December 17, 2021
By Steve Blumenthal

“I would say, asset valuations… are somewhat elevated.”

– Federal Reserve Board Chair Jerome Powell,
Wednesday, December 15, 2021

One part of today’s On My Radar missive is dull, the second is obvious, and the third is outright intoxicating. We’ll look at the Fed, consider their hawkish pivot in the face of rampant inflation and record-high market valuations (grossly understated in the quote above), and we’ll listen to a genius, Chamath Palihapitiya. Chamath is the founder and CEO of Social Capital LP. An extremely successful investor who backs breakthrough companies in areas such as healthcare, education, climate change, and space.

The Fed

The Consumer Price Index hit 6.8% this month, the highest year-over-year number since 1980. Gasoline prices increased approximately 58%. Grocery prices are up 6.4%. Steak is up nearly 25%, bacon 21%, eggs 8%, apples 7.4%, and flour 6%. Shelter costs, which comprise about one-third of the CPI, increased 3.8% on the year, the highest since 2007 as the housing crisis accelerated. And wage pressures are real and not transitory.

In response, the Fed slammed on the brakes this week. The Fed had been buying $80 billion per month of U.S. Treasurys and $40 billion per month of mortgages. Last month, they reduced the total purchases of $120 billion per month to $105 billion. On Wednesday, Powell said the Fed will reduce its bond purchases to zero by the end of March 2022.

After the bond-buying goes away, Powell said the Fed will begin to raise interest rates. Three rates hikes are expected next year. My friend David Rosenberg thinks the surprise will be they won’t raise rates at all. Due to the excessive amount of debt in the system, rising rates will prove to be a liquidity constraint on financial assets. The response in the bond market is signaling agreement. Since the Fed’s Wednesday announcement, the 10-year and 30-year Treasury bond yields are lower since the Fed’s announcement.

The last time we attempted to shrink the balance sheet and raise rates, we had a major dislocation in the stock market. And as we’ll see next, market valuations were not as inflated as they are today.

To be clear, this is an about-face from the endless quantitative easing of just a few months ago. Suddenly, the Fed is going to accelerate tapering. We’ve seen this movie before.

The Fed raised the Fed Funds rates five times in 2018 from approximately 1% to 2.5%. The stock market declined sharply late in the year, down approximately 20%. Then came the famous Powell Pivot at Christmas time. The Fed admitted they were wrong, changed course, and what followed until now was on the greatest liquidity injection of all time.

The Fed is taking the punch bowl away. If they stay on this new path, we will be in a recession by 2023. I could be wrong, but I don’t believe the Fed can raise rates for too long. Expect the next 20% stock market decline to be met with another pivot. More goodies with similar inflationary consequences. The Fed is in a tough spot.

Valuations

In his remarks on Wednesday, Powell cited asset valuations as one of four key areas the central bank looks at when assessing financial stability risk. “I would say, asset valuations … are somewhat elevated,” Powell said. Right!

First the big picture (red is bad):

Median P/E

Price-to-Forward Earnings

Price-to-Sales

Buffett Indicator – Total Stock Market Cap-to-GDP

Stock Market Cap as a Percentage of Nominal Gross Domestic Income

Note the historical return stats in the upper left-hand section of the chart. Negative for 1-, 3-, 5-, 7-, 9-, and 11 years. Not saying the same will happen from today’s current starting place, just saying if you overpay for an asset, your return outcome will not be as good as when you buy an asset at a favorable price.

Jim Bianco does excellent work. He’s another Camp Kotok fishing friend and heads Bianco Research. If you are not following him on Twitter, I recommend you do. I pulled this next chart from one of his posts. Just five stocks (Facebook, Apple, Amazon, Microsoft, and Alphabet) stocks make up 24.02% of the S&P 500 Index. Apple is the largest. Never before folks, have so many been so highly concentrated in the same few names.

Bottom line: I could be wrong, but I continue to believe we will get a better entry point. One of my favorite ETF asset managers is 3EDGE Asset Management. They have never in their history been more defensively positioned as they are today. The team has been managing money since the mid-1990’s. Doesn’t make them right. But I find it hard to take the other side of that trade.

My two cents is we don’t have to settle for negative 11-year returns as forecasted above. Like the 2018 Fed Taper Tantrum, I believe a 20% to 30% correction is probable. If I’m right, my best guess is Powell and team will pivot and give us more QE. The markets will likely respond favorably. Game plan: Target for the S&P 500 Index is between 2,900 and 3,500. Then, less defense (risk management) and more offense.

