Past is Not Prologue - Are Valuations Irrelevant?

As markets rise, bullish market pundits are very prone to offer explanations for why fundamental valuation metrics shouldn't matter. But valuations have proven time and time again to be one of the strongest predictors of future returns.  We've covered this topic several times in past and have highlighted relevant work from Hussman Funds, GMO. as well as Research Affiliates.   At a recent investment symposium in London hosted by Research Affiliates, Rob Arnott dissected for a large group of institutional investors what today's valuations are telling us about future expected returns. 
Rob is the founder and chairman of the board of Research Affiliates, a global asset manager dedicated to impacting the global investment community through its insights and products. Please click here to view Rob's full video presentation and/or a copy of his Powerpoint presentation where full size versions of the images contained in this article can be accessed.  The content is free but you will need to become a register user with Research Affiliates to gain access. 
The following summarizes the key takeaways from Rob's presentation in bullet point form with accompanying charts:  
  • The link between starting valuations and subsequent returns is very powerful.  The chart below highlights the high correlation of starting cyclically adjusted price earnings and subsequent 10 year returns.  The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the U.S. S&P 500 stock market index. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. 
As the chart highlights, a high CAPE correlates with lower subsequent investment returns and a low CAPE is indicative of higher future returns.  The average correlation between CAPE and subsequent 10 year returns has been 75% across all of the major developed markets, including the U.S.  As John Hussman has repeatedly emphasized in his market commentary,  valuation levels are not useful, in and of themselves, for timing market tops and bottoms.  The experience of the later part of this bull market cycle is certainly a testament to this fact as valuations have continued to rise beyond previous valuation extremes despite obvious economic, trade, and political stresses.  Hussman believes that technical measures of investor risk appetite (market divergences, credit spreads, etc.) provide far better clues as to market timing than pure valuation metrics.  The current period of extraordinary Fed monetary policy of quantitative easing and test of the zero rate interest rate bound have fueled investor risk taking and severely limited market timing signals/warnings derived from traditional valuation limits.
CAPE Regression

  • Even after making multiple adjustments, U.S. equities face potentially severe headwinds from valuation contraction as valuations revert to their historical mean over time.  As depicted in the chart below, late October's headline CAPE for the U.S. of 29.4 was in the 95th percentile historically.  This compares to 1) the simple historical average of CAPE of 18.2 from 1926 through June 30, 2019, 2) the simple historical average CAPE of 21.2 since 1977 (modern market era), 3) Research Affiliates' adjusted CAPE for changes in business cycle and macro volatility of 21.6, 4) CAPE of 27.7 excluding the highest and lowest earnings years in the past 10 years, and 5) 28.7 if the lowest earnings year of the past 10 years is excluded.
    Research Affiliates estimates the current CAPE valuation differential implies an approximate 3% annual degradation in nominal S&P 500 total returns over the next 10 years as the market CAPE ratio reverts to more normal levels.


  • The largest stocks by capitalization are often the most expensive and have historically under-performed after reaching a top 10 valuation milestone.  Today's top ten are dominated by the six names of FANMAG (Facebook, Apple, Netflix, Microsoft, Amazon, & Google; third blue bar in chart below).  FANMAG's combined market valuation of $4.0 trillion is larger than only 2 out of 61 countries in the Morningstar Global Markets Index.  U.S. market excluding FANMAG valuation of $25.7 trillion and Japan $5.5 trillion are the two markets that exceed the valuation of FANMAG. Wow!




  • This next chart below walks through the valuation components of Research Affiliates 10 year expected nominal return of 2.6% for the S&P 500 - dividend yield of 1.9%, plus 1.2% of real growth and 2.1% from inflation, less (2.7%) valuation change as prices revert to CAPE historical norms.


US Large Cap

  • Across asset classes higher return potential exists in international and diversifying markets based upon Research Affiliates CAPE based valuation analysis.  The chart below depicts Research Affiliates expected 10 year nominal returns of various international markets compared to its 2.6% annual return expectations for the S&P 500.   Research Affiliates expects international developed markets (EAFE) to return 7.4% annually and emerging markets as a whole to return 9.4% with certain high risk markets like Turkey and Russia in the upper right expected to return more than 12%.  Arnott highlighted the United Kingdom as particularly attractive developed International market from a valuation standpoint with a 10 year expected return of close to 9%.  The market implied Brexit risk premium has made the U.K. market much more attractive than domestic U.S. equities.  
    Arnott suggested that investors balance their return maximization goals with risk relative to more conventional benchmarks (U.S home bias) as they explore the attractive valuations of developed and emerging international markets as a whole and individual country market allocations as risk appetites allow.


