August 8, 2014
By Steve Blumenthal
I was interviewed by a very bright Bloomberg fixed income reporter yesterday. His area of expertise is high yield credit and he had recently read the piece I wrote for Forbes, Code Red in High Yield. He jumped right in with question number one, “is this the top in high yield?” I thought to myself, it is funny how often we tend to think this way in our business.
Since the Forbes piece was published, the high yield market has experienced a relatively quick and hard sell-off. His question got me thinking about how we all want to get the great call right (you probably have a few too many clients expecting such perfection of you). Yet, how few, if any, can do it consistently… and even if we get the fundamental argument correct, the market will likely do its best to show us we are wrong along the way.
So I answered the question with a cautious maybe. I then shared with him an insider’s view on the pre-2008 sub-prime crisis days. How logic and common sense said one thing yet the game pushed forward a few years longer than I thought it would. Several hedge fund greats were shorting well crafted sub-prime structures and lost many clients, who exited upset with declining account values just before those shorts made millions.
I remember getting pitched on a Bear Sterns leveraged credit hedge fund. Run by several smart guys with big resumes. They were on the other side of the trade. I passed feeling pretty sure sub-prime and CDOs would blow up. I remember the day that fund cracked thinking “here it comes”, yet it took about 12 more months before the whole house of cards crashed down. Is this the top? Don’t know. I told him that the situation in high yield credit feels much the same way to me today as it did pre-crisis 2008 (past performance means zippo – just saying).
It is with this thinking that I thought I’d share some thoughts on how the next 18 months might play out. I say might due to the interplay of some very powerful forces – The Fed immediately comes to mind as in don’t fight the Fed. I believe we must ask ourselves if Fed liquidity and zero interest rate policy propelled risk assets higher, what might the other side of that picture look like and when. Let’s take a best guess shot at the “maybe and when”.
I share the following in this week’s On My Radar:
- The Maybe and When
- Positioning for Today’s High Yield Sell Signal – Blumenthal’s 8-8-14 Forbes Blog
- Trade Signals: Risk Remains High – 08-6-2014
The Maybe and When
“I don’t know what the trigger for the next debt crisis will be, but whatever it is, it will result in an even deeper liquidity crisis than we saw in ’08. That is just the nature of the beast.”
John Mauldin
I agree with the above quote. Here are a few short thoughts on what I believe is probable yet keep in mind that while it is easier to get the risks right, getting the timing right (the maybe and when) is nearly impossible to do consistently:
- The reversal of Fed policy is the probable trigger to the next credit crisis in my view. Timing – first rate increase is expected in June 2015.
- It is the second rate increase that markets have historically responded negatively to. Timing – September 2015.
- FOMC Participants’ Assessments of Appropriate Monetary Policy. Latest “Dot Plot” sees median between 1% to 1.25% in 2015. This up from today’s near zero percent interest rate policy. The median view on Fed Funds rate target for 2016 is 2.50% up from 2.25% in last quarter’s Dot Plot. Here is the latest chart.
- Keep in mind that a data dependent Fed may keep rates lower for longer and could introduce a QE round 4. The economy could slow between now and then keeping “Don’t Fight the Fed or the Tape” in play. In a perfect world I’d go with September 2015 as the turning point. Ultimately – timing unknown.
While the cracks in the system began to show in 2007, someone kept on buying and, as I mentioned, the equity market and other fixed income markets (certainly high yield) continued to move higher. “Who is buying this stuff”, I remember shouting back then. We later learned it was AIG and the Germans among others. So despite our recent timely sell high yield bond market signal, a process we follow religiously, this is unlikely to be the “when” and I have a thought that has been building in my mind. It is a coming “melt up” in the US equity markets tied to governments implementing gates on fixed income funds and special net worth taxes (aka penalties and wealth confiscation schemes).
- I believe it highly probable that US equities will be seen as global assets of choice as Cyprus like EU wealth confiscation activity accelerates in Europe. Something I see as highly probable – resulting in a melt up in equity prices as foreign money and pension assets exit sovereign bonds and seek better treatment. It is a follow the money flows. Put it in the maybe category. As to when: sometime between now and 2015. My best guess upside target on the S&P 500 Index is 2250. Will it happen? Don’t know.
