It’s Time To Go To Cash For The Next 7 Years – Update

“I will go to my grave… believing that really loose monetary policy greatly contributed to the Financial Crisis. There were obviously problems with regulation, but when we had a 1% Fed Funds rate in 2003 after, to me, it was pretty obvious that the economy had turned (up) and I think the economy was growing at 7% to 9% nominal in the fourth quarter of 2003 and that wasn’t enough for the Fed. They had this little thing called ‘considerable period’ on top of the 1% rate just so we would make sure that their meaning was clear. And it was all wrapped around this concept of an insurance cut… I’ve made some money predicting boom-bust cycles. It’s what I do. Sometimes I am right. Sometimes I am wrong, but every bust I had ever seen was proceeded by an asset bubble generally set up by too loose policy…”

– Stanley Druckenmiller

Introduction

Bulls and bears have been playing a proverbial tug of war for roughly a year now, and either side could argue that we are in a bull market or a bear market as I articulated in this recent article.

It’s A Bear Market, No Wait, It’s A Bull Market – Published January 10th, 2022

Looking back exactly one year ago, on January 20th, 2021, I published one of my more popular, and controversial articles, which was titled “It’s Time To Go To Cash For The Next 7 Years.” This article generated a lot of discussion, and was controversial because it argued that simply being in cash would be a better alternative for many traditional investors over the forthcoming seven years, because collectively investors were starting from their worst valuation point in modern market history.

Naturally, this struck a nerve, with many arguing in the comments section that cash was trash, undervalued equities existed, and that it was impossible to time the market.

If you simply look at the one-year performance chart of the SPDR S&P 500 ETF (SPY) or the Invesco QQQ Trust (QQQ), you could certainly say my prediction for the average investor of sitting out the markets for the next seven years was off to a bad start, at least in the first year.

This is the surface level view, however, and there’s much more nuance below the surface, as I will describe later in this article. More specifically, we’re in a rolling bear market that most investors have already experienced with the price of their average stock holding. In this light, my prediction of holding cash for the next seven years for the traditional investor looks more palatable. Keep in mind, this was an exaggerated expression, and of course, you want to invest this cash to earn safe interest income, and of course you want to deploy this cash into the depths of a bear market if one comes along.

Many of those commenting on my first article in this series glossed over the concluding section, which argued there were more compelling alternatives than many traditionally favored stocks or stock proxies if you are an active investor or stock picker.

We have written about many of these companies the past several years, and we are vastly outperforming the market benchmarks by a very wide margin. On this note, our Best Ideas Model Portfolio gained over 50% in 2020, and this Portfolio gained over 100% in 2021. For comparison purposes, the SPDR S&P 500 ETF finished higher by 18.3% and 28.7%, respectively, in 2020 and 2021. Highlighted companies that have significantly outperformed included the following partial list of companies that I have authored public articles on over the past two years.

Antero Resources Is A Generational Buy: Dispelling The Myth Of Antero As High-Cost Producer – Published February 19th, 2020

Antero Midstream Shares Are Significantly Undervalued Too – Published February 20th, 2020

Warrior Met Coal Stock Is Poised For A Free Cash Flow Bonanza – Published July 27th, 2021

Occidental Petroleum Stock: Still Too Cheap To Ignore – Published July 30th, 2021

Antero Resources: Buy The Forgivable Dip – Published August 2nd, 2021

EQT Corp Stock: Buy The Dip At A 20% Free Cash Flow Yield – Published August 4th, 2021

Cenovus Energy Is A Very Cheap Mini-Major – Published August 13th, 2021

The bigger picture point of referencing these articles discussing Antero Resources (AR), Antero Midstream (AM), Cenovus Energy (CVE), EQT Corp. (EQT), Occidental Petroleum (OXY), and Warrior Met Coal (HCC) from this time frame is that I was both bullish on out-of-favor, undervalued, under-followed equities, and bearish on extremely in-favor, overvalued, and over-owned equities.

The dividing line could be as simple as avoiding the price insensitive and valuation insensitive fund flow favorites, and embracing the free cash flow yielding alternatives that many investors have shunned.

Two relevant examples in this regard, are the ARK Innovation ETF, which is down by over 50% the past year, and Exxon Mobil (XOM), whose shares have significantly outpaced the share price Salesforce.com (CRM) since CRM replaced XOM in the Dow Jones Industrial Average (DIA).

