December 11, 2018
Hosted by
Steve Blumenthal
Executive Chairman, Chief Investment Officer, and Co-Portfolio Manager
John Mauldin
Chief Economist and Co-Portfolio Manager
Brian Schreiner
Senior Vice President, Private Wealth Group
Transcript
Brian: Good afternoon. Thanks for joining us today. My name is Brian Schreiner. I am Vice President of our Private Wealth Group here at CMG Capital Management Group. Before we get started, I wanted to let you know that you are muted and in listen-only mode today. If you have a question, you can either type it into the Q and A, which is located at the bottom center of your screen, or at the end of the webinar, we’re going to offer our contact information so you can reach out to us directly. In a moment, I’ll introduce our speakers. But first, I want to give you a brief background on our firm, CMG, and also a quick rundown of what we’re going to cover in today’s webinar.
CMG was founded in 1992. We’re an SEC Registered Investment Advisor located in King of Prussia, Pennsylvania, just outside Philadelphia. CMG works with a select team of independent advisors, individuals, and institutions who require access to best-in-class investment and risk management strategies to create and safeguard wealth, augmented by partnerships with world-renowned thought leaders and investment managers.
Since our founding, CMG has embraced the application of rules-based active investment strategies with the goal of preserving our client’s assets — available to you in both mutual funds and separately managed accounts. Now, the markets have been under considerable pressure the last several months. John Mauldin has been writing about debt and pension issues. He calls it “The Great Reset.” Steve Blumenthal has been writing about “The Challenges at the End of the Long-Term Debt Super Cycle.”
In today’s 2019 presentation, John and Steve are going to address what they feel are the most pressing issues they believe you should focus on in the New Year. Specifically, I’m going to ask my co-hosts, Steve and John, to address the top eight or nine topics so that we can gain a good understanding of how they expect the economy and markets to perform in the coming year.
Steve Blumenthal is the Executive Chairman and Chief Investment Officer here at CMG. Mr. Blumenthal founded our firm in 1992. He began his career at Merrill Lynch in 1984 and has over 30 years of investment management and industry experience. Steve is Co-Portfolio Manager of the CMG Mauldin Smart Core Strategy.
John is CMG’s Chief Economist and Co-Portfolio Manager of the CMG Mauldin Smart Core Strategy. John is also a New York Times bestselling author and pioneering online commentator and publisher. John and his staff at Mauldin Economics, proudly host the annual Strategic Investment Conference, an annual gathering of some of the world’s most brilliant economists, analysts, and money managers. This year, the conference was held on May 13th through the 16th in Dallas, Texas. We’ll be hearing more about the conference in the coming weeks.
Okay, let’s get started. Steve, first question is for you. Recent headlines have been warning of slowing growth in the US. Other headlines express concern about the trade, the yield curve and the Fed. Recently, the IMF reduced its global growth forecast for 2019. Mark Yusko of Morgan Creek says, “The chance of recession in 2019 is close to 100%.” Dennis Gartman puts the probability at 50%. So given where we sit today, what’s your probability of a recession in the US in 2019? What data and signals do you track to determine that view?
Steve: Brian, thank you, and a special thank you to you for joining us today on the webinar. Brian, I’d put the risk of recession at 40 to 50 percent, but really that’s just a guess. It’s kind of data dependent as they say. I believe it’s really important to know that our initial investment starting conditions matter in terms of both the risks that we face and in terms of the returns we’re likely to receive over the coming seven to 10 years.
First, we currently sit late in an economic cycle, all economic cycles. You have expansion periods and they end with recession. The longest expansion cycle was 1991 to 2001. It lasted 10 years or 120 months. The average since 1854 is 40 months and then recession, then expansion, then recession. The 2001 post-recession recovery lasted 80 months. It, of course, ended with the great recession in a way. We are 114 months into the current expansion, the longest 120 months. This is the second longest in history. Recessions always follow. The problem with recession is that the stock market declines on average of about 37%. The last two got us minus 50% each.
John and I have both written about Ray Dalio’s book, specifically about the difference between normal business cycles and long-term debt accumulation cycles. Most of us are familiar with these short-term cycles, one or two recessions every year, every 10 years since 1950, but few of us have witnessed a long-term cycle. The last was in the 1930s. Bottom line: we’re late stage, late cycle. I’m uber-focused on recession because I think that that’s where the big risks will present.
Brian: John, I’d like to bring you into the conversation. Steve, were you finished there?
Steve: No, no, go ahead.
