- Stocks, bonds, and 60/40 had terrible first half. No surprise.
- The market has potentially 50% more downside, but that is not the worst case.
- Reflationary investments and the commodity super cycle are in bull markets
- Energy policy failures create multiple market opportunities.
- Backward looking strategies are doomed in new inflationary cycle.
The stock market had its worst first half in 50 years. Bonds and the 60/40 portfolio strategy had their worst performance on record. These historic and costly market returns are no surprise to our clients, readers and Seeking Alpha which has published Irrational Pessimism: The Market Is Bottoming (March 2020), 2 Generational Trends Reverse: The Fed Inflation Policy And The FAANG Stock Boom (September 2020), Unexpected Inflation Will Be Jerome Powell’s Titanic (May 2021), and Major Warning Signs Point To Market Top (Seeking Alpha’s Editor’s Choice, August 2021), The Market Crack Heard Around The World (February 2022), and Inflationary Commodity Super Cycle Is Investment Game Changer (Seeking Alpha’s Editor’s Choice, June 2022).
The global markets are in deep and dangerous waters. The potential downside to the S&P 500 could be 50% from these levels; however, there is also the chance that the economy could have a soft landing and the secular bull market could resume. What is certain is that inflation is at 40 year highs and this fact has fundamentally changed the investment environment such that following the rules of the last deflationary cycle (2009-2021) and the post-Volker 40 year environment of declining rates could lead to capital losses and protracted underperformance in stocks, bonds, and real estate.
What has been working for our clients and what will work in the years ahead is portfolio construction which embraces today’s war enhanced inflationary environment and offers fundamentally sound investments that should benefit from rising or persistent inflation. Most investment darlings and strategies of the recent past will underperform; when combined with investor psychological tendencies such as, sunken cost fallacy, investors will hold past leaders and strategies rather than rotating to new investments which reflect today’s new inflationary economy. By rotating into inflationary investments and portfolios strategies, new bull market opportunities are actionable for those willing to change their investment perspective.
Why So Glum Chum?
Equity markets are still dangerously overvalued. With Nobel Laureate Robert Shiller’s Cyclically Adjusted Price Earnings Ratio at 28.7 — levels comparable with peaks in 1907, 1929, 1966, 2000, and 2008, — the chart below suggests a market multiple decline to 14.4 or 50% lower, is normal market price reversion. If we have higher energy prices, inflation could surely lead to higher interest rates which are associated with lower PE ratios. A team of JP Morgan analysts led by Natasha Kaneva wrote in a report on Friday that oil prices could rise to $380/barrel, if the G7’s proposed mechanism to cap Russia’s oil prices in response to Russia’s unprovoked attack on Ukraine leads Russia to retaliate and cut its oil production by 5 million barrels a day. They forecast a cut of 3 million barrels a day and an oil price rise to $190/barrel. This risk is not remote when you consider that the Biden Administration and Energy Secretary Jennifer Granholm are also pursuing policies which hinder and seek to eliminate domestic fossil fuel production to address climate change. Income Growth Advisors, LLC fully support policies which facilitate an energy transition to net zero by 2050, but not through policies which risk global depression and could dramatically increase world poverty.
Another sobering example of downside risk is Warren Buffett’s so called favorite indicator which compares GDP to the total capitalization of the Russell 5000. This indicator compares the “real economy” as measured through gross domestic product and the financial markets shown through the Willshire 5000. Today, the indicator shows markets are 35% above historic averages. 35% downside is meaningful, but this measure does not anticipate negative economic outcomes like an oil price spike, 6% 10-year US Treasury Note yields, or a recession.
On The Other Hand:
Markets could navigate this Black Swan Russian invasion with Russia and Ukraine finding peace later this year. In this hopeful scenario, oil prices and inflation could decline, and equity markets would improve in a post COVID-19 recovery where the global economic growth machine again lifts global fortunes.
The New Inflationary Investment Strategy:
Today’s inflationary cycle requires a totally different investment approach. Inflation is changing the fundamental factor inputs which drive asset prices.
After 40 years of declining interest rates, this inflationary cycle will not benefit long duration assets like growth and technology stocks. Additionally, reflationary assets should out-perform. The chart below delineates inflationary and deflationary cycles over the last 140 years. Cycles are demarcated by the ratio of the S&P 500/the PPI Index (log).
