January 15, 2021
By Steve Blumenthal

“We’re in uncharted waters… Nobody has gotten by with
the kind of money printing now for a very extended period
without some kind of trouble.
We’re very near the edge of playing with fire.”

– Charlie Munger,
Vice Chairman, Bershire Hathaway

Last year, the S&P 500 Index was up 18%, growth stocks 33%, the NASDAQ 44%, and an equally weighted portfolio of FAAAM—Facebook, Apple, Amazon, Alphabet (Google), Microsoft—and Netflix was up 55%. Value stocks gained 1.4%.

Think about that for a second: Six stocks in the S&P 500 Index gained 55% (equally weighted) and accounted for 14% of the 18% index return. That means the S&P 494 stocks gained just 4%. Warren Buffett’s Berkshire Hathaway, you wonder? Just 2.3%. (Hat tip to good friend and partner Kevin Malone, Greenrock Research.)

Recall a time when cab drivers, while waiting for their next fare, traded stocks on their hand-held “Quotrek” devices. It sure feels like 1999. An advisor told me last week that value-oriented managers just don’t get it. Sadly, that sounded all too familiar?

Take a look at some quick stats for 2020:

That value-oriented guy, Charlie Munger (and his partner Warren Buffett) – they just don’t get it? Tell me a return of just 2.30% vs. the market (all hail the S&P 500 Index) is the judge and jury of their experience and proven talent. “Get me out of that Berkshire Hathaway stock!” your client screams. That’s what’s going on, dear friend—1999 indeed.

Our starting conditions today are challenging and, we could argue, unlike any we’ve experienced in our investment lifetimes. The macro issues are as follows:

• Interest rates are near zero and negative in some parts of the world. Central banks cannot help economies the way they did in years past. The consequences: Recessions will likely hit harder, become more frequent, and last longer.
• The level of debt has never been bigger. MMT and restructuring has begun. Nobody has gotten away with the kind of money printing that’s happening now without some kind of trouble… (What Munger said.)
• My friend Felix Zulauf sees the U.S. debt topping $40 trillion (doubling from here).
• Valuations have never been higher. Market cap relative to GDP (Buffett’s favorite), market cap relative to domestic income, sales to earnings… etc., etc.
• Forward return probabilities are lower than they were in 1999. The decade that followed lost about 1% per year. It took nearly 15 years, 2000 to 2015, for tech to get back to breakeven (inflation adjusted).
• The quality of debt has never been worse—especially in the European Union, as member countries are handcuffed by a flawed monetary structure. Many US corporations are in equally rough shape.
• We’re seeing a near-record level of zombie companies: they compose 15% of corporations in the U.S., and an estimated 20% of corporations globally. They’re fueled by zero-percent interest rate policy and investors’ desperate search for yield. This will end badly with default levels spiking in the next crisis.
• We’ve got record margin debt. The system is uber leveraged. Leverage is risk.
• The aging demographics in the western countries, Japan, and China are not favorable conditions for growth.
• The gap between the haves and have-nots is widening. Mix slow growth, low wage growth, and higher costs of goods into the equation and people aren’t going to know what him them, but they will further feel it.
• A rising superpower, China, is challenging a declining superpower, the United States.
• Bottom line: The current boom is the third great bubble of the past quarter century. We are heading down the same path as the dot.com bubble of the late ’90s and the real estate bubble that burst in 2008.

Watch what they do, not what they say… As Munger said, the “Frenzy is so great, and the systems of management, the reward systems, are so foolish.” That’s a large part of the reason why valuations have reached such extremes. It is perhaps the greatest debt-to-equity swap of all time. Capitalism gone wild. It will reset.

Timing? Impossible to know. It could peak next month. It could arrive in late 2021, or sometime in 2022. I do expect the next bear market will exceed average bear market declines. Average is in the negative mid-30 percent range. The next is likely similarly to the tech and real estate bubble declines: think -50% range.

Sounds depressing, but I argue that it is an opportunity. It’s depressing only if you don’t navigate it well. The bubble is in passive investment management. I share some ideas around investment position below. Hint: I like bio-agriculture, commodities in general, Asia, gold, value stocks (high and growing dividend stocks) and good old fashioned trading strategies. Think differently about your bond exposure but don’t dip your head… you can find short-term private credit yielding high single digits.

Grab that coffee, find your favorite chair, and click on the orange On My Radar button below (or simply scroll down if you are reading on the website). Last week, we looked at Louis Gave’s “Inflation Will Come Back with a Vengeance.” He may be right, and there are indicators we can watch to help us see it coming. To that end, I shared with you my favorite inflation watch indicators in that post as well. This week I’m giving you my thinking around investment positioning and ideas on how to navigate market cycles.

If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.

Included in this week’s On My Radar:

• Thoughts on Investment Positioning
  
• On My Radar: Navigating Stock Market Cycles (How to Grow and Defend Your Wealth)
• Trade Signals – A Secular Bear Market in Bonds Has Begun
• Personal Note – Gratitude

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Thoughts on Investment Positioning

It’s either higher interest rates or a declining dollar. I suspect the Fed will implement some form of yield curve control (buy US bonds to suppress the yields). They can’t allow the borrowing side of the US budget to get out of control. If the Fed plays the yield curve hand, the dollar will drop 20% (my best guess).

If this occurs, investments in Asian equities in dollar terms alone will rise 20%, as will the costs of goods manufactured in Asia. This means prices on all sorts of things—from component parts to semiconductors, TVs, and clothing will rise by 20%. All that offshoring to capitalize on lower-cost labor will shift due to the rock and hard place between which the Fed finds itself. Easy money has its consequences. I like Asian equities: Japan, Taiwan, South Korea, and China.

