June 5, 2015
By Steve Blumenthal
“We fail to comprehend how owners of claims on money (that is, bondholders) can continue to ignore the fact that the goal of generating more inflation is aimed precisely at reducing the value of their capital. The opportunity, then, is to short bonds.”
– Paul Singer
Do you remember that feeling you had when you were a kid as you walked out of school and opened the door to summer? Yesterday, Susan’s oldest graduated from high school. I loved the closing commencement remarks, “now go forward and shine your light bright.” Caps in the air. What a feeling!
Man, I wish I could have that feeling again. Though it is nice to see it on the faces of our children. But alas, a family to raise, bills to pay, and inflation and bond yields on my mind. So back to work we go and fortunate that this is a fun business.
It’s been a wild week for bonds. The 10-year has gone from 1.92% to 2.40% since early April. A loss of 4.24%. Over the same period, the 30-year has gone from 2.62% to 3.11%. A loss of 9.51%. (Source: StockCharts.com)
I’m on record saying that the greatest bubble of all time is in the bond market. I believe that is where the greatest risks to your portfolio exist. Are we seeing warning shots across the bow? I think so.
So today, let’s take a look at the current state of inflation and the direction of interest rates and peek at a few processes that may help us better navigate the rough waters ahead. My gut says it will be the bond market that jerks the Fed’s chain. We’ll see. I do agree with Singer, “The Great (Greatest) Short” is in the bond market.
Included in this week’s On My Radar:
- Inflation and Interest Rates – Signs Point to Mild Disinflation (What I’m Watching)
- A Few Ideas on Managing Interest Rate Risk
- Investors Spent 75% of The Time Recovering From Loss (1900 to present)
- Trade Signals – Bond Yields a Mess, Equity Trend Positive, Sentiment Neutral
Inflation and Interest Rates – Signs Point to Mild Disinflation (What I’m Watching)
I sent a note to Ned Davis a few weeks ago asking him what indicators he looks at for inflation.
Ned replied with the following:
“This is a hard one for me. I think the most important indicator for the inflation super-cycle is the debt super-cycle, but it is very complicated. For something more current, I would look at our Inflation Timing Model. Other individual charts with great records I have found useful are E960A, E708A, E0720, E764 and DAVIS191. Obviously, looking at those charts suggests I think wage inflation is very important.”
Some chart code to dissect in that email so I’ll try to make some sense for you (and me).
First of all, what I like about NDR is their data approach to investment research. This business is confusing enough and often what many believe will happen is completely the opposite of what actually does happen. So into the data we dig.
This first chart is NDR’s “Inflation Timing Model.” It shows that with overall inflationary pressures at -9, we are in a period of “moderate disinflation”. (Bottom section reading as of 4-30-15 is -9) Note the -1.1% decline in the CPI per annum when in the moderate disinflation zone.
Next are two charts that show inflation to be low:
1) Inflation vs. U.S. Dollar:
Note in the bottom section of the next chart how disinflationary a rising dollar historically tends to be (bottom clip with stats on the current state shaded in the upper clip).
2) Consumer Price Index (Year-to-Year Change).
Here, too, we see low inflationary pressure today.
However, there are some signs that core CPI inflation is turning. Ned noted that over the last four months, year-over-year core CPI inflation has gone from 1.65% (January 2014 to January 2015), 1.70% (February to February), 1.75% (March to March), and the latest reading was 1.81% in (April to April).
Service inflation is running at 2.3%, shelter inflation is running 3% and CPI for medical care is 2.9%. As Ned shares, “Shelter and medical care are of course big deals.”
So which is it? Deflation, disinflation or inflation. It still looks like disinflation with signs of inflation on the horizon. Wages are important and with a high .85 correlation to Core PCE, you can see a big uptick since late 2014 below (dotted red line). Note how closely the blue line (Personal Consumption Expenditures) follows the dotted red line. Kind of a good news (wages are going up), bad news thing (inflation).
Each week in Trade Signals I post my favorite “Recession Watch” chart. It is titled The Economy (The Index of Coincident Economic Indicators) yet I follow it because it has done a great job historically at signaling periods of recession starts. I share it next.
Note the down arrows signal recession and most have been correct. The -1 or +2 tell you how many months before (a minus number) or how many months after (a plus number) the actual recession occurred. Recessions are only known many months after they actually start due to the delay in reported economic figures. So it is ahead of time that we are after and this process has done a great job calling recessions. Also, while not all signals have proven correct, those that missed didn’t keep you out of sync for long.
With a 79% correct signal history and the major declines in equities and high yield bonds that accompany recessionary periods, I believe this chart can help us in our portfolio risk management process.
In short summary, no major inflation at this time but some clouds are gathering. Also, there are no signs of recession at this time. That is good news.
A Few Ideas on Managing Interest Rate Risk
So let’s next look at a few ideas that may help you identify the price trend and position in a way that allows you to participate and protect.
As for interest rates, I believe there are a few processes we can follow to help us position properly. None are perfect, yet, nor were all of the Wall Street economists who felt interest rates would rise in 2014 predicting a move from 3% (as measured by the 10-year Treasury) to 3.25% by that year-end. It fooled them all – interest rates moved lower and finished the year at 2.2%. They missed the fourth best year in bond history.
