On My Radar: The Fallacy of Overlooking SecondaryConsequences

March 21, 2016by Steve Blumenthal

of CMG Capital Management Group

“So what do we do? Anything. Something. So long as we just don’t sit there. If we screw it up, start over. Trysomething else. If we wait until we’ve satisfied all the uncertainties, it may be too late.” – Lee Iacocca

“This is the persistent tendency of men to see only the immediate effects of a given policy, or its effects only on aspecial group, and to neglect to inquire what the long-run effects of that policy will be not only on that special groupbut on all groups. It is the fallacy of overlooking secondary consequences.” – Henry Hazlitt, Economist

It is the fallacy of overlooking secondary consequences that is keeping me up at night. Try telling that one to your spouse.

“Draghi and the ECB announced that they will start a series of targeted longer-term refinancing operations (TLTRO). Thefirst will occur in June 2016. The term will be four years. The cost of this borrowing by a bank is likely to be a zero interestrate. But under certain conditions, it will be at the negative policy rate. Thus the central bank will be paying the commercialbank to borrow from it.

Imagine what would happen in the United States if the Federal Reserve structured a program so that any bank, whetherBank of America or your local community bank, were to be paid by the Fed when that bank borrowed from the Fed andused the funds to make loans to you or to buy assets in the market.” – David Kotok, Cumberland Advisors

David added, “This is a massively expanded stimulus program. It has extremely bullish implications for financial assets andfor asset prices in Europe. And because of its size and lengthy term, it is a bullish force for the entire world. We expectother NIRP jurisdictions to use their version of this model. Keep a sharp eye on Japan’s next move deeper into NIRP.”

NIRP stands for Negative Interest Rate Policy. On its own it is a deflationary policy that, I believe, is ill-designed to help usexit the current excessive debt, global deflationary mess we find ourselves in.

Now look at them yo-yos that’s the way you do it You play the guitar on the M.T.V. That ain’t workin’ that’s the way you do it Money for nothin’ and your chicks for free. Dire Straits – Money For Nothing Lyrics

Banks can borrow for nothing (0%), expand their loan book by 2.5% (by the end of January 2018) and get an extra 40 bpskicker from the ECB. Get your “chicks for free”. Ok, maybe not “chicks” but certainly “money for nothing”. What they arenot saying is that the banks are in trouble. Let’s hope the banks can find some qualified and motivated borrowers.

This next quote pretty much sums it all up for me, “In the last three years plus, central banks have had little choice but to dothe unsustainable in order to sustain the unsustainable until others do the sustainable in order to restore sustainability.” –Mohamed A. El-Erian, The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse (RandomHouse, 2016)

What does this mean? I explained it to someone on our research team this way: It’s like you have a shoulder issue. You goto the doc and get a cortisone shot. Perfect, you feel good again. Six months go by and the pain is back. Another shot,another short-term fix. You do it again until finally the doc tells you she’s done all she can do for you. All that cortisone isreally bad for your system in the long term. You need to go to a different doctor, a surgeon, who has the tools to fix thestructural problem in your shoulder.

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El-Erian calls it a handoff: from the Fed (injecting the juice) to our elected officials (who have the power to implementstructural reform). I.e.: Individual and corporate tax reform, U.S. foreign profit dollar repatriation, grand infrastructureprojects (aged bridges, natural gas pipes, highways, technology) and entitlement reform/repair (we are nearing a breakingpoint). Simply, policies that stimulate growth. This requires action.

The problem is that the authorities who have the ability to fix the problem don’t seem to be motivated to get to work. Powerstruggle gridlock. At some point, they’ll get motivated but it might take another financial crisis to wake them up. This has tohappen in Europe, Japan and China as well. Debt is a mess everywhere. See this study from McKinsey “Debt and NotMuch Deleveraging“.

Are global central banks nearing the “unsustainable?” No one knows for sure. Stay alert and expect the unexpected. IsZIRP, QEs 1, 2 and 3, TARP, LTRO, NIRP and coming QE4 (helicopter money) working? Going to work? My two cents isthat we have a very long way to go.

Buying government and now corporate bonds. What are we enabling? Debt has not come down. What are we messagingto corporate fiduciaries, bank prop desks, levered investors? What did low rates and no-doc mortgages do for the housingmarket. Who are we helping or hurting with repressed interest rates? Keep your guard up. These are highly unusual times.Stay alert and expect the unexpected.

