The S&P 500 remains near its all-time high and is closing in on the longest bull market on record. However, for the most part, even with unemployment at 50-year lows and consumer confidence resilient, investors are concerned and uncertain as to what lies ahead. Markets seem vulnerable to a wide variety of potential risks, including a possible escalation in trade tensions between the U.S. and China, which could serve to put the brakes on global economic growth. Investors also seem to hang on every utterance from the Fed and other of the world's major central banks in the hope that central bank liquidity will once again propel asset prices even higher.
Rather than being focused on the noise of the day-to-day, let's look at the research output from our proprietary model of the global capital markets, which is the result of over four decades of study, as a barometer for the current state and potential future direction of the markets. Our model research is indicating the potential for the following key investment themes:
- U.S. Equities appear significantly overvalued
- Emerging Market Equities appear relatively undervalued
- Gold may be the best hedge against the monetization of debt
Global Economic Trends
We believe there is a risk that the synchronized global growth of 2017 is now facing headwinds and could develop into a synchronized global economic slowdown. The U.S. economy, which has continued to grow faster than the rest of the world eventually could be pulled down by the weight of a slowdown in global growth. During periods of global expansion, geopolitics tend more towards globalization and cooperation among countries and regions. However, once the global economy slows, history has shown that there tends to be a rise in global conflicts with countries fighting over a fixed or even shrinking economic pie, as well as more heightened nationalism, populism, and protectionism. Another potential risk of a global slowdown is that it could hinder the capacity to service the unprecedented amount of debt currently being carried by governments, companies, and individuals alike.
- U.S. Equities appear significantly overvalued
We believe that traditional P/E ratio analysis may not be sufficient in providing adequate insight into equity valuations. Therefore, we have developed our own methodology for understanding equity market overvaluation by comparing 3EDGE's model of current P/E ratios adjusted for normalized profit margins to fair value P/E calculations that incorporate both existing and long-run cost of capital in addition to implied growth rates. Our model research indicates that U.S. equities are currently more overvalued than other major markets and nearly as overvalued as they were just before the bursting of the tech stock bubble in 2000 and just before the crash of 1929. Of course, it is also true that markets can ignore fundamental factors and become even more overvalued for a period of time before correcting to fair value.
The Road to U.S. Equity Overvaluation
Since the financial crisis of 2008, markets have been on the receiving end of an unprecedented degree of Fed stimulus, which has lowered the cost of capital for U.S. companies. This access to exceedingly cheap capital has led to a record amount of corporate stock buybacks, which in turn has allowed companies to reduce the number of shares outstanding and report record earnings per share (EPS) growth. U.S. corporations have also benefitted from corporate tax cuts and de-regulation.
Critical Threats to U.S. Equity Market Overvaluation
End of the Virtuous Credit Cycle
Since the financial crisis which began over ten years ago, there has been a powerful virtuous cycle of credit, wherein extremely easy monetary policy and central bank liquidity led to a lifting of asset prices, creating an increased pool of collateral able to support higher levels of borrowing. As low interest rates provided a cheap source of capital which encouraged more borrowing, this additional debt was often used by corporations to buy back their company stock, thereby raising their company's EPS. In addition, extraordinarily low interest rates also sent investors searching for yield, which helped to narrow credit spreads further driving up asset prices. However, as growth slows this virtuous credit cycle can unwind, and that can begin at a time when the economy still looks strong, benefiting from the previous stimulus. Credit cycles can sustain themselves if there is sufficient economic growth, but when the economy slows borrowers are no longer able to rely on growth to service their debt, and lenders demand that the borrowers begin to deleverage. At that point, the credit deleveraging cycle may accelerate into a vicious downward spiral.
Reversion to the Mean of U.S. Profit Margins
Recently corporate profit margins have reached record highs; however, historically profit margins are mean reverting (when profit margins are either exceptionally high or exceptionally low, they eventually revert to their mean). For example, the long-run average profit margin for the S&P 500 is approximately 8%, and presently U.S. corporate profit margins are close to all-time highs at nearly 12%. However, U.S. corporations cannot remain immune to a slowdown in global growth forever. Many factors can depress corporate profit margins, including falling sales; increased competition; increased regulation; higher taxes; an increase in the cost of capital; and higher input prices due to tariffs or supply chain disruptions.
