Performance Report: 12/31/2023
All performance data for our strategies is net of all fees and expenses. All performance data for indexes or other securities is from sources we believe to be reliable. All data is as of 12/31/2023.
Any parent knows the gravity of this statement. When the wife looks at the husband and says "It's time." I can remember every minute detail of that moment when my wife uttered those words to me. As for the capital markets, I can say with some level of confidence, "It's time". The current bull market in stocks is set to pass and give birth to a new cycle.
Last week we saw my wife's cousin who has four kids all under the age of five (no twins). She is pregnant with her fifth. She says the process is getting familiar but at the same time, each is its unique experience. I add this because I am now experiencing my fourth market top. And while every market top looks unique, they are similar in many respects. These similarities included:
- The"Irrational Exuberance" sentiment which is fraught with danger as market participants completely ignore obvious risks that can easily topple the economy. In 2008, home prices were clearly falling and foreclosures were skyrocketing, yet the markets were content to believe the risk was "contained". In 2022, the markets were convinced inflation was temporary and interest rates would not rise. Today, the geopolitical risks are too obvious yet the stock market has shunned them like "water off a duck's back."
- Then there is the "Bad News is Good News" phenomenon which always strikes me as odd. Over the past two months, the stock market has rallied with each lousy employment report translating it as the FED can finally back off.
- And finally, we have the "soup du jour" catchphrase. Every bubble is defined by some trendy, overly optimistic language that is regurgitated ad nausea. In 2000, it was "It's different this time"; in 2007, there were the calls for "Goldilocks...not-too-hot, not-too-cold"; in 2021, there were the infamous words spoken by Chairman Powell, "inflation is transitory"; and today we keep hearing about the inevitable "soft-landing". These narratives come in hot and heavy at the end of each bull market cycle. Market participants have to find a way to talk themselves into the insanity that is late-stage investing.
If you will, let me address how crazy maintaining stock market exposure is at this juncture. There are only a handful of tenants that approach the status of "gospel" in the world of investing. One would be "buy low, sell high". Another one is the Dow Theory. In short, Dow Theory states that equities are to be priced relative to the risk-free rate of US Treasury bills. There has only been one time in history before today when the long-term prospects of stock market returns were less than the risk-free rate, which was in 1999/2000. And we know how that ended. Currently, the Shiller P/E calculation is just over 32. The all-time high was 43 in 2000. Over the past decade, the P/E ratio has been as high as the mid-30's but all those instances took place when the risk-free rate provided by US Treasury bills was much lower than it is today. Thus, a higher multiple or P/E ratio was reasonable.
The historical average P/E ratio for US Equities has been around 15. A P/E of 32 means an investor is paying more than twice as much for a $1 of earnings than what has been offered throughout history. Thus, expected returns should be half the historical returns. Given that the historical average return for the stock market is pegged somewhere between 8 - 10%, an investor should now only expect half that return, somewhere in the 4 - 5% annual return range. Therefore, the risk-free rate is higher than the expected future returns of the S&P. Again, only in 1999 was this the case. So why would anyone be venturing into equity markets when risk-free US Treasuries should provide a better outcome?
The fundamental outlook for US equities is certainly bleak. But why then did the US equity markets do so well this past year? And how can I say with any degree of confidence, that the market is ready to capitulate and finally come to its senses?
I have a high level of confidence in making the call that "IT'S TIME". My confidence is derived from several studies I have done on the history of capital markets. First is the extreme move for the S&P 500 over the past two months. Through November and December, the stock market appreciated eight straight weeks without a single decline. Over the past 30 years, the index has only accomplished this feat on four separate occasions. The first occasion ended in January of 2004. Once the rally was completed, the S&P 500 did not eclipse its 1/16/2004 high for 10 months. The second occasion was in October of 2010 just as the FED approved permanent QE. This was a one-off event that radically changed monetary policy and defined markets for the next decade. The third instance was in February of 2012 and the stock market subsequently fell for the next six months. The most recent instance was in August of 2020 as the economy was rebooting after the pandemic in addition to $5T of FED money hitting the markets. The NASDAQ accomplished the same feat on two separate occasions, once in December of 1999 and then in January of 2021. In both instances, the NASDAQ continued higher over the next few months but eventually crashed. Starting in March of 2000, the NASDAQ started a decline of 75%.
The second factor is simply timing. There are a host of cycles at play that appear to be converging at the current time. I've covered the 7-year cycle in past updates. As long as the S&P 500 does not eclipse its 2022 high, then the 7-year bear market, "Year of Remission", cycle is still valid.
Then we have a much longer 50-year cycle. Every 50 years a significant event has occurred which has defined the next generation in the capital markets. In 1973, there was the OPEC oil embargo which led to the Petrodollar arrangement. Since 1973, every barrel of oil purchased from OPEC was bought in US dollars, which were then recycled into US banks and/or US arms suppliers. This allowed the US economy to run up spectacular deficits as our nation was afforded the opportunity to export copious amounts of monetary inflation.
