Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014

In a May 24, 2007 commentary titled “Leverage, Leverage, and more Leverage” (four months before the peak of the last bull market), I emphatically stated: “Despite what the mainstream media says, there are now signs that liquidity conditions are deteriorating … Make no mistake: This “pillar” of liquidity [subprime lending] of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households’ liquidity for many years to come.

By early October 2007, I was discussing why I was short the U.S. stock market and why investors should be trimming their equity long positions.

We believe there are 3 distinct pillars to superior investment performance: 1) Investing in non-correlated strategies (e.g. Japanese stocks in the 1960s and 1970s), 2) the ability to find inefficiencies in selected markets (e.g. private real estate or the ability to influence markets, such as that of PIMCO), and 3) recognizing shifts in investment regimes ahead of the curve, and adjusting one’s asset allocation or investments accordingly.

If an investor or adviser has no ability to engage in 1), 2), or 3), then he or she should leave the industry and do something else. This certainly applies to most advisers and investment managers I have met.

But I digress. Back in May 2007, we recognize that there existed unprecedented leverage in the global financial system–and more important, the availability and ability to pile leverage on leverage was drying up. The desire to speculate using immense leverage was not limited to the subprime or LBO markets. Consider that Japanese households were actively engaged in the Yen carry trade, with margin currency trading increasing by 41% to US$896 billion in the Japanese retail market during 1Q 2007 alone. In fact, Japanese individuals were responsible for as much as 30% of all FOREX trading in the Tokyo time zone by early 2007.

Another leverage indicator was U.S. margin debt outstanding. We like to use this age-old, proven benchmark to measure the amount of speculation in the U.S. stock market. While we recognize that both institutions and high net worth individuals can gain access to leverage through futures or OTC swaps, the amount of U.S. margin debt outstanding is much more transparent and is reported monthly. More important, the rate of change in U.S. margin debt outstanding has had significant correlation to other leverage indicators, as well as major peaks and troughs in the U.S. stock market.

For example, in the same May 24, 2007 commentary, we mentioned that the six-month increase in margin debt ($74 billion) had risen to its highest level since March 2000, while the 12-month increase ($77 billion) rose to its highest level since September 2000. We also mentioned that the 12-month increase in margin debt for month-end May 2007 would rise again. In fact, margin debt outstanding rose by $40.2 billion for the month of May 2007 alone. The 12-month increase in margin debt outstanding would eventually surge to a record high of $160 billion by the end of July 2007. At the time, we believed–at the very least–a significant correction was at hand.

Fast forward to today. Many of our stock market indicators are overbought (see our January 10, 2014 commentary “The Message of the CB Capital Global Overbought-Oversold Model“). In our December 22, 2013 commentary (“CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish“), we asserted that U.S. stocks in 2014 will return in the single-digits, i.e. 5% to 10%. Furthermore, the latest margin debt numbers (as of December 31, 2013) also suggest of a highly overbought U.S. stock market, as evident in the below chart. In fact, the 12-month increase in margin debt has risen to $123 billion–the highest level since July 2007, and certainly the highest level since the current bull market began in March 2009. Seen in this context, even a single-digit return outlook in U.S. equities in 2014 could be construed as being too optimistic.


The Message of the CB Capital Global Overbought-Oversold Model

I hope all our clients are off to a great start this year. If we could summarize our long-term global outlook in one word, it’d be “transformation.” e.g. Most U.S. college students are being forced to re-evaluate their life options, as 1) a university degree is no longer a ticket to sure-and-life-time employment, and 2) rising tuition costs mean opportunity costs of attending college (versus entering a trade) have become cost-prohibitive for many Middle Class Americans. A constant debate at CB Capital has been whether the rise of the American Middle Class in the mid-20th century was an anomaly–or if, more likely (in my opinion)–we are seeing the rise in the Global Middle Class, and that the American Middle Class is meeting them half-way.

