On My Radar: The Italian Referendum; What it Means to You, Me and the Markets

Transcription

1 On My Radar: The Italian Referendum; What it Means to You, Me and the Markets December 5, 2016 by Steve Blumenthal of CMG Capital Management Group There are three things we should all do every day: Number one is laugh (you should laugh every day), number two is think (you should spend some time in thought) and number three is you should have your emotions moved to tears (tears could be for happiness). Think about it that s a heck of a day. Jimmy Valvano Up Next The Italian Referendum. While on the surface the Italian Referendum appears to be only about the structure of government power and Prime Minister Matteo Renzi s desire to pass economic reforms, beneath the surface is a serious financial issue that has the potential to impact not just Italy, but Europe and beyond. This may sound small and meaningless to you and me but it is not. A No vote or a Yes vote? A No vote means the government remains fat and stuck. A No vote would prolong Italy s political and economic stagnation. Structural reforms would be put off while Italy s lawmakers haggle over voting systems. Such government inertia is nothing new in Italy. But the country may no longer be able to afford it. A Yes vote gives Renzi the authority to shrink the government. His goal is to get it moving. Here is what is at stake: That risk centers on trouble at Italy s third-biggest bank, Monte dei Paschi di Siena. The government is hoping investors will recapitalize it, but they are reluctant to commit their money unless the vote is Yes. Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 Investors are watching the vote closely. The structural reforms that would result from a more streamlined (albeit more concentrated power structure within Parliament) would in theory stimulate the Italian economy, thereby increasing a favorable resolution for the bank and pulling investors in off the sidelines. Should the bank collapse, it could ignite a full-blown (and potentially global) banking crisis. Polls conducted before a ban on publication (yes you read that right a ban) took effect, two weeks before the end of the campaign, showed the No camp ahead by approximately four percentage points. But 40% to 60% of voters were still undecided or planning to abstain. Bottom line, a No vote could unleash a devastating financial chain reaction. You can read more on this in The Economist. The irony of the vote is that, like the UK Brexit, voters may vote in a referendum that they do not fully understand. Here is the irony: Italian households own about 170 bn worth of bank bonds, or 49% of the total. Under new EU rules, bond holders and depositors (bank clients) would be responsible for absorbing some of the losses of the bank. The consequences of a No vote on their daily lives has a direct impact on their own personal financial interests. I m not sure voters fully understand this. In short, those same No vote Italian voters are likely to be the ones bailing out Monti dei Paschi di Siena. Or should I say bail-in? Remember Cyprus? The EU, especially Germany, is sitting strongly in the bail-in camp. With Deutsche Bank on a cliff s edge, how can Germany demand Italian citizens bail-in their bank and not do the same in Germany for DB? The domino effect of a No vote could lead to a crisis of government. No mandate for Renzi will he resign like David Cameron did after the Brexit vote? At immediate risk is a run on the Italian banks, a spike in Italian bond yields and new crisis within the European Central Bank (ECB). There is no shortage of palace intrigue as the head of the ECB, Mario Draghi (an Italian), would once again be tasked with riding to the rescue with ECB resources. In Germany, Angela Merkel would have to walk a fine line as an election looms next year. If push comes to shove, don t be surprised if a compromise between Germany and Italy saves not only Monti dei Paschi di Siena, but also helps provide DB the oxygen it needs. Keep this issue On Your Radar. Debt s a bitch man and it is getting more and more interesting by the day. The Italian vote is December 4. Keep your eyes on Sunday s evening news! Maybe we should heed Jimmy V s sage advice: Laugh, think and cry. I m going to keep working on that. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Grab a coffee and find your favorite chair. As we do early each month, this week you ll find updates on valuations (they remain high), forward returns (low), debt and the Fed. I hope you find the information helpful. If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. Included in this week s On My Radar: Valuation Charts and Comments Forward Returns Debt Foreign Policy Trade Signals U.S. Equity Bull, Global Equity Bull, Fixed Income Bear; Sentiment Suggests Caution Valuation Charts and Comments Market Cap-to-GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001 he remarked in a Fortune interview that it is probably the best single measure of where valuations stand at any given moment. How can t I agree? Let s first look at the current data (next chart) then think about what it means with regard to probable 7- year and 10-year forward returns. 