Cam Hui, CFA | [email protected] Page 1
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Quantitative & Strategy
A LOST DECADE: BIDEN’S PYRRHIC VICTORY?
June 29, 2020
EXECUTIVE SUMMARY
It has been a bad few weeks for President Trump, as he has been sinking in the polls. The
latest PredictIt odds show that a rising chance of a Biden victory in November, which is
becoming our base case scenario. Should Biden win the White House in the next election,
he may only win an economic Pyrrhic Victory, as investors are likely to sour at the prospect
of a “lost decade” for equity returns.
Some analysis has recently emerged pointing to a bleak decade for equities, and U.S. equities
in particular. Mark Hulbert highlighted a model outlined in the Philosophical Economics
blog, entitled “the single greatest predictor of future stock market returns”. The model is
based on U.S. household allocation to equities and uses the levels as a contrarian indicator.
Consider a simple econometric model I constructed from quarterly household equity allocation data since
1951 and the stock market’s subsequent inflation-adjusted total return at each step along the way. Based
on the year-end 2019 allocation level, that model projected a 10-year inflation-adjusted return of negative
1.3% annualized.
In addition, Bridgewater Associates is warning of a possible “lost decade” for U.S. equities
owing to a retreat in globalization.
We believe investors are facing a low return setting over the next decade. However, there
are a number of pockets of opportunity for investors. Gold, value stocks, selected cheap
foreign markets and the use of tactical asset allocation are all ways of enhancing returns in
a difficult investing environment.
Cam Hui, CFA [email protected]
Table of Contents
A Possible Pyrrhic Victory ........................ 2
The Bridgewater Warning......................... 3
Gold: Confidence Indicator ....................... 5
Where Can Investors Hide? ..................... 8
Cam Hui, CFA | [email protected] Page 2
June 29, 2020
Quantitative & Strategy
A Possible Pyrrhic Victory
It has been a bad few weeks for President Trump, as he has been sinking in the polls. The latest
PredictIt odds show that a rising chance of a Biden victory in November, which is becoming
our base case scenario. Should Biden win the White House in the next election, he may only
win an economic Pyrrhic Victory, as investors are likely to sour at the prospect of a “lost
decade” for equity returns.
Exhibit 1: Biden Gaining Ground in Betting Markets
Source: PredictIt
Some analysis has recently emerged pointing to a bleak decade for equities, and U.S. equities in
particular. Mark Hulbert highlighted a model outlined in the Philosophical Economics blog,
entitled “the single greatest predictor of future stock market returns”. The model is based on
U.S. household allocation to equities and uses the levels as a contrarian indicator.
Notice that the household equity allocation is the flip side of the coin from household cash — sometimes
referred to as sideline cash. Higher cash levels are therefore bullish and, sure enough, household cash
allocations have risen markedly as equity allocations have fallen. But backtesting has shown that
household equity allocation is the better predictor. In fact, according to Ned Davis Research, it is able
to explain 77% of the variation in the stock market’s return in all 10-year periods since 1951. I am
aware of no other indicator that does as well.
Cam Hui, CFA | [email protected] Page 3
June 29, 2020
Quantitative & Strategy
Exhibit 2: Household Equity Allocation Inversely Correlated with Future Returns
Source: Mark Hulbert
Hulbert continued:
Consider a simple econometric model I constructed from quarterly household equity allocation data
since 1951 and the stock market’s subsequent inflation-adjusted total return at each step along the
way. Based on the year-end 2019 allocation level, that model projected a 10-year inflation-adjusted
return of negative 1.3% annualized.
That -1.3% expected real return was based on year-end 2019 data. Q1 2020 figures are in, and
we all know what happened in March, namely the COVID Crash. According to Hulbert,
projected annualized real returns improved to a positive 2.3% based on March 31 levels. Fast
forward to today, the market has recovered most of its losses, and expected inflation-adjusted
returns are undoubtedly negative again.
The news is even worse than that. The projected returns are calculated before fees. If an
investor were to create a balanced portfolio consisting of some stocks and bonds, add in some
trading costs and management fees, diversification and frictional costs could easily subtract
another 1–2% from overall returns.
