January 16, 2022
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This newsletter issue takes a look at the self-reinforcing cycle that stuffed excess global capital into the US stock market over the past 40 years (and especially the past decade) like a sponge soaking up water, along with an examination of catalysts that could cause this cycle to reverse.
The Capital Sponge
The United States put in place a set of policies over the past four decades that pulled a lot of domestic and global capital into its stock market. This naturally had some pros and cons associated with it.
Each country generally has a set of political priorities, and those priorities can change over time. Compared to other developed nations, the US has favored its corporate sector above most else since the early 1980s, which made the US stock market an attractive sponge to absorb capital from everywhere.
As a result, the US stock market capitalization currently represents 61% of the global stock market capitalization, despite the fact that US GDP is only 23% of global GDP.
Source: MSCI All Country World Index
This also means, however, that the US economy is more reliant on consumer spending and external financing than most other developed countries. As a result, the “tail can wag the dog”, meaning that a drop in the stock market can negatively affect consumer spending, economic growth, and foreign investment to a greater extent for the US than other developed countries.
For example, public US equities now represent about 200% of US GDP, which is an all-time high:
Chart Source: St. Louis Fed
If the stock market falls by one quarter, it would evaporate an amount of net worth that is equal to about half of the country’s GDP. That doesn’t mean GDP itself goes down by 50%, but it means that a massive amount of purchasing power relative to the size of the economy would go away if even that type of moderate price decline were to occur and remain down for a while.
Some people assume that this increase in market capitalization to GDP is just because companies are selling more products like iPhones abroad. However, the opposite is true; US companies have a slightly lower percentage of their revenue coming from outside the US today when the market capitalization is 200% of GDP, than they did ten years ago when the market capitalization was 90% of GDP. So, it’s not as though the US market simply became more global during that time.
Instead, the increase in stock prices are primarily due to higher domestic corporate earnings and especially from higher valuations on those earnings, rather than international expansion.
We can list some of the primary policies that fueled this effect.
Reason 1) Lower Interest Rates
After a very inflationary period in the 1970s, the US and the rest of the developed world have been in a four-decade trend of declining treasury rates.
This chart shows 10-year Treasury yields in red compared to the cyclically-adjusted price/earnings ratio of the S&P 500 in blue:
Chart Source: Professor Robert Shiller, Yale
There is a significant inverse correlation between long-term interest rates and S&P 500 valuations over the long run, although not on a year-by-year basis. The main exception to that general trend of inverse correlation was in the 1940s during World War II, when interest rates were low (artificially pegged at 2.5% by the Fed), inflation was high, and the future was more uncertain than usual, resulting in low equity valuations as well.
And this next chart shows the federal funds rate compared to headline price inflation. Short-term yields have spent most of the past twelve years below the prevailing inflation rate, meaning that bank accounts and Treasury bills have gradually lost purchasing power over time:
Lower interest rates allow for equity valuations to be higher, and incentivizes owning excess stock exposure, because it reduces the hurdle rate for investment.
If 10-year Treasury notes yield 5%, for example, and you want at least a 3% equity risk premium, then you’ll only invest in a stock if you think you can get an 8% annualized return or higher. However, if 10-year Treasury yields are 1.5%, and you still want a 3% risk premium, then you’re willing to pay a higher valuation, and thus accept a lower dividend yield and lower expected returns from stocks; even 4.5% expected annualized returns would be better than a 1.5% Treasury yield.
The danger comes, however, if interest rates start going sideways, or even start going up, structurally.
Low interest rates have affected different countries in different ways. For many countries such as Canada, Australia, and several European nations, the low rates have propped up their real estate valuations more-so than their equity valuations, in part because their domestic investors instead invest a lot of their capital into US growth stocks.
In the US, people tend to have a lot more equity exposure, and the rest of the world buys our stocks as well, and so it has pushed up US equity valuations to a greater extent than our housing valuations. US home prices are not expensive relative to the rest of the world, while our equity market is, even on a sector-by-sector basis.
Growth stocks are more sensitive to interest rates than value stocks, and the S&P 500 has become very growth-heavy over the past decade compared to most other international equity indices. The US stock market is more vulnerable to rising interest rates than many other stock markets that are more value-oriented.
Reason 2) Corporate Tax Cuts
Headline tax rates get a lot of attention, but it’s the effective tax rate after all the deductions and loopholes that matters in practice.
