Investors should adjust their portfolios to emphasize gold and commodities and reduce their holdings of stocks and bonds. Income Growth Advisors, LLC believes the future performance of bonds over the next decade is likely to be in the low single digits and the benefits of declining interest rates are diminishing. The European and Chinese economies are slowing and risk dragging the US economy into a recession. Further, if US economic growth turns negative, earnings will decline and then this ten-year old bull market will be over.
The Cyclical Transition to Gold and Commodities:
The following chart popularized by DoubleLine CEO Jeffrey Gundlach shows powerful cyclical moves in commodities relative to investing in the S&P 500 can lead to tremendous outperformance. The periods 1970-1974, 1987-1990 and 1998-2008 show outperformance of commodities relative to the S&P 500 on the order of 800% occur with cyclical regularity. Today’s geopolitical and economic conditions are deteriorating exacerbated by the US China trade war and Hong Kong protests which are accelerating the reallocation to gold and commodity. Participating in this asset class transition could lead to dramatic investment performance outcomes that could impact investors and their lifestyles like those previous periods 1970-1974, 1987-1990 and 1998-2008 which encompassed four historic equity bear markets and commodity rallies.
Several commodities have been under persistent price pressure due to their over-investment in production during the 2000’s. Oil’s current low price, nearly half its 2014 peak price of $107 per barrel, is also suppressing the turn in the commodities relative S&P 500. However, trade wars, wars and economic downturns could interrupt commodity supplies and this performance relationship decisively. Those risks are rising.
Gold is Leading the Transition:
Historically gold is a dependable fungible store of value, which makes gold a unique commodity, relative to other components in the S&P GSCI commodity index. Due to negative interest rate bonds and competitive currency devaluations, foreign governments and other institutions are increasingly likely to add gold to their reserves or holdings and drive gold price to significantly higher. This explains the outperformance of gold to the S&P 500. The chart below compares gold to the S&P 500 and it is turning up.
Source: Income Growth Advisors, LLC
Negative Interest Rates!?
The stunning growth and the existence of $16 trillion dollars of negative interest rate bonds make gold’s appeal increasingly compelling. Until recently, safe money was invested in government securities like US Treasuries or foreign sovereign debt. These conservative investment options are disappearing globally and are being replaced by negative interest rate debt securities. Consequently, gold is gaining popularity as a store of wealth due to the increasing existence of negative interest rate securities and lack of interest rate bearing sovereign debt or securities.
The chart below shows that the amount of negative yielding debt globally has expanded from $6 trillion in 2018 to $16 trillion today. This bizarre phenomenon’s mind-bending impact on kitchen table investment logic is exemplified by the recent introduction in negative interest rate mortgages in northern Europe. While lower interest rates have historically stimulated economic growth, as global interest rates continue to decline into negative territory, their economic simulative value is shrinking. These circumstances further enhance gold’s relative value appeal.
Gold’s Technical Breakout:
The chart below of the “GLD” gold ETF shows that gold has broken above technical resistance. Specifically, on Friday August 23rd, the price of gold and GLD rose while the S&P 500 declined 2.57% and the Dow Industrial Average dropped 623.34 points. These divergent moves are in response to China’s announcement of $75 billion in additional tariffs against the United States and then US President Donald J. Trump’s even more aggressive response. Friday’s market action is demonstrative of the type of market behavior we fear in the years ahead.
The long-term chart below of the GLD Gold ETF shows gold breaking through multi year resistance. The GLD ETF is a proxy for gold bullion when its price is multiplied by ten.
Is Hong Kong a Black Swan?
The sheer size of the protests in Hong Kong resulting from China’s effort to adopt an extradition treaty had caught our attention. When reports that “troops are amassing” reminded me of bond market gossip prior to the Iraq invasion of Kuwait in the summer of 1990. That was a very good time to get out of the stock market. The British transfer of Hong Kong to China in 1997 was based on the understanding that Hong Kong would maintain its democratic political systems and rule of law. That now appears in question. Hong Kong is China’s financial gateway to the global economy. Hong Kong is a major global financial market providing nearly 65% of China’s access to international capital. Should Hong Kong’s situation turn into an authoritarian crack down akin to Tiananmen Square in 1989, a black swan event could surely develop. Undoubtedly, the political risks are causing higher anxiety in global markets and has been evident in equity market volatility and rising demand for negative interest rate bonds and gold.
The U.S. China trade war and Hong Kong protests are not the only source of geopolitical anxiety and uncertainty in the news. The newly elected British Prime Minister Boris Johnson has promised a Brexit by October 31. How and if this will be resolved is another source of political and economic uncertainty on the front burner. Further, Britain’s prospective withdrawal from the European Union could likely usher in other EU departures leading to a potentially disruptive collapse of the entire European Union. Uncertainty is no friend to economic growth or optimism, but it adds to an environment which favors gold as an investment.