Idea #1:
Each week I post the Zweig Bond Model. The data is evaluated weekly and the model is updated after every Friday’s close. It helped me stay long bonds in 2014 despite the consensus opinion to the contrary. The model turned negative in early April (timely) suggesting to shorten maturity exposure to something like a short-term Treasury Bill ETF (“BIL”) and remained in a sell until last Monday. Based on the price action this past week, it will likely move back to a sell next Monday. A rough head fake but that can happen. The goal it to get the major trend moves right.
Note the process highlighted in orange and the historical performance On Buy and On Sell signals (see orange arrow).
I often look to moving averages to keep me up-to-date with the trend. Another way to manage risk is to lengthen maturities when the 13-week EMA is above the 34-week EMA. See Trade Signals (link below) for a deeper explanation. There are other approaches – my favorite is the Zweig Bond Model Trend Signal.
Note next how the trend in the 10-year Treasury Note Yield is about to move to a “Cyclical Bear or Rising Interest Rate” period (yellow highlight).
Same with the 30-year Treasury bond:
Why is this so important? We are at historically low interest rates. When rates rise, the risk to portfolios is significant. If our starting place was much higher interest rates, the risk dynamic would not be as severe.
If the greatest short of all time is in the bond market, then we can position to profit, we can position to side-step the decline in the bond market’s losses, or we can get run over.
I favor a process with a high probability win rate. I really don’t know nor do I believe anyone else knows the timing of higher interest rates. What I do believe is that the global central banks intend to and will create inflation. With unprecedented action comes unintended consequences. So defend ourselves we must.
Finally, as it relates to bonds, it looks like high yield bonds are turning lower. I shared some ideas on how to participate and protect in a webinar recently titled, The Opportunity of a Lifetime – Just Not Yet. Click here to access the video.
Investors Spend 75% of The Time Recovering from Loss (1900 to present)
We put together an educational piece for our advisor clients to use, if they wish, in their work with clients. It is titled The Merciless Mathematics of Loss. The piece begins with:
One of our advisors asked to see the data post the great depression in the 1930s. A great question as that period took 25 years to recover from the loss (1929 to 1954). So I shot an email over to my research support team at NDR.
- NDR first looked at the period 1900 to present (updated as the quote above is several years old). It shows that the market spent 74.1% recouping losses and just 25.9% of the time making new highs.
- If we start the data in 1954, it shows that the market spends about 33% of the time making new highs and 67% of the time in bear markets or recovering from loss.
While I think 25 years recovering from loss is abnormal, recall that it has taken 15 years to recover from the 2000 tech wreak.
So let’s settle on somewhere between 67% and 74% of the time. Either way, it is for this reason that investing is so hard for so many.
Trade Signals – Bond Yields a Mess, Equity Trend Positive, Sentiment Neutral
Note today the Zweig Bond Model’s “Buy” signal for bonds. The data takes into account price activity and is updated weekly based on Friday’s closing data. The last three days have been wild. The yield on the 10-year Treasury has gone from 2.09% to 2.36% in just two days. I suspect that the Zweig Bond Model will switch back to a sell after today’s up move in yields (decline in price).
Click here for the updated trend and sentiment charts.
Personal note
I was in NYC for meetings earlier this week. On Monday I spent the day with my long-time friend John Mauldin. Joining us for a morning meeting was Robert Schuster from Ned Davis Research. John, Robert and I visited a new “smart beta” index provider hosted by Rory Riggs and his team at Locus Analytics. It was a productive meeting. Exciting stuff – more soon.
John and I then rushed to a lunch at the Princeton Club to listen to the great George Gilder present. Loved his humble way. Jim Grant asked a number of thoughtful questions and Steve Forbes concluded the presentation. I approached Forbes and told him I write frequently for Forbes. He gave me a warm smile having no idea who I am but that’s OK. Mauldin steadied the iPhone and took the following shot.
Finally, last week I promised to share a photo and quick update on Team 6 (the rec soccer team Susan’s three and my two boys play on together). After five mini games, Team 6 reached the finals but fell short of winning the coveted victory medal (well plastic); but it is far more than the “Ws” we play for (something I’m still trying to learn myself). I loved how Susan summed up the importance of sports in an email to the team,
“I am a big believer that “sports imitate life.” The commitment (doing things when you’d rather do something else), the repetition of work, the ups and downs of relationships (teammates and coaches), the unfairness of decisions that are out of your control… all mirror life’s harder moments. Soccer in particular is a low-scoring game so you learn to appreciate the beautiful moments along the way and not just the goals and the outcomes.”
Thirteen of our twenty players showed up to play. We were down to 11 for the finals. Hire anyone of these eleven when they graduate. They’ve got grit and drive.
Guess which one of our boys is all about that “W” (next photo). That’s Kieran in the middle (Susan’s youngest). Pictured with Jack, Kyle, Matthew and Connor (Susan’s middle son).
Here is to the “beautiful moments” in life and a nod to the bumps that help us better see them.
“Now go forward and shine your light bright.” I really like that thought. The head of the school pulled the boys together, paused and yelled “class dismissed.” Caps flew in the air. What a great feeling!
Have a wonderful weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.
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