- The 60/40 model is broken.
- Inflation is rising rapidly, and the Fed is scrambling.
- Inflation and Fed taper end 40 year bond bull market.
- Fed’s balance sheet expansion reversal will hurt.
- Rotate away from large cap growth and bonds.
After forty years of declining interest rates the 60% 40% stock bond allocation model is broken. Both stocks and bonds are historically expensive and risk long term underperformance and losses. To protect your assets against losses it is critical to understand which new investments and strategies will outperform in the economic environment unfolding before us. In addition to embracing the great rotation and owning commodity related assets, adding derivatives, emerging markets, small capitalization stocks, and private equity should reduce your portfolio risks and increase your investment prospects in the years ahead.
The 40 year Bond Bull Market is Over:
The 40 year trend of declining interest rates is over. The Federal Reserve is no longer buying $120 billion of Treasuries and mortgages a month, and the post COVID-19 economic recovery will lead to higher interest rates. If inflation persists, bonds will decline – no longer offering the safe return of capital and hedging against declining stock prices, as they have for 40 years.
The chart below shows that 10-year US Treasury yields peaked in September 1981 at 15.32% and have been declining in lockstep with inflation. With the August 2020 Jackson Hole Federal Reserve meeting, Fed policy reversed four decades of its staunch inflation fighting stance, as astutely cautioned in our September 2020 letter: https://www.incomegrowthadvisors.com/two-generational-trends-reverse-fed-inflation-policy-and-the-bursting-technology-bubble/. Unfortunately, in the 15 months since the Federal Reserve’s policy reversal to tolerate 2% inflation, inflation recorded some of the highest data in 31 years. This inflation will inevitably drive higher interest rates and cause real trouble.
Stocks are Pricier than in 1929:
Equities have been at historically high valuations for years, but bonds’ inflated prices are the result of unprecedented Federal Reserve accommodation. To bail the economy out of the Financial Crisis and the COVID Crash, the Federal Reserve has used its balance sheet to purchase Treasuries and mortgages. Today the Federal Reserve’s balance sheet is $9 trillion, and its asset buying program is ending. Artificially low interest rates drove ever higher stock prices because “there is no alternative” (investment) or “TINA” as traders would quip. This week, Fed Chair Powell testified that the Federal Reserve is comfortable with accelerating its taper of monthly purchases of Treasuries and mortgages. The taper precedes the Fed’s tightening cycle, a process historically linked to stock market declines.
The chart below shows Shiller’s Cyclically Adjusted Price Earnings ratio (“CAPE”) puts the S&P 500 at 38.3, an extreme only exceeded by the 2000 Tech Bubble. The chart also shows the secular decline in 10-year Treasury yields since 1982 which drove the price earnings multiple expansion of this record breaking bull market.
The Buffett Indicator chart below provides another example of the equity market’s extraordinarily high valuation. The Buffett Indicator compares the ratio of the Russell 5000 to the US GDP. In effect, it shows the aggregate US stock value compared to the US Gross Domestic Product. Today, this indicator shows 216%, 69% over its historical average of 120%.
The chart below shows the ratio of the Goldman Sachs Commodity Index to the S&P 500 total return index through January 8th. We expect that both rising commodity prices and declining equity prices will start a tremendous commodity cycle. We want to capture the 800% cyclical outperformance that Gundlach described in past commodity cycles.
The Fed Model Justifies Bubble Prices:
While the Shiller CAPE ratio and the Buffett Indicator scream overvaluation, the “Federal Reserve Model” offers contingent relief. Asset valuations are viewed within the context of competing investment alternatives. The Fed Model or Risk Premium Model compares the value of stocks versus bonds by comparing the S&P 500’s earnings’ yield to the 10-year US Treasury Notes’ yield. The S&P 500 earnings estimate for 2022 is $222.149 and $204.93 for 2021. With the S&P 500 closing at 4594.62, the S&P earnings yield for 2022 is 4.83%. Compared to 10-year US Treasury notes which pay 1.482%, the earnings yield of the S&P 500 is higher by 3.22%. That 3.22% “risk premium” is the extra yield the stock market must offer to forgo the safety of a US Treasury Note to justify the inherent risk of owning stocks which do not promise to return your principal plus interest.
Currently, the 3.22% risk premium has historically been an attractive level where investors have had good equity returns by buying stocks. Last year during the COVID-19 Crash, when the risk premium rose to 6% our letter “Irrational Pessimism” provided a compelling and clarion call to buy stocks. In March 2000, when Shiller published Irrational Exuberance and the NASDAQ peaked, the risk premium was negative 2.21%.
