November 22, 2013
By Steve Blumenthal
Each week it is the same routine. As I read through a diverse pool of research my head clicks, “doesn’t matter, doesn’t matter, matters.”
Who are the players at the table (prop desks, market makers, hedge funds, pension managers, foreigners, individuals, the Fed and global central banks)? What are their motivations? Money flows? Human tendencies like recency bias, anchoring and herding? What about world trade, currency flows, company valuations, investment spreads, Fed policy and investor sentiment?
The markets are overdue for a 5% to 20% correction and I believe that sometime within the next 18 months we will experience a market dislocation similar to 2008 and 2000-2002. Like a game of musical chairs, at some point the Fed’s music will stop and not everyone will find a chair. I think we are getting close.
As I share below, this will be a good event if you are properly hedged, leaving yourself positioned to “buy when everyone else is selling”. If I’m wrong, the cost to risk protect is nominal. If I’m right, the value in the protection is priceless. Learn how to inexpensively hedge. It is not as difficult as you might think.
This week, I share the following research:
• Grantham: Ignoble Prizes and Appointments
• The Economic Confidence Model: Martin Armstrong
• Risk Parity Rebuffed: Dalio versus Ineichen – Barclay Leib
• Trade Signals: Even Higher Extreme Sentiment Readings – 11-20-2013
Grantham – Ignoble Prizes and Appointments
“At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fi t the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).
We are told that investment bubbles have not occurred and, indeed, could never occur, by the iron law of the unproven assumptions used by the proponents of the EMH. Yet, in front of our eyes there have appeared in the last 25 years at least four of the great investment bubbles in all of investment history. First, there was the bubble in Japanese stocks, which peaked in 1989 at 65 times earnings (on their accounting) having never peaked at over 25 times previously, to be followed by a loss of almost 90% in the MSCI Japan index! Second, we had the Japanese land bubble peaking a little later in 1991. This was probably the biggest bubble in history and was certainly far worse than the Tulip Bubble and the South Sea Bubble. And, yes, the land under the Emperor’s Palace, valued at property prices in downtown Tokyo, really was equal to the value of the land in the state of California. Seems efficient to me … California is so big and unwieldy. Next, we had by far the largest U.S. equity bubble in 2000, which peaked at 35 times earnings compared to a peak of 21 times in 1929, yet had had previous growth rates less than half of those in 1928 and 1929.
Finally, we had what I described in 2007 as the first truly global bubble. It covered all global stocks, fi ne arts and collectibles, and almost all of the real estate markets. The last of these was led by the U.S. housing market, which, having benefitted from its great diversity had historically been remarkably stable until Greenspan got his hands on it. Compared to previous ultra-stable data, this measured as a 3.5 sigma event, which, according to the EMH assumption of perfect randomness, should have occurred only once every 10,000 years. Yet, encouraged (brainwashed might be a more accurate description) by the EMH, Bernanke (and Yellen) could not, or would not, even recognize the risk, to our very substantial cost.”
On the markets, Jeremy believes, “In the meantime investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years – and that most foreign markets having moved up rapidly this summer are also overpriced but less so. In our view, prudent investors should already be reducing their equity bets and their risk level in general. One of the more painful lessons in investing is that the prudent investor (or “value investor” if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve.”
Click here to read this outstanding piece. Note that Jeremy’s letter starts on page 7.
The Economic Confidence Model – Martin Armstrong
Several years ago a good friend and colleague turned me on to Martin Armstrong’s work. Martin’s Economic Confidence Model is a refined theory of the Business Cycle. As Martin puts it, “The Business Cycle has been observed by many over the centuries and the driving mechanism is indeed complex, but it certainly incorporates many aspects from the repetitive forces of nature as in the changing seasons to the human passions of man that to a large extent result in the repetitive forces driven by the passions of man.”
His model incorporates centuries of data and details what he believes is an identifiable pattern. I have seen no other model with such a collection of historical data. In the “it matters” category, it is his base understanding of global capital flows and business cycle patterns that catches my attention.
Here is a sample of his model.
Here is a quote from a recent blog, “The whole proposition that money has to be tangible is like trying to argue that the world should be vegetarian. Animals eat animals. That is nature. You cannot change that. This idea that money should be tangible and always retain its value is up there with Marxism. It defies history and you cannot show any period in the past where such a Utopian world of finance ever existed. Bretton Woods collapsed as did every attempt to create any monetary system of some fixed value. There is a natural course of a business cycle to the economy you cannot flatline or eliminate no matter how many schemes you invent from central banks, Keynesianism, Monetarism, Socialism, or Communism. It just cannot be accomplished.
Sorry – been there, done that countless times.”
I enjoyed the following quote:
“Even the previous Chairman of the Federal Reserve Arthur Burns (1904-1987) shared the same view. Government with all its power and endorsement of John Maynard Keynes (1883-1946) who argued that the economy can be managed to eliminate the Business Cycle, has been unable to prevent recessions and economic booms.
