August 27, 2021
By Steve Blumenthal
“Change happens quickly and, often, unpredictably. And as we will see,
the unpredictable part is actually a mathematical principle.
It’s time passing without change that causes the worst problems,
including some historic economic catastrophes. It turns out we shouldn’t
just accept change; we actually need it.”
– John Mauldin, Financial Expert, New York Times Best-Selling Author,
and Chief Economist and Co-Portfolio Manager of CMG Maudin Smart Core Strategy
John Mauldin recently republished what I believe to be his best “Thoughts from the Frontline” letter of all time. The letter is titled “Ubiquity, Complexity, and Sandpiles” (you can find it here). I encourage you to read it.
John begins his letter,
As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic bucket and making sandpiles? Slowly pouring the sand into ever bigger piles until one side of the pile starts to collapse?
Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time, it’s a small one. But sometimes, it builds up, and it seems like one whole side of the pile slides down to the bottom.
Well, in 1987, three physicists named Per Bak, Chao Tang, and Kurt Wiesenfeld began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Actually, piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles; they were more interested in what are called “nonequilibrium systems.”
They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out there is no typical number:
Some involved a single grain; others, ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.
The pile was indeed completely chaotic in its unpredictability. Now, let’s read this next paragraph slowly. It is important as it creates a mental image that helps clarify the organization of the financial markets and the world economy.
To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, “ready to go,” color it red. What do you see? They found that at the outset, the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots.
If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever. (Emphasis mine.)
Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which liquid water would change to ice or steam or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus (and very casually, for all you physicists), we refer to something being in a critical state (or use the term critical mass) when there are the conditions for significant change.
But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]… . In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.
Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes, in wholesale changes in an ecosystem, or in a stock market crash? “Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?” Buchanan asks.
Buchanan concludes in his opening chapter:
There are many subtleties and twists in the story… but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things.
At the heart of our story, then, lies the discovery that networks of things of all kinds—atoms, molecules, species, people, and even ideas—have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.
SB here: John goes on to write about Fingers of Instability.
So, what happens in our game?
[A]fter the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into “fingers of instability” of all possible lengths. While many are short, others slice through the pile from one end to the other. So, the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate, or long finger of instability.
Now we come to a critical point in our discussion of the critical state. Read this next excerpt with the markets in mind (and this is critical to our understanding of markets and change. Maybe you should read it two or three times.):
In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point.
What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size. (Emphasis mine.)
Now, let’s couple this idea with a few other concepts. First, economist Dr. Hyman Minsky showed how stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist, and then the more dramatic the correction when the trend fails.
The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
Relating this to our sandpile, the longer a critical state builds up in an economy—or in other words, the more fingers of instability that are allowed to develop a connection to other fingers of instability—the greater the potential for a serious avalanche.
Motivated by John’s letter, I thought we’d walk down a different path in this week’s On My Radar and examine current market conditions through the lens of a large sandpile reaching a critical state. Since excessive leverage is always the bad actor, let’s begin there first. Also, spend an extra minute or two on the long-term trend chart below. I believe you’ll find it to be a great tool to know when the market is in a high risk/low return state and when it is in a low risk/high return state.
Grab a coffee and find your favorite chair. We jump immediately to the Trade Signals section and I’ll conclude today’s OMR with a quick story. Note: The charts may appear geekish upon first glance, but bear with me, I do my best to translate them in a way most everyone can easily understand. Not that there is anything wrong with being geekish!
- Trade Signals – Observations on Market Euphoria
- Personal Section – Coach
Trade Signals – Observations on Market Euphoria
August 25, 2021
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Notable this week:
As you’ll see below (or when you click the link if you’re reading this in On My Radar) the “dashboard of indicators” is green for US equities. “Don’t Fight the Tape and the Fed” remains bullish with a positive one reading (positive two is best, negative two is worst). However, there are reasons for caution. Extremely high market valuations, investor optimism, and leverage top the list–especially leverage.
With that in mind, let’s look at “Margin Debt as a Percentage of GDP” first. Then, we’ll get into several additional observations on market euphoria.
Margin Debt as a Percentage of GDP
Given that leverage, or the unwinding thereof, is always the bad actor in the equation, let’s take a look at the current state of leverage in the system today.
The following chart looks at margin debt relative to US Gross Domestic Product (GDP). Don’t get hung up on the equation; just think of it as another measure of investor behavior and the degree of potential risk. Focus on the orange line. Simply note the recent record-high leverage reading (marked “we are here” in red) and compare it to other periods in time.
