Investors need to consider about assets that are independent of the US economy and policies, and the risk of lower dollar values. With the passing of the US tax cuts, the increase of bond offerings is inducing higher interest rates. The recent slide of the dollar also makes bond valuation more discouraging for foreign buyers. The intrinsic value analysis will suggest an easy way for measurement of bond values.
Although money creation by global central banks is slowing, inflation of financial asset prices especially stocks are at the highest level and bonds prices are still expensive despite the recent fall. On the contrary, real investment assets such as gold as oil are low and attractive with more upside. This is an opportunistic time to allocate a higher percentage to assets with better risk and return potentials. This article lays out reasons about the urge for the shift.
Intrinsic Analysis with Dollar Index
The US Dollar Index, (NYSEARCA: UUP), is a measure of the value of the US dollar relative to a basket of foreign currencies. The Dollar Index is commonly used in valuing all assets denominated in US Dollar. Having a strong dollar is beneficial to most of us which means all our assets are more valuable.
Dollar index is a proxy to reflect the strength and health of the US economy. To explain the recent dollar's demise, the reasons are higher budget deficit, higher trade deficit, increase national debt and tensions with trading allies.
The intrinsic value of an asset is simply the product of the asset with UUP.
Generally, all assets behave inversely with UUP but to a different degree. The change of individual asset value depends on many other factors. New charts in this article are used to track the trends of the assets, the ability to understand and interpret the charts can lead to investment success.
The above is the Underlying Inflation Gauge (UIG) from the New York Fed. UIG captures sustained movements in inflation from a broad set of price, real activity, and financial data. The UIG derived from the "full data set" in blue color increased to 2.98% in December 2017. UIG may be the most honest government gauge on inflation. Lately inflation is heading up, which will lead to higher interest rates.
The dollar reached a peak in January 2017 and has declined 14%. This peak may be the start of a new leg of down cycle which averages 9 years. Lower dollar usually means higher inflation.
The dollar weakens despite rising interest rates and quantitative tightening. The weakness implies that there is a reduced appetite for US currencies and bonds. Some foreign central banks announced a hold or reduction in US dollar denominated reserves.
Inflation and Oil Prices Projection
The rise in price of oil will bring about more global inflation that will becomes more apparent in the coming months.
To explain the main reason for low inflation for the past year by the actions of central banks. They provided ample liquidity to the commercial banks, to send excess funding to the companies for money losing projects; to add to the persistent oversupply situations that suppressed product prices which kept inflation low.
After 3 years of low prices, the situation is improving. Growth in supply will be weaker than expected mostly because of lack of capital expenditure for the preceding 3 years.
The decline of the dollar is helping oil price, as represented by the USO. So, the outlook for oil price is quite favorable towards July 2018. The chart below shows that the uptrend is intact since oil bottomed in February 2016 and is rising more than 8% per year for 2 years. Dollar, Oil, dollar index multiplying oil or UUP*USO in purple color, offers another view representing the real value of oil. The higher lows in June and then August denoted entry points and floors for oil to rally. With upward acceleration of oil price, higher global inflation likely will follow within 6 months. Oil price is shown as USO below.
My prediction on oil price started 23 months ago with the first published article.
Price resumed the upward movement since last July and is accelerating upward, above my original projection back in April 2017. Because of the healthy increase in demand, which was causing a deficit of 0.7 million B/D as evident by lower world inventory in 2017. This deficit will continue for at least 6 more months; until higher prices result a reduction in world demand. The following chart serves as a good way to track oil price towards July 2018.
Oil company earnings for Q4 will be much better than Q3 2017, and Q1 2018 earnings will be even better with even higher oil prices. Currently, stock prices of many oil companies have yet to reflect fully the uptick of oil prices and present good opportunities.
Debt and Interest Rates
The national debt is surpassing 20 trillion. The budget deficit is rising towards $1 trillion in 2018, which means there is an increase of treasury bonds offering each month. The bond buyers will be reluctant to add more treasury holdings that will force interest rates higher. High interest rate is negative to bonds, and eventually will bring down the high-flying stock market.
The falls in bonds and then stocks will bode well for the undervalue real assets such as gold and commodities.
Stock Market Overvaluation
All the major stock market indexes are at record, and SPY represents SP500. But according to Dollar SP500, UUP*SPY in gray color line above, the real value of the stock market is ascending less. When the ascent slows and reverses, that will serve as an additional indicator to identify the peak reversal. The previous minor crashes in 2015 and early 2016 are characterized by drops in both dollar index and SPY.
