September 18, 2020
By Steve Blumenthal

“My metric for everything I look at is the 200-day moving average of closing prices.
I’ve seen too many things go to zero, stocks and commodities.
The whole trick in investing is: “How do I keep from losing everything?”
If you use the 200-day moving average rule, then you get out.
You play defense, and you get out.”

– Paul Tudor Jones,
Founder, Tudor Investment Corporation and Founder, Robin Hood Foundation

Today, I thought I’d share with you a few ideas about risk management. It’s simple, practical advice on how to use trend following to protect your backside. But keep in mind that no process is perfect all the time. There just aren’t any guarantees in this game.

It’s no secret that the market sits late cycle, and that it’s overvalued (the most in history) and Fed dependent. This recent Barron’s magazine cover captures current investor sentiment. Not ready to pop? It sure feels like it is. I am going to go on record and calling an October 2020 stock market crash. But truthfully, it’s just a guess. I have no way of knowing—I could be wrong.

Maybe Barron’s and all the new young Robinhood traders are right. Call me old school, but I don’t think so.

With that said, given today’s lofty valuations, I think some form of risk management is important—if not mandatory. At CMG, we’ve analyzed all sorts of processes from simple stop-loss percentage swings, rate of change rules, overbought/oversold triggers, reversion to mean signals, volatility signals, investor sentiment extremes, and simple moving averages. I post a few each week in Trade Signals (link below).

Ned Davis Research and others have done a great deal of work analyzing various indicators. My favorite for the large-cap U.S. stock market is the Ned Davis Research CMG Long/Flat signal. It is a “weight of evidence” process that looks at the short-term, medium-term, and long-term price trends across 24 sub-industry sectors that make up the S&P 500 Index. I also keep a close eye on Ned Davis’s popular Big Mo indicator (Mo stands for Price “Momentum”). Both processes are price-based indicators and measure the trends across the various market sectors. Which one is better? Frankly, I like them both, and that’s not the right question. Neither are perfect. That’s why diversifying trading strategies is essential.

When compared side by side, Long/Flat has done a little better than Big Mo this year, outperforming it by about 7% or so. Over a longer look back, they have similar return/risk profiles. Long/Flat has been in a risk-on signal most of the time since the 2008-09 bear market and so has Big Mo.

Of all of NDR’s market indicators, Ned’s personal favorite indicator is Big Mo—at least as I far as I can tell from reading Ned for nearly 25 years. I keep a close eye on Big Mo each week. Both indicators are signaling a mildly bullish risk-on. If Long/Flat and/or Big Mo move to a sell signal this month or next, the odds of my October 2020 crash call will improve. I’m following my trend indicators despite my gut feeling. Call me an old dog who has made a few mistakes attempting to follow my fundamental views. Far more times than not, process was the right call.

My point today is not to say one is better than the other. My point is to say that no one process is perfect all the time. Thus, I favor diversifying to several risk-managed trading strategies. I believe it is a healthy way to defend and carefully grow your “core” wealth. Defending your “core” wealth enables you to “explore” with a smaller portion of your portfolio. What does “explore” mean? Think transformational ideas in AI, technology, battery technology, biotechnology, genomics, magnetic power, health care innovation, etc. The idea is to look for opportunities with tremendously skewed reward-risk opportunities. These are potentially wealth-creating opportunities, and a 40% stock market correction means very little ten years from now. I believe it’s this strategy: defending and carefully growing your core that enables you to take on the types of risks that may create great wealth. Key word: strategy.

When you click through below (or page down if you are reading this on the website) you’ll find a few simple risk management processes that I hope give you a feel for how trend following can help you better manage risk. You’ll also find a section that looks at what current high equity market valuations are telling us about coming returns. I have no idea what the next few months will bring, but I think we can get a really good estimate of what the coming 3-, 5-, 7- and 10-year returns will be.

Sometimes the odds are stacked in your favor and sometimes they are not. This isn’t a game of perfect. It’s a game of probabilities and risk management. If you are grounded in the math around loss, you understand that it takes a 100% subsequent return to recover from a 50% decline. Lose 75% and you need a 300% return to recover. Lose 20%, you need a 25% subsequent return. The idea with creating a “core” portfolio strategy is to make sure your strategy fits your personal return needs relative to your risk profile.

Finally, I have a great story to share with you about Gary Player (“The Black Knight”). Last Saturday, my daughter, Brianna, invited her co-worker Joe to play golf with us at Stonewall. Coming down from the practice range to the first tee, we looked left and saw a small crowd gathered around the ninth hole. A friend walked by and said, “That’s Gary Player.” We went on to play the front nine. As we made the turn, Gary was coming down 18. We paused our round to join a small crowd gathered near the 18^th green. Gary parred the hole and finished his round with a 73. What he did next was amazing. A 45-minute impromptu golf clinic full of optimism, humor, and advice. More about Gary Player in the Personal section below, along with a video in which Gary gives us a few pointers.

