January 23, 2015
By Steve Blumenthal
“I often disdain economic forecasts as a stock market indicator. First, the consensus forecasts of economics are often wrong, and more importantly, the stock market tends to lead the economy, so it is like trying to put the cart in front of the horse.”
Ned Davis – Relative Macro Trends Work
I have shared my view that despite the aged cyclical bull move and overvalued nature of the U.S. equity market, the global picture favors the dollar over most other currencies. And by extension, global money that flows into the U.S. dollar should push U.S. share prices higher. In the evolving global currency war games (I’m guessing we are in the seventh inning), the United States looks to be the best positioned of the over-indebted, entitlement-challenged, deflationary-pressured developed market players.
In each week’s “On My Radar” I post a collection of research and share my opinion as to what I believe to be most meaningful. Thirty plus years in this business, some wonderfully important relationships, and of course a number of bumps on the head along the way, have helped shape my thinking and taught me to remain humble. No one bats 1,000 in this game. Ours is a game of risk allocation, diversification, and risk management.
One of my personal goals is to carry a positive energy. Fear closes the mind. Not only do I believe it helps me evaluate things clearer but also because I feel better when I’m in that mind frame. Like most, I have good days and bad days but I try my best. CMG’s Tom Hannafin likes to say, “you gotta cut the sandbag from the balloon”.
As I reflect back on much of what I posted the last several months, I wonder how it impacts you—debt, deflation, austerity, taxes, QE, currency wars, purgatory, and bubbles. As you read my missives, it is my hope that the research proves helpful for you in your work with your clients. In movement is opportunity. I really hope you feel optimistic, balanced, and open to the opportunities ahead.
Crisis does not have to equal pain. Remember that some investors made a fortune when the world broke in 2008. Some defended (hedged) their equity exposure and were in a position to profit in the recovery. Bad isn’t necessarily bad—bad events create exceptional opportunity.
So as you view the landscape ahead, see opportunity. Any twinge of fear closes the lens -opportunity lost.
From a money management perspective, consider incorporating a stop-loss risk management process that enables you, if wrong on any particular allocation decision, to limit your downside exposure.
Why risk management matters:
I have always felt that the first lesson we should teach investors is how money compounds and how important it is to minimize loss. Ed Easterling put together the following chart. It does a nice job not only reminding us that large losses happen, it clearly shows how hard it is to come back from a large loss.
A picture is worth a thousand words – This is why risk management is so important.
Included in this week’s On My Radar:
• Relative Macro Trends Work
• Ideas Around Portfolio Construction – 30-30-40
• Inside ETFs Conference – The World’s Largest ETF Conference: January 25-28
• Trade Signals – Extreme Pessimism (ST Bullish for Stocks), Trend Positive
Relative Macro Trends Work
I grabbed the intro quote to today’s OMR from a recent NDR research piece. I highlight it as I’ve been looking for evidence to prove my strong dollar view incorrect.
Recently I’ve written about yield spreads, comparing 10-year Treasurys against Japan and Europe and talked about the deflation pressures that have taken hold. Further, we are at the tail end of QE and they are at the beginning. Our rates are higher and our economy is stronger and both of their debt is too high relative to their GDP – something we may soon find out simply cannot be. Thus my strong dollar view. Add to this the potential for a sovereign debt crisis. Such an event will cause a flood of global capital to dollars. Advantage for U.S. dollars and U.S. assets for now.
Ned Davis noted:
On the chart, we look at the U.S. manufacturing PMI against the global PMI, and we see that the S&P 500 often outperforms when the U.S. data is stronger than global purchasing managers’ surveys.
The next chart shows a similar ratio against the trade-weighted U.S. dollar, which is itself a relative currency. When the U.S. macro data is stronger, the U.S. dollar generally does very well, and just as logically, it under-performs when the U.S. is relatively weak.
He further compares U.S. Business vs. U.S. Consumer and notes that “as for now, trends favor the U.S., U.S. consumers, and the U.S. dollar. While the trends are getting stretched they still look healthy long term.”
I continue to read a lot about the death of the dollar, but I’m just not seeing that view supported by the current weight of evidence.
A quick aside: Years ago I read Ned’s book, Being Right or Making Money and it has stuck with me since. He recently had the book updated and I highly recommend it to you. We’d all like to be right on all of our investment calls but that just isn’t going to happen. Investing is more about understanding the power of compound interest and the importance of avoiding material loss. He is one of the truly brilliant independent minds in the investment business! Here is a link to his book. “Being Right or Making Money, by Ned Davis” It doesn’t disappoint.
With an eye towards risk and portfolio construction, I had a conversation with an advisor client this week and shared with him the following – think of it as a potential allocation game plan tied to probable forward returns.
