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You would not know it from looking at the bond market, however, inflation expectations are rising.
At some point, being short the iShares 20+Year Treasury Bond ETF (TLT) is going to be a monster trade.
The only question here is one of timing, so it is a “when” not “if” development, at least from my perspective,
WTK
After rising for 24 of the past 33 weeks, and 12 of the past 16 weeks, the iShares 20+Year Treasury Bond ETF (TLT) made a new all-time, intraday high, before closing lower on Friday during the past week (and actually closing lower by a fraction for the week).
Bigger picture, TLT has been on a remarkable run, rising concurrently with the broader U.S. stock market (SPY), as inflation expectations have been in free fall.
Is this rise in the bond market overdone?
Yes, is the unequivocal answer, as there has been an amazing deterioration in both business confidence, and investor confidence.
With four interest rates cuts priced into the fed fund futures market, including the growing probability of a 50 basis point cut at the July FOMC meeting, what happens if economic data strengthens, and both business confidence and investor confidence improve?
In this scenario, the bond market may have already priced in a future that is different from what actually happens, and this could be the trigger for a capital rotation bigger than the one that occurred from 2000-2002.
For a look at a different research approach, I am offering a 20% discount to membership to “The Contrarian“, the lowest price point since the founding members price, where we have a live documented history dating back to late 2015, including an updated valuation and price target list for over 103 targeted companies, including several companies that offer upside appreciation potential that rivals the best opportunities of late 2008/early 2009, in my opinion.
Additionally, I am offering a limited time 50% discount to a host of research options through this site, including a lower price point option. To get this offer, go here, and enter coupon code “june 22”.
Reach out with any questions via direct message (for members here, I have a couple articles that I will post later this weekend).
Via my research services, or another avenue, please do your due diligence, and take advantage of what I believe is a historic inflection point,
WTK
P.S. Heading out to Costco (COST) with family/kids, and then some errands, so if you sign up or message, I will get back to you later this afternoon/evening.
This past week saw extremely volatile price action in the broader equity markets, though other market barometers behaved much more normally, including the U.S. Dollar Index, down -0.4% for the week, which is surprising price action in an environment where U.S. stocks and bonds have been the safe-haven’s for global capital flows for the past decade.
Commodities, the red-headed step child of the three major asset classes the past decade (stocks, bonds, and commodities), also performed surprisingly well, with copper prices up 1.4% on the week, gold prices (GLD) up 1.3% on the week, natural gas prices (UNG) higher for their fourth week in a row by 0.6%, and precious metals equities (GDX) and smaller precious metals equities (GDXJ) up 5.9%, and 6.1% respectively.
The notable exception in the commodity space was oil (USO), and energy equities, which both finished down sharply for the week, with oil prices lower by -4.0% ($WTIC), and -4.2% ($BRENT). Energy equities declined even more, with large-cap energy stocks (XLE) down -5.4%, smaller exploration and producers (XOP) down -5.7%, including a -14.8% loss in California Resources Corp (CRC), one of the leading performing energy equities in 2018, and oil service stocks (OIH) down -5.5% for the week.
Ironically, the energy sector had been a bright spot in the commodity space this year before the rout last week, and year-to-date returns for oil, and for some energy equities are still healthy. However, energy equities have generally lagged the rise in oil prices since their lows in 2016, and this still represents a material opportunity, from my vantage point.
To provide a bigger picture perspective, here are the following year-to-date returns through Friday’s close (October 12th, 2018).
Dow Jones Industrial Average (DIA) – Up 4.0%
Invesco QQQ Trust (QQQ) – Up 12.5%
S&P 500 Index (SPY) – Up 4.8%
iShares 20+ Year Treasury Bond (TLT) – Down -8.0%
iShares U.S. Real Estate (IYR) – Down -4.1%
MSCI EAFE (EFA) – Down -7.4%
Emerging Market Equities MSCI (EEM) – Down -13.9%
Chinese Large-Cap Stocks (FXI) – Down -12.0%
$WTIC Oil Prices – Up 18.1%
$BRENT Oil Prices – Up 20.5%
$NATGAS Prices – Up 7.0%
Large-Cap Energy Stocks (XLE) – Up 3.1%
Smaller-Cap E&P Energy Stocks (XOP) – Up 11.3%
Oil Service Stocks (OIH) – Down -7.0%
Copper Prices – Down -15.2%
Silver Prices – Down -14.6%
Gold Prices – Down -6.8%
Large-Cap Precious Metals Stocks (GDX) – Down -15.0%
Small-Cap Precious Metals Stocks (GDXJ) – Down -14.2%
Looking at the YTD performance of the various sectors selected above, the NASDAQ QQQ Trust, and crude oil prices are the winners, thus far, in 2018, while precious metals, and precious metals equities have been at the bottom of the performance metrics.
Last week provided a reversal in this performance ranking, with precious metals equities leading a rebound, while the broader U.S. stock market leaders sold off sharply.
Will this price action market a turning point?
It is too soon to tell right now, however, similar to late 2015/early 2016, or late 2008/early 2009, or in late 1999/early 2000, the price action in precious metals equities might be signalling that a capital rotation is imminent, out of winners of the past decade, and into more value-oriented opportunities, including commodities, or international equities.
Building on this narrative, despite the strength of oil prices since the secular bottom in commodity prices in 2016, which preceded the secular top in the bond market in 2016, commodities still represent a generational opportunity, especially relative to U.S. equities, as measured by the S&P 500 Index.
Looking at the chart above, at some point, there is going to be a massive reversion-to-the-mean trade in commodities versus U.S. equities, bigger than what we saw even after U.S. equities topped in 2000.
Meanwhile, U.S. stocks are poised to deliver their worst real returns in modern market history, according to data I tabulate from GMO (shown in the table below), and also according to other real return forecasts, including Goldman Sachs (GS), whose Bull/Bear Market Indicator of future returns is shown below the GMO table.
Wrapping everything up, a different Portfolio construction is going to be needed in the next 10 years, compared to the past 10 years.
Simply sitting out the market in cash is not a bad idea in my opinion, especially as short-term interest rates rise, though I believe there will be extraordinary opportunities in out-of-favor equities, specifically in commodity equities, and selected international equities, whom all have been thrown overboard on a absolute and relative return basis over the past decade.
Getting to these returns, however, has not been easy, as the broader financial markets are at major inflection points, including potentially the end of a 35+ year bull market in bonds, and potentially the end of an extraordinary bull market in U.S. equities, which has been fueled by investor distrust for a majority of the past decade.
The length of the prevailing market trends means that psychology and sentiment are uniquely ingrained, so in my opinion, this makes inflection points more volatile, and harder to navigate.
An alternative to simply sitting in cash, at least in my opinion, is for investors to have a significant part of their core asset allocation in a long/short portfolio.
Building on this narrative, since trend following has dominated equity market price action the past decade, fueled by passive index and ETF flows, as this comes to an end, it should be a golden age of opportunity for active investors.
In closing, the Contrarian All Weather Model Portfolio had a very good performance week, on both a relative and absolute basis, as the offsetting short positions in SPY finally paid some dividends, and several long positions, including RH (RH), which announced another stock buyback (I wish RH’s management could be ported over to SWN, RRC, AR, CHK, X, etc.), and Barrick Gold (ABX), which rose 9.0% and 8.7%, respectively.
On the negative side of the ledger, American Airlines (AAL), which I think is remarkably cheap, and an opportunity here, continued its free-fall, falling -15.2%, and shares of AAL are now down -40.2% YTD in 2018.
Union Pacific Corp (UNP), a previous bull market leader in 2018, also stumbled last week, with shares falling -6.8% for the week, though shares are still higher by 15.6% in 2018. Sothebys (BID) also continued its move down, falling -4.1% last week, and shares of BID are down -16.6% in 2018. I keep an eye on BID shares, as they have had a history of leading broader market moves.
Without further ado, the latest Contrarian All Weather Model Portfolio Update is presented below.
We have had a good discussion in The Contrarian lately regarding the Fed, specifically their pace of interest rate increases, and how close we are to the end of the current market cycle.
This has got me thinking, researching, and discussing, the end-game to this cycle over the past several days, and I wanted to put these thoughts on the proverbial paper.
Ultimately, I believe the Fed is behind the cycle, and the late-stage cycle investments are only at the beginning of their rally, with the first leg higher in these assets occurring in 2016, and the next leg higher set to commence, perhaps imminently.
The Federal Reserve and the rest of the world’s central banks fear deflation, as 2007-2009 is still planted firmly in their minds, and thus monetary policy has stayed looser for longer, and will continue to do so, resulting in elongated investment cycles and a long runway for inflationary assets.
On March 16th, 2017, I published an article for members of The Contrarian titled, “Market Historian – What Happens When The Fed Hikes Rates“, examining what happens to the markets in Fed tightening cycles.
Midway through the article, which looking back was very prescient (and I wish I would have followed my own rationale, reasoning, and logic better in 2017), I talked about the Taylor Rule, and posted a chart showing the differential in the Fed Funds Rate, and what the Fed Funds Rate would be projected to be under the Taylor Rule.
Back in March of 2017, the gap between the actual Fed Funds Rate and the Fed Funds Rate predicted by the Taylor Rule was pretty large, around 4%.
As economic growth in the United States has accelerated, and Fed Fund Rate increases have lagged past rate hiking cycles, that differential gap has widened further today.
With the Effective Federal Funds Rate hovering around 2%, and the Taylor Rule projecting the Federal Funds Rate should be 7.5% today (read that again and think about it) the gap between the projected Fed Funds Rate by the Taylor Rule, and the actual Fed Funds Rate has widened to 5.5%.
