July 26, 2019
By Steve Blumenthal
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.
And believe me, it will be enough.”
– Mario Draghi, President, European Central Bank (July 26, 2012)
Still reeling from the financial crisis, central bankers were scrambling to find footing. A few short words changed our course, “whatever it takes.” The impact was immediate. A pebble thrown into the pond, traders reacted immediately, the ripple effect was global.
Draghi’s famous statement was exactly seven years ago today. Now, approximately $13 trillion in global debt yields less than 0%. Hope for inflation remains elusive. The global debt-driven deflationary grasp holds tight. It must be reset. A “debt jubilee!” The question is how? We don’t yet know.
Last week, I shared with you Ray Dalio’s latest article entitled, “Paradigm Shifts.” My colleague, John Mauldin, wrote a series of letters debating the world’s largest hedge fund manager called, “Ray Dalio is Kinda, Sorta, Really Wrong.” If you are going to pick a fight, it is usually not a good idea to poke a giant. Yet, that’s what Mauldin did and the giant responded in eloquent fashion (here). It’s a healthy dialogue that is important for our nation and the world.
Mauldin and I met in NYC on Tuesday. We discussed his recent public debate with Ray Dalio and Dalio’s latest article. We concluded that Ray Dalio is really, really, really right. Here is the link to On My Radar: Dalio’s “Paradigm Shifts.”
Dalio says that, by understanding how economies work, understanding the tools at policymakers’ disposal and understanding probable human behavior, we can position our wealth accordingly. Imagine a seat at the investment committee table of the world’s most successful hedge fund. Dalio is openly sharing his investment process with you, me and the global policymakers who pull the levers. We can debate what we may or may not like, but we are going to get an outcome and we should be flexible and prepared for what that outcome might be.
As an aside, when I get stuck in my thinking, I jump on the phone. An upside to my many years in the business are the relationships and friends I’ve gained along the way. I pick up the phone and I learn. When I spoke to my good friend, Mark Finn, in 2007 about subprime, CDOs and what he believed would be a serious crisis, my lights turned on. I learned and did well navigating that period. This past April, Mark said, “Steve, I’ve turned very bearish.”
Dalio is signaling that we should turn our lights on. Finn is signaling that we should turn our lights on. When you get calls from clients saying that QE worked over the last 10 years, it will work again and they desire to get back into stocks, remind them we sit late cycle, stocks are overvalued and now is not a good time to get aggressive (2009 was good, 2007 was not, 2002 was good, 2000 was not). Just say no, unless they have a solid investment process in place. I remain fundamentally bearish, underweight equities though technically bullish (see the dashboard of trend indicators in the Trade Signals section below). Key to the equation is process. I believe we are very close to a secular turning point. Lights on.
Dalio put it this way:
During the 50 or so years that I’ve been a global macro investor, I’ve found that markets and market relationships tend to operate in a certain way (which I call “paradigms”) over relatively long periods (about 10 years). When one paradigm shifts to another, the relationships in the new paradigm are often more opposite than similar to the prior period. Identifying these shifts and navigating them well is critical to being successful as an investor. I believe that we are likely approaching such a shift…
What Might a Paradigm Shift Look Like?
From an investment perspective, the following chart from friend, Louis-Vincent Gave, does a great job simplifying the secular regimes. It’s basic but informative. Cutting to the chase, it shows that different economic cycles favor and disfavor different investment themes. For example, the late 1970s and early 1980s were an “Inflationary Boom” cycle. It favored real estate, gold, commodities and, if you were a bond investor, you got crushed (as interest rates spiked to 15+% by 1982.) That set up an exceptional investment opportunity in stocks and bonds when the next shift occurred. It’s been a “Disinflationary Boom” for much of the last 40 years.
Today, “whatever it takes” is designed to prevent “Disinflationary Bust.” If “whatever it takes” central bank policy wins, and I believe it will, then we shift up and to the right (red arrow next chart) and you will want to overweight the assets in that quadrant.
Here’s the chart:
Grab that coffee and find your favorite chair. When you click through on the orange On My Radar button you’ll find a few telling charts on debt (to help you see the enormity of the problem we face) along with the most recent Trade Signals post. I hope you find the information helpful. Thanks for reading.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- A Look at Debt
- Trade Signals – Golden Rule Good, Not Perfect
- Personal Note – Soccer, NYC and Camp Kotok
A Look at Debt
When your credit card balance gets too high, you have to take more of your income to pay back both the interest and principal due. As one spends more, the balance owed increases. That current spending came not from income but from debt. It fueled the economy today, but at the expense of tomorrow as ultimately the debt must be paid back. It’s clear, as we collectively take on debt, we reach a point where more of our income is spent on paying off the debt and fewer dollars are available to buy more things. Our economy slows. It’s the same when you look at the world.
We have short-term debt cycles and long-term debt cycles. The last long-term debt cycle peaked in the 1930s. Our biggest challenge today is the massive level of debt accumulation.
Debt is a drag on growth. The conclusion that high levels of debt are correlated with lower growth is supported by studies from the Bank for International Settlements and the International Monetary Fund.
Reinhart and Rogoff looked at advanced economies going back to 1800. They concluded, with some controversy, that when debt-to-GDP exceeded 90%, economic growth declined from 2.8% per year to 1.8% per year. And if you look at growth globally from 1980 to 2000 and growth from 2000 to present, this is about what we see.
My point is that if 90% seemed to be the over/under the threshold, current readings of greater than 300% debt-to-GDP is crisis.
Here’s what it looks like globally (country on left, focus on red arrow):
Definitions: Total Domestic Debt is the total outstanding debt owed by all domestic sectors (households and non-profit institutions, financial and non-financial corporations, farms, state and local governments, federal government) and includes government bonds, corporate bonds, bank loans, other loans and advances, mortgages and consumer credit. Non-financial Corporate Debt is the total outstanding debt owed by all companies with the exception of financial companies. Household Debt is the total outstanding debt owed by the household sector, which includes households and non-profit organizations. (Source: Ned Davis Research.)
But wait, there’s more. The total IOU (add in pension obligations, Medicare, Social Security) in the U.S. is near 1000% of GDP. The next chart is from Dalio’s “Paradigm Shifts” article:
This is what state and local government retirement funds look like courtesy of Philippa Dunne. Plans were 80% funded on average back in 2000. They are less than 50% funded today and the baby boomers are coming for their promised retirement money. This is a real problem folks, and no one is taking about it.
Bottom line: High debt means slower growth. Slower growth means slower growth in income. The aged demographics in the developed world are not favorable to growth. Deflation has us in its grip. A “Paradigm Shift” takes time. We’ll see it coming. Lights on.
Trade Signals – Golden Rule Good, Not Perfect
July 24, 2019
S&P 500 Index — 2,995
Notable this week:
Each week I share a number of equity market charts with you. The 50-day vs. 200-day moving average signal is known as the “Golden Cross.” Since 1929 and 1999, all of the gains for the market have come when the 50-day intermediate-term trend line is above the 200-day longer-term trend line. But as with all things in investing, not every investment process is perfect all the time. To this point, this next chart shows the gains in the S&P 500 Index over the last 12 months when following the Golden Cross trading rule. Note the two green arrows below. The right-hand arrow shows the gains in the last 12 months occurred when the 50-day was below the 200-day. And when above the 200-day moving average, the S&P 500 lost money. The left-hand arrow points to data 1999 to present. Following this rule in the last 12 months would have you frustrated but that in no way invalidates the risk management process. As you’ll see in Chart 2, the S&P 500 is up 6.52% over the last 12 months. The point I’m trying to make is that no process is perfect all of the time.
Chart 2: SPDR S&P 500 ETF (“SPY”)
Source: Morningstar
The big picture remains the same. The trend for U.S. equities remains bullish. There are no material changes to our trade signals this week.
The global economy is likely in recession. We continue to diligently monitor both the U.S. and global recession indicators. We see high probability of U.S. recession by Q1 2020. Low risk of U.S. recession in the next three to six months. You’ll see below that the 3-month vs. 10-year Treasury yield has been inverted for more than three months. Recession has followed in all prior cases yet with a lag. Thus, I believe U.S. recession is probable within six to nine months. Further, a few weeks ago, the New York Federal Reserve Bank published an update to their recession probability index, indicating an increase in the probability of a U.S. recession in the next 12 months. It’s important to note that, every time since 1960 that this index breached 30%, a recession occurred.
High grade corporate bonds and Treasury bonds remain in buy signals. Gold remains in a buy.
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.
Click here for this week’s Trade Signals.
Personal Note – Soccer, NYC and Camp Kotok
I’m thankful for the break in the heat in the Northeast this week. Last weekend was simply unbearable. There is some personal news to report to you. If you have been reading OMR for some time, you know I’m crazy about my Susan. She has three boys and combined with my daughter and two sons, we have six kids. A Brady Bunch of sorts. We met on a soccer field and played on a co-ed team together. Those were fun times. The competition and fitness was fun but what I miss most are the post-game beers with teammates. Anyway, soccer is kind of in the family blood. Susan coaches youth soccer at a high level and also teaches several licensing courses for U.S. soccer. My coaching and soccer playing days are over, so I live vicariously through her. Last week, Susan accepted the head coaching position for the Malvern Prep Friars. But here’s the catch, her youngest son, Kieran, is a senior on that team. “I don’t like it, but I don’t not like it either,” was his first response. Raw and honest. Love it. They have a close relationship, but the mom hat goes off when the coach hat goes on. I’m really excited for the season watching from the bleachers rooting for Kieran, the Friars and Coach Sue.
Travel remains steady in early August. I’m back in NYC next Wednesday and Thursday for meetings. On August 8, I fly to Bangor, Maine and then drive north for two hours to Grand Lake Stream for David Kotok’s annual fishing trip. It’s called Camp Kotok and David is an exceptional host. This will be year three for me and I’m really looking forward to the mind share… and the peacefulness of the glide in a canoe on top of a glass-like lake with fishing rod in hand. Attending are some of the sharpest minds in the investment business: economists, former senior Fed officials, Wall Street analysts and investment managers. Old and new friends… I’m looking forward to learning and will share with you what I can in a future post.
Wishing you some downtime, a nice cold beer or a glass of wine with those you love most. New to my favorite list: SingleCut IPA (Queens, NY) and Levante Cloudy and Cumbersome (West Chester, PA). Give them a try if you are an IPA fan.
Have a great weekend.
Best 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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A Note on Investment Process:
From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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