Today’s record inflation unequivocally shows that we have entered a new inflation cycle. With the Russian invasion of Ukraine, inflation risks will increase further due to new supply chain problems and commodity shortages associated with military engagements. Historically, commodities and the S&P 500 are inversely correlated. With inflation rising, soaring energy and commodity prices should continue to pressure the S&P 500 for the next several years. The investment consequence of this new inflation cycle is a critical investment paradigm shift from the deflationary environment of the last 13 years. Whereas technology, growth stocks, and bonds had generated persistent high returns, now commodities and inflation beneficiaries will decisively outperform while technology, growth stocks, and bonds will underperform.
The chart below shows periods of inflation and deflation delineated by the ratio of S&P 500/PPI indexes.
With inflation rising as shown in the Producer Price Index chart of commodities below, soaring energy and commodity prices should continue to pressure the S&P 500 for the next several years. Historically, when inflation becomes entrenched it takes years to stop the cycle. Additionally, wars including WW1, WW2, Vietnam and Iraq tend to increase inflation, hurt financial assets, and reward commodities.
To illustrate the dramatic return differentials from combining prudent sector rotation with inflation cycle timing, we compared the Investco QQQ Trust (QQQ) ETF of the NASDAQ 100 index to the Energy Select Sector SPDR Fund ETF. During the inflationary period between 1999 and 2008 the XLE returned 22% on an annualized basis while the QQQ declined 3.157% on an annualized basis over the same period. From 1999 to 2008 an investment in the XLE and not an investment in QQQ would lead to an incremental 25% annualized difference in performance.
During the deflationary period from 2009 to 2022, the QQQ returned 20% annualized and the XLE returned just 3.68% annualized over the same period. Those return differentials are massive. Understanding economic history and the fundamental factors which drive asset pricing can significantly impact one’s investment prospects.
This inflation-driven sector rotation is clearly shown in the chart below of the S&P 500 to the CRB index ratio. The chart below shows commodities made a bottom in early 2020 when COVID first appeared, and oil futures turned negative. The chart window insert below titled “New Commodity Cycle?” shows inflation becoming a trend further worsened by war and 13 years of excessive financial accommodation by the Federal Reserve.
Stock Market Caution is Warranted:
The S&P 500 is wildly overvalued according to Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio which shows current stock valuations at 37.8. Today’s CAPE ratio exceeds the 1929 level but is below the 2000 technology bubble peak. This valuation chart adds to our bearish perspective on the S&P 500 and QQQ.
Since the CAPE ratio does not include interest rates, our valuation concerns are enhanced by the prospect of rising interest rates which will increasingly offer attractive safe-yielding investments in the fixed income markets.
The chart above shows the historic decline in interest rates over the last 40 years: the 10-year US Treasury yield has declined from 15.3% to 2%. We expect rates to move higher due to the Federal Reserve reversing asset purchases and raising the Fed Funds rate.
New Inflation Portfolio Strategy:
Below are our holdings for our discretionary accounts. As of February 25th, our discretionary accounts are at highs and our picks have been producing positive returns on most of this year’s hard down days, including Friday. While gratifying, the positive relative strength and negative correlation to the S&P 500 tells us that we are properly positioning for the unfolding inflationary environment we are experiencing.
We chose these investments to benefit from rising inflation. Our top holdings are in the natural gas, MLP, coal, gold, and steel industries. Most stock holdings trade at low price-earnings multiples:
- Master Limited Partnerships “MLPs”: Enterprise Products (EPD) (7.8% yield), Energy Transfer (ET) (7.2% yield), Magellan Midstream (MMP) (8.9% yield), and MPLX LP (MPLX) (8.9% yield).
- GAMCO Global Gold, Natural Resources and Income Trust (GGN) (9.4% yield).
- Antero Midstream Corporation (AM) – 9.4% yield.
- Antero Resources Corporation (AR) – premiere natural gas producer.
- Tellurian Incorporated (TELL) – a new Liquid Natural Gas producer.
- Peabody Energy Corporation (BTU) – coal.
- Warrior Met Coal, Inc. (HCC) – coal.
- Barrick Gold Corporation (GOLD) – gold.
- Sebanye Gold Limited (SBSW) – gold and platinum.
- United States Steel Corporation (X) – steel.
- Cleveland-Cliffs, Inc. (CLF) – steel.
The investment playbook has changed. Our inflation portfolio strategy deemphasizes bonds and replaces the S&P 500 core with an inflation beneficiary core of commodities and commodity cyclical stocks. Only a portfolio that emphasizes value and investments which benefit from inflation should outperform in the years ahead.
Traditional asset allocation strategies like the 60/40 stock-bond balanced portfolio should perform poorly as the S&P 500 and longer-term bonds will both decline. Since the 60/40 strategy is deeply embedded in traditional investment planning models, we expect passive inflows into the S&P 500 and bonds will abate if not reverse as money flows seek better returns in the years ahead.
Relying on past performance can be especially treacherous during this dynamic transformative period. Never has the boilerplate disclaimer “Past performance is no guarantee of future results” been more accurate.
It is time to think differently.