March 31, 2023
By Steve Blumenthal
“Quantitative easing ‘worked’ by flooding the economy with so much zero-interest base money that investors lost their minds, driving even long-term interest rates to record-low levels, and driving our most reliable stock market valuation measures beyond even their 1929 and 2000 extremes.”
“The simplest thing that can be said about current financial market and banking conditions is this: The unwinding of this Fed-induced, yield-seeking speculative bubble is proceeding as one would expect, and it’s not over by a longshot.”
– John P. Hussman, Ph.D.
President, Hussman Investment Trust
Re·al·is·tic – Representing familiar things in a way that is accurate or true to life.
The price you pay for something matters. Whether it’s gas, eggs, hamburgers, or stocks and bonds. When the price goes down, your money buys you more. When the price goes up, you can get less.
In the past year, the price for a dozen Grade A Large eggs have gone from less than $2 per dozen to over $4 per dozen. Your two dollars used to buy you 12 eggs, but today it only buys you six. If you do the shopping in your family, you’re well aware of the increase. And it’s not just in the price of eggs.
In both this week’s and next week’s OMRs, I’ll share several equity market valuation metrics. Importantly, we’ll be looking into what the data tells us in terms of coming 3-, 5-, 7-, 10- and 12-year annualized returns. 12 eggs, 6 eggs, or 1 egg?
Today, we’ll look at 12 years. Next week, we’ll zero in on the other time frames.
It’s a quarterly ritual for me—one that keeps me grounded and alert to both risk and opportunity. You’ll find no new surprises this quarter. Thirteen years of zero-interest policies have driven investors into a frantic state. Valuations remain extremely elevated.
As you’ll see next, the 12-year forward return potential is lower than the periods just prior to the 2000 tech bubble peak and the 2007 Great Financial Crisis and is eerily similar to the level seen in August 1929 (unfortunately, not a typo).
Setting re-al-is-tic return assumptions
John Hussman publishes a monthly article commenting on the market, and he has a bit of a unique way of slicing data. Quant geeks like me love it. If you decide to dive in, put your geek goggles on. For those of you who don’t, here are some key points from his latest article:
- Looking at the data updated on March 17, 2023, the coming estimated 12-year total annualized returns for a 60% stock, 30% Treasury bonds, and 10% Treasury bills portfolio is 1.03%. As you view the chart, note how the maroon-colored “actual 12-year annual total return” line closely tracked the blue “estimated return” line.
- That means, with Treasury bonds and bills yielding more than 3.50%, the forecast in his model is for negative annualized total S&P 500 returns over the coming 12 years.
- It sure makes a 5%-yielding 1-year Treasury bill look good. TINA (there is no alternative) is gone! This is a viable alternative; thus, not a bullish dynamic for stocks.
More from Hussman:
“The chart below shows our estimate of likely 12-year total returns for a conventional passive investment mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills, along with actual subsequent total returns. At present, this estimate stands at just 1.03%, matching the level of August 1929. By contrast, the average return for this conventional portfolio mix across history is just over 7% annually, which is where current pension return assumptions stand. That’s another way of saying that investors are setting their return assumptions based on average historical returns, ignoring the valuations that actually drive those returns.
“Notice that by late-2021, a decade of speculation by yield-starved investors had driven prospective investment returns to negative levels. That’s something that didn’t even occur at the 1929 and 2000 extremes. The sudden crises and financial strains emerging today are just the consequences of the extreme valuations and inadequate risk-premiums engineered by reckless zero-interest rate policies.”
Further, healthy stock markets see the majority of stocks advancing in price. We are not seeing that today. As Jim Bianco pointed out, just “eight stocks are keeping the YTD gains in the S&P 500 positive.”
