October 30, 2020
By Steve Blumenthal
“It is not the critic who counts: not the man who points out how the strong man stumbles
or where the doer of deeds could have done better,” Theodore Roosevelt explained.
“The credit belongs to the man who is actually in the arena, whose face is marred by dust
and sweat and blood, who strives valiantly, who errs and comes up short again and again,
because there is no effort without error or shortcoming, but who knows the great enthusiasms,
the great devotions, who spends himself for a worthy cause; who, at the best, knows, in the end,
the triumph of high achievement, and who, at the worst, if he fails, at least he fails while daring
greatly, so that his place shall never be with those cold and timid souls who know neither
victory nor defeat.”
– Theodore Roosevelt, Paris Speech 1910
In the arena there are millions of small business owners, men and women who are striving valiantly and coming up short. An unforeseen shock. And if they fail, the fire inside does not go out. They—we—get up, jump back into the arena, and create some more. That effort is the heartbeat of America and many places around the world. We’ll get through this and be stronger for it.
But you must be aware of the significant risks that affect your portfolio, your wealth, and your retirement. “If you know where to not make mistakes, you have a better chance of avoiding catastrophes,” a corporate risk consultant said to me this week. With valuations near record highs, interest rates near record lows, and the level and quality of debt a mess, oh boy, do we see risk.
Harry Truman, Doris Day, Red China, Johnnie Ray, South Pacific, Walter Winchell, Joe DiMaggio… Joe McCarthy, Richard Nixon, Studebaker, television, North Korea, South Korea, Marilyn Monroe… Eisenhower, vaccine, England’s got a new queen, Marciano, Liberace, Santayana goodbye…
We didn’t start the fire, it was always burning, Since the world’s been turning…
Fed, Congress, Fiscal Spend, QE to the Very End… Blue Wave, Red Wave, MMT… Fake News, Real News, TV’s Got the Best of Me…
We’ll figure it out. Along the way, it’s going to be bumpy. The place on which to focus most is the debt markets. A wave of defaults is rolling our way. Today, let’s take a look at what that means, how we can protect ourselves, and where the epic investment opportunity that will present will show up. I believe we are nearing the tipping point. Two months or two years? I don’t know, but it’s coming.
“No central bank wants to admit that it’s out of firepower.
Unfortunately, the U.S. Federal Reserve is very near that point.”
– Former New York Fed President Bill Dudley (Bloomberg)
The Greenspan Put
In the Greenspan put the holder is implicitly all market players and the counterparty is the Federal Reserve with an “obligation” to buy at an above-market price. The obligation was not, in this case, contractual but an implicit or expected willingness of the Fed to buy assets at prices well above the going market rate in case of a crisis.
During Greenspan’s chairmanship, when a crisis arose and the stock market fell more than about 20%, the Fed would buy bonds essentially without limit at high prices, lowering the Fed Funds rate — sometimes to the point of making the real yield negative — and bailing out the holders of bad assets. The Fed added monetary liquidity and encouraged risk-taking in the financial markets to avert further deterioration.
The Fed first engaged in this aggressive expansion of liquidity and purchase of otherwise sinking assets after the 1987 stock market crash, which prompted traders to coin the term Greenspan Put.
The Greenspan Put — the expectation of a Fed bailout of private parties in case of market decline — created substantial moral hazard: knowing that they could sell sinking assets to the Fed traders would take on risks with high upside possibilities while ignoring the downside risk because it was likely to be absorbed by the Fed.
The Fed also injected funds to avert further market declines associated with the savings and loan crisis and Gulf War, the Mexican crisis, the Asian financial crisis, the LTCM crisis, Y2K, the burst of the internet bubble, the 9/11 attacks, and repeatedly from the early stages of the Global Financial Crisis to the present.
The Fed’s pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. Investors increasingly believed that in a crisis or downturn, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the perception became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking. Joseph Stiglitz criticized the put as privatizing profits and socializing losses and implicates it in inflating a speculative bubble in the lead-up to the 2008 financial crisis.
