupting yourself is absolutely key when the world is shaken from above and shaken from below. What are the secrets of disrupting yourself?
- Take yourself out of your comfort zone, ask the question “what if?” And ask yourself a difficult question: what mistakes am I likely to make? Because we all make mistakes. And ask, what mistakes can I afford to make. Distinguish between the mistakes you can afford to make from the ones you can’t afford to make. Have that discussion before the world gets really volatile.
- Recognize that you do have blind spots and unconscious biases. We all do. Often, we all evolve and learn differently. What is the easiest way to overcome them? Cognitive diversity. You get this through gender diversity and other cultural diversity. (SB: make sure you are considering a number of diverse views).
Another tip. Let structure do the heavy lifting. Build in a cash allocation, build in a scenario analysis on a regular interval, build in the difficult discussions as part of your normal routine so that structure helps you. Otherwise it will get crowded out.
Finally, you are basically trying to develop three attributes. If you don’t have them you really need them and that is true whether you are an asset manager, a provider of indices, an ETF provider (he was speaking to the crowed but these are valuable for all investors):
- Resilience – You have to be able to stay in the game
- Optionality – You have to be able to change your mind
- Agility – You have to be able to react quickly when you get better information on where we go
These three things are critical!
So my message to you is that it has been a wonderful ride so far. We have central banks to thank. But it is not clear whether they will remain effective especially as we enter the world of the great divergence in monetary policy. (This divergence is) where, on the one hand, the Fed is easing off the accelerator, while, the ECB (and other central banks) is pressing hard on the accelerator(s).
It is not clear whether we can continue in this volatility repressed world when that happens. I don’t know what the outcome is other than I am pretty sure it is a T-Junction.
I do know what the characteristics are that you need to succeed in such a world. The corporate world and the government world are full of examples of those who have succeeded and those who have failed. It is about self-disruptions and you cannot self-disrupt if you have resilience, optionality and agility.
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Trade Signals – HY Bonds Are Breaking Down
December 9, 2015
“We’re looking at some real carnage in the junk-bond market. This is a little bit disconcerting that we’re talking about raising interest rates with the credit markets in corporate credit absolutely tanking. They’re falling apart.”
– Jeffrey Gundlach, DoubleLine Capital
The HY bond market has a good history as a leading economic and equity market indicator. As Gundlach pointed out today, “They’re falling apart.” Our high yield model triggered a short-term trade signal (sell) several weeks ago. Safely positioned in cash or Treasury Bills, we believe a better opportunity is ahead of us.
Let’s take a look today at a long-term trend chart (13/34 Week Moving Average measure), a weekly chart and a daily chart.
Below is the overall cyclical bear market trend (red arrow far right). Note the dominant bull market trend from early 2009 to July 2015 (with the exception of two short corrections in 2011 and 2014). Note the growing length of the current bear trend (vertical red line markets the change in trend). That is where the 13 week MA dropped below the 34 week MA). This looks serious folks. (Click the link below to view the HY charts).
Included in this week’s Trade Signals:
Equity Trade Signals:
- CMG NDR Large Cap Momentum Index: Sell Signal – Bearish for Equities
- Long-term Trend (13/34-Week EMA) on the S&P 500 Index: Buy Signal – Bullish for Stocks
- Volume Demand is greater than Volume Supply: Sell Signal – Bearish for Stocks
- NDR Big Mo: Buy Signal – Bullish for Stocks
Investor Sentiment Indicators:
- NDR Crowd Sentiment Poll: Neutral Optimism (short-term Neutral for Equities)
- Daily Trading Sentiment Composite: Neutral Optimism (short-term Neutral for Equities)
Fixed Income Trade Signals:
- The Zweig Bond Model: Buy Signal
- High Yield Model: Sell Signal
- Don’t Fight the Tape or the Fed: Indicator Reading = 0 (Neutral for Equities)
- Global Recession Watch Indicator – High Global Recession Risk
- U.S. Recession Watch Indicator – Low U.S. Recession Risk
Click here for the link to the charts.
It is supposed to be in the high 60’s here in Philadelphia this weekend but there is a big snowstorm coming to Snowbird Utah and I’m sneaking away. The plan is to ski Sunday and Monday followed by a client meeting on Tuesday to talk about high yields, a managed futures strategy and the global markets in general. The discussion will likely focus on 2016 as well as the last two OMR posts. I’m really looking forward to seeing longtime good friends (and clients) Dave, Rhett and Brent at IMC.
I just went online to check the weather and the expected two feet of new snow looks less promising. I’m hoping the storm front stalls over the mountain. More is better. I return home on Wednesday after a quick visit to Dallas to spend an afternoon with Mauldin. That should be fun.
The balance of the month will be spent doing strategic planning for 2016, finishing my white paper on portfolio construction and some needed down time. Oh, and I better get shopping. I imagine you are in the same camp. As El-Erian shares, it’s gonna get bumpy so set some structure/strategy in place.
Have a wonderful weekend!
With kind regards,
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
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AdvisorCentral is being updated with new educational resources we look forward to sharing with you. You can always connect with CMG on Twitter at@askcmg and follow our LinkedIn Showcase page devoted to tactical investing.
A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
Trade Signals History: Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of years ago, I found that putting pen to paper has really helped me in my investment management process and I hope that this research is of value to you in your investment process.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
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