March 16, 2018
By Steve Blumenthal
“A period of stability induces behavioral responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets – all combining to weaken the ability of the economy to withstand even modest adverse shocks.”
― Laurence Meyer, former Federal Reserve Governor
Today begins a six part series where I share with you my high level notes from the Mauldin Economics Strategic Investment Conference. Nearly 600 attendees and another 700 watching via simulcast listened to a purposeful selection of some of the brightest economists and investment minds present on the challenges and opportunities immediately ahead. It is by far the best investment conference I attend each year. Let’s begin today with perennial leadoff hitter, David Rosenberg.
If you are not familiar with David, he is Gluskin Sheff’s Chief Economist/Strategist and was Chief North American Economist at Merrill Lynch in New York for seven years, during which he consistently placed in the Institutional Investor All-Star rankings.
“We have never experienced a monetary policy tightening cycle that we are going to experience today,” he said and added, “Recessions are followed by expansions and expansions are followed by recessions.” David said, “Regime Change should be the title of this presentation” – speaking to the shift in central bank policy. My notes follow in detail (bullet point format) when you click through below.
As a quick aside, and not surprisingly, several of the speakers were strongly in the interest rates are heading higher camp. Some see the Fed raising rates three times this year and another three times next year. That will put the fed funds rate at 3% by the end of 2019 and the 10-year Treasury at 4% to 5%. That would be a stunning move and not good for bond investors.
To this end, I will be hosting a webinar on April 4. Here is the information if you’d like to join me:
Ok, grab a coffee and find your favorite chair. I hope you enjoy this week’s David Rosenberg Year of the Dog piece as much as I enjoyed writing it for you (well, selfishly for me too, as I get much out of going back and reviewing my notes). Next week, we’ll dive into Dr. Lacy Hunt’s presentation. Ok, lots of charts…let’s go.
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
Included in this week’s On My Radar:
- David Rosenberg – Skunk at the Picnic
- Trade Signals – Trade Signals Remain Bullish on Equities & Bearish on Bonds
- Personal Note
David Rosenberg, Skunk at the Picnic
John introduced David and told him, “I want a solid double. We’ve got to get a runner on base.” David responds, “Okay, he set the bar pretty low.”
His intro was humorous, “It’s always an honor to speak at John’s conference. And I’d say you’re not going to find too many Canadians complaining about being in San Diego in early March. And you probably think, as economists, strategists and analysts we agonize over getting our forecasts right but really, we agonize the most over getting our presentation titles right. And I struggled over this one.
I was going to call it “Regime Change.” I was going to call it “We’re All Dead in the Short Run,” but our marketing team at Gluskin Sheff didn’t like that one so much. So I was thinking, when in doubt, revert to the Chinese zodiac.
So I thought, it’s the “Year of the Dog.” And, of course, I say, will it bark or bite?” The dog he is referring to is new Fed Chairman Jerome Powell.
- David noted that 2006 was the last Year of the Dog and curiously enough was also the last full year of the business cycle, which I think we’re going through right now and is what I’m going to talk about today.
- David added, “I remember back in 2006, when my nickname at Merrill Lynch wasn’t Perma-bear, it was Skunk at the Picnic.” (My motivation for today’s OMR title)
In 2006, David was “yelling from the mountain top” to de-risk. And I wasn’t saying 100% cash or 100% hedge funds. There’s no such thing as a sure thing in this business. But I was saying at the time, whatever your comfort level is, whatever your benchmark is, start to take the beta and the risk down in your portfolio (and he is recommending the same today).
Following are charts and my select bullet points: Please note it is going to read crisp and to the point in note-taking format:
Chart: Euphoria Everywhere You Looked:
- Note the high level of investor “euphoria” and the record number of days without a 3% and 5% correction.
- The FAANG stocks are the big winners.
Chart: S & P 500 End-2018 Consensus Forecast
- This next chart shows the consensus forecast summary of Wall Street analysts for year-end price target for the S&P 500 index.
- David is noting that on January 26, the S&P 500 had already hit 2,873. Just two points shy of the mean forecast.
- He added, “The reality is that last year, we had a grand total of just eight days with the S&P 500 moving just 1%. We’re barely more than two months into this year, and we’re already up to 16 sessions. So, we have a lot more volatility, more general weak tone of the market.
