Current Macro Themes

August 2, 2020

This special report focuses on high-level macro trends and my long-term asset class trade ideas that are associated with them.

The goal is to update the themes that I often write about or have described on podcast appearances over the past year, and summarize my overall outlook as it pertains to portfolio positioning in one place for subscribers.

When my view on these themes materially changes in some way, I’ll publish a new version of this special report to update those themes.

This can help newer members become familiar with my outlook, and help longer-term members keep up with views that may be changing, either because new themes are initiated or because older themes play out and get retired.

I’ll also treat this special report as a bit of a self-assessment, to see which themes have been working out as expected, and which ones are deviating from my base case. This way, readers can see my thought process and specific concerns or high convictions as appropriate, so that they have plenty of information to make their own decisions.

Whether something works spectacularly in our favor, or fails to do as we thought within our expected timeline, it’s important to re-assess the situation from time to time.

If the idea worked out perfectly, then the question is to determine whether it has become a crowded trade, or whether it has much more room to run. If the idea deviated from what we expected, then the question is to determine if we were merely early on it, or outright incorrect on it, and to see if there are certain catalysts we can look for going forward.

Summary of Themes:

• Long-Term Cycle of Wealth and Debt • Heavy Fiscal Reliance • An Inflationary Trend Shift • Precious Metal Outperformance • A Bitcoin Bull Run • A Weaker Dollar Cycle • Growth vs Value, US vs International • The Decade of Commodities

Long-Term Cycle of Wealth and Debt

A lot of people are familiar with normal 5-10 year business credit cycles.

At the start of an economic expansion, businesses and consumers start to recover from the previous recession, and so they take on more debt and risk with monetary conditions generally being loose. This higher level of debt and eventual over-investment (from businesses) and over-consumption (from households) make them increasingly leveraged and fragile as the expansion progresses. Asset prices generally move from cheap to expensive during this process as well.

Eventually, some negative catalyst (external or self-imposed), combined with the elevated debt levels, triggers an economic shock and period of deleveraging, which is recessionary. Policymakers usually respond by offering liquidity and stimulus to offset this otherwise deflationary period, many defaults occur, the system cleans out some of the excesses of malinvestment and problematic leverage, and then starts the cycle anew.

However, fewer people are familiar with the long-term cycle of wealth and debt, which can be described in various ways.

Long-Term Debt Cycle

Ray Dalio, founder of Bridgewater Associates, focuses mostly on the financial aspect of this, and refers to this as the long-term debt cycle that happens every 50-100 years. The idea is that after each business cycle deleveraging, debt levels as a percentage of GDP still tend to be elevated compared to their starting point, and interest rates tend to be lower than their starting point, so it’s not a complete deleveraging each time.

In fact, the policy response with lower interest rates and other stimulus can encourage more leverage and risk-taking in the next cycle. After maybe a dozen of these business cycles, so much debt accumulates in the economy and government that it reaches a breaking point and requires a larger-scale deleveraging including a currency devaluation.

Here’s his graphic:

Chart Source: “How the Economic Machine Works” by Ray Dalio

In practical terms, here’s the past seven decades of corporate debt as a percentage of GDP, showing these shorter-term business cycles within the upward portion of the current long-term debt cycle. Each deleveraging period results in a “higher low” of corporate debt as a percentage of GDP:

Chart Source: St. Louis Fed

And here’s what U.S. total (government, household, and corporate) debt-to-GDP levels look like over the past 150 years, with both a modern chart for this upward phase of the long-term debt cycle, and an ultra long-term chart that puts it into longer context against previous long-term debt cycle peaks:

Chart Sources: St. Louis Fed, Hoisington Capital Management

Total debt is smoother than corporate debt, because when corporations de-leverage in recessions, the government usually increases its leverage for stimulus and other measures.

The last time that much of the western world encountered the peak of a long-term debt cycle was in the 1920’s-1940’s era. So, about 80+ years later, in the 2008-present period, we’re running into that again. In many ways, the financial crisis of 2008 has a lot of parallels to 1929, and the crisis of 2020 has a lot of parallels to the 1940’s.

The main way to tell that it’s getting close to the end of the long-term debt cycle in modern economies, is when interest rates hit zero. At that point, traditional monetary policy runs out of room, so policymakers turn to nontraditional ways to stimulate the economy and devalue the currency.

Here, for example, is Bridgewater’s 2019 chart of interest rates and the monetary base. I updated it post-COVID-19 and added some annotations, to describe the major fiscal stimulus as well:

Chart Source: Bridgewater Associates 2019, updated and annotated by Lyn Alden 2020

As you can see, in both of these debt bubbles, interest rates finally ran into zero, and so fiscal stimulus funded by debt monetization was used to stimulate the economy from there.

In the 1920’s, the United States built up a lot of private debt, but had low federal debt. In the 1930’s, as the private sector deleveraged, the federal government added a lot of debt to its balance sheet as a policy response to try to get the economy out of the situation it was in, and devalued the dollar relative to its gold peg from $20.67/oz to $35/oz. And then, the 1940’s war era resulted in tremendous government deficits and debts, which were inflated away over the subsequent decade via debt monetization and yield curve control from the Federal Reserve.

Similarly, the 2008 financial crisis saw a popping of a private debt bubble, and in response to that, we kicked the problem up to the sovereign level, as the federal government quickly went from 65% to 105% debt-to-GDP from stimulus and bailouts. As we enter the 2020’s pandemic era, we have a lot of similarities to the 1940’s war era. Massive government deficits (over 20% of GDP this year), soaring federal debt-to-GDP levels of 130% and above, and the possible re-introduction of yield curve control to cap Treasury yields below the prevailing inflation rate to effectively inflate part of the sovereign debt away.

Looking back at 200 years of data, there are exceedingly few countries that reached over 120% sovereign debt-to-GDP and didn’t default in real terms within the next decade. Normally, they inflate away their debt if the debt is denominated in their own currency, rather than default nominally.

For example, during the late 1930’s through 1970’s, during the peak and resolution of the previous long-term debt cycle, U.S. Treasuries were killed on an inflation-adjusted basis.

This chart shows nominal 10-year Treasury note interest rates (blue line) contrasted with the forward annualized inflation-adjusted returns of those 10-year Treasury notes over the subsequent decade (orange bars):

Data Sources: Prof. Robert Shiller, Prof. Aswath Damodaran

In other words, what that chart shows is that Treasury note returns failed to keep up with inflation during a four-decade stretch from the mid-1930s to the mid-1970s. The U.S. government effectively inflated away a substantial portion of its debt from the peak of the previous long-term debt cycle in real terms. Currency lost considerable purchasing power during that period.

The Heartbeat of Wealth Concentration

There’s a good short read, The Lessons of History (1968), by Will and Ariel Durant (winners of the Pulitzer Prize and the Presidential Medal of Freedom for another work of theirs), which has some economic chapters that cite specific examples of the long-term debt cycle all the way back to ancient

Greece and Mesopotamia, with an emphasis on the associated wealth concentration that goes with it.

It’s ultimately a combination of math and human nature that fuels the cycles, regardless of economic frameworks that are being adopted at the time, although of course some economic frameworks can exacerbate or mitigate the effect.

These long-term debt cycles tend to include periods of wealth concentration and wealth redistribution, sometimes in a moderated manner (Solon of Greece, or the New Deal of the United States) and sometimes involving violent change (French Revolution or Russian Revolution), and almost always involve currency devaluations in one form or another.

