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On My Radar: What Current Valuations Tell Us About Probable Future Returns, and Mauldin’s Recession Call

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March 18, 2021
By Steve Blumenthal

“Now it’s 2022 and another strange recession looms. That’s right, I’m calling it: Recession is here, or will be soon. And unfortunately, it will be a global recession. Like the COVID recession, this one has little to do with the business cycle. It’s a recession of choice—not your choice or mine, but Vladimir Putin’s. He clearly miscalculated how hard capturing Ukraine would be and how the West would react.”

­– John Mauldin, CMG Chief Economist and Co-Portfolio Manager, CMG Smart Core Strategy

Each month, I like to work through a series of valuation charts. They’re informative from the perspective of probable coming returns over the next 10 years and meaningless when it comes to market timing. For me, it’s about maintaining a sense of balance and setting a game plan: knowing when returns are best (and risk is at its lowest) and when the opposite is true. We’re seeing some modest improvement since I last shared the data with you a few months ago but we are not yet at a good entry point. Let’s take a look.

Median Price to Sales Ratio

Median PE

One of my very favorite valuation charts captures median PE. Why do I love it so much? Simply because it can give us some ideas as to the entry points when we’ll get more return for our money.

Here’s how to read the chart:

  • “Median” refers to the middle stocks in the S&P 500 Index. The current median PE is 24.1. Throw out the high and low PE, and you get a 58-year median of 17.4. That’s as good a guess as anything regarding when the market is reasonably priced.
  • The left-hand arrow points to the level at which the S&P 500 Index will need to correct to get back to “median fair value.” It’s the level I’m keeping my eye on. When we get there, I’ll consider putting the investment offense back on the field.
  • Take a look at the right-hand arrow. We’ve dropped off from the valuation extreme, but we’re still in the “overvalued” zone.

The Buffett Indicator: Total Stock Market Cap to GDP

 “I’m going to buy hamburgers for the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying—except stocks.”

– Warren Buffett

Here’s how to read the following chart:

  • Buffett has said his favorite valuation metric is the stock market’s total value compared to GDP (what the U.S. produces as a nation).
  • Red circles mark prior valuation peaks.
  • The upward-sloping dotted line is a linear regression trendline. Note how prior peaks have corrected back to or below that long-term trendline.

I’ll continue to share this chart with you over the coming months, and when you review it, think of what the great Warren Buffett said: “When stocks go down and you can get more for your money…”

What does this mean in terms of coming 5- and 10-year returns?

There are many ways to look at valuations. Shiller PE, price to book, price to operating earnings, and total stock market cap to domestic income are other good measurements. The story is similar across the board.

There is also a lot of data around current valuations and forward returns. For the most part, nominal return probabilities are in the 0% to 4% range over the coming 10 years. Not a guarantee, as there can be one-offs, but that range is as good as any from a probability standpoint.

Here’s one last future return chart I like to keep on my radar…

S&P 500 Long-Term Trend

Here’s how to read the chart:

  • The middle section plots the market’s long-term trendline. The orange line represents the real S&P 500 Index—“real” meaning after inflation is factored in. The blue dotted line is the long-term trend.
  • The bottom section measures just how far above or below the market is from its long-term trendline. The idea here is that it provides a historical perspective on how far above or below the trend the market sits at any given point in time. Expensive hamburgers or will we get more meat (return) for our money?
  • Lastly, the red arrow points to the data box showing subsequent 5-year and 10-year returns based on extreme deviation above trend, and the green arrow shows the returns that happened when the market was significantly below trend.
  • Bottom line: Expect annualized returns below 2% over the coming 5 years and slightly better than that over the coming 10 years. A better risk on entry lies ahead. Look at the return difference (green arrow) when the market is below its long-term trend (ie: the early 1980’s and again in 2008/09). In 2021, we hit the highest high since 1929 (“We are here” arrow in chart). Remain patient.

Some quick stats on Bear Markets (Source: Hartford Funds):

  • Stocks lose 36% on average in a bear market. By contrast, stocks gain 114% on average during a bull market.
  • Bear markets are normal. There have been 26 bear markets in the S&P 500 Index since 1928. Meanwhile, there have been 27 bull markets—and stocks have risen significantly over the long term.
  • Bear markets tend to be short-lived. The average length of a bear market is 289 days or about 9.6 months. That’s significantly shorter than the average length of a bull market, which is 991 days or 2.7 years.
  • Every 3.6 years: That’s the long-term average frequency between bear markets. Though many consider the bull market that ended in 2020 to be the longest on record, the bull that ran from December 1987 until the dot-com crash in March 2000 is technically the longest (a drop of 19.9% in 1990 nearly derailed that bull, but just missed the bear threshold).
  • Bear markets have been less frequent since World War II. Between 1928 and 1945 there were 12 bear markets, or one about every 1.4 years. Since 1945, there have been 14—one about every 5.4 years.

