Prepare for Transition Year
in Politics and Markets
It’s time to take a fresh perspective on investing opportunities and strategies. Don’t assume that what worked well as an investment strategy last year will work this year. By the same token, investments that failed to pay off in 2014 could be the shining stars of 2015.
Some trends are clearly unsustainable. Oil and commodity prices won’t continue falling forever. The dollar and bonds won’t continue rising forever. Pinpointing a future inflection point for trend changes in each of these asset classes is impossible. But at some point this year a number of significant trend changes may take place.
Whether the U.S. stock market’s major uptrend can continue in 2015 remains to be seen. Another year of modest gains or a final blow-off phase to the major bull market that began in 2009 are both plausible scenarios. But valuation indicators are flashing warning signs about expected returns for long-term investors. More on that later in this story…
Voters Give Republicans Another Chance: What Happens Now?
One transition that we know is coming is in the makeup of government. Republicans will control 54 seats in the U.S. Senate and expand their House majority. Gains in state legislatures and governorships are even more impressive.
But voters hoping for a new direction in spending and debt accumulation may be disappointed. Incoming Senate Majority Leader Mitch McConnell and House Speaker John Boehner have never been known in their long political careers as agents of fundamental change. The GOP establishment seems more concerned with sidelining the Tea Party than de-funding President Obama’s agenda.
Nevertheless, there will be some changes in the way America is governed which have some investment implications. The energy sector may get a
boost from a Senate that will now be more favorable toward the Keystone pipeline and coal power and less smitten with regulatory overreach by the Environmental Protection Agency. The beleaguered coal ETF (KOL) finally has an opportunity to rebound.
Oil stocks may also be due to make up some ground they lost in 2014. Legendary oil investor T. Boone Pickens predicts that crude oil will rebound to $100 a barrel within the next 18 months. When oil dipped below $60 per barrel in December, the booming shale industry started going bust. Lower prices means less shale oil production. Dividend-paying energy stocks that have withstood the slide in oil will gush profits when prices pick up.
Even Bulls Now Admit that Stocks
Are “Crazy Expensive”
The broader market, though, does not appear well positioned to deliver outsized performance – at least not from a fundamental perspective. Some in the financial media are promoting stocks anyway. A Marketwatch headline (December 3, 2014) blared, “Stocks are crazy expensive, but here’s why 2015 could feed the bull.”
Yes, stocks priced expensively can get more expensive. But betting on an overvalued market to become more overvalued is not a prudent long-term investing strategy.
Usually, buyers of stocks at stretched valuations regret their decision at some point in time. Markets can slowly creep higher for months or even years, then give back all those gains and more in a fraction of the time. Bear markets move a lot faster than bull markets. It’s better to get out too early than hold on for too long.
The Shiller 10-year inflation-adjusted price/earnings ratio for the S&P 500 now stands at 26.3. That’s 58% higher than the historical mean of 16.6. If the Shiller P/E reverts to the mean over the next few years, the investors face the prospect of no capital appreciation (dividends may be your only source of gains). If the P/E contracts toward a lower-end reading, then investors face the prospect of a devastating bear market.
Watch for This Clear Sign of
Another metric to gauge the stock market’s valuation is to compare total market capitalization to gross domestic product (GDP). If the stock market is worth more than the nation’s actual economic output, that’s a warning sign of overvaluation. Stocks headed into year end 2014 trading at 1.2 times GDP. That’s loftier than they were at the 2007 top. And nearly as extreme an overvaluation as was seen in 2000.
The market has decoupled from the real economy. Most people are not experiencing a boom in their personal finances. As the Washington Post (December 12, 2014) notes, “Median household income peaked at least 15 years ago in 81 percent of U.S. counties. That means that when incomes are adjusted for inflation, most middle class households are actually earning less money than they did years ago.”
The Federal Reserve’s liquidity pumps have flowed into the bond and equity markets, leaving the real economy – and many of the real assets that underpin it – behind. The Fed has kept M2 money supply growth running at about 6% per annum. Yet because credit is still contracting in the private sector, the total monetary base is actually declining. From a peak of $4.1 trillion, the US monetary base has declined to $3.7 trillion as of December 2014.
