At WJ, our investment philosophy is to prepare in advance for inevitable stock market downturns, much like building a levee before the rain starts to fall. By diversifying across multiple asset classes, employing uncorrelated strategies, utilizing tactical strategies that can adapt to market conditions, and maintaining a clear understanding of potential risks, our portfolios are built to help clients weather the storm. Ultimately, successful investing is about survival, and this objective, above all else, drives our investment process.
Importantly, our success doesn't depend on making precise predictions. And this is by design, because no one can predict the future with enough accuracy to make all-in or all-out portfolio shifts at the right time. Together with our managers, we make adjustments in small increments, recognizing that we are fallible. We do not tear down our levee or build it sky-high solely based on an outlook.
As you read the WJNotes, keep in mind that we are intentionally emphasizing potential risks facing the US economy and stock market. There are, of course, arguments and evidence that support a more positive view. After all, if everyone shared our concerns, the market wouldn't still be rising.
Our approach to portfolio protection is dynamic, with safeguards sometimes being added or scaled back as needed. In this edition of the WJNotes, we make some observations about the economy and markets, and highlight the trades we recently placed in portfolios to increase resiliency.
US Stocks are Richly Valued
Many years of strong returns and rich valuations suggest lower future returns in US large stocks. The US market now represents over 70% of global market capitalization, the highest ever for any single country. Note that the US makes up only 4% of the world's population and 26% of its GDP. With most investors already fully invested in US stocks, further growth may be limited.
We are contrarians and view booming markets and the shrugging off of bad news as a warning sign. A signal to take profits and add protection by investing in areas not as richly valued, such as international stocks.
The table below compares several valuation metrics with those at the peak of the Internet bubble.
Valuations by all the metrics shown are comparable to those at the peak of the Internet bubble.
We acknowledge that these measures are useless in predicting short-term market movements. However, over the long term, valuations are an excellent predictor of longer-term returns. Today's levels strongly suggest low future returns for large US stocks.
Corporate Credit Spreads Are at Historic Lows
Credit spreads are historically tight and provide minimal protection if the economy weakens and companies struggle to repay their debt. Credit spreads represent the additional yield that investors receive for taking on credit risk compared to risk-free options, such as US Government bonds. Today, as the chart illustrates, the extra yield is minimal, offering little protection in the event of an issuer default.
Why does this matter? Because if you are not compensated for taking risk, those risks should be avoided. As a result, we are reducing credit exposure in our portfolios.
Policy is Erratic and More Opaque Than Usual
We don't think it is necessary to go into much detail on this topic. Businesses and consumers spend and invest more when they feel confident about the future, as confidence is closely linked to a sense of certainty. It is not surprising that we are beginning to see weakening economic indicators, as both groups are sitting on their hands and waiting for greater clarity before making financial investments and decisions.
Taxes (Tariffs) Are Rising as the Economy Slows
Tariffs are taxes paid by businesses and consumers. So far this year, total tariffs collected have reached $195 billion. This is $195 billion transferred from businesses and consumers to the Government. If businesses absorb tariffs, profit margins and earnings are squeezed, which is negative for stock prices. If consumers pay tariffs, higher prices curb spending, which weighs on the economy and ultimately affects stock prices. Either way, raising taxes during an economic slowdown is a clear reason for caution.
The Inflation Rate is Rising Along with the Unemployment Rate
High and rising inflation, combined with a flagging economy, is the nightmare scenario for any central banker and investor. Under these conditions, the 1970s were terrible for both stock and bond investors.
Although inflation is only slightly higher than at the start of the year, the following chart highlights our concern about future trends. The light blue line, representing service CPI inflation, has been steadily declining for a while. In contrast, the gold line, which tracks core goods inflation, has moved from deflation to inflation relatively quickly. The likely culprit, of course, is tariffs. They have little impact on services but a significant impact on goods. If this trend continues, overall inflation could rise beyond the minimal amount it has so far this year.
The economy is slowing, as fewer jobs are added each month.
Why is this a nightmare scenario? Bonds typically perform poorly when inflation is high and rising, while stocks tend to underperform during periods of economic weakness. And the Federal Reserve's main tools, such as adjusting interest rates, can stimulate growth but may also fuel higher inflation, leaving policymakers with limited options to address both challenges effectively.