In 1923, the FOMC (FED Open Market Committee) was established giving the FED the right and responsibility to openly manipulate capital markets for the purpose of banking stability. From 1923 through 2023, the FED has exercised an increasing amount of control over capital markets, which may have peaked just this past month. In years to come, looking back at 2023, rather than discussing "Peak Oil" or "Peak Inflation", the history books will denote "Peak FED".
1873 was the beginning of the first Great Depression. Starting in 1873, our nation's banking system suffered a series of panics and multiple failures. These panics took place in rapid succession in 1873, 1884, 1893, 1896, 1901, 1907, and 1910. Imagine suffering through a period like 2008 every five years. Prior to 1873, banking panics existed but occurred far less frequently. There were only two major bank panics in the US between 1823 and 1872.
1823 marked the first national banking crisis in the US and the peak of the 2nd chartered US Central Bank.
Just as the 7-year cycle has a direct link to the Bible, the 50-year cycle does as well in that the Lord dictated that all land should be returned to its rightful owners every 50 years as well as all debts were to be forgiven (Leviticus 25: 8 - 13).
The last cycle I'll address may be the most interesting, and likely the most disturbing and controversial. Since 1910 when the FED was conceived, there is a series of cycles defined by the number 666.
666 days separated the peak of the S&P 500 and NASDAQ indexes on February 15, 2020 before the Covid Crash and the mid-point between the all-time high in the NASDAQ and the S&P 500, which occurred on December 12, 2021.
666 weeks separated the Financial Crisis low on March 6, 2009 and December 12, 2021.
666 months separated the current record high for the NASDAQ and May 1966. May 1966 was when France defaulted on the London Gold Pool effectively ending the US gold standard. And it was 666 months between May 1966 and November 1910 when the FED was conceived at a secret meeting on Jekyll Island. So the FED operated for 666 months under a gold standard and then 666 months free from the shackles of a gold standard.
Which brings us to today. The S&P 500 is just a stone's throw from a new all-time high which means if the 666 pattern is any kind of omen, the stock market can't go much higher. If the FED and its Wall Street member banks can continue to push the S&P to that level, then a new bull market would be official. But as long as the December highs hold, the long-term downtrend in stocks and bonds is still valid. And as long as they are valid, prices should be headed lower. I'm inclined to believe the 666 pattern is not a mere coincidence and maybe an omen that the world is about to endure significant change.
A much shorter-term omen is the fact that the Santa Claus Rally failed to materialize. Historically, the six trading days starting on Boxing Day have generated an average gain of just over 1%, a 40% annualized gain. But this year, stocks fell about 1% during the Santa Claus rally stretch. So will the old expression, "If Santa Claus should fail to call, bears may come to Broad and Wall" materialize? Over 80% of the time, the performance of the stock market during this brief six day stretch has correctly determined how the stock market performs the rest of the year! Using this as our guide, there is an 80% change the S&P 500 will decline this year. Here is a link to an article on yahoo.com and one on CNBC.com which explain how powerful of an indicator the Santa Claus rally has been.
2023 Thesis Update
About this time last year, I wrote my 2023 Thesis which stated that the FED and its member banks (i.e. Wall Street) were overtly shorting commodities to keep inflation in check. And this shorting behavior would at some point backfire leading to a once-in-a-lifetime short-covering rally. Well, 2023 has come and gone and there was no short-covering rally. In my defense, I did disclose that I didn't know the timing of the short-covering rally but that it would happen at some point. At this point, am I wavering on my thesis? Absolutely not.
For more anecdotal evidence that my thesis is intact, let's examine the market for crude oil. Over the past quarter, crude oil prices have fallen about 25%. During this three-month stretch, there has been an incredible number of bullish developments that should have resulted in higher, not lower, oil prices:
- The first major war since 1973 broke out in the Middle East and is showing no signs of being resolved. 1973 was the year the US and Saudi Arabia came to the Petrodollar agreement that solidified the USD's position as the world's reserve currency. I've studied the Israel-Palestine conflict extensively and during the 1960's, the devasting losses suffered by Palestine and its allies at the hands of the IDF were incredible. The ratio of lives lost between the Yom Kippur War (1973) and the Six Day War (1966) was more than 15:1 in favor of Israel. The cornerstone of the Petrodollar arrangement was to fortify Sauid with best-in-class weaponry to defend itself against Israel and Iran. In the 50 years since, the fighting in the world's most hostile area has been fairly subdued, at least until this past October.
- In their November meeting, OPEC+ agreed to a deeper production cut of 2M barrels/day. While a few smaller OPEC+ participants balked at the arrangement, Saudi Arabia has upheld the lower quotas and continues to maintain them.
- OPEC+ and the BRICs move closer to a unified economic force. During the quarter, the BRIC nations invited several OPEC+ members to join their ranks. The overlap between these two economic unions is becoming deeper and wider. Between the two, they represent well over half the oil exports in the world providing them with considerable pricing power. At any moment, they could agree to a price floor that would rock energy markets and possibly the world economy.
