The Compound and Friends - The Four Most Important Market Indicators (with Josh and Tom Lee)

Episode Date: November 13, 2019

Josh here - I really enjoyed talking with former JPMorgan strategist and the founder of Fundstrat Research about how he uses the evidence to understand what's happening in the markets.  Tom cites four indicators he uses to explain current trends and think about where markets and the economy might be headed. Among them, credit spreads, demographics and volatility.  Tom also talks about his bullish stance and why he isn't terribly worried about the yield curve inversion we saw this summer.  You can learn more about Tom's work at the site:  https://fsinsight.com/ Follow Tom Lee on Twitter here: https://twitter.com/fundstrat 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey, it's Downtown Josh Brown. I'm here with my guest today, Tom Lee. Tom is the former chief strategist at J.P. Morgan. He is the co-founder and head of research at Fundstrat. Tom is going to tell us about the most important indicators and things he looks at to understand what's happening in the market. Stick around. This is going to be great. First of all, thanks for coming up, coming down. You're in the 50s? Yeah, I'm in the 50s. Okay. I've been reading your stuff for 10 years. And one of the things I found most interesting about your work is that you've been almost consistently bullish throughout this entire,

what I call a secular bull market. And you've been mostly right. And there have been times where you didn't look right because markets were getting more volatile than what we're accustomed to. But you've pretty much stayed the course. And I think people who have listened to you on balance have done better than people who have listened to some of the more hysterical or gloomy voices out there. Do you give yourself pats on the back or do you just feel like this is what I do I try to understand? Well you know I've been doing research for 27 years and when I was a kidder the director research said you know never

get too happy with yourself because you're only good as your last call so I think we're always paranoid looking over our shoulders. Right like what could go wrong, where am I wrong? I hear that consistently from people that you know are in a similar situation that you're in. So I wanted to ask you about, we're going to get into your conclusions later, but I wanted to ask you about your process. What would you tell someone are the most important things to look at to understand why the markets are doing what they're doing? At Fundstrat, we'd say that there's a couple cornerstones of our research process. The first is we do evidence-based research.

So we really don't want to say something unless history can show it or we can show some correlation or probabilities. Okay, so you look at historical returns. Yes. Okay. And that's largely driven by demographics. So believe it or not, population has explained almost every bull market cycle since 1900. of these 20-year generations peaked.

The greatest generation peaked in 1974. The silent generation peaked in 1930. The boomers peaked in 99. Gen X peaked in 2018. Okay. Every major market top has coincided with a generational peak. When you say peaked, you mean the number of births in that cohort turning a certain age? Yeah.

So what happens is the cohort grows over time because there's immigration and births and then deaths. So it's really immigration that's a big swing factor as well as the birth. So you could almost predict every major market top with a 40-year lead time just by tracking births. So if you're looking at demography and population, how is it that you were able to draw the right conclusions from that? Whereas one of the foremost authority, I don't want you to criticize someone else's research, but let's take Harry Dent Jr., who looks almost exclusively at population from what I've read, and has drawn the exact opposite conclusion you have and has not been correct. Yes. So last week, just coincidence, I'm not name dropping, I was with Masaaki Shirakawa, 30th

Bank of Japan governor, father of QE. And we were doing a panel together about population. And one of the takeaways he had was that in Japan, the reason you can't say QE failed and Japanification happened is because their workforce actually shrank. When you have a shrinking workforce, you can't really grow the economy. It's really this prime age workforce and really this 30 to 50 year old band, this 20 year band that drives the economy. So you have to track how that grows and shrinks over time. Okay. So the 30 to 50 year old is having children, buying a home, earning toward their peak, if not at their peak, and spending more than people in the other age

groups. That's right. So Chase credit card data from the Chase Institute, anyone can download, shows that that cohort is the only cohort driving credit card spending growth in any year. Okay. So boomers are actually, you know, older people are actually cutting down their spending. And then when you look at Urban Institute data, leverage per person rises from age 20 to 50. So that group is really driving the credit impulse, and it's the GDP multiplier of the economy.

Okay. So then from that lens, how does the United States look in terms of that cohort and where we are in that cycle? So we have many charts on this, and it's about to blast off. This number, 20 to 50-year-olds, actually went negative in 2005 because Gen X was a contracting generation. Smaller than the one before. Correct. And it bottomed in 2008.