More on the Fed follows in the Trade Signals section. But first, I encourage you to plugin, grab your sneakers and listen to the fantastic Barry Ritholtz – Chamath Palihapitiya podcast. Chamath is a genius. Here’s a teaser:

“We need to go after cancer, diabetes, climate change,
the substantive problems of the world that, if were solved, would create immense
wealth and opportunity that would cascade across countries.”

– Chamath Palihapitiya

This is a discussion about the challenges of groupthink, the challenges with governments, and how this self-made multi-billionaire is using his money to make the world a better place. I think a lot of people lose sight of how they are not just investors, they are stewards of capital. You may not agree with everything Chamath says, but I promise he will get you thinking, and, like me, you may just learn a few things too.

Bloomberg’s Barry Ritholtz – Chamath Palihapitiya Podcast

“We need to divorce ourselves from venture capital as an occupation
and focus on using capital as a way to take really big bets on things that just seem totally audacious.”

– Chamath Palihapitiya

Chamath is the founder of Social Capital and one of the more interesting and successful venture capitalists in Palo Alto. He was an early senior executive at Facebook, working at the company from 2007 to 2011. Following his departure, he founded Social Capital, through which he invested in several companies, including Yammer and Slack. And he is a co-host of the podcast All In.

Chamath is 45 years old and was born in Sri Lanka to Sri Lankan parents. At the age of five, he and his family moved to Canada as refugees. His father was frequently unemployed, and his mother did low-paying housekeeping jobs. Chamath worked at a Burger King to help his family. He attended Lisgar Collegiate Institute and graduated at the age of 17. After graduating from the University of Waterloo in 1999 with a degree in electrical engineering, he worked for a year as a derivatives trader at the investment bank BMO Nesbitt Burns. He then changed jobs to one under Winamp, a Microsoft Media player, and moved to California. (Source: Wikipedia)

Following are a few notes – selected by me. Here is the link to the full podcast.

One of the things that resonated most with me was Chamath’s discussion about investing and how he invests his own wealth. He runs his own VC fund. He’s looking for asymmetric returns. He sets a certain amount of his wealth aside for safety and then he is risk-on with the majority. And he looks for investments that will make the world a better place. The way he thinks is important and something more investors should consider.

He talked about how we’ve grown to be taught the same way, we think the same way, invest the same way.

And then the more insidious problem is actually the human capital inside the funds themselves. And what I mean by that is not that they’re bad people, they’re wonderful people. But they are products of a very specific and very rigid hierarchy.
You know, they typically went to a handful of schools, right? They typically are educated in exactly the same way. They typically have the exact same kind of risk tolerance as a result of all those things. And so, when the rubber meets the road, this Harvard MBA or the Stanford MBA, they want to treat the venture capital organization as their version of the S&P 500. Very predictable, steady Eddy. Let me make a good salary… Don’t rock the boat.
So, what happens? Crypto stuff gets underfunded until it’s obvious, hard tech and life sciences get underfunded until it’s obvious. SaaS gets overfunded until it’s obvious. And that’s the whipsaw that you face.
Now there are a handful of organizations that have fought against that and have done a brilliant job, so when you look for example, like Founders Fund. They have an incredible set of investors who are iconoclasts to the core. They are atypical and every dimension. There’s not a single drop of real pedigree amongst them except they’re all incredible entrepreneurs.
If you look at Khosla ventures, same situation, incredibly atypical in their intellectual makeup and the way they think and what they value and to a one, they’re generally great entrepreneurs.
So, you see this recurring theme. So, for me what I’ve tried to do is recalibrate my time, around that realization.
I have a fixed amount of capital. If I surround myself with these good smart people (i.e., that treat the venture capital organization as their version of the S&P 500. Very predictable, steady Eddy), it will lead me astray because I will get risk-off.
And the whole goal of this business is to be 100% massively risk-on and so that’s how I live my life. I have a small allocation of capital in case all of this goes to zero, but otherwise, 99% of my net worth and wealth is massive risk-on.

Chamath talked about his thinking about investing to make the world a better place. Here are a few excerpts.