Another structural force that is putting pressure on the wages of the Global Middle Class is the rise of “Smart Machines.” A decade ago, it was still too expensive to automate most tasks–even repetitive tasks with the exception of auto manufacturing and semiconductor production. In many ways, increasing automation over the last decade was simply an extension of a trend in place since the dawn of the Industrial Revolution in the late 1700s, i.e. automate simple, repetitive tasks through more capital intensive processes. The rise of Smart Machines is now altering the fundamental fabric of working labor, especially among Emerging Market Countries. In the past, upstart EM countries were able to industrialize (e.g. China in the 1980s to 2000s) by taking advantage of their low-cost labor and a significant export market. The rise of lower-cost, Smart Machines will put an end to this, as we will discuss in our 2014 inaugural global macro issue.

“Transformation” and structural trends notwithstanding, we are also big believers in “reversion-to-the-mean” trades. At the same time, we believe in the increasing evolution of the global human condition, so we (for the most part) don’t believe in shorting overvalued markets as measured by traditional benchmarks such as P/E or P/B ratios. We do, however, like to go long in distressed or oversold opportunities, as long as the long-term economics make sense.

Our global macro commentaries have always been more tactical and granular. We have discussed individual commodities, as well as certain conditions in specific countries, such as China and India. For most of our clients, we realize it is very difficult to keep track of all country-specific market indices and new international ETF products. To that end, we have constructed a simple model designed to keep track of the overbought/oversold conditions in all Developed and EM investable countries and regions as tracked by the MSCI indices.

The inner workings of the CB Capital Global Overbought-Oversold Model are rather simplistic. For each country or region, we first compute the month-end percentage deviation from its 3-, 6-, 12-, 24-, and 36-month averages. Each of these percentage deviations are then ranked (on a percentile basis) against all their monthly deviations stretching back to December 1997 (May 2005 for the MSCI Frontier Market Index). This way, we are comparing apples to apples and can control for country- or region-specific volatility. Following is our Global Overbought-Oversold Model readings for the major indices and Developed Markets as of December 31, 2013.

Global Overbought Oversold Model Dec 2013 1

All the percentile rankings highlighted in red or green represent rankings: 1) in or below the 10th percentile, and 2) in or above the 90th percentile, respectively. That is, relative to the historical percentage deviations of the same country or region, a ranking highlighted in red is more oversold than 90% of its readings going back to December 1997; while a ranking highlighted in green is more overbought than 90% of its readings. For example, the world’s developed markets (MSCI World) is highly overbought on a two-year time frame, as its current price level’s deviation from the two-year average is higher than 94.2% of all historical deviations going back to December 1997. Similarly, the U.S. stock market is now highly overbought on a two- and three-year time frame. This is one reason why–as discussed in our 2014 U.S. Stock Market Outlook–we are more cautious on U.S. stocks this year, even though we do not foresee a peak in U.S. equity prices anytime soon.

Note that Emerging Markets is only mildly oversold on all time frames. Such readings do not guarantee above-average returns this year, especially with challenging fundamentals such as social conflicts and deteriorating trade deficits (e.g. India, Indonesia and Brazil). Following is our Global Overbought-Oversold Model readings for Emerging Markets as of December 31, 2013.

Global Overbought Oversold Model December 2013 2

Despite the recent selling in Thailand and Turkey, none of the readings for EM countries are sufficiently oversold to warrant even a speculative trade on the long side. When it comes to reversion-to-the-mean trades, investors better make sure the underlying story has not changed–or else, an oversold condition could turn into a market crash (e.g. purchasing Japanese stocks during WWII, Asian bank stocks in 1997, or money-losing U.S. tech stocks in 2001). At this point, Thailand is only oversold on a 3-month time frame; its longer term readings are not attractive enough to warrant a long position, given the country’s current societal conflicts and political uncertainty. A much better trade would have been going long on the MSCI Germany (could be readily purchased through the MSCI German ETF) in December 2011, when the index was highly oversold on both a 3- and 12-month time frame. A long position taken on the MSCI German ETF at the end of December 2011 would have returned 32.1% in the next 12 months–far outpacing a long position in Developed Markets (MSCI World: +16.5%) and the U.S. (MSCI U.S.: +16.1%).