Cam Hui, CFA | [email protected] Page 4
June 29, 2020
Quantitative & Strategy
The Bridgewater Warning
Bloomberg reported that Ray Dalio’s Bridgewater Associates has a different take on long-term
equity returns. The firm is projecting a possible “lost decade” for U.S. equities:
A reversal of the strong growth seen over the years in U.S. corporate profit margins could lead to a
“lost decade” for equity investors, Ray Dalio’s Bridgewater Associates warns.
The margins, which have provided a big chunk of the excess return of equities over cash, could face a
shift that would go beyond the current cyclical downturn in earnings, Bridgewater analysts wrote in a
note to clients dated June 16.
“Globalization, perhaps the largest driver of developed world profitability over the past few decades,
has already peaked,” the analysts said. “Now the U.S.-China conflict and global pandemic are further
accelerating moves by multinationals to reshore and duplicate supply chains, with a focus on reliability
as opposed to just cost optimization.”
The pandemic-induced collapse in demand has already resulted in a huge fall in profit margins in the
short term, the analysts added.
The Bridgewater thesis is based on margin mean reversion. Branko Milosovic’s famous
elephant chart showed that the winners of globalization were the middle class in the emerging
economies, and the top 1% of population, who engineered the globalization boom.
Exhibit 3: Globalization Winners and Losers
Source: Branko Milanovic
The reshoring trend outlined by Bridgewater isn’t just attributable to the desire to duplicate
supply lines and focus on reliability over cost optimization. Bloomberg reported that the Trump
administration’s non-tariff barriers against Chinese competition have prompted a scramble by
American companies to comply with the unexpected fallout of new legislation.
Aerospace, technology, auto manufacturing and a dozen other industries are engaged in a lobbying
frenzy ahead of an Aug. 13 deadline to comply with a far-reaching provision that was tucked into a
defense spending bill two years ago.
Cam Hui, CFA | [email protected] Page 5
June 29, 2020
Quantitative & Strategy
The broadly written defense law could implicate virtually all companies that count the federal
government as a customer, including global subsidiaries and service providers deep in a firm’s supply
chain. Excluding subcontractors, more than 100,000 companies provided $598 billion in goods and
services directly to the U.S. government last year, according to a Bloomberg Government tally.
To date, measures taken by the Trump administration against Huawei and other Chinese tech
companies have been aimed at cutting off their access to American components and networks. This law
would ratchet up the pressure even more, putting the onus on U.S. government contractors to comb
through their businesses to ensure they have no connections to banned Chinese companies.
Just as America weaponized its dominance in finance to force any bank doing business with
sanctioned entities access to the U.S. banking system, this law weaponizes the procurement
process to deny any company doing business with Huawei and ZTE from business with
America.
Section 889, part B, of the National Defense Authorization Act would require companies to certify
that their entire global supply chain — not just the part of the business that sells to the U.S. government
— is devoid of gear from Huawei, ZTE, Hikvision and other targeted Chinese tech firms.
The measure could apply to virtually all companies that count Uncle Sam as a customer, including
subsidiaries and service providers deep in a firm’s supply chain. Excluding subcontractors, more than
100,000 companies provided $598 billion in goods and services directly to the U.S. government last
year, according to a Bloomberg Government tally.
Imagine a company has a foreign office. That office will naturally have a phone system which
connects to the local phone network. If the phone network has any component that uses
Huawei equipment, the company is not compliant. That’s how far reaching these measures are.
There are alternatives to Huawei equipment. Singapore recently announced its decision to use
Nokia and Ericsson to supply its 5G systems. They’re just more expensive, which puts pressure
on margins.
Cam Hui, CFA | [email protected] Page 6
June 29, 2020
Quantitative & Strategy
Gold: Confidence Indicator
These low equity return expectations are consistent with our previous publication highlighting
gold as a confidence indicator (see What Gold Tells Us About Confidence). The relative downtrend
of the stocks to gold ratio is an ominous sign for long-term equity returns
Exhibit 4: Falling Stock/Gold Ratio = Falling Confidence
Source: StockCharts
Here is one explanation for the lack of confidence. One of the bedrocks of long-term return
expectations is valuation. While valuation tells us little about what stock prices will do over the
next year, they are highly predictive of long-term returns. Global forward P/E ratios are back
to dot-com like valuations.
