CMG

Wealth through ingenuity

Linkedin

On My Radar: For Want of A Nail

  • Share This:
Print Friendly, PDF & Email

 

January 20, 2023
By Steve Blumenthal

“Debt crises are inevitable. Throughout history, only a very few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done badly due to how the cycle affects people’s psychology to produce bubbles and busts.

Most debt crises, even big ones, can be managed well by economic policymakers and can provide investment opportunities for investors if they understand how they work and have good principles for navigating them well.”

– Ray Dalio

The debt drama stepped to center stage yesterday. Treasury Secretary Janet Yellen said the $31.4 trillion debt ceiling had been reached and that the Treasury would begin taking “extraordinary measures” to avoid default. She warned, however, that there is “considerable uncertainty” around how long such measures can continue before the US government runs out of cash.

“Extraordinary measures” means cost cutting. And the government will certainly run out of cash in the coming months unless Congress reaches an agreement to raise the debt ceiling. “I respectfully urge Congress,” Yellen said, “to act promptly to protect the full faith and credit of the United States.”

Such an agreement may not come easy, though—a hot battle is brewing on the Hill. The debt ceiling challenge follows November’s midterm elections, which left Democrats in control of the Senate and Republicans with a slim majority in the House of Representatives. Republican Kevin McCarthy was elected Speaker of the House after a historic 15 rounds of voting and a dramatic series of events on the House floor. In the end, to ensure his election, McCarthy gave considerable concessions to a group of far-right conservatives, including an easier path to his removal. Speaking to reporters after his victory, he said, “It’s time for us to be a check and provide some balance to the president’s policies.” He added, “We commit to stop wasteful Washington spending; to lower the price of groceries, gas, cars, housing; and stop the rising national debt.” (emphasis mine)

I intended to move past the debt crisis topic this week; however, the government’s funding needs came sooner than expected. The Republicans in Congress are hardened to rein in President Biden’s spending, and the first shots have been fired. McCarthy accused Mr. Biden of arrogance earlier this week for failing to negotiate borrowing limits. More drama immediately ahead.

A debt restructuring will ultimately occur, either intentionally (which is most probable as explained in my short summary of Dalio’s recent piece below) or unintentionally, by market and economic forces such as inflation, deflation, defaults, depression, and selling pressures affecting stock and bond markets driven by asset holders rushing for liquidity.

Your job and my job is to navigate the coming restructure well and not get run over. To do so, let’s take a step back, zoom out, and look at the big picture (as in Dalio’s “Understanding Big Debt Crises”). Few of us have lived through a big debt crisis before—that’s the big “Aha” here—and we’ve hit another pocket of turbulence this week. The seat belt signs are back on. Buckle up.

Here is a quick bullet-point summary of Ray Dalio’s recent post (bold emphasis is mine):