Equity market valuations remain high and the bull market is aged. Hedge that equity exposure, broadly diversify andoverweight to non-directionally dependent strategies. I continue to favor a 30/30/40 (equities, fixed income and liquidalternatives) portfolio mix and hedge that equity exposure. We can change the tilts to overweight equities and removehedges when forward return potential is high (at which point valuations will be lower and attractive).

To that end, this week you’ll find a great equity market chart that shows us what the forward S&P 500 Index returns arelikely to be based on the percentage of household equity ownership. It may help guide your thinking as to when to becomemore aggressive again.

♦ 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:

All ‘Bout That Fed, ‘Bout That FedWhat Henry Hazlitt Can Teach Us About Inflation, by James GrantCharts That Matter – Forward 10-year Annualized Return 3-4% for EquitiesTrade Signals – “Aged”: The Average Bull Market Lasts 59 Months, This One is Now 84 Months Old

All ‘Bout That Fed, ‘Bout That Fed

Following are several pieces I found interesting – comments on the Fed:

Peter Boockvar, from the Lindsey Group, prior to the Fed’s Wednesday FOMC meeting wrote:

If the Fed was TRULY dependent on the data, they would be raising interest rates TODAY. The six-month job gain averageis 235k, the unemployment rate is right at the Fed’s long-term forecast, the core PCE y/o/y rate gain of 1.7% is one-tenthabove the Fed’s year-end forecast, the S&P 500 is just 5% from its record high, the US dollar is at the same level it wasabout one year ago as negative rates from the BoJ and ECB has stopped working in weakening their currencies, oil pricesare up 15% from the last Fed meeting, the CRB food stuff index is at a three-month high and the Journal of Commerceindex of 19 industrial materials is at a 4½-month high. Also, as the Fed likes to talk about inflation expectations, the 10-yearbreakeven at 1.50%, the same level it was at in August and the same spot it was at when the Fed hiked rates inDecember. It is not until September however that the Fed Funds futures market is 100% confident that under the currentcircumstances they will raise again. We are at 64% for June.

Assuming the Fed doesn’t want to shock the market, they won’t raise today (and they didn’t as we now know) as no oneexpects it because the Fed seems to be worried about everything else (China and international developments, mediocreUS growth, the prospect of another round of a tightening of financial conditions, their own shadow, etc…). WilliamMcChesney Martin, the Chairman of the Fed from 1951 to 1970 once said this in a speech, “The idea that the businesscycle can be altogether abolished seems to me as fanciful as the notion that the law of supply and demand can berepealed.” He said that in 1955.

And this from Danielle DiMartino, QE Program – An Embarrassment of Stitches

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“And so we hear the latest, that the Chinese government will launch its answer to the U.S. TARP program, whereinChinese commercial banks swap out bad debts to the government in exchange for equity in said bank. Reported non-performing Chinese bank loans rose to $614 billion in 2015, a decade high, even as their economic growth slumped to a25-year low. Of course, the aim of the package is identical to that of all stimulus measures launched since 2008 — to spuryet more lending to lift economic growth. More and more yet of the same.

Which brings us to the European Central Bank (ECB), which added non-financial corporate bonds to the menu of fixedincome instruments it can buy to achieve its goal of flooding the markets with 80 billion in euros every month so as to…drum roll, please…incentive, more lending. It seems that there were simply not enough sovereign bonds and asset-backedsecurities to get the job done, and that’s before the ECB expanded its QE program from 60 billion euros a month beforelast Thursday’s meeting.

No doubt, with 900 billion euros outstanding, the ECB has an appreciably large pool of assets at which to aim its buyer-not-beware bazooka. A gut check, though, should prompt the question as to why European policymakers are so keen toincrease their own QE program when the effort has produced so few results everywhere else it’s been attempted.

A fine point: at roughly $50 billion in outstanding bonds, life insurers top the list of eligible targets for ECB purchases. Justso we understand each other, ECB President Mario Draghi envisions buying non-financial corporate bonds in the sectormost damaged by the policies he’s deployed since vowing to do whatever it takes to reignite inflation via record low interestrates. Recall that low interest rates are the bane of insurance companies that depend on reasonably high interest rates tomake good on the long-term promises they’ve made to those who pay stiff premiums in exchange for those promises.”

Ok, you get the picture. Debt is a mess pretty much everywhere and is a drag on global growth. By the way, I think thecentral banks will ultimately create inflation. But is might be in a stagflation environment.