In summary, even though the Fed has accelerated their pace of tightening in 2018, they have actually allowed monetary policy to become looser relative to economic growth, and this easy monetary policy environment has the potential to spark an inflationary boom, which would be the best possible environment for inflationary equities, specifically commodity equities.
The Fed has been predisposed to easier monetary policy for a long time. The graph above would date this predisposition to around 1990, and as a market historian, I would say it began earlier, really with Fed Chairman Greenspan, particularly following the October 1987 U.S. stock market crash, where the Fed began easing interest rates immediately, after tightening them from February of 1987.
After the 2000-2002 U.S. stock market downturn, the Federal Reserve was noticeably slower to raise interest rates, waiting all the way until June of 2004 to lift rates from the 1% bottom.
Remember, 2003 was a very strong year for risk assets, so the Fed waited the entirety of 2003 and into 2004, and then they began raising rates at a steady pace.
How steady?
As I wrote in the member Market Historian article, the Fed raised rates 17 times from June of 2004 to June of 2006, which was a much faster rate hike cycle than we have seen in the current economic expansion and equity bull market.
Interestingly, the Fed stopped tightening in June of 2006, about a year-and-a-quarter before the U.S. stock market, as measured by the SPDR S&P 500 ETF (SPY), peaked late in 2007.
Adding to the narrative, commodity prices increased during the Fed tightening cycle in June of 2004 to June of 2006, adding to their advances from 2001 through June of 2004.
The price action of commodities in the chart above from 2004-2008 is of particular interest today, as I believe we are on the same path with regards to the economic cycle and financial markets today as were were back then.
Specifically, index funds dominated fund flows from 2003-2007, in a prelude to what we have seen during the current bull market, and volatility was muted, before an unwind.
It is my personal belief that the current U.S. equity bull market is sort of a hybrid between the 1990-2000 U.S. equity bull market, with growth assets dominating as I wrote about recently for members, and the 2003-2007 U.S. equity bull market, when passive flows became the go to investment vehicle for institutions on the traditional equity side.
With the Federal Reserve, and the world’s central banks sticking with a policy of negative real interest rates for longer than ever before, I believe investment cycles have lengthened.
From the Martin Pring graphic above, I think bonds have topped, with sovereign bonds making their secular highs (lows in yields) in 2016, so we are somewhere between Stage 4 and perhaps at the early part of Stage 5.
Keep in mind, the 4-5 year time-frame in the graphic above applied to U.S. markets historically, so again, I think investment cycles, especially on a global basis, have been elongated, so each stage of the cycle could be running 2x to 3x what is shown above.
For that reason, the current investment landscape, with large-cap growth outperforming has seemingly persisted forever.
This is the bad news.
The good news is that the other stages should be elongated too, so there should be an even longer runway for our favored late-stage asset plays today.
The first thought that comes to mine is to buy iShares 20+Year Treasury Bond ETF (TLT) puts.
Why?
1. The Fed is clearly way behind in their interest rate hiking cycle, and adding to this narrative, they may stop at a terminal rate that is significantly below what could be called for in a higher growth/higher inflation landscape.
2. Sovereign interest rates have clearly bottomed in 2016, yet there is a reluctance to embrace this right now, and with 2007-2009 still fresh in most investor’s minds, the natural inclination is to buy bonds for a safety trade.
The second thought is that commodity equities, which have dominated the Top-Ten List, should be primed for their second leg higher.
The SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which is already in the midst of its second leg higher, with the first leg occurring from the Spring of 2016 through the end of 2016, followed by a difficult pull-back for the majority of 2017, before embarking on the beginning of its second leg higher in the depths of despair in 2017, is a good leading indicator for the rest of the commodity complex today, in my opinion.
Thus, if XOP continues its uptrend of higher highs and higher lows, I think this will be a good sign for commodity equities in general, a few of which I have identified as particularly juicy opportunities, at least from my vantage point, in a recent member post titled Volatility Creating Opportunity.
The third thought that is on my mind is that the current equity bull market could go on longer than expected, as the late-stage cycle investments, have not really even gotten underway in what should be a longer than normal time-frame for late-stage cycle assets.
Having said that, projected real returns for the broader stock and bond markets are beyond abysmal today.
In summary, there really are only select pockets of value, and commodity equities are one of the sweet spots in my opinion.
The Fed is farther behind in their rate hiking cycle than every before, and their glacial pace of interest rate increases in the current almost decade long equity bull market is a prime factor behind the price dislocations that we are seeing today.
Imagine for a second that monetary policy was normalized from 2009-2012.
Would we have the excesses and the imbalances that we have today?
Probably not.
However, you have to play the hand you are dealt.
Building on that narrative, the dislocations and dispersion in the financial markets the past decade is creating a Golden Age for active investors, as the supply/demand dynamics of many economically sensitive industries have been stretched to extremes, highlighting the importance of the capital cycle, and providing what I think are the investment opportunities of a lifetime.
Looking forward to what should be a dynamic rest of 2018,
Travis