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On My Radar: Hard or Soft?

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February 24, 2023
By Steve Blumenthal

“We find no instance in which a central [bank]–induced disinflation occurred without a recession. [. . .] Simulations of our baseline model suggest that the Fed will need to tighten policy significantly further to achieve its inflation objective by the end of 2025.”

– Co-authors Stephen Cecchetti, Michael Feroli, Peter Hooper, Kermit Schoenholtz, and former Fed Governor Frederic Mishkin

The consensus is that the Fed has the resolve to keep raising interest rates if inflation pressures don’t recede. This morning’s data showed that consumer spending and inflation heated up in January, which means we need a more serious economic downturn to pause Powell’s inflation fight. Can you imagine another 1% increase in the Fed Funds rate? History tells us that inflation won’t come down until the Fed Funds rate is above the inflation rate. With the most recent inflation figure at 6.4% and the Fed Funds rate at 4.75%, we can see the Fed has a ways to go before those numbers pass each other. Interest rate hikes will continue.

CNBC reported this morning that according to a research paper released today that examines the history of central bank efforts to create disinflation, “the Federal Reserve is unlikely to be able to bring down inflation without having to raise interest rates considerably higher, causing a recession.” The researcher said, “Simulations of our baseline model suggest that the Fed will need to tighten policy significantly further to achieve its inflation objective by the end of 2025.”

This brings us to the debate on whether we’ll have a hard or soft landing coming out of this period. “Despite the sentiments of many current Fed officials that they can manage a ‘soft landing’ while tackling high prices, the paper says that is unlikely to be the case,” the reporters concluded. I’ve had my feet officially planted in the “hard landing” camp for some time and thought we’d be in recession by now. So far, my prediction is a miss; I’m not yet seeing a recession in our models.

If we do end up with a hard landing, know that a hard landing means a hard recession—but expect to see a large dose of soft-landing optimism before we get there. I ran across the following collection of news clippings from Piper Sandler on Twitter this week, and it seems particularly relevant to share with you today. Judging by the headlines, Piper Sandler found, “it always looks like a soft landing” in the news.

 

 

Let’s go deeper

Earlier this week, I met with Ed Clissold, Chief U.S. Strategist at Ned Davis Research, and Robert Schuster, who recently joined our CMG team. Robert, a CFA like Ed, also worked at NDR for 33 years and knows Ed well. It was like putting three kids on a candy store together. After an hour, we walked out with a sugar high. It was a fun meeting.

A lot of work has been done on the soft-vs-hard landing debate (i.e., the referenced paper). Let’s look at a few stats first, followed by my favorite indicators, which I’ve shared below. (Hint: The high yield bond market price indicator.)

If your friends are encouraging you to invest as soon as the Fed stops hiking, don’t listen. That’s just not what history tells us to do. Keep this basic understanding in mind as you read on: The high-yield bond market is a leading indicator of the stock market; the stock market is a leading indicator of the economy. In that order.

Since the stock market leads the economy, bear markets have always begun prior to the start of a recession. Additionally, bear markets have never ended before a recession has started. So, where are we now? It’s like a long car ride with the kids. Turn toward the back seat and tell them, “No. We’re not there yet!”

Here are some interesting stats Ed shared:

  • The current bear market started on January 4, 2022.
  • The median number of months from when a bear market has started to when a recession has started is 6.2 months.
  • The shortest time frame was 0.5 months (July 1990).
  • The longest was 16.8 months (Sept 1978 to Jan 1980).
  • It has now been 14 months since the current bear market started, and the recession has not yet started.

Equally interesting is the time between when a recession starts to when a bear market ends. More stats:

  • The median number of months from the beginning of a recession to the end of a bear market is 5.3 months.
  • The shortest time frame was 0.8 months (April 2000).
  • The longest was 12.4 months (July 1981 to Aug 1982).
  • Ed said his data suggests the recession has not yet started.

For everyone getting excited about the potential for the Fed hitting the rate hike pause button—let alone a reversal (Fed Pivot)—keep this top of mind:

  • Historically, the stock market bottomed approximately 14 months after the last Fed interest rate hike.
  • It does not appear the Fed is done.
  • There were shorter periods than 14 months, but another bear market followed every single short-term bull rally.

Bottom line: The average bear market decline is roughly 35%. With valuations high, signaling low anticipated 10-year annualized returns for the S&P 500 Index, serious caution is advised.

