An Optimist Sees the Opportunity in Every Difficulty – CMG Capital Management

“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”
– Winston Churchill

Perhaps it is my early business roots that set my orientation towards a trading approach to the markets. Some of our clients take a longer-term approach, some a shorter-term approach. There is a place for both. Valuation and potential forward returns for equities (low today) help shape the tactical weightings. The key is understanding the correlation between the different sets of risk one uses to create a portfolio –Â i.e. “all the eggs in one basket” is not a good thing.

This weekly piece is about identifying the global macro risks, zeroing in on probable 10-year forward returns (low today) and identifying periods in time when risk management (hedging or raising cash) makes more or less sense to apply. Success depends on your ability to hedge and the mix of low correlating strategies held within your portfolio. No need to hedge when forward equity returns are greater than 10% to 15%. Today high valuations and high household equity ownership are signaling 2% to 3% annualized returns over the next 10 years.

Between today and the next great equity buying opportunity, I see three significant risks that are unavoidable:

• Sovereign Debt Crisis – It’s not about Greece (but France, Spain, Portugal, etc.).
• Emerging market dollar denominated debt crisis – The strong dollar is choking the borrowers.
• A coming pension crisis – Low yields are starving painfully underfunded plans.

Currently, the commodity market is signaling global deflation. China’s currency shot across the bow is a reaction to the global slowdown – it is telling us something. The currency wars, intended or unintended, are alive and real. Rinehart and Rogoff nailed it some years ago. Debt is a drag and the central banks’ “boo-boo” band-aids are not doing the trick.

We sit, we hope and we pray for Fed rescue.

A former adviser to Dallas Fed’s Dick Fisher, Danielle DiMartino Booth, speaking in a CNBC interview slams the Fed for “allowing the [market] tail to wag the [monetary policy] dog,” warning that “the Fed’s credibility itself is at stake … they have backed themselves into a very tight corne r… the tightest ever.”

Each nation, attempting to make itself more competitive to foreign consumers, devalues its currency. Global recession is afoot. If the Fed raises rates, it risks further rise in the dollar. It is stuck. Lick the finger, stick it in the air, and take the best guess.

To this end, St. Louis Fed Vice President Stephen Williamson is critical, “There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed — inflation and real economic activity.”

Recalling Greenspan saying, “There was a flaw in my ideology.” Watch this clip – you can’t make this stuff up. Temper our expectations we must.

In a white paper titled Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay (dissecting the U.S. central bank’s actions to stem the financial crisis in 2008 and 2009), Stephen Williamson finds fault with three key policy tenets:

• He believes the zero interest rates in place since 2008 that were designed to spark good inflation actually have resulted in just the opposite.
• He believes the “forward guidance” the Fed has used to communicate its intentions has instead been a muddle of broken vows that has served only to confuse investors.
• He asserts that quantitative easing, or the monthly debt purchases that swelled the central bank’s balance sheet past the $4.5 trillion mark, have, at best, a tenuous link to actual economic improvements.

Williamson added, “But as for spurring inflation, reducing employment or otherwise generating sustained economic activity, the results, particularly for QE, are “at best, mixed.” In addition to muted inflation, gross domestic product has yet to eclipse 2.5% for any calendar year during the recovery, while wage gains and, consequently, living standards, have been mired around 2% or less. There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed — inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation.”

In Williamson’s view, that’s a product of policymakers wed to the Taylor rule, which dictates the level of interest rates in regard to economic conditions. The thinking essentially is that low rates beget low inflation, trapping central banks in zero interest rate policies (or ZIRP).

“With the nominal interest rate at zero for a long period of time, inflation is low, and the central banker reasons that maintaining ZIRP will eventually increase the inflation rate. But this never happens and, as long as the central banker adheres to a sufficiently aggressive Taylor rule, ZIRP will continue forever and the central bank will fall short of its inflation target indefinitely,” Williamson said. “This idea seems to fit nicely with the recent observed behavior of the world’s central banks.” Source: CNBC

This week has been a bloody week for the bulls. I share some ideas today on what we can do in this overvalued, aged and over-leveraged equity bull market. Importantly – let’s see opportunity.

Included in this week’s On My Radar:

• Currency Wars – Understanding What is Happening
• Focus On Commodities
• Book Value – The Market Remains Overvalued
• Trade Signals – Temperatures Rising – Ramping Up The Risk Barometer

Currency Wars – China, the IMF and SDRs

This from my friend Jim Rickards: The Yellen playbook was revealed in a speech she gave in Providence, Rhode Island, on May 22, 2015. This was reported under headlines that read, “Yellen to Raise Rates This Year.”

But that’s not what she actually said. Her speech said three things:

1. She will raise rates if the economy acts in accordance with her forecast.
2. Her forecast is for 5% unemployment, 2.5% growth and 2.0% inflation.
3. She will not wait until she hits those targets. She will act a bit early if data is trending toward them.