Cam Hui, CFA | [email protected] Page 7
June 29, 2020
Quantitative & Strategy
Exhibit 5: Global Stock Valuations Are Highly Stretched
Source: Bloomberg
Much of the heightened valuation is attributable to U.S. equities, which account for roughly half the weight of global stocks. But U.S. equity valuations have soared against their non-U.S. counterparts.
Exhibit 6: U.S. Equities Premium Skyrockets
Source: Bloomberg
Cam Hui, CFA | [email protected] Page 8
June 29, 2020
Quantitative & Strategy
Equity overvaluation cannot be just explained by expensive U.S. stocks though. Bloomberg
reported that Longview Economics found that “80% of the markets [they] track have a
valuation in the upper quartile relative to the market’s history — the greatest percentage on
record using data since the mid-1990s”. Everything is expensive.
Exhibit 7: Everything Is Expensive
Source: Longview Economics
It’s not just stocks that are expensive, bonds can hardly be described as cheap on an absolute
basis. Austria recently issued another 100-year bond at a yield of 0.88%. The offering was well
subscribed, which is another sign of a bond bubble.
In short, this is a low-return environment and there are few attractive alternatives.
Cam Hui, CFA | [email protected] Page 9
June 29, 2020
Quantitative & Strategy
Where Can Investors Hide?
This begs the question: Where investors can hide in such a low return environment?
Much of the answer depends on the degree of monetary accommodation that global central
bankers are willing to provide. The intermediate-term outlook is based on the Fed’s focus on
unemployment irrespective of asset prices. Consider this exchange at the last post-FOMC press
conference between Bloomberg reporter Michael McKee and Fed Chair Jerome Powell.
I came across a statistic the other day that amazed me. Since your March 23 emergency announcement,
every single stock in the S&P 500 has delivered positive returns. I'm wondering, given the levels of the
market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop
and setback the recovery significantly, or that we might see capital misallocation that will leave us worse
off when this is over?
Here is how Powell responded:
So, we — we’re not looking to achieve a particular level of any asset price. What we want is investors to be
pricing in risk, like markets are supposed to do. Borrowers are borrowing, lenders are lending. We want the
markets to be working. And again, we’re not looking to — to a particular level. I think our — our principal
focus though is on the — on the state of the economy and on the labor market and on inflation.
The Fed is signaling a “whatever it takes” moment to bring down unemployment. The Fed has
an array of tools to achieve those goals, such as asset purchases, yield curve control and even
negative interest rates. Translated, the Fed is willing to engage in financial repression. Other
central banks are either following suit or are ahead of the Fed’s curve. The ECB has already
experimented with negative rates.
A bet for financial repression, at least for the next 2–3 years, is a bullish bet on gold. Historically,
real 10-year TIPS yields (inverted scale) have been highly correlated with gold prices. As long
as the Fed is willing to engage in suppressing rates and yield curve control, it should put upward
pressure on gold prices.
Exhibit 8: Negative Real Rates Are Bullish for Gold
Source: Bloomberg
Cam Hui, CFA | [email protected] Page 10
June 29, 2020
Quantitative & Strategy
Is it any wonder why the stock/gold ratio is falling? However, standard portfolio construction
solutions call for the weight of gold in a well-diversified medium-risk portfolio to be no more
than high single-digit or low double-digit percentages. We agree with that assessment. That
means investors still need some exposure to equities as a source of growth.
One option is boost long-term returns to consider beaten-up value stocks. The growth to value
performance ratio has gone parabolic and the growth to value relationship is extremely
stretched.
Exhibit 9: Growth vs. Value
Source: StockCharts
A commitment to value investing comes with two caveats. First, value-style portfolios are
generally overweight in financial stocks, and financial stocks don’t perform well under
conditions of financial repression. As well, the growth/value ratio is still skyrocketing and
showing no signs of a rollover. From a tactical perspective, it may be wise to wait for a pause
and reversal of the ratio before making a full commitment to value investing.
