“Not In our lifetimes” A quick trip down memory lane And Much More

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“Would I say there will never, ever be another financial crisis?
You know probably that would be going too far.  But I do think we’re much safer and
I hope that it will not be in our lifetimes, and I don’t believe it will be.”

– Janet Yellen, Federal Reserve Chair on June 27, 2017

“… and I don’t believe it will be.”  Hubris?  You might recall another point in time.

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PE Exit Multiples Have Stayed Steady At Elevated Level

Badgered by lawmakers, former Federal Reserve Chairman Alan Greenspan denied the nation’s economic crisis was his fault on Thursday but conceded the meltdown had revealed a flaw in a lifetime of economic thinking and left him in a “state of shocked disbelief.” (Source: NBC News 2010.)

To a large extent, the U.S. financial crisis was actually made by the Fed… It was ultra-low rates that fueled the search for higher yield that enabled creatively engineered mortgage products (CDOs, CDOs of CDOs, adjustable rate and no-doc mortgages and AAA-rated garbage).  Low interest rates enabled greater affordability.  Investors were hungry for whatever they could find that paid a higher yield.  Wall Street engineered the mortgage pools’ greater liquidity.  More investors, more mortgages, more home buyers, higher prices.  It was great until it wasn’t.

Greenspan later said no one saw the crisis coming.  Both he and his 2006 successor, Ben Bernanke, would remind us frequently “there is no bubble in the housing market.”  How could they have been so wrong?

Grab a beer and have some fun with me.  Here is a quick trip down memory lane:

  • June 2005 — “We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”
  • October 2005 — “House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.”
  • November 2005 — “With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly.”
  • February 2006 — “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”
  • February 2007 — “Despite the ongoing adjustments in the housing sector, overall economic prospects for households remain good. Household finances appear generally solid, and delinquency rates on most types of consumer loans and residential mortgages remain low.”
  • March 2007 — “At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.”
  • May 2007 — “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.  The vast majority of mortgages, including even subprime mortgages, continue to perform well.”
  • October 2007 — “It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.”
  • January 2008 (two months before Fannie Mae and Freddie Mac collapsed and were nationalized) — “They will make it through the storm.”
  • January 2008 — “The Federal Reserve is not currently forecasting a recession.”

We now know that recession officially started in December 2007.  In the face of all that noise, what were you to believe?  I wrote back then, “This is going to end badly.”  Readers thought I was nuts.  At times I thought I was nuts.  The markets kept moving higher.  Until they didn’t.  It turned out to be far worse than I expected.

Today, ultra-low interest rates have sent investors on a search for yield.  Many have piled into junk bonds and real estate investment trusts and all kinds of risky assets.  All of that money has allowed lowly-rated companies access to easy funding and at terms that give investors little protection.  Really junk… junk.  Like sub-prime before, it too will get its clock cleaned.

Greenspan later said that a market crisis was inevitable.  “If it weren’t the subprime crisis it would have been something else,” he said.  That is because an era was ending that had seen “disinflationary forces” from developing countries such as China and a “protracted period” in which there was an “underpricing of risk.”

Reflecting on Yellen’s comment last week, “But I do think we’re much safer and I hope that it will not be in our lifetimes, and I don’t believe it will be.”  As Greenspan did before her, I believe she’ll recant those words within two years.

It is with this thinking that I point you to an exceptional piece entitled, Central Banks to Investors: “I know nothing! I see nothing! I hear nothing!,” by ex-Fed insider Danielle DiMartino Booth.


In her missive, Danielle cleverly writes about “Hogan’s Heroes” and Sergeant Schultz (pictured above) and Janet Yellen and she appropriately reminds us and her ex-friends at the Fed about debt.  “I see nothing?” (Insert the word “debt”).  “I see nothing?” (Insert the word “hubris”).

My siblings and I watched every show.  Sgt. Schultz’s famous line rings in my ear.  Loved that show.  I hope it triggers as fun a memory for you as it does me.