Grab that coffee and find your favorite chair. If trend following and forward returns are not your thing, don’t miss the note about Gary Player. Read on…

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Included in this week’s On My Radar:

A Few Ideas Around Risk Management
3-, 5-, 7-, 9-, 10- and 11-Year Coming Return Forecasts
Trade Signals – Interest Rates will be Lower for Longer
Personal Note – Gary Player, The Black Knight

A Few Ideas Around Risk Management

There are times when risk management makes perfect sense. That’s generally when valuations are high and forward return potential is low. There are other times when it’s safer to keep your foot on the accelerator. That’s when valuations are low and forward return potential is high.

So, more risk management when the risk is highest and perhaps less when risk is lowest (let ‘em run). With this thinking in mind, let’s look at a few different processes to get a feel for how rules-based trend following works (Not a recommendation to buy or sell any security. For information and education purposes only):

12-Month Smoothed Moving Average Rule

Here’s how it works:

The 12-month smoothed moving average is represented by the dotted black line in the next chart
Buy signals occur when the S&P 500 Total Return Index (blue line) rises above the black dotted smoothed MA line
Sell signals occur when it drops below the black dotted line
The data is hypothetical and goes back to 1926
The market is in an uptrend 73.17% of the time from 1926 through August 31, 2020
Return comparisons are in the upper left of the chart (yellow marks the current signal)

NDR looked at the same process, but from 1960 through August 2020 and found similar results:

50-Day vs. 200-Day Moving Average Cross

I share this next chart with you each week in Trade Signals. The 50-day vs. 200-day MA cross signal is a slower signal process compared to the simple 200-day MA rule, but the results are somewhat similar in the long run.

Here is how to read the chart:

Shown in the middle section are signals dating back to 2007
The data box in the lower left goes back to 1926

Data Over the Last 12 Months

While the 50-day vs. 200-day signal did an excellent job protecting in 2008-09 and 2000-02 bear markets, the process is not perfect. The recent COVID-19 crisis was sharp to the downside and sharp back to the upside. If you’ve used the 50-day vs. 200-day rule the last twelve months, you are disappointed. This time, the market did best when the 50-day MA was below the 200-day MA. That is very unusual.

52-Week Rate of Change Signal

Another trend-following process that’s done an excellent job since 1968 looks at the rate of change in the price in the Value Line Index over the last 52 weeks.

Buy signals occur when the 52-week rate of change of the Value Line Index (orange line in the lower section of chart) rises above 0.7 or -45 (lines are the two lower dashed lines in the lower section of the next chart
Sell signals occur when the orange line falls below 9.3
Return box is in the upper left (current signal is a sell as of 9-4-2020)
This process is in a buy signal just 47.04% of the time since 1968

One last point: a trader can speed up the sensitivity to the signal by changing the measurement period. If a 26-week rate of change is used instead of a 52-week rate, there are more trades, but the results are similar. (Note: the 26-week rate of change signal may be more appropriate if you are an options trader.) Here is a look:

In all of this historical back-tested data, trade costs are not reflected and those high brokerage commissions that existed when I got into the business in 1984 would have made the process untenable for most investors. Today, brokerage commissions are near or at zero. Please review important NDR and CMG disclosures.

You’ll see in Trade Signals that the NDR CMG Long/Flat indicator is modestly bullish with a 75 reading. Sell signals occur when the model equity line drops below 50. Scores range from 100 to 0 and are based on the price movement of 24 sub-industry sectors that make up the S&P 500 Index. You’ll also find an explanation as to how it works in the Trade Signals section. Results are hypothetical back-tested results. Not a recommendation to buy or sell any security.

NDR’s Big Mo also leans bullish. Not a strong signal, but bullish.

3-, 5-, 7-, 9-, 10- and 11-Year Coming Return Forecasts

Here, I’m sharing one of my favorite coming return charts. It looks at the overall size of the stock market as measured by the S&P 500 Index and compares it to U.S. Gross Domestic Income.

Here is how you read the chart:

The very bottom section plots the Stock Market Cap as a percentage of Gross Domestic Income (how much we collectively make). Focus on the blue line
When the blue line is above the dotted back line, the market is in the “Top Quintile – Overvalued” zone
When the blue line is below the bottom black dotted line, the market is in the “Bottom Quintile – Undervalued” zone
We currently sit in the overvalued zone
The red arrows point to the subsequent 1-, 3-, 5-, 7-, 9- and 11-year subsequent returns. IMPORTANT: Returns are not annualized
The picture that is being painted is that in past periods when the market was overvalued, subsequent actual returns we negative in the following 1 to 11 years as noted
Bottom line: Expect zero to slightly negative returns over the coming 9 years and a flat return over the coming 11 years. Negative to zero progress.

