CMG AdvisorCentral

Tactical investing news, views and resources for financial advisors

Animal Spirits and the “Fear Gauge”

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In Friday’s On My Radar, Steve Blumenthal wrote, “Last Monday, the VIX broke below 10 to close at 9.77, the lowest level in more than a decade.  There are only three other days the index has closed at lower levels, all of them in December 1993.  Investors are complacent to risk.  They shouldn’t be.”

Investment consulting firm 720Global also recently wrote about market volatility in The Unseen, “Volatility: A Misleading Measure of Risk.”

As investors, we are negligent if we follow the Fed’s lead into this complacent stupor. By prodding economic growth with unproductive debt and reigniting asset bubbles, the central banks have simply done more of what created the spasms of 2008 in the first place. Despite the markets calm façade and historically low perception of risk, the vast chasm that lies between perceived risk and reality is troublesome.

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Fed Leaves Interest Rates Unchanged; Expresses Confidence in Economy

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Following a two-day meeting of the policy-making Federal Open Market Committee (FOMC), the Federal Reserve held current interest rates steady, but the central bank is likely to raise rates in the coming months (possibly in mid-June).  Fed officials are not worried about the slow pace of growth during the first quarter of 2017.  (U.S. GDP grew at an annualized rate of 0.7 percent.)  The Fed said the slowdown was “likely to be transitory.”

“Inflation measured on a 12-month basis recently has been running close to the committee’s 2 percent longer-run objective,” the Fed said.  Household spending rose “only modestly” but the fundamentals underpinning consumption growth “remained solid.”

Declines in the unemployment rate has been the primary driver behind the Fed’s recent rate increases.  The unemployment rate fell to 4.5 percent in March, the lowest level since 2007.  (The Labor Department will release the April jobs report on Friday.)

Charts of the Week

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I personally believe that recessions can be forecast in advance.  While no indicator is perfect, there are a few processes that have had a high correct signal rate in the past.

The reason that getting in front of recession is important is that it is during recessions that all the bad corrections tend to happen.  Bad as in -40% bad.

The other problem with recessions is that they are only known in hindsight.  It takes two quarters of negative GDP growth for the chief recession czars at the National Bureau of Economic Research to tell us when the recession actually started.

Following are three of my favorite leading “recession watch” indicator charts:

Chart 1: The Economy (no current sign of recession)

Here is how you read this chart:

  • Believe it or not, the stock market is a great leading indicator for the economy. It tends to turn down in advance of recession.
  • This process (bottom section of the chart) plots the S&P 500 Index (red line) and also a five-month smoothed moving average of the S&P 500.
  • The smoothed dotted line (green in lower section) represents the trend of the market’s prices.
  • When the red line (S&P 500 Index) drops below its smoothed moving average trend line (dotted green line) by 4.8% or more, a recession signal is generated.
  • When the red line rises above the dotted green line by 3.6% or more, a bullish signal is triggered for the economy.
  • The down arrows are the recession signals, up arrows are the expansion signals.
  • The gray vertical shaded lines mark the beginning and end of all the recessions since 1948.
  • In total, 79% of the signals have been correct though some have been a little early or just a little late. There were a few false signals but they didn’t keep you offsides for long.  All in all, in my opinion, pretty darn good.

0317.00

Chart 2: The Economy vs. the Employment Trends Index

Here is how you read the chart:

  • 100% correct signals
  • Down arrow – recession signal is generated when the Employment Trends Index drops by 4.8% from the most recent high watermark.
  • Up arrow – expansion signal is generated when the Employment Trends Index rises from its most recent low watermark by just 0.4%.
  • Data 1979 through 2/28/2017

0317.01

Chart 3: Global Recession Probability Model

Here is how you read the chart:

  • High global recession probability when the blue line is above the dotted red line.
  • Low global recession probability when the blue line is below the dotted green line (like today).
  • The box at the bottom right shows what happened. When above the dotted red line (the 70 level on the chart), recession occurred 81.46% of the time.  54% of the time (including the most recent high recession risk reading in 2016), a recession did not occur.  This is a probability game, folks… but pretty good accurate history.

0317.06

Conclusion: Low current risk of a U.S. recession.  Low current risk of a global recession.

Charts of the Week

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This week we offer several charts concerning inflation, interest rates, U.S. economic recoveries, equity market performance and equity mutual fund flows.

This chart plots U.S. economic recoveries.  Note the blue line.  Debt’s a major drag:

0224-04

Source: Crestmont Research

Keep an eye on inflation (rising):

0224-05

Year-over-year change in CPI – look at the January numbers in the far right of the chart. The most recent BLS – Bureau of Labor Statistics Annualized Inflation Rate year-over-year equals 2.5%.  The Fed’s target has been reached:

0224-06

Source: Advisor Perspectives

And if you were wondering what inflation looks like by category:

0224-07

Source: dshort.com

0224-08

Source: dshort.com

Here is the current probability of a Fed March interest rate hike:

0224-09

Switching to equities, Ned Davis Research has something they call “Top Watch Indicators”… meaning indicators that help them spot a probable market top.