The last two inflationary cycles were 10.5 and 9 years. This historic precedent suggests that this inflationary cycle should last ten years ending around 2030.
Another tool we use to delineate inflationary and deflationary cycles is the chart below. DoubleLine’s CEO, Jeffrey Gundlach, flagged this chart around 2018 as a potential source of outperformance on the order of 700-900%. The chart shows the ratio of the CRB Index divided by the S&P 500 index. With commodity prices rising and the S&P 500 turning down, this ratio is now rising sharply. We expect based on recent history and the fundamentals around financial assets and the commodity super cycle, we believe outperformance of commodities and commodity related investments could be on the order of 700% to 900% over this decade. That outperformance equates to 23.11% annually.
Source: IGA research and Tradingview.com
The above chart also dovetails with the commodity super-cycle case forecast by Goldman Sachs’ Jeffrey Currie.
Sector Selection Alpha Generation:
IGA studied the sector performance differentials between the Energy Select Sector SPDR Fund (XLE) and the Invesco QQQ Trust (QQQ) Technology ETF. We chose the XLE Energy ETF as a proxy for inflation and the QQQ as a proxy for deflation.
The chart below shows that during the 1999 to 2008 period, the XLE produced an annualized return of 22% and the QQQ annualized return was -3.16%. The delta between the two ETFs — the performance differential — was 25.16% annualized for nine years. That is a massive return differential. Conversely, during the 2009 to 2022 deflationary period, the deflationary QQQ ETF annualized 20% and the inflationary proxy XLE returned 3.6% CAGR. In the deflationary period, the performance differential was about 16.4% annually over twelve years. These monumental return differentials challenge the conventional wisdom of investing in the S&P 500 when compared against a risk managed sector allocation strategy based on inflationary and deflationary cycles that can produce superior risk adjusted returns.
Source: IGA research and Yahoo.finance.com
New Inflationary Portfolio Strategies:
Energy Is A Safe Haven:
In recent years, fossil fuels have been demonized by the ESG movement as Climate Envoy John Kerry and others have touted a seamless transition from fossil fuels through renewables. This idea is both simplistic and illogical. 85% of global baseload energy comes from fossil fuels, while 15% come from renewable and nuclear. The idea that you can transition that much baseload energy into cleaner alternatives simply by eliminating fossil fuels is proving to be a terribly costly strategy.
The US is not alone in its aspirations for Net Zero and a clean climate friendly world. Europe, a leader in climate and environmental policies, was led by Angela Merkel, the former German Chancellor, who began denuclearizing Germany following Japan’s Fukushima nuclear reactor disaster in 2011. Germany fully embraced renewables — solar and wind energy — to replace its shuttered nuclear energy. Last summer, Europe had a hot and windless summer which led to a wind energy power generation deficit that led it to draw down its energy storage. This led to energy shortages throughout Europe last year which were forecast by Charif Souki, Executive CEO of LNG upstart Tellurian Inc. (TELL).
Russia’s Unprovoked Invasion of Ukraine:
On February 24, 2022, the world changed when Vladimir Putin’s Russia invaded the Ukraine after solidifying a dominant position supplying western Europe with natural gas.
Since the market’s bottom in March 2020, IGA has been advocating deeply discounted energy investments, natural gas, and LNG stocks. IGA has been buying MLPs and natural gas stocks including Antero Resources Corporation (AR), Antero Midstream Corporation (AM), and Tellurian Inc. (TELL) which have returned 3518%, 304%, and 190% since March 20, 2020, respectively. One characteristic which increased our conviction in Antero Resources Corporation, even when some analysts were negative on the stock, was that the company was buying back both its shares and debt.
The chart below shows three of IGAs largest holdings. They are in the natural gas sector which is the cleanest fossil fuel.
Source: IGA research and Yahoo.finance.com
We applied this screen to the energy sector and found 29 energy stocks which are now buying both their stock and bonds.
Traditional portfolio allocation would suggest one allocate an S&P 500 share of energy to your portfolio. We disagree. Energy was once 20% of the S&P 500 and had declined to 2% in 2020 when energy investing was suffering peak ESG divestitures. Today energy is 5% of the S&P 500 and generates 9% of S&P earnings. Given the asymmetric downside risk of a spike in oil prices, we have much higher allocations in our portfolios. Depending on client age and their income needs we are generously allocating to MLPs and income generating stocks like Antero Midstream Corporation, which yields 10%, and other energy equities where the management is buying back both their debt and stock.
