March 18, 2016
By Steve Blumenthal
“So what do we do? Anything. Something. So long as we just don’t sit there. If we screw it up, start over. Try something else. If we wait until we’ve satisfied all the uncertainties, it may be too late.”
– Lee Iacocca
“This is the persistent tendency of men to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary consequences.”
– Henry Hazlitt, Economist
In April, Li Lu and Bruce Greenwald took part in a discussion at the 13th Annual Columbia China Business Conference. The value investor and professor discussed multiple topics, including the value investing philosophy and the qualities Li looks for when evaluating potential investments. Q3 2021 hedge fund letters, conferences and more How Value Investing Has Read More
It is the fallacy of overlooking secondary consequences that is keeping me up at night. Try telling that one to your spouse. J
“Draghi and the ECB announced that they will start a series of targeted longer-term refinancing operations (TLTRO). The first will occur in June 2016. The term will be four years. The cost of this borrowing by a bank is likely to be a zero interest rate. But under certain conditions, it will be at the negative policy rate. Thus the central bank will be paying the commercial bank to borrow from it.
Imagine what would happen in the United States if the Federal Reserve structured a program so that any bank, whether Bank of America or your local community bank, were to be paid by the Fed when that bank borrowed from the Fed and used the funds to make loans to you or to buy assets in the market.” – David Kotok, Cumberland Advisors
David added, “This is a massively expanded stimulus program. It has extremely bullish implications for financial assets and for asset prices in Europe. And because of its size and lengthy term, it is a bullish force for the entire world. We expect other NIRP jurisdictions to use their version of this model. Keep a sharp eye on Japan’s next move deeper into NIRP.”
NIRP stands for Negative Interest Rate Policy. On its own it is a deflationary policy that, I believe, is ill-designed to help us exit the current excessive debt, global deflationary mess we find ourselves in.
Now look at them yo-yos that’s the way you do it
You play the guitar on the M.T.V.
That ain’t workin’ that’s the way you do it
Money for nothin’ and your chicks for free.
Dire Straits – Money For Nothing Lyrics
Banks can borrow for nothing (0%), expand their loan book by 2.5% (by the end of January 2018) and get an extra 40 bps kicker from the ECB. Get your “chicks for free”. Ok, maybe not “chicks” but certainly “money for nothing”. What they are not saying is that the banks are in trouble. Let’s hope the banks can find some qualified and motivated borrowers.
This next quote pretty much sums it all up, “In the last three years plus, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable in order to restore sustainability.” – Mohamed A. El-Erian, The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse (Random House, 2016)
What does this mean? I explained it to someone on our research team this way: It’s like you have a shoulder issue. You go to the doc and get a cortisone shot. Perfect, you feel good again. Six months go by and the pain is back. Another shot, another short-term fix. You do it again until finally the doc tells you she’s done all she can do for you. All that cortisone is really bad for your system in the long term. You need to go to a different doctor, a surgeon, who has the tools to fix the structural problem in your shoulder.
El-Erian calls it a handoff: from the Fed (injecting the juice) to our elected officials (who have the power to implement structural reform). I.e.: Individual and corporate tax reform, U.S. foreign profit dollar repatriation, grand infrastructure projects (aged bridges, natural gas pipes, highways, technology) and entitlement reform/repair (we are nearing a breaking point). Simply, policies that stimulate growth. This requires action.
The problem is that the authorities who have the ability to fix the problem don’t seem to be motivated to get to work. Power struggle gridlock. At some point, they’ll get motivated but it might take another financial crisis to wake them up. This has to happen in Europe, Japan and China as well. Debt is a mess everywhere you look.
Are global central banks nearing the “unsustainable.” No one knows for sure. Stay alert and expect the unexpected. Is ZIRP, QEs 1, 2 and 3, TARP, LTRO, NIRP and coming QE4 (helicopter money) working? Going to work? My two cents is that we have a very long way to go.
Buying government and now corporate bonds. What are we enabling? Debt has not come down. What are we messaging to corporate fiduciaries, bank prop desks, levered investors? What did low rates and no-doc mortgages do for the housing market. Keep your guard up. Stay alert and expect the unexpected.
Equity market valuations remain high and the bull market is aged. Hedge that equity exposure, broadly diversify and overweight to non-directionally dependent strategies. I continue to favor a 30/30/40 (equities, fixed income and liquid alternatives) portfolio mix and hedge that equity exposure. We can change the tilts to overweight equities and remove hedges when forward return potential is high (valuations low and attractive).
To that end, this week you’ll find a great equity market chart that shows us what the forward S&P 500 Index returns are likely to be based on the percentage of household equity ownership.
