Lyn Alden's Expectations for the Next Decade
US Stocks, Bonds, & Gold
(Last edited on Oct. 2, 2020 and prior to that on Jan. 24, 2020)
Overview. I provide broad brush strokes discussing asset allocation across US stocks, US bonds, and gold when the holding period is expected to be a decade. This material comes from Lyn Alden. I then provide
my own thoughts; I've done this in blue font. Finally, I provide
my afterthoughts, which I've done in purple font.
Outline
- US Corporate Earnings
- Short-term vs Long-term Forecasting
- US Stock Returns over the Next Decade
- Stocks vs Bonds?
- Stocks vs Gold?
- US vs International Stocks (& US Dollar)
- Concluding Remarks
Corporate Earnings
Last year (2019), the US stock market (as represented by the S&P 500) returned almost 30% whereas the year before it, returns were -6%; source. Looking at corporate earnings -- this chart -- you wouldn't have guessed so; corporate earnings grew by 20% in 2018 and by less than 1% in 2019.
Lyn Alden describes the current situation for corporations as follows:
"With corporate earnings growth at a potential standstill against a backdrop of rising labor costs and heavy balance sheets, the next step for many corporations if they want to further boost their earnings in the short term is to reduce their labor force.
And rising unemployment is typically the final nail on the coffin for a business cycle. We haven’t had that yet during this business cycle."
My personal thoughts: (1) John Hussman has been pointing out deteriorating market internals for a while; for example, see this Tweet. (2) Many pundits are forecasting a US recession sometime in 2020 or otherwise in 2021. See Duke CFO Survey via this Tweet. A US recession would be bearish for stocks ...
Short-term vs Long-term Forecasting
Lyn Alden writes,
"It is one of those unintuitive aspects of finance that it is easier for fundamental investors to predict long-term returns than short-term returns, although both exercises are quite challenging."
These charts contain supporting evidence if not a definite proof. They show that forward P/E ratios have a higher correlation with returns over 5 years than with returns over 1 year. (This correlation corresponds to the "R^2" figures in the charts. "R^2" is read as "R-squared".) The difference is by a factor of almost 5: R^2 of 46% vs R^2 of 10%.
The thing to note is as follows. In moving from the chart on the left to the one on the right, the dispersion of dots around the orange trendline shrinks. Its meaning is that there's less variance in 5-year forward returns than in 1-year forward returns.
US Stock Returns over the Next Decade
The Cyclically-adjusted Annualized S&P 500 Earnings Yield (blue line) has a high correlation with forward 10-year returns (orange bars). This can be
visually confirmed from this chart. (Cyclically-adjusted Annualized S&P 500 Earnings Yield is simply 1 divided by CAPE Ratio where CAPE Ratio is the Shiller P/E Ratio. This is none other than Stock Price divided by
10 years worth of Earnings averaged. For more details, see
here.)
US stock forecast for the coming decade: Not good. The blue line is the second lowest it has ever been since 1925, almost 100 years ago. (This forecast is consistent with John Hussman's; see
here for example.)
Since inflation is a factor influencing consumption, it may be preferable to look at real returns instead of nominal returns. The above chart showed stock returns in nominal terms. This chart (orange bars) shows them in real terms. The blue line is the same as before.
The point here is that currently the Inverse CAPE Ratio is low. At two other instances in history, when this Ratio was low, inflation decimated stock returns. That was in the late 60's and early 70's and for a shorter period in 1999 and 2000. Could this happen again? Hmmm ...
My personal thoughts: John Hussman says that if we sorted the S&P 500 constituents by P/S ratio and grouped them into deciles, we would see that all deciles are overvalued relative to their own history; see chart via this Tweet. So, what is an investor who is still interested in investing in US stocks supposed to do? It might make sense to partition the universe of stocks by economic sector and sort by P/S ratio ... Then, one would invest in the low P/S sectors or go long the low P/S sectors while shorting the high P/S sectors. Since the energy sector is the sector with the worst return over the past 10 years, it may very well be the sector with the lowest P/S ratio ...
I did a Google search and discovered that Barclays has products based on sector CAPE ratio; see here for an Index which invest in the US. They also have similar indices which invest in Europe and Asia Pacific. Furthermore, they have an Index based on individual stocks' CAPE ratio as opposed to sector CAPE ratio; see here. It's not clear to me which one would perform better ... (Interesting side discovery: Shiller Barclays Global Multi-Asset Index. Somewhat similar to Elm Partners' Balanced Fund.)
Afterthoughts: One should look at the above charts and pretend that it's 2009 and the stock market has crashed. One should then ask: what was the CAPE Ratio back then and what did it feel like if you were to go long the US stock market? It must have felt scary or very uncertain. So, the right investments today would be those that feel scary or uncertain, and not those which make you feel safe and certain. (US stocks certainly feel safe and certain. At least, to me they do.)