The current Shiller PE is at 28.99. Better, but as you’ll see next, the AVG BEGIN P/E for the highest prices DECILE was 27. The best S&P 500 Index Total Return ten years later was 3.6%, the worst ten-year return was -1.8%, and the RETURN DECILE AVG was 1.3%.  Note the red “We are here” arrow and the green “We’d be better off here” arrow.

Ed mentioned a few positive factors currently supporting the economy—mainly some liquidity improvement in terms of the Treasury’s General Account (Janet Yellen spending money from the Treasury’s checking account) and the tendency for year three of the presidential election cycle to be positive for stocks. Think of year three as the year the leadership gives us more goodies in advance of nearing elections. (Yep, that happens.) It will be particularly interesting this year with the debt ceiling battle looming this summer. It took 14 voting rounds, and considerable concessions before Republican Kevin McCarthy was elected Speaker of the House. We are about to find out just how much oomph he has in the fight.

The Treasury needs the debt ceiling raised to allow them to issue new bonds. When raised, the Fed will print and buy the bonds from the Treasury, and the Treasury will use the newly created money to cover the projected $2 trillion deficit.

Why the increased deficit? Part of the problem is the recent 8.7% cost of living adjustment (“COLA”) in Social Security, which as a program, is the largest spending item on the government’s books. At some point, higher interest rates kill the free money golden goose.

Last fall, Stanley Druckenmiller appeared on CNBC to discuss the deficit. Here were his important points:

  • The Fed is enabling fiscal transfers. (SB note: Think of it this way—the government programs need money, but tax revenue doesn’t provide enough money to completely fund the programs. So, by printing money with the click of a computer stroke to provide the rest needed to fully fund the programs, the Fed enables the government’s fiscal mismanagement.)
  • The government couldn’t be funding all its programs without the Fed. The Fed is monetizing their activity.
  • I mentioned all the QE after vaccine confirmation and retail sales. We’ve had $850 billion in direct transfers; of the total, $575 billion came after retail sales were above trend. $575 billion!
  • I’m old enough to remember the bond market vigilantes. I used to be one of them. Without the Fed buying something like 60% of all the debt issued (I don’t know the exact number), the bond markets would be totally rejecting this.
  • So, the Fed is enabling this massive expansion in fiscal policy, and the problem is, no matter if you end up with inflation or not, the debt is going to be big either way. (SB note: Druckenmiller did this interview prior to the spike in inflation we are now experiencing.)
  • Since baby boomers are in and reaching retirement age, we’re now seeing accelerated growth of the population receiving governmental programs like Medicare, Medicaid, and Social Security. Meanwhile, we’ve just added $6 trillion of new debt—again, all enabled by the Fed.
  • If the Fed wasn’t doing it, bond rates would go to a prohibitive level. (SB here: At the time of Druckenmiller’s interview, interest rates were half the current level.)

We’re nearing $900 billion in annual interest payments on the debt the U.S. government owes. (Note the spike on the far right-hand section of the chart.) More debt outstanding plus higher interest rates. Yikes.

Source: FRED

Druckenmiller said he’d be shocked if there was no recession in 2023, and at CNBC’s Delivering Alpha Investor Summit in New York City in September, he predicted a hard landing. He believes the Federal Reserve’s attempt to quickly unwind the excesses it helped build up for a decade with the easy monetary policy will not end well for the U.S. economy.

Hard landing?

“So, our central case is a hard landing by the end of ’23,” Druckenmiller told CNBC host Joe Kernen. “But I don’t know—I’ve been wrong on a lot of things. I could be wrong on this, but since I do it for a living, that’s our forecast, which is a recession in ’23.”

I subscribe to Felix Zulauf’s institutional research letter, and in yesterday’s edition, he made some interesting points regarding the Fed’s tightening. He reminded readers that we no longer have the Fed tailwind of lower interest rates and QE at our backs. “The Fed’s balance sheet has now contracted by 6% over the last 12 months,” he wrote. “The last time this happened was in September 2018, at a peak of the S&P before it declined from 2946 to 2317, or 22%, within less than three months.” If you’d like to learn more about the Zulauf research publication, email my friend Jennifer Mendel or find more information on his website.

Grab that coffee and find your favorite chair. I mentioned high yield as a leading indicator of the stock market and the stock market as a leading indicator of the economy (recession/expansion). Each week in Trade Signals, I post a high-yield chart that provides an excellent weekly economic warning signal. High yield market first, then the stock market, then the economy. That’s the order.