The contingent risk to this model is that Treasury yields are artificially depressed, and inflation is building at rates not seen in 31 years. As interest rates normalize and adjust for inflation, 10-year Treasury yields could easily rise to 3% and possibly far higher. If 10-year Treasury yields rise to 4.7% the risk premium would drop to zero. The chart below shows a negative risk premium has not been seen since 1999-2002 during the Technology Bubble. That valuation extreme presaged 51% and 82% declines in the S&P 500 and NASDAQ 100 indices, respectively.
Fed Balance Sheet’s Expansion:
With the economic risks created by the Financial Crisis in 2009, the Great Recession and the COVID-19 Crash, the Federal Reserve and policy makers have grown comfortable financing our ballooning national debt and protecting the global markets against downturns. This expansion appears untenable as the Fed is buying an increasing share of the US Treasury’s debt issuance. The Federal Debt is $28.9 trillion. The risk of rising interest rates on the debt service could dangerously increase if inflation spirals higher. Further, the US which benefits from its reputation as the most secure debt issuer in the world, risks losing credibility as its aggregate debt to total GDP rise and as its debt service obligations grow ever higher.
The Federal Reserve is Driving Wealth Disparity:
The Federal Reserve’s financial support through asset purchases since 2009 has exacerbated the wealth disparity in the United States. Consider these facts from CNBC and highlighted by KCI Research:
- “The wealthiest 10% of American households now own 89% of all U.S. stocks, a record high that highlights the stock market’s role in increasing wealth inequality.
- The top 1% gained over $6.5 trillion in corporate equities and mutual fund wealth during the pandemic, according to the latest data from the Federal Reserve.
- The bottom 90% of Americans held about 11% of stocks and added $1.2 trillion in wealth during the Covid-19 pandemic.”
Bank America captures the massive $10 trillion in wealth accumulation among the “FAANG” stocks since the market bottom in 2009 and its tight correlation with the Federal Reserve’s balance sheet growth which is rapidly ending.
Beyond stocks, real estate prices have been rising quickly. Purchasing a home is becoming more difficult even as wages have risen modestly. In addition to rising real estate prices, inflation increases the cost of living through higher food, utility, and energy prices. The little guy is losing to the wealthy.
Inflation Could Burst this Bubble:
In October the CPI rose 6.2% on a year over year basis. This was the fastest pace since 1990 and the fifth month in a row above 5%.
The Fed initially suggested that a little inflation is good and, under the Fed’s Jackson Hole policy, inflation will be “transitory.” This week Fed Chair Powell reversed his position stating “it’s probably a good time to retire that word (transitory) and try to explain what we really mean”. Essentially, the Fed’s new Jackson Hole policy is not working as planned and this policy mismanagement is an ominous sign for the most important financial institution in the world.
The question is how sticky will this inflation be? Normally, in a free market environment, high prices attract capital and new supply is created to bring down prices. With Green New Deal thinking, the current administration has proactively restricted the oil industry and energy prices’ sigificant rise is unlikely to revert. Many progressives believe that higher fossil fuel prices will facilitate growth of renewable energy and quickly lead to a clean green future. We believe this is another policy error.
After this year’s inflation, businesses must forecast expenses and will likely assume higher inflation in the future, adding a secondary layer of inflation which will likely exceed 2% in both 2022 and 2023. Some inflation is the result of shortages and supply chain issues which will revert; however, wages, housing and energy will likely persist.
We estimate CPI inflation will rise 6%, 4% and 4% in 2021, 2022, and 2023 respectively and 10-year US Treasuries will yield 4% by year end 2023. However, if the Federal Reserve does not correct its policy error and regain the markets’ confidence, higher inflation will ensue and 10-year Treasury Note yields will rapidly rise toward 3.5% in 2022. Uncontrollable inflation could drive higher interest rates and lead to a significant decline in the NASDAQ and or S&P 500 in the year ahead.
Protecting Your Investments with The Great Rotation:
We are in the early innings of a commodity supercycle similar to the 1999 to 2008 period. We have been following this commodity cycle with the chart below which tracks the ratio of the Goldman Sachs Commodity Index versus the S&P 500 index. If past is prologue, then we could see 800% outperformance in commodities versus the S&P 500 in the next seven years. This provides a roadmap to protecting your hard-earned wealth.
Rotating from large cap growth to large cap value is one strategy to capture the unfolding commodity supercycle. The chart below by Crescat Capital shows growth stock underperformance from the 2000 Tech Bubble Peak to 2007 when oil traded to $147/barrel.