“I think this whole market cycle in some sense has been bizarre. I’ll show you how the Fed’s thumbprints have been all over asset prices for the past eight or nine years. But last year was something really extraordinary. I think to some extent that maybe there’s a payback this year. And I don’t expect it to be calm.
Everything went up last year. Even asset classes that are historically inversely correlated, all rallied together.
- This was basically a once-in-a-century event—that everything went up. Whether it was bank stocks, emerging market bonds, most all stocks, the CRB, oil—every single market, even global bonds.
- Barkley’s Bond Index globally generated a 7.5% return. The least-risky asset class in a risk-on year generated an equity-like return of 7.5%. So, I was saying to our asset mix team, and our portfolio managers, that if you believe in mean reversion, there will be payback from something that was truly a once-in-a-century event last year. (emphasis mine)
And so we get to this year, and up to January 26, it’s just a straight line up. And by January 26, the S&P 500 is up 7.5%. I remember going into that weekend and the headlines everywhere—Barron’s and the New York Times and the Wall Street Journal all talking about headlines—the best January since 1987.
And my response was…
- It’s funny because when I surveyed people in 1987, they don’t remember January 1987. They remember October 1987. And I say that because my first day as a straight economist was October 19, 1987.
- I take that dark cloud wherever I go. I’m like Eeyore, the donkey. The point is that the most dangerous thing to have done was to extrapolate that January, just as it was in 1987, where we had trade wars, we had a weak US dollar and we had a new Fed chairman tightening monetary policy.
- Not everything is the same, but there’s a lot of similarities.
But look what happened on January 26 when the S&P 500 closed at 2,873…
- The market hit the consensus forecast for the entire year that day, of 2,875.
- And it’s funny that the consensus, instead of saying, “We hit our target 47 weeks early,” they took their forecast off the table and raised the forecast to 3,000.
- Because when you’re Wall Street strategists, that’s what you do.
So now, according to the consensus, we are even higher at the end of the year. I would fade that view.” David noted Jeremy Grantham was in the press on January 3, 2018 calling for a market melt up. As a contrarian, that hit David hard. He said, “… this is like a bunch of vegans lining up at Five Guys for a hamburger.”
“Listen to the smart guys that have experience. On Sam Zell, David asked the audience, “Has anybody ever been in the room with Sam Zell?” He’s always the smartest guy in the room. I remember back in 2007 when I was loaded for bear, and I was a lonely bear. I remember back in February ’07, Sam Zell actually unloaded his real estate portfolio to Blackstone. If you look at his track record, he’s way more right than he’s wrong. And people will come back and say, “Oh, well, he was early. He was eight months early.
Yeah, he was eight months early, and he saved 15 billion dollars. Yeah, I think I’ll take that trade.”
David’s major point:
- You want to listen to the smart guys that have experience.
- Experience in this business is tough to replace.
As a quick aside, I spoke with an advisor client of ours yesterday. He has a young CIO (chief investment officer) at a platform he does some work with telling him his portfolios are too conservative. While the young guy’s CFA credentials are nice, I advised him to listen to what someone like Stan Druckenmiller and compare it to what the young CIO has to say and determine who he trusts more. Then shape his clients’ portfolios in a way that is forward looking and not backward looking. BTW, if you have 30 minutes over the weekend listen to what Stan had to say this last December on CNBC.
And there are others with experience…
- Then we have Howard Marks and his view, of course. Valuation parameters are among the richest, I agree with him… And I don’t always try to seek out corroborating evidence. But there are some serious people out there saying some very serious things about the longevity of the cycle.
- Alan Greenspan, I know that people today have a different view of him than they used to when we called him “Maestro.” But, then again, who knows bubbles better than he does?
- It’s like John Dillinger saying, “That guy is a killer.” He says we have a stock market bubble, and we have a bond market bubble.
David shared several valuations slides:
- I could show a lot of technical indicators in breadth and volume, but what really unnerves me is plain old valuation.
- I was in Toronto about three or four weeks ago, and I was listening to this portfolio manager give a speech at one of the hotels, and he says, “I don’t pay attention to valuations.” And I’m thinking, I would never give a penny to that guy. How are you supposed to do any sort of expected return analysis?
- Whether it’s in real estate or equities, Treasuries, corporate bonds. So look at the forward P/E, 83rd percentile, price-to-sales, 99th percentile. None of this has been corrected in this latest correction.
- Price-to-book, 85th percentile, and I look at EV/EBITDA, 98th percentile.
