When allocating capital to asset classes, investors must analyze the underlying fundamentals before determining which investment provides the best outlook for their investment dollar. The following analysis will describe the outlook over the next 3-5 years for each of the major asset classes: 1. Stocks, 2. Bonds, 3. Real Estate, and 4. Gold.
Raw Data Source: http://www.econ.yale.edu/~shiller/data.htm
Looking at Robert Shiller's cyclically adjusted P/E ratio, it highlights the fact that the stock market is overvalued on an adjusted P/E basis, with a current adjusted P/E ratio of 21.9 vs. a long-term average of approximately 16x earnings.
Note: Corporate Profits as a Percentage of GDP
Source: GMO's James Montier: "What Goes Up"
Corporate profits are mean reverting and above the historic average of 6%. Over the next 3-5 years higher input prices will add significant pressure on margins. Compounding the problem is the fact that analysts are currently forecasting even greater increases in profit margins through 2013. With analysts forecasting profit margins at such unsustainable levels, future estimate cuts will be even greater, which will add downward pressure on broad stock market indexes like the SPDR S&P 500 Index (SPY).
Performance During Inflation:
With a rapid increase in the money supply many investors look to equities to provide inflation protection. An examination of the last period when the U.S. economy had significant inflation (the 1970's) shows that although the CPI increased by over 100%, stocks remained relatively flat. During periods of high inflation profit margins often contract. Additionally, higher interest rates result in a higher discount rate used to discount future earnings, which cause P/E multiples to compress. Even during an extreme example of hyperinflation, as seen in the German Weimar Republic, the nominal increase in stock prices were astronomical, but equities lost approximately 60% of their value in real terms.
The stock market has limited upside potential, as there is a double top in the S&P at around 1,550 (only approximately 15% above its current price of 1,350) which will be met with an exceptional strong amount of resistance. With market fundamentals as weak as they currently are, it is unlikely the S&P will be able to move significantly above 1,550 without a major form of stimulus from the Fed. Even if the Fed does continue to provide increasing amounts of stimulus, the broad market would likely underperform gold as additional easing would severely hurt the dollar, and cause inflation to spike.
Unsustainable Low Interest Rates:
Raw Data Source: http://www.econ.yale.edu/~shiller/data.htm
Bonds are at the end of a 30-year bull market that has provided investors with a source of income as well as large appreciation in bond prices as the price of previously issued higher-yielding bonds consistently increased to adjust for lower current rates. Bond prices are extremely leveraged to changes in interest rates because small changes must be compounded over the life of the bond. To illustrate, bonds leverage to interest rates; in 2011 investors in the iShares 20+ Year Treasury Bond Fund (TLT) had an annual return of 33.6% as bond prices increased dramatically to account for lower rates. Within the next 3-5 years, it appears the tables will have turned for bond investors. With long-term interest rates at only 2%, bond investors' potential for price appreciation is limited and current coupon payments are below the rate of inflation. A return to the long-term average interest rate of approximately 4.6% would destroy a large percentage of treasury investors' purchasing power. Over the next 3-5 years the risk reward profile of bonds is extremely negatively skewed.
The Debt Problem:
Note: Total Public Debt from 1970 to 2012.
Note: Gross Federal Debt as a Percentage of GDP.
Note: Growth of Total Public Debt and GDP Using 1970 as a Base Year of 100.
The U.S. national debt is currently $15.7 trillion dollars. With GDP of $15.2 trillion, annual tax revenue of $2.3 trillion, and spending of $3.6 trillion the result is a current year budget deficit of $1.3 trillion. Gross Federal Debt as a percentage of GDP has been rising rapidly. As debt approaches unsustainable levels, bond investors will demand higher yields to compensate for the increased risk and inflation. Having high debt levels can lead to a crisis of confidence. Spanish bond yields are currently 6.3% and rising while they were under 4% in 2010, which illustrates how quickly interest rates can change course. At 5% interest, U.S. annual interest payments would be $785 billion dollars, which is approximately 34% of annual revenue. Bond investors are exposing themselves to significant declines in bond prices in exchange for negative real interest rates.
