Jordan Roy-Byrne: Hello again everyone, welcome back to the Atlas Investor podcast with Tiho Brkan. This is episode number 18. Tiho, my friend, it's great to speak with you again today. I understand we're going to be doing a two-part podcast. Today will be the first part of that. Please discuss what you'll be covering today.
Tiho Brkan: Sure. Great to hear from you too, Jordan. Podcasts have been a little bit slower in the last couple of months as I've been busy. Regards from beautiful Prague where I'm doing a real estate project as I remind my listeners and readers. So, we're going to focus on where to invest your capital in today's market. We're in a late cycle of the economic expansion as well as in the United States' stock market. The actual bull market's been running for nine years straight now, and the valuations are very high, and therefore future expected returns could be low. It could disappoint some of the investors that are not prepared for that. So, the question is, where should we put our capital today?
We're going to look at the risks of investing today, as well as the potential of still understanding that the business cycle can go on for a little bit longer, and you have to continue to perform, especially if you're somebody like me who needs to invest clients' money. They are not willing to wait for a next one or two or three years until the downturn comes. So, therefore, in a two-part podcast, we're going to cover where to put your capital today and what you should invest in.
Jordan Roy-Byrne: Okay, Tiho. First things first, let's start and discuss where we are with respect to the economic cycle and equity valuations. Is the US expansion the longest in post-war history yet? How much longer is there to go to reach that feat?
Tiho Brkan: Well, it's not the longest yet. It's a great question, by the way, and I've got a chart for those watching on YouTube or reading the website. We're at, I believe, about 107 or 108 months, and we need about a year to get to the record, which is 120 months. That was set during the late '1990s' tech boom, the go-go years of the internet and the dot-com bubble under Bill Clinton. So, it was a very prosperous time for the United States' economy and for investors of course. So, we are sort of repeating that period with respect to the expansion.
I don't think a recession will start over the next quarter or four months. Right now, the economy looks like it's going to grow. It's hard to make a forecast after that, and there are no signs of slowing down. Things are looking pretty good everywhere apart from maybe China, which is slowing down a little bit. However, generally speaking, there are no risks of a recession.
We could make it toward the record or even break it, Jordan. It's difficult to forecast 12 months in front because the economy could change and various things could happen. It depends on what the United States' president will do or what the Chinese premier will do. A trade war has started, so the situation is a lot different than it was during Ben Bernanke's green shoot years back in June 2009 when this expansion actually started.
Jordan Roy-Byrne: Okay. Next, let's take a look at valuations. Now, perma bulls always decry these statistics and charts, while perma bears will push them in your face as a reason that the market should crash. Could you cover a couple of these and share your opinion?
Tiho Brkan: Sure. Well, we could look at a variety. I like to use Price to Sales, Price to Book, and CAPE: cyclically adjusted price-to-earnings, but then, a variety of others as well: shareholder yield, and we can go on and on.
Price to Book, recently in January of 2018, during that blow off top that we had, hit 3.3 for United States equity market, which is basically the highest level outside of late 1997 to 2000, 2001 period. It was also higher than, I believe, 1929, but the data back then is a bit iffy, and it was much higher than 1987 before the crash and much higher than 2007 before the crash.
So, valuations themselves are not necessarily a catalyst for a market crash, but they do warn you that the future expected returns over, let's say, a decade or even multiple decades could disappoint. But that can still mean that over the next two to three years the market does well and then one of these years it's just a disaster, like 2008 or 1987.
US equities remain very expensive as far as the CAPE ratio, once again. While we're not as high as 1929 and the year 2000, or better yet said the late 1990s until the early 2000s during the tech bubble, we are still fairly elevated. So, generally speaking, United States' stocks are at nosebleed levels. Buying here for the next 10 years, you're probably going to get a flat return if that. It all depends.
Some statisticians and investors would argue that you might get about a 4% return, and other indicators used by statisticians will argue that they might get a minus 2% nominal return or at least a negative real inflation-adjusted return over the next decade. So, if you take that range of possibilities you're probably going to end up with a flat return. Even if you make 1% a year, it's still flat.
Jordan Roy-Byrne: Now, Tiho, I just have a quick follow-up on that, because when you look at some valuation indicators, it seems like over the last 20 to 30 years or so that the range of valuations are becoming more extreme on the upside. I know it'll take decades for us to figure out if valuations are going to mean revert on the downside, or if they will remain elevated even when they decline.
