December 30, 2022
By Steve Blumenthal

“There are only two ways to live life. One is as though nothing is a miracle.
The other is as though everything is a miracle.”

– Albert Einstein

Forecasting the future. It’s an annual ritual played out on Wall Street, in C-suites, and in small businesses everywhere. From an investment perspective, forecasting is about probable outcomes and capital positioning.

Before writing today, the first thing I did was look back at last year’s forecast. On December 31, 2021, I wrote, “The investment picture going into 2022 is the relatively high probability the global economy will slow dramatically from the stimulative-driven pace we are now exiting. Equity market valuations are at record highs, U.S. household ownership of U.S. equities is at an all-time high, foreign ownership of U.S. equities is at an all-time high, and never before has so much money been concentrated into the same few names (FAANG stocks). Most concerning is the high level of leverage in the system: margin debt has exceeded the insane levels reached at the prior two bubble peaks (see the orange line in the center section below) in 2000 and 2007.”

In short, investors had all the chips pushed to the middle of the table. They were all-in and levered-up.

Now, the Nasdaq is down 35% from a year ago. Meta (formerly Facebook) stock is down 65%, Apple is down 30%, Amazon is down 51%, Netflix is down 52%, and Google is down 39%.

This may have been the most important sentence I wrote last year: “Get your mind around this data: In the last 12 months, in-flows to U.S. equities total $1.1 trillion. That compares to in-flows over the last 19 years totaling $1.1 trillion combined. More buyers than sellers, and prices go up.” (Source: BofA Global Investment Strategy, EPFR)

And much of the buying came from corporations buying back their own stock, as I wrote about, too:

“Where is a good portion of that money coming from? Corporate share buybacks. We’ll be talking about this someday in the future and shaking our heads. A consequence of the Fed’s zero-interest-rate policy and the structure of executive stock option incentive packages.

“Courtesy of Lance Roberts at RIA Advice, ‘The surge in the repurchase of shares over the last decade remains one of the more significant supports to the financial markets. (Such is because it is mostly the major market-cap-weighted names that can afford multi-billion share buybacks. The chart below via Pavilion Global Markets shows the impact of buybacks on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:

• 21% from multiple expansions,
• 31.4% from earnings,
• 7.1% from dividends, and
• 40.5% from share buybacks.“

“In other words,” Roberts’s assessment continued, “in the absence of share repurchases, the stock market would not be pushing record highs of 4700 but instead levels closer to 2800. The risk to stocks is a reversal of that support from the Fed.”

As I concluded last year, “This helps explain some of the record inflows into U.S. equities. With individuals, foreigners, and corporations all in, one has to wonder where the future buying demand will come from. The salient point is, the market is priced to perfection, euphoria is at an epic high, leverage has never been greater, and too few see the risks.

My outlook for 2022 followed, and I’ve copied it here. “No guarantees,” I said. “I could be wrong.”

2022 Outlook

• A difficult first half of 2022 with the potential for a 30% or greater market decline.
• Fed responds aggressively, and the equity market bottoms. Strong second half of 2022.
• Similar to inflation cycles of the past, some moderation in inflation into mid-year. Inflation picks back up in the second half with the return of Fed Quantitative Easing (QE).
• Bullish outlook for 10-year and 30-year Treasury bonds. The 10-year yield may decline from 1.5% to 1% in the first half of 2022.

“As we enter 2022,” I continued, “inflation is calling the Fed’s hand. The Fed is pulling liquidity from the system and anticipates raising rates three times next year. If I’m correct in my view that inflation, rising rates, and debt will lead to a meaningful economic slowdown (‘stagflation’), then the first half of 2022 will surprise investors. A -30% market decline into mid-year is a real threat. If correct, I suspect the Fed will reinstate QE, we’ll bottom, and we’ll be off to the races again.

• Bullish dollar first half of 2022, as the global slowdown and market turmoil favor a strong dollar. Longer-term, bearish view on the dollar, but I wonder relative to which other currency. The developed world is collectively debasing its currencies.
• The outlook for gold is the opposite of the dollar. Long-term very bullish on gold with a target of greater than $5,000.
• Bullish on commodities, agriculture, uranium (nuclear fuel), and oil for the foreseeable future.

“This is all a big ‘if’ because there are many unknowable pieces. We don’t know what role the Covid virus will play or what inflation will look like. You and I can’t control the geopolitical risks: China/Taiwan, Russia/Ukraine, Iran’s apparent pursuit of nuclear weapons. And we can never know for sure what big liquidity guns the Fed may fire next. The risk-on party may have more euphoria left in its run.”