Grab a coffee and find your favorite chair. I’m growing increasingly concerned about the escalating risk of war. I share a few thoughts about China—the rising power challenging the existing power. The risk is real. Let’s pray for peace. You’ll find a short YouTube clip – Tom Keene and Lisa Abramowicz’s interview with Jim Bianco (the Fed is not ready to pivot, recession ahead, then the pivot). I also share with you my partner, John Mauldin’s, thinking about the latest bank issues and what that means for the Fed. To summarize his thoughts…” doesn’t mean the Fed is finished tightening. It means the tightening will now come from an additional source as banks reduce credit availability. The effect isn’t small, either. I’ve seen estimates [that] it will be equivalent to the Fed hiking an additional 150 basis points. So, if you thought 5% short-term rates were going to push us into recession, what would 6% to 7% do? That was on no one’s radar a month ago. Now it seems highly possible, if not probable.” Hard landing ahead. Keep your seat belt on.
Each week’s OMR is broken into sections. Feel free to read them one at a time or all in one sitting. Here are this week’s sections:
- China – Russia – Iran
- Jim Bianco on Bloomberg News
- Mauldin on Thinking the Unthinkable
- Random Tweets
- Trade Signals: Recession by Fall 2023
- Personal Note: 62, Colorado, and Texas A&M
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
China – Russia – Iran
America v China
The Economist is out with a piece today titled, America v China – A new and dangerous phase of the Sino0-Amrican contest is underway. Don’t underestimate the fallout.
- The U.S. sees an authoritarian China that has shifted from one-party to one-man rule.
- President Xi Jinping will likely be in power for years to come and is hostile to the west.
- His meeting with Putin this month confirmed that his goal is to build an alternative world order that is friendlier to autocrats.
- The U.S. is accelerating its military containment of China in Asia, rejuvenating old alliances, and creating new ones, such as the AUKUS pact with Australia and Britain.
- The U.S. is widening its embargo on semiconductors and other goods. The goal is to slow Chinese innovation and maintain technological supremacy.
- China sees this as an attempt to cripple it. China believes America will tolerate China only if it is submissive, a “fat cat, not a tiger” (see Chaguan).
- Given the contradictory world views, it is naive to think that more diplomacy alone can guarantee peace.
Next are a few more observations points – (My two cents).
Seeking to punish Russia, the Biden administration confiscated Russian assets and kicked them out of the SWIFT payment system. The consequence of this is that unfriendly countries will stop buying U.S. bonds.
- China has been a net seller of U.S. Treasurys every month for the last 8-months
- China – Russia – Iran – India – Brazil – Saudi Arabia – The plan is a competing currency backed by commodities and stored onshore for countries to keep the assets safe from the U.S.
- Negative for U.S. treasury bills, notes, and bonds.
- Negative implications for the dollar.
- Xi is preparing his country for war.
- China and Russia may have an advantage with hypersonic missiles. China believes the advantage will close quickly.
- Taiwan is up next. A Chinese attack would start WWIII.
- The U.S. seems to be pursuing a policy of confrontation. Not a judgment, just an observation.
- China – Russia – Iran seem to be pursuing confrontation.
Tensions are high. The risk level is high. The question is, do we engage in war or find a diplomatic solution?
- I’m worried!
Jim Bianco on Bloomberg News
Mauldin on Thinking the Unthinkable
The latest bank issues have shed new light on Fed policy, which just weeks ago looked like more tightening as Powell and crew sought to stamp out inflation. Many had said the rate hikes and QT would continue until something broke. Bank failures would seem to qualify.
But remember, we’re talking about a complex system here. All these actions by different parties combine and interact in unpredictable ways. As it’s turning out, the bank failures could lead to more tightening, not less. But the channel isn’t necessarily obvious.
First, think about how monetary policy works. Faced with price inflation (in this case largely its own fault, but set that aside for now), the Fed responds (usually late) by raising the price of money and restricting credit, which theoretically reduces demand for goods and services bought with borrowed money. Producers then cut prices, reduce hiring, lay off workers, and do other deflationary things. It generally works but takes a long time.
Lenders have different constraints and incentives. For them, the interest rate level is less important than the spread between their cost of funds (what they pay depositors) and the rate they get from borrowers.
When this “net interest margin” is wider, banks have more profit potential and can take risk on less qualified borrowers. That’s been the case since 2020 as the Fed’s ZIRP policy kept deposit rates near zero. Flush with cash in checking and savings accounts, banks could loan at attractive rates and still make good interest revenue.