Brian: Okay, good. Well, John, I want to bring you in here. On November 16th, you wrote about the Federal Reserve’s interest rate policy and their commitment to reaching the so called “natural rate of interest.” Meaning, the interest rate that the market would set absent the Fed’s interventions. You said at that time in mid-November that your personal belief was that we were very close to that point. The first part of my question for you is this: Do you still believe that the interest rates today are near their natural rate? And then secondly, what do you think is the most likely path for the Fed in terms of raising rates in the coming year?
John: Thank you, Brian. Again, thanks everybody for listening. I do think that we’re close to the natural rate. I believe the Fed, we’re two days out from a Fed meeting. It looks likely they’re going to raise rates at the December meeting. I think they will raise rates one more time in the first half of next year. My gut tells me they’re going to wait through December to get some, I mean through January meeting, to get to December data really embedded so they can see how much the economy is going to slow down. It is going to slow down.
The question is they want a little bit better handle on it. Sometimes, in the first half of next year, I think they will raise rates one more time. And then I think, quite frankly, they’re done because I think for the time we get to the second half, they’re going to see an economy that is going, is slowly receding for a lot of reasons we’re going to talk about later. I actually think after they raise rates next year, the next move will make, in terms of rates, will actually be down, not up.
Steve: One of the indicators that I watch every month from Ned Davis Research is the Global Recession Probability Model. It’s on the screen right here. The Fed’s got to be factoring in. So, what this model does is it measures leading indicators across 35 countries, and based on those indicators, if you follow this blue line, it ranks the probability of recession. It’s done a pretty darn good job at calling the periods of recession. The gray bars that you see are those periods of recession. In simple terms, if you look at the red arrow and the yellow highlight, that was last month’s reading, the end of November. Any reading above that red dotted line of 70, when that’s occurred, 90.91% of the time we’ve been in recession.
I have to believe that that’s a global recession. The US economy here really looks pretty good and we’re going to look at that next. But, your thoughts, John, on how the Fed is factoring in what’s going on globally and how that impacts ultimately our economy.
John: Thank you. The one thing I would point out on this chart, and it is a very useful chart, is every time the indicator has gotten to this level, it doesn’t indicate a coming global recession. It says we’re in one. Let’s go back and look at every one of the gray bars. For the time it got to there, we were already in a global recession. It’s a weakness of economists. We only know we’re in a recession when we look back over the past data and they go, wow, we were in a recession. I remember it was like in 2003 or four that NBER who are the official recession accounting group went back to the… By the way, there was a quarter in 2000 that we were in a recession just for one quarter. It was three years later they tell us this.
Now, it didn’t change anybody’s trading when they announced it and nobody noticed it because it was three-year-old news. But, economists are pretty bad at this thing. We’ll find out whether we’re in a recession or not. Is the Fed watching that? Absolutely, because the longer this expansion goes and the further the effects of globalization go, it means that we’re really all in this together. The effects from the rest of the world will have an impact on what happens in the US and for the Fed not to be paying attention to that. Somehow or another, to think we’re an island unto ourself is not just in the cards. We will be impacted by what happens in the world.
Steve: So, there are a number of recession indicators, like post five of them every week on Wednesdays in my Trade Signals blog. One of those indicators is this employment trends index. What I like about it, so we don’t know a recession until we have two back-to-back quarters of negative growth. We’re not going to know that for six, seven months from now. It’s important to get in front of those periods because that’s when the bad stuff happens in recession to equity prices. Well, this particular indicator is one of the five that I post, and it looks at the year-over-year change in the employment trends index. Just focus in on the bottom section of the slide with the yellow highlights and the red arrows. Every time that the year-over-year change in employment trends has dropped below zero or turned negative, recession has followed. So, it’s been good, none of these are perfect. This has been a pretty good indicator and the bottom line with this one, if you look at the “We are here” arrow, currently, the employment trends in the US are pretty good.
This next chart looks at the yield curve. You’re hearing a lot about that. We’ve gotten a lot of questions and a few interviews in the last week or so about the yield curve inverting. John, I remember you writing about the yield curve in 2000 when it inverted and the probable recession. What this shows is the difference in the yield between, again, focus on the bottom section, the difference in the yield between the six-month Treasury bill and the 10-year Treasury note. When short-term yields are higher than long-term yields, it’s called an inversion. It’s measured on this chart, the times that it’s happened or when it drops below the dotted green line. We’ve highlighted that in yellow circles. And then, I also put an arrow underneath those numbers. What happens is, typically, it’s nine to 12 months, and the mean has been 15 months between the time of an inversion and the time that recession happened. It’s a good tool, an early warning system tool to the economy and something that we can follow. John, do you have any additional comments?