Bond Market Overvaluation
The long duration treasuries TLT, being the most sensitive to interest rates changes, in green color peaked in July 2016 and is in downward trend. The intrinsic value which is Dollar TLT, UUP*TLT in gray color, declined more and lost about 21% from the peak. This loss feels especially real to foreign investors because the currency loss is included. By adding a 3% TLT yield per year, the loss is lessened to about 15% which is still very significant.
There may be a slow-motion bond crash forming. At 2.6%, the 35-year down trend of 10-year yield was broken this week. The yield curve also steepens from flat positions lately. The Fed is scheduled to raise interest rate 3 times in 2018. All these developments are poor outlook for bonds in the coming years.
Below is a 30-month chart in comparing UUP, SPY and TLT. Since UUP is an oscillating item, and both SPY and TLT have compound gains over time. I remove the gains for both SPY and TLT, so the comparisons are more meaningful. The idea is to illustrate the inverse and rotational relations between SPY and TLT, with UUP as reference.
According to the chart, timing to invest in bond is limited to brief short-term gains, when there is a correction in the stock market.
Bonds generally behaves inversely with stocks, which implies the ongoing weakness in bonds is good for stocks for a while until the trend changes.
The figure below illustrates the effect of interest rates on long-term bond prices, with respect to falling and then rising interest rates from 2011 to 2021. There was fun then and now pain persists. The concept applies to all bonds by just changing the scales on the y-axis and shifting the time slightly on the x axis. Long duration bond peaked in July 2016 and the peaks in shorter duration bonds have formed and are forming. Fed's intent of three more interest rate hikes in 2018 will bring about more losses to almost all bonds, the start of a bond bear market is firmly set. The simple image depicts both the duration and magnitude of the ongoing bond bear market by dialing up interest rates and dialing down bond prices. The transition from virtuous to vicious cycle of money printing are unraveling. This picture can be applied to international bonds too to visualize the future downfall in bonds as interest rates rise globally.
Real assets such as gold offer a much better future investment profile than bonds. Take the clues from major central banks and banks, they hold and add a lot of gold for reserves; to divest from fiat currencies.
Gold has been rising at 10% annually for the past 2 years, in comparing to long-term bonds which are trending down.
New Gold Demand In The Coming Years
- Increase in global gold demand, physical or ETF, especially in Germany
- Foreign central banks will prefer more gold
- The price uptrend attracts more buyers
Therefore, having gold which is a real asset, instead of the fiat currencies and bonds, is a much smarter long term holding.
The above 30-month chart compares the intrinsic values of TLT, GLD and SPY by multiplying each item with UUP. Notice the peaks for TLT and UUP were formed in 07/2016 and 01/2017 respectively. These peaks are very significant because they are likely to be the markers of the beginning of the new bear markets in bonds and dollar. Intrinsic value analysis, which includes the effect of the dollar index, offers an alternative view of asset performances.
Continuing rise in interest rate will eventually drag down stocks later this year.
Gold will remain to be the more desirable asset with appreciation potential, because of excessive money printing that will cause higher inflation in the future. The major bottom of gold in January 2016 set the stage as a starting point for the ongoing bull run which should continue for another 4 years.
Gold miners have been lagging gold in performance in the past 12 months. Gold price is rising the past month and may surpass the $1370 high of 2016 soon. Gold being an inverse with the dollar index, which is lower today than the last time gold peak back in August 2106. So, gold should be higher according to dollar index alone. What is lacking to spur gold higher now is relative calm in geopolitics.
Miners are very profitable at today's gold price. The potential target for gold miner is about 30% if gold approaches the 2016 high again. Silver miners will have a bigger potential target if silver price regains the same high of 2016. Any further weakness of the dollar from the current low levels can make these targets more achievable.
Industrial commodities have been performing well this year, because of healthy global economic growth. So are the precious metals as stated earlier. Agriculture prices, which are weather dependent, have been soft. If inflation picks up due to the increase in global money supplies and dollar devaluation, all commodities will perform nicely. A change in sentiment from financial to real assets will aid commodity prices.
The intrinsic value analysis over all assets should warrant more attention and research. There are many uses for the intrinsic value analysis, such as an additional view in technical analysis, determining real value, potential leading indicator for trend change, locating and confirming true tops and bottoms and true magnitude of gains and losses especially for foreign buyers.
Migration from overvaluation to undervaluation assets is sensible in providing higher profit potential and reducing risk. Commodities, especially gold and oil, remain to be the few assets that deserve more focus. Actual stock investments usually are placed on the companies that produce the commodities.
Disclosure: I am/we are long GDX,XLE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.