January 24, 2020
By Steve Blumenthal
“We’re just in the craziest monetary-fiscal [policy] mix in history.
It’s so explosive, it defies imagination. It reminds me a lot of early ’99 [when inflation was low and stock markets were soaring].
The difference is the fed funds rate was 4.75% — today it’s 1.62%.
Then we had a budget surplus, today we have a 5% deficit — you can’t make it up. … It’s crazy times.”
– Paul Tudor Jones
It’s time for the annual World Economic Forum in Davos, Switzerland. Jones was interviewed by CNBC earlier this week. He said, “The current stock market rally has a long way to go, due to a combination of abnormally low interest rates and unprecedented government budget deficits stimulating the economy and pushing investors toward riskier assets.” A long way to go? Maybe he’s right.
Last week David Tepper, a prominent hedge fund manager, shared similar thinking. I remember when Tepper turned bullish shortly after the March 2009 meltdown. His message? Don’t fight the Fed and QE. He told CNBC’s Joe Kernen that he “has been long and will continue that way.” He equated the stock market to a horse, saying, “I love riding a horse that’s running.”
Bridgewater Associates founder, Ray Dalio, said, “Cash is trash” in the 2020 market. Ray recommends some gold as a diversifier, along with a broadly diversified global portfolio. Speaking to low-yielding and negative-yielding bonds, he asked, “How much lower can interest rates go? I could be wrong but why would you want to hold bonds? Tell me why that makes sense…” CNBC’s Andrew Ross Sorkin asked Ray, “When do you jump off the train?” Here is the Dalio interview:
Do you remember the record-high asset flows into the stock market in March 2000? There was no sign of the top, but those flows nailed it. Speculation and euphoria—check.
But today—despite last year’s strong equity market performance—record flows are not to stocks; the money is racing into bonds. As my good friend Mike G. might say, “100% fact-based!” We’ll take a look at those money flow facts today and what that means in terms of risk and reward. The flows do make sense when you consider the aging demographics. The Baby Boomers are booming. Retirement is near. But are bonds as safe as Boomers think—and can they provide the income retirees need? I think not.
Grab a coffee and find your favorite chair. This week, we’ll look at the money flow into bonds and out of stocks. You’ll also find a grid that shows what happens to bond returns when interest rates rise and fall. As Dalio said, “Why would you want to hold bonds?” I just don’t believe most individual investors are aware of the risks. I’ll show you the math.
I also share with you an update on the stock market’s long-term growth trend. Think in terms of where we sit in the long-term bull market cycle and what that tells us about probable coming 5- and 10-year stock market returns. Many are touting the merits of “buy-and-hold” investing, and if you’re young that makes great sense. Add money every year, double up when the market dips, and enjoy the long ride (and ignore the bumps).
However, from what I’ve seen, poor investor behavior plagues both the young and the old. Call it experience (the 1987 crash, the 1991 recession, 1998, 2001-02, 2008-09). Dare I say, fear will rule reason this next time too? But that doesn’t mean you’re out of luck. We’ll look at the long-term trend and you’ll find there is some good information that you can use to your advantage. When the market reverts back to and below its mean, buy-and-hold will lose its relevance at exactly the time the approach will offer the best returns.
Lastly, I was recently interviewed by S&P Dow Jones Indices and we discussed the VIX, also known as the “Fear Index.” A link to the video can be found below in the personal section. Be fearful when others are greedy and greedy when others are fearful, Warren Buffett has advised. Watching the VIX can help. Lights on!
