Stocks vs Bonds: Who Will Win?

In recent years, we have regularly seen market participants argue between two investment assets: stocks and bonds. One camp claims that stocks are cheap as recovery continues and earnings keep growing, which will eventually put pressure on bonds and drive yields higher. The other camp argues that the recovery is very weak and stocks are overpriced. As deflation and slowdown fears set in again, bonds will outperform while stocks disappoint. On both sides of the argument exist perma bulls and perma bears, who have instantly high and low targets for both assets.

Chart 1: Year to date performance of Tech Stocks vs Treasury Bonds

Stocks vs Bonds Source: Stock Charts (edited by Short Side of Long)

Well… guess what? In 2014, both camps are right. As we can see in Chart 1, higher beta Nasdaq 100 stocks are up 14% year to date, while Treasury Long Bond is up almost 19% (both are total return).

So how can that be? Well, we find ourselves in a period which will most likely be known as “the mother of all easing cycles”. Basically, zero percent rates and additional money printing is pushing up both stocks and bonds simultaneously. And since money velocity hasn’t risen yet, high inflation has not been a problem.

So which asset should investors should buy or continue to hold, and which one should they sell? My personal opinion is that this question is a little bit more difficult to answer, because it is not just as simple as choosing between either one. I will try and answer the question in two parts.

Chart 2: US technology stocks have been rising at extra ordinary pace

Nasdaq 100 ETF Source: Stock Charts (edited by Short Side of Long)

First of all, year to date chart does not tell the whole story. Instead let us look at the price action for both assets since at least 2013. As you can see Nasdaq 100 has been storming higher and at faster rate too. It hasn’t traded at or below its 200 day moving average since late 2012. While this index is extremely overbought even now, it seems to be stubbornly shaking off any downside risks as it tries to recapture its 2000 peak in a hurry.

On the other hand, while Treasuries have done better then stocks in 2014, they are only really recovering from the huge drawdowns in 2013. In other words, those who purchased stocks at the beginning of 2013 are up a whole lot more than those who purchased bonds. Therefore, from a  contrary perspective, does this mean that stocks are a lot more extended then bonds?

Chart 3: Bonds have rallied, but its only a recovery from the ’13 sell off!

Long Bond ETF Source: Stock Charts (edited by Short Side of Long)

Well maybe in the US, but not in a lot of other Developed Markets around the world, where government bonds have been bid up to extreme levels (some yields are actually negative) as fear of bank defaults, deflation and recession worries keeps investors in risk aversion mode. For example, certain government bond markets are just extended as Nasdaq seen in Chart 2. All we have to do is look at the recent several years of performance in German Bunds or the last decade in Japanese JGBs. So, this brings me onto the second point…

Chart 4: There is decent probability that both stocks & bonds disappoint

Stocks & Bonds Future Expected Returns Source:  Ray Dalio & BridgeWater

Since we are going through “the mother of all easing cycles”, the other side of the saga could be a disappointment for all investors, both those who favour stocks as well as bonds.  Let me first say that as long as the artificial easing continues, noir just by the Fed, but by all other major central banks, things could stay in the current goldilocks environment.

Therefore, these warnings do not necessarily mean that both stocks and bonds sell off tomorrow, but they do imply that returns over the next decade could be very low indeed. According to Bridgewater Hedge Fund, Chart 4 shows that when adjusted for inflation (if you believe the government data), risk-weighted average expected return for both stocks and bonds could be just 1% per annum. That is not only below average, that is actually at the lowest level in modern history.

I think none of us are exactly sure how the end game will play out, as central banks pull back on their easing programs and credit gets tighter, but one thing is for sure. A wise man once said that on Wall Street, there is always a bull market somewhere. Since returns have already been superb, the question is which asset class will benefit next?

Explaining My Portfolio

I have received quite a lot of questions regarding the newsletter portfolio as well as my major holdings. In this article I will try and explain some of the basic points of what my asset investments are, as well as what is and what isn’t on my watch-list.