It stayed negative until 2016. Just turned positive because of millennials. The oldest millennial is 37. And it's about to go up and to the right, looking a lot like the early 70s. So it's actually very bullish. Okay. I love that frame with which to then ask you, okay, so you have that as like a baseline. Correct.

That, okay, according to history, given the size of this cohort and where they are in their age, this is the right time. What else are you looking at? On top of that, we have a third sort of framework, which is that equities are the junior piece of the capital structure, which means that economics and credit lead what equity should do. So I think our favorite indicator there is really watching high yield because it is the market closest to the equity markets and high yield has always led equities at the turns. Okay. So high yield, junk bonds, basically they're bonds, but they have equity-like features in terms of their volatility, and they're not quite as senior as – Yes.

Okay, like treasuries. It's almost a smarter market because the principal is not guaranteed. Default risk can rise, and when there is default, your recovery rate is low. So high-yield bonds are very macroeconomically sensitive. When you look at high yield bonds, are you looking at the credit quality of the universe or are you looking at spreads over what you can earn in an investment grade bond or both? Yeah, it's both. So it's a spread. So we want to watch spread because that's a measure of perceived risk. But we also want to watch route to value.

So when high yield yield to worst, which if you invert it, you get PE. If that's yielding more than equities, then equities are cheap. So you want to buy equities until they're actually a lot more expensive than high yield. But you do get false signals in the high yield market. 2015 and 16 was a pretty good example because of how much of the high yield market was made up by energy companies. And oil falls from 80 to 20. And as a result, you do get some spreads blowing out. But I don't recall you looking at that signal and saying, here we go, downturn. Yeah. So what's interesting, and you bring up a really

good analog. So when high-yield has a year like 2016 or 2015, where total return was negative, yeah, that's a massive signal to us., one, it's really hard for Hiale to have a negative total return year. It's only happened five times since 1984. Wow. And five of five times, stocks had a positive return the following year. Why does that happen?

Well, it's a real shock to cause total return for Hiale to be negative. And it happened in 2008. You're saying calendar year negative returns for total. So even if you got the interest payment, you still lost money because the price of the bond fell. Yeah, so you broke par. Okay. It's really rare.

In fact, high yields never posted two negative years back to back. So when they have a total return negative, high yield has amazing following total return year. So 2018, high yield had a negative total return year. This year, it's up double digits. But to us, that was why we started the year so bullish is because we knew high yield was telling us this would be a great equity year. Okay. What else do you look at? So positioning and risk reward are the other two. So positioning, now we look at prime brokerage data, which not everybody who's watching this can access, but I think the simplest measure we like to use is the AAII sentiment survey.

I think it's really bulletproof and it's been around for more than 30 years. This is for positioning? For positioning, yes. Okay. And it's a contrarian signal. When the AAII bulls less bears is extreme negative, so minus 20 percentage points or worse, 100% of the time, it's a buy signal six months out. Okay, because the market tends to trade higher, and then the people that had gotten bearish end up chasing it up. Yeah, that's right, because when people are bearish, and so sentiment's really negative, they've likely sold.

So that's the consensus view and therefore good news can be good news. Okay. So how often do you get an extreme reading in something like the AAII poll? It's a two sigma. So meaning you'll get it every 50 weeks or every 20 to 50 weeks. Yeah. And that's a free data source. They just publish it. Yeah, they publish it weekly. I find that remarkable. Yeah. Okay, and then what was the last one? Risk-reward, which probably the simplest way to measure it is the VIX. Okay.

So the VIX, which everyone is very familiar with because they know when it's going up, there's a lot of fear. But it's really measuring the cost of term premium for an option. It's implied volatility. Okay. And so when it's rising, then you know there's a lot of fear because people are trying to buy protection. So for this audience, the VIX rising signifies people who are essentially buying insurance against the stocks they own in their portfolio or against the overall market.

Yeah. Okay. And there's a little twist to the VIX, which is using the VIX futures, which anyone can still access even through Yahoo. But the VIX has contracts expiring one month all the way through 12 months forward. If you see the price of a one-month contract above the four-month, that means people are more fearful of things in the next month versus four months out. So it's an inverted curve.