There are a number of other alternatives for U.S. investors considering the value style. One is
Barclays Shiller CAPE ETN (ticker CAPE), which buys the top four cheapest sectors based on
CAPE that exhibits relatively strong price momentum. Another is the shares of Berkshire
Hathaway, which is not strictly value investing, but quality (wide-moat) companies at a
reasonable price. Both CAPE and BRK have lagged the market in the past year, but they have
outperformed the value style over the last few years. As well, the last time Warren Buffett was
this widely ridiculed for his performance was in 1999, which was a year before the dot-com
bubble popped. That said, Buffett has become so successful with Berkshire that the company
has a size problem and it has trouble deploying its cash as efficiently as it did in the past. In
effect, it has become a cash generative conglomerate, with a sizable position in Apple and a
large cash hoard.
Cam Hui, CFA | [email protected] Page 11
June 29, 2020
Quantitative & Strategy
Exhibit 10: Selected Alternatives to Simple Value Investing
Source: StockCharts
Another option for U.S. equity investors is to look abroad. Rather than simply ranking countries
by CAPE, which can lead investors into value traps, such as Europe where stocks appear cheap
because of lower growth potential, Research Affiliates ranked country valuations relative to
each country’s own historical range of CAPE. Based on this analysis, U.S. large-cap stocks are
wildly expensive, with Switzerland coming in second place and U.S. small caps in third. At the
other end of the spectrum, Turkey, Malaysia, Poland, South Korea, Thailand and South Africa
are the cheapest countries, in that order.
Cam Hui, CFA | [email protected] Page 12
June 29, 2020
Quantitative & Strategy
Exhibit 11: Country CAPE Valuations Relative to Their Own History
Source: Research Affiliates
Before plunging into some of these small and somewhat illiquid markets, it’s one thing to buy
cheap stocks and markets and it’s another to watch the markets become cheaper as
fundamentals further deteriorate, which is otherwise known as a value trap. To avoid that
problem, we overlaid a relative price filter to look for price stabilization in order to avoid the
value trap problem. Looking at the relative performance of these countries compared to the
MSCI All-Country World Index (ACWI), Turkey and South Korea are the standouts. They
have tested relative support and they are forming bases by consolidating sideways. The relative
performance of Thailand may be constructive and bears watching. Thai stocks are trying to
form a bottom after breaking a key relative support level. The other three are all in relative
downtrends and should be avoided for now.
Cam Hui, CFA | [email protected] Page 13
June 29, 2020
Quantitative & Strategy
Exhibit 12: Selected Cheap Markets Relative to ACWI
Source: StockCharts
As well, the degree of non-U.S. commitment will partly depend on the outcome of the
November elections. Current polling indicates a Biden lead over Trump, and recent victories
by progressives in primaries is likely to push the Democrat agenda leftward. A Blue Wave
victory in November, which is becoming the base-case scenario, will mean MMT-style stimulus
and increased U.S. corporate taxes. These developments will be USD negative and non-U.S.
equity, especially EM, positive.
In addition to a buy-and-hold strategy, investors can consider allocating funds to tactical asset
allocation as a way of enhancing returns. While we are not claiming that our Trend Asset
Allocation Model represents the Holy Grail of investing, an asset allocation switching strategy
that uses the out-of-sample signals of the Trend Model has achieved equity-like returns with
Cam Hui, CFA | [email protected] Page 14
June 29, 2020
Quantitative & Strategy
60/40 like risk. The usual caveats about how past performance is not indicative of future returns
apply.
Exhibit 13: Trend Asset Allocation Model Report Card
Source: Pennock Idea Hub
In conclusion, investors are facing a low return setting in the next decade. However, there are
a number of pockets of opportunity for investors. Gold, value stocks, selected cheap foreign
markets and the use of tactical asset allocation are all ways of enhancing returns in a difficult
investing environment.
Cam Hui, CFA | [email protected] Page 15
June 29, 2020
Quantitative & Strategy
Disclaimer
I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am
confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit
every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but
final responsibility is my own.
I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing
this commentary.
This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for
the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may
contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and
assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of
the information contained in this note.
This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,
express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.
This article does not constitute an offer or solicitation in any jurisdiction.
Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub