IN-DEPTH: TRANSCRIPTION - LONGWave – 11-09-22 - NOVEMBER – The Beta Drought Decade
SLIDE DECK
TRANSCRIPTION
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Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussion purposes ONLY.
Always consult a professional financial advisor before making any investment decisions.
COVER
Let’s start with a few important facts:
- Central banks do not print Growth.
- Governments do not boost Productivity.
- However, both perpetuate inflation and both have an incentive to increase debt.
Adding these facts to your investment thinking may not guarantee high returns, but most importantly it is likely to prevent enormous losses.
AGENDA
As many longer term subscribers to MATASII.com are well aware, we follow Warren Buffett’s sage, Three Rules of Investing:
- Don’t Lose Money,
- Don’t Lose Money,
- Never forget Rule #1 & #2!
We believe we have now entered an era of extremely difficult investing. We at MATASII.com refer to this period as the Beta Drought Decade which we believe was originally coined by the Australian Gerard Minack who founded Minack Advisors.
I thought it timely to layout why we came to feel this way. As such we will discuss the subjects outlined here.
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Stagflation - that is the risk ahead. A Fed pivot would do nothing to bring markets higher in that scenario.
Stagflation periods have proven to be extremely poor for stocks and bonds. They are even worse when governments are unwilling to cut deficit spending, because the crowding out of the private sector works against a rapid recovery.
We are highly confident of seeing this Stagflationary period ahead, which we have previously written and produced video’s about this coming problem.
We have increasingly become convinced this Stagflationary period will be historic and might be labeled in the future as the Stagflationary Debt Crisis Era. Time will tell.
Let’s just focus this session on what we are confident of and that is an era of Stagflation.
The Debt Crisis element has a lot of yet to be answered questions about how the powers to be will once again; “cheat”; or change accounting & regulatory rules; or employ any numbers games to simply “Kick-the-Can-Down-The-Road”.
A road we have been on since the Dot.com bubble imploded in 2000.
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"US investors have enjoyed historic beta for a dozen years.
A 60:40 equity/bond portfolio generated a 10½% annual average return between March 2009 and January 2022.
There have been four Beta Droughts since 1900: extended periods of little or no beta return.
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- Three of the four historical beta droughts – in the 1910s, 1940s and 1970s – were caused by rising inflation - typically decade-average CPI inflation of over 5%.
- Those three inflation episodes were associated with WW1, WW2, and the 1970s oil shocks.
The US may now be entering another Beta Drought. US returns are now at risk from both the prospects of higher inflation AND the headwinds to returns from high starting-point valuations.”
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Larry Fink, the Founder, Chairman & CEO of BlackRock recently emphasized the following numbers:
Just a year ago, the US 2Y Treasury Notes were yielding 25 basis points. Today, they’re earning 4%, with corporate bonds over 5% and high yield above 9%.
If we go back to 1995, before congress repealed the Glass-Steagall Act (brought into being as a result of the 1929 stock market crash of 1933), you could get a 7.5% yield, with a portfolio of simply 100% RISKLESS bonds.
If you fast forward 10 years, in 2005, it had to be 40% equities, 50% bonds, and 10% alternatives.
Then move another 10 years, and in 2016 you needed 60% equities, 15% bonds, and 25% alternatives.
This describes the growth of several markets with investors having to take on significantly more risk for even a shot at the same return.
Today, to get that same 7.5% yield, a portfolio could be 85% bonds, and the 15% equities and alternatives. We are not far from returning to potentially 1995 benchmark levels.
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What this suggests is that the increasing risk that investors have accepted over the last decade will likely to be purged over the next decade or at least lowered.
S&P 500 real prices and Cyclical Adjusted PE Ratios are more than likely to regress to more normalized levels represented by the dotted exponential plots.
The famous George Soros’ lieutenant, Stanly Druckenmiller believes that could be the case. I quote him:
“There’s a high probability in my mind that the market, at best, is going to be kind of flat for 10 years, sort of like the ’66 to ’82 time period.”
Druckenmiller added that with inflation raging, central banks raising rates, de-globalization taking hold, and the war in Ukraine dragging on, he believes the odds of a global recession are now the highest in decades. He points out that globalization has a “deflationary” effect because it increases worker productivity and speeds up technological advancement. However, that tailwind is now fading.
To quote Druckenmiller again:
“When I look back at the bull market that we’ve had in financial assets really starting in 1982. All the factors that created that boom not only have stopped, they’ve reversed.”
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All of the excess of unproductive debt issued during a period of complacency will exacerbate the problem in 2023 and 2024. Even if refinancing occurs smoothly but at higher costs, the impact on new credit and innovation will be enormous, and the crowding out effect of government debt absorbing the majority of liquidity and the zombification of the already indebted will result in weaker growth and decreased productivity in the future.
