Lucy, Charlie Brown and the Fed

October 16, 2015
By Steve Blumenthal

David Rubenstein, co-founder and co-CEO at The Carlyle Group, on Bloomberg TV several days ago, said, a U.S. recession is “inevitable.”  “We have not really had a recession in six years,” Rubenstein explained. “We came out of the last recession in June of 2009. We tend to have recessions every seven years, more or less in the United States, since World War II.  So at some point in the next year or two or three, you can expect a recession.”

I place the odds at 50% in 2016.  QE4 or higher rates?  Not sure.  Most are calling for higher rates.

The IMF (International Monetary Fund) is out with a report this week. Here are the guts of the piece:

• Massive monetary policy stimulus has rekindled growth in developed economies since the deep recession that followed the collapse of Lehman Brothers in 2008; but what the IMF calls the “handover” to a more sustainable recovery – without the extra prop of ultra-low borrowing costs – has so far failed to materialize.

• Meanwhile, the cheap money created to rescue the developed economies has flooded out into emerging markets, inflating asset bubbles, and encouraging companies and governments to take advantage of unusually low borrowing costs and load up on debt.

• “Balance sheets have become stretched thinner in many emerging market companies and banks. These firms have become more susceptible to financial stress,” the IMF says.

• Meanwhile, the failure to patch up the international financial system after the last crash, by ensuring that banks in emerging markets hold enough capital, and constraining risky borrowing, for example, means that a new Lehman Brothers-type shock could spark another global panic.

• “Shocks may originate in advanced or emerging markets and, combined with unaddressed system vulnerabilities, could lead to a global asset market disruption and a sudden drying up of market liquidity in many asset classes,” the IMF says, warning that some markets appear to be “brittle”.

• So as the U.S. Federal Reserve lays the groundwork for a return to peacetime interest rates, from the emergency levels of the past seven years, financial markets face what the IMF calls an “unprecedented adjustment” and the world looks woefully underprepared.

Further, the Bank for International Settlements believes interest rates have been too low for too long, encouraging too much risk-taking in financial markets.  All of them fear that the global financial system is primed for a crisis.

All over the world, all eyes are zeroed in on the Fed.  No pun intended.  Earlier this week, I tweeted a link to a CNBC interview with former Dallas Fed CEO Richard Fisher (here).  He said they (the Fed) have “egg on the face.”  Adding, their behavior “is like Lucy pulling the football away every time Charlie is about to kick it.”

As a quick aside, I’m finding my way into the maze of all things social media.  I finally get it…kind of!  Do you remember where email was in 2000?  Not entirely new but it sure was new to most.  I couldn’t get my father to set up an email account.  Finally, one day dad sent me an email from his new AOL account.  In the game – he caught on.  Now look at all of us today.

Social media is not new but somehow I feel a bit like my dad did 15 years ago.  Trying to understand the leverage of LinkedIn and Twitter.  As I dive deep into research each week, I’ve been tweeting more and more.  Mostly it is what I believe to be important, meaningful and timely as it relates to the economy and the markets.  Seeing Richard Fisher speak candidly gives us all an inside peak into what must be going on behind closed doors.  If you’d like to, you can follow me on Twitter at @SBlumenthalCMG and @askCMG.

I can just hear my kids saying “duh dad” but hey, like my old man before me, I’m catching on.  It’s pretty amazing how much information you and I have at our fingertips.  You can also connect to me via our LinkedIn Showcase page here.  Additionally, if you are an advisor, my social media team will be posting my Top Tweets on our advisor central blog page.  You can sign up here.  My hope is that you find the material helpful to you and with your work with your clients.  I try to share the best insights each week in OMR.  If you have yet to do so, get yourself on LinkedIn and set up a Twitter account.  Advisors are using these mediums to communicate with their clients and gain valuable new relationships that help them grow their businesses.

Finally, before we jump into this week’s piece, I received a number of emails asking for more information on using ETF put options to hedge equity exposure.  You will find a few educational links below.

Ok, given the significant importance recessions play in our economy and markets, let’s take a look today at recessions – specifically how we can predict them in advance.  It might just be the most important thing we get right, as it relates to our financial health, over the next few years.

Included in this week’s On My Radar:

• The High Yield Bond Market and Recessions – Getting In Front of Recessions
• How to Hedge Equity Exposure Using Put Options
• Trade Signals – Sentiment Remains Pessimistic (ST Bullish), Cyclical Down Trend, Zweig Model Remains Bullish on Bonds

 

The High Yield Bond Market and Recessions – Getting in Front of Recessions

Our HY strategy is back in a buy signal.  It’s been a bit of a wild ride for HY over the last several months.  Prices dropped and yields rose to north of 8%.  That is a pretty attractive yield; however, risk remains high.  As a high yield manager for more than twenty years, here are a few thoughts:

• First of all, HY is a great asset class and appropriate as a percentage allocation in most portfolios. The asset class, as with equities, struggles most during economic recessions.
• I’ve seen three major buying opportunities over my many years of trend following (trading in and out) HY. All came at recession lows.  If you borrowed and you can’t pay it back, you default.
• A credit default cycle remains ahead of us. The next recession will flush out the weakest credits.
• The HY market has grown from $1 trillion to $2 trillion in total size in just five years. Many less fit companies were able to fund themselves.  The Fed’s zero interest rate policy caused investors to chase into riskier asset classes like HY bond ETF/funds and the managers needed to put that money to new work.  A lot of bad lending has taken place.
• It is difficult to find new funding during recessions. A large number of bonds are set to mature over the next few years.
• Expect significant defaults in the next recession. My best guess is 2016 but it could be sooner or later.
• If I’m right on recession timing, borrow and extend will go away. Bankruptcies will spike. I have a few recession indicator models I follow each week in Trade Signals.  Here are two:

Above chart: Note the down arrows in the upper section prior to the recession since 1950 (highlighted in gray).  Correct signals at 79%.  Not perfect but remember that we only know the actual recession start date about 6 months after it started.  We need to get in front of recessions.

