October 14, 2022
By Steve Blumenthal
“My biggest concern is that further tightening will test the fragilities of market plumbing,”
– Scott Minerd, Chairman of Guggenheim Investments and
Guggenheim Partners Global CIO
Fragilities indeed. During last week’s team call, our debate turned into a wager: Will the Fed raise rates another one or two times by the end of the year?
I went in bold: “No rate increases at all.” My partner David joined me. Everyone else said they thought there’d be at least two more rate hikes.
After yesterday’s CPI inflation report, it’s a bet I’m pretty sure I’m going to lose. Odds-makers are placing a 96% probability on the Fed raising the Fed Funds Rate 75 bps to the 3.75%–4.00% range at their November 2–3 meeting. Further, they place a 71.5% probability that the Fed will raise rates an additional 75 bps at their December 14–15 meeting. (Source CBOE)
To be clear, my bet rests on the extremely high level of fragility in the system. It’s a bet I don’t want to win. I believe the Fed will slam on the brakes. But that will only happen when something in the engine breaks. Cracks are evident almost everywhere. Keep your defense on the field.
Last week, I promised an updated look at valuations. There’s some good news for those of us with patience. So go grab that coffee and find your favorite chair. And grab your geek goggles too—you’ll find a number of charts ahead. I’m not sure about you, but they help me stay disciplined. You’ll see my red “we are here” arrows and green “we’d be better off here” arrows. Trade Signals and the Random Tweets section follow as well. By the time this hits your inbox today, I hope to be drinking a cold IPA with my beautiful wife. The MP Friars soccer game is at 4 pm. Sitting at 5 wins, 7 losses, and 1 tie, Coach Sue and the team needs a W! And beers always taste better after a W.
Thanks for reading.
(Reminder, this is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only).
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Various Market Valuations – Better But Not Yet
“Market Valuation and Actual Subsequent 10-Year Total Returns Points of ‘secular’ undervaluation such as 1922, 1932, 1949, 1974, and 1982 typically occurred about 50% below historical mean valuations and were associated with subsequent 10-year nominal total returns approaching 20% annually. By contrast, valuations similar to 1929, 1965, and 2000 were followed by weak or negative total returns over the following decade. That’s the range where we find ourselves today. Of course, we also won’t be surprised if the S&P 500 ends up posting weak or negative total returns in the 2007-2017 decade, which would require nothing but a run-of-the-mill bear market over the next couple of years.”
– John Hussman, January 2015
I want to set the stage for this week’s valuation review with advice to keep all sharp objects out of reach. More from Hussman (September 2022 Investor Letter):
“The same dynamic that created the mortgage bubble – yield-seeking speculation driven by a pile of zero interest monetary hot-potatoes – is precisely what has now given us the broadest speculative episode in U.S. history. The speculation has been broader and more sustained because the Federal Reserve’s profligacy has been greater. At the beginning of this year, U.S. investors were being forced to choke down a stunning 36% of GDP in zero-interest monetary hot potatoes, most of which they held indirectly through bank deposits earning nothing. Somebody had to hold it, and nobody wanted to.
Forcing that much zero-interest cash onto investors who didn’t want to hold it, and couldn’t – in aggregate – get rid of it, contributed to a ridiculous array of financial speculation. That’s how the Fed helped to drive valuations beyond their 1929 and 2000 extremes, setting up pension funds, retirees, charities, and every type of passive investor for negative expected returns, by our estimates, for more than a decade. Breathtaking amounts of “market capitalization” emerged, temporarily, in even the sketchiest alternatives. In my view, Fed-induced speculation was also at the root of the bubbles in meme stocks and cryptocurrencies, which have proliferated like digital Pokémon, because nothing animates a speculative herd more than a parabolic advance in an “asset” unconstrained by any standard of value. You won’t be surprised that I expect the unwinding to end in tears. Still, having adapted to deranged Fed policy years ago, nothing in our discipline relies on that outcome.
When the collapse comes, and I believe it will, my hope is that the blame goes to the right place. It will not be because the Fed was forced to tighten, but rather because the Fed adhered to its “ample reserves regime” for so long.” – John Hussman
The Buffett Indicator – Total Market Cap to GDP (Gross Domestic Product). Much better, but still a ways to go:
The popular PE 10 ratio. Still high:
Courtesy of AdvisorPerspectives, Jill Mislinski, October 11, 2022: Here is a measure of four popular valuation metrics. Call the black line “fair value.” We are looking for a move to or below that line. That’s when forward returns will be attractive again. Note: both the Crestmont PE and the Cyclical PE average PE over 10 years. This is slower moving.
