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“My dear fellow, life is infinitely stranger than anything which the mind of man could invent. We would not dare to conceive the things which are really mere commonplace of existence.”
—Sherlock Holmes (to Watson) in A Case of Identity from Sir Arthur Conan Doyle’s The Works of Sir Arthur Conan Doyle
Where is the Stock Market?
My last Client Update Letter was published on March 16, 2020 just a few days before the very bottom of the Corona-crash (I just made that up). In that Letter I said that it was an excellent time to be buying stocks and I had your portfolios “all-in” on stocks which means that they held the highest percentage of stocks allowed within your individual strategies and risk frameworks. The best market calls are always made uncomfortably. The broad U.S. stock market, as measured by the S&P 500 Index, has since rallied by about 41% back to the all-time high level it was at in late February 2020. Other U.S. stock market index measures like the Dow Jones Industrial Average (30 of the largest companies broadly representing U.S. industry) and the small capitalization indexes are still below their all-time levels. The S&P 500 index has outperformed due to its heavy (and getting heavier) weightings of the largest U.S. technology companies—namely Apple, Microsoft, Amazon, and Alphabet (Google), but more broadly, stocks are still down on the year. The S&P 500 index is market capitalization weighted which means the largest companies comprise a larger piece of the index. The index performance has been distorted this year because these giant technology companies have soared this year. I heard a statistic the other day—I don’t recall the exact number—that something like 300 stocks of the 500 stocks in the S&P 500 are still down 20% or more this year. The main story is one of a divergence between a minority of stocks doing exceptionally well and a mediocre majority of stocks. This dynamic has distorted the true picture of what is really going on underneath the surface of the stock market. The following monthly chart of the S&P 500 Equal Weighted index—an index where all 500 stocks are given an equal weighting in the index—reveals that stocks broadly peaked in February 2020 and are now on a longer term downward trend.
chart courtesy of barchart.com; click to enlarge
My outlook heading into 2020 was that stocks were going to peak in the first half of the year and I still hold this view. I do not see stocks going much higher from here in the short-term. From my perspective, the regular S&P 500 index is putting in a double top and is soon going to start heading back down. Right now this monthly S&P 500 Equal Weighted Index reveals a longer term pattern of lower lows and lower highs.
In mid-March 2020 it seemed impossible to many seasoned stock market professionals that stocks would rally so quickly and powerfully back to all-time high levels which is one reason why it was a great time to buy. Now, very few seasoned stock market professionals expect the market to take another major swoon down which, given the conditions, is one reason why it is a great time to be cautious. Allow me to repeat: the best market calls are always made uncomfortably.
Money Creation
In our current monetary system, money comes into existence 3 ways.
The U.S. Central Bank—The Federal Reserve System (a group of regional reserve banks)—issues coins and paper money which makes up a small percentage of U.S. money supply (e.g., less than 5%).
Commercial Banks create money electronically (through accounting entries) when they lend money or when they purchase assets. This is explained brilliantly by Professor Richard Werner in a previous True Vine Letter where I posted a video on the subject. (Money is also removed from the system when loans are repaid and when commercial banks sell assets.) Through the double-entry bookkeeping of bank accounting, money is added (and removed) from the economy by assets being added or removed from bank balance sheets. What we routinely call “money” is simply electronic bank credits.
The Federal Reserve also creates (or removes) money from the system when they buy and sell assets from the non-bank sector.
The increase or decrease of money in the economy has important implications for investment markets. It is something that I have been studying this year and I am presently building my own tools to analyze it deeper.
The economy went into recession earlier this year. It is important to remember that the virus did not cause the recession, governments did. An economy really cannot be shut down for more than a week or two without causing serious long-term issues. We have yet to truly realize just what all those issues are but when excessive government borrowing finally stops, we will. At some point, I am expecting a crisis in city and state budgets to force some sort of Federal involvement that could be the impetus for higher inflation.