RA Expected Returns

  • As the extreme FANMAG valuation might suggest, Arnott sees pockets of value within U.S. and global equities based on various value factors that they monitor (value factors flag cheap stocks rather than momentum factors that chase growth) that they believe offer higher potential forward looking returns.  Based upon Research Affiliates' analysis, the three factors highlighted in green below offer interesting relative value with expected annual returns in excess of 5% - value composite developed markets, value composite U.S., and value composite emerging markets. 
  • Growth factor have been outperforming value factors for a number of consecutive years much like they did prior to the 2000 Dot-com bust and 2008/09 Global Financial Crisis.  Research Affiliates analysis of market history suggest that markets will revert to the mean with value factors outperforming growth factors at some point in the future.  True to form, the domestic markets witnessed a large rotation in fund flows to value factors in September with value outperforming growth by 3.5% for the month.  The market rotation into value and out of momentum and growth has continued through October and into November.


Value Factor


Volatility and Tail Risk Scenarios

Global VIX Bottom


Servant Financial's risk aware portfolio positioning has successfully dampened volatility in periods of market corrections when they occur, such as S&P 500 index's losses this past February and March which marked the first run of back-to-back monthly market declines in over two years.  Volatility re-emerged beginning in February, 2018 from a prolonged period of calm and investor complacency.  From its nadir of 9.14 on November 3, 2017, the Chicago Board Option Exchange (CBOE) VIX index (the so called equity fear index) spiked dramatically on February 5, 2018 by 20.01 points (or 115.6%) to close at 37.32.  One has to go all the way back to August, 2015 for a date when the VIX exceeded 40 when fears of a China hard landing and plunging oil prices spooked investors.   We believe that the pronounced market action early this year portents the resumption of more normal market volatility going forward and the potential for tail risk scenarios. 

The chart above from Seeking Alpha article entitled "The Return of Volatility" dated February 5, 2018 depicts the downward path in the global average VIX in red against the rise of global equity index MSCI ACWI (All Country World Index).   We believe that global equity implied volatility will continue to rise given extreme valuations and suppressed equity risk premiums, particularly in the United States, a maturing  global economic cycle, and central bank policy tightening led by the Federal Reserve.

Fundamentally, we believe that valuations and volatility levels are mean reverting in an inverse manner and often on a contemporaneous basis.  Excess equity valuations will decline and suppressed volatility and equity risk premiums will rise toward their historical and normative levels over time.  This mean reversion process can occur gradually or suddenly.  

We've shown the chart below (registration required) of GMO's 7 year expected real returns (excludes inflation impact on nominal returns) of asset classes a number of times over the years.  It is downright perplexing and scary to see with hindsight how GMO's 7 year expected real returns have progressively deteriorated from low or no expected returns in 5 or 6 years ago to the point where now GMO is forecasting negative expected real returns across all major asset classes except for emerging market equities +1.9%, emerging market debt +1.6%, and cash +0.8%.  Who could have imagined an investment opportunity set this awful would emerge as valuations continued to rise from already excessive valuation levels?  Reality is once again stranger than fiction and behavioral finance experts have another exceptional period of investor euphoria to challenge the rational market assumption underlying the efficient market theory.


GMO 7 Year 4-30-18

GMO projects real annual losses on U.S. large caps of (4.2%), U.S. small caps of (2.4%) and even U.S. high quality stocks of (2.1%) over the next seven years.  

In GMO's first quarter 2018 letter (registration required) to investors entitled "Is Investing Starting To Get Difficult Again?: I Hope So", Ben Inker, Co-Head of GMO's Asset Allocation team, discussed the resumption of normal levels of volatility and its impact on the investment process.

