June 16, 2023
By Steve Blumenthal
“Price and value aren’t always the same: Don’t pay too much.”
“Price is what you pay. Value is what you get.”
After ten consecutive Fed rate hikes, Fed Chairman Powell decided to “skip” another increase this week but announced that he expects there to be two more increases by year-end. He also noted that it will be a long time before the Fed begins to cut rates.
Something got lost in translation, however. According to the market, it would seem what Powell really meant was that he is “pausing” hikes now and will begin to cut rates this year. Stocks sold off initially on Wednesday, June 14, but then rallied convincingly over the course of the day as well as on Thursday, June 15.
I think the market has it wrong. Powell means what he is saying.
Investor sentiment has reached a level of extreme bullish optimism, seen just ten times in the last 20+ years. As I note in the Trade Signals section, channeling my inner Sir John Templeton, this is a sell-when-everyone-is-buying moment. Will it be different this time? Doubtful.
Grab your coffee and find your favorite chair. This week, I share some thoughts about “The Skip” by the Fed, put “The Size” of the U.S. stock market into perspective, and compare it to the size of “The Ten” largest U.S. stocks. Throughout the history of the stock market, there have only been a few times when too few stocks have made up so much of the value of the total stock market. The last time this happened was in March 2000.
You’ll also find a great chart that tells us what to expect in terms of probable 10-year future returns. I hope you find it as interesting as I do. I conclude this week’s On My Radar with some ideas as to how to approach investment positioning in the period ahead. The idea is to simply say there is much we can do.
Here are the sections in this week’s On My Radar:
- The Skip – A Mistake?
- The Size
- The Ten
- What Investor’s Stock Ownership Tells Us About Coming Returns
- Trade Signals: Extreme Optimism Signals SELL
- Personal Note: The Water We Are In
(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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The Skip – A Mistake?
“The skip — I shouldn’t call it a skip — the decision… I would almost say that the conditions that we need to see in place to get inflation down are coming into place… The things are in place that we need to see. But the process of that actually working on inflation is going to take some time,” said Jerome Powell in the press conference after the Wednesdays Fed meeting.
After digesting the”skip” decision comments, the market rallied. The market tanked on the initial move, then it suddenly recovered. On Thursday, everything rallied. Stocks, commodities, oil, gold…
Powell said he would skip and then raise rates two more times by the end of the year. The markets didn’t seem to believe him. The market is thinking pause, then a cut.
If Powell is intent on continuing the inflation fight, and I personally believe he is, his “skip” comment looks to have been a mistake.
Regardless, investors should keep top of mind that historically stocks bottomed after the last Fed rate cut. Not the first skip, not the first pause, not the first cut.
The Size
In the world of finance, the Total U.S. Stock Market reigns supreme. Its sheer size and magnitude make it a subject of great fascination among investors. Its value, commonly referred to as the Total Market Cap represents the combined worth of all publicly traded companies in the United States.
As of June 15, 2023, the Total U.S. Stock Market Cap (represented by the Wilshire 5000 Index) equals approximately $46.4 trillion.
At any given moment, the Total Market Cap reflects the collective strength and performance of the U.S. stock market. Among its various constituents, the S&P 500 stocks stand as a mighty force.
As of June 15, 2023, the S&P 500 Index Market Cap equals approximately $36.5 trillion, representing roughly 79% of the Total U.S. Stock Market.
This dominance showcases the critical role these top 500 companies play in shaping the overall health of the U.S. stock market. Their performance holds sway over the sentiments of investors, causing periods of either excitement or concern in the financial landscape.
Yet, within the vast sea of the Total Market Cap and S&P 500 Market Cap, a select few stocks, which I discuss in the next section, now tower above the rest. These giants capture our attention with their exceptional growth and influence. Today, their combined worth forms a substantial portion of the Total Market Cap. You’ll find the math for all of it below.
(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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The Ten
As of June 15, 2023, the Top Ten Stocks Market Cap, seen below, equals approximately $12.7 trillion.