Again, note that the above model is a price-only model and therefore doesn’t take into account valuations. As has been emphasized, it also does not work well for countries that are experiencing secular changes, or for timing peaks in the stock market (the quickest way to lose money is shorting a market or a stock that has high positive momentum and/or high valuations). One thing that comes in very handy, however, is the model’s ability to evaluate oversold countries/regions and to provide initial ideas on the long side. Going forward, we will update this as appropriate for our clients.

CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish

At 12:01 pm, on Thursday, September 20, 1920, a bomb exploded outside 23 Wall Street, the worldwide HQ of J.P. Morgan & Co. The massive dome on “The Corner“–the pride of J.P. Morgan–shattered. Dwight Morrow, Morgan partner, college friend of Calvin Coolidge, and later ambassador to Mexico, was hit and suffered cuts and bruises. 38 people died and 143 were hurt. The “Wall Street bombing” took more lives than the 1910 bombing of the Los Angeles Times building–the deadliest act of domestic terrorism up to that time.

All of the ticker machines inside the offices of J.P. Morgan & Co. were destroyed–save one. The clacking noise of Clarence Barron’s Dow Jones ticker machine could still be heard–printing out news of the bombing, speculation on the consequences, and news that the NYSE will reopen the next day. The clacking on the Dow Jones ticker machine sent a clear message to the terrorists, anarchists and socialists: U.S. commerce–and the U.S. entrepreneurial spirit –will not be stopped.

Indeed, the 1920s would come to be known as the “Roaring Twenties”–one of the most prosperous times in U.S. history.

A review of 2013 shows something extraordinary: The S&P returned 30% YTD, while the Russell 2000 of U.S. small cap stocks returned 34%. The performance of U.S. stocks in 2013 ranks as the 8th best performing year going back a century. In our 2013 outlook last year, I gave Developed Markets (which includes Canada, Western Europe, Japan, Australia, Singapore, and Hong Kong) a return rating of “7,” suggesting an above-median return. I was also relatively bullish on U.S. stocks versus other developed markets. I (Henry) expected U.S. stocks to return in the mid- to high-teens. An inherent optimist, even I did not anticipate that U.S. stock market returns would hit 30% this year (we were more bearish on emerging markets equities–but we certainly did not foresee their -6% return this year).

With the exception of the Greek (+39%), Finnish (+38%) and Irish (+37%) markets, the U.S. was the best-performing stock market in the world this year. The U.S. Consumer Discretionary sector returned 40%, while Healthcare returned 39%. This extraordinary performance in U.S. stocks sends a strong signal to the doubters, the terrorists and socialists: U.S. capitalism remains alive and well. U.S. commerce, innovation, and ingenuity will not be stopped.

That said, we are much more cautious on the U.S. stock market outlook for 2014. As mentioned, this year’s performance of 30% was extraordinary, especially with the major U.S. indices making all-time highs week after week. In our opinion, the market has already discounted a stable global macro environment, improving U.S. employment in higher-paying healthcare and engineering professions, as well as future productivity improvements stemming from increasing automation and the U.S. energy revolution. As such, we believe U.S. stocks will return 5% to 10% in 2014, or slightly below the historical average. We anticipate the S&P 500 to settle in the 1,900 to 2000 range by the end of 2014. This is equivalent to a return rating of “4” for Developed Equities (on a scale of 1-10).

As part of our 2014-16 “barbell” investment strategy, we recommend selective risk-taking within various industries in the global equity markets. As discussed in our latest issue (please contact us for a copy), we believe there will be a buying opportunity in gold (-29% YTD) and low-cost gold producers sometime in H1 2014 (note that we recommended a short position in gold in January of this year). More details are forthcoming in our next global macro newsletter in January 2014.

I now want to address a couple of clients’ questions or concerns regarding valuations of U.S. equities. Firstly, yes, U.S. stocks are the most expensive relative to that of Europe, Japan, or Emerging Markets (using traditional ratios such as P/E, P/B, and PEG). While we are slightly concerned (this is why we are only targeting a 5-10% return in the S&P 500 in 2014), clients should recall that valuations–even on an individual stock level–have not been a great timing indicator. Firstly, none of our proprietary fundamental, technical, or sentiment indicators are flashing strong sell signals–signals that were paramount to us exiting/shorting the U.S. stock market during the March 2000 and October 2007 peaks. Secondly, the valuation factor (namely, the price-to-book ratio) only comes second to the momentum indicator (12-month price change) in terms of predicting performance in relative individual stock timing. In fact, investing in value stocks (i.e. cheaper on a P/B basis) has been a big loser for sustained periods of time, namely the 1930s, the late 1990s, and 2007-08. One academic study after another has shown that momentum investing is superior in most periods in global stock market history.

That said, we certainly keep track of valuations–both absolute and relative valuations. We never bought the S&P at a trailing 40 P/E ratio in early 2000; we became very concerned once the 10-year Treasury yield rose above the S&P earnings yield in late 1999. As of December 19, 2013, the S&P earnings yield (chart below courtesy Goldman Sachs) is still 3.5% higher than the 10-year Treasury yield. This 3.5% yield gap is just below its 10-year average but is still high on a historical basis (1976-present). That is, U.S. stocks are still cheap relative to U.S. Treasuries.

GSvaluationFinally, after 18 months of consistent outflows, U.S. equity fund flows turned positive in January this year (source: ICI). By the summer, investors began rotating their investments from bonds to stocks for the first time since late 2008 (chart below courtesy Goldman Sachs). Since fund flow trends tend to last for many months (401(k) investors don’t change their investment selections very often), we believe U.S. equity fund inflows will remain strong in 2014–further supporting U.S. stocks. We will not become concerned until the S&P 500 rises above 2,000 or the 10-year Treasury yield surpasses 3.5%.


Fed Refuses to Taper – Yes, it’s a Big Deal

No major firm anticipated this, but by staying on course with its $85 billion-a-month purchases in Agency MBS and Treasury securities, the Fed has sent a strong signal to global financial markets: We will stay fully committed to QE3 until inflationary expectations become well-anchored at the 2% level and until U.S. hiring begins to accelerate. These are tangible benchmarks (the former garnered from TIPS prices, and the latter from U.S. weekly jobless claims) that are disclosed and digested by investors at least on a weekly basis. In other words, investors no longer need to guess–global liquidity will continue to stay elevated until the U.S. employment picture definitively improves and inflation hits and stays at 2%.

The U.S. economy is still far away from hitting these benchmarks. U.S. inflation in August was lower-than-expected, with year-over-year CPI growth at 1.5%. According to the Cleveland Fed, ten-year inflationary expectations as garnered from TIPS prices are still near a record low, while the ECRI U.S. Future Inflation Gauge (a leading indicator for U.S. inflation) just hit a 19-month low (in the Euro Zone’s case, this indicator just hit a 40-month low).  Geopolitical events notwithstanding, certainly the U.S. economy is at no significant risk of higher inflation anytime soon.

In essence, the Fed has: 1) sent a strong signal that global liquidity will stay elevated, and more important, 2) prior to any tightening, investors would get strong signals from both market indicators and the Fed–i.e. there will be no surprises. It is thus not surprising to see India and Indonesia–two countries with strong recent outflows–spiking up immediately after the publication of the Fed’s FOMC statement. As we are writing this, India is up more than 3%, while Indonesia is up by more than 8%. Keep in mind that both markets were down earlier this morning. Asia is going to go gangbusters tonight. More important, the Fed has eliminated any potential systemic risk in Asia (prior to today’s announcement, we believed India and Vietnam were the two countries most at risk to Fed tapering). U.S. home buyers, as well as gold and oil speculators, can also celebrate.

U.S. Real Estate No Longer (That) Attractive

Note: In our July 31, 2013 post (see “Our Revised 12-Month Outlook on Major Asset Classes“), we downgraded Developed Equities from a return rating of “5” to “4.” Since then, the Dow Industrials and the S&P 500 have declined by 4.4% and 3.1%, respectively. Meanwhile, our upgrade of Emerging Markets was based on valuations. With the exception of India, Indonesia, and the Philippines, EM equities have done okay (Chinese equities have risen since July 31). Note that in general we never advocate any long positions on the weakest links–those being India, Vietnam, and probably Indonesia right now.