I’ve circled the March 2000 and October 2007 margin debt peaks. Comparatively, there has never been a period in history with this degree of leveraged speculation. I suspect the words “margin call” will grace the front page of a major newspaper in the not-too-distant future. I could be wrong, of course, but I don’t believe I’ve miscalculated the level of embedded risk. Record-high valuations and record-high margin debt make for a large and unstable sandpile. Which grain of sand will trigger an event? We don’t yet know.
Other Observations (Cash Levels, Asset Allocation, and Bad Market Breadth)
- As of August 23, Rydex Mutual Fund allocations to stocks, bonds, and cash were as follows:
Rydex domestic and global equity mutual fund assets: 93.84%
Rydex domestic and global bond mutual fund assets (long-only): 1.31%
Rydex money market fund assets: 7.60%.
Looking at the numbers from 2000 to present, stock exposure is at an all-time high, bond exposure is near an all-time low, and money market exposure is just off an all-time low. Source: Ned Davis Research (NDR) and Guggenheim. Bottom line: Investors are all-in on stocks.
- Another measure of investors’ individual exposure to equities is “Stocks as a Percentage of Household Financial Assets” (not including pension fund assets). I’ll spare you another geeky chart and just focus on the conclusion: Individual investors have 45.7% allocated to stocks as a percentage of their total financial assets. This is the highest level we’ve seen dating all the way back to 1951.
Following are the prior secular bull market peaks (vs. 45.7% on March 31, 2021):
37.1% to stocks in 1966
44.5% in 2000
37.4% in 2007
I suspect the data from June 30, 2021, which we should be getting shortly, will show an even higher allocation to stocks.
Meanwhile, at secular bull market beginnings, ownership was low:
11.6% in 1982
28% in 2002
21.3% in 2009
The mean over the entire period (December 31, 1951 to December 31-March 31, 2021) is 27.8% stocks as a percentage of total household financial assets. Source: Federal Reserve Board and NDR.
- Generally, market breadth indicators measure the percentage of stocks in an index trading above moving averages. Think of it as the number of individual stocks rising in price relative to the number of stocks that are falling in price. Technicians look at the S&P 500 Index vs. the advance-decline line of all the stocks on the NYSE. When fewer stocks are driving markets higher and more stocks are breaking down, you are left with a weaker army. Note the diversion in the orange line (which peaked in May 2021 and is trending down) vs. the blue line in this next chart by Liz Ann Sonders: Source: Advisor Perspectives – Charles Schwab, Bloomberg, as of August 20, 2021. (Indices are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.)
- Another breadth measure looks at the number of stocks making new 52-week highs vs. the number of stocks making 52-week lows. It’s harder for the indices to continue advancing higher when more of their constituents are moving lower. Because of the cap-weighted construction rules of popular indices, fewer stocks are able to propel the market higher; however, if too many players receive a red card, your chances of winning the game are lower.
- As the next charts show, the number of stocks in the S&P 500 Index that are above their 50-day moving averages and 200-day moving averages have been deteriorating since the first week in May, and the data is worse for the NASDAQ and Russell 2000.
S&P 500 Compared to Its Long-Term Trend
This last chart is one of my all-time favorites. It looks very busy, but I’ll do my best to put it in plain English. It provides a feel for how the stock market cycles over time.
The S&P 500 Index price movement from 1928 to the present is plotted in orange in the center section of the chart. The dotted blue line is the steady upward-sloping long-term trend. Note how it has moved above and below the dotted blue line. I like to think of the dotted baby blue upward-sloping long-term trend line in the center of the chart as what stocks will give us over time (that number has been approximately 10% per year over the last 100 years). Simply, if you buy in when the market is at the dotted blue line, I believe it is probable to expect the S&P 500 Index to provide you with a 10% annualized return over time. That’s what the market has provided over the long term. No guarantees, of course.
Fortunately, we can measure where we sit in bull and bear market cycles at any particular point in time. Risk is highest when prices are high (above the long-term trend) and lowest when prices are low (below the long-term trend). As you’ll see, only one time prior have we been this far above long-term trend, and that was in 1929.
Here’s how to read this chart (notations are mine):
- You can see that, over time, the stock market moves above and below the long-term growth trend line. Sometimes it’s far above it, and sometimes it’s far below it (like 1932, 1982, and 2009).
- You can also see (middle section) how far above, near, or below the trend line the market is back to the 1920s. The best time to invest in a popular index like the S&P 500 is when the orange line is at or below the dotted blue line.
- The bottom section of the chart plots how far the market has deviated from its long-term trend line. That’s the gap between the orange stock market price line and the long-term blue dotted trend-line. The worst time to invest is when the orange line is well above the dotted blue line. In terms of the sandpile analogy, we can better know when the sandpile is less stable, like today.
- I’ve circled in red prior bull market extremes (the lower section) and mirrored those exact points in time in the middle section, so you can see what happened to the stock market following periods of extreme deviation above trend.
- Take a look at the 1966 peak and the 15-year bear market that followed (red arrow in the center section). Also, recall that the 1970s was a time of significant inflation. We have yet to see that sort of inflation regime since. Today? Transitory? Maybe, maybe not.
- Bottom line: We sit higher than the extremes reached in 1966, 2000, and 2007. Only 1929 was higher. Does the Fed have our backs? Fed Chair Powell gave a very dovish Jackson Hole speech today. For now, the answer is YES – but, but, but… until inflation calls their hand. Then the narrative changes.
- Also note, there wasn’t a single instance in which price didn’t correct back to or below the long-term dotted blue trend line (center section).
Here’s how to use this chart: If you wait to buy when the market corrects back to the orange long-term trend line, I believe you can reasonably expect returns of approximately 10% per year. You’ll get even better returns when the S&P 500 is below the long-term trend. But it takes patience and discipline and a very strong stomach. The best entry points come not during periods of market euphoria, but during periods of market fear.
- Lastly, the data box in the upper left-hand corner shows how the market performed over subsequent five- and 10-year periods when in the “top quintile” (largest deviations above trend) and the “bottom quintile” (largest deviations below trend).
I spoke with a physician friend this week. His brother-in-law told him he can get him returns of 20% per year. My friend is 64 years old. From our current starting point, 20% per year is not going to happen. Even 10% is not going to happen. I could be wrong, but I don’t like the odds. A 64-year-old cannot afford a 50% market decline and the 10 to 15 years it will take to get back to even (like 1966 to 1982 and 2000 to 2010). Retirement income? Gone. Markets may go higher, but this is a gambler’s market, not an investor’s market. Take advantage of the euphoria. Raise cash and/or hedge. Be patient.
A better entry point will present, just as they have in prior cycles. Consider using the orange line as a guide. This is “euphoria,” wait for “fear.”
So, what can you do? Find well-collateralized short-term private credit opportunities yielding in the 6% to 8% range. Stagger maturities one, two, three to five years. Diversify! Find niche LIBOR plus spread income-generating funds to eliminate rising interest rate risk. Rates rise, your yields rise with them. Find a handful of experienced active risk-managed trading strategists. Hedge your existing must-hold equity positions with put options until the euphoria passes.
- That will be when the orange line corrects back to the dotted blue line in the above chart.
You’ll want to be in a position to buy when stocks are fairly priced or even underpriced if the unwinding of record leverage sends the market back down below the long-term trend line (bottom quintile). Then pivot back to buy-and-hold.
Finally, let me conclude by saying this is not a specific recommendation for you to buy or sell any security. Talk to your advisor or reach out to Team CMG Mauldin if you’d like to learn more about the opportunities we are seeing and excited about. Reach us by emailing firstname.lastname@example.org.
Click HERE to go to the balance of Wednesday’s Trade Signals post.
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 – Coach
Tomorrow is the first scrimmage game for Susan’s high school team. She’s the head coach of high school boys varsity soccer team. It’s been a challenging week for those kids. Tryouts were Monday and Tuesday–60 kids vying for about 50 slots. Some kids hoping to make varsity made JV, others didn’t make either team. There were some hard conversations and one unpleasant email from a parent. Many of us don’t want our children to be disappointed, and in our efforts to spare them that disappointment, yet, in hindsight, we may be robbing them from one of their greatest teachings. The week ended on a beautiful note for all involved, most importantly for one very mature young man.
Game one is tomorrow. I’ll be sitting in the stands away from others, rooting for the boys and rooting for Coach Sue. There is one player I’m really excited to watch. A few weeks ago, Susan invited a top-level coach to run a training session for the team. The coach gave the boys some pointers, then sat back and watched. After a few minutes, he turned to Susan in awe, pointed to one of her players, and said, “Who is that?” With an eye for rare talent, he added, “That boy could play professionally.” She smiled and said the boy only plays soccer three months a year. No club team, no outside training. Just an amazing athletic gift.
The season is beginning with great excitement. The team looks strong and Coach has high expectations. I’m really looking forward to the season, to watching the team, and to watching my favorite coach do what she loves to do. Go Friars!
If you have young kids, enjoy your time on the sidelines. It goes by quickly. And here’s a hat tip to the trip to the ice cream store after game.
Have a great week!
All the best,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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