So grab a coffee and jump in.  This week’s post is short.  Let’s take a quick look at the most recent valuations and see what they are telling us about coming 7-year and 12-year equity market returns.  Hint: Valuations sit at the second highest level in history.  Hint: As for returns, “I see nothing” as in negative for 7-years and near 0% annualized for 12-years.  Margin debt sits at an all-time high.  Expect some bumps.

It is important to add into the current equation that all the major central banks took steps toward reducing monetary accommodation this month.  Every single recession in the last 100 years has been preceded by a Fed interest rate tightening cycle.  Today, you’ll also find several of my favorite recession indicator charts.  The good news is that there is no sign of recession within the next six months.

Side note – I frequently tweet out links to articles I find important, like Danielle’s this past week, and hope you do too. You can follow me on Twitter @SBlumenthalCMG.

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Included in this week’s On My Radar:

  • Valuations and Coming 7- and 12-Year Equity Market Returns
  • Margin Debt is at a Record High
  • A Quick Look at the Recession Indicators – No Signs Yet
  • Trade Signals — Trend Signals Remain Bullish on Both Equities and Fixed Income
  • Personal Note

Valuations and Coming 7- and 12-Year Equity Market Returns

Chart 1: Here is a summary of the four market valuation indicators we update on a monthly basis.

  • The Crestmont Research P/E Ratio (more).
  • The Cyclical P/E Ratio using the trailing 10-year earnings as the divisor (more).
  • The Q Ratio, which is the total price of the market divided by its replacement cost (more).
  • The relationship of the S&P Composite price to a regression trend-line (more).

Note in the chart that three of the four measures sit at their second highest most overvalued level in history.  Second only to the high in March 2000.


Source: Advisor Perspectives

Chart 2: Average of the Four Indicators

The next chart gives a simplified summary of valuations by plotting the average of the four arithmetic series (the first chart above) along with the standard deviations above and below the mean.

At the end of last month, the average of the four is 86% — unchanged from the previous month and at the interim peak.


Source: Advisor Perspectives

Chart 3: Price-to-Sales

Second highest level in history.  Nearing 2000 peak (red line)


Chart 4: Median P/E is high at 24.08

Here is how you read the chart:

  • Note the red circle.
  • By this measure, the market is 9.9% above what is considered an “overvalued” market level.
  • Fair value is based on the 53.3 year median P/E of 16.5.
  • If the market corrected back to “fair value,” it would take a 31.5% drop to get there.
  • Overtime, markets tend to move from overvalued states to undervalued states as you can see when looking at the red line in the middle section.
  • Undervalued, or when the “hamburgers are really cheap” and you can buy a lot for your money, by this chart’s measure puts the S&P 500 Index at 1134.54 or 53.2% lower than the current level.


Chart 5: Stock Market Cap as a Percentage of GDP

This is Warren Buffett’s reportedly favorite valuation indicator.  Here too, current reading is the second most overvalued level in history.


Chart 6: A Lot of Red Everywhere

A dashboard-like look at a number of the most popular valuation metrics:


Keep in mind that valuations tell us very little about market tops or bottoms, but they do tell us a great deal about probable coming returns.

Here are two charts that speak to what 7-year and 12-year annualized returns are likely to be:

Chart 1: GMO 7-Year Asset Class Real Return Forecasts (May 31, 2017)


Source: www.gmo.com

Chart 2: Hussman Strategic Advisors 12-year Annualized Forecast

Here is how you read the chart:

  • The chart below illustrates this using the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), which we find better correlated with actual subsequent S&P 500 total returns than any other indicator.
  • Market Cap/GVA is shown in blue on an inverted log scale.
  • The red line shows actual S&P 500 12-year average annual nominal total returns.
  • Presently, we associate current valuations with prospective S&P 500 12-year returns of roughly zero, coupled with the likelihood of a 50-60% interim market loss.


Source: Hussman Funds

Not bad news, just simply “it is what it is” news.  No need to get run over on the way to those cheap hamburgers.  Participate and protect.  More defense than offense. Goal is to be in a position to buy when you get a lot more for your money.