They could also use deposits to buy government and agency securities, which became a more attractive choice in the last year as the Fed hiked rates and ended quantitative tightening. This carried no credit risk but did produce the kind of interest rate risk that contributed to Silicon Valley Bank’s downfall.
However, this was attractive only with low deposit rates. Bank deposit rates are always relatively low because those balances are “sticky.” Households and businesses typically keep base amounts in their bank accounts to cover normal expenses. At some point, however, non-bank rates rise enough to entice some of that money away. That point appears to have arrived.
Meanwhile, higher rates are starting to have the Fed’s desired demand reduction effect in leveraged sectors like housing. This reduces loan volume, which means less bank revenue no matter where interest rates land.
Now combine that with some high-profile bank failures and fears of more. In that scenario, banks are motivated to get more liquid, which means less money available for lending. At the macro level, that amounts to additional tightening on top of whatever the Fed does. The Fed knows it, too.
Last week, as many others talked about the Fed pausing, I said they would hike rates again while expressing their vigilance over banks. The FOMC statement included this new language:
“The US banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”
Let’s break that down.
“The US banking system is sound and resilient.” Of course, the Fed would never say anything else. And I think it’s correct; the banking system is sound, though some banks clearly aren’t. The Fed’s new lending facility gives banks more liquidity than they had two weeks ago. This will be important going forward as low-interest loans reset and borrowers face additional stress.
“Recent developments are likely to result in tighter credit conditions for households and businesses.” This is a little odd, if you think about it, since tighter credit conditions are exactly what the Fed has been producing. While it would be très gauche to celebrate the help they are getting from the banks, I’ll bet there are more than a few tight-lipped smiles. Tighter margins combined with higher liquidity requirements mean less incentive to lend.
Note in the graph below that the percentage of banks tightening loan standards is back to levels associated with recessions. This is from a survey taken before the latest bank events, too.
In the Fed’s view, this is actually helpful. The rest of that sentence in their statement explains why. Tighter credit conditions will “weigh on economic activity, hiring, and inflation.” Those are exactly what Federal Reserve policy has been trying to produce. They are goals, not regrettable side effects. Or as the techies say, “feature, not bug.” Jerome Powell wants to reduce economic activity because that’s how he will reduce inflation.
In that sense, the banking industry’s challenges actually help the Fed. They are bringing its desired slowdown closer without the Fed having to lift a finger. That may be why the new FOMC economic projections still forecast a 5.1% peak rate this year, implying we should expect only one more quarter-point hike, then a pause.
That doesn’t mean the Fed is finished tightening. It means the tightening will now come from an additional source as banks reduce credit availability. The effect isn’t small, either. I’ve seen estimates it will be equivalent to the Fed hiking an additional 150 basis points.
So, if you thought 5% short-term rates were going to push us into recession, what would 6% to 7% do? That was on no one’s radar a month ago. Now it seems highly possible, if not probable.
“Highly Attentive to Inflation Risks”
Frankly, I don’t see how we avoid recession now, but there are mitigating factors. For one, the post-2008 reforms helped make the private economy somewhat less leveraged. Combined with all the pandemic relief money, it may also be why the Fed’s rate hikes haven’t seemed to reduce demand as much as many expected. The economy is simply less rate-sensitive now.
We also have a different demographic situation. The percentage of retirees is rising and working-age population growth isn’t meeting the demand for labor. At some point recession would “solve” this problem by reducing employment and wages. Recent technology sector layoffs might be an early sign but the weekly unemployment claims are still holding steady near the pre-pandemic level.
Of course, no one wants mass unemployment. We all hope for a “soft landing” with inflation subsiding while everyone keeps their jobs. And up to this point, that’s kind of been happening. Inflation is still high but not like last summer. Job growth is weakening only gradually. Consumer spending is still strong. All good news.
The question now is whether, between higher rates, continued QT and tighter credit will be enough to change these trends. Note that FOMC paragraph I quoted above: “The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”
The Fed is not letting down its guard. Reducing inflation remains its top priority. The strategy is changing a bit now that banks are being drafted into the fight, but that doesn’t mean Fed officials are folding. They are not.
For now, the dot plots say they expect core PCE inflation will drop below 3% next year. If that starts to look unlikely, I expect to see new measures. Rate hikes could resume or maybe they’ll try something else.
