November 13, 2020
By Steve Blumenthal
“History does not repeat, but it often rhymes.”
– Mark Twain
JPMorgan is out this week predicting the S&P 500 Index will reach 4,500 by the end of next year. I hope they are right, but I have doubts. What might cause such a move? High stock market valuations make it improbable.
An advisor client asked me about the prediction, and I told him it could occur in a melt-up scenario caused by a sovereign debt crisis in Europe. Money flees to U.S. equities. Something similar to the late 1920s—the last time we were near the peak in a long-term debt cycle. Why? If someone tips you off that your bank is about to go bust, you’d immediately run there and move your money. The European Union structure is flawed and the country debts are larger than in many other parts of the world. Japan and the U.S. may be able to paper over their problems, but is Germany willing to bail out Spain, or Italy, or France?
Total domestic debt outstanding by economy looks like this:
Europe has a “bail in” clause, meaning depositors’ money can be used to bail out the banks. The banks own a great deal of sovereign debt. If a country defaults, the banks default and the individual depositors take the hit. Yes, the European Central Bank may print and buy but ultimately is Germany willing to bail out France, Spain and Portugal? I’m not so sure. In the U.S., we use taxpayer money to bail out the banks. Are we happy with that? No. But if you knew your bank was going under, you’d take your money and run before word got out.
More than 35% of the world’s government debt and 25% of all global debt now has a negative yield and we’re edging closer to the record highs seen in August 2019, Deutsche Bank multi-asset research strategist Jim Reid notes. That includes around $1.1 trillion of negative-yielding corporate bonds. Greek bonds yielding less than U.S. Government bonds? Historical declines in economic growth rates have coincided with record levels of public and private debt. None of this is healthy. The global debt system is ill.
Felix Zulauf said it well in a recent research piece, “It seems that the government’s share of our economies will continue to rise or stay very elevated for much longer than many had assumed. Our economies are becoming more state economies with central planners trying to manage them. They will fail over the long term, but this set-up may be bullish for selected risk assets and before the long-term negatives hit.” Keep your risk management goggles on. “They will fail over the long term….” I think he’s right.
Grab that coffee and find your favorite chair. When you click on the orange On My Radar button (if you are reading this in your email inbox) or scroll down (if you are reading this online), we’ll look at why the “5% rule” won’t work. I also share an excellent piece from GMO that advises—soundly in my view—why the popular 60/40 portfolio allocation won’t work.
Finally, if you’re a golfer, you are well aware that the Masters Tournament is this weekend. I have fond memories of watching the tournament over the years with my old man. The last time was in 2011, just before he passed away. I laid in his hospital bed with him with Starbucks lattes in hand, and we watched one final time together. That was a good day. That story, along with some positive news on Parkinson’s disease is in the personal section below. Thanks for reading!
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Included in this week’s On My Radar:
- The 5% Rule Won’t Work
- Avoid the Conventional 60/40 Portfolio… Just Like 1999
- Trade Signals – Recession Watch Update
- Personal Note – The Masters
Last week we looked at valuations and what they tell us about coming 10-year returns. No one knows what’s going to happen in the next two months to two years, but I think we can get pretty close to predicting what will happen in the next ten years.
In my partner John Mauldin’s last Thoughts from the Frontline piece, titled “Complexity Wins Again,” he wrote briefly about the 5% withdrawal rule. This is really important if you are nearing or in retirement. From John’s piece:
My friend Ed Easterling at Crestmont Research notes there have been numerous 20-year periods where stock market returns were below zero, especially when taking into account inflation. Ed’s website has one of the best data treasure troves anywhere:
A number of advocates and studies provide for 5% withdrawal rates: “I only want $50,000 from my million dollars” and have it last for 30 years. The calculated success rate for that rate of withdrawal is 73%. Pretty good odds…except when we consider the impact of valuation.
“SWR” stands for Safe Withdrawal Rate, and the safe amount varies considerably depending on market valuations when you start. The table shows that if you are in the top 25% of valuations and each year withdraw 5% of your $1 million retirement savings (to generate $50,000 for living expenses), you would run out of money 53% of the time. On average you have less than 21 years of retirement then run out of money. Good luck if you are still alive and kicking.
With valuations in the top 10%, like they are today? It is even worse.
If your financial planner says you can take out 5% per year “safely” based on a 60/40 (stocks to bonds) portfolio, then you should take your papers and walk out the door.