Next is a chart produced by AdvisorPerspectives that inverts the S&P 10-year total returns. They noted, John Hussman says, “the most reliable correlation between valuations and subsequent returns is on a 12-year horizon, which is the point where the autocorrelation profile of valuations typically hits zero.”Here is the Hussman return chart – please note it is inverted.
SB Here: Note the low to negative 10-year nominal total returns from the prior most overvalued periods: 1929, 1965, and 2000. Also note the opportunities that were presented in 1932, 1949, 1982, and 2009. Markets always cycle from a bull to bear and back to bull again. We are in the corrective grips of a bear market cycle today.
Setting some line of site targets – Next is a look at “Median PE Ratios” for Multi-Cap, Large-Cap and Small-Cap Indices. Note the highlighted yellow circles and the dotted black lines. Opportunity is nearing. It just won’t feel like an opportunity when we get there… Put your contrarian tin foil hat on and be ready to be ready!
I often have shared with you the 10-year PE valuation vs long-term trend. Here’s a look at the 5-year. Note the “We are here” red arrows and the “We’d be better off here” green arrows. Crisis takes us to the “Bottom Quintile.” We don’t need a crisis to get good returns. But it is what we may get. Hats on!
Other popular valuations measurements like Median Price to Earnings, Price to GAAP Earnings, Price to Shiller Earnings, Price to Operating Earnings, Price to Forward Earnings, Price to Sales, Price to Book, Price to Cash Flow, and Dividend Yield are all in the Extremely Overvalued to Moderately Overvalued. The good news is that about half of the indicators are now Moderately Overvalued. An improvement from Extremely Overvalued… Moving in the right direction.
The Buffett Indicator Measures Market Cap to GDP. Ideally, anything in the .32 to .75 range is where past bear markets bottomed in the US.
A history of subsequent 10-year S&P 500 Annualized real returns based on PE 10:
Actual Subsequent S&P 500 12-year Nominal Annual Total Returns
The coming 12-year annualized return forecast is less than 0%. Note the 9/23/22 date and arrow in the chart.
From Hussman, The below chart shows our most reliable valuation measure: nonfinancial market capitalization to gross value-added (MarketCap/GVA), and its relationship to actual subsequent market returns, in data since 1928. Based on current valuations, we estimate that average annual S&P 500 total returns are likely to be negative on a 12-year horizon.
Conclusion: I hope I didn’t geek you out too much. I’ll conclude by saying that depressed labor costs and depressed interest costs have significantly boosted corporate profits over the past decade. Flip that picture upside down. We have rising labor costs and rising interest rates. Add in rising tax rates on corporations, and we have to think about the impact on corporate earnings and profits. If the E in PE (price to earnings ratio) declines, that means prices much come down just to keep the PE unchanged. The point is we are sailing into a stronger headwind. We are not yet out of the woods.
Valuations don’t matter to most people most of the time, but they should matter to us all at extremes. The hard part is they can stay extended for very long periods of time. More defense than offense when extremely high (hedge equity market exposure). More offense than defense when they are low. Use valuations as probable coming return indicators to know which team is best to put on the field. By the way, click on this link to read John Hussman’s full post. Excellent stuff.
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“Keep an eye on derivatives—$600 trillion in notional value, almost all linked to interest rates/currency differentials.”
-Former Fed nominee Judy Shelton, via Twitter, 10/6/22
My message to the funds involved and all the firms is you’ve got three days left now. You’ve got to get this done.
–Bank of England Governor Andrew Bailey, 10/11/22
China’s Chip Industry – This Just In!
Supporting the odds of my losing bet:
We like Ag:
Commodity Bull Market:
October 11 – Yellen, October 12 – Yellen. Really? Bueller, Bueller, Anyone… Anyone.
Average Hedge Fund performance is holding in. Flat for the year.
Better – While I’m not a fan of Forward PE, this is starting to look attractive:
My high and growing dividend stocks and ARK contrarian spyder senses are starting to tingle!
More Random Tweets next week. Please follow me on Twitter, where I do my best to highlight what I feel is most important… @SBlumenthalCMG
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Trade Signals: The 2022 Great Bond Bear Market
October 14, 2022
S&P 500 Index — 3,609
Notable this week:
I’m writing today’s Trade Signals mid-afternoon Friday, October 14. What a wild week. CPI prints higher yesterday morning, the stock markets fell sharply, declining more than 2%, and without a word, rallied to close the day more than 2% higher. As you’ll see in the next chart, we didn’t see the same manipulation in the bond market. My conspiracy mind is whirling with the initials PPT. Yes, no, maybe. When major Wall Street speculators are massively short, it doesn’t take too much tweaking to get the pros racing to cover their bets. It’s hard to want to be short. Easy to get your head handed to you. But bear market it is, and yesterday’s action, in the face of the bad inflation news and the movement in the bond market, reaks of Plunge Protection Team activity.
