Putting Your Money With The Mega Trends
It’s been a few weeks since my last update. That tends to happen around year end. My apologies. This is an important update for all investors (clients and non-clients). Why? Because there are some new asset class trends and accelerating older trends that you must clearly understand if you plan to make a return on your capital for the next decade plus.
The “New” Relationship Between Bonds and Stocks
Everyone who has been investing since the late 90’s understands that Treasury Bonds and Domestic stocks move higher with almost perfect negative correlation. When stocks are up, bonds are down in a “risk on” trade. When stocks are down, bonds are up in a “flight to safety”. The net effect for most passive investment strategies was a very long-term environment in which an investor could simply own the well-publicized 60/40 (stocks/bonds) portfolio and do quite well with very few changes, costs or concerns. As of the end of last year, we believe that long-term relationship has come to an end. Now, Treasury bonds are pricing in a growth economy and early signs of inflation (higher wage pressure, higher Producer Prices and stronger demand (PMI) globally). Today, we can’t say that stocks and bonds are tracking together with positive correlation yet as they did prior to the year 2000 but they are certainly angling that way, and ultimately will once inflation takes hold. As strange as it seems, this is not really new. Bonds and stocks trended together from the early 80’s all the way through the late 90’s as the main concern then was fighting inflation. We’re headed back in that direction now as there are signs everywhere that the age of deflationary pressure is coming to an end.
Bloomberg did an article on this today and we agree.
What will this mean to the common investor with the 60/40 portfolio?
Several things:
First, the 60/40 portfolio was built and maintained on the premise of diversification among non-correlated asset classes. And it did so quite well. But when two asset classes in a portfolio become positively correlated, meaning move directionally the same, our diversification goes away. Stocks and bonds will soon begin trending together if we see a continuation of the inflationary pressures we see today. That means they will both rise and fall at the same time. The bears are arguing that the return potential for both US Treasury bonds and US stocks has approached zero for the next 7-10 years (GMO, Ned Davis and Co.) based on valuations. We’re not convinced of that. But, we do understand that bonds will not save one’s portfolio from a stock market decline looking ahead. In fact, they may ultimately be the cause of a stock market decline in the form of rising interest rates!
Second, in order to make and keep your returns from this point forward, investors are going to have to become trend followers and have systems in place to cut stock and bond market exposure rather dramatically. I would also include a trend following system to engage with commodities and other inflation hedges at this stage – more on this in a minute. Most investors don’t have a clue how or when to own commodities in an investment portfolio. Of course, this is what we do and have done for the last 25 years.
Finally, selection on the stock side of a portfolio will be infinitely more important than is has been in the last seven years. By selection, we mean the ability to find and stick with leadership while avoiding laggards and out of favor sectors, countries, etc. Stock pickers will move to the front of the performance line again as they are capable of concentrating assets in the leadership sectors and the leading stocks. “Selection” is our second process screen behind Net Exposure and we spend a lot of time on this focus. In the current environment, selection criteria would choose late cycle leadership and tangible value segments including financials, banks, energy, materials, metals, and technology. Healthcare, utilities, consumer staples and other defensive sectors should be avoided for now. Commodities (but not gold necessarily) may also be on the very cusp of a new long-term buy signal after forming a perfect base over the last couple years. Here are a few examples of what we’re seeing.
Watch Commodities! The environment is nearly perfect for a big run higher.
Today, the US stock market is still rising strongly from the low last February. We have been “Buying the dips” since that time including through Brexit and our own surprising elections. Returns have been healthy and we expect that to continue, as there are no real signs of technical deterioration yet. But this is not a time for complacency. Valuations are high, earnings are coming in fast and the Trump factor could be very disruptive.
Accelerating Older Trends
In an effort to save time and space, I’ll be brief by listing several established trends that are accelerating and beginning to change the look and feel of our economic standards. Here they are:
- The Death of Big Box Retail – Amazon is eating everyone’s lunch. Brick and mortar retail is giving ground every day to on-line sales. Those who have failed to adapt, will not make it. Macy’s and Kohls just announced massive layoffs and store closings. Walmart is struggling. Sears is probably gone. Trump will not save these jobs or stop the long and persistent death march of big box retail.
- Energy Revolution – Electrification of transportation, Utility-scale smart grids, mega move from coal to natural gas, renewable energy adoption are already well past the point of fads. Costs, economics, and 25-year power purchase agreements are driving an acceleration in this trend. No doubt, there will be tests ahead with the new administration but we must remember that some of the best years for the energy revolution occurred under GW Bush.
- Fountain of Youth – Another accelerating trend in consumer healthcare preferences. The baby boomers started it with body part replacements and other “enhancements” but the trend has obviously been accelerating into genomics, biotech, medical devices and other methods of allowing us to live longer, pain-free, active lives. The world will pay whatever it can for the fountain of youth. Healthcare insurers and providers may be challenged in the wake of changes coming to the ACA but the global need and demand for cost effective healthcare solutions is just getting started. The question will really be about who pays more than anything. Healthcare will also be one of the best sources of employment looking forward as human-to-human care is really hard to automate. Someone should tweet Donald.
- Technology Replacing Humans – You know this one and it’s also accelerating. I saw a video of a robot laying bricks a few weeks ago. The US is not going to become a global manufacturer until our wages are the same or lower than foreign wages- probably not in my lifetime. So labor is going to be challenged unless it can find a lucrative home in industries that cannot be automated or fulfilled better by a semiconductor.
- The Rise of Developing Markets – This trend is also accelerating as we continue to see China, Latin America and the Developing world gain share of global GDP. The US and Developed Europe are not the growth centers anymore for a number of reasons. These trends have been in place since the late 90’s and they will continue. If you are a US fortune 500 company, you cannot ignore the source of your revenues as more than 50% are now generated overseas. Yahoo is barely alive today and has almost no enterprise value beyond their lucky stake in Alibaba (China’s Amazon).
The times they are a changin’ – faster and faster. We’re working hard every day to keep our clients’ money in the right place, at the right time.
Until next time
Sam Jones