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Included in this week’s On My Radar:
- Bond, Inflation, and the Fed
- A Look at Long-Term Trend and Subsequent Market Gains
- Trade Signals – Near-Record Bullish Investor Sentiment Screams Caution
- Personal Note – Steve’s S&P Dow Jones Interview
Baby Boomers keep shoveling money into bond funds and bond ETFs. Now twenty years older (recall the record flows into stocks in March 2000—the stock market peak). One has to wonder what aging demographics mean to asset flows. There is so much money in simple target date funds, much of it in 401(k)s and other retirement programs. Here’s the concept: You pick a fund that is tied to your approximate retirement date. Say you’re 40 years old in 2000, and you wish to retire at age 65. You would have picked a 2025 target date fund. The fund takes this into account and continuously rebalances your stock vs. bond investment allocations. As you grow older, your allocations to equities decrease and your allocations to bonds increase. Your 60/40 (stocks to bonds) goes to 50/50, then 45/55, then 40/60, then 35/65, then 30/70. That’s basically how it works. The idea is that portfolios should de-risk as retirement nears and your need for income and safety increases. But with interest rates near 5,000-year lows, bonds just can’t do for us what they did before. When interest rates begin to spike, all that money flowing into bond funds is going to see risk like it’s never seen before. The stock market is richly priced, but I continue to contend that the mother of all bubbles is in the bond market. Boomers beware.
Chart 1: Here’s a look at the flows of money into bond funds and stock funds (mutual funds and ETFs). This data captures retail investor behavior.
- The top red arrow highlights last week’s spike into bond funds (I believe that is due to aging demographics and the annual rebalancing of target date funds). It’s interesting to note that flows to bond funds have been strong the last year and many of the last several years.
- The bottom red arrow highlights the outflows from stock funds and stock ETFs. The outflows from equities is notable in light of a currently strong equity market trend.
I’m concerned about the bubble because most individual investors, I believe, are unaware of the risk to bonds when rates rise. Not only are yields pathetically low, risk is much higher.
Chart 2: Captures what happens to bond returns when rates rise or fall by 1% or more from current levels.
- The 10-year Treasury Bond is shown in the top section of the chart and the 30-year Treasury Bond is in the bottom section.
- Today, the 10-year is yielding 1.75%. If rates rise by 1% to 2.75%, the 10-year Treasury loses 8.69%. If rates rise 3% to 4.75%, the loss is 23.66%. Recall that the 10-year yielded 5.5% in October 2007.
- Today, the 30-year is yielding 2.375%. If rates rise by 1% to 3.375%, the 30-year Treasury loses 18.77%. If rates rise 3% to 5.375%, the loss is 44.45%.
- The green circles to the left show what happens if rates fall by 1%. If you are in the “rates are moving lower” camp, and they do, there is still more run in the bond market. Those will be pretty good gains.
I hope the chart above gives you a good sense of the risk and reward based on how much interest rates move. For now, the predominant trend in interest rates is lower, which is good news for bonds. With rates at historic lows, bonds just can’t do for you what they did in years past. Stay tactical with your bond approach. Risk is as high as it’s ever been.
Chart 3: Inflation
Inflation and/or a credit crisis will cause rates to rise. The Fed will try to keep the lid on rising rates, but the problem is bigger than the ammo they have. And the pressures will be global. Think about the negative interest rates in Europe and the risks that will present when they rise. Anyway, here’s a look at my favorite inflation indicator. At some point the Fed will get what they wished for: rising inflation. But I’m not sure they’ll be able to control the inflation beast once it gets out of its cage.
Here’s how to read the chart:
- Focus on the lower section.
- The data is updated monthly. Currently, inflationary pressures are in the “Neutral” zone, having just moved from the “Low Inflationary Pressures” zone. So, no major concern at the moment. We’ll keep watch…
A Camp Kotok fishing buddy put out an excellent post this week discussing the Fed and its 2% inflation target. Sam Rines is chief economist at Avalon Advisors, an outstanding poker player, and an average fisherman. 😉
If your best friend touts his or her full faith in the Fed covering our collective backsides, don’t bite. This thoughtful note from Sam:
- Bottom line: A 2% core PCE inflation target is more of a dream than a target—even the ’90s boom saw 2% frequently missed. If QE, forward guidance, and 0% fed funds, is it realistic? Not really.
- Greenspan’s Fed had a 2% inflation target in 1996, but it was not until 2012 that Bernanke publicly announced it.
- The Fed’s track record of a hitting a 2% core PCE target is poor, and—despite this—there have been suggestions that raising the inflation target or playing catch-up is a viable option for the Fed.
- With the Fed reviewing its monetary policy framework, it is worthwhile to review the track record. Spoiler: it is not good.
- It is difficult to see how the Fed could be found credible with a significantly altered framework or monetary policy target (since it’s not credible within its current one).
A 2% core PCE is more than a bit arbitrary. If you follow this link to the NPR interview with the author of Greenspan’s biography, it is incredible how the Greenspan Fed landed on 2%. Believe it or not, inflation targeting in the U.S. can be traced to Janet Yellen, a member of the Board of Governors at the time. And the U.S. was following Canada’s lead. Greenspan decided it was best to keep the target a secret, and it took almost two decades to be formally recognized as the inflation target by the Fed.
But—given the target was instituted in 1996—judgment can be passed on nearly 25 years of the Fed attempting to hit an inflation target. And the track record is not a great one. The subsequent years have been witness to persistent undershoots of the target. In particular, the years following the 2012 formalization have disappointed.
Aside from the rather back-of-the-envelope manner with which the 2% target was chosen, there has not been much of a tangible or noticeable commitment to the target. After all, the Fed first hike off the zero lower bound was in the face of falling inflation. Certainly, there is the argument that monetary policy works with lags. But when a combination of QE and 0% fed funds have failed to generate inflation, it should be considered a signal that inflation pressures are tepid.
At any rate, part of the problem for the Fed has been a persistent decline in the “natural rate of interest” or “neutral” or “r-star”. Basically, this represents the inflation-adjusted (real) level of monetary policy that does not put a brake on the economy or push down on the gas. In the late ’90s, it was measured to be around 3%. Currently, it is around 0.6%. That severely restricts the ability of the Fed to move interest rates higher—as seen in 2018.
There are a few takeaways from the persistent inability to hit the 2% target. The first being that raising the inflation target is nonsensical. Most of the options (or suggestions) that have been thrown out for the Fed to adopt in the future have focused on either a hiking of the inflation target or a “catch-up” strategy of some sort. In nearly everything tossed around, there is a requirement or suggestion that the Fed would “allow” an inflation overshoot. In other words, inflation above 2% for some period of time. The Fed has not hit 2%, and few people will believe that there is a legitimate opportunity to hit a higher target.
Another takeaway is that the Fed will need to stay “looser for longer” in the future to hit any target. And this makes it interesting. The lack of inflation makes looser for longer a necessity for that framework. Without having hit the inflation target, the Fed moved into restrictive territory. That is not a confidence builder in any future changes to the monetary policy framework.
Needless to say, the Fed’s track record is not impressive on hitting the inflation goal. Any changes will need to be done with a past is gone attitude. Looking backward and committing to compensate for those errors and misses is simply not going to be credible.
For the Fed, inflation targeting has been a nightmare. And it simply is not credible at this point. Being far too hawkish far too quickly in a falling neutral interest rate environment. The question is whether it is willing to be looser for longer to allow inflation pressures to build or will simply move on to a new framework. If the Fed doubles down on inflation targeting, it will be committing to a far more dovish framework than the past couple of decades have witnessed.
Samuel E. Rines
Avalon Investment and Advisory
Bottom line: My fundamental view is rates are going to make one last push lower. I don’t believe all the king’s horses and all the king’s men (the Fed and the European Central Bank, the Bank of Japan, the Swiss National Bank, and the People’s Bank of China) can collectively get it just right. The global zero and negative interest rate coupled with global QE is an unprecedented experiment. I have no idea when rates will rise. I look to what price is telling us. My go-to is the Zweig Bond Model (see Trade Signals for chart and rules). It remains bullish on bonds. So, I’m bullish on bonds… for now. But I will be refinancing my mortgage to lock in low long-term rates. Cheap money while you can get it. I think we are near the end of the ultra-low interest rate cycle.
Markets move in cycles over time, from bull to bear and back to bull again. Yes, equities will produce a predictable return over the long term. It’s 10.01% since 1926. (Send me a note if you want to see the chart). But over time, prices move above the long-term growth trend and then back down below the trend.
