December 18, 2020
By Steve Blumenthal
“There will come a time when the economy does not require
increasing amounts of policy accommodation,
and when that time comes, and that will be uncertain… is some ways off.”
– Jerome H. Powell,
Chair of the Federal Reserve Board
The Federal Reserve was created by Congress on December 23, 1913, to provide the nation with a safer, more flexible, and more stable monetary and financial system. President Woodrow Wilson signed the Federal Reserve Act into law.
The Fed sets the cost of money and assets are priced relative to that cost. Today, the cost of money is effectively zero. “Don’t fight the Fed,” you say? Since 1913, there has been much evidence to support this view.
Bull markets ultimately end when the Fed reverses course. “Three steps (rate hikes) and a stumble” is the Wall Street adage. “Two stumbles (rate cuts) and a jump” is the other side of that coin.
But like everything in life, it’s not quite that simple. Following is the data from January 1915 to present. The signals are impressive but imperfect.
Ned Davis Research examined and found the DJIA has declined a median of 17% from sell signals to Ned Davis Research (NDR) defined bear market bottoms. DJIA has risen a median of 55% from buy signals to NDR bull market tops. While that’s impressive, there were 7 bad signals: early sell 1928; early buy 1929; late sell 1978; late buy 1995; early buy 2001; early sell 2004; and an early buy 2007.
Source: Ned Davis Research
Recall that in the fourth quarter of 2018, the Fed had raised rates five times. The S&P 500 Index was down approximately 18%. On December 18, 2018, Powell signaled that more rate increases were to come. Within a few weeks, he pivoted: the famous “Powell Pivot.”
The Fed concluded its last meeting of the year this past Wednesday. Powell and team ended the year with rates near 0%. The one major change is a promise to continue to buy at least $120 billion of bonds each month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
Stock prices were lower after the release of the statement, but joy returned when Powell said that the Fed is committed to keeping monetary policy “highly accommodative” for “quite some time.”
Stanley Druckenmiller, one of the greatest investors of our time, is currently bearish on U.S. equities, saying, “We are deep into the longest period ever of excessively easy monetary policies.” He added that this “radical dovishness” has not only prevented firms and individuals from deleveraging, but has encouraged them to take on more debt, which has been frittered away on “financial engineering,” rather than investment. He feels that “higher valuations, three more years of unproductive corporate behavior, limits to further easing, and excessive borrowing from the future suggest that the bull market is exhausting itself.”
No one knows the Federal Reserve Act better than my friend Dr. Lacy Hunt. In his latest quarterly letter, Lacy and his partner Van Hoisington wrote the following about Asymmetric Central Bank Powers:
Economic scholars have long argued that for monetary policy to be able to stimulate economic growth, four basic conditions must be met:
- First, the Fed must be able to control the monetary base by increasing its liabilities, which are assets of the depository institutions. The Fed can create these liabilities at will electronically. In the old days, textbooks said that these IOUs were created at the “stroke of the bookkeeper’s pen.” These liabilities, however, do not meet the definition of money which must be a medium of exchange, store of value and unit of account.
- The second requirement of the Fed’s power to stimulate economic conditions is a stable relationship between the monetary base (a consolidation of the Fed and Treasury balance sheets) and the money supply, M2. The money multiplier, which is defined as M2 divided by the base, is the measure of that stability.
- Third, the velocity of money (V) must be stable, although not constant. If V is stable, then changes in M2 will control swings in nominal GDP.
- Fourth, the Fed must have wide latitude to lower the short-term policy interest rate. It had been long recognized that if short-term rates approached the zero bound, monetary capabilities would be diminished. (emphasis mine)
Four decades ago, the consensus view was that all of these conditions prevailed, and monetary policy was a potent tool of not only restraining economic growth, but also stimulating economic growth. Currently, of these four conditions, only the first one prevails, and it is the least important of the four. The Fed can control the monetary base by increasing its liabilities (bank reserves). The three other, and far more critical, conditions are no longer present due to the extreme over-indebtedness of the U.S. economy.