Here’s how you view the next chart:

  • When the green bars in the lower section rise above the horizontal dotted line (50), a market top is indicated.
  • The vertical dotted lines and shaded area indicates the times that more than 50% of their top watch indicators signaled a market top.
  • Percentage declines are indicated.
  • Green bar on the far right shows where we are as of 2-14-17.

0224-10

Source: Ned Davis Research

Chalk one little dot up for the active fund managers.  All the money has been flowing into passive index funds and ETFs:

0224-11

And all that money that chased into “high dividend papers?”  In a few short months, they’ve given up six years of excess returns.  I continue to be cautious on high dividend stocks due to over popularity, low interest rates and the risk of rising rates.

0224-12

Diversification has been under pressure the last few years.  The average university endowment lost 1.90% in 2016.  However, it is best viewed over the long term and designed to achieve a certain return relative to an acceptable amount of risk.  100% allocation to stocks is for a different investor risk profile.  Not wise to compare one asset class to a diversified investment plan.  With that said, in case you were wondering… this is how the 10 richest universities invested their money in 2016:0224-13

A Look at U.S. Domestic Debt

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Total Credit Market Debt in the U.S. is 352.4% of GDP.  Post the peak in 2008 at north of 380%, this chart shows deleveraging has begun.

Recall the Reinhart/Rogoff study that debt greater than 90% of GDP slows growth.  We’ve certainly witnessed slow growth in the 2% range for the last 16 years.  Debt’s a drag on growth.

0210-06

Source: Ned Davis Research

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2017 Predictions

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I hate making predictions.

I got the tech wreck and sub-prime right, but was far too early on those predictions.  Importantly, the predictions below could most certainly be wrong.  We live in a highly complex world.  We can measure instability, we can score up risk but we can’t precisely know timing.The clear risk to me today is in the bond market.

  • U.S. stocks will remain in an uptrend fueled by a strong dollar.
  • Tax cuts, infrastructure spending and $2 trillion in tax repatriation will drive capital flows to the U.S.
  • The European sovereign debt crisis will be the first major crack to crack. Unmanageable debt in Portugal, Italy, Greece and Spain.  Include France and Germany in their dysfunctional union.  Confidence in government/political leadership is lost.
  • The European banks sit on the fault line. Watch the banks.  Hope so… Not so sure.
  • The smart money races out of EU banks to U.S. dollars and U.S. assets.
  • In China, debt too is the major concern. Ghost cities lacking rental income will prove unable to support the structured debt that financed the construction.  Defaults mount.
  • Drastic measures are put in place to prevent the flow out capital to the U.S.
  • Gates, tariffs, currency wars escalate – trade wars escalate.
  • Loss of confidence in government here, there and most everywhere.
  • Global and U.S. inflation become a major concern as global growth remains well below the average of the last six post-recession expansions.  Click here for a great chart.
  • Stagflation returns. Low growth/high inflation.  Interest rates move higher with the 10-year touching 3% this year and 6% within a few short years.
  • The great bond bull market is over. Bond investors lose money.
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Sprechen sie risk?

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2000px-ghs-pictogram-exclam-svgNaturally, because there’s a presidential election this year, every news cycle is very noisy.  It’s critical, however, that we maintain our focus on monitoring and assessing important financial news and managing potential risk.  Such is the case regarding the financial condition of Deutsche Bank (DB).  DB is one of the largest financial institutions on the planet.  And, right now, it may be one of today’s great systemic risks.  Think Bear Stearns, Lehman Brothers…

Due to super-sized leverage (like gigantic beer steins at Oktoberfest) and significant counterparty risk, a stumble at DB will ripple through the world’s financial system and would cause great harm.  Read more in this week’s On My Radar.

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Brexit – Italian Banks

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CMG Capital Management Group Market AnalysisLet’s take a quick look at Brexit-related news this week.  Think in terms of contagion.  We are at the beginning of the Brexit-related issues and not the end.  My personal view is that the single largest systemic risk we face is a sovereign debt crisis stemming from Europe.  But it could come from China or Japan or the EM.  Debt is the common denominator.  The globe is facing a long-term debt deleveraging cycle few of us alive have witnessed.

The debt problems are above the 90% debt-to-GDP level in most of the developed world.  We’ll get through this somehow, but as Yoda might say, “think differently we must.”

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Global Deflation Alert

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By Steve Blumenthal, CEO, CMG Capital Management Group

Deflation alertI highlighted three valuation measures earlier this month Click Here: one based on reported earnings through 12-31-2014, one based on operating revenue, and Warren Buffett’s favorite valuation indicator Stock Market Capitalization as a Percentage of Gross Domestic Income.  The market is expensively priced.  The problem is that when valuations are high, the probable forward returns are low.  This doesn’t mean the U.S. equity market can’t go higher from here; but it does mean that risk is much higher.

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