December 20, 2024
By Steve Blumenthal
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
– Sir John Templeton
An essential and prescient quote for the current state of play.
Investor and GMO investment and asset management co-founder Jeremy Grantham spoke about such market euphoria in an interview on the podcast The Long View last week. To him, it’s no accident that the four “most euphoric periods in the market’s history”—1929, 1972, the tech bubble of 2000, and the housing bubble of 2008—were all followed by the worst periods of economic setbacks and poor market returns in history.
“We all learned at business school that high PEs are meant to reflect the best possible future, and what we find is, the highest four PEs reflecting the highest amount of euphoria are precisely followed by the four worst economic outcomes: the Great Depression, the Great Recession of 1973-1974 (the worst since the Depression), the crash and the recession after the tech bubble burst, and—the real moment of truth—when the great financial crash occurred [and] the whole financial system of the developed world teetered on the edge of total meltdown. So, what a strange paradox that the market’s predictive power is precisely, perfectly, the opposite of what we were taught?”
On that note, Felix Zulauf hosted a client webinar this week and shared an interesting long-term valuation chart on the Price-to-Earnings ratio, which you can find in the following chart(with 10-year smoothed PE data). Look at the four prior PE extremes. We’re currently at Number 5. The chart indicates something slightly different from Grantham’s comments above, but it’s in the same direction. What’s important to look at here is the degree of extreme overvaluation prior to each bubble burst. This is where standard deviation comes into play. Simply, think of standard deviation as a statistical measure used to quantify the amount of variation or dispersion of a set of values.
Here’s how to view the chart:
- The dotted rising horizontal red line plots a 1.25 standard deviation going back to the year 1885.
- We are looking at extreme moves as measured from the norm.
- In this case, the blue dotted line is the long-term trend. Fair value is at an 18x PE. We are currently at 32.6x.
Source: Bloomberg data, Steifel Esimates, Zulauf Consulting
Bottom line: This is a bubble. This is euphoria.
Could we challenge the 2000 level? Yes. Maybe.
Set your sights on the area between the blue trend line and the green -1.25 standard deviation line. We’ll find “Pessimism” somewhere near that green dotted line.
For fun, I asked ChatGPT to draw me a cartoon picture of a person looking through binoculars at the rising stock market in a state of euphoria (which is what we’ve had up until mid-December). I then asked it to show a character looking at the stock market with pessimism and fear. Within five seconds, it gave me these two images:
Source: Steve Blumenthal, ChatGPT
Emotions are measurable. The cycle looks something like this:
Pessimism → Skepticism → Hope → Optimism → Excitement → Thrill → Greed → Euphoria
After Euphoria comes:
Anxiety → Denial → Fear → Panic → Pessimism
Euphoria is the moment that offers the worst financial opportunity, while pessimism offers the most. Graphically, it looks something like this:
Source: CMG Investment Research
What we can measure is risk vs. reward and investor mindset. One way to measure these is by looking at how investors are positioned. For example, Bank of America does a global fund manager survey. You can see in the next chart that red circles in the top section mark periods when investors were extremely overweight equities. The lower section plots overweight cash.
Take a look at the overweight to cash in 2008 and 2009.
Source: BofA, @johnauthers
This next chart shows “Unprecedented Bullishness” (hat tip to John Authers—follow him on X @johnauthers). He shared some insights in a Bloomberg Opinion post this week. Look at the percentage of “Consumers expecting Stocks to Rise.” It’s the highest reading dating back to the mid-1980s. Euphoria indeed!
Source: Conference Board, Bloomberg, @johnauthers
I watched David Rosenberg kind of throw in the bear towel this week. My first thought was, That’s it. The top is in. He later softened his view, not fully departing from his bearish outlook. I remember Stan Druckenmiller pivoting from short tech stocks to long in 1999 and getting crushed by the unrelenting tech bubble. Short means selling stocks, betting they’ll decline in price, while long stocks mean buying them on a bet that they’ll rise in price. Druckenmiller later pivoted back to his bearish stance and made a killing when tech stocks crashed.
In summary:
- Stocks are at record highs.
- Valuations are at record highs.
- Investors are concentrated in just a handful of companies—The Magnificent Seven.
- Market breadth is deteriorating as measured by the number of stocks trading below their 200-day moving averages.
- We sit near the end of a long-term debt accumulation cycle.
- Government finances are in horrible shape.
- Protectionism and reshoring manufacturing is increasing.
I could go on and on, and so could the stock market.
