These Eight Charts Give Us a 'Sense for Where We Stand'
The past and the future meet in the present... These eight charts give us a 'sense for where we stand'... Stocks are more expensive than ever before... But they're excellent long-term investments, too... Deeply negative 'real' yields on bonds... The best hedge against inflation... When commodities outperform stocks...
We're never in the past or the future – only the present...
That's not exactly deep analysis, I (Dan Ferris) know. But my point is...
In Tuesday's Digest, I looked backward at 2021. We focused on what I said back in January and how everything played out this year. Next Friday, I'll look forward to 2022 and beyond.
That leaves the present... And that's what we'll examine today.
In short, I'm taking inspiration from Chapter 15 of investor and author Howard Marks' must-read classic, The Most Important Thing...
Marks chose that title for his book because he found himself telling his clients, "The most important thing is..." countless times over the years. Finally, he realized that he wasn't giving them just one important thing for investors to do... He was giving them 18.
Chapter 15 is titled, "The Most Important Thing Is... Having a Sense for Where We Stand." Marks sets the tone for today's Digest when he begins the chapter...
We may never know where we're going, but we'd better have a good idea where we are.
So with that in mind, let's get a sense of where we stand in some of the major financial markets right now. It's impossible to do that without referencing the past, but I'll do my best to downplay the future in this discussion...
The past and the future meet in the present...
You can't work, invest, love, or live in the past or in the future. You can only do those things in the present.
It sounds simple, but it doesn't make life any easier... That's because the present is always changing.
Prices... interest rates... returns... economic data... your net worth... your health... it's all in constant motion. Everything changes minute by minute, day by day, in the eternal "now."
It's absolutely critical that investors learn to understand the present moment... After all, that's precisely where they'll make all the decisions that will influence their returns in the future.
To learn where you stand at any given moment, you must know what preceded that moment. It's easiest to do this visually, so let's get a sense for where we stand with eight charts...
With Chart No. 1, we'll figure out where the stock market stands today...
Though valuation is a lousy short-term timing mechanism, it's the force of gravity over the long term. And the price-to-sales (P/S) ratio is the easiest way to understand the overall stock market's valuation...
Chart No. 1 shows the P/S ratios for the benchmark S&P 500 Index, the tech-heavy Nasdaq Composite Index, and the small-cap-focused Russell 2000 Index since November 16, 2001. (That's the earliest date available for P/S data on all three indexes.) Take a look...
Today, all three indexes aren't far below their all-time valuation highs, which they hit earlier this year. It makes you wonder what happened since this chart data began that might explain why valuations are at all-time highs right now.
It's impossible to explain such a massive shift in vast, complex, multitrillion-dollar equity markets. Having said that, I believe two fairly recent historical developments might help to explain why equities carry higher valuations today...
First, the big, successful software-based companies that dominate the popular equity indexes are much more consistently profitable and far less capital-intensive than building mines, factories, and railroads. The new index dominators – companies like Apple, Microsoft, Amazon, Meta Platforms (formerly Facebook), and Alphabet (formerly Google) – earn much higher returns on the capital they deploy.
Those higher returns on capital are worth more to equity investors... In turn, these investors have bid valuations generally higher over the past two decades – and at a more rapid pace over the past few years, as you can see in Chart No. 1.
The rise of so-called "passive investing" is a second reason that might explain why equity valuations are higher today. An influx of index funds means more investors than ever are buying stocks without any reference to the price they're paying for them compared to what the fundamentals might suggest the businesses are actually worth.
In short, passive investing is taking over the stock market...
According to news service Bloomberg, U.S.-based passively managed equities overtook U.S.-based actively managed equities in August 2018. And today, 54% of the $11.6 trillion U.S. equity-fund market is passively managed.
This shift has led many professional investors to claim that the stock market's ability to value businesses has been impaired...
The idea is that active managers with opposing views on the same stocks keep the market in equilibrium (more or less, of course – it's always subject to cycles). But fewer actively managed equity portfolios means fewer active managers expressing bearish views... That's because passive portfolios are overwhelmingly "long only" vehicles.
So in other words... as passive investing grows in popularity, market valuations could potentially become less influenced by business fundamentals and more influenced by money flows into passive portfolios and other non-fundamental means.
