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Merryn Somerset Webb: Hello and welcome to the MoneyWeek Magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. And with me today, I have Tim Hayes, who is chief global investment strategist of Ned Davis Research, or NDR. Tim, thank you very much for joining us today.
Tim Hayes: Thank you.
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Merryn: You are new to our podcast. So, again, much appreciated. But I suspect that a lot of our readers won’t know NDR. So, I wonder if you could just tell us briefly about the organisation and what it is that you do?
Tim: Yes. NDR is an independent research firm, that basically covers everything from the macro-outlook to global asset allocation. Very focused on historical analysis to try to determine where the markets are going. And essentially, providing allocation recommendations and viewpoints on how we see things right now. So, that’s what we do, basically.
Merryn: Great. I’ll tell you what I know about NDR, which is that whenever I hear the very phrase Ned Davis Research, I think, bullish. These people are bullish. They’re always bullish. Am I right? It’s a very bullish outlook you have had for the last decade or so, and I think do have at the moment.
Tim: Well, yes. I think when we address that question, we need to really think about what time frame we’re talking about. We’ve basically been making the case since 2000… After 2009, that the 2009 bottom was a secular low, and that we’ve been in a secular bull market. We do also make tactical calls in our asset allocation recommendations, where we will cut our allocation. In fact, we were… You could call us bearish, really, from 2018 into… For most of that time. We started getting back into the market in 2019, and then cut back again early last year, to our minimum allocation.
As we got out of last year’s decline and the global recession, and the indicators started to improve, then we were able to move back into the market starting last year, and then brought us to what is now a maximum allocation.
Throughout that, we’ve looked at the market in the context of these long-term trends and saying, you do get cyclical bear markets within secular bull markets. And what that means is you want to be ready to get back aligned with the secular bull once you’re coming out of one of these cyclical bears, which we had last year.
So, just going back. If you go back to 2000, we were bearish then. We’ve been bearish at other times. But I think it’s fair to say we’ve been constructive on this market. And a major reason for this is what we find at secular extremes, is that the market will get extremely overvalued at a secular high, undervalued at a secular low, and it tends to be global. In fact, we had single-digit valuations in most markets around the world in 2009.
And then what really drives the secular trend is liquidity. And that’s what the central banks provided, massive amounts of liquidity back in 2009, and that did work to start reflating the global economy.
And so, what tends to happen is you go through these adjustments like 2011. When the market would get ahead of itself, a global slowdown would arrive. And it also happened in 2015, and that also happened in 2018, and then, of course, it happened last year.
So, you get these periods of economic weakness that will then have a negative impact on earnings, and the market will anticipate this and have a cyclical decline. But then what happens is at the end of these cyclical declines, you get this more infusions of liquidity that reset the secular bull, and that becomes a good opportunity to get in line with it. So, again, it’s more we have our tactical asset allocation adjustments within that longer term secular view. So, that’s how we can get bearish within that longer term positive view.
Merryn: OK. So, when you felt bearish last year, was that before Covid became a problem, or this was a direct result of Covid?
Tim: Yes. What happened was the indicators started to deteriorate as we got into this year. And of course, Covid, we started hearing about it late in 2019. But then when it started to really have an impact on the markets, our indicators picked that up earlier in the year, and then we cut our allocation in response to that.
But the key point is that we need to have confirmation. We’re not going to try to pick the top or pick the bottom because you really never know what that bottom is. We wait for the market to form a bottom, and then give us the confirmation that now the worst is behind us and it’s safe to start moving back in, because we definitely don’t want to try to buy into a market that’s still on a decisive downtrend.
Merryn: OK. So, here we are, year and a half later. Where are we now in your secular bull?
Tim: So, like I said, we moved to overweight allocation, and actually we have a maximum overweight allocation which we [overtalking].
Merryn: What does that mean, maximum overweight? Sorry.
Tim: The way I try to explain this is, of course, everybody has… That means something different to everyone. What fully invested one person is different… That means something different.
So, what we do is we say, we’re going to use a benchmark allocation of 55% stocks, 35% bonds, and 10% cash, and then 70% is the maximum. So, we basically say, and what we said in January was, you should be at whatever your maximum would be. We call that 70%, but that can be 100% the one person. That might be 50% to somebody else. But we just say, be fully invested, as far as you would go. And then since then…
Merryn: I’m sorry, one more question. If you’re 70% in equities, what does that mean? 20% in bonds, and 10% in cash? Where’s the other 30?