- So when you look at these four parameters, this is a 92nd-percentile valuation event. In other words, only 8% of the time in the past has the stock market in the United States been as richly priced as it is today.
- And if you want to come up with reasons why that’s the case, that’s fine. But just understand that we are extremely pricey. We’re more than just a one standard deviation event versus the historical average. (In English: its standard deviation tells you how far you might be in rarified air… how far above the norm. Two and three standard deviation moves are even more extreme. Some valuation measures like Median Price to Sales Ratio sits at a 3SD move. It has never been this high before.)
Chart: Paying more for slower growth
Here is how David explained this next chart:
- This is one of my favorite tables. There’s a lot of numbers here. But I think this actually defines everything. (It defines the valuation levels he discussed.)
- And that’s why I put the red rectangle here (note in chart), David said. Let’s take a look at what happened in this cycle. This cycle, the S&P went up at a 17.3% average annual rate, and that’s almost bang in line with the average in the median. You see what I mean?
- But historically, you get a 17% growth rate in a bull market with nominal GDP at 7, and real GDP almost at 4. This time around, we did it with 3.6% nominal, and 2.1% real growth. Do you see what I’m saying?
- We basically had a typical bull market in the context of economic growth that was barely half of what it normally was. And when you look at these numbers and say, “What if?”—What if the stock market had done what the economy had done in terms of relationship between appreciation in the stock market and growth in GDP? The S&P 500 today would be 1,550. It would basically be a thousand points lower than it is today.
- And there’s a reason for that. This is just a different way to show how excessive the valuations are. Then I get to my hero. Everybody knows that my hero is Bob Farrell and the 10 market rules to remember.
Chart: Bob Farrell’s 10 Rules To Remember
- I like number nine right now, when all the experts and forecasts agree, then something else is going to happen.
- But I want to focus on number one: the classic mean reversion. Rule #1: Ratios revert to the mean.
- So when I get a lot of credit … of course, I was crazy early in the last cycle and people said to me, “How do you get the housing sector right?” Well, I look at house price-to-rent ratios, mortgage-to-GDP ratios, housing values-to-rent ratios, real estate valuations on household balance sheets. I could see that we were two or three standard deviations above the norm. So either you believe in mean reversion, or you don’t.
Chart: What’s Every Peak Typically Followed By?
This chart shows the ratio of household net worth in the United States to personal disposable income.
- Look at that chart. I’m rich, I’m poor, I’m rich, I’m poor, and now I’m rich again.
- Take a look and see what happens as you hit new cycle highs and where we’re going next.
- And this time around, it’s not housing, it’s the equity market.
David’s final comment on this slide: I think we would all agree the previous two peaks, in
perfect hindsight, were bubbles. So what do you want to call this?
And how about this next warning from the San Francisco Fed: “… zero growth in real equity prices over the next ten years.”
As a quick aside, I presented at the conference on valuations and probable 7-, 10- and 12-Year returns. My video presentation will be available to you for free next week. If you are interested in access to all of the video presentations simply click on the following picture. For a cost, you can gain access to downloadable audio files (think podcast – for your long walk) and slide presentations for all of the speakers. Please know, I do not get paid for recommending… just a big fan. Be on the lookout for my presentation next week.
OK – back to David… he takes us back to the Household Net Worth to Disposable Income slide (above) and adds:
- And similarly to the PE ratio, the ratio I showed you before— household net worth to disposable income—look what they say.
- This ratio tends to revert towards the historical average, and doesn’t remain in extreme values, either high or low, for prolonged periods.
- So, you see, this is not like the depth of the recession when we’re at a low. We are at an all-time high on that ratio. The household net worth to income ratio is so valuable. This is the Fed telling you this. They are telling you 100% right that this is going to mean revert. And you know that when you mean revert, you don’t stop at the mean.
- But let’s say we just stopped at the mean on the household net worth ratio, because I did the math on it. That ends up, if we mean revert that household net worth PE ratio, everybody in this room is going to feel that. Because what it means is that the savings rate will go from 2% to 6%, that’s the math.
- And that alone, as a static shock, will take GDP down 3%. Just mean reverting to the average (the dotted average line in the chart).
- People read these words and they think, “Okay, I’m going to the next page.” I read these words and I think, what does this mean for the economy? As my grandmother always said—forewarned is forearmed.