Yes, the PPT is real. But do please forgive me. I sound so much like my old man. Sometimes he was certain football officials were on the take. Oh my, oh my.
With no conspiracy theory top his mind, Jeffrey Gundlach believes a hard economic slowdown is ahead, and the 10-year Treasury yield will drop to 2% by this time next year. I think he is right.
If you have the brass, a great trade is setting up.
Chart of the day: Look at the spike in yields to 4.02%.
If rates decline back to 2%, the popular TLT 20-year Treasury Bond ETF will gain more than 30%. Note the gain if TLT moves from 99 (its current approx. price) to 130 (red bracket in the chart). Not a recommendation for you to buy or sell any security. I am just pointing out what I believe is a great trade setting up. No guarantees. I could be wrong.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizons, and risk tolerances.
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Personal Note: Soccer, Life, and Golf
We are a soccer family, and all of us know the most talented of our bunch is Mom. Susan played in college, then in Europe, and she holds a U.S. Soccer A-level coaching license. Watching her over the years, and seeing how U.S. Soccer has evolved, I’ve come to learn it’s really about teaching, focusing on the players, and keeping the game fun.
U.S. Soccer uses a coaching structure called “Play-Practice-Play,” which optimizes practice time around learning through game-like scenarios. Research showed that youth players were quitting the game around the age of 14 and U.S. Soccer wanted to learn why. So, they commissioned a study, and found that kids were quitting because “it was no longer fun.” That set the organization on a mission to change the way it teaches coaches. Now, training sessions begin and end with the reason they’re there: the chance to play the game.
We can read something in a book and think we “know it,” but nothing beats firsthand experience— failing and learning, and learning from failing, time after time . U.S. Soccer is getting away from coaches barking orders and running endless drills and moving toward letting players experience through game play. After all, the lessons learned on the field are the greatest teachers. Watching Susan teach the methodology to other coaches and seeing her work with her players reminds me how much I really don’t know.
My knowledge was put to the test this past Monday. And, honestly, I failed.
It happened during Monday’s game against the very talented Germantown Academy team. With literally two seconds on the clock, the ref called a handball in the box for the opposing team. Germantown Academy scored the penalty kick, and after ten minutes of overtime, the game finished 2-2. As things unfolded on the field, I zeroed in on one of our players. He seemed afraid to win the ball. I was frustrated with his lack of effort, and I got on him a bit too much. “Your work rate is at a four, and it needs to be at a nine or –ten. You’re too good and too strong to be playing so soft!” I yelled. “Get in there and hit somebody!” As the game intensified, I stayed on him. I was loud—too loud. It wasn’t good.
One point of clarity: by “hit somebody,” I meant to get aggressive, to go in for a clean tackle, and to restrict his opponent’s space to work. To get up in their grill, if you will.
My job at the games is to help the kid who’s down and report on our opponent’s formations, talent, and weaknesses. It’s been great fun so far and a nice distraction from my day job. I’m enjoying getting to know the boys. And maybe because I’m getting to know them, the games mean more to me than I thought…
No excuse, though. I’ll pull the young man aside and tell him how much I care about him. I’ll look him in the eyes and tell him I was wrong.
Failing and learning, learning from failing, ever forward! Even for old guys.
Today, the Fighting Friars find themselves at 5 wins, 7 losses, and 1 tie. Pretty much a must-win game. I’m hitting the send button and will report back in with you next week.
The weekend weather looks beautiful. The trees are more spectacular than last week, and fall is at its best. I have a dear friend, Mike G, coming in from Chicago, and we’ll be golfing at Stonewall tomorrow afternoon. The morning will start with coffee in hand, reading Mauldin’s weekly missive, with Premier League soccer on the TV. Number 10–ranked Penn State plays at number 5–ranked Michigan at noon. The Phillies are in the playoffs, and my Eagles host the Cowboys Sunday evening. A sports junkies weekend is ahead!
I’ll be in Tampa on November 8 and 9 and Dallas on November 16, hosting a dinner with Mauldin and some clients. The plan is to up the business travel across the country. Stay tuned.
Click on the next photo to link to Spotify, where you can find a link to each week’s On My Radar recordings.
Wishing you a great week!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Forbes Book – On My Radar, Navigating Stock Market Cycles. Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.
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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