Here are two excerpts that I think summarize the Durants’ view well.

The first excerpt is their description of Athens in the 6th century B.C.:

“In the Athens of 594 B.C., according to Plutarch, ‘the disparity of fortune between the rich and the poor had reached its height, so that the city seemed to be in a dangerous condition, and no other means for freeing it from disturbances seemed possible but despotic power.’ The poor, finding their status worsened with each year- the government in the hands of their masters, and the corrupt courts deciding every issue against them- began to talk of violent revolt. The rich, angry at the challenge to their property, prepared to defend themselves by force. Good sense prevailed; moderate elements secured the election of Solon, a businessman of aristocratic lineage, to the supreme archonship. He devalued the currency, thereby easing the burden of all debtors (although he himself was a creditor); he reduced all personal debts, and ended imprisonment for debt; he cancelled arrears for taxes and mortgage interest, he established a graduated income tax that made the rich pay at a rate twelve times that required of the poor; he reorganized the courts on a more popular basis; he arranged that the sons of those who had died in war for Athens should be brought up and educated at the government’s expense. The rich protested that his measures were outright confiscation; the radicals complained that he had not redivided the land; but within a generation almost all agreed that his reforms had saved Athens from revolution.”

Sound eerily familiar? As of this writing, we have politicians calling for erasing student debts, canceling rent, providing more government assistance for education expenses, gradually devaluing the currency with Modern Monetary Theory for societal investments or support, overhauling the healthcare system to be more accessible or universal, taxing billionaires at higher rates, and so forth. And then on the other hand we have people concerned about the devaluation of their savings, high tax rates, rising populism, the growth of the state against individual liberty, how much the youth are idealizing state socialism, and so forth.

It’s amazing how little human societies change even over 2,600 years from Athens to now; this is a cycle as old as time. It remains to be seen how well we will be able to thread this needle this time around, but the number of times in history around the world that this specific class divide shows up, especially at the culminations of long-term debt cycles, is numerous.

The second excerpt comes to the Durants’ conclusion after citing multiple successful and failed examples of dealing with wealth concentration in various societies:

“Since practical ability differs from person to person, the majority of such abilities, in nearly all societies, is gathered in a minority of men. The concentration of wealth is a natural result of this concentration of ability, and regularly recurs in history. The rate of concentration varies (other factors being equal) with the economic freedom permitted by morals and the laws. Despotism may for a time retard the concentration; democracy, allowing the most liberty, accelerates it. The relative equality of Americans before 1776 has been overwhelmed by a thousand forms of physical, mental, and economic differentiation, so that the gap between the wealthiest and the poorest is now greater than at any time since Imperial plutocratic Rome. In progressive societies the concentration may reach a point where the strength of number in the many poor rivals the strength of ability in the few rich; then the unstable equilibrium generates a critical situation, which history has diversely met by legislation redistributing wealth or by revolution distributing poverty. We conclude that the concentration of wealth is natural and inevitable, and is periodically alleviated by violent or peaceable partial redistribution. In this view all economic history is the slow heartbeat of the social organism, a vast systole and diastole of concentrating wealth and compulsive redistribution.”

Putting aside differences in practical ability, another way to think about this is simply that capital compounds exponentially, while labor earns linearly, and after a long enough timeline, that exponential-vs-linear dynamic eventually leads to a high level of wealth concentration within a society that starts stretching the perceived social contract and the bounds of the system.

Those who manage to get capital, in other words, have an easier time exponentially growing that capital from that point, and then it can eventually turn into cronyism where those with capital get more power over the nation’s fiscal policy and monetary policy to protect and grow their capital even more, until populism rises enough to challenge that entrenched trend.

Sometimes populism can take fairly rational approaches to address its grievances and agree to compromises, while other times it turns to extremes, and overturns capitalism itself. In general, history shows that it’s not capitalism itself that is the error (all prosperous economic systems need that incentive), but rather, the error is capitalism combined with toxic fiscal or monetary policies that fail to address some of the imbalances in the system, and instead exacerbate those imbalances. Nonetheless, many revolutionary movements target capitalism itself.

During the height of these cycles, wealth concentration can reach a point where the top 0.1% of the population have as much wealth as the bottom 90% combined, meaning that the average member of the top 0.1% has 900x as much wealth as the average member of the bottom 90%.

Over the past century, these peaks in the level of wealth concentration correlated very strongly with the peaks in the long-term debt and interest rate cycles:

Chart Source: Bridgewater Associates

The Fourth Turning

Neil Howe and William Strauss, the demographers that coined the now-ubiquitous term “Millennial” to describe people born in the 1980’s and 1990’s, and perform a lot of historical research with multiple published books, focus more on the social aspects of this cycle and refer to it as the Fourth Turning, happening every four generations, or about every 80-90 years and lasting 20+ years. Fourth Turnings, as Howe and Strauss define them, tend to happen at the culminations of long-term debt cycles.

During Fourth Turnings, institutions that existed for the better part of a century or more, eventually get questioned by subsequent generations, and then partially torn down and rebuilt, for better or worse. These cycles tend to occur with a logical progression, rather than pure randomness or some astrological justification or things like that.

For example, a lot of the book’s predictions from the late 1990’s about what would be happening in the 2010’s and 2020’s were quite accurate. Their book, The Fourth Turning, had specific date-ranges listed for economic calamities happening from the mid-2000’s into the 2020’s, with finer details listed throughout.

Here’s a chart that captures some of the cycle from a cultural perspective:

Chart Retrieved: Mission.org, via Medium

Nonetheless, I’m a numbers person and an investor, so I tend to emphasize the financial aspects more than the cultural or political aspects that occur through these wealth and debt cycles.

This is because while political or social outcomes are qualitative and thus can more easily surprise one way or another, high system-wide debt levels have a pretty clear and inevitable mathematical outcome that can be tracked and analyzed as it plays out. I leave social commentary to others, except in specific ways when it intersects with finance directly.

The Cycle Summarized

Having a historical understanding of these debt and wealth cycles helps provide financial and cultural context as we move through the next decade in much of the developed world. People are often shocked each time this happens, believing that the actions are unprecedented, when really it’s just a matter of modern tools applied to the same age-old problems each time in surprisingly predictable patterns, with of course some new aspects each time.

Our job, as investors, is to navigate this cycle in a way that preserves and hopefully grows wealth. This period in the long-term cycle is often described as dark and scary, and to some extent it always is, but characterized in neutral terms, it is simply transformative. Sometimes that transformation creates something better, and sometimes it creates something worse.

This long-term cycle overview sets the stage for the next two themes: 1) heavy fiscal spending and 2) an inflationary trend shift, and those two themes in turn set the stage for many of the more specific asset class themes that follow.

Further Reading on this Theme:

• The Subtle Risks of Treasury Bonds • Fixing the Debt Problem • QE and MMT and Inflation/Deflation: A Primer • Why This is Unlike the Great Depression • The Global Dollar Short Squeeze

Heavy Fiscal Reliance

After several years of post-crisis relative austerity and declines in U.S. federal deficits as a percentage of GDP from 2010 through 2015, U.S. federal deficits as a percentage of GDP began growing again in 2016.