John: Well, I mean, I have probably written about the yield curve as much as I’ve written about anything over the last 19 years. The original data was written by Campbell Harvey. He was a professor when he did his Ph.D. study back in ’82. He did another study in ’86. Strehlow picked it up with the paper. He did it before he joined the Fed. This is history just so you know. Sthrelow in Michigan did a paper for the Fed in 1996 without crediting Campbell. He’s only a little bitter about. But, they demonstrated that out of 20 indicators, the yield curve inversion is the only one that’s reliable as a predictor of indicators. I called him about that and he indicated that he’s since done another private study, which I read at the time. He actually uses 30 different indicators and none of them were as useful as an inverted yield curve, but it’s always nine months, 12 months, 15 months ahead.
If you’ll notice from looking at this chart, the yield curve is actually nearly always turned positive before we actually go into recession. I will tell you painfully because we’re bringing up bad memories. I called the recession after the yield curve inverted and the markets promptly went up anywhere from 10 to 20 percent after I called the recession. I said there was a recession coming. You need to get out of the market. We haven’t even really started the process of inverting. The 3’s and the 5’s were inverted for few days and everybody was running around talking about the sky falling.
We are in the beginning of an inversion. The Fed’s going to raise rates a couple more times. That’s why I don’t think they’re going to raise it three or four times like they were forecasting three or four months ago, because that would be them inverting it on purpose. I think they’re going to allow it to just naturally do that and then they will be more alert and they will be quicker to begin to solve the monetary policies than they’d have been in the past. But I just think that’s Powell’s modus operandi. We need to be aware that we could have a market melt-up very easily while the yield curve is inverting or even after it’s actually inverted the 2’s and the 10’s.
Steve: Thank you. That’s really helpful. Well, we’re talking about an outlook for 2019 and the reason that staying in front of a recession is important. Currently, bottom line: the market is late cycle, the economic expansion is aged, the market is overvalued, some more defense than offense. What this is telling us is that we’ve got some time. The economy, the US economy is basically in good shape. That doesn’t mean we can’t have non-recession bear markets — that can happen. The average decline in a non-recession bear market is 23%. I think we were down as much as 10% just recently. But, this is relatively good news as it relates to the US economy so far.
Brian, we touched on the Federal Reserve policy. We can see the Fed is, it’s probably another important message to where we are in our starting conditions. These are entirely different investment environment with the Fed that is raising rates. In fact, they raised them eight times, as opposed to the QE that the world has lived off of and zero interest rate policy that lasted from 2009 all the way to 2016.
Brian: Steve, thank you and thank you, John. Let’s turn the conversation outside the US now. First, turn towards Europe. John, I think many of us, including myself, depend on you to decipher news coming out of Europe and the rest of the globe. When it comes to Europe, there are so many topics today that present themselves as both real risks and headline risks for investors in the global economy. Frankly, I’m not sure where to start. Let me ask you. On your list of concerns, if you would just name maybe the top three and discuss what you see as the main concerns in Europe as we move into the New Year.
John: First, I think I would have to say the ECB is beginning to remove their accommodation. They’re reducing the amount of, call it QE, they’re doing each quarter. Pretty soon, they will be down to… They’re putting no more money into the world, into Europe and into the world. You got to realize that there was a time when we had four major central banks who were all doing QE. Now we’re down to two. Pretty soon, we’re down to one, and the Bank of Japan has reduced theirs. All of that stimulus is going away. Frankly, when the European Central Bank begins to raise monetary rates and they tend to go in 20 basis-point runs, so the first hike will still be negative 20%, negative 20 basis points. But, it will make a difference and it is going to change the way that banks and businesses operate in Europe. We must remember that Europe gets 80% of European businesses. They get 80% of their financing from banks. Banks are constrained right now. Deutsche Bank has a big target painted on his back.
I would not be surprised if Germany, either overtly or covertly, has to come in and rescue Deutsche. They’re not going to let Deutsche fail. That’s like letting your mother or your child or your wife to just walk into a train wreck. They’re not going to do that. That’s too much. It’s too painful for them. That being said, Italy’s banks are not high on the list of concern in Germany, in Brussels. They’re worried about them, but they’re not going to go out to rescue them. Italy has to do that. They don’t have any money. They have to get that from the ECB. The ECB is saying, “Well, if you don’t balance your budget, we’re not going to help you.” It is a game. That is my second worry — is Italy.
