Author: admin

One thing I can tell you is that it feels a hell of a lot better to sell when you want to, rather than when you feel you have to.

I have been bearish on the US Stock Market since the summer of 2017. This is when my understanding of macroeconomic fundamentals and markets accelerated. I believe that if I had gained enlightenment sooner, then I would have become bearish earlier. I consider myself to have been luckily ignorant. As they say, “Don’t confuse brains and a bull market.”

My immediate family has been luckily ignorant as well. My dad had been fairly aggressive and to our benefit this landed us with more or less of an overall allocation near 80% equities (largely US) and 20% bonds.

The story goes that I became bearish and wanted to essentially sell everything. Conventional family money managers were disciplined and helped us to not blow our selling load too fast. We took some chips off the table and that probably landed us around 65% stocks, 25% bonds, 5% gold, and 5% cash. We have continued to take chips off the table, but I know many have not. At this point in the cycle, one could very easily argue that 65% is still an extreme over allocation to stocks.

I want to convey why 65% stocks does not make sense. If I told you that you could get to the same end portfolio amount at retirement with less big swings, wouldn’t that make you happier? Basically, if you were on a plane would you rather it be turbulent or smooth?

In portfolio management, we have a measure for this tradeoff. It is called the Sharpe Ratio. The idea is to try to create a portfolio that will reach the highest return above the risk free rate for the least portfolio volatility. This is attractive because if you should need your capital sooner than you had priorly anticipated, then it is less likely that your portfolio will be at a disadvantageous level to draw from. Also, from an emotional standpoint, a higher Sharpe Ratio relieves stress of downturns and removes potentially ill-timed panic sales. So what has been an optimal Sharpe Ratio recently? Play around below if you like, but I will give you some examples.

https://www.portfoliovisualizer.com/efficient-frontier

The simple way to use the Sharpe Ratio is to find a portfolio that fits your return goals and risk tolerance and you let it ride from there. This is lazy.

Using the past 5 5-year periods and a 5-asset class universe consisting of US Stocks, US Bonds, Non-US Stocks, Gold, and REITs, the optimal way to achieve a beloved 10% a year has been…

From 2014-2019, the optimal way to achieve a 10% return was 57.80% US Stocks, 4.82% US Bonds, and 37.39% REITs.

From 2009-2014, the optimal way to achieve a 10% return was 39.16% US Stocks and 60.84% US Bonds.

From 2004-2009, the optimal way to achieve a 10% return was 59.97% US Bonds, 1.03% Non-US Stocks, 36.28% Gold, and 2.72% REITs.

From 1999-2004, the optimal way to achieve a 10% return was 61.66% US Bonds, 1.55% Gold, and 36.79% REITs.

From 1994-1999, the optimal way to achieve a 10% return was 24.30% US Stocks and 75.70% US Bonds.

The optimal portfolio allocation is constantly changing. One must understand that setting a portfolio allocation and riding it to end of the Earth is foolish. The probabilities that either US Stocks, US Bonds, Non-US Stocks, Gold, and REITs will be the most optimal portfolio allocation is changing every single day. That does not mean you should change your portfolio every single day, but you are doing yourself an enormous disservice to not question from time to time, “Is my portfolio ready for the next year?”

US Stocks were the most optimal asset allocation in the past 5 years. Interestingly enough, this was the first 5 year period that that was the case in the past 5 of such periods. If they win only 1 in every 5 5-year periods (based on the last 25 years), and starting points are important, do you feel good about being over allocated to US Stocks when they are currently the best?

And I know that for the most part the conventional wisdom money manager will tell you to ride that portfolio, but they have jobs to protect. Going against the herd is difficult for them. Therefore, a paid fiduciary is only working in your best interest to the extent that they will continue to make money from you. If others fiduciaries are about to lose, they will lose with them.

The main surprise from this analysis should be that US Stocks were only the primary asset allocation in 1/5 of the last 5 5-year look back periods. From purely a historical perspective, you should realize that the optimal way to earn 10% a year is usually with your primary allocation being to US bonds. I bet most of you reading this are seeing the statistics in front of you and are still unwilling to see the reality because you have been told for your whole life to invest in stocks. It is never too late to wake up.

I also know that most people have essentially a 0% allocation towards gold because they or their money managers can’t understand an asset that doesn’t pay a yield. Newsflash. Not only is gold pretty, but it is an integral part of much of our technology and thus has demand. That’s the easy part to understand. The important part is that it is the only true money that exists and from time to time it basically re-accounts the whole monetary system and at those times, it is a must own asset. Aside from it being a must own once asset every 40 years or so, make sure you didn’t miss that a small allocation towards gold is usually a necessary piece to creating an optimal portfolio.

In terms of “re-accounting” the system, imagine a world where there are $100 and one ounce of gold. Gold should be valued at $100. Remember, although we are not on an official gold standard, gold has a funny way of maintaining that role, which I will display below. If the government decides to print $100 more dollars, then there will be $200 in the system. The intrinsic value of gold should then be $200. The times to buy gold are when there are more dollars than gold ounces multiplied by the current price.

In Wealth Cycles by Mike Maloney, he shows a graphic that displays a pattern of government money creation, gold lagging in price, and then gold catching up to its intrinsic value. The green line is basically all the dollars that exist, and the gold line is all the ounces of gold that the US Treasury holds multiplied by the gold price. From 1944 to 1971, gold lagged in this relationship under the Bretton Woods system. This system pegged all currencies to the dollar and $35 to one ounce of gold. Well, as all governments eventually do, the US spent recklessly and eventually holders of dollars began to doubt that if everyone redeemed their dollars for gold at the same time that there would be enough gold. This is visible below. Gold was $35 from 1944 to 1971, so in order for the yellow line to go down the US Treasury must have been hemorrhaging gold from doubtful dollar holders.

