7.5% Yield Portfolio Allocation.
The US stock market is historically overvalued and should generate low single digit returns for the next decade. The enormous success of US technology has led to a bubble in the Magnificent 7 stocks and an irrationally exuberant market sentiment. We believe the best future returns will not be generated by overweighting the US mega cap stocks that have created enormous wealth over recent decades for a few companies and their shareholders. Today’s irrationally exuberant market sentiment occurred during historic US stock market bubbles like 1929, 1970, and 2000 and is due to investor recency bias – the cognitive belief that recent market behavior is the norm. Our analysis of market cycles, asset valuations, and portfolio construction, suggests that great value can be found in emerging markets, precious metal stocks, and high yielding stock and bonds forgotten by the Magnificent 7 boom. This letter will provide a sample 7.5% yielding portfolio that provides the income, diversification, and value that neither the Magnificent 7 or 60/40 models do.
The chart below of the Fed Model or Risk Premium Model shows that the S&P 500 compared to the 10-year US Treasury yield offers scant value to investors. In fact, the red shows that the last time the S&P 500 was this overvalued was during the 2000 technology bubble
Historic returns for equities are in the low double-digit range, which, over time, allows for high returns and wealth accumulation for buy and hold index investors. However, at today’s high equity prices, the chart below shows that prospective returns for the S&P 500 will be in the low single digits over the next decade. This analysis suggests that an over-weighted S&P 500 allocation will provide little potential for real returns over inflation or wealth accumulation beyond the rate of inflation.
Stock charts are graphic illustrations of both equity returns and market psychology. The two charts below from Crescat Capital illustrate the precarious overvaluation in the Magnificent 7. The chart on the left shows how the current mega cap tech bubble is parabolic like the 2000 tech bubble. The chart on the left shows how the market capitalization of the Magnificent 7 is 62% of gross US domestic product – an unsustainable wealth concentration.
In July 2024, we flagged Nvidia as a stock whose parabolic ascent was likely to end and whose earnings would inevitably decelerate. The law of large numbers ultimately makes companies whose earnings are growing at rates more than 100%, like NVDA, experience an earnings deceleration. Decelerating earnings is a classic sell signal which often traps investors blinded by recency bias to hold a great company whose shares can be a costly investment mistake. We believe that NVDA will experience an earnings deceleration and multiple collapse, and NVDA’s share price moderation will lead the Magnificent 7 stocks lower in the months, quarters and years ahead.
The current 4.23% yield on the 10-year US Treasury note is uninspiring. We don’t know the direction of inflation, the economy or interest rates. Furthermore, the 4.23% yield offered by 10-year US Treasury notes is not a meaningful premium to inflation to justify its duration risk.
Recent decades of declining interest rates may bias investors into believing that declining inflation and declining interest rates are a certainty. Unfortunately, that assumption could easily prove wrong. The chart below shows that after the sharp rise in inflation from 2020 through 2022, inflation declined sharply, but inflation’s decline paused in recent months. While politicians, the Fed, and recency bias may encourage us to believe inflation and rates will surely decline, that is not assured. Consequently, we are partial to higher yielding equities and bond investments to provide attractive income to mitigate market risk while producing yields that are two to three times that offered by 10-year US Treasuries. We view shorter term Treasuries and money markets whose yield are comparable to longer duration treasuries a pragmatic source of diversification, duration mitigation and income that is especially attractive to older investors.
Historic stock market peaks in the US typically preceded inflationary or commodity cycles. We believe the current US stock market bubble argues for commodity linked investments and against an S&P 500 being overweight. This sector rotation phenomenon was clear in the 1970s when the S&P 500 was stagnant, but commodities like gold and oil performed spectacularly. Likewise, in the 2000 to 2009-11 period, the performance of the S&P 500 was flat while gold and oil significantly outperformed the S&P 500.
We believe that gold has entered a new bull market. The chart below shows how gold has become a top performing asset in the last year, up nearly 50% for the trailing 12 months. While we can only speculate how much higher gold can appreciate, we believe that the investment case for gold mining shares is especially compelling because gold stocks have lagged gold price appreciation as shown in the chart below of the (GLD) gold ETF versus the (GDX) gold mining ETF. Recent high gold prices will assuredly drive higher revenues, gross margins, cash flows, and earnings, but the gold equity markets (GDX) have yet to reflect those improved financial and earnings prospects.