The bulls will say, valuations will remain in a higher range in the future because that's what's been happening over the last 20 or 30 years, whereas bulls will just say, "No, we're in a big bubble, and valuations will eventually go back to where they were for most of the last century." I know it's a tough question to answer, but do you have any thoughts on that?
Tiho Brkan: Well, one thought that I do have, and it comes straight to my mind, is that nobody really knows. So, I wouldn't really bother with other people's opinions, and I personally don't. We cannot figure that out, and we will not know until later.
Valuations also change from generation to generation. In Japan now, if you look at the CAPE ratio, in the 1970s and 1980s, it was in triple digits. It was getting close to 100 or even over 100 if my data is correct, and now, it's come back to a little bit more of a norm. And relatively speaking to the 1989 level when it was a Japanese bubble, valuations are now very cheap in Japan, especially back in 2012 just as Abe was getting elected and Japanese Yen started to become devalued under Bank Of Japan's monetary policies, so it's really difficult to say.
While valuations are very high in the United States now, relative to history, they are not very high in many other places. So, if you don't like to invest there, or if you have caution about investing there, you can always be underweight the United States. If it performs you still make a profit, and if it doesn't perform, you don't lose a lot. And you can be overweight other countries or other regions of the world where valuations are attractive and expected returns relative to history and relative to the current valuations should do really well both in nominal terms and real inflation-adjusted terms, Jordan.
Jordan Roy-Byrne: Okay, thank you for that. That was a great answer. Now, Tiho, next I want to ask you about this chart that we both have seen recently; it's been making the rounds on Twitter. Now, according to a 60/40 portfolio, financial assets are in their longest bull market ever. The question I have is not when this ends, but what kind of bear market or correction do you think will follow?
I know you hate these prediction questions, but I ask this question with respect to the chart, because looking at the history and kind of visually comparing where we are now to these past great bull markets in financial assets, I mean, if we're going to compare it, could we be in the late '20s, the late '50s or the late '90s? Again, this is where the bulls would say, "We're in the late '50s, we're not going to have a massive bear market," but the bears would say, "No, we have to be in the late '20s or the late '90s due to valuations."
So, as someone who allocates capital and tries to make money for your clients, how do you gauge this moving forward for the inevitable correction and bear market?
Tiho Brkan: Number one thing that I would say to my listeners is the trend is your friend until the nasty bend at the end. So, we have to stay invested, and I've always said, (even though we've been discussing quite a lot about the valuations in many of our podcasts, and we anticipated the correction correctly within a few months, and the correction was still going on in emerging markets, which dropped about 17% from January highs, after such a strong momentum, the assets that are doing well), you have to stay with them because there's a momentum there, and valuations only mean so much. Valuations together with negative momentum means a lot more.
Are we in the 1920s, are we in 1950s, are we in 1980s or 1990s? It's a great question, Jordan. One of the things that I'll say is that there was a mega crash after 1929, and everybody kind of compares today to 1929 or 1987 or the late 1990s. Yes, the bull market has been running for a long time and, as we discussed, so has the expansion. But it all depends on what is the catalyst, and what are the drivers for the next recession?
We've seen bull markets in the 1950s followed by very mild bear markets, and then, we've seen mega bear markets after World War I into 1921, which was the first depression, and that was a massive bear market, but the preceding bull market price of that was not that strong at all. So, sometimes, stocks can correct significantly even without being over-extended, and sometimes, stocks can correct a lot when they're over-extended. Sometimes, the bull market just keeps running and running and running, and we've seen that in the '80s and the '90s.
I remember a famous investor, who I'm not going to mention here, but he and Warren Buffet are very good friends, and he has his own hedge fund. He famously said that the United States' stock market was overvalued, relative to history, using a CAPE ratio or Price to Book ratio in 1993. Well, we know what happened for the rest of the seven years. He was underweight. He made money elsewhere. He's a great fund manager, don't get me wrong. So, like I said, if you don't like the valuations, you can always invest elsewhere.
