At which point do rising interest rates spark the fire? Rates are key to the equation of risk. In Friday’s On My Radar, Steve surveys what the current equity market valuations tell us about risk… and likely forward returns. Should you be playing more offense than defense or more defense than offense? Valuations can help.
READ MOREDebt and Demographics – Two Powerful Ds
From On My Radar (September 29, 2017):
The global economy continues to improve. Recession probability for the U.S. remains minimal in the next six to nine months. Europe’s economy is on better footing. Risks persist, including North Korea, a sharp slowdown in China, fiscal dysfunction in the U.S. (e.g., tax cuts, fiscal spend), and growing protectionist risks to global trade. Debt remains a significant headwind to growth as can be seen in this next chart.
Total Credit Market Debt-to-GDP
Here’s how to read the chart:
- The chart looks at a number of growth factors.
- For example, nominal GDP (before inflation is factored in) is lowest when Total Credit Market is above 318% Total Debt-to-GDP.
- The blue line tracks the Total Debt-to-GDP ratio over time.
- Note the upper dotted “high debt” line at 318%.
- The yellow highlights show the growth when in the high debt zone.
- Note how much better growth is when in the low debt zone. Also note that Total Debt-to-GDP peaked in late 2009 but remains high.
Source: Ned Davis Research
Also note the very last data box “Non-Financial Productivity.” Overall GDP growth comes from the total number of workers multiplied by their collective productivity. More workers producing more equals greater growth. With aging demographics (typically people moving into their lower spending years… they have a lot of stuff and kids out of the house) and fewer workers… you can see the pressure it can put on growth. And then with debt to be repaid, how much extra money is there to spend on things. Growth suffers.
Two Ds: Debt and Demographics are headwinds to growth. It is going to be hard for corporations to grow earnings much faster than GDP. Some will, of course, but in the aggregate, it’s a headwind and we are seeing it consistently in the low growth GDP stats. What we really need is Dedication, Determination, and Discipline. Let’s tell that to our representatives in Washington.
READ MORERecessions by Decades – Will This be the First Without One?
Take a look at the recession data in the next chart. Since 1930, there have been at least one or two recessions every decade. Three of the post-1930 decades had just one recession and five of the decades had two recessions. There have been zero recessions so far this current decade.
Will this be the first without recession? I doubt it very much. Often I share with you my favorite recession indicator signal charts. There is no current sign of recession within the next six months. I’ll keep you posted. Here are the recessions by decade chart:
Source: Crestmont Research
Let’s continue to keep our eye on leading recession indicators. The best is an inverted yield curve. The equity market is also a good leading indicator. No need to cover this today.
Monthly Valuation Update
Every month, Steve reviews several market valuation metrics in an effort to provide visibility into forward 7-, 10-, and 12-year returns. In this week’s On My Radar, Steve looks at Median P/E and also shares GMO’s 7-Year Asset Class Real Return Forecasts. It’s a must-read!
READ MORE“The S&P 500: Just Say No”
James Montier from GMO along with his colleague, Matt Kadnar, put out an excellent piece last week. They explained how GMO gets to the -4.2% annualized real return forecast for U.S. Large Cap stocks.
With everyone herding into passive index funds, James and Matt begin by addressing what you are probably hearing from your clients. “U.S. stocks have outperformed for the last number of years, so I see no reason why that should not continue.”
Yes, but not likely. Here is a look at their forward return estimates for various asset classes.
Click below to read more about GMO’s methodology and forward estimates for the S&P 500.
READ MORECharts of the Week
In Friday’s On My Radar, Steve posted his “Charts of the Week.” Be sure to click below to view charts regarding market volatility and the VIX, fund flows between passive and active managers, stocks of companies involved in robotics and artificial intelligence, probability of further interest rate increases and currency valuations.
Stay informed!
READ MORE“A Century of Evidence on Trend-Following Investing”
In recent years, there has been a proliferation of academic research that evidences the positive benefits of trend following. I’m a trend follower and have been since I founded my business in 1992. Maybe I was just optimistic when I started, but many years and a track record I’m proud of tells me it works. The reason is tied to our human behavioral tendencies. I’m not sure why but we humans seem to wash, rinse and repeat and in that is your and my opportunity.
AQR’s Brian Hurst, Yao Hua Ooi and Lasse Heje Pedersen authored a white paper in 2014, “A Century of Evidence on Trend-Following Investing.”
They concluded:
Trend-following investing has performed well in each decade over more than a century as far back as we can get reliable return data for several markets. Our analysis provides significant out-of-sample evidence across markets and asset classes beyond the substantial evidence already in literature. Further, we find that a trend-following strategy has performed relatively similarly across a variety of economic environments, and provided significant diversification benefits to a traditional allocation. This consistent long-term evidence suggests that trends are pervasive features of global markets.
Trend following is integral to our investment approach at CMG. Click below to read more about trend following and the research that demonstrates the validity of the approach.
READ MOREWhat does the latest Fed rate increase mean for stocks?
The Fed raised rates last week and bond yields sank lower. Many expected the opposite reaction. If you missed last summer’s mortgage refi opportunity, I believe you are going to get another chance. Interest rates appear to be heading back down towards their July 2016 lows.
And what are the implications of Fed policy on the U.S. stock market? Ned Davis Research’s Ed Clissold pointed out in a tweet late yesterday, “Today’s #FOMC decision is a reminder that even slow tightening cycles eventually impact the stock market. #fed @NDR_Research.”
The chart Ed shared in his tweet follows. Here is how to read it:
- NDR compares market gains during slow tightening cycles (black line in chart) vs. fast tightening cycles (red line in chart) vs. non tightening cycles (green line in chart), and more.
- It looks at what happened historically to the stock market in periods when the Fed was quickly raising rates vs. slowly raising rates – like the current cycle.
- The purple line is the current Fed tightening cycle that began in December 2015.
- Note how NDR breaks out % Gain During 1st Year and % Gain During 2nd Year. We now find ourselves in year 2. Purple line (right-hand side of chart).
- Year 1 gains averaged 10.8%
- Year 2 gains averaged -1.8%
- The green line shows non-cycles… markets do better when the Fed is lowering (easing), not raising (tightening), interest rates. “Don’t fight the Fed” as they say.
Animal Spirits and the “Fear Gauge”
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.
READ MORE“Risk On” — U.S. Equity Market Capital Flows
Notwithstanding historically high market valuations, market flows continue into U.S. equities, specifically (see the chart below) into Large Caps and Total Market.
In certain strategies, we remain “risk on” with an allocation to equities, however you have to find something that works for you. Something that you can have full conviction in… then stick to your process. For your core portfolio allocations, you could diversify to several global ETF trading strategies.
Broad diversification is key. On the other side of the next recession is the next great equity market opportunity. It is not today.
Read more in this week’s On My Radar.
ON MY RADAR