This next line had the audience smiling, “So, once again, the Boomers screwed the Millennials. We found a way to do it. The new buyers have no opportunity here to buy the market. But they will. This is not sustainable.” (SB here: I can just envision my daughter reading this line and not laughing… and she has every right not too.)
David noted the major role the Fed played in the October 1987 market crash and he sees some parallels to today. Though not calling for a crash. But the cartoon pretty much sums up his current view.
Chart: The Fed Has Sliced Its Neutral Policy Rate Forecast. Here are some comments on the Fed:
- I look at people doing their valuations in the stock market—and I’m guilty of this, too—you know, 12-month trailing, 12-month forward. But you know, the duration of the S&P 500 is 50 years. We always do one year forward, at most. It’s pretty crass.
- But when you look at this from a dividend discount model, you actually end up bringing home, to the present time, those future values of earnings based on this terminal rate. The discount rate is so important.
- Do you know that taking this down from 4 1/4 to 2 3/4 alone added a thousand points to the S&P this cycle? Just the power of the discount rate coming down. So the Fed’s taking down the discount rate, it’s taking down this estimate of the full employment/unemployment rate 4.6—they used to think it was 5 just a couple of years ago. I find it very fascinating that the Fed, for structural reasons, understands why it is that the terminal fed funds rate is lower than it should be.
- They’ve taken down their estimate of full employment. We’ve actually been below 4.6 now for 11 months in a row. On Friday, it’ll be 12. But they haven’t changed their definition of price stability. If you go back to when they started talking about inflation targeting, in the summer of 1996 — this is from the FOMC transcripts, to show you what I do for fun when I’m on the tarmac—so they’re having this discussion about inflation targeting, in ’96.
- That’s when they decided it would be 2%. But when Janet Yellen, who was then a governor, asked Greenspan, who was then chairman, what’s your definition of price stability? He says it’s zero. It’s not 2%.
- Every central bank has got 2%, as if that’s price stability. In 40 years, the price level is up 50%. How is that price stability?
Chart: There is Little (IF ANY) Slack Left in the Labor Force
- Note the uptick prior to the last two recessions (bears watching)
Chart on Inflation: An Ever-Elusive 2% Target
I thought David was spot on with his comments on inflation: Here are my bullet notes:
- I find it very interesting that the Fed, because of structural changes in the economy, has adjusted its NAIRU estimate, it’s adjusted its fed funds neutral estimate, but has never once thought that maybe price stability in today’s world is not 2% — maybe it’s 1%. And it probably is 1%.
- I’m not going to say it has to be zero. You want a little wiggle room. But in 25 years, they haven’t changed their estimate of what price stability is in this high-tech economy. It’s a little weird, don’t you think?
- So they’re chasing this elusive core PCE target of 2%. My lord, that’s what the doves hide behind. We’re full employment, we’re below full employment, but we haven’t hit our inflation target. Yeah, because your inflation target is basically irrelevant in today’s economy. They haven’t hit 2% on the core PCE deflator—which, curiously enough, is the lowest inflation rate you’ll find in the US. They haven’t hit that since April 2012. In 10 years, they’ve seen that target hit just 10% of the time because they’re chasing an elusive target. (next chart)
More commentary on the above 2% target:
- Now, we may never get the 2% core PCE. Or maybe we’ll get there five years from now. But what I know is this: I know that we’ve never seen this condition before, where the fed funds rate, in real terms, is still negative at this stage of the cycle. These bands, by the way, the shaded regions, these are not recession bands. Normally, you’ll find on my slides, and most other people’s slides, these are bands where the output gap is closed, when we’re at full employment. And we’ve been at full employment now for almost a year. Usually, when we’re at this stage of the cycle, the Fed has already adjusted the fed funds rate in real terms to 2%. Which, today, would be close to 3. In the old days, maybe closer to 4. But it’s interesting to me that the Fed has already given us a lot of information. We know that we’re in the realm of price stability. Come on, whether it’s 1 1/2 or 2, that’s noise. Whether full employment is 4 1/2, 4, or 3 1/2, we’re pretty well in the realm of price stability, full employment, and they’ve already told us that the neutral funds rate, the funds rate appropriate for that setting, is 2 3/4 percent. I showed you that before with those bars. And today, we sit at 1 3/8, or half that level.