I personally think that this 9.2-year bull market will see some kind of a mean reversion. And because we have such a high amount of debt all around the world - this is the highest level of debt we've had in a peacetime - definitely, the recession that's coming around the corner, whenever it comes, and it will come one day soon, it's going to hurt a lot. I think the artificial sea of liquidity that we've seen from central banks, the three major central banks, which is the European Central Bank, the United States Central Bank, and the Bank of Japan, and then, on top of that, you throw in the Chinese liquidity that they've created and the debt that they've amassed, even though it's in local currency, majority of it, nonetheless it's all going to hurt the global economy.
So, from my perspective, it's not going to be pretty, it's not going to be like the 1950s. In the 1950s, the interest rates were rising, and the debt was very high after the World War II, so a lot of people connect that to today, and that's also possible too. But like you said at the beginning of the question, Jordan, I don't like predicting, so take my predictions with a grain of salt. It might not work out the way I said.
But if you're cautious in US equities, I repeat once again, there are plenty of assets out there, which we'll discuss in this two-part podcast, to which people can allocate their capital and hopefully, over the next five to 10 years, they might do better than allocating it to United States' equities and perhaps being disappointed with future expected returns.
Jordan Roy-Byrne: Okay, Tiho, before we discuss the outlook for the next 10 years, let's recap performance of global financial assets over the last 10 years.
Tiho Brkan: Sure. Well, I prepared a great chart. This chart is actually from Research Affiliates. They do great charts like this, so you should jump on their website and have a look. They do really, really good research, as I said, and I highly recommend it, so I'm very grateful that they release these charts to private investors like me, like you, and many others who are listening to this podcast.
Clearly, the theme over the last decade has been the US, and that's partly due to the US dollar rally. The US dollar bottomed on 2008, so over the last decade, US assets have outperformed international assets, because assets that are priced in other currencies, international currencies, have been sinking against the US dollar, and therefore, once they're compared to US equities on equal terms, apples to apples, in other words, US dollar-denominated to US dollar-denominated, we see that those assets have underperformed.
So, in particular, US Large Caps and Small Caps, as well as US rates, have performed best over the last 10 years. Therefore, the 60/40 portfolio with the chart that we just discussed, Jordan, for those watching on YouTube or on the blog, that chart of 9.2 years, a record, the longest bull market in a diversified US portfolio, it's done really, really well too. And I think now the 10-year rolling return will soon be from 2009, which was the major low. You will see US assets having a wonderful decade. So, it's going to be a wonderful decade for those, like Warren Buffet who bought at the end of 2008 and made an absolute killing.
Moving along and looking at global financial assets performance of the last three years, which is a little bit of a shorter term time frame and one that I like to invest based on, we see US Large and US Small Caps doing really well. US rates also did pretty well, and therefore, it shouldn't be a surprise that the 60/40 portfolio did better than a lot of the other assets or diversified portfolio strategies precisely because of that. It had a pretty low volatility too, Jordan. So, risk-adjusted returns too are very good.
Jordan Roy-Byrne: Okay, I just want to follow up about that, Tiho. I mean, for something that performs the best over a 10-year period, does that have any staying power over the next 10 years? Does that leadership ever repeat over the following 10 years, or does it tend to mean revert?
Tiho Brkan: Well, the 10 years is not particularly a perfect number. It could be 10, it could be 14, it could be seven. Historically, looking at the relative performance between emerging markets and US stocks or international developed markets, excluding the US against the US stocks, there's been periods where they outperform for a few years, then six or seven years, and then there's a period where the outperformance lasted for 14 or 15 years.
We had a great US dollar bear market after the Plaza Accord in 1985, and European stocks and Japanese equities were flying into the early '90s. Obviously, Japan peaked in 1989, 1990 period, but that was a huge under-performance by United States' stocks. And also, we had another period from 2002 until 2007 when international equities did really well relative to US equities. That was once again because of the US dollar.
So, there's been a lot of periods, some of them last longer, some of them last even shorter, but generally speaking, the trend is not finished until we probably see the peak in the US dollar and a meaningful decline. That kind of started in 2017 but now in 2018, US dollar has recovered back to those levels of late 2017, and we are going through a short squeeze, and obviously, there's a lot of emerging markets and European equities and other asset classes such as commodities which are suffering now.
Commodities have been a disaster. They've been a disaster over a decade, and they've been a disaster over the last three years. Actually, I have some friends who are interested in betting on commodities, and I understand the whole contrarian position. I have looked at charts of commodities that show their relative under-performance and their nominal performance for the 10-year rolling period. It is so bad that we have to go back to the great depression of 1932 to see commodities this weak.
