2020 Archives - Aspen Funds

Spring 2020 Economic Update – COVID-19

We hope you’re staying healthy and safe. In light of the recent impact of the Coronavirus, we’ve been getting a lot of questions from investors. Our Co-Founder and CFO, Robert Fraser, put together a quick 24-minute video covering the following topics: 

  • COVID-19 Analysis (starting at 0:35)
  • Impact on the economy (5:24)
  • Hardest hit sectors (6:48)
  • Effect of the stimulus packages (9:49)
  • Impact on the housing market (13:15)
  • Potential impact on Aspen’s funds (19:08)

Video transcript:

Hi, everyone. Bob Fraser here, principal of Aspen Funds. We’ve been having a lot of questions about the economy and about Aspen in particular, and what does the current extraordinary circumstances, how is it going to play out in the economy? And so, I wanted to take a few minutes and answer some of those questions and give my perspective on what is happening and how things are going to play out.

So, let’s take a look real quick. I want to first just take a look at the virus and how it’s playing out. I think it’s important to know that while it’s a very serious disease, COVID-19, the Coronavirus has a 4%-ish mortality rate. It’s far below other historical mortality rates, including Ebola, 40%, MERS 34%. It is more prevalent, so there’s a lot more cases going on, so I’m not underplaying it, but I do want to point out that it’s not as deadly as some other diseases have been.

It is primarily focused on the younger ages. This is from the Centers for Disease Control. You can see the mortality rate compared to the flu. It’s definitely quite a bit higher. This is the flu over here, but you can see what’s happening is, for the below 50, right here, you see a mortality rate of 0.3% of people who contract the disease die. So, again, that’s a very low number, but it ends up being a disease that’s very much focused on the elderly. An 80 year old who contracts the disease has a 14% chance of dying. So, it’s very much focused on the older generations. I want to point out just in historical context that this Coronavirus is not a world ending disease. There’s a lot of talk out there about how this is going to change the world.

And I am a student of history and this is from my book, Kingdom Horizon. And I want to point out here the Black Death in the 1300s literally killed one third of the world population. The Spanish Flu, the 1918 flu, it was somewhere around 3%. I mean, we’re going to be way down here with hundreds of thousands, potentially died from the disease. Again, I don’t want to minimize that and if you’ve lost someone, my heart goes out to you. But from a global historical context, this is not as severe as things in the past. Now, we’re seeing US cases still rising exponentially. Basically the number of cases is doubling every two and a half days in the United States. I expect that to continue for the next few days because the US has been far behind other nations in terms of testing.

And so, as they test, you’re going to see the cases come forth. But as people are isolating themselves and practicing social distancing, as the retail is being shut down, you’re going to see this thing start to flat line, I believe. And so, right now it’s doubling, but I want to show you what’s happening in China. So, China basically after 30 days right here, they started flat-lining their cases. So, they were successfully isolated the cases and was able to keep this disease from spreading. I’m hopeful that the United States will flatline as well. So, we’re at day 20, China’s at day 30, again, we may be a little behind China’s prevention, but our government is on it. Trump just enacted the National Production Act and is getting medical supplies produced, is also fast tracking cures and there’s at least four immediate answers.

One includes the Chloroquine, which is the drug they use for malaria. There’s also two general purpose antivirals that have proven effective. And there’s also plasma transfusions. Of course, the real thing everybody’s working for is the vaccine, which they say is 12 to 18 months out. But my guess is we’ll see because so much resources and brain power is being focused on this, we’ll see these answers coming soon. Now, some people have argued that the data out of China is suspect, but I would also point out that South Korea as well has flatlined. So, as people are taking this seriously, they’re actually able to prevent the rapid spread of the disease. So, we’re hoping to see that.

The biggest impact is not just the healthcare system, really the bigger impact is on the economy. So, the response that the nations are doing and America is doing is having a massive effect on the economy. So, this is from Goldman Sachs who are some very smart guys who’ve done an economic analysis and they’re calling for a 25% drop in GDP Q2. So, that’s a very big number. That means that economic activity will drop by 25% in the quarter from April 1st to June 1st. That seems fairly realistic to me. They’re also calling for a 11% gain, positive gain in Q3 and continuing. So, it’s more of a V shaped recovery, right? Boom. And again, that’s what seems right to me. So, no one knows the future, but so 25% is extremely serious and it’s affecting a large part of the economy because 70% of the economy is consumer spending and so that’s being severely impacted and curtailed.

The retail apocalypse has been accelerated. This is, retail ETF has dropped huge. It’s interesting, it’s a three PE ratio for those trust track stock prices. But while the P has gone down, the E is about to go down. So, I’m not saying we should buy this, but retail has already been a sector that has been massively under pressure because of the online giants and retail is in huge transition. So, this is an event that’s pushing a sick man over the cliff and commercial real estate, as well, is being particularly hard hit. This is a CMB and you’ll see pretty significant discounting happening. These are retail landlords and office space landlords. And this may change, people want office space, but will the fact that everybody’s working virtually now, will people get used to that?

