Good investors and traders make a habit of putting their thoughts into words. The discipline of demanding clarity from oneself is important to having a clear head when making investment decisions. I have been writing a quarterly piece for my family since last year, and thought perhaps I have come far enough on this road to share my thoughts with a wider audience. I welcome your comments whether you agree, disagree, or think I’m just delusional.
This is not investment advice and I have opted not to provide my detailed asset allocation in this forum, only the directional changes and thought process.
Foreign Capital is Exiting the U.S.
The big news is that after decades of inflow, foreign capital (particularly from Europe and Japan) is going home. Foreign portfolio investment inflows hit $637 billion in the third quarter of 2024, and reached a total of $33 trillion, We should expect a weaker dollar and higher inflation barring a global recession.
Economic Uncertainty
We are facing a reordering of the post-World War II global economic order, as I wrote in my piece, The World Turned Upside Down. This increases uncertainty to levels not seen since the FDR administration.
Trump wants to massively reduce the US trade deficit to restore manufacturing jobs to America. His weapon of choice is tariffs, but what we really need is to de-value the dollar by massive amounts. The Yuan needs to double and the Yen and Euro need to rise as well.
As Brent Johnson, the inventor of the Dollar Milkshake Theory recently posted, there are four things to watch to give us a sense of where things are headed, the Chinese Yuan exchange rate (currently 7.32 per dollar, but with purchasing power parity of 3.25), the interest rate on 10-year US treasuries (currently 4.36%), the price of gold, and short-term bank repo rates (known as SOFR – Secured overnight funding rate).
The U.S. cannot afford for the ten-year treasury rate to increase much above 5%, or the cost of funding our deficit will balloon, and asset prices will suffer. To solve the trade deficit, the Yuan must revalue higher against the dollar, but the CCP wants to weaken the Yuan to continue its export dominance. Since the seizing of the Russian central bank assets after the Ukraine invasion, central banks are shifting away from treasuries and towards gold as their reserve asset of choice. Lastly, the SOFR rate measures the degree of stress in the Eurodollar banking system, the offshore, unregulated market equally as large as the domestic banking market.
The Stock Market
The S&P 500 hit a peak of 6,149 on February 19th and has dropped 12.8%, to close at 5,363 on April 11th. Recent trading has been wild with three consecutive days of 5% losses followed by a 10% one-day gain on April 9th.
One-day gains of this magnitude historically occur in the middle of bear markets. During the GFC we saw gains of 11.58% on October 13, 2008, and 10.79% on October 26, 2008. Similarly, during the Great Depression there were four days with even larger gains – September 21, 1932 – 11.81%, October 6, 1931 – 12.36%, October 30, 1929 – 12.53%, and March 15, 1933 – 16.61%.
Valuations are difficult to gauge based on the traditional metric of the forward P/E ratio as tariff uncertainty makes forecasting earnings difficult at best. A reasonable guess for S&P 5000 2025 earnings is $250, which puts us at a 21.5X P/E – not cheap with a 4.5% ten-year treasury. Fair value may be 17X or 4,250. Of course, the market rarely trades at the theoretically fair value, it overshoots in both directions for long periods.
While a near-term bounce is likely, I believe we are about one-third into a Bear market. However, there is still a real possibility we may see new all-time highs over the next few months. Stock markets operate on sentiment. Here is the generic sentiment chart of the stock market cycle. I think we are in the area circled in red, but again, nothing is certain.
Federal Reserve Policy
The Fed is stuck between a rock and a hard place. We have seen that when they cut short-term rates, long-term interest rates rise instead of falling, as the market questions their commitment to low inflation. They would like to ease if the economy shows measurable signs of weakness. The market is currently pricing in a 25 basis point cut by June, to 4.0% from the current 4.25-4.5% target, with a mean expectation of rates dropping to 3.62% by mid-December.
Gold
Gold has doubled since its low in November 2022 and shows no sign of slowing as the world’s central banks move their reserves from U.S. Treasuries to gold bars. With the dollar now weakening, a significant core position in gold is appropriate for all U.S. investors.
Gold may be overbought, but I believe central banks will step in to buy any price decline.
Oil and Energy
The other key global commodity is oil, which is hitting new lows since Saudi Arabia and OPEC’s surprise decision to raise production limits on April 3rd. WTI has found a new range of $60-62 since the announcement. This is good news for inflation as the cost of energy is baked into everything. The oil price is going to be whatever the Saudi’s want it to be.
Currencies
Currency movements tend to last for years. I have added exposure to the Yen and Euro through the ETFs FXY and FXE.
Bitcoin
Bitcoin has traded as a high-volatility proxy for the NASDAQ for the past few years but is decoupling from this correlation. Now is the moment of truth – can Bitcoin begin to function as digital gold and an anchor of value in a fiat currency world? I don’t know the answer, but I think Bitcoin is at risk of a blow-up of Michael Saylor’s pyramid scheme, MicroStrategy. I will watch carefully, there is likely to be a great buying opportunity sometime in the near future.
Asset Allocation
Since December, my recommended asset allocations have adjusted towards international equities. I have a number of 1-2% put positions on what I see as overvalued growth stocks and private equity firms. I have reduced growth and energy stocks. I have also reduced overall commodity exposure and shifted to precious metals and calls on both the Yen and Euro. My personal holdings include value stocks in Latin America and ETFs in Japan and Europe. I see my large cash position is an option to jump on opportunities.
Extra Credit
Here are a series of brilliant essays compiled by Grant Williams on the markets, the world, and life.
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