The trouble with logic

Is the dollar going to keep going down or will it now turn back up. This is the question on many minds and the trouble with logic is that a reasoned argument can be easily rebutted by an equally logical response. It seems it’s the same with any binary option these days; Brexit, the price of gold, tech stocks, value investing, inflation / deflation.

So what is an investor to do to escape this dilemma and the inevitable personal biases which get in the way far more often than we are prepared to admit. Keynes got pretty close to the solution when he said “when the facts change I change my mind.”

At the present time we are in the midst of what seems like a bubble in everything; stocks, particularly tech and biotech, bonds, 10 year yields are approaching the zero bound in the US and the UK and are well below that in Europe and Japan, gold, silver and the associated mining stocks. The only thing going down is the dollar which has been driving the rise in the aforementioned bubblicious parts of the market.

Technology stocks have led the way since the March denouement on the basis that they are immune to the effects of the virus and we will all need more Zoom meetings, more films on Netflix, more productive business software think automation / AI, more online shopping and home delivery. The NASDAQ 100 Tech index has recently made new all-time highs courtesy of the five FANGs ;Facebook, Apple, Amazon, Alphabet (Google) and Netflix as well as Microsoft. They now account for close to 25% of the S&P 500 in terms of market cap, a concentration higher that it was in the last tech bubble in 2000.

There have been tentative signs recently that the tech story might be on the verge of breaking down, but the relative outperformance against the broader S&P 500 is still very much in place. So until the facts change …

NASDAQ 100 outperfromance v. S&P500 since 2006

However at some point in the future, we will look back at Microsoft on 11.5 times sales, Tesla on 10.5 times sales, and Facebook on 9.5 times sales and remember the words of Scott McNealy, the CEO of Sun Microsystems, who said of the early-2000 valuation of his company:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends… That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can

maintain the current revenue run rate… Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

As growth stocks continue their relentless rise value investing has been declared officially dead in some quarters. The “old” economy is going to struggle in the new world order we will find ourselves in. The UK index comprises a large proportion of such stocks and has been the weakest of the Western markets; banks and oil stocks making up a significant percentage. Banks in Europe have already found that negative rates seriously restrict profitability, and with the UK banking sector making new all-time lows that message has arrived here too and will likely travel across the Atlantic in due course.

Value has historically outperformed in the recovery phase in the past, but this recession is like no other so the outcome cannot be a foregone conclusion at this stage.

Sovereign bond yields are still falling . Bond markets “tell the truth” about economic prospects and lower nominal and real yields hint at slower growth than the V-shapers would have us believe. The yields on the US Treasury bond complex from 3 months to 30 years are still positive although real yields are already negative. In the UK, 2 and 5 year yields are negative and the 10 year gilt nominal yield is all of 0.10%.

Source US Department of the Treasury

Can they go lower? Yes they can but the risk reward ratio is looking very weak for sovereigns, let alone most credit issues in bond world. This has led some notable bond houses to start looking around at other asset classes.

The continued fall in real yields is helping to drive the bull market in precious metals and miners and this bond manager for one has started to take notice.

“Safe government bonds have always played a very important role as a portfolio diversifier and will continue to be, but we have to recognize that their potency is diminishing due to the low absolute level of yields,” said Geraldine Sundstrom, who focuses on asset allocation strategies for Pacific Investment Management Co. in London.

“We need to diversify our diversifier and look for safe haven beyond government bonds. Given Pimco’s view that rates will be kept very low for years to come causing depressed levels of real yield, gold feels like an appropriate diversifier,” she said. Pimco, which manages $1.9 trillion in assets, is far from alone. In a May note, Citigroup Inc. cited “new non-traditional investors in bullion, including insurance companies and pension funds” as part of the fuel behind the rally.

Back in the 70s and early 80s institutions typically had between 5-10% allocated to gold mining shares; it was less easy to access bullion directly and there were no ETFs. So any transition back towards these levels will be hugely supportive for precious metals and mining stocks. Gold does have the propensity to rally strongly followed by fairly savage corrections to test the bulls resolve before heading on up again. The top is usually marked by a spectacular blow off which some of us witnessed in early 1980. Gold doubled from $425 in mid-December 1979 to $850 in January.

This is what a blow off top looks like  

On the day of the top the price surged $100 in trading in the Far East before returning to earth and a 20 year bear market ending with Gordon Brown’s infamous sale of a goodly portion of the UK’s gold reserves at around $260…

We haven’t seen anything like a blow off yet, but short term with gold making headlines pretty much everywhere (we are waiting for its front page appearance in the Economist) a correction would be healthy. Why the run up in gold? It has a lot to do with inflation expectations resulting from the heroic expansion of the Federal Reserve’s balance sheet, which has so far reached $7 trillion. Deutsche Bank have recently suggested that to fill the “policy gap” re spending intentions, it may have to go as high as $20 trillion.

$20 trillion?

Source Federal Reserve Bank of St Louis

In the short term the enormous disruption to demand is deflationary which is why bond yields are still falling. The release valve is currently the dollar that is falling too, which has been giving impetus to precious metals and miners. A falling dollar is an early indicator that holders are getting concerned about the huge and continuing rise in the Fed’s balance sheet with associated inflationary implications.

Having said that we are not in an inflationary environment…yet, but starting to think about inflation proofing one’s portfolio makes sense. Gold’s purchasing power in real terms is high on the list with inflation linked bonds and infrastructure projects, with inflation linked income streams, as other options.

The currently held belief is that the Fed’s massive liquidity injection will solve the crisis; in the vernacular, “don’t fight the Fed”. We are however in uncharted territory (see chart above!) and are on the lookout for central bank policy mistakes, not to mention the other known unknowns including US / China relations, Biden in the White House and burgeoning unrest amongst the populace. If the facts change we will change our minds.

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