April 24, 2020
By Steve Blumenthal
“In order to understand why empires and their economies rise and fall and what is happening to the world order right now, you need to understand how money, credit, and debt work. Understanding how they work is critically important because that which has historically been, and still is, what people are most inclined to fight for is wealth—and the biggest single influence on how wealth rises and declines is money and credit.
So, if you don’t understand how money and credit work, you can’t understand how economies work, and if you can’t understand how economies work, you can’t understand the most important influence on economic conditions, which is the biggest driver of politics and how the whole economic-political system works.”
– Ray Dalio
Founder and Co-CEO, Bridgewater Associates, LP
Today, let’s take a look at how money and credit work. They compose the critical foundation that affects our businesses, our work, and our wealth. With insight on the ins and outs of money and credit, we can better understand how economies grow and how they contract—including our own.
Last week’s OMR post was about debt. It’s gotten to be too big here, there and everywhere. Debt is good for economies as it grows. When it reaches capacity, economies slow. And when it resets—a painful but important process that clears out the bad debts—economies struggle and suffer. Such resets occur in recession. After which, a new cycle begins.
Emerging market debt, developed market debt, corporate debt, mortgage debt, student loans, credit card debt, auto loans. Debt of every ilk—with the exception of mortgage debt—is higher than in 2007. Mortgage debt is nearing the astronomical levels reached just prior to the housing crisis. You can find last week’s debt post here. I recommend pouring yourself a stiff drink before reading.
But what does all this mean? How does debt affect economies, how does debt affect investments, and how does it drive our politics? You’ll find Ray Dalio’s April 23rd post titled, “The Changing World Order, Chapter 2: Money, Credit, and Debt” when you click on the orange On My Radar button below. It’s excellent. Share it with your children (since those are the poor souls to whom we baby boomers are gifting all this debt.)
Before you jump in, I want to share something I clipped last fall and have been saving for the right time. It captures how insane the bond market has become! From Bloomberg’s Lisa Abramowicz (September 23, 2019):
I’m not saying Citadel is going to default. What I’m saying is that this is not unique to Citadel. It’s been a feeding frenzy at the liquidity trough, enabled by near-zero Fed interest rate policy. Because of low rates, investors seek higher yields in riskier bonds, bond funds, and ETFs. That new cash needs to find a home. And what do many corporations do to capitalize on all that available liquidity? Issue bonds and use the cash to buy back their own shares. Companies such as Citadel rush in to take advantage of the available funding, and because there is so much money available, they can set favorable terms for themselves, not investors. Debt is good on the way up… and it was good for key employee stock options. Remember the Trump corporate tax cuts and the repatriation of cash held offshore? Share buybacks! But such terms leave investors with less protection to recover loss should a company’s business go south.
My friend David Rosenberg estimates that the last 1,000 points in the S&P 500 (2,390 to the high of 3,390 on February 23, 2020) came from corporate share buybacks. He may be right. Debt is good on the way up. But you have to ask yourself, “Is this game over?” I think it is.
I’m not judging anyone, I’m just pointing out what happened. Debts are good on the way up. Not so much when they can’t grow anymore. Or when they must reset.
There are so many problems under the surface we just can’t see yet. Asian dollar-denominated debt, EM debt, European sovereign debt. Will Italy stay in the EU? And there’s that sticky issue of $2 trillion in BBB-rated debt, with much of it sitting on the fringe of credit-rating downgrades. Can the Fed’s SPVs (Special Purpose Vehicles) bail it all out? Find the political appetite for that. I don’t think so.
The global business system has been hit by the mother of all systemic bombs. This won’t be a quick recovery. When business suffers, revenue suffers, and the pressure to support all that debt makes for more than a few sleepless nights. When credit rating agency downgrades come (a high probability), the size of the high-yield junk bond market will likely double. That’s bad news, but what’s worse is that many institutions will be forced to sell. Why? Certain foundations, pensions, and other investors—by policy mandate—can only hold investment grade-rated debt. Think of it like a margin call that causes forced selling. Knowing this, do you think market makers will step up to make a market? Who might the brave buyers be? The smart money will step aside, let the system clear, and buy back in at distressed levels. Stay tuned. And watch the credit agencies!
Felix Zulauf, CEO of Zulauf Asset Management AG, said it well: “We have just had the longest economic expansion in the history of the United States, and we have had a stock market boom of more than ten years. A cycle like this does not end with a mere month-long correction. A real bear market is only over when no one is interested in stocks anymore. You must feel sick when you think of equities. That’s when you know that the right time to buy stocks for the long term has arrived.”