As previously stated, we see potential downside risk to the S&P 500 and allocating to the rest of the S&P 500 makes no compelling logic to us. Unfortunately, traditional financial planners will stick with the steady and successful 60% equities and 40% bond portfolio strategy and expose nonprofessionals to risks they are oblivious too. Sadly, institutional self-interest will not lead major publicly accessible investment entities toward new, unconventional, and fundamentally based strategies. Articulating potentially negative market prospects can scare their clients away. Consequently, the customers best advice is not always in the best interest of the investment firm who may be concerned about their operating income and choose to hope for the best and tout what has worked historically.
ESG and Inflation Beneficiaries:
Twice in the last month, the author moderated ESG 2.0 panels at IVY FON (Family Office Network) conferences in San Francisco and New York. We hosted ESG experts addressing new technologies and solutions to advance the energy transition. Among the promising growth areas are circular economic solutions, biomass, biofuel, cleaner manufacturing processes, nuclear, hydrogen, and LNG, which are part of a broader transition to Net Zero by 2050 and stopping climate change. This energy transition will entail trillions in new investment over the coming decades and will be a source of many new growth opportunities.
Ironically, mining which is generally associated with environmental pollution is critical to global sustainability. Mined minerals including copper, lithium, zinc, cobalt, and nickel, are needed to build new energy capital equipment and products, including batteries, energy storage, renewable energy sources, electrical vehicles, and green infrastructure.
Agriculture is a promising growth sector benefiting from higher prices. By investing in companies which help produce food and farm products, like fertilizer, seeds, and insecticides, we expect strong demand growth and improved operating results over the years ahead.
IGA also identified 29 companies buying their own stock and debt that are in the mining and agriculture industries.
Cash as a Strategic Asset:
Due to the expected market volatility and probable market duress, owning higher levels of cash in the coming years and quarters makes sense as it allows for buying assets that are being sold at “fire sale prices” — a rare and rewarding portfolio strategy. Further, with interest rates rising, money market yields are rising. Compared to the expected return of both the S&P 500 and longer term bonds, cash has reemerged as a valuable strategic asset.
Within the context of a portfolio holding 40% cash, we advocate using inverse ETFs to short certain sectors or markets when those markets or sectors experience bear market rallies which typically are short term spikes within a down trend.
Inverse ETFs allow for investors to short sectors and indices with lower risk than shorting individual stocks, which, as the Meme stock bubble of 2021 illustrated, can lead to massive losses even to sophisticated professionals, like Melvin Capital. Inverse ETFs allow investors to short markets that they view as over-valued and execute a risk managed portfolio market strategy in a bear market. Several ETFs can be actively employed in this environment allowing portfolio managers to short bear market or counter trend rallies. This provides an active management option for portfolios with large cash balances. Among the ETFs that are attractive to us are:
ProShares Short S&P500 (SH) an inverse S&P 500 ETF.
ProShares UltraShort 20+ Year Treasury (TBT) an inverse on 20-year US Treasury ETF.
ProShares UltraPro Short QQQ (SQQQ) is a 3 x leveraged inverse ETF on the NASDAQ 100 (QQQ).
SARK is an inverse ETF designed to short Cathy Wood’s Ark Innovation mutual fund ARKK. ARKK has become emblematic of early stage technology stocks in the COVID-19 technology market bubble.
Today’s declining market regularly produces oversold bounces or bear market rallies where these ETFs have had 20% moves that could make such an operation an attractive investment strategy when properly executed. Incorporating volatility index parameters can provide objective indicators to buy dips and sell rallies.
Covered writing is a low risk way to collect income and reduce risk without selling long positions. Writing calls against long positions makes sense in flat or down markets. As a rule, writing calls in an environment like this should provide relatively consistent returns as the call premiums typically decay to zero when and if the stock is not appreciating. In bull markets, stocks usually appreciate. In bear markets stocks usually move sideways or decline. Properly executed, covered writing provides an excellent source of income and risk mitigation when properly executed.
