January 16, 2015
By Steve Blumenthal
“All I can do is advise you on what has happened before. Once one country goes, capital will look around and turn on whoever they think is next. Eventually, this will move from one to the next. The dollar will be the last man standing. After that, we are looking at some new world currency that should emerge. We have reached the extreme point in government debt.”
Martin Armstrong
I highlighted three valuation measures earlier this month Click Here: one based on reported earnings through 12-31-2014, one based on operating revenue, and Warren Buffett’s favorite valuation indicator Stock Market Capitalization as a Percentage of Gross Domestic Income. The market is expensively priced. The problem is that when valuations are high, the probable forward returns are low. This doesn’t mean the U.S. equity market can’t go higher from here; but it does mean that risk is much higher.
With a 10-year Treasury yield touching 1.81%, the bond market is clearly telling us something. We are in a high debt, low growth trap. The world is fighting deflation. I have written a great deal about the coming currency wars and probable outcomes. This past week deflationary forces claimed their first “currency war” victim, Switzerland.
Next week, Mario Draghi enters center stage as tensions grow with the legal authorities in Germany. He may indeed turn out to be “Super Mario”. Assuming he can shock and awe with large scale QE – I believe he may finally attempt to act on his “whatever it takes” statement. Germany has a significantly different view. Making this is a potentially explosive inflection point for the EU. You’ll find a link below to the beautifully penned and organized thoughts of Ambrose Evans-Pritchard on this topic.
Essentially, I see it as advantage dollar and U.S. stocks and U.S. bonds for now. That puts the Fed into a challenging box. Six years of zero interest rate policy and a desire to move off that peg (for many reasons if not to test the ability of the markets to stand strong) will further accelerate the flood of global capital into dollar denominated assets.
Today, I share a collection of thoughts around deflation, the Fed, the ECB, the dollar and conclude with the usual link to Wednesday’s Trade Signals post. For now, trend evidence remains favorable and “Don’t Fight the Fed” an important theme while risk is high. Broad portfolio diversification (that includes strategies that can tactically pivot between stocks and bonds) and an eye toward risk protection as risk management is, I believe, mandatory (despite how often your client may compare everything he has to the S&P). This is why you are so important to your clients’ long-term success. Volatility is picking up. We will be tested. Stand your ground.
Included in this week’s On My Radar:
- Switzerland ‘capitulates’ on franc as currency wars take next victim. World deflationary forces have swept away Switzerland’s defenses – Ambrose Evans-Pritchard
- The European Court of Justice has this time departed a long way from the rule of the law, even by its own elastic standards – More from Evans-Pritchard
- Navigating High Stock Valuations in a Deflationary World – GaveKal
- Something is Not Right – Jeff Gundlach
- Trade Signals – Margin Debt, Sentiment and Liquidity – 01-14-2015
Switzerland ‘capitulates’ on franc as currency wars take next victim. World deflationary forces have swept away Switzerland’s defenses, says Ambrose Evans-Pritchard
The Swiss National Bank has lost control. It is the latest in a list of venerable central banks to be overwhelmed by deflationary forces and global economic disorder.
The country is already in deflation. The Swiss franc ended Thursday 13pc higher after the SNB abandoned its three-year efforts to defend a currency floor of 1.20 to the euro. “We have a free exchange rate once again,” said the SNB’s president, Thomas Jordan.
The title pretty much says it all. Here is the link to the full piece.
The European Court of Justice has this time departed a long way from the rule of the law, even by its own elastic standards. More from Evans-Pritchard
Mario Draghi steps center stage once again next week. Essentially, we have reached a face-off between the ECB and the German courts.
Germany’s view:
The European Court of Justice has this time departed a long way from the rule of the law, even by its own elastic standards. Further: “Europe’s imperial court is a threat to all our democracies”.
Draghi’s view: “What-ever-it-takes”
Here is the gist of what is at stake:
“The European Court of Justice has declared legal supremacy over the sovereign state of Germany and therefore of Britain, France, Denmark and Poland as well.
The ECJ’s advocate-general has not only brushed aside the careful findings of the German constitutional court on a matter of highest importance, he has gone so far as to claim that Germany is obliged to submit to the final decision. “We cannot possibly accept this and they know it,” said one German jurist close to the case.”