In 1971, Nixon decided that dollars would no longer be redeemable for gold. This essentially allowed gold to float freely, and the result was that the gold price rose to re-account for all of the past spending.

This graphic from Santiago Capital is of similar nature. It shows the gold price necessary to re-account for various different countries and their gold holdings.

Over the past year, the fundamentals, geopolitical risks, and liquidity factors have all deteriorated, yet we are still near all time highs. This is the definition of irrational exuberance. If you still have a heavy allocation towards stocks, then this may be your last chance.

Sell high, buy low. Sell stocks, buy gold.

Let me leave you with this. A historically normal mean reversion of the Dow to Gold Ratio would be a move from 20 to 8. With the Dow near 25,000 and Gold near $1,300 and holding the opposite asset constant, either gold would need to rise above $3,000, or the Dow would need to fall under 11,000.

The current chart though is eerily similar to that of the 1966 peak, 1974 trough, and the 1976 retracement, before the eventual 1980 trough where the Dow was roughly the price of an ounce of gold. If that scenario unfolded and holding the opposite asset constant, then the Dow would need to go down about 95% or gold would need to go up about 18 times.

In conclusion, do you feel lucky?

It goes without saying that one of the main themes of this website is the gold market and its eventual breakout to new all time highs.

Before trying to decipher “Is this it?” We must define the drivers of the yellow metal that are in play at any given time.

These drivers are…

1. The investing public’s confidence in central banks
2. The general public’s confidence in governments
3. The volatility of equity markets causing some investors to hedge
4. The ability to find real yields
5. Inflation
6. Technical resistance and support levels

So what has occurred recently to suggest that this may be “it?”

The chart below has surfaced on twitter and it is perfect for the top 3 drivers. In 2015, volatility reared its ugly head in the stock market. Zone 1 on the gold chart displays the results. Then, President Trump was elected in November of 2016. One could say this created a confidence in government. The result was soaring equities and a sideways move in the gold market as can be seen in zone 2. Finally, in October the middle peak in the triple top of the equity market broke. This brought equity market volatility, and gold began to rise. The powerful thing about this zone is that it marks the beginning of the end of the central bank experiment. The public wanted, whether they actually did or not, to believe that FED balance sheet normalization was possible. This facade is finally coming to an end as the markets have woken up to the notion that the balance sheet will be expanding again, and we will be going back down to zero on the Federal Funds rate faster than we have previously believed.

It was just March when the market was pricing in virtually no chance of a rate hike by the September FOMC meeting. Now, the probability is nearly 70%.

Let’s recap.

1. Equity Markets are volatile
2. The market now knows the FED will not normalize the balance sheet
3. Do we have confidence in our government?

Well, we have a President playing tariff games with China and now Mexico. And to add insult to injury, Trump went rogue on this one apparently…

So, we don’t have confidence in our central bank, we don’t have confidence in our government, volatility is back, as rates get cut real yields will be harder to find, Bloomberg may have just marked the bottom on inflation from a contrarian perspective, and we have just broken out of the descending triangle. (I sort of sound like the anti-Kudlow…link below)

First things first. Let’s hope the breakout sticks, then on to test the 5 year resistance band around 1350-1370.

As any market follower knows, there has been an abundance of news over the past 3 months essentially telling market participants that a trade deal is imminent. It is tough to say why such obvious market jawboning was dismissed, but the time is here to wake up to reality. I also want to bring up that these past 3 months have made me wonder if news algorithmic trading programs have the ability to exhibit headline skepticism, but that’s another conversation.

Below, you will find the tweet that has caught market participants off guard. It is now apparent that the trade war is in fact not coming to an end any coming Friday, but in fact getting taken to the next level.

So why did this happen and what are the ramifications?

One can speculate that Trump was not getting all he asked for in the deal room with Xi. I think what is important to remember is that Trump is up for reelection in 2020 and Xi is a lifetime leader. If Xi is unsatisfied, then he can simply wait for the next President.

Forecasts for the 2020 election become key in understanding the dynamics of the situation. We know that Trump is largely running on the use of an economic scorecard. If the scorecard looks good by 2020, then Trump is likely going to win and vice versa. The economic scorecard basically consists of the stock market, GDP, and unemployment.

Please view an overly simplistic decision tree below.

Trade Deal-Market Rally-Trump Wins 2020 Election

Trade War Intensifies-Market Sells Off-Trump Loses 2020 Election

The point is that Xi has the luxury of time and will use that to his advantage to basically choose who opposes him in the deal room.

Moving on. Why did this really happen?

Is Trump performing some sort of “Art of the Deal?” Maybe in his mind.

But perhaps, he is aware that GDP is due to come in weaker in quarters to come with the huge inventory builds. He does not appear able to get Powell to cut rates in order to pull demand forward, so maybe he has decided to attempt to influence the GDP number. One thing that I think is fairly straight forward is that if we are in an official recession by 2020, then Trump has no chance of winning the election. So, let’s assume that Trump knows that future GDP may be under threat, and he understands that he does not have monetary policy in his arsenal at the moment, then what does he do?

He tariffs (taxes) domestic producers’ imports in order to influence them to build inventories again. Theoretically, this could short-term boost GDP as it did with the last round of tariffs. From the chart below, it is apparent that the level of contribution of inventory to GDP mean reverts around 0%. This should make sense intuitively as businesses build inventories one period, they are less likely to need to build inventories in the next period as well.

I will wrap this up with some things to watch out for.

Will the yuan depreciate against the dollar again to offset the tariff?

Will tariffs of this magnitude spur inflation as producers have to pass tariff costs to consumers?

Will producers who are already sitting on large inventory hordes build again?

At what level on the major indexes will Powell announce that QT will end before the expected September 30 date?