An article printed in the FT in December also cautioned that stock market returns over the next decade are expected to be lower than the last 3 decades and much lower than the last decade. See this Tweet thread.
Stocks vs Bonds?
The yield-to-maturity of 10-year US Treasuries (blue line) shows a pretty good correlation with 10-year forward inflation-adjusted returns on 10-year US Treasuries (orange bars).
US bond forecast for the coming decade: Not good. It's quite possible that the next decade will resemble the period from the late 1930's through the mid 1970's when inflation-adjusted government bond returns were negative. (Note that currently, the 10-year US Treasury bond has a yield of 1.8% and more than $10 trillion worth of European and Japanese bonds have a negative yield; this figure was as high as $17 trillion last summer.)
Lyn Alden writes,
"Overall, the current situation for stocks and bonds is reminiscent of the 1960’s, in my view. Investors generally have a recency bias, and often use the past business cycle or two as a likely model for how the next one will play out. However, I think some of the older periods, like the late 1960’s or late 1930’s, have more in common with today’s situation than the late 2000’s or late 1990’s."
My personal thoughts: Buying bonds make sense only if one is expecting deflation. We should keep in mind the presence of $200-$300 trillion in unfunded entitlements in the US. Coupled with fiscal deficits, they seem to call for lots of increases to the money supply. This doesn't sound like deflation. (Thinking of Ray Dalio and this Tweet.)
Afterthoughts: The reason bonds performed well from 1980 until the present is because interest rates were falling. Bonds generate their returns in two ways. One is through capital gains which come about when interest rates fall. The other is through coupon payments which is their yield. An investor buying bonds today and holding them until maturity would be locking in a very low yield. (I can't get excited about a 1-2% yield on a US Treasury bond.) Given that yields are low, an investor's hopes for any capital gains would have to rest on yields falling even lower. Yields falling even lower than where they are would correspond to a heightened demand for bonds or a reduction in their supply ...
If the US enters recession, a number of corporations will probably default on their bonds. This will cause bond yields to rise; i.e. there will be bond selling en masse because bond-holders would want to reduce their risk of loss on future defaults. Bond prices will fall. (Stocks too?)
The only way that bond prices can undergo a heightened period of buying is if there was a crisis which caused investors to seek shelter in bonds; predominantly in government bonds, and assuming that they viewed such bonds as a safe haven. How or why would one view bonds of an over-indebted sovereign nation as a "safe haven" is hard for me to fathom. This is the reality for most developed countries, including the US, Europe, and Japan. (Under this scenario, gold is likely to shine. High-grade corporate bonds may offer better returns than sovereign bonds.)
Stocks vs Gold?
Lyn Alden writes,
"This chart shows the outperformance or underperformance of the S&P 500 compared to gold over the subsequent 10-year period (orange bars) based on various levels of the Cyclically-adjusted S&P 500 Earnings Yield (blue line).
As the chart shows, gold has historically outperformed stocks whenever stocks were this expensive."
Please compare with the third previous chart, the one showing nominal forward 10-year returns for stocks.
Gold forecast for the coming decade: Good!
My personal thoughts: What Alden doesn't discuss but which may be consistent with her bullish thesis on gold might be a bullish thesis on Commodities in general.
Afterthoughts: Aside from CAPE considerations, gold bulls have their own arguments as to why investors should be buying gold. For example, they point to heightened central bank gold buying; this Tweet provides a chart. Grant Williams' talk from last November contains interesting charts in favor of buying gold.
Fundamentally, three factors influence gold's price: US real interest rates, US dollar, and US money supply. Gold moves inversely to the first two and alongside of the third factor. In other words, gold's price increases when US real interest rates fall, the US dollar falls, or the US money supply increases. For more details, see my earlier blogpost here.
Here's one way that people might perceive gold rising with rising inflation. When inflation increases, if nominal yields don't rise because of capital controls, it would mean that real yields are falling, and gold does rise with falling real yields. Recall that the nominal yield on a bond is equal to the real yield plus the inflation rate. Real yields are highly correlated with real economic growth as measured by real GDP growth. In an environment where there's not much economic growth (e.g. today), real yields will be low. (I've used the words "yield" and "interest rate" as synonyms.)
For the positive correlation between real yields and economic growth; see the paper by Professor Richard Werner. (This is inconsistent with how central banks act, which is to lower interest rates in order to spur economic growth, but that's another story.)
US vs International Stocks? (& US Dollar)
Lyn Alden's argument regarding this topic is that we ought to expect dollar weakness, which is usually bullish for international stocks relative to US stocks ...
I will refrain from discussing further because I don't have much insights on international stocks.
My personal thoughts: Assuming that we were to hedge the currency risk, it would make sense to invest in countries with low CAPE Ratios. Alden lists her preferred countries here; they include Russia, South Korea, and Singapore. Meb Faber lists his here.