That's got to be very encouraging if you're looking for an opportunity to buy. Correct. It's only happened seven times since 2009. I was going to say, that sounds like it would be a really rare occurrence. Yeah. And we had one this year. When does that happen? Like around elections or around things that seem like they might have a binary outcome?

Correct. Exactly. So it could happen around Brexit. It could happen around elections. It could happen around Brexit. It could happen around elections. It could happen around trade tensions. It happened this year, and we used that as a signal to tell our clients that tradable bottom was in. So are you quantifying these things on some sort of a numerical scale, or is it really more art than science, and you're just saying, I like what I'm seeing according to these four indicators? Or is it a mixture of the two?

Yeah, so we accumulate the data. So Josh, we provide our clients the probabilities. So when AEI is minus 22, we show the three-month, six-month, nine-month. But the six-month probability of a gain is 98%. So it's almost as good as 100. And with the VIX, now N equals only seven, but seven of seven times it was a tradable bottom. So I think the way we look at indicators is when there's extremes, so more than a two standard deviation reading, it's signal. So as a research person, you must, I assume most of the people that you cater to are asset managers, hedge fund managers. Do you find as a research person that a lot of what people want from you is confirmation bias, meaning they already have their own view and what they want is the

information from you that will back that up? And if that's the case, do you fight back at all and say, I know you don't want to hear this, but, or like, how do you see your role in that relationship? Yeah. So in the research business, we're trying to do signal from noise because you can imagine all of our clients get a lot of information. We're surrounded by noise. Yeah. Everyone's, right. We're generating our own noise. Yes. And because we're independent research, we don't make money through anything except advisory. Okay.

So we always want to be their top three source. That's really what we're fighting for. And we have about 150 clients. Okay. So we always want to be their top three source. That's really what we're fighting for. And we have about 150 clients. Okay. I would say half of them use us for a ballast. So at times of stress, we're helping them with stock lists and also trying to essentially prevent them from doing something catastrophic.

Okay. But in years where the markets like this where consensus was quite negative, they've been happy to hear our variant view, even if they don't agree. This has been a challenging year because I think people kind of have been a little snarky because they're like, Tom, you're ignoring the fact that we're about to tip into recession. Or they're going to tell you, yeah, you're always bullish no matter what. Exactly. But I think that fortunately, it does look like the industrial sector is bottoming, which was our view, and we're mid-cycle. And so I think people just appreciate that we're not trying to respond to the tape.

We're trying to provide ballast to the tape. So speaking of sentiment extremes, the Barron's poll that everyone's talking about. So Barron's does this big money poll. They talk to actual professionals, portfolio managers, et cetera. And it was the lowest reading for bulls in something like 20 years are you serious yeah um wow yeah so it was like the it was like uh it was it was like a 27 percent bull reading or something and it hadn't been under 30 in a certain amount whatever the number is not important um so i know that doesn't really enter into the data that you're using, but it coincides nicely with that. It speaks to everything, yeah. So my question is, speaking of noise, like, what if some of the stuff that you're looking

at and that you have determined is historically important conflicts so widely with everything else? Like, do you ever have those kind of moments of truth where you'll say, I must be missing something? Yeah. Okay. So how do you deal with that? Well, it's happened several times this year.

One was the yield curve inverted. And as you know, people- So that happened in the spring. Correct. It's kind of cleared itself up now a little bit. Yes. But we're still close. But it's the 10-year three-month.

Yep. Now, it's considered a bulletproof signal. And it would have been the death knell if indeed a recession followed. But what we highlight to our clients was if you look at the nine times since 1950 of the first inversion of the 10-3, once an expansion starts, okay? Okay. Eight of the nine times, it's because the Fed was raising Fed funds. So the three-month jumped above the 10-year. Okay.

So it was the central bank is engineering the inversion. Only in 1998 did the inversion happen because both rates were falling, but the 10-year fell faster. That's what happened this year. So we were explaining to our clients that this is an anomalous inversion, just like 98, and it was not an economic signal.

Well, you eventually did get a recession subsequent to the signal in 1998, arguably caused by the blowing up of a stock market bubble. Yes. So I'm not sure if that enters into your thinking about... Yeah, I'm sorry. Yes, it does, Josh. But in 98, it was long-term capital that caused the risk-off.