So, from the contrarian aspect, it should rebound eventually. But I don't like investing in any assets that are not income-producing, because if they don't rebound, well, you're not earning any cash flow, and for me, cash flow is the holy grail of finance. I'd rather stick to stocks, bonds and real estate and even private businesses or private equity and so forth. So that, for me, works much better than let's say betting on commodities, which even if the dollar declines might not do so well. That happened during part of the '80s and the '90s.
But to come back to the original question, generally speaking, US equities won't be the only game in town forever, Jordan.
Jordan Roy-Byrne: Okay, Tiho. So, with that said, what can we expect over the next 10 years? I see this chart here, and your favorite sector by this projection is going to produce the best return over the next decade.
Tiho Brkan: Yeah, exactly. I've been very favorable on emerging markets, actually, since late 2015 and early 2016. That's not a secret. And they go through periods of rallies and retreats, and emerging markets are really underperforming over the last six months, once again. I understand that they haven't produced all that well relative to US equities and so forth, but they have done really well since the January 2016 low. They actually bottomed one month before S&P 500 did, which was the February 2016 low. They were up by almost 90% in 24 months. It's only normal for something that goes up so much and has so much of a volatility, (annualized volatility factor to it and more of a riskier asset), for that asset to also correct and have maybe a 17% correction as it has now.
When it comes to expected returns over the next 10 years, they are not set in stone, and these are not something that will definitely happen. It's very difficult to predict the future, this is just something that's a possibility. I'm not sure how much of a possibility, but something like a template that should be used which shows you the valuations of assets that are offered to you around the world. So, it's once again, in my opinion, a big currency play.
The asset classes here that could do well are emerging market equities, emerging market debt, local currency denominated, international stocks in Eurozone and developed Asia. We're looking at Japan, we're looking at the overall EU, European Union, and we're looking at Hong Kong, Singapore, Australia, and the Pacific, those kinds of economies. And then, we're looking at private deals, private real estate, private equity leveraged buy-outs in Europe.
There are plenty of companies, and there is plenty of value after so many crises here in Europe one after another and always some country is having problems. The counter-discussion would be that Europe hasn't solved its problems. There's a lot of debt here, and it's still going to be a disaster. Maybe even the European Union will eventually break up properly or the currency will change, and I get all that. But if none of that happens, you're going to earn a large amount of money in European assets or emerging-market assets. That's clear.
So, the question is, and what I would like to cover in-depth in the next podcast, Jordan, is which one of the countries should we focus on in emerging market region or European region, you know?
Jordan Roy-Byrne: Yes, I'm looking forward to that, but I'm also looking forward to your comments on my next question because let's just do a quick valuation comparison in regards to the CAPE for the US and developed markets against emerging markets.
What I find fascinating right now, Tiho is there's such a huge gap between the CAPE for the US and the CAPE for emerging markets. If you go back over the last 20, 25 years or so, in the mid-'90s, the valuation between the two is the same, also around 2008, also around 2011. So, it looks like over time, at some point, you would expect this gap between the valuation in the US and emerging markets to close.
Tiho Brkan: Yeah, they call it the shark mouth or something like that, right? It's the widespread open jaws, and there's a huge divergence there between asset classes, and clearly, that's happened before.
As we discussed, in 1989, it was Japan that was a total bubble and an absolute screamer, and Japan was so much more expensive than the United States, and in the year 2000, it was the US, and Asia had a catastrophic crash. So did Russia with the bankruptcy and the Asian financial crisis. Also, Latin America was a disaster, Brazil was a disaster into 2001 and so forth. India was also very cheap and plenty of other countries too.
And then in 2007, it was really an over-valuation story with commodities, China, and emerging markets, and they actually became more expensive than any other region for a brief moment there. Then, we had a big crash where everybody lost a lot of money who wasn't smart and stayed invested too close in the trend as it ended, as I said at the beginning of the podcast. And now, we have a divergence. Since 2008, US dollar has been doing very well, and only the US equities, the US bonds, US credit, only these asset classes have outperformed.