Please also note we will also never advocate any substantial long positions in an asset class that led the last bull market. E.g. We did not advocate much buying of tech stocks during the 2003-2007 bull market. Rather, we advocated the purchase of precious metals, commodities, etc. As a rule, the asset classes that led the last bull market (those would be U.S. real estate, U.S. financials, EM equities, and commodities) typically under perform in today’s bull market. Already–based on our deal flow and conversations with clients–we are seeing green shoots and revolutionary, but practical breakthroughs in the U.S. technology sector. We believe U.S. tech will lead the current bull market to new heights over the next several years.

In the meantime, both U.S. and global equities are undergoing a corrective phase. Based on our proprietary technical and sentiment indicators (which we will cover in latter commentaries), they are still not close to a buying point. We expect this corrective phase to last another 2 to 3 months. We also expect the U.S. and global economy to slow down for the rest of the year, given increasing anxiety over the uncertainty of U.S. monetary policy, the change in the Fed chairmanship (most likely, Lawrence Summers will head the Fed, which will not be constructive in the short-term), and uncertainty over the Chinese and Indian economic slowdowns.

We believe U.S. real estate–despite its recent positive momentum–will suffer a slowdown as global investors pull back, and as U.S. interest rates continue to rise (this morning alone, the 10-year Treasury rate spiked by 15 bps to 2.9%). Since the beginning of this year, we had given a return rating of “9” to U.S. commercial real estate–our most bullish return rating this year thus far. Both U.S. commercial and residential real estate prices have significantly over-performed this year–reaffirming our bullish view. Keep in mind, however, that our bullish outlook on U.S. real estate was predicated upon: 1) ongoing monetary stimulus, 2) severely oversold valuations and dislocation in U.S. real estate, 3) an undervalued US$, which generated significant foreign interest, 4) a re-allocation by institutional investors (e.g. pension funds and sovereign wealth funds) to U.S. real estate from other global risk assets. Given the heavy investment activity and the rise in U.S. real estate prices this year, we are no longer as bullish. In addition, the recent spike in interest rates, including the 30-year mortgage rate, is generating significant concern among CB Capital.

30-year mortgage rates

The recent spike in the 30-year mortgage rate (on a % basis) is the most severe since the spike during summer 2006, which preceded the bursting of the U.S. housing/mortgage bubble in 2007. We are not as concerned this time around (we went short U.S. equities in late 2007) as the U.S. housing market–unlike the typical post WWII economic cycle–did not lead the U.S. recovery over the last several years. However, the history of the above chart cannot be ignored. As such, we are downgrading our return outlook on U.S. commercial real estate–from a “9” to “8,” and increasing our risk rating from “5” to “6.” We would also not be surprised if some kind of financial “dislocation” emerges in other parts of the world, such as India, Vietnam, or even the Euro Zone. The last time we witnessed a combination of spiking interest rates and Fed uncertainty (i.e. 1994), Orange County filed for bankruptcy, and many investment banks and hedge funds lost substantial amounts betting on the carry trade. Investors should dial back risk-taking in general for the next two to three months.

12-month Outlook September 2013

Our Revised 12-Month Outlook on Major Asset Classes

In our inaugural 12-month asset price outlook published on January 7, we rated Developed Equities a “7.” A rating of “5” suggests a return outlook close to its historical average (since 1926, the annualized total return of the S&P 500, with dividends reinvested, is just under 10%). i.e. We were relatively bullish on Developed Equities, as our rating of “7” in the beginning of this year suggests a higher-than-average return outlook. We were less bullish on Emerging Markets, however, as we believed countries like Brazil and India were: 1) experiencing inflationary pressures due to the lack of infrastructure and educational investments over the last decade, 2) the commodity bull cycle was maturing, and 3) China, the number one growth country in the world, was experiencing a structural growth slowdown (we projected a 5% to 8% growth rate over the next 5 years, versus a 8% to 11% growth rate over the last decade). As such, we rated Emerging Markets a “5” only.