- Remember, Greenspan, in 2004 or 2005, called it a conundrum that financial conditions were easing, even as the Fed raised interest rates. This is the Kansas City, St. Louis and Chicago Fed, they produced these financial stress indicators. And what’s interesting is that even as the Fed has raised interest rates, financial conditions this cycle, since December of 2015, even with the balance sheet reduction right now, even with the Fed raising rates five times, financial conditions are easier. Equity valuations are much higher, high yield spreads and credit spreads, cap rates are much lower. So, the Fed is running on a treadmill, but they’re not running fast enough.
- And once again, it’s Greg Ip (WSJ reporter). And I knew him when he was a beat reporter with the National Post, when he was a little kid, writes in The (Wall Street) Journal, “Stock Boom Brings Bubble Deja Vu.” And I think he’s probably right. And we’ve got to be on guard for that.
More on the Fed stuck between a rock and a hard place (SB here: my words)… David hits on a big point here next (bold emphasis is mine): His comments here are important… “A new sheriff in town.”
- It all started with Alan Greenspan, and it started when I started in the business. And this again, is from the transcripts. Look at this—December 16, 1987, the stock market had already bounced 10% off the lows. Greenspan wants to add more juice: “If rates go up under these conditions, I suspect the stock market would go down and I’m fearful of the extent of that particular decline.” That was already two months after the crash. And then in February, the market’s up another 5% and he’s still scared to raise interest rates. Eventually, he did, but it was too late.
- And that sowed the seeds for the savings and loan crises, commercial real estate and the recession we had in 1990/91. Then we got Bernanke. And look at Bernanke. The day after QE2, he plants an editorial in the Washington Post, amazingly, to defend his action. Higher stock prices—it’s all about the equity market—will boost consumer wealth, help increase spending, increase confidence, which should also spur spending. Every step of the way, the Fed has been focused innately on the stock market.
- And then, I couldn’t believe that then governor and future chairperson Janet Yellen says at the December 12, 2012 FOMC meeting, “We do not intend to take the punch bowl away just as the party is getting going. We will at least keep refilling the punch bowl until all the guests have arrived.” Can you believe that? You know she said that? Had we known, we should’ve gone long (invested) with the SPX all day long. And then, of course, in her parting comments in December, despite the valuations being so far higher than their averages and the credit spread so far tighter, she doesn’t see red, she doesn’t see orange.
- It’s interesting because, very recently, a report was published by these two university professors, and I highly recommend it. I wrote about this in my daily, showing how, of all the variables, economic, inflation, that the most important variable for the Fed in the past number of decades has been the stock market. So we can talk about inflation targeting, talk about unemployment rate, but the stock market is all that has mattered for this Fed. And that’s what is changing. That’s when I said regime change should be the title of this presentation. It’s because there’s a new sheriff in town. And this is where I think people have got it wrong, is that they think that Powell is a Yellen clone. I think he’s starting to attack that notion.
Martin Feldstein wrote an article recently in the (Wall Street) Journal, and he’s a guy worth paying attention to because he headed the National Bureau of Economic Research, which are the people who actually date the recessions. They’re the ones that determine the business cycle. He headed that for 27 years.
- The Feds should have started raising the fed funds rate several years ago, reducing the incentive for investors to reach for yield and drive up equity prices.
- And the (Wall Street) Journal’s editorial, “We’ve never lived through a monetary policy reversal like the one that is coming.”
- And I think it is coming. And I think that Powell is going to be more hawkish than people think. And I believe that even if the market goes down 20%, he’s not cutting interest rates. It would have to really materially, seriously affect their economic forecast.
SB here: So do we lose the Fed put? I’m not so sure but how does an extremely inflated and overvalued market respond. I think the risk is -60% not -20%. A quick time-out. I realize this sounds all too depressing. Just see it as data. See it as our current starting conditions and imagine the opportunity that will present on the other side of a potential reset (like 2002… like late 2008/09). Ok, back to Dave…
- What we know is this: We know we were in the middle of a Fed tightening cycle. And we know how it ends. It ends either with a recession, a soft landing, or some sort of financial calamity. There’s never been a Fed tightening cycle that did not have a real sharp spasm in one part of the financial markets. And I mentioned before, about corporate bonds, about credit in general—we just recreated a new credit bubble this cycle. I think equity markets are very expensive, but I’m actually more concerned about subprime autos, about credit card debt, corporate bonds in particular. Not just high yield, but investment grade.