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Included in this week’s On My Radar:
- All ‘Bout That Fed, ‘Bout That Fed
- What Henry Hazlitt Can Teach Us About Inflation, by James Grant
- Charts That Matter – Forward 10-year Annualized Return 3-4% for Equities
- Trade Signals – “Aged”: The Average Bull Market Lasts 59 Months, This One is Now 84 Months Old
All ‘Bout That Fed, ‘Bout That Fed
Following are several pieces I found interesting – comments on the Fed:
Peter Boockvar, from the Lindsey Group, prior to the Fed’s Wednesday FOMC meeting wrote:
If the Fed was TRULY dependent on the data, they would be raising interest rates TODAY. The six-month job gain average is 235k, the unemployment rate is right at the Fed’s long-term forecast, the core PCE y/o/y rate gain of 1.7% is one-tenth above the Fed’s year-end forecast, the S&P 500 is just 5% from its record high, the US dollar is at the same level it was about one year ago as negative rates from the BoJ and ECB has stopped working in weakening their currencies, oil prices are up 15% from the last Fed meeting, the CRB food stuff index is at a three-month high and the Journal of Commerce index of 19 industrial materials is at a 4½-month high. Also, as the Fed likes to talk about inflation expectations, the 10-year breakeven at 1.50%, the same level it was at in August and the same spot it was at when the Fed hiked rates in December. It is not until September however that the Fed Funds futures market is 100% confident that under the current circumstances they will raise again. We are at 64% for June.
Assuming the Fed doesn’t want to shock the market, they won’t raise today (and they didn’t as we now know) as no one expects it because the Fed seems to be worried about everything else (China and international developments, mediocre US growth, the prospect of another round of a tightening of financial conditions, their own shadow, etc…). William McChesney Martin, the Chairman of the Fed from 1951 to 1970 once said this in a speech, “The idea that the business cycle can be altogether abolished seems to me as fanciful as the notion that the law of supply and demand can be repealed.” He said that in 1955.
And this from Danielle DiMartino, QE Program – An Embarrassment of Stitches
“And so we hear the latest, that the Chinese government will launch its answer to the U.S. TARP program, wherein Chinese commercial banks swap out bad debts to the government in exchange for equity in said bank. Reported non-performing Chinese bank loans rose to $614 billion in 2015, a decade high, even as their economic growth slumped to a 25-year low. Of course, the aim of the package is identical to that of all stimulus measures launched since 2008 — to spur yet more lending to lift economic growth. More and more yet of the same.
Which brings us to the European Central Bank (ECB), which added non-financial corporate bonds to the menu of fixed income instruments it can buy to achieve its goal of flooding the markets with 80 billion in euros every month so as to…drum roll, please…incentive, more lending. It seems that there were simply not enough sovereign bonds and asset-backed securities to get the job done, and that’s before the ECB expanded its QE program from 60 billion euros a month before last Thursday’s meeting.
No doubt, with 900 billion euros outstanding, the ECB has an appreciably large pool of assets at which to aim its buyer-not-beware bazooka. A gut check, though, should prompt the question as to why European policymakers are so keen to increase their own QE program when the effort has produced so few results everywhere else it’s been attempted.
A fine point: at roughly $50 billion in outstanding bonds, life insurers top the list of eligible targets for ECB purchases. Just so we understand each other, ECB President Mario Draghi envisions buying non-financial corporate bonds in the sector most damaged by the policies he’s deployed since vowing to do whatever it takes to reignite inflation via record low interest rates. Recall that low interest rates are the bane of insurance companies that depend on reasonably high interest rates to make good on the long-term promises they’ve made to those who pay stiff premiums in exchange for those promises.”
Ok, you get the picture. Debt is a mess pretty much everywhere.
What Henry Hazlitt Can Teach Us About Inflation in 2014, by James Grant
“The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups.” (Henry Hazlitt)
I mentioned Henry Hazlitt in a June 2014 On My Radar.
Here are several highlights from the piece:
- “In 1946, as now, the government held up the threat of deflation to justify a policy of ultra-low low interest rates and easy money. Now ladies, and gentlemen, I have devoted thirty-one years of my life to writing about interest rates, and I have to tell you that I can’t see them anymore. They’re tiny. And so they were in 1946. Then, as now, the Fed had been conscripted into the government’s financial service. Just as it does today, the central bank pushed money-market interest rates virtually to zero and longer-dated Treasury securities to less than 3 percent. Just as it does today, the Fed had its thumb on the scales of finance.”
- “If interest rates were artificially low, it would follow that prevailing investment values are artificially high. I contend that they are, and you may or may not agree. But you must allow the observation that we live in a kind of valuation hall of mirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates would be in the absence of central-bank manipulation. Natural interest rates — free-range, organic and sustainable — are what we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones we have.”
- “When interest rates are kept arbitrarily low by government policy, the effect must be inflationary,” he wrote. “In the first place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is the rate that would be established if the supply and demand for real capital were in equilibrium. The actual money interest rate can only be kept below the natural rate by pumping new money into the economic system. This new money and new credit add to the apparent supply of new capital just as the judicious addition of water add to the apparent supply of real milk.”
