February 8, 2019
By Steve Blumenthal
“He went from being “Pragmatic Powell” to a “Powell Put.” But I do worry about people buying the dip because
it does remind me a little of how the credit crisis developed with sub-prime starting to crack in 2007
it cracked down to $80 and people bought that dip. It did go up 20% subsequently but the market
cracked again buyers got scared and turned from buyers to sellers.
There is potential for that here because the panic in December was a buying panic, not a selling panic.”
– Jeffrey Gundlach,
CEO, DoubleLine Capital LP
Let’s keep this week’s On My Radar short. I promised I’d share with you the latest recession watch charts and you’ll find them when you click through. Recently, Seth Klarman, a hedge fund billionaire some call the next Warren Buffett, wrote a sobering letter warning his investors of global tensions, rising debt levels and political divides. Seth’s letter caused buzz during the annual World Economic Forum meeting in Davos, Switzerland. (Source: CNBC.)
Mark Yusko and David Rosenberg see the potential for recession later this year. Ray Dalio recently pointed to 2020. I see 50-50 odds of recession this year and much higher odds by 2020. The global economy is likely in recession. That as much as anything may be why Fed Chairman Jerome Powell reversed course so quickly. I’m a data guy, so let’s look at what my favorite recession watch charts are telling us. I do think they can help us better navigate the way. Grab a coffee and find your favorite chair.
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Included in this week’s On My Radar:
- No U.S. Recession within the Next Six to Nine Months
- The Framing of Decisions and the Psychology of Choice
- Trade Signals – Red Zone – Upside Limited
- Personal Note – It Ain’t Easy, Kid
No U.S. Recession within the Next Six to Nine Months
Following are four of my favorite U.S. recession watch charts. While I see little risk of recession in the next six to nine months, I want to begin this “recession watch” section with one that looks at the stock market’s trend as a leading recession indicator and it recently fired a recession signal.
The Economy Based on the Stock Market Indicator – High U.S. Recession Risk
Chart 1 compares the economy as represented by the Commerce Department’s Composite Index of Coincident Indicators (top clip), with the monthly closing price of the S&P 500 Index (bottom clip). Here is the thinking:
- The S&P 500 is a capitalization-weighted (price times number of shares outstanding) index of 500 of the largest and best known common stocks. These include industrials, transports, utilities, and financials.
- The S&P 500 generates an expansion signal for the economy when it rises above its five-month smoothing by 3.6%. Conversely, it generates a contraction signal for the economy when it falls below its five-month smoothing by 4.8%.
- The signals indicate that economic activity accelerates above trend when the stock market is strengthening. Conversely, economic activity slows below trend or contracts when the stock market is underperforming.
- Therefore, it shows that the stock market is a good leading economic indicator as it is a barometer of investor confidence in future business activity (as well as a source of capital for industry).
It generally peaks ahead of recessions and troughs ahead of expansion. It most recently fired a “contraction” signal. See the down arrow at the upper right-hand corner of the chart. Note, too, that while 80% are correct signals, its track record is not perfect, as there have been stock market corrections and bear markets, which are not associated with recessions. Bottom line: time to keep our lights on. Recession risk is rising by this measure.
I feel the next chart is worth sharing with you. While we get excited about the Fed’s “U-turn,” we should note that the S&P 500 Index peaks after the Fed is done tightening and changes paths and not before. The next chart from Ed Hyman shows us that the last Fed interest rate hike is always the mistake. It shows us that markets peak after the Fed is done tightening and reverses course.
Recession Probability Based on Employment Trends – Low U.S. Recession Risk
Chart 2 looks at the trend in employment to determine probability and timing of recessions.
Here is how to read the chart:
- Focus in on the up and down arrows. Down is a recession signal. Up is an expansion signal.
- Expansion signals are generated when the employment trend’s index rises by 0.4% from a low point.
- Contraction signals are generated when the index falls by 4.8% from a high point.
- Current signal indicates expansion. Last signal date in 2009.
Credit Conditions – Recession Indicator – Low U.S. Recession Risk
Chart 3 takes a look at the Ned Davis Research (NDR) Credit Conditions Index. When lending conditions are “favorable,” the economy does well. When lending conditions are “unfavorable,” the economy runs into trouble. What fuels the economic system is spending of income and the spending of credit. When liquidity dries up, risks rise.
Here is how to read the next chart:
- Focus in on the lower section of the chart. Note the “favorable” and “unfavorable” zones above and below the dotted green line. That line is basically the line in the sand.
