May 24, 2019
By Steve Blumenthal
“What we know about Fed tightening cycles is that they always expose and then expunge the bubble
they created during the previous period of monetary expansion. I can take you back a century
and show it to you. It’s like Mary Shelly’s Frankenstein… build up the monster then tear it down.”
“There is not a snowball’s chance in hell that we went through eight years of free money
and didn’t create a bubble. The question is, where is the bubble?”
– David Rosenberg, Chief Economist & Strategist, Gluskin Sheff + Associates
2019 SIC Presentation
You could feel the tension in the air. The conference was about to kick off. Up next, I was backstage getting prepped. Mauldin put his arm around David Rosenberg and said, “Wow, this is your tenth year kicking off my conference. I remember when you turned bullish eight or nine years ago.” David answered, “Yes, and everyone hated me. In fact, I lost 25% of my readership.” “But you were right!” John told him.
David is the Chief Economist and Strategist for Gluskin Sheff. You may know him from his days at Merrill Lynch or on CNBC, Bloomberg, etc. David is one of greats. He ranked first in economics in the Brendan Wood International Survey for Canada the past seven years and was on the U.S. Institutional Investor All American All Star Team for the last four years. Last year, he said we were in the 7th inning in terms of the bull market and business cycle. This year, he said we are in the top of the 9th and there is one out. He’s turned bearish.
This week I offer part II of what I believe will be a four to six week series sharing key insights from this year’s Mauldin conference. We will move from economics and markets to geopolitics to healthcare, and I’ll then conclude the series with my thoughts, key takeaways and select ideas to help you navigate the path ahead. If you missed last week’s post, you can find Part I – Dr. Lacy Hunt here.
When you click through below, you’ll find my notes from David Rosenberg’s presentation along with select slides. It was outstanding presentation. I try my best to translate in a way that your client may better understand (if you are an adviser) or you if you are an individual investor. Please let me know if you have any comments/questions.
So grab a coffee and find your favorite chair. My bullet point summary notes and charts follow. Rosie is sharp, witty and doesn’t hold back. Hint: he sees interest rates going lower with the Fed Funds rate going back to zero. The long-term bull market in bonds remains in place. You’ll find a few other actionable ideas.
If you would like to receive my free weekly On My Radar letter by email, you can subscribe here.
Included in this week’s On My Radar:
- Mauldin SIC 2019: David Rosenberg
- Trade Signals – Record Share Buybacks, Trend Signals Mostly Positive (HY Sell Signal)
- Personal Note – Graduation
Mauldin SIC 2019: David Rosenberg
My father used to always teach me by starting first with the conclusion and then working our way into it. I liked that because it helped me connect the dots along the path on the way to the conclusion. So I’m going to do that with you today and, if you are a long-time reader, this may seem familiar. Anyway, it’s just how my brain works and I hope it works for you as well. Here we go:
I concluded last week’s Dr. Lacy Hunt post with the following:
- McKinsey studied 24 periods of debt accumulation – in all 24 cases, the debt problem had to be solved by austerity (defined as a multiyear increase in savings). But what everybody is trying to do is come up with some sort of gimmick that we will have an increase in debt and it will somehow help the economy… but that can’t do it.
What’s going to happen?
- I [Lacy Hunt] think we are going back to zero bound (Fed Funds rate to zero percent). Because we expect velocity to fall and we are concerned that we will be stuck in a quagmire with a zero percent bond for some time. Yield curve will be a lot flatter. His fund has greater than 20-year duration.
- It will be ugly economically.
- We are not going to get growth. We are not at the end of the declining rate cycle… we haven’t seen the low in yields. He favors investing in long-term government bonds for total return.
David Rosenberg: Conclusion First then Notes and Charts:
Rosie argues that recession is coming, rates are heading lower and we will move to even more unconventional Fed policy.