That’s a lot of data, but somehow I always feel better after going through the drill. I hope you find the information interesting and helpful.

Now, grab a coffee and find your favorite chair. The above is pretty easy to understand. Let’s jump into some complexity next. Below you’ll find more from Ray Dalio on the war and his broader perspective on “The Changing World Order: How the Sides are Lining Up.” It’s worth the read.

I believe Russia and China previously perceived the West as disconnected and relatively weak. However, the Western powers have come together in a manner that has surprised Russia and China. We can look to the visceral reaction and aggressive actions they’ve taken on the corporate front as evidence. I had no intention of sending more Dalio material to you this week but found his latest missive compelling. If you don’t know who Ray is, you can learn more here.

Private equity great David Rubenstein interviewing Ray Dalio.

Also, my good friend and partner, John Mauldin, made a recession call last week in his weekly Thoughts From the Front Line piece and did a great job explaining, in simple terms, his reasoning. You’ll find the link to that piece below.

Finally, this week’s Trade Signals looks at the Fed and its first interest rate hike since 2018. While the U.S. stock market has had a good week, several more trend charts have turned negative. You’ll also see that margin debt is rolling over. Add that to the market correction concern pile. There are, however, several short-term positives to note: Investor sentiment remains “extremely pessimistic,” generally a short-term positive for the markets, and the Daily MACD for the S&P 500 Index is in a buy signal. Overall, the risk of a cyclical bear market correction is elevated, caution is advised—more defense than offense.

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The Changing World Order: How the Sides are Lining Up

By Ray Dalio, Co-Chief Investment Officer & Chairman of Bridgewater Associates, L.P.

There are too many dimensions to what is now happening and too many analogous cases of these things having happened in history to cover in any single post, so I will share them bit by bit in a series of posts relating what’s happening today to the patterns of history I describe in my book Principles for Dealing with the Changing World Order. In this post, I want to pass along what I’m seeing about the sides coalescing in a fight for control of the world order.

In today’s brief post, I want to show some early indications of how countries are coalescing into one of two sides or remaining neutral. The table below is derived from watching their actions. It speaks for itself. Those closer to the top are more aligned on one side, those on the bottom are more aligned on the other, and those in the middle are more neutral in this increasingly bipolar world. While these ratings are preliminary, they are already more precise than labels like “NATO countries.” For example, look at the rating of Turkey which is a NATO country but not fully aligned with other NATO countries in its actions. Of course, this is heavily influenced by the Russian-Ukrainian situation, though if one looks at most positions taken on most issues, the picture is similar. I will update this table as more data comes in, though I doubt the positioning will change much because I think that the table already does a good job conveying where these countries stand.

This table is not just interesting because it shows which ones are on which sides, but it is valuable in helping us to begin to imagine what goods, services, and financial assets those countries lower on the list might bring into Russia while we are seeing those items from countries higher on the list being pulled out of Russia. In this way, we can begin to imagine whether or not Russia will be ruined by sanctions or can get through them, and we can begin to imagine how powerful the United States’ sanctions weapon will be, which is critically important in gauging how powerful the US will be. Because the sanctions weapon is the United States’ most unique and most powerful weapon (because the military weapons of the leading powers appear to be roughly comparable in their abilities to cause mutually assured destruction so nobody wants to use them—by the way, Russia and China have superior hypersonic missiles [1]), seeing how effective American-led sanctions are—and whether opposing countries will impose their own sanctions on the US and other countries on the top part of the list—will tell us a lot about how the next phase of this war for control of the world order will likely play out.

As previously explained, the external war cycle and the indicators of where we are in it suggest that we could be on the brink of military war between the great powers, though that also seems inconceivable because it’s so obviously a step toward a catastrophe that nobody wants. To be clear, I am not saying that we are going into a military war between the great powers. I believe that all parties want to avoid a catastrophic (e.g., nuclear) war and I have seen many cases in which conflicts brought us to the brink of war (starting with the Cuban Missile Crisis) and there was a pullback from it.  At the same time, I believe that there are irreconcilable existential differences that the leading powers could fight to the death for, and I believe that they could play a game of chicken to see which side blinks first. So I believe that we are in a very risky position and that we will learn a lot over the next couple of weeks. 