The former chart of ARKK is important because it shows that for a vast portion of the broader market that cash was indeed not trash over the past year. Elaborating on this further, the average Nasdaq Composite (COMP.IND) stock itself is down north of 40% from its highs, so the carnage is not limited to ARKK, it has been far more widespread. The latter chart of Exxon Mobil’s share price performance is important because it shows that a historical capital rotation has been ongoing for longer than many market participants realize.

Wrapping up this introductory section, there has been immense share price destruction the past year, in ARKK, in the average Nasdaq Composite stock and in SPACs, to name a few pain points. This rolling bear market is now spreading to even the largest perceived safe-havens, with the “Teflon 5” as I like to call them, which were five stocks representative of 65% plus of the Nasdaq Composite’s gains mid-December 2021, breaking down recently. More specifically, Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), (GOOG), Tesla (TSLA), and Nvidia (NVDA) are all below their 50-day moving averages.

There also has been a historic capital rotation occurring hidden in plain sight because most investors do not own the stocks that are outperforming. A prominent example of this is the red-hot energy sector which still comprises less than 3% of the S&P 500 Index (SP500), yet has trounced the SPDR S&P 500 ETF in share price performance gains, particularly over the past year.

Lost amidst the rolling bear market and the capital rotation is the fact that broader market indices are now correcting too as the largest market capitalization equities give way to the price destruction under the surface of the indices. With starting valuations still extremely poor, I’m sticking to my outlook that the average investor will be better off simply holding cash over a seven-year time frame, dating to the January 20th, 2021, publication of the original article in this series.

ARKK Echos The Dot Com Collapse

In the first article in this series authored last year, I harkened back to the ebullient early 2000 period prior to the dot.com bubble collapse. That was an era that Jim Cramer famously claimed that you could buy a basket of stocks everyday, something he called the “Winners Of The New World,” regardless of price or valuation, and you would be fine a decade later. Here is a direct quote, with the emphasis added my own.

We are buying some of every one of these this morning as I give this speech. We buy them every day, particularly if they are down, which, no surprise given what they do, is very rare. And we will keep doing so until this period is over – and it is very far from ending. Heck, people are just learning these stories on Wall Street, and the more they come to learn, the more they love and own! Most of these companies don’t even have earnings per share, so we won’t have to be constrained by that methodology for quarters to come.

– Jim Cramer, February 29th, 2000

This quote cited above was from February 29th, 2000, and of course, we know, with the benefit of hindsight, that the Nasdaq Composite topped in March of 2000. From there, Cramer’s Winners Of The New World stocks were decimated, as the following table, first published by Kirk Bostrom in a Seeking Alpha article authored on June 22nd, 2015 showed.

Think about the table above, and now think of the holdings in the ARK Innovation ETF, shown in order by their size in the ETF as of 1/20/2022, and their respective one-year share price performances, which are shown below.