That leads us to wonder, for example, if the "meme stock" phenomenon could have happened at any other time except during the currently overlapping ages of passive investing and social media.
When fundamentals cease to matter and emotional ideas can quickly spread among millions of naïve investors, there are no limits to equity valuations in the short term... At least, that's how it has been recently.
Investors might've taken "indexing" too far... but they started doing it for good reason.
Stocks have been the best way for most folks to build real wealth with their savings over the long term...
Chart No. 2 is the S&P 500 starting the day before I was born – November 17, 1961. (I was born on a Saturday, so the markets were closed.)
This chart draws us to a simple conclusion... No matter how bad things ever looked in the markets for my entire lifetime, maintaining a long-term perspective and staying invested was the right thing to do.
This chart is why you've never heard me tell you to sell all your stocks.
Whatever I might think about the stock market being more expensive than ever, it has been a mistake to pull all your money out of it for very long. That's true right up to the present moment. Every crisis has been a major buying opportunity...
Since the day before I was born, the S&P 500 has risen annually by an average of 7.2%. It doesn't sound like much, but it's a great return if you can keep it up for 60 years...
Every $10,000 invested 60 years ago is worth $640,000 today. That's not bad for doing absolutely nothing for 60 years... though I must admit that someone probably doesn't have a lot of capital on hand the day they're born.
My point is... Equities are near all-time-high valuations today, and anybody who has held them for decades knows they've been a tremendous long-term investment.
That's my sense for where we stand with stocks. Now, let's do the same exercise for bonds...
Of course, "bonds" is a very broad term...
All kinds of bonds exist in the world – from the riskiest, high-yield (or "junk") bonds to the most highly rated sovereign debt. But by far, the most popular bond-market benchmark is the 10-year U.S. Treasury note. When you hear someone talk about "credit spreads," they're mostly referring to a bond's yield minus the current U.S. 10-year Treasury yield.
Chart No. 3 is the inflation-adjusted 10-year U.S. Treasury yield – also known as the "real yield" – from late 1970 to today.
The 10-year U.S. Treasury's real yield has been consistently negative since September 2019. And just yesterday, it hit an all-time low for as far back as I can find data...
In other words, real yields have never been this negative... And the damage from the recent uptick in inflation is a tiny bit worse than during the "Great Inflation" of the 1970s. As we noted on Tuesday, inflation recently logged its highest uptick in 39 years.
Nominal interest rates are scraping 5,000-year lows, according to Sidney Homer's classic book A History of Interest Rates (hat tip to legendary newsletter writer Jim Grant for pointing this out)... And rising inflation has added insult to injury.
It brings us to a simple result for where we stand with bonds in the present... All-time-low yields amid the highest inflation rates in decades.
Now, let's get a sense for where we stand with gold in the present...
Chart No. 4 shows the monthly gold prices since August 1971.
That's when the Bretton Woods agreement ended, severing the U.S. dollar's last ties to gold. The official gold price used for converting U.S. dollars to gold was $35 per ounce. Here's what happened next...
Once the Bretton Woods agreement ended, both the dollar and gold traded freely... The market responded by devaluing the dollar versus gold. Gold rose to more than $180 per ounce by December 1974. It eventually spiked up to $850 per ounce in January 1980.
There are two frequent complaints about gold today...
First, bitcoin has outperformed the precious metal recently. As a result, many folks say that bitcoin is replacing gold.
Second, gold has performed poorly as an "inflation hedge"... The U.S. government has spent trillions of dollars since the COVID-19 lockdowns began in early 2020. And as we just discussed, inflation is surging right now. So why has gold underperformed since then?
You'll see how these two complaints overlap as we take a quick look at how gold and bitcoin have performed recently...
In a panic, investors sell everything for cash – including gold.
An ounce of gold traded for about $1,517 at the start of 2020... It rose as high as $1,680 per ounce in the ensuing weeks, then fell to around $1,470 per ounce at the bottom of the COVID-19 panic in late March 2020.
Since then, it has reached an all-time high of $2,063 per ounce in August 2020. And it's trading around $1,800 per ounce today... Although that's down from 16 months ago, it's still a gain of roughly 22% off the COVID-19 bottom.
