January 6, 2023
By Steve Blumenthal

“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”

– Charlie Munger

“Cash combined with courage in a crisis is priceless.”

– Warren Buffett

Last week I reviewed my investment outlook for 2022 with you—what I got right, what I got wrong—and shared some of my thinking about the coming year as we begin 2023. (If you missed it, you can read it here, or listen to it on Spotify here.)

The truth is that making predictions for what will happen in a year is really just guessing. As we learned in 2020 with Covid and in early 2022 with Russia’s invasion of Ukraine, there are so many unknowns that come into play. The broader picture is far more important, and I believe the probabilities of investment outcomes become clearer, of course, requires ongoing monitoring.

Here are our starting conditions in January 2023:

• A 3.75% 10-year Treasury yield will earn us 3.75% per year for the coming 10 years. The question is whether or not that is a good enough return for you. For me, the answer is no.
• We also have a pretty good idea as to what the S&P 500 is going to earn in the coming 10 years. What will $100,000 invested on January 1, 2023, look like 10 years from now, on December 31, 2032? (Hint: Better, not yet great. With the S&P 500 trading at 3,800, the return outlook has improved compared to where we stood a year ago when the index was at 4,800. We’ll quantify potential returns today.)

I mentioned in last week’s On My Radar that this is the decade we will solve the debt issue. U.S. government debt is nearing $32 trillion, or 122% of the GDP. Not included in that number is another $22.3 trillion in Social Security and $34.8 trillion in Medicare to be paid out to senior citizens over the course of the decade.

Debt’s the big elephant in the room.

And there’s one guy who’s thought a lot about debt that we would all benefit from listening to: Ray Dalio. Dalio doesn’t know it, but he’s become a bit of a cult hero to my kids. Most of them have read his book Principles. I also recommended they read one of his other books, Principles for Navigating Bid Debt Crises. (You can get a free PDF version of the book here.) As he lays out in that book, Dalio believes that almost everything happens again and again throughout time. So by studying patterns, he argues, one can understand the cause-and-effect relationships behind events and develop principles for dealing with them well. He shares his template in the hopes of reducing the chances that big debt crises hap­pen and helping Fed officials and legislators manage the debt better in the future.

Dalio founded Bridgewater Associates, the largest and arguably most successful hedge fund management firm…ever. He credits his understanding of debt cycles with helping him navigate the last financial crisis well. Given the current state of debt—far worse than 2008 and rapidly growing since then—it’s nice, and likely beneficial, to know what he’s thinking today.

So, grab your coffee, find your favorite chair, and come sit in on an investment committee meeting with Ray Dalio. You’ll find a link to his recent LinkedIn post, but first, let’s look at several interesting year-end valuation metrics and consider them our starting conditions.

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

Price to Cash Flow

Much better than in 2021 and 2022 though still in the “Extremely Overrvalued” red zone. However, a better investment opportunity will present in the “white” zone or “Fairly Valued.”

PE 10

The P/E 10 ratio is a valuation measure for equities that uses real per-share earnings over 10 years. The P/E 10 ratio also uses smoothed real earnings to eliminate net income fluctuations. The P/E 10 ratio is also known as the cyclically adjusted price-to-earnings (CAPE) ratio or the Shiller PE ratio. There are many ways to look at market valuations in order to determine if a market is richly priced or not. This is one of them.

To set the stage, the following chart is a long-term history of the PE 10 ratio. For non-geeks, simply look at the rising red horizontal line in the center of the chart. The “extreme patience with extreme decisiveness” Charlie Munger is talking about are the periods in time the grey S&P 500 index line dropped below the upsloping red long-term trend line.  Bottom line: The market is way above its long-term trendline.

We can also use a percentile analysis to put today’s market valuation in the historical context. As the chart below illustrates, the latest P/E10 ratio is approximately at about the 92nd percentile of this series. Better vs. a year ago, but still high.

Price to Median PE

Still in the red zone. The price to Median PE was 23 on 12-31-2022. The 58.8-year median PE is 17.5.  That falls into the “Fairly Valued” white zone.