What to do? He recommends the following asset classes will outperform (see next chart) and suggested that the 10-year Treasury may earn a total return of 11.5% over the coming 12 months. He likes quality dividend payers and going long volatility. For non-geeks, that is a bet that volatility will pick up to the downside (it will get very bumpy) and a way to play that for profit is to invest in the VIX. My dad would say, a play that is “not for the faint of heart.” A safer play is to overweight high dividend payers and Treasury notes and bonds. Please talk to your adviser first about ETFs that you might use to trade Rosie’s general recommendations.
His 55-minute, 70+ slide high octane presentation ended with this fun slide (when yields go down, the high-quality Treasury notes and bonds gain in price):
Rosie thinks we are moving towards a “debt jubilee.” Some form of debt monetization but we are years away from that. There is much more to gain from his presentation. I do suggest you read through the following notes (and charts) section to gain a better understanding. With my old man and Rosie’s end conclusion in mind, let’s now walk from start to finish.
“Year of the Pig (Lipstick Won’t Help)”
Notes and Charts:
The title of Rosie’s presentation this year was “The Year of the Pig (Lipstick Won’t Help)” because that is the Chinese zodiac sign for this year. He suggested the Chinese zodiac sign is actually a great predictor.
- He said, those of you who were here last year know my presentation was titled, “The Year of the Dog.” The question was will the dog (i.e., the Fed – Jay Powell) bark or bite? As we say, he barked, he bit and whimpered.
- But people keep saying this is the best start to a year since 1987. David noted, “Why is it that everyone I talk to only remembers October of that year [the October 1987 market crash]?”
Let’s talk about interest rates. It is what we know.
- So let’s talk about the power of interest rates, the interest rate cycle with a lag, the market cycle with a lag and the economic cycle with a lag.
- Jokingly he said, you can forecast the direction of interest rates over time by the height of the chairperson. Which makes him wonder why if President Trump is really a low interest rates guy, why did he go with a 6-foot Jay Powell when he could have had Arthur Laffer.
The forecast of the year for last year went to the WSJ editorial board. And boy, were they ever right.
- They talked about the optimism as the market hit the first high, the deregulation kicking in and the tax cuts and we are going to be seeing a huge monetary policy reversal and they were right.
The next chart shows one aspect of what the WSJ was predicting: the front-end of the yield curve (the one-month T-Bill yield).
- When rates move higher, it impacts all other asset classes. (Meaning how they are valued.)
- At one point, the yield on the one-month T-Bill was greater than the dividend yield on the S&P 500 Index. Did you notice we stopped hearing about TINA [There Is No Alternative]?
- The up interest move started with former Chairwoman Janet Yellen and ended with Powell.
Does anyone think you are not going to have a recession?
- When you have a Fed policy reversal, as the WSJ put it, recessions do follow.
You have to not only look at what the Fed is doing with interest rates, but also the movement of what the Fed was doing with its balance sheet.
- They’ve taken it down by 25% in the last year.
- If you couple what they have done with nine rate hikes and balance sheet reduction, the Fed has actually tightened by 350 bps.
- And we haven’t yet seen this in the economy yet, but we will.
There are lags, but as you can see, when you have a monetary policy like we’ve had, recessions do follow:
This new guy, Powell, comes into the Fed and starts talking about how we have to neutralize interest rates. A mythical place is this concept of a “neutral rate.” A place of full employment and price stability. This non-academic guy from the credit markets starts talking about this nebulous idea called the neutral rate.
- Powell, “We’ve been patient in removing accommodation, and I think that patience has served us well.”
- On October 3, 2018, he hit Trump on the head with a 2-by-4, saying we are a long way from neutral and we have to go past neutral.
- Then a little later he says we are getting close to normal… we are just below normal…
- And then, of course, we had the “big pivot” in January and that was after we had the rate hike on December 19 in the middle of the market storm. Which, by the way, a hike like that never happened before in the midst of such a storm.
- So in October, he tells us we have a long way to go, we are not there yet, we have to go past neutral and four months and one rate hike later he pivots… we are there (somewhere past neutral).
