Bubbles/Crises/Manias
Highlights On a timeframe of a few years, a net deflationary shock is a near-certainty even if we do not know its precise nature or its precise timing. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will ultimately reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this presents a mouth-watering 100 percent return on the long-duration T-bond. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should steer towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Fractal trade shortlist: Taiwan versus China, Netherlands versus China, and Sweden versus Finland. Feature Chart I-1For Long-Term Investors, A Shock Is A Near-Certainty Predicting shocks is easy. The precise nature and timing of shocks is not predictable, but the statistical distribution of shocks is highly predictable. This means that the longer our investment timeframe, the more certain we are of encountering at least one shock – even if we cannot predict its precise nature or timing. Many economists and strategists blame their forecasting errors on shocks, such as the pandemic, which they point out are ‘unforecastable.’ Absent the shocks, they argue, their predictions of the economy and the markets would have turned out right. This is a valid excuse for short-term forecasting errors, but it is not a valid excuse for long-term forecasting errors. On a long-term horizon, encountering a major shock, or several major shocks, is a near-certainty. Hence, economists and strategists who are not incorporating the well-defined statistical distribution of shocks into their long-term investment forecasts and strategies are making a mistake. Individual Shocks Are Not Predictable In the 21 years of this century so far, there have been five shocks whose economic/financial consequences have been felt worldwide: the dot com bust (2000); the global financial crisis (2007/8); the euro debt crisis (2011/12); the emerging markets recession (2014/15); and the global pandemic (2020). To these we can add two wide-reaching political shocks: the Brexit vote (2016); and Donald Trump’s shock victory in the US presidential election (2016). In total, this constitutes seven shocks, four economic/financial, two political, and one natural (Chart I-2). Chart I-2The Seven Global Shocks Of The Century (So Far) Some people argue that economic/financial shocks are predictable, because they arise from vulnerabilities in the economy or financial markets, which should be easy to spot. Unfortunately, though such vulnerabilities are obvious in hindsight, the greatest economic minds cannot see them in real time. The greatest economic minds cannot see economic vulnerabilities. Infamously, on the eve of the global financial crisis, Ben Bernanke was insisting that “there’s not much indication that subprime mortgage issues have spread into the broader mortgage market.” Equally infamously, on the eve of the euro debt crisis, Mario Draghi was asking “what makes you think that the ECB must become lender of last resort to governments to keep the eurozone together?” (Chart I-3 and Chart I-4) Chart I-3Bernanke Couldn't See The GFC Chart I-4Draghi Couldn't See The Euro Debt Crisis Which begs the question, what is the current vulnerability that today’s great economic minds cannot see? As we have documented many times, most recently in The Rational Bubble Is Turning Irrational, the current vulnerability is the exponential relationship between rising bond yields and the risk premiums on equities and other risk-assets (Chart I-5 and Chart I-6). Meaning that $500 trillion of risk-assets are vulnerable to any substantial further rise in bond yields. Chart I-5A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... Chart I-6...Than When The Bond Yield Started ##br##At 3 Percent The second type of shock – political shocks – should be predictable as they mostly arise from well-defined events such as elections and referenda, which an army of political experts analyses ad nauseam. Yet the greatest political minds could not see Brexit or President Trump coming. Indeed, even ‘Team Brexit’ didn’t see Brexit coming, because it had no plan on how to implement Brexit once the vote was won. The third type of shocks – natural shocks – are clearly unpredictable as individual events. Nobody knows when the next major pandemic, earthquake, volcano eruption, tsunami, solar flare, or asteroid strike is going happen. Yet, to repeat, while the precise nature and timing of shocks is not predictable, the statistical distribution of shocks is highly predictable. The Statistical Distribution Of Shocks Is Highly Predictable The good news is that shocks follow well-defined statistical ‘power laws’ which allow us to accurately forecast how many shocks to expect in any long timeframe. The 7 shocks experienced through the past 21 years equates to a shock every three years on average, or 3.33 shocks in any 10-year period. The expected wait to the next shock is three years. The next few paragraphs delve into some necessary mathematics, but don’t worry, you don’t need to understand the maths to appreciate the key takeaways. If the past 21 years is