On My Radar: Purgatory and Bubbles

November 21, 2014
By Steve Blumenthal

“A safe investment is an investment whose dangers are not at that moment apparent.”
– Lord Bauer

All investments involve risk. Cash under your mattress (theft or fire), bank accounts, CDs, bonds, stocks… Truly, nothing is safe – yet some risks are less and some are more. Investing is about combining multiple risks together within one portfolio. Perhaps the hardest part of investing is the emotional pull into risk assets like stocks and high yield bonds (usually when the dangers are not at that moment apparent). This time is no different.

This week I share an outstanding piece from GMO’s Ben Inker. He sees two potential investment environments in the immediate future. One he identifies as “purgatory” and the other he identifies as “hell”. Nice. I know. By the way, in this story, I’m rooting for purgatory. Grab a coffee and let’s jump in.

Included in this week’s On My Radar:

• Ben Inker – Is This Purgatory, Or Is It Hell?
• Bubble Watch Update – Jeremy Grantham
• Notes on Russia – Ian Bremmer
• Recession Watch – Keep this Chart On Your Radar
• Trade Signals – Good News and Bad News (Mostly Good)

GMO’s Ben Inker – Is This Purgatory, Or Is It Hell?

Following is my best shot at summarizing Ben’s piece. You’ll find a link to the full piece HERE.

• When we started building our asset class forecasts in the mid 1990s, we felt sufficiently confident that we knew where cash rates were going that we didn’t worry much about it. Somewhere around 1.5% to 2% over inflation seemed right…
• But the events of the last 12 years or so call into question the confidence we used to feel in the level of normal cash rates.
• At our internal investment conference in September, we had a lively debate over “Secular Stagnation” – the argument, popularized by Larry Summers, was that the developed world is suffering from a lack of aggregate demand that has driven the equilibrium cash rate far lower than it had been in the past 40 years.
• I wouldn’t say that the stagnation proponents decisively carried the day, but it was striking how little consensus there seems to be across the firm.

As a quick aside, if inflation is at 1.5% then the yield on cash should be 3%. We painfully know that Treasury bills and money market funds are yielding close to zero. Also, you’ll find Ben referencing “real” returns. Real means the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation. If the S&P 500 returns 6.5% and inflation is 1.5%, the real return is 5%. By the way, it is really nice for us to be able to get a peak at GMO’s process, the depth of their internal debate and their open expression of what you can consider doing given the analysis. Ben continues:

• The two basic camps were 1) our current base case – real cash rates in the developed world will move to around 1.25% on average in the long run, and 2) secular stagnation – cash rates in the long run would average around 0% real. (bold emphasis mine as are bold highlights that follow.)
• The average response in the post-conference survey was 0.75% real with fairly close to half of the GMO investment professionals believing that rates were going to be close to zero real into the indefinite future.
• And make no mistake about it, a world in which cash rates average 0% from here on out is a fairly hellish one.
• It is our belief that investors get paid for taking unpleasant risks. That compensation is in the form of a risk premium over the “risk-free” rate, and while there are no truly risk-free assets out there, T-Bills are a good enough approximation for many purposes. If that rate is going to be zero real, stocks, bonds, real estate, and everything else investors have in their toolkit should have their expected returns fall as well.
• In that world there are likely to be no assets priced to deliver as much as 5% real, and the expected return to a 65% stock/35% bond portfolio would drop from 4.7% real to about 3.4% real. Starting from 4.7% real, it’s easy to believe you can do enough smart things to get your portfolio to a return of 5% real or above.

Ben goes on to talk about the impact of the 0% rate outlook (low equity returns and low returns on savings) stating, “It is pretty inconvenient for anyone saving for retirement. So we can all hope we aren’t on the road to Hell.”