It is historically unusual to have a sustained period of rising deficits as a percentage of GDP at times when the unemployment rate is declining (outside of an active war), but that’s what we had from 2016-2019. Here’s a chart I’ve been using in a lot of articles for the past year and a half:

Initially this was due to aging demographics, as Social Security and Medicare became increasingly top-heavy due to Baby Boomers beginning to retire in significant numbers.

In other words, the ratio of people paying into Social Security and Medicare compared to people receiving those benefits is currently far lower than it was decades ago, due to aging demographics, more expensive treatments, and

longer lifespans, and this trend will continue to get more top-heavy into the mid-2020s.

Then, the tax cuts at the start of 2018, without associated spending reductions anywhere else in the federal budget, further grew this fiscal deficit.

So, we went into 2020 with structural $1 trillion+ annual deficits, equal to 5% of GDP annually.

The pandemic and subsequent recession, of course, blew that number out. On top of a structural annual deficit of over $1 trillion, the CARES Act and add-on bills totaled about $3 trillion, the next round of fiscal stimulus is likely to be $1 trillion at minimum, and using 2008/2009 as a reference, annual tax receipts could be down by $500 billion or more this year and next.

The first round of stimulus included one-time $1,200 checks for most people, $600/week in extra federal unemployment assistance on top of the normal state unemployment programs, an expansion of the unemployment system to cover self-employed people that lost income streams, $500+ billion in small business loans that mostly turn into grants, and a variety of corporate bailout packages, hospital assistance, and so forth. The next round of stimulus is in the works, but is said to include another set of widespread helicopter checks and some lower federal employment benefits, and a variety of other parts of the package.

Overall, we’re looking at a $5+ trillion deficit and national debt increase for 2020, corresponding to 20-25% of U.S. GDP or more. This level of deficit spending and debt accumulation has not been since since World War II.

This deficit will likely decrease from peak 2020 levels in 2021 and thereafter, but keep in mind that it took about 5 years for deficits to return to normal after the 2008 crisis, and this is a far larger loss of employment than that was, and we went into it with larger structural deficits in place. I expect to see double digit percent deficits for a few years, but I’ll adjust that view as we get more clarity over time.

J.P. Morgan Asset management, in my view, has a rather low estimate for federal deficits over the next few years. They took the CBO’s pre-pandemic

baseline and added their blue additions. The green marks are from me, showing that I think deficits are likely to be higher:

Chart Source: J.P. Morgan Guide to the Markets, 6/30/2020

J.P. Morgan Asset Management sees deficits returning roughly to normal in 2022, almost as though this never happened. However, look at the deficits over the baseline from 2009 through 2014, which I emphasized on the chart. This employment shock is far larger (30 million people currently receiving unemployment insurance, vs less than 7 million at the peak in 2009), and some of the issues are more structural. I don’t think my green line additions are aggressive; they’re not my high-end estimates, just a base estimate for now.

The Federal Reserve on its own is mostly tapped out. Interest rates are at zero, they are buying assets to provide liquidity, but it’s the 30+ million people relying on employment benefits, countless struggling small businesses, debt-heavy corporations, and the banks that lend to all of them, that remain in trouble. In other words, it’s a solvency issue more-so than a liquidity issue over the next couple of years.

The Federal Reserve can combat liquidity issues, but it takes the fiscal authority to combat most types of solvency issues, unless they simply want to allow a big deflationary bust and default, which most politicians do not.

Investing in this environment unfortunately becomes a matter of watching for fiscal cliffs. With this level of gross insolvency in the system, whenever

politicians try to withdraw fiscal stimulus, we’re likely to see heightened levels of civil unrest and a potential sell-off in risk assets. When they do fiscal stimulus, we’re likely to see periods of relative calm, but a devaluation of the currency over time.

The bottom 50% of the population in the United States has just 1.4% of the nations’ net worth. Back in the 1990’s, this was about 3x higher, at over 4.2%:

Chart Source: St. Louis Fed

In other words, the bottom half of the population (and some percentage of the top half as well) live paycheck to paycheck. Their assets are light, their liabilities are heavy, and there are no real savings there.

And they find that necessary expenses take up their whole paycheck now, which is a key factor for why their savings have been so nonexistent. Here’s the median male income compared to four major critical expenses over time for a family of four:

Chart Source: Washington Post, Oren Cass

It used to be that the median male worker could make enough money to support a spouse and two kids, covering the major expenses as well as some room for the random other expenses of life. However, that is no longer the case; he now either needs a higher-than-average income, or both spouses need to work, in order to make ends meet.

I think that chart overstates housing expense; numbers I’ve seen for housing payments aren’t quite that bad when you normalize for house/unit size and lower interest rates. However, rising healthcare and education costs (and the increasing importance of education for most types of well-paid work) have severely damaged the median family income vs expense ratio.

With widespread unemployment and few assets to draw from these days, the incentive structure tends to promote protesting for those that find themselves out of options, given the context of where we are in the long-term debt and wealth cycle.

Further Reading on this Theme:

• The Big Tax Shift (Aug 2020) • The American Consumer is More Fragile than People Realize (Sep 2019)

An Inflationary Trend Shift

Going back to Dalio, he describes three forms of monetary policy.

Monetary policy 1 involves manipulating interest rates to try to serve as a stimulus or to reign in inflation. As a long-term debt cycle plays out over time in the current central banking system, interest rates get lower and lower in each subsequent business cycle, until they hit the zero bound, or even venture into shallow negative territory. There was a 40-year period of interest rate reductions in the United States from about 1980 to about 2020, which is shown in some of the earlier charts in this report.

Monetary policy 2 is used when interest rates hit zero and can’t go much lower. So, the central bank prints money in the form of bank reserves, and uses that money to buy financial assets, such as government debt and mortgage debt, which adds liquidity to the system and encourages a “wealth effect”. In this cycle, the Federal Reserve first used this from 2008 to 2014. In modern times this is called quantitative easing; it has been used in earlier history as well, but the name itself is relatively modern.

Monetary policy 3 is used when the zero bound has been reached, and the central bank has already bought a ton of financial assets. So, the central bank works closely with the fiscal authority. The fiscal authority spends a lot of money directly into the economy (infrastructure stimulus, major tax cuts, or helicopter money and bailouts, and so forth), and the central bank monetizes this fiscal spending by printing money to buy the associated massive government bond issuance, using banks as intermediaries.

Back in 2008/2009, many people mistook monetary policy 2 (the introduction of “quantitative easing” in the United States) as something that would be inflationary. However, while monetary policy 2 can offset a deflationary shock and boost asset prices, it tends to not be particularly inflationary for broad consumer prices, because the money doesn’t get out into the economy.

During the 2008/2009 crisis, household net worth declined by $11 trillion from 2008 to 2009 as stock prices and housing prices collapsed. The Fed “printed” $3.6 trillion, but this was small compared to that deflationary asset price reduction, and a lot of that printed money went to recapitalizing banks.

Banks went into the crisis with 3% cash as a percentage of assets in 2008, and were pushed up to 15% cash as a percentage of assets from the Fed buying some of their assets by the time the third round of quantitative easing ended in 2014.

Here’s a chart of large bank cash levels as a percentage of assets over nearly four decades:

Chart Source: St. Louis Fed

Back in 2008, when the financial crisis was just beginning, large banks had their lowest levels of cash + Treasury holdings as a percentage of assets in at least the past four decades. With just 14% of their assets held as cash and Treasuries combined (3% cash, 11% Treasuries), they instead were over-leveraged in real estate loans and other risky shenanigans with the rest of their assets, and that all blew up.

