January 3, 2020
By Steve Blumenthal
“First, investors should understand that the present combination of low interest rates
and elevated stock market valuations implies low prospective returns on the entire portfolio mix.
Last week, our estimate of prospective 12-year nominal total returns on a conventional portfolio mix
(60% S&P 500, 30% Treasury bonds, 10% Treasury bills) fell to just 0.3% annually,
the lowest level in history, breaching even the dismal prospects observed at the August 1929 pre-crash peak.”
– John Hussman, Ph.D.
President, Hussman Investment Trust (January 2020)
Welcome to a new decade. May it be a prosperous, healthy, and joy-filled ten years for you and your family. Ever forward my friend, ever forward. Here’s a toast to creating something wonderful and seeing and seizing the opportunities that present. Don’t let the above quote get you down. Bear markets follow bull and bull markets follow bear. Where you sit in the cycle matters, as it informs and helps you shape your investment game plan. The opportunities ahead will be great. Let’s get to them with wealth intact.
The best teams remain focused on the basics every day. A few weeks ago, I shared with you a short video New Orleans Saints running back Reggie Bush secretly recorded. It features quarterback Drew Brees on the field after practice, physically working through his plays. During the past month, Brees passed for 1,188 yards with 15 touchdowns and no interceptions. He boasted a 137 passer rating and broke Peyton Manning’s career passing touchdowns record, connecting on number 540 with a pass to tight end Josh Hill in the third quarter against Manning’s former team, the Indianapolis Colts.
Every day, after every practice is over, one man on the field working hard in silence. Being a sports junkie, I just love that! I think many of us feel the pros have already mastered the basics, but it is their ongoing commitment to perfecting them that make them great. Yes, Drew Brees is talented, but that talent isn’t what made him the incredible player he’s become. My late, great coach Walter Bahr used to say, “It’s the little things.” Focus on the basics—don’t stray from them. They’re the little things that will keep you on track to reach something bigger and better, even when the going gets tough.
At the beginning of each month, my favorite valuation metrics are updated, reflecting shifts in prices and additional earnings, sales, and profit information. With that said, the changes are often small, as time—at least in this context—moves slowly. However, the information is valuable and, for me, there is comfort in the repetition—and that comes with its own value. I not only get insight on coming returns, but the process—with its incremental shifts—helps me stay grounded and keeps my emotions in check. And that’s a worthy exercise, particularly as we enter a new year and a new decade.
With that in mind, let’s take a look at the updated analysis on where we sit in the stock market cycle, what that tells us in terms of coming risks and returns, and the key indicators—in my view—that are best kept on our radars. Let’s slice through the noise, zero in on what matters most, and talk game plan for 2020 and beyond.
The single best piece of New Year’s resolution investment advice I can give you is this: be in tune with your emotions. When you feel fear the most, investment return opportunities are greatest. When you are overconfident, risk is greatest. Warren Buffett said it best: “Be greedy when others are fearful and be fearful when others are greedy.” Simple? For Warren, yes. For most of us, no.
But while the great investors had to rely solely on feeling in the old days, today, we can look to daily data as well. We have reached a bullish extreme, as you’ll see below in this week’s Trade Signals post entitled, “Welcome to 2020! Equity Signals Continue to Flash Green, Extreme Investor Optimism Signals Caution.”
Combine extreme optimism with extreme valuations and odds for successful returns are low. Combine extreme pessimism with fair valuations and the odds for success improve. Combine extreme pessimism with low valuations and that’s when the best return opportunities present.
A second piece of resolution advice: Where we sit in the market cycle matters.
The S&P 500 cap-weighted index has gained 10.1% per year over many years. Call that the return the stock market will give you over time. I think that number can be improved if you own those same 500 stocks in a more diversified way, something a New York City-based company called Syntax Advisors has figured out how to do (full disclosure: I’m an advisor to Syntax). You can find research on their methodology here.
By achieving better diversification while owning the very same stocks, I believe Syntax can improve upon that 10.01% by a few more percentage points. So, let’s say that 12.50% is the return we should expect from owning a diversified basket of large US companies. In a chart, that 12.50% is the line that grows from the lower left corner to the upper right over time. If you are young and add to your portfolio regularly, sit back and let time work to your advantage. You’re likely to get the 12.50% and that will be great—though there are no guarantees, of course.
