October 10, 2014
By Steve Blumenthal
“We’re in a period with many daily (often hourly) points that represent pixels in the market’s
picture. The short-run trends (the cyclical cycles) of the market are hard to predict. Without
extraordinary powers of clairvoyance, the best plan is a diversified, non-correlated portfolio
with a few engines to counterbalance the weaker components of the portfolio.”
Ed Easterling, Crestmont Research
There have been quite a few “pixels” in the market this week. Volatility is back and the level of market indigestion is on the rise. I think many of us have become programmed to immediately look to the Fed.
‘It’s all about dat Fed, ‘bout the Fed, more trouble’. The jingle rings in my head. Art Cashin pointed out one such pixel in this mornings Cashin’s Comments, “Draghi Brings an Empty Plate and Markets Implode”. There is slowing in Germany, the balance of Europe, Japan and China. Recession seems certain there.
Cashin’s talks about currency, culture and chaos. As the Fed’s grand experiment plays forward, it is a reminder of the risks of such action. He concludes his piece with the following:
“Here’s what John Maynard Keynes said on the topic:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.
Lenin was certainly right. There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.”
I also highlight Bill Gross this week and share what I feel is perhaps his most succinct piece: He shares,
“I have the following tough love advice – somewhat resembling the counsel given to me in recent weeks: there is a new financial era. Accept it and modify your behavior accordingly, so that your future is safe, secure, and you look forward to a brighter tomorrow.” He sees forward bond market returns in the -3% to 4% at best and stocks -5% to 6% at best. He goes on to explain the current thinking. I provide the link below. Personally, I see a coming pension crisis.”
Given the historically low forward return projections, I remain of the view that it is prudent, as Art Cashin states, to “stay wary, alert and very, very nimble”. A future opportunity will present itself, just as it did in 2009. When? Don’t know. In the mean time, hedge your stock exposure and add more flexible strategies into your portfolio.
Best to be in a position of strength to buy more equity exposure when stocks become attractively priced. Now is not the time to be aggressive. You may find it to be an emotionally healthier way of navigating the challenging road that lies ahead.
Included in this week’s On My Radar:
- Art Cashin’s Comments: Currencies, Culture and Chaos
- Bill Gross’s First Letter as a Fund Manager at Janus
- Private Investors Heavily Overweight Credit – Put this in the “bubble” category
- GaveKal Blog Post: T-Bond Yields Falling Back in Line with Taper
- Trade Signals – Margin Debt at Record High – 10-8-2014
Art Cashin’s Comments: Currencies, Culture and Chaos
I provide selected highlights and link to the full piece below:
• Today we will revisit one of the most devastating economic events in recorded history. It all began with the efforts of a few, well-intentioned government officials. Originally, on this day (+1) in 1922, the German Central Bank and the German Treasury took an inevitable step in a process which had begun with their previous effort to “jump start” a stagnant economy. Many months earlier they had decided that what was needed was easier money. Their initial efforts brought little response. So, using the governmental “more is better” theory they simply created more and more money.
But economic stagnation continued and so did the money growth. They kept making money more available. No reaction. Then, suddenly prices began to explode unbelievably (but, perversely, not business activity).
So, on this day government officials decided to bring figures in line with market realities. They devalued the mark. The new value would be 2 billion marks to a dollar. At the start of World War I, the exchange rate had been a mere 4.2 marks to the dollar. In simple terms, you needed 4.2 marks in order to get one dollar. Now it was 2 billion marks to get one dollar. Thirteen months from this date (late November 1923) you would need 4.2 trillion marks to get one dollar. In ten years the amount of money had increased a trillion fold.
• Thirty years ago an older member of the NYSE (there were some then) gave me a graphic and memorable (at least for me) example. “Young man,” he said, “would you like a million dollars?” “I sure would, sir!” I replied anxiously. “Then just put aside $500 every week for the next 40 years.” I have never forgotten that a million dollars is enough to pay you $500 per week for 40 years (and that’s without benefit of interest). To get a billion dollars, you would have to set aside $500,000 dollars per week for 40 years. And a…..trillion that would require $500 million every week for 40 years. Even with these examples, the enormity is difficult to grasp.
• Let’s take a different tack. To understand the incomprehensible scope of the German inflation, maybe it’s best to start with something basic….like a loaf of bread. (To keep things simple, we’ll substitute dollars and cents in place of marks and pfennigs. You’ll get the picture.) In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents. Two years later it was 19 cents. Two years more and it sold for 22 cents. By 1919 it was 26 cents. Now the fun begins.
In 1920, a loaf of bread soared to $1.20, and then in 1921 it hit $1.35. By the middle of 1922 it was $3.50. At the start of 1923 it rocketed to $700 a loaf. Five months later a loaf went for $1200. By September it was $2 million. A month later it was $670 million (widespread rioting broke out). The next month it hit $3 billion. By mid-month it was $100 billion. Then it all collapsed.