Investors have been forced into riskier assets. The objective has been to inflate asset prices and the Fed has succeeded. With this risk, the market has elevated in a way that feels all too familiar (aka “there is no bubble in the housing market”, Greenspan in 2007).
The bubble is in the debt market and a credit crisis is a coming. In Forbes this week I shared some additional thoughts on how to play to risk in a way that can keep you growing while mindfully risk protecting your clients’ wealth.
Positioning for Today’s High Yield Sell Signal – Blumenthal’s 8-8-14 Forbes Blog
Click here for the link to Positioning for Today’s High Yield Sell Signal – Forbes
Simple tactical based trend following and relative strength based investment processes may help you in this regard. As you’ll see in this week’s Trade Signals post, Big Mo remains in a cyclical bull market trend and the 13 over 34-week EMA on the S&P 500 index continues to favor being long the S&P. The CMG Zweig Bond Model continues to signal to be long high quality bond exposure and our CMG Managed High Yield Bond model has moved us to cash.
Mix various sets of risk to build portfolios for the probable period that remains ahead.
Could this be the top in HY? Maybe, but I doubt it. By the time we know for sure it will be too late to sell. Markets tend to dislocate quickly. Then what do you do? When might you get back in? I find a disciplined strategy with conviction in its process is a better way.
Trade Signals – Low Cash High Debt
Click here for this week’s Trade Signals.
Conclusion
The reporter from Bloomberg asked me what I though about shorting HY via one of the relatively new ETFs. If I am right on the coming credit risk (a wave of nearly $1.6 trillion in defaults starting perhaps next year), then why not short HY. I answered that I would avoid ETF products that are based on bank issued credit default swaps. While you could be right in your directional bet (in this case short HY), not only do you have to deal with the time factor of being wrong on your way to being right and paying away a negative carry (you owe the yield payment to the person on the other side of your trade), there is a risk that the bank counterparty the ETF provider you use via a credit default swap agreement may not be able to pay you out when you are right for they may default (another risk I see as probable).
I intend to do another piece for you that dives deeper into the hypothecation clauses that exist within the various bank created SWAP agreements. In short, this is leverage on top of leverage. The clause provides banks with the ability to leverage the collateral in client accounts for other bank purposes, creating a web of interconnected risk. One customer default can set in motion a domino-like affect not too dissimilar to sub-prime mortgage bonds rolled up and repackaged within tranches of higher rated collateralized debt obligations (CDOs). There are trillions of dollars in credit default swaps. Wall Street financial engineering at its worst. “Too big to fail” may actually fail. I know – depressing but see the potential opportunity. It is a big issue – slot it in the possible risk category for now.
The interview concluded on a beautiful note. Well, I actually used the word beautiful in a way I may later regret. It seemed a bit corny at the time. I said I see a beautiful opportunity ahead and realize that may be a bit insensitive to the masses that will likely again ride another train over another cliff. Of course, there is no guarantee I’m right in my outlook. I hold confidence that my trend following approach can keep me on path and right now that path has us on the sidelines in cash.
Anyway, I hope I leave you with a sense of hope and opportunity. We are living in truly interesting times. Have a plan to approach the risks in a way that doesn’t leave you sitting on the tracks in front of the next oncoming train and perhaps, more importantly, one that leaves you in a position to take advantage of the “beautiful” opportunity that will present on the other side of the next credit crisis. There is a lot of maybe as to when but there is a way to get in front of this with an actionable game plan right now.
I’m on a plane today heading to Denver for several afternoon meetings then up to Estes Park to pick up my youngest son (now 15). He has spent the last 3 ½ weeks at a camp called Cheley located in the heart of the Rocky Mountains – hiking, camping and connecting with friends. If you have kids, do you remember how they felt empowered after doing an activity that challenged them (like scaling a rock climbing wall). Overcoming a fear – pushed to a new level and left with the felling “I can”. That is what this place has done for my son. It sure beats texting and PlayStation. I’m going to do a few mountain hikes and see if I can’t find that “high on life” feeling.
Wishing you too a wonderful “high on life” weekend.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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