Several Ideas Around Portfolio Construction: 30-30-40
I shared some of our thinking on portfolio construction with an advisor client. The call went something like this:
First, take a look at the probable forward return:
• If valuations are low (quintiles 1 and 2 below chart), then overweight equities and do not hedge. Risk is lower at those points in time and forward return much higher. (15.66% and 12.93% 10-year Forward Expected Returns)
• If however, we are in an environment of high valuations (quintile 5) then underweight and risk protect (hedge) your equity exposure. Just a 4.28% 10-year Forward Expected Return (yellow line – orange highlight)
• Consider exposure that ranges from 30% to equities when in quintile 5 up to 60% to equities when in quintile 1.
• Consider a stop-loss process (see Trade Signals) when in the higher quintiles and perhaps even in quintile 1 (however, some may disfavor when the return to risk level is far more favorable).
Given today’s quintile 5 reading, I went on to suggest the following framework:
• Consider 30% exposure to equities when in quintile 5 (low expected returns / higher risk)
• Consider 30% to fixed income today (but given today’s ultra low yields – stay tactical)
• Allocate 40% to tactical strategies that have the ability to pivot between stocks and bonds. Such strategies, by process, can increase or decrease your risk exposure.
• Of course, there are a number of other strategies that may add value (Global Macro, Long Short, Managed Futures, Precious Metals, etc.). Put those in the tactical/other bucket.
• Perhaps gold is a 10% weighting. It is simply a hedge against the insanity of politicians and central bankers. Use a 100-day MA rule to take the position down to 5% if it drops below its trend line. Also look at a 13 over 34-week EMA (see Trade Signals for further explanation).
When the market corrects (and it will), forward equity returns will present more favorably. I suggest considering the following:
• Begin to increase your equity exposure based on the forward return potential
• At quintile 1, a portfolio might look like: 60% equities, 20% fixed income and 20% tactical/other
Forward return over the next year or so is anyone’s guess but the returns become much more likely when you look ten years out. Use the return potential to shape your risk exposure. Include other weighted allocations should you have a strong view yet weight the exposure smartly.
When I think about the above allocation mix and weighting game plan, I think about it for a moderate risk type of investor. I’d tilt my equity exposure more aggressively for more aggressive investors and more conservatively for more conservative types. Of course, this is not a recommendation for you. I simply want to share it from the perspective of balance and being in a position to react to opportunity when it presents again.
As for risk management, I post several charts in Trade Signals each week that help keep me in line with the trend.
Inside ETFs Conference – The World’s Largest ETF Conference January 25-28
I’ll be escaping the coming snow storm and heading to hopefully a warm and sunny eastern Florida. Up next is ETF.com’s 8th annual conference.
Speakers include:
• Jeff Gundlach
• Rob Arnott
• Richard Bernstein
• Meredith Whitney
• Terry Bradshaw
• John Hyland on ETF Strategists
• Karl Rove and James Carville
I’ll be taking notes and will share the crib notes from the various presentations with you via Twitter.
We have created an advisor only site and I’ll be updating from the Conference.
Follow me on Twitter or at our advisor only site here.
Please note that this information is for professional advisor use only.
Trade Signals – Extreme Pessimism (ST Bullish for Stocks), Trend Positive
Don’t Fight the Tape or the Fed evidence remains favorable as do my two favorite cyclical trend indicators (Big Momentum and 13/34-Week EMA). Daily Investor Sentiment is reading Extreme Pessimism – a short-term bullish signal for stocks.
Looking at bonds, the Zweig Bond model, as well as our tactical fixed income relative strength strategies, remain bullish on bonds. High yield bonds remain in a “buy” signal according to my 20+ year managed HY bond strategy.
A handful of economists are now calling for a 1% 10-year Treasury yield (currently 1.85% after touching 1.77% on January 15). Most continue to sit in the higher interest rate camp. With rates so low (risk high), I favor a rules based tactical approach to bond exposure.
Tomorrow will likely be an exciting day for the markets (it was) as ECB’s Mario Draghi steps to the stage. He is expected to announce aggressive QE accommodation. We may finally see what “what-ever-it-takes” means. The road block to action has been the Germans – fasten your seat belts. Let’s keep a close eye on the Fed.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains
- Volume Demand Continues to Better Volume Supply – Remains Bullish for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Neutral Optimism (short-term neutral for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term bullish for stocks)
- The Zweig Bond Model: The Cyclical Trend for Bonds Remains Bullish
Click here for the full piece.
Summary
I’m hoping for warm weather in Florida and I am forever hoping to continue to “see opportunity“.
Have a wonderful weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
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