By the end of 2014, due to the Fed’s quantitative easing and other programs (printing money and using that money to buy some of these bank assets, such as mortgages), banks were brought up to 30% cash + Treasuries combined as a share of their assets. A variety of regulations were added to try to prevent banks from reaching those extreme leverage ratios again, even though some of the policies put in place in the late 1990’s and early 2000’s led to that bubble in the first place.

Overall, the amount of printed cash that found its way directly into the economy during the 2008-2014 period was pretty marginal. Mostly it went to recapitalize banks, with some trickling out into extra unemployment benefits and other modest stimulus efforts.

However, 2020 is a different story. Banks went into this crisis with 7% cash and 21% Treasuries, or around 28% combined holdings in those assets as a percentage of assets. This massive quantitative easing program brought them up to a modern record of 34% combined cash and Treasuries, but that relatively modest increase shows that most of the remaining amount went into the real economy. Banks were already capitalized with reasonable leverage ratios this time, and it was some percentage of their millions of clients (businesses and consumers) that became insolvent.

In other words, the 2008 crisis began inside the over-leveraged banks and emanated out to the broader economy. The 2020 crisis began within the broader economy, and by extension hit the banks as well, despite being less leveraged this time.

So in 2020, trillions of dollars were handed out by government fiscal spending to consumers and companies, and the quantitative easing by the Federal Reserve this time around was mainly for the purpose of monetizing that fiscal spending. This is monetary policy 3, which after several years does have a tendency to be more inflationary because that money is getting out into the economy.

As a tangible chart, here is annualized government transfer payments over the past seven decades. Transfer payments are direct checks and grants, basically. The blue line shows the absolute annualized amount, and the red line shows the year-over-year percent change in that annualized amount. The year 2020 has been a massive increase in government transfer payments beyond anything in modern history:

Chart Source: St. Louis Fed

As you can see, most recessions involve some sort of increased transfer payment activity, as the government tries to alleviate the shock on consumers and businesses. However, 2008 didn’t stand out at all on this chart; most of the unusual measures that the government and central bank took went to recapitalize the banking system and promote the wealth effect (monetary policy 2), rather than going out as massive transfer payments (monetary policy 3) to the rest of the economy.

This 2020 crisis, on the other hand, was a major shift towards monetary policy 3, with a $2+ trillion increase (roughly an 80% year-over-year percent increase) in government transfer payments, and the year still isn’t over, with another round of $1 trillion or more in transfer payments currently being negotiated by Congress.

Many people talk about monetary policy 3 coming, but it’s already here, and the March 2020 CARES Act marked its beginning. The questions now are what magnitude will it continue to occur in, and for how long.

Yield Curve Control

Depending on specifically what reference point you use for GDP as the denominator, the U.S. federal debt-to-GDP ratio is now at or over 130% and climbing. Large deficits are likely to persist for several years, so this is likely to hit 150%+.

Aside from rapid money-printing and transfer payments, a policy tool that central banks have to devalue their currency is “yield curve control”. With this approach, the central bank says that if its government bond yields go above a certain amount, they’re willing to print money and buy those bonds to drive them back down to that target rate.

The Federal Reserve used this policy in the 1940’s, the only other time U.S. debt-to-GDP reached over 100%, to fund World War II. They locked the 10-year Treasury yield at 2.5% or below and the T-bill yield at 0.38% or below.

This chart, for example, shows the inflation rate compared to the 10-year Treasury yield in the 1940’s. Even as inflation occasionally spiked into the double-digits, the Fed kept nominal yields firmly locked to 2.5%:

Data Source: Prof Robert Shiller

The result was that by the end of the decade, although Treasuries produced a positive nominal return, they lost purchasing power by deeply underperforming broad CPI inflation:

Data Source: Prof Robert Shiller, Prof Aswath Damodaran

The government, in other words, inflated away part of its debt burden and devalued the currency. And the Federal Reserve had to buy quite a bit of Treasury securities across the duration spectrum to perform this yield curve control:

Chart Source: Federal Reserve Bank of Cleveland

Some of those numbers seem small by today’s standards (indeed, the Fed bought up to $75 billion per day in Treasuries in March 2020, or 3x as much as the entire $25 billion amount they held in 1947), but these were 1940’s dollars and a much smaller economy, so this was a sizable chunk of new Treasury issuance at the time. The Fed increased their holding of Treasury securities by roughly tenfold from 1942 to 1946. I documented the details of this in my article: The Subtle Risks of Treasury Bonds.

Ever since 2019, the Fed officials have been discussing potentially performing yield curve control again, both in public talks and within FOMC meeting minutes. These discussions amplified in 2020 in response to the major deficits associated with the pandemic. In meeting minutes, Fed officials described comparisons to Japan and Australia today (both are currently implementing

some form of yield curve control policy on government bonds), and the United States in the 1940’s.

My argument is that the Fed has already been doing “soft” yield curve control across the duration spectrum since March 2020, and arguably since September 2019 for the short end of the curve. In other words, they don’t have a firm nominal yield target, but they are buying plenty of Treasuries to take excess supply off the market to keep yields low and to keep the market liquid.

For example, during the big liquidity crunch and dollar spike in March 2020, the foreign sector abruptly sold $250 billion worth of Treasuries, and risk parity hedge funds sold Treasuries, especially on the long end of the curve. The Treasury market became illiquid with wide bid/ask spreads, and yields briefly spiked. The Fed cited this repeatedly in their meeting minutes, and responded by buying record amounts of Treasuries, up to $75 billion per day, during the heart of the crisis:

In other words, there was a lot of Treasury security supply, combined with a lot of sellers and not enough buyers, so the Fed took a lot of that excess supply off the market by buying it with new dollars. This was deficit monetization for

major stimulus, or monetary policy 3. The Fed bought over $1 trillion in Treasuries during a mere 3-week period in the second half of March and into early April, to re-liquify the Treasury market and hammer that yield spike back down.

Interestingly, in the months that followed, nominal 10-year yields have been astonishingly flat, even as inflation breakevens (the yield differential between inflation-protected Treasuries and normal Treasuries) sharply rebounded:

Although they have tapered their purchases, the Fed is still buying tens of billions of dollars worth of Treasuries per month to this day.

Jim Bianco has also presented a view that the Treasury market is acting like we have yield curve control, with record low Treasury market volatility according to the MOVE index, which is like the VIX index except for bonds:

Chart Source: Bianco Research

A lot of people rely on Treasury yields for market signals, but what happens if the Federal Reserve is the biggest buyer of Treasuries, and significantly affects prices? We already know they can outright lock yields at a certain rate if they want to, let alone do “softer” versions of yield management by simply buying in large volumes.

The biggest pushback I receive from this view is that, during the Fed’s bond buying programs from 2008-2014, Treasury yields unintuitively went up rather than down.

My counterpoint to that is that the yield response to the Fed’s purchases depends significantly on the reason for the Fed’s bond purchases. In 2008-2014, there was still plenty of foreign demand for Treasuries, and federal debt as a percentage of GDP was much lower, and deficits were less extreme. The

bond buying that the Fed did was optional, to promote reflation and a positive wealth effect and to inject cash into banks, which can result in higher yields as investors move into equities and out of bonds.