Tim: 25% in bonds, and 5% in cash. So, we’re overweight equities, maximum overweight equities, underweight both bonds and cash. I should emphasise that we use a model that guides us to this allocation based on both a stock bond composite and a bond cash composite. And those are combined together to give us recommended allocation, and then we use that as our major input to what we’re recommending.
And so, since moving to that maximum overweight, we basically said all year that the market risk was single-digit correction risk, not double-digit bear market risk. And that’s a pretty key distinction because if it’s single-digit correction risk, then mostly you’ll get these corrections like we had in September, and what it does is it’ll be driven by a lot of negatives. This last one were worries about oil prices, rising bond yields, supply chain, China, Covid concerns still lingering, and it creates a lot of, the debt situation in the US, creates a lot of pessimism.
The market sells off on that, all of these worries. But then what ultimately happens, once you’ve priced in these things, and then as we’ve seen just last week or so, is that the market then returns its focus to the fundamentals. In this case, earnings, which are coming through very strongly, and also the increased confidence that we actually will get past this negative Covid influence, and the economies will perform better going forward, and the supply chain issues will ease eventually, and that’s what the markets now are rallying on.
So, we’ve made the case for a year-end rally, and I think that started. We went back September. I think October 4th was the low. What often happens, the market will go back and test the lows, and then starts to rebuild momentum as confidence comes back in. In this case, the earnings were giving the market some more confidence.
And then we’ll see what things look like as we get toward the end of the year and into next year. Right now, things look pretty good, and there’s no major, at this point, risk that we’re going to move back into a more decisive downtrend.
Merryn: OK. So, you have confidence yourself that we are moving beyond Covid, and that the supply chain issues that we’re seeing around the world are, as we keep saying, transient, and therefore the inflation is also transient.
Tim: Yes, I think that is still the expectation. I think that’s still likely. And so, all these negative effects from the supply chain disruptions, as those get reversed, then it starts to have that opposite effect. As goods start moving around, and then you don’t get that inflationary pressures, inflationary worry then starts to recede.
And actually, I showed a chart this week of… Just look at Covid, new cases on Covid, and the correlation with the market, with the All-Country World Index, and as you would expect, it’s been an inverse correlation. And the Covid cases just continue to fall. If that trend continues, it seems like it will… One of the sources of concern was another outbreak over the winter, but that’s… Because we’ve had so many disappointments on this.
But if we don’t get that, now that we’re in a much better phase with the vaccinations, and confidence will continue to come back, that actually we’ll have a pre-pandemic economy going forward, which would…
Merryn: And even I think we’ve seen a more long-term change to the way we will operate supply chains. One of the things that we’ve been talking about is this shift from a just-in-time supply chain to a just-in-case supply chain. So, everyone is trying to build more resilience. Everyone is trying to build more locality. Everyone is trying to make sure they have excess supply rather than not quite enough supply. And that’s a long-term structural change to the way global supply chains work, as opposed to a temporary post-pandemic blip.
Tim: Yes, I think that probably is what’s happening. I guess what we can’t predict, what kind of impact would that have? It seems to me that would ultimately probably be digested pretty well by the markets. I don’t think that would necessarily be...
Merryn: What about then employment in the US? We’re watching with fascination the falling participation rate among the labour force in the US. I’m wondering where these people are going, and why your labour force seems to be rather reluctant, and the effect that might have long term on inflation.
Tim: Yes, that also has, of course, an impact contributing to the supply chain problems. You don’t have enough trucks, truckers. You don’t have enough people unloading goods. So, I guess once we get past a lot of the… The cheques aren’t being given out anymore. Once people start to want to go back to work, and actually if the wage pressures do start… The wage demands start to have an impact and entice people to come back, and we’ll see how that…
Certainly, it can go in a negative way. Certainly, if this results in some sort of wage inflation, that stagflationary risk would become an issue. But I think it’s probably one of these effects that should normalise going forward.
Merryn: For now, you’re definitely sticking with transient.
Merryn: Even if we have just slightly redefined transient over the next six, seven months or so.
Tim: Yes, I think that’s right.
Merryn: OK. So, let’s look then at the markets that you’re most interested in. I can see from your work that when you say you’re overweight, you don’t mean overweight the world. You mean overweight the US in particular, and also Europe. Although maybe we’ll delve a little into what you mean by Europe. But being bullish US, and we’ve talked about why it is that you feel that there’s a secular bull market going on here. But do you think about valuations? We keep looking at America and saying, these markets are really trading near historical highs. Doesn’t this matter?
Tim: Yes, it does. But what we need to keep in mind about valuations is that… Look, I show this in the opposite of the price range ratio. If you look at the earnings yield… So, rising earnings yield, the market is getting cheaper. Dropping earnings yield, it’s getting more expensive.
The first thing that started happening last year, we look at the forward earnings yield, take earnings expectations, and the market started to look much better. And then this year, the earnings themselves, the trailing earnings came through. So, actually, the valuation has improved because the earnings were coming through faster than the market had been rising.
And this is what happened in 2017. You can have a situation where the valuations improve even as the market is making a record high, and the only way that can happen is that the earnings are going to maintain strength and gain momentum, and that’s what happened then, as has happened this year.
The risk going forward, I think, really… We’ve heard it again over the last week how earnings are beating expectations, and this is something we’ve been seeing all year. Not only earnings beating expectations, but they’re doing it at an increasing rate.
So, what’s happening is the beat rate is getting better and better. The risk is that then the market starts to get complacent and are expecting the beat rate to improve. So, it’s often said, an earnings surprise. Well, if you’re expecting it, it’s no longer a surprise. And so, therefore, the risk is that we get into a future earnings season, and the earnings don’t come through as quickly. I’ve actually shown how when you have a declining momentum of the beat rate, that usually happens when the market is not performing very well and often gets into a bear market.
So, I think that’s probably the biggest risk next year, is that we… May we get through this current earnings season pretty well, that helps drive a year-end rally. Get into next year, and all the expectations are priced in, and then the market maybe will be vulnerable to disappointment at some point.
And that’s when valuations matter, because then what happens is instead of the valuations improving because earnings are coming through, people start to see the valuations worsening again. So, the focus returns, and then the question becomes, are these valuations justified? Well, if the earnings aren’t coming through, then they’re not justified. So, you have to sell, and that gets the market in trouble.
So, yes, that is a future concern. But right now, because we’ve actually had better valuations than we had a year ago because of the earnings, I don’t think that’s an immediate concern.
But the other thing about the US to keep in mind is that it has… And we use the MSCI indices. So, we basically go with what they define as the All-Country World Index, or any of the regional indices. And then we can also look at sector representation. MSCI US Index is 70% technology. We’re really heavyweight tech. That’s not the case in other regions.
So, tech is usually the driver. Tech has gotten relatively expensive. So, if tech is going to be the one that’s going to get in trouble, that’s going to be a problem for the US. And then the US weight, it’s about 60% of the global weight. So, then the US can start to weigh down the global trend.
But actually, since the secular bull started in 2009, one of the characteristics is, usually, tech has… Over the course of that time, the US has outperformed, and tech has outperformed. They’ve gone through corrections, which usually have been associated with these cyclical bear markets I was talking about, but ultimately they come out of it, and they tend to outperform. So, that shows you…
Merryn: But does that change, perhaps, as interest rates start to rise? Which is again a big topic of conversation, the extent to which tech stock valuations are reliant on very low interest rates.
So, as we move into a more inflationary environment, presuming we do, and central banks finally feel that they must raise rates slightly, then the whole dynamic around the present value of future cash flows on these very highly valued tech stocks changes.
Tim: Absolutely. That’s the other element of it, is from the relative valuation point has been… Actually, bonds have been in a secular bull market for more than four years. What that means is bond yields have continued to trend lower.
And I do think the biggest secular risk, what would really upend the secular bull market started in 2009, it would be a combination of the market, at the current levels of valuations, having to deal with rising inflation and interest rates, and then relative valuation gap, which has remained… For 20 years, we’ve had earnings yields above bond yields.
And that doesn’t mean you can’t have a bear market. For example, that was the case in 07. Earning yields were above bond yields. The difference then was the global financial crisis was such a negative offset that it didn’t matter that stocks were relatively cheap. They kept getting cheaper.