- Then, in the Q&A after the Fed meeting, he said, “Well you don’t really know about neutral until the economy and the markets tell you that.”
It was only seven years ago that the Fed was telling everyone that the “neutral rate” is 4.25%.
- Could you imagine if we were at 4.25% today?
But over time, the neutral rate has been coming down and for a lot of the reasons Liz Ann Sonders was telling us yesterday:
- Disinflationary effects of technology, aging demographics and excessive debt.
And the first thing Jay Powell did when he came to the Fed was raise interest rates to target an unknown neutral rate and now he has taken it back down again.
“What I’m trying to say,” Rosie said, “is to tell you that a recession is less than a year away.” I’ve done my research on this… I’m looking at inflation for things you can observe. Most of the scholarly research pegs the Fed Funds rate at 0.6% to 0.8%.
- What I show in the next chart that the neutral nominal Fed Funds rate is closer to 1.5%. Therefore, the Fed has once again overtightened by between 75 and 100 bps (0.75% to 1.00%).
- With a lag, there will be a price to be paid for this!
- The Fed’s tightening has caused money supply growth to completely vanish for the first time since the last recession.
Powell got surprised by this:
- Two-year low in the Citi U.S. Economic Surprise Index
- Five-year low in the Citi Global Economic Surprise Index
And this is exactly what the bond market is telling you. Maybe not the stock market just yet but the bond market is right.
- Let’s focus on the leading indicators:
- Down 16 months in a row global OECD
- Down 11 months in a row in the U.S.
- Both at lowest levels since we were emerging gingerly from the Great Financial Crisis a decade ago…
So where is this notion that the global economy or U.S. economy or fake economic data from China (generated by previous stimulus, which is now fading) shows we are in good shape? Yet investors don’t see it. (See next slide – cartoon).
- [SB here: his point is that investor confidence still remains high and that’s what happens at market tops. See Trade Signals for Investor Sentiment data.]
- The great Sir John Templeton comes to mind, “Buy when everyone is selling and sell when everyone is buying.”
- Or be fearful when others are greedy and be greedy when others are fearful.
What we know about Fed tightening cycles is that they always expose and then expunge the bubble they created during the previous period of monetary expansion. I can take you back a century and show it to you. It’s like Mary Shelly’s Frankenstein… build up the monster, then tear it down.
There is not a snowball’s chance in hell that we went through eight years of free money and didn’t create a bubble. The question is, “Where is the bubble?”
- And who knows bubbles better than Alan Greenspan. He says there are two:
The stock market is not reasonably priced:
- The Shiller P/E is still over 30.
- Only two other times: late 1920’s and the dot-com craze was it higher.
- “The market is too expensive for my liking. Though valuations should be used as a forward return tool and not a market timing tool.”
We now have asset and debt cycles…
And this is what the San Francisco Fed published on January 8, 2018, saying coming returns will be zero percent. Right when Jeremy Grantham, of all people, was calling for a market melt-up.
- Since the SF report, despite hitting three new record highs, the real return on the S&P 500 (since Jan 8, 2018) is zero.
- This is clearly a statement for how to make money in the market is by TRADING it, not by BUY-AND-HOLD.
We are paying higher prices for slower growth… What this next chart is showing is that it is normal for the stock market to go up 16% per year in a bull market.
Focus on the red section:
- We got 16% in this cycle.
- What isn’t normal is that we got almost less than the GDP growth both in terms of nominal GDP and real (after inflation is factored in) GDP.
- The point he is trying to make is that the stock market doesn’t correlate with the economy… what drove this?
What has happened this cycle is corporate stock buybacks.
- Because of the buyback craze, the number of shares outstanding is at a two-decade low.
- And that’s why you have the appearance of a significant equity market rally, but it tells you nothing about the economy [SB here: what he is saying is the bond market is the right signal, not the stock market… and recession likely within a year. Stock markets do not do well in recession… listen to the bond market.]
This next chart is really important!
It shows the biggest equity for debt swap of all time. And the symmetry is almost perfect:
- $4 trillion of QE.
- The Fed pulled $4 trillion in safe assets out of the market and the corporate sector filled that void by issuing $4 trillion in new debt.
- And they used that debt to buy back $4 trillion of their shares.
- As Herb Stein famously said, “Anything that can’t last forever by definition won’t.”
You can only imagine what happens to corporate balance sheets when we do go into a bear market (recession) correction.
The next crisis will be different than the last crisis.
- The debt bubble this time is not the same as last time. Lightning doesn’t strike in the same place twice.
- Recessions come and go but they are caused by different things. This bubble is not about the banks.
- And it’s not about the household balance sheet. Just like it wasn’t about household balance sheets in 2002.
- That one was also about corporate debt.
In the next chart, look at the size of corporate debt relative to GDP.
- Note that it peaks late cycle.
- No matter how you slice it or dice it, we have the most overleveraged corporate balance sheets in history.
And leverage continues to increase…
The quality of debt has never been worse.
This is on the Fed’s worry list and it should be on your worry list…
- 50% of bonds in the investment grade category are rated just one rating above junk status.
- We have never had a junkier corporate bond market.
- If you get downgraded from here, you are a fallen angel, you move to the junk bond category.
- 30% of the BBBs has a debt-to-EBITDA that is higher than the average of the entire junk bond market but still sit in the triple-B category.
- Only 5% of the BBBs have a negative rating outlook by the rating agencies. And you may say, there goes Moody’s, S&P and Fitch (the rating agencies) screwing the investor again, but I’m going to show you later that isn’t what is happening.
There are other things happening from pushing these bonds into the junk bond category.
- But if they get downgraded, 30% of the BBB space is $1 trillion.
- Junk is $1.2 trillion. Could you imagine the non-investment grade market doubling in size and what that would mean for the markets in general?
- That would double the size of the junk bond market and really reset risk pricing.
- And then we layer on top of this: We have a huge debt servicing calendar coming up.
- Over $1 trillion a year over the next five years [SB here: imagine trying to refund your debt in a recession. Rates will rise rapidly and some companies will go bust – those that are living on borrowed money to survive.]
- Three quarters of the corporate bond market is going to need to be refinanced over the next five years: Who is going to make it and who’s not going to make it?
- For anybody who managers a credit book, this is going to be really important [SB here: as I keep saying, the coming opportunity is going to be “epic.” It will take a traders mentality to get to it.]
And can you imagine rolling over a $1 trillion per year in the corporate debt market competing with the safety of Treasury bonds. What do you think will happen to spreads [the difference between the yield on corporate bonds and safer Treasury bonds]? Next chart shows the funding requirements of the U.S. government.
So companies are going to have choices to make and this may have an influence on the share buyback craze. Cash flow will have a lot of competition with servicing the debt.
This next chart from Merrill Lynch, half of investors want to see companies improve their balance sheets…
And this will come at the expense of capital spending. And that is what companies are doing.
- But capital spending is part of GDP.
- How am I going to have accelerating GDP when capital spending is slowing?
- Companies are cutting back on capital spending because their focus is on servicing the debt and improving their balance sheets.
- They are going to tighten their belts and it will come at the expense of the economy.
Not just that, we are going to go through a forced deleveraging cycle.
- Demand for corporate loans is down.
- Contracting for the first time since the last recession.
David said, “I take no joy in being so bearish. But I want to help people just like I did a decade ago.”
- Bottom line: We are late cycle.
It looks like this:
But people might say cycles don’t die of old age.
- But they do die by the hands of the Fed.
In terms of baseball, last year I would have said, we are at the 7th inning stretch.
- Today I say we sit at the top of the 9th, with one out.
Next chart from the San Fran Fed came to the conclusion that the yield curve still matters.
- Don’t fall for it when others say it doesn’t.
What the San Fran Fed shows is that when shorter-term rates move higher than longer term rates (known as an inversion), recession follows.
- Left-hand side of next chart. Note rate inversions prior to recessions (shaded grey areas).
- Right-hand side shows unemployment (red circles).
- [NOTE – SB here: when your brother-in-law cites the great employment numbers as reason for the stock market to keep rising, ask yourself when was the right time to invest?]
- It was when unemployment was highest, not at a record low (today).
- What the chart on the left tells us is we have 9-10 months from inversion until recession comes.
- David said if he is trying to time this (and no one is a perfect market timer), this cycle has a bullseye on its forehead for the 4th quarter of this year. If I’m wrong, he said, I’m wrong by a quarter and it is Q1 2020.
But people say, the Fed has stopped tightening. Meaning that’s bullish for the markets.
- It’s not!
In the investment business you have to play the probabilities.
- There have been 13 rate hiking cycles and 10 have landed us in recession.
- That’s 80% odds.
- You have to play the odds.
You can’t rule out a soft landing, but in those periods, the unemployment rate was 6% not 3%, and we were three years into an expansion cycle, not 10 years.
- And the Fed tightened aggressively in those three periods.
- Our current starting point of a 2.25% Fed Funds rate is far lower than where Fed Funds were in those prior periods.
- David gives low odds for avoiding recession.
The NY Fed publishes its own recession odds indicator.
- When it crosses where we are right now, there is no turning back.
- It is 28% recession odds right now, it was 11% a year ago.
What I’m saying [David speaking], is that your asset allocation can’t look the same today as it did a year ago.
- No matter if I am right or wrong in my view, what the above chart is telling us is that recession risks are elevated and they are rising.
- And we have to maneuver our portfolios in line with the risk.
But you might say, Powell says no recession is coming…
- Bernanke said, “The Federal Reserve is not currently forecasting recession.” History tells us it started a month prior to him making that statement.
- Greenspan said on January 3, 2001, we are just going through an “…inventory readjustment process.” In fact, we had a deflationary detonation of the Tech market and the recession starts two months later.
- Can’t trust these guys.
Now who has a more sophisticated macro-economic model then these Ph.D’s from the Fed?
On the eve of the recession, they never called for recession!
- So I guess we’ll have to do our own work.
The Boston Fed president. I love the raw honesty from “the other Rosie.”
- “But not of actual outcomes.”
The majority see recession in 2021…
Which brings us to my mentor, Bob Farrell’s, “Ten Market Rules.”
- “When all the experts and forecasters agree, something else is going to happen.”
Markets decline 30% in recession on average from high to low.
- The last two were far worse.
This is what it looks like:
- The S&P 500 Index is on the left (you peak before the recession starts, and you bottom just before the recession ends).
- The Fed injects enough liquidity and valuation get to a very attractive level and the new bull market begins.
- On the right is the 10-year Treasury. Bond yields move down.
How should you be positioned?
- People are talking a lot about Emerging Markets. This is a period where you want as much liquidity as you can get.
- Emerging Markets are markets you cannot emerge from in an emergency.
This is a period you don’t want to be in passive investing.
- You want to be nimble and trade the market.
Pointing to the fact that he is not a perma-bear, you want “stuff on the right.”
- High quality bonds, dividend stocks (if you have to be in the equity market) and long volatility.
- And have some cash for sure.
- My biggest conviction call is to be long Treasurys.
Finally, Rosie said inflation peaked at 2.4% and noted that it was the lowest level where inflation peaked in history. The forces of technology, demographics and debt. Wages and prices have peaked for this cycle. And as we know, when we go to the other side of the mountain, the Fed has very few conventional policy bullets left in its chamber.
Can you not see that what Jay Powell tried to do was push the envelope? How far can I go, how far can I go? [In raising rates.] Well, we found out. He could get the Fed Funds rate to 2.5%. But historically when the Fed fights recession, they cut the Fed Funds rate by 4.70%. So, we’ve got a bit of a problem here, folks.
And on the fiscal side, because of these clowns in Washington, eased fiscal policy at completely the wrong time. Don’t get me wrong, the U.S. needed tax reform. The inversions were ridiculous and costly. But the spending and all the other bells and whistles. So we are going into the next downturn with a deficit-to-GDP ratio of 5%. This has never happened before. We normally go into this stage of the cycle with a balanced budget. Not this time.
So what is going to happen in the future? How are they going to fight the recession? They are going to cut rates back down to zero, more QE and go to the Bernanke playbook.
Rosie then cited research Fed papers from the various Fed banks. This is their plan friend. And the San Fran Fed just published a report suggesting negative interest rates. These are the sorts of things they are talking about… And helicopter money. The END GAME is a debt jubilee.
The last resort is debt monetization. Rosie doesn’t see it for years but that’s where we are going. This is the mother of all debt cycles. In case you are wondering why interest rates can’t go up. This is why:
That concludes today’s notes. “The end game is a debt jubilee.”
“In the end the only way out of this mess is inflation.”
– William White
Former Chief Economist of the Bank for International Settlements
More next week. I think we’ll focus on William White’s presentation. Stay tuned…
Trade Signals – Record Share Buybacks, Trend Signals Mostly Positive (HY Sell Signal)
May 22, 2019
S&P 500 Index — 2,856
Notable this week:
Notwithstanding significant geopolitical risks, such as the latest chapter in the US-China trade war and elevated risk of conflict in the Middle East, equity and fixed income market indicators remain bullish. We note the Ned Davis Research Daily Trading Sentiment Composite remains in the mid-30’s, indicating “extreme pessimism,” which is typically (and counter-intuitively) short-term bullish for the S&P 500 Index. The Don’t Fight the Tape or the Fed remains at a bullish “+1” signal. The Daily Gold Model, however, moved to a sell signal this week.
There was a lot of discussion in Dallas last week about debt accumulation and corporate share buybacks. The chart below shows the amount of cumulative corporate share buybacks vs. flows from households and foreigners and cumulative flows into ETFs and Open-End Mutual Funds. Clearly, the buying is coming from corporations.
The problem is much of the money is being financed by debt. Financial engineering at its best. Recall the 2000-2002 period, as well as 2008-2009. We now sit at a record-high level of corporate debt relative to GDP. In my view, it’s not a good position. One has to wonder how much more marginal buying can come from corporations buying back their own stock.
Click here for this week’s Trade Signals.
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.
Personal Note – Graduation
“Always remember, the closer you get to realizing a dream or
breakthrough the greater the resistance becomes. Don’t stop! It’s just a test.”
– Jon Gordon, The Seed: Finding Purpose and Happiness in Life and Work (2011)
There are many special moments in life, but none as special as watching your family celebrate important milestones in their lives. When the kids were little, the school shows were such fun. A dividend of sorts on the time, love and energy poured into their growth. They on the stage excited to present to us and we equally excited to watch and share in their joy. Not to mention the joy it gave us.
I’m writing from Ithaca, NY this morning and racing to get to graduation. Stepson Tyler is graduating from Cornell University. There are several days of ceremony and perhaps none greater than his commissioning into the Marine Corps as an officer. Tyler has spent four years in the ROTC program and after today will no longer be a civilian. Tomorrow, we’ll listen to Bill Nye, The Science Guy, with graduation to follow in the afternoon.
Susan has rented us a house on the lake just outside of the University. The coolers are loaded, the food is ordered and tonight we celebrate with Tyler’s best friends, Chase and Cob. Both joining him as Marine Corps officers. Our three families and friends will be holding glasses high in celebration of these three excellent young men. What a journey… “Don’t stop!”
A fun night of celebration ahead. I expect some extra coffee will be needed in the morning.
Following are a few photos.
Here is a toast to you and your family. Ever forward! Thanks for reading.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
If you find the On My Radar weekly research letter helpful, please tell a friend … also note the social media links below. I often share articles and charts during the week via Twitter and LinkedIn that I feel may be worth your time. You can follow me on Twitter @SBlumenthalCMG and on LinkedIn.
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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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A Note on Investment Process:
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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