However, before I continue I would like to say to all those who subscribe and follow my portfolio: you shouldn’t do what I do. You shouldn’t listen to me or anyone else on the internet / tv / radio. There is a particular reason why I hold various assets and these reasons might not make any sense to you. You should buy and sell assets which make sense to you. Therefore, do your own research so that you can win (or lose) your own money. That is always the best way.

Chart 1: Where does one see value in current global macro environment

Source: Internet

The question I recently receive is why do I chose to invest into “strange” assets such as Silver and Sugar? Wouldn’t it be just smarter to own the SPY ETF? Well, there are variety of reasons. Firstly, they are not strange. I believe these assets are extremely cheap on historical basis, unlike the SPY ETF, particularly when adjusted for inflation. And with the on going global currency devaluation, eventually the price of everything will rise and these raw materials will not be an exception.

Away from the fundamentals and the price valuations, I chose to own Silver and Sugar because these assets are some of the most volatile in the world. Historically, both Silver and Sugar tend to move up and down with incredible buying and selling pressure. You see, I am young and therefore my risk appetite is high. I want to get rich and that is why invest.

I understand the risks involved, therefore I am prepared to live with the volatility and huge drawdowns. I understand that its very common for Silver or Sugar to experience bear markets of 50% or more every several years, the same way it is just as common for Silver or Sugar to rally 3 to 4 fold in a very short space of time (sometimes even more in only a couple of years).

Chart 2: Silver’s bear market is now ongoing for almost 3 and half years 

Silver Source: Bar Chart (edited by Short Side of Long)

I started to accumulate Silver once again as it sold off about 50% from its record highs in April 2011. Initial purchases were conducted in late December 2011 and July 2012. However, a bear market follow through occurred in 2013, as Gold crashed. That did not stop me, as I continued to accumulate Silver first in May 2013 and later in July 2013 and January 2014. Silver is by far my largest holding, at times reaches over 80% of my NAV. Therefore, keep in mind that my other positions are at times, almost irrelevant.

Despite the fact that Silver’s bear market is now almost 3 and half years old, and has declined by more then 60%, my average entry is only a few dollars above the current level. However, I am not so sure that the final low is in as of right now. Therefore, I’ve recently placed a hedge on my overall long position. If I am wrong and Silver starts to take off above $22, I will immediately take the hedge off.

Chart 3: Sugar is one of the most disliked agricultural commodities… 

Sugar Source: Bar Chart (edited by Short Side of Long)

Sugar is the other commodity I also favour in coming years. It is not as easy to buy-and-hold Sugar as it is with Precious Metals. The commodity tends to fluctuate from a backwardation to a contango and back again. Nevertheless, I started to accumulate Sugar around 50% sell from its recent 2011 highs as well. Initial purchase was conducted in early December 2012. Not the best of purchases I must admit, as the price just slowly rolled down for months (haha!).

However, I continued to accumulate the soft commodity in August 2013, December and January 2014; and once again only a couple of days ago. Keep in mind that while my average entry looks pretty decent in the chart above, Sugar has been suffering from a contango in recent quarters, so the drawdowns are a little bit bigger.

Chart 4: Uranium is one of the most oversold industries in the world… 

Uranium Source: Bar Chart (edited by Short Side of Long)

With the global stock market screaming ever higher, mainly thanks to the S&P 500′s record breaking run, it is very difficult to find value in shares. I know a lot of “experts and gurus” on CNBC and Bloomberg will disagree with me, but I’m in charge of the capital and I judge value my own way.

I also understand that certain investors single out various European or Emerging Markets opportunities with low valuations. Others focus on Taiwan and Japan after a prolonged secular bear market, and a few are even nibbling into Chinese & HK shares despite the potential property cycle risks.

Personally, I have chosen to invest into the Uranium sector during the recent sell off in May of 2014. Down more then 75% from peak in early 2011 and on track for a forth consecutive annual loss, this is probably the most oversold and least liked industry.

Chart 5: Australian economy has not suffered a recession for 23 years!

