“If you’re young, take the whack [and] if you’re old, pray for the Fed to keep going.” – Jeremy Grantham
Grantham was the opening keynote at the Morningstar Investment Conference in late June. There were several notable insights I share with you this week. The intro quote above pretty well sums up his outlook. All about that (bass) Fed, about that (bass) Fed. The jingle continues to ring in my mind.
I believe the high yield debt market can help us identify market inflection points. High yield tends to be a leading market indicator. A default wave is in our near future and I suspect the opportunity it will create may arrive sooner than many expect.
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Coho Capital commentary for the second quarter ended June 30, 2020. Q2 2020 hedge fund letters, conferences and more Dear Partners, Coho Capital returned 46.6% during the first half of the year compared to a loss of 3.1% in the S&P 500. Many of our holdings, such as Netflix, Amazon, and Spotify, were perceived beneficiaries Read More
I’m not sure if you saw the recent heated debate between Blackrock’s Larry Fink and the great Carl Icahn. It was about the potential illiquidity in fixed income ETFs. Icahn said, “There is no liquidity. That’s my point. And that’s what’s going to blow this up.” I’m grateful for all Fink has created but put me in the Icahn camp on this issue. My two cents is the inherent problem will be one of the driving sources of the great future opportunity.
It is estimated that nearly three quarters of U.S. investment wealth will be in the portfolios of pre-retirees and retirees by 2020. While the younger investor can “take the whack”, the pre-retiree and retiree can’t. Ten years recovering from decline is different for a 45 year-old than it is for a 65 year-old. “Pray for the Fed to keep going”- indeed.
Another storm is ‘a brewing. Yet, we don’t need to take the whack. As was the case in prior overvalued, over-leveraged and aged bull markets, the game for now is to participate and protect.
Let’s also take a look today at what is going on in high yield bond market. I believe it can tell us a great deal about the timing of future opportunities.
Included in this week’s On My Radar:
- Grantham – Keynote Highlights (Morningstar Investment Conference)
- What Do High Yield Maturities Tell Us About Timing the Credit Cycle? GMO’s Ara Lovitt
- Gold – What to do with Gold
- Trade Signals – Zweig Back On A Buy, Trend Remains Positive, Sentiment Bullish – 07-22-2015
Grantham – Keynote Highlights (From the Morningstar Investment Conference)
- Equity valuations are heading toward the “two-sigma” level that is the requisite threshold for a true bubble (referring to a 2 standard deviation move from its long-term trend)
- A “trigger” will precipitate the reversion back to the mean levels
- He said, “The market is driven by career risk where investors’ job descriptions are to keep their jobs. They deal with the mindset to “never be wrong on your own” and if you are going to be wrong, make sure you have plenty of company.” This process guarantees that investors herd together and drive asset class valuations way beyond fair value.
- GMO’s seven-year forecast assumes valuations will normalize over a seven-year time horizon, with both lowered profit and PE levels.
- GMO is forecasting a -2.3% seven-year return for U.S. large-cap stocks.
- In order for equity yields and returns to increase, “we have to take a hit because the market is overpriced”
- A younger investor with less accumulated assets will benefit more than an older investor with more accumulated assets
- Government policies have prevented capitalism from working in normal ways
- Fed policy has fueled high margins, a stock-option culture and a fixation on short-term results
- 30 years ago, 20% of senior management pay was attributed to stock options; today it has exploded to 80%.
- In line with this incentive, corporate management teams have chosen the much less risky path of stock buybacks to drive valuations and profitability. It is easier for corporations to meet their quarterly numbers through stock buybacks than it is through capital investment.
- The pace of stock buybacks has accelerated dramatically and is at a record annualized rate of $700 billion per year to date while capital spending is 4% below average even after a six-year recovery with record profit margins.
- This is a high price to pay to make senior management rich and the lack of capital spending is a drag on economic growth. Management teams are more comfortable buying back stock, pushing stock price up and making their stock options more valuable.
- He challenged the Fama-French market efficiency theory citing his team’s work that identified 28 important investment bubbles that all “broke completely”. Citing a 2 standard deviation move above the mean, in all cases two-sigma events, were highly predictable and lead to collapses.
- GMO’s research showed that we are getting close to another two-sigma event, as the markets are hovering around 1.5 sigma.
- He said, “There is no chance it will break until we get over two sigma.”
- He believes the market will “plod higher” and follow the Fed at least until the election; citing the election as a potential bubble breaking trigger. He added, “I’m going to be incredibly prudent closer to the election.”
- There are no “institutional pessimists,” he said, “and there will be no trigger until individuals pour into the market. We need to wait until deals become more frenzied and individuals become crazy buyers.”
- He does not see a Fed rate hike as the trigger. He forewarned the audience, “you have to wait for the trigger so be brave.”
What Do High Yield Maturities Tell Us About Timing the Credit Cycle? GMO’s Ara Lovitt
I favor price behavior to best identify the high yield market’s primary trend but clearly underlying fundamentals matter. I’ve been writing to you about a coming default wave and how I believe it will be the largest default crisis on record. Too many low quality companies have received funding and at terms least favorable to investors. There will be defaults and there will be many. It will be crucial to get the timing right if you want to take advantage of the opportunity the sell-off will create. Oftentimes, analysts look to the maturity calendars as logical market inflection points. That is the date the IOU comes due and without refinancing, there is not enough money in the corporate kitty to pay back the lenders (bond holders).
PJ, President of CMG, forwarded me a new White Paper on the high yield market. It is loaded with a number of important insights. Here are a few (I then link to the full piece):
- For those invested in high yield bonds and leveraged loans, accurately timing the cycle will be the difference between safely clipping coupons and realizing painful losses.
- The turn of the cycle should create the next great opportunity.
- Credit strategies and portfolio managers frequently point to the timing of debt maturities as a major determinant of near-term default rates.
- Over 50% of the outstanding debt matures within the next three to six years.
- Lovitt took a closer look at three of the last credit cycles looking to see if the “maturity wall” gave investors a useful “buy” signal at the cyclical bottoms of the market. Contrary to popular belief, he found that often companies default years before their debts technically mature.
- Credit cycles typically turn after a long boom. Toward the tail end of the boom, most companies with access to capital markets are likely to have refinanced their debts, thereby pushing their maturities far into the future.
- While helpful to individual companies, it did nothing to stop the last three cycles from turning.
- Whether due to a recession, tightening credit conditions, or something else, eventually corporate cash flows are pressured and debt is downgraded and there are defaults.
- Credit cycles eventually stabilize after a painful sell-off.
In short summary, focusing on the maturity wall is not helpful to the investor looking at timing the top of the current cycle. Sharing with you an honest point of self-reflection, I’ve written a lot about the coming maturity calendar citing it as a possible time frame for a high yield market top. While my high yield trading strategy looks at price behavior to drive its buy and sell signals, I want to say that I believe I’ve been wrong in citing the maturity calendar. A special thank you to Ara Lovitt and the brilliant minds at GMO. Here is the link to the white paper.
Next is a visual on high yield price behavior: The trend is your friend. High yield is currently in a down trend. Keep your eye on the trend.
The high yield market forewarned of the declines in 2000 and 2008. The high yield market is a good recession indicator and a good equity market lead indicator. This is important as recessions can be hazardous to your wealth. The largest declines for both high yield and equities come during recessions. Let’s keep a close eye on the recession chart posted each week in Trade Signals (link below).
By definition: The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession. Recessions are only known in hindsight but as investors, we need foresight and that is where a defined process, such as tactical trend following, can help us.
What to do with Gold?
I’m often asked what I think about Gold. The direct answer is that Gold is in a cyclical bear market. Nothing has changed since early 2013. I believe that a simple trend based process can identify the major bull market and bear trends and help us position accordingly. Next I show a 13-Week over a 34-Week moving average trend indicator. When the 13-Week price trend is above the 34-Week trend, Gold is in a cyclical bull market. Note the short-term technical support in “GLD” at $100.
Within a total portfolio, we underweight exposure to Gold allocating approximately 5% of the portfolio when it is in a cyclical bear market and depending on various opportunities may size it up to a 15% weighting when Gold is in a cyclical bull market. This way we can minimize our risk exposure in more difficult periods such as Gold is experiencing today.
That is part of our own investment process, yet others may choose to have zero exposure to Gold during cyclical bear periods or own much more in bullish cycles. See On My Radar: Three-Way Asset Strategy for other ideas on how to position to Gold.
Trade Signals – Zweig Back On A Buy, Trend Remains Positive, Sentiment Bullish – 07-22-2015
The title to this week’s update pretty much captures the weight of evidence. The market has rallied off of the Extreme Pessimism readings of just a few weeks ago and investor sentiment remains in an area that has produced positive returns for the market.
Concerning is the Volume Supply vs. Volume Demand chart. It is in a sell signal and this process has historically been a good market directional indicator. Big Mo remains in a buy signal and the 13/34-Week EMA trend chart remains positive. The heavy boat floats forward. Put in place downside stop loss risk processes and stay tactical. The charts are updated below.
A quick updated summary of the various charts on Trade Signals:
- Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
- Volume Supply is Greater than Volume Demand: Sell Signal for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Extreme Pessimism (short-term Bullish for stocks)
- Daily Trading Sentiment Composite: Extreme Pessimism (short-term Neutral for stocks)
- Don’t Fight the Tape or the Fed: Modestly Bearish – Watch Out for Minus Two
- U.S. Recession Watch – My Favorite U.S. Recession Forecasting Chart: Currently signaling No U.S. Recession
- The Zweig Bond Model: The Cyclical Trend for Bonds is Bullish
Click here for the link to all of the charts.
A few concluding thoughts:
“Don’t wait for the perfect moment, take the moment and make it perfect” -Unknown Arthur
I walked 18 holes yesterday with a close friend who is dealing with stage four colon cancer. He’s on the winning side of the battle and I believe so much of it is due to his amazing outlook and clarity of mind. I tried to remember exactly what he told me on the course about making the moment perfect. I googled “great quotes about life” and the above came close to capturing what my friend said.
Take the moment and make it perfect. Like that… Wishing you a perfect weekend.
With kind regards,
Stephen B. Blumenthal Chairman & CEO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman, CEO and CIO. Steve authors a free weekly e-letter titled, On My Radar. The letter is designed to bring clarity on the economy, interest rates, valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Click here to receive his free weekly e-letter.
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