Keeping It Simple

Given the pace of recovery in asset prices, without a proportional recovery in economic activity, it is necessary to understand the drivers before erring on the side of caution.

If you remember, the Feb-March swoon was a liquidation of all asset classes. Investors and institutions raised cash given the existential threat posed by the pandemic-induced lock down. The S&P 500 fell 35.4% and has recovered 37.3% (all data referred to in this post is as of last Friday), yet still needs to recover 12.7% just to get back to even.

The Nasdaq Comp is another animal, just 3 days removed from all-time highs, as well as the Nasdaq 100. What has occurred is astounding, but also continues to prove that the Nasdaq remains the best marketplace for medium- & long-term investors, with the Nasdaq 100 as its primary proxy. I expect most to understand that the small cap world is much riskier, though the organic rotation that it suffers is a better representation of healthy price discovery. The Nasdaq tends to have a better rotation of drivers, over time, that make it more attractive for medium to long term investors.

Still, liquidation events frighten investors that don’t have a process for managing the decision-making process. Understand, I am making a distinction between risk managing and decision making. Risk management is often a process for what to do with current positions, but doesn’t always have an answer for where to go or how to pivot.  The only service that does this well consistently is Hedgeye Risk Management.

My process is much simpler than theirs, and most advisors for that matter, but that isn’t the purpose of this post.  The purpose of this post is to highlight certain factors which affect my model.

Many are calling for an end to the bull market in fixed income, but the Federal Reserve is “printing” and buying fixed income ETF’s, both high grade and junk.  As I “attempt” to finish this, @lumiloz on Twitter posted the following four snapshots which are proof that the Federal Reserve putting a floor under the HY & HG bond market, which results in a cap on yields.  If you have a buyer of last resort, that can “print” currency actively participating in a market, the interest rate risk you bear as issuer goes down. Look at Japan. Enough said.

With yields capped, what will investors do?  Better yet, what option does the suffering middle class have to recoup lost savings in the last 20 years?  With long bonds yielding 1.4%, they have to take on more risk to even be able to dream of retirement.

yield comparo

So, what can we expect from equity returns for the next 10 years?  By some estimates, US large-cap & small-cap should be exceeded by international large-caps.  This case has often been made, with limited results, though at this point in time I believe it to be a reasonable one.  Even so, international stocks tend to be a rollercoaster and over time I have never seen any foreign index that matches the Nasdaq 100.  My model’s database goes back to 1985 and that conclusion is quite obvious.

Now, going back to the money printing facet of all this, it is important to notice a phenomenon that has been with us for a while that resists the academic conclusion that money printing results in massive inflation.  I will not go into the minutia of why that isn’t the case, it would make this post much too long. Suffice it to say that money printing through 3 recessions since 2001 (the US is in a recession, as per the Sahm Rule) have failed to sustain velocity of money.  Growing levels of debt in all sectors only suppress willingness to go out and spend.  All people are doing are working to pay off ever increasing debt loads, which becomes a vicious cycle, a debt trap. A crude way to put it is as follows: financial slavery.

fredgraph (5)

Given the present scenario, there is still a case for broadening exposure in my model.  We are in a perfect situation for continued strength in commodities in general. The rupture in global supply chains, brought on by the US-China trade war and COVID-19, has created a perfect storm for raw materials that are needed to produce goods. Savings are derived in different pockets, but in general, the adjustment to source goods and create sanitary environments is causing shifts in how companies and people spend their money.  Unfortunately for me, my model limits me to focus on liquid, easily accessible assets for exposure, with ample history to model and back test my strategy.  It just so happens that Gold & Silver are very liquid and easy to access by every day investors. Neither will ever be a backstop for fiat currencies, but it is widely reported that central banks are accumulating it and they still serve as hedges against inflation.  If history is precedent and if 2008-2011 are any indication of possible performance, these two metals now are prominent pieces of the model.

This isn’t to say that I am changing the model at all.  Simple correlation comparisons make it quite clear that the model works great.  Bitcoin is by all indications a risky asset, while Gold and US Long Bonds remain negatively correlated with the S&P 500. This serves the need to know what assets to rotate into when it is necessary to position “Risk Off”.


Keep it simple.

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