Most importantly, in the relatively near future we will probably learn: 

  • …whether or not there will be a settlement and, if there is a settlement, whether Putin or the NATO powers win. In my opinion that settlement will either be a) a win for Putin (by which I mean it will give Putin a regime change in Ukraine and tolerable conditions in Russia) or b) it will be a loss for Putin (by which I mean no regime change and sanctions that cripple Russia).
  • …if there is no settlement whether there will be a big escalation (e.g., Russia threatening nuclear war and the Western powers threatening a more severe sanctions war). I think that if there is no settlement there will be a big escalation. I think it won’t be long before we find out what happens because the existing path is unsustainable.
  • …what those in the lower part of the list (more aligned with Russia), most importantly the Chinese, will do, and what the Americans will do in response to what they do. That will matter a lot for a few reasons. Most importantly we will see how much those on the lower part of the list will ignore the sanctions and provide support to Russia despite them (my guess is a lot) and what the American retaliations will be if they don’t do what the Americans want them to do. That is what the contentious discussion between the American and Chinese sides in Rome was about. Also, the situation with Russia and Ukraine and that with China and Taiwan can’t be totally ignored so it must be monitored, as history shows having wars on two fronts simultaneously is an often used strategy. To be clear I am not saying that I expect China to become more aggressive regarding the Taiwan issue anytime soon. I believe that all parties would like a peaceful resolution of the Ukraine and Taiwan issues. But what I am saying is we have to watch out for these sorts of tit-for-tat escalations. I think there is a much higher than normal probability of them occurring.
  • …how effective the American-led sanctions will be and what that will mean for American and American-allied powers. Right now United States sanctions powers look awesome, but this will be tested. Right now U.S. led sanctions look awesome, but they will be tested by Russia’s ability to adapt and by what those in the lower part of the list do, e.g., if India and China replace the items and parts being withdrawn from Russia. They are especially powerful against Russia because it needs to import practically everything. But there is a lot to be seen.  I have many questions that will soon be answered by observing what is happening. For example, I wonder if Russian payments for its imports from China and Chinese loans to Russia will be made in CNY through the Chinese clearing system instead of being made in dollars through the US/Western-controlled payments system.
  • …what will happen to the countries on each side in the war relative to the neutral countries? As mentioned in this war and always, there are three types of countries—those on one side of the war, those on the other side, and those that are neutral. History shows us, and logic makes clear why the neutral countries and their markets do best during wars until the “winner” is known.

Dalio concludes, “While watching the fight, it is important to remember that we are only partially through the first round of this new struggle for control of the world order and that nothing is assured. Still, we will learn a lot by watching how things transpire, which will set the stage for the next round. At the end of this round, we will see which side won the round and how. We will have seen the terrible suffering of war and its human and economic costs. We will also see which weapons were most effective and which were not used and/or not effective. At this moment, close to the end of this first round, Putin’s conventional military power has shown itself to be much weaker than most people expected, the American-led sanctions have proven to be much stronger than most people expected, and non-conventional weapons (e.g. cyber, chemical, biological, space, and nuclear) haven’t played as much of a role as expected. While we have gotten some pretty strong signs of how the countries are lining up into the two sides and in the middle (i.e., non-aligned), we haven’t yet seen much about how they will play their hands and how effective they will be. We will see that pretty soon. When this first round comes to an end, most people will probably misconstrue it to as the end of the fight, but it will only be the beginning.

So, in summary, I believe a) history is a great guide for understanding the big cycle changes in the world order that are now unfolding, b) we have to watch what is happening closely because nobody can foretell how wars will play out, but we can learn a lot from watching how they do play out, and c) I expect that we will soon learn a lot.

PS

If you are interested in learning more about how the Big Cycle works and is working now and haven’t seen my animation explaining the archetypical Big Cycle, I suggest that you watch it here, and if you haven’t seen my discussion with Henry Kissinger about the Big Cycle and where we are in it, I suggest that you watch it here.”

Another Strange Recession

By John Mauldin, Mauldin Economics

Back in the good old days, recessions were simply the unpleasant part of the business cycle. Consumer choices, exuberant businesses, and monetary policy would periodically generate growth contractions. We debated the timing, but recessions didn’t come out of the blue.

Then in 2020, a recession did come out of the blue, or nearly so, when COVID unexpectedly changed behavior. Working from home, avoiding travel, etc., caused a sudden drop in services demand, and thus recession. This wasn’t part of the business cycle.

Now it’s 2022 and another strange recession looms. That’s right, I’m calling it: Recession is here, or will be soon. And unfortunately, it will be a global recession. Like the COVID recession, this one has little to do with the business cycle. It’s a recession of choice—not your choice or mine, but Vladimir Putin’s. He clearly miscalculated how hard capturing Ukraine would be and how the West would react.

Most recessions are preceded by an inverted yield curve, when long bond rates drop below short bond rates. Further, the inversion had to go relatively deep and last for some time to really be reliable as a recession predictor. When I called a recession in 2001 and in 2007, those conditions existed. Like a fever indicates something is wrong in your body, an inverted yield curve tells us there is something wrong in our economic body.

In this case, the economy was already slowing down and at stall speed. We’ll look at some data to demonstrate that. But this war will make it worse and the longer it goes the worse it will get. I don’t see the sanctions ending as long as Putin stays in power. Further, I think Western countries will change who they rely upon for energy in any event.

We always get through recessions and there will be a recovery. It’s not the end of the world, just a readjustment. But regardless, we’re here. And I think we’ll be here for quite some time.

SB Here: John goes on to talk about the challenges with food production and prices, “The other aspect of this, not yet getting as much attention as it should, is the very real possibility of global food shortages. Russia and Ukraine are both major grain exporters. Spring planting season will be difficult for farmers in the battle zones. Meanwhile, the same economic sanctions that hinder Russian energy exports will have a similar effect on agricultural goods. That’s why wheat futures prices have been hitting their daily limit.”

And there’s yet more. “Normal” recessions end when consumers and businesses make adjustments sufficient to restore growth. That hope is slim this time, at least in the short term. As I noted last week, this is change squared. The entire world order is experiencing a shock adjustment—economically, geopolitically, and otherwise. We are not going back to January 2022. That world is gone—even if Putin and Zelensky reach some kind of cease-fire agreement soon.

My friend Vitaliy Katsenelsen (whose Coming to America story I sent you in December) has been following Russian media and talking to friends who still live there. He is not optimistic about Putin losing power. More the opposite: In a chilling tweet, he said “They are preparing to turn Russia into North Korea.”

That parallel, if accurate, is economically problematic. North Korea has been cut off from most of the world economy for decades, yet the regime survives. The sanctions we have placed on Russia, while necessary (and certainly preferable to a wider war), could last a long, long time.

I think we can adjust to a world split between two blocs with limited interaction. I don’t see how we complete the adjustment this year, though. Shifting supply chains takes time, and creating new production facilities takes even more time and money.

You can find the link to the full piece here.  And if you are not reading John, you’ll love his work. You can subscribe for free here.

Trade Signals – Fed Day / Hike #1

March 9, 2022

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: Fed Day / Hike #1

 

I don’t believe seven rate hikes will happen.

This week, the Zweig Bond Model moved from a buy signal to a sell signal. Along with the other bond market indicators, all are signaling higher interest rates. The Ned Davis Research CMG U.S. Large Cap Long/Flat Index remains near a sell signal. The 13-week vs. 34-week price moving average moved to a sell signal. Sell signals occur when the shorter-term 13-week moving average price line (blue) drops below the slower moving 34-week moving average price line (red). As you can see in the chart, sell signals (red down arrows) happen relatively infrequently. Following is a quick look at the price trends since 2005.

The Golden Cross: The golden cross occurs when a 50-day short-term moving average crosses above or below a long-term 200-day moving average. Market technicians view such crosses as a definitive change in the market trend. The S&P 500 Index 50-day moving average crossed below its 200-day moving average, signaling a declining trend. Of course, not a guarantee; as you can see, there have been a few head-fakes over the years. However, this process did an excellent job helping investors sidestep the 2000-2002 tech wreak and the 2008-2009 great financial crisis.

Lastly, as I’ve mentioned in previous Trade Signals, margin debt is rolling over.

Margin debt is debt a brokerage customer takes on by trading on margin, meaning they borrow part of the initial capital to buy a stock from their broker. Market crashes are generally due to the unwinding of margin debts and other leveraged products manufactured on Wall Street. Think margin calls and forced selling. It’s why bear markets tend to form “V” shaped bottoms. One of my favorite ways to look at the level of risk is to look at the total amount of “Margin Debt as a Percentage of GDP.” You can see in the following chart we are off the recent all-time highs, and the current reading has dropped below its 15-month smoothed moving average trend line. Lights on!

There are several short-term positives to note: Investor sentiment remains “Extremely Pessimistic” and the Daily MACD for the S&P 500 Index is in a buy signal.

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.

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Personal Note –  A Prayer for Peace

We find ourselves amid perhaps the most critical geopolitical moment in most of our lifetimes. Depressing, tragic, unconscionable. I do believe in our higher angels, I believe in kindness, I believe in friendship, I believe in love, and I believe in joy.

Feeling sad and angry, like you, I’ve watched the “battle for power” unfold and continue to watch with great concern. I’ve found myself meditating more and praying more. When I wake, I think about Susan, our children, fill my heart with love, and then send the energy I feel inside out to the world. A beam of bright light to the Ukrainian people and all those supporting and caring for the victims. A beam of light for a compassionate world. A beam of light for love.  A beam of light for peace. I have no idea if it helps. I sure hope it does…

A prayer for peace! If you feel inclined, send some love to the world. Humanity needs a big hug.

I wish you and your family the very best.

With kind regards,

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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