And now, France. France is getting ready to go past the — a line in the sand that Brussels had set. Their deficits are going to be higher and Macron is really behind the eight ball. I mean, I saw pictures yesterday, I can’t confirm them, but there were UN blue helmet troops or European troops in the streets yesterday because the French troops weren’t willing to push or fire on their own citizens. It’s a very difficult situation in France, and that’s a concern. It almost feels like the pressures in Europe. If you go around, Eastern Europe especially, you’re seeing a lot more willingness for them to push on the mandates the Brussels has, the forms of that they have. It’s almost like Europe is spinning a little bit away from whatever centralization there is.
And then on top of that, we get my third worry, which is Brexit. May is going to survive her life. They’re going to survive her in no-confidence vote, which will mean that they can’t hold another no-confidence vote for a year. But that gets her pass the hard Brexit. We walk away deadline. It’s like she’s playing a game of chicken. She’s going to wait until almost the last moment and say, “Well, you need to get a hard Brexit,” which nobody on either side in their right mind wants a hard Brexit. And she’s saying, “You need to take a hard Brexit, which is going to destroy everything and wreck everybody, or you’ve got to accept my program.” Maybe the EU looks at it and goes, okay, we’ll give you this and this and this when you get to the deadline to make it a little bit better. But the Brexit she has proposed really almost makes it more difficult for Great Britain to get rid of the ties with Europe. It gives Brussels more authority over what those look like, which is why so many people are opposing what she’s offered. Brexit is a worry. If it doesn’t get done properly, it can upset the entire European basket. As I mentioned earlier in the conversation, all of that will come and visit the US shores.
Steve was right. The US economy is slowing a little bit for basically technical reasons, but we’re okay. We’re still growing at 2% percent and we shouldn’t have a recession apart from something else shoving us into recession — Europe, China — or maybe shooting ourselves in the foot with tariffs. That’s kind of where I’m sitting right now, Brian.
Brian: Well, another story that has definitely been prominent throughout the year has been the so-called trade war with China. John, how do you see this playing out next year? Or maybe paint a couple of scenarios or possibilities on how the trade war with China may play out.
John: I think Trump is focused on the market. If you read his tweets, he was owning every time that the market went up. He says. “The markets are confirming that I’m right. They love me.” Well, now, you can’t send those tweets out. I’m sure he’s paying attention, and his economic staff has got to be saying, “Well, the market is not happy.” The uncertainty about tariffs is one of the main reasons and I think the push on him to get tariffs under his belt and away is going to be big. The market will breathe a big sigh of relief. You see China yesterday said, “We’re going to take automobile tariffs from 40% down to 15%. I mean, the negotiations had started. It would not surprise me to see some kind of tariff deal because Trump needs to signal to the markets that he’s got everything under control.
You can actually see, if you could get a positive Brexit outcome somehow in the next 30, 60 days and you get a positive tariff outcome, you can actually see a market melt-up despite all the other things that Steve and I are talking about that are concerns.
Brian: Well, John, a number of years ago, you wrote one of your most popular letters, your most popular Thoughts From the Frontline letters and it was called “Fingers of Instability”. I know you’ve republished it a couple of times over the years under the title of “Sandpiles.” Talk for a moment about the idea of these so called Sandpile in today’s global economy.
John: It was a paper done back in 1986 by three researchers in computer science. Basically, they simulated a sandpile, just like we have out on the beach. They started dropping one grain of sand onto a sandpile, seeing when you would get avalanches. It turns out these avalanches varied in size and they varied in size according to what’s known as a “power law.” I’m not going to get into the mathematics of power laws. But, they wanted to know why. So, they started noticing the condition of the grain of sand when it landed. As it turns out, the grains of sand where they randomly landed on the beach would either be stable, nestled down among its brother or be unstable. They’re kind of on the edge or chipping off. What they would notice in the various avalanches, whether they were small or large, is that you would see fingers of red. So, they call them fingers of instability that would connect all through the sandpiles. What happened in large avalanches is you would get these monster fingers of instability that would be connected, but nothing would set them off. And then one day, a grain of sand comes up, hits that sandpile, expose a finger of instability, and the entire avalanche proceeds.
The real world application to that in economics is that central banks, regulators, governments want to do everything they can to prevent even a small avalanche. It goes back to Nassim Taleb’s concept of infragility. It says it’s much better to allow small recession, small hiccups in the economy. Just let things clear. Don’t try to save companies. Don’t try to go out of your way. Let the markets clear in small ways rather than trying to stave off any problems until it builds up into this one large finger of instability. I’m mixing my metaphors here, but it’s the little Dutch boy at the dike. He runs out of fingers. And at some point, waves just come over the top of the dike, and you get large default, like the great recession. I mean, everything was set up to try to be stable. They did everything they could to keep from having problems. But eventually, the problems got so large. They overwhelmed and everything went down.