1. Corporate Equities to GDP: Think of the next chart as the market value of all publicly traded securities as a percentage of the country s business. Key points to focus in on: Note the levels (33.0% and 32.2% highlighted in yellow) at the beginning of the last two longterm secular bull markets ( and the greatest bull market of all time: ). Next, note the valuation level in January Crazy right? Then investors poured record amounts of money into technology funds (the largest single record month of new money inflows occurred in March of 2000). As a quick aside: 75% of the money at Fidelity Funds was in their technology-oriented funds. Tech finally made a new all-time high in Sixteen years of no gain and technology stocks was where most of the money sat. If you lose 75%, your $100,000 drops to $25,000. An investor would need a return of 300% just to get back to even (and in tech s case SIXTEEN YEARS!) Today, the market sits at a point more expensive than it was before the great dislocation in It sits at just off of the second highest level in history. Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 Source: Jill Mislinski (12/2/2016) Finally, what to do? Buffett opined, For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. Hard to argue with the Oracle. 2. Median P/E = 22.8 (The Market Remains Overvalued) The next chart looks at median P/E and compares the current reading with each month-end median P/E dating back to The dotted lines in the middle section show various valuation zones that range from Very Overvalued to Bargains. The current reading of 22.8 puts the S&P 500 index in the Overvalued zone. What does this mean in plain English? Well, we can look at the median P/E history and see what the returns were in subsequent 10-year periods of time. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 You ll find that in the next Forward Returns section. It is in this way, median P/E can tell us a lot. Also, note the red arrow at the bottom of the chart. I put that in to show you, from a historical perspective, the level of the S&P 500 relative to 52.8 years of data. Median Fair Value on the S&P 500 equals Overvalued (or a 1 standard deviation move above fair value) puts the S&P 500 index at The S&P 500 was at at the market close on By this measure, the market is 2.9% above Overvalued and 25.6% above Median Fair Value. In short, the market remains richly priced. One last thought on valuations. Markets can grow to be overvalued for periods that last longer then we might have patience, e.g., I do not see the crazy euphoria that typically occurs at market tops. The timing of the turn remains unknown. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 My point is that valuations do matter and can help us to know when to get more cautious and risk protect and when to aggressively buy (like 2009 or 2002). When do you want to get more aggressive with equities? Watch for this: As Buffet said regarding his favorite valuation indicator: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. For now, hedge that equity exposure. Risk is high. Let s next look at probable forward returns. Forward Returns Household Equity Percentage vs. Subsequent Rolling 10-Year S&P 500 Index Total Return This first chart is one of my favorite predictors of forward returns. Interestingly, it is not based on valuations, it is based on how much money households, you and I and millions of our best friends, have in equities as a percentage of our total household financial assets. Think supply and demand if we are overweight equities, we have less available resources (buying power) to buy stocks. Here s how to read the chart: First, the blue line shows the percentage in equities on a quarterly basis all the way back to The data is on the left axis. The current reading, as of is 52.4%. Next, the red arrows highlight specific dates. For example, in 2000, the percentage of household financial assets in equities was 62%. The red arrow shows what the probable return was to be. Call it -3% annualized for the coming 10 years. The dotted black line plots what the actual return turned out to be. In the case of 2000, the projected return and what turned out to be the actual performance were pretty close. The S&P 500 Index (Total Return) averaged nearly -3% annualized. Next, note how closely the dotted black line tracks the blue line over time. The correlation coefficient since 1951 is Translated from geek to English, a 1.0 is perfect correlation. 91 is a very high historical correlation. The green arrows show you where we were in 2009 and We won t know the actual 10- year returns for the 2009 period until 2019 but it is pretty evident by the post-crash low rally that they are likely to be high. But honestly, were your clients/friends buying or selling in 2009? Finally, the small red arrow shows us where we are at the most recent data post ( ). It is telling us the probable annualized return for the coming 10 years is likely to be approximately 3.25%. That seems reasonable enough to me. Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 Median P/E = 22.8 Median P/E, Price-to-Book, Price-to-Sales, Price-to-Operating Earnings, etc. Of these, I tilt towards Median P/E because it tends to remove a lot of the accounting gimmicks (special one-time adjustments, etc.) and from its level, I believe it gives us a good sense of coming 10-year probable returns (this process based on valuations). Here are a quick few examples of how helpful median P/E can be: Note the dates, the starting median P/E on those month-end dates and the subsequent 10-year annualized returns. Green is good, red is bad. Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.

