November 13, 2015
By Steve Blumenthal
“The European Central Bank is likely to continue negative rates, extend and enlarge QE, and acquire more balance sheet assets over time. ECB policy influences other nearby non-euro jurisdictions. Essentially, all short-term interest rates of higher-credit-grade and mid-grade countries in Europe are negative, and the policy of negative rates is spreading as the rates go even lower (more negative).”
– David Kotok
I really love when a trader/investor is able to speak honestly about his/her mistakes. The best seem to be able to change course and adjust quickly. I read a piece from Ned Davis recently where he reflected on the biggest mistake he made in the business. It was in the late 1990s and was tied to record high equity market valuations. He cut back on equity exposure too soon. He wasn’t alone.
In early 2000, Stan Druckenmiller went all in to technology – at the top of the great tech bubble top. One of his great mistakes. He was down more than 25% before he changed course, changed bets and ended the year higher. This to simply to point out, as you well know, how hard it is for even the very best among us to consistently get the market right all of the time. At every speech, he reminds investors how quickly he might change course. You’ll find a link to a recent video interview he did with CNBC’s Andrew Ross Sorkin below about the Fed, the ECB and why he feels this is all going to end badly.
What I believe is different today than in 1999 and 1968 (both prior secular bull market peaks) is that there is no speculative euphoria. Recall tech in 1999. Cab drivers making more money trading stocks on their handheld QuoTrek device. I spend a lot of time in taxis and I don’t see cabbies or Uber drivers on their iPhones trading stocks. Nor do I hear my friends bragging about their stocks. No euphoria. Noda. Not yet.
What is also different today is the behavior of the global central banks. Let’s take a look today at what the negative rates in Europe means for the U.S. dollar, for U.S. equities and the positioning effect it has in Europe and the balance of the developed world.
The Fed is likely to raise rates in December (odds makers are at a 66% probability) and Mario Draghi hinted that the ECB will boost its economic stimulus in December (lower rates, more QE), this is putting more pressure on the Euro and furthering U.S. dollar gains. Excessive debt and too much leverage (margin debt and derivative related counterparty risk) has caused the system, like 2008, to become highly unstable.
Deflation is winning. Zero interest rates and now negative interest rate policies may be the problem (not the solution). The central bankers are poking at the beehive.
In the concluding thoughts section below, I talk about a possible U.S. equity market “melt-up” and share with you the high conviction trade I recently shared with my mother-in-law (one that may haunt me a year from now – what in the world was I thinking). Ok, grab a coffee and let’s jump right in.
Included in this week’s On My Radar:
- The Fed, Draghi and the European Central Bank
- The Catastrophe Of Negative Rates
- CNBC – Druckenmiller with Andrew Ross Sorkin
- Trade Signals – Excessive Optimism (ST Bearish)
The Fed, Draghi and the ECB
This is how extreme the European Bond Market pricing has become:
- In Germany, the 1 year government bond yield closed yesterday at -0.33%
- The 2 year bond closed at -0.35%
- The 7 year is the first maturity that pays a positive yield at +0.12%
- The 10 year is +0.61%
Compare this to the U.S. Treasury:
- The 2 year is +0.87%
- The 5 year is +1.71% and
- The 10 year is +2.33%
Would you rather own U.S. 10-year notes yielding 2.33% or German bunds yielding 0.61% or Italian bonds (currently rated BBB by the S&P – the lowest possible investment grade rating) yielding 1.63%?
The U.S. is contemplating raising interest rates – likely in December. Europe is going the other way. As Draghi just signaled, the European Central Bank is likely to continue with negative interest rates and extend and enlarge QE (print and buy bonds and other publically traded investment assets).
Such moves don’t stand in isolation. There is a ripple effect both locally and globally. Since the EU is a trade union, other European countries are forced to depress their rates (to depress their currencies) in order to compete on trade: Denmark, Sweden, Switzerland, Australia and New Zealand are all easing. In order to position themselves more favorably (also to compete for a greater share of global trade), China too is easing and so are India, Korea, Indonesia, Hungary, Poland, Russia, Turkey and Mexico. Japan is likely to jump right back into the mix in the near future. In short, we are in the middle of a global currency war.
Zero bound rates are no longer simulative enough. Negative rates are now a reality. Globally, about $1.9 trillion value of intermediate-term bonds are now trading at negative rates. (Source: Bloomberg)
Come on folks – this is madness and that number is going to go higher. We borrowed from the future and spent for today. The system is in an unstable state. A stronger dollar means the payback on the $9.6 trillion in dollar denominated borrowings by foreigners goes up. They took those low interest loans when U.S. rates were lower than their own borrowing rates and they believed then that U.S. Fed policy would further depress the dollar. We were in the early days of QE. They had not yet started.
That dynamic has flipped. The dollar is up approximately 25% in the last two years and another 15% move makes the loan payment due $11 trillion. It was a bad bet. Some (many?) will chose to default. The point to note here is that currency wars combined with underlying systemic instability exists and there will be consequences. Thus, we investors most focus on risk protection.
Global recession looks highly probable. More QE to come. That may further push recession down the road. Not sure. Don’t know.
The economist noted that approximately 60% of the world’s population and economic output is linked to the U.S. dollar (some foreign currencies are pegged in some form to the U.S. dollar). Some want to de-link as the stronger dollar makes their exports more expensive.
In the late 1920s, there was a melt-up in the U.S. market. Global capital was racing to the United States. Confidence lost, get me to safety. Both the currency and the markets melted up. We know what soon followed. I’m not saying a repeat is likely, I’m saying global capital flows matter. Despite an overvalued market, it could become more overvalued. Eventually, the currency wars of the late 1920s came back to bite the United States. Recession and depression followed. The U.S. economy is dependent on the world economy.
I came across a great piece this past week from Charles Gave (courtesy of my friend John Mauldin). Let’s look at a short summary next.
The Catastrophe Of Negative Rates
Charles Gave wrote an interesting piece this week that hits at the heart of where Europe is today and where we may be heading in the not too distant future – concluding, “Eventually, negative interest rates will kill growth.”
Imagine you decide to lend me money. You expect that I will pay you an interest rate and that I will pay you back. The interest rate is charged so that you get compensated for my use of your capital and the uncertainty about the future – my ability to pay you back.
Lend money to your brother (he never really worked that hard) and your risk might be greater than if you lend to your sister with a medical degree. Charge a higher rate or a lower rate depending on the risk you are taking. After all, this is excess capital (your savings) that you’re seeking to earn an investment return on. Pretty straight forward stuff.
A bullet point summary of Gave’s piece (link below).
- “This is the heart of the Keynesian doxa, which requires interest rates to be lowered as soon as the economy slows down. That would be fine except, of course, that an abnormally low rate of interest acts as a tax on (those) who save, for the benefit of the asset-owning rich.
- If interest rates are reduced to zero, then it follows that all my future consumption should be brought forward to the present, and therefore that my savings rate should fall to zero. Again, that’s fine with me. I understand.
- However, if interest rates are pushed into negative territory, we have a totally new ball game. If interest rates really are there to compensate me for an uncertain future, then in philosophical terms negative rates must mean that the future is more certain than the present. This is idiotic; the future cannot be more certain than the present—a logical certainty if ever there was one.
- So with the European Central Bank’s deposit rate at -0.2% (and the Riksbank at -0.35% and the Swiss National Bank at -0.75%), the whole of European monetary policy is based on something that is not only plainly idiotic but totally illogical to boot.
- How intelligent people could believe that an idiotic and illogical policy will lead to favorable results is beyond me. But then maybe I had the wrong professors all those years ago, and their influence is preventing me from seeing the truth today.
- In a world of negative interest rates, the logical thing is to borrow money rather than to save more. This will work as long as there are savings pools left in the system. But eventually there will be no savings left. And since savings are required to fund investment, at that point capital spending will collapse, causing productivity growth to stall and economic growth to grind to a halt.
- By far the biggest pools of savings today are the pension funds and the life insurance industry. With negative rates, these are doomed (see Towards System Failure). They are being sacrificed to allow governments to avoid reform, and perhaps to “save” the commercial banks.
- The sacrifice will not work. Abraham Lincoln is supposed to have said: “You cannot help the poor by destroying the rich.” It was, and still is, a very pertinent quote (even though it wasn’t Lincoln who actually said it).
- Nevertheless, I would like to suggest a small change to make the axiom more relevant to today’s world and today’s central bank policies: “You cannot make the rich richer by making the poor poorer”. Yet this is what the central banks are doing.” – Charles Gave
Here is the link to the full piece. In an attempt to tie this all together, I share a few concluding thoughts immediately following Trade Signals.