Things did not go badly instantly. Yes, the deficit soared but much of it was borne by foreign and domestic bond buyers. As had been noted by scholars…..“The foreign and domestic public willingly purchased new debt issues when it believed that the government could run future surpluses to offset contemporaneous deficits.” In layman’s English that means foreign bond buyers said – “Hey, this is a great nation and this is probably just a speed bump in the economy.” (Can you imagine such a thing happening again?)
When things began to disintegrate, no one dared to take away the punch bowl. They feared shutting off the monetary heroin would lead to riots, civil war and, worst of all, communism. So, realizing that what they were doing was destructive, they kept doing it out of fear that stopping would be even more destructive.
Currencies, Culture And Chaos – If it is difficult to grasp the enormity of the numbers in this tale of hyper-inflation, it is far more difficult to grasp how it destroyed a culture, a nation and, almost, the world.
• People’s savings were suddenly worthless. Pensions were meaningless. If you had a 400 mark monthly pension, you went from comfortable to penniless in a matter of months. People demanded to be paid daily so they would not have their wages devalued by a few days passing. Ultimately, they demanded their pay twice daily just to cover changes in trolley fare. People heated their homes by burning money instead of coal. (It was more plentiful and cheaper to get.)
The middle class was destroyed. It was an age of renters, not of home ownership, so thousands became homeless.
All hope and belief in systems, governmental or otherwise collapsed. With its culture and its economy disintegrating, Germany saw a guy named Hitler begin a ten year effort to come to power by trading on the chaos and street rioting. Then came World War II.
We think it’s best to close this review with a statement from a man whom many consider (probably incorrectly) the father of modern inflation with his endorsement of deficit spending. Here’s what John Maynard Keynes said on the topic:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some…..Those to whom the system brings windfalls….become profiteers.
To convert the business man into a profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards.
Lenin was certainly right. There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose….By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract….governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.
Cashin then moves on to discuss the prior day’s stock market action:
• It was deflation rather than inflation that worried markets yesterday.
• Draghi Brings An Empty Plate and Markets Implode – Stocks opened softer Thursday as German exports dropped a stunning 5.8%, reinforcing the growing perception that the world’s economies were slowing down.
The selling was contained for the first 90 minutes. Then Mario Draghi stepped to the microphone. He had disappointed markets at the ECB press conference several days ago so there was some expectation that he would use this speech to soothe the markets. Not even close.
Draghi basically said that European monetary policy needed fiscal reform to become effective. Traders know that such reform would require cooperation from the various EU leaders. Since they make our Congress look collegial, that made reform highly unlikely. That made traders fear that the Draghi toolbox was empty and they began to sell stocks in earnest.
• Adding to the stock selloff was a virtual crash in crude with West Texas dipping below $85 and Brent breaking $90.
• The selling eased slightly around 1:30 pm and then markets reverted to a choppy mode with several attempts to retest the recent double bottom around S&P 1925 (the closest they got was 1927).
• Ultimately, they closed not far off the day’s low. It was an ugly day with little to give it merit. The selling was very broad, with over 2800 stocks declining, while less than 400 gained.
Here is a link to the full piece. He writes in a fun and witty way.
Please let me know if you’d like to sign up to receive Art’s daily letter. Send me an email and I’ll forward it to Art to have him add you to his list.
Bill Gross’s First Letter as a Fund Manager at Janus
There is one section in particular that I want to highlight as I think it is one of the clearest, well-worded explanations of the current financial world I have seen. Specifically, the way he discusses discounting of future cash flows / returns with an artificially low interest rate – that factor is what will cause this market to crumble when rates rise. Here are a few excerpts:
I have the following tough love advice – somewhat resembling the counsel given to me in recent weeks: there is a new financial era. Accept it and modify your behavior accordingly, so that your future is safe, secure and you look forward to a brighter tomorrow. I will explain.
Financial markets are artificially priced. In the bond market, there is nothing normal about a three year German Bund yielding “minus” 10 basis points. Similarly, UK Gilts and U.S. Treasuries have in recent years never experienced such low yields and therefore high prices. The same comparison can be applied to stocks. While profits in many cases are at record highs, the discounting of future profit streams by an artificially low interest rate results in corresponding high P/E ratios. Real estate cap rates, which help to price homes and commercial shopping centers, are affected in the same way. While monetary policy with its Quantitative Easing and forward guidance for low future interest rates have salvaged a semblance of growth and job gains – especially in the U.S. – they have brought prosperity forward in the financial markets. If yields can’t go much lower, then bond market capital gains are limited. The same logic applies in other asset categories. We have had our Biblical seven years of fat. We must look forward, almost by mathematical necessity, to seven figurative years of leaner: Bonds – 3% to 4% at best, stocks – 5% to 6% on the outside. That may not be enough for your retirement or your kid’s college education. It certainly isn’t for many private and public pension funds that still have a fairy tale belief in an average 7% to 8% return for the next 10 to 20 years! What do you do?