I concluded it was Time to Hedge.

In hindsight, I didn’t do too badly with my forecasting. I was correct on the stock market’s direction, inflation, the dollar, gold commodities, agriculture, uranium, and oil. The glaring mistake was my prediction that the market would bottom, with a strong second half of the year tied to the Fed reversing policy from quantitative tightening (QT) to quantitative easing (QE). The Fed remained vigilant—correctly in my view—in its inflation fight. No QE whatsoever. Additionally, my call for a decline in 10-year Treasury yields from 1.5% to 1% before moving higher was not even close. The 10-year yield grew from 1.5% to nearly 3% by June 30, 2022, and sits at 3.83% today.

It’s important to tie the fundamental view with technical evidence. On the technical side, the Zweig Bond Model (see Trade Signals) signaled higher interest rates for most of the year, and equity market trend indicators remained bearish. That proved helpful.

With the same humble caution on market predictions, here’s my forecast for the coming year.

2023 Outlook

• We are on the back end of the first in a series of inflation waves.
• The Fed funds rate, currently at 4.5%, will peak in 2023 at 5% or 5.25%.
• Due to high debt levels, the impact of higher interest rates, combined with high inflation pressures, will cause a recession in 2023. It won’t be your garden variety recession.
• We’re in for a hard economic landing – immediately ahead. Access to liquidity will worsen, and defaults will rise. This will set up the best-in-a-generation opportunity in high yield bonds and distressed debt. Think yields in the low 20% range.
• Inflation will decline to 3.50%, giving the Fed cover to pivot.
• The median stock market decline in a recession is -38.5%. An additional stock market decline of ~20% from the current level of 3,830 will take the S&P 500 to ~ 3,000.
• We’ll look at the year-end valuation metrics next week, but an early peak at Median PE on the S&P 500 Index puts “Fair Value” at 2,970.32. That squares nicely with the median stock market recession decline data.
• Recession and investor pain will provide the backdrop for the Fed to pivot. The Fed will respond aggressively by lowering rates and injecting liquidity into the system.
• Bearish first half of the year for U.S stocks. Bullish outlook into 2024 tied to / dependent on the Fed and probable legislative responses.
• The recession call is bullish for 10-year and 30-year Treasury bonds. The 10-year yield may decline from 3.80% to 2.50% in the first half of 2023, creating a trading opportunity for bond investors. The 40-year bull market in bonds is over. Trade bonds, don’t buy and hold.
• For single and multi-family housing, the supply and demand mismatch (very low and very high, respectively) will remain the fundamental bullish factor in the housing market. Rising mortgage rates are the bearish factor. If I’m right about recession, easing inflation, and declining interest rates, expect mortgage rates to move to 5% by January or February 2023. (Hat tip to good friend and Real Estate guru Barry Habib for this one.)
• Over time, the supply-demand mismatch, and longer-term inflation pressures are positives for single and multi-family housing. Remain bullish on housing.

As we enter 2023, inflation is no longer a potential problem. It is the major problem. It continues to call the Fed’s hand, requiring continued quantitative tightening. It’s important to remember that markets bottomed after the first Fed interest rate cut, not the last hike; one or two more hikes are a reasonable probability. If I’m correct in my view that inflation, rising rates, and debt issues will lead to a meaningful economic slowdown (“stagflation”), then 2023 will remain challenging. Another -20% market decline is probable.

If correct, the Fed will reinstate QE, we’ll bottom, and we’ll be off to the races again into 2024 and maybe 2025. Liquidity is intoxicating. I’d rather the system clear, but I don’t believe the Fed will allow it.

A few more bullet points on the coming year-plus:

• Bullish dollar first half of 2023, as higher U.S. yields, the global slowdown, and market turmoil favor a strong dollar.
• Longer-term: bearish view on the dollar, but to which other currency, I don’t yet know. The developed world is collectively debasing currencies as well.
• The outlook for gold is the opposite of the dollar. Long-term: very bullish on gold with a target of greater than $5,000. Short-term: neutral.
• Bullish on commodities, agriculture, uranium (nuclear fuel), and oil for the foreseeable future.
• The geopolitical challenges remain. Tensions between China and the U.S. keep increasing. The shifting and reshoring of supply chains continue. Priorities are no longer the lowest cost.
• Higher costs either are pushed onto consumers (inflationary) or impact corporate earnings—or both.
• The first phase of the correction was a leverage adjustment, and margin debt has indeed come down.
• The next phase is an earnings correction. Once Wall Street lowers earnings expectations, we’ll see a negative impact on equities.
• The fundamental environment is stagflation.
• Best guess is a series of inflation waves over the balance of the decade, much like in the 1970s. We are on the back end of Wave 1.
• The Fed pivots, injects liquidity, resumes bond-buying programs, and expands to buy corporate securities to support risk assets.
• Inflation Wave 2 follows, and we repeat the pattern.
• Expect an up-and-down stock market over the balance of the decade.
• We’ll look at valuations next week as they tell us a great deal about coming 10-year returns. They will be better, but expect flat returns from current levels.
• There will always be opportunities and ways to earn high, single-digit to mid-teens returns. Traditional buy-and-hold from current levels and 3.85% 10-year Treasury bonds won’t do it.
• A meaningful correction to 3,000 in the S&P 500 will mean that coming 10-year probable returns will be in the 10% range. That will be a much better point to consider traditional equities.
• If you must be in stocks due to capital gains and investment mandate, I concluded with the same message concluded with a year ago. It’s Time to Hedge.

 

The Decade We Solve the Debt Problem

“One million seconds is 11 days ago. One billion seconds is 1991. One trillion seconds is 30,000 BC.”

– Unknown, courtesy of Barry Kitt

Let that quote sink in for a second.

The U.S. Government Debt is $31 trillion. We owe much more when you factor in Social Security, Medicare, and pension liabilities.

When debt is low and begins to grow, it’s good for the economy. If you earn $100,000 and borrow $10,000, you have $110,000 to spend. Get good credit, then borrow more and spend more—and so on. We get economic growth from your income and the money you borrowed and spent. At some point, you owe too much and have to pay off your debts, which leaves you with less money to buy things. Debts become a drag on growth. Rising interest rates and rising inflation compound the problem.

We can focus our attention on many things, but debt is at the top of the problem list. I’ve said in prior letters that we will print our way out of the problem. That inflation is a feather in our cap, not a bug. In other words, it’s part of the solution. If I’m correct, though, we have an inflationary challenge over the coming decade. Combining high inflation and low growth equals “stagflation”—not the environment most people have experienced over the last 40 years.

We’ll keep discussing debt over the coming year. (Below is a picture of the problem.) But the U.S. is not alone.

I’m not sure if this is the decade we solve the debt problem, but I hope it is. Mauldin, my partner, calls it “The Great Reset.” We are certainly on that path. Ray Dalio talks about “a beautiful deleveraging.” We’ll figure something out but expect the path to be bumpy.

Source: US Debt Clock

Grab a coffee and find your favorite chair. Some sage advice from the great Robert Farrell follows, along with a few Random Tweets and the year-end Trade Signals update. Please see the important disclosure information at the bottom of this email. My views are data-dependent and subject to change at any moment. Wishing you a Happy New Year!

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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Random Tweets

 

The United States: The 6-month decline in the Conference Board’s leading index has never been this large without a recession. Source: The Daily Shot

Source: @TheTerminal, Bloomberg Finance L.P.

 

Source: KKR Global Institute

 

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you can subscribe here.

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Trade Signals: Recession is Near!

December 29, 2022
S&P 500 Index — 3,783

Markets move in cycles, and cycles will always exist. Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. Trade Signals is a summary of technical indicators to help you identify where we sit in short-, intermediate-, and long-term cycles. We track important valuation metrics to help assess the probability of coming returns. Valuations can tell us a great deal about coming probable returns. Simply, where is opportunity best/worst? This allows you to set targets strategically (i.e. more defense than offense, or more offense than defense). Trade Signals also tracks select investor sentiment indicators with the objective of going against the crowd at points of extreme. As Warren Buffett often reminds us, “Be fearful when others are greedy, and greedy when others are fearful.”

Stay on top of the current trends with “Trade Signals.”

Market Commentary

You’ve got to go all the way back to the 1970s and early 1980s to find the yield curve more inverted than it is today. The term “yield curve” refers to the relationship between the U.S. Treasury’s short- and long-term interest rates. Under normal conditions, short-term interest rates are lower than longer-term interest rates.

A few bullet points:

• An inverted yield curve occurs when short-term interest rates exceed long-term rates.
• Inverted yield curves are unusual since longer-term debt should carry greater risk and higher interest rates, so there are implications for consumers and investors alike when they occur.
• An inverted Treasury yield curve is one of the most reliable leading indicators of an impending recession.
• Bottom line: Recession is near.