End of Investor Complacency
Throughout this equity bull market, which has now gone ten years without a 20% plus market correction, investors have embraced "buying the dips" and "buy and hold" strategies and have been rewarded for these approaches. Investors also seem to believe in the Fed Chair's "Powell Put" and have come to expect the Fed to take action should global markets look like they may be in for a material decline. These factors have contributed to a sense of investor complacency, and in such an environment once investor behavior gives way, the fear of an impending bear market can serve to magnify the downturn.
- Emerging Equities appear relatively undervalued
Since the bull market in equities began in 2009, U.S. equities have dramatically outperformed every other asset class, including Emerging Market (EM) equities. Presently, our research indicates that Emerging Market equities are somewhat undervalued in absolute terms and highly undervalued relative to U.S equities. One reason that EM equities have struggled for an extended period is because of the ongoing strength of the U.S. dollar, which punishes emerging market companies and governments because they tend to borrow in U.S. dollars. A strong dollar means that debt service becomes more burdensome. As the Fed begins to take more dovish actions the U.S. dollar could weaken, which could provide relief to emerging market economies. Also, should China continue to attempt to stimulate its economy to offset the effects of the U.S. tariffs, emerging market economies could benefit.
- Gold may be the best hedge against the monetization of debt
Going forward, there is a concern that there may not be sufficient global economic growth to service the amount of debt outstanding. Therefore, an alternative solution becomes the monetization of debt, which implies the need for the government to create additional fiat currency. Monetization of debt by printing more fiat currency also means the potential for lower or even negative real interest rates and a weaker U.S. dollar. Gold bullion is a form of money that central banks cannot print, but which can always be exchanged for paper currency. Monetization of the debt means it would take more paper money (fiat currency) to buy an ounce of gold bullion or in other words, the price of gold would increase. That is why it could well be a time for the price of gold to begin to reflect the inevitable monetization of growing levels of debt.
Late Market Cycle Behavior
Investors do seem to be able to agree on one thing, and that is we are in the late stages of both the current equity market and economic cycle. Historically, there are specific characteristics frequently associated with capital market behavior in late market cycles and these include:
- - markets may tend to be more prone to market melt-ups and melt-downs
- - market corrections are often interrupted by relief rallies caused by government or central bank intervention
- - as interventions lose their impact over time, the bear market begins to take hold
- - bear market rallies may occur throughout a bear market period
- o For example, during the bear market in equities from October 1929 to June 1932, the S&P 500 declined by more than 80%. However, during this period, there were six significant bear market rallies.
- o The most recent rally in the S&P 500 index (from December of 2018 through June of 2019) may well fit the profile of a bear market rally.
In summary, based upon our model research and decades of experience in managing portfolios, we believe that now is a time to assume a bit more defensive posture towards portfolio allocations as the risk of a material correction in the equity markets continues to increase. This is not to say that we will be entirely out of the equity markets now or in the future. For purposes of diversification and risk management, our 3EDGE strategies will always hold a minimum amount of equities at all times. Also, even if we are currently entering into what could turn out to be an equity bear market, we know from history that there can be interim periods of significant bear market rallies which we may seek to advantage of along the way.
DISCLOSURES: This Commentary is provided to current and prospective clients of 3EDGE Asset Management (“3EDGE”) for informational purposes only. The opinions expressed in this Commentary are those of 3EDGE and are subject to change without notice in reaction to shifting market conditions. 3EDGE's opinions are not intended to provide personal investment advice and do not consider the investment objectives and financial resources of the reader. Information provided in this Commentary includes information from sources 3EDGE believes to be reliable, but the accuracy of such information cannot be guaranteed. Investments including common stocks, fixed income, commodities, and ETFs involve the risk of loss that investors should be prepared to bear. Past performance may not be indicative of future results.
© 3EDGE Asset Management
© 3EDGE Asset Management
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