The combination of rapidly increasing debt levels and sluggish GDP growth has pushed the U.S. to its limits. The underline premise of Keynesian economics is that governments run surpluses in good times, which help offset the deficits needed in bad times. The basic flaw of the current fiat money system is that it allows countries to run huge deficits in good times and even larger deficits in bad times due to the appearance of an infinite supply of cheap money and a lack of fiscal discipline. Although the U.S. had a higher debt-to-GPD ratio coming out of WWII, the U.S. economy is now a fully matured economy. The days of sustainable 4%+ real GDP growth are behind us. Growth is the savior of a thousand poor decisions, but growth will not head our cries for help as it has so many times in the past. With a chronically high unemployment rate, low labor participation, and an aging population; the outlook for the next 3-5 years is bleak.
Although housing prices have dropped significantly from the peak in 2007; looking at a long-term chart of the Case-Shiller index, it is clear housing prices are still well above historic averages and have recently retraced back to 2003 levels.
As of January 2012 there are 1.6mm homes in shadow inventory that will exert significant downward pressure on residential real estate prices for years to come. Half of the shadow inventory consists of serious delinquent homes that are not currently in the foreclosure process. For every two homes available for sale, there is one home in shadow inventory. Although there have been 3mm distressed home sales since January 2009, the shadow inventory remains unchanged.
An Aging Population:
The U.S. has an aging population which will be selling more homes than they absorb. As the baby boomers get older many of them will look to sell their homes to relocate, move into more economical apartments/retirement homes, or to cash out their equity as a source of additional capital, and ultimately exit the housing market.
Interest Rate Sensitivity:
Residential housing is sensitive to interest rates. Looking at the Long-Term Interest Rate Chart it is clear rates are at historic lows and far below the long-term average of approximately 4.6%. Interest rates have been declining for 30 years, and are currently near the end of a generational phenomenon. When interest rates begin their reversion to historic norms, housing will suffer as a result of larger monthly payments for buyers. Additionally, a low savings rate in the U.S. will make it difficult for most buyers to come up with larger down payments required to offset the effect of rising rates.
Note: Although residential housing appears to face significant headwinds in the coming years, certain productive real estate assets, such as farmland, do offer investors significant upside potential as emerging economies continue to develop.
The Falling Dollar:
Source: Bureau of Labor Statistics
Since the inception of the Federal Reserve in 1913 the dollar has been in steady decline. Gold's long-term correlation with the dollar is approximately -.5, which provides investors with protection against a continued decline in the world's reserve currency.
Central Banks Are Buying:
Source: BullionVault via WGC, IMF, GFMS
Central banks have become net buyers of gold for the first time in decades. Continued central bank purchases support gold as an investment thesis, as buyers of size will ultimately determine gold's true price.
Gold is Under-Owned:
Source: CPM Gold Yearbook 2011
Source: Casey Research, Dr. Marc Faber
Gold is under-owned relative to other asset classes and long-term averages. The gold market is relatively small, so an increase in institutional buyers of gold would result in a dramatic increase in the price of gold. The world is currently undergoing a paradigm shift in the way people perceive money and its use as a store of value. Last year University of Texas' endowment purchased $1B dollars in physical gold. As the prevailing shift in people's perception of money continues gold will likely become available in smaller quantities at higher prices.
Gold Performance During Inflation:
While the stock market remained relatively unchanged in the 1970's, the gold price increased over 1,000%, while the CPI increased just over 100%. Additionally, gold is relatively uncorrelated to other asset classes which make it a great diversifier. Every portfolio should have a portion allocated to gold at a minimum as a type of insurance policy. While stocks and bonds suffered in the 1970's, investors who allocated just 5%-10% of their portfolio to gold were protected.
Stocks 3-5 Year Outlook:
- Fundamentally overvalued by approximately 27% on a historic basis as indicated by Shiller's cyclically adjusted P/E ratio.
