July 6, 2018
By Steve Blumenthal
“The major signs that would herald the beginning of the next recession are not yet in place.
Unemployment is low and likely to decline further; wages are rising, but not sharply;
the Federal Reserve is tightening, but real interest rates are zero; inflation is moving higher slowly;
the yield curve is not inverted; profits are increasing; and the leading indicators are still rising.
Until some of these indicators change, the expansion is likely to continue.”
– Byron Wien, Vice Chairman of Blackstone Advisory Partners, L.P. (June 22, 2018)
Wien continued, “Our bullish thesis will likely be tested this summer. Mid-term election year stock market performance is notoriously bad. Historically, the market has corrected an average of -18.9% from peak to trough leading up to the election, based on data going back to 1962. But July in particular is typically the most painful month, as history shows it is the month when the market loses its gains, turning negative in the year to date column. Over the years there have been many theories attempting to explain the weakness seen around mid-term election, none particularly good, but still the pattern seems to persist. The summer months may be rough but we are optimistic for year end, and stick with our S&P 500 target of 3,000.” Wien believes, “…that the current business cycle has at least several more years left to run.”
In 2000, Byron Wien was named the most widely read analyst on Wall Street and the number one investment strategist. It’s good to have our ears to the tracks when he speaks. His recent article was re-printed in Advisor Perspectives.
Our collective bet and hope is that the aged and overvalued market soldiers on. Odds? I put them at less than 50-50. Yet, it’s tough to bet against Byron. Personally, I’d feel a lot better if the Fed weren’t pulling the punch bowl away from the global liquidity party, the strong dollar threatening all of that Emerging Market dollar denominated debt and, of course, the debt and pension cliff that’s approaching here, there and everywhere. Mostly, I’d feel better if our current starting conditions were one of low valuations and high expected future returns. Unfortunately, that’s just not the case.
Today, let’s do two things. First, we’ll take a look at the latest month-end valuation levels and what they are telling us about the coming 7-, 10- and 12-year returns… you’ll see that we just aren’t getting a lot for our investment money. Second, we’ll take a look at what the latest “Recession Watch” indicators are telling us… you’ll see that they agree with Byron’s assessment, “no recession in sight.”
Grab a coffee and find your favorite chair. When I read through various research each week, my head clicks, “doesn’t matter, doesn’t matter, matters!” You’ll find a few cool charts that I think “matter” when you continue reading below. Hope you find them helpful.
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Included in this week’s On My Radar:
- Valuations and What They Tell Us About Coming 7-, 10- and 12-Year Returns
- Recession Watch Update – Latest Signals
- Trade Signals — Dow Theory Sell Signal
- Personal Note
Valuations and What They Tell Us About Coming 7-, 10- and 12-Year Returns
Let’s take a look at two popular valuation measures: the Shiller P/E and Median P/E (my favorite). You’ll also find a dashboard-like summary of a number of other valuation measurements, most all of which reflect an expensively priced market. Then, let’s take a look at what they tell us about coming 7-, 10- and 12-year returns.
- Shiller P/E CAPE (2nd highest reading in history, expect low forward returns)
- Median P/E
What I like about the Median P/E is that a lot of company shenanigans are removed from the data. It simply looks at the P/E in the middle of the data set. For example, out of the stocks in the S&P 500 Index, median is the P/E reading of 250 stocks above it and 250 stocks below it.
With that as a starting point, take a look at the following chart:
- The Median P/E is currently at 24.2.
- Higher than at the market peaks in 1966 and 2007 and second only to the late 1990’s and 2000-2002 period.
- Also take a look at the data (yellow highlight/orange arrow bottom of the chart). Fair value, based on 54.3 years of Median P/E history puts the S&P 500 Index at 1921.89. The S&P 500 Index was at 2718.37 on June 30, 2018 and is 2660 today (July 6, 2018). It will take a decline of 30% to get back to fair value. The market is very overvalued… Expensive hamburgers!
Further, the middle section of the chart plots something called “Standard Deviation.” In 1999, Median P/E was 2 standard deviations above the long-term median valuation trend line (the green dotted line – currently a reading of 17.1).
I like the way Ned Davis Research (NDR) frames out the downside risk to various levels (overvalued, fair value and undervalued). And we’ll tie this together in the section below titled, “Expected Returns.”
- Summary of other valuation measures (green is good, red is bad)
- 7-Year Returns
One look at this chart and you’re going to want to call it a day. It comes from Jeremy Grantham’s shop, GMO. Jeremy is one of the all-time great value investors. The reason I review his 7-year forward return forecast each month is that the data history goes back years and his correlation of prediction to outcome has been extremely high.
Here is how you read the chart:
- Stocks on the left, bonds on the right.
- Yellow highlights the eight out of 11 asset classes expected to return less than 0%.
- Note the dotted line showing the 6.5% long-term real returns for equities.
Bottom line: If you are a buy-and-hold investor, expect negative “real” (i.e., after inflation) returns over the coming seven years. Emerging market stocks, EM bonds and cash are expected to be the best asset class performers. Pension funds expecting to earn 7.5% are in trouble.
- 10-Year Returns
What does the high P/E mean? NDR broke the equivalent to the Shiller P/E into five quintiles that ranged from “Cheapest 20%” of all P/E month-end readings (data back to 1881) to the “Most Expensive” 20% of all readings. Then they looked at what the subsequent actual 10-year real returns turned out to be (after inflation). You’ll see that data shortly below.
- 12-Year Returns
John Hussman does some great work. Yes, I know he’s had some fund performance challenges (he hedged too soon and missed some good upside), but that doesn’t negate what he has to say, especially around his work on valuations.
In the following graph, the red arrow points to the expected returns, based on Hussman’s process, over the coming 12 years. Bottom line: Expect negative annualized returns over the coming 12 years.
Here is how to read the next chart:
- Focus on the maroon and blue lines. The blue line is the level of the Hussman Margin-Adjusted CAPE. (Left scale.) The maroon line plots the subsequent (actual) 12-year S&P 500 annual total return. (Right scale.)
- Try not to get lost in the financial lingo and simply note how closely they track each other. When valuations are lower, returns are higher. And vice versa…
- Finally, the big red arrow shows us what the coming 12-year return outlook is. The last time it was this low was in the late 1920’s. Enough said… stay risk minded and protect your downside…
John Hussman on valuations and probable forward returns:
Valuations have a profound impact on 10-12 year market returns, and on potential losses over the completion of any market cycle, but have little impact on market outcomes over shorter segments of the market cycle.
This has clearly been true in recent years. A moment’s thought should make it obvious that the stock market was only able to reach extremes like those of 1929, 2000, and today because valuations failed, for some portion of the market cycle, to collapse from less extreme levels. So while valuations haven’t “worked” in recent years, as is often the case during speculative periods, there’s nothing in recent market behavior to suggest that the relationship between valuations and subsequent full-cycle market returns has changed at all. Investors who believe that valuations have somehow become irrelevant because they haven’t “worked” in recent years simply don’t understand how valuations actually work.
Before discussing the profile of risks facing investors at present, it will help to quickly review the central considerations of our investment discipline.
While valuations are the main drivers of long-term, full-cycle market outcomes, they often say very little about market outcomes over periods substantially shorter than 10-12 years. On shorter horizons, investor psychology matters more. How does one measure that? I’ve frequently emphasized that when investors are inclined to speculate, they tend to be indiscriminate about it. So the uniformity or divergence of market internals across a broad range of securities tells us a great deal about whether investors are inclined toward speculation or risk-aversion.
Hussman’s latest letter is entitled, “Mind the trap door.” His conclusion is also worth sharing,
Because even steeply overvalued markets can continue higher provided that investors are inclined to speculate, a certain amount of flexibility is required in the way that we talk about market conditions. Presently, we observe a combination of extreme valuations and divergent market internals. This combination suggests that investors have shifted toward risk-aversion at a point where risk premiums are unusually low, and it opens up a trap door that has historically permitted very steep market losses, as we observed in 2000-2002 and 2007-2009.
While I’m inclined to view the January market high as the bull market peak for this cycle, which would suggest that stocks are already in a bear market, we also have to allow for the possibility that investors will again take the speculative bit in their teeth, which we would infer from the behavior of market internals. There’s no assurance that stocks have entered a bear market, nor does our investment success require stocks to collapse. It’s just that in the presence of both extreme valuations and deteriorating market internals, investors had better allow for that possibility, and even its likelihood.
Think of the market the way Warren Buffett thinks about hamburgers. When they are low in price you get a lot more for your money… “We in the Buffett family love hamburgers, when they go down in price we sing the hallelujah chorus, when they go up in price we weep.” He thinks investors should think about stocks the same way.
Recession Watch Update — Latest Signals
The obsession with recession is simple. It is in recession that all the bad stuff happens — especially to individuals and companies out over their skis in debt. Average stock market decline is approximately 38%. The last two recessions gave us corrections of more than 50%.
Byron Wien is right. “The major signs that would herald the beginning of the next recession are not yet in place. Unemployment is low and likely to decline further; wages are rising, but not sharply; the Federal Reserve is tightening, but real interest rates are zero; inflation is moving higher slowly; the yield curve is not inverted; profits are increasing; and the leading indicators are still rising. Until some of these indicators change, the expansion is likely to continue.” We watch, we monitor and we wait.
Following are a few of my favorite recession watch charts.
The Stock Market and the Economy
Here is how you read the chart:
- First, know that the stock market is a great leading economic indicator.
- This data set looks at the S&P 500 Index (red log scale lower half of chart) vs. its five-month smoothed moving average. Think of the MA as a trend line.
- When the red line drops below the green five-month MA line by 4.8% or more, a recession (down arrow) signal is generated.
- Note the down arrows prior to the grey shaded vertical recession lines.
- An expansion signal (up arrow) is generated when the red line rises above the green five-month MA by 3.6%.
- Data back to 1948. Correct signals: 79% (in probability terms… that’s very good).
The Employment Trends Index
The next chart looks at something called the Employment Trends Index (think in terms that more people being employed is good for the economy).
- Expansion signals are generated when the ETI rises by 0.4% (up arrows).
- Contraction signals are generated when the ETI declines by 4.8% from a high water mark (down arrows).
- Grey horizontal lines mark recessions. Not quite perfect timing on the down arrows but pretty darn good. Correct signals: 100%.
For geeks only… here is a look at the Employment Trends data (just in case you need a little help falling to sleep):
NDR’s US Recession Probability Model based on State Conditions
- Currently showing a near 0% probability of recession.
Index of Coincident Economic Indicators
Ok, put those goober goggles back on… In this next chart, just focus in on the lower section.
- Note that when the red line dips below the lower dotted horizontal line, a recession typically follows.
- Right now the index of leading indicators is showing “Strong Upside Momentum.”
- Bottom line: No sign of recession in the next six to nine months.
The Global Recession Probability Model
I shared the next chart with you in last week’s post. It looks at the probability of a global recession. It looks at all kinds of global economic data indicators.
- Note the while the U.S. is in good shape, the probability of a global recession is rising.
- The model is at 59.32, which is two points higher from the end of May 2018.
- A reading “Above 70” indicates the probability of a global recession is greater than 90% (note the data left of the red arrow).
The Inverted Yield Curve
Everyone has their eye on the yield difference between the 2-Year Treasury and the 10-year Treasury. When the 10-year yield becomes lower than the 2-year yield, the yield curve becomes inverted. Normally, longer-term rates are higher than short-term rates. When they invert, a recession typically follows within six to 18 months.
So far there is no sign of inversion. Bloomberg recently published the following opinion piece from Brian Chappatta, “Thanks to Fed, an Inverted Yield Curve Is Imminent.” The central bank signals that it plans to hike rates beyond neutral in short order. So yup, there’s that!
Here is a look at the current spread differential:
Bottom line: The U.S. economy is in better shape than the global economy. However, not immune… a global recession will come home to bite the U.S. Advancing trade wars don’t help. Let’s stay alert and keep watch.
Trade Signals — Dow Theory Trade Signal
S&P 500 Index — 2,713 (07-05-2018)
Daily investor sentiment readings are now in the Extreme Pessimism zone, which is short-term bullish for equities. The Dow Jones Industrial Average has breached its 200-day MA line, as has the Dow Jones Transportation Average. The Dow Theory rule says the primary trend of the market turns bearish when you get an intermediate-term low in both the DJIA and DJTA, followed by a substantial rally that does not make new highs, followed by joint penetration of those initial lows. The bear market conclusion stays in effect unless the market makes joint new highs.
Bottom line: In “Dow Theory” terms this suggests a top is forming in the market and should give investors reason enough to consider defensive measures. Seasonal patterns also suggest caution.
Here is how to read the following chart:
- Bottom section: Data since 1900 compares returns when both the DJIA and the DJTA are above their 200-day moving averages
- Dotted lines are the 200-day moving average lines
Further, I am seeing continued deterioration in the NDR CMG Large Cap Long/Flat model equity line; however, that trading strategy continues to recommend 80% exposure to large cap stocks. Our shorter-term trend indicators remain more cautious as you’ll see below. Seasonally, July begins the worst period for NASDAQ stocks and since they’ve been leading the equity markets higher (doing most of the heavy lifting). Expect the next several months to be challenging. Stay alert and risk minded. Participate and protect. I continue to favor diversifying to a handful of actively managed trading strategies.
The next section walks you through all of the Trade Signals charts.
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.
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.
I’m trying my best to keep each week’s On My Radar posts short, tight and meaningful to you. I’m rushing to finish as my stepson Tyler, Susan’s oldest, is graduating from Officer Candidate School early Saturday morning and I’m going to do my best to get on I-95 South in an attempt to beat the weekend beach, bay and Washington, DC rush hour traffic. I’ll be on the way to Quantico, Virginia by the time today’s note hits your inbox.
I’m not sure what the kid is allowed to tell us, but we know it’s been a challenging six weeks. Tyler is entering his senior year in college and is in the Marines ROTC program. The last six weeks were perhaps his most important test. Susan and her boys traveled down last night. At 7:00 am this morning, Tyler’s platoon will cross the finish line surrounded by family after a long marathon run in boots and wearing weighted backpacks. It’s supposed to be an awesome, emotional experience. I’m heading down early afternoon with my two boys and Brianna is training down from NYC. A big day ahead! We are excited to see and celebrate Tyler.
Hope your 4th of July was full of fun and family or friends. Have a great weekend!
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With kind regards,
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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