The United States has reduced its effective tax rate for corporations persistently over the past several decades:
Chart Source: St. Louis Fed
This came partially from declining headline tax rates, but also from an increase in deductions for companies. Companies spend increasing sums of money for lobbying efforts, and these investments have provided a high rate of return.
The tax base has shifted away from taxes on corporate profits, and more towards payroll taxes, which are paid by workers (the employee side) and by companies that employ a lot of workers (the employer side). The big winners of this tax shift are labor-light companies (software, pharmaceuticals, finance, and so forth) that don’t need to employ a lot of domestic workers to earn high revenue.
Reason 3) Recycled Trade Deficits
In 1974, the United States set up the petrodollar system with the Kingdom of Saudi Arabia and then the rest of OPEC, which was an agreement wherein OPEC countries would only sell their oil in US dollars (no matter which country is buying it) and would also invest a good chunk of those dollars that they earn in Treasury securities. In exchange for this commitment, the US would provide military protection, arms deals, and other benefits to the kingdom, as well as maintain stability in the region with its military might.
If you want to go down the rabbit hole of the geopolitics on this situation and the cost associated with this relationship, simply start with the Wikipedia article on the subject of US and Saudi relations to see how much the US looks the other way on Saudi issues in order to keep them in this deal. Let’s just say, the dollar isn’t exactly the most ESG-friendly asset out there.
This agreement, maintained for nearly five decades now despite multiple scandals, made it so that every energy importing country in the world needs dollars, and they would generally sell their non-oil exports in dollars as well so that they could get dollars to buy oil. This maintained the dollar as the global reserve currency despite the United States’ default on the 1944-1971 Bretton Woods system, and specifically put the US Treasury security at the heart of the global financial system as the primary reserve asset.
As the FT described in a clever article back in 2019, this petrodollar system ironically gave the United States a form of Dutch Disease. For those who aren’t familiar with the term, Investopedia has a good article on Dutch Disease. Here’s a summary:
The term Dutch disease was coined by The Economist magazine in 1977 when the publication analyzed a crisis that occurred in the Netherlands after the discovery of vast natural gas deposits in the North Sea in 1959. The newfound wealth and massive exports of oil caused the value of the Dutch guilder to rise sharply, making Dutch exports of all non-oil products less competitive on the world market. Unemployment rose from 1.1% to 5.1%, and capital investment in the country dropped.
Dutch disease became widely used in economic circles as a shorthand way of describing the paradoxical situation in which seemingly good news, such as the discovery of large oil reserves, negatively impacts a country’s broader economy.
As the FT argues (correctly in my view), making virtually all global oil priced in dollars basically gave the United States a form of Dutch Disease. Except instead of finding oil or gas, we engineered a system so that every country needs dollars, and so we need to export a lot of dollars via a structural trade deficit (and thus, the dollar as a global reserve asset basically served the role of a big oil/gas discovery).
This system, much like the Netherlands’ natural gas discovery, kept US currency persistently stronger at any given time than it should be on a trade balance basis. This made actual US exports rather uncompetitive, boosted our import power (especially for the upper classes) and prevented the US balance of trade from ever normalizing for decades.
Japan and Germany became major exporters at our expense, and for example, their auto industries thrived globally while the US auto industry faltered and led to the creation of the “Rust Belt” across the midwestern and northeast part of the country. And then China grew and did the same thing to the United States over the past twenty years; they ate our manufacturing lunch. Meanwhile, Taiwan and South Korea became the hubs of the global semiconductor market, rather than the United States.
The top 10% or so of the US income spectrum benefited from this policy at the expense of the bottom deciles. If you worked in healthcare, government, technology, media, or finance in the US, you got all of the primary benefits of living in the country with the global reserve currency, without the drawbacks. But if you worked in manufacturing or other blue collar jobs centered around manufacturing (including various service jobs in manufacturing regions), you got some of the benefits but also got the full force of the drawbacks (lost jobs, suppressed wages, economic stagnation, etc).
Meanwhile, the accumulated US trade deficits from this system and associated policies are a staggering $14 trillion:
Chart Source: Trading Economics
All of those trillions in accumulated trade deficit dollars are surplus dollars for other countries, like OPEC nations, Japan, Germany, Switzerland, Taiwan, China, etc. Those countries take those dollars and buy a lot of US assets for their foreign-exchange reserves, sovereign wealth funds, and pension funds. Decades ago, they primarily bought US Treasuries, but they increasingly now use those dollars to buy other assets as well, including US corporate bonds, US equities, US real estate, and US private companies.
