December 18, 2015
By Steve Blumenthal
“There is a doctrine in finance called the dividend discount model. It says that the price of a common stock is the present value of its future cash flows discounted by a suitable rate of interest. Now what would happen to the calculation of the value of that stock if the rate of interest were unsuitable — if it were artificial?
Hazlitt says this: “Excessively low interest rates are inflationary because they mean that bonds, stocks, real estate and unincorporated businesses are capitalized at excessively high rates, and will fall in value even though the annual income they pay remains the same, if interest rates rise.”
If interest rates were artificially low, it would follow that prevailing investment values are artificially high. I contend that they are, and you may or may not agree. But you must allow the observation that we live in a kind of valuation hall of mirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates would be in the absence of central-bank manipulation. Natural interest rates — free-range, organic, sustainable — are what we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones we have.”
-James Grant
There is a battle going on between deflation and inflation. Right now, deflation is winning. It is winning globally. In the extreme, neither is desired, yet perhaps the worst of the two is deflation as it leads to depression. The global central banks are fighting to create inflation and it is fight that I think they will ultimately win (though it may take years).
I just reread a piece I set aside more than a year ago. It is entitled, “What Henry Hazlitt Can Teach Us About Inflation in 2014,” by James Grant. Grant is the author of many books and pens the popular Grant’s Interest Rate Observer newsletter.
Given the Fed’s tiny baby step move towards normalizing interest rates this week, Hazlitt’s thinking seems particularly apropos today.
Inflation you say? Yeah, what inflation? Let’s look back in history to an interest rate time somewhat similar to today.
Grant wrote, “With this in mind, let’s hear from Hazlitt himself, master of economic clarity. Here he is in June 1946 — in the New York Times, no less — taking the government to task for its misplaced worry about a return to the 1930s.”
“A Washington correspondent of the Wall Street Journal reports that the government economic experts are now convinced the ‘deflation’ and not inflation will be the big problem six months to a year from now,” Hazlitt began. “Planners of federal financial policy make no secret of their belief that the danger of post-war inflation was passed in late spring, and that from now on the greater danger lies in too-rapid deflation. Such a belief on the part of the government planners in Washington would not be surprising, the whole economic philosophy they have adopted leads them to believe that ‘the real danger is deflation,’ whatever the evidence may be on the other side.”
In 1946, as now, the government held up the threat of deflation to justify a policy of ultra-low low interest rates and easy money. Now, ladies and gentlemen, I have devoted 31 years of my life to writing about interest rates, and I have to tell you that I can’t see them anymore. They’re tiny. And so they were in 1946. Then, as now, the Fed had been conscripted into the government’s financial service. Just as it does today, the central bank pushed money-market interest rates virtually to zero and longer-dated Treasury securities to less than 3 percent. Just as it does today, the Fed had its thumb on the scales of finance.
Hazlitt urged the government to remove it:
When interest rates are kept arbitrarily low by government policy, the effect must be inflationary,” he wrote. “In the first place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is the rate that would be established if the supply and demand for real capital were in equilibrium. The actual money interest rate can only be kept below the natural rate by pumping new money into the economic system. This new money and new credit add to the apparent supply of new capital just as the judicious addition of water add to the apparent supply of real milk.
Hazlitt concluded that “the money rate of interest can be kept below the real rate of interest only as long as the supply of new money exceeds the supply of new real capital. Excessively low interest rates are inflationary in the second place because they give an excessive stimulation to the volume of borrowing.”
Why, I could quote those perfectly formed sentences in Grant’s article today (and I believe I just might). They’re as timely now as they were during the administration of Harry S. Truman. The effective federal funds rate has been zero for well nigh six (seven now up until this past week) years.
There is a doctrine in finance called the dividend discount model. It says that the price of a common stock is the present value of its future cash flows discounted by a suitable rate of interest. Now what would happen to the calculation of the value of that stock if the rate of interest were unsuitable — if it were artificial?
Hazlitt says this: “Excessively low interest rates are inflationary because they mean that bonds, stocks, real estate and unincorporated businesses are capitalized at excessively high rates, and will fall in value even though the annual income they pay remains the same, if interest rates rise.” (Reread that last sentence).