Keep the next chart top of mind: The Elite Eight Versus Historic Bubble Composite. The stocks are Amazon, Apple, Microsoft, Alphabet (Google), Facebook, Netflix, Tesla, and Nvidia. They have risen from around $1 trillion to $8 trillion in eight years. (Source: Ned Davis Research)
And keep Dudley’s quote top of mind as well: “No central bank wants to admit that it’s out of firepower. Unfortunately, the U.S. Federal Reserve is very near that point,” says the former president of the New York Federal Reserve Bank.
The Greenspan Put, the Bernanke Put, the December 2018 Powell Pivot, and today’s Powell Put. All ye with endless faith in the Fed, I recommend a re-read of the Greenspan Put above. The Fed is in control until they are not in control.
Another financial crisis will present when confidence is lost. The system is extremely leveraged, margined up with investors heavily concentrated in too few names. This is what a bubble looks like. Great companies, bad valuations. Buy low, sell high. Buy low is coming.
Grab that coffee and find your favorite chair. We’ll look at debt and how to risk manage to minimize loss. An outstanding opportunity will present when the system clears. More defense than offense (hedges, risk management, and diversification). Note: Last week, I promised you the Q&A from the Bob Farrell-David Rosenberg research call. It was excellent, but I’m pressed on time and late to get this post to my edit and compliance team, so we’ll do a quick refresh today and bump the Q&A notes to next week.
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:
- Debt and Risk Management
- Scott Minerd – In the Eye of the Storm
- Trade Signals – WWPD: What Will Powell Do?
- Personal Note – Healthy Debate
“While few could have foreseen the pandemic’s toll on the economy, the depth of investors’ pain from
corporate distress was all too predictable. Desperate to generate higher returns during a decade of
rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening
loopholes, and turned a blind eye to questionable earnings projections. Corporations, for their part,
took full advantage and gorged on astronomical amounts of debt that
many now cannot repay or refinance.”
– Jeremy Hill and Max Reyes,
“Bond Defaults Deliver 99% Losses in New Era of U.S. Bankruptcies,” Bloomberg
It’s that last part, “many now cannot repay or refinance,” where we find ourselves now.
Bloomberg News published an excellent article explaining what’s going on in a way most of us can easily understand. This, from “Bond Defaults Deliver 99% Losses in New Era of U.S. Bankruptcies:”
More and more, these are the kinds of scraps that bondholders are fighting over as companies go belly up.
Bankruptcy filings are surging due to the economic fallout of Covid-19, and many lenders are coming to the realization that their claims are almost completely worthless. Instead of recouping, say, 40 cents for every dollar owed, as has been the norm for years, unsecured creditors now face the unenviable prospect of walking away with just pennies — if that.
While few could have foreseen the pandemic’s toll on the economy, the depth of investors’ pain from corporate distress was all too predictable. Desperate to generate higher returns during a decade of rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening loopholes, and turned a blind eye to questionable earnings projections. Corporations, for their part, took full advantage and gorged on astronomical amounts of debt that many now cannot repay or refinance.
It’s a stark reminder of the long-lasting repercussions of the Federal Reserve’s unprecedented easy-money policies. Ultralow rates helped risky companies sell bonds with fewer safeguards, which creditors seeking higher returns were happy to accept. Now, amid a new bout of economic pain, the effects of those policies are coming to bear.
The loose lending terms that investors have agreed to mean that by the time corporations file for bankruptcy now, they’ve often exhausted their options for fixing their debt loads out of court. They’ve swapped their old notes for new ones, often borrowing against even more of their assets in the process. Some have taken brand names, trademarks, and even whole businesses out of the reach of existing creditors and borrowed against those too. While creditors always do worse in economic downturns than in better times, in previous downturns, lenders had more power to press companies into bankruptcy sooner, stemming some of their losses.
“We’ll see companies gradually hitting the wall — it’s just a question of when and how fast,” said Dan Zwirn, founder of Arena Investors, a $1.7 billion investment firm with an emphasis on credit. “There’s just going to be way more downside.”
Put me in Zwirn’s camp. I have traded the trends in the HY bond market for nearly 30 years. There have been three epic investment opportunities. The first presented when I was a young 30 years old. Michael Milken, the father of the high-yield junk bond market, and Drexel Burnham were in trouble. Drexel failed and Milken served jail time. It was in the early 1990s—recession occurred, and the high-yielding, high-yield bond market dropped about 40% in price.