• Tesla, 8.3% of ARKK – Up 17.9% the last year
• Zoom Video (ZM), 6.5% of ARKK – Down 60.1% over the last year
• Teladoc Health (TDOC), 6.4% of ARKK – Down 67.6% over the last year
• Roku (ROKU), 6.2% of ARKK – Down 61.7%
• Coinbase Global (COIN), 5.7% of ARKK – Down 12.2%
• Exact Sciences (EXAS), 4.7% of ARKK – Down 48.9%
• Unity Software (U), 4.6% of ARKK – Down 22.0%
• Spotify Technology (SPOT), 5.6% of ARKK – Down 35.2%
• Twilio (TWLO), 4.1% of ARKK – Down 46.7%
• Block (SQ), 4.0% of ARKK – Down 43.6%
• UiPath (PATH), 3.8% of ARKK – Down 37.0%
• Intellia Therapeutics (NTLA), 3.5% of ARKK – Down 0.0%
• Shopify (SHOP), 3.2% of ARKK – Down 12.2%
• CRISPR Therapeutics (CRSP), 3.0% of ARKK – Down 67.6%
• Beam Therapeutics (BEAM), 2.9% of ARKK – Down 42.7%
• Palantir Technologies (PLTR), 2.7% of ARKK – Down 45.3%
• Twitter (TWTR), 2.4% of ARKK – Down 18.7%
• DraftKings (DKNG), 2.3% of ARKK – Down 58.3%
• Fate Therapeutics (FATE), 1.8% of ARKK – Down 65.6%
• PagerDuty (PD), 1.6% of ARKK – Down 38.8%
• Robinhood Markets (HOOD), 1.5% of ARKK – Down 63.5%
• Invitae (NVTA), 1.5% of ARKK – Down 80.0%
• Iridium Communications (IRDM), 1.5% of ARKK – Down 26.6%
• 10x Genomics (TXG), 1.3% of ARKK – Down 50.8%
• Trimble (TRMB), 1.2% of ARKK – Up 6.9%
• TuSimple Holdings (TSP), 1.1% of ARKK – Down 46.9%
• Ginkgo Bioworks (DNA), 1.1% of ARKK – Down 50.2%
• Signify Health (SGFY), 1.0% of ARKK – Down 49.1%
• Pacific Biosciences (PACB), 1.0% of ARKK – Down 73.5%
• Veracyte (VCYT), 1.0% of ARKK – Down 49.0%
• Stratasys (SSYS), 0.8% of ARKK – Down 38.3%
• Roblox Corporation (RBLX), 0.8% of ARKK – Up 69.3%
• Twist Bioscience (TWST), 0.7% of ARKK – Down 73.1%
• Skillz (SKLZ), 0.7% of ARKK – Down 79.3%
• 2U, Inc. (TWOU), 0.7% of ARKK – Down 64.9%
• Materialise (MTLS), 0.6% of ARKK – Down 73.6%
• Cerus (NASDAQ:CERS), 0.4% of ARKK – Down 26.0%
• Editas Medicine (EDIT), 0.4% of ARKK – Down 72.4%
• Berkeley Lights (BLI), 0.3% of ARKK – Down 88.7%
• 3D Systems (DDD), 0.2% of ARKK – Down 40.2%
• Compugen (CGEN), 0.2% of ARKK – Down 71.8%
• Iovance Biotherapeutics (NASDAQ:IOVA), 0.0% of ARKK – Down 72.1%

Looking at the list of stocks above, there clearly has been significant share price destruction over the past year. Many stocks are down 50%, 60%, or 70% from their highs, echoing the share price collapse of the 1999 and early 2000 technology favorites. Many investors forget, however, that Amazon shares were down 94% peak to trough from 2000-2002. Additionally, Microsoft shares, when Microsoft was one of the largest market capitalization companies at the end of 1999, declined roughly 65% from 2000-2002, and roughly 70% from the 2000 highs to the 2009 lows.

Additionally, keep in mind, the share price performance shown above for the ARKK holdings is just absolute performance for the year, not percentage declines from the highs for the year. On this note, even some of the stronger relative performing stocks like Tesla, Coinbase, Trimble, and Roblox have seen their stock prices decline significantly from their absolute high points in the past year.

What has happened in ARKK, and the holdings in ARKK, was something I forecast in 2021, notably with this article, “ARKK Implosion Is On The Horizon,” which was published on August 10th, 2021.

Today, I often get the question of what to do now with regard to many of these out-of-favor technology stocks. Ironically, as contrarian investors, we’re combing through these stocks, looking to the future for opportunity. The caveat is that if you use 2000-2002 as the template, there will be many sharp rallies, that ultimately prove to be false starts, as the creative destruction process of capitalism works its magic over time

SPACs Echo Dot Com Collapse Too

Less touted than the headline grabbing declines in ARKK, and ARKK’s individual holdings, has been the implosion in SPAC’s, whose fervor also peaked alongside ARKK shares in the spring of 2020. This list from Bill Mann, published on December 7th, 2021, shows the share price destruction in SPAC’s, which has only gotten worse the past month-and-a-half.

Just this morning, I was talking to a friend of mine, who discussed an investment strategy where Virgin Galactic Holdings (SPCE) could be bought ahead of its rocket launches.

Will that strategy continue to work?

Only time will tell, however, any longer-term investor in SPCE shares is generally underwater here, something increasingly true for many SPAC holders.

Ultimately, will there be longer-term opportunities that come out of the carnage here? The answer could be yes, however, investors are going to have to go through the venture capital process, where many companies fail to find a few winners, under the bright lights and discerning microscope of the public investment markets.

Generals Starting To Falter Now

With the underbelly of the equity markets compromised, the safe-havens of the market are falling one by one. A perfect example of this is the stocks I like to call the Teflon 5, specifically Apple, Microsoft, Alphabet, Tesla, and Nvidia, which are all trading below their 50-day moving averages.