If interest rates were artificially low, it would follow that prevailing investment values are artificially high. I contend that they are, and you may or may not agree. But you must allow the observation that we live in a kind of valuation hall of mirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates would be in the absence of central-bank manipulation. Natural interest rates — free-range, organic, sustainable — are what we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones we have.
Hazlitt understood the effects of these intrusions in the market. More than that, he was able to explain them in words so simple, yet so elegant, that the proverbial milkman in Dayton could follow his argument. What a remarkable man he was, and how well it would suit us all to live more closely to his example.” (Source)
Amen to that…
My favorite valuation measure is Median PE, which is based on the prior 12 months of reported earnings. I have month-end PE data back to the 1970’s. We can look at any month-end value and see what the annualized total return was for the S&P 500 over subsequent 10 years. When median PE was low, your annualized returns were high. When high, your annualized returns were low. Red arrows point to expensive valuation periods and what happened 10 years later. Green arrows to bargain periods. The bottom red arrows show where we are today.
If you would like, pick a few dates and send me a note, I am happy to send back to you what the subsequent 10-year annualized return turned out to be. Like me, I believe you’ll find this process to have proven highly predictive.
I don’t know when we’ll get inflation but I do believe we’ll see it sometime within the next 10 years. Right now, the developed world is fighting a debt deflationary spiral coupled with aging demographics issues. Not a good combination for strong growth. We are still looking at a sub-par GDP in the 2% range.
In the “what we do know” category are the following: We know that there has never before been a period in time when interest rates were held at zero percent for so long. We know that it is extremely unusual to see central bankers (Fed, ECB, JCB, and China) actively engaged in the securities markets (purchasing bonds and even stocks). We know that such behavior tends to distort price discovery. What we do know is that asset prices are inflated.
In the last several On My Radar posts, I have written about beautiful or ugly deleveraging and Mohamed El-Erian’s T Junction (he sees a 50/50 chance of a successful handoff from Fed activity to political leaders putting in place structural reform). It is the important fight we must win to soft land the debt mess. I see it more like 25/75. Washington has been and remains frozen. It may take a crisis-like event to unfreeze them. Don’t know. We’ll have to wait and see and continue to measure the evidence as it comes our way.
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
Today, let’s take a look at a few predictions for 2016 and keep and take a look at what I believe are the most important charts (recession watch charts) for us to keep an eye on in the year(s) ahead. I also threw in some 2016 prominent market strategist predictions published in last week’s Barron’s. I’ll share mine with you next week.
Included in this week’s On My Radar:
- Various 2016 Predictions – Barron’s
- It’s back: A bad S&P 500 Data Point Last Seen at Dot-com Bust
- Recession Watch Charts – Global Recession (yes), U.S. Recession (no)
- Concluding Thought – A Very Different Interest Rate Cycle
- Trade Signals – Christmas Rally?
Various 2016 Predictions – Barron’s
BARRON’S SURVEYS a group of prominent market strategists at big banks and major investment firms each September and December, to gauge their outlook for stocks, bonds, and the economy in the months and year ahead.
A year ago, the pros predicted stocks would rally 10% in 2015; that target seems far-fetched today, with just 8 trading days left in the year. Here are their 2016 predictions:
- Of the 10 stock market strategists interviewed, the highest 2016 target price for the S&P 500 is 2500, the lowest is 2100
- Five strategists predicted 2200
- The Street’s seers expect S&P 500 earnings per share to rise just 5% next year, from this year’s estimated $118. Their mean forecast for 2016 is $123.50.
- Last December, these seers were more upbeat, expecting earnings to climb 8% in 2015.
- On an aggregate basis, corporate earnings are flat this year, and could turn negative when all of the data are in.
- The strategists expect earnings growth to be the key driver of stock prices in the new year. Few foresee an expansion of the market’s P/E multiple, and some think the P/E will contract.
- The strategists’ measured view is apparent, as well, in their newly narrow focus on just two industry sectors—financials and technology—that seem poised to outperform in the coming year.