Australian Dollar Source: Bar Chart (edited by Short Side of Long)

Australian economy has been in a mega-boom since the early 1990s, when the country saw its last official recession. After 23 years of constant growth, we have a whole generation of young people who believe that “property prices can never fall” & that “good jobs and highs salaries come easy”.

Could they be wrong? Could Australian growth falter after a 23 year record run? Could the Australian property market finally correct? And if any of those occur, would the RBA “stimulate” the economy through global monetary policies by following the likes of Bernanke, Yellen, Draghi, Kuroda, King and the crew. You know the drill… cut rates, print money and devalue the currency!

This is what I have been betting on since late 2012, when I initiated my first large Aussie Dollar short. It was quite a big contrarian bet at the time, as hedge funds held record net long positions believing in further currency appreciation. Several weeks ago I opened another smaller short, adding to my existing position.

To be quite honest, despite a strong USD rally in recent months, Aussie has held up well so far and I am not happy with my new position. Therefore, I’ve put a tight stop loss at 94.00 cents for the 2nd trade, initiated recently.

Chart 6 & 7: I do not want anything to do with US stocks or US bonds!!!  

Future Expected Stock Returns Future Expected Bond Returns Source: Ray Dalio & BridgeWater

There are many other trades that I hold and have held in my portfolio over the years. But they are very very small compared to my NAV and therefore quite irrelevant for this article.

Now, let us focus on some future prospects. Let me just say that since you are smarter then I am, you probably see more opportunities around the world then I would. While I could sit here and number variety of trades I am currently looking at, I will just focus on a few existing and new ones.

Let me first say that I do not see any value in the broad US stock market or the US government / junk bond market right now (refer to Chart 6 & 7). This could change if the prices were to decline meaningfully. However, with a recent powerful bull market in both of these assets, future expected returns could be a real disappointment in the coming decade… at least according to Ray Dalio and his BridgeWater team (thanks for the charts).

Chart 8 & 9: I am closely tracking Russian stocks & Gold Mining Juniors

Gold Mining Stocks 

Russian Stocks  Source: Bar Chart (edited by Short Side of Long)

Personally, I continue to hold both Gold and Silver in high regard. If prices do eventually go lower, my plan is to add to my current positions and start a new position in Gold as well. I will use new cash inflows as well as profits from the current hedges. On the other hand, if the price breaks out on the upside, I will still continue to add positions as I build my overall portfolio around the PMs theme. The same can be said with Sugar, but just on a much smaller scale.

Two assets I have not yet purchased in a meaningful way are Gold Mining Stocks and Russian Stocks (I do own a small position in Russia equities from early March of this year). Both of these indices are extremely cheap and could outperform in superb fashion in coming years. However, I am still waiting patiently on both, because further selling and lower lows could be in the cards. I believe the main catalyst will the end of the US Dollar bull market and we are just not there yet.

Gold’s Performance

Sticking with the precious metals topic, as it seems to be generating a lot of interest. I’ve received a lot of emails, some of which love the content and the charts, some of which totally disagree with ever buying Gold or Silver, and some of which think I’m crazy (those are standard haha).

Before I start, I would like to say that I am not to sure why some people make it a habit of disagreeing in frantic fashion. The point of this blog is to show you what I am doing with my money. If I lose money, it is my own fault and I get poorer, not richer. I am not really giving out financial advice and many of you who have been reading the blog for awhile would have noticed that my favourite line is to win (and also lose) money based on your own research and analysis. Don’t listen to what anyone including me has to say.

Chart 1: Rarely has the price of Gold fallen by one third over a few years!

Gold Performance Source: Short Side of Long (click to enlarge for full view)

The chart above shows Gold since it floated on the free market exchange in late 1960s, together with a 1 year and 3 year rolling performance. The bottom of the chart has a grey shaded area, which represents an oversold zone. Historically, the price of Gold has rarely fallen by 30% or more over any rolling 1 year or 3 year period. In 2013, Gold just fell by 30% over 12 months and this week marks close to a three year anniversary of the Gold’s bear market, pushing it into an extremely oversold zone, down 32% in the last 36 months.

Several periods that market performance as awful as today were:

  • in middle of 1970s the 1 year rolling performance fell by more then 30%
  • in early 1980s both 1 and 3 year rolling performance fell by almost 40%
  • in middle of 1980s the 3 year rolling performance fell by more then 30%
  • in late 1990s the 3 year rolling performance also fell by more then 30%

All of those occurred at or near major Gold bottoms. Therefore, drawdowns from extremely oversold levels were usually on a smaller scale from a value investors point of view (unlike traders, who think a drawdown of 5% is huge). The indicator marked major bottom almost immediately in 1976, 1985 and 1999. During the Precious Metals bubble crash of early 1980s, the oversold indicators persisted for longer and initial signals did not work properly.

For the record the worst annualised loss was -39% in 1981 and the worst 3 year rolling loss was -42% in 1983. Currently, Gold is down -32% over the last three years.

Precious Metals Bear Markets

Traders buy and sell assets everyday. For example, despite ridiculously high P/E ratios and a huge gain over the last 5 years, there are traders who continue to purchase Biotech stocks every single day. On the other hand value investors are different. Their main goal is to buy an asset on cheap, or as the old adage states “buy low, and sell high”. The problem value investors face is figuring out what cheap is, and when low is low enough to be the bottom (or at least close to it so the drawdown is limited).

If you are a value investor today, surely you would be looking to allocate at least a small portion of your portfolio towards the precious metals sector. Unlike the US stock market, which has tripled in value over the last 5 years, precious metals have been selling off lower since middle of 2011 and offer great value. The question most investors continue to ask is how low do the metals go, before that value starts showing up in the P&L?

Chart 1: Gold bear market is turning three years old in early September

Gold Bear Market Analogue Source: Short Side of Long

There is no easy way to answer that question, but one way to try and estimate it is by looking at previous historical bear markets. Both Gold and Silver started its free market trading in early 1970s, so the data is obviously limited to just over four decades. During that time frame both Gold and Silver have suffered many pullbacks and corrections, but have only gone through 8 serious bear markets.

Since Silver is one of the most volatile assets on the planet, we do not use a simple 20% sell off rule for a bear market, and instead gauge it based on a more serious sell off and a prolonged downtrend of lower lows and lower highs. Finally, the observations made below are done with an assumption that the bear market will still produce one final lower low. If this does not end up being the case, both metals have already bottomed in middle of 2013.

Starting with Gold in Chart 1, we can make a few observations:

  • The current bear market has so far been the third longest in time. The longest bear market for Gold started from the peak just before 1988 and lasted for 5 long years, all the way to the beginning of 1993. Assuming we follow a similar pattern, Gold would move sideways until October 2016. If this was to be the case, those who purchased Gold would not experience a large downside risk, however there capital would be trapped in a nonperforming asset. This is commonly known as a value trap.
  • The closest correlation the current downtrend has with previous ones, is the 1996 to 1999 bear market drawn in yellow (refer to Chart 1). The initial sell off lasted about two years, at which point a long consolidation started. Both bulls and bears became frustrated at the lack of a trend, similar to what has been happening as of late. While the Gold bulls claimed that it was a basing pattern at the time, the price actually collapsed one last time into a final low before a bull market took off.

Chart 2: Silver has now been in a bear market for 3 years and 4 months!

