July 18, 2021
Recent Articles:
I published a longform research piece on the global energy market, how different types of power sources compare to each other, and why the oil and gas sector is likely going to be a significant component of global energy for a long time. Plus, there’s an article on the use-cases of bearer assets, such as gold and bitcoin:
- The Case for a Longer-Term Oil and Gas Bull Market
- An Overview of Bearer Assets (Cash, Gold, Bitcoin)
This newsletter issue takes a look at household allocations to various assets, including record equity exposure. But first, it examines inflation and interest rates, since those numbers are directly and indirectly leading people to have such high equity allocations.
Normally I publish a newsletter every 6 weeks on average, but this one had a 9-week gap since the May issue because I was working on the 2021 International Report and some other commitments during an unusually busy period.
The Backdrop: Currency Weakness
My May 2021 newsletter discussed the topic of fiscal-driven inflation, which is what the US is experiencing at the moment.
Due to stimulus effects and a rapid growth in the broad money supply, consumers have more money in their pockets to spend, while the production of certain supplies and services remains constrained in various ways. That combination results in prices going up for whichever goods and services are constrained, until those prices go up enough to curtail demand.
That May newsletter issue examined how transitory or not-transitory the price inflation could be, with the conclusion being that it’s likely somewhat transitory in rate of change terms, but not very transitory in absolute terms. It also showed, quantitatively, how fiscal-driven inflation (like what occurred in the 1940s) differs quite a bit from loan-driven inflation (like what occurred in the 1970s).
In other words, prices can jump up quickly and then cool off for a time, but remain at a permanently higher range compared to pre-pandemic levels, since there is a lot more money in the system now and currency itself was partially devalued in a stepwise fashion.
For example, when Chipotle Mexican Grill (CMG) raises worker wages and raises their prices by 4% to compensate for that, those wages and prices aren’t ever coming back down. It might or might not go up another 4% next year (meaning it could be transitory in rate of change terms), but that’s the new price floor that it likely will never return to (meaning it’s not transitory in absolute terms).
The effects of fiscal-driven inflation are still occurring, with 5.39% year-over-year average price increases (and a boost of 0.9% just over the past month), while interest rates on bank accounts and Treasury notes remain very low:
If we zoom out, here’s the real interest rate of 3-month T-bills over the long run, meaning the interest rate that T-bills pay minus the prevailing consumer price inflation rate:
Chart Source: St. Louis Fed
Those T-bills tend to be a pretty good proxy for bank account interest as well. Basically, whenever that blue area is below zero, it means that interest rates for bank accounts and short-duration Treasuries are not keeping up with inflation, and thus are losing purchasing power.
This is currently happening because, along with large fiscal stimulus, the Federal Reserve is holding their key interest rate below the prevailing inflation rate, which is historically unusual:
In other words, folks holding cash in a bank, or holding government bonds, are gradually losing purchasing power on their holdings, since the interest rates aren’t keeping up with inflation, and aren’t even keeping up with inflation expectations as measured by the TIPS market. The last time the Fed held rates this low while inflation ran this hot, was the 1940s.
Interestingly, this policy roadmap was explained with great accuracy prior to the pandemic, back in mid-2019. BlackRock released a paper, advised by former Vice Chairman of the Federal Reserve Stanley Fischer, explaining that in the next recession, policymakers will need to combine fiscal spending and central bank financing of that spending, to stimulate their way out of the downturn. In plain speak, despite the government performing inflationary fiscal policy to offset a weak economy, interest rates would remain low, below the inflation rate.
From the paper (emphasis theirs):
There is not enough monetary policy space to deal with the next downturn: The current policy space for global central banks is limited and will not be enough to respond to a significant, let alone a dramatic, downturn. Conventional and unconventional monetary policy works primarily through the stimulative impact of lower short-term and long-term interest rates. This channel is almost tapped out: One-third of the developed market government bond and investment grade universe now has negative yields, and global bond yields are closing in on their potential floor. Further support cannot rely on interest rates falling.