- Monetary policy is left with one-sided capabilities i.e., they can restrain economic activity by reducing reserves and raising rates, but they are not capable of stimulating economic activity to any significant degree. The Fed can stabilize distressed financial markets through their powerful lending abilities.
- Countries in a debt trap like the U.S., Japan, the U.K., and the Euro Area have experienced a fall in short-term interest rates to the zero bound, and in some cases into the territory of negative rates, thus eliminating the fourth criterion for monetary policy to play a stimulative role in supporting the economy.
- Debt financed fiscal policy can provide a short-term lift to the economy that lasts one to two quarters. This was the case with the debt financed stimulus packages of 2009, 2018 and 2019. However, the benefit of these actions in 2009, 2018 and 2019, even when the amount of the funds borrowed and spent were substantial, proved to be very fleeting and the deleterious effects of the higher debt remain.
- Substantial econometric evidence indicates that government debt as a percent of GDP in all of the major economies are well above the levels where these detrimental effects occur. The multi-trillion dollars borrowed for pandemic relief in the second quarter encouraged the beginnings of a “V” shaped recovery, but this additional debt will serve as a persistent restraint on growth going forward.
- When government debt as a percent of GDP rises above 65% economic growth is severely impacted and becomes very acute at 90%.
If all that didn’t confuse you enough, here’s Lacy and Van’s bottom line:
- As long as the federal government’s policy prescription is ever higher levels of debt, the path toward disinflation will hold and long Treasury bonds will be the preferred area of the curve.
You can find the full post of Lacy and Van’s recent quarterly letter here. Worth the read.
To put some perspective to the 90% debt threshold mentioned, let’s take a look at the U.S.:
Note that Government (federal, state, and local) Debt-to-GDP is 123.7% (above the “very acute at 90%” level).
But in total, the debt picture is far worse. Total Domestic Debt Outstanding as a percent of GDP looks like this:
- United States = 392.5% Debt-to-GDP
- France = 648.7% Debt-to-GDP
- Eurozone = 539.1% Debt-to-GDP
- Japan = 689.5% Debt-to-GDP
- UK = 591.4% Debt-to-GDP
My two cents: The Fed is not out of ammunition and “the Fed has our back” narrative is in control. However, debt is the elephant in the room and it is growing most everywhere. Until the bad debt clears, low growth is all but guaranteed. We live in a massively complex and interconnected global system. The debt makes the system unstable. What snowflake trips the next avalanche? That remains unknown. Don’t believe the narrative can hold indefinitely.
Today, let’s consider the optimism that exists everywhere at the moment. Years ago, the great Sir John Templeton said, “The secret of my success is that I buy when everyone is selling and I sell when everyone is buying.” Today, optimism on the U.S. equity markets has rarely, if ever, been this bullish. We’ll look at how U.S. investors are positioned, various sentiment indicators, and some interesting data showing how professional asset allocators are positioned. Two words: “All in!”
I shared the latest valuation data with you last week—valuations are extremely high. Forward coming returns are likely flat to negative over the coming 1, 3, 5, 7, 9, and 11 years (from today’s starting point). This doesn’t mean you can’t make money; it just means the 60/40 cap-weighted stock/bond mix isn’t going to do it for you.
If there was ever a Sir John “sell when everyone is buying” moment, it’s now. If there was ever a time to hedge, it’s now. Down 50% to 60% remains a real risk. Put options make for a good hedge. Your adviser/broker can help you get the risk protection sizing right. We may go higher… the Fed may decide to step in and buy equities. Don’t know. That’s the bet. Stay on your toes and keep top of mind that faith was bestowed on both Greenspan and Bernanke also, and that bullish Fed narrative lasted until confidence was lost. All bubbles eventually pop.
