July 17, 2015
By Steve Blumenthal
“When it does happen, it’s usually not the first-derivative event that people are caught off guard by. They’re caught off guard by the second, third and fourth derivative events. It’s ‘Oh yeah, when interest rates go up, that happens.”
– Gary Cohn, Goldman Sachs’ President and COO
“When interest rates go up…” To this we watch and must defend. Several weeks ago I wrote about the extreme valuations in dividend paying stocks. Starved for yield, investors have raced into high dividend paying stocks. So it caught my eye yesterday when Bloomberg’s Dave Wilson highlighted a chart from Richard Bernstein, one of my longtime favorite analysts.
As a quick aside, Bernstein joined Merrill Lynch in 1988 (I started at ML in 1984) and he went on to become ML’s Chief Investment Strategist. In those days the research reports were mailed to each office. Do you remember the “mailroom”? Gone. A quick Google search and shazam. We live in an amazing time.
I read everything Bernstein put out. Candid and with opinion – I liked him and so did others. Richard was voted to Institutional Investor Magazine’s annual “All-American Research Team” eighteen times, and is one of only fifty analysts inducted into the Institutional Investor “Hall of Fame”. He’s pretty good.
This week let’s take a look at Bernstein’s Black Widow missive. He says, “Strategies based on stretching for yield have a long history of surprising investors with unanticipated risks.” High dividend payers are way overvalued. If you own them, have a plan in place that enables you to participate in further (potential) gain and also have a process that allows you to protect your capital. A sizable correction is in our near future. When? Soon. Who knows? I will share an idea or two around risk management.
I started to write about Greece again but all I can say is Greece is screwed. Germany’s iron fist is going to come back to bite them. Greece, per say, doesn’t matter due to its small size; but this is not just about Greece. An unavoidable divide has occurred – particularly with France. Confidence and trust is lost. The deal is an economic disaster. Germany wants a smooth divorce. They just might get it – Greece should exit.
Italy, Spain, Portugal and France are up next. The debt and entitlement obligations are not manageable – period.
This is a sovereign debt crisis and I’m not sure investors understand the depth of the crisis. The tipping point is near or perhaps it occurred this past week. Call it the Greek headlock. We’ll see.
Included in this week’s On My Radar:
- The Black Widow Returns – Richard Bernstein
- Valuation: Most Recent Data, A Quick Update
- Trade Signals – Sentiment Suggests a Bounce – Trend Evidence Deteriorating
The Black Widow Returns
Highlights from Richard Bernstein’s piece:
“In 1989 I wrote a report titled “Dividends: The Black Widow of Valuation”. The report demonstrated that investing for high income can sometimes be extremely risky despite the irresistibility of higher dividend yield. Certainly, income-oriented equity portfolios tend to have lower long-term betas than do portfolios focused on capital appreciation. However, strategies based on stretching for yield have a long history of surprising investors with unanticipated risks.
Investors today seem to be as myopic toward the risks of income investing as they were in 1989. MLPs, REITs, emerging market debt, and other income categories all seem to have risks that investors today are largely ignoring. One must remember that excess returns in the financial markets are always accompanied by excess risk. Yields that are abnormally high typically carry abnormally high risks as well, and a proper assessment of those risks should never be taken for granted.
The deflation of the global credit bubble remains our primary investment focus. The problems related to oil, Greece, Puerto Rico, China, Brazil, gold, and other credit-related investments should not be a surprise given the secular deflation of the global credit bubble. Yet, investors’ unwillingness to accept the end of the 1998-2008 credit paradigm has caused considerable financial market volatility.”
On Deflation, Bernstein wrote:
“It should be no surprise that debt-related problems are cropping up around the world given this deflationary backdrop. Inflation can “cure” debt problems in that borrowing entities can pay back loans with cheaper currencies and inventory profits. However, deflation typically exacerbates debt problems. So, why are investors surprised by Greece or Puerto Rico?”
On MLPs:
Here is a link to the full piece.
Last week I highlighted the following Global Recession Chart. There is an 88% probability that we are in a Global Recession. Note that I do not believe the U.S. is in recession but we should watch closely. The largest market declines happen during recession. Further, what is happening globally will ultimately impact the U.S.
Here is a link that explains the chart in further detail: High Probability of a Global Recession
I shared this chart last week as well. Note that the largest recession declines occur when valuations are most extreme.
The yellow highlight shows the current valuation level (again, see link for full story) relative to past valuation levels. Yikes.
So where are we valuation wise? Next are several of my favorite valuation charts I review each month.
Valuation Update
Median PE (NDR Calculation) – The S&P 500 is overvalued with a 21.5 S&P 500 Median PE as of June 30, 2015.
That puts the market in the highest price quintile. In such cases, forward returns have been profitable but in the low single digits. I like how it shows overvaluation and undervaluation targets (upper left in blue) as well as Median Fair Value.
Next let’s look at Operating Earnings – Note the returns 3 months to 24 months later (upper left box in this next chart) when the Price to Operating Revenues is greater than 18 (current number is 18.68). The market is expensive.
If you want a broader look, next is a dashboard like layout summarizing various different valuation measures (red to green color far right).
Here is the dShort data tied to the market recession based decline data shown above.
Lastly, here is what Warren Buffett said is his favorite valuation measure (blue line – second highest reading in history. It’s higher than the 2007 overvaluation.)
Trade Signals – Sentiment Suggests a Bounce – Trend Evidence Deteriorating
Investor sentiment remains the major positive story for the market. Current readings reflect extreme pessimism which is historically bullish for the market.
I see continued deterioration in trend evidence yet both Big Mo and the 13/34-Week EMA suggest the market trend remains up. However, I’ve grown more concerned as selling demand is higher than buying demand. One of my favorite indicators moved to a sell signal on June 30, 2015 (chart below – NDR Volume Demand minus NDR Volume Supply).
As for bonds, the Zweig Bond Model remains in a sell and our CMG Managed High Yield Bond Program has moved from a sell to a hold – in this case hold means that we remain positioned in treasury bills or cash.
A quick updated summary of the various Trade Signals:
- Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
- Volume Supply is Greater than Volume Demand: 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: Modestly Bearish – Watch Out for Minus Two
- U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Currently signaling No U.S. Recession
- The Zweig Bond Model: The Cyclical Trend for Bonds is Bearish
Click here for the link to all of the charts.
A few concluding thoughts:
A lot of travel this week. I’m in Chicago speaking today at the Brookstone Capital Management Advisor Conference. They happen to be the fastest growing independent advisory firm at TD Ameritrade. What a fantastic business model lead by a man with a magnetic personality, Dean Zayed. Fun to watch.
I’m home next week with some vacation time in the near future. I so enjoy the travel but maybe it is that feeling I get knowing I’m heading home. An emotional roller coaster this week as my son Matthew was rushed to the hospital. He battles Crohn’s Disease and there were some complications. However, he is doing much better. I’ll see if I can sneak him in a Pat’s Cheesesteak. Well – maybe not a good idea. I land at 8:00 pm tonight and will head straight to see Matthew. It is nice to come home. Wishing you and your family the very best.
Have 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.
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