Indeed, the Business Cycle is as regular as the four seasons for even weather is incorporated within it. As weather has fluctuated according to a 300-year cycle in the energy output of the sun, mankind has been driven hither and yon in search of better weather and food supply. Thus, migration throughout the world has also been a by-product of the Business Cycle. Even if we look at the economic composition of society since the late 1700s, we can see how nothing remains stagnant but is always captured within the fluctuations of the Business Cycle.
I have followed Martin Armstrong’s blog for several years. He provides the information for free. You can do some research on him and come to your own conclusions as to what motivates him. Despite the many typos and sometimes confusing text (which after a while you will totally get what he is saying), I think he is brilliant.
Here is a link to his website.
Risk Parity Rebuffed: Dalio versus Ineichen – Barclay Leib
I had an enjoyable day yesterday reconnecting with a long time friend, Barclay Leib. Our friendship goes back to our joint hedge fund days. Today, he is a Portfolio Manager in Alternative Investments at Fortigent and he is truly one of the sharpest thinkers I know.
He hails originally from Princeton University’s Woodrow Wilson School of International & Public Affairs where he was named a Wilson Scholar (a distinction deemed “above Highest Honors”). Ok – pretty smart. Prior to joining Fortigent, Barclay ran his own alternative asset consulting business, Sand Spring Advisors LLC, and for years wrote a quarterly piece on market cycles. I always looked forward to his research. (Hint to Barclay – get that letter back in circulation. He has a great feel for long-term market cycles.)
I once again enjoyed reading my friend’s work. He is candid in opinion and makes a number of important points in his most recent piece, Risk Parity Rebuffed: Dalio versus Ineichen. Here is link and following are a few highlights:
After taking a jab at Dalio, Barclay states, “… Ineichen follows the logic of Professor Mark Buchanan that traditional equilibrium economic thinking (that so many of us learned within our Samuelson Econ 101 texts) is actually quite passé. Per the Ineichen/Buchanan view, markets and economies behave more in a fractal matter like the weather, where small incremental changes (think “Butterfly Effect”) can and do build into occasional tornadoes and typhoons. Such “tail risk” events are actually normal and to be expected both in the natural world and — by extrapolation — within our capital markets. And yet, when central bankers try to suppress these occasional market tornadoes and typhoons, traditional Austrian economic analysis would suggest that the ultimate storms that build will only be more severe.
Within such a world, risk is perhaps better defined not by the relative volatilities of two investment assets but more by the risk of permanent capital impairment from a portfolio allocation mistake. In Ineichen’s words: “When risk for an asset class is defined as “potential years under water in real terms,” i.e. the longevity of capital compounding negatively, bonds are more risky than equities.”
Matters!
Summary thoughts:
We are in a unique period of time. Global central banks are creating currency units at a pace we have never before witnessed. The developed countries are all printing at the same time. The problem is unmanageable debt and entitlements. Can they soft land this thing? Maybe – though I doubt it. Too many moving parts and their political motivations are far too shortsighted (positioning for the next election). Unfortunately, their business aptitude, market knowledge and economic experience are simply non-existent.
Today’s solutions turn in to tomorrow’s problems. No one can change the business cycle and frankly that is a good thing as that drives future innovation and progress. Not everyone gets a trophy. Sometimes, most times, failure becomes our greatest teacher.
I believe Barclay correctly identifies fixed income as the greatest portfolio risk that exists today. This is a huge problem as every asset on the planet prices its risk relative to interest rates. The good news is that there are a number of relatively simple ways to protect your portfolio from this risk. As Barclay states, “Or maybe, per yet another academic thinker, Dr. Andrew Lo of MIT, the true last frontier of efficient allocation theory (yet to be broadly learned by most allocators today) will be for investors to learn how to short assets.”
I was pleased to see his mention of Dr. Andrew Lo, as he and his team at Alpha Simplex serve as sub-advisor to our Global Equity Strategy.
Trade Signals: Even Higher Extreme Sentiment Readings 11-20-2013
I share some ideas around using liquid equity options as a tool to hedge equity risk exposure. They can also be used to hedge against rising interest rates and other fixed income related risks. There are other liquid tools available to you as well. Forewarned is forearmed. Stay armed with some sort of formal plan. A once in a generation buying opportunity is ahead.
Here is the link to Wednesday’s post.
This year it is Thanksgiving at our house and the house will be packed. Brianna’s coming home from school and NYC boyfriend is joining us this year. I’ll make sure her five brothers run the guy through the mill. Susan’s parents are coming up from Florida and they are a total joy to be with. My two sisters and their families are coming. I can’t wait. Thanksgiving is my favorite holiday.
I hope you get to slow down, unwind and totally enjoy the love you share with your family. Matters!
Wishing you a wonderful Thanksgiving!
With kind 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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