So, emerging markets even over the last six months, if you really zoom in on the chart and if you're watching on YouTube or looking at this at Atlasinvestor.com, you can really see that the US is recovering back towards the highs, and the valuations are once again rising. FANG stocks, technology, and Small Caps have already made new highs. At the same time, emerging markets are back to valuations of 2017, so, once again, they're getting cheaper and definitely relatively speaking too. So, the question is, which one of these is very cheap, and this is something we'll be covering in part two of the podcast.
Jordan Roy-Byrne: Yes. Now, finally, a more important question, because you always say, "Don't tell me what to buy, tell me when to buy." So, Tiho, we know that emerging markets are in good position for strong long-term returns, but how do we know when is the time to get into this market without the risk of a sizeable decline before the real bull market starts? It's so difficult to pinpoint that exactly. Can you just share a few of your insights on that question?
Tiho Brkan: Well, first of all, I'm so happy to hear that you remember some of the stuff that I say and repeat, all this great wisdom, you know? It's not going to waste. Yes, so this is the reason why we're making the podcast right now as opposed to when people make the podcast at other times. I like to make podcasts with correct themes and topics around the possible time frames when it's smart to make a timing move into emerging markets. And we can always be wrong about it, and therefore, the number one thing with investing is risk management.
You always protect your downside. You have a stop-loss mechanism. You should have a mental stop-loss, you should balance your portfolio correctly so you don't overweigh a certain asset class that is very volatile and you can get caught in a crash, just as you said. So, emerging markets right now are right at an important polarity line. The previous resistance which lasted for, I believe, 10, or actually 11 years, creating a lost decade is now possibly support. So, we're about to see if it's going to hold.
We had a rebound over the last few days, and emerging markets rebounded right at the point and a support and resistance polarity line where it should have rebounded. Whether they're going to stay here, and whether the US dollar where current sentiment is so high, like nosebleed bullish levels, is going to decline, is another question. An unwinding of US dollar bullish sentiment would really help this region of the world and the equity market here.
So, it's very important to have a look if emerging markets could rebound here, if they will hold a breakout that they succeeded in achieving in late 2017, 2018, and if this previous resistance will now act as a support. That's the key, Jordan. That's why we're talking about emerging markets, this is what we're talking about when we say where to invest next. Has the bull market started, or is this just a false hope and actually a bull trap?
If you do buy and this line breaks, if you're smart about it you should just have a risk protection mechanism in place, and you're not going to lose a lot of money on the bet or speculation. That's what we do here. We try to invest for the long-term by finding the right places and the right times to invest, and then if we're wrong, our downside protection kicks in. If you keep your losses small and you eventually let your profits run, over a long period of time you should do very well.
So, I'm definitely looking at emerging markets, and I'm looking forward to podcast episode number 19, part two of this theme, and discussing which emerging markets could perform well. Also, by that time, we should have a look if emerging market prices will actually follow through and rebound from this support. It's a very important technical area.
Jordan Roy-Byrne: Okay, Tiho, before I let you go, would you please summarize some of the key themes in this podcast?
Tiho Brkan: Sure. Well, the important things to take away is that we're in a late cycle, and the official economic expansion is now approaching post-World War II record, which is 107 months, and we're edging towards 120 if the economy remains strong over the next few quarters.
Valuations are very high for the United States, and therefore, future expected returns could be flat, and it could disappoint a lot of the investors. So, just because the United States has been outperforming for the last nine years, and the bull market is up nine years in a row, and it's the longest ever bull market in a 60/40 stocks and bonds split, doesn't mean that it will continue to be the best out-performer for the next 10 years. That doesn't mean one should get bearish in the US and try to short it, which is what some of the less experienced traders and investors do. It just means that you should maybe reduce your weights in the United States and look elsewhere.
So, we are trying to find out where to look, and according to valuations and the potential of US dollar eventually declining, it's hard to say when, but there's a potential that it could, after rallying and being in the bull market against the Euro and many other currencies for over a decade, that emerging markets, international developed stocks, as well as private equity deals and real estate deals outside of United States, could eventually perform a bit better, and also outperform the United States.
In particular, I like emerging markets, and they happen to be, right now, at a very important technical polarity line, and it's important to watch whether this old resistance will now act as a support. If it does, the breakout that we witnessed over the last six to seven months is most likely real, and emerging markets might have another leg or two higher. That could be very exciting, Jordan, after underperforming and having a lost decade since 2007.