• The pandemic will end, the economy will recover, and interest rates will rise.

  • The bond market’s 40-year bull run is over.

  • Interest rates are rising, and bonds should be sold.

  • The stock market bubble is poised to burst.

  • The economic recovery will drive commodities and cyclical stocks higher.

  • The pandemic will end, the economy will recover, and interest rates will rise.

The current investment environment is dangerous, and this letter will provide insight and solutions to address these dangers.

Markets are unpredictable and overvaluations can persist for years. Despite market timing risks, the COVID-19 economic recovery provides compelling new investment opportunities and strategies that will endure if not thrive with rising interest rates and declining financial assets. The markets of the 2020s will be reminiscent to that of the 1970s. In the 1970s, commodities like gold and oil created wealth and preserved purchasing power while both stocks and bonds performed poorly.

Investment Legend Warns of Historic Bubble:

On January 5th, 2021, GMO founder, Jeremy Grantham joined our cautionary market position. Grantham correctly identified both the 2000 Internet bubble and the 2008 US housing bubble and is one of the most prescient and talented investment strategists today. Grantham wrote:

“The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.

These great bubbles are where fortunes are made and lost – and where investors truly prove their mettle.” GMO January 5th, 2020.

Grantham’s words “These great bubbles are where fortunes are made and lost…” should give any seasoned professional investor pause. For individual investors seeking to outlive their assets, epic bubbles can wipe out life savings and retirement plan assets.

Stock and Bond Market Risks:

The chart below shows Robert Shiller’s CAPE (Cyclically Adjusted Price Earnings ratio) is at valuation levels only exceeded in 2000, and comparable to the 1929 and 2020 peaks before their crashes. Nobel Laureate Robert Shiller’s chart shows unequivocally that the current stock market is near record valuations and historic price levels for both the S&P 500 stock market index and 10-year US Treasury notes.

Shiller’s chart above shows that interest rates are at historically low levels. 10-year US Treasury yields have declined from 15.32% in 1981 to 0.66% in 2020. Today, the 10-year Treasury yields over 1.12% and is rising. Yields will rise because the economy is recovering, and interest rates are artificially low.

Below is a three year chart of the 10-year US Treasury yield. With a full economic recovery and a more inflation friendly Federal Reserve, rates can easily rise to the 1.5-3.0% range in the next two years, and then higher.

Commodities and the Commodity Cycle:

Financial assets and commodities tend to be inversely correlated. Stocks and bonds benefit from declining yields, but commodities appreciate in rising rate environments. Three years ago, DoubleLine CEO, Jeffrey Gundlach wrote “commodities are very, very cheap. Commodities have long cycles, as well. A fascinating chart has been circulating within the investment industry. It compares the total return of the Standard & Poor’s 500 index to the total return of the Goldman Sachs Commodity Index, and it goes in tremendous cycles. In the 1970s, commodities started to outperform. They outperformed the S&P 500 by 800%, and then gave it all back. Then there was another wave up, and commodities outperformed again by 800%, actually 900%, and that continued into 2008.” Since Gundlach warned of commodity inflation three years ago, gold rose 37% and other commodities like corn, soybeans, timber, and copper have rallied; however, oil, the largest commodity index component, continued in its bear market until last May when it traded to minus $37/barrel. Today, several commodities are in uptrends, and the global economy is just regaining its footing.

Like Jeremy Grantham and Robert Shiller, Jeffrey Gundlach also correctly identified both the 2000 Internet bubble and the 2008 US housing bubble and is one of the most prescient and insightful investment strategists today.

The chart below shows the ratio of commodities versus the S&P 500 referenced by Gundlach. The chart shows the commodity super cycles of 1969-1975, 1999-2007, and the likely start of a new cycle of commodity outperforming the S&P 500.

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.

Investment Themes for the Double Barreled Bear Market:

In a rising rate environment, certain sectors perform better than others. Banks, energy, industrials, and materials do better in a rising rate environment. Alternatively, utilities, REITs, and technology tend to underperform in a rising rate environment. The chart to the right, from Ari Wald of OPCO, provides a simple ranking of stock sector performance in rising interest rate environments. Our portfolios emphasize sectors that perform well in a rising rate environment.