  • Over time environments will shift between those that are good and bad for lender-creditors and borrower-debtors, and it is critical for everyone who is involved in markets and economies in any way to know how to tell the difference. While this balancing act and the swings between the two environments take place, sometimes conditions make it impossible to achieve a good balance. That causes big debt, market, and economic risks.
  • The best way for policymakers to reduce debt burdens without causing a big economic crisis is to engineer what I call a “beautiful deleveraging,” which is when policy makers both 1) restructure the debts so debt service payments are spread out over more time or disposed of (which is deflationary and depressing) and 2) have central banks print money and buy debt (which is inflationary and stimulating). Doing these two things in balanced amounts spreads out and reduces debt burdens and produces nominal economic growth (inflation plus real growth) that is greater than nominal interest rates, so debt burdens fall relative to incomes.
  • If done well, the deflationary and depressing reduction of debt payments and the inflationary and stimulating printing of money and buying of debt by the central banks balance each other. In the countries I studied, all big debt crises that occurred with the debts denominated in a country’s own currency were restructured quickly, typically in one to three years. These restructuring periods are periods of great risk and opportunity.
  • History shows us that when central banks can’t lower interest rates anymore and want to be stimulative, they print money and buy debt, especially government debt. That gives debtors, most importantly governments, money, and credit to prevent them from defaulting and allows them to continue to borrow to spend more than they are earning, so their debts can continue to increase. That is what has been happening since 2008.
  • What hasn’t changed through these shifts in monetary systems over the millennia—and hasn’t been eliminated as a problem—is the creation of unsustainably big debt liabilities and assets relative to the amounts of money, goods, services, and investment assets in existence, which can lead to a run for the money and the goods and services that have intrinsic value.
  • Because the only value of debt assets and other financial assets is to buy goods and services, if the holders of those financial assets actually tried to convert these assets back into money and goods and services, they would see that they couldn’t get the buying power they believe exists which could cause a run that’s like a bank run. For that reason, there remains the risk that those who are holding financial assets will turn them in for money to buy goods and services, which would cause either inflationary spirals or severe economic weakness, depending on how much the central bank tries to fight the economic contraction effects by printing money and making credit easily available.
  • While central banks can more easily and flexibly print money and give it to debtors to alleviate the debt problems and give spenders the ability to spend in a fiat monetary system, it should be noted that their doing so doesn’t eliminate the rises in debt assets and debt liabilities that become excessive and produce debt crises. My examination of past cycles, including those in fiat currencies, shows the debt cycle dynamics I described, including very big debt crises, always existed in virtually all countries.
  • I see no reason to believe they will stop. On the contrary, debt assets and debt liabilities are now very high and still rising, so it looks more likely that most economies’ central banks, most importantly the US’s Fed, Europe’s ECB, and Japan’s BoJ, are approaching the limits in their abilities to continue the money-credit-debt expansions that have been true throughout our lifetimes.
  • To repeat, when there are big debt crises, central banks have to choose between keeping money “hard,” which will lead debtors to default on their debts which will lead to deflationary depressions, or making money “soft” by printing a lot of it which will devalue both it and debt. Because paying off debt with hard money causes such severe market and economic downturns, when faced with this choice, central banks always eventually choose to print and devalue money.
  • If debts are denominated in a country’s own currency, its central bank can and will “print” the money to alleviate the debt crisis. This allows them to manage it better than if they couldn’t print the money, but of course, it also reduces the value of the money.
  • Debt crises are inevitable. Throughout history, only a very few well-disciplined countries have avoided debt crises. That’s because lending is never done perfectly and is often done badly due to how the cycle affects people’s psychology to produce bubbles and busts.
  • Most debt crises, even big ones, can be managed well by economic policymakers and can provide investment opportunities for investors if they understand how they work and have good principles for navigating them well. Source and full disclosures here.

My client and good friend David B sent me a nice email this week that included the following proverb:

“For want of a nail, the shoe was lost.
For want of a shoe, the horse was lost.
For want of a horse, the rider was lost.
For want of a rider, the battle was lost.
For want of a battle, the kingdom was lost,
And all for the want of a horseshoe nail.”

(Source: Robert M. Williamson)

Benjamin Franklin used a version of this proverb, preceded by the words “A little neglect may breed great mischief,” in Poor Richard’s Almanack in 1758 when the American colonies were at odds with the English Parliament. An important reminder of how fragile, complex systems are…and how a minor misstep can have grave consequences.

We sit at the end of a long-term debt super-cycle—the last time this occurred was in the 1930s.

If you’re a Netflix series–watching junkie like Susan and me, I feel like we just started Season 14 (fourteen years since 2008) of a mini-series, let’s call 2023: Debt Wars. Season 14 Episode 1, titled “For Want of A Nail,” stars Yellen, McCarthy, and Biden. The radical right fights the socialist left while the middle tries to hold firm. The debt ceiling has been reached sooner than expected. This episode is going to be exciting.

While I was skiing in Snowbird last week, I asked my son Kyle to audio-recorded Ray Dalio’s “Navigating Big Debt Cycles” work and post it on our Spotify page. For me, I found listening to the audio recording while reading the text a better way to absorb the information. I’m not sure what works best for you, but here is the text version, and if you missed the OMR post last week, you can find the audio recording on Spotify here.

I know I’m hitting the end of the long-term debt cycle topic hard. I could be wrong, but I do believe it to be the seminal issue of our day. Frankly, if stock market valuations were fairly priced, I’d be less concerned about the equity market. But they’re not, as you’ll see below in the section titled “The History of PE and Subsequent Returns,” where I share a few great charts from my friend Ed Easterling at Crestmont Research.

Grab that coffee and find your favorite chair. I’ve got a handful of interesting tweets for you in the Random Tweets section, updated Trade Signals, and a short summary of “Where’s Waldo?” in the personal section. Tampa, California, and Park City are up next. Yahoo…

(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.)

If you are not signed up to receive the free weekly On My Radar letter,
you can subscribe here.

The History of PE and Subsequent Returns

The following reflects the P/E 10 (orange line) and the S&P 500 Index Rolling 10-year Total Return history from 1900 through 2022.

From Crestmont Research: Keep in mind that P/E drives returns. This happens in two ways. First, the level of P/E drives dividend yield (high P/E causes low dividend yield). Second, the starting level of P/E largely affects whether P/E rises or falls over ten-year periods (Components chart), which adds or detracts from the total return. The propensity to rise is greater when P/E is lower. Conversely, P/E is more likely to decline from relatively higher levels.