Silver Bear Market Analogue Source: Short Side of Long

Now for some Silver observations, so please refer to Chart 2:

  • Silver bear market is currently almost 3 years and 4 months old. By historical precedent, this is one of the longest bear markets since Silver started trading in late 1960s. We have just taken over the 1983-86 downtrend and in a month this bear market will also be longer then the 1968-71. In theory, if Silver does make a lower low, we are now only months away from setting a new record. Already we are given a hint that the downtrend is exhausted, so a lower low well into 2015 would be a true historical anomaly and most likely a terrific buying opportunity.
  • Since Silver peaked around a similar price point in both 1980 and 2011, precious metal bears were once again predicting a 1980s style bust and total wipe out. After peaking at $50 in early 1980, Silver fell to $5 per ounce (90% decline) in a space of just over two years. However, as the analogue clearly shows, the current bear market isn’t anything like the 1980-82 bubble crash. It is actually correlating more with 1983-86 and 1987-91 downtrends in both time and price drawdowns.
  • Each one of the final bottoms produced some kind of an extraordinary gain. After bottoming out in 1971, Silver shot up by more then 450%. As the 1974-76 downtrend ended, Silver managed an amazing performance of 1200% or 12-fold over the next 4 years. This was the end of a secular bull market. The huge bust in 1982 eventually saw the metal triple from the lows. The 1986 bottom saw gains of 100% within the following 12 months. The 1991 bottom was the most disappointing of all even though it was the lowest low, as Silver spent majority of the time moving sideways. Gains of 100% only showed up year years later in 1998, as Buffett was reportedly buying the metal. Silver’s bottomed in 2001 produced gains of over 500% in coming years, while the Global Financial Crisis bottom of 2008 produced another 550% plus rally in less then three years. Even without counting the speculator gain in late 1970s, Silver averaged around 350% gain after every bear market. As we can see, buying Silver at the bottom is incredibly difficult task, but has amazingly lucrative gains for those who have the skill and luck to execute it.

Guessing isn’t very useful when it comes to investing, but if I had to make a guess I would say that both metals sell off one final time into a lower low by early 2015. Based on historical analogues alone, Gold seems to be following the 1996-99 bear market quite well and could bottom around March 2015. At the same time if Silver falls to a lower low around March 2015, that would be one of the longest and most oversold downtrends (not including the 1980-82 bubble crash).

US Stocks At Record Highs

Chart 1: S&P 500 is now approaching the psychological 2000 point level

Market Breadth Source: Short Side of Long

S&P 500 posted a new closing record high last night at 1992.37, with Nasdaq Composite also accomplishing the same thing. The short term oversold conditions have once again worked like a charm for the bulls, which pounced on the dip taking the stock market to higher high. Dow Jones Industrial is lagging slightly behind, while the Japanese & German stock markets are not yet at higher highs either (despite weaker Yen and Euro).

Agriculture Selling Pressure Stops

Chart 1: After awful three months agricultural commodities are basing

Agricultrue Source: Fin Viz (edited by Short Side of Long)

About a week ago, we looked at extremely bearish sentiment conditions in the Agricultural sector. We concluded that 5 out of the 6 main ag-commodities were going through extreme pessimism, which usually tends to occur right on or very near intermediate lows.

Grains have been beaten down the most and the selling pressure there has eased of since the beginning of the month. Furthermore, in recent days various soft commodities such as Sugar and Cotton have also started to bounce a bit. Personally, I have added some more positions to my Sugar trade as of last night, and might soon even consider buying the overall agriculture index ETF such as JJA or RJA.

What’s Next For Precious Metals?

As predicted, precious metals have been weak as of late. During the price reversals in early July, I warned that sentiment became overly optimistic while prices remained in a technical downtrend. Even though I hold large core Silver investment, I decided that a smart thing to do was to hedge this investment with Gold and Silver short hedges. I did this just as other speculators were piling in, expecting higher prices. A sell off has run for several weeks now, so what’s next for the precious metals sector?

Chart 1: In August hedge funds continue to build bullish Gold positions

Gold Sentiment Source: Short Side of Long

Price wise, the yellow metal continues to consolidate in a triangle formation. Recent price action shows that the price of Gold has fallen to the lower support range of this triangle. At the same, we have now broken below the 200 day moving average. I am sure a lot of technical analysts will now be concluding that this is a worrisome signal.

While sentiment isn’t overly bullish right now, futures positioning via CFTC’s commitment of traders report shows that hedge funds and other speculators have continued to add Gold net longs even as the price is falling. I must admit, it is remarkably difficult to make a bullish case with that in mind. Side note: please remember that COT and survey data is delayed by a week.