- The yellow circles highlight drops below the green line. Recessions followed the last three times credit conditions became “unfavorable.”
- Note the green “We are here” arrow. Bottom line: No current sign of U.S. recession. Data through January 31, 2019.
U.S. Economy vs. Yield Curve – Low U.S. Recession Risk (but as of 1/31/2019, risk is nearing)
Chart 4 may be the most widely followed recession watch indicator. It compares the difference in the six-month Treasury bill yield to the 10-year Treasury note yield. When the short-term yield moves above the longer-term yield, it is termed “an inverted yield curve.” It’s an unusual occurrence and signals something is wrong in the economy. You’ll see that recession has followed every time the yield curve inverted.
- Watch for a drop below the green dotted line.
- Such drops below 0 is what is known as an inverted yield curve. An inverted yield curve has preceded every recession since 1958 (lower section of chart).
- No current signal of U.S. recession, but inversion is nearing.
- Note that once the yield curve inverts, recession follows about a year later. That is the orange arrow on the chart (1966). While recession didn’t follow until 1970, the secular bull market did peak in 1966 and it wasn’t until 1982 that a new secular bull market started.
- Bottom line: The yield curve last inverted in 2006. Recession began 21 months after that inversion. The stock market peaked in October 2007. You and I know what happened to stocks during the Great Financial Crisis in 2008-2009.
- Bottom bottom line: Once inversion occurs, recession follows seven months to 21 months later with the median lead time being 14 months. Keep an eye on this excellent recession watch signal and when it drops below 0 (inverts) get your ducks in order. You should have a few months to prepare.
Global Recession Has Likely Started
On the global economy… from Real Time Economics: While the U.S. service sector slowed, it’s still going strong. Europe is not. IHS Markit’s services gauge for the Eurozone held at a 49-month low in January. France posted its fastest decline in almost five years, Italy shows no sign of emerging from recession and outside the currency bloc, the U.K. posted its weakest service-sector growth in two-and-a-half years. What gives? Brexit, “yellow vest” protests in France, Italy’s clashes with the EU and trade tensions. “Political uncertainty, both global and local, is increasingly taking a toll on growth, dampening demand and driving increased risk aversion,” said Chris Williamson, IHS Markit’s chief business economist.
Next is my favorite global recession watch chart.
I’ll update the recession watch charts for you again early next month in Trade Signals and I’ll note in OMR if there are any meaningful changes.
A big special thanks to the excellent information from Ned Davis Research. I’ve been a loyal subscriber since the mid-1990s and I’ve found their independent research invaluable. I’m able to share the above charts with you because of the permission they have granted me.
Please note there are important disclosures at the bottom of this newsletter.
If you’d like to learn more about their services, please drop me a note and I’ll get you to the right person.
The Framing of Decisions and the Psychology of Choice
By Amos Tversky and Daniel Kahneman
I’m constantly asking myself where I might be wrong. I do find myself being drawn to individuals with a similar view. John Mauldin, of course, Ray Dalio, Howard Marks, David Rosenberg, Lacy Hunt and work that zeroes in on cycles and human tendencies. I try to justify my logic with data, like valuations and probable forward returns, and I believe it is sound reasoning, but yet I do read research that presents different views and I try to remind myself to game theory different perspectives. I’m not so sure I’m honest with myself in this way all the time.
As a trader for many years, I can tell you there were many times I’d look at a buy signal and say no way. The “no way” was generally my emotions calling out supporting my personal fundamental view. That happened again in early January. Since the early 1990s, I’ve traded a high yield bond market trend-following strategy. It is based on price movement and a buy signal was triggered.
High yield bonds ended 2018 with a sharp drop. The Bloomberg Barclays U.S. HY Corporate Index declined 2.14% in December and lost 4.53% for the quarter. I traded our CMG Managed High Yield Bond Program to Treasury bills in early October avoiding the majority of the decline. That was an easy trade to make given my views on debt, poor covenant creditor protection and elevated valuations. The early January buy signal really surprised me. Emotionally, I could tell you all the reasons why one shouldn’t buy, but in this business, process is mandatory and, so far, the trade has been one of the better trades we’ve had in the last few years.
I guess my point is that the investment game is emotional. And creditable research shows investors tend to make the same mistakes over and over again. I don’t know if the recent equity market “Powell Pivot” move is going to continue supporting stocks. I hope so. The valuation data tells me there are limits. The investor sentiment data tells me investors are once again too bullish. Maybe Jeff Gundlach (see intro quote) is right. To me, it does feel like subprime all over again except the risk is not in the banking system, it sits in the portfolios of millions of individual investors who have chased into riskier asset classes, such as HY bonds, bond funds and ETFs.
I’m doing some investor behavior research for the book I am writing. I recently came across a paper I read some years ago titled, The Framing of Decisions and the Psychology of Choice by Amos Tversky and Daniel Kahneman. In summary:
The psychological principles that govern the perception of decision problems and the evaluation of probabilities and outcomes produce predictable shifts of preference when the same problem is framed in different ways. Reversals of preference are demonstrated in choices regarding monetary outcomes, both hypothetical and real, and in questions pertaining to the loss of human lives. The effects of frames on preferences are compared to the effects of perspectives on perceptual appearance. The dependence of preferences on the formulation of decision problems is a significant concern for the theory of rational choice.
Good friend, Ben Hunt, often talks about “The Narrative.” The Fed Put or Powell Put simply means the Fed has our back and will prevent the market from severe decline. It is the break from a narrative that changes the game. It occurs when trust is lost; when a new insight is gained. What then?
I hear Gundlach ringing in my ear…
But I do worry about people buying the dip because it does remind me a little of how the credit crisis developed with sub-prime starting to crack in 2007 it cracked down to $80 and people bought that dip. It did go up 20% subsequently but the market cracked again buyers got scared and turned from buyers to sellers. There is potential for that here because the panic in December was a buying panic, not a selling panic.
We operate in a globally connected complex system. It’s why trade wars and protectionism worry me. Both will mess up well-established and deeply-entrenched global supply chains; negotiations/business partnerships that took years to build. Break it and that narrative changes. Of course, we’ll adjust but not without consequences.
If our current starting conditions are richly-priced assets, an aged business cycle, debt north of 350% debt-to-GDP in much of the developed world and central bankers stuck at near-zero percent interest rate policies (negative in some places), the shocks will be greater. We do not sit in a position of strength. It would be better if our starting conditions were opposite what they are today. So risk is high, keep your lights on and have a downside stop-loss risk management game plan in place. Recall that post the1966 bull market peak, 16 years (1966-1982) was a very long time to get back to even. No one is talking about that… I believe the fix to the global debt and pension mess may just usher in a period of inflation (like last seen in the 1970s). Though we just can’t possibly know that just yet. What a change in narrative that might be. Anyway, trying to think around as many corners as I can… it will matter in terms of the investments we make.
So let’s watch central bankers and legislative policy makers and hope they can find a beautiful solution to the significant challenges at hand. You’ll find my current framing on the stock and bond markets in the Trade Signals sections next.
I believe the next big dislocation will come in recession. The good news is current risk of U.S. recession is low. So grab a weekend beer and party on. We’ll take another look at the recession watch charts again next month.
Here’s where I believe we currently sit:
- With the Fed Put reactivated, traders will buy most dips.
- I see the market range-bound between 2,900 and 2,200. Call it +6% upside potential and -19% downside potential from Wednesday’s S&P 500 Index close at 2,732. Overall, not a great risk-reward opportunity.
- Frankly, I’m less worried about the -19% than I am about the -50% to -70% I believe will occur in the next recession. Thus, my recession watch obsession.
- You’ll find my logic supporting this case, spelled out in the Trade Signals section that immediately follows.
Trade Signals – Red Zone – Upside Limited
February 6, 2019
S&P 500 Index — 2,730
Notable this week:
One of my favorite valuation charts is Ned Davis Research’s S&P 500 Median Price-to-Earnings Ratio. For much of the last few years, median P/E sat in the “overvalued” zone. More recently, due to the October-December market correction and improvement in 2018 corporate earnings, median P/E sits above fair value but no longer in the “overvalued” zone. To put this in perspective, over the last 54.9 years median P/E was 17.2. The current median P/E as of 1/31/2019 is 21.1 — still a good bit higher than the 54.9-year average. What does this mean?
I like handicapping the market’s upside and downside potential for stocks and I believe valuation levels can help. For example, to drop to the “Median Fair Value” or a median P/E of 17.2, the stock market would have to drop from 2,704.10 (the January 31, 2019 closing level) to 2,195.73 or a decline of 18.8%. (See red arrow in chart below.) Given the Fed’s recent “U-turn” or “#PowellPut,” I believe that the Median Fair Value is likely the short-term downside support. As for the upside, rarely since 1964 has the market been more than 1 standard deviation above Median Fair Value. One standard deviation simply shapes a rare event. Two standard deviations is even more rare (see the black dotted lines above and below of the green dotted line in the next chart). As you can see in the next chart, “Overvalued” would be at 2,874.46.