However, things are different in 2020. With high debt levels and massive Treasury issuance, and a Treasury market that became illiquid and pretty much broke in March, and the foreign sector not really buying those Treasuries, the Federal Reserve is buying Treasuries out of necessity, due to lack of demand relative to the large supply of those Treasuries. In fact, the Fed has had to buy Treasuries due to a supply/demand mismatch since the September 2019 repo rate spike, as I described in detail in this article.

An astonishing statistic is that the Federal Reserve purchased more Treasuries during a six-week period in March and April (over $1.5 trillion), than the entire foreign sector accumulated over the past six years (about $1 trillion):

Data Sources: U.S. Treasury, U.S. Federal Reserve

Market sentiment among private Treasury buyers (concerns about more deflation/disinflation ahead) is still helping to keep nominal yields low, and there’s no outright rejection/selling of Treasuries by major holders, so the Fed hasn’t been forced to use formal yield curve control yet. However, there’s also not a lot of Treasury buying compared to the amount of issuance, and so the Fed has been buying large swaths of the bonds to manage supply/demand balance and ensure adequate liquidity, which I contend is a form of soft yield curve control.

In other words, with the Federal Reserve as the biggest current buyer of Treasuries, and having demonstrably hammered down a Treasury rate spike in March, and with a huge set of mixed economic signals involving areas of sharp reflation and other areas of sharp deflation and solvency issues, what are the odds that the Treasury market volatility would be at record lows on its own? Clearly the Fed’s purchases are making a difference for yields, liquidity, and volatility.

My outlook is that the Federal Reserve, and many other central banks, will keep nominal yields on government bonds across the duration spectrum at rather low rates, regardless of what happens with inflation, at least for quite a while. The mechanism for this is that they print money to buy government bonds as needed to ensure a good supply/demand balance, even if yields fail to keep pace with inflation. This likely eventually results in currency devaluation and some degree of higher inflation, but mathematically, they have little other choice until they inflate away a substantial portion of government debt, and private debt more broadly.

What I don’t know, is what number precisely the Fed’s high limit allowance is for where they would let Treasury yields rise to. They haven’t discussed a specific limit in meeting minutes. I would speculate it’s somewhere between 1% and 2.5%. Soft yield curve control is sufficient unless inflation gets to noticeably high levels, at which point the Fed may do formal yield curve control.

Fiat regimes whose debts are denominated in their own currency and that have the capacity to print currency, rarely die by ice (deflation). Instead, they tend to die by fire (inflation) by printing as necessary to fix deflationary debt burdens.

In other words, outright deflationary economic collapses and sovereign nominal defaults are rare, but long periods of government bonds failing to keep pace with inflation, and occasional stair-step currency devaluations, are both common occurrences in history when long-term debt cycles reach an apex.

I think the deflation-to-inflation trend shift largely happened during Q1 and Q2 2020, but we’re still in the middle of a serious recession and it could take some time for inflationary pressures to grow, as we head deeper into the 2020’s decade.

The precise timeline, in my view, depends in significant part on fiscal spending, which will likely come in bursts, offset by periods of gridlock, so deflationists and inflationists will likely both look “right” for periods of time, back and forth, until a stronger trend shift occurs.

Precious Metal Outperformance

I added gold and silver ETFs, mining companies, and royalty companies, to my newsletter model portfolio in October 2018, and then expanded it a bit in the subsequent months. I started writing a lot of bullish articles on precious metals in early 2019, and the most recent article was about a month ago. I’ve also written a number of times that I bought physical bullion as well, and made a guide on precious metals.

The thesis for being bullish on precious metals rests on a few reasons, ranging from the obvious to the subtle.

One reason is that precious metal prices tend to keep up with aggressive expansions in the money supply over the long run, and money supply is growing rapidly.

The second reason is that precious metals tend to do very well in periods of low or negative real interest rates (because the opportunity cost for holding a scarce but yieldless asset goes away when yields on Treasury securities are super low and don’t even keep up with inflation).

The third reason is that although many people think that this environment of money-printing and low real yields is a short-lived phenomenon, those who

study history and recognize the likely adoption of yield curve control as we wrap up this long-term debt cycle, can see this playing out to a larger degree than many realize in the years ahead. In other words, in order to manage debt levels as a percentage of GDP, central banks around the world are likely to cap sovereign yields as necessary, even if heavy fiscal spending drives inflation levels somewhat higher, and thus are likely to maintain negative real yields on government bonds for quite a while.

Being long precious metals and their associated stocks since October 2018 has been my high conviction trade and a strong generator of alpha so far. Basically, it has been my killer theme:

However, due to this success, we must ask if the trade has become crowded. Did the market catch up with this thesis, and extract all the gains from it already?

The short answer is that I think gold played out a significant part of bullish reasons one and two (money supply growth and negative real yields), but not yet reason three (structural deficits and yield curve control). When consensus

realizes reason three as we move a couple years into the 2020’s decade, the gold price could reach surprisingly high levels.

On one hand, the gold-to-S&P 500 ratio bottomed in 2018 and broke above its 50-month moving average in 2o20; and I think this gold-over-S&P 500 performance has a multi-year runway ahead:

Chart Source: StockCharts.com

By most of my quantitative metrics, as described in my recent gold article, I continue to view gold as fairly-valued, while the stock market and Treasury market are both overvalued.

In addition, the silver-to-S&P 500 ratio just broke out too:

Chart Source: StockCharts.com

Instead of describing gold and silver breaking out vs the S&P 500, the most intuitive way to describe those gold-to-SPX and silver-to-SPX charts is perhaps to flip them over, and simply say that the S&P 500, as priced in either gold or silver (rather than dollars) peaked in 2018 and has recently broken down below its 50-month moving average from overvalued conditions, and is likely destined to go lower in these terms, before eventually finding a bottom some years in the future.

On the other hand, with gold touching record highs after such a strong two-year rally, gold is becoming overbought on the monthly chart, and has high sentiment indicators, meaning it is in some ways becoming a crowded trade.

However, a great long-term chart from SentimenTrader shows that gold was routinely at high sentiment during its previous decade-long bull run. The top chart is the price and the bottom chart is a measure of bullish/bearish sentiment:

Chart Source: SentimenTrader

In a structural bull market for fundamental reasons, overbought conditions can mean that near-term corrections and consolidations are likely, even as the overall bull market remains intact, and this is healthy because it removes euphoria from the space and lets gold climb the wall of worry over time.

I wouldn’t be surprised over the next year or two to see brief deflationary shocks or other catalysts that could push down the price of gold, or at least halt its advance for a while. However, I would remain a buyer of those corrections as part of a diversified portfolio.

Gold and silver miners and ETFs still aren’t really on the Robinhood Top 100; retail buyers aren’t crowding in. Institutional portfolios continue to have negligible gold exposure. RIAs continue to have minimal gold exposure for their private wealth clients. Generalist investors haven’t piled in to bid up precious metals to overvalued levels according to my valuation metrics, even if they’re tactically overbought at the moment. Gold continues to be a small enthusiastic niche market, and silver even more-so.

Gold is back at the price it hit in 2011, but since then, money supply has increased substantially, so the gold price hasn’t gotten ahead of itself this time yet, like it did back in 2011. I still think it has a long way to go before it ends this overall bullish cycle, but not necessarily in a straight line up from here after such a nice run already.

One way to diversify out of precious metals is to hold Treasury Inflation-Protected Securities, or TIPS, as well. These securities keep pace with official inflation measures.