My two cents: We are not yet out of the woods. Expect crisis. Expect Fed and government response. Next crisis, next response. It’s going to get bumpy on the way to fixing the debt and underfunded pensions. Defaults, sugar from governments, sugar from central bankers, more defaults, more sugar on our way to grand debt jubilee. Defaults, forgiveness of debts, restructurings and, yes, more bailouts remain in our future. The Great Reset has begun.
With that said, there are actions you can take to grow and defend your wealth. It’s part of why understanding the impact money, credit, and debt have on the economic system—and on political systems—is so vital. Overweight active management and trading strategies. Take a look at high and growing dividend stocks and ETFs. And know that there will always be certain special investment opportunities—think transformational businesses with the potential to grow 5x to 10x over the coming 10 years.
With care, strategy and steady hand, you can put yourself in a position to make a handful of more aggressive bets with a smaller percentage of your wealth. An experienced advisor can help you set a game plan in place. If you are an accredited investor, I’m happy to share ideas from my network of trusted relationships with you. Email me or have your advisor email me. Overall, the message is this: be adaptive in your approach. Long-term buy-and-hold index investing will be back in favor when the market is better priced. But for now, that cycle is over.
Before you click through to the Dalio piece, I want to share a quick personal story with you—one that starts at my dining room table, where hundreds of letters were spread across its surface. My wife, Susan, coaches soccer, and like everyone everywhere, her players are required to stay at home. No practice. Susan had an idea. She reached out to her teams with two requests:
First, she encouraged the kids to create daily challenges, record them, and share them in their team group texts. One girl challenged her teammates to juggle a soccer ball 20 times, the last touch being a shot to a basketball hoop. Watching the replays on Susan’s phone was fun. A handful of the girls were successful. It was uplifting to see them react when the ball sailed through the net—imagine how many times they failed before the shot sank in.
But it was Susan’s second request that made my day: to do something nice.
She asked the kids to write letters to residents in various nursing homes in our area. Susan would deliver them. A box was placed outside of the soccer club’s offices. She was expecting some participation; but she found herself standing in front of the box in awe when she arrived for the first pickup. The box was full. And the letters just kept coming.
Coffee in hand? Smile on your face? Together—and apart—we’ll win! You’ll find Dalio’s post, this week’s Trade Signals, and a few more letters from the kids in the personal section below.
“Keep Smiling!” And I really like the blue card with the rainbow, “Take a deep breath, drink your coffee, everything will work out.” Amen to that… I sure hope it lifted the spirits of our seniors – The Greatest Generation!
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:
- “The Changing World Order, Chapter 2: Money, Credit, and Debt” by Ray Dalio
- Trade Signals – Waterfall Declines and Re-tests
- Personal Note – Lead with Love
Note: To make this an easier and shorter article to read, I tried to convey the most important points in simple language and bolded them, so you can get the gist of the whole thing in just a few minutes by focusing on what’s in bold. Additionally, if you want a simple and entertaining 30-minute explanation of how what a lot of what I’m talking about here works, see “How the Economic Machine Works,” which is available on YouTube.
This article, along with others in this series, are an early preview of a book I’m working on called The Changing World Order. I will publish the book this fall but felt that, as I was writing it, the learning I was getting from my research was very helpful in understanding what is happening right now, so I wanted to pass it along to you as a work-in-progress. If you’d like to sign up to receive updates on this series, go to principles.com. You can also pre-order the book at Amazon or Barnes and Noble.
In order to understand why empires and their economies rise and fall and what is happening to the world order right now, you need to understand how money, credit, and debt work. Understanding how they work is critically important because that which has historically been, and still is, what people are most inclined to fight for is wealth—and the biggest single influence on how wealth rises and declines is money and credit. So, if you don’t understand how money and credit work, you can’t understand how economies work, and if you can’t understand how economies work, you can’t understand the most important influence on economic conditions, which is the biggest driver of politics and how the whole economic-political system works.
For example, if you don’t understand how the Roaring ’20s led to a debt bubble and a big wealth gap, and how the bursting of that debt bubble led to the 1930-33 depression, and how the depression and wealth gap led to conflicts over wealth all around the world, you can’t understand the forces that led to Franklin D. Roosevelt being elected president. You also wouldn’t understand why, soon after his inauguration in 1933, he announced a new plan in which the central government and the Federal Reserve would together provide a lot of money and credit, a change that was similar to things happening in other countries at the same time and similar to what is happening now. Without understanding money and credit, you wouldn’t understand why these things changed the world order nor would you understand what happened next (i.e., the war, how it was won and lost, and why the new world order was created as it was in 1945), and you won’t be able to understand what is happening now or imagine the future. However, by seeing many of these cases and understanding the mechanics behind them, you will be able to better understand the past, the present, and what is likely to happen in the future. I did this study because I personally needed what it would teach me and am passing it along to you in the hope that it will help you and the world understand the economic pandemic that is now transpiring.
