This week we will look at a few charts and discuss a macro thesis, which is based on key beliefs, which I will discuss below.
This investment premise today is essentially based off of a set core world views, and placing long term bets on those world views as to CB action and where we are in the business cycle.
It is less about making grand predictions about the end or continuation of the U.S. bull market or even setting SPX targets, all of which are increasingly meaningless to my methodology.
My approach is to favour to favour undervalued assets, which today would be selected emerging markets and commodity assets, and escrew overvalued / popular assets, which today could include areas like speculative US biotech stocks.
This approach will not outperform in the short term, but I'm confident buying assets when nobody wants them and exercising patience, is the path to long term outperformance. I'll discuss a few ideas below.
Core world views, and related probabilities, with associated trades:
1. CB's are determined to create inflation, are terrified of repeating mistakes of the 1930's by tightening too soon, and will not be rushed. They continue to talk a responsible game about tightening (aka the Fed) but in the end will not tighten until forced to by increasing inflation expectations, and resultant sell off in long term bonds. This is similiar to many past cycle's. Eventually Bond markets will lose patience with the Fed and other CB's, and move rates for them.
Btw --- The long term Fed Funds curve is predicting a very, very slow rise in short rates. The risk here is definately that the market has it wrong.
Related probability: A large chance of sector outperformance in inflation - related stocks, like metals, agriculture, and energy, and a move higher in long term treasury rates.
Trade: Buy inflation assets, and short long term treasury bonds.
On a long term chart, TLT has broken down from a spike top at the beginning of 2015. A reasonable target might be the 2014 lows around 105. Time will tell if this move would affect stocks adversely, or a bigger move would be required. I believe the answer would be the markets perception on whether the move is caused more by increasing inflation expectations vs healthy growth rates.
I will reiterate historically the average real yield, or yield plus core inflation, has been 2% for 10 year bonds. Currently, with core CPI at 1.8%, this would make 10 year yields 3.8%, vs 2.2% currently.
2. Inflation expectations are increasing, and the prerequisites are there for higher levels of increase:
Wages are increasing at the bottom end -- I think this is key. A slew of fast food outlets, restaurants, and retailers have (been forced to by labour supply) to raise wages. I believe this is the start of a trend, with almost record low jobless claims, and will feed into CPI in time.
Oil appears to have bottomed.
Health care costs are up.
Rental and housing costs are soaring. Their is a huge underlying housing demand because of this and household formation outstripped new home sales for a number of years.
While much of this -- like wages -- are good for the economy, I think the jury is out on how good these developments will be for financial assets, after so many years of markets thriving on weak wage growth and middling economic data. What do markets want, is the question -- a roaring economy or permanent zero bound rates? We will see in time. For now if these changes develop, asset allocation is key.
The Trade: Short companies affected by higher wage growth, and potentially, higher food costs. (I'm short 2 of these) So far, my bets on agriculture (corn and soybeans) have not worked out, in spite of a firmer oil price, and the most lopsided bearish sentiment on these commodities since at least 1991.
However, 2 related Ag companies are breaking out here from long term bases, and I am long both, (NYSE:CF) and (NYSE:DE) Stocks often lead commodity movements. I firmly believe, these commodities may move higher soon, and I am waiting on a trend reversal to re-enter these trades.
3. U.S. markets are overowned, popular, and pricey, while emerging markets (except China) are ignored, much cheaper, with both higher growth rates and greater margins of safety.
Probability: EEM emerging markets will outperform SPX over the next major bull cycle.
The trade: Allocate to EEM broadly long term capital, or to selected regional or country ETF's. Let's conclude by looking at one distressed country that at one time was one of the worlds brightest stars, Brazil. (NYSEARCA:EWZ).
There is no doubt Brazil is a huge mess today, but one must look ahead. What if the present government is impeached (a fairly good possibility according to reports) and a new, pro capitalism government takes power, that regains the trust of investors and the public, at the same time a higher inflation period takes hold, favouring commodity assets so important to Brazil?
A subset of this would be instead of buying US Shale oil producers with high debt loads and (according to some) questionable reserves, allocate to international, cheap conventional names. Everyone is chasing yield today, but with my view on higher rates, that's exactly the wrong thing to do.
2 suggested names would be Seadrill (NYSE:SDRL) and Petrobas (NYSE:PBR) PBR is affected by confidence in Brazil -- but what is overlooked is their absolutely massive, proved reserves. Now the risk that has been priced into the stock is nationalization and to do with the recent scandals -- but that's when one should take a look, as China has, extending a massive credit facility.
SDRL blew up over their Russia connections and low oil prices --- lets remember they have the best, youngest offshore drilling fleet in the world.
To close, From my chair of 16 years as a floor trader turned investor, there are few industries more ethically questionable than the vast majority of mutual funds, hunting down Mom and Pop through their "licensed and certified" , your Financial Adviser or Certified Financial Planner.
These folks are so often nothing but salesmen for the mutual fund industry, and it's all about AUM -- assets under management -- and driving those fees. Switching fees, front end fees, back end, trailer, the list is endless. Churning accounts, special leveraged loan products, nothing is too much in the search for fees.
There are few industries I have greater disdain for. Be careful who you listen to. There are some good advisors out there, but rare. The conflicts of interest are great.
Buy assets when no one wants them. Best wishes to all investors.
Disclosure: The author is long PBR, SDRL, DE, CF.
Additional disclosure: Consult advisor, author is not a professional or licensed. Readers must do their own due diligence. Short TLT via puts. Author has multiple positions that change as required, without notice. This is not investment advice..