As Elon Musk passes Warren Buffett in net worth, it is time to sound one more warning about the market’s valuation. FactSet reported that the stock market is trading at a forward 12-month P/E of 22.0, which is well above its 5 and 10 year averages.
 

Here is why these circumstances are highly unusual.
 

The historical record

The following chart compares the forward P/E ratio to the Misery Index, which is the sum of the unemployment rate and inflation rate. In the past, P/E multiples have have been inversely correlated with the Misery Index. P/Es have weakened whenever the Misery Index rose to a local peak, usually because of the recessionary stress of rising unemployment. Today, the unemployment rate spike to levels only exceeded by the Great Depression, and the forward P/E rose instead of falling.
 

Earnings do matter. Callum Thomas presented a long-term perspective of stock prices and forward EPS. The only significant divergence that occurred between since the two series began in 1985 is today.
 

One explanation is US equity market leadership has been concentrated in a handful of large and profitable technology names. The stock market isn’t the economy, and the economy isn’t the stock market. Nevertheless. forward earnings are still highly correlated with business sales, which have tanked.
 

Stress levels are already evident in the especially vulnerable small cap stocks. 42% of the Russell 2000 are not profitable, which is a level consistent with recessionary conditions.
 

Is it any wonder why small caps are continuing to lag large caps?
 

Health care warnings

Can the development of a vaccine be cause to celebrate, in light of the recent hopeful news?

The economy may not be able to take much comfort in the development of a vaccine. The Guardian reported a UK (non-peer reviewed) study found that antibody protection fade rather quickly over time. This means that it man be difficult to achieve herd immunity. At best, vaccinations will require annual booster shots. At worst, they won’t provide much protection at all.

In the first longitudinal study of its kind, scientists analysed the immune response of more than 90 patients and healthcare workers at Guy’s and St Thomas’ NHS foundation trust and found levels of antibodies that can destroy the virus peaked about three weeks after the onset of symptoms then swiftly declined.

Blood tests revealed that while 60% of people marshalled a “potent” antibody response at the height of their battle with the virus, only 17% retained the same potency three months later. Antibody levels fell as much as 23-fold over the period. In some cases, they became undetectable.

To be sure, some vaccines are not designed to prevent infection, but to mitigate symptoms once a patient is infected. An Italian study found that patients with post-COVID infections suffer symptoms two months after recovery. Only 13% had no symptoms after two months (ht George Pearkes).
 

If the results from these studies hold up, it implies that this virus will have a far more lasting impact on the growth outlook than consensus expectations. COVID-19 will have a long-term negative effect on productivity. Analysts will have to downgrade their growth and earnings expectations – with a corresponding downward revision in equity price targets.

The market has been getting excited by the prospect of a V-shaped recovery. It points to data such as the ISM Manufacturing PMI, which rose from 43.1 in May to 52.6 in June, indicating expansion. The employment index improved from 32.1 to 42.1, and the new orders index increased from 31.8 to 56.4..
 

While those are positive developments, this is not indicative of a V-shaped rebound. PMIs are designed to measure month-to-month changes. The economy is still in a big hole it’s trying to dig out of, and there are signs the recovery is stalling.
 

June Employment Report

Let’s begin by analyzing the June Employment Report. The economy added 4.8 million jobs, which was well ahead of expectations. In addition, the diffusion index spiked, indicating a broad rebound. That’s good news.
 

The picture looks far less rosy beneath the surface. Here are the good, the bad, and the ugly parts of the report.

• Good: Low-wage positions like retail and leisure and hospitality, were devastated by the shutdown, and they have bounced back strongly.
• Bad: The high-wage white collar job recovery is stagnant.
• Ugly: Government job growth skidded during the pandemic, and state and local governments are facing urgent budget pressures. Without federal aid, there will be another wave of layoffs in that sector.

The story is the same within the blue and pink collar job sector. Low paying retail jobs have bounced back nicely. The rebound in high paying manufacturing jobs has been less strong, and transportation and warehousing job growth is stagnant.
 

So far, the jobs recovery can be seen in the reversal of temporary furloughs. The unfortunate news is the number of permanent jobs lost.
 

The V-shaped recovery can only be found in low-wage positions. The rest of the jobs market faces a far cloudier outlook.
 