These stocks collectively accounted for roughly 65% of the Nasdaq Composite’s gains circa mid-December of 2021, and they improbably gained relative strength during the fourth quarter of 2021.

The start of the new year in 2022 has seen even these safe-havens compromised, however, as these favorites are now trading below key moving averages and losing relative strength.

Even though there’s a bear market in the Nasdaq, with the average Nasdaq Composite stock down over 40%, many investors do not feel the bear market yet. This is true in the Invesco QQQ Trust, or even the SPDR S&P 500 ETF, where the largest companies have been repositories for capital, not sources of capital.

When this changes, which it already appears to be doing, then the average investor who invests passively will feel the weight of the rolling bear market that is already occurring.

This has started to happen here in 2022, with the Invesco QQQ Trust down 7.9% as I write this piece, and the SPDR S&P 500 ETF down 4.9%. For their part, Apple shares are down 6.4% year-to-date, Microsoft shares are down 9.8%, Alphabet shares are down 6.7%, Tesla shares are down 5.8%, and Nvidia shares are down 14.8%.

Said another way, the armor of the Teflon 5 is starting to be penetrated, and since these companies are such large weights in the benchmark indices, the average investor is going to really see the impact of the downturn in their share prices when and if it occurs.

Scorecard Of A Classic Bubble Popping And Starting Valuations Are Still Extremely Poor

The classic bubble went much further than many anticipated, including Jeremy Grantham.

Back in the fall of 2017, Jeremy Grantham spoke about a classic bubble forming in the S&P 500 Index. He actually walked back upon this proclamation in a CNBC interview in the spring of 2019, yet he has firmly cast his stance upon the matter with the research piece titled, “Waiting For The Last Dance,” published on Jan. 5, 2020.

Going back to late 2017, Grantham outlined the path of a potential classic bubble with the following hypothetical chart of the S&P 500 Index fund below.

What has the actual path been?

Well, in the S&P 500 Index, the bubble has gone higher than many could have anticipated, even those looking for a bubble.

Obviously, the pandemic, and the expansion of the Fed’s balance sheet, which has correlated strongly with stock prices helped the developing bubble expand further than it might have done otherwise.

With the Fed set to dial back their balance sheet expansion fully by March of 2022, and potential balance sheet contraction on the way, the tailwinds that have buoyed the benchmark indices and the markets largest capitalization stocks appear to be fading.

This is a problem because valuations are still near all-time highs, as the following chart from Advisor Perspectives illustrates succinctly.

The chart above confirms what we see from a version of Buffett’s famous valuation ratio, the market-cap-to-GDP chart.

Put simply, even with the rolling correction that we are seeing in the markets, the valuation excesses are nowhere toward being worked off at this juncture. When you consider the bigger picture valuation backdrop, then that gives more weight to GMO’s seven-year real asset return forecast, which is shown below.

Keep in mind that the table above shows the expected annual real returns. If this pans out, or anywhere close, cash may not be the best option, however, it is certainly going to be far from the worst option. This is especially true for many traditional investors who are stuck in a 60/40 or 70/30 stock and bond allocation that is hopefully challenged because of today’s starting valuations, and the headwinds facing this historically prudent allocation.

Closing Thoughts: See The Markets Through Cathie Woods Lens Or The Lens Of A Value Investor

Boiling down what’s important in the markets today is as simple as this, in my opinion, which is you want to own companies that have robust free cash flow yields, while shunning companies that are relying on far in the future cash flows to justify today’s valuations.

Using that template, I was struck by this headline from Cathie Wood yesterday, where she suggested the real bubble was in value stocks.

After proclaiming that commodities would collapse it the fall of 2021, something I refuted here in this article, and that $WTIC oil would never trade above $70, with $WTIC oil above $85 today, you think Cathie would dial back on her prognostications. However, that is not her style, taking a view that is out of the consensus forecast, and trying to turn this into an opportunity.

From a true contrarian investor, this approach is admirable, however, it’s flawed because Cathie is looking through the wrong lens right now, in my opinion.

Building on this narrative further, from ARK’s quarterly report, Cathie outlines these views espoused by her firm

• In our view, long-term inflation fears are overblown because inventories are stacking up in the face of weak consumption.
• It’s ARK’s view that the real risk to the market outlook is deflation versus inflation.
• Nominal GDP growth is likely to be much lower than expected, suggesting that scarce double-digit growth opportunities will be rewarded accordingly. Growth stocks and innovation-driven stocks could be the prime beneficiaries.