It’s not one domino. Sometimes people want to say, “Well, the great recession was caused by subprime.” No, there were lots of dominoes. So, think of it as, rather than a linear set of dominoes where you see these push one domino and the next hundred go down, think of it as a circular series of dominoes. There’s dozens of dominoes, but it’s all set up in a circle. If you could push any one of them, that would be the starting point, but they’re all going to fall down. In the next credit crisis and the next recession, whether it’s the stock market having a bear market, which creates lack of liquidity, which rolls over into the bond market, which rolls over into housing, which rolls over on and on and on and on. It could be anything. It doesn’t make any difference. That first domino that’s poked the entire circle of dominoes is eventually going to go down and we’ve been trying to prevent any domino from falling. We have a large finger of instability running through global markets right now. Does that make sense, Steve?
Steve: That is beautifully said.
Brian: Well, speaking of dominoes, I think some people look around in the markets and are wondering which is going to fall first or what’s going to be the catalyst. Steve, I was looking at a recent MarketWatch report. It was last week. What’s been amazing to me is to learn about the enormous amount of corporate debt. That’s poised to be downgraded at least potentially to junk status. Almost $3 trillion US corporate debt is rated just one level above junk. That’s almost triple the amount of 2008. This makes up almost half of the entire investment-grade bond market today. My question for you is, what implications does this have for the bond market and how should investors be thinking about bonds in their portfolios?
Steve: What I love about John’s writing and his discussion on sandpiles is that you see these pockets of instability build up. At some point, the system is unstable. And then, it crashes down and you build a new sandpile again. Well, in the financial world, the biggest risks, those pockets of red and pockets of instability, almost always is tied to leverage. Whether it is the massive amount of debt in the world at north of 350% of what we can produce. John recently pointed out, when you really add all the off balance sheet stuff in north of $500 trillion, which is in a $75 trillion global economy, that’s a lot of leverage and that’s a lot of risk.
When you lower interest rates to zero and you’re an investor that was used to savings accounts at your bank, used to CDs or other forms of investment, where do you go to get return? So much money, because of I believe the central bankers trying to keep the dominoes from falling and the QE and all the support getting interest rates all the way down to zero percent. Buying bonds, Europeans are buying bonds, the Japanese investing in bonds and also owning over 60% of their exchange-traded funds in their equities. When you start to see this sort of thing, you’re almost forcing investors to risk assets. Across every risk asset category for the most part, assets have accelerated in price beautifully. The hope was that would fuel animal spirits and the economies will recover and we would get out of it.
The problem is, as you can see from this particular chart, it also enables some instability and some bad behavior. All this money racing into high yield bond funds, corporate bond funds, leverage loan funds, also there is a new relatively new category that’s become really popular. Well, what this chart you’re looking at shows is the growth in the corporate bond market. It’s three plus times bigger than it was in 2008. Those are the two big red arrows. And then specifically, if you take a look at that BBB area, so this is the area that I think is going to create a phenomenal opportunity. We’ll talk about that next, but you’ve got so many companies that are getting financing because the money’s there, the liquidity is there. It’s easy for them to borrow. Not only is it easy for them to borrow, but they’re able to borrow in terms that don’t protect you and I as an investor.
For example, they can use money that they issue in one of their bonds to pay bonuses to their senior team. They can also put covenants in place to say, “We’re going to continue to borrow.” There’s no limit to how much where we’re going to stop. Most times, those things and those sorts of restrictive covenants exist inside of the bond structures. Well, a lot of that’s gone. Fourteen percent of the companies in the S&P 500 Index don’t have enough, three years’ worth of earnings to pay their debt, 14%. Recently, that nearly a third of the companies in the Russell 2000 Index aren’t making money. You’ve got a lot of companies that are living on borrowed debt. They’ve been able to borrow because interest rates moved to zero, investors chased out on the risk spectrum. If you look at those maroon arrows, look at the size that exist now and that BBB space. That’s one notch above of junk, and that’s why recession creates some problem when you have so much leverage in a system at some point. What I love so much of John’s explanation of sandpiles is because it applies to economies and markets quite well.
This next slide, just simply focus in on the bottom section of the chart and what it looks at, this is another chart data set that’s on my radar. I post this one also in Trade Signals each week. What it looks at is, whether or not the credit conditions are favorable, meaning is it easy for people to borrow or corporations to borrow, or our credit conditions are unfavorable. Let me add also for governments to borrow. Right now, we are here in September, a couple months ago. We haven’t changed that much. We are here also. Currently, the credit conditions are favorable. But also note that when they’ve dropped below 50 to the zone that’s unfavorable, that recession has followed post that period. It’s another one of my early warning recession charts. I think that this is really important because it plays into what I’ve been trading since the mid-1990 or the intermediate-term trends in the high yield space.