And will office space actually be in lower demand in the days ahead? No one can answer that. But right now you’re seeing pretty big disruptions in retail and in office space happening and they’re early, but commercial real estate, some sectors of it, some parts of it are in turmoil right now. My best guess is that while retail will continue to suffer that other parts of the commercial real estate space will do well. And the reason is, they’re going to drive bonds and interest rates to the floor and doing that will put pressure on cap rates, which mean prices will go up. So, other hard hit sectors besides retail is oil. I’ve been bearish on oil for probably five years now. Gasoline, interestingly enough, just hit 60 cents a gallon in the wholesale market, which translates to about a dollar 30 at the pump.

But I’ve been bearish on oil for several years. You’re going to see probably a lot of oil bankruptcies, unless there’s bailouts and you’re going to see … Again, they’re highly leveraged. A lot of these oil producers are extremely highly leveraged and so you’re going to see bankruptcies. You’re going to see bankruptcies in retail and probably in travel as well, but bankruptcies are not all negative. So, a bankruptcy, a business bankruptcy. What happens is the equity shareholders are wiped out, typically, and but the debt is restructured and the assets remain. So, planes don’t disappear. Commercial real estate doesn’t disappear. Oil wells don’t disappear. They just get restructured and the debt gets restructured and they continue operating. So, these other sectors are obviously very hard hit. Again, oil is another sick man that I think got pushed. In my opinion, I think we’ll see recoveries in these, good time to start booking your travel for later in the year, in my opinion.

So, the big reason why I’m more optimistic than I would otherwise be is the bailouts, they have learned their lesson. They learned from 2008 crisis that moving fast matters. That moving fast makes a big difference because there’s lasting impact. The economy will damage itself and injure itself to the point where it cannot be recovered at some point. And so, it’s super important to give it life support to keep it from getting injured at this point, so they’re acting fast. There’s bipartisan support, who can say hallelujah with me? It’s just awesome to see people actually working together in DC. I’m very excited that Trump is at the helm because Trump understands the economy. There’s a lot of wonder if we’ll see a V-shape recovery. I do think we have a very good shot at that, especially if Trump is at the helm because he understands business. He understands the economy.

We saw a very, very slow recovery in the 2008 crisis, and it was primarily because Obama does not understand business. He didn’t understand that jobs were created by businesses. And that you have to support business in order to create jobs, that you can’t create jobs by making a great speech. And so, we had this very, very slow, very, very lackluster recovery, which I believe we will see different. And depending on how the elections go in 2020, later this year, we’ll see. But I remain bullish at this point. So, the bailout includes 700 billion in bond purchases. Again, it’s extraordinary expanded unemployment benefits, tax day extended 90 days. They’re working right now on a $2.5 trillion additional bailout package, which includes direct payments to individuals, forgivable loans to businesses, help for student loans, payments, et cetera.

And we’ll see what all this is, but it’s going to be big. Europe also just passed about a $1 trillion stimulus. So, this is global and money is global today. So, when Europe stimulates, it stimulates America too. Bottom line is it will work, it will work. We will see a post COVID economic recovery. We need to get through this, the dark part of this virus, which again, as I pointed out, I’m hopeful that that’ll happen. I do believe we’ll see some sectors permanently altered like retail, potentially travel, potentially commercial real estate and some others. But bottom line is we’re not going to see lasting damage to the economy.

On the bailout, the Fed injected in one day, three days ago, $107 billion in purchases. Here’s the Fed’s balance sheet. You see it just skyrocketed here to the tune of, like I said, $107 billion in purchases just in one day. So, this is huge. They’re buying bonds, which is depressing, which is driving down interest rates across the economy. Regarding the housing market, the residential housing market. I agree with Kyle Bass who said, “We’re going to see 0% interest rates. We’re going to see enormous amounts of liquidity. I think inflation is going to run hot.” I don’t agree with him there, but he says, “I think it’s going to be really interesting housing market. I don’t expect housing prices to drop much in the United States.” I agree with him on that. In fact, prior to this crisis, we just saw existing home sales soar to a 13 year high in February.

So, we’re seeing huge demand for housing, as I have been saying for many, many years, that we see massive fundamentals and bullish fundamentals in the housing market. Single family housing. The Federal Reserve has driven mortgage rates to the ground. Look at this. Mortgage rates actually hit what? 3.3% on average, for a 30 year fixed mortgage. Their purchasing of bonds is going to continue to drive this down. Kyle Bass says, “0% interest rates.” I don’t know if we’ll get that far down. Can you imagine having a 0% mortgage on your house? What would that do to housing prices? And refinances, so you’re going to see a ton of refinancing. Just anecdotally talking to mortgage brokers, they’re saying, they’re 90 days out from closing right now. They’re so busy. So, housing prices have had a strong recovery.

So, we’re near the peaks, the previous peaks. But as I pointed out in my previous economic forecast, real housing prices, meaning adjusted for inflation, are well below the previous peaks, well below it, about 15% below the peak. How can this be? Well, so back in 2005 you could buy a piece of land, you could build a house on that land and you could sell that house and you could make a profit. Today, if you bought land and built a house on that land and sold it, you would actually lose money. Why is that? Well, because the building prices have continued to go up, including building materials and labor have continued to go up because of inflation. So, what’s happened for the last 15 years, inflation has made the steady track up. It has not stopped, but housing prices took this massive dip down and are now going back up.

So, they have to catch up. So, in order for housing … New housing is not going to be built until it can be built profitably. And that is not going to happen until prices rise further. So, we’re going to see prices rise further in the housing market. I’m just going over the fundamentals here. Price to rent ratios, which was one of my favorite housing fundamental analysis is very, very strong. You’ve seen basically for the last 15 years, rents have continued to rise, but housing prices, again, haven’t. And so you’re seeing the price to rent ratios are extremely low. So, it’s actually right now, in my region, it’s cheaper to buy a home and pay a principal and interest payment on a mortgage, than it is to rent a home. And as long as that’s happening, well guess what’s going to happen? People are going to buy instead of rent if they’re able.

So, you’re going to see lots of demand into single family homes. The housing prices had been buoyed by a massive supply squeeze. And saying this again, we’ve seen the month’s supply of houses in the United States is just extremely low and housing has been under-built for the last 14 years. Here’s the big crash in 2008. You see single family housing starts has crashed and it has not really recovered. It’s still way below its normal. This is multifamily, the green is multifamily, it too crashed, but it rapidly recovered. So, the cranes are out there building multifamily apartment complexes, but no new homes, single family homes that are being built are very, very few. So, it’s well below any time in the last 20 years. Again, there’s a huge shortage and supply squeeze for single family homes.

And I just, I did this, this is the same chart of single family homes divided by population. And you can see it’s lower, the population has continued to grow while single family homes have not. So, you’re seeing it well below anytime in the last 50 years. The bottom line is, is fundamentals of single family homes is still very, very strong and debt service as well. So, we enter this recession with consumers really having very low debt service payments. Meaning the cost of their debt relative to their income is at a low. So, specifically, again, I think our economy, I’m hopeful that we’ll see a V-shape recovery, and the bailout is huge and it’s going to have a massive impact. Now, let’s talk about Aspen in particular. I want to talk about our Aspen I, our income fund and I’m just super pleased with this fund.

It is just now coming in its eighth year and it’s just been a stellar performer, throughout that time we’ve made just minor tweaks here and there to the business model and it just continues to perform. I don’t see our ability to generate preferred returns impaired, at this time. People are protecting their homes, they’re wanting to stay in their homes and they’re making their payments. It’s interesting having people that do have their jobs are spending less money on extras. So far, out of some nearly 400 loans in our portfolio, we’ve had one request for a virus related payment holiday. Now, I do expect we will have more, but it’s just not material at this point. Our models are proving out. So, we’ve thought a lot about our business models. We’ve built this to be recession proof and so far it’s looking like it is.

First of all, as I said before, residential real estate is a bright spot, I believe it’s going to continue to be a bright spot with mortgage rates being driven to the floor and with demand, fundamental demand still being off the chart, I think it’s going to continue to be a bright spot. Very, very conservative underwriting. We’ve been telling you in our newsletters for the last several years we’ve been aggressively getting more conservative on our portfolio just to be defensive. So, this is our ITV, this is our investment to value. This is how much money we’ve invested in a loan, relative to the price of the loan. And you can see, basically two thirds of our portfolio is below 65%, or below 70%, sorry, below 70% of the value of the house.

So, that’s very, very conservative. Very, very conservative and not only that, not only do we have our monthly borrower payment streams, so that we get monthly payments from our borrowers, but we have had very strong deployment ratios. We’re running about 125% deployment ratio right now because we have a credit line with about 25% leverage. So, it means we’ve got a lot of loans that are actively paying. And then the final thing is, is that people are refinancing. So, what happens is, is you remember from our models, we buy loans at a steep discount. So, if we pay 50 cents on the dollar for a loan and that loan gets refinanced out, we get paid 100 cents on the dollar, so it’s a huge profit. We’ve already seen several refinance takeouts this quarter, which is not yet ended, as I record this, but we’re going to continue to see more.

So, bottom line is Aspen I is in fantastic shape. I’m not making guarantees or promises, but it looks amazing right now. So, our non-performing side, again, we’re very happy. We are seeing a few things happening here. One is court holidays, delaying court cases. So, this is where we buy nonperforming loans and we work them out. Well, a lot of that depends on court activity for us. And so we’re seeing courts actually saying, “We’re not accepting new cases or we’re pushing our calendars out 90 days.” So, we’re seeing a lot of that happening. We’re also seeing moves toward temporary moratoriums on foreclosure activity and these are the states wanting to just support and offer help to borrowers, homeowners and renters. We’re seeing a lot of that. And we’ve been seeing some slowdown in our portfolio.