(This paragraph added on Oct. 2, 2020) Investing in low CAPE ratio countries on itself isn't a sufficient criterion because the decision would only be based on a cross-sectional comparison. One has to also compare a country's current CAPE ratio to its own historical past. Only if the current CAPE was depressed relative to historical CAPE would investing in a particular country make sense.
I used Google search to discover Star Capital which has a list of CAPE by country here; they list Russia and Turkey as the only countries with single-digit CAPE Ratios; Greece is also single-digit, but it has the only negative-valued CAPE Ratio listed!
Barclays has an interactive tool which provides historical charts of CAPE by country spanning 1982 to the present. The cheapest countries at the moment are Russia, Korea, Singapore, Spain, and Turkey.
The Dollar. There are two schools of thought on the dollar. One school believes that the US dollar has to weaken; see Tweets 1 & 2 referencing currency expert A.G. Bisset. Alden also falls within this group and has written about it, so does Luke Gromen and bond manager Jeffrey Gundlach. America's "twin deficits" (fiscal deficit + current account deficit) are going to kill dollar strength. See here for an explanation of twin deficits. See chart of twin deficits by country.
Alden has written about trade deficits (which is part of current account deficits) as the major driver of the US dollar here and here.
There is a second school of thought which says that even though the dollar has to weaken, it doesn't mean that it will. This school of thought includes macro traders / fund managers Brent Johnson, Raoul Pal, and Jim Rogers.
We need to keep in mind that both groups might be correct but over different time horizons. The second school of thought believes that the dollar will strengthen first before weakening. This second school tends to shun international stocks and sticks to the US due to safety / crisis concerns.
A chart of US dollar shows mild weakening since late September (i.e. 3.5 months ago). Recall that the "repo rate spike" occurred on Sept. 16, 2019 and led to the Fed starting not-QE which was intended to increase dollar liquidity. This increased dollar liquidity shows up in the chart as dollar weakness. (In order to judge the dollar's longer-term trend, one would need to look at a chart going further back than just 4.5 years.)
Afterthoughts: Alden summarizes nicely here by saying that there are three factors which determine the direction of the dollar:
1) US current account balance ("deficit" would be bearish for US dollar)
2) global dollar liquidity shortage ("shortage" would be bullish for US dollar)
3) US central bank policy ("expansionary" would be bearish for US dollar)
Brent Johnson explains his bullish dollar view in these two interviews dated Q4 2019.
Investment strategy. Investors who aren't comfortable going all-in and following the above recommendations could break up their investment budget into, say, three parts. They would invest one part now. They would invest the second part once they had perceived the arrival of some inflection point; e.g. dollar peak. Finally, they would invest the third part after that inflection point had passed. This would give them the opportunity to jump ship if they had a change of mind mid-way. It would also allow them to educate themselves further in the interim, something which always helps: it brings conviction. In general, investing ought to be viewed more as an on-going process than a one-shot thing.
Concluding Remarks
Resources: List of ETFs for asset allocation, by Lyn Alden. (Note that there's not one Commodity ETF mentioned therein; so here's where these are listed.)
Issue of Confidence. I searched my Tweets for the word "dollar" to see whether I had overlooked anything worth mentioning. Here's one thing that stood out. It's Martin Armstrong saying that "Confidence is the ultimate determinant of Price" -- link to Tweet. Something to keep in mind when making forecasts about the dollar (or making asset allocation decisions).
Currency of the Previous World Power. Before the US became the world's greatest power, that privilege belonged to Great Britain, up until the end of WWII probably. So, I asked myself, what happened to the British Pound in the last 100 years? A Google search revealed charts here and here from which I was able to calculate a -1.28% yearly depreciation rate for the British Pound relative to the US dollar. (The "-1.28%"is the average of -1.37% and -1.18% calculated from the two sources. The first rate spans 1920-2019 whereas the second rate spans 1953-2019.) If we assume that going forward, the US dollar will depreciate at the same rate as the British Pound, it'll mean that in order for the Dollar to lose 10% of its value, it would take 8 years. For it to lose 25%, it would take 22 years and for it to lose 50%, it would take 54 years. (In contrast A.G. Bisset is forecasting a more significant dollar depreciation over the next 15 years: about -50%. See chart. A -50% drop over 15 years corresponds to a yearly drop of -4.52%. In the referenced chart from A.G. Bisset, the average Dollar depreciation over the past 3 cycles was -53.5%.)
(US vs British Inflation. The source for the first chart of these two charts was this website. It had "inflation calculators" for both the British Pound and the Dollar. I used it to infer that over 1900-2019, goods denominated in British Pound experienced an average annual inflation rate of 2.94% whereas the corresponding rate for goods priced in US dollars was 4.03%. But I seem to be digressing, except to note that with the Dollar being the global reserve currency, the dollar-denominated goods experienced higher inflation of the two ...)