• That puts the S&P 500 Index “Median Fair Value” at 2,925.  About 20% lower than the current level.
• Back-of-the-napkin math puts the return potential if you channel your inner Warren Buffet and put money to work at that entry-level at approximately 8% per year for the following 10 years.

 

If your mandate says you have to be invested, there are stocks in the market priced much better than the S&P 500 Index. Consider companies that have high free cash flow relative to their enterprise value. More on this in a future letter.  Just pointing out that there are opportunities in stock selection.

Q Ratio

The Q ratio was popularized by Nobel Laureate James Tobin and invented in 1966 by Nicholas Kaldor. It is also known as Tobin’s Q, which measures whether a firm or an aggregate market is relatively over- or undervalued.

• It relies on the concepts of market value and replacement value.
• The simplified Q ratio is the equity market value divided by equity book value.

Smithers & Co., an investment firm in London, incorporates the Q Ratio in their analysis. In fact, CEO Andrew Smithers and economist Stephen Wright of the University of London co-authored a book on the Q Ratio, Valuing Wall Street. They prefer the geometric mean for standardizing the ratio, which has the effect of weighting the numbers toward the mean. The chart below is adjusted to the geometric mean, which, based on the same data as the two charts above, is 84%.

Bottom line: Significantly better than a year ago. A good entry target zone, in my view, is near the solid black 0% line.

Source: AdvisorPerspectives

We can get a sense of how far above or below we are from the long-term trend.  Think of long-term trend as the return the market will give us over a long period of time. Over time we move from overvaluation to undervaluation. The orange line in the center section is the “real” S&P 500 Index price line.  The dotted blue line is the long-term real trendline.

• Next, take a look in the data box in the upper right-hand corner.
• While significantly lower than a year ago, we still currently sit in the “Top Quintile,” or the highest 20% readings above trend since 1928.
• Note the 10 Years average % change in the S&P 500 when in the Top Quintile vs. the Bottom Quintile.
• The Great Financial Crisis in 2008 presented an excellent “Bottom Quintile” buying opportunity.
• Bottom line: Expect $100,000 to grow to $142,290 by December 31, 2032 (up 42.29% in 10 years). Or compounded annual returns of about 3% (before inflation is factored in) 10 years from now. We’d be much better off buying when the market is below its long-term trend line. If we get that shot, which I believe we may, your $100,000 will grow to $458,860 in 10 years (up 358.86% in 10 yers).
• Not a guarantee, and there is no way the future will be like the past. The idea here is to give you a sense that it’s far better to buy when there is a crisis (extreme undervaluation) than when there is extreme overvaluation.

Finally, John Hussam believes the best measure for future returns is the 12-year “Margin Adjusted PE data with the highest historical collaboration to estimated forward returns to actual returns.

• Note the small arrow at the bottom of the chart pointing to slightly positive nominal annual returns.  Better than a year ago, but I don’t think 1% is getting your mojo flowing.

Source: HussmanFunds

A few more charts that put the last 22 years of market performance into perspective: both from a nominal and “real” after inflation perspective.  From Jill Mislinsky at AdvisorPerspectives.com, “The charts require little explanation. So far, the 21st Century has not been especially kind to equity investors. Yes, markets do bounce back, but often in time frames that defy optimistic expectations.”

 

Note also the nearly 15 years for the S&P 500 Index to get back to even. The pink section is the period less than 0%.  It was longer for the Nasdaq.  A good part of the reason is the flaw in the weight index rebalancing process that is part of the cap weight structure. More on this in another missive.

“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.” – Charlie Munger

(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)

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Random Tweets

 

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Trade Signals: 40-Year Record Inversion

January 5, 2022
S&P 500 Index — 3,813

Markets move in cycles, and cycles will always exist. Trade Signals provides a weekly snapshot of current stock, bond, currency, and gold market trends. Trade Signals is a summary of technical indicators to help you identify where we sit in short-, intermediate-, and long-term cycles. We track important valuation metrics to help assess the probability of coming returns. Valuations can tell us a great deal about coming probable returns. Simply, where is opportunity best/worst? This allows you to set targets strategically (i.e. more defense than offense, or more offense than defense). Trade Signals also tracks select investor sentiment indicators with the objective of going against the crowd at points of extreme. As Warren Buffett often reminds us, “Be fearful when others are greedy, and greedy when others are fearful.”