Understanding when the return odds are stacked in your favor can aid you in your investment process over time. If you add more at the “We’d be better off here” points in time (the familiar chart pictured above), you’ll earn even more. If you are in your 20s or 30s, that’s your game plan (take advantage of your 401k plan too, especially if your employer matches some of your contributions).
What if you don’t have as much time on your side? Your investment game plan should be more adaptive if you are, like me, 55 or older. Today, 75 percent of all the money out there is in the hands of investors age 55 and older. That’s a very big number. And it can be a big problem if you find yourself, like we do today, at the “We are here” point in the cycle. It doesn’t bode well for risk and coming returns.
Today, after a spectacular 2019 US stock market performance, valuations sit at the second highest level in history. When were they at their highest? March 2000. If you were age 55 back then and invested in the S&P 500 Index, you wouldn’t have gotten back to even until age 69 (after factoring in inflation). That’s 14 years without any gain. And that’s if you didn’t panic out of the market and move to cash at the market lows in 2002 and 2009. Many of your friends did. If you are too young to remember what that looked like, ask your parents. We sit today at a point in time similar to 2000, with valuations higher than they were in 2007.
But valuations were very high at the end of 2017 and 2018, you may say—and you’d be correct. The same was said in 1998 and 1999. Valuations are great at telling us what coming 3-, 5-, 7-, 10- and 12-year returns are likely to be, but they are lousy in terms of cycle timing. So, what does that mean for you, particularly if you don’t have twenty or thirty years to go before retirement?
A third piece of resolution advice: Have a game plan.
Here’s a simple game plan for those 55 and older, dependent on what the market is doing:
- Market tops = high complacency, good news, and divergences. Your plan: More defense than offense.
- Market bottoms = panic, high volatility, and high asset correlations. Your plan: More offense than defense.
Set your game plan by identifying where we sit in the cycle:
- The popular cap-weighted large-cap indices will return approximately 10% annually over time, based on the S&P 500 Index since 1926 (source: S&PDJ Indices). I believe you can improve upon it by a few percentage points.
- The curved line in the graph above shows how the market moves above and below the long-term growth trend (investor behavior is the culprit).
- More defense at cycle tops simply means you use processes that seek gains and risk protect. Overcoming 50% corrections takes years. Overcoming a 20% correction takes less time. Overcoming 10% even less. You can shape your portfolio allocations by mixing different assets and strategies, enabling you to target a desired return tied to a desired level of risk. Trend following processes will help limit your downside.
- When the cycle is extended well above trend, play more defense than offense and tighten your stop-loss rules.
- Mentally prepare to take advantage of other people’s poor behavior. More offense at cycle bottoms, loosen your stop-loss rules and let returns run. The returns will be greater than 12.5% annually and the risk of loss less, as the largest amount of risk will have already occurred. That is what resets valuations and price. Then, others will be fearful and you get greedy.
One of the reasons I favor trend following risk-managed strategies is that they tend to keep you invested in line with the predominant trend. The same is true for factor-based volatility managed strategies and global macro trading strategies. Find several experienced managers who use liquid ETFs and charge a relatively low fee. They exist. Fundamentally, I remain concerned on a number of fronts beyond just valuations: Geopolitical risks are high, as evidenced by the concerning news about Iran last night, plus trade tensions, protectionism, the wealth gap and the stress it is applying to our society, rising rates, central bankers, the REPO market, European banks, global sovereign debt levels, and the record poor quality of US corporate credit. However, with all that in play, it’s been a good year. The trend remained up, high-yield credit did well… and, as was reflected in Trade Signals, the trends in equities, fixed income, and even gold were bullish for the majority of the year.
Resolution advice number four: Timing – the HY bond market holds the key.
There are a number of indicators you can follow to help you better zero in on timing. I’ve created a dashboard of my favorite indicators and I share them each week in Trade Signals. At the beginning of each month, I update my go-to recession watch charts. Like everything in this business, they are not perfect—but they do have high historical win rates. Again, this is about accessing return and risk and better knowing where we find ourselves in the cycle. Frankly, my writing to you really helps me to stay focused, balanced, and on plan.