representative, we propose that the number of shocks in any 10-year period follows a so-called Poisson distribution with parameter 3.33. From this distribution, it follows that the probability of going through a 5-year period without a shock is just 19 percent, and the probability of going through a 10-year period without a shock is a negligible 4 percent (Chart of the Week). The result is that if you are a long-term investor, then encountering a shock is a near-certainty and should be built into your investment strategy. How can we test our assumption that the number of shocks follows a Poisson distribution? The maths tells us that if the number of shocks follows a Poisson distribution with parameter 3.33, then the ‘waiting time’ between shocks follows a so-called Exponential distribution also with parameter 3.33. On this basis, 63 percent of the waits between shocks should be up to three years, 23 percent should be four to six years, and 14 percent should be over six years. Now we can compare this expected distribution with the actual distribution of waits between the 7 shocks encountered so far in this century. We find that the theory lines up closely with the practice, validating our assumption of a Poisson distribution (Chart I-7 and Chart I-8). Chart I-7The Theoretical Waiting Time Between Shocks… Chart II-8…Is Close To The Actual Waiting Time Between Shocks To repeat the key takeaways, on a long-term timeframe, encountering at least one shock is a near-certainty, and the expected wait to the next shock is three years. A Shock Is A Near-Certainty, And It Will End Up Deflationary Nevertheless, there remains a pressing question: Will the next shock(s) be deflationary or reflationary? It turns out that all shocks end up with both deflationary and reflationary components: either a deflationary impulse followed by a reflationary backlash or, as we highlighted in The Road To Inflation Ends At Deflation, a reflationary impulse followed by a deflationary backlash. But the crucial point is that the deflationary component will swamp the reflationary component. In the seven shocks of this century so far, six have been deflationary impulses with a weaker reflationary backlash; and one – the reflation trade of 2017-18 – was a reflationary impulse with a stronger deflationary backlash. It is our high conviction view that in the next shock(s), the deflationary component will continue to hold the upper hand (Chart I-9). Chart I-9Each Shock Has A Deflationary And Reflationary Component... But The Deflationary Component Tends To Dominate The simple reason is that as financial asset prices, real estate prices, and debt servicing costs get addicted to ever lower bond yields, the economy and financial markets cannot tolerate bond yields reaching previous tightening highs and, just like all addicts, need a new extreme loosening to feel any stimulus. This means that when the next shock comes – as it surely will – it will require lower lows and lower highs in the bond yield cycle. Let’s sum up. On a timeframe of a few years, a shock is a near-certainty even if we do not know its precise nature – economic/financial, political, or natural – or its precise timing. Furthermore, the shock will be net deflationary. Hence, investors must build such a deflationary shock or shocks into their long-term investment strategy. Specifically: The 10-year T-bond yield will eventually reach zero, and the 30-year T-bond yield will ultimately reach 0.5 percent. For patient investors, this constitutes a mouth-watering 100 percent return on the long-duration T-bond. The 10-year T-bond yield will eventually reach zero. The structural bull market in equities will continue until T-bond yields reach their ultimate low. Patient equity investors should tilt towards ‘growth’ sectors that will surge on the ultimate low in T-bond yields. Candidates For Countertrend Reversals This week we have noticed an unusual decoupling among the tech-heavy markets of Taiwan, Netherlands, and China (Chart I-10). Chart I-10An Unusual Decoupling Between Tech-Heavy Netherlands And China Among these three markets, the strong short-term outperformance of both Taiwan and Netherlands are due to supply bottlenecks in the semiconductor sector that have boosted Taiwan Semiconductor Manufacturing and ASML, but we expect these bottlenecks ultimately to resolve. On this basis and combined with extremely fragile 130-day fractal structures, Taiwan versus China and Netherlands versus China are vulnerable to reversals (Chart I-11 and Chart I-12). Chart I-11Underweight Taiwan Versus China Chart I-12Underweight Netherlands Versus China Our first recommended trade is to underweight Netherlands versus China, setting a profit target and symmetrical stop-loss at 5 percent. Another outperformance that looks fragile on its 130-day fractal structure is Sweden versus Finland, driven by industrials and financials versus energy and materials (Chart I-13). Chart I-13Underweight Sweden Versus Finland Our second recommended trade is to underweight Sweden versus Finland, setting a profit target and symmetrical stop-loss at 4.7 percent. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The post-2008 boom in stocks, corporate bonds, and real estate is a ‘rational bubble’, because the relationship between risk-asset valuations and falling bond yields is exponential. But the ‘rational bubble’ is turning into an ‘irrational bubble’. Stay tactically neutral to stocks for the next few weeks to see whether valuation can revert to rationality. This means keep existing investments in the market, but hold fire on new deployments of cash. If valuation reverts to rationality, then investors can safely deploy new cash into the market. But if valuation moves into irrationality, then it will require a completely different investment mindset, in which fractal analysis will become crucial in identifying the bursting of the bubble, just as it did in 2000. Fractal trade: the Chinese stock market is vulnerable to correction. Feature Chart of the WeekA 'Rational Bubble' And An 'Irrational Bubble' Regular readers will know that we have characterised the post-2008 boom in stocks, corporate bonds, and real estate as a ‘rational bubble’. Rational, because the nosebleed valuations are justified by a fundamental driver. And not just any fundamental driver, but the most fundamental driver of all – the bond yield. However, the ‘rational bubble’ is turning into an ‘irrational bubble’, akin to the dot com mania in which valuations became totally disconnected from fundamentals (Chart of the Week). What should investors do? The Relationship Between Bond Yields And Risk-Asset Valuation Is Exponential Everyone realises that a lower bond yield justifies a lower prospective return from competing investments, such as stocks, corporate bonds, and real estate. As valuation is just the inverse of prospective return, a lower bond yield justifies a higher valuation for all risk-assets. (Chart I-2). Chart I-2House Prices have Decoupled From Rents Again (And It Didn't End Happily Last Time) But few people realise that a lower bond yield justifies an exponentially higher valuation for risk-assets. To visualise this exponential relationship, look again at the Chart of the Week. The bond yield is plotted on a logarithmic (and inverted) left scale, while the stock market forward price-to-earnings is plotted on a linear right scale. The inverted log versus linear scales demonstrate that, in the ‘rational bubble’, the lower the bond yield, the greater the impact of a given decline in the bond yield on stock market valuation. Few people realise that a lower bond yield justifies an exponentially higher valuation for risk-assets. Chart I-3 and Chart I-4 also demonstrate the exponential relationship using the earnings yield as a proxy for the prospective return on stocks. A 1.5 percent decline in the bond yield had a smaller impact on the earnings yield when the bond yield started at 4 percent in 2014 than when the bond yield started at 3 percent in 2019. At the higher bond yield, the prospective return on stocks fell by 1 percent, but at the lower bond yield, the prospective return on stocks plunged by 2.5 percent. Chart I-3A 1.5 Percent Decline In The Bond Yield Had A Smaller Impact On The Earnings Yield When The Bond Yield Started At 4 Percent... Chart I-4…Than When The Bond Yield Started ##br##At 3 Percent To repeat, the lower the bond yield, the greater the impact of a given move in the bond yield on the prospective return from stocks. The intriguing question is, why? To answer this question, we must venture into a branch of behavioural psychology developed by Nobel Laureate Daniel Kahneman and Amos Tversky, called Prospect Theory. Prospect Theory Explains The ‘Rational Bubble’ Prospect Theory’s key finding is that we consistently overvalue the prospect of a tail-event, both positive and negative. For example, if there is a one in a million chance of winning a million pounds, then the expected value of this prospect is one pound. Yet we will consistently pay more than one pound for this positive tail-event. This willingness to overpay for a positive tail-event is the foundation of the multi-billion pound gambling and lottery industry. Now consider an ‘inverse lottery’, in which there is a one in a million chance of losing a million pounds. In theory, we should take on the risky prospect for one pound. Yet in practice, we will consistently demand more than one pound to take on this negative tail-event. In other words, we will demand a substantial ‘risk premium’. Prospect Theory explains that we overvalue tail-events because we are bad at comprehending small probabilities. Hence, the prospect of winning a million pounds, while in practice a negligible possibility, generates excessive optimism which results in overpayment for the bet. Likewise, the possibility of losing a million pounds, while in practice a negligible possibility, generates excessive pessimism, for which we demand payment of a ‘risk premium’. In the financial markets, stock markets tend to ‘gap down’ much more than they ‘gap up’. Hence, the risk of owning stocks is like the discomfort of the inverse lottery. This explains why investors normally demand a risk premium – an excess prospective