All Aboard
You don’t have to look too hard to find signs of the ‘U.S. exceptionalism’ trade reaching an extreme. I’ll get into more on this below, but the FOMO crowd is determined to pile into the Mag7 and Bitcoin as we head into year-end with these two assets among the select few that are positive so far in December. Last week was tough for both the stock and bond markets as breadth continued to deteriorate in equities with just 67% of members trading above their 200-day-moving-average (lowest level since the early August sell-off). Interest rates moving up was a bit of head scratcher with the batch of in-line to better than expected inflation readings we got - modestly better inflation prints are not going to cut it against a growing perception that year-over-year inflation prints marked a short-term bottom in October.
Most stocks outside of the Tech sector have been in the midst of a mild but persistent selloff. Over the last ten trading days (through Friday), more stocks in the S&P 500 declined than rose, which is the longest such stretch since 2000. The Dow is on a seven-day losing streak, and the S&P 500 Equal Weight index has declined for 6 of the last 7 trading days. Though, not everything is weak, a newly created meme coin called “Fartcoin” which was created by an experimental A.I. chatbot known by the name of ‘Terminal of Truth’ has amassed a market cap exceeding $800 million (larger than 40% of all publically traded stocks). So, at least we have that going for the market, which in some form has turned into a forum for degenerate YOLO gamblers.
On the week, the Dow slipped -1.8%, the small-cap Russell 2000 sank -2.6%, the S&P 500 slid -0.6%, and the S&P 500 Equal Weight index fell -1.6%. In a sign that fewer and fewer stocks are supporting the market, the percentage of Nasdaq constituents hitting 52-week highs has declined since the rally that got underway following the November 5th election. This is a bit of a dilemma for investors, given we are in a month where the seasonality is typically very strong. Maybe this is nothing more than a much-needed consolidation phase that will set the stage for the next leg higher as we move into 2025. That appears to be the view emanating from the publishers over at Barron’s, where the front cover of this week’s issue, “Why the Stock Market Could Gain Another 20% in 2025,” concluded that, “Investors should embrace the expanding bubble.”
Time, as always, will be the ultimate arbitrator of such a forecast, but my two cents is that when you reach the stage of the cycle where we’re encouraging investors to “embrace the expanding bubble,” it's usually time to start looking for the exit ramps. Sure, you may very well leave some money on the table, but if your stack of capital is already more than you need, then it is hard to conclude you failed to achieve your financial objectives if your returns lag what is becoming a more dangerous course to navigate. Lost in the allure of how well the S&P 500 has performed over the last two years and the fact that it has become the world's savings account is the reality that it is a highly concentrated index with the Mag7 back to commanding over one-third of its weighting. The S&P 500 is up +27% year-to-date with roughly 52% of that gain attributable to the Mag 7. Without question, these are arguably the seven most dominant companies in the world and are deserving of the compounding gains they have earned, but their gains are also a result of the structural changes that have taken shape in capital markets that are driven more than ever by computerized trading models that favor momentum and the unquenchable passive bid.
Jim Bianco put out an enlightening thread on X over the weekend casting some light on this phenomenon:
The study Jim is referring to is a piece recently published by Morningstar, in which they sight a study set to be released in January by Aizhan Anarkulova, an assistant professor of finance at Emory University's Goizueta Business School and co-author of Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice. See the link below to the article. in fairness, the author focuses on capital allocation for individuals saving for retirement and not necessarily already in retirement and living off the capital base (these are two very different things).
100% stocks for retirement? A new study says dump the 60/40 portfolio and target-date funds.
Heading into 2025, the question must be addressed: What is a razor-thin equity risk premium (ERP) telling us? Investors willingly investing in the market today in this environment, can only rationally be doing so if they are in it for the long run; never to sell under any circumstances. If that is your belief, then I concur - stocks for the long-run and enjoy the ride (won’t always be pleasant). This is your sort of market. But if you believe that the ERP should be positive or anywhere close to the long-run mean of 300 or 400 basis points, then arithmetically, only three things can happen: interest rates have to come down, the equity market will have to come down, or some combination thereof.
Another thing that is relevant for investors to consider heading into 2025 versus 2023 and 2024, where the S&P 500 generated more than 20% returns, is that the setup today is the polar opposite of where we were at the start of 2023. Back then, investors were still licking their wounds from one of the worst years for returns on record. Not because the S&P 500 declined almost 20% (there have been many deeper declines in equities throughout history), but because bonds also declined nearly 20%. It was a year where there was nowhere to hide but cash. Eventually, that is what many investors and institutions ended up doing. However, at the end of 2022, the Fed pivoted from tightening monetary policy to setting the stage for a loosening cycle starting in 2023. Additionally, data started to improve, interest rates began to slide from fifteen-year highs, and equity prices started to rise. Then capital started to flow back into equities as washed-out negative sentiment and positioning had to rebalance out of a capital preservation posture and into a capital appreciation posture. Below is the results of a survey conducted by Ally Financial of investors' expectations for the stock market heading into 2023 after a lousy 2022.
Only 25% of respondents thought equities would increase in value, and more than 60% said they would remain flat or decline. Investors' expectations today differ dramatically, as equities comprise 70% of household balance sheets, and institutional investors sit on record low liquidity ratios of barely more than 1%. Look, I get it; the collection of evidence in the post-GFC era of investing strongly supports the superiority of equities above all other assets (with the exception of cryptocurrency), so why waste your time and effort on anything else? Furthermore, venturing outside of owning anything other than the S&P 500 or Nasdaq index has made you look foolish for having dedicated any thought, analysis, or rigor to your investment strategy. A point validated for a second straight year where roughly only 30% of stocks in the S&P 500 are set to outperform the index, a feat we haven’t seen play out in back-to-back years since the Tech Bubble peak in the late-90’s (chart compliments of Michael Hartnett at BofA):
Then there are the actions of policymakers over the past fifteen years; time and again, they stepped in and provided a backstop to asset prices. When it comes to the Fed, any panic in the stock market has been met with a vigorous response. Bernanke got the ball rolling when he discovered that lower interest rates were no replacement for outright QE – the first round of the intervention helped finally end the bear market in March 2009. And the subsequent QEs that came our way were unabashedly described as a means to generate a positive wealth effect on spending. Then Powell took the reins and was shortly tested, where, at the first hint of a deep and potentially protracted correction in late 2018, the previous hawkish Powell embarked on three rate cuts in 2019, even with the economy operating at full employment. The ante was raised even further after COVID-19, where Powell revealed how important risk assets were to the Fed and the economy when they committed to buying corporate debt (including high-yield bonds) to backstop the bond market.
Investors are smart; like Pavolov’s dogs, we begin to catch on. Then, we begin to anticipate and front-run policy actions. So, perhaps it makes sense that we now have 70% of household financial assets in equities and passive ETF index investing rapidly approaching a record 60% share of the S&P 500 market capitalization. Add to this the fact that we have an incoming president that wasn’t shy in his last term about using the stock market as his measuring stick and you have yourself a very good narrative supporting why the “U.S. Exceptionalism” trade has more room to run. So, you can’t fight it because current trends can persist for far longer than one can imagine, but it doesn’t mean you have to commit to it in a manner that puts you in a vulnerable position if it unwinds in a sudden and dramatic fashion. That’s all I’m trying to say. Recognize and be aware of the growing fragility. It’s not the time and place to be ‘irresponsibly long’ risk exposure. It’s the time and place to be prudent, disciplined, and unemotional. This goes for both the bears and the bulls. The bears can rightly point to valuation, greed, unsustainable profit margins, and government spending artificially inflating growth…but these arguments could have been made a year ago and the year before that; they aren’t new. Definitely more extended than they were, but if this kept you from having exposure to risk assets and equities in particular, you did yourself and/or investors a disservice.
While diversification is being shunned and has become a dirty fifteen-letter word, it is very important at this juncture. I don’t see anything wrong with having a sleeve on one’s portfolio allocated to parts of the bond market offering a safe and secure mid-single-digit yield.
The current 5.4% 30-year Ginnie Mae yield trades the same as long-term corporate bond yields. One has no default risk; the other, indeed, does have default risk. That’s an easy choice. Only once, in February 2000, at the peak of the Tech-induced bubble era, was there no spread between the two (historically, Ginnie Mae mortgages have traded at a -130-basis point discount to reflect the lower inherent risk). The yield on a 2-year T-bill, at 4.25%, typically trades 75-100 basis points below the 10-year T-note rate, and today, it is 15 basis points lower. Historically, the T-bill yield has averaged 125 basis points above the S&P 500 dividend yield, and now that spread is closer to 300 basis points.