Ultimately, the Eurozone needs QE to avoid a deflation trap. The inflection point is now: Does the ECB have the power to act?
This from CNBC this week: “Mario Draghi, President of the European Central Bank… will have to act “forcefully” in reaction to the deflationary numbers in Europe in the January 22 meeting.”
The European Court of Justice’s green light makes it more difficult for Germany to spoil his next move. And this should be the big move. Oh, the powers that be.
Next week it is “all about ‘dat Draghi”. Fasten your seat belt.
To get a deeper understanding as to what is at stake, click here for the full article.
Navigating High Stock Valuations in a Deflationary World– GaveKal
As we highlighted yesterday, stock valuations jumped again in December to another cycle high. As the first two charts show, the cyclically adjusted P/E multiple has only been higher on several occasions and the median stock is trading at a record price to cash flow multiple as far back as we have data. These high valuation levels leave stocks at risk.
Compounding the risk of high valuations is the fact that world economies and financial markets continue to exude deflationary signs, which if anything are intensifying. As the below charts show, we have our World CPI Proxy at the lowest level since 2009, crude, copper, iron ore and commodity prices in general plunging, global government bond yields making new all-time lows, the US yield curve flattening and TIPS implied inflation expectations at the lowest level since the equity selloff in 2011.
It is evident that global deflation is winning. The above pictures tell a thousand words.
GaveKal goes deeper in the post. Smart guys. Click here to read the full piece. Page down to the January 14, 2015 post.
Something Is Not Right – Jeff Gundlach
I always like to keep an eye on what some of the brightest money managers are saying. Here are a few bullet points to a post I came across recently (bold emphasis mine).
- It is interesting how you have been beginning to see signs of investor concern around the edges about the health of the economy and about the financial system. Historically, when junk bonds give up the ghost and treasuries remain firm, it is a signal that something is not right.
- So what is wrong? I think that certain things are starting to concern investors and maybe it is all tied around speculation on the Federal Reserve raising interest rates. As prospects for a Fed tightening have increased over the year, the Dollar has strengthened and the Treasury bond market has been declining in yields. It is almost as if the treasury market and the junk bond market are projecting that the Fed raising interest rates will cause a recession. I am not going to predict that myself. I am just reading what the market’s message is. How could you explain all these markets acting this way? Well, it seems like as if it had something to do with a policy mistake.
- They (Fed) have not fully gotten out of QE, they are still reinvesting. Also, I suspect that raising rates would be a bigger deal than just reducing bond buying. That is because buying bonds was easy to replace. The amount of bonds the Fed used to buy was taken over by foreigners in China and Europe because of the yield differential and because there was not a lot of fear of being in the Dollar. But raising rates is different. You cannot really replace that. You cannot suddenly have some other entity lending to you at zero. So I think it will change people’s behavior and it will really start to cause volatility in the currency market. (SB here – higher rates will push the dollar higher)
- The Fed has never kept rates stable for six years, let alone at zero. I just believe that the Fed may want to raise rates simply for that reason. They must be aware that the longer they keep rates at zero the more distorted investor psychology and behavior becomes.
- So they want to raise interest rates largely just to see what happens. (SB again – I believe the Fed believes it must test the ability of the markets and they know rates are far from normalized)
- I think they are just nervous about zero interest rate policy going on this long and not having tools to fight any future weakness in the economy.
- It is really a mistake to compare today’s unemployment rate to what would have been an unemployment rate around 6% roughly twenty years ago. Today, there is a great shift towards part time employment. For example Wal-Mart is very visible in this regard. They intentionally hire people for less than 26 hours a week to avoid Obamacare. Well, that means that what used to be three jobs is now five jobs. There is not more money into the economy. Also, what you have is employment growth for people who are over 55. Why is that? They cannot retire because interest rates are at zero. With interest rates at zero an infinite amount of money earns zero, let alone a finite amount of money like $300’000 or $800’000 or whatever the particular individual has saved. There is no chance that they can live off of that. Therefore, what many older people do is they work. But there is very little movement regarding young people. So it seems like the Fed, for reasons that are philosophical rather than fundamental, may raise interest rates.