For the last eight years, investing has seemed to be a pretty easy activity to most observers.  Not only have markets given strong returns, but the apparent riskiness of both individual assets and overall portfolios has been low.  It has not simply been the lack of giant, horrifying market dislocations that gives the impression of low risk, but the combination of very low general market volatility and an extremely friendly correlation structure such that stocks and bonds have been wonderfully diversifying.  For most investors, this has been a happy combination.  For those investors targeting a given level of volatility, whether through risk parity or otherwise, it has been a license to lever up their exposures significantly, to generally good results.  Last quarter, investing started to seem a little harder.  Not only were returns to most assets mildly negative, but volatility rose and correlations shifted.  That’s a good thing, probably a necessary thing if investors are to achieve their long-term goals.  On the other hand, we’ve only started the transition from easy to hard, and that path is, almost by definition, not a pleasant one.  Investing is often a case of “be careful what you wish for.”  “Easy” is fun in the shorter term, and the shorter term can go on for a surprising amount of time, but it winds up being self-defeating.  “Hard” is, well, hard, and it’s hard to like things that are hard.  Personally, I’m hoping for a return to hard.  Not only should it lead to better long-term returns to investors, but it is also a good deal more interesting.  Maybe last quarter was a blip and we are going to go back to “easy” for a while longer.  If determining when easy turns to hard were easy, well, hard wouldn’t be as hard.  But portfolios built for “easy” are poorly designed for “hard.”  If conditions prevailing in the first part of this year persist, asset valuations will very likely have to fall, and the process could become disorderly if levered positions have to be unwound reasonably quickly. (emphasis added)

In the first three months of 2018, volatility rose and correlations between stocks and bonds shifted.  In other words, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years than the very low volatility and strongly negative stock/bond correlations of more recent memory.  The change, albeit only over a short period, should have investors evaluating whether the “easy” environment that we’ve seen through this bull market will continue.  If it does, the returns we “deserve” to earn as investors should be low.  If not, we can hope for a bumpier but more profitable future in the long run.  Which path will the future take?  My money is on the latter.  As Hyman Minsky put it, “Stability breeds instability.

Likewise in his latest investor letter entitled "Comfort is Not Your Friend," John Hussman examines Minsky's stability mantra from the standpoint of investors' perceptions of comfort and safety in peaking economic and investment trends:

The key point is that strong investment opportunities are almost always born out of discomfort.  Likewise, market collapses are almost always born out of confidence and euphoria.  Markets peak when investors feel confidence about the economy, are impressed by recent market gains, and are comforted by the perception of safety and resilience that follows an extended market advance.  So several features generally go together: 1) extreme optimism about the economy and corporate earnings, 2) depressed risk-premiums, and 3) steep market valuations.  Poor subsequent market returns ultimately follow, though not always immediately.  In contrast, markets trough when investors are frightened about the economy, are terrified by recent market losses, and are paralyzed by the perception of risk and fragility that follows an extended market decline.  So several features generally go together: 1) extreme pessimism about the economy and corporate earnings, 2) steep risk-premiums, and 3) depressed market valuations.  Strong subsequent market returns ultimately follow, though not always immediately.

The chart below illustrates this regularity.  The areas shaded in red are rather comfortable periods, featuring an unemployment rate below 5% and within 1% of a 3-year low, an S&P 500 price/revenue ratio above 1.15, typically reflecting a period of strong recent market gains, and an ISM purchasing managers index above 50, reflecting expectations for an expanding economy.  Notably these periods of comfort were followed by S&P 500 total returns averaging zero over the following 3-year period, with deep interim losses more often than not.  In contrast, the areas shaded in green are rather uncomfortable periods, featuring an unemployment rate above 5% and within 1% of a 3-year high, an S&P 500 price/revenue ratio below 1.15, typically reflecting a recent period of dull returns or market losses, and an ISM purchasing managers index below 50, reflecting expectations of a contracting economy.  Notably, these periods of discomfort were followed by S&P 500 total returns averaging 15.3% annually over the following 3-year period.


Hussman economic

Hussman closes this discussion with this uncomfortable warning:  

The upshot is straightforward: the best investment opportunities emerge from reasonably valued markets and uncomfortable economic conditions, while the worst risks emerge from richly valued markets and comfortable economic conditions. 

Investors make a very expensive habit of buying stocks at elevated valuations because things feel very comfortable, which is exactly what they are doing now.  Later, they sell stocks at depressed valuations because things feel very uncomfortable.  Over the complete market cycle, that constant desire for comfort is extremely costly. 