Given the Fed’s change of stance, absent U.S. recession (the recession charts show little risk the next six months), I believe the market will be largely range bound between 2,875 and 2,195 and has likely reached a point of short-term exhaustion at the 200-day moving average line (top of the red zone). Overall, the rally may continue but I see more downside risk than upside potential.
Given the sharp increase in investor optimism, as measured by the Daily Sentiment data, I believe we have reached a challenging point for the recovery run. I shared this chart several weeks ago. The red zone highlights probable overhead resistance for the S&P 500 Index. The market closed today (2/6/19) at 2,731.61, just below its 200-day moving average line at 2,742.08.
I wrote the following on December 26, 2018: “Daily Investor Sentiment is the lowest since 1995. It’s lower than anytime during the Great Financial Crisis. This is as extreme as it gets. Expect a rally.” Then the S&P 500 Index stood at 2,351. Today it is at 2,731. Daily investor sentiment is now back in the extreme optimism zone (which is bearish for stocks). A long way from the extreme pessimism reading (which is bullish for stocks) on December 26.
As it relates to the U.S. equity markets, my current framing looks like this: With the Fed Put reactivated, traders will buy most dips. I see the market range bound between 2,900 and 2,200. Call it +6% upside potential and -19% downside potential. Not a great risk-reward opportunity.
Frankly, I’m less worried about the -19% than I am about the -50% to -70% I believe will occur in the next recession. So keep your core portfolio in a “participate and protect” like posture and find special investment opportunities that have accelerated growth potential with or without a reset to prices. They exist.
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 – It Ain’t Easy, Kid
“Enjoy the little things, for one day you may look back and realize they were the big things.”
– Robert Brault
I remember the days each of my children were born. What awesome miracles. I watch many friends and colleagues with their young children. Their personal miracles. And I’m sure this is the same for you with your family and your own miracles. Is there anything more rewarding in life than to experience love?
I found myself thinking about my daughter, Brianna, this morning. I remember the day she was born and she needed to stay in the hospital for a few extra days. The challenge resolved but the fear and helplessness we felt was scary. At age three, the belly flop jump from the couch onto a bean bag chair, her head snapped back and I watched her eyes roll to the back of her head. We raced to the hospital. She was ok. I was shaken.
The school work, Halloween parades, teacher conferences, choir performances, sports practices, the games, the wins, the losses… I watch my younger friends today with much envy. But as my grandmother used to say, “It ain’t easy, kid.” But boy is it worth it. And maybe that’s why it means so very much.
The days are long but the years go by too fast someone recently told me. Brianna is now an adult and working in NYC. Her birthday is tomorrow and I’ll be jumping on an early plane to Florida to celebrate it with her and a few close friends in Miami. We will both be attending Inside ETF’s Annual Conference that begins on Sunday. “Dad,” she said, “Wear your nicest jeans and a dark t-shirt… It’s Miami!” Dad will obey… with a smile and love written all over my face. And it’s 75 degrees and sunny according to my weather app.
I’m looking forward to seeing old friends, learning more and making new friends. The ETF revolution has been amazing. Tools exist for you and me to seek opportunities in so many different ways. So as much as my current investment narrative is as it is, please know there are many things you and I can do. Think of ETFs as a giant investor tool kit. More on what I learned in next week’s post.
Utah follows on February 27 to March 1 for a Winter Symposium on best practices and trade execution. I’ll be in Austin on April 3 and Dallas on April 4 for speaking engagements. More on that soon. And I hope you can join me in Dallas this year for the 2019 Mauldin Strategic Investment Conference on May 13-16. It is the single best conference I attend each year. President Bush is going to present on his debt initiative. I hope to see distressed debt king, Howard Marks, interview President Bush. On my wish list anyway… You’ll find a registration link immediately below. (Please know I am not compensated in any way if you register.)
Confirmed speakers include:
- President George W. Bush
- Howard Marks, CFA and co-chairman at Oaktree Capital
- Dr. Lacy Hunt
- Carmen Reinhart, world-renowned economist and best-selling author
- Felix Zulauf, hedge fund manager and 30+ year Barron’s Roundtable member
- Jim Mellon, hedge fund manager and billionaire investor
- Bill White, former Executive Committee Bank for International Settlements
- Plus, long-time SIC favorites David Rosenberg, Grant Williams, Mark Yusko and more
I hope to see you in Dallas in May.
Thank you for reading On My Radar. Please know how much I appreciate you and the time you spend with me each week. Have a great weekend.
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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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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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