The investment environment has radically shifted to a commodity driven inflationary super cycle. Inflation has not been this severe in 40 years. Regrettably, commodity shortages, like those in fossil fuels, are not seeing the capital investment required to create new supply and then lower prices. Today’s new investment environment is transforming the rules for investing. This letter will explore the new investment environment and factors essential to portfolio construction and security selection. By understanding how today’s new factors, like inflation and rising commodity prices, impact security prices, this letter will provide a roadmap for investing in the 2020s. We believe that today’s best strategies and investment ideas are distinctly different than those which succeeded over the last 40 years of declining interest rates.
The stock market is off to its worst start since 1939. While the stock market is due for an oversold counter-trend rally, today’s inflationary environment will persist for years. While major US stock indices should underperform for years, new bull markets in reflationary assets, commodities, emerging markets, commodity stocks, small capitalization stocks, and value stocks are emerging.
The chart below illustrates inflationary and deflationary cycles over the last 115 years. The last two inflation cycles, 1971-1982 and 2000-2009, lasted 10 years on average.
Since 1907, each inflationary cycle commenced with a market crash. This was true in 1907, 1929, 1971, and 2000. This year’s equity market performance, the worst since 1939, fits our thesis that we have entered a new inflationary cycle and it may last a decade.
The ratio of the S&P 500 to CRB (Commodity Research Bureau) Index is another timing indicator which is signaling the commencement of this inflationary cycle or commodity super cycle. This cycle began when West Texas Intermediate oil traded to $11.26/barrel in April 2020 and crude futures traded to negative $37/barrel in May 2020. Since energy is a 39% weighting in the CRB Index and crude oil is its largest component, the beginning of this inflationary cycle we estimate around May 2020 and is shown in the chart below.
Historically, during inflationary periods, the CRB Index outperforms the S&P 500 on the order of 700-900%. This cycle is two years old and commodities or reflationary assets should outperform the S&P 500 for another five to ten years. Our inflationary cycle forecast dovetails with the “commodity super cycle” case made by Goldman Sachs’ commodity analyst Jeffrey Currie.
To translate our cycle theory to investment return potential, we compared two ETFs, one to appreciate during an inflationary cycle and the other to outperform during a deflationary cycle. As a proxy for and beneficiary of an inflationary cycle, we chose the Energy Select SPDR Fund (XLE). As a proxy and beneficiary of a deflationary period, we chose the NASDAQ 100 (QQQ), due to its long duration and productivity enhancing association.
Please review the chart below which compares the performance of the XLE compared to the QQQ from April 1999 until July 2008. The XLE outperformed the QQQ by 25.157% for eight and a quarter years. Conversely, during the deflationary period from April 2009 until February 2022, the QQQ outperformed the XLE by 16.4% annually for nearly 12 years. Within the context of investment manager return histories, 25% and 16% relative outperformance over a long stretch of time is extraordinary.
To illustrate how severe the technology sector decline could get, we quote from Crescat Capital’s latest letter “…, the popular NASDAQ 100 Index is already 23% off its highs, but it is still trading at lofty valuation multiples with price to book and enterprise value to sales multiples of 6.7 and 4.2 respectively. If we look at comparable bear market regimes, there is still substantial downside risk for this large cap tech index. For instance, after the tech bust in October 2002, the NASDAQ 100 bottomed with a price to book value of 2.7 and an enterprise value to sales ratio of 2.1. And, during the Global Financial Crisis, in March 2009, the index bottomed with multiples of 2.5 and 1.3 respectively. Conservatively, if we assume flat sales and earnings over the next one to two years during a probable recession, there is another 50% to 69% downside risk. Sure, the market may bottom at higher valuations, but this is the eyes-wide-open risk based on math and history.”