What Henry Hazlitt Can Teach Us About Inflation in 2014, by James Grant

“The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The badeconomist sees only the direct consequences of a proposed course; the good economist looks also at the longer andindirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particulargroup; the good economist inquires also what the effect of the policy will be on all groups.” (Henry Hazlitt)

I mentioned Henry Hazlitt in a June 2014 On My Radar.

Here are several highlights from the piece:

“In 1946, as now, the government held up the threat of deflation to justify a policy of ultra-low low interest rates andeasy money. Now ladies, and gentlemen, I have devoted thirty-one years of my life to writing about interest rates, andI have to tell you that I can’t see them anymore. They’re tiny. And so they were in 1946. Then, as now, the Fed hadbeen conscripted into the government’s financial service. Just as it does today, the central bank pushed money-market interest rates virtually to zero and longer-dated Treasury securities to less than 3 percent. Just as it doestoday, the Fed had its thumb on the scales of finance.”“If interest rates were artificially low, it would follow that prevailing investment values are artificially high. I contend thatthey are, and you may or may not agree. But you must allow the observation that we live in a kind of valuation hall ofmirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates wouldbe in the absence of central-bank manipulation. Natural interest rates — free-range, organic and sustainable — arewhat we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones wehave.”“When interest rates are kept arbitrarily low by government policy, the effect must be inflationary,” he wrote. “In thefirst place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is therate that would be established if the supply and demand for real capital were in equilibrium. The actual money interestrate can only be kept below the natural rate by pumping new money into the economic system. This new money andnew credit add to the apparent supply of new capital just as the judicious addition of water add to the apparentsupply of real milk.”Hazlitt concluded that “the money rate of interest can be kept below the real rate of interest only as long as the supplyof new money exceeds the supply of new real capital. Excessively low interest rates are inflationary in the secondplace because they give an excessive stimulation to the volume of borrowing.”“Why, I could quote those perfectly formed sentences in Grant’s today (and I believe I just might). They’re as timelynow as they were during the administration of Harry S. Truman. The effective federal funds rate has been zero forwell-nigh six years.”

Well-nigh almost eight years now…Page 3, © 2020 Advisor Perspectives, Inc. All rights reserved.

Click here for the full article.

Charts That Matter: Forward 10-year Annualized Return 3-4% for Equities

1. Household Equity Percentage vs. Subsequent Rolling 10-Year S&P 500 Index TR

Early each month, I share with you the most recent median P/E data. You can see the early March post on valuations here.

This next chart too is amazingly accurate in assessing the probable returns to come over the next ten years. It looks at thepercentage of household equity ownership. Think of it this way, when investors are heavily committed in their portfolios toequities, much of the buying power (that may drive equity prices higher) is already in the game. The blue line measures theequity percentage and the dotted line shows what the annualized return was ten years later. The red circle shows theextremely high equity exposure in 2000 and the dotted line within the circle shows what the actual annualized return turnedout to be.

The green circles and the green arrows show when equity ownership was low and returns high. The yellow rectangleshows where we are in terms of equity ownership most recently and tells us to expect 3.75% annualized returns over thecoming ten years.

Note how closely the actual returns, the dotted line, tracks the percentage ownership line with a high 0.93 correlation.

2. BofA Merrill Lynch Global Liquidity Tracker (red line):

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3. Earnings rolling over?

Recessions are highlighted in gray. A richly-priced equity market and declining earnings do not mix well. Risk is high.

4. Core CPI

Strength in Core CPI Inflation (green line in next chart) – remember that the Fed is targeting inflation at 2% (CPI is at 1%,Core CPI is now at 2.3%). Note the high correlation between the two lines.

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Core CPI is rising: Nothing to worry about just yet, but let’s keep a close eye on this.

5. Money Velocity

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Note – at all-time lows. This should cause concern.

6. The Shrinking Middle Class

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Hazlitt suggests that, “the whole of economics can be reduced to a single lesson, and that lesson can be reduced to asingle sentence. The art of economics consists in looking not merely at the immediate but at the longer effects of any actor policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

Here is a link to Henry Hazlitt’s book, Economics in ONE Lesson. An oldie but a goodie.

Trade Signals – “Aged”: The Average Bull Market Lasts 59 Months, This One is Now 84 Months Old

Equity Trade Signals:

CMG Ned Davis Research (NDR) Large Cap Momentum Index: Sell Signal – Bearish for EquitiesLong-term Trend (13/34-Week EMA) on the S&P 500®Index: Sell Signal – Bearish for EquitiesVolume Demand is greater than Volume Supply: Sell Signal – Bearish for EquitiesNDR Big Mo: See note below (active signal: buy signal on 3-4-16 at 1999.99).