I’m often asked if there is one indicator that is best in terms of getting out before the next crisis or even profiting from it. Great traders like Stan Druckenmiller and Paul Tudor Jones made most of their money at cyclical turning points. Stan talks about his success in bear markets. When you are a macro trader and have the tools to bet either up or down, getting the direction right is the key to making money. Most everyone else is just investing for bull markets.
So, is there a standout market timing crisis indicator? I’ve shared it with you in past letters. It’s what is happening in the price trend in the high-yield junk bond market, and it’s especially important today, since so much money has flooded into high-yield bond and bank loan funds. This is because the Fed and other central bankers moved rates to zero and even negative in some parts of the world, causing investors to find higher-yielding solutions. Two trillion dollars has moved into BBB-rated bonds (one notch above subprime) and a trillion dollars moved into even riskier high-yield bonds since the last crisis. It will end badly. Investors have lent to corporations and have very little covenant protection backing the bonds they bought (directly or via mutual funds and ETFs). The last two crises saw high-yield bond prices collapse 40% to 50%. The next crisis will see prices drop 70%. That’s my best guess, no guarantee. But you can bet there will be a next crisis, and due to massive investor misbehavior, the opportunity it will create will be epic. And do think of it as the next great opportunity. So, remember your game plan. Focus on investor fear and be mentally prepared to buy when it’s palpable. Keep in mind too that #RiskHappensFast.
Since 1990, I’ve been trading the high-yield bond market. I’ve written that it is the most important market signal we can follow. Why? Because when the funding markets dry up, bad things happen. The weakest companies die first and those are CCC junk bond-rated companies (a.k.a. high-yield bonds). So, the trend in the HY market holds the key.
Historically, it has turned down prior to the stock market turning down, which tends to turn down prior to the economy cycling into recession. The really bad stuff happens in recession. The poor stewards of capital get washed out and the strong survive. The system resets. And that’s when we will be at the “We’d be better off here” part in the cycle.
Watch HY. I shared two of my favorite charts here and again here. And I’ll keep you posted in future Trade Signals and On My Radar updates. For now, the CMG Managed HY Bond Program signal remains in a “buy.”
As for the market cycle, no one can tell you with certainty when the trend will end. Put a game plan in place that fits your return, income and risk objectives. Below you will find the Year-end Valuation Dashboard, a link to an excellent market letter from John Hussman, Ph.D., and a summary with link to this week’s Trade Signals post. The chart section is a quick read. You may want to take a break and come back to the Hussman letter. But do take a look – it’s outstanding. Thanks for reading. I really appreciate the time you give me each week. Happy New Decade! Let’s rock it!
Find your favorite chair and, with coffee in hand, read on…
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:
- Year-end Valuation and Forward Return Data
- One Tier and Rubble Down Below by John Hussman
- Trade Signals – Welcome to 2020! Equity Signals Continue to Flash Green, Extreme Investor Optimism Signals Caution
- Personal Note – Go Birds
I have 52 valuation charts on my monthly dashboard. Below I offer to you what I believe to be the most important charts.
Chart 1: P/E10 – The first chart is from Ed Easterling, founder of Crestmont Research. The chart is the equivalent of the Cyclical P/E10 ratio chart Advisor Perspectives has been publishing on a monthly basis for the past several years.
The Crestmont P/E of 34.5 is 135% above its average (arithmetic mean) and at the 100th percentile of this 14-plus decade series. The prior P/E10 high was in 2000 at 33.7. Note the other peaks and troughs in the lower section of the chart.
A much better entry point is highlighted in green. That will be a move back towards the long-term P/E10 growth trend line (red).
The 2011 article “P/E: Future on the Horizon” by Ed Easterling provided an overview of Ed’s method for determining where the market is headed. His analysis was quite compelling. Accordingly, we include the Crestmont Research data to our monthly market valuation updates. See also his latest update: “Understanding Secular Stock Market Cycles.”
