July 13, 2018
By Steve Blumenthal
“The elephant in the room is and has always been the Federal Reserve
since it has a very large say in what liquidity conditions are going to look like.
I see the Fed continuing to raise rates, albeit gradually, and to also continue in its Quantitative Tightening phase,
which really steps up substantially in the final quarter of the year – from $30 billion per month last quarter,
to $40 billion per month this quarter, to $50 billion per month in the final three months of the year.
By the end of next year, the balance sheet will shrink by $900 billion as we play QE in reverse.
This is a really big deal for risk assets…”
– David Rosenberg, Gluskin Sheff, “Breakfast with Dave” (July 12, 2018)
One of my favorite go-to equity market risk models is the Ned Davis Research (NDR) CMG Large Cap Long/Flat Index. It measures the overall health of the S&P 500 Index by looking at 22 industry sub-sectors. We plot and measure it every day. A weakening in the model trend line tells us that fewer stocks are doing well. In bull markets, a vast majority of stocks do well. In bear markets, the opposite is true. The NDR CMG Large Cap Long/Flat Index is a price-based indicator. Price matters! “Listen to the cold bloodless verdict of the market,” Ned Davis once said. That is what price-based indicators accomplish.
You may be familiar with the 200-day Moving Average (MA) rule. The rule recommends that an investor should get defensive when the price of a stock, or index of fund drops below its 200-day MA. Get aggressive when it rises above. A 200-day trend line takes the average price over the last 200 trading days, creating a smooth trend line. You can see in the following chart that the market does better when the smoothed line (black dotted line in chart) is rising vs. falling. The idea is to stay on the right side of the trend (the current trend is shaded in grey – bottom section in chart). It is currently rising, so that’s good.
The NDR CMG Large Cap Long/Flat Index is different in that it looks at the underlying trend evidence across sectors. The 200-day MA rule is effective, but I was after something more robust. For years, I had been following NDR’s “Big Mo” indicator, which helped me a great deal in the 2000-2002 bear market and did exceptionally well in the 2008-2009 great financial crisis. The Big Mo indicator signaled a sell signal in late 2007 and did so again in mid-2008 with a market re-entry signal in April 2009. I wanted something similar, so we did some work with NDR and created a signal process that is unique to us for, as size in a strategy grows, you want to be careful not to get front-runned on your trades. We use the Long/Flat indicator for our U.S. large cap ETF market portfolio exposure.
Each week I post the NDR CMG Large Cap Long/Flat Index chart in Trade Signals. If you been following it, you know that the model signal is moderatly bullish, though the overall score continues to trend lower. It has shown enough deterioration (fewer sectors showing strength) that the process suggests 80% exposure to large cap stocks, down from 100% exposure. I like the process because it systematically reduces or increases exposure based on the level of evidence and it is absent of human emotion.
I also like it because market tops behave differently than market bottoms. Tops tend to roll over as various sectors break down and bottoms tend to “V” bottom as forced margin call and panic selling drives would-be buyers to the sidelines. With sellers flushed out, new buyers are met with less resistance and markets recover. The model, much like Big Mo, is designed to get you back in quickly. It is another reason why I favor the process over the 200-day MA rule. That 200-day MA rule takes longer to get back in and the gains off market bottoms can be attractive. The good news for now is the overall strength in trend remains moderately bullish. No guarantees, of course.
If you were invested in 1999, your broker likely had you overweight tech stocks. I remember the value managers just couldn’t catch a break. Unloved and forgotten. Kind of like today, actually. Why? Value was out of favor and tech was in, and if you didn’t have exposure, you were depressed. Just a few stocks were carrying the market higher. The same is true today. And, again, it’s largely tech.
I tell my team that it feels to me a lot like it did in 1999. Indeed, a few days ago from CNBC, “Just three stocks are responsible for most of the market’s gain this year.” Amazon, Netflix and Microsoft together this year are responsible for 71 percent of S&P 500 returns and for 78 percent of Nasdaq 100 returns. Further, in total for 2018, the six stocks make up 98 percent of S&P 500 returns and 105 percent of Nasdaq 100 returns. Add in Apple, Google (Alphabet) and Facebook. Apple contributed 12 percent of both S&P 500 and Nasdaq 100 returns, while Alphabet and Facebook contributed 8 percent to each.
Those FANG stocks may just come back to bite us. David Rosenberg talked about the elephant in the room. That elephant, the Fed, is draining liquidity from the system. It is liquidity that moves markets! One can guess and get out now, but when is the guess to get back in. That, to me, leads to uncertainty and worry. I’d rather not worry. Having a well-defined gameplan in place can help.
The last few months have been a bit of a recession obsession for me. It’s mostly because that’s when the really bad stuff tends to happen. We’ve had one or two every decade since the 1950’s. The last was in 2008-09… we’re due.
I find it really interesting that in recessions and bear markets that the bulls love to say ‘don’t fight the Fed’ and yet, when everything seems rosy and the Fed is tightening, I never hear ‘don’t fight the Fed.’ So here is the reality: every bull market, every bear market , every expansion and every recession had the Fed’s thumbprints all over them. Not fiscal. Not regulatory.
History can’t be rewritten folks. The Fed is not on hold. It is tightening and don’t be fooled by the funds rate alone. When you go back to the post-WWII era, there have been 13 Fed tightening cycles, and 10 landed the economy in recession, and the consensus missed all 10. As for the three ‘soft landings,’ the mid-60’s, mid-80’s and mid-90’s, well, those cycles were into year four or five, not 10. I’m playing the odds based on history.
Like I did in 2007, and acknowledging that what I’m saying is as obvious to the naked eye as it was back then. But nothing I see on the macro side passes the sniff text, and the markets themselves have sent me enough of a signal to shift to start becoming much more defensive.
(David Rosenberg, July 12, 2018.)
There are short-term debt cycles and long-term debt cycles. I believe we are at the end of a long-term cycle. The last long-term debt cycle peaked in the mid-to-late-1930’s. I think we sit in a similar place though it doesn’t mean we have to have the same outcome. My point is that bonds may not be so safe. It looked something like this:
When stocks began to rally after the first leg down in 1929, bonds sold off slightly as investors started dipping their toes back into stocks. When the stock rally ended, bonds rallied one last time before the great bond crash. Notable is that bonds crashed in 1932 at the same time that equities crashed again. That happened because of liquidity concerns and the fear of inflation as a result of massive government stimulus. There are parallels to today. The biggest is the amount of debt. The big inflation wave will likely come when we dissolve the debt. Until then, the deflationary environment because of the debt remains the primary secular trend. But how this plays out remains to be scripted.
Hope – there is always reason for hope.
I’m sure you watched with concern and hope for the Thai soccer players and their coach trapped in the cave for 17 days. Their situation looked dire. An experienced diver died attempting rescue. Holes were drilled from above to inject oxygen but missed the target. Two-and-a-half miles deep in the cave with portions of the escape flooded, the boys would need to swim, yet few if any knew how to swim. Days passed, oxygen levels worsened and a number of potential rescue plans considered. All with risk.
How to get from here to there? The rescue team, pieced together a plan that invoved multiple divers, oxygen tank stations, a pull rope backup system and rope tethered diver to child. One by one, the boys and their coach were pulled out alive. What appeared impossible was solved.
I think of our current situation much the same. We just haven’t yet figured out how to get from here to the other side. The debt will reset but what will that look like? Who will get hurt? What plan might we invent? We don’t yet know.
The big concern I have today is that it will take political will, global political cooperation and global central bank coordination to reset the debt and pension issues. My good friend, John Mauldin, calls it the “Great Reset.” I think he’s right. Today, I just don’t yet see that rope and pulley system coming together and we are running out of oxygen. I sure hope we can figure it out but I’d keep a downside risk protection plan in place just in case. I do have my doubts that the legislators can come together in time… it may take another financial crisis to unite the forces. We’ll see.
As for the immediate near term, I like how Rosenberg summed things up in his recent post. He said, “Larry Kudlow has always been fond of saying that ‘profits are the mothers’ milk’ for the stock market, which is probably true. But liquidity, your best buddy in a bull market and the biggest coward in a bear market, is the ‘oxygen tent’ for investors. Even a child can live without mother’s milk but nobody can breathe without oxygen.”
Grab a coffee and find that favorite chair. I share a few more thoughts around recession… Charles Gave is predicting the next one begins in March 2019. He has an interesting take you’ll find below. Tomorrow I’m heading to Maui with my family. A much-needed break and, boy, am I excited. More on that below.
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Included in this week’s On My Radar:
- Recession Watch Update (Part II) — Charles Gave
- Trade Signals — Equity Trend Remains Bullish, Bonds and Gold Bearish
- Personal Note — Don’t be a Stick in the Mud
Recession Watch Update (Part II) — Charles Gave
I met Charles Gave of Gavekal Research several years ago at a Mauldin Economics Strategic Investment Conference. I’ve been a fan ever since. This past week, John Mauldin shared with me Charles’ July 11, 2018 post. He wrote:
Over the last three months, I have become increasingly concerned recession will hit the world economy in 2019. In this paper, I shall explain why. My reasoning is simple, and is based on the behavior of an indicator I have long followed, which I call the World Monetary Base, or WMB. Every time in the past that this monetary aggregate has shown a year-on-year decline in real terms, a recession has followed, often accompanied by a flock of “black swans.” And since the end of March, the WMB has again been in negative territory in year-on-year terms (see the chart below). As a result, and as I shall explain, there is a significant risk of a recession next year.
The World Monetary Base
Before I launch into a detailed examination of my reasoning, I should perhaps recap what the WMB is and why it is so important. It starts with the US Federal Reserve, which, because it controls the dominant reserve currency, acts as de facto central bank to the world. By purchasing government bonds from domestic banks, so flooding them with reserves, the Fed can engineer an increase in the US monetary base. The Fed also provides “reserves” to other central banks. Typically this happens when the US dollar is overvalued and/or when the US economy grows faster than the rest of the world. This combination leads to a deterioration in the US current account deficit, which means that the US starts to pump more money abroad. These excess dollars appear first in the hands of foreign private sector companies. But if they earn more than they need for working capital, they sell the excess to their local central banks in exchange for local currency.
[SB here: Note the dip below the 0% line far right of chart. Note prior dips (circled) that preceded recessions. Thus the warning.]
So, if I take the US monetary base, and add to it the reserves deposited by foreign central banks at the Fed, I get my figure for the World Monetary Base. From this aggregate, I can get a rough idea of the pace of base money creation around the world, either through direct intervention by the Fed in the US banking system, or indirectly through US dollar accumulation by foreign central banks. When the WMB is growing, I can be relatively confident about the future nominal growth of the global economy. And when it’s contracting, it makes very good sense to worry about a recession. It is contracting now. So, based on the experience of the past 45 years, it seems likely that the world is entering its seventh international dollar liquidity crisis since 1973. (Emphasis mine.)
- Already the usual suspects—Argentina, Brazil, Turkey, South Africa—are having a tough time. And the times are likely to get even tougher for those countries which have external debts in US dollars coupled with a current account deficit.
- Already, the US stock market is outperforming all other major stock markets (most of which are actually going down)—a sure sign that the world is starting to suffer from a shortage of US dollars.
- Already the spreads between the US bond market and a number of government bond markets outside the US have started to widen. This is a sign that countries outside the US have started to raise interest rates in an attempt to stabilize their exchange rates. Unfortunately, the attempt is destined to fail, if, as I believe, the problem is not an overabundance of local currencies but a shortage of US dollars.
So, as the chart on the above suggests, there are reasons to be alarmed. But this chart merely offers an observation, not an explanation. For the prospect of a recession in 2019 to be taken seriously, I will have to outline the sequence of events which will result in recession.
The first effect to watch out for is a contraction in international trade as a consequence of the US dollar shortage. Every time in the past that there has been a contraction in the WMB, six or so months later there has been a steep decline in the volume of world trade (at least since 1994—I only have the data back that far). These declines have almost always led to a recession, either in the OECD, or outside the OECD, as in the case of the Asian crisis. I see no reason why the same should not happen again this time around, especially as I am starting to detect a range of other signs that typically accompany the march towards a recession. For example, if a recession is coming, it is natural to expect commodities prices to roll over. And as the chart overleaf shows, that is what is happening.
When the volume of trade goes down, together with the prices of commodities, commodity-producers (essentially the emerging markets outside Asia) usually see their stock markets tank. And ex-Asian emerging markets have certainly taken a beating recently.
Needless to say, if these countries are having a hard time today because they have borrowed too freely in US dollars in the past, then it stands to reason that whoever lent them those dollars must be feeling the heat too. And sure enough, bank shares have cratered lately.
And, to add insult to injury, the US dollar is going up, as it tends to do every time world trade slows down or contracts.
Conclusion
A world-wide recession is looking more and more probable. And if the time lag is similar to those in the past, it could hit by March 2019. Indeed, looking at the performance of markets over the last six months, it looks as if a bear market may have already started everywhere but in the US. As I have written repeatedly in recent months, bears are sneaky animals. Their victims seldom see them coming.
Trade Signals — Equity Trend Remains Bullish, Bonds and Gold Bearish
S&P 500 Index — 2,779 (07-11-2018)
What a difference a week of Trade War rhetoric makes. One would think it would be a headwind for stocks, but that hasn’t been the case. Last week, I shared with you a Dow Theory chart. Then, both the DJIA and DJTA were below their respective 200-day moving average (MA) lines. A Dow Theory sell signal. This week the trend has reversed to the upside. In “Dow Theory” terms, when both are below their respective 200-day MAs, plus a few other rules, a sell signal is generated. By most measures, that was the case. This week, both are back above their 200-day MA lines.
DJIA and DJTA 200-day trend lines: As you can see in the shaded section below the chart, that is bullish for equities.
Here is how to read the following chart:
- Bottom section: Data since 1900 compares returns when both the DJIA and the DJTA are above their 200-day MAs.
- Dotted lines are the 200-day MA lines.
The NDR CMG Large Cap Long/Flat model equity line continues to deteriorate and is below 65 for the first time in several years. That means that a greater percentage of the 22 sectors we measure are showing weakness in trend. Thus, the model indicator continues to signal 80% exposure. I’ll get more concerned when the model line dips below a reading of 50. You can learn more about how the indicator works below. Overall, the weight of trend evidence for equities is moderately bullish.
The Zweig Bond Model remains in a sell, suggesting risk of higher interest rates; thus, short-term T-Bills are favored over longer-term high quality bond exposure. Our CMG Managed High Yield signal moved back to a buy signal. Expect the next several months to be challenging. Stay alert and risk minded. Participate and protect. I continue to favor diversifying to a handful of actively managed trading strategies.
The next section walks you through all of the Trade Signals charts.
Click HERE for the latest Trade Signals.
Important note: 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.
Long-time readers know that I am a big fan of Ned Davis Research. I’ve been a client for years and value their service. If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at 617-279-4876. John’s email address is jkornack@ndr.com. I am not compensated in any way by NDR. I’m just a fan of their work.
Personal Note — Don’t be a Stick in the Mud
Tomorrow Susan, me and our six kids are heading to Hawaii. I have to admit, I’m feeling a bit uneasy about heading to Maui. Yes, of course, I am excited, but I feel uneasy nonetheless. At 3:00 am on October 19, 1987, the phone rang in my Maui hotel room. I was on a Merrill Lynch award trip and was startled awake. The market was crashing and Dr. Ginsberg was in an all-out panic. My assistant sounded distressed, filled me in and then my manager jumped on the line. “Get on the first plane home!” I spend the next 10 hours talking with clients. It was 100% fear, 100% panic.
Maybe it’s the “Minsky Moment” thing. “A Minsky moment is a sudden major collapse of asset values, which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money.” Basically, debt builds up to excessive levels, investors borrow on margin and periods of stability move to periods of instability. Everything cycles!
We sit in an unstable state. If the market crashes while I’m away, then we’ll have to add a new indicator to the Trade Signals site. We’ll call it the “Blumenthal Maui” indicator… Ugh, I’m supposed to think positive thoughts… So I will! I’ll be checking in with a shortened post or, if my wife Susan and my assistant Linda have their way, the next two Friday OMR posts will be very short… I’ll be keeping my eye on the charts.
I thought I’d share with you several photos from stepson Tyler’s Officer Candidate School graduation last Saturday morning in Quantico. I have to say I wasn’t expecting it to be as emotional as it was. Some happy tears! A proud moment is an understatement. We were thrilled for Tyler and he was thrilled it was over.
Conner, Kieran, Brianna, Tyler, Steve, Matthew, Kyle and Susan (left to right)
Tyler Barr
After the graduation, we went into DC and ate at a restaurant on the Potomac River called Farmers Fishers Bakers. Do visit if you are in DC. They have an all-you-can-eat brunch buffet and let’s just say the new Marine got his money’s worth. The stories were fun to hear… a large part of the training objective is to break you down and see how you respond under various degrees of stress. Sleep deprivation is a big part of the plan and the miles of running with 75-pound packs took its toll. Integrity was tested at times of extreme fatigue and failure to do right got you a quick return ticket home. Making good decisions and doing right is an important part of the code. No wonder we love our military.
My favorite part came at the end of the ceremony. The men and woman were congratulated and set free. That was a fun moment for all.
https://youtu.be/KXehj5P-zgI
Vacation is immediately ahead. I hope for you as well. I see more than a few IPAs over the break. There are also exercise plans to earn that cold beer. Books are downloaded (to which a number of you shared ideas with me – thank you) and we are really excited to have some downtime… especially together. And we just learned that Susan’s mother Patricia is a last minute thumbs up. Her best friend told her, “Don’t be a stick in the mud… go!” She’s the best to be around. It’s such a long flight and there is always much to do… so a big thumbs up to grandma.
Message of the week… “Don’t be a stick in the mud.” Life’s too short…
In early August, I’ll be in Bangor, Maine at David Kotok’s annual Shadow Fed Fishing trip. Several former Fed officials along with a number of well-known economists and money managers. The Fed is draining liquidity from the system. I see no recession in sight (next six to nine months) but, as you saw above, Charles Gave is predicting one in Q2 2019. We’ll be debating and sharing thoughts on the path ahead.
I’m really looking forward to some downtime and hope you are too.
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With kind regards,
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.
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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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