8 I have a lot more data on this subject. You can find that research in a piece I wrote titled, The Total Portfolio Solution. You can find it here. Last month, I wrote about valuations in a piece titled, You ve Only Got to Remember Two Things. There are a lot of great charts in there I ll shorten this week s comments by saying that after the recent Trump rally, valuations are even higher. Median P/E has risen from 21.9 to 22.8 as of November 30, Thus, no change in what this tells us about the probability for low forward 10-year returns. To give you a sense for the depth of data I look at regularly, here is just a small set. Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.

9 A quick aside and brief, completely uncompensated endorsement for Ned Davis Research. I ve been a happy client of Ned Davis Research since the mid-1990s. Their practical way of thinking sits well with Page 9, 2018 Advisor Perspectives, Inc. All rights reserved.

10 me. If you are a professional investor, Dan Dortona at ddortona@ndr.com if you d like to learn more about their services (I do not get paid a penny from NDR for this testimonial just a big fan of their work). GMO s Seven-Year Asset Class Real Return Forecast U.S. Large Cap Equities: -2.7% annualized U.S. Small Cap Equities: -0.80% annualized U.S. Bonds: -1.70% annualized The equity numbers are slightly better than last month s GMO forecast though U.S. Bonds is worse. Debt 1. U.S. Government Debt Many credible academic studies suggest that debt becomes unproductive Page 10, 2018 Advisor Perspectives, Inc. All rights reserved.

11 when it exceeds 90% of Debt-to-GDP. Think of it this way, if your brother-in-law earns $100,000 but his credit card, auto and mortgage debt is greater than $90,000, he can no longer borrow and spend, he has to earn and pay back. At a certain point, the stress builds. He s paying more each month of what he earns to pay down his debt. Plus, what bank is going to loan him more? He is no longer credit worthy. The same goes for states, corporations and governments. Debt is a drag on growth. How we deal with the issue is what you and I need to keep on our radars. The problem is not going away anytime soon. As you view the chart, note that I ve highlighted in yellow the spike in debt since Let s call it a giant debt bubble. The red arrow points to where we were in The red line sits on top of the two prior highs in 1955 and Total Credit Market Debt Equals 352.6% of GDP Oh, but unfortunately, it is bigger than we think. Collectively, this is what the U.S. Total Credit Market Page 11, 2018 Advisor Perspectives, Inc. All rights reserved.

12 Debt looks like (next chart). Government, individuals and corporations. Low interest rates make debt payments manageable but it is rising interest rates, due to the high levels of debt, and the return of inflation that should concern us. Here you can see that the Total Credit Market Debt is 352.6% of GDP. That s a big problem should rates rise. Note too the breakdown by category: Government Debt is over 100% debt-to-gdp, Household Debt (you and me) has come down. Total Domestic Nonfinancial Debt is the total outstanding debt owed by all sectors with the exception of domestic financial companies and foreigners. Both it and Government Debt are at all-time highs. 3. Components of Household Loans For fun, here is a look at where the U.S. consumer debt sits. Mortgage loans have come down, auto loans up, credit card debt higher (but lower than 2008) Student loans are at a record $1.36 trillion (a big problem we ll hear more about) and Other Consumer Loans has spiked higher as well. OK, maybe not so fun for students and their parents. Page 12, 2018 Advisor Perspectives, Inc. All rights reserved.