- The most significant development of all is the unreal decision by the UAE to break free from the Petrodollar. This is the first time an OPEC member who is friendly with the US has decided to default on the Petrodollar. The significance of this event cannot be overstated. The entire US economy is predicated on the idea that the USD retains its status as the world's reserve currency which is based on the fact that everyone in the world who buys oil has to do it in USDs. If a sufficient number of OPEC members break free of the Petrodollar agreement, the USD loses its status as the world's reserve currency, period. As it stands now, Russia, Iran and now the UAE, three of the seven largest oil exporters, are now pricing oil in local currencies rather than the USD.
I can't remember a more bullish setup for oil in my 25 years of experience in the investing industry, yet prices collapsed 25% over the past quarter. The most likely explanation for this price move is that the FED is proactively shorting the energy space knowing that if oil prices move higher, inflation will remain elevated. And given that our banking sector desperately needs inflation to calm down so that interest rates can come down as well, the FED is fully committed to doing whatever it must do to keep inflation under control.
But as I've stated over and over again, the FED can only control the paper market for any commodity, including oil. They cannot affect the physical market in perpetuity. If the physical market decides to break free of the paper market, the paper shorts will be squeezed and experience sizeable losses.
Given the precarious position of the equity markets, I'm steering clear of cyclical, high-beta stocks. If the S&P 500 manages to climb out of the small hole it is in as I write this and closes at new highs, I'll reevaluate my stance. While the short-term trend is up, the intermediate down-trend is still intact, but barely.
I am growing more confident that the energy space will be the commodity that breaks the paper markets. There are too many dominos lined up in the energy space for the FED to circumvent them all. At any moment, a myriad of actions could lead to energy prices shifting out of their downtrend.
There are a couple of other sectors to watch as well. Gold is interesting as it held above $2000 for the first time in history. I addressed this issue in last month's update. The FED has proactively shorted gold since the 1960's London Gold Pool was established. On several occasions, they have failed to control the price of gold. It would take a herculean effort to squeeze the gold or silver market but someone may be working on it. We know central bank gold buying is at all-time highs. The fundamental case is there. Before now, every time gold approached $2000, it quickly retreated. For the first time ever, gold has reached the $2k mark and sustained its gains. If the December high in gold is breached, it could portend much higher prices.
The final sector I'm watching closely is Commercial Real Estate (CRE). I have kept a keen eye on CRE for some time. The pandemic rocked the CRE space. Now, higher interest rates are compounding the issues in this space. Higher interest rates negatively impact CRE in two ways. First, CRE is often purchased as an income play and with US Treasuries providing a higher yield, CRE must respond to provide a commensurate yield. Currently, IYR, the largest CRE ETF, is yielding just 2.5%. Why would anyone assume the risk of real estate when it only pays half of what risk-free US Treasury bills are paying?
The second issue is financing. Most all CRE deals are heavily leveraged. The leverage involves notes from banks to help finance the deals. As rates charged by the banks increase, the profits from the investment decrease. Some of the debt will be refinanced from time-to-time and when it is, higher rates will have a direct impact on profitability.
Over the past two years, REIT funds that own CRE have underperformed the S&P 500 by a wide margin. In all prior bear markets, the sectors that performed the worst leading into the decline continued to be the worst performers throughout the decline. While the S&P and NASDAQ are only a few percentage points below their all-time highs, the Dow Jones REIT index is 25% below its 2021 all-time high.
Despite the dire fundamental outlook for CRE, REITs experienced strong growth in the past two months. After all, "a rising tide lifts all boats." I'm looking to see if REITs and other CRE-related investments break below their Q4 lows before the S&P 500 does. If so, it's likely REITs will lead the market lower.
It's really quite remarkable how market participants repeat the same behaviors over and over again. How intelligent persons cannot understand that "Goldilocks" and "soft-landing" are synonymous? How FED members have come to believe that they have an omnipotent power to manipulate the real economy through intangible financial instruments even when it's failed every single time it has been tried in the past. I've fooled myself into believing this time they would be more astute and adjust accordingly. That this time would be different, but in reality, this time they have dug in their heels even deeper. The FED has never been so far out on a limb. The current market has all the trappings of a market top. But the FED is a formidable force. Perhaps they can carry on their charade a little longer. At this point, I'm not counting on it but I'll look for clues to the contrary.
If I'm right about the stock market, it will be painful for most of our country but our nation will adjust and get through it. The Pandemic was tough but we came out on the other side just fine. The 2008 Financial Crisis was rough as well but we bounced back. And the same for the dot.com bust. Yes, for those who were not protected from the downside moves in capital markets during these tough times suffered life-altering losses. But for those who were prepared and protected, wonderful profit opportunities were abundant. I plan to be prepared and take advantage of some of the opportunities that the capital markets provide for us over the next couple of years.
As always, please do not hesitate to call me at 512-553-5151 if I can be of assistance.
1) Inception date of 4/30/2019
2) All benchmark prices are obtained through the Yahoo!Finance website. S&P 500 Index is calculated using the index price. AOM is the iShares Core Moderate Allocation ETF. Global Balanced is calculated using a 40% allocation to the S&P 500, a 40% allocation to BND, and a 20% allocation to IEFA.
3) VORR is our "Value over Risk Ratio": Calculated by taking the total return divided by the sum total of all negative months. Ideally, the ratio represents how much loss an investor has to endure to get X gain. A negative RORR score implies there is more risk in the investment than return.