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Lance Roberts at Real Investment Advice has some great analysis that shows valuations by their very nature are horrible predictors of 12-month returns. However. in the longer term valuations are strong predictors of expected returns as can be seen here of real total rolling 10Y returns.
Over-paying for value can be expected to lead to lost decades.
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Another chart Lance uses shows this more clearly by highlighting the three most recent points for reference.
- The “Dot.com” bubble peak.
- January 2009 (Start of the current bull market cycle)
- Ending valuation for 2021.
There are two crucial points to take away from his data.
- There are several periods throughout history where market returns were not only low but negative. (Given that most people only have 20-30 functional years to save for retirement, a 20-year low return period can devastate those plans).
- Periods of low returns follow periods of excessive market valuations and encompass the most negative return years.
The problem going forward, as Druckenmiller also notes, is the reversal of globalization and financial inputs that increased annualized return rates over the last decade.
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While the Wall Street Journal tries to make the case that profit margins were responsible for the gains, the reality is that most excess returns came from just two unique sources.
- A decade of monetary interventions and zero interest rate policies; and,
- A massive spending spree by corporations on share repurchases.
The chart below via Pavilion Global Markets shows the impact of stock buybacks on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:
- 21% from multiple expansions,
- 4% from earnings,
- 1% from dividends, and
- 5% from share buybacks.
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Since 2001 the S&P 500 alone has employed ~$10 Trillion of corporate capital to buy back its shares with no other real purpose than other to drive up stock prices. Prices that have now started to come down as nearly $29T in wealth has been extracted from the equity and bond markets since the beginning of the year!
I put the bond market loses in that number because a substantial amount of the money used for buying back corporate shares was borrowed. The primary way of doing that was issuing new corporate bonds.
Effectively they swapped future debt obligations for equity prices today. Those who sold the corporate equities today have had the opportunity to exit before the debt has to be paid! They have fled the party as market prices became unsustainable, since knowingly debt payments would eventually depress earnings.
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Corporations also used borrowed money to pay dividends. These dividends paid more than treasuries and bank rates thereby making stocks attractive to yield starved investors and institutions.
This coupled with stock buybacks was a giddy cocktail for the markets.
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According to a just released Fed paper entitled: “The coming long-run slowdown in corporate profit growth and stock returns”
I quote from the report:
'The reduction in interest and tax expenses is responsible for a full one-third of all profit growth over the prior two-decade period. That boost to corporate profits is unlikely to continue, indicating notably lower stock returns in the future.'
When profits and growth fall, normally cash flow falls off.
This means:
- A high probability fall-off in the $10T rate of stock buybacks,
- Reduced cash and borrowing capabilities for inflating dividend payouts
- Instead of reduced interest expense we are now seeing rising interest expense,
- Instead of reduced tax expense we now seeing rising tax expense with the US government’s new 15% Minimum Corporate Tax being implemented as part of the just signed “Inflation Reduction Act”.
We can therefore expect the Beta Drought to be a very real eventuality!
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As demand weakens domestically and globally, investors should not expect corporate profits to remain near record levels. As shown, the current gap between asset prices and corporate profits is at the greatest deviation on record.
According to Jeremy Grantham (and I quote):
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system, and it is not functioning properly.” – Jeremy Grantham
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According to the well followed and respected analyst Dr John Hussman (and I quote)
“ Surveying the current condition of the financial markets, we presently observe a combination of still historically-extreme valuations, rising yet still only normalizing interest rates, measurably inadequate risk-premiums in both equities and bonds, and ragged, unfavorable market internals, suggesting continued risk-aversion among investors. In this context, it’s worth repeating what I’ve noted across decades of market cycles – a market collapse is nothing but risk-aversion meeting an inadequate risk-premium; rising yield pressure meeting an inadequate yield.”
Hussman’s chart shown here lays out his best estimate of the expected 12-year total return for a conventional passive investment portfolio invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills. Notice that recent market losses have markedly improved prospective returns for a passive investment allocation, yet only to a level of about 1% annually.
Indeed, the expected return of the S&P 500 component is still negative.
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I encourage you to review some of the detailed analysis on total expected returns over the next decade that Hussmann’s analytics strongly indicate. I list here is latest three reports.
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According to research by Deutsche Bank, history shows that once inflation rises above 5% in developed economies, it takes at least a decade to bring it down to 2%.
Even the OECD expects persistent inflation in 2023 against a backdrop of weakening growth.
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I have written extensively about the reality that we have both Inflation and Deflation concurrently. They exist concurrently in different areas of the economy and shift. What shifts in a much larger manor however is public perception, media narrative and market focus.
In 2020 as Covid-19 hit I put out a video entitled “Inflation PLUS Deflation” specifically reinforcing this point. It can be found on the Gordon Long YouTube Channel.