Fiscal policy should play a greater role but is unlikely to be effective on its own: Fiscal policy can stimulate activity without relying on interest rates going lower – and globally there is a strong case for spending on infrastructure, education and renewable energy with the objective of elevating potential growth. The current low-rate environment also creates greater fiscal space. But fiscal policy is typically not nimble enough, and there are limits to what it can achieve on its own. With global debt at record levels, major fiscal stimulus could raise interest rates or stoke expectations of future fiscal consolidation, undercutting and perhaps even eliminating its stimulative boost.
A soft form of coordination would help ensure that monetary and fiscal policy are both providing stimulus rather than working in opposite directions as has often been the case in the post-crisis period. This experience suggests that there is room for a better policy – and yet simply hoping for such an outcome will probably not be enough.
An unprecedented response is needed when monetary policy is exhausted and fiscal space is limited. That response will likely involve “going direct”: Going direct means the central bank finding ways to get central bank money directly in the hands of public and private sector spenders. Going direct, which can be organised in a variety of different ways, works by: 1) bypassing the interest rate channel when this traditional central bank toolkit is exhausted, and; 2) enforcing policy coordination so that the fiscal expansion does not lead to an offsetting increase in interest rates.
That was written pre-pandemic, and the United States fiscal and monetary policymakers followed that playbook rather closely.
Year-over-year average price inflation is 5.39% in the US at the moment. Inflation expectations by the Treasury market, as measured by the difference in yields between normal Treasuries and inflation-protected Treasuries, are 2.32%. And yet, the Fed’s central interest rate and T-bill rates are near zero, and the 10-year Treasury rate is 1.31%.
So, holders of paper assets are losing value, and that policy roadmap of fiscal-driven inflation accompanied by low bond yields is playing out.
Hedge fund billionaire Ray Dalio forecasted this roadmap over the past few years as well, with his concept of the long-term debt cycle and currency devaluation. My September 2020 article went into detail on that topic, with one of my conclusions being:
Investors would do well to watch for this phenomenon in the 2020s decade. The “endgame” for the current high-debt environment will likely involve a combination of high fiscal deficit spending (monetized by central banks), cash and Treasury yields held persistently below the prevailing inflation rate, a trend shift from disinflation to inflation, and subsequently a period of currency devaluation.
Rotating Sources of Inflation
This 5.39% year-over-year inflation rate might not remain this high by next year, and certain prices naturally have to come down from very specific bottlenecks resolving themselves.
For example, my May newsletter included a rather fortunately-timed observation on lumber when it was still over $1400:
I’d suggest fading headlines and parabolic commodity price spikes. Lumber prices, for example, already hit extremely high levels and in recent days have been turning back down. That’s not a commodity I’m particularly bullish on from current elevated levels.
Indeed, the price of lumber sank like a rock from there over the past two months:
This lumber crash is a good example of how consumer price inflation doesn’t happen in a straight line. It happens in waves, or in various starts and stalls, and with different magnitudes in different places.
It’s also important to separate deep supply bottlenecks from surface-layer ones. Timber (the precursor to lumber) didn’t have a shortage and didn’t spike in price. That’s because the bottleneck was in sawmill capacity, referring to the facilities that turn timber into lumber. This bottleneck was caused by a temporary demand surge for new houses while sawmill capacity was finite, and sawmill operators rightly choose not to invest capex into expanding their capacity, knowing that this elevated demand level wouldn’t last forever.
That was a true example of a transitory problem with a shallow supply shortage, which is different than a more structural/deep supply shortage that we would have if say, timber itself was in short supply. Deep supply shortages take years to resolve, like bringing new copper mines to market, or rebuilding large swaths of a global supply chain.
It continues to be my base case that inflation will be hotter and more persistent than consensus expectations, but not in a straight line, and the precise magnitude and duration will depend on a variety of factors.
When mortgage rates dropped to record lows and millions of people wanted out of cities and into suburbs at the same time, housing prices and lumber prices soared due to shortages in both. Plus, semiconductor shortages are limiting new car production, which is playing a role in sharply driving up the prices of used cars. Shipping rates have soared. Copper, iron, and other commodity prices soared.