return – to own stocks versus bonds. However, the risk relationship between stocks and bonds changes when bond yields approach their lower bound. Now, as bond yields have less scope to move down versus up, bond prices can gap down much more than they can gap up. The upshot is that the risk of owning bonds becomes no different to the risk of owning stocks, and the risk premium to own stocks versus bonds disappears. At ultra-low bond yields, the bond yield and the equity risk premium move up and down in tandem. Given that the prospective return on stocks equals the bond yield plus the risk premium, we can now answer our intriguing question. At ultra-low bond yields, the prospective return on stocks moves by more than the move in the bond yield, because the bond yield and the risk premium are moving up and down in tandem. The result is an exponential relationship between the bond yield and risk-asset valuations. And this explains how the post-2008 collapse in bond yields to unprecedented lows has generated a ‘rational bubble’ in stocks, corporate bonds, and real estate (Chart I-5 and Chart I-6). Chart I-5A Rational Bubble In Risk-Assets... Chart I-6...Everywhere The Rational Bubble Is Turning Irrational The post-2008 boom in risk-asset valuations is rational given the exponential relationship with a collapsed bond yield. But the rational valuation is turning irrational. Over the past few months, the stock market’s forward price-to-earnings multiple has continued to increase despite a backup in the bond yield. Note that this multiple is calculated on the next 12 months of earnings, so it already incorporates a strong post-pandemic earnings rebound (Chart I-7). Chart I-7The Rational Bubble Is Turning Irrational Furthermore, since 2009, the bond yield (plus a fixed constant) has defined a reliable lower limit for the technology sector earnings yield, meaning a well-defined upper limit for the technology sector’s valuation. Since 2009, this valuation limit has effectively defined the limit of the rational bubble and hasn’t been breached. That is, until now. The recent breach of the post-2008 valuation limit means that the rational bubble is turning irrational (Chart I-8). Chart I-8The Post-2008 Rational Valuation Limit Has Been Breached There are three ways that an irrational valuation can revert to rationality: Stock prices decline. Bond yields decline. Stock prices and bond yields drift sideways while (forward) earnings gradually rise to improve stock valuations. The Investment Decision The decision to be invested in the stock market is probably the most important decision for all investors, including those in Europe. Furthermore, the direction of the stock market is a global rather than a local phenomenon. Our current recommendation is to stay tactically neutral for the next few weeks to see whether risk-asset valuations can revert to rationality. This means keep existing investments in the market, but hold fire on new deployments of cash. Hold fire on new deployments of cash. If valuation reverts to rationality in any of the three ways listed above, then investors can safely deploy new cash into the market. But if valuation turns into irrationality, then it will require a completely different investment mindset. After all, you cannot analyse an irrational market using rational tools! In this case, technical analysis becomes much more important, and front and centre of these techniques is fractal analysis. Specifically, as investors with longer and longer time horizons join the irrational bubble, there will be well-defined moments of heightened fragility, at which correction risk increases. This is what burst the irrational bubble in 2000 (Chart I-9), and will burst any new irrational bubble. Stay tuned. Chart I-9The Dotcom Bubble Burst When All Investment Time Horizons Had Joined It Fractal Trading System* The recent strong rally and outperformance of the Chinese stock market is fragile on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to underweight China versus New Zealand (MSCI indexes), setting a profit target and symmetrical stop-loss at 9 percent. In other trades, the continued momentum of reflation plays has weighed on some recent positions as well as stopping out short MSCI World versus the 30-year T-bond. Nevertheless, the rolling 12-month win ratio stands at 54 percent. Chart I-10MSCI: China Vs. New Zealand When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights There is too much euphoria and complacency in global markets. The main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. Yet, it does not mean that the bull market will continue uninterrupted. This rally might be short circuited by gravitational forces as happened with the S&P 500 in 1987 and Chinese onshore stocks in 2015. Investors should consider going long EM equity or EM currency volatility to hedge their exposure. Feature There is growing evidence that the global equity rally has turned into a frenzy. Signs of investor euphoria include: The number of traded call options in the US equity market has surged to an all-time high (Chart 1). The number of put options has