Our July 9th letter cautioned that the parabolic rise in Nvidia shares is reminiscent of the “irrational exuberance” that historically accompanies generational peaks like 1929, 1966, and 2000. Since then, Nvidia (NVDA) and the NASDAQ 100 index (QQQ) have declined 16.9% and 9.3% respectively. While that call was well-timed and appears to be part of a mega cap topping process, we fear that the end of declining interest rates has also removed a key fundamental factor which drove US stocks, bonds, and real estate over the last four decades and these pillars of US wealth creation are also peaking. This letter will highlight out-of-favor markets where new bull markets may be developing and compare them with the long duration and high valuations in US stocks, bonds, and real estate.
The Peaking of NVDA and the Mega Caps:
Below is a chart of NVDA shares which have rallied 11 folds in 20 months. We now expect NVDA will consolidate or decline until its earnings catch up with the company’s high price to earnings multiple over the next few quarters or years.
The chart below of the NASDAQ 100 (QQQ) also appears to be peaking following a multi-decade bull market. The QQQ is up over 10 folds since April 2009 and acts like the parabolic end of a generational technology bubble like 2000. The mega cap technology stocks like Alphabet (Google), Apple, Amazon, Meta (Facebook), Microsoft, Netflix, Nvidia and Tesla are not as expensive as the market leaders in the 2000 technology bubble. Nevertheless, the euphoria surrounding these stocks has all the trappings of irrational exuberance seen in generational market peaks.
The chart below of the technology sector as a percentage of the S&P 500 also looks hyper-extended
at 44% and noticeably above the 34% weighting in the S&P 500 at the peak of the technology bubble in 2000.
While we readily see signs of a tech/mega cap market peak and AI irrational exuberance, the valuations on today’s mega cap stocks are not nearly as stretched as they were in 2000. The table below by GMO shows high valuations, but not absurd ones like the 2000 bubble. Nevertheless, caution is warranted.
Rising Unemployment Warns of Recession:
While a couple data points do not make a trend and the recent weakness in unemployment may be elevated due to Hurricane Beryl, Friday’s U.S. Department of Labor employment numbers of 114,000 workers being below forecasts of 175,000 workers caused some panic selling in the stock market. Furthermore, the rise in the unemployment rate to 4.3%, the highest level since October 2021, triggered the Sahm rule which has successfully predicted every recession since 1970.
Below is a chart of the Sahm rule which shows the three month moving average of unemployment has now risen over 50 basis points from its previous low.
The chart below of the unemployment rate since 1970 shows the powerful correlation between rising unemployment and recessions beginning.
Recession Risks are Serious:
The consequences of a recession can be serious. Recessions lead to earnings declines and sharp drops in stock prices. Remember the S&P 500’s declines following 2000, 2008-9, and 2020. Macroeconomic Intelligence’s Julian Bridgen’s chart below shows that recessions historically lead to 30% declines in equity markets. Declines of that magnitude can dramatically change retirement plans and lifestyles.
While we aren’t seeking to be overly dramatic, the number and type of warning signs combined with today’s historically high valuations need to be considered seriously. Not since our letters warned of the bottom in interest rates in September 2020 and the equity peak in the Final Stages of a Historic Bubble in January 2021 have we cautioned that current market dynamics are so consequential.
Equity and Bond Valuations:
The chart below of the Shiller CAPE ratio and 10-year US Treasury yield shows the S&P 500 index CAPE ratio at 35.5 — a historically high level, higher than that achieved during 1929, but lower than the levels hit during the market peaks of 2000 and 2020. Those equity peaks in 2000 and 2020 were achieved during favorable periods of declining interest rates or historic Federal Reserve monetary accommodation which we do not anticipate being repeated for years.
Below is the Risk Premium or Fed Model which compares the value of bonds versus equities by comparing the earnings yield of the S&P 500 to the yield on the 10-year US Treasury. The difference of the earnings yield minus the Treasury yield is 0.86%, which means equities are expensive and that they offer little “premium” to take the risk of owning equities when compared to the yield of 10-year US Treasury notes. The last time that US equities were this expensive relative to bonds was in 2002 — 22 years ago.
Today, neither 10-year US Treasury yields at 3.79% nor stocks offer compelling return profiles and should not be overweighted in a conservative portfolio.
Generational Rotation and Sensible Asset Allocation:
We continue to believe that the 60% equity 40% bond asset allocation to be unattractive and risky for today’s markets. We continue to recommend a 25% stock/ 25% bond/ 25% money market/ 25% commodity allocation for retirement plans and for retired individuals.
To reiterate the argument that equities are historically over-priced and could be at risk of a 30% decline, the chart of the “Buffett Indicator” shows equity values are two times GDP.
Below is a chart showing how assets are allocated at the average family office. By comparison, our commodity allocation is 25% compared to 1%; our money market and cash equivalent is 25% compared to 8%; our equity allocation is 25% versus 28%; our bond allocation is 25% versus 7%. We don’t have a real estate allocation but would likely substitute half our 25% bond allocation into real estate for income and inflation protection.
Everybody Loves Real Estate:
After 40 years of declining interest rates, real estate has grown popular and widely perceived as a great source of returns and wealth creation for investors. Like stocks and bonds which we believe to be expensive, we believe real estate both residential and commercial is also overvalued and not the great investment prospect it has been. Below are two charts which reflect our concerns about real estate. The chart of home prices divided by the median US income shows real estate is as expensive as it was in 2006, which was two years before the mortgage crisis.
Real estate is an attractive inflation hedge. The chart below shows that the Case-Shiller home price index divided by the CPI is near record high levels and is not particulary attractive as an inflation hedge today.