Bottom line, there are places in the capital markets that provide a reliable and secure return stream close to the 8% average annual return from U.S. equities. I know it is tough to go against the crowd in an era when 15% annual returns have become the expectation (and close to what the S&P 500 has delivered over the past five years), but the starting point for each asset class is dramatically different today.
I’m going to share one more thought on this “American Exceptionalism” theme before closing up this week’s missive. One of the major contributors to why the U.S. economy and markets have outpaced everyone else over the past fifteen years and more dramatically over the past five is that our government is spending more and is willing to run bigger deficits than most other countries. It’s difficult to see U.S. GDP weaken dramatically when Uncle Sam taps the credit card for an extra $2 trillion per annum, equivalent to 6 – 8% of GDP. When it comes to fiscal expansion and ensuring that whatever is temporary will always be made permanent, nobody does that better than the U.S. (well, maybe France). This is much more powerful than the AI craze in terms of the macro impact. The same deficit ratio that is being resisted in France is being embraced in the U.S., where the ability to buy economic growth via endless government support is unrivaled by all other developed countries.
This brings me to Elon Musk and DOGE, where there is a lot of enthusiasm over what they will do. I’d guess not much when all is said and done. Think through it. Donald Trump has already said he’s not going to touch entitlements. This leaves defense spending, interest expense, and discretionary spending as the only other options, with the latter one as the only real option. Trump is on the record as saying he isn’t even willing to change the age at which the benefits kick in despite the secular rise in life expectancy. As for the DOGE plan to trim the fat, the reality is that without fundamental reforms to entitlement spending, spinning the dial on these massive deficits will require drastic action on the tiny share of public spending that is discretionary – the cut here will have to be at least 75% and include a complete decimation of the federal civil service.
However, rather than focusing on what the U.S. can or cannot do, I think the following interview of market historian Russell Napier is a must read; “ We Are Headed Towards a System of National Capitalism” where he focuses on what the rest of the world will do in reaction to the policies being pursued by the U.S. Speaking plainly, I find Russell’s view and conclusions to be profound, but that doesn’t mean they shouldn’t be respected or contemplated. In particular:
You mentioned that you see the world moving towards a system of national capitalism. This would upend everything that most investors today take for granted: free flow of capital, market based bond yields, and the like.
“Yes. The most important part is the idea that national savings shall be used for national purposes. There will be a big push to repatriate capital, back to Europe and back to Japan, for example. The other part is that we need to understand how much of the current world financial system is based on China and its decision in 1994 to manage its currency against the dollar. After the 1997-98 Asian Financial Crisis, most Asian countries started to do the same thing. The result was an exponential growth in dollar reserves. These were all non-price-sensitive buyers of Treasuries and other US assets. This huge flow of capital has pushed interest rates down and equity prices up. Today, 58.5 trillion dollars worth of American assets are owned by foreigners. Arguably, this system started falling apart in 2014, when global forex reserves peaked. It’s now coming to an end, because it’s not working for China anymore. China has reached the end of the rope, both in terms of its total debt to GDP and also in terms of the rest of the world not willing to absorb China’s overproduction anymore. Historically, every thirty or forty years monetary systems collapse. The current one, the one we have lived with since 1994, is collapsing in front of our eyes.”
I’ll say it again, the entire interview is worth a read, but this is yet another grain of sand on the pile that adds to the fragility of U.S. asset prices where everyone is crowded into the same place and betting on the same outcome – U.S. exceptionalism only gets better under Trumps “Make America Great Again” agenda. Look, I have no problem admitting that I like and want some of this administration's policy agenda to work. So no, this isn’t some anti-Maga statement, but when I look at the chart below showing the percentage allocation foreigners hold in U.S. equities at its highest level ever (by far) and then entertain the notion that this capital could be repatriated home to fulfill other nations national agendas – it represents a potential large seller of U.S. equities that would be almost impossible for other drivers to offset.
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