Lastly, a reminder that markets take years to gain, but they disconnect quickly when liquidity evaporates. As we move along in the cycle from Optimism to Excitement to Thrill to Greed to Euphoria, cash that was previously on the sideline moves into the markets, and growing confidence increases the use of leverage. It’s demand and supply: More buyers than sellers push prices higher. The problem comes when the liquidity flow reverses. Market-makers and would-be buyers step aside, markets lose support, and a downside trap door opens.
I remember the moment in 1985 when, as a young Merrill Lynch advisor, my manager tapped me on the shoulder and said, “Get to the Union League!” Sir John Templeton was going to be speaking. I hurried down, and I’m glad I did! Sir John stepped onto the stage and told the room of brokers and advisors that if we could follow one piece of advice, we’d be the best in the business. “It may sound easy,” he cautioned, but he assured us it would be one of the hardest things for us and our clients to do. “The secret to my success is, I buy when others are despondently selling and sell when others are euphorically buying.”
This quote encapsulates his contrarian investment philosophy: seeking opportunities in undervalued markets when others are overly pessimistic and exercising caution during periods of exuberant optimism.
I believe we’ve passed euphoria. I’m positioning accordingly and looking forward to despondent selling.
Grab that coffee and find your favorite chair. But before you read on, I want to let you know how grateful I am that you spend time with me each week—wishing you a Merry Christmas, a Happy Hanukkah, and a warm and wonderful time with your family.
On My Radar:
- The Grand Master, Felix Zulauf Part II
- Trade Signals: December 18, 2024 Update
- Personal Note: Merry Christmas, Happy Hanukkah, and Best Wishes
See Important Disclosures at the bottom of this page. 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.
If you like what you are reading, you can subscribe for free.
The Grand Master, Felix Zulauf Part II
My friend Ed D’Augostino from Mauldin Economics interviewed Felix. I share the podcast with you next.
Here’s Felix on deglobalization:
You will see now with Donald Trump, he will try to make America great again and he will try to de-risk the US more, or more friendship and deglobalization, whatever you call it… You reduce your risk on the supply chains and risk to other trading partners and you go nationalist, and that’s a new trend.
We go nationalist or regionalism. The Europeans will try to do that, because they have no choice. The Chinese will try to do that, and America is trying to do that. Of course, that has certain ramifications, because in that process along the line we will move further and further towards state capitalism.
State capitalism means that the government dictates to investors where they should invest and it dictates the investments that should be taken.
What are the broader effects of potential tariffs on the US economy? What lies ahead for oil and other commodities? And where should you invest in 2025 to benefit from the changing world order?
Click the image above to hear Felix’s take, along with his thoughts on quantum computing, gold, and the Japanese yen. A full transcript of our conversation is available here.
Last week, I wrote about Felix and shared my high-level takeaways with you in bullet point format. Felix was interviewed by Monetary Matters, Jack Farley. Spotify link here. For comparison purposes, I’m re-sharing my notes.
How Felix is thinking about the market:
- Felix recalled a recent conversation with Mario Gabelli where they discussed the market bubble. “No question this is a bubble. We are at the highest or second-highest level in the history of the US stock market.”
- What’s driving the bubble is liquidity. Liquidity needs to grow all the time. If liquidity stops growing, then the bubble breaks. Liquidity has been massively bullish in the last two years. Felix noted it took him a while to figure that out. Liquidity came from unlocking sterilized money on the Fed’s balance sheet of the over $2 trillion that was injected into the system and was the driving force for the markets and the economy (it has partly to do with the functioning of the reverse repo market). About $600 billion remains, and he feels it will not get into the system. That source of liquidity is virtually spent.
- There is ~ $800 billion in the Treasury’s general account (TGA) that could be spent and injected into the system. Still, Felix believes it’s unlikely that the new incoming Treasury Secretary will use it. Instead, he will save it for a time of need.
- Therefore, we are coming to the very end of the liquidity injection into the U.S. stock market.
- He doesn’t believe the world economy is in good shape. Many are painting a rosy picture; he doesn’t see it that way.
- Expect a 1000+ point S&P 500 correction in Q1/Q2 2025, beginning in a few weeks, followed by a potential rally depending on the central bank rescue response.
- Bearish medium-term on bonds, commodities, and crypto; cautious on China (deflation and won’t bail out aggressively as the West had done), Europe is a mess.
U.S. Stock Market Bubble:
- Currently at the highest or second-highest valuation in 140 years (U.S.).
- Liquidity has been a key driver, but sources like reverse repos ($2T to $600B) are drying up.
- Expects a 1000+ point S&P 500 correction in Q1/Q2 2025 (to ~5000).
- A possible rally after correction if Fed eases, potentially to 7000-7500 later in 2025.
- Volatility will increase significantly; a “decade of roller coasters” is ahead.
- Timing is tough. Bubbles can go on for longer than we might think.
- Trigger will likely be associated with the yen carry trade.
- Felix also sees a bubble in the private credit and private debt markets.
Global Liquidity and Yen Carry Trade:
- Global liquidity is drying up, especially from the unwinding yen carry trade.
- The yen weakening from 80 to 160 vs. the USD provided a primary source of global liquidity.
- Potential yen strengthening could unwind carry trades, tightening global liquidity.
- U.S. and Japanese interests align in wanting a stronger yen.
- Yen strengthening is likely to push up global bond yields and tighten liquidity.
U.S. Dollar and Currencies:
- Capital flowing to the U.S. due to economic/geopolitical factors and the AI narrative.
- The dollar index could rise from 107 to 110 in the short term.
- Medium-term dollar top forming; correction possible in the second half of 2025.
- Europe is facing structural issues; the euro is unlikely to strengthen significantly.
Federal Reserve and Monetary Policy:
- Felix is concerned about the Fed cutting rates despite the relatively strong U.S. economy and persistent inflationary pressures.
- Criticism of recent Fed chairs as “short-term operators” vs. Volcker’s long-term focus.
- Real inflation likely higher than official figures; deep-rooted U.S. inflation problem.
Global Economic Concerns:
- Europe faces a “major economic calamity:”:structural issues, uncompetitive energy costs, and a flawed euro currency experiment.
- China is in a “deflationary trap” and the real estate bubble will take 10-20 years to resolve. This is worse than what happened in Japan when it entered its deflationary trap in 1990.
- U.S. manufacturing is in a recession-like environment despite overall strength.
- The U.S. employment issue is interesting, as there are more jobs than available labor for the first time in U.S. history.
Trump Administration Market Impact:
- Proposed tariffs could be inflationary, potentially damaging to global trade. He noted the Smoot Hawley Tariff Act in 1930.
- Felix is unsure if Trump is threatening for bargaining reasons, but if not, it is not good.
- If Trump initiates half of the intended tariffs, it will be equivalent to the period before WWII 1929, which was an economic catastrophe and led to war.
- Potential for a trade war of massive proportions.
- He expects these announcements in the first six months of the presidential term and believes the markets will be rough.
- Pro-growth policies like flat taxes are favorable economically, but he noted we are in a different debt situation vs. the Reagan era.
- Attempts to cut government waste may face bureaucratic challenges.
Commodities Outlook:
- Generally bearish in the next 6 months due to the weak global economy (ex-U.S.).
- Oil could fall to the low $60’s before the potential geopolitical spike.
- Gold correction to ~$2400 over next 4 months; long-term bull market intact.
- Agricultural commodities are bottoming; upside potential from geopolitical disruptions.
Crypto and Bitcoin:
- Correlating to liquidity, expect 50-80% correction when liquidity tightens.
- Potential short-term run to $115k-120k before a major correction.
- The record inflows into Bitcoin in the last few weeks are another sign of what you see at market tops, not bottoms (referring to both Bitcoin and stock markets).
Key Next Steps
- Watch the yen strengthening as the key indicator for global liquidity is beginning to dry up.
- Monitor technical indicators for potential stock market reversal in the coming weeks. He uses moving averages, trend analysis, put-call ratios, and investor sentiment surveys to gauge investor sentiment.
- Prepare for increased market volatility throughout 2025.
- Reassess longer-term outlook after potential Q2 2025 market low.
Felix spoke about his proprietary trend indicator. He favors an intermediate trend (weekly data) process using a short-term moving average compared to a longer one-term moving average. If you are a Trade Signals subscriber, you’ll find the Weekly MACD charts on various equity, fixed income, commodity, and currency indices.
Please note that I’ve done my best to summarize Felix’s podcast discussion. I cannot guarantee accuracy, nor are the views a recommendation to buy or sell any security. His views are subject to change at any time.
Finally, if you are interested in subscribing to Felix’s Research letter, contact my friend Jennifer Mendel at jennifer@bluefoxadvisors.com.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
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The views expressed herein are solely those of Steve Blumenthal as of the date of this report and are subject to change without notice. Not a recommendation to buy or sell any security.
Personal Note: Merry Christmas, Happy Hanukkah, and Best Wishes
“You do not survive in the business for 50 years if you do not find out where the exit signs are the minute you enter a room.”
