March 12, 2021
By Steve Blumenthal
“Cycles are inevitable. Every once in a while, an up- or down-let
goes on for a long time and/or to a great extreme,
and people start to say ‘this time it’s different.’”
– Howard Marks,
Co-Founder and Co-Chairman, Oaktree Capital Management
Less spending, more savings. And the savings are finding their way into the market. With $1.9 trillion coming our way, the bet is on spending—but my gut tells me the savings rate will remain high.
Historically, a high savings rate correlates with slower economic performance. That makes sense, since personal consumption drives 70% of the economy. Since 1959, when the savings rate was more than one standard deviation above trend (think much higher than normal), U.S. economic has performed worst. The difference is material (source: Ned Davis Research):
- Savings rate high: economic growth 0.31% per year
- Savings rate neutral: economic growth 2.34% per year
- Savings rate low: economic growth 3.51% per year
In general, that means companies in aggregate will earn less, and if earnings remain low, the current overvaluation of equities—absent a meaningful correction—will remain high. In my view, the most vulnerable areas are the most richly priced, and the least vulnerable are those areas more fairly priced. Bottom line: Tech and growth in general are high risk, while value plays like high dividend paying companies are more fairly priced. Think 1999 all over again.
Each month, I review valuation and (most months, at least) I share the information with you. For me, it’s about process. I do it monthly since the data refreshes after each month’s end. Slow and boring… yes. But it does help me set some targets for offense and defense.
In my book, On My Radar: Navigating Stock Market Cycles, I talk about how to use valuations to help you set your own game plan. One of the charts I share tracks the median P/E ratio of the S&P 500 Index. I like that it’s based on actual month-end prices and actual trailing 12-month earnings. Take the price and compare it to earnings and you get median P/E. Last month’s median P/E was 31.4. (“Median” refers to the middle of the set. Since there are 500 stocks in the S&P 500 Index, there were 250 P/Es higher and 250 P/Es lower than 31.4.)
Ned Davis Research (NDR) plots each month-end median P/E dating back to 1964 (tracked by the orange line in the next chart.) The average median P/E of the last 57 years is 17.3. Let’s call that “fair value.”
Now, what I like best about this particular chart is that NDR adds standard deviation zones. To keep your head from spinning off, let’s keep it simple. It takes an extreme upward move in price relative to earnings to get to the “very overvalued” zone. That’s when the dot-com stocks went crashing down in 2001-02. Such events rarely happen. But look at where we are today (red “We Are Here” arrow) vs. just prior to the great tech wreck in 2000. Rare means only one time prior, since 1964, have we been this far above “fair value.” Take a look at the chart.
At some point, and nobody knows that exact point, the orange line will move down. And then it will move up again. Prudence tells me, a much better entry point is at the “overvalued” dotted line or 2,759.27 in the S&P 500. And I suspect we’ll return to the “median fair value” line, which will provide a much better investment return opportunity—historically about 10% per year. A decline to 2,096.13 would shake a few folks. It can’t be ruled out.
Much of the overvaluation extreme is tied to the “super six” tech stocks. It’s not that they are bad companies; it’s that everyone is over concentrated in the same names. While the Reddit crowd has found new courage, I suspect there will be stories they’ll share with their children some day.
Just a few more charts, then we’ll take a look at margin debt.
The Buffett Indicator: Corporate Equities to GDP
Highest ever — enough said.
Wall Street brokerage firms like to report P/E in terms of what their analysts are estimating future earnings to be. I like this least because there is a long history of overstating and then later walking back earnings estimates. Yet it is popular indicator, and if read through the right lens, it is informative.
Bottom line: Red is bad. White and green are good.
The price-to-sales ratio (price/sales or P/S) is calculated by taking a company’s market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company’s total sales or revenue over the past 12 months. The lower the P/S ratio, the more attractive the investment. (Source: Investopedia.com)
Bottom line: Red is bad. White and green are good.
Lastly, let’s take a look at what the return probabilities are for the S&P 500 Index, from today’s starting point over the coming one to 11 years.
Stock Market Capitalization as a Percentage of Nominal Gross Domestic Income
The next chart plots stock market capitalization as a percentage of nominal gross domestic income. Think of it as how much we collectively earn.
Here’s how to read the chart:
- The orange line in the middle section tracks the month-by-month ratio between the value of the total U.S. stock market as a percentage of our collective incomes. NDR plots an upward sloping trendline.
- The light blue line in the bottom section plots just how far above or below the current valuation (stock market to gross domestic income) is from the trendline. The long red arrow points to February 2021 month end. Simply compare it to the other peaks. (Note: the data goes back to 1925.)
- Now look at the data box in the upper left-hand corner. Considering all of the month-end data, NDR asked, What happened to the S&P 500 Index one, three, five, seven, nine, and 11 years later? Note the subsequent average returns when in the “top quintile – overvalued” and the “bottom quintile – undervalued.”
Bottom line: More offense when at or near the bottom quintile, more defense today.
“What a wise man does in the beginning, a fool does in the end.”
– Warren Buffett
In my book, I chart a strategy of sorts to create an investment game plan. I think of it as the best of On My Radar, comprising indicators that matter most and insights on how to use them to create a process that works best for you. With that in mind, bonds won’t work today. We favor secure/collateralized short-term private credit and risk-managed trading strategies. We believe value will do much better than growth over the coming decade. Put that in the “not everything is overpriced” category. We think active stock selection, smarter indexing, and hedged option strategies also make sense.
My worry is for investors who are all in on the “super six” stocks and the cap-weighted index funds and ETFs that are top heavy with them. To me, the market message is loud and clear: We are at euphoria, and with valuations and margin debt at record highs (see the Trade Signals section next), remember that “defense wins championships.”
“Investing is the intersection of economics and psychology.
The economics, the valuation of the business is not hard.
The Psychology—How much do you buy? Do you buy it at this price?
Do you wait for a lower price? What do you do when it looks like the world might end?
Those are the harder things.”
– Seth Klarman,
Chief Executive and Portfolio Manager, Baupost Group
Klarman’s quote sits at the beginning of the last chapter of my book. The chapter is titled “What Matters Most.” In it, I suggest an 80% CORE and 20% EXPLORE investment approach. Defend your CORE wealth, or the majority of your money. Do it in a way that gets your 80% back to 100% in four to five years. That enables you to invest in EXPLORE-type opportunities. The EXPLORE area takes more patience, involves a certain amount of risk, as well as an ability to source and research ideas. These are investments in new drugs, medical technologies, battery technologies, AI and deep learning, gene editing, and other disruptive technologies. They offer asymmetric, wealth-enhancing return opportunities. The psychology—that’s the hard part. It is made easier if you have a solid, disciplined game plan.
If you’re interested, you can buy my book on Amazon, here.
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Trade Signals – Margin Debt Record High
March 10, 2021
S&P 500 Index — 3,898
Notable this week:
Margin Debt as a Percentage of GDP has never been higher. It too screams caution. Add this chart to your list of euphoria indicators.
Increasing margin debt is good on the way up. More buyers than sellers. The problem isn’t on the way up, it’s on the way down. When a decline becomes large enough, margin calls kick in and that can lead to indiscriminate selling (forced selling) as the brokerage firms seek to limit their own exposure. Would-be buyers step out of the way and a crash occurs.
With new stimulus money soon to hit America’s bank accounts, I suspect much of it may find its way into stocks. Betting with the house’s money so to say. I suspect there is a little more room in the run. I could be wrong.
Supporting the bullish trend are the green lights on the Trades Signals Equity Dashboard. The Trade Signals Dashboard of Indicators follows next.
One last thought: Not all areas of the U.S. equity markets are overvalued/over-leveraged. Value is about as unloved as it was in early 2000. Notable this week is the switch in the Value vs. Growth model signal. It has moved to neutral. At CMG, we continue to favor high and growing dividend stocks. Value is inching closer to a buy.
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.
Personal Note – Answer to a Reader’s Question
We have outstanding thinkers/investors like my Dr. Lacy Hunt and David Rosenberg out there. Both are steadfast in the deflation-and-interest-rates-are-not-yet-done-moving-lower camp, and I believe the low in bonds is in, as I wrote last May: On My Radar: Deflation Now, Inflation Later – The Sell of a Lifetime for Bonds.
10-Year Treasury Yields since May 1, 2020
- 64% May 1, 2020
- 36% August 4, 2020
- 54% August 27, 2020
- 54% March 11, 2021
Close, but early again. The low occurred in August. Yet what I’m after isn’t perfect timing; it’s the major direction. I use this to show the challenges of investing in low-yielding bonds. Since late August 2020, yields are 1% higher. My experience over the years working with individual investors (and sadly even some advisors) is that many people forget that bonds lose money when interest rates rise.
What the next chart shows is how much is at risk for every 1% rise in bond yields (red arrow pointing right). Shown are the 10-year Treasury note and the 30-year Treasury bond. Zero in on the -9.24% and -21.67% numbers. That’s the current loss in rise in interest rates since late August. Note the losses should rates move up another percentage point from here too. This is why I say the bond market is broken. A 1.54% yield with inflation above that number does nothing to help your portfolio. Further, should rates continue to rise, you lose money. The reward-to-risk is just not there.
A reader sent me a note following week’s post, On My Radar: The Powell Bluff, asking about my shift away from Hunt and Rosenberg on inflation/deflation. Here is my reply:
Thanks for the note. I believe inflation is the most important issue for us to understand and the inflation regime has begun. Yet, it won’t be a straight line.
Rosie and Lacy say “not yet here.” Listening to a recent Rosenberg Research webinar, Lacy’s best guess is two years. Rosie thinks a little sooner. If one were to make a short-term trade, we are at a spot Lacy and Rosie might think to be a good entry.
I follow Zweig Bond Model, which is not yet signaling a buy. If triggered, I might be tempted to go long bonds.
My view is the change began last year. Chinese manufacturers are now raising prices. They have done nothing but lowering prices for years. The U.S. is very dependent on buying goods from China. China is raising interest rates. This would lead to a higher Yuan, if not pegged to dollar.
That could change. Tensions between the free world and China are real and growing. The U.S. is printing. Issuing debt. Spent $8.6 trillion last year, took in about half of that in tax revenue and borrowed the balance.
Bearish implications for the dollar. I see a decline in the dollar in the 25-30% range over the coming few years. We are big importers. Down 25% means our input costs are higher. Inflationary. Reshoring manufacturing (inflationary) and/or moving to another country causes temporary supply shocks. New make America’s infrastructure great money… inflationary.
I get their output gap is big argument. I get their debt is deflationary argument. But I believe we’ll see inflation here sooner than Rosie and Lacy. And boy, it’s hard to go counter to Lacy.
In any event, both Rosie and Lacy believe we will get inflation. We differ on timing.
My guess 3% CPI by July and a 2 to 2.5% 10-year. So, I’m not jumping on the bond bull trade, especially with the Zweig Bond Model in a sell. Hope that helps.
On the personal front, it was 70 degrees and sunny in the Philadelphia area yesterday. I left the office at 4 pm, and with golf clubs in the trunk, I raced off to play a few holes at Stonewall. That did much to lift my spirits.
Temperatures in the low 50s are forecasted for the weekend. The snow is gone and the clubs are still in the trunk. Hope you’re doing something fun for you.
Have a great week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Consider buying my newly published Forbes Book, described as follows:
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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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