And so what happened was if you bought on the data that inversion, you were up 40% 18 months later. Oh, yeah, 99 was one of the best years ever. Yes. I agree. Yeah. Okay. So when you are speaking with clients about what's happening right now, and just like in general terms because people watch this video for years to come, a lot of what people are referencing is, as you mentioned, the recession probability seems to be going up.

The Fed seems to be partially fueling that concern because they're essentially bowing to, I guess, market and non-market pressure in accommodating, which is rare outside of a potential recession. How do you help people make constructive investment decisions in an environment like this generally? And then what do you think people specifically have wrong about what's happening right now? So we have this list called granny shots. Granny shots. Granny shots. And it's a tribute to Rick Barry, who was a free thrower, but he threw underhanded,

an unconventional free throw. But probability of success, yes. That's the mechanically physics best way to throw free throws. So we won three Matic portfolios, and we have a quant overlay. And so our granny shots are the stocks that appear in the most. And so it's really low vol, high quality stocks. And that's what we want really like our parents to buy. Right.

But in terms of what you said, what people maybe have gotten wrong this year, and I'm not saying anyone's wrong because the year's not over yet, but I think three things have happened. One is I think that there is an oversensitivity to think the cycle's ending because of age. Because of how long markets seem to have been going up. Yes, because 10 years of expansion, longest in history, and almost everyone thinks we have to be late cycle as a consequence. Right.

Which you could understand. Yes, it makes sense. But we have two fairly bulletproof measures of cycle, which is employed to population ratio and in private investment to GDP spend. And they're not saying that? They're mid cycle, yeah. Okay. All right.

The second is, I think people tend to think the center of gravity of growth in the world is China, which was true for the last 20 years. But our work is showing that it's actually going to be the U.S. the next 20. Wow. So we have a huge structural shift taking place. China might actually be Japan in the next 20 years. And a lot of this is coming from demography, you're saying? Yeah, demography. And if you look at wealth accumulation or value capture, the U.S. has captured $100 trillion of household wealth, which is one third of global wealth.

And they've actually widened their lead in the next 20 years. I think U.S. might control over 50% of global wealth. Okay. So what you're saying is not to just take at face value these prognostications that we're entering into the Chinese decade or the Chinese century simply because of their size catching up to ours, that there are more important considerations. Yeah, that's right. So China is going to be the second most important economy. But in the next 10 years, the U.S. is clearly the most important. There's the millennials inheriting $75 trillion of wealth. And building their own.

Building their own. Right. They're about to hit their 30 to 50 range, which means they're going to be buying a lot of houses. No other country that's developed except for India is going to see this. So there's only two regions that are going to see this sort of hyper growth, U.S. and India. And the third is I think there's a lot of people that want a recession because they either want to change the White House or their long bonds. And so we think there's recession mania. You know, people are carrying 2008 hammers looking for 2008 nails.

Oh, so the last thing I would ask you to build on that point, though, isn't it possible that enough people expect a recession? You'll have one because they'll change their spending behavior? Or is that is I think Schiller would probably agree with what I just said. Yes. Yeah, that's the animal spirits. OK. Yeah, that's right.

Keynes would certainly agree with that. Yeah. You think that's overblown as a concern? I think that could be true at the CEO level. I think CEOs could get cautious. But I think that the average American will measure this by his job and his stock portfolio. And by those two measures, his wages are increasing,

his job security is rather high. You look at that In the jolts Quit rates Yeah And of course His 401k This year Has had a terrific year

Yeah in fact I would say retail Has outperformed Active managers this year Right Because retail 60-40 Is double digits on both And stopped guessing

Yeah Right Well Tom Thank you so much For coming to talk About this stuff I'm going to post a link To where people

Can read more of your stuff Would you send them To fundstrat.com Or fsinsight.com. So Funstrat's more for our institutional. Okay. fsinsight.com is for RIAs and individuals. You got it. And you're on Twitter as at Funstrat. Yes. Everybody follow Tom Lay. Thanks for joining us today. Tom's a great follow. If you're on Twitter, make sure you go ahead and smash that follow button. Go ahead and subscribe to the channel if you haven't yet. And we'll talk to you soon.