The trailing 10-year earnings yield in the S&P 500 is 2.7%, one of the lowest levels in over 110 years. That means that investors aren’t getting paid a lot to make a big bet on stocks today. [1]
But we believe there are big opportunities to make bets on a variety of other assets.
In this newsletter we review what makes these bets unique, and how we can maximize the reward in investing in them while minimizing our risks.
Valuations Don’t Allow Much Room for Error in Stocks Today
Stocks are a bet on the profitability of Corporate America:
- The largest 500 U.S. firms have turned more and more profitable over many decades
- Earnings are the fundamental driver of stock market performance
- U.S. businesses have benefited from many tailwinds for decades, like falling interest rates (i.e., lower cost of debt, higher valuations) and falling tax rates
- Those tailwinds are starting to reverse, which would negatively impact profits and valuations
The best time to bet big on stocks is when there are big doubts about their earnings potential:
- When earnings growth looks doubtful, the earnings yield of the S&P 500 increases (i.e., investors pay less for the same dollar of earnings because they’re more uncertain)
- High earnings yields are associated with higher returns for the S&P 500
- High earnings yield = bigger margin for error as bad news are already priced-in
However, today’s low earnings yield imply below-average returns for stocks in the next decade as a lot of good news are already priced-in.
Treasury Bonds Have Become More Attractive
While the S&P 500’s earnings yield is a mere 2.7%, long-dated treasury bonds are yielding over 4% today.
- Bonds were expensive between 2009 and 2020, but today their yield is around the historical average
- Bonds perform exceptionally well during recessions (bond yields fall and bond prices rise)
- Investors who dare buy Treasuries when yields are spiking get rewarded two-fold when the economy slows:
- They lock in a high annual yield
- They see the price of their bonds rising
Bonds have a great track record of outperforming stocks and other defensive assets, like precious metals, in recessions.
Bonds underperformed gold and silver only when inflation was accelerating, like in the early-1970s.
While we’re unconvinced by Treasuries as a long-term bet, they look like a great bet today with high risks of a recession on the horizon.
Precious Metals: Inflation Hedges and Bets on the Dollar
If bonds are the best recession hedges, then what role do precious metals like gold offer in a portfolio?
Gold’s traditional role is that of a store of value.
It doesn’t yield anything so it’s not always the best asset to own, but its returns can be extraordinary in specific macro environments:
- Gold increases in value when the dollar weakens (i.e., need more dollars to buy 1 oz. of gold)
- The best returns occur when the dollar and the S&P 500 fall together, as investors have little alternative in how they can preserve their wealth
Precious metals hedge against different forms of inflation:
- In the 1970s, precious metals rose as inflation expectations were surging
- In the early 2000s, precious metals rose as the market expected high levels of liquidity to counterbalance the economic weakness
Gold and real interest rates move in opposite direction. Investors who think the risks of economic weakness and stubborn inflation are high should own gold.
The risk of owning precious metals is that the economy holds up well while inflation remains low. The dollar and real yields would be moving higher in that environment, and gold would be falling.
Oil and Crypto Offer Volatility and Diversification
Precious metals and bonds are defensive assets that offer unique forms of protection against macroeconomic risks like inflation and recession.
On the other hand, industrial commodities and crypto offer exposure to volatile price swings that are uncorrelated to the stock market.
Oil, for example, shows much higher volatility than that of stocks around recessions. This makes them great shorts heading into an economic downturn, and great longs when recovering from one.
Bitcoin is even more volatile. Since 2015, its weekly returns have been 70% more volatile than oil’s, and 300% more volatile than the S&P 500’s.
Those returns have also been uncorrelated to those of equities, offering diversification potential:
- Before Covid, correlations between stocks and Bitcoin were low, oscillating around zero
- Correlations jumped during Covid due to fiscal stimulus-driven risk-on behavior
- As the stimulus faded, correlations fell back to zero in 2023, even below those of bonds
Volatility cuts both ways. The risks with commodities and crypto is that the extreme volatility can move against you, generating large losses.
Conclusion: Where We See Opportunity
Our bets today reflect where we find the risk-reward tilted the most in our favor.
We don’t find U.S. stocks attractive given their expensive valuations. Hence, we’re looking elsewhere for opportunities. Some of them include:
- In equities, we prefer buying recession hedges on the cheap like Utilities (XLU), and shorting those with high downside risk in a recession like Energy (XLE)
- Treasury Bonds (TLT) is one of our highest conviction bets given their likelihood of melting-up in a recession while having little downside in a soft landing that only sees disinflation
- We like Gold (GLD) and Silver (SLV) as bets that the Fed cuts rates in a recession, pushing the dollar and stocks down, as well as if inflation re-accelerates
- We prefer calculated bets like Ethereum, with returns uncorrelated with those of equities, while offering significant upside in a Fed pivot as a catch-up trade to stocks
- Short Oil as a play on downside potential heading toward the end of the cycle, while long Copper as an uncorrelated play on Chinese fiscal stimulus with large upside potential
Below are our updated asset ratings.
Footnotes
[1] Trailing 10-year S&P 500 earnings yield = average of 12-month earnings-per-share over the last 10 years divided by market capitalization. It’s a measure of how much investors are paying for the earnings produced over the last 10 years.