The Generational Rotation:
Declining interest rates have been a key driver of US stocks, bonds, and real estate—critical pillars of US wealth creation for the last four decades. Now all three asset classes are expensive and may underperform or decline in the months and years ahead. We believe money will flow from stocks, bonds, and real estate to new markets in the years ahead.
The chart below shows 140 years of inflationary cycles and deflationary cycles. We believe the last 40 years have been generally deflationary and drove higher prices in stocks, bonds, and real estate. It now appears that we are in an inflationary cycle where commodities, emerging markets, and value stocks will emerge as new market leaders.
To hedge or reposition your assets in the years ahead, we have studied other markets during the 1970s and 1999-2011 period and believe great opportunities will emerge from long dormant markets. Historically, tremendous returns in precious metals and energy have been generated during past inflationary cycles but other dormant inexpensive sectors or styles should be considered. The 1970s and the 1999-2011 inflationary cycles saw attractive returns in value stocks, small cap stocks, foreign stocks, emerging market stocks, commodity stocks, precious metal stocks, commodities and precious metals.
We have reproduced several long term charts which appear to be emerging sectors, geographies, or investment styles that may offer attractive return prospects in the years ahead.
The chart below of the GDP growth of the top 25 countries in the world shows how dominant the US economy has been relative to the rest of the world. We expect new countries to enjoy rapid growth and be investable at attractive valuations. The most populous country in the world, India is one geography we favor. Argentina led by Javier Milei’s libertarian governmental reforms also appear to be an attractive new foreign geography where great returns could be found.
The chart below shows that emerging markets boomed during the last inflationary cycle and are currently very inexpensive relative to developed markets.
The US equity market dominance relative to the rest of the world’s markets is clearly shown in the chart below. We believe that there may be other markets abroad which should emerge in the year ahead, but are currently unpopular.
We believe that gold and silver should out perform stocks as the have in past inflationary cycles. The chart below shows how sharply gold and silver performed in the aftermath of the 2000 bubble, a market environment that we see as analogous to the upcoming period.
The boom in growth stocks was shown in the earlier parabolic chart of the NASDAQ 100 (QQQ) 10 x rise since 2009. The chart below comparing the MSCI Growth Index to the MSCI Value Index shows that value has significantly underperformed growth as much as it did during the 2000 technology stock market bubble.
Another style dichotomy is between cyclical stocks and defensive stocks. Cyclical stocks are now expensive and vulnerable while defensive stocks are attractive and stable.
Gold Pushes to New Highs:
The recent uptick in unemployment and concerns about the economy create a new powerful catalyst to buy precious metal stocks. In May we wrote about why gold and gold miners should outperform over the next several years in a manner consistent with the inflationary cycles of the 1970s and 1999-2011. During those periods significant returns were generated and we believe they are compelling analogues to the years ahead.
With unemployment rising, the Federal Reserve may begin easing short term interest rates, and this should increase demand for gold and precious metals. The chart below shows how when 2-year Treasury yields decline and gold prices rise. We now anticipate that the Federal Reserve will ease policy and 2-year Treasury yields will decline over the next few months and gold will continue higher.
Since our May letter, gold has pulled back and then continued to move to new highs. These higher prices will, in turn, drive higher margins and earnings for gold stocks in the quarters and years ahead.
The long term chart below shows the giant rallies in the post bubble environments following the 1966 and 2000 of 1834% and 612% respectively. The 1970s move was distorted because gold was not deregulated until August 1971, so that 1834% move was not a free market move. Gold move three folds from its midcycle peak in November of 1974 until its peak in January 1980 of $642/oz. Gold moved three folds from its peak in 1980 to its peak in 2011 at $1825/oz. Tripling the $1825 2011 peak leads us to conclude that gold could achieve a peak of $5,475/oz in the years ahead.
Gold continues to break to new highs and above its 2011 peak. Today, central bank purchases, de-dollarization, fifteen years of unprecedented monetary accommodation, and inflation are creating new buyers for precious metals. We believe that gold will attract more buyers as it is recognized as a viable non-correlated source of investment performance, safe haven, and currency.
The chart below shows both gold and silver prices since 2006. Gold and silver peaked in 2011 after the Federal Reserve eased rates aggressively to address the great financial crisis. After peaking in 2011 gold and silver formed deep saucer bottom and started breaking to new highs in 2019. We wrote that gold was a new market leader in September 2019. https://seekingalpha.com/article/4291385-gold-and-silver-return-investment-leaders
Source: Trading Economics
Conclusion:
The stock market appears to be putting in a major long term peak. Equity market valuations are near historic highs and the exuberance surrounding Artificial Intelligence resembles manias that often describe market peaks historically.
Last week’s continued rise in unemployment triggered the Sahm rule which has a good record of predicting economic recessions. An economic recession or slowdown historically leads to weaker earnings and declines in the stock market in the 30% range.
To position your assets against a potentially severe equity market decline, we recommend a 25% equity, 25% bond, 25% money market and 25% commodity allocation and abandoning the popular 60% equity 40% bond allocation.
Since August 1981, a four decade period of declining inflation and interest rates has ended. Because of the recurring cashflows generated by bonds, real estate, and stocks, these asset classes are particularly sensitive to interest rate risk and likely experiencing generational peaks.
Beyond shifting asset allocations to a 25%/25%/25%/25% from a 60%/40%, we suggest allocating to geographies, assets, sectors and styles which are out-of-favor, undervalued, and prospectively new bull markets. Small cap stocks, value stocks, international stocks, emerging market stocks, dividend stocks, commodity stocks, precious metal stocks, commodities and precious metals appear to be attractive new sectors to consider for attractive returns in the future.
At this writing gold looks especially attractive, but so do silver and precious metal stocks which look poised for a major bull market worthy of investment consideration.