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Druckenmiller: Problem is, Fed’s managing for short term
Legendary investor Stan Druckenmiller talks to Andrew Ross Sorkin about the Fed, Europe, and why this is all going to end badly. Also available in the App Store
Trade Signals – Excessive Optimism Remains Despite Market Decline (ST Bearish for Equities)
Included in this week’s Trade Signals:
Equity Trade Signals:
- CMG NDR Large Cap Momentum Index: Sell Signal on June 30, 2015 at S&P 500 Index 2063
- Long-term Trend (13/34-Week EMA) on the S&P 500 Index: Sell Signal – Bearish for Stocks
- Volume Demand is greater than Volume Supply: Sell signal for Stocks
- NDR Big Mo: Buy Signal for Stocks
Investor Sentiment Indicators:
- NDR Crowd Sentiment Poll: Neutral Optimism (short-term Neutral for Equities)
- Daily Trading Sentiment Composite: Excessive Optimism (short-term Bearish for Equities)
Fixed Income Trade Signals:
- The Zweig Bond Model: Buy Signal
- High Yield Model: Sell Signal
Economic Indicators:
- Don’t Fight the Tape or the Fed: Indicator Reading = -1 (Modestly Negative for Equities)
- Global Recession Watch – High Global Recession Risk
- U.S. Recession Watch – Low U.S. Recession Risk
Click here for the link to the charts.
Concluding Thought
I find myself with some conviction that the market, like 1999, may grow to become even more overvalued than it is today. The reality is that the equity market might just “melt-up” with global capital flows with the knowing that money will move to where it is treated “best”. With U.S. interest rates low but positive and a Fed looking to raise vs. negative rates in Europe and more ECB QE to come. Though in all cases “best” is always a relative term. Advantage U.S. dollar.
Melt-up? That is my equity market view today, absent a change in recession indictors, but my view may change tomorrow and right now the negative long-term market trend and high valuations have me with lower equity exposure and the 30% I favor is hedged in some form.
Further, high yield looks to be breaking down again, it has been nearly seven years since the last recession and the bull market is aged. I may get a pat on the back in a few years from now (if I’m right on my melt-up thesis) but just how right might I actually be? Don’t know. What if I’m wrong? How much conviction do I have to stay the path when I’m looking wrong on the way to being right? Risk is high – thus the hedge.
I was right on subprime and CDOs and avoided the majority of the High Yield bond meltdown but I could have made much more if I shorted the bank stocks. Short subprime? Go all in U.S. stocks today? How much conviction did I really have? How big of a bet do I place? I do find myself thinking about shorting the EU banks for my personal account. Put options a maybe. Not yet, due to ECB QE is what I’m thinking.
As a quick aside, frankly, I have more conviction in a long dollar, short Euro and short Japanese yen trade than I do in my melt-up thesis. There are a few ETFs to trade that can express that view. In a moment of possible insanity, I shared the idea with my mother-in-law a few weeks ago. It is a binary outcome with great personal risk as it may cause her to think less of me at some point next year. Or hey, she may think I’m brilliant. I like that thought. Time will tell.
In the end, I feel diversification is the healthiest path to take. Built in a way to keep losses contained to allow money to take advantage of the magic compounding math brings us over time. It’s to hard to come back from a 50% decline. Diversification, to me, means shaping portfolios in ways that include a number of diverse and low correlating investment risks.
To this end, and because of low probable 10-year forward equity returns and low interest rates, I remain in the 30% equities (hedged), 30% fixed income (flexibly and tactically managed) and 40% alternatives (tactical, managed futures, equity long/short, etc.) mindset.
Often, investors expect a diversified portfolio to outperform “the market” (a concentrated basket of stocks like the DJIA or S&P 500). I just published an education piece titled, When “Beating the Market” Isn’t the Point. It, I hope, answers the client question you may get (especially after a nice run up in the stock market): “why didn’t I beat the market?” Feel free to share it with your clients. You can find the link here.
Personal note
My boys (Matt and Kyle) are in the PA state (high school) soccer quarterfinals today. I love watching their games, but this one is five hours away in Pittsburgh and on Fridays I have my nose buried in research and writing. A few dads have my cell number and I’m looking forward to the text updates. I’m rushing to finish – the text’s should start coming soon.
Wishing you and your family many wins with an appreciative nod to the abundant growth that comes with loss. Remember those long bus rides back after defeat. Grueling. The game starts at 4:00 pm. Hoping a win extends the season at least one more week. Also, dinners are better with wins. Go Gators!
P.S. The Fed finds itself painted into a corner. I have a suspicion that negative interest rates are a very bad thing. I believe the Keynesian’s have it wrong and we’ll ultimately experience a tough loss because of it. Hope it will not be too grueling. That game is ongoing. Stay tuned.
Have a great weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
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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.
Trade Signals History: Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of years ago, I found that putting pen to paper has really helped me in my investment management process and I hope that this research is of value to you in your investment process.
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
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