Chamath: And, you know, if you have enough capital, at some point, you’re like, well, why do I need any more money? There is a safer route to take, right?
I have this different view, which is I want very specific kinds of progress that will not happen unless I am a tip of the spear on a bunch of things that I want to change.
And I’m using my money as a mechanism of showing the change that I want to see in the world. With the idea that if free markets are ultimately efficient, other money will follow and it will unlock and create change.
There’s something very valiant in building a company of any kind. I don’t care what it is because you end up hiring people, you end up creating your own little economy, you know, by hiring good people and paying them. You’re giving them a path… you know, some amount of purpose in their lives.
So, any form of company building I think is heroic. The person that chooses to build a company, I don’t care what it is, it could be a garbage business, an AUM business, you know, they’re all to me, where I look at the founders of those things like you (Barry Ritholtz), and you’re in a class of hero for me.
Everybody may not view it the same, you know, sometimes. Now founders unfortunately sometimes can get vilified for being an entrepreneur. But, in general, I think they’re heroic.
But that’s not what I was trying to do to my returns in society. I wanted to be expressed by a different kind of change and a different kind of purpose, which is to solve practical problems.
I want reforestation to be, you know, done differently.
I want a gene-editing solution to be so cheap and available to many. We can eradicate, the 32,000 inherited Mendelian diseases.
I want to figure out how to get, sub $100 solar on everybody’s roof and to build a massive, distributed energy utility in America.
It turns out, I’m doing all those things now. I can do that with my capital, and that’s really great.

SB here: There is so much more. And it will get you thinking about how you allocate your own wealth in a purposeful way. Here is the link to the full podcast.

Hope you enjoy it as much as I did. As a quick aside, I shared it with my kids, and they loved it. Pass it on to your children…

Trade Signals – Fed to Aggressively Dial Back Bond Buying, Sees Three Rate Hikes in 2022

December 15, 2021

Posted each Wednesday, Trade Signals looks at several of my favorite equity markets, investor sentiment, fixed income, economic, recession, and gold market indicators.

For new readers – Trade Signals is organized into three sections:

Market Commentary
Trade Signals — Dashboard of Indicators
Charts with Explanations

Market Commentary

Notable this week:

The decision is in. Federal Reserve Chair Jerome Powell said the Fed will aggressively dial back its bond-buying program and they see three rate hikes in 2022. Inflation is winning. I believe they are wrong-footed and late. The Fed’s move will make borrowing costs higher and add to the global slowdown outlook into mid-2022. In a word, “Stagflation.”

In his press conference, Powell noted the Fed is two meetings away from stopping their bond-buying and that raising rates won’t begin until bond buying ends.

Short-term interest rates are higher, the 10-year Treasury and 30-year Treasury rates are flat but lower since earlier in the year before inflation got out of the box. The 30-year Treasury yielded 2.50% in March 2021, touched 2.18% in October, and is at 1.84% at the time of this writing (December 15, 2021). Yields are just slightly higher after the Fed’s announcement.

Our dashboard of indicators follows below. Gold is in a sell and the S&P 500 Index Daily MACD Indicator moved back to a buy. No major changes since last week. Before you take a look at the dashboard, one quick comment on the outlook for the global economy. If a slowdown is coming, we’ll see it in the flattening of the yield curve (higher short-term rates and lower long-term rates… which is happening), and we’ll see it in the price of copper. Let’s take a look at “Dr. Copper.”

Dr. Copper – A Ph.D. in Economics

Copper is often said to have a “Ph.D. in economics” because of its ability to predict turning points in the global economy. It is because of copper’s widespread use in most sectors of the economy, from homes and factories to electronics, power generation, and transmission demand. Thus, the price of copper is viewed as a reliable leading indicator of global economic health.

The following chart, courtesy of StockCharts.com, plots the monthly price of copper back to 1972 (black line, top section). The red line in the top section is a 12-month Moving Average line. The bottom section plots a momentum indicator that measures various rates of change in price over different time frames (black line). To avoid going all-out quant goober on you, when the black and red lines cross, a signal is given. The green sections show an expanding economy and the white sections a slowing economy. Note the far right side (black line nearing cross below the red line) in the lower section of the chart.

My fundamental view and, of course, I could be wrong, is that we are going to go into a major global slowdown into next summer. Dr. Copper is rolling over and nearing a bearish economic signal. Stay tuned.

Click HERE to see the Dashboard of Indicators in Wednesday’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 horizon, and risk tolerances.

Personal Note – Merry Christmas

Everyone is coming home for Christmas and Susan and I are very excited. We love when we are all together. And I’m sure you feel the same with your family.

Overall, I think we are ahead in the game in terms of gift buying. Thoughts of an early January ski trip have faded along with the poor snow conditions to date in the West. If we get a few days in the 40’s with little wind, the kids and I will be walking the course at Stonewall. Daddy will like that.

The wine cellar is stocked (Italian Brunellos, French Bordeaux, and California Cabs), cold IPAs are in the refrigerator, wood is next to the fireplace and the tree is up and looking good. I’ll be taking a few days off next week to relax with my family. There will be no On My Radar next week.

With red wine glass held high, here’s a toast from me to you. May joy and love be your greatest gifts.

Wishing you a warm and wonderful holiday.

Thanks for reading,
Steve

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

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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.

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On My Radar: The Fed, Valuations, and Genius