However, I want to say again, we’re in the right sector. Residential real estate. Our asset queue is very, very deep, so if a loan gets stalled, we simply move to the next one. We have a massive queue of loans that we’re working on right now, so we’re just moving to the next one. We are aggressively staffing up our workout department and I want to point out that our partners are not paying for that, we’re paying for that as a management company. But we’re aggressively staffing and growing because there’s so much opportunity in this space. And we’re also rapidly improving our internal systems to work efficiently and to better work our assets. We’re doing lots and lots of deployments, which I’m super excited about, in new tools, new modeling, new systems that we’re building that are going to massively increase our productivity, is our hope.

Bottom line, we will see some impact, primarily the slowing of some of our workout processes for 90 days or so, on some of our assets. So, it remains to be seen the degree at which how we’ll be affected, but it doesn’t look like it’s going to be much. It’s just maybe marginally reduced returns for the second quarter is what it looks like now. Again, no promises, no guarantees, but that is my best estimate at this time. So, to all, that’s my economic update. That is my assessment of Aspen for this spring and the Q2 and Q1. And just to wish you all a happy and healthy home life as you sequester yourself in your house and trust you to make the best of this season. And thank you for being our partners and we’ll talk to you soon. All right. Bye-bye.

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2020 Economic Forecast

Published Jan, 2020

Recently, we have been frequently asked by investors about our perspective on the economy as we head into 2020. Are we heading into a recession? When will this happen? Will it be as bad as 2008?

Obviously, this is something on the forefront of investor’s minds. But, it’s also hard to give a succinct answer. We decided to put together our thoughts on where the economy is headed and other “hot topics” that many investors are thinking about.

We will be putting together a 5-part economic series that covers a variety of topics ranging from the U.S. economy, stock market valuations, inverted yield curve, and the real estate market. If you’ve had questions about any of these topics, we hope you’ll find value in our perspectives.

Our Economic Forecasting Approach: Macroeconomic Fundamental Analysis

Before we dive into the data, it’s important to take a step back and explain our approach to analyzing the economy. The news media has not done the average investor any favors. The stock market is up one day, and down the next. Catchy headlines dominate the conversations of the commentators. There is no real synthesis of the data, just noise.

It is important to differentiate between the stock market and the economy, as they can sometimes be used interchangeably. Generally, in the long-term, the stock market follows where the economy leads. Though, in the short-term, the stock market doesn’t always act in concert, and is anyone’s guess what it will do.

But, if you study the underlying fundamental data of the economy, you’ll have a good idea what the stock market will do in the mid-long term. We call this the difference between the tides and the waves. If you look at the stock market and the barrage of daily news, you’ll have a hard time determining what’s coming. But if you study the underlying economic data you can discover identifiable trends that underpin all investment classes, just like tides.

And finally, we focus our analysis on evaluating macro-economic data, or the key drivers of the economy and the direction they are heading. Our process is simple: look at as much meaningful data as possible and determine what the preponderance of evidence is suggesting.

Now we don’t have a crystal ball, but we do hope this series will be illuminating for you and hopefully shine the light into the drivers of the U.S. Economy and where it is headed.

US Economy

Unless you’ve been living under a rock or hiding in a cave, you’ve been hearing chatter about an impending recession. With all the news media and catchy headlines, it’s hard to know what is meaningful and what is noise.  Our goal with this series is to take a comprehensive look at several facets of the economy and hopefully answer many of the questions on investors’ minds.

Our co-founder and CFO, Bob Fraser, has been a longtime economic researcher with an impressive track record, and mostly reserved his economic newsletter for our investors and friends. But we want this information to get into as many investors’ hands as possible so they can be prepared for what lies ahead.

Diving in deeper, we are going to look at the US economy from a variety of factors that impact economic health: employment, household income, consumer and business sentiment, GDP growth, money printing and inflation.


Despite all the political undercurrents surrounding our president, Trump’s tax plan has actually done what it was supposed to: jumpstart the economy, and it has done so, in precisely the ways Bob forecast two years ago. Boiled down, this tax plan aimed at rewarding business owners and investors, which in turn created more jobs and boosted employment rates. And when people start working, they become optimistic and spend money.

We are seeing steady gains in employment rates. Currently we are at the lowest headline unemployment rate (U3 – the number of people without a job actively looking for work) since 1969, now at 3.6%. This is the lowest it’s been in 50 years! Because 70% of the economy, as measured by Gross Domestic Product (GDP), is driven by consumer spending, low unemployment rates have a huge impact on the economy. If consumers have jobs and feel optimistic about their lives and futures, they will spend more freely, which then stimulates the economy.