• But the other option, you’ll remember, wasn’t an immediate trip to Heaven, but a stay in Purgatory. So what is Purgatory, and is it really any better? The answer to that really depends on your time horizon. Purgatory would mean that cash rates will eventually go back up to more “normal” levels of around 1.25%, which means that the rest of the financial asset pyramid will go back to more normal expected returns as well.
• The bad news is that valuations will have to fall in order to get there, so if you are thinking about returns over, say, the next seven years, Purgatory is actually worse than Hell.
• Exhibit 3 shows our current seven-year asset class forecasts, which assume a Purgatory path, compared to the forecasts under the Hell scenario.

 

My two cents is that seven year returns of -1.5% per year for U.S. Large Cap or -2.4% per year for U.S. Small Cap won’t be a long, drawn-out, slow and painful decline, it will come quite quickly (aka 2000-2002 and 2008) and in that relatively quick decline, purgatory is not purgatory for those prepared for such risk – it is opportunity.

Ben goes on to discuss a put selling strategy and compares it to the HFRI hedge fund return index. Here is a look at those returns in comparison over time. Note the underperformance of the last five years.

 

And the underperformance of each to the S&P 500 over the last few years:

 

He then concludes with the following:

• It would be incredibly convenient right now to know if we are going down the Purgatory route or the Hell route. Our official forecasts are for the Purgatory path and our hopes are there as well because Hell is a very unpleasant long-run outcome for investors. But if we knew we were in Hell, the right solution today is a decently risked-up portfolio. That portfolio doesn’t make sense in a Purgatory scenario, as the extra risk gives almost no additional return. There is no solution that is right for both scenarios, but having assets whose expected returns are reasonably unaffected by which path we go down is a help. (Bold emphasis mine.)
• The strategies that most fit the bill are the very “hedge fund-y” strategies that have so disappointed investors in recent years. That benefit is well short of an argument for happily paying 2% and 20% for such strategies, but if you can find a way to do it more cheaply (or you can actually find some managers talented enough to pay for their fees)
• We believe now is a pretty good time to be on the look-out for shorter-duration ways to take standard risks.

That concludes my cliff notes attempt at summarizing Ben’s piece. Click here for the full piece. Note you will also find Jeremy Grantham’s discussion on the January Rule and The Four Year Presidential Election Cycle immediately following Ben’s letter. It is titled Bubble Watch Update.

So what does this mean to you and what can you do?

Learn more about tactical relative strength and trend following strategies. They are not a “holy grail” but nothing is in this business. Sometimes they may perform better than stocks and sometimes they may not. Since they can move to many different asset classes including bonds, to compare them to a straight up stock market just doesn’t make sense.

Relative strength strategies look at recent price momentum and compare several assets against each other. The goal is to invest in the ETF, mutual fund, sector, stock or bond showing the strongest price leadership. In both bull and bear markets something is always going up in price. The strategies are short-term in nature holding positions from several weeks to several months.

You can create your own (see a great book on the subject titled, Smarter Investing in Any Economy: The Definitive Guide to Relative Strength Investing by Michael J. Carr) or you can hire a strategist for fees that generally range from 50 bps to 75 bps. If you are an individual investor, your investment advisor will likely have access to a handful of seasoned strategists. Ask your advisor. If you are an advisor and would like to learn more, please reply to this email and we’ll get you some additional information.

Also look into hedging your equity exposure and consider using some form of trend following strategy to better manage downside risk. This advice on a very simple trend following strategy from one of the all time great investors, Paul Tudor Jones:

Tony Robbins asks, “Since asset allocation is so important, let me ask you: If you couldn’t pass on any of your money to your kids but only a specific portfolio and a set of principles to guide them, what would it be?”

Paul Tudor Jones: “I get very nervous about the retail investor, the average investor, because it’s really, really hard. If this was easy, if there was one formula, one way to do it, we’d all be zillionaires. One principle for sure would get out of anything that falls below the 200-day moving average.” Source: MONEY Master the Game: 7 Simple Steps to Financial Freedom by Tony Robbins

10-year S&P 500 Median Total Returns Based on Five-Year P/E Quintiles (1926-2014)

Last week we talked about forward returns of just 4.28%. With 1.5% inflation, that makes the real return just 2.78%. Not good. If you missed it, following is that chart again and you can find last week’s piece on Valuations here.