Long-time readers know that I am a big fan of Ned Davis Research.  I’ve been a client for years and value their service.  If you’re interested in learning more about NDR, please call John P. Kornack Jr., Institutional Sales Manager, at (617) 279-4876.  John’s email address is [email protected].  I am not compensated in any way by NDR.  I’m just a fan of their work.

Margin Debt

Just one chart – margin debt is at record highs (by a mile)

Here is how you read the chart:

  • Red arrow marks current level of margin debt.
  • Green arrow shows how margin debt got washed out in last two recessions – unwind of risk and panic selling (forced selling via margin calls, etc.)
  • Red circles show levels of margin debt at prior bull market peaks.
  • Conclusion: Risk is significantly elevated. The market is leveraged up.


Source: Advisor Perspectives

No Sign of Recession — A Few Great Indicators

We should keep our eye on coming recession because in recession is when all the bad stuff happens to the stock market.  The average stock market decline is approximately 38%.  Given the total global debt issues (and how debt chokes growth), record high margin debt and near 36% of investor money positioned into passive index funds and ETFs risk is substantially elevated today.

My concern is that with 75% of the investable assets in the hands of pre-retirees and retirees (by 2020 according to Blackrock), those investors can’t afford to take the next 38% hit.  And I believe we are looking at a probable -50% to -70%.  So we keep watch on coming recession and have a game plan in place to protect.

Chart 1: HY Bond Yields vs. the 10-year Treasury Note Yield

This first chart plots the spread between the yield on the Barclays HY Corporate bond index vs. the 10-year Treasury.  The reason we look at it is that this spread has been a decent leading indicator of the economy since 1984.

Here is how to read the chart:

  • Recessions are shared in gray.
  • Red is the difference between HY and 10-year Treasury yields.
  • When the red line is rising, high yield bond yields are falling relative to Treasuries. Indicating a better economy… Note the current rising red line.
  • When the red line is falling, yields on HY bond yields are going up much faster than 10-year Treasury yields, indicating a worsening economy.
  • Conclusion – there is no current sign of recession.


Chart 2: The Stock Market is a Good Leading Economic Indicator

This chart is one of my favorites.

Here is how to read this next chart:

  • Recession signals (down arrows in the chart) are generated when the stock market declines by 4.8% below its five-month smoothed moving price average.
  • Expansion signals (up arrows in the chart) are generated when the stock market rises by 3.6% above its five-month smoothed moving price average.
  • The green dotted line is the five-month smoothed moving average. The red line is the price line of the S&P 500.
  • The stats are posted in the upper left-hand side of the chart. Note the 79% correct signals.  Also note the timing of the down arrows.  Not perfect but pretty darn good.  Thus, I keep watch.
  • Conclusion: No current sign of recession.


Chart 3: Employment Trends

Here is how you read the chart:

  • When the labor market is improving, there is lower risk of recession.
  • When the labor market is weakening, there is higher risk of recession.
  • Note the red circles that show the transition to weakening and note the timing just before prior recessions (gray vertical shaded lines).
  • There was one false signal in 2004.
  • Current signal: No current sign of recession.


Chart 4: Employment Trends Data – Recession Signal Version

Here’s how you read the chart:

  • Expansion signals are generated when the employment trends index rises by 0.4% (up arrows).
  • Contraction signals are generated when the employment trends index falls by 4.8% (down arrows).
  • Note the down arrows and the shaded areas that represent past recessions. Most signals just prior to or early into recession.
  • Correct signals: 100%


Chart 5: Philly Fed General Business Activity Index vs. Real GDP Growth

Here is how to read this next chart:

  • Look how closely Real GDP Growth has tracked the Philly Fed General Business Activity Index.
  • This chart says Real GDP Growth should move higher.
  • Because of the debt and demographics headwind we are facing, I don’t see 4% Real GDP Growth in our near future by moderate growth for the economy looks to remain probable.
  • Conclusion: No current sign of recession.