So, if you get into a situation where we see something we haven’t seen for more than 20 years, which is bond yields above earnings yields, the question is, will the market tolerate that? And will then we get a whole new dynamic?
And the biggest risk… There’s been a lot of talk here recently about stagflation. Getting back to the point that you made. If it’s transitory, we’re not going to have stagflation. But if we did get a much worse inflationary outlook, and you start to see bond yields break out and inflation rise, it starts to look like the 1970s, that’s a secular bear market environment, where equities continue to perform poorly. But that’s not our expectation right now.
Merryn: OK. Now, the other big regional area that you’re bullish on is Europe. You’re saying in your work you’re overweight on the US and Europe. When you say Europe, what do you mean? And why are you bullish there?
Tim: Actually, again, we have a seven-way framework, based on MSCI indices. The top ten markets are within those seven. Europe ex-UK is the index we use, and its most weight is Germany, France, and Switzerland. And then we use a model based on the seven regions. The others, I can go through as well, if you’d like.
But for Europe, what happened in Europe, really had some headwinds with Covid and trying to get things… But they’ve really done well with the vaccinations, and I think confidence came back economically in Europe. And actually, more recently, it went through a really good, strong period of outperformance and have become down here recently more of a market performer. But I think a lot of it just had to do with there seemed to be a real turn in economic expectations and earnings expectations that really supported Europe.
One drawback about Europe, it doesn’t have as much of… It’s a relatively consumer-heavy region, which is good, because consumer stocks tend to do well over the course of the secular bull market. Relatively little technology. So, that’s sort of a drawback to the other… What we also want to keep in mind are these markets that have a lot of resource orientation. The UK has a lot of that. That’s helped them recently but hasn’t generally helped over the course of the secular bull.
Merryn: Yes. You separate out the UK market from Europe, don’t you [unclear]? The Brexiteers among us appreciate it. Thank you. And you suggest that you’re not so keen on the UK, underweight the UK market.
Now, this is interesting because we have had on this podcast, over the last year or so, an awful lot of people who’ve said, you know what? The UK is ridiculously cheap relative to the rest of the world. Cheap not just in relative terms, but a lot of it is cheap in absolute terms. There are some genuine deep value in this market, yet it’s still being ignored by international investors.
And we feel to ourselves, maybe we’re being ignored because of Brexit, because that pissed everybody off. Or are we being ignored because we haven’t got a huge tech sector among our biggest companies? What is it that makes international investors ignore the value that appears to be standing out to so many UK investors?
Tim: Again, I think the key point, as we approach this, is to look at the components of these indices. The MSCI UK Index is really less of a reflection of the UK economy as it is more the resource stocks. It’s more of a multinational commodity-oriented index. And so, therefore…
Merryn: That seems like a good thing.
Tim: Well, it has recently been, yes. Actually, the UK has started to come back here. But I mentioned technology earlier, in the US, and consumer sectors. When the characteristics of a secular bear has been, that’s when resource stocks did really well, from 2003 to 2010.
During the secular bull, they’ve had good runs. And I would put in the same category emerging markets, which had a really good run. And we went overweight last year on emerging markets, and then that pretty much ended. It went for six to nine months, and then that turned around. Emerging markets have started to come back here with some of the resource areas.
But within a secular bull market, these runs… And I’m thinking about that more broadly with commodities, is that we’ve had this rally in commodities, but to the extent that it’s really been supported by the supply chain problems. Once those start to ease, what’s going to happen to commodities? If we don’t really have a true inflationary environment, that might turn out in retrospect to be short lived.
Usually, when you go back and look at secular trends, and I do this with equities, and bonds, and commodities, for most of the time, we find that commodities and equities are going opposite directions. And you can have these cyclical runs like we’ve had with commodities and the resources, but they just don’t tend to last. And then what happens is that you get rotation back into these areas that tend to have longer term growth possibilities, like technology and some of the consumer areas.
So, I go through that to say that, I guess, with the UK, either the composition of the index would have to change, or you’re going to have to get into a different environment for commodities and resources in general, I think, to be a longer term source of support for that index.