Some of those extreme price increases rolled over from their peaks. They haven’t come back down to pre-pandemic levels or crashed anywhere near what lumber did, but they’re down a bit from their recent highs. Here is the price of copper, for example:
The Manheim Used Vehicle Value Index is up almost 50% from 2019 to 2021, and this is partly related to the semiconductor shortage since it has limited the amount of new cars that can be produced:
That category is showing some initial signs of cooling off as well. Used vehicle prices might do what many commodities did and roll over to some extent, but I wouldn’t necessarily count on them going all the way back to 2019 levels. Semiconductor bottlenecks are a “deeper” type of supply constraint than, say, sawmill capacity. It requires many billions of dollars, and plenty of time, to construct new semiconductor foundries.
Recently, it has been energy prices that are moving up quickly, and still remain elevated. US nationwide average gasoline prices are at their highest level since 2014:
Due to years of oil and gas oversupply and low prices, followed by a period of sharply reduced demand from the pandemic lockdowns, oil and gas producers cut their capital expenditures that would otherwise contribute to new supply coming online, so spare oil supply outside of OPEC+ is pretty tight at the moment. Rising ESG mandates that restrict capital to oil and gas companies, along with a decade of bad energy investor returns that make investors uninterested in aggressive financing for producers, could keep this lower production in place for a while.
I’m structurally bullish on energy in general, but I’m seeing the Delta virus variant and government lockdown responses to it as a near-term risk factor for a correction in the industry. This could put the energy bull market briefly on pause for a few months, in other words. I’m honestly not sure in the near-term, because it’ll depend on government policies rather than just market forces.
So the first round of price increases was from commodities and semiconductor shortages, and the second one here is coming from energy supply constraints and general wage increases from labor shortages.
As we head into the autumn, a third inflation variable to watch is likely to be rent prices. This recent spike to 5.39% official year-over-year broad price inflation occurred at a time when year-over-year rent increases, which are one of the biggest components of the inflation basket, were on the downtrend to below 2%.
Now, however, rent year-over-year inflation is showing a potential bottom:
Chart Source: St. Louis Fed
Owners’ equivalent rent (which is the government’s indirect way to include housing costs in the CPI calculation, without including the home price itself as a capital asset) historically follows the prices of homes with an 18-month lag:
Source: Jeroen Blokland
With the rate of rent inflation seemingly bottoming and rolling up now, with eviction moratoriums coming to an end, and with high housing costs, an uptick in rent and owner’s equivalent rent appears set to provide the next round of overall price inflation to keep the broad CPI number somewhat elevated.
Record Household Equity Allocations
Historically, holding cash in the bank, or holding Treasuries, was a way to preserve purchasing power until good investments made themselves available to you. Their interest rates were generally equal to or higher than the prevailing inflation rate. You wouldn’t gain value while sitting in cash, but at least you wouldn’t lose value.
But as previously described, that’s not the case now. Cash and Treasuries are bleeding out their purchasing power at these rates. This gives investors a short time preference and an urge to speculate. Plus, many people received stimulus checks at a time when they were restricted in things they could do, due to lockdowns.
So, they used some of that money to pile into equities or cryptos. Some of that was warranted, but portions of it were speculative.
The risk, of course, is that some of these assets can be bid up to very high valuations, which then are more likely to provide poor rates of return from those elevated levels.
Plus, companies can take advantage of their high equity valuations by issuing more equity, and thus diluting the ownership of existing equity holders. Many companies who don’t make a profit have been raising cash by issuing new shares and diluting the existing shareholders:
Chart Source: Bloomberg
Ironically, these speculators ended up “saving” some of the companies. Meme stocks like AMC were able to raise a lot of cash by issuing equity at elevated valuations, which gives them more survivability in a difficult operating environment.
US household allocations to stocks are currently at a record high percentage of total US household assets, from a combination of high valuations and speculation. The red line in the chart below represents stocks as a percentage of total household assets, while the blue line represents stocks as a percentage of just their household financial assets (including mainly stocks, bonds, and real estate):
Chart Source: St. Louis Fed
Over these seven decades, periods of unusually high household equity exposure tended to have poor forward equity returns from those levels. This next chart shows household allocation to stocks in blue, and the forward annualized rate of return for the S&P 500 over the next ten years from that point in orange:
As we can see, there is a significant inverse correlation there. When stocks are cheap and households have low stock exposure, stocks tend to do very well from that point. From those low levels, there is more room for stock valuations to expand and for households to increase their allocation to stocks. However, when stocks are expensive and households already have high stock exposure, there is less room for them to expand in valuation and allocation.
