June 1, 2018
By Steve Blumenthal
“… [T]he trigger for a crisis could be anything if the system as a whole is unstable.
Moreover, the size of the trigger event need not bear any relation to the systemic outcome.
The lesson is that policymakers should be focused less on identifying potential
triggers than on identifying signs of potential instability.”
– William White, former Chief Economist of Bank for International Settlements
My friend John Mauldin puts it this way, “My thesis is that over the next decade we will endure increasingly damaging debt crises that culminate in a coordinated global default – “The Great Reset,” as I call it. There are limits in how much leverage the world can handle and I think we are already beyond them. And that is before we have a global recession. The only question now is how we will manage the collapse.” I think he’s right, but what do you do?
Recently, I made a small but meaningful investment into a private company. Essentially, the company has figured out how to edit the genome of a plant cell so that the plant can produce a greater yield, be resistant to herbicides and fungus and grow in dryer or wetter climates. Across the globe, many universities and researchers have been attempting to figure this out, yet this company has apparently solved it in five plants. They have a meaningful head start and patents in place to protect that lead. The business model is simple: produce seeds and sell to farmers. The upside looks promising. 50x in 10 years? Maybe. But maybe not. A zero? Maybe. Sized correctly, I like the bet. While the science seems sound, risk remains with execution, business decisions to be made, and metrics to be met.
How we manage the collapse. Instability and opportunity. My point is not to sell you on a specific investment opportunity. It is to say that opportunities present, we all can manage our downside risk and an understanding of our current starting position matters a great deal. The challenge you and I face is finding opportunities, risk managing our core and figuring out how to best size our bets.
Today, let’s take a look at the most recent equity market valuations and what they are telling us about coming seven- and 10-year returns. You’ll see that they do not look so good. Nothing new to report. I believe we sit in a similar bubble-like place as we did in 1999. High valuations turned to low and forward return potential became attractive. It took a 50% decline in the S&P 500 and a 75% decline in tech stocks but present it did. More defense than offense was the prescription in 1998, 1999 and 2000 and again in 2007-2008. More offense than defense after the recessions/corrections.
Sitting on the young end of the baby-boomer curve, I find myself in the pre-retiree zone. It is estimated that 75% of all investable assets by 2020 will be in the hands of pre-retirees and retirees. The demographic problem we hear a lot about. Know that the behavior patterns and needs of retirees are different than people in their 20s, 30s and 40s. Time is the ally of the young buy-and-hold investor. It is not so friendly if you’re near or in retirement.
From a risk-reward perspective, a history of starting conditions looks like this:
- The best starting points are at the bottom of the red lines.
- Yellow shows the recovery periods.
- Green shows the periods of newly created gains.
The problem is that it can take years to recover from an equity bear market. I’ve shared a story about a client named Roberta who went all in on stocks in December 1999. She transferred her account to a wirehouse broker and told me she was investing in “safe stocks.” Her $1 million turned into $450,000 in two short years. She was 71. In fear, she exited the stock market and never recovered. “Safe stocks,” she told me. Right. Had she stayed the course, at age 85, she would have gotten back to break-even (see the inflation-adjusted 14 years to recover in chart above).
In a webinar I recently did with VanEck, I shared the following chart. Here’s how you read it:
- Since 1928, the S&P 500 Index has been in a bull market 54% of the time. In the fine print you’ll see that when dividends are added in, the percent of time is 59%. Better, but I believe if you poll a lot of people, they’d come in north of 75%. Especially if that poll was taken late in a bull market move.
- Interesting is that 31% of the time the market has been in “Market Decline.”
- 7% of the time was spent recovering from decline, while 30.3% of the time was spent creating new wealth.
- Overall, equity markets spent 70% of the time in market decline and recovery periods.
Another look with data from 1900 to present is presented next:
- The top section of the chart looks at the S&P 500. Green is the defined secular bull periods. White represents the secular bear periods.
- There is a small box showing the GPA or “gain per annum” in secular bull vs. secular bear periods.
- The middle section shows the trend in bond yields. Green shows yields in secular decline, white shows periods of rising yields. The return is a bit confusing as it measures the decline or rise in yields per annum. When bond yields decline, your bonds gain in value. Don’t get hung up on the numbers.
- The bottom section shows the bull and bear market secular cycles for commodities. Green is bull trend, white is bear trend. We are currently in a bear trend, but I am getting bullish. A buy-when-everyone-is-selling opportunity. Because of the length of the bear market and decline from nearly 1800 to 1000, I like some exposure to the risk.
The point: everything cycles! Your starting conditions matter.