 

Notes on Russia – By Ian Bremmer November 17, 2014

First a quick note on Ian Bremmer. He is an American political scientist specializing in US foreign policy, states in transition and global political risk. He is the president and founder of Eurasia Group, a political risk research and consulting firm. Ian is a sound source. Let’s not forget the growing geopolitical risks and the rising risk of war.

Copied as is from John Mauldin’s most recent Outside the Box letter. Link to the full piece provided below.

“The Russians are taking every opportunity to escalate an already plenty hostile relationship with the United States and some selected allies.

The G20 summit was particularly negative on that front, with Russian President Putin bringing along some warships to Australia, while Canadian Prime Minister Stephen Harper led a rope line of Western leaders calling Putin a scoundrel and a liar.

Putin left early, claiming a need to catch up on sleep and some other business to attend to.

Like in Ukraine.

I had a chance to talk with some senior Russians last week, including two advisers to the Kremlin.

They explained that Putin expected his offer of a ceasefire in southeast Ukraine would be sufficient to get the Americans to tolerate a status quo, while bringing the Europeans to the table with some sanctions reductions.

That didn’t happen: Instead a coordinated harder line policy stayed in place, while the Americans and Germans looked set to put more sanctions in place unless the Russians actively backed down.

Despite mounting economic pressure on the Europeans, the frozen conflict/long game the Kremlin was playing didn’t look like it was going to succeed. And so the Kremlin moved backed to escalation, dramatically expanding their direct military presence in the region – confirmed by NATO and the typically­ conservative OSCE, denied by the Russian government – and announcing plans to build up troops in Crimea. They’re preparing both sides to consolidate their territory, initially through taking the port city of Mariupol… potentially then a land­bridge between eastern Ukraine and Crimea and beyond (Odessa being the most obvious place).

The most likely path is the Kremlin now looking for provocations to “go further” – they’ve already expressed a level of outrage around the Ukrainian government severing economic ties to the separatist region – then the fiction of ceasefire is erased and the Russians/separatists take more territory. Ultimately, whatever the formalized “governance” structure, the Kremlin is moving towards making Crimea and southeast Ukraine a single place.

There’s very little the Ukrainians can do. The Ukrainian military will remain badly outgunned, and the local populations in the region remain fairly anti­Kiev, even if they’re skittish about the notion of Russian takeover.

We’ll see a pickup in international calls to provide arms for the Ukrainian military, but they’ll be rejected, most particularly by the United States. At best we’ll see a step up in intelligence and training support, to little consequence.

Putin’s military efforts are also stepping up outside Ukraine: the “unknown” but clearly Russian submarine off Sweden, a Russian nuclear armed exercise during an intelligence meeting in Denmark; bomber patrols in the Gulf of Mexico.

They’re all bluster, but a clear message to America and its allies… and pose a far higher potential for accidents – one Scandinavian airlines flight recently made an emergency alteration to its flight path when a Russian military jet suddenly appeared in front of it.

The likelihood of Moscow backing down in this environment is near zero. the sanctions aren’t having a meaningful impact on the Russian economy (yet) and the popularity of the Kremlin isn’t taking a hit.

The speech from former soviet general secretary Mikhail Gorbachev – no fan of Putin, but clearly pointing the finger at the west for Russia’s troubles – makes that clear. And it’s getting harder for the Americans to find an out.

German chancellor Angela Merkel continues to be the best opportunity for compromise but her relationship with Putin is now only barely functional (the Kremlin advisers I spoke with said this was the single biggest misstep from Putin to date – they believed his bilateral conversations with her were too aggressive and led Merkel to feel misled; neither believed the relationship could be salvaged near­term).

And so Russians are now presuming the sanctions environment will be there for the long haul, and are thinking about the longer term economic implications.

I’d now say that’s meaningful before we get to Russia’s 2018 elections: further sanctions causing steep recession leading to unrest in the regions, which begins to metastasize to the cities. That would spook Russian elites, some of whom could split from the Kremlin.