While the US equity market is grossly overvalued, it is the opposite story with commodities. Under-loved and under-owned, I believe commodities are at the beginning of a secular bull market.

If I’m correct, rising inflation and commodity prices will present an investment period more similar to 1966-1982 than 1982-2000 and 2009-2021. Most market participants have only experienced interest rates declining from 15% to 1%, which has also fueled a bull market for equities. Investors need to be savvy. No bond manager today has lived through a rising rate environment.

This will favor active trading and the passive buy-and-hold investor will be caught off guard. Put a stop-loss trading process in place on every stock you own, or find an option tail risk hedging manager who can help you protect against the -50% I believe is on the horizon.

A secular bear market in bonds? Most every manager has only experienced a bull market in bonds. Few alive today know what a bear market in bonds even looks like. But they’re about to find out: I think the secular bear market in bonds has begun.

Yields today are not the same as the 7% corporate bond and 5% Treasury yields found just prior to the bear market in 2007. Corporate bond funds yielding 2% and 10-year Treasury bonds yielding 1% won’t help you.

That requires a change of approach. What to do? In my view, I would consider highly collateralized short-term private credit that earns high single-digit to low double-digit yields, but do work with someone who knows how to do the necessary due diligence. Reach out to me if you’d like to learn more.

I think we are in for markets that require trading capabilities. Long-short managers and absolute return managers will come back in vogue. Don’t project the last few years of performance onto the future. Don’t pick your 401(k)-fund selection(s) by allocating to the fund that gained the most last year. Investors have to be very aware that the whole situation is changing.

We use the CMG Mauldin Smart Core strategy, a blend of four ETF trading strategies, and select short-term private credit as a replacement for the role bonds used to play. Trend following approaches like those shared in Trade Signals do a good job of managing risk while seeking to participate in up-trending markets.

I like high and growing dividend stock strategies. Dividend yields are in the 4% range and we expect the dividends to grow to nearly 7% ten years from now. We utilize a highest-conviction portfolio of approximately 20 stocks. If the price of the select equities goes nowhere, a return gained from the dividends in the mid-5% range is reasonable versus the zero to negative 10-year probable return for US cap-weighted stock indices. Mauldin likes to say, “Friends don’t let friends buy and hold passive index funds.” I think he’s right.

I like thinking about wealth in terms of “core” wealth and “explore” wealth. Designate a portion of your wealth that you will grow and defend to get it back to the full amount in five or six years. There are no guarantees of course but this is about preserving and carefully growing your core. This then gives you the ability to explore with the balance. Here, you look for asymmetric-type return opportunities and size your bets accordingly. Visually, it looks like this:

The ARK Invest Disruptive Technology Portfolio, a high conviction portfolio of about 10 stocks, is something I put in the explore bucket. And I’m really excited about two opportunities in which I am personally invested, along with some of our family office clients. It’s a bio-agriculture company (think gene editing) that has the ability to make a nature-identical edit to the DNA of a plant so that the seeds produced are resistant to disease or herbicide or grow a stronger pod. This means farmers may spray 50% to 100% less chemical on the crops, reducing both the carbon footprint and the cost of production. Better for the earth, the plant, and people. Better margins for the farmer. It is a total disruptor to the big chemical companies. I’m also excited about a drug that makes a significant difference for people suffering from Parkinson’s disease. Both investments are currently private, though I suspect one of them could be listed on an exchange within the next few years. That will enable non-accredited investors to invest.

My concluding point is simply to adapt to the period ahead and put in place a game plan that can help you succeed. I like the core-explore approach, but there are others. There are always opportunities. With all that said, if you are younger, just keep on dollar-cost averaging into a low-fee ETF and add even more during periods of dislocation. You’ve got the time. We baby boomers can’t afford to take a 50% hit. It may take fifteen years to recover and those lost years eat into our life clock.

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On My Radar: Navigating Stock Market Cycles (How to Grow and Defend Your Wealth)

If you are interested in the book, you can learn more here.

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Trade Signals – A Secular Bear Market in Bonds Has Begun

January 13, 2021
S&P 500 Index — 3,802 (open)

Notable this week:

The Zweig Bond Model has moved to a sell signal. The following chart plots the yield on the 10-year Treasury Note. I remind you that the yield was 5.30% at the high in 2007 and it dropped to 2% by the end of 2008 (the Great Financial Crisis). By the summer of 2009, the 10-year yielded 4%. Last March, the 10-year yielded 0.40% and as of today, January 13, 2021, the 10-year is yielding 1.10%. I argue that the we all must rethink our allocation to bonds. In my opinion, I would consider higher risk bond funds yielding 2% or less, a 10-year Treasury yielding 1.10%, or short-term (well collateralized) private credit yielding 7% or more. Further, I favor diversifying to select risk-managed trading strategies that may provide a return to risk opportunity bonds provided us from 1985 to 2009. The bond game is different today thanks to zero interest rate policy. A secular bear market in bonds has begun. Adapt.

The trend for equities remains bullish. The Ned Davis Research CMG U.S. Large Cap Long/Flat indicator remains on a strong buy signal.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon and risk tolerances. 

Click here for this week’s Trade Signals.

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Personal Note – Gratitude 

“Gratitude unlocks the fullness in life.
It turns what we have into enough, and more.
It turns denial into acceptance, chaos to order, confusion to clarity.
It can turn a meal into a feast, a house into a home, a stranger into a friend.
Gratitude makes sense of our past, brings peace for today, and creates a vision for tomorrow.”

– Melodie Beattie

What a nice quote.

Enough said!  Grateful for you. Thanks for reading. Time for an ice-cold IPA.

Enjoy the long weekend.

Wishing you the very best!

Steve

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

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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.

Click here to receive his free weekly e-letter.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.  

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