Some recent claims have been made that the current state of the US economy is only helping those that are already rich, rather than the whole population. Well, the data says otherwise:

  • Black unemployment rates have fallen to 5.5%, setting new record lows
  • Hispanic / Latino unemployment rates, currently at 4.2%, are also setting new record lows

These are incredible trends. Minorities are getting jobs, some of them for the first time.

Think about when a person gets a job for the first time. They “enter” the economy. Well, then the GDP grows. They go buy a car, they make improvements to their house, they go to the doctor, they think about starting a business. This creates a massive amount of economic activity.

For the purposes of measuring tides, I prefer to look at broader measures of employment like the U6 rate, or the even broader labor force participation rate. This measures how many people are in the workforce relative to the entire working age population. This is important because it measures the percentage of the population that is contributing to the economy’s GDP. This measure has reversed its downward trend and skyrocketed since 2015 (despite an aging population). This signals that the population is hopeful and optimistic, so people are re-entering the economy. Whenever someone enters the economy, GDP grows.

Household Income

Household income is another measure that is important to consider. Real household income (which is income that has been adjusted for inflation) in the US rose during the 90s internet boom, but then has been flat or in decline since 2007. Starting in 2012, household income has completely skyrocketed. Real household income is now higher than both the late 90s and prior to the Great Recession. And this number is a median number (versus an average), meaning it’s not skewed by the wealthy making more.

Because inflation has been so low in recent years, it boosts real income growth. Each dollar goes farther. And real income is what boosts optimism. If people have some excess, they spend it – going out to the movies, to dinner, on vacation, etc. This excess contributes to a positive consumer sentiment, or optimism about the state of the economy.

Consumer and Business Sentiment

Consumer sentiment, which is an economic indicator measuring how optimistic consumers feel about their finances and the state of the economy, bottomed in 2009, but has been on a tear since 2010, though it is beginning to flatten. This indicates that despite the current political climate, consumers are still very optimistic about the economy and their finances.

Business sentiment, on the other hand has been dropping. Business spending drives job creation and investment for future growth. If you run a business and are optimistic about your growth, you’ll go buy new equipment, hire more people, expand your operations, etc. This sentiment decline isn’t great, but it’s also not alarming.

You can see that that business sentiment changes much more frequently than consumer sentiment as they are concerned with taxation, regulation, interest rates, competition — and other factors outside general economic trends. So, it’s harder to determine clear trends in the data.

While business sentiment is important, it doesn’t bear as much weight overall as consumer spending, which again accounts for a majority of the GDP.

GDP Growth & Monetary Policy

GDP is essentially the measure of economic activity in a country. This number represents the total value of all the goods and services produced in a country’s economy. We saw about a 4% real GDP growth in the 90s (during the internet boom), which was abnormally high for a mature economy. Now we’re seeing between a 1.5-3% real GDP growth since 2010. That’s solid growth. This slow but steady growth is a product of increases in productivity and the participation rate.

Meanwhile, globally, the central banks’ total assets have been increasing substantially since 2007, up until last year. When these central banks buy assets, they are essentially “printing” money to do so, sending infusions of cash into the economy and causing asset prices to go up (stocks, bonds, real estate). This is what’s been happening up until now. The Federal Reserve, European Central Bank, People’s Bank of China, and the Bank of Japan have been on massive money-printing programs since 2008. Their assets have grown from $5T total to $20T. These infusions of cash in the system act to keep interest rates low and encourage people to spend money.

When central banks print money, this liquidity flows into asset prices, including stocks and housing. This is why we’ve seen the stock market go on a tear, even in the midst of a slower growth economy. This has created another “tide” that buoys the stock market and housing market.

Since 2018, this growth in the central banks’ balance sheets has been declining slightly, including the Federal Reserve, which has eased off printing money. But the global economy is still awash in liquidity. And because the central banks have used an easy monetary policy before, without negative consequences, there’s nothing to stop them from doing it again if the economy begins to suffer.

Historically, the common belief was that easy monetary policy, like what we’ve seen in the last decade, would cause a rampant inflation, potentially even hyper-inflation. But, as we’ll cover in our next section, there are many systemic deflationary forces in the economy. These deflationary forces have prevented the monetary policy from creating unwanted inflation.


The Federal Reserve’s mandates are generally to keep the unemployment rate low, as well as maintain price stability. And in spite of the global easy money policies, and against common wisdom, since inflation has remained stubbornly low. Inflation is basically non-existent right now and we predict will continue to be for the next decade, if not longer. The Fed’s inflation measure increased only 1.4% over the last 12 months. The reason inflation has hardly risen is because there are massive deflationary forces at work, holding inflation at bay.

There are 2 kinds of inflation: asset price inflation and consumer price inflation (CPI). Asset price inflation (i.e. stock market and housing prices) has been increasing substantially. But CPI has been flat. CPI has 3 main inputs, which are all in systemic, deflationary trajectories: wages, energy, and commodities. These long-term trends are keeping inflation relatively flat.