The yield curve is the most inverted since Paul Volcker whipped inflation 40 years ago. Compare the current level—the red “We are here” arrow—to the 1970s and early 1980s. Note, too, that a recession has followed every inversion since 1958, with a median lead time of 11 months following the inversion before the recession’s start, according to Ned Davis Research (chart E641). If you’d like a copy of the chart, please email me at blumenthal@cmgwealth.com.

A few more bullet points:

• We are now six months since the yield curve inverted in June 2022.
• Since 1946, the average S&P 500 Index bear market decline in a recession was 35.8% versus 27.9% on average without a recession. (Source: Reuters)
• All the bad stuff happens in recessions. Defaults, bankruptcies, liquidity dries up, etc.
• The 2000 and 2008 recessions saw equity markets decline more than 50%.
• Since recessions are only known in hindsight, it’s important to have a high-probability way of knowing in advance. The inverted yield curve indicator is one of the best.

I’ve been sharing the next chart with you for some time. Let’s take look at it again today.

Here are a few takeaways:

• The average decline during a recession is 35.8%, which puts the correction target at 3,094.
• A reasonable target is 3,000 to 3,200. I’m calling it the Fed pivot zone.
• The red circle in the next chart shows what a 35.8% correction looks like (red bracket from January 2022 market top at 4,818 to 3,094).
• A Fed pivot may or may not happen. Thus, -50% can’t be ruled out.

An equity market decline of -50% would take the S&P 500 Index to 2,400. While certainly possible, I believe a recession and the likely Fed and Fiscal responses come back into play before we get there.

The Dashboard of Indicators follows next. Stocks remain in a bear market. Mostly red across the Equity Trade Signals board. The Zweig Bond Model is back in a sell signal suggesting higher interest rates and lower bond prices. The trend in HY bond prices also points lower. The dollar is turning bullish, as is gold.

Click HERE to see the Dashboard of Indicators and all the updated charts in this week’s Trade Signals post.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizons, and risk tolerances. TRADE SIGNALS SUBSCRIPTION ACKNOWLEDGEMENT / IMPORTANT DISCLOSURES 

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Personal Note: Happy New Year!

I was sad to learn that Scott Minerd, Guggenheim Partners Global CIO and Chairman of Guggenheim Investments, passed away last week. He was a gentle giant in the industry, both brilliant and kind. CMG’s Brian Schreiner shared the following video with me today, of a CNBC interview with Minerd from September, and I’d like to share it with you. Here are a few of the more notable, recent quotes from Minerd:

“Things could get a lot worse. Stocks could fall another 20%.”

“This will end in tears for everyone who holds risk assets.”

“We’ve never seen a stock market bottom while the Fed is increasing rates.”

He sees a generational opportunity coming in the high-yield bond market. I totally agree. Remain patient and ready to pounce.

Here is the interview. With a prayer and warm wish, welcome home, Scott. Welcome home. You’ll be greatly missed.

Argentina vs. France

Argentina vs. France

Susan, I and the kids enjoyed the World Cup final in which Argentina beat France in a penalty-kick shoot-out after 90 minutes of regulation play and 30 minutes of overtime. It was the single best game we’ve ever watched. And we’ve watched many games.

The NY Times’ Ben Shpigel put it this way, “In the most thrilling finish to the most thrilling final in World Cup history, Argentina edged France, as Lionel Messi and Kylian Mbappé delivered again and again and again and again and again and again — and again.”

You can watch a quick 4-minute YouTube summary by clicking on the following photo:

Snowbird, Utah, and Tampa, Florida

We had a wonderful holiday break, which ended early yesterday as I dropped Brie, Matt, and Kyle off at Philadelphia International to fly home to Southern California, escaping what has been a frigid cold spell in the Northeast, as you well know. Eighth-ranked Penn State is playing Utah in the Rose Bowl on Monday, January 2, and the kids will be going to the game. We’ll all be pulling for my Nittany Lions, though Susan and I will be cheering from afar.

Our trip to Snowbird, Utah, immediately follows, from January 6 to 13, and the snow keeps falling. I’m flying out with step-sons Tyler and Kieran and meeting Brie, Matt, and Kyle. It’s been a long time since we’ve been able to all ski together, and I’m really looking forward to it. Connor heads back to college, and Susan is likely to fly to Utah from Florida, but that decision is not yet firm. I’ll be working and skiing (though, hopefully, mostly skiing). Fingers crossed that the powdery snow keeps falling!

After Utah, on January 25 and 26, I head to Tampa for a due-diligence meeting, which includes golf at Old Memorial! I hear it is exceptional. I’m checking in happy and excited for the coming year.

I hope you have some fun plans in your immediate future.

A toast to Albert Einstein and seeing miracles!

Happy New Year!

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

 

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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