The most extraordinary thing to my mind . . . was the dovetailing of the commonplace habits of our social order with the first beginnings of the series of events that was to topple that social order headlong.
—H. G. Wells, The War of the Worlds (1898)
While H. G. Wells’s The War of the Worlds was written twenty years before the Spanish flu pandemic, it is routinely referred to in historical accounts of the flu. The reason is obvious. Wells described an invasion of Earth by Martians that was unstoppable. The Martians’ spindly tripod war machines, complete with heat-ray devices and poison gas, were practically impervious to weaponry the military powers of the day could bring to bear. The Martians ran rampant, killing humans, destroying buildings, and burning farms. Then, just as humans were facing their own possible extinction, the Martians suddenly died. Wells describes the scene:
And, scattered about it, some in their overturned war-machines . . . were the Martians—dead!—slain by the putrefactive and disease bacteria against which their systems were unprepared; . . . slain, after all man’s devices had failed, by the humblest things that God, in his wisdom, has put upon this earth.
. . . There are no bacteria in Mars, and directly these invaders arrived, directly they drank and fed, our microscopic allies began to work their overthrow. Already when I watched them they were irrevocably doomed.
Wells’s work was extremely popular and well known worldwide. His phrase “disease bacteria against which their systems were unprepared” resonated with sufferers of the Spanish flu, which was believed by most scientists at the time to be caused by a bacterium; the virus theory was not proven until 1931, and no virus was seen by scientists until 1935, shortly after the invention of the electron microscope. Spanish-flu victims were as vulnerable as fictional Martians, and many suddenly died. Reference to The War of the Worlds is back in the news due to SARS-CoV-2, another lethal virus to which victims have no immunity.
Wells had another theme in his novel that was aimed at readers in 1898 and is highly relevant to investors today. This theme is the gap between perception and reality. It arises when one objective reality exists yet observers are either unprepared to accept reality or unaware of it. In The War of the Worlds, the Martians had indeed landed on Earth and begun assembling their war machines. Still, most humans either didn’t believe it or didn’t care. The news spread slowly in concentric circles from the Martian landing zone to local towns and finally to London and around the world. Still, the news was met with indifference or disbelief at every stage. Eventually reality sank in; by then it was too late. The Martians were on a rampage and there was no time to escape. Wells intended this as a warning—not about Martians but about technology and human indifference to the dangers it posed. The American social psychologist Leon Festinger gave this phenomenon the name “cognitive dissonance” in 1957, yet the phenomenon is as old as civilization.
Over time, the perception gap between reality and individual beliefs creates psychological tension. Either the observer must change his views to conform to reality or reality will overwhelm the observer, potentially causing great harm. It’s like standing on railroad tracks and seeing a train approaching and somehow convincing yourself that’s there no train, or it’s not moving, or it will stop in time. In the end, the observer either decides it’s a moving train and jumps off the tracks or is run over and killed.
Cognitive dissonance is the best way to describe the behavior of most market participants today. On the one hand, the United States is experiencing its worst pandemic since the Spanish flu, the worst depression since the Great Depression, and the worst rioting since 1968 at the same time. On the other hand, major U.S. stock market indices recovered most of the February–March 2020 losses by early June; the NASDAQ Composite Index reached a new all-time high of 12,056 on September 2, 2020.
Stock market bulls claim the market is not looking at today; it’s looking at the future and discounting that state of the world in today’s prices. A positive forecast justifies the new bull market. That’s the perception of some; the reality is entirely different.
Unemployment will decline, but it will decline from the highest levels in seventy-five years and not return to prepandemic levels for at least five years, perhaps longer. Growth will return but will be modest. The 2019 output level will not be reached until 2023 at the earliest. Lawyers are lining up at the bankruptcy courts to file a record number of large-business bankruptcy cases. Many small and medium-sized businesses will never reopen their doors, despite bailout money and soft loans. Price-to-earnings ratios for the S&P 500 stocks are at levels not seen since the early-2000 dot-com bubble. First-time retail investors are cashing IRS bailout checks and opening online brokerage accounts to buy Hertz, a company already in bankruptcy. New investor Dayanis Valdivieso said of her stimulus check, “It was basically free money, so, you know, I decided to play around with it. . . . It’s like a gambling game.” During bankruptcy proceedings, equity is often valued at zero. Yet novices like Valdivieso tripled their money as Hertz stock went from $0.72 per share to $5.50 per share on sheer speculation in the first week of June 2020. Hertz shares then collapsed when an NYSE delisting notice was issued on June 10. The novices got a quick education in bankruptcy and securities law.
As for the economy, which is it? A rapid recovery and return to normal with a great chance to buy stocks while they’re still cheap? Or a slow recovery with weak growth, high unemployment, an output gap, and another stock bubble waiting to crash? Both scenarios can’t be right. One must be reality and the other an exercise in denial. This gap between perception and reality is an example of cognitive dissonance as practiced by market participants. The perception gap creates huge opportunities for gains by investors. If the stock market has it right, the economy will soon boom and investors will see gains in commercial real estate, corporate credit, emerging markets, and the travel and hospitality industry. If the stock market has it wrong, the profitable opportunities will come from shorting stocks, buying Treasury notes, shorting the U.S. dollar, and buying gold. Which is it?
This thought experiment in cognitive dissonance demonstrates several essential facts for investors. The first is that you can make money in every kind of market. The idea that in bear markets you should quickly go to cash and move to the sidelines is untrue. That move will preserve wealth, yet an investor will miss out on profit-making opportunities that exist in bear markets. Unfortunately, investors are taught that stocks, notes, and cash are the only asset classes they can consider (and 401(k) plans are structured exactly that way). Yet there are liquid markets in property, private equity, alternative investments, natural resources, gold, currencies, fine art, royalties, insurance claims, and other asset classes. These asset classes don’t just add range to tired allocations between stocks and bonds; they add true diversification, which is one of the few ways to increase returns without commensurately increasing risk.
The second lesson from cognitive dissonance is that profit opportunities are manifest if you understand that markets are not about being right or wrong; they’re about information. There’s a myth that markets are efficient venues for price discovery that smoothly process incoming information and adjust continuously to new price levels before investors can catch up and take advantage. That has never been true, and it’s less true today than ever before. This “efficient markets hypothesis” was an idea dreamed up in the faculty lounge at the University of Chicago in the 1960s that has been propagated to generations of students ever since. It has no empirical support; it just seems elegant in closed-form equations. Markets are not efficient; they freeze up at the first sign of trouble. They do not move continuously between price levels; they gap up or down in huge percentage leaps. This can produce windfall profits for longs or wipeout losses for shorts. That’s life; just don’t pretend it’s efficient. Most important, the efficient-markets hypothesis was used to herd investors into index funds, exchange-traded funds (ETFs), and passive investing based on the idea that “you can’t beat the market” so you might as well just go along for the ride. That works for Wall Street wealth managers, who simply collect fees on account balances and new products. It does not work for investors who take 30 percent losses (or worse) every ten years or so and have to start over to rebuild lost wealth. You can beat the market using good forecasts, market timing, and a perfectly legal form of inside information. That’s what pros do. That’s what robots do. And everyday investors can do it too.
The fact is markets are more likely to be wrong than right in their forecasting. When markets get the forecast wrong, the gap between perception and reality can benefit investors. The 2007–9 financial crisis came into view in the spring of 2007 when mortgage delinquencies rose sharply. There was liquidity stress in August 2007; two mortgage hedge funds and a money market fund closed their doors around the same time. Then the problem seemed to go away. In September, Treasury secretary Hank Paulson announced the Super SIV (a roll-up special investment vehicle designed to refinance commercial bank off-balance-sheet liabilities; it never happened but sounded good at the time). Stocks hit a new all-time high in October 2007 (that’s six months after the crisis started), partly based on unfounded assurances from Paulson and Ben Bernanke. In December 2007, a clutch of sovereign wealth funds from Abu Dhabi to Singapore bailed out the commercial banks by buying preferred stock and debt. All was well, or so it seemed.
Yet in March 2008, the investment bank Bear Stearns failed. It was quickly taken over by JPMorgan, and markets breathed a sigh of relief. Then in June, mortgage-finance giants Fannie Mae and Freddie Mac failed. Congress pushed through a bailout bill and markets again became complacent. Once more, the worst was over!
It was obvious we were witnessing sequential failures after the August 2007 warning. It was equally obvious that the failures were not over. Lehman Brothers had been the weakest link in the Wall Street chain since 1998 and was widely regarded by insiders as the next firm to fail in the new crisis. I explained this threat to John McCain’s presidential campaign’s economic team in August 2008. I was laughed off the call and not invited back. Markets continued to behave as if nothing were wrong.
Finally, on September 15, 2008, Lehman Brothers filed for bankruptcy. That was the point at which the gap between perception (“the crisis is over”) and reality (“the crisis is just beginning”) closed abruptly. Most investors got crushed. The point is that markets did not see it coming, and neither did Fed chair Bernanke, who said in 2007 that the mortgage problems would blow over. Markets were not efficient discounting mechanisms of future events. Cognitive dissonance had allowed investors to believe in the best outcomes while the truth was grim. Markets were in la-la land and got a brutal reality check that September.
Markets did not see the crash coming in 2008. And they did not see the crash coming in 2020. That’s not what markets do. Understanding what’s coming next is up to you.
How can you beat the market? There are three steps: Get the forecast right, get the policy reaction function right, and trade ahead of both. Those three steps are explained below using original models and optimal action plans. That technique is then turned into concrete investment recommendations.
Before diving into methodology and recommendations, one more piece of background advice is needed: It is essential to stay informed and be nimble.
The Wall Street mantra of “set it and forget it” is a great way to lose money. The idea that you can buy an index fund and “invest for the long term” is nonsense. When you lose 30 percent to 50 percent of your market value every ten years, there is no long term. Just because markets eventually regain their losses does not mean you should suffer losses in the first place. If the Dow Jones Industrial Average Index was at 29,000 and went down to 18,000, it might eventually get back to 29,000, but that could take five to ten years. Wall Street says, “Yeah, but you made your money back!” Not really. What happened is you ended up where you started after five years in Death Valley. What if you sold out at 28,000 (missing out on the rally’s last 3.5 percent), bought back in at 19,000 (missing out on the first 5.5 percent of the new rally), and rode the market back to 29,000? Your incremental return during the market round-trip is 53 percent. The long-term investor who rode the market down and back up again made 0 percent. That’s what Wall Street wealth managers never tell you. They just want your money in the account earning wrap fees. They don’t care about you, your wealth, or your retirement.
This technique (“stay informed and stay nimble”) is not limited to the stock market. It can be applied to every asset class, including bonds, private equity, and gold. I continually run into people who are surprised by a particular recommendation I make. They say, in effect, “Six months ago you said the opposite!” That’s right. Ideas that were perfect six months ago may have performed as expected, producing significant profits, and now the time has come to close out the position, pocket profits, and try something new. This is particularly true in currency and commodity markets, where dollar prices can be range bound and subject to predictable reversals. The EUR/USD exchange rate may move between $1.00 and $1.60, but it will not go to zero like a bankrupt company or to exorbitant heights like Apple. Reversing course around critical pivot points is an essential trading technique. Markets change, conditions change, and news changes daily. You need to switch your portfolio mix in at least some respects to outperform markets.
This is not day-trading (which I do not endorse). The goal should not be to scalp nickels and dimes on a daily basis. Some traders are good at this, yet most lose their shirts. Instead it’s a medium-term outlook (six months forward) with continual updating. This does not mean a position can’t be profitable for five to ten years. It can. Nonetheless, you should be evaluating positions on a rolling six-month-forward basis to provide time to get out of the way of an oncoming train if needed. Markets don’t do this well; they tend to get run over by the train and take investors down with them. Yet individual investors can execute this strategy with the right models and the right forward-looking trades.
A word on models: I have been extremely critical of most economic models for years. Models such as the Phillips curve, NAIRU, R-star, the “wealth effect,” Black-Scholes, the “risk-free rate,” and others are junk science. They bear no relationship to reality. They are a leading cause of the gap between perception and reality that leads to periodic shocks when reality breaks down the door of the faculty lounge. These models (which go under the name of dynamic stochastic general equilibrium, or DSGE, models) should be scrapped. They won’t be, because three generations of academic economists have too much time and effort invested in their creation and perpetuation. That’s okay; the academics’ loss is your gain. If policy is guided by flawed models and you know the flaws, you can front-run the policy.
A word on diversification: It works. Diversification is a sure way to improve returns without adding commensurate risk. The problem is most investors don’t understand what diversification is, and neither do their wealth managers. Your wealth manager will tell you that if you own thirty stocks spread among ten different sectors (say, energy, materials, industrials, consumer discretionary, etc.), you are diversified. You’re not. You may have thirty stocks spread among ten sectors, but they’re all in equities, which is one asset class. Stock prices are increasingly correlated to one another and to the market as a whole. They rise and fall together. There are exceptions, yet not enough to mitigate the concentration risk. There are reasons for this correlated behavior, including passive investing, index investing, hot money, ETFs, and robots. You don’t have to be expert on those causal factors. Just understand that buying different stocks does not give you diversification. True diversification comes not within an asset class but across asset classes. It’s fine to have some stocks. Still, you should add bonds, gold, real estate, private equity, and other asset classes that are not highly correlated with stocks. That’s how you improve returns.
A word on robots: Over 90 percent of all stock trading today is done not by humans but by robots. No matter how often the information is repeated, investors don’t get it. These are not merely electronic order-matching systems that offer anonymity and cheap execution. Those have been around since the 1990s. Trading today is done by real robots that use coded algorithms to make buy and sell decisions and execute trades in nanoseconds without human intervention. When you make investment decisions, remember you’re not competing with other investors; you’re competing with robots.
That’s good news because robots are dumb. They do exactly what they’re told. When you hear the phrase “artificial intelligence,” you should discount the word “intelligence” and focus on the word “artificial.” Robots are programmed with code developed by engineers in Silicon Valley, many of whom have never set foot on Wall Street. They use large data sets, correlations, and regressions, and they read headlines and content for key words. When certain key words are encountered, or when price action deviates from a predetermined baseline, the robot is triggered and executes a buy or sell. That’s about it.
Once you understand the robot algorithms, it’s easy to front-run them. Robots assume the future resembles the past. It doesn’t. Human nature may not change, yet conditions change all the time. That’s why we have history. Robots assume that the people who utter the key words know what they’re doing, but they don’t. The Fed has the worst forecasting record of any major economic institution; the IMF is no better. Official forecasts should always be listened to and never relied upon. The officials in charge have no idea what they are doing. The robots’ massive databases may have a huge volume of data, but they don’t go back very far in time. Twenty or thirty years is not enough to form a good baseline. Ninety years is better. Two hundred years is better still. Robots routinely “buy the dips,” chase momentum, and believe the Fed. When you know that robots are leading markets over a cliff, you can front-run the inevitable correction and profit from the robots’ blind spots. Once again, you profit from the gap between reality and perception.
A word on insider trading: It’s legal (most of the time). Insider trading involves using material, nonpublic information to trade ahead of big moves and beat the market. It’s illegal only if you steal the information or receive it from someone who breached a trusted relationship, such as a lawyer, accountant, director, officer, or just someone who had a “hot tip” where you believe that person got the information improperly. If you obtain information legally by developing it yourself using better analysis, better models, or proprietary systems that you invented or receive as a subscriber, then you didn’t steal the information and it’s perfectly legal to trade on it. In fact, academic research shows that trading ahead of markets on inside information is the only way to beat the market. That results from a combination of good models and market timing. That’s the key to outperformance. Yet it also explains why you need to be nimble, because model output is always changing based on updated information and conditional correlations.
To summarize:
Use models that work (as described below).
Update continually (with a rolling six-month horizon).
Diversify (across asset classes, not within one asset class).
Acquire proprietary inside information (legally).
Use market timing (to beat the crowd).
Front-run the robots (they’re not that smart).
Own the perception gap (reality always wins in the end).
Be nimble.
That’s the playbook. Now let’s look at specific models and specific portfolio allocations.
The prior section described the defective models used by policy makers and Wall Street wealth managers. So what forecasting models actually work?
Our model-construction technique uses four branches of science that are consistent with reality and can also solve for uncertainty. The first branch is complexity theory. This teaches that outcomes in complex dynamic systems are unpredictable as to timing yet are highly predictable as to the degree distribution of shocks. In plain English, this means that large market-moving events happen more frequently than normal distribution (the “bell curve”) or equilibrium (DSGE) models predict. If the bell-curve model expects that an extreme event will happen once every hundred years, yet you know (using complexity theory and the power curve) that the event will happen once every seven to ten years, then you will be well positioned to profit from the event while others are running around yelling, “Black swan!” (a content-free cliché that even those yelling it can’t explain). Complexity theory also teaches that the nature of extreme events (emergent properties) cannot be inferred from complete knowledge of the factors in the system. That’s why shocks are not only more frequent than Wall Street expects but also different in kind. That doesn’t mean you can predict the next shock with precision. It does mean you can expect the unexpected with some frequency. That alone makes you a better investor.
The second branch in model construction is Bayes’ theorem, a formula from applied mathematics. Bayes’ theorem is the tool you use when you don’t have enough information to solve a problem by deduction. If all the information needed to solve a problem were right in front of you, a bright high-school student could solve it. What do you do when you don’t have that much information (which is most of the time)? What do you do when you don’t have any information? That’s where Bayes’ theorem is used. Bayes’ also helps to overcome the uncertainty factor in complexity theory. That’s why they work well together. I learned to use Bayes’ while working in the U.S. intelligence community from 2003 to 2014. The CIA and the Los Alamos National Laboratory use it for everything, from counterterrorism to nuclear-explosion simulations, unlike Wall Street, which scarcely uses it at all. Again, Wall Street’s loss is your gain.
You begin working the problem by making an intelligent guess about the answer, expressed as a probability based on experience, history, intuition, anecdote, or whatever data scraps you have. Conventional statisticians and academic economists disdain the guessing part; they demand more data. Yet when you don’t have data and the problem is too important to leave on the shelf, a smart guess is the best you can do. Next you update the a priori guess with posterior information. When the new data arrives, you ask yourself: What is the conditional probability that the second data point would appear if the first guess were true (or false)? This is challenging because you have to be honest with yourself (if the original guess was wrong) and avoid confirmation bias (evaluate all new data, not just the bits you agree with). Humility is your best friend at this stage.
Eventually the likelihood of the guess being right goes down (in which case you discard it) or increases (in which case you can bet real money). When the likelihood of the guess being right reaches 90 percent, you can even go on TV and make categorical forecasts, as I did in 2016 when I correctly predicted Trump would win that election and that UK voters would vote for Brexit (both correct forecasts, which were made in the face of overwhelming odds favoring Hillary Clinton and “remain” in the UK vote). In both cases, I did not rely exclusively on polls but used anecdotal information, such as counting yard signs from a Greyhound bus, visiting an Evangelical compound in the Ozark Mountains, and holding everyday conversations with taxi drivers, hotel clerks, and London barmen. My advice to Wall Street analysts is to get out of the office more and get away from their screens. Few follow that advice.
The third branch is history. Academic economists and Wall Street analysts despise history or simply ignore it because it can’t be quantified and used in equations. That’s their loss; there’s no better teacher than history. Individual story lines may not repeat, but the pattern does. History may be difficult to quantify, yet you can use it to create factor nodes in a cognitive map. The strength of the interactions of those nodes with other nodes can be quantified. Complexity theory can help one draw the map, and Bayes’ theorem can be used to assign numeric strength to the nodal outputs. This illustrates how branches of science work together on an interdisciplinary basis.
It’s interesting to hear analysts today refer to the Thucydides trap, an idea advanced by author Graham Allison. He uses the fifth-century b.c. Peloponnesian War between a rising power (Athens) and an established power (Sparta) as a warning of a coming conflict between a new rising power (China) and today’s established power (the United States). That’s a good example of how history can be used to enrich macroanalysis today. For forecasting purposes, I remind readers that Sparta won in part because of a pandemic.
The fourth branch is behavioral psychology. This is a field that has received enormous attention in economics and almost no application in macroeconomic models. In some ways, it’s the scientific study of common sense, which reveals that people are often “irrational” as economists define the term. Well-designed experiments have been able to identify distinct cognitive biases and show that these biases guide human decision making, whether they make sense to economists or not. The most famous practitioners in the field today are Princeton professor (emeritus) and Nobel Prize winner Daniel Kahneman (who credits his deceased collaborator Amos Tversky) and Duke professor Dan Ariely. Among the many biases they identified are “confirmation bias” (we tend to accept data we agree with and discard data that we disagree with), “anchoring bias” (we get stuck on an old idea and won’t change despite contrary evidence), and “recency bias” (we are unduly influenced by the latest idea). If you sense that some of these biases contradict each other, you’re right. That’s part of the overall irrationality. These biases apply to a wide range of behaviors, but they are particularly useful in analyzing capital markets. Behavioral psychology helps to explain market bubbles (confirmation bias lets investors ignore warning signs) and market crashes (a loss-aversion bias causes investors to value avoiding loss more than they value making money). The work is compelling and highly useful. Behavioral science gets lip service on Wall Street and is discussed at cocktail parties, yet it’s not used in most models. Standard risk-management models still assume that the future resembles the past, bubbles don’t exist, and crashes are “hundred-year storms” (they actually happen all the time). In contrast to Wall Street, improved techniques embed the insights of behavioral psychology in predictive analytic models.
The fusion of complexity + Bayes’ + history + psychology in the new models is just a beginning. From there one can construct cognitive maps consisting of nodes (individual cells that represent critical factors or tradable results) and edges (lines connecting the nodes in a dense network). Separate maps are created for each market or asset class (interest rates, stock indices, currencies, commodities, etc.). These maps are constructed under the guidance of subject-matter experts who have the best grasp of relevant factors. The edges are given a direction (A —> B) and assigned a weight. Some edges are omnidirectional due to recursive functions (A <—> B). The nodes contain coded instructions based on a new branch of applied mathematics. Finally, the nodal processing is populated with both market data and plain-language reading ability from massive news feeds more sophisticated than mere headline readers. Edge weights and nodes are updated continually to reflect market and political conditions. The tradable output node is typically geared to a six-month horizon, which can be lengthened or shortened as needed.
This is our predictive analytic system. It’s not for day traders. The new models can’t tell you what will happen tomorrow. They can tell you what will happen in six months. That allows an investor to trade ahead of markets, which is the key to consistent risk-adjusted profits and excess returns. And it’s the key to avoiding meltdowns.
Here’s a summary of our predictive analytic views for the postpandemic world of 2021 and 2022:
Deflation (or strong disinflation) will prevail.
Stocks have not hit bottom.
Interest rates will fall further.
Bonds will continue to rally.
Gold will go significantly higher.
The COVID-19 recovery will be slow and weak.
Unemployment will remain near 10 percent.
Commercial real estate will fall further.
Residential real estate is an attractive opportunity.
The dollar will be strong in the short run, weaker by 2022.
Oil will surprise to the upside based on output reductions and sanctions.
Following are specific portfolio allocations based on these predictive analytics:
Stocks have further to fall. The April–September 2020 rally in stocks had several factors supporting it, yet none is sustainable and all are far removed from the on-the-ground reality of the U.S. economy and individuals’ preferences.
The first driver of the stock rally is the influence of robots. The algorithms are designed to buy stocks on Fed ease, buy stocks on positive pronouncements by public officials, buy stocks on momentum, and buy stocks on pullbacks. This software did not anticipate a decline from Dow 29,551 on February 12, 2020, to Dow 18,591 on March 23—a 37 percent drawdown in less than six weeks. Still, the robots knew that every drawdown in eleven years had been followed by a Fed-supported rally. Once the Fed cut interest rates to zero at an unscheduled meeting on March 15, the robots had their green light to buy the dip. Congressional agreement on the $2.3 trillion CARES Act stimulus bill, signed into law on March 27, also confirmed to the robots that practically unlimited fiscal stimulus would accompany monetary stimulus. Fundamental analysis and earnings projections were unneeded; the algorithms saw money printing and deficit spending (with more on the way) and lifted stocks off the bottom. From there, further monetary and fiscal stimulus, combined with a positive narrative about a V-shaped recovery and pure momentum, carried stocks most of the way to their recent all-time highs. The second driver for stocks is an overly optimistic belief that the U.S. economy will trace a simple V shape and bounce back quickly from the March 2020 collapse. It’s certainly the case that the stock market itself has traced a V, as if anticipating the economic bounce-back scenario.
There are three problems with this sanguine view. First, there is no evidence that a V-shaped economic recovery is in the cards. Modest recoveries from extremely low levels hardly constitute a bounce-back; they are to be expected. Gains so far have been slight and powered mainly by never-before-seen deficit spending and zero interest rates. Those boosts will not be repeated; you can only go to zero once without raising rates again. Fed chair Powell declared on June 10, 2020, that markets should not expect rate hikes before 2022. Further fiscal deficits are politically if not legally dead beyond the current baseline and continuation of some ongoing programs, such as higher unemployment benefits. With those tools off the table, there will be no recovery without increased aggregate demand from consumers and businesses. Neither are inclined to spend at the moment. The second problem is that even advocates of the V-shaped recovery project a flattish right leg of the V. It’s more a shallow bounce than a quick return to the former level of total output. Third, stocks are being boosted by pure speculation from retail investors, momentum chasing by hedge funds, and the dominance of index funds that have no choice but to buy the index.
The problem is these dynamics are at odds with reality. Fiscal stimulus does not work because of excessive debt. Monetary stimulus does not work because of falling velocity. The economy and corporate earnings will recover slowly if at all. A perception gap has opened up between stock market prices and economic reality. Since reality won’t budge, stock prices must fall to converge with reality. This won’t happen overnight; reality checks take time.
Of course, some individual sectors and companies will outperform in this new drawdown. It may be expected that defense stocks will benefit from higher military spending as international tensions rise in hot spots like the Taiwan Strait, the South China Sea, North Korea, Syria, Iran, and Venezuela. U.S. adversaries will take advantage of preoccupation with the pandemic both to test the U.S. and to distract attention from their own pandemic problems. The natural-resource sector (oil, water, agriculture, mining) will benefit from a global scramble for necessities and commodity inputs as supply chains are disrupted and alternatives are sought. The technology sector is clearly least affected by the pandemic, yet those stocks are so richly priced it’s not clear how much upside remains. Yet sheer momentum could carry them higher.
As fourth-quarter 2020 data emerges, and as the reality of slow growth, rising bankruptcies, nonperforming loans, persistent high unemployment, and deflation are taken into account, stocks will fall back to earth and the perception/reality gap will close. The improved models project the Dow at 16,000 and the S&P 500 at 1,750 by late 2021, with some outperformance in the defense, natural resource, and technology sectors.
Why gold?
That’s a question I’m asked frequently. I sympathize with the interlocutors. The fact that people don’t understand gold today is not their fault. Economic elites, policy makers, academics, and central bankers have closed ranks around the idea that gold is taboo. It’s taught in mining colleges, but don’t dare teach it in economics departments. If you have a kind word for gold in a monetary context, you are labeled a “gold nut,” a “Neanderthal,” or worse. You are excluded from the conversation.
It wasn’t always this way. I was a graduate student in international economics in 1974. Observers believe that the gold standard ended on August 15, 1971, when President Nixon suspended the redemption of dollars for gold by foreign trading partners. That’s not exactly what happened.
Nixon’s announcement was a big deal. Still, he intended the suspension to be temporary, and he said so in his announcement. The idea was to call a time-out on redemptions, hold a new international monetary conference similar to Bretton Woods, devalue the dollar against gold and other currencies, then return to the gold standard at new exchange rates. I confirmed this plan with two of Nixon’s advisers who were with him at Camp David in 1971 when he made the announcement. In recent years, I spoke with Kenneth Dam, an executive branch lawyer and later deputy secretary of the treasury, and the late Paul Volcker, undersecretary of the treasury for monetary affairs in 1971 and later Fed chairman. They confirmed that the suspension of gold redemptions was meant to be temporary, and the goal was to return to gold at new prices.
Some of what Nixon wanted did happen; some did not. The international conference took place in Washington, DC, in December 1971 and led to the Smithsonian Agreement. As a result of that agreement, the dollar was devalued from $35 per ounce of gold to $38 per ounce (later devalued to $42.22 per ounce), and the dollar was also devalued against the major currencies of Germany, Japan, and the UK.
Yet the return to a true gold standard never materialized. This was a chaotic time in the history of international monetary policy. Germany and Japan moved to floating exchange rates under the misguided influence of Milton Friedman, who did not understand the role of exchange rates in international trade and direct foreign investment. France dug in her heels and insisted on a return to a true gold standard. Nixon got caught up in his 1972 reelection campaign, followed closely by the Watergate scandal, so he lost focus on gold. In the end, the devaluation was on the books but official gold convertibility never returned.
This international monetary wrangling took a few years to play out. It was not until 1974 that the IMF officially declared gold was not a monetary asset (although the IMF carried thousands of tonnes of gold on its books in the 1970s, and retains 2,814 tonnes today, the third-largest gold hoard in the world after those of the United States and Germany).
The result was that my graduate school class was the last to be taught gold as a monetary asset. If you studied economics after that, gold was consigned to the history books. No one taught it and no one learned it. It’s no surprise most investors don’t understand gold today.
Yet gold did not entirely exit the scene. In 1974 President Ford signed a law that reversed President Franklin Delano Roosevelt’s Executive Order 6102. FDR had made gold ownership by American citizens illegal in 1933. Gold was contraband. In 1974 President Ford legalized gold again. For the first time in over forty years, Americans could legally own gold coins and bars. The official gold standard was dead, but a new private gold standard had begun.
Now, with gold trading freely, we saw the beginning of bull and bear markets; these don’t happen on a gold standard because the price is fixed.
The two great bull markets were 1971–80 (gold up 2,200 percent) and 1999–2011 (gold up 760 percent). Between these bull markets were two bear markets (1981–98 and 2011–15). Yet the long-term trend is undeniable. Since 1971, gold is up over 5,000 percent despite two bear-market episodes. Investors worried about day-to-day volatility in gold prices and occasional drawdowns are likely to miss this powerful long-term dynamic.
The third great bull market began on December 16, 2015, when gold bottomed at $1,050 per ounce after the prior bear market. Since then, gold’s dollar value has gained over 90 percent. That’s significant, but still a modest gain compared with the 2,200 percent and 760 percent gains in the last two bull markets. This pattern suggests the biggest gains in gold prices are yet to come.
No time series of prices moves in a straight line. A huge initial rally in gold from December 16, 2015, to July 6, 2016, was powered by both fears of a Hillary Clinton victory in the 2016 presidential race and a brief fear trade after the Brexit vote, on June 23, 2016. After that, gold sold off sharply on profit taking and higher interest rates from the Fed. Gold rallied back to $1,303 per ounce on the Hillary fear trade, then crashed again once Trump won the election. Trump’s victory signaled that stocks were the place to be; gold retreated to $1,125 per ounce in the aftermath of Trump’s 2016 election.
Gold traded sideways from early 2017 to early 2019 on a risk on / risk off dynamic and the tempo of the trade war between Trump and China. On June 20, 2019, gold hit $1,365 per ounce—exactly where it had been on July 8, 2016, just after Brexit. There were peaks and valleys along the way. Still, for the long-term investor, gold had moved sideways for three years. Then the gold price took off like a Roman candle. Gold soared to $2,000 per ounce by August 18, 2020, producing a 45 percent gain in just over one year. This gain was powered by low interest rates, fears of inflation, and ongoing concern about stocks due to the impact of the pandemic on earnings.
Where does gold go from here?
The price of gold is driven by three principal factors. The first is safe-haven buying, the so-called fear factor. This is actuated by geopolitical developments, financial warfare, market collapse, and the new pandemic. The second factor is the level of real interest rates, itself a function of nominal rates and inflation. Gold has no yield and competes with cash equivalents for investor dollars. When real rates are higher, cash becomes more attractive. That’s a headwind for the dollar price of gold. The third factor consists of fundamental supply and demand. Gold is no different from other commodities in this regard. If supply is abundant and demand is weak because of poor sentiment, that’s a headwind for the dollar price of gold. At any point in time, these three factors can align or not. All three might push for a higher gold price, all three might push gold lower, or the vectors may be mixed, with one or two factors acting as headwinds while a third gives gold a boost.
The fear factor is volatile. In the early stages of the pandemic, fear was one factor driving gold prices higher. Declining new-infection rates in the United States and a rising stock market in April–September 2020 then tempered the fear to some extent. This pause will not last. The combination of a weak recovery, a pullback in the stock market, a second wave of SARS-CoV-2 infections, and confrontation with China in East Asia will put fear on the front burner and boost gold prices in the near term.
Real interest rates had been a persistent headwind for gold because of the Fed’s double dose of monetary tightening from 2015 to 2018 in the form of rate hikes and money-supply reduction. That’s over. Now the Fed has set rates at zero (and will keep them there indefinitely) and the money supply doubled in a matter of months (to $7 trillion from $3.5 trillion). The real-rate headwind has become a tailwind, since even modest inflation will produce negative real rates when nominal rates are zero.
The third factor, fundamental supply and demand, has been positive for gold. China, Russia, Iran, Turkey, and other nations have been buying hundreds of tonnes of gold without so far triggering a price impact that could cause disorderly markets. At the same time, global mining output has flatlined. Annual global gold mining output has been flat at about 3,100 tonnes since 2015. This de facto ceiling on gold production is attributable to the fact that many gold-mining projects in the major producing nations (China, Australia, Russia, the United States, and Canada) were shut during the gold-price collapse in 2013. Some of that capacity is now coming back online, yet the process is slow. It can take five to seven years to acquire needed capital, permits, and the drilling and milling equipment needed to reopen closed mine production and start new mines. In the meantime, capacity is static as strong demand persists. That’s a recipe for higher prices.
What will drive gold out of its recent pandemic consolidation pattern and push it firmly over $2,000 per ounce and headed higher? There are three drivers.
The first is a loss of confidence in the U.S. dollar in response to massive money printing to bail out investors in the pandemic. If central banks need to use gold as a reference point to restore confidence, the price will have to be $10,000 per ounce or higher. A lower price would force central banks to reduce their money supplies to maintain parity, which is highly deflationary.
The second driver is a simple continuation of the gold bull market. Using the prior two bull markets as reference points, an average of those gains and durations would put gold at $14,000 per ounce by 2025. There is no necessary connection between the prior bull markets and the current one, but their history does offer a useful baseline for forecasting.
The third driver is panic buying in response to a new disaster. This could take the form of a second wave of infections from SARS-CoV-2, failure of a gold ETF or the Commodity Exchange to honor physical delivery requirements, or an unexpected geopolitical flare-up. The gold market is not priced for any of these outcomes right now. It won’t take all three events to drive gold higher. Any one will suffice. None of the three can be ruled out. These events or others would push gold well past $2,000 per ounce, on the way to $3,000 per ounce and ultimately higher for the reasons described above.
Gold-mining stocks generally follow the gold price higher or lower with a lag and leverage. As gold moves higher in 2021, gold stocks will also rally. Yet that stock rally will generally run six months or more behind the bullion rally. This implies gold-mining stocks will be significantly higher by late 2021. This is typically frustrating for gold-mining stock investors, who watch the bullion price running away and don’t understand why mining shares are not following. They will; it just takes time. Gold shares also act as leveraged bets on gold bullion. This is because of the mix of fixed costs and variable costs in the mining industry itself. It takes time to produce enough revenue to cover fixed costs, yet once that is done, incremental revenue drops to the bottom line, net of variable costs (which can be relatively low). The market applies a multiple to recurring revenue that is reflected in the stock price. It’s not unusual to see gold-mining shares go up 300 percent or more as gold moves 100 percent (again, with a lag).
These gold share-price dynamics compared with bullion are well established and won’t change. This does not mean that gold-mining shares are an automatic winner once gold prices move further. Stocks are idiosyncratic. Not all mining companies are created equal. The single largest factor in price appreciation (apart from the gold price itself) is management and engineering expertise. Some gold miners are extremely well managed by seasoned teams with strong financial controls. Others are fly-by-night speculations, some have incompetent management, some are frauds. The gold price will be strong. Not all management teams are. Only gold-mining companies run by highly professional and experienced teams will be winners in the coming gold price boom. Subject to that gating issue, smaller miners are a better value because they can attract a takeover premium, as large miners find it easier to acquire reserves from the junior miners rather than discover them independently.
Physical gold bullion will move from $2,000 per ounce past $2,500 per ounce by early 2021. From there, further gains to $14,000 per ounce by 2025 are likely. That will produce 700 percent gains over the next four years. Shares of well-run gold-mining firms are likely to produce 2,000 percent gains over the same time period, with a six-month lag to advances in the bullion price.
Unlike physical gold, which is an element (atomic number 79) the same in all times and places, no two real estate parcels are alike. This makes real estate valuation more art than science. The key valuation variables are usage (residential or commercial), location, quality of construction, date of construction, occupancy, rents, financing costs, and fundamental factors including economic conditions and the level of interest rates. This can make diverse real estate investments either attractive or unattractive at the same time, depending on the mix of factors. There is no one-size-fits-all solution to real estate investing. That said, and based on our economic forecast, the following appears to be true.
Commercial real estate in general has further to fall. This is both because of the challenging environment from the pandemic lockdown and new depression and due to factors unique to the industry, including bankruptcy of major retailers, store closures even by solvent retailers, pullbacks by bank lenders, a de facto rent strike by tenants, pervasive lease renegotiation by remaining tenants, and general deflationary trends.
In addition to these persistent factors, there are onetime factors that further cloud the picture. Damage from the 2020 riots will extend the reopening phase of lockdown relief as tenants conduct both cleanup and renovation operations. Looting and property damage to high-end retailers will add to insurance costs. Some retailers will not reopen; others will relocate to lower-density areas, leaving an overhang of high-end shopping district vacancies. On June 21, 2020, luxury retailer Valentino sued its landlord at 693 Fifth Avenue in New York to break a long-term lease on four stories of opulent retail space. Valentino’s contention was that “social and economic landscapes have been radically altered in a way that has drastically . . . hindered Valentino’s ability to conduct high-end retail business.” The lawsuit is a reminder of how quickly perceptions of retailers and customers can change, and why commercial real estate will remain distressed.
Alongside these retail headwinds, many commercial and manufacturing companies, from warehouses to assembly-line operations, will relocate from troubled cities such as Minneapolis and New York to safer cities and counties. This will take time, and some buildings will remain partially vacant in the meantime.
Damage to the travel, hospitality, resort, and gaming industries was an obvious consequence of the pandemic and lockdown. This damage will not be undone quickly. Reopenings will be staggered, former capacities will be reduced due to social distancing and other precautions, and consumers will not surge back to these venues even when reopenings are complete, due to residual infection fears and reduced discretionary income.
Beyond this, there will be a new standard when it comes to commercial office space. Employers and employees were surprised at the success of work-from-home arrangements. Despite costs in terms of lost social interactions, the benefits in terms of reduced need for high-cost prime office locations in major cities was obvious. Extensive reductions in demand for corporate office space will result.
Finally there is the overhang of prepandemic problems. The most prominent of these is the near failure of WeWork, a major office space operator with prime locations in most major U.S. cities. Its properties are mostly leased, not owned, yet the leases were entered with leverage near the market top in 2017–19. Demand for WeWork facilities is down across the board, because of both the failures of small-business tenants and the new acceptability of work-from-home models. WeWork is the largest office tenant in New York City, with over 8.9 million square feet of leased office space concentrated in Penn Plaza, Chelsea, Gramercy Park, and the Wall Street area, among other high-priced locations. Other new construction projects were undertaken in anticipation of WeWork as the prime tenant, including the glitzy six-story Dock 72 tech center in the Brooklyn Navy Yard. These and other leases will now be put on hold or go into arrears while WeWork reorganizes. The result will be further downward pressure on rents and increases in vacancies at the worst possible time.
Some cities, including Seattle, Minneapolis, Chicago, and New York, will be particularly hard hit by this blend of factors. Other cities, including Phoenix-Scottsdale, Miami, and Washington, DC, will do relatively better because they present attractive go-to options and better economic fundamentals. As always, location counts.
Commercial real estate will rebound, but not soon. Whatever the long-term prospects are, there’s no point in investing until the bottom is in sight. No one can call an exact bottom. Still, we have enough information to know the bottom won’t be before late 2021 at the earliest. It will take time for rent renegotiations, relocations, bankruptcies, evictions, and the work-from-home revolution to emerge in the form of lower prices. This is a sector to keep an eye on and for which to keep some dry powder in terms of cash and leverage available for opportunities. Patience will be rewarded compared with jumping in too soon.
Residential real estate is another matter. The urban-to-suburban (or exurban) migration is just beginning in response to COVID-19 (made worse by high-density locations), degrees of freedom allowed by the work-from-home ethic, and a desire to escape urban unrest and increased crime as the defund-police movement gathers momentum. Rock-bottom interest rates on mortgages in desirable locations, combined with sky-high taxes in cities victimized by riots, make the decision to move easier. This trend is also propelled by demographics: The average millennial is turning thirty years old in 2021, even as the oldest millennials approach forty years of age. Investment opportunities in existing housing are limited. Still, investment opportunities available in new housing construction in attractive towns with low taxes and good schools away from urban hot zones will produce attractive returns. As with gold-mining shares, seasoned management of construction and development companies among those offering investment units is a key differentiator. Attractive destinations in Arizona, Texas, and Florida will be in demand. And investors should not overlook attractive locations in the Pacific Northwest, the Rocky Mountains, and the mountains and seashores of New England, especially the zero-personal-income-tax states such as Washington, Wyoming, Tennessee, and New Hampshire.
In summary, commercial real estate that has not hit bottom yet will present attractive investment opportunities on a selective basis in late 2021. Residential real estate is attractive today, subject to seasoned talent in the offering management companies and desirable locations away from older cities and toward low-tax, low-cost regions.
Cash is the most underrated asset class in the mix. This is a mistake by investors, because cash will be among the best-performing asset classes for the next two to three years.
The reason cash is disparaged is because it has a low yield. That’s true; the yield is close to zero. Yet that truism misses several points. The nominal yield may be zero, yet the real yield can be quite high in a deflationary environment. If you have $100,000 in the bank with a zero yield, your nominal yield is zero. But if we experience 2 percent deflation during a one-year holding period, then the real yield is 2 percent. The cash amount is unchanged, yet the purchasing power of that cash has risen by 2 percent (the decline in prices), so the real yield is positive 2 percent. The math is counterintuitive (0 − (−2) = 2), but it works. In a deflationary world, other asset classes are likely to be losing value, while cash can yield in the low single digits in real terms. That’s a winning allocation.
Another underrated advantage of cash is optionality. When you make an investment, it may work or it may not, but either way there is a cost to exit if you want to reallocate your assets. At a minimum, you will pay brokerage commissions or cross the bid/offer spread or both. In the case of an illiquid investment such as private equity, real estate, or a hedge fund, you may not be able to exit at all for several years. In contrast, cash has no exit fee. If you have it, you can be the nimble investor who can respond on short notice to an investment opportunity others may have overlooked or not seen coming. Cash is your call option on every asset class in the world. Optionality has value that most investors don’t understand. Still, it’s real and adds to the value of your cash hoard.
Finally, cash reduces your overall portfolio volatility. The nominal value of cash is unchanged in all states of the world (although the real value can fluctuate, as explained above). A diversified portfolio contains volatile assets, including stocks, gold, and bonds. Cash reduces portfolio volatility compared with the volatility of those separate asset classes. Functionally, it’s the opposite of leverage, which increases portfolio volatility. There’s enough volatility in the world today. Cash smooths out portfolio returns and helps investors sleep at night.
In summary, cash is not a sterile asset. It has real yields in deflation, it offers holders the ability to be nimble, and it reduces portfolio volatility. That’s an attractive trifecta.
U.S. Treasury notes come in a range of maturities, from two-year notes to thirty-year bonds with diverse maturities in between. In general, a longer maturity provides higher yields at the cost of greater volatility (called “duration”) in response to changes in interest rates. Longer maturities also offer greater potential for capital gains if rates fall or capital losses if rates rise. Maturities of five to ten years are a sweet spot offering good liquidity, slightly higher yields, and significant capital-gains potential.
The criticism of Treasury bonds, which we’ve heard with increasing shrillness for the past ten years, is that rates are so low they have nowhere to go but up. The bears recite the fact that we are at the end of the greatest bond bull market in history and are on the brink of a new superbear market. They advise you to dump bonds, go short, buy equities, and enjoy the ride.
At least, that’s what they did until March 2020. In fact, bond bears, including famous names such as Bill Gross, Jeff Gundlach, and Dan Ivascyn, have proved to be completely wrong. Interest rates are near all-time lows, while capital gains on Treasury notes have been historically large. Some of the lesser-known bond bears have been carried off the field feetfirst as their funds failed and investors fled.
What did the bond bears miss? They failed to grasp the critical distinction between nominal yields and real yields. It’s true that nominal yields have hit progressively lower levels for almost forty years. We’ve seen one of the greatest bond bull markets in history. As yields approached zero, it seemed as if the party must end. Yet real yields are not low at all; in fact, they’re quite high, which is one reason the stock market crashed in the fourth quarter of 2018 and again in the first quarter of 2020. A real yield is the nominal yield (the rate you see in the media) minus inflation. I borrowed money in 1980 at 13 percent. Was that a high interest rate? Not at all. Inflation at the time was 15 percent and taxes were 50 percent (my interest was tax deductible). So my real after-tax rate was negative 8.5 percent (13(0.50)−15 = −8.5). The bank was paying me 8.5 percent to take its money. That’s a low rate. Today, with lower tax rates and lower inflation, the real after-tax rate is about −0.75, which is orders of magnitude higher than the −8.50 percent I paid in 1980.
That said, can rates go even lower than they are today? The answer is they can, and they will. Lower rates bring the concept of negative rates into play. The market yield to maturity on a ten-year Treasury note can go deeply negative, even if the Federal Reserve stops at the zero bound and does not adopt a negative policy rate for Fed funds. The reason is that secondary-market buyers of notes that have positive nominal yields can offer sellers a premium that is greater than the value of the strip of interest payments. This produces a negative yield to maturity because the buyer never recovers his full premium from the future interest. The buyer’s premium is a capital gain for the seller. In other words, the bull market in bonds has far to run, as long as deflation is a threat and real yields are too high to stimulate a recovery. Both conditions prevail today. The bull market in bonds is not dead. Long may she run.
The forgoing overview of market conditions, rigorous modeling, and accurate forecasting and the survey of asset classes provide visibility on an optimal portfolio asset allocation that is robust to deflation, is robust to inflation, preserves wealth in a continuing crisis, and provides attractive risk-adjusted returns in both the fast- and slow-recovery scenarios. It appears as follows:
|
Cash |
30 percent of investible assets |
|
Gold |
10 percent of investible assets |
|
Residential real estate |
20 percent of investible assets |
|
Treasury notes |
20 percent of investible assets |
|
Equities |
10 percent of investible assets |
|
Alternatives |
10 percent of investible assets |
Some caveats are in order. To start, the cash allocation may be temporary. It’s designed to offer optionality, yet the time may come in late 2022 when the investor will have greater visibility and wish to pivot to equities (if the recovery exceeds expectations), gold (if inflation emerges sooner than expected), or commercial real estate. Gold and Treasury notes come closest to the “buy and hold” category. Gains in gold will play out over five years, so there’s no need to change the allocation based on short-term volatility. Likewise, Treasury notes are a classic asymmetric trade. Rates may go down (as I expect), yet they almost certainly will not go up (as the Fed has promised), so you will either make money or retain wealth; the chances of losing are low. The equity allocation should be weighted to natural resources, mining, commodities, energy, water, agriculture, and defense. These are the true countercyclicals that will do well in bear markets and will outperform in bull markets. Real estate and gold are the inflation hedges. Treasury notes and cash are the deflation hedges. This portfolio offers true diversification, preserves wealth, is robust to shocks, and offers material upside potential. In an age of pandemic, depression, riots, and global threats, that’s as good as it gets.