Wage Deflation

Manufacturing output has gone up since 1970 (first chart), however manufacturing jobs have steadily decreased (second chart). Why is this? Productivity, automation, better equipment. This is happening across many industries.

We have massive wage deflation primarily due to automation, aging population, and globalization. According to McKinsey, by 2030, 23-44% of current work hours will be automated. This means that between 8-33% of the workforce will need to change occupations.

Jobs like those in customer service will decrease with the rise in online systems. Efforts are underway to build automated burger flippers. Self-driving vehicle advances could replace Uber drivers and truck drivers in the near future.

While those with specialized skills can continue to earn more in a wealthier world, the rise of robotics and other technological advances provides a significant deflationary force on the median wage globally. As jobs disappear, more people are making less wages, compressing the median wage. Essentially, automation creates a cap on wages. At some point it’s cheaper to buy a million-dollar robot than to pay employees an inflated wage.

So what does this mean for the job market? Over the next 10 years we will see unemployment rates go up and participation rates go down, unless we see the economy remain strong and we retrain people to do jobs less susceptible to automation and keep unemployment low.

On top of this, demographically, the workforce is getting older and the working population is expected to fall as the global population growth rate slows. This will create downward pressure on potential growth and inflation.

Food Deflation

Despite grainland area being harvested dropping significantly, the yield per hectare is increasing disproportionately. Rises in production output are due to global biotechnology advances which are significantly improving yields. In some parts of the world, we can now see multiple harvests from the same hectare within a calendar year.

Additionally, global trade has expanded such that food supply is now worldwide. We import and export grain, produce, and other commodities quite commonly. This insulates us from regional production shocks and shortages caused by droughts or other weather anomalies. These trends also act as deflationary forces.

Oil Deflation

In the 1970’s, oil was the major factor driving global inflation. Does anyone remember the Arab oil embargo? But many are surprised to hear that the US is now the largest producer of oil in the world. How did this happen? New technologies like horizontal drilling and fracking. Regardless of what you think about these technologies, they have unlocked massive amounts of oil reserves. On top of that, US energy consumption is now flat (this is due to a variety of factors like moderate GDP growth, populations driving fewer miles and using more efficient cars, and less trucking). So, if consumption is flat, production is soaring, then prices will fall. What will happen when US-pioneered production advances are deployed in the giant and super-giant oilfields in Russia, Saudi Arabia or Indonesia? We will never in our lifetimes see $100 oil again. By the time these technologies run their course, electric vehicles will be the dominant form of transportation and oil consumption will be in permanent decline.

Bottom line

There is still a lot of strength in the fundamentals of the economy: unemployment is near record lows, GDP growth is solid, consumer sentiment is high, and inflation is being kept in check. These are all positive signals for the economy.

Obviously, the long-term deflationary trends in wages are concerning, but those won’t create significant impact on the economy for some time.

The Stock Market & Valuation

As we’ve discussed earlier, it is important to differentiate between the stock market and the economy, as they can sometimes be used interchangeably. Now that we’ve evaluated the data on the fundamentals of the economy, we will spend some time looking at the stock market.

The stock market has had an incredible run over the last decade. However, many investors are becoming increasingly nervous, and are questioning whether it can continue going up.

Market Valuation Metrics

You may have heard the term “value investing.” This subset of investing philosophy has been popularized by famous investors such as Warren Buffett – and for good reason – Buffett is the most successful investor in history. And simply, the philosophy espouses that the price you pay for an investment is just as important as the investment itself. For example, Amazon is a great company, but is it worth the price of its stock?

Price to Earnings Ratio

A simple measure of valuation is the P/E ratio (price to earnings ratio). This is the price of a given stock divided by the earnings of that company. Collectively, for the S&P 500, as of the time of this writing, the P/E ratio is 30x. That means effectively, a business that earns $1,000 per year would be valued at $30,000. Would you pay $30,000 for a business that puts $83/month ($1,000/year) in your pocket? In essence, that is what you are doing if you are buying the stock market right now. This ratio changes over time and, as you can see in the chart below, generally is higher before market corrections or recessions (though not always the case). At a 30x P/E ratio, the valuation of the stock market is historically expensive.

And many companies have a much higher P/E ratio, like Amazon, which is currently over 70x. Value investing is not the only way to make money in the stock market, but it is probably the most respected. And value investors are shunning this market. Buffett said in his most recent annual letter, “Prices are sky-high for businesses possessing decent long-term prospects.”

And it makes sense — the more you to pay for an investment, the less you are likely to profit. And in the mid-long term that is generally the case.

Modern money management theory has purported the idea that it’s always a good idea to be invested in the stock market, because, “over the long run, the stock market goes up.” Well, as you will see, that is not always true. Valuation has a large part to play in this and has been a great predictor of future stock market returns.