This chart shows the value of US equities held by foreign entities. It’s up to over $12 trillion:
Chart Source: St. Louis Fed
The chart is parabolic with very large numbers, so perhaps it helps to explain it in percentage terms instead. At the end of World War II, the rest of the world owned about 2.6% of non-bank US corporate equities. About three decades later when the petrodollar system began in the mid-1970s, the foreign sector owned about 4.3% of non-bank US corporate equities. So, the percentage increased moderately from a low base before this system was put in place. Then, from the mid-1970s into 2021, this percentage rapidly increased, and the foreign sector now owns about 25% of non-bank US corporate equities.
The net international position of a country measures how much foreign assets they own minus how much of their domestic assets are owned by foreign entities. When a country runs persistent trade surpluses, it collects capital and buys foreign assets. On the other hand, when a country runs persistent trade deficits, it sends capital to the rest of the world, and the rest of the world uses that capital to buy larger and larger percentages of that country’s productive assets.
The US used to be the world’s largest creditor nation (meaning it had a massively positive net international investment position), but now it’s the world’s largest debtor nation (meaning it has a massively negative net international investment position). Here’s a long-term chart of net international investment position as a percentage of GDP:
Specifically, US entities own $34 trillion in total foreign assets, while foreign entities own $50 trillion in total US assets, as of late 2021. As a result, the US net international investment position is $16 trillion, and foreign entities increasingly own the productive assets of the US. Basically, the US in aggregate is selling its appreciating capital assets in exchange for depreciating consumer products.
Imagine, for example, that there are two corporations. Corporation A sells a lot more products to Corporation B than the other way around, and so Corporation A collects a lot of dollars each year from Corporation B, and then uses them to buy shares of Corporate B. Over time, Corporation A will own a larger and larger percentage of Corporation B. Corporation B is constantly selling parts of their own company to pay for ongoing deficits to Corporation A.
Or imagine, as a second example, that there are two neighbor homeowners. Homeowner A sells his services to Homeowner B each month, including mowing his lawn, repairing things, and cleaning his pool. In exchange, Homeowner B sells off small chunks of his property to pay for it. Homeowner A ends up owning a portion of Homeowner B’s yard, owns his shed and tools, and then owns his pool. Homeowner A just keeps using the money he makes by providing value to Homeowner B each month, and using it to buy more and more of Homeowner B’s property over time.
That’s what the United States is doing with the rest of the world with its productive assets as it goes deeper and deeper into a negative net international investment position.
This is the multi-decade capital sponge. The US began exporting tons of dollars to the rest of the world via structural trade deficits month after month, and by extension, basically exported its industrial base piece by piece over decades since our industrial base was relatively uncompetitive. The foreign sector would then take these dollars and buy US capital assets. After decades of this, the US became a major debtor nation, and many other countries became massive creditors, meaning they own a lot more US assets than the US owns of their assets. It has been great for the US stock market at the cost of other things, and is arguably stretching the bounds now for how far it can go.
As for the median American? They didn’t necessarily benefit from this situation:
And that is in large part because the top 10% of Americans own 89% of US household equity exposure and are not really impacted by the persistent labor offshoring, while the other 90% only own the remaining 11% of equities and face most of the consequences of that offshoring. And I say that as someone comfortably in the top 10%, enjoying these benefits.
Basically, a sizable portion of the bottom 90% of Americans have been getting their jobs or wages geographically arbitraged by rapid globalization trends over the past 25 years (more so than other developed countries, many of which have trade surpluses), and the gains from this arbitrage are going towards corporate profit margins, which are 89% owned by the top 10% of the population.
US policies (under both Republican and Democrat administrations) put pressure on the working class and middle class in order to maintain US hegemon status and to enhance the status of US corporations and the US wealthy.
I don’t comment on politics in my analysis unless it directly ties into investment implications, and this is an example where it does. Kind of like how a potential corporate tax cut or a tax raise would be important to monitor for investment performance, we need to be aware of the existing policy structure in order to observe the ongoing status of its investment implications as it relates to equity valuations, trade balances, rising populist sentiment against this establishment, and so forth. A growing number of politicians have been raising concerns about the trade deficit in recent years, and yet those trade deficit dollars are in significant part responsible for pushing up US stock valuations to such high levels.
