Inflection Points In Long Term Trends

By Steve Ayer on March 25, 2020

As the Coronavirus continues to ravage the global economy as “social distancing” has been added to our collective vocabulary, we turn our attention towards many long term cycles that appear to be at important inflection points.  Our intent here is to take a step back and try to view forest while removed from the trees, so that we can gain some important insight into what might lie ahead after the dust settles on this crises.

There are many folks out there who are saying that we are at the tipping point for the next recession, which honestly, makes sense because we’ve been in the longest expansion in history and the Coronavirus is wreaking havoc on the economy across the country and parts of the world.  One might say that it’s even a “no brainer” that we’ll have a recession to accompany this new bear market at this point, but does that even matter in terms of one’s investment/market outlook from this point?

Of course, no one knows for sure what is going to happen in the future, but from our perspective, there are a few very important things to take notice of at this time because underneath the surface of the market, some very important long-term trends appear to be near or at critical inflection points.  This is true whether a recession comes in the US or not because historically, the market has looked ahead 6-9 months from it’s current situation, so even if we have a recession, the market may begin to look beyond that into the fourth quarter already along with 2021.

Stimulus in the form of monetary policy (central bank origination) along with fiscal policy (government origination…, & yes, there is a difference between the two) are both being announced and considered in unfathomable quantities here in the US and abroad and we’ll probably need more time over the coming weeks to see it’s fullness, if not a big longer.  Fiscal stimulus, in particular, is going to take center stage and this could provide a glimpse of what we’ll see in the future, especially when we see what Europe showcases.  Over the past 11 + years, stimulus has proven to be quite effective when it comes to impacting markets, for not only the short term, but over longer periods of time as well and there is no reason to believe that today is any different.

 “Opportunities are seldom labeled”  – John A. Shedd

Cycles occur in all areas of our lives & are critical to the understanding of markets as well.  The most feared saying in market analytics is that “it’s different this time”… because it never really is, it’s simply a matter of the dataset that you’re using to measure.  Let’s just get right to the point here while not getting too technical; here are the major trends that appear to be at critical inflection points:

• The under performance of Value Stocks vs Growth Stocks Cycle, particularly in the US
• The 40 Year Bull Market in Bonds Cycle
• The Under performance of International Equities vs US Equities Cycle

 Value Stocks vs Growth Stocks in the US Cycle:

Since 2009, Growth stocks have outperformed Value stocks at a dramatic pace, which have brought the level of out performance of Growth relative to Value stocks to historic levels.  We have seen many cycles over the past 50 years where over multiple years, Growth outperforms Value and then we see that relationship flip over a number of other years where Value outperforms Growth.  We’re now at historic levels of this Growth cycle of out performance and with the massive hit to financial and energy stocks over the past few weeks (both sectors are considered Value stocks), it appears as though the cycle has ended with a bang!

It’s not uncommon for the end of a long-term cycle to end in spectacular fashion like we’ve just seen, but it’s always impossible to know when or if it will happen & to what degree the move will ultimately represent.  This final push in the same direction of the existing trend within the cycle is often called a “Blow-Off” event and can occur on either the upside or the downside of a market at the end of it’s trend.  The “Blow Off” selling that has occurred in oil stocks along with financial stocks recently fit the bill for an extraordinary period where market participants sell with reckless abandoned no matter how cheap the fundamentals might be…, they just want out & this is precisely how these markets have behaved recently in conjunction with the “Blow Off” rally in bonds (more on this below).

At this point, it now appears that the stage is set for a multi-year period of out performance in the Value sector relative to Growth in US stocks.  I could spend a fair amount of time going over some fundamental rationale for this along with critiquing many charts for you to look at as well, but I don’t want to dilute this with too much technical research/jargon right now, though it might be a good exercise to walk through in the future.  Cycles of under performance and out performance occur for many reasons, with valuation, earnings, economic climate, society, culture along with many specific factors contributing to how and why cycles occur.

At this point, I think that what is most critical to understand is that we have a very strong set-up for the beginning of a long-term trend of out performance in US Value Stocks relative to their Growth Stock peers.

The 40 Year Bull Market in Bonds Cycle:

Interest rates peaked in 1980 after the rampant inflation of the 70s.  Even today, I still routinely talk with folks who when they took out their first mortgage, they were paying 13, 14 or even 15% on their first home when they purchased it in the 70s.  Then, along came Paul Volcker to lead the Federal Reserve and rates have been in a downward path ever since.   Bull markets in bonds have historically been much longer than bull markets in stocks, but at 40 years, it has gotten quite long in the tooth.  This comes back to the “Blow Off” rally in bonds that I mentioned earlier because just was we’ve seen Value Stocks tank over the past several weeks, even relative to Growth Stocks, we’ve also witnessed a “Blow Off” top in bonds, with long term interest rates plummeting to lows never witnessed before in the history of the US.

Nothing is ever cut and dry in the world of finance, but there are several reasons beyond the technical pattern along with the duration that we’ve just witnessed that leads me to believe that we’ve just witnessed the end of the bond bull market.

The velocity of money (the rate at which money is exchanged in an economy) has been falling for years, despite all of the massive levels of monetary and fiscal stimulus, so the authorities are searching for new ways to create a higher velocity of money.  Some might poo-poo their ability to do so after years when they have been unable to raise the velocity & I understand that perspective, but just to be clear, we are talking about the world’s most powerful institutions with the full authorization to print money at will and increase stimulus to combat deflation, viruses, or any other issue that they determine that they need to address.  Let me be as clear as possible here…, either the world’s central banks will be able to create inflation on their own through new stimulus programs and/or policy changes (a new universal income policy comes to mind here; especially in Europe & Japan) or they will be forced into inflation/rising interest rates because the investing public loses confidence in their ability to manage the system.