Chart 2: NDR Total Stock Market Value vs. Money Market Funds
Here’s how to read the chart:
- As of December 31, 2019, the top section shows the Total Stock Market Value equals $33313 billion.
- As of December 31, 2019, the middle section shows the Total Money Market Fund Assets: $3.6 trillion.
- As of December 31, 2019, the bottom section shows that Total Money Market Fund Assets are 10.8% relative the $33.3 trillion Total Stock Market Value. It’s as if you have $1 million in the stock market and you have $110,800 in your money market account.
- The idea here is just how much money do you have sitting on the sidelines that might be used to buy stocks. Keeping in mind we all need some cash available for certain spending needs or emergencies. Thus, the balance rarely gets too low.
- The red arrows show when investors are aggressively invested in stocks (little money in reserve to buy and bid prices up). Note the dates and think about Sir John’s advice. This chart shows what investors are actually doing with their money.
- The green arrows are the big buying opportunities. Again, note the dates. This chart is a good statistical visual of investors doing the wrong things at the wrong times. Look at all the cash in 2009. No wonder it was such a great buying opportunity.
- Finally, the red/yellow circle shows what the stock market performance when cash is “Below lower bracket” vs. “Between brackets” and when cash levels were highest “Above upper bracket.”
Chart 3: Total Stock Market Capitalization as a Percentage of Gross Domestic Product (a.k.a. Warren Buffett’s Favorite Chart)
Here’s how to read the chart:
- Simply focus on the blue line. It tracks the total value of the U.S. common stocks (NDR Estimate). As of December 31, 2019, the stock market is valued at $33.31 trillion and US Gross Domestic Income (nominal means before inflation) is $21.54 trillion.
- The Total Stock Market Capitalization as a Percentage of Gross Domestic Product is 154.6%. To put that into perspective, it is the second highest in history looking at data back to 1924.
- Other high periods are identified in red: 1929, 1973, 2000 and 2007.
- Think of the entire US market as one singular business. What is our revenue relative to the value of our business? Ours is a big business and we can only grow our business so fast. Prior to 2000, we grew our GDP north of 3% per year. Since 2000, we’ve been growing at 2% per year. Note too how over time the blue line moves above and below its long term up trending line (black dotted line). Better value will present, like it did in 1980, 2003 and 2009 at or below the long-term growth line.
- Bottom line: By this measure, the stock market sits at the second most overvalued level in history. More defense than offense.
Chart 4: Total Stock Market Capitalization as a Percentage of Gross Domestic Income (A Variant to Warren Buffett’s Favorite)
Here’s how to read the chart:
- The dotted red line in the middle section is a real-life equivalent to the chart from Howard Marks (above in the introduction). Note over time how the black line moves above and below the long-term up trending dotted red line.
- The yellow circle in the bottom right indicates we are in the most overvalued market environment, by this measure, since 2000. Higher than all other periods, including 2007’s market peak, with the exception of the Great Depression and the 2000 tech bubble period.
- Lastly, the small light red arrow in the upper left of the chart points to the subsequent 1-, 3-, 5-, 7-, 9- and 11-year returns when the market was in the “Top Quintile Overvalued” zone. Not good enough.
Chart 5: Normal Valuation
Here’s how to read the chart:
- The normal valuation line is calculated from six independent valuation lines based on: Dividends, Earnings, Cash Flow, Sales, CPI-adjusted P/E and Trend. It’s the dotted orange line in the upper section of the chart. The blue line is the S&P 500 Index.
- The data is updated monthly with each month-end taking the median of these six measures. On December 31, 2019, the S&P 500 was at 3,230.78 and the Normal Valuation Line was at 2,158.95.
- Note too, that the blue line moves above and below the orange dotted normal valuation line. The best return on your money comes when the blue line is at or below the orange long-term normal valuation line.
- The bottom section is interesting. The data box located in the bottom right shows the percentage Gain Years Later for the S&P 500 Index based on the percent over or undervalued the S&P 500 is compared to normal valuation. The worst returns ½-year, 1-, 2-, 3-, 5-, and 10-years later is when in the “Overvalued” zone or “Above 20.0.” That’s where we find ourselves today.
