Five Key Elements in a Long-Term Investor's New Playbook

Jerome Powell's words move mountains (of capital)... The conventional '60/40' portfolio is dead... Five key elements in a long-term investor's new playbook... Small-cap stocks are suddenly soaring... The small-cap idea we just added in Extreme Value...

Jerome Powell quickly discovered that every single thing he says can move mountains...

Mountains of capital, that is.

Powell became the 16th chairperson of the Federal Reserve in early 2018. And less than a year into the job, he found out just how powerful his words can be...

As the Federal Open Market Committee ("FOMC") – the Fed's policymaking arm – prepared to convene in December 2018, the S&P 500 Index was down roughly 13% from its previous all-time high set about two months earlier. Investors were getting antsy, and they were looking for a reprieve from the rate-hiking cycle that the Fed started in December 2015.

Then... the Fed raised the benchmark short-term rate by another quarter of a percentage point. After the meeting, Powell made the following statement (emphasis added)...

Today we raised our target range for the short-term interest rates by another 1⁄4 percentage point. As I've mentioned, most of my colleagues expect the economy to continue to perform well in the coming year.

Many FOMC participants had expected that economic conditions would likely call for about three more rate increases in 2019. We have brought that down a bit and now think it is more likely that the economy will grow in a way that will call for two interest rate increases over the course of next year.

In other words, while acknowledging the emergence of economic softening at the time, Powell and the FOMC concluded that the gradual rise in interest rates should continue.

The decision shocked investors... Over the next week, mountains of capital abruptly left the stock market as it completed one of its harshest (and fastest) declines in 70 years. The S&P 500 bottomed on December 24, losing nearly 20% of its value in three months.

The entire episode showed how much Powell's words – and the Federal Reserve's interest rate actions – can mean to investors. That's still true today, though his message is the exact opposite of the one from late 2018... Nowadays, Powell says we can count on interest rates staying near zero for years – even if inflation begins to exceed the Fed's 2% target.

But as I (Mike Barrett) will show you today, while Powell's words might be different, they are again moving mountains of capital... And it's time for you to consider a new game plan.

You see, the prospect of earning almost nothing on U.S. Treasury bonds – and by extension, the rest of the bond market – means investors are now rethinking what has been a hallmark of financial planning for decades... the conventional "60/40" investment portfolio.

U.S. economist Peter Bernstein regarded the 60/40 portfolio to be the 'center of gravity' between risk and return...

We're talking about a 60% allocation to stocks and 40% allocation to bonds.

The idea behind the 60/40 portfolio was simple... Stocks would provide investors with capital appreciation, while bonds would offer both income and a hedge against "black swan" events – like a pandemic, for example.

Bernstein considered the 60/40 portfolio as the "ideal asset allocation" model for investors. And in his day, a 40% bond portfolio did generally provide folks with real diversification (and real income). When stocks swooned, bonds typically rose... and vice versa.

But as the pandemic took hold in February and March, the 60/40 portfolio failed miserably...

Investors expecting similar results with their bond holdings were in for a rude awakening. Morningstar reports that core bond strategies actually lost 3% on average during this span.

Now, that doesn't sound bad compared with 30% losses (or worse) in stocks. But the 3% "average" loss also masked incredible volatility – something you don't expect with bonds. For instance, the Vanguard Total Bond Market Fund (BND) was down an astounding 13.5% at one point in March.

Rick Rieder, chief investment officer of BlackRock's $2.4 trillion global fixed-income group and co-manager of the BlackRock Strategic Income Opportunities Portfolio (BASIX), knows that investors can no longer trust this traditional approach. As he recently told Barron's...

If you are holding the same portfolio as two years ago and expect it to do the same, it won't. You have to restructure how you think about asset allocation, especially fixed income.

Ben Inker, head of asset allocation for prominent money manager GMO, concurs. In the firm's second-quarter letter to its clients this year, Inker noted that...

All portfolios that include government bonds have both lower expected returns and higher risk than anyone had a right to expect them to have previously.

So with the old playbook becoming obsolete, what should investors do now?

About a month ago, living legend Howard Marks published his latest essay, "Coming Into Focus." In it, Marks reasoned that the Fed's insistence to keep interest rates near zero for the foreseeable future leaves investors like us with five less-than-ideal options...

1. Invest as you always have (meaning 40% in bonds) and settle for today's low returns
2. Reduce risk in deference to the high level of uncertainty and accept even-lower returns
3. Go to cash at a near-zero return and wait for a better environment
4. Increase risk in pursuit of higher returns
5. Put more into special niches and special investment managers

For most investors, the first three possibilities aren't really an option at all. Settling for lower returns or going entirely to cash – when Powell has made it abundantly clear that near-zero rates will be the norm for years – simply makes no sense.

That means the fourth and fifth items on the list are your only real options today. No matter what moves you make under these options, it's clear that you need to make some changes.

In other words, long-term investors need a new portfolio playbook.

The good news is... my colleague Dan Ferris and I have constructed an ideal replacement for our Extreme Value subscribers. And for the rest of today's Digest, I want to outline how we're helping these folks sleep well at night while they take on more portfolio risk.

We'll start with the cornerstone of our strategy...

First, you should add exposure to stocks – but only when the risk-reward trade-off is clearly in your favor...

Renowned finance professor Jeremy Siegel thinks "75/25" is the new "60/40."

Dan and I don't make specific allocation recommendations – such as 75/25 – in our recommended Extreme Value playbook. But we do agree with Siegel's strategy shift...

Investors must now increase their exposure to stocks in order to pursue higher returns.

The problem is, practically every other investor is doing the same thing. And of course, that has driven up stock prices – particularly high-quality, widely held names like Amazon (AMZN) and Microsoft (MSFT).

Remember, though, a great stock bought poorly often produces bad investment results. So to stack the odds of success in your favor, you must insist on buying only when the trade-off between risk and reward is clearly in your favor.

In a recent blog post, New York University finance professor Aswath Damodaran published a graphic that perfectly illustrates how we address this challenge in Extreme Value. Notice "the gap" between a company's intrinsic value and its current share price...

In short, stock prices are driven by investor sentiment. Meanwhile, a company's intrinsic value is a product of future cash flows. Alternatively, you can think of intrinsic value as the highest expected price a knowledgeable buyer would pay for the entire business.

When investors become euphoric, intrinsic value and share price converge. The gap closes, eliminating what we call the "margin of safety."

In other words, the share price starts to resemble the highest sales price that the business would command. And in turn, the stock's potential further upside becomes limited.

The vast majority of stocks today fit into this group, according to our research.

Extreme value occurs when the opposite scenario happens... Pessimism reaches an extreme, causing the gap between intrinsic value and the share price to widen. In turn, the margin of safety expands.

This is when the risk-reward trade-off is most in your favor. That's because the risk of further downside is limited, while the potential upside is much greater.

To see what I mean, let's look at a great business we recommended in April as pandemic-related fear raged...

Constellation Brands (STZ) owns a stable of leading alcoholic beverage brands. Its holdings include the No. 1 imported beer in the U.S. (Corona), the No. 1 sauvignon blanc in the U.S. (Kim Crawford), and the No. 1 imported vodka in the U.S. (Svedka).

The business has an army of loyal consumers who buy its products over and over. That helps Constellation to earn large profits and consistently produce tons of free cash flow.

But as you know, when the pandemic hit, the ensuing shutdowns across the country crushed the restaurant and bar industry. In turn, investors panicked out of Constellation's stock... It plunged from about $210 per share in February to the low $140s by early April.

More important, as this sell-off played out, the "gap" between Constellation's intrinsic value and share price became so large that you could drive an oversized 16-wheeler through it...

And while consumers were stuck inside due to COVID-19 restrictions, they didn't quit drinking... They simply drank at home. Investors overlooked the fact that roughly 85% of Constellation's business is done "off premise" at places like grocery stores and liquor stores.

So the shift to drinking at home actually played to Constellation's strength. Plus, the company already had about 70 days of inventory for its beer business working through the U.S. That forward thinking enabled Constellation to easily replenish any ongoing demand.

In short, the pandemic didn't hurt Constellation nearly as much as investors expected. And the huge gap between its price and intrinsic value at the time allowed us to help our subscribers profit in a big way... Seven months later, Constellation is once again trading for more than $200 per share. Subscribers who followed our advice in early April are up about 45%.

In a world of near-zero rates, you must shift exposure toward stocks and away from bonds... which increases your portfolio risk. So to sleep well at night, you absolutely need to become attuned to the gap between share price and intrinsic value. And you should insist on only adding new positions where the odds of success are clearly stacked in your favor.

Now, let's move on to the second component of our new portfolio playbook – hold plenty of cash...

Cash is the ultimate "sleep well at night" holding.

As your exposure to stocks rises, cash provides an essential counterbalance. And on rare occasions – like the panic this past March – its stable, near-zero return can actually look better than everything else.

Cash also provides maximum optionality for investors... When buying opportunities arise elsewhere, it can quickly be deployed to take advantage.

But over time, cash loses purchasing power, which leads to the third important aspect of our portfolio playbook...

In the current environment, investors need to own a portion of their wealth in precious metals...

Bernstein's 60/40 portfolio ignores precious metals... And so does Siegel's 75/25 portfolio.

That's a big mistake with "nominal" (actual) interest rates near zero... since the risk of negative "real" rates is so high. By real rates, I mean the difference between the actual rates and the rate of inflation.

Real rates aren't supposed to be negative, of course, but they are right now... The three-month Treasury bill yields about 0.09% today, but inflation (before seasonal adjustments) is 1.4% – producing a negative real interest rate of around 1.3% (0.09% minus 1.4%).

This means investors are currently losing purchasing power by holding dollars in short-term Treasury bills. Inflation is destroying the little interest they're earning... and more.

When this happens, investors do what you'd expect... They trade more and more of their dollars for assets that protect their wealth – like gold and silver. In turn, this pushes up the prices of these precious metals... That's a big reason why they've both rallied this year.

In the May 5 Digest, I noted two big reasons the negative trend in real rates could worsen – and really light a fire under precious metals. From that essay...

First, the Federal Reserve is determined to keep nominal interest rates low...

Second, inflation at the consumer level is poised to rise.

Since then, the case for both reasons has only strengthened...

In late August, Powell "moved the goalposts" in regard to the Fed's game plan. He reset the central bank's inflation framework, noting in his accompanying speech that...

Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.

In other words, the Fed will likely let inflation move above its 2% long-term target for an extended period before it begins raising rates again. And higher inflation is indeed headed our way...

For instance, the Bloomberg Agriculture Spot Index is at its highest level in more than four years, signaling higher food prices. Keep in mind that food accounts for 14% of the Consumer Price Index... That's more than double the impact of energy prices.

So in addition to well-bought, high-quality stocks and a healthy stockpile of cash, Dan and I believe you should own up to 10% of your liquid net worth in precious metals.

And we know that many folks prefer to have at least some of this exposure in stock-like instruments... rather than owning physical bullion and needing to worry about storing it yourself. That's why our model portfolio includes two exchange-traded funds that give you real ownership of metals stored in a vault... And they can be redeemed for physical metal.

The fourth part of our new playbook is perhaps the most controversial – owning bitcoin...

If you're a regular Digest reader, you know several Stansberry Research analysts have written extensively this year about the merits of owning bitcoin. I won't belabor those arguments about why you should buy the world's largest and most liquid cryptocurrency.

Instead, I'll give a quick overview of supply and demand... how they're likely to change over the next five years... and what that might mean for the price of bitcoin. Keep in mind that these numbers are rough estimates. I'm just trying to frame the big-picture opportunity.

Today, more than 18.5 million bitcoin exist in the world. But about 60% of the world's bitcoin (11 million) hasn't traded in at least a year. That means crypto buyers are effectively competing for the remaining 40% being traded – or about 7.5 million bitcoin.

So when it comes down to it, that's the current supply.

Evaluating demand for bitcoin is trickier... We can't know precisely how many people own bitcoin. But we can make a reasonable guess... Coinbase, the largest bitcoin exchange, reportedly has more than 35 million accounts. And Blockchain.com reports the creation of more than 56 million crypto wallets. If we add those together and round up, we get an estimated 100 million users. That works out to about 1.3% of the global population.

To summarize, we can estimate that nearly 100 million crypto users are competing for about 7.5 million bitcoin today. Now, let's imagine how things will look in 2025...

As additional blocks of bitcoin transactions are confirmed, small amounts of new bitcoin are released into circulation. The maximum amount of bitcoin that will ever exist is 21 million... And Coindesk estimates the amount in circulation in 2025 will be about 19.5 million.

Let's assume 60% of the world's bitcoin continues to be held for investment purposes and isn't traded. That would leave about 7.8 million to satisfy demand. In other words, in five years, the effective supply of bitcoin isn't likely to change much from its current level.

Meanwhile, demand is likely to soar...

In the Digest, we've discussed digital-payments leader PayPal's (PYPL) new service that will enable customers to buy, hold, and sell cryptos directly from their accounts. The company also plans to allow folks to use it for purchases at its 26 million merchants worldwide.

More than 300 million consumers currently use the PayPal platform in more than 200 markets globally. So as you can see, that's a lot of potential demand – and it's just one source. Imagine how many other demand sources we'll see between now and 2025.

As bitcoin's utility expands, so will the number of people who own it...

Let's assume its ownership will rise to just 2% of the world's population over the next five years. That would mean another 50 million people (and a total of 156 million) will then be competing for approximately the same amount of bitcoin in existence today.

This is a recipe for much higher prices.

Dan and I believe this could be the most asymmetric opportunity of our lifetimes... That's why we recommend owning up to 5% of your net worth in bitcoin today. While it's a relatively small stake, you could potentially experience life-changing capital appreciation. And at the same time, you won't stay up worrying at night about taking on too much risk.

Now, let's close with what might be the most important component of our new portfolio playbook...

In addition to the proper diversification I've described today, you need a plan to manage volatility...

Think back over your portfolio activity since March...

Were you adding to core holdings that were suddenly down 30% or more? Were you buying new stocks you've always wanted to own but had always been too expensive?

If you're an Extreme Value subscriber, you were.

Two of our stock positions plunged more than 50% in March alone. And bitcoin fell from $10,000 to less than $4,000. Except for a temporary, two-week hold on stock positions (but not bitcoin, gold, or silver) starting in late March, our advice has remained the same...

Buy!

Today, anyone who took that advice is a happy camper... Both left-for-dead stocks are up more than 140% from their March intraday lows. And bitcoin has quadrupled over that span.

For positions in which we had less conviction, we set hard stops. Prior to the pandemic, we also compiled a watch list of elite businesses we wanted to own when they got cheap again. We've since added several of these names to our portfolio.

My point is this... Decide in advance how you'll react to any future volatility.

Make sure you know which stocks (and other assets) you want to own... what you're willing to pay for them... and what you would be willing to part ways with amid elevated volatility. Always view market pullbacks as opportunities to upgrade the quality of your portfolio.

Jerome Powell and the Fed have made the conventional 60/40 investment portfolio obsolete...

So as an investor, you need a new playbook.

Insist on adding more stocks, but only when the risk is worth it... Build cash... Own precious metals and bitcoin... Make a plan for how you'll deal with volatility... And sleep tight.

I hope that I've helped you learn in today's Digest how you can employ these simple guidelines. And if this type of playbook sounds like something that might work for you, I'd like to invite you to join Dan and I as a subscriber to our Extreme Value newsletter.

As my colleague Corey McLaughlin has noted over the past couple of Mondays in the Digest, positive vaccine news from Pfizer (PFE) and Moderna (MRNA) has propelled stocks higher.

And one part of the market has particularly shined since the first news broke – small-cap stocks... The S&P SmallCap 600 Index is up 11% since November 6. That's more than triple the S&P 500's return over the same span. And our good friends at SentimenTrader.com say this abrupt shift from large- to small-cap stocks is one of the most extreme in 75 years.

That tells us our latest recommendation is coming at a great time...

Last Friday, we added a small-cap stock to our Extreme Value model portfolio that's a COVID-19-resistant business... It operates in an industry that all politicians love... Its long-term growth outlook is excellent... And best of all, it has a clear margin of safety.

Of course, in fairness to our loyal subscribers, I can't give away all the details in this essay. But if you sign up for Extreme Value right now, you'll get instant access to our complete analysis. And today, we're offering a special deal for all Digest readers. Learn more here.

This stock is trading within pennies of our recommended "buy up to" price. So if you're on the fence about whether you want to sign up, I'd encourage you to act before it's too late.

New 52-week highs (as of 11/16/20): ABB (ABB), Analog Devices (ADI), Booz Allen Hamilton (BAH), Reality Shares Nasdaq NexGen Economy Fund (BLCN), Berkshire Hathaway (BRK-B), Comcast (CMCSA), Cresco Labs (CRLBF), Corteva (CTVA), Futu Holdings (FUTU), Alphabet (GOOGL), GrowGeneration (GRWG), W.W. Grainger (GWW), Ingersoll Rand (IR), Intellia Therapeutics (NTLA), Palo Alto Networks (PANW), Starbucks (SBUX), Southern Copper (SCCO), Silvergate Capital (SI), ProShares Ultra S&P 500 Fund (SSO), TFI International (TFII), T-Mobile (TMUS), Trane Technologies (TT), Vanguard S&P 500 Fund (VOO), and Verisk Analytics (VRSK).

In today's mailbag, feedback on yesterday's Digest about vaccines and more thoughts on Dan Ferris' Friday Digest. What's on your mind? As always, you can tell us at feedback@stansberryresearch.com.

"Many folks suggest that health care professionals should be the first to receive the vaccine. Great idea!? If the unproven vaccine causes serious side effects, then many of these critical personnel will be disabled and we will be without medical care." – Paid-up subscriber Bernie K.

"A concern of many is, what else – apart from the COVID-19 virus – is in the vaccine? Labs totally independent of any commercial influence could identify and comment on the toxicity or otherwise of the ingredients... There are serious concerns amongst the general public. Thank you." – Paid-up subscriber Patricia H.

"Dear Dan, you are firing on all cylinders these days, and I love it. This Friday's Digest has got to be among your best. And your analogy of the USFS to the forest and the Fed to the economy I think is spot on.

"The USFS has caused more harm than just forest and property damage. My uncle has first-hand knowledge of this as he has helped in the counseling of firefighters who have lost their co-workers while trying to fight such uncontrollable fires. All I can say is that from my perspective, anyone who has been inside a forest fire has experienced a special kind of hell. My sympathy goes to anyone who has lost loved ones due to this.

"I fear the same may eventually happen, or has already begun, within our society. The riots over the summer have literally produced similar types of destruction, and the unchecked rage of the rioters has already killed people.

"To only blame the Fed for this would be irresponsible of me, as every individual still has free will. However, the Fed, as you so eloquently put it, has allowed and even encouraged the dried tinder to accumulate. Through its programs of bailouts and money printing, the Fed has exacerbated the inequalities that have always and will always exist in society. Especially since the 70s (when gold was removed as a reserve for the dollar), these inequalities have only gotten worse. It doesn't matter which political party was in power. The widening gap between the haves and the have-nots has been consistently trending for a while. What else can you expect from a central planner that has a policy of asset price inflation?

"As an aside (adding fuel to the inevitable fire) for over a century, the government has made empty promises of entitlements; stating this would be the key to a great society. Now, we have the culmination of expectations from the masses (having been warped into fantasy land) abruptly hitting the wall of reality. Unfortunately, it just requires one little spark of dissatisfaction of the status quo to ignite all that dried tinder (the false hope) built up in the populous. And the cancel culture and increased tribalism embraced by both parties and their constituents have only added to that fuel.

"Through QE and buying up bad debt, the Fed is actually being suppressive to the economy. You get more of what you subsidize and less of what you tax. A healthy economy is one that is productive, but if the Fed keeps subsidizing unproductive things, it is actually suppressing growth. Say's Law explains this accurately. It is supply (production) that constitutes demand. All the Keynesian economists have it wrong, if not completely backwards.

"This is why you can't print your way to prosperity. It is an economic impossibility. Once you understand and fully integrate this, the world makes a lot more sense.

"Now, with the increasing acceptance of [Modern Monetary Theory], the Fed may actually finally get the CPI inflation that it is so desperately seeking. However, this particular price inflation wouldn't be caused by a healthy economy. It will be caused by an exodus from the dollar into anything non-fiat. This will happen amidst a sick economy, possibly amidst the burning of multiple cities, and the Fed may finally realize how powerless it really is.

"Many thanks, Dan. Keep up the great work." – Paid-up subscriber Bret R.

Regards,

Mike Barrett
Orlando, Florida
November 17, 2020