This number equates to a staggering 34.7% of the S&P 500 Index and 27.4% of the Total Market Cap.
Source: Companiesmarketcap.com
These giants hold immense power, their fortunes capable of influencing the entire market, as is the current case.
One of the less-understood concepts of the cap-weighted structure is the flaw in the index’s design. By rule, index funds like the Total U.S. Stock Market Index (there are many ETFs, mutual funds, and managed accounts that replicate the index) and the S&P 500 Index rebalance the indices’ weighting on a quarterly basis based on the size of the underlying constituents. Meaning the higher the price goes, the higher the weight a stock gets in the index.
Since all of the market gains this year are coming from the top 10 stocks, the index, by rule, increases the percentage of exposure to the stock. Think of it as a momentum play: The higher the stock’s price goes, the more the index is forced to buy. The problem comes not on the way up but on the way down.
See, when the big stocks’ valuations are eventually corrected, the index, by rule, must sell its exposure to the stock. You pile it on the way up, overweight too much at the top, but when the correction comes, you are underweight at the bottom, and you don’t get the benefit of the eventual recovery. In contrast, the only time equal weight underperforms and cap weight outperforms is when investors go crazy for the in-favor stocks at market tops. As a result, equal weight has done better than cap weight over a full market cycle. And there are even better ways to diversify than equal weight.
The last time we had such an extreme level of market concentration in such a low number of stocks was in early 2000. My recommendation? Friends don’t let friends own cap-weighted indices. It’s an excellent momentum play on the way up, but it’s bad on the way down, with a big disconnect coming after the market bottoms. You can’t capture the recovery since the index lowered your percentage exposures to the darlings.
(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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What Investor’s Stock Ownership Tells Us About Coming Returns
I’ve shared this next chart with you before. It is one of my favorites because it gives us a sense of just how much investors have allocated to equities as a percentage of their investments (equities, bonds, and cash… and the data includes mutual funds and pensions). This way, we can see if investors are overweight equities or underweight.
The other thing this chart shows, looking at the historical data from the end of 1951 through March 31, 2023, is the very high correlation between equity ownership and subsequent 10-year total return outcomes. The idea here is that if investors are fully invested in equities, they have less desire to add more. More buying than selling, and prices go up. If you exhaust the buying desire, you lose the fuel that propels prices higher. You can also think about demographics in the equation as individuals age; they generally shift their focus to income-producing investments.
If you need to increase your retirement income and bonds yield 3% or less, you’re likely to hold onto your equity allocation. TINA – ‘there is no other opportunity’ kept them in stocks. Now, safer investment returns are above 5%. Older investors may be enticed to reduce equity exposure and pick up safe income-producing bonds. The point here is to understand what the household equity percentage picture looks like and what it means in terms of expected future returns. Let’s take a look.
Here’s how to read the chart:
- This chart compares the percentage of total household financial assets invested in equity to the subsequent 10-year total return on the S&P 500 (inverted).
- When households are heavily invested in equity, the subsequent 10-year returns are low or even negative, while the subsequent 10-year returns are high when household equity holdings are low.
- The blue line plots the Equity as a Percentage of Total Household Equities, and the dotted orange line plots the 10-year subsequent total return that was actually achieved.
- Note the high correlation between household equity allocation and the subsequent inverted 10-year return.
- For example, near and into the bull market top in March 2000 (just prior to the Tech Wreak), households had 62% allocated to equities. The 10-year returns from 2000-2010 were negative 2 percent per year.
- Minus two percent per year for ten years turns your $100,000 into $81,700.
- And look at the awesome returns that followed periods where equity ownership with below 40%. The 1970s, 1980s and early 1990s. And then again after the great financial crisis in 2009.
- This result is in line with most other long-term sentiment/liquidity indicators, as market peaks and troughs tend to be inversely correlated with investor liquidity.
The U.S. household equity allocation data is from DAVIS188 and is based on the Federal Reserve’s quarterly Flow of Funds report (Z.1), and also includes mutual fund asset data from the Investment Company Institute.