Inflation can only be expected to trend higher as we inevitably head towards a final hyperinflationary blow-off of fiat currencies.
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Meanwhile we can expect Deflationary pressures to increase. It is highly likely the next major Deflationary pressure will soon come from Recessionary pressures.
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We are likely very near that pivot point now. However, don’t be mislead!
Inflation will be with us for the next decade. It may fall based on “official” numbers to let’s say 5%, but it will be there nevertheless. We will be in an era of continuous policy initiatives to rein in inflation to manageable levels.
However with the size of global debt the opportunity to inflate away some of that debt is not going to be missed.
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We are now only in the first phase of what is likely to be a three phase process before we see inflation being possibly contained. We are now in the midst of an Energy refining & extraction Crisis that will last minimally through 2023 if not much longer.
In 2023, energy will likely be the only thing that matters to investors. Everything else, including the Fed will be a side-show. Who’s ready for the insanity wave??
We just had a half-year pause in my oil thesis, now it’s potentially about to resume with vigor!
Soon we will see a global food crisis which is already being felt in many emerging countries. It is likely to be a prime inflationary fire in 2023-2024.
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in the 2020’s, we could find ourselves in a radically different situation to the 2010s. Inflation will always be a little too high (as opposed to too low), and with both monetary and fiscal policy pivoting a full 180 degrees, we will again have a “tug of war”, but a battle that pushes firmly in the direction of higher interest rates, rather than the disinflation and NIRP of the post-GFC era.
Inflation and Deflationary pressures will come at us from major shifts in the world order.
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What I am talking about by world order is the change in trend in the items outlined here.
My colleague, Charles Hugh Smith and I have done three 45 minute videos this year on exactly the importance of these shifts. All can be found on the MATASII.com web site.
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We fully expect a major crisis within the $2.2 Quadrillion derivatives complex to ignite yet another government money printing episode of even more egregious new government policies.
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The broken Credit Transmission Mechanism is now fractured for many reasons but most of all because of a shortage of unencumbered collateral.
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We have reached the point where Credit growth can no longer sustain an over-indebted and over leverage systems.
The US and most developed economies debt is quickly becoming unfundable without dramatic actions being taken.
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If this is not enough – US productivity is now in free fall because of a decade of malinvestment and under investment in productive assets.
It will take the next decade (or possibly more) to clear the monetary mal-practice, fiscal excessive and global imbalances from the system. It will be a Beta Drought Decade.
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The coming decade will likely be referred to as the Great Stagflation. Similar to the 1930’s be called the Great Depression.
There is all likelihood it may be worse and eventually be labeled the “Great Stagflationary Debt Crisis”
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Throughout the last decade China has come to the rescue of the global economy on four separate instances.
This isn’t going to happen again. In fact China may soon become a serious economic problem to the world similar to what occurred in Japan in the 1990s . Like Japan imploding from being an export lead dependent economy, China as even a larger export lead economy but additionally dependent on capital formation may soon experience major problems. Problems associated with De-Globalization, De-Financialization, Re-shoring, De-Growth and Global economic re-balancing.
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The black-hole of inflation is very real, especially to the US.
That is because we have been fooling ourselves with bad economic , inflationary and growth information.
Like a black hole, stagflation is similar in that the only real solution is to avoid its deadly grasp. You must stay above the event horizon at all cost.
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Unfortunately, because of false and manipulated date on Inflation ….
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.. and economic growth the US is already below the event horizon before we can even begin to fight Stagflation.
I have outlined this in prior videos available on our site.
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What can we conclude?
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The evidence is pretty overwhelming that the next decade is going to be challenging! There is a lot of data that suggests the “Dam Has Broken”!
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However, never, never under estimate the games the powers to be will stoop to keep the game going. They can be expected to change the rules to “Kick-the-Can-Down-The –Road”.
We fully expect that and as this chart shows we don’t think the markets have yet sopped rising. We are likely to see a new high or a “double top” before the game finally implodes.
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That lift will again be built on a false foundation of bad data, flawed accounting and regulatory gaming.
That market lift shown here will be short lived and eventually will only be seen to be a major counter rally in a potentially historic Bear market.
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A Bear Market in financial assets that will coincide with a stark resetting of the Standard of Living in the US and other major Developed Economies.
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There will be a lot of wealth both destroyed and transferred. This is always the case in Bear Markets.
The challenge is not to be fearful but to be knowledgeable about how events are likely to unfold. No one has a crystal ball but sometime s only thing that is needed is common sense!
We suggest you give a lot of thought to what is likely soon to emerge. One area we see as a possibility is a Commodity Super-Cycle.
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As I always remind you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
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I would like take a moment as a reminder:
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussion purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2022 turn out to be an outstanding investment year for you and your family.
Thank you for listening.
