Weekly comment - April 28, 2020

Apr 28, 2020 | Nick Foglietta


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Financialization is having its finest hour.

The Return to Normal

Below is a CBS poll that I want to use as a launch pad for the thoughts of this letter.

Two thoughts came to mind when I saw this poll:

  1. The Yes/No columns will rebalance over time. But during the rebalance history suggests a “second wave” of infection that will create another lockdown type response before things rebalance long term.
  2. A vaccine, quality treatment, or reliable testing could accelerate a rebalance in a relatively short period of time.

With those two thoughts considered, lets think about where things stand economically now two months into the COVID-19 impacted economy.

  1. Food Chains are being disrupted.
  2. Energy demand and storage is dislocated.
  3. Real estate is seeing a supply shock.
  4. Mortgage lending is being constrained.
  5. Globalization (trade) is being disrupted and the ability to move products via freight/flight is difficult.
  6. People, companies, pensions and governments are now trapped under massive debt burdens with little or no revenue to make payments.
  7. Service industries (restaurants, gyms, etc.) have zero visibility to demand even when given a green light to go back to usual business.

When we consider the points above the obvious conclusion is that a quick return to normal is not possible.

On the other side of the ledger is an insane effort on the part of Federal governments around the world to try and print enough money to fill the “demand vacuum” that has been created.

The central bank and government formula should be well known to all investors by now. The song remains the same…and so do the results.

Asset prices are supported but the “mains-street” economy is not.

Each time the central bank play book calls in a “Quantitative Easing play” the inequality of the result gets significantly worse.

How does printing money help create demand? Said another way, how does printing more debt help solve a debt problem?

The two charts below show global manufacturing and services indexes going back six years. In the first chart (manufacturing) it is quite clear that it was in a downtrend way BEFORE the COVID shock hit the global economy.

The services index only fell off a cliff after the start of the COVID crisis.

That is why people said we lived in a services based economy and that was enough to support stock and real estate prices.

That was a lie of course. It was only enough because the central banks created an environment where stock repurchase plans could support the stock markets and low interest rates could subsidize the real estate market.

Which brings me to the problem we as investors face and need to understand to be successful in coming months and years.

Last week, in the editorial titled “Confirmation Bias” we looked at three forecasts for the next couple of years. A BULL, a MODERATE, and a BEAR forecast.

Any of those three forecasts could be correct.

So here is the critical question. How would your personal financial plan fare in each of those scenarios?

I would image most would say they would be fine with the BULL scenario. Who wouldn’t?

The MODERATE would not make people much return, but they would most likely be ok too.

But what about the BEAR scenario?

Be honest. What is your plan if the BEAR scenario is what ends up happening?

Right now is the perfect time to ask this question. Stock valuations are at all-time highs.

The graphic below is startling. It shows the numerical closing level of the S&P500 on January 17th, 2018, March 1st, 2019, and last week. Then it goes on to show a pile of correlative data that goes into valuing stocks.

Let me just highlight three lines of the supporting data.

  1. NTM EPS – or present earnings expectations $146.77 down from $171.
  2. NTM EPS Growth – Earnings growth rate is a weak -15.2%.
  3. Unemployment rate – 12.8% and rising.

These are not market statistics that support a stocks trading at over 19x earnings (2800 S&P500 / 147 earnings = 19.05 times earnings).

Summary:

Stocks are expensive and supported by unprecedented monetary policy. If you own a lot of stocks here…at least know what you own.

The S&P500 has trended sideways for two weeks now. (Black circle) It is consolidating its gains BELOW the 200 day moving average (green dotted line).

This tells me that any one of our BULL, MODERATE, or BEAR cases still has a chance of being correct even in the short term.

But beyond the technical backdrop defined above, the gap between “Main Street” and “Wall Street” is now as large as any time in modern history.

Financialization is having its finest hour.

Could the S&P500 double in the next two years…Yes.

Could the S&P500 fall by 80% in the next two years…Yes.

Could the S&P500 trade in a 30% range for the next ten years…Yes.

How does your investment discipline handle each of these outcomes?

Ah…now that is a good question.

A Reply to All of the Messages I Received About Gold

Wow, a lot of you are interested in gold. Thanks for all the feedback.

I guess that kind of supports my thesis that gold may be entering a new phase of its BULL market.

If you recall, what I was proposing is that gold is moving from a “contrarian based” BULL market (where only gold-bugs are BULLISH) to a time when the general investment community is BULLISH.

Most of your replies were asking me what to buy to gain exposure to gold.

My simple answer: If gold is in a new BULL market of general acceptance by a broad spectrum of investors, then most everything gold related will tend to go up in price.

But I want to clarify something that still bothers me about the gold BULL market.

This is really important to understand.

GOLD IS STILL STRONGLY CORRELATED WITH OTHER RISK ASSETS AT THIS POINT IN ITS BULL MARKET.

What that means is that on days the stock market does well…gold tends to do well. And on days when stocks are weak…gold tends to be weak.

There is no problem with stocks and gold being strongly correlated. As a matter of fact, it is wise to do some diversifying in correlated asset classes.

But the real point of owning gold over stocks is to own an asset class that will rise when stocks are falling.

So far, that is not what is happening.

Historically, this is normal at this phase of most gold BULL markets. For the gold BULL market to progress, the next decline in stock markets is critical.

Let me flesh out my expectation if gold is moving to the next level BULL market.

  1. In coming weeks I expect stocks to correct back down.
  2. I expect gold to correct back down with the stock markets but in a shallow correction. (This means the correlation will remain as it has been).
  3. BEFORE stocks bottom, I would expect gold to start moving higher.
  4. As stocks bottom and begin to recover, I expect gold to rocket higher.

Please realize these are general expectations. They are a basic roadmap of expectations.

Why do I mention this?

Because gold BULL markets are really hard to stay invested in.

They tend to have a lot of price volatility if you choose to use gold stocks and they tend to swing back and forth erratically in an upward trend.

Personally, I prefer holding larger amounts of gold bullion (in ETF form) with some exposure to gold stocks.

Hopefully that helps you think about what plan you might want to use IF you choose to hold some gold exposure in your portfolio.

Give me a call, or send me an email, if you have any questions or want to discuss anything in this post.