- Great interview, by the way, with Sheila Bair, who got the call right in ’07 when she was head of the FDIC, to deaf ears. Great interview in Barron’s, worth reading. (Sheila Bair Sees the Seeds of Another Financial Crisis.) Corporate debt also has not gotten as much attention as it should. I can’t believe how many people, the same people that think Powell is a Yellen clone, seem to think that corporate balance sheets in America are in great shape. No, they’re not.
- Outstanding corporate debt in the US, as a share of GDP, has hit a new, all-time high. It’s already taken out the last two peaks. All that debt used to buy back stocks.
Chart: Corporate Balance Sheets are NOT in Good Shape!
Chart: Nearly Half of Investment-Grade Companies are Rated BBB
- And it’s not just high yield. The triple-B share of the investment-grade bond market is at an all-time high of 48%.
Chart: Corporate Bond Investors Have Little Protection
- And little investor protection should those companies get in trouble.
David commented on rates and inflation:
- Rates are going up. You saw the annotated Fed chart before. There’s never been a Fed tightening cycle that withdrew liquidity that did not cause the excesses to come out of the marketplace. Be very careful about how you’re positioned.
- A few words on inflation. We’re not in a deflationary environment. I don’t think we’re in a pernicious inflationary environment. The peak keeps coming down.
- But I want to make this point: Inflation has come down for almost 40 years, but it does get punctuated by cyclical pressures. I don’t have a big inflation forecast for you, okay? The reason we got onto low inflation to begin with those demographics, excessive debt, the fourth industrial revolution, robotics, automation, the shared economy, that hasn’t gone away. But we do have cyclical pressures.
- ’05 and ’06, people forget—even with China joining WTO in 2001, we had late-cycle inflation pressures. The core PCE got to almost 2 1/2%. The core CPI, people forget, got to almost 3% in the last cycle.
- So, we have a long-term trend line on inflation, and we have deviations. Those deviations can last a couple of years. So I’m not going to talk about the 30-year view. I am going to say that we are seeing cyclical inflation pressures, and for the time being, they’re going to persist.
- And that’s one of the reasons why I’m less bearish on bonds (still bearish_ than I have been for some time. Not that I’m outright bearish but I’m relatively bearish for the time being. He sees long-term secular disinflation trend punctuated by periods of short-term cyclical inflation (next chart).
Chart: Secular Disinflation, Punctuated by Cyclical Inflation
Chart: Cyclical Pressures Build
However, cyclical inflation pressures are there…
Comments on the dollar and the direction of interest rates…
- But the whole notion that we have to have a zero trade deficit is dangerous to me. And that’s another reason, from my perspective, why I wanted to call it a regime change. There’s just so much uncertainty right now.
- What does that mean for the duration you want to have in your bond portfolio? What does it mean for your fair value estimate of the price earnings multiple? What does it mean for how comfortable you are with credit spreads or cap rates? This is really nutty economic policy.
- And then, of course, the US dollar is going down. It was down 10% last year. And that breathed a lot of liquidity into the global marketplace. And I just can’t believe it.
- By the way, I have de-risked my personal portfolio several times in the past year, but no more than the day when Mnuchin spoke in Davos about the benefits of a weak dollar. When the dollar was already down 10%. As a Treasury secretary, how can you say that?
- The last time a Treasury secretary called down the dollar as it was having the stuffing knocked out of it was James Baker on October 18, 1987. What are these guys doing? And, of course, he was only backing up Donald Trump. Can you imagine?
- Trump says, “I think our dollar is getting too strong, and partly it’s my fault because people have confidence in me.” You can’t make this stuff up.
- It’s very hard to compete when you have a strong dollar and other countries are developing their currency. By the way, when he said this, the US dollar was already down 5% from its peak. Of course, he had to go back up, Mnuchin. He didn’t really mean it and so forth. But we know that they’re trade protectionists.
- The importance of Gary Cohn leaving is the white flag, the protectionists have won. And the protectionists also want a weak US dollar.
- This is all going to come out very strangely. I cannot believe that US 10-year note yields are 220 basis points over German bonds, double the historical norm, and yet the speculators retain this net speculative short position on the intercontinental exchange. It’s so weird.
- You’d think the US dollar, with tighter monetary policy, looser fiscal policy… You should see the dollar be firming. And it’s not happening, maybe because there’s this view that you have a policy shift in Washington to try and weaken the US dollar.