Strong investment opportunities are almost always born out of discomfort.  Likewise, market collapses are almost always born out of confidence and euphoria.

What made the recent cycle unusual in that respect is that the Federal Reserve’s deranged policy of zero interest rates encouraged investors to speculate even after euphoria and extreme “overvalued, overbought, overbullish” syndromes repeatedly emerged.  That speculation finally amplified valuation extremes beyond what we observed at the 1929 and 2000 market peaks.  It was certainly an aspect of this half-cycle that we had to adapt to (by requiring explicit deterioration in market internals before adopting a negative market outlook, regardless of the severity of “overvalued, overbought, overbullish” conditions, and with no exceptions).

But the relationship between euphoria and subsequent loss hasn’t been repealed.  Rather, the duration of this episode of euphoria has been stretched to an extent that will make the depth of subsequent losses far worse than in most prior market cycles.  Based on the valuation measures we find best correlated with actual subsequent market returns across history, I continue to expect the S&P 500 to lose nearly two-thirds of its value over the completion of the current market cycle, with slightly negative total returns on a 10-12 year horizon. (emphasis added)

Servant model portfolios have been positioned for the resumption of volatility, an increase in risk premiums and cross asset class correlations, lower valuations and the instability that comes with "hard" and "uncomfortable" times and concomitant tail risk. 

Precious Metals Review

Sprott G&S

Servant Financial has long held a certain portion of its model portfolios in a precious metal fund – Central Fund of Canada (NYSE symbol: CEF).  We have found that not only can a portfolio allocation to gold and silver provide a source of diversified returns, but precious metals may also serve as a good hedge against market volatility in their historical role as safe haven assets. 

In January of this year, CEF was acquired by another fund manager and was renamed Sprott Physical Gold and Silver Trust.  Accordingly, we think that it is a good time to review the new management of CEF, as well as revisit the benefits of an allocation to precious metals within a diversified portfolio. 

Sprott is a global asset manager, with over 30 years of experience, managing over $10 billion in precious metals and real assets.  Based in Toronto, Sprott has several precious metals trust funds, holding physical bullion in storage allocated to each individual investor.  The Sprott Physical Gold and Silver Trust (CEF) is a closed-end trust that invests in unencumbered and fully-allocated physical gold and silver bullion in London Good Delivery bar form.  Each unit of CEF equals 0.0066 ounces of gold and 0.2984 ounces of silver that is held and stored in trust by the fund.  Therefore, each CEF unit should directly track changes in the prices of the precious metals it holds.  The value of each CEF unit is represented by approximately 63% gold and 36% silver holdings.  CEF shares are also redeemable (over certain value thresholds) for delivery of actual bullion.  Aside from CEF,  Sprott also manages PHYS – Sprott Physical Gold Trust (100% gold), PSLV – Sprott Physical Silver Trust (100% silver), and SPPP – Sprott Physical Platinum and Palladium Trust.   

What are the benefits of investment in precious metals like gold? 

Servant's investment philosophy focuses on broadly diversified portfolios which invest in a number of asset classes, geographies and sectors.  Diversification spreads out the risk inherent in any single investment – when one asset or sector suffers a decline, another may outperform.  In this way investors can mitigate asset specific risks and lower the volatility of the overall portfolio and lowering the chances of wild swings in performance compared to an investment in a single asset portfolio.   An allocation in precious metals is one of ways to diversify a portfolio as well as provide a hedge against unexpected downturns in other highly correlated asset classes.  The price appreciation in gold historically has had a negative correlation to the returns of equities – meaning that when stocks go down, the price of gold tends to go up. However, over time, gold can also outperform equities even when the returns for stocks are also positive.


Gold vs S&P 500


The chart above (provided by Sprott) compares the historical change in the spot price of gold with the cumulative returns of the S&P 500 index including dividends since 2000.  While the total return for the S&P index has more than tripled at a compound annual growth rate (CAGR) of 6.32%, the spot price of gold has increased almost five-fold during the same time period, yielding a CAGR of 9.65%. 

Looking forward, there are currently many good reasons to hold precious metals.  These mainly revolve around the possibility of the U.S. dollar (USD) weakening, which usually corresponds with increases in the value of gold, as well as the use of precious metals as a safe-haven investment in times of geopolitical risk or other times of great uncertainty. 