Ned Davis Research measured the long-term trend and then did something interesting. They plotted the price of the S&P 500 Index over time in relationship to the long-term trend and broke the data into quintiles (five groupings) that measure how far above and how far below the market is from its long-term growth trend.
Here’s how you read the chart:
- The middle section plots the Real S&P 500 Total Return Index vs. the long-term trend (red dotted line).
- The bottom section plots the degree of deviation from the trend. Think in terms of how far above or how far below we are at any given point in time. The yellow circle with its red “we are here” arrow shows the most recent month-end data. We sit in the top quintile, or top 20% of most overvalued readings.
- Further, you can see how the current reading compares to past periods. NOTE: this doesn’t tell us anything about timing the top. That will forever remain elusive. But it does give us a good sense for when we should adapt our approach—more defense than offense when in the top quintile, and more offense than defense when at or below the long-term (red dotted) growth trend line.
- I favor trend following rules to help me avoid the really big downside mistakes (see Trade Signals for several simple processes). Like David Tepper said, “I love riding a horse that’s running.” Right now, the horse is running.
January 22, 2020
S&P 500 Index — 3,328
Notable this week:
Inflation pressures are ticking higher. It will be important to watch the global bond markets (direction of interest rates). We’ll be looking at those trends in Friday’s On My Radar. But for now, collectively, global interest rates are below their 10-month smoothed moving average trend lines and the MSCI World Total Market Index is above its 12-month trend line. We can see in the chart below (courtesy of Ned Davis Research) that when both indicators are in favorable trends, the Total Return Performance is best.
However, investor bullish sentiment is off-the-charts extreme. This screams caution. Valuations remain near all-time record highs and the cyclical bull market is 11 years old (oldest on record). You’ll see my favorite trend indicators remain bullish in the data that follows. First the summary “Dashboard of Indicators” section, then the charts. Stay alert, nimble and trade with stops in place (my two cents).
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.
I recently did a video interview with S&P Dow Jones Indices in New York. We discussed the “VIX,” which is an index that measures volatility. From Investopedia, “Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. It is also known by other names like ‘Fear Gauge’ or ‘Fear Index.’”
Click on the photo below to view the short interview. (My answers begin at the 2:50 mark). Put your geek hat on… I share how one of our strategists uses the VIX. I do hope I explain it in a way that helps you better understand VIX as an investment tool. VIX, by the way, is trading just under 13. Note to self: Slouching is not good, and boy am I looking more and more like the Baby Boomer I am. 100% fact-based. Ugh. Double ugh.
Here is a good chart you can use as a reference point. It looks at VIX going back many years. Lows are in the 10 to 13 range and spikes above 20 should catch our attention. Just look at that FEAR spike in late 2008. This gives a similar type of “investor sentiment” reading, but uses options prices (real people betting with real money) to measure behavior. Bottom line: we should be cautious when everything is super calm and more bullish when pessimism shoots to extremes. Not a bad tool. Keep your eye on the VIX.
I’m heading to Hollywood, Florida later this afternoon. Dinner meetings tonight and golf tomorrow with Dr. P., a dear client. Last year, it was my twosome against Doc and his partner. Doc parred and birdied three of the last four holes, sinking a 12” putt on the 18th hole for the come-from-behind victory. His partner fell to the ground in joy and shouted, “When you’re nearly dead, call the doctor!” The money went to the doc. I’m excited to golf and I’m shooting for the W.
On Sunday, the 2020 Inside ETFs conference begins and runs through Wednesday. I always learn a few things. Much of it occurs in the networking and discussions with friends new and old. I’ll share my top takeaways with you in next week’s post. You can learn more about the conference here. A little sun, a round of golf, early mornings, late nights, great food, friends, and fine red wine is just ahead. I’m checking in excited, happy, and grateful. Ever forward.
Hope you’re injecting some excitement and fun into your near-term plans.
Wishing you a great 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.
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