The bank situation remains problematic, too. As I’ve said, inflation has cumulative effects, and so do higher interest rates. Many banks are highly exposed to commercial real estate, having made loans for office buildings and shopping centers which are now struggling against post COVID changes. The work-from-home change appears to be sticking and that may mean a lot of unrented office space for a while. Bad news for both developers and their lenders.
On balance, I think the latest events raise recession odds. I suspect Powell and the other FOMC members made their peace with that possibility months ago. They hope to avoid recession, but they know continued inflation would be even worse. And now we’re entering a phase with additional dynamics outside their control.
All this is iterative. What we’re seeing now is the inevitable result of decisions in the past, which were the result of decisions further in the past and so on. Each decision to defer pain into the future simply makes the pain bigger. At some point it becomes undeferrable. That point is getting closer.
What’s an FOMC to Do?
Many in the market are screaming for the Fed to stop hiking rates and pause and cut soon. Obviously, it is hurting their businesses. I understand. Inflation is a problem for everyone, but mostly for the bottom 80%. That is why the Fed is finally focused on inflation.
Let me paint a different scenario. Come the May 2‒3 meeting, what will the Fed be looking at?
Atlanta Fed GDPNow is uncharacteristically more optimistic about the first quarter than the Blue Chip Economist consensus. The Atlanta Fed is nowcasting a GDP number for the first quarter of 2023 at 3%+. The Blue Chip Economists center on about 1%, with some calling for recession.
Deloitte echoes the Blue Chip forecast, except more optimistic as their baseline is for 2%. It is easy to find forecasts but it seems most say recession is in “the future,” whenever that is.The headline unemployment rate is close to all-time lows at 3.6%. The overall labor market appears to be getting tighter.
We will know the first estimate for Q1 GDP by the May FOMC meeting. They will go into the meeting with annualized GDP at 2‒3% and unemployment very low. Inflation will still be well above 4%. A strong economy, a tight labor market, and high inflation? I’m not saying what I think the Fed should do. I am simply saying that under those conditions they are going to raise rates again.
Yes, there are multiple signs of impending recession. By definition, a recession is deflationary and will help the Fed achieve its goal. The New York Fed’s yield curve recession probability is the highest since 1980.
Note that 1982 was the last “intentional” recession and also one of the deepest. Volker purposely threw the US economy into recession to break inflation. While 2023 isn’t the same, it does rhyme. The Fed cannot say this, Powell cannot say this, and they all hope that it won’t come to this, but they’re willing to intentionally put the US into recession if necessary to once again stop inflation. No, they don’t want to, but they recognize it’s a significant risk.
Thinking the unthinkable? What happens if the economy remains relatively strong (1‒2%), unemployment is benign, and inflation is still above 4% going into the June and August FOMC meetings. Could we see more rate hikes? Absolutely! If the economy rolls over and inflation is still above 4%, then we could see that fabled pause. But as Powell said, he doesn’t think a rate cut is likely this year.
John Mauldin is CMG’s Chief Economist and Co-portfolio manager. Thoughts from the Frontline is a free weekly economics e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com. Thoughts from the Frontline is not affiliated with CMG. Views are John Mauldin’s and subject to change at any moment. Not a recommendation to buy or sell any security.
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More Random Tweets next week. Follow me @SBlumenthalCMG.
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Trade Signals: Recession by Fall 2023
“If you add the present value of all the costs, the U.S. is not $31 trillion (about $95,000 per person in the US) in debt, it is $230 trillion (about $710,000 per person in the US). Debt to GDP is not 130% it is 800%.”
– Felix Zulauf, President Zulauf Asset Management, A Swiss based Hedge Fund
Overall, we remain bearish on equities into the fall with an S&P 500 target of 2,900 to 3,200. The 59-year median “fair market” value based on median PE is 2,900. Debt, as the Zulauf quote signals, is a headwind to economic growth. If we are correct in our recession view, expect corporate earnings estimates to be adjusted lower, which will impact stock prices. If we are correct in our assumption that the Fed and other central banks will pivot back to QE, then it’s very possible the market could rally back to new all-time highs into 2024/25. Then, another round of inflation and even bigger problems with debt and the cost to service that debt. Seeing a 10% yield on the 10-year Treasury seems impossible. It can’t be ruled out.