Now, I do think that official inflation measures will understate actual inflation levels in the 2020’s decade if we heat up (and the Federal Reserve buys TIPS, which reduces natural price discovery for the securities), but on a comparative basis vs normal Treasuries, I think the inflation-protected versions are a better buy for long-term portfolio allocators.

A Bitcoin Bull Run

I wrote my first article on Bitcoin back in autumn 2017 when it was $6,500-$8,000, after a year-long bull run, since I was receiving many emails from readers to write a piece on it. In my article, I offered a neutral-to-bearish outlook, and took no position. The asset had a volatile 2.5 years of sideways performance from that point.

In my April 12, 2020 premium report, I highlighted Bitcoin as a bullish opportunity at around $6,900. I went long myself on April 20th, also at around $6,900, and I’ve been topping off my position with some dollar-cost averaging since then. Bitcoin is now over $11,000 as of this writing.

So, this is another trade that went well so far. However, I don’t think this trade is finished, and in fact I suspect Bitcoin’s performance has a decent chance to beat gold and silver and most other asset classes over the next 18 months. I explained the details of this in my July 16th public article on Bitcoin, when it was in the $9,000+ range.

Bitcoin is the only position where I have a quite specific time-frame in mind, at around 18 months or so. We’ll know if the trade works out or not by the end of 2021. Either way, it’ll be volatile.

The short version is this: Bitcoin is a decentralized scarce digital asset that has a strong network effect among its users. Approximately every four years, the protocol undergoes a “halving”, which means the new supply of Bitcoin that is generated every 10 minutes, gets cut in half. If the existing user-base is holding onto their coins with strong hands (which quantitative data suggest they are), and new demand continues to come into the space (which it is), then the reduction in new supply means that this new demand has to compete for a smaller liquid supply of coins, which tends to be positive for the price, often in exponential terms.

Historically, most of Bitcon’s price appreciation happens in the 12-24 months after each halving, and the recent halving was in May 2020. This chart, for example, shows Bitcoin’s price, with the beginning of the launch cycle and the beginning of each halving cycle, marked with red dots:

Chart Source: Blockchain.com

And this chart shows the performance of each launch/halving cycle, normalized to the starting price at that cycle:

Chart Source: PlanB, @100trillionUSD

Even after this recent price rise, I continue to be very bullish Bitcoin. While I don’t have a specific price target in mind, my base case is that this fourth cycle will have a similar shape to the previous three cycles, meaning an explosive first two years, a big pullback, and then a consolidation thereafter. The bullish part likely plays out by late 2021 if this pattern holds.

Each cycle reaches a lower magnitude of percent gains than the previous cycle, but still rather explosive gains, and I’d actually be somewhat surprised to see Bitcoin not reach $30,000+ in this halving cycle. That seems like a lot, but it would be by far the weakest halving cycle so far in terms of percent price appreciation from the halving point. The upward potential is much higher than that.

The volatility and risk are high, and this view could very well fail to play out, but this can be mitigated by maintaining a small position. I consider it to be an asymmetrical bet within the context of a diversified portfolio, and given what I currently see, I wouldn’t want to have zero Bitcoin exposure at the moment, even if I wouldn’t want to risk a ton of money on Bitcoin exposure either.

It’s my favorite play for the speculative side of my portfolios at the moment.

A Weaker Dollar Cycle

In my June 2018 and April 2019 Global Opportunity Investment Reports, I ranked the dollar as being better than the euro. Specifically, I was mildly bullish on the dollar in 2018, neutral on the dollar in 2019, and somewhat bearish on the euro in both years. This played out reasonably well, with the dollar outperforming the euro from those points.

However, when the United States experienced the repo spike in September 2019, and shifted from reducing its balance sheet to increasing its balance sheet, I became structurally bearish on the dollar. This transition from large deficits and tight monetary policy, to large deficits and loose monetary policy, combined with a structural trade deficit and current account deficit, tends to result in weak currency fundamentals.

This early October 2019 article called “The Most Crowded Trade” got a lot of exposure and marked my shift to being bearish on the dollar. I recognized the possibility for a dollar spike, but argued in the article that: “Any major dollar breakout would likely be brief, self-correcting, and unpleasant.”

The pandemic and resulting global liquidity crisis gave us that spike, and I followed this article up with an early April 2020 article, entitled “The $40 Trillion Problem”, which further outlined the reason why a spiking dollar is ultimately self-defeating. I covered the global dollar liquidity problem and the spiking dollar in multiple premium reports around the March and April timeframe as well.

My May 2020 Global Opportunity Investment Report (available in the members’ Google Drive) re-iterated this long-term dollar bearish view and downgraded the U.S. dollar’s score as a currency from neutral in he previous report to below-average in this report.

So far, this thesis played out. The dollar peaked shortly after the September repo spike, right around late September or early October 2019, and turned down through the remainder of 2019. It then had that brief but sharp spike during the worst of the COVID-19 liquidity crunch and risk asset crash in March 2020, and has since continued its decline:

Chart Source: StockCharts.com

July 2020 was the dollar index’s worst month in about a decade. It was a total bloodbath in rate-of-change terms.

So, the question now is whether the dollar is oversold. Has being bearish on the dollar become a crowded trade?

I do think that in the near term, this has been a pretty fast decline from March, and especially from May, and a bounce should not surprise anyone. Especially since the euro is such a big part of the basket of currencies that the DXY dollar index is compared to, a lot of the multi-month moves come from political outcomes.

If we take a step back and look at the full duration of time under this current global monetary system as currently structured since 1971, the dollar has had three major cycles of strength and weakness relative to a basket of major currency comparisons:

Chart Source: StockCharts.com

My contention is that this third cycle of strength may be ending, ever since the repo spike that triggered a fundamental monetary policy shift, although the pandemic recession threw a curveball in there that spiked the dollar up a bit further first. However, the dollar index has now reached 2-year lows and has broken down below its 50-month moving average.

There were only two times in history, 1985 and 2002, where the dollar index broke below its 50-month moving average from a higher starting point than where it is now, and both of those were associated with the end of a dollar cycle and quite a rapid fall.

There was, however, a fake-out short-lived break below the moving average in 2017, although that was from a slightly lower starting point than where it broke down more recently. The other breakdowns below the moving average were all during choppy weak phases for the dollar as it found a floor and began the next cycle of strength.

During strong dollar environments, the foreign sector doesn’t buy many Treasuries, so domestic balance sheets or the Federal Reserve have to become the primary buyers of U.S. Treasury security issuance. We’ve seen this play out in all three dollar cycles. The green line is the percentage of U.S. federal debt held by the foreign sector, and the blue line is the dollar index, through the end of 2019:

Chart Source: St. Louis Fed

The dollar cycle isn’t magic, in other words. It’s just a shift of multiple factors involving relative monetary policy between major nations, the exhaustion of various types of balance sheet space to hold Treasuries, and so forth. Referencing the chart above, although it ends in 2019 as presented, I think there’s a good chance that the March 2020 spike likely represents the third set of “red dots” and shift in the blue line (dollar index) to the structurally downward direction.

On the other hand, the broad trade-weighted dollar index has been rather flat lately, rather than down. It showed some weakness in Q4 2019, then spiked in early 2020 as the pandemic played out, and has come back down:

Chart Source: St. Louis Fed

The trade-weighted version has more emerging market and nearby neighbor currency exposure, since it is weighted by trade, and so it doesn’t flow in quite the clean cycle that the DXY dollar index does. The currencies of countries like China, Canada, and Mexico have a much bigger weighting in this version of the index and the euro has a much smaller weighting in this index, than in the DXY dollar index.

