A LOST DECADE: BIDEN’S PYRRHIC VICTORY? · 2020-06-29 · In conclusion, investors are facing a low return setting in the next decade. However, there are a number of pockets of

Cam Hui, CFA | [email protected] Page 1

Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub

Quantitative & Strategy

A LOST DECADE: BIDEN’S PYRRHIC VICTORY?

June 29, 2020

EXECUTIVE SUMMARY

It has been a bad few weeks for President Trump, as he has been sinking in the polls. The

latest PredictIt odds show that a rising chance of a Biden victory in November, which is

becoming our base case scenario. Should Biden win the White House in the next election,

he may only win an economic Pyrrhic Victory, as investors are likely to sour at the prospect

of a “lost decade” for equity returns.

Some analysis has recently emerged pointing to a bleak decade for equities, and U.S. 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 U.S. household allocation to equities and uses the levels as a contrarian indicator.

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.

In addition, Bridgewater Associates is warning of a possible “lost decade” for U.S. equities

owing to a retreat in globalization.

We believe investors are facing a low return setting over 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.

Cam Hui, CFA [email protected]

Table of Contents

A Possible Pyrrhic Victory ........................ 2

The Bridgewater Warning......................... 3

Gold: Confidence Indicator ....................... 5

Where Can Investors Hide? ..................... 8

mailto:[email protected]

https://www.marketwatch.com/story/the-single-greatest-predictor-of-future-stock-market-returns-has-a-message-for-us-from-2030-2020-06-19

http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/




June 29, 2020


A Possible Pyrrhic Victory

It has been a bad few weeks for President Trump, as he has been sinking in the polls. The latest

PredictIt odds show that a rising chance of a Biden victory in November, which is becoming

our base case scenario. Should Biden win the White House in the next election, he may only

win an economic Pyrrhic Victory, as investors are likely to sour at the prospect of a “lost

decade” for equity returns.

Exhibit 1: Biden Gaining Ground in Betting Markets

Source: PredictIt

Some analysis has recently emerged pointing to a bleak decade for equities, and U.S. 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

U.S. 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.


https://www.marketwatch.com/story/the-single-greatest-predictor-of-future-stock-market-returns-has-a-message-for-us-from-2030-2020-06-19



June 29, 2020


Exhibit 2: Household Equity Allocation Inversely Correlated with Future Returns

Source: Mark Hulbert

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.



June 29, 2020


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 U.S. 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.

Exhibit 3: Globalization Winners and Losers

Source: Branko Milanovic

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.


https://www.bloomberg.com/news/articles/2020-06-18/dalio-s-bridgewater-warns-of-possible-lost-decade-for-stocks

https://www.bloomberg.com/news/articles/2020-06-10/dread-over-impending-anti-huawei-law-grows-at-u-s-companies


June 29, 2020


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 U.S. 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.



June 29, 2020


Gold: Confidence Indicator

These low equity return expectations are consistent with our 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

Exhibit 4: Falling Stock/Gold Ratio = Falling Confidence

Source: StockCharts

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.


https://humblestudentofthemarkets.com/wp-content/uploads/2020/05/20200525-What-gold-prices-tell-us-about-confidence.pdf


June 29, 2020


Exhibit 5: Global Stock Valuations Are Highly Stretched

Source: Bloomberg

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

Exhibit 6: U.S. Equities Premium Skyrockets

Source: Bloomberg



June 29, 2020


Equity overvaluation cannot be just explained by expensive U.S. 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.

Exhibit 7: Everything Is Expensive

Source: Longview Economics

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.



June 29, 2020


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 23 emergency announcement,

every single stock in the S&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 are 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.

Exhibit 8: Negative Real Rates Are Bullish for Gold

Source: Bloomberg



June 29, 2020


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-digit percentages. We 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.

Exhibit 9: Growth vs. Value

Source: StockCharts

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 U.S. 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.



June 29, 2020


Exhibit 10: Selected Alternatives to Simple Value Investing

Source: StockCharts

Another option for U.S. 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, U.S. large-cap stocks are

wildly expensive, with Switzerland coming in second place and U.S. 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.



June 29, 2020


Exhibit 11: Country CAPE Valuations Relative to Their Own History

Source: Research Affiliates

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.



June 29, 2020


Exhibit 12: Selected Cheap Markets Relative to ACWI

Source: StockCharts

As well, the degree of non-U.S. 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 U.S. corporate taxes. These developments will be USD negative and non-U.S.

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 we are not claiming that our 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



June 29, 2020


60/40 like risk. The usual caveats about how past performance is not indicative of future returns

apply.

Exhibit 13: Trend Asset Allocation Model Report Card

Source: Pennock Idea Hub

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.



June 29, 2020


Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub


A LOST DECADE: BIDEN’S PYRRHIC VICTORY? · 2020-06-29 · In conclusion, investors are facing a low return setting in the next decade. However, there are a number of pockets of

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