The consumer pulls back

The June Employment Report is a snapshot of the economy in mid-June. High frequency data since then has shown a stalling in consumer activity. Morning Consult reported that consumer confidence is starting to roll over. The weakness began just after mid-June, which was just after the data date of the Employment Report.
 

The ECRI Weekly Leading Index has flattened out in the last two weeks.
 

As well, Chase reported that consumer card spending is also weakening.
 

Blame the pandemic

The slowdown is probably related to a rise in COVID-19 cases in the US south and southwest. Mobility is slowing in the states showing high case growth rates.
 

The surge in case counts in a number of states is well-known.
 

Deaths have not risen so far, which is attributable to a number of reasons. First, young people are being infected, and they tend not to be as vulnerable as the older population, which was the group that was the most affected initially. There is also a lag in the data. The sequence of reports is case count, followed by hospitalization, and deaths. The lag between case count and death is roughly four weeks. Hospitalizations exacerbate the fatality rate, because hospitalization is a signal that a case is serious, and at risk of death or serious complications. However, there is no national database of hospitalizations, and some states, like Florida, do not report hospitalization. Nevertheless, hospitalization rates are rising, with Texas and Arizona being the most seriously affected states.
 

The death rate has not risen for now. If the lagged sequence of case count, hospitalization, and death were to hold, the daily fatality rate in the key states is expected to rise to 1,000 per day or more by late July.
 

Regardless of what happens with the virus, the high frequency data shows that the consumer is already reacting with greater caution. State and local authorities are also reacting to the rising infection rates with new edicts. Texas is the first state to re-impose a lockdown after reopening its economy. The mayor of Jacksonville, Florida, began requiring face masks to be worn in public last week, and the measure could jeopardize the Republican National Convention, which is scheduled for August 24-27 in that city.

Forget about the V. Business Insider reported that Christophe Barraud, who was ranked by Bloomberg as the most accurate forecaster of US economic data eight years in a row, said the US won’t return to its fourth quarter 2019 real GDP level until at least 2022. For some European countries, a recovery won’t happen until 2023.
 

Investment implications

Looking ahead, the trajectory of stock prices will depend mainly on investor reaction to the Q2 earnings season, and the official policy response.

As we enter the Q2 earnings season, companies will undoubtedly discuss their near-term outlook. The latest update from FactSet shows that the Street is lower near-term 2020 estimates, while raising longer term 2021 estimates. Much will depend on the companies’ body language this earnings season, though an extraordinary number of withdrawn guidance owing to high levels of uncertainty.

The Transcript, which monitors earnings calls, gives us an early glimpse of the tone of Q2 earnings reports. The latest update shows reports of a rebounding economy combined with nervousness from executives about rising virus cases in some states and countries.
 

Policy response has several elements: fiscal policy, monetary policy, and health care policy. The economy has been supported by what amounts to “battlefield surgery” fiscal support, which runs out at the end of July. It is clear the economy needs further support beyond July, but it is unclear whether the Republicans and Democrats can agree on a second rescue package so close to an election.
 

The June FOMC minutes gave the market some direction on the path of monetary policy. The Fed is clearly concerned about the pandemic response, and it stands ready to act.

Participants all agreed that the effects of the pandemic would weigh on economic activity in the near term and that the duration of this period of weakness was uncertain. They further concurred that the unpredictable effects of the coronavirus outbreak were a source of major downside risks to the economic outlook…Participants stressed that measures taken in the areas of health care policy and fiscal policy, together with actions by the private sector, would be important in shaping the timing and speed of the U.S. economy’s return to normal conditions. Participants agreed that the Federal Reserve’s efforts to relieve stress in financial markets would help limit downside near-term outcomes by supporting credit flows to households and businesses, and that a more accommodative monetary policy stance would provide support to economic activity beyond the near term.

The effectiveness of the Fed’s response is in the eyes of the beholder. The Fed’s balance sheet shrank for a third week in a row. The reduction in the first two weeks was mainly attributable to the unwind of USD swap lines with foreign central banks, and the latest decline can be traced to a reduction of bank repos that injected liquidity into the banking system. The repo unwind should continue for a few more weeks. The Fed is continuing its purchase of Treasuries and other fixed income instruments during this time.

There has been an apparent near-term correlation between stock prices and the size of the Fed’s balance sheet. Arguably, the recent stall in the market can be explained by a rollover in balance sheet size. On the other hand, the size of the Fed’s balance sheet had flattened and began to fall in 2017, and stock prices continued to rise.
 

As for health care policy, NBC News reported that the White House is pivoting to a “learn to live with it” message in battling the virus:

At the crux of the message, officials said, is a recognition by the White House that the virus is not going away any time soon — and will be around through the November election.

As a result, President Donald Trump’s top advisers plan to argue, the country must figure out how to press forward despite it. Therapeutic drugs will be showcased as a key component for doing that and the White House will increasingly emphasize the relatively low risk most Americans have of dying from the virus, officials said.

However, there is some hope on the therapeutics front.

Next week administration officials plan to promote a new study they say shows promising results on therapeutics, the officials said. They wouldn’t describe the study in any further detail because, they said, its disclosure would be “market-moving.”

Stay tuned for the new “market moving” announcement. Will it be any more than a one-day wonder, or will it have a sustained effect on the outlook?

Trading note: The market has been strong today owing to a melt-up in the Chinese markets. I am conducting a more detailed analysis of the trading framework, which I will publish in the next one or two days.
 

Some analysis has recently emerged pointing to a bleak decade for equities, and US equities in particular. Mark Hulbert highlighted a model outlined in the Philosophical Economics blog, entitled “the single greatest predictor of future stock market returns”. The model is based on US household allocation to equities and uses the levels as a contrarian indicator.

Notice that the household equity allocation is the flip side of the coin from household cash — sometimes referred to as sideline cash. Higher cash levels are therefore bullish and, sure enough, household cash allocations have risen markedly as equity allocations have fallen. But backtesting has shown that household equity allocation is the better predictor. In fact, according to Ned Davis Research, it is able to explain 77% of the variation in the stock market’s return in all 10-year periods since 1951. I am aware of no other indicator that does as well.

Hulbert continued:

Consider a simple econometric model I constructed from quarterly household equity allocation data since 1951 and the stock market’s subsequent inflation-adjusted total return at each step along the way. Based on the year-end 2019 allocation level, that model projected a 10-year inflation-adjusted return of negative 1.3% annualized.

That -1.3% expected real return was based on year-end 2019 data. Q1 2020 figures are in, and we all know what happened in March, namely the COVID Crash. According to Hulbert, projected annualized real returns improved to a positive 2.3% based on March 31 levels. Fast forward to today, the market has recovered most of its losses, and expected inflation-adjusted returns are undoubtedly negative again.

The news is even worse than that. The projected returns are calculated before fees. If an investor were to create a balanced portfolio consisting of some stocks and bonds. Add in some trading costs and management fees, diversification and frictional costs could easily subtract another 1%-2% from overall returns.
 

The Bridgewater warning

Bloomberg reported that Ray Dalio’s Bridgewater Associates has a different take on long-term equity returns. The firm is projecting a possible “lost decade” for US equities:

A reversal of the strong growth seen over the years in U.S. corporate profit margins could lead to a “lost decade” for equity investors, Ray Dalio’s Bridgewater Associates warns.

The margins, which have provided a big chunk of the excess return of equities over cash, could face a shift that would go beyond the current cyclical downturn in earnings, Bridgewater analysts wrote in a note to clients dated June 16.

“Globalization, perhaps the largest driver of developed world profitability over the past few decades, has already peaked,” the analysts said. “Now the U.S.-China conflict and global pandemic are further accelerating moves by multinationals to reshore and duplicate supply chains, with a focus on reliability as opposed to just cost optimization.”

The pandemic-induced collapse in demand has already resulted in a huge fall in profit margins in the short term, the analysts added.

The Bridgewater thesis is based on margin mean reversion. Branko Milosovic’s famous elephant chart showed that the winners of globalization were the middle class in the emerging economies, and the top 1% of population, who engineered the globalization boom.
 

The reshoring trend outlined by Bridgewater isn’t just attributable to the desire to duplicate supply lines and focus on reliability over cost optimization. Bloomberg reported that the Trump administration’s non-tariff barriers against Chinese competition have prompted a scramble by American companies to comply with the unexpected fallout of new legislation.

Aerospace, technology, auto manufacturing and a dozen other industries are engaged in a lobbying frenzy ahead of an Aug. 13 deadline to comply with a far-reaching provision that was tucked into a defense spending bill two years ago.

The broadly written defense law could implicate virtually all companies that count the federal government as a customer, including global subsidiaries and service providers deep in a firm’s supply chain. Excluding subcontractors, more than 100,000 companies provided $598 billion in goods and services directly to the U.S. government last year, according to a Bloomberg Government tally.

To date, measures taken by the Trump administration against Huawei and other Chinese tech companies have been aimed at cutting off their access to American components and networks. This law would ratchet up the pressure even more, putting the onus on U.S. government contractors to comb through their businesses to ensure they have no connections to banned Chinese companies.

Just as America weaponized its dominance in finance to force any bank doing business with sanctioned entities access to the US banking system, this law weaponizes the procurement process to deny any company doing business with Huawei and ZTE from business with America.

Section 889, part B, of the National Defense Authorization Act would require companies to certify that their entire global supply chain — not just the part of the business that sells to the U.S. government — is devoid of gear from Huawei, ZTE, Hikvision and other targeted Chinese tech firms.

The measure could apply to virtually all companies that count Uncle Sam as a customer, including subsidiaries and service providers deep in a firm’s supply chain. Excluding subcontractors, more than 100,000 companies provided $598 billion in goods and services directly to the U.S. government last year, according to a Bloomberg Government tally.

Imagine a company has a foreign office. That office will naturally have a phone system which connects to the local phone network. If the phone network has any component that uses Huawei equipment, the company is not compliant. That’s how far reaching these measures are.

There are alternatives to Huawei equipment. Singapore recently announced its decision to use Nokia and Ericsson to supply its 5G systems. They’re just more expensive, which puts pressure on margins.
 

Gold as a confidence indicator

These low equity return expectations are consistent with my previous publication highlighting gold as a confidence indicator (see What gold tells us about confidence). The relative downtrend of the stocks to gold ratio is an ominous sign for long-term equity returns.
 

Here is one explanation for the lack of confidence. One of the bedrocks of long-term return expectations is valuation. While valuation tells us little about what stock prices will do over the next year, they are highly predictive of long-term returns. Global forward P/E ratios are back to dot-com like valuations.
 

Much of the heightened valuation is attributable to US equities, which account for roughly half the weight of global stocks. But US equity valuations have soared against their non-US counterparts.
 

Equity overvaluation cannot be just explained by expensive US stocks, though. Bloomberg reported that Longview Economics found that “80% of the markets [they] track have a valuation in the upper quartile relative to the market’s history — the greatest percentage on record using data since the mid-1990s”. Everything is expensive.
 

It’s not just stocks that are expensive, bonds can hardly be described as cheap on an absolute basis. Austria recently issued another 100-year bond at a yield of 0.88%. The offering was well subscribed, which is another sign of a bond bubble.

In short, this is a low-return environment, and there are few attractive alternatives.
 

Where can investors hide?

This begs the question: Where investors can hide in such a low return environment?

Much of the answer depends on the degree of monetary accommodation that global central bankers are willing to provide. The intermediate term outlook is based on the Fed’s focus on unemployment irrespective of asset prices. Consider this exchange at the last post-FOMC press conference between Bloomberg reporter Michael McKee and Fed Chair Jerome Powell.

I came across a statistic the other day that amazed me. Since your March 23rd emergency announcement, every single stock in the S and P 500 has delivered positive returns. I’m wondering, given the levels of the market right now, whether you or your colleagues feel there is a possible bubble blowing that could pop and setback the recovery significantly, or that we might see capital misallocation that will leave us worse off when this is over?

Here is how Powell responded:

So, we — we’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk, like markets are supposed to do. Borrowers are borrowing, lenders are lending. We want the markets to be working. And again, we’re not looking to — to a particular level. I think our — our principal focus though is on the — on the state of the economy and on the labor market and on inflation.

The Fed is signaling a “whatever it takes” moment to bring down unemployment. The Fed has an array of tools to achieve those goals, such as asset purchases, yield curve control, and even negative interest rates. Translated, the Fed is willing to engage in financial repression. Other central banks are either following suit, or ahead of the Fed’s curve. The ECB has already experimented with negative rates.

A bet for financial repression, at least for the next 2-3 years, is a bullish bet on gold. Historically, real 10-year TIPS yields (inverted scale) have been highly correlated with gold prices. As long as the Fed is willing to engage in suppressing rates and yield curve control, it should put upward pressure on gold prices.
 

Is it any wonder why the stock/gold ratio is falling? However, standard portfolio construction solutions call for the weight of gold in a well-diversified medium-risk portfolio to be no more than high single digit or low double digits percentages. I agree with that assessment. That means investors still need some exposure to equities as a source of growth.

One option is boost long-term returns to consider beaten up value stocks. The growth to value performance ratio has gone parabolic, and the growth to value relationship is extremely stretched.
 

A commitment to value investing comes with two caveats. First, value style portfolios are generally overweight in financial stocks, and financial stocks don’t perform well under conditions of financial repression. As well, the growth/value ratio is still skyrocketing and showing no signs of a rollover. From a tactical perspective, it may be wise to wait for a pause and reversal of the ratio before making a full commitment to value investing.

There are a number of other alternatives for US investors considering the value style. One is Barclays Shiller CAPE ETN (ticker CAPE), which buys the top four cheapest sectors based on CAPE that exhibits relatively strong price momentum. Another is the shares of Berkshire Hathaway, which is not strictly value investing, but quality (wide-moat) companies at a reasonable price. Both CAPE and BRK have lagged the market in the past year, but they have outperformed the value style over the last few years. As well, the last time Warren Buffett was this widely ridiculed for his performance was in 1999, which was a year before the dot-com bubble popped. That said, Buffett has become so successful with Berkshire that the company has a size problem and it has trouble deploying its cash as efficiently as it did in the past. In effect, it has become a cash generative conglomerate, with a sizable position in Apple, and a large cash hoard.
 

Another option for US equity investors is to look abroad. Rather than simply ranking countries by CAPE, which can lead investors into value traps, such as Europe where stocks appear cheap because of lower growth potential, Research Affiliates ranked country valuations relative to each country’s own historical range of CAPE. Based on this analysis, US large cap stocks are wildly expensive, with Switzerland coming in second place, and US small caps in third. At the other end of the spectrum, Turkey, Malaysia, Poland, South Korea, Thailand, and South Africa are the cheapest countries, in that order.
 

Before plunging into some of these small and somewhat illiquid markets, it’s one thing to buy cheap stocks and markets, and it’s another to watch the markets become cheaper as fundamentals further deteriorate, which is otherwise known as a value trap. To avoid that problem, we overlaid a relative price filter to look for price stabilization in order to avoid the value trap problem. Looking at the relative performance of these countries compared to the MSCI All-Country World Index (ACWI), Turkey and South Korea are the standouts. They have tested relative support and they are forming bases by consolidating sideways. The relative performance of Thailand may be constructive and bears watching. Thai stocks are trying to form a bottom after breaking a key relative support level. The other three are all in relative downtrends and should be avoided for now.
 

As well, the degree of non-US commitment will partly depend on the outcome of the November elections. Current polling indicates a Biden lead over Trump, and recent victories by progressives in primaries is likely to push the Democrat agenda leftward. A Blue Wave victory in November, which is becoming the base case scenario, will mean MMT-style stimulus, and increased US corporate taxes. These developments will be USD negative, and non-US equity, especially EM, positive.

In addition to a buy-and-hold strategy, investors can consider allocating funds to tactical asset allocation as a way of enhancing returns. While I am not claiming that my Trend Asset Allocation Model represents the Holy Grail of investing, an asset allocation switching strategy that uses the out-of-sample signals of the Trend Model has achieved equity-like returns with 60/40 like risk. The usual caveats about how past performance is not indicative of future returns apply.
 

In conclusion, investors are facing a low return setting in the next decade. However, there are a number of pockets of opportunity for investors. Gold, value stocks, selected cheap foreign markets, and the use of tactical asset allocation are all ways of enhancing returns in a difficult investing environment.