Valuations matter as well. While off their December 2021 valuation highs, the market remains richly priced.
Let’s take a look at what Shiller PE means in terms of historical returns.
Here is how to read the next chart:
- Red arrow is bad. (Note: red “We are here.”)
- Since 1909, the best 10-year subsequent total S&P 500 Index return was 3.6% per year.
- The worst 10-year was -1.8% per year. The average was 1.3% per year.
- Focus on the “AVG BEGIN P/E” column vs. where Shiller PE is today and what PE levels are best (below the solid black line – think of them as entry targets).
- The green arrow is good: Take a look at the returns when buying when the PE is 17 or lower.
One last point:
The Top Ten PE’s as of 6-15-23:
-
- AAPL PE = 31.23
- MSFT = 36.08
- GOOG = 27.54
- AMZN = 154.17
- NVDA = 196.33
- TSLA = 75.53
- BRK-B = 23.21
- META = 28.07
- V = 35.80
- UNH = 20.03
Finally, let’s take another look at the big picture. You make the call.
Macro picture summary:
- We’re seeing high stock market valuations.
- The Fed has raised rates from 0.25% to 5.25% at the fastest pace since 1980.
- We are in or very near recession. Stocks decline more than 30% in a recession.
- We’ve seen three bank failures and tightening liquidity.
- We have both a deep internal divide and an external geo-political divide.
- We’re at the end of an 80-year long-term debt super-
Let’s look at that last point in more detail. Here’s the progression of the global debt–to–GDP ratio: In the 1970s, the total global debt was roughly 100% of GDP. In the year 2000, it was about 150% of GDP. In the year 2020, it was 250% of GDP. And from 2020 to 2022, it grew to 350% of GDP.
A restructuring of sovereign debts, public pensions, and currencies between 2025 and 2030 remains a high probability. Governments reach a point when they restructure the debt and fund the pension system. Unlike what happened in the 1930s, this time I believe that governments will save the economy, backstop systematically important companies, and have the Fed print and buy enormous amounts of government debt. I predict this will happen in the U.S. and maybe be in coordination with other developed countries, like Japan, the UK, and the EU.
For the balance of this decade, we will likely continue experiencing rolling waves of inflation and rising interest rates. We are currently on the back end (declining inflation) of inflation wave number 1. Wave 2 will come out of the next round of QE.
Back to the macro summary:
- The 35+ year tailwind of declining interest rates ended in 2020. We are likely to see interest rates stay higher for longer for the foreseeable period.
- We’ve seen an inverted yield curve for 11 months and are already in or very near recession. Stocks decline more than 30% in a recession.
- If valuations were low, making equity investments attractive again, I would favor benching risk management and putting the buy-and-hold strategy on the field.
- Much of the developed world faces aging demographics.
- Advances in AI, genomics (gene editing), and longevity science are massive potential drivers moving forward.
- Overall, the vast majority of the money is allocated to the buy-and-hold passive index approach. For those investors, expect a wild up-and-down roller coaster ride for most asset classes over the balance of the decade.
General Ideas
What should you do about it? The following list includes a few ideas (Note: This is not personal advice for readers as I know nothing about each of your financial goals, risk objectives, or time horizon. For personalized advice, please consult your advisor.):
- The picture I’ve painted is a wild, up-and-down ride over the coming 10 years, resulting in slightly positive to slightly negative annualized total returns for the major equity market indices. If you are OK with that, stick to the plan and dollar cost average each time the market swings violently down.
- The environment ahead favors active management. Find experienced stock pickers.
- Build a CORE portfolio that includes:
- Well-collateralized first lean short-term private credit – You can find funds yielding high single digits. Think: Base lending rates plus a spread, so very little interest rate risk. Not risk-free, but low-risk due to the collateral position. You want strong, experienced credit managers.
