December 15, 2023
By Steve Blumenthal
“So it will be a period that differs completely from what we have lived through, what everybody who is active in the markets today has ever experienced. It’s completely different. And I just want to tell people to be prepared for a change in the environment, for a change in the markets, and for a change in the way markets behave; it will be much more volatile, because when you enter uncertain times, and things appear that you have never seen before, you are afraid, you become fearful.“
– Felix Zulauf
It’s been an exceptional rally for the stock market, and Fed Chairman Jerome Powell poured some more fuel on the fire this week. He signaled that we could see three rate cuts ahead in 2024. If we avoid a recession and the Fed stays true to its game plan, that will be good for equities. If we have a recession and the Fed cuts rates, however, it will be not so good. With a shuffled deck, Powell has played a new hand. Instead of fighting inflation alone, his Fed is now fighting inflation and avoiding recession.
Markets loved Powell’s verbal pivot. The 10-year Treasury yield is trading below 4% (down from 5% in October). The S&P 500 Index is approaching the all-time high of 4,818 reached in 2021.
But hold on—NY Fed President John Williams was on CNBC this morning and said the central bank isn’t “really talking about rate cuts right now.”
“We’re very focused on the question in front of us,” he said, “which, as Chair Powell said…is, ‘Have we gotten monetary policy to a sufficiently restrictive stance in order to ensure the inflation comes back down to 2%?’” He dialed back the rate cut talk. Nothing like a bucket of ice-cold water to cool the exuberance.
Frankly, I don’t believe the Fed knows what to believe. The bullish scenario depends on a soft landing / avoiding recession and a Fed rate cut. However, there has always been talk of a “soft” landing before past recessions. According to David Rosenberg, there have been 14 Fed interest rate–hiking cycles since 1950. Eleven of them landed us in recession. The most recent rate-hike cycle has been the fastest and most aggressive of the prior 14. In my view, a “soft” landing is improbable.
Rosenberg Research
Recession Comes After the First Fed Cut
Keep the following data from Rosenberg Research at the top of your mind:
Pause or Cut—The Math Is About the Same
Rosey says, don’t buy stocks on the first rate cut. The numbers are similar to when the Fed pauses. He says, the average decline from the date of the Fed pause to the ultimate low in the S&P 500 is -25%; the median is -20%. Some bear markets are better or worse than others. Markets have historically bottomed when the Fed gets 70% of the way through the rate-cut cycle, which is typically about 16 months after the pause. If we follow that same pattern this time, that would put the market bottom sometime in 2024. Rosey’s advice is, “Fade the Fed pause, as well as the first rate cut (but buy the last cut). “
Bottom line: The market believes that the Fed cutting rates will be bullish. That may be true if there is no recession, as happened in 1995. But in 1995, neither valuations nor the level of debt were as high as they are today—something to keep in mind. Stocks remain overvalued, but not as much as they were in 2021. They are worse relative to bond yields.
It’s been a while since we last looked at valuations, though. Today, let’s look at the most recent data through a different lens and channel our inner Charlie Munger: “Extreme patience combined with extreme decisiveness.” You’ll find there are areas of opportunity.
Grab your coffee and find your favorite chair. I think you’ll find it interesting.
Here are the sections in this week’s On My Radar:
- Valuations and Forward Returns
- Transcript to Zulauf – Blumenthal Podcast
- Random Tweet’s
- Personal Note: Holiday Season
- Trade Signals: Weekly Update, December 14, 2023
(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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Valuations and Forward Returns
Chart 1: S&P 500 Vs. Stock Market Capitalization as a Percentage of Gross Domestic Income
This is neither a trading model nor a recommendation to buy or sell security. I use it to gauge how markets have performed when this valuation measurement was in the bottom 20% (most underpriced) of all readings dating back to 1925 vs. periods when in the highest 20% (most overpriced) of all readings.
- The yellow line tracks the valuation level of the S&P 500 index as a percentage of nominal GDI
- The blue line in the lower section plots the level that the yellow line is above or below the dotted blue line.
- Looking again at the lower section, when the blue line is above the top horizontal dotted line, it signals the 20% most overvalued readings. Below the bottom horizontal line signals the 20% most undervalued readings.
- Finally, the data box at the bottom section shows the average percentage change in the S&P 500 Index 1-, 3-, 5-, 7-, 9- and 11-years later.
- Clearly, the best opportunities present when Stock Market Capt as a Percentage of Gross Domestic Income is in the bottom quintile.