Chart 6: Some concern can be seen in the Citi Economic Surprise Index

Here is how to read the chart:

  • The chart measures how much data in the last three months is beating or missing median estimates in Bloomberg surveys.
  • Current signal is located in the table at the bottom right-hand side. When the reading is below -16, the S&P 500 Index gain per annum performance is -1.03%.
  • It is telling us to expect very little to no gain from the S&P 500 Index in the period immediately ahead.


Chart 7: Inverted Yield Curve

One of the best predictors of recession has been the spread between the two-year Treasury yield and the 10-year Treasury yield.  An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It typically only happens with Treasury note yields. That’s when yields on one-month, six-month or one-year Treasury bills are higher than yields on 10-year or 30-year Treasury bonds.

An inverted yield curve simply means that investors have little confidence in the economy.  As was the case in 2000 and 2006 (last inversions), this next time too will prove challenging, but perhaps more so.  The next recession starts with our national debt over $20 trillion dollars and the Fed’s balance sheet at $4.5 trillion.  When the yield curve inverts, expect similar challenges in both the markets and the economy (markets are leading indicators so expect the economy to turn down after the markets).

A New York Fed paper found that:

  • The three-month rate is best represented by the secondary market rate, expressed on a bond-equivalent basis to match the ten-year rate.
  • The ten-year constant maturity rate produces good results.
  • Levels of the spread are more informative than changes.

Current three-month Treasury yield: 1.03%
Current two-year Treasury yield:  1.39%
Current 10-year Treasury yield: 2.35%

Conclusion: No inverted yield curve.  No immediate sign of recession.

The bigger challenge this time is that the yield curve will invert from a much lower starting point than at any other time in our history and this time it will occur with the Fed and Treasury’s balance sheets already severely impaired.

Participate and protect.  Let trend following help you.  See Trade Signals below.  If you were prepared for the -50% corrections in 2000-2002 and -50% correction in 2007-2009, then you were put in a position to take advantage of the buying opportunity.  I believe another will soon come our way.

Overall, let’s keep watch but no current signs of recession. The labor market points to moderately faster growth in the second half of this year.  We’ll keep an eye on the charts as well as the potential debt limit standoff in the fall, increased economic policy uncertainty, and geopolitical events.

One last chart – China’s yields have just inverted.  A recession there is likely in the near future.  They’ve been a global engine for growth.  Stay tuned.


Trade Signals — Trend Signals Remain Bullish on Both Equities and Fixed Income

S&P 500 Index — 2,427 (7-5-2017)

Notable this week:

The longer-term bullish equity market trend remains intact.  On June 13, 2017, the Ned Davis Research CMG U.S. Large Cap Long/Flat Index suggested an 80% exposure to the S&P 500 Index, down from 100% exposure.  As you’ll see in this week’s NDR CMG U.S. Large Cap Long/Flat Index chart below, the trend is weakening.  Thus, the slight reduction in exposure.

You’ll also see in the chart the bad stuff tends to happen when the Index’s equity line drops below 50.  It is at a relatively strong 68.1 today (scale of 0 to 100).  Don’t Fight the Tape or the Fed remains a strong +1 reading.  Buying demand continues to outpace selling pressure as measured by more up volume than down volume.  More buyers than sellers, as they say.

In short, the data continues to support the equity bull market.  This despite my aged, overvalued, over-leveraged, high debt, shifting Fed policy…risk concerns.

Click here for the charts and explanations.

Personal Note

With great disappointment, I’m passing on a good friend’s post-wedding celebration this weekend.  It would involve a trip to Texas and Susan isn’t ready for the travel.  She is on the mend following recent total knee replacement surgery and with trips to Omaha, Dallas and Chicago in my immediate future I’m going to stick close to my girl.  I sure do have a much greater appreciation for the pain involved and the challenges in balancing the pain meds.

Susan’s a youth soccer coach and the surgery was timed between season-end and the start of the next.  She’s hitting the physical therapy hard with that goal in mind.  We’ve taken a few short walks the past week.  The doc says she won’t hate him anymore in a few short weeks.  If you or a loved one has gone through the process, I have a whole new appreciation for your journey.  As is most things in life, “the prize is worth the price.”  Susan is almost there.

Wishing you a wonderful weekend!

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