These types of valuation and allocation assessments don’t tell us much about 1-year or 2-year forward returns, but they give us an idea of what sort of long-term returns we should expect. For example, markets were expensive in 1998, but that didn’t stop them from getting even more expensive in 1999 and 2000, but then they did eventually run into trouble and provided poor long-term returns from those levels.
From this level, the broad market is unlikely to provide high inflation-adjusted returns over a 5-10 year period.
Looking at another measure, here is US household net worth as a percentage of US gross domestic product, which is also at record highs of over 600% or 6x, in part thanks to a multi-decade decline in interest rates:
Chart Source: St. Louis Fed
Over the long run, US household net worth averaged about 4x as high as GDP. This chart shows US household net worth in absolute terms, and US GDP in absolute terms multiplied by four:
Chart Source: St. Louis Fed
As one more macro valuation chart along these lines, here is the absolute value of US stock market capitalization, US GDP, and US broad money supply. This one is in log form for better clarity:
Chart Source: St. Louis Fed
This is the first time that the US stock market reached 200% the size of US GDP.
Many people assume that is because the US has global companies that earn a greater and greater percentage of their revenues from outside of the US, and therefore they are not constrained by the US GDP. However, over the past ten years, the percentage of S&P 500 revenue that comes from outside of the United States has actually mildly decreased as a percentage of their total revenue. These companies are slightly less global, rather than more global, than they were a decade ago (but still quite global, overall).
Instead, this period of equities outpacing GDP by such a wide margin has mainly been a result of increasing valuation ratios like price-to-earnings, price-to-sales, and so forth.
Sector by Sector
Despite all these bubble charts, there are very different valuations among different equity sectors.
Some software firms like Cadence Design Systems (CDNS) for example are at unusually high valuation levels compared to their history:
Chart Source: F.A.S.T. Graphs
In that chart, the black line is the stock price, while the blue line is what the stock would be at if it was trading at its 20-year average price/earnings ratio. What we see there is a big decoupling of the price and the fundamentals, with the stock trading at a higher valuation than normal. And it doesn’t pay a dividend, the only gain investors can make going forward is with its stock price.
As an example in the opposite direction, the midstream energy sector (responsible for transporting and storing crude oil, natural gas, natural gas liquids, refined products, and petrochemicals) remains at depressed valuations not seen since 2009. Here is Enterprise Products Partners (EPD), which pays a 7.5% distribution yield while you hold it:
Chart Source: F.A.S.T. Graphs
Here is a chart of the enterprise value to revenue ratio for both of these stocks, where lower means cheaper and higher means more expensive. There were times when Cadence was actually as cheap or cheaper than Enterprise, but right now Cadence has the biggest valuation gap over Enterprise ever:
Similarly, here is EV to EBITDA for them. In 2010, Cadence didn’t have much EBITDA so that’s kind of a noisy moment in the data. But the 2001 vs 2021 comparison is useful:
This next chart is a total return ratio between Enterprise and Cadence. When the line is going up, it means Enterprise is outperforming. When the line is going down, it means Cadence is outperforming:
After the dotcom bubble, from 2000-2008, value stocks outperformed growth stocks in general, and Enterprise crushed Cadence in terms of total returns (price appreciation and reinvested dividends). For several years they were about equal in terms of performance, and then since 2015 there was a huge period of growth stocks outperforming value stocks in general, and Cadence crushed Enterprise. The ratio seems to be bottoming at the moment.
Both companies have the same BBB+ credit rating as well. So it’s not like EPD is a greater credit risk; it has one of the strongest balance sheets in its industry. And it mainly focuses on transporting natural gas liquids, natural gas, and petrochemicals with only minimal crude oil exposure, which makes it reasonably well-protected against the growth of the electric vehicle market.
Naturally, a growing software company should trade at a higher absolute valuation than a high-yielding energy infrastructure company. But the point is, the current size of that valuation gap is almost unprecedented, and this is the case for many stocks from these two sectors, and between other growth-vs-value sectors.