The US China trade dispute remains a pivotal conflict that pits the world’s two largest economies at odds and the Trump Presidency against the increasingly ominous economic and military goals of China. With China suggesting the United State’s “black hand” is driving the Hong Kong protests, the trade negotiations’ prospects are now being linked to the political unrest in Hong Kong and this threatens to deepen and complicate matters. And the world is watching.
Paradise Lost? Democracy and Capitalism at a Crossroads:
Americans have grown up in the wake of the United States’ World War II defeat of tyrannical regimes like Nazism and imperialism and unwavering faith in the virtue and inevitable spread of democracy globally. With the collapse of the Berlin Wall, America’s confidence in capitalism as the most effective engine of economic growth also became a fundamental and unquestioned belief. With the information age, some believed peace, democracy and capitalism would increasingly flourish. Unfortunately, these beliefs are being challenged by Vladimir Putin’s reign over nuclear rival Russia. China’s Xi Jinping also is not following the American script of spreading democracy and capitalism. These conditions present risks to the record of economic growth and global stability many Americans take for granted. At a minimum, these new realities threaten the economic gains of the last 36 years, since 1981, when 10-year US Treasury Notes peaked at 15.32%. Then, the price earnings multiple on the S&P 500 was 7.74 and its dividend yield was 5.5%.
Today the S&P 500’s market multiple is 16.4 with dividend yield of 1.82%. The chart below from Robert Shiller’s Irrational Exuberance website graphically portrays the massive decline in interest rates and rising stock market multiple of the last 40 and 130 years.
Over the last 38 year, the chart shows a period of significant earnings growth, multiple expansion and declining interest rates. Our view is that the current state of geopolitics and economics does not favorably augur for stocks and bonds as much as they have historically. This argues the case for gold and commodities today.
The critical factor when assessing equity market risk today is earnings growth. The Federal Reserve Model chart composite below suggests earnings growth has plateaued but not turned down. [See second panel with red earnings line.] If earnings decline as they did in 2000 and 2007-8, the stock market risks a serious decline. On the other hand, the Federal Reserve Model, which compares the earnings yield of the S&P 500 to the 10-year US Treasury shows that the US stock market is attractively priced. The earnings yield of the S&P 500 is 6.07%. Compared to the 1.58% yield of the 10-year US Treasury, the 4.54% differential or “Risk Premium” suggests that stocks are attractively priced.
The prospects for the S&P 500 depends on the direction of the US economy and the rest of the world to a lesser degree. Low US unemployment have driven strong consumer spending which constitutes 70% of US GDP or economy.
Bull Market Peak?
Though we cannot predict the future, geopolitical and economic conditions could worsen and earnings could turn down. On the other hand, a resolution of the current trade talks and reduction in geopolitical tensions combined with Federal Reserve accommodation and fiscal stimulus could lead to continued growth in earnings and a further extension of the bull market.
Our heightened concern stems from the volume surge which accompanied the markets decline in early August. A recent interview of technical analyst Milton Berg, an acclaimed analyst for trading legends George Soros, Michael Steinhardt and Stanley Druckenmiller, suggests that market peaks and troughs are accompanied by significant surges in volume in equity trading. In addition to the early August spike in trading volumes in equities, trading volumes also surged in currencies, commodities and bonds simultaneously. Berg’s argues that these spikes in volume reflect a definitive signal of a critical change in market psychology.
Our opinion is that sentiment has changed in early August, and this volume surge represents the first crack in the stock market like that described by Milton Berg in August 1987. See his YouTube interview as it is intriguing – https://www.youtube.com/watch?v=zmP_uiNeiZk “How to Time the Market with Milton Berg.”
Additionally, a central catalyst in today’s market is the Hong Kong protests. The chart below suggest that Hong Kong’s Hang Seng index had a “death cross” which is when the 50-day moving average declines below the 200-day moving average. This suggests that the protest themselves are starting to carry important negative technical, economic and psychological significances, suggesting spreading economic weakness emanating from Hong Kong.
While we cannot draw any definitive conclusions, the risks to the stock market have risen and the possibility that a major stock market peak was hit in July is rising. The technical, fundamental and political factors suggest that market conditions could worsen leading to a meaningful decline in the coming months. While we remain hopeful that the trade and economic issues will improve leading to a continuation of this ten-year-old bull market, we think that it would be imprudent to consider both near and long-term risks.
At a minimum, increasing or adding gold to one’s portfolio seems compelling. A thorough portfolio review appears particularly timely. We are offering more diversified and defensive portfolio strategies with a healthy allocation to gold and other commodities that are fundamentally conservative should the market environment turn more negative.
We always welcome any questions you may have and welcome your calls. We believe this may be an important turning point and being prepared and informed is never a bad idea.
Tyson Halsey, CFA
Income Growth Advisors, LLC