Meanwhile, bitcoin started 2020 at around $7,200. And according to data compiled by Bloomberg, it hit a COVID-19 bottom of just less than $5,000 on March 16, 2020.
Then, as regular Digest readers know, the world's most popular cryptocurrency soared at the end of 2020 and into this year... Bitcoin reached an all-time high of more than $67,000 last month. It's down to around $47,000 today, which is still a huge gain in two years.
That brings me to Chart No. 5. It shows the changes in bitcoin, gold, and the U.S. Bureau of Labor Statistics' Consumer Price Index ("CPI") – the most widely followed inflation indicator on Earth – since January 2020...
According to the CPI, consumer prices have risen a little less than 8% since the beginning of 2020. During that time, gold is up about 19%... And bitcoin is up 562%.
So you tell me... Between gold and bitcoin, which one looks like it responded appropriately to an uptick in the CPI, and which one reminds you of that scene in Pulp Fiction when John Travolta brings Uma Thurman back from death by injecting pure adrenaline into her heart?
Making more than 500% on bitcoin in two years is great... But I don't know how anyone can claim it has anything to do with inflation. It's so volatile that it performs like the love child of a biotech IPO and a mining-exploration stock. It doesn't scream "inflation hedge" to me.
Which characteristic would you prefer in a store of value – wild volatility or the combination of modest downside risk and reasonable upside potential?
Now, I don't mean that bitcoin is a lousy store of value because it's more volatile. I'm just saying that no matter what anyone believes about bitcoin, where it stands right now in the present is clear... Its history of just 12 years clearly demonstrates extreme volatility.
In other words, some people believe bitcoin is replacing gold as a store of value precisely because gold has demonstrated the exact characteristics you want in a great store of value – stability and modest volatility.
As I've said before, I agree that bitcoin has the potential to become one of the greatest financial innovations in history. But we don't really know how it will play out yet... It might become a really great new form of money – or it might not. That uncertainty leads to massive volatility.
The bottom line is... bitcoin is far more volatile than gold and inflation.
This is an irrefutable, historical fact at this point. Not understanding that reveals too much ignorance about what gold has been for 5,000 years and what bitcoin has been for 12 years.
Indulge me a little more on the idea that gold is a poor inflation hedge...
Since it became untethered from the U.S. dollar in August 1971, gold's price has risen 51-fold from the official exchange rate of $35 per ounce. It has performed very well over the long term.
Meanwhile, in U.S. dollar terms, something that cost $1 in 1971 costs around $6.70 today. A 1971 dollar is now worth about $0.15.
Said another way... prices have risen nearly sevenfold relative to the U.S. dollar over the past five decades, equating to an 85% drop in the currency's value. And over that same span, gold has risen 51-fold.
The only way gold hasn't worked for you as an excellent long-term inflation hedge and store of value is if you didn't own it.
I'm aware that you could make charts showing periods of time over the past five decades when the rate of inflation increased more than the price of gold. But when we look at the full picture over the long term, the precious metal has done its job well into the present.
Another quick reminder about gold, courtesy of Chart No. 6...
Gold has dramatically outperformed the S&P 500 in the 21st century. That's largely due to stocks being horribly overvalued at its beginning, but you can see what I mean below...
I won't bother with a long-term chart of bitcoin, since everybody knows it sold for pennies shortly after it was invented in 2009... And it has been as high as $67,000 this year.
It has been a phenomenal run, especially for anyone who got on board early and has "HODLed" it. I continue to recommend holding bitcoin and believe it has much more upside in the coming years... But it's not about inflation or storing value, not yet anyway.
When inflation roared in the 1970s, gold did well. When inflation ticked back up again recently, gold did well. When stocks did lousy starting in 2001, gold did well.
In the end, it seems like a pretty good hedge and store of value.
That's where we stand with gold in the present, relative to the U.S. dollar and bitcoin.
Next, let's get a sense of where the broader world of commodities stands today...
Chart No. 7 shows the S&P GSCI commodity index from 1971 to the present.
You can clearly see two distinct eras...
The first era is after Bretton Woods, starting in 1971. Commodity prices adjusted higher and ratcheted sideways until around 2004, when the rapidly growing "BRIC" economies (Brazil, Russia, India, and China) started consuming more raw materials.