I’ve seen three outstanding investment opportunities in my nearly 28 years of trading high yield. Three of them. They’re all based around recession and circled in the center section of the chart. You see the 1991 recession. I’ll explain that in a second – the 2001, 2002 recession, and then the great reset recession or what that’s coming. Sorry John, I don’t want to steal your Great Reset, the great financial crisis reset. What that showing is the black line is charting the yield of high yield. How much more yield it’s paying than a safe Treasury bond is paying? So, you got a 10-year Treasury note or high yield. That’s the spread or the amount of interest. When you look at 1800 on the right hand side, that means that that was paying 18% more than you could get by investing in a 10-year Treasury. Well, if you’re getting 18% more, that meant that the price of a high yield bond, a typical bond, went down 40%, 30-40% in price. You’re able to buy the same bond for 60 cents on the dollar.
Well, that’s a heck of an opportunity as long as you’ve got yourself into that, in great shape to that opportunity. What I think is going to come in the next one and what I’m watching for where that red arrow is on the right-hand side is when the yield moves above 500% more than Treasurys. That’s a warning sign. Things are starting to move in that direction. I’ve been trading high yield for a lot of years and the major message that I’d like to impart, I know John’s in the same camp is — we could look at all this great reset, sandpiles and instability and problems with Italian banks and all the super leveraging corporate debts and record amounts of margin investment and investors’ accounts. All those things create the instability. But, if we have a plan and we manage to that game plan and we risk protect on the bottom, the opportunity is great. I can tell you in each of those three recessions, I was scared. When I got my buy signal, I was scared. But as a trader, you act. I learned that when I’m most scared, that’s when the best opportunity is. We had yields of 22% when we bought after the crisis in ’09.
One can see crisis. One can see opportunity. My big message is, see opportunity. I’m going to jump here quickly to this next slide and I’ll just touch on it quickly. My big concerns are: we’re late in the business cycle, US economy is still okay, and valuations are super expensive. What we’re looking at here are four popular valuation measures, but I could show you a lot and by almost every single measure, except next year as Wall Street guestimates, so what earnings are going to be, which I don’t like that metric. We’re at the second most overvalued stock market prices in history. So 2018, the “We are here” arrow, if you look at how much higher we are than we were ’07, that decline was a minus 55% decline to the equity market. Or the market in 2000, that’s the highest peak and that was the greatest bull market that the markets experienced, or 1966, the top of that bull market, or 1929.
What this is saying is it tells us nothing about what forward returns are going to be for the next year, but tells us a lot about what returns are likely to be over the next coming 10 years. That’s in the minus one, maybe +5% range, best case and investors are expecting more. We’d like to point out that the bottom section of the chart where it says, “We’d be better off here,” think about what the buying opportunity looks like. That’s what I’m excited about for the future with high yield when that sandpile does break and what that will present for equity. We’re late cycle, market is expensive and I just think we should be very risk-minded in how we approach our investments.
John: Well, that’s a very good point, Steve. We have to remember that the buying opportunities happened at the bottom of the markets when everybody is scared. It’s not just high yields, it’s equities, it’s real estate. There just one thing after another. I often like to tell people that they’re worried about having too much cash and I’d tell them cash is an option on the future. It’s money that you’re sitting there, having there. It’s not earning very much right now, but it’s going to earn a whole lot. When you bought those bonds in 22% yield, the capital gains you made over the next five or six years were phenomenal as interest rates came back down to real world numbers. That always happens. The returns that you got into the stock market from getting back when you’re at the bottom were phenomenal. I’m not looking at this and just going, “Oh my gosh.” I’m rubbing my hands and there’s going to be a sale on all sorts of assets and we get to buy cheap.
Steve: Right. There’s your concept with “the Great Reset” — to get there in good shape, to be able to take advantage of the opportunity.
John: Right.
Brian: Well, thinking about next year, it’s interesting right now as we look at the headlines. Certainly for the last few months, the news flow has definitely changed its tone. For many years, it seemed like all news was good news and now it seemed like all news is bad news. But, if you could name just one thing, John, just one thing that you might see as a possible upside surprise in 2019, what might you point out?