Grab that coffee, find your favorite chair, and click on the orange On My Radar button below (or simply scroll down if you are reading on the website). The motivation for this week’s “Optimism Everywhere” post came as I was going through my Trade Signals charts. I was a bit stunned at the record level of optimism. Sir John Templeton indeed…
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Optimism Everywhere
- Have No Fear, the Fed is (Still) Here
- Trade Signals – High Inflationary Pressures
- Personal Note – Food Banks
“The lessons and warnings of history are clear if one looks for them,
most people don’t look for them because most people learn from their
experiences and a single lifetime is too short to give them those.”
Co-Chief Investment Officer & Co-Chairman of Bridgewater Associates, L.P.
Rydex Mutual Funds’ Asset Allocation
Latest data, 12/15/2020:
- Note that Equity Mutual Fund Assets are at 91.89%.
- That’s higher than the bull market peaks in March 2000 and October 2007.
- This is hard data—not an investor survey poll. Real money.
U.S. Household Stock Asset Allocation
Here’s how to read the chart:
- Total stocks (stocks, equity mutual funds/ETFs, and pension funds) = 55.66%.
- Total bonds (bonds, bond mutual funds/ETFs, and pension funds) = 20.84%.
- Total cash (including pension funds cash) = 32.08%.
- Note how there tends to be high stock holdings associated with market peaks and low stock holdings at market bottoms.
- One idea is to take on more risk when the amount allocated to stocks drops below the long-term mean of 44.49%.
Rolling 10-Year S&P 500 Total Returns and U.S. Household Stock Allocation
Here’s how the read the chart (red notations mine):
- The orange line in the middle tracks the amount of U.S. household stock allocations (note the red “we are here” arrow).
- The light blue line tracks the rolling annualized gain that occurred 10 years later. It stops in September 2011 because that is the last known 10-year annualized return.
- You can see that when the orange line is in the upper zone (above the top dotted line in the chart), the returns that occurred the subsequent 10 years were lowest (the blue line on the bottom).
- The data box on the bottom left plots the results. We are currently in the highest 20% of U.S. household stock allocations. The lowest 10-year subsequent annualized gain was -3.03% per year. The single highest best result was 8.43%, and the average of all occurrences was 4.01%. This is the collection of all data back to 1951. I like going with the average for handicap purposes. And yes, there is a chance returns could challenge the 8.43% subsequent return record or turn out worse than the -3.03% low. No guarantees.
Stock Mutual Funds Have Record Low Cash-to-Asset Ratio
- The amount of cash as a percentage of assets is at a record low.
- Cash is currently just 1.7% of portfolio assets on average across all stock mutual funds.
- It was 4% in March 2000, and 3.75% in October 2007.
American Association of Individual Investors Allocation Survey (as of 11-30-2020)
- 2% allocated to equities.
- 3% allocated to bonds.
- 4% allocated to cash.
Foreign Investors in U.S. Equities as a Percentage of Foreign-Held U.S. Financial Assets is at 26%
- Higher than 1999 at 22.4%. It was 19.8% in 2008.
Investor sentiment data is shared in the Trade Signals section:
- Currently matching the bullish extreme sentiment high in 2007 and higher than the bull market high in March 2000 (and any time prior—the data goes back to 1994).
Markets cycle from bull to bear to bull again:
Margin Debt at Record High
- Margin account balances are at a record high $659.31 billion in debt. When margin debt is increasing, investors are generally using it to buy new shares of stock. There are more buyers than sellers and stock prices go up.
- The concern is not on the way up; it is when the debt unwinds. A swift market decline could kick in margin calls and forced selling. Markets crash because of leverage.
- What I like about NDR’s data in this next chart is that they show the performance of the market when the trend in margin debt is moving higher vs. when margin debt is being reduced. Makes sense. However, it doesn’t account for periods like 2000–02 and 2008–09. We’ll keep an eye on this chart in OMR moving forward.
- The other consideration here is that this is why markets V bottom. Forced selling means would-be buyers back away. When the trend in debt turns back up, as it did in 2003 and 2009, the opportunities are best.
