September 24, 2021
By Steve Blumenthal
“In the absence of the ability to see the future, how can we position our portfolios for what lies ahead?
Much of the answer lies in understanding where the market stands in its cycle
and what that implies for its future movements.”
― Howard Marks, CFA,
Co-Chairman, Oaktree Capital Management
There are moments in time when you step into the uncomfortable. While no one enjoys these spaces, they are often where opportunities lie. In Trade Signals this week, I stepped into the uncomfortable and concluded, “It’s Time to Hedge.”
In my view, the downside risk is a decline of 20% to 40%. With expectations for a global economic slowdown. Evergrande and China a trigger? Maybe.
Of course, I could be wrong. But the cost to hedge is small. And if I’m right, neither you nor I will feel comfortable but that is when the forward return profile will be good again.
Yesterday, Thursday, September 23, the S&P 500 Index closed at 4448.98. The coming opportunity—best guess—is somewhere between 2636.72 (“median fair value”) and 3491 (“overvalued”). Thus, my conclusion of -20% to -40% (the orange arrow in the bottom section of the next chart).
To be clear, there is no way to know the timing. But we can know where we sit in a particular cycle: valuations, deviation from long-term trend, investor euphoria, technical warning signals, the Fed’s fragile footing, debt levels in general and record high margin debt in particular.
In the early 1980s, households had approximately 15% of their assets allocated to stocks. It grew to 44.50% by March 2000. By 2002, they had 26% in stocks. Then, confidence returned—just prior to the Great Financial Crisis, households had 37.3% of their wealth allocated to stocks. By early 2009, they had just 21.7%. As of the most recent data, June 30, 2021, the number is a record 47.50%. Higher than 2000, higher than 2007, and higher than any prior period dating back to 1951. Opportunity lies in the uncomfortable, just as we saw in 2003 and 2009.
The market is ripe for a hard knock on the head. If you haven’t done so already, “It’s time to hedge.”
As promised last week, today, let’s take a look at debt. You’ll quickly see that it is not just a U.S. problem. Focus in on the change in the last year as well as the “% of GDP.”
Total domestic debt is the total outstanding debt owed by all domestic sectors (households and nonprofit institutions, financial and non-financial corporations, farms, state and local governments, federal government) and includes government bonds, corporate bonds, bank loans, other loans and advances, mortgages, and consumer credit.
Total Domestic Debt as a Percent of GDP – data as of 3-31-2021 (select countries) Source: Ned Davis Research (NDR)
How to Think About Debt: As a Drag on Future Growth
Reinhart and Rogoff did an excellent review of history. The bottom line–plain and simple–is that economies get into trouble when debt-to-GDP is north of 100%. Debt is our number-one problem. It is why the economists I respect the most believe deflation will continue to be the dominant force. In the end, we will monetize the debt and the path to that end game will be volatile. I could be wrong, but I believe U.S. debt will double by 2030 to $50 trillion and as William White said, “In the end, there will be inflation.” I think that is the path we are on. I believe there is a high probability he is right. We’ll have to adapt our portfolios accordingly.
The debt binge will continue but for stock investors it is margin debt that is the immediate concern. Why? The unwinding of margin debt, especially when it is large, is the reason that market corrections happen quickly. Let’s take a look.
Margin Debt to GDP
Total margin debt at the end of May 2021 reached a record high of $861.63 billion. Three months later, it reached $911.55 billion. This represents a record high in margin debt relative to GDP.
To gain some perspective, Margin Debt to GDP reached a then-record high 3% in early 2000, it peaked at 2.9% in 2007, and is now 4.01% total market debt relative to GDP. To get a sense for what this means, the current level is the highest in history. Higher than the last two major bull market peaks (2000 and 2007). Investors are betting with the largest amount of borrowed money in history.
Next is a chart I shared with you a few months ago (I found the data through August 2021, but today’s message is the same):
- Plotted are investor credit balances. Think of it as cash in brokerage accounts minus margin debt. The red bars show periods when credit balances were negative. The yellow text boxes call out various dates. The red bar in the lower right-hand side of the chart labeled “current level” represents current negative credit balances.
- Compare the current level to prior periods like the Tech Bubble, June 2007, and May 2021.
- Focus on how investors behaved when prior bubbles popped. The green bars show positive credit balances. The blue line plots the S&P 500 Index.
- Bottom line: When margin calls kick in, panic rules reason and all the leverage unwinds. We want to be in a position–with capital in good shape–to take advantage of the buying opportunity that panic will create.
From Advisor Perspectives:
Margin debt data is several weeks old when it is published. Thus, even though it may, in theory, be a leading indicator, a major shift in margin debt isn’t immediately evident. Nevertheless, we see that the troughs in the monthly net credit balance preceded peaks in the monthly S&P 500 closes by six months in 2000 and four months in 2007.
We are potentially now past the longest bull market in history. The peak in margin debt preceded the peak in the monthly S&P closes (the December 2019 peak) by 19 months, much longer than the previous shifts prior to corrections. Margin debt is currently at its peak, as is the S&P… could this mean that the S&P will continue to rise for at least another four months?
There are too few peak/trough episodes in this overlay series to take the latest credit balance data as a leading indicator of a major selloff in U.S. equities. This has been an interesting indicator to watch and will certainly continue to bear close watching in the future.
One timing signal I keep my eye on looks at margin debt as a percentage of GDP in comparison to a six-month smoothed moving average line. It’s market debt unwinding (and forced selling by brokerage firms) that causes crashes. As you can see in the next chart, margin debt has yet to decline.
Bottom line: Margin debt is very high. Investors are leveraged up. Risk is high. Keep an eye out for a change in trend. In the end, leverage is always what blows things up.
Trade Signals – It’s Time to Hedge
September 22, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
Evergrande: The Chinese market reopened last night and equities began the session significantly lower before climbing back. The People’s Bank of China (the Chinese central bank) was said to inject $13.9 billion into the financial system, showing a commitment to calming markets. Evergrande said a debt payment due tomorrow has been “resolved,” though details are foggy. The “Lehman” like moment fear is easing and markets appear to be finding some footing.
Evergrande’s problems stem from the Chinese government’s efforts to reduce housing speculation. This weakened sales over the last year, making it difficult for the company to keep generating cash. From Gavekal, “A systemic crisis is unlikely, but default by such a large and financially connected company will still have visible economic effects.” China is tightening its belt and not just in housing. Evergrande is not the only construction firm in trouble. In their wake alone are suppliers, shippers, and construction workers, etc. The tide has gone out, we’ll see who else is swimming naked.
Bottom line: China has been the world’s growth engine. Their economic slowdown will be felt globally. Expect a global slowdown into 2022. The timing of which clashes with peak investors’ confidence (reflected in record ownership) in U.S. equities and margin debt relative to GDP higher than the 2000 and 2007 market tops.
The U.S. equity market trend remains in a bullish uptrend; however, divergences beneath the surface are signaling weakness and bear watching. Just four stocks (Apple, Google, Microsoft and Tesla) account for half of the S&P 500 Index gains over the trailing three months. Greater than half of the stocks in the index are down over 10% from their highs. Market breadth is weak: the NYSE Common Stock Only Advance-Decline line has fallen to its lowest level since the spring. This is a measure of the number of stocks advancing in price vs. the number of stocks declining in price. Further, the percentage of S&P 500 Index stocks above their 50-day moving average line has gone from 95% in late April 2021 to the low for the year at 32%. This means just 32% of the 500 stocks in the index are above their 50-day moving average price trend line.
Bottom bottom line: With more stocks breaking down, fewer stocks are supporting the S&P 500 Index (and other cap-weighted indices). Generally, a warning that the broader market is weaker than the major market indices are signaling. A warning sign that increases the odds of more selling to come.
Bottom bottom bottom line: If you haven’t hedged your equity exposure, it’s time to hedge.
Click HERE to read to the balance of Wednesday’s Trade Signals post.
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.
Personal Note – The Ryder Cup
I was a guest presenter on an ETF Trends webinar emceed by my good friend and ETF legend Tom Lydon and sponsored by Allianz Investment Management. Brendan Cavanaugh, an ETF product specialist at Allianz, was making the case for their “Buffered Outcome ETFs.” Think U.S. large-cap equity exposure with risk mitigation built in.
There was something Brendan said that really hit home for me. He explained that back in 1991, an investor’s portfolio could have 98% in cash and 2% in fixed income to generate an expected 7% return with a standard deviation of 1.1%. In comparison, an investor is required to include 97% in growth assets to earn the same return of 7.0% in 2021, but this more complex mix of growth assets could come with a standard deviation of 17.3%. Put simply, you have to take on much more risk to achieve a 7% return today. Here is a link to the post-webcast write-up.
And given probabilities for slightly negative to low single-digit equity market returns over the coming three, five, and 10 years, how does someone hit that 7% bogey? The traditional stock, bond, and cash opportunity set is not currently positioned to deliver. It doesn’t mean it can’t be done. My optimistic message is to look elsewhere…
Here are a few ideas for the CORE portion of an investment portfolio:
- A two-year, 6% well-collateralized first lien short-term private credit Reg A bond
- A 7%-yielding debt fund well-collateralized by pharmaceutical royalties (accredited investors only)
- A 7%-yielding well-collateralized high grade corporate lending fund
- An 8%, five-year well-collateralized first lien short-term private credit Reg D bond
- A 10+% short-term focused trade finance fund (qualified persons only)
If you are an accredited investor, email me at email@example.com or talk to your CMG Advisor Rep if you’d like to learn more.
The Ryder Cup
Europe is the current holder of the Ryder Cup after winning the match play event by seven points in Paris in 2018. The tournament, postponed last year, began today. It is happening at the famed Whistling Straits Course, a links-style course sculpted along two miles of the Lake Michigan shoreline.
I have the Ryder Cup playing in the background as I finish writing to you today. The stands are full, the energy is high, and the fans are loud. With the exception of the Masters Tournament, the Ryder Cup is my favorite golf event to watch. The U.S. needs 14.5 points to regain the cup. Tune in and check it out. Even if you are not a golf fan, you’ll get to see a beautiful part of the world.
On the personal front, the weekend weather forecast is outstanding: sunny with temperatures in low 70s. Brianna is coming home Sunday for a quick visit. She, Matthew, and I will be golfing together. And we’ll be cheering on the U.S. team, hoping they’ll beat the European team in the Ryder Cup.
Wishing you a fun weekend… Go USA!
All the best,
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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