- Worries about a persistently strong dollar, sluggish global growth, and plunging commodity prices have weakened the attraction of most other sectors.
- A year ago, pros predicted the S&P 500 would rally 10% in 2015. That won’t happen with just 8 trading days left in the year. The S&P 500 is down approximately 1% ytd though noon today.
- Wall Street’s experts see little likelihood that the U.S. economy will reach “escape velocity” in the months ahead. Instead, they think industry and investors will have to learn to live with relatively meager annualized growth of 2.5% in gross domestic product.
Here is the breakdown:
Source: It’s Back: A bad S&P 500 Data Point Last Seen at Dot-com Bust (CNBC)
Each week in Trade Signals (below), I post the CMG/NDR Large Cap Momentum index. It is a weight-of-evidence approach that looks at the markets trend and also measures the markets breadth (how many stocks are moving up or down). It moved to a sell signal on June 30, 2015 and remains in that position today.
So the following article from CNBC (sent to me from a good friend) caught my eye and I share it with you today.
“The S&P 500 has a big performance issue that should be a focus for investors: Too much of the index return is coming from too few of its stocks.
The 10 most valuable companies in the market are up roughly 21.4 percent as a group this year, versus a loss of 2.6 percent for the rest of the stock market.
That 24 percentage-point spread between the biggest stocks and the index as a whole is the widest since 1999, heading into the dot-com bust.
“If narrow leadership stumbles, there’s not much support,” said S&P Capital IQ strategist Sam Stovall.
That leadership comes primarily from a few tech stocks.
Shares of Microsoft, Amazon.com, Alphabet and Facebook have led the way, while Johnson & Johnson, Berkshire Hathaway and ExxonMobil have turned in lackluster performance. The only non-tech stock to deliver among the biggest S&P 500 stocks is GE.
“A widening of the spread between the market’s best performers and the rest of the market should be viewed as a cautionary sign,” wrote Jason Trennert of Strategas Research Partners in a recent note to clients, citing research conducted by Strategas partner and chief technical analyst Chris Verrone.
The S&P 500 margin expansion story is as troubling. In the post-2009 bull market, half of the margin growth in the index has come from tech stocks — 69 companies out of the 500. And 20 percent has come from Apple alone, according to recent research from Goldman Sachs.
The data is critical for an investor’s next steps, because the maxim to “Sell in May and go away” turned out to be prescient — with a flat market over the past six months — and now is when investors can make choices in time for winter months that typically lead upward moves in stocks, Stovall said.
Goldman Sachs strategist David Kostin wrote in a recent note that the moves in tech and Apple made sense because the industry, led by its most valuable company, was sharply improving profit margins, but that widening in margins is expected to slow down in the next year.
Kostin predicts a “bifurcated market” in which the overall market will look flat but there will be clear gaps between high-performing consumer cyclical stocks focusing on U.S. markets and U.S.-based industrial companies hurt more by economic weakness in export markets.
But here’s what really matters for investors: Goldman could only identify 28 companies in the S&P 500 that it thinks can continue to expand profit margins by at least 0.5 percentage points of sales in 2016 and 2017 — expanding margins is the key to growth in a sluggish global economy. And among the 10 stocks responsible for the huge spread in index returns this year, only Amazon and Alphabet make the cut. And despite the outlook for higher interest rates, which leads to expectations of better returns for bank stocks, not one financial services company is on the Goldman list.”
Here is the link to the full CNBC article.
♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦
Recession Watch Charts – Global Recession (yes), U.S. Recession (no)
These are the important recession watch probability indicator charts I’m keeping an eye on. I’ll post them in future pieces, especially when there is a meaningful signal. Send me a note if you have any questions on how to read them.
The reason recessions are so important to get in front of is that the most severe market declines come during recessions (declines have tended to be greater than 40%).
1.) Global Recession – Highly Probable a Global Recession Has Started (yellow circled area is above the dotted red line. Historically, recession has happened 84.83% of the time the reading was above 70). Recession is typically defined as a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.