13 The Bottom Line on Debt: Further: Debt, when initially taken on, is good for growth. It is a steroid shot in the arm to the economy, but it comes at the expense of future consumption and investment. And with more money owed to be paid back in the future, there is less money to spend, so future demand is less. This is the slowing we are experiencing today. At high levels of debt, the rate of GDP growth is about half. Low interest rates make servicing that debt easier; however, we continue to see GDP growth at 1.5% before inflation. Rising interest rates make servicing that debt more expensive and puts a further drag on the economy. Page 13, 2018 Advisor Perspectives, Inc. All rights reserved.

14 Debt is too high. Too much debt remains our primary issue (here, there and everywhere). Low interest rates make debt payments manageable, but it is rising interest rates, due to the high levels of debt, and the return of inflation that should concern us. As I wrote last week, I believe The Secular Low in Yields is IN. Foreign Policy As an asset manager, I believe it is imperative that we consider various risks. Valuations and debt levels are two distinct risks. A sovereign debt crisis in Europe is another. A systemic shock to the global banking system stemming from Germany or Italy or as was the case in 2008, the U.S. The risk of war is a risk. To that end, I do believe that foreign policy matters and this cartoon caught my eye. Kind of funny and kind of not funny. We step forward and watch. The dragon represents China, the bear represents Russia and Uncle Sam is in the middle. Trade Signals U.S. Equity Bull, Global Equity Bull, Fixed Income Bear; Sentiment Page 14, 2018 Advisor Perspectives, Inc. All rights reserved.

15 Suggests Caution ( ) S&P 500 Index 2,207 ( ) Posted each Wednesday, Trade Signals looks at several of my favorite stock, investor sentiment and bond market indicators. It is my weekly risk management dashboard, designed to keep me better in sync with the major technical trends. I hope you find the information helpful in your work. Click here for the most recent Trade Signals blog. Personal Note Bonds have gotten clobbered. Rates have moved up more than 1% since July. The 10-year Treasury Note is down more than 8%. The 30-year down more than 16%. That said, it s been an outstanding period to be in active/tactical bond management and a disaster for buy-and-hold. I ll share more on this with you next week. I blink and another month has passed. December already! Hard to believe. I fell asleep on the couch and woke to a replaying of Jimmy V s 1993 ESPY Speech last night. It was great to watch it again. Jimmy Valvano was nearing the end of his long fight with cancer. He, of course, was one of the alltime great basketball coaches. He shared a great message for all of us along with a really funny coaching story. He said, there are three things we should all do every day: Number one is laugh (you should laugh every day), number two is think (you should spend some time in thought) and number three is you should have your emotions moved to tears (tears could be for happiness or sadness). Think about it that s a heck of a day. I m going to watch it again with my kids. Speaking of kids, my daughter Brianna is on a flight home from New Zealand. She spent some time off with her childhood friends. They met at age eight and bonded at 14,000 feet hiking the mountains in the Colorado National Forest. She s now 23, independent and living life fully (Dad s proud). My two high school boys are heading to Penn State this weekend to visit with cousins (Dad s worried). Matthew is checking his every few minutes as he s praying for acceptance to attend PSU s business school next fall. I m all things crazy about Penn State, so Dad s pretty happy. Susan and I are going to be mostly solo for the weekend. She coaches a few youth soccer teams so I ll be on the sideline watching. Her youngest son has an exhibition game, so we have the sideline chairs packed and ready. And finally, CMG hosts its annual Holiday Party tonight so I better hit the send button. The Berwyn Tavern is in our near future as is an ice cold IPA or two. We are a pretty laid back crew when we get outside the office and the venue and, of course, the company is great fun. Grateful! I will be in Chicago on December 7-8 and in NYC on the 15 th. Thereafter, I have some downtime scheduled until January where I ll be speaking at the Inside ETFs 2017 Conference in Hollywood, Page 15, 2018 Advisor Perspectives, Inc. All rights reserved.