There is a seemingly endless number of charts available within NDR’s service.  I did a recent search and came across this next chart.  Again, not perfect on exact timing but pretty darn close (with a 100% accuracy rate).  No guarantees – past performance cannot guarantee anything in this business but I do like the correlation history.

Next is the data that drives the signal to the above chart.

• In my view, the recent HY sell-off and snap recovery was more of a liquidity issue than a credit problem. The big opportunity will present itself when defaults spike.  Again, best guess is 2016.  I’ll continue to post the above data and notify you via this newsletter if a down arrow materializes.
• More on HY: Some rising concerns on the liquidity front:
  • A recent Fed survey found that more than one in three dealers reported a reduction in the liquidity and functioning of the high yield market over the past three months, the most since Q4 2011.
  • Market makers reported that average daily trading volume has begun to roll over in high yield and other sectors.
  • Martin Fridson on HY – Bloomberg (a link to a short video discussion on risk, liquidity and maturities)

Here is the bottom line: See the investment opportunity that a recession will bring.  It is probable that a 2002- or 2008-like buying opportunity is coming.  Yields reached 20% in 2008.  The stock market declined 50% by the end of the 2001-02 recession and more than 50% by the end of the 2008-09 recession.  Recessions bite hard.

Stay tactical with your HY portfolio allocation.  Hedge equity exposure.  Participate, risk manage, protect.

♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦

How to Hedge Equity Exposure Using Put Options

I hope the below links provide some insight and education on what option put spreads are and how to implement them as a hedge on your equity exposure:

• Bear Put Spread – Hedge
• Covered Calls
• Fidelity – Option Strategy “Bear Put Spread” – Profit from a falling stock price, while potentially limiting risk.

Trade Signals – Sentiment Remains Pessimistic (ST Bullish), Cyclical Down Trend, Zweig Model Remains Bullish on Bonds

The CMG NDR Large Cap Momentum Index remains in a sell (June 30, 2015 at S&P 500 Index level 2063).  Two weeks ago, NDR’s Big Mo indicator moved to a sell signal and last week moved back to a buy signal.  Interesting.  I favor the CMG NDR Large Cap Momentum Index signal.  Overall, the trend evidence remains negative for equities.

Sentiment remains pessimistic which is short-term bullish for the market.  I share some thoughts on the S&P 500 Index (resistance levels – technical challenges) below.  The Zweig Bond model remains bullish on high quality bonds.

I remain in the hedge/sell the rallies camp.  The market remains over-valued, the Fed wants to raise rates, global growth is slowing and a probable recession is near.  This would all be less of an issue if the market was attractively priced.  It is not.  See “Valuations, Forward Returns and Recession”.

Here is a summary of this week’s Trade Signals:

• Cyclical Equity Market Trend: Sell Signal

1. CMG NDR Large Cap Momentum Index: Sell Signal on June 30, 2015 at S&P 500 Index 2063
2. 13/34-Week EMA on the S&P 500 Index: Sell Signal
3. NDR Big Mo: Buy Signal on October 9, 2015 at S&P 500 2014.89

• Volume Demand is greater than Volume Supply: Sell signal for Stocks
• Weekly Investor Sentiment Indicator:
  NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)                                                                                                                  Daily Trading Sentiment Composite: Extreme Pessimism (short-term Bullish for stocks)

• Don’t Fight the Tape or the Fed: Indicator Reading = 0 (Neutral for Equities)
• S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Signaling No Recession
• The Zweig Bond Model: Buy Signal

Click here for the link to the charts.

For years I have subscribed to Ned Davis Research.  They are an independent research firm.  Their clients are institutional (professional) investor clients like CMG.  They are one of the most respected research firms in the business.  NDR offer several levels of subscription. You can contact them directly at Ned Davis Research at 617-279-4878 to learn more (ask for Dan).  Please know that neither I nor CMG are compensated in any form.  I’m just a big fan of their research and their way of thinking.  Ned Davis authored one of my favorite books titled, Being Right or Making Money.  I highly recommend it.

Personal note – Lunch with Lenny

Did you ever read the book Tuesdays with Morrie?  It was about an old man and a young man and life’s greatest lesson.  Once a month for many years, we were treated to lunch with Lenny.  A client since 1990, Lenny passed away several years ago at age 86.

Len would bring in Philadelphia hoagies and a great Jewish apple cake.  We’d all gather in our large conference room and Len would want to know about what was going on in each of our lives.  He was loving, fun and loved to talk.

Last Monday, the Love From Lenny Foundation hosted its second annual golf outing.  This is a charity event to raise money for people with brain injuries.  The foundation was founded by his two children, Michael and Randy, inspired by Len quietly helping one of Michael’s childhood friends.

Len or Uncle Len was everyone’s best friend.  So, here is a toast to Uncle Len and a toast to that special wise old soul who touched and continues to touch your life.

Pictured below is Team CMG (Avi, Adam, Jason and Andrew) along with a picture of me and my wonderful friend.

I googled looking for some of the top quotes from Tuesdays with Morrie.  Here are two that seem apropos:

• “Death ends a life, not a relationship.”  Amen to that.

• “Love is how you stay alive, even after you are gone.”

And here is one from Len:

• “Guys, sell it for less.”  He owned a Ford agency before he retired.

 

Wishing you a great 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 that here.

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
https://www.trademonster.com/marketing/upcomingWebinarEvents.action?src=TRADA2&PC=TRADA2&gclid=CKna3Puu6rwCFTRo7AodRiQAlw

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.

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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).