- When the trend reverses, I’ll again share this chart.
Here’s the risk, well presented by Dr. John Hussman (Hussman Funds):
Presently, I expect that the completion of this market cycle is likely to involve a loss in the S&P 500 on the order of 65–70%. I realize, of course, that this sounds insane. The problem is that this projection is fully in line with a century of evidence and is consistent with the extent of market losses that would be run-of-the-mill given present valuation extremes. Indeed, the only reason that the S&P 500 did not lose a similar amount during the 2000–2002 collapse (though the tech-heavy Nasdaq 100 lost a weirdly precise -83%) is that the market did not actually reach its valuation norms by the end of that cycle. Instead, the market went on to breach its 2002 bear market low during the 2007–2009 collapse. That’s when valuations finally moved to levels that I viewed as undervalued from the standpoint of historical norms (as I noted in late-October 2008).
The chart below provides some perspective about where the S&P 500 stands relative to its long-term valuation norms. Notice in particular that movements in the blue line (the S&P 500) well above the green valuation line tend to be transient, while market advances toward the green valuation line from below are typically not surrendered in later market cycles. It would take a roughly 67% market loss simply to reach that green line from here.
Source: Hussman Funds – Hypervaluation and the Option Value of Cash
“Fed chairman Jerome Powell is (still) here to save financial markets,” by Dion Rabouin, Axios (Dec. 17, 2020)
Fed chair Jerome Powell sought to reassure financial markets at the Fed’s latest policy meeting that even though the economy is improving faster than expected, the housing sector has “fully recovered” and equity markets are hitting all-time highs, the Fed isn’t even close to thinking about raising U.S. interest rates.
Why it matters: The bonanza in the stock and housing markets have been buoyed by expectations for the continuation of rock-bottom rates and an avalanche of Fed bond buying.
- Powell and other central bankers have been warning that the economy faces grave risks from the coronavirus pandemic in the near and medium term.
- And his words also assured traders, investors and speculators that the party in asset markets can continue.
Details: The lone major change to the Fed’s policy statement this month was a promise to continue to buy at least $120 billion of bonds each month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
- That’s great news for stock traders because it means the central bank will continue to push investors out of less risky assets like government bonds and money will keep flowing into riskier investments like equities.
On the other hand: The Fed increased its economic expectations for the economy, raising its real GDP forecast to a contraction of 2.4% in 2020, compared to a decline of 3.7% predicted in September.
- The Fed also raised its 2021 GDP forecast to 4.2% from 4%.
- And the central bank now estimates the unemployment rate will fall to 6.7% this year, an improvement from its projection of 7.6% in September.
Driving the news: Stock prices initially edged lower after the release of the statement, but turned higher during Powell’s press conference as he doubled and tripled down on the Fed’s commitment to keep monetary policy “highly accommodative” for “quite some time.”
What’s next: “There will come a time when the economy does not require increasing amounts of policy accommodation, and when that time comes, and that will be uncertain, and in any case, is some ways off,” Powell said during his press conference.
- “So I can’t give you an exact set of numbers. We, of course, as we approach that point, will be evaluating that.”
Powell even weighed in on the debate over whether stock prices had reached unreasonable levels, as many on Wall Street have warned in recent weeks.
The bottom line: Powell argued that while historic market metrics like companies’ price-to-earnings ratios were high, “that’s maybe not as relevant in a world where we think the 10-year Treasury is going to be lower than it’s been historically from a return perspective.”
- “We’re thinking that this could be another long expansion,” he said later in his press conference.
- “What we’re saying is we’re going to keep policy highly accommodated until the expansion is well down the tracks.”
December 17, 2020
S&P 500 Index — 3,701 (close)
Notable this week: INFLATION
It’s been a long time since inflationary pressures have been present. For investors, monitoring inflation can be critical since turning points in inflation often determine turning points in the financial markets. The Ned Davis Research (NDR) Inflation Timing Model consists of 22 indicators that primarily measure the various rates of change of such indicators as commodity prices, consumer prices, producer prices, and industrial production.