The key early warning indicator would be meaningful defections of any insiders to the west. But critically, we’re at least a year or two away from that. by which time Ukraine has been economically devastated, while the strategic shift of Russia­china is thoroughly entrenched.” Source: Notes on Russia. Mauldin’s Outside the Box 

Recession Watch – Keep this Chart on Your Radar

Earlier in January, I posted a chart from Bloomberg’s Rich Yamarone and mentioned that retail sales were such a concern that Rich called the following chart the most important chart of the year.

Simply, Rich noted that when the year-over-year change in the level of real final sales falls below 2.0 percent, the economy eventually slips into recession. In early January 2014, we were at 1.6 percent. I reached out to Rich and he sent me the most recent data. Chart below.

In short, no recession is immediately in sight. Note that the current level is back above 2.0 percent.

 

Trade Signals – Big Mo (Momentum) Still Says Go – 11-19-2014

In summary: Big Momentum (“Mo”) still says go yet excessive optimism warns to expect a sell-off. I remain modestly bullish on equities. Buy the dips and own equities but hedged. Risk remains high due to high valuations and the length of the aged bull market. Positives are interest rates, corporate buy backs and global central bank liquidity.

As for the bond market: The Zweig Bond Model remains bullish. Caution is advised on high yield bond exposure. Rates are low, provide less value to a portfolio and the risk of rising rates within the next three years is real. Be more strategic with the portion of your portfolio allocated to bonds.

Included in this week’s Trade Signals:

• Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains Bullish (as measured by NDR’s Big Momentum indicator and separately by the 13/34-Week EMA S&P 500 Index Trend Chart)
• Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Extreme Optimism
• Daily Trading Sentiment Composite: Extreme Optimism
• The Zweig Bond Model: Cyclical Bull Trend for Bonds (supporting longer-term treasury and Corporate bond exposure)

Click here for the full link, including updated charts, to Wednesday’s Trade Signals post (trend and sentiment charts)

Conclusion

For more than 22 years I’ve been trading the intermediate-term trends in the high yield market. I wake up each day, grab a coffee and sit in my favorite chair. With laptop online, the first thing I do is look at the prior day’s high yield bond mutual funds’ closing prices – it’s a pretty long list. Do anything for that long a period of time and you gain a feel for trend. Of course, my wife looks over and says, “Looking at charts again”. It has remained so interesting to me. I know – I need to get a life.

Anyway, I’ve been warning on the coming default wave in high yield and I can say with some confidence that high yield is usually one of the first asset classes to warn of recession. Though, of course, past performance means zilcho in this business.

Our trend following process moved us from HY to very short-term bond exposure this past week. Much of the weakness is tied to the price of oil as a meaningful percentage of high yield bonds are tied to the energy sector. Yet, more than $1 trillion of new money has flowed into the space over the last five years. Investors are seeking higher returns due to six years of zero bound interest rates and trillions in Fed-related QE bond buying driving yields to near all time lows.

So it is a good idea to remember that, “A safe investment is an investment whose dangers are not at that moment apparent”. That is particularly true for high yield today. It is also true for stocks yet both could continue even higher.

Will this be the high yield market sell signal that we look back on that identified an inflection point? I doubt it but I can tell you we’ll only know in hindsight. Today, more than any time I recall in my 30 plus years in the business: risk management is mandatory.

December 3, 2014 ETF Trends Webinar:
If you want to learn more about relative strength trading strategies, I will be presenting on a panel alongside Dorsey Wright at 2:00 pm ET on December 3. The program is titled, Getting Active with ETFs. This from ETF Trends: Join four of the country’s leading relative strength experts for an engaging webinar on how to improve risk/adjusted returns by tactically rotating ETFs in the portfolio. Our panel of experts will show you how to use different types of relative strength and tactical rotation strategies to improve portfolio performance.

If you are a registered investment advisor or registered rep, here is the registration link:

I am really looking forward to Thanksgiving. Please know how grateful I am for your interest in this letter.

Wishing you a warm and wonderful Thanksgiving holiday!

With kind regards,

Steve

Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.

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