We See Signs of Speculative Excess
Speculative activities are much more prevalent when markets are peaking rather than bottoming. This chart shows performance since the day of liberation. The "junk" has done the best.
Margin loans (money borrowed to buy stocks) are at an all-time high.
Shitcoins (an actual term, not opinion) and associated bets are rolling again.
And the youngsters are giving up real work to day trade.
The new American hustle is dividends over day jobs." Jaded Gen Zers hellbent on quitting and retiring early… [are] piling into ETFs offering eye-popping yields generated by complex derivatives." — Denitsa Tsekova and Vildana Hajric, Bloomberg Markets
These are all signs of speculative excess that are not present except during times of euphoria. They point us to a more cautious stance.
Artificial Intelligence
AI will change the world, and we want to state that unequivocally. This discussion, however, is not about all the ways AI may benefit us. Instead, it focuses on the consequences of introducing revolutionary technologies and their short-term impact on the economy and investment markets. And rather than letting ChatGPT drone on about our views (kidding), we've chosen a passage from a real human being, Jeremy Grantham. Mr. Grantham, who owns and runs the firm GMO, has an exceptional long-term investment track record and also helps manage one of the funds in our portfolio discussed below. The passage is lengthy, but we felt it was important to include in full.
The bigger the new idea, the bigger the new invention, the more the market becomes overpriced, the more it attracts euphoria. It's not accidental. Really great things happen in the internet phase, '98-'99. But they overdo it. They overdid it with the canals apparently in England. They overdid it magnificently all over Europe, particularly the UK, but also the US with railroads. They were spectacular bubbles. The canals were huge; the railroads were even much more profound—changed everything. They were serious, but that didn't stop them from attracting too much capital, charlatans, putting eight different railroad lines between Manchester and Liverpool, or planning them and raising capital for them when one or two was clearly enough. And the result was a bubble that broke for canals and railroads, and then somewhat the same with automobiles and radio and so on in 1929. Electrification of everything and development of mass markets for a lot of them.
And then the internet. The internet was serious. We all use the internet. We can't live without our iPhones, and yet it was overdone. Everyone knows that Amazon went up multiple times in '99. I forget how many times, but several times. It was the star of '99, which was a great year to be a star. And then in the break, they went down 92%. Very few people realize that. Amazon, a huge success, went down 92%. And then it rose from the wreckage, as did a handful of them, and inherited the earth. But how many, what fraction of those stars of '99 survived? I think 80% of the internet stocks just ceased to exist. Some were bought for scrap iron price. Basically, they ceased. And a handful of super leaders emerged.
So, the fact that it's a real idea doesn't say that there won't be a crash. It's quite the reverse. The more important the idea, the more guaranteed almost it is, historically, that it will attract too much short-term attention, then there will be a crash, and then the railroads will change the world, the internet will change the world, AI will change the world. But it would be classic for it to be overdone. That's what the history book is shouting at us. . . .
So, where we go from here, I think, is back to the history books. When you have these great developments, they overdo themselves in the short term, they crash in the intermediate term, and then they come out of the wreckage and change the world in the long term. And that's what I expect will happen this time.
Mr. Grantham's point is that history shows revolutionary technologies tend to lead to massive short-term investment speculation, which leads to bubbles and crashes. Yet, even though many investors get wiped out, the technologies change the world.
Are we seeing massive investment in AI compared to other technologies? This chart shows the % of GDP invested in AI so far. It is comparable to railroads and the telecom/fiber bubble. This chart does not include the likely trillions that will be invested in AI in the future.
We are now spending more on data centers than offices.
These trends are unlikely to reverse anytime soon.
And we've already seen enormous gains in the stocks of AI-related companies. Larger gains than we saw in other bubbles. You will note that all the gains were ultimately given back in the previous bubbles.
So, are we in an AI bubble? Mr. Grantham and history would suggest the answer is likely yes, but no one can say for certain. What we do take from this discussion is that the probability of a bubble is rising/the likelihood of a storm is building. Our response is to raise the levee and strengthen resiliency, as outlined below.
Portfolio Trades
Increasing Diversification Among Alternatives
We value the diversification that alternative strategies (alts) can provide. The issue is that they tend to trail when stocks are performing best, making them painful to hold in bull markets. Said another way, alts historically have reduced risks in portfolios, but at the expense of return.
