February 28, 2014
By Steve Blumenthal
If the big bubble is in the bond market, as I believe, we need to keep a close eye on the direction of interest rates. I have my own long-term fundamental views towards higher rates (Fed QE driven), but the question is when. Patience is required.
As a trader, you look for those infrequent yet large profit opportunities. I think another big one is on the horizon. Fortunes are made on such moves but only for a few. As investors, we clearly want to minimize exposure to the next bear market. Remember, markets decline nearly 40% on average in such corrections.
On my worry list are the expanding deficits, expanding debt, significantly underfunded pension and entitlement promises. Beneath this sits interest rate risk that when stirred may just prick the biggest bubble of them all – the bond bubble.
The system is set and loaded for potential hardship (or opportunity depending which side of the trade you are on). At the very top of my list is the potential for another major crisis tied to unimaginable size of the derivatives books sitting on banks’ balance sheets.
They are the “weapons of mass destruction” as Warren Buffett called them prior to the last crisis. Greater leveraged exposure exists today than in 2007.
Further, distressed companies are writing covenant lite loans and getting funding as if quality companies. This too rings of 2007. There is no distressed debt today. I repeat, there is no distressed debt today. Meaning bad companies are getting financed at healthier company rates.
The balance in the system hinges on interest rates. I believe it will be a sharp and unexpected rise in rates that triggers the next crisis. Fed or no Fed.
So today let’s take a quant eye’s look at what is going on and see if there is something that can keep us on the right side of the risk or better positioned and/or prepared to profit.
Today, I share the following in this week’s On My Radar:
- Employment and low unit labor costs
- The Trend in Commodity Prices – Materials Prices
- Inflation Timing Model and a Look at Recession Models
- Tactical Strategies – What Price Momentum is Telling Us About Market Leadership
- Trade Signals – Extreme Optimism Once Again
Employment and low unit labor costs
Currently, we have good economic growth and low labor costs. One of the triggers for the Fed to begin raising interest rates is an employment rate target of 6.5% though they have added in some wiggle room. The following chart has a great record of calling the trend in the unemployment rate. This is a poll of hiring plans, pushed forward four months, which leads the unemployment rate with a 0.89 (high) correlation coefficient when inverted.
The idea is that lower unemployment leads to higher wage inflation which then leads to price inflation. Wage pressures at the corporate level finds a way of working into higher prices of goods as executives push to grow their earnings. Of course, there are other sources of inflation pressure but this is a big one.
So with an eye on labor costs, while we see some evidence of wage pressures beginning to build in several industries, the next chart shows that labor costs are contained for now and not rising.
Evident is the pick up in industrial materials prices. Note in the next chart how the economy performs when base metals prices are rising. A good sign for growth and that growth may just free up some of the cash sitting on reserve at the Fed. The idea here is to keep on eye on what causes the Fed to raise rates and inflation to take form. Growth is good but higher interest rates and price pressures on margins are not good for an overvalued stock market. It is a spike higher in interest rates that can prick the bond bubble. What is good might just turn out to be bad.
In short, hiring trends are solid, materials prices are pointing to more growth yet there is little pressure on higher unit labor costs so for right now we have low costs and good growth. It is the change in Fed posture and a move to higher rates that we are stepping towards. Expect more tapering and keep a keen eye on drivers to higher interest rates.
Too Much Optimism in Commodity Prices
With everyone optimistic about commodity prices, we are just not yet seeing the impact and note how wrong the majority are at points of Optimistic Extreme.
Within our CMG Tactical Rotation Strategy we allocate monthly to the top two out of the following six ETFs: SPY (S&P 500 Index), EFA (Developed Market Stocks), VNQ (Vanguard REIT), BND (Treasury Bonds), DBC (Commodity ETF) and Cash. We look to identify and lock onto leadership. Positions are then held for at least one month. Since price momentum tends to do a good job at identifying market leadership, the positions are typically held for a number of months.
The point to note here is that noticeably absent from the strategy has been an allocation to DBC. The last meaningful and consistent exposure to commodities was in 2007 and 2008. I’m watching carefully for a change and will post if a trend towards higher commodity prices develops. In hindsight, and appropriately, the strategy has been largely SPY, EFA and VNQ.
While I have had many meaningful debates with very smart advisors about future inflation (and yes, I’m a big fan of John Williams’ ShadowStats letter), it is not showing up in a way that drives the Fed to raise interest rates, and absent a spike in rates, the dance continues. I think it will come but we are still early. Next is a look at inflation.
Inflation Timing Model and a Look at Recession Models
Look what happens to gains in bonds when everyone believes interest rates will rise. Here too the data shows the majority are wrong at points of extreme: this chart continues to support the rally in bonds (for now).
Tactical Strategies – What Price Momentum is Telling Us About Market Leadership
Price momentum is a good tool to use to identify and lock into major leadership trends. After avoiding bond exposure for most of last year, we have seen a decided pick up in that exposure. Absent has been exposure to commodities and that remains the case today.
As a side note, we continue to see exposure to U.S. equities and are also seeing health care and technology leading over most other sectors.
If inflation does indeed begin to pick up, I expect to see commodity funds and ETFs moving to a position of leadership within our tactical strategies. So despite my concern about inflation, it is not yet showing on our radar screen.
Trade Signals: Extreme Optimism Once Again
Click here for a link to Wednesday’s Trade Signals.
Trade Signals identifies the equity and fixed income markets’ cyclical trend and suggests ways to hedge your long-term focused equity exposure tied to periods of excessive investor optimism. Charts are posted weekly on Wednesdays.
In conclusion
The big bubble today is in the bond market and the potential for future profit as well as loss is meaningful. Keep an eye on labor costs, inflation pressures and commodity leadership and be prepared to act. Right now inflation remains in the future. What matters most is Fed activity and the direction of interest rates. I’m confident we’ll see price momentum identify directional leadership in inflation related sectors. I’ll update the charts for you from time to time. Feel free to email me if you have any interim questions.
Some more good news for the Midwestern and Northeastern parts of the country – plenty of new snow is on the way! At this point, you just have to laugh.
I’m writing from 34,000 feet on my way home from San Diego. I understand it is 14 degrees in Philadelphia and another big snow storm is on the way. I just can’t wait to break out the shovels – again.
Hoping you too find some humor in the midst of the mess.
Have a great weekend!
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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