“How do I like my steak? As long as it’s not through my heart, any way is okay.”
“Never bet on the end of the world, because it only happens once.”
“A rumor without a leg to stand on will find a way to get around somehow.”
– Art Cashin
On our way to dinner to honor Art Cashin, John and I walked up 5th Avenue heading to Fresco by Scotto on East 52nd Street; we looked to our left and saw the tree at Rockefeller Plaza. We paused and decided to take a picture. Christmas spirit was in the air.
Barry Habib, Danielle DiMartino Booth, and Peter Boockvar were joining us—the dinner was spectacular, the conversation more intoxicating than even the fine wine Peter picked out.
Steve and John Mauldin
John Mauldin, Barry Habib, Danielle DiMartino Booth, Peter Boockvar, and Steve
It was a fun-filled, macro-geek fest of a dinner. I’ve gone fishing at Camp Kotok with John, Peter, and Danielle, but this dinner gave us more fun one-on-one time, discussing the Fed, the incoming administration, and how the economy may shake out in the next few years.
Danielle wrote the best-selling book Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad for America. She worked for Richard Fisher at the Dallas Fed and thinks the institution needs to be broken up. She’s also critical of Chairman Jerome Powell. Exceptionally smart, her recall and command of both current and historical data in our conversation were impressive.
Interestingly, she shared her belief that the government has been painting false employment numbers. We all nodded in agreement. With Trump re-entering the White House, we’re about to see the BLS restate the jobs numbers like never before. We all agreed the employment numbers are likely near recession-like levels. We are concerned the economy is about to get crushed…
Peter shares his thoughts on all of this regularly in his daily Boock Report. I particularly enjoy his deep dives into quarterly earnings calls and data. The calls are often nuanced and well-scripted, but listen more closely (as Peter does), and you can gain a feel for what’s really happening in the economy.
Danielle also believes Powell knows how bad things are for the bulk of the population and is responding correctly by cutting rates. To be clear, she is not a Jay Powell fan, but agrees that cutting interest rates is the right move, considering that a third of the population is already in deep trouble, and the middle is about to be hit hard, she said. The top few are doing fine.
We moved on to discuss the state of the global economy and that of other countries. Canada is presently in a deep dive, and the tariffs Trump has threatened will put it in a depression, Danielle believes. Germany, too, is nearing depression, and France is a mess. Plus, China faces a similar lost decade fate as the one Japan experienced in the 1990s, but perhaps a longer one due to the extent of the country’s real estate bubble. Tariffs on these countries, and Canada in particular, could sink their economies and have reverberating impacts on ours. The hope is that Trump will simply use the threat of tariffs as a negotiating tactic. The Art of The Deal? We’ll see.
We liked the idea of instituting the Department of Government Efficiency (or DOGE), though. Danielle doesn’t believe they’ll be as successful as everyone hopes, but I hope she’s wrong. In our discussion about it, John said he believes a “Great Reset” will arrive by 2028. Danielle thinks it’ll happen sooner.
Barry has an interesting way of parsing economic data. Fed policy is based on employment and inflation, but the real numbers are sometimes questionable. What Barry and all of us are trying to do is figure out the direction and depth of monetary policy. He primarily focuses on real estate market forecasts, but his approach inherently involves interest rate predictions, as well, since mortgage rates and the direction of the housing market are influenced by interest rates. Barry’s track record can be put up against the best in the game. In fact, Zillow and Pulsenomics have awarded him the Crystal Ball Award three times (2017, 2019, and 2020) for the most accurate real estate forecasts among 150 top economists in the U.S.
Predictions aside, my biggest takeaway from the dinner was the joy we all got from sharing our passion for the economy and markets. I imagine our friend Art watched us with a smile on his face (and a Dewars on ice in his hand).
In sports news, Indiana plays Notre Dame tonight, and Penn State plays SMU in Happy Valley at noon tomorrow. The college football playoffs begin. Go Lions!
I hope this note finds you looking forward to the holiday. Susan and I are doing some shopping this weekend. (We are far behind.) Matthew flies home this evening, Kyle on Tuesday, and Tyler and Connor arrive on Sunday. Brianna is in Asia traveling. She FaceTimed me last evening, inviting me to meet her in Japan in late January to ski (and bring her equipment with me). Sadly, I have to pass. These are busy times! It’s likely for you, too.
Speaking of…Merry Christmas, Happy Hanukkah, and best wishes to you and yours!
Steve
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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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