- My best ideas is very pedestrian – and, unfortunately, totally noncontroversial: The Dollar is getting stronger. That is the thing I am most convinced of. Already at the year-end of 2013 the strengthening of the Dollar was the consensus viewpoint and it turned out to be right. Everybody thinks the Dollar is getting stronger – it is almost uncomfortable. But sometimes the consensus is right.
- How does your personal portfolio look like? Most people’s risk profile – including mine – is way too low. I have that disease as well, I do not take enough risk. That is because I just do not like to lose. I am a buy-low-person not a buy-high-person. So at present, I hold more cash than I have ever had. If you forget about art and about DoubleLine, when I look at stocks and bonds and other financial assets than I am probably at 40% cash. And I do not feel like I am losing very much. The things that are going up like Picassos I am long the market. And frankly, I was walking around my house last week and I was like: «I do not think I can put anything everywhere else. It is all so crowded.» You do not want every wall to have something on it. That is some sort of weird. (SB again – He’s obviously had a good run.)
- What has changed in the financial markets is the strength of the Dollar.
Trade Signals – Margin Debt, Sentiment and Liquidity
The general idea behind each weeks Trade Signals post is to provide useful tools that you may consider using to risk manage both your fixed income duration exposure and your overall equity exposure. I include my favorite trend and sentiment charts. A process I have followed for years.
The idea is that at times of high valuation (like today) risk is high and when that condition is so then portfolios should be positioned more tactically to protect against serious decline. The tools exist and technology has advanced to a level that makes total portfolio management easy to implement. When valuations become more attractive (and they will via bear market correction) then there is less need to hedge. Those market states are easily identified.
Here is a short summary from Wednesday’s post: “Today, along with the updated cyclical trend and sentiment charts, let’s take a look at margin debt and liquidity. You’ll see that margin debt is at a record high and liquidity is very low – not a favorable combination. However, the cyclical trend evidence remains bullish, the Fed is being supportive and volume demand exceeds supply. Forward returns are low (high valuations project low forward returns); thus, risk is high. Keep stops in place and continue to hedge your equity exposure.
As for bonds, the Zweig Bond model as well as our tactical fixed income relative strength strategies remain bullish on bonds. Global deflation remains the dominant theme. Because yields are so low, here too, risk is high. I favor tactical over traditional bond buy-and-hold.”
Special note – Daily Trading Sentiment is now reading “Extreme Pessimism”. Of the two sentiment charts I post each week, Daily Trading Sentiment has been the better performing over the last year or so. Today’s reading has turned short-term bullish for the market. Here is today’s chart:
Click here for the full piece
Summary
The ETF.com Conference in Hollywood Florida, NDR Meeting in Venus, Florida and Ohio State
The Ohio State–Oregon Championship football game Monday night was a blast. A solid statement for the Big 10 and that should by extension financially help my alma mater – Penn State. I did enjoy rooting for the Ducks all season. A great year and a tough loss. The excitement of sport and how it can bring people together is a really good thing.
Uncle Jim is the nut with the face painted. I purposely hid the white “O” I painted on my face (I know – Penn State blasphemy). We had a lot of fun.
Chicago was predictably cold yet the meetings were productive. As always, it was nice to return home. I landed around 4:00 pm and met Susan at the Philadelphia Convention Center before we headed out for some sushi. The National Soccer Convention is there this week. As I was waiting for her to grab her jacket from coat check, I looked to my right to a swarm of people with camera phones held high in the air. Ten years away was the famed soccer player, Pele. I felt like a little kid again. Soccer has always been in my life and Pele a long-time hero. No photo unfortunately. But a big wow for me.
A week from Sunday I’ll be heading to Florida for the ETF.com Conference. I’m again looking to escape the cold northeast. An upside to all the travel. More than 1,500 advisors will be attending. It is the world’s largest ETF conference. Look for me, Mike, Andrew and Avi in the ETF Strategist section at the conference in Florida. Please stop by and say hi.
Following is a link to the registration information if you can fit it into you schedule. http://www.etf.com/inside-etfs-conference/index.html?h_campaign=inside-etfs&h_medium=banner&h_content=600×90-article
Have a wonderful weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
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