July 27, 2018
By Steve Blumenthal
“One last thing – as for this debate about the yield curve needing to invert to warrant a recession call,
the reality is that at the ultra-low levels of rates, bloated central bank balance sheets
that are in the process of gradually unwinding, and in the face of record volumes of debt outstanding,
you do not need to see curve inversion.
Japan is the template – each of its last four recessions occurred with the yield curve still positively sloped!
The U.S. bubble is not in real estate credit this cycle, but the chart of corporate debt to GDP today
looks a whole lot like the chart of mortgage debt/GDP just over a decade ago. There will be a price to be paid,
in a tightening Fed policy environment, for creating a bubble condition such that half of the investment-grade
corporate bond market today is one notch away from being downgraded to junk.
According to Moody’s, leveraged loan covenants are now the weakest they have ever been.
Expect to hear the terms “fallen angels” and “destruction of value” in the next year or two
(perhaps why having some dry powder on hand right now is going to pay off big time as the credit cycle shifts into reverse).”
– David Rosenberg, “Breakfast with Dave” (July 26, 2018)
I’ve just returned home from a beautiful 12 days in Maui with my family. Wow. Sad it’s over, but I find myself relaxed and ready to run, so let’s run. This week, let’s zero in on what I believe is the number one macro issue we face. We sit at the end of a long-term debt supercycle. You and I have experienced short-term debt cycles, but few of us have experienced the consequences associated with the unwinding of debt that occurs at the end of long-term cycles.
As a quick aside, if you haven’t seen Ray Dalio’s “How the Economic Machine Works,” I encourage you to watch the short video here. It is the basis from which I believe we should think about how the economy works. Debt, or borrowing, helps facilitate expansion, but when one reaches the limit to which he or she can borrow and spend, a slowdown occurs. Teach this to your children. Dalio runs the world’s largest hedge fund. It is from this “Economic Machine” understanding that he has built his investment success.
The last time we faced the end of a long-term debt supercycle was in 1937. There are a number of similarities again today. Now, this doesn’t mean war or a global meltdown in risk assets, though both risks are possible and the latter likely. One way or another there will be a resetting of the global debt. “The Great Reset,” as my good friend John Mauldin calls it. It’s on the horizon… So top of mind is macro issue number one – the end of a long-term debt supercycle. Let’s look deeper into this today. How we position ourselves to both profit and protect is what I believe must remain our main priority.
Few profited in shorting subprime debt. There will be great opportunity in shorting corporate debt when the economic cycle turns. Recession timing is key. My current best guess is the second quarter of 2019. Keep those risk goggles on.
The Ned Davis Research CMG Large Cap Long/Flat Index continues to lean bullish. It’s a different story for bonds. You’ll find the link to the latest Trade Signals post below. Also, VanEck recently posted a great article on the Index in their Guided Allocation blog. Worth a read!
Next Thursday I’ll be heading to Maine for the annual Camp Kotok “shadow Fed” gathering of economists, former Fed insiders and money managers. I’m interested in the collection of thoughts around how we solve the debt mess… a “debt jubilee” of some sort? I’m really looking forward to the sharing of views and the stress testing of convictions. I’ll be sure to share with you what I learn.
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Included in this week’s On My Radar:
- Why it Might be a Good Time to Revisit Ray Dalio’s 1937 Analog, by Jesse Felder
- Tightening at the End of the Supercycle? by Ray Dalio
- Populism: The Phenomenon, by Ray Dalio
- Trade Signals — No Major Changes, but Weekly Sentiment Moves to “Excessive Optimism”
- Personal Note
Why it Might be a Good Time to Revisit Ray Dalio’s 1937 Analog, by Jesse Felder
- Debt Limits Reached at Bubble Top, Causing the Economy and Markets to Peak (1929 & 2007)
- Interest Rates Hit Zero amid Depression (1932 & 2008)
- Money Printing Starts, Kicking off a Beautiful Deleveraging (1933 & 2009)
- The Stock Market and “Risky Assets” Rally (1933-1936 & 2009-2017)
- The Economy Improves during a Cyclical Recovery (1933-1936 & 2009-2017)
- The Central Bank Tightens a Bit, Resulting in a Self-Reinforcing Downturn (1937)
And if these fundamental parallels weren’t enough, we now have a rather interesting price parallel to consider. The correlation between the S&P 500 over the past four years (black and white candles in the chart below) and the four years leading up to the 1937 top (blue candles) is roughly 94%. As I have suggested in the past, price analogs are not very valuable on their own but when the fundamentals also parallel closely they become far more interesting.
In this case, the fundamental parallels are only getting tighter as time passes. Despite the yield curve currently sending a clear red flag, the markets are now pricing in better than even odds of two more rate hikes this year. It seems ‘central bank tightening into a self-reinforcing downturn’ is becoming a more distinct possibility as the economic cycle ages and inflation pressures grow. In other words, “the policy stakes are now very high,” and history provides a clear road map for markets.
Source: The Felder Report
Tightening at the End of the Supercycle? by Ray Dalio
Dalio wrote this exceptional piece in March 2015. This was before the Fed began its current interest rate tightening cycle and, given the more than two years since the December 2015 start (first increase in Fed Funds rate), it is important to revisit the parallels to the rate hiking cycle when the last debt supercycle peaked in 1937.
Following are a few charts from the piece:
[SB here: Note the 50% drop in equities in 1937-38 (above right).]
I encourage you to click here to read more… what happened in 1936, 1937 and later… it is an important study of a time in history, the end of a long-term debt supercycle that is most similar to what we are facing today.
Which leads us to “populism.” As you put your game theory hat on, simply note that populism is a factor in the “what may happen” equation.
Populism: The Phenomenon, by Ray Dalio
This report is an examination of populism, the phenomenon—how it typically germinates, grows, and runs its course.
Populism is not well understood because, over the past several decades, it has been infrequent in emerging countries (e.g., Chávez’s Venezuela, Duterte’s Philippines, etc.) and virtually nonexistent in developed countries. It is one of those phenomena that comes along in a big way about once a lifetime—like pandemics, depressions or wars. The last time that it existed as a major force in the world was in the 1930s, when most countries became populist. Over the last year, it has again emerged as a major force.
To help get a sense of how the level of populist support today compares to populism in the past, we created an index of the share of votes received by populist/anti-establishment parties or candidates in national elections, for all the major developed countries (covering the US, UK, Japan, Germany, France, Italy, and Spain) all the way back to 1900, weighting the countries by their population shares. We sought to identify parties/candidates who made attacking the political/corporate establishment their key political cause. Obviously, the exercise is inherently rough, so don’t squint too much at particular wiggles. But the broad trends are clear. Populism has surged in recent years and is currently at its highest level since the late 1930s (though the ideology of the populists today is much less extreme compared to the 1930s).
Source: Bridgewater Associates, LP, Bridgewater Daily Observations.
Trade Signals — No Major Changes, but Weekly Sentiment Moves to “Excessive Optimism”
S&P 500 Index — 2,817 (07-25-2018)
The Ned Davis Research (NDR) CMG Large Cap Long/Flat Index composite score remains below 65 for the first time in several years, indicating a weakening in trend. Accordingly, the Index continues to signal 80% equity exposure. We will become more concerned when the model composite score declines below 50. Overall, the weight of trend evidence for equities continues to be moderately bullish.
The NDR Crowd Sentiment Poll is 67.7 this week, indicating excessive optimism, which is a short-term bearish sign for equities. Don’t Fight the Tape or the Fedremains at +1, which is a moderately bullish signal. The indicators that comprise this reading are a combination of NDR’s Big Mo and the 10-Year Treasury yield. It highlights just how important Fed activity is to market performance.
The Zweig Bond Model remains in a sell, suggesting risk of higher interest rates; thus, short-term T-Bills are favored over longer-term high quality bond exposure. The CMG Managed High Yield signal remains in a buy signal.
Expect the next several months to be challenging. Stay alert and risk minded. Participate and protect.
Important note: 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.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is firstname.lastname@example.org. I am not compensated in any way by NDR. I’m just a fan of their work.
My personal two cents was shared several weeks ago in Nobody Can Breathe Without Oxygen. I wrote,
I’m sure you watched with concern and hope for the Thai soccer players and their coach trapped in the cave for 17 days. Their situation looked dire. An experienced diver died attempting rescue. Holes were drilled from above to inject oxygen but missed the target. Two-and-a-half miles deep in the cave with portions of the escape flooded, the boys would need to swim, yet few if any knew how to swim. Days passed, oxygen levels worsened and a number of potential rescue plans considered. All with risk.
How to get from here to there? The rescue team, pieced together a plan that involved multiple divers, oxygen tank stations, a pull rope backup system and rope tethered diver to child. One by one, the boys and their coach were pulled out alive. What appeared impossible was solved.
I think of our current situation much the same. We just haven’t yet figured out how to get from here to the other side. The debt will reset but what will that look like? Who will get hurt? What plan might we invent? We don’t yet know.
The big concern I have is it will take political will, global political cooperation and global central bank coordination to reset the debt and pension issues. Today, I just don’t yet see that rope and pulley system coming together and we are running out of oxygen. I sure hope we can figure it out but I’d keep a downside risk protection plan in place just in case. I do have my doubts that the legislators can come together in time… it may take another financial crisis to unite the forces. We’ll see.
This doesn’t mean we lack ways to risk manage and profit. Certain investments will do well no matter what happens. Others won’t… I continue to like advance and protect strategies for a substantial portion (~50-80%) of one’s core portfolio and selective high return opportunities for the balance. With growth, we will have the ability to invest in a handful of exceptional return opportunities that may enhance your wealth. Just how you size your core and other select bets depends on your needs, risk tolerance, goals and time horizon.
Following are a couple photos from our trip to Hawaii. We were fortunate to be able to stay in a close friend’s home on Maui. In 2012, he offered the home to Susan and me, as we were getting married. At the time, Grandpop Bob was in poor health so we passed. Last fall, at an event, my friend approached me and implored us to use the house. He said he would be offended if we didn’t. What an amazing offer! To say it is the nicest property I’ve ever stayed at is perhaps too cliché, but it really is… Susan and I and our six children and Grandma Pat had a wonderful time. We’re grateful.
August is a few short days away. I sure hope you find some down time, recharge and then get back to the business of creating more great things in your life. All will benefit, especially you. Ever forward, never backward! Wishing you the best.
Have a great weekend!♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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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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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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