The Single Most Important Chart for Stock Market Investing

Historically, when P/E ratios were lower, it was a good time to buy stocks, and when P/E ratios were higher, it was a good time to sell stocks. We’ve put together a chart to display this relationship between valuation and future returns. As you can see in the chart below, there is a clear negative correlation between them. And again, it makes intuitive sense that the more you have to pay for something, the lower your future returns will be. Contrary to what your money manager says, you should not always be in the stock market.

This chart plots the actual historical P/E ratios over the last 60+ years relative to the subsequent 10-year annualized return. Each dot represents a monthly data point – the actual P/E ratio on the first of the month, and actual annual return you would have received over the next 10 years had you invested on that day. As you can see, there is a clear negative correlation – the higher the P/E ratio, the lower the annual returns. So, for example, when the P/E ratio was low (around 10x), over the following 10 years, the stock market return was 10% on average. But, when the P/E ratio was high, like during the internet boom in the late 90s when it was in the 40s, you would’ve earned -3% (i.e., lost money) over the next 10 years on average.

So where are we now, you are probably asking? With a current P/E ratio hovering around 30x, we are at the high end of the historical range. And if history is any predictor, you can expect the next 10 years’ annualized returns to be less than 5% (and Morgan Stanley agrees with us — see Don’t celebrate the Dow record too much, Morgan Stanley predicts dismal returns the next decade.)

Warren Buffett’s Favorite Investment Indicator 

Another valuation metric that is commonly used is the total Market Capitalization to GDP ratio. Very simply, this measures the total value of all publicly traded companies relative to the GDP, or the value of all goods and services produced annually. It is in essence the ratio of the stock market relative to the economy. This is one of Warren Buffett’s favorite ratios, who has stated, that it’s “probably the best single measure of where valuations stand at any given moment.” It gives a relative historical trend for valuations of the stock market. If you compare this chart to the historical P/E chart, you can see how similar they are.


Buffett, who is one of the most famous value investors, continues to hoard the cash of his company, Berkshire Hathaway. As of the writing, his total cash exceeds $120 billion and has been steadily growing. The primary reason for this has been Buffett’s opinion on prices being too high.

Don’t Short this Stock Market

But, before you decide the market is overheated and it’s time to short the stock market (shorting is investing to make money when the market drops), it’s important to look at one of the key drivers of equity demand. As you can see in the chart below, the largest purchaser of equities over the last several years have been corporations through stock buyback programs. This is when companies spend their profits to buy their own stock. And buybacks are expected to remain high in 2020. Repurchasing shares can increase corporation’s earnings per share (EPS), as it reduces the number shares outstanding. Corporations are largely price insensitive buyers, so it isn’t wise to bet against them.

The other reason not to short this market is the 800-pound gorilla sitting in the corner – the Federal Reserve. At any time, they could decide to prop up the market by lowering rates or restarting their bond purchasing program, flooding the system with cash. And while we don’t see a lot of immediate downside in the stock market given the strong fundamentals of the economy, there also is limited upside, due to the high valuation and moderate economic growth. Two years ago, our economics team predicted the stock market would have an upside bias, but with a lot of volatility. As you can see below, this has proven to be true – the drawdowns have been sharp and frequent, but the upside bias is clear. Today our forecast for the next year remains the same: high volatility, but with an upside bias.

Volatility – Why Does it Matter?

This is an aside, but an important concept to understand. Though the stock market has had an upside bias, many investors don’t realize how volatility negatively impacts actual returns.  Some may say that volatility is not a concern if you are a long-term investor, and despite the ups and downs of the stock market, over the long-term you’ll come out ahead. But what they don’t understand is that volatility kills compounding. Here’s a scenario that might change your mind.

Below, are two scenarios where you initially invest $100,000 and let it grow over 30 years.

  • In Scenario #1, you invest the $100,000 in the stock market. You have big gains, but also big losses (i.e. volatility).  But, your “average” return over 30 years is 10%. Not too bad, right?
  • In Scenario #2 you earn a boring, stable 9% return per year, every year.

Albert Einstein is purported to have said, “Compound interest is the eighth wonder of the world.” You can see below in Scenario #2 the incredible power of consistent compounding. Look at Scenario #2 below. A consistent, stable 9% return turned $100,000 into $1.3 million in 30 years.

Now look at Scenario #1. The average return is higher: 10% vs. 9%. You would expect the returns to be proportionally higher. But in this example, our investor yields are volatile – high then low year to year. Even though the average yield is higher, the overall return is six times lower. Volatility is kryptonite against the superpower of compounding.


What We Would Recommend

The fear surrounding the Coronavirus perfectly illustrates the volatility of the stock market, as we have witnessed large price drops. We expect more volatility throughout the year. Our recommendation for your holdings in the stock market is to remain long or reallocate. Again, we don’t advise shorting the market at this point, as there is still strong equity demand from corporations. But, given the valuation metrics, we expect continued volatility in 2020. Now is a good time to take some of your gains from the market and reallocate into alternative asset classes.