spiked only in the past couple of weeks and remains well below the number of call options. Chart 1A Call Buying Frenzy Is A Symptom Of Investor Exuberance Critically, there is currently too much complacency: the US put-call ratio is as low as it was in 2000 (Chart 2). The volume of stocks traded on and off all US stock exchanges has exploded since late October, reaching an all-time high (Chart 3). Chart 2A Sign Of Equity Market Complacency Chart 3US Equity Trading Volumes Are At All-Time Highs Chart 4Retail Investors Haven Been A Powerful Force In Korea And Taiwan Equity fervor is prevalent not only among American individual investors but also in many parts of the world. For instance, the breathtaking rallies in the KOSPI and Taiwanese stocks has been primarily driven by local retail investors, as shown in Chart 4. The surge in Taiwanese share prices is stunning because it completely ignores the escalating geopolitical tensions over Taiwan. BCA Research’s Chief Geopolitical Strategist, Matt Gertken, recently argued that while China is unlikely to invade Taiwan immediately, a military stand-off cannot be ruled out. China and the US have yet to arrive at a mutual understanding regarding China’s access to computer chips made in Taiwan. Overall, since the lockdowns in March last year, individual investors have rushed into equities in many countries such as the US, Korea, Taiwan, Japan, India and Brazil, to name a few. Finally, US institutional investors are fully invested, as shown in Chart 5. Besides, Chart 6 reveals that US-domiciled EM equity mutual funds’ liquidity ratio (cash as a percentage of assets) is very low. Chart 5US Institutional Investors Are Long Stocks Chart 6US-Domiciled EM Mutual Funds' Cash Is Low There have been doubts within the global investment community about the potential for small individual investors to move the needle in the overall market. We believe that their impact has been substantial: First, there is plenty of anecdotal evidence to suggest that individual traders have been involved in options trading since the pandemic erupted. By purchasing call options, retail investors exert substantial upward pressure on share prices: dealers – who sell/write call options – typically hedge their risks by acquiring and holding the underlying stock for the duration of respective options. In short, by putting even small amounts of money at work to purchase call options, individual traders meaningfully affect share prices. Second, price formation in financial markets is influenced by the marginal investor. Everything else being equal, the entry of a new buyer into the marketplace leads to higher prices. Further, retail investors’ impact on financial markets has not been limited solely to stocks they purchase. Rather, there has been a ripple effect on the broader market. For instance, there is evidence that individual investors flocked to the market in March and April and bought en masse shares of companies most negatively affected by the pandemic, such as cruise operations, hotels, airlines and energy producers. As individual investors provided substantial bids for these stocks, institutional investors were able to offload these stocks and buy others. For instance, in Q2 last year Warren Buffett offloaded his airline stocks and allocated that capital to natural gas storage and pipelines, banks, pharma and auto stocks. If retail investors had not provided support to stocks of companies hit hard by the lockdowns and social distancing, Warren Buffett and other professional investors would not have had the opportunity to exit their positions in these stocks at acceptable prices and acquire other securities. This is the mechanism whereby the impact of new market entrants extends beyond the specific equities they purchase. Chart 7A Mini Call Option Mania Among Retail Investors Finally, Charts 1 and 3 above clearly illustrate the surge in both the number of call options and trading volumes since last March. Among call options, transactions with a small number of options have ballooned (Chart 7). This reflects individual investors activity. Consistently, the number of brokerage accounts for retail investors has mushroomed in the US and elsewhere. Bottom Line: It is obvious that the ongoing equity market euphoria is considerable. Individual investors have been playing a vital role in fostering it. The GameStop stock saga, among others, reinforces this point. When And How Will It End? This bull market shares some similarities with previous market cycles, but it also has its distinct features. Similarities: Retail investors typically rush into financial markets toward the end of a bull market. The current US equity market rally began in 2009. After the S&P 500 showed its resilience by rebounding quickly and making new highs following the selloffs in 2015, 2018 and 2019, retail investors were reassured to jump on the bull market train when the 2020 crash occurred. In short, it took about 11 years of a US equity bull run for individual investors to feel comfortable enough to play the stock market. This is a characteristic of a late cycle/mature bull