We believe that the emerging markets will outperform in the post bubble years ahead as they did during the 2000 to 2008 post bubble period when emerging markets outperformed relative to the S&P 500 and MSCI US. The chart below by Market Intelligence 2 Partners shows the outperformance of the MSCI Emerging Market index during this period of dollar weakness. We expect emerging markets will outperform the S&P 500 in the years ahead.
Below are global equity markets’ CAPE ratios ranked to identify the cheapest emerging markets. While certain countries have important dynamics which weigh on EM country selection, Argentina, Brazil, Poland, Hungary, Hong Kong, South Korea and China appear compelling investment countries.
Source: Crescat Capital.com SiblisResearch.com
The chart below of the FXI China large cap index illustrates the 4x return China delivered in the post 2000 bubble period. While there are many serious risks in China, this developed market country offers many attractive equity opportunities for those comfortable with its sovereign risk. Our favorite names in China are BYD Company Limited (BYDDY), Daqo New Energy Corp. (DQ), Weibo Corporation (WB), and PDD Holdings Inc. (PDD).
The 7.5% yield portfolio is allocated:
- 25% gold, precious metals and gold stocks
- 25% high yield closed end bond funds, an emerging market bond CEF, and a resource focused covered writing ETF.
- 25% is invested in high yielding equity CEFs, an India CEF with a 12% yield and Petróleo Brasileiro S.A. – Petrobras (PBR)
- 10% is allocated to our favorite Chinese large capitalization stocks and
- 15% is allocated to MLPs.
The average yield of this portfolio is 7.49%.
Yields can be increased by reducing the precious metals exposure and the Chinese stock investments.
Increased investments in Templeton Emerging Markets Income Fund (TEI) and GAMCO Global Gold, Natural Resources & Income Trust (GGN). These two ETFs would offer high levels of diversification in both commodities and emerging markets.
MLPs are a sector that is attractive, however, it is not cheap. In the first half of 2020 we wrote several articles recommending MLPs and MLP funds. Today, the yields are still attractive, but they are not the rare and exceptional opportunity they were in 2020 when we highlighted their bargain prices in three separate letters.
Much fanfare has been attributed to the 60% equity 40% bond allocation over the last four decades. In the 1970s Nobel Laureates William Sharp and Harry Markowitz developed the Modern Portfolio Theory which popularized the 60% stock and 40% bond allocation. In 1981, the S&P 500 had a dividend yield of 5.4%, a PE multiple of 8.5, and 10 year US Treasuries yielded as much as 15%. An amateur investor at that time could have invested hundreds of billions in 60% in the S&P 500 index and 40% in 10-year US Treasuries and delivered spectacular returns over the next several decades. Unfortunately, recency bias and the erudite aura of the 60% stock 40% quantitative asset allocation make adoption of the 60% 40% appealing when it offers low income, little geographic diversification, and an unattractive risk reward profile. A 25% money market/2-year Treasury, 25% commodity, 25% bond, and 25% equity (with international exposure) is a far more pragmatic allocation for pension plans, endowments, and retired investors.
Conclusion:
The current speculative fervor and enthusiasm for mega cap technology stocks like the Magnificent 7 is emblematic of a speculative peak. While the 2000 tech bubble was more extreme in valuation and followed shortly by the 9/11 terrorist attacks, we do believe that today’s market bubble resembles many of the risks which unfolded in the eight to ten years which followed that peak. The period from 2000 to 2008 and the 1970s are post stock market bubble environments which we believe to be appropriate historic investment analogues to guide compelling returns for investors.
Philosopher George Santayana famously said that those who do not study history are doomed to repeat it. We believe that his advice is applicable to global market investment and our post equity bubble market analysis. Broadly speaking securing high yields through closed end equity funds can generate double digit incomes in sectors and geographies that are attractive risk adjusted alternatives to 10-year US Treasury notes. Investing in emerging market equities directly through funds and CEFs can provide compelling equity valuations in geographies that have been largely ignored for nearly twenty years.
By reviewing your asset allocations for duration risk and US mega cap tech bubble risks could have a profound impact on your investment future. Realignments need not occur unilaterally and entirely in the near term; however, a process of reallocation over the coming quarter’s would be prudent tactical asset allocation for today’s exuberant and historically overvalued equity markets.