(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.

A Few Thoughts on High Yield

There are some useful leading indicators for the economy.

Common Leading Indicators include

• Housing starts
• Building permits
• Orders for consumer goods
• Interest Rate Spreads: Invested Yield Curve
• Junk Bond or High Yield bond market price behavior and yields (my personal favorite)

Increased junk bond spread is a financial symptom of the business cycle. These are the companies that are most at risk. Because they are at risk, they pay a higher interest rate to attract investors. Investors tend to keep closer tabs on their higher-risk investments. In any event, when liquidity goes away, the riskiest of companies are first to fall. Corporate bankruptcies are more common in economic downturns (recessions). Thus bond defaults are more common in recessions. Think of the high-yield junk bond market as a “canary in the coal mine.”

When junk bond yields go up, prices go down. Both are measurable. I like to follow prices.

I’ve been trading the intermediate-term trends in the High Yield bond market since 1991. Most of the time, watching HY bond prices move is like watching paint dry. Slow and very boring. I’ve traded through three major market dislocations since 1991. The opportunities they presented when they bottomed were epic.

  • Event #1: In 1992, we had a recession and a near-death experience for the HY market. Drexel Burnham and Michael Milken stood at the top of the HY food chain (investors of the market in the 1970s), and when Milken was sentenced to jail for insider trading at the same time the recession hit, the HY market tanked. Importantly, the declines in price preceded the recession. There was the collapse of Long Term Capital Management in 1998. That was challenging but not epic.
  • Event #2: The busting of the tech bubble and the 2000-2002 recession. Our HY signal turned negative in 1998 and again in 1999. Our returns with solid but not as solid as the near tripling of gains in the Nasdaq. I remember a client leaving our program to transfer her account to a local Merrill Lynch broker. I asked her what she was going to invest in, and she said, “Safe stocks.” I nearly fell out of my seat.  In 2003, her husband (who remained a client) asked if he could stop by. He said Roberta had just opened her account statements, and she was panicking. Down 75%. We were up over the same period ~ 30%. And then the great opportunity to invest at low prices and crazy high yields.
  • Event #3: The great financial crisis in 2008/09. We sidestepped the majority of the decline, and when markets turned, we bought back in at much lower prices and yields greater than 20%.

We don’t always make money. Zero interest rate policy and easy financing have made high-yield bond investing challenging over the last number of years. It really hasn’t been the place to be, but that tide will turn. I believe the next great dislocation will create the single greatest investment opportunity I’ve seen in my more than 30 years of trading the high-yield market. Think yields in the mid-20 % range and prices more than 40% below where they are today. Why? Easy money has enabled too many zombie companies to live without making any money. When liquidity dries up, they default and die. It’s estimated that 40% of the companies in the Russell 2000 index are unprofitable. Living on debt that they’ve been able to roll over and expand. Higher interest rates and the Fed’s inflation fight will likely knock them out.

Ok, here’s what to watch.

My proprietary trading process is really quite simple. While I won’t give you the formula, I can tell you that if you put a simple 30-day or 50-day moving average on a high-yield price stream, not every trade will win, but more than half likely will, and you’ll likely sidestep the big dislocations. But you don’t need to use it to trade the HY bond market; use it as a leading indicator of risk to the economy. The canary in the coal mine.

Pictured is a chart of the Pimco High Yield bond Fund.  The first chart dates back to 1998.  I’ve identified two of the three periods I discussed above (2000-2002 and 2008-09’s ~ 33% declines), added in the Covid meltdown (-20.7%), and included the most recent 14.94% drawdown (pictured upper far right-hand side of the chart). The solid blue line is a 30-day smoothed moving average daily price line.

This next chart is a zoomed-in view of the more recent period. One approach is the sell when the price line drops below the blue 30-day smoothed moving average line and buy back in when it moves above the blue line. Another is to use a 50-day or 100-day moving average line. There are fewer whipsaw trades that way. Another is to use the MACD cross, which is identified by the red and green arrows in the bottom section of the chart.

Finally, it is important to note that there is NO perfect process, but as you can see in the above chart looking back to 1998, how well the moving average rule worked at identifying coming challenging periods. I think we should really zero in on what can help us stay in front of the next recession, given the challenging fundamental backdrop of higher interest rates which likely leads to the next liquidity crisis. When liquidity vanishes, zombie companies won’t find funding and will go bust.

(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

Focus on the blue line vs. the green line (green is consistent with a 10% annualized stock market return).

