Markets and geopolitics are changing. It’s time for investors to review their portfolios and ensure they have a long-term plan.
Key Takeaways
- Geopolitical Threats Increasing: Iran, China, Russia, and North Korea are collaborating to undermine Western democracies, particularly the USA.
- Stock Valuations Still Matter: Nvidia’s market value exceeds that of the entire Russell 2000, despite having significantly lower revenues.
- Rate Cuts are Coming: The Federal Reserve’s decisions on interest rates are crucial for the valuation of stocks, especially during economic slowdowns.
Global political tensions are mounting. Stock valuations are elevated, even after the current market sell-off. And the Fed is on the cusp of cutting rates and entering a new “easing” cycle.
Below is an overview of key themes I am seeing in the market today and their potential impact.
What is the “axis of evil”?
As Americans we often do a lot of naval gazing. By that I mean that we tend to ignore what is going on in the rest of the world. Following recent events, it is now clear that the “Axis of Evil”, which I describe as Iran, China, Russia and North Korea, are working together to weaken Western democracies and especially the USA. They are doing this both economically and politically, especially when it comes to aggressively working to decrease the importance of the US Dollar in the global economy.
Iran has not forgotten that Trump was behind the drone execution of Soleimani. It is not too farfetched to think that the recent assassination attempt on Trump could have had an Iranian connection. With the spread of nuclear weapons there are many global hotspots that could engender a “tactical” nuclear war. While I think the reality of one of these types of events is unlikely, markets move on expectations. As such, as pressures from these nations mount there is likely to be further increases in market volatility.
Stock valuations – do they matter?
To quote Warren Buffett: “Price is what you pay, and value is what you get”. Value is determined by comparing the price to a number of different “good things” such as revenues (sales), cash production per share and earnings per share. In the chart below, we compare the market value of a single stock (Nvidia) to the market value of a 2,000-stock index (Russell 2000).
We see that Nvidia’s market cap (total value of the company) is slightly greater than that of the Russell 2000 small cap index. In order words, the market believes the value of Nvidia to be greater than the aggregate value of all 2000 companies that comprise the Russell 2000 index.
As a sanity check, we also compare the aggregated sales (revenues) of both Nvidia and the Russell 2000 companies. Here we see that Nvidia’s sales are a fraction of those of the Russell 2000. The contrast here highlights a key theme occurring in the markets – a massive pull forward of growth expectations. While companies like Nvidia will likely continue to be very successful and grow, the market has pulled forward a lot of the future growth into today’s price.
Is the Fed our friend?
There has been much hue and cry from investors over the last year demanding that the Federal Reserve lower interest rates (at least the ones they can control). Taking a step back, the primary reason that the Fed would consider lowering interest rates is that the economy is slowing down (employment is one of its two mandates).
Most companies do not do as well when the economy is slowing down. It is difficult to cut your costs fast enough to preserve your profit margins. This is consistent with something called a “bear steepener” in the shape of the yield curve. Early in a recession, short term rates are lowered by the Federal Reserve while longer term rates stay the same or rise. This change in shape from inverted (short term rates higher than long term rates) to “normal” (long term rates higher than short term rates) is a time when bonds outperform stocks.
The key point is that interest rates are a key input into the valuation of common stocks. We expect the next Fed move to be a rate cut, which would align with the latest economic data suggesting the US economy is slowing (but not entering a recession). The effect of rate cuts may be two-fold – while lower rates will help to support companies that face economic headwinds, it could also amplify excessive valuations further.
What is the convergence of cycles?
We are all familiar with the average four-year business cycle. It is illustrated below. It is driven by over and under investment by businesses in equipment, software etc. The engine for this volatile cycle is lending.
When the short-term business cycle coincides with a long-term secular cycle then the range of possible outcomes increases dramatically. Therefore, it pays to have a means of identifying long term cycles.
I have written a great deal lately about Elliot Wave analysis. It was designed to highlight overarching long-term cycles which have more to do with human nature than econometrics.
It seems that every four generations we must learn the lessons of our grandparents or great grandparents. Many experienced Elliot Wave practitioners believe that we are approaching the end of a massive cycle that began in 1932. Fortunately, there are very specific guidelines for identifying the end of such a cycle. It involves a five-wave pattern down from the peak with one last rally to the upside before the massive reversal begins.
Please stay tuned for further updates.
ENDNOTES
Disclosures
This commentary reflects the personal opinions, viewpoints and analyses of the author providing such comments, and should not be regarded as a description of advisory services provided by Defiant Capital Group or performance returns of any Defiant Capital Group client. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Defiant Capital Group manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary.
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