Furthermore, many planners use a total return model which starts in the 1920s and shows that over time markets will give you an 8 to 9% return. They simply (and lazily) plug in that 8–9% number for each and every future year, assuming that time will take away the effects of a bear market and recession. And that is probably true if you have 80 to 90 years. If, however, you are retiring when the markets are at a very high valuation, like now, your model will likely give you really bad advice.
Pension funds are going to get devastated in this decade. So are many retirees. And it all comes from bad models on top of more bad models. It’s a big problem.
I do believe valuations matter, especially if you’re heading into retirement and depending on your life savings to fund it, as John pointed out.
Ned Davis Research (NDR) plots subsequent 10-year real returns based on price-to-earnings (P/E) ratio. It’s clear to most of us that when you buy an asset at a good price, you get a better return on your money. This next chart looks at data back to 1925 and sorts P/E into five categories, or quintiles, ranging from “Cheapest 20%” to “Most Expensive 20%.” It then shows the returns that followed ten years later.
And here is the hard part… the outcome ten years from now could be as good at 11% per year (that was the single best actual outcome 10 years later in the “Most Expensive 20%” category). Note, though, that there was one occurrence out of hundreds of data points in which the market lost -6% per year 10 years later in the “Most Expensive” zone. The more probable outcome is between +5% and -1%. Take a look at this next chart:
Bottom line: What John is saying is that where we are in the cycle matters.
And speaking of cycles, here is a look at bull and bear market cycles for stocks, bonds, and commodities since 1900—a quick reminder that cycles do happen.
JPMorgan may be right. But keep this in mind, over the coming 10 years we may see 4,500 in the S&P 500, then a correction back to 2,200 (current median fair value based on median P/E), on our way back up to 4,500 ten years from now. That would be a painful ride to the low returns current high valuations are suggesting. Of course, nobody knows for sure. The system and the players (Fed officials, central bankers, legislators) within it are changing and the solutions to the debt problem are yet to be known.
But do remain optimistic. There are opportunities, depending on investment positioning. Note: It’s just not in the traditional 60/40 stock-bond mix. As GMO writes in the next section, 60/40 is the wrong game plan today. Think differently about what’s out there. Ideas include medical technologies, DNA gene editing for plants to feed a growing population more efficiently, and medicine that may be a game changer for people with Parkinson’s disease (I share a story with you about that in the personal section below). It’s really exciting.
In an excellent piece titled, “TONIGHT, WE LEAVE THE PARTY LIKE IT’S 1999,” GMO’s Peter Chiappinelli wrote,
“History does not repeat, but it rhymes,” as Mark Twain observed. As such, we are struck by the eerie and dangerous parallels between today’s markets and the markets back in 1999. Back then, Value investing and Value managers were under the gun for having underperformed their Growth brethren for too long. Valuation spreads between the U.S. and Emerging Market equities were wide, the U.S. was witnessing speculative and “bubbly” behavior on the part of retail investors, and, yes, GMO was looking stupid for still believing that valuations mattered and the gravitational pull of mean reversion would eventually work. While it is, of course, not 1999, we see ominously similar market phenomenon today. And for that reason, our advice is clear – it’s time to leave the party like it’s 1999.
Avoid the Conventional 60/40 Portfolio… Just Like 1999
Currently, we are advising all our clients to invest as differently as they can from the conventional 60% stock/40% bond mix, just as we were advising them in 1999. Back then, we were forecasting a decade-long negative return for U.S. large cap equities. And that is exactly what happened. Today, the warning is actually more dire. U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession, and CAPE3 levels are well above 2007 levels, within shouting distance of the foreboding highs reached in October 1929. But it gets worse. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon.4 We believe the chances of a lost decade for a traditional asset mix are dangerously high.
Exhibit 1 lays out the long and sad history of these numerous lost decades for 60/40 portfolios. What they all had in common was that each began with stocks or bonds being expensive. Today, stocks and bonds are pricey. This frightens us and it should frighten you. Few investors want to hear this because the 60/40 portfolio has worked so wonderfully for the past 10 years. Unfortunately, they were saying the same thing back in 1999, right before it failed them for a decade. (Emphasis mine.)
Click here to read the full GMO piece.
November 11, 2020
S&P 500 Index — 3,330 (open)
Notable this week:
Below you’ll find the updated month-end Recession Watch Indicators. There is no material change. Currently signaling economic expansion, which is good news for the economy in general, though I don’t believe we have yet exited the current recession. Keep in mind that the indicators are forward looking.