Since January 7, the MSCI World Index (representative of Developed Equities) returned 11.8%, while the MSCI Emerging Markets Index declined by 10.4%. The return gap of over 20% between Developed and Emerging Market Equities (despite the ongoing troubles in the Euro Zone) over the last seven months is the largest running seven-month return gap between Developed and EM equities since month-end September 2000, and prior to that, the Brazilian/Russian crisis in fall 1998. Our constructive outlook on Developed Equities relative to Emerging Equities was thus prescient, although we did not expect Emerging Market equities to under perform so severely. Emerging Markets, in general, have been hurt by an overweight in the commodity and materials industries, as well as country-specific troubles such as the crash in the Indian Rupee, the slowdown in China (and domestic investors’ preference in Chinese real estate over Chinese stocks), and the near-recession in Brazil.

Developed and EM Return Gap

That said, Emerging Markets in general are in very good shape.  Balance sheets at most EM governments and corporations are flushed with cash, while EM’s dependence on US$ funding has declined substantially. Domestic ownership of EM equities has grown substantially–thus minimizing any potential fallout from a mass exit by foreign investors. SE Asian countries, in particular, have pooled their resources to create a $240 billion multilateral currency swap agreement. Dubbed the “Chiang Mai Initiative,” it was designed to prevent a repeat of a systemic fallout in SE Asia similar to the Asian Crisis. We think growth in EM countries and EM equities are poised to re-accelerate; and are thus overweight EM relative to Developed Equities over the next 12 months. We are raising our return rating for EM equities to “6,” while downgrading our return rating for Developed equities to “4.”

Our true value-add, however, was our highly bearish outlook on gold. On January 7, we gave gold a return rating of just “2,” with a very high risk rating of “8.” Our risk-reward outlook for gold was timely, as gold prices subsequently declined from $1,645.25 an ounce to $1,314.50 an ounce today–representing a decline of 20.1% in just under seven months. Gold is now hugely oversold in the short-run. We are thus raising our rating on gold from “2” to “3” (with a corresponding risk rating revision from “8” to a more benign “7”) despite our recent 6- to 12-month gold price target revision from $1,100-$1,300 an ounce to $1,000-$1,200 an ounce. Our 12-month revised outlook on major asset classes is published below. Any feedback or comments are welcome.

12-month Outlook July 2013

The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices

Neoclassical economics cannot explain the spike in real global wealth per capita (nearly 10x) in the 20th century. The classic Cobb-Douglas Model attempts to explain global GDP growth through three major inputs: 1) “Total factor productivity,” 2) labor (L), and 3) capital (K). Both L and K can be quantified and explained. However, studies have shown that fully 70% to 80% of the increase in economic output during the 20th century came from “total factor productivity,” i.e. an exogenous factor that resembles technological growth and adoption—leading to increased overall productivity. Economists have a hard time explaining the origin of “total factor productivity.” We know that education (investment in human capital), venture capital, the capitalist system, and the sharing of ideas all play a role, but we do not truly understand why their benefits were unique to the 20th century (and to a lesser extent, the 19th century, when real global wealth per capita grew by 3x—please request a copy of our January 2013 newsletter for a more detailed analysis).

What we do know is that the vast majority of global economic growth in the 20th century was predicated on an exponential increase in energy consumption. In other words, productivity growth—20th century’s main economic driver—was mostly a result of increasing energy consumption. Every technological breakthrough, such as modern-day jets, computers, fiber optics, automobiles, etc. required the consumption of increasing amounts of energy. In some areas, we have made efficiency breakthroughs (e.g. the shrinkage of CPUs), but in other areas, not so much (e.g. the internal combustion engine). Such growth is especially amazing given the mass human failures of the 20th century, such as World War I & II, the rise of communism and Nazism, as well as the Korean and Vietnamese Wars. More important: If the 21st century global economy is to grow in the same trajectory as that of the 20th century, global leaders will need to find cheaper and alternative sources of energy—horizontal drilling and fracking notwithstanding.