The NDR Inflation Timing model totals all the indicator readings and provides a score ranging from +22 (strong inflationary pressures) to -22 (strong disinflationary pressures). High inflationary pressures are signaled when the model rises to +6 or above. Low inflationary pressures are indicated when the model falls to zero or less.
I remain in the “deflation now, inflation later” camp yet the following chart is signaling different.
Also notable this week is investment advisors have never been more bullish. Twenty years ago I was president of a trade organization called NAAIM (National Association of Active Investment Managers). NAAIM surveys their members weekly and plots the data. The current reading is the second most bullish reading since the survey was initiated. Optimism is higher than it was at the stock market peak in October 2007. Rydex Funds are popular amongst the group as they have both bull and bear funds (and funds with leverage). That data too is tracked (data back to 1-3-2000). Note in the next chart Rydex reports 91.89% of the money is allocated to Equity Mutual Funds (record high), 1.97% is in Bond Mutual Funds and 6.14% is in Money Market Assets (record low).
With all that said, the weight of the intermediate-term trend evidence remains bullish. But caution is advised, here is a look at my favorite short-term trend indicator, it just turned bearish (note red arrow lower right-hand side of chart):
In conclusion, consider buying some puts. They are inexpensively priced simply because no one wants them. The great Sir John Templeton said, “The secret to my success is I buy when everyone is selling and I sell when everyone is buying.” We have reached the epitome of that statement. There has rarely been a better time to hedge equity market exposure.
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.
Click here for this week’s Trade Signals.
“We make a living by what we get. We make a life by what we give.”
– Winston S. Churchill
This morning, Susan and I found ourselves talking about the high rates of food insecurity and what we could do about it. After our discussion, I asked Susan if she could write something about food banks. Here’s what she shared:
When Friday rolls around, Steve is up early, in his favorite chair, completely locked into writing OMR. This morning, I meandered in to say hello, and our interesting conversation led to the dire food crisis in our country right now. Last March, in the early days of coronavirus lockdown, I got involved with a local food drive and learned so much about the operations and needs of running a non-profit food bank. Sourcing, transportation, warehousing, refrigeration, and distribution are just some of the logistical challenges these organizations endure.
It will come as no surprise that food donations are down due to lack of gatherings in schools, offices, and places of worship. Volunteer numbers have dropped too as many of those who donate their time are in high-risk groups and thus staying at home. Food is a basic human need. That means it’s time for action—let’s go! Some ideas as to what we can do:
Donate Money. You can give through a nationwide network or donate locally. Here are some ideas:
- Feeding America
- The Salvation Army Coronavirus Food Insecurity Program
- Search locally for a food bank
Donate Food. Peanut butter and jelly, cooking oils, canned tuna and meat, canned fruit and vegetables, canned stews and soups, oatmeal/breakfast cereal, pasta and rice, juice, and boxed milk are all good options.
Donate Time. Volunteer to deliver food in your community. Call your local food bank or connect with Meals on Wheels.
I’m sure you’ve seen long car lines at your neighborhood food distribution sites. While the light at the end of the tunnel is in sight, COVID-19 has devastated small businesses all at the same time. That takes time to repair. Plus, rates are high, and most states are again shut down. This is just awful. And add this to the emergency pile: The government stopgap funding expires at midnight tonight.
I do hope our legislators can get their act together and compromise on additional support. It’s needed.
We had about six inches of snow and much of the northeastern U.S. received about a foot. The skier in me loves it. Stepson Kieran and I found the sleds and hit the hill in the backyard. Great fun.
By the way, my book, On My Radar: Navigating Stock Market Cycles, is now available for Kindle on Amazon. The hardcover will be released in January and is also available for pre-order (and price guarantee). The book is about investment process and how to navigate bull and bear market cycles. Please reach out to me if you have any questions and, if you check it out, let me know what you think.
Wishing you a wonderful week!
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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