Chart 6: Median P/E
Bottom line: I like to look at the data in the bottom section of this chart. What it is saying is that the market is sitting up in rarified air. The 55.8-year median P/E mean is 16.8. NDR calls that “Fair Value.” A much better entry point would be at 2,212.08 on the S&P 500 Index. It will take a 29.6% market correction to get us to a better entry point. I believe we will see that level over the course of a full market cycle. That will be a good point to start getting excited again.
I also like Price-to-Sales, Price-to-Book, Price-to-Cash Flow, and others. Pretty much no matter how you slice it, the market is “Extremely Overvalued.” Here’s a look at various other metrics. Red is bad, green is good. You get the picture.
A special thanks to Ned Davis Research. For more information, please visit NDR at www.ndr.com. Please email me if you’d like to learn more about their service. I am not compensated by NDR in any way. Just a big fan and long-term client.
One Tier and Rubble Down Below by John Hussman
John Hussman, Ph.D. penned this excellent piece this week. It’s worth your time and attention. You’ll find he takes a deep dive into valuations and comes to the same conclusion as above. But he does so in a way that shapes the risk in terms that I think many people can better understand.
When I joined Merrill Lynch in 1984, no one wanted to own stocks. Do you recall the “Nifty Fifty” craze in the 1970’s? I do. It was the bubble of the day. John Hussman shared this in his piece:
“The Nifty Fifty appeared to rise up from the ocean; it was as though all of the U.S. but Nebraska had sunk into the sea. The two-tier market really consisted of one tier and a lot of rubble down below. What held the Nifty Fifty up? The same thing that held up tulip-bulb prices long ago in Holland – popular delusions and the madness of crowds. The delusion was that these companies were so good that it didn’t matter what you paid for them; their inexorable growth would bail you out.” (Forbes Magazine, 1977, “The Nifty Fifty Revisited”)
John then shares what happened next:
Blue Chip Performance: 1973-1974
Du Pont -58.4%
Eastman Kodak -62.1%
Ford Motor -64.8%
General Electric -60.5%
General Motors -71.2%
Philip Morris -50.3%
He added, “We forget.”
And he then takes us through 2000-2002.
Blue Chip Performance: 2000-2002
Cisco Systems -89.3%
JP Morgan -76.5%
He added, “We forget.”
Along the way, John shows valuation data and compares today’s valuations to times past and shows what that means in terms of risk.
Blue Chip Performance: 2007-2009
Bank of America -94.0%
Coca Cola -42.3%
JP Morgan -68.5%
Cisco Systems -60.0%
Is this going to happen again? We don’t know. But what is clear is that, as John puts it, “A passive stock-bond portfolio mix currently faces the lowest prospective returns in history.”
Everyone is overweight passive indices, funds and ETFs. The 60/30/10 S&P 500, Treasury Bond and T-Bill mix fell to just 0.30% annually over the coming 12 years. “The lowest level in history, breaching even the dismal prospects observed at the August 1929 pre-crash peak.”
Trade Signals – Welcome to 2020! Equity Signals Continue to Flash Green, Extreme Investor Optimism Signals Caution
January 2, 2020
S&P 500 Index — 3,138
Notable this week:
As was the case for the majority of 2019, the weight of the trend for the equity market remains bullish. The Zweig Bond Model and CMG Managed High Yield Bond Program signals remain bullish. It’s been an outstanding two months for the high yield market and a solid year for all risk assets. Gold too remains in a bullish trend signal. Welcome to 2020… the trend remains our friend.
Interest rates have moved higher recently. Put that on your watch list. Also, remain mindful that, since 1901, 25.68% of the time the market is “Making New Wealth,” 35.38% of the time it’s been “Recovering From A Loss” and 33.60% of the time its been in a “Falling (Bear Market) cycle. It’s that falling part we need to worry about. That’s where trend following can help. And despite my global macro concerns, the Trade Signals kept me on the right side of the trend in 2019. Signals are flashing green going in early 2020 and the cycle remains in the “Making New Wealth” zone. Happy New Decade to you. Here is the New Wealth Creation chart on the DJIA back to 1901 (hat tip to Ned Davis Research):
Warren Buffett is famous for saying, “Be greedy when others are fearful and fearful when others are greedy.” The late great Sir John Templeton said, “The secret to my success is that I buy when everyone is selling and I sell when everyone is buying.” One way to measure investor sentiment is the Ned Davis Research Crowd Sentiment Poll. The Poll is designed to highlight short- to intermediate-term swings in investor psychology.
The indicator is based on seven different individual sentiment indicators. The indicators used are mostly based on ratios of relative bullishness or bearishness (bullish investors as a percentage of all investors) among different categories of investors, including data from: Investors Intelligence — surveys of stock market newsletter writers. The American Association of Individual Investors — surveys of market expectations among individual investors. The CBOE Put/Call ratios — ratio of the volume of call options to total options traded (calls plus puts) on Chicago Board Option Exchange. Rydex fund assets — ratio of assets invested in bullish market timing Rydex funds to total assets in bullish plus bearish Rydex funds. MBH Commodity Advisors Daily Sentiment Index for the S&P 500 — surveys of non-professional retail traders. And several other surveys of investors and traders.
This chart is useful because it aggregates several different sentiment indicators, and highlights levels at which investor sentiment has reversed in the past. It can therefore help in anticipating reversals in investor psychology, and thus stock prices, going forward.
Source: Ned Davis Research. See Important Disclosure and disclosure links below.
I share this next clip to highlight that there have been few readings since 1996 above 70. The reading this week hit 70.4. Look at the low 40.9 reading in early January 2019. Few were optimistic about the market. A perfect “buy when others are fearful” moment. Today, we sit at the exact opposite — everyone is bullish. Valuations remain elevated (the second highest in history), the market sits well above its long-term return trend, the bull market is aged, investors are overweight equities and now sentiment is more bullish than it was in 2000 and nearly as bullish as it was in 2008. The current reading is 70.4. Compare vs. other Investor Sentiment Extremes (above dotted top line). Stay nimble with downside risk protection firmly in place.
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.
“Underdogs are hungry dogs and hungry dogs run faster.”
– Jason Kelce, Center, Philadelphia Eagles
My Philadelphia Eagles have a home playoff game this Sunday. All of the kids are home and the plan is to head to the stadium early and tailgate. It really is a massive party and the energy is high. While Susan and I have been nodding yes to the kids, hesitation is creeping in. The Eagles are banged up. Last week, one of the commentators joked about the waiting line to get looked at in the injury tent. Pro teams now have a covered area where players are evaluated after injury. Teams will do almost anything to not give an edge to the opposing team.
If you like underdogs, this is where the story gets to be fun. The Eagles have a handful of former practice squad players who have been elevated to the first team. These are players who generally went undrafted and are used as practice bodies against the starting team. They are generally not good enough to ever see playing time. The breakout star of the group is a 5’6’’ running back from Louisiana Tech named Boston Scott. He’s been amazing. Another is a quarterback from the University of Houston named Greg Ward. He’s now our star receiver. Ward is playing only because he told the coach that, “If you need a receiver, put me in.” Well, with all the receivers on injured reserve, he got the nod. And he’s doing great.
From good friend and fellow crazed Eagles fan, Kol E. came a nice Happy New Year’s text adding, “And here’s to a series of highly improbable Eagles wins over the next 5 weekends.” The Blumenthal gang will be cheering, fingers crossed with hopes of getting to another game. Underdogs are hungry dogs… Hoping they run faster. Go Birds!
Hard to believe it is 2020. I find myself excited and looking forward to a fun year. One of my kids shared a great idea. When you have to create a new password for any particular account, make it an affirmation of something you wish to create. For example, UnendingJoy123 or IHavePerfectHealth or 2020Abundance or my winter favorite since a ski trip is nearing, BlueSkyPowderDays. I must note that given my age and a repaired left knee, MoreSpeedMoreAir has been removed from all devices.
Wishing you a Happy New Decade. Dream big and go for it. Best to you and your family and, if you don’t have a home team to cheer for this weekend, send some love to my Eagles. Yes, there is a judge and a courthouse in the stadium basement. It is true what you hear… Some of our Birds fans really do need better affirmation passwords.
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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