In the meantime, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that—despite the increase in U.S. oil production—a rising global economy will lead to higher crude oil prices (China just surpassed the U.S. as the number one oil importer). A prediction for future oil prices thus requires an analysis of the performance of the global economy, given the globalized nature of oil. Using the Leading Indicators data for 30 major countries in the Organization for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia, we have constructed a “Global Diffusion Index” which have historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. We label it the “CB Capital Global Diffusion Index” (“CBGDI”), which is essentially an advance/decline line of the OECD leading indicators—smoothed on a three-month moving average basis. Historically, the rate of change  of the CBGDI has led WTI crude oil prices by about three months, with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (not surprising, since stock prices are one component of the OECD Leading Indicators). Following is a monthly chart showing the year-over-year % change in the CBGDI, and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in the MSCI All-Country World Index and the year-over-year % change in WTI crude oil prices from March 1990 to February 2013. All four of these indicators have been smoothed on a three-month moving average basis:

CBGDI February 2013As noted on the above chart, the rate of change (second derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented producers from hedging their production. The second derivative of the CBGDI troughed at the end of 2011, and has continued to rise—implying higher global stock and energy prices. While we recognize that U.S. crude oil production is set to rise by 1.4 million bbl/day over the next two years (not a trivial amount, as 1.4 million bbl/day is equivalent to total Indonesian oil consumption), recent strength in the CBGDI suggests that WTI crude oil prices have at least bottomed, for now. More important–unless celllulosic ethanol or second-generation biofuels are commercialized in the next several years (or unless room-temperature superconductors are discovered tomorrow)–this suggests that the secular bull market in oil prices is not over.

As we are finalizing this commentary, we understand that Cyprus may be experiencing a bank run, as the EU had suggested taxing bank deposits to pay for the country’s bailout. If implemented, this will set a very bad precedent and will have long-term (adverse) repercussions in the European banking system. Such a Black Swan scenario may weaken commodity and energy prices in the short-run, but we believe WTI crude oil is a “buy” on any further price weakness.

Developed Equities Overbought

Since the publication of our 2013 outlook on January 7, the MSCI World has rallied by 3.7%, the MSCI EAFE by 4.1%, the Dow Industrials by 4.7%, and the S&P 500 by 3.5%. Our constructive outlook on developed equities relative to emerging markets equities was prescient, as Emerging Markets remained flat during the period. Meanwhile, Frontier Markets rallied by 5.0%. Based on our technical and sentiment indicators, both developed and U.S. equities are now overbought. For example, last week’s survey of 40 NAAIM (National Association of Active Investment Managers) member firms shows an equity exposure of 104.25%, the highest level since early 2007!  This survey (courtesy contains data from leveraged and long-short strategies, and thus responses can vary widely. The results are then averaged every week. Inception of this poll is 2006. The latest result shows active money managers to hold a net leveraged long position, which has only occurred the second time since inception of this poll. From a contrarian standpoint, U.S. (and developed equities) are now highly overbought.


We are still constructive on developed equities, given ongoing central bank easing (the BOJ has vowed to adopt a more aggressive easing policy by actively underwriting more government spending), decent valuations, and the elimination of certain tail risks as discussed in the inaugural issue of our monthly newsletter (please email us for a sample). However, we cannot ignore the market’s overbought conditions. As such, we are revising our 12-month outlook on developed equities. Our 12-month return outlook for developed equities is revised down from a rating of 7 to 5, while our risk rating is revised from 6 to 7. Our outlook on developed equities is now on par with that for EM equities Our ratings for other major asset classes remain the same, although we are keeping a close eye on U.S. Treasuries, gold, and WTI crude oil.

12-month outlook February

CB Capital’s 2013 Price and Risk Outlook for Major Asset Classes

Happy New Year. Following is our 2013 price and risk outlook for selected major asset classes. We are publishing our annual price and risk outlook for the first time, so a little explanation is required. Our rating score summarizes our view on where we believe prices will head over the next 12 months. A rating of “5” is considered neutral–close to the asset class’ historical median return. Our risk score summarizes the probability for significant deviation from our price outlook. For example, gold’s risk score of 8 suggests the significant possibility that the asset class could remain elevated near $1,700 an ounce (as opposed to our downward forecast), as the price/demand of gold depends on many differentiated factors, such as jewelry demand in China and India; as well as a reemergence of systemic risk in peripheral Europe. The outlook on global monetary, fiscal, and global bank regulatory/lending policy is anything but certain in 2013.

More details will be provided in our CB Capital’s inaugural monthly newsletter. It will be published in the next 7 to 10 days, and will be provided to selected clients. All the best for 2013.

2013 outlook