Investor Sentiment Indicators:

NDR Crowd Sentiment Poll: Neutral reading (short-term Bullish for Equities)Daily Trading Sentiment Composite: Neutral reading (short-term Neutral for Equities)

Fixed Income Trade Signals:

Zweig Bond Model: Buy SignalHigh-Yield Model: Buy Signal

Economic Indicators:

Don’t Fight the Tape or the Fed: Indicator Reading = +1 (Bullish for Equities)Global Recession Watch Indicator – High Global Recession Risk

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U.S. Recession Watch Indicator – Low U.S. Recession Risk

(S&P 500® Index monthly declines of -4.8% or greater below its five-month smoothing (MA) signaled recession 79% of thetime: 1948 – Present). Data is updated each month end.)

Gold:

13-week vs. 34-week exponential moving average: Buy Signal – Bullish for Gold

Tactical — CMG Opportunistic All Asset Strategy (update):

Relative Strength Leadership Trends: We are seeing relative strength in International Equities and several EmergingMarkets. Utilities, Gold and Telecom continue to show strong relative strength. Fixed Income has held top ranking ina number of our models over the last number of months; however, we are seeing a shift towards sector-orientedfunds/ETFs, equities in general and International Equity exposure.

Here is a link to the Trade Signals blog page.

Personal Note

We in the Blumenthal home love soccer. Most Saturday mornings, Susan makes the coffee and asks me to see whatEuropean soccer games are on TV. The boys wake up later and usually join us. She continues to coach and all of our kidsenjoy the game. I love it. And life is great.

Our Philadelphia Union plays its home opener this Sunday afternoon. Excitement has been building at the dinner table, talkof new players and of course we are hoping for a successful year. Chickie’s and Pete’s chicken fingers or a Phillycheesesteak, crab fries and a cold Victory Hop Devil beer awaits. Don’t tell my doctor. Hoping I’m not overlooking“secondary consequences”.

Wishing a fun filled weekend to you and your beautiful family!

I’ll be writing from San Francisco next week. Several meetings and some time to enjoy the city. Meetings in Denver lateMarch then business and media in NYC on April 6. Chicago and Dallas (Mauldin’s Strategic Investment Conference) followin May.

Thanks for reading.

♦ If you are not signed up to receive my weekly On My Radar e-newsletter, you can subscribe here. ♦

With kind regards,

Steve

Stephen B. Blumenthal Chairman & CEO CMG Capital Management Group, Inc.

Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Chairman and CEO. Steveauthors a free weekly e-letter entitled, On My Radar. The letter is designed to bring clarity on the economy, interest rates,valuations and market trend and what that all means in regards to investment opportunities and portfolio positioning. Clickhere 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 andinvestors about tactical investing. We launched CMG AdvisorCentral a year ago to share our knowledge of tacticalinvesting 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, “UnderstandingTactical 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

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connect with CMG on Twitter at @askcmg and follow our LinkedIn Showcase page devoted to tactical investing.

A Note on Investment Process:

From an investment management perspective, I’ve followed, managed and written about trend following and investorsentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-basedindicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included withina 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 isparamount in a long-term investment process. When to hedge, when to become more aggressive, etc.

Trade Signals History:

Trade Signals started after a colleague asked me if I could share my thoughts (Trade Signals) with him. A number of yearsago, I found that putting pen to paper has really helped me in my investment management process and I hope that thisresearch is of value to you in your investment process.

Following are several links to learn more about the use of options:

For hedging, I favor a collared option approach (writing out-of-the-money covered calls and buying out-of-the-money putoptions) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, considerbuying deep out-of-the-money put options for risk protection.

Please note the comments at the bottom of Trade Signals discussing a collared option strategy to hedge equity exposureusing investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experiencedadvisor to help you. Never write naked option positions. We do not offer options strategies at CMG.

Several other links:

http://www.theoptionsguide.com/the-collar-strategy.aspx

https://www.trademonster.com/marketing/upcomingWebinarEvents.action?src=TRADA2&PC=TRADA2&gclid=CKna3Puu6rwCFTRo7AodRiQAlw

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Past performance is no guarantee of 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 (includingthe investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc.(or any of its related entities, together “CMG”) will be profitable, equal any historical performance level(s), be suitable foryour portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer orsolicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are forillustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase orsell such securities.

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