market. Speculative instruments and schemes are designed and launched. The IPO boom in SPACs1 will probably go down in history as a key feature of the speculative excesses in this cycle. Valuations overshoot during stock market euphoria but investors find reasons to justify lofty equity multiples. FAANGM stocks and other parts of the US equity market are expensive, but investors are using extremely low US bond yields – artificially suppressed by the Federal Reserve – to justify the current multiples. In such a case, the bond market will likely hold equities hostage. As bond yields rise going forward, equity valuations will be threatened. In fact, we believe rising bond yields, not the outlook for economic growth, to be the primary risk to US share prices akin to the late 1960s (Chart 8). Differences: Typically, retail investors feel comfortable investing in the stock market when the economy is strong. In this cycle, they jumped on the stock market train when the economy crashed due to the pandemic. This is a departure from previous cycles. Massive stimulus and ongoing vaccination deployment suggest the economic outlook for the US and many emerging economies is positive. In particular, EM corporate profits are set to recover (Chart 9). Chart 8The US In The 1960s: Share Prices And Treasury Yields Chart 9EM EPS Is To Recover Hence, it is hard to be bearish on stocks based on the cyclical outlook for growth, assuming vaccination campaigns will allow many major economies to fully reopen in H2 2021. Yet, a lot of this good news seem to be already priced in. Retail investors arrive to the stock market party usually in the late stage of a business cycle – when unemployment is low, inflation is rising, and policymakers are tightening policies. That combination proves lethal for the equity market and a major top in share prices ensues. Presently, due to the pandemic-induced lockdowns, we have the opposite occurring in the US and in many EM economies. Unemployment is high, inflation remains contained, and policymakers are committed to providing unlimited stimulus. In short, the main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. History doesn't repeat itself, but it does rhyme. Does it mean that the bull market will continue uninterrupted? Not necessarily. This rally might be short circuited for reasons that may differ from those that terminated previous stock market frenzies. First, speculative bubbles could burst without policy tightening. An example of this is China’s equity bubble in 2015, which crashed without policy tightening due to gravitational forces reasserting themselves. Another example is the 1987 US stock market crash that occurred without an economic or fundamental financial cause. Chart 10 illustrates the cyclical trajectories of US GDP and the Fed funds rate did not change materially before and after the equity market crash. In short, the 1987 equity crash was a case when excessive speculation/overbought conditions rather than policy tightening or a recession caused an abrupt equity sell-off. Second, in the EM equity universe, leadership has been extremely narrow. Only a handful of companies have outperformed the aggregate benchmark, propelling the index to 2007 highs. These include a few Chinese new economy stocks, and Korean and Taiwanese technology stocks (Chart 11). Outside North Asian markets (China, Korea and Taiwan), every single EM bourse has underperformed both the EM and global equity benchmarks in the past year. Chart 10The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy Chart 11Euphoria In Asian TMT Stocks Chart 12Global ex-TMT Stocks Have Not Broken Out Yet If these global and EM TMT stocks relapse, they will inflict major damage on the EM and global indexes. The EM index has become extremely concentrated with the top five stocks accounting for 24% of the MSCI EM equity index’s market cap. Interestingly, global ex-TMT stocks have not yet broken out to new highs (Chart 12). Finally, US overall equity and global TMT valuations are vulnerable to rising US bond yields. The latter could rise without the Fed hinting at policy tightening if fixed-income investors decide that the Fed is behind the inflation curve. This could trigger a major selloff even if policymakers do not tighten policy. Investment Conclusions Chart 13Go Long EM Equity And Currency Volatility We are in a euphoria phase where fundamentals are less pertinent. The market can either rally a lot or sell off hard regardless of the profit outlook. Navigating through such markets is challenging. Going long EM equity or EM currency volatility offers a good risk-reward profile (Chart 13). Volatility will likely rise in the coming months in both scenarios: either risk assets continue rallying or they sell off. For global equity and credit portfolios, we continue recommending a neutral allocation to EM. The long-term US dollar outlook is negative, but it is oversold and odds of a near-term rebound are still high. Our currency strategy remains to short a basket of EM currencies versus an equal-weighted average of the euro, CHF and JPY. This basket of EM currencies includes the BRL, CLP, ZAR, KRW and TRY. We continue receiving 10-year swap rates in Mexico, Colombia, Russia, China, India, Indonesia and Korea. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Special Purpose Acquisition Companies (SPAC), also known as “blank check companies”, are organizations with no commercial operations that raise capital through an IPO, which is then deployed to purchase an existing company. This process is done to bypass the lengthy process of launching a traditional IPO for a young company. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Recommended Allocation Chart 1Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3). Chart 2New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3). Chart 6The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide Chart 9Bankruptcies Are Surging… Chart 10...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off Chart 13Hedge Against A Disputed Election Result Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic Chart 16Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market Chart 18EM Stocks Are Cheap Chart 19Short USD Is Now A Consensus Trade Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation
Highlights ‘Value’ sector profits are in terminal decline. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain. Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources. Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. As such, structurally overweighting the value-heavy European market versus the growth-heavy US market is a ‘widow maker’ trade. The caveat is that a vicious snapback out of growth into value is possible when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. This would create a burst of outperformance from Europe, but any such snapback would be a brief interruption to the mega downtrend. Fractal trade: Long RUB/CZK. Feature Chart of the WeekValue' Has Underperformed For 12 Years... But The Mega Downtrend Isn't Over I have just returned from a summer holiday, on which I took a clean break from the financial markets. A clean break that is highly recommended for anybody who looks at the markets day in, day out. Nevertheless, I made two market-relevant observations. First, that having to wear a face mask on an aeroplane was an unpleasant experience. Tolerable for a short-haul flight lasting a couple of hours, but something that would be unbearable for the duration of a long-haul flight. Second, that even the most popular bars and restaurants in the most popular places were operating at half capacity. They were fully booked, yet the requirements of physical distancing at the bar, and between tables, meant that their operating capacity and revenues had collapsed. Worse, the owners feared a further hit in the winter when eating and drinking in their outdoors spaces became impossible. The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others. These first-hand experiences simply confirm the message in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs.1 The use of face masks and physical distancing cripples any economic activity that requires you to have your (uncovered) mouth and nose in proximity to others – like flying, or drinking and eating out. Hence, if governments remove the financial incentives for employers to retain workers while the pandemic is still rampant, expect structural unemployment to rise sharply. In which case, expect bond yields to remain ultra-low, and where possible, go even lower. And expect ‘growth’ sectors to continue outperforming ‘value’ sectors. Explaining Recent Market Action Returning to the financial markets after a break, several things stood out. Apple has become America’s first $2 trillion company, while HSBC’s share price is within a whisker of its 2008 crisis low. This vignette encapsulates that growth sectors – broadly defined as tech and healthcare – have been roaring ahead, while value sectors – broadly defined as banks, oil and gas, and basic resources – have been struggling. Hence, the growth-heavy S&P500 has reached a new all-time high, while the value-heavy FTSE100 and other European indexes are still deeply in the red for 2020 and have recently drifted lower (Chart I-2). The combined effect is that the strong recovery in global stocks has taken a breather. Chart I-2US Market At All-Time High, But European Markets Still Deeply In The Red In turn, the breather in the stock market explains the recent support to the dollar. Significantly, the 2020 evolution of the dollar is a perfect mirror-image of the stock market. Nothing more, nothing less. If the stock market gives back some of its gains, expect the countertrend strengthening in the dollar to continue (Chart I-3). Chart I-3The Dollar Is A Mirror-Image Of The Stock Market Yet the best performing major asset-class in 2020 is not growth equities, nor is it gold. Instead, it is the US 30-year T-bond, which has returned a spectacular 32 percent (Chart I-4). Chart I-4The Best Performing Major Asset-Class Is The 30-Year T-Bond Suddenly, everything becomes crystal clear. If the ultra-long bond has surged, then other ultra-long duration investments must also surge. Within