Last comment on the above slide. More defense today provides the ability to take advantage of the return opportunity that will present in the “Undervalued” zone. Doesn’t mean you have to lose money. Also note the buying opportunity in 2009.

S&P 500 10-year Returns Based on Shiller P/E (10-Year Earnings):

Let’s look at the Shiller price-to-earnings (P/E) ratio. It currenly reads 30.69 as of Friday, September 18, 2020. You can see the 1929 level, 1966 (bull market top), and 2000 tech bubble top. Look how low it got in 2009 (I wrote then, “It’s So Bad It’s Good.”).

Valuations provide us with the opportunity to look back at history and see what kind of return we earned on our money based on P/E valuation starting conditions. This data set is pretty cool.

Here’s how to read the chart:

The yellow highlight is where we sit today, in the “Most Expensive 20%” of occurences since 1881
The lowest 10-year subsequent return achieved when in the most expensive zone was -6% annually for 10 years
The highest 10-year subsequent return achieved when in the most expensive zone was +10% annually for 10 years
The median 10-year subsequent return achieved when in the most expensive zone was +3.5% annually for 10 years (I think this is a reasonable expectation)
The yellow box also highlights a range of +5% to -1% annually. I believe we end up somewhere between those return numbers

Here is another look at the data, but after inflation is calculated:

Note, we should get more aggressive in the left three valuations zones… Big market declines create great forward return opportunities

GMO’s 7 Year Asset Class Real Return Forecasts – August 31, 2020

You’ve seen this next chart from me many times in past months. Plotted are GMO’s return expectations based on their valuation process for various assets.

Negative annualized return in stocks and bonds for the next seven years
Bottom line: Go get a drink and wait until a meaningful market decline creates a better return opportunity (that may present in two months or two years). For now, just drink…

See important disclosures below.

Trade Signals – Interest Rates will be Lower for Longer

September 17, 2020

S&P 500 Index — 3,385 (previous close)

Notable this week:

No major changes to equity and fixed income trade signals this week. You will note below that NDR’s Daily Trading Sentiment and Crowd Sentiment indicators retreated from excessive optimism levels we’ve seen recently. Current sentiment levels are neutral/slightly bullish for equities.

Yesterday, following its two-day policy meeting, the Federal Reserve indicated that, provided inflation is not excessive (over 2%), it expects to keep interest rates near zero through 2023 until it hits “maximum” employment. Additionally, the Fed revised its GDP estimate to be 3.7% below its year-earlier level in the fourth quarter as opposed to 6.5% lower. They also now estimate the unemployment rate averaging 7.6% in 4Q, rather than 9.3%. Analysts believe that the Fed has set a high bar for raising rates in the future.

Put this on your radar for a coming discussion (not today but it’s coming):

Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.

Click here for this week’s Trade Signals.

Personal Note – Gary Player, The Black Knight

I first met Gary Player twelve years ago. I was invited to play Pine Valley Golf Course. If you are a golfer and ever get that invite, you drop everything you are doing and you say yes. My host was a soccer friend and his firm hired Gary’s son Wayne to do a few client and charity events. To my great surprise, we met Gary in the grill room and he joined us for golf.

Meeting him once was a joy. The second time was equally uplifting. Coming off the 18^th green at Stonewall, Gary stopped in front of the small gathering and spoke to us. First, he did a golf demonstration. Most helpful to me was his “Light the match” concept for chipping. Here is a short video. Note his fun way.

He went on to tell us that the vast majority of our golf practice should be spent 20 yards from the hole on in, chipping and putting in order to score. Tiger and Phil, their drives are all over the place. Then they post their score: 65. It’s the chipping and putting that saves them.

Then came a wonderful five-minute discussion about life and about America. He shared four pieces of advice:

Eat half as much as you do (weight is death),
Exercise twice as much as you are currently exercising,
Laugh three times as much every day,
and LOVE (our humanity depends on it).

Gary then got serious, he talked about how a foreigner can come to America and create a wonderful life. Everyone in the world knows about America. It’s the home of the free. We should get on the ground every day and kiss the earth here. “What are we doing?” he asked. “We are fighting each other. We used to appreciate our differences more, now we are killing each other. Stop! We have to stop.” Amen to that!

Gary is 85 years old now and in great shape as you can see from the video. His exercise twice a day is paying off. What a bright light for humanity. I love how he uses his position to lift others. What a day!

Wishing you a wonderful week.

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Warm regards,

Steve

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

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.

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On My Radar: A Few Ideas Around Risk Management