I continue to be structurally bearish on the dollar as a base case, while acknowledging that rapid declines and oversold conditions are likely to be offset by reactive bounces. After the dollar’s abrupt decline in July, many short positions have piled onto it, and naturally I get concerned about such a crowded trade forming, and wouldn’t mind somewhat of bounce here to keep the dollar bears honest.

Essentially, the crux of my dollar bearish outlook is that ever since the United States shifted mainly to debt monetization by its own central bank to fund its large fiscal deficits (beginning with the September 2019 repo spike), the major strong dollar trend has likely broken and turned into the next major dollar weakening cycle. Tight monetary policy and the global offshore USD shortage

were what was holding the dollar up to elevated levels since its strong cycle began in late 2014, and this recent reversal in monetary policy to the Federal Reserve being the primary financier of U.S. government deficits may relieve that upward pressure and present significant downward pressure on the dollar.

Adding onto that, the post-1971 global monetary system has reached some straining points, and now several countries like China and Russia are actively de-dollarizing, and using an increasing amount of euro, yuan, and ruble in their international trading.

Growth vs Value, US vs International

With precious metals, Bitcoin, and the dollar generally going as expected so far, the area of my portfolios and my theme that has notably lagged expectations, is my view on a reversion to mean in equity markets. Since 2018, I’ve been looking (prematurely, it turns out) for a rotation into some equity regions and factors that have underperformed U.S. growth stocks in the preceding years. Specifically, I was looking for a potential shift into high-quality value stocks and more broadly, high-quality international stocks.

In general, I’ve been expressing the view that after the huge 2017 rally, U.S. growth stocks have become stretched in terms of valuation. I didn’t specifically argue that the trend had to reverse right away, but I did specify that I prefer to hold stocks with more of a value+quality blend at appropriate valuations, rather than crowd heavily into growth names.

If we look at the ratio of the Russell 1000 Value index to Russell 1000 Growth index, it has been brutal against value in this cycle. When the line in the following chart goes up, it means value is outperforming, and when it goes down, it means growth is outperforming, and I marked the part where I started to get concerned with growth valuations:

For a while this 2018 rotation view seemed well-timed; the brutal Q4 2018 equity market sell-off hit U.S. growth stocks particularly hard, and we had a sharp bounce in the value-vs-growth ratio. Companies like Apple, Alphabet, and Netflix declined far more than the broader market, while dividend/value stocks, and international stocks (including emerging markets) held up better during that time. My newsletter model portfolio, with a bit of a value-tilt, international exposure, and precious metals, crushed the S&P 500 and a typical 60/40 portfolio during that period.

In fact, that big sell-off is when I created the “growth stock” section in my newsletter portfolio, by buying some of those beaten-down growth stocks right at the start of 2019 after their sell-off, and dollar-cost averaging in ever since. That growth section wasn’t a part of the original portfolio, but it was a great addition to add at that point.

Ultimately, though, that growth-to-value rotation victory was short-lived. U.S. growth stocks came back strong in 2019, and then especially when the pandemic happened in early 2020, many of these U.S. growth stocks actually benefited sharply from the pandemic, as people turned to online shopping and

electronic devices more than ever, while other sectors in the economy suffered tremendously.

In addition to doing well fundamentally, though, the valuations on those growth stocks became stretched. Investors have flooded into growth sectors. People are willing to pay up for growth and especially software-as-a-service at virtually any price. That’s my key reason for bearishness on some of those growth names, even though many of them have fine fundamentals.

Today’s situation looks a lot like the equity landscape in the late 1960’s, where there was a collection of several dozen blue chip stocks called the Nifty Fifty that were thought to be good at any price, because they are unbeatable. These were companies we still know today, like Coca Cola and Xerox. The result was that although most of them did do very well fundamentally over the coming decades, their equity returns were terrible over the next 10-15 years due to a starting point of unreasonably high valuations.

Here is the recent chart for Cadence Design Systems, which makes software for electrical and computer engineers (and which I’ve personally used). The blue line is what the stock price would be at its historically average adjusted price-to-earnings ratio, and the black line is the actual stock price, which is flying away like Superman:

Chart Source: F.A.S.T. Graphs

Cadence has shifted primarily to a recurring/subscription model over time and also benefited from tax cuts in recent years. So, this isn’t a permanently fast-growing company; they had a nice multi-year boost into a stronger business model with lower taxes, and now analysts expect a more modest high single digit growth rate. And yet, the market has piled in, pushing the stock price way above fundamentals into a sky-high PEG ratio.

I’m on the record for saying it was overvalued at $70-$80, and here we are at well over $100. Clearly not my best call, timing wise. These things have a tendency to stretch further than most people think, myself included.

On the other hand, here’s a company like Amgen, which is a large cap, increasingly diversified bio-pharmaceutical maker with a growing dividend stream:

Chart Source: F.A.S.T. Graphs

Amgen had faster growth over the full chart period than Cadence, although it had less of growth spurt in recent years than Cadence had, and Amgen’s analyst consensus 2021 and 2022 average forward growth rates are about the same as Cadence. And yet, Cadence’s price-to-earnings ratio is about 3x higher, and totally disconnected from fundamentals, unlike Amgen.

I’m not saying Amgen will definitely outperform Cadence going forward; I’m just saying that this is a trend I see in many growth-vs-value stocks, when comparing stock price vs fundamentals. And I’d rather own a basket of stocks with charts like Amgen’s, rather than a basket of stocks with charts like Cadence’s.

I’ve had (and still have) many growth/tech stocks in my portfolio. Microsoft, Lam Research, and Apple were part of the original dividend stock section, and I eventually sold Apple for valuation reasons and still have the other two. Alphabet, Visa, Paypal, Adobe, Nvidia, Skyworks Solutions, some Chinese tech stocks, and others were added into the growth section right after the Q4 2018 sell-off, and I’ve gradually removed some of them after significant price appreciation but still hold most of them.

Nonetheless, the top 5 mega-cap tech stocks in the United States account for over 40% of the Nasdaq 100 and nearly 25% of the S&P 500, which is a record level of concentration. Since I haven’t overweighted tech/growth to quite that extent in my portfolio, and instead have diversified into a variety of types of stocks and geographic regions, this diversification has been a bit of a drag on portfolio performance, mostly due to price action rather than fundamentals. Owning almost anything other than U.S. growth stocks has been an anchor vs cap-weighted benchmarks in recent years.

This has not been one of the best investment decisions within the context of a portfolio and has offset some of the gains from the precious metals theme, but nonetheless, I continue to invest more-so in companies where the price action is in sensible range relative to the fundamentals, rather than chase momentum stocks whose prices have decoupled from fundamentals.

This doesn’t mean I invest in value stocks over growth stocks out of principle, but rather, I analyze individual stocks and look for a blend of quality, growth, and valuation such that the price action is sensible relative to the fundamentals from a long-term compounding perspective. For ETFs, I buy broad exposure with less concentration into the mega-caps.

If an eventual growth-to-value rotation is to occur, I think the most likely catalyst for a reversal is a reflation event, with an upward trend shift in inflation. Many investors have piled into these growth names for lack of anywhere else to invest and due to the virtuous cycle of passive investing into momentum names, but this perceived safety can turn into risk if valuations of those growth names become unreasonable, which I’d argue they have, at least for many of them.

