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On My Radar: What Inflation Means to Stock Prices

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November 19, 2021
By Steve Blumenthal

“People don’t care how much you know until they know how much you care.”

― Theodore Roosevelt Jr.,
26th President of the United States

If you’ve been following the journey of my wife Susan’s soccer team often highlighted over the last several months in each week’s personal section (below), this week I conclude with a beautiful story about team, about leadership and about the growth of a talented player. The story begins with the Teddy Roosevelt quote.

But before we go there, I promised you an update on a chart I have shared with you from time to time that helps us gauge degrees of equity market risk. I’ve mentioned it is something for us to keep “on our radars.” We’ll take a look at leverage in terms of margin debt to see what it is signaling to us today. It’s in the unwinding, especially from elevated levels, that the bad stuff happens. We are not at that point today.

Speculation can be measured in terms of the size of margin debt. We can assess the relative size and compare it to a number of things. The chart I shared with you last August (and again today) compared total U.S. margin debt to U.S. Gross Domestic Product.

Think about margin debt as additional capital that is used to buy stocks. When it is low, there is more potential capital available to be used to buy stocks. More buyers than sellers and stocks go up. The challenge always presents when margin debt unwinds. More selling begets more selling, and, at some point, margin calls kick in and investors are forced to sell.

In a bull market, as confidence grows, margin debt increases. Borrowing on margin allows a person to double the size of a position. If you own $100,000 worth of Amazon stock, your brokerage firm will let you borrow another $100,000 and you can own $200,000 worth of the stock. Low borrowing rates makes it even more attractive. Awesome on the way up. The challenges begin on the way down.

Think of it this way, if the price of Amazon shares declines 30%, the $200,000 investment declines to $140,000 and since $100,000 was borrowed, only $40,000 remains. If the stock drops 50%, the investor is completely wiped out. Margin rules require your broker to have you deposit more money into your account (a/k/a a margin call). If you don’t deposit the money, they will sell your stocks whether you like it or not. In all cases, it’s pretty much “not.”

When margin debt is high and the concentration into similar names is high, and the selling begins, not everyone can pony up the required money and the brokerage firms sell the stock. At which point, they are interested in protecting here backside and not yours. That’s why markets dislocate. Too much leverage is always the culprit. Fortunately, we can measure and monitor this.

In the following chart, note the peaks (orange line, center section). I’ve circled in red the euphoric margin peaks in 2000 and 2007 and note where we are today. What I like most about this chart is the comparison of the orange line to the black dotted moving average line. The big problems begin when margin debt declines from excessively high levels and that’s why it is important for us to keep an eye on this data.

Bottom line: Euphoria remains; however, the trend in margin debt continues to rise. When the orange line drops below the black dotted line, watch out.

Speculation can also be measured in terms of investor positioning. I like to follow Rydex Mutual Fund allocations as it is real money in real time.

Other Observations (Cash Levels, Asset Allocation, and Bad Market Breadth) 

As of November 18, Rydex Mutual Fund allocations to stocks, bonds, and cash were as follows:

  • Rydex domestic and global equity mutual fund assets: 94% (Data back to 1-3-2000. 94% is an all-time high.)
  • Rydex domestic and global bond mutual fund assets (long-only): 1.33%
  • Rydex money market fund assets: 4.68% (All-time low.)

Looking at the numbers from 2000 to present, stock exposure is at an all-time high, bond exposure is near an all-time low, and money market is at an all-time low. Source: Ned Davis Research (NDR) and Guggenheim.

  • Bottom line: Investors are all-in on stocks.

Another measure of investors’ individual exposure to equities is “Stocks as a Percentage of Household Financial Assets” (not including pension fund assets). I’ll spare you another geeky chart and just focus on the conclusion:

  • Individual investors have 47.5% allocated to stocks as a percentage of their total financial assets. This is the highest level we’ve seen dating all the way back to 1951.

Following are the prior secular bull market peaks (vs. 45.7% on June 30, 2021):

  • 37.1% to stocks in 1966
  • 44.5% in 2000
  • 37.3% in 2007

Meanwhile, at secular bull market beginnings, ownership was low:

  • 11.6% in 1982
  • 27.8% in 2002
  • 21.7% in 2009

The mean over the entire period (December 31, 1951 to December 31-June 30, 2021) is 28% stocks as a percentage of total household financial assets. (Source: Federal Reserve Board and NDR.)

What I’ve always felt would be the trigger to the next secular bear market is inflation and its impact on the economy, the impact on interest rates (higher) and ultimately on corporate earnings/valuations (lower).

And inflation is clearly in play. If you want to get a feel for what inflation means in terms of stock market performance, this next chart is the chart of the week. When inflation is rising, the stock market performs worse. In periods of disinflation, the stock market performs best. The current state is the orange circle highlight in the chart. Check out data boxes in the lower section.

On the wall in my office, I have a whiteboard where I post my short-term, medium-term and long-term outlook for inflation, bonds, U.S. stocks, global stocks, gold, the economy, commodities/oil and special situations. Of course, I could be wrong, but it helps me to see the big picture map and then assess/adjust as time moves forward.

Outlook Summary (November 2021). Here’s how to read the chart:

  • The dates at the top are target dates. 1-3 Months, 6-9 months (Mid-2022), intermediate term (2023–2025) and longer-term (2026–2030).
  • Green is bullish on the asset class, red is bearish. Arrows point direction.
  • Not a recommendation to buy or sell any security.

Big picture: The number one problem is the level of debt. Long-term debt cycles have resolved themselves before. When confidence in the Fed is lost, the next secular bear market cycle will begin. Rising food prices and rising inflation is really starting to upset people. Confidence is waning. Inflation and rising interest rates are kryptonite to debt.

What concerns me is the high concentration into a handful of names. If you own the S&P 500 Index via a mutual fund or ETF, the top 5 stocks, Apple – Microsoft – Amazon – Facebook (Meta) – Alphabet (Google) represent 21.5% of your investment. As you’ll see in the first chart, higher than 2000. The remaining 495 stocks make up the difference.

Forget the coffee and go grab your Virtual Reality goggles. You won’t need the coffee after you view the next three charts. Also, you’ll find the weekly Trade Signals summary and I conclude with the story I mentioned at the start of today’s letter. I hope you enjoy it.

Top 5, 10, and 20 Stocks by Market Cap as a Percentage of the Total S&P 500 Market Cap

The idea here is to get a feel for how much money is concentrated into just a few names and to compare the current state to 2000 and even back to the Nifty Fifty days in the 1970’s.

  • The high concentration and the level of margin debt in the system is what we should think about in terms of risk.
  • The unwind will hurt the largest concentrations and the cap-weighted indices the most. Not too dissimilar to the challenges post the Tech Bubble from 2000–02. Value and high and growing dividend stocks did well. Tech lost 75%. High concentration in too few names combined with the unwinding of margin debt.

Here is a look at the top 5 stocks as a percentage of the Total S&P 500 Market Cap:

Here is a look at the top 10 stocks as a percentage of the Total S&P 500 Market Cap:

Here is a look at the top 20 stocks as a percentage of the Total S&P 500 Market Cap:

Hat tip to the excellent work at Ned Davis Research.

Trade Signals – “Sticky” is the New “Transitory”

November 17, 2021

Posted each Wednesday, Trade Signals looks at several of my favorite equity market, 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:

“Exponential rapidly rising or falling markets usually go further than you think,
but they do not correct by going sideways.”

– Rule No. 4 of Bob Farrell’s 10 Rules

Bob Farrell is one of the greatest market technicians of all time. A Wall Street veteran who draws on some 50 years of experience in crafting his investing rules. After finishing a master’s program at Columbia Business School, he launched his career as a technical analyst with Merrill Lynch in 1957. In the 1980s, as a young ML broker, I’d turn the volume up on the squawk box that sat on my desk to listen to what Mr. Farrell would advise doing. 

“Sticky” is the new “Transitory.”

The year-over-year increase in inflation came in at 6.2%. You know that news by now, but let’s take a look at that number through a broader lens. It is easy to see in the next chart (blue line – top section – far right) that the level is the highest in the last 30 years but what the media didn’t report is that it rivals all peaks dating back to 1962 with the exception of just two periods (both in the 1970s). Central bank policy, the abandonment of the gold window, Keynesian economic policy, and market psychology all contributed to the great inflation in the 1970s. Tough love in the form of Fed Chairman Paul Volcker arrived and whipped inflation in the early 1980s.

I want to draw your attention to several things in the top section of the following chart:

  1. Yellow circles mark prior peaks (except for the two in the 1970s). Note how every peak was transitory. But define transitory? a few months? A few years? Transitory to me is a year or less. Sticky is longer, and we are seeing the word “sticky” more than the word “transitory.” Sticky is the new transitory. Sticky is real. Transitory is hope.
  2. Important to note that spikes in inflation were usually followed by a recession (1969-70, 1973-75, 1980, 1982, 1990-91, 2001, 2008-09). Note the decline in inflation from 1970 to 1972, then the spike higher to over 12%, then the decline to 5% then the spike to 15%.
  3. Today, the Fed continues to prime the inflation pump with zero-bound interest rates and $120 billion per month in bond purchases (though minor tapering is set to start). I’ll explain more below.

I believe the next few years are going to be particularly bumpy. Somewhat similar to the 1970s. My wife Susan asked me about inflation at dinner last evening. Inflation has affected food prices, wine prices (something we love), gasoline prices, shipping, asset prices, etc. “Here’s what’s going on,” I told her. The Fed is holding interest rates at 0% but, more than that, they are buying $120 billion in bonds from the marketplace each month. That puts more money into the system. $40 billion per month is used to buy mortgage bonds. If we go to the bank and refinance our mortgage, the bank can put that mortgage on their books or they can earn an origination fee and sell the mortgage to the Fed. That’s $40 billion in newly printed money that is going into the system.

The Blumenthal family gets a lower interest rate so we have more money to spend each month. We may decide to pull out extra money since the price of our house has doubled and we use the money to rebuild our patio, fix the fireplace, or even use the extra money to buy stocks or invest in a short-term private credit fund earning 10+%. The spread alone may offset the mortgage cost. Oh, my mind is spinning with ideas.

The problem is, much like all of the mortgage bond liquidity cleverly created by Wall Street in 2005, ’06, and ’07 (CDOs, MBSs, etc.). It fueled the housing bubble, in a sense the Fed is doing what Wall Street did leading up to the Great Financial Crisis. Printing money out of thin air and putting it into the system. It’s fueling another housing bubble and another stock market bubble. And it’s fueling inflation. When too much money is chasing too few goods, prices go up.

My best guess is that inflation is peaking short-term and will dip along with the slowing economy into next year. I could be wrong, but I believe we are heading into a major economic slowdown and recession is a real risk by next summer. However, much like the 1970s, I believe the Fed (and other central banks) will respond with even bigger guns and that the risk of a 1970s inflation repeat is very real. Because debt is so large here there and everywhere, each time the Fed comes in more money is thrown at the problem. Ultimately, like they are doing now, governments will monetize a large percentage of existing debt. Big guns mean bigger inflation as they debase the currency. The question to me is how the dollar holds up relative to the other major currencies since the debt problem is global. Call it a 2024-2026 problem. We’ll get through it.

With all this said, I recommend staying anchored to the overall weight of market evidence. It’s why I personally review my favorite Trade Signals each week. The intermediate-term equity market signals remain bullish, though I note the short-term MACD just moved to a sell signal. Don’t Fight the Tape or the Fed remains in a bullish +1 signal. None are perfect so diversify your risk management trading strategies like you diversify stocks.

It’s because of Bob Farrell’s Rule #4 (and all his other rules) that risk mitigation is so important. It’s because of how money compounds and how merciless the math is when it declines. Gain 100% and then lose 50%, you are back to even. No matter how well-informed my particular view may be, I must have the technicals confirm the fundamentals. For me, it’s a process to know when to put my defense back on the field.

Bob Farrell’s Rule #4: “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

Click HERE to read to the balance of 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 – “Champions behave like champions before they are champions”

“People don’t care how much you know until they know how much you care”

– Theodore Roosevelt Jr.,
26th President of the United States

“Champions behave like champions before they are champions.
They have a winning standard of performance before they are winners.”

– Bill Walsh,
Former Head Coach of the San Francisco 49ers

The speech was about leadership. The speech was about culture. There was humor, joy, love and even tough love delivered with intention. The room was filled with players grades nine to 12 and their parents. The banquet began. Susan took the stage.

Coach Sue and her 2021 Malvern Prep Soccer Team

If you read last week’s post about my wife Susan’s high school soccer team, they had just lost a quarter-final State Championship playoff game. One game remained in the regular season and their opponent had just advanced to the Pennsylvania State Championship game.

At the start of the season, I wrote about one young man in particular. He is, as Susan told him at the banquet, the greatest athlete she’s ever seen. Not ever coached, ever seen. He was a challenge to coach, and she enjoyed coaching him… most of the time.

In college, I had a teammate named Jim Stamatis. In 1979, Jimmy was a senior and I was a freshman. He led our team to the NCAA championship semifinals. Jimmy was recruited by many top colleges but elected to play at Penn State because of Coach Bahr’s honesty that Stamatis would need to earn a place on the team. Stamatis worked hard and developed into one of the top collegiate forwards.

In 1978, Stamatis was named as a first team All American. The following year, Stamatis was selected as the 1979 winner of the Hermann Trophy, awarded annually to the most outstanding player in all of American college soccer.

But Jimmy appeared to some to be lazy. Our defenders would joke about how Jimmy would never come back to the defensive half of the field. His effort was outstanding when he was in the attacking third of the field, but he made it clear to his teammates that it was not his job to play defense. And given his exceptional talent, he was right. I’d watch Coach Bahr, and Coach would never say a word.

Jimmy was a handful for an opponent to guard. He was a goal scoring beast. Built like a racehorse, strong, fast, and deceptively quick. He had a competitive fire in his belly, and Coach knew how guide him.

Susan’s player is the closest thing to Jimmy I’ve seen since Jimmy. The boy cannot be stopped. He has fire in his belly. He wants to win. And he’s hard on himself when he doesn’t, he’s hard on himself when things don’t go his way, and he can be hard on his teammates. His players understand him. Coach knows how to guide him, and I think he’s on the right track.

The season concluded last Saturday. Late in the first half, the kid beat one player, then a second and then a third and scored a beautiful goal to put MP up 1-0. I felt as if I just watched Jimmy Stamatis score that goal. By half-time, Malvern Prep was up 2-0. And the team finished strong with a convincing 3-0 win. A great day for the boys and a great day for Coach.

Coming together as a team is a really special thing to watch. It doesn’t always happen, and I think it is because it takes time to create trust. “People don’t care how much you know until they know how much you care.”

At the banquet, Susan spoke about culture. She addressed each player and shared something she found uniquely special about them. First, the captains, then the seniors, then the younger varsity players. She then turned to the JV players and paused, “To be clear, we are here to win. Not everyone of you will play.” If you want it, it’s up to you, get to work. The challenge delivered.

She concluded with Bill Walsh’s quote, “Champions behave like champions before they are champions. They have a winning standard of performance before they are winners.” The stage is set. And frankly, great advice for all of us.

In the bigger picture, it’s not about soccer. Jimmy Stamatis went on to play professionally then went back to school to complete his Civil Engineering degree. He took a job with Louis Berger Group and rose to become President and Chief Executive Officer. Jimmy needed his defense and we all needed Jimmy’s ability to score goals. It takes the right kind of coach for the right kind of player. Coach Walter Bahr has since passed and I’m sure he’s still smiling when he thinks about Jimmy. I’m sure Jimmy is forever grateful for what Coach taught him about life. As I watched my Susan address the room, I smiled as I wiped a tear from my eye.

One last update, I called Susan this morning to make sure I got the Roosevelt and Walsh quotes correct and she told me she just got off a call with an Ivy League coach with interest in the goal scoring player. The coach received a tip from one of his friends that refereed several MP games. It will take the right kind of coach to help him grow.

I started the season with a special place in my heart for the young man. I’m ending the season with great hope for his future. It’s going to be a lot of fun to watch what he will create next.

Thanks for indulging me.

Have a great week!

All the best,
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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