2.) U.S. Recession Watch – Currently Signaling No Recession
3.) Employment Trends as a Recession Watch Indicator
Note the correct signals at 100%. Of course, NOT A GUARANTEE. Also note that it tended to lag just a month or so from the start (down arrows) and from recovery (up arrows) – but all in all pretty close.
4.) Data on the Employment Trends Index (above chart) – signals occur when the red line crosses the dotted line (a zero).
As mentioned, let’s keep a close eye on the above charts in 2016.
Trade Signals – Christmas Rally?
Click here for the link to Trade Signals (updated charts and commentary).
Concluding Thought – A Very Different Interest Rate Cycle
We are looking at a very different interest rate cycle. Seven years of zero interest rate policy is now behind us (at least temporarily) and we need to remember that this is an important shift.
2015 is turning out to disappoint your and my expectations for above average or at least average returns. It has been a challenging environment for both stocks and bonds. Several periods of sharp decline have made it challenging for tactical momentum strategies. The technology has been and appears (for now) to continue to be a bright spot.
The commodity bear market that began in 2011 spiked lower in 2015 with oil taking the hardest hit. Slowing global growth and a glut of supply has caused an oil price collapse that surprised even the most bearish analysts. EM, International equities, materials, metals and commodities have had a difficult year. From a tactical perspective, it has been important to avoid those exposures.
A bright spot for the year has been the managed futures space doing well after several years of subpar performance. Though I imagine allocations to such strategies to have been underweight in most portfolios.
I’ll share my predictions (always a tough task) on 2016 and some ideas around portfolio construction in next week’s piece. I do see some pockets of opportunity.
To that end, I was in Investor’s Business Daily a few days ago with a three speculative ETF ideas. Here is the link to the article (important note: not a specific recommendation for you. No guarantees. Risk of loss.)
Here is a quick wish to both you and me (mostly me) to keep our pre-holiday last minute shopping stress low.
Have a wonderful weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
Social Media Links:
CMG is committed to setting a high standard for ETF strategists. And we’re passionate about educating advisors and investors about tactical investing. We launched CMG AdvisorCentral a year ago to share our knowledge of tactical investing and managing a successful advisory practice.
You can sign up for weekly updates to AdvisorCentral here. If you’re looking for the CMG White Paper Understanding Tactical Investment Strategies you can find thathere.
AdvisorCentral is being updated with new educational resources we look forward to sharing with you. You can always connect with CMG on Twitter at@askcmg and follow our LinkedIn Showcase page devoted to tactical investing.
A Note on Investment Process:
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.
Trade Signals History: Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of years ago, I found that putting pen to paper has really helped me in my investment management process and I hope that this research is of value to you in your investment process.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. Mutual Funds involve risk including possible loss of principal. An investor should consider the Fund’s investment objective, risks, charges, and expenses carefully before investing. This and other information about the CMG Global Equity FundTM, CMG Tactical Bond FundTM and the CMG Tactical Futures Strategy FundTM is contained in each Fund’s prospectus, which can be obtained by calling 1-866-CMG-9456 (1-866-264-9456). Please read the prospectus carefully before investing. The CMG Global Equity FundTM, CMG Tactical Bond FundTM and CMG Tactical Futures Strategy FundTM are distributed by Northern Lights Distributors, LLC, Member FINRA.
NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Hypothetical Presentations: To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the model if the model had been used during the period to actually mange client assets; and, (3) CMG’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model. Please Also Note: Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (i.e. S&P 500 Total Return or Dow Jones Wilshire U.S. 5000 Total Market Index) is also disclosed. For example, the S&P 500 Composite Total Return Index (the “S&P”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. Standard & Poor’s chooses the member companies for the S&P based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The historical performance results of the S&P (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10 year period would decrease a 10% gross return to an 8.9% net return. The S&P is not an index into which an investor can directly invest. The historical S&P performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet, his/her investment objective(s). A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professionals.
Written Disclosure Statement. CMG is an SEC registered investment adviser principally located in King of Prussia, PA. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at (http://www.cmgwealth.com/disclosures/advs).