- Current valuation and analyst forecasts are not taking into account a reversion of corporate profit margins to a more sustainable level of 6%.
- Rising input costs will put downward pressure on margins, and force analysts to reduce their overly optimistic estimates.
- Technically the market is only 15% from its previous high of approximately 1,550 in the S&P that will provide significant resistance.
- Higher interest rates will lead to a higher discount rate for future earnings, and cause P/E multiples to contract.
- The market is unable to stand on its own due to its addiction to cheap money.
- GDP growth has slowed to 2.2% in Q1 2012 vs. economists expectations of 2.5%
- The unemployment rate remains exceedingly high, with the lowest labor participation rate since 1983.
- The scheduled expiration of the Bush tax cuts in 2012 will provide additional problems for the economy and broad market.
- The market is under constant threat from the European sovereign debt crisis.
- A lack of trust of the legitimacy of the stock market by individual investors will limit future upside potential.
Bonds 3-5 Year Outlook:
- The current interest rate on government bonds is less than inflation.
- A reversion to more normal long-term interest rate will result in a significant loss of purchasing power to bond investors, as bonds are leveraged to changes in interest rates.
- With long-term interest rates at 2% bond investor's potential for price appreciation is significantly limited.
- Large increases in the money supply will result in higher inflation, and ultimately higher yields.
- The bond market is being artificially manipulated by the Fed, but all manipulation is ultimately unsustainable.
- As sovereign debt concerns spread west investors will demand higher yields as they realize U.S. treasuries are not "risk-free" in real terms.
- Bonds are typically the worst performing asset class in periods of high inflation.
- PIMCO's Bill Gross has expressed significant concerns regarding the expected return bond investors will receive in the coming years.
Real Estate 3-5 Year Outlook:
- The Case-Shiller index indicates prices are still well above historic averages.
- The shadow inventory of 1.6mm homes hasn't declined from January 2009, and will continue to exert downward pressure on residential real estate prices.
- Aging baby boomers will become net sellers of real estate.
- Home prices are falling, even with the Fed's ZIRP, and tax credits for first-time homebuyers.
- As sovereign debt concerns spread higher interest rates with reduce home affordability, and result in newer home buyers becoming underwater.
- A chronically high unemployment rate combined with such a low labor force participation rate will make it hard for individuals to purchase real estate. A detailed analysis of the jobs report is available here.
- The low savings rate in the United States make it difficult for the average American to come up with the required 10%-20% down payment to purchase a new home.
Gold 3-5 Year Outlook:
- Performs extremely well in periods of inflation due to the inability to increase production unlike paper money.
- The long-term gold correlation to the USD is approximately -.5, which is significantly better than other commodities.
- Other commodities like copper are closely tied to the global economy, where as gold is strictly a monetary asset.
- Gold is viewed as a safe haven asset, which allows it to perform well in the worst times.
- Gold is a universally accepted currency.
- Physical gold has no counterparty risk.
- Long-term gold prices are less volatile than the S&P 500.
- Gold has a low correlation with other assets that make it a great portfolio diversifier.
- Institutional and individual ownership is extremely low, with significant upside potential.
- Gold is already the unofficial world reserve asset.
- Holding gold in your portfolio is like having an insurance policy.
- Gold often does the best when other major asset classes are at their worst.
- Central banks have become net buyers of gold, with China and India creating strong demand for the precious metal.
- Gold provides investors the opportunity to take advantage of the historical trend in precious metal price appreciation, as real interest rates continue to be negative for the foreseeable future, and the Fed planning to keep interest rates at historic lows until at least late 2014.
- When times get tough central banks around the world have proven they will take the easy path of printing money.
Over the next 3-5 years gold offers investors a stronger investment thesis than stocks, bonds, or residential real estate. Investors without a gold position should consider accumulating a position on the recent pullback, whether it is through physical bullion, SPDR Gold Shares (GLD), Sprott Physical Gold Trust (PHYS), or mining stocks (for investors with a high risk tolerance) such as the Market Vectors Gold Miners ETF (GDX).
Additional Gold Miner Equity Research: