July 23, 2021
By Steve Blumenthal
“In its purest form, capitalism is an evolutionary process.
Businesses that best adapt to changing conditions survive and grow.
Typically, that means offering a product or service superior to current ones
or giving consumers more choices. Weaker or poorly managed businesses
that don’t adapt to the new situation wither and eventually die.
That’s not always pleasant but it’s how nature works.
Joseph Schumpeter coined the term ‘creative destruction’
to describe the process. It is not pleasant when you are on the destruction
end, but the creative side can bring innumerable joys and sometimes even wealth.
The difference, however, is we don’t have capitalism in its purest form,
or anywhere close. It has been tweaked, modified, corrupted and/or regulated
into something else, the particulars of which vary. The common thread
is that survival depends on other non-random forces that can be manipulated.
Governments can and often do create barriers to entry,
protecting favored constituencies and groups from competition.”
– John Mauldin,
Chief Economist and Co-Portfolio Manager, CMG Mauldin Smart Core Strategy
This week, one of John Mauldin’s 700,000 readers sent John the above quote that John had written several years ago. John humbly replied, “Perhaps one of my more important insights….The common thread is that survival depends on other non-random forces.” That captures the moment. Like it or not, it’s our current state with the Fed’s zero-bound interest rate policy and monthly buying of Treasurys ($80 billion) and mortgage bonds ($40 billion). It continues until it does not.
I was asked my views on how I see things playing out. What follows is my best guess (I could be wrong, but here we go). The current state is easy to identify: The stock market is overvalued, overleveraged, and euphoric. And, as you’ll see in Trade Signals below, the deviation from trend has now matched the tech bubble high. These are all signs of a market top. One very big narrative supporting further price gains is everyone believes that everyone believes the Fed has our backs. I think it holds true for now.
Howard Marks made the comparison to tickets in a fishbowl. More tickets in the bowl might have a winning number, or fewer tickets may have it. When there are more winning tickets, the odds of you pulling one out are greater. When there are fewer, the odds of you winning are worse. Today, because of extreme overvaluations and leverage, there are fewer winning tickets in the bowl, yet markets could go higher. The Fed accounts for more than a few tickets in the fishbowl.
With this said, I expect a 10% correction in the second half of the year. Maybe -20% but that’s the hard line in the sand. Why? “Non-random forces that can be manipulated.” If the Fed can violate the Federal Reserve Act and buy high-yield junk bond ETFs, what’s next? My guess is the current Fed narrative holds true – for now.
From a technical perspective, during the first half of the year, the weight of evidence was bullish based on broad participation across most market sectors. Most stocks, most sectors performing well. However, since April, the percentage of stocks above their 50-day moving averages has fallen from 78% in late April to 29%. The percentage of those above their 200-day moving average has fallen by less, from 92% to 67%. (Source: Ned Davis Research)
The fab six FANMAG stocks are carrying the S&P 500 Index and other cap-weighted indices to new highs. You’ll see in the Trade Signals section below that the weight of evidence remains bullish. So overall, best guess is -10% to -20% downside risk in the second half of the year with a V-like recovery pattern as the Fed steps back in to save the day.
I believe the Fed narrative holds until a point in time when inflation gets out of control and calls the Fed’s hand. Not there yet, but the first few pitches have been thrown.
As you read on, you’ll find two charts. One shows that “fair value” for the S&P 500 is -47.8% below current levels. Call that a good target point to buy equities when the Fed narrative is lost. The second is GMO’s most recent 7-year Asset Class Real Return Forecast. Compounding at -8% per year for seven years is not what investors are expecting. If it turns out to be true, cap-weighted, buy-and-hold index investors will find retirement to be less pleasant. You’ll also find the latest Trade Signals commentary as well, and a short personal note about late-night summertime golf. Thank you for reading!
- Fair Value and Forward Returns
- Trade Signals – Deviation from Trend Matches 2000 Tech Bubble High
- Personal Section – Summertime
Fair Value and Forward Returns
The first chart looks at the current Median P/E vs. the 57.3-year Median P/E average.
- Middle section (orange line) plots the monthly history back to 1964. Median P/E is highest on record.
- Lower section (red arrow) shows how far the market has to correct to get back to “Fair Value.”
- One could argue that with zero-bound interest rates, we might not ever get back to “Fair Value.” I’d argue, “What happens when rates rise?” Thus, the inflation conundrum.
GMO has a process to calculate probable coming 7-year Real (after inflation) Asset Class Returns.
- I’ve never seen it this low – as in a minus eight percent per year for seven years. Do the math on that compounding.
- If GMO is correct, picture the S&P 500 Index at that Median P/E Fair Value level of 2243.55.
- We’d much rather be a buyer at Fair Value than a buyer today. Time to hedge!
Trade Signals – Deviation from Trend Matches 2000 Tech Bubble High
July 21, 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:
Watch what they do, not what they say. True in life, in business, and in markets. With inflation evident most everywhere, the bond market is telling a different story. The US Treasury 10-year yield touched 1.20% yesterday. It closed at 1.28% today. It was at 1.75% two months ago. The 10-year and 30-year US Treasury bond yields are important since the Fed has far less ability to affect longer-dated maturities. The move lower in yields (high grade bonds moving higher in price) is notable and bears watching. You’ll see below that the Zweig Bond Model and the 10 Year Treasury Weekly MACD indicators both remain in buy signals.
However, the CMG Managed High Yield Bond signal moved to a sell signal this week. In last week’s Trade Signals, the high yield junk bond market is a leading indicator. It’s a risk-management probability game. This sell may turn out to be “transitory” but worth attention as discussed last week… Keep a close eye on HY.
Deviation from Trend Matches 2000 Tech Bubble High
I share this next chart with you somewhat frequently. It looks at how far above or below the S&P 500 Index is from its long-term trend line. Historically, the best returns come when the S&P 500 (orange line middle section – following chart) is below the dotted light blue line. Think of this as an area to overweight to stocks (less risk and higher return potential). The weakest returns are when the S&P 500 is extended far above the dotted light blue line. The best returns come when well below the dotted blue line.
Each month, Ned Davis Research plots the deviation from the long-term trend (lower section in chart). Data is monthly back to 1928. I’ve inserted a red line (lower section in chart) to show that the current deviation matches 2000 Tech Bubble mania high. Blink twice, rub eyes, look again. The only other period in time the S&P 500 was this far above trend was in 1929. We are well into bubble territory.
Lastly, the red arrow in the upper left shows the “Average % Change in the S&P 500 Index” 5 years and 10 years later based on the deviation from trend. Bottom line: It is better to buy-and-hold stocks when in the “Bottom Quintile” vs. in the “Top Quintile.”
- $100,000 has grown on average to $110,002 5 Years later (on average when in the Top Quintile) and to $140,650 10 Years later.
- On an annualized basis that works out to less than 2% per year over five years and less than 3.5% per year for ten years.
- This is not the 14.5% per year investors are expecting according to a recent Natixis investor survey.
- When the S&P 500 moves below the dotted light blue line, and into the Bottom Quintile, take the risk management brakes off. For now, keep them on.
Click HERE to go 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 – Summertime
I wrote last week that Michael Jordan won five NBA Championships. My Chicago readers and others were quick to correct me: Michael won six. Sorry for my miss. While I am a die-hard Philadelphia 76ers fan, I enjoyed watching every one of them. I especially liked the series against Magic Johnson and the Los Angeles Lakers. Magic vs. Michael, that was great. If you haven’t watched “The Last Dance” on Netflix, check it out.
When I was a kid, my mom would drop me off at the golf course. Kids were allowed to play after 4 pm. Each time, I’d beg for a late pick up, but 7:30 pm was the latest she’d agree to. The good news for me was that mom had a habit of being late.
With bag on back, I’d get in as many holes as I could. If I was lucky, I could replay hole one and hole nine. Both were close to the parking lot.
By 8:15 pm, the summer sun would have set and, on most nights, I’d be walking down the ninth fairway as I’d hear mom’s old Fiat hatchback speed up to the top of the empty parking lot. Mom would slam her hand to that high-pitched Fiat horn and keep it there for too many unpleasant seconds. No cell phones in those days; just a Fiat horn that could be heard through the valley. I’d race like crazy to the car with my golf bag bouncing on my back. The experience is cemented in my memory. Those were great days.
I met son Matthew at Stonewall on Wednesday night. Susan was coaching, and there was no rush to be home. The sun was setting, no one was on the course, and just one car sat in the parking lot. I smiled remembering mom.
If you have a second, below is a short video. Stonewall is a beautiful place. A peaceful night… Especially absent that Fiat horn.
We are in the heart of summer. Grab a cold IPA, a fine glass of wine, or your favorite beverage, and raise it high. Here’s a toast to your mom, peaceful nights, great memories, and time with those you love most.
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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