Precious metals, like gold, are “safe haven” assets and well understood and accepted store of value. We expect precious metals, like gold and silver, in particular, could soon experience major bull markets that could last for years. Gold is an excellent hedge if one of several problematic geopolitical or economic scenarios play out over the coming decade. As stocks and bonds stop appreciating, investors will find comfort in investing in precious metals like gold and silver. Billionaire John Paulson, who made $5 billion in the yellow metal in the 2011 time frame, said a rally in gold could be quite robust. Paulson explained on the David Rubenstein Show that the Federal Reserve’s massive liquidity injections during the financial crisis went to repair bank balance sheets. Today, by contrast, the Federal Reserve’s recent massive liquidity injections have gone into individuals’ pockets rather than bank balance sheet repair and could now flow to into the gold market. We expect this up-move to occur in the coming months and quarters, when the dollar stops strengthening, as the Federal Reserve starts moderating its current tightening program. In the next few months, we expect the massive inflows into short term US Treasuries will abate and money flows will shift into gold.
The chart below shows a chart of the GLD gold ETF ready to break out on the upside. A breakdown in the US dollar could start a secular bull market in gold.
Source: IGA research and Interactive Brokers Trader Workstation
June Was The Cruelest Month:
Two market scenarios impacted the stock market and primary sector trends in June. The first scenario relates to the market’s perception of the Federal Reserve’s ability to reduce inflation to 2% — its stated goal. The world is focused on the Federal Reserve today as it battles 40 year high inflationary prints. Whether the Federal reserve can tighten rates enough to stop inflation and reverse policy as it did in 2018-2019 is a critical policy concern with global ramifications.
On June 10th, the CPI report shocked investor expectations when it came in at 8.6% for the last year. The market narrative was that peak inflation had been seen and inflation would moderate in the second half of 2022. This report suggested that the Federal Reserve was not ahead of market expectations and would need to apply more severe tightening measures to rein in inflation and allow for a soft landing. Between June 8th and June 17th, the S&P 500 declined 12.9% in eight trading days. This ferocious decline occurred until the Federal Reserve tightened policy expectations to regain market confidence. The Federal Reserved raised Fed Funds 75 basis points in June, signaled another 75 basis points in July, and possibly 50 more basis point in September. Market watchers worry about unchecked inflation such as was experienced in the US in the 1970s, when ineffective Federal Reserve policy led to persistent high single digit inflation and economic stagflation. One of the clear downside risks to the market will be if the Federal Reserve loses market confidence in its ability stop inflation.
Source: IGA research and Interactive Brokers Trader Workstation
Commodities experienced a sharp correction in the second quarter. Corn, wheat, copper, natural gas, and oil pulled back sharply giving back gains in our commodity heavy portfolios. The pullback was a normal consolidation in the commodity super cycle. The world is commodity constrained and global supply needs to increase to stop the long term trend in higher prices. Increasing supply is a multi-year process. The commodity correction fed a “reversion trade” where, 2022’s top performing sectors, energy and commodities in general, pulled back sharply, and technology investments, 2022’s worst performing sector, experienced a “dead cat bounce”. Institutional portfolio managers, who had seen great returns in commodity investments, sold their winners to book some gains and provide fresh capital to average down on past tech winners like Facebook now Meta Platforms Inc (META) down 53.5% y-t-d and Netflix (NFLX) down 70.6% y-t-d.
The chart below shows a 22.5% June decline in the XLE energy ETF a surrender of over 50% of y-t-d gains from up 66.69% to 31.11%. Likewise, the QQQ which is off 29.5% this year stabilized in June. These rebalancing moves are the “reversion trade” which provides an opportunity to add to the fundamentally solid energy sector and for tech heavy portfolios to reallocate toward inflation beneficiaries.
Source: IGA research and Yahoo.finance.com
Global economies are seeing a major spike in inflation. Historic precedent and fundamental factors lead us to expect we are in an inflationary cycle which will last until 2030. The investment winners of the past 40 years, during which interest rates declined dramatically, and recent deflationary cycle winners since 2009 such as growth stocks, tech stocks, FAANG stocks, the S&P 500 and bond investments will no longer provide their attractive historic returns due to inflation.
Because of inflation, an inflationary cycle has commenced where many popular investments and strategies that provided superior returns in the past will now underperform in the years ahead. We have identified numerous investment themes, securities, and strategies that we expect will lead to meaningful outperformance during this inflationary cycle. Unfortunately, institutional bias and market memory will keep the investing public invested in past leaders and investment strategies. Consequently, those backward looking investors will experience lackluster success or failure in the years ahead. Due to an unwillingness to incorporate the fundamental impact of inflation on asset pricing, security selection, and investment strategy, a tough road lies ahead for timid backward looking investors.