- Three epic declines: 1990, 2000-01, and 2008.
- The three epic opportunities presented in 1991, 2002, and 2009.
I could be wrong, of course, but I believe the coming opportunity will be the GOAT (greatest of all time). Pain for some, opportunity for others. I sit patient and ready.
What to Look for and What You Can Do to Protect Your Backside
First, let’s take a look at yields. We were getting 22.5% yields when we bought back into the HY market in late 2008. That was the best of the three opportunities.
In 1999, I remember one client in particular who was upset about 10% yields and her account’s performance, which was up over 30% the prior two years. She transferred her account to a Merrill Lynch broker in December of 1999 to invest in what she was told were “safe stocks.” She was nearly 70 years old then and being up 30% in two years looked small in comparison to the safe tech stocks she traded into—which were up 100% over the same period of time. Then the crash came. She lost over 60%. Meanwhile, our strategy had moved to cash and the trade back into HY funds yielding more than 20% rewarded us well.
Assuming she stayed the course, it would have taken her 15 years to recover from that loss.
Today, yields are just 5.72%. Look at the yield history again above. I suspect we’ll see a spike similar to what occurred in 2008—maybe higher.
Might the Fed jump in and offer up the liquidity you are I are unwilling to provide? That Powell Put we touched on earlier. Is it fair for you and me to bail out other investors’ poor behavior? That’s what happens if the Fed buys the bonds and puts them on the government balance sheet. When do we say “no mas?” When confidence is lost.
In the meantime, if you currently have HY fund exposure via ETFs or mutual funds, here’s one idea of how you may navigate the storm that is, in my view, racing towards us.
This next chart plots the price of the PIMCO High Yield Fund from late 2007 to present. The green line is a simple 50-day moving price average. The trend-following rule is straightforward: When the price line rises above the green 50-day MA line, the trend is positive (a buy signal). When it’s below, the trend is negative (a sell signal). No process is perfect. Think about trading as a probability game. There will be false trades. However, avoiding the really big mistakes that typically come during recessions—where we tend to see bankruptcies and defaults—is when risk management is most important.
To be transparent, CMG does not trade using the 50-day rule. Our process is different and tends to be a little bit quicker. We use simple moving average rules and we factor in the degree of current price volatility. Based on how volatile the HY market is, based on price behavior, we use a shorter MA rule or a longer MA rule.
In the end, a 50-day or 100-day MA rule does a good job. You don’t always need to risk manage your exposure. However, I believe now is one of those times when you do.
Last thought on HY: I believe you really want to prepare for the opportunity that is coming. I think it will be the best in my 30 years of trading HY. You’ll be nervous or maybe even scared when it presents. I will be too. That’s when you’ll need to react. I know because I’ve lived it. The key is execution.
I talked about a storm that’s coming. As I was preparing this week’s letter, the following crossed my desk (via email). It’s worth the quick read.
From Over My Shoulder, by Patrick Watson and John Mauldin:
Scott is Chairman of Investments and Global CIO at Guggenheim Investments. He mentioned that the recent relative calm isn’t the end of the storm; it is just the eye. He thinks the kind of volatile conditions we saw in March and April will be back soon.
- Lack of fiscal action raises the likelihood of a negative Q4 GDP print.
- Any post-election political chaos could tighten financial conditions and further reduce consumer spending.
- High yield debt is far greater than in the 2008-2009 period and defaults are likely to worsen.
- Price activity suggests the market is “coiling” to make big moves.
- The 10-year Treasury yield’s next stop will be around 40 bps, with a good chance for 10 bps by year-end.
- Reinvestment risk will become significant with Treasury yields at or below zero and investment grade corporates around 1%.
Bottom Line: Minerd echoes what Mark Grant has been saying: rate-sensitive investors like insurance companies, pension funds, and retirees should prepare for a market in which positive yields are hard to find.
BTW, Over My Shoulder is a great and inexpensive newsletter in which John Mauldin shares research from sources he reads each week and relationships he has. There is always a gem or two of information. As you may know, Mauldin is CMG’s Chief Economist and co-portfolio manager of CMG Mauldin Smart Core and the CMG Mauldin Portfolios Platform. Mauldin Economics is John’s publishing/newsletter/conference business run by Olivier Garret and Ed D’Agostino, to which I am a subscriber. I receive no compensation for singing its praises; I’m just a big fan.
You can learn more (sign up) for Over My Shoulder by clicking here.
October 28, 2020
S&P 500 Index — 3,330 (open)
Notable this week:
Election indigestion and COVID-19 has the market on edge. Famed hedge fund investor David Einhorn said this week, “Technology stocks are in an enormous bubble.” And added, “Our working hypothesis, which might be disproven, is that September 2, 2020 was the top and the bubble has already popped. If so, investor sentiment is in the process of shifting from greed to complacency.” He may be right. I too could be wrong but it sure feels a lot like the 1999 bubble to me. The following chart from Ned Davis Research looks at the Elite Eight stocks compared to past bubble peaks in terms of time and magnitude. It looks like this:
If you are a short-term focused trader, the daily and weekly signals I watch both moved to sell signals. Sell signals trigger when the black line crosses the red line (red arrow in the bottom section of each chart):
I like to keep an eye on the above two charts but favor intermediate- and long-term trend charts. To that end, the equity and fixed income signals you’ll find below remain unchanged.
We mentioned last week that the Ned Davis Research’s Daily Trading Sentiment indicator signaled “Excessive Optimism,” which was short-term bearish for equities. Investor sentiment is now neutral. Here’s a quick look (more below):
My favorite intermediate-term indicator is the CMG NDR Large Cap Long/Flat model. The trend as measured across 24 sub-industry sectors is weakening.
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.
“It is not our differences that divide us.
It’s our inability to recognize, accept, and celebrate those differences.”
– Audre Lorde
One of the things I love most about my family and business is the opportunity to sit and debate. “Dad, what’s your opinion on socialism,” son Kyle asked recently. He’s hearing about it in school, to which I cringe.
“Imagine you have a community of ten friends,” I told him, “and that you all go off the grid (with WiFi of course) and are assigned certain jobs to help sustain the group. People are motivated in different ways. Some are motivated by money, some recognition, some from simply giving to others, and some don’t care about much at all. Four of you are working really hard, four are doing their jobs, and two are sitting around playing Xbox. If the group didn’t catch enough fish that day because everyone wasn’t pulling their weight, should Xbox Johnny and Xbox Jill get the same serving size you do?” Now, if you and your friends started a business – your money, your sweat, your twelve-hour workdays and sleepless nights, and your creation turned out to help many and make you millions, should you share your gains equally with Xbox Johnny? If he worked for you, you’d fire him. And maybe that would be a good thing for him. I’m sure you’d help your friend but steal from him the opportunity to work hard and create for himself? Free money does that.
“Capitalism isn’t perfect.” I continued, “but please show me an example in history where socialism worked.” He was thoughtful in his response, and I think we both really enjoyed the conversation. We agreed on basic needs and the need to help people who can’t help themselves. Perfect doesn’t exist and I’m open to ideas. I do believe we are on a path towards some sort of hybrid model. I vote for compassion and kindness and supporting each other, I vote for teaching others how to fish. I don’t vote for giving away free fish. I told Kyle I believe we feel better when we create and feel less well when we take.
Sometimes I come into a discussion set in my ways. Especially in situations like those, I seem to walk away having learned the most. I tell my team we are better together, and I believe that when we work collectively, we get to a better place than we would on our own. That collaboration is effective as long as there is a safe place to express one’s perspective.
As we head to the polls, I’m frustrated with how politically divided we are today, and I bet you are too. Frankly, I believe that blame rests not just with one person in Washington, but with the senior leadership on both sides of the aisle. As it relates to my friends and family, I like what Thomas Jefferson said: “I never considered a difference of opinion in politics, in religion, in philosophy, as cause for withdrawing from a friend.”
Have a great weekend and do get out to vote. Whoever you are voting for, your vote is important. Thanks for indulging me in my rant. I sure hope I did not offend you in any way. We are better together.
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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