June 17, 2016
By Steve Blumenthal

“Everyone focuses on the Fed’s balance sheet – the $3 trillion dollars and the problems that creates.  Don’t forget there is another balance sheet – that’s the balance sheet of us in the market that sold them the bonds and were forced into the risk assets that they’re so desperate to have us in.  We have been forced into securities at subsidized prices.  And when those subsidies are removed, those prices will adjust and they will do so immediately and they will do it on no volume…  I predict from the beginning to the exit, the wealth effect of QE will have been negative.”

-Stanley Druckenmiller, CNBC 2013
(Note: The Fed balance sheet today is over $5 trillion. Yikes!)

“Raise the floor on interest rates to two percent and vow to never again breach that raised floor.”

-Danielle DiMartino Booth

Nearly halfway through 2016, most of the issues we faced at the beginning of the year remain today.  With little overall market movement, the two most popular averages, the S&P 500 and DJIA, are little changed on the year – both up a small yet positive 1.5%.

The S&P 500 is lower than it was in December 2014.  Perhaps not so coincidently, the Fed ended QE3 in October 2014.

At the same time, the global central banks continue to message, we’ve got your back, yet there are signs our collective faith in their power is waning.

I would feel much more at ease if valuations were reasonable.  Unfortunately, they are not.  At the end of May 2016, median price-to-earnings ratio (P/E) stood at 23.23.  This compares to a 52.3 year average of 16.9.  The median P/E was 22.0 on December 31, 2015 and it was 11.0 at the last crisis low in 2009.  Here is a look once again at a few select periods in time.  Buy low, sell high you say?  Have a look at some evidence.


So let’s handicap the trading range this way.  Fair value puts the S&P 500 Index at 1526.59.  Undervalued (as measured by a one standard deviation move below fair value) puts the downside risk at 1061.03.  Overvalued (a one standard deviation move above fair value) puts the upside target at 1991.21.  We are trading near 2075 at the time of this writing.

Trading range:

Upside overvalued target: 1991.21
Fair Value: 1526.50
June 16, 2016 close: 2078 (4.4% above fair value)

The macro issues remain large (debt, deflation and aging demographics).  Much of the developed world is in recession though not yet here in the U.S.  Recessions matter to our collective wealth.  That is typically when the large market dislocations occur and I believe one is nearing (2017 or sooner).  So we stand watch.

Keep your eye on these six key recession points:

  1. Global trade has gone negative – that has never happened without a recession.
  2. The year-over-year change in Wall Street consensus 12-month earnings forecasts goes negative. When this happened in the past, a recession always occurred.  It went negative at December 2015 quarter-end.
  3. Copper is signaling the global economy is in trouble.
  4. We have now had six consecutive quarters in earnings decline (year-over-year) – signaling recession.
  5. In the “not yet but we must watch closely” category: Recession occurs when the S&P 500 falls below its five-month smoothed moving average line by -4.8%.  Since 1950, that measure has predicted 9 of the 11 recessions at or near the recession’s start.
  6. In the “not yet but we must watch closely” category: A negative yield curve has always signaled recession.

Risk is high and I believe we should be thinking a lot more about wealth preservation and a lot less about stretching for that extra base.  Can the market trend higher?  Sure.  But at some point, investors are going to have that very difficult argument with reality.  Let’s not be one of them.

My son Matthew was asking me about the economy.  He’ll be interning at CMG this summer and I have to say it is so much fun having kids that ask really great questions about the economy and the markets.  Entering the program, we have our interns read Ray Dalio’s 300-page letter on How the Economic Machine Works.  Google it.  It’s great!  Share it with everyone you know.  Matt is reading it now.

Try explaining to your teenager how the economic machine works, the role of the Fed, the meaning of Brexit (and related risks), global capital flows, what trillion means and how the various players in the game (you, me, institutions, politicians, central bankers, hedge funds, advisors, etc.) are going to behave.  Or start with what is an ETF.  A bit of a foreign language.  So imagine how most of our clients must feel.  Confusing stuff.

I’ve been doing a lot of writing about the Fed recently.  In short, we are in an environment where it really is, “All ‘bout that Fed” and the global central bankers.  But that will last until confidence is lost and, to that end, cracks are beginning to appear.

Over the last few weeks I’ve shared my conference notes with you.  Click here for my summary of former Dallas Fed President Richard Fisher’s presentation.  I walked away from my close interactions with Fisher and his analyst of many years, Danielle DiMartino Booth, a bit numb.  Yes, I think numb is the right word.  It was a peek behind the great Fed curtain with many beliefs confirmed.

“Unfortunately for the global economy, the inmates running the central banks’ insane asylums don’t get it.”   

A reader sent me his market commentary this week and I shared it with Matt.  I told him we’ll look back one day and say that the Fed was calling their plays from the wrong play book.  Here is what I mean… as expressed exceptionally well in Jeffrey Miller’s letter… read on:

“There is a mountain of overvalued debt in the world and folks are beginning to wonder how long it can exist before it washes out to sea.  About $8 trillion in debt around the world is currently trading at a negative interest rate, implying that the holders of this debt expect deflation for the foreseeable future.  Smart, rational investors around the world are bemoaning the stupidity of this situation in increasing numbers, but central bankers push onward with their quest to drive rates even lower, in the hope (wrongly) that lower rates will spur lending by banks and investing by companies.

Yes, you read that right – the geniuses in Brussels think that lower rates will make banks want to lend more.  Why?  Because that’s what their broken models tell them. Don’t believe me?  Watch this video on the inner workings of the ECB’s bond buying operations.  Skip ahead to the 2:30 mark for the explanation of why they are doing it, but be sure you’re alone, because if you think about what he says, you’re going to want to scream.  If you want to understand the crazy distortions in bond markets today, take 3½ minutes to check it out.

These economists all follow the Keynesian theory that we have a consumption problem – i.e., that consumers aren’t buying enough stuff to create scarcity and drive up inflation to their preferred target.  For some

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