equities, this means that growth sectors, whose profits are skewed to the very distant future, must receive a huge boost to their valuations. Whereas value sectors whose profits are not growing will receive a smaller (or no) valuation boost. In fact, the value sectors have a much bigger structural problem. Not only are their profits not growing. Their profits are in terminal decline. Since 2008, Overweighting Value Has Been A ‘Widow Maker’ In the 34 years through 1975-2008, value trebled relative to growth.2 Albeit, with the occasional vicious countertrend move, such as the dot com bubble. But through 2009-2020, the tables turned. For the past 12 years, value has structurally underperformed growth and given back around half of its 1975-2008 outperformance (Chart of the Week). This means that for the past 12 years ‘proxy’ value versus growth positions have also structurally underperformed. The best example of such a proxy position is overweighting the value-heavy European market or Emerging Markets versus the growth-heavy US market. Since 2008, underweighting the US market has been a ‘widow maker’ trade. A widow maker trade is when you are on the wrong side of a megatrend. A widow maker trade is when you are on the wrong side of a megatrend. It is a widow maker because it can kill your career, or your finances, or both. The big danger is that a widow maker trade can last for decades. As the uptrend in value versus growth lasted more than three decades, there is no reason to suppose that the downtrend cannot also last a very long time. What drove value’s outperformance for 34 years, and what is driving its underperformance for the past 12 years? The simple answer is the structural trend in profits. Until 2008, the profits of banks, oil and gas, and basic resources kept up with, or even beat, the profits of technology and healthcare. This, combined with the higher yield on these value sectors, resulted in the multi-decade 200 percent outperformance of value versus growth. But since 2008, while the profits of technology and healthcare have continued their strong uptrends, the profits of banks, oil and gas, and basic resources have entered major structural downtrends. It is our high conviction view that these declines are terminal, and the reasons are nothing to do with the pandemic (Chart I-5). Chart I-5Value Sector Profits Are In A Major Structural Downtrend Sector Profit Outlooks In One Sentence Each When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Essentially, the sector has entered a terminal decline. As strong believers in brevity, we can summarise the reason for the terminal declines in one sentence per sector, as follows: When a sector’s profits flip from a multi-decade uptrend to a multi-decade downtrend, it is almost unheard of for them to reflip into a new uptrend. Bank profits are in terminal decline, because private sector credit is now ‘maxed out’, and the intermediation between borrowers and savers can be done more cost-effectively by the blockchain (Chart I-6). Chart I-6Bank Profits In Terminal Decline Oil and gas profits are in terminal decline, because we now rely less on the energy stored in ‘chemical bonds’ of portable fossil fuels, and rely more on the energy of ‘moving electrons’ generated from unportable alternative energy sources (Chart I-7). Chart I-7Oil And Gas Profits In Terminal Decline Basic resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources (Chart I-8). Chart I-8Basic Resources Profits In Terminal Decline Conversely: Technology profits can grow, because we now rely more on information, ideas, and advice, and over half of the world’s population is still not connected to the internet (Chart I-9). Chart I-9Technology Profits Continue To Grow Healthcare profits can grow, because as economies (and people) mature, they spend a much greater proportion of their income on healthcare to improve the quality and quantity of life (Chart I-10). Chart I-10Healthcare Profits Continue To Grow Nevertheless, a vicious snapback out of growth into value is possible. Indeed, it is to be expected when a universally accepted treatment for Covid-19 is found. Or if bond yields spike. But any such snapback, even if vicious, will be a brief countertrend rally in a terminal decline. This is because the megatrends driving down value sector profits were already in place long before the pandemic hit. The pandemic just gave the megatrends an extra nudge. This is our high conviction view. Fractal Trading System* This week’s recommended trade is long RUB/CZK, with the profit target and symmetrical stop-loss set at 5 percent. In other trades, the explosive rallies in precious metals reached exhaustion as anticipated by their fragile fractal structures. This has taken our short gold versus lead position into profit. However, short silver was stopped out before its rally eventually ended. The rolling 1 year win ratio now stands at 60 percent. Chart I-11RUB/CZK When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs", dated July 30, 2020 available at eis.bcaresearch.com. 2 In total return terms. 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