September 7, 2018
By Steve Blumenthal
“[A] grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots.”
– Mark Buchanan, Ubiquity, Why Catastrophes Happen
I woke up early last Saturday morning and found John Mauldin’s Thoughts from the Frontline newsletter on “The Growing Economic Sandpile” in my inbox. In my favorite chair with coffee in hand, I finished the letter and sent him a note, “The best letter you’ve ever written!”
The story is about complexity theory and how three physicists were seeking to determine which grain of sand might cause a sand pile to crash. Remember sitting on the beach and building sand castles with your kids? They would all crash in different ways. Mauldin wrote:
Some involved a single grain; others, ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.
The pile was indeed completely chaotic in its unpredictability. Now, let’s read the next paragraph slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (Emphasis mine.)
To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, “ready to go,” color it red. What do you see? They found that at the outset, the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.
Thus, they asked themselves, “Could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes; in wholesale changes in an ecosystem; or in a stock market crash? Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?
Mauldin’s letter is about stability and instability and this has important implications to the markets you and I invest in. Stability: after a recession cleaned the system of less sound businesses, defaults occurred, margin debt unwound, cash accumulated and valuations reset, you’d have a more stable state. The sand pile broke, the strong survived, we found our footing and create anew. Instability is the opposite state. Fortunately, for you and me, this is something we can both see and measure. Unfortunately, we don’t know what or when which grain of sand will cause the sand pile to crash down.
“A grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots.” Red spot? Emerging market debt is a red spot. Specifically, the impact of the strong dollar on emerging market debt. Grain of sand? Turkey is a grain of sand (metaphorically to this story, of course). Much of their private debt (corporations and individuals) has been borrowed in dollar and euro currency based loans. Their currency is crashing. Those borrowers earn money in Turkish lira, but have to convert that money to U.S. dollars to pay off the loan. In the last year, the lira has halved in value relative to the dollar. Or taken the other way, the dollar has doubled in value relative to the lira. Inflation is out of control. The economy is in crisis. A Turkish business that previously borrowed $100,000 would have to come up with $200,000 worth of lira today to repay the loan. Doable? Doubtful. Defaults will spike.
How could that affect me, you might say? Typically, the International Monetary Fund (IMF) might step in to provide crisis needed loans. But the IMF intervenes to bail out governments, not private companies and individuals. Martin Armstrong wrote, “Turkey’s problems through the combination of government and corporate debt can trigger a very critical global contagion.” And we are not talking about just Turkey. Add in much of the world to the list that borrowed in dollars.
So who’s on the hook? Pension funds, mutual funds, ETFs and banks who have lent into emerging markets in search of high yield. The invisible hand of zero interest rate policy is becoming visible. Red spot! More from Armstrong, “Portuguese and Spanish banks are heavily invested in Turkey. If Erdogan defaults and turns to Russia, he would take the euro down with him.” Bank-to-bank counterparty risk. First domestically, then globally. Is this the grain of sand that sets a slide?
Right now, the U.S. dollar has the EM debt market’s head in a vice. And the Fed plans to keep on raising rates. Crisis abroad will likely drive capital to U.S. markets. A stronger dollar is likely. Turn the screws another few notches. Today’s sand pile is big and I think Mauldin did a brilliant job of explaining the confusing dynamics of macroeconomic systems in a way we can all better understand. So, a big hat tip to you my great friend.
Everything cycles. It just does. We can measure levels of risk and use the information to help us profit. In a letter in the not too distant future, I’ll be signaling a “green” stable state. As confident and calm we feel in today’s unstable state, we’ll all be feeling distress and fear following a “reset” when the state turns stable. More defense than offense when unstable, more offense than defense when stable.
Today, let’s look at valuations. Another red spot. You’ll see what the current levels tell us about stock market returns over the coming 7, 10 and 12 years. When the price of hamburgers are down, we get a lot more meat for our money. When high, we get less for our money. Prices are high today. Warren Buffett said it better, but you get the point.
You’ll also find my favorite probable forward return chart and it has nothing to do with sales or earnings or book value. It simply looks at the percentage of individual portfolios (you, me and everyone) invested in stocks. If we are “all in” on equities and underweight bonds and cash, there is less fuel in the tank (buying power) available to drive prices higher. This chart is suggesting forward returns will be about 1% for the U.S. stock market over the coming 10 years. Red spot.
So grab that coffee and find your favorite chair. I conclude in the personal section with a final thought on market timing and update you on what I feel is turning into a bit of a “where’s Waldo” weekly update. Don’t tell my kids I’ve called myself Waldo.
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Included in this week’s On My Radar:
- Valuation and Probable 7-, 10- and 12-year Returns
- “The Growing Economic Sandpile” by John Mauldin
- Trade Signals — More Buyers Than Sellers
- Personal Note — New York, Dallas, Baltusrol and Chicago
Valuation and Probable 7-, 10- and 12-year Returns
“So I think you’ll see rates go up and stocks go up in tandem at the end of the year.”
“If you asked me to think of similar time periods, I’d say 1987 in the U.S., I’m not saying we are going to have a crash.
It was a time when you had a budget deficit and you had stocks and rates going up together for a period of time.
1999 in the U.S. also jumps to my mind where things got crazy at the end of the year.
1989 in Japan: they had strong fiscal and monetary pulses that worked their way through the stock market…
So I can see things getting crazy and particularly at year-end after the mid-term elections. I can see things getting crazy to the upside.”
– Paul Tudor Jones, CNBC, June 12, 2018
As you dive into the charts that follow, you’ll see that valuations are high almost every way you slice and dice them. However, keep Paul Tudor Jones’ quote, one I shared last June in OMR titled: Paul Tudor Jones — Crazy to the Upside at Year-end, front of mind. Why? What if we see a fracture in the sand pile begin in Emerging Markets? Could it spread to European banks? Might that cause a chain reaction, much like the late 1920’s sovereign debt crisis, where capital seeking safety flees to where it believes is its safest home? Might that safe home be U.S. equities? The buying frenzy would push up the Dow and the S&P 500 – the likely recipients of the capital flows. Might it happen? Maybe. Let’s keep our eye on price trends (see Trade Signals below).
Valuations tell us a great deal about coming 7-, 10- and 12-year returns but very little about the returns immediately ahead. With that in mind, following is what I’m seeing today:
Median Price to Earnings (P/E)
Here is how to read the chart:
- Focus on the bottom section. The red line tracks the month-end Median P/E readings from 1964 to present. Each reading is based on the prior 12 months of actual earnings. The current level is 23.8 and is showing some improvement (down from 27 in January this year) due to improved earnings, tax incentives, stock buybacks); however, the number remains higher than 2007 and almost every other reading since 1964 with the exception of the tech bubble period.
“Price Move Of”
- I like handicapping the market’s upside and downside potential based on how far away the current P/E is from its 54.3-year median (currently 17.1). Take a look at the bottom “Price Move Of” section of the chart. Note a one standard deviation move to the downside from August 31, 2018 S&P 500 Index close of 2901.52 (1SD is a relatively rare event but happened a lot in the 1970s and early 1980s for a prolonged period of time), would put the market down 50.4% from the August 31, 2018 close to 1439.15.
- The market currently sits at more than one standard deviation above the historical median P/E (currently 17.1), which means it is about 6% above what history suggests markets an overvalued level line.
- A correction to Median Fair Value requires a 28.2% drop. That’d be a better entry target if you want to get more aggressive.
Bottom line: The market is overvalued by this measure.
Buffett’s reported favorite: Stock Market Capitalization as a Percentage of Nominal GDP
Here is how you read the chart:
- NDR adds up the value of 3,900 US common stocks combined to come up with a value of the stock market. They take the number of shares outstanding of each company, multiply those shares times the closing price at the end of August and adds them together to get the sum or total stock market capitalization. They then compare that number, $31.64 trillion at the end of August to the total US GDP (what we as a nation produces).
- This gives us a sense of how much stocks, in aggregate, are worth relative to what our country produces. Buffett’s preferred measure of valuation.
- Note the green dotted “Very Overvalued” line that runs horizontally across the chart.
- Note how high the blue line is (far right) at 155.0% market cap-to-GDP (second highest only to 2000). Red “We are here” arrow.
- Note the red line. Similar to the blue line except it looks only at the S&P 500 companies to determine stock market cap. I think the blue line is close to the total value of all stocks outstanding. Thus, preferred. Simply, compare the blue line to the blue line and the red line to the red line. In both cases, you can see valuations are nearly as high as they were at the top of the greatest bull market in history that ended in March 2000. Higher than the 1966 and 2007 bull market peaks.
Bottom line: The market is extremely overvalued by this measure.
Bottom line: Record high. Red “We are here” arrows. The market is extremely overvalued by this measure.
A Bunch of Other Measures
Red is bad, green is good.
Bottom line: The market is extremely overvalued by most every measure.
P/E10 or Shiller P/E Ratio
We can also use a percentile analysis to put today’s market valuation in the historical context. As the chart below illustrates, the latest P/E10 ratio is approximately at the 97th percentile of this series. This chart from Advisor Perspectives.
Forward Return Potential
All of the above valuation charts suggest we should be realistic about coming returns. Let’s next take a look at what probabilities look like:
Here is how you read the chart:
- NDR sorted the history of 10-year smoothed earnings to determine P/E and then put all of the history of P/E into five categories ranging from “Cheapest 20%” to “Most Expensive 20%.”
- Each month-end P/E was determined and then they calculated what actually happened over the subsequent 10 years. Data is from 1881 through March 2018.
- The current starting condition, where we sit today in regards to high valuations, is highlighted in yellow.
- The black line in the middle of the yellow box shows median 10-year annualized real return. Roughly 3.25%.
- The red line shows the worst of all 10-year outcomes and the green line shows the best.
Bottom line: By this measure, expect stocks to return 3.5% per year over the coming 10 years. It could hit 9% (an outlier) or it could come in at -6% (also an outlier). Hope this helps you shape your risk and return bets.
GMO 7-Year Forward Asset Class Return Forecast
Hussman’s 12-year Full Cycle Return Forecast
My Favorite Forward Return Potential Chart – Household Equity Percentage vs. Subsequent Rolling 10-year S&P 500 Index Total Return
All of the above valuation charts suggest we should be realistic about coming returns. This next one is based on how much money investors have in stocks as a percentage of their household investments:
- Red oval shows us what the probable 10-year coming annualized return is likely to be. It is based on the “Household Equity Percentage” far left side of chart vertical line. Idea is that investors are heavily invested in stocks. Where might future buying power come from?
- Note 2000 level and red arrow showing predicted return. Then look at the dotted black line. That line shows you what happened. You can see that the dotted black line stops in 2008 and that the actual return since 2007) approximately 8.5% annualized) beat the projected return marked by red arrow pointing to the 1% level.
- Note too how well the black line has correlated to the blue line. Blue is the prediction and black the actual outcome.
- Bottom line: based on investors overweight exposure to equities, expect low coming 10-year returns.
“The Growing Economic Sandpile” by John Mauldin
I met John sometime in 1999 or early 2000. I’ve been reading him since. His great skill, in my opinion, is his ability to explain complex concepts in a way you and I can better understand. I admire his writing, have read all of his books (five best sellers) and believe his following has grown so large because of his forward way of thinking and accuracy of his major economic predictions. Of course, past performance cannot predict or guarantee future performance.
I encourage you to read Mauldin’s most recent article. I think it’s his best. You can find the link to his full piece here.
If you didn’t know already, I’m thrilled to let you know that John joined CMG as our Chief Economist and co-portfolio manager of the CMG Mauldin Solutions Core Fund a couple months ago. We are in NYC next week for meetings and media events and will be bringing a number of audio and video interviews to you in the near future. We’ll also do live roundtable webinars where you can dial or log in and ask us questions. Stay tuned.
Trade Signals — More Buyers Than Sellers
S&P 500 Index — 2,888 (09-05-2018)
No significant changes in the signals. The Ned Davis Research CMG U.S. Large Cap Long/Flat Index signals 100% exposure to S&P 500 Index exposure (large-cap equities). Volume Demand remains stronger than Volume Supply , that is, more buyers than sellers is bullish for equities. The 13-week over 34-week moving average continues to signal the market is in an uptrend. Investor optimism remains in the Extremely Bullish zone (a short-term bearish indicator for equities). The Fixed Income, Economic Indicators and Gold signals remain unchanged since last week.
Keep in mind that September and October are seasonally challenging months for equities. Our current starting conditions matter: Market valuations remain extremely high and the cyclical bull run is aged.
For additional commentary, click HERE for the latest Trade Signals.
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.
Personal Note — New York, Dallas, Baltusrol and Chicago
The overall message about stable and unstable sandpiles might best be summed up in this next chart. I expect a bit more Euphoria before the swing down.
September is off to a good start. I feel recharged and ready to run. I hope you too are in a good place!
I’m in New York City next Monday and Tuesday (September 10 and 11) for meetings and several media interviews. Dallas follows on September 17 and 18 and then back to NYC on the 25th and 26th for a mutual fund board meeting. Some fun is mixed in… golf at famed Baltusrol is scheduled for October 2 with several of our adviser colleagues, followed by meetings in Chicago on October 10 and 11. If time permits, let me know if you are in the area and have a few minutes for a quick coffee. I’d love to get together.
Penn State is playing Villanova tonight in soccer. It’s a double-header with the Villanova women’s team playing Virginia Tech followed by the PSU-Villanova men’s game. My former teammate and great friend, Jeff Maierhofer, has invited 24 guests, mostly PSU alumni, to join us in a club suite at the Philadelphia Union’s stadium tonight. Two of Susan’s former players are freshmen at Virginia Tech. A party is immediately ahead and it’s going to be fun. The Eagles won the season opener last night and son, Kyle, is coming home for the weekend. Feeling good… I’m checking in happy!
Hope you are doing great!
Enjoy your weekend!
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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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