Here’s the exciting (and insightful) part. The starting P/E for the next nine rolling decades is already known! They occurred from 2014-2022, which correspond to the nine future rolling ten-year periods ending 2023-2031.

Bottom line: PE 10 is high; expect coming 10-year returns for the S&P 500 cap-weighted index to be low.

Here’s how to read the chart:

  • Annualized 10-year actual achieved total returns are the green bars
  • Note that when the orange P/E 10 line is below the long-term 10% annualized total return purple line, the subsequent 10-year annualized returns are best.
  • When the orange P/E 10 line is above the long-term 10% annualized total return purple line, the subsequent 10-year annualized returns are worst.

Here is a bit more from Ed Easterling:

  • The green bars represent the total return (market gains and dividends) for all ten-year periods since 1900. The first bar is 1900-1909; the second bar is 1901-1910, etc. The right-most bar is 2013-2022.
  • The orange line is the P/E ratio for the market at the start of each ten-year period. The left-most point on the line is P/E for 1900. In other words, the P/E line is shifted to the right by nine years.
  • The P/E line reflects P/E for each year. The bars reflect annualized returns for each rolling ten-year period.
  • The chart aligns the level of P/E at the start of each bar’s decade with that decade’s return. For example, the point on the line above the bar for 2013-2022 is the P/E for 2013.

I shared this next chart in my book, On My Radar: Navigating Stock Market Cycles.  I’ve asked Ed to outdated the chart, and he’s working on it.  What I like about it is it gives the range of actual outcomes based on starting PE. The message remains the same as it did in 2019.

 

Here is some additional color on Shiller PE or P/E 10 from Gurufocus:

Prof. Robert Shiller of Yale University invented the Shiller PE Ratio to measure the market’s valuation. The Shiller PE is a more reasonable market valuation indicator than the PE ratio because it eliminates fluctuation of the ratio caused by the variation of profit margins during business cycles. This is similar to market valuation based on the ratio of total market cap over GDP, where the variation of profit margins does not play a role either.

GuruFocus calculates the Shiller PE ratio of individual stocks and different sectors. Here you can see the Sector Shiller PE, it shows you which sectors are the cheapest. Here you can see Shiller PE of individual stocks.

How Is the Shiller PE Calculated?

  1. Use the annual earnings of the S&P 500 companies over the past 10 years.
  2. Adjust the past earnings for inflation using CPI; past earnings are adjusted to today’s dollars.
  3. Average the adjusted values for E10.
  4. The Shiller PE equals the ratio of the price of the S&P 500 index over E10.

Why Is the Regular PE Ratio Deceiving?

The regular PE uses the ratio of the S&P 500 index over the trailing 12-month earnings of S&P 500 companies. During economic expansions, companies have high-profit margins and earnings. The PE ratio then becomes artificially low due to higher earnings. During recessions, profit margins are low, and earnings are low. Then the regular PE ratio becomes higher.

The highest peak for the regular PE ratio was 123 in the first quarter of 2009. By then, the S&P 500 had crashed more than 50% from its peak in 2007. The PE ratio was high because earnings were depressed. With the PE ratio at 123 in the first quarter of 2009, much higher than the historical mean of 15, it was the best time in recent history to buy stocks. On the other hand, the Shiller PE ratio was at 13.3, its lowest level in decades, correctly indicating a better time to buy stocks.

(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.)

If you are not signed up to receive the free weekly On My Radar letter,
you can subscribe here.

Random Tweets

Mortgage rates have come off their highs and are down from the November 2022 high (chart below) but still elevated at approx. 5.5% 

 

Interest expense on U.S. government debt at $1.2 trillion is now greater than the U.S. defense budget:

Higher interest costs on mortgages and other forms of debt, plus the higher cost of goods due to inflation, equals a slowing economy.  Recession is here.

 

A well-executed political kabuki dance, indeed:

Harold Malmgren. Yup, what he said…

I am a really big Tulsi Gabbard fan:

That concludes my favorite captured tweets of the week. Follow me @SBlumenthalCMG.

If you are not signed up to receive the free weekly On My Radar letter,
you can subscribe here.

Trade Signals: 10-Year Treasury Falls to 3.38% – Bullish Signal on Bonds Remains

January 18, 2023
S&P 500 Index — 3,929

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-term, intermediate-term, and long-term cycles. We track important valuation metrics as they can help us assess the probability of future returns (when investment opportunity is best/least). Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators.

