Global markets remain uncertain and volatile. The Trump Administration has taken an audacious approach to trade, wars, economics, law, and immigration which has led to more market volatility than any US administration in modern history. The S&P 500 is expensive. This combination of overvaluation and uncertainty led to our timely warning that the market was prone to a collapse in our February 4th letter. Commencing on February 19th, the S&P 500 declined 21.4% before Trump rescinded his draconian tariffs against China leading to a 21.7% rebound which ended May 19th. Much Ado About Nothing?
While the brief correction may have had a salutary effect on US equities, we believe the Great Rotation and the Inflation Cycle are providing clear insight into where to allocate assets. We believe Mega Cap technology stocks and large capitalization indices are over-valued, and rotating into small cap, value, emerging market, foreign and commodity equities is demonstratively prudent.
In addition, 10-year US Treasury bonds yielding 4.5% are not compelling fixed income investments or yield investments. We believe selective closed end funds and Master Limited Partnerships offer more income and potential growth. Consequently, a 25% bond allocation instead of 40% as implied by 60/40 advocates combined with CEFs and MLPs should produce higher income and diversification for retirement aged investors.
The Federal Reserve Risk Premium model below offers little, only 0.2%, to invest in the S&P 500 over 10-year US Treasury notes. Equity valuations in other sectors, regions, market capitalizations and styles offer compelling equity alternatives to the S&P 500.
We believe that inflationary and deflationary cycles significantly impact sector leadership and that we have now entered an inflationary period which will reward investments in commodities, foreign markets, and value investments. Rotating out of the S&P 500, NASDAQ 100, and mega cap growth, and investing in value investments in precious metals, energy and emerging markets is prudent.
The chart below shows the stock market peaks following deflationary cycles when the S&P 500 peaked as occurred in 1907, 1929, 1970, and 2000. Furthermore, a weak dollar should aid foreign markets and commodities for a decade long cycle.
The outperformance of foreign markets and emerging markets is already manifesting itself this year in the major indices shown below.
The iShares MSCI EAFE ETF (EFA) is an attractive allocation away from the S&P 500.
We are tracking the QQQs and Nvidia closely as we believe that AI may be overhyped and the MAG 7 could see a significant decline in the months and years ahead. Nvidia’s earnings were good given the tariff related write off but still should see decelerating earnings which should lead to a lower multiple and a potential decline such as Cisco and Nokia experienced following the 2000 technology bubble.
The charts below show the parabolic rise of the Magnificent 7 stocks and their similarities to the 2000 technology bubble which experienced a significant decline between 2000 and 2003. Our concerns with the artificial intelligence space is that the market caps of its leading stocks is so large that greater competition could lead to lower growth, lower margins, and multiple collapse in mega cap tech stocks. Allocating away from mega cap tech and cap weighted indices and investing in sectors where valuations are compelling is prudent.
Below are two examples that show how even a small allocation away could materially help your portfolio performance. First is the idea of buying battered emerging markets when they are down 90%. In this case, Mark Mobius argued that if those countries’ indices recover to their previous highs, that investment could return 10x.
Likewise, Rob Arnott recently shared how by allocating into small cap value in March 2000 and out of the NASDAQ, your reallocated capital would have effectively tripled when compared to staying in the NASDAQ.
Unfortunately, most asset allocation strategies are not that adroit, and are mechanically driven. Consequently, sectors can grow overly popular and overvalued and when everyone is fully committed to the fad de jour, the momentum breaks and a collapse can ensue as it did following the March 2000 peak in the NASDAQ.
Recency bias makes investors believe that the past will repeat itself. From 1981 to 2020, interest rates decline from 15.85% to 0.5%. This massive decline in interest rates helped the fundamentals and valuation models of equities, bonds and real estate. For 40 years, high returns were generated in equities, bonds and real estate benefiting greatly from lower interest rates. Since the prospects for lower rates are no longer compelling, we believe allocating to assets which have not benefited from decades of declining and low interest rates is prudent diversification. Changing fundamental factors is what changes investment leadership and underpins our great rotation and inflationary cycle rationale.
With 10-year US Treasury yield around 4.5%, we don’t see a compelling argument to invest in longer duration Treasuries, and prefer shorter term treasuries and money markets for preservation of capital.
To generate attractive cash flow, Master Limited Partnerships offer businesses that provide stable toll road business models that invest in US energy infrastructure. MLPs are Master Limited Partnerships not corporations and pay a distribution rather than a dividend and issue a K-1 instead of a 1099. Two MLPs we like are Energy Transfer LP (ET) and Western Midstream Partners, LP (WES). Both are beneficiaries of the huge natural gas resource the US has, and the current administration is seeking to capitalize on. Energy Transfer LP yields 7.49% and the bulk of that distribution is a return of capital. For individuals with in the 35% tax bracket, ETs taxable equivalent yield is 10.11%.
Western Midstream Partners, LP yields 9.73%. The bulk of their distribution is a return of capital and has a taxable equivalent yield of 13.13%. The tax treatment of MLPs is complex, but the value of a high tax advantaged yield is compelling.
Another area which makes compelling sense to Income Growth Advisors is gold mining stocks.
Since 2005, gold has outperformed the S&P 500, and in the last year, its outperformance has accelerated. What strikes us as an extraordinary value is that gold mining stocks have declined since 2011, despite the fact that gold has appreciated 80% since 2011. If the price of the product a company sells has gone up 80%, all other things being equal, why would those companies not rise with the sector’s improved product pricing? In the chart below, the two lower lines show the GDX, the Van Eck Gold Miners ETF, and the GDXJ, the Van Eck Junior Gold Miners ETF. Since August 2011 the GDX is down 19.5%. The GDXJ is down 60% from its high in April 2011.
The chart below of the GDXJ and the SPDR Gold Shares ETF (GLD), reflects this extraordinary anomaly where the Junior gold miners ETF is 60% lower than its highs in 2011 and the gold ETF GLD is up 117% since April 2011. Our market experience conclusively demonstrates that share prices are correlated with share earnings. And for this reason, we fully expect that earnings across the junior gold mining space will improve strongly with recent strength in gold prices. Furthermore, if John Paulson’s recent forecast of gold trading at $5000 per ounce in 2028 proves accurate the GDJX and its components are terribly undervalued and could see significant appreciation in the years ahead.
Conclusion:
Due to persistent overvaluations in Mega Cap Technology and capitalization weighted indices like the S&P 500 and the NASDAQ 100 combined with the high levels of uncertainty that is likely to persist with the current administration’s audacious agenda to “Make America Great Again” we believe that rotating away from Mega Cap Tech and capitalization weighted indices and into attractive value propositions like small cap value stocks, emerging markets, foreign markets, commodities, precious metals, and MLPs is prudent.
We feel that junior gold miners are exceptionally cheap and should see significant upside should gold prices continue to move towards John Paulson’s forecast of $5000/ounce in 2028.
Master Limited Partnerships like Energy Transfer and Western Midstream Partners offer high tax advantaged yields which we believe offer 10% and 13% taxable equivalent yields to investors and are a solid investment vehicle and alternative to longer term Treasuries like the 10-year US Treasury note.
Investing in the iShares MSCI EAFE ETF (EFA) is a conservative way to increase foreign equity exposure and benefit from a weaker dollar and diversify away from the S&P 500 and the NASDAQ 100 cap weighted indices.
We believe the market volatility experienced this year is a healthy reminder to review your portfolio objectives and risk profile with us.