One issue with alternatives is that there are only a limited number of options that are truly unique to each other. Although there may appear to be 100s of different "products" branded as alternatives, many have the same underlying risk factors. Fortunately, as innovation in the fund space increases, we have the opportunity to add new tools to the toolbox to improve portfolios.
Funds like the ones we're adding allow us to add alts to the portfolio while maintaining our weight in stock. This is done by using derivatives (usually futures) that are inherently levered. The end result is that for every $1 of these funds, you get $1 of alts and $1 of stock. We've written about these types of funds in the past. See "Introducing Enhanced Growth" and "Is Leverage Risky?” as examples. Below is a summary of two of our new funds.
QHFIX – AQR Multi-Strategy HV: AQR is one of the most highly respected asset management firms in the world and has contributed much of the industries most cited research on portfolio management. We’ve used their products for over a decade, and this year they’ve added a new suite of options, called fusion funds. Fusion funds are similar to the return stacked funds currently in portfolios, in that they add some type of diversifier on top of a passive stock index (in this case the S&P 500). In this case, they are adding several alternative strategies, such as equity market neutral, global macro, and macro trend. Without getting too into the weeds on each, these strategies have long established track records with solid returns, but most importantly they’ve done so with low correlations to stock and bonds. By adding this strategy to the portfolio, we are able to layer on additional uncorrelated returns without necessarily increasing overall risk in bear markets.
RSSY – Return Stacked US + Carry: RSSY is similar to the above, but they stack a “carry” strategy onto the S&P 500. As the name suggests, a carry strategy tries to earn a return from different assets that pay you just for “carrying” them. Think of a dividend from a stock, or an interest payment on a bond. What’s unique is it does this across stocks, bonds, commodities and currencies, and funds each purchase by selling short a similar asset with a lower yield. So think of borrowing money at 4% to buy a bond of similar risk that pays 5%. A carry strategy would earn that 1% spread. The complicated part is then finding dozens of similar trades across the globe and blending them in a way that gives you a steady return stream. Carry strategies have been around for decades but were only recently made available in this stacked structure that we prefer.
Adding to Tactical, Flexible Managers
Due to the environment described in the earlier portions of this WJNotes, we believe it’s time to “raise the levee.” No one has done that better historically than the team at GMO, and Mr. Grantham mentioned above. GMO’s rigorous, contrarian approach buys assets at deep discounts to their fundamental value, while avoiding, and in some cases outright shorting, assets it believes are in a bubble. GMOs unwavering approach means they tend to trail when markets are manic, but flourish when the party ends.
Their funds have been in portfolios for a long time, but we are increasing our exposure as we believe they are positioned to excel in the next storm.
Higher Quality in the Bond Portfolio
As discussed earlier, credit spreads are tight, meaning your compensation for taking risk in junk bonds is minimal, thus, we are temporarily eliminating our exposure. This has nothing to do with the fund itself, but the high-yield credit space generally. With the proceeds we’ll be purchasing long-term treasury bonds through a popular ETF called TLT.
TLT – iShares 20+ Year Treasury: TLT simply buys long-dated US treasuries, typically with 20-30 years till maturity. These bonds yield about 4.5% today, and tend to provide protection when the economy slows.
Where We End Up
The net result of all trades for the Growth and Stable Growth portfolios is full exposure to stocks, an overweight position in higher-quality and longer-duration bonds, an increased position in uncorrelated alternatives, and enhanced value and tactical capabilities with GMO.
As our most aggressive portfolio, Enhanced Growth has 100% exposure to stocks. To further improve returns, we layer on diversifiers such as bonds and alternatives. With these trades, we further diversify our diversifiers (say that 5 times fast), which should allow us to outperform on a more consistent basis.
Closing
We are grateful for the trust you place in us. Our investment approach is built with resiliency at its core, as we have limited insight into short-term market movements. We focus on building and reinforcing the levee to provide protection, whatever the future may bring.
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PAST PERFORMANCE IS NOT A GUARANTEE OF CURRENT OR FUTURE RESULTS. Examples of historical information included in this presentation do not, nor are they intended to, constitute a promise of similar future results. Specific client portfolio allocations, risks and returns can and may deviate from these examples depending on accounts and types of investments available through each account. Future market views by WJ Interests, LLC may vary significantly from the historical examples presented herein and no one receiving this summary should assume that WJ Interests, LLC will be able to replicate successful views in the future.