- I don’t know how this plays out, but I will say this much: The negative view on the US dollar is a real crowded view right now. I look at these numbers every week that come in the trader’s report. It’s really important to focus on, among everything else—I talk about valuations—you have to look at technicals, you have to look at fund flows, you have to look at the fundamentals. You have to take a real eclectic approach.
- You have to look at the market positioning. If there’s a short recovering rally in the U.S. dollar. The last time that happened was in late 2015, early 2016, and that was not particularly good news for the US exporting stocks, and it wasn’t good news for emerging markets, and not good news for commodities.
- That’s the big risk in the interim, is if these guys start to think the Fed’s going to do more, the dollar’s going to go up, they start to get into the short positions, you get a snapback on the US dollar. That will hit every single asset class that’s in your portfolio, make no mistake.
What about bond yields? I know Lacy Hunt will be talking about this on Friday. We have [second] bull market, and just like inflation, it gets punctuated by cyclical bear markets. (SB here: in English he sees rates and inflation higher short-term but sees rates lower long-term… as does Lacy. I too see the same.
- So it’s totally irresponsible for anyone to tell you a bold comment, like the [second] bull market is over. Although, it may well be. We should keep an open mind. But we just don’t know yet.
- But you could see that in each cycle, the long-term trend line is punctuated, and if you look at that table, you’ll see that if we break above 3.85% this cycle, and we make a new high, then you can say the [second] bull market is over. But you know, we’re 100 basis points away from that. And actually I don’t think we’re going to break 3.85, although I am a little bearish on the near term.
- But just to show you, just like the inflation charts, these are two years. Hopefully, John (Mauldin) will invite me back. I’m not going to give you 30- or 10-year views. Hopefully, we’ll continue to have these sessions, but let’s not ignore the two-year view.
- In all those different cyclical bear markets, and the 10-year note, the cumulative increase in the yield in those periods was 2,000 basis points. So no matter what your secular view is, you don’t want to stand in front of that for your clients.
- So right now, we have a cyclical correction or a deviation around the mean, and I don’t think it’s over yet. The one thing I will say is, if you’re trading the bond market, just take note. Like the US dollar, the net spec of the short position is the second highest ever. Very interesting… from a market positioning standpoint.
Chart: A Return to Large Fiscal Deficits
Chart: Trillion-Dollar Deficits (Two Trillion??) Lie Ahead
Several more important charts…
Chart: The U.S. Cycle is Very Late
- Recessions follow periods of growth and growth follows periods of recession
Chart: There Have Been 13 Fed Hiking Cycles, 10 Landed in Recession
Chart: As the Cycle Turns…So Should Your Portfolio
Several comments on where we are:
- A lot of people want to know, where are we in the business cycle? Well, here’s where we are. We’re probably in the bottom of the 8th inning. We’re heading into the last inning of the cycle, and across the sole containment of the business cycle, there’s an optimal asset mix, and an optimal sector representation in your equity portfolio.
- The operative word is to de-risk.
Chart: And the Fed Will Have Very Leeway in the Next Downturn
- Have cash, hedge funds should shine in this environment.
- But focus on taking the beta down, tuck in your risk.
- Focus on companies with earnings visibility, not variability, balance your quality imperative, be mindful of your duration.
- And I would say near-term inflation protection for the time being, I would say for the next several months. I still like TIPS.
- And then maybe, in two years, we’ll be back here, and I’ll be very bullish and we’ll build up some great valuations and we’ll see what happens. Or not.
David’s concluding thoughts:
“Let’s finish off with this,” David said. This is something we all need to be cognizant of, because we’re late-cycle. I think the recession is a year away, so I don’t think this game is going into extra innings. And we have to be mindful of the Fed.
I find it interesting from a human nature standpoint that when the Fed’s cutting rates, people say, “Don’t fight the Fed.” When the Fed’s raising rates, nobody says, “Don’t fight the Fed.”
But let’s just say this much: Historically, in a recession, the Fed cuts the funds rate by more than 400 basis points to fight the recession. Last cycle, they cut by 500. How are they going to do that this time? We’ve got to be thinking about this. We’ve got to stay ahead of the pack. We’ve got to focus on the forest past the trees. They will not be able to cut the funds rate 400 basis points like they have in the past. We’ve got to think about that.
How are we going to fight the next recession looking at the debt ratio, looking at the deficit ratio? The next recession, we’re going to be running 8% of GDP deficits—that’s 2 trillion dollars. Can you imagine, we will be running 2 trillion dollars in the next recession.