If you are new to private alternative investments, we have resources on our website, including this article on several benefits of alternative investments.

Does the Inverted Yield Curve Signal an Impending Recession?

If there’s one economic headline that caused a lot of stir recently, it was the news the yield curve had inverted. This inversion has many investors in a panic about the future of the US economy. In the headlines it is typically touted as a sure-fire indicator of an upcoming recession (“An inverted yield curve has predicted the last 7 recessions”). And while we agree it is something to take note of, we have a slightly different outlook.

But we’ll get to that.

First, let’s look at what the yield curve is and why it inverts.

What is an Inverted Yield Curve?

When you buy a bond, you receive interest payments in return, giving your bonds a “yield.” Typically, the longer the term of the bond, the higher yield you receive.  For example, take a look at the yield curve chart below. Look at the green line, which is the “normal” yield curve from the summer of 2018. If you lent your money for 3 months, you would receive a 2.03% yield. If you went out to a year, you would get 2.44%; 10 years, 2.96%, and so forth.

But last summer, the yield curve inverted – meaning that longer term investments produced smaller yields. Look at the orange line. If you invested for 1 year, you would get a 1.76% yield, but if you lent for 10 years you would get just 1.5%.

Today’s yield curve (the blue line) is much more pedestrian, just a slight inversion between 3 months and 1 year.

Why Does the Yield Curve Invert?

Historically, watching the yield curve was helpful to see investors’ appetite for risk. Generally, investors will move more money from the stock market into the “safety” of bonds when they perceive greater risk in the economy. There has been a recent influx of cash into the bond market, and many are tying this to the volatility of the stock market. When investors pile into bonds, it drives down the long-term yields. (It’s worth noting that short-term bond yields are determined by the Federal Reserve’s monetary policy, while long-term bonds are dictated by the bond market. That’s why they change independently of each other.)

Now, this can happen when investors are pessimistic about the future of the economy or the stock market. But there are a lot more factors at play in the bond market that are important to consider.

What’s All the Fuss About an Inverted Yield Curve?

Here’s why many people are alarmed: an inversion of the yield curve has pre-dated a recession every time it has happened in the last 40 years. It’s surprisingly been a fairly accurate early indicator of recession, generally occurring 18-36 months before a recession.

Because of its historical accuracy, alarm bells went off when the yield inverted recently.  And while an inversion is cause to investigate what is going on, we think it’s premature to say that the next recession is now inevitable.

In fact, we believe that a yield curve inversion has much less predictive power than it once did.

Here’s why.

Why the Inverted Yield Curve Might Not Be an Indicator of a Recession

Based on our research, there are 4 key factors that are creating “noise” in the yield curve. This noise is what makes an inversion a much less reliable indicator.

1. First, we’ve been in a long-term low-inflation period and will continue to be for a while (we covered some of these macro-trends in part 1 of this series). Low expected inflation, means lower expected future growth, which dampens long-term yields.

2. We also have an aging population and slowing population growth. This will generally cause long-term yields to decrease. Overtime, a larger percentage of the population will not be productively participating in the economy which lowers potential GDP growth.

3. Another overlooked factor contributing to the inversion is that the Fed has been buying bonds since the last economic crisis in 2008, driving yields down. The Fed’s monetary policy has created a price-insensitive buyer of bonds, which creates distortion in the market.“The predictive power of this indicator requires greater context following the Federal Reserve’s unprecedented monetary accommodation during the financial crisis in 2008,” says Phillip Nelson, the Head of Asset Allocation at NEPC in Boston. “The central bank’s large balance sheet has driven Treasury term premiums to historic lows, potentially enabling more frequent yield curve inversions without the associated risk of a recession” (source).

4. Perhaps one of the biggest contributors to the noise in the yield curve is the global interest rate environment. The bond market is now not just indicative of the U.S. economy, but also reflective of the global reality. Several central banks have created negative interest rates. This creates a scenario in which lenders are effectively paying the government to borrow their money. As larger institutional investors, in Europe for example, are looking for yield and the only domestic option are bonds with negative interest rates, a better option is to invest US bonds with a currency hedge. International money has been moving into the US bond market, creating a lot of noise. The yield curve is now no longer just a predictor of US growth, it’s a predictor of US growth plus the lack of growth and yields of other countries’ markets.

The inverted yield curve has had predictive power in the past, but given all these reasons, it’s clear there’s a lot of extra noise in the bond market that makes this much less significant than it has been in the past. Capital Economics agrees: “Inverted yield curves in the US and elsewhere tell us very little about the timing of the future downturns and, for now at least, the economic data are more consistent with a slowdown than a downturn in the world economy” (source).

Or as the South China Morning Post puts it: “While an inverted yield curve could be taken as a sign that a recession is in the offing, US manufacturing activity and consumer sentiment remain robust. The inversion in US yields is more a by-product of excessively low yields in Europe and Japan” (source).

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