On the other hand, technology stocks do poorly in a rising rate environment. The chart below shows a compelling valuation case to sell technology stocks by comparing their earnings relative to interest rates.

We believe that technology stocks peaked on September 2, 2020 and will experience difficult year-over-year earnings comparisons in the upcoming quarters. Tech stocks were significant beneficiaries of the COVID-19 lockdown economy. As 2021 first, second, and third quarters are reported, tech stocks will experience a measurable deceleration in earnings momentum. Decelerating earnings momentum is deadly for growth stocks. Tough tech earnings will come while interest rates are rising and when tech stocks are priced at historic valuation extremes. Lastly, big tech is getting hit with antitrust litigation which is never good. This combination of factors reinforces our conviction that large-cap tech stocks should be sold. The current bubble in tech stocks is comparable to the 2000 peak.

Below is a five-year chart of the FAANG stocks and the NASDAQ 100 (“QQQ”). Returns in tech stocks have been massive and those rates of returns are mathematically unsustainable.

Energy and Technology Opportunities:

Energy has been the worst-performing sector of the last 10 years. The chart below shows a five year 58.7% decline in the Energy Select Sector SPDR Fund ETF (“XLE”) and 70.5% decline in the Alerian MLP ETF (“AMLP”). Owners of energy stocks have suffered significant declines in recent years, but a sector bottom and turnaround appear at hand.

Tech has been in a huge bull market. The chart below of top-performing and worst performing sectors suggest that energy stocks should exit their long term bear market and technology stocks are due for a pause.

The ESG investment movement has significantly reduced fossil fuel holdings in portfolios for five years. Combined with years of underperformance, energy is now an attractive sector where high yields, good values, and growth in cleaner energy stocks can be found. We will add to energy stocks on any market pullback. Natural gas stocks Antero Resources Corporation (“AR”) and Antero Midstream Corporation (“AM”) have been big winners for our clients this year. These pure play natural gas stocks have appreciated so rapidly, we have taken profits. We look to repurchase both names on normal 30% pullbacks and believe that AR can be a $20/share stock and AM can be a $13 stock in the next two years.

Conclusion:

Global markets are at the foothills of major new bull and bear markets. Bonds have experienced nearly forty years of declining interest rates which have fueled massive bull markets in housing and equity markets. Bond yields will rise as the global economy recovers from the pandemic. Further, greater Federal Reserve tolerance of inflation and rising commodity inflation could create sharp declines in longer-term bond holdings.

Rising interest rates will accelerate and deepen the impending equity market decline from this “epic bubble.” Equity valuations are at record levels, and technology stocks, the largest weighting and driver of the S&P 500, is poised for a sharp correction that will pressure the broad market.

Commodity prices are poised to rally, and a period where commodities outperform the S&P 500, by as much as 800%, could soon unfold.

Modern investing is driven by computers and asset allocation models and the 60% 40% stock-bond portfolio allocation is how the vast majority of financial assets are oriented. As interest rates declined, after peaking in August 1981, diversified stock and bond portfolio investors enjoyed decades of success as both asset classes benefited from the declining interest rates. A symbiotic feedback loop of stock and bond rebalancings allowed diversified investors to steadily accumulate wealth for 40 years.  These strategies could see negative returns in the coming years.

The requisite strategy to address the double barreled bear markets is a rotation to value, inflation beneficiaries, commodity investments combined with a significant reduction in growth stocks and long duration bond holdings. The next several years will reward portfolios oriented toward rising interest rates. Portfolios mirroring the asset classes and sectors allocations that enriched investors in the 1970s should outperform.

Unfortunately, today’s average mutual fund and ETF investor may soon be confounded with losses in the investment strategies that have served him well for decades. Unfortunately, making money and keeping it is not as easy as Wall Street wants us to believe.

We welcome your thoughts and comments at this dangerous time.

Sincerely,

Tyson Halsey