In response to this economic lockdown the Federal Reserve (the “Fed”) went into overdrive expanding its balance sheet by purchasing all sorts of bonds and implementing programs in coordination with the U.S. Treasury and commercial banks to lend into the economy. From money creation point #3 above we can see that this adds more money in the economy. Because economic activity was so severely disrupted the Fed flooded the system with money. The following chart shows how M2—a measure of broad money supply—soared as the economy went into this government induced recession:
click to enlarge
From early March 2020 through early August 2020, the Fed created money (expanded its balance sheet) by purchasing roughly $2.7 trillion worth of financial assets. $1.8 trillion of this went into buying U.S. Treasury bonds. This explains how the U.S. Treasury was able to borrow about $3 trillion over this same 5-month period without interest rates rising. The investment community bought the remaining $1.2 trillion of U.S. Treasury bonds. This was a lot for the investment community to absorb in such a short period of time and the fact that it did, and at lower rates, implies that the consensus outlook is for deflation and economic weakness.
The Fed’s massive monetary expansion is an inflationary force colliding with the deflationary forces of an economic recession. The unemployed and those who have had their salaries cut spend less. Companies that have reduced revenues have to cut spending. These are deflationary forces. Yet, we have not felt the full effect of this yet because the government has been sending out stimulus payments and paying higher-than-normal unemployment benefits.
When the Federal reserve creates money and buys these bonds from investors, the investors have cash that they can do something else with. Some of this money flows into riskier, higher yielding debt and stocks, many of which pay dividends that are a lot higher than what can be had from bonds with quality credit ratings. This is why it is important to understand the money flows. All else being unchanged, if the Fed is buying assets from the investment community (non-bank sector) then they are adding liquidity to financial markets which supports stock prices.
At present, the Fed is buying about $20 to $25 billion per week of U.S. Treasury bonds which on an annual basis equates to about as much as the U.S. Federal deficit (pre-recession). In other words, the Fed is currently creating enough money to finance the U.S. budget deficit. This is where things get interesting. If the U.S. Congress passes another $1 trillion stimulus package (the Democrats want $2 trillion), then the U.S. Treasury would have to borrow $1.2 trillion more than what the Fed is currently on pace to buy. This could be as high as $2.2 trillion if the Democrats have their way on a $2 trillion stimulus package.
This raises an important question: does the investment community have the willingness to buy another $1.2 trillion of Treasury bonds in only 4 months, yet alone as much as $2.2 trillion? Yes, but at higher interest rates or potentially significantly higher rates under the $2.2 trillion scenario. More importantly though, this would mean a significant amount of money would be flowing out of the financial markets (liquidity drain) to buy these bonds and that is a negative for the stock market.
At the same time, the economy could continue to recover at a strong pace and inflation could heat up, especially considering global supply chain issues and the expected drop-off in U.S. oil production (higher gas prices eventually). Higher than expected near-term inflation could be another negative for the bond market, especially if the mainstream consensus switches from deflation to inflation. If inflation climbs to a consistent annual level of 3% to 4%, do you really want to keep holding long-term bonds paying less than 1% and thus guaranteeing 2% to 3% annual losses in real, inflation-adjusted terms?
When I was writing the Industrial Minefinder newsletter I did an analysis on silver about 2 years ago where I discovered that the #1 thing that silver is correlated to is inflation expectations. Silver has shot up in recent weeks which implies that some investors are expecting higher inflation ahead.
At some point, the bond market is going to have a reckoning. The investment community is sold on the idea that the Fed is going to “control” bond yields which essentially means they would keep printing money to buy enough Treasury bonds to keep interest rates down, however, the Fed’s recent meeting minutes poured water on that idea for now.
I am expecting a strong move higher in longer term interest rates at some point and I have your bond portfolios positioned for it. I continue to monitor the money flows closely because liquidity drives markets.
Higher inflation is coming but we may have a deflationary shock first. Ultimately, there is no doubt that higher inflation is coming because that is the only way the government is going to deal with the massive debt build-up that is underway.