Reason 4) Passive Investing
Especially in the United States where stock ownership is very common, passive investing has become the main trend over the past decade. Indeed, fund flows into passive index investments have now surpassed fund flows into active products. Many 401(k) plans just pour money each and every week into the S&P 500 and similar indices that closely benchmark themselves to the S&P 500.
Since most passive indices are weighted by market capitalization, it means that more and more capital flows into the largest and most expensive companies. In addition, because passive global indices are mostly weighted by market capitalization as well, it means more capital flows to the largest and most expensive stock markets around the world. It’s inherently a large cap momentum strategy.
For lack of good money, we monetize other assets instead. Rather than holding cash that offers interest rates that are below the rate of price inflation, we shovel money into market-weighted equities even if their valuations go up dramatically. This works well as a rather liquid store of value until we stretch valuations to their sustainable limits, and those limits are not really knowable in advance.
US households now have record high allocations to equities, from a combination of inflows and valuation increases. The red line in the chart below is US household equity exposure (currently 29% of total assets) and the blue line is US household real estate exposure (currently 25% of total assets):
Chart Source: St. Louis Fed
That means we have to start asking where the marginal buyer will keep coming from. What pools of capital, domestic or foreign, will shift more of their capital into US equities than they have already allocated?
Will US household allocations of equities go higher, to 35%? Will US market capitalization eventually reach 65% of global market cap, even as its share of GDP continues to decline from 23% of global GDP? Probably it could, but the higher these numbers go, the heavier they get.
There may be more places out there to draw from (and there is technically no hard limit), but we’re probably scraping the bottom of the jar by this point in terms of how much discretionary domestic and global capital can be further allocated to US equities.
Potential Catalysts for Reversal
A few months ago I joked on Twitter that if I summed up my last five years of investment research it would be, “Stocks are kind of expensive; here’s why I’m buying them anyway.”
And indeed stocks have kept going right up, recovering from every dip and correction that they encountered.
Basically, despite being on the expensive side, stocks over this period appeared at the time to be a better investment than bonds, and better than holding cash, given how low yields were on bonds and cash. And I knew with a high probability that due to how indebted everything was, that large fiscal stimulus, monetized by the central bank, would be used for major crises, which was correct.
However, I am becoming less bullish on US equity indices going forward. That’s not to say this is necessarily “the top” or anything like that (trying to time tops and bottoms is usually a fool’s errand), but I increasingly want to be diversified into other types of assets when looking out multiple years.
There are a handful of possible catalysts that could cause a structural stagnation of this four-decade US equity bullish trend:
1) As of now, although long-term interest rates bounced from their mid-2020 pandemic lows, they are still within their four-decade downward channel of lower highs and lower lows. A cessation of the structural decline in interest rates would be a significant headwind against ever-higher US equity valuations. In other words, if 10-year Treasury rates start trending sideways or up, that’s likely not good for stock indices.
2) If US corporate tax rates don’t keep going lower like they have been, that also takes away another lever that has contributed to their persistently strong performance. There seems to be less political and public appetite for more corporate tax cuts.
3) If supply chain problems, conflicts with China, and other global issues became more persistent, the cost/benefit ratio and deflationary impact of labor offshoring could diminish, putting a stop to the profit margin arbitrage that US corporations have enjoyed between high revenue and suppressed labor costs for the past several decades. That doesn’t mean globalization goes away; it just means the world might stop getting more globalized than it already is.
4) Voters and politicians seem to have an increasing (and somewhat bipartisan) appetite to take anti-trust measures against mega-cap tech stocks, which have been the main drivers of the US stock market outperformance during the past decade.
5) The commodity supply/demand situation could shift from abundance to scarcity (as I’ve argued is happening lately), resulting in persistently higher average inflation in the 2020s decade than the 2010s decade (which is my base case). That would put pressure on corporate margins and their equity valuations, especially if central banks try to fight that inflation by tightening their monetary policies.
6) Equity valuations in general could simply become so high that the ongoing fund flows required to keep them up at these levels could become insufficient, especially as the Federal Reserve tightens its monetary policy in response to inflation. Upward momentum could turn into downward momentum, causing the marginal investor to shift away to other assets and other markets.