Chart 2: In July sentiment and positioning on Silver was overly bullish

Silver Sentiment Source: Short Side of Long

Relative to Gold, Silver’s sentiment was even more exuberant in early July. As already mentioned in earlier posts, I was just astonished as to how quickly hedge funds and other speculators went from being extremely negative to overly positive in the Silver market. Observing the price, Silver fell below its 200 day moving average well before Gold and is currently down six weeks in the row.

This market is narrowing into a ridiculously tight range, especially for an asset that is one of the most volatile in the world. The pattern of lower highs still remains in place, and until broken, signals bears are in firm control. Side note: please remember that COT and survey data is delayed by a week.

Chart 3: Could Gold Miners be leading the metals out of a bear market?

Gold Miners vs Gold Source: Short Side of Long

However, the situation is not as simple as concluding that Gold and Silver will continue to sell off lower. While metals look sluggish, Gold Miners are acting a lot more confident, as if an upside breakout could be around the corner. In recent posts, I’ve discussed the fact that internal breadth of Gold Miners stands at the highest participation in 3 years. Furthermore, after disastrous few years, Gold Miners are starting to outperform other major global macro assets. Finally, the index of mining companies continues to consolidate just below the important resistance neckline (refer to Chart 3), even though US Dollar has been rallying and pressuring the overall PMs sector (refer to Chart 4).

What is even more interesting is the way Gold Miners are outperforming Gold right now. The blue line in Chart 3 looks at the relative strength of miners vs the yellow metal. One could make a conclusion that the mining index has bottomed out just like in 1998, 2000 and 2008. Mind you, the outperformance did not last all that long in 1998, and eventually Gold Miners fell to a final lower low.

So, could Gold Miners be leading the metals out of a bear market? It is hard to say right now. To make a positive case, miners would have to breakout on the upside first. From the technical perspective HUI Gold Bugs Index needs to close above 255 to 260 area, GDX ETF above $28 and GDXJ ETF above $46. We would also need to see an improvement in the metals. Finally, it would help to see US Dollar Index potentially pull back from its overbought levels right now. Either way, the market is about to reveal its hand very soon, so stay patient and watch Gold Miners closely!

Chart 4: Dollar rally has become overbought from short term perspective

US Dollar Overbought Source: Stock Charts

Dollar Strength, Euro Weakness

Chart 1: Trade Weighted Dollar is pushing towards 52 week new highs!

US Dollar Performance Source: Short Side of Long

Quite a lot of interesting movements in the markets, however i have been quite busy as of late and unable to update the blog properly. Tonight we have a quick look at the recent currency majors. As we can clearly see in Chart 1, Traded Weighted US Dollar Index has been pushing higher in recent weeks and now sits very close to posting 52 week new highs.

One of the major US Dollar strengthening stories has been the weakening Euro theme. Recent economic data, which I always state is rather lagging at best, points to a slowdown in the overall Eurozone. We recently got a strong hint that German economy is quite close to a technical recession, while French economy is struggling just as much. Once again, Italy has already entered a recession and the debt levels in the overall union continues to rise.

Chart 2: Euro has been weak as of late as the Eurozone economy slows 

Euro COT Source: Short Side of Long

It seems the market has already been busy discounting these developments. Currency investors have been selling down the Euro very consistently since the major daily reversal occurred in early May on the day of ECB press conference. It seems to me that the market participants are pricing in a potential further ECB easing policies, just as the EU economy weakens.

Does that mean, one should rush out and short the Euro tomorrow morning? I am not so sure about that right now, even though I think Euro will be much lower in a year from now. Technically speaking, Euro has become quite oversold from the short term perspective, short positions continue to pile on and various sentiment surveys show that the current downtrend is very well “telegraphed” to all market participants. And when a trade becomes obvious to the public, it might be obviously wrong for the next little while, as potential mean reversion kicks in.