The chart below shows how gold and U.S. dollar tend to have an inverse relationship to each other.  It compares the daily LBMA fix gold price (orange line and left price scale) with the daily closing price for the broad trade-weighted U.S. dollar index (blue line and right price scale) over the last 10 years.  You can see that gold tends to perform best when the U.S. dollar weakens. 


Gold vs Dollar


Currently there are many looming risks to the value of the dollar.  After many years of low inflation below the Federal Reserves target rate of 2%, we are finally seeing inflation rise.  In 2017, the average inflation rate in the U.S. was 2.1%.  The current inflation rate for the twelve months ended March 31, 2018 was 2.4%.  Hence, we have seen the Federal Reserve become much more aggressive in raising interest rates with 2-3 more rate hikes expected this year in an effort to keep inflation rates from overshooting further the Fed's target 2% rate. 

If a central bank is able to effectively keep inflation in check by raising interest rates, it is generally good for a country’s currency.  However, if inflation continues to increase (despite the Fed waving its magic wand), or factors such a weakening trade balance or out-of-control debt levels come into play, the dollar will likely depreciate relative to other currencies and precious metals.  Current rhetorical threats of tariffs and the dissolution of current trade agreements such as NAFTA have raised the specter of possible trade wars which could lower demand for our exports around the world.  The possibility of destabilizing global trade has heightened uncertainty in global markets, and this has manifested as increased currency volatility in 2018.  

The strength of the dollar may also be adversely affected by our ever-growing national debt levels.   As of March, 2018, the U.S. national debt reached over $21 trillion.   According to a report released last month by the non-partisan Committee for a Responsible Federal Budget, the Tax Cuts and Job Act of 2017 will increase our debt to $29.4 trillion by 2028.  Many fear that the debt levels of the U.S. are unsustainable as they have become untethered from our underlying domestic output or gross domestic product (GDP).  U.S. debt is growing much faster than our national wealth and productivity.  Similarly, since the 2016 election, the S&P 500 has increased 7 times faster than GDP, and 45 times faster than corporate profits.   While the rise in equity markets shows a great deal of optimism for future growth, this euphoria may easily be tempered by bad news, such as lower-than-expected growth in GDP and/or corporate earnings.   

There are many scenarios in which owning precious metals can be a good alternative investment to provide some stability to a well-diversified portfolio: whether the U.S. dollar weakens as a result of inflation, trade wars, or unmanageable debt levels; or if equity markets are shaken by disappointing economic results,  earnings reports or unforeseen global threats.  Servant currently allocates between 4% - 6% of its model portfolios in CEF.

This blog article was contributed by Helen Dospod, Servant's analyst responsible for individual ETF and fund research and portfolio risk analysis.  


CEF details

Inflation Watch



There has been quite a bit of discussion lately on rising inflation and interest rates so we thought we would focus this month's feature article on the inflation watch.

The Federal Open Market Committee's (FOMC or the Federal Reserve) met most recently on January 30 - 31, 2018.  The Fed press release issued afterward signaled growing confidence in the U.S. economy and reaffirmed their plans to continue to gradually raise interest rates with an 0.25% increase as soon as their next meeting in March.  According to the meeting minutes, several Fed officials believed the economy was positioned to grow faster than their growth projections that were raised at the Fed's December meeting.  The stronger potential economic growth confirmed the Fed's plans to raise interest rates three times in 2018 and introduced the potential for a fourth gradual rate hike into the policy discussions if incoming economic data remains robust.  

The Fed official statement reads: "The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up this year and to stabilize around the Committee’s 2 percent objective over the medium term.  Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely. (emphasis added)"

The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy affirmed at their last meeting on January 30, 2018 further delineated the Fed's inflation and interest policy goals as follows:

"The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation.  The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.  The Committee would be concerned if inflation were running persistently above or below this objective.  Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maxi- mum employment in the face of significant economic disturbances.(emphasis added)"

Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes.  A price index measures changes in the price of a group of goods and services.  The Fed considers several price indexes because different indexes track different products and services, and because indexes are calculated differently. As highlighted above in the Fed's longer run policy statement, the Fed's preferred inflation measure is the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce. The PCE index covers a wide range of household spending. The Fed also closely tracks other inflation measures, including the consumer price indexes (CPI) and producer price indexes (PPI) issued by the Department of Labor.