Investment Portfolios
Technology related stocks are currently the largest sector exposure for the stock portion of portfolios. One long-time favorite that I have been taking some profits on lately as it hit new all-time highs, but continue to hold a core position in for you, is KLA. KLA is the dominant manufacturer of process control and yield management solutions for semiconductor manufacturing. The manufacturing of the integrated circuits (“chips”) that go into all the various smartphones, computers, robotics, servers, and other advanced technologies that are all around us today are optimized through the use of KLA’s tools and solutions. If technology is a gold rush, KLA is the company that makes the machines that optimize the machines that make the picks and shovels.
In some Client Update Letters in the recent past I talked about how your portfolios held several bank stocks. Specifically, these were Bank of America, Fifth Third Bank, and JPMorgan. You also held preferred shares in Bank of America and U.S. Bank. Thankfully, I sold Fifth Third Bank at its peak before the market crash. Back in the April timeframe, I did my own “stress tests” on the balance sheets of Bank of America and JPMorgan and estimated what I think their loan losses could end up being from this present debacle. Both banks have very strong capital positions and will do just fine, however, this analysis brought them down in my evaluation models so I sold everything and in many cases was able to exit at prices that were higher than what they are trading for now. Bank stocks, as a whole, continue to remain weak which is a bad forward-looking sign for the economy.
Gold has been doing very well this year for many of the reasons I highlighted in the previous section. Although you do not own any primary gold mining stocks right now the largest holding in most, if not all, portfolios is now the Australian copper producer OZ Minerals which derives 25% to 33% of its revenue from gold. (I actually looked at Barrick Gold a few days before it was announced that Warren Buffett’s crew bought it but determined its costs are too high and there is a lot of jurisdictional baggage - good luck Warren!) OZ Minerals was a top-ranked pick when I was writing Industrial Minefinder and my investment thesis then is now being realized as the stock price has broken out and continues to climb higher.
OZ breaks out …
click to enlarge; chart courtesy of barchart.com
OZ is currently bringing on its second large, low-cost copper mine and this is driving production and earnings growth. This stock is still considerably undervalued and that is using only $2.75 per lb. copper and $1,600 per oz. gold prices. This valuation gap will close as its Carrapateena mine in South Australia continues to ramp-up production. The above weekly price chart confirms that this stock is headed for the AUD $20+ level.
For those interested, here is link to a recent Bloomberg interview with OZ Mineral’s Chief Executive Officer, Andrew Cole.
The following chart from Visual Capitalist shows that copper has historically been an excellent long-term inflation hedge—actually better than precious metals:
click to enlarge
Defund the Police?
After hearing about movements to defund the police it did not take me long to add Sturm, Ruger to your portfolios. Whether the police are actually defunded anywhere or not, the mere suggestion of such a ridiculous proposition in modern day America alongside all the other mayhem going on in our cities helped light a fire under the stock. Ruger is running all three of its factories at full capacity, has no debt, is flush with cash, and recently paid a special $5 dividend which equates to roughly a 7% payout on the average price I paid for the stock in your portfolios. Despite not only being an excellent company, shares of Ruger are often a hedge against bad political outcomes.
Conclusion
Portfolios are now positioned very conservatively and we are ready for the rough waters that I think we will see over the remainder of 2020. At some point over the next 6 to 9 months, I expect we will once again get another great long-term buying opportunity.
I am working hard to protect and grow your wealth. Thank you for your business.
God bless,
Joshua Hall
Disclosure
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, and a Registered Investment Advisor in the U.S.A. The information presented is for educational purposes only and should not be regarded as specific financial or investment advice nor a recommendation to buy or sell securities or other investments. It does not have regard to the investment objectives, financial situation, and the particular needs of any person who may read this Letter. In no way should it be construed as personalized investment advice. True Vine Investments will not be held responsible for the independent financial or investment actions taken by readers. All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive evaluation of financial strategies or specific investments and consult a professional before making any decisions. Positive comments made regarding this Letter should not be construed by readers to be an endorsement of Joshua Hall’s abilities to act as an investment advisor.