16 Florida. If you are planning on attending, please let me know. I d love to grab a coffee or better yet a good beer with you. Time to find the office party. Have a great weekend and keep your eye on Italy this weekend. If you find the On My Radar weekly research letter helpful, please tell a friend also note the social media links below. I often share articles and charts via Twitter that I feel may be worth your time. You can follow If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. And from the great Jimmy V, laugh, think and cry and don t give up, don t ever give up! Wishing you a heck of a day! Ciao, Steve Stephen B. Blumenthal Executive Chairman & CIO CMG Capital Management Group, Inc. Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, On My Radar. Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management. The objective of the letter is to provide our investment advisors clients and professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and client communication. Click here to receive his free weekly e-letter. Social Media Links: CMG is committed to setting a high standard for ETF strategists. And we re passionate about educating advisors and investors about tactical investing. We launched CMG AdvisorCentral a year ago to share our knowledge of tactical investing and managing a successful advisory practice. You can sign up for weekly updates to AdvisorCentral here. If you re looking for the CMG white paper, Understanding Tactical Investment Strategies, you can find that here. AdvisorCentral is being updated with new educational resources we look forward to sharing with you. You can always connect with CMG on Twitter and follow our LinkedIn Showcase page Page 16, 2018 Advisor Perspectives, Inc. All rights reserved.

17 devoted to tactical investing. A Note on Investment Process: From an investment management perspective, I ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution. My objective is to position in line with the equity and fixed income market s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc. IMPORTANT DISCLOSURE INFORMATION Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc. or any of its related entities (collectively CMG ) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or Page 17, 2018 Advisor Perspectives, Inc. All rights reserved.

18 provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. Mutual funds involve risk including possible loss of principal. An investor should consider the fund s investment objective, risks, charges, and expenses carefully before investing. This and other information about the CMG Tactical All Asset Strategy Fund TM, CMG Global Equity Fund TM, CMG Tactical Bond Fund TM, CMG Global Macro Strategy Fund TM and the CMG Long/Short Fund TM is contained in each fund s prospectus, which can be obtained by calling CMG-9456 ( ). Please read the prospectus carefully before investing. The CMG Tactical All Asset Strategy Fund TM, CMG Global Equity Fund TM, CMG Tactical Bond Fund TM, CMG Global Macro Strategy Fund TM and the CMG Long/Short Fund TM are distributed by Northern Lights Distributors, LLC, Member FINRA. NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE. Hypothetical Presentations: To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser s use of the model if the model had been used during the period to actually manage client assets; and (3) CMG s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model. Please Also Note: Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (e.g., S&P 500 Total Return or Dow Jones Wilshire U.S Total Market Index) is also disclosed. For example, the S&P 500 Total Return Index (the S&P 500 ) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. S&P Dow Jones chooses the member companies for the S&P 500 based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The historical performance results of the S&P 500 (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10-year period would decrease a 10% gross return to an 8.9% net return. The S&P 500 is not an index into which an investor can directly invest. The historical S&P 500 performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet, his/her investment objective(s). A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models. Certain information contained herein has been obtained from third-party sources believed to be Page 18, 2018 Advisor Perspectives, Inc. All rights reserved.

19 reliable, but we cannot guarantee its accuracy or completeness. In the event that there has been a change in an individual s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional. Written Disclosure Statement. CMG is an SEC-registered investment adviser located in King of Prussia, Pennsylvania. Stephen B. Blumenthal is CMG s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG s current written disclosure statement discussing advisory services and fees is available upon request or via CMG s internet web site at CMG Captial Management Group Page 19, 2018 Advisor Perspectives, Inc. All rights reserved.