October 17, 2014
By Steve Blumenthal
“Investors should understand that prices and valuations are high is another way of saying future returns have already been realized, leaving little to be gained for quite some time.”
John Hussman
In 2005, I was pitched a Bear Stearns leveraged hedge fund that was run by several smart guys with long, impressive resumes. They were investing in various tranches of Wall Street- engineered mortgage debt. I passed, thinking that bundling low-rated subprime mortgages into large pools of AAA-rated structured products, like trying to turn lead into gold, was a bad idea.
In June 2007, Bear Stearns pledged up to $3.2 billion in loans to bail out the very hedge fund I was pitched. My immediate thought was, “Here it comes.” I never imagined that one default would be the tipping point for a crisis that would nearly collapse the entire U.S. financial system.
All of the elements that went wrong in 2008 are far bigger and potentially more harmful today than they were in 2007. The banks are bigger, the derivatives markets are bigger, and the Fed’s balance sheet has grown from $800 billion to over $4 trillion.
The above three paragraphs are the intro paragraphs to a piece I wrote this week for Forbes titled, Watch Junk Bonds For Early Warnings Of A New Financial Crisis. In it I detail the degree of leverage that is in the system and recommend owning equities (but hedged) and to include an overweight allocation to more flexible investment strategies like tactical. I know I’m sounding a bit like a broken record but risk is high and I’d rather be positioned in a way that gives me the ability to take advantage of the opportunity a new crisis will create when it occurs.
With richly priced markets (both equities and fixed income), forward return potential is low to negative. We can measure the degree of current risk and the likelihood of forward expected returns and we can create portfolios more aggressively tilted or more conservatively tilted based on that potential. But what few, if any, can ever predict is the timing of a market dislocation.
To that end, I highlight John Hussman’s latest letter below. Yes, I know he has missed in his portfolio management but the data should not be overlooked. I particularly liked this quote, “overvalued, overbought, over-bullish extremes are associated with total market returns below risk-free interest rates, on average, but that average features an unpleasant skew: most of the week-to-week returns are actually positive, but the average is harmed by large, abrupt losses.” Bold emphasis mine as I highlight what life feels like for our clients.
This past week is a reminder of such risk. It may be “buy the dip” this time but at some point buy the dip will turn to “what was I thinking?” John Bogle may be able to buy and hold forever. Good advice for those with his conviction and his mega net worth; not so good for Mr. and Mrs. Jones with a modest net worth and five years until retirement. It is just not one size fits all.
I’m in the buy the dip camp as long as the cyclical bull trend evidence remains positive (see Trade Signals). Note: I thought Hussman did a good job at game planning allocation weightings in his piece. It was creatively explained and worth a read.
Included in this week’s On My Radar:
- Watch Junk Bonds For Early Warnings Of A New Financial Crisis
- Air-Pockets, Free-Falls, and Crashes – Hussman
- Trade Signals – Market Support Targets – Sentiment at Pessimistic Extreme – 10-15-2014
Watch Junk Bonds For Early Warnings Of A New Financial Crisis, Blumenthal Forbes 10-16-14
I often think back to the 2008 pre-crash warnings that were crystal clear in hindsight but easy to dismiss prior to the great crisis. Banks were leveraged north of 30 to 1, margin debt at a record high and homes being refinanced (often several times) to access the extra cash created by home price gains and the ease to borrow. Homes were being used as ATM machines.
I wrote about Freddie Mac and Fanny Mae, subprime problems, CDOs, a coming opportunity in high yield and the coming crisis. Steve, “you’re such a bear” came the response. This time is different came the call. It was argued that housing prices had never declined. Cited was Greenspan’s “there is no bubble in the housing market”. Frankly, the crash was far worse than I anticipated.
As I share in the Forbes piece below, the systemic risk to the system is more than it was in 2008. I’m pretty sure I’ll get some push back from the piece (just as I did pre-2008). A few examples I expect to receive: banks are more heavily regulated than in 2008, Dodd Frank has limited bank risk, most derivative positions are hedges so the overall risk is not so big. To all of this I say, bull. If you haven’t yet, take a look at the Goldman Tapes and tell me who you think is in control.
Anyway, as advisors, our job is to measure risk and do our best to position accordingly. A crisis is coming and with forward return expectations low, we need to find different ways to both grow our clients’ capital and mindfully help to preserve it.
Here is a link to the full Forbes article. Please know I appreciate your candid feedback.
Air-Pockets, Free-Falls, and Crashes – Hussman 10-13-14
From Hussman Funds:
Fed policy and risk premiums
Recall that very early into the 2000-2002 and 2007-2009 bear markets, the Federal Reserve began to aggressively ease monetary policy, but that did not prevent stock prices from going on to lose half or more of their value (see Following the Fed to 50% Flops). The short-term responses of the market were certainly positive, but those responses turned out in hindsight to be exit points. As I’ve noted before, if one is going to invest by aphorism, history teaches that “don’t fight the trend” strongly outperforms “don’t fight the Fed.” With respect to our own experience in the half-cycle since 2009, the primary lesson to be drawn is not that Fed policy trumps all other considerations. Rather, the lessons to be drawn relate to the criteria that distinguish periods where monetary easing is supportive to the markets from periods where policy shifts are irrelevant or even contribute to the loss of investor confidence.
Again, that distinction has a great deal to do with market internals and trend uniformity, because those measures of market action provide a signal about the tolerance or aversion of investors toward risk. In effect, Fed easing is effective provided that risk-free cash is considered an inferior holding. Fed easing is useless if investors actually prefer to hold risk-free cash as a safe haven.
There’s certainly a feedback circle to this: the purely psychological belief that Fed liquidity is a magical risk-removing fairy dust can certainly support increased risk tolerance, but that tolerance should still be read directly out of market internals and trend uniformity. When investor preferences shift toward risk aversion, more liquidity doesn’t support stock prices. Yield-seeking speculation fails to emerge because low or zero interest rates on cash arepreferred to the prospect of steeply negative returns. As the market collapses of 2000-2002 and 2007-2009 demonstrate, aggressive Fed easing does not prevent extraordinary market losses once investors have the risk-aversion bit in their teeth.
The Fed certainly has a legitimate and often helpful role in crises when it is needed to act as a “lender of the last resort” by lending to solvent but liquidity-constrained financial institutions. Good public policy acts to responsibly relieve legitimate constraints on the economy that are actually binding. At present, however, the financial system is already drowning in trillions of dollars of idle cash reserves, which don’t need to “go” anywhere, because once a dollar of base money (currency or bank reserves) is created, it remains in existence, in the form of base money, until it is retired by the Federal Reserve. In other words, zero-interest sideline cash is zero-interest sideline cash and will remain zero-interest sideline cash until it is retired, and the only thing that $4 trillion of base money does for the economy is to change hands as a hot-potato that nobody wants to hold so long as risky assets appear to offer better returns than zero.
No doubt – this pile of zero-interest hot potatoes has helped to compress risk premiums across the entire range of risky assets toward zero (and we estimate, in some cases, below zero). But understand that the bulk of the advance in financial assets in recent years has not been a reasonable response to the level of interest rates, but instead reflects a dangerous compression of risk premiums.
The effect of zero-interest rates is measurable, and the arithmetic is straightforward. The expectation of another 3-4 years of zero interest rates (versus normal short-term interest rates of say, 4%) implies that risky long-term assets could reasonably be priced 12-16% above where they would be priced in a normal interest rate environment. That premium would reduce the prospective returns of those risky assets by that same 4% for 3-4 years, but would preserve normal risk premiums. But on valuation measures that are reliableacross a century of history, including recent years, the valuation of the S&P 500 is now more than double its pre-bubble historical norms (and only looks more tolerable because investors do what they always do at cycle peaks, which is to capitalize peak cycle earnings as if they are fully representative of the entire stream of future long-term cash flows).
In short, every 3-month period of additional zero-interest rate policy promised by the Fed is worth about a 1% premium over historical valuation norms. Another year would be worth a premium about 4% over historical norms. But with the market more thandouble historical norms on reliable measures, the Fed would have to promise aquarter of a century of zero interest rate policy before current stock valuations would reflect a “reasonable” response to interest rates. No – stocks are not elevated because low interest rates “justify” these prices. They are elevated because the risk premium for holding stocks has been driven to zero. We presently estimate negative total returns for the S&P 500 on every horizon shorter than 8 years.
At present, prospective market return/risk should not be read from Fed policy. It should be read from valuations and the quality of market internals and trend uniformity, which we view as the best way to infer investor risk tolerances, the level of risk premiums, and the pressure on them. If these measures improve, a fresh easing of Fed policy would allow for further yield-seeking speculation. But in the context of extremely compressed risk premiums that are being pressed higher; in the context of an overvalued, overbought, overbullish market that has been joined by deteriorating market internals, broadening dispersion, and a loss of trend uniformity – all bets on the Fed are off, as they were in 2000-2002 and 2007-2009, until we observe a favorable shift in those measures of investor risk preferences.
Warning: Examine all risk exposures
All of that said, there’s no assurance that the present instance will match historical experience. As I noted at what in hindsight turned out to be the market peak in October 2007, in a piece that bears the same title as this section (see Warning: Examine All Risk Exposures):
“There is one particular syndrome of conditions after which stocks have reliably suffered major, generally abrupt losses, without any historical counter-examples. This syndrome features a combination of overvalued, overbought, overbullish conditions in an environment of upward pressure on yields or risk spreads. The negative outcomes are robust to alternative definitions, provided that they capture that general syndrome. We can’t rule out the possibility that investors will adopt a fresh willingness to speculate (which we would observe through an improvement in market internals). Such speculation might prolong the current advance modestly, but even this would not substantially alter the risks that have ultimately been associated with overvalued, overbought, overbullish conditions.”
Though we should allow for a potential improvement in market conditions, I do believe that now is a particularly bad time to rely on the idea that “this time is different” with money you cannot afford to lose. This does not require forecasts about market direction – only proper consideration of market risk. Make sure that the portfolio of risks you do hold is the portfolio that you want to hold over the completion of the market cycle, understand the risk profile and actual losses that various asset classes have experienced over prior market cycles, take account of the prospective returns that are embedded into current valuations, and insist on historically reliable measures of valuation that demonstrate a strong association with actual subsequent returns over numerous market cycles across history.
My view is that even passive buy-and-hold investors should primarily focus on ensuring that the effective duration of their portfolio is not significantly longer than the horizon over which they expect to spend the funds. In other words, the duration of the assets should be matched with the anticipated horizon of spending needs (or liabilities). The estimated durationof the S&P 500 Index is roughly 50 years, 10-year Treasury bonds presently carry a duration of about 9 years, and cash has zero duration, so a passive investor expecting the averagedate of spending to be about 15 years in the future might match that with an asset portfolio of similar duration. Examples would include a 20%-55%-25% mix of stocks, bonds, and cash, respectively, or perhaps a 24%-33%-43% mix, but in any case not more than about 30% in equities.
The challenge here is that we associate each of those 15-year duration portfolio mixes with expected nominal total returns of less than 2% annually over the coming decade. Based on historically reliable valuation measures, we presently estimate prospective 10-year S&P 500 nominal total returns of just under 2% annually here, so increasing the equity portion does not improve the expected portfolio return. Investors should understand that “prices and valuations are high” is another way of saying “future returns have already been realized, leaving little to be gained for quite some time.”
Fortunately, as valuations retreat, durations shorten. For example, at the 1982 low, the dividend yield of the S&P 500 reached 6.7%, bringing the duration of the index down to 15 years, so from a duration-matching standpoint, even an investor with an expected spending horizon averaging 15 years could have been comfortable with 100% of assets in equities. At the 2009 low, the yield was a more moderate 3.8%, but that still implied a 26-year duration, making a 60% equity allocation quite reasonable even for a passive investor expecting to spend the assets, on average, 15 years hence.
Alternative investments are a bit trickier, as their exposure to market risk can vary. Since the potential for portfolio loss is a significant consideration, one approach might be to gauge relative risk by comparing maximum losses on a compound (log) basis. For example, if the worst historical drawdown of A has been 33% over several market cycles, and the worst drawdown of the market has been 55%, the relative risk of A might be estimated as log(1-.33)/log(1-.55) = 50% of that of the market. That odd-looking compounding arithmetic essentially captures the fact that it takes two back-to-back 33% losses to produce one 55% loss. Similarly, if worst historical drawdown of B has been 18%, the relative risk of B might be estimated as log(1-.18)/log(1-.55) = 25% of the market itself, as it takes four back-to-back 18% losses to produce one 55% loss like the S&P 500 experienced in 2007-2009.
An active investor would typically consider allocations not only from the standpoint of duration, but also broader conditions that affect returns over shorter portions of the market cycle. Presently, we don’t believe that active investors should expect a positive return from unhedged equities at all here, given the combination of rich valuations and deteriorating internals, which suggests skewing holdings toward cash or hedged alternatives until more favorable conditions emerge. Again, we view the strongest market return/risk profiles, and the best opportunities for unhedged investment, as coupling a material retreat in valuations with an early improvement in market internals. Now is the antithesis of those conditions.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse. Only comments in the Fund Notes section relate specifically to the Hussman Funds and the investment positions of the Funds.
Here is a link to the full Hussman letter: http://hussmanfunds.com/wmc/wmc141013.htm
Trade Signals – Market Support Targets – Sentiment at Pessimistic Extreme – 10-15-2014
The S&P 500 is down nearly 10% from its September high of 2019. I’m going to tilt back the risk meter just a bit as investor pessimism is now at levels of extreme pessimism and the market is testing some technical support.
To that end, the market is currently testing the April 2014 low at 1814. The next support level is 1737 which was the February 2014 low and September 2013 high. There is more significant support at 1661.77 which represents a 38.2% retracement from the October 2011 low to the September 2014 high.
Several other trend charts I favor are turning negative; yet my two favorite, Big Mo and the 13/34-Week EMA, remain in a cyclical bull market buy signal. I show a special chart today that looks at advancing volume vs. declining volume, which is essentially looking at demand vs. supply. It turned negative yesterday. I highlight that chart below.
On the concern list: QE is ending this month and Europe, Japan and China are in decline (with recession in Europe), commodities are in a steep sell-off (signaling global economic weakness), war risk, and add Ebola. We know risk to be elevated – whether a short-term market scare or the beginning of another crisis remains to be seen.
I’ve been advocating “own equities but hedge” and “overweight to tactical strategies” for some time. To that end, our tactical strategies are performing as we hoped. I know several of the large tactical shops are not doing well. Diversify.
If you are a CMG client, know that our overweight to cash and long bond exposure in our CMG Opportunistic All Asset Strategies has helped performance, our 50% SPY and 50% BND (Vanguard Bond Fund ETF) has helped our Tactical Rotation Strategy minimize decline, our overweight to long bond exposure in our CMG Vantage Flexible Bond Strategy has produced unusually favorable returns and our CMG High Yield Managed Bond Strategy moved once again defensively to a sell signal yesterday.
We investors have to take risk. There is no other choice. Putting money under a mattress is risk, buying a CD is risk, bonds are risk, stocks are risk, everything we do is risk. However, we can control our risk exposure and, fortunately, there are tools available to build broadly diversified and healthier portfolios.
If your equities are hedged and your portfolio includes good tactical strategies (and other liquid and more flexible return drives), then the storm should be weathered with far less emotional and financial indigestion.
For the moderate investor, I favor 30% allocated to equities (hedged), 30% to fixed income (flexible and tactical) and 40% to tactical strategies. When valuations become more attractive, shift back to overweight equities. The key is to have a game plan and the discipline to stick to that plan.
For overall market trend, I follow Big Mo and the 13/34-Week Trend chart. Should either turn negative, then further adjustments in the 30/30/40 mix must be made to reduce market exposure even further. I think sentiment can be used in a helpful way. Neither trend indicators has turned negative and sentiment is now signaling a buy. I continue to favor 30/30/40 and that weighting mix is holding up well.
Trade Signals is my process for thinking about market risk, portfolio structure and forward game plan. It really helps me to go through the charts and to put my thoughts on paper each week. I hope that some of the information can help you and your clients as well.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Cyclical Bullish Trend for Stocks Remains Bullish (as measured by NDR’s Big Momentum indicator and separately by the 13/34-Week EMA S&P 500 Index Trend Chart)
- Weekly Investor Sentiment Indicator – NDR Crowd Sentiment Poll: Extreme Pessimism (Bullish for the Market)
- Daily Trading Sentiment Composite: Extreme Pessimism (ST Bullish for the Market)
- The Zweig Bond Model: Cyclical Bull Trend for Bonds (supporting longer-term treasury and Corporate bond exposure)
- Demand/Supply Chart – In a “SELL” Signal for the First Time Since 2012
Click here for the full link, including updated charts, to Wednesday’s Trade Signals post (trend and sentiment charts)
CMG Advisor Central
Please know that we here at CMG Capital Management Group are committed to bringing you the latest intelligence on the markets and tactical investing strategies.
We launched Advisor Central six months ago to offer advisors a quick read on trade signals in the fixed income and equity arkets, commentary on economics and investing, and trends in the financial advisory business.
You can sign up at http://advisorcentral.cmgwealth.com for updates and you’ll get a weekly digest delivered to your in box.
We also created a LinkedIn Showcase Page devoted to tactical investing. Tactical investing has been our sole focus for 20+ years. We aim to give this investing style clear definition and scope as investor awareness of ‘tactical’ develops. Follow the LinkedIn Tactical Investing page here for periodic updates. https://linkedin.com/company/tactical-investing
Important Links
- CMG’s AdvisorCentral: http://advisorcentral.cmgwealth.com
- CMG’s Tactical Investing LinkedIn Page: https://linkedin.com/company/tactical-investing
- CMG on Twitter: @askcmg
- Steve Blumenthal on Twitter: @SBlumenthalCMG
- CMG Research and Insight: http://www.cmgwealth.com/research-insight
Conclusion
Well, excitement turned to disgust in just six short minutes as my Philadelphia Union blew a 2-0 lead – letting in 3 in what can just be described as an epic collapse. By doing so, they were eliminated from the MLS playoffs. Such high hope dashing is all too familiar here in Philadelphia. We step forward as it is time to put all hope in our Flyers and Eagles. (With the exception of young Connor who somehow became a Chicago Blackhawks fan. It just drives the brothers nuts. It’s kind of fun actually.)
I’m headed to Denver next week and to Ohio the following week. A trip to Arizona follows in early December as I’m speaking at IMN Global Indexing & ETFs Conference in Scottsdale. Please let me know if you are attending and we’ll grab a coffee.
Wishing you a fun filled weekend and thank you for your interest in this letter. It’s appreciated.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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