I shared the 10-year Treasury Note yield chart with you last week. Here it is again and it bears watching. Note the cyclical bull and cyclical bear market cycles marked by the 13-week vs. 34-week moving average crosses. Also note the red arrow. While still in a cyclical bull trend (bond prices higher, yields lower), yields have gone from 0.50% to nearly 1% in the last few month. I remain in the deflation camp and see yields moving towards 0%. But I could be wrong. If I’m correct, this move up in yields presents an attractive trading opportunity. I am concerned about the potential move to a bear market in bonds. It will have all sorts of implications on risk assets. Therefore, I expect the Fed to implement yield curve control (buy Treasurys to drive yields lower). That may work for a while. Interesting times…
The equity market trend indicators remain bullish. HY is back on a buy signal. The Zweig Bond Model remains on a sell signal, suggesting shorter-duration high quality Treasury Bill exposure vs. long-duration exposure. Gold is under some degree of downside price pressure. The gold trend indicator remains bullish on gold. Don’t Fight the Tape or the Fed moved to a less bearish -1 signal.
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 started working out in 1944… when the other exercise done
by the players was taking an olive from one martini to the other.”
– Gary Player, Retired Professional Golfer
Gary Player is as spritely at 85-years-old as he’s seemingly ever been. His secret, he says, comes down to his “60/40 rule.”
As a young boy, I’d cuddle up on the floor of our family room and watch golf with my father. The Masters became an annual event for the two of us. Arnold Palmer, Jack Nicholas, and Gary Player dominated in the early days. In April 2011, a week before my dad passed, I laid in his hospital bed with him. He was in and out of consciousness—mostly out. The cancer and chemo had taken its toll, and his mind wasn’t always clear. My daughter Brianna called from the local Starbucks and asked if Pop would like a latte. I tapped him on the shoulder and asked. He looked up at me like a young boy and asked, “Can I? Is it ok?”
Brie arrived and the three of us drank our coffees. Dad was staring at the TV. The Masters Tournament was on again, but this time, he didn’t know what he was watching. Suddenly, his lights turned on. I think it was Brianna’s gift coffee. He sat up in bed, and, for one last afternoon, he was back.
Prostate cancer ultimately took my dad’s life, but Parkinson’s disease stole much of the last few years from him. The shaking, the hallucinations, and the loss of the desire to strive for life.
When I think about wealth-generating opportunities, one that I’m invested in is personal to me. It’s a company based in Philadelphia called Enterin, and their work is largely focused on Parkinson’s. The team there believes they have identified the source of the disease: It begins in the gut. They have come to realize that if the gut’s nervous system becomes damaged, it affects the brain. In the case of Parkinson’s, they think that gut damage results from a particular protein that clings to the lining of the stomach.
Further, they believe that the nervous system, in certain instances, can be repaired— providing hope not only for those with Parkinson’s, but potentially autism and other neurological diseases. Their research is focused on a compound that comes from a shark with a lifespan of around 450 years. Enterin calls that compound Squalamine, and they think it may be more powerful than the antibiotics we use today.
Click below to watch an interview with Enterin’s founder, Dr. Michael Zasloff.
This is exciting, and after watching my father suffer, you can imagine how hard it hits home. When I talk about opportunities, this is the type I slot into the “Explore” portion of my portfolio. I’m biased, of course—which creates conflict for me both emotionally and as an investor. And I could be wrong and lose my investment. Thus, I size my risk exposure accordingly.
If you are an accredited investor and would like to learn more, let me know and I’ll keep you informed should an investment opportunity in Enterin arise (there are none at the moment). I do hope a new funding round opens, but there is no guarantee one will.
And if you have a friend or family member suffering from Parkinson’s, there will be another trial likely next year, and there may be a way for them to get in. Reach out to me and I’ll make the introduction.
Lastly, if you’ve been reading OMR for some time, you know that I wrote about Gary Player recently. He has such an infectiously positive way about him; it’s wonderful to watch. He just turned 85 and still shoots even par. He does one thousand sit-ups a day and says we should all eat half as much as we do, exercise twice as much as we are currently, laugh three times more each day and love—our humanity depends on it.
Enjoy the Masters! I’ll be having an extra hot latté and holding a toast with glass high in the air, sending love to my old man. I really miss him. Dustin Johnson is a favorite and in the lead at 9 under early Friday, Tiger Woods is in the hunt but I’m pulling for Justin Thomas who sits at -5.
All the best to you and your old man too!
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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