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

Market Commentary

Equity markets sold off over the course of the day as the S&P fell just over 1.5%, and the Nasdaq closed around 1.25% lower, the worst drop for the S&P in around a month.  In economic news, retail sales dropped more than projected, and producer prices fell more than anticipated in December, which may have prompted the Fed to shift from its tightening policy. Still, several FOMC officials today reiterated the need for further hikes.  It looks like hiring freezes are coming into effect again, with BofA telling executives to pause hiring for non “vital” positions and Microsoft announcing it would cut 10k jobs.” Source: 1-18-23 market close summary from our friends at Wallach Beth

The Zweig Bond Model and 10-Year Treasury MACD signals remain bullish on bonds signaling lower yields and higher bond prices. Following is Vanguard’s Extended Duration Treasury ETF. It’s been a wild ride for long-term bond investors over the last two years. Note the move higher in the bottom right-hand section of the chart. While the Fed stays firm in its inflation fight, the bond market tells us the economy is weakening.

Daily investor sentiment reached extreme optimism coinciding with technical resistance in the S&P 500 Index at 4,000. The dominant market trend remains down (red line). The intermediate and long-term equity market signals remain bearish.

The Dashboard of Indicators follows next which includes the economic and select recession watch and gold indicators.

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 

If you are not signed up to receive the free weekly On My Radar letter,
you can sign up here.

Personal Note: Tampa, California, and Park City

The weather has been relatively mild here in the Northeast this week. Susan has me joining her at an impact fitness class, and I feel my addiction to it setting in. It’s a 30-minute strength and cardio workout, and the 30-something owners are upbeat and passionate about diet and exercise. Their excitement is contagious, but I think the key is the 30-minute length. Very doable. Overall, it’s good for the body and a “bubble bath” for the brain (hat tip to daughter Brie for the phrase).

Next Tuesday, I fly to Tampa for a day of due diligence on several investment opportunities we’re researching. My golf clubs are flying down with me. The plan is to play Old Memorial on Thursday morning before catching my flight home later that afternoon.

Brianna has a big birthday coming up, so Susan and I are flying to California to spend a weekend celebrating with her. We are thinking of flying into San Francisco and driving down the coast, making a stop or two along the way. Let me know if you have any recommendations for us.

Last up: WallachBeth Capital is hosting its annual Winter Symposium in Park City, Utah, in the first week of March. A combination of early morning business meetings, skiing in the afternoon, and bourbon tasting in the evening. I’m really looking forward to the WB event as well.

Ok, enough about me—thanks for the indulgence. I hope you have some upcoming fun to look forward to. Here’s one piece of advice an investment advisor can guarantee. Mix some joy into your business adventures. It brightens the journey.

Remember to listen to On My Radar on Spotify.

Wishing you a great week!

Steve

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

If you are not signed up to receive the free weekly On My Radar letter, you can sign up here. Follow me on Spotify, Twitter @SBlumenthalCMG, and LinkedIn.  

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

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.

IMPORTANT DISCLOSURE INFORMATION

This document is prepared by CMG Capital Management Group, Inc. (“CMG”) and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives, or tolerances of any of the recipients. Additionally, CMG’s actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing, and transaction costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This material is for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment, or other advice.

Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by CMG), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CMG. Please remember to contact CMG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. CMG is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice.

No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.

This presentation does not discuss, directly or indirectly, the amount of the profits or losses realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, has not been independently verified, and does not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. See in links provided citing limitations of hypothetical back-tested information. Past performance cannot predict or guarantee future performance. Not a recommendation to buy or sell. Please talk to your advisor.

Information herein has been obtained from sources believed to be reliable, but we do not warrant its accuracy. This document is general communication and is provided for informational and/or educational purposes only. None of the content should be viewed as a suggestion that you take or refrain from taking any action nor as a recommendation for any specific investment product, strategy, or other such purposes.

In a rising interest rate environment, the value of fixed-income securities generally declines, and conversely, in a falling interest rate environment, the value of fixed-income securities generally increases. High-yield securities may be subject to heightened market, interest rate, or credit risk and should not be purchased solely because of the stated yield. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). Investment-grade investments are those rated from highest down to BBB- or Baa3.

NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.

Certain information contained herein has been obtained from third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness.

In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional.

Written Disclosure Statement. CMG is an SEC-registered investment adviser located in Malvern, Pennsylvania. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy, or exclusively determines any internal strategy employed by CMG. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at www.cmgwealth.com/disclosures. CMG is committed to protecting your personal information. Click here to review CMG’s privacy policies.