In practical terms, this means that if we see, say, 5.2% unemployment, 2.3% growth and 1.8% inflation with momentum toward the 5%, 2.5%, 2% trifecta, then she will raise rates quickly. So there’s the model.

Recent unemployment has been at 5.3% the last several months. GDP growth for the first half of the year was approximately 1.5%. The Atlanta Fed GDP tracker is showing 1% growth for the third quarter as of early August. And inflation is moving lower not higher. The Fed’s preferred measure of inflation, personal consumption expenditures, is just 0.3% year over year. Well, below the Fed’s 2% target.

Jim’s view and I agree, “The time to raise rates was 2009-2012. Bernanke blundered by not doing so. The Fed missed an entire rate cycle. If they had raised then, they could cut now. But they didn’t, and they can’t.”

China

There is more going on with currency positioning than just the beggar thy neighbor desperation policies to spur growth. China wishes to join the world money basket that is printed by the IMF (International Monetary Fund). The basket is called the Special Drawing Right or SDR.

For years, China has pegged its currency to the dollar. If the Fed tightens (raises rates), by default China tightens, too. The U.S. essentially controls who enters the SDR basket. Think of it as a potential alternative currency to the dollar. The balance of the world wants to move in that direction. The U.S. has insisted that China peg the yuan to the dollar in exchange for allowing China entry into the SDR currency basket.

The U.S. dollar has been strong. U.S. interest rates are higher than the balance of the developed world. For example, the 10-year Treasury bond is yielding 2.05% today compared to our global competitors’ comparable 10-year rates: German Bund at 0.59%, UK at 1.69%, France at 0.93%, the Netherlands at 0.77%, Switzerland at -0.24%, Italy at 1.83%, Spain at 2.00%, Portugal at 2.56% and Greece at 9.24% (but forget about Greece).

Asia, Japan at 0.36%, Hong Kong at 1.60%, Australia at 2.57%, Singapore at 2.55%, South Korea at 2.28% and India at 7.77%. Source: Bloomberg

Which capital markets on the planet are the most developed with the broadest market participation (diverse sets of players)? Advantage U.S.

Talk up the dollar or raise rates? The U.S. becomes even more attractive. Where is global capital going to seek return? Add in a sovereign debt crisis and loss of confidence in government – the smart capital exits. Forget return; safety is sought.

The U.S. and China account for roughly 30% of global GDP. China’s move in the face of desired entry into the SDR basket is telling us that global growth is in trouble.

Commodity prices are down some 60% (note forecast in the next section) and emerging market currencies – Brazil, Turkey, Malaysia – are getting destroyed relative to the dollar.Â

It is estimated that some $9 trillion-plus was borrowed by foreign borrowers with those loan prices in dollars. If your home country currency drops by 33%, that $9 trillion debt is now $12 trillion. Back at a time when it was cheaper to borrow from a U.S. lender (U.S. rates were lower than, say, the lending rates in Brazil) it looked like a good idea. Now in crisis. Expect defaults.

You can see why the Bank of International Settlements (BIS) and the IMF are pressing for the Fed to remain on hold or perhaps lower rates (though lowering from zero is tough to do).

This from Morningstar: “Stock Selloff Accelerates On Global Growth Fears – U.S. stocks extended this week’s sharp losses with a renewed selloff on Friday as worries about global growth, fueled by carnage in China’s stock market persists.”

This is all getting very interesting.

Focus on commodities

The dying commodity super-cycle remains the most important influence throughout the commodity complex. It is the factor that trumps all others, still in 2015.

Some thoughts:

• This has been the case for the last four years, and we suspect it stays that way for a while, knowing that the average bear lasts about 20 years (see the chart).
• A bear super-cycle is essentially a black hole, sucking in most commodity-related situations. Avoiding it is nearly impossible.
• Fighting it is futile. Commodity prices and investors alike eventually succumb.
• From the moment we began studying commodity super-cycles, we were struck by the repeatedly sharp moves during the transition from bull to bear. Each parabolic rise was met with a thundering crash, obliterating all parabolic gains and then some. No exceptions.
• The early bear years are consistently the hardest on commodity prices as this is the time that the black hole churns at max strength.
• And with no yield to buffer the fall, commodity prices lose ground fast and persistently. Welcome to how commodity super-cycles die.

Source: NDR

Book value – The market is overvalued

I touched on valuation a few weeks ago and ran across this quote from Ned Davis in one of his recent posts:

“Book value used to be fairly easy to calculate, but with all the creative accounting, buybacks, mergers and changes to the lists of stocks, the numbers are very hard to calculate. Perhaps as important, we have had a change to the composition of our economy with more service and social media companies and less manufacturing, which some argue have less need for net assets (thus higher price/book value).

continue reading: http://www.cmgwealth.com/ri/7388-2/