The Dollar on Watch
The dollar index, which tracks the US dollar compared to a basket of major foreign currencies, gave a warning sign last week. Historically, when the dollar index becomes overbought on the weekly chart (green boxes in the chart below), and then rolls over into negative momentum (purple boxes in the chart below), that often leads to a significant decline in the dollar index after that point:
There are some instances of that signal where the dollar merely goes flat or grinds up more slowly rather than going down, but more often than not, it goes down more than ten points after giving that signal.
My base case is towards a weaker dollar in 2022, but I’ll be monitoring the technicals on that view.
A trader saw my dollar chart on social media and posted a cleaner version which I find to be very illustrative as well:
Chart Source: @SwellCycle
It’s quite possible that after the Omicron wave of the virus winds down, global markets will open up more and collect some of the capital that has poured into US growth stocks during the pandemic. A weaker fiscal environment in the US, along with high valuations, could lead investors to look elsewhere, resulting in both lower equity valuations and a weaker dollar.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
Since the latest newsletter, I rotated a small amount of growth exposure such as CERN and MSFT into more value exposure such as FDX, MO, and AFL.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus I have larger personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts
A lot of US growth stocks look like this:
Chart Source: F.A.S.T. Graphs
In other words, Costco’s fundamentals (blue and orange lines) did amazing, but their stock price (black line) did even better thanks to a major valuation increase on top of that fundamental performance. Interest rates came down, domestic and foreign investors alike piled quite heavily into it, and their tax rate was cut significantly in 2018.
Over the past decade, Costco went from trading at 25x annual earnings to 43x annual earnings, and also had a significant tax cut that gave it a stepwise boost in earnings. That’s what happened to a lot of the top companies in the S&P 500.
Does that mean I think Costco (COST) is topping at these lofty levels? Maybe, but not necessarily. That’s too specific of a call. I think over the very long term, it’s a great company and at certain price points will be a good investment, like it often has been in the past for nearly four decades since it was founded.
Instead, I would merely say that I don’t love the risk/reward ratio on it at a 43x price/earnings level with its expected level of growth compared to other alternatives, such as certain high-quality value stocks, certain international stocks, certain commodity exposures, and so forth.
For example, after a massive period of outperformance, Costco stock has been underperforming energy stocks since autumn 2020. This chart shows the ratio of Costco to the energy sector, and we can see that the ratio is getting rather heavy around high levels:
The case for this continuing to trend down (Costco underperforming energy stocks over the longer-term) is that we may have entered a more structural inflationary period in the 2020s with tighter labor and energy capacity compared to the disinflationary 2010s decade. This would be an argument against overweighting expensive growth stocks like Microsoft (MSFT), Apple (AAPL), Tesla (TSLA), Nvidia (NVDA), Costco (COST), Nike (NKE), Cadence Design (CDNS), and various names like that until they come down to more normal valuations.
On the other hand, the case for this just being a minor reversal before another big leg up in terms of Costco’s (and other expensive growth stocks’) outperformance is that after this post-pandemic inflationary impulse, disinflationary trends will regain control and growth stocks will resume their march upwards in terms of price/earnings ratios compared to cheaper sectors like energy or healthcare. Global economic growth will be slow, yields will fall, and capital will keep pouring into growth sectors at any price.
My base case is towards the former (energy sector and overall value outperformance compared to many growth stocks), but I continue to watch some of the indicators to see if that thesis remains on track.
Back in the 1960s, there was a group of large growth stocks referred to as the “Nifty Fifty” that were considered so good that you could basically buy at any price. It was inconceivable to people that they would be bad investments, because their growth was so strong. They included names that are well known today like Disney (DIS), Coca Cola (KO), Procter and Gamble (PG), Texas Instruments (TXN), and Sears (now bankrupt).
Most of them indeed went on to perform wonderfully over the next several decades, with rising revenue and earnings. Analysts were correct about that.
However, the majority of them were terrible stock investments for a 10-15 year stretch starting in the 1970s, as inflation and interest rates ramped up. In other words, their stock prices did a lot worse than their fundamental performance, due to overvaluation in the late 1960s, and a transition from a disinflationary period with oversupplied commodities to an inflationary period with undersupplied commodities.
I think some of today’s big growth plays could run into 5-year performance stagnations, where their underlying business continues to grow but their stock prices offer less-attractive returns, especially when indexed against inflation.
Best regards,