The great rotation is based on rising interest rates. Consequently, selling long duration assets like bonds and growth stock and buying commodity related assets is key.
The Energy Transition: “Too Much EQ Not Enough IQ”
We support the green decarbonization trend which has led to considerable weakness in the fossil fuel industry; however, politicians’ and policymakers’ overreliance on renewables has naively miscalculated the energy needs of the world. This is especially consequential to 80% of the world which is less economically developed. This poor planning ironically undermines the top priority of the UN’s 17 Sustainability Goals: End Poverty. Poor planning inhibits lifting the living standards of 80% of the world not residing in Europe and North America.
Mark Mills of the Manhattan Institute explains the physics and economics of energy in the must watch YouTube video below:
For this reason, Master Limited Partnership and natural gas investments continue to offer attractive investment return prospects. Natural gas companies are particularly well positioned as natural gas can provide critical power while the energy transition evolves over the next decades.
This letter has focused on asset preservation by highlighting the risks in stocks and bonds. However, there are other risks which should compel your attention. Within the last 12 months we have seen the geopolitical environment worsen.
China has emerged as our military adversary and not just an economic competitor. China’s 1.6 billion people plus its massive technological, industrial, and military advancements has become an increasingly ominous threat. With hypersonic missiles, military islands in the South China Sea, abrogating its British China Treaty regarding Hong Kong, and provocations against Taiwan gaining increased coverage, China could easily rattle our precarious markets.
Likewise, Russia is behaving provocatively toward the Ukraine. Whether it is Russia or China who might invade disputed territories, these threats will undermine the US position as leader of the free world.
Cracking Market Momentum:
The market’s parabolic rise is losing momentum. More and more highfliers are guiding down their estimates and experiencing sharp stock price declines. Consider the charts below of market darlings such as Zoom Video Communications, Inc. (ZM), Peloton Interactive, Inc. (PTON), DocuSign, Inc. (DOCU), and salesforce.com, inc. (CRM). The severity of these declines suggests silly season is over, wild market speculation is cooling, and momentum is waning.
Source for charts below are from Interactive Brokers Trader Workstation.
Below is the One Year Chart of Zoom Video Communications, Inc. (ZM):
Below is the One Year Chart of Peloton Interactive, Inc. (PTON):
Below is the One Year Chart of DocuSign, Inc. (DOCU):
Below is the One Year Chart of salesforce.com, inc. (CRM):
Momentum is waning and is one of the most highly weighted inputs in quantitative modeling. Quantitative investment decisions drive nearly 80% of market volume. The parabolic rise in the NASDAQ is seeing more frequent and severe pullbacks. Psychology is shifting from buying every dip to selling every rally.
Below is the One Year Chart of the NASDAQ 100 (QQQ):
Below is the five year chart of NASDAQ 100 (QQQ) and it shows a parabolic rise eerily similar to 1929, 1987 and 2000.
Paul Tudor Jones said that parabolic rises never end well.
Conclusion and Investment Ideas:
The keystone 60/40 strategy at the heart of modern investing is broken. The surprising and rapid rise of inflation combined with a reversal in the Federal Reserve accommodation policy has ended the 40 year bull market in bonds. Without the persistent support of ever lower interest rates, equities will face a headwind that could last for years. Traditional investment strategy sits at the precipice of a paradigm shift that could be disruptive for years. Disappointing returns with poor risk managed attributes is driving a sea change in investments. This investment paradigm shift could lead to outflows reversing the most significant driver of capital inflows of the last 40 years.
By adding new commodity related assets, you can add diversification to your assets and gain from the destructive influence of inflation over the coming years. Adding short positions through ETFs which short the stock indexes and bonds can also help you hedge against higher rates and declining stock prices. Floating rate bond funds, inflation hedged Treasuries, and novel interest rate strategy bond funds can help your wealth preservation. While the US has enjoyed a massive multi-year bull market in bonds and large capitalization equities, underinvested sectors like emerging markets, small capitalization stocks, precious metals and private equity can also reduce risk and improve returns.
Recent market weakness and continued positive earnings should lead to a yearend rally. With inflation and Fed Policy undermining the 40 year period of declining interest rates, we anticipate a fundamentally challenging environment for stocks and bonds while both are priced for perfection. A fundamental reassessment of your investment strategy is prudent with the investment sea change unfolding before our eyes.
We welcome your thoughts and comments at this dangerous time.