Prices adjusted higher around that time. And since then, they've ratcheted sideways a second time – with plenty of volatility...
Commodity prices have always been volatile – and they likely always will be, too.
That's because these industries tend to be capital-intensive, low margin, and highly competitive. Commodity producers don't have the luxury of setting the price at which they'll sell their product. With supply and demand setting prices, it leads to a lot of volatility.
The last thing we should note about commodities in the present leads us to our final chart in today's Digest...
In short, commodity prices have ripped higher this year.
The S&P GSCI is up 33%... That's about nine percentage points better than the S&P 500.
It's important to compare commodities to stocks and see where we stand in the cycle...
You see, learning to read commodity market cycles can be a very lucrative proposition – and it can offer excellent diversification during times of poor equity returns.
Chart No. 8 shows the decade-by-decade total gain or loss for the S&P 500 and the S&P GSCI commodity index. Take a look...
The S&P 500 has tripled your money or better in three of the past five decades. But as you can see, in the other two decades... commodities outperformed the benchmark stock index.
Equities performed poorly due to inflation in the 1970s and the bursting of the dot-com bubble in the 2000s. So even though equities underperformed for different reasons in those two decades, commodities proved to be an incredible hedge for investors both times.
The point is... commodities are highly cyclical and tend to be volatile, but they've provided an effective hedge in decades when equity returns have disappointed. And as I mentioned earlier, they've done better than stocks so far this year.
That's my sense for where we stand with commodities.
Now, since we've covered a lot in today's Digest, let's sum it all up...
We started with our look at the present by establishing that stocks are more expensive than ever before. And we learned that passive investing and capital-efficient businesses that dominate the indexes today have contributed to these currently high equity valuations.
Chart No. 2 showed us that stocks have generated excellent returns over the long term. And as we learned later in today's Digest, investors could've tripled their money or better by simply investing in the S&P 500 in three of the past five decades.
Meanwhile, bonds have never been more expensive in 5,000 years of recorded history. And related to that, real bond yields have never been this deep into negative territory before.
In terms of inflation hedges, gold is a 51-bagger since it became untethered from the U.S. dollar in 1971. It has outperformed the S&P 500 substantially in the 21st century... And it's up 18% since January 2020.
While bitcoin has skyrocketed more than 500% over the past two years, it has been much more volatile... So in the present, that leads us to see gold as the better inflation hedge.
And finally, commodity prices have risen substantially since 1971. They've fared poorly in decades when stocks have soared... and they've shined in the decades when stocks have done poorly.
When it comes to the present, commodities have outperformed stocks in 2021. We can't know what will happen in the future... but perhaps this is a glimpse of a new market cycle.
That's my sense for where we stand in the present. You might feel differently.
Also, don't worry about resolving any seemingly conflicting items on this list – or on your own list if you make one.
Life is messy. No law of nature says it has to make sense, even when you're doing it right.
My sense for where we stand in the present suggests that the markets are approaching an important turning point... A decade of higher commodity prices and generally poor equity returns would be right in line with the picture we've just painted.
We'll see what happens between now and 2031.
In the meantime, I hope you'll come back next Friday... In that Digest, I'll indulge some ideas about the future – including my list of potential surprises for investors in 2022.
New 52-week highs (as of 12/16/21): AbbVie (ABBV), Berkshire Hathaway (BRK-B), CVS Health (CVS), Quest Diagnostics (DGX), Digital Realty Trust (DLR), Expeditors International of Washington (EXPD), Flowers Foods (FLO), General Mills (GIS), Hershey (HSY), Coca-Cola (KO), McDonald's (MCD), Nestlé (NSRGY), Novo Nordisk (NVO), Procter & Gamble (PG), PLDT (PHI), Thermo Fisher Scientific (TMO), Consumer Staples Select Sector SPDR Fund (XLP), and Utilities Select Sector SPDR Fund (XLU).
What's on your mind? As always, we welcome your thoughts, comments, and observations on the markets at feedback@stansberryresearch.com. While we can't provide individual investment advice, we do read every note that we receive.
Good investing,
Dan Ferris
Eagle Point, Oregon
December 17, 2021