Finally, one last chart before you click through to view the valuation and forward return data:
- A comparison of prior secular bull markets comparing the length beginning to end.
- The 2009 to present bull market move may still have legs to run, in comparison to the 1921-1929, 1942-1966 and 1982-2000 bull market moves. I found the chart interesting and hope you do too (hat tip to Ned Davis Research with disclosures and link below).
So here is an idea for you. A thought on portfolio construction and game plan: I personally like to allocate about 80% of investable capital in a way that seeks growth while risk managing against major market declines (I call that my “core” portfolio). Participate and protect is my meaning of core. With the base built, I like to make a number of what I feel are high probability, targeted investment plays with the remaining 20%. The thinking is that my 80% will grow back to a 100% in five or so years, give or take a few, and I’m not risking the bank in a way that takes me out of the game. In 2006, I invested in a VC fund and it has been the best performing asset in my liquid portfolio. It’s done well and one of the underlying biotech companies may go public in the fall. It’s an exciting story. If you are in the business long enough, you develop a trusted network of relationships. We see many opportunities. I swing at what I feel are the best and size in a way that no one position can hurt too much. Such positions may be difference makers. No guarantees of course. My point is there are always opportunities even in the face of what I believe will be a meaningful market correction.
Which leads me to last week’s piece about Alexander Hamilton and Stan Druckenmiller. A few readers sent me notes that it basically left them in search of antidepression medication. The system is complex and fragile, and we are nearing the end of the current long-term debt cycle. Each week I share my view on what’s happening and what the road ahead looks like. The trigger for the next crisis could be anything. But I’m pretty sure it will take crisis to get the debt and entitlement messes figured out. When? Don’t know. My best guess is in the next recession, so let’s keep that on our radars. If you are young with many years to run, buy-and-hold and dollar cost average in each year. Don’t worry… be happy! If not so young but still young at heart, use your gained wisdom and think differently. My best two cents for what it’s worth.
Happy to share ideas with you if you’d like to learn more. I do think the next recession will create an even greater opportunity than the last two. Let’s not get run over and be in a position to re-weight our portfolios more aggressively then. Send me an email and I’ll share what I can. Some investment ideas require a certain level of net worth (SEC rules). And I’ll let you know about the agriculture gene editing company I touched on above after it goes public. Then, anyone can invest in it. Best though to make sure if fits into the game plan you and your advisor created.
Finally, it’s been a bumpy week again in the markets. The 10-year Treasury yield remains well below the 3.07% line in the sand, equities have been Trump’ed and Italian bumped around but are rallying again today.
Grab a coffee and find your favorite chair. You’ll find a few valuation charts and please know I’m trying my best to keep each post meaningful yet short and easy to read. I hope you find the information helpful. Have a fun weekend!
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Included in this week’s On My Radar:
- Valuations — A Quick Look at What They Tell Us about Coming Returns
- Italy, EU Banks and Trade Wars
- Trade Signals — Italy, EU Banks and Trade
- Personal Note
Valuations — A Quick Look at What They Tell Us about Coming Returns
Median Price to Earnings (P/E)
Here is how to read the chart:
- Focus on the bottom section. The red line tracks the latest Median P/E reading based on the prior 12-months of actual earnings. The current level is 24.3.
- I like handicapping the market’s upside and downside potential based on how far away the current P/E is from its 54.3-year median (currently 17.1).
- A one standard deviation move to the downside (a relatively rare event but happened a lot in the 1970’s and early 80’s), would put the market down 51.4% from the May 31, 2018 close.
- The market currently sits at a 1.5 standard deviation above the historical median P/E, which means it is about 8% above the overvalued level line at +1 SD.
- A correction to Median Fair Value requires a 29.7% drop. That’d be a better entry target if you want to get more aggressive.
Buffett’s reported favorite: Stock Market Capitalization as a Percentage of Nominal GDP
Here is how you read the chart:
- Note the green dotted “Very Overvalued” line.
- Note how high the blue line is (far right) at 149.2% market cap to GDP (second highest only to 2000).
- Note the red line. Similar to the blue line except it looks only at the S&P 500 companies to determine stock market cap. I think the blue line is closes to the total value of all stocks outstanding. Thus, preferred.
Forward Return Potential
Here is how you read the chart:
- NDR sorted the history of 10-year smoothed earnings to determine P/E and then put all of the history of P/E into five categories ranging from “Cheapest 20%” to “Most Expensive 20%.”
- Each month-end P/E was determined and then they calculated what actually happened over the subsequent 10 years. Data is from 1881 through March 2018.
- The current starting condition, where we sit today in regards to high valuations, is highlighted in yellow.
- The black line in the middle of the yellow box shows median 10-year annualized real return. Roughly 3.25%.
- The red line shows the worst of all 10-year outcomes and the green line shows the best.
Bottom line: expect returns in the -1% to 5% range with the highest probable outcome at 3.25%. Of course, it could be better or worse. Do look at how much better the returns get when the market is not so expensively priced.
I’ll share a few more next week that show probable forward returns in the +2% to -2% range and of course there is that great work from GMO on probable coming seven-year real returns… last chart:
More defense than offense…
Italy, EU Banks and Trade Wars
I talked with Mauldin about Italy this morning. He’s writing about them in his Thoughts from the Frontline letter today. He provided me with an early draft:
Italy is not Europe’s only problem. The big Kahuna is Germany, which spent years offering generous vendor financing to the rest of the continent to entice the purchase of German goods. The result: a giant trade surplus for Germany and giant, unpayable debts for those who bought German goods. Greece, for instance.
But a lot of that debt is on the balance sheet of European banks. S&P just cut the ratings for Deutsche Bank to BBB+. That is only a few notches above junk ratings. And if there were Italian issues? A lot of German banks could see their ratings fall to below junk. Ugh. Will Germany let Deutsche Bank fail? Simple answer, no. But they may not feel the same love for Deutsche bank shareholders.
Spain is not quite the basket case that Italy is, but its banks are certainly wobbly. Spanish lawmakers this week gave a no-confidence vote to Prime Minister Rajoy’s conservative government and installed a socialist prime minister. The Spanish economy is actually much improved; other issues are creating political instability.
The UK is still winding its way down the Brexit path, which doesn’t directly affect the euro but is disruptive nonetheless.
All in all, Europe is mostly stable but has problem spots like Italy, and all it takes is one of them to bring the whole structure down. That’s why we see market moves like Italian two-year bond yields zooming from below zero to almost 3% within days and then falling below 0.8% the next few days. That some serious volatility. (h/t for chart to Peter Boockvar)
That’s not normal and doesn’t happen in a monetary union in which all the members share the same goals. And that’s kind of the problem: European governments have irreconcilable interests and thus don’t trust each other. By accident of history and geography, the continent is fractured into dozens of competing economies, languages and cultures. Unity has long been a dream, but only a dream. Simply avoiding war is hard enough.
The Euro currency union is fatally flawed because it leaves each member state to set its own fiscal policy. There are good reasons for that, but it is not sustainable indefinitely. The Eurozone must get either much more centralized or fall apart. All the Rube Goldberg contraptions the ECB and others invent are temporary fixes. They’ve worked so far. They won’t work forever. And that brings us to the latest strange proposal.
You can find the balance of John’s latest piece, “The Italian Trigger,” here. It’s worth the read.
The largest bank in Europe is Deutsche Bank (DB) and it’s not in good shape. I tweeted this out on Wednesday:
The systemic piece is tied to the global web of related to counterparty risks. The systemic piece is the pure size of derivative exposures. In 2016, it looked like this:
Enough said, or I will become depressed. Instability indeed.
Trade Signals — Italy, EU Banks and Trade
S&P 500 Index — 2,702 (05-30-2018)
Notable this week:
Sorry for the late post. It’s been a bumpy week for equities. Italy, EU banks and Trade Wars again take center stage. Risk remains elevated. Notable changes to the trade signals this week include Don’t Fight the Tape or the Fed moving back to “0” (a neutral signal). The longer trend models for equities (NDR CMG U.S. Large Cap Long/Flat signal remains moderately bullish as does the 13-week EMA vs. 34-week EMA trend signal). CMG’s short and intermediate CMG Tactical All Asset and CMG Tactical Equity models remain defensively positioned in Treasury Bills — something we have not seen in the history of the models. We have our eyes wide open. I continue to favor diversifying to a handful of investment strategies that seek growth while doing so in a way that provides risk management in down markets. The economy, the equity markets and the fixed income markets are late cycle. The charts follow below. Please let me know if you have any questions.
The next section walks you through all of the Trade Signals charts.
Important note: 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.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is firstname.lastname@example.org. I am not compensated in any way by NDR. I’m just a fan of their work.
Susan has been in San Diego all week. Her middle son Conner did an internship with the biotech company I talked about in my intro. His text to her on day two said, “I’m in heaven.” That made mom cry. He’s the scientist of the six kids and he got under the hood with lab coat on. They are taking the red eye home tonight.
So much to share with you concerning business developments. Let’s hold that off until next week.
Have a wonderful weekend.
Wishing you the very best.
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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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.
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