Well the obvious advice on a personal level: Retire later, save more, accept a revised standard of living. But the financial advice varies with your age and willingness to take risk. Younger investors with a Texas Hold’em “all in” attitude could push all of their chips onto the equity table. Boomers nearing retirement probably cannot afford to. A lengthy bear market could force them permanently out of the game. So, one size does not fit all here. It never has.
What might be applicable for most generations, however, is an “unconstrained strategy” that I managed well for the past few years at PIMCO and which now provides me the opportunity for 100% of my time at Janus. An unconstrained strategy sounds very open-ended, and it is. But it allows a professional and experienced investment firm like Janus to select the most attractive alternatives across many asset categories while hopefully diminishing the risk of bond and stock bear markets. The strategy seeks to protect principal while providing an acceptable return in this low yielding, low returning world that I have just described. Unconstrained investors should expect a shorter average maturity for bonds; an ability to profit from currency movements currently taking place with the euro and the yen fits the description as well; taking advantage of what is known as “optionality” and investing in what I have successfully applied in the past with what is called “structured alpha,” would be an important component too. The simple explanation of an unconstrained strategy:
It is one of my favorite Bill Gross letters. Here is a link to the full piece.
Private Investors Heavily Overweight Credit – Put this in the “bubble” category:
As JP Morgan Nikolaos Panigirtzoglou explains, “The rising bond ownership by central banks has not only eroded bond overweights but has also made private non-bank investors very overweight credit”.
Successive QE programs since 2009 have made private non-bank investors increasingly more overweight credit.
Source: http://www.zerohedge.com/news/2014-10-06/chart-day-why-every-corporate-bond-manager-freaking-out
GaveKal Blog Post: T-Bond Yields Falling Back in Line with Taper (October 6, 2014)
For about 15 days between the end of August and mid-September, the action in the Treasury bond market deviated from our model comparing bond yields to the change in the size of the Fed’s balance sheet. Our model simply calculates the three month difference in total assets held by the Fed projected out through the beginning of 2015, when the three month difference will fall to zero.
From the end of August to mid-September long-term t-bond yields rose even as our model predicted they would continue to fall. Since mid-September, though, gravity seems to be reasserting itself on yields as they have fallen nearly all the way back in line with our Taper model. Yields have yet to make a new low on the year (the 30-year is still 4bps off the low and the 10-year is still 7bps off the low), but our Taper model, if it is still valid, suggests new lows are not far off.
Source: http://gavekal.blogspot.com/2014/10/tbond-yields-coming-back-inline-with.html
Trade Signals – Margin Debt at Record High – 10-8-2014
All but a few sectors of the stock market are under pressure. Many are below their 50 and 200 day moving averages and more stocks are declining than advancing. The health of the market is in decline; however, the overall trend evidence remains positive and Don’t Fight the Fed remains an important theme.
Big Mo remains in a buy signal and the S&P 500 index’s 13-week EMA remains above its 34-week EMA. Investor sentiment has become more pessimistic which is short-term bullish for the equity market. Those are the positives.
What concerns me most is how the market will react to a Fed QE exit. With Europe, Japan and China in economic decline (if not triple dip recession in both Europe and Japan) coupled with an overpriced (“bubble territory” as mentioned last week) and excessively margined equity market (this week’s special chart) the risk needle remains pointed to the far right. Own equities but hedge.
As for the bond market, after a pretty healthy sell-off, our high yield strategy has moved back into a “buy” signal (note 10-10-14: this is now challenged with yesterday’s sell-off).
The Zweig Bond Model is also back in a “buy” signal reflecting a bullish environment for longer-term treasury and corporate bond exposure.
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: Neutral (Bearish for the Market)
- Daily Trading Sentiment Composite: Extreme Pessimism (ST Bullish for the Market)
- Excessive Margin Debt is Another Concern
- The Zweig Bond Model: Cyclical Bull Trend for Bonds (supporting longer-term treasury and Corporate bond exposure)
Click here for a link to Wednesday’s Trade Signals (updated market and sentiment charts)
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Conclusion
We are pretty crazed soccer fans in the Blumenthal household. All six of our combined children play though mom and dad are dealing with knee and hip issues. My father always used to say, “the prize is worth the price”. I have to say I agree as I down some more Advil.
A number of games are on the calendar this weekend and our Philadelphia Union are home tomorrow night. Three games to go and seven points are required to make the playoffs. Our house is excited and forever hopeful.
If you have children or grandchildren and you’re heading to a weekend little person soccer tournament, grab that lawn chair and your smart phone and catch up on some reading during the many hours of downtime.
Thank you for your interest in this letter. It’s appreciated.
Have a great weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
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