My Long Term View and How I’m Positioning Portfolios (Oct, 2015)

I’ll preface this post by saying that this is a long one (sorry about that) but it’s worth the time.  To continue on the post from earlier this week where I mentioned that the best long-term investment opportunities typically come with short-term volatility, I’d like to outline my long-term view on how the world, global economy and markets are changing, and how I’m transitioning investment portfolios accordingly.

I think the crisis in 2008 marked the beginning of a major turning point in the way the global economy functions.  If so, it will have huge implications for global trade, policy, investment decisions, the way we measure economic statistics – just about everything!  In short, I think the debt driven industrial age is over and we’re now quickly transitioning into the age technology, innovation, and intellectual capital.  This really should come as no surprise to anyone, but where I think people are slow to change is the adaptation of the economic and investment portfolio models that dominate the current means of thinking.  The scary part is that this means the Federal Reserve and our politicians are continually focusing on the wrong data which often leads to poor decision-making.  This is the classic GIGO model – “Garbage In, Garbage Out.”

After 2008, governments went on a spending spree to revive economic production. Once the developed world began to slow again around 2010 (the first Euro debt crisis), China reignited their construction boom as a bridge to help the developed world with more time to recover. But in 2011 that ended as they ran into the constraints of too much debt and ever since anything related to the old story of China, primarily commodities and industrial production, has significantly underperformed.

Then began the currency wars as everyone was trying to get a leg up by wrongly focusing on the old-world economy where they need a lower currency to boost demand in the short-term.  But not everyone can have a weaker currency at the same time…  It began with the Fed and Quantitative Easing, forcing everyone else to follow suit.  But QE has ended and ever since the US dollar has been on a strong move higher.  You can seen in chart below that the US dollar began its move higher in 2008 during the global recession.  The vertical red line marks the change in trend of the US dollar in the summer of 2008 when the banking crisis started to unravel.  The shaded areas represent the Fed’s QE programs (I left Operation Twist off the charts because that was more a manipulation of the slope of the yield curve), with the QE3 box ending when they began to taper bond purchases (they continued purchasing bonds until October 2014 but you can see how the dollar began to rise a few months ahead of time once it was clear the program was ending).   Notice how the dollar acted without QE vs. during QE.  The rising dollar that we’ve seen over the last year is not from new pressures from the divergence in central bank policy.  The upward pressure has been there since 2008; it was just masked by the Fed for a few years to delay this economic transition, but it looks like we’ve now made the turn and the assets that have been mispriced are adjusting quickly.

US dollar Index – 10 years (monthly chart)

The big issue with this currency war is that these countries are still looking backwards and failing to look ahead at how the economy will work moving forward.  The only two major countries that were not purposely devaluing lately were the United States and China (since China’s currency has been pegged to the US dollar).  But this also changed a few weeks ago when China decided to end the currency peg.  I think we will look back on this event as the straw that broke the camels back (the trigger point of the transition).  I wanted to take a few weeks to see how markets reacted but I’m pretty certain of this now.  Most of my activity lately in client portfolios has been repositioning to cut risk and significantly reduce exposure to those areas I feel will underperform moving forward.

Here are the major themes I see in transition, in no particular order:

• Demographics – The demographics are a disaster in the developed world with not enough working age people to support retirees. The age of socialism and entitlements is drawing to a close. It’s a system that simply cannot be sustained unless you want to suffer a fate like Greece.  This leads to one of two outcomes: 1) developed market assets significantly underperform for quite sometime if developed nations decide to go through the long slow process correcting their deficits and debt.  Or 2) which is currently the path we’re on, central banks continue to monetize government debt to allow governments to continue running deficits.  I don’t know how this will play out but I do know that many emerging nations have far better demographic structures then the developed nations which means that’s where you want to be doing business if you’re a company.  As a side note, it doesn’t necessarily matter where a company is based as so many companies can so easily do business throughout the entire world.  From an investment perspective, the domicile of the company does matter from the currency point of view though.  This is where you can wrong by using a mutual fund or ETF, as they typically have exposure to a certain country or market by owning companies that are domiciled there. That isn’t always the best way to benefit or invest in a country, especially in countries that lack the rule of law or rely heavily on foreign investment flows.

Do you like these population pyramids…?

Or this pyramid?

 

• Deflation – Advancements in technology is extremely deflationary, not just for tech related products, but everything. This is hugely beneficial to you and I as consumers but makes for a very tricky variable for prospective investments.  If the prices of products/services are falling every year from competition, a company’s revenue/profit is likely falling as well unless they hold an absolutely dominant position.  Plus, as technology continues to accelerate, the time it takes for copy-cats to pop up is continually shrinking, forcing tech related companies to continually innovate.  Again, this is great for consumers, but very costly in terms of R&D for companies that never seem to be able to enjoy the fruits of their labor for very long.  As Warren Buffett would say, they don’t have a very good moat around their business.  This leads to…
• The economic models that the Central Banks and economists use are all based on the past which obviously has many limitations and flaws. It’s human nature to use our own experiences in understanding how things work. For example, the Baby Boomer generation, which tends to still be in most decision-making positions of the Federal Reserve and Government, have a hard time understanding the Millennial generation and the things that they value.  Long gone are the days of getting a stable job with benefits and pension. Millennial’s care more about experiences and the rise of “the sharing economy” is the perfect example, and technology is at the heart of making this all possible.  Information and communication flows freely and quickly around the world.  The emergence of companies like Uber and Airbnb are quickly changing the world, just as past innovations made the prior way of doing things obsolete.  From an investment perspective, this means that certain technologies and innovation will be for more valuable.  It also means that the companies in industries of the past 80 years, the ones that worked so well before, will not be the best investments to own moving forward – not by a long shot!  As an example of how technology is so deflationary, just look at the price of oil.  Once new advancements in hydraulic-fracturing (“fracking”) emerged a few years ago, energy production in the US went through the roof!  Which led to this…

Oil – 4 years (weekly)

Again, good for consumers but bad for inflation numbers which the Fed insists on maintaining at 2% per year.  Their fear of deflation is a big reason why they haven’t raised interest rates yet which is bad for consumers but has been great for inefficient companies leading to the misallocation of capital because they can borrow indefinitely at next to nothing.  The Fed doesn’t seem to realize that these falling prices are not “transitory.”  They’re structural and they’re being exacerbated by their own policies!  Apparently Japan’s failed attempt at fighting recession and deflation for 25 years isn’t enough evidence.  As long as the Fed is at the helm, steering the ship with their antiquated models, you can expect further booms and busts.

• China – The Chinese economy, Chinese stock market, and potential for companies to make money by doing business in China are 3 very different things. The Chinese economy is in transition from massive levels of industrial production and construction into a consumer driven economy. This transition cannot be accomplished without the rate of growth slowing – it’s mathematically impossible unless the world allows them to take on an infinite amount of debt.  Despite posting positive growth, the rate will continue to decelerate which means the equity markets should underperform for quite sometime.  However, There are still 1.3 billion people in China making it a great place to do business if you are a consumer goods company.  The main question is whether or not the Chinese government will allow you to do business there as they tend to favor Chinese companies over foreign.  But in the meantime, as their stock market is getting crushed it’s pulling down anything and everything related to China. Some of these stocks are in serious trouble but others, like the consumer related companies, are not which makes this a long-term buying opportunity in those names.
• Debt – Global debt is up $57 trillion since 2007 (as of 2014)… up to 286% of global GDP… yet we’re struggling to grow, global trade is collapsing and the rising US dollar is crushing foreign borrowers of US dollar denominated debt. This will not end well and only adds to the deflationary forces in the global economy.  I think we’ll see serious issues in the debt markets in the years ahead and thus have cut investments in over-indebted companies that will struggle if/when the credit markets tighten.
• Commodities – Commodities have become very tricky the past few years. Everything topped out in 2011.  Anything related to the old-school style economy of industrial output has been absolutely crushed since. The rising US dollar and general deflationary trend has pulled basically all commodities down with it and as the Federal Reserve and other central banks employed massive QE programs, all money has flowed into equities and bonds and out of commodities. However, not all commodities are alike. For example, historically agriculture has tended to shift in the general direction of commodities but the ups and downs are largely tied to supply shocks (demand for food remains constant and steadily grows as the world’s population rises). The bust in industrial commodities is very different from the recent drop in the price of agricultural commodities. Long term, investing in agriculture is still one of the “safest” investment themes.  I also think lumber is starting to look interesting.  Lastly, gold is a beast of its own. It tends to fall in and out of favor based on the general faith in governments and paper currencies.  If things play out as I see them occurring moving forward, I think we will see gold make a new all-time highs in the years ahead.

Copper, Oil and Coal – 5 years

S&P 500 (black) vs. Gold (pink) – 4 years – red line indicates when QE3 began which was the start of the low volatility climb higher in stocks

 

• Real Estate – I’m not very optimistic on real estate looking ahead for a few reasons. First, it was the last big boom-bust cycle and typically it takes years to work off the excesses that were created.  Second, REIT’s are pretty expensive right now (low yields) and I think certain areas of commercial real estate, like office buildings, will face a slow decline in demand as more and more people work on the go and work from home (another victim of technology).  Lastly, most Millennials either can’t afford to buy (too much student debt?), can’t get a loan, or simply don’t want to be tied down with a big mortgage for the typical white picket fence.  This view mainly applies to investing in broad-based Real Estate in a portfolio – obviously individual rental homes are a completely different story and very market specific.  By the way, there’s been a lot talk lately about another big pick-up in housing right now, but the lumber futures, which tend to lead housing, beg to differ…

Lumber – 5 years

 

• Healthcare – Despite aging populations, and particularly in the US, I don’t think healthcare (as a whole) will be as great of an investment theme as most people think. Healthcare has been one of the leading sectors the past few years, but this was largely from biotech (discussed below) and because insurance companies are making a killing from Obamacare.  The population and demand for healthcare is there but pricing will come down, people/governments just can’t afford the continual increases.  Also, the cost of healthcare is substantially higher in the US than in other countries for many identical services and drugs.  I think pricing will be forced to come down and the current expectations of years of big growth will not be met.

S&P 500 (black) vs Healthcare (green) – 5 years

Will probably be hard to continue the outperformance…

 

• Technology – Technology is one of the hardest areas in which to invest but it will certainly continue to be one of the best. Anything that makes business or your personal life easier/better/more efficient will receive the greatest investment dollars and highest valuations.  Some examples include:
  • streamlining your business operations with cloud-based services
  • robotics and automation
  • ease of accessibility and flow of information
  • the need for cybersecurity
  • being able to control, manage and access everything from your smart phone
  • being able to track and monitor your personal health information
  • new, safer, more efficient modes of transportation

• Biotechnology – Biotechnology the past couple of years has been a significant outperformer in terms of stocks. Some people are calling this a bubble but I disagree, especially when it comes to the larger names. I simply think the market is finally beginning to properly discount how incredible the amount of innovation is within biotechnology.  We are literally curing tons of diseases and on the brink of curing many more.  People are willing to pay for that because what’s more valuable than your health?  As long as innovation continues, I think biotechnology will be a core investment theme in the years ahead.
• Consumer Discretionary – As we reap the benefits of this technological wave of deflation (lower cost of energy, etc.), people have more money to spend on discretionary things whether it be products or experiences like traveling. This has also been one of the best areas to invest the last few years and it should continue (with the usual bumps in the road and transitions between who’s executing well and who’s falling behind).
• Everything else – just about everything else, especially those areas related to the old-style economy of industrial production, will most likely underperform. Now there will always be individual names that are positioned well or have a good run but on the whole these other industries face headwinds.  Plus, just about everything is trading at expensive valuations after the Fed decided to prop up all asset prices.  As it always does, technology is slowly killing many industries that are slow to adapt.  I’m looking at you cable TV!

S&P 500 (black) vs Technology (pink), Biotechnology (yellow) and Consumer Discretionary (blue) – 5 years

Probably will continue to outperform…

I’ve been very active this year in transitioning portfolios to align with these views.  Once China broke the Renminbi’s peg to the US dollar, we started to see some of these industrial themes unwind pretty quickly.  If we see stocks continue to slide it could lead to some really nice opportunities in the industries of the “new economy of innovation.”

Thanks for following and have a great weekend!

-Nick