Framework for understanding the market

Stocks end a lengthy bull market with high P/Es & sentiment and an inverted yield curve. A bear market
begins. As stocks begin to fall, Fed responds by dropping short-term interest rates and printing money.
Inflation rises. Real rates fall. The yield curve begins steepening.

Thus, during an equity bear market, commodities (esp. gold) tend to be in a bull market. This was the
case during 1930s, 1970s, and 2000s. See the boxed regions in the PPI (inflation) chart below.

Stocks end a bear market with ultra low P/Es & sentiment and a steep yield curve. A bull market begins.
Fed raises rates and the yield curve begins flattening. All this is summarized in the chart below.

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Where to invest now
Your investment options are: Stocks, Bonds, Gold, and Real Estate.

1. Bonds are yielding zero, so ignore them.

2. Gold & real estate are highly correlated, as both follow real interest rates. Treat them as one.

3. Gold tends to do well when stocks are in a bear market (and vice versa). This was also discussed
in the previous section.

Thus, you really have just 2 options: risk-on (hold stocks) or risk-off (hold gold/real estate). Now let’s
analyze each of these two options.

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Risk-on (Stocks) looks terrible

1. High valuations
o Adjusted Shiller PE Ratio1 hit 150-yr channel resistance in early ‘18. Each time resistance
was hit in the past, we had a long bear market. Today, valuations are still near the upper
end of the channel, and so this bear market has a ways to go (see chart below).
o Growth companies like Snowflake, Zoom, Shopify (with market caps > $100B) are
trading at over 50x forward sales and over 100x forward earnings (link)

2. High Sentiment
o Record low put/call ratio.
o Record flows into global stocks (link), especially in high-flying tech ETFs (link)
o SPACs, Fuel cells, Golf carts (EV’s), and fringe cryptocurrencies have been flying

3. Bearish Technicals
o TSX monthly chart is at the resistance of a bearish 20yr rising wedge
o SPX monthly chart is showing bearish momentum divergences

4. Macro
o Fed is keeping rates low for a long-time because they are concerned that the economy is
weak relative to the high equity valuations
o Yield curve inverted last year

1
Lower bond yields justify higher PE ratios, and vice versa. To account for this, we take the raw Shiller PE and
multiply it by [(1+current 10yr bond yield)/(1+historical 10yr bond yield)]10. The Adjusted Shiller PE tells us the
valuation of stocks relative to bonds.

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Risk-off (Gold/real estate) looks great

1. Low valuations
o Gold miners have very low valuations and have become Free-Cash-Flow machines (link).
o Vancouver Real Estate valuation model2 says RE became undervalued this year for the
first time since 2017.

2. Low sentiment
o Gold has low sentiment after a 15% drop from Aug-Dec this year. This is based on
several measures: DSI, NDR Composite, HGNSI, BofA Flows, and NDR Flows.
o Everyone has become distracted by Bitcoin and tech stocks

3. Bullish Technicals
o Gold, Silver, Platinum, and miners have made major multi-year breakouts and are in
strong uptrends (see chart below)
o Real bonds made a breakout recently within a strong 3yr uptrend (see chart below)

4. Macro
o Fed is committed to keeping nominal rates low for years and letting inflation run hot
(link). This means real bond yields will fall, boosting gold and real estate

2
Expected return on real estate = Rental Yield – Mortgage Rate + Real Rent Growth + Breakeven Inflation. This is
identical to Bogle’s formula: Expected return on stocks = Dividend Yield + Real Earnings Growth + Breakeven
Inflation. The model then finds fair value as the price at which expected return = 0.

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Stocks relative to Gold

Our separate analysis of stocks and gold is in perfect agreement. Let's tie it all together by looking at the
SPX:GLD ratio.

The chart below shows that Gold has outperformed SPX since the late 90’s. SPX had a counter-trend
rally from 2011-2018. For the past 5 years, the SPX:GLD ratio has been forming a topping formation,
indicating that GLD is about to outperform SPX drastically in the coming years.

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The End Game

The one area of the market you can definitively say is in a bubble is Bonds. With nominal yields near-
zero (and real yields negative), you are getting little return while exposing yourself to interest rate risk.
Eventually, rates will rise, and the bond bubble will burst. But how?

Again, the Fed is committed to keeping bond yields low because they are concerned. Given high equity
valuations and sentiment, another sizeable drop in stocks is inevitable. During this, the Fed will not only
keep rates low but do fiscal stimulus. Thus, inflation will rise while bond yields remain low, real yields
will fall, and so hard assets like Gold and Real Estate will rise.

After stocks fall, the difference between equity earnings yields and bond yields will be very juicy. Once
this spread is wide enough, enough institutional money / smart money will transition their bond
allocation (yielding nothing) into stocks (yielding a lot). This will end the bond bubble (and cause gold &
real estate to fall), while launching a new secular bull market in stocks.

False Narratives
There are so many false narratives and so much misinformation on FinTwit:
1. “Fed policies will destroy us”
2. “Fed policies have launched a new bull market”
3. “Fed ZIRP justifies infinite valuations”
4. “Bitcoin is the new Gold”

Let’s explore why each of the above narratives may be misguided.

1. Fed dampens the economic boom/bust cycle by controlling short-term interest rates. This
creates much-needed economic stability. During an economic downturn, the Fed prints money,
which it uses to buy bonds, which causes short-term interest rates to fall, which stimulates the
economy. After the ensuing economic boom, the Fed raises short-term rates by selling its bonds,
and takes the proceeds to pay off their debt/reduce the money supply. Thus, the racking up of
Federal debt during a downturn should not be scary since it is temporary.

2. Stocks crash after they reach nosebleed valuations and there’s rampant speculation. In
response, the Fed drops interest rates. This drop is not meant to create another bubble. It’s
meant to create a floor/cushion to prevent an excessive drop in stocks, which could threaten
businesses & the economy. The fact that the Fed is committed to keeping rates low for years is
not because they want to create a giant bubble, but because they believe the underlying
fundamentals are weak relative to equity valuations and want to provide a floor for stocks when
they fall again.

3. While low interest rates do justify higher valuations (see my Adjusted Shiller PE from earlier),
they don’t justify infinite valuations. This is because stocks carry high risk, and the earnings yield
is not guaranteed. Thus, forward earnings yield needs to be sufficiently higher than bond yields.

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 4. Bitcoin is not the new Gold. Yes, it has some design properties that are better than Gold such as
a capped supply, greater portability, easier verification, better divisibility, and no storage costs.
But when you look at the downsides, you realize it’s a very different animal.

First, Bitcoin is early in it’s adoption and highly volatile. While Gold and real estate track real
bonds, Bitcoin acts more like a high-beta stock. When stocks rise, Bitcoin explodes higher. When
stocks fall, Bitcoin falls much harder. This is seen in the 10-year chart below.

Fringe crypto like XRP and BCH has been recently getting pumped and dumped in sync with
highly speculative stocks like Fuel Cells and EVs. In 2017, it was moving in tandem with
speculative pot stocks.

Bitcoin also carries other significant risks such as:

- Government regulation (which has already hit XRP hard recently)
- Threat of being hacked with future quantum computing technology
- Reliance on others to secure the network (Bitcoin mining is concentrated in China)
- If you lose your password, you lose your wealth
- Ownership is heavily concentrated

Further Reading

1. The bullish case for gold is summarized in more detail in my blog post here.
2. Crescat Capital makes a great case for selling stocks and buying gold. See presentation here.
3. Fred Hickey explains the beautiful setup in the gold space. Link

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