Chart 2: S&P 500 Vs. Long-Term Trend
In this next chart, we are looking only at the S&P 500 in comparison to its long-term trend.
- A similar idea in terms of looking for extreme deviations in the price above and below the long-term trend line. Center section of the chart.
- Note the annualized return box in the upper left corner. We currently sit in the “Top 20% of Readings.”
- Note the average annualized returns 1-, 3-, 5-, and 10-years later.
Chart 3: Buffett’s Favorite – Stock Market Cap as a Percentage of Nominal GDP
How to read the chart:
- The blue line is the estimated value of 4300 U.S. common stocks.
- Compare it to the rising dotted trend line in the center of the chart.
- Above the line, the stock market is overvalued. Below the line, it is undervalued.
- The chart has a lot going on, but that’s the basic concept.
- I guess that this is likely one of the main reasons Berkshire Hathway, Warren Buffett’s company, is sitting on record amounts of cash.
Chart 4: Shiller PE Ratio vs. S&P 500 Return by Decile
I post this next chart each week in Trade Signals.
First, note the current reading as of today is 30.90. You can look back over the prior 143 years to see how the current level compares to history.
- Currently near the 1929 peak, lower than the 2000 tech bubble, and lower than the 2021 peak.
- Bottom line: Still too high signaling the stock market is over priced.
This final chart is courtesy of Ed Easterling at Crestmont Research. The data goes back to 1909. Crestmont looks at returns over subsequent 10-year periods.
- First, they determine the PE level using the 10-year PE ratio. That’s what Shiller does in the chart above.
- Then, they create ten categories (or deciles) that range from most expensive (highest 10% of all PE readings) to least expensive (lowest 10% of all PE readings).
- I like how Creastmont sorts the return ranges by decile, ranging from lowest subsequent 10-year return to highest, and then plots the average. Average is a good way to handicap potential outcomes. No one really can know for sure. Such is the water in which we swim.
- Bottom line: “We are here” in the most expensive readings, and returns are likely to be flat over the next ten years. “We’d be better off here” in deciles 6 through 10.
Not a recommendation to buy or sell any securities. Opinions expressed may change at any time.
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Transcript to Zulauf – Blumenthal Podcast
I received several requests for a transcript of the podcast. You can find a printout of the discussion by clicking here.
And, if you are like me and learn best by reading along while listening to the audio, open the print version and then click on the picture to link to the full audio discussion posted on Spotify.
Not a recommendation to buy or sell any securities. Opinions expressed may change at any time.
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Understanding Private Credit
One of the areas wealthy investors are looking at is short-term senior secure floating rate private credit. If you listen to the Zulauf – Blumenthal podcast, you’ll get a sense of Felix’s and my outlook on the direction of inflation and interest rates and broader macroeconomic challenges in general. Owning a 10-year Treasury Note yielding 4.00% will be challenged in an environment that may see interest rates rise to 5% or even 10% in the next inflation wave I foresee ahead. Yes, we may see 3.5% before we see 5% again, but the return potential is low relative to the high principal loss risk. One may consider trading the intermediate-term trends vs. buying and holding bonds.
Alternatively, we favor senior secure floating rate private credit investments and other types of alternative investment strategies, which we write about in a paper titled Understanding Private Credit. A simple introduction to the world of private credit. Click on the following link to sign up to receive the paper.
UNDERSTANDING PRIVATE CREDIT – THE FIRST IN A SERIES OF PAPERS TO BETTER UNDERSTAND THE TYPES OF ALTERNATIVE INVESTMENTS AVAILABLE TO ACCREDITED INVESTORS (FREE TO READERS)
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change. Your privacy is important to us.
Random Tweet’s
Every year Byron Wein publishes his top 10 surprise list. Here is the link:
We’ll actually there are three ways – a combination of A and B:
Current Top 5 stocks make up approximately 26% of the S&P 500 Index:
Click on the image to learn more from Jim:
Red circle bottom right in the chart:
Follow me on X (formerly Twitter) @SBlumenthalCMG.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
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Personal Note: Holiday Spirit
“A few years’ experience will convince us that those things which at the time they happened we regarded as our greatest misfortunes have proved our greatest blessings.”
– George Mason (December 11, 1725 – October 7, 1792)
I woke up this morning, grabbed a coffee, and thought about my father. Today would be his 88th birthday. Dad “graduated,” as I like to say, in 2011. I sure do miss him. He had a wonderful way of calming me down whenever things got tough, giving me a gentle reminder that, as the quote says, from our greatest misfortunes come our greatest gifts. How perfect is that? Happy birthday, old man.
I hope this note finds you in full holiday spirit. I’m starting to feel it, and I better get to work. That’s the plan this weekend (except for some golf tomorrow due to the sunny, 50-degree forecast). Next Tuesday is our office holiday party. I’ll be bringing the wine, and I told Avi to order the bagels, lox, and cream cheese. “Make sure there’s some kipper salmon and gefilte fish, too,” I said. Few non-Jewish people I know have had the opportunity to experience gefilte fish. I think it’s a polarizing food: You either really like it or you don’t. Tread carefully, friends. For the party, Chick Filet is right across the street from our office if all else fails. Most importantly, it will be nice to have the team together.
It will also be nice for Susan and me to have all our children together with us over the holidays. We enjoy being empty-nesters—it is much easier than when the kids were younger—but seeing them create for themselves brings us great joy. Even watching misfortunes turn into blessings!
I’m sure you feel the same about your children, grandchildren, and/or your sibling’s children. Two of our six children, Kieran and Conner, arrived home this week from college. Tyler lives near home in a revitalized town called Phoenixville, Pennsylvania. It’s got great food, shops, and fun. He works for a cyber security firm focused on the next-level quantum computing. Brianna has been in Australia for much of the last six weeks and begins a new job in NYC in January. I’ll pick her up at the Phila airport on Sunday. Susan and I are thrilled she is moving back to the East Coast. Matt and Kyle fly home next week—a joy to be had for sure.
I’ll be in NYC next week for a meeting before the holidays. Trips to Colorado, Utah, and Western Canada are on the schedule for February and March. Two for fun, one for work. Bring on the snow. Ski season is here!
All the very best wishes to you and yours!
Trade Signals: Weekly Update – December 14, 2023
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Notable this week:
Post yesterday’s (December 13, 2023) Fed meeting, Chairman Powell said the Fed expects to cut interest rates three times in 2024. Equity markets loved the news and rallied after the Fed decision. The S&P 500 and Nasdaq indices were both higher by ~ 1.30%. This is a larger cut in 2025 than the Fed has previously signaled. Powell said that policy has moved into restrictive territory and that the Fed will proceed carefully as inflation is still too high. But he added that recent signs of inflation easing without rising unemployment are a move in the right direction.
Both the Zweig Bond Model and the 10-year Treasury Weekly MACD signals remain bullish. It has been an exceptional rally in bond prices.
Felix Zulauf
In last week’s Zulauf-Blumenthal podcast, Felix talked about the primary indicator he uses on all asset classes and individual stocks. It is a version of the Weekly MACD based on time-weighted momentum. Felix said this,
“I use a proprietary momentum tool on virtually all assets in the world, from the macro assets to individual securities. And it’s based on time-weighted momentum. It is faster than the MACD. It’s time-weighted momentum. It’s not perfect; it has its weaknesses. But I have been working with this tool since the late 70s, and I’m familiar with the weaknesses and with the strengths.”
What is Time Weighted Momentum?
AQR Capital Management’s Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen contribute to the literature on time-series momentum with their June 2017 study, A Century of Evidence on Trend-Following Investing” — an update of their 2014 study, “Time Series Momentum.” They find that “a diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets.”
MACD is a version of time-weighted momentum. The following are a few bullet points from Investopedia,
- MACD triggers technical signals when the MACD line crosses above the signal line (to buy) or falls below it (to sell).
- MACD can help gauge whether a security is overbought or oversold, alerting traders to the strength of a directional move, and warning of a potential price reversal.
- MACD can also alert investors to bullish/bearish divergences (e.g., when a new high in price is not confirmed by a new high in MACD, and vice versa), suggesting a potential failure and reversal.
Felix often posts a Weekly MACD in his institutional subscription service. They are similar to the MACDs I share each week in Trade Signals. If you’d like to learn more about MACD, the above can help. I’m happy to send you a sample of the chart and the momentum math that is used. Email me at Blumenthal@cmgwealth.com.
The dashboard of indicators and the stock, bond, developed, and emerging market charts, along with the dollar and gold charts, are updated each week. We monitor inflation and recession as well. If you are not a subscriber and would like a sample, reply to this email, and we’ll send you a sample.
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Stephen B. Blumenthal
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