- Hazlitt concluded that “the money rate of interest can be kept below the real rate of interest only as long as the supply of new money exceeds the supply of new real capital. Excessively low interest rates are inflationary in the second place because they give an excessive stimulation to the volume of borrowing.”
- “Why, I could quote those perfectly formed sentences in Grant’s today (and I believe I just might). They’re as timely now as they were during the administration of Harry S. Truman. The effective federal funds rate has been zero for well-nigh six years.”
Well-nigh almost eight years now…
- Click here for the full article.
Charts That Matter: Forward 10-year Annualized Return 3-4% for Equities
- Household Equity Percentage vs. Subsequent Rolling 10-Year S&P 500 Index TR
Early each month, I share with you the most recent median P/E data. You can see the early March post on valuations here.
This next chart too is amazingly accurate in assessing the probable returns to come over the next ten years. It looks at the percentage of household equity ownership. Think of it this way, when investors are heavily committed in their portfolios to equities, much of the buying power (that may drive equity prices higher) is already in the game. The blue line measures the equity percentage and the dotted line shows what the annualized return was ten years later. The red circle shows the extremely high equity exposure in 2000 and the dotted line within the circle shows what the actual annualized return turned out to be.
The green circles and the green arrows show when equity ownership was low and returns high. The yellow rectangle shows where we are in terms of equity ownership most recently and tells us to expect 3.75% annualized returns over the coming ten years.
Note how closely the actual returns, the dotted line, tracks the percentage ownership line with a high 0.93 correlation.
- BofA Merrill Lynch Global Liquidity Tracker (red line):
3. Earnings rolling over?
Recessions are highlighted in gray. A richly-priced equity market and declining earnings do not mix well. Risk is high.
- Core CPI
Strength in Core CPI Inflation (green line in next chart) – remember that the Fed is targeting inflation at 2% (CPI is at 1%). Note the high correlation between the two lines.
Core CPI: Nothing to worry about just yet, but let’s keep a close eye on this.
- Money Velocity
Note – at all-time lows. This should cause concern.
6. The Shrinking Middle Class
Hazlitt suggests that, “the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”
Here is a link to Henry Hazlitt’s book, Economics in ONE Lesson. An oldie buy a goodie.
Trade Signals – “Aged”: The Average Bull Market Lasts 59 Months, This One is Now 84 Months Old
Equity Trade Signals:
- CMG Ned Davis Research (NDR) Large Cap Momentum Index: Sell Signal – Bearish for Equities
- Long-term Trend (13/34-Week EMA) on the S&P 500® Index: Sell Signal – Bearish for Equities
- Volume Demand is greater than Volume Supply: Sell Signal – Bearish for Equities
- NDR Big Mo: See note below (active signal: buy signal on 3-4-16 at 1999.99).
Investor Sentiment Indicators:
- NDR Crowd Sentiment Poll: Neutral reading (short-term Bullish for Equities)
- Daily Trading Sentiment Composite: Neutral reading (short-term Neutral for Equities)
Fixed Income Trade Signals:
- Zweig Bond Model: Buy Signal
- High-Yield Model: Buy Signal
- Don’t Fight the Tape or the Fed: Indicator Reading = +1 (Bullish for Equities)
- Global Recession Watch Indicator – High Global Recession Risk
- U.S. Recession Watch Indicator – Low U.S. Recession Risk
(S&P 500® Index monthly declines of -4.8% or greater below its five-month smoothing (MA) signaled recession 79% of the time: 1948 – Present). Data is updated each month end.)
- 13-week vs. 34-week exponential moving average: Buy Signal – Bullish for Gold
Tactical — CMG Opportunistic All Asset Strategy (update):
- Relative Strength Leadership Trends: We are seeing relative strength in International Equities and several Emerging Markets. Utilities, Gold and Telecom continue to show strong relative strength. Fixed Income has held top ranking in a number of our models over the last number of months; however, we are seeing a shift towards sector-oriented funds/ETFs, equities in general and International Equity exposure.
We in the Blumenthal home love soccer. Most Saturday mornings, Susan makes the coffee and asks me to see what European soccer games are on TV. The boys wake up later and usually join us. She continues to coach and all of our kids enjoy the game. Life is great.
Our Philadelphia Union plays its home opener this Sunday afternoon. Excitement has been building at the dinner table, talk of new players and of course we are hoping for a successful year. Chickie’s and Pete’s chicken fingers or a Philly cheesesteak, crab fries and a cold Victory Hop Devil beer awaits. Don’t tell my doctor. Hoping I’m not overlooking “secondary consequences”.
Wishing a fun filled weekend to you and your beautiful family!
I’ll be writing from San Francisco next week. Several meetings and some free time in the city. Meetings in Denver on March 27-31 and on to NYC April 6 for several media interviews. Trips to Chicago and Dallas follow in May.
Have a great weekend.
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With kind regards,
Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.