Historic Valuation Bubble:
The Shiller CAPE chart below shows that today’s equity overvaluation is equal to the peak level hit in 1929. The chart below also shows the 40-year decline in 10-year US Treasury yields (shown as red dashed line) that primarily covered a deflationary period of declining inflation and rising US productivity. It is also worth noting that market valuation extremes take years if not decades to reverse.
The Buffett Indicator:
Buffett’s so called favorite indicator provides another metric that shows current financial asset valuations are extremely rich and for the stock market to revert to its mean will be a multiyear if not decade long process.
The Buffett Indicator compares the Wilshire 5000 Index to the Gross Domestic Product of the United States. The chart below shows that the ratio is already contracting consistent with this year’s evolving bear market. Further, from the bubble top in 2000 to the bottom in March of 2009, the duration of that inflationary period was nearly a decade.
Crude Oil Price’s Impact:
Energy is 39% of the CRB index and crude oil is its largest constituent. Oil price inflation permeates the entire economy. Oil prices rose sharply in the 1970s and again from 1999 to 2008. This current inflationary cycle commenced in the spring of 2020 when oil bottomed at $12.54 in late April 2020. The combination of rising oil prices, COVID-19 related supply chain disruptions, trillions in federal monetary and fiscal stimulus, and the Federal Reserve’s 2020 Jackson Hole inflation tolerance policy, produced this perfect storm which prompted inflation readings not seen in 40 years.
The chart below shows the CRB index has risen 171% since March 2020.
The Problem with Oil and ESG:
The price chart of oil below shows a high price correlation with the CRB index chart. We believe the CRB index will move higher for longer. Our view is based on Goldman Sachs’ Jeffrey Currie’s oil forecast that as a base case of $125/bbl and upside of $175/bbl. This forecast suggests further upside for oil prices and the CRB index.
Our bullishness on oil and our bearishness on the S&P 500 is exacerbated by the Biden Administration’s aggressive climate policy of discouraging energy investment in order to eliminate global warming. Domestic energy production repression is leading to higher gasoline, diesel, and jet fuel prices. Fossil fuels generate 85% of energy and alternative energy produces 15%. While we fully advocate sensible climate policy, unfortunately cost competitive renewables are insufficient to quickly replace fossil fuels with clean alternatives. This energy transition is a two decade process and simply cannot be fully implemented today.
To illustrate the difficulty of this energy transition, consider the recent European experience. Europe, led by Germany’s former Chancellor Angela Merkel, moved aggressively, following the Fukushima Nuclear disaster in 2011, to close nuclear facilities and replace that energy with solar and wind energy. In the summer of 2021, Europe experienced a hot windless summer that led to energy shortages before Russia’s invasion of Ukraine. The Biden Administration appears determined to limit US fossil fuel development with the expectation that cleaner alternatives can be quickly invented, developed, and deployed in the US. This policy makes the current inflation outlook discouraging, if not frightening. While the emotional appeal of a clean and cool earth is logical, poor policy planning played a significant role in Russia’s attack on Ukraine, and Russia’s belief that Europe could be politically divided by using Russia’s huge energy resources as leverage.
The amount of time for energy supply demand imbalances to correct in fossil fuels should take 3-5 years conservatively.
Undoubtedly, supply chain disruptions growing out of the COVID pandemic have created shortages which will take two more years to resolve. The inflation from these supply chain problems, restrictive energy policy, and massive monetary and fiscal stimulus supports our expectation of heightened inflation for years.
The chart below shows oil’s rapid rise since 2020 as well as during the 1999-2008 inflationary cycle.
Investing in Energy:
We remain bullish on energy. Energy will remain an out-performer and driver of inflation for the next several years. We are especially keen on natural gas. Natural gas is now being recommended as a key energy transition fuel until new energy technologies can be developed and renewables can displace the 85% of energy generation coming from fossil fuels. This energy transition should take two decades.
Natural gas offers the high calorific output needed to power economies which provides economic growth to reduce poverty and raise the economic conditions of the 3.5 billion people who don’t have access to continuous electricity. Natural gas produces energy with half the carbon emissions of oil and coal. Along with LNG, natural gas is considered a key transitional fuel.