Stay on top of the current trends with “Trade Signals.”

Market Commentary

The Fed warned investors, bluntly stating any pivot prediction is misguided. Minutes from the December Fed meeting were released yesterday (Wednesday, January 4, 2023) – the Fed was blunt, “No participations anticipated that it would be appropriate” to cut rates.

40-Year Record Inversion

On 12-31-22, the Yield Curve is the most inverted since the late 1970s and early 1980s.  Bottom line: It is nearly impossible to bet against recession. We are now in the 7th month since the yield curve inverted. The “Median Lead Time” from inversion is 11 months.  The shortest was 7 months (1960), and the longest was 21 months (2008).

The high-yield trend signal is back in a buy signal. Keep stop loss triggers tight. It’s my view that the next recession will cause a meaningful number of bankruptcy’s causing a generational buying opportunity with prices much lower than current levels and yields perhaps in the 20% range. Of course, I could be wrong. For now, stay nimble and keep stop-loss triggers tight.

The Zweig Bond model sits at -2, signaling an up trend in interest rates.  A bearish trend signal for high-grade bonds. The intermediate trend in equities remains down. The extreme bearish put/call ratio reading is back to neutral. The equity market trend signals remain mostly red across the Equity Trade Signals Dashboard.

Volume Supply remains greater than Volume Demand. It is a measure of selling volume vs. buying volume. There are currently more sellers than buyers. NDR plots the data back to 1981. When volume demand is above volume supply, the percentage gain per year was 11.79%. When volume demand was below volume supply, the percentage gain per year was -1.37%. This is a good indicator to follow, and we’ll keep a close eye on it in 2023. Note the indicator has been bearish since January 2022.

The Zweig Bond Model is back in a sell signal suggesting higher interest rates and lower bond prices. The dollar is turning bullish. The trend in gold is bullish.

Grab a stiff drink. Here is your 2022 stock and bond market review:

A performance summary from our friends at Franklin Templeton. Not that you need a reminder.  An excellent year for Energy. A disastrous year for  Communication Services. Various bond market returns are reflected, as are key market indicators. The trend in the Fed Funds rate is higher, as the Fed aggressively warned us this week. Inflation is cooling, Unemployment is rising, and I expect GDP to decline in recession.

Click HERE to see the Dashboard of Indicators and all the updated charts in this week’s Trade Signals post.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizons, and risk tolerances. TRADE SIGNALS SUBSCRIPTION ACKNOWLEDGEMENT / IMPORTANT DISCLOSURES 

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Personal Note: Going Skiing 

One day in 1995, I was sneaking out through an office parking lot on my way to grab lunch when I ran into a young guy named Rich. Rich’s grandfather owned the building next door, so Rich parked his car in the office lot. Since we were heading in the same direction that afternoon, he asked where I was getting lunch and invited me to his coffee shop, Gryphon Café, which was having its grand opening that very day. He was so excited, sharing with me his passion for coffee and his new business.

Gryphon Café is now located in Wayne, Pennsylvania. While it’s no longer a quick walk through an ally, after twenty-seven years (and more wrinkles), it’s still my favorite coffee shop. Over those years, I’ve watched Rich grow his business and his family, and his passion for the café is as strong as it was that opening day. My go-to order is an oat milk latte and his hummus, cucumber, and tomato sandwich on multi-grain bread. And the soups? Excellent. If you’re ever in town, please do stop by.

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I was up late last night packing the ski bags. We fly to Snowbird, Utah, this evening, and the forecast is showing a lot more snow—a skier’s dream. In fact, I’m rushing to wrap up my writing early today so I can finish packing and get to the airport. I’ll share a few Snowbird photos with you next week, and I’ll post a few on Twitter. In the meantime, thanks for reading!

Remember to listen to last week’s 2023 Investment Outlook episode on Spotify, and let me know if you like the audio version.

Wishing you a great week!

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

 

If you are not signed up to receive the free weekly On My Radar letter, you can sign up here. Follow me on Spotify, Twitter @SBlumenthalCMG, and LinkedIn.  

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

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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.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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