And then what often happens with value areas is that they’re value for a reason, and then they stay value. So, you need something to really inspire people to take advantage of that valuation. That requires a view, really, that this is going to be a significant, sustainable change, and therefore they look cheap, it’s time to get in.
Merryn: Rising energy prices and rising commodities prices might do that. I’ve seen you writing a bit about gold. Tell us about that. Are you pro or anti?
Tim: Well, pro gold. I was bullish on gold starting in 2019. And then we went to neutral during the consolidation. Went back to bullish. And one of the things we did when it went back to bullish is I emphasise the major fundamental driver of gold, which tends to be supportive, is negative real interest rates. And inflation came through. Gold has really not done as well as you might expect.
Merryn: Yes, it’s been disappointing, hasn’t it?
Tim: Yes. And I wonder if it’s because maybe there’s a view that if the inflation is transitory, and people aren’t buying into the inflation case, and maybe the real interest rates aren’t as strong a motivator for people to get into gold. And the other element with gold, it tends to… I’m always looking for relationships, correlations, how they might change. One of the more consistent correlations is the inverse correlation between the dollar and gold, and the dollar has been holding up pretty well recently.
But I would say, in a negative real rate environment, where you’re not going to have a real… Have a positive rate differential… In other words, unless we start to see US interest rates really run away on the upside relative to non-US rates, and also on a real basis, so after inflation, I don’t really see a strong case for the dollar. And if there’s not a strong case for the dollar, there’s not a real bearish case for gold. And gold has actually been maintaining a series of higher lows over time. So, I’m still staying with gold, but certainly it’s been disappointing. It’s has been more of a trading range, in a trading range here over the last several months.
Merryn: So, how would you put gold into a portfolio, the one that you’ve got, say 75% equities, 25% bonds, 5% cash. Where does gold fit into a portfolio like that?
Tim: If real interest rates are negative, you definitely don’t want to be having a lot of cash, so I’d probably take it out of the cash part of it.
Then what happens is if you have a steepening yield curve, and then bond yields start rising, then you don’t want to be in bonds, because you’re going to lose money in your bonds. And you don’t have short-term rate rise. You don’t want to be in cash.
The other thing about the yield curve is that, what’s been happening here recently is as long-term yields have moved higher, it’s really been more about growth expectations rather than the kind of worries about inflation that would send short-term rates higher, and that will then send the yield curve downward. But on the question of gold, I would probably take it out of the cash component at this point.
Merryn: OK. And would you have any cryptocurrencies in there, Tim?
Tim: No, I’m not a fan of cryptocurrencies. I think there’s just too much volatility. If you go back to the beginning of Bitcoin, the average daily change of Bitcoin runs consistently two to three times higher or more than any other asset class. If you’re going to get into it, you either have to…
In fact, when we try to develop indicators, we look at relationships between markets and data, economic data and markets. You try to do that with Bitcoin, it doesn’t correlate. It doesn’t have much history. So, you can’t really develop indicators, other than short-term technical indicators.
So, that kind of speaks to the approach you have to take. If you’re going to get into Bitcoin, I think you have to really think of it as a short-term trading vehicle, but I wouldn’t… If you think about what happened in a year like 2018, when Bitcoin was down more than 80%, that’s not really something you want to have on your portfolio.
Merryn: Maybe not this kind of portfolio. Tim, I think we have to leave it there. Thank you so much for joining us today. I really appreciate it. It’s actually wonderful to hear a different voice on the podcast. Thank you.
Tim: Thank you. Happy to do it.
Merryn: OK, good. And is there a way that our readers can hear more from you? Are you on Twitter? Or does the company have a Twitter account or other social media they can look at?
Tim: Yes, I mean…
Merryn: It’s fine. No is absolutely fine.
Tim: I’m not sure exactly what… Maybe Camren [?] might know more about that. I don’t do anything on Twitter. But there might be other ways we can share information.
Merryn: We’ll have a look at it, and I’ll inform readers if there is anything. Thank you very much for joining us.
Of course, readers, as you know, you can hear more from us at moneyweek.com. You can sign up there for our newsletter Money Morning. And you can follow us on Twitter @moneyweek. Me on Twitter @merrynsw. John on Twitter @john_stepek. And if you’ve enjoyed the podcast, please do review it on your podcast provider of choice. If you haven’t enjoyed it, please do not. Thank you very much.
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