In doing this study of history as it relates to the present and future, I spoke with several of the most knowledgeable historians and political practitioners. In those discussions, it was clear to both them and me that we each had different pieces of the puzzle that made the picture clearer when we put them together. They lacked adequate practical understanding of how money and credit work, and I lacked adequate practical understanding of how politics and geopolitics work. Several told me that this has been the biggest missing piece in their quest to understand the lessons of history. It is understandably difficult for those who are experts in history and politics to simultaneously be experts in money, credit, economics, and markets, and for those who are experts in money, credit, economics, and markets to simultaneously be experts in history and politics. That is why, in doing this study, I needed to learn from, and triangulate with, the best experts in history and politics and why they wanted to do the same with me about money, credit, economics, and markets. Through this triangulation, we came away with a richer understanding of how the whole machine works that I’m sharing in this book.
Let’s start with the timeless and universal fundamentals of money and credit.
CLICK HERE to read the full post. I recommend that you bookmark it so you can return to it from time to time.
April 22, 2020
S&P 500 Index — 2,807
Notable this week:
There is absolutely no way to know for sure, but I believe the waterfall low on March 23 at 2,180 in the S&P 500 is likely the low. Best guess. If I’m correct in my thinking, then fair value, approximately 2,200 to 2,400 in the S&P 500 Index, would mark a good area to add to equity exposure. There remains a smaller probability that 1,700 remains in play. Most times, markets don’t just settle back to their long-term trend growth lines, they drop below. You can see the trend over time in the middle section in the next chart. The blue dashed line is the trend growth over time. The orange arrow points to a level that is approximately between 2,200 and 2,400. Thus, my best guess.
Further supporting my guess is one of my favorite valuation metrics: median price-to-earnings (P/E) ratio. Median P/E looks at actual reported 12 months reported earnings and takes the middle P/E out of the roughly 500 stocks that make up the S&P 500 Index. We can then look at 56 years of data history to determine fair value. Cutting to the chase, fair value at March 2020 quarter-end is 2,370. I believe that’s a good entry target for equities; however, note in the chart the 2009 dip below median fair value.
Finally, with the S&P 500 Index near 2,800 (April 22, 2020), in a picture it looks like this (orange “We are NOW Here” arrow):
The probability of a re-test of the March 23, 2020, 2,190 crash bottom remains high. Given the record acceleration off the low and the Fed and fiscal authority responses, it is likely a re-test would present an attractive entry point. Given the devastation to the economy, challenges in the energy markets (i.e., oil) and the likelihood of additional defaults, a re-test is my base case. Expect several more powerful shots from the Fed’s money bazooka. Similar to the last ten years, I expect the Fed to allow markets to find their own footing and come in with the heavy firepower when they dislocate. No way to know for sure. I could be wrong. I’m looking to add to equity exposure on a re-test of the waterfall low.
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.
“Lead with love.”
– Kyle Blumenthal
Just as I felt watching the soccer challenge replays, my spirits lifted when I walked into the dining room to see those cards, colorful and filled with love. In the face of difficulty, there is always a lesson—and often a special gift. That gift I see is genuine kindness on full display, especially directed toward the heroes on the front lines.
But the gift is coming at a great cost. I’m sure you are affected. Maybe you’ve even lost a loved one. A dear friend lost his father a few days ago. Heartbreaking.
It looks like the fog begins to lift mid-May, if I’m being optimistic. That’s my guess as to when some businesses may begin to reopen. I’m not sure what getting back to normal will look like. I suspect more saving, less spending, and a slow recovery when it comes to dining, sporting events, and travel plans. That’s going to reset the baseline for certain business valuations.
It will be nice to get moving again and nice to be with friends, even if it means some distance and droplet protection. Perhaps we’re looking at June 1. Thankfully, technology is so advanced that learning, and for some, business can continue.
Selfishly, the Blumenthal gang is missing golf. But the kids and I set up a chipping area in the backyard. We’ve cracked a few flower pots (targets), so that’s good, as that part of my game is improving. I still usually lose a buck or two to son Matt and that remains good fun, except the losing part. An advisor friend suggested I take up pickleball. A net and four rackets have been ordered. I’ll let you know how that goes.
Son Kyle and I were talking about the pandemic and about dying. I believe there is more after this life… a long personal story for another day.
So, I asked him what he believes. His answer was beautiful. He said, “I suspect there is more, but I’m really not sure. Still forming my beliefs. But what I do believe is we should all ‘lead with love.’” That’s a religion I can get behind.
In that spirit, here’s a special hat tip to the Penn Fusion Academy soccer family and those wonderful cards. Talking about leading with love.
One last card from the soccer kids:
We will win! Stay safe, stay well, hang tough!
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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