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About Trade Signals
Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. We provide a summary of technical indicators to help you identify where we sit in short, intermediate, and long-term cycles. We track important valuation metrics to determine the probability of future returns (i.e. when return opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. Trade Signals is now a low-cost subscription service, about the cost of two Starbucks lattes every month. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.
Not a recommendation for you to buy or sell any security. For information purposes only. Please discuss needs, goals, time horizons, and risk tolerances with your advisor. Investing involves risk. You can lose some or all of your money.
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Personal Note: 62, Colorado and Texas A&M
Susan and I were in NYC on Tuesday and Wednesday of this week for some business lunches. I met my friends at the new Centurion Club in Midtown. The view from the 55th floor was spectacular, and the few hours with my friends were thoroughly enjoyable. I must admit that while living in a Zoom world does work, there is nothing better than meeting in person.
On Tuesday evening, Susan and I went to see A Beautiful Noise: The Neil Diamond Musical. Wow! What a creatively written story.
The show begins at a point in time when an aged Diamond was grumpy and depressed and difficult to live with. We first see Diamond in a therapy session, which he attended only after being pressured by his wife and kids to seek help. To try to uncover the source of Diamond’s depression, the therapist takes him through his voluminous songbook.
Realizing that he had spent too long writing hits for other artists—like “I’m a Believer,” which he wrote for the Monkees (SB here: I didn’t know that!)—Diamond sets out to perform his own material with his unique voice. He lit up when he was on stage, but the clouds still appeared when he stepped off. Despite his internal struggles, he topped the charts consistently by the late 1960s, forever putting his mark on his generation and many generations since.
As Susan and I walked the streets after leaving the theater, I couldn’t get “Coming to America” out of my mind—a song exemplified to its fullest in New York City.
We’ve been traveling far
Without a home
But not without a star
Only want to be free
We huddle close
Hang on to a dream
On the boats and on the planes
They’re coming to America
Never looking back again
They’re coming to America
Don’t it seem so far away
Oh, we’re traveling light today
In the eye of the storm
In the eye of the storm
And I can’t leave out “Sweet Caroline,” the hit that made him immortal. “Hands, touching hands, reaching out, touching you, touching me… Sweet Caroline!” We really are all in this together. Crank up the volume and sing with me! Bum bum bum, good times never felt so good! So good! So good!
Needless to say, we loved the musical. If you’re in or headed to New York soon, put it on your list.
62, Colorado, and Texas A&M
I’ll be holding a glass of fine red wine high in the air, praying to the age-reversal gods on Sunday as I celebrate birthday number 62. No complaints, lucky, happy—ever forward. (But it can’t hurt to pray, right?) Susan’s mother, Patricia, is visiting this weekend, and I’ve pulled the good wine out from hiding. I know our adult children are on to me… 😉
Bum bum bum… so good!
Next weekend, we’ve got a trip to Denver to visit my son Matthew. My daughter Brianna is flying in from California to join us. Our plan is to book an Airbnb for the weekend up in Frisco, CO, and ski one day at Copper Mountain and one day at A-Basin. That should put the skis to bed until next year.
Later this month, I’m headed to Texas A&M. Britt Harris invited me to attend one of his Leadership classes—something I’ve really been looking forward to doing. A&M created a special program for select students they believe will be some of our future leaders. I’m looking forward to learning more about what they are doing. Also, one of our private investments is a leader in nature-identical gene editing. Think in terms of better traits for plants that improve farming – fewer herbicides and pesticides, less fertilizer, less water, and more. A&M is one of the leading agriculture schools in the world. I’ll be meeting with some of the research team at the school. Plus, I have a few Aggie friends that live nearby, and I have a beer bet I have promised to make whole.
Lots coming up in the weeks ahead, and plenty of good things as spring warms up. I hope there are plenty of good things in store for you as well.
With that, have a great weekend!
All the best,
Forbes Book – On My Radar, Navigating Stock Market Cycles. Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.
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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