Let's take a look at the most recent reports for each of these inflation measures.  


PCE Trimmed Mean 12-17


The Trimmed Mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE).  It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA).  (A trimmed mean is a method of averaging that removes a small designated percentage of the largest and smallest values before calculating the mean.  After removing the specified observations, the trimmed mean is found using a standard arithmetic averaging formula.)  

The Trimmed Mean PCE inflation rate for December was an annualized 1.8 percent.  According to the BEA, the overall PCE inflation rate for December was 1.3 percent, annualized, while the inflation rate for PCE excluding food and energy was 2.1 percent.  The annualized six month Trimmed Mean PCE inflation rate for December was also 1.8 percent. The overall PCE inflation rate for the last six months was 2.4 percent, annualized, while the inflation rate for PCE excluding food and energy was 1.7 percent.  The Fed historically likes to exclude volatile food and energy costs when looking at inflation trends as if you don't need to eat or commute.




The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January, 2018 on a seasonally adjusted basis as reported by the U.S. Bureau of Labor Statistics.  As depicted in the chart above, the all items index rose 2.1 percent over the last twelve months before seasonal adjustment, the same increase as for the twelve months ended December, 2017.  The index for all items less food and energy rose 1.8 percent over the last twelve months, while the energy index increased 5.5 percent and the food index advanced 1.7 percent.


Chart copy


According to the U.S. Bureau of Labor Statistics (chart above), the Producer Price Index for final demand increased 0.4 percent in January, 2018, seasonally adjusted.  On an unadjusted basis, the final demand index rose 2.7 percent for the twelve months ended in January.  

The index for final demand less foods, energy, and trade services rose 0.4 percent in January, the largest advance since increasing 0.5 percent in April 2017.  For the twelve months ended in January, prices for final demand less foods, energy, and trade services moved up 2.5 percent, the largest rise since 12-month percent change data were available in August 2014.  The PPI series may be an early indication of inflation building up in the system if producers are forced to pass on price increases to end consumers.

In addition to backward looking measures of inflation like PCE, CPI and PPI, the Fed also looks at inflation expectations under the premise laid out by Former Fed Chairman Ben Bernanke in a 2007 speech entitled "Inflation Expectations and Inflation Forecasting" that "the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability."

As depicted in the chart below from the St Louis Fed, market expectations have risen in concert with economic growth trends and traditional inflation measures.  The chart presents the expected 10 year inflation rate as measured by the difference between like duration Treasury Inflation Protection Securities and regular way U.S. Treasuries.  The breakeven rate increased to 2.1% in January, 2018 after falling to 1.2% in February, 2016.




According to the University of Michigan's latest sentiment survey in December, 2017, consumers expect a 2.7% rise in inflation over the next year.  The chart below from the St Louis Fed provides a historical perspective on consumer inflation expectations since the rampant inflation of the 1980s.  Moreover, year-ahead inflation expectations have also risen among businesses surveyed by the Federal Reserve of Atlanta to 2% in February, 2018 after remaining below that Fed targeted level previously.  Both consumers and businesses are beginning to anchor their inflation expectations at higher plateaus. 


Fredgraph copy


The foregoing data points suggest that inflation is trending closer and closer to the Fed statutory mandate of 2% with some potential to accelerate through that target given synchronized global growth, dollar weakness, and rising Federal budget deficits and funding requirements of the Trump administration's tax reform, infrastructure, defense and other government spending initiatives.  

On February 27, 2018, the new Fed Chairman Jerome Powell gave his first official statements as Fed Chairman before Congress.  He testified that the strong economic outlook will prompt the Fed to review its rate-hike path.  As reported by Bloomberg, Powell stated, “My personal outlook for the economy has strengthened since December.” “We’ve seen continuing strength in the labor market,” Powell told the House Financial Services Committee.  “We’ve seen some data that will in my case add some confidence to my view that inflation is moving up to target. We’ve also seen continued strength around the globe, and we’ve seen fiscal policy become more stimulative.”

Post-testimony markets equity and bond prices fell as markets repriced the odds of a fourth Fed rate hike in 2018 to 50%. These developments may provide additional feedback to consumers and businesses that it is anchors away for former inflation expectations and create a feedback loop for higher inflation trends.