Natural Gas Investments:
Below is a chart of three of our largest holdings: Antero Resources Corporation (AR), Antero Midstream Corporation (AM), and Tellurian Inc. (TELL). Since the market bottom on March 20th, 2020, these stocks have generated two year returns of 4,288%, 359% and 355%. The selection of the astronomical AR was flagged by IGA in part by its rare corporate action of accumulating both its debt and stock with open market purchases — though some Wall Street analysts were bearish on AR due to its large debt obligations. Those buybacks have continued and now AR, after incrementally paying down its remaining debt, will spend half its cash flow on buying back AR stock. Since AR has a market capitalization of about $10 billion and expects to generate $10 billion in cash flows over the next four years, we remain quite positive on the company’s return prospects.
Income Growth Advisors, LLC recently screened the energy sector for other stocks which are buying back both their own stock and debt. We found 29 companies meeting this profile. With Federal administrative and fossil fuel financing repression, we see high energy prices well into the future. In this environment, is sensible to buy well run energy companies buying back their own stock and retiring their own debt while enjoying rising commodity prices.
Master Limited Partnerships:
Another beneficiary of the repressive energy development regime is Master Limited Partnerships aka “MLPs”. The current development regime is restricting investment in new energy pipelines, exploration and processing. Consequently, those companies which currently own those assets are benefiting from rising replacement costs and scarcity value to their pipeline systems. As a result, we own MLPs for their high tax advantaged yields and strong correlation to oil prices. Given the prospect for rising oil prices and the bearish investment prospects for bonds in an inflationary environment, MLPs offer a compelling income alternative to bonds.
The chart below reflects a cautionary tale of the price correlation of MLPs to crude oil prices. From 2014 to 2020, oil declined from $100/bbl to $12/bbl and MLPs, and the ALPS Alerian MLP ETF (AMLP), declined 87.5%, before distribution, from September 2014 to May 2020. Until US oil production ramps up and/or oil prices turn down, the investment prospects for MLPs are attractive.
Gold is Poised to Move Higher:
Gold is another reflationary asset which we believe is a good investment. Gold historically has been an outstanding performer against the nominal value of the US currency or dollar. Gold is a good inflation hedge. When the Federal Reserve’s current tightening cycle pauses or ends, gold could start to outperform other investment asset classes as energy has outperformed over the last two years. Demand may rise from foreign central banks as they look to shore up their balance sheets as varied international currencies, including the US dollar, increasingly become fiat currencies.
The chart below shows the eight year chart of the ETF. It is near its eight year highs.
As this equity bear market unwinds, we believe a severe decline in crypto currencies could lead crypto investors to shift to gold as a store of wealth. A meltdown in the massively parabolic crypto bubble would be normal market late cycle behavior emblematic of wild eyed speculators capitulating to today’s equity bubble’s bear market.
While we currently are in a massive bubble for stocks, bonds, and real estate, those not reevaluating their investment strategy due to today’s inflationary cycle, may miss the emerging new bull markets which can be as rewarding as the bull markets were in growth and technology stocks since 2009.
Unfortunately, market memory and human psychology make investors fearful of investment strategy changes. Investors tend to believe that what has worked in the past will continue to work in the future. However, the fundamental factors driving today’s markets have changed radically. This portends a future distinctly different from the recent past. Inflation has returned to 40 year high levels. High inflation is creating problems for the Federal Reserve and financial assets in general.
For forty years, stocks, bonds, and real estate have benefited from declining interest rates. This great driver of performance disappeared with the return of inflation. By investing in assets that benefit from the current inflationary environment and commodity super cycle, investment fortunes can be made or preserved in the decade ahead. Those looking to past performance as a guide to investment strategy risk an experience not dissimilar to a driver who drives by looking in the rear view mirror.