- Distressed credit – It’s likely to offer excellent returns—around the mid-teens. A lot of companies are going to get into trouble in the next recession; defaults will rise, and only certain managers will be able to take advantage of the distressed environment.
- High and growing dividends – I like the high and growing dividend story and believe such stocks should perform much better than the basic indices over the coming 10 years, much like the outperformance from 2000 to 2010.
- Active management instead of passive management.
- Alternative ways to make money – Long-short equity funds, absolute return strategy funds, and multi-strategy funds.
- Oil, agriculture, commodities… Things the world needs.
- Broad diversification!
- Build an EXPLORE portfolio that includes:
- Venture capital and Private Equity – Create relationships that provide you with co-investment opportunities.
- Companies that have an edge in technology, good management, and good people around them (boards, VC firms, PE firms). You want companies that are going after a massive market, disruption potential, and/or unmet needs. If they win a piece of the market, it could be a home run. Outside of inheriting wealth or building it through your business, this is how meaningful wealth is created.
- 20% on a handful of bets – As a general rule, place no more than 5% exposure to any one risk. If you allocate to 10 different investments with 2% to each risk and one of the investments turns out to be a zero, you are down only 2% on your overall portfolio.
- The 80% CORE should grow back to 100% within four years (requires a 7% annualized return). If all your EXPLORE bets turn to zero in 10 years, you are still in the game. The CORE enables the EXPLORE.
- Investment in companies you believe may see 10x or higher return over the decade – It will be a bumpy ride, so really make sure you understand the companies you are investing in.
As a general rule: 80% to a diversified CORE portfolio and 20% to EXPLORE
I hope this dialog helps you think more broadly. The challenging macro forecast paints a negative picture of traditional investing. This doesn’t mean you lack opportunities. It doesn’t mean your wealth can’t succeed. You just have to reorient your investments in the right ways.
(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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Trade Signals: Extreme Optimism Signals SELL
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Market Commentary June 14, 2023:
Fed day: The Fed left rates unchanged Wednesday, June 14, at the 5% – 5.25% range, and they forecast the Fed Funds rate rising to 5.6% by year-end. Fed Chair Powell said, “it may take even years to cut rates.”
Equity markets were up and down and closed mixed, with the S&P 500 Index gaining a tenth of a percent and the Nasdaq higher by 40bps.
The most glaring signal this week is the extreme level of investor sentiment. It is screaming optimism. The status of extreme has been achieved just ten times in the last sixteen years.
The great Sir John Templeton is famous for saying, “The secret to my success is I buy when everyone else is selling and I sell when everyone else is buying.”
Bottom line: This is a sell when everyone else is buying moment.
Here’s how to read the chart:
- I’ve painted a thin red line across the top in the middle orange section of the chart.
- Look at those rare readings and then draw a mental line from the point of extreme above the red line to the S&P 500 price line at the top of the chart.
- Note too (data box) the negative market performance that followed prior Extreme Pessimism readings.
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Personal Note: The Water We Are In
“There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, ‘Morning, boys. How’s the water?’ And the two young fish swim on for a bit, and then eventually, one of them looks over at the other and goes, ‘What the hell is water?’
– David Foster Wallace (2005)
I’ve got nothing big to report on the personal front. Some golf is in the weekend plans, as is work around the house. I’ll be in Akron, Ohio next week at an advisor-client event that I’m really looking forward to. It’s about a six-hour drive through central and western Pennsylvania and across the Ohio border. The event is Thursday night, with meetings on Friday morning before heading back home that afternoon. I’ll load up some podcasts and make phone calls along the drive. I already have something saved to share with you in next week’s OMR.
I borrowed the above quote from an edition of my good friend Ben Hunt’s Epsilon Theory newsletter titled “This Is Water”. Ben is smart, witty, and about as nice of a person as you can meet. To conclude today, I point you back to the Macro Summary Picture I shared with you above. I believe it is “The Water We Are In.”
We’re in for a wild ride, we’ll get through it, and we’ll be ok.
Have a great week,
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com
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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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