One way I’m playing this since the pandemic sell-off in 2020 is simply by owning the equal-weight S&P 500 index (via the RSP ETF) rather than the standard market-weighted &P 500 index, which has the most concentration into the top 5 names in over 40 years. The market weight S&P 500 has 25% of the 500-company index into just the top 5 stocks, while the equal weight version has 0.20% in every stock, or a combined 1% in the top 5 stocks.

Over the long run, the equal weight version has outperformed because it re-balances itself, but it tends to under-perform late in business cycles, and rebound early in business cycles. Investors pile into existing market leaders late in a business cycle, but a major market shift (usually a reflationary shift

after a recession, but not always) generally results in a rotation of market leadership, under-performance of previous leaders, and thus a period of equal weight outperformance over market weight.

Here’s the long-term chart of the equal-vs-market weight ratio for the S&P 500, with a close-up to the past year as well:

As long as that double-bottom in May and July holds, I remain favorable to equal-weight S&P 500 over the market-weight version. If that support breaks, however, and we go even lower in this ratio within this cycle, it would likely mean we’re in a more dis-inflationary environment, investors continue to pile into growth names, and the decision to go into the equal-weight version would have still been premature.

I also like the Invesco FTSE RAFI US 1000 ETF (ticker: PRF) at this price level, which invests in large U.S. stocks weighted by fundamentals rather than equally or by market capitalization. In other words, it ranks companies by sales, cash flows, dividends, and book value, and invests in that proportion. So, Apple and Microsoft are still the biggest holdings in the fund, but the fund is not weighted quite as heavily into them as the pure market weight version, since the strategy doesn’t chase the fact that their valuations outpaced their fundamentals in recent years.

Investing in international stocks is another way to express somewhat of a value tilt, with geographic diversification. I’ve been relatively bullish on emerging markets since late 2016, and bearish on foreign developed markets, until more recently when I began to warm up to foreign developed markets too, after their period of underperformance and reasonable valuations.

Over the past year, emerging markets have actually outperformed the equal-weight S&P 500 (and matched it since about early 2016, which is surprising to most), but underperformed the normal market-weight S&P 500. In other words, it’s mostly a handful of mega-cap U.S. stocks that have been keeping broad U.S. equity indices up so much:

The Decade of Commodities

I was cautious on commodities in the past few years, but invested in a handful of some of the most rock-solid commodity companies in terms of balance sheets and low production costs, like Southern Copper and Lukoil, which have held up quite well compared to their peers.

This investing approach was a trade-off between the observation that commodities are historically cheap vs broad equities, and yet I was seeing signs that we were late in the business cycle in 2019, and a recession often hurts commodity prices for a time.

Imagine seeing an investment idea that you think is likely to do very well over 5-10 years, but likely to do poorly over 1-3 years, and figuring out how to play it in terms of trying to time it precisely, or just buying and likely taking a near-term hit with the willingness to add more when that happens. I did a bit of both; I invested in some of the conservative producers with a less-than-full allocation, and waited to add more when the time was right.

Post-pandemic, with that tension behind us, I’ve increased my allocation a bit towards beaten-down base commodity producers. I added Freeport-McMoRan (FCX) which so far has been a nice add, and I’ve dabbled in Royal Dutch Shell and Canadian Natural Resources and a variety of other commodity producers as well.

Here’s a version of the classic commodities-to-Dow that has been getting a lot of attention over the past few years:

Chart Source: Incrementum IGWT 2020 Report

Historically, whenever the ratio is extremely low (commodities cheap + equities expensive), it has been an amazing time to buy commodity exposure. This only happens every few decades, such as the late 1920’s, the full 1960’s, the late 1990’s, and now.

However, the big trough during the 1960’s shows that this trend can persist for a very long time and require a lot of patience to play out. That’s why I’ve been so cautious; commodity production is a pretty crappy business model with low returns on capital, but when commodity prices move, they really move.

We’ve been in a long period of under-investment in the natural resource sector, outside of shale oil. This is because, as well-known natural resource investor Rick Rule often says about the sector, “bear markets are the authors of bull markets, and bull markets are the authors of bear markets.”

In other words, when there is a ton of demand for commodities, the market overestimates the longevity of that demand, and tons of capital flows to the industry to open new supply, and that new supply ends up outpacing demand and killing commodity prices. Then, after a prolonged bear market, nobody

wants to risk capital to produce new supply of commodities that barely earn their production cost, and mines have a very long term period of development before they start producing. So, supply fails to keep up with demand, until finally demand outpaces supply and starts a new bull market in commodity prices, and the cycle starts all over. These are 10-20 year periods.

Interestingly, despite the high exploration costs in the early 2010’s decade, there wasn’t much reserve expansion for gold or copper:

Chart Source: S&P Global World Exploration Report 2019

Conductor metals like copper and silver and others are critical for the tech-heavy future that most people envision. Without abundant supply, however, that vision gets pretty expensive. Unfortunately, it’s a rather environmentally damaging process to mine for critical metals, and the regulation and development of such mines often takes many years.

I’m quite bullish on silver, copper, nickel, various battery metals, and even oil during the 2020’s decade.

China over-consumed copper in the 2000’s and early 2010’s which led to copper’s supply glut, but even now, China has significantly less copper installed per-capita than western countries like the United States. And India has a small fraction of China’s installed base of copper per capita. There is a pretty long runway for gradual copper demand growth from emerging

markets, electric vehicles, the electrical grid improvements required for mass electrical vehicle adoption, and yet not a lot of new supply on the horizon.

So far, this commodities theme has gone reasonably well, but not as well as precious metals or Bitcoin. It was good to be cautious over the past few years and we’ve limited downside risk compared to the broader commodity producer industry by focusing on quality, and some of our latest picks such as Freeport-McMoRan have done very well from post-pandemic price lows. However, this theme is still likely in its early stages, and success has been a mixed bag so far.

Summary

Although each one has the potential to act independently, many of these trades are facets of one structural shift.

That is, the end phase of a long-term debt cycle playing out, the introduction of monetary policy 3, the shift for the Federal Reserve to monetize large structural U.S. government deficits, and the subsequent shift towards a weaker dollar, high global liquidity, and a trend change from disinflation to higher inflation, either in the form of reflation or stagflation, depending on the country and other variables.

The things that have done well over the past several years benefited from disinflation, a strong dollar, and tightening global liquidity. This includes things like U.S. equities broadly, U.S. mega-cap growth stocks especially, long duration Treasury bonds, and gold.

My base case for the 2020’s decade is to see gold, silver, TIPS, value stocks, international stocks, and commodity producers outperform many of the expensive U.S. mega-cap growth stocks (several of which don’t even have much growth at this point, although some do) and long duration Treasury bonds. I also think Bitcoin is an asymmetrical bet over the next 18 months or so as a smaller position.

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All of the analysis in this research report is presented for informational purposes about investments in general and does not constitute investment advice.

Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do you own due diligence before making investment decisions. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general investment information only, is not individualized, and as such does not constitute investment advice.

Every effort is made to ensure that the research content in this report is accurate, but accuracy cannot be guaranteed and all information is presented “as is”. Investors should consult multiple sources of information when analyzing investments.

Investments may lose value. Investors should use proper diversification and maintain appropriate position sizes when managing their investments.

Best regards,