Let me give you a recent example:  When Greece first went into crises ten years ago (their first of three bailouts and yet their problems have only grown with each passing bailout), their interest rates sky-rocketed because people lost confidence in their ability to manage the system.  So, interest rates can rise if the central banks/governments can figure out a way to increase the velocity of money after years of being unsuccessful or they can rise when the market says enough is enough and rates rise out of fear.  The former is much more desirable…

The deeply ingrained “whatever it takes” mentality of central banks and governments across the world point towards to new & bigger policies for much greater fiscal stimulus relative the monetary stimulus when dealing with this Covid-19 virus than we’ve seen previously.  Could we see a Universal Income component to the fiscal stimulus going forward??  Perhaps, but regardless of how they accomplish it, the bottom line is that the world’s authorities appear to be prepared to follow their “whatever it takes” perspective as far as they need to in order to begin to create inflation and that is precisely why interest rates appear to be bottoming here.

Again, there are many charts and fundamental reasons that I could share here, but this paper is already getting too long, so let’s leave that for another day (especially on the topic of Universal Income).

The bottom line here is that there are many reasons to believe that one way or another, the “Blow Off” rally in bonds that we’ve recently witnessed looks to be close to or at the conclusion of the 40 Year Bond Bull Market.  The Fiscal stimulus that we see over the coming weeks, particularly out of Europe, will help us understand this a little more clearly, so stay tuned.

The Under Performance of International Equities vs US Equities Cycle:

For approximately the last 10 years (depending upon the market you’re focused on (Emerging Markets or Europe), US stocks have been outperforming their international brethren consistently and by wide margins.  As with most things, there are exceptions to this rule, with Japan being one of them, but international stocks overall have been dismally under performing US equities for a very long time.  As we have seen with the Value & Growth cycles, there are periods throughout the last 50 years when there was out performance of US stocks along with periods of under performance and the same can be seen here.

From 2001 until 2007, the Emerging Market stocks handedly outperformed US stocks, but since 2011, while the bull market was very strong here in the US, Emerging Market stocks are flat at best.  Keep in mind that the Emerging Market (EM) countries have continued to grow more quickly than the US over this time-frame and earnings in EM have grown nicely over this time-frame as well, but the equities in the EM index has gone NOWHERE!  The same had been seen in European equities, but it was actually much worse.  European stocks haven’t gone much higher since year 2000, so their period of significant under performance has now lasted 20 years!

Japan’s market climbed significantly over the past 10 years primarily because of their central bank buying stimulus programs.  Think about this:  The Bank of Japan has created a stimulus program that allows them to print money and instead of just buying bonds, which is the standard central bank stimuli from the European Central Bank (ECB) & the Federal Reserve (Fed) along with others, they can take some of that digitally created money and purchase stocks via ETFs and REITs in the open market.  So, let me ask you a question:  if one of the world’s most powerful institutions comes out with a policy that allows them to print money and buy stocks to support their stock markets any day that they choose, what do you think happens?  People become comfortable with the fact that a central bank can buy stocks, which then puts a safety net underneath the market and people take the risk themselves and then buy stocks as well.

There is a very good chance that the ECB could also adopt this strategy and down the road, the Fed might choose to do so as well, but it’s a little early for that here right now in the US, but not Europe…  Actually, Eric Rosengren, a Federal Reserve governor recently spoke on this topic, just a few weeks ago, but again, it doesn’t appear to be on the docket over the foreseeable future in the US, but watch for this to occur in Europe if their fiscal and monetary stimulus are not deemed as enough.  “Whatever it takes”  just might include a stock purchasing program out of the ECB and/or other central banks.  Japan just increased theirs…, so this is a very real possibility for others sooner than later.

As I eluded to previously about Greece, Europe’s debt/GDP ratios are much worse than the US’, their growth rates are lower, their demographics are worse, and they don’t have the world’s reserve currency like we do either, so they are much more constrained in terms of their financial position.

You might be wondering, since they are in much worse shape than we are economically, why might their stocks outperform ours going forward?  It’s because they will have to come up with a more dramatic stimulus package (s) to get themselves out of the funk that they are in and whether that is universal income or printing money to buy stocks or something else, it appears that they will do “whatever it takes” in order to stimulate from this point forth and history shows that whoever is stimulating in dramatic fashion, sees out performance follow.

Believe it or not, the emerging markets, which have better fundamentals than Europe or most other developed countries (especially Japan, which is the world’s worst economy in my opinion) appear to be the more conservative strategy when it comes to international investing, because they won’t be relying upon stimulus as much as Europe will.  In all my career, I’ve never seen a time where the Emerging Markets might be looked upon as a more conservative investment than the developed world, but many market pundits are suggesting that this could be true right now because of their extremely low valuations relative to their developed market peers.

All three of these cycle, which I am suggesting might feed off of one another, so if one of them begins to show signs of turning, the others might either go in lock-step or in due order thereafter.  Let me give you and example:  If Europe begins a universal income program, then you better believe that policy will create inflation as well and as a result of that policy, interest rates will bottom here and will rise much higher over the coming years.  Another example:  If Value begins to outperform here in the US relative to Growth stocks, then investors will look towards international stocks to purchase them as well because they are the deeper Value than US stocks on a relative basis.

I am not saying that it will be impossible to get a mutually exclusive trend change in one or two of the three major cycles that was mentioned earlier to be at major inflection points, but from my perspective, I think that the most likely outcome is that we will see all of the above occur, though perhaps more staggered…, I guess that time will tell.

Please reach out with any questions or comments,

Sincerely,

Steven Ayer

Strata Wealth Partners

55 Main St., Suite 370

Norwich, CT 06360

888-992-9690

sayer@hightoweradvisors.com