John: Well, I think I already pointed it out, but Trump coming in and backing off the tariffs and announcing a deal of some kind, Brexit happening, you could get an infrastructure bank. I mean, one of the things that you could get a majority of, I’m not saying they should do this, I’m not saying I’d vote for it, but you can get a majority of Democrats and Republicans together to vote for a new infrastructure bank that looks like Fannie Mae or Freddie or the Federal Home Loan Land Bank. It would have government backing. The Federal Reserve would be able to buy its bonds if they decided to do QE again. You could easily get, as these other institutions have a trillion dollars, $2 trillion, a proven programs that have to set standards around what applies, what those systems are buying, statues and parks or your favorite local politician don’t. But, you could get a lot of positive feelings because that’s what drives the market is, its feelings. You can get a lot of positive feelings about the bipartisan infrastructure bank. Frankly, the one thing we all know we need is more infrastructure. While I’m against most debt in general, at least that debt would be producing something that would have payoffs in the future, as opposed to borrowing money to pay for government programs right now that are immediately expanded and have no future value.
Brian: Steve, thinking about upside surprise, actually looking first, I guess this was an interesting chart that we came across last week. Ned Davis Research, one of our research partners, puts markets into eight big asset classes — everything from bonds to US and international stocks and commodities. But interestingly, not a single one of them is on track to post a positive return of more than 5% this year. The last time we saw this was in 1972. The first part of my question is, why do you think this happened? And then secondly, how many asset classes, if I may put you on the spot, do you think might be up 5% or more in 2019?
Steve: First, when you’re looking at this chart, if you look at the top section, you see green and all the way across, it goes up and down and certain years are better performing than other years, all the way until you get to this current year in 2018. It really sticks out as an outlier. The bottom section of the chart shows the range of return for those eight different asset classes, the best returning asset classes at the top of the bar with a little blue dash, the median return of the eight is the green mark, and the worst of the returns of the eight different asset categories is the red mark.
Why? I think that, we’ve been writing about this for some time. You really are now entering a different period. John, I remember at, this year, in March at your Strategic Investment Conference, the discussion around a Fed policy and the Fed is exiting QE and they’re cutting back on their buying. And then, when we did our fishing trip, there were some interesting things that we learned in talking to some former senior Fed chief economist in what the plan is with balance sheets. Not to get into all of that, but the discussion in March at the conference was the Fed’s backing off. But you know what? The EU is not backing off. Japan is not backing off. Collectively, the liquidity and the global system was still increasing, not decreasing. You had these four major central banks. They pumped something like a 16, 17 trillion dollars into the economy. We were four and a half of it. Now, we’re at a whole different dynamic where you’ve got everybody back in a way.
John, you mentioned, and I think is the European, is [Mario] Draghi’s bond buying. Is that stopped this December or if not, it stops within a couple months. At least they’re going to attempt that.
John: I think it was shortly after the end of the year.
Steve: Yes, so that stimulus is going away and then they’re going to let it.
John: We have to remember the Fed’s selling $150 billion. It’s not only they’re not putting stimulus in there, they’re taking it out. They’re trying to do $600 billion next year.
Steve: I remember Stan Druckenmiller saying, “It’s about the Fed. It’s always about the Fed. It will always be about the Fed.” I would add to that it’s about the Fed and the central bankers. This unique window that we haven’t seen since 1972 was probably largely driven by the inflation of the global central bank policy enabled with all sorts of asset classes, interest rates driving them down to zero, huge gain for bonds. Now, we’re trying to exit that and maybe that’s what we’re seeing in this chart.
As for next year, I have no idea. I remember, going into the year 2015, they interviewed 25 out of 25 Wall Street economists and said that interest rates were going to rise. The 10-year was at 2.75%. The average expected was for the yield to go to 3.25%. That’s bad news for bond investors when interest rates rise, bonds lose value. And 25 of 25 them were wrong. One of my favorite bond, what direction of interest rate indicators is something we post called the Zweig Bond Model, and I kept looking at that thing and it kept me on-sides. Interest rates went lower. It finished the year less than two and a half percent. It was a good year for bonds, but if you followed 25 economists.
I’m a price person. I like to see what price is telling us about the trend. I think that the game plan is continue to participate, put a stop-loss metric on everything that you own that enables you to minimize downside and get to the other side of what could be a great opportunity. No idea what the returns will be looking at next year. It really is just a guess. But overall, our starting conditions do matter and they’re not looking so good. Were richly priced, the market’s aged, the cycle’s aged and we should be careful.