The Fed appears set to start raising interest rates as soon as this spring. Where does that leave precious metals?
Precious Metals Outlook. Yes, There Really is One.
The gold and silver markets enter 2015 struggling to regain investor interest as a hedge against inflation and financial crisis. The Consumer Price Index produced an essentially flat reading of 0% in the fourth quarter of 2014, with falling energy prices contributing to downside momentum.
Will we get deflation first, then inflation? That’s one scenario to prepare for. In such a case, gold and silver may have one more sell-off but would still likely hold up better than equity markets once they roll over.
Holding a 20%-25% allocation in precious metals is still prudent in my view. As former Fed chief Alan Greenspan said, “Gold is a good place to put money these days given its value as a currency outside of the policies conducted by governments.”
More Evidence of Manipulation Mounts
Massive manipulations by governments, central banks, and investment banks have caused gold and other assets to behave abnormally. According to a report ecently submitted to the U.S. Senate Committee on Homeland Security and Governmental Affairs, “Possible conflicts of interest permeate virtually every type of commodity activity… If the bank’s affiliate operates a commodity-based exchange-traded fund backed by gold, the bank may ask the affiliate to release some of the gold into the marketplace and lower gold prices, so that the bank can profit from a short position in gold futures or swaps, even if some clients hold long positions.”
According to the report, the “problem with mixing banking and commerce is that, in the context of physical commodities, it invites market manipulation and excessive speculation in commodity prices.”
The way to fight back against the dominance of the financial sector and central banks in the economy is to own and invest in real assets – especially precious metals in physical form. The financial barons may win some battles, but they can’t vanquish the laws of supply and demand.
Prudent Asset Allocation Suggestion
Here Can Cover Your Bases
As always, stay diversified. Prudent investors never bet everything on one asset. Particularly now, when so many variables can cause forecasts to go awry, don’t bet on one single investment theme.
We’ve highlighted the Permanent Portfolio Fund (PRPFX) in previous issues. It holds stocks, bonds, precious metals, and foreign assets. It remains a fool-proof way to invest if you can’t figure out what to buy or if you would just rather not bother trying to construct your own portfolio.
I believe most investors can ultimately achieve better diversification, more security, and greater efficiency by owning gold and silver in physical form and constructing their own index fund/ETF portfolio to track other targeted asset classes and sectors.
Here is Independent Living’s model Safe Harbor Portfolio:
- 35% Vanguard Total World Stock Index (VT)
- 25% Physical Precious Metals
- 12.5% gold; 12.5% silver
- 20% iShares Lehman Aggregate Bond (AGG)
- 5% Vanguard Total International Bond (BNDX)
- 5% iShares Barclays TIPS (TIP)
- 5% SPDR Global Real Estate (RWO)
- 5% Treasury Bills or Cash Equivalents
The Safe Harbor Portfolio will enable you to survive through either deflation or inflation. But if your aim is to prepare for the eventual resurgence of inflation and try to profit from it, then you might consider setting up a more aggressive portfolio. Independent Living’s Model Portfolio for Inflationary Times features overweightings in precious metals, resource stocks, and foreign assets.
There is no single asset that is guaranteed to beat inflation over any given time period. However, the following Model Portfolio assembles a number of assets that, taken together, can help you weather an inflationary storm of virtually any shape, size, or duration:
- 40% Physical Precious Metals
- 15% gold; 15% silver; 5% platinum; 5% palladium
- 10% Vanguard Total World Stock Index (VT)
- 10% Vanguard Emerging Markets (VWO)
- 10% Market Vectors RVE Hard Assets Producers (HAP)
- 10% SPDR Global Real Estate (RWO)
- 5% iShares Barclays TIPS (TIP)
- 5% SPDR International Inflation-Protected Bond (WIP)
- 5% Market Vectors Gold Miners (GDX)
- 5% Merk Hard Currency Fund (MERKX)
Elsewhere in this issue you’ll find additional investment themes and specific instruments you can own to play them. When in doubt, diversify!