Refuting these points one by one, I think inflation is going to continue to surprise versus the 2011-2020 timeframe, economic growth is poised to surprise too, which is a different trajectory than the one that we followed post 2007-2009, and inventories need to build because end demand growth is going to continue to exceed muted expectations.

Try to order anything from a car to a new garage door to a piece of furniture. The supply chain continues to be a real issue, and the unspoken culprit is that end demand is sustainably higher, eloquently shown by this chart from the Federal Reserve Bank of Atlanta.

Consider the fact the chart above is showing us that real GDP is estimated to have grown at nearly a 5% level in the fourth quarter of 2021. This is especially important because this growth took place amidst another outbreak of the pandemic. Said another way, GDP is growing above trend, and this growth will accelerate once everybody acquiesces to the fact that we simply have to live with the virus. Incidentally, this is happening real time right now, as evidenced by the ending of vaccine passes, face mask mandates, and all restrictions in Britain.

Specific to inflation, it may indeed moderate, however, the level it moderates to is the key.

Looking at the picture above, even under the best circumstances, a return to normalized inflation rates is a long way off, and this normalization is not guaranteed. Said another way, much like her prediction with $WTIC crude oil prices, Cathie Wood could be wrong again with her forecast. This will be especially true, if monetary velocity picks up, something that I’m forecasting.

The biggest wrench in Cathie’s forecast above, in my opinion, comes from the capital cycle.

The pattern is clear here, meaning that even in an environment of record prices for many commodities, including in coking coal, thermal coal, international natural gas prices, etc. and structurally increasing commodity prices across a whole range of other commodities, there’s a reluctance to add supply online. In fact, quite the opposite is happening as companies shed high cash flowing assets to improve their perception and carbon footprint as they are pressured by ESG mandates.

This lack of willingness to invest capital expenditures in new supply, amplified by the lack of elevated valuations, which all traces its roots back to capital flows, is collectively providing a wrench in the wheel of the capital cycle.

Said another way, if we all use traditional energy sources in our daily lives, yet a majority of us choose not to fund new investments here, prices have only one direction to go.

The market is already sensing this sea change in perspective, as evidenced again by this chart I showed in the introduction section of this article.

The price performance is the market’s way of trying to induce supply, yet stocks like Exxon Mobil have been shunned so much, losing board seats to investors who have no interest in capital expenditures, that the supply increase is going to be delayed, at best.

Looking back to August of 2020, I’m pretty sure that the substantial majority of investors would have preferred Salesforce.com to Exxon Mobil for their candidate for a better total return going forward. We know that S&P Global (SPGI), who is home to the human individuals who make indexing decisions, chose this path for the Dow Jones Industrial Average (DIA).

We knew then as contrarian investors that this could be a historical inflection point, as we penned this article for Seeking Alpha.

Exxon Mobil Exit From Dow Reveals S&P 500 Index Structural Flaws – Published August 28th, 2020.

Today, we are even more confident of that outcome, at least in the intermediate term, and this all traces its roots to where there is too much capital in the world (think technology), and where there is too little capital being deployed (think the traditional energy sector).

In summary, quietly, we have already seen a passing of the baton of market leadership. Most investors are simply not aware of this leadership transition yet. Recognizing this changing backdrop after years of study, including being too early, I have been pounding the table on the extremely out-of-favor commodity equities for several years now, and I still think we’re in the early innings of what will be a longer-term price appreciation. Personally, I think we will supersede the capital rotation that took place from growth-to-value during 2000-2007.

Investors skittish of commodity equities should research cast aside financials as they also will benefit from rising inflationary expectations and rising long-term interest rates. Understanding the bigger picture, then having an understanding of the bottoms-up fundamentals has been the key to outperformance, and this is a path that has not been easy with those participating confirming this reality. However, the road less taken is sometimes the better one, and I firmly believe that today, as traditional stocks, bonds, and real estate offer very poor starting valuations and very poor projected future real returns from today’s price levels. More specifically, the out-of-favor assets and asset classes, including commodities and commodity equities and out-of-favor specific securities, are where the historic opportunity has been, and that’s where it still stands, from my perspective.