Economic & Investing Tipping Point




In bestselling author Macolm Gladwell's debut book, "The Tipping Point: How Little Things Can Make a Big Difference", he defines a tipping point as "the moment of critical mass, the threshold, the boiling point."  The tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire.  Just as a single sick person can start a flu epidemic, this human phenomenon can give rise to a rapid adoption of new technologies or trends like cryptocurrencies such as Bitcoin.

Mohamed El-Erian, chief economic adviser at insurance and financial services firm Allianz, parent company of PIMCO asset management, believes the world will converge on an economic and investing tipping point in the next two years.  He expects a fundamental shift in the global economy that will either result in a powerful economic boom or in renewed economic tremors which will shake financial markets.  While at PIMCO, a team led by El Erian and "Bond King" Bill Gross developed the concept of "New Normal" in early 2009 to describe their concept of a novel economic reality of slow growth and super low interest rates that they expected to emerge in the aftermath of the global financial crisis in 2008/09.  The New Normal economic concept is broadly accepted today.  With El Erian now forecasting an end to the New Normal and a foreboding economic crossroad ahead, the remainder of this feature article will summarize his views and consider its implications on portfolio construction and the current global investment opportunity set.

The following are the most relevant excerpts on this crossroad theme from an interview with El Erian covered in a blog post at Value Walk.

"Rather than seeing the New Normal continuing I think the world is nearing a tipping point.  We are heading toward a T-junction which has three fundamental implications: One is, that the road we’re on is going to end.  The second message is that what comes afterwards is very different from what we’ve had.  And the third message is that it can be one of two things.  So it’s a bimodal distribution with two modes: really good or really bad.  We either tip into high and inclusive growth or we tip into recession with renewed financial instability."

"I think within the next two years we are going to tip one way or the other.  The probabilities are pretty equal and that’s what makes it very hard for decision making."

When asked "What will define the direction in which we are going to tip?" El Erian replied:

"The major difference will be what the politicians do. It’s not an economic question, it’s a political question.  When you grow an economy slowly and in a non-inclusive way, the politics of anger take over and you get improbable outcomes like Brexit, the election of President Trump in the US or the difficulties chancellor Merkel is having in coming up with a new coalition.  The list is long.  Sometimes the politics of anger result in growth reform candidates likes President Macron in France, sometimes they result in a very disruptive outcome like Brexit.  But the politics of anger starts dominating which means that the political establishment becomes less secure."

"This anti-establishment-movement is like a technological disruption: It shakes the system to a better or to a worse equilibrium.  In the case of Macron, what you see is a shake to a better equilibrium. In the case of President Trump, we are starting to see congress take on measures that it hasn’t been able to take on for a very long time."

The last thought provoking comment from the interview related to the question, "What’s your take on the financial markets after an exceptionally good year?"

"Markets have been conditioned to buy every dip, regardless of how elevated asset prices are and regardless of how decoupled asset prices are from fundamentals.  That can continue for a while.  It takes a lot to derail this market because that strategy to keep buying the dips is very simple and it has been very profitable repeatedly – and there is nothing that markets like more than a simple strategy that is repeatedly profitable.  But when it stops, there’s an air pocket that comes afterwards."


Hussman Margin Adjusted CAPE


We'd like to put an exclamation point on El Erian's final point by referencing the chart above from John Hussman's market commentary dated January 15, 2018 entitled "When Speculation Has No Limits."

This chart displays Hussman's Margin-Adjusted CAPE, which improves the correlation of the Shiller cyclically-adjusted P/E (now at 34.4 times) with subsequent total returns by accounting for variation in the embedded profit margins (assumes currently high corporate profit margins will experience mean reversion to historical lower averages).  Hussman's Margin-Adjusted CAPE is at 45 times and is now beyond both the 1929 and 2000 extremes, placing current market valuations at the richest level in U.S. history.  If the aftermaths of the 1929 and 2000 bull markets are any guide, we are in for one doozy of an air pocket.