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 diversified the growth stocks section a bit, sold IVOL in favor of STIP, and rotated some of the individual stocks.
M1 Finance doesn’t have an option to hold bitcoin; I hold bitcoin in cold storage. However, I recently added a small digital asset section to include some bitcoin-related stocks. I moved MSTR to that pie from the growth stock pie, and added MARA, RIOT, and COIN.
Primary Retirement Portfolio
My retirement portfolio consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 through 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash to 40%. This was due to higher stock valuations and being later in the market cycle more generally.
After equities took a big hit in Q1 2020, I shifted some of the bonds back to equities, and it is now 71% equities (46% domestic, 25% foreign), and short-term bonds and cash is now down to 29%. For my TSP readers, this is equivalent to the 2040 Lifecycle Fund.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years if needed, based on market conditions, which reduces volatility and makes the retirement account feel less like a casino than many indices these days.
This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have more exposure to precious metals, commodities, and digital assets in that account if it were an option.
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.
I recently published my annual 2021 International Report for premium members, which looks at various metrics for 30+ countries to find undervalued opportunities and to quantify some of the large macro imbalances or bottlenecks.
Final Thoughts: Living with the Virus
One of the biggest risks facing markets over the next couple months is this new wave of Delta-variant virus cases that is starting to occur. These are the global COVID-19 numbers:
Chart Source: Worldometer
There are some areas like Southeast Asia that are being hit hard by it. After the harsh spike in cases and deaths in India in May, the harsh spike moved onto surrounding countries like Thailand, Vietnam, Indonesia, and Malaysia in July. Many of them are currently in lockdowns. Indonesia is grappling with over a thousand reported deaths per day from it, with the caveat being that the country has 270 million people.
There are other places that, despite rather high vaccination rates, are reinstating some major anti-virus measures. Los Angeles county, for example, is reinstating a mask mandate:
July 15 (Reuters) – Los Angeles County will reimpose its mask mandate this weekend in the latest sign that public health officials are struggling with an alarming rise in coronavirus cases tied to the highly contagious Delta variant.
Australia has a mildly rising daily new case count, only had about two deaths from the virus in the past month, and yet some of their cities are doing another round of lockdowns:
SYDNEY, July 17 (Reuters) – The Australian city of Sydney on Saturday ordered a shutdown of building sites, banned non-essential retail and threatened fines for employers who make staff come into the office as new COVID-19 cases kept rising three weeks into a citywide lockdown.
Chart Source: Worldometer
This sort of behavior makes judging company performance difficult over the next 3-6 months. I’m long-term bullish on energy as a sector for example, but these virus variants and government lockdowns can put a pause on that market.
We have to watch the virus itself, then watch government reactions to the virus, and then watch the peoples’ reactions to the government’s reactions to the virus, since overall public tolerance for lockdowns appears to be on the downtrend.
Plus, later this year, some of the people who had vaccinations towards the beginning of this year will likely start having their antibodies wear off, and then we’ll be dealing with politics around booster shots. Much like the flu shot, updated vaccines will be offered for the ever-changing coronavirus over time.
Beyond that, there’s only so much that can be done to halt Mother Nature, but each country and various communities within countries will have different thresholds regarding how much resources they feel they can spend on the problem as these virus variants come and roll around the world.
If the people who can’t work from home are disallowed from working or running their businesses, they either get compensated with printed money or they face outright financial loss from being disallowed to do their work, depending on the country in question.
For that reason, along with the environment of high equity valuations (particularly in the US), I think it is prudent to hold some defensive assets at this time like cash, TIPS, and gold alongside a core equity portfolio, or to at least maintain an unlevered or conservatively levered asset mix. The risk/reward ratio is becoming less attractive for many types of assets out there.
Some of my preferred equity sectors at this time are healthcare and midstream energy; these areas remain relatively attractive on both a valuation basis and in terms of being able to maintain their cash flows against any potential economic shutdowns. A subset of the Big Tech plays also look decent at this time, although some of them have better valuation characteristics than others in my view, and so they need to be considered individually rather than as a group.
Best regards,