And fiscal deficits—the Fed has no capacity to cut interests rates like they have in the past. The personal savings rate is barely more than 2%. We have just brought forward so much growth, we have brought forward so much policy accommodation on the fiscal and monetary side, we have left nothing, nothing left over.
We did not learn from Joseph in the Old Testament, about the seven lean years, the seven years of famine. The biggest constraint on the economy, and I’m sure Lacy Hunt would agree with this, it’s not just aging demographics. It’s the outstanding debt, another huge debt cycle.
The outstanding level of debt in America, in this cycle, went from 33 trillion to 50 trillion, to generate barely more than 4 trillion of nominal GDP. The credible multiplier is actually weakening. But we’re going to go into the next recession with this balance sheet. Fifty trillion dollars of debt, and 250% of GDP.
And that’s why I think in the next cycle when you ask me what’s going to happen… I mentioned this last year, read Bernanke, read the “what if” speech he gave when he was governor in November 2002. Think about the last cycle. Did anybody know what QE was? Everybody knows QE. I used to have to do teach-ins at Merrill on what QE was, back in 2007/2008. Now QE is in the vernacular. Every single acronym the Fed did, including QE, was right here. People thought I was some sort of genius. But I believe in full disclosure, so I said, I’m not a genius, I just know how to read.
And so, this guy was governor when he gave this speech, now he’s running the show, and this is what he’s doing. But the one thing he didn’t do is on page 16, which is the debt jubilee.
There ultimately will be a debt jubilee. And it’s got historical connotations as well. This will happen in the next cycle, that we will basically have a situation where the Fed and the Treasury will do a swap. And then we’ll move on, reset the button, and we’ll be talking more about inflation then, than we are today. But that’s for another day. This is still very relevant in terms of having something on your night table to read. I would say, make sure you have some single malt in your glass beside you when you read it. But that’s where I think the end game is going to be in the next few years.
Chart: The End Game is the Debt Jubilee
SB here: That concludes my notes on David’s presentation. We’ll get through this and we’ll all be fine. Let’s just not get run over on the way to the next great opportunity. And a hat tip again to John Mauldin. I note David’s “reset” and I believe it is in our not too distant future.
“A period of stability induces behavioral responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets–all combining to weaken the ability of the economy to withstand even modest adverse shocks.”
The next recession will provide us with an epic investment opportunity. It just will feel exceedingly scary in that moment. I believe the opportunity is nearing. It will come in recession. The good news for now is there is no sign of recession within the next six to nine months.
As you’ll see in the next Trade Signals section, the equity market cyclical bull trend remains bullish and the fixed income trend remains bearish. Keep that risk management hat on.
Mauldin Economics 2018 SIC: You can sign up for audio and slide presentations HERE. I believe it costs $195 and please know I do not participate in any of that fee. I’m just providing in case you are interested.
Trade Signals — Trade Signals Remain Bullish on Equities & Bear on Bonds
S&P 500 Index — 2,750 (03-14-2018)
Notable this week:
No significant changes since last week’s Trade Signals… despite the drama in the White House. The growing protectionist theme is troubling as is the rise in Libor lending rates. Keep on your radar. Stay risk focused and alert. The market is aged, overvalued and getting more and more interesting by the tweet
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 email@example.com. I am not compensated in any way by NDR. I’m just a fan of their work.
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.
I’m really looking forward to the weekend. I see a cold IPA and some peanuts in my near future. Tomorrow, the Philadelphia Union has a home game and they are showing some promise this season. Beer and peanuts… I do look in the mirror and see more and more of my dad. Time moves forward too quickly.
Susan’s oldest son Tyler is coming home from school for the weekend with plans to celebrate St. Patrick’s Day with friends. I told him I have four extra tickets – hope he can join us. Sunday it’s looking like 47 degrees and sunny so maybe some golf then. There are pockets of snow on the ground but I’m hoping the course is playable. Fingers crossed.
NCAA’s March Madness will soon be followed by the Masters. Two fun sports events and for me, they are early signs of spring. We are almost there… And if you are into basketball, good luck with your bracket(s).
CMG’s Linda is celebrating her 20th anniversary with the firm today. It is she and I tackling the last few edits and posting of today’s OMR. She is outstanding… I’d be lost without her. I hope you’re enjoying your work, the people you are creating it with and, most importantly, your beautiful family as much as I am mine.
Have a great weekend!
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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