John: Let me just throw a quick thing in. You’ve got 50 Blue Chip economists. They’re all from the biggest firms and they put out their forecasts. Going back for multiple decades, I don’t want to say how long, but it’s been for a really long time, longer than I’ve been following. They have never, ever once seen a recession coming. They’ve been wrong. There’s zero for however many there is. They’re going to be wrong the next time because their models don’t see those types of things.
Brian: Well, it doesn’t make sense for them, career-wise, either to predict recession. Because when they’re wrong and everybody else’s right, they’re out of the loop. They’re not going to get the next job or the next promotion.
Steve: They’re either out of a job.
Brian: Gentlemen, looking at the question submission, we’ve got 27 questions to answer. You ready to go?
Steve: Wow.
John: I think we’re running out of time, but we will get to them. We’ll look at the questions and we’ll get back to those.
Brian: Absolutely. We actually are overtime. We did mean to at least take a few questions, but since we’re over time, we don’t want to go any longer. But each and every one of you who has submitted a question, we will personally respond to you. If you have not yet submitted a question and you would like to, we will also personally respond to you. Please do contact us. You can see our email addresses. My phone number is there on the screen. You can dial that extension, comes right to this phone on my desk. Happy to answer questions about anything we’ve talked about today about Mauldin Smart Core, about CMG.
I do want to get the two quick items before we let you go. If you have not read John’s new white paper called “Mauldin Smart Core: Investing during the Great Reset”, and you would like a copy of that, please send me an email and I will respond very quickly with a link to that report. Should you be interested to read that, get my email addresses on the screen. And then finally, John, we have made it a tradition of attending your conference, Strategic Investment Conference in the past. I always loved the line-up you put together. Who do you have lined up so far? If you can tell us, I don’t know how much you can reveal at this point, but let us know what you can about the upcoming conference.
John: Well, good. I’m going to be writing about it this weekend. We’re going to open up registration. You do want to take advantage of the early bird because the prices do go up. My partners are relentless about that. After the early bird, they raise the prices. But, we have Howard Marks from Oaktree. We’ve got Felix Zulauf coming from Switzerland and he’s been in the Barron’s Roundtable for years. I’ve got Carmen Reinhart along with Ken Rogoff. They wrote This Time is Different. We’re going to be talking about credit crisis. A big focus of this conference is going to be on credit crisis. I’ve written and have an invitation out and that it may maybe positive for somebody else who’s famous about credit crisis. We’ve got Bill White coming in, former Chief Economist from the Bank of International Settlements. He and Lacy Hunt are going to be talking about credit crisis and longer-term government debt problems. I’ve got Jim Mellon coming in and talk to you about investment opportunities. I’m hoping to get Mary Meeker and some other really large names. George Friedman will be there, of course.
And, this year I’m bringing President Bush, George Bush. I’m not going to ask him the normal questions. He has a think tank called the Bush Institute that has seven different initiatives. One of them is economic initiative and they’re focused on government debt. I want to talk to him about his experience of trying to basically put social security bank to a solvency basis and getting zero response, and what he thinks it’s going to take to get our government to deal with our own unfunded liabilities. I mean, social security is the easy one, and then you’ve got to get to healthcare. What’s it going to take? I want to talk to him about that experience, what do you think he’s going to do. His institute’s going to be sponsoring the last half day where they’ll be talking about their own views on debt and the real problems that we have.
I’ve got so many of the usual suspects that I quote all the time. Mark Yusko will be there, David Rosenberg. I mean, I’ve got four slots open. They’re not — I’ve got invitations out and the quality is the best it’s ever been. When you see the invitation, you just want to sign it. May 13th to 16th, you want to be there.
Steve: Well, as a fan for a lot of years and reading you and meeting you around the year 2000, I’ve been at just about every one of the conferences. When you say it gets better every year, you wonder how it can get better. But, I really am excited about this year’s. I’ll add that, what I liked most in this unique, in investment business, we go to a lot of conferences and we speak at a lot of conferences. What you’re able to do is bring an all-star lineup of, not only global thought leaders, but also top investment managers, managers like Howard Marks who doesn’t do many of these. He is a distressed debt investor. I’m anxious to talk to him about the things that he’s seeing and how they’re positioning. But what I like most about your conference that you do is, after a panelist or a presenter presents, you always put him together or her together with another group. It’s fun to watch the debate and each of their convictions get stress tested on stage. It certainly helps me learn a great deal and I’m grateful for the conference that you put together every year.
Brian: Well, I’ll just say, John, thank you for joining us today. Steve, thank you very much for your time and especially you for attending today’s webinar. We appreciate it and look forward to connecting with you.
Steve: Thank you.
Brian: Thank you. Have a great a great afternoon.
Steve: Thank you for joining us.
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