From a portfolio construction and risk management standpoint, these obscene domestic equity valuations have led Servant Financial to seek relative values across global asset classes and adopt a bar bell approach with client portfolios.  As the chart of expected 10 year real returns and volatility from Research Affiliates below graphically depicts, this risk bar bell includes an overweight allocation to higher expected returning emerging market equities (6.0% real return and 22.6% volatility) and developed international EAFE equities (4.4% real return and 18.0% volatility) while underweighting U.S. large cap equities (0.2% real return and 14.6% volatility).  To dampen the volatility of our international equity overweights and reduce overall portfolio risk levels below strategic levels, we are overweight high quality domestic fixed income securities and cash while aggressively managing portfolio duration and interest rate risk - U.S. bond aggregate (0.5% real return and 3.7% volatility) and U.S. Treasury intermediate (0.5% real return and 3.5% volatility).  As we articulated a year ago in the January 2017 post "Omne Trium Perfectum,"  we have assembled a diversified portfolio of inflation hedges to provide a Third Pillar to traditional client allocations to stocks and bonds.   This potential inflationary backdrop with the incoming Trump administration led us to research various asset classes that provide protection as inflation hedges - U.S. Treasury Inflation Protection Securities (TIPs), commodities, real estate investment trusts (REITs), floating rate senior bank loans (where interest rates are reset every 30 to 60 days), emerging market equities, debt (local and U.S. dollar based), and currencies.  Many of these Third Pillar securities have been added to client portfolios and will benefit if the road ahead leads to a powerful economic boom.


RA Asset Allocation 1-22-18


We need to do more work on this topic, but we initially think this is an appropriate way to respond to El Erian's economic intersection theory and expected bimodal economic distribution of high and inclusive growth or recessionary conditions and renewed financial instability.  In a continued global synchronized growth scenario, we would expect emerging and developed international equities and Third Pillar inflation hedges to outperform U.S. equities.  Both developing and developed international equities outperformed U.S. equities in 2017.  Meanwhile, in a recessionary scenario we would expect the overweight to high, quality domestic corporates and U.S. treasuries to provide much needed ballast in a recessionary induced market correction.  Developing and developed international equities would arguably outperform domestic equities in a recession given their substantial valuation discounts.


Minack CAPE Comp


In the case that the foregoing analysis was insufficient justification for exploring unconventional portfolio construction approaches in these unusual times, we've included the following forward thinking investment analysis by Jeremy Grantham entitled "Investing in A World of Overpriced Assets", part 2 of this linked GMO quarterly letter to add further credence.  Grantham's analysis of liquid securities markets concludes it is time to overweight emerging market (EM) equities.  

The synopsis of his investment analysis and recommendation is as follows:

"To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death.  I believe only a very large investment in EM equities will give an excellent chance of survival."

"Since February 2016, EM equities have already moved 11% relative to the US.  But their three earlier moves since 1968 were at least 3.6x the developed world markets!  Absolutely, at around 16x Shiller P/E, EM equities can keep you alive."

"Exhibit 3 (chart above), from Minack and Associates in Sydney, suggests that GMO’s forecast may still be understating the opportunities in EM equities.  It plots the straightforward measure of Shiller P/E (price over 10 years of average real earnings after inflation).  My using an outside source is deliberate: to cross-reference and also to suggest that GMO’s estimates, in the interests of safety, are conservative.  Note that at the recent low in February 2016 (Point 1), the multiple on EM equities was lower than after the crash in 2009! Remarkable.  Meanwhile (Point 2), the multiple on the US had gone from 12 to 22, an almost 100-percentage-point spread in favor of the US in just 7 years.  The Emerging index had sold at 38x in late 2007 (Point 3), a very substantial premium (52%) by any standard over the 25x of the US index.  It had sold again at a premium as recently as 2011 after the crash.  And early last year, the US was at a 120% premium the other way.  When you see the absolute and relative volatility of these three indices in Exhibit 3, doesn’t it suggest money to be made and pain to be avoided, even with less than perfect predictive power?  It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level."

"Be brave.  It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior.  I believe a conventional diversified approach is nearly certain to fail."

The data and analysis of each of the foregoing experts - El Erian, Hussman, Research Affiliates, and Grantham - point to very hazardous conditions and a potential economic conflagration ahead.  They have all signaled in different ways an economic and investing tipping point ahead the likes of which we have never seen before.  Proceed with caution.  Look for alternative routes and unconventional methods to preserve your financial wellbeing.

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