Here is a better view of the chart clipped directly from Hussman’s site – His most recent piece is titled “Headed For The Tail”

  • “At present, we estimate that a market loss of about -30% would be required to restore expected 10-year S&P 500 total returns to the same level as 10-year Treasury bond yields; about -55% to bring the expected total return of the S&P 500 to a historically run-of-the-mill 5% premium over-and-above Treasury yields; about -60% to bring the estimated 10-year total return of the S&P 500 to a historically run-of-the-mill level of 10% annually.The chart below may offer a sense of how far we are from Kansas, Toto. The green line shows the level of the S&P 500 that we associate with run-of-the-mill expected returns averaging 10% annually. The blue dotted line is the level we associate with a historically run-of-the-mill 5% premium over-and-above Treasury yields, and the orange dotted line shows the level of the S&P 500 that we associate with 10-year expected returns no better than those of 10-year Treasury bonds. The yellow bubbles show periods when our 10-year estimate for S&P 500 total returns was below the prevailing 10-year Treasury bond yield.From a valuation perspective, it should not be surprising that the total return of the S&P 500 lagged the total return of Treasury bonds from August 1929 to July 1950, from December 1968 to December 1987, and from March 1998 to March 2020. Stocks don’t always outperform bonds, and starting valuations help to identify when they probably won’t.

The highest level in 16 years:

Rosey, expecting recession in Q2 and noting the profits recession has already begun:

TGA stands for Treasury General Account. Think of it as the Treasury’s checking account. Meep! Meep! is when the checking account balance approaches zero, and congress hasn’t extended teh debt ceiling allowing more liquidity:

Fun stuff…

More Random Tweets next 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: Bear Market – Recession Stats

February 22, 2023
S&P 500 Index — 3,991

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

Over time, markets move in cycles from bull-to-bear and bear-to-bull. There are short-term cycles and dominant long-term cycles. Trade Signals provides a weekly summary of technical indicators designed to identify where we sit within these cycles in the stock, bond, currency, commodity, and gold markets. Additionally, stock market valuations are informative in terms of probabilities for coming 10-year annualized returns. You’ll find valuation and forward return updates each week to help you identify when investment return opportunities are best/least. Finally, Trade Signals also tracks investor sentiment indicators and economic and select recession watch indicators. 

Trade Signals is Organized in the Following Sections: 

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  • Trade Signals – Dashboard of Indicators 
  • Current Stock Market Valuations and Subsequent 10-year Returns
  • Charts with Explanations  

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Trade Signals is now a low-cost subscription service. You can find the archive of weekly Trade Signals posts (2008 through 2-15-23) by clicking here.

Please email me at blumenthal@cmgwealth.com if you have any questions.

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. 

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Personal Note: Powder Snow in Utah

The journey continues. To which I’m checking in happy and grateful. I fly to Salt Lake City on Sunday morning and land around 10 am. The plan is to Uber to either Snowbird (hopefully) or Park City. I say, hopefully, Snowbird because of the amount of snow they received this week. Over two feet on Wednesday, and in the photo, you can see they received another 14″ in the last 48 hours. More snow is in the Sunday forecast.

The annual WallachBeth Winter Symposium begins on Tuesday in Park City. I’ll be working Monday morning and skiing later in the day. Unless there is more fresh powder. Fingers crossed.

The rule is “no friends on a powder.” Look how deep the snow is for the skier in the photo. It is so hard to describe the feeling.

It really is like floating peacefully down a mountain. A rhythmic dance that you crave for life once the feeling gets in you. If you’ve felt it, you understand the no-friends rule. You’ve got to get as many fresh tracks in before they get skied off. If you can ski, it’s so much fun to do it together. If you can’t, finding a lost ski after a fall takes too long. Selfish, yes, but we can always catch up for a late-day beer and hit the groomers together the next day. Selfish guy buys!

The conference runs Tuesday through Friday. There will be 125 attendees. Meetings are in the morning, and we ski in the afternoon. Many old friends, some new friends, and great food and fine wine at night. I looked at the agenda earlier today and saw the High West Distillery dinner event is a go. If you like Rye’s, try the High West Double Rye, it’s excellent.

Hope your weekend plans are looking fun!

To listen to the audio recordings of OMR, follow On My Radar on Spotify. Note there is generally a lag of one week to record and post. And follow me on Twitter @SBlumenthalCMG, and LinkedIn.  

Wishing you a great week!

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com

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.

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