By John Goltermann, CFA, CGMA
“The big money is not in the buying and the selling, but in the waiting.”
– Charlie Munger
If you blinked, you missed it. The 2nd quarter carried much drama with a major decline in stocks on the heels of Trump’s tariff announcements then a rebound back to where they started as full
implementation was “paused” for negotiations.
I won’t rehash the details, but, in short, investors de-risked with the economic uncertainty that comes with effective tariff rates in the US at the highest level since the 1930s. But as pauses were announced, speculators stepped back in and juiced stock prices on the hopes that tariffs were simply a negotiating tactic, that there would be no economic impact and that the selling was overdone.
Foreign stocks have performed well this year as US stocks and treasury bonds are flat-to-down. But gold ended up the big winner as it has now arguably replaced US treasury bonds as a safe haven investment. This, in my opinion, is not a situation that investors want, but were forced into wholly due to fiscal mismanagement in Washington. That mismanagement has occurred over a long period of time and is a result of political incentives enabled by the US dollar being the world’s reserve currency: A paradigm that may be in the early stages of unwinding.
When we had a near 20% selloff in the S&P 500 in late March/early April, interest rates went up and the dollar went down almost 10% (see chart below). Normally in a “risk-off” environment, meaning when market participants are selling stocks, bonds rally because of a flight to (perceived) safety, and the dollar rallies because participants buy dollars to pay back dollar-based loans (large amounts of the borrowing in markets are non-dollar-based loans). That did not happen in the last quarter.
Source: tradingview.com
What does this mean?
In my opinion, this largely reflects widespread recognition that the US fiscal situation is untenable. With $37 trillion (and rising) of treasury debt and rising interest expense, the US may be near a tipping point where kicking the economic can down the road through interest rate suppression and fiscal spending is not a viable strategy any more.
The recent enthusiasm on the part of stock investors for a more business-friendly administration economy is understandable. But caution in stocks is still warranted because valuations (on US stocks in aggregate) are much higher now than they were in 2017 when Trump 1.0 began (see below). The chart below shows Warren Buffett’s favorite market environment indicator (total US stock market value (market cap) relative to US economic output (GDP)). As you can see, total US stock values are around 220% of GDP and they were around 120% at the beginning of Trump’s first term. That means they are much more expensive now.
Source: www.marketsentiment.co
The chart below is one reason our portfolio is not set up to track the S&P 500 and why we are cautious overall: The so-called equity risk premium shows high-risk territory. The equity risk premium is the difference between the ‘earnings yield’ on the S&P 500 (sum of all S&P 500 EPS weighted by market cap) divided by the S&P 500 price) and the yield on the 10-year Treasury. Data sources differ, but right now I calculate the S&P 500 earnings yield to be 3.62% ($218.87/6034.40 as of this writing) and the yield on the 10-year is 4.41%. So, the spread is -0.79 and the mean is probably somewhere between +2.0 and +3.0.
Source: Financial Times
Think of the equity risk premium as how much one is compensated for holding equities vs. simply earning interest on a risk-free asset like the 10-year T-note. Right now, you earn less by owning stocks (and taking on equity risk (downside)) than you do by owning 10-year Treasurys. From a long-term positioning basis, S&P 500 owners are not well-compensated for their risk.
We’re notching all-time lows again on this spread at a -0.79, which is not a stable situation. Or looked at differently, S&P 500 owners are betting a lot that 1) long-term Treasury rates will come down big time, 2) EPS on the S&P 500 will exceed what is expected; or 3) that inflation will be good for the S&P and bonds won’t sell off if it increases. All of those, amidst everything happening (and vs. history), are likely to be bad bets. But, of course, are possible.
The equity risk premium can be distorted by factors such as excess market liquidity, leverage (heavy retail participation in short-dated options), complacency, mass indexation and algorithmic investing, heavy foreign investment through high capital account surpluses, and fiscal spending in the US (higher rates because of deteriorating creditworthiness of the issuer (the Treasury)). I believe all of the above are happening, so in the near term this spread has limited use in predicting the near-term direction of markets but can be used to understand the broad risk environment and to guide positioning.
A word on Israel-Iran: This piece is being written four days after Israel’s attack on Iran and its nuclear capabilities. This attack was not entirely unexpected and probably the inevitable result of decades of proxy wars and posturing. The middle east has been unstable for a long time. Iran’s nuclear goal is to make its regime more stable and permanent through nuclear threats. Israel ‘s (and the US’s) goal is to stop that from happening.
If Iran is successful, it would make Israel less secure and the US’s enemies more powerful. The US’s fear is that if Iran is successful, it could become a regionally dominant player. If this happens, it would likely be allied with the Russia/China combination, which, obviously, threatens the United States and the West. The big question is whether this conflict closes the Straits of Hormuz, which would certainly impact the global economy. If oil prices stay high, and other problems arise, the risk of stagflation goes up. So, this is high stakes geopolitics.
One of the factors that have helped returns this year is our positive exposure to rising geopolitical risk through defense companies, resource investments and gold, as well as positioning for the rising risk of stagflation through foreign stocks, insurance companies and short bond durations. We have been cautious for various reasons mentioned, while other investors throw caution to the wind and chase the S&P 500 and the AI craze. In terms of AI, we do think it will continue to advance. But how to invest in AI is a different matter. It is highly possible the easy money has been made on the technology side and that valuations now reflect bubble-level enthusiasm (see chart below). But